Fund Manager Quarterly Commentaries - March 2017
Read the latest fund manager commentaries for the quarter ending 31 March 2017.
Global economic activity appears to be recovering, with recent upbeat data from the mainland easing fears of a Chinese hard landing, while Japan’s manufacturing output rose at its fastest pace in three years after flat growth in the previous three months. Economic expansion in the UK seemed to shrug off Brexit worries, whereas eurozone inflation hit a four-year high, signalling to the European Central Bank to reassess its monetary policy stance. Meanwhile, the lack of clarity at Trump’s inaugural Congress address and the Fed’s hint of a possible interest rate hike in the near term has not caused markets to falter significantly.
Nonetheless, we remain cautious in view of the potential bumps in the road ahead. These include the beginnings of Brexit negotiations and a possible reprisal from a possible Scottish referendum, as well as political and economic jitters in Asia and Europe.
We continue to remain true to our investment process and will capitalise on market volatility to add to our preferred holdings on weakness, or initiate new names with compelling valuations and intact long-term growth drivers.
The portfolio performed well, outperforming the Russell 1000 Value and S&P 500 indices, both of which comprise large-caps. The outperformance was split equally between our sector allocations and the individual selection within those sectors. Our overweight in healthcare, which had been suffering a headwind, began to bear fruit, as did our underweight in energy stocks.
In healthcare, Medtronic has recovered much of the losses experienced in 2016. The company has suffered from a product disconnect as its newest insulin delivery device was approved for sale well in advance of its capability to manufacture it. Medtronic has ramped up production and should be to market with the MiniMed pumps early next quarter.
In consumer staples, food retailer Kroger has been weak. Low inflation combined with higher raw material costs have proven to be a significant challenge for all food retailers. We believe this difficult environment masks the fundamental improvements taking place at Kroger.
Looking forward, while the US markets are not as statistically ‘cheap’ as they might have been a year ago, the vast sums of money flowing into passive index funds have skewed the data. Our process is designed to seek out what we believe to be quality businesses that continue to show good value and should prosper over longer periods of time.
UK & International Income
After a slow start to the year, equity markets picked up as the quarter progressed. It is difficult to generalise as to why, especially as the Trump boost appears to be fading. Perhaps the improvement in economic growth is the primary cause, although it has been a long while coming, with plenty of false dawns along the way. In the UK, the short-lived ‘bid’ for Unilever helped the more defensive part of the market to rally. There was something for everyone, as banks continued to recover, and mining shares extended their gains thanks to commodity prices refusing to fall as analysts had expected.
Meanwhile, the Brexit-sensitive parts of UK markets continued to tread water, although there were exceptions such as housebuilders.
We added a little to our financials through increasing our Lloyds and Barclays stakes and purchasing Nordea.
We decided to sell Microsoft as the positives are widely articulated and are reflected in the valuation. Latterly we reduced our holding in Sanofi, which has given us a good absolute return but more importantly no longer offers a discount to the sector, which was what attracted us in the first place.
Worthy of note is that equity markets have been a one-way street for a good while and volatility is low so a change in sentiment would not be surprising.
Global and Worldwide Opportunities
Global stocks saw solid gains in the quarter. Emerging markets stocks led, but developed world stocks were broadly positive. A weaker pound contributed to gains for sterling-based investors.
Among our top contributors were Samsung Electronics and Medtronic. Samsung is seeing strong earnings, benefiting from the rising price of memory chips. The company also announced a large additional buyback, reaffirming its commitment to return 50% of free cash flow to shareholders through buybacks and dividends. Recent news regarding alleged corruption among Samsung executives has had little impact on the share price – a testament to the strength of Samsung’s underlying business and strong balance sheet. Medical devices company Medtronic bounced back from a tough fourth quarter as quarterly results showed broad-based strength and solid execution.
The largest detractors were Tesco and Qualcomm. Tesco’s share price gave back gains made toward the end of January, when the company announced the acquisition of Booker, the UK’s biggest wholesale food distributor. Qualcomm, a global leader in mobile phone technology and equipment, reported good quarterly results, but its share price declined as Apple filed a lawsuit claiming Qualcomm has withheld payments totalling $1 billion since the end of June 2016.
We purchased Unilever and Helmerich & Payne and exited Workday and Amor Pacific in favour of more attractive opportunities.
The first quarter of 2017 saw a continuation of the trends seen in late 2016: respectable returns from equities, particularly from emerging markets and Asia Pacific (excluding Japan), and flagging bonds. The US Federal Reserve increased interest rates in March but this had been well flagged, so it generated no drama. The UK government triggered Article 50 as expected and seems intent on negotiating for a hard Brexit. Economic data has generally been supportive, as has the 2017 company earnings’ outlook. We are yet to see any significant stimulus from President Trump but the US economy is performing well in any case.
We made no significant change to asset allocation, maintaining a large position in cash and a commensurate underweighting in bonds. When compared with our peer group, we own no alternative assets and are overweight in listed equities as a result.
The corporate news background appears satisfactory for equity investors, though market valuations look only fair rather than compelling. There are a number of events ahead that might cause volatility: the Brexit negotiations, elections in France and Germany, the extent of the tightening interest rate cycle in the US and the 19th Party Congress in China in October. Nevertheless, with a reasonable global growth outlook, we are comfortable with our bias towards equities rather than bonds.
Global economic data pointed to a pick-up in the pace of activity. The UK saw little immediate impact from the triggering of Article 50. The US Federal Reserve raised interest rates again with expectations of further rises to come later in the year. Following the rise in the oil price that had been sparked by the OPEC agreement in December, there was consolidation around $50 a barrel as US shale output began to rise.
Equity markets were generally buoyant during the quarter and earnings forecasts were supported by the improving global outlook. Unilever was a particular feature due to the short-lived bid from Kraft Heinz. Many of the portfolio’s higher-yielding holdings were broadly unchanged in capital terms, thereby lagging the market. Good share price moves were seen for Conviviality, FDM Group and IQE on the back of good trading. In contrast, St Ives was very weak following another profit warning.
New holdings were purchased in BT Group (reducing the underweight position) and Xafinity. The holdings un Accrol Group, DX Group, Firestone Diamonds and Shoe Zone were sold. In addition, the holding in Conviviality was reduced.
UK Absolute Return
A gradual improvement in growth and inflation expectations helped financial markets climb higher over the quarter. The spectre of political uncertainty in Europe and the lack of further clarity on the new US administration’s economic plans failed to hold back momentum. The US Fed’s March rate rise was validated by strength in the US economy.
Following strong gains late last year, a difficult start to 2017 was overcome as the portfolio consolidated its net asset value in the first quarter. The long book (positive investments) drove performance with the short book (negative investments) posting losses. Notable gains came from BAT as the tobacco giant renewed takeover plans for Reynolds American. A long position in Serco was the key detractor as the strong improvement in the business through 2016 was accompanied by more muted forward guidance which disappointed shareholders.
The portfolio should benefit from a gently rising interest rate but, importantly, retains only modest market exposure, which will be beneficial should a correction in equities materialise. For now, the positive impetus behind the global economy has been enough to keep volatility at surprisingly low levels; though we are sceptical as to whether this can persist for long. Additionally, corporate behaviour continues to be shaped by the low cost of debt, with the low level of sterling providing further enticement for international investors.
The start of 2017 has been characterised by the global reflation theme, which has driven asset prices and investor sentiment. This has extended from the United States to Europe, Asia and emerging markets. The pro-growth environment has led to strong returns for risk assets, whilst heightened political concerns in Europe have buoyed traditional safe-haven assets.
Assets have generally enjoyed positive returns through the first few months of the year. An exception to this has been oil, which has suffered on the back of investor concerns that US shale production will compensate for cuts by OPEC, which had driven prices through the end of 2016.
However, this was offset by gold, as prices rose on the back of a weaker dollar following dovish comments by the Federal Reserve, even as they raised interest rates. The portfolio has seen strong returns from other real assets such as water, timber and clean energy. Looking forwards, political events seem set to remain at the fore, with the upcoming French and Italian elections and Britain’s forthcoming EU exit negotiations.
Through to the end of February, clean energy (S&P Global Clean Energy Index), water (S&P Global Water Index) and emerging market infrastructure (S&P Emerging Market Infrastructure Index) contributed the most to the positive returns through the period, whilst commodities (Dow Jones-UBS Commodity Index) marginally detracted.
Index Linked Gilts
Despite higher inflation, gilt yields fell over the period, on concern around the patchy nature of the UK’s economic growth and slowing retail figures. These suggested the economy’s post-Brexit resilience may be waning, lessening pressure on the Bank of England (BoE) to raise interest rates.
The New Year finally brought some clarity on Brexit, with Prime Minister Theresa May laying out a 12-point plan for secession, which confirmed the UK will leave the single market, and then triggering Article 50 on 29 March.
The UK ended 2016 on a strong note, with the economy growing 0.6% in the fourth quarter; this was the same rate as the previous quarter but one tenth more than expected, deflating fears of a post-Brexit slowdown. Nevertheless, there is concern about the uneven nature of the growth – the dominant services sector accounted for most of the expansion, while production and construction lagged. Both the International Monetary Fund and Bank of England revised up their forecasts for 2017 growth.
However, inflationary pressures continued to build. In January, consumer price growth accelerated at the fastest rate in 31 months, and in March consumer price inflation exceeded the central bank target.
Perhaps reflecting inflationary pressures, retail sales figures for January decreased for the second consecutive month. Retail sales slowed by 0.3%, significantly below the 0.9% rise forecast. The Bank of England left interest rates unchanged at its February and March meetings.
The portfolio has generally been positioned in line with the benchmark over the period.
After President Trump’s January inauguration, almost every country in the world felt the effects of his policies, as the US president immediately withdrew the US from a major trade treaty with Asia, and threatened the same for deals with the EU and North America.
In the US, there was a surge in equities, with some indices hitting record highs, as investors anticipated stronger growth for US companies. Planned tax reliefs for business and the middle class, positive fourth-quarter news on corporate earnings and strong domestic economic data buoyed sentiment.
Equities in the UK also touched new highs, while economic growth was positive and unemployment was held down at 4.8%. MPs voted to begin the exit process from the EU and Article 50 was triggered at the end of March.
Eurozone equities were marginally negative in January (although positive in sterling terms), but improving growth and unemployment figures offered tailwinds later in the quarter, especially in Germany and France. Mario Draghi suggested quantitative easing could potentially continue.
Markets in Asia recovered from initial fears over Trump-era trade, helped by signs of an economic upturn in the region. Japan saw sluggish GDP growth in the fourth quarter, while China saw service sector expansion and rising inflation. The oil price rose slightly over the month, as did the value of many metals – gold touched a three-month high.
UK & General Progressive
Continuing the trends from last year, UK, eurozone and US economic and employment data remained supportive, with rising inflation and growth expectations leading the US Federal Reserve to increase rates by 0.25%. In the Netherlands, the first of the European elections for 2017 passed without a major upset.
Notable corporate activity within the portfolio has included BAT’s agreed purchase of Reynolds American, a company in which it already owns a 42% stake. This gives the group greater exposure to the US tobacco market, which is viewed as offering potential for future price increases. Reckitt Benckiser purchased US formula milk group Mead Johnson for $16.6 billion – Mead will benefit from Reckitt Benckiser’s innovation and management acumen. Although Kraft failed in its bid for Unilever, which is not in the fund, the move has concentrated the minds of a number of the management teams we have since met, potentially impacting boardroom decisions later this year.
Recent corporate results for fund holdings have been mixed; Next provided a cautious outlook for the year, but we expect the group to mitigate cost inflation and improve its mobile offering. Melrose, Shire and RELX all reported excellent results – RELX enacted a dividend increase and a £700 million share buyback. These businesses have excellent earnings growth opportunities in coming years, while wider market earnings growth outside of currency gains is likely to remain scarce.
Ongoing accommodative monetary policy from central banks globally and surprisingly robust macroeconomic data from the US, China and the eurozone provided a solid backdrop for risk assets, including emerging market corporates. Oil and commodity prices were also somewhat stable for the most part (albeit volatility increased in March). Meanwhile, in a well-telegraphed move, the US Federal Reserve increased interest rates in March, although comments from the Federal Open Market Committee indicated the future rate hiking path may be softer than expected.
However, against this backdrop, emerging market high-yield corporates continued to perform well, boosted by the ongoing commodity and oil-price backdrop and positive idiosyncratic stories; in addition to the, by now familiar, hunt for yield from investors. The portfolio also performed well, largely due to its overweight bias towards Brazilian credits, notably in the distressed space; Brazilian corporates also continued to benefit from the ongoing positive sentiment surrounding Temer’s government policy reforms. The portfolio’s selection of metals & mining and oil & gas companies also contributed to relative returns, which did well against the aforementioned overall positive commodity/oil-price backdrop.
Looking ahead, we remain positive on the asset class from a fundamental perspective, given the continuing deleveraging trends we are seeing at the individual corporate level coupled with a more benign view on defaults than the market is currently pricing. Consequently, we are running overweight beta in the portfolio, with a preference for commodity-sensitive sectors, and a regional tilt towards Latin America on relative value grounds.
High yield continued its positive run into the first two months of 2017, albeit showing signs of capitulation later in the quarter. While spreads have rallied over the last 12 months, the yield on the asset class remains compelling relative to other areas of global fixed income. During the quarter, the Fed announced an increase to its base rate from 0.75% to 1%. Given expectations for additional hikes in 2017, it is Brigade’s view that B-rated credits should outperform.
A position in iHeartCommunications, Inc. was a top contributor during the quarter. The company announced strong earnings for the fourth quarter and launched an exchange offer for several of its notes.
With the US economy on firm footing and business and consumer confidence improving, Brigade remains largely positive on credit markets. Given the sharp move upwards in valuations over the past year, Brigade is cognizant of the cyclicality of the asset class and is monitoring closely for potential triggers of market volatility and price falls, such as Fed policy, China’s economic output, and broader geopolitical risks. Overall, Brigade is excited about the current market dynamic and believes that this environment has the potential to benefit managers with the ability to differentiate between credits.
Greater European Progressive
The portfolio outperformed the broader European equity market during the first quarter. The stock returns of our branded consumer goods companies followed this same pattern. The Kraft Heinz offer for Unilever provided the market with a reminder of the value of top-quality branded consumer goods companies.
We purchased Unilever shares in February 2011. It has generated returns of more than 13% per year (plus dividends) in euro terms, which is quite satisfactory. Nevertheless, management has only achieved underlying operating profit growth of 3.3% per year since 2010.
We suspect that margin improvement potential was the biggest reason that Kraft Heinz, with the backing of 3G and Warren Buffett, saw value in Unilever, and thus made its unexpected €134 billion offer. We agree with Unilever that it has a very different culture and approach, and that the initial offer was insufficient. However, Kraft Heinz might have significantly increased its offer if Unilever had not slammed the door so quickly.
We have been supportive long-term shareholders of Unilever, although we think they could have worked – and should now seek to work – more urgently at organically improving efficiencies, margins and profit growth. Additionally, we encourage them to not resort to putting up takeover defences and to continue to make decisions based upon long-term shareholder interests.
Burgundy’s concentrated global portfolio started 2017 with strong returns, although slightly behind the global equity markets. Our conservative approach, grounded in long-term business fundamentals, can lag in periods like this; namely, periods when animal spirits are alive in markets that are already expensive. One manifestation of these animal spirits is large acquisition proposals; for example, Kraft Heinz’s bid for Unilever.
Kraft Heinz’s offer to Unilever is a reminder of the value of top-quality branded consumer goods companies, and that, in some cases, part of the value is their potential to be run more efficiently. We expect our portfolio companies to work hard at continuously improving each year in terms of effectiveness and efficiency. This is quite relevant to you as we own Nestlé, Heineken, Henkel, Pepsico, and Unicharm in your portfolio.
To return to the topic of acquisitions, we are generally skeptical of our portfolio companies making them, especially when equity valuations are quite high.
International Corporate Bond
The global senior secured market had a strong start to 2017 as spreads tightened at the end of February driven by strong investor demand. The strong returns came in spite of rising US interest rates. The US senior secured market did relatively well in the beginning of the year compared to the European senior secured market as the commodity rally continued.
However, in March, we saw a reversal of this as we saw weakness in the US high-yield space due to a significant decrease in oil prices, large outflows from US high-yield exchange-traded funds and some headwinds from US rate increases. This has led to a drawdown in the market, while the portfolio has been modestly affected given the European bias and robustness of credit names.
In general, the portfolio has seen good and robust returns across credits and we continue to see healthy credit fundamentals with modest leverage and large and stable equity cushions. We participated in a number of attractive primary market bond issues during the quarter, ranging from global companies in the packaging industry to senior secured bonds from UK and Swiss technology, media and telecom companies. We remain underweighted in energy as we remain cautious on cyclical commodity-related names.
Equity markets are trading close to all-time highs, boosted by optimism that President Trump’s fiscal policies will help deliver global growth coupled with reduced fears of an ongoing swing to populism in Europe. We know that Trump’s fiscal measures are likely to include spending on infrastructure and defence, which could help boost corporate profits, while tax cuts will reduce US corporate tax and make the US more competitive globally.
However, we are mindful that the US employment rate is very high and thus any boost to its economy will likely lead to rising inflation, which may provoke an interest rate response from the Federal Reserve. We therefore believe Trump’s policies are likely to be neutral for growth but, at worst, could be negative. For these reasons, we have downgraded our weighting in US equities from neutral to underweight.
In Europe, equity markets reacted positively. But France goes to the polls later this month and it remains to be seen whether the electorate will back Marine Le Pen and her anti-EU platform. A ‘Frexit’ would place great strain on the European financial system, especially its beleaguered banking sector and likely lead to increased market volatility.
In the UK, the Budget contained little of note beyond a political headache for the chancellor, who had to perform a U-turn on his announcement that self-employed workers would have to make increased National Insurance contributions.
Emerging markets continued to outperform developed markets in anticipation of stronger global growth; and a high number of companies stated their earnings will be better than expected, with India, Turkey and Poland leading the pack. However, fears remain that US protectionism and a stronger dollar could yet hit corporate earnings across the region.
We would characterise the current market as a normal operating environment, meaning that while opportunities can be found, they aren’t prevalent. We’re starting to find value in areas which we’ve avoided for some time, such as businesses in or with exposure to emerging markets, as well as interest-sensitive names.
As bottom-up stock-pickers, our investments are grounded in fundamental analysis with a strong emphasis on diversification – traditionally, the investment industry assesses this by sector or geographic exposure. We see this as a naïve interpretation and think that what really matters is that our portfolio is diversified by business idea.
For example, we have two long-term investments that represent exposure to US financials and two new investments representing exposure to European real estate. The rest of the businesses in the portfolio each represent a unique idea which allows us to hold concentrated positions while remaining diversified. Further, while our exposure to industrial holdings may seem high at first glance, it masks a wide variety of end markets ranging from rail and truck transportation to commercial and residential construction. All investments in the portfolio are based on an identified future growth opportunity that is not generally understood, something we refer to as ‘proprietary insights’.
Asian equities have had a positive start to the year. In particular, Indian equities rallied, boosted by a better-than-expected earnings season despite the chaos of demonetisation. Taiwanese equities also outperformed, with Apple’s supply chain companies lifted by a renewed tech cycle.
However, Trump’s economic outlook remains a concern and our overall cautious positioning across the Asia Pacific portfolios have not changed. We fear that a more politicised world and a rise in protectionism is likely to be negative for Asia. This, coupled with rising levels of inflation and tightening measures in the US, has the potential to accelerate capital outflows from the region and weaken Asian currencies.
Despite our many qualms, we believe there are still some good investment opportunities in Asia. Although we keep a watchful eye on macro and political events, our portfolio decisions are not dictated by them. Instead, we focus on long-term investment themes that we think should play out in the next five to ten years or longer. As bottom-up investors, our focus remains on finding high-quality management teams and businesses that have, over time, delivered predictable and sustainable returns comfortably in excess of the cost of capital, despite the prevailing headwinds.
Global Emerging Markets
Enthusiasm for the emerging markets equity opportunity has picked up this quarter, but we believe that it is important to stick to our belief not to compromise on quality, to maintain a long-term approach and to apply a strict valuation discipline. The fact that emerging markets have immature legal and political systems often means inadequate levels of minority shareholder protection and higher levels of economic volatility compared to developed markets.
The most significant investment activity this quarter within the portfolio has been adding to our exposure to the family-owned Aditya Birla Group, by starting positions in both Grasim Industries and Aditya Birla Nuvo. Grasim is a diversified Indian conglomerate, with cement operations through its majority ownership of India’s leading producer, Ultratech, as well as businesses in textiles and chemicals production. The Birla family is a respected one that has built some strong brands and has an impressive track record of corporate governance and creating value for shareholders.
Instinctively, we find ourselves becoming more cautious as shorter-term market commentators become bullish on lower-quality and more cyclical emerging market assets. Lower-quality assets include many state-controlled enterprises and companies listed in countries with little or no respect for property rights. The timing of these bullish views, which follow a period of strong absolute returns from the asset class, appear based more on momentum than fundamentals.
High-yield bond markets rallied during January and February before then consolidating some of their recent strong performance in March.
One of the catalysts for this change has been the oil price. During March, the price of West Texas Intermediate crude oil fell from US$54 per barrel at the start of the month to US$48 in mid-March. The US high-yield market, which has high exposure to energy companies, came under pressure as a result. European markets which have less exposure were less volatile, but still experienced some weakness. Political risk surrounding the French presidential elections was a further source of uncertainty.
The fundamental backdrop for high-yield bond markets is generally pretty good. Economic growth is slow but steady, and although interest rates are starting to rise, particularly in the US, they’re still very low by historical standards. Valuations have however become more challenging, with around 80% of the European high-yield bond market yielding less than 4%.
Positioning remains focused around three broad themes. First, we are maintaining a relatively high allocation to liquidity (cash and government bonds). This mitigates the impact of periods of market stress and means we are well placed to exploit opportunities when they do arise. Our favoured sector remains financials, where by selectively buying more junior bonds in banks’ capital structure we are able to achieve more attractive yields. Outside of the financial sector, the companies that we are looking at are those with predictable earnings profiles and recurring cash flows – sectors such as utilities, telecoms and cable companies.
The populist tone in the US and the UK continued to stoke optimism in local equity markets, with the FTSE 100 and the S&P 500 continuing to test new highs during the opening weeks of the year. Financials were in favour, especially in the US as the sector benefited from raised expectations of interest rate hikes by the US Federal Reserve. The UK saw inflation nudge closer to the Bank of England’s 2% target and this re-inflationary theme echoed around the globe as policy makers are facing the dilemma of how to juggle rising inflation with sometimes anaemic growth expectations.
During February, government bonds markets rallied in both the US and Europe as there was a re-evaluation of political risk – this included the potential difficulties President Trump may face in implementing his pro-growth policies and a number of election-related issues in Europe. We added two new ideas to the fund during January and February.
Overall, we believe economic growth will be positive, albeit subdued. However, it is becoming harder to talk of ‘global’ growth, policy and inflation; the world appears to be fragmenting as economies emerge with different growth and policy drivers since the financial crisis. The US may see a fiscal boost to economic growth, but other headwinds remain, and future growth momentum in Europe could be hindered by political uncertainty.
Global equities continued to navigate the uncertain landscape brought about by Trump’s protectionist policies. Despite the lack of clarity surrounding his next move, it appears investors are willing to give him the benefit of the doubt as equities continued to perform well. Strong economic data from the US economy has undoubtedly provided a supportive backdrop for Trump and played into his pro-growth vision. This in turn is facilitating a faster pace of interest rate increases by the US Federal Reserve, and it seems unlikely that, in the near term, these increases will prove large enough to derail the economic recovery. Interestingly, we have seen a modest recovery in the more defensive sectors so far this year.
Within the portfolio, at the sector level, our selection of consumer staples stocks and our zero-weighting to energy stocks were the main drivers of outperformance over the first quarter. Our overweight exposure to healthcare companies also contributed positively as stocks recovered from oversold positions. More negatively, unfavourable stock selection within the IT sector dragged on relative returns against the benchmark as measured by the MSCI All Country World Index.
Despite the seemingly positive noises coming from the global economy at present, we continue to believe that the economic recovery remains uncertain. Uncertainty from EU elections, Brexit, the outlook for China, and global inflation remain. However, in spite of the risks, we still believe there are opportunities to make money in global equities, following a quality income approach.
The idea of a recent rotation from ‘quality’ to ‘value’ is compelling but wrong. Certainly market leadership changed during 2016, led by resources and industrials stocks and more recently by financials. The higher-quality sectors have lagged, but they haven’t really fallen; there are no particular bargains.
Elsewhere high-yield corporate bond spreads and the volatility index, VIX – a popular measure of the implied volatility of S&P 500 index options – are back to levels seen in mid-2014 and early 2007. Equity valuations are stretched across the board, with low dispersion, and corporate debt levels are high. The market appears to be prepared to front-load all the good macro and micro news whilst ignoring the long list of potential banana skins.
We remain cautious and have been reducing our cyclical/industrial exposure as valuations have risen. What differentiates us from most equity investors is our awareness of downside. Intrinsic value is a function of future cash flows, and there is a range of plausible outcomes for these.
In order to maintain conviction in the face of rapidly rising share prices, we need a reason to believe that the worst-case scenario is improving, not simply that sentiment is currently focusing on the best-case outcome.
UK General and Progressive
There remains little value in this market and we continue to stick to our absolute valuation discipline rather than fold just as the market noise reaches its peak. After all, when uncertainty rises, asset prices should fall, and clearly the world has uncertainty in abundance. Nonetheless, markets remain Teflon-coated, for the time being at least.
We cannot do anything about the big items in the world’s in tray. But we will remain focused on identifying those market-leading companies that have strong balance sheets and the pricing power that allows them to produce compounding growth over the long haul, while being mindful of any dilution in the prospects of our existing portfolio names.
One of our major concerns as investors at the moment is the collapse in corporate pricing power we see all around us. Despite a persistent decline in corporate investment over the past four decades, capacity is rising even faster than production. The inevitable consequence of excess capacity is that firms’ pricing power is being crushed, a problem only compounded in retail by the relentless rise of online.
Technology is obviating the need for workers or capital and creating surplus capacity that is forcing many firms to become price-takers rather than price-makers. We remain watchful of those in the former camp.
Investment Grade Corporate Bond
Synchronised improvements in leading indicators in the US, eurozone, China, and other emerging markets added to an uptrend in corporate earnings and continued to support risk assets for much of the quarter. As anticipated, market expectations were met by the Federal Reserve’s Federal Open Market Committee, as its policy rate was raised to 1.00%. The Fed kept its policy concerning its balance sheet unchanged and provided very little guidance on the path of future rate hikes, although the expectation is for another two by year-end.
Corporate spreads generally performed well during the first half of the quarter. US spreads outperformed Treasuries as the Trump euphoria has waned to some extent, but the outlook for corporates continues to benefit from the administration’s plans to stimulate the economy. Allocation to communications, banking, and capital goods sectors contributed positively. Hard currency emerging market credits from Latin America, particularly Brazil and Chile, also added value. Issuers from technology and consumer sectors were another positive source of relative returns.
In the US, one of the unknown risk factors remains trade policy, as increased protectionism and/or a potentially disruptive ‘border tax’ could weigh on growth. Economic numbers are expected to remain supportive as the dollar has stabilised, and corporate earnings appear to be improving.
Catalysts for volatility remain as Europe continues to face a number of political challenges such as the French and German upcoming elections, still-unresolved Italian leadership and banking situations, and ongoing repercussions from Brexit
Major share markets have advanced this year, supported by optimism about US economic growth and corporate profits in the context of policies of the Trump administration, and more hawkish commentary from the US Federal Reserve. Positive sentiment has also been evident in Europe, aided by progression of the UK’s Brexit process, positive economic data and favourable signals from the corporate earnings season.
Investments in Apple, Visa and Lowe’s made the largest contributions to performance during the period. Apple was our best-performing stock this year. Its share price has been driven to a record high following its latest quarterly earnings update. iPhone popularity remains high and iPhone 7/7+ sales are continuing to grow, driving double-digit growth in the number of Apple product users.
Visa’s share price has advanced following the release of higher-than-expected first-quarter earnings which demonstrated strong payments and cross-border transaction volumes across its regions.
Target – the second-largest discount store group in the United States – has been the main detractor from performance this year. Target’s share price declined following the release of the company’s fourth-quarter earnings, in which comparative sales were negative over the Christmas period and the company’s management concurrently announced very material downgrades to earnings expectations. This was due to implementation of new strategic initiatives which will entail resetting profitability to contend with an increasingly competitive retail environment.
UK Growth and UK & General Progressive
Over the quarter, despite data highlighting evidence to the contrary, we witnessed a reversal of the inflation trade that had begun to emerge in the second half of last year; correspondingly investors returned to consumer staples after a small softening in valuations. We think investors don’t fully understand why the global economy picked up over the last year and as a result many now underestimate the risks of a slowdown within the next 12 months.
To understand why, you have to consider what has been driving the improvement over the last 12 months. There have been four main drivers, three of which are in the process of reversing: the sharp drop in oil prices in 2014/15, the subsequent collapse in bond yields to historic lows, and continued super-loose monetary policy. The fourth, which is probably peaking, is the major fiscal and monetary stimulus in China, which commenced in mid-2015.
Being conscious of our commitment to a flexible approach and desire to perform for our clients in all market conditions, we are positioning the portfolio to navigate these uncertain times: we have reduced our commodity exposure, retaining a preference for gold miners, increased our exposure to fixed and mobile telecommunications and some undervalued UK consumer stocks, and continued to favour UK food retailers and banks. There remain a number of attractive money-making opportunities in these areas.
Pleasingly, over the quarter a number of our smaller holdings contributed positively to performance.
Centamin, the gold miner focused on Egypt, reported strong operational improvement and a 7% dividend payment (an increase from the previous payment), following a 26% increase in annual production.
The hedge fund Man Group reported a difficult set of results for 2016, but noted encouraging performance across most strategies at the start of 2017. Ashmore, the emerging market debt-fund specialist, reported the doubling of pre-tax profits for the six months to the end of 2016 indicating strong cost control and a gradual bottoming in fund flows after a volatile post-US election period last year.
On the negative side, Pearson’s headline losses in the report of its full-year results weakened the share price; but from a long-term viewpoint, the company is continuing on a path of positive reform. We have met management and have retained our holding.
BP also softened fund performance after its quarterly results fell short of consensus expectations as the impact of a lower oil price was felt. However, we have confidence in its dividend-paying ability, and the firm recently raised its projections for cash flow over the next five years. We remain focused on finding companies that we believe are improving operationally, in whatever sectors we can find.
Global Equity Income
Most global equity markets advanced over the period as increased investor optimism, which began after the US presidential election, continued into the New Year. Economic data from the US and Europe showed improvement and progress, giving investors further confidence. Much of the market’s attention was placed on the potential for US economic policies under President Trump to stimulate growth; as well as on upcoming political developments abroad, with elections to be held in Europe; and the UK’s exit from the European Union.
An underweight allocation to the energy sector and stock selection in the financial sector contributed to the strategy’s performance, with individual contributors including Philip Morris International, Apple and Wolters Kluwer.
Stock selections in the consumer discretionary and telecommunication services sectors detracted from performance, with individual detractors including Total, Ralph Lauren and Verizon Communications.
We continue to believe that valuations remain elevated. Looking forward, global earnings growth expectations remain similar to the US, at around 13%, and markets are increasingly dependent upon this being delivered. To date, the year has started as it ended 2016, with investors largely embracing the reflationary policies being discussed. Defensive positions seem to have funded more cyclical ones. Within our portfolio we remain fairly evenly balanced between the extremes of these two positions, with both a large position in the US financials sector as well as a reasonable position in the global consumer staples sector, and focus on income.
The high-yield asset class started 2017 with a continuation of the rally we saw throughout 2016. Through the first two months of the year, the high-yield market was in positive territory and, as in 2016, riskier CCC assets (namely in energy and metals/mining) led the way. Spreads continued to tighten, and broad market yields declined to multi-year lows. In terms of capital flows, high-yield mutual funds received inflows in 11 of 15 weeks since the election in November, totaling $8.7 billion. Beginning in early March, however, the tone began to shift.
Several factors have led to a downdraft in high-yield markets: rising US Treasury yields ahead of a likely series of Fed rate hikes, the largest setback for oil prices in 12 months amidst a supply glut, and a record new-issue calendar. Recent outflows for high-yield ETFs have represented a 40% unwinding of inflows since the November US election. High-yield bond yields and spreads have begun to bounce higher from their multi-year lows. As this volatility continues, either as a function of higher rates, commodity swings, or geopolitical concerns, we stand ready to capitalise on the dislocation by adding to quality credits at lower levels.
International Corporate Bond
Reflecting investors’ optimism that President Trump’s pro-business agenda will stimulate the US economy, risk-bearing assets staged an impressive rally over the first two months of the year. While equities shined the most, high-yield bonds also earned healthy returns, meaningfully outperforming investment grade bonds through February. However, investor sentiment reversed course in March. In particular, this was due to high-yield bonds coming under selling pressure over the first two weeks of the month amid lower oil prices, a flurry of new issues, and the prospect of future Fed rate hikes.
Despite the price volatility, credit fundamentals in the high-yield bond market are sound. Corporate profits remain stable, balance sheets are solid and the high-yield bond market default rate is expected to fall below the long-term average in 2017.
We believe a coupon-like performance is the most investors should expect this year from high-yield bonds. With bond prices hovering around par, it’s unrealistic for the asset class to generate the outsized returns we saw in 2016. Even so, for investors looking to clip an attractive coupon, high-yield bonds remain compelling relative to other fixed-income alternatives.
Investment volumes in the UK commercial property market remain muted in comparison to recent years, which seems to be more due to a lack of sellers than lack of investor demand. However, it has been possible to source quality, well-let stock and we have acquired three new assets during the quarter, with a total investment value of £64.2m. The properties acquired were a prime industrial estate in Reading, a gym in Wandsworth let to Virgin Active for a further 19 years and the dominant retail park in Christchurch, Dorset. These properties all have a durable income stream emanating from strong tenant demand, which in turn is underpinned by location.
The occupational market remains active across the portfolio. We continue to sign new lettings and lease renewals across the UK and across retail, office and industrial sectors. By way of example during the quarter, we have signed new leases at the Vitrum Building in Cambridge (office), Priory Fields Retail Park in Taunton (retail) and Trinity Trading Estate, Sittingbourne (industrial).
The portfolio is generally invested in prime stock with low vacancy rates. It is also well-diversified, with over 100 property assets and more than 900 tenants. Notwithstanding Brexit and other uncertainties that lie ahead, it is well-placed to continue to deliver a sustainable income stream.
Given the potential for volatility of prices in other capital markets, the income-dominated style of return from commercial property continues to make it a valid long-term investment option as part of a diversified portfolio.
Global Smaller Companies
In the first quarter of 2017, we witnessed early indications of a synchronised global expansion.
US business and consumer confidence is strong, with unemployment claims hitting multi-decade lows. This is positive for domestically oriented consumer discretionary holdings such as NASCAR racetrack operator International Speedway Corporation.
EU output growth hit a six-year high, and 100% of Markit’s 22 detailed sectors registered growth in February after all but one grew in January. The fund is significantly overweight to Europe and is therefore well-positioned to benefit from a continued recovery in the region.
With the help of a weakened yen, Japanese exports turned positive, reversing a long slide. This yen weakness is beneficial to export-oriented holdings such as Kansai Paint.
China has seen business confidence improve and FX outflows stemmed by capital controls. While the fund typically avoids exposure to mainland Chinese equities due to governance concerns, this stability has broadly positive effects on emerging markets, where we maintain material exposure.
Counterbalancing these reasons for optimism are a host of lingering concerns. Negative-yielding sovereign debt paints a very different picture of the outlook for both Europe and Japan. Chinese debt is also problematic due to the past decade’s rapid credit expansion. Rising protectionism in the US, France, and elsewhere is another force that threatens to derail this nascent global upturn.
Diversified Bond and Multi Asset
This year began with business confidence rising strongly as improving global economic data and the prospect of less regulation and tax cuts in the US led to a worldwide equity rally. The increase in risk appetite initially led to a rise in global government bond yields, although February saw a reversal as European political uncertainty led to a ‘safe haven’ bid for bonds. Nevertheless, rising inflation expectations and steady economic growth in the US made investors shrug off European concerns and March saw a renewed rise in risk appetite and government bond yields. Stronger growth and the low level of defaults led to outperformance by all credit sectors, with high-yield and emerging markets providing the best returns
The absolute return strategy produced solid returns in this environment. Mortgage-backed and asset-backed securities were the top contributors to returns, closely followed by investment grade corporates. Exposure to emerging market debt also contributed positively as commodity prices strengthened. Our long US dollar position had little performance impact as the currency remained range-bound. With volatility now at very low levels and following the sustained tightening in credit spreads, we have recently pared back our high-yield allocation in favour of government bonds, awaiting more attractive valuations before increasing credit holdings.
The UK market has made a steady start to the year and so far has not been by the risks that are likely to accompany the Trump presidency or the UK’s exit from the EU. The market’s rise has been driven by the hope that the Trump administration can be successful in driving higher rates of growth in the US and that the Brexit negotiations won’t derail the UK economy.
On both counts, we cannot know whether the markets are right to be so relaxed except to say that the risks are real and share prices will likely prove to be vulnerable if the UK and US economies don’t behave as hoped. Following the sharp rise in the UK market over the last 12 months, the market price-to-revenue of the typical UK company is at the highest level that it has been for many years and around double the average level of the last 40 years. We therefore continue to be concerned that valuations are full and that accordingly the level of expectation baked into many of today’s share prices is unrealistically high.
There are a number of good opportunities available in today’s market; it is just that they are not as numerous as they have been in the past. Accordingly, we think it is sensible (although temporarily uncomfortable) to keep some cash on hand to take advantage of a more widespread improvement in stock valuations.
Continental European and Greater European Progressive
We continue to believe that Europe presents a compelling investment opportunity. Our view that the European economy is somewhat stronger than many believe was further supported by the publication of a raft of very encouraging data over the past quarter. Impressively, the eurozone manufacturing PMI has risen to its highest level for five and a half years. The Spanish PMI was notably strong. Spanish job creation, furthermore, has risen at the fastest rate since the collapse in the property market a decade ago. France, likewise, continues to shine with the French PMI reaching a five-year high. More importantly, perhaps, recent company meetings attest to a vigorously recovering economy.
Brexit is rarely mentioned in our numerous company meetings as a threat to the recovery. Remember, the UK accounts for just 6% of eurozone exports. Although, of course, we have to be alert to the risk that Brexit could threaten, by a sort of contagion, the whole ‘European project’. Despite the Italian rejection of constitutional reform, there seems to be scant parliamentary backing for referenda in other member states. Curiously, Italy was the strongest performing market in Europe following the vote. Current opinion polls, furthermore, suggest that is rather unlikely that populists will gain power in the upcoming French or German elections.
We seek to invest in leading growth businesses that are capable of sustaining above-average earnings growth. Often this steers us toward innovative companies that we believe are benefiting from structural change and secular trends – distinct from cyclical economic factors – that provide select industries and businesses with powerful growth tailwinds.
One such trend is ecommerce, and how it has revolutionised the way consumers buy and retailers sell. Though it is the fastest-growing segment of retail sales, ecommerce still accounts for less than 10% of the total worldwide retail market. Innovators such as Amazon and Alibaba have disrupted the status quo for shopping, making a wide variety of goods a mere click and two business days away. Brands now have the ability to directly target and interact with consumers through social media platforms such as Facebook.
Transparency has increased in niche markets such as travel bookings, as Priceline and other sites allow for easy comparison shopping. Small businesses can now gain greater exposure through selling platforms including Shopify; and tools such as Visa Checkout (Visa is a current holding in our portfolio) reduce the frictions associated with payment. We believe ecommerce has a long runway for growth, in regions where incomes are growing, as well as in those areas where internet usage remains relatively nascent. In our view, identifying businesses with such sustainable growth tailwinds is crucial to adding value for our clients.
Strategic Income and Multi Asset
Following a subdued start to the year, equity markets picked up mid-quarter. The income generated from the equity portfolio through high-dividend stocks and supplemented by the sale of some uncertain upside potential was ahead of our long-term performance objective and returns were also strong over the quarter.
Given the risk-on environment, we would typically expect income strategies to underperform. However, high-yielding stocks, which underperformed in previous months, began to correct in February and outperformed the broader market.
This may be due in part to a flight to quality given uncertainty surrounding the upcoming European elections, the new US administration and the triggering of Article 50 in the UK.
The level of risk in the equity portfolio was relatively low and fell over the period. As the portfolio value advanced, it reached new all-time-highs and its risk budget was significantly below the overall volatility of the equity basket. The systematic downside risk management mechanism was not activated and the portfolio remained fully exposed to equities over the period.
The portfolio continued to make progress in the first quarter as investors focused on an improved outlook for growth in both the US and Europe. This was a favourable environment for the portfolio’s equity investments however, acted as a headwind for its fixed income assets.
UK equity performance lagged the FTSE All-Share index as the portfolio’s recovery style of investing, which resulted in considerable outperformance in 2016, went unrewarded in the first quarter as the resurgence in value stocks appeared to have stalled.
However, the level of value stocks’ underperformance relative to growth stocks remains at the level last seen during the dot-com bubble in 2000. For those willing to be patient, the outperformance on offer from a true deep-value or recovery portfolio represents the most attractive opportunity available to equity investors today.
An example of a stock where we see good recovery prospects is education business Pearson. It performed poorly in the first quarter after downgrading 2017 profit guidance. However, as long-term investors we are encouraged by Pearson’s meaningful progress in shifting sales towards digital and services as well as strengthening its balance sheet significantly via the sale of non-core assets.
While 2016 was characterised by numerous macro risks, we start 2017 with clear signs that the global economy is strengthening. The US dollar has appreciated over 40% on a trade-weighted basis since mid-2011, which has been a headwind to US economic growth in recent years and has also hindered emerging markets (increasing debt-service costs and forcing central banks to tighten monetary policy to protect their currencies).
Today, however, we believe the US economy is likely to experience accelerating GDP growth despite political challenges. European and Japanese exporters are currently significant beneficiaries of multi-year US dollar strength, and the clear momentum in eurozone economic indicators (and the large negative output gap, in contrast to the US and UK) should keep inflation in check and allow the ECB to remain accommodative amid an acceleration in European growth. The UK economy has also performed better than we expected since the Brexit vote, though we worry that the inflationary consequences of sterling weakness have yet to be felt.
Against this backdrop, markets overall have continued their persistent march upwards. In general, we tend to be buyers of our favourite businesses in market weakness and sellers in market strength. Our cash balances are lower today compared to previous quarters. In 2016, more cyclical, capital-intensive and lower-quality businesses outperformed in a sector rotation that unearthed a number of opportunities to buy certain companies that we have long admired at attractive prices. We remain disciplined about deploying capital at present valuations but will be swift to act when opportunities arise.
Diversified Bond and Strategic Income
Despite an undercurrent of political uncertainty, the credit market began the year in a constructive mode as President Trump’s promise of fiscal stimulus has led to strong expectations of an extension to the US credit cycle. As a result, investors have been actively trying to put to work the high quantity of cash stockpiled in the later part of 2016, which helped create a strong technical backdrop.
The Dutch election passed without incident, which also helped market sentiment, and although the run-up to the French presidential election has been beleaguered with controversy, the market is confident that Marine Le Pen will fail to gain the necessary support in the second round vote. Approaching the quarter-end, the Fed hiked US interest rates as expected, but the rhetoric was more dovish than anticipated, which gave the market rally additional support.
Given the supporting backdrop, we have kept the risk bias in place. However, indications that the new issue volume is picking up has resulted in a slightly more prudent portfolio, thereby giving flexibility to add favoured assets during any near-term correction in credit levels.
Emerging Markets Equity
The financialisation of emerging markets – particularly with respect to insurance and lending – has been a key investment theme in the portfolio. As an economy matures and its elements become more interdependent, insurance products play an increasing role in rationally distributing the various risks posed to human and investment capital. Likewise, lending is instrumental in allocating capital to its most productive uses.
Formalisation has been another important theme. Strictly speaking, the formal sector of an economy – as opposed to barter and other informal arrangements – includes all jobs with normal hours and regular wages on which taxes must be paid. In emerging markets, we also consider formalisation to encompass the gradual shift toward obtaining goods and services from professionally managed businesses that are more specialised, more reliable and more efficient than their informal competitors.
A rough proxy for the emerging market universe, the MSCI Emerging Markets Index, has made little headway over the past seven years — even as earnings of its underlying companies have increased. As a result, emerging market equities as a group have become more attractively valued, especially in relation to developed markets. Local currencies in emerging markets generally have become less costly as well. Looking forward, we think these factors are likely to provide tailwinds for equities of well-positioned, high-quality businesses.
Developed market sovereign yields were volatile over the period. They initially trended upwards at the start of the quarter as economic data suggested widespread global growth, and Donald Trump’s inauguration as president brought expectations of reflationary policies. Geopolitical concerns – Trump’s protectionist executive orders and impending elections in the Netherlands and France – caused a reversal in yields and sovereigns to rally, although yields rose again as markets priced in a March interest rate hike in the US. When it happened, the Fed’s dovish accompanying tone surprised, which saw yields generally decline.
The UK market cycle continues to be fairly steady, although conflicts still exist. The labour market continues to strengthen but remains non-inflationary. Low wages and stable inflation expectations do not give the MPC much case to raise rates; yet equally, better-than-expected growth and employment outcomes in both the UK and Europe general suggest that more stimulus is unlikely. On the political agenda, the prime minister triggered Article 50 and the Scottish Parliament is demanding a referendum before Brexit. Although the former did not surprise markets too greatly and the latter is unlikely to happen as it requires the support of the UK parliament, this additional noise is bound to affect market sentiment in the UK. We expect the Bank of England base rate will remain unchanged.
UK High Income
The turning of a calendar year is an important cultural event but it rarely carries much significance for financial markets. Thus the first weeks of 2017 saw a continuation of the previous year’s trends. As the quarter progressed, however, the shine did appear to be coming off the ‘reflation trade’, with excitement over the outlook for growth in China and the US giving way to a more sober assessment of the global economic environment.
This saw a shift in market leadership, driven in part by the earnings season during which several large index constituents in the energy and finance sectors failed to meet the elevated expectations that have become built into share prices in recent months. This was beneficial for the portfolio, which has no exposure to these companies.
With the valuation of the UK stock market now looking quite full, it’s difficult to envisage another year of strong returns unless we see a resumption of robust earnings growth – something which we don’t expect to happen across the broader market. Nevertheless, there are pockets of attractive valuations within the market; and by focusing the portfolio towards these undervalued opportunities, we are confident that it is well-positioned to deliver attractive returns in the years ahead.
Past performance refers to the past and is not a reliable indicator of future results. The value of an investment with St. James’s Place will be directly linked to the performance of the funds you select and the value can therefore go down as well as up. You may get back less than you invested.
The information contained herein represents the views and opinions of our fund managers and are subject to market or economic changes. This material is not a recommendation, or intended to be relied upon as a forecast, research or advice. The views are not necessarily shared by other investment managers of St. James’s Place Wealth Management.
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