Fund Manager Quarterly Commentaries - December 2016
Read the latest fund manager commentaries for the quarter ending 31 December 2016.
Despite the recent relief rally, the global economy’s anaemic growth outlook persists. Investors’ euphoria over Trump’s pledge of tax cuts, deregulation and infrastructure spending seem somewhat premature. The actual implications of Trump’s presidency will play out over the longer term, and it remains unclear what impact increased protectionism and a stronger US dollar will have on both developing economies and the US itself. Meanwhile, political risk has shifted to Europe, with the UK’s Brexit negotiations, Italy’s ill-fated referendum and a series of domestic elections likely to contribute to near-term volatility. Another risk is China’s rapid credit expansion and industrial overcapacity, which could stunt the nascent rebound in commodities.
There is also a renewed focus on inflation risk in advanced economies. The shift towards fiscal reflation is likely to boost headline inflation rates, while the potential reversal of globalisation and sustained currency weakness could push price levels higher.
While this points to further market turbulence, we view the unpredictable climate as an opportunity to add value to our portfolio. We believe that our holdings are able to weather these transitory headwinds, and remain focused on investing in fundamentally-sound and well-managed businesses at reasonable valuations.
US markets seemed to react negatively to the prospects of President Trump. However, as the sun rose, markets took off. The S&P 500 index was negative prior to the election and finished the quarter in positive territory. The rebound was acutely felt in financials, industrials and materials.
The portfolio performed well, our holdings in financials reacted positively to the prospects of marginally higher interest rates with both Morgan Stanley and Bank of America up over 30%. In contrast, health care holdings underperformed. In addition to disappointing earnings reports, Medtronic experienced a delay in a new renal device, and Amgen announced pricing pressure on its flagship Enbrel brand.
AT&T announced its intention to acquire Time Warner for $107.50/share. The stock reacted positively to the news but still traded below the buy-out offer. Coty closed on the acquisition of P&G’s health and beauty care brands, which doubled the size of the company. While the integration of the brands has gone well, it appears that Coty has not adequately supported its existing brands.
While post-election market expectations were immediately reflected on markets, business values change much more slowly. Investors are afforded time and opportunity to analyse potential changes. We will continue to keep an eye on the news while focusing most of our attention on uncovering great businesses.
UK & International Income
Although on the surface the UK equity market took the Trump victory in its stride, the undercurrents caused a significant rotation for the second successive quarter. Fresh from the post-Brexit rotation into overseas earners at the expense of domestic stocks, Trump’s economic tweets led to rising bond yields: cue a switch away from fully priced bond proxies to oils, miners and banks.
The relief rally in pharmaceutical shares when Hilary Clinton did not win was short-lived as the realisation sank in that Trump is not necessarily going to be better for business.
For our part, notwithstanding a recent purchase of Sanofi, we have made significant reductions in our holdings of drug stocks during the course of the year. In addition, the sale of our remaining holding in Reckitt Benckiser Group was well timed given subsequent events.
We added to Aviva and RSA and counter intuitively sold Lockheed and BAE on valuation grounds. In the case of the latter, having reached a dividend yield of just 3.5%, we see future dividend growth as muted, particularly in the light of its pension liabilities. Whilst we believe that defence spending may increase, there are many budgetary demands to be fulfilled and we sense the market has become overly optimistic with regard to future defence budgets.
Global and Worldwide Opportunities
The final quarter of 2016 saw global stocks remain modestly positive. US stocks led developed markets on the heels of a somewhat surprising presidential election result, aided by a stronger US dollar, while emerging markets trailed. On balance, currency was less of a factor over the period relative to the third quarter for sterling based global returns. Among our top contributors were bank stocks BNY Mellon, Citigroup, Citizens Financial Group, UBS and ING.
Financial stocks have generally performed well due to the expectation of rising rates and easing regulation. Tesco was another top contributor after reporting encouraging results and establishing 2019/2020 margin targets that provided assurance around long-term profitability.
The largest detractors were ISS and Medtronic. Recently reported quarterly results for ISS showed growth has remained at a steady level. However, the company moderately narrowed its organic growth guidance for the full year, implying a weak fourth quarter partially because of a delayed contract signing. Medtronic reported quarterly results in November showing organic growth up low single digits against the company’s objective of mid-single-digit revenue growth, disappointing investors. The company is expecting growth to pick up in the second half of its fiscal year, bringing it closer to full-year targets.
We purchased Bank of America and exited Hexagon in favour of more attractive opportunities.
The final quarter of 2016 saw significant rotation in markets: from bonds into equities and within equities, out of highly rated bond proxies into more cyclical value stocks. Although quantitative easing continued in Japan, Europe and the UK, investors considered that the central banks were running out of fire power for monetary stimulus and that fiscal measures would be needed in future to boost growth. Donald Trump’s election in the US gave support to that view for he had promised, during his campaign, significant investment in infrastructure and tax cuts. The resources sector was particularly strong, helped by re-stocking of base metals by Chinese companies and by OPEC’s reduced target for oil production.
We made no changes in asset allocation during the quarter, maintaining a large position in cash and commensurate underweighting in bonds, which worked well as bond yields rose everywhere. The performance of the equity element of our fund, however, was disappointing as our growth style was out of favour and we tend to underweight resources and financials, which benefited from rising interest rate expectations.
US interest rates are expected to rise in 2017 but no increases are expected elsewhere. If President Trump’s policies are implemented quickly, economic growth should be a little better in the US. Elsewhere, activity may be similar to that in 2016, so the recent sector rotation may have gone far enough.
The UK economy continued to show little impact from the Brexit decision. Growth rates around the world appear to be picking up and Donald Trump’s policies should provide support to US growth. The key factor for equity markets was a sell-off in the bond markets and this led to a de-rating of yielding equities. In contrast, financials, especially the banking sector, benefitted. In addition, the mining sector was firm as commodity prices rose.
This overall background was detrimental to performance, as were disappointing trading updates from Devro and Senior. During the quarter a new holding was established in DFS where the shares had fallen post Brexit. It offers an attractive yield, with a strong probability of special dividends. Both Greencore and Phoenix Group had rights issues which were taken up to help add to positions. The holdings of Chenavari, Entu, Park Group, Quantum Pharma and Redefine, were sold.
The pace of interest rate rises in the US will set the tone for equity markets. As the trigger of Article 50 nears there could be more clarity as to the outlook for the UK economy. Inflation will rise as the impact of the fall in sterling is felt. The Bank of England is likely to overlook this rise unless there are signs of significant wage inflation. The majority of domestically orientated shares are discounting much tougher trading conditions.
UK Absolute Return
The value rotation continued in equity markets throughout the final quarter of 2016 on hopes of a positive step-change for inflation and growth. The surprise result in the US election reinforced this trend, with a surprisingly benign market response also arising out of the ‘No’ vote in the Italian referendum. The portfolio continues to navigate current market conditions well.
Our long positions provided much of the return in the fourth quarter, though the short book has also contributed positively. Positioning in the industrials sector, for example, has seen gains from both the long and short side. Financials have been beneficiaries of the steepening yield curve, with Lloyds and HSBC featuring as key contributors. Companies exposed to the US, such as Wolseley and Carnival, have also made gains with expectations rising that the US economy will see a significant boost from President Trump’s infrastructure spending plans. Detractors have included a short position in the basic materials sector and from BAT as it’s defensive characteristics rather than company fundamentals have impacted the share price over the period.
Despite the significant rise in bond yields in recent months and the effect this has had on bond-like equities, there is still the potential for further normalisation of the yield curve as bonds remain expensive relative to history. We remain cautious on the shape of the equity market and expect a low-growth, low-return world to persist.
The final quarter of 2016 was a memorable period, primarily due to the US election. Following on from the Brexit vote in the summer, we witnessed another shock political outcome with a Trump victory. Markets were volatile in the runup to the vote. However, they did not follow forecaster’s’ predictions when the result came in and reacted positively, especially in the US, to expectations of a pro-economic growth and deregulation agenda. Following concerns of a ‘hard Brexit’ at the start of the period, UK markets recovered marginally; however, sterling remained weak.
Developed market equities finished the period higher. However, emerging and peripheral markets suffered amidst prospects of protectionist US trade policy and the cessation of agreements such as the Trans-Pacific Partnership. With the election result, there are early signs of a potential rotation away from new energy to traditional natural resources, benefitting timber and negatively impacting clean energy and clean water. Broader commodities markets also posted negative performance through the period to mid-December, despite oil providing positive returns. Meanwhile, traditional safe-haven assets struggled as bond yields moved higher in most markets.
The Federal Reserve raised interest rates by 0.25% in mid-December (as expected by the market) and made minor changes to economic forecasts. Political events and central bank policy look set to be the key influencers on markets through 2017. Following on from the Brexit vote, Article 50 in the UK no later than 31 March, whilst French and German general elections are also on the horizon.
Index Linked Gilts
Gilt yields backed up over the period as robust UK data fuelled concerns about inflationary pressures and concerns over central bank policy. Additionally, the US election result in early November took markets by surprise and added to expectations of a reflationary environment. Yields rose again after the Autumn Statement as gilt issuance was higher than expected – an increase of £15bn to the year’s remit.
The UK economy continues to confound expectations of a post-Brexit slowdown and performed well overall. In the third quarter, the economy grew by 0.5%, only a small slowdown from 0.7% growth in the second quarter and stronger than most economists had predicted after Brexit. Other data, including October’s and November’s composite PMI were also strong. However, Brexit has proven to be a double-edged sword for Britain’s manufacturing industry as sterling depreciation has boosted exports but increased the cost of raw materials – in October price inflation for goods being bought by manufacturers hit its highest rate for 69 months and was at its fourth-highest since the survey began in 1992. UK employment data is a mixed picture; although unemployment fell to an 11-year low in the quarter to September (down 37,000 to 1.6m), the social welfare claimant count rose by 10,000. Average weekly earnings grew by 2.3% in the year to October, however, wage growth is still relatively tepid.
The Bank of England voted unanimously to keep the Bank Rate on hold at 0.25% and its £435bn quantitative easing programme unchanged over the period. It revised up its inflation expectations for 2017 to 2.7% from 1%. The bank also raised its forecast for economic growth in 2017 to 1.4% from 0.8%. Despite this, the chancellor outlined in his Autumn Statement that the effects of Brexit will see government finances take a £122bn hit by 2020.
In October, a weak yen led to equity market rises in Japan, while sterling’s weakness supported gains in the UK stock market. For US equities, October was muted and markets pulled back, as the country awaited the result of the presidential election. US economic news was generally positive, with third-quarter GDP figures showing an economy growing at 2.9% annualised.
The first post-Brexit GDP figures showed that the economy expanded by 0.5%, led by the services sector. It was also a positive month for European equities as good news emerged on Spanish employment figures and German manufacturing. In November, the US presidential election saw Donald Trump claim victory. US equity markets fell initially, bringing down equity markets across the globe. Emerging market currencies were also hit at the prospect of moves against global free trade. However, it did not take long for US equities to begin a strong rally as investors began to consider the prospect of potential benefits for business.
OPEC’s members agreed to curb oil production and equities in most oil-producing nations rose. In the eurozone, there was lacklustre economic news, with Germany posting its weakest GDP growth for the year and France seeing unemployment figures at 10%. UK’s data was more positive. Sterling rose from its lows against several currencies; inflation and unemployment were both up. However, Chancellor Philip Hammond warned in his Autumn Statement of considerably more sluggish growth. As the economic news from the US continued to be relatively strong, there was a strong belief that the Federal Reserve would bring in a rate rise before the year’s end which was confirmed when the Fed raised rates by 0.25% to 0.75% in December.
UK & General Progressive
Stock market performance in the fourth quarter was driven by anticipation of a change in policy direction in the US leading to higher economic growth, inflation and interest rate expectations. The US Federal Reserve suggested it would permit above-target inflation levels and the US presidential election result added to expectations for government spending to increase. OPEC’s agreement to cut oil production represented a change in stance and led to the oil price increasing.
Within the fund, the likely beneficiaries from a reflationary environment performed well and included Barclays, which also reported stronger-than-expected revenues, whilst Wolseley rose on expectations of an increase in US infrastructure spending. Sky rose strongly following a takeover offer from 21st Century Fox at a premium to the pre-bid share price. We expect Compass, BAT, Reckitt Benckiser and RELX to grow their earnings given durable high returns, yet they also display a bond-like consistency to their dividends. These defensive characteristics in the face of steepening bond yield curves in the US and UK have caused their share prices to fall.
The range of economic outcomes from here is wide due to ongoing geopolitical risks, not least given forthcoming elections in Europe and Brexit-related uncertainty. The global nature of the UK stock market continues to provide opportunities to invest in companies which demonstrate sustainable competitive advantages. We believe the earnings power of these businesses is underappreciated and undervalued by the market, particularly over three to five years rather than over a few months.
Having delivered exceptionally strong returns for much of this year, the final quarter saw something of a pullback for the performance of the emerging market (EM) corporate bond market. Negative returns were driven almost exclusively by the rise in US Treasury yields in the wake of the election of Donald Trump as US president in early November, as the market began to price in higher inflation and an increase in Federal Reserve rate hike expectations for 2017 and beyond. Despite this, EM corporate spreads have behaved fairly well and ended the quarter tighter. On a relative basis, the high yield EM corporate market fared significantly better compared with all other EM asset classes. For context, EM hard currency and local currency sovereign debt has returned -5% and -7% respectively over the same period.
Against that backdrop, the portfolio continued its strong run of performance, keeping pace with the index in the up market and mitigating downside risk when the market took a turn. Strong performance came from our exposures in the commodity-sensitive sectors (oil & gas and metals & mining) in particular.
Looking forward, although we remain positive in our fundamental outlook, the uncertainty around the Trump administration is not to be underestimated. We do however feel that, given the higher yield cushion (>7%) and the lower duration (approx. 4years), the EM corporate high-yield debt market should continue to perform well, and the volatility should present us with lots of opportunities to generate growth.
High yield bonds finished the year with a double digit return after another positive quarter. Despite initially wavering on the largely unexpected election result in the US, markets have responded well to the new administration’s rhetoric around fiscal spending and tax cuts in the hopes that such policies will bolster GDP. Energy markets were also stronger into year end, supported by OPEC’s agreement around supply constraints. As such, high yield default activity remains muted outside of the metals & mining and energy sectors with a 12-month high yield default rate of 0.55% as of 30 November.
A position in Sprint Corp. was one of the top contributors during the fourth quarter. Performance was driven by strong quarterly earnings. One of the largest detractors was Valeant Pharmaceuticals as negative headlines continue to impact the credit. We remain positive on this position and have added to the holding over the period.
Our near- and medium-term outlook assumes a continuation of the moderate growth pattern we have been experiencing over the past several quarters, which should be positive for high yield corporate bonds. Nonetheless, while we expect credit spreads to grind tighter into early 2017, we are closely monitoring the impact of a rise in interest rates, the potential return of a more inflationary environment and other US and global macroeconomic factors.
Greater European Progressive
There were many notable events in 2016. Long-term government bond yields hit record lows, the UK voted for Brexit, and the US voted for Donald Trump. The electorates of both countries, although highly divided, voted for change. So far, the Trump win has driven a risk-on stock rally, taking US equity indices to all-time highs. It has also further strengthened the US dollar to its highest level against the UK pound since 1984. Looking forward, we think it’s prudent to be prepared for both long-term negatives and positives for European companies from Brexit and Trump.
The stocks that suffered most in this risk-on environment were those of companies deemed of high quality and not overly impacted by a stronger, or weaker, economic outlook. As such, many stocks in our portfolio did poorly this quarter, especially branded consumer goods and pharmaceuticals. Generally, the share price movements of these companies did not reflect a weakening outlook for long-term cash flow growth. Our branded consumer goods companies now trade at an average P/E ratio of 17 and provide an average dividend yield of more than 3%. Our pharmaceutical holdings, Novartis and Roche, have a P/E ratio of approximately 15 and a dividend yield of approximately 4%.
There were many notable events in 2016. Long-term government bond yields hit record lows, the UK voted for Brexit, and the US voted for Donald Trump. The electorates of both countries, although highly divided, voted for change. So far, the Trump win has driven a risk-on stock rally, taking US equity indices to all-time highs. It has also further strengthened the US dollar to its highest level against the UK pound since 1984.
Our global portfolio has lagged this risk-on period. Our branded consumer goods and pharmaceutical holdings had among the weakest share price developments this quarter as investors rotated to assets perceived as more impacted by a strong (or weak) economy. Lower share prices, with a generally unchanged outlook on underlying profits, provide better value going forward.
Some of our shares, that may benefit from Trump’s policies, performed very well lately. For example, BB&T, one of the highest-quality banks in the US, would materially benefit from a sustained increase in interest rates and a change from a strong regulatory headwind to a tailwind.
Our consistent philosophy of investing for the long-term in high quality companies at reasonable (or, ideally, significantly undervalued) prices has lagged other risk-on periods in the past. We will continue our discipline of selling portfolio holdings that become overvalued and adding to portfolio and Dream Team companies that become undervalued based upon our view of their long-term fundamentals.
International Corporate Bond
The global senior secured bond market started the fourth quarter on the same positive note that it ended on in the previous quarter. In November, the market was dominated by overseas political events as the US election went into the last inning. On 8 November, Donald Trump was elected president. The initial market reaction was muted, with markets being down in theUS and Europe; however, focus quickly shifted to positive growth effects of the expected fiscal stimulus to be initiated by the new president. This also caused interest rate volatility which, not surprisingly, affected longer-dated bonds.
In terms of portfolio construction, we continue to be cautious on interest rates and maintain our duration underweight. We also managed to participate in a number of attractive new senior secured deals as companies used the relatively calm markets to issue debt. At the same time the portfolio has benefitted from avoiding some of the names that have struggled lately, particularly within the healthcare sector (such as HCA and Tenet).
Going forward, prudent bottom-up security selection will be increasingly important as lower market returns are being more and more impacted by idiosyncratic developments. We continue to see good value in the senior secured part of the debt capital structure, which provides investors with an attractive yield combined with good downside protection.
Global stock markets, including the UK, ended 2016 close to record highs. During the final months of the year, optimism about the US economy drove the biggest rally in US shares since the aftermath of the financial crisis. But fears of higher inflation caused government bond prices to fall, amid concerns that their 30-year bull market may be at an end.
It looks to be a positive backdrop for the start of Donald Trump’s presidency, the US Department of Commerce reported that the US economy grew at a far faster pace in July to August 2016 than previously thought — an annualised rate of 3.5%. Since the 1980s, the only president to have taken office while the economy was growing at a faster rate was George HW Bush.
Rising oil prices were another feature. After two years of low oil prices, the world’s biggest producers joined forces to tackle a global supply glut. OPEC and non-member countries, primarily Russia, agreed to cut production for the first time since the global financial crisis. Oil prices rose to end the year in the mid-$50s per barrel.
2016 was a bumper year for companies raising money through bond issues. Negative interest rate policies in Europe and Japan encouraged them to raise money at historically cheap rates.
Going into 2017, the big question is whether the high levels of economic growth, inflation and company profits built into stock prices will be delivered.
For several years, we have cautioned that the global economy may be entering a period of ‘slower for longer’ economic growth. Key factors that tend to characterise a ‘slower for longer’ economy include: excessive global debt, an excessive regulatory environment, global overcapacity in industrial manufacturing and demographic changes in the form of slowing population growth. From an investment perspective it will be important to find businesses that have the potential to grow faster than the overall economy without paying for that growth.
Recently, we have expressed concern at the increasing popularity of the so-called ‘safety’ sector investments among many financial market participants. We felt the valuations of businesses in the utility, telecommunication and consumer staple sectors were expensive and didn’t believe their fortunes would continue if interest rates increased. Our fears were given credence in November as these sectors have begun to lag the overall market. We have also cautioned about the futility of timing the market, an idea given increased credence after the US election. Most prognosticators didn’t predict the election result or how financial markets responded. We have always said we don’t have the ability to predict macro events. If we focus on maintaining a disciplined investment approach grounded in bottom-up fundamental research, we believe we have a chance at outperforming the market over the long term.
The surprise result of the US presidential election in November caused markets to whipsaw. Trump’s protectionist campaign rhetoric has weighed heavily on Asian equity markets, with exporters in particular bearing the brunt of the market’s flux. However, as bottom-up stock selectors with a long-term investment horizon, we have not focused much on the market’s short-termism; instead we have concentrated on building the portfolio with good quality companies that we can be comfortable owning for many years to come.
Our top holdings include CK Hutchison Holdings, a multinational conglomerate which operates diverse businesses such as ports and related services, retail, infrastructure, energy, telecoms, finance and investments. We believe the management have a prudent attitude to risk, a long-term view on investment and have proven to be sensible allocators of capital. We also own Taiwan Semiconductor (TSMC), the world’s largest foundry services manufacturer and one of the primary suppliers of mobile chips to Apple. TSMC has been a major beneficiary of the global trend towards integrated circuit outsourcing and has been steadily growing market share.
We maintain our cautious near-term outlook, but we believe there are still attractive investment opportunities to be had on a longer-term view. We have taken advantage of market dips to buy into quality companies at more reasonable valuations.
Global Emerging Markets
The last year has reinforced our belief that it is important not to compromise on quality, to maintain a long-term approach and to apply a strict valuation discipline. The fact that Emerging Markets (EMs) have immature legal and political systems often means inadequate levels of minority shareholder protection and higher levels of economic volatility compared to developed markets. We believe this requires a risk aware stock-picking approach that seeks to preserve as well as grow capital.
The longer-term opportunities for investment in some EMs are significant and well documented. Supportive demographic trends, such as population growth and a rise of the middle income consumer, are driving demand for a broad range of products and services. One example is South Africa where we believe some well-run businesses currently trade at reasonable valuations. Conversely, we see risks in investing in state-owned corporations, which are often hindered by a lack of alignment between minority shareholders and the government. As a result, we have a relatively low exposure to Chinese companies.
Monetary policy initially took centre stage with the European Central Bank, US Federal Reserve and the Bank of Japan injecting first pessimism and then optimism into financial markets. Oil also featured as OPEC agreed a cap to production, helping prices higher. While economic data in the UK continued to confound the doomsayers, the various flavours of Brexit – hard, soft or otherwise, hogged the headlines.
Sterling continued to devalue as Prime Minister Theresa May appeared to hint towards the hard version, which would mean limited or no access to the single market. Politics also provided the focus in the US where, following an incredible campaign, the eventual victory of president-elect Donald Trump saw opinion pollsters once again wrong-footed by a political mood. This campaign and unexpected victory provided the backdrop to a jarring global sell-off in bonds as markets anticipated the future president’s economic programme, with which he hopes to ‘Make America Great Again’. Given our two- to three-year investment horizon, it is important that we do not over-react to market events. However, every major market move will cause us to assess not just the individual investment ideas but also our central economic thesis. Part of our economic thesis highlights the impact on market volatility of political uncertainty. The Trump victory and the difficulty in assessing his future policies and their impact are a great example of this. We will continue to reassess ideas’ return expectations given any changes to our own economic outlook, and also to ensure they are offering the expected level of diversification.
Monetary policy initially took centre stage with the European Central Bank, US Federal Reserve and the Bank of Japan injecting first pessimism – and then optimism – into financial markets. Oil also featured as OPEC agreed a cap to production, helping prices higher.
While economic data in the UK continued to confound the doomsayers, the various flavours of Brexit – hard, soft or otherwise – hogged the headlines. The pound continued to devalue as Prime Minister Theresa May appeared to hint towards the hard version, which would mean limited, or no, access to the single market. Politics also provided the focus in the US where, following an incredible campaign, the eventual victory of President-elect Donald J Trump saw opinion pollsters once again wrong-footed by a political mood. This campaign, and unexpected victory, provided the backdrop to a jarring global sell-off in bonds as markets anticipated the future President’s economic programme, with which he hopes to “make America great again”.
Given our two- to three-year investment horizon, it is important that we do not overreact to market events. However, every major market move will cause us to assess not just the individual investment ideas but also our central economic thesis. Part of our economic thesis highlights the impact of political uncertainty on market volatility. The Trump victory and the difficulty in assessing his future policies and their impact are a great example of this. We will continue to reassess the return expectations of our ideas given any changes to our own economic outlook, and also to ensure they are offering the expected level of diversification.
2016 has turned out to be an extraordinary year from a political perspective – whether it was Britain’s Brexit vote or Donald Trump’s US presidential victory. Trump’s victory caught the imagination of investors, who bought in to the idea that his plans to increase infrastructure spending and cut taxes would support economic growth. Cyclical sectors, such as banks and industrials, continued their recent trend of outperforming more defensive consumer staples and utilities sectors.
Within the portfolio our overweight positions in consumer staples and healthcare companies detracted from performance over Q4, as did our lack of exposure to financial, energy and materials companies. Our zero weighting in the more capital intensive defensive sectors such as utilities and telecoms and our low allocation to real estate, contributed positively to relative returns against the index.
Against a backdrop of market volatility, heightened valuations and political risk, we believe that stock selection will be more important than ever in 2017. As long-term, active investors, we must embrace volatility in order to exploit opportunities to buy great businesses at discounts to their intrinsic value. We continue to focus on attractively valued companies that have an ability to grow their dividends through the market cycle. We firmly believe that as the market becomes more macroeconomic focused, there will be plenty of opportunities to do just this.
The widely unexpected triumph of Donald Trump in the US presidential election in November provided a perfect illustration of the importance of building a resilient, balanced portfolio capable of surviving a volatile market and a range of macro outcomes. In particular, it is encouraging that our efforts to insulate the portfolio from the impact of rising bond yields appear to be paying off thus far.
We suspect that rising bond yields have at least as much to do with technical factors (the unwinding of crowded investment trades and the looming bond issuance in a world of greater fiscal stimulus) as they do with genuine expectations for returning inflation. The structural forces of deflation – debt and demographics – remained strong, even if they had been taken to extremes to justify an overbought bond market. So, rather than chasing the ‘inflation trade’, we will continue to run the portfolio in a balanced way which can cope with both outcomes. In particular, we will prioritise both strong balance sheets (essential in a deflationary environment) and pricing power (vital in an inflationary environment).
UK General and Progressive
We rarely tread a consensual path as investors, but admittedly it is a nice feeling when we find a kindred spirit with a similar view on the challenges facing UK plc and the wider western corporate sector. Step forward Sir Martin Sorrell, founder and CEO of global advertising group WPP. Drawn from an article first published in ‘The Economist – The World in 2017’, we came across a recent LinkedIn post from Sorrell which resonated strongly with us. It chimes with our frequent complaint that western company management teams are all too often eschewing the long-term approaches to business and investment needed to create enduring value.
Rather, they are focusing too heavily on the quarterly earnings cycle and obsessing with overly generous dividends and share buy-backs to inflate share prices, often inappropriate behaviour that typically has its roots in ill-constructed executive pay schemes that prioritise the short term over longer lasting, sustainable corporate success.
We thought we would share one of the most relevant paragraphs: “In this environment, procurement and finance departments (rather than growth-drivers such as marketing and R&D) have the whip hand. Risk-aversion and shorttermism rule in the world’s boardrooms. This attitude is entirely understandable—and entirely wrong. Calculated risk-taking, in the form of investment, is the lifeblood of any business that wants to be successful in the long-term.”
Investment Grade Corporate Bond
Fixed income total returns were challenged by the Trump victory and resulting repricing across rates markets. US corporate credit spreads were relatively resilient however. The positive boost to UK investment grade, that occurred during August as a result of the BoE’s corporate bond buying announcement, seemed to fade with spreads cumulatively wider. The repercussions from Brexit on UK economic performance will be important to the credit outlook, and while the latest GDP figures positively surprised, credit markets have not responded.
The Italian referendum defeat did not unsettle markets, which had largely expected the result. We anticipate a recapitalisation of the weakest Italian banks, and would use any widening in European bank spreads to possibly add exposure. Somewhat faster global growth, higher Federal funds rates, and a locally stronger US dollar are the expected background to asset returns in 2017. We end 2016 with slightly less credit exposure than mid-summer, a modestly defensive duration posture and a bit more enthusiasm for emerging market ideas than before their election-driven sell-off.
The modest allocation to high yield credit continued to add value during the period. Positions in selected banks, life insurance, and energy companies contributed positively as well. Positive results were mitigated by an underweight stance in a few tech giants that outperformed. Issuers held from the automotive sector also moderately weighed on returns.
Equity markets have been focused on political developments, particularly the US election and the Italian constitutional referendum. The Trump/Republican win has pushed US bond yields higher and led to a growing consensus of expansionary policies being implemented. Market sentiment has shifted towards growth-oriented sectors which are perceived beneficiaries of Trump’s policy agenda which includes corporate and individual tax cuts along with increased spending on infrastructure and defence.
During the period, investments in Wells Fargo, Target and Microsoft made the largest contributions to performance. Wells Fargo performed well following the US election and growing expectations of higher bond yields. Target’s share price rallied following a stronger than anticipated earnings result, while Microsoft has continued to perform well following another strong earnings result, featuring continued revenue growth within its Productivity and Intelligent Cloud businesses.
The main detractors from performance were eBay, CVS Health and Novartis. Weakness in eBay’s share price resulted from its latest earnings release. The company is continuing to invest to improve its platform and drive future earnings growth, but this may pressure near-term margins. CVS Health registered weak performance following its recent earnings update, where management cut its full-year earnings expectations due to volume losses at its retail pharmacy. Novartis’ share price reflected weakness in the health care sector associated with the US election and implications for pharmaceuticals.
UK Growth and UK & General Progressive
Our portfolio gained during the quarter from long-established overweight positions in UK banks, food retail, mining and oil and gas. While we are cautious about 2017, UK banks continue restructuring and offer attractive valuations; both Barclays and Royal Bank of Scotland shares did well, while the wider financials sector benefited from the news of Donald Trump’s election win.
We built several mining positions while the sector was still unfashionable, thus the markets’ belated recognition of the operational improvements taking place, for example at Anglo-American − boosted further by commodity price recovery – contributing to positive performance.
Tesco, another stock previously shunned by the markets, also continues to perform well in your portfolios, as it implements its improvement strategy. Our underweight exposure to the consumer goods sector also served them well, as conviction in ‘bond proxies’ lessened.
Elsewhere, the UK mid-cap, Rentokil Initial, gave back some performance, despite a healthy trading update in the previous quarter.
We believe that current valuations do not reflect the structural headwinds facing consumer staple stocks, and we are also conscious of the inverse correlation between the yield on long dated sovereign debt and ‘bond proxy’ type stocks; we continue to avoid these areas of the market.
During the quarter the life insurance sector continued to do well for the portfolio. The Dutch insurer, Delta Lloyd, which we view as an undervalued improvement story, boosted performance after being subject to an unsolicited takeover bid from its largest domestic competitor.
Both Legal & General and Aviva have continued to rally from their lows following the UK’s EU Referendum. The interbroker dealer, Tullett Prebon, was another strong performer, following a trading statement that demonstrated some long-awaited revenue growth, which in turn catalysed a partial re-rating, ahead of its completion with ICAP. We remain underweight the consumer goods sector, where ‘bond proxies’ lost some steam.
The main detractors to the fund’s performance were HSBC, mining and oil and gas, all areas where we are underweight versus the wider market. Mining has performed well in Q4 as a number of commodity prices have spiked due to inflation and the demand pull from a recovering China. Oil & gas has benefited from the recent OPEC agreement to scale back production growth, reflecting this agreement we have now moved to an equal weight position in this sector but with a focus on exploration and production businesses that have used the downturn to massively improve the quality of their operations.
We remain focused on finding stocks that re-rate through operational improvement and delivering a solid income yield through good cash generation, paying us to wait for this operational improvement to happen.
Global Equity Income
The performance of global equities was mixed over the period as investors focused on election results in the US and Europe as well as the potential for policy changes from global central banks. Several sectors, including Financials and Energy, rallied on perceived policy impacts of the US election. Emerging markets were weaker as the US dollar rallied and uncertainty around the impact on global trade was priced in.
Stock selection in the financials and information technology sectors contributed to the strategy’s returns over the period. Individual contributors included PNC Financial Services Group Inc., Huntington Bancshares Inc. and Wells Fargo & Co.
An overweight allocation to the consumer staples sector and stock selection in the industrials sector detracted from the strategy’s returns. Individual detractors included Japan Tobacco Inc., Nestlé SA and Ahold Delhaize.
Global challenges of deflation risk, excess debt and political uncertainty may overwhelm the possibility of real global economic growth. We are maintaining the strategy’s underweight allocation to commodity-related industries, with the Energy sector being our only exposure. We are also maintaining an underweight position in the European financials sector, although this is offset by a reasonable exposure to the US financials sector as well as large exposures to quality franchises in sectors such as health care and consumer staples.
The fourth quarter saw the return of volatility in what has been an exceptional rally in the high yield market for 2016. In November, the high yield index was down approximately -16 bps, the first month with negative performance since January 2016. The metals & mining and energy sectors are the top performing industries in the fourth quarter and remain the leading gainers for the year. US high yield is up over 16% for the year.
The Yield curve (e.g. spread between 2 and 10 year Treasuries) has risen rapidly, implying rising rate and inflation expectations. The post-election rally in spreads and sell-off in rates seems to be taking hold. We remain positively inclined on the high yield asset class given our belief that high yield bonds spreads carry strong relative value in the context of the current low default environment.
We anticipate that volatility will spike in coming months as uncertainties around US policies and global events (European referendums and China) cause some concerns. Within our portfolio, we continue to seek to add positions that have been overlooked by the market and trade at exceptional values, while looking to exit the positions that we feel have met their price potential.
International Corporate Bond
The unexpected Trump victory in the US Presidential election jolted financial markets in the fourth quarter. While equity investors cheered Trump’s pro-growth agenda, the investment grade bond market weakened amid sharply higher interest rates. In this environment, high yield bonds couldn’t keep pace with the outsized returns delivered in the first three quarters. Even so, the asset class was the best performer within the fixed income market in the fourth quarter, outpacing higher rated bonds.
While the uncertainty of the new US administration may add to volatility, the credit fundamentals of the high yield bond market remain sound. Corporate profits have been steady, and the default rate is expected to remain relatively low. Without question, fixed income instruments, including high yield bonds, are vulnerable to rising interest rates. However, high yield bonds typically have a shorter duration – and thus are less interest rate sensitive – than investment grade bonds. As a result, they should fare better than investment grade bonds in a period of rising interest rates. We continue to believe high-yield bonds represent an attractive investment opportunity. In our view, yield spreads in today’s market provide ample compensation for bearing credit risk. With their relatively high coupons, we believe highyield bonds are one of the few fixed income asset categories that provide an attractive yield in today’s market.
After a period of relative inactivity post-referendum, turnover in the property investment market has started to pick up. There are now more buyers in the market, both UK and overseas, which in turn has given sellers the confidence to bring assets to the market. Whilst activity is significantly below the record levels of Q4 2015, it has been possible to acquire good quality, well let property, capable of sustaining long term income streams. By way of example, we have acquired the Kingsway Retail Park in Derby for £57.3m reflecting an initial yield of 5.75%. The park is fully let to 16 first class retailers including Next and Marks & Spencer.
The occupational market has remained encouragingly active, particularly outside London. We continue to sign new lettings and lease renewals across the UK and across retail, office and industrial sectors.
The St. James’s Place property funds are generally invested in good quality prime stock with low vacancy rates. The portfolios are well diversified, over more than 100 property assets with over 900 tenants and notwithstanding the Brexit and other uncertainties that lie ahead, they are 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 multi asset portfolio.
Global Smaller Companies
Markets are still digesting the shock outcome of the US presidential election. For now, the pendulum of sentiment has swung from fear surrounding Candidate Trump’s extreme stances on trade, immigration, and foreign policy toward hope regarding President-elect Trump’s pro-growth regulatory and tax reform agenda.
US small caps have been on an absolute tear since 9 November. Many of our US holdings – particularly financials – have benefited from this rally, but this reflects our approach of holding a low-risk, balanced portfolio that should thrive under a variety of scenarios rather than of positioning for one particular outcome.
As a low-turnover, price-conscious, fund, we are not chasing financial and infrastructure-related stocks pressing to fresh highs. To the contrary, we find ourselves even more cautious with regard to both stretched valuations and the extent to which investors are pricing in robust US growth. We suspect the most optimistic amongst us are likely to be disappointed once the honeymoon period ends and political realities take hold.
Outside the US, global smaller company returns have been more muted in the face of dollar strength and questions about rising protectionism. Export-oriented emerging markets are the most vulnerable to these headwinds, but we will not shy away from maintaining substantial EM exposure so long as the companies in question offer the defensive attributes we seek in any holding.
Diversified Bond and Multi Asset
The fourth quarter of the year saw bond yields rise as a combination of factors made investors reassess the attractiveness of safe-haven government bonds. First, investors focused on the US presidential elections and the surprise victory of Mr Trump. Expectations that increased government spending, less regulation and tax cuts could lead to stronger growth and higher inflation in the US led to a sell-off in bonds across the board.
In Europe, the decision by the European Central Bank to reduce its asset purchase programme to € 60 bn per month from € 80 bn further undermined European bonds.
In what was a generally challenging environment for government bonds, our strategy benefitted from a defensive positioning. The portfolio’s low interest rate duration and higher allocation to floating rate securities helped to mitigate some of the losses from the rise in bond yields.
The legacy non-agency mortgage-backed sector was the largest positive contributor, while the allocations to investment grade and high yield corporates, as well as emerging market debt, detracted modestly from returns. In anticipation of diverging central bank action, the strategy continues to balance fixed and floating-rate exposures and looks opportunistically to add credit during periodic episodes of yield spread widening.
The UK market has enjoyed a good year despite the potential upsets coming from the Brexit vote, Donald Trump’s election win and the Italian referendum. The fall in the value of the pound has provided a profit tailwind for the many companies that earn their profits in overseas markets; although this is to some degree offset by the increased challenges facing those companies with more of a domestic focus.
It is too early to draw any conclusions about how the UK economy might fair post Brexit. The initial signs are encouraging in that consumers still seem to have the confidence to spend; although as a country we continue to run very large deficits, making the UK more vulnerable to unforeseen shocks.
At the individual company level, the market is giving off mixed messages with a number of companies warning that profits will not meet market expectations while others continue to make satisfactory if unspectacular progress. Overall, we continue to think that it is right to be relatively cautious. For most companies, conditions continue to be challenging and valuations provide little support against any deterioration in the backdrop. In some cases, we are concerned that companies have become overly leveraged, increasing the risks to shareholders.
It is encouraging to see that the portfolio’s holdings in Sky and RBS have performed well in recent weeks.
Continental European and Greater European Progressive
We continue to believe that Europe presents a compelling investment opportunity. In our view, Italy’s decisive rejection of constitutional reform does not materially alter our more positive outlook. In the short term, President Mattarella should be able to form a stable technocratic government. Longer term, whilst elections may have to be brought forward to autumn 2017, this should still allow enough time to address the issue of non-performing loans within the banking system. On the political front, furthermore, it is not clear that the ‘No’ vote will lead to an imminent referendum on Italy’s place within Europe. Current opinion polls continue to suggest that the Italian people overwhelmingly wish to remain in Europe and with the euro.
More importantly, the Continental European economy continues to recover nicely, with the eurozone manufacturing PMI rising to its highest level, since January 2014, in November. We have also been pleasantly surprised by the significant recovery in German exports. France is also witnessing the beginnings of a very healthy economic recovery. The British economy, furthermore, appears to be hitherto largely unaffected by the Brexit vote. Indeed the composite PMI nudged even higher in September. Our numerous company meetings, furthermore, attest to a relatively buoyant economy. As we have written before, however, we will only begin to have some idea of the real impact of the vote when negotiations begin in earnest.
The 2016 US presidential election season finally concluded in early November with a Donald Trump victory, and with Republicans maintaining control of Congress. Most prognosticators were surprised by the outcome, and are now projecting how the new administration’s policies might influence different industries and geographies – even though the new President’s stance on many key issues remains unclear.
The election’s outcome does not change our geographic investment preferences, as our regional exposures are primarily a by-product of our bottom-up investment process. We seek to invest in what we believe are leading growth franchises globally, and this often steers us to companies that are creating their own markets or disrupting existing industries, rather than companies that are levered to exogenous factors such as commodity prices or a given region’s GDP growth.
Outside of the US, this had led to a preference for businesses in India and Southeast Asia, and companies that are levered to the Chinese internet and consumer – though not necessarily domiciled in China. We haven’t invested in many European or developed Asian companies due to their reliance on economies with tepid growth expectations. Latin America’s equity market is skewed towards financials, consumer staples, and materials – sectors not typically associated with high growth. We remain business-focused and macro-aware. The only certainty in global financial markets is the constant of change, and therefore we expect that selectively owning the right businesses will be the main driver of our ability to add value for clients with prudence over time.
Strategic Income, Managed Growth and Multi Asset
The portfolio continued to generate a yield in line with its objectives through dividends received in the global equity income basket (‘the equity basket’) and through regular premiums received.
From the perspective of investment style, yield-oriented strategies struggled to keep pace with the market during the fourth quarter as investors continued to rotate out of defensive and into cyclical sectors. This trend was evident for most of the second half of the year, corresponding to an overall ‘risk-on’ environment which benefited sectors such as technology, financials and industrials and presented headwinds to utilities and staples.
The equity basket is designed to offer a relatively high and consistent income with an emphasis on quality and diversification. At the time of writing the equity basket’s rolling 12-month yield is slightly ahead of its stated objective, while the performance during the quarter was favourable due to its focus on quality.
The volatility of the equity basket was relatively subdued at the start of the period but increased in November in the build-up to the US presidential election. However, this did not exceed the risk budget available in the portfolio and thus the systematic downside risk management mechanism was not triggered in this case.
Setting aside one’s broader views on the US presidential election, the short-term economic implications of a Trump presidency are strongly pro-US GDP growth given the expectation for broad corporate and personal income tax cuts and the opportunity to repatriate US corporate cash overseas. The environment for small businesses and specific areas of the US economy, such as domestic oil & gas exploration and the banking system, will also likely benefit. Long-term economic costs will require offsetting fiscal discipline in other areas or will result in widening deficits and government debt. We expect interest rates will likely rise steadily over the next two years amid a tighter jobs market and higher inflation risk.
While we remain positive on the US economy, the world appears likely to face short-term challenges. We continue to be concerned over rising political instability in developed markets, the consequences of unprecedented monetary experiments of recent years and sustained negative momentum in global GDP growth. Europe’s rising populist tide, as revealed in last year’s UK and Italian referendums, will be given additional forums in which to express itself. Meanwhile, China will need to effectively manage the diminishing ability of credit growth to yield economic growth and the increasing risks of asset bubbles.
Given our cautious outlook, we retain our strong bias towards companies that make their own luck and have focused on those that exhibit quality, resilience and stability.
Diversified Bond and Strategic Income
The fourth quarter of 2016 was dominated by the US election and the ramifications of the surprise result. The uncertainty for investors now is what will be the extent of the fiscal expansion under the Trump administration, the impact this will have on US inflation and how this will drive the Federal Open Market Committee in terms of setting the federal funds rate.
Here in the UK, market uncertainty increased as the process surrounding the submission of Article-50 was taken to the Supreme Court for clarification; while in Italy, Prime Minister Renzi resigned following defeat in the key constitutional referendum. Although the Italian referendum result wasn’t a surprise, the ramifications are potentially destabilising as much-needed amendments to legislative process, including banking reforms, are now unlikely to proceed; and it also increases the chance of an early election, with the popularist anti-EU Five Star Movement leading in the polls. We positioned a credit-spread hedge going into the vote and kept a significant cash balance to take advantage of any market volatility producing cheaper assets. However, the ECB announced an extension of its asset-purchase programme which kept the market steady into the year-end.
In the first half of 2017 there will be a number of headwinds for the market to contend with (e.g. Dutch and French elections), which could see a rise in the anti-EU vote. However, the key driver is likely to come from the US, with the incoming Trump administration potentially leading to a pick-up in the momentum of a federal funds rate hike. We are therefore positioning the portfolio in a more defensive manner, with a focus on shorter-dated credit spreads to drive a steady return.
Emerging Markets Equity
On 8 November, in a surprise move aimed squarely at the country’s underground economy, India’s government invalidated over 85% of its currency in circulation and ordered people to deposit the money in banks or redeem the money for new currency notes. The sheer boldness and scope of the decision put to rest any lingering doubts about Prime Minister Narendra Modi’s willingness to enact difficult but necessary reforms. The longstanding problem of socalled ‘black money’ – unaccounted wealth held as currency – has enabled both corruption and tax evasion to flourish in India, sapping resources needed to fund infrastructure projects and other public spending vital to the country’s growth and development.
Although the currency overhaul produced considerable turmoil as millions of Indians rushed to redeem their worthless currency notes prior to the December deadline, we believe the potential benefits far outweigh the costs. Coupled with a new ’Goods-and-Services Tax’ (GST), India’s demonetisation programme is likely to foster a fairer, simpler tax system in which compliance and enforcement are greatly enhanced.
As with a number of other emerging markets, India’s fiscal and current-account situations have improved significantly in recent years. We believe the stronger fundamentals have left the currencies of these countries better positioned to weather a possible rise in global interest rates. In general, emerging market currencies appear more undervalued now than at any other point in our decades-long investment careers.
Gilts (Class L) and Gilts (Class R)
Most developed market sovereign yields rose during the fourth quarter of 2016 as government bonds sold off following Donald Trump’s win in the US presidential election, and hawkish Fed rhetoric following an increase to the policy rate for only the second time in eight years. Global equity markets rose and the US dollar surged on expectations of an expansionary fiscal policy and stronger US growth, while emerging markets assets suffered on concerns about trade protectionism.
The UK economy has proved remarkably resilient since last June’s vote to leave the European Union (EU) – probably because policymakers have injected a huge amount of stimulus into a system that had little spare capacity; in anticipation of a shock that hasn’t yet occurred. Now the risks are that the stimulus will fade in the first quarter as rates stay on hold, the Bank of England will choose not to extend quantitative easing past February, and no further fiscal stimulus will occur – just as the break with the EU begins. One key uncertainty is when Article 50 will be triggered in the first quarter, which depends greatly on when the UK Parliament sets a date for the vote following the Supreme Court ruling.
UK High Income
The final quarter of 2016 marked the end of a difficult year for the funds. Market leadership has been narrowly concentrated in sectors to which our portfolios have no exposure. In particular, resource-related stocks have accelerated away from the rest of the market in the aftermath of the US election, fuelled by (in our view, misplaced) optimism about what President Trump may mean for economic growth.
Outside of the hot resources sectors, returns from the broader market have been much more modest. Within the portfolio, there have been one or two stock-specific disappointments but, for the most part, we are satisfied with the operational performance of our holdings. Much of this progress, however, has not yet been reflected in share prices. Indeed, much of what we have seen this year does not appear to be grounded in fundamentals. In the long run, fundamentals are all that matter for share prices, but over shorter time periods, they can be overtaken by other drivers, such as sentiment and momentum. When this happens, it is important that we stick to our investment disciplines, revisit our basic assumptions and if they continue to hold true, maintain conviction in our strategy. In so doing, we remain very confident the portfolios are appropriately positioned to deliver very attractive long-term returns as fundamentals reassert themselves.
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.
FTSE International Limited (“FTSE”) © FTSE 2017. “FTSE®” is a trade mark of the London Stock Exchange Group companies and is used by FTSE International Limited under licence. All rights in the FTSE indices and / or FTSE ratings vest in FTSE and/or its licensors. Neither FTSE nor its licensors accept any liability for any errors or omissions in the FTSE indices and / or FTSE ratings or underlying data. No further distribution of FTSE Data is permitted without FTSE’s express written consent.