Lorna Blyth provides an update on the impact of recent market events on the Governed Range.
"Most asset classes have traded in a narrow range over the summer months but since the start of September there has been renewed enthusiasm in equity volatility which has continued throughout October. This volatility has occurred on a backdrop of further restrictions being implemented across Europe to reduce the spread of the virus, a divisive US election and further uncertainty around the threat of a no-deal Brexit. We expect a lot of this uncertainty to continue into Q1.
One year returns across the portfolios to the 6th November are ranging from 1.2% to -3.4% across the GPs and GRIPs. All the underlying funds are outperforming their benchmarks except for commodities and sterling high yield. Longer term returns remain strong with GPs returning between 5-8% annualised since launch and GRIPs returning between 4-7%. All performance numbers quoted are net of a 1% charge and you can find returns to month end for all the portfolios in the link at the end of this update."
Please note that this is a fast-moving environment and markets and impacts on portfolios are changing. Opinions contained in this document represent views of our fund managers at time of writing.
The strong recovery in global equity markets from the lows of March means that risk and return are more balanced in the shorter term, with global equity valuations around long averages. Uncertainty remains around both the speed and the shape of the economic recovery, hampered now by new lockdowns, and this continues to create market volatility. A failure to agree a post-Brexit trade deal or political and social tension post the US Presidential elections are other potential negative surprises.
We remain constructive on global equities, however, but moved to a more neutral position as two-way risk increased post the Q2-3 rally. Our Investment Clock model has gone from being positive on growth in January to negative in the first lockdown but now points to global recovery in the coming year (virus allowing). While we continue to favour the US and emerging markets over the UK, and technology and consumer discretionary over energy, we have dialled down our stronger weightings. In particular, UK equities could benefit from more clarity around a trade deal with the EU, although perversely could also perform well if sterling fell sharply as the value of overseas revenues would increase. UK equities are also attractively valued relative to European and US stocks.
While significant upside from current levels for global equities will require the world economy and earnings growth to recover more strongly than currently, and possibly an effective vaccine for Covid-19, further volatility in global equity markets could represent an opportunity to increase our equity weightings. There may be challenging periods over the next 12 months driven by further waves of the virus; however, it is clear that governments and central banks are committed to the long haul with extreme monetary and fiscal policies in place to spur recovery in the next few years. In the longer term, equities offer significant value against negative real yields from government bonds and cash.
The UK left the EU in January 2020. Ongoing trade negotiations are now in their final stages with both sides taking positions in line with their own self-interests. Our view is that if the UK and EU are rational, compromise from both sides could lead to a free trade deal, avoiding a further hit to economies already suffering due to the coronavirus crisis. Political positioning could, however, lead to a "No Deal" accident.
We deal with this uncertainty by being broadly diversified across asset classes and geographies and through the application of our active tactical asset allocation processes. Diversification is the first line of defence against market volatility resulting from geopolitical events.
In the case of Brexit, a bad outcome for the UK economy would probably result in a sharp drop in sterling on the foreign exchanges. While commercial property and domestically-focused stocks could see further mark downs, large cap UK equities have significant overseas earnings and would most likely rise in value as they did after the 2016 referendum when the pound dropped by 10% overnight. Commodities would also most likely rise in value as the pound dropped as prices are determined by global supply and demand and are quoted in US dollars. There could be a further benefit in this scenario if UK gilts in the portfolios rise in the face of extended Bank of England stimulus.
One of our key responses to the Brexit trade negotiations has been to underweighting sterling relative to its weighting in the strategic asset allocation. We have been underweight for most of the period since the vote to leave the EU in 2016 and deepened our positions in early September 2020 as tensions began to rise once more. Should the markets go too far or should prospects for a trade deal improve, we are able to move to be overweight sterling again.
While we have moved further underweight sterling we have taken the opposite approach with our UK equity exposure. We have been underweight UK equities for most of the period since the vote to leave the EU in 2016. The UK has been a significant underperformer compared to the US equity market, where we have been overweight, so this positioning has benefited the portfolios. However, we have reduced our underweight in UK equities to a small underweight (see chart) as part of what we view as sensible risk control. The political situation will be hard to predict and we don’t want to be underexposed to UK equities should the pound take a sudden move downwards and overseas earners in the FTSE100 rise.
GDP data for Q3 over the past two weeks confirms strong early stage economic recoveries in the US and Europe. The recent picture has become rapidly more downbeat, however, especially in Europe following the imposition of national lockdowns. Contractions in GDP now seem likely in Q4 in the UK and euro area, albeit more modest than in Q2. Covid-19 case numbers continue to rise in Europe and the US. Once the US election is fully behind us, the worsening in the US’ Covid-19picture may be more of a focus again. Beyond the election result (and, in particular, the make-up of the Senate), it is the Covid-19backdrop that could end up being the determining factor around what scale of US fiscal stimulus we get.
Contractions in GDP now seem likely in Q4 in the euro area and UK, albeit more modest than in Q2. Not only are lockdowns somewhat less strict, but activity is already starting from a lower level; the quarter is already part way through; firms are likely to be better prepared this time around; households are likely to be more adept at moving activities online. However, for some businesses, this second round of lockdowns may prove the ‘final straw’. There is every chance that the lockdowns last longer than the few weeks being signalled by policymakers. In which case, emerging analyst forecasts of 0-4% contractions in output on the quarter could prove too optimistic.
Extra stimulus will help though, both in the near term and in limiting long-term economic damage from the virus. The ECB were unusually clear in their signalling that there would be more easing announced in December and the Bank of England have just added £150bn to their asset purchase programme. On the fiscal front – still the front line in economic policy defence against damage from the virus – further fiscal measures were have been announced over the past couple of weeks in countries including France and the UK (where the latter’s furlough scheme was finally extended to March 2021, more in line with peers in the rest of Europe). Easing is already built in to many euro area budget plans for 2021, supported by the EU’s Recovery Fund.
Where prospects for more fiscal stimulus now look weaker than many were perhaps hoping, is in the US. The presidential race may have been called, but as ever with US presidential elections though, it doesn’t just matter who is president – it matters who takes the House and the Senate. Results are still not final, but it looks like the Democrats are on course to retake the House but the Senate to stay Republican. A large fiscal stimulus in the New Year (or before) is unlikely to materialise with a Republican senate. But some form of stimulus is, and something a bit less than $1tln still looks plausible. Senators were willing to pass more piecemeal measures just a few weeks ago and Covid-19 numbers are rising sharply again. In the meantime, the onus falls on the Fed to provide continued support for the economy (and markets). The Fed continue to keep policy loose, to strongly signal that they are nowhere near raising rates and they continue to insist that there is more they can do if needed (there were "full" discussions at their recent meeting around the parameters of the asset purchase programme). At this stage, however, it is fiscal policy that can do more and in a more targeted way for the particular problems generated by the Covid-19 crisis than monetary policy.
Finally, we are still in a key period for Brexit talks, where a deal is needed soon to allow time for the legislative process, including scrutiny and ratification before the 31st December when the UK exits the transition period. That both sides are still talking intensively is positive, but it is clear that there is still quite some distance between the two sides and, at the time of writing, no decisive breakthrough. With Covid-19 cases high and lockdowns across much of the UK, this is not a good time for the government or businesses to be dealing with the challenging practicalities of Brexit. Even with a deal, some disruption, e.g. to cross border trade, seems very likely over the turn of the year. Without a deal, such disruption is likely to be significantly worse.
The laundry list of negative issues that investors have to contend with continues to be long but ultimately, for equity and credit investors, not especially price moving. It does beg the question: if a pandemic, the risk of a hard Brexit and a contentious presidential election can’t stop the upward move in asset prices, what will? Taking these issues in turn, we do think a second wave of Covid infections was largely expected and those companies most affected by it have already seen their share prices fall considerably to the point they have become small parts of indicess thereby reducing their influence on overall asset class returns. We also think a hard Brexit would be a positive for the UK stock market given the almost inevitable fall in sterling that would follow, and the benefits of that to what is a very international market. Finally, we don’t believe presidential cycles are that consequential for markets. Donald Trump was elected with a pledge to support the US oil and coal industries, and to tackle large technology companies. The former have been the worst investments over the last four years, the latter the best. Equity markets and industries do well despite US politics, not because of it.
It seems likely to us that the primary influence on asset prices remains that of central banks. In particular, markets are trying to understand and discount the generational shift in the change of policy from the US Federal Reserve. Since Paul Volcker in the 1980s the tone from the Federal Reserve has been one of keeping inflation down. Recently this changed under Chairman Powell to getting inflation up. Under the former policy the bias was to raising interest rates to control economic activity and therefore inflation. Now the bias is to keep interest rates down to encourage growth and inflation. This essentially means no interest rate increases until at least 2023 under the analysis provided by the Fed. But consider this: the 2% inflation target in the US was implemented in 2012 and has never been met in strong economic times; how likely is it now in weak economic times? Maybe interest rates will remain at current levels beyond 2023? Were this to happen the value of equities, as investors would be willing to take a lower return to hold them, would continue to rise and maybe significantly so. This is what we believe we are seeing today. An over focus on pandemics and politics is missing the key variable in the room, a generational shift in central bank policy in the largest economic region in the world which may have major and not yet discounted consequences for asset prices.
As we enter winter and second lockdowns, it is easy for morale to fall. We do think though there are grounds for optimism when we look forward. It seems more likely than not to us that the pandemic will be largely over by this time next year. There are currently over 350 vaccines in development, with a number of promising candidates. Those vaccine companies we speak to think a working and safety tested vaccine by Q1 2021 is achievable. Then it will come down to how fast it can be manufactured and rolled out by governments around the world, with estimates suggesting that by Q3 2021 large parts of the population will have received a vaccine. Of course there are many hurdles to overcome, but our point is if this were to occur and we were free to go back to life as it was, where would asset prices be then and what would perform well?
Under this scenario many (but not all) investments that have fallen of late will rise again, and equally those who have been more attractive as they have not been impacted by Covid will seem less relatively attractive. This could be the basis for some kind of rally in what are considered ‘value’ stocks in the short term. Unusually a value rally has been missing in the recent market rise; following a bear market this is usually a high probability bet, as investors want to buy less liquid, more indebted and cyclical companies. Beyond any short-term rally though, the key question will be what has structurally changed in all our behaviours that has increased or impaired the value of key sectors and industries. That is clearly still to be seen, but we believe that many value sectors (airlines, oil, retail, property) will be structurally impaired and that the winners will be areas such as healthcare and technology. Beyond a short-term rally in ‘value’ we do think what has done well this year will continue to do well in the future.
We continue to be happy with the performance of our sustainable funds. All remain significantly ahead of benchmarks and peer groups year to date, itself a consequence of having largely avoided the key areas of capital destruction this year, and having been positioned in those companies seeing their future prospects improve in a post pandemic world. Our preference for equity over credit (within the parameters of their mandates) has served the mixed asset funds well. We still think the hurdle rate for equities to become more attractive than credit is still low enough for us to have confidence in preferring equities. Credit does however remain a valuable source of income and stability given the continued turbulence in markets. Our new Global Sustainable Equity Fund has been added to the RLP fund range and you can find out more about that here (link to webpage).
One common question we get is about whether or not there is a valuation bubble forming in those equities with strong sustainable credentials. These stocks will be benefiting from the large increase in flows into sustainable funds and, as inflows generally have to be invested, will have less price sensitive buyers. Our answer to this is nuanced. First of all, as noted above, nearly all equities are becoming more expensive, so this isn’t simply a sustainable issue. We do think however that we are noticing certain leading sustainable companies becoming prohibitively expensive for us to own. These tend to be smaller, less liquid companies where there is not much trade in the underlying shares. This lack of liquidity makes them more prone to mispricing occurring. We have recently started to reduce our position in Tomra, a Norwegian company operating in the circular economy and plastic recycling. Despite mixed operational performance, the shares have done exceptionally well and are priced at a level similar to more liquid, higher growth, higher returning and equally sustainable businesses we can own. Descartes was another investment we have sold; a small Canadian software company making software to make supply chains more efficient which became unattractive due to its price. Of course both Tomra and Descartes could be successful investments but we think the probabilities of this have been reduced to unacceptable levels for us. We do however think there are ample opportunities for us to invest in elsewhere, and we have been building a holding in Nordson, a US engineer providing sophisticated equipment to make key manufacturing processes more efficient and environmentally friendly.
A number of clients have recently commented to us how complicated investment markets are at the moment, to the point where making decisions has become difficult. Acting effectively and rationally in investment markets is a key ability any fund manager needs. To understand how best to do this it is worth looking at two distinct sets of circumstances where decision making goes awry: when we panic and when we choke.
Panic is an undue focus on one issue and one issue alone. Investment markets in March were in a panic and unable to think beyond Covid, leading to suboptimal decision-making, particularly when selling after markets had fallen so far. Choking is thinking of too many variables. This is actually more prevalent in the sports world. If anyone has seen a sports person choke from a winning position, or just generally, afterwards they will often talk about losing their flow and trying to correct too many things. Arguably it would be easy to choke in investment markets today given so many uncertain issues exist. The key is to find balance between focusing unduly on one issue and focusing on too many.
The way we think about current investment markets is really to try and find a small number of big things from which to make decisions around. We won’t get everything right, but it gives us an effective framework for day-to-day decision making. Financially we think the generational shift in Fed policy is critical, sustainably we think about digitisation, decarbonisation, health and hygiene as key trends. These are the key things which are influencing our thinking currently, allowing us to make effective decisions on your behalf.
The latest investment performance data provided by the MSCI UK Monthly Index indicates a relatively stable position, with total returns in September of +0.3%. This marked the sixth consecutive month of improvement with returns back to pre-crisis levels. The key theme currently faced by owners of property is one of polarisation between sectors. The COVID pandemic has accelerated diverging occupier trends that already existed, with many high street occupiers looking to rationalise store numbers, whereas demand for logistics and warehouse space has surged, as more consumers switched to online channels.
The outlook for retail and leisure assets remains weak in the near term, with a second lockdown compounding the issues faced by businesses in this sector. More business failures and CVA announcements are anticipated and rent collection could prove to be challenging. In contrast though, the industrial sector has coped with the crisis relatively unscathed and surprised on the upside. Data from DTRE shows that for the nine months to September, take-up levels for "big box" logistics warehousing are up 69% year-on-year. A second lockdown is likely to see e-commerce rates pushed up again, so momentum in this segment of the market is unlikely to cool, particularly as online demand is likely to settle at a higher level.
The impact of COVID on the office sector is still to be determined. As businesses take stock of the implications of the pandemic, and come to terms with what it means for their office requirements and how they utilise space more effectively, decisions are postponed. This has been reflected in very low levels of take up so far this year. The overwhelming majority of office occupiers, where possible are likely to put off decisions until 2021. To date though, there has been little evidence of downward pressure on headline rents as new and refurbished space remains in such short supply.
On the investment side deal volumes increased to £1.2bn across London in Q3 which is double the £595m that traded in Q2, as a result of months of pent up vendor demand. Since the beginning of August, there has been approximately £3.4bn of sales come to the market, across 53 properties.
Investment volumes in September reached £700m, up from the £370m transacted in August. Activity is definitely picking up despite continuing and potentially increasing COVID restrictions.
Evidence suggests that demand for high quality space remains strong across major markets, with occupational enquiries in play in each of the major CBDs. Vacancy rates are still well below average and many occupiers will retain space to accommodate office redesign strategies. We expect the downturn initiated by the COVID-19 pandemic to be short-lived in terms of rental impacts and therefore a recovery is predicted for next year.
There are different outlooks for different sectors within Property. Retail will continue to struggle as high street stores close their doors. Office space will still be a viable investment but buildings will be used for more collaborative approaches so redesign will be vital in terms of having more large spaces and less desks. Many of our current office buildings are focused in London and the South East which are the top performing regions which we expect to continue. Industrial properties also provide strong growth potential as online businesses such as Amazon and ASOS continue to look for out of town storage and delivery facilities. We do expect challenges on property over the shorter term due to recent shifts away from retail and office and more on warehouse and alternative property, such as residential estates.
The current cash level in RLP Property fund is around 10%. The fund sees inflows of around £400-500m annually which means the liquidity profile is strong and we can purchase properties without having to sell something first. This provides us with the opportunity for property to continue adding real value as a diversifying asset class within a portfolio.
The second lockdown is expected to last until 2nd December, while the government has extended the furlough scheme until the end of March 2021. They have also increased the self-employment income support grant. Unlike lockdown 1, the impact on the economy is expected to be smaller as a greater proportion of business can remain open.
As expected, the Bank of England (BoE) kept the bank rate at 0.1%. The big surprise was the extent of further quantitative easing (QE) – its bond buying programme. Instead of the £100bn we were expecting, the BoE has raised planned government bond purchases by £150bn; it plans to keep the pace of government bond purchases steady for now. By contrast, the stock of corporate bond purchases remains at £20bn, with the BoE not committing to any additional corporate bond buying.
To put this into some context: completion of the extended QE programme will take the stock of bonds bought by the BoE to £895bn, of which £875bn will be conventional gilts. At the present time, the size of the UK conventional gilt market is £1.8tn. This increased during the QE programme, reflecting the rapid rise towards a £400bn public spending deficit. In broad terms, the BoE is heading towards owning half of the conventional gilt market.
Somewhat surprisingly, given the lower economic projections, inflation is expected to be 2% in two years’ time in the Bank’s central projection, as the impact of spare capacity on inflation will be a little less than expected.
Did we just get the worst case scenario in the U.S. election? A closely contested Presidency which now has been called but litigation risk remains and a Senate which didn’t flip so ensuring no easy path to Fiscal stimulus. Oh and we have a resurgence of lockdowns in Europe and a hard Brexit (still) on the table, yet our markets reacted to all of this with incredible calm.
The events of last week hours are unremarkable to us because credit markets are underpinned by continued central bank support, and with the BOE the latest to expand its QE program, we see this continuing well until the pandemic dissipates.
Whilst the last few weeks saw our markets cheering a Blue wave (in terms of short-term additional support for our markets) we recognised the cost of this would have been medium-term pressure in terms of taxation and regulation constricting valuations. We therefore see the market cheering congressional deadlock (albeit with a politer tone) as an equally rational response – we now have no medium-term headwinds and as an asset class we really should be significantly tighter spread wise.
From a policy perspective healthcare reform is now back with the Supreme Court to possibly strike down with no replacement (with mixed impacts in the credit world but all within current expectations). Energy is in a marginally weaker position (larger stimulus would help the oil price through the demand side) but any radical changes (fracking bans) are now off the table. Tax increases will likely need another Senate election so we are at least two years away from any real dent on corporate valuations. This also removes the headwind of a steeper government yield curve which means that government yields will likely remain suppressed. We see the first check on protectionism for a few years which will be good for the more cyclical parts of our market (autos in particular).
We expect the recent lockdowns in Europe and the UK to be followed by State lockdowns in the US as there will be a winter effect (especially in most areas of the world without closed borders or an effective test and trace system). Equally the economic impact of these lockdowns is smaller and less significant than earlier in the year due to policy support (fiscal and monetary). Even our most Covid-19 facing credits (despite six months of zero revenues in some cases) have better liquidity now than they had in March. Whilst there are credits that will default, we think this will simply bring forward the date for some parts of our market with a negligible impact on the rest. Our default rate expectations are incredibly benign, especially in Europe where the lockdowns are the most severe.
So we have policy support (via the Fed), plentiful liquidity at our companies supressing defaults and fewer alternative income yielding assets – it leaves us as bullish on our asset class as we have been as we still think markets are not reflecting the reality in front of them. The credit curves are incredibly flat and spreads remain elevated – over recent weeks we have been active adding higher beta credit risk in our Global High Yield and MAC Funds – a mix of Covid-19-exposed survivors (eg Expedia), recovery stories where new equity has been injected (Aston Martin, Rolls Royce) – as well as core stable delevering companies (Primo Water). In our short duration funds we see no need to chase the volatility in Covid-19 names as credit curves remain so flat that our core stable sectors continue to provide us with an array of attractive opportunities.
Please see our latest performance.
Past performance is not a reliable indicator of future results. The value of investments and the income from them is not guaranteed and may go down as well as up and investors may not get back the amount originally invested.