Governed Range strategic asset allocation update webinar

4 December 2020

Share

Share

Catch up on our webinar where Trevor Greetham, Head of Multi Asset at Royal London Asset Management joins Lorna Blyth, Head of Investment Solutions to discuss our proposed SAA changes.

Lorna Blyth:             

Hello. Good morning and welcome to this morning’s update from Royal London where you will hear details of the changes we’re making to the strategic asset allocations of the Governed Portfolios and the Governed Retirement Income Portfolios. My name is Lorna Blyth, Head of Investment Solutions at Royal London and we are also joined today by Trevor Greetham, Head of Multi-Asset at RLAM.

I’m going to start the session by providing some context and background to the SAA reviews that we do here at Royal London before handing over to Trevor who will take us through the results of the review, the changes we are making and the rationale. We’re likely to run for around 40 minutes and then we’re going to open up for questions. So please add these to the chat box and we’ll pick them up at the end.

So, let’s start with some context. The Governed Range is sitting at around £38 billion assets under management and it has an 11 year track record. Over that time, it has delivered strong returns. It comes with regular rebalancing and tactical changes as well as independent oversight. We set strategic asset allocations which represent our long term view of an efficient asset mix for each portfolio. That is based on the target risk metrics and long term objectives. We are one of the most diversified investment solutions around and that is deliberate. We believe that a wider range of asset classes will result in more consistent performance over the longer term, across a wider range of economic scenarios and that belief hasn’t changed.

Every quarter the Investment Advisory Committee review how the portfolios are performing in relation to the current strategic asset mix and every three years, we formally review the asset mix to ensure it remains appropriate. Really, we are doing two things here: (1) is to identify if there has been any fundamental shifts to our long term risk return forecast for each of the asset classes used but, we are also looking to identify if there are any new asset classes that we can introduce which will improve the risk adjusted returns of each portfolio.

Now, the objective of the review is to improve long term outcomes for customers across the majority of scenarios. The strategic asset allocations set the guiderails for the tactical asset allocations which are taken by the multi-asset team at RLAM. The latest SAA review was completed during the summer of this year and we’ve now gone through our governance process. We are now able to share the results of that review along with the changes we are making and to take us through that in detail, I’m going hand over to Trevor Greetham. Trevor. Welcome.

Trevor Greetham:   

Thanks Lorna. Thanks everyone for joining the call today. The main thing we have been focusing on in this SAA review, is maintaining broader diversification across a range of asset classes that we think can help us meet our long term objectives. Those long term objectives are to maximise the return after UK inflation or a given level of risk while, at same time, improving diversification and improving long term expected returns as well.

There are two main things we’ve done in this review. The first things is, we have reduced exposure to Property to increase Global High Yield. Global High Yield was an asset class we introduced in the Strategic Asset Allocation review in 2016. We think it has a lot of attractions to it. We have increased the weighting in Global High Yield and we have reduced Property by about 2.5 per cent in some of the key portfolios. You can see the numbers in a moment and that, we think, improves diversification and improves liquidity.

We’ve also taken advantage of the fact that by decreasing Property and increasing High Yield, we’ve got a little bit more risk budget to deploy within the risk targets. What we’ve done is, we’ve increased the risk level very slightly within the equity mix in order to give more access to faster growing countries and the emerging markets and faster growing sectors, particular the technology sector available in developed market equities. So, UK Equities have come down a further step after the step from 2016. Let me go through that in a bit more detail and give the investment context and then we’ll come back with Lorna on the impact on customers and we’ll have Q&A at the end.

So, the new equity split goes to 35 per cent FTSE All Share, 55 per cent FTSE World and 10 per cent MSCI Emerging Markets ESG Leaders. Let me say a little bit about that mix and we’ll do some more slides on it in a moment. The first thing is, that the UK Equity weight ends up just a bit below 40 per cent - not the 35 you see on the screen because the 55 per cent is FTSE World rather than FTSE Overseas Equities. It used to be World ex-UK and we’ve done that to allow us to use global building blocks, if we wish to, in portfolio construction. So the UK weighting which was 50 per cent has gone down to just a bit below 40.

We’ve added to the overseas exposure there by increasing the world allocation and we’ve added quite a bit more to emerging markets. Again, this is something we’ve been doing over the years and, in particular there we're using the ESG Leaders tracker that Royal London Asset Management manages. That means, it’s a Screened Index – screening out companies that do to have good environmental, social or governance track records.

We mentioned the Property allocations coming down by 2.5 per cent across the portfolios with the higher Property weights, so that’s except GP3 and GP9 and Global High Yield allocations going up to compensate. So, let’s see the numbers. I’ll leave this on the screen for a little moment and just recap the key points. The mix within equities has shifted more towards Global Developed and Emerging Markets. Property weightings have come down so, for example, you can see there in GPs 4, 5 and 6 the Property weightings are now 10, 12.5 and 15 going from right to left. Beforehand they were 12.5, 15 and 17.5.

If you look at the High Yield allocations - where is says G-H-Y, that stands for Global High Yield – you’ll see those allocations have nudged up a further element. So by introducing the asset class and then increasing it, we’ve got a bit more diversification than we had previously.

We’ve made changes as well to the retirement income portfolios, the GRIPs. The main thing we’ve done here is that we’ve adjusted the equity split in the same way – the 35/55/10 blend. Equity allocations have also gone up slightly for GRIPs 1 and GRIPs 2 as part of that risk analysis that we do to make sure the portfolios are within their risk bands. Also, we’ve increased Global High Yield and UK High Yield allocations in those lower risk portfolios as well, reducing Gilts, Index Linked Gilts and Corporate Bonds accordingly. I’ll show you those numbers as well. It is available on replay so you will be able to see these slides at more leisure and I’m sure they’ll appear in various other communications as well but these are the allocations within the GRIPs – GRIPs 1 to GRIP 5. So again, GRIPs 3, 4 and 5 the changes is the equity split and in GRIPs 1 and 2 there is also a slight increase in Equities and in the Global High Yield and UK High Yield categories.

So let’s think about these changes and put them in some context. The first is, there have been a lot of changes over the last five years within our Strategic Asset Allocation reviews. The Governed Range is, very much, a kind of living investment product and we are always thinking about the right sort of asset mix for the portfolio to try to meet its long term objectives of beating inflation.

So I joined in at 2015 – you see there at the first dot on that five year journey. We now have a multi-asset team of about 10 investment professionals and we’re quite active in our tactical asset allocation positioning. In 2016, we changed the benchmark within equities to 50/50 for UK versus over overseas – it had been 55 per cent UK so that was the first step in terms of international diversification. We have a specific allocation to the UK market which I’ll come back to later because we think that helps to ensure that we can match UK inflation over the long run through income generated by UK companies. Emerging Market exposure was introduced to the Fund shortly after that and then we added a Global Equities Fund.

We added futures and forwards overlay in 2018 – this is when we started implementing within global managed regional tactical asset allocations strategy sector, tactical asset allocation strategy and currency strategies. Those, this year, have added value and we’re talking now about the proposal to increase Global and Emerging Market Equities.

Quick look at returns. Well, this has been a very tough year, for UK assets in particular, and that has meant that our more diversified asset mix, with a tilt towards UK real assets has lagged behind some other portfolios, particularly Global Balanced Funds. So the year-to-date returns you see there – the mixed asset portfolio, I think, this is for Governed Portfolio 5 was down year-to-date by about 7 per cent as of, I think, 31 October. Markets have rallied a bit since then, as you know, so it’s not quite that bad at the moment but, if you look at what’s done really badly it’s been the UK stocks. Commodities have dropped a bit, Property has dropped a fair bit, about 5 per cent from Property and its Global Stocks and Gilts and Linkers. Index Linked Gilts have done really well. 

So, what you’re seeing there is a really wide spectrum of returns in 2020. I haven’t got the year up yet on the screen here, but the last time we saw this sort of dispersion was in 2008/2009. Similarly there, our more diversified blend underperformed in 2008 and bounced back very strongly in 2009 and we’re hopeful that the broader diversification and the more inflation-linked assets we’ve got will help us in the more inflationary post-COVID recovery. In a deflationary shock, like COVID, it’s not surprising to see Gilts and Index-Linked Gilts do really well. Global stocks have done really well on the back of the technology sector as a growth sector that tends to do well when bond yields drop and the fact that we are all now using a lot of tech. So that’s the performance context.

Talking about High Yield, in particular, the high yield market has had unprecedented monetary support. The graph you’re looking at on the screen here shows the High Yield spread over government bonds in dark blue. In red we have a survey of banks, whether they’re tightening or easing their lender criteria to companies.

The COVID shock caused a very dramatic tightening of bank lending criteria but you’ll see that the High Yield bonds spread, came back in very dramatically. That was because one of the most noteworthy things about the 2020 stimulus after COVID hit, was the US Federal Reserve earmarking a trillion US Dollars, if necessary, to buy the corporate bond market and, indeed, even the High Yield Bond ETF. This was the central bank saying that, we can’t let the credit markets fail. We don’t want to turn the health crisis into a financial crisis. So, in the same way that in 2008/9 on the screen there, the banks were too big to fail.

In 2020, it was the US credit markets which were too big to fail. They had taken the place of bank lending, got very big and immediately they got central bank support. We think that’s the sign that this, if you like, is a favoured asset class amongst central bankers at the moment and it will see support in shocks and the spreads are still fairly attractive. Bank lending, by the way, is starting to free up again a little bit. So, the most recent plot, since we put these slides together, of that red line is it’s come back down a little bit.

So adding to High Yields is something we wanted to do to improve diversification. It’s an area, that tactically, we’ve been overweight. Property is the area we reduced to increase High Yield and it’s worth, actually, just getting some long term context on Property. What you see on your screen here is a long term plot of the three main growth assets that we include in the Governed Range. So, we’ve got here UK Equity is in dark purple. We’ve got Global Equities in light purple and we’ve got Property in dark red. They’re all shown over the long run with on an algorithmic scale.

On the same scale there, you will see CPI and RPI – so Consumer Price Inflation or Retail Price Inflation. So they’ve all generated very good real returns over the long run. That’s what these portfolios are trying to do and you can see, actually, they pretty much end in a similar place to each other over this period. But Property does have some diversifying qualities. It got hit quite hard in the financial crisis in 2008 but in 2001/2/3 the dot.com crash, Property just sailed on. In this particular correction, Property has done quite a bit better than UK Equities. Down 5 per cent, it’s down about 3 per cent now year-to-date. It is a relatively modest hit given what’s happened.

I think, some people are quite surprised how resilient Property is proving and it’s worth just bearing in mind that, high street retail – the area that’s really been hurt by COVID - is about 3 per cent, 3.5 per cent of the benchmark mix that our Property Fund follows. There’s been quite a big exposure to industrial warehousing which is benefitting from the likes of Amazon selling more and needing more distribution hubs. So, we think, Property is a decent asset class. We think that, in a very low interest rate world the fact that it’s yielding 5 or 6 per cent is very attractive. It’s an asset class that we believe offers great diversification for us and helps to deliver on our inflation-beating growth mandate. But we’ve reduced it a little bit to improve liquidity and to increase diversification.

Turning to Equities, we could have designed these funds using a Global Equity benchmark so that a typical balance fund might have - I don’t know, 50 per cent in Global Equities and 50 per cent in UK bonds. If we had done this, this is the Global Equity benchmark we’d be looking at and you can see you’d have 64 per cent of your exposure in the US – a big chunk of that in the Technology sector. So altogether 22 per cent of the index and only 4 per cent in the UK. We prefer to have a more blended mix with less reliance on particular overseas markets. Now, of course, in 2020 that has led to an underperformance of our Fund versus a Global Equity Fund with the bigger UK weighting but, I’ll come back to that in a moment.

We’ve been tactically underweight the UK market. We’ve been tactically underweight Europe as well and we’ve been overweight North America and Emerging Markets. So, tactically, we’ve been tilting towards the faster growing countries and sectors. With this asset allocation change for the strategic mix, we’re enshrining those tactical positions by adjusting the overall benchmark mix of the Fund. That’s because we think that the US and Emerging Markets will grow faster than the UK over the sort of time horizon we are looking at. Now, this is partly taking into account slower growth in the UK either way after Brexit.

So if we look at the optimisation that led to this decision, this is looking at a lot of different mixes of portfolios and trying to work out what the risk return trade-off is over the long run. You can see there Emerging Markets – 100 per cent there, almost 30 percent long term volatility but with a better long term return. The UK Equities with just about 18 per cent volatility and the lower long term return.

We have been at that 50/50 mix you can see marked on the screen. What we’re doing is, because we are reducing risk very slightly by shifting Property into High Yield bonds, we have the ability to increase the risk slightly within the equity mix. That takes us from that 50/50 spot on the efficient frontier to the 35/55/10 that I’ve been describing. So it’s very much part of the optimisation, part of the process we go through to ensure that we are in the risk bands that we need to be in for your customers.

Quick word on the Emerging Markets. Emerging Markets have been growing more rapidly, particularly China, over the most recent period. If you look at the dashed line on the screen here, it shows you Emerging Markets are now 40 per cent of global GDP but they are only a few fraction of the global stock market. So we want to increase long term return. We think that diversification allows us to have more exposure to the Emerging Markets but doing it in an environmentally and socially and governance friendly way. We’d rather have more than the market capitalisation weight there so we’ve put 10 per cent into the Emerging Markets ESG Tracker as part of that mix.

Then looking at the developed markets, the big difference between the UK and the rest of the world is the sector mix. So if you look at the sector weightings in the UK market, the UK has one or two per cent in Technology versus the 22 per cent we saw a moment ago in Global Equities. The UK also has more exposure to, if you like, COVID losers and that’s something to bear in mind when we think about what could be happening in a turnaround with wide-scale vaccination. So things like personal and household goods, the financially services resources – a lot of these areas that the UK has quite heavily weighted towards have done really badly in 2020 but won’t do really badly forever.

This shows you the differences in the sector weightings and it is really Technology that stands out so by increasing the global equity element, we are getting more exposure to that faster growing sector but we are not overly reliant on it. Why don’t we want to be overly reliant on it? Well, the valuation matters here as well. The chart you are looking at on the screen here on slide 20 is long term valuation metrics for the US market, for the European market and for the UK market.

So, the European market is that sort of cyan, greeny-blue colour. This is the measure of valuation that’s adjusted for the business cycle, it’s called the cyclically-adjusted price earnings ratio. Try saying that quickly. You can see it on the axis there C-A-P-E and it was invented by an American academic called Bob Shiller at Yale University. What it does is, it takes the price and divides it by the 10 year average of real earnings for each company. So it’s really a 10 year average smoothing out the business cycles just how expensive are stock markets. You’ll see that the US is the most expensive it’s been outside of the dot.com bubble so about 30 to 35 times earnings, which is really quite expensive.

Europe’s much cheaper and the UK, the bottom of those three lines, is actually the cheapest it’s been in 30 years. It’s something like 12 or 13 times earnings, so far better valuation available in UK markets for obvious reasons. This has been a terrible year for the UK, we’ve been hurt much more by the COVID crisis in terms of deaths than any other developed economy as a proportion of the economy. We’ve also had the stock market mix that means we’ve missed out a lot of the technology boom that’s happened this year in particular because of COVID and also we’ve got Brexit risk.

If you look longer term, it makes sense to own markets that are cheaper and we think in a most inflationary post-COVID recovery, that UK allocation will come good. I think we’ve had a bit of a dress rehearsal of that really in the weeks since the vaccine announcements with the UK up 14 per cent month-to-date which is quite [something].

Worth bearing in mind as well, that the reduction we’re making to the UK still allows us to get allocations back to similar levels to what we had before the reduction by using our tactical asset allocation bandwidth. The solid line here is the UK benchmark weight. I mentioned it started off at launch at 55 within Equities, it went down to 50. In 2016 it’s going down to just a bit below 40 but we have the ability to go tactically overweight the UK and bring the portfolios back to the sort of levels we had before. I mentioned this slide because, when we speak to advisors about these sorts of changes, some people think we’re too late to make the change and some people think we’re too early. The point is that we do have that tactical bandwidth and if the UK really starts to outperform, we can move the UK back up again using the tactical asset allocation.

Commodities are also something which could do better in a more inflationary recovery. This is a chart showing Chinese industrial production which has bounced back very sharply. China is strengthening a lot. President Xi of China has said he wants to double the size of the economy by 2035. That works out at, roughly, a 5 per cent growth rate every year. If China starts to delivery on that promise, then I think commodity markets could do a lot better.

One of the reasons that the UK market has underperformed the rest of the world in recent years, is the weakness of commodities. In the first half of that long term chart we showed earlier on with Property, the UK was outperforming because China was building cities. So there could be a bit of a turn going on at the moment in long term inflation, partly because of China but also, if you think about, because of the amount of debt that the developed economies are building up because of COVID.

When you have a big debt mountain, you can try to go through austerity. I think that would, politically, very difficult. You can try to raise taxes aggressively but if you do that you could hurt growth and growth is very important when it comes to paying debt down. Or you can keep interest rates too low and let inflation rise a bit and that’s called financial repression when interest rates are too low. Allowing inflation to rise a bit obviously does benefit the more inflation seeking asset classes that we have quite high allocations to.

So let me wrap up, before handing back to Lorna by recapping the sort of asset mix that you get when you buy a Governed Portfolio.

I’m highlighting here GP5 which is the middle fund in the balanced lifestyle journey. GP5 has roughly the same level of long term risk as a Global Balanced Fund with 50 per cent in Global Equities and 50 per cent in UK bonds. But let’s compare GP5 in a few different ways with that Global Balance Fund. So GP5 has about 50 per cent of its exposure in asset classes you can argue, have a passing acquaintance, at least, with UK inflation. So I’m including there UK Equities. We know there’s lots of global exposure in UK Equities but it’s also the market with the most domestic exposure and as UK companies raise prices and pay dividends, that’s quite a close link in the prices and the dividend growth of UK companies with UK inflation.

We’ve also got the 12.5 per cent exposure with the reduced figure to UK commercial property. Again rents, over the long run, you’d expect to grow with UK inflation.

We’ve got 5 per cent exposure to the UK Index Linked Gilts and their coupons grow with UK inflation. That brings me to 45 per cent – if I add in Commodities as another inflation hedge that we have that a global balanced fund wouldn’t have, we’re up to 50. So in that balanced fund, 50 per cent of the exposure is in asset classes that have a linkage, of some kind or other, with UK inflation. If you look at it in terms of the income generated by the fund, two-thirds of the income generated into GP5 is UK real income of one form or another.

Just to mention, in passing, the Global Balance Fund I’m talking about there would have 50 per cent of its assets in Global Equities of which only about 2.5 per cent would be in UK Equities and that’s the only asset class in a Global Balance Fund that has any link to UK inflation. So 50 per cent versus 2.5 per cent and in income terms, about two-thirds of income which is UK real income in a Global Balance Fund you’ve got 7 per cent.

Now obviously Global Balance Funds have done really well in 2020, a deflationary shock has been great for Gilts, it’s been good for the technology sector. Tactically, we still like the technology sector – we’re still overweight the technology sector, but on a longer term basis, we think this broader diversification with a closer link to what the fund’s objectives are with the UK real assets makes sense. So we’re different but we’re deliberately different. Lorna.       

Lorna Blyth:             

Hi guys. So this slide here shows the impact on customer outcomes. So every time we look at and review our strategic asset allocations, we’re looking to make sure that the changes we’re making can improve outcomes for customers. We look to do that across a wide range of scenarios. So what this table is showing here, is a typical customer and we look at a poor scenario which is represented there by a fifth percentile value. We look at an average scenario which is represented by the expected value and we look at a good scenario which is represented there by the 95th percentile. We do that across the Governed Portfolios, so all nine of them, and we also do that looking at the GRIPs which are on the next slide and again showing that the proposed strategic asset allocation changes improve outcomes for customers across the majority of those scenarios.

You can find all of this information and more details of the changes that we’ve been talking about on our website. There is also a brochure there that has these numbers in it so you can get that. We will also be sending these slides after the presentation so you’ll get a copy and you’ll be able to look at that in a bit more detail yourself.

So, in summary, I think that then talks about the fact that we are increasing our expected returns from the current levels while maintaining the risk adjusted efficiencies. We’ve had a few questions about whether these changes will impact the risk profile of the portfolios and their DT ratings for example or the different third party risk mappings that we have for the portfolios. But when we’re looking at our asset allocations, we’re not looking to change the risk profile so all of these changes keep us within our current risk targets that we have set. What we’re trying to do is improve the returns that we achieve while maintaining that risk profile so we don’t expect any changes to any of the risk ratings that the portfolios are mapped to.

We are looking to diversify across regions and sectors and Trevor spoke about gaining more exposure to faster growing sectors and countries and that’s what the equity change is designed to do. That equity change will take place through the Global Managed Fund which will impact all of the Governed Portfolios and all the GRIPs. We are looking to improve outcomes relative to UK inflation. These portfolios are designed for our pension savers. We have UK customers and so the objective is to maximise returns above UK inflation so that’s the kind of North Star that we look to design them around. We believe that these changes will help us to do that.

There is a slight adjustment to the Property weightings and that really reflects a change in the kind of shift in the correlation that we see of Property with Equities over the longer term. Again, we’ve got a slight change to High Yield exposure where we are increasing that slightly. Again, just to improve some of the liquidity across the portfolios and improve the diversification.

I think another key point really is, that all of these changes are in line with where we are tactically positioned. So, we’ve had quite a questions in around our UK positioning and when’s the right time to reduce UK and is this the right time based on what’s going on in the UK market and we’re saying the UK market’s cheap. But what we’ve shown here are the numbers - or the SAAs, and they’re the guiderails. Tactically, Trevor will be positioned overweight or underweight based on the current market views. I don’t know, maybe, if it’s worth talking a little bit more about where we are positioned tactically at the moment, Trevor?        

Trevor Greetham:   

Yes, so let me chip in on that. So, there’s been a question as well about reducing Property and are we going to be selling buildings into a poor market? The property weightings have already declined and they’ve declined over 2020 when we had the period when the funds were suspended across the market and assets were still coming in to the Governed Range and equity markets were going up. So the property weights we’ve been monitoring very closely, have actually drifted down to the sort of levels anyway that we would be moving to tactically. So we’ve been underweight Property already and the benchmark weight, if you like, is coming down towards the actual Property weights. So there will be no selling of buildings required in this change.

Also, tactically, we’ve been really quite largely overweight High Yield bonds all year and that’s benefitted the portfolios because already overweight the High Yield bonds, when that benchmark weight comes up, there’s no trading we have to do. We may decide actually to buy some more but we don’t actually have to trade the High Yield bonds in order to make the benchmark change.

Within the UK and global equity element, there are some moving parts here, so since 2015 when I joined Royal London, we’ve consistently been underweight the UK. It’s almost always been our least light equity market tactically. Recently, we’ve actually rated up to neutral so in the last few weeks we raised the UK to neutral because we started to see better performance. Well, actually, the first reason we raised the UK towards to neutral is Brexit. Just to say that point because Brexit, whether there’s a deal or no deal, it can impact the pound which can have an impact on which way the UK stock market goes. Because we don’t have a crystal ball, we wanted to be taking less risk on our UK position so we raised the UK towards neutral and then we got the vaccine news and the UK is doing better.

We may find ourselves overweight in the UK in 2021, tactically, but that means, as the weight comes down the implementation of this benchmark change will be over the next couple of months, we can actually move tactical asset allocation the other way and end up with the similar sort of exposure that we had before to the UK. So tactical asset allocation has already been overweight High Yield, overweight Technology, overweight Emerging Markets. We’re moving the benchmarks in those directions but we still have lots of tactical bandwidth to reflect what we think is happening on a shorter term basis.

Lorna Blyth:             

Yep, and it’s worth saying, so while the Property and High Yield changes have kind of naturally shifted because of the way markets have been over the year, the equity changes haven’t been implemented yet and that’s something that will take place over Q1 and Trevor and his team will decide when’s the right time to do that.

We’ve had a question on how much of a drag has Brexit been on UK Equities and how do we see that lifting as we get past the end of December?

Trevor Greetham:   

Well, regular followers of my analysis over the years will know I’m not a great fan of Brexit in terms of its impact on the economy. The long term impact of Brexit – if you remember under Theresa May’s government, there were estimates made of what the long term impact of Brexit would be and the Free Trade Agreement that Boris Johnson is trying to get, would have shrunk the economy by 6 per cent over 15 years whereas no deal would be shrinking the economy by 9 percent. That is part of the thinking to reduce the strategic weight of UK Equities. If you’re looking for growth in the world we are actually deciding, for one reason or another, to reduce our growth rate – that’s just part of the trade-off involved.

How much has it impacted UK Equities? I think it’s been in the mix but, to be honest, by far the biggest impact in 2020 has been COVID. It’s been the real hit to retailing, to leisure, to services, to financial companies and to the resource companies when commodity prices dipped. That’s caused this really tremendous underperformance of the UK. It’s the biggest relative underperformance in a one year period I think the UK has seen, ever. That’s mainly what we’re talking about right now so let’s try and separate out the short term effects and that could bounce back versus the long term growth story where, I think, Brexit is part of various calculations that have resulted in the reduction in the UK and the increase to faster growing areas. 

Lorna Blyth:             

We’ve had a few questions on inflation. So, obviously, we’ve talked about the fact that these portfolios are designed to maximise returns above UK inflation. What’s your views on the inflation outlook in the UK, Trevor?

Trevor Greetham:   

Well, in the near term, it’s a bit tricky to say. So, in the near term you’ve got lots of countervailing forces. So while social distancing is in force, there’s a reduced supply potential of the economy and that means that demand picks up. It could be that inflation picks up in some areas in the short term. So, for example, if a lot of factory workers are off work because they’re unwell or they’re self-isolating and we all go the online shops and try to buy their products, they’ll raise their prices because they’ll have to ration that reduced supply. So you will see areas of inflation.

If there is a no deal Brexit and we get tariffs, then you’ll see areas of inflation. There could be quite a big increase in, you know, Danish butter prices apparently. But, on the other hand, unemployment has been rising. If companies are actually laying people off and that takes some time to bounce back from, then that could push wages lower and inflation lower. So, in the shorter term, I think it’s a bit difficult to say. I think there could be some very short term effects around the end of the transition period. Inflation could stay quite low for a year or two but if stimulus stays in force, as I expect it to, and if the economy bounces back really quite dramatically when social distancing ends, I think inflation over the longer term is likely to rise.

There is that incentive, if you are the UK government and your debt to GDP ratio is risen over 100 per cent and you find it hard to do austerity or you think that’s not the right thing to do and you don’t want to hurt growth with tax rises, there will be a temptation to let inflation overshoot. It could be operated through the Bank of England, by the Bank of England dressing it up in a different way saying, there are so many risks in terms of big balance sheets out there that we want to err on the side of avoiding deflation.

If you look around the world and other central banks have actually shifted their inflation targets to say, it’s ok to be above inflation targets for a period of time after a deflationary shock has happened in American and in Canada. So, I think, it is a longer term story the inflation. Shorter term, it’s hard to say. Inflation could actually drop if there’s lots of spare capacity for a while but, I think, on a five to 10 year horizon I would be betting UK inflation will be higher than we’ve been used to.

Lorna Blyth:             

Thanks Trevor. We’ve had a few questions in on Property as an asset class. We have got fairly high levels in Property compared to many of our competitors, I guess. So we’re getting asked, why we have that. We’ve also had a question around the FCA as we know, are looking to potentially implement a 180 day notice period. How might that impact the portfolios?

Trevor Greetham:   

Okay. Well, obviously I’ll take the FCA point first. That’s an open consultancy exercise at the moment so we'll have to wait to see what the results of that are. With the Governed Portfolios, we’ve got lots of moving parts so we have a lot of liquidity in the funds in terms of new premiums coming in. We managed to navigate, if you like, a period with the Property funds entirely frozen for flows over 2020 so having a slightly longer delay in getting money in and out of a Property fund we don’t think is actually going to change the way these funds operate in a meaningful way. So that’s the first point, that we aren’t sort of day trading with lots of flows in and out – we’re managing a long term pensions’ proposition so, for us, I think it would be relatively straightforward to adopt new rules if they come in.

The asset class itself though does have some really, really great long term properties. So, we saw that chart – I’ll just flip back to it actually if I’m still sharing my screen, if I can do that – which compared the performance of Property to Equities. So this was the chart and that solid red line, the dark red line, is Property. So there is a kind of long term diversification sense here. I mean, there is a similar long term return but, as I mentioned, if you look at the recessions - which are those shaded, vertical, purple areas of the four recessions on the screen there - in 1990 Property we didn’t get hurt very much. In 2000 it kept going up. In 2008, it got hurt as much as Equities. Then in 2020, it depends, it was better than UK Equities but worse than Global Equities. So there is an element that Property is smoother return generator and, sometimes, it will behave quite differently in a recession and that can be really helpful in terms of long term returns.

Also, it’s an asset class that’s yielding five or six per cent. If we’re right that interest rates stay too low and inflation is allowed to rise, you can buy that asset class shielding five or six per cent, you know, out of bonds or out of cash yielding nothing. So, you’re picking up that income. So if you’re picking up at the five per cent additional income every year for five years, it doesn’t matter if the capital value falls 25 percent, you still break even. So I think there is a big attraction to property because of its income generation and that income can grow.

There is more adjustment to be had, particularly in the retail sector so we don’t think property is necessarily at its low point yet, it may continue to drift lower for part of next year. But we think in the longer run you are buying an asset yielding five or six per cent, it’s a cheap asset, you’ve got very cheap funding and its income should grow in the long run in line with inflation. So it’s an asset class which is a pain to manage at times. We have a very large property team, a very professional team, out there with surveyors looking at buildings all the time. It has its difficulties but as a big insurance provider with the scale to do it, it’s something we can offer which I think is a real benefit to the portfolios.          

Lorna Blyth:             

Trevor, when you take your tactical decisions I’m aware that some of those are taken through the use of derivatives and some are not so we’ve been asked specifically around our Global High Yield exposure and how do we capture that?

Trevor Greetham:   

Yes, good question. So the tactical positions I’m just flashing up on the screen here within Global Manage, where we say things like we’re underweight UK or overweight Emerging Markets, we typically use futures within the Global Managed Portfolio. If we are adjusting currency positions, we’ll use currency forwards. We also use futures for the sector positioning and that’s something we introduced to the funds a couple of years ago. So there are sector futures in America; you can buy a Future which, rather than tracking the S&P 500, just tracks the technology sector and so we have long and short positions in these sector futures to take tactical views as well.

With Global High Yield, we don’t use derivatives for that. We buy one of two funds within Royal London, it’s a Global High Yield fund and there’s a short duration Global High Yield fund and they are both managed by Azhar Hussain and the Global High Yield team at Royal London. Those are the ways that we get access which is beneficially actually because it means that we know the strategy that that portfolio manager is applying. For example, in recent years, he set very low exposure to the oil sector and the big problems we’ve had in High Yield in the last few years have been because of the US oil companies struggling with the low oil price. So it’s a physical exposure to the High Yield funds that get us that exposure.

Lorna Blyth:             

One question that has come in is, what are your parameters for tactical adjustments? So you had a slide there I think, that showed the sort of range that we could move?     

Trevor Greetham:   

Well, the parameters for the – it’s a good question. I mean, the parameters – there are no set parameters but we do have risk budgets so we have tracking error limits for each of the different Governed Portfolios and that does impact on the degree of tracking error versus the benchmark mix that we will operate with in Global Managed.

We are also thinking about what we’re trying to achieve with tactical asset allocation and, over the long run, we’re trying to add an average of about 1 per cent of additional return a year which compounds up very well over the long run. Because we’re not trying to shoot for the fences if you like, there is a limit implied on how much we move exposures around.

While the UK is a big part of the strategic asset allocation, it’s just another market in the world of tactical asset allocation. So even though the UK has got a big weighting there on the screen, we won’t be overweighting and underweighting it by 30 or 40 per cent to buy a different market. We’ll think about each market in a tactically sense on an equal footing and that means the amount we are underweight or overweight the UK will be similar to what we would do with European markets or the US or Japan say.

I’ve tried to put on the screen a kind of rough idea of the sorts of parameters we are likely to operate within depending on levels of conviction. So a high conviction overweight in the UK market after the benchmark change will get us back to a similar sort of weighting to a neutral to slightly underweight conviction prior to the benchmark change. 

Lorna Blyth:             

Okay. We’re getting lots of questions on Property and outlook for commercial property in the different sectors and I think actually, it’s maybe worth us running a separate webinar specifically on Property as an asset class. We’ll look to do that to kind of take you through and hear directly from the fund manager and I think that would be quite useful for lots of people in the call. Yeah. So if we come back, there’s still quite a few coming through on commodities, your view on gold within the Commodities sector?

Trevor Greetham:   

So Commodities generally, they’ve been a relatively poor performer. We’ve put them into the portfolios in 2016. The primary reason for putting them in was to improve diversification and resilience to inflation shocks. What we’ve seen since then are deflation shocks, so I’m not surprised that the performance hasn’t been brilliant for Commodities over that period but, again, the world is changing I think in terms of Chinese growth which is a big driver of commodities, so we could see some better performance there.

We do think quite carefully about the sectors within Commodities and I think you’ll start to see sectoral positions within Commodities put up from time to time.

Gold tends to do best when the dollar is weak and when real interest rates are dropping. So there have been periods in 2020 when it has been a very strong performer. About 25 per cent of your Commodity exposure through the Governed Range is in gold and precious metals so we’ve had some exposure to that but obviously oil has done much worse and that’s what’s been affecting the overall return.

Gold specifically – it’s a bit of a two-way pull for me because I think the dollar could continue to be weak and in the near term, given the virus acceleration going on in America and the lack of proper lockdown to cope with it at the moment, I think we could see a period of dollar weakness and that would help the gold price. But if you start to see the reflation trade take hold, where people start to say I can see across the valley there’s going to be a proper recovery in 2021, then you might find real interest rates start to rise. If real interest rates rise, that’s really bad news for gold. It’s had a brilliant time in 2020 but I think it’s a bit more mixed for 2021.

Lorna Blyth:              

So speaking of interest rates, is there a chance that interest rates remain low and the potential of inflation rising that then triggers a flight to risk and keeps equity asset prices high for a long period of time?

Trevor Greetham:   

Yes, it’s quite plausible. We’re doing an asset TV webinar later on within RLAM on the outlook for 2021 and it will be broadcast later on and that’s one of the things we’re really thinking about.

I think the real question is, do central banks keep rates too low for too long? If they do, then that does build up for more inflation pressure but while those interest rates stay low if they can keep the bond yields down as well then the valuation of these expensive growth sectors doesn’t get hurt too much.

So in terms of the stock market, the best possible outcome is that interest rates actually stay low throughout 2021 and into 2022 and bond yields stay low but there’s a recovery. So the value sectors – the UK market, the oil and gas sector – all of these sort of sectors outperform but at the same time you don’t get a drop in the price of the technology stocks.

If you have an environment where bond yields rise sharply so central banks signal they are going to start tightening at some point and they let bond yields rise sharply, then you might get a year – I mean, we’re old enough to remember this, like 1994 and in 1994 although there was a strong recovery and Commodities did well and Property did well, the overall stock markets struggled. It was sideways to down because the growth sectors saw their price earnings multiples drop.

So that’s the really key question. I think it’s a great question. We don’t actually know the answer but my inkling is that central banks will err on the side of doing too much [stimulus] still rather than too little. That’s because there are going to big uncertainties about the rollout of the vaccine, how many people take it, is it available in the right places, will there be mutations in the virus? I’m optimistic but I still think central banks will err on the side of caution and they’ll keep interest rates low. 

Lorna Blyth:             

Thanks Trevor. Okay. So just to kind of wrap up then, we’ve had a few questions around the communication of the changes so, as I said, on the website at the moment there’s details of the changes that we’re planning, there’s a brochure that talks in more detail around the numbers and once the changes have gone through we will be communicating that at that time so look out for that.

We’ve been asked about whether – we’ve talked about the fact that we’ve got Emerging Market exposure and that’s through an ESG Screened Index and how we will be looking at applying the ESG more broadly across the portfolios. There will be more information coming out around that as well and Q1 so keep your ears and eyes peeled for that.

I think the final thing to talk about is, within the Global Governed Portfolios and the GRIPs, there is that flexibility to remove Global Managed and add in additional equity funds from our range. A couple of people have asked, in particular around global sustainable equity fund which is available in our range and also the world wide fund which is run to a more global market cap index. We do have alternatives. Obviously using the Global Managed, that gives you the strategic asset allocation that we’ve worked through and that’s the governance and the process that we follow. That gives you your risk rating but there are options to replace that with another if you’ve got a different view on the outlook.

Okay. Now the questions that have come through, we haven’t answered all of them but some of them are getting into a bit more detail so what we’ll do is, we’ll have these all captured and we’ll be able to respond individually to the people that have asked these questions. We'll get back to you on email with the rest of the answers to the questions that are there.

In the meantime, I would like to thank you all for your time today. Thank you Trevor and everybody stay safe. Thank you.         

Trevor Greetham:   

Thank you. Bye-bye.

Lorna Blyth:             

Bye-bye.

This website is intended for financial advisers only and shouldn't be relied upon by any other person. If you are not an adviser please visit royallondon.com.

The Royal London Mutual Insurance Society Limited is authorised by the Prudential Regulation Authority and regulated by the Financial Conduct Authority and the Prudential Regulation Authority. The firm is on the Financial Services Register, registration number 117672. It provides life assurance and pensions. Registered in England and Wales number 99064. Registered office: 55 Gracechurch Street, London, EC3V 0RL.