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Sector strategy 2016

Gill Hutchison

Gilts and the inflation spectre (October 2016)

Gill Hutchison is Head of Investment Research at The Adviser Centre by City Financial.

Fixed income allocations in portfolios, and more specifically gilt allocations, have been strong performance drivers for much longer than many commentators expected. There was much fretting about gilt valuations when the 10-year was still yielding well over 2% a few years ago. In August this year, 10-year yields almost touched 0.50%. At that moment, there was a feeling that the market was ringing a bell for the low in yields for this extraordinary, if distorted, phase in markets.

Since then, gilt yields have indeed marched upwards and at the time of writing, the 10-year offers a yield of 1.12%. This is a nasty reversal in fortunes for gilt investors but in spite of this short-term knock, the year-to-date return for the broad gilt market is not far off +12% for the year until 13/10/16.

This recent slide in gilt prices means that UK government bonds are underperforming other sovereign bond markets. Renewed sterling weakness and worries about increasing inflation have inevitably rattled investors, as has the government’s apparent “hard Brexit” stance. Last week’s “Marmite” spat between Tesco and Unilever was a newsworthy sign of the pressures that are undoubtedly coming up the tracks.

Inflation and negative real yields

Monthly inflation data released on 18/10/16 showed inflation (CPI) rising faster than expected, to the highest since November 2014, and given the weak sterling effect, upward pressure upon inflation will only intensify. A higher oil price is also playing its part in pushing up prices.

If gilt yields stay where they are, real yields will be significantly negative next year; the last time this was the case was for a brief period after the global financial crisis, when sterling’s devaluation also led to a sharp rise in inflation - gilts were being bought by the Bank of England then as well. History tells us that authorities rely on negative real yields to finance their past debts and herein lies the major risk for investors in bonds.

Turning fiscal

Authorities are finally admitting openly that financial repression, which is occurring through the process of ultra-low interest rates and quantitative easing, is not the answer to a maiden’s prayer for the economy. Fiscal stimulus is the new (old) game in town.

It sounds like a logical plan, especially when governments can raise funds at yields of next-to, or less-than-nothing. This assumes there are adequate buyers of the debt, of course, and in the case of the UK, this is a moot point. George Osborne’s aspiration for a budget surplus by 2020 has been cast aside and Philip Hammond has signalled a new phase of borrowing to mitigate the effects of Brexit-related uncertainty. With the value of sterling sliding away and a deteriorating national balance sheet, the “kindness of strangers” - the overseas buyers of our debt - may well become more elusive. With gilt yields already on the rise, the UK government is likely to find that increased borrowing will not come quite as cheaply as it had hoped.

When it comes to the long-term effectiveness of fiscal spending, the jury is out. While followers of Keynes would argue that increases in government spending result in much larger increases in overall spending, there is also evidence of contrary effects. We can look at the experience of Japan for reference, where repeated fiscal expansions over the last 25 years, notably through infrastructure spending, have done little to spur sustained economic growth. The reality is that bouts of fiscal stimulus may simply pull forward economic growth from the future, storing up problems for a time when government spending recedes again.

In the meantime, the temporary but positive impact of fiscal spending upon growth brings with it the risk of pushing inflation sharply higher. History also shows that this is particularly the case when unemployment is relatively low, as it is in the US and the UK. Such a course of events clearly runs the risk of causing a disorderly re-pricing of the rates markets and bond investors are now eyeing this possibility nervously.

Duration effects Until the past few months, fixed income managers have had little prospect of keeping up with their benchmarks if they have been underweight in duration, even by a modest degree.

Given the unappetising risk/reward picture for government bonds, most bond managers have, logically, been light on duration. This is most vividly seen in the IA £ Strategic Bond sector. With less interest rate sensitivity in aggregate, the sector has underperformed the IA £ Corporate Bond sector over one and three years (to 13/10/16, source: Morningstar). In turn, the IA £ Corporate Bond sector has underperformed the IA UK Gilts sector over these time periods.

Now, the tide is turning and those funds with the least interest rate sensitivity have been outperforming over the past few weeks. Why hold gilts now? Unappealing as UK government bonds look at the present time, given that we can’t predict the future, there are reasons to maintain an allocation. One is the possibility that the fiscal push fails to materialise and low interest rates and quantitative easing stay with us for the very long term. Another is that government bonds provide one of the few easily accessible refuges in a time of crisis. Finally, if the world adjusts to higher inflation and higher interest rates, bonds would decline, but in all likelihood, equities would be worse!

Gill Hutchison Head of Investment Research, The Adviser Centre 18th October 2016

Visit www.theadvisercentre.co.uk to access our free-to-air fund research and consultancy service 

Disclaimer: No information or opinion contained should be construed as a solicitation or a recommendation with respect to the purchase or sale of any investments nor does it contain the necessary information on which to form the basis of a decision to invest in any investment product. Opinions are always stated honestly and with careful consideration but they can change at any time and should not be relied upon. Any investment’s value and any income from it may fall as well as rise, as a result of market and currency fluctuations. Investors may not get back the amount originally invested. Please be aware that The Adviser Centre, a trading name of City Financial Investment Company, does not offer investment advice.


Gill Hutchison

Desperately seeking equity income (August 2016)

Gill Hutchison is Head of Investment Research at The Adviser Centre by City Financial.

Investors looking for income from equities have a wide variety of funds to consider, over and above the traditional starting point of the IA UK Equity Income sector.

Ultra-low interest rates around the world have spurred a search for income that has extended investors’ exposures, both down the market cap scale and across to overseas markets that would not previously have been considered, or indeed been available. If we thought emerging market income products were stretching normal boundaries, they were exceeded a few months ago when we spotted an advert for a biotechnology product that specifically targeted investors seeking income. This reminded us of the dangerous days of the TMT boom, when unsuspecting retail investors were encouraged to sample the delights of European small-cap technology growth funds, and we all know what happened next…

Many flavours of UK equity income funds

For UK investors, another driver behind this extension to less typical income-paying areas has been nervousness around the concentration of big dividend payers in the FTSE 100 index. The issue was brought to a head in the aftermath of the tragic events of BP’s Gulf of Mexico disaster in 2010, after which the company’s dividend was suspended. The more recent tribulations in the oil & gas sector have once again brought dividend policies into sharper focus. According to the FT, Royal Dutch Shell accounts for over a tenth of total dividends paid by UK companies; while it seems unlikely that the firm would choose to overturn its promise to uphold the dividend (and many investors are relying upon that), should the oil price remain at these lower levels for an extended period of time, a re-consideration of this promise would likely be brought to the table. That would be quite a shock for the UK market.

In response, the IA UK Equity Income sector now features greater diversity, affording investors more options if they wish to steer away from the traditional blue-chip hunting ground. A greater number of managers use the flexibility of the IA’s sector rules to extend their portfolios to overseas stocks (up to 20%) and furthermore, several all-cap managers have been building track records in this space. Notwithstanding this year’s sea-change in relative performances between large, mid and small caps, all-cap managers have had a fair crack of the whip in the past few years. A benign environment for medium and smaller companies (including a relatively low cost of capital) has supported these businesses and hence their ability to sustain and grow their dividends.

The IA Global Equity Income sector

Although still relatively small, the IA Global Equity Income sector features funds in a variety of shapes and sizes and therefore with different risk and return profiles. Illustrating this, the top-performing fund over the past 12 months to 29/07/16, Newton Global Income (Recommended within The Adviser Centre), has delivered a return of around 32%, while funds at the bottom of the table are in single digit territory (source: Investment Week/Morningstar).

Clearly, the global palette of these funds increases the opportunity set and therefore the range of possible outcomes, thanks to variations in geography, market cap and currency. Given sterling’s fall during 2016 so far, currency has been a defining factor in the outcome of globally-exposed funds for UK investors. Indeed, the returns from unhedged global funds so far this year have been nothing short of staggering! The other important point of note concerning global equity income funds is that currency fluctuations also impact upon the sterling value of dividends. Therefore, there is scope for a greater degree of variability in income payments than investors experience from UK-only income funds, as currencies fluctuate.

Universal income challenges

Whilst the opportunity set for global funds is far greater, managers have been grappling with many of the same challenges as their UK equity income brethren.

  • “Expensive defensives”: some sectors, notably consumer staples (food & beverage, tobacco) – a natural hunting ground for income investors - have become expensive the world over.
  • Value: Cheaper areas of the market are often more troubled, which calls the level of future dividends into question. Areas such as oil & gas, mining and banks are nerve-wracking areas for income managers.
  • Emerging markets: Until this year, emerging market exposed stocks have faced headwinds.
  • US: more a problem for global equity income managers, the US is a lower yielding market and yet the index has been a persistent outperformer. Furthermore, the US dollar has been strong.

Extended valuations = stark choices

According to analysis from Lazard Asset Management, high yielding stocks globally have outperformed since 1990 and particularly since the TMT bust at the beginning of the century. This period coincides with the long march downwards in bond yields around the world.

Dividend-paying stocks have been supported by the dual tailwinds of the powerful demand for yielding investments, combined with the attraction of more valuable future income streams, thanks to the falling discount rate. Today, equity income investors everywhere are faced with elevated valuations for many of their preferred, dependable, income-paying stocks.

What are their choices?

  • Do they hold their noses, stick with the momentum of the “expensive defensives” and accept the rising risk of capital loss, in return for the security of that income stream? If they do this, how do they prepare their investors for the potential of greater capital losses than they have come to expect from investing in “safer” income stocks, especially after such a favourable period for this style?
  • Or, do they look elsewhere for income, those cheaper sectors and/or non-household names that, whilst unloved, may ultimately offer less capital risk (because of their already low share prices) but can still deliver resilient, and preferably, growing dividends? If they do this, they must accept the risk of missing out on the momentum that is still taking the beloved income stalwarts higher.

Practically speaking, most income managers reside somewhere in between these two extremes. Unsurprisingly, those managers with the strongest value biases have faced the greatest performance struggles in recent times, notwithstanding a better 2016 to date. For example, Jacob de Tusch-Lec, manager of the Artemis Global Income fund (Recommended within The Adviser Centre), is grappling with these very challenges. He does not want to be drawn into stocks that have unpalatable valuation metrics and equally, he is unwilling (or unable, for reasons of income and/or quality thresholds) to move into the more treacherous deep value arena, where some strong performances have been seen this year. The resultant portfolio consists of a mix of some low volatility mega-cap stocks with some lesser-known mid-cap stocks and is relatively unusual in its make-up compared to most peers. The portfolio has not been graced by the fair wind of momentum, but he argues that it is currently cheaper than the market and has superior growth prospects than the market.

Income investors, across all asset classes, are facing the full force of the challenges created by this era of financial repression. Not surprisingly, fund managers’ sense of discomfort is palpable.

Disclaimer: No information or opinion contained should be construed as a solicitation or a recommendation with respect to the purchase or sale of any investments nor does it contain the necessary information on which to form the basis of a decision to invest in any investment product. Opinions are always stated honestly and with careful consideration but they can change at any time and should not be relied upon. Any investment’s value and any income from it may fall as well as rise, as a result of market and currency fluctuations. Investors may not get back the amount originally invested. Please be aware that The Adviser Centre, a trading name of City Financial Investment Company, does not offer investment advice.


Gold regains its lustre (July 2016)

Gold has regained its lustre this year. From its low point in December 2015, when the gold price bottomed at just over $1,000 per ounce, it reached a high this year of over $1,300 per ounce earlier in July, before falling away in the past week (as at the time of writing, 15th July 2016) as risk assets have moved back into favour. That rise of almost 30% in US dollar terms is enhanced by another 10% or so for sterling-based investors. Silver arrived a little late to the precious metals party, but has been a star performer since mid-January, making it one of the best performing global assets this year.

Not a fail-safe insurance policy

  • The inflated price of gold: Probably the most obvious reason was that the gold price had risen exponentially before its peak price of over $1,900 per ounce, which was reached in 2011. Thereafter, waning investment demand precipitated its fall and this was illustrated vividly by the huge flows out of gold bullion ETFs.
  • Falling inflation: Gold is also regarded as a hedge against rising inflation. The decline in the gold price over the past five years has mirrored the fall in inflation expectations. Economic growth has been lacklustre at best and deflationary influences persist, as the global debt mountain grows and emerging markets move through a cyclical downturn.
  • Hunt for yield and the central banker “put”: As investors earned precious little interest from their bank accounts, they looked elsewhere to fill the income gap. They have been encouraged into risk assets, notably fixed income assets and equity income strategies. The hope, or expectation, that central bankers “have their backs”, in the form of low interest rates and QE, has helped investors to have greater confidence in these holdings. This has lessened the appeal of gold, particularly given its lack of yield.

Prospects for the gold price

Following this large scale abandonment of gold on the part of investors, hence its under-ownership, it was not a surprise to see its price move up smartly in January and February this year when equity and credit markets came under pressure. Notably, gold maintained its price as other markets recovered their poise through the spring. It resumed its march onwards during June in the run-up to the EU referendum.

Gold fund managers are constructive on the prospects for the gold price from current levels for political, macro-economic, relative value and fundamental reasons.

  • Political uncertainty: The price action in gold in the run-up and aftermath of the Brexit vote followed the pattern we would expect of a safe-haven asset. The EU referendum marked the first of a series of important political events in the coming months, the most critical of which is the US election in November. With anti-establishment voters in an emboldened frame of mind, there is great potential for more upset.
  • Global economic growth: We are around seven years into a so-called recovery and yet economic growth has failed to reach “escape velocity” in any definitive way. China continues to be a concern as its stimulus measures fade. Japan is considering more direct measures to encourage its ageing, savings-heavy population to spend and thereby inject inflation into the system. Brexit has thrown another punch at the febrile European economy and as for the UK itself, who knows? Interest rates around the world are on (or through) the floor and bond yields point toward recession at best, depression at worst. Investor demand for gold has risen, particularly from the Japanese and the Europeans at the point that negative interest rate policies were introduced.
  • Negative bond yields and pricey equities: As a non-yielding asset, gold has been at a disadvantage compared to bonds in a yield-hungry world. With bond yields at such paltry levels, gold’s relative attraction is on the rise. Equities appear to be somewhat blind to the calamitous pricing of bonds and broadly speaking, they are richly priced, given the lacklustre economic backdrop and a questionable earnings outlook. This challenging backdrop for traditional assets means that investors are more inclined to diversify into alternative assets, such as gold.
  • Inflation: Inflation may be a distant concern for now, but the authorities are playing a dangerous interest rate game. Investors should be prepared for ever-more desperate measures, including the potential for public debt to be written off. Old-fashioned, wage-inspired inflation should not be ruled out either, as the US nears full employment. Gold’s appeal as an inflation hedge would come to the fore in such circumstances.
  • Supply and demand: The demand for gold is rising at the same time as a declining production profile. The earlier fall in the gold price caused the mining companies to cut production capex dramatically. Declining ore grades and an absence of new discoveries mean that production is diminishing from its peak level, which was reached in 2015. Furthermore, development capital is falling at the same time as gold discoveries become more elusive (source of information: BlackRock).

Physical gold versus gold equities

There are clear differences in the behaviour of the pure commodity compared to gold mining shares. Both display relatively high volatility, although the gold bullion price is typically less volatile than the equities. As well as being sensitive to the movement in the gold price, the share prices of the mining companies are also exposed to the ebb and flow of corporate risk.

Mining companies have not covered themselves in glory over the years. They used the ever-higher gold price to embark upon increasingly ambitious projects, raising debt and deploying capital poorly. As a result, they were badly positioned for the extended fall in the gold price, which was then the catalyst for significant changes in the industry. Companies were forced to embark upon a period of cost-cutting, management changes and retrenchment, with many development projects cancelled or postponed. Investors who held gold miners as a way of exposing themselves to the gold price were bitterly disappointed, as the relationship between the commodity and the equities broke down and shares underperformed the gold price materially, particularly in 2012-13.

This year so far, we have witnessed the mirror image of this phase, with the shares of gold equities rallying sharply and far exceeding the rise in the price of the metal. As well as being sensitive to the rise in the gold price (particularly as it is now closer to the cost of production), sentiment towards the miners has improved as many have put their houses in order and are once again viable businesses, even at lower gold prices. The lower quality mining companies responded most dramatically to the improvement in the gold price.

Fund recommendation

Within The Adviser Centre, we currently recommend BlackRock Gold & General, where the team has a long heritage of specialist resource investing. They are biased towards the better quality miners, in terms of asset quality, management credibility, responsible capital allocation and appropriate capital structure. BlackRock’s investment stewardship team also assists them in the review of corporate governance and environmental or social issues.

The team notes that this is one of the most supportive environments for gold in 20 years, whilst being somewhat cautious in the short term, given the strong recovery in share prices so far this year. Their view, like others, is that the challenging backdrop for markets, economies and politics will support the case for gold as an attractive structural holding for portfolio allocators.

Disclaimer: No information or opinion contained should be construed as a solicitation or a recommendation with respect to the purchase or sale of any investments nor does it contain the necessary information on which to form the basis of a decision to invest in any investment product. Opinions are always stated honestly and with careful consideration but they can change at any time and should not be relied upon. Any investment’s value and any income from it may fall as well as rise, as a result of market and currency fluctuations. Investors may not get back the amount originally invested. Please be aware that The Adviser Centre, a trading name of City Financial Investment Company, does not offer investment advice.


Are we there yet, Dad?  Perspectives on value… (June 2016)

The Adviser Centre's Gill Hutchison gives her thoughts on the revival of value' funds and asks whether their long-term underperformance may finally be starting to reverse.

There has been a good deal of press lately about the renaissance in the performances of value-orientated funds. Is this a passing phase, or we are finally seeing the beginning of more rewarding time for value managers, after the longest ever period of underperformance from the style?

Alastair Mundy of Investec Asset Management, a rare champion of long-term value in an industry that is increasingly short-term in its perspectives, pointed us to an interesting piece that was written by US investment manager, Kopernik Global Investors.  

As value investors, Kopernik has been sharing in the heartache of their compatriots in this lonely land. As the underperformance of their style became more extended, so their clients were more inclined to ask, “when will this end?”. Their response, much to the frustration of weary investors in value funds no doubt, is that “when” is not the question to ask. It is far more effective to ask, “why?” and, “how?”. Good equity analysts are able to determine why a company makes for a good investment and they are also able to calculate how much they expect to make. But as for when it is going to work, well, that is Mystic Meg’s territory.

All-time highs….and a bear market

The S&P 500 may be close to its all-time highs, but Kopernik argues that the US is already in a bear market.  The enthusiasm for “quality growth” stocks over the past few years has masked a bear market that has been moving stealthily through other, less glamorous sectors. They see parallels to 1972, when the outstanding performance of the “nifty-fifty” stocks obscured devastation elsewhere in the market. Eventually, they couldn’t defy gravity and late in 1973, they capitulated too. 

In the current era, it has been the FANGs (Facebook, Amazon, Netflix and Google, or more correctly, Alphabet - how pesky of Google to ruin an entertaining acronym), biotech companies and consumer super-brands that have camouflaged a good deal of pain taking place elsewhere.

This means that in their value world, the US is in the latter stages of a long and deep bear market. This is, of course, cause for optimism, as money-making opportunities have become more plentiful for them. They see much of the value in the US market in the resources, emerging markets, transportation and infrastructure areas.

Where is the value in the UK market?

Of course, the largest companies in the UK market don’t whet investors’ appetites quite as much as the glamour of the FANGs. While our home market is not as richly priced as the US, it is nevertheless trading above its long-term average valuation and like the US, is experiencing declining earnings.

Alastair Mundy, well known for courting danger (within the safety of balance sheet strength), is less enamoured with the scale of opportunities in his market than Kopernik, but highlights two main areas of interest. Food retailing is one, where he argues that the major players are fighting back against the upstarts, Aldi and Lidl.  The banking sector is the second –  even more so after Mark Carney indicated recently that the peak of the regulatory burden was near. He argues that underlying profitability for banks is healthy and assuming this can be maintained, it represents a relatively attractive profit stream. If this doesn’t sound like a resounding shout from the rooftops, it’s not meant to. He argues that banks look attractive compared to other value plays in the market because unlike some others, they do not need core profits to increase to validate current valuations. In an ideal world, value investors seek stocks that look cheap based upon current depressed earnings, not based upon a hope for earnings improvement in the future. For him, opportunities in “ideal” value names are limited. 

Managers of the Schroder Recovery fund, Kevin Murphy and Nick Kirrage, have similar areas of focus at the present time. In spite of a turnaround in the relative performances of their funds so far this year, they are not inclined to signal the dawn of a new, value-driven phase quite yet. This is because the “safety-first/hunt for yield” trade, which has been in place since the financial crisis, has not yet lost its appeal.  On this subject, they are vocal in warning investors of the valuation dangers inherent in stocks that are perceived to be safe and stable. They remind us that there is no such thing as an asset that is always safe, or one that is always risky - your risk is determined by the price you pay for it.

So, are we there yet?

The value-orientated managers we speak to remain cautious and are having to work hard to make the combined valuation and investment case stack up. Cash and gold continue to be favoured by those who can hold them, hardly a ringing endorsement for risk assets. 

Overall, equity markets remain richly valued compared to history and are supported primarily by low bond yields, rather than a rosy outlook for corporate profits. The cost-cutting / declining debt servicing era is over – these positive influences upon earnings cannot happen twice from here. The market knows that central bankers are close to being out of bullets and investors are eyeing the myriad of risks that lurk on the sidelines. 

So, the answer to the question in an absolute sense is certainly not a resounding, “yes”. In a relative sense, the picture is more mixed. Splitting the true bargains from the possible value traps is critical, unless you can see a booming cyclical recovery on the horizon which will drag the marginal players out of trouble. Managers who do this successfully and are holding cheap, unloved stocks, which have priced in a lot of the bad news, should be in relatively good shape, notwithstanding the usual bumps in the road.  They are certainly better placed to take the blows, from whichever direction they come. Commonly-owned, loftily-valued quality growth/income stocks are arguably not so well placed, as Mr Murphy and Mr Kirrage suggest.

As a closing comment, Richard Colwell, manager of Threadneedle UK Equity Income, referred to Jeremy Grantham of GMO in a recent presentation, as follows, “Although value is a weak force in any single year, it becomes a monster over several years. Like gravity, it slowly wears down the opposition.”.

To view our featured funds by style and market cap category, please visit the IA Overviews section of The Adviser Centre (www.theadvisercentre.co.uk).


Europe ex UK (May 2016)

In her latest Sector strategy column for Adviser-Hub, Gill Hutchison, head of investment research at City Financial and The Adviser Centre, talks about Europe ex UK - a story of financials. 

The importance of financials

The approach that managers have taken to financials has been a critical factor in their ability to out or underperform over the past decade. In spite of its travails, financials remain the largest component of the main indices, at a weight of over 20%. Following the financial crisis, the majority of managers were quite correctly under-exposed to banks but in the rehabilitation phase, they have been a more difficult play, with short bursts of strong performance having the potential to push relative performance off course. When it comes to structural holdings, most have played it safe(er) by holding the higher quality, less troubled banks and they may choose to dip into the recovery plays for tactical holdings only. Some also use banks as a quick way to increase or decrease the beta of their portfolios.

This year has once again seen European banks and other financials at the eye of the storm and the whole sector has been de-rated. They face a myriad of challenges; the increased regulatory burden, greater capital requirements and the growing scale of non-performing loans were already in investors’ sights. Now, with interest rates firmly in negative territory, concerns about the ability of financial institutions to sustain their business models on wafer thin net interest margins have come to the forefront. The first few weeks of the year saw precipitous falls in the share prices of even the most pre-eminent financial institutions. Although we have seen a rebound since then, share prices remain very weak on a year-to-date basis. It is difficult to envisage broad European indices making sustained progress whilst the banking system remains under such a cloud.

ECB treats

The ECB played its part in easing the pressure on banks following its March meeting. I will defer to the comments of the Macro Strategy team from Deutsche Bank, who brilliantly captured the unexpected scale of Draghi’s largesse in his package of measures: “Imagine you were expecting a trip during the school holidays in a caravan around the country, but instead, you can take two weeks off school, fly first class to Disneyworld, have a go in the cockpit on the way, stay at a hotel made of chocolate. Then you can go on every ride, every day, without queuing, and have a private play session with the real Mickey Mouse as each day draws to a close.” Nonetheless, while European credit markets justifiably felt that they had won Willy Wonka’s golden ticket, the benefits to equity investors at this stage are far from clear. Indeed, if we look back over a longer period to Draghi’s last “bazooka”, announced in January 2015, the initial enthusiasm petered out rapidly and in practice, the measures have had no apparent lasting impact on sentiment.

As well as reducing interest rates further, the measures included a new series of targeted longer-term refinancing operations (TLTRO II), which offer attractive funding conditions to banks with a view to stimulating credit creation and reinforcing the transmission of monetary policy by incentivising lending into the real economy.

By lowering borrowing costs further, Draghi still hopes to coerce consumers into spending. However, the evidence suggests that the reverse is actually occurring, with individuals minded to save even more, given the paltry return on their investments. The continuous decline in bond yields is also very bad news for European insurance companies, which have liabilities to meet and precious few ways of making a return to meet them. This is not a story for today but should poor returns persist, insurance companies will become increasingly challenged.

More positively, it is bonanza time for companies seeking to finance at ultra-low yields and bond issuance in the euro market has been very heavy in the past few weeks. The ECB begins its investment grade purchases in June and there is nothing like a large, non-economic buying agent to buoy up a market.

Style factors

This story of the financials partly explains why the IA sector features few funds that display “value” credentials. Since the financial crisis, financials have been the major value play and with most managers underweight, the sector’s aggregate tilt towards growth has become more overt.

As in other markets, growth as a style has been in favour for several years, particularly so in 2015.This year has been more mixed, as financials’ underperformance has been matched by outperformance by the other value sectors of oil & gas and basic materials; industrials have also made good ground, at the expense of healthcare, consumer goods and consumer services, where managers are typically well exposed.

“Growth” valuations are a challenge

European fund managers are not alone in struggling with the valuation case for those companies that have been able to forge a growth path through a lacklustre economic backdrop. This is seeing many managers focusing upon their highest conviction ideas where they can see very clear stock specific drivers but inevitably, this trend is typically not a bullish sign for the market in aggregate. With equity investors less enamoured of central bank actions, earnings growth is key to driving markets higher and that, for the moment, is somewhat elusive.

Featured funds

The IA Europe excluding UK sector features a richer seam of successful active managers compared to many other equity sectors. Within The Adviser Centre, we feature nine funds, which are spread across five market cap/style categories, as follows:

• Larger-Cap Blend: Henderson European Selected Opportunities, JOHCM Continental European and JPM Europe Dynamic (ex-UK)

• Larger-Cap, Growth-Biased: BlackRock Continental European, Jupiter European Special Situations, Schroder European, Threadneedle European Select.

• Growth-Biased: Jupiter European

• Income-Orientated: BlackRock Continental European Income

Visit www.theadvisercentre.co.uk to access our free-to-air fund research and consultancy service

Disclaimer: No information or opinion contained should be construed as a solicitation or a recommendation with respect to the purchase or sale of any investments nor does it contain the necessary information on which to form the basis of a decision to invest in any investment product. Opinions are always stated honestly and with careful consideration but they can change at any time and should not be relied upon. Any investment’s value and any income from it may fall as well as rise, as a result of market and currency fluctuations. Investors may not get back the amount originally invested. Please be aware that The Adviser Centre Limited does not offer investment advice.

Sector strategy 2015

Gill Hutchison

Stormy waters – Emerging markets (December 2015)

In her latest Sector strategy column for Adviser-Hub, Gill Hutchison, head of investment research at City Financial and The Adviser Centre, identifies the many problems afflicting the emerging markets – and the faint glimmer of light at the end of the tunnel 

After decades of rapid economic growth, emerging markets have begun to slow down and mature. Now they are only growing at a modestly faster rate than developed economies, with no obvious reason for them to return to the heydays of the 1990s and 2000s.

In many cases, the economic ‘miracle’ the emerging markets experienced has been wasted. Countries, corporates and individuals have been busy leveraging their balance sheets – private sector debt-to-GDP has doubled since 2001 and is now north of 120%, according to data from BCA Research. Nominal wages have been pushed up aggressively, thereby squandering opportunities for productivity advantage, and many economies have seen serious currency declines, which is the major release valve to improve competitiveness.

"With hot money cleared from the system, sentiment at rock bottom and a daily dose of tough headlines moving across the screens, the case for dipping a toe back into these stormy waters is building."

Many have experienced – or are experiencing – serious economic setbacks and painful reforms are being enacted. The likes of Mexico and India are the poster children for these reforms while others, such as Brazil, are dragging their feet. While equity prices in aggregate appear to reflect many of these issues, the polarised valuations of stocks and sectors in these markets reinforces the fact that the process has some way to go, although the light at the end of the tunnel is clearly visible.

This polarisation mirrors patterns that are seen in many equity markets at present, as well as in the world of credit. Aggregate market valuations mask significant valuation disparities below the surface – explained to a large extent by investors’ cravings for higher quality and growth at the expense of cyclicality and lower quality (and therefore cheapness).

This divide is persisting for much longer than would normally be expected and is as uncomfortable for emerging market managers as it is for managers in other markets – either their quality/growth bias means their portfolios are expensive compared with the market, or their value-driven approaches mean they are forced to contemplate situations that are still deteriorating. Neither scenario is appealing.

Cyclical downturn continues

For now, economic data points indicate that the cyclical downturn for emerging markets has some way to go. In spite of the positive consumer growth story in emerging markets, they remain heavily geared into the global industrial cycle. 

With signs of weaker activity levels in North America and major disruption in the oil and commodity markets, recent data depicts a contraction in global manufacturing, rising inventory levels and falling imports and exports. The prices of steel, iron ore, cement, rubber and coal have been falling for years but have taken another sharp leg down. At the same time, corporate and household debt has risen materially over the past decade. Deflationary forces and high debt levels are a toxic mix.

Currency weakness has been the other important feature of this phase. Emerging market countries with open capital accounts are simply not in a position to control both their exchange rates and their interest rates. With central banks opting to suppress interest rates and inject liquidity into the system, currencies have had to take the strain.

Malaysia, Indonesia, Turkey, South Africa and Colombia are the most potent examples of this development. This is a challenge for foreign investors – either, central banks will keep interest rates low, in which case the currencies will remain on a weakening track, or rates will have to rise, thereby jeopardising economic growth. This conundrum is exacerbated by the amount of foreign currency debt held by companies and banks, which is becoming ever more expensive to service.

The weak economic backdrop is reflected in company performance and return on equity has plunged in all sectors, apart from technology. Corporate leverage is also higher across the board, again with the exception of technology where it has been falling (source: BCA Research). Earnings per share peaked four years ago and the negative surprises have kept coming. A valuation discount to developed markets is justified.

Proceed with caution

Nonetheless, the relative valuation argument is becoming more compelling all the time. Furthermore, all-important dollar-based investors have a powerful currency with which to buy these cheaper markets. While optimism seems premature, anecdotally, emerging market fund managers tell us they are sending out proposals again. Interestingly, there are also signs that some investors are moving from passive vehicles into active strategies.

With hot money cleared from the system, sentiment at rock bottom and a daily dose of tough headlines moving across the screens, the case for dipping a toe back into these stormy waters is building, but caution remains the watchword. Sustained outperformance from emerging markets needs to be led by the cheaper, cyclical sectors but that dynamic is out of reach for now.

The Adviser Centre is designed by City Financial specifically for financial advisers. To access its free-to-air fund research and consultancy service, click here

Fund highlights from The Adviser Centre

While value-biased approaches are few and far between in the IA Global Emerging Markets sector, those funds that display stronger value credentials have found the going very tough. Lazard Emerging Markets is one such example. The process behind M&G Global Emerging Markets also incorporates a strong value element and so has underperformed its more growth-oriented peers.

At the other extreme, Stewart Investors’ focus on quality and growth has enabled its Emerging Markets Leaders fund (which resides in the IA Specialist sector) to retain a strong relative performance record for an unusually long period of time. Aberdeen Emerging Markets has a strong bias to quality in its process and particularly strict guidelines with regard to corporate governance, which has a material influence on positioning. As a result, the fund’s performance tends, to a degree, to carve its own course.

Investec Emerging Markets Equity is managed according to the firm’s ‘4Factor’ process and, while it incorporates plenty of active risk, its balanced and objective approach means it is closer to a core offering than many competitors. The new team behind Goldman Sachs Growth & Emerging Markets Broad Equity Portfolio seek growth opportunities in the region although valuation assessments also form an important part of the process. This fund also has meaningful exposure to mid and small-cap stocks.


Gill Hutchison

Here we go again – Fixed income (November 2015)

In her latest Sector strategy column for Adviser-Hub, Gill Hutchison, head of investment research at City Financial and The Adviser Centre, says both the credit market’s behaviour and pricing are telling investors risks are now building and it is time to tread carefully

Most would agree we are entering a more complex phase for fixed income markets. The 30 year-plus bond bull market is in its final act and all eyes are on the timing of the US Federal Reserve’s ‘lift-off’ interest rate rise. Prevailing views are the Bank of England will follow suit in the foreseeable future. While December 2015 was beginning to look like a real possibility for action by the Fed, the full repercussions of the appalling terrorist acts in Paris, which are unknown at the time of writing, may alter the expected course.

Corporates and individuals have been busy squeezing out the last juices from this extended period of ultra-low interest rates. This is a logical response to the availability of cheap financing but, of course, low interest rates inevitably encourage less rational behaviour and questionable capital allocation, not to mention the suppression of the creative destruction that is necessary for a healthy and progressive economy.

"Summer’s 1,000-point fall in the UK index saw unloved stocks just became even more unloved, which did not help anyone very much."

Although we have not revisited the heady and liquid days of pre-credit crisis bond markets, which were characterised by aggressively structured, if poorly understood, debt instruments, there are plenty of signs that markets are entering the later stages of the credit cycle – most overtly in the US credit markets. 

* Mergers and acquisitions (M&A): Over the past year, there has been an increase in companies coming to the debt markets for help in the funding of acquisitions. M&A activity is rising as companies rush to capitalise upon low interest rates while they are available. With top-line profitability under pressure in some sectors, companies are naturally scouting for opportunities to buy the growth they need to satisfy their shareholders.

* Debt-funded dividends and share buy-backs: Companies, notably in the US, have been leveraging up their balance sheets and using debt to support their dividend policies or to buy back shares. Such shareholder-friendly activities cause credit deterioration and are distinctly bondholder-unfriendly. McDonalds is one example of this – it has just announced it intends to issue $10bn (£6.6bn) in debt as part of a plan to return $30bn to shareholders over the next three years. This caused its credit rating to fall from A to BBB.

* Covenant protection: The past five years has seen a trend of weakening covenant protection across the European and US high yield bond markets.

These trends are symptoms of the expansion phase of the typical credit cycle, where growth has returned and improved confidence drives debt growth, M&A and capital expenditure activities. As animal spirits eventually take hold and credit fundamentals deteriorate, the market typically moves into the downturn stage when confidence is shaken, credit availability shrinks and companies retrench due to high borrowings and weakening cashflow.

The Adviser Centre features ‘Recommended’ and ‘Established’ funds from a range of fixed income sectors, including five ‘Recommended’ Sterling High Yield Bond funds, which are managed according to different styles:

* Aberdeen European High Yield Bond
* AXA Global High Income
* Baillie Gifford High Yield Bond
* Kames High Yield Bond
* Standard Life Investments Higher Income

Visitors will also find corresponding IA sector overviews that put the various funds into context to help with building the fixed income portion of a portfolio.

The credit cycle begins again in the spirit of repair, as companies focus upon surviving and bolstering their balance sheets. As the environment improves, credit growth accelerates and the appetite for risk-taking slowly returns during the recovery phase.

Not so typical cycle

Today though, there is an oddity. The late cycle behaviour we are seeing usually takes place as a function of robust economic conditions, when interest rates are already at more elevated levels and hence in keeping with higher growth. Not so today. This peculiar state of affairs is another example of the distorting effects of super-low interest rates and quantitative easing policies.

Now, Fed policymakers clearly want – and need – to move rates upwards but the risk is they end up doing this, albeit gradually, when companies are poorly placed to cope. Cheap financing encourages us all to borrow from the future – why not, when it is cheap to do so? – and companies are no different. The problem is that the music has to stop at some point.

Time to tread carefully

It has been a fruitful few years for credit investors since the dark days of the financial crisis, many of whom have grown accustomed to robust total returns from their allocations as we moved through the cycle from repair, to recovery and towards expansion.

Risks are now building again and the credit market’s pricing and behaviour is telling us this – spreads in general are vulnerable to ‘risk-off’ episodes, specific sectors are under scrutiny, idiosyncratic risk is rising and the lower reaches of credit markets are deteriorating quickly. It is a time to tread carefully and certainly to prepare for greater volatility. Avoiding the losers is more important than ever and in this environment, active managers have a good opportunity to prove their worth.

The Adviser Centre is designed by City Financial specifically for financial advisers. To access its free-to-air fund research and consultancy service, click here

European credit versus US credit 

The good news is that corporate animal spirits are far less in evidence in the UK and European credit markets compared to the US. Furthermore, European credit markets continue to enjoy the fruits of the ECB’s quantitative easing activities, lending a stronger technical bid to the market. This more favourable credit picture is reflected in tighter credit spreads in Europe compared with the US, which is a departure from the historical norm.

The European credit market has deepened and matured from the technology, media and telecoms-heavy platform it was a few years ago. Its overall size and the number of issuers participating in the European high yield market have multiplied and its overall credit quality has improved. Its relative risk premium has declined as a result.

The other important difference in the structure – and, as a consequence, the performances – of credit markets, is that energy is a significant component of the US high yield market. This sector’s distress has been played out in brutal fashion in the credit arena and this is a stark reminder of the asymmetrical nature of bond investments.


Gill Hutchison

Time for value? – UK equities (October 2015)

Gill Hutchison, head of investment research at City Financial and The Adviser Centre, suggests any investors who have been enjoying unusually good relative performance from growth-biased portfolios may now want to consider introducing some balance

We talk a good deal about how tough it is to outperform equity indices – particularly on a net-of-fees basis. In UK equities over the past five years, this objective has been much more attainable if you have been able – or have chosen – to invest materially in small and mid-cap stocks.

This has not necessarily been a shameless ‘beta play’ on the part of performance-hungry fund managers. There is a wealth of opportunity further down the market capitalisation scale. Managers can access decent quality companies that can be more easily understood, pay dividends and … wait for it … grow their profits. Growth-biased small and mid-cap managers have found themselves particularly well-positioned to capture this opportunity.

"Summer’s 1,000-point fall in the UK index saw unloved stocks just became even more unloved, which did not help anyone very much."

Meanwhile, it has been a much tougher battleground for large-cap managers, with the big sectors all having their particular issues. Banks have been in a rehabilitation phase; oil and gas companies have been in a price adjustment phase; pharmaceuticals have been in a restructuring phase – add some large miners into the mix and it is clear to see that managers have faced a real cocktail of challenges.

Nowhere to hide

The current and concerning conundrum is that managers of all types find themselves in a kind of market cul-de-sac, which has seen portfolio activity levels decline and greater concentrations in the most trusted stock ideas. At the heart of the problem is an increasingly stark choice between the ‘expensive and appealing’ and the ‘cheap and troublesome’.

At the expensive end of the spectrum, growth managers can still find the earnings growth they crave – but they are being asked to pay handsomely for the privilege. Similarly, the more defensive and/or income, quality-biased managers are wincing at the price required to buy relative safety. On the other side of the coin, value-biased managers are able to find cheap stocks but they face the stark reality that, in many cases, fundamentals are still deteriorating. At what stage are they prepared to buy stocks when they are still in the earnings downgrade phase?

Alastair Mundy of Investec UK Special Situations and Kevin Murphy and Nick Kirrage of Schroder Recovery are some of the most courageous investors in the UK sphere and these two funds have been struggling in relative performance terms for some time. In the past, their capacity to walk a lonely investment path has been rewarded by powerful bursts of performance and we see no reason why this should not happen again in the future. 

In aggregate, however, there is very little to get excited about from a value perspective – as Henry Dixon, the manager of Man GLG Undervalued Assets, recently highlighted, the summer’s 1,000-point fall in the UK index was not enough to generate additional value, according to his process. The unloved just became even more unloved, which did not help anyone very much. 

How did we get here?

How did this gulf between the loved and the unloved become so extreme? Here are some of the reasons:

* The paltry income available from bank accounts has encouraged more investors into equities.

* Many of those investors have a preference for income/defensive equity styles, pushing up the investor demand for naturally lower growth sectors, such as consumer staples.

* Furthermore, a greater appetite for retirement products has spawned a host of multi-asset portfolios, which are very often income/defensively biased, again increasing the demand for dividend-paying, higher-quality companies.

* In the post-financial crisis, QE-supported world, economic growth has been muted and so those companies generating profits growth have been prized – hence the rise and rise of small and mid-cap indices. The relative strength of the domestic economy has reinforced the case for UK-orientated small and mid-cap stocks.

* The prices of commodity stocks have been responding to the changing demand/supply dynamic and the inevitable slow-down of China’s economy for a long time. The broader market was slow to wake up to this – hence the carnage of the past year as investors suddenly realised the commodity supply response, long in the making, was being met by demand fade as China's consumption patterns shifted.

Time for value?

Investor positioning is rarely at such extreme levels. The loved/unloved nature of the index constituents is reflected in the performances of different fund types in the Investment Association’s UK All Companies sector. Mid-cap growth funds have been a near permanent feature at the top of the performance table and value/contrarian funds have languished at the bottom. 

The main UK index return so far this year would be placed in the third quartile of the UK All Companies sector, but this has moved up from the bottom quartile a month ago. This degree of underperformance is unusual and not a sudden indication of overwhelming fund manager brilliance. Rather, it has typically been a sign of a forthcoming change in market direction or dynamics – just look at 1999 and 2007 for reference … 

For those who like to observe short-term performances, it is worth looking at what happened during the first week of October as an illustration of how quickly under-owned, cheap sectors can turn around on better newsflow or sentiment. Not surprisingly, the aforementioned value/contrarian funds suddenly found themselves at the top of the leader board. Short-lived as this was, it was instructive. 

What we are really trying to say is, if your UK equity blend is biased to growth and small and mid-cap stocks and you have been enjoying unusually good relative performance, it is probably a good time to introduce some balance. Value-biased funds may not always be comfortable holdings but they have the benefit of being less expensive than the market and the managers have the courage to get involved in buying stocks when there is ‘blood on the streets’. 

Five ‘value-biased’ funds from the UK All Companies sector currently feature within The Adviser Centre and all are ‘Recommended’. They are Investec UK Special Situations, JOHCM UK Dynamic, Jupiter UK Special Situations, Man GLG Undervalued Assets and Schroder Recovery.

Except for Man GLG Undervalued Assets, all the funds are in the bottom half of the sector performance table through to 15 October 2015. Schroder Recovery represents the most dogged of the value styles that characterise these funds and its performance has been under the greatest pressure this year. It also delivered one of the strongest performances in the sector at the beginning of October during the brief market rotation.

The Adviser Centre is designed by City Financial specifically for financial advisers. To access its free-to-air fund research and consultancy service, click here


Gill Hutchison

Rise and fall – Energy (September 2015)

Gill Hutchison, head of investment research at City Financial and The Adviser Centre, assesses the state of the oil price and the opportunities and risks associated with investing in the unloved energy sector

The oil price fall and its implications have been a major feature of the market and economic backdrop in both 2014 and 2015. Given its significance in the UK index, domestic equity investors are particularly alert to the sector’s fortunes.

This piece will therefore discuss the significance of the supply and demand balance and where we are now; how, through time, the oil price moves between the marginal cost of supply and the price at which demand destruction occurs; and the opportunity and associated risks.

"What has been absent in most commentaries recently is the reality of an overvalued US stockmarket, in which participants are willing profit-takers."

Before going any further, it is well worth noting that our meetings with sector specialist investors are always highly informative and our recent review with the managers of the Guinness Global Energy fund was no exception. Much of the factual material in this piece is drawn from the team’s detailed presentation, for which I am very grateful.

The supply picture

The huge investment into shale gas development in North America signalled a step change in the supply of oil. Indeed, North America has generated all of the non-OPEC oil production growth over the past four years. OPEC’s decision to keep pumping oil in the face of a falling price in December 2014 was a surprise and a measure of Saudi Arabia’s (tacit) determination to deter US production, in spite of the ‘own goal’ it would score against its own economy.

US shale production growth is now slowing as companies are starved of cash and the pain of the lowest-quality producers is being played out before our eyes in the US high-yield bond market. The US drilling rig count has fallen by about half from its peak, although improving technology offsets this raw number to an extent. Outside of the OPEC countries and the US, many new projects are being cancelled in response to the persistently low price. 

The demand picture

On the demand side, the International Energy Agency’s Oil Demand Report tells us that both OECD and non-OECD demand increased during 2015. Indeed, the report indicates growth across almost all areas, including China. Oil demand has grown incrementally over the past 10 years, with the exception of 2008 and 2009, and this progressive picture belies the huge movements in the price of the commodity.

The US remains far and away the largest consumer of oil and, so far this year, data implies that demand growth has been running at 3% to 4%, with lower prices spurring demand. China’s demand picture is also robust, in spite of an economy that has been weakening for some time.

Guinness Global Energy

For energy-related equity investments we recommend the Guinness Global Energy fund, managed by Tim Guinness, Will Riley and Jonathan Waghorn. It invests globally in oil, natural gas, coal, nuclear, alternative energy and utilities through an equally-weighted portfolio of 30 positions. The team is highly experienced and operates with a value bias, which means they are alive to the opportunities that are emerging in this challenging sector at the present time.

The oil price’s ‘book-ends’

While supply/demand dynamics are a strong influence on oil price movements, the longer-run price progression is shaped by the marginal cost of supply. Through time, the oil price trades in a wide but well-defined band between the operating cost of the cheapest producers – those in the Middle East and Africa – and the price at which demand destruction takes place.

Guinness Asset Management estimates this range to be a Brent oil price of $10 (£6.50) per barrel at one end and $125 at the other. Non-OPEC producers are incentivised to embark upon new projects at various prices above $60. Critically, OPEC countries require $90 to balance their budgets and so this level has to be their ultimate goal. 

At the time of writing, oil is trading at close to the estimated marginal cash cost of supply – hence the so-called ‘creative destruction’ we are now witnessing. Eventually this destruction brings the market back into balance, while demand should have been reinvigorated by a lower price.

The opportunity

Oil-related assets continue to be challenging portfolio holdings. There is huge volatility in the oil price as it is buffeted both by relevant newsflow and by risk appetite in general. On 18 September alone, supportive data on a further decline in the US rig count was eclipsed by equity market weakness –hence the oil price fell by 5%. Comments from the Kuwaitis reinforcing their strategy of market share defence, rather than production cuts to bolster the oil price, added to the negative sentiment. 

Equity fund managers in aggregate have been overwhelmingly underweight the oil & gas sector and this has clearly been of benefit to relative performance. It is important to be aware of the under-ownership of this unloved sector, however, as any marginal improvement in sentiment is likely to trigger a rapid reassessment of the opportunity and a rush by some to close out short/underweight positions.

From a valuation point of view, we are certainly at an interesting juncture – the relative price-to-book ratio for the energy sector versus the S&P 500 index has only been this extreme in 1986 and 1998, both of which proved to be rewarding entry points for investors. Guinness Asset Management’s expectation is for the oil price to trade in a $50-$70 range in the near term, but with volatility. 

The risks

Without postulating the much longer-term risks to the oil sector, key reasons why the oil price and oil-related equities could remain under pressure are: 
* Supply: OPEC could persist with its strategy of market-share defence; helped by technology improvements, US shale production could prove more resilient than expected; and Iranian and/or Libyan production could recover. 
* Demand: global economic growth could weaken; and the US dollar could strengthen.
* Investment risk appetite: equities could remain under pressure; we may see energy-related defaults in the high-yield bond sector.

Looking further into the future, the shift to cleaner energy production is a key risk. Technology is advancing, costs are reducing and the economic arguments are becoming clearer. Saudi Arabia is a major investor in renewable energy for good reason. Perhaps this is why ‘$20 oil’ is now being mooted by some of the headline grabbers. The last time we saw such extreme views was in March 1999 with the infamous ‘$5 oil’ headline from The Economist – and we know what happened next …

The Adviser Centre is designed by City Financial specifically for financial advisers. To access its free-to-air fund research and consultancy service, click here


Gill Hutchison

Reasons not to be cheerful – US (August 2015)

US investors have been nervous for some time, says Gill Hutchison, head of investment research at City Financial and The Adviser Centre, with the China story just happening to be the straw that broke the camel’s back

Why is active management in US equities such a challenge? Before putting fingers to keyboard for this article, I updated our Investment Association (IA) Sector Overview for the North American fund grouping – which you can find here – and was reminded of the challenges of running active money in this market.

"What has been absent in most commentaries recently is the reality of an overvalued US stockmarket, in which participants are willing profit-takers."

This is a well-rehearsed but nevertheless perplexing subject and we would cite the following factors as headwinds for active managers:

* The efficiency of the market: Gaining an information edge, particularly in the larger-cap arena, is tough.

* Regulatory constraints: When speaking to company management, fund managers are increasingly concerned about inadvertently obtaining information that is not in the public domain and having to declare themselves insiders.

* The S&P 500 Index Committee: The composition of the index is controlled by an Index Committee, which decides upon additions to and removals from the index. The Committee’s mission is to ensure the S&P 500 represents the US equity market, with a focus upon the large-cap segment. Company size, liquidity, minimum float, profitability and balance with respect to the market all have a part to play in the decision-making process, but the rules are not rigidly applied and the Committee has some discretion in selecting stocks or responding to market events.

* Bulk trading activity: The growing presence of ETFs and high-frequency trading vehicles in the US market is often cited as a challenge for fundamentally-driven, longer-term investors. Arguably, this indiscriminate activity should also represent an opportunity for investors with a long-term time horizon, who can take advantage of price anomalies. In practice, however, few managers enjoy the privilege of a loyal investor base that is patient enough to allow long-term investment strategies to reach fruition.

According to Morningstar Direct, the IA North America sector average has underperformed the S&P 500 index over the one-year, three-year and five-year periods to 6 August 2015. More stylised funds, and funds that take greater relative risks, can have powerful bursts of performance, but they are also vulnerable to periods of meaningful underperformance when their styles are out of favour. Buying such funds after extended periods of underperformance – where, of course, you have confidence in the management – can be very rewarding but this clearly requires a degree of nerve.

There is little to suggest that native US managers, who have retail-focused funds available in the UK, deliver better results over time. Indeed, US-based managers operating in the US mutual funds market appear to have similar performance challenges to those who are active over here.

According to S&P Dow Jones Indices, just 23% of all large-cap, core active funds outperformed the S&P 500 index in the three-year period to the end of 2014. Furthermore, again according to S&P Dow Jones Indices, there have only been two occasions in the past 10 calendar years when more than half of active managers have beaten the index.

The worry list

The ‘will they, won’t they’ debate on US Federal Reserve action persists. US economic data broadly suggests policymakers should raise rates, although many still make the argument that monetary stimulus should have resulted in a far stronger economy by now.

Ongoing economic data releases are germane to the decision, but the Fed is not blind to the influences of events away from US shores and the fragility of market confidence. There is certainly a desire to take some action – if only because it means at least a slither of firepower to tackle the next downturn.

The surprise Chinese devaluation moves during the week of 10 August 2015 unnerved all risk assets and caused sovereign bonds to rally (and precious few investors will have been positioned for that). Since then, the China slowdown story has gripped the headlines although, as the weakness in commodities has been telegraphing this issue for months, that should not really come as much of a shock.

The treacherous market conditions that have ensued were notionally triggered by the China crisis but what has been absent in most commentaries recently is the reality of an overvalued US stockmarket, in which participants are willing profit-takers after more than six years of an uptrend.

Renewed weakness in the oil price is an additional cross-current that is disruptive and has wide ramifications. Add this to deflationary impulses from China and other emerging markets and it is no surprise that – for the third year in a row – people’s conviction in a Fed interest rate move is waning once more.

The recent US earnings season confirmed the challenges of a strong US dollar and chaos in the energy sector. Inevitably, the strong currency suppressed international earnings, while domestic earnings were more encouraging.

With analysts’ earnings expectations set low, earnings beats were strong but sales beats were disappointing. Earnings-enhancing share buybacks and dividend payments have caused investors to cheer over the past few years, but equities ultimately require sustained revenue growth, capital expenditure and business investment to make long-term progress.

Technically speaking, declining market breadth has been a concern over recent months. In essence, fewer stocks had been making progress, meaning the US market has been reliant upon a diminishing number of companies to lead the index forward. A range of technical indicators confirmed the market was in an unhealthy state and was running low on momentum.

Again, this was simply telegraphing increasing nervousness and the China story just happened to be the straw that broke the camel’s back. Recent market action has reinforced the importance of index support levels in explaining the behaviour of short-term investors and hedge funds. Technicians continue to be concerned about further downside as these levels are breached. Any bounces that are caused by short-covering should be treated with extreme caution.

In short, keep your tin hats on and buckle up …

The Adviser Centre is designed by City Financial specifically for financial advisers. To access its free-to-air fund research and consultancy service, click here

The Adviser Centre’s featured funds

The challenging reality of the US explains why we only feature four funds within The Adviser Centre. All four have distinctive styles and we retain our view the passively-managed funds are the best way to gain broad exposure to the US equity market.

Mid to Large-Cap, Growth

AXA Framlington American Growth: A North American equity fund that is managed with a strong growth style and a mid-cap bias. The managers are focused on companies that have the ability to grow their top line regardless of economic conditions.

Legg Mason ClearBridge US Aggressive Growth: A benchmark-agnostic, all-cap portfolio of US companies that are deemed to have above average, defensible growth prospects. Managed with a long-term time horizon and featuring high-conviction holdings in the top 10.

Income-Oriented

JPM US Equity Income: Provides diversified exposure to US equities through a fund that seeks to generate a yield of 1% above that of the index. It is large-cap biased and managed according to a well-established, value-driven approach.

Small to Mid-Cap, Blend

Schroder US Mid Cap: The fund provides exposure to both mid and small-cap US stocks and is managed by a highly experienced practitioner. It is diversified across higher growth, stable growth and turnaround companies


Gill Hutchison

The equity income conundrum (July 2015)

Gill Hutchison, head of investment research at City Financial and The Adviser Centre, sizes up the challenges equity income fund managers face as a consequence of extreme monetary policy and the drive for yield and safety

We stand at a fascinating juncture for markets, but that is hardly big news. Nor is it news that the prospect of monetary tightening is highly significant for all asset classes – after all, the industry has been commenting liberally on the subject. Nevertheless, the associated challenges for equity income fund managers are an interesting insight into the consequences of extreme monetary policies and the drive for yield and safety.

Markets and investors have been behaving rationally during this protracted phase of emergency-level interest rates. Fixed income yields across the credit curve have fallen to historically low levels, which is entirely logical.  Equities have re-rated and dividend-paying stocks have been particularly sought after, as their cashflows are perceived to be more valuable in a low yield, low growth world. The same dynamics have caused real estate assets to re-price. This is all as it should be when the cost of money and levels of economic growth and inflation have been so low.

"When emerging market equities and biotech stocks are being touted for their income credentials, you know we have reached the final mile."

At the same time, quantitative easing activities have increased the flow of money through the financial system and it has been looking for a lucrative home. ‘Talky’ central bankers have helped further by providing far greater visibility about the path of interest rates than we have been privy to in the past.

If we make the assertion that, in aggregate, asset markets are fully priced, company earnings – or, more precisely, revenues – will have a more critical focus, particularly as interest rates rise and therefore the cost of capital moves upwards. On this score, progress has been conspicuously absent and this concern goes to the heart of fund managers’ current sense of discomfort.

Equity income funds have been key beneficiaries of central bankers’ largesse as a growing band of naturally more conservative, income-seeking investors have been looking to the equity market to satisfy needs that used to be met by cash and bonds. This has ushered in an unusual phase of higher-yielding, lower-growth sectors performing relatively well during positive market conditions.

With higher stock prices suppressing the yields available on many of the old income favourites, managers have been considering how best to position their funds – not only with a view to capturing better yields, but also to lessen the risk of being exposed to increasingly expensive stocks. These shifts include:
* Considering companies with poorer dividend cover;
* Considering companies that have greater operational risk;
* Looking for companies that have dividend growth potential; and
* Adding interest rate-sensitive stocks, such as banks.
In short, where such companies offer greater value, managers are substituting valuation risk for corporate execution risk.

The Adviser Centre features nine UK Equity Income funds, which are managed according to different styles: Artemis Income; Aviva Investors UK Equity Income; BlackRock UK Income; Fidelity MoneyBuilder Dividend; Rathbone Income; Royal London UK Equity Income; Standard Life Investments UK Equity Income Unconstrained; Threadneedle UK Equity Income and Threadneedle UK Monthly Income.

It also features four Global Equity Income funds: Artemis Global Income; Fidelity Global Dividend; Lazard Global Equity Income; and Newton Global Income.

Herein lies the conundrum. When equity markets enter more challenging phases, the less racy, reliable companies that are better placed to see you more safely through tough conditions – and pay you that all-important income while you wait – are usually a good hiding place. This is what makes equity income styles appealing to more conservative investors, who not only like the income, but probably also the fact that drawdowns tend to be less severe. Today, however, elevated stock prices have dented their safe-haven credentials.

As always, there is a counter-argument. Rising interest rates pose a challenge not just for fixed income but for all asset classes, and equities typically perform poorly during these transition phases. Some managers point out that it is still possible for those supposedly safer, so-called ‘bond proxy’ equities to offer some sanctuary in a period of market turmoil, in spite of valuation concerns.

Richard Colwell, co-manager of the Threadneedle UK Equity Income fund, neatly summarises three possible scenarios:
1. Bond yields steepen gradually as growth improves;
2. Lack of GDP growth means a rise in short rates leads to a flattening of the yield curve/stagflation; or
3. We bid farewell to the 30-year bond bull market and suffer a big sell-off.

Investors will be hoping for number 1, but must prepare for the possibility of numbers 2 and 3.

The Adviser Centre is designed by City Financial specifically for financial advisers. To access its free-to-air fund research and consultancy service, click here

Extremes of policy and positioning

Extreme monetary policy has had its consequences – both intended and unintended. The authorities’ actions have supported asset markets and allowed the financial system time to heal, but the benefits to the real economy are more difficult to discern. In the UK, property prices are the most obvious beneficiary but it is mainly asset-rich, high-net-worth individuals who have reaped the rewards.

Less wealthy savers have had the raw end of the deal. In seeking greater returns on their capital, many have left the safe harbour of cash and moved into riskier asset classes. Bond funds and equity income funds have grown in size. Multi-asset income funds have proliferated.  When emerging market equities and biotech stocks are being touted for their income credentials, you know we have reached the final mile.

One unintended consequence of forcing yield-starved investors into riskier income-generating assets is that we just do not know how the less experienced holders, who are potentially out of their comfort zone, will respond to a period of market stress. What we can say with certainty, however, is that positioning in these areas is at an extreme – and this is rarely a good sign.


Gill Hutchison

Problems, problems, solutions – Mixed investments (June 2015)

Gill Hutchison, head of investment research at City Financial and The Adviser Centre, looks back at a lost era for asset allocation and forward to a new world of managed and multi-asset solutions

It is funny to observe the way managed funds, in all their guises, have become the new sexy things in the fund industry. It seems we have come full circle since the days of the traditional managed funds and, along the way, we have seen fund managers indulging investors – and themselves – in niche and esoteric products that were only ever going to have a limited shelf life. Small-cap European technology funds, for example, may have had their time in the sun but, boy, did they become unpopular as the nineties gave way to the noughties. 

In all the excitement of rewarding equity markets through the 1990s, led by the mighty US, asset allocation skills became an endangered species. Who needed cash and bonds when stocks generally pointed upwards? And doesn't inflation wipe out your real return from fixed income anyway? 

"The past is littered with asset allocation shipwrecks. In truth, very few managers are good at asset allocation and a number of those who really excel have probably retired."

The 2000s ushered in a harsher era for equities. As markets were still digesting the TMT boom and bust, the tragedy of 9/11 was the catalyst for an era of proactive monetary policies to support the global economy. With developed market interest rates set in a much lower range than the current generation of investors was used to, the temptation to feast on cheap money culminated in the global financial crisis in 2008. Interest rates have been lodged at emergency levels ever since. 

Navigating equity markets was a more challenging exercise through these years and many investors found out they did not have the stomach for such a high level of risk. They also eyed government bond investors with envy, as the asset class justified its reputation as the ultimate safe haven.

As we live on with the ramifications of a global debt overhang, certain parts of the fixed income market have provided generous returns to investors, with rates still locked down at close to zero. How long this persists is clearly the debate of the day, and markets are responding to the prospect of a ‘lift-off’ by US rates with some trepidation. 

This rapid trip down memory lane serves to explain, to some degree, why managed and multi-asset funds have returned to the spotlight. Many investors simply lost their confidence and opted to delegate the day-to-day job of running money to full-time professionals. 

The other important parts of this equation are the changes to the regulatory environment and the introduction of greater pension freedoms. These forces for change in the world of financial planning have made the advisers’ role more complex, meaning that business processes need to be as efficient as possible. With investments just one part of an adviser’s overall service proposition to a client, the fund industry needs to provide solutions that are trusted, understandable and easily mapped to investors’ attitudes to risk and investment goals. 

Indeed, fund managers have responded to the opportunity by launching new products – particularly within ‘multi-asset income’. Looking at the statistics sourced from Morningstar, the number of funds in the Mixed Investments 20-60% Shares sector has moved up from 114 to 134 over the past three years. In the Mixed Investments 40-85% Shares sector over the same period, the number of funds has moved up from 116 to 132.

Wood from the trees

Wonderful as it is to have the luxury of choice, making an appropriate selection is becoming a more troublesome task. At The Adviser Centre, we know many of the long-standing managed propositions well and we have also been looking at the newer kids on the block.

When we are looking at a new multi-asset proposition, a couple of questions are at the forefront of our minds, the most important of which is: what is the fund manager claiming can be achieved? We have seen some fantastical investment objectives and targets cited over the years and, sadly, there are still some around these days. Income delivery and capital growth expectations must be calibrated for the world we are in today – so always take account of where interest rates and economic growth levels currently stand. If a fund is targeting that magical 5% a year income, ask how this is being done, what risks are being taken to get there and the extent to which capital is being put at risk as a result.

Making claims about limiting capital volatility should also be carefully tested – is this hoped-for outcome a residual of an innately conservative portfolio, is it a function of diversification or are derivative strategies used overtly to protect the portfolio? How much do protective strategies cost? We all know diversification and hedging strategies sometimes fail to perform their job as expected – is the fund manager open about this and can the process be observed through periods of market stress?

Another key question is: what is the asset allocation structure? Is there a framework or do the managers have a free rein? What is their asset allocation heritage? The past is littered with asset allocation shipwrecks. In truth, very few managers are good at asset allocation and a number of those who really excel have probably retired. Is the fund organised around a structural asset allocation framework and/or a risk budget, or is it a flexible offering? Not many would have willingly held government bonds over the past few years without a framework forcing them to do so, or a strong sense of risk diversification telling them they needed an offset in the portfolio in case their base scenario proved incorrect.

Asking these questions can help to see the wood for the trees when looking through the myriad of managed and multi-asset funds that are available, but we do not pretend that the task is straightforward. As always, look for relevant manager experience and resources that are appropriate for the task in hand and be very wary of overly ambitious claims – tempting as they may appear. If it looks too good to be true, it probably is. Also remember that, sometimes, the simplest fund structures are the best – they are easier to explain, less complex and usually cheaper to manage and they often have a funny habit of delivering better results.

The Adviser Centre is designed by City Financial specifically for financial advisers. To access its free-to-air fund research and consultancy service, click here

Matching retirement needs with fund solutions

* Income priority: For some retirees, the delivery of a regular, maximised level of income is the absolute priority. Such investors need to accept capital volatility in return for this high yield. Fund examples would include Aberdeen High Yield BondArtemis High Income and Invesco Perpetual Monthly Income Plus.

* Income and capital growth: Investors approaching retirement or in early retirement may be seeking a regular income but still wish to see growth of their capital. Fund examples would include Artemis Monthly DistributionFidelity MoneyBuilder BalancedHenderson Cautious Managed and Investec Cautious Managed

* Capital preservation: For those who are fortunate enough to have sufficient income or access to funds and so wish to grow their nest-egg while protecting the downside as far as possible, we suggest risk-diversified, multi-asset funds. Here, fund examples would include Aviva Investors Multi-Strategy Target ReturnInvesco Perpetual Global Targeted Returns and Standard Life Investments Global Absolute Return Strategies.


Gill Hutchison

Forces for change – Japan (May 2015)

Japan has for decades been a market reserved for nimble value investors but, suggests Gill Hutchison, head of investment research at City Financial and The Adviser Centre, an improving environment of increased profitability and positive economic growth and inflation could now support growth strategies

The Japanese equity market has been the bane of asset allocators’ lives for decades. In the 1990s, the market was dismissed as ‘super-cyclical’, destined to perform only when global growth was booming – in other words, if you wanted to add cyclical beta to your portfolio, Japanese equities were an answer.

Having reached outrageous price/earnings multiples by the end of 1989 (54x, according to Nomura Research), the Japanese equity market went into freefall, spending much of the next 20 years pedalling furiously for short periods, but never really breaking free from a debt-induced deflationary spiral.

"Financial market reforms provide the most potent arguments for a positive outlook on Japanese equities."

Prime minister Junichiro Koizumi made the first serious attempt at meaningful supply-side reforms in the early 2000s, but society’s deeply embedded vested interests eventually defeated him. On a relative basis, the Japanese economy fared quite well through the global financial crisis, with domestic banks having limited exposure to the securitised and leveraged world that was prevalent in western developed asset markets.

However the crisis led to a substantially weaker global environment, leaving Japan with nowhere to hide. With government debt spiralling out of control, another solution had to be found, particularly after the devastation caused by the 2011 earthquake and subsequent tsunami. 

At the end of 2012, prime minister Shinzo Abe was swept into power on a reform package to end the decades of stagnation in the Japanese economy. Abe had been forced to retire in 2007 in his first term as prime minister due to ill health, but his second term was very much a restatement of his original goals – namely to undertake bold monetary expansion, adopt flexible fiscal policies and drive through structural reforms.

These goals were given the nickname of the ‘three arrows’ after a Japanese legend, in which a lord asked his three sons to snap an arrow, which each did. However, when they were asked to break three arrows at once, none of them could. The story speaks to the idea that Japanese companies, investors and the government must work together in order to strengthen Japan’s economy.

Enduring investment opportunity or short-term trade?

For too long, an allocation to Japanese equities has been treated as a short-term trade, with foreign buyers parachuting into the market on occasions, but rarely having staying power. The third arrow of structural reforms could hold the key to changing investors’ attitudes towards the market, and Abe’s strong political capital following his success in last December’s early general election gives him a fighting chance of achieving successes. The key areas of focus for Japan’s reforms are summarised in the box below.

The Adviser Centre features four funds from the IA’s Japan sector, which are managed according to different styles:

* GLG Japan CoreAlpha
* Invesco Perpetual Japan
* Legg Mason Japan Equity
* Schroder Tokyo

This fascinating backdrop of structural change is accompanied by the market’s relatively attractive valuation compared with other developed market peers, with price-to-earnings and price-to-book ratios below those of the US and Europe, according to figures from Goldman Sachs Asset Management. Earnings-per-share growth is also likely to outpace other regions from here.

Highlighting this encouraging picture is by no means an attempt to underplay the huge economic challenges of generating sustained GDP growth and raising inflation, as well as reducing Japan’s eye-watering debt burden, but, as we know, equity markets are quite capable of parking such enduring concerns while the focus is elsewhere.

Progressing out of the disinterest phase

After years of treading water, Japan has not been the market of choice for younger fund management talent. The sector is dominated by seasoned investors such as Andrew Rose of Schroders, Stephen Harker of GLG and James Salter of Polar Capital. They are true experts in this fascinating but persistently disappointing market. 

As Fidelity recently pointed out, for the last 25 years, Japan has been a market reserved for nimble value investors. An improving environment of increased profitability and positive economic growth and inflation should support growth strategies, notably those that are most keyed into the drive for improving returns on equity and better corporate governance. 

It is interesting to see Goldman Sachs Asset Management planning to make its Japanese secular growth strategy available to the UK market. Perhaps this era of change in Japan will encourage greater engagement in the market by the fund management community?

The Adviser Centre is designed by City Financial specifically for financial advisers. To access its free-to-air fund research and consultancy service, click here

Japan’s reforms – key areas of focus

* The labour market: The demographic picture in Japan is bleak and deteriorating. To boost the workforce, Abe’s government is promoting a higher female participation rate, including increased support for young mothers.

* Improved conditions for temporary workers: Stagnant economic growth resulted in greater use of temporary workers, who suffered vastly inferior working conditions, resulting in income inequality and a slow-down in productivity. New legislation is designed to address this trend.

* Trans-Pacific Partnership (TPP): The agreement between 12 countries is due to be reached around the end of 2015. Japan is the one of the most closed economies among this group and stands to benefit substantially from the TPP and attract increased foreign direct investment. These benefits will be enhanced by further weakness of the yen.

* Agriculture: One of the most protected sectors in the world and is run with huge subsidies. Abe is looking at long overdue reform of the Agricultural Cooperative System.

* Energy sector: Abe aims to restart Japan’s nuclear power generation after the Fukushima disaster, which should improve the trade balance and reduce electricity costs in the coming years.

Financial market reforms provide the most potent arguments for a positive outlook on Japanese equities.

* Government Pension Investment Fund: One of the largest institutional investors and it has raised its target allocation to equities from 24% to 50%.

* Stewardship Code: Aims to ensure that institutional investors are engaged in corporate governance and are protecting the interests of their clients.

* Corporate Governance Code: Incorporates a range of principles aimed at shifting the mind-set to that of profit-maximisation. In turn, these should improve the poor return-on-equity record and encourage the corporate sector to return some of its aggregate cash pile back to shareholders.

* JPX-Nikkei 400 index: Membership of this index, launched in January 2014, is regarded as a badge of honour. Listing requirements are based around the efficient use of capital (including a focus on return-on-equity) and shareholder-focused governance.


Gill Hutchison

Collective caution – UK equities (April 2015)

UK equity fund managers may have a variety of ways to skin the investment cat, says Gill Hutchison, head of investment research at City Financial and The Adviser Centre, but at present they are unified by an overriding sense of nervousness about pricing and policymakers

In contrast to the innate sense of discomfort expressed by the vast majority of the fund managers we speak to, UK equities have moved ahead smartly since the beginning of the year. We had some meaty things to consider at the turn of 2015, including the ECB’s QE announcement, the Greek election and its aftermath, deflation and the implications of oil price weakness – not to mention a perplexing UK election to look forward to. 

But perish the thought that challenging or downright disturbing news should get in the way of the liquidity train. The ‘TINA’ market is alive and kicking – that is to say, ‘there is no alternative’ when cash is earning peanuts in the bank and policymakers seem intent on supporting asset markets and their march higher.

"Perish the thought that challenging or downright disturbing news should get in the way of the liquidity train."

When to step off the escalator?

All fund managers have an innate style and a way of looking at the world that underpins their comfort – or their discomfort – with regard to market conditions and opportunities. Thus, for example, value-style managers step off the escalator early, as sufficiently cheap opportunities dwindle away while blended-style managers stay on board for longer but have to rely more heavily upon growth prospects, rather than good value, to justify the investment case

For their part, growth-style managers have the luxury of carrying on up the escalator towards the top as they look ahead to the sunny uplands of earnings growth, without having to worry about current valuations. These generalisations are brought alive in the conversations we are having with fund managers, who use a range of styles to approach the UK equity market. 

In The Adviser Centre’s ‘Value-Biased’ category, Alastair Mundy of Investec UK Special Situations is usually one of the first managers to express concern about a lack of value in the market. He is unusually demanding on valuation – hence he has been raising the red flag for a couple of years. This struggle is reflected in the fund’s underperformance but is precisely what we should expect from him at this time – remember, he is also one of the first to get involved when there is blood on the streets. 

In our ‘Larger-Cap, Blend’ category, JPM UK Dynamic is managed according to the tenets of behavioural finance investing and the portfolio is exposed to value, quality and momentum factors. The team has been struggling to identify stocks with strong value characteristics over the past few months and are therefore relying more heavily on the quality and momentum factors when populating the portfolio. They note that, not surprisingly, oil stocks now make up a meaningful proportion of the overall market’s value credentials and managers clearly have good reasons to remain cautious here.

In our ‘Growth-Biased’ category, Nigel Thomas of AXA Framlington UK Select Opportunities is a growth investor – but at the right price. Taking advantage of his unconstrained, all-cap mandate, he is still able to find companies that have good growth attributes but do not exceed his P/E pain threshold. He finds relatively few large-caps attractive.  

Fund managers have a variety of ways to skin the investment cat but what unifies them all at present, whatever their approach, is an overriding sense of nervousness about pricing in all markets, policymakers’ actions and the continuing lack of aggregate demand in economies.

In the face of the obvious challenges, asset prices are moving up – but thanks in large part to the largesse of global central banks. Looking at pricing objectively:
* Fixed income pricing assumes recession, at best;
* Commercial property pricing assumes we will achieve future rental growth, thanks to a cyclical recovery; and
* Equities have re-rated on the assumption earnings growth re-establishes itself.

Which price is right?

Alongside this disturbing conundrum is the reality that asset prices can keep moving upwards, as long as the market continues to applaud stimulus tactics, with the result that more and more people are sucked into assets that are moving higher relentlessly. We only have to look at exchange-traded fund flows over recent weeks for confirmation of this. 

As such, fund managers have to decide whether they stay fully involved, walk the tight-rope between some caution and some racier positions, or check out as much as is physically possible without breaching the regulatory and IA sector rules on cash holdings. 

Whichever path they tread, most accept that a good thump is on its way – either that or we throw away all the textbooks.

The Adviser Centre is designed by City Financial specifically for financial advisers. To access its free-to-air fund research and consultancy service, click here

UK equity flows and positioning

* Portfolio turnover levels have typically been very low, with managers retreating to the companies in which they have greatest conviction and/or those that offer greatest resilience.
* UK equity fund managers are feeling the effects of the pre-election nerves, with fund inflows slowing dramatically.
* Given the high degree of uncertainty about the election, it is difficult to position with any conviction ahead of 7 May. A Labour win is likely to impact those sectors perceived to be politically vulnerable – notably banks, energy, utilities and tobacco. Sterling would also be likely to come under pressure. 
* The oil price trauma has created interesting challenges and opportunities for the UK market. Managers are typically underweight in the sector, due to the size of the oil majors in the index. The question is, are oil stocks cheap enough? In practice, the majors have held up relatively well – in part because of the commitment to their dividends – but extended oil price weakness has the potential to threaten future pay-outs, thereby removing this all-important support for stock prices.
* On the other side of this coin, managers are attracted to the beneficiaries of oil price weakness, such as consumer and transport stocks. 
* Sentiment towards banks is improving and portfolio weightings are increasing.
* Sectors such as telecoms and pharmaceuticals understand how to operate through price deflation – something that may prove a valuable skill …


A funny kind of ‘region’ – Global emerging markets (March 2015)

Gill Hutchison, head of investment research at City Financial and The Adviser Centre, is unable to pretend the outlook for emerging markets is anything but challenging

 

My favourite fund manager comment of recent days has been from Prashant Khemka of Goldman Sachs Asset Management, who said that articulating a view on global emerging markets is like, “asking for a weather forecast for the world”.

Treating the countries that are featured in the global emerging markets index as a single investment unit is anachronistic but also inevitable. After all, how else would you squeeze emerging Asia, Latin America, Europe, Africa and the Middle East into a UK investor’s portfolio?

"We have long believed the most successful emerging market funds are born of strong Asian competence."

Emerging Asia is by far the most important regional component of the benchmark, with the MSCI Emerging Markets index currently featuring almost 70% there. Latin America is a long way behind at around 15% while emerging Africa and emerging Europe are approximately 7% and 8% respectively. The Middle Eastern representation is minimal (source Lazard Asset Management, January 2015). We have long believed the most successful emerging market funds are born of strong Asian competence and, if the index is anything to go by, this is more relevant now than ever before.

Are emerging markets cheap?

On a price to book basis, emerging markets are trading at a discount to other markets – most notably the US equity market. Is this justified? We can look at the problems being experienced by the large emerging market economies of Brazil, China and Russia to partly explain this.  

Sector recommendations

We feature six emerging market equity funds within The Adviser Centre – four from the IA Global Emerging Markets sector and two from the IA Specialist sector. The sheer breadth and diversity of these markets presents immense challenges to fund managers and this goes a long way to explaining a relative lack of choice.

Investec Emerging Markets Equity is the only mainstream ‘Recommended’ fund we feature. Aberdeen Emerging Markets, Lazard Emerging Markets and First State Global Emerging Markets Leaders all attract our ‘Established’ endorsement, signifying they are at, or close to capacity. M&G Global Emerging Markets features on our ‘Positive Watch’ list. Specialist fund, Fidelity Emerging Europe, Asia & Africa is also ‘Recommended’. 

Brazil:The economic backdrop is very concerning here. Brazil enjoyed an export-fuelled boom during the heydays of higher commodity prices, but this is now unwinding. A dependence upon foreign funding has left the country heavily indebted to the rest of the world. At the same time, the Brazilian real is under severe pressure and interest rates have been hiked in response. The government deficit, which continued to widen during the boom years, is deteriorating further. Manufacturing output is weakening, as is domestic demand. All in all, this is a toxic mix for the country. 

Russia: The situation here is well documented. As one of the world’s largest oil producers, Russia is painfully exposed to the collapse of the oil price. The Ukraine-related sanctions are also applying downward pressure to the economy. The rouble is responding in kind and the economy is heading for recession. 

China: The largest emerging economy dominates sentiment towards the sector and uncertainty about the path of growth has overshadowed the outlook and appetite for the asset class for some time. The authorities have responded to economic weakness by easing monetary policy, which set the stockmarket alight at the end of last year. It remains to be seen if this loosening action will be sufficient to overcome the effects of the credit excesses of previous years.

Capital spending and construction data is weakening and anti-corruption measures have hit the luxury goods and property markets. China’s neighbours and manufacturing competitors are busy devaluing their currencies, rendering Chinese goods more expensive. It is only a matter of time before the renminbi joins the devaluation game.

The final BRIC – India shines

India has been the jewel in the Asian crown in recent months. Optimism for long-awaited reforms inspired by prime minister Narendra Modi is high. The stockmarket is home to better quality companies and earnings growth, that rarest of commodities these days, is in evidence.

However, the market is even more expensive than usual and over-owned by regional investors. Indeed, many Asian and emerging market fund managers are citing an overweight allocation to the market as a key contributor to relative performance over the past year. 

So what are the prospects?

We cannot pretend the outlook is anything but challenging. Emerging markets are experiencing a cyclical downturn at the same time as coping with the dislocation of the oil price fall. Simultaneously, developed markets, with the possible exception of the US, are struggling to generate any meaningful growth and, like it or not, economic progress in emerging markets still depends heavily upon western demand. 

From a capital flows point of view, any sustained shift in favour of cyclicality on the back of better economic indicators in the developed markets is likely to encourage risk-seeking further afield and therefore lend support to emerging markets.

Relatively cheap markets, combined with weak currencies, will eventually attract global asset allocators, but with currencies weakening still further, the debt burden rising, export prices slipping and earnings under pressure, emerging markets are some way from being at the top of international investors’ shopping lists. A rising US interest rate cycle would also present challenges.

The Adviser Centre is designed by City Financial specifically for financial advisers. To access its free-to-air fund research and consultancy service, click here

Key pointers for fund selection

* Given its size and importance, we believe competence in the Asian region is a pre-requisite for a strong emerging markets proposition.

* The scale and diversity of the investment universe demands the resources of an extensive and efficient team or, at the very least, a disciplined and comprehensive screening process to capture a huge array of information.

* An appreciation of political and cultural effects in individual countries remains extremely important.

* Governance issues tend to be high on the agenda and can have a meaningful influence on investment decisions.

* Capacity in the most popular funds remains an issue but the pressure has subsided as the appeal of emerging markets has declined.


Gill Hutchison

Heaven and hell – Specialist funds (February 2015)

Gill Hutchison, head of investment research at City Financial and The Adviser Centresizes up the extremes on offer to investors within the Specialist sector, with a particular focus on gold

The Investment Association (IA) Specialist sector is a land both of milk and honey and of drawdown hell – very often at the same time; a land that requires careful navigation and a keen eye on investment timing. Putting together this article proved a useful reminder of what is inside this treasure trove of funds that do not have a home anywhere else.

Here is a broad summary of the groupings therein – country and regional equities (for example, Brazil and Eastern Europe), energy, agriculture, resources, gold, infrastructure, various total/strategic/targeted return funds, specialist multi-manager funds, mortgage-backed securities, global financials, healthcare, biotech, currency funds, convertibles, timber … oh, and not forgetting First State Global Emerging Markets and First State Global Emerging Markets Leaders, after their shunt across from the IA Global Emerging Markets sector.

"As is often the case, the point of maximum exuberance about gold on the part of investors coincided with its peak price."

Technology & Telecommunications became a sector in its own right several years ago but has dwindled in size after the pricking of that particular bubble. The IA Global sector also captures some of the more specialist funds.

Within The Adviser Centre, we feature five funds from the IA Specialist sector – BlackRock Gold & General, Fidelity Emerging Europe, Middle East & Africa, First State Global Emerging Markets Leaders, Goldman Sachs India Equity Portfolio and PFS TwentyFour Monument Bond. We also feature GAM Star Technology, GLG Technology Equity and Polar Capital Global Technology from the IA Technology & Telecommunications sector. From the Global sector, we feature First State Global Listed Infrastructure, First State Global Resources and Guinness Global Energy.

A focus on gold

As a commodity, gold has enduring appeal for investors. Some regard it as a long-term store of value that plays a structural role in a portfolio. They may see it as a hedge against rising inflation and a weaker dollar. Furthermore, it can play a useful role as a safe-haven asset as its price tends to respond positively to financial system instability or geopolitical crises.

Over the past two years, the gold price has fallen from the highs of around $1,800 (£116z) per ounce to recent lows of close to $1,100. This decline has matched the fall in inflation expectations. As is often the case, the point of maximum exuberance about the commodity on the part of investors coincided with its peak price. Its fall was precipitated by the waning of investment demand, as expressed by huge flows out of gold bullion exchange-traded funds during 2013 and 2014.

As a commodity, gold is unusual in that it does not have a significant industrial application. According to Investec Asset Management/World Gold Council, based upon an analysis taken from the third quarter of 2014, 57% of the demand for gold was for jewellery, 22% was for investment purposes, 11% was used in technology and 10% was accounted for by central bank net purchases. This renders the metal more susceptible to pure investment-driven flows than other commodities.

Gold bullion v gold equities

Retail investors have the choice of investing in physical gold via an exchange-traded funds, or investing in gold-producing companies through a fund such as BlackRock Gold & General. Apart from the obvious comment, which is that investing in gold company shares entails different risks to investing in the underlying commodity, the other issue is that the correlation between the two asset types has fallen in recent years.

The result has been that investors in shares have been heavily exposed to corporate risk and this has proved to be a very rocky road. To reinforce the point, until very recently, the FTSE Gold Mines index, representing gold equities, has been falling since 2011 while the gold price did not fall meaningfully until 2013. In that year, gold bullion fell by 29% but this was still outdone by the 54% fall in the Gold Mines index (Source: BlackRock, returns in sterling terms).

With the gold price at much lower levels and closer to companies’ cost of production, share prices are now more sensitive to moves in the price of the commodity. This is helpful for investors who are using gold equity funds to provide exposure to the underlying commodity.

What are the prospects for the gold price and for gold equities?

While the weak global growth backdrop and lack of inflationary pressures are a headwind for the gold price, there are a sufficient number of economic and geopolitical concerns around the world for it to appeal to investors and to play a role in a portfolio – indeed, exchange-traded funds have seen large inflows again recently.
 
Gold is a non-yielding asset. With yields on government bonds now very low, or even negative, the opportunity cost of allocating to gold, in terms of income, is minimal. If seen as a currency alternative, gold is appealing in a world of competitive devaluations. Nonetheless, higher US interest rates and the rising US dollar are a challenge for the commodity.

Demand from India and China has been increasing since the gold price bottomed – although these markets are very price-sensitive – while central banks have shifted to a net purchase position since 2010. Meanwhile the supply side is supportive, with gold production forecast to decline in the coming years. Additionally, the number of large gold discoveries has fallen over the past 20 years.

For investors in gold equities, the backdrop certainly looks brighter than it did. Share prices have fallen significantly and, at the same time, gold producers have cut costs and capital expenditure in response to the lower gold price and pressure from shareholders.

However, quality remains the watchword for fund managers. The improvement in capital allocation does not apply across the board.  Some gold producers, particularly the juniors, need more capital and they have been returning to the equity market in recent months, taking advantage of more favourable conditions. Investors need to pick their way carefully – all that glisters is certainly not gold in this investment arena. 

The Adviser Centre is designed by City Financial specifically for financial advisers. To access its free-to-air fund research and consultancy service, click here


Gill Hutchison

Challenges and p;rospects - Commercial property (January 2015)

Gill Hutchison, head of investment research at City Financial and The Adviser Centre, reviews the recent showing of commercial property before weighing up the asset class’s future prospects and challenges

Low interest rates, quantitative easing, gradually improving fundamentals and supply constraints have done wonders for property as an asset class since 2009. Over one year to 2 January 2015, according to Morningstar data, The Investments Association’s Property sector average posted a return of 13.3%.

By way of comparison, the Sterling Corporate Bond sector delivered an average return of 9.7% while the UK All Companies sector average stands at a very modest 0.9%. As a sub-group, most of the traditional UK commercial property funds delivered double-digit returns in 2014 – not bad for an asset class that is supposedly all about the income yield.

"With almost no return available on cash, investors have been bounced along the investment risk curve into higher-yielding asset classes."

As a reminder, the sector features traditional UK commercial property funds, property securities funds (those focused on single areas and also those with global remits), residential property funds and student accommodation funds.

Prices up, yields down

The monetary policy backdrop and quantitative easing activities that have been pursued since the global financial crisis have many implications, some of which are overt while others will only be truly understood in the fullness of time. A dominant theme for all asset classes has been that of yield compression. 

With almost no return available on cash, investors have been bounced along the investment risk curve into higher-yielding asset classes – gilts to credit to property to UK income stocks to global income stocks to general equities. As a traditional income play, property in all its guises has been the beneficiary of this trend of 'yield compression'.

Diversification? Yes but …

Commercial property often features in meaningful allocations in diversified portfolios and, given its less volatile price stream, is certainly beloved of risk-profiling tools. Nonetheless, we believe we should be careful not to overemphasise the underlying diversification benefits. Economic growth is an important component of property demand, given its impact on corporate health and incomes – so in this sense it is correlated to GDP growth.

The Adviser Centre features four ‘Recommended’ funds from the IA’s Property sector, which are managed according to different styles:

* Aviva Investors Property Trust
* Legal & General UK Property
* M&G Property Portfolio
* Threadneedle UK Property trust

Other factors, such as supply/demand dynamics, the cost and protracted nature of property transactions and the slower pace of price discovery in the world of physical property, all play an important part in its apparent low correlation to other asset classes.

While the events of 2008 were extraordinary in many ways, the redemption challenges suffered by commercial property funds served to remind investors of the shortcomings of an illiquid asset class – especially when cash is king but difficult to come by.

Bricks and mortar + open-ended funds = liquidity mismatch

Offering daily liquidity to investors through open-ended funds can be somewhat problematic in all asset classes but it is fair to say that offering such a facility when the underlying assets are shopping centres, offices and warehouses requires a particularly steady nerve. The lessons of recent years have been learnt, to the extent that funds are now more aware of liquidity requirements, holding cash and possibly securities and derivatives in order to handle high levels of redemption requests. 

Of course, the disadvantage of a higher cash buffer is that property funds have little chance of keeping pace with the price moves of the underlying asset class, as measured by the IPD, when it is performing well. This is exacerbated by the lack of return on cash balances and the material impact of property transaction costs, as well as the other charges and taxes that property funds attract. In this sense, the IPD indices are extremely harsh performance task-masters – not only are they fully invested, they also do not suffer the associated costs of transacting properties and managing a property vehicle.

Fundamentals and valuations are supportive

Strong capital growth in commercial property, during 2013 and 2014 in particular, has not only been a function of the monetary backdrop. With the economy slowly moving out of its post-financial crisis slumber and the property market recovering from the 2008 liquidity shock and subsequent period of de-leveraging, prices have responded in kind.

During a recent meeting, Fiona Rowley, manager of the M&G Property Portfolio – a ‘Recommended’ fund within The Adviser Centre – neatly summarised why she still has a reasonably positive outlook for UK commercial property:

* UK economic fundamentals are improving.
* Capital flows are positive.
* The yield premium over bond yields is stable and high on a historical basis – the net initial yield of the IPD Monthly Property index is currently 5.4%.
* The lending environment is improving.
* Interest rates are stable – albeit with the risk of rises in the near future, which will present challenges, not least because property’s yield premium over gilts will diminish.

Better sentiment in commercial property is driving transaction volumes, which have returned to the buoyant days of 2007. Also notable is that the strongest momentum for capital growth is now – at last – outside central London, as investors look further afield to achieve more attractive returns. With the yield compression story reaching its conclusion (at least mathematically), rental growth is key to the next leg of returns from the commercial property market.

The Adviser Centre is designed by City Financial specifically for financial advisers. To access its free-to-air fund research and consultancy service, click here

Why PAIFs?

The rules for Property Authorised Investment Funds (PAIFs) were introduced by HM Revenue & Customs in 2008. A PAIF is a type of tax-efficient property fund that has advantages in terms of its tax treatment compared to that of traditional authorised property funds. At present, property funds that are not in a PAIF structure must pay corporation tax on the rental income they receive at a rate of 20%.

PAIF structures provide a means by which eligible investors can receive income gross of tax. PAIFs are required to divide their income into three different streams for UK tax purposes, with property rental income and interest income paid gross to eligible investors and therefore not subject to 20% tax within the fund. Please note, however, that dividend income is still paid net. Eligible investors include those who are holding the fund in an Isa or a pension and also UK non-tax payers. Charities and pensions funds also benefit from the tax advantages of PAIF structures.

The requirement to divide the income into different streams can make PAIFs challenging for some platforms to administer – hence the take-up thus far has been slower than might be expected. Feeder funds – currently on offer from the likes of M&G, Ignis, Kames, Legal & General and Standard Life Investments – are available for non-eligible investors and feature more widely on platforms.


Gill Hutchison

2015 preview - more of the same?

Gill Hutchison, head of investment research at City Financial, and the rest of The Adviser Centre team summarise their thoughts with regard to the key issues for the forthcoming year

* Once again, central bankers will sit front and centre stage this year

* Policy prescriptions will need to involve more players and in higher doses for the patient to respond

* Demographics and debt levels continue to hamper the prospects for a secular recovery in the global economy

* Currency wars are set to intensify as global central bankers outside the US press the print button.

* In other words, the risks are high and rising – but these are being met by ever higher levels of stimulus.

* The stimulative effect of lower oil prices is being underestimated at this point as investors worry that the decline reflects a significantly weaker global economy.

Suggested strategy

* Risk assets remain the primary beneficiary of global monetary stimulus but asset prices are increasingly dependent on the largesse of central bankers. Expect far higher levels of volatility in all asset prices, notably in response to authorities’ rhetoric.

* It is increasingly difficult to rationalise bond pricing, where the market seems to be responding to the rapid fall in the price of oil and other commodities, rather than the medium-term outlook for inflation.

* In the first half of the year, we suspect that buying the dips in equities will be a profitable exercise as actual or expected additional stimulus bolsters risk assets. For the second half of the year, we expect a more cautious strategy may be in order as certain realities come home to roost.

* The brutal reality is that a continuation of the positive, but sub-trend, global growth scenario will be supportive of asset prices in 2015. However, this scenario is finite in its delivery.

* At some point, either the stimulus will work and we will achieve escape velocity, in which case we are likely to see a violent, 1994-style bond market led sell-off, or investors will give up hope as economic growth fails to reignite. The former is uncomfortable but a clear long-term buying opportunity. The latter is far more damaging.

The Adviser Centre is designed by City Financial specifically for financial advisers. To access its free-to-air fund research and consultancy service, click hereFor a more detailed explanation of its views, please see its latest Monthly Viewpoint

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