LEADING EDGE RLAM’S REGULAR REVIEW OF INVESTMENT MARKETS • DECEMBER 2016
What’s brewing in high yield? Azhar Hussain considers the different flavours of high yield on the market and introduces RLAM’s recently bolstered team.
Preparing for all weather: Short duration positioning in credit
Credit Product Specialist Guy Cornelius explains why he believes short duration is a good option for income seeking investors.
Trumpflation and other stories
Following the surprise US election result, Economist Ian Kernohan considers the implications of a Trump presidency for the global economy.
The Great British Break Off
RLAM’s UK Equity Fund Managers Martin Cholwill, Richard Marwood and Henry Lowson provide a postBrexit overview of UK equity markets.
Head of Short Rates and Cash, Craig Inches considers how to deliver efficient cash management in an inefficient market.
For professional investors only, not suitable for retail clients
2 | TITLE OF MAG | APRIL 2015
Head of Distribution
Get in touch We welcome your thoughts on the e-zine and our communications with you in general, so please do give us your feedback by emailing: email@example.com Tel: 020 7506 6678 Fax: 020 7506 6796 Web: www.rlam.co.uk For professional customers only. The views expressed are the authors’ own and do not constitute investment advice. Past performance is not a guide to future performance. The value of investments and the income from them is not guaranteed and may go down as well as up and investors may not get back the amount originally invested. For more information concerning the risks of investing, please refer to the Prospectus and Key Investor Information Document (KIID). All rights in the FTSE All Share and FTSE 100 indices (the “Index”) vest in FTSE International Limited (“FTSE”). “FTSE®” is a trade mark of the London Stock Exchange Group companies and is used by FTSE under licence. The UK Equity Income Fund (the “Fund”) has been developed solely by Royal London Asset Management. The Index is calculated by FTSE or its agent. FTSE and its licensors are not connected to and do not sponsor, advise, recommend, endorse or promote the Fund and do not accept any liability whatsoever to any person arising out of (a) the use of, reliance on or any error in the Index or (b) investment in or operation of the Fund. FTSE makes no claim, prediction, warranty or representation either as to the results to be obtained from the Fund or the suitability of the Index for the purpose to which it is being put by Royal London Asset Management.
Welcome Welcome to the latest edition of Leading Edge. Since our last e-zine was published, we have seen some significant changes across the economic, political and market landscapes.
We’ve seen seismic changes in the political world. The new US Presidentelect, Donald Trump, was seen as a joke candidate when he announced he was going to run last year. Now commentators are scrabbling to work out what a Trump Presidency will look like. Here in the UK, the vote to leave the EU saw a dramatic restructuring of the UK government, along with changes across the UK’s major political parties. Since then, sterling, UK GDP prospects and equity markets have all been closely scrutinised. While these indicators have broadly recovered from the initial shock to varying degrees, speculation around the investment outlook across the UK and Europe has been rife. In this issue, RLAM’s UK Equity Team considers the prognosis for UK companies across the market cap spectrum, reflecting on the ‘keep calm and carry on’ mantra that has pervaded. One of the areas most visibly impacted initially by the Brexit result was property. The industry saw the closure of a number of open-ended funds, which suspended dealing in their shares after being overwhelmed by a spike in withdrawals. RLAM’s property fund remained open. Gareth Dickinson outlines how the team weathered the storm and discusses the market dynamics impacting real estate. Since the summer’s events, monetary and fiscal stimulus have been ramped up in the UK, while the Federal Reserve is being closely watched in the US. Given the anti-establishment flavour of voting this year, 2017 elections in France and Germany will be closely watched. Trevor Greetham, RLAM’s Head of Multi Asset, examines current conditions, updating on the position of the Investment Clock and its impact on asset allocation. With our focus firmly on the longer term, RLAM has bolstered our Fixed Income Team, with a view to offering a diversified multi asset credit solution. We introduce some of the new members of the team and consider some of the nuances involved in investing across the diverse universe of high yield assets. As ever, we’d love to hear your thoughts on the e-zine, so if you have any comments, feedback, or suggestions for future articles, please share them by emailing firstname.lastname@example.org I hope you enjoy the issue. Rob Williams Head of Distribution
DECEMBER 2016 | LEADING EDGE | 3
Preparing for all weather: short duration positioning in credit
The Great British break off
Credit Product Specialist Guy Cornelius explains why he believes short duration is a good option for income seeking investors.
Also in this issue 6 A storm in a teacup Following fears of a much publicised sell-off in UK property, Gareth Dickinson and Tim Greenway offer their outlook for the asset class.
ead of Short Rates and H Cash, Craig Inches considers how to deliver efficient cash management in an inefficient market.
RLAM’s UK Equity Fund Managers Martin Cholwill, Richard Marwood and Henry Lowson provide a post-Brexit overview of UK equity markets.
What’s brewing in high yield?
Trumpflation and other stories
Following several new appointments to RLAM’s Global High Yield Team, we take a closer look at the diverse range of opportunities in this space.
Following the surprise US election result, Economist Ian Kernohan considers the implications of a Trump presidency for the global economy.
Trevor Greetham discusses what time the investment clock is telling and outlines how he is positioned in light of this.
4 | LEADING EDGE | DECEMBER 2016
Preparing for all weather:
Guy Cornelius Credit Product Specialist
Short duration positioning in credit
Low yields have been ingrained in global bond markets since the financial crisis of 2008, as investors have intermittently sought refuge in â€˜safe havenâ€™ assets, and governments have tried to drive down borrowing costs. We believe that as economic growth improves and glimmers of sun continue to appear through the clouds, keeping yields so low is unsustainable. In this article, we explain the core reasons behind our short duration views, and illustrate why we think this is the best option for investors who wish to protect capital while drawing income from their bond portfolios. Prepared for a change in pressure Short duration has been a core position for our credit funds throughout 2016, as we have expected government bond yields to rise from their prolonged nadirs. Yields are now rising, but we have had to be patient this year. Following the announcement in August of monetary policy support and a rate cut by the Bank of England (BoE), new troughs were hit, although in the UK at least, yields remained above zero, unlike in Germany and Japan. Since the surprise election of Donald Trump, yields have changed direction. Amid concerns over sterling weakness and the potential for inflation in the UK, yields have risen and are now at pre-referendum levels. Our current forecast for the Consumer Price Index (CPI) in the UK for the end of 2017 is 2.7%; against this backdrop, we see UK 10-year yields rising to above 2% by the end of 2017, and 30-year yields rising to 3%. Benchmark government bond yields in Germany have returned to positive territory, and US yields have also moved decisively higher. Chart 1 shows the 5-year versus 30-year gilt yield movement in the UK since the Brexit referendum. We anticipate that the curve will steepen further. The question for investors is, what can this do to long bond prices?
A sweater or sunglasses? Or both? Chart 1 5 year versus 30-year gilt yields 140 135 130 125 120 115 110 105 100 Jul 16
Chart 2 Vodafone 3% 2056 price movement: August to November 2016 105 100 95 90 85 80 Aug 16
Source: Bloomberg, as at 17.11.2016
DECEMBER 2016 | LEADING EDGE | 5
Let us take Vodafone 3% 2056 bond (Chart 2) as an example. This is a sound, investment grade company. This bond currently offers an extra 200 basis points (bps) in yield, compared to the equivalent maturity gilt. If our end2017 forecast for the 30-year gilt yield is correct, and if the spread of 200bps were to remain constant, investors would see their investment fall 17% further in price (from 81.00 to 64.00) – this particular bond has already fallen 18% since issue in August of this year, as demonstrated by chart 2. This comes as a result of the rise in yields that’s occurred since its issue and shows the price volatility inherent at the longer end of the market, and the sensitivity to the yield increases of October and November. Patchy rain We think, with a high degree of certainty, that markets will experience increased levels of volatility as the unclear global political outlook takes a more concrete shape and inflation risk becomes more prominent; capital preservation will therefore be even more important. In the UK, Brexit negotiations remain clouded by uncertainty, and even the views of the government remain opaque. Movements in sterling have been as much affected by politicians’ announcements as by economic fundamentals, and the likelihood of further storms as negotiations unfold is high. In Europe, many national elections are scheduled for 2017. The recent election of Donald Trump as president of the USA has heightened worries over right-wing populism, and has also revealed the inaccuracy of pre-election polling data. Combined with Brexit, which is broadly considered to be as hazardous for Europe as for the UK,
uncertainty is likely to hamper markets. Meanwhile, the BoE’s corporate bond purchase programme continues: of the target £10bn, £3bn has so far been bought. Initially, prices of individual bonds and sectors rose as markets speculated over which would be bought, but these movements have been retraced. The market impact has been minimal, in marked contrast to the European market. So far, equity markets have viewed the US election in a positive light; the political system is, after all, bigger than just one person. Despite checks and balances, the president does have some broad powers in trade and foreign policy to act without Congress. Markets are usually encouraged by fiscal stimulus and deregulation. There is more concern regarding trade policies but, for now, the feeling is that the impact of stimulus will feed through faster than any serious constriction of trade. Bond markets, however, have exhibited uneasiness regarding the inflationary impact of a sizeable fiscal stimulus at a time when the headline unemployment rate is low, although Trump’s plans may be capped by the current level of debt to GDP, which is at a historical high. Although the choice of president is unlikely to have a long-term impact upon global markets, we expect some short-term volatility. While equity markets can acclimatise to higher yields in the near term, a rapid unwinding of the 30-year bull market in bonds would be an unstable backdrop for many fixed income assets. Checking the forecast As bond yields increase, particularly in the
sterling market, we would expect to see a movement towards ‘de-risking’ by pension funds, a substantial part of this market, which would involve selling equities into bonds. This, in combination with growth-limiting debt levels, and political difficulties will put a limit on bond yield rises but for now, the path of least resistance is higher yields and steeper curves. Against this backdrop, we would highlight our range of shorter duration focused credit funds, both in investment grade and high yield markets. Our Short Duration Credit Fund is a great example of how we apply our philosophy of concentrating our research on secured, senior high quality bonds, and placing more importance on the underlying credit value than liquidity. In addition, we have been buying increased amounts of secured Floating Rate Notes (FRNs) in recent months to reduce sensitivity to interest rate movements. All our shorter duration credit funds have significant underweight exposure to sovereign and supranational bonds, with a preference for higher yielding corporate bonds, which we expect to outperform over the long term. This greater flexibility gives us the scope to seek to outperform other short duration strategies that are primarily focussed on single asset classes.
The value of investments and the income from them is not guaranteed and may go down as well as up and investors may not get back the amount originally invested. The views expressed are the manager’s own and do not constitute investment advice. For funds that use derivatives, their use may be beneficial, however, they also involve specific risks. Derivatives may alter the economic exposure of a fund over time, causing it to deviate from the performance of the broader market.
6 | LEADING EDGE | DECEMBER 2016
A storm in a teacup? An overview of the UK property market Property hit the headlines over the summer when high-profile funds put the brakes on redemptions as investors piled out in a Brexit-fuelled dash. As the hasty escapists retrace their steps, our property managers Gareth Dickinson and Tim Greenway assess the short-term effect and longrun implications of the decision to leave the European Union for the UK property market, and highlight some of the risks and opportunities that lie ahead.
Summer storm While the extent of redemptions in the post-referendum frenzy was surprising, the market actually fell by less than 5%. With many panicked calls being reversed; the pace of decline has slowed markedly. In the run-up to the vote, all asset classes showed signs of investor hesitation, and property was no exception. Our analysis shows that property was nearing a cyclical peak, and we were expecting a slower summer; although the whirlwind of outflows pushed markets to unexpected troughs, the subsequent rebound has contained the short-term impact. Isolated showers Uncertainty caused by Brexit is a mediumterm risk. Clear signs of concern for the property market would be large numbers of jobs leaving the City; while there have been negative statements from some leading banks, no concrete evidence has yet been revealed. A drop in consumer confidence would hurt the retail market, and at the extreme, a complete exit from the single market could have a serious effect.
Head of Property
The value of investments and the income from them is not guaranteed and may go down as well as up and investors may not get back the amount originally invested. For funds that use derivatives, their use may be beneficial, however, they also involve specific risks. Property-based pooled vehicles, such as the Fund, invest in real property, the value of which is generally a matter of a valuer’s opinion. It may be difficult to deal in the shares of the Fund or to sell them at a reasonable price because the underlying property may not be readily saleable, thus creating liquidity risk.
While the shape of the ‘ex-EU’ UK remains unknown, the likelihood of these risks materialising hangs in the balance, and there is much scope to take advantage of opportunities as the property market continues close to its forecast non-Brexit trajectory. Our current area of focus is the industrials sector, which is benefitting from rental growth, huge demand for land and strength across both primary and secondary markets. Robust office demand is a further area of interest; here, we are concentrating on the South East and Greater London. The retail market has been quieter, while
the leisure sector is stable. On the riskier side, our development projects have been successful. Overall, property returns have been positive this year, reflecting the yield premium offered by the asset class. The diversification of property assets, yields and risk levels, we believe, means that the sector will continue to offer opportunities for a wide range of investors seeking long-term returns. Patchy sun with outbreaks of rain Brexit has gone from being an acute problem to a chronic one, and the economic outlook over the next three years will be pivotal for the UK property market. While we cannot know the precise impact, we are confident that the market is in better shape than when the 2008 crisis took hold. Most areas show a good balance between supply and demand, and debt availability is restricted, meaning that the market is not teetering precariously on leverage. There is also more flexibility: although property funds did halt redemptions, many explored options such as alternative pricing and dilution levies, demonstrating the expanded set of tools available for managing cashflows. Put the kettle on The investor base in the UK property market is a broad church, and the sector’s attractions of capital preservation and quality of stock and yields available are particularly strong for foreign investors. The auction market remains robust, demonstrating investors’ hunt for income amid record-low bond yields. We think that the attractions of bricks and mortar in a distorted market, combined with reliable income generation, bode well for the longterm UK property outlook.
DECEMBER 2016 | LEADING EDGE | 7
Cash conundrums Efficient cash management in an inefficient market
ecord low bond yields have hit the headlines in a number of contexts: pension funds, borrowing costs, bond returns. But there has been surprisingly little focus on what rock-bottom rates are doing to cash investments. Craig Inches, our Head of Short Rates and Cash, discusses how companies can diversify their cash holdings to increase yield and mitigate risk while maintaining liquidity.
The second pot would comprise nonoperational funds that could be invested for three to six months or longer. Here investors have more options: they may choose a ‘cash plus’ vehicle with a higher yield than a pure liquidity fund. Generally investors would receive a minimum of two-day liquidity in a pooled vehicle with a variable net asset value. Typically these funds are AAA rated and have a duration of three to nine months.
A third pot would be for ‘war chest’ cash held on a 12-month or longer horizon. For this, an ‘enhanced cash plus’ vehicle may be appropriate, which in addition to cash instruments would invest in short-dated credit, covered bonds and asset-backed securities. This will give a higher yield, but may experience some volatility in terms of price movements. For this reason these funds have a slightly lower credit rating of AA, and a duration of six months or higher.
All companies and pension funds have cash requirements, from operational everyday movements to longer-term ‘war chest’ projects. Cashflow is vital to the proper functioning of a business, like blood flow round the body. In recent years, however, the range of available instruments has shrunk and yields have tumbled, multiplying the challenges for efficient cash investment. Since the credit crisis of 2008, the downgrading of many institutions has meant that there is a decreasing number of high quality, liquid assets on offer in the market. Demand for the highest rated securities, and for ‘safe haven’ assets in general, has remained strong, pushing yields to extremely low levels. We believe that investors can enhance the low yields and poor liquidity on offer by utilising a structured, blended approach to cash investment. This may hold many advantages in terms of risk management, diversification and returns. Cash kaleidoscope Cash may be divided into three main pots: the first is operational cash that needs to be immediately accessible. For this pot, investors are limited to call accounts and/or liquidity style funds.
Conclusion Although cash is typically a short-term holding, successful cash management is a long-term necessity. While the current climate of economic uncertainty continues, we believe that investing cash holdings across a suitable range of funds will help to enhance a portfolio with liquidity, diversification and higher yields. With increasing pressure on returns, every part of a portfolio, including cash, needs to pull its weight. The value of investments and the income from them is not guaranteed and may go down as well as up and investors may not get back the amount originally invested. The views expressed are the manager’s own and do not constitute investment advice. For funds that use derivatives, their use may be beneficial, however, they also involve specific risks. Derivatives may alter the economic exposure of a fund over time, causing it to deviate from the performance of the broader market.
RLAM has a range of three cash solutions which fit broadly into these categories: the RL Short-Term Money Market, RL Cash Plus and RL Enhanced Cash Plus Funds. These are structured to meet a range of return and income objectives, investing across a number of different asset types from deposits to short dated fixed income securities. Investing cash appropriately widens the universe of available assets, thereby increasing diversification and potentially mitigating risk. Introducing assets such as covered bonds into a portfolio enhances the yield, increases the rating and improves the liquidity. By using a broader range of instruments, it is also possible for investors to vary the interest rate sensitivity of their portfolios. In our ‘enhanced cash’ and ‘cash plus’ strategies, we use floating rate notes, some of which are covered, which help reduce the portfolios’ exposure to rising interest rates.
Craig Inches Head of Short Rates and Cash
8 | LEADING EDGE | DECEMBER 2016
The Great British Break-Off An overview of UK equity markets
Despite predictions that a vote to leave the European Union would result in an economic apocalypse, UK equities have shown the market equivalent of a stiff upper lip: bouncing back, keeping calm, and carrying on. Although the road towards Brexit remains clouded in uncertainty, UK equities offer a range of opportunities to investors seeking returns against a backdrop of low government bond yields. We talk to our managers Martin Cholwill, Richard Marwood and Henry Lowson about the UK equity market, and they offer an overview of some of the opportunities on the horizon across their income, growth and smaller companies strategies.
Smaller companies: cracks in the surface? In the immediate aftermath of the Brexit vote, there was a marked divergence in performance between the FTSE100 index and the small and mid-cap indices, with the FTSE100 proving much more resilient. The weakness of sterling after the referendum proved to be beneficial to large companies with more international earnings streams. Smaller domestically focused firms were hit by the backlash of a hasty flight away from UK assets. Nevertheless, smaller companies bounced back during July and August, returning to prereferendum levels as a new Prime Minister took the helm and the Bank of England activated further monetary support. It is also worth noting that although in 2016 the FTSE100 has outperformed the smaller indices, it has been the small and mid-cap stocks over the last five years which have outperformed larger companies. Indeed, market swings and bouts of volatility can provide opportunities to take advantage of indiscriminate selling to purchase attractive companies at low valuations. However, we seek to invest in companies that not only exhibit attractive bottom-up fundamentals, such as good cashflow and strong management, but also those that are supported by long-term market drivers, economic tailwinds and â€˜self-helpâ€™. By this process, we seek to protect the Fundâ€™s investments from the ebb and flow of the normal economic cycle. The nature of smaller companies means that they are at an earlier stage of their lifecycle and therefore offer attractive growth potential. Furthermore, the hunting ground is large, with around 1,500 firms in the smaller companies investment universe.
Senior Fund manager
Senior Fund manager
Senior Fund manager
Growth: sweet and sour Sterling has lost a significant proportion of its value against the US dollar this year. While a low
DECEMBER 2016 | LEADING EDGE | 9
FTSE 250 v FTSE 100 120% FTSE 250 100%
Watch a brief video with Martin Cholwill and Richard Marwood discussing dividend prospects.
60% 40% 20% 0% -20% Nov ’11
Mar ’12 Jul ’12 Nov ’12 Mar ’13
Jul ’13 Nov ’13
Mar ’14 Jul ’14 Nov ’14 Mar ’15
Jul ’15 Nov ’15
Mar ’16 Jul ’16 Nov ’16
Source: FE bid to bid, total return in GBP over 5 years as at 31.10.2016
currency is likely to prove challenging for companies that rely on imports, for those with export-focussed operations, it may provide a competitive edge over overseas peers. It also makes British companies attractive targets for overseas buyers – we have already seen some activity in this field, with the acquisition of Arm Technologies by Japanese firm Softbank over the summer. The current low-yield environment may be beneficial for domestic debt-funded mergers and acquisitions, as companies are able to take advantage of lower borrowing costs. We look very carefully at companies’ capital structures and earnings growth in order to assess their cashflow profile and stability, which are crucial to their long-term potential and sustainability of dividend payments. By focusing on firms that are fundamentally sound and avoiding those that are over-leveraged and built on shaky foundations, we aim to protect our portfolios from short-term volatility with a view to holding stocks for the long term. Dividends: running out of ingredients? Dividend cuts have been a popular topic over recent weeks, particularly following the Bank of England’s rate cut. For companies with defined benefit pension schemes, liabilities have soared as a direct result of the sharp decrease in UK government bond yields, thereby widening the gap between the sums to be paid out and the value of assets available to fund these payments. As a consequence, a number of firms have hit the headlines with their decisions to divert cash away from dividends, and instead to use it to decrease their pension deficits. Dividends are funded out of free cashflow. The decision to pay a dividend to shareholders
is a reflection not just of cash being available, but of the company’s own decision that this is the best use for the cash. Clearly, a company that struggles to generate free cash, that is highly levered and that has a significant pension deficit will struggle to pay dividends. We think that a company’s pension deficit should be included in the enterprise value calculation, and regular payments towards reducing this deficit should be accounted for when looking at the company’s free cashflow, which is the source from which dividend payments will be made. Thorough analysis not only of a company’s cashflow position, but also its management capabilities, are crucial in selecting those investments best placed to generate sustainable, long-term returns against a backdrop of record-low government bond yields. Recipe for the future We are sceptical about how effective August’s interest rate cut will be in stimulating economic growth. More quantitative easing may have the unintended consequence of making pension-fund deficits balloon even further, which is unlikely to encourage those companies to invest in job-creating capital expenditure; it is more likely to provoke cost cutting. One area of the market where we are keeping a close watch is inflation, which would be likely to spark an increase in interest rates. Although growth is sluggish, a weak currency means that inflation could easily be imported through higher prices of foreign goods and services. While it is probable that the government will announce further supportive spending measures, we are still positioned for an anaemic outlook. The Brexit negotiations throw uncertainty into the mix, so we still
expect growth to be positive, albeit weak. Government bond yields are likely to remain low for the near future, putting further pressure on investors to broaden their search for yield. The UK is likely to experience macro volatility as the Brexit conundrum twists and turns. However, our funds are focused on the micro fundamentals of companies, and as such we view any volatility as providing an opportunity. For us, one of the most important challenges is to identify companies that are well-placed to offer long-term earnings and dividend growth. We still believe the UK is likely to experience an extended period of political and economic uncertainty and we will continue to monitor economic developments closely. We believe it best to avoid knee-jerk changes to our portfolios until the implications of Brexit become clearer. Our funds are underpinned by cautious economic growth assumptions, and their focus on companies with strong market positions, growing earnings, stable cashflows and robust balance sheets seeks to provide resilience across a range of possible economic outcomes.
The value of investments and the income from them is not guaranteed and may go down as well as up and investors may not get back the amount originally invested. The views expressed are the manager’s own and do not constitute investment advice. For funds that use derivatives, their use may be beneficial, however, they also involve specific risks. Derivatives may alter the economic exposure of a fund over time, causing it to deviate from the performance of the broader market. Investment in smaller companies may be riskier and less liquid than larger companies, which could mean that their share prices and therefore fund performance is more volatile.
10 | LEADING EDGE | DECEMBER 2016
Telling the time on the investment clock It’s been a momentous few months: first the Brexit vote, then the election of Donald Trump. In both cases, the results came as a shock to markets but in both cases investors have for the most part seen better not worse returns on their portfolios.
Trevor Greetham Head of Multi Asset
2016: a good or bad year? Against a backdrop of major political upsets, an upsurge in populism and increased uncertainty, there is a common refrain that 2016 has been a bad year. But from the perspective of market returns, 2016 has been exceptional. The ‘patchwork quilt’ of calendar year asset returns (figure 1) shows that to the end of October, a sterling-based investor made money almost irrespective of where they invested. In part, this has been due to the significant falls in sterling since the UK’s vote to leave the EU this summer which meant that almost any overseas investment made money on the currency effect alone. Figure 1 A very good year? Year
EM Stocks +37%
EM Stocks +24%
Global Stocks +21%
EM Stocks +13%
EM Stocks +63%
EM Stocks +43%
UK Stocks +30%
Global Stocks +4%
UK Stocks +21%
UK Stocks +12%
Global Stocks +21%
Global Stocks +17%
Global Stocks +12%
Global Stocks +12%
UK Stocks +1%
Global Stocks +28%
EM Stocks +8%
UK Stocks +13%
UK Stocks +1%
Global Stocks +11%
Global Stocks -18%
UK Stocks -3%
UK Stocks +5%
Global Stocks -7%
UK Stocks +15%
UK Stocks -30%
EM Stocks -5%
EM Stocks -10%
EM Stocks -35%
EM Stocks -18%
4 +6% 5
6 +5% Property
Source: DataStream, Total returns in sterling terms. YTD return as of 28 October 2016
DECEMBER 2016 | LEADING EDGE | 11
Putting into practice today – positive on equities
Sterling efforts Sterling has fallen by around 15% against both the US dollar and the euro in the first 10 months of 2016. Any time a politician talks about ‘soft’ Brexit we see sterling rise, while fears of ‘hard’ Brexit tend to push it lower. Given the uncertain political backdrop since June, it is little surprise that sterling volatility is at the highest level seen since the Exchange Rate Mechanism (ERM) crisis of 1992.
Our current view is that growth is strong. It may not be as strong as we’ve seen in some historic boom periods, but it is above the longterm trend as unemployment is falling in all of the developed economies. Inflation is low and unlikely to get out of control in the near term, but it is rising. This puts us in the Overheat section of the clock, suggesting an overweight position in commodities. China’s economy is growing strongly again and this is good news. However, most commodities still face a headwind from oversupply built up during the boom years before the financial crisis and dollar strength, reinforced by Donald Trump’s plans for fiscal stimulus, is a headwind for the asset class.
The investment clock The economic cycle is familiar to most investors. Economic growth speeds up and slows down, inflation rises and falls. The extent and length of boom and bust may change, but the cycle itself cannot be abolished. Our own Investment Clock links the economic backdrop to the performance of specific asset classes and investments. Figure 2 sums up analysis looking back to the 1970s to see what performs best in different conditions.
We choose to be neutral on commodities. Instead, we have a positive bias towards
UMER DIS ONS CR &C ET IO
, H E A LT H C A
High Yield Bonds
GROWTH MOVES BELOW TREND
Y AR N
IALS & ENE TER RG MA Y
GROWTH MOVES ABOVE TREND
LOGY & INDUSTR NO IAL CH S TE
Within equities, as expectations of a December rate hike in America rise, we have been trimming an overweight position in emerging market equities and adding to Japan, a market that tends to do well when the dollar is strong. We’ve continued to reduce emerging market exposure in light of Trump’s surprise victory but we are unlikely to move to an outright underweight in emerging market exposure as global growth is likely to be strong in 2017, led by the US and China. We have had an underweight in Europe since the Brexit vote and increased the scale of this position after the US election as the increase in populism raises political risks ahead of a busy electoral period across the Continent. Caution on bonds and sterling
Figure 2 The investment clock
that was already underway and this benefits stocks at the expense of bonds. There remain many important unknowns as to how a Trump presidency will operate and the market may be volatile for a while.
Source: RLAM. For illustrative purposes only
There are four key phases of the economic cycle – reflation, recovery, overheat and stagflation – depending on the strength of growth and direction of inflation. For instance, if you are worried growth will slow down, you invest in the lower half of the Clock, in so-called safe haven assets such as bonds, cash, gold and defensive equity sectors like telecoms and healthcare. If you think inflation will increase, you invest on the right hand side of the Clock, in assets such as commodities, cash, inflationlinked bonds and the materials and energy sectors of the stock market. These rules don’t always work, but they are a great place to start.
equities. Central banks would typically be starting to raise interest rates at this point in the cycle, but two things are causing hesitation. First, inflation is low in an historical context. Second, there is reluctance to increase rates too early for fear of tipping debt-laden economies into recession. A cynic would say governments have an incentive to let inflation eat away the real value of their debt so won’t be arguing with central banks on this one. A combination of a recovery in growth and low interest rates is usually supportive of equities. Furthermore, Trump’s reflationary policies could accelerate a pick-up in global growth
We fund this preference for equities by underweighting exposure to bonds – particularly government bonds – where we think that yields are still too low and in most cases, below central bank inflation targets. Our analysis suggests that to justify these ultra-low levels, interest rates would have to remain at or near historic lows for at least a decade. We suspect the all-time low in gilt yields happened in the weeks after the UK’s vote to leave the European Union. If anything, Brexit increases the incentive for the UK to inflate away its government debt, though any upside in yields will be constrained by a likely economic slowdown in 2017. Sterling weakness was a tailwind for UK investors in 2016. While we are not predicting similar falls in 2017, we do think that politics will remain a key influence over its movements. The economy has held up well since the referendum but we expect growth to slow in 2017 as uncertainty weighs on capital spending and a rise in inflation squeezes real consumer incomes. Policy will need to ease further and sterling will be part of the mix. We are positioned for sterling to be slightly weaker, rather than for an unwinding of the moves seen in 2016. The value of investments and the income from them is not guaranteed and may go down as well as up and investors may not get back the amount originally invested. The views expressed are the manager’s own and do not constitute investment advice. For funds that use derivatives, their use may be beneficial, however, they also involve specific risks. Derivatives may alter the economic exposure of a fund over time, causing it to deviate from the performance of the broader market.
12 | LEADING EDGE | DECEMBER 2016
What’s brewing in high yield? A closer look at market opportunities What do high yield and coffee have in common? If you’ve ever made the mistake of asking for ‘just a coffee, please’ in Starbucks, you’ll understand. Like ‘coffee’, the label ‘high yield bonds’ is an umbrella term for a menu that has expanded and evolved over recent years to include a diverse set of assets that may share very few common features. Different sizes, many flavours and meaningless (or even misleading) names mean that the key to success lies in experience and diligent research. Our Head of Global High Yield, Azhar Hussain, discusses some of the niche asset classes available to high yield investors, and introduces some new members of the team. Quantity versus quality The ability to access a variety of assets in the high yield market means that we can construct portfolios with a broad and diversified exposure to risk and returns, despite the stale economic backdrop of record-low yields. Many
firms are taking the window of opportunity offered by the current low-rate environment to borrow at very low costs; for investors searching for income, the attraction of these higher yielding assets is clear. The pertinent questions are, however, what type of risk are you taking on, and whether the price and yield of the bond are a fair reward. Our interest in looking across the full range of high yield bonds lies in finding those opportunities where the risks are transparent and can be fully understood, and to exploit inefficiencies where they have been mispriced by the market. A new flavour: leveraged loans The leveraged loan market is a new area of focus for us, although it stems from a natural extension of our core capabilities in structured and secured debt. In a global market where correlations are increasing, the diversification of the leveraged loan market adds a shot of flavour in the form of decreased correlation to investment portfolios. For long-term investors who are able to invest in less liquid assets,
it can be a good way to access a liquidity ‘premium’, and to access efficient risk exposure. The loans we are looking at are typically those made to companies who already have a stock of outstanding debt, but wish to finance a project, for example an acquisition, to refinance debt, or to change its capital structure, for example by financing a share buyback. They form an increasing share of the global high yield market, and by moving into this space, we broaden our investment universe significantly. The broad range of loans in the market means that the key to investing in this area lies in distinguishing quality amid the vast quantity available for purchase. Like all esoteric assets, the barrier to entry is analysis. Our expert Credit Analysts, who specialise in high yield and leveraged loans, undertake rigorous data assessment and due diligence of the opportunities available in order to sort the top quality, rich espresso from the freeze-dried, calorific imitation.
Source: RLAM as at 31.10.2016. The value of investments and the income from them is not guaranteed and may go down as well as up and investors may not get back the amount originally invested. The views expressed are the manager’s own and do not constitute investment advice. For funds that use derivatives, their use may be beneficial, however, they also involve specific risks. Derivatives may alter the economic exposure of a fund over time, causing it to deviate from the performance of the broader market. Sub-investment grade bonds have characteristics which may result in a higher probability of default than investment grade bonds and therefore a higher risk.
DECEMBER 2016 | LEADING EDGE | 13
Expanding “ our Global High
Watch a short video with Azhar Hussain, Eric Holt and Jonathan Platt discussing the outlook for bond markets
Yield Team enables us to extend our capabilities into further corners of the market.
Our high yield team Expanding our Global High Yield Team enables us to extend our capabilities into further corners of the market. Additional fund management and research expertise is essential in covering the broad base of this varied and exciting investment universe. Earlier in the year we added a new Fund Manager, Karum Sharih, a Credit Analyst, Sebastien Poulin and two Assistant Credit Analysts, Gary Ewen and Thomas Elliott to the team. The new members, pictured, bring a diverse set of skills and experience, having varied careers across the high yield and leveraged loans areas. The addition of this new expertise is aimed at equipping the team to offer a diversified approach to investing in credit. This comes ahead of the planned launch of a multi asset credit fund, allowing us to focus on the alternative part of the credit universe.
The right blend
RLAM’s Global High Yield Team Azhar Hussain
Head of Global High Yield
Senior Credit Analyst
20 years’ experience
11 years’ experience
Global High Yield Fund Manager
Multi Asset Credit Fund Manager
9 years’ experience
17 years’ experience
Assistant Credit Analyst
Assistant Credit Analyst
3 years’ experience
2 years’ experience
14 | LEADING EDGE | DECEMBER 2016
Trumpflation and other stories
One month on, and it is the tension between globalism and nationalism which helps explain the outcome of the US election. Mr Trump won a majority in the electoral college and not in the popular vote, however it was blue collar states such as Ohio and Wisconsin, which gave him his victory. The Republican Party has also retained a majority in the House and Senate. Their majority in Senate is slim: many issues will require a super majority of 60 votes, however fiscal votes require only a simple majority.
Though the US political system builds into its structure important checks and balances, the President has broad powers in trade and foreign policy to act without Congress. In contrast to many Congressional Republicans, Mr Trump is conservative on global trade, but not conservative on fiscal matters. Many Republicans are against deficit financing per se, and are believers in smaller government overall. This is not the platform which Mr Trump stood on, and so there is a general question about the likely size of the gap between his campaign rhetoric and policies which will need the consent of Congress. We outline the key policy areas below. Markets are most concerned about Mr Trumpâ€™s anti-free trade rhetoric, which if implemented, would be a long-term negative for US and global growth.
Ian Kernohan Economist
Tax reform and deregulation Mr Trump proposes personal and business tax reform: cuts in personal tax rates, a reduction in the corporate income tax rate to 15%, and one-time 10% tax on all foreign earnings not yet taxed by the US (companies will be free to repatriate these earnings without additional tax, once this tax has been paid). There is broad support for tax reform within the Republican party. There is also support for Trumpâ€™s policies of deregulation in the energy and financial sectors (repealing parts of Dodd-Frank) and repealing much of the Affordable Care Act. Trade and immigration restrictions Congressional Republicans are much less keen on Trumpâ€™s policy proposals in this area (as is consensus market opinion). However, the new President-elect has considerable support in so-called rust belt states, which he will be reluctant to ignore. Trade policy is an area where a US President has significant room for discretion to act without Congressional approval: Congress must approve trade agreements, but the actual legislation usually authorises the President to ratify an agreement which has already been concluded. Presidents have the authority to withdraw from bilateral and multilateral trade agreements, such as the North American Free Trade Agreement (NAFTA). Together with more general fears about a shift in the post-cold war defence arrangements, investors are likely to be most concerned about any retreat on global free trade. The consensus amongst economists is that, while freer trade raises income distributional questions (which should be offset by other policies), trade restrictions are negative for everyone, including those who are supposed to lose from greater free trade. Freer trade allows countries to specialise (comparative advantage), helps keep inflation low and boosts productivity. Additional tariffs would most likely boost inflation, and have a mixed short-run but negative long-run impact on growth, especially if met by retaliation from other large economies, such as China.
DECEMBER 2016 | LEADING EDGE | 15
Spending on infrastructure and defence Mr Trump specifically mentioned infrastructure spending in his acceptance speech. His pre-election plan was for up to $1 trillion of additional spending over 10 years, or $100bn per year (c.0.5% of GDP). Congressional Republicans are less keen on unfunded infrastructure spending than they are on tax cuts, however Congressional Democrats would be keen on such spending. There may have to be some compromise on the spending plan, with many in Congress keen to save such a major spending boost until it is really needed in the next downturn. The Fed Mr Trump has been critical of ultra-low interest rates and quantitative easing, and has accused the Federal Reserve of being too “political”. His advisers will no doubt tell him that a battle with the Fed is best avoided and as with many issues, he has said different things about monetary policy on different occasions. In addition, we believe that interest rates are set to rise before the end of this year anyway. Janet Yellen’s term is due to end in 2018 and she has confirmed that she will serve out her full term. Impact on US economy Although there will be compromise on the scale of the package, a significant easing in US fiscal policy is likely. Tax cuts for higher income brackets will have an impact on spending, however savings ratios for these groups tend to be higher, so the impact will be limited. The impact of corporate tax cuts and infrastructure spend will also take some time to feed through to aggregate demand, especially given a shortage of shovel-ready projects. In short, we think any significant economic impact from the fiscal stimulus will not appear until 2018 at the earliest. We haven’t changed our US economic base case for 2017: we already expected faster GDP growth and further hikes in interest rates. Given trends in wage pressures, rising bond yields, easier monetary conditions
overseas and a lower neutral rate, there is little need for the Fed to step up the pace of tightening beyond what they have already signalled. To shift expectations now towards “one hike per quarter in 2017” would be premature, when Mr Trump hasn’t even been inaugurated and the timing and scale of any fiscal stimulus is not known. However, looking further ahead, we do have some concerns. Mr Trump’s pre-election proposals included a GDP growth target of 3.5%, and a pledge to create 25m new jobs over 10 years. This would be more than three times the rate of job creation since 2006 and comes at a time when both domestic and global fundamentals have held back the pace of US expansion. Since the global financial crisis, potential GDP growth has slowed, as boomers retire and labour productivity has weakened. Even if productivity picks up a bit, it’s difficult to see the US economy growing at 3.5% without running into inflationary overheat, and a more hawkish Fed. Impact on the Rest of the World To the extent that a major fiscal stimulus is positive for US growth, there will be a knock-on impact to global growth. On the other hand, a more hawkish Fed and greater trade restrictions would be negative for growth, especially in many emerging market economies. On Europe, Mr Trump has said that the continent ought to bear more of the financial burden of its own defence. His election also raises political risk ahead of some key EU votes, while a US-EU trade deal now looks less likely. In the UK, Mr Trump’s election has changed the debate about a likely US-UK trade deal, however his anti-globalisation rhetoric is not helpful to a medium sized open economy seeking to re-orientate its trading relationships. London could also lose business to New York, if large parts of Dodd-Frank are repealed at a time when UK trading relationships with the EU are unclear.
Mr Trump may well declare China a “currency manipulator”, although ironically China has been trying to slow renminbi depreciation in recent years. The more important issue is whether the 45% tariff idea on China’s goods exports to the US will prove to be just campaign rhetoric. US firms (including Apple) have deep connections with China assembly lines. Also, China has recycled a large share of its export earnings into treasuries, so is not without some leverage in these matters. Market implications In summary, tighter immigration controls, greater fiscal stimulus and anti-free trade rhetoric suggest a more inflationary bias in the Trump economic programme. So far, markets have placed greater emphasis on this than on fears about global trade of any likely response by the Fed. For now, the feeling is that the impact of stimulus will come through faster than any serious rolling back of free trade: naming China as a “currency manipulator” is not the same as slapping 45% tariffs on their goods. Bond markets have taken fright on the inflationary impact of a sizeable fiscal stimulus, coming at a time when the headline unemployment rate is low. Mr Trump appears much less predictable than many new US Presidents, and it is this unpredictability, together with a sense that this is a watershed moment, not just in domestic economic terms but in geopolitics, which creates a two-way pull for treasuries. Should they focus solely on the domestic stimulus, or the greater geopolitical and economic risk? For now, it is very much the former.
The value of investments and the income from them is not guaranteed and may go down as well as up and investors may not get back the amount originally invested. The views expressed are the manager’s own and do not constitute investment advice.
The views of our Multi Asset Team are regularly shared via our dedicated Investment Clock blog. With comments on economic trends, all asset markets and regular updates on the Investment Clock model driving the Team’s strategy.
For our institutional investors, our ‘Bonds and beyond’ blog features comments from our Fixed Income Team as well as thoughts on key themes impacting pension funds and their advisers.
For wealth managers and financial advisers, our Income Activists - our managers dedicated to identifying sustainable sources of income - offer thoughts on how they’re navigating uncertain markets.
At RLAM we aim to regularly share the views of our investment experts, helping you keep abreast of our latest thinking on key economic and market themes.
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