David Prosser runs through the major political and economic factors that will affect returns in 2019, and outlines some promising investment ideas.
What does 2019 have in store for the investment trust sector?
Investors will be hoping for a better year after a difficult 2018. However, while there is cause for optimism, 2019 looks likely to be another year in which the macro dominates the micro. The political and economic drivers that have delivered a rollercoaster ride over the past year haven’t gone away. Expect more thrills and spills.
Inevitably, the Brexit saga will dominate the UK political agenda, at least until 29 March, when the UK is due to leave the EU. But while there is every chance of the government continuing to lurch from crisis to crisis, many investment advisers believe markets have priced in the worst-case scenario.
“Sentiment towards the UK is so dire that any outcome other than a hard Brexit could come as a relief to investors,” says Charles Cade, head of investment companies research at Numis Securities. He adds: “Many investment trust managers believe UK domestic-facing businesses are significantly undervalued and due a recovery.”
Iain Scouller, managing director of investment trust research at Stifel, says: “If an EU withdrawal agreement is finally passed, I would expect a strong rally from sterling, to the benefit of investment trusts focused on the UK. Even in the event of a managed no-deal Brexit, I think the markets will defy the gloomier predictions.”
The infamous Brexit dividend may finally arrive, in other words, with any outcome other than a disastrous no-deal Brexit providing a boost. UK investment trusts will benefit most, particularly those that specialise in small and mid-caps, which have a more domestic flavour. On the flip side, overseas funds carry a currency risk, as a stronger pound undermines their sterling performance.
There is one caveat to this upbeat analysis, however. Whatever your politics, it is likely that markets will be spooked if the chances of Jeremy Corbyn becoming prime minister are perceived to increase. Cade says: “Investors would get very nervous if the government lost a vote of no confidence and an election were called.”
Shifting global sentiment
The recent inversion of the US bond curve, a reliable (though not infallible) indicator of global recession in the past, means investors are signalling that they expect central banks to have to cut interest rates in the medium to long term, to cope with a downturn.
Despite headwinds such as the aforementioned Brexit, US president Donald Trump’s trade clash with China and emerging market debt contagion, the global economy was resilient in 2018, with the International Monetary Fund estimating that it grew by 3.7%.
Nevertheless, by March, the world will have notched up its longest period ever without a recession, and many economists are fearful. Simon Elliott, an investment trust analyst at Winterflood Securities, says: “It does feel that this year has seen an inflection point, with the end of quantitative easing in the US, the UK and the eurozone, and an acceleration in the ‘Trumpian’ agenda.”
Alan Brierley, a director in the investment companies team at Canaccord Genuity, is also worried that tougher times are ahead. “Our flexible model portfolio is now the most defensively positioned it has been since the 2007/08 financial crisis,” he says. “Central banks have created a fertile environment for equities, which have responded by delivering exceptional returns, but with global debt at record levels, it remains to be seen what happens as policies are normalised.”
For Brierley, that has led to a shift into alternative assets, including infrastructure, credit and private equity. These areas have low correlations to equities so will in theory provide shelter if the storm does break.
Alternatively, says Matthew Read, senior analyst at Marten & Co: “The flexible investment sector has allocations to a variety of asset classes and, all things being equal, should perform better than a pure equity strategy [in a recessionary environment].”
Another escalation in trade tensions between the US and China certainly represents one potential trigger for a slowdown, but the US is key in another regard too. Having lost control of the House of Representatives in November’s mid-term elections, Trump may now struggle to push ahead with further tax reforms and major infrastructure spending. That could slow the US economy significantly, with knock-on effects worldwide.
Emerging market value
Plunging emerging markets in 2018 may have created value opportunities, investment trust analysts argue, and in any case, the negative sentiment created by fears about over-leveraging in countries such as Turkey may overstate the problems in other geographies.
The strength of the dollar in the year ahead is the big question for emerging markets, many of which have large dollar-denominated debts. Here, the bullish case is that the US economy slows while other regions also begin to raise interest rates, in which case the dollar should weaken.
On the negative side, Trump’s trade war with China has already damaged confidence in emerging markets throughout Asia. More bad news would therefore be a negative – although the impact on the ground has been limited, says Elliott.
He adds: “The impact of Trump’s tariffs on sentiment both to and in emerging markets has proved a considerable headwind, despite having a negligible impact so far on reported earnings. With discounts wide on investment trusts in this space, we believe this again provides a contrarian or value opportunity.”
Read shares this view and picks out India as an area to focus on. “Emerging and frontier markets have been so out of favour that there could be some opportunities there,” he says.
Cade likes Vietnam, which he describes as “well-positioned to maintain its strong growth, supported by positive demographics: a population of 100 million and an emerging middle class”.
Moving away from the macro issues, investment trust analysts urge investors to consider the discount situation. “Widening discounts for investment trusts can’t be ruled out, particularly as discount levels remain at historically narrow levels for the sector overall,” says Elliott. “We would be wary of investing in trusts that don’t have discount controls or have no track record of reducing discount volatility through the use of buybacks or periodic liquidity mechanisms.”
That said, the ability of investment trusts to pay income through thick and thin provides ongoing demand support in this ongoing period of low interest rates.
It is also possible that discount variations will create valuation opportunities. Scouller points to the private equity sector. “Many private equity funds are on discounts in the high teens and low twenties in anticipation of write-downs at the next valuation point,” he says. “A lot of bad news that may not come through is already priced in.”
Closed-ended trust refuge
One final thought. With volatility likely to remain the dominant feature of markets in 2019, the investment trust sector offers structural advantages.
Cade says: “In bear markets the advantages of the closed-end structure come to the fore, as managers are not forced sellers of assets in weak markets, and the vast majority of equity investment trusts should be able to maintain dividends through using revenue reserves.”
Read adds: “This environment should favour managers that are good stockpickers and able to see through the ‘noise’, although investors will need to be patient.”
This underpins the case for investment trusts, where managers tend to be less constrained by benchmark-driven mandates.
Investment trusts to play the big themes in 2019
How do investment trust analysts suggest investing to take advantage of the themes they have identifified and exploit valuation opportunities? Here are their picks for 2019.
In the UK, Winterflood’s Simon Elliott suggests that deratings in the UK equity income sector, particularly of domestically focused trusts, have created opportunities. He likes Perpetual Income & Growth and Temple Bar. Numis’s Charles Cade also picks the Perpetual trust but adds Edinburgh Investment Trust to his recommended portfolio.
Also in the UK, Mick Gilligan, head of fund research at Killik & Co, believes small- and midcap trusts are a good place to start the value hunt in 2019. His favoured plays are Mercantile and River & Mercantile MicroCap.
In emerging markets, Elliott goes for JPMorgan Asian and Schroder Asian Total Return as value plays, while Cade picks out two Vietnam trusts to target his interest in the country, VinaCapital Vietnam Opportunity and Vietnam Enterprise Investments. Mick Gilligan is a fan of Mobius Investment Trust and Utilico Emerging Markets.
For investors interested in alternatives, Stifel’s Iain Scouller picks out the private equity (PE) sector as an area where discounts have become too wide. His preferred trusts include ICG Enterprise, Pantheon and NB Private Equity.