Respectable returns were blunted somewhat by the Brexit dilemma.
Between the end of May and the start of October, our long-term growth fund portfolio returned a respectable 5.5%. “That performance is reasonably pleasing,” says the portfolio’s manager, Mike Deverell at Equilibrium. “Most things in there made some money. Of course, some didn’t, and unsurprisingly those were UK assets. But everything else went up.”
Predictably,in a quarter that saw central banks around the world lower interest rates, some of the portfolio’s strongest performance came from bond funds. L&G Allstocks Index Linked Gilt Index gained 5.6%, while the BlackRock Corporate Bond Tracker fund was up 5%.
The real star of the show, however, was H20 MultiReturns, which returned 13.3%. This fund is not strictly a bond fund, as it invests in currencies alongside fixed income. Deverell says: “It is essentially a bond fund that can go aggressively long or short as well as take currency positions.” The fund, he says, is actually short a lot of the high-quality sovereign bonds that have done well lately, which has worked against it. However, he adds: “It still made money from its long bets. In particular, it gained on Italian and other European peripheral debt.”
Deverell says the H20 fund is a strong addition to the portfolio because its returns are not correlated with those of other holdings, and also because it can go short and bet on currency movements. “It is different from the rest of the portfolio,” he adds.
The second-best performer in the quarter was the Vanguard US Equity Index, which return just above 10%.
“The US in general has been one of the best-performing markets,” says Deverell. As with fixed-income performance, this was largely driven by the US Federal Reserve and other central banks cutting rates over the period. Markets are now expecting further cuts and policy easing. He notes that large-cap growth tech stocks, which dominate the US market, perform well in an environment of easing rates.
On a knife edge
Deverell says the fact that both equities and fixed income have done well at the same time is a concern, as prior to the implementation of quantitative easing following the 2007/08 financial crisis, the two asset classes did not usually perform well in tandem. However, their correlation in the past four months cannot go on forever: He adds: “We are at a tipping point. But I don’t know which way it will go.”
On the one hand, the global economy could continue to slow and tip into recession – perhaps as a result of an escalation in the trade war being waged. That would result in further rate cuts from central banks, including the US Federal Reserve, which would boost the price of bonds. But a slowdown would also threaten equity values, as recessions typically do.
On the other hand, in the absence of trade shocks, economic growth could accelerate. That would initially be good for stocks, but it could mean that expected rate cuts start to be taken off the table. The first victim of that would be fixed income. Yet markets are already pricing in further monetary easing. “There is a slight concern that things are not quite as bad as the market thinks,” says Deverell.
With loose monetary policy the primary driver of equity price growth, the prospect of rate hikes would probably hit already richly valued US equities.
Deverell says the next few months will be crucial in indicating which way markets are headed, but he is unwilling to make any predictions. Meanwhile, his portfolio will stay diversified.
Deverell is relatively bearish about US equities, with the portfolio underweight on the country. The concern is not just that a recession may set in or thattightening central bank policy might hurt equity returns, but also that US stocks are currently very expensive.
He also notes the risk of slowing US earnings growth. He says: “Eventually, earnings are going to start hitting the market,” he says. “The US economy has done really well on the back of Trump’s tax cuts, which have boosted earnings. But those have worked their way through now, and we may be back to sluggish growth.”
Deverell is still overweight Japan, with the portfolio holding a relatively large position in Baillie Gifford Japanese. He comments that Japan has had a tough year as a result of the trade war: “The trade war has exposed how interlinked certain Asian markets are. What hurts China hurts other parts of Asia too.”
However,performance in the Japan sector has picked up recently. The Baillie Gifford fund returned 9.2% in the third quarter, the portfolio’s third-largest gain. Because of the portfolio’s large position in the fund, the fund’s performance made the greatest contribution to total returns in sterling terms.
This was largely the result of negative sentiment around Brexit. But not all UK funds made losses. Lindsell Train UK Equity returned a very respectable 6.9% while Royal London UK Equity Income returned 5.8%.
“This tells you about a real split in the UK,” says Deverell. Both Miton and Marlborough have exposure to domestic-facing small caps. “With Brexit, at the moment people are avoiding those stocks,” he adds. In contrast, the Lindsell Train and Royal London funds are both large-cap focused, so they primarily hold companies that make a significant amount of their earnings overseas.
Deverell is holding on to his smaller-cap UK holdings, however. He says: “There is a lot of good value among UK smaller caps. Until we get certainty around Brexit, they will continue to struggle, but it is a position we will stick with.”
Brexit-linked volatility has allowed Deverell to carry out a ‘volatility trade’ using the Fidelity UK Index fund. When the FTSE 100 was at 7100, he bought into the index. He sold out when the index rose to 7500 and netted a 5% increase in the fund’s cash position. “It is something you can do when the market is volatile, as long as you keep some cash,” he says. “It allows you to eke out some extra returns.”
Ins and outs
At the end of second quarter on 31 May, Deverell sold two struggling funds, Invesco GTR and Merian GEAR. He says both, being absolute return funds, struggled to make money in the current market conditions, where news about events such as Brexit or the trade war can quickly turn market sentiment. Both were sold at a lower price than they stood at a year ago: Invesco GTR was down 1.3% and Merian GEAR 10.8% over the year to 31 May.
Deverell replaced the two funds with Foresight Infrastructure and Henderson UK Absolute Return. He says the Henderson fund is an absolute return fund, so it is a like-for-like buy. Foresight is slightly different, as it is an infrastructure fund with a heavy focus on renewables. “It aims to yield about 5%, and that income should go up with inflation.”
As with the two absolute return funds sold, the two new funds are diversifiers that will provide returns uncorrelated to the general direction of the market.
Most equity funds made some money and bond funds did well overall
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Notes: *Bought on 3 June. Less £20 dealing costs for sale of old fund and new purchase. **Bought on 3 June. Less £20 dealing costs for sale of old fund and new purchase. ***Bought 16 August, sold 27 September at 5% gain. ****Cash increased by gain of 5% on volume trade – £20 dealing costs. Source: Equilibrium, as at 1 October 2019