Spotlight - July 2020
As lockdown restrictions ease, we look beyond the short-term impacts of coronavirus to what may be the pandemic’s more lasting effects.
Nick Britton
As we make the first tentative steps towards a return to normality, I wonder how we’ll look back on this period of our lives? For some, the loss of loved ones will sadly dominate their memories. Others are facing job insecurity and worries about paying the bills. But for those fortunate enough to avoid these struggles, lockdown has not been an altogether negative experience.
Since I gave up the family car last year (who needs one in London?) and have avoided public transport, I have spent the last three-and-a-half months within a two-mile radius of my home. One consequence of this is that I have got to know my neighbours a lot better. One warm evening last week, a bunch of us got together on my front drive for a few drinks. We now have a WhatsApp group including four households and a tentative plan to extend this gradually down our street.
Of course, the million dollar question is to what extent these changes of behaviour, habit and lifestyle will simply revert to normal when COVID is no longer a threat. The key may be to separate those changes which are obvious aberrations (like London neighbours talking to each other) from those which are continuations or accelerations of previously existing trends.
Among these is what has been called the ‘reverse’ or ‘retreat’ of globalisation. Gervais Williams, manager of the Diverse Income and Miton UK Microcap Trusts, wrote a book on this theme back in 2016, the year Trump was elected and the UK voted for Brexit. Since then we have seen US-China trade wars and the weakening of global institutions such as the World Trade Organisation. The COVID-19 pandemic has encouraged this tendency to pull up the drawbridge on the rest of the world.
Source: AIC/Morningstar. Daily share price total returns from 1/1/2020 to 26/6/2020, AIC sector averages.
While these developments are often seen as clouds over the investment landscape, like the lockdown they could have their silver linings. Gervais believes that we are returning to a world more similar to the one he experienced when he started out in fund management in the early 1980s. At this time, he explained in an AIC media roundtable this week, there was no “tailwind” of stock market appreciation that investors could rely on. Institutions sought to improve their returns with meaningful allocations to smaller companies.
In contrast, he describes markets in the last 30 years as being like a dartboard “where you could hit anywhere and make money”. Allocations to smaller companies have dwindled because it has been enough to own the index. The retreat of globalisation holds the prospect of tougher markets where stock selection will become more important again. The UK, with its vibrant market of smaller quoted companies, could be well placed in this new world, where we will focus more closely on opportunities on our doorstep.
Hugh Young, manager of Aberdeen Standard Asia Focus, agrees that “globalisation has been the driver of the world in my career”. And he concedes that it’s had its excesses. But he sees the threat to globalisation as unhealthy: in his view, it will lead to the world becoming a more dangerous place. “Barriers are not a good thing, whether within a society or between societies,” he adds.
It’s entirely possible that Gervais and Hugh are both right, and that the retreat of globalisation will create both opportunities and threats. One thing seems more or less certain – it’s happening and it will have important consequences for our lives and our investments in future. You can read more views from Hugh, Gervais, and other fund managers focusing on Europe, the US and Japan, in this month’s Spotlight.
The reverse of globalisation is also set to impact levels of inflation. After all, globalisation has been one of the forces holding inflation down over the past few decades. We have gathered views of various investment company managers on the prospects for inflation (or deflation) and while there is broad agreement about the short-term outlook, with the impact of COVID being widely seen as disinflationary, the medium-term picture is more uncertain. Peter Spiller, manager of Capital Gearing Trust, points out that “once the crisis abates public debt will be at levels not seen since the Second World War”. He goes on to argue: “The solution to such problems will be the same now as then: financial repression, a prolonged period of low interest rates and elevated inflation.”
Not everyone agrees. According to Charles Luke, manager of Murray Income Trust, “Rising unemployment and the likely staggered recovery in consumption will weigh heavily on the outlook for wage and price growth. Fiscal and monetary policy stimulus should help cap some of these disinflationary forces, but are unlikely to fuel inflationary pressures over the next two years.”
Last week, shareholders in Scottish Mortgage voted to increase the investment company’s maximum allocation to unquoted companies from 25% to 30%. The increasing importance of private companies as part of the investment universe has been undiminished by the debacle at Woodford Equity Income last year. But they must be accessed using an appropriate structure. David Prosser rounds off this month’s Spotlight with a review of some research from Pantheon suggesting the advantages of an allocation to private equity.
Finally, I look forward to the first in our series of four webinars next week, Investment trusts explained. I know that many of you have signed up but for those who haven’t, there is still time to do so here.
Spotlight will be taking a break until September, so if you aren’t joining us for the webinars, I hope you have an enjoyable and relaxing summer.
Nick Britton, Head of Intermediary Communications, AIC
Upcoming webinars
9-21 July - Investment trusts explained
A series of four 45-minute webinars presented by Nick Britton that will explain all you need to know about investment trusts.
Global gathering
Managers Hugh Young, Gervais Williams and Francesco Conte discuss prospects for their regions.
The world is embarking on a long journey back to social and economic normality, but the full extent and long-term impacts of COVID-19 remain unknown. What effect has coronavirus had on different regions around the world? Where are managers seeing opportunities and what’s the outlook for investors post COVID?
On Tuesday 30 June 2020, the AIC hosted a media webinar with Hugh Young, Manager of Aberdeen Standard Asia Focus, Gervais Williams, Manager of Diverse Income Trust, and Francesco Conte, Manager of JPMorgan European Smaller Companies, to discuss the impact of coronavirus, how their portfolios are positioned and the outlook for the regions in which they invest.
Their views have been collated alongside comments from Nicholas Price, Manager of Fidelity Japan Trust and Tony Despirito, Co-Manager of BlackRock North American Income.
COVID-19
Hugh Young, Manager of Aberdeen Standard Asia Focus, said: “Obviously COVID-19 has affected the whole world badly. Asia is a curate’s egg, most countries have dealt with it well and virtually all arguably better than the UK. Clearly it will be a recessionary year for the region as a whole, and a number of companies may well fold whilst others will seize the opportunity.”
Nicholas Price, Manager of Fidelity Japan Trust, said: “In Japan, we were in a semi-lockdown for around 1-2 months. The mortality rate and hospital cases look to have peaked here. Tokyo exited from a partial lockdown at the end of May (with regional areas before that), and the Japanese government is in the process of lifting the remaining voluntary restrictions on businesses and domestic travel. At a company level, overall balance sheets are in good health relative to other regions and the banks have plenty of capacity to lend. We are seeing some dividend cuts and I would expect buy backs to be more limited going forward, but I don’t see that causing a significant impact.”
Tony Despirito, Co-Manager of BlackRock North American Income, said: “Upbeat fourth-quarter earnings, improving business sentiment and a phase 1 US-China trade deal compelled US stocks higher to begin the year, until the global spread of coronavirus brought a swift and sudden reversal. Concern over the human and economic toll of COVID-19 has prompted emergency measures from governments and central bankers. Some investors have only experienced bull markets, as we’ve lived in one for 11 years.
“Volatility never feels good, but the foundation underlying it is important. Daily market moves in response to the COVID-19 outbreak have matched the scale of those seen during the global financial crisis, but we believe this is not 2008. The coronavirus shock is not one caused by a crisis in the core of the financial system and spreading to the rest of the economy. The economy is on a much stronger footing and the financial system is much more robust. In fact, we believe policy measures and safeguards put in place since 2008 have only strengthened the financial system.”
Outlook
Gervais Williams, Manager of Diverse Income Trust, said: “Generally, I think the prospects for the UK economy are unexciting. The government has bridged the corporate cashflow squeeze at present, but if there are ongoing virus hotspots, we worry that the government won’t be able to keep borrowing at an elevated rate for too long. So overall, we think the economic recovery won’t be robust, and that at times we may face further setbacks. This is a difficult environment for mainstream companies to grow, as it is hard for those with major market shares to grow when the world isn’t growing.
“In contrast we anticipate that small cap companies will be able to take market share from those that have become insolvent. Some will acquire insolvent businesses and keep the skilled labour but reinject additional working capital, to generate an attractive cash payback. I think this will lead to small caps outperforming the mainstream stocks. In that regard the UK is very different from most other stock markets, it is the world leader in quoted small caps. Overall, in my view the UK stock market will outperform most others because of its quoted small cap universe.”
Francesco Conte, Manager of JPMorgan European Smaller Companies, said: “Europe’s strength is its ability to manufacture highly engineered premium products that are exported worldwide. It should not be a surprise that with global trade having been bruised as a result of the pandemic, Europe’s dominance in premium cars, aeroplanes and luxury goods will have had a negative impact on the region. Conversely following unprecedented fiscal and monetary policy, we should not be surprised that as the current anaemic economic recovery morphs into a synchronized global recovery, Europe will once again benefit. From a valuation viewpoint, the case for equities remains compelling. The shape of the path to recovery is uncertain but our investments include many world leaders in markets that should grow.”
Tony Despirito, Co-Manager of BlackRock North American Income, said: “Stock volatility is likely to persist as investors weigh the impact on corporate earnings and global supply chains. We expect earnings will be hard hit in 2020 but see coronavirus as a transitory event (perhaps three to six months) that does not permanently impair the world economy and company earnings power.”
Nicholas Price, Manager of Fidelity Japan Trust, said: “Japan continues to offer an attractive combination of cash-rich companies, low relative valuations and secular growth opportunities. Being here on the ground is invaluable for looking at the micro level and speaking to company management to fully understand the current dynamics. This puts us in a strong position to continue to identify mispriced winners and reward investors.
“Globally, bear markets often create turning points and changes in market leadership, so I am looking at some of those discarded stocks that are not being focused on and are likely to emerge from this changing situation. Significant fiscal stimulus and government subsidies are likely to throw up new leadership and new winners from discarded losers. Although volatility may continue in the short term, this enables us to invest in strong growth names at attractive valuations, which should create positive long-term outcomes for clients.”
Opportunities
Francesco Conte, Manager of JPMorgan European Smaller Companies, said: “Analysing the trust today, the most common threads in our investments can be grouped under wellness, technology and the environment. COVID-19 has not changed these trends but in fact reinforced the importance of them.
“Wellness – Amplifon, the global leading hearing aid retailer, looks well placed to benefit from the need for personalised and distinctive hearing solutions for a rapidly growing ageing population. With an excellent management team, rising revenues and a cash-generative business model, we believe the Italian company is well placed to continue growing rapidly through organic and acquisitive growth.
“Technology – Online shopping has grown rapidly over the last few years and was accelerated during the pandemic. One company that has benefited from this trend has been the German online pharmacy, Shop Apotheke, as people avoid social contact. Moreover, the German parliament has made it mandatory for all prescriptions to be online by 2022, raising the possibility that the market may accelerate further in the future.
“Environment – we believe that reducing pollution, plastic, and our carbon footprint is key to better welfare. These trends should accelerate further as European companies prepare to adopt new rules that will require them to disclose their environmental, social and governance risks from 2021. There are several companies in Europe spearheading the drive to environmental sustainability. Tomra based in Norway is by far the world leader in reverse vending machines for the recycling of plastic bottles. Last year, thanks to their machines, some 3.5 billion bottles were recycled.”
Hugh Young, Manager of Aberdeen Standard Asia Focus, said: “Small caps in Asia offer a myriad of opportunities, there are thousands of them across geographies and sectors. The key is to sort the wheat from the chaff. Hence our large, long-established team across the region. There are also opportunities from price movements – when markets fell sharply we were able to invest in certain companies that were on our radar screen or top up existing holdings where we could still be confident of the prospects notwithstanding the impact of the virus. For example, we recently took advantage of share price weakness to initiate a holding in Singapore’s Raffles Medical, a leading healthcare provider with hospitals and clinics across Asia. Its long-term prospects appear attractive, fuelled by its expansion in China.”
Tony Despirito, Co-Manager of BlackRock North American Income, said: “The healthcare sector has held up better than the broad market since the downturn began on February 19. The MSCI Health Care Index was down nearly 22% through March 16 versus an S&P 500 decline of roughly 29%. This is what we would have expected given the sector’s defensive characteristics and limited reliance on the economic cycle. We continue to like healthcare for its history of resilience.”
Risks
Gervais Williams, Manager of Diverse Income Trust, said: “We fear that virus hotspots will continue to keep popping up, and that this will slow the economic recovery. Specifically, we fear that there will be numerous redundancies, and that many over-levered companies will go bust, most especially within the consumer sectors. In general, Diverse Income Trust has avoided the consumer sectors, unless they are taking market share such as companies like AO World.”
Nicholas Price, Manager of Fidelity Japan Trust, said: “In Q1 a number of factors came into play. The large uncertainty created by the coronavirus starting in Asia severely affected holdings in areas like automotive semiconductors, tech and travel. As the crisis worsened, I looked at company balance sheets and survivability, reducing some of the winners from 2019 which I thought were vulnerable to profit taking. On the ground, we’ve obviously gone through a poor earnings season but it has been encouraging that stock prices generally haven’t reacted, which I think indicates a lot of the bad news is already discounted in prices.”
Hugh Young, Manager of Aberdeen Standard Asia Focus, said: “There are always plenty of risks from the political, macroeconomic and epidemiological points of view, but our concentration is on the risks at the individual company level, where we rely on our thorough due diligence. Long-term business outlook, experienced professional management, strong finances and good governance - incorporating all ESG aspects - are vital to our process. This, with a spread across sectors and countries, mitigates risks.”
Inflation or deflation?
We canvass opinions from investment company managers.
With lockdown restrictions having caused sharp drops in demand and rising unemployment, the impact of COVID-19 has been disinflationary. The UK and US have registered the lowest levels of inflation since 2016 and 2015 respectively. Is this set to continue, or will government stimulus measures lead to more significant inflation over the longer term? The AIC has spoken to investment company managers about how they’re viewing the prospects for inflation and how their portfolios are positioned.
COVID-19
Charles Luke, Manager of Murray Income Trust, said: “The pandemic will impact the UK and global economy in a myriad of areas, but higher inflation is unlikely. In fact, just like in the aftermath of the global financial crisis the risk is more of a disinflationary threat. Any pockets of price pressures that may have built up from supply constraints will be more than offset by weak demand. Rising unemployment and the likely staggered recovery in consumption will weigh heavily on the outlook for wage and price growth. Fiscal and monetary policy stimulus should help cap some of these disinflationary forces, but are unlikely to fuel inflationary pressures over the next two years.”
Peter Spiller, Manager of Capital Gearing Trust, said: “Any demand shock is in the short term deflationary, and in this regard COVID-19 is no different. How the balance of supply and demand evolve over the coming months and years is more complex and harder to predict. Marginal capacity will be mothballed and investment in new capacity put off but all this will take time. The desired savings rate for both consumers and corporates will rise: a natural psychological reaction to these tumultuous events. Governments have already stepped in to attempt to fill this demand gap via various stimulus measures, furlough schemes and so forth. Further fiscal stimulus remains likely though its exact form – whether student debt forgiveness, a green new deal, or helicopter money – is not clear. Globalisation of trade, the single greatest factor in keeping inflation in check over the last 20 years, has come to a halt and may yet go into reverse: driven partly by a souring relationship between China and the US and partly by the newly apparent fragility of ‘just-in-time’ globalised supply chains.”
Hamish Baillie, Fund Manager of Ruffer Investment Company, said: “The debt-financed promises from governments to protect jobs and the economy require negative real interest rates in order to be affordable. This will result in bond yields being nailed to the floor and a relatively laissez-faire approach being taken to inflation running above target. In addition to the benefits and necessity for government finances, this is also politically palatable as it acts as a transfer of wealth from savers (the elderly and well-off), to borrowers (the younger and indebted generations).”
“At a company level, supply chains and balance sheets are going to change from an ‘optimised’ just-in-time model to a just-in-case model. This will result in closer control of supply chains, greater inventory and some rainy-day reserves being held on balance sheets. All things being equal this will reduce profitability and so prices will rise to match this – the costs of those places in a half empty aeroplane, restaurant or hotel are going to be more expensive not cheaper.”
Walter Price, Portfolio Manager of Allianz Technology, said: “We expect inflation to stay low for the next year with a 20% unemployment rate and workers that have to find new jobs to replace those in many areas that aren’t coming back soon.”
Simon Edelsten, Fund Manager of Mid Wynd International Investment Trust, said: “Our priority in managing Mid Wynd is to achieve real returns to investors over the long term and we are well aware that the greatest threat comes from periods of unexpected economic turbulence. The current pandemic and governments’ lockdown measures have led to a sharp decline in economic activity and higher unemployment though these may moderate as lockdown measures end. These factors tend to be sharply deflationary. However, we have also seen announced very large stimulus measures around the world and this expansion can concern investors and tend to be inflationary and may make some currencies weaken.”
“The need for inflation”
Peter Spiller, Manager of Capital Gearing Trust, said: “Most important of all is the need for inflation. Once the crisis abates public debt will be at levels not seen since the Second World War. The solution to such problems will be the same now as then: financial repression, a prolonged period of low interest rates and elevated inflation. The tools available to governments and central banks are the same as then, we cannot see the outcome being any different.”
Portfolio positioning
Simon Edelsten, Fund Manager of Mid Wynd International Investment Trust, said: “Mid Wynd invests in companies which have very strong market positions and which, therefore, tend to be able to raise prices when there is modest inflation or deflation – for instance Thermo Fisher, the world leader in scientific equipment, faces little price competition, rather competes on quality of product. Indeed a long period of deflation, such as has been seen by global investors in Japan over the last twenty years, tends to favour growth stocks with world leading technology over other investments. Very high inflation, perhaps triggered by excess public spending, is a challenge for equity and bond investors so we have a modest allocation to gold mines in the fund which should offset part of this risk to capital value if it arises – we do not expect it to happen, but we are prepared just in case.”
Charles Luke, Manager of Murray Income Trust, said: “The portfolio is not driven by top down themes. However, on the basis of our assessment of fundamentals the portfolio has limited exposure to banks which would tend to benefit from an environment of higher interest rates and a more meaningful exposure to pharmaceuticals and consumer goods companies, such as AstraZeneca and Diageo which should benefit from a relatively low inflation environment.”
Peter Spiller, Manager of Capital Gearing Trust, said: “Low interest rates and elevated inflation means strongly negative real interest rates. The best performing asset class in this environment is likely to be index linked bonds. We favour US TIPS but also hold index-linked bonds in Japan, Sweden and Australia. Gold could do well too, though of course it is rather harder to value. In such an environment any cashflow that is reasonably secure with good inflation correlation should become more highly valued by the market. To that end we have been buying property, particularly with long leases and good covenants.”
Hamish Baillie, Fund Manager of Ruffer Investment Company, said: “What don’t we own? Conventional bonds, cash other than for short-term tactical reasons and a large exposure to equities. What do we own? Government backed inflation-linked bonds in the UK and US, gold and a low weighting to equities.”
Longer term - globalisation “more important” than technology
Peter Spiller, Manager of Capital Gearing Trust, said: “Since the onset of COVID-19 the impact of monetary policy has largely been to inflate the value of asset prices rather than prices in the real economy. We expect this to change as prolonged low interest rates are combined with expansionary fiscal policy over an extended period of time. Technological developments have and always will be deflationary. However, the pace of technological change today is no greater than average over the past 200 years and possibly rather slower. Of greater significance in recent times has been the impact of globalisation and the entry of previously untapped labour pools into global markets. As the tide of globalisation turns and perhaps starts to ebb, this trend should reverse.”
Hamish Baillie, Fund Manager of Ruffer Investment Company, said: “At a geopolitical level, globalisation is in retreat. Trade wars and reshoring are in the ascendency. The removal of the deflationary force of globalisation will see upward pressure on prices. Technology has been a deflationary force for the last 20 years but as some of the more monopolistic large tech businesses mature they will focus on profitability over growth and so in some sectors there will be upward pressure on prices. In others, like automation, there may be continued downward pressure on prices and wages, but this will likely be dwarfed by the aforementioned inflationary pressures from the fiscal and monetary channels plus the growing impetus to tackle income inequality.”
Charles Luke, Manager of Murray Income Trust, said: “The longer-term outlook for inflation will depend on the impact of COVID-19 on some of the secular drivers of inflation that had been in place over the past few decades. Technological progress has also had a huge bearing on inflation and will continue, intensifying international competition and suppressing wage growth.”
Quote unquote
David Prosser looks at the case for an allocation to private equity within a well-diversified portfolio.
David Prosser
Should advisers be increasing the allocations to private equity they hold in clients’ portfolios? New research suggests the answer is yes, with private equity potentially increasing both absolute returns and risk-adjusted performance.
The study, published by Pantheon, looked at portfolios of alternative assets, rather than conventional portfolios of equities and bonds. Alternatives feature increasingly prominently in the plans of private client wealth managers, stockbrokers and retail investors themselves, offering diversification benefits and, often, attractive levels of yield. But Pantheon says such portfolios often overlook private equity.
This is potentially a mistake. Tracking back, Pantheon looked at the performance of two different portfolios over the past 10 years. The first included equal allocations to gold, hedge funds and real estate; the second added private equity to the mix. The impact of private equity turned out to be significant. The second portfolio outperformed the first by an average of 2.4% a year. And while it was more volatile, the extra return more than compensated for the extra risk.
This is, of course, just one study, looking at a distinct historical period of investment returns. But the boost given by private equity was so significant that it’s worth taking account of. And there are good reasons for that boost: private equity, offering exposure to fast-growing, often immature unlisted businesses - all through the prism of professional management and an ecosystem of support - does have an outstanding long-term performance record.
That begs the question of why intermediaries and individual investors have not embraced the asset class to the extent one might expect. The explanation is complex but most of the factors centre around access. Private equity has traditionally required very large commitments to illiquid funds – most investors simply do not have the capital to meet minimum subscriptions and are not happy to lock their money in for extended periods.
However, listed private equity funds resolve these difficulties. The 20 or so funds in the investment company industry's private equity sector offer a highly liquid and affordable route into this universe. Just like other investment companies, their shares are tradable on the open market, meaning investors can get in and out as they desire, investing as much or as little as they are comfortable with.
It will be interesting to see whether the Covid-19 crisis prompts increased interest in these funds, with investors on the look-out for bargains. Private equity traditionally fares worse during periods of market turmoil, since there may be uncertainty about the true value of funds’ portfolios, particularly compared to listed assets. And many private equity investment companies have been through a torrid time in recent months; shares in the average fund in the sector currently trade at a discount to the underlying assets of just over 20%, but the figure is substantially larger in many cases.
Some advisers and investors will see this as an opportunity to increase their exposure to the private equity industry, in search of the performance benefits identified by Pantheon’s research. In which case, we may see allocations to private equity, with all the potential advantages it brings, begin to increase.
