Market Background
The 6-month period covered by this interim report has taken place against a backdrop of steadily falling global growth forecasts, both in developed and emerging economies. Having started the period expecting steady growth into 2020, economic forecasters now predict a significant slowdown in global GDP to levels below the previous post-crisis trough in 2016. Accompanying this change in growth forecasts has been a marked shift in the expected direction on global monetary policy.
Initially markets focussed on the ability of the US economy to withstand a potential further tightening of monetary policy. At 10 years, the current US economic cycle represents the longest expansion in its history and market concerns centred on whether the US Federal Reserve might tighten policy too far and thereby tip the US economy into recession. There was some relief, therefore, that the Fed appeared ready to respond to market conditions and looked set to put rate rises on hold. In addition, there was optimism that trade talks between the US and China would be resolved in advance of the US presidential elections next year. However, rather than the hoped-for boost to global growth were a trade deal to be stuck, the period witnessed an escalation in trade tensions, with the US initially raising tariffs on $200m of Chinese imports from 10% to 25% and subsequently imposing 10% tariffs on an additional $300bn of exports. Market fears have grown that this escalation raises the likelihood of a global recession and recent economic data has only confirmed that key areas of the economy are indeed witnessing a slowdown. In the US the economic impact of these tariffs has been most obviously seen in manufacturing data but is also leading to a notable decrease in business confidence. US business investment contracted in September, its first decline since 2016. Consumer confidence has held up despite the trade uncertainty, reflecting the tight labour market, but may come under pressure as higher import prices associated with trade tariffs feed through. Europe has flirted with recession, with industrial production data highlighting the weakness of manufacturing sector across the region, but particularly in Germany. In China, activity readings have been disappointing and suggest that the intensifying trade war is impacting the domestic economy, despite the increased stimulus measures by the authorities. As the data has deteriorated, the closely watched US yield curve inverted (ie the difference in yields between the 10-year and 2 year government bonds turned negative), which historically has been watched as a predictor of an impending global recession.
Against this backdrop, there has been a marked reversal in the direction of global monetary policy. Having previously expected tighter policy across the major global economies, forecasts are now for the US to end the year with interest rates 0.75% lower than 2018 and all the other major economies are on a path to looser monetary policy. However, the effectiveness of QE and a Zero-interest rate policy is increasingly debated and there are signs that governments are also looking to take advantage of historically low interest rates to embark on more fiscal stimulus to jump start economic growth.
On the domestic front, Brexit has dominated the agenda. Theresa May has been replaced by Boris Johnson and markets have priced in a greater probability of a ‘No-deal’ outcome. Quarterly economic growth has been volatile as businesses built up inventory in preparation of a cliff-edge departure from the EU that hasn’t yet transpired . Parliament appears to have reached a state of paralysis and it seems most likely that the deadlock will only be resolved by a general election. Uncertainty over the timing and nature of our departure has seen sterling languish at the lowest levels since the vote in 2016 and domestically UK-exposed equities price in what appears to be a very disorderly Brexit outcome.
Whilst this all sounds gloomy and the data does indeed point to a slowdown in economic growth, we are not yet in a position where economic forecasts predict a global recession in the imminent future. Monetary policy has become increasingly supportive and both the trade tensions and Brexit are issues that could be resolved politically and indeed surprise investors on the upside. Facing a re-election in 2020 President Trump will be under pressure to do a trade deal or stimulate the economy with further tax cuts if the US economy does continue to slow. Similarly, any resolution to the Brexit impasse could unleash a boost both to UK equity markets, as an extreme valuation anomaly normalises, and to the economy on the back of increased business investment and improved consumer sentiment. However, markets do not appear to be factoring in any possibility of either outcomes happening. The US 10-year government bond yield, a good barometer of market sentiment towards long term economic growth, is as low as it has been since the financial crisis in 2008 and is at the same level as was in the Eurozone crisis in 2012, indicating a significant level of pessimism. In financial markets, such pessimism and confusion around the political and economic outlook means the premium being paid for certainty of return is extremely high, even when, in the case of a third of global bond markets, that return to maturity is negative. We continue to believe there are significant opportunities available to invest in attractive, higher yielding assets where those yields can grow, but the trade-off is a willingness to embrace risk, whether that be domestic Brexit-related risk or investing in more cyclical, international businesses, which are currently being buffeted by the US-China trade impasse. We can not be sure when uncertainty over these issues will clear but we can be certain that valuations already reflect a deteriorating outlook for earnings and, in many cases, these earnings are already depressed in a cyclical context.
Against this backdrop, the performance of risk assets (equities & industrial commodities) has proved extremely challenging whilst low-yielding safe havens, such as gold, bonds, and yen performed strongly. Within equity markets historically expensive, defensive sectors delivered strong returns, whilst economically sensitive sectors and those that benefit from higher rates, such as financials, underperformed.
Performance
Over the six months of this report, covering 1st March to 31st August 2019, TB Wise Multi-Asset Income made a total return of -3.7%. Over this time, we underperformed both the CBOE UK All-Companies Index, up 3.8% and the average fund in the IA Flexible sector, up 6.2%. This underperformance is extremely disappointing to us but clearly reflects our unwillingness to relinquish the clear value process that underpins the portfolio. Relative to our peer group, our lack of exposure to US equities, bonds and gold proved costly. We have avoided the former two on valuation grounds whilst gold, as a non-yielding asset, acts as a significant headwind to our performance objective to deliver a yield on the fund in excess of the CBOE UK All-Companies Index. The performance of US equities continues to be driven either by high growth, technology stocks or predictable, defensive consumer staples. Growth and predictability are the primary factors influencing investors, whilst valuation is a secondary consideration. We believe this leaves them vulnerable to any improvement in pessimistic forecasts for global growth. Similarly, a large proportion of the global bond market currently guarantees investors will lose money should they hold those bonds to maturity. These traditional safe havens are now priced in such a way as to now be anything but safe. We do see significant value in domestic UK equities and property, where uncertainty over the terms and timing of our departure have seen these companies trade at an obvious valuation discount since 2016. Uncertainty is leading to earnings for these companies coming under some pressure and the continued weakness of sterling has proved a further headwind to having a domestic UK tilt to the portfolio. Whilst sticking to our valuation discipline has been painful, we remain confident that there is a high level of inherent value in the portfolio and a number of catalysts exist that could reverse recent underperformance (for example, a Brexit resolution, a trade deal, a shift from ultra-low monetary policy to looser fiscal policy). Extreme valuation dispersion in the market means such moves could be quite sudden and equally extreme.
Looking at performance attribution in more detail, our direct equity performance was negatively impacted, as discussed above, by our underweight exposure to highly-rated, defensive sectors, such as beverages, healthcare & equipment, pharmaceuticals, personal goods and food producers. Conversely, performance was further impacted by our overweight exposure to property and financials, particularly life insurance. Brexit related concerns, low bond yields and structural concerns over the changing landscape for retail property have converged to leave companies in both sectors trading on exceptionally low valuations. Legal & General, our largest direct equity holding, closed the period at its lowest level since 2016. Despite a 10-year track record of 10% compound earning growth and record recent profits, the company ended the period trading on less than 7x earnings, yielding more than 7%, despite anticipated, sustainable growth of 7% per annum in that dividend. The company is a global leader in the transfer of corporate pension fund risk, has a global market share of c.2% in Investment Management and a portfolio well-hedged for lower bond yields. NewRiver Reit, which we have added to the portfolio during the period, also reflects similar pessimism towards anything exposed to domestic demand. Whilst having to navigate the structural headwinds the internet is inflicting on the retail property sector, the company is well-managed and securely financed. The retail exposure is diverse, convenience focussed, with a growing exposure to pub assets, rents are low in absolute terms and are affordable to their tenants. The asset value is also underpinned by alternative use yet the shares ended the period at a 33% discount to their forecast net asset value and are forecast to deliver a yield to investors over 13%. In both cases we recognise there is some uncertainty ahead but feel, as investors taking a long term view, we are being handsomely rewarded for embracing these risks. Holdings in the portfolio, such as Chesnara, Morses Club, Aviva, RBS, British Land, Ediston Property and Palace Capital, all appear to have seen indiscriminate selling and offer compelling value.
There have been some bright spots during the period, notably Princess Private Equity, the largest holding in the portfolio which rose 14.4% over the period, entirely driven by strong NAV performance whilst the NAV discount widened slightly to nearly 17%. Similarly, Ecofin Global Utilities & Infrastructure, an investment trust investing in areas such as transport infrastructure and utilities rose nearly 19% driven by strong performance from its underlying assets whilst the NAV discount also widened . We are also encouraged that the value we see in the market is being crystallised in certain instances via corporate activity. Telford Homes, Tarsus and Marstons have either directly or indirectly benefited from being taken over or bids for competitors at attractive relative valuations.
There have, however, been some stock specific disappointments which have compounded what was a difficult market backdrop. Notably, our retail holdings have felt the combined impact of poor weather over the summer and a more cautious consumer faced with Brexit uncertainty. We have reassessed our holdings in this area, adding to certain companies where we feel the extent of the market reaction to the recent trading updates has been overly harsh and pruning those companies where we are concerned that weak balance-sheets or undifferentiated propositions leave them vulnerable should conditions remain weak. As such, we have added to Lookers and ShoeZone and exited Moss Bros, McColls and Halfords. Finally, Kier Group, the UK construction company, has continued to be weak despite its rights issue before Christmas. We believe there is further work to be done on restoring its balance-sheet but the strategy of disposing of its housing operations and releasing capital from its property development division should achieve this. Once delivered, we believe the market will focus on the strengths of its regional building and infrastructure operations and there is significant scope for recovery, at which point we believe there will be a better opportunity to exit.
Allocation changes
Within the direct equity element of the portfolio, there has been a recycling of the portfolio within the domestically exposed holdings, as described above. Morgan Sindall, a high-quality, well-capitalised construction, partnership housing and fit-out company has seen its share price languish as competitors have struggled and we took advantage to initiate a position in an industry leading operator. Similarly, we added to Henry Boot, a construction company and promoter of land to the housebuilding sector, whose shares now trade at a discount to asset value, despite a highly conservative accounting approach. Other similar additions include U&I, Palace Capital, BT, Vodafone and Bakkavor. We added certain high-quality but economically sensitive companies which offer good cyclically-adjusted value. We initiated a position in XP Power, a global provider of power solutions, with an exceptional long-term track record of growth, that has been hit on the back of trade tensions and a slower semiconductor equipment market. We also added Elementis, a global manufacturer of talc, cosmetic and anti-perspirant active ingredients, as well as more cyclical coatings and chrome products, which has been hit extremely hard following recent acquisitions. Similarly, we added both to Blackrock World Mining Trust, at a healthy NAV discount and to Rio Tinto. In addition to the changes with our property holdings, we added to certain financial holdings, such as Polar Capital, Royal Bank of Scotland and Standard Chartered and increased our holding in Chesnara. In part this was funded via a disposal of Lloyds Banking Group and reducing the holding in Aviva.
We have reduced or sold down entirely stocks which had performed well, namely Telford Homes, Marstons and Tarsus (on the back of corporate activity), Savills, Ashmore, Impact Healthcare REIT as a well as Aberdeen Asian Income Fund. Furthermore, we have focussed on eliminating companies where we have residual concerns about the strength of their balance-sheets or the strength of their business models.
Outlook
The aim of the TB Wise Multi-Asset Income is threefold: to provide an attractive level of income higher than the CBOE All-Companies Index; to increase that income in line with inflation or better over the medium to long term; as well as increasing capital in line with inflation or better over the same time period. Whilst delivering on the initial objective in the period, it is clearly disappointing this has been achieved at the expense of capital growth. We continue to believe that markets today are highly skewed in valuation terms and whilst the fund has an extremely wide remit, which allows us to invest in the broadest possible range of assets, in whatever proportions we believe is appropriate, we prefer to invest in a relatively narrow set of assets (broadly equities and specifically UK exposed equities and property), where we feel there currently is an extreme valuation opportunity.
The yield that this portfolio offers is high, with a historic yield of 5.9%. We believe this is an attractive level and one that has scope to grow in real terms. Political noise will continue to dominate the immediate investment horizon but we remain cautiously optimistic that the inherent value within the portfolio will be realised.
General update
The TB Wise Multi-Asset Income fund started the interim period with assets of £112m and ended with £102m , mainly as a result of performance and dividend distributions of £3.7m. We recognise this has been a challenging period for investors in the fund and I would like to personally and on behalf of the Wise Funds Team, thank all our investors for their ongoing support. We are pleased also to announce that we have a new member of the team joining shortly and look forward to updating you further in our monthly factsheets. Please feel free to contact us if you would like a meeting or have any questions .
Philip Matthews
Fund Manager
Wise Funds Limited
September 2019