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Creation Commentary - February 2022

Date: 18 March 2022

Market review

February was a month of two parts. The first, saw a continuation of January’s mounting inflationary pressures causing investors  to expect more urgent US interest-rate increases. This made life hard for both bond and equity markets.

However, markets recoiled in the second part of the month following Russia’s 24 February invasion of Ukraine. The price of oil, gas, industrial metals and other key commodities began to spiral forcing markets to fret over the likely consequences for inflation and the prospect of a prolonged energy crisis in Europe.

Economic sanctions imposed by the West on Russia included freezing the central bank’s currency reserves and excluding several Russian banks from the SWIFT messaging system used for international payments. By the month’s end, Russia’s rouble had tumbled over 20%, its stock market had halted trading, and the price of Brent crude oil had broken $100 per barrel.

Our tactical equity positioning proved beneficial to performance.

Due to its bias toward growth companies, the MSCI USA Index was the worst-performing regional equity market in April, down 4.6%. Its heavy weighting to technology stocks was costly in a month when the MSCI Information Technology Index was down more than 7.5%.

Meanwhile, US annual inflation reached a 40-year high of 8.5% in March. In the UK, the Consumer Prices Index (CPI) rose by 7% from a year earlier. The sharp rise in western inflation had been stoked by increased demand as economies come out of lockdown, an ongoing energy crisis and renewed lockdowns in China due to its ‘zero-covid’ policy.

Elsewhere, the UK equity market’s extensive weighting to energy stocks was a major positive for the local indices as was its sizeable exposure to more defensive sectors such as consumer staple and healthcare stocks. This helped the UK indices to deliver small positive returns with the FTSE 100 Index gaining 0.8% while the broader FTSE All-Share nudged up 0.3%.

European equities lost further ground but notably outperformed the US market. Recent corporate earnings releases have generally been better than expected, helping temper negative investor sentiment as the knock-on consequences of the sanctions on Russia are expected to hit the region particularly hard. Consequently, the MSCI Europe ex UK Index declined by 1.7%.

In bond markets, the rapid sell-off continued in April. The suggestion of 0.75% interest-rate hikes from one US Federal Reserve (Fed) board member caused panic while expectations also grew for the European Central Bank (ECB) to cease its bond-buying programme over the summer and begin raising interest rates.

Corporate bonds declined more than US Treasuries with the Bloomberg Global Aggregate Corporate Index (sterling hedged) falling 4.4% in April while the Bloomberg Global Aggregate Government Treasuries Index (sterling hedged) declined 2.3%.

In currencies, the Fed’s commitment to reining-in inflation with interest-rate rises, coupled with the broader risk aversion sweeping financial markets, buoyed the US dollar. It strengthened around 4.5% versus sterling.

The weakness of the Japanese yen this year also remains a major story. Despite the significant recent weakness of sterling, the yen is still more than 5% down against the pound since the start of March, when its rapid depreciation began.

Consequently, although the MSCI Japan Index retreated 4.4% for sterling investors in April, around half of this loss was the result of the yen’s painful decline.

(All performance figures in sterling and rounded to one decimal point, unless otherwise stated.)

Note: Currency hedging of foreign investments dampens the effect of currency fluctuations on returns and reduces the volatility of your investment. Under most circumstances, we currency hedge foreign currency bond holdings, except in cases where the foreign currency exposure is an explicit return-driver (eg emerging market local-currency debt exposures).

Performance review

All portfolios within the Creation range delivered losses in February, varying from 1.2% to 1.6%. This resulted from a month characterised by volatile markets following Russia’s invasion of Ukraine, and a general risk-off tone in markets.

However, aside from Creation Conservative, the portfolios all outperformed their respective Investment Association performance comparator, as conservative risk positioning proved beneficial in the challenging market environment.

With global equity markets lower over the month, albeit with some regional variations, the tactical equity tilts in the portfolios made a positive contribution to performance. Our underweight position to the Europe ex UK region and an overweight exposure to the healthcare sector, were particularly advantageous.

US growth and value managers outperformed in the month.

Manager selection within the portfolios was slightly more challenging in the month, with all of our UK managers struggling to match the MSCI UK Index, which features large cap companies and high exposures to the commodities and financials sectors.

Therefore, where managers tended to have a bias towards medium and smaller-sized companies (as this usually offers more opportunity for excess returns), this proved detrimental  to performance. The biggest detractor from returns was the Quilter Investors Equity 1 Fund, a mid-cap growth strategy managed by Jupiter as it suffered from a combination of underperformance from the mid-cap growth segment of the  market, as well as stock specific weakness.

Other equity regions proved more positive, with our US growth and value managers outperforming in the month. There was  also a defensive bright spot provided by the Wellington Durable Enterprises Fund within our global equity allocation, as well as overall outperformance from our Asian, Japanese and emerging market equity exposures.

However, tactical tilts including a low level of interest-rate sensitivity in the portfolio, as well as a regional bias towards US dollar-denominated government bonds was positive for returns.

Our exposures to high-yield and emerging market bonds were a headwind for the portfolios and, as such, offset some of the positive contributions of the tactical tilts.

Meanwhile, the allocation to alternatives was helpful in terms of diversifying our returns, particularly within our investment trust holdings. These are held in the inflation-protection bucket because of their inflation-linked cashflows and their returns in the month were ahead of broader equity markets. However, our absolute return fixed-income and equity managers delivered negative returns, which meant alternatives overall detracted from performance.

Outlook

While the events in Ukraine are tragic from a human perspective, we believe the broader economic effects will be less impactful than the current market pricing and volatility suggests. Specifically, we believe the situation is unlikely to derail the global economy from returning to a post-covid ‘normality’ where GDP growth remains resilient, and companies are still able to grow revenues and profit.

Against this backdrop, we continue to see central bank policy changes as being of the utmost importance for risk assets in the medium term, meaning the primary risk for markets remains a policy misstep.

That being said, the increased geopolitical risk creates challenges. Sustained, high commodity prices could complicate central bank decision making as it would simultaneously raise inflation data points while potentially also destroying demand.

The risk of more widespread or deadly conflict remains a low probability event in our minds but in this more challenging environment we reiterate the need for quality in the portfolio. Outside of the managers we own, the healthcare sector, with its higher margin, lower leverage business profile is one of the ways that we have implemented this in the portfolios.

With little sign of a global recession but a very negative market backdrop, where we anticipate global earnings growth in the high single digits, we are more likely to add risk to the portfolios at lower levels, rather than sell. However, we remain focused on challenging and checking our views and we remain open to changing those positions as the data changes and events develop.

Our investment trust holdings were ahead of broader equity markets.

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Ian Jensen-Humphreys

Portfolio Manager

Sacha Chorley

Portfolio Manager

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