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Creation Monthly - May 2020

UK: Suitable for retail investors

Date: June 2020

In this month's edition:

 

Market review

May saw a number of major countries taking the first steps toward easing their respective lockdown restrictions. In most cases, such moves were tentative due to the risk of a second wave of coronavirus (covid-19) infections.

Official figures released in May showed that the UK economy shrunk by 2% in the first quarter of 2020, the largest quarterly fall since 2008, as the lockdown restrictions impacted economic growth. Even so, the FTSE All-Share index shook off concerns of a looming recession to gain a modest 3.4% in sterling terms.

Elsewhere, the UK sold government bonds with a negative yield for the first time, while the Bank of England’s new governor, Andrew Bailey, said he wouldn’t rule out negative interest rates. The ICE BofA 1-10 Year UK Gilt index was up just 0.4% by the end of the month.

Earlier in May, the third round of talks between the UK and EU started up in a bid to define their future trading relationship. However, an exchange of public letters between the chief negotiators illustrated that the process had got off to a frosty start.

In Europe, the Italian government approved a second coronavirus support package worth €55bn, while early estimates for the first quarter suggested that German GDP growth had contracted 2.2% quarter-on-quarter. This was the biggest quarterly drop for the eurozone’s largest economy since the global financial crisis. Despite the poor economic data coming out of Europe the MSCI Europe ex UK index delivered 7.8% during the month, making it the top performing regional market in May.

In the US, covid-19 deaths topped 100,000 as President Trump’s handling of the crisis came under fire. The publication of non-farm payroll data showed that more than 20 million people in the US lost their jobs in April. In spite of this, the MSCI USA index ended the month 7.3% higher.

In May the US also held its first sale of a 20-year bond since 1986, prompting a fall in US 10-year and 30-year Treasury bond yields. During the month, the ICE BofA US Treasury index notched up a minor gain of 1.7% for sterling investors as higher-risk bonds raced away; the ICE BofA US High Yield index delivered 6.7% over the month.

Towards the end of the month, anti-racist demonstrations calling for an end to police violence broke out across the US, placing Mr Trump’s administration under further scrutiny. 

Trade tensions between the US and China also flared up as the president threatened to hit China with new tariffs. Mr Trump has continued to blame China for the covid-19 outbreak and announced that the US would be withdrawing from the World Health Organisation (WHO), which he claims is too biased towards China.

Meanwhile, China held its annual meeting of parliament, in which it announced it would abandon its GDP growth target, citing the uncertainty caused by the global pandemic. During the meeting, the National People’s Congress also announced further fiscal stimulus and offered more support for small and medium-sized companies.

However, the decision to impose national security laws on Hong Kong prompted protests to restart in the region. Despite having been one of the first countries to exit lockdown, the MSCI China index made only a modest 1.5% gain in May.

Emerging market equities made minor progress in sterling terms, with the MSCI Emerging Markets index notching up a return of 2.8% during the month. In May it also became clear that emerging markets were struggling to contain, or even adequately track, their respective outbreaks.

By late May, Russia was thought to be the second-worst impacted country after the US while an explosion in covid-19 infections had pushed Brazil into third place globally, with India rising ominously up the rankings. India’s number of infections hit a new high the same day it decided to resume internal flights as part of its lockdown easing.

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

Performance review

May was another month of positive returns for the Creation portfolios thanks to the continued rise in risk assets like equities and bonds as major economies began to slowly wind down their lockdown measures.

Although we were slightly underweight to equity risk at the start of the month, which may have detracted a little from performance, this underweight was moderated during the month as we increased our equity exposure.

In general, manager performance was strong in May and our manager-specific changes within the portfolios were limited. These included small trims to our positions in the Quilter Investors Equity 1 Fund (managed by Merian Global Investors) and the BNY Mellon US Equity Income Fund.

The former allowed us to take some recent profits to redeploy elsewhere, while the latter allowed us to reduce our exposure to ‘value’ stocks, which continued to struggle.

The difference between ‘growth’ investment strategies and ‘value’ investment approaches is that growth investors tend to focus on capital growth by typically targeting companies with earnings that are expected to increase faster than those elsewhere in their industry or the wider equity market.

Meanwhile, value investors tend to look for companies that are trading at less than their intrinsic or ‘book’ value, suggesting that their current price doesn’t correspond to their long-term fundamentals. So-called ‘value’ stocks can often be identified by their high dividend levels, which means that equity income fund strategies that target such companies have a natural bias toward value investing.

Similarly, we reduced our position in the Merian Global Income Fund and rotated the proceeds to our existing holding in the Quilter Investors Global Equity Growth Fund, managed by Fidelity. Elsewhere, we disposed of our position in Riverstone Energy, an oil and gas-centric private equity trust.

In the fixed-income portfolio, we reduced our exposure to corporate bonds after the recent recovery in prices. This included a reduction in the Wells Fargo Short Term High Yield Bond Fund and the PIMCO Dynamic Bond Fund.

Elsewhere, we sold out of our holdings in both the Merian Local Currency Emerging Market Debt Fund and the Merian Financials Contingent Capital (CoCo) Fund.

We also bought option contracts – financial instruments that allow you to buy or sell an underlying asset at a set price on a set date – that increased our total exposure to government bonds, a small move that helped to reduce our underweight relative to our peers.

 

Outlook

The global outlook remains particularly cloudy as populations start to emerge from their lockdowns. Possibly the most important data for markets comes from the periodic updates on new covid-19 cases from regions that are loosening their restrictions.

To date, the readings have been cautiously optimistic and this, along with renewed support from central banks and governments, has pushed risk assets higher with many traditional valuation metrics rendered temporarily irrelevant.

With a raft of institutional cash still sitting on the side-lines, there’s also the possibility of further gains to come as underweight investors are forced back into the market. So far, this rally has been especially ‘fragile’, powered for the most part by a small group of the world’s biggest technology stocks; there’s been little sign of the market exuberance spreading to other industry sectors.

We expect that further incremental good news and reduced covid-19 cases will be required to sustain this rally. Meanwhile, a second wave of infections would likely trigger another sharp decline in markets and another delay to when we might see a return to economic ‘normality’.

Bond yields still have room to move higher from here although central banks will be keen to maintain loose financial conditions and this should cap any losses if investors suddenly decide to sell their government bond holdings.

Sacha Chorley

Portfolio Manager

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