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Generation Commentary - July 2020

UK: Suitable for retail clients

Rest of Europe and Singapore: For sophisticated investors only

In this month's edition:

 

Market review

Governments around the world tentatively reopened economies but at the same time, many countries faced a resurgence in coronavirus cases, prompting concerns that a ‘second wave’ was already underway.

In the UK, Chancellor Rishi Sunak delivered his summer statement in which he announced a VAT cut for the hospitality sector, the introduction of a jobs retention bonus and a reduction in stamp duty. Despite the economic stimulus measures and extra precautions, the FTSE All Share ended the period delivering a total return of -3.6%. By the end of the period, 10-year UK government bond yields had reached new lows, with the ICE BofA 1-10 Year UK Gilt index returning 0.3% over the period.

Several European countries witnessed a spike in coronavirus cases, including France, Spain, Belgium and Luxembourg. With the pandemic still very much a threat in the region, the MSCI Europe ex UK index generated a total return of -1.6% during the period.

Data published in July by Eurostat revealed that the eurozone economy contracted by a record 12.1% in the second quarter compared with the first quarter – the sharpest decline since 1995. Spain recorded the biggest decline, as its economy shrunk by 18.5% in the second quarter. The data showed that Portugal’s economy contracted by 14.1%, while France saw a decline of 13.8% in the second quarter. Talks between the UK and EU about a post-Brexit trade deal continued. But the EU’s chief negotiator Michel Barnier warned that “significant divergences remain” between the two sides.

Across the Atlantic, the US earnings season got underway. The US Commerce Department published data which showed GDP in the second quarter shrunk by 32.9% on an annualised basis, making it the fastest quarterly contraction on record. Shortly after the economic data was published, President Donald Trump tweeted the 2020 presidential election should be delayed, calling into question the accuracy of the postal voting system, as Democratic nominee Joe Biden continued to lead the polls. The US dollar had its worst month in a decade, with the dollar index (DXY) down more than 4%.

The US dollar dropped by 5.5% versus sterling, which masked what was otherwise a strong month for US assets in local currency terms. The MSCI USA index consequently delivered a total return of -0.3% in sterling terms as the equity market focused on better than expected corporate earnings but this was eclipsed by the fall in the currency, dragged lower by mounting coronavirus cases and rising tensions between China and the US. At its two-day meeting towards the end of the period, the US Federal Reserve left its policy unchanged, noting that it remains committed to deliver more stimulus if required. The ICE BofA US High Yield sterling hedged index ended the period delivering a 4.5% return, while the ICE BofA US Treasury sterling hedged index, recorded total returns of 1.1% in sterling terms. This is compared to the returns of the unhedged indices where the weakening of the dollar against sterling pushed both indices into negative territory in sterling terms.*

Chinese stock markets rallied further in July, even as the country battled to contain a slight increase in coronavirus cases and trade tensions with the US rose. The National Bureau of Statistics reported 3.2% year-on-year GDP growth for the second quarter, following a contraction in the first quarter. The positive economic data helped buoy the MSCI China index which ended the period up 3%. Emerging market currencies climbed over the period as the US dollar declined in value, weighed down by worries about the economic recovery. This helped emerging market equities, with the MSCI Emerging Markets index returning a positive 2.6%.

The gold price extended its rally during the period, surpassing $1,900 per ounce (oz) and eventually hitting a record $1,945.16/oz, beating the previous high set in September 2011 of $1,921/oz.

(All figures in sterling terms unless otherwise stated).

*Currency hedging of foreign investments removes the risk of currency fluctuations affecting the returns on your investment. Under normal circumstances, in the Generation Portfolios we currency hedge our foreign bond holdings.

 

Performance review

The Generation Portfolios delivered mixed returns in July, with the Generation CPI+3 Portfolio up 1.1%, Generation CPI+4 up 0.3% and Generation CPI+5 down 0.5%. This compares to a background of small gains in fixed income markets on a currency hedged basis, and small losses for global equities once returns were translated back into sterling.

From an asset allocation perspective, the portfolios’ equity exposure moved slightly higher over the month, most notably in Generation CPI+3 where it increased by 2.3% due to the use of a US equity derivatives strategy that will automatically increase US equity exposure and aim to capture market moves as the US equity index rallies. Meanwhile, our fixed income and alternatives exposures remained stable.

Key contributors to absolute performance during the month included the iShares Physical Gold exchange-traded fund (ETF), which rallied 10.7%, and the Ashmore Emerging Markets Short Duration Bond Fund, which continued its recovery, rallying 5.4% over the month. The portfolios’ corporate bond exposures also added value in July, with the underlying funds returning between 2-3% as credit spreads - the difference in yield between government bonds and corporate bonds - contracted slightly.

Within equities, our growth-oriented managers continued to outperform their benchmarks, including the Quilter Investors US Equity Growth Fund, managed by JPMorgan, and the Liontrust UK Growth Fund. However, headwinds remained in place for strategies more focused on either income or value, such as the BNY Mellon Global Equity Income Fund and the Usonian Japan Value Fund.

During July we started to reposition some of the fixed income exposure in the portfolios, in particular rotating away from UK investment grade corporate bonds into global corporate bonds. This resulted in reductions to the Quilter Investors Bond 2 Fund, managed by Fidelity, and the Quilter Investors Corporate Bond Fund, managed by Jupiter, which were offset by a new addition to the portfolio in the form of the iShares Global Corporate Bond ETF. We also reduced our weighting to the PIMCO Global Income Fund and the Quilter Investors Bond 1 Fund, managed by TwentyFour Asset Management, in favour of a switch to a passive strategy, the Vanguard Global Bond Index Fund.

Other portfolio activity during the month included the removal of the Merian Systematic Positive Skew Fund, which was a result of the fund’s closure following Merian’s merger with Jupiter. The proceeds generated from this liquidation were reinvested back into existing alternative strategies within the portfolios.

 

Outlook

There are currently three main areas we are focused on as we move towards the end of the year, the most pressing of which is the prospect of a second wave of coronavirus cases causing further disruption globally.

Headline data showing rising new coronavirus cases has been alarming, although breaking down the US data shows that current hospitalisations and deaths are not nearly as high as in March and April. Hospital utilisation therefore appears to be far from capacity, which indicates states will be reluctant to impose more draconian lockdown measures as they seek to aid the economic recovery. This is key for equity markets, which have so far remained relatively sanguine. Provided the situation does not deteriorate further in the US, markets still retain the potential to drift higher from here, powered by the wave of liquidity pumped into the global financial system by the major central banks and by hopes of an imminent vaccine to combat the virus.

Meanwhile, the US dollar sell-off witnessed in July has had a meaningful impact on unhedged overseas equity returns. Our view is that this currency weakness has been a function of the decline in US interest rates as well as the relatively weaker potential US growth trajectory. As the US grapples with coronavirus outbreaks and potentially more onerous or longer lockdowns.

The key beneficiary of this has been the euro, which has rallied materially versus the US dollar. Ironically this risks curtailing European growth given the strong focus on exporting for European corporates, as with costs in euros and revenues in US dollars their profit margins may come under pressure. The weaker dollar is also supporting commodity prices, in particular gold and silver, which are also benefiting from low real interest rates (which reduces the opportunity cost of owning a non-income-producing asset).

The US presidential election, meanwhile, is also starting to generate more attention as we move closer to November. We believe the race is likely to be closer than the polls currently suggest (they show a clear advantage for Joe Biden) and would expect that a close result in favour of either side will be disputed due to the likely large scale use of postal votes, which are more susceptible to errors or fraud. Any such prolonged uncertainty would likely be bad for markets.

A key issue will also be the result of the Senate elections. Currently Republicans hold the Senate, while Democrats hold Congress – but if the Democrats can take control of the Senate, this opens up the possibility of a Democrat “clean sweep” where they would control Congress, Senate and Presidency (if Biden is elected). This raises the likelihood that Biden could push through his campaign promises such as increasing the corporate tax rate – which would be unambiguously bad for US equities.

Sacha Chorley

Portfolio Manager

Ian Jensen-Humphreys

Portfolio manager

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