Global economic recovery is underway following the pandemic and the major economies are starting to re-open and ease restrictions. Inflation is rising as demand for resources, goods and services increases. It is therefore possible that the major central banks might have to increase interest rates to prevent inflation getting too high and economies “overheating”. Global equities have continued to make headway in this environment of economic recovery and the MSCI World index has gained 10.41% in the year-to-date in Sterling terms whilst the FTSE 100 has returned 11.64%.
Increasing inflation and the potential for higher interest rates leads our Investment Committee to currently prefer corporate bonds to government bonds. The reason for this is that presently corporate bonds offer better yields than government bonds. Higher yields are likely to provide more of a “cushion” if bond prices fall in response to increasing inflation and interest rates. We also prefer bond funds which have a lower “duration”, which is a measure of sensitivity to interest rates. With this in mind we have recently made a decision to switch from a global bond tracker fund to an actively managed Strategic Bond fund within a number of our model portfolios. The managers within the Strategic Bond fund aim to be nimble and invest globally in any type of bond according to where the best perceived opportunities are and the economic outlook.
Within equity fund selection, recent media discussion has centred upon the merits of and outlook for “growth” versus “value” investment strategies. Growth investing is about investing in the future. Growth managers look for companies which are creating new end markets or entering new geographical areas. Many growth companies are developing or providing novel products or services which connect with long term growth themes such as cloud computing, electric vehicles, green energy and new medical treatments. Others are established multi-national companies which are entering emerging markets where affluence and therefore demand is rising.
By contrast value investing centres upon stocks which fell out of favour and can be bought at a cheap share price compared to the perceived intrinsic “book” value of the company. Companies become “value” for a number of reasons – poor management decisions, industry change or the economic environment. A fund manager might choose to buy a company which is under new management with a clear turnaround strategy to address previous poor decisions or to address change within the industry. They might also buy companies such as oil or mining stocks, which became good value at the height of the pandemic due to global economic restrictions and then performed well once the vaccine breakthrough was announced. Whilst value companies with potential for turnaround can still be found it is important that managers who follow this style are able to avoid “value traps” – companies which will not recover because their business is in decline due to changes within their industry. Media and retail are good examples of where the internet and technology have been disruptive and have driven some companies out of the market because they cannot compete with new entrants.
Attempting to time entry and exit from particular investment styles and “rotate” between “growth” and “value” is tricky and has the potential to create unnecessary volatility within portfolios. Rather than try to time entry and exit from specific investment styles within our fund selections we instead aim to keep the equity component of our model portfolios diversified with a mix of defensive, cyclical and economically sensitive stocks. Defensive stocks are in the healthcare, consumer staples and utilities sectors. Cyclical stocks fall within the financial services, discretionary consumer, basic materials and real estate sectors. Economically sensitive stocks encompass the technology and communications, industrials and energy sectors. The range of exposure to defensive stocks within our model portfolios is 11-20%, for cyclical is 19-30% and for economically sensitive is 12-36%. We have the ability to flex these exposures via our fund selections according to the economic outlook. We also frequently review the underlying holdings within our equity fund selections and meet with fund managers to look “under the bonnet” of the fund and discuss specific stock holdings. This approach naturally creates exposure to both “growth” and “value” stocks and this diversification aims to spread risks within the model portfolios.
Our over-riding ethos is to find funds which have exposure to good quality companies, defined as those with robust financials and a strong business model. We also look for managers who do not invest in excessively overvalued companies which could be subject to a price correction. We vary the exposure to large, medium-sized and smaller company stocks according to the economic outlook and the main asset allocation move so far in 2021 has been to steadily increase our exposure to medium-sized and smaller company stocks as economic recovery gets underway .
Valuation concerns and a desire to increase the exposure to mid-sized and smaller companies have influenced a recent US equity fund switch. We opted to sell our discretionary holdings in an S&P 500 tracker ETF and to recommend the sale of this fund to our advisory clients. The replacement fund is a more concentrated actively managed fund with exposure to US companies of all sizes. The S&P 500 ETF has a 38% allocation to technology stocks and the top holdings include Amazon, Apple, Facebook, Microsoft and Alphabet/Google. We are concerned about the valuations of these major technology companies and the potential impact of proposed regulation and possible capital gains tax and corporate tax increases on their performance.
US economic growth increased at an annual rate of 6.4% in the first quarter of 2021, reflecting continued economic recovery, reopening of establishments, and the stimulus provided by the government to support the economy. The US personal saving rate was 20% in January 2021, reflecting the fact that many retail and leisure opportunities had been restricted during the pandemic. By April it was 15%, indicating that as economic re-opening occurs individuals are now spending more. Economic growth and increased consumption is potentially positive for domestically focused US companies, some of which are mid-size or smaller companies. The replacement fund has the flexibility to invest in US companies of all sizes and is positioned for economic recovery and re-opening. The portfolio currently has a 54% allocation to small and mid-sized companies. The managers do not invest in any companies which they consider to be overvalued and there is currently no exposure to the “big six” technology companies in the portfolio.
This article is for information purposes only. It does not constitute investment advice and is not a recommendation to invest. The value of investments and the income from them may go down as well as up and you may not get back your original investment. Past performance is not a guide to the future.
Date of publication: 25 June 2021
