It’s fair to say that this quarterly reporting period has been unique, dominated by market uncertainty and volatility in the run-up to the EU Referendum, the Brexit vote, the resulting political fallout and ongoing speculation about the future.
The initial shock at the widely unexpected Brexit result caused frenzied market activity, which forced the FTSE 100 down about 8 per cent within minutes of the market opening on the morning of the result, but finished the week as a whole 2 per cent higher! Just a week later, the FTSE 100 hit a 10-month high and enjoyed its best week since 2011.
Similarly, the pound, which shortly before polls closed on Thursday 23 June had been hovering around the $1.50 mark, collapsed in a few hours to as low as $1.3232, the largest one-day fall in 31 years. Despite a subsequent recovery, underlying downward pressure on sterling has kept its value depressed at a 31 year record low.
In a post-EU referendum poll, more than half of City economists now expect a recession in the UK, as the plunging pound raises prices and leaves less discretionary cash in people’s pockets. The political and economic uncertainty is also expected to lead to a sharp reduction in capital spending plans by business leaders.
More than half of City economists now expect a recession, as the plunging pound raises prices and leaves less cash in people’s pockets
HSBC has forecast that Inflation may increase to 4 per cent within 18 months as a result of the pound’s collapse, which would put the Bank of England under pressure to raise interest rates. However, this is not a widely held view, as generally, the markets do not believe that the Bank has any intention of tackling inflation. Government borrowing costs for ten-year debt fell from 1.38 per cent to a record low of 1.08 per cent, as markets priced in the prospect of a rate cut from 0.5 per cent to 0.25 per cent this year and pushed a first rate rise out to about 2020. A cut in Bank rate is now viewed as a near-certainty; ahead of the EU referendum, a reduction was considered an even-money bet.
It is now widely expected that the Bank of England will cut interest rates within the next two months to shore up plummeting business and consumer confidence and spending in the wake of the EU referendum result.
Stagflation, the combination of low growth and high inflation, will pose a problem for the BoE, which has a target of keeping inflation at 2 per cent but also to support growth. The Bank would normally be expected to raise rates if inflation was forecast to hit 4 per cent, but economists would be shocked if it did. Many believe that it will “look through” the sterling effect — in other words, ignore it.
The plunge in the pound is set to deliver a boost to exporters and companies with big overseas operations, but is bad news for domestically-focused businesses and those highly dependent on imports.
The plunge in the pound is bad news for domestically focused businesses.
If the UK was not in the single market or the European Economic Area (EEA), it would mean the loss of "passporting", which allows banks to operate without restriction in all EEA countries. Consequently, a number of major financial companies are considering whether they will need to move thousands of employees to other EU jurisdictions, to continue offering pan-European financial services.
Contrary to warnings that London’s financial sector will be crippled by the UK’s decision to leave the European Union, legal experts believe that international banks will not have to move thousands of jobs away from London and will still be able to do business with the rest of Europe despite Brexit.
After an initial slump in the first two trading days following the Brexit vote, the index of Britain’s top 100 companies promptly regained all its losses and is now at its best level since last August. Part of the reason for the recovery is the growing belief that article 50, the mechanism to trigger the UK leaving the EU, will not be triggered for months, whoever ends up with the prime minister’s job. So in some senses it is business as usual for the moment, and the City tends to take a rather short-term.
The continuing weakness in the pound could well help the FTSE 100 hold on to its gains, although there is also the possibility that investors may decide to cash in some of their recent gains. A summer interest rate cut would also help leading shares, and keep the pressure on sterling.
But with the continuing political uncertainty and the prospect of some tricky negotiations between the UK and the EU about their future relationship, there is likely to be continuing volatility in the market. The approaching holiday season will lead to lower trading volumes, which tend to exaggerate share movements in both directions. And companies with large UK earnings will still struggle as domestic growth slows.
UK Property Funds
One area of concern is the move by a number of UK property fund managers to change the charging structure, impose ‘Fair Value Adjustments’ or even suspend trading of their unit trust/OEIC funds. These moves have been in response to net outflows due to a surge in redemption requests caused by worries about the fate of their property funds and the tumbling price of the pound.
Large-scale outflows cause problems for commercial property funds because they are based on assets that are difficult to sell quickly when investors want their money back. Restrictions on withdrawals are then put in place to give fund managers time to sell their properties. Otherwise, they would be forced to sell assets at fire-sale prices to fund the redemption requests. That would drive down the fund’s value, encouraging more investors to cash out, creating a vicious circle.
Following the decision by Standard Life Investments, the fund arm of insurer Standard Life, to suspend all trading in its £2.9bn UK commercial property fund, the fund management divisions of Aviva and Prudential as well as M&G Investments followed suit by blocking investors from pulling money from their multibillion-pound property vehicles, as anxiety intensified about the damage that Brexit could do to the economy.
Standard Life said that it had “gated” its £2.9 billion commercial property fund. Several other fund managers are expected to follow suit.
M&G said the “temporary suspension” on its £4.4 billion property portfolio would “allow the fund manager time to raise cash levels in a controlled manner, ensuring that any asset disposals are achieved at reasonable values”.
Aviva Investors stopped clients from withdrawing investments from its £1.8 billion property trust.
The extraordinary market circumstances, which are impacting the wider industry, have resulted in a lack of immediate liquidity... Consequently, we have acted to safeguard the interests of all our investors by suspending dealing in the fund with immediate effect.
Reflecting heightened uncertainty in the market, several funds, including Henderson, Aberdeen, Legal & General, M&G and Standard Life, have recently imposed “fair value adjustments” that have cut their fund values by 4 – 5%.
Open-ended property funds have come under severe pressure in recent days amid investors’ concerns that Brexit could lead to a slump in business activity in the UK, leaving buildings standing empty and new construction projects abandoned. Those investors have clamoured to get their money out of funds that are invested in large property developments, which are almost impossible to sell quickly. The pressure has resulted in funds eating into their cash buffers.
These recent developments affecting UK open-ended property funds highlight the advantages of holding exposure to illiquid assets like property through closed-end investment companies rather than open-ended funds. While property investment companies (REITs) face the same valuation issues as open-ended funds, managers do not have to manage liquidity buffers when challenged with a surge in redemption applications.
The Financial Conduct Authority (‘FCA’), has warned that the regulator might have to impose changes in the £24 billion open-ended property investment sector, in which investors traditionally are able to buy and sell units at will. The FCA has said that property funds without liquid assets might have to be reformed “from the point of view of conduct and systemic stability”.
No one knows for sure where property is headed over the next couple of years. If the pound remains weak, it is possible that foreign buyers will see UK property as a cheap safe haven. In the meantime, rental yields will underpin investment returns. Therefore, being locked into a commercial property fund may not be the worst thing to happen if it prevents a hasty response to the recent sudden change in sentiment.
In terms of Reeves IWM Investment Strategy, the following funds were in our recommended portfolios:
- Threadneedle UK Property Authorised Trust
- Aberdeen Property Trust
Where clients still have these funds included within their portfolio’s we have recommended these are retained for now.
The suspensions will be formally reviewed on a regular basis and will cease as soon as each fund group deems it viable. Our portfolios do contain other property assets however, these are not affected in the same way because they are of a different legal structure or overseas. We will keep the situation under review and advise accordingly.
By April 2006 we had identified a short to medium term risk in the UK Commercial Property market. Whilst not anticipating any suspension of trading, our investment board did expect unit prices in this market to come under pressure. We therefore responded by recommending that clients exposure to UK Commercial Property be reduced, and thus the negative impact of the EU Referendum on our portfolios was mitigated to a degree.
Commercial property continues to have a valid place in a balanced portfolio and so our current portfolio’s still provide exposure in this market, though this is lower than would be the case in our standard risk-aligned portfolios.
Despite recent market wobbles, commercial property continues to have a valid place in a balanced investment portfolio
In our previous quarterly Reeves IWM Market Outlook report, we highlighted a number of benefits and advantages of investment trust companies over unit trusts and OEICs. This recent development in the UK property fund sector has highlighted further advantages of investment trusts, in that they are always tradable in a liquid secondary market, i.e. the London Stock Exchange and fund managers don’t have to resort to ‘re-pricing’, ‘gating’ strategies, ‘fair-value adjustments, suspended trading or intervene in any other way to manipulate and distort the market in a retail investment fund.
Selected real estate investment trusts (‘REITS’), such as Empiric Student Property Plc, GCP Student Plc, & Target Healthcare REIT Ltd) have formed an integral part in the composition of Reeves IWM managed pension funds for some considerable time now.
Baillie Gifford Shin Nippon plc Investment Trust
Based on the benefits and advantages of investment trust companies highlighted in our previous quarterly Reeves IWM Market Outlook, in the face of difficult markets, we continue to seek new opportunities for our clients. As an example, we have incorporated some investment trust holdings in our managed pension portfolios, one of which is the Baillie Gifford Shin Nippon investment trust.
As this is a relatively new portfolio investment, we thought it may be interesting and useful to provide a focussed overview of the investment company.
Baillie Gifford Shin Nippon PLC was launched in July 1985 in order to capitalise on the investment opportunity available among companies too small and illiquid for Baillie Gifford Japan Trust PLC, which had been launched successfully four years before. Shin Nippon, which means New Japan, has as its objective the pursuit of long-term capital growth principally through investment in small Japanese companies which are believed to have above average prospects for capital growth.
Now managed by Praveen Kumar, a member of Baillie Gifford's Japan equities team since 2011 and successor to the much-respected John MacDougall, this trust has been a regular winner of our Best Japan Trust award in recent years.
The trust focuses on investing in ‘The most dynamic, innovative smaller businesses' emerging in Japan. These include companies with innovative business models, disrupting traditional Japanese practices, or with market opportunities such as growth from overseas.
The portfolio is constructed through the identification of individual companies which offer long term growth potential, typically over a three to five year horizon. The portfolio is actively managed and does not seek to track the comparative index, hence a degree of volatility against the index is inevitable.
In constructing the equity portfolio a spread of risk is achieved by diversifying the portfolio through investment in 40 to 75 holdings. Although sector concentration and the thematic characteristics of the portfolio are carefully monitored, there are no maximum limits to deviation from comparative index stock or sector weights.
On acquisition, no holding shall exceed 3% of the portfolio and any holding that as a result of good performance exceeds 5% of the portfolio is subject to particular scrutiny. A holding greater than 5% will continue to be held where the managers are convinced of the ongoing merits of the investment case.
The Company may invest in UK and Overseas domiciled pooled funds, including UK listed investment trusts, which invest principally in Japanese securities. On acquisition, no more than 15% of the Company’s gross assets will be invested in such companies or funds.
From time to time, fixed interest holdings, or non-equity investments, may be held on an opportunistic basis. The Company may use derivatives which will be principally, but not exclusively, for the purpose of efficient portfolio management (i.e. for the purpose of reducing, transferring or eliminating investment risk in its investments, including protection against currency risks).
The Company recognises the long term advantages of gearing. Although the Company may have maximum equity gearing of 50% of shareholders’ funds, the Board would seek to have a maximum equity gearing level of 30% of shareholders’ funds at the time of drawdown.
Borrowings are typically invested in securities when it is considered that investment grounds merit the Company taking a geared position to securities. Gearing levels, and the extent of equity gearing, are discussed by the Board and Managers at every Board meeting. The Managers are tasked with ensuring that gearing is managed efficiently and within the parameters set by the Board and any loan covenants.
Among the trust's best-performing stocks in 2015 were several of its long-term internet-related holdings which focus on rapidly expanding domestic niche markets. Companies seen as beneficiaries of the record numbers of Chinese tourists visiting Japan were also very strong performers over the period.
Cumulative Performance as at 06/07/2016
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Baillie Gifford Shin Nippon PLC
Japanese Smaller Companies
Despite the strong run the Japanese market has had over the past few years, Baillie Gifford says the trust continues to find exciting, attractively valued investment opportunities with the potential to deliver high earnings growth.
NB – the above does not represent a recommendation. It demonstrates how we might utilise a fund to diversify holdings, seek opportunities for returns, and spread risk within a balanced portfolio. You should always seek advice before making any investment.
Reeves IWM Managed Pension Balanced Portfolio
In terms of Reeves IWM clients, in our recent proposed portfolio amendments we have maintained relatively high cash positions (a position that has been questioned by some clients and competitors), we have held more property funds but have just moved significant holdings from UK to overseas. We have also held general global cautious managed funds to enable flexibility and diversification away from UK equities but which are capable of beating cash. The above should protect your assets relative to bog standard UK managed and equity funds.
The following table shows the current Reeves IWM Managed Pension Balanced Portfolio, with holdings ranked in ascending order of performance over the past week, following the recent Brexit vote. This demonstrates that the vast majority of our investment holdings have performed better than the FTSE All Share benchmark. The one notable exception is the recently acquired JP Morgan Mid Cap investment trust, which has inevitably taken a significant hit because of its focus on UK mid-cap FTSE 250 companies. However, this is a strategic long-term hold, which represents just 1.67% of the Balanced portfolio. Overall, this is a commendable short-term performance in such challenging times, having endured the market shock of Brexit and ongoing uncertainty and continued volatility.
Benchmark:FTSE AllSh TR GBP
Marlborough Special Situations P Acc
JPMorgan Mid Cap Ord
Empiric Student Property PLC
AXA Framlington Financial Rl Acc
Lazard European Smlr Coms Retl C Acc
Schroder European Sm Cos Z Acc
Liontrust Special Situations I Inc
Jupiter Financial Opportunities Inc
Schroder US Mid Cap Acc
Fidelity American Special Situations
JPMorgan European Smaller Comp Ord
Legg Mason IF CB US Eq A Acc
Investec Cautious Managed I Acc Net
Fidelity Global Technology W-Acc-GBP
Threadneedle Eurp Sm Cos Ret Z GBP Inc
Schroder Global Real Estate Secs Z Acc
Henderson Global Technology I Acc
AXA Framlington Global Technology Z Acc
Jupiter North American Income Acc
GCP Student Living Ord
Target Healthcare REIT
Tritax Big Box
AXA Framlington Biotech GBP Z Acc
Baillie Gifford Shin Nippon Ord
iShares Core S&P 500*
iShares US Property Yield*
*funds are new and so relative data is not available.
Look out for our specific advice e-mails as the markets change.