What to look for in the final furlongs of 2016

Any advisers and clients who followed the old market maxim “Sell In May” will be cursing, as equity, bond and commodity markets generally look and feel bouncy after a summer of gains.

Anyone with money in property funds may grimace a little, although Legal & General UK Property Fund is now removing its downward ‘fair value’ adjustment to its portfolio, amid what it calls a “marked increase in the level of confidence from our valuers.” Except for wheat, whose dive to ten-year-lows is unlikely to rattle too many portfolios, the only real fallers of note over the summer were the pound and UK interest rates.

That begs the question of what is coming next, as the full adage reads “Sell in May and come back again on St. Leger day”. Saturday 10 September is St. Leger day this year, as Doncaster’s Town Moor track hosts the final ‘Classic’ horse race of the Flat season, so advisers and clients may now feel this is the time to assess their strategy as we prepare for the run-in to the year end.

The key issues to address may well include the following:

  • Politics: Italian Prime Minister Matteo Renzi will try to win a referendum on his Italicum constitutional changes in the autumn and defeat could see his resignation, condemning the Eurozone to more self-doubt should another leading proponent of the European integration project bite the dust. On the other side of the pond, the US Presidential Election of 8 November will dominate everything.
  • Economics: Advisers and clients will continue to receive more data on the UK economy, enabling them to assess whether the EU referendum vote has done any damage or not – with the caveat that ‘Brexit’ is still yet to happen. The Bank of England may cut rates again, the US Federal Reserve will continue to debate whether to hike borrowing costs at its September, November and December meetings while the Bank of Japan and European Central Bank could further loosen policy.
  • Markets: A number of clear themes emerged over the summer and it will be interesting to see if they continue. First, the loose monetary policy tide helped to lift pretty much all major asset classes, as already noted. Second, the prospect of interest rates remaining lower-for-longer intensified the scramble for income, providing particular support to long-dated Government bonds and junk bonds, as well as equities. Third, emerging markets continued to enjoy a return to favour. And finally, the pound was the only real major loser. That meant advisers and clients really needed to have parked money overseas, to get the translational benefit provided by sterling’s slide.

The British currency has tried to rally in the early days of September, to beg the question whether it is time to look at domestic plays once more. If so, that could imply it is time to do more research on funds which favour small and mid-caps rather than the titans of the FTSE 100, or special situations collectives which target laggards and underperformers across the full spectrum of the UK equity market.

Basing strategic asset allocation decisions on currency alone is a mug’s game and something no-one should try, owing to the unpredictability of the foreign exchange markets. But currency should be one part of the portfolio construction process and if a revitalised pound does prompt greater interest in small-to-mid caps then the good news is there are plenty of funds from which to choose.

The first two tables look at the top-five performers on a five-year view from the small-cap and flex-cap sectors (the latter to capture the broader mandate of special situations funds):

Best performing UK equity small-cap funds over the last five years

Source: Morningstar, for UK Small-Cap Equity category.
Where more than one class of fund features only the best performer is listed.

Best performing UK equity flex-cap funds over the last five years

Source: Morningstar, for UK Equity Flex-Cap category.
Where more than one class of fund features only the best performer is listed.

The next table looks at investment trusts which cover the full range of UK stocks, over the same five-year period.

Best performing UK equity investment trusts over the last five years

Source: Morningstar, The Association of Investment Companies, for the UK All Companies category
* Share price. ** Includes performance fee

There are also plenty of potentially-cheaper passively-run, Exchange-Traded Funds (ETFs), although the choice of small-cap funds is limited and the majority of ETFs will lean toward the megacaps of the FTSE 100 simply owing to the construction of the underlying indices that they are designed to follow. This final table therefore looks at the performance of the select list of dedicated UK mid-cap ETFs over the last five years:

Best performing UK mid-cap Exchange-Traded Funds over the last five years

Source: Morningstar, for UK Mid-Cap Equity category.
Where more than one class of fund features only the best performer is listed.

Summertime snooze

As of the close on Tuesday 6 September, the FTSE All-Share had risen by 8.9% since 1 May. Despite the siren charms of the ‘Sell in May’ saying that represented the twenty-seventh time since 1965 (out of 52) that the benchmark had actually gained over the summer months.

Looking back over the prior 26 advances, the All-Share then rose 18 times and fell just eight times between the running of the St. Leger and the end of the year – although the average increase in the end was just 1.9% over those 26 cases, with the best performance an 11.3% gain in 1993 and the worst 1987’s juddering 24.5% loss.

This goes to show there are no certainties in markets, just as there are no such things in horse racing either (and this column will be published before we find out whether the odds-on favourite for the St. Leger, the Irish-trained Idaho, wins or not).

The FTSE All-Share has risen 18 times out of 26 after a summer of gains, since 1965

Source: Thomson Reuters Datastream

As such, advisers and clients still need to proceed with care with their equity allocations, even if many will have enjoyed the summer markets, where four clear themes have emerged:

First, all boats have risen with the monetary policy tide. All major asset classes rose (in sterling terms), helped by record-low interest rates and central bank Quantitative Easing programmes (or mere inactivity in the case of the Federal Reserve). About the only things to fall over the summer were the pound and UK interest rates (unless you start digging about among the weeds of the commodity markets where wheat remained very weak):

All major asset classes rose over the summer

Source: Thomson Reuters Datastream. Returns given in sterling terms.

Second, the scramble for income intensified. A fresh interest rate cut and more QE from the Bank of England, alongside further pussy-footing about from the US Federal Reserve, has persuaded many investors that interest rates are going to remain lower for a lot longer than many had thought. This has prompted a fresh dash for yield, as evidenced by how long-dated Government bonds have done best since May, closely followed by US high-yield corporate and Emerging Market sovereign debt:

Bondholders enjoyed a bumper summer with long-dated paper doing best

Source: Thomson Reuters Datastream. Returns given in sterling terms.

Third, the best place for advisers’ and clients’ cash to be was overseas. The pound’s post-referendum plunge increased the value of assets held outside the UK, in sterling terms. The FTSE All-Share has rallied nicely but the UK has been the worst performer of the eight major regions over the summer in sterling terms, with emerging markets (EM) doing the best.

Currency movements also helped bring EM back into fashion. The US Federal Reserve’s decision not to raise interest rates weakened the dollar and, as regular readers of this column know, the greenback and EM have historically had an inverse relationship (so a strong buck has tended to mean weak EM asset prices and vice-versa). Some improvement in commodity prices and the prospect of political reform in key markets like Brazil also boosted sentiment toward EM over the summer after five years of marked underperformance relative to developed markets:

Overseas equity markets provided the best returns, helped by the pound’s post-referendum decline

Source: Thomson Reuters Datastream. Returns given in sterling terms.

Fourth, within the UK, the pound’s weakness went a long way to shaping sector and stock performance. Dollar-earners and firms with substantial overseas assets or revenue streams tended to do best, while domestic plays lagged amid (as-yet-unproven) fears the UK economy could suffer from the referendum decision to leave the EU.

Within the FTSE All-Share, the best-performing sectors over the summer have included Industrial Engineering, Forestry & Paper, Electricals & Electronics and Pharmaceuticals (while Tech Hardware has topped the list thanks to Softbank’s £24.3 billion bid for ARM).

Exporters and dollar earners took the UK equity market higher as domestic plays lagged over the summer

Source: Thomson Reuters Datastream

The laggards included Real Estate Investment Trusts, stodgy domestic plays like Electricity and Fixed Line Telecoms and also General Retailers, where the pound has potentially a big role to play. Retailers Next and Sports Direct have both flagged how a weaker pound could increase raw material costs next year and the final chart shows how for the past ten years a weak pound has resulted in a weak performance from the FTSE All-Share General Retailers sector and vice-versa.

The pound has now started to rally to above $1.34 so if investors are looking for ways to play any further advance in sterling it is possible that retail stocks may be one area fund managers will start to research again, especially as very few flex-cap equity (special situations) funds look to have substantial exposure here.

One exception is Alex Savvides’ JOHCM UK Dynamic Fund which has a top-ten holding in supermarket chain Morrison, although the sterling-sector relationship for the FTSE All-Share Food & Drug Retailers category seems less clear-cut than it does for the FTSE All-Share General Retailers area.

That said, we all know only too well that past relationships are no guarantee for the future, not least as correlation does not mean causation and both the General Retailers and Food & Drug Retailers have other issues to face besides sterling, not least the price-crushing powers of the internet and the cost increase posed by increases to the Minimum and Living Wage.

The FTSE All-Share General Retailers sector has historically been influenced by sterling’s fortunes

Source: Thomson Reuters Datastream, Bank of England

The FTSE All-Share Foods & Drug Retailer sector has also apparently taken note of the pound’s ups and downs

Source: Thomson Reuters Datastream, Bank of England

AJ Bell Investment Director

Russ Mould’s long experience of the capital markets began in 1991 when he became a Fund Manager at a leading provider of life insurance, pensions and asset management services. In 1993 he joined a prestigious investment bank, working as an Equity Analyst covering the technology sector for 12 years. Russ eventually joined Shares magazine in November 2005 as Technology Correspondent and became Editor of the magazine in July 2008. Following the acquisition of Shares' parent company, MSM Media, by AJ Bell Group, he was appointed as AJ Bell’s Investment Director in summer 2013.

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