Economic developments

During the last quarter of 2017 there were a number of events that had a material impact on the outlook for the overall stock market, sectorial performance within the market and the likely performance of value vs. growth and cyclicals vs. defensives. The passage of the tax measures in the US, the first major Trump success on policy, will add momentum to an already strong US economy. We showed last month that consumer, manufacturing and business confidence are close to, if not at, record highs in the US. This backdrop will extend the current strength in economic activity; it will mean the Federal Reserve continues to increase interest rates/shrink its balance sheet; and it will help lead to higher wages, all of which will contribute to higher bond yields. We exited 2017 with US 10-year treasuries trading at 2.4% (close to the highest point of the year), and we expect this to push higher from here. We expect defensives to continue to underperform financials and cyclicals in 2018, and the Fund remains positioned accordingly.

In the UK, the Brexit breakthrough in December with agreement to move to the next phase of discussions is a major positive versus the implied outcome and the assumed (very negative) trajectory of the UK economy that is priced into domestic-related assets. Meanwhile, economic data is not as negative as portrayed. Wage growth inched higher to 2.3% (from 2.2%). As we highlighted last month, we expect this to move towards 3% during 2018, with a likely sharp shift higher in the first half against weak comparatives. Latest data on EU migration into the UK showed those arriving looking for work (as opposed to those with a definite job) were at the lowest level since 2004 (for EU 8) and 2011 (for EU 15). This will place increased pressure on an already tight labour market. As inflation falls from the current level (which will be the peak as the effect of the Brexit sterling devaluation drop out of the data) real wages will start to expand. Whilst the Citi UK Economic Surprises index (which is a barometer of how all economic data is progressing in relation to forecasts) has rebounded strongly since August. This corresponds to the narrative we hear from many of our UK holdings when we meet management teams. We expect sterling to continue its gentle appreciation. The biggest risk to the UK economy would be a Corbyn-led Labour government. This is the main reason we have been measured in the pace of our increase in domesticity. 

In Europe, data remains strong, particularly in France and Spain. This trend will hopefully be cemented and augmented by policy actions in 2018 that will create a better structural growth story. The recent introduction of Kingfisher to the portfolio and the increase in our DS Smith position are good examples of how we are trying to increase our exposure to these trends.

Finally, the oil price remains important to the Fund. This is due in part to our large positions in the two UK oil majors but also because of its implications for inflation. We discussed the OPEC decision to extend production cuts in last month's commentary. Along with better-than-expected demand growth and some questions over the pace of supply growth from US shale, the cuts have helped stabilise the oil price at around US$60/bbl. This is 30-40% higher than the low point in mid-2017, which means oil and oil derivatives will place upward pressure on global inflation as we move through 2018, contributing to the higher bond yield narrative, which, as shown above, is critical to how the equity market evolves. 

This is the backdrop we have built the Fund around as we move into 2018. We are overweight oil/commodities; we are overweight financials; we continue to gradually increase UK domestics; and we are overweight small caps, where the valuation signal continues to be powerful. Against these active positions, we remain very underweight defensives, utilities, pharmaceuticals and other bond proxy type sectors/stocks. 

Performance    

The market was strong during December, with the FTSE All-Share Total Return Index (12pm adjusted) posting an increase of 3.18%. The Fund marginally outperformed the index in returning 3.24%. For 2017 as a whole the Fund finished up 18.11%, beating the benchmark return of 13.10%. 

Looking at the peer group, the Fund was ranked first decile within the IA UK Equity Income sector in 2017. On a longer-term basis, the Fund is ranked first decile over three years, 10 years and since launch (November 2004) and first quartile (second decile) over five years.

The mining sector performed well in December following a sluggish few months where the focus was on China. The narrative broadened with a number of good capital market events, a renewed focus on the benefits that electric vehicles will bring the sector (particularly Glencore with its positions in copper, cobalt and nickel) and supportive valuations. Our new small cap name Central Asia Metals performed the strongest. 

Our domestic names performed well, partly as a function of the agreement to move to the next stage of Brexit negotiations but also partly as a delayed reaction to the November budget. Our brick producers, particularly Ibstock, performed well while a number of our other construction-related names also moved higher, including Severfield and Costain. In other UK domestics, Kingfisher continued to perform well and ITV recovered somewhat. 

A number of our best performers during 2017 continued to do well: Brewin Dolphin, following results in late November, BBA Aviation (which we have now sold – see below) and Savills. 

Offsetting these trends we had a number of negatives, two of which were driven by negative news flow. Low & Bonar announced a second profit warning at the same time it announced its CEO had been poached by a much larger company (not a usual combination of events); the stock fell 20%. Elsewhere, CMC (down c.10%) was affected by the announcement of new EU regulation on CFD/spread betting. Whilst the new rules will hurt profitability – something that was already baked into market thinking after the FCA's announcement in December 2016 on the same subject – it is likely to lead to the closure of aggressively-run, offshore and lightly-capitalised competitors. In the long run, therefore, it should be a positive. Laird also fell, although there was no notable news flow. 

Portfolio activity

We sold one stock from the Fund during December, BBA Aviation, and finished adding to a small cap name which we have not previously mentioned, Polar Capital Holdings.

We acquired BBA Aviation in late 2015 when it came under technical pressure from a large rights issue conducted to fund the acquisition of Landmark. This deal made it the largest owner/lessor, by some margin, of fixed base operations in the US (effectively airports for private jets). This transaction created one of the best assets in the Fund at a very good entry price. The share price has risen c.75% since the deal was consummated, with the stock contributing c.60bp to the Fund's relative performance. The position was sold purely on valuation grounds, with it trading on a P/E of 18x and yielding less than 3.5%. 

Elsewhere in the Fund we also reduced our positions in Savills, Brewin Dolphin and Keller. All three of these stocks have performed well in recent months and have risen towards our target prices. We believe all still have moderate upside. We also slightly reduced our position in Barclays after it bounced following a period of share price weakness linked to a disappointing Q3 update in October. We remain very positive on Barclays from a valuation perspective, albeit some technical changes mean the tangible book value will decline in 2018, meaning the price-to-book discount will narrow to c.20%. It trades on a low multiple of normalised earnings (8x P/E) and, after the sale of the African operations, has adequate capital (with tier 1 capital now over 13%). A slightly lower weighting is appropriate for the following four reasons: firstly, the recent sluggish operational performance; secondly, the ongoing legacy issues (SFO inquiry into previous management and US mortgage-backed security litigation); thirdly, the likely delay to the full ramp up in the dividend reflecting the previous point; and fourth and finally, the narrowing of the price to tangible book value. Nevertheless, it remains a top 10 active position.

We added Polar Capital to the Fund progressively over the second half of 2017. Our average entry price is c.430p (vs. the current price of 535p). Polar is an asset management company with a good track record of performance and strong positions in some attractive niche areas (e.g. technology/healthcare). It has a solid balance sheet, with net cash of £70-80m. We acquired the stock for two reasons. When we first acquired it, it was clear to us that the underlying momentum of the business, in terms of both performance and new assets, was better than the headline figures suggested. The latter was distorted by continued outflows from its Japan fund, which used to be the dominant product in the group. In addition, Polar has also recently hired Gavin Rochussen as its new CEO, whom we rate highly from his time as CEO of JOHCM. He is likely to broaden distribution (which is very UK-centric) and fill product gaps (e.g. EM, Global). 

Elsewhere, we added marginally to Morgan Sindall, which has been our best-performing stock in 2017. A positive trading update and capital markets event, coupled with our view that normalised EPS is >200p, suggests this can continue to perform well. We also added to employment agency Sthree, the mining sector (primarily Anglo American and Glencore) following weakness in the early part of the month, DFS and Palace Capital. The other notable change was packaging company DS Smith. We had reduced our position in the run up to its results, as its share price was buoyed by the stock's likely entrance into the FTSE 100 index (subsequently confirmed). After results which were very strong, particularly the acceleration in organic growth to 5.2%, raw material inflation recovery and the initial performance of the recent US acquisition, it fell back c.10%. We added about 30-40bp back to our position. 

Fund dividend

Last month we upgraded the 2017 Fund dividend growth forecast to 13%. The final outcome was slightly above this at 13.4%. The discrete Q4 dividend was up c.7%.

As we indicated in November, the dividend base of the Fund looks strong as we move into 2018, with a solid growth trajectory across a number of areas. Large active positions like Aviva, DS Smith and National Express are expected to deliver good dividend growth in 2018; the strength in the mining sector will continue (we estimate this factor alone adds around 2-3% to the Fund dividend growth); and we expect the banks sector to continue to move towards a more normal dividend framework. When we look at our detailed, bottom up, stock-by-stock dividend forecasts, there is less identifiable stock-specific risk this year compared to last year. The main risk relates to currency, particularly moves in the GBP/USD exchange rate across the year. We do expect sterling to strengthen for the reasons we lay out above, which would place pressure on the overall UK dividend base. The sensitivity of the Fund's dividend growth rate to a five cent move in both the pound/dollar and pound/euro rate is c.2%.

Given all of these factors, and building in a buffer for the FX risk, our initial guidance for the Fund dividend growth in 2018 remains at mid single-digit percentage growth. This would mean the Fund would yield 4.35% on a 2018 prospective basis. We will update this guidance at the end of Q1 2018 when we have seen the trends evident in the full-year results reporting cycle. 

Outlook

The path to policy normalisation has categorically begun in the US, the UK and Europe. The true distortive impact of effectively zero interest rates in the developed world on various asset classes will only become apparent in future years. However, without doubt it has pushed valuations of many assets and individual instruments to elevated levels that will be hard to justify if the cost of capital rises. There are also a number of geopolitical risks that make for a more cautious tone from a future market return perspective – namely Korea, Trump/Russia, tensions in the Middle East, Brexit and so on. We would not be surprised if markets, after a strong run over a number of years, found life tougher at a headline level. 

However, within the equity market, we strongly believe that the overvaluation is most apparent in consumer staples and other perceived defensive sectors such as utilities and pharmaceuticals. It is pleasing that we have started to see chinks in the armour in the operational performances of these businesses in the last year. 

We believe that many of the areas that we are exposed to will respond well to a change of stock market leadership if monetary policy were to normalise, particularly financials. Elsewhere, valuations in both the oil and mining sectors continue to look attractive to us, whilst there are also selective opportunities in the UK domestic arena, too.

The first breakthrough in the Brexit discussions in December provided a more balanced narrative for the domestic side of the UK equity market. As reflected in the gilt and FX markets and within the domestic side of the stock market, sentiment does, however, remain polarised. Even a small amount of additional progress in 2018 would cause a big adjustment in these markets given the level of risk priced in and the absolute valuations, which have all trended to around a P/E of 10x and a dividend yield of 5%.  

The long-term performance of the Fund is heavily correlated to the Fund’s dividend growth and the resulting absolute level of the dividend. The delivery of 13.4% growth in 2017, which continues a track record of strong growth since the Fund’s inception and the confidence (even allowing for some sterling appreciation) in the 2018 dividend outlook is an important driver of the unit price. As noted above, the Fund's prospective yield for 2018 is c. 4.35%. This yield, strong dividend growth and low valuations embedded across the portfolio, coupled with the shift in monetary policy, leave us cautiously optimistic in our outlook for the Fund. 
 

Economic developments

During the last quarter of 2017 there were a number of events that had a material impact on the outlook for the overall stock market, sectorial performance within the market and the likely performance of value vs. growth and cyclicals vs. defensives. The passage of the tax measures in the US, the first major Trump success on policy, will add momentum to an already strong US economy. We showed last month that consumer, manufacturing and business confidence are close to, if not at, record highs in the US. This backdrop will extend the current strength in economic activity; it will mean the Federal Reserve continues to increase interest rates/shrink its balance sheet; and it will help lead to higher wages, all of which will contribute to higher bond yields. We exited 2017 with US 10-year treasuries trading at 2.4% (close to the highest point of the year), and we expect this to push higher from here. We expect defensives to continue to underperform financials and cyclicals in 2018, and the Fund remains positioned accordingly.

In the UK, the Brexit breakthrough in December with agreement to move to the next phase of discussions is a major positive versus the implied outcome and the assumed (very negative) trajectory of the UK economy that is priced into domestic-related assets. Meanwhile, economic data is not as negative as portrayed. Wage growth inched higher to 2.3% (from 2.2%). As we highlighted last month, we expect this to move towards 3% during 2018, with a likely sharp shift higher in the first half against weak comparatives. Latest data on EU migration into the UK showed those arriving looking for work (as opposed to those with a definite job) were at the lowest level since 2004 (for EU 8) and 2011 (for EU 15). This will place increased pressure on an already tight labour market. As inflation falls from the current level (which will be the peak as the effect of the Brexit sterling devaluation drop out of the data) real wages will start to expand. Whilst the Citi UK Economic Surprises index (which is a barometer of how all economic data is progressing in relation to forecasts) has rebounded strongly since August. This corresponds to the narrative we hear from many of our UK holdings when we meet management teams. We expect sterling to continue its gentle appreciation. The biggest risk to the UK economy would be a Corbyn-led Labour government. This is the main reason we have been measured in the pace of our increase in domesticity. 

In Europe, data remains strong, particularly in France and Spain. This trend will hopefully be cemented and augmented by policy actions in 2018 that will create a better structural growth story. The recent introduction of Kingfisher to the portfolio and the increase in our DS Smith position are good examples of how we are trying to increase our exposure to these trends.

Finally, the oil price remains important to the Fund. This is due in part to our large positions in the two UK oil majors but also because of its implications for inflation. We discussed the OPEC decision to extend production cuts in last month's commentary. Along with better-than-expected demand growth and some questions over the pace of supply growth from US shale, the cuts have helped stabilise the oil price at around US$60/bbl. This is 30-40% higher than the low point in mid-2017, which means oil and oil derivatives will place upward pressure on global inflation as we move through 2018, contributing to the higher bond yield narrative, which, as shown above, is critical to how the equity market evolves. 

This is the backdrop we have built the Fund around as we move into 2018. We are overweight oil/commodities; we are overweight financials; we continue to gradually increase UK domestics; and we are overweight small caps, where the valuation signal continues to be powerful. Against these active positions, we remain very underweight defensives, utilities, pharmaceuticals and other bond proxy type sectors/stocks. 

Performance    

The market was strong during December, with the FTSE All-Share Total Return Index (12pm adjusted) posting an increase of 3.18%. The Fund marginally outperformed the index in returning 3.24%. For 2017 as a whole the Fund finished up 18.11%, beating the benchmark return of 13.10%. 

Looking at the peer group, the Fund was ranked first decile within the IA UK Equity Income sector in 2017. On a longer-term basis, the Fund is ranked first decile over three years, 10 years and since launch (November 2004) and first quartile (second decile) over five years.

The mining sector performed well in December following a sluggish few months where the focus was on China. The narrative broadened with a number of good capital market events, a renewed focus on the benefits that electric vehicles will bring the sector (particularly Glencore with its positions in copper, cobalt and nickel) and supportive valuations. Our new small cap name Central Asia Metals performed the strongest. 

Our domestic names performed well, partly as a function of the agreement to move to the next stage of Brexit negotiations but also partly as a delayed reaction to the November budget. Our brick producers, particularly Ibstock, performed well while a number of our other construction-related names also moved higher, including Severfield and Costain. In other UK domestics, Kingfisher continued to perform well and ITV recovered somewhat. 

A number of our best performers during 2017 continued to do well: Brewin Dolphin, following results in late November, BBA Aviation (which we have now sold – see below) and Savills. 

Offsetting these trends we had a number of negatives, two of which were driven by negative news flow. Low & Bonar announced a second profit warning at the same time it announced its CEO had been poached by a much larger company (not a usual combination of events); the stock fell 20%. Elsewhere, CMC (down c.10%) was affected by the announcement of new EU regulation on CFD/spread betting. Whilst the new rules will hurt profitability – something that was already baked into market thinking after the FCA's announcement in December 2016 on the same subject – it is likely to lead to the closure of aggressively-run, offshore and lightly-capitalised competitors. In the long run, therefore, it should be a positive. Laird also fell, although there was no notable news flow. 

Portfolio activity

We sold one stock from the Fund during December, BBA Aviation, and finished adding to a small cap name which we have not previously mentioned, Polar Capital Holdings.

We acquired BBA Aviation in late 2015 when it came under technical pressure from a large rights issue conducted to fund the acquisition of Landmark. This deal made it the largest owner/lessor, by some margin, of fixed base operations in the US (effectively airports for private jets). This transaction created one of the best assets in the Fund at a very good entry price. The share price has risen c.75% since the deal was consummated, with the stock contributing c.60bp to the Fund's relative performance. The position was sold purely on valuation grounds, with it trading on a P/E of 18x and yielding less than 3.5%. 

Elsewhere in the Fund we also reduced our positions in Savills, Brewin Dolphin and Keller. All three of these stocks have performed well in recent months and have risen towards our target prices. We believe all still have moderate upside. We also slightly reduced our position in Barclays after it bounced following a period of share price weakness linked to a disappointing Q3 update in October. We remain very positive on Barclays from a valuation perspective, albeit some technical changes mean the tangible book value will decline in 2018, meaning the price-to-book discount will narrow to c.20%. It trades on a low multiple of normalised earnings (8x P/E) and, after the sale of the African operations, has adequate capital (with tier 1 capital now over 13%). A slightly lower weighting is appropriate for the following four reasons: firstly, the recent sluggish operational performance; secondly, the ongoing legacy issues (SFO inquiry into previous management and US mortgage-backed security litigation); thirdly, the likely delay to the full ramp up in the dividend reflecting the previous point; and fourth and finally, the narrowing of the price to tangible book value. Nevertheless, it remains a top 10 active position.

We added Polar Capital to the Fund progressively over the second half of 2017. Our average entry price is c.430p (vs. the current price of 535p). Polar is an asset management company with a good track record of performance and strong positions in some attractive niche areas (e.g. technology/healthcare). It has a solid balance sheet, with net cash of £70-80m. We acquired the stock for two reasons. When we first acquired it, it was clear to us that the underlying momentum of the business, in terms of both performance and new assets, was better than the headline figures suggested. The latter was distorted by continued outflows from its Japan fund, which used to be the dominant product in the group. In addition, Polar has also recently hired Gavin Rochussen as its new CEO, whom we rate highly from his time as CEO of JOHCM. He is likely to broaden distribution (which is very UK-centric) and fill product gaps (e.g. EM, Global). 

Elsewhere, we added marginally to Morgan Sindall, which has been our best-performing stock in 2017. A positive trading update and capital markets event, coupled with our view that normalised EPS is >200p, suggests this can continue to perform well. We also added to employment agency Sthree, the mining sector (primarily Anglo American and Glencore) following weakness in the early part of the month, DFS and Palace Capital. The other notable change was packaging company DS Smith. We had reduced our position in the run up to its results, as its share price was buoyed by the stock's likely entrance into the FTSE 100 index (subsequently confirmed). After results which were very strong, particularly the acceleration in organic growth to 5.2%, raw material inflation recovery and the initial performance of the recent US acquisition, it fell back c.10%. We added about 30-40bp back to our position. 

Fund dividend

Last month we upgraded the 2017 Fund dividend growth forecast to 13%. The final outcome was slightly above this at 13.4%. The discrete Q4 dividend was up c.7%.

As we indicated in November, the dividend base of the Fund looks strong as we move into 2018, with a solid growth trajectory across a number of areas. Large active positions like Aviva, DS Smith and National Express are expected to deliver good dividend growth in 2018; the strength in the mining sector will continue (we estimate this factor alone adds around 2-3% to the Fund dividend growth); and we expect the banks sector to continue to move towards a more normal dividend framework. When we look at our detailed, bottom up, stock-by-stock dividend forecasts, there is less identifiable stock-specific risk this year compared to last year. The main risk relates to currency, particularly moves in the GBP/USD exchange rate across the year. We do expect sterling to strengthen for the reasons we lay out above, which would place pressure on the overall UK dividend base. The sensitivity of the Fund's dividend growth rate to a five cent move in both the pound/dollar and pound/euro rate is c.2%.

Given all of these factors, and building in a buffer for the FX risk, our initial guidance for the Fund dividend growth in 2018 remains at mid single-digit percentage growth. This would mean the Fund would yield 4.35% on a 2018 prospective basis. We will update this guidance at the end of Q1 2018 when we have seen the trends evident in the full-year results reporting cycle. 

Outlook

The path to policy normalisation has categorically begun in the US, the UK and Europe. The true distortive impact of effectively zero interest rates in the developed world on various asset classes will only become apparent in future years. However, without doubt it has pushed valuations of many assets and individual instruments to elevated levels that will be hard to justify if the cost of capital rises. There are also a number of geopolitical risks that make for a more cautious tone from a future market return perspective – namely Korea, Trump/Russia, tensions in the Middle East, Brexit and so on. We would not be surprised if markets, after a strong run over a number of years, found life tougher at a headline level. 

However, within the equity market, we strongly believe that the overvaluation is most apparent in consumer staples and other perceived defensive sectors such as utilities and pharmaceuticals. It is pleasing that we have started to see chinks in the armour in the operational performances of these businesses in the last year. 

We believe that many of the areas that we are exposed to will respond well to a change of stock market leadership if monetary policy were to normalise, particularly financials. Elsewhere, valuations in both the oil and mining sectors continue to look attractive to us, whilst there are also selective opportunities in the UK domestic arena, too.

The first breakthrough in the Brexit discussions in December provided a more balanced narrative for the domestic side of the UK equity market. As reflected in the gilt and FX markets and within the domestic side of the stock market, sentiment does, however, remain polarised. Even a small amount of additional progress in 2018 would cause a big adjustment in these markets given the level of risk priced in and the absolute valuations, which have all trended to around a P/E of 10x and a dividend yield of 5%.  

The long-term performance of the Fund is heavily correlated to the Fund’s dividend growth and the resulting absolute level of the dividend. The delivery of 13.4% growth in 2017, which continues a track record of strong growth since the Fund’s inception and the confidence (even allowing for some sterling appreciation) in the 2018 dividend outlook is an important driver of the unit price. As noted above, the Fund's prospective yield for 2018 is c. 4.35%. This yield, strong dividend growth and low valuations embedded across the portfolio, coupled with the shift in monetary policy, leave us cautiously optimistic in our outlook for the Fund.