Economic developments

President Trump was a busy man during July, with a trip to Europe to visit its political leaders, irregular updates on his tariff strategy and direct criticism of his own central bank’s monetary tightening and its role in the strengthening of the dollar. In recent months, it has been his negotiating style on trade tariffs that has had the most impact on markets. Commodity prices (such as copper) are down 15% from the levels seen six weeks ago, and the Chinese renminbi is under pressure given concerns about slower future growth rates. However, the Chinese response has been both rapid and significant, easing monetary policy and providing a fiscal boost to offset the potential future risk to growth. Furthermore, this policy easing began in April and has already started to have an impact, with Chinese purchasing manager (PMI) surveys beginning to improve and electricity consumption showing higher rates of growth, too. The modest devaluation of the Chinese currency also provides a useful offset to any further escalation of the trade dispute with the US. Given this response, it would be surprising if industrial commodity prices did not show a recovery in the next few months, unless the rhetoric around tariffs ratchets up further.    

The fact that the 10-year US Treasury yield in the US ended the month at 2.96%, approximately 15bps higher than they started the month, is especially noticeable given some of the perceived headwinds listed above. Furthermore, 10-year government bond yields in Japan threatened to break above the psychologically significant level of 0.10%, as investors began to detect a subtle shift in policy from the Bank of Japan. Even more strikingly, 10-year Gilt yields in the UK finished the month higher than they started, despite the resignations of Brexiteers Boris Johnson and David Davis adding to the tortuous Brexit debate. In many respects, markets may be anticipating an extension to the 30 March 2019 Article 50 deadline given how little progress has been made so far. 

The other reason UK bond yields have been relatively stable is the strong bounce back in economic activity during the second quarter, something we have highlighted over the last couple of months. Whilst the latest average weekly earnings were flat at 2.6%, this was only because last year’s data was revised higher, creating a distorting base impact. Furthermore, with the vacancies number hitting an all-time high of 824,000, combined with the highest ever employment rate for 16-64 year-olds of 75.7% and public sector wage caps now being loosened, it is easy to see why there is upward pressure on wages, even with the headwinds of automation and Brexit. 

Given a weather-assisted stronger showing for retail sales in Q2, it is anticipated that the Bank of England will finally inch rates higher later this week. Whilst the Bank has delayed too long, an upward move would still be welcome. It would begin to reduce the numerous unintended consequences of QE, and it does need to give itself ammunition to ease when the next material downturn arrives. 

In Europe, sentiment around the path of future economic growth has also been buffeted by Trump‘s tariff rhetoric. Whilst there has been some softening in industrial lead indicators, they still imply reasonable growth rates for now. However, this less exuberant outlook has allowed ECB President Draghi to kick the can down the road somewhat in terms of moving towards a tighter monetary policy. But wage inflation is now building across the continent, with Germany the standout country, reporting 4% growth in negotiated pay settlements in May. As this process builds and broadens across Europe, it is likely to force the reluctant hand of the ECB to begin to tighten policy/withdraw stimulus during the coming months.      

Performance    

The FTSE All-Share Total Return Index (12pm adjusted) was up 1.09% during July. The Fund had a difficult month, returning -0.89%. Year to date the Fund is up 2.37%, behind the index, which has returned 3.70%.

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

The drivers of the Fund’s underperformance during July fell into two buckets, each of which had a similar impact. 

Firstly, the continued risk-off tone in the market (which hurts the Fund as we are underweight defensives and overweight financials/cyclicals) was compounded by negative news flow surrounding Brexit. In addition, a number of the stocks that fit into the defensive basket, British American Tobacco and Reckitt Benckiser in particular, had positive quarterly results, further accentuating this effect. 

Secondly, we encountered three stock-specific issues over the month: a profit warning and removal of the CEO at TCAP (stock down c. 33% relative) - the combination of these events shifted the forecast agenda materially as the board moved to invest cost back into the business; negative news flow for Glencore (stock down 10% relative) on a potential US regulatory review of transactions in a number of countries; and a warning from brick-maker Ibstock (stock down 20% relative) that it would need to run with higher maintenance costs over the next two years to improve efficiency/factory utilisation. 

Whilst these were disappointing developments, we feel the share price reaction to each has been excessive and have added to all three on the weakness. Ibstock is a good example of this overreaction: the downgrade to earnings forecasts was c. 7-8% for the two years affected, with the third-year forecast held largely flat after the maintenance cost catch up falls away. It is therefore, in our view, a transitory effect in a market where demand trends (underpinned by the help-to-buy policy) exceeds supply, part of the reason the plants have been running at full capacity. 

Each of the three July laggards are also very cheap, in our opinion, with Ibstock trading on a free cash flow yield of c.9-10%, Glencore on a free cash flow yield of c.15% and TCAP trading on eight times earnings.

The commodity sectors were also weak, particularly mining, although the sector did start to pick up towards the end of the month, driven by the Chinese policy changes noted above.

A smaller than normal number of stocks outperformed. The standouts were Liontrust, up 12% relative following good results; Urban Exposure, a recent portfolio addition, up 8% relative following a good contract win and a solid trading update; and Paragon, up 4% relative after a good bolt-on acquisition was announced. 

Portfolio activity

We added one new stock, Hipgnosis, to the portfolio in July via an IPO. This is a fund that will own music rights and exposure to their intellectual property rights. Music consumption is increasingly trackable and auditable as platforms such as Spotify and iTunes take over from illegal downloads. Music content’s value has therefore started to increase. Hipgnosis is focused on this value inflexion, but it will also benefit from its focus on tier one artists / songs where the value will have a longer duration (evidenced by its first acquisition announced shortly after the IPO). 

Secondly, it benefits from an experienced management team, who will manage the portfolio more aggressively than its larger competitors, generating more revenue and profit opportunities. The starting yield is 5+%, which should rise as the portfolio is built and the second point comes into play. 

We noted in last month’s update that a number of stocks in the Fund were in the process of conducting rights issues to finance acquisitions. Three of these, DS Smith, Phoenix and Diversified Gas and Oil, consummated during the month, with associated rises in their weightings.

To fund these additions, we continued to reduce our position in AstraZeneca. This stock has continued to perform well, partly due to the more defensive tone of the market and partly due to sterling’s weakness. However, the stock is close to yielding less than the market average, which would move it outside our selection criterion. It is now also one of the most expensive stocks in the Fund, on a P/E of over 20x (the earnings this multiple is based upon also includes ‘one-off’ earnings, which means the normalised P/E is substantially higher). We also reduced our position in other overseas-earners, such as HSBC and Keller.  

As noted above, the mining sector was weak for much of the month. We used this opportunity to add to each of our four mining holdings (Glencore, Anglo American, Central Asia Mining and Rio Tinto). The Fund has just over 10% exposure to the sector.

We added to selected UK domestic-facing stocks, which were also weak: Galliford Try, Countryside, Hammerson and ITV, amongst others. In contrast, Northgate (which is operationally split between the UK and Spain) performed well, helped by good results at the end of June. We modestly reduced our position, removing the additional amount we had invested when the stock had become oversold during the first part of the year. If the new management team can execute on their strategy, we feel there is material upside potential. It remains a core holding. 

Outlook

Most investors are fearful that this economic cycle is highly extended in terms of duration. Consequently, worries about tariff wars or central bank policy mistakes are tending to have a magnified impact on markets. However, as we have observed many times since the 2008 crisis, whilst this has been a long period of economic expansion, it has also been one in which there has never been a great deal of exuberance. This is mainly because of the unprecedented nature of QE and its uncertain exit route. As such, most business leaders have firmly kept their capital expenditure budgets on a tight leash, constantly with “one hand on the exit door”. This relative lack of new capacity is probably partly responsible for the anaemic productivity progress that we have seen across developed market economies. But at the same time it has led to many tight demand/supply dynamics and ever higher corporate margins.  

As such, the sustainability of corporate margins is a key debate. Could they be eroded by the collective labour force rediscovering its pricing power? Thus far, this is the dog that has not barked. Decreasing levels of unionisation and the growing fear of artificial intelligence replacing human labour has kept wage increases restrained. But with US GDP growth pushing above 4% and unemployment rates falling to multi-decade lows in economies such as the UK, there is the potential for a step higher in wage settlements. This would force the hand of many central bankers to tighten more aggressively. 

The other area of threat to corporate margins is greater regulation, caused in part by the dis-satisfaction of electorates and, commensurately, politicians. In this regard, the growing antagonism towards many of the largely unregulated technology groups, including Facebook, Amazon, Google, Uber and Airbnb, is noteworthy, particularly with respect to the leadership of stock markets. There is a perfectly valid argument that many of these groups are already too large and complicated to regulate meaningfully. However, that is unlikely to prevent politicians having a go, a process that does now appear to have started. Any success in this regard would clearly threaten the premium stock market ratings of many of these types of names, but, just as critically, may mark a turn in the perceptions of companies that have somewhat suffered from the ever increasing influence of these groups.    

If both of these developments gain momentum over the coming months, we anticipate that bond yields will continue to move higher and that the highly stretched relationship between ‘growth’ and ‘value’ within stock markets might begin to reverse somewhat. In the meantime, we will continue to focus upon moderately valued companies exhibiting healthy rates of dividend growth. The latter should help continue the Fund’s strong track record of dividend progression.   
 

Economic developments

President Trump was a busy man during July, with a trip to Europe to visit its political leaders, irregular updates on his tariff strategy and direct criticism of his own central bank’s monetary tightening and its role in the strengthening of the dollar. In recent months, it has been his negotiating style on trade tariffs that has had the most impact on markets. Commodity prices (such as copper) are down 15% from the levels seen six weeks ago, and the Chinese renminbi is under pressure given concerns about slower future growth rates. However, the Chinese response has been both rapid and significant, easing monetary policy and providing a fiscal boost to offset the potential future risk to growth. Furthermore, this policy easing began in April and has already started to have an impact, with Chinese purchasing manager (PMI) surveys beginning to improve and electricity consumption showing higher rates of growth, too. The modest devaluation of the Chinese currency also provides a useful offset to any further escalation of the trade dispute with the US. Given this response, it would be surprising if industrial commodity prices did not show a recovery in the next few months, unless the rhetoric around tariffs ratchets up further.    

The fact that the 10-year US Treasury yield in the US ended the month at 2.96%, approximately 15bps higher than they started the month, is especially noticeable given some of the perceived headwinds listed above. Furthermore, 10-year government bond yields in Japan threatened to break above the psychologically significant level of 0.10%, as investors began to detect a subtle shift in policy from the Bank of Japan. Even more strikingly, 10-year Gilt yields in the UK finished the month higher than they started, despite the resignations of Brexiteers Boris Johnson and David Davis adding to the tortuous Brexit debate. In many respects, markets may be anticipating an extension to the 30 March 2019 Article 50 deadline given how little progress has been made so far. 

The other reason UK bond yields have been relatively stable is the strong bounce back in economic activity during the second quarter, something we have highlighted over the last couple of months. Whilst the latest average weekly earnings were flat at 2.6%, this was only because last year’s data was revised higher, creating a distorting base impact. Furthermore, with the vacancies number hitting an all-time high of 824,000, combined with the highest ever employment rate for 16-64 year-olds of 75.7% and public sector wage caps now being loosened, it is easy to see why there is upward pressure on wages, even with the headwinds of automation and Brexit. 

Given a weather-assisted stronger showing for retail sales in Q2, it is anticipated that the Bank of England will finally inch rates higher later this week. Whilst the Bank has delayed too long, an upward move would still be welcome. It would begin to reduce the numerous unintended consequences of QE, and it does need to give itself ammunition to ease when the next material downturn arrives. 

In Europe, sentiment around the path of future economic growth has also been buffeted by Trump‘s tariff rhetoric. Whilst there has been some softening in industrial lead indicators, they still imply reasonable growth rates for now. However, this less exuberant outlook has allowed ECB President Draghi to kick the can down the road somewhat in terms of moving towards a tighter monetary policy. But wage inflation is now building across the continent, with Germany the standout country, reporting 4% growth in negotiated pay settlements in May. As this process builds and broadens across Europe, it is likely to force the reluctant hand of the ECB to begin to tighten policy/withdraw stimulus during the coming months.      

Performance    

The FTSE All-Share Total Return Index (12pm adjusted) was up 1.09% during July. The Fund had a difficult month, returning -0.89%. Year to date the Fund is up 2.37%, behind the index, which has returned 3.70%.

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

The drivers of the Fund’s underperformance during July fell into two buckets, each of which had a similar impact. 

Firstly, the continued risk-off tone in the market (which hurts the Fund as we are underweight defensives and overweight financials/cyclicals) was compounded by negative news flow surrounding Brexit. In addition, a number of the stocks that fit into the defensive basket, British American Tobacco and Reckitt Benckiser in particular, had positive quarterly results, further accentuating this effect. 

Secondly, we encountered three stock-specific issues over the month: a profit warning and removal of the CEO at TCAP (stock down c. 33% relative) - the combination of these events shifted the forecast agenda materially as the board moved to invest cost back into the business; negative news flow for Glencore (stock down 10% relative) on a potential US regulatory review of transactions in a number of countries; and a warning from brick-maker Ibstock (stock down 20% relative) that it would need to run with higher maintenance costs over the next two years to improve efficiency/factory utilisation. 

Whilst these were disappointing developments, we feel the share price reaction to each has been excessive and have added to all three on the weakness. Ibstock is a good example of this overreaction: the downgrade to earnings forecasts was c. 7-8% for the two years affected, with the third-year forecast held largely flat after the maintenance cost catch up falls away. It is therefore, in our view, a transitory effect in a market where demand trends (underpinned by the help-to-buy policy) exceeds supply, part of the reason the plants have been running at full capacity. 

Each of the three July laggards are also very cheap, in our opinion, with Ibstock trading on a free cash flow yield of c.9-10%, Glencore on a free cash flow yield of c.15% and TCAP trading on eight times earnings.

The commodity sectors were also weak, particularly mining, although the sector did start to pick up towards the end of the month, driven by the Chinese policy changes noted above.

A smaller than normal number of stocks outperformed. The standouts were Liontrust, up 12% relative following good results; Urban Exposure, a recent portfolio addition, up 8% relative following a good contract win and a solid trading update; and Paragon, up 4% relative after a good bolt-on acquisition was announced. 

Portfolio activity

We added one new stock, Hipgnosis, to the portfolio in July via an IPO. This is a fund that will own music rights and exposure to their intellectual property rights. Music consumption is increasingly trackable and auditable as platforms such as Spotify and iTunes take over from illegal downloads. Music content’s value has therefore started to increase. Hipgnosis is focused on this value inflexion, but it will also benefit from its focus on tier one artists / songs where the value will have a longer duration (evidenced by its first acquisition announced shortly after the IPO). 

Secondly, it benefits from an experienced management team, who will manage the portfolio more aggressively than its larger competitors, generating more revenue and profit opportunities. The starting yield is 5+%, which should rise as the portfolio is built and the second point comes into play. 

We noted in last month’s update that a number of stocks in the Fund were in the process of conducting rights issues to finance acquisitions. Three of these, DS Smith, Phoenix and Diversified Gas and Oil, consummated during the month, with associated rises in their weightings.

To fund these additions, we continued to reduce our position in AstraZeneca. This stock has continued to perform well, partly due to the more defensive tone of the market and partly due to sterling’s weakness. However, the stock is close to yielding less than the market average, which would move it outside our selection criterion. It is now also one of the most expensive stocks in the Fund, on a P/E of over 20x (the earnings this multiple is based upon also includes ‘one-off’ earnings, which means the normalised P/E is substantially higher). We also reduced our position in other overseas-earners, such as HSBC and Keller.  

As noted above, the mining sector was weak for much of the month. We used this opportunity to add to each of our four mining holdings (Glencore, Anglo American, Central Asia Mining and Rio Tinto). The Fund has just over 10% exposure to the sector.

We added to selected UK domestic-facing stocks, which were also weak: Galliford Try, Countryside, Hammerson and ITV, amongst others. In contrast, Northgate (which is operationally split between the UK and Spain) performed well, helped by good results at the end of June. We modestly reduced our position, removing the additional amount we had invested when the stock had become oversold during the first part of the year. If the new management team can execute on their strategy, we feel there is material upside potential. It remains a core holding. 

Outlook

Most investors are fearful that this economic cycle is highly extended in terms of duration. Consequently, worries about tariff wars or central bank policy mistakes are tending to have a magnified impact on markets. However, as we have observed many times since the 2008 crisis, whilst this has been a long period of economic expansion, it has also been one in which there has never been a great deal of exuberance. This is mainly because of the unprecedented nature of QE and its uncertain exit route. As such, most business leaders have firmly kept their capital expenditure budgets on a tight leash, constantly with “one hand on the exit door”. This relative lack of new capacity is probably partly responsible for the anaemic productivity progress that we have seen across developed market economies. But at the same time it has led to many tight demand/supply dynamics and ever higher corporate margins.  

As such, the sustainability of corporate margins is a key debate. Could they be eroded by the collective labour force rediscovering its pricing power? Thus far, this is the dog that has not barked. Decreasing levels of unionisation and the growing fear of artificial intelligence replacing human labour has kept wage increases restrained. But with US GDP growth pushing above 4% and unemployment rates falling to multi-decade lows in economies such as the UK, there is the potential for a step higher in wage settlements. This would force the hand of many central bankers to tighten more aggressively. 

The other area of threat to corporate margins is greater regulation, caused in part by the dis-satisfaction of electorates and, commensurately, politicians. In this regard, the growing antagonism towards many of the largely unregulated technology groups, including Facebook, Amazon, Google, Uber and Airbnb, is noteworthy, particularly with respect to the leadership of stock markets. There is a perfectly valid argument that many of these groups are already too large and complicated to regulate meaningfully. However, that is unlikely to prevent politicians having a go, a process that does now appear to have started. Any success in this regard would clearly threaten the premium stock market ratings of many of these types of names, but, just as critically, may mark a turn in the perceptions of companies that have somewhat suffered from the ever increasing influence of these groups.    

If both of these developments gain momentum over the coming months, we anticipate that bond yields will continue to move higher and that the highly stretched relationship between ‘growth’ and ‘value’ within stock markets might begin to reverse somewhat. In the meantime, we will continue to focus upon moderately valued companies exhibiting healthy rates of dividend growth. The latter should help continue the Fund’s strong track record of dividend progression.