25 Jan 2018
On Britain’s railways, a double yellow light is an instruction to exercise “preliminary caution”. On seeing it, a train driver should continue to move forward but be prepared to begin slowing at the next signal; there may be an obstruction ahead. These are the conditions under which investors seeking income currently operate.
Financial assets in general, and those that produce a yield in particular, are no longer receiving unconditional support from central banks. In the US, interest rates are creeping higher and quantitative easing is being unwound. Broader uncertainties, political and economic – and elevated valuations in many areas – also indicate that caution is prudent. Equally, however, there are still sources of income ahead. In managing the Artemis Monthly Distribution Fund, we are aware of the calculated risks we must take to produce a good level of monthly income. Here, we explain that although we proceed, we do so with caution and with an eye for any dangers that might lie further down the track.
1) UK politics and Brexit
Unfortunately, Brexit is likely to dominate the news for the next five years. The vagaries of every headline will move sterling and the gilt market (bonds issued by the UK government), but perhaps as large a worry for markets would be the election of a Labour government. Were the current government to fail and be replaced by one led by Jeremy Corbyn, expenditure would increase significantly, which would be perceived as extremely bad news for gilts. For now, we think the chances are low; the Conservatives won’t want another election however difficult the internal wrangling over Brexit becomes. If, however, there are a number of by-elections, then the chance of a general election will increase. Not surprisingly investment decisions are being delayed and this is slowing growth.
Ten-year gilt yields are around 1.3% but inflation is running at 2.7%. That makes little sense to us. Add-in the prospect of a high-spending radical government and the gilt market will eventually take fright. Another fact to consider is record low levels of unemployment and a European workforce less prepared to work in the UK (because of uncertainty about Brexit) must mean that higher wage inflation is a risk, putting pressure on the Bank of England to raise rates more than it might otherwise want to.
2) Expansion of personal credit
Personal credit is another area of concern. Provident Financial’s woes last year were well documented. To be fair, this is probably as much due to mismanagement as it is to pressures in its market. But sub-prime lending is a dangerous place when inflation is rising, when real wages are being squeezed and when regulators (and politicians) are getting nastier.
Related to this is a risk that may have slipped beneath the radar of the regulators: car financing deals. Personal contract purchases (PCPs) now account for over 80% of car sales. We question whether adequate credit checks are in place. If not, the credit providers could be at risk because the FCA tends to favour the consumer. Remember that they are guaranteeing the future value of these cars. A whole generation of diesel cars is being shunned, as the world realises that diesel is a dirty, noxious fuel. Petrol cars, meanwhile, are likely to be replaced by electric cars, albeit over a long timescale. The future second-hand value of the car may not match the rosy expectations of the seller. In that case, the guarantors will be on the hook for any shortfall. Those guarantors are certain banks and the car manufacturers themselves (and their finance arms). We are concerned the liabilities could be enormous so are avoiding these accordingly.
3) Inflation and monetary tightening
Economic growth has been strong, especially in the US, and unemployment is at record lows. Trump’s tax cuts could well boost an economy that is already performing well. The consequence is likely to be inflation, which the Federal Reserve will have to counter by raising rates. The Fed is already selling some of the bonds it has accumulated, reducing the size of its balance sheet. Unemployment is still high in Europe, but in the US it has fallen to levels not seen since the 1960s, when inflation was at 6%.
Across the globe, companies talk of capacity constraints and many claim they have some pricing power. All this will lead to higher inflation, which will lead to higher interest rates, and lower government bond prices. The Federal Reserve has commented that it expects three interest rate increases in 2018. That seems reasonable. The market, however, only expects one. Meanwhile, at the end of 2017, the comments from various European Central Bank (ECB) members turned more hawkish, favouring a rise in interest rates. The absolute level of quantitative easing (QE) – printing money and buying bonds – was halved from 1 January and is likely to be reduced further. Secondly, inflation is on the rise. Clearly, that makes conditions for government bonds – and investment-grade bonds – more challenging.
4) An issuance bonanza
In a market flush with cash, any company (or government) – even the most poorly managed– can raise money. For example, Argentina issued a 100-year bond with a 7.125% coupon last year. It has defaulted eight times in the last two centuries – and twice in this century alone. Such exuberance will inevitably lead to disappointment. There has been a bonanza of issuance in the investment-grade bond market. Companies are taking advantage of strong demand and are taking on more debt. The issuance has been broad-based, coming across all sectors and with yields that we have often found very unattractive.
5) Low yields on ‘high-yield’
High-yield bonds (those rated below BBB which are considered low credit quality) have been stellar performers this year. The fund has been a beneficiary of this strength. Having had over 50% of the portfolio invested in this asset class has proven wise. Today, however, yields have fallen to unprecedented levels. In Europe, the high-yield index now yields about the same as 10-year US Treasuries. That is madness.
1) Owning overseas assets
Spreading risk globally – across countries and regions with differing business and monetary policy cycles and their own political dynamics – has always been a sensible long-term strategy. Today, however, a tangle of challenges faced by the UK economy is transforming diversification from a matter of long-term prudence into a tactical defence against shorter-term uncertainties. To be clear: for investors seeking income, the UK remains home to a wealth of excellent assets. At present, however, the uncertainty arising from Brexit negotiations, inflation, rising interest rates and faltering consumer spending are conspiring to cloud the outlook for some UK companies. At the end of 2017, just 23% of the fund’s portfolio was invested in UK assets.
2) Shorting US Treasuries
As unemployment in the US drops to very low levels, the Federal Reserve is likely to continue raising interest rates. For this reason, we retain our short position (benefiting when prices fall) in US Treasuries as bond yields will rise with interest rates, pushing bond prices lower.
3) In high-yield, favouring the US
There is far less value than there was in the high-yield market, particularly in Europe. But there are still instances in which yields compensate us for the risks we are taking. Among our high-yield bonds (those rated below BBB) we have been increasing our positions in the US and anticipate this will continue. European high-yield, although attractive fundamentally (defaults have been falling) are not good value. We have seen repeated and extensive rounds of QE by the ECB. This has lowered yields to artificial levels and benefited all bond markets including high-yield. Even in the US, selection is key: you won’t find us buying Tesla’s bonds or other similar companies with negative cashflows.
4) In investment grade, favouring (European) banks
We have avoided nearly all of the recent issuance in the investment-grade market, where yields are low and the cushion of additional yield relative to government bonds (the ‘spread’) uncomfortably thin. The main exception has been some banks: our exposure to their riskier junior bonds has risen. Bonds issued by banks and insurance companies remain a core part of the portfolio. Higher interest rates means improved returns on banks’ reserves. Further, an improving economy means lower defaults. However, in the UK, uncertainty surrounding Brexit has begun to have an impact on our decision-making. We have been reducing our UK bank exposure in favour of those of European lenders. They have been the beneficiary of a more positive mood towards the sector, with stress tests generally passed, dividends paid and the improved economy helping confidence. We have, for example, bought Intesa, Banco Santander and ASR (Dutch insurer).
5) In equities, investing in ‘value’
Since its launch, the fund’s equity component has had holdings in a number of classic income sectors often called ‘bond proxies’: real-estate investmnet trusts (REITs), utilities and tobacco. These stocks offer reliable earnings and predictable dividends, making them good substitutes for fixed income. However, universally strong growth in the global economy, high valuations for many classic income stocks and rising interest rates make it unwise to hold too many bond proxies: as bond yields rise, their attractions will fade and their prices come under pressure.
So we have shifted the fund’s equity component further away from the highest quality, most expensive defensives and bond proxies. Today, the fund has more exposure to cheaper cyclical value stocks than it did a year ago. Companies such as General Motors benefit from stronger growth in the global economy, while our financial stocks such as Citigroup, Bank of America and Zions Bank are direct beneficiaries of rising rates (a steeper yield curve improves banks’ lending margins) as well as a stronger US and global economy.
Jacob de Tusch Lec and James Foster manage the Artemis Monthly Distribution Fund; visit the fund page for further information about the fund, its performance and current positioning.
THIS INFORMATION IS FOR PROFESSIONAL ADVISERS ONLY and should not be relied upon by retail investors.
Risks specific to the Artemis Monthly Distribution Fund
The fund may invest in emerging markets. The fund may use derivatives to meet its investment objective, to protect the value of the fund, to reduce costs and with the aim of profiting from falling prices. The fund may invest in fixed interest securities. The fund may invest in higher yielding bonds. The fund holds bonds which could prove difficult to sell. As a result, the fund may have to lower the selling price, sell other investments or forego more appealing investment opportunities.
The fund's annual management charge is taken from capital. The additional expenses of the fund are currently capped at 0.14%. This has the effect of capping the ongoing charge for the class I units issued by the fund at 0.89% and for class R units at 1.64%. Artemis reserves the right to remove the cap without notice.
Any research and analysis in this communication has been obtained by Artemis for its own use. Although this communication is based on sources of information that Artemis believes to be reliable, no guarantee is given as to its accuracy or completeness.
Third parties (including FTSE and Morningstar) whose data may be included in this document do not accept any liability for errors or omissions. For information, visit artemisfunds.com/third-party-data.