Tony Cousins, the CEO of Pyrford International, portfolio managers for the Nedgroup Investment Global Cautious Fund, provides an update of the Fund’s recent performance and an outlook for the markets.
The Fund seeks to deliver a stable stream of real returns in excess of cash over 3 years through a low weighting to equity and a high allocation to fixed income products. A typical investor is someone looking to take money offshore but who doesn’t want to take a lot of risk or invest in cash because of the low returns on offer.
Q2 Fund performance
The Fund delivered a positive gross return of 4.5% for the quarter. We increased our exposure to equities in Q1, which benefitted the Fund in Q2 where US equities delivered 18.9% and non-US equities 10.6%. Non-US Dollar bonds returned 5%, largely due to the weakness in the US Dollar. US bond yields fell sharply in Q1 effectively delivering zero in Q2. Cash and currency hedgings were negative contributors at -1.5%. We run the non-US unhedged exposure up to the maximum of 45%. To the extent that we are owners of non-US assets in excess of 45%, we have to hedge back to stay within that risk parameter, so the weaker Dollar was an opportunity missed. Our US and overseas equity stocks tend to lag very strong liquidity driven rallies, which is what we saw in Q2 and is why they didn’t quite keep pace with the market.
Q2 portfolio actions
The markets fell incredibly sharply from the end of February to the end of March and we took that opportunity to increase the equity weighting from 25% to 30%. We are constrained in that we cannot go above 40%. The additional equity weighting was all allocated to non-US equities as US equities remain significantly more expensive. We have seen a phenomenal rally in equities. The EAFE Index (Europe, Australia and the Far East), which is essentially the world excluding North America, rose 22% between 12 March and 4 June. However, the dividends paid on that index fell 27% during the period. The yield on the market fell from 4.4% to 2.64% over that time hitting one of our trigger points and we took a decision on 4 June to remove 5% from the equity weighting bringing it back down to 25%. All our equity decisions are made in line with our pre-set trigger points, which are based on our value indicator. This is our key assessment of value and consists of the dividend yield on the market plus our long-term forecast of sustainable growth in earnings and dividends per share.
We believe that equity markets have now returned to quite heady levels and that the end June cyclically adjusted P/E ratio of US equity markets will have surpassed the 2008 market peak, reaching a 20-year high. Markets are clearly discounting an incredibly strong recovery in earnings in the US, which we think is overly optimistic and is why we’ve taken a more cautious view on equities.
US Dollar Q2 performance
The performance of the Dollar was very strong in Q1, which is typical during times of market panic. This was reversed to a degree in Q2. We use purchasing power parity to measure currency valuation, which is effectively a measure of export competitiveness. If a currency remains significantly overvalued on this measure for an extended period, its exports will be priced out of the market and its trade and current account will deteriorate, resulting in currency weakness to correct that position. What we’re seeing with this tool is that the US Dollar is an extremely expensive currency. It is 25% overvalued against the Pound and this is also mirrored in the other currencies that we have left unhedged in the portfolio. This is why we are at the top end of our 0%-45% risk parameter in the portfolio as we expect the US Dollar to continue to weaken over time.
Q2 Portfolio positioning
We remain very conservative with 72% in high quality bonds. The duration of these bonds is very low at 1 year, which is a form of capital preservation. The majority of the bonds (42%) are outside the US Dollar. Our view on fixed income is that long duration bonds, which are highly volatile, are effectively return-free risk. The yield is minimal, but the risk you take is enormous. The portfolio also has 3% in cash, 10% in US equities, 15% in non-US equities and 30% in US bonds. We have a significant position within the Asian markets (excluding Japan) who we think will recover better than the rest of the world and has a greater growth potential than other developed markets. Our exposure to continental Europe is entirely in central to Northern Europe with no exposure at all to peripheral Southern Europe, an area that’s in a lot of trouble.
The investment world continues to digest the threat that COVID-19 poses to the world economy. Global supply chains remain fragile while global demand has been decimated as governments scramble to understand and contain the virus. A big slice will be taken off world growth in Q1 and Q2 and a sharp economic rebound seems increasingly unlikely. It is impossible to time the bottom as this crisis is unprecedented. Central banks have moved to ease monetary policy, but have little room to cut rates further hence the large scale fiscal spending plans that continue to be announced. The private sector in most advanced economies is heavily leveraged as is the government sector. Central banks are effectively acting as the buyer of last resort and adding staggering sums to their already bloated balance sheets. Most government bonds will end up being owned by their central banks. Oil stocks have also suffered on broad fears of a global slowdown, followed by oversupply concerns and more recent issues around storage given the lack of demand. Valuations reflect the view that earnings growth will recover over 2021 despite continued uncertainty on the duration of a recovery and the impact of unprecedented government borrowing. We believe that global growth will remain subdued for many years. The economy and the stock market are totally disconnected and with geo-political issues returning, we expect continued volatility for the rest of the year.