Smith & Williamson Short-Dated Corporate Bond Fund Quarterly review- Q3 2017 For professional advisers use only
Executive summary The Fund produced a gross GBP total return of 0.1% in the third quarter (Q3) 2017 ( Z share class). For reference, GBP 3m Libor returned 0.1% in Q3 while the Gilts All Stocks index returned -0.5%. 1 The Fund continues to target an income yield that is more attractive than that available on cash while also seeking to deliver very low volatility. We continue to emphasise high-quality investment-grade credit with no exposure to bank debt, to reflect the Fund s unusual position on the asset allocation spectrum between cash and mainstream (i.e. longer duration) corporate credit funds. Market environment Q3 was a game of two halves as far as fixed income markets were concerned. For much of the quarter, benchmark 10-year yields were in a clear downward trajectory. However, this supportive environment came to an end in September, as markets focused on central bank rhetoric and the possibility of rate rises in the US and UK, despite sub-par levels of GDP growth. The result of this central bank rhetoric was for short term yields in the UK to retrace back towards pre- Brexit referendum levels and volatility to rise in the long end of the yield curve. Looking forward: The future continues to look uncertain as central banks attempt to carefully unwind almost a decade s worth of expansionary policy and politicians take over the job of supporting GDP growth. Rising political tension in the US, UK and across Europe threatens to derail the recovery, which on the plus side should limit the pace of rate rises but on the downside could jeopardise anaemic GDP growth and allow the recent spike in inflation to gain momentum. Building up positions in more defensive assets whilst most risk assets continue to defy gravity seems sensible, in our opinion. For professional advisers use only - Short-Dated Corporate Bond Fund 1
Q3 review Q3 was a game of two halves as far as fixed income markets were concerned. For much of the quarter, benchmark 10-year yields were in a clear downward trajectory. However, the mood music changed abruptly in September as comments from European Central Bank (ECB) President Mario Draghi indicated that the ECB s decision to taper its asset purchase programme could come in October (which it subsequently did, saying it would scale back its asset purchases from January). Meanwhile the Bank of England s (BoE) Monetary Policy Committee (MPC) gave their clearest indication yet that UK interest rates could be set to rise this year. The result of this central bank rhetoric was for short term yields in the UK to retrace back towards pre-brexit referendum levels and volatility to rise in the long end of the yield curve. 3.0 10 Year Generic Gilt Yields 2.5 10 Year YTM 2.0 1.5 1.0 0.5 0.0 Jun-17 Jul-17 Aug-17 Sep-17 UK - Generic 10 yr YTM Germany - Generic 10 yr YTM US - Generic 10 yr YTM Source: Bloomberg, October 2017. From our perspective, ECB tapering and higher UK rates are expected by markets the question is over the pace of monetary policy tightening and how this will impact the already fragile growth in these regions. The ECB has a well-deserved reputation for being somewhat lethargic in its policy actions, and October s announcement showed that tapering should be a gradual and incremental process. The BoE, on the other hand, was probably too quick to cut rates after the Brexit shock last year and now seems determined to raise rates even though the domestic picture probably does not warrant it. UK consumers have been squeezed hard by surges in retail price index (RPI) and consumer price index (CPI) inflation, gross domestic product (GDP) growth remains weak and there is now a genuine risk of policy impasse following PM May s Tory party conference speech. To our minds, the BoE intention is more to talk up sterling to offset some of the cost-push inflationary pressure and therefore ease some of the pain for consumers and corporates. A modest hike in November is expected (this commentary was updated in late October), but in our view, growth and Brexit uncertainty keeps the long term outlook for rates relatively subdued. In contrast to the moves seen in the UK and Europe, US Treasuries were a relative rock of stability in Q3. By historic standards, US inflation has been well behaved although we would argue that this has been driven by overcapacity and a lack of pricing power. Ordinarily, that slack would have been taken out by the process of what Schumpeter called creative destruction but that has been delayed by aggressive monetary policy in developed markets, driving interest rates to historic lows following the global financial crisis of 2007-2008. Some of that slack is now beginning to unwind (see recent developments at the likes of Caterpillar for example, where the outlook seems to be the best that it has been for years according to our global equity colleagues), but the bottom line is that US growth remains weak compared to long-term trend levels and there are few signs of this changing anytime soon. President Trump s tax plans could provide a shot in the arm for the economy, but he will face challenges in the form of Republican fiscal hawks and wider concerns about the debt ceiling. Perhaps more importantly, the early months of his administration have shown again and again that promises are much easier made than delivered. For professional advisers use only - Short-Dated Corporate Bond Fund 2
US CPI & Unemployment US Unemployment (LHS) 12 10 8 6 4 2 6 5 4 3 2 1 0-1 -2 US CPI (%) 0-3 Sep 08 Sep 09 Sep 10 Sep 11 Sep 12 Sep 13 Sep 14 Sep 15 Sep 16 Sep 17 US Unemployment (%) LHS US CPI (%) RHS Source: Bloomberg, October 2017. In terms of the US s growth trajectory from here, it is worth remembering that there have been 13 Fed hiking cycles in the post-war period with no less than 10 of these ending in recession (i.e. a bond-friendly outcome). Only three hiking cycles (in the 1960s, 1980s and 1990s) resulted in a soft landing. Given the low/anaemic rates of US GDP growth versus history, it remains to be seen just how well the US economy will tolerate a hiking cycle this time round. It seems unlikely to us that corporates will want to put much capital to work before the tax review is completed. Moreover it is important to remember that both corporate and consumer balance sheets are still extended, particularly as some corporates continue to issue debt in order to increase shareholder returns. 1400 1200 1000 800 600 400 200 U.S. Nonfinancial Corporate Total Adjusted Debt & Shareholder Returns (Share Buybacks + Dividends) 0 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017(f) 2018(f) Median Total Adjusted Debt Median Buybacks+Dividends (f) = Forecast Source: Standard & Poor s Financial Services, October 2017. For professional advisers use only - Short-Dated Corporate Bond Fund 3
Outlook So, where to from here? Janet Yellen s speech in late September chimes with our view that low inflation is likely to reflect structural as well as more temporary factors that might fade over time, and is expected to stabilise at around 2% over the medium term. 1 That is not high inflation by any stretch of the imagination, but is certainly a big enough number to make a material difference to real returns, particularly in low yielding asset classes such as cash and fixed income. As with the ECB and BoE, we would expect any further Fed policy tightening to be gradual and still with a low terminal rate compared to history but Yellen remains vocal on the risks of moving too slowly. Overall, we would concur with Yellen that the current uncertainties support a gradualist approach to policy tightening, and, if it has got it wrong, the Fed (unlike some central banks) does at least have a little bit of wiggle room to cut rates, should the need arise. Finally, it is worth remembering that Yellen s term expires in January and it is still not known at the time of writing whether she will remain in post or be replaced (once again, Trump has failed to deliver anything concrete on this). At the current juncture, there is a risk that what the market considers to be the wrong candidate is appointed (i.e. Trump appoints someone who he likes on a personal basis, rather than hiring the most able candidate). All in all, the future continues to look uncertain as central banks attempt to carefully unwind almost a decade s worth of expansionary policy and politicians take over the job of supporting growth going forward. Rising political tension in the US, UK and across Europe threatens to derail the recovery, which on the plus side should limit the pace of rate rises but on the downside could jeopardise the somewhat anaemic growth and allow the recent spike in inflation to gain momentum. Building up positions in more defensive assets whilst most asset classes continue to defy gravity seems sensible. Sources: 1 Morningstar Direct 2017 and Smith & Williamson as at 30.09.17. For professional advisers use only - Short-Dated Corporate Bond Fund 4
Key risks: Investment does involve risk. The value of investments can go down as well as up and investors may not receive back the original amount invested. The Fund will invest substantially in short-dated corporate bonds globally and will therefore carry a lower degree of interest rate and capital risk than funds investing in long term fixed income or equity securities. However, please note that bond funds may not behave like direct investments in the underlying bonds themselves. By investing in bond funds the certainty of a fixed income for a fixed period with a fixed return of capital are lost. The Fund will be exposed to credit risk on parties with whom it trades and may also bear the risk of settlement default. When investments are made in overseas securities, movements in exchange rates may have an effect on the value of that investment. The effect may be favourable or unfavourable. Past performance is not a guide to future performance. Investment is subject to documentation (Prospectus, Key Investor Information Document (KIID) and Terms & Conditions), copies of which can be obtained free of charge in English from Smith & Williamson Investment Management LLP, 25 Moorgate, London EC2R 6AY or online www.sandwfunds.com Important Information: For professional advisers only - not for use by or distribution to retail investors. This document contains information believed to be reliable but no guarantee, warranty or representation, express or implied, is given as to their accuracy or completeness. This is neither an offer nor a solicitation to buy or sell any investment referred to in this document. Smith & Williamson Investment Management (SWIM) documents may contain future statements which are based on our current opinions, expectations and projections. Smith & Williamson Investment Management does not undertake any obligation to update or revise any future statements. Actual results could differ materially from those anticipated. Appropriate advice should be taken before entering into transactions. No responsibility can be accepted for any loss arising from action taken or refrained from based on this publication. The opinions expressed are those held by SWIM at the time of going to print and are subject to change. This material should not be considered by the recipient as a recommendation relating to the acquisition or disposal of investments. This material does not contain sufficient information to support an investment decision and investors should ensure that they obtain all available relevant information before making any investment. There can be no assurance that the professionals currently working for SWIM will continue to work for SWIM or that the past performance or success of any such professional serves as an indicator of such professional s future performance or success. There can be no assurance that the Fund will achieve its investment objective, the target return or any other objectives. Any target return shown is neither guaranteed nor binding on the Manager. Any information about specific stocks or investments is given for illustrative purposes. It is considered to be accurate at the time of writing but no warranty of accuracy is given and no liability in respect of any error or omission is accepted. Any examples of specific stocks are included solely to illustrate the investment process and strategies which may be utilised by the Fund. These investments are not necessarily representative of future investments that the Fund will make. The Smith & Williamson Short-Dated Corporate Bond Fund is a sub-fund of Smith & Williamson Investment Funds PLC, a Dublin domiciled OEIC regulated by the Central Bank of Ireland. The Fund is a recognised scheme under section 264 of the Financial Services and Markets Act 2000. The rules made under the Act for the protection of private customers (for example, those conferring rights to cancel or withdraw from certain investment agreements) do not apply in connection with an investment in the Fund. In addition, the protections available under the Financial Services Compensation Scheme and the Financial Ombudsman Service may not be available. Issued in the UK by Smith & Williamson Investment Management LLP which is authorised and regulated by the Financial Conduct Authority (registration number is 580531). Ref: 140017sb For professional advisers use only - Short-Dated Corporate Bond Fund 5
For professional advisers use only - Short-Dated Corporate Bond Fund 6