Affinity Market Commentary July 2020
Economic data reverses gains in Europe
The EU member states’ agreement on the structure of the COVID-19 Recovery Fund had provided some support for European equities early in the month, and news of progress towards a COVID-19 vaccine had seen the DAX30 up by as much as 7% before falling back to sub-13,000 levels towards the end of the month, after industrial production and GDP data showed the extent of the economic damage to particularly the major European nations.
Technology stocks continue to lead
The US market continued to power ahead during the month and the July performance showed evidence of a wider market participation in the rise, rather than being led by technology alone, as had been seen previously. The rally appeared to gain momentum and spread to other areas of the US economy. US stocks often do well in an election year, and this year’s election is very hard to forecast.
Japanese industrials out of favour
Japanese equities fell in July, as the major industries in the Japanese indices, motors and finance were poor performers. Shares in Toyota – the largest company on the Japanese stock market – fell by almost 5%, whilst life/finance companies, the second largest sector were broadly flat-to-negative over the month. The BoJ has been less active during the Covid crisis, as its monetary policy was already loose. The lack of a clear successor to Shinzo Abe, when his current term ends next year, also casts a shadow over the future economic policy.
Emerging markets push ahead
Emerging markets, laden with US dollar debt, and therefore traditionally sensitive to the fortunes of the dollar, were boosted in July by the weakness of the US currency. This was based on increasing dollar liquidity, low US interest rates, and the prospect of a prolonged period of fiscal deficits for the US. China rose strongly, gaining more than 10%, whilst South American markets were generally strong, and emerging European markets were the outright laggards, driven lower by the poor economic data from their larger peers and from the Eurozone as a whole. The wider Asian region gave mixed performances, but was also broadly positive.
The World at a Glance
Source: Bloomberg – National benchmark indices in local currency
July saw much more mixed returns from the global equity markets, in contrast to the strong performances recorded in Q2, as investors began to recover confidence following the global shutdowns. US equities appeared strong once again, although this continues to be a very narrow rally, led by technology stocks. Emerging markets were also pushed much higher, with both Asian and South American nations performing well. Europe, particularly the UK, was a laggard, as investors focused on the resurgence of Covid as economies unlock, and Japan was weak as its major industries – autos and finance – were out of favour.
Source: Bloomberg – National benchmark indices in local currency
July was a poor month for European equities, with the resurgence of Covid-19 undermining sentiment, and weak economic data and corporate earnings weighing on the markets later in the month. Early gains in the month were wiped out by a sell-off in the last week. The German DAX30 was the best performer among the majors, gaining as much as 7%, with industrial production and factory orders data surprising on the upside. However, the Index ended the month flat, as second quarter GDP numbers for France, Germany and the Eurozone drove the majority of markets sharply lower.
Investors focused on the unlocking of the UK economy during July, rather than Brexit deal pessimism, to make Sterling the best performing G10 currency in July. The currency was boosted by comments from Michel Barnier that he remains confident that a deal will be reached. Conversely, the dollar was weak against both Sterling and the euro, as improving confidence saw flows out of the traditional safe haven currency, and the stimulus package announced by the Eurozone was seen as giving stability to the area, and reducing the euro risk premium.
Bonds were positive again in July, with all sections of the global fixed income markets returning a gain in local currency terms, although the strong performance of the pound meant that the bond indices measured in Sterling appeared negative. Government bonds continued to be bought, with yields falling across the major markets, and the European issues with negative yields continued to edge further into negative territory. Although the 10-year yield in the UK remains positive, the Treasury did recently auction its first gilt (a short-dated 2023 bond, sold in May) at a marginally negative yield, and the price of that bond has risen, pushing the yield lower. Further issuance from governments seems likely, and it would therefore not be surprising to see yields below where they are today.
*A Generic bond is a theoretical bond that always has the specified tenor, unlike a Benchmark bond, which is a physical bond, with a decreasing tenor.
The rise and rise of ESG
One of the consequences of Covid-19 has been a boost to the already growing area of ethical investment. Within a fortnight of lockdown, we all saw the pictures of dolphins in Venice, witnessed wildlife venturing onto the streets in our own towns and cities, and marvelled at the satellite images of unpolluted skies over China. This has led even more investors to re-evaluate the social and environmental impact of their investments. This month, we look at how these considerations are applied in practical terms, to investment selection. In June, Barclays reviewed 150 emerging investment trends for the 2020s. Of these, 22 were in the field of ‘Energy and Environment’, and a further 30 were under the heading ‘Society and Culture’ (https://www.investmentbank.barclays.com/our-insights/150-trends-for-investors-to-watch-in-2020s.html?cid=paidsearch-textads_google_google_themes_150-trends_uk_150-trends_phrase_306047259748&gclid=COKWxYji9-oCFYs-Gwod9GICtA&gclsrc=ds). ESG is set to continue growing in importance for fund managers and private investors, and a recent proposal by the US Department of Labor, to force private pension administrators to prove that they were not sacrificing financial returns by putting money in ESG-focused investments, was publicly attacked by State Street, which has $2.5trn under management (https://www.ft.com/content/128c5c92-203b-4a87-8f53-315b23018f9a). Nevertheless, flows into ESG funds have grown rapidly and are predicted to continue on that trajectory.
Ethical, sustainable and responsible funds are all slightly different, but come under the broad heading of ESG funds; ESG stands for Environmental, Social and Governance. Whilst most fund managers would be expected to pay close attention to the G – the corporate Governance issues surrounding a company, ESG funds also screen for companies that maintain certain standards of environmental and social conduct. Each fund will specify its own criteria for a company to be included, and this quickly highlights the problem that not everyone has the same priorities when it comes to ethical issues. Some investors may feel strongly about animal welfare and sustainable energy and resources, but less so about human health and wellbeing. Others may have the exact opposite view.
Fund managers may operate positive or negative screens, or both. Positive screening means actively seeking out companies that contribute positively to society and the environment. These would include, for instance, manufacturers of safety equipment, nutritional products or healthcare equipment. More typically, however, funds operate a negative screening policy, whereby companies are excluded if they are involved in certain areas of business. The common exclusions for a fund of this type would be tobacco, alcohol, weapons, animal testing, pornography and human rights abuses. However, there are many more areas that can and are included, such as unsustainable timber resources and gender representation on company boards.
This may seem very straightforward, but there are massive grey areas. Consider the major oil companies, which have a demonstrably negative effect on the environment, pumping chemicals into the ground and flaring off gas into the sky. These same oil companies are the biggest investors in renewable energy sources. What about the pharmaceutical companies? They may have an excellent track record of producing life-saving drugs, and giving away medicines to less developed nations, but they usually use animal testing. These are but two examples of the dilemmas facing fund managers when they are considering whether a company is investable within an ESG mandate.
To help with this problem, businesses have sprung up that specialise in scoring companies on the E, the S and the G, and providing data that compares companies to show up those that score well and those that score badly. In turn an ESG fund can then be rated according to the scores of the shares that it holds. This, however, creates as many problems as it solves. The data provided may be out of date, it may be based purely on the company’s own statements, it may not take account of steps being taken by the company to improve its ESG credentials, and, particularly with smaller companies, the scoring body may not provide coverage at all, which makes nonsense of the fund’s ESG rating. In addition to these issues, large companies have set up whole departments to produce information on their ESG record, and to spin the company’s activities in a way that appears more favourable. Company statements may include specific trigger words that are searched for by automated ESG screening software. Smaller companies do not have this level of sophistication, and may be scored lower simply because they do not present their business in the right way.
ESG funds exhibit very different characteristics from their more conventional counterparts. Whilst the UK, and to a lesser extent Europe, have already moved a fair way down the road to ESG investing, this is not the case in Asia or the Americas, hence an ESG-based portfolio will be heavily skewed towards the UK and Europe, meaning much less geographical diversification. The make-up of an ESG portfolio will also be very different, as it will naturally exclude some of the largest sectors in the market, such as oil, mining and tobacco. This can lead to a very different performance profile, particularly when one of the sectors that is omitted goes through a particularly strong or weak period. ESG funds generally saw a boost to their relative performance in 2014, when resources company shares were falling, and again this year, when the oil price collapsed. This might lead some investors to the conclusion that limiting investment to a subset of the available market will also limit the potential for profit. Historically however, this has not proven to be the case, and, in fact, there is little difference between the long-term performance of ESG funds and their ‘conventional’ counterparts. The chart below shows a comparison between the MSCI World Index (reference MXWO and in orange) and the MSCI World ESG Leaders Index (reference GSIN and in white) over five years:
When we meet with fund managers, we record data on the ESG policies and practices for their funds. This is an important part of our research process for all the funds in which we invest – not just the specialist ESG funds. When we interview managers, we specifically spend time discussing in detail how they integrate ESG considerations into their fund selection process, and maintain a database of this information to make comparisons both with other funds, and with the same fund in the future. Most fund houses now have a specialist team that focuses on ESG analysis, but we look for funds where the managers themselves are also playing a part in ESG issues. Also, we look for funds where independent assessment is made of a company’s ESG record – i.e. the managers do not simply rely blindly on an external agency’s scoring. ESG analysis is still more of an art than a science, and there is not yet any definitively right way to translate a company’s behaviour into a number; this is still an evolving theme, but we believe that ESG will form a standard part of investment analysis in the future, and that having a methodology for assessing this will be essential.
Disclaimer: The information contained in this report is for illustrative purposes only and should not be construed as a solicitation nor offer, nor recommendation to acquire or dispose of any investment. Specifically the share class used to create the illustrations may not be available on all platforms nor be suitable for individual investors. This report was produced by Independent Strategic Research Limited (ISR) for Affinity Integrated Wealth Management (AIWM) and while AIWM and ISR use reasonable efforts to obtain information from sources which they believe to be reliable, neither AIWM nor ISR make any representation that the information or opinions contained in this report are accurate, reliable or complete. The information and opinions contained in this report are subject to change without notice. Model returns are calculated using the most appropriate share class of the underlying funds, having regard to the illustrative nature of the report, with all income being reinvested. As a result, real portfolio performance may vary from model performance. Where model portfolio histories are shorter than three years, historic model returns are substituted prior to inception date with returns from an ISR performance benchmark. This benchmark is constructed from the average returns of all ISR portfolios with similar risk profiles that existed during that time. The value of investments and the income from them can go down as well as up and past performance is not a guide to the future performance. Affinity Integrated Wealth Management is a trading style of Buryfield Grange Limited, Buryfield Grange Life Planning Limited and Affinity Integrated Wealth Management Ltd. ‘Buryfield Grange Limited’ is authorised and regulated by The Financial Conduct Authority. Not all services provided by Buryfield Grange are regulated by the Financial Conduct Authority. ‘Buryfield Grange Limited’ is registered in England and Wales at Inspire House, 20 Tonbridge Road, Maidstone, Kent, ME16 8RT. Company registration number 4568338. ISR is registered in England and Wales at 34 Southwark Bridge Road, London, SE1 9EU. Company registration number 09061794. Data Providers: Bloomberg L.P. and ISR.
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