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What fund firms tell us about the reflation trade

Asset managers' views on equities and bonds, and how popular funds have been performing
What fund firms tell us about the reflation trade

Most asset managers in our survey expect cyclical assets and markets to continue a strong rebound

The UK has grown considerably in popularity

The asset managers we surveyed are much less upbeat about bonds than at the start of the year

Watching professional investors is always instructive, even if only to show that well resourced asset managers also make mistakes. This could be one way of looking at our roundup of leading fund firms’ asset allocation views at the start of 2021 (Lessons from fund managers for 2021, IC 22.01.21), as not one of the 10 companies surveyed had a positive view on the UK. But the domestic market has subsequently roared back to life racing ahead of most other regions.

With the first half of the year behind us and the cyclical rebound appearing to at least pause for breath, it's worth once again assessing how our sample of leading fund firms view specific sectors and asset classes. As in January, we have set out the proportions of the asset managers surveyed that stated positive, neutral or negative views on a given area.


Open for business

The debate about the cyclical rebound and the extent to which it can resume after appearing to lose momentum continues to divide investors. Yet the asset manager outlooks we surveyed show a fairly clear consensus on this. In commentaries compiled at the halfway point of 2021 and published in the following weeks, most firms appear confident that cyclical assets and markets will continue to lead a strong rebound for the stock market.

This is particularly obvious when it comes to regional equity preferences. The UK, previously ignored by the fund firms in our sample, has grown considerably in popularity. Some 40 per cent of our sample viewed the region positively at the end of June, with 60 per cent taking a neutral view. This compares with 80 per cent taking a neutral stance and 20 per cent feeling negative towards the UK at the start of 2021.



Europe, another fairly cyclical market which often fails to inspire confidence in investors, has experienced a similar boost. As the chart shows, 70 per cent of the sample had positive feelings about Europe at the halfway point of the year, up from 40 per cent in early 2021. The fund firms have also grown much warmer on Japan, another market which is cheap relative to the US. Valuation-minded investors may note that while UK and European indices have surged since November, Japan’s market has lagged most of its peers – even if some value-oriented funds such as Man GLG Japan CoreAlpha (GB00B0119B50) have prospered.

Some argue that Japan could pick up as a result of global and domestic factors. In a recent asset allocation update Fidelity's multi-asset team notes: "Japan’s equity market is geared to the global cycle and vaccinations are rising with restrictions being slowly lifted. Domestic activity could also improve with the stabilisation of the Covid-19 situation."

More broadly speaking, investors should remember that beneficiaries of the recent cyclical rebound could falter again if the case for economic growth becomes more complicated. Given the conservative stance of our sample at the start of the year, it is unsurprising that even firms with positive views on cyclical assets have caveated their arguments. Royal London Asset Management states: “As economies reopen further this year, we expect risk assets to continue their recovery, led by more cyclical assets.” Yet the firm added that “uncertainty regarding inflation, new virus variants and geopolitical risks remain, and hawkish turns in [monetary] policy or extensions to lockdowns could be challenging for risk assets given current valuations.”

Such concerns may explain why more firms are not outright positive on the UK.

Similarly, a number of firms have taken some profits on positions in cyclical markets even if they still believe value investing will continue to serve them well. And some are choosing between the best cyclical plays. For example, while still positive on the UK, Fidelity's team says it has "reduced conviction... offset by a more positive view on European equities".


Bond broken

We recently noted in Good news, bad news from the bond market (IC, 16.07.21) that government bond yields fell in early July, marking something of a recovery from when they rose, and prices fell in the first quarter of 2021. This has been interpreted by some as a sign that investors are now less concerned about the prospect of inflation or less bullish about economic growth. Because inflation and any resulting interest rate rises can be extremely damaging for fixed income, this would be reassuring for many bond investors.

Yet even if investors in general are more relaxed, the fund firms in our sample seemed much less upbeat about bonds at the time their mid-year updates were compiled than six months earlier. Not a single firm had a positive view on government bonds this time round, while the proportion of asset managers taking a positive view on investment grade credit tumbled from 67 per cent at the start of 2021 to 22 per cent at the end of June. The vast majority of companies in our sample are now neutral on emerging market debt.

Concerns about government bonds are not new, but some asset managers suggest that they have become too expensive to act as effective diversifiers against equity market volatility, while the eventual prospect of rising interest rates would be a serious threat. As Aviva Investors puts it: "We are strategically underweight nominal government bonds given their diminished ability to act as portfolio ballasts with yields near lower bounds. Rising debt levels may eventually pose risks to the low [interest] rate regime. Tactically, we prefer inflation-linked bonds – particularly in the US relative to the euro area on valuations."

Meanwhile high-yield debt, which has a strong correlation to equities and can be viewed as a cyclical asset, has also seen its popularity fall, even if it remains the most widely favoured form of fixed income. Half of our sample were positive on high-yield bonds and the other half took a neutral view.

High-yield bonds tend to fare well when economic conditions are favourable. And Fidelity was among those which had a positive view on high yield due to improving fundamentals. “Default projections are falling, higher quality issuers have room for spread compression and global policy stimulus continues to be a tailwind,” the fund firm notes. Yet not all asset managers are convinced that high yield looks attractively valued, something that partly reflects its dip in popularity.

BlackRock has downgraded high yield from positive to neutral, arguing that spreads – the gap between yields on high-yield debt and government bonds – are below a point that suggests attractive value. Generally, a wider spread suggests that investors are being more generously compensated for taking on risk. BlackRock said that it currently prefers to take risk in equities rather than corporate bonds.


Last year’s winners

Asset managers have mixed views on the markets that led returns at the height of the pandemic. The limited level of positivity towards Asian and emerging markets equities at the start of 2021 has collapsed even further, with just a tenth of the asset managers we surveyed taking an upbeat view on each region. This may or may not prove surprising: Asian markets were seemingly more vulnerable to a drop-off in valuations after an extremely strong 2020 led by big gains in China. Since then, the region has encountered various issues from trouble vaccinating its citizens against Covid-19 to specific Chinese issues. The world's second biggest economy has started slowing down its credit growth, while a tougher approach to big tech firms has been detrimental to the returns of companies like Tencent (HK:700) which dominate Asian and emerging markets indices.

Emerging markets have had other problems. Aviva Investors points to the fact that “many emerging markets have less policy space to continue fiscal profligacy,” even as some will be forced to return to normal. It adds: “Emerging market finance ministers must find a way to tighten budgets and consolidate deficits even as damage from Covid-19 persists.” And BlackRock notes that such belt tightening could lead to "a greater risk of scarring" in these economies.



But there may be some silver linings in the longer run. BlackRock says that while credit tightening and a regulatory crackdown on the likes of big tech names in China could hurt in the shorter term, these could be "important aspects of China's efforts to improve the quality of growth." Notably, the firm has started to assess China as a region in its own right, separately to emerging markets.

Not all of 2020’s winners have fallen out of favour, partly because of their role in the economic and market recovery. The US continues to rack up strong returns even amid a market rotation that has challenged big tech and, as the chart shows, it was the strongest performing market in sterling terms during the first half of 2021. Perhaps unsurprisingly, more firms are positive on the region at the halfway point of 2021 than at the start.

However, this is not necessarily a vote of confidence in the likes of the FAANGs - Facebook (US:FB), (US:AMZN), Apple (US:AAPL), Netflix (US:NFLX) and Google owner Alphabet (US:GOOGL). Some continue to favour smaller company stocks as a play on the economic recovery in the US and more widely. JPMorgan Asset Management likes US small caps as part of a strategy focused on “cyclical equity regions and value.”

Domestic factors are fuelling some optimism. Aviva Investors argues that fiscal stimulus should serve as a boon for US assets. "We still expect the US to implement a large infrastructure package in [the second quarter], the benefits of which outweigh any tax hikes and re-regulation," it explains. "Additional tax cuts and redistribution may also provide an offset to declining older stimulus." 

While big tech faltered notably in the first quarter of this year after a blockbuster 2020, these troubles should be put into context. The US tech sector has remained relatively resilient, bouncing back strongly as the halfway point of the year approached. The Nasdaq 100 index, a concentrated play on the big US tech names, among others, made a 12.2 per cent sterling return in the first half of this year and a 9.2 per cent return in June.


The impact on funds

Popular funds with a focus on growth and quality stocks have also made it through the first half of 2021 relatively unscathed, having bounced back recently. Over the first six months of this year, Fundsmith Equity (GB00B41YBW710) made a 13.1 per cent sterling total return and LF Blue Whale Growth (GB00BD6PG563) made 10.7 per cent. And Scottish Mortgage Investment Trust (SMT), which had struggled notably in parts of February and March, made a share price total return of 9.8 per cent.

Popular UK equity funds with less of a cyclical focus also held up well. For example, Liontrust Special Situations (GB00BG0J2688) made an 11.5 per cent total return and CFP SDL UK Buffettology (GB00BF0LDZ31) delivered 6.5 per cent.

Global growth stocks were not far behind their value counterparts as we hit the end of June, as the second chart shows, though there were some extremes among funds. The best performers in the Investment Association (IA) Global sector over the first half of 2021 tended to be energy and financial sector funds, with iShares Oil & Gas Exploration & Production UCITS ETF (SPOG) racking up a huge 50 per cent total return.

Yet the picture is more nuanced when it comes to less volatile, more generalist funds. Value funds such as Schroder Global Recovery (GB00BYRJXP30) ranked among some of the IA Global sector's best performers, but its 17.8 per cent total return did not put it vastly ahead of some of the growth and quality funds mentioned above.



There were starker differences in more cyclical markets. For example, MI Chelverton UK Equity Growth (GB00BP855B75), which invests in small and mid-caps, made a total return of 23.2 per cent and Premier Miton UK Value Opportunities (GB00B8QW1M42) was not far behind it. Both notably outpaced Liontrust Special Situations over this six-month period, though you may question whether this can continue.