The economic indicators signalling a recession within the next two years have not improved, according to Investec Asset Management’s Jason Borbora-Sheen, who said the risk of a downturn by 2020 remains high.
Last year was a challenging one for fund managers of all stripes as markets dealt with several macroeconomic and geopolitical headwinds.
The decision by the Federal Reserve to press on with its path to policy normalisation was particularly painful for markets, while the potential for a US-China trade war also loomed.
Up and down the risk scale funds struggled to protect – and grow – investor cash, even at the more cautious end.
As such, just one fund in the IA Mixed Investment 0-35% Shares sector – where only up to 35 per cent is permitted to be held in equities and at least 45 per cent of the fund must be held in investment grade fixed income or cash – managed to deliver a positive return in 2018: Investec Diversified Income.
Borbora-Sheen, a co-manager on the fund alongside industry veteran John Stopford, said the strategy has grown to around £2.5bn, spread across a UK-domiciled OEIC and a US dollar-denominated offshore Sicav.
“Clearly the 2018 performance of the fund has highlighted its ability to be used as a defensive alternative,” said Borbora-Sheen, noting that both sub-funds had delivered positive performance.
“Both had a positive year on a net basis. Both even had a positive October, which was fairly rare,” the manager said. “I think that brought it onto people’s screens the ability to use the fund as an alternative in a context where most asset classes had a negative year.”
Performance of fund vs sector in 2018
Source: FE Analytics
While the average IA Mixed Investment 0-35% Shares peer lost 3.35 per cent during 2018, Investec Diversified Income remained in positive territory with a small gain of 0.41 per cent.
Many peers struggled during the latter part of the year because of stronger correlation between bonds and equities; however, this is something that Borbora-Sheen said the strategy actively tries to combat or manage.
Security selection, which plays an important role in the strategy, helped the fund navigate what was quite a changeable market environment last year.
Being active allowed it to move out of defensive stocks – in sectors such as consumer staples and healthcare – which became expensive towards the end of the year, into cheaper cyclical areas such as financials poised to benefit from any rally.
“The first quarter saw a significant rewriting of cyclical stocks relative to defensive ones and that meant that we sold down some of those more cyclical names in favour of more defensive ones,” he said. “I suppose it’s been a bit of a round trip, in that you've seen quite significant revolutions within markets.”
Performance of sector indices Q3 2018-Q1 2019
Source: FE Analytics
The Investec Diversified Income co-manager added: “As far as the broader environment goes, I’d say our approach is obviously different to a traditional multi-asset fund. We struggle with the macro questions that we sometimes get asked.
“What we’re trying to do is select individual securities and trying to size them so that we’re not overly correlated when there’s a risk of markets not producing positive, forward returns and then actively hedge the strategy when there’s a risk of a drawdown.”
The risk of a drawdown remains a real threat for Borbora-Sheen and Stopford, who believe that a US recession could occur within the next two years.
“If we look down at the more I suppose cycle issues that inform the structural management of correlation the fund, we still see it as being late cycle,” he said.
“Our recession risk indicators would suggest that there’s more than 50 per cent risk of there being a recession in the next two years.”
The team’s view on recession was driven by three indictors – the output gap (the difference between actual GDP and potential GDP), economic growth relative to trend and the yield curve – none of which have improved in recent months.
Borbora-Sheen added: “In the context of market valuations, this isn’t necessarily reflected in the price that investors are paying for assets, particularly for corporate bonds, which to us look very expensive on our models.”
The Investec manager said while there had been an improvement in liquidity as the Federal Reserve moved from tightening to holding rates (with the potential for cuts) there was a danger that “investors have extrapolated that too far”.
“Now as the forward pricing off interest rates suggests that there will be up to potentially three interest rate cuts over the next three years, we are somewhat concerned that central banks prove to be more hawkish than investors might expect,” he said.
Another threat to liquidity is dollar supply, which he said is heavily influenced by trade, where there have been further doubts cast as US president Donald Trump continues to pursue a hard stance with China and other trade partners.
“Most trade transactions tend to be invoiced in dollars, so when you have trade disputes one of the first-round impacts is less trade gets conducted,” he explained. “The second-round impact of that is that fewer dollars are released into the system and that can create pressure on emerging market economies in particular, but also indebted companies.
“That comes back to why we’re concerned about corporate bonds at this point.”
Currently investment grade corporate and high yield corporate debt make up 13.2 per cent and 3.8 per cent of the portfolio respectively, compared with equities representing the largest asset class allocation at 28.4 per cent. Developed market sovereign bond exposure makes up 27.5 per cent, while emerging market local currency-denominated debt represents a further 18.5 per cent.
Performance of fund vs sector under Stopford
Source: FE Analytics
Borbora-Sheen was named co-manager of Investec Diversified Income earlier this year alongside Stopford. Since Stopford took over running of the fund in July 2012, it has made a total return of 37.43 per cent compared with a 31.01 per cent gain for the average peer.
The £872.8m fund has an ongoing charges figure (OCF) of 0.76 per cent and a yield of 4.07 per cent.