Liontrust SF Managed Growth Fund

The Fund returned -0.7% over the quarter, compared to 0.1% return from the IA Sterling Corporate Bond sector (comparator benchmark) and -0.5% return from the iBoxx Sterling Corporates 5-15 Years Index (target benchmark)*.

Market review

In many ways the second quarter of 2024 could be viewed as similar to the first – yields moved higher, volatility remained elevated, and the incoming economic data charted an unpredictable course. Latterly, however, developments in that data have provided encouragement that supports our strategic view, though the path will no doubt be a bumpy one.

The narrative of a US ‘no-landing’ scenario was one which gathered both pace and credence early in the quarter, particularly as the March inflation report, released in April, provided the third upside surprise in a row to both headline and core CPI. Core services ex-shelter, one of the Federal Reserve’s (Fed) preferred measures, was particularly firm and showed signs that this strength might have been becoming entrenched. Alongside a fairly modest loosening in the labour market, the strength in both spot inflation and in some of the pricing components of the survey data led yields to rise markedly in April, with the US 10-year spiking almost 50 basis points (bps) higher.

While some of the survey data seemed to soften, and measures of consumer health such as delinquency rates picked up meaningfully, the market has moved to push out the timing of the first rate cut. Indeed, at the Fed meeting in June, the ‘dot-plot’ suggested that the median voter saw only one rate cut in 2024, down from three at the previous projection. The May inflation report was more encouraging, however, and we think there are other tentative signs that the “US exceptionalism” narrative might diminish somewhat. Although marked by volatility,10-year yields ultimately fell over both May and June, ending the quarter a little over 20bps higher than they started.

UK rates markets have largely, and somewhat frustratingly, behaved almost in lockstep with their US counterparts, despite economic data generally seeming more subdued and having started on a less sure footing. While growth has been firmer than expected, the inflation backdrop has been more mixed. Headline inflation reached the Bank of England’s (BoE) 2% target in the May report, although services inflation has remained somewhat stickier than both we and the Bank would have hoped. Given the ongoing signals from the labour market that seem to suggest further loosening ahead, we would expect to see that persistence dissipate over time. While the strength in services inflation had put paid to any hopes of a June cut to Bank rate, the BoE did leave the door open to an August move.

Given the communications embargo due to the impending general election, the only tool available to the Monetary Policy Committee (MPC) was the published minutes of their meeting. Though the vote split remained at 7-2, they elected to use the minutes to guide the market on some key points: firstly, that a number of members had considered joining the two who had voted to reduce rates; secondly, broadening out their emphasis to a range of survey indicators which have shown weakness of late; and finally, highlighting the importance of the August Monetary Policy Report in outlining their views on the direction of travel. While the timing of the first cut and the minutiae of the MPC’s messaging are less important than the overall path for interest rates, this was nevertheless seen as an indication of the BoE’s willingness to begin to ease their pressure on the monetary policy brake.

The picture in Europe has been somewhat different, despite a similar narrative on the inflation side with services remaining stickier than many anticipated. Despite this, the European Central Bank became the first of the three central banks mentioned here to reduce rates, arguing that monetary policy remained restrictive. The cut itself was well telegraphed, while the resulting message was one of absolute data-dependency, with no pre-commitment to any particular course of action from here. Given the range of views on the governing council, this pragmatic approach seemed designed to achieve such a compromise, and we wouldn’t be surprised to see the BoE adopt a similar approach following their first move. The end of the quarter saw euro markets’ attention shift to political risk, as the surprise calling of snap elections saw a blowout in French-German spreads as markets priced greater fiscal uncertainty amid the likelihood of a more extreme style of government.

Amid this backdrop, corporates have remained resilient. Continued easing in inflation data and moderate US growth have kept the economic environment stable. Sterling corporate spreads ended the quarter little unchanged from its start. Modest growth in Europe also supported spreads but these ticked up towards the end of the quarter over election concerns. Election uncertainty and expectations for rate cuts also caused issuers to postpone coming to market, with issuance numbers down compared to the previous quarter. Default rates did tick up over Q2, as the effect of higher monetary policy continues to filter through the economy, but remains below long run averages.

Duration

We started the quarter 1.00 year overweight the UK relative to the benchmark and maintained this level throughout the period. Although the overall duration position remained stable, we initiated a cross-market trade, taking a 0.25 year long position in 10-year UK Gilt futures versus a corresponding 0.25 year short position in 10-year German Bund futures. The rationale behind this position is our view that Gilt yields are relatively further away from our fair value target than Bund yields are, while UK markets have exhibited a higher beta to the US than their German counterparts, a relationship we think should reverse as UK economic data weakens. We also sought to challenge the difference in market pricing for cuts in both economies, where UK pricing was more akin to the US than the Eurozone.

Although headline inflation dropped to the BoE’s 2% target in the May report, services inflation, a metric closely followed by the Bank, has fallen less than expected in all three prints over the quarter. This led to a sharp rise in yields towards the end of May, which was only partially offset by a rally in June which largely mirrored moves in the US treasury market. As a result, gilt yields widened by 24bps over the quarter, which detracted from performance given our overweight duration positioning.

Credit performance

The Fund’s credit performance remained flat over the period. The sterling corporate index also remained flat in the second quarter.

Within our portfolio, sector selection was positive, due to our overweight position to subordinated securities within banks, which fared well over the quarter, and our underweight position to the utilities sector, which suffered spread widening. However, our allocation to gilts detracted slightly from performance, as government yields delivered a negative return. 

Generally, riskier assets outperformed over the quarter. In the US, strong earnings growth across the Magnificent Seven, a group of influential and leading technology stocks, drove market strength, and economic data for the Euro area surprised to the upside. This led to lower rated bonds outperforming on a total return basis.

In terms of security selection, we delivered positive performance from REITs. This primarily came from our exposure to logistics names, which continued to perform well due to their strong operational performance. This was offset by negative stock selection from the utilities sector, as our longer dated holdings reversed gains made earlier in the year. We did, however, benefit from not holding Thames Water bonds, which faced significant funding and operational risks with a recent default at the holding company. Within the banking sector, we have a neutral weighting to French banks, which were subject to spread widening due to the surprise political developments, and therefore did not suffer from relative underperformance. These however have subsequently recovered after the quarter end with the lack of a clear majority.

Regarding favoured sectors, we have not made any material changes to positioning. We continue to see intrinsic value in financials and hence remain overweight in banks and insurance. We have also retained our overweight in telecoms, as we like the sector from both a fundamental perspective and their ability to pass on costs to consumers. Our maintained underweight in utilities reflects our more cautious view on the sector’s current valuation relative to the index. Similarly, we remain underweight consumers, as we believe they will face a more challenging outlook due to higher policy rates constricting disposable incomes.

Trades

Compared to the start of the year, trading activity fell. As political uncertainty grew due to a snap election in France and upcoming elections in the UK and US, fewer issuers came to market towards the latter half of the quarter.

Following spread compression within financials, we reduced our position in Rabobank. We also switched between senior Barclays paper to a similar tenor alternative, which offered an attractive pickup in spread.

Outside of financials, we established a new position in Motability over the quarter, which was funded by reducing our positions in Verizon and Orange. Motability operate the Motability Scheme, which allows people with disabilities to lease a car, scooter, or powered wheelchair in exchange for their mobility allowance. All profits are reinvested into the business. This supports continued investment in enhancing customer service, including subsidised adaptations, wheelchair accessible vehicles, and an increasing number of electric vehicles on offer. We also established a new position to British Telecom following positive news-flow regarding lower capital expenditure and stronger cash generation.

Outlook

European and UK corporates remain in a strong position with continued low leverage and ample liquidity. Interest coverage has fallen from its high, as the cost of funding has trended higher but remains well above its long-term average. We believe corporates are well positioned as we approach the period where monetary policy should be relaxed from its current restrictive levels. Considering how resilient corporates have been to rates above 4%, we would expect this to remain the case, even if rates were to be held at current levels for a prolonged period, which is not our base case scenario.

Although elevated services inflation has been a common theme across many developed market economies, we broadly expect those inflationary pressures to reduce in the coming months. Labour market loosening should aid this process, while the ‘long and variable lags’ of monetary policy transmission continue to work their way through the respective economies. Indeed, we are seeing ongoing signs of moderation in several economic indicators, particularly in the US and UK.

In the US, inflation has been moderating after a series of strong prints, while measures of consumer delinquencies have risen sharply. In the UK, survey indicators have suggested falling inflation and wage expectations, while mortgage arrears have continued to tick up to levels not seen since 2016. Nonetheless, this moderation is occurring against a backdrop of fairly healthy economic fundamentals, and, as such, we are not anticipating a dramatic economic slowdown, but rather a gradual cooling which should allow central banks to ease policy.

Credit spreads have tightened over the first half of 2024, primarily due to supportive fundamentals and technical factors which have supported markets so far this year. Although further spread tightening potential is more limited at these levels, progress on inflation and a lowering of rates should provide ongoing support for corporate credit.

We therefore believe that current spreads offer sufficient compensation for fundamental risk, with all-in yields hovering around 5.5%, and investment-grade credit offering an attractive return profile given our outlook for both the asset class and the broader economy.

Discrete years' performance (%) to previous quarter-end**:

*Source: FE Analytics, as at 30.06.24, B share class, total return, net of fees and interest reinvested.

**Source: FE Analytics, as at 30.06.24, primary share class, total return, net of fees and interest reinvested.