Kenny Watson discusses the drivers of performance for the Sustainable Future fixed income funds including changes in the economic environment.
The Sustainable Fixed Income strategies have delivered strong performance over the quarter ending 30 September 2024, with both the Sustainable Future Month Income Bond Fund and the Sustainable Future Corporate Bond Fund delivering net returns of over 3%, comfortably outperforming their respective benchmarks.
The key drivers of this performance have been a combination of the Fund's strong credit selection as well as long interest rate risk positioning. During the third quarter, the focus of many investors in the UK, US and Europe has shifted away from upside risk to inflation to downside risk to growth. This was substantiated by central bank actions with the Fed, the ECB and the Bank of England each taking first steps to normalise policy rates from their respective peaks. The most notable of these was the Fed's 50 basis point rate cut in September, with Chair Powell repeatedly referencing a 'recalibration of monetary policy', as weakening in the US labour market brought both sides of the Fed's dual mandate –price stability and full employment – into balance.
Our current outlook for developed market economies is consistent with how we saw things panning out earlier in the year. In the US, economic data was strong over the first four to five months of the year, emphasising the robust starting position of the American economy. This partly explained the underperformance of global government bond markets in the first half fo the year, with yields in other markets dragged higher in sympathy with the US moves, as the pricing of Fed cuts for 2024 and beyond was reduced.
The developments since the summer have however, forced something of a turnaround in market pricing. The US labour market has shown signs of loosening across various measures, while trends in inflation are suggesting a more benign backdrop following the upside surprises seen in earlier months. The consumer side has also shown some signs of weakness, as measures of consumer delinquencies have risen sharply. The Fed's 50 basis point cut exceeded market expectations, with Chair Powell seeking to reassure markets they were not overly concerned about the underlying economy, but rather that this was an exercise in prudence. The incoming data will dictate the speed of further moves and ultimately the terminal level of interest rates, but for now markets have largely bought into this narrative of a gradual cutting cycle.
The ECB moved earlier, having now reduced rates twice, while advocating a data-dependent approach. While the growth and inflation path may remain subject to volatility, many measures of economic activity are suggesting a drop-off in momentum. The fiscal outlook is also challenged, with many governments now facing excessive deficit procedures and a need to rein in spending over time.
In the UK, we continue to think the economic backdrop is fundamentally weaker than in the US, and that market pricing should move to better reflect this. We think longer -term structural growth dynamics in the UK also suggest that 10-year gilt yields should decline from their current levels, and that the UK should trade more like the Eurozone than the US.
The UK went through its own period of stronger than expected economic data, as GDP numbers were revised significantly higher in the first half of the year. We think that this was flattered in part by government consumption and are less confident on the outlook for the consumer, something that many forecasters are projecting as the basis of reasonably firm GDP growth next year.
Meanwhile, the labour market and inflation paths have been very interesting. While inflation has continued to decline, the progress in services inflation has been slower than we expected earlier in the year. We still think there are encouraging signs on this front however, with labour market cooling continuing across a variety of indicators, which we think should feed through to demand and weigh on services inflation going forward. Risks remain, of course, with the uncertain fiscal situation and the implications of large increases in mandated minimum wages being two aspects to watch very closely. Nevertheless, our general thesis remains intact. We are not forecasting a deep and dark recession, and our base case is that developed market economies continue to perform reasonably, with slowing growth and contained inflation, as the restrictiveness of monetary policy is dialed back. We think that yields continue to offer value here, particularly in the UK, given the economic landscape, and we remain comfortable with our long position to UK duration.
Turning to credit, we have been constructive on the outlook for corporate credit, and this has been supported by strong fundamentals, combined with favourable market technicals. Investment grade corporate balance sheets remain robust, with interest cover well above long run averages, whilst issuance remains low. Against the backdrop of volatility, credit has proven to be very resilient, with spreads flat over the quarter. We have seen periods of spread widening however, but these prove to be short-lived, and corporate bond spreads retraced this widening as markets regain their poise.
The water sector has continued to come under pressure, and our decision to exit Thames Water on sustainability grounds early in the year has contributed to the credit outperformance. What do we expect from credit and corporate bonds looking forward? We still believe that with gross redemption yields at circa 5.5% that our corporate bond funds offer significant value to investors. There is the potential for capital appreciation as well, with this driven more by underlying government bond yields moving lower, given where corporate spread levels are. In addition, when central banks loosen monetary policy against the backdrop of low to no economic growth, historically this has been a supportive backdrop for corporate credit spreads.
KEY RISKS
Past performance is not a guide to future performance. The value of an investment and the income generated from it can fall as well as rise and is not guaranteed. You may get back less than you originally invested.
The issue of units/shares in Liontrust Funds may be subject to an initial charge, which will have an impact on the realisable value of the investment, particularly in the short term. Investments should always be considered as long term.
The Funds managed by the Sustainable Future Team:
Are expected to conform to our social and environmental criteria. May hold overseas investments that may carry a higher currency risk. They are valued by reference to their local currency which may move up or down when compared to the currency of a Fund. May hold Bonds. Bonds are affected by changes in interest rates and their value and the income they generate can rise or fall as a result; The creditworthiness of a bond issuer may also affect that bond's value. Bonds that produce a higher level of income usually also carry greater risk as such bond issuers may have difficulty in paying their debts. The value of a bond would be significantly affected if the issuer either refused to pay or was unable to pay. May encounter liquidity constraints from time to time. The spread between the price you buy and sell shares will reflect the less liquid nature of the underlying holdings. May invest in companies listed on the Alternative Investment Market (AIM) which is primarily for emerging or smaller companies. The rules are less demanding than those of the official List of the London Stock Exchange and therefore companies listed on AIM may carry a greater risk than a company with a full listing. May invest in smaller companies and may invest a small proportion (less than 10%) of the Fund in unlisted securities. There may be liquidity constraints in these securities from time to time, i.e. in certain circumstances, the fund may not be able to sell a position for full value or at all in the short term. This may affect performance and could cause the fund to defer or suspend redemptions of its shares. May, under certain circumstances, invest in derivatives, but it is not intended that their use will materially affect volatility. Derivatives are used to protect against currencies, credit and interest rate moves or for investment purposes. There is a risk that losses could be made on derivative positions or that the counterparties could fail to complete on transactions. The use of derivatives may create leverage or gearing resulting in potentially greater volatility or fluctuations in the net asset value of the Fund. A relatively small movement in the value of a derivative's underlying investment may have a larger impact, positive or negative, on the value of a fund than if the underlying investment was held instead. The use of derivative contracts may help us to control Fund volatility in both up and down markets by hedging against the general market. The use of derivative instruments that may result in higher cash levels. Cash may be deposited with several credit counterparties (e.g. international banks) or in short-dated bonds. A credit risk arises should one or more of these counterparties be unable to return the deposited cash. Outside of normal conditions, may hold higher levels of cash which may be deposited with several credit counterparties (e.g. international banks). A credit risk arises should one or more of these counterparties be unable to return the deposited cash. May be exposed to Counterparty Risk: any derivative contract, including FX hedging, may be at risk if the counterparty fails. Do not guarantee a level of income.
The risks detailed above are reflective of the full range of Funds managed by the Sustainable Future Team and not all of the risks listed are applicable to each individual Fund. For the risks associated with an individual Fund, please refer to its Key Investor Information Document (KIID)/PRIIP KID.
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