Market & Investment Updates

Cautious Income Portfolio (GBP) Update

Andrew Hardy, CFA

25 March 2020

How has the Portfolio performed?

The Harmony Cautious Income Portfolio (GBP E accumulating class) has fallen 16.4% year to date. This compares to a fall of 20.2% for the Harmony Sterling Growth Portfolio over the same period and 23.1% for a Vanguard UK Equity ETF.

Between 19th February 2020 and 23rd March 2020, representing the recent peak through to the subsequent trough for the UK equity market as well as for global indices, the Harmony Cautious Income Portfolio experienced a drawdown of 22.1% which is smaller than the drawdowns for the Harmony Sterling Growth Portfolio (-26.2%) and the UK equity market (-33.9%).

However, the Portfolio’s downside participation rate has been higher through the recent market falls than we have observed through previous equity market corrections since inception:

What have the main performance drivers been?

Over the main drawdown period for Harmony Cautious Income nearly all asset classes have fallen materially. There was essentially nowhere to hide, except in a portfolio of cash and government bonds. (Even then, a UK Gilts ETF fell over 10% between 9th March and 18th March.)

The Harmony Cautious Income Portfolio is designed to be more defensive compared to the other risk profiles within the Harmony range, but still has a modest strategic allocation (30%) to equity markets. This, along with the strategic exposure to listed real assets (15%) has driven a significant proportion of the decline, despite our strong bias towards higher quality businesses within those asset classes. The Portfolio’s strategic allocations to fixed income (50%) has made a similar contribution to portfolio downside, given its higher weighting together with unusually weaker performance than one would have expected in this type of environment (see chart above).

Why has the Portfolio proved less defensive through the recent decline in markets?

A clear feature of market moves in the last few weeks has been the indiscriminate nature of the sell-off, which reflects a huge withdrawal of liquidity via any and all tradable securities. The effects of this can be seen through three high-level examples below, all of which are relevant to holdings in the Cautious Income Portfolio. Many of these market moves are excessive in our opinion and are creating excellent buying opportunities for long term investors. In the short term, they have made the Portfolio fall by considerably more in value than we believe is justified by the expected future change in underlying fundamentals.
Quality equities; many of the highest quality businesses globally are expected to maintain or grow earnings over this period (e.g. consumer staples businesses) or may actually emerge the other side with a stronger competitive position (e.g. cloud-based software businesses) and yet their share prices have generally fallen by as much as broader equity indices. This is providing a chance to buy leading businesses at heavily discounted prices.

Listed property and infrastructure; the underlying assets are typically defensive because in most cases their cash flows are less dependent on economic activity than other investments. Instead, their valuations are backed by physical assets and in most cases very long-term contracts. These asset classes have historically behaved like ‘bond proxies’, so usually outperform equity markets as interest rates decline. However, as with quality equities, they have sold off broadly in line with or more than broader markets. While there will undoubtedly be some small parts of property and infrastructure markets that are substantially weakened for now, such as airports and retail properties, the vast majority will remain resilient and will continue to deliver steady cashflows or dividends.

Corporate bonds; yields on most corporate bonds have increased by more and at a much faster pace than at any time since the global financial crisis, which itself represented a totally systemic type of banking crisis. At current levels markets are implying higher multi-year default rates than anything observed in history. If defaults end up being lower than those implied, as we fully expect, then this will turn out to be an exceptional buying opportunity. Note that many of these bonds are now in scope for support from central bank purchases, as part of their monetary stimulus packages, which should provide substantial pricing support for holders.

What is the outlook for returns of the Harmony Cautious Income Portfolio?

The underlying dividend yield of the Portfolio has increased to approximately 5.5% to 6.0% as at the end of March. We expect all our underlying holdings to maintain their dividend distributions, so this yield is sustainable from here. This compares to yields of below 1% for most government bond markets around the world, which have little to no capital growth prospects.
The Harmony Cautious Income Portfolio will maintain its quarterly distribution rate at 0.0095 per share (for distributing classes only). This represents a distribution yield of approximately 4.5%. Those distributions that we receive but do not pay out (i.e. the difference between the yield of the fund versus that of the underlying holdings) will accrue in the NAV as capital growth. In time we would expect to grow the quarterly distribution rate (a benefit that government bonds do not offer).

We have maintained our asset allocation through the recent market falls. We always perform detailed due diligence ahead of making any investments, so we understood the risks and sensitivities of the Portfolio well beforehand. We have not had any negative surprises from the underlying holdings, notwithstanding the severity of recent market moves, so we have not felt the need to adjust our positions or de-risk. Therefore, the Portfolio remains fully invested and fully exposed to the eventual market rebound and realignment to fundamentals as the economic picture becomes clearer. As markets have stabilised towards the end of the month, the Portfolio valuation has rebounded by approximately 6% in just four days.

Looking out further than the next six to twelve months, we believe the massive fiscal and monetary stimulus announced to date will provide long-lasting support for the valuations of equity and fixed income securities. This point is particularly relevant for the Harmony Cautious Income Portfolio, given its higher allocation to assets with steady and predictable cash flows, which should prove more valuable for the foreseeable future given interest rates are lower for (much) longer.

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