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Q2 2020 Commentary

Market summary

Equity markets recovered well from their March lows following the significant monetary and fiscal responses to Covid-19 and as hopes rose that lockdowns had contained the first wave of the virus. However, market levels in the UK are still considerably lower than where they were at the beginning of the year. While this recovery was at odds with very weak economic data, some of the unofficial, high frequency indicators, such as Google mobility data, suggested the economic downturn may have passed its worst point. Sentiment was also helped by news of progress with various vaccine trials and treatments for those suffering from the worst effects of Covid-19.

The UK equity market returned 10.2% during the quarter lagging the US (20.5%) and German (24.2%) markets. The US market was aided by the strong performance of the technology sectors where the UK market is less well represented. German equities benefited from better containment of Covid-19 and its commensurately shorter lockdown. The UK equity market's weighting in the oil sector was also unhelpful.

Central banks and governments added to the already record levels of support for financial systems and economies announced in Q1. The Chinese government confirmed a new fiscal stimulus package while the European Central Bank (ECB) and Bank of England (BoE) further expanded their quantitative easing programmes. Meanwhile, the European Commission proposed a €750 billion recovery fund to tackle the after-effects of the crisis. The developments helped sentiment towards equities and risk appetite more broadly, as also reflected in the ongoing tightening of corporate credit spreads.

The cost of the government programmes announced in Q1 to cushion the blow from unemployment and the loss of income as a result of the lockdowns became apparent in borrowing figures released in Q2. While government debt to income levels are already high in many economies as a result of the global financial crisis, they now look set to rise significantly higher, raising questions about how to fund spending going forwards. Many economists became more concerned about the longer-term impact of the crisis, downgrading GDP forecasts as a result, while epidemiologists stressed the risks of a second wave of Covid-19 infections.

At its latest monetary policy meeting the Federal Reserve indicated base rates would be kept close to zero for an extended period. Meanwhile, there was speculation of negative rates being implemented in the UK after the BoE's governor told parliamentarians they were under review, although many commentators saw this as an unlikely prospect. Brexit came back into the spotlight towards the end of the period as the deadline passed to extend the transition period, which expires on 31 December 2020.

Investment outlook

Given the diversity of revenue sources for UK listed companies, the fortunes of the global economy will inevitably have significance for company profits and share price performance. The varying degrees of recovery from the pandemic from individual territories will therefore be an important consideration in coming months. Governments face a trade-off between getting the economy back to work and the Covid-19 health risks to the population. We continue to assess the portfolio and its holdings with a range of potential economic scenarios in mind as the future remains uncertain.

Our central view for the UK equity market is that the aggregate level of earnings, having collapsed in 2020, will most likely bounce back in 2021 but it will take until 2022 for overall market earnings to approximate to the level achieved in 2019. We are cognisant also of the risks of possible economic scenarios but in our view we believe the recovery is likely to be U shaped.

Evidence of an improving public health situation, including vaccine hopes, and the related expectations of the easing of lockdowns have contributed to a rally which has seen other indications of increased risk appetite in financial markets. We believe there are many exciting individual stock opportunities in the market, but it is important after the progress which the UK and other bourses have made that we are cognisant of the risk facing the market in the form of a potential second wave of coronavirus cases.

We have been engaging with companies on capital expenditure requirements, borrowing arrangements, equity issuance and dividend policy. Acquisitions and disposals have also been discussed since the dislocations experienced by countless industries are throwing up opportunities for companies to make value-accretive strategic decisions about the ongoing shape of their businesses. Our overall engagement approach has been informed by the belief that capital markets are critical in channelling support to deserving businesses with viable futures in times of crisis such as now.

We have preferred stocks exhibiting defensive qualities, reasonable growth prospects, attractive valuations and the ability to maintain dividend payments. Our portfolio does include some stocks that have cut or suspended dividend payments given the current Covid and economic uncertainties, but where we believe these companies will be in a position to resume payments in due course. Many, although not all, of these companies are more cyclical and we see good prospects for a recovery in profits and attractive valuations their robust market positions.

Quarterly overview

Equity markets recovered well from their March lows following the significant monetary and fiscal responses to Covid-19 and as hopes rose that lockdowns had contained the first wave of the virus. Generally speaking, the recovery was led by those cyclical stocks which had been hardest hit in the sell-off. Conversely, those defensive stocks which had held up relatively well in Q1 generally lagged the market rally. Growth stocks however remained sought after and continued to perform well in Q2 as they had in Q1.

NAV performance was ahead of the benchmark over the period, with returns being boosted by the fund’s gearing as the market began to recover. Positive contributors to performance included the portfolio’s holdings in a number of the more cyclical areas of the market which outpaced the benchmark. In sector terms, the decisions to be underweight banks (notably not owning HSBC) and oils (in particular the fund’s underweight position in Royal Dutch Shell) were beneficial, as was stock selection in financial services (holdings in Intermediate Capital and M&G) and life insurance (holdings in L&G and Prudential).

Not owning HSBC was the top contributor to relative performance from a stock perspective. We do not own the stock due to the economic outlook of weaker growth weighing on low interest rates and higher bad debts.

Financial services firm Intermediate Capital was the top stock contributor to relative performance over the quarter. The shares recovered much of their Q1 underperformance as investors concluded that a recovery in economies and capital markets would be supportive for the asset value of the company’s investments.

Our relatively new holding in asset management and insurance company M&G was positive as it recovered some of the sharp losses experience in Q1. Greater market stability, together with payment of their final dividend, helped close some of the mispricing.

Meanwhile, bookmaker William Hill bounced sharply from its March lows as markets responded to a quicker-than-expected opening up of its US and UK betting markets, together with accelerated growth in online gaming.

A number of our previous outperformers, specifically positions in robust businesses with strong balance sheets, lagged the rising market in the second quarter and were detractors over the period.

After a previously strong period of share price performance, defensive retailers Pets at Home and Tesco lagged the market in the second quarter, as did defensive real estate investment trust Assura and defence firm BAE Systems. We are encouraged by the continued success of the turnaround at Pets at Home while our confidence in Tesco’s competitive position, strong balance sheet and valuation is underpinned by recently executed business disposals in Asia and Poland. Our holding in BAE Systems also lost ground against the market with the more cyclical industrial companies performing better as market risk appetite increased. As an owner of primary healthcare properties, Assura, having previously outperformed, lagged the rising market due to its defensive characteristics.

Lastly, travel and leisure stocks remained weak as it became clear that they would be late to benefit from the easing of lockdown restrictions. Our holding in Premier Inn owner Whitbread underperformed as a result, while their announcement of a rights issue also surprised the market.

Discrete yearly performance (%)

	Q1/2015 - Q1/2016	Q1/2016 - Q1/2017	Q1/2017 - Q1/2018	Q1/2018 - Q1/2019	Q1/2019 - Q1/2020
Share price	-8.6	21.0	4.1	3.9	-20.2
Net Asset Value	-3.9	19.5	0.1	5.2	-21.3
FTSE All Share Total	-3.9	22.0	1.2	6.4	-18.5

Source: Morningstar, net income reinvested, net of ongoing charges and portfolio costs and where applicable, performance fees, in GBP.

The value of investments and the income from them may go down as well as up and investors may not get back the amount originally invested. Past performance is not a guide to future performance and may not be repeated.

What are the risks?

Past performance is not a guide to future performance and may not be repeated. The value of investments and the income from them may go down as well as up and investors may not get back the amount originally invested.

Companies that invest in a smaller number of stocks carry more risk than funds spread across a larger number of companies.

The Company will invest solely in the companies of one country or region. This can carry more risk than investments spread over a number of countries or regions.

As a result of the fees and finance costs being charged partially to capital, the distributable income of the Company may be higher, but the capital value of the Company may be eroded.

The Company may borrow money to invest in further investments, this is known as gearing. Gearing will increase returns if the value of the investments purchased increase in value by more than the cost of borrowing, or reduce returns if they fail to do so.

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Please remember that the value of investments and the income from them may go down as well as up and investors may not get back the amounts originally invested.

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Issued by Schroder Unit Trusts Limited, 1 London Wall Place, London EC2Y 5AU. Registered Number 4191730 England.

Schroder Unit Trusts Limited is an authorised corporate director, authorised unit trust manager and an ISA plan manager, and is authorised and regulated by the Financial Conduct Authority.

On 17 September 2018 our remaining dual priced funds converted to single pricing and a list of the funds affected can be found in our Changes to Funds. To view historic dual prices from the launch date to 14 September 2018 click on Historic prices.

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