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Q2 2019 Commentary

Market summary

Pacific ex Japan equities gained in the second quarter in GBP terms. Trade tensions and economic risks dominated investor sentiment, while global monetary policy was another key focus. In particular, the US-China trade war escalated in May after the US raised tariffs on US$200 billion worth of Chinese imports and added Chinese telecommunications group Huawei to a trade blacklist. China countered with retaliatory tariffs on US goods. Both countries subsequently agreed to a truce and will resume trade negotiations following a meeting between their leaders in June.

Against such a backdrop, ASEAN markets outperformed. Thailand and Singapore notched big gains. The Philippines was helped by strong advances in communication services and consumer staples stocks. Indonesia, where President Joko Widodo was re-elected, also fared well.

In Greater China markets, Hong Kong benefited from the rally in financials stocks, while investors also cheered the suspension of a contentious extradition bill. Taiwan edged up as gains in consumer staples and industrials stocks outweighed declines in the healthcare sector. Conversely, Chinese stocks fell, though losses were pared in June thanks to easing trade tensions and hopes of further stimulus measures.

Elsewhere, Australia, where interest rates were cut to a record low, made notable gains. Conversely, South Korean stocks lagged the broader region, weighed down by poor corporate earnings.

Investment outlook

A shift in policy stance from the US Federal Reserve (Fed) and the Chinese authorities towards more accommodative positions have marked a significant reversal in sentiment coming into 2019.

In the US, subdued inflation data and more dovish Fed commentary have significantly altered market expectations for future interest rates, with a cut in rates now considered likely in the next 12 months in contrast to the path of steady rate hikes expected six months ago. Tapering of the Fed balance sheet is also likely to end sooner than previously thought. In line with this more accommodative stance and concerns over the impact of the trade war on global growth, long bond yields have fallen dramatically from their November highs. In a world where the US dollar remains the key reserve currency and many Asian economies need to adjust their own policy stance (at least loosely) along with the Fed to support their local currencies, this shift in US dollar money markets has positive implications. At the same time, the oil price has corrected from its October highs, which is beneficial for the trade balances of the many oil-importing economies in Asia and improves disposable incomes for consumers around the region. Supporting this view, we have recently seen interest rate cuts in India, Malaysia and the Philippines – reversing hikes put through in 2018 when external conditions were more hostile.

We have also seen an important shift in China’s policy stance in the last six months. Reserve requirement ratios have been cut and banks have been encouraged to lend more aggressively to small and medium-sized enterprises (SMEs) and the private sector. The recent acceleration in credit data suggests that local financial institutions are responding to this top-down guidance. Fiscal spending also appears to be picking up to support growth, with lower income taxes for consumers and reduced value-added tax for corporates being announced and an acceleration of some infrastructure spending coming through.

These have been seen as supportive of medium-term growth and should offer favourable liquidity conditions. Until early May this year, there was also greater optimism among investors about the prospects for a trade deal between the US and China, although more recently negotiations have stalled and restarted again, indicating that the threat of a further increase in tariffs remains a major overhang for markets.

Even so, on a medium-term view, structural deflation will mean that bond yields remain lower for longer. The demographic trend of an aging global population will underpin dividend investing in the longer term.

Overall, dividend investing is starting to look attractive again as interest rate expectations moderate and rate cuts are now considered likely in the next 12 months in contrast to the path of steady rate hikes expected six months ago. Its strong bias to quality businesses with sound capital structures and strong cash flow generation remains relevant as the nearer term growth outlook remains uncertain. In Asia, where payout ratios remain amongst the lowest globally, steeply rising profitability, historically low gearing and burgeoning free cash flows present the best conditions for dividends to surprise on the upside. The propensity for dividends to surprise in Asia is further helped by improving corporate governance and regulatory changes in the region.

Given this backdrop, we continue to tread carefully in equity markets. However, some defensive names including bond proxies have performed well and now look relatively fully valued. Our preferred areas of investment remain in select blue chip names in Australia, Hong Kong and Taiwan, across sectors including real estate, technology, consumer discretionary and banks.

We maintain a bottom-up investment approach and we continue to look for good companies where we can see a strong income case and potential for capital growth.

Quarterly overview

The fund (NAV) gained over the quarter and outperformed the MSCI AC Pacific ex-Japan Net TR GBP index.

The fund’s underweight exposure to China was the main driver of performance in a weak quarter for the country’s equity market. Our overweight in Singapore was also a significant contributor, so too stock selection in Australia.

On a sector basis, stockpicking in real estate and communication services drove fund returns.

Meanwhile, detractors geographically included stock selection in Hong Kong. Within sectors, the main detractors were an underweight in financials and stock selection in energy.

Discrete yearly performance (%)

	Q2/2018 - Q2/2019	Q2/2017 - Q2/2018	Q2/2016 - Q2/2017	Q2/2015 - Q2/2016	Q2/2014 - Q2/2015
Share price	14.0	0.5	26.7	10.3	8.6
Net Asset Value	8.8	5.1	23.3	13.5	8.7
MSCI AC Pacific ex-Japan Net TR GBP	3.9	8.1	29.9	5.2	7.6

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.

Investors in the emerging markets and the Far East should be aware that this involves a high degree of risk and should be seen as long term in nature. Less developed markets are generally less well regulated than the UK, they may be less liquid and may have less reliable arrangements for trading and settlement of the underlying holdings.

The Company invests in smaller companies that may be less liquid than in larger companies and price swings may therefore be greater than investment trusts, companies and funds that invest in larger companies.

The Company holds investments denominated in currencies other than sterling, investors should note that exchange rates may cause the value of these investments, and the income from them, to rise or fall.

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.

Investment in warrants, participation certificates, guaranteed bonds, etc will expose the fund to the risk of the issuer of these instruments defaulting. Deducting charges from capital can result in the income paid by the company being higher than would otherwise be the case and the growth in the capital sum being eroded.

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

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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.

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