• 2018 year to date returns have been flat to down outside US equities
• Given this backdrop Henderson Alternative Strategies Trust net asset value (NAV) has returned +3.1%
• Returns have been driven by a number of special situations, while significant future NAV gains have near-term catalysts
• The outlook for equities and bonds looks challenging with a backdrop of rising rates, reversal of QE & trade wars
This year has been dominated by the rise in the trade-weighted US dollar and its consequences for other assets. Global equity markets rose marginally in US dollar terms but much more significantly for sterling investors. The US has been the clear leader, returning 13.26% whilst the Eurozone is down and emerging markets suffering the most significant losses (Source: Bloomberg).
There was some divergence in major sovereign bond markets as US Treasury yields rose but German government bond yields fell. However, credit spreads (the difference in yield between corporate and government bonds) were broadly wider. The US dollar impact was clearly felt in emerging market debt and gold, which both saw meaningful declines.
Disappointing economic data, trade tensions, and political risk have all been blamed for the rise in the US dollar over the year. While the US economy remained strong following tax cuts and higher spending commitments, economic data was weaker than expected in Europe and Japan. This weakness is currently expected to have been temporary and there are signs that it is already fading.
The wider economic threat comes from the wave of trade tariffs coming out of the US. What started with washing machines and solar panels, and then moved into steel and aluminium, continues to widen in scope. Given the higher export share of the European, Japanese and Chinese economies, it is unsurprising that this is impacting their currencies and causing the US dollar to advance.
A stronger US currency has put pressure on emerging markets, which tend to have a significant amount of US dollar borrowing. Several countries have come into the spotlight as a result. Argentina has received support from the International Monetary Fund (IMF) and Turkey has seen its currency depreciate rapidly following political issues. More broadly, emerging markets have historically benefited from globalisation and any retrenchment due to trade conflict could have a meaningful impact. A rising US dollar has highlighted these issues more acutely, but in aggregate emerging markets do not appear to be particularly stressed.
European politics returned to the headlines this year, led by the fallout from the Italian election in March. Struggles to form a coalition were eventually resolved as the non-mainstream League and Five Star Movement came together. Investors were clearly wary of the new government as Italian equities fell and the yield on Italian government debt shot up from 2% to +3% over the following the months (Source: Bloomberg). Concerns are focused on unaffordable spending increases, the hostility towards the core European Union leadership and previous comments that Italy’s membership of the euro should be in question, although we are now seeing worries dissipate slightly due to the coalition implying they will stay within the EU budget.
Given this macro backdrop Henderson Alternatives Strategies Trust has returned 3.1% in NAV total return terms year to date as at the end of August. The Company has seen a widening of its discount over the same period resulting in a share price total return of -2.6%. The benchmark long-term has returned 8.4% over the same time period. Whilst this relative performance is disappointing we believe it reflects the fact that market returns this year have been extremely diverged. The United States had an average weighting of 55% in the FTSE World Index during the eight months to the end of August. This 55% weighting of the US equity market generated 7.9% or 94% of the 8.4% FTSE World Index Total Return in sterling terms over the same period. This means that the remaining 34 countries representing 45% of the FTSE World Index contributed just 0.5% to the Index level return. Indeed the FTSE World ex-US Total Return Index returned just 1.4% in sterling terms over the first eight months of 2018. Further, the US market has been driven higher by a select number of sectors in 2018, particularly Healthcare and Information Technology.
In summary, equity returns outside of the US and selected sectors have been muted or negative in 2018. The company is unlikely to ever allocate 55% to a single equity market given it is a diversified, international, multi-asset portfolio. Indeed, given weak returns globally in 2018, with the exception of US equity markets, we are pleased with the Trust’s NAV performance. We took particular comfort from the shallow drawdown the Trust’s NAV exhibited when markets fell sharply in late January and early February. Given this, we are disappointed by the Trust’s share price performance.
The highest contributing investments year-to-date have been special situations. Sigma Capital Group plc (“Sigma”) is a leading developer of private rental sector housing. Sigma Capital Group are also the Investment Adviser of the PRS REIT plc. We invested in Sigma believing that the PRS REIT plc IPO would be transformational. Year to date Sigma has returned 52%, driven by a secondary capital raise in the PRS REIT plc at the start of the year. We believe a further capital raise will provide further share price support.
EF Realisation (“EFR”) is an investment company that was established to hold and liquidate the less liquid assets of Ecofin Water and Power Opportunities plc which delisted in 2016. EFR returned 84.5% between the start of the year and the end of June, when we exited the position. The catalyst for this return was the largest investment within EFR, Lonestar Resources Inc (“LONE”). LONE has seen extremely strong performance this year driven by a recovering oil price and a return to strong growth after a period of focusing on improving the Company’s capital position via share issuance, and paying down outstanding debt.
Our worst performing holdings can mostly be explained by the poor performance in emerging markets assets with Ashmore EM Local currency bond fund, Sloane Robinson Emerging Markets fund and Schroders GAIA Indus PacifiChoice hedge fund being the largest detractors. Another significant detractor was US Private Equity holding Safeguard Scientifics Inc (“SFE”). We have been very disappointed with the share price performance of SFE especially considering during the quarter, they sold 40% of their largest position back to management at a multiple of 4x their initial investment. This exit was overshadowed by a full write off of one other portfolio company. We believe that as successful exits emerge that the share price will see a significant re-rating.
Upcoming NAV catalyst
The fund’s second largest position (5.6%) is currently CEIBA Investments Ltd, which primarily invests in Cuban commercial real estate. The investment is currently being held at a 25% discount to the audited net asset value, primarily as a liquidity discount. However, we are expecting that early in the fourth quarter the Company will list on the Specialist Fund Segment of the London Stock Exchange allowing us to remove this discount.
We see a number of reasons to be cautious on markets going forward. These concerns include but are not limited to rising interest rates, the onset of quantitative tightening, high valuations, trade wars, high levels of corporate debt in the US and mistimed US fiscal policy.
US markets have been propelled by tax cuts and fiscal stimulus in 2018 which has led to high GDP and earnings growth. One knock-on effect of this earnings growth has been a de-rating of the US equity market forward price to earnings multiple in 2018 despite the market rising by 10%. Many investors have seen this as justification to increase exposure to the US equity market. We believe that as the fiscal stimulus begins to fade in 2019 that GDP and earnings growth will normalise and the market will once again be trading at extreme valuations. Indeed on a cyclically-adjusted price to earnings basis the US market has only ever traded more expensively at two points in history, just before the dotcom crash and just before the Great Depression of 1929.
Since the 2008 financial crisis world central banks have provided significant support to investment markets through quantitative easing and interest rate cuts. We are now at the tipping point at which quantitative easing will become quantitative tightening. We believe that interest rates will rise pressuring credit spreads and lead to a re-pricing of all asset classes as the discount rates used in valuation models increase. We believe that we are also at peak support from share buybacks that have provided the equity market a significant tailwind in recent years. As interest rates rise corporates will be less willing to borrow to fund share repurchases. Another concern is the level of corporate debt in the US. Indeed debt levels are higher than they were in 2008. As interest rates rise companies will be faced with the difficult choice of refinancing at higher costs or reducing growth rates to bring interest expenses under control.
Last of all, recent years have seen rising support for populist parties and measures. At the time of writing the US has just announced further tariffs on China to come into force on September 24th 2018. We see tariffs as inflationary and wonder whether the US consumer will continue to be supportive of Trump’s policies when the price of everyday goods begins to rise. A tight labour market, more tariffs and an increasing US budget deficit despite 4% growth suggest to us that the Federal Reserve will have little choice in continuing to raise rates. This could lead to a higher US Dollar and tightening liquidity globally.
We continue to move the portfolio to a more defensive stance given these concerns. Our hedge fund allocation has been increased at the expense of listed private equity and high risk credit funds. Recently we have taken the opportunity to increase our emerging market exposure at more attractive valuations. We have also topped-up our position in Safeguard Scientifics Inc.