M&G UK Sustain Paris Aligned Fund - Q3 2023 Review, Activity and Outlook

Global ‘Style’ Performance

From a stylistic perspective, market rhetoric is that 2023 has been a ‘growth’-driven year. Unsurprisingly, rhetoric and reality can be very different, especially when you dig into the detail. Market commentary is often expressed through an American lens, I suppose to reflect its material composition within the global index.

If you gaze across the pond to the US, then the perception of growth’s performance is entirely accurate. The S&P 500 has been powered by the explosive rise of the ‘Magnificent Seven’ (Apple, Microsoft, Alphabet, Amazon, Nvidia, Tesla and Meta). Most notably, Nvidia’s AI-fuelled 190% return year-to-date has been nothing short of astonishing.

These seven stocks account for all of the S&P’s positive returns this year. If you stripped them out then the index’s return would be flat (the index’s equal-weighted return is -1.6% YTD)¹. If you break down factor performance, ‘quality’ and ‘growth’ have outperformed ‘value’ by 20% and 33%, respectively. North American and Global fund managers with value or income mandates are finding life very difficult faced with this backdrop.

Past performance is not a guide to future performance

However, if you cast your eyes towards the UK, Europe and Japan, the story is the polar opposite. 2023 performance has been dominated by ‘value’. ‘Quality’ as a factor has underperformed in these regions by 12%, 11% and 33%, respectively. Conversely to the US, 2023 for a quality-focused UK investor has been painful. To make matters worse, within the UK, the ‘sin sectors’ of Oil & Gas and Defence have performed strongly due to the ongoing conflict in Ukraine and the emerging war in the Middle East, as well as OPEC’s relentlessly tight grip on the oil and gas markets. Those two sectors have contributed 2.9% to the FTSE All-Share’s YTD return of 1.2%, meaning that without them the UK index would have been negative.²

The unfortunate reality of all the above is that for the M&G UK Sustain Paris Aligned Fund we continue to be buffeted by the same stylistic and sector headwinds we saw during 2021 and 2022.

View from the Ground

The robust macroeconomic data seen over the last few months, despite borrowing costs hitting multi-year highs, have taken the market by surprise. Bond yields have reacted to a ‘higher-for-longer’ narrative, with the long end of the yield curve repricing in response. Up until recently, the market was pricing in Fed rate cuts in 2024 in the expectation that tight monetary policy would have started constraining economic activity. That hasn’t happened. Conversely, the labour market has remained rock-solid and consumer spending has been surprisingly resilient. Expectations for Fed rate cuts have been booted into 2025, whilst the magnitude of future cuts has also been re-evaluated lower.

The ‘soft-landing’ outlook may indeed be correct, but what we’re hearing and seeing from companies in their calendar Q3 reports, and what we’re observing in the high-frequency data, suggest a more worrisome foundation. We’re noticing multiple pockets of weakness, and although the issues seem more severe in the UK, a similar trend can be seen globally. Most notable to me are poor durable goods sales, consumer technology, hiring moratoriums, anything relating to residential new-build and RMI (repair, maintenance and improvement), industrial de-stocking and declining order books, a troughing semiconductor value chain and elongation of sales cycles (particularly software and IT).

Within management guidance, it feels like a lot of companies have baked in a strong second half of 2023. I think many companies were hoping for and expecting a pick-up in activity post the summer lull. Across various sectors, we think this recovery has failed to develop, with activity very much bumping along the bottom. It doesn’t feel like panic stations yet, but I do think the tepid lead indicators mean that profit warnings will be a regular occurrence as we move to year-end. The UK index is probably pricing-in a lot of that weakness given the 11x PE multiple. I can’t say the same for the S&P 500, which trades at above 19x forward earnings.

What intrigues me is when and if what we are seeing on the ground starts appearing in the headline economic data that influence the over-arching market dynamics. The soft-landing narrative will be tested if the long and variable lag from monetary tightening starts to rear its head. Ultimately, for the weakness we are seeing to deepen into something more sinister, it is going to have to feed through into higher unemployment. As of yet, that is showing very few signs of budging.

Portfolio Activity

It was a quiet quarter in terms of portfolio activity. To some extent that is a reflection of where valuations were and the inability for us to find truly compelling investment entry points. For much of the quarter, the market wasn’t sure about which side of the hard/soft landing fence to sit. However, towards the end of the quarter and into October that definitely changed, and suddenly we feel spoilt with investment opportunities. So hopefully my Q4 update will have more interesting portfolio activity to talk about.

We did sell one holding during the quarter: Watkin Jones. I think Watkin Jones is actually a great company. However, having gone through a couple of property downturns with them, I’ve come to the realisation that public markets will never value the inherent volatility of its business model. Its capital-light nature means that the company needs institutional capital to fund its developments. The problem is that this capital is prone to being turned on and off depending on which direction the macroeconomic winds are blowing.

We’ve now seen that capital pulled from underneath the company twice in three years. Without capital feeding the development funnel, the conveyor belt nature of its projects grinds to a halt. There is definitely structural growth in both student and build-to-rent flats, but over the long term the company will have to face sporadic funding vacuums. For me, that is probably a model more suitable to private ownership than public markets.

Fund performance

Past performance is not a guide to future performance.

Quarterly, YTD (%), and rolling years performance (%pa)

Calendar year performance, five years (%pa)

Benchmark = FTSE All-Share Index

The benchmark is the target for the fund’s financial objective and is used to measure the fund’s financial performance. The index has been chosen as the fund’s benchmark as it best reflects the scope of the fund’s investment policy.

The benchmark is also used to define a Low Carbon Intensity Company. The fund manager considers the fund’s weighted average carbon intensity against the benchmark when constructing the portfolio, but the benchmark does not otherwise constrain portfolio construction.

The fund is actively managed and within given constraints, the fund manager has freedom in choosing which investments to buy, hold and sell in the fund. The fund’s holdings may deviate significantly from the benchmark’s constituents and as a result the fund’s performance may deviate materially from the benchmark.

The fund changed its name, investment objective and investment strategy on 13 July 2022. Prior to this date, the fund was named M&G UK Select Fund. Fund performance before this date was therefore achieved under different circumstances.

Source: Morningstar, Inc., as at 30 September 2023, GBP Class I Acc shares, income reinvested, price-to-price basis. Benchmark returns stated in share class currency.

Please note that the fund invests mainly in company shares and is therefore likely to experience larger price fluctuations than funds that invest in bonds and/or cash.

Further risks associated with this fund can be found in the fund’s Key Investor Information Document.

¹Source: M&G, Bloomberg, 22 October 2023
²Source: Blackrock Aladdin, 22 October 2023