Firstly, we had material declines in stock markets in February and March.
The February correction appears to have been an adjustment to investor sentiment, which had become rather bullish about the outlook for 2018 (share prices reached record highs in January).
The March correction was more fundamentally focused as it coincided with President Trump’s first announcement of the plan to impose tariffs on some US imports from China.
Markets have resumed an uptrend so far in the second quarter, but the US/China trade disputes are no nearer a resolution and in late May we have the spectre of ongoing Italian political instability heralding a summer with the eurozone back on the front pages.
Despite these ongoing challenges we are not seeing signals of an impending recession in the major economies and we continue to expect a year of robust earnings growth.
Equity valuations are no longer particularly elevated, whereas bond prices remain stretched.
One new holding added to the portfolio in the first quarter was Schlumberger, the world’s largest oil services company.Equities continue to be relatively attractive and we maintain our overweight position in the asset class, along with a corresponding underweight in bonds.
Within equities, we are overweight industrials, specifically those which can grow free cash flow on a sustainable basis without being too expensive.
In the technology sector, we continue to have meaningful exposure but remain highly selective as we do not expect a repeat of 2017 when a narrow field of stocks led the market.
That said, we are still very positive on Amazon, which continues to move higher on expectations of strong operating momentum and with less risk of potential regulatory oversight than the social media names.
Our chief areas of underrepresentation are utilities and banks.
We have concerns about both the growth prospects and return profile of banks as the era of cheap funding from quantitative easing comes to an end.
We also see growing signs that digital disruption and alternative sources of loan financing could undermine traditional banking models in the future.
One new holding added to the portfolio in the first quarter was Schlumberger, the world’s largest oil services company.
It offers superior technical expertise, equipment and oil field data that helps its customers to improve efficiency, thereby lowering their costs.
Over the past few years, we have witnessed a sustained period of low capital expenditure in the oil sector, as lower oil prices drove subpar returns on capital and shortfalls in cash flow.
Companies have consequently depleted their reserves to the low end of historical norms. At some point, production levels will have to increase to replace this used inventory and Schlumberger’s revenues are directly linked to this increase in activity.
Although one should expect a time lag between a rising oil price and increased spending, there are early signs (beyond US shale producers) that this is starting to occur, which may also give Schlumberger’s management the opportunity to increase pricing for the first time in many years.
Our US analysts conclude that current expectations underappreciate the company’s potential recovery in sales, margins and free cash flow, especially given the superior profitability of its international operations, and we believe the shares represent good value at current levels.
Union Pacific, another recent holding for the fund, is a US railroad company with 32,000 miles of track, transporting freight.
Revenues are strongly linked to the US industrial cycle, which has been experiencing something of a renaissance, and rail remains the most efficient way of transporting bulk goods.
Rail pricing is generally 10 per cent below its key competitor, trucking, due to the lack of door-to-door delivery that trucks offer.
Union Pacific may also benefit from a number of structural problems facing the trucking industry, including driver shortages and significant wage inflation, forcing truck companies to increase prices.
This has, in turn, allowed the railroad operators to increase pricing but without the equivalent increase in costs, and Union Pacific has concurrently been investing to make its network more efficient.
The company benefits from having very long tracks with far fewer stops than peers which, on the whole, operate in smaller geographic regions. This enables Union Pacific’s trains to run faster and ultimately earn a higher return on the company’s assets.
Our US analysts think that this blend of pricing power and focus on efficiency will lead to significant cash flow growth and outperformance.
In conclusion, while we remain very much on the lookout for signs that there will be a change in the positive earnings trend, we continue to find good investment ideas and are happy to run our overweight equity position.
Alexandra Buchan is co-manager of the Waverton Portfolio fund
