Yesterday, we wrote about Stifel Funds view on why they believe inflation may fall more quickly than many expect
Today we take a look at their views on some of the fund sectors available in their report:
- Small and Mid-Cap Funds
- Private Equity Funds
- Commodities & Mining
- Infrastructure
- Renewable Energy
Small and Mid-Cap Funds
Small and mid-cap companies tend to be relatively sensitive to interest rates both as a result of levered structures and because of the predominance of high growth companies that are relatively sensitive to discount rates in the sector. Over the year to 31/10/22, the UK Mid Cap Trust sector saw an NAV total return decline of -28%, with the discount widening to 13%, which compares with a discount range of 17% to 6% over the year. The UK Smaller Company Sector had performed in a similar way, with a -29% fall in the NAV total return. The average discount was also similar at 11%, with the 12-month range 17% to 4%. We would expect the Small and Mid-Cap funds to be one of the fastest areas to recover if the environment changes to falling inflation and lower interest rates. We have seen some clear signs of this in the last three months: the FTSE 250 Index has risen +14.4% and the FTSE Small Cap (ex IT) +15.9%, with the average discount narrowing to 9% at 03/02/23.
Private Equity Funds
The sector is sensitive to higher interest rates given the levered structures typically used in the private equity industry, and the implications of higher debt costs on company earnings has been one factor weighing on investor sentiment in recent months. Another concern has been the risk of valuation writedowns as a result of the falls in valuations of comparable-listed small and mid-cap companies, given the managers use earnings multiples in their valuation processes. We think a recovery in valuations of comparable listed companies, should be helpful for the sector. Similarly, less pressure on levered financial structures after interest rates peak would be helpful for investor sentiment. We think these factors will likely to lead to a positive re-rating and narrowing of discounts for the listed private equity sector. The funds in the listed Private Equity sector are typically trading on discounts of 30% to 40% to our expectations at the 31/12/22, and 31/03/23 valuation points
Commodities & Mining
This sector tends to be relatively sensitive to inflation, and the funds saw some sharp rises in their NAVs in the six months to March 2022. However, NAVs fell back over the summer, due to falls in the valuations of some mining companies, reflecting some pullback in commodity prices in the face of a potential recession. Over the past year, BlackRock World Mining’s price total return has risen by +26.7% (Figure 5), with the price rising by +10.1% over the past month alone, partly on hopes for a pickup in demand for commodities following China’s reopening. This enthusiasm for the sector has been reflected in relatively strong demand for the shares of many mining and commodities funds, resulting in discounts being relatively narrow. BlackRock World Mining is actually trading on a premium of around 6% to NAV at 03/02/23. This compares with its range of a 4% discount to an 8% premium over the past year. We think lower inflation may remove some of the investor enthusiasm for this sector, potentially resulting in some premium erosion and widening of discounts in such a scenario.
Infrastructure
One of the key attractions of the infrastructure sector has been its inflation linkage, with PFI/PPP projects typically making payments to their investors that are linked to RPI inflation. The funds with the highest inflation linkage are HICL and INPP. In the case of HICL, if inflation is +1% higher than assumed for all future periods, it adds +0.8% to returns and for INPP it adds +0.7%. The sector had been performing well in price and NAV terms for most of the past year, with some growth in NAVs in large part due to the high level of inflation compared with the level assumed in the manager’s models. However, the sector de-rated sharply when the UK 10 year gilt yield moved up to 4.5% in early October, reflecting concerns about the impact of rising discount rates. Whilst we are expecting discount rates to rise at the 31/12/22 valuation point, we think this may be offset by a higher inflation outturn and in some cases forex gains. With the UK gilt yield declining to 3.26% at 06/02/23 from 3.6% at the end of 2022, we think there may be scope for a marginal fall in discount rates at either the 31/03/23 or 30/06/23 valuation points assuming gilt yields are around or even below current levels at these valuation points.
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Renewable Energy
As with infrastructure, one of the attractions of the renewables sector has been the gains in NAVs from higher-than-assumed inflation. This reflects the fact that the UK subsidy schemes incorporate inflation linkage, with Renewable Obligation Certificates (ROCs) linked to the RPI inflation and the newer Contract for Difference (CFD) payments linked to CPI inflation. Another driver of rising NAV returns has been high power prices. These factors meant that NAV total returns from the sector were typically in the range of +10% to +15% over the first half of 2022. As with the infrastructure sector, we think if the inflation rate falls back from current elevated levels, the exceptional gains that we have seen from this factor will not continue in 2023; however, we would not expect lower inflation to be a significant negative, given that the managers are typically assuming relatively low inflation in the next few years. By way of example, the TRIG portfolio valuation assumes +6.0% RPI inflation for the UK in June to December 2022, +3.5% in 2023 and +2.75% thereafter.
The sector has been trading well in price total return terms over the past year to 03/02/23, with examples being JLEN Environmental +22%, Bluefield Solar +23% and Greencoat UK Wind +19%. However, the sector did de-rate from trading on a premium, to a discount in early October on concerns about a potential price cap that may be imposed on UK electricity generators and higher discount rates following the rise in gilt yields. However, the sector has rallied following the clarification around the details of the UK Government’s Electricity Generation Levy in November. There have also been some positive trading statements on Q4 performance such as from Greencoat UK Wind, which saw an NAV gain of +7.8% over the quarter.
In conclusion, in a lower inflation environment the renewable funds will not see the exceptional gains that have been delivered in the past year against a background of high inflation. However, the managers have been cautious in their future inflation assumptions, in our view, with a reversion to more normal inflation rates not having a negative impact on future NAVs given the assumptions used. We also think a lower inflation and interest rate environment could result in some decline in discount rates over time, which, other factors being equal, would have a modest positive impact on NAVs. As discussed above for the infrastructure funds, with the UK gilt yield declining to 3.26% at 06/02/23 from 3.6% at the end of 2022, we think there may be scope for a marginal fall in discount rates at either the 31/03/23 or 30/06/23 valuation points assuming gilt yields are around or even below current levels at these valuation points.
In tomorrow’s final article in the series, we’ll follow up with 5 more fund sectors.
