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Will ‘peak pension freedoms season’ return after pandemic-induced withdrawals slump in 2020?

This email was received yesterday, 11/04/2021, and this article was written by Tom Selby, a Senior Analyst at A. J. Bell.

Until 2020, the beginning of a new tax year has traditionally been peak pension withdrawal season, with UK savers taking advantage of a fresh set of tax allowances to access larger amounts from their retirement pots.

In fact, before the pandemic hit withdrawals in the first three months of the financial year had been between 10% and 33% higher than in subsequent quarters.

That all changed last year, when retirement income investors spooked by the uncertainty of lockdown – not to mention double-digit market falls – tightened their belts, with year-on-year withdrawals dropping 17%.

This likely reflected people choosing to either delay accessing their pension, pause withdrawals or reduce the amount they were taking as income in the face of profound uncertainty.

While most of us still have fewer things to spend our money on at the moment – particularly given restrictions on foreign travel – the success of the coronavirus vaccine and more stable market conditions mean we should expect to see a significant jump in withdrawals in the coming quarter.

For those accessing their retirement pot during this period, there are various pitfalls and bear traps to watch out for.

Source: HMRC

1. Taking taxable income flexibly from your pension will trigger an irreversible £36,000 cut in your annual allowance

Anyone considering taking taxable income from their retirement pot for the first time needs to be aware of the severe impact it will have on their ability to save tax efficiently in a pension in the future.

Taking even £1 of taxable income will trigger the money purchase annual allowance (MPAA), reducing the amount most people can save in a pension each year from £40,000 to just £4,000.

Furthermore, if you trigger the MPAA you will lose the ability to ‘carry forward’ unused pensions allowances from up to 3 previous tax years, meaning in some cases the impact will be a £156,000 reduction in the potential annual allowance in the current tax year, from £160,000 to £4,000.

To avoid an annual allowance cut, savers who have the option should consider using money held in vehicles such as ISAs or cash savings accounts first. For those who only have their pension, just taking your 25% tax-free cash will also allow you to retain the £40,000 annual allowance.

2. Your first taxable withdrawal will be subject to emergency ‘Month 1’ taxation

Since the pension freedoms launched in April 2015, around £700 million has been repaid to savers who were overtaxed on taxable withdrawals.

When you first take a flexible payment from your pension, HMRC will automatically tax it on an emergency ‘Month 1’ basis. This means that the usual tax allowances are divided by 12 and then applied to that first withdrawal.

For example, if someone made a £12,500 taxable withdrawal in 2020/21 and had no other taxable income, they might expect to be charged 0% income tax as the withdrawal is within their personal allowance.

However, because it is their first taxable withdrawal only £1,042 (£12,500 personal allowance divided by 12) is taxed at 0%. The next £3,125 (£37,500 basic-rate tax band divided by 12) is taxed at 20%, with the remaining £8,333 taxed at 40%.

In total, rather than paying zero tax they would face an initial – potentially shocking – bill of £3,958.

For those taking a regular income this shouldn’t be a problem, as any overpaid tax in the first month will be ironed out via your tax code. However, where it is a single payment over the tax year there are two options – wait until the end of the tax year for HMRC to hopefully sort it out, or sort it out yourself by filling out one of three forms.

Once you’ve filled out and sent off the relevant form, HMRC says you should receive a refund of your overpaid tax within 30 days.

View the tax refund form

  • If the withdrawal used up your entire pension pot and you have no other income in the tax year, use form P50Z;
  • If the withdrawal used up your entire pension pot and you have other taxable income, use form P53Z;
  • If the withdrawal didn’t use up your pension pot and you’re not taking regular payments, use form P55.

3. Think about the sustainability of your retirement plan – and beware big withdrawals during falling markets

Last year saw the first bear market – characterised by falls in stocks of more than 20% – since the pension freedoms launched in 2015. The pandemic and global economic shutdown brought into sharp focus the importance of understanding the investment risks you are taking and managing withdrawals sustainably.

This is particularly the case where large withdrawals come at the same time as big falls in markets, a phenomenon often referred to as ‘pound-cost ravaging’.

As an example, someone taking a 5% inflation-adjusted income from their fund who suffered a 20% hit in their first year of drawdown and 4% growth thereafter could see their pot run out after 18 years – three years sooner than if they suffered the hit 10 years into retirement.

To put this into context, whilst on average life expectancy at 65 is 18.6 years for men and 21 years for women, a man has a 1 in 4 chance of living another 27 years, while a woman has a 1 in 4 chance of living another 29 years.

Savers wanting to manage withdrawals sustainably and avoid selling down their capital at a low point in the market could use other cash resources – such as ISAs, savings or their 25% tax-free cash – in order to keep their underlying pension intact.

Taking a natural income has also been a good strategy previously, although finding companies paying the dividends needed has been a real challenge over the past 12 months.

For those who do take capital withdrawals from their pension, the key is to have a plan in place and review your income strategy regularly, ideally with the help of a regulated adviser, to ensure you aren’t risking running out of money early in retirement.

4. If you’re just taking your tax-free cash, don’t forget about the remaining 75% of your fund

The vast majority of savers cite accessing their 25% tax-free cash as the main reason for entering drawdown*. This is understandable given this is one of the main tax benefits of saving in a pension.

Although accessing your tax-free cash won’t necessarily mean a change in your underlying investments, it is worth using this as an opportunity to review your retirement plans and ultimate goals.

For example, someone planning to take a regular income after accessing their tax-free cash will likely have a different asset allocation to someone who doesn’t plan to touch the remaining money for 15 years.

While many will understandably be spooked at the prospect of investing at the moment, it is worth remembering that short-term volatility has historically been the price you pay to enjoy longer-term growth.

Investors also need to be aware of and comfortable with the risks they are taking.

Although investments can go down in value as well as up, the value of cash will be eaten away by inflation over time.

5. Do you want to spend your pension or leave it to loved ones after you die?

Pensions are no longer just about providing an income in retirement. Since 2016, savers have been able to pass on leftover pensions tax-free if they die before age 75.

Where the pension holder dies after age 75, the remaining funds will be taxed at their recipient’s marginal rate when they make a withdrawal.

For those who want to leave assets to loved ones, it therefore often makes sense to leave as much of your pension untouched as possible in order to minimise your tax bill.

This means when you come to flexibly access your pension for the first time, you should think not just of your retirement income strategy but also your IHT plans.

It’s also important to ensure your nominated beneficiaries are up-to-date so the right people inherit your pot.

Useful input from Tom at A. J. Bell.  There is nothing new here, since the new ‘Pension Freedoms’ were introduced in April 2015 we have had the freedom to withdraw capital and/or income from age 55 from our fund value based pension pots with greater flexibility.

However, we have had some form of Pension ‘Drawdown’ legislation in place since 1995.

This is a key area for independent financial advice.  The pitfalls are substantial if you don’t fully understand what you are doing.

In general terms, it’s probably better for the majority of the population not to access their pension funds until they retire or at least semi retire.  There are exceptions to this.

My focus as an IFA is in the following areas:

  1. Overall tax efficiency, holistically and with your partner if applicable
  2. Sustaining your pension assets for potentially a long-term retirement.  We are living longer on average
  3. Retaining your ability to fund pensions at a good level if at all possible
  4. Building your assets for your eventual full retirement, a variety of assets to aid tax efficiency and risk control

Retirement planning is not a ‘one size fits all’ approach.  We need to carefully take into account our client’s circumstances, plans and objectives.

The earlier you start planning for retirement the better.  We can do a lot more with a 15 year term to retirement than we can with a few months.  However, even if you are coming to this ‘Pension Freedom’ late, near drawing benefits, please do take advice.

Steve Speed

12/04/2021

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The Silicon Valley of Green Tech?

Please see the below article from Invesco:

The health crisis of 2020 created a synchronised economic depression requiring equally radical policy responses.

Europe’s response was the creation of a €750bn European Recovery Fund. However, rather than just deploy the capital, member states chose to focus on a Green Recovery and hence use the funds to address the existential threat of climate change. In practice this means the European Commission spending is being guided by the newly developed sustainable finance taxonomy. Promoting activities supportive of the environmental objectives of climate change mitigation and adaption:

  • Sustainable use and protection of water and marine resources
  • Transition to a circular economy
  • Pollution prevention and protection of biodiversity and ecosystems
  • It also contains criteria that ensure activities ‘do no significant harm’

European environmental legislation is not new. For years Europe has been a first mover in safety standards and best practices that become global standards, however, the European Green Deal marks a more dynamic approach. Taxonomy is the means by which the market will administer the carrot or the stick to companies. Winners will be those seen to solve the environmental crisis and losers will be those thought to be the cause.

This comes at a time of other changes to the investment landscape. Savers now demand their asset managers embed sustainability into allocation decisions. Fund regulation is playing its role too, through the deployment of SFDR this year, funds will be classified dependant on embedding ESG principles thereby making it easier for savers to pick compliant funds and avoid others. Lastly, the pandemic has created the political cover to deploy the significant European Recovery Fund to sustainable companies.

Combined these elements create the foundations for success. European companies that comply with taxonomy will see their cost of capital fall vs those that don’t.

The EU Recovery Plan is interlocked with the Commissions’ 2019-24 priorities that included the realisation that “Europe needs a new growth strategy that will transform the Union into a modern, resource efficient and competitive economy”. This is an inclusive plan with The Just Transmission Mechanism’s goal that ‘no person or place left behind’. At least E150bn is being made available to address socio-economic effects of the transition out to 2027 – a topic we discuss in greater detail in another piece (link to The Just Transition article). However, the real prize isn’t intra-Europe it’s global.

The goal of climate neutrality requires significant investment and innovation. If the transition is effective through taxonomy rewarding companies in the transition phase, we will grant our existing enterprises a competitive advantage though access to the cheapest capital. This will create more dynamism through more innovation and the creation of products, services and refreshed skilled jobs to achieve all the EU goals. Brown companies can become Green.

This idea of creating a pathway isn’t new. Europe has 2030 targets not just 2050, including transition plans for hybrid ahead of full electric vehicles, coal to gas electricity generation and developing blue hydrogen ahead of green hydrogen being viable. Through this approach we can incentivise European companies to allocate their existing cashflow towards green innovation as opposed to being forced into ever larger dividend yields.

Silicon Valley is perhaps the best example of the prize on offer. The birth of Silicon Valley was a confluence of skilled science-based research, education, venture capital and defence spending, particularly through the creation of NASA and the space race. The success and longevity of which is a function of being the first and with it a sustainable multiplier effect.

We are already starting to see the positive effects from this focus on transition. European oil companies lead the way in reallocating hydrocarbon cashflows towards greener alternatives (Total, Repsol, BP). In renewable energy, Europe is home to the leading wind turbine manufactures (Vestas, Nordex and Siemens Gamesa) and our power generators are world leaders in green production (Enel, EDP, Acciona). In technology, European semiconductor companies have leadership in Auto electrification (Infineon and STMicro). We also have expertise in building materials and renovation focused on reducing energy consumption (SaintGobain, Wienerberger, Kingspan). Europe’s paper companies are transitioning to sustainable packaging and biofuels (UPM) and Europe is home to worldwide leaders in the circular economy (Veolia and Suez). All are stocks that are held in portfolios across the team, to a varying degree.

Europe has grand ambitions and a once in a generational opportunity to steal a march on other continents through early adoption of regulation and technology. Through incentivising companies to innovate and embrace climate change Europe can become a global exporter of Greentech products and services to the rest of the world and enjoy the multiplier effect. Europe has the potential to achieve net zero and in doing so become the Silicon Valley of Green Tech including the vibrancy, jobs and sustainability that comes with it.

Please continue to check back for a range of blog content and regular updates from us.

09/04/2021

Andrew Lloyd

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Brewin Dolphin – Markets in a Minute

Please see below this weeks update on markets from Brewin Dolphin. This update was received late yesterday afternoon:

Please continue to check our Blog content for advice and planning issues and the latest investment, markets and economic updates from leading investment houses.

Please keep safe and healthy.

Carl Mitchell – Dip PFS

IFA and Paraplanner

08/04/2021

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Invesco Insights: Israel’s economic data starts to show the impact of vaccines

Please see below for one of the latest Invesco Insight articles written by Kristina Hooper, Chief Global Market Strategist at Invesco Ltd. This article was received by us today 07/04/2021:

A month ago, I wrote about the great progress Israel was making in terms of inoculating its citizens against COVID-19. At the time, I said that we would want to follow economic data in Israel closely for indications of what the US and UK could expect in the near future — as they are making swift progress in vaccinating their respective populations — as well as what any country can expect once it successfully vaccinates a significant portion of its population. Therefore, I think it’s worth re-visiting Israel to see the impact that widespread immunization has had on its economy. It’s clear that Israel’s vaccination program is not only having a substantial impact on consumer confidence, but also on spending.

Israel’s data shows the impact of vaccines

While vaccinations only began in December, they ramped up quickly. As of April 4, Israel has given at least one dose of a COVID-19 vaccine to 59% of its population, with 54% fully vaccinated.1 The economic impact was seen relatively early on. As morbidity moderated, restrictions eased and the third lockdown was rolled back — and the Bank of Israel’s Composite State of the Economy Index for February increased by 0.4%.2

Mobility, which we have found to be a helpful indicator of economic activity, has increased substantially. By the end of March 2021, retail and recreation mobility (restaurants, cafes, shopping centers, movie theaters, etc.) was off by only 6% from January 2020 levels, while grocery and pharmacy mobility is actually higher than those early 2020 levels.3 And, not surprisingly, economic activity accelerated in March. Daily credit card data shows that the value of transactions for the week ending March 22 was actually 15% higher than it was in January 2020.4 By comparison, back in April 2020, the value of transactions was more than 40% below its level in January of 2020.4 The rebound in spending has been strongest in some of the areas hardest hit by the pandemic, especially leisure and tourism.

Why is this time different?

What makes this time different than past economic re-openings, like we saw in spring 2020? Before broad vaccinations, the re-opening of an economy was a double-edged sword. Typically, a re-opening would often be followed, after a lag, with an increase in COVID-19 infections. In addition, the increase in economic activity would typically be tempered because some consumers would be reluctant to go out and spend despite the re-opening because of health safety concerns.

I believe this time is different because vaccinated consumers will be more likely to re-engage in pre-pandemic economic activity and, according to medical research, should be well protected against COVID-19 — so spending should not be tempered as in past re-openings. Israel’s re-opening is already proving that vaccinations are leading to an uptick in consumer activity, and they haven’t seen another wave of COVID-19 infections.

A preview of what’s to come in the US and UK?

In my view, Israel’s current state illustrates what we can soon expect in countries such as the United States and then the United Kingdom — and in any country once it has achieved broad vaccination of its population. In the United States, 31% of the population has received at least one dose of a vaccine, and 18% have been fully vaccinated.1 In the United Kingdom, 47% of the population has received at least one dose of a COVID-19 vaccine, although only 7.8% of the population is fully vaccinated.1

The US economy is already seeing significant improvement, further helped by fiscal stimulus. For example, the March employment situation report saw a far-better-than-expected increase in non-farm payrolls at 916,000.5 And we just got the ISM Services PMI for March, which was also far better than expected, clocking in at 63.7 with all 18 services industries reported growth.6 The only problem is that COVID-19 infections are on the rise in some states in the US, so vaccinations will need to maintain momentum in order to slow and ultimately stop the rise in infections.

The UK is a bit more complicated and hasn’t shown as much improvement yet because it remains at a relatively strict level of pandemic-related lockdown, although stringency is being eased gradually.

Investment implications

I expect that rising vaccinations and improving economic data are likely to lead to a continued rise in bond yields and outperformance of smaller-cap and cyclical stocks, especially in countries that are leading the recovery.

I should add that in the US, there are a few clouds on the horizon in the form of growing fears of rising taxes. And that is likely to be the case for a number of countries burdened with higher debt levels created by the pandemic. While far from a reality at the moment, if an increase in taxes becomes more likely — especially a large increase in corporate taxes – we could see some shift in leadership, albeit modest, to larger-cap and more defensive names. However, it’s important to stress I don’t believe this would end the stock market recovery, but could just cause some rotation in leadership.

But right now, the focus is on the virus and vaccinations. As the Brookings-FT Tracking Index for the Global Economic Recovery has indicated, the ability to control COVID-19 is likely to be the main determinant of economic success in 2021.7 That is why the index shows major economies such as China and the US leading the global recovery. The index suggests that there may not be a coordinated global economic rebound, but that instead there may be a time lag for some countries, especially Europe and Latin America, given their lack of progress in vaccine rollout and general difficulties in controlling the virus. This isn’t surprising — and it’s something we anticipated last year when putting together our 2021 outlook. In other words, we believe an economic recovery is in the future for all parts of the world, but its timing and strength will be dictated by control of the virus and vaccine rollout progress, and so we will want to follow this data closely.

Key takeaways

Recent data has been positive

Mobility, which we have found to be a helpful indicator of economic activity, has increased substantially in Israel.

A preview of what’s to come?

In my view, Israel’s current state illustrates what we can expect in countries that achieve broad vaccination of their populations.

What might this mean for stocks?

I expect this economic recovery to be very robust, which may lead to outperformance by smaller-cap stocks and cyclical stocks.

Please continue to utilise these blogs and expert insights to keep your own holistic view markets up to date.

Keep safe and well.

Paul Green DipFA

07/04/2021

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Weekly Market Commentary – Gains for equities despite European lockdown concerns

Please see below detailed economic and market news update received from the in-house research team at Brooks Macdonald yesterday afternoon.

A far stronger than expected US employment report spurs gains in equities

While Europe was on holiday, a bumper US jobs report on Friday drove risk assets higher on both sides of the Easter weekend. Survey data also beat expectations, and this was enough to allow equities to look through the pickup in global COVID-19 numbers.

The closely watched minutes from the March Federal Reserve meeting are released on Wednesday

The number of new jobs created in the US in March hit 916,000, far in excess of expectations of 660,0001. Standout areas included leisure and hospitality sectors, which are both reopening after being the hardest hit areas from the curbs on activity. The broadest measure of US unemployment, U-6, which includes not only the unemployed but those that are underemployed or discouraged from the workforce, fell but remains in excess of 10%2. For context, this measure was at 6.9% in January 20203 before the pandemic hit and still points to a sizeable gap until the US economy returns to ‘full’ employment. This elevated level of broad unemployment is often cited by US Federal Reserve (Fed) Chair Powell as a sign of the economic output gap that needs to be filled before inflationary pressures could become sustained. 

Since the Fed meeting in March, we have seen the market price in additional rate hikes as the vaccine rollout continues amidst the aforementioned stronger data. The Fed’s last statement said relatively little about how the bank would respond should benchmark Treasury yields continue to rise. As a result, this will be keenly watched for in the minutes released on Wednesday. The disconnect between what the market believes will occur and Fed guidance is widening by the day, so any sign that they will take concrete action will be important for the central bank to remain in the driving seat. This week also sees the European Central Bank minutes released on Thursday, where investors will be looking for further guidance on the pace of quantitative easing purchases over the next few months.

Third COVID-19 wave concerns continue in Europe as France enters lockdown

The counter to the data optimism is the third wave of the coronavirus pandemic which has caused Europe to move further towards lockdowns, with France beginning its lockdown over the weekend. This will remain a hot topic this week as the complicated interplay of vaccine rollouts and rising cases continues to muddy the short-term economic outlook.

Although the UK has been successful in its vaccine rollout so far, it is important for Europe and the rest of the world to achieve mass-vaccination as well. We will continue to publish relevant content as the lockdown rules continue to be relaxed.

Stay safe.

Chloe

07/04/2021

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Engagement with BP and Shell on the transition to a greener future

Please see the below ESG case study article from Invesco:

The below case study pertains to engagement within our UK equities team, which are a part of the Henley Investment Centre. While guided by our central ESG team, all of our investment professionals ultimately have discretion in their ESG decisions, and do not all follow the same approach. Learn more about how we integrate ESG across our wide range of strategies here.

Responsible oil and gas companies have a critical role to play in being part of the solution to environmental problems: in helping enable the global economy to successfully transition as rapidly as possible, and in a sustainable manner, towards targets for much reduced global emissions.

This can be achieved through actions taken by companies to successfully manage down a sustained decline in output of oil & gas, while at the same time maximising cash flows from operations for investment in new low carbon energy businesses.

Investing in oil companies that set out to achieve these objectives – and holding them accountable – is we believe entirely consistent with true responsible investing, which incorporates environmental, social, and governance (ESG) criteria into the investment process.

Whatever the moral burden that should fairly be borne by UK-listed companies, such as BP and Shell, for their historical actions, what is important for investors to understand is how the oil companies themselves now fit into the global industry.  Investors want to know what the impact of oil companies will be on that industry and on society, going forward: what role they have to play in the future.

How BP and Shell are transitioning towards a greener future

Although many investors focus on oil & gas producers as large Scope 3 emitters of carbon, if the world is to achieve net zero emissions in 2050 it ultimately requires reform of demand, and not just supply.

Supply in the industry (in the long run) very closely mirrors actual demand (the easiest place to store oil is still in the ground!). It is important here to also reflect that the global publicly quoted US and European oil companies only account for around 12.3 mb/d out of total current production of approximately 100mb/d, with US privately owned production around a further 8mb/d.

Put another way, state owned oil production (including Saudi Aramco) accounts for almost 80% of global production. The reality is that any cuts in production by any of the publicly quoted oil majors does not in itself affect global oil demand.

BP turning off the taps tomorrow would have a negligible effect on global carbon emissions. The same emissions will still be made but fuelled by output from another supplier who is less accountable to investors.

Responsible oil companies do, though, have a very significant role to play in accelerating a sustainable transition to low carbon alternatives that can reduce demand for fossil fuels by providing a viable substitute product.

For example, BP and Royal Dutch Shell are both actively involved in promoting the transition through defined strategies that look to maximise cash flows from existing carbon resources, and then re-allocate cash flows to low carbon alternatives.

Because of the many and varied uses for oil as a fuel, as a key component in a wide range of everyday products, and the practical limitations associated with various alternatives currently available, the process of transition is likely to be gradual. It is clearly both necessary and highly likely that demand for oil will reduce over time, however we do not foresee at any time in the next ten years at least, a “Kodak moment” for oil.

Our role as responsible shareholders will encourage positive change

An investor in BP or Shell who is willing to support, encourage and also hold the company to account during its transition period is, we believe, able to be well rewarded financially, through dividends and share buy backs, as well as by the prospect of owning a new “low carbon” and retail business whose growth has been fully funded from existing company resources.

Responsible oil & gas companies such as BP and Shell therefore have a critical role to play in being part of the solution: in helping enable the global economy to successfully transition as rapidly as possible, and in a sustainable manner.

This objective can be achieved through actions taken – with the support of shareholders – to successfully manage down a sustained decline in output, whilst at the same time maximising cash flows from operations for investment in new low carbon energy businesses.

We believe, investing in oil companies that set out to achieve these objectives, and holding them accountable, is entirely consistent with our philosophy of responsible investing, which focuses on engagement and dialogue with portfolio companies, and not simple divestment if there is something that we don’t like.

We expect big companies in this sector will be investing capital at scale in renewable energies and are well placed to manage large and complex engineering projects in hostile natural environments.  Again, the sector is part of the solution rather than just part of the problem.

Our engagement and dialogue – in practice

As active fund managers, ESG integration and dialogue is an important consideration for us. Over the past three years we have regularly engaged with various members of the Boards and Management Teams of both BP and Shell, on ESG matters in general, and on carbon emissions in particular.

In the case of BP, for example, we have had meetings with the BP Chairman to discuss the risks and opportunities associated with their carbon transition plan.

We have also provided feedback to the chair of the remuneration committee to ensure management incentivisation is aligned to group strategy and their environmental targets.

Furthermore, we have engaged with independent board members and attended company strategy sessions. The enhanced monitoring of our BP position over the last three years means that we believed that the strategy and objectives the company was setting were achievable.

Our engagement enables us to measure the board and management against their strategy and objectives. We believe there are good returns to be made from businesses which transform to become fit for the future.

When it comes to ESG or socially responsible investments, its important not just to use the traditional ethical investment screening (i.e. staying away from certain companies/ sectors etc), but to engage with companies to help deliver positive change.

By engaging with companies and holding them accountable, it forces them to think about the future, their practices and operations and helps to guide them into a better way of thinking.

It’s not about steering clear of companies or disinvesting if something happens investment managers don’t like, but about engaging with them, providing feedback and guidance about how they want things to work.

Positive engagement will help everybody to learn and adapt to what seems to becoming (or will become) an industry standard in how ESG processes are embedded into companies and the industry as a whole.

Keep checking back for more ESG related content from us along with our usual market commentary, planning points and other key issues we like to keep you up to date with.

Andrew Lloyd

06/04/2021

Team No Comments

J.P. Morgan – The impact of ESG factors on portfolio returns

Please see article below from J.P. Morgan which looks at the impact of ESG factors on portfolio returns, received 29/03/2021

The ESG factors that we expect to drive markets are at their infancy in terms of both introduction and market impact.

Karen Ward

How does incorporating information on environmental, social, and governance factors affect the performance of a portfolio?

Does incorporating these factors put a portfolio on a better footing to cope with a changing world and enhance returns? Or does ‘doing good’ with your capital come at a cost?

What about volatility? Does accounting for a wider range of future risks reduce the bumps? Or, by excluding sectors and companies, do we end up with a more concentrated and therefore more volatile portfolio?

In this piece, we look at this deeply complex issue. Empirical backtesting to gauge relative performance is fraught with practical difficulties, largely due to the lack of  quality historical data on which to score companies, though preliminary analysis suggests there is a relationship between ESG score and asset return.

There are also reasons to question whether historical analysis of this topic serves much purpose in thinking about future performance. Consumer preferences and regulatory and policy initiatives to tackle environmental, social and governance issues are moving at such pace that investors who are ahead of the change might be expected to see portfolio benefits, as certain recent events have demonstrated.

This paper lays out the issues that will be explored in more detail in our 2022 Long-Term Capital Markets Assumptions, which will be released in autumn this year.

Historically difficult to test

Before looking into preliminary results, it is worth pointing out some significant caveats to our ability to back-test the performance hypothesis. Problems arise in how to score a company on its E, S and G characteristics. There are external ratings agencies that provide company ‘scores’ but there are three issues worth remembering.1

First, methodology can be opaque and subjective and different providers often produce conflicting scores. A well-known electric vehicle producer is an oft-cited example: it is rated highly by one rating agency for its green credentials and poorly by another based on the agency’s assessment of its governance.

Second, coverage of companies isn’t always complete, and is particularly sketchy for smaller companies and in fixed income markets. In emerging markets, language issues can also be a barrier to the collection of accurate data.

Third and finally, the further we go back in time, the more likely it is that the scoring data does not adequately capture the real- time ESG challenges. The data may not have been available or disclosed at the time, and, more importantly, the data that is actually relevant to asset pricing has likely changed over time. Twenty years ago, governance may have been the biggest non- financial metric of concern for assessing the sustainability of corporate performance. Today, environmental issues are increasingly moving into sharper focus, as is the diversity of the workforce.

These data issues suggest we should be careful about leaning too heavily on backtesting. However, with these statistical caveats in mind, Exhibit 1 – which ranks companies using J.P. Morgan Asset Management’s proprietary ESG scores – suggests that there does appear to be a relationship between ESG score and performance relative to benchmark.

We will do future work on this question ahead of the publication of our Long-Term Capital Markets Assumptions, in order to assess the statistical significance of the relative performance, whether the relationship changes through time, and the relative importance of E, S, and G factors by region. Another important question requiring further exploration is whether it is the absolute ESG score or the change in the score that matters.

Exhibit 1: Mean active return by ESG quintile

% active return

Source: J.P. Morgan Asset Management. Charts show the mean active returns of the top and bottom quintile portfolios based on JPM proprietary quantitative ESG score, excluding transaction costs, in USD. Calculation periods are 31/12/2012 – 26/02/2021 for ACWI, Europe and North America and 28/02/2013 – 30/11/2020 for EMAP. Figures are shown as an annual rate. ACWI portfolios and benchmark constructed in the MSCI ACWI IMI universe filtered by market capitalisation > $1 billion, Europe portfolios are constructed using the Europe constituents of the aforementioned universe, North America portfolios are constructed using the North America constituents of the aforementioned universe, EMAP portfolios are constructed from the MSCI Emerging Markets index, stocks are weighted equally across the universe. Past performance is not a reliable indicator of current and future results. Data as of 28 February 2021.

It may be that the answer is ‘both’, with ‘good’ companies benefiting from macro news such as regulation and policy announcements and improvers representing company-specific or micro developments. We also need to evaluate the impact on portfolio volatility.

While it’s important to be careful about drawing conclusive evidence from past data, it is worth noting that we observe a relationship between ESG score and other traditional financial characteristics of ‘good management’, such as high return on equity (Exhibit 2), low leverage and low earnings variability. For this reason, incorporating ESG factors is often seen as an additional ‘quality’ screen. And the performance of companies screened on quality metrics is clear over the long term: MSCI Europe Quality has outperformed MSCI Europe by close to 4% annualised over the past 10 years.

Exhibit 2: Return on equity by ESG quintile

% return on equity

Source: J.P. Morgan Asset Management. Charts show the mean return on equity of the top and bottom quintile portfolios based on JPM proprietary quantitative ESG score, USD, ROE winsorised at plus / minus 100. ACWI portfolios are constructed in the MSCI ACWI IMI universe filtered by market capitalisation > $1 billion, Europe portfolios are constructed using the Europe constituents of the aforementioned universe, North America portfolios are constructed using the North America constituents of the aforementioned universe, stocks are weighted equally across the universe. Past performance is not a reliable indicator of current and future results. Data as of 28 February 2021.

Exclusions and short-term returns

The analysis above focuses on returns over long time periods.  At certain points in the economic cycle, excluding certain companies – such as gambling, tobacco, nuclear power, weapons, alcohol and energy companies – for ESG reasons can have meaningful implications for relative performance. Most obviously, excluding traditional energy companies from a portfolio will likely lead to outperformance when oil prices are falling, but potentially underperformance when oil prices and energy prices are rising. If energy is a large proportion of a benchmark, the relative impact is even greater. Looking at the impact of excluding energy in the UK (where energy is over 10% of MSCI UK) vs. the US (where energy is 3% of the S&P 500) during the rollercoaster in energy prices in 2020 demonstrates this point (Exhibit 3).

Exhibit 3: Impact of excluding energy from an index

Relative total return index level, rebased to 100 at the start of 2020

Source: MSCI, Standard & Poor’s, J.P. Morgan Asset Management. Past performance is not a reliable indicator of current and future results. Data as of 18 March 2021.

In addition, companies that do not have good long-term growth opportunities or ESG scores can still generate good financial returns, when profits are returned to shareholders or when there’s a grab for yield. A notable example is American tobacco companies, which have returned 13% annualised (including dividends) over the last 20 years, compared with 8.5% for the S&P 500.

Of course, for many investors, any return sacrifice may be entirely acceptable given their broader investment ambitions beyond financial returns.

The asymmetries in fixed income

On top of the issues described above, it’s worth spending a moment thinking about ESG, returns and fixed income. An equity share does not have a predefined time horizon, so for an equity investor the return depends on the payout prospects for the life of the asset. A fixed income investor holding a bond to maturity is just concerned about getting the agreed coupons and then the principal returned over a fixed time horizon, and this creates an asymmetry.

For example, consider a company that is on the right side of a new government announcement (for example, the producer of an alternative to single-use plastics after an announcement of a ban on single-use plastics). The stock investor sees a jump in the stock value, reflecting the enhanced outlook for long-term profits. A bond investor planning to hold the bond to maturity would not see an enhanced coupon or dividend, and so would not receive the same benefit from the announcement.

Now consider the company that is on the wrong side of a government announcement, with the long-term viability of its current business model challenged. The stock investor loses out immediately. Whether the fixed income investor loses out over the lifetime of the bond depends on whether the coupons or principal are at risk. They may not be on a very short-dated bond, but would be on a longer-dated bond.

Given this asymmetry, incorporating ESG factors in a fixed income portfolio might be expected to affect returns. Incorporating ESG factors can limit downside risk in a portfolio by capturing a broader range of potential sources of default risk. However, it could lead to underperformance if the issuer doesn’t default within the time horizon of the bond and the investor has forgone the higher spread that resulted from the pricing in of that risk.

In addition, as with equities, high yield energy will likely underperform when oil prices fall and outperform when they rise, so ESG exclusions can lead to periods of underperformance as well as outperformance. Again, in both instances, any return sacrifice may be entirely acceptable to investors who are seeking sustainable outcomes as well as financial returns.

Most importantly, history is unlikely to be a guide to the future

Even if it were possible to draw firm conclusions using historical index data, we would argue that history is unlikely to provide a guide to the future. That is because the ESG factors that we expect to drive markets are at their infancy in terms of both introduction and market impact.

Below we list five specific areas in which we believe ESG considerations have the potential to create market winners and losers:

Government ambitions and regulatory policy – Encouraged by the demands of their electorates, governments are increasingly focused on tackling issues such as social injustice and climate change. Policymakers have a variety of sticks and carrots at their disposal to drive change. One example of a ‘stick’ policy being used to tackle climate change is carbon pricing, which exerts a cost pressure on less energy efficient companies. An example of a carrot policy is a scrappage scheme that encourages consumers to dispose of petrol-fuelled cars for electric vehicles.

There is clear evidence that such political announcements have market implications. Take two examples from the last year. The surprise announcement by President Xi that China would commit to net-zero carbon emissions propelled solar and wind power companies higher (Exhibit 4). These companies are set to benefit from this positive policy support via an increase in subsidies as China moves to increase capacity, in line with its environmental goals of peak CO2 emissions in 2030 and net zero by 2060. This comes at a time when coal-fired producers are facing higher costs from rising coal prices and the cost of wind and solar are in decline. Renewable energy sources in China are expected to achieve grid-price parity with coal-fired producers in the next year.

Exhibit 4: Chinese renewables gain on policy announcements

Average of A and H share listed companies in each industry, rebased to 100 = 31 Jan 2020

Source: FactSet, J.P. Morgan Asset Management. Past performance is not a reliable indicator of current and future results. Data as at 12 March 2021.

Clean energy stocks have significantly outperformed global equities on the prospect of increased policy support from a Joe Biden presidency (Exhibit 5). Following the announcement that Biden had secured enough delegates for the Democratic nomination, clean energy stocks began to rise with the prospects of a Biden win at the election, as investors anticipated more policy action to address climate change. The rally in clean energy took another leg higher following the US election result, when a future infrastructure package came into focus.

January and February of this year provided a timely reminder that, even with these key policy supports in place, these sectors can still prove volatile. Investors should also be cognisant of the price that they are paying to access these secular trends, now that the policy tailwinds have become starkly apparent. The 12-month forward price-to-earnings ratio for the MSCI Global Alternative Energy Index has risen from 17x at the beginning of 2020 to 30x at the end of February 2021.

Exhibit 5: Clean energy performance

Total return index level, rebased to 100 at the start of 2020

Source: MSCI, J.P. Morgan Asset Management. Indices shown are total return in local currency. Past performance is not a reliable indicator of current and future results. Data as of 18 March 2021.

In essence, what is happening is governments are internalising the externality of environmental damage. But, almost by definition, this will come at a cost to some businesses. The UN Climate Change conference (COP26) in early November is a date investors should watch for the potential slew of new market-moving initiatives.

Central bank asset purchases and regulatory initiatives – While government policy is increasingly influencing the macro landscape, central banks are being asked to support these endeavours by ensuring that private capital forms part of the solution. Indeed, increasingly central banks (for example, the Bank of England) are having green targets added to their mandates. This works through two channels: 1) central banks can tailor their asset purchases to favour climate friendly companies and sovereigns and 2) they can use their regulatory levers to direct capital towards higher scoring companies (for example, through pension fund requirements).

The ambition and the potential consequences for asset prices are made clear in a recent speech by Pablo Hernández de Cos, governor of the Bank of Spain:2

“If we succeed in incorporating these [climate] risks into the decisions of the financial sector, this will translate into a change in the relative prices of financial instruments. And, in turn, that will help to internalise those consequences originating from both transition and physical risks that affect directly providers and users of funds. This will be a powerful and much-needed complement to the use of the fiscal and environmental instruments that are needed to fight against climate change.”

Disclosures – Central banks, regulators and governments are increasing transparency about ESG factors by forcing companies to disclose more ESG information about their businesses, from diversity statistics and pay of their employees to carbon emissions. This allows both consumers and investors to make more informed choices.

Consumer choices – Attitudes and resultant behaviours among consumers are changing rapidly, with potential consequences for the long-term profitability and potential performance of companies. Areas where consumers are having a significant impact range from specific preferences (such as the increasing rejection of single-use plastics) to reputational risk from poor corporate ESG choices. The latter is increasingly important given that intangible capital (brand) is an increasingly large component of many companies’ market value.

Cost of capital – All of the above factors have the potential to affect the revenue stream of companies. But there is also increasing evidence that they are driving corporate cost of capital (this yield premium has come to be known as the ‘greenium’). Therefore, from both revenue and cost sides, ESG factors are affecting the profitability and viability of companies.

Exhibit 6: Credit spread differential between green bonds and traditional bonds

Basis points, option-adjusted spread difference between green and traditional bonds

Source: Barclays Research, J.P. Morgan Asset Management. Data shown is for a Barclays Research custom universe of green and non-green investment grade credits, matched by issuer, currency, seniority and maturity. The universe consists of 94 pairs, 58 euro-denominated and 36 dollar-denominated, and 48 financials and 46 non- financials. Past performance is not a reliable indicator of current and future results. Data as of 9 February 2021.

Conclusion

Further work is required to demonstrate conclusively the extent to which E, S, and G factors have affected past performance. However, even when that analysis is complete, we would be cautious about using historical results as a guide to the future. We expect the shifts in government policy, regulation and consumer preferences to result in much larger leaps forward that will shift the macro landscape. It is by being ahead of those announcements in the coming years that we see the potential for investors to generate enhanced portfolio returns.

Please continue to check back for more ESG related articles and insights along with our usual blog posts and market updates.

Charlotte Ennis

01/04/2021

Team No Comments

Invesco – Why investors both love and fear the Fed

Please see article below from Invesco received this morning – 31/03/2021

Why investors both love and fear the Fed

Kristina Hooper – Chief Global Market Strategist, Invesco Ltd

Key takeaways

Investors fear the Fed
Stocks have been volatile due to fears about what the Fed would do if inflation rises.

But they also love its policies
While stock market investors fear the Fed, they also love its easy money policies.

If you had to quickly describe the relationship status between investors and the Federal Reserve, your best bet might simply be: “It’s complicated.”

Stocks are moving up and down, and leadership in the stock market is rotating, based on market fears of inflation — or, to put it more accurately, fears about what the Fed will do if inflation does rise. But while stock market investors fear the Fed, they also love all the good things it has done for them. After all, the great stock market rally that began in March 2009 can be largely attributed to the Fed’s extraordinarily accommodative monetary policy — especially its quantitative easing. And the year-long rally that began in March 2020 has the Fed’s easy money fingerprints all over it. In other words, investors have developed a powerful bond — some might say a dependency — with the central bank.

The Fed’s reassurances have fallen flat

Now the good news is that the Fed is trying to be sensitive to investors’ wariness about what it might do next. Fed Chair Jay Powell doesn’t want stock market investors to worry. At every turn, he has tried to reassure them that the Fed will maintain its easy money policies for some time to come and that any rise in inflation will be transitory. Last week, for example, Powell was on Capitol Hill, providing comfort and reassurance. He made it clear that he wasn’t concerned about the rise in long-term bond yields, suggesting that they reflect growing optimism: “It seems that rates have responded to news about vaccination and ultimately about growth.” 1 Powell stressed that it has been orderly and that the Fed would only react if it is disorderly.

Powell reiterated that he doesn’t believe long-term price trends will be changed by the most recent fiscal stimulus package, supply-chain bottlenecks, or a surge in consumer demand, which is widely expected to come later this year as the economy re-opens. Powell said that while the Fed expects upward pressure on prices, he expects it will be transitory. He was emphatic: “Long term, we think that the inflation dynamics that we’ve seen around the world for a quarter of a century are essentially intact. We’ve got a world that’s short of demand with very low inflation … and we think that those dynamics haven’t gone away overnight and won’t.” 1. But investors didn’t believe him, based on the stock market reaction that day — they’re still wary that inflation will go up and the Fed will be forced to tighten.

It seems that market participants want to believe the worst of the Fed. They don’t believe Powell when he utters dovish words, but they latch onto any comments that can be perceived as hawkish. On Thursday, Powell gave an interview to NPR. He reiterated many of the reassurances he provided on Capitol Hill earlier in the week. He also shared his optimistic economic outlook for 2021. However, he also tried to be honest and transparent by stating the obvious: “… as we make substantial further progress toward our goals, we will gradually roll back the amount of Treasuries and mortgage-backed securities we’re buying.”2 He talked about raising interest rates in the longer run, but said that such tightening would be very gradual and transparent. However, that sent stock market investors into a panic. The NASDAQ Composite Index, S&P 500 Index, and Dow Jones Industrial Average all dropped significantly in just a few hours before investors regained their senses and started buying.

Investors have to wait and see how the Fed would respond to inflation

My best advice is that investors shouldn’t let the Fed — or any central bank — overly influence their long-term investment strategy. I believe the Fed will honor Powell’s pledges, but many market participants are clearly skeptical. These participants must come to terms with the fact that they won’t know if Powell will follow through on his assurances until inflation actually spikes and the Fed has the opportunity to insist it is transitory and sit on its hands. They won’t know if the Fed has really abandoned pre-emptive tightening until it proves to us that it has.

The silver lining of this environment — in which so many investors have allowed themselves to be dependent on the Fed — is that other investors can take advantage of “Fedspeak”-related sell-offs, which can create tactical buying opportunities for investors with a longer time horizon. And if markets actually become disorderly, I believe Powell will likely step in.

Is the Fed the only source of concern for investors? No, there are others. But the lesson is the same: Instead of parsing — and panicking about — every utterance from Powell and others, I believe investors’ time would be better spent focusing on fundamentals and long-term goals.

Looking ahead

In the coming week, I’ll be paying close attention to COVID-19 infections in Europe. The region is in the throes of a third wave of infections, which threatens to be the worst of the waves. This is not dissimilar to the third wave that the US experienced several months ago, which was its worst wave. Unfortunately, Europe’s vaccine rollout has been disappointing to say the least, and more infectious strains of the virus are spreading quickly. Lockdowns are being extended and could become more stringent as government officials warn that hospitals are being overwhelmed. This could further delay the eurozone’s economic recovery, which has already been delayed by the slow vaccine rollout. The ability to control infections in the eurozone is critical.

I’ll also be paying attention to China’s economy, with the government’s manufacturing and non-manufacturing Purchasing Managers’ Indexes (PMI) and the Caixin manufacturing PMI being released this week. China’s economic recovery has been strong thus far this year, and I want to make sure there are no negative surprises in the offing.

I’ll also be following the volatility in stocks created by the fallout from the Archegos hedge fund unwinding. I think this is not dissimilar to the volatility created by Reddit-related stocks such as GameStop that we experienced earlier this year: I don’t see this as a source of widespread contagion, although it will likely weigh down some specific stocks over the shorter term. 

And finally, I will be paying attention to Friday’s US jobs report. I suspect non-farm payrolls will be very strong for the month of March, beating expectations, but could trigger a rise in the 10-year yield and concerns about inflation — and therefore stock market jitters — as investors are likely to worry again about whether the Fed will really sit on its hands …  

Please continue to check back for our regular blog posts including market updates and insights like this article.

Charlotte Ennis

31/03/2021

Team No Comments

Equities mixed as third wave undermines recovery

Please see below article received from Brewin Dolphin yesterday evening, which analyses the performance of markets in relation to the big news events of the past week. 

Global equities were mixed last week after renewed lockdown restrictions in Europe dented hopes of a broad economic reopening.

Stock markets in Asia suffered the most, with Japan’s Nikkei declining 2.1% and Hong Kong’s Hang Seng falling 2.3%. In Japan, the recent lifting of the state of emergency in Tokyo provided some optimism, but this was outweighed by concerns that Europe’s third wave of Covid-19 infections could delay the global economic recovery.

France’s CAC 40 ended the week in the red after the country extended its lockdown to cover a third of the country. Germany’s Dax and the UK’s FTSE 100 posted gains of 0.5% and 0.9%, respectively, following a rebound on Wall Street and positive UK retail sales data.

In the US, the S&P 500 edged up 1.6% following Joe Biden’s pledge to vaccinate 200m Americans in the first 100 days of his administration – double his previous target. Energy stocks performed particularly strongly after the closure of the Suez Canal boosted oil prices. The Nasdaq declined 0.6% amid ongoing interest rate and inflation concerns.

Stocks flat after hedge fund fire sale

Stock markets were largely flat on Monday as investors turned their attention to the fall-out from the collapse of family office hedge fund Archegos Capital Management.

Archegos was forced to sell billions of dollars’ worth of shares after its positions turned sour, prompting a margin call from its prime brokers. Nomura and Credit Suisse, who were among the banks handling Archegos’ trades, warned of significant losses after Archegos defaulted on the margin calls, forcing brokers to dump shares.

So far, the impact of the fire sale has been limited to the stocks that were part of Archegos’ portfolio and its banking and brokerage partners. The Dow edged up 0.3% on Monday, while the S&P 500 and the Nasdaq ended the day down 0.1% and 0.6%, respectively.

European shares also managed to brush off the fall-out from Archegos, with the STOXX 600 adding 0.1% and Germany’s Dax gaining 0.5%. The FTSE 100 closed down 0.1% as the pound gained 0.03% on the dollar.

The FTSE 100 was up 0.7% in early trading on Tuesday, following encouraging news about the vaccine roll out in the UK and the US.

Suez Canal blockage disrupts trade

Last week’s headlines were dominated by the blockage of the Suez Canal – one of the world’s busiest trading routes. On 23 March, the 200,000-tonne ship Ever Given ran aground, resulting in a queue of approximately 370 ships either side. Some ships resorted to rerouting around the southern tip of Africa.

Around 12% of world trade flows through the canal, carrying more than $1trn worth of goods every year. Delays can cause severe disruption to supply chains, ultimately leading to a shortage of goods and higher prices. On the day after the ship ran aground, there was a 5.8% spike in the price of Brent crude oil.

The Ever Given was finally freed yesterday (29 March), but clearing the backlog of container vessels, tankers and bulk carriers is expected to take several days.

Europe extends lockdown restrictions

Last week also saw renewed lockdown restrictions in several European counties, as a third wave of Covid-19 infections spreads across the continent.

Data released on Sunday revealed the number of new Covid-19 patients in intensive care units in France has risen to 4,872 – close to the November peak but below the high of 7,000 in April 2020. In Germany, the incidence of the virus per 100,000 rose to 130 on Sunday, from 104 a week ago.

Rising infections, a slow vaccine rollout and renewed lockdown measures are threatening Europe’s economic recovery. The European Commission is calling for tougher controls on vaccine exports, after its own data suggested 77m doses have been exported outside the bloc, while 88m doses have been delivered to its members.

Vaccine rollout affecting services recovery

The speed at which vaccines are being distributed is having a profound effect on the recovery of the global services sector. In the eurozone, the manufacturing PMI has surged to a three-year high, whereas the services PMI is stuck in contractionary territory below 50. The recovery in services is expected to be pushed back because of delays in issuing the vaccine and the surge in new coronavirus cases.

In contrast, the UK’s services sector is outpacing manufacturing for the first time since the start of the pandemic. In March, the services PMI rose to a sevenmonth high of 56.8, while the manufacturing PMI stood at a three-month high of 55.6. The rebound in services suggests businesses are getting ready for a reopening from mid-April.

Meanwhile, the US manufacturing PMI rose to 59.0 in March, while the services PMI increased to 60.0 from 59.8. The University of Michigan revised its gauge of March consumer sentiment to 84.9, its highest level in a year, while weekly jobless claims fell more than expected to 684,000. Sales of existing and new homes tumbled in February, but this was largely because of severe winter weather.

We will continue to publish relevant content as lockdown restrictions begin to ease over coming the coming weeks. Please check in again with us soon.

Stay safe.

Chloe

31/03/2021

Team No Comments

LGIM Blog

Please see below the latest article received from Legal & General Investment Management’s Asset Allocation Team which was received yesterday afternoon and covers their views on a number of topics:

Please continue to check our Blog content for advice and planning issues and the latest investment, markets and economic updates from leading investment houses.

Please keep safe and healthy.

Carl Mitchell – Dip PFS

IFA and Paraplanner

30/03/2021