Disruption is the key investment theme of the decade and even fixed assets such as real estate are not immune.
The winds of change are buffeting all major investment classes in the sector, from office and commercial through to industrial and retail properties.
A recent briefing by senior managers of AEW Capital Management – underlying manager of the Pendal Global Property Securities Fund – highlighted the risks and opportunities thrown up by unprecedented market shifts occurring against a backdrop of one of the strongest runs by the sector in decades.
Like any sector, property moves in cycles – and globally the decline in interest rates has put a floor under the market.
The JLL Global Office Index – which tracks returns from commercial office assets – jumped 49 per cent from its 2004 low to 2008 peak. It’s still risen by about 32 per cent in the subsequent nine years – a more modest, but sustainable performance.
The changing valuation equation
Underpinning global property markets are negative yields on sovereign debt, coupled with a heightened risk of geopolitical uncertainty.
Against this backdrop, real estate remains an investment class that continues to offer sustainable yields along with diverse investment opportunities offering sustainable growth. But capturing that growth can be a challenge.
Large direct holdings of property assets can hamper an investor’s ability to quickly take advantage of market shifts, both locally and abroad.
That’s one reason real estate investment trusts have become an attractive investment option, says AEW director J.T. Straub.
“The returns screen has always been attractive,” he argues. “We see the returns of the past several years continuing. There are also attractive sub-sectors such as data centres.
“In addition, their liquidity gives us flexibility. So for example, we’re underweight Hong Kong, and use these types of environments to take advantage of situations.
“To go from a 6 per cent to 10 per cent property allocation takes time if you hold property directly”, Straub says. “But if you invest via a REIT, the flexibility means shifts in portfolio allocations can be achieved quickly and painlessly.
“The key is that the central banks are helping. Once one central bank cuts, others have to follow. It is likely the Fed will cut again and others will too,” says AEW’s Singapore-based Peter Ho. “As rates decline, valuations will go up.”
This will continue to drive demand for sustainable returns and keep real estate markets buoyant, he says.
“There is a lot of capital coming into the sector that can’t find a home,” says Ho. “To get into Australia, you need to know the REITs. It is the same in Singapore.”
AEW doesn’t take regional bets; rather it takes sectoral bets. It holds an overweight exposure to offices in Asia, for example, and underweight in other regions.
Looking broadly at the global market, AEW is underweight in areas of falling rent such as Hong Kong office and retail sectors, along with US shopping malls.
Similarly it is underweight retail in both Japan and Singapore, even though the decline in rents is slowing.
Areas of rising rents, such as US industrial and ‘other’ residential, along with UK and Australia industrial rents and data centres in Asia, has prompted it to take an ‘overweight’ investment stance.
New economy, new opportunities
Areas of the ‘new economy’ are throwing up both challenges and opportunities.
In the commercial office sector, flexible working operators such as WeWork have attracted a lot of attention, bringing both opportunity and threat. This sector alone accounts for an estimated 7 per cent of total stock.
“In Amsterdam, co-working is a large portion of the market, but it is still less than 15 per cent,” AEW’s Straub says.
“In London it is around 6 per cent. In Sydney and Melbourne, around 2 per cent.”
Straub argues growth in co-working has helped drive net absorptions in the office market globally – although the difficulties of WeWork’s IPO has focused attention on the downside potential.
“There is a liability mismatch,” he says. “Some see [flexible working] as being bad for REITs,” AEW’s Ho says. “If co-working continues its current trajectory, it will double the demand for space.”
“The challenge of the WeWork model is that since it is loss-making with a long-term lease, how much space do you want exposed?
“There is potential credit and liquidity risk. For example Regus has better credit quality.”
Environmental, Social and Governance impact
Listed property investors are also increasingly taking into consideration environmental, social and governance (ESG) factors, says AEW’s Ho.
ESG has gone from “nice-to-have to a need-to-have over the past decade”, he says. And there’s a range of data demonstrating a correlation between higher ESG scores and profitability.
Commercial properties in particular can be energy-intensive and tend to have environmental impacts —not only in construction but also through ongoing maintenance programs.
Industrial property revolution
Demand in the industrial real estate sector has also been driven by e-commerce.
As digital natives, Millennials are driving a wholesale shift in demand for industrial real estate.
“Increasingly a shed is not just a shed,” as AEW’s Straub puts it. Occupants are demanding automated storage systems, renewable energy and tracking systems spanning fleet management through to efficient truck-dock management.
“In Tokyo, there has been a lot of industrial supply,” AEW’s Ho says. “In three years there’s been a 50 per cent increase in industrial warehouses. Demand is so strong even with record absorption. And with [a low] 2.7 per cent vacancies, rents are rising.”
The strong underlying demand has AEW positive on the sector. The manager is overweight industrial assets in Asia, Europe and North America.
Data centres are an adjunct sector to new economy real estate. The rise in cloud computing is driving demand both for ‘last-mile’ centre operators located near client offices and data centres servicing a single client, which can be located in distant locations.
Either way, these centres are big energy users with ready access to electricity a prime driver of location.
Still, the longer the present market strength continues, the more investors will be asking how much longer can it go.
“We keep waiting for real estate to over-build,” AEW’s Straub said. “That’s how it ends.
“But the banks have been tightening lending restrictions – they’re not over-lending.
“There will come a time, but we’re not there yet.”
Edwina Matthew, Head of Responsible Investments at Pendal, talks about our approach to responsible investing and current issues we have been working through with investors.
James Syme (pictured) is a London-based senior fund manager with Pendal subsidiary J O Hambro.
There are two broad drivers of the emerging market equity asset class: global growth and US dollar liquidity. This update serves to point out that neither of these drivers is showing any sign of being supportive, but also that a robust investment process and differentiated portfolio can still find opportunities in the asset class.
Global growth is sick and failing to respond to treatment because no treatment has been applied. In the developed world, the US has seen the weakest ISM manufacturing survey in 10 years as well as weakness in the crucial services data, while eurozone 2019 real GDP growth forecasts have been steadily revised down to the current level of just 1.1%.
In the emerging world, recent Chinese data has been particularly soft, with fixed asset investment (+5.5% year-on-year), retail sales (+7.5% year-on-year), industrial production (+4.4% year-on-year) and exports (-1.0% year-on- year) all coming in both low and below expectations.
Exports and the dollar
The exports of the most cyclically-exposed emerging economies tell a similar story, with Korean exports -11.7% and Taiwanese exports -4.6% in the year to September. Meanwhile, the inherent strengths of the US economy relative to the rest of the world, combined with the asymmetric impact of the trade war, have kept investors more optimistic about US assets and/or more pessimistic about the need to have sufficient US dollar-denominated assets. This has happened despite the enormous increase in the US fiscal deficit (federal government gross issuance will be around US$11.3 trillion in FY2019, up from around US$10 trillion in FY2018, with the majority of that issuance at maturities of six months or less), which represents a huge drain on global dollar liquidity.
The net effect of this has been a resumption of the uptrend in the US dollar relative to other global currencies that began in 2011. The slide in growth and tight liquidity have been transmitted into emerging economies, with negative GDP growth revisions in almost all of the 26 emerging market economies during 2019. Even previous areas of strength, such as India, Pakistan and Thailand, have been caught up in the slowdown, with the 2019 GDP growth estimate revised down 0.8% in India, 1.2% in Pakistan and 0.8% in Thailand. Global conditions remain tough.
Country focus yields opportunity
Our investment process is designed to seek opportunity, principally at the country level, and we have found various areas of opportunity through our process this year. One would be areas where GDP growth estimates have held firm, including Eastern Europe, where aggregate GDP revisions are about flat year-to-date. We have held some exposure in the Czech Republic, which has been a slight laggard, and considerably more in Russia, which has substantially outperformed.
Another source of opportunity is in the pricing (both equity and currency) of these macro conditions. Even where growth is weakening, panicking investors can drive valuations to levels that overstate the challenging fundamentals, and we aim, through a disciplined monthly review, to identify these opportunities.
One such opportunity has been Turkey. With 2019 GDP growth revisions of -1.5%, Turkey has been the second-weakest of all emerging economies year-to-date (Brazil, at -1.6%, is in last place). However, in May the pricing of that slowdown became wildly excessive and the Turkish stocks we bought at the end of that month have very substantially outperformed (and, importantly, have actually made money for investors). Interestingly, Turkey’s 2019 GDP growth estimate has in fact been revised up since the end of May, suggesting that the worst of the selling pressure (and the greatest opportunity for us) was right before the turn. Most, perhaps all, investing is a trade-off between fundamentals and valuation, and we look to use both to identify top-down, country-level opportunities in EM equity, no matter how good or bad the global environment is at that moment.
With another cut from the RBA in October and expectations for further easing, in this update we examine the outlook for one of the central bank’s key targets; inflation. Our cash manager, Steve Campbell assesses the direction for the other – the labour market, which received greater emphasis in the latest statement from Governor Lowe. Meanwhile, the path of domestic credit continues to be directed by the global macro backdrop and as such we explain why we maintain flexible positioning.
Finally, humans’ impact on the environment has garnered even greater attention over the past several months and its importance for our clients continues to grow. We explain the evolving area of impact investing and illustrate the positive contributions it makes to the environment and broader society.
Australian Quarterly Update
Updated asset allocation ranges and neutral positions
Following a review of the asset allocation ranges and neutral positions of Pendal’s diversified funds (Funds) and Pooled Superannuation Trusts (PSTs):
• the asset allocation ranges will be changed effective 6 November 2019 and
• the asset allocation neutral positions will be changed effective 6 November 2019.
Details of these changes can be found here. The Funds’ Product Disclosure Statements (PDS) have been updated and are available here.
The changes are expected to deliver an improved investment outcome for investors through better expected risk-adjusted returns. The changes reflect our latest asset class assumptions for return, risk and inter-asset class correlations and position the funds to take advantage of future market conditions.
Changes to the Fund’s management costs
Pendal Sustainable Conservative Fund (APIR: RFA0811AU, ARSN: 090 651 924)
Reduction in management costs from 25 September 2019
From 25 September 2019, the issuer fee for this Fund will reduce from 0.80% pa to 0.70% pa.
The banking sector may no longer be the defensive investor’s place of refuge for relatively stable and reliable returns. But the Financials sector houses a range of opportunities beyond banks and insurers that may provide a different risk-return experience.
Pendal’s Ashley Pittard shares his thoughts on investing in the lesser observed constituents of the financial world – stock exchange operators.
Find out more about the Pendal Concentrated Global Share Fund.
Financial stocks made up 26%^ of the global share market index before the Global Financial Crisis.
That’s now down to around 15%* today thanks to a shake in the sector and ‘de-yielding’ of the global monetary system.
The sector heavyweights of the banking fraternity have experienced a general de-rating with many investors turning away from the sector.
US banks — which form a large part of the global banking segment — have materially underperformed the market since the GFC.
They are now back to levels last seen in 2009 and 2016 as you can see in the following chart which tracks the relative performance of US banks against the broader US equity market.
US Banks now at pre-GFC levels
Source: Bloomberg, Pendal using representative exchange traded products
In mid-2016 at the inception on the Pendal Concentrated Global Share Fund we formed a view on a range of major influencing factors including Brexit, interest rates and inflation.
This led us to take a deeper review of the sector to identify areas of interest.
We already knew that many of the sector’s participants were well established with considerable economic moats and scale. This research culminated in establishing material positions across the financials sector.
Within the banks we favoured the regional players over the globally focused competitors which typically have significant investment banking exposures.
This led to positions being established in Wells Fargo, Lloyds Banking Group, Caixa Bank and KBC Group.
The banks we hold are of higher quality as they have generated higher returns than their peers through scale-driven cost efficiencies.
This has enabled them to build the capital required by regulators and be in a position to return the remaining free cash flow in the form of dividends and buybacks to shareholders during a tough environment.
Considering the regional nature of these businesses we expect this cohort will continue to exhibit a degree of resilience should the broader banking sector experience further de-rating.
However, if the broader environment does instead improve, we expect these companies to outperform the market much like they did following the dislocations in 2009 and 2016.
Stock exchanges – the forgotten financials
The other often overlooked segment of Financials are stock exchanges.
Stock exchanges generate revenue based on trading volumes, with an inter-related link to market volatility.
As market uncertainty develops, the derivative products issued by exchanges tend to generate higher revenues as a function of increasing spreads on pricing as well as through higher trade volumes.
Market volatility remains depressed and near historically low levels.
This negatively impacts revenue for companies like CME Group — operator of the Chicago Board of Exchange which holds a 90% market share in global futures trading and clearing services.
We launched the Fund with half of the financials exposure held in stock exchange operators.
This has made a strong contribution to the Fund’s returns over the period. Collectively, our investments in stock exchange operators have generated an average annual return of 23% (in Australian dollar terms).
In December 2018 we took profits on one of these businesses — Intercontinental Exchange — after the stock reached our valuation threshold of a 5% buyout yield.
Staying true to form
Stock exchanges remain a centrepiece of the Fund’s financials exposure and we expect these stocks to continue to re-rate as market volatility increases.
Our process is designed to identify fundamentally sound companies which have been flat or underperformed for a number of years.
Of course, the present environment is far from certain for banks in the short term amid the macro policy tensions but, from a long term perspective their valuations remain compelling to us.
At these levels history has shown it can be beneficial to look through the immediate market concerns and noise and invest in high quality companies wherein their intrinsic value is not being reflected in their current stock price.
^ Source: Bloomberg. Financials weight as represented within the MSCI World Index as at 31 December 2016.
* Source: Bloomberg. Financials weight as represented within the MSCI World Index as at 31 August 2019.
Ratchet: a device consisting of a bar or wheel with a set of angled teeth in which a pawl, cog, or tooth engages, allowing motion in one direction only; a situation or process that is perceived to be changing in a series of irreversible steps
At first, I mulled if ‘Treppenwitz’ is an apt word to describe President Trump’s comebacks to the tariff pronouncements by China. I have experienced this phenomenon before. When someone says something to me which overwhelms me, leaves me speechless, and I cannot come up with a snappy comeback on the spot. Yet once I have walked away from the situation, the perfect response suddenly pops into my head. Literally translated, Treppenwitz, a German word, means staircase joke, because the witty retort hits you in the stairwell on your way out. By then it is usually too late.
However, I quickly realised my folly. That is probably the opposite of how President Trump reacts. He is more off the cuff, speak your mind and ratchet. Since mid-2018, one of the risks markets have to contend with is whether this trade war will persist for a long time. If ever there was a doubt on that outcome, it was possibly snuffed out in August 2019. I think it is fair to say that decision-makers in China and companies on both sides of the tariff divide have decided that a resolution, if any, will at best be temporary in nature.
Then what about the other ratchets around the world? Prime Minister Johnson has engaged on a path that seems to indicate a very high probability of a no-deal Brexit. In Argentina, despite a US$57b bail-out by the IMF, we have capital controls, while Ms Legarde, the ex-IMF chief, will head the ECB. These different, seemingly unconnected events manifest themselves in the markets in one measure – the strong US dollar.
Source: Bloomberg
When risk aversion increases, the usual beneficiaries of the flight to safety trade reflect this angst. I have no clue whether we are in a phase of an even stronger or possibly weaker US dollar. History provides a reasonable guide to outcomes in markets in either case. However, in an era of nationalism, policy activism and intervention, it would take a brave soul to predict the future.
Luckily, I remember that fortune favours the brave. As the tiff with China has intensified, you might have noticed that we have ratcheted up our holdings in China, particularly the ‘A’ share market. At the end of last month, our holdings in ‘A’ shares represented approximately 10% of the portfolio. Our rationale is threefold:
1. Invest in quality businesses with high or rising margins/return metrics (with low volatility of those metrics) and a growing top line. In a world of low growth, it is a global phenomenon that higher growth companies are being rewarded more by the markets. However, these companies must have the ability to withstand disruption (whether online or policy) or benefit from it.
2. From 1978 until around 2015, China enjoyed almost uninterrupted high economic growth. In that environment, it is not easy to pinpoint businesses that have genuine resilience to economic cycles. Yet from 2015/16, we have witnessed a marked slowdown in growth, volatility in the renminbi and sharp policy zigzags in China. What is normal in any other emerging market companies in China are now facing with gusto. This provides a more fertile environment for companies that can manage better than the average ones. (Additionally, in the past, some of the best firms listed in either Hong Kong or the US, obviating the need to access the ‘A’ share universe).
3. With index providers increasing weightings for Chinese ‘A’ shares, there will be a trend over the long term towards the ‘institutionalisation’ of equity markets. Trading is currently dominated by retail investors, tends to be short term in nature and mostly, I hear (no pun intended), based on rumours and news flow. Over time, as larger pools of institutional capital pour in, it is reasonable to expect this to change. There is a caveat to this, of course. If most of the capital flows from index funds and ETFs perhaps that stream of capital might not focus on the quality names we have an interest in.
Time will tell whether this line of thinking is brave or foolhardy. Increasingly, there are signs that lower interest rates and looser monetary policy engineered by central banks are less potent than before. Some term it the ‘Japanisation’ of a world marked by disinflationary tendencies and beset with debt. Countries held hostage to external funding, like Argentina, pay a price in the US dollar value of assets. Those who have an ability to finance themselves with domestic debt pay a price in lower and faltering growth. If this indeed turns out to be the case, China might indeed be more like Japan. The probability that high growth domestic business make good long-term investments might be high. As insurance, we do hold some in the portfolio. Yet, as stated earlier, our attempt is to find and invest in more of the quality names in ‘A’ shares in China.
Fund Manager commentary for the month ended 31 August 2019 covering market reviews, Pendal fund performance and our outlook for the period ahead.
Access the monthly commentary here.