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“The day the US dares tease our nation with a nuclear rod and sanctions, the mainland US will be catapulted into an unimaginable sea of fire.”

North Korean ruling party newspaper Rodong Sinmun, 6 August 2017

Followers of our investment views will be aware of our enthusiasm for the South Korean equity market. We have a significant overweight position in the country, as we find the stable currency, attractive equity market valuations and powerful corporate governance reform prospects an enticing top-down story. In addition, the wide and liquid equity universe offers a good number of attractive bottom-up investments to access the country-level opportunity.

However, everybody knows one thing about investing in South Korea, and that thing is North Korea. As the above quotation shows, the rhetoric surrounding the tension (technically, an unfinished war) between North and South is hair-raising, and clearly geopolitical risk on the Korean peninsula is something we have had to get comfortable with in order to like the market.

We believe one of the main reasons that geopolitics does not rule out investing in South Korea is the fundamental stability of the situation. While the leadership has changed in both Koreas, China and the USA, the broad ideological stances and narrow strategic goals have not. Even with ongoing missile and nuclear weapon tests, the North Korean regime has a theoretical long-term ambition to unify the Koreas under their leadership and a very real near-term ambition to stay in power. South Korea seeks a good relationship with China under the umbrella of the 63-year old mutual defence treaty with the US. China and the US both seek a broadly stable geopolitical environment and, where China is starting to challenge US hegemony in the region, it is more an issue with Taiwan and/or the South China Sea.

It is important to note the successes of the South Korean economy and equity market have come despite ever-present tension with the North. We can remember being told in the late 1990s that South Korea was uninvestable because of geopolitical risk. In the 20 years to the end of 2017, the MSCI Korea index has delivered a US dollar total return of 1,480%, or 14.8% annualised, massively outstripping both emerging and developed market equities (ie the MSCI Emerging Markets Index and MSCI World Index).

More recently, investors in South Korea have had muted reactions to 2017’s provocations by the North. On 3 September, when the North tested by far their most powerful nuclear weapon, the MSCI Korea index fell only 2.0% in US dollar terms, while the average Korean market decline on the four long-range missile tests in 2017 was only 0.7%. There is little evidence that the equity market or currency move with seemingly-problematic strategic developments; we believe this is because a return to a devastating war has always been a highly unlikely but definitely possible outcome, and these new developments are not actually new risks.

We would contrast the stability of the Koreas with a situation that we find far more concerning (and where we currently have no investments): the Middle East. There is a brutal war underway in Yemen, chaos in Iraq and Syria, huge anti-government protests in Iran, a rapid worsening of relations between the various parties in the Israel-Palestine conflict following the US decision to recognise Jerusalem as Israel’s capital, a diplomatic crisis in Qatar (with Iran and Turkey backing the Qatari regime), the seeming collapse of the improved relations between the US and Iran, and an aggressive reform programme in Saudi Arabia that some have likened to a coup. Each one of those problems is unfolding dynamically, even chaotically, with complicated interlinkages to the other problems.

Whilst we recognise the risks in South Korea, it is the Middle East where we find geopolitics a barrier to investment at this time, as there is a substantial risk, we feel, of a disastrous range of outcomes.

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BT Investment Management’s Crispin Murray, Vimal Gor, Peter Davidson and Ashley Pittard provide a summary of the key drivers of investment markets in 2017 and share their thoughts on the prospects for each asset class in 2018.

Look beyond the headlines

It is customary to sit back and take stock at this time of year to contemplate what has been, could have been and what is likely to be. Participants in investment markets are accustomed to navigating developments on many fronts and 2017 has offered its fair share of these. Fear factors ranged from North Korea’s nuclear aspirations, Trump’s ambitions to thwart those of Kim Jong Un, Amazon’s desire to scare domestic retailers, Holden marking the end of car manufacturing in Australia and Tesla revealing it fell short of its production targets due to a shortage of batteries to power electric cars. Add to these the constant reminders of escalating household debt, housing affordability, persistently low wages growth and pundits even warning of the next global financial crisis, the average investor has had enough reasons to be fearful.

However, capital markets didn’t quite see it that way. Australian and offshore share markets have delivered healthy gains to investors and other asset classes have achieved positive returns. It shows that market noise can be disparate to reality. Investors who looked beyond the headlines with a degree of perspective and remained invested have done well this year.

Australian shares

Investors in Australian shares oscillated between fear and favour for Resources and bond-sensitive stocks, although Resources may have won the battle this year, with a sector return of 17.5%, compared to 8.4% for Industrials. But look a little deeper within the sectors and there are a plethora of winners and strugglers. Consider the retailing segment, Breville Group (+56.9%) has continued to be a solid performer, although sellers of Breville products like Myer Holdings (-40.0%) and Harvey Norman (-16.9%) languished. Within the travel and leisure segment, Qantas (+78.5%) materially outpaced Virgin Australia (+21.7%). In Media, Ten Network (-82.7%) ran into financial trouble while Nine Entertainment (+61.5%) saw a strong recovery in ratings and earnings.

These varied results provide another timely reminder of the importance of deep and rigorous company research to identify risks and opportunities within the market. Most importantly, the quality of a company’s management team and its strategy in navigating a challenging environment to ultimately drive stock performance should not be underestimated.

“The uncertainty created by disruption is unlikely to abate. This leads to mispricing and therefore great opportunities for active fund managers like us to add value, which is what we saw this year.”
Crispin Murray
Head of Equities

The Australian market does not have the same proportion of high growth stocks as the US so we won’t face the same issue with market valuations in that market. At recent levels the market is considered fair value. In the year ahead, valuations will largely be driven by earnings which are expected to be around mid-single digits. Add a sustainable dividend yield of 3-4% and we should see another healthy total return from Australian shares in 2018.

Australian Listed Property

The listed property sector produced healthy double digit returns over the 12 months to November on the back of solid earnings growth and rising asset values, although some of the gains were surrendered in January. Retail property was an expected focal point for investors, given the economic influences of dwindling retail sales and wages growth together with household indebtedness and the anticipation of Amazon’s arrival in Australia. Hence, retail property was not the place to be for investors, with weak returns from Westfield, Scentre Group, Vicinity Centres and Stockland – which together represent over 40% of the A-REIT index. The Office and Diversified REITs sectors delivered double-digit returns, while Industrial REITs – which are limited in offerings – was the best performing sector.

“US bond yields are an unavoidable headwind for the listed property sector, but the market can really be differentiated by qualitative factors”
Peter Davidson
Head of Listed Property

Filtering the sector for quality provides a fundamentally attractive picture. Despite the interest rate headwinds, key support factors such as the net withdrawal of Sydney office supply, low debt profiles, long term leases with inflation provisions and low vacancy rates make listed property an attractive asset class in 2018. The sector offers fair value and is priced at a discount to the direct property market, based on prices paid in major property transactions this year. We are expecting total returns of 6-8% in 2018.

Global shares

Global equities did a reasonably good job of delivering the growth our super funds aspire to achieve, with more than half of the companies within the MSCI World Index rising by at least 10% (in Australian dollar terms). Most regions registered double-digit gains, led by the US (+19.9%) with two thirds of US stocks achieving a positive return. Investing in the mega-techs – Facebook (+46.9%), Netflix (+44.5%) and Alphabet (ie. Google, +24.7%) – delivered exceptional returns. The S&P500 Index closed at record highs 59 times this year. In contrast, the UK (+6.4%) was a distant laggard while the euro zone (+12.0%) was backed for early signs of economic recovery.

We continue to believe that the tailwinds over the last five years which have rewarded indiscriminate broad market exposure are becoming headwinds. This approach is unlikely to yield as market valuations become less compelling and monetary support is ratcheted back. Moving into 2018, the market environment will be best suited to selective ownership of quality companies that are well positioned to withstand a higher interest rate environment and an uncertain geopolitical landscape.

“Share prices are unlikely to continue moving ahead in unison. The changing market environment means investors need to be conscious of valuation, conscious of franchise strength and cautious on cash flow”
Ashley Pittard
Head of Global Equities

Fixed Interest

Australian fixed income posted reasonable returns in 2017, with little differentiation between the Government and credit sectors. Markets began pricing in expectations of rate hikes early in the year before pushing out the theoretical tightening timeline. Returns across the major overseas bond markets ranged from -0.9% to +2.0%, with the global fixed income asset class as a whole returning -2.7% . The Australian dollar appreciated 4.8% against the US dollar but weakened against the euro and British pound over the year. Although returns were muted across the government sector, credit investments performed well as they benefitted from strong share market performance. Strong appetite for risk also transferred to the high yield market, where the yield premium over investment grade credit tightened to levels not seen since 2014 when the market began to correct.

“Looking to the year ahead, we are wary that the goldilocks environment that kept yields range-bound and risk assets supported in 2017 will not be sustainable. We believe a defensive fixed interest allocation remains a critical component of an investor’s portfolio.”
Vimal Gor
Head of Income & Fixed Interest

Factors like an unprecedented unwind of accommodative central bank policy and a leadership-directed shift in the composition of Chinese growth highlight the risks facing credit and government bond markets. This in turn threatens to spark the return of volatility, as well as imbalances like the strong run from high yield credit to correct in 2018.

Investment implications

Investors need to be resilient to market gyrations and ensure risks are appropriate within their overall investment portfolio which is less likely to replicate the path set in 2017. Asset allocations need to be balanced to reflect the inherent shifts in market leadership on many levels. Interest rates are more likely to increase than decrease, albeit in a trajectory that follows evidence of sustainable economy recovery. Investors should also maintain an allocation within a multi-asset portfolio to the Alternatives sector through a selection of strategies that have a low correlation to equity and bond markets and therefore offer additional diversification with the potential for enhancing returns.

Thankfully, I do not have to make predictions on markets. Looking back to January 2017, who would have guessed the direction and particularly the trajectory of markets in Asia? With that said, we are to some extent in the business of estimating future outcomes. By buying or holding certain stocks, I do make implicit assumptions of what I hope or anticipate might occur over time.

Questions, questions, questions

There are several big issues for markets to grapple with. We are in a synchronised global economic recovery. Commencing around mid-2016, growth has accelerated globally in 2017. How strong and how long it will last is the big question. Central banks, especially the Federal Reserve, seem to indicate a determination to ‘normalise’ monetary policy. Will the Fed raise rates four times in 2018? Will the unwinding of its balance sheet be smooth, or will it disrupt asset prices across the world? Geopolitics, both in the Middle East and around North Korea, keeps hitting the headlines. With President Trump seemingly embroiled in several unfavourable domestic issues, will the US resort to distracting domestic attention towards foreign entanglement? In my naïve analysis, signs of inflation seem to be sprouting everywhere – whether it’s commodity prices or wage inflation or in the general cost of doing business. Will inflation reflect in the numbers in the US and drive long bond yields higher? And, finally, a benign liquidity environment has powered a rally in momentum growth stocks. Does that pause or continue? Will out-of favour sectors and countries be the beneficiaries if that happens?

Liking North Asia, tech and financials

By looking at the allocations in the portfolio, the tilts you can observe are towards North Asia for countries and technology and financials for sectors. Technology stocks have delivered high growth but valuations have expanded as well. With that combination comes susceptibility to a pause in momentum investing as well as a rise in bond yields which can impact valuations for these names. I am reviewing some of my technology holdings in the hardware manufacturing area with a high possibility that I could trim some of them. A large allocation to China indicates my assumption of a benign outlook in China. GDP growth might not be stellar, but growth in cash profits and earnings for corporate China could be surprisingly robust. Internet-related companies are likely to sustain growth over time.

The tilts you can observe are towards North Asia for countries and technology and financials for sectors.

In the ‘old’ economy, a couple of developments are worth noting. The resolve demonstrated by the government in removing capacity in the steel, cement, coal and aluminium industries has been, in my view, a significant event. Take steel as an example. By shutting approximately 7% of capacity in the past 15 months, the surviving companies are generating solid cash profits.

After sustaining cash losses in 2015 and early 2016, the steel industry in China is now earning substantially higher cash margins per tonne of steel. Once considered a big negative in China – diktat by the government – now looks like the saviour. Whether it is due to environmental pressures or the threat of trade sanctions, these capacity restraints have helped the steel industry recover smartly. Cynics will ask how long can this last. Can the government remain committed to these shutdowns? Will such high profits not tempt the industry to reopen those plants that were shut down? Of course there are valid questions and there is a risk of re-openings. However, in my view, apart from the survivors which benefit from capacity shutdowns, there is an unintended positive impact on China’s banking sector. In the past, banks were directed to lend to companies that created jobs and resulted in GDP growth. Never mind that the rising capacities imperilled the profitability of borrowers and in turn hurt the banks due to rising non-performing loans. With several ‘old’ industries generating better growth in profit and cash flow, the banking sector in China is starting to see a positive change in the health of their leveraged borrowers. GDP growth might not be stellar, but, for a change, cash flows and profits for industrial China are growing. If this lasts, it will be positive for macroeconomic stability and for the banking system as a whole.

Rising Chinese bond yields

For banks and financials in China, another development worth noting is the rise in 10-year government bond yields. A rise in the cost of money is exactly what China needs. In the past, I’ve commented on the fact that money was too cheap and abundant in China, which in turn allowed growth in leverage and misallocation of capital.

The clampdown by authorities on capital outflows is likely one reason for this increase in the cost of money. The shutdown of irrational borrowers, like the Anbang Insurance group or the HNA group, and the recent crackdown on P2P lenders and micro-lenders are signs of a return to some rationality in China. As these irrational borrowers disappear from the scene, the genuinely good financial institutions (yes, there are some in China too!) are starting to assert their competitiveness. We own two of them: Ping An Insurance and China Merchants Bank. If my analysis is right, not only will they benefit from higher margins but also from a large increase in market share at a time when economic growth is stabilising and profits for China corporates in general are better. In sum, I am a bit more sanguine on profit growth in China, wary of momentum and aware that the biggest risk we face is a dislocation of bond yields if inflation reflects in numbers in the US. I do think we have a balance in the portfolio to mitigate some of that inflation risk, but, as always, time will tell.

I wish you a Merry Christmas and a prosperous 2018.

Tax reform legislation finally seems to be moving along in the US. While the equity markets cheer, the consequences for junk-rated issuers can be very unpleasant. As much as 4/5 of the high yield issuers could be worse off as a result of the proposed changes, which may in turn exacerbate and accelerate the current default cycle.

Under the current tax “reform” bills that have been passed by the US Senate and House, legislators have imposed a cap on interest deductibility at 30% of EBIT and EBITDA, respectively. On the flipside, issuers will also receive a lower rate of tax at 20% and have the ability to fully expense capital items in the year purchased rather than depreciate over a number of years. It has been argued that allowing immediate expensing of capital expenditure will promote more spending and economic growth.

Our concerns with these likely tax changes are both the intended as well as unintended consequences to credit markets. Various estimates suggest that under the House version of interest deductibility (maximum 30% of EBITDA) approximately 40% of non-financial issuers will be unable to fully deduct their interest expense. However, that is the more generous of the two proposals. Under the Senate version that has interest deductibility maximum of 30% EBIT, approximately 83% of non-financial issuers will be worse off than present. Prima Facie, with no change other than the interest cap, investors can determine that high yield companies that do not have greater than 3x interest coverage (‘low end’) will be worse off. The negative impact of the proposed legislation largely affects B and CCC rated issuers, and will lead to increased spread dispersion among high yield issuers – a trend that has been developing over much of this year even in the absence of the latest set of tax proposals.

Our concerns with these likely tax changes are both the intended as well as unintended consequences to credit markets.

The proposals not only put further pressure on the already strained cash flows of many high yield issuers, but also amplify the downside of credit cycles. Since the deductibility of interest is a function of earnings, as earnings wane so will the issuers’ ability to claim a deduction for interest, creating a double-whammy effect on corporate earnings and liquidity in late economic cycles. Consequently, such a tax law will only increase the volatility of cashflows experienced by high yield issuers. This increases the jump-to-default risk of levered issuers that have low levels of interest coverage.

As such, we believe a cautious stance towards high yield credit remains warranted. This is alongside a number of other concerns for the area including a wave of industry disruption, which poses a particular threat to the Consumer Discretionary and Telco sectors. Considered within the context that spreads are near their pre-GFC lows, the potential limited rewards do not justify the increasing risks.

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2 Performance net of fees, before taxes versus relevant Fund benchmark. We have more information on fund benchmarks and fund performance.

This year I’ve made significant changes in the portfolio. In our monthly updates and calls, I’ve mentioned the challenges I’ve had with performance over the past 12 months. The reasons can be summed up in three buckets:

1. A couple of stock-specific mistakes (Giant Manufacturing and PChome Online, both listed in Taiwan) where disruption of their businesses by internet-enabled competition affected them in a sudden and unexpected manner.

Giant’s bicycle manufacturing business, which I thought was relatively immune from the challenge of online retail, was upended by the proliferation of app-based bicycle sharing business models in China. The novelty and ease of renting bicycles has dramatically cut back the desire to own them, especially the high end ones. Giant’s sales growth in China and margins overall suffered as a result.

PChome Online had a reasonably dominant hold on online shopping in Taiwan until a private/venture capital-funded company (which only recently listed) came up with a much better user interface and offered free delivery for goods, forcing PCHome Online to respond and sacrifice margins and profits. I have since sold out of those names.

2. Post the US elections, interest rates rose a trifle, coinciding with a global cyclical recovery. China Mobile and KT&G in Korea, (both are cash-generating business with low to slow growth) suffered a de-rating on their multiples. I sold out of both.

3. Indian Prime Minister Modi’s decision to demonetise high value currency notes in November 2016 caught me off guard – some of our holdings were rural consumer focused; the impact of the withdrawal of notes was felt mostly in rural India where cash still remains the primary medium of exchange. Small businesses across the country and the agricultural sector were hurt badly and many people employed in these areas witnessed a tough economic situation. Many consumer-oriented businesses reach rural India through the ‘wholesale’ trade. The wholesalers – middlemen – in turn reached far corners of the country dealing with ‘mom and pop’ stores in rural areas. This part of the chain deals in physical cash. This link of the distribution chain was severely affected. Some of our holdings had an adverse adjustment to their business models and they are still recovering from that blow.

India in focus

A year since demonetisation, I thought it would be apt to take stock of its impact, the performance of stocks as well as the exposure of our portfolio to India, which has come down over the past year. It’s not just my reduced holdings but also the composition of those holdings which has changed. From 2015 when almost one third of the portfolio was invested in quality Indian stocks, our exposure to India stands at around 12%, of which half is in cyclicals.

Many commentators rightly point to the long-term attractive nature of the Indian market. I have never disagreed with that premise. I won’t bore you with the details but favourable demographics, rising income, aspirational middle class, well-managed businesses and, of course, a change in government in 2014 were just some of the arguments in favour of India. Yet, in my opinion, the Indian stock market does not seem to be as attractive relative to the other Asian markets.

For any asset to deliver positive investment returns, we need a combination of three factors: the asset has to be cheap on an absolute or at least on a relative basis; the asset should display either rising earnings or improving cash flow profile; and we must encounter a benign and improving liquidity environment.

A benign liquidity environment, thanks to a depreciation of the US dollar has been a common factor for all of Asia. However, only in North Asia have all three factors come together in my view. India, on the other hand, remains a haven for liquidity. The external benign liquidity remains turbocharged by the super abundant domestic liquidity. This was a direct result of demonetisation, when all of the cash in circulation was forced into the banking system. Deposit growth surged at a time when loan growth moderated due to a much weaker economy.

While the liquidity situation in India remains very conducive, in a regional context, the stock market is not cheap.

Two traditional stores of value, gold and property, were adversely affected by demonetisation. These asset classes were typically the repositories of unaccounted cash and, after 8th November 2016, it was not easy to transact in those assets. In effect, savers in India had very little choice. By default, equities became the preferred asset. Inflows into the domestic mutual funds have sky-rocketed in the past year.

This mismatch between deposit growth and the need for loans/funding by the economy was so wide that interest rates started to come off sharply. Since that initial shock to demand, especially in the rural and agricultural parts of the economy, demand conditions have remained subdued. Reported GDP numbers for India have shown the nature of the slowdown in India. Witness the credit growth conditions in India broken down by regions and scale of industries below.

But in this subdued environment, there is just one area which has witnessed an exceptional boom: personal lending – some for mortgages but mostly for unsecured loans – soared.

There are several explanations for this. As the shock of demonetisation affected smaller industries, many smaller businesses and individuals were forced to borrow money to stay afloat. State-owned (SOE) banks are in dire condition due to non-performing loans (NPLs) and are in no position to lend. As interest rates fell, non-banking financial companies (NBFCs) benefited the most from a reduction in their cost of borrowing; they have more than adequate capital. Along with better technology to assess borrowing needs, wider reach through branches and agents in urban areas and credit bureau infrastructure to assess risks, almost all NBFCs have powered ahead in their lending spree.

There is no doubt that a good credit bureau system and use of technology to assess risks are big positives. As I mentioned, SOE banks are on the floor and in no position to compete. With unsecured loans still a very small percentage of GDP, there is genuine room for growth.

All these are very valid and sane arguments. Yet there is always an element of unbridled optimism when it comes to unsecured lending. Currently in India, there is a surge in new finance companies (not just fintech) starting up to take advantage of this big opportunity. With the government about to recapitalise the SOE banks, they, too, might be in a somewhat better position to compete in this space. I do not mean better from a risk assessment or technology standpoint, just better on interest rates. Ultimately, similar to any banking system in the world, the price of loans will be the key area of competition, thus in a way undermining the risk characteristics of this lending opportunity.

India’s near-term blues

The bigger question that plagues my mind is the effect of a slowing economy on disposable income. So far, almost every company we meet remains very optimistic for the long term, but over the next 12-18 months suggest a very uncertain and muted demand environment. The effect of the Goods and Services Tax (GST) in consolidating industry structures in favour of the bigger listed firms is self-evident. Yet there are teething troubles in implementation of GST. That is a minor impediment. The bigger one is the disruption to small-scale businesses which leads to a fall in employment. Similar to the rest of the world, technology disruption will also have a dampening effect on employment generation in India. Data is hard to come by, but anecdotal evidence suggests that job creation still remains the single biggest challenge for the country. Demonetisation and introduction of GST in quick succession has dealt a significant blow to small enterprises.

While the liquidity situation in India remains very conducive, in a regional context, the stock market is not cheap. Indian stocks have always enjoyed a premium over the region, but that was at a time when the rest of the region had little to no earnings growth. As we look into March 2018 and March 2019 growth estimates, what strikes me is the very narrow group of stocks particularly in materials and banks that will contribute to the earnings growth expectations.

While private sector banks and NBFCs will deliver 15-25% earnings growth, they trade on P/E multiples of over 20x while their price-to-book ratios average 4x for 20-22% ROEs. That is not cheap in my view, by any means. These premium multiples I cite for banks are what I also observe for comparable Indian businesses in the quality space. As the saying goes, that the grass is always greener on the other side. But my question is: is this grass or AstroTurf?

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.

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North Korean ruling party newspaper Rodong Sinmun, 6 August 2017

We feel it is paramount as investors to maintain valuation discipline at all times