Investing in companies that will be beneficiaries of an interest rate-easing cycle should provide rewards, says mid-caps portfolio manager BRENTON SAUNDERS

• Real estate trusts, long duration could benefit
• Discretionary retail and commodities “tough to call”
• Find out about Pendal MidCap Fund

FINDING early cycle opportunities and bond-sensitive stocks should pay dividends for investors.

That’s according to Brenton Saunders, who manages the Pendal MidCap Fund.

“Investing in companies that will be beneficiaries of an ongoing interest rate easing cycle – real estate investment trusts being an obvious one – along with long duration, high multiple sectors, especially the growth stocks, should provide rewards,” Saunders says.

But that doesn’t mean investors should buy into all interest rate-sensitive sectors.

“Discretionary retail is still a tough one to call – some parts of it are doing really well and others are quite challenged,” he explains, adding that it depends on the landing scenario and whether we get a soft or hard landing.

“Some of the deeper cyclicals, whether they be industrials or resources, will probably take longer to improve in a convincing way,” Saunders continues.

“Commodities will depend on the efficacy of ongoing Chinese stimulus which, to date, has been unconvincing.”

The main macroeconomic driver of equity markets is the turning economic – and interest rate – cycle.

Saunders expects two or three rate cuts in the US, adding that so far, Australia is an exception to the rate-cutting trend and likely to remain the case until 2025.

Turns in economic cycles introduces a level of uncertainty in markets, and Saunders says the most recent earnings season demonstrates nervousness about the economic outlook.

“The market disproportionately rewarded companies with either earnings surprises and/or higher guidance, and disproportionately punished companies that had an issue,” he says.

“The re-rating and de-rating during reporting seasons is still about two-and-a-half times what we were seeing pre-COVID.”

What this means is stocks that are doing well are doing even better, and those on the nose remain that way.

“Turn-around stories for earnings, especially among cyclical stocks, remain difficult. Some stocks that investors have been buying in the expectation of an earnings recovery continue to battle,” Saunders says.

Among sectors, banking stocks continue to rally – in some cases ahead of what fundamental analysis suggests.

“During the earnings season, in aggregate there was some margin compression among industrials, though there were some exceptions to that. What it shows is the ability to pass price on is slowly starting to get undermined,” he continues.

“The growth sectors [such as technology] continue to do well both in terms of the numbers they are reporting and their price performance,” Saunders explains.

“The sector that continues to do really badly, based on the global cyclical theme, is resources. Most parts of resources are on the nose, with the exception of gold.

“Iron ore prices fell below $US90 a tonne, lithium is incredibly cheap – highlighting how a lot of future facing commodities are challenged. Oil is normally a good barometer of global economic activity and aggregate demand, and oil prices have been falling.”

For ASX mid-cap investors, three mega-trends remain central to markets, says Pendal portfolio manager Brenton Saunders

• AI accelerates demand for data centres
• Gold an opportunity, up 20 per cent in AUD terms
• Find out about Pendal MidCap Fund

THREE major trends continue to underpin ASX investing in 2024, says portfolio manager Brenton Saunders, who manages Pendal MidCap Fund.

“The first one is international and ubiquitous – data centres and artificial intelligence,” he says.

“Demand for data centres has been a trend for a long time and AI has accelerated that demand.”

“More recently, we’ve seen a very tangible escalation in demand for data centres among big and small corporations.

“There’s a land grab going on and there’s limited availability that meets all the criteria corporates want.”

New supply isn’t meeting demand, making established players like NextDC (ASX: NXT) attractive investments, he says. (Pendal holds NXT).

But investors should keep an eye on data-centre power requirements, which continues to present a growing challenge.

“Data centres are very power intensive and in the brave new world of decarbonising baseload energy, power is becoming harder to access, more volatile and more expensive.

“The advent of AI and its adoption and commercialisation has focused the minds of the bigger corporations on procuring data, storage space, and finding areas where they can train large language models for AI,” Saunders says. “Power is part of that.”

Decarbonisation

The second big trend is around the ongoing decarbonisation of the mainstream electricity supply and the length of time it is taking.

“Renewable generation capacity is continuing with reasonable success, but there have been delays in terms of both timing and capacity.

“That means a range of sectors — from coal and gas producers to electricity producers and even refiners — have benefited, even though some thought demand for their fossil-fuel-generated power would be downscaling by now.

“This is enabling many of these companies to generate good profits for longer.”

Whitehaven Coal (held by Pendal) has benefited, Saunders says.

In regard to coal, because many corporates are no longer investing in the sector, the coal companies are able to buy good assets at cheaper prices. Whitehaven’s purchase of two mines from BHP last year is an example.

The trend has also benefited uranium stocks.

“Uranium has belatedly been recognised and accepted as part of the decarbonisation of the grid.

“Several OECD countries are reversing plans they had to reduce their reliance on uranium and have recommissioned old facilities and are contemplating new ones.”

Electrification

The third trend is around electric vehicles and battery-aided power, as well as the inputs needed for the sector.

“The performance of some stocks in the sector, particularly lithium companies, has been disappointing.

“High prices stimulated new lithium production faster than the growth in market demand. A similar issue has plagued the market for rare earth elements.

“There is also the maturing of the electric vehicle market globally alongside a softer macroeconomic environment. We have seen a notable shift away from battery electric vehicles towards plug-in hybrids.”

While these ripples have arisen in recent times, the electrification trend remains intact.

Gold

Gold is an investable thematic in 2024, though possibly not as long-lived as the other three trends, Saunders says.

“We’re now seeing a number of developed markets cut interest rates and gold has reacted.

“It is up more than 20 per cent year-to-date in AUD, allowing the gold producers to more than offset the high cost inflation of the past two years,” Brenton says.

“Margins have expanded, and companies have been able to generate more cash. They are paying down debt and there’s been more M&A activity, making the sector more buoyant.

“It’s a thematic we think will play into next year.”

Here are the main factors driving the ASX this week, according to Pendal portfolio manager BRENTON SAUNDERS. Reported by portfolio specialist Chris Adams

• RBA board “not ruling anything out” on interest rates
• Market-implied pricing suggests a rate cut before 2025 looks unlikely
• Find out about Pendal MidCap Fund

THE artificial intelligence revolution marches on, with Nvidia touching a US$3.2 trillion market cap last week – second only to Microsoft – and the broader S&P 500 gaining another 0.63%.

Markets look technically extended on momentum indicators, but corporates continue to trade reasonably well – with economies remaining resilient in the face of high interest rates.

Labour markets have weakened at the margin, but slower than anticipated, and remain in good shape.

Strong interest income and asset price strength has supported the top end of the consumption cohort. 

The fixed interest market continues to contemplate the potential for rate cuts in the US, while many emerging markets and some developed markets have already started easing.

The Swiss National Bank cut interest rates by 25 basis points (bps), while the Bank of England said it was close to cuts, with inflation having reached the target range in May.

The RBA, on the other hand, delivered what was seen by some as a hawkish pivot in its comments around the decision to hold rates steady.

It implied that the potential for one or possibly two rates hikes before year’s end was firmly back on the table, much to the dismay of the Federal Government.

The S&P/ASX 300 gained 0.93% for the week.

Elsewhere, US bond markets were largely unchanged, with ten-year treasury yields rising 5bps to 4.25%.

Brent crude oil rose 3.2%, base metals and gold were down between 0.5% and 1.5%, and iron ore was flat.

Lithium marched lower on weak auto sales and continued share gains from plug-in hybrids – which require less lithium – at the expense of battery electric and internal combustion engine vehicles.

US economy and policy

Data points last week tended to underpin the view of an economy softening at the margin, but holding up reasonably well:

• Industrial production beat expectations, with manufacturing output up 0.9 per cent in May – recouping all the declines of the previous two months.
• The March quarter current account deficit widened by $15.9 billion (7.2%), largely reflecting an expansion in the goods deficit. The deficit represents 3.4 % of nominal GDP, up from 3.2% in the previous quarter.
• Advance retail sales for May came in at 0.1% versus the 0.3% forecast. April was revised 0.2% lower to -0.2%. Sales excluding auto and gas rose 0.1% versus the 0.4% expected. April was also revised down on this measure, from -0.1% to -0.3%. 
• Initial Jobless claims declined 5,000 to 238,000. Continuing claims decreased 10,000 to 1.81 million.
• Housing starts fell 5.5% in May (the lowest level since June 2020) and permits fell by 3.8%, the third consecutive monthly decline. The weather is having some impact, but new home construction is now at a four-year low.
• The NAHB Housing market indicator slipped to 43, with weakness across the sub-indices and against the expectation for some improvement.
• The Composite Purchasing Managers Index (PMI) was 54.6, moderately ahead of the 53.5 forecast. The Manufacturing PMI was 51.7 (51 forecast) and Service PMI was 55.1 (54 forecast).

Several comments from US Federal Reserve policymakers noted recent encouraging trends on inflation.

New York Fed President John Williams noted that the labour market is slowing to more sustainable levels and that he expects rates to come down over the course of the year.

Thomas Barkin and Susan Collins, Presidents of the Richmond and Boston Feds respectively, both noted the encouraging inflation figures and said that, while patience was required, there were scenarios where rates were cut once or twice this year.

Dallas Fed President Lorie Logan also saw recent indicators of colling inflation as “welcome news”, but said that several more months of data is required to confirm the trend.

The net effect was very little change over the week in market-implied expectations around rate cuts.

China

May’s retail sales surprised to the upside, rising 3.7% year-on-year – the first monthly reading to beat expectations after six misses.

That said, sales – in part – reflected strength in spending on electronic and communications devices as several new products were launched in the month.

Despite this, the dynamics in China remain weak.

Infrastructure investment is slowing, the housing sector is yet to bottom, and the consumer is losing some tailwinds.

Industrial production was weaker than expected and slowed to 5.6% year-on-year in May, from 6.7% the previous month.

Electricity output also slowed from 3.1% to 2.3%.

Australia

The most interesting thing domestically last week was the debate around the RBA following the Tuesday meeting where it left rates on hold at 4.35%, as expected.

There are a lot of “known unknowns” facing the RBA, including the lagged effect of previous hikes, the impact of tax cuts and the wealth effect of higher home prices and lower inflation on consumption, the effect of tighter labour markets and slowing demand on prices, as well as an improving outlook for the US and possibly China, and higher commodity prices.

At the end of its minutes, the RBA noted: “Inflation is easing but has been doing so more slowly than previously expected and it remains high. The Board expects that it will be some time yet before inflation is sustainably in the target range.”

The Board is also not ruling anything in or out in terms of interest rates.

Some economists have a hawkish take on the statement and Governor Bullock’s press conference.

This view is that the RBA and Federal Government’s views are diverging, and that the central bank may be positioning for a potential hike depending on inflation data from Q2 2024.

Key points for this argument are that inflation remains persistent and above target and that the pace of decline has slowed, while data suggests continued excess demand and elevated costs in the economy.

Real disposable incomes have also stabilised and may be bolstered by lower inflation and tax cuts.

This view was reinforced by Governor Bullock’s comments that the case for a hike was discussed at Tuesday’s meeting, while the case for a cut was not considered.

Market-implied pricing suggests that an interest rate cuts before 2025 looks highly unlikely.

All of this suggests the Australian economy is six-to-nine months behind the US in terms of its economic and interest rate trajectory.

Elsewhere, job ads on the Indeed platform declined 2.1% in May and are down 8.2% year-on-year. Demand for labour continues to weaken and, with population growth supporting an expanding workforce, the unemployment rate should continue to trend higher.

Despite weaker consumer sentiment, higher-for-longer interest rates and the threat of more rate rises, consumption data remains resilient in nominal terms, which is supportive for corporate Australia.

Price inflation has materially offset volume weakness in most categories and, so far, corporate margins have been maintained by the ability to pass on price.

The question is whether margins come under pressure the longer interest rates remain high.

We are seeing signs of pressure on margins in the consumer electronics space, which was reinforced by feedback during the week and suggests risk are building for retailers in this space.

Aggregate household spending remains strong and rose in April versus March, but is slowing in a number of discretionary categories.

Aggregate household expenditure is buoyed by high wage increases, resilient employment data and population growth.

The resulting inflation remains resilient at levels above RBA targets, with few inflation categories showing much decline.

How is a post-pandemic Thailand competing with regional rivals such as Indonesia, Taiwan, India and China? Portfolio manager SAMIR MEHTA visited to find out

• Thailand has many advantages, but strong regional competition
• A case of watch and wait
• Find out about Samir Mehta’s Pendal Asian Share Fund

TO ESCAPE the constant hyperbole of all things Gen AI, we recently went to Thailand to meet a few companies.

Bangkok is normally gridlocked, but fortuitously we were there during school holidays. The pace was laid back and refreshingly languid.

Known as an export base for autos – especially trucks – Thailand has suffered from the advent of electric vehicles, which are dimming the future of internal combustion engine vehicles.

Tourism – including medical tourism – is a pillar for economic growth, but Covid upended that for a while.

Chinese tourists, a backbone of visitor numbers till 2020, have not yet returned in force.

Meanwhile, another chapter of political uncertainty hasn’t helped.

Demographically challenged with a comparatively smaller workforce and an ageing population, Thailand faces severe competition from other ASEAN countries such as Vietnam and Indonesia.

Lower disposable income growth, high levels of personal debt and a generally slower global economic recovery are also headwinds.

No wonder stocks in general have been a disappointment.

We do not presently own stocks in Thailand, but cheap valuations prompted us to visit some of those on our watchlist.

A few observations:

The geopolitical realignment around China is manifest in several ways.

Some foreign companies are relocating to Thailand as an alternative to China. They are increasingly supplemented by Chinese companies expanding in Thailand to circumvent tariffs or quotas on goods manufactured in China.

Thailand’s smaller and higher-cost workforce sets it at a disadvantage to its neighbours.

Companies looking for larger unskilled or lower-skilled employees prefer Vietnam.

India and Indonesia attract firms targeting their respective domestic markets rather than just exports.

Thailand’s advantage is that its people tend to be better educated and higher-skilled.

Officials at Thailand’s Board of Investments are engaging and willing to go to almost any lengths to smooth inward investments.

Thailand’s small number of free trade agreements is an impediment which the government is fervently working to address.

They have streamlined visa applications (renewal now takes two minutes) and further simplified new investment licensing processes.

One company that owns, develops and sells land in industrial estates narrated a sea change in demand over the past 18-24 months.

Chinese EV producer BYD bought a piece of land from the government, which was four times larger than the previous largest parcel ever sold by them.

Another Chinese EV company is on the verge of signing for almost a similar size plot.

Besides EVs, companies are pursuing data centres as we witness a rush to set up server farms to meet the needs of AI and its attendant infrastructure.

Skilled, English-speaking workers in demand

Availability of a skilled workforce fluent in English and educated with an international curriculum will increasingly be in demand.

We met the founder of an international school whose 20-years-plus struggle is finally paying dividends.

Initially with fewer than 200 students, founded by a set of parents, he has grown to 4200 students with potential to expand into the next decade.

Close to 30% of his students are Chinese nationals. Mostly children of employees from Chinese companies but partly from a certain class of Chinese society with the means to migrate away from China and more comfortable residing in an Asian country. 

Medical tourism is booming

Medical tourism was always a forte of Thailand – most leading hospitals have multilingual staff, significantly lower total costs for top-notch medical expertise.

Keeping with the times of social media-driven transformations, aesthetic clinics (a euphemism for plastic surgery) offer a one-stop shop service to “rectify” any part of the anatomy.

Billboards are emblazoned with doctors portrayed as celebrities, social media influencers extolling the virtues of clinics and clinics appealing to the vanity of the insecure (even in neighboring countries like Indonesia).

Business is booming.

Retail quiet

What was missing was the vibrancy of retail traffic in malls. The absence of tourists has been compounded by a big expansion of retail space.

Ironically, the supermarket and convenience store space has consolidated dramatically.

With an absence of any form of anti-trust action, one family almost dominates the scene – though they have relied on copious amounts of debt which in my view burdens an otherwise good business.

Wait and watch

Overall, the “China plus one” de-risking strategy is real.

The consequences of capacity creation outside China – whether in ASEAN, Latin America or Europe – might become more pressing in a year or so if the global economy slows.

Thailand has many competitive advantages, but competition from rival countries with large domestic markets or bigger workforces is a challenge.

We return with no real compelling cases for investing in Thailand when Indonesia, Taiwan, India and even China present alternatives.

It’s a case of wait and watch – and back to the stream of next new things in GenAI.

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About Samir Mehta and Pendal Asian Share Fund

Samir manages Pendal Asian Share Fund, an actively managed portfolio of Asian shares excluding Japan and Australia. Samir is a senior fund manager at UK-based J O Hambro, which is part of Pendal Group.

Pendal Asian Share Fund aims to provide a return (before fees, costs and taxes) that exceeds the MSCI AC Asia ex Japan (Standard) Index (Net Dividends) in AUD over the medium-to-long term.

Pendal is a global investment management business focused on delivering superior investment returns for our clients through active management. 

Contact a Pendal key account manager here

There are no Asian equivalents of the AI-driven ‘Magnificent Seven’ US tech stocks. But there are AI opportunities in Taiwan if you know what to look for. J O Hambro’s SAMIR MEHTA explains

• AI hardware makers have big technical challenges to overcome
• Taiwanese companies such as Jentech have the knowhow
• Find out about Samir Mehta’s Pendal Asian Share Fund

I WAS amused recently to read about the viral resurgence of the iconic Stanley Thermos from a dusty attic relic to an Instagram darling.

Similarly, an ordinary home cleaning product became a coveted possession almost overnight in the UK thanks to a Tik Tok “cleanfluencer”.

Scalability or virality is one of the most desired attributes for a business, especially when accompanied by minimal asset intensity.

The powerful “network effect” of social media propels this concept in ways that boggle the mind.

These are not software products or video games, which have an innate quality of achieving scale if conditions are right.

Making physical stuff is hard to do at scale while ensuring quality and consistency, managing supply chains and such.

Yet we can see a similar effect today among some Asian companies benefiting from the AI story.

Asia does not have a ‘Magnificent Seven’ tech stock equivalent.

But a select group of Taiwanese hardware manufacturers can stake claims as the unsung heroes of an AI-driven shift.

Semiconductor maker TSMC is well known as a critical supplier in this rapidly growing market.

Today I want to outline another example – Taiwanese component maker Jentech Precision Industrial. 

But first, an update on how the rapidly changing AI landscape is impacting the manufacturing of chips and servers.

And who else to help us with this question but Google’s AI app Gemini?

I asked Gemini to list the key challenges for manufacturers of AI chips and AI servers as these components become the workhorses of AI.

These are the challenges Gemini highlighted for AI chip manufacturers:

1. Complexity and Cost:

AI chips often employ specialised architectures like “tensor” cores, which are more intricate to design and fabricate compared to standard computer chip cores. This means higher manufacturing costs and lower yields (usable chips per wafer).

Pushing performance boundaries requires ever-smaller transistors, requiring expensive and cutting-edge lithography techniques that aren’t readily available at scale.

Fabrication complexity and cost is also increased by the need to integrate high-bandwidth memory directly onto a chip for improved communication.

2. Heat dissipation:

AI computations demand significant power, leading to intense heat generation. Traditional packaging and cooling solutions often don’t suffice, requiring innovative thermal management methods.

And here are the challenges Gemini nominated for AI server manufacturers:

1. Scalability and efficiency:

Combining different chips (CPUs, GPUs, specialised AI accelerators) within a server demands new designs for efficient communication and data flow.

Power and cooling is again a challenge. Accommodating high-power AI components necessitates robust power delivery and intricate cooling systems, impacting server design and layout.

Server hardware also needs to be tightly coupled with optimised AI software for efficient resource use and minimised bottlenecks.

2. Changes and new designs:

There is a trend away from rigid, fixed setups to modular designs that allow for flexible configurations based on specific AI workloads. This improves efficiency and scalability but requires innovation.

Traditional air cooling might not be enough for high-density AI servers. Liquid cooling systems, while effective, pose challenges in terms of cost, complexity and potential leaks.

New high-bandwidth, low-latency interconnect technologies are needed to facilitate efficient communication between diverse processing elements inside a server.

What this means for Asian tech leaders

I apologise for quoting at length but I think it’s important to understand the complexity of the challenges posed by the fast-growing AI industry.

Gemini’s list above tells us there is a great deal of development still to come if we are to reap the benefits of AI in ways that are meaningful and significant.

I believe Asian economies are likely to benefit from this process in ways that are not yet recognised by international investors.

We own several companies across this spectrum of innovation and change in manufacturing.

One of them is Jentech Precision Industrial.

With poor analyst coverage, Jentech was lumped in with machining and casting businesses.

It was seen as another component manufacturer in a long list of components in a very cyclical industry.

But changes in AI server technology have led to significant added value and potentially an expanded business cycle.

The simplest way to understand this is the likelihood of a PC and device replacement cycle (in companies and consumers) driving volumes.

Also, a monstrous increase in “active server pages” required for AI-related critical components.

It’s difficult to cite averages, but I believe there could be an almost 8-to-10 times increase in realisations for some component makers compared to normal server components.

Jentech crafts intricate “heat spreaders” which keep AI servers cool under pressure.

Its products help dissipate heat from integrated circuits and strengthen thermal modules while avoiding warping.

Companies like Jentech are defined by years of manufacturing know-how.

Another secret to competitiveness is longer durability of their moulds which reduces costs over the long run.

As Jentech’s client AMD moved to larger heat spreaders, Intel had no choice but to approach Jentech too.

Now Jentech’s thermal solutions play an important role in data centres powering AI breakthroughs and even find uses in self-driving cars.

Shovel-makers for Nvidia’s goldmine

Think of it this way: While Nvidia stole the spotlight, Taiwanese companies like Jentech were busy building the props and the stage machinery, ensuring the show went on without a hitch.

Manufacturers like Jentech are the shovel-makers for Nvidia’s goldmine.

From what I understand, most of Nvidia’s clients want to ensure they are not solely dependent on Nvidia – which means the rest of the Magnificent Seven could become potential customers for these Taiwanese companies in time.

Nothing in technology can be taken for granted.

But many of these Taiwanese firms are the go-to partners of choice with very few alternatives when it comes to leading-edge technologies.

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About Samir Mehta and Pendal Asian Share Fund

Samir manages Pendal Asian Share Fund, an actively managed portfolio of Asian shares excluding Japan and Australia. Samir is a senior fund manager at UK-based J O Hambro, which is part of Pendal Group.

Pendal Asian Share Fund aims to provide a return (before fees, costs and taxes) that exceeds the MSCI AC Asia ex Japan (Standard) Index (Net Dividends) in AUD over the medium-to-long term.

Pendal is a global investment management business focused on delivering superior investment returns for our clients through active management. 

Contact a Pendal key account manager here

Amid the noise from earnings season, long-term mid-cap trends continue to provide opportunities for investors. Pendal PM BRENTON SAUNDERS explains

• Beyond the earnings cycle, long-term mid-cap trends provide opportunities
• Data centres, decarbonisation and transition fuels, EVs worth considering
• Find out about Pendal MidCaps Fund

MOST equities investors know they need to look beyond the ASX50 get better exposure to the fastest-growing industries.

We consider the ASX’s midcap space to cover companies in the ASX51-150 – where market caps can typically range from around $1 billion to $10 billion.

These medium-sized companies tend to offer higher earnings growth than large-cap companies, often with less risk than small caps, says Pendal portfolio manager Brenton Saunders, who manages Pendal MidCap Fund.

Three enduring mid-cap themes that offer opportunities for investors over time are data centres, transition fuels and decarbonisation, and electric vehicles, Saunders says.

“These trends are creating high-quality growth metrics that are investable,” he says.

Here’s a quick overview of the three themes:

Data Centres

“Whether we are speaking to software-as-a-service companies or corporates, the whole notion of data migration into the cloud and trying to integrate AI into processes at a meaningful level is ubiquitous,” Saunders says.

Data-centre operators are an integral part of the shift, which provides opportunities for companies like NextDC (ASX:NXT) and among small caps, Macquarie Technology Group (ASX:MAQ), he says. (Pendal holds NXT and MAQ).

“We continue to see inflections in already high rates of adoptions for incremental storage from all the big players in the market like Microsoft, Amazon and Apple.

“On top of that you have demand from governments and corporates.”

The rise of artificial intelligence has accelerated demand for data centres.

“Somebody that might have been looking for 10 megawatts a few years back is now looking for 20 to 25 megawatts.”  

Outside of pure storage and processing of data companies, there are investment opportunities among more progressive users of the available infrastructure, Saunders says.

Pendal-held imaging group Pro Medicus (ASX:PME) is an example, he says. It relies heavily on moving large quantities of data to the cloud, and then being able to access the information quickly.

“The platform that Pro Medicus is using to do that didn’t exist five or ten years ago,” he says.

Other local players using data-centre infrastructure in innovative ways include Wisetech Global (ASX:WTC), Altium (ASX:ALU) and Technology One (ASX:TNE) — all held by Pendal.

Transition fuels and decarbonisation

There is a mismatch in Australia — and globally — between the necessary ramping up of renewable power sources and the planned decommissioning of old forms of generation, Saunders says.

“Annually in Australia, we should be aiming for between four and five gigawatts of renewable power growth every year. At the moment we’re generating a little over one.

“Yet we still plan to decommission a lot of the baseload carbon-based generation.

“From an investment perspective, that fact will continue to create volatility in power markets. The good generators have an opportunity to take advantage of the volatility in markets.

“Companies like AGL Energy (ASX:AGL) and Origin Energy (ASX:ORG) could benefit.”

“There are also the refiners in the market that are priced as if they are going to be defunct in ten years time,” Saunders says, nominating Pendal-held Viva Energy (ASX:VEA) and Ampol (ASX:ALD).

“But we probably won’t reach that point for 15 years or more.

“Their earnings will remain higher for longer. That gives them more opportunity to return capital to shareholders and diversify their businesses in a meaningful way.”

Electric vehicles

“The sector finds itself in all sorts of pain because of over-investment in a group of raw materials, particularly lithium,” Saunders notes.

“But there is absolutely no going back on it.

“It’s going to be cyclical in nature and we are experiencing that now, but it is a thematic that will have duration and opportunity for investors.”

Saunders notes that the shift to electric vehicles is one part of the decarbonisation roadmap on schedule, particularly in China and Scandinavian countries.

“It’s easy to ignore investing in raw materials for EVs because the prices of commodities like lithium, cobalt and nickel are low.

“But we think it’s another thematic that has plenty of durability.”

A number of Aussie mid-cap companies are taking advantage of political and economic reforms taking place in India, says BRENTON SAUNDERS

• Consider ASX midcaps with exposure to India
• Watch a webinar about ASX midcaps and the lithium sector
• Find out about Pendal MidCaps Fund

INDIA’s growth story — propelled by reforms and digitalisation — was recently highlighted by Pendal’s emerging markets team.

But Aussie equities investors need look no further than the local bourse for stocks with exposure to the sub-continent, says Pendal portfolio manager Brenton Saunders.

Saunders, who leads Pendal MidCaps Fund, recently returned from a research trip in India.

“India — a democracy of 1.4 billion people — has had a number of false starts in growth, political and economic reform,” says Saunders. “But now it’s had four or five years of achieving reform.

“Sovereign wealth funds and private equity money is moving into the economy.

“India has a lot of similarities to China in the early 2000s with it’s fast-growing, economically-active population. “

“Right now only about 70 million indians are economically very active — and they’re responsible for the recent growth. But that number is accelerating.”

A growing middle class

On his recent trip, Saunders observed rising literacy rates, improving education standards and a huge, skilled workforce.

“There are a lot of foreign-educated business school graduates and engineers who have returned to India.

“They are very entrepreneurial and successful at sourcing capital and building businesses.”

With a growing middle class, there are opportunities across the economy, from consumption to infrastructure and housing, Sauders says.

ASX-listed stocks with India exposure

Property-focused digital advertising business REA (ASX: REA) — held in Pendal MidCaps Fund — is an example of an ASX-listed mid-cap with a presence in India.  

“REA is taking its home-grown skill set and applying it in a marketplace where private ownership of real estate is still at a formative level, and consumption is growing with demand for new and better housing.

“There’s a lot of technology associated with price discovery and sourcing of properties by commercial and private buyers.

“That’s where REA is strong. It has a powerful, well established, AI-based classifieds platform, which it can leverage into a very fast-growing real estate market that is gaining momentum.

“It’s a small but fast-growing business in India with a very impressive management team.”

While the REA business in India isn’t “needle-moving” yet, it does provide an opportunity for the mid-cap in coming years, Saunders says.

Another Aussie mid-cap operating in India is IDP Education (ASX: IEL), a former Seek-owned operation which listed on the ASX in 2015.

IDP is also held in Pendal MidCaps Fund.

“IEL has established a powerful global students placement business and has a big share in the world’s largest English language proficiency testing business,” Saunders says.

“India makes up the biggest geography for those businesses globally.

It has about half a million students in terms of placements into foreign universities and education facilities. Mostly they are going into Commonwealth countries like Australia, Canada and the UK – all big beneficiaries.

“IEL is by far the largest incumbent and most respected provider in India,” he says.

Competition has increased for IEL with a growing number of well-funded competitors in the space in India.

“That competitive dynamic is still going to play out in terms of placements and English language testing.

“But the system is still growing. There will be a bigger part of the population wanting to become more English proficient and travel for education as GDP per capita continues to increase.

“Remember, there’s 70 million active consumers in the Indian market. You can expect that to double over the next seven or eight years.

“And that provides enormous opportunity for anyone that is well positioned in the Indian marketplace.”

The turmoil at OpenAI suggests investors are better off ignoring ideology and sticking to tested principles that make markets work – profits and self-interest. SAMIR MEHTA explains

• Parallels between OpenAI turmoil and China’s view of the world
• Don’t get captured by ideology: Mehta
• Find out about Samir Mehta’s Pendal Asian Share Fund

HERE’S a puzzle. Name an organisation that would fit under this mission statement:

Prioritising collective welfare over financial gain, and guided by a philosophy that aims to transform society for the greater good, our mission is to create a lasting, positive impact for the people, free from capitalist constraints.

If you said the Chinese Communist Party, you’d be right.

If you said OpenAI, the high profile not-for-profit that tried to oust its CEO two weeks ago — you’d also be right, points out Samir Mehta, who manages Pendal Asian Share Fund.

“Chinese president Xi Jinping has a genuine belief that the Western world is corrupt; the CCP and only the CCP has the moral rectitude to decipher the right way ahead,” says Mehta.

“This means a new world order, away from profit, capitalism and democracy.

“I find it fascinating that OpenAI was formed with somewhat similar intentions of saving humanity.

“But they never considered the fact that doing good for humanity needs a lot of money.”

What we can learn from OpenAI’s failed coup

The ouster of OpenAI CEO Sam Altman was engineered by OpenAI board members who feared that his plans for unbridled development of AI technology posed an existential threat to humanity.

Only a non-profit, highly-regulated and collectivist approach by people who know what is good for humanity could safely develop the technology, they reasoned.

The boardroom coup failed.

Altman was soon reinstated with the backing of major shareholder Microsoft – and the board members were replaced.

What can investors – especially those keeping an eye on China — learn from this astonishing episode?

The struggle for control at OpenAI highlights the tension between a non-profit mission to benefit humanity and the capitalist reality that billions of dollars are required to make that happen, says Mehta.

“It reminded me of when Xi Jinping came down on Chinese companies like Ant Financial and Alibaba’s founder Jack Ma,” says Mehta.

And yet, Chinese fast-fashion retail giants such as Shein and Temu continue to conquer the world.

“There are parallels between Chinese and American ideologies,” says Mehta.

“They are ostensibly diametrically opposite, but when it boils down to business and you peel away the onion, there is very little difference between the two.”

China’s underlying capitalism

For all the policy action in China, capitalism continues unabated, says Mehta.

“There are shackles (literally in some cases) put onto individuals who have been made examples of, like Jack Ma. Yet business in China is ultimately the survival of the fittest.

“Look no further than electric vehicles.

“There were hundreds of EV companies in China nurtured by different provincial or city governments that you and I will never hear about.

“Ultimately, a handful – likely led by BYD, X-Peng and Nio – will expand and dominate.”

Lessons for investors

The lesson for investors? Don’t be tempted to bet against capitalism, argues Mehta.

“At the end of the day, rapid technological change drives people, companies and nations to act for their own benefit.

“When Russia invaded Ukraine and energy prices rose, even Europe suspended its bans on coal and bought cargoes of LNG at exorbitant spot prices that were contracted to poorer countries like Pakistan.

“Attempts to mandate changes to behaviour ultimately make little dent to the reality of what is driven by power, profits and capitalism.

“Government intervention can help — but in the big picture, it is marginal.”

What does that mean for investors?

Look through threats of regulation and dreams of altruism to hold the best, profit-generating and well-managed businesses, argues Mehta.

New global players such as Chinese fast-fashion retailers Shein and Temu (not held in Samir’s Pendal Asian Equities Fund) are a case in point, he says.

“Western consumers are willing to buy cheap, disposable fashion ultimately destined for landfills.

“Yet these businesses are innovative and are disrupting some of the best companies in the world.”

Mehta points to Chinese equities held in his Pendal Asian Share Fund such as gaming giant Netease, which has survived a regulatory crackdown and is “absolutely swimming in cash”, and Tencent Music, which has transformed and prospered despite restrictions on the live streaming parts of its business.

“Despite the communist party’s ideology, the Chinese economy still has pockets of very aggressive, capitalism.

“That capitalism is what is driving new technologies, new ways of doing business and new businesses.”

The OpenAI lesson

As for Open AI and other generative AI businesses, a similar story will play out, believes Mehta.

“A huge fissure divides those who believe in the possibility that AI will harm us and others who believe AI will help solve humanity’s problems.

“Whichever side is more right than wrong, we are already on a path of AI progress which is difficult to control.  

“It is such a powerful technology that someone or other will step into the void and run with advancement.

“The lesson for stock investors is that when faced with a crisis and negative perceptions around how regulation will likely overwhelm businesses, you want to dig below the surface and find those companies and managements who might be able to come through the crisis.

“Therein lies an investment opportunity.”

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About Samir Mehta and Pendal Asian Share Fund

Samir manages Pendal Asian Share Fund, an actively managed portfolio of Asian shares excluding Japan and Australia. Samir is a senior fund manager at UK-based J O Hambro, which is part of Pendal Group.

Pendal Asian Share Fund aims to provide a return (before fees, costs and taxes) that exceeds the MSCI AC Asia ex Japan (Standard) Index (Net Dividends) in AUD over the medium-to-long term.

Pendal is a global investment management business focused on delivering superior investment returns for our clients through active management. 

Contact a Pendal key account manager here

Pendal portfolio manager BRENTON SAUNDERS outlines three mid-cap themes that look good right now

• Oil, renewables and uranium provide opportunities
• Data centres, battery materials worth considering
• Find out about Pendal MidCap Fund

IN the ASX midcap space three themes – energy, data centres and battery materials – look like opportunities at the moment, argues Pendal portfolio manager Brenton Saunders.

Saunders manages Pendal’s MidCap Fund, which invests in the 100 biggest companies outside the ASX50, where market caps typically range from around $1 billion to $10 billion.

Theme one: energy

“A number of factors provide a constructive backdrop to the energy picture in the short, medium and longer terms,” Saunders says.

Short-term considerations revolve around oil prices and the geopolitical backdrop.

“It’s not just a function of the conflicts in Israel and Ukraine but also how the United States economy performs especially ahead of the election next year.

“Ultimately the people that control the oil market – OPEC and its aligned bodies – view an oil price in the $US90 to $US100 a barrel range as a more acceptable outcome than one in the 60s or 70s.

“I think they will reverse-engineer that market to achieve that outcome,” he says, adding that the dynamics in oil markets will play into coal markets as well.

“The medium-term considerations are more around opportunities available to companies that have strong positions in transition fuels, like natural gas.”

Saunders highlights some stocks held in Pendal MidCap Fund:

“An example in that space is Beach Energy (ASX: BPT),” Saunders says.

“The more tangential opportunities, in the medium term, are the oil refiners which are using the decarbonisation period to reinvent their strategies.

“We’ve seen Viva Energy (ASX: VEA) delve much more into convenience retail, for example.

“We also think energy generators could possibly benefit as economies struggle to replace baseload power with renewables. That helps companies like Beach Energy, Viva and Whitehaven Coal,” he says.

In the longer term, Saunders believes there are opportunities in uranium.

“The narrative around uranium is not as just a transition fuel, but possibly a renewable baseload fuel.

“Countries have progressively comes to terms with the fact that they will need to add uranium to their mix of fuels over time.”

Theme two: date centres

Another opportunity in the midcap space is data and data centres, as business demand for bandwidth and data storage grows.

Saunders believes this bodes well for NEXTDC (ASX: NXT) — another holding in Pendal Midcaps Fund. 

NXT is well placed with respect to existing and planned data centres.

Its premium land bank in Australia and growing ambitious in ASEAN provide a strong and long growth pipeline, he believes.

“The advent of generative AI and the broadscale the adoption of it in some industries is accelerating the need for the transmission of data and the storage of data.

“With think this has a relatively long timeframe to play out.”

Theme three: battery materials

The third thematic among mid-caps is the battery materials markets.

“It is on the nose at the moment, but the demand for demand for batteries and battery materials continues to ramp up aggressively,” Saunders says.

“With both supply of — and demand for — lithium compounding at 20 to 30 per cent a year, there is a fairly big dislocation as lumpy new supply comes into the system.

“At the moment we are dealing with an oversupply of some raw materials for batteries, and of batteries themselves. This should clear as electric vehicle penetration continue to progress.

“Pricing for materials and for stocks in the space is relatively depressed and has sold off significantly in the last four or five months.

“But we think this is a trend that has longevity.

“The sector will have some cyclicality in growth and we are experiencing that now, and that provides investable opportunities.

“We retain good exposure to that through our lithium names and our rare earths names.”

Higher interest rates are already flowing through to company reports. But have investors adjusted to the new reality? SAMIR MEHTA outlines strategies for a higher-rates world

• Higher rates are changing the game for investors
• Near term cashflows are key
• Find out about Samir Mehta’s Pendal Asian Share Fund

IF rates stay higher for longer, investors need to rapidly rethink what has worked in recent years.

That means a few things, says Samir Mehta, portfolio manager of Pendal’s Asian Shares Fund:

• Doubling down on valuation as a critical investing metric
• Understanding the ramifications of tighter credit on business finances
• Carefully considering the second and third-order effects of higher rates, and
• Focusing on near-term cashflow generation ahead of future earnings projections.

The effect of higher rates is already showing up in Asian company reports, says Mehta.

For example, Korean battery maker LG Energy Solutions recently told shareholders that electric vehicle sales would slow next year due to higher rates.

A luxury residential project in Seoul is in difficulty after failing to get an extension on US$344 million in bridging loans.

Altice, a telco giant built by French-Israeli billionaire Patrick Drahi, has put everything it owns up for sale as it struggles to service US$60 billion in debt.

India’s outsourcing industry, a bellwether for the health of global firms, shed more workers last quarter that any comparable period in the past five years.

Borrowing by governments, companies, consumers, and financial firms across Asia is well above levels prior to the global financial crisis, lifting the risks of default, according to the IMF.

“The question is — are the rules of the game changing?” says Mehta.

“We lived through a world with very easy to access capital and low rates as central banks were adding liquidity.

“That environment has shifted, but I don’t think that most of us have as yet adjusted our thinking around what new environment we’re living in.

“The mindset of every economic participant has to now turn on its head 180 degrees.”

Near term cashflow beats future earnings growth

Adjusting to a new world of tighter credit potentially means moving away from investing strategies that have worked in the recent past.

“When rates were low, cost of capital was subdued,” says Mehat. “You had to own assets with long duration cash flows well into the future.

“That was partly because perceptions about growth in the future can’t be tested — assumptions are just based on people’s imaginations — and partly because at a low discount rate, the present value of those future cash flows is amplified.”

In today’s world, investors should instead be looking for cash flow that can be generated in the near term, with a higher degree of certainty, argues Mehta.

That means gravitating towards companies that can find cost savings, reduce working capital and cut capital expenditure; preferably using that cash generation to buy back shares and reduce debt.

“The ability to generate cash today is more important than cash in the distant future.”

Second and third-order effects

This year’s frenzy for AI stocks and weight-loss drug manufacturers are echoes of the low-rate era, Mehta believes.

“Everyone’s coming out with assumptions and predictions of what the impacts may be — but it’s all in five, ten, fifteen years.”

A similar story has played out in recent years for companies supplying the renewable energy industry, he says.

But as the costs of finance rises, these industries will find it harder to raise the capital to continue to invest in what are often unprofitable projects.

“As an investor, you must think about the ramifications of higher interest rates on the businesses themselves — not only the effect on household and mortgage holders.

“Many of these companies have been tolerated by investors because the cost of financing has been very low.

“But as the cost of money has gone up, all of a sudden, the viability of many projects is in question.

“It’s a chain reaction. In solar and wind projects, the equipment manufacturers that supply into these projects are now feeling the pinch.

“In semiconductors, it’s not only the chipmakers feeling the pressure, but their suppliers.

“In China, the bursting of the property bubble is having a follow-on effect on not just suppliers of steel and cement but even real estate agents finding that they have commissions that haven’t been paid.

“You have to step back and change the aperture of your lens to think about business community as a whole.

“That is the ramification of the rising cost of money. And the speed of that rise hasn’t hit us yet.”

Caution warranted

Above all, Mehta urges caution.

As credit tightens, businesses fail and unemployment rises, many analysts expect central banks and governments to go back to their old ways – cut interest rates and inject liquidity.

“Some macroeconomic gurus take the view that a potential geopolitical crisis could compound an economic downturn.

There are bond bulls who think that a slowdown or recession will mean central banks will have to moderate their stance on raising rates and therefore we are close to the peak of the interest rate cycle. 

“But if the rules of the game have changed, we really must question even that assumption of central banks injecting liquidity.

“Because if you think about it, in my view, what the Federal Reserve and other central banks got wrong is that their ultra loose policy exacerbated the inflation problems we are facing.

“If you were a central bank faced with an economic downturn yet lingering inflation pressures, would you take the same path you did during COVID?

“Or are you also going to change the way you think about the world?”

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About Samir Mehta and Pendal Asian Share Fund

Samir manages Pendal Asian Share Fund, an actively managed portfolio of Asian shares excluding Japan and Australia. Samir is a senior fund manager at UK-based J O Hambro, which is part of Pendal Group.

Pendal Asian Share Fund aims to provide a return (before fees, costs and taxes) that exceeds the MSCI AC Asia ex Japan (Standard) Index (Net Dividends) in AUD over the medium-to-long term.

Pendal is a global investment management business focused on delivering superior investment returns for our clients through active management. 

Contact a Pendal key account manager here