Amy Xie Patrick, Portfolio Manager, Bond Income & Defensive Strategies:
It is our belief that the world has moved past the peak of globalisation, and now begins the messy and drawn-out process of individual actors working out the next-best way in which to interact with each other, be they friend or foe.
In this paper, we visit the key issues surrounding ongoing US-China tensions, including offering a perspective of the conflict from both sides. We provide our view of what drives continued tensions, as well as an analysis of the likely scenarios going forward and their potential impact on growth and policy responses.
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Convulsion: a sudden, violent, irregular movement of the body, caused by involuntary contraction of muscles and associated especially with brain disorders such as epilepsy; a violent social or political upheaval
Our long-planned trip to visit companies in China could not have been better timed. A breakdown of negotiations between the US and China prompted President Trump to impose higher tariffs on a wider range of product imports from China. Combined with the imposition of sanctions on Chinese telecom and technology giant Huawei, this has convinced almost all seasoned observers of geopolitics that the ‘genie is out of the bottle’. The posturing and counter-moves by the two global economic giants is just the start of what could be a long lasting ‘economic war’ for ideological dominance in the decades to come. It is beyond my remit to posit on this development, yet suffice to say all countries will need to rethink and adjust as we undergo a massive change to the current global political and economic order.
“Overall the mood in China was combative and downbeat”
Most of the companies we met were cautious to downbeat. To generalise, as industrial profit growth in China slows sharply and export orders come under a cloud, almost every firm is understandably affected. There was a common thread running through most companies’ future expectations: government policies will save the day. I met a few companies which rank very high on the quality and growth score (in the health care and consumer space) but valuations reflect a lot of positivity. Those are on my radar to buy in case markets face further challenges, but overall the mood in China was combative and downbeat.
Our working assumptions are that growth rates (in China and globally) will moderate while volatility of growth will increase. In what is not just a case for China, governments and central banks across the world will increasingly try to cushion negative outcomes for growth in almost every country. Hence, risk of policy mistakes – knowable only in hindsight – will exacerbate asset price moves. Corporate capital expenditure and consumer spending might reflect a high degree of caution as confidence and clarity is diminished.
Pumping life through the economy
In other news, election results in Indonesia and India have given an increased mandate to incumbents. Both leaders face similar challenges: revitalising growth, job creation, growing income levels and infrastructure investment are the priorities. These challenges have no immediate solutions. In a challenged external environment bordering on protectionism, government subsidies will play an increasing role to help the lower strata of society. The constraint will be the fiscal deficit of both countries, but, from what I have read, the initial thrust of both governments will be on devising strategies towards this end. By way of example, Indonesia’s actions of the past few years may be indicative of policy direction for its peers.
Indonesia: Purse wide open
Source: CLSA Securities
Despite these efforts, growth has been difficult to come by. In Indonesia’s case in particular, there is an urgent need to address relatively inflexible labour laws. This has been the most cited reason for the lack of significant relocation of manufacturing at a time when firms are looking for alternatives to China.
Cautious, yet confident
From a portfolio standpoint, there is a fair bit of defensiveness through most of our holdings. I have tried to focus on companies that have managed the disruptive forces of online commerce and stand a better chance of success. With uncertainty emanating from restrictive trade policies, vigilance on monitoring second order effects (like moderation of consumer demand) will be important. There is genuine concern over the economy in China, yet even in these times there are pockets of growth. With this in mind I am keen to add to a couple of names in the ‘A’ share market if there is a further sell-off.
Mexico is the latest emerging market to undergo volatility as a result of politics-related trade uncertainty. As we are currently overweight Mexico in the Pendal Emerging Markets Opportunities Fund, we wanted to provide an update on our views.
For context, Mexico is one of the more stable and institutionally robust emerging markets, with an established democracy, OECD membership and an investment-grade credit rating. That is not to downplay some of the country’s challenges (such as violence and crime, or corruption, or the standard of the education system), but Mexico has smaller challenges than those faced by newer democracies such as South Africa or Russia.
The Mexican economy has performed moderately well since the Tequila Crisis of 1994/5, with real GDP growth averaging 2.6% pa, with the benefits of exports via NAFTA membership being a key driver. Despite this modest economic performance, Mexican equities have performed relatively well, with the MSCI Mexico index averaging 9.1% pa in US dollar terms from December 1995 to December 2018, ahead of both peer Brazil (the MSCI Brazil index has annualised 8.6% over the same period) and the broad MSCI Emerging Markets index (up 6.0% pa). This outperformance of equities relative to the economy is among the best in emerging markets; we attribute this to the competitive strengths of many large Mexican companies, from both good corporate management and also a less competitive structure to many key industries.
We have held a modest overweight position in Mexican equities since May 2017. At that time, we felt that the constructive approach of US Trade Representative Robert Lighthizer was indicative of easing external geopolitical risk for Mexico. We also felt that external demand from exports to the US was strong, domestic demand conditions were reasonable, and that the valuations of both the equity market and the Mexican peso were attractive. Since we initiated that position, our Mexican holdings have contributed positively to performance.
Notwithstanding recent announcements, we have to recognise that the threat by President Trump to impose steadily increasing import tariffs on Mexico is a significant change in the opportunity. Over 75% of Mexico’s exports go to the US and the degree of integration of the two economies means there will be a meaningful impact on both if the threat is carried through. More importantly, the change of direction in the Trump administration’s policy must cast doubts about the final form of the USMCA trade agreement that replaced NAFTA, and was previously thought settled following the signing in November 2018. For ratification, the agreement must gain legislative approval in both in the US and Mexico. The Democratic majority in the US Congress was already a challenge to overcome, but with President Trump seemingly also opposed to free trade with Mexico, it would seem that USMCA enjoys little support in the US and may well be in doubt, despite a continuing constructive approach from the Mexican government.
Political risk has just stepped up in Mexican assets, but we are not immediately turning bearish for a number of reasons. Firstly, Mexican equities look extremely cheap against their history (generally down to levels previously seen in the Global Financial Crisis), in a world where many asset classes look historically expensive. Secondly, real interest rates are historically fairly high and interest rates should follow inflation lower over the next year, providing further support to equities. Thirdly, we own a set of high quality, defensive stocks with very limited exposure to either exports or exporters. It has mostly been the good results from these companies that have supported returns over the last two years.
Finally, and with bigger implications, we believe that trade enables countries to exploit comparative advantage and seek larger markets than their own domestic base. The US protectionist turn is negative for US growth, and financial markets have moved to rapidly price in US interest rate cuts. Any such cuts are likely to drive US investors towards higher carry, higher growth and cheaper valuations, which will benefit emerging markets, including Mexico. It may be that more compelling country opportunities appear, and our process is designed precisely to identify those opportunities, but for now we retain confidence in the part of the Mexican equity market we are exposed to.
With responsible investing continuing to rise in popularity and importance among investors, Richard Brandweiner, CEO of Pendal Australia, joins netwealth’s Joint CEO Matt Heine as part of netweath’s Between Meetings podcast series to discuss:
– intermedation
– peak employment in funds management (vs asset owners)
– the evolution of impact investing and ESG
– philanthropy vs impact investing
– creation of the Pendal brand and taking full ownership of Regnan
– the role of active management and the concept of stewardship
Listen to the podcast
Fund Manager commentary for the month ended 31 May 2019 covering market reviews, Pendal fund performance and our outlook for the period ahead.
Access the monthly commentary here.
Does ownership of shares by a company’s senior leadership actually align interests and drive better results? And what is a true measure of alignment anyway? In our experience, effective alignment actually goes beyond having financial incentives in place.
A true sense of alignment requires a mindset that engenders belief in the long term success of a company.
The words of Texas Instruments’ CEO last month are particularly poignant in this regard and characterise his inherent mindset.
“To me, at the highest level, it’s a philosophy or a belief of a couple of things. First it is act like owners, owners that are going to own the place for decades, and then when you get inside of that you start to look at and make sure you’re focused on getting stronger, and not just bigger … and in many ways. We spend a lot of time on this internally, if you’re focused on getting stronger and you’re aimed at the right markets, the result is you will get bigger”
Rich Templeton
CEO, Texas Instruments Inc
Source: Sanford C Bernstein Strategic Decisions Conference, New York, May 27th 2019
Although a company is never immune to the economic cycle, the Texas Instruments leadership team exhibit complete ownership of the business strategy to ensure it is able to ride through the difficult times.
Texas Instruments is the world’s number one analogue semiconductor company which forms the nucleus of our many and varied connected devices. Its leadership offers a prime example of the owner-operator mindset we look for in company management.
One of the key tenets of our very different approach to investing is to apply this lens on a company’s management. Through time we have found a high degree of success in backing company management teams that exhibit an owner-operator mentality. This goes beyond any financial incentives in place as it is an indicator of a longer term sustainable growth mindset.
Texas Instruments is positioned for continued growth, with a highly diversified product mix skewed to the secular growth industries of automotive and industrial, where they operate across six and 13 sub-sectors, respectively.
For the past 15 years we have witnessed success in this management philosophy. Through this time they have delivered, on average, double-digit growth in free cash flow and a dividend which has increased each consecutive year.
This kind of stewardship is at the core of its success.
At a critical juncture in Australian monetary policy, Pendal Head of Bond, Income & Defensive Strategies Vimal Gor provided this in-depth interview to the AFR’s Sarah Turner on why he is so bullish on bonds, the RBA’s reluctance to ease and comparing the UK’s painful divorce from the EU to the decline of Rome.
View the AFR article
To date, a weaker Chinese Yuan has helped to offset a lot of the pain felt by China from US-imposed tariffs. In this interview with Bloomberg TV Pendal Portfolio Manager Amy Xie Patrick discusses the likely direction of the CNY versus the USD given recent additional tariffs imposed, rehetoric and general sentiment.
View the interview
More about our Bond, Income & Defensive Strategies team
– Conditions for emerging markets (EM) ex-China look better for the next few years than they have in recent years.
– Using IMF forecasts from April’s World Economic Outlook database, EM ex-China should grow at 3.7%pa from 2020-23, 2.3% faster than the developed world.
It has long been generally thought to be the case that two of the key drivers of the relative performance of EM equities versus developed world equities are the growth differential between emerging economies and developed economies, and the strength of the US dollar against other global currencies. These relationships can be made more meaningful by excluding China from the EM component of this model (for complicated reasons to do with China’s closed capital account, and more simple reasons to do with the quality of China’s GDP growth statistics).
Supporting this, JP Morgan has published research showing a fairly strong regression relationship between EM vs. DM growth differentials, the move in USD/EUR and capital flows to emerging markets (ex-China). Its research concludes: ‘robustness tests run with a diverse set of external and domestic variables regularly show EM-DM growth differentials and US dollar performance to be dominant drivers of capital flows.’
With this in hand, how do prospects stack up for the rest of 2019 and into 2020?
Growth differential: EM vs DM
The good news is that conditions for EM ex-China look better for the next few years than they have in recent years. During the ‘golden years’ of 2002-12, when the MSCI Emerging Markets index substantially outperformed the MSCI World index, EM ex-China (GDP-weighted) had average GDP growth of 4.6%pa, 3.2% faster than the developed world (source: IMF, for all GDP data here). The difficult period for EM in relative performance terms was 2013-2018, when the EM ex-China relative GDP growth gap was only 1.2 per cent. Using IMF forecasts from April’s World Economic Outlook database, EM ex-China should grow at 3.7%pa from 2020-23, 2.3 per cent faster than the developed world. This should support EM equity outperformance over the next few years.
Looking into what is driving this, two trends appear. The first is the key role of a few Asian economies in driving EM ex-Chinese GDP growth. India is the largest ex-China EM economy (2019 GDP: US$3 trillion) and is the fastest growing (2020-2024 average GDP growth forecast 7.7%), and the combination of these two means that India is expected to represent 35% of the total growth in EM GDP outside of China. As such, India is a key opportunity for EM equity investors, despite not being among the very largest markets by index weight). Smaller, but also key, are Indonesia (US$1.1 trillion; 5.3%) and Korea (US$1.7 trillion; 2.9%). Other markets are mostly too small (eg the Philippines, Egypt) or too slow growing (eg Russia, South Africa) to make a big contribution. Brazil is perhaps the one that might also make a big contribution, although regular followers will be aware of our concerns regarding the success or otherwise of social security reform there.
It should be noted, also, that the IMF forecast a steady slowing of Chinese GDP growth down to 5.6% in 2023, which will act as a headwind to wider EM growth. While that fits with our shorter-term expectations, any successful stimulus policy in China should lift the EM relative growth gap, improving the outlook for equity investors.
USD strength
So, a positive growth outlook, but a note of caution is the other half of the global macro environment: the US dollar. While we are not G7 currency experts, one trend in the IMF’s forecasts is that the US has had the largest increase in forecast 2020-23 GDP growth of any of the developed markets, which might point to renewed US dollar strength in the future. That would then put focus on inflation, current account balances and other macro-drivers of individual EM equity markets, which is why our process also looks not just at growth, but also the sustainability of that growth.
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Fund Manager commentary for the month and quarter ended 30 April 2019 covering market reviews, Pendal fund performance and our outlook for the period ahead.
Access the monthly commentary here.