What has happened?

In 2014, as the military conflict in Ukraine escalated, the EU and the US (and various other nations) imposed a series of economic sanctions on Russian individuals and entities. From an equity investor’s point of view, the key components of the sanctions were a ban on buying and issuance of new equity for four large listed Russian companies: energy firms Rosneft and Novatek and banks Sberbank and VTB Bank. The securities of all four remained tradeable, as long as they did not issue new equity, which they have not done. There was also a ban on the provision of technology, equipment or assistance by Western firms to Russian offshore, deepwater or shale energy projects.

With further concern about the actions of the Russian government and/or entities connected to Russia’s Government, on 6 April 2018 the US Treasury department announced a new suite of measures, which has had a significant effect in Russian capital markets.

A series of Russian private citizens and government officials (including, importantly, Oleg Deripaska), and firms connected to those individuals, have been designated for sanctions. Crucially, these specifically bar the trading in securities of designated companies as well as limiting those companies’ access to the US dollar payments system. The listed companies designated were mostly unlisted, but did include Rusal (primary listing in Hong Kong) and EN+ (listed in Moscow, London and Paris in depository receipt form).

This had two immediate effects: the two main clearing houses for security transactions moved to immediately limit trades in the securities of Rusal and EN+ (Clearstream has said it will not process trades at all, and Euroclear will only process sales). Additionally, Rusal warned of potential credit defaults and asked its customers to suspend payments while it finds a way to be paid without breaching sanctions.

Market impact

The initial impact of this latest round of sanctions was severe. Perhaps with the US$8.9 billion fine levied on BNP Paribas for breaching sanctions on Iran in mind, there was a broad sell-off in Russian assets, and a very severe sell-off in the shares of the most affected companies, Rusal and EN+.

Rusal and EN+ fell over 50% in US dollar terms, with broad declines in other large cap stocks. The large energy names fell around 10%, Norilsk Nickel fell 18.7% and Sberbank fell 21.6%. Overall, the MSCI Russia US$ Index fell 12.4%, driven partly by a 4.2% fall in the Russian rouble to 62 to the dollar, while Russian sovereign CDS (5-year US$) moved from 120 to 140 (and subsequently widened further). Clearly, these are very substantial moves, and far greater than seen with previous rounds of sanctions.

Top-down implications

Whilst the stock-specific implications could be disastrous for the designated companies, the overall economic effect is likely to be more limited. As an exporter of US$-priced commodities, Russia is vulnerable to disruptions to its use of the US dollar payments system, but elsewhere Russia has considerable strengths. Crucially, Russian exports are commodities and essentially fungible. Barring world-wide sanctions, Russia can supply energy and bulk commodities to other parts of the world (crucially China) and be paid in an alternative currency (probably Chinese renminbi). Furthermore, Western and Central Europe depend on Russia for natural gas, with Gazprom representing a 40% share of supply in 2017.

Additionally, Russia runs a current account surplus (forecast at 3.0% of GDP in 2018) and a very limited fiscal deficit (forecast at 0.3% of GDP in 2018), thereby reducing vulnerability to reduced exports or financing.

The last year has also seen a steady rise in the oil price, which is ultimately the key driver of the Russian economy. With Brent crude currently trading at over US$70 per barrel, the Russian economy will continue to strengthen. A comparison of the oil price with the rouble, or with Russian sovereign CDS, shows the anomaly of the last week’s market moves.

That anomaly represents increased political risk, especially both the wider and more severe nature of the latest sanctions, the risk of Russian retaliation, and the consequent potential for even harsher sanctions. Markets are discounting the world’s cheapest equity market even further in a classic fear-driven, risk off move.

For comparison, the 2015 peak in CDS was 628 and the 2016 low in the rouble was 82.45 to the US dollar. Underpinned by a strong oil price, it is hard to see current risks in Russian equities as comparable with those that existed when the oil price traded below US$45 per barrel.

Portfolio changes

At the start of the month, our portfolio held four Russian stocks: larger positions in Sberbank and miner Norilsk Nickel, and smaller positions in retailers Lenta and Magnit. We have sold our entire position in Norilsk Nickel. The company has a superb operating asset, with large by-product credits giving an effective negative cash cost of production for nickel, while nickel prices remain over US$13,000 per tonne. The stock has fallen to 8x consensus 12-month forward earnings, and could potentially have a 10% dividend yield in the next year. However, Norilsk’s largest shareholder is Rusal, with a 27.8% stake. Rusal has been sanctioned along with its parent EN+ and Oleg Deripaska, EN+’s controlling shareholder. Norilsk Nickel has not been designated as the US Treasury applies a 50% control rule and Rusal owns less than 50% of Norilsk. However, there is a very clear risk that a further round of sanctions could result in Norilsk being designated. This risk is further increased as Oleg Deripaska has recently been nominated to Norilsk’s Board of directors. We consider this stock-specific risk to be unsuitable for our strategy, especially given the attractive valuations available elsewhere in the Russian equity market.

We have increased our position in Sberbank to around 3.0% of the portfolio. Sberbank is a parastatal, with a control stake owned by the Central Bank of Russia; Sberbank’s bonds trade approximately in-line with the sovereign. Sberbank has had strong operational performance in 2017, with a 38% year-on-year increase in net earnings, balance sheet growth with good cost control and some impressive developments in using technology to service both retail and corporate customers. 2017 return on equity was 23.8%, the balance sheet is strong with a Tier 1 capital ratio of 11.4% and a trailing non-performing loan ratio of 1.8% (and a loan loss reserve multiples of the non-performing loans). As such, the decline to a trailing price/book ratio of 1.3x and a 12-month forward price/earnings ratio of 5.2x seems excessive given where the oil price and Russian CDS are (and given the parastatal status of Sberbank). Sberbank is one of our highest conviction stock ideas and we have invested accordingly.

In the mid-cap space, we have maintained our positions in the retailers, and also added a position in a high quality industrial name, GlobalTrans. GlobalTrans is the leading rail freight transport company in Russia, specialising in bulk transport of commodities. GlobalTrans’ controlling shareholder, Konstantin Nikolaev, has not been designated for sanctions. Recent results have been very strong, as the company’s investments in both its fleet and its logistics capabilities have come through – the industry is one with very strong network effects, as minimising the proportion of empty runs is the key operational edge. H2 2017 earnings (EBITDA) growth was 35% year-on-year, with a 51.4% EBITDA margin and a 20% return on invested capital.

One of the reasons we are very positive on GlobalTrans is the management’s excellent capital discipline. Having invested in the fleet, strong free cash flow is being returned to shareholders, with special dividends bringing the trailing dividend yield to 6.5%, and there is a commitment to maintain the dividend policy unless attractive acquisitions become available. The company’s recent investments in its own locomotive fleet for rail tank traffic has been paying off, and we find the combination of a highly profitable business with excellent capital management, good growth prospects and a 12-month forward price/earnings ratio of less than 10x very attractive.

Political risks have undoubtedly increased in Russia in recent weeks, but a strong oil price is a very substantial offset, as is the strong current account and fiscal position. Where valuations are attractive, we will look for opportunities. We always prioritise stock-specific ownership and corporate governance matters in our bottom-up research process, as demonstrated by our sale of Norilsk Nickel and investments in Sberbank and GlobalTrans.

Fund Manager commentary for the month and quarter ended 31 March 2018 covering market reviews, BT Investment Management fund performance and our outlook for the period ahead.

Access the monthly commentary here.

Access the quarterly commentary here.

As active investors, we hold the fundamental belief that markets are inefficient and that, through the application of a well-considered and well-tested investment process it is possible to outperform over the longer term. As top-down investors, we believe that a lot of that inefficiency can be found at the country level, through excessive optimism or pessimism about growth prospects, sustainability of growth, currency outlook or the political and governance environment in that country. As growth-at-reasonable-price investors, we pragmatically believe that markets will, at times, misprice part of the growth-value spectrum in the asset class.

Current concerns: the aggressive and excessive re-rating of growth

We believe that anomalies currently exist within the emerging markets equity asset class in the pricing of growth and fundamentals in both top-down and sector/stock-specific dimensions. Following are some examples…

Chinese internet stocks

Chinese internet stocks soared in 2017. One of the biggest winners was Tencent, a colossus of the Chinese technology landscape, in large part because of its ubiquitous WeChat messaging app which has one billion users. At the time of writing, Tencent is valued on a dizzying multiple of 37 times its 12-month forward price/earnings ratio (P/E). This represents over one standard deviation above the historic mean 12-month forward P/E ratio for the stock, which is statistically material. Previous occasions when the stock has been valued at this elevated level have been followed by de-ratings back to its average price. Should Tencent finish 2018 at its long-term average valuation (29.7 times 12-month forward P/E), the stock would finish the year below its current level, assuming it achieves consensus 2019 earnings. And this assumes that Tencent continues to grow its revenues by greater than 50% for the foreseeable future in an economy growing at an estimated 11% in nominal terms.

Tencent’s toppy valuation

Source: Bloomberg

Other Chinese internet names have lower but still demanding valuations, arguably weaker business models and more challenging governance aspects. Of particular note is the re-rating of Alibaba, which has just enjoyed three very strong quarters in terms of growth in revenue per active user within China and from international revenue, but which seems to have been factored into the share price (the share price has more than doubled since the start of 2017).

An additional component of our growing caution on Alibaba is the firm’s use of cash flow. Since the end of 2015, the company has generated RMB 196 billion in cash flow from operations. This might not seem much over eight quarters for a company with a market cap of RMB 3 trillion (US$482 billion), but of that cash flow, RMB 117 billion was used to fund acquisitions in everything from e-commerce in other emerging markets to luxury malls, newspapers and supermarkets. It remains to be seen whether all of those assets will attract the 29 times 12-month forward P/E multiple that Alibaba currently trades on over the longer term.

Beyond Tencent and Alibaba, other Chinese internet names have experienced similar performance, reacting to strong operational growth with very large share price rises over the past year. The space has enjoyed growth, price momentum and significant investor interest, but it remains our view that share prices cannot outstrip earnings indefinitely.

Lofty valuations in some segments

It is not just in the Chinese internet sector where valuations have exploded far beyond levels supported by underlying earnings fundamentals. There are a number of companies within emerging markets that are challenging even the most generous of assumptions to arrive at the market’s lofty valuations. A few notable examples include Mercado Libre, the operator of an online trading site in Latin America; Celltrion, the largest of a group of related Korean biotechnology companies; and HDFC Life, the life insurance subsidiary of a leading Indian financial services firm, HDFC. By way of example, HDFC is trading on a price/book value of 25 times (no, the decimal point is not missing!) Compare this valuation to industry-leading regional insurer, AIA, which trades at a price/book value of 2.4 times and China Life Insurance trades which trades at 1.7 times and the degree of exacerbation becomes apparent.

To illustrate the degree of dispersion across emerging market companies we have created a composite value measure of index constituents to track their valuation over the past five years. The chart below highlights the degree of dislocation in valuations.

The most expensive emerging market stocks have become far more expensive
 

Source: JOHCM. Composite value measure of MSCI Emerging Markets Index constituents, based on price/book, price/earnings and inverse dividend yield, 2011 = 1.0. Data as at 23 January 2018.

Looking into the top and bottom quartiles (by composite valuation), we find some interesting trends. The top quartile is dominated by China (based on benchmark weight), with India and Indonesia over-represented. At a sector level, information technology, consumer staples and consumer discretionary make up over 70% of the top quartile. The bottom quartile sees South Korea, China and Russia over-represented at a country level while financials is the dominant sector.

There is no natural limit to the premium to which growth stocks can trade at over other stocks. Nonetheless, we certainly feel that parts of the asset class (Chinese internet, consumer growth stocks in parts of Asia) will experience valuation headwinds from these levels.

It is clear that these companies very much represent the growth end of the growth spectrum, and this aggressive rerating of growth stocks is borne out in the index-wide data. By constructing a composite valuation measure (using price/book ratio, price/earnings ratio and the inverse of dividend yield), we can look at the re-rating of the most expensive stocks. The chart above clearly shows that the top-quartile of stocks has re-rated away from the rest of the asset class.

A distorted index: no time for a passive approach

One further impact from the aggressive re-rating of growth over the last two years has been its effect on the valuation of the overall asset class, as calculated by market cap-weighted or free-float-weighted indices. As these larger growth stocks have performed and re-rated, they have driven the overall valuation of the MSCI Emerging Markets Index higher. Some of these growth stocks now dominate the benchmark. At the time of writing, Tencent represents 5.6% of the Index, Alibaba 3.8% and the Chinese internet sector in total represents 12.6%. Naspers (a portfolio holding) has significant exposure to Chinese internet stocks and is a further 2.2%. Collectively, this 15% weighting is slightly larger than the index weight represented by the whole of Latin America plus Turkey plus Poland.

This really matters when one considers passive investing in emerging markets equity. An investor putting US$100 to work in a passive, MSCI Emerging Markets Index-based fund is putting the first US$15 into Chinese internet exposure and only about US$11 in total into the long-term growth stories of India, Pakistan, Indonesia and Egypt. Seen from another perspective, this hypothetical investor is putting over US$27 into information technology exposure and just over half of that into energy and materials.

Naspers – market-leading internet exposure at a discount

The portfolio retains a large position in Naspers, a South African-listed consumer stock. Naspers is a media holding company, with the single largest asset being 33% of Tencent. It also owns 28.7% of Russian internet company, Mail.ru (also listed). Naspers also has substantial investments in pay TV, e-commerce, online classifieds and online marketplaces.

“Passive flows, factor investing and active momentum investing are causing an increasing deviation between valuation and fundamentals”

By subtracting the current market value of the Tencent and Mail.ru stakes from Naspers’ market cap, it is possible to calculate the net value of Naspers’ other assets (including net debt and central costs). This stub has historically had a small positive value, but in 2016 it began to fall as Tencent outperformed Naspers, finishing the year with a valuation US$13.4 billion less than its stakes in Tencent and Mail.ru. In 2017, the stub value fell substantially (touching -US$50 billion and finishing at -US$42.3 billion) despite some very positive operational and financial developments in the stub. We see this as a major mispricing and as a further indication that passive flows, factor investing and active momentum investing are causing an increasing deviation between valuation and fundamentals in parts of the emerging market equity space.

Active opportunities

None of this is to call for a crisis in emerging markets. Global economic conditions remain robust. For about the last two years, exports and manufacturing purchasing manager surveys (PMIs) across the world have been robust, while an absence of inflation has allowed central banks to tighten slowly while longer-dated bond yields remain benign. This environment of stronger global growth but supportive global monetary policy is an ideal one for emerging economies. We believe this will create exciting investment opportunities in the emerging markets equity asset class. We are particularly positive on opportunities within India, South Korea and Taiwan.

India – a coiled spring

India has been a serial economic underperformer despite its potential to be one of the world’s fastest-growing economies. It has struggled recently with below-trend growth, but the conditions are in place for growth to explode over the next two years. In the short term, a general election to be held by 2019 at the latest means we can expect plenty of fiscal stimulus by the Modi Government to ensure that India’s economy is firing on all cylinders going into the polls.

On a more long-term structural note, last year saw two major developments in India that only add to our optimism towards India’s economy and, by extension, Indian equities. The first was the announcement of a recapitalisation of the state-owned banks of approximately US$32 billion over the next two years. This was by far the most significant move of any recent Indian Government to tackle the under-capitalisation of the state-owned banks.

The second was the announcement of a US$105 billion five-year road building plan to improve transport infrastructure to allow the economy to benefit fully from the liberalising effects of the national goods and services tax (GST). These steps are indicative of a government keen to ensure that the positive effects of its reforms are felt before the election.

We believe India’s economy resembles a coiled spring waiting to be released. Moreover, it is a growth story that should materialise irrespective of developments in the China and US economies. While India’s equities are not cheap in an absolute sense, the premium they attract over the average for emerging markets is slightly below its normal level, and we feel that the very strong growth opportunity and the prospects for further reforms justify current valuations.

South Korea – a winner on corporate governance

We believe South Korea stocks are cheap for corporate governance, not geopolitical reasons. Korea’s companies are rich in cash, yet Korea has the lowest payout ratio of any major market in the world. This is explained by a lack of effective oversight that allows company managers to simply hold cash back from shareholders, however this practice is changing. The behaviour of corporate Korea and the related lack of dividends has become a growing issue in Korea’s politics, as an ageing population needs income from its investments. We feel that both Korea’s public’s response to a recent corruption scandal and the resulting election of a left-wing administration will put huge pressure on Korea’s companies to reform. This will be the catalyst to unlock much of the hidden value in Korea’s equity market.

Taiwan – a play on global growth and rising yields

Taiwan is currently our third large overweight country position in the portfolio. As a heavily export-oriented economy with a large tech sector, it is an obvious beneficiary of the synchronised recovery in global economic growth. But it’s not just the export growth story that attracts us here. Taiwanese financials such as Cathay Financial Holding stand to profit from rising interest rates and bond yields, especially insurance names with large, established policy accounts.

Active on country and intricate on company

The multitude of economic, political, industrial and social factors that interplay in developing countries present many risks and opportunities for astute investors. Furthermore, the companies operating either within or across these markets can present their own set of interesting dynamics. Remember that these companies aren’t immune to the rapid shifts emanating from competitive forces and technological evolution that are more commonly related to companies in developed markets. However, focusing on either the country or the company in isolation can lead to overlooking a sizeable intersection of these two realms. It is what makes investing in emerging companies truly interesting and truly rewarding for investors who can appreciate the convolutions and the intricacies in tandem.

Topsy Turvy: In utter confusion or disorder; with the top or head downwards.

It is stating the obvious that trade wars will likely hurt economic activity for all involved. From a Goldilocks-like situation for global economic growth, this tit-for-tat introduces an unexpected degree of uncertainty. With US markets already buffeted by concerns of potential regulation on technology stocks, central banks withdrawing liquidity and normalising monetary policy, this tariff war is a completely unwelcome development. My expectation that the synchronised global economic recovery which started in late 2016 would likely persist a while is looking increasingly tenuous. 

With that moderation in view, I have made some changes to the portfolio. I’ve started to pare back on some of the cyclical holdings, raised some cash while starting positions in a few core holdings. In the past 12-15 months, a few stocks from our core screening universe had either de-rated or seen a strengthening of competitive positions. 

One such name I’ve bought back in the portfolio is LG H&H (Household & Health Care), a Korean company that has three main businesses: beauty (cosmetics), household goods (health) and beverages. The latter two businesses are mature and the past three years margins have trended lower on account of raw material cost inflation. It is LG H&H’s cosmetics business that was and still remains the key growth driver. It represents over half the group’s total revenues. You might recollect in September 2016, relations between China and South Korea hit a very rough patch. The then South Korean president moved unilaterally to deploy a missile defence system (bought from the US) ostensibly to protect against a North Korean missile attack. 

China’s reaction was swift and strong. The Chinese authorities targeted several South Korean businesses in China. One group, Lotte, had several of its department stores and supermarkets shut down on inspections from authorities. There were ‘suggestions’ to travel agents in China not to book group tours from China to South Korea. LG H&H’s business was affected, both in mainland China, where some customers boycotted its products, and in Korea, when Chinese tourists, who are the largest buyers of these products, stayed away. It was a challenging time for the company yet it managed to survive this unexpected slowdown. Ultimately, consumers desire for their cosmetic products remains strong and the company kept spending on brand promotion and advertising throughout that period.

Much water has flowed under the bridge since. The then president of South Korea was impeached and removed from office, and the new president has taken a more conciliatory tone towards China. In this recent trade war between the US and China, LG H&H’s cosmetics business might turn out to be the potential beneficiary. China’s relations with South Korea have improved since that missile episode and the Chinese will likely woo its neighbours in this economic tit-for-tat with the US. Tourist traffic from China has resumed and queues at Korean department stores in Seoul for buying cosmetic products have started to get longer.

Welcome to the inaugural BTIM Australian Quarterly Update.

While we offer our broader global macro insights in my monthly piece, we believe a more Australia-focused update will be valuable to our readers. This newsletter will draw from our strong expertise and range of capabilities in the domestic market. We therefore commit to providing views on the local economy, rates, credit and ESG developments from our portfolio managers.

I hope you find the piece useful and we welcome feedback from readers.

View our first Australian Quarterly Update here.

Headline earnings growth for Australian corporates reflects a continuation of favourable operating conditions, with aggregate results broadly in line with expectations and fewer negative surprises than usual.  Forward earnings growth expectations are largely unchanged at around 6% and are well underpinned by the resources sector.

Key themes emanating from the results season include:

1. Stable earnings outlook which supports reasonable return expectations
2. A distinct lack of negative surprises
3. Earnings momentum is emerging in the cheaper sectors
4. Commodity prices provide a buffer for earnings growth

While the market’s valuation is above its long term average, it is not egregiously so and is entirely consistent with the low interest rate environment. However, conditions are differentiated at an industry level and we are cognisant of the ongoing wave of disruption to traditional business models and industry structures. Equally, we aware of earnings momentum gathering among previously unloved industrial cyclicals and these are presenting a range of compelling investment opportunities.

Access our full report

There are two attitudes you can take to the February 2018 “flash crash”. The first, and overwhelmingly the most popular, is that this was a technically driven correction in the markets, exacerbated by carry monkeys such as the short-VIX crowd, and that the pause since then has provided a refresh in a bull trend that remains well and truly intact. The second view, and much closer take to ours, is that the highs seen in the S&P 500 index on 26th January will be the highs of this cycle and the ensuing volatility marked the beginning of a protracted period of adjustments needed to realign asset valuations with a new reality. I suppose there could be a third attitude which is that the February crash signalled “game over” and equity markets are going to be taken round the back of the bike sheds for a kicking, and normally I would be the first to voice that position, but not right now. Not yet.

As Q1 drew to a close, we were hearing a mix of optimism and caution among our client base, with questions ranging from “shouldn’t you be less bearish given the tax deal struck in the US?” to “why has LIBOR-OIS widened to crisis levels and does this mean we’re on the doorstep of the next market melt-down?” Certainly a lot has happened over the last three months, some of which have been obvious (US tax reform) and others less so (LIBOR-OIS), and a lot is still going on (threat of trade wars, Facebook probes). In this month’s newsletter, I’ll try to piece together the bigger picture as we see it, what it means for markets and asset allocation, and how we’ll position for our views.

View the newsletter here.

“The luxury of today is the necessity of tomorrow. Every advance first comes into being as the luxury of a few rich people, only to become, after a time, an indispensable necessity taken for granted by everyone.” – Ludwig Von Mises.

Most of us can relate to that statement. The best manifestation of this societal norm is the smartphone. Perhaps the millennials of today might include ride-sharing and home-delivered food in that category. But could Von Mises have ever dreamt it could apply to policies by the central banks? As every major central bank talks about normalising monetary policy, all of us have to wonder whether asset markets and, in turn, the real economy are hooked on the necessity of quantitative easing.

Recent data indicates the global economy remains healthy with few clouds on the horizon. This naturally raises a question on the possibility of higher inflation across the world. Several data points suggest that inflation indeed is on the rise. If this portends a structural rise in interest rates, there will be an inevitable need to normalise monetary policy. At the same time, advances in AI, machine learning and robotics indicate a structural deflation, which could mean this nascent rise in inflation is just cyclical in nature.

Cleaner Chinese skies over chasing growth

Amidst this macro uncertainty, I do want to emphasise a distinct change for the better in the Chinese financial system. In no way do I suggest it is in pristine health. Accumulated debt from the stimulus-induced binge post 2009 and the spread of shadow banking to prop up the property markets very much remain a lurking risk. Yet, as I have mentioned before, the closures of capacity in several basic industries is a development worth noting. As a commentary from Gavekal Economics puts it: “There seems to be a change in the incentive system for the party officials and heads of governments across China.” 

Personally, I still think that the improving global economic scenario and diminishing financial risks in China are bigger positives that outweigh the potential risk of trade war rhetoric. – Samir Mehta

In the past, every Chinese government official was measured by GDP growth they delivered, no matter the cost. If the by-product of that obsession with growth meant too much debt and rising leverage, or massive overcapacity, or pollution, so be it. But with President Xi Jinping now focused on reducing pollution, we have seen some drastic cuts in capacity in steel, coal, cement and maybe aluminium. If this change in focus is sustained, the new incentive system will mean that growth is subjugated to quality growth. The result will be better cash flows and healthier companies. This in turn helps the banking system, as the banks’ non-performing loans have in probably peaked for the moment. Simultaneously, the quasi-nationalisation of Anbang Insurance is evidence of the seriousness of the authorities to clamp down on debt accumulation. A company formed in 2004 as a motor insurance firm had accumulated USAUD$3080bn of assets by 2017 – most of them acquired from borrowed short duration money!

Deeds not words

The risk of a trade war and imposition of tariffs is a real risk for economies across the world. Yet, similar to much that comes from this White House, I would rather wait and see how much of what is said is finally implemented. I recollect in the early days of the Trump administration talk of levying an import tax. Analysts worked on various scenarios and modelled spreadsheets with ‘what if’ scenarios. Ultimately, this talk came to naught. With a return of volatility, markets are bound to gyrate around worst-case scenarios of possible tariffs and extrapolate them to infinity. Personally, I still think that the improving global economic scenario and diminishing financial risks in China are bigger positives that outweigh the potential risk of trade war rhetoric.

19 March 2018

Changes to the BT Wholesale European Share Fund (APIR: BTA0124AU, ARSN: 087 594 429) – Important Information

What is the change?

Following a review, J O Hambro Capital Management Limited (JOHCM) will replace MFS International (U.K.) Limited (MFS) as the investment manager of the Fund. This change will take place on or around 23 April 2018.

The Fund will continue to be an actively managed portfolio of European shares investing in companies listed in countries within the MSCI Europe (Standard) Index and opportunistically in companies domiciled outside Europe, from time to time.

Whilst both MFS and JOHCM utilise a bottom up, fundamental stock selection process with a focus on value and high quality businesses, JOHCM adopts a more active approach to portfolio construction.  JOHCM’s investment process for European shares is a high conviction, contrarian approach that seeks to identify companies they believe to be undervalued in the near term but offer long term capital growth.

The JOHCM strategy is also benchmark agnostic, meaning that the benchmark’s weights are not used as a reference point during portfolio construction. With JOHCM’s investment approach being less constrained by the benchmark than MFS, they are able to focus on risk-adjusted returns rather than benchmark relative returns. As a result, JOHCM will build a more concentrated portfolio (typically between 20-25 stocks) reflecting their best investment ideas.

Why do we think the change in manager will be a better outcome for investors?

We believe that JOHCM’s more active and benchmark agnostic approach to portfolio construction will deliver an improved investment outcome to investors compared to the more benchmark aware approach of MFS.

What will be staying the same?  

The Fund’s investment return objective will stay the same: ‘The Fund aims to provide a return (before fees, costs and taxes) that exceeds the MSCI Europe (Standard) Index (Net Dividends) in AUD over the medium to long term.’ 

We believe it is important for investors to be able to continue to measure and compare the Fund’s performance against the market even though the JOHCM strategy is benchmark agnostic.

There will also be no changes to the Fund’s management costs of 1.00% pa and buy-sell spread of 0.30%.

About J O Hambro Capital Management Limited 

JOHCM is a boutique investment firm with investment offices in London, Singapore, New York and Boston and is a wholly owned subsidiary of BT Investment Management Limited.

JOHCM actively manages a range of different global and regional equity investment strategies. As at 31 December 2017, JOHCM has £31.3bn of assets under management across 23 equities strategies covering UK, US, Europe, Japan, Asia ex Japan, global and emerging markets. Over 85% of JOHCM’s strategies are currently ranked within the top quartile of their respective industry peer groups.

A letter has been sent to existing investors and advisers, with clients invested in the Fund, providing additional information regarding the change of investment manager.

Equity markets, particularly in the US, have been in a well-established bull run accompanied with very low levels of volatility. In fact, the S&P 500 had not experienced a greater than 5% drawdown over the 18 months to January 2018. This bull market has been facilitated by concerted efforts from central banks to provide freely flowing liquidity. After such a long cycle it is not unusual to see a spike in market volatility as investors’ sensitivity is heightened in anticipation of a change.  We saw this in early February, with the catalyst being a jump in inflation expectations in the US.

The following provides thoughts from each of our investment boutique heads on the implications for markets and how they are responding.

Australian equities

The Australian market’s fall in early February reflected an adjustment in relative valuations with the US, rather than concerns specific to our market. There are also signs that the selling was exacerbated by some investors scrambling to unwind their low-volatility positions. Despite this, the size of the decline was lower than for the US, given Australia’s more defensive character. These falls were followed by a reasonable rebound, resulting in a 0.3% return from Australian shares for the month of February.

The recent company reporting season revealed quite a different scenario. Earnings growth for industrial companies, in aggregate, was around 9% which exceeded market estimates and we have seen a net upgrade to consensus forward earnings expectations. It is earnings growth that has driven the market’s returns over the past year. A number of companies have reported resilient operating conditions and we expect earnings growth of mid-single digits this year. Add the return from dividends and we can expect to so total returns in the high single digits for the year.

We believe the market’s rating will be supported at current levels, which is underpinned by several factors:

•   Valuations are not excessive. The 12-month forward P/E for the S&P/ASX200 is slightly higher than its historical average, but consistent with the low interest rate environment with the RBA showing no indication of a material policy shift in the near term.

•  There is no sign of a recession. Australian growth remains muted, however tailwinds are emerging, such as the rise in corporate capital expenditure and the large pipeline of infrastructure. In combination with a small pick-up in mining investment and a housing slowdown which remains moderate and controlled, we think the Australian economic outlook remains reasonable.

•  Inflation in Australia remains benign. The monetary conditions in the US do not reflect the situation in Australia, where inflation remains muted and the RBA has given no indication of aggressive hiking.

•  Liquidity withdrawal remains modest. The withdrawal of liquidity from the equity market as a result of central bank actions does present a risk to valuations over the medium term. However, we expect this trend to be moderate globally. The US economy has displayed a historical sensitivity to bond yields and we would expect the Fed to temper their tightening efforts if there are signs of an inordinately adverse effect on growth.

“Bouts of volatility can provide the opportunity to pick up stocks we like at an attractive buying point.”
Crispin Murray, Head of Australian Equity Strategies

As active managers, market volatility creates mis-pricing – and more mis-pricing means more opportunities. Any change in volatility does not typically change our fundamental view of the market and where we see compelling investments. For example, at the moment we see the disruption of long-standing industry structures and business models as a key area of opportunity. Likewise, we also hold some previously unloved stocks where we think the market has not yet appreciated a turnaround in earnings. We also see some opportunity among those growth stocks which have not been pushed to challenging valuations. Bouts of volatility can provide the opportunity to pick up stocks we like at an attractive buying point and our large and experienced team looks to take advantage of these moments as they occur.

Global equities

The US earnings season commenced in late January and indications to date show no material shift in the operating environment for industrial companies. According to data based on 90% of S&P500 companies that reported quarterly earnings, 79% of those exceeded the market’s consensus estimates. The group has on average delivered 14.9% earnings growth over the prior period and commentary from management has been generally favourable.  Against this backdrop it is difficult to call the February correction in share prices as anything other than a realignment of valuations. The fundamentals of a bear market are just not there.

“Rather than be concerned over higher future interest rates, we would seriously question the quality of companies that have not taken advantage of ultra-low interest rates.”
Ashley Pittard, Head of Global Equities

We take the proposition of higher interest rates in the US this year as a given, and inflation will find its way in a lagging fashion. Returns from global equities are likely to remain positive this year, although we expect a greater degree of divergence in fortunes across markets and geographies. In broad terms we expect:

•  A story of two halves – Global equity markets are likely to experience a strong first half, buoyed by strengthening economies and the broad-ranging boost of Trump’s corporate tax cuts and incentives. These conditions are likely to force the hand of the Fed and interest rates will rise ahead of market expectations for the year and weigh on equities. Hence, returns should be similar to their longer term average.

•  US and European companies are well placed to continue to do well – Earnings reports are continuing to show that companies are operating well. Europe has entered their earnings season and given the synchronised growth globally for the first time in a decade, European corporates should deliver similar aggregate results to their US counterparts.

•  Aussie dollar stability – The Australian dollar is likely to be range-bound in the US$0.75-80 band as we have seen over the past five years, which shouldn’t have a material impact on returns from global equities.

•  Market valuations in select areas to remain attractive – Although the market has rallied, certain industries remain fundamentally attractive. Consider that US banks are trading below 1.3x book value, while pharmaceuticals are on an unchallenging PE ratio of 10x.

What is more of interest to us is balancing the assessment of companies that are achieving operational excellence and are using the buoyant economic conditions to generate strong cashflow. Rather than be concerned over higher future interest rates, we would seriously question the quality of companies that have not taken advantage of ultra-low interest rates to skilfully deploy capital and grow their businesses. We give merit to companies that have shown the ability to command a dominant position in their industry. They are much better placed to show resilience in varied market conditions.

Bond markets

Over the past year the market has been focusing on forward indicators of consumer sentiment and US economic growth such as manufacturing and services sector outputs to support expectations of economic growth. These have been in a generally positive trend over the past few years, however, consensus expectations of higher inflation have failed to materialise. We think that inflation will surprise on the upside this year but we are weary of expecting too much of a rise until we see sustained wages growth coming through. Pent-up expectations to seize upon the first signs of inflation was taken by the market as a precursor to inflation rising from stagnant levels.

 “We are cautious of expecting any meaningful pick-up in inflation until we see the whites of its eyes.”
Vimal Gor, Head of Income & Fixed Interest

Whether a benign inflation outcome can continue is the subject of much debate. We are cautious of expecting any meaningful pick-up in inflation until we see the whites of its eyes. What is of significance to markets is if central banks expect inflation to pick up and continue to unwind their unprecedented monetary stimulus. This is a real possibility in the US given that there are two major fiscal forces now in play – company tax cuts and an extension of the debt ceiling. It is exactly the wrong time to be adding stimulus when the economy is running at near full capacity. We believe this will force the hand of the Federal Reserve to counter the inflationary impact, which will be negative for bond yields as the yield curve steepens. The risk then arises that this compensatory tightening will lead to recession in late 2018 or in 2019.

In the shorter term, we expect:
•  Higher volatility for both equity and bond markets – Historically, heightened inflation expectations have been followed by a pattern of higher market volatility. 

•  Investment grade credit to outperform sovereign and high yield debt – Segments that benefitted strongly from the global wave of liquidity are now the most vulnerable areas of the credit world. This includes certain emerging market sovereigns and high yield corporates. An unwinding of favourable market conditions may be particularly unkind to these areas versus more structurally resilient investment grade credit.

•  Australian inflation to lag the US – Inflation in Australia will surprise on the downside. Hence, the RBA will need to closely watch unemployment and wages growth before it can consider any pre-emptive strike against inflation. We find it difficult to build a scenario where the cash rate rises while wages languish and spare capacity remains.

Looking more broadly, the easy financial conditions and fiscal support from the past decade have left a legacy of debt, which raises concerns over financial stability and ultimately results in higher levels of market volatility going forward. We are positioned to capitalise on this environment with tactical exposures to investment grade credit.

Asset allocation

It is important to put bouts of market volatility into context. Markets have experienced strong gains in the last few years so a correction like the episode in February was inevitable. However, what market volatility does illustrate is the importance of a well-diversified portfolio. While equities are a critical component in delivering long-term growth to a portfolio, this exposure needs to be balanced by assets that are diversifying – bonds, foreign exchange exposure and alternatives can all help to stabilise returns.

“One interesting feature of the recent sell-off is that bonds, in general, failed to provide a cushion against market volatility.”
Michael Blayney, Head of Multi Asset

Each episode of market volatility is different. For example, in the global financial crisis the correction was led by credit, with equities following and government bonds providing capital gains to help insulate portfolios. One interesting feature of the sell-off (although a very small correction compared to the GFC) is that bonds, in general, failed to provide a cushion against market volatility.

In a “normal” equity market sell-off, government bonds benefit from a ‘flight to quality’ effect, as investor demand for bonds increases. As the most recent volatility was initially triggered by fears of inflation and rising interest rates (poor conditions for bonds) this caused US bonds to sell off (with Australian bonds mixed depending on the term). The reaction in credit markets lagged equities, and while spreads widened, eventually there was no sign of panic, with investors exhibiting greater focus on strong underlying corporate fundamentals than shorter term equity market volatility.

While we believe that bonds are an important component of a portfolio, this instance of market volatility also illustrated the importance of holding both foreign currency and alternative assets – when one of your stabilisers fails to provide the desired protection it is important to have others. Currency exposure was particularly valuable in this instance, with the recent fall in the Australian dollar from US$0.81 to below US$0.78 providing a cushion to market volatility. When the Australian dollar falls in value, assets denominated in foreign currency become more valuable for Australian investors.

Recognising the inherent uncertainty of financial markets, we continue to hold a broad range of diversifying exposures to seek to smooth out inevitable bumps in the road.