We believe that good corporate governance and sustainability is a central factor to a company’s long-term success. To support our investment decision making processes we have developed a comprehensive Responsible Investment philosophy statement to provide guiding principles for our investment teams.
Responsible Investment Philosophy Statement
2018 has started with a bang. First we saw the melt-up and then we saw the crash down. The S&P is virtually unchanged from year-end levels, but the volatility has been massive. To put it in perspective, this was the strongest January performance the S&P has seen since 1989, which was then followed by a brutal selloff which saw cryptocurrencies slammed and the VIX jump from 10 to 50.
In this Newsletter I have a look at the leverage in the system and why volatility is suddenly spiking now.
There is also an addendum where I remember the similarities of these markets to 1994.
View the newsletter here.
One of the most common questions that we get from our investors is why do we not have more exposure to China? We answer investors by saying that while we may not be directly invested in any Chinese listed stocks we do have exposure to China through our investment to Hong Kong Stock Exchange and the US-listed Chinese search engine, Baidu. We also have significant indirect exposure to China through our holdings in technology, beverage, fast food and casino companies. This leads to the second most common question asked by investors: Are you concerned about the high risk of owning casino companies in Macau?
Our Concentrated Global Share Fund is actually invested in two US-listed companies, Las Vegas Sands (LVS) and MGM Resorts International (MGM). Both companies develop and operate a suite of world renowned resorts. They also own a majority stake in Hong Kong-listed Macau casinos, as well as casinos within their US properties. In the case of LVS, they also own the Marina Bay Sands resort in Singapore. Whilst we refer to these companies for simplicity as casinos, in reality this is a misnomer given that both companies are owners and operators of integrated resorts that offer five star hotel accommodation, numerous food and beverage options, retail, convention facilities and entertainment venues, as well as casino facilities.
Both LVS and MGM hold indirect exposure to Macau’s hotel and leisure establishments. LVS’ Macau exposure is through a 70% holding in the HK-listed Sands China Ltd, which accounts for around 50% of total earnings (EBITDA). Sands China has a large market share of around 23% and holds the number-one position in terms of gross gaming revenue (GGR), mass-market gross revenue share (29%), and share of total Macau resort earnings (approximately 35%). MGM, who have the largest market share on the famous Las Vegas Strip, derive their Macau exposure through their 56% holding in HK-listed MGM China Holdings Ltd, which currently accounts for 13% of MGM’s total revenue. This is set to grow after MGM China open their second casino in Macau at the end of January 2018.
Tainted perceptions of Macau
We believe that the perception of Macau’s inherent “risk” by some investors dates back to the significant share price declines experienced by the six HK-listed Macau casinos in 2014. This followed the introduction of smoking bans and a country-wide corruption crackdown in China which saw GGR fall from around US$44 billion in 2014 to US$28 billion in 2016. However, our view is the latter initiative will result in an industry that is able to sustain greater long term growth with higher margins, whilst the former will no doubt result in healthier patrons and staff. In assessing the risks and opportunities in Macau, investors need to look through the lens of the Chinese Government’s underlying agenda for the island to appreciate the context.
Macau’s European heritage
Up until 1999, Macau was a Portuguese colony which was renowned for organised crime, illegal gambling and prostitution. In 1999, Macau was handed over to the People’s Republic of China, and like Hong Kong, became a Special Administrative Area (SAR) of China. In 2000-2002 the Macau Government, under the control of the Chinese Government, issued what resulted in effectively six gaming licenses with 20-year terms.
Today, the only real form of legal gambling in China takes place in Macau. Although there was no exclusivity placed on the six licenses, the Chinese Government has been resistant to issue any further gaming licenses given lack of land availability and a focus on developing additional non-gaming attractions. The tax rate was set at a relatively high 39%, and was reviewed ten years later although no changes were made. Hence, the licensing arrangement for the six concessions has remained consistent since China established control.
Macau consists of three distinct land masses – Macau Peninsula, Coloane and Taipa – connected by bridges and covers 30,000 square kilometres. Macau shares a border with the Chinese province of Guangdong. The Peninsula of Macau was the first area to be developed following the handover to China and today accounts for approximately 40% of Macau’s total GGR and about 30% of property earnings.
Sands China was the first to develop the reclaimed land bridge between Coloane and Taipa called Cotai. They were also the first to develop an integrated resort in Macau, the Venetian Macau in Cotai. Sands China now owns close to 13,000 hotel rooms , four theatres with total seating capacity of over 5,000, an arena with a total seating capacity of 15,000, as well as two million square feet of retail facilities and another two million square feet of conference, exhibition and meeting space. MGM, with only one casino and 580 hotel rooms on the Peninsula, will open their second casino in Cotai with an additional 1,400 rooms. Cotai itself has since become home to numerous integrated resorts and now accounts for about 85% market share of the casino-owned hotel rooms and the bulk of the non-gaming facilities, creating a cluster effect not unlike the Las Vegas Strip.
Changing the Macau tourist dynamic
VIP gambling became a feature of Macau and has certainly been a driver of GGR growth from the time the first casino licenses were issued. The VIP business is divided into direct VIP and junket VIP sources. Direct VIP tours are arranged directly by the hotel, while in the third party model, the junket acts as a ‘middle man’, promoting relationships with wealthy individuals in China, organising their visits to casinos in Macau and extending credit. Both forms involve the extension of credit by either the casino in the case of direct VIP, or the junket for the latter. The junkets are paid a handsome commission for their services by the casinos which equates to around 40-45% of net casino revenue from the group. As a result, VIP earnings margins are around 10% and a lot lower than mass market margins which average 35%.
“The Chinese Government’s longer term agenda is to promote Macau as a family-friendly tourist destination”
The Chinese Government wagered a crackdown on VIP gaming in 2014 to control the illegal flow of money from mainland China and address corruption among the junket operators. At its peak, VIP business accounted for 73% of Macau’s gaming revenue. Today, in large part as a result of the corruption crackdown and the introduction of anti-money laundering regulations, VIP revenue is closer to 50% and the number of VIP tables has been reduced by 35% since 2013. Through this curtailing, the Government has facilitated growth in the mass-market segment, which forms part of the longer term agenda to promote Macau as a family-friendly tourist destination.
In 2016, Macau welcomed 31 million visitors and recorded a higher number of overnight visitors than day trippers for the first time. For the casinos, this is important as the average overnighter spends about four to five times that of a day tripper. Of these, 66% of the visitors were from mainland China and 20% from Hong Kong. Given the proximity, 44% of mainland China visitors come from the neighbouring Guangdong Province, and arrive by ferry.
Yet, penetration of Macau tourism in China is only 2-3% of the 1.4 billion population, significantly lower than Las Vegas’ penetration of 13% of US resident visitors. We believe there are a number of reasons behind the relatively low penetration, including lower average personal income, restricted travel, limited hotel capacity and transport infrastructure bottlenecks. Over time, we expect these issues to present less of a barrier to entry.
Major investments to expand capacity
Today, Macau’s aggregate hotel capacity is 36,000 rooms, with typical occupancy of 85% (>90% on weekends and holidays). Based on current development proposals, we expect this number to rise to more than 40,000 by 2020. In addition, more than US$22 billion of transport infrastructure is also expected to reach completion by 2022 which will significantly change the current tourist dynamic. The new transport links will allow more mainland Chinese from further afield to travel to Macau more efficiently, which will encourage longer stays.
One of the flagship infrastructure projects is the Hong Kong-Zhuhai Bridge, a 55-kilometre link due to open in early 2018 which will be among the world’s largest sea-crossing roads. This will allow passengers flying into Hong Kong Airport to arrive at the Macau border by road in 30 minutes. The same journey currently takes an hour by ferry, which operates infrequently.
Expansion of the five airports that serve Macau and development of the National High Speed Rail Network should also drive increased visitation. Cotai, which currently appears as a giant construction site, will be linked by the Macau Light Rail to allow easy access to all the integrated resorts on Cotai. The growth in tourism will take time, however the Chinese Government has made it clear that transportation infrastructure and the development of the Greater Bay Area (which encompasses mainland China, Hong Kong and Macau) is a priority.
Easing the barriers to entry
Chinese visitors currently require a visa to enter Macau. They can either enter Macau on a Group visa as part of a group tour, or under the individual visitor scheme (IVS). Only the residents of 49 cities within China (21 of which are in the Guangdong province) are eligible to enter through the IVS. With the implementation of new technology at border gates, increases in hotel capacity, expansion of non-gaming facilities and infrastructure improvements, we expect that the IVS will be extended to some of the other 650 cities in China over time. China continues to transform into a consumer-driven economy with a burgeoning middle class and we expect those second and third-tier cities to benefit. The World Travel & Tourism organisation is expecting 200 million Chinese to travel outside the mainland by 2020, up from 135 million in 2016. We expect Macau to benefit from the above-mentioned improvements to capacity which will increasingly attract a Chinese population that is more able to travel and has more money to spend. The Macau Tourism Industry body shares this view, with forecasts suggesting “under a modest growth scenario, visitation should range between 38-40 million by 2025”.
Shifting the focus away from casinos
The recent development of Macau has been closely overseen by the Chinese Government. The corruption crack-down is not going away, nor will Chinese officials tolerate illegal activity. They have also made it clear through the Government-sponsored Macau Tourism Industry Development plan, that the goal is to develop Macau into a world “Centre of Tourism and Leisure” and brand it as a “multi-day destination” that offers diversified tourist products and services.
The Government expects the six existing gaming concessions to generate at least 9% of their earnings from non-gaming activities by 2020. LVS already generate more than 30% of earnings from non-gaming revenue streams, with non-gaming and mass gaming accounting for close to 90% of Sands China’s profits in the most recent quarter. MGM China’s new Cotai resort will include a spa, retail, theatre and convention facilities to target non-gaming revenues, which are expected to account for between 12-15% of total revenues by the end of next year.
Both LVS and MGM have fostered strong relationships with the Chinese in order to gain a deep understanding of the Government’s objectives for Macau. By way of example, LVS appointed Wilfred Wong as President of Sands China in 2015. Wong is an experienced and extremely well connected former construction and property executive, who is active in the Hong Kong arts scene. Prior to his private sector work, Wong was also an elected member of the National People’s Congress of China and was involved in the restructuring of Hong Long into a Special Administrative Region. The Co-Chair and Executive Director of MGM China is Pansy Ho, who also owns a circa 22% stake in MGM China. Ho comes from a prominent Hong Kong family with a long history in the Macau gaming industry and has been instrumental in developing Macau as an exhibition space for fine art. MGM have also further engaged with the Chinese through a hospitality joint venture with the State-owned Diaoyutai Guest House. The business has developed hotels in Sanya and Shanghai and is in the development stages for hotels in Beijing and Frankfurt.
Future growth is not in gaming
We believe the future growth drivers of Macau will be the completion of transport infrastructure projects, expansion of hotel rooms, additional non-gaming attractions, and a rapidly expanding Chinese middle class. The Chinese will come from further, stay longer, and spend more in Macau than is practically possible today.
The growth prospects of both Sands China and MGM China are closely aligned with the Chinese Government’s objectives for growing Macau over the next five years. With the opening of MGM Cotai, we do not think earnings growth of 30% in 2018 for MGM China is unrealistic. As capital expenditure recedes, the growth in earnings are likely to be used to pay down debt and allow management to increase the dividend payout ratio from 35% in 2017 to closer to 100% by 2019.
The companies we own have diversified revenue streams that are less dependent on the lower margin and higher risk VIP revenue. As owners of MGM China’s major shareholder, MGM Resorts International, we expect our investors to benefit from these changing dynamics. With the dominant market share that Sands China has in the Macau mass market, we also think it is uniquely positioned to benefit from the longer term growth in Macau. The company has a strong balance sheet and we expect management to remain committed to returning capital to shareholders, namely LVS, their 70% shareholder. Both the Chinese Government and the resort operators are aligned in the transformation agenda which bodes well for more profitable and socially desirable patronage in the years ahead.
Fund Manager commentary for the month and quarter ended 31 December 2017 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.
Ebullience: An issuing forth in agitation, like boiling water; overflow; enthusiasm, extravagance.
What a difference a year makes. Gloom enveloped equities in Asia at the beginning of 2017. This year could be hardly different. There is a general sense of optimism as global economic growth shows signs of acceleration. China, at least in the near term, neither faces a capital account crisis nor deflationary bust. China and other related North Asian economies are recovering from a deep slowdown of 2015/16. While debt still is the elephant in the room, incremental cash flows and earnings for old stack companies display robust positive trends. Stock prices are made at the margin; with data looking positive to distinctly bullish, equities are responding to this fundamental evidence. This chart of China’s foreign exchange reserves China captures the dynamic very well.
China’s improving foreign exchange reserves
You would be excused in feeling ultra-bullish on markets. Several sell side strategists have increased their targets for returns and pronounced this uptrend in its second or third innings. Even the dreaded geopolitical issue of North Korea and the spectre of a nuclear war have receded. Last week there were indications of a potential conversation between South and North Korea, and this week the cameras flashed as dignitaries met in the DMZ to confirm North Korea will send a team to the upcoming Winter Olympics in South Korea.
I do not have much to add to the comments in the press, whether on economics or geopolitics. Stars seem to be aligned at the moment; our job is to monitor developments and watch for risks. Apart from the company-specific risks that are asymmetric in nature, the ones that I think we still need to keep a watch on are: protectionism for general trade; regulation for the tech sector (internet companies in particular); rising inflationary pressure forcing the Federal Reserve to hike more than expected; and a sudden shake out of liquidity as central banks reverse their QE policies.
Learn more about the BT Wholesale Asian Share Fund
“The day the US dares tease our nation with a nuclear rod and sanctions, the mainland US will be catapulted into an unimaginable sea of fire.”
North Korean ruling party newspaper Rodong Sinmun, 6 August 2017
Followers of our investment views will be aware of our enthusiasm for the South Korean equity market. We have a significant overweight position in the country, as we find the stable currency, attractive equity market valuations and powerful corporate governance reform prospects an enticing top-down story. In addition, the wide and liquid equity universe offers a good number of attractive bottom-up investments to access the country-level opportunity.
However, everybody knows one thing about investing in South Korea, and that thing is North Korea. As the above quotation shows, the rhetoric surrounding the tension (technically, an unfinished war) between North and South is hair-raising, and clearly geopolitical risk on the Korean peninsula is something we have had to get comfortable with in order to like the market.
We believe one of the main reasons that geopolitics does not rule out investing in South Korea is the fundamental stability of the situation. While the leadership has changed in both Koreas, China and the USA, the broad ideological stances and narrow strategic goals have not. Even with ongoing missile and nuclear weapon tests, the North Korean regime has a theoretical long-term ambition to unify the Koreas under their leadership and a very real near-term ambition to stay in power. South Korea seeks a good relationship with China under the umbrella of the 63-year old mutual defence treaty with the US. China and the US both seek a broadly stable geopolitical environment and, where China is starting to challenge US hegemony in the region, it is more an issue with Taiwan and/or the South China Sea.
It is important to note the successes of the South Korean economy and equity market have come despite ever-present tension with the North. We can remember being told in the late 1990s that South Korea was uninvestable because of geopolitical risk. In the 20 years to the end of 2017, the MSCI Korea index has delivered a US dollar total return of 1,480%, or 14.8% annualised, massively outstripping both emerging and developed market equities (ie the MSCI Emerging Markets Index and MSCI World Index).
More recently, investors in South Korea have had muted reactions to 2017’s provocations by the North. On 3 September, when the North tested by far their most powerful nuclear weapon, the MSCI Korea index fell only 2.0% in US dollar terms, while the average Korean market decline on the four long-range missile tests in 2017 was only 0.7%. There is little evidence that the equity market or currency move with seemingly-problematic strategic developments; we believe this is because a return to a devastating war has always been a highly unlikely but definitely possible outcome, and these new developments are not actually new risks.
We would contrast the stability of the Koreas with a situation that we find far more concerning (and where we currently have no investments): the Middle East. There is a brutal war underway in Yemen, chaos in Iraq and Syria, huge anti-government protests in Iran, a rapid worsening of relations between the various parties in the Israel-Palestine conflict following the US decision to recognise Jerusalem as Israel’s capital, a diplomatic crisis in Qatar (with Iran and Turkey backing the Qatari regime), the seeming collapse of the improved relations between the US and Iran, and an aggressive reform programme in Saudi Arabia that some have likened to a coup. Each one of those problems is unfolding dynamically, even chaotically, with complicated interlinkages to the other problems.
Whilst we recognise the risks in South Korea, it is the Middle East where we find geopolitics a barrier to investment at this time, as there is a substantial risk, we feel, of a disastrous range of outcomes.
Read more on the
Pendal Global Emerging Markets Opportunities Fund
Pendal Concentrated Global Share Fund
Pendal Wholesale Asian Share Fund
“China’s Tencent surpasses Facebook in valuation a day after breaking $500 billion barrier.”
CNBC, 21 November 2017
Over the long run, emerging market equities have delivered a total return of about 11.3% pa in US dollar terms (since the MSCI Emerging Markets Total Return index came into existence in 1988). This compares to an 8.0% annualised total return for developed market equities (based upon the MSCI World Total Return Index over the same time period).
For the year-to-date to 30 November, the MSCI Emerging Markets Total Return Index has returned 36.3%, far outstripping its long-term returns. More significant, though, is the make-up of those returns. The median stock in the index has returned only 21.6%, while 49 index constituents have returned more than 100% year-to-date. Of the 49 stocks to have more than doubled, 22 are in the information technology space, including Chinese internet heavyweights Tencent and Alibaba. Other mega-cap Asian technology names have also performed very strongly: Samsung Electronics +58.0%, Taiwan Semiconductor Manufacturing Company (TSMC) +41.6% and Naspers, a South African holding company with a 33.2% stake in Tencent +76.5%.
Even with strong underlying growth in these companies, we feel it is paramount as investors to maintain valuation discipline at all times. We do not intend to cover all our research on these stocks in this article, but would like to provide an update.
We feel the Tencent business model is one of the strongest in the world. Whilst its total addressable market is smaller than Facebook’s, its core business continues to grow revenues successfully without overly relying on advertising. Cloud and payments have beaten analysts’ expectations, while the cost pressures in the video business seem to be abating. Against this, though, is the degree to which the share price has out-run earnings. Tencent is valued at 37.6x 2018 consensus earnings, which is near the 40x earnings which has historically formed the upper limit to the stock’s valuation range. Even modelling for significant success in cloud, payment and video, we find it difficult to see great upside from here and do not hold Tencent directly. Rather, we hold a significant position in Naspers. Naspers trades at a deep discount to its underlying net asset value (in fact, Naspers trades at a discount to its stake in Tencent alone), and we see Naspers as undervalued, with an exciting portfolio of assets other than Tencent, as well as a cheap and defensive way to have exposure to Tencent. We retain a significant position in Naspers.
We feel it is paramount as investors to maintain valuation discipline at all times
Alibaba is a stock which has delivered very strong results in the last two quarters, both from monetisation of the Chinese user base, and also growth in the international business. Again, this seems to have been significantly valued in by the recent share price rise, and we find limited value above the US$180 per share level (note that we initially bought Alibaba at US$64 about two years ago). We have been reducing the position into strength and are now significantly underweight relative to the index weight.
Similarly, in the semiconductor space, we find TSMC challenging at above 15x forward earnings and have been reducing into strength. There is no denying the company’s edge in its sub-20nm products for high-performance chips, nor the strong return on capital seen in the last four quarters of results, but even pricing this in, we find reduced upside and prefer to allocate capital elsewhere. In contrast, and as previously detailed, we find the low valuation, strong operational performance and improved corporate governance at Samsung Electronics highly attractive and retain a substantial investment in the stock.
Large index constituents delivering strong returns can be challenging for active portfolio managers. We have enjoyed strong returns from mega-cap Asian technology stocks, but our valuation process is now causing us to increasingly differentiate between them.
Fund Manager commentary for the month ended 30 November 2017 covering market reviews, BT Investment Management fund performance and outlook for the period ahead.
Access the commentary here.
In this final newsletter of the year I want to broaden out our analysis of the global reflation theme. While that theme begins and ends in China, I believe this year’s award for ‘Most Improved Economy’ should go to Europe. We take a detailed look at the quality and composition of Europe’s recent growth spurt, assess the sustainability of these growth sources, and break down the ECB’s (and other European central banks’) approach to rate setting, QE and tapering into 2018.
View the newsletter here.
BT Investment Management’s Crispin Murray, Vimal Gor, Peter Davidson and Ashley Pittard provide a summary of the key drivers of investment markets in 2017 and share their thoughts on the prospects for each asset class in 2018.
Look beyond the headlines
It is customary to sit back and take stock at this time of year to contemplate what has been, could have been and what is likely to be. Participants in investment markets are accustomed to navigating developments on many fronts and 2017 has offered its fair share of these. Fear factors ranged from North Korea’s nuclear aspirations, Trump’s ambitions to thwart those of Kim Jong Un, Amazon’s desire to scare domestic retailers, Holden marking the end of car manufacturing in Australia and Tesla revealing it fell short of its production targets due to a shortage of batteries to power electric cars. Add to these the constant reminders of escalating household debt, housing affordability, persistently low wages growth and pundits even warning of the next global financial crisis, the average investor has had enough reasons to be fearful.
However, capital markets didn’t quite see it that way. Australian and offshore share markets have delivered healthy gains to investors and other asset classes have achieved positive returns. It shows that market noise can be disparate to reality. Investors who looked beyond the headlines with a degree of perspective and remained invested have done well this year.
Australian shares
Investors in Australian shares oscillated between fear and favour for Resources and bond-sensitive stocks, although Resources may have won the battle this year, with a sector return of 17.5%, compared to 8.4% for Industrials. But look a little deeper within the sectors and there are a plethora of winners and strugglers. Consider the retailing segment, Breville Group (+56.9%) has continued to be a solid performer, although sellers of Breville products like Myer Holdings (-40.0%) and Harvey Norman (-16.9%) languished. Within the travel and leisure segment, Qantas (+78.5%) materially outpaced Virgin Australia (+21.7%). In Media, Ten Network (-82.7%) ran into financial trouble while Nine Entertainment (+61.5%) saw a strong recovery in ratings and earnings.
These varied results provide another timely reminder of the importance of deep and rigorous company research to identify risks and opportunities within the market. Most importantly, the quality of a company’s management team and its strategy in navigating a challenging environment to ultimately drive stock performance should not be underestimated.
“The uncertainty created by disruption is unlikely to abate. This leads to mispricing and therefore great opportunities for active fund managers like us to add value, which is what we saw this year.”
Crispin Murray
Head of Equities
The Australian market does not have the same proportion of high growth stocks as the US so we won’t face the same issue with market valuations in that market. At recent levels the market is considered fair value. In the year ahead, valuations will largely be driven by earnings which are expected to be around mid-single digits. Add a sustainable dividend yield of 3-4% and we should see another healthy total return from Australian shares in 2018.
Australian Listed Property
The listed property sector produced healthy double digit returns over the 12 months to November on the back of solid earnings growth and rising asset values, although some of the gains were surrendered in January. Retail property was an expected focal point for investors, given the economic influences of dwindling retail sales and wages growth together with household indebtedness and the anticipation of Amazon’s arrival in Australia. Hence, retail property was not the place to be for investors, with weak returns from Westfield, Scentre Group, Vicinity Centres and Stockland – which together represent over 40% of the A-REIT index. The Office and Diversified REITs sectors delivered double-digit returns, while Industrial REITs – which are limited in offerings – was the best performing sector.
“US bond yields are an unavoidable headwind for the listed property sector, but the market can really be differentiated by qualitative factors”
Peter Davidson
Head of Listed Property
Filtering the sector for quality provides a fundamentally attractive picture. Despite the interest rate headwinds, key support factors such as the net withdrawal of Sydney office supply, low debt profiles, long term leases with inflation provisions and low vacancy rates make listed property an attractive asset class in 2018. The sector offers fair value and is priced at a discount to the direct property market, based on prices paid in major property transactions this year. We are expecting total returns of 6-8% in 2018.
Global shares
Global equities did a reasonably good job of delivering the growth our super funds aspire to achieve, with more than half of the companies within the MSCI World Index rising by at least 10% (in Australian dollar terms). Most regions registered double-digit gains, led by the US (+19.9%) with two thirds of US stocks achieving a positive return. Investing in the mega-techs – Facebook (+46.9%), Netflix (+44.5%) and Alphabet (ie. Google, +24.7%) – delivered exceptional returns. The S&P500 Index closed at record highs 59 times this year. In contrast, the UK (+6.4%) was a distant laggard while the euro zone (+12.0%) was backed for early signs of economic recovery.
We continue to believe that the tailwinds over the last five years which have rewarded indiscriminate broad market exposure are becoming headwinds. This approach is unlikely to yield as market valuations become less compelling and monetary support is ratcheted back. Moving into 2018, the market environment will be best suited to selective ownership of quality companies that are well positioned to withstand a higher interest rate environment and an uncertain geopolitical landscape.
“Share prices are unlikely to continue moving ahead in unison. The changing market environment means investors need to be conscious of valuation, conscious of franchise strength and cautious on cash flow”
Ashley Pittard
Head of Global Equities
Fixed Interest
Australian fixed income posted reasonable returns in 2017, with little differentiation between the Government and credit sectors. Markets began pricing in expectations of rate hikes early in the year before pushing out the theoretical tightening timeline. Returns across the major overseas bond markets ranged from -0.9% to +2.0%, with the global fixed income asset class as a whole returning -2.7% . The Australian dollar appreciated 4.8% against the US dollar but weakened against the euro and British pound over the year. Although returns were muted across the government sector, credit investments performed well as they benefitted from strong share market performance. Strong appetite for risk also transferred to the high yield market, where the yield premium over investment grade credit tightened to levels not seen since 2014 when the market began to correct.
“Looking to the year ahead, we are wary that the goldilocks environment that kept yields range-bound and risk assets supported in 2017 will not be sustainable. We believe a defensive fixed interest allocation remains a critical component of an investor’s portfolio.”
Vimal Gor
Head of Income & Fixed Interest
Factors like an unprecedented unwind of accommodative central bank policy and a leadership-directed shift in the composition of Chinese growth highlight the risks facing credit and government bond markets. This in turn threatens to spark the return of volatility, as well as imbalances like the strong run from high yield credit to correct in 2018.
Investment implications
Investors need to be resilient to market gyrations and ensure risks are appropriate within their overall investment portfolio which is less likely to replicate the path set in 2017. Asset allocations need to be balanced to reflect the inherent shifts in market leadership on many levels. Interest rates are more likely to increase than decrease, albeit in a trajectory that follows evidence of sustainable economy recovery. Investors should also maintain an allocation within a multi-asset portfolio to the Alternatives sector through a selection of strategies that have a low correlation to equity and bond markets and therefore offer additional diversification with the potential for enhancing returns.