It has been an extremely positive six years for asset owners: equities have experienced their strongest and longest run since the end of the Second World War and the credit bull market is not far off its best historical run. Yet a deep scepticism pervades capital markets that the recovery from the Global Financial Crisis is an illusion, with acolytes of secular stagnation seeing “lower for longer” interest rates as the new normal. Notably, private and institutional fund flows have overwhelmingly favoured bond funds since mid-2007. What if investors are wrong about their asset allocations?
An unusual cocktail
We are in the very unusual position of experiencing both liquidity support and economic recovery at the same time – and it is difficult to predict how long this overlap will last. What we do know is that the growth outlook is the best it has been since 2010, and that the recovery is broadening and deepening. A number of key factors have altered to favour continued expansion. Among them, global fiscal policy tightening as a percentage of gross domestic product (GDP) is diminishing, notably in the US and Europe. Additionally, oil prices have more than halved since mid-2014 and should be viewed as a global tax cut for consumer nations.Volatile headline inflation data masks steadier core figures – and oil’s decline should begin to wash through the former measure.
Inflationary forces
We see evidence in economic releases that conditions are improving and could, in due course, engender a rise in inflation. One key barometer is developed economies’ employment figures, as wage growth tends to accompany labour market tightening. Another area that we are following closely is the US housing market because it provides growth and jobs across multiple sectors.
A 2007 Jackson Hole paper entitled “Housing is the business cycle” posited that residential investment consistently and substantially contributes to weakness before the recessions and that, similarly, the recovery for residences begins earlier and is complete earlier in the cycle than other areas of spending investment. Looking at US housing starts, the numbers of new residential construction projects started each month are still around their 1990s lows: this suggests that the cycle has yet to fully kick in. If it does, investors could be potentially wrong-footed in their bearishness.
For the recovery to gel, however, we do need to see the stronger resumption of corporate confidence. In the wake of the financial crisis, companies turned their attention to shoring up their balance sheets and driving down costs to help their bottom lines. The upshot was increased efficiency, and higher levels of profitability, but the overhang has been businesses’ desire to hoard cash. Companies have the ability to borrow at incredibly low rates of interest, so it is puzzling that we have not seen a more substantial pick-up in mergers and acquisitions activity. We would suggest that many investors are ill prepared if (or when) ‘animal spirits’ make their comeback.
The potential for a central bank policy error and the notable rise of dissenting political voices across Europe arguably pose a threat for risk assets, but we are inclined to be more sanguine about economic growth strengthening to take the baton from stimulus as the markets’ driver. The upshot in this scenario is that equities are, for the meantime, the best place for us to be.
Bill McQuaker is Co-Head of Multi-Asset at Henderson GI.
Photo: Gabriel Jorby. Chinese Tech Entrepreneurs Take a New Path
Since the first Internet companies from China began going public on the NASDAQ exchange about 15 years ago, investment bankers have typically been able to find comparable U.S. companies during IPO road shows in order to help investors better understand the business nature. However, these days when I visit companies in Asia or attend investor conferences, it takes a bit more time and effort to understand the basic business models for some new market entrants. These new start-ups are no longer just copycats of any U.S. counterparts, but are now more deeply rooted in unique economic fundamentals, and more evolved in their own ways. So what makes today’s technology entrepreneurs in China different from earlier pioneers?
First, new ventures need to be better aligned between technology and current lifestyles. China’s earlier Internet start-ups were mostly website portals, search engines or developers of instant messenger applications. One wired desktop was all people needed, whether they were in New York or the other side of the Pacific Ocean. Nowadays, however, things are different. Take ride-sharing companies, for example, which need to work with local taxi unions, city by city. As the Internet and technology have become well integrated into modern lives, a higher level of engagement is often needed in order for new ideas to succeed.
It took 30 years for the U.S. to grow its GDP from US$1 trillion to US$10 trillion (from 1970 to 2000). Meanwhile, China replicated this success in only 16 years, from 1998 to 2014. There, people live different lifestyles. While many don’t have landlines at home, cellphones are a “must have” to navigate the modern world, having leapfrogged the full household penetration of landlines. In addition, a much bigger proportion of Chinese household income is spent online as department stores never developed an efficient supply chain to lower costs. In terms of real estate, when Chinese buyers purchase condominiums, they tend to require additional work from construction companies to build them out as they are more like shells that need much outfitting. And, as an example, of an auto-related new business model, new firms are springing up to help China’s car shoppers verify mileage on pre-owned cars as odometers can often be tampered with in the country’s aftermarket sales.
Secondly, entrepreneurs are now more creative, and capital markets are more sophisticated these days. Earlier entrepreneurs are mostly “returnees”—people who grew up in a much less commercialized society, often obtained their bachelor degrees in China, went to the U.S. for graduate school, and secured jobs in places like Silicon Valley before returning back home to copy and implement U.S. business models. Over a decade ago in China, venture capital was still a foreign concept. When people with ideas in China wanted to start their own businesses, family and friends were often the first and only ones they could turn to for loans. Not surprisingly, many start-ups struggled with financial obligations from day one and struggled to get off the ground. Now, all one needs is simply an idea, a business proposal and a capable team. There are hundreds of experienced venture capitalists who have the money, market knowledge and most importantly, the ability to differentiate between the quality of various entrepreneurial teams.
Although China’s economy has been slowing, I am excited by the new generation of entrepreneurs that is viewing some of the country’s earlier challenges as opportunities.
Raymond Z. Deng is Research Analyst at Matthews Asia.
The views and information discussed represent opinion and an assessment of market conditions at a specific point in time that are subject to change. It should not be relied upon as a recommendation to buy and sell particular securities or markets in general. The subject matter contained herein has been derived from several sources believed to be reliable and accurate at the time of compilation. Matthews International Capital Management, LLC does not accept any liability for losses either direct or consequential caused by the use of this information. Investing in international and emerging markets may involve additional risks, such as social and political instability, market illiquidity, exchange-rate fluctuations, a high level of volatility and limited regulation. In addition, single-country funds may be subject to a higher degree of market risk than diversified funds because of concentration in a specific geographic location. Investing in small- and mid-size companies is more risky than investing in large companies, as they may be more volatile and less liquid than large companies. This document has not been reviewed or approved by any regulatory body.
Photo: El coleccionista de instantes. Central Banks Have Distorted Reality in the Volatility Market
The major impact of Central Banks actions all over the world has been a massive decrease of interest rates. This rates move has led to very good performances for bond investors, but reduced their potential of future returns. As a consequence, investors started to look for alternative yields, for example by allocating more risk to Equities, but also by selling volatility to extract the volatility risk premium and generate yield.
This is where Central Banks have distorted reality in the volatility market: volatility has become abnormally low and abnormally stable compared to the uncertainty over global recovery.
The consequence for the volatility market is that is at some point there is uncertainty regarding Central Banks (Tapering talks in June 2013 or more recently Fed Rates hike talks, or ECB QE), volatility can spike quite sharply, like we experienced in October 2014.
As Central Banks in general around the world will stay very accommodative in 2015, we at Seeyond expect volatility to stay artificially low in average, ie lower than where it would be otherwise, but with some key periods ahead (Fed rates hike, ECB QE effects, etc) we expect to see volatility short lived spikes few times in the coming year.
Simon Aninat, portfolio manager at Seeyond, subsidiary of Natixis Global AM.
CC-BY-SA-2.0, FlickrPhoto: Mark Moz. China for Sale?
Over the past few years, there have been questions about whether the “smart money” is leaving China. For example, high-profile, Hong Kong businessman Li Kashing has been reorganizing his empire to lighten the amount of Chinese property assets he owns, and refocusing on other parts of the world, principally Europe. So, is the smart money leaving? Well, in this case, it is hard to know, as it can be very difficult to separate personal issues from hard-nosed investment decisions or tactical shifts in allocations between regions.
In any case, mainland property assets are still a very significant part of Li’s wealth and in some cases, even though he has been shedding some property, associated companies still retain an interest in the management of those properties. More recently, too, other businesses with at least as strong a pedigree in China have been making significant acquisitions in their core businesses there, particularly in consumer-facing sectors. So, not all the “smart money” is necessarily moving in the same direction. There have definitely been some recent retrenchments from China by multinational companies. As American businessman Jeffrey Immelt has said, “China is big, but it is hard. Other places are equally big, but not quite as hard.” Sometimes it is easier for home-grown companies, focused primarily on their domestic market, to succeed.
Perhaps more significant are the recent sales by some Hong Kong banks of banking assets held on the mainland. Is this a way of taking some of the risk out of the balance sheets of Hong Kong banks? There has been some concern in recent years over the growth in loans to the corporate sector, and potentially in exposure to rising nonperforming loans on the mainland. Since last year, the Hong Kong Monetary Authority (HKMA) has been far more public about lending details of Hong Kong bank loans to Chinese corporates. Mainland assets at the end of 2013 had grown to 17% of Hong Kong bank assets. Hong Kong remains eager to grow its role as a financial center for China over the long term. But it seems apparent that the HKMA is at least somewhat concerned over the pace of growth of the mainland market and its ability to regulate such activity. In addition, some regional banks with mainland loans have been reassessing the risk of these assets, particularly among state-owned enterprises. But even here, though the near-term concern is over rising non-performing loans, this reassessment may be in part a symptom of the belief that these companies will become gradually slightly more commercial and lose some of the implicit backing of the state. Apart from the implications for banks’ risk, would that be such a bad thing?
Then there is the long term—who are the buyers of China’s assets. Well, I would argue—we are. U.S. investment in Chinese securities is at very low levels. According to Treasury data, less than 3% of U.S. residents’ holdings of foreign equities are in China and Hong Kong combined. Although the absolute level has grown throughout the 2000s, it is now little changed since 2010. And it makes sense from the point of view of diversification for the U.S. to be buying more Chinese assets and the Chinese to be buying more U.S. assets.
Let’s not forget that every sell is a buy – greater foreign ownership of China is likely to go hand in hand with greater China ownership of foreign assets– witness China’s investment abroad climbing from 2% of the world’s total (as of 2006) to nearly 6% as estimated at the end of 2013. Indeed, we have seen some Chinese insurance companies starting to buy real estate and other assets since China’s regulators made this easier in 2012. (New York’s Waldorf Astoria is now Chinese-owned.) Programs such as the development of the corporate bond market in China, the development of an over-the-counter market, the mutual fund industry, better regulation of and capital allocation by the Chinese banking industry and capital markets all has a dual purpose: not only to raise the efficiency and attractiveness of investing for domestic investors, but also to reassure and attract foreign investors. For it is only by achieving long-term demand for Chinese assets (alongside the significant demand for Chinese goods) that China is likely able to achieve international status for its currency.
So, is China for sale? Most assuredly yes. This partly reflects the decisions of some high profile businessmen, which grab headlines but which are an imperfect guide to the real trends. It partly reflects, one suspects, an attempt by regulators and banks to get a handle on growing mainland risk exposure. But it also reflects a natural trend of greater cross-border holdings of assets between China and the rest of the world. Over the long term, China will likely continue to be “for sale,” in my opinion, as demand for Chinese assets from foreign investors and central banks continues to grow. As always, it only really matters what price you pay.
Robert Horrocks, PhD, is Chief Investment Officer at Matthews Asia.
The views and information discussed represent opinion and an assessment of market conditions at a specific point in time that are subject to change. It should not be relied upon as a recommendation to buy and sell particular securities or markets in general. The subject matter contained herein has been derived from several sources believed to be reliable and accurate at the time of compilation. Matthews International Capital Management, LLC does not accept any liability for losses either direct or consequential caused by the use of this information. Investing in international and emerging markets may involve additional risks, such as social and political instability, market illiquidity, exchange-rate fluctuations, a high level of volatility and limited regulation. In addition, single-country funds may be subject to a higher degree of market risk than diversified funds because of concentration in a specific geographic location. Investing in small- and mid-size companies is more risky than investing in large companies, as they may be more volatile and less liquid than large companies. This document has not been reviewed or approved by any regulatory body.
CC-BY-SA-2.0, FlickrPhoto: Antonio Zugaldia. Move To a Tactical Neutral on Equities
The European equity rally is both impressive and entirely warranted. Investors had been very sceptical on Europe at the beginning of 2015 but they are now seeing the ECB’s bigger-than- expected Quantitative Easing in action as well as encouraging signs of an economic recovery.
The pace of European growth is now much stronger, mainly due to household spending which had previously been rather soft. And countries like Italy are also seeing an incipient recovery after a long period of stagnation. Economic activity is gaining traction and the most obvious signs of deflation are on the wane:
Bank lending has been stabilizing over the last two months after a long period of contraction;
After a spectacular collapse, Spanish property prices rose by 1.8% YOY in the fourth quarter of 2014.
We are confident in the outlook for earnings growth especially as we believe European company margins have genuine upside if the economy continues to grow at a reasonable pace.
Consequently, we are still overweight Eurozone equities despite the impressiverise. But our overweight is still likely to be adjusted from time to time to reflect mounting political risk in Greece. We continue to believe talks between European institutions and the new Greek government will end up succeeding but, in the meantime, the process is proving chaotic with Athens resorting increasingly to political provocation and not much European enthusiasm over reform proposals from Alexis Tsipras. All this suggests we should be more cautious. Nobody really knows how long Greece can continue to honour its commitments but the risk of a payment accident is rising all the time and that would obviously trigger market volatility.
Based on this scenario, we have moved to a tactical neutral on equities due to:
1. Less buoyant conditions in the US.
The US economy has lost some steam. Statistics have been hard to read due to another exceptionally severe winter but the question now is how the US economy will perform with a strong dollar, an energy sector forced to adapt to much lower prices and the failure so far of household spending to stage a strong recovery. Against all the odds, retail sales have not yet benefited from low oil prices. Consumers have chosen instead to save more over the short term.
Tame inflation and lacklustre economic conditions may push back the launch date for a rate hike but it is still on the agenda judging from comments from Fed committee members.
We are still optimistic on the US economy but we are moving out of a period when US growth was underpinned by very laxist monetary policy and into more uncertain territory with the likelihood of more orthodox monetary policy.
2. Uncertainties over the UK elections.
May’s parliamentary elections and the risk that a Conservative minority government will end up organizing a referendum on membership of the European Union can only introduce a local risk premium. We have accordingly reduced exposure to UK equities.
Regarding the bond market, we continue to prefer high yield bonds and Eurozone convertibles due to the ECB’s move on QE. This is encouraginginvestors to take on more risk to avoid negative returns. We remain cautious on US bonds. As Janet Yellen recently said, investors remain very sceptical on the Fed’s intentions and/or scenario.
Given today’s very low bond yields, investors will probably wait for clearer indications that inflation is returning, before selling the US bond market. Wages will be in focus. At the moment, the US yield curve is the steepest and therefore the most profitable among industrialized countries. We believe that the risk of wage inflation will be high in coming months and drive volatility in the US. Hence our decision to remain underweight US bonds.
Benjamin Melman is Head of Asset Allocation and Sovereign Debt in Edmond de Rothschild Asset Management (France).
CC-BY-SA-2.0, FlickrFoto: The Tax Haven. ¿Triunfar en el largo plazo? No siga a la masa
It’s human nature to follow the pack whether people find safety in numbers or fear they’ll miss an opportunity others are enjoying. For your clients as investors, however, joining the pack might do more harm than good. It could mean they’re jumping in and out of the market at the wrong times, causing irreparable damage to their long-term returns. Or the pack might take them where they don’t belong — into higher risk or “hot” products that don’t match their investment goals.
Let the ship sail
As advisors, you know all too well how investors run toward the strongest performance and run from the weakest. They want to win. They don’t want to lose. In reality, though, by the time most investors decide to dive into a fund or abandon a sinking ship, they’re already in troubled waters. More often than not, pack-driven investing results in buying close to market peaks and selling at market troughs; it rarely leads to sustainable returns.
In fact, during the global financial crisis of October 2007 to February 2009, $208 billion flowed out of equity funds during the last 12 months of the downturn, and from March 2009 to December 2013, $161 billion flowed into equity funds during the last 12 months of the rebound. Those investors would likely have been better off in funds with longer views and high-quality portfolios designed for less volatility in choppy markets. Of course, many investors who stayed the course and continued making contributions throughout the downturn also had some good growth in their accounts due to the simple but powerful benefits of dollar-cost averaging.
Turn down the trends
For investors, trends can be tempting and tough to ignore. Whether it’s the promise of better returns in exotic fixed-income strategies designed to combat a low interest rate environment, or a new “uncorrelated” asset class for those who think equities have run their course, products like liquid alternatives and unconstrained bond funds are entering the market in waves. But these products can be complicated — and expensive. As evidence, the average expense ratio for alternatives is 1.71%, compared to 0.74% for equity funds. For an unconstrained bond fund, the average expense ratio is 1.15%, compared to 0.81% for core bond funds.
Are these costs justifiable? Do these products truly align with your clients’ long-term goals, or is the appeal performance-driven? As an advisor, are you confident that the investment managers have the relevant expertise — in derivatives, for example, given that many liquid alternatives use leverage to boost returns? Just because investment managers can bring new products to market, doesn’t necessarily mean they should. The best companies in this business will only bring to market products where they see promise in the long-term value proposition of an asset class and where they have the requisite expertise and resources in place to deliver on that promise.
More importantly, there are always opportunities in traditional equity and fixed income if you’ve got a skilled active management team to find them. I’d suggest this is as true now as ever, especially as we continue to see more market volatility. That’s when active management provides the greatest opportunity to differentiate returns. That’s when good research pays off. And that’s when focusing on solid fundamentals, which truly drive value and sticking with your convictions, regardless of short-term momentum, provide the most meaningful opportunities for clients.
To get your clients to leave the pack mentality behind, take a page from the playbook of active managers. They purposely turn away from the pack — in this case their benchmark — avoiding full market risk and choosing the risks they take intentionally. Think of it this way: If everyone is fishing in the same pond, they’re all swayed by the same tide and they’re after the same catch. So it stands to reason, if you fish somewhere else and know where to look, you can reel in opportunities that others are missing.
James Jessee is Co-head of Global Distribution at MFS Investment Management. His comments, opinions and analyses are for informational purposes only and should not be considered investment advice or a recommendation to invest in any security or to adopt any investment strategy. Comments, opinions and analyses are rendered as of the date given and may change without notice due to market conditions and other factors. This material is not intended as a complete analysis of every material fact regarding any market, industry, investment or strategy.
Photo: Glenn Beltz. Oil & Gas: The Cashflow Conundrum
With the oil price declining steeply during the fourth quarter of 2014, the prospects for dividends from oil companies are worth special attention. Though they rose 5.8% in 2014 to $134.1bn, according to the Henderson Global Dividend Index (HGDI), making this the second largest dividend-paying industry, there are question marks over the sustainability of their dividends going forward, as lower prices feed into lower profits.
We believe the oil and gas sector is likely to be challenged in terms of growing dividends for the next few years. Oil service companies such as Seadrill and Fugro have already cut their dividends and with further cuts to capital expenditure likely from oil majors, more of their peers may also cut.
The big oil producers themselves, which account for around three quarters of the sector’s dividend payments, should be able to hold dividends for a while as their balance sheets are strong. However, if the oil price does not meaningfully recover over the next couple of years then cashflow will not be strong enough to allow for required investment and dividends.
In the shorter term the oil majors are likely to prefer to allow dividend cover (the ratio of a company’s earnings over the dividend paid) to fall by paying out a larger percentage of their profits rather cutting the dividend they pay. Royal Dutch Shell is commonly the largest dividend payer in the world (though it was beaten in 2014 by Vodafone). Royal Dutch Shell has not cut its dividend since World War II, despite wide swings in the price of oil since then. French multinational oil and gas company, Total (ranking 17th in terms of top dividend-paying companies in 2014) has not cut its dividend for 40 years.
Emerging market cuts
Companies in Emerging Markets are more likely to cut given fewer opportunities to cut capital expenditure and weaker balance sheets. The fall in the price of oil is a key factor influencing our decision to reduce our expectations for overall dividend growth from Emerging Markets, where dividends from oil companies account for 26% of the region’s total, around twice their share in global markets overall.
Fund exposure
The fund’s exposure to the oil & gas sector is currently low at 2.9%, versus 6.7% of the index. This is due to concerns over cashflow growth and the ability to grow dividends. With the significant fall in the oil price over the last six months this position has aided performance on a relative basis.
Andrew Jones is member of the Henderson Global Equity Income Team
CC-BY-SA-2.0, FlickrPhoto: Cabeza de Turco. Thumbs Up for Equities, Avoiding the US and Emerging Markets
Global equity markets remained in an ebullient mood in February, with the MSCI World index producing a US dollar total return of 5.9%. In the US, the S&P 500 broke through a series of record highs (although it has subsequently given up a little ground in March) while in the UK the FTSE 100 finally eclipsed its previous all-time closing high of 6930 (set in late 1999), finishing the month at 6946.7. European, Japanese, Asian and emerging market (EM) equities also made strong progress in local currency terms.
In contrast to the strength seen in equity markets, US and UK government bonds had a difficult month, with the yield on the benchmark US 10-year treasury climbing from 1.64% at the end of January to 1.99% at the end of February. The broad UK gilt market registered a sterling total return loss of -4.2%, with long gilts (-7.6%) performing particularly poorly. European core bond markets were largely insulated from these moves, with the 10-year bund yield finishing the month at 0.3%. At the time of writing, yields on a number of short-dated European government bonds are negative, and Swiss government bonds offer negative yields out to 10 years.
In equity markets, we are positive on all the major regions except the US, where we have a neutral weighting in our asset allocation model, and emerging markets, which we continue to underweight. In our view, the US is undoubtedly the strongest of the developed world economies and is home to a range of world leaders across a range of sectors, and we continue to find interesting long-term stock-level opportunities in areas with exciting growth potential, such as immunology. For the broader market, however, valuations are less compelling and we continue to believe that a strengthening dollar is likely to provide a headwind for US multinationals.
EM equities trade at a significant discount to developed markets and there are good opportunities in the countries that are beneficiaries of lower oil prices and where the respective governments have committed to business-friendly reforms. Unfortunately, commodity-exporting EMs, such as Brazil, remain under pressure, and similarly the low oil price is a headache for a range of EM oil exporters with knock-on adverse effects for their currencies.
In Asia ex Japan, valuations are attractive versus other markets and in Japan itself we expect a weaker yen to provide a significant tailwind for corporate earnings this year. UK equities have been the focus of some of our asset allocation meetings over the past month, and despite the broader re-rating of the market, our UK team continues tofind companies that are committed to boosting shareholder returns. The UK also remains an M&A target, due to the relative ease of the takeover process, and the market’s high dividend yield is still attractive in a global context.
In bond markets, we see an increasing disconnect between the US and UK, where yields should move higher, and Europe, where the ECB began intervening in secondary markets on 9 March. Previous episodes of QE have been a case of ‘buy the rumour, sell the fact’ when it came to rates markets, but for Europe we think that the sheer scale of the ECB purchases will be positive for markets from here. This appears to be borne out by price action; as I write, 10-year bund yields have declined further to just 0.2%. A second-order effect of the ECB’s policy is that many non-euro corporate issuers are tapping European bond markets due to the very cheap financing that is available; one estimate suggests that of the €37.8 billion of investment grade non-financial issuance that was seen in February, some €30.8 billion of this was from companies that are incorporated outside the eurozone!
For bond markets more broadly, the next major catalyst could come in the form of the Fed; any change in its language is likely to be seen as laying the ground for a rate rise, although the strong dollar and low oil prices suggest that the broad CPI readings are likely to remain subdued, meaning there is no obvious rush to raise rates. The recent strength in labour markets will provide food for thought for the Fed however, and we will be watching developments closely in the coming weeks.
Column by Mark Burgess, CIO at Threadneedle Investments
One of Japan’s most powerful lobby groups—Japan Agriculture Group Zenchu (JA Zenchu)—has effectively controlled the country’s agricultural sector from behind the scenes along with other arms of the umbrellla group, the JA Group. The other divisions include agricultural trading company Zen-noh and financial services arm No-Chu.
JA Zenchu holds extraordinary power based on Japan’s Agricultural Cooperative Law, which has long granted it the exclusive authority to “audit and advise” local farming co-operatives. It charges such co-ops a fee for services, even though some say their advice is useless, and the funds have frequently been used in turn to peddle political influence. If you’ve ever wondered why Japan has maintained extremely high import duties for agricultural products, JA Zenchu has a lot to do with this.
For decades, JA Zenchu has been a reliable vote-gathering machine for the ruling Liberal Democratic Party (LDP), a major driving force that has kept the LDP in power for most of the post-World War II era. However, last month, Prime Minister Shinzo Abe announced that JA Zenchu (grudgingly) accepted his proposed changes to strip the group of its exclusive “audit and advise” power. Local farming co-ops will be able to hire their own audit firms, and will no longer have to pay JA Zenchu for their advice. This will effectively dismantle JA Zenchu. Why is Prime Minister Abe trying to change a winning formula for his own party?
Japan’s agricultural sector faces a number of challenging issues like an aging farming population, and low ratio for food self-sufficiency. But the biggest problem is that the industry has been coddled for decades, protected by high import duties and government subsidies. In recent years, the percentage of products distributed through non-JA channels has increased, but still, many farmers, particularly rice and vegetable growers, have opted to sell their products exclusively through the JA Group instead of building their own brands or sales channel. In fact, in some cases JA Group has discouraged entrepreneurship as it feared that might undermine its influence and control. However, ongoing negotiations for the Trans-Pacific Partnership are expected to lower import duties for many agricultural products exposing farmers to competition that they are ill-prepared to face. Removing the shackles of JA Zenchu is the first step to liberalizing Japan’s farming sector, and allowing the sector to attract capital and talent that could drive innovation and productivity.
Frankly, liberalizing the country’s farming industries is a daunting challenge. Agriculture is unpopular among the younger generation for its notoriously harsh labor requirements. For the same low pay, there are far easier jobs to be had. Institutionalized farming corporations account for less than 7% of total farmland area. I wouldn’t bet on a revival of Japanese farming at this point. Still, you have to start somewhere, and dismantling a major lobby group that has stood in the way of entrepreneurialism is a good place to start. At least, it shows that there are no sacred cows when it comes to structural reforms. Another third arrow has been fired.
Kenichi Amaki is portfolio manager at Matthews Asia.
The views and information discussed represent opinion and an assessment of market conditions at a specific point in time that are subject to change. It should not be relied upon as a recommendation to buy and sell particular securities or markets in general. The subject matter contained herein has been derived from several sources believed to be reliable and accurate at the time of compilation. Matthews International Capital Management, LLC does not accept any liability for losses either direct or consequential caused by the use of this information. Investing in international and emerging markets may involve additional risks, such as social and political instability, market illiquidity, exchange-rate fluctuations, a high level of volatility and limited regulation. In addition, single-country funds may be subject to a higher degree of market risk than diversified funds because of concentration in a specific geographic location. Investing in small- and mid-size companies is more risky than investing in large companies, as they may be more volatile and less liquid than large companies. This document has not been reviewed or approved by any regulatory body.
Photo: Mark Fischer. EM’s Diverging Universe: Opportunities and Risks
2015 is definitely not the year to be making general statements about emerging markets (EM). The EM asset class is made up of a diverse mix of credits with varying risk and reward prospects, and the fortunes of the various economies within EM are currently increasingly diverging. There is a particular contrast between commodity exporting and commodity importing countries. Additionally in emerging Asia, there are different dynamics between commodity importers and manufacturers. The shifting dynamics make active management and fundamental research particularly important. For the selective strategy, EM credit currently offers a compelling investment case with certain countries attractive on valuation and fundamental grounds, others presenting tactical opportunities, while some markets are best avoided.
Expanding divergence
A high level look across the EM universe demonstrates the dynamics currently at work:
Asia is changing. Asian countries are increasingly becoming consumption-driven, shifting from their manufacturing-dominated economic status of the past; innovations in e-commerce are driving growth while demographics silently act as a further catalyst. The trends, while well-rehearsed, are ever important and are set to continue for a number of years. Meanwhile lower oil and commodity prices will work to the benefit of importing countries, such as India and China. The strong reform agenda pursued by India strengthens the country’s prospects while China is slowly becoming increasingly consumer-driven.
Latin American economies are on a different path; their pace of growth has now generally slowed and will likely continue at sub-par levels. Hurt by weakening commodity prices and the strength of the US dollar, their depreciating currencies present challenges. Additionally, the desire to raise interest rates to control inflation is a dilemma for many given the need to simultaneously stimulate growth.
Elsewhere, growth is weakening in Central and Eastern Europe, despite some signs of resilience in domestic demand. With Russia in recession and likely to remain there at least for the next two years, countries with currencies directly linked to the euro will continue to suffer but will have some insulation with the support of the European Central Bank’s quantitative easing programme.
Technical and fundamental support
While certain macro and geopolitical risks remain, there is currently strong support for a constructive stance on EM.
Technical factors are positive
With government bond yields close to all-time lows and in some cases in negative territory, there is strengthening demand for corporate bonds (credit) and higher yielding assets around the globe. Chart 1 shows there are now close to €1.2tn of negative yielding assets globally and the levels of assets within various other sectors, including EM sub sectors. This implies a lengthy, more protracted multi-year environment of searching for yield and diversification, with EM a likely beneficiary.
For investors seeking additional compensation, chart 2 shows the balance of risk and reward of moving down the credit spectrum, which markets can offer higher yields and how liquid those markets are. Each bubble represents the total volume of outstanding issues within the particular sector.
Notably, the US dollar-denominated EM corporate bond market has grown significantly in recent years and the depth that this provides makes an allocation to this asset class within a portfolio potentially attractive. While the demand continues, there will, of course, be intermittent periods of volatility in this extended credit cycle as more investors are crowded into the same markets. We believe it will therefore be increasingly important to have a sharp ‘credit picking’ focus with the current environment of more credit rating downgrades than upgrades in EM set to continue.
The expected rise in demand for higher yielding assets corresponds with a time of reduced supplies in EM, with big issuing countries such as Russia and Brazil, finding it difficult to issue new debt. While investors shy away from Brazil on macroeconomic concerns, Russia faces a list of financial headaches. These include currency weakness and a looming recession as the country absorbs the double blow of Western sanctions over Ukraine and the sharp decline in the oil price since June 2014.
For euro investors there is, however, likely to be more euro-denominated issuance in EM credit, which should meet demand. On the flip-side, this would detract supply for dollar investors. A further supporting factor is the momentum gathering in the pace of inflows into EM external debt markets. This again is chasing a limited pool of securities relative to the scale of the demand and should therefore buoy prices.
Valuations favour EM
In many areas EM valuations are attractive relative to markets outside the sector. For example, on a 5-year historical basis, EM high yield credit is more attractively valued than US or European high yield.
Putting divergence to work
The current themes in our portfolio reflect the differentiation in EM and that we see this as a fundamentals-driven market. While headwinds remain at a macroeconomic level, fundamentals are improving for certain sectors and names. Careful selection between countries, sectors and stocks should therefore make a marked difference to overall returns.
Chinese overweight: The biggest overweight in the portfolio is China. This weighting is a result of credit specific opportunities, particularly within state-owned enterprises, infrastructure and quasi-sovereigns such as the ICBC, where we hold the subordinated additional tier 1 (AT1) perpetual bonds issued in October 2014.
Brazil/Mexico – macro challenges but credit specific opportunities: In Brazil there are a number of companies that are attractive from a valuation perspective. We have overweight positions in oil and gas and infrastructure (Petrobras and Odebrecht), and the ‘protein sector’ (meat and poultry). The latter is one of the biggest export markets for Brazil. In Mexico, the chemicals sector is attractive, although selectivity is required given the impact of overcrowding and valuations becoming rather rich.
Russia – look beyond the headlines: Russia is still interesting from a technical point of view and also on valuation grounds. However, we are highly selective in our approach. Favoured names include Gazprom, Lukoil and VimpelCom; the latter is a strong cash generative business, which is also buying back its bonds.
Markets currently to avoid: At the opposite end, there are areas that we do not favour on fundamental grounds (Argentina and Venezuela), while valuations elsewhere make investments unattractive at current levels. In Latin America these include Chile and Peru; in Asia, Thailand, Malaysia and Korea and finally in Europe, the Central and Eastern European countries.
Steve Drew is portofolio manager for Emerging Market Corporate Bond Fund. These are fund manager views at the time of writing and may differ from those of other Henderson fund managers. The information should not be construed as investment advice. Before entering into an investment agreement please consult a professional investment adviser.
