May 2018 Market Update – Trade Wars

Welcome and opening remarks:

What an interesting time it is! A little while back we had BREXIT, then the election of Donald Trump who is constantly making waves…. or tsunami’s, rising interest rates in the US, the Banking Royal Commission that has been more explosive than anyone had ever imagined and State and Federal budgets.

Today, markets are up strongly. Consumer Discretionary, Energy and Industrials are the key drivers with Financials being a key laggard.

Global Markets and Risk

Global growth is solid and the OECD upgraded its growth expectations in Feb vs October. Most materially for the G20 and in particular the US due to tax reform.  But there are still significant risks in the system. These flow from high debt levels and assets prices fuelled by the low rates as well as politics (including a trade war).

Inflation spiking is a real risk in the US as we have seen massive fiscal stimulus at a time of near full employment. There is some slack in the labour participation rate, but not a lot. Tariffs could also feed into this. The real problem will be if the US Federal Reserve gets behind the curve and has to lift faster and by more than expected to rein in inflation.

European sentiment is slowing, but growth is still ok. In part this was expected due to the stronger than expected 2017, but it also reflects a more political situation. Specifically populists were the big winners in the Italian elections, uncertainty over Brexit and talk by the UK opposition of nationalising assets at below market value.

Australian Economy:

Australia’s economy is strengthening boosted by commodity price strength. The big constraining factor in Australia is household debt, which remains at record levels despite the slowing in house prices.

If economic growth leads to higher inflation, rate rises are likely to have an outsized impact.

Asia Pacific and Property Markets

In Admiral Investments annual outlook published last December, the headline call was that, among the Asia Pacific markets, Singapore has the best fundamentals as it has just emerged from a mini-downcycle from 2014 to 2016. We continue to stand by this view today, even though geo-political events are adding uncertainty to the region.

Short-term news flow has switched from a discussion on inflation and interest rate to the concern of a trade war.  At this point, we think that a full-fledged trade war, defined as the material disruption of trades among the major countries, remains a tail risk event, and the more likely resolution would be the renegotiation and realignment of individual industries.

Nonetheless, events such as trade wars have significant idiosyncratic risks because the relevant decisions are made by a limited set of political actors, who may choose to ignore advices if they prioritize a different objective.  We think that the following events, should they occur, are signs that the trade war is escalating.

China retaliates against US industrial and tech products

• Chinese companies, especially in the IT and railway sectors, face true supplier risk’s
• A sudden depreciation of the RMB or the HKD
• Other western bloc countries such as Europe and Japan adopting a more hawkish stance

We stress that we continue to see trade war as a tail risk event.  But its related news flow will drive short term sentiment in the market.

Another topic we wish to address is the pension system in China.  All Chinese provinces (and some legacy entities such as the Xinjiang Construction Corps) maintain a defined benefit pension fund for all citizens with a local household registration.  China’s population has reached a potential support ratio, defined as the number of working adults divided the number of retirees, of 2.8, and the ratio is likely to fall in the next ten to twenty years before it stabilizes.

When tracking the health of pension plans, one commonly used metrics is the monthly equivalent metric, which is the net asset value of a pension fund divided by the current monthly pension outflow.  As of December 2016, the weight average monthly equivalent metric of all provincial pension plans is 17.2 month. This, however, masked the situation faced by many smaller provinces. We believe that the Chinese central government has more than enough resources to re-capitalize these smaller, often poorer provinces, but the situation is wroth tracking closely.

Beyond China, we continue to see healthy deal flow into Japan and Australia.  Japan’s tourist arrivals have grown by more than three times since 2012. The 2020 Tokyo Olympic and 2025 Osaka World Expo should stimulate further tourist growth.  Tourist growth also often stimulate retail spending, which improve business sentiment and private sector investment. Thus, we have seen a noted increase in investor interests for Japan assets in recent month.

Australia is in the third year of its rental upcycle, which we think will remain stable.  Rental yield, while low versus historical levels, is relatively attractive to investors in Asia.  Thus, we also continue to see fund flows into Australia.

Model Portfolios

Core Australian Equities

Throughout the financial year so far we have made incremental changes. Throughout the year we have increase exposure to the financial sector and particularly the banks. The banks have a solid capital position ahead of APRA’s ‘unquestionably strong’ CET1 ratio targets. CBA had underperformed relative to peers and WBC has a repricing advantage in the interest only mortgage market. When CBA reported in February this year we noted:

The result highlighted solid margin trends, which read across positively for the broader sector. On this front we note the following:

1. while the benefit from recent mortgage repricing is well understood, results this week point to limited risk from prolonged elevated interest-only switching,
2. in recent months, wholesale funding conditions have been at some of the most supportive levels seen since before the GFC,
3. basis risk tailwinds,
4. higher lending margins in the half, and
5. a diminishing drag from the low interest rate environment. The main NIM headwind through the period was the banking levy.

The banking royal commission has surprised. Normally one does not call for such a deep dive into the inner workings if you don’t already know the answer. We await more information (reporting for ANZ, NAB, WBC and MQG over the 1^st weeks of May) before acting further.

While we were not specially looking for an energy retailer, CTX kept on coming up particularly after it lost its bid to keep its Woolworths supply agreement. This created a great entry point for us.  CTX’s strategy includes a disciplined approach to securing new volumes as well as investing in its supply chain; post the pending Milemaker/Gull NZ acquisitions (for which CTX guided for c. A$50mn in EBIT combined), we expect further bolt-on acquisitions may be more challenging to come by.

CTX trades on an undemanding PE of 13.3 and an exceptionally strong balance sheet. In addition, CTX has excess franking credits. The combination of strong balance sheet, excess franking credits and few acquisition opportunities leads us to believe that management may look to buy-back shares, preferably off-market. A buy-back would be well received if acquisitions elude. A comprehensive strategy update will be released in August which we look forward to reading with a view to increase this initial position we are making today.

Additions were made to QUB and RHC during the year. Each business has a solid investment thesis. We also participated in entitlements for TCL and ORE both of which we have long term view. We also participated in the share purchase plan for NHF which continues to be strong performer.

Finally we exited BXB. BXB surprised us, we were expecting to see a strong lift in margins and volume as global economies improved. Instead, we saw new competitors enter the market. They drove up costs and price down…….never a good sign for business profitability.

Self-Funding Instalment Portfolio

The self-funding instalment portfolio attempts to mimic the portfolio and any changes with the additional benefit of internal leverage where available.

Interest Bearing Securities

As bank capital positions improved we started to take a look at our investment thesis for NABHA. The thesis included a possible redemption and return to $100 by 2022 on the assumption NAB would need to restore capital. This would generate annual strong annual returns. However, given the strong capital adequacy of the banks and likely divestments of other non-core assets we found this thesis to tenuous. An unfranked running yield of 3.93% started to look very expensive and we choose to exit.

The replacement for NABHA was MXUPA, also a perpetual security. This one however is somewhat under-researched due to the fact its parent company is not listed in Australia. As such the major brokers and researchers refuse to cover it. The Royston Capital Investment Committee has no such constraint and found Brookfield to have an excellent balance sheet. While there are some risks with MXUPA we feel they would not play out due to significant reputational damage it would do, besides, we are comforted by Brookfield’s 8+%holding and a yield more than 7% investors are being well compensated.

Finally we produced a Flash Note “The Chase for Yield” on why we didn’t proceed with offers from WBC and CBA. This is available on our website.

International Fund of Funds

The international Fund of Funds has generally tracked the global indices through its performance history while out performing during periods of poorer returns. We felt the portfolio was too focused on North America and wanted to see a shift towards Europe without buying into a Euro specific fund. We Found Cooper Investors to be strongly aligned to Royston Capital’s investment philosophy and had a greater propensity to look beyond the North American borders for investment opportunities.

CI’s investment philosophy is based on the premise that high quality and attractively valued companies will outperform the market over the long-term. CI expects that bottom-up, fundamentally driven security selection will be the primary driver of the Fund’s risk/return profile. The Fund strongly leverages off the output from the stock selection process holding the investment team’s best stock ideas. Given the benchmark unaware approach of the Fund, allocations at a sector and country level are a residual of the stock selection process. However, portfolio guidelines exist to ensure that the Fund is sufficiently diversified.

ARIF

There have been no material changes to the ARIF. The portfolio participated in the TCL entitlement offer.

Disclaimer:
Royston Capital is a privately owned and operated business. (AFSL: 438262 ABN: 98 158 028 392)
This information is of a general nature only and has been provided without taking account of your objectives, financial situation or needs. Because of this, you should consider whether the information is appropriate in light of your particular objectives, financial situation and needs. No representation is given, warranty made or responsibility taken about the accuracy, timeliness or completeness of information sourced from third parties. Because of this, we recommend you consider, with or without the assistance of a financial adviser, whether the information is appropriate in light of your particular needs and circumstances.
Sources: Admiral Investments, CommSec, PIMCO, Reserve Bank of Australia, Morningstar;
Past performance is not a reliable indicator of future performance. Projected earnings are not guaranteed.