Download Insights from PIC`s investment managers At 30 September 2014

Insights from PIC’s investment
managers
At 30 September 2014
PIC’s investment managers regularly provide us with their views on economic conditions and a wide range of other
topics. Here are some views from their September quarter reports that may interest you. Of course, their views may
change over time and may be different from PIC’s.
Observations on the Australian share market
Vinva, Australian shares manager
‘The Australian market has corrected approximately 6% from its recent high, underperforming global equities over
the same period. The key drivers of local market weakness include ongoing weakness in the iron ore price,
regulatory concerns in respect of the housing market and the banking sector and a falling Australian dollar, which
encouraged selling of Australian equities by foreign investors.
‘Market valuation based on a price to earnings measure has improved from approximately 14.8 times to 13.7 times
one year forward consensus earnings. The market remains relatively fully valued which presents a constraint on
performance, but not excessively so, and we are of the view that modest performance will be achieved over the
next 6-12 months.
‘On the upside, the August reporting season was solid and there are no signs of broad-based deterioration in the
earnings backdrop (consensus earnings estimates were relatively flat over the past month). While a lower
Australian dollar may have led to short-term weakness driven by capital outflows, the decline is expected to assist
large sectors of the economy and improve the outlook for earnings.
‘However, there is the risk that the Australian equity market could be dragged lower by weakness in offshore
markets, given the global growth cycle remains relatively weak. While the US economy is showing signs of
improvement, economic conditions in Europe and Japan remain soft, with calls for expanded quantitative easing in
those regions. Concerns over China’s economy remain, as the latest economic data confirmed a sharp slowing of
activity and falling property prices.’
Northcape Capital, Australian shares manager
‘Following the recent correction we feel the market, on fundamentals, is a touch below fair value. In general,
earnings revisions are still negative and we have yet to really see, from an earnings perspective, a marking to
market of the current iron ore price among the large resource companies. The market during the quarter had
become moderately overvalued, so we were pleased to see the pull-back we have had from a valuation
perspective, potentially avoiding a larger correction down the track.
‘Globally, the relevant macro issues have remained the same but sentiment appears to have skewed to be more
negative. In the US, we have seen massive focus with respect to the timing of the first and the pace of potential
interest rate rises, which has made the market jittery. After several recent field trips by the team, we remain of the
view that a moderate recovery in the US is in place and there appears little need to raise rates quickly.
‘The world has become bearish on China (again) and this has sentiment implications for our market. Resource
stock prices seem to have had the majority of this factored in, though we remain skewed to the majors, with good
balance sheets and low cost positions, while avoiding smaller bulk plays.
Private Investment Consulting™ Review for the year ending at 30 September 2014 | Page 1
Insights from PIC’s investment managers
‘Europe, similarly, has seen rising nervousness about economic recovery and now the potential for deflation. We
continue to see a very slow recovery from this region and would prefer defensive exposures from any Australian
companies there.
‘On the positive front, management teams continue to manage costs well and seem to be deploying capital
sensibly. The lower Australian dollar (finally) will assist offshore earnings from our companies and the lower oil
price will assist transport costs and some operational areas. These benefits will flow through to earnings over
coming periods. Market expectations for earnings growth are probably a bit high for Fiscal Year 2015, but less so
than we have seen at the same time in recent years.’
Observations about China
JCP Investment Partners, Australian shares manager
‘Following our recent annual trip to China, we remain consistent in our view that China is experiencing a structural
slowdown, albeit at a gradual pace.
‘A number of major themes emerged, such as: a tipping point in Fixed Asset Investment (FAI) is approaching; the
anti-corruption campaign is here to stay; China’s heavy industry economy is slowing; and the pollution problems
are creating major changes in technology and innovation. Capital flows into Australia are here to stay, the shift to
consumption-led growth is proving tough and China’s new services economy is evolving fast.
‘China’s new services economy actually looks really exciting and should ensure China continues a measured
slow-down, rather than a hard landing. The problem from an Australian economy perspective is that Australia
stands to benefit little from the move away from China’s old construction-intensive economy to the new services-led
economy. Our bearish outlook for the Australian economy is driven by this slowing of China’s old economy and is
reflected in our bulk commodity long-run forecasts. We will continue our hunt for exposure to China’s increasingly
affluent consumers within their strengthening service economy. However, as we learnt while in China, they have
developed services business, such as those that operate in the education and tourism industries, that are already
doing it better than many Australian companies are offering.’
Australian shares
Maple-Brown Abbott, Australian shares manager in PIC Wholesale IncomeBuilder
‘The June 2014 reporting season has come and gone and outcomes were generally seen in a favourable light. In
broad terms earnings growth was approximately 10%, with Resources growing in the mid 20% range, Financials
around 10% and Industrials being the laggards, at less than 5%. The industrial segment of the market was
negatively skewed by a few specific situations, such as losses from Qantas and losses in the mining services
space. Excluding these factors, the growth rate was north of 5%. This positive picture for earnings is, however,
unlikely to be repeated in 2015, with lower commodity prices looming and benefits from factors such as cost-out
and lower bad debt charges for the banks likely to impact less. Consensus earnings growth numbers for the market
for 2015 are around 5%, with further downgrades for resource names possible.
‘With the outlook for earnings growth being fairly muted, the prospects for further dividend growth look to be
similarly challenged, unless the dividend payout ratio increases further. Dividends have, however, been growing
faster than earnings and payout ratios are at or near record levels. Thus, we see little scope for dividends to
continue to grow faster than earnings on a sustainable basis. We think this matters because our market has been
very well supported by its attractive yield in a yield-starved environment.
Private Investment Consulting™ managers’ insights at 30 September 2014 | Page 2
Insights from PIC’s investment managers
‘The banks are the largest source of dividends in the market, reflecting both their significant index weight plus their
high payout ratios. For the banks, the past three years or so has been a particular “sweet spot” where recovering
net interest margins, lower bad debt charges and constrained asset growth with a strong mortgage bias has seen
solid earnings growth delivered at the same time as strong capital generation. Steadily increasing bank dividends
have been a significant contributor to the strength of our market, and of course to the strong performance of the
banking sector. These trends don’t last forever and there are indications that we may be at or near an inflection
point, with sector net interest margins looking as if they have peaked and bad debt charges having little scope for
further falls. However, the biggest challenge facing the banks’ dividend paying capacity is probably the Financial
System Inquiry.
‘While initial expectations were that the Inquiry would be largely neutral for the banks, this view has changed over
recent weeks and months. The Inquiry has formed the view that capital ratios for the large Australian banks may
not be as globally-leading as many had thought, and that it could be argued that further strengthening is required
given the reliance that Australia’s banking system has on global wholesale funding. This has raised the prospect of
the Inquiry recommending that more capital be held, probably under the domestic systemically important bank
(DSIB) category. In addition, focus is increasingly turning to the internal models that the large banks use under
Basel 3 regulations to calculate risk weightings for most of their lending assets. In this regard, the view is that these
models may prove to be unreliable (ie too generous to the banks), resulting in the related capital ratios lacking
credibility. Mortgage risk weightings are most in focus and there is significant risk that minimum risk weightings will
be introduced, resulting in the large banks being required to hold more capital against existing mortgages.
‘While higher capital levels in the banking system seem likely, the extent is unknown and a wide range of
possibilities can be speculated on. Any additional capital requirements should, however, be relatively easy to
finance. However, the key point is that in a sector that was already facing a sluggish earnings outlook, the
additional capital raised will likely dilute whatever growth there might otherwise have been, with a resultant impact
on dividend growth. This would in turn have the potential to undermine prices in a sector that has been a key
contributor to the strength of our market.’
Global shares
Harding Loevner, global shares manager
‘We were asked recently to comment on how we manage geopolitical risks in the portfolio. Our response is that the
only reliable defence is diversification. In the case of Russia, we look at the risks involved – such as potential
sanctions from the West, possible expropriation by the government, and capital controls hampering the extraction
of capital – from a portfolio perspective. Therefore, while we are aware that the risks of investing in Russia are
elevated, we also believe that investments in high quality Russian companies – when their stocks are pricing
widely-appreciated risks – offer potentially high returns that have little correlation with the market and company
risks in the rest of the portfolio – a rare source of diversification.’
Tweedy, Browne, global shares manager
‘It is probably not a coincidence that oil prices declined from around $112 to approximately $93 per barrel during
the quarter. While oil prices can move around significantly in the short run, we are of the opinion that over the
longer term, increasing demand coupled with higher development costs should keep oil prices from staying low for
too long.’
Private Investment Consulting™ managers’ insights at 30 September 2014 | Page 3
Insights from PIC’s investment managers
Global real estate investment trusts (REITs)
Resolution Capital, global property manager in PIC’s wholesale diversified portfolios
‘Global listed real estate delivered a total return of -1.3% in local currency terms in the quarter ended 30 September
2014. A weaker Australian dollar helped offset negative returns, with a total return of 3.1% in AUD unhedged terms.
‘The September quarter started quite robustly as momentum continued through from the first half of the year.
However, macro concerns, interest rate fears and abundant equity issuance prompted a market sell-off heading
into quarter end. The top-performing region was Hong Kong, while the US was the laggard. Hong Kong drifted
higher on the back of well-received residential launches, some improvement in government cooling measures, and
as a continued rebound off its lows earlier in the year. Late in the quarter, however, mass demonstrations for
electoral reform led to a sharp selloff in the Hong Kong market, including property stocks.
‘Operationally, US REITs continue to perform strongly, with high occupancy levels and limited new construction
activity (although it is on the rise once again!). Still, US REITs traded off after gorging themselves on new equity
issuance and on heightened concerns of interest rates rising sooner than previously expected. We note that Japan
has been a disappointment recently, even as Tokyo’s real estate market tightens further. The general economy
does not appear to be improving significantly, and “Abenomics” seems to have run out of steam this year,
particularly following the slowdown after April’s consumption tax hike.
‘The September quarter was marked by a significant level of corporate and property level investment activity, which
was supported by open and accessible capital markets. There were initial public offerings (IPOs), equity offerings,
M&A, (both public-to-public and public-to-private), highly priced acquisitions and similarly priced dispositions.
Several companies used strong investor demand to cull their portfolios of lower quality assets, continuing a trend
that we’ve discussed previously. There continues to be a very strong bid for core assets in core markets and recent
transactions illustrate that direct real estate market values remain higher than those implied by the public REIT
market. Given the apparent discount to the direct market, it is interesting to observe that there are six property
portfolios which are either pursuing or expected to commence an IPO later this year. Unlike the ‘cash box’ IPOs
seen in the US in 2010 and Spain earlier this year, this next crop of IPOs are those whose existing portfolios should
be additive to the investment opportunity set for public investors.
‘Looking ahead, global listed property stocks largely enjoy solid operating fundamentals, which we expect to
continue into 2015. Tenant demand continues to return, although large pockets of weakness remain, such as in
Continental Europe and Australia. Development finance has not returned with a vengeance, which has limited the
amount of speculative construction activity. It’s a bit of ‘Goldilocks’ from an operational perspective in the US and
the UK. Share prices, however, are struggling in the face of expectations for higher interest rates, and in this
regard, the sell-offs in the US and UK are illustrative in the short term. We still remain cautious on REIT valuations,
noting they have travelled far since the GFC. REITs continue to trade at discounts to direct market evidence in
most markets around the world, and so, hard asset values provide an important backstop to listed real estate.’
Private Investment Consulting™ managers’ insights at 30 September 2014 | Page 4
Insights from PIC’s investment managers
Fixed income
UBS, Australian bonds manager
‘The outlook for credit continues to be positive and should remain so for the rest of 2014. From a fundamental
perspective, local corporate fundamentals and the global macroeconomic backdrop remain supportive for credit;
however, the credit market locally continues to be driven by strong market technicals. With cash rates at historically
low levels and likely to stay low for some time yet, we see an ongoing and increasing appetite for securities that
offer an attractive yield.
‘From a global perspective, Australian yields are high and Australian corporate yields are even higher. An
international investor can obtain a higher yield from a portfolio of Australian dollar investment grade corporate
bonds than they can achieve on a portfolio of European high yield bonds currency unhedged. We continued to see
an increasing amount of interest from offshore for Australian corporate debt particularly from out of Asia. Recently,
the European corporate bond market and Australian bank market have become highly competitive and a cheaper
source of funding for local corporates. We have seen a number of Australian corporates issue debt into the
European market rather than issuing bonds in Australian dollars. This has meant that the local corporate bond
market has seen very little supply of new deals during 2014, but demand has remained extremely strong and
resulted in corporate spreads continuing to tighten.’
Wellington, global non-government bonds manager
‘Some of our equity analysts have noted that slightly slowing PMI data is consistent with the feedback we have
been getting from company managements, who have noted that “it feels worse than the indicators have been
saying”. This has been particularly true of commentary from Europe and Brazil, where economic data had been
showing growth improving in the northern spring, but companies just weren’t seeing it. Commentary from
companies on China is mixed, while they note that the US and Canada are “still better than anywhere else.”
Company managements have noted that overall, spending has been tight and there is pent-up demand. Industrial
companies want to spend more, maybe not for blocks of capacity yet, but for productivity, strategic and regulatory
purposes. But as long as the data remains weak and there is political uncertainty they remain reluctant to open the
purse strings other than for very strategic projects (eg R&D positioning).
‘We have also heard from the European bank credit analysts that while the European Central Bank (ECB) wants to
provide liquidity, they are not yet seeing the loan demand from small and medium-sized enterprises to justify taking
a lot of cash from the ECB.’
Franklin Templeton, global multi-sector bonds manager
‘We continue to see differentiations among specific emerging market economies; some have healthy current
account and fiscal balances, with large international reserves, while others struggle with deficits and economic
imbalances. We believe economies with healthier balances and stronger growth prospects may continue to see
currency appreciation over the long term, while those with imbalances are more likely to face currency weakness
and economic strains.’
Private Investment Consulting™ managers’ insights at 30 September 2014 | Page 5
Insights from PIC’s investment managers
Amundi, global multi-sector bonds manager
‘The European Central Bank’s (ECB’s) quantitative easing plans have gained the upper hand against the
geopolitical tension affecting the eurozone. While the risk of deflation has risen, the response to this risk has
paradoxically been very encouraging.
‘On the monetary policy front, the ECB has shown its readiness to significantly expand its balance sheet if needed,
a stance that serves to weaken the euro. On the political front, momentum is building. For the first time, the
European authorities seem to agree on taking measures to stimulate demand.
‘In the US, interest rates remain low despite the end of bond purchases by the US Federal Reserve, proving that
monetary factors alone do not determine long-term rates. With the weakening of potential growth (in both the
advanced and emerging economies), equilibrium interest rates also weaken. This serves to raise the equilibrium
level of other assets, all other things remaining equal. On the equity side, equilibrium P/E ratios are probably higher
than the averages for the past 30 years would suggest.
‘Against this backdrop, investor appetite for risky assets should remain in place (equity, credit, emerging debt). In
the short term, the regions that will see their currencies depreciate, and which remain discounted, still offer some
potential (eurozone, Japan). That being said, investors must also understand that the structural weakening of
growth should in future be accompanied by structurally weaker financial returns.’
Peridiem Global Investors, global absolute return and multi-sector bond manager
‘Despite growing concerns over slowing global economic growth, Russian aggression in Ukraine, and the potential
for an Ebola pandemic, companies in the US continue to forecast stable but slow earnings growth. The major
themes as we headed into the fourth quarter are the drop in global oil prices due to a perceived supply glut, an
economically challenged eurozone, and slowing growth in emerging market countries. While company managers
remain cautious, there is nothing in their forecast that leads us to believe we are on the cusp of a new US
corporate default cycle.’
Shenkman Capital, global bank loans manager
‘In general, issuers have been focused on generating free cash flow, with much of it being applied towards paying
down bank debt. This is a function of tighter cost controls, some revenue growth and required excess free cash
flow sweeps. Solid equity markets in the US have also allowed companies to go public, which can be beneficial for
deleveraging and/or having a “currency” for acquisitions.’
Peridiem Global Investors, high yield bond manager
‘A high level of fund flow activity into and out of the high yield asset class continues to draw headlines. The
magnitude of flows as a percent of the market has steadily increased over the last few years and the past few
months were no exception. The bulk of the volatile flow activity is being driven primarily by retail exchange-traded
fund outflows. The high yield market experienced over $20 billion in outflows since early July, which abated in the
later part of September.’
Private Investment Consulting™ managers’ insights at 30 September 2014 | Page 6
Insights from PIC’s investment managers
Oaktree, global high yield bonds manager
‘We believe the third quarter’s weakness in the high yield bond market was not caused by weaker fundamentals,
but was technically driven, as sizeable retail fund outflows and a robust new issue calendar created a significant
supply/demand imbalance. Stricter capital requirements at the banks, which constrain their ability to deploy trading
capital, only served to aggravate volatility in this weak period. Notably, collateralised loan obligation (CLO)
issuance is on pace to set a record for the largest dollar amount raised in a single year. The volatility experienced
in the US equity and debt markets has been largely muted in the loan market due to very strong demand from CLO
managers.’
Important information
This information has been provided by MLC Investments Limited (ABN 30 002 641 661) and MLC Limited (ABN 90 000 000 402) members of
the National Australia Bank group of companies, 105–153 Miller Street, North Sydney 2060.
This communication contains general information and may constitute general advice. Any advice in this communication has been prepared
without taking account of individual objectives, financial situation or needs. It should not be relied upon as a substitute for financial or other
specialist advice.
Before making any decisions on the basis of this communication, you should consider the appropriateness of its content having regard to your
particular investment objectives, financial situation or individual needs. You should obtain a Product Disclosure Statement or other disclosure
document relating to any financial product issued by MLC Investments Limited and MLC Nominees Pty Ltd (ABN 93 002 814 959) as trustee of
The Universal Super Scheme (ABN 44 928 361 101), and consider it before making any decision about whether to acquire or continue to hold
the product. A copy of the Product Disclosure Statement or other disclosure document is available upon request by phoning the MLC call centre
on 132 652 or on our website at mlc.com.au.
An investment in any product offered by a member company of the National Australia Bank group of companies does not represent a deposit
with or a liability of the National Australia Bank Limited ABN 12 004 044 937 or other member company of the National Australia Bank group
and is subject to investment risk including possible delays in repayment and loss of income and capital invested. None of the National Australia
Bank Limited, MLC Limited, MLC Investments Limited or other member company in the National Australia Bank group guarantees the capital
value, payment of income or performance of any financial product referred to in this publication.
Past performance is not indicative of future performance. The value of an investment may rise or fall with the changes in the market. Please
note that all performance reported is before management fees and taxes, unless otherwise stated.
The investment managers are current as at the date this communication was prepared. Investment managers are regularly reviewed and may
be appointed or removed at any time without prior notice to you.
Private Investment Consulting™ managers’ insights at 30 September 2014 | Page 7