23 November 2018
At GAM Investments’ Weekly Investment Meeting held on 21 November 2018, the speakers were Michael Biggs, who took a look at what is behind the recent sharp falls for risky assets, Jian Shi Cortesi, who highlighted the attractive valuations in China and Asia, and Roberto Bottoli, who summarised M&A activity in markets and resulting merger arbitrage opportunities.
- We believe markets are at an interesting stage. Assets including equities, high yield and credit have come under pressure in the last six weeks or so. Looking back over the last 20 years, the S&P 500 index and US ISM have been closely correlated, but this relationship has clearly broken down in recent times. So what is the reason behind these sharp falls for risky assets?
- There are two schools of thought. The first is that global shocks such as trade wars, the volatility spike earlier in the year and the oil price have led to assets underperforming and therefore we need some better macro numbers to come through. An alternative view is that recent weakness stems from the Federal Reserve’s withdrawal of liquidity and concern that when it commences quantitative tightening there will be an increasing number of market shocks – suggesting it is a not a great time to be holding risky assets. Matt King at Citi has produced some interesting analysis showing how asset prices are driven by changes in global liquidity as proxied by central bank purchases that supports this theory. However, we do not believe this latter view is correct. If central bank purchases were zero, this logic suggests equities would fall by 50%. This has clearly not happened historically so at some point we expect this theory will break down.
- Moreover, credit demand has softened, as highlighted by the US Senior Loan Officers Survey. If liquidity conditions were tightening we would expect US credit conditions to also tighten, however they are continuing to ease.
- We think the euro area will rebound in Q4. Q3 weakness was closely linked to auto production and we expect this will likely improve in the fourth quarter. We believe this rebound will be supported by a positive credit impulse, a stabilisation in China and strength in the US. There are several key data releases to watch out for between now and early December: euro area flash Purchasing Managers’ Index (PMIs), the IFO Business Climate Index and the Industrial Production Index (IP), orders and car production. These should add further clarity to the backdrop for risky assets.
Jian Shi Cortesi
- We feel the best time to buy China is when everything seems negative. Investors across the globe are currently pessimistic and scared about the Chinese market. At the same time, though, we believe valuations are low, at 11x forward P/E including internet stocks, and 8x forward P/E without. In addition the government has started to support the economy more actively.
- The Chinese equity market could be likened to a department store at present, with plenty of companies on sale. Good examples of this may include Baidu, often described as the Chinese Google, which is on a P/E ratio of 20, which is the same level as at the bottom of the 2008 crisis. Similarly, Geely Automobile, which owns Volvo, is currently trading on just 10x earnings.
- Looking at the wider Asian picture, valuations are attractive, with the P/E of the MSCI Asia ex-Japan index some 40% lower than that of US equities. The relative P/E is at levels that to us equate to a trough in the market. The only time this has been lower was in 1999 during the Asian financial crisis.
- Meanwhile the Asia Dollar index is close to its lowest level since the global financial crisis. Any reversal of US dollar strength would be favourable for Asian equity performance, in our view.
- We remain focused on the best industries driven by big trends, trying to select leaders with sustainable competitive advantages. China makes up a significant position, with allocations to Korea, Taiwan, Hong Kong and India the bulk of the remainder.
- In terms of positioning, we have our largest allocations to financials, communication services and consumer discretionary, with zero weightings in materials, energy and industrials.
- We favour mid- and small-cap companies as we can potentially earn a premium from these positions. In our view, these are the least crowded parts of the market, where it is possible to achieve higher returns for the same level of risk. Holding companies in this part of the market-cap scale also removes much of the antitrust risk, as we believe such deals do not alter the competitive structure of a specific market. We believe the lower funding risk associated with mid-and-small-caps makes this part of the market a ‘sweet spot’.
- A low concentration in any one single position can limit risk. We also want to be involved in quality stories – the safest situations in the arbitrage market. We will only invest in a company where the deal has been announced, and is considered a ‘friendly’ deal, and we have a strong preference for certain types of arbitrage spreads. While deals can be terminated from time to time, we work hard to minimise the number and effect of these. Our event-driven approach has enabled us in the past to keep terminated deals to around 2%, compared with the wider market figure of 10 to 15%.
- Trade wars have been a big driver in the M&A market this year. Other significant events have included the US Department of Justice seeking to block the AT&T / Time Warner merger; the Fresenius / Akorn deal running into trouble on a possible breach of clinical data integrity; the Ultra Electronics / Sparton deal being called off on antitrust grounds; and the NXP / Qualcomm merger being terminated due to China-related issues.
- Low funding costs and decent economic growth are supportive of M&A activity in the medium term, in our view. We saw a decisive pick up of volumes and number of transactions in 2018: possible reasons could be the approval of US tax reform, as well as sector consolidation in IT and media. In addition there has been a recent slowdown in new deals requiring SAMR (Chinese antitrust) review.
- M&A activity in the US is being supported by cash repatriation and tax savings. The cash repatriation opportunity is largest in the healthcare and technology sectors; as of the end of 2017 they accounted for 73% of the S&P 500’s total overseas cash. Repatriation by US multinational companies hit an all-time high of USD 306 billion in Q1 2018.
- The market is still providing a good pipeline of deals. The current arbitrage spreads universe is split in two blocks: ‘safe’ deals that trade at tight spreads and riskier deals which trade at high double-digit annualised spreads. Some of the main risk drivers are US antitrust, in the case of vertical deals such as Aetna / CVS and Express Scripts / Cigna; and Chinese antitrust, which could still be used for potential retaliation against US protectionist measures in the case of US deals with exposure to China, for example Rockwell Collins / United Technologies and Oclaro / Lumentum.
- Going forward we intend to have less exposure to drivers of trade friction and more to what we would call plain vanilla, low-risk situations. Through the increase in the gross exposure, we believe the strategy will still be able to target appealing returns in the medium term.
The information in this document is given for information purposes only and does not qualify as investment advice. Opinions and assessments contained in this document may change and reflect the point of view of GAM in the current economic environment. No liability shall be accepted for the accuracy and completeness of the information. The mentioned financial instruments are provided for illustrative purposes only and shall not be considered as a direct offering, investment recommendation or investment advice. Reference to a security is not a recommendation to buy or sell that security. Allocations and holdings are subject to change. Past performance is no indicator of current or future trends.