At GAM Investments’ Weekly Investment Meeting held on 8 May 2019 the speakers were Jeremy Smouha, who discussed the improved fundamentals for the subordinated debt universe, and Reiko Mito, who highlighted the strong earnings from Japanese companies.
Developed Market Credit
Central bankers have turned more dovish as the year has progressed; it is now likely interest rates will not rise as much as expected which will not help those searching for yield, but is good news for subordinated debt. At the same time the late cycle in the US economy and the likelihood of lower growth going forward as China slows – even if the US was strong in the last quarter – means investors are back into the search for ‘quality yield’ rather than yield at any price.
In terms of credit quality, fundamentals for the universe of subordinated debt are stronger than ever in our view. Over the last five years there has been a huge amount of deleveraging in European financials. This comes at a time when many are worried about the increased leveraging in the corporate and high yield bond markets in the US and elsewhere the sharp growth of BBB- debt. Some asset allocators are looking at switching some of their high yield allocations to our asset class of subordinated and hybrid debt.
Good examples of European financial institutions with strong fundamentals are HSBC, Lloyds Banking Group, RBS, Barclays and Rabobank; each of these has significantly built up their Common Equity Tier 1 (CET1) buffer. We have no doubts about the ability of any of these to pay either their coupon or the principal back on their subordinated debt, independent of market conditions. We anticipate that the UK banks in particular will continue to increase their equity buffer and significantly de-risk, even with the continued uncertainty around Brexit. We have witnessed the likes of RBS increase its CET1 from 8.6% to 16.7% between 2013 and 2018. This continuation of banks strengthening their balance sheets is in part why we remain so constructive on the sector.
Valuations remain attractive, in our view. Despite strong performance year-to-date, spreads have only tightened by a third from last year’s widening and this to us represents a buying opportunity as there is still price catch up to be had on top of the accumulation of monthly coupon income accrual.
Our outlook for the remainder of 2019 is one of continued credit quality improvement, with company fundamentals strong and steady, predictable levels of coupon income while valuations in both relative and absolute terms remain attractive.
Meanwhile extension risk was very much last year’s story. Worries about extension risk are overdone and priced in and, in our view, actually represent an opportunity. We believe ongoing regulatory changes such as the European Commission's CRR2 bank capital proposal and Basel IV should create further opportunities.
In our view, the health of Japanese equities can often be misinterpreted by investors because of the tendency to look at broader economic growth measurements, such as GDP, rather than focusing on the underlying earnings-related data. The compound annual growth rate of Japanese listed companies has been expanding at a much higher rate than the country’s economic growth rate and Japanese earnings have actually beaten the global ex Japan rate over multiple time periods. Yet, despite this robust profit growth the Japanese stock market has underperformed global markets. We attribute some of this underperformance to Japanese companies taking a very conservative stance with their forward guidance, despite reporting positive earnings; the market has tended to react to this negativity but we believe this should reverse over time as investors respond to the firmer underlying fundamentals.
We expect Japanese companies to sustain this long-term profit growth, supported by a positive macroeconomic backdrop. While growth momentum has been moderating in some manufacturing sectors, the global recession risks appear low in our view. Furthermore, labour conditions remain tight, which could potentially lift wage growth and overall we believe the lower oil price and other input costs are a positive for companies.
We believe growth in Japanese corporates over the medium term should continue to benefit from a number of themes: Artificial Intelligence, as well as the Internet of Things, should continue to activate new business opportunities and enable more efficient work processes; the evolution of technologies such as 5G, the cloud and the electrification of cars (and autonomous driving) should also stimulate demand. We have identified some opportunities in the healthcare space, where companies are developing innovative technologies that could massively improve hospital processes as well as aid patient recovery times – Asahi Intecc’s developments in catheter treatments are a good example here. Finally, a system of cashless payments is being driven by the government which should be particularly beneficial to medium and smaller business by creating efficiencies for companies with a smaller workforce. We are also observing a noticeable pick up in the adoption of Environment, Social and Governance practices – a change that is largely being driven by demand from investors and by society as a whole.
Corporate governance has undergone significant change over the last five years. There are over 2,000 companies listed on the Tokyo stock exchange, but there are moves currently underway that will seek to reduce this number by raising the minimum market capitalisation from USD 20 million to USD 250 million, which could reduce the number of listings by around 30%, thereby creating a more stable and attractive index for investors. In addition, a new regulation is to stipulate that listed companies will have to release their results in English as well as Japanese; at present only 35% of companies do so, therefore this move should serve as a catalyst to generate wider global interest and make the Japanese market more understandable for foreign investors.
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Source: GAM unless otherwise stated.
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. Past performance is no indicator for the current or future development. The companies listed were selected from the universe of companies covered by the portfolio managers to assist the reader in better understanding the themes presented. The companies included do not represent any recommendations by the portfolio managers. Reference to a security is not a recommendation to buy or sell that security.