At GAM Investments’ Weekly Investment Meeting held on 17 July 2019 the speakers were Michael Biggs, who provided a macro overview, Gregoire Mivelaz, who outlined the latest in the developed market credit space, and Swetha Ramachandran, who explained why she continues to feel optimistic about the outlook for luxury equities.
We believe the global macroeconomic environment looks good for risky assets – the risks of a US recession appear modest due to low levels of private sector new borrowing, and inflation remains subdued. Equity and bond returns are still negatively correlated, which lowers overall portfolio volatility and provides a supportive backdrop for risky assets.
The investment outlook is further improved by the China stimulus. New lending has remained strong throughout 2019, and the positive credit impulse should feed into demand and imports. Industrial production strengthened in June, and we expect property sales will strengthen in coming months. The China stimulus should also boost Asian exports. We anticipate property sales will strengthen in coming months. Risky assets should benefit if global trade picks up even as G10 central banks ease policy rates.
The risks stem from a deterioration in the trade war. Global trade fell after the US increased tariffs on imports in Q3 2018 and the risk is that global trade falls again following the further increase to tariffs in May 2019. Early signs suggest exports could be down sharply in June, and this is likely to weigh on industrial production. The weakness appears to be linked to the US trade tariffs – US shipping volumes from Asia were weak, and Chinese exports to the European Union were stronger than those to the US despite more robust US demand.
Finally, a fall in dynamic random-access memory (DRAM) prices since the turn of 2018 has weighed on semiconductor sales and hurt Asian export growth. We believe there are some signs, however, that this has started to turn.
Thus far markets appear to have priced in lower future interest rates without lowering their expectations of economic growth. As a result, most financial assets have rallied. The risk is that the trade war hurts growth more than the market is anticipating, and asset prices fall as a result.
Developed Market Credit
With the level of negative yielding debt now at an all-time high of around USD 13 trillion, the traditional view is investors can only capture a decent level of yield by either taking more interest rate risk or more credit risk. One alternative to this is subordinated debt from investment grade issuers, which in our view offers a number of positive attributes: strong credit metrics, a highly regulated and liquid market, attractive valuation levels, supportive technicals and a significant pick up in yield.
Our approach is to search for high income in good quality companies – what we call “quality yield”. European banks, for example, have materially increased the quality and quantity of regulatory capital, as reflected by their equity buffer or CET1, which increased from 6.1% in 2007 to 14.8% in 2018, increasing their capacity to absorb losses in a severely adverse scenario. This is making the sector stronger and more resilient, as indicated by the result of both stress tests that were conducted by the European Central Bank (ECB) as well as the Bank of England (BoE) last year.
While European banks will continue to face headwinds due to low rates, regulation that continues to strengthen banks’ credit profiles is one of the key catalysts for the sector, in our view. The implementation of Basel IV should lead to further capital accumulation and with its long phase-in period, ie from 2022 to 2027, this will allow for a gradual capital build up organically through profit retention.
On top of strengthening capital positions, European banks have also significantly cleaned up their balance sheets, as reflected by the average NPL (non-performing loans) ratio for EU banks which has fallen from 6.5% in 2014 to 3.1% at the end of the first quarter of 2019; another strong credit positive.
Year-to-date issuance of additional Tier 1 (AT1) bonds has been front loaded, with EUR 18 billion issued so far this year compared with our base case of EUR 25 billion for the full year. New issuance has been extremely well absorbed so far with deals trading on average 5 points higher than at issuance and demand for these bonds has been very strong. For example, inaugural additional Tier 1 bond issuance from a major German bank was USD 1 billion and demand on the primary was USD 11 billion, meaning the deal was covered 11x on the primary. Given we expect limited additional supply for the rest of the year, this should be supportive from a technical standpoint.
A strong focus for us is utilising the capital structure of financial institutions, for example accessing subordinated debt from banks or insurance companies. These bonds offer a more attractive yield versus senior unsecured debt, with a significantly higher spread, equating to a higher income for the same default risk and similar duration. Another strong focus is to invest in bonds that have been issued under Basel II and Solvency 1 and that do not comply with requirements set by Basel III and Solvency 2. We call such bonds legacy or grandfathered bonds and as these are losing their eligibly as regulatory capital, it makes them expensive and inefficient securities for issuers but great investments for investors.
We maintain a constructive view for the second half of 2019. Macro and political uncertainties reduced during June, and we believe the dovish stance adopted by central banks should help contain any potential volatility these might create. Due to the low interest rate environment it is becoming more challenging for investors to find yielding securities without taking excess interest rate or credit risk. We feel subordinated debt from companies we deem “national champions” remains the sweet spot.
From an investment perspective, we continue to seek exposure to emerging market growth at a developed market cost of capital. The Chinese end consumer remains an area of focus since China’s rapidly growing middle class accounts for around one third of industry demand and two thirds of industry growth. The rise of milllennials and ‘Gen Z’ (the adjacent demographic cohort) are proving a real game changer for the luxury industry, with these groups numbering 415 million in China and 440 million in India. It is also interesting to observe that 70% of Chinese millennials own their homes outright, so theoretically the vast majority of their income is available for discretionary expenditure; research suggests the Asian middle class may drive 80% of new consumer spend over the next five years. A further engine of growth is digitisation, which is bringing forth new ways for luxury brands to connect with consumers.
At the company and brand level, we can see that the difference between the performance of winners and losers is much greater than in the preceding era, where a rising tide of luxury sales, during an earlier stage of China’s growth, effectively lifted all boats. Furthermore, the latest phase of the evolution of luxury from pure goods, such as handbags, towards luxury services and experiences, such as health and wellness and travel (“experiential luxury”), is expanding the opportunity set for active investors. As such, the industry is a very fertile arena for research-focused stock selection in our view.
Although we firmly believe that a conviction-driven approach to portfolio construction can add real value in the luxury space, the investment potential of the broader industry is very evident from an historical analysis of MSCI benchmarks. Over the last 20 years or more1, the World Textiles, Apparel & Luxury Goods Index has generated growth of 10% per annum (on a compound annualised basis) in excess of the MSCI Emerging Markets Index. And since most of the strongest brands in luxury are owned by European or US companies, the levels of shareholder friendliness and corporate governance in the sector are higher than that typically seen in emerging markets equities.
1Period analysed 1 January 1988 to 20 June 2019
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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. Reference to a security is not a recommendation to buy or sell that security.