September 21, 2016

Sifting through the fog and finding value in an era of monetary policy divergence


Mark Causer


In the past couple of days we have witnessed the power that global Federal Reserves have over our markets. In particular, the US Federal Reserve’s decision to increase (or hold) interest rates has become the subject of intense market speculation and volatility, which has impacted share markets, bond markets and currency, globally. 

In the past couple of days we have witnessed the power that global Federal Reserves have over our markets. In particular, the US Federal Reserve’s decision to increase (or hold) interest rates has become the subject of intense market speculation and volatility, which has impacted share markets, bond markets and currency, globally. 

Hamish Douglass, Chief Executive Officer, Chief Investment Officer and Lead Portfolio Manager at Magellan shares his view on this and also touches on a couple of individual company stories.

“We’ve been through an extraordinary period where global asset prices have been dramatically influenced by the activities of the major central banks. We don’t need to look too far to gain a perspective on whether the world is ‘normal’ at the moment.

Two-year government bond rates in virtually every European country except Portugal and the UK are currently negative. This includes Spain, where unemployment is above 20%. Mexico recently issued a 100-year bond, while Unilever issued a four-year bond at a zero yield. Is this the ‘new normal’?

Central banks distorting asset prices

These sorts of dynamics in bond markets are having rather unusual consequences. Investors now pay Japan or Switzerland to hold their money for the next decade to achieve some semblance of a yield. This is clearly a distorted situation caused by the G7 central banks. It’s also distorted by countries such as China, Saudi Arabia and (until recently) Switzerland, which are actively accumulating foreign exchange and buying bonds. The central banks of these countries have bought 70% of all debt issued by the US, Europe, the UK and Japan over the past 10 years or so.

A situation where central banks buy vast amounts of bonds is unprecedented. As more bonds are bought, prices rise and interest rates fall. This leads some investors to the conclusion that government bonds are not attractive in this environment, so they invest in the next closest asset: investment grade corporate bonds. In trying to visualise the impact of central banks pouring more money into the system, think about a champagne glass pyramid, where champagne is poured from the top and eventually overflows and floods the glasses below. In a financial markets context, flooding the market with liquidity means everything gets repriced – even emerging markets, junk bonds and commodities. The central bank actions that began in 2009 and ran through to June 2015 are having quite a pronounced impact: bond prices and equity markets have soared while junk bond spreads have halved.

The questions that need to be answered are these: when will central banks start selling the assets they have bought? When will the US Federal Reserve start shrinking its balance sheet? When will the European Central Bank stop its printing presses?

I argue that we have seen the first ‘canary in the coalmine’ over the past year as China, Saudi Arabia and Switzerland have started to sell some assets. And there has been a repricing of assets such as high-yield or junk bonds, and a fall in some emerging-market currencies. When central banks eventually tilt away from extraordinary monetary policy measures, other assets might find new lower levels.

The fund manager’s dilemma

We are at a definitive fork in the road. As a fund manager entrusted with fiduciary responsibility for the life savings of many individuals, it’s a real dilemma positioning yourself in a world where interest rates could either rise or fall from today’s extraordinary low levels. In our view, the most likely scenario is a stabilising environment. Markets have bounced back from their early 2016 lows and we have seen more benign economic signals from China, so we don’t expect a major fall in the renminbi.

But there could easily be further economic turmoil, which is why the Fed is holding fire at the moment. The Fed doesn’t have enough evidence regarding China’s economic prospects. That said, we absolutely recognise the risk of the complete opposite occurring: a world-wide recession. I put this probability at only about 15%, although a year ago I rated it at only a 5% chance of occurring.

Where we still find value

We have retained a cautious stance on equity markets for the past two years, which is reflected in our portfolio positioning in high-quality names, along with a material exposure to cash. We want to pay our investors a satisfactory total return on the capital they’ve entrusted us with over the long term, and we are not concerned about what markets do in the short term.

We invest in many companies that feature globally recognisable brands: Apple, eBay, Oracle, Microsoft, MasterCard, PayPal, Alphabet (Google), Lowes, Home Depot and Woolworths (in Australia). The positions in these names reflect some major trends that we see playing out over the medium to long term. For example, there are powerful technology platforms that are having a profound impact on the way people interact and do business.

There is a trend towards moving computer power away from offices to huge data storage facilities around the world known as the ‘cloud’. Alphabet and Microsoft have large businesses here.

There are two huge digital advertising platforms in the world: search-based advertising controlled by Google and social media-based advertising controlled by Facebook.

The monetisation of consumer services via smartphones is led by Apple and Google. In 10 or 15 years, cash will become largely redundant in the world as digital payment systems are entrenched in our everyday lives. We own MasterCard, Visa and PayPal, which are clear beneficiaries of this trend.

Apple’s success in recent years has been tied to the iPhone, with about 70% of its profits generated from handset sales. But history tells us to be wary of this sector. There are plenty of examples where seemingly cutting-edge devices are rapidly developed, only to become commoditised. Nokia was once the darling of the mobile phone market; today it doesn’t exist. Microsoft bought the company for US$8 billion and has written down almost the entire amount. Remember the Blackberry? And the Motorola Razr was the fastest-growing consumer electronic device in history before the iPhone; it no longer exists.

But today, Apple really shouldn’t be seen as simply a hardware device manufacturer. Its intrinsic value lies within the operating platform and it’s the software inside the phone that reflects its future earning power. Today there are just two operating systems in the world, Google’s Android and Apple’s iOS. This duopoly is here to stay and it is highly unlikely we will see another operating system developed in at least the next 10 to 20 years.

Buying an iPhone actually represents a subscription to the ecosystem, which adds about $30 a month to your phone bill. Look forward a few years and Apple won’t be worried about ‘winning the war’ because nearly all handsets sold will be replacements. There is still plenty of new growth potential as only about 40% of people globally have a smartphone. We believe Apple is fundamentally cheap because the market’s short-term focus is on how many phones were sold in the past year.

Our job as a fund manager is to focus not on the past six months, but on the next three to five years. It’s a different mindset when considering the long-term prospects for people’s retirement savings.”

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