Tuesday, 03 April 2018 06:28

Trump and Trade War Risks

Written by

Written by Shane Oliver - Chief Economist AMP

 

Introduction

After the calm of 2017, 2018 is proving to be anything but with shares falling in February on worries about US inflation, only to rebound and then fall again with markets back to or below their February low, notwithstanding a nice US bounce overnight. From their highs in January to their lows in the last few days, US and Eurozone shares have fallen 10%, Japanese shares are down 15% (not helped by a rise in the Yen), Chinese shares have fallen 12% and Australian shares have fallen 6%. So what’s driving the weakness and what should investors do?

What’s driving the weakness in shares?

The weakness in shares reflects ongoing worries about the Fed raising interest rates and higher bond yields, worries that President Trump’s tariff hikes will kick off a global trade war of retaliation and counter retaliation which will depress economic growth and profits, worries around President Trump’s team and the Mueller inquiry, rising short-term bank funding costs in the US and a hit to Facebook in relation to privacy issues weighing on tech stocks. The hit to Facebook is arguably stock specific so I will focus on the other bigger picture issues.

Should we be worried about the Fed?

Yes, but not yet. The risks to US inflation have moved to the upside as spare capacity continues to be used up and the lower $US adds to import prices. We continue to see the Fed raising rates four times this year and this will cause periodic scares in financial markets. However, the Fed looks to be tolerant of a small overshoot of the 2% inflation target on the upside and the process is likely to remain gradual and US monetary policy is a long way from being tight and posing a risk to US growth.

What’s the risk of a global trade war hitting growth?

In a nutshell, risk has gone up but is still low. This issue was kicked off by Trump’s tariffs on steel imports and aluminium and then went hyper when he proposed tariffs on imports from China and restrictions on Chinese investment into the US and China threatened to hit back. It looks scary and is generating a lot of noise, but an all-out trade war will likely be avoided.

First, the tariff hikes are small. The steel and aluminium tariffs relate to less than 1% of US imports once exemptions are allowed for and the tariffs on Chinese imports appear to relate to just 1.5% of total US imports. And a 25% tariff on $US50bn of imports from China implies an average tariff increase of 2.5% across all imports from China and just 0.375% across all US imports. This is nothing compared to the 20% Smoot Hawley tariff hike of 1930 and Nixon’s 10% tariff of 1971 that hit most imports. The US tariff hike on China would have a very minor economic impact – eg, maybe a 0.04% boost to US inflation and a less than 0.1% detraction from US and Chinese growth.

Second, President Trump is aiming for negotiation with China. So far the US tariffs on China are just a proposal. The goods affected are yet to be worked out and there will a period of public comment, so it could be 45 days before implementation. So, there is plenty of scope for US industry to challenge them and for a deal with China. Trump’s aim is negotiation with China and things are heading in this direction. Consistent with The Art of the Deal he is going hard up front with the aim of extracting something acceptable. Like we saw with his steel and aluminium tariffs, the initial announcement has since been softened to exempt numerous countries with the top four steel exporters to the US now excluded!

Third, just as the US tariffs on China are small so too is China’s retaliation of tariffs on just $US3bn of imports from the US, and it looks open to negotiation with Chinese Premier Li agreeing that China’s trade surplus is unsustainable, talking of tariff cuts and pledging to respect US intellectual property. While the Chinese Ambassador to the US has said “We are looking at all options”, raising fears China will reduce its purchases of US bonds, Premier Li actually played this down and doing so would only push the $US down/Renminbi up. It’s in China’s interest to do little on the retaliation front and to play the good guy.

Finally, a full-blown trade war is not in Trump’s interest as it will mean higher prices in Walmart and hits to US goods like Harleys, cotton, pork and fruit that will not go down well with his base and he likes to see a higher, not lower, share market.

As a result, a negotiated solution with China looks is the more likely outcome. That said, trade is likely to be an ongoing issue causing share market volatility in the run up to the US mid-term elections with Trump again referring to more tariffs and markets at times fearing the worst. So, while a growth threatening trade war is unlikely, we won’t see trade peace either.

Australia is vulnerable to a trade war between the US & China because 33% of our exports go to China with some turned into goods that go to US. The proposed US tariffs are unlikely to cause much impact on Australia as they only cover 2% of total Chinese exports. The impact would only be significant if there was an escalation into a trade war.

Should we worry about Trump generally?

Three things are worrying here. First, it’s a US election year and Trump is back in campaign mode and so back to populism. Second, Gary Cohn, Rex Tillerson and HR McMaster leaving his team and being replaced by Larry Kudlow, Mike Pompeo and John Bolton risk resulting in less market friendly economic and foreign policies (eg the resumption of Iran sanctions). Finally, the Mueller inquiry is closing in and the departure of John Dowd as Trump’s lead lawyer in relation to it suggests increasing tension. The flipside of course is that Trump won’t want to do anything that sees the economy weakening at the time of the mid-term elections. But it’s worth watching.

What about rising US short term money market rates?

During the global financial crisis, stress in money and credit markets showed up in a blowout in the spread between interbank lending rates (as measured by 3-month Libor rates) and the expected Fed Funds rate (as measured by the Overnight Indexed Swap) as banks grew reluctant to lend to each other with this ultimately driving a credit crunch. Since late last year the same spread has widened again from 10 basis points to around 58 points now. So far the rise in the US Libor/OIS spread is trivial compared to what happened in the GFC and it does not reflect credit stresses. Rather the drivers have been increased US Treasury borrowing following the lifting of the debt ceiling early this year, US companies repatriating funds to the US in response to tax reform and money market participants trying to protect against a faster Fed. So, it’s not a GFC re-run and funding costs should settle back down.



Source; Bloomberg, AMP Capital  

Is the US economy headed for recession?

This is the critical question. The historical experience tells us that slumps in shares tend to be shallower and/or shorter when there is no US recession and deeper and longer when there is. The next table shows US share market falls of 10% or greater. The first column shows the period of the fall, the second shows the decline in months, the third shows the percentage decline from top to bottom, the fourth shows whether the decline was associated with a recession or not, the fifth shows the gains in the share market one year after the low and the final column shows the decline in the calendar year associated with the share market fall. Falls associated with recessions are highlighted in red. Averages are shown for the whole period and for falls associated with recession at the bottom of the table. Share market falls associated with recession tend to last longer with an average fall lasting 16 months as opposed to 9 months for all 10% plus falls and be deeper with an average decline of 36% compared to an average of 17% for all 10% plus falls.

Our assessment remains that a US recession is not imminent:
 

  • The post-GFC hangover has only just faded with high levels of confidence driving investment and consumer spending.
  • US monetary conditions are still easy. The Fed Funds rates of 1.5 - 1.75% is still well below nominal growth of just over 4%. The yield curve is still positive, whereas recessions are normally preceded by negative yield curves.
  • Tax cuts and increased public spending are likely to boost US growth at least for the next 12 months.
  • We have not seen the excesses – debt, overinvestment, capacity constraints or inflation – that precede recessions.


We have not seen the excesses – debt, overinvestment, capacity constraints or inflation – that precede recessions.


Falls associated with recessions are in red. Source: Bloomberg, AMP Capital.

What should investors do?

Sharp market falls are stressful for investors as no one likes to see the value of their wealth decline. But I don’t have a perfect crystal ball so from the point of sensible long-term investing:

First, periodic sharp setbacks in share markets are healthy and normal. Shares literally climb a wall of worry over many years with numerous periodic setbacks, but with the long-term trend providing higher returns than other more stable assets.

Second, selling shares or switching to a more conservative investment strategy or superannuation option after a major fall just locks in a loss. The best way to guard against selling on the basis of emotion after a sharp fall is to adopt a well thought out, long-term investment strategy and stick to it.

Third, when shares and growth assets fall they are cheaper and offer higher long-term return prospects. So the key is to look for opportunities that pullbacks provide.

Fourth, while shares may have fallen in value the dividends from the market haven’t. So the income flow you are receiving from a well-diversified portfolio of shares remains attractive.

Fifth, shares often bottom at the point of maximum bearishness. And investor confidence does appear to be getting very negative which is a good sign from a contrarian perspective.

Finally, turn down the noise. In periods of market turmoil, the flow of negative news reaches fever pitch. Which makes it very hard to stick to your well-considered long-term strategy let alone see the opportunities. So best to turn down the noise.

Mark Draper recently met with Andrew Clifford (Platinum Asset Management) to talk about the change in CEO at Platinum Asset Management and what it means for investors in Platinum funds.

Below is a podcast of the discussion and also a transcript.

 

 

 

 

Speakers:  Mark Draper (GEM Capital) and Andrew Clifford (Platinum Asset Management)

Mark:  Here with Andrew Clifford, Chief Investment Officer, or currently Chief Investment Officer of Platinum Asset Management, soon to be Chief Executive Officer of Platinum Asset Management.

Andrew, thanks for joining us.

Andrew:  Good morning. It’s good to be here.

Mark:  Shooting this in Adelaide, too, by the way. So, welcome to Adelaide, Andrew.

It was announced to the market recently that the joint founder of the business, alongside of you, Kerr Neilson, who is the current CEO of Platinum Asset Management is going to step down as CEO, still stay within the business.

I just want to talk about that this morning for our Platinum international investors.

Are you able to give us an overview? What does this actually mean for the business?

Andrew:  I think what people should understand is that we’ve built over the last 24 years, a very deep and experienced investment team. I think also it would be good for people to understand just exactly how the process works internally to understand the role, how Kerr’s changing role affects us.

Across that team, one of the things that we think if very important in coming up with investment ideas is that there’s a very thorough and constructive debate about investment ideas. If you put someone in the corner of a room and leave them to their own devices for four weeks to look at a company, on average through time, they’re not going to come up with good ideas, they’re going to miss things.

Part of our process is that the ideas, even from the very beginning, should we even be looking at this company or this industry, is something that is thoroughly debated all the way along.

We have five sector teams and also our Asia team. These are teams of sort of three to five people and they’re working away, coming up with ideas, debating them internally before they’d even presented to the portfolio managers for a potential purchase.

Then what happens is we have a meeting around that and you get all the portfolio managers for whom that is relevant and the idea is further debated and one of the things to understand about the process is we’re not trying to all come to some lovely agreement about whether this company is a good idea. We’re trying to work out what’s wrong with it.

Then ultimately, what happens after all of that, invariably there’s more questions to follow up and work to be done, but what happens is then each of the portfolio managers make their own independent decision on whether to buy that company or not.

The important role of the portfolio manager, as I see it, is everyone always thinks of them as these gurus who are making a decision about buying this stock or investing in this idea, and certainly they have that final responsibility. But I actually think their most important role is leading that discussion and debate.

Indeed, what happens in the places, that you can see that if an idea comes through to buy a certain company, if I buy it and Clay Smolinski doesn’t or Joe Lai doesn’t, when it’s an Asian stock, or Kerr does, but he buys 3% in the fund and I buy half a percent, there’s some kind of difference of opinion there that needs to be further debated and discussed. We have particular meetings where we do that.

I give this all as a background to say that there’s a very—

Mark:  It’s a bigger process.

Andrew:  —deep and proper process there.

Mark:  It’s not one person pulling the strings.

Andrew:  That’s right, absolutely. When it comes to Kerr and his role, Kerr will continue to be part of the investment team, he will continue to work away on investment ideas, which is his love. When you do this job, you’re never going to stop doing that.

He’ll still be there working away on this idea or that, as pleases him. Also, he will be looking at the ideas other people are putting forward because that’s what excites him.

He will still be part of our global portfolio manager’s meeting, which is the meeting of the most senior PMs, where we actually debate those ideas, where those differences of opinion are occurring amongst the PMs.

He’s still there going to be doing that and as Kerr would say, the demands of being a—of running a global portfolio, are not inconsequential in terms of the time and effort. What he is hoping to be doing is then being able to take that time where he doesn’t have to think about absolutely everything we’re doing to focus on what he believes are the really good ideas.

It is a change, but it may not be as significant as it sounds to people.

Mark:  I think the interesting thing from my perspective is that it’s not like Kerr is resigning from the company, selling all his shareholdings and just walking away. This is very much—sounds like a planned event. He is still going to be in the business, he’s just moving out of the CEO role so he can focus on the investment side and still remain contributing to the company. Is that…

Andrew:  Yeah, I mean, absolutely. Because I think it’s one of these things is that you, as I said, you can’t really retire from investing. You’re going to be doing it one way or the other. This is a great way for him to continue to do what he loves doing and it’s great for the rest of the organization to still have that input from him. It’s something that the younger members of the team will value because he will, as he does today, he’ll walk across the floor to talk to someone about what they’re working on and be quizzing them on that idea.

Because along with that idea, all those sort of more formal processes of how an idea comes to life, there’s also the discussions in the kitchen when you’re making a cup of tea and what have you.

He’s going to remain there as a full-time employee and part of the investment team.

Mark:  What’s he likely to do with his shareholding? Because he does own a significant amount of Platinum Asset Management. I think he said publicly in the press that he’s just retaining them. Is that—

Andrew:  Yes, so it’s hard for me to talk for him, so I can really only repeat what he has said, which is that I think at the moment there’s no intention to sell any of the stock at this stage.

Mark:  Going back to the funds for a second, what are the changes to the management of the funds and with a particular focus on the Platinum International Fund, which is the flagship fund, and also Platinum Asia. Probably the easiest one to start with is Platinum Asia.

Andrew:  Really, for Platinum Asia, there’s no changes in the management of that. Joe Lai has been running that in its entirety for a number of years now.

What you would expect with what we’ve done with Asia previously, with myself and Joe, when I used to run that, he started at 15% of the fund and progressively moved up to half and then the whole fund. That’s something—this is all part of both the development of individual members of the team and also building in that succession planning across the firm.

While there’s no intention to change that today, at some point in the future, you would expect that we will bring in another portfolio manager to run a small part of that fund and then build that up through time.

Mark:  I think that’s really interesting because Joe started out having a smaller amount of that fund, got built up, and then is now running all of it. The Platinum International Fund is not too dissimilar to that, in that Clay Smolinski, who has been with Platinum for quite some considerable time and is a very high quality investor, he’s currently managing 10% of the Platinum International Fund.

Andrew:  Yes.

Mark:  What’s going to change in that respect?

Andrew:  Clay’s also been running the un-hedged fund for a number of years now.

Mark:  Which has performed really, really well.

Andrew:  It’s performed very well, as the European Fund did, or continued to, even after Clay left, but is also—he did a very good job running that.

What’s going to happen is Clay will take 30% of that fund and what you again might expect at some point in the future, that is a third portfolio manager will be brought in there. One of the reasons for not doing that—a lot of people ask us why we’re not doing that today and it’s simply that these types of changes now, five years ago, didn’t attract a lot of attention, these days, the research houses are very focused on these changes. We’ve already given them quite a bit to think about in the last month. So, rather than make yet another change at that point, we want to leave that for a point in the future.

But people might be interested, across the range of our funds, that besides moving to that 30%, we will essentially bring—

Mark:  And then you manage 70%?

Andrew:  I manage 70%.

Mark:  You’re currently managing around half?

Andrew:  40.

Mark:  40, so you got a lot and so does Clay.

Andrew:  But some of our other funds that are similar mandates, this is not so much relevant for Australian investors, but our offshore uses product will also be 70/30. I will take over the management of Platinum Capital, whereas Clay will take over the management of—

Mark:  Platinum Capital being the listed investment company?

Andrew:  Listed investment company, yes.

Mark:  We have some invested in it.

Andrew:  But then also there are funds, the Platinum Global, which is the in fund, that its mandate is much more similar to the un-hedge fund, so Clay will take over that.

Mark:  Right.

Andrew:  They’ll be changes in other funds as well.

Mark:  Yeah. You touched on research houses. One of the things—and this is probably more relevant for Platinum Asset Management investors, rather than investors of the funds, but it strikes me that one of the key things is what the research houses say about you in their capacity as acting as a gatekeeper between you and financial advisors, like us.

What’s been the reaction of the research houses, Morningstar, Lonsec, etc.? What’s their reaction been to this, Andrew?

Andrew:  As you can imagine, we were on the phone to them, in for a meeting within 24 hours.

Mark:  You’re very much on the front foot, I must say, with that.

Andrew:  Yes. Both Morningstar and Zenith have reaffirmed the writings across our fund, so there’s been no change there. I don’t really want to speak for them either. They’re very independent in their views and their positions can be read. But essentially, I think, this was not unexpected in their minds and they’ve reaffirmed those writings, but as always, they’re watching carefully to see how we go.

Mark:  As always.

Andrew:  As it stands today, while we’ve had feedback from Lonsec, we don’t know what their final decision is at this stage.

Mark:  I do know Morningstar were out in the press last week, I think, saying they think that the management of Platinum Funds just continues as is. They were actually quite supportive in the press.

Andrew:  Yes. And I think that came on the back of the one that had that we won the Morningstar, not just the fund manager, the International Fund of the Year, but we also got the Fund Manager of the Year Award, which means that’s won against the entire, you know, all comers who are doing product across the range. And they assured me that was decided before any of the decisions anyway, but it was actually very nice timing to win that at that point for the organization and the investment team because it really recognizes what has been a period of very strong performance.

Mark:  Yes.

Andrew:  After a period where actually we didn’t think our performance was that poor, but in a relative sense, we had lagged the market for a while, by a very small margin, but I think that it was very nice to win that aware at that point.

Mark:  Absolutely.

Andrew:  We stuck to doing things the way we’re doing and the end result has been good. As I say, I’m not one to normally get too excited about awards, but it was a lovely time to get it and at this point in time as well.

Mark:  Congratulations, by the way for that. The track record, so Clay and yourself are running the flagship fund. There’s no changes to Platinum Asia. The track record of Clay and you has been really good over a long, long period of time. Are you able to provide any context around that? I know that’s actually a hard question.

Andrew:  This is the thing, I go back to where we started and talk about the process that is there, and I don’t want to take away from Clay’s excellent record, but here’s the thing, over our 24 years of history, we’ve had 14 different portfolio managers running money. Every one of them, their long-term record was one of out performance. That’s quite extraordinary. I don’t think you find that many easily, in any market.

Now, of those 14, 10 are still with us. 2 of them were other founders who have stepped aside. But I look at this say, this is the system. If I have a flippant response to people when they worry so much about the role of the portfolio manager because if I’m sitting here, I have 30 people in the office bringing me great ideas. If they only bring me great ideas, because they’re well thought through and well argued out,  then all I need to do is buy every one of them or flip a coin and buy every second one, whatever it is.

Now, there’s more to it than that. But the job of running money becomes easy when you’re supported by a strong team.

Mark:  The main message really here is that. This is very much a team business and it’s a big team. You’re probably one of the deepest teams in the country, in international equities.

Andrew:  I think in the country, very easily and across probably all investment teams in terms of depth of experience and what have you, I mean, there will be other people globally who have similar histories.

But, you know, I think the thing that we see when we talk to clients overseas, is that the things that differentiate us very strongly, not any one of these things, but a collection of all of them, is that we’ve been going for a while, 24 years. We’re managing a substantial sum of money with 27-odd billion Australian dollars. Very defined investment approach and extraordinarily deep team, and a long-term record of out performance. You’ll find that people who have got four of the five or three of the five, but there aren’t many.

What I should say, I think one of the things that stands out with overseas clients is when we say we construct our portfolios independently of the MSCI Index, is that we genuinely do. There are many other people who say they do.

Mark:  Say they do and they don’t. [Laughs]

Andrew:  But they still end up with—and some of those who’ve got great records, but they still end up with 45% in the U.S., even though they say they’re not doing that, which interests us. We genuinely are—

Mark:  You’re true to label though, aren’t you? You’re very much true to label. What you say you’re going to do, you do.

Andrew:  We do. I think that maybe sometimes in Australia that’s not valued quite as much as it could be because we’ve been around a long time and people know us. But I think it is—there’s no one else we know of that can show all those attributes.

Mark:  Our position, Andrew, is that we know the depth of your management team at Platinum Asset Management, and you individually have been managing that team for the last five years officially, I believe, in any case.

Andrew:  Officially, yes. Unofficially, for longer than that. [Laughs]

Mark:  Yeah, that’s right. [Laughs] From our perspective, nothing has really changed other than it’s a change of role for Kerr, but he’s still in the business. We’re still positive on Platinum Funds, clearly.

Have you got any last thing that you would like to say for our Platinum investors or PTM shareholders?

Andrew:  I think the other thing that people ask about is, I’m taking on this additional role of CEO and what are the—how much of a workload, how does that—I guess the fair concern is how does that detract from the investing side of things?

Again, I think that not everyone will be aware of just how strongly our organization, that investment team is supported by the other functions. Liz Norman, who was there on day one and I think most clients and financial planners in this country know her. I make the joke, I walked into the Morningstar Awards and everyone is saying, “Hi, Liz. Who are you?”

Mark:  [Laughs]

Andrew:  But you know, he’s run all of that part of the business for 24 years, does an extraordinary job. On the other parts of the business, the accounting, legal, compliance, tax, we had a great founding CFO, Malcolm Halstead. He left the business a few years ago, but he built an extraordinary team of people. There’s all these boring things people wouldn’t know about, portfolio accounting and registry, but these are very important functions because when they go wrong, they can create havoc and they can cost—well, they never cost the clients money but they’ll cost—

Mark:  They cost the business and it’s a management distraction.

Andrew:  It costs the business money and a lot of distraction and we have an incredibly strong team there, now led very well by Andrew Stannard, our current CFO.

When it comes to the role of CEO, the reality is that Liz and Andrew and their teams, they run the business. We want an investment person as CEO because ultimately the CEO makes the final, critical decision on important things and we want those decisions taken from a perspective of is this going to impact the investment process? You can have all these great ideas, we should have this product, we should do this, we should open an office in New York, we can have all the great ideas in the world, but ultimately, they need to be run through the filter of how does this impact the way the investment team functions.

All of those things, those sort of decisions, can impact and hurt that and that’s why I’ve taken on that role. In reality, yeah, there will be times where there’s more to do, but in fact, the way it’s worked, is Kerr and I have already long divided those responsibilities. So, most of the accounting and compliance-type discussions where it’s come through to the management committee, which is Andrew Stannard, Liz, Kerr, and myself, they’ve tended to be my area and Kerr is focused more on the client side of the business. I’ve been part of those discussions for 24 years, so it’s not like I have to all of a sudden get on top of, or how does this work or how does that work? I’ve been there the whole time.

There will be some time into that, but I don’t believe that it will be substantial.

Mark:  Good answer. Andrew, all the best for the new role as CEO and I know you’ve been there forever [laughs], so all the best for the transition. Thanks very much for making the time to talk to us about it.

Andrew:  Thank you.

[End of Audio]

Transcription by Fiverr.com bethfys

We are planning to add Montgomery Investment Management to our recommended list of investments early in 2018.  In particular we are impressed by their Global Investment team who have had an impressive track record since the fund began a few years ago.

The Montgomery Global Fund is listing on the ASX on 20th December 2017 and is a portfolio of high quality global companies aiming to pay a half yearly income distribution of 4.5%pa.  We will have further details on this fund in the new year.

In the meantime, here is a sample of how Montgomery Investment Management think about investing in a comprehensive report that makes excellent reading over the Festive Season.  The articles are written by the investment team at Montgomery Investment Management, rather than a marketing spin doctor and are very informative. 

 

To read the report simply click on the picture of the report below.

Some of the content in this edition include:

1. How the changes in the $AUD impact global facing businesses

2. Why do Montgomery's own Facebook

3. Should you own Wesfarmers?

And many more articles.

 

Thursday, 07 December 2017 10:01

Bubbles, Busts and Bitcoin

Written by

Shane Oliver - Chief Economist AMP

 

The surge in bitcoin has attracted much interest. Over the last five years, it has soared from $US12 to over $US8000; this year it’s up 760%. Its enthusiasts see it as the currency of the future and increasingly as a way to instant riches with rapid price gains only reinforcing this view. An alternative view is that it is just another in a long string of bubbles in investment markets.

Nobel Economics Laureates Daniel Kahneman, Robert Shiller and Richard Thaler and many others shown that investors and hence investment markets can be far from rational and this along with crowd psychology can drive asset prices far from fundamentally justified levels. This note provides a refresher on the psychology of investing before returning to look at bitcoin.

Irrational man and the madness of crowds

Numerous studies show people suffer from lapses of logic. In particular, they:
 

  • Tend to down-play uncertainty and project the current state of the world into the future – eg, resulting in a tendency to assume recent investment returns will continue;
  • Give more weight to recent spectacular or personal experiences in assessing probabilities. This results in an emotional involvement with an investment – if it’s been winning, an investor is likely to expect it to keep doing so;
  • Tend to focus on occurrences that draw attention to themselves such as stocks or asset classes that have risen sharply or fallen sharply in value;
  • Tend to see things as obvious in hindsight – driving the illusion the world is predictable resulting in overconfidence;
  • Tend to be overly conservative in adjusting expectations to new information – explaining why bubbles and crashes normally unfold over long periods; and
  • Tend to ignore information conflicting with past decisions.

This is magnified and reinforced if many make the same lapses of logic at the same time giving rise to “crowd psychology”. Collective behaviour can arise if several things are present:

  • A means where behaviour can be contagious – mass communication with the proliferation of electronic media are perfect examples of this as more than ever investors get their information from the same sources;
  • Pressure for conformity – interaction with friends, social media, performance comparisons, fear of missing out, etc;
  • A precipitating event or displacement which motivates a general investment belief – the IT revolution of the late 1990s or the rapid industrialisation of China which led to talk of new eras are examples upon which were built general believes that particular investments will only go up.

Bubbles and busts

The combination of lapses of logic by individuals and their magnification by crowds goes a long way to explaining why speculative surges in asset prices develop (usually after some good news) and how they feed on themselves (as individuals project recent price gains into the future, exercise “wishful thinking” and receive positive feedback via the media). Of course this also explains how the whole process can go into reverse once buying is exhausted, often triggered by bad news.

The chart below shows how investor psychology develops through a market cycle. When times are good, investors move from optimism to excitement, and eventually euphoria as an asset’s price moves higher and higher. So by the time the market tops out, investors are maximum bullish and fully invested, often with no one left to buy. This ultimately sets the scene for a bit of bad news to push prices lower. As selling intensifies and prices fall further, investor emotion goes from anxiety to fear and eventually depression. By the time the market bottoms out, investors are maximum bearish and out of the market. This sets the scene for the market to start rising as it only requires a bit of good news to bring back buying.

The roller coaster of investor emotion



Source: Russell Investments, AMP Capital

This pattern has been repeated over the years. Recent examples on a globally-significant basis have been the Japanese bubble and bust of 1980s/early 1990s, the “Asian miracle” boom and bust of the 1990s, the tech boom and bust of the late 1990s/early 2000s, the US housing and credit-related boom and bust of last decade and the commodity boom and bust of late last decade into this decade. History may not repeat but rhymes and tells us asset price bubbles & busts are normal.

Where are we now?

Our assessment in terms of global share markets is that we are still around “optimism”. Investor sentiment is well up from its lows last year and some short-term measures are a bit high, warning of a correction (particularly for the direction-setting US share market) but we are not seeing the “euphoria” seen at market tops. The proportion of Australians nominating shares as the “wisest place for savings” remains very low at 8.9%.

But what about bitcoin? Is it a bubble?

Crypto currencies led by bitcoin and their blockchain technology seem to hold much promise. The blockchain basically means that transactions are verified and recorded in a public ledger (which is the blockchain) by a network of nodes (or databases) on the internet. Because each node stores its own copy, there is no need for a trusted central authority. Bitcoin is also anonymous with funds just tied to bitcoin addresses. Designed to work as a currency, bitcoin therefore has much to offer as a low-cost medium of exchange with international currency transfers costing a fraction of what, say, a bank may charge.

However, bitcoin’s price in US dollars has risen exponentially in value in recent times as the enthusiasm about its replacement for paper currency and many other things has seen investors pile in with rapid price gains and increasing media attention reinforcing perceptions that it’s a way to instant riches.

However, there are serious grounds for caution. First, because bitcoin produces no income and so has no yield, it’s impossible to value and unlike gold you can’t even touch it. This could mean that it could go to $100,000 but may only be worth $100.

Second, while the supply of bitcoins is limited to 21 million by around 2140, lots of competition is popping up in the form of other crypto currencies. In fact, there is now over 1000 of them. A rising supply of such currencies will push their price down.

Third, governments are unlikely to give up their monopoly on legal tender (because of the “seigniorage” or profit it yields) and ordinary members of the public may not fully embrace crypto currencies unless they have government backing. In fact, many governments and central banks are already looking at establishing their own crypto currencies.

Regulators are likely to crack down on it over time given its use for money laundering and unregulated money raising. China has moved quickly on this front. Monetary authorities are also likely to be wary of the potential for monetary and financial instability that lots of alternative currencies pose.

Fourth, while bitcoin may perform well as a medium of exchange it does not perform well as a store of value, which is another criteria for money. It has had numerous large 20% plus setbacks in value (five this year!) meaning huge loses if someone transfers funds into bitcoin for a transaction – say to buy a house or a foreign investment – but it collapses in value before the transaction completes.

Finally, and related to this, it has all the hallmarks of a classic bubble as described earlier in this note. In short, a positive fundamental development (or “displacement”) in terms of a high tech replacement for paper currency, self-reinforcing price gains that are being accentuated by social media excitement, all convincing enthusiasts that the only way is up. Its price now looks very bubbly, particularly compared to past asset bubbles (see the next chart – note bitcoin has to have its own axis!).

Because bitcoin is impossible to value, it could keep going up for a long way yet as more gullible investors are sucked in on the belief that they are on the way to unlimited riches and those who don’t believe them just “don’t get it” (just like a previous generation said to “dot com” sceptics). Maybe it’s just something each new generation of young investors has to go through – based on a thought that there is some way to instant riches and that their parents are just too square to believe it.



Source: Thomson Reuters, Bloomberg, AMP Capital

But the more it goes up, the greater the risk of a crash. I also still struggle to fully understand how it works and one big lesson from the Global Financial Crisis is that if you don’t fully understand something, you shouldn’t invest.

At this stage, a crash in bitcoin is a long way from being able to crash the economy because unlike previous manias (Japan, Asian bubble, Nasdaq, US housing in the chart above) it does not have major linkages to the economy (eg it’s not associated with overinvestment in the economy like in tech or US housing, it is not used enough to threaten the global financial system and not enough people are exposed to it such that a bust will have major negative wealth effects or losses for banks).

However, the risks would grow if more and more “investors” are sucked in – with banks ending up with a heavy exposure if, say, heavy gearing was involved. At this stage, I think it’s unlikely that will occur for the simple reason that being just an alternative currency and means of payment won’t inspire the same level of enthusiasm that, say, tech stocks did in the late 1990s (where there was a real revolution going on).

That said, it’s dangerous to say it can’t happen. There was very little underpinning the Dutch tulip mania and it went for longer than many thought. So it’s worth keeping an eye on. But as an investor I’m staying away from bitcoin.

What does this mean for investors?

There are several implications for investors.
 

  1. The first thing investors need to do is recognise that investment markets are not only driven by fundamentals, but also by the often-irrational and erratic behaviour of an unstable crowd of other investors.
  2. Investors need to recognise their own emotional capabilities. In other words, investors must be aware of how they are influenced by lapses in their own logic and crowd influences.
  3. To help guard against this, investors ought to choose an investment strategy which can withstand inevitable crises & remain consistent with their objectives and risk tolerance.
  4. If an investor is tempted to trade they should do so on a contrarian basis. Buy when the crowd is bearish, sell when it is bullish. But also recognise contrarian investing is not fool-proof – just because the crowd looks irrationally bullish (or bearish) doesn’t mean it can’t get more so.
  5. Finally, while crypto currencies and blockchain technology may have a lot to offer bitcoin’s price is very bubbly.
Thursday, 07 December 2017 09:52

Gerard Minack - what's in store for 2018

Written by

Well known investor Gerard Minack, who also sits on the board of Morphic Asset Management recently produced this video on this thoughts for investment markets for 2018.

This video was produced for the Morphic Asset Management roadshow and has been reproduced with their permission.

 

Investment research mouseEvery bull market has it's pin up boy.  In the early 2000's, it was the technology stocks where we witnessed companies 'reinventing' themselves by adding .com to their name, accompanied by large share prices increases.

Today, the Technology companies that are rising rapidly are underpinned by significant growth in revenue and profits, something that was missing from much of the tech sector early this century.

But there is a new 'Next Big Thing' that is attracting investment, probably from many who have not seen market cycles before, or fads come and go.  We are of course referring to Crypto currencies, led by Bitcoin.

At this point we wish to make the point that when discussing crypto currency it is important to separate the technology behind crypto currency from the currency itself.

The technology behind Bitcoin and other crypto currencies, known as Blockchain, is real and likely to influence the financial system around the world as banks, stock exchanges and share registries are investing heavily in the technology.  Put simply “The blockchain is an incorruptible digital ledger of economic transactions that can be programmed to record not just financial transactions but virtually everything of value.”

Picture a spreadsheet that is duplicated thousands of times across a network of computers. Then imagine that this network is designed to regularly update this spreadsheet and you have a basic understanding of the blockchain.

Information held on a blockchain exists as a shared — and continually reconciled — database. This is a way of using the network that has obvious benefits. The blockchain database isn’t stored in any single location, meaning the records it keeps are truly public and easily verifiable. No centralized version of this information exists for a hacker to corrupt. Hosted by millions of computers simultaneously, its data is accessible to anyone on the internet.

So the technology behind Bitcoin and others is real and is likely to materially impact the global financial system, particuarly to reduce processing costs and times and 'cut out the middle man'.

Our concern in this article revolves around the trading of Bitcoin and other crypto currencies by those seeking to get rich quickly.  The chart below tracks the rise of some of history's great bubbles, including Bitcoin.

What prompted us to write about this is when I began seeing a friend of mine uploading a Bitcoin market report everyday on Facebook and scoffing at those who invest in "old world" sectors like fixed interest and the share market.  I can remember these type of conversations during the tech boom of early 2000's.

 

We are not professing to be experts on Bitcoin, or cryptocurrencies, we simply wish to highlight the issues that we would want to satisfy ourselves with before investing.  You can then make your own conclusion.

Cryptocurrency is a form of digital money that is designed to be secure and, in many cases, anonymous, making it ideal for money laundering, organised crime and drug/arms dealers.

It is a currency associated with the internet that uses cryptography, the process of converting legible information into an almost uncrackable code, to track purchases and transfers.  There are new cryptocurrencies being issued every week, and these are known as Initial Coin Offerings.

It is being suggested by enthusiasts that cryptocurrency will become the global currency benchmark, replacing paper money and the existing financial system.  We would caution against such a view as one of the key differences between cryptocurrency and say $USD, is that there is a Government standing behind the $USD.  So unless the Government were to default, the currency has value.  There is no Government support behind cryptocurrency.  In fact recently the Chinese Government  announced that public cryptocurrency exchanges would be shut down.

Our other questions include:

1. Why are cryptocurrencies not being embraced by larger insitutional investors, often referred to as 'smart money'?

2. What legal protections are available to investors who trade cryptocurrency in the event of fraud or other online mischief?

3. What is the intrinsic value of what investors are buying?  (ie the intrinsic value of buying a company is the future cash flow a company generates)

 

We leave this article quoting two famous investors (made famous for different reasons).  

Jordan Belfort, the original "Wolf of Wall Street" says that initial coin offerings "are the biggest scam ever" and "are far worse than anything I was ever doing".

Howard Marks, one of the worlds most famous investors, from Oaktree Capital talked about cryptocurrencies in his recent investor newsletter.  His word of caution was "They're not real".

 

 

Thursday, 12 October 2017 04:42

Business model disruption has only just begun

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From a presentation by Hamish Douglass (CEO Magellan Financial Group) in October 2017

 

There’s a lot of business model disruption in the world and many companies will be left behind by the changes. There will be winners and losers in the years ahead, but sometimes business model disruption isn’t obvious. There are first-order effects when you have changes to business models, but when new technology and new businesses develop, it affects other businesses and other industries and it’s often not foreseeable. This is Part 1 of a two-part transcript.

Watch for second-order effects

If you look at a photograph of the Easter Parade in New York in the year 1900, it is full of horses and carriages. If you fast forward to 1913, the photograph is full of petrol-powered automobiles. Think about what had to happen, such as rolling out petrol stations. Transportation fundamentally changed in 13 years. In 1908, Henry Ford rolled the first Model-T Ford off the production line which enabled an automobile to be mass-produced at an affordable cost.

Many first-order effects are fairly obvious. If you manufactured buggy whips, you effectively went out of business. If you collected manure in the streets, you went out of business. There were 25 million horses in the United States in 1910 and 3 million in 1960.

The second-order effects aren’t as knowable. The second-order effects are what the automobile enabled to happen. An entirely new industry could move goods around far more efficiently. People could start the urban sprawl and move further away. We developed regional shopping centres due to the automobile.

Consider a simple change in technology, the automated checkout, such as in Woolworths and Coles in Australia. Walmart started rolling out these automated checkouts in around 2010 at scale and the other major retailers started doing the same. The first-order effects were a loss of jobs of the people working the checkouts, and retailers reduced their costs. And if one major competitor does that, other competitors follow, otherwise their cost structure is out of line.

But what of the second-order effects? Chewing gum sales have lost 15% of their volume since the introduction of automated checkouts in the US. The checkouts have disrupted the business model of impulse purchases. People do not drive to the supermarket to buy chewing gum, but when you used to stand in those checkout lines, you would pick up some chewing gum. I think mobile phones have had a bit to do with it too, because you now do other things when you’re standing there.

Our job as fund managers is to try and spot the next Wrigley. In 1999, at the peak of the technology bubble, Warren Buffett was asked by a group of students why he doesn’t invest in technology. He said he could not predict where the internet was going but investing in a business like Wrigley will not be disrupted by technology. And look what’s happened. Wrigley sales had gone up for 50 years, every year, before this change happened.

The pace of change is accelerating

Technology adoption appears to be accelerating. The chart below shows the number of years it takes to reach 50 million new users. We saw the rapid adoption with smart phones, and it only took Facebook five years to move from 1 billion to 2 billion users. These new technology-related businesses can scale at an incredibly fast rate.

I think there’s a whole series of factors explaining why this is happening, and a lot of things are starting to come together.

First, globalisation and the internet have enabled products to spread rapidly to much larger audiences around world. A second factor is the digitalising of goods and services. We have digitalised books, newspapers, music and videos. With Facebook, Google or Netflix, all their services are digital goods. Instead of spreading atoms around the world, we’re now spreading bits around the world where an identical copy of a digital good is produced at zero cost.

Third, the mobile phone today is more powerful than the world’s most powerful super-computer in 1986, in the year I left school, which is absolutely incredible. And now we’re connecting all these devices in ‘cloud computing’, where massive data farms don’t need computers to sit locally, and you can share all this information. So there’s a whole lot of infrastructure and change that’s enabling very rapid change.

The incredible power of two digital platforms

Consider the ‘GAF effect’ from Google, Amazon and Facebook. I don’t mean specifically those companies, but how they are affecting industries and important business models. First is the advertising industry. Google and Facebook know an enormous amount about their users. Anyone who uses Google has something called a Google timeline (unless you’ve opted out of it). On your Google timeline, in your user settings, you can go back five years and it will tell you exactly what you did five years ago if you carried your mobile phone, and most people do.

It tells you what time you left your house, whether you walked to the bus, which bus you boarded, if you went to work or not because it knows the address. If you take any photos on a day, it will put those photos on the timeline. It will tell you where you went for lunch, when you went home and if you went to dinner, it will tell you the restaurant. And this goes for every other day of your life for the last five years. It’s collecting enormous amounts of data about you, as are Facebook and others. That enables these platforms to start highly-targeted advertising and make it incredibly efficient.

In the last decade, traditional print advertising has lost about 24% market share, and I predict this will go to zero. It is extraordinary that outside China, two companies (Facebook and Google) have taken nearly the entire market share of a global industry that had many, many players in the world – magazine producers, newspapers producers, classifieds producers. All this revenue has ended up with two digital platforms that have this massive network effect. Television advertising, which is the largest pot of advertising money, has not yet been disrupted. We’re starting to see the rise of YouTube but it is still relatively small, as shown below. It’s probably got between US$6-8 billion of revenue at the moment, but it’s an industry with US$150-180 billion of revenue outside China.

Television is next

The television advertising business model is the next to fall due to two big factors. We’re experiencing the rise of these streaming video services. Think of Netflix, Amazon Prime, Stan, and Hulu, and Apple wants to enter this game. These businesses are spending enormous amounts of money on content creation. Amazon and Netflix this year will spend US$10 billion creating original content. They are far outspending anyone else on the planet. Facebook just bid US$600 million for the Indian cricket video streaming rights and were outbid by News Corp’s Fox. I think that’s one of the last-ditch efforts to protect sporting rights and there’s a battle going on between the television and the movie networks. Apple and Netflix are bidding for the next James Bond.

They are taking viewers away from television and pay TV which reduces advertising revenues. Then on the other side, the costs of producing the content and buying the best shows is being bid up. It is not a great business model if your revenues go down and your costs go up.

We’re also seeing the advent of new video advertising platforms. The streaming services are not advertising businesses, they are subscription businesses. But YouTube and now Facebook (and they’ve just launched Facebook Watch) are advertising business models, and I believe that a huge amount of the revenues that are currently in television and pay TV are at risk. It’s fundamentally different, because this is targeted advertising. These platforms know so much about the users that advertisements can be delivered specifically to what the users are watching on these new platforms.

The television advertising model as it currently stands gives a number of companies in the world a huge advantage because there are massive barriers to entry to promote products on television if you want to advertise at scale. It will be much easier to enter one of these new platforms. You can do very specific programmes if you are developing a new brand on Facebook, YouTube or Google compared with advertising on television.

The Amazon effect

Amazon is a business with an estimated US$260 billion in sales (including Whole Foods), the second largest retailing business in the world after Walmart. It’s a fascinating company. They run a ‘first-party’ business, where Amazon buys the goods, stores them in their warehouse and then sells them to their users via the Amazon website or mobile apps. Then they have a ‘third-party’ business called Fulfillment by Amazon, where other retailers put their own inventory into Amazon’s warehouse and then Amazon sells that inventory to their customers as well. So customers suddenly have a much greater selection, and Amazon charges other retailers rent for having their goods in the Amazon warehouse, then charges a commission for selling to the user base.

Amazon also is a massive logistics company. They are expanding warehouse space by about 30% a year and they are incredibly advanced from a technology point of view. They have developed with a robotics company something called the Kiva robot, with about 45,000 of these robots in their warehouses at the moment. Humans are good at putting goods in a package, adding a label and sending them off. But it’s inefficient for the human picker to run around the warehouse to find the shelf where that good is stored in these massive, multiple football field-sized spaces. So these robots automatically go around the warehouse and bring the shelves holding the product to the packers.

The loyalty scheme called Amazon Prime started out with two-day free shipping, then same-day and 2-hour free shipping in a number of cities around the world. Amazon Prime members receive free video, free music and free ebooks with the service.

Amazon is a also a data analytics company. They understand enormous amounts of information about what the customer wants to buy. Amazon members see web pages that look different to anybody else’s. There are 50 million goods available in Amazon so customers receive a particular look into the world.

Amazon’s Jeff Bezos wants to fulfil all of his customers’ shopping needs. He worked out that if you want to be in their everyday shopping, you need to be in the grocery shopping habit. They started with Amazon Fresh, an online grocery shopping business that’s very niche. But if you want chilled vegetables or meats or ice cream, it’s inconvenient to have them delivered on the verandah if you’re not there for two hours. A lot of people want to look at their fresh fruit and vegetables and not have anyone else choose that for them. So Bezos bought Whole Foods, the largest fresh food retailer in the US. It had a reputation for expensive produce, lots of organics, incredible displays. On the first day Bezos took control, on the key lines people are interested in, he dropped the prices 35-45%. People shop for incredibly good, fresh groceries then everything else can be put together.

He wants to connect your home by the ‘Internet of Things’. Many goods like washing detergent and milk will have computer chips on them that will connect to the internet to know when you are running out. Washing machines and fridges will automatically generate shopping lists. He’s adopting a voice platform for your house with a digital personal assistant.

What’s next?

There’s a massive number of these revolutions. You may think Amazon and Facebook and Google are big at moment, but we’re in the early stages of where this technology and these businesses are heading. Advertising and retailing is the start. Next week, I’ll discuss which large companies will suffer, and bring in the perspectives of Warren Buffett and Charlie Munger.

 

Tuesday, 26 September 2017 09:21

Rocket Man Kim - Keep calm and BUY shares

Written by

by Jack Lowenstein (Morphic Asset Management)

 

A few weeks ago, US Ambassador Nikki Haley to the UN intoned that “the North Korean can couldn't be kicked any further down the road because there was no more road”. But a few weeks seems to be a long time in rhetorical road building because the can has just had another boot applied, and is still on terra firma. 

Meanwhile after brief jitters when North Korean missiles were flying and the dust from underground nuclear tests was settling, global stock markets reached new all-time highs again last week, and several major central banks confirmed they were moving ahead with monetary policy tightening. 

Many investors ask us why we don’t tend to get more nervous about potentially catastrophic geopolitical events.

This note is a brief description of why we try to stay calm even in the face of potentially devastating instability on the Korean peninsula, and what might make that wrong. For the record, we used recent jitters to slightly top up our investment in Korea’s largest company Samsung Electronics, which makes it now the largest holding in our portfolios.

I first had to contemplate the implications of tensions on the Korean Peninsula and their potential resolution in 1990. In most regards, nothing has changed. That doesn't mean it never will - but probably not for some time. 

That year, when I was still a journalist at Euromoney magazine, I was sent to Seoul to write about the financial consequences of the Koreans copying Germany and reunifying. It must have looked like a smart idea from the distance of London, where people were still excited about the end of the Cold War and the demolition of the Berlin Wall. 

In Seoul, it quickly became apparent the proposition was laughable. 

The South, with its population of 45m or so had a per capita income generally estimated at eight times as much as that ‘enjoyed’ by the 25m in the North. Having only just escaped extreme poverty, itself, however it could little afford the cost of investing in the North to bring it up to its level quickly or cope with an influx of starving northerners moving south. So few in the leadership had any real interest in reunification, even if they had to go through the motions of aspiring for it in public. 

In North Korea, the ruling elite would lose all their privileges if not their lives if their regime collapsed, so they would never support reunification. 

The other four interested parties also had no real interest in demarche. China didn't want a western-leaning democracy on its doorstep. Russia didn't want to lose a distracting irritant to the other superpower, the US. The US didn't want to lose valuable forward bases in Korea and Japan that were nominally justified by a belligerent Pyongyang. And Japan didn't want to lose a fully engaged US military in the region. Nor did it have much appetite for a larger northeast Asian economic competitor.

Today similar factors apply. 

Pyongyang has buttressed its position through nuclearisation. “Rocket Man” Kim, as President Trump has undiplomatically dubbed him, would know his chances of preserving power, wealth or indeed his life would be negligible under a united regime.

South Korea could probably afford to integrate the North now, but the challenge from internal migration would be acute, given per capita GDP in the south is now at least 20 times higher than the north. 

Japan might worry less about Korean reunification than in the past, given the greater threat the present situation poses than in the past. The increased challenge from China now also justifies the retention of US bases in Japan to both Washington and Tokyo. A resurgent Russia, however, would probably be more opposed.

The Chinese dilemma is exquisite. Many in the Beijing leadership probably hate being held hostage by Rocket Man. But to give him up, would entail a loss of face. There would still be no interest in a country with a western orientation being directly on the border, even if it was agreed US bases would be closed.

Sadly the most likely way this impasse changes is by accident. And it is almost impossible to manage money in preparation for that kind of discontinuous event. 

Challenger superpowers like China are highly prone to start wars. Sometimes this is to distract from temporary economic setbacks, like the three wars Germany fought against Denmark, Austria and France between 1860 and 1870. Sometimes, like emerging Japan prior to WW2, wars can happen because a field commander can make a blunder and no one at the capital wants to lose face by bringing him into line. 

Pyongyang has too much to lose from deliberately attacking anyone, but what if a rocket veers off target and lands in Japan or South Korea? Or someone in the line of fire erroneously believes a rocket attack is under way?

My old friend Jonathan Allum of SMBC Nikko today drew my attention to the story of Stanislav Petrov who has died at the age of 77. On the 26th September 1983, he was the duty officer at a Soviet military facility that monitored the threat of missile attacks. The following is condensed from the BBC version of what happened that day.

In the early hours of the morning, Soviet early-warning systems detected an incoming missile strike from the United States. The protocol for the Soviet military would have been to retaliate with a nuclear attack of its own. But duty officer Stanislav Petrov decided not to report it to his superiors, and instead dismissed it as a false alarm.

"If I had sent my report up the chain of command, nobody would have said a word against it… The siren howled. All I had to do was to reach for the phone; but I couldn't move. I felt like I was sitting on a hot frying pan…Twenty-three minutes later I realisedthat nothing had happened. If there had been a real strike, then I would already know about it. It was such a relief”

A subsequent investigation concluded that Soviet satellites had mistakenly identified sunlight reflecting on clouds as the engines of intercontinental ballistic missiles… 

A salutary tale. Let’s hope the world stays this fortunate. But these really don’t seem to be risks we can hedge.

Monday, 04 September 2017 22:32

North Korea and investment markets

Written by
Written by Shane Oliver - Chief Economist AMP
 
Tensions with North Korea have been waxing and waning for decades now but in recent times the risks seem to have ramped up dramatically as its missile and nuclear weapon capabilities have increased. The current leader since 2011, Kim Jong Un, has launched more missiles than Kim Il Sung (leader 1948-1994) and Kim Jong Il (1994-2011) combined.

Source: CNN, AMP Capital
 
The tension has ramped up particularly over the last two weeks with the UN Security Council agreeing more sanctions on North Korea and reports suggesting North Korea may already have the ability to put a nuclear warhead in an intercontinental ballistic missile that is reportedly capable of reaching the US (and Darwin).

US President Trump also threatened North Korea with “fire, fury and, frankly, power” only to add a few days later that that “wasn’t tough enough” and “things will happen to them like they never thought possible” and then that “military solutions…are locked and loaded should North Korea act unwisely”. Meanwhile, North Korea talked up plans to fire missiles at Guam before backing off with Kim Jong Un warning he could change his mind “if the Yankees persist in their extremely dangerous reckless actions”. 
 
This is all reminiscent of something out of James Bond (or rather Austin Powers) except that it’s serious and naturally has led to heightened fears of military conflict. As a result, share markets dipped last week and bonds and gold benefitted from safe haven demand, although the moves have been relatively modest and markets have since bounced back.
 
At present there are no signs (in terms of military deployments, evacuation of non-essential personnel, etc) that the US is preparing for military conflict and it could all de-escalate again, but given North Korea’s growing missile and nuclear capability it does seem that the North Korean issue, after years of escalation and de-escalation, may come to a head soon. It’s also arguable that the volatile personalities of Kim Jong Un and Donald Trump and the escalating war of words have added to the risk of a miscalculation – eg where North Korea fires a missile into international waters, the US seeks to shoot it down, which leads to a cycle of escalating actions. This note looks at the implications for investors.

Shares and wars (or threatened wars)

Of course there have been numerous conflicts that don’t even register for global investors beyond a day or so at most if at all. Many have little financial market impact because they are not seen as having much economic impact (eg the war in Afghanistan in contrast to 1991 and 2003 wars with Iraq, which posed risks to the supply of oil). As such, I have only focussed on the major wars/potential wars since World War 2 and only on the US share market (S&P 500) as it sets the direction for others (including European, Asian and Australian shares).
 
  • World War 2 (September 1939-September 1945) – US shares fell 34% from the outbreak of WW2 in September 1939, with 20% of this after the attack on Pearl Harbour, and bottomed in April 1942. This was well before the end of WW2 in 1945. Six months after the low, shares were up 25% and by the time WW2 had risen by 108%.
  • Korean War (June 1950-July 1953) – US shares initially fell 8% when the war started but this was part of a bigger fall associated with recession at the time. Shares bottomed well before the war ended and trended up through most of it.
  • Vietnam War (1955-1975) – For most of this war US shares were in a secular bull market but with periodic bear markets on mostly other developments. Rising inflation and a loss of confidence associated with losing the Vietnam war may have contributed to the end of the secular bull market in the 1970s – but the war arguably played a small role in this.
  • Cuban Missile Crisis (October 1962) – Shares initially fell 7% over eight days as the crisis erupted but this was part of a much bigger bear market at the time. They bottomed five days before it was resolved and then rose sharply. This is said to be the closest the world ever came to nuclear war 
  • Iraq War I (August 1990-January 1991) – Shares fell 11% from when Iraq invaded Kuwait to their low in January 1991 but again this was part of a bigger fall associated with a recession. Shares bottomed 8 days before Operation Desert Storm began and 19 days before it ended and rose sharply.
  • Iraq War II (March-May 2003) – Shares fell 14% as war loomed in early 2003 but bottomed nine days before the first missiles landed and then rose substantially although again this was largely due to the end of a bear market at the time.

Source: AMP Capital
 
The basic messages here are that:
 
  • http://www.ampcapital.com.au/custom/reskin/images/bg-bullet-dot.png); padding-left: 11px; margin-bottom: 5px; background-position: 0px 8px; background-repeat: no-repeat no-repeat;">Shares tend to fall on the initial uncertainty but bottom out before the crisis is resolved (militarily or diplomatically) when some sort of positive outcome looks likely; 
  • http://www.ampcapital.com.au/custom/reskin/images/bg-bullet-dot.png); padding-left: 11px; margin-bottom: 5px; background-position: 0px 8px; background-repeat: no-repeat no-repeat;">Six months after the low they are up strongly; and
  • http://www.ampcapital.com.au/custom/reskin/images/bg-bullet-dot.png); padding-left: 11px; margin-bottom: 5px; background-position: 0px 8px; background-repeat: no-repeat no-repeat;">The severity of the impact of the war/threatened war on shares can also depend on whether they had already declined for other reasons. For example, prior to World War 2, the Cuban Missile Crisis and the two wars with Iraq, shares had already had bear markets. This may have limited the size of the falls around the crisis.

Possible scenarios 

In thinking about the risks around North Korea, it’s useful to think in terms of scenarios as to how it could unfold:
 
  1. Another round of de-escalation – With both sides just backing down and North Korea seemingly stopping its provocations. This is possible, it’s happened lots of times before, but may be less likely this time given the enhanced nature of North Korea’s capabilities.
  2. Diplomacy/no war – Sabre rattling intensifies further before a resolution is reached. This could still take some time and meanwhile share markets could correct maybe 5-10% ahead of a diplomatic solution being reached before rebounding once it becomes clear a peaceful solution is in sight. An historic parallel is the Cuban Missile Crisis of 1962 that saw US shares fall 7% and bottom just before the crisis was resolved, and then stage a complete recovery. 
  3. A brief and contained military conflict - Perhaps like the 1991 and 2003 Iraq wars proved to be, but without a full ground war or regime change. In both Iraq wars while share markets were adversely affected by nervousness ahead of the conflicts, they started to rebound just before the actual conflicts began. However, a contained Iraq-style military conflict is unlikely given North Korea’s ability to launch attacks against South Korea (notably Seoul) and Japan.
  4. A significant military conflict – If attacked, North Korea would most likely launch attacks against South Korea and Japan causing significant loss of life. This would entail a more significant impact on share markets with, say, 20% or so falls (more in Asia) before it likely becomes clear that the US would prevail. This assumes conventional missiles - a nuclear war would have a more significant impact.
     
Of these, diplomacy remains by far the most likely path. The US is aware of the huge risks in terms of the likely loss of life in South Korea and Japan that would follow if it acted pre-emptively against North Korea and it retaliates, and it has stated that it’s not interested in regime change there. And North Korea appears to only want nuclear power as a deterrent. In this context, Trump’s threats along with the US show of force earlier this year in Syria and Afghanistan are designed to warn North Korea of the consequences of an attack on the US or its allies, not to indicate that an armed conflict is imminent. Rather, comments from US officials it’s still working on a diplomatic solution. As such, our base case is that there is a diplomatic solution, but there could still be an increase in uncertainty and share market volatility in the interim. Key dates to watch are North Korean public holidays on August 25 and September 9, which are often excuses to test missiles, and US-South Korean military exercises starting August 21.

Correction risks

The intensification of the risks around North Korea comes at a time when there is already a risk of a global share market correction: the recent gains in the US share market have been increasingly concentrated in a few stocks; volatility has been low and short-term investor sentiment has been high indicating a degree of investor complacency; political risks in the US may intensify as we come up to the need to avoid a government shutdown and raise the debt ceiling next month, which will likely see the usual brinkmanship ahead of a solution (remember 2013); market expectations for Fed tightening look to be too low; tensions may be returning to the US-China trade relationship; and we are in the weakest months of the year seasonally for shares. While Australian shares have already had a 5% correction from their May high, they are nevertheless vulnerable to any US/global share market pull back. 
 
However, absent a significant and lengthy military conflict with North Korea (which is unlikely), we would see any pullback in the next month or so as just a correction rather than the start of a bear market. Share market valuations are okay – particularly outside of the US, global monetary conditions remain easy, there is no sign of the excesses that normally presage a recession, and profits are improving on the back of stronger global growth. As such, we would expect the broad rising trend in share markets to resume through the December quarter.

Implications for investors

Military conflicts are nothing new and share markets have lived through them with an initial sell-off if the conflict is viewed as material followed by a rebound as a resolution is reached or is seen as probable. The same is likely around conflict with North Korea. The involvement of nuclear weapons – back to weapons of mass destruction! – adds an element of risk but trying to protect a portfolio against nuclear war with North Korea would be the same as trying to protect it against a nuclear war during the Cold War, which ultimately would have cost an investor dearly in terms of lost returns. While there is a case for short-term caution, the best approach for most investors is to look through the noise and look for opportunities that North Korean risks throw up – particularly if there is a correction.
Monday, 04 September 2017 22:00

New Magellan listed trust - with a loyalty bonus

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Magellan Financial Group have announced a new listed investment vehicle, the Magellan Global Trust.

This ASX listed trust will commence trading on 18th October 2017, targetting an income yield of 4%pa and will be invested similarly to the Magellan Global Fund which has been established since 2007.

Existing investors in Magellan funds (both listed or unlisted) can apply for units in a priority offer and receive 6.25% worth of bonus units on the first $30,000 applied for.  Bonus value is up to $1,875, and to be eligible the Magellan Global Trust must be held until 11 December 2017.

The Priority Offer is open to any person who has a registered address in Australia or New Zealand and who, as at 5.00pm (Sydney time) on 1 August 2017, was a direct or indirect holder or investor in any one of the following (each an "Eligible Vehicle"):

  1. a)  Magellan Financial Group (ASX: MFG);

  2. b)  Magellan’s Active ETFs: Magellan Global Equities Fund (Managed Fund) (ASX: MGE), Magellan Global Equities Fund (Currency Hedged) (Managed Fund) (ASX: MHG) and Magellan Infrastructure Fund (Currency Hedged) (Managed Fund) (ASX: MICH);

  3. c)  Magellan’s unquoted registered managed investment schemes: Magellan Global Fund (ARSN 126 366 961); Magellan Global Fund (Hedged) (ARSN 164 285 661); Magellan Infrastructure Fund (ARSN 126 367 226); Magellan Infrastructure Fund (Unhedged) (ARSN 164 285 830); and Magellan High Conviction Fund (ARSN 164 285 947); and

  4. d)  at Magellan’s discretion, any fund or investment strategy for which Magellan is the investment manager or adviser.

 

GEM Capital will be flagging this issue to its clients directly, but in the meantime we attach a fact sheet about the offer.

 

Download Magellan Global Trust Fact Sheet

 

Download Magellan Global Trust Product Disclosure Statement

 

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