Welcome to the July edition of the Generate KiwiSaver Scheme Newsletter. The swings in global share markets seen in June neatly summarised the first half of 2018. Optimism about earnings growth early in the month drove share markets higher. However, this optimism quickly evaporated after a series of tweets by President Trump reignited worries that there is a risk we are seeing the early stages of a fully-fledged Trade War. The net result of these moves was solid but not spectacular performance - all three funds ended the month up a little over 1%.

Returns to 30 June 2018 (after fees* and before tax).

*except the $3 per member per month fee.

**the funds opened on 16 April 2013

Note: Past performance is not necessarily an indicator of future performance.

In June the market environment best suited the Growth Fund, which benefited from a larger allocation to NZ and Australian listed property and infrastructure companies. These investments performed better than global equities in a month where the risks that Trump could ignite a Trade War re-emerged. More specifically, the Growth fund generated 1.22% in June, Focused Growth was up 1.10% and Conservative was up 1.05%

The top-performing Property and Infrastructure stock for the Funds in June was Oceania Healthcare, which was up 7.7% over the month. Arguably, Oceania was simply playing catch-up with the rest of the aged care sector. Aged care companies have featured regularly as our top performing Property and Infrastructure stocks in 2018. Summerset achieved the top position two months in a row and Ryman was the top performer last month.

Kiwi Property Group was the lowest returning Property and Infrastructure stock in June declining -1.6%. The stock enjoyed a strong month in May but gave back some of those gains in June.

The best performing international investment was Magellan’s listed investment trust, Magellan Global Trust. The Trust was up an impressive 5.5% in June, which was largely due to strong underlying returns, enhanced by a reduction in the discount to net asset value that this listed trust trades on.

The lowest returning international investment was Alibaba, which was down -6.3% in June. This stock was hit by the perfect storm of negative investor sentiment: a Chinese company that has exposure to international trade. While disappointing, the month’s performance has done nothing to deter our optimism about the company’s long-term prospects. Alibaba is one of the world’s largest online marketplace businesses. A staggering US$768 billion worth of goods went through its websites last year, and it managed to grow revenues by an impressive 58% while maintaining high-profit margins.

Emerging market investments have recently been making headlines for all the wrong reasons. Some spectacular currency declines and a trifecta of macroeconomic headwinds have seen some commentators start to speculate that we may be seeing the very early stages of an emerging market crisis. While this seems a little premature, it is worth understanding some of the risks of emerging market investments.

First, the very easy monetary policy put in place following the global financial crisis by the United States and Europe has pushed down interest rates in emerging markets and stimulated growth. As the Federal Reserve and European Central Bank reduce this stimulus it is likely to also create headwinds in emerging markets.

Emerging market borrowers that have US dollar denominated debt are likely to be particularly hard hit. An increase in short-term US interest rates not only increases the interest rate but could well also push up the value of the US dollar (effectively increasing the size of the loan), making it more difficult to service the debt. This can prompt concerns over credit quality, which in turn can put further pressure on the emerging market’s currency. This has the potential to create a nasty self-fulfilling spiral.

Second, emerging market economies rely on global trade. With the noteworthy exception of China, emerging market economies are not directly impacted by the latest round of tariffs, but are likely to feel the second-round impacts if there is an escalation in trade tensions. Again, this has the potential to put further pressure on the ability of companies and governments to service debts, which adds to investors’ concerns. However, we would note that an escalation of trade tensions could see the Federal Reserve change its course, which would mitigate the damage of an escalating trade war.

Third, a rising oil price creates major headwinds for a number of emerging economies as they suffer a deterioration in their current accounts, which again can cause currency weakness.

To put this back into perceptive, at this stage stress is only evident in a handful of emerging economies. EM typically grows more rapidly than developed economies, and consequently offers attractive returns, across the market cycle, making them attractive to long-term investors. While the funds do not hold any solely emerging market-focused funds at present a severe sell-off in these markets could create an opportunity for our growth funds to add to this exposure.

US equities produced modestly positive returns in June. The month started strongly with optimism stoked by increasing confidence that second-quarter results due to be released from mid-July will be strong. A hike from the Fed and news that it expected it would need to raise rates twice more in 2018 had no impact on the US share market.

A series of announcements by Trump mid-month that not only confirmed the implementation of tariffs but also threatened a significant escalation if other countries retaliated was met with equally aggressive responses from the rest of the world. This was enough to reverse momentum and wipe out most of the gains made early in the month. More specifically, the S&P 500 index was up more than 3% mid-month, but ended the month up just 0.6% (total return in local currency).

Looking forward, the approaching second quarter’s reporting season looks likely to confirm that US companies are still enjoying very strong earnings growth. According to data compiled by FactSet, analysts now expect the S&P500 to post 20% growth in earnings in the second quarter. Interestingly, during the second quarter analysts nudged up their growth numbers by an average of almost 1 percentage point. This is significant because analysts typically reduce their estimates in the months before earnings are released. For instance, FactSet estimates that on average over the last decade analysts have reduced their estimates of forecast earnings growth by 3.4 percentage point in the quarter before they are reported.

Eurozone equities again produced modestly negative returns in June, with the Bloomberg European 500 returning -0.1%. Europe largely followed the same pattern as in the US with a good start to the month before an escalation of trade concerns wiped out the early gains.

The key difference was that political concerns continued to weigh on European share markets. Investors welcomed the news that the Italian President would accept an Italian coalition after they dropped their eurosceptic finance minister.  However, political uncertainty in Spain remained, and later in the month question marks over the strength of Germany’s governing coalition began to emerge. More specifically, Chancellor Merkel agreed to a two-week deadline from her junior coalition partner to negotiate an agreement with other EU governments to return migrants to the country where they were first registered.

The Chinese share market had a very difficult month with the Shanghai Stock Exchange Composite Index ending the month down -7.3%. The market battled the twin concerns that the economy seems to be slowing (with growth in industrial output and retail sales softer than expected) and escalating trade concerns with its largest trading partner. In a bid to alleviate some of the growth/liquidity concerns the People's Bank of China cut the reserve ratio by a further 0.5% in June.

June was another weak month for emerging markets equities, which were down -2.9%. Concerns that the tighter monetary policy of developed nations will hit this group hard was exacerbated by the escalation of trade tensions between China and America.

Over the ditch, the Australian Stock Exchange 200 Index notched up a 3.3% return. A diverse range of sectors all performed well: energy, information technology, consumer staples and utilities all generated 6%+ returns. In fact, the only sector to post a negative return was the telecommunications sector, which was dragged down by a particularly poor performance from Telstra following a strategy update that included news of further revenue declines, plans to split off its infrastructure assets and another round of layoffs.

The local share market posted another strong month with the NZX50 Gross Index (NZX50G) gaining 3.3%. To date, the local market has been largely immune to trade war worries. Interestingly, the NZ share market also took reductions in NZ GDP growth expectations and more cautious comments from the RBNZ in its stride. This strength in the face of adversity has seen the NZX50G comfortably outperform the other markets covered in this newsletter year to date. For instance, its year to date return is almost 4.5% above the MSCI World Index.

It is worth noting that the Australian and NZ dollars traded down over the month (-2.1% and -3.4% respectively) against the USD. Some would argue that currency has done the heavy lifting leaving the share markets to continue to make new record highs.

After 50 years at the helm of Berkshire Hathaway (which is currently one of the largest investments for both of our growth funds) Warren Buffett has become widely regarded as one of the world’s greatest investors. In his annual letters to shareholders, and in various interviews he has given, he has shared many of the lessons he has learned during his career. This month:

" Charlie and I believe it’s a terrible mistake to try to dance in and out of [the market] based upon the turn of tarot cards, the predictions of ‘experts’, or the ebb and flow of business activity. The risks of being out the game are huge compared to the risk of being in it.”

Here Buffett is referring to the perils of trying to “time the market”. Timing the market is effectively buying stocks when the market is low and selling out when it is high. This is a very difficult strategy to execute successfully, hence why Buffett tends to buy quality companies and hold them for a long period of time. He would certainly never sell all of his investments just because he thought the market was expensive.

Diversification

Diversification is one of the golden rules in investing. We all know the phrase “Don’t put all your eggs in one basket.” Unfortunately, time and again people do not apply this to their investments. For example, during the GFC when New Zealand finance companies were collapsing, thousands of New Zealanders lost much or even all of their savings. Many thought their hard-earned savings were diversified by having invested in a number of different finance companies. Unfortunately, this is not diversification, as all their investments were in one highly-leveraged sector of the same economy.

Diversification is a key component of Generate’s investment philosophy. As such, we invest our members’ savings across a number of geographies, sectors and asset classes.

Please log in to your account to see your full portfolio breakdown.

Metlifecare

Metlifecare provides accommodation and care to Kiwis in their later stages of life. One of the key attractions of Metlifecare and the other aged care providers is that they are leveraged to the aging demographic. All things being equal this thematic should see the demand for aged care accommodation double over the next few decades. This growth allows Metlifecare and the other providers to develop new villages.

To understand the value of development it is useful to review the typical business model of the NZ listed aged care companies. They charge retirement unit residents an upfront fee for the lifetime licence to occupy the unit. At the end of the resident's stay in the village, the initial lump sum is refunded less a management fee (which is typically 20-30%).

One of the key implications of this business model is that the development of villages is self-funding. More specifically, once the development is completed and retirement units are sold the developer has no capital tied up in the village.

This allows the company to grow without needing to return to capital markets for additional funding. It also makes the economics of development very attractive. While the developer no longer has cash tied up in the village they still receive management fees paid by exiting residents and gains in the retirement units value (units can be resold at higher prices assuming that the property market appreciates over time).

The Funds own Metlifecare because it trades relatively cheaply. For instance, Metlifecare is currently trading at a discount to its book value while the sector leader Ryman is trading at over three times it book value! Admittedly, Ryman has a fantastic long-term earnings track record and has successfully developed a large number of villages. Consequently, we are not arguing that Metlifecare’s share price should triple. Given the value of development and the book value multiples of other stocks in the sector; we expect the market to re-rate Metlifecare to a premium of book value if it can successfully raise its development rate.

Next month:

Tilt Renewables