Welcome to the March edition of the Generate KiwiSaver Scheme Newsletter. After a strong year, markets took a breather in February. Ironically the market weakness was a result of news that US economic growth was likely to be stronger than expected. We delve into this in more detail later in the newsletter (“the risk of higher rates”). We would also recommend reading the article “Understanding the highs and lows of KiwiSaver investing” to learn more about market volatility and the impact on KiwiSaver accounts.

Returns to 28 February 2018 (after fees* and before tax).

*except the $3 per member per month fee.

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

After an extended period of healthy performance, the funds all had negative returns in the month of February. The Focused Growth, Growth and Conservative Funds returned -2.17%, -1.90% and
-0.68% respectively over the month, but were still up 19.71%, 14.93% and 5.27% over the past year (all returns after fees and before tax).

The International Equity Manager (IEM) or large-cap international stock with the highest return was Polar Capital Technology Trust (PCT), which returned 0.2% (in NZD) in February. One of the key contributors to PCT’s modestly positive performance was Apple, which performed strongly over the month after lagging behind its peers in January.

The IEM or large-cap international stock with the lowest return for the month was Ping An with a return of -8.1% (in NZD). To put this decline into perspective Ping An has enjoyed a period of strong share price appreciation since the funds invested in the company back in September (up 50% to the end of January). Ping An is a large Chinese insurance company that has invested heavily in technology, which is expected to drive profit growth in the years ahead. In February, Ping An’s share price was caught in the head winds of a sell-off in both Chinese technology and insurance companies.

The top-performing Australasian stock for the funds in February was local retirement village operator Summerset (SUM) with an impressive return of 11.3%. Summerset reported stronger than expected (and guided) results for 2017 and upped its future target development rate to 600 units per annum.

Z energy’s share price declined by 8.5% during February, which made it the lowest returning Australasian stock in the fund. The company downgraded earnings guidance in late January at a time when investors are increasingly concerned over the impact of electric vehicles on Z energy’s prospects.

The share market sell-off during February can largely be attributed to an increase in US Government bond interest rates, compounded by increasing fears that rates would continue to rise in the short to medium term. This raises three questions: why did these interest rates increase? Why does the share market react to interest rates? And why can’t higher rates be positive?

At the start of 2018 interest rates in the US and around the world were low by historical standards. The market interest rate for the 10 year US Treasury at the start of this year was 2.4%. The chart below puts these levels into perspective showing the interest rate for the US 10 year Treasury over the last 30 years.  Interest rates below 3% were unheard of prior to the Global Financial Crisis; for instance, the 10 year average running up to the Crisis was 5%.

US 10 year Treasury

Source: Bloomberg

In February, evidence that inflationary pressure was picking up caught the markets attention. More specifically, unexpectedly high inflation in January combined with tight labour markets (low unemployment) and increasing pressure from fiscal stimulus (tax cuts and infrastructure spend) pointed to inflation increasing over 2018 and beyond.

This prompted the market to begin to re-price US treasuries. A key concern for investors is real returns (i.e. the return they receive after taking into account the erosion of purchasing power from inflation). The low interest rates offered on these instruments provide a minimal buffer for unexpectedly high inflation. Consequently, the risk of building inflation caused investors to demand higher interest rates.

Higher interest rates are good news for prospective bond investors as they can buy bonds with higher yields. However, this comes at a price to current investors. To achieve an increase in yield the market prices of bonds currently on issue has to fall.

The potential for US interest rates to move significantly higher after an extended period of ever lower rates also caused share markets to weaken. This was due to the market factoring in the risk that money would be attracted away from shares and into bonds and the risk that valuations would be negatively impacted by higher discount rates.

Interestingly, share market investors refocused on growth in the second half of February and global share markets recovered a good proportion of the losses seen earlier in the month. While stronger growth may lead to inflation it should also feed through to faster earnings growth.

In our view, the building blocks for higher inflation in the US are in place. Low unemployment suggests limited slack in the economy at a time of extremely accommodative monetary policy and increasing stimulatory fiscal policy (in the form of tax cuts and increasing infrastructure spend). Consequently, in our view, it is relatively easy to build an argument that the inflation rates currently built into asset values could well prove to be too low.

It is worth noting that the risk of inflation is concentrated in the US. While NZ may import some inflation, we do not expect the Reserve Bank of New Zealand (RBNZ) to come under the same pressure to manage inflation as the US Federal Reserve will do over the coming year. The risk to NZ bonds comes from increasing interest rates being demanded by investors because US interest rates have increased. This pressure is typically more intense with longer dated bonds as short-term interest rates are more directly influenced by the RBNZ.

To mitigate the risk of higher rates, the bonds that are held in the funds are NZ domiciled and, as a whole are not long dated, which means they are less impacted by movements in US interest rates. The funds also have a more cautious stance towards equities that are more sensitive to interest rates.

After an extended period of relatively stable returns volatility picked up in February.

US equities ended the month down 3.7% when measured using the S&P 500 including dividends, which was the first down month in over a year when dividends are included.

The month started with dramatic declines (-8.6%) before the market rebounded. Stronger than expected labour market data refocused the share markets attention on the risk that inflation would accelerate forcing the US central bank (the Fed) to lift interest rates and further reduce quantitative easing.

These fears were graphically illustrated by the VIX index, which measures expected future market volatility and is widely known as the “fear index.” The VIX almost tripled over the first few days of February before halving again over the remainder of the month.

Eurozone equities also registered losses in February with the Bloomberg European 500 Index dropping 3.7%. Again, fears that higher than expected inflation would put upwards pressure on interest rates in the US were a key driver of markets.

Minutes from the European Central Bank’s (ECB) January meeting provided more evidence that the “Block’s” ultra-loose monetary policy stance would end sooner rather than later. More specifically, commentators interpreted the commentary to signal the ECB could tighten monetary policy this year.

In China, the Shanghai Stock Exchange Composite Index followed the lead set by major developed markets earlier in the month but failed to recover at the same rate. Consequently, the index ended the month down 6.4%.

Emerging equity markets as a whole also suffered a reversal of fortunes in February with the MSCI Emerging Markets (EM) Index slumping 4% (in local currencies). It is worth noting that after a strong January these markets were still up 2.5% for the calendar year to date.

In Australia, the share market drifted lower for the second month running with the ASX200 Index ending the month down 0.6%. The global share market sell-off was a key reason for the weakness.

Back home the NZX 50 Gross Index nudged 0.8% lower in February. While the New Zealand share market missed out on the large gains in January the losses in February where relatively minor in comparison to some share markets.

It is worth noting that the dispersion of returns stepped up significantly in February. Fletcher building was down 17% during the month after another downgrade to guidance while A2 Milk was up 44% over the month after it surprised the market with stronger than expected earnings and a new partnership with Fonterra.  Further, CBL Insurance (which we have never held) went into a trading halt and may prove to be worthless.

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 recently published newsletter Buffett highlighted the risk that inflation poses to investing in bonds:

"Investing is an activity in which consumption today is foregone in an attempt to allow greater consumption at a later date. “Risk” is the possibility that this objective won’t be attained… I want to quickly acknowledge that in any upcoming day, week or even year, stocks will be riskier – far riskier – than short-term U.S. bonds. As an investor’s investment horizon lengthens, however, a diversified portfolio of U.S. equities becomes progressively less risky than bonds, assuming that the stocks are purchased at a sensible multiple of earnings relative to then-prevailing interest rates. It is a terrible mistake for investors with long-term horizons – among them, pension funds, college endowments and savings-minded individuals – to measure their investment “risk” by their portfolio’s ratio of bonds to stocks. Often, high-grade bonds in an investment portfolio increase its risk.”

We believe that Warren Buffett’s annual letter to shareholders is essential reading for anyone with an interest in financial markets and can be found here. Buffett explains above that high quality bonds can at times be anything but “risk free.” Although the risk of not receiving your principal back at maturity is remote - when inflation exceeds the yield to maturity the risk of a fall in purchasing power is very real. Over long periods of time diversified equity portfolios have outperformed high quality bond portfolios. When interest rates are very low and inflation is increasing a decision to add more high quality bonds is in fact laden with risk.

Active versus passive

Broadly speaking there are two investment approaches: Active and passive. Actively managed investment funds employ investment professionals to scour the fund’s universe for the most attractive investments. Passively managed funds attempt to replicate the returns of the fund’s investment benchmark.

For instance, a passively managed NZ equity fund with an NZX50 benchmark will hold the 50 companies that make up the index in the same weights as the index. An actively managed fund will own the companies that in the view of the fund’s portfolio manager have the most attractive prospects.

Those supporting passive approaches argue that the market is efficient, all publicly available information is incorporated into share prices and it is not possible to use this information to generate superior returns. Consequently, investors should employ a passive approach and avoid the costs of active management.

We disagree with this point of view. First, in our view, it is possible to select well-resourced skilful managers that can generate superior performance. Second, tests of market efficiency are largely focused on the US market. This market has significantly more research attention making active management relatively more difficult than in markets like NZ where a significant proportion of companies have limited research coverage. For instance, according to Bloomberg, 22 companies in the NZX50 have 5 or less sell side analysts with investment recommendations compared to only 7 companies in the S&P 500 - an index with 10 times the number of companies! You can imagine what analyst coverage is like for companies outside the NZX50… Third, market commentators also argue that the increasing popularity of Exchange Traded Funds* (ETFs) creates additional risks. The easiest of which to observe is that large ETFs can distort market prices; this is particularly evident for NZ stocks during MSCI and FTSE index rebalances.

*ETFs tend to mirror or closely resemble share market indices.

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Tencent

Tencent operates China's largest social networking and entertainment platform. It was founded in 1998 and has grown into China’s largest listed company.

The company initially developed a PC based messaging platform, which was eventually named QQ. Tencent successfully managed the transition on to mobile for the QQ platform while at the same time developing a mobile orientated social media and messaging app known as WeChat. WeChat has continued to grow its user base, which recently surpassed the 1 billion user mark. It now offers an extensive range of services ranging from mobile payments to wealth management to ordering food and booking taxis or accommodation. The extensive range of services means that the average user spends over an hour per day on the social media app. The dominance of this app is probably best evidenced by trials in southern China to replace government ID cards with digital versions attached to the app.

Tencent has also developed a strong gaming business holding number 1 position in both smartphone and PC games in China. These businesses currently drive strong revenues in the form of subscription payments. Online gaming generated over 40% of Tencent’s revenues (3Q17), which equals the contribution from the social media apps when online advertising is included.

Next month: Facebook