Global Outlook November 2018

Tactical Asset Allocation

We build our TAA funds including bonds, equities, commercial property and other assets and looking over a 12-month time horizon. Our decision-making sequence is first to consider the outlook for each asset class (e.g. government bonds), followed by our views within that market (e.g. the US versus Europe, or the economics of core European countries versus the periphery). As these funds are broad-based multi-asset portfolios, we can use a number of levers to both take and mitigate risk over the above time horizon. This may result in positions that differ from other internal portfolios which do not have this range of levers and/or time horizon.

TAA Model Portfolio - 20th October 2018

TAA Model Portfolio - 20th October 2018



Craig Hoyda, Senior Quantitative Analyst, Multi-Asset Investing

The market environment remains challenging as investors continue to digest the effects of a slowing global economy, trade tensions and political uncertainty amid US monetary policy tightening.

However, we advise investors to continue to look through the noise and study underlying investment fundamentals. While not as strong as before, conditions continue to support some of the higherrisk asset classes as we go into 2019. However, the importance of implementing a diversified portfolio should now be front of mind for all investors.

Andrew Milligan, Head of Global Strategy, argues that asset allocators must examine market valuations and still-supportive corporate profits while considering the array of risks. Investors should also remember that behavioural factors can cause a dislocation in markets from their true fundamentals.

While acutely aware of short-term market movements, we are long-term investors. One region that offers great long-term return potential is Asia. The chart on the right shows the return of Asian economies as drivers of world economic growth; with this expansion the requirement for capital to fund infrastructure has grown. Omar Ene and Tzoulianna Leventi of the Multi-Asset team look through the lens of China’s Belt and Road Initiative as a tool to construct domestic infrastructure, as well as build global influence. They compare this with India’s chosen route to development. The liberalisation of financial markets in both countries has been critical to access the additional sources of capital required for large projects.

The US is also deeply in need of increased infrastructure spending, with promises of higher spending likely to be met by greater debt issuance. China and Japan are the largest overseas holders of US Treasuries, but have been reducing their holdings.

This is explained in part by the build-up in global influence by China provoking protectionist policies. An analysis of cross-border capital flows conducted by Ken Dickson and Matthew MacFarlane from a foreign exchange standpoint allows us to understand better the medium-term drivers of not only currency, but also bond and equity markets.

Diving deeper into Asian asset classes, Irene Goh, Head of Multi-Asset Investing Asia Pacific, and team argue that there are relative value opportunities within the region, specifically between Chinese onshore stocks and Hong Kong equities. She presents a case based on monetary policy flexibility, the economic growth and geopolitical environment, and also on valuation grounds.

Finally, Toshio Tangiku, REITs Analyst, looks at the development in corporate governance in the Japanese Real Estate Investment Trust market. He argues that while buyback trends are supportive for shareholders, firms must continue to deploy capital wisely. All in all, Asia offers a range of opportunities, as well as some risks, for a global or regional investor.


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Chart 1: Return of Asia

% Share of GDP

1 A.D.



2023 (estimate)

Source: Angus Maddison, IMF (as of July, 2018)

versus policy

Chapter 1


Andrew Milligan, Head of Global Strategy

While investors worry about fiscal, monetary and trade decisions affecting global growth, valuations are supportive when the outlook remains one of positive profits growth.

What is the state of the cycle?

It is useful for any investor to ask some important questions regularly. Among these is “What is priced into the market?”, which is related in turn to “How are the markets positioned?” This matters even more after the sharp equity market sell-off in October, a repeat of the early February episode. Financial markets are driven by hard economic fundamentals: inflation and interest rates, taxes and regulation, technology and demographics, to name a few. However, as students of behavioural finance are well aware, there are human aspects to investing as well, such as fear and greed, herding and anchoring.

Political uncertainty can quickly feed into investor uncertainty

Political uncertainty can quickly feed into investor uncertainty. Answering the question of what is priced into markets is helped by an array of investor surveys about positions and the rationale for recent moves. Several aspects currently stand out. The first is a very strong overweight position in US assets, especially equities and the dollar, and to some extent government bonds as well. This has been understandable in the context of the major fiscal stimulus affecting the economy, as well as the impact of the President’s ‘Make America Great’ policies on trade and capital flows. Investors must then consider: for how much longer? The second message concerns the above average holdings of cash; again this is understandable in the context of an environment where politics, policy making and geopolitics are more uncertain than they have been arguably since the late 1980s. This relates to surveys showing low levels of investor optimism.

Examining the fundamentals

At times of stress, it is important to focus on core issues. First, we need to address the length of this economic cycle and whether it will end soon. It is the case that this expansion is on the verge of becoming one of the longest lasting since the 1950s. It is also the case that we expect the third major economic slowdown in this cycle (the first relating to the European sovereign debt crisis of 2011-12, the second to the oil shock of 2015-16). However, this is a very different view to saying that a US or global recession is imminent. The flattening of the US yield curve this year is in line with an expected deceleration in growth over the next few quarters, say reflecting the slowdown in the housing market. Conversely, other areas of the US economy continue to power ahead, especially business investment, and we expect positive, if moderate, growth into 2019. 2020 is the first year when the probability of a recession is noticeable, although history suggests such an outcome is less likely in the year before than in the year after a Presidential election. When China, Europe and Japan are taking steps to stimulate activity, through a mixture of monetary and especially easier fiscal policies, then a moderate growth path is expected. The risk to our forecasts would be a broader emerging market crisis, possibly resulting from a rapidly appreciating US dollar, Federal Reserve (Fed) tightening policy, a depreciating Renminbi or a surge in oil prices. Such analysis feeds into the profits forecasts which continue to drive our asset allocation decisions. US profits growth is strongly supported by both easier fiscal and regulatory policies into 2019. Elsewhere, a variety of factors, such as commodity prices, the shapes of yield curves or wage pressures need to be taken into account. However, we still expect global profits growth of over 5% in 2019. The Asian technology sector looks well supported by structural trends, global energy stocks by favourable demand and supply factors, and consumer goods by slowly improving unemployment. Share buybacks remain an important feature in this environment.

Chart 1: Pocket of emerging market vulnerabilities

Source: National sources, UBS (as of Q2, 2018)

Some important assumptions lie behind such analysis. One is that core inflation will remain restrained, and that central banks will react appropriately. While headline inflation will be affected by oil prices recently reaching $85 per barrel for Brent, and there could be further upside as Iranian supply declines, central banks will look through such trends, especially as new shale supply from the US will help oil prices fall back into 2019. There is a moderate upward trend in core inflation, but pressures from tighter labour markets are offset by other factors, whether cyclical in the sense of high unemployment rates in parts of Europe and the emerging markets (EM), or structural in the sense of technological innovation encouraging a trade-off between labour and capital. Central banks do not need to be aggressive in this environment.

Political uncertainty can quickly feed into investor uncertainty

Risks to the downside

The latest quarterly Global Investment Group meeting did lower our risk positions, while maintaining a pro-risk stance. The rationale for that was not just recognition of the range of disruptive events which are worrying investors. These include the situation in EM in general and Turkey or Argentina in particular, the impasse over Brexit or the trade tensions between the US and China, but an expectation that some of these will get worse before they get better.

The difficult question for investors is whether the US and China will be able to reach agreement

It is important to differentiate between those political events which have limited spill-over effects for other countries and those with a potentially greater impact. A small number of high-profile EMs are in difficulty, but the contagion effects are limited in terms of trade or capital flows. Financial imbalances are not widespread (Chart 1). Elsewhere, some situations could reach a tipping point. So far European equities have not been unduly affected by the easier fiscal policy proposed by the Italian government. However, if the situation moved on to worries about the outlook for the Eurozone as a whole then wider Italian bond spreads could morph into selling of many European assets.

Much the most important of the issues concerns the relationship between the US and China. We do expect that harsher trade tariffs will be implemented from January onwards, with a noticeable effect on growth, inflation and trade flows. Business surveys are starting to reflect this. The difficult question for investors is whether the US and China will be able to reach agreement, as has been seen between the US, Korea, Mexico and Canada in recent weeks, or whether these are the first stages of a deterioration in relations, in effect a new Cold War appearing between these two countries. Hence, intellectual property, technological supremacy and access to the South China Sea become some of the key battle areas. The results of the US mid-term elections in November may have some bearing on the situation.

Our base case is for the US to enact tariffs on at least $200 billion in additional imports from China, and to implement tariffs on autos, including parts, albeit potentially at low levels initially. Other economies affected by higher US trade barriers are expected to respond, but less than proportionately. In the case of China, for example, this could include actions against US companies operating in that country (Chart 2).

How much of the bad news is in the price?

Financial markets are forward looking, and therefore a degree of bad news is already in the price after October’s share price falls. At the time of writing, US equities are flat year to date, but valuations are less stretched – for example a price-to-earnings ratio (P/E) ratio of 18x. In contrast, the MSCI EM Index has fallen 20% year to date resulting in a P/E ratio of 11x. Put another way, Chart 3 shows the wide differential between the performance of US and non-US equities, and value vs growth styles. Looking at other assets, global government bond yields have risen given Fed tightening, corporate bond spreads have widened, and EM local currency bonds have sold off sharply, reflecting the attraction of the dollar as well as trade risks. The relative outperformance of EM since the cycle 2016 low has been erased.

Typical historical performance in a midcycle slowdown, combined with what has already happened, suggests generally compressed asset returns from here. However, any positive surprises – either in the form of stronger-than-expected growth, looser-than-expected monetary and fiscal policy or better trade and geopolitical news – would probably lead to solid gains in most risk assets and limited gains to losses for defensive ones. Apart from our valuation analysis, there are also increasingly widespread signs of behaviour becoming very risk averse, with sentiment and positioning data at or near extremes on risk appetite in general. Investors appear to be long US equities, short EM assets, long dollars and short US duration.

Looking forward, we are assessing several triggers to ascertain whether our more negative, but non-recessionary, base case for growth is playing out. These include the impact of US fiscal easing on consumer and business sentiment and investment; positive signals on trade policy, as demonstrated by the recent agreement between Canada, Mexico and the US; further stimulus in China lifting its growth rate into 2019; credit expansion and a shift towards easier fiscal policy in Europe, led by Italy; or more signs that the stress in financial markets is causing central banks to become more accommodative – in effect fewer Federal Reserve increases in 2019-20 than are priced into the market.

Chart 2: Trade war not ‘tarrific’ for some

Pocket of emerging market vulnerabilities

  US revenue exposure by sector US earning estimated 219 tariff impact
Sector Revenue % exposure to China China as % of foreign revenue 25% tariff imposed by China 25% tariff imposed by US
Consumer Discretionary 4.0% 19.0% -1.2% -8.0%
Consumer Staples 2.0% 8.3% -0.2% -0.4%
Energy 14.0% 28.6% -0.2% -0.1%
Financials 1.0% 5.3% 0.0% 0.0%
Health Care 2.0% 11.8% -0.5% -0.5%
Industrials 3.0% 9.4% -2.7% -3.3%
Information Technology 8.0% 15.7% -0.3% -6.3%
Materials 8.0% 17.0% -1.8% -1.1%
Real Estate 0.0% 0.0% 0.0% 0.0%
Telecommunication Services 0.0% 0.0% 0.0% 0.0%
Utilities 0.0% 0.0% 0.0% 0.0%
Total 4.0% 14.8% -0.4% -0.3%
Source: National sources , UBS (as of Q2, 2018)

Our house view

Our portfolios remain modestly overweight in global equities in the US, Japan, Europe and Emerging Markets. However, a pro-risk position requires some diversification if our central view about solid profits growth proves incorrect. One diversifier is the Japanese yen, representing a classic safe haven asset. Another would be overweight positions in US government bonds, nominal and inflation-linked, to help protect the portfolio if trade tensions worsen considerably or late cycle inflation appears. While we do expect this economic cycle to continue for some time, we are cautious about the outlook for global real estate, with the supply-to-demand balance more favourable in Europe than other parts of the world.

Most fixed income markets are not attractive at current yields. Returns on most government bonds over the next year are likely to be modest. One exception is the US Treasury market, where we have added to positions once the yield on 10-year bonds breached 3%. Valuations and investor positioning also combine to support our overweight positions in emerging market local currency bonds.

Currency movements have been of considerable importance in determining investor returns during 2018. The rise in the US dollar – up about 5% in tradeweighted terms since its low in April – has contrasted with sharp declines in many of the emerging market currencies. The dollar has seen a fairly normal, if not always consistent, function of behaving as a risk-off asset, displaying negative correlations with equities, government bonds, and corporate bond spreads during most of 2018, and we remain long of the dollar and yen versus euros as a defensive hedge. These positions have protected portfolios against weakness in EM currencies, which have reflected the generalised loss of growth momentum, but also negative spillovers from tightening US monetary policy and the risk of further increases in trade barriers. Currency has been one of the largest sources of value in our asset allocation this year, in a world of limited positive returns.

Chart 3: Mind the return gap

Source: Thomson Reuters Datastream (as of 24 October, 2018)
The difficult question for investors is whether the US and China will be able to reach agreement

Emerging opportunities and
risks along the Belt and Road

Chapter 2


Omar Ene, Global Strategy Analyst, Multi-Asset Investing

Tzoulianna Leventi, Investment Analyst, Multi-Asset Investing

Infrastructure spending by China has a large external component via the Belt and Road initiative, while India’s investment is domestically focused. How is financial market liberalisation in both countries being used to fund such projects, and how will others interpret their actions?

The world needs infrastructure investment. Indeed, McKinsey estimates around $3.7 trillion per annum up to 2035 is necessary for developing and developed countries. Both China and the US have announced trillions of dollars in infrastructure initiatives, all of which will require funding. Consequently, governments are more likely to “pump prime” than fund the total, looking to public and private markets to contribute the rest. A key difference is that America’s investment focus is domestic while China’s Belt and Road Initiative (BRI) seeks not only to build physical infrastructure, but also its influence, across Asia, Africa and Europe. We consider what it would take to attract international investors, and potential responses from other countries and companies.

What are China’s prospects of succeeding with BRI and, by comparison, how will India fare? China and India, as the largest emerging Asian economies, have important regional roles and influence, and both have taken steps towards the liberalisation of their capital markets. Their integration into global markets will have a significant impact on investors. We look at the developments and prospects for these emerging behemoths within the context of the BRI.

China – from zero to market hero

After a hiatus of 40 years, China’s financial markets have developed at a blistering pace since 1990. It now boasts the world’s third-largest equities and bond markets. As part of market liberalisation, foreign investors can access local capital markets in various ways: they can trade as Qualified Foreign Institutional Investors on the China Interbank Bond Market, as well as via the Stock and Bond Connect programmes, launched in 2014 and 2017 respectively. The introduction of these routes has significantly increased foreign participation, albeit from a very low base. Research suggests foreign participation in China could increase 10- fold over the next few years as Chinese securities become part of global indices. The A-H Share Premium can be thought of as a rough measure of China’s market liberalisation. In theory, once China fully liberalises its markets in Shanghai and Shenzhen, mainland A-Shares and offshore, Hong Kong-domiciled H-shares should trade at parity. Over the last two decades this premium has declined significantly from highs of several multiples to a market cap weighted premium of circa 30% (Chart 1).

As a rule of thumb, China only takes steps towards opening when capital flows have been healthy

Lack of domestic opposition means Chinese President Xi can accomplish tough market reforms, even at the expense of growth. China’s stance on further liberalisation is constrained by increased focus on financial stability. As a rule of thumb, China only takes steps towards liberalisation when capital flows have been healthy. However, while this has recently been the case (Chart 2) this may now be under threat due to trade and currency issues. China is pursuing a number of strategic plans for which further financial opening is crucial. Ultimately, the internationalisation of the renminbi, the BRI and the “Made in China 2025” strategic plan serve the goal of returning China to its former Han dynasty glory. Indeed, there is a pipeline of “opening up” measures, including lowering restrictions on foreign financial institutions, the launch of a Shanghai-London Stock Connect and the opening of local bond ratings to global agencies. These efforts are not going unnoticed, with further plans to include Chinese securities to major indices for both stocks and bonds. MSCI allocated a weighting of up to 5% to China A-shares in its flagship emerging market (EM) index with a target of 20% next year, citing market accessibility. In contrast, India’s 8.5% weighting may be reduced.

Chart 1: Not all shares are equal

Source: Bloomberg (as of 24 October, 2018)

Chart 2: Healthy flows - relationship subdued, for now...

Source: Bloomberg (as of 24 October, 2018)

India – open to all?

India’s equity markets date back to 1875, but have been relatively closed in modern times while the economy languished. Like China, India introduced wide-scale economic liberalisation in 1991, marking the transformation of the economy into a more market-oriented system. Since then India’s economy has grown at 6-8% per annum. Market-friendly measures included devaluing the rupee, opening markets to foreign investment and financial sector deregulation.

Foreign investment enters through one of two routes, designated “Automatic” and “Government Approval”. Most foreign direct investment occurs via the automatic route, where significant reduction of bureaucratic oversight tangibly enhances foreign investor access. However, a number of strategic sectors, including Broadcasting and Defence, require government approval once ownership surpasses a predefined percentage. Additionally, prohibited sectors, such as Lottery and Atomic Energy, remain closed to foreign investors.

Comparing the investor base of the stock markets, China’s ‘A’ share stock markets remain dominated by domestic investors. The majority of stocks are either held by Chinese corporations, mainly state-owned enterprises (SOEs), or sovereign wealth funds. In comparison, ownership of Hong Kong’s Hang Seng Index and India’s stock indices is more diverse and more international (Chart 3).

For some investors, index inclusion is a positive, allowing tracking exposure without the expense or friction of direct investment in the underlying stocks. For others, there is comfort in the fact that stocks have been vetted by the index provider and included stocks should be more liquid. Market liquidity when investing and selling stocks is important and, depending on the investor, so is assurance on governance. Having more than one index and multiple venues can fragment liquidity unless there is free movement, a negative for both China and India. International listings of active derivatives and hard currency denominations on bonds would be positive.

Chart 3: China and India stock exchanges ownership breakdown

China (mainland) 33.5% 97.6% 95.2%
Hong Kong 11.8% 1.2% 2.6%
United States 18.0% 0.3% 0.6%
United Kingdom 10.6% 0.1% 0.3%
Singapore 1.5% 0.1% 0.4%
Other 24.7% 0.7% 1.0%
Investor Type
Corporation 42.4% 75.3% 84.5%
Soveriegn Wealth Fund 12.9% 10.1% 0.6%
Investor Advisor 20.4% 6.6% 12.9%
Government Agency 2.4% 6.3% 0.0%
Insurance Company 0.1% 0.5% 0.2%
Investment Advisor / Hedge Fund 14.8% 0.5% 1.1%
Other 7.1% 0.8% 0.7%
HSI - Hong Kong Hang Seng Index
SSEC - Shanghai Stock Exchange Composite Index
SZSC - Shenzhen Stock Exchange Composite Index
Index NSEI Sensex
India 66.5% 63.3%
United Kingdom 10.2% 11.8%
United States 11.9% 12.6%
Japan 3.1% 3.8%
Singapore 2.4% 2.6%
Other 6.0% 5.9%
Investor Type
Corporation 41.2% 38.5%
Investor Advisor 21.1% 22.0%
Government Agency 13.3% 12.5%
Insurance Company 9.1% 10.3%
Investment Advisor / Hedge Fund 8.5% 9.0%
Soveriegn Wealth Fund 1.4% 1.4%
Other 6.9% 7.7%
NSEI - Nifity 50 Index
Sensex - S&P BSE Sensex Index
Source: Thomson Reuters Datastream (as of 21 September, 2018)

BRI: navigating obstacles

Chinese policy makers are concerned with international geopolitical and economic expansion. While China contends with US challenges on trade, tariffs and intellectual property disputes, it is seeking to develop alternative markets and relationships. This has not been a priority for India, with a focus more on domestic economic reform and politics. However, for reasons including sovereignty, security and China’s increasing influence in the east, India will not sit idly by while China pursues its own agenda.

India’s relatively underdeveloped bond market meant that historically infrastructure financing came primarily from the state banks. However, the banks’ experience of infrastructure-related non-performing loans and relatively cheap financing available through bonds, means issuance has been increasing rapidly. Based on the need for significant Indian infrastructure investment, it is likely that despite geopolitical motivations to hold off China’s incursions into its traditional sphere of influence, investment is more likely to be directed inwards rather than towards external expansion.

Capital markets and government reserves of most BRI countries are small and undeveloped. With local market financing not viable, the cost of BRI projects represents a significant portion of GDP. Consequently, the majority of funding to date has come from Chinese policy banks and commercial state lenders in the form of loans to joint ventures. However, China needs to expand financing channels to meet the funding requirement.

BRI Bond Financing

In March 2018 China’s main exchanges began a pilot BRI bond programme, allowing domestic and overseas companies to issue bonds to finance BRI-related projects. Much of the increase in US$-denominated issuance by Chinese corporations since BRI was announced in 2013 is thought to be linked to BRI financing (Chart 4). These bonds are attractive to international investors in comparison to local currency counterparts because Chinese firms are effectively taking the RMB currency risk onto their books.

Chinese companies which have struggled to raise capital domestically due to the deleveraging campaign benefit from this, and dollars are easier to use to fund acquisitions and investments abroad. These bonds are relatively liquid for emerging markets and large issue sizes add to their appeal to large international investors. In comparison to domestic bond markets there is higher participation from foreign investors – indeed foreign investment managers hold 9%. These bonds have largely populated the maturity curve; this augurs well for long-term BRI infrastructure projects – as maturities more closely match the liability.

As a rule of thumb, China only takes steps towards opening when capital flows have been healthy

A bumpy road

If the current US/China trade war escalates, it raises concerns that the impact to China’s economy and currency could force China to succumb to US demands. A more cynical view might be that the US is less concerned about trade imbalances and more intent on disrupting progress of a potential competitor. As China aims to move up the value chain utilising technology acquired from developed economies, it challenges US dominance. Should Western countries, especially the US, adopt more protectionist approaches, China could respond with more liberalisation, stepping up to fill the void created by America’s withdrawal from its global role.

BRI headwinds include funding, sustainability, geopolitical countermoves

Similarly, increasing uncertainty over relations with developed economies encourages more open trade with emerging trade partners. Here, the concept of ‘EM decoupling’ is that developing economies become more self-sufficient, trading between themselves and serving growing EM middle-class populations – rather than selling to the developed world. With the mounting importance of trade with developing economies, accompanied with rising tensions with the west, it is in China’s best interest to open up faster and help develop the economies of EM.

By building their own end markets, they will reduce their reliance on the west. China’s rate of growth in exports to the US has remained broadly in line with that of exports to the rest of the world, growing just less than 50% over the last decade. In comparison, growth in exports to other developing countries has doubled over the same time period.

Chart 4: Rise of $-denominated bonds

Source: Bloomberg (as of 24 October, 2018)

Alternative routes

India has objected to BRI’s infringements on its sovereignty – the China-Pakistan Economic Corridor (CPEC) passes through the disputed Kashmir province. It is also concerned about supply chain security and China’s prominence in the region. Japan, meanwhile, remains open to “participating in those parts of the project which were in sync with standards of the international community”.

India is pursuing strategic partnerships with other countries such as the US, Japan and Australia, to establish an alternative regional infrastructure scheme. So far however, there has been limited progress on a concerted response. India is not alone in being concerned about China’s ambitious plan. There has been increasing scrutiny of the sustainability of China’s debt funding and economic viability of some BRI projects. With the bankruptcy of Hambantota Port in Sri Lanka as a case study of the risks of unsustainable BRI debt, China’s funding approach will be closely monitored. China’s largest BRI partner, Pakistan, is starting to explore other funding options for CPEC projects. China is willing to explore alternative financing channels such as the Build-Operate-Transfer model proposed by Pakistan officials, which would see debt risks transferred to investors or companies rather than the government.

Glory road or bridge too far?

China’s Belt and Road Initiative is unquestionably ambitious. Its recent track record of delivering major infrastructure projects at home is impressive. Achieving something on a similar or larger scale involving multiple countries and where it lacks natural authority will involve negotiating numerous obstacles. China will liaise closely with other developing countries, but will face growing scrutiny and hostility. Headwinds with its other priorities – growth, a shift up the value chain, plus rising tensions with the West, will also challenge the BRI. India will firstly have to focus on internal investment and politics if it is to meaningfully respond to China’s expansion goals.

Countries along the BRI are not positioned to fund projects for the foreseeable future. However, companies in these countries (and some multinationals) stand to benefit from increased external investment. Over time, support for the BRI will become more diversified, incorporating funding from capital markets (both public and private) as well as backing from other countries and alternative funding mechanisms. This will move risk away from BRI governments as well as reducing reliance on loans from China. There is great potential for Chinese capital markets. This could facilitate funding for the BRI as they continue to integrate into global markets.

For instance, the focus could move to investment markets as they might be in five, 10 or 20 years; a different balance of geographies; ownerships across capital structures and not simply within asset-class buckets; or active ownership of assets and not funds. Ideally, pension portfolios will be created that reflect the changing nature of the world’s financing basket and maximise the opportunities available. In this way, pension providers can strive to meet their end-goal of being able to pay that last pensioner liability in 40 or 50 years’ time.

BRI headwinds include funding, sustainability, geopolitical countermoves

Analysing cross-border
capital flows

Chapter 3


Ken Dickson, Investment Director, Global Strategy

Matthew Macfarlane, Analyst, Global Strategy

Cross-border flows often have permanence to them, especially when regulatory changes open up private flows or political decision making affects public flows. Such analysis can improve our understanding of the medium-term drivers of currency, bond and equity markets.

For every buyer there is a seller

Trade tensions and tariff wars have never been far from the headlines in recent months, but the volume has been turned up even louder in recent weeks as the Trump administration gears up for November’s midterm elections. Mexico, Canada, European auto manufacturers – and, most notably, China – have all borne the brunt of the US president’s fiery rhetoric, sparking fears of tit-for-tat tariffs.

Since 2000 China and Japan have consistently been the top holders of US Treasuries

Global trade is worth $18 trillion a year – a not insubstantial figure. But compare that to the volume of foreign-exchange transactions, which amount to $5 trillion – every single day!

For this reason, it is instructive for a global investor to assess investor positioning and cross-border capital flows: that is to say, who is buying what and why.

Numerous surveys can help us to assess sentiment and the rationale for how and why pension schemes and insurance funds are positioned as they are.

However, we can also use a range of official data. These help, in particular, to ascertain who is buying US assets, the largest single component of many major global indices, or whether US investors are buying overseas assets, as we saw throughout 2017. One important source is the US Federal Reserve’s flow of funds reports, a comprehensive set of accounts on the assets and liabilities of households, businesses, governments, and financial institutions. As there is a lag in producing and therefore analysing this information, so the US Treasury’s International Capital (TIC) monthly report is useful. This shows net foreign acquisitions or sales of long-term and short-term US securities as well as banking flows. In addition, information about Euro-area and Japan net portfolio flows helps to flesh out the broader picture.

Such analysis can help us answer the question: who is buying US government bonds? The backdrop is that the relatively high Federal government deficit in the post-crisis period has been bolstered by the impact of the sizeable fiscal stimulus (the Tax Cut and Jobs Act) agreed by Congress last spring. The net result is that the Federal deficit is expected to expand from 3.2% of GDP in 2017 towards 4% in 2018 and over 5% in 2019. Much of the expansion in the budget deficit was met by the Federal Reserve through its quantitative easing programme, but this ended in October 2017 when it began to reduce its Treasury holdings.

Asian investors filled the gap

Overseas investors have been an important source of funding for the US public sector. Since 2000 China and Japan have consistently been the top holders of US Treasuries. In the period between 2000 and 2011, the Chinese built up sizeable holdings of US securities as part of their rapidly growing foreign exchange reserves; since then their holdings of US Treasuries has remained fairly constant at around $1.2 trillion, while showing in 2016 they have no problem periodically selling large volumes to protect their currency. In the future we would expect smaller Chinese holdings of US debt, either reflecting the worsening trade dispute with the US or as part of a currency intervention. China is opening up its capital account to bolster two-way flows into Chinese equity and especially bond markets via its Connect programmes.

At various times, Japanese and European institutional investors have also been keen buyers of US debt. In 2014, Japan reached peak holdings worth $1.2 trillion. A particular driver has been the need from a number of insurance companies to find higheryielding securities to meet the requirements of guaranteed products. This was made even more difficult in an environment of negative interest rates, meaning bonds with a negative yield comprised well over 20% of the global universe. Many reserve managers and institutional investors are mandated not to hold such assets.

During 2017-18, however, this source of demand also began to fall back due to the costs of currency hedging. The yen-hedged yield from the US 10-year bond is around zero, while the yield on domestic Japanese 30-year bonds is more than 0.9% (Chart 1). Not surprisingly, Japan’s holdings of US Treasuries are down 16% from peak levels.

Discussions with Japanese investors reveal a greater interest in buying European fixed income, as long as political and inflation stresses can be contained.

Chart 1: Comparison of yields for Japanese investors

Source: Bloomberg (as of 24 October, 2018)

Past performance is not a guide to future results.

Make America Buy Bonds Again

As Asian demand has fallen back, domestic US investors have stepped up to the plate. Over the period from June 2016 to June 2018, Treasuries held by the Federal Reserve and government accounts increased by just 2.5%, overshadowed by an increase of 14% from private accounts. The largest increase (49%) in privately-held Treasuries reflected a range of investors including government sponsored enterprises, brokers and dealers, bank personal trusts and estates, corporate and non-corporate businesses. The second major source (39%) was mutual funds, money market funds, and closed end investment companies. In other words, as US bond yields rose, especially in real terms, so domestic investors replaced overseas investors as holders of US government debt. This may have bolstered demand for Treasuries but reduced demand for the dollar.

Although Asia has bought fewer US bonds, other countries have stepped up their purchases: $71 billion in the six months to August. Major sources included Brazil, and Ireland and Luxembourg via their large custodian businesses. After US companies repatriated overseas cash holdings in early 2018, reflected in the decrease of US Treasury holdings in Ireland and Luxembourg, US firms appear to be investing their super-profits into Treasuries again.

Looking ahead, one of the reasons we are only moderately overweight US dollars is the expectation that overseas investors will have less interest at the margin in buying US fixed income, especially when the curve has been flattening. Clearly their preference for buying US equity will depend on expectations for the US profits cycle into 2019.

Since 2000 China and Japan have consistently been the top holders of US Treasuries

Why the dragon could
slay the golden pheasant

Chapter 4


Irene Goh, Head of Multi Asset Investing Asia Pacific

Additional contributors

Multi Asset Asia Pacific Team

Slowing economic growth, the escalating trade conflict and rising US rates present a strong case to diversify. But that does not have to mean sacrificing returns. Volatility will throw up divergences to take advantage of, such as a relative value play on Chinese A-shares.

Economic growth is slowing across most nations worldwide and there are numerous risks to contend with – not least a strong US dollar, global trade disruption and rising US interest rates. It’s why we believe investors should look to moderate their risk exposures. Diversification is a good way to achieve that without necessarily sacrificing investment returns.

Higher rates create a more pressurised environment for the housing market - a cornerstone of Hong Kong’s economy

As a multi-asset investor we can express our views tactically, for example by overweighting or underweighting an asset class or country. While this won’t alter our long-term views, it does give us the flexibility to boost returns during challenging market conditions.

Given today’s macro-economic, geopolitical and policy-making uncertainties, we can take a dynamic approach to capitalise on any volatility and divergence in performance between asset classes or investments. We see a value opportunity for China’s A-share market relative to Hong Kong, for example.

Both economies stand to be negatively affected by the slowdown in global growth as well as rising US rates – a reflection of how far out of step the US growth cycle has become with the rest of the world due to fiscal stimulus in the form of tax cuts.

But the People’s Bank of China (PBoC) has independence in setting monetary policy, while the Hong Kong Monetary Authority (HKMA) remains tied to US Federal Reserve policy courtesy of its currency peg.

It means the PBoC can tilt policy in response to evolving economic and market conditions, providing the flexibility to balance domestic and external pressures. This year China’s central bank has cut the reserve requirement ratio for liquid assets that banks need to hold as a buffer on their balance sheets by 250 basis points since the start of 2018. That has led to a reduction in the domestic interbank lending rate, helping to safeguard efficiency in the banking system and reduce risk in China’s financial marketplace.

While the PBoC has imposed measures to curb credit growth in non-bank lending, it has also loosened policy where required to ensure sufficient credit is available in key areas, such as local government financing or funding for small and medium-sized enterprises. We note that municipal bond issuance has increased markedly in recent months.

By contrast, the HKMA has been tightening monetary policy in line with the Fed. It has raised the domestic rate by 110 basis points already this year, while its aggregate balance – a measure of liquidity for interbank lending – has fallen 55%. Higher rates create a more pressurised environment for the housing market – a cornerstone of Hong Kong’s economy. The city’s tie to the currency board system increases the risk that monetary policy will become disconnected from its domestic economic cycle.

Higher rates create a more pressurised environment for the housing market - a cornerstone of Hong Kong’s economy

Relative value

When we look at fundamental factors, we can see that growth is slowing in both economies. Their unemployment rates are close to multi-year lows and inflation is ticking up moderately.

We think China’s stock market is well placed to outperform Hong Kong’s during market volatility

Consensus estimates for corporate earnings growth are below the long-term averages for both, at 15-20% for mainland China and 10-15% for Hong Kong. But looking ahead, China appears to have relatively stronger growth in forward earnings per share.

Although average return on equity – a key measure of corporate profitability – is comparatively similar at 13% for China and 12% for Hong Kong, we can see that credit growth to non-financial corporations has been stronger in Hong Kong since 2015, with China having stabilised leverage levels over the period.

Moreover, although both stock markets have suffered large declines of late, Chinese A-shares remain cheaper than their Hong Kong counterparts to judge by forward price-to-earnings ratio on both a historical and cross-sectoral basis.

When we look at the price-to-book ratio, we can see Chinese equities have a higher absolute value (see Chart 1), even as both markets continue to trade below their median historic levels.

Financial stocks dominate both markets. But Chinese financials are trading at a large discount to peers on the MSCI World Index, while Hong Kong financials are trading at a premium. Overall we can see Chinese A-shares are more attractively valued.

Even though China is more directly exposed to US trade tariffs, Hong Kong, as an open market connected to both China and the West, would also be negatively affected. Its economy is closely linked to China’s, while it is less diversified.

We think China’s stock market is well placed to outperform Hong Kong’s during market volatility, presenting a relative value opportunity for investors to capitalise on.

Chart 1: Earnings are cheaper onshore in China

MSCI A50 index relative to MSCI Hong Kong index

Source: Thomson Reuters Datastream, Aberdeen Standard Investments (as of 28 September 2018)
We think China’s stock market is well placed to outperform Hong Kong’s during market volatility

Cometh the moment,
cometh the JREITs

Chapter 5


Toshio Tangiku, REIT analyst, Real Estate

Attempts at improving corporate stewardship in Japan have been heeded by the REIT sector. Buyback trends are supportive for shareholders, although firms must continue to deploy capital wisely.

History often doesn’t repeat itself, but it rhymes

Japanese Real Estate Investment Trusts (JREITs) have suffered a tough time over the recent period. They endured a steady stream of selling triggered by outflows from investment trusts, which spread into a broader sell-off by foreign and domestic funds alike. These rapid outflows sent share prices lower, while real estate values continued to rise. The combination of lower share prices and higher asset valuations resulted in a substantial number of JREITs trading below their net asset values (NAV). This can be viewed as a worst-case scenario; the traditional growth model of a JREIT is to acquire assets, generally from related entities, through fund-raising via the equity market. Because JREITs typically acquire assets at near-market values, this can mean that if a JREIT chooses to buy such an asset with equity raised when the share price is at a discount to NAV per share, the outcome is a dilution in the post-deal NAV per share. This is because the JREIT is procuring equity at a discount and using this money to buy a security at market value. Understandably, investors dislike the prospect of having the value of their shareholdings diluted. So when the market suspects that JREITs are about to engage in a bout of dilutive issuances, they tend to be sellers of JREITs. This is a major reason why JREIT share prices were depressed for years after the global financial crisis. It was not until early 2012 that share prices recovered in the sector, driven by heightened growth and inflation expectations after the onset of Abenomics. The JREIT sector once again found itself at a fork in the road; with share prices trading at small discounts to net asset value, equity issuances would be dilutive and the sector risked being abandoned by the markets once again.

Management’s interests were finally aligned with those of shareholders

Heeding the call

This time, however, it has been different. After the Japanese government called for improvements in the quality of corporate stewardship, the JREITs stepped up to heed the call. The process was set in motion by small- to mid-sized JREITs, many of which had only listed recently, that had ambitions to grow and – most importantly – were not associated with the powerful (but traditional) real estate companies. These companies had a need to win approval from the market, because this would push their share prices into premium territory, thus allowing them to raise capital for asset acquisitions. In this way, management’s interests were finally aligned with those of shareholders. These REITs sought to arbitrage the huge gap between the strongly appreciating physical real estate market and the discounted valuations of JREIT share prices by selling assets and crystalising the gains that were embedded in them. This was also an activity in exploiting differences in real estate expertise, where the buyers were often wealthy individuals, overseas investors or funds that did not have the same ability to source, operate, and manage assets like JREITs. Because of this, JREITs were often able to divest assets at a significant premium to appraisal values, meaning that they made money on the sale of the asset and recouped funds for more productive uses. There were two key means of redeploying capital. The first was to use their superior asset sourcing abilities to identify and acquire real estate of better quality and at higher yields. The second was to undertake share buyback programmes.

Land of the rising buybacks

The buybacks that were undertaken as part of this optimisation of capital allocation were the first ever to be conducted by any JREIT. This was a significant development because it put the JREITs on the radar of investors who had, hitherto, overlooked companies in the real estate sector in favour of firms that were more proactive in improving shareholder alignment.

Asset sales and redeployment of capital in these ways boosted profits and dividends per share: when JREITs make money on the sale of an asset they will typically pay out most of the capital gains in the form of dividends. Thus, a profitable sale itself provides a temporary boost to dividends per share. Selling assets at a premium to appraisal value and then using this money to acquire more competitive or higher-yielding assets allows the JREIT to enhance both the quality and profitability of its portfolio. Buybacks help reduce the number of outstanding shares, thus directly increasing profitability on a per-share basis.

More importantly, the fact that the JREITs embraced change in this way drove a positive shift in investor expectations. Previously, a JREIT that traded at a discount to its NAV would either destroy shareholder value through dilutive equity issuances or simply sit and wait until its share price recovered.

With a new-found willingness to look within their own portfolios to find ways of optimising returns, the new breed of REITs both significantly improved their potential for profit growth and reduced their reliance on the fortunes of the market. As Chart 1 shows, the nine JREITs that displayed the most shareholder-friendly actions since 2017 have outperformed the broader JREIT market.

Chart 1: Improved governance, better performance

Source: Bloomberg, Aberdeen Standard Investments (as of 16 October, 2018)

A balancing act

It is important to keep in mind that asset sales, share buybacks, and other similar operations are all a means to an end. There are only a finite number of non-core assets that a REIT can sell profitably and because they pay out most of their distributable income, there is limited cash-flow with which to conduct buybacks without increasing debt or raising capital. Thus, management must employ these tools judiciously to support earnings and distribution growth. Managed well, a higher and smoother trajectory of growth should provide support for higher share prices. In turn, higher share prices will increase the chances that a JREIT will be able to raise equity from the markets and acquire assets in a way that is profitable to per-share growth.

Management’s interests were finally aligned with those of shareholders

The views and conclusions expressed in this communication are for general interest only and should not be taken as investment advice or as an invitation to purchase or sell any specific security.

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