Market Thinking - a view from the equity market - commentary from Mark Tinker, AXA IM - The impending Fourth Industrial Revolution
Tuesday 4th July 2017
- The second quarter ended with an unwind of political risk premia to match the unwind of economic risk premia in the first quarter. Meanwhile monetary policy is quietly normalising.
- Symbolic developments in Asia include the incorporation of Chinese A-shares into the MSCI Emerging Market indices and the opening of the Bond Connect programme, both of which further demonstrate the ongoing integration of China into world markets.
- I spent much of last week talking about the fourth industrial revolution in Robotics and Automation, something that has become a true cross sector and cross border thematic. Indeed it is difficult to think of any growth company not somehow exposed to this theme.
A quiet week in markets thanks to US holidays and the onset of (Northern hemisphere) summer gives us time to look back at the first half of 2017 and also to look further ahead at what is increasingly being referred to as the Fourth Industrial Revolution in Automation and Robotics, a cross-border cross-sector theme that we believe will come to dominate growth investing.
Looking back as we pass the half year mark, the contrarian plays from the end of 2016 continue to do best and the call to be in mid-caps at the beginning of the year also looks to be paying off. Europe was up the most in dollar terms in the second quarter (and, largely, year to date), helped by the depressed first quarter as markets worried about the French election, but Asia is next and the Americas last. Hong Kong continues to stand out as a market, helped undoubtedly by the southbound flows from China.
The second quarter had more of a momentum feel to it than the first as the narrative shifted to ‘explain’ why the consensus was wrong in Q1. The end of the reflation trade we were told, but the reality was that risk premia put on at the end of 2016 simply unwound. Whether it was emerging market risk premia based on unwarranted worries over a strong dollar, high interest rates and debt or political risk premia in Europe based on understandable concern over potentially huge policy change. The rally in Europe has pushed the dollar back down as the euro went higher on relief that it wasn’t going to break up any time soon and the dollar, as measured on its trade-weighted basis broke lower and is now below its pre Trump rally level. Historically, that should have helped both oil and gold, but as noted last week, they have also broken long term support and while oil has rallied from an over-sold condition last week, momentum remains poor, consistent with the supply side story of weak pricing. Their weakness helped to confirm, for some, the Q2 narrative of ‘no reflation’, but I would maintain this is more about excess supply, than weak demand.
Meanwhile the extra-ordinary behaviour of Bitcoin continues. When at the end of Q1 I had a conversation with a visiting millennial who was hoping to pay for his gap year by trading Bitcoin, I freely admitted that I had no idea where this crypto currency was going beyond the fact that if every 19 year old wanted to buy it then it would certainly go higher until there were no more 19 year olds left to buy it based on ‘what their mate told them’. Moreover that when someone started to sell it, then things could get tricky. I really hope that he sold some after it almost tripled (!) in Q2. Where it goes next is still frankly anyone’s guess although I would note two technical factors that are now present (that were not at the end of Q1). The short term moving average was attacked twice and now appears as resistance rather than support and with lower highs and lower lows, there is all the appearance of a top formation.
Moving to assets - as opposed to tradable prices - the ‘no reflation’ narrative nevertheless helped US Treasuries and while US long bonds ran into profit taking as the quarter/half year closed, they still managed to be only just behind US equities in total returns year to date. In terms of the curves, – the 2s-10s and 2-30 Treasury curves have subsequently steepened from what were decade lows. As we approached those lows, some were trying to suggest that it was some prediction about a recession, but experience suggests that this is far more often a function of internal market positioning as people borrowed short and lent long – rarely a recipe for long term success. Also interesting when looking at yield curves is the steady onwards and upwards move in Libor, which continues to grind higher, standing at 1.299%, only 9bp below 2 year Treasuries. If this can let the air out of leveraged carry trades, then all the better.
There is a sense that monetary policy is quietly normalising. The selloff in bonds towards the end of the month was partly profit taking, but also I suspect a recognition that monetary policy, both from the Federal Reserve (Fed) and the European Central Bank (ECB), is moving away from quantitative easing (QE) and ultra-low nominal rates. In my view, the biggest risk to the Western economies remains the high levels of consumer debt and the liquidity and cash flow implications of higher mortgage payments. The UK, Ireland, Spain, Portugal and Greece have all proven historically to be highly sensitive to mortgage rates due to their floating rate nature, while the shift away from fixed rate refinance-able mortgages in the US in the mid-2000s significantly increased US household sensitivity. The world’s top central bankers are all changing over the next couple of years, Yellen, Kuroda, Carney and Draghi as well as Zhou at the People’s Bank of China (PBOC) and limiting leverage in financial markets without collapsing housing markets will be the real challenge for monetary policy going forward. It does not however mark an end to the process of financial repression, whereby capital requirements and other regulations more or less force pension funds and insurance companies to hold bonds. This should keep a bid for bonds that would offset any sell off related to carry trades unwinding.
My concern remains less about the macro environment and more about the internal de-stabilisation of markets through so-called ‘portfolio insurance products’. As previously discussed, the reverse VIX ETF, XIV is up another 75% or so this quarter as VIX stays low, which continues to make me nervous. Momentum traders buying XIV are effectively selling volatility and the problem is compounded because the observed levels of low volatility are attracting a different crowd of ETFs, those chasing low volatility as a risk factor and generating a second set of momentum trades. Indeed, as my colleague Simon Weston (manager of the AXA WF Framlington Asia Select Income fund) noted, the low volatility directional trend of large cap tech stocks has made them (new) favourites of the low volatility ETF crowd, creating factor based momentum to add to simple price momentum. The problem (broadly) with the proliferation of these higher frequency algorithmic (algo) trades is that once a ‘factor’ starts to exhibit performance, money is thrown at it and the factor becomes self-fulfilling, right up until it doesn’t. In effect factor ETFs risk turning every factor into momentum.
Here in Asia we have had some symbolic events in capital markets at the end of the half year. Last week MSCI announced the inclusion of China A-shares in the Emerging Markets index, which triggered some meaningful north bound flows over the Stock Connect and a rally in the CSI 300 index. Secondly, with the 20th anniversary of the handover in Hong Kong we got the first symbolic trade on the new Bond Connect, a mechanism to allow international investors to trade Chinese onshore bonds via Hong Kong. While this is not a short term ‘wall of money’ in either direction (I am still waiting for the one that was supposed to come from Japan to the UK in 1988), it does run up a flag for international investors to say that you can no longer pretend China is not coming to your world. Whether you like it or not.
This has been much less dramatic than in 2015 when the prospect of MSCI inclusion was largely behind the huge run-up in the Chinese markets in the second quarter of 2015 as domestic speculators chased stocks, usually with margin, on the basis that valuation was not important, as some ‘dumb’ passive investor would simply be forced to buy off you at any price. That didn’t happen of course and the various indices fell back to earth – the Shenzhen Index had shown Bitcoin-like performance, almost trebling in the 18 months from the beginning of 2014. Note from the chart below, however, that the performance of ‘China’ can very much depend on which index you look at. The Shenzhen Index, which is more ‘new economy’ is down this year but is still up 70% over the last three years, while the CSI 300 China index, the best performer of the four this year, is almost exactly flat on 3 years.
Chart 1: How well the Chinese market is doing this year depends on which index you look at
Source: Bloomberg AXA IM, July 2017
In the credit markets, low US treasury yields and tighter conditions in China have led to a surge in dollar denominated debt issues. In particular Evergrande just issued $6.6bn of debt, 40% of which was replacing old debt, but the rest was new borrowing. Doubtless encouraged by their very strong stock price performance this year, (+215% year to date) creditors should nevertheless note that Evergrande has never generated positive free cash flow since its listing in 2009. While not worried about systemic risk with bad debts in China, we are wary at the individual stock level. Also we note that the Chinese authorities are cracking down on some of the big mergers & acquisition players like Anbang, HNA and Wanda which will undoubtedly undermine some of the confidence that these companies might be buyers of last resort for otherwise unprofitable small and mid-caps. Moreover, while a number of meetings recently with credit agencies and other specialists have made me more confident over the bad debt provisions of the big banks, I do remain concerned about some of the involvement in corporate lending to some of these more aggressive acquirers.
The big US banks all passed their annual stress tests recently and what originally began as a process of demonstrating solidity of balance sheets and confidence in the system has now become more an assessment of the ability to pay out higher dividends or buy back equity. After an incredibly good second half of 2016, US banks had traded broadly flat year to date before a 10% run in the last month, largely on expectations of a better pay out. This also likely contributed to a bout of profit taking and rotation out of some of the big tech names into quarter end. Nasdaq has hit a six week low on this rebalancing albeit it is still +16% year to date, and while all the FANG (Facebook, Amazon, Netflix and Google) names are below their 50 day moving averages this feels more like a correction than a big sell off.
An interesting point raised recently by the Financial Times is that previously emerging markets used to be around 10% tech and 30% commodity, but that now this has all but reversed with commodities representing around 12% and technology around double that at just over 25%. While on the one hand it shouldn’t really be a surprise, the point of emerging markets is that they are, indeed, emerging, it also helps to explain why they don’t really perform as they are ‘supposed to’.
The increasing focus on technology in emerging markets mirrors the changes in the underlying economies. At the consumer end, the lack of legacy infrastructure has meant users have gone straight to mobile and the rapid growth of internet based shopping has been well documented. The same is happening with payments systems - it is almost harder to use cash than pay by phone in China these days, so dominant is WeiChat Pay. This is particularly true among millennials, and given that more than half the world’s millennial population lives in emerging markets this is driving a form of globalisation of consumption. Smart phones have moved from being a luxury to a necessity. UBS estimate that between 2013 and 2015 some 500 million users gained access to the internet. A twenty-something living in Shanghai probably has more in common with a twenty year old in Mumbai or Seattle than with their 60 year old neighbour. Connected homes, wearables, smart health products and of course (semi) autonomous vehicles are all possible now thanks to the cloud, cheap storage and big data analytics.
Capital investment has poured into building this infrastructure and of course high quality precision manufactured smart phones and tablets in turn require precise engineering in high tech factories, rather than cheap labour sweatshops. As such, factories have become more automated and high tech, leading to an explosion in the use of automation and robotics, what is being referred to as the Fourth Industrial Revolution. This is a global phenomenon, China is now the world’s biggest buyer of industrial robots as it seeks to catch up with the robot penetration rates of the likes of South Korea and Japan. Initially dominated by the autos sector, industrial automation is spreading to every sector, making it a true cross border, cross sector thematic. Factories are becoming smarter with sensor and optics improving accuracy and efficiency while a new generation of smaller robots (or ‘co-bots’) are being deployed alongside humans to further enhance quality and output. Businesses are having to automate or die, partly because demographics are pushing up labour costs everywhere, but also because the precision of robotics delivers a quality factor that customers demand. The cloud and big data are bringing forth the internet of things which means that every factory – as well as potentially every home – is becoming smarter. For investors, process automation can raise margins as well as sales, implying higher share price multiples while the evolution of traditional manufacturing companies towards more software businesses is also leading to stock re-rating. Importantly though, in our opinion, it is not enough to simply be ‘in the robotics and automation space’, like all thematics, it needs to be tied into improving profitability and cash flows.
For investors there is also the problem that pure plays are hard to find; the market for robotic equipment for example is very concentrated, with really only 4 big players – Fanuc, ABB, Yasakawa and Kuka (the latter just bought by the Chinese. Perhaps it was because they saw this video). Similarly the market for process automation is dominated by around half a dozen players who control around 80% of the market for sensors, measurement equipment and so on. As more companies appear in this space, investors need to be on the lookout for new opportunities, but also wary that the companies they have already invested in can survive the new competition. This applies everywhere of course and here in Asia we are keeping a particularly close watch on what is coming from China – either quoted or unquoted.
There are however, many more companies in the ‘enabler’ category, including software, semiconductors and other system components. The concept of robotics and automation is spreading to other areas such as medicine and of course the next stage of automotive automation – autonomous driving. The cloud, big data analytics, sophisticated software and sensors and autonomous driving captures the main elements we see driving (sic) this theme and, as we would argue, driving growth investors more generally. Ultimately investing is a bottom up process, focussing on cash flow and how much we pay to participate in those flows, but understanding the macro headwinds and tailwinds that companies are likely to face is more important than ever in this Fourth Industrial Revolution, which is bringing in ever faster disruption to existing business models.
P.S. The Kuka video above might be fake news, but it’s still pretty impressive!
Head of AXA IM Framlington Equities Asia
Notes to Editors
All data sourced by AXA IM as at Tuesday 4th July 2017.
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