Tuesday 28 January, 2020
2019 Year in Review
The most impactful news story of the year was the trade war between the US and China, with global
markets rising and falling as the prospects of reaching a trade deal shifted.
This led senior company executives to hold back on spending, with global manufacturing data signaling a recession and the Eurozone hit disproportionally. Germany, in particular, saw weakness in its trade-related sectors (auto, chemicals, machinery) and just missed going into outright recession. Tensions rose further in October amid the prospect of Britain having a ‘hard’ crash out of the EU.
As a result, central banks around the world cut interest rates. But 2019 ended on a more positive note as
trade tensions between the US and China thawed, and a decisive election victory by UK Prime Minister
Boris Johnson made a hard Brexit less likely.
In the context of all the political turbulence, 2019’s middling global growth of 2.4% was quite respectable.
Following negative returns from global equities in 2018, the past year saw share markets shrug off the impact of political and economic headwinds to record strong returns.
The MSCI All Countries Index – a broad measure of global share markets – rose 26% in NZ dollar terms. Despite a couple of rocky patches in the third quarter, the rise was generally steady throughout the year.
The trade war had broad implications for the economy and equity markets. In essence, tariffs made products more expensive for consumers and the uncertainty of a deal being reached caused businesses to delay investments. Additionally, American farmers were hurt as China limited purchases of major US agricultural exports. Despite the negative effects of the trade war, investors largely viewed the impact as temporary.
Concerns over global manufacturing confidence led the US Federal Reserve to cut interest rates three times over the second half of the year. The Fed’s move helped support equity markets, even as the yield curve inverted (which often precedes a recession).
Broader political turmoil was driven by Brexit uncertainty and the approaching US presidential election in 2020. While this uncertainty drove short-term volatility, investors chose to focus on structural developments such as continued job growth and the health of the US consumer.
Bond interest rates hit multi-year lows in 2019 against the backdrop of the US-China trade war which dominated headlines.
After starting the year at 2.7%, the interest rate on the often-watched US 10 year maturity government bond sagged to a low of approx 1.5% in August. As trade tensions eased towards year end, the rate bounced back to a less anemic approx' 1.9%.
New Zealand was not immune from these trade-induced moves. The yield on a 10 year New Zealand Government bond fell from 2.4% to an all-time low of 1.0% in mid-August, before ending the year at 1.7%. Agricultural factors also played a part, including insect infestations in Europe that sent Kiwi log prices tumbling as forests were cut down preventatively. On the positive side, horticulture continued to boom, milk prices were strong amidst drought conditions in competing dairy nations, and protein of all kinds boomed towards year end in the wake of the devastating pig disease in China (with beef prices rising 19% in a single month).
In domestic politics, the prospect of a capital gains tax in the first quarter clearly caused business confidence to falter, and although it was slow to recover, confidence had improved by year end.
It was unsurprising when the Reserve Bank (RBNZ) cut its Overnight Cash Rate (OCR) by 25 basis point from 1.75% to 1.5% in response to the increased gloom. However, the Reserve Bank shocked the market with a meaty 50 basis point cut in August, and then surprised again by declining to cut rates further in November.
The rationale became clearer in December when the new bank capital regulations were finally announced, requiring banks to raise $20bn of rainy-day funds (aka capital). A slightly better than anticipated outcome for the banks meant the Reserve Bank was factoring in less economic shrinkage as banks withdraw less profitable loans. That would result in a lower likelihood of cutting interest rates. The icing on the cake came with the government’s announcement of an additional $12 billion of infrastructure spend over the next 5 years, creating something of a floor under the NZ economy should things turn down globally.
Despite fears of a global economic slowdown we saw enough pockets of growth to maintain a positive view on share markets through 2019. However, we approached the year with caution as equity valuations were relatively full and macro headwinds, particularly the trade war between the US and China, loomed large.
We remained reasonably fully invested (90% and above) in equity risk through the year in a range of broadly diversified strategies that we believe can perform through the cycle. We augmented these equity exposures with positions in Alternative strategies that offer diversification from share market risk.
Fixed Interest Strategy
2019 was a pleasing year for the Kiwi Wealth Fixed Interest Fund (Fixed Interest PIE) which returned 3.9% after taxes and fees, outperforming the benchmark by 80 basis points. We started the year adding company bonds aggressively but added less and less as that market grew more expensive. This was in anticipation of lower interest rates and therefore higher prices for bonds. However, we found it hard to chase these yields down, given the global economy was sputtering but not in recession.
Performance by Growth Strategy
The Kiwi Wealth Growth Fund (Growth PIE) rose 21.3% (after tax and fees) underperforming the
benchmark which increased 23.4%.
The main equity components of the Growth PIE are Global Thematic, Global Quantitative and Core Global, alongside an investment in Alternatives and any residual fixed interest and cash. The returns of these underlying components are set out in the following sections.
 Investors pay tax in the funds at their marginal rate but for the purposes of this calculation we assume the top rate applicable which is 28%. A fee of 1.5% for the Kiwi Wealth Growth Fund (Growth PIE) and 0.5% for the Kiwi Wealth Fixed Interest Fund (Fixed Interest PIE) is assumed. These are the same fees used in the respective benchmarks. We use the Growth PIE and Fixed Interest PIE as proxies for performance of client portfolios. This is because these funds are fully tax paid and reflect the most accurate performance of client portfolios.
The Global Thematic fund had another strong year of outperformance amid a largely buoyant 2019, returning 30.3% in NZD versus the benchmark MSCI AC which rose 26.5% (before tax and fees). Our focus on high-quality companies and secular growth themes helped strengthen the portfolio as we continued to build on our longer-term track record of outperforming the benchmark.
Companies exposed to our themes of the rising demand for connected devices (ASML, Taiwan Semiconductor), electronic commerce (Prologis, Visa, Mastercard), athleisure (Lululemon, Adidas, Nike), snack foods (Nestle, Coke), and online advertising (Facebook, Alphabet, Tencent) made positive contributions to portfolio returns.
On the negative side of the ledger, we reduced our exposure to the health care sector when fears about the future of the US system were swirling. In our efforts to de-risk, we sold down some key medical companies prematurely (Medtronic, AstraZeneca).
The Global Quantitative fund underperformed the benchmark in 2019, with the strategy’s preference for cheaper value stocks the biggest drag, especially in the Technology sector. In the third quarter, the Quant team reduced this value preference after reassessing the likelihood of these companies making a prolonged comeback. This helped to stem underperformance in the fourth quarter, with the strategy ending the year up 21.9%, trailing the benchmark by 4.7%.
Real Estate and Energy were our top performing sectors this year, with a boom in the build-out of 5G networks helping communications infrastructure stocks like American Tower Corporation and SBA Communications. The portfolio also benefited by maintaining an underweight position in Energy for most of the year.
Underperformance predominantly came from the Communications Services, Health Care and Technology sectors. In Technology, we were hurt by a value bias towards hardware companies like Konica Minolta and HP Inc, rather than growth-oriented semiconductor companies like NVIDIA and ASML Holding. Communications also saw value companies like Telefonica and Telephone & Data Systems detract from performance, while Health Care’s regulatory worries around price controls pushed down some holdings.
Again, as in 2018, Quantitative equity funds in general struggled to make much headway in a growth-leaning market.
Core Global and Alternatives
The Core Global fund performed well in 2019, closing out the year ahead of its benchmark by over 1%. The portfolio continues to target an expected tracking error of less than 1% and is neutral with respect to country and sector allocations relative to benchmark. Much of the outperformance was driven by stock selection in the Asia Pacific and Europe region, with technology and communication services leading some of the highest gains.
Alternatives enjoyed solid performance from March to August before falling in the later part of the year, ending with a return of -2.68%. We invest in alternatives to smooth out the ups and downs in equity market returns, which worked well in August when alternatives gained 0.46% against a drop in the New Zealand Dollar (NZD) hedged benchmark of 2.11%.
Private Portfolio Client Returns
We have used the returns from the Fixed Interest PIE and the Growth PIE as the basis for calculating a proxy for client portfolio returns in broad mandate groupings:
An ‘Income’ portfolio is calculated as a simple weight of 75% Fixed Interest PIE and 25% Growth PIE;
A ‘Balanced’ portfolio is calculated as a simple weight of 50% Fixed Interest PIE and 50% Growth PIE; and
A ‘Growth’ portfolio is calculated as a simple weight of 25% Fixed Interest PIE and 75% Growth PIE
2019 Performance Summary
Returns are after tax and fees with an assumed tax rate of 28%.
Most pundits are projecting a relatively quiet start to the front half of the year, but we expect things to heat up as we approach the November US presidential election (not forgetting our own election in NZ!). Central banks appear on the sidelines, the Trade War is easing somewhat, and a hard Brexit out of Europe is off the table for now. All of this is conducive to a relatively benign economic backdrop.
With the US election looming in the back half of the year, bookies are giving odds of 50:50 on Trump being re-elected. Markets are unlikely to be significantly impacted, provided the Democratic candidate is relatively centrist, which will be known in early March.
New Zealand has its own election in 2020 and early indications are that it will be tight. Whoever wins, the government’s books are in good shape, and the $12 billion infrastructure stimulus which is due to peak in 2021 should set a higher hurdle for further interest rate cuts in New Zealand.
Given the increasing support of large institutions, we expect that Environmental, Social and Governance (ESG) issues will continue to have a greater impact on market performance. Kiwi Invest is well positioned in this regard, using ESG principles to invest across all our strategies. Expect to hear more on ESG both from us and the financial media at large in 2020.
The prospect of tepid economic conditions in 2020 means the team is focused on finding secular growth stories that can thrive regardless of the macro environment. Many of our winning themes of 2019 we are sticking with, such as Athleisure, Connectivity, and targeted areas of Health Care such as cardiovascular devices and oncology.
We are also taking the portfolio down a more defensive, yield-conscious route. Having enjoyed stellar returns from market giants in the Technology sector over the past seven years, we now see some of the trends that have driven these gains beginning to slow. As a result, we are targeting more modest gains from companies involved in Real Estate and Electricity Distribution to buffer the portfolio against a market sell-off.
Despite challenging times for such strategies, we still see the multifactor approach as a promising one. We expect continued demand for companies with good ESG policies to support prices for these stocks, and we recently strengthened our approach in this area by bringing on a new ESG signal provider.
Our strategy is currently steered towards lower risk value stocks as we have found that these tend to outperform their higher risk counterparts over time. We also see encouraging signs in emerging markets at present but expect ongoing trade wars to be a possible source of frustration.
The risk management framework underlying our strategy should help control such risks by ensuring we do not get overly concentrated in any one area.
Fixed Interest Team
On the fixed interest side, the bar is set very high for any interest rate hikes globally. That will likely allow governments and companies to feed at the trough: borrowing money at low rates for long maturities. We remain wary of bonds with prices that can fall sharply when long term interest rates go up, which is a possibility if Europe finally turns a corner. One catalyst could be if new European Central Bank head, Christiane Lagarde, can get wealthier European nations to start spending more.
Closer to home, the wild card is Australia. Terrible forest fires and weakening consumer spending point to a 60% chance of its overnight rate being cut from 0.75% to 0.5%. There is even talk of “unconventional policies” such as buying back government bonds. If Australia is forced to act, it seems unlikely that New Zealand rates would remain at 1% given the Reserve Bank’s sensitivity to the Aussie-Kiwi exchange rate.
Finally, we expect company bonds to remain at their current expensive levels in the coming year.