for a Changing China, Accelerating Disruption
and more Political Discourse
*Wednesday, 11 January 2017 - Hong Kong*
Twice a year, our investment professionals gather at the Allianz Global Investors Investment Forum to form a global economic outlook that develops our long-term thinking, and helps us make smarter decisions on behalf of our clients. The Forum allows our leading investment professionals to exchange ideas on the issues that matter most, including the top investment themes affecting multiple asset classes and regions, and the key macroeconomic and market developments creating new opportunities and risks.
Over 200 AllianzGI colleagues from around the world gathered for the first Investment Forum of 2017 on the 11th January in Hong Kong, an appropriate location for an event that featured China as one of the three key topics for discussion. Geopolitics and Disruption were the other two items on the agenda, with 17 presentations and numerous break-out discussions across the day around these central themes.
Neil Dwane, Global Strategist, set the scene by discussing our views since the last time we gathered in Frankfurt on the 7th September 2016. Since the last Investment Forum we have continued to see political events dominate both headlines and financial markets.
In November, Donald Trump shocked the establishment by winning the US election, and in December Prime Minister Renzi resigned after the no vote in the constitutional referendum in Italy.
Globally, there continues to be a trend away from globalisation and free trade towards the politics of populism and protectionism.
Neil Dwane, Global Strategist
As we look forward to 2017, Neil argued that investors should be thinking about the three big themes of China, Disruption and Politics. Together, these issues will dominate financial markets, and clients must continue to take appropriate risks to earn returns.
Is China an asset class?
Why Investors’ Understanding of
China is Changing
Stefan Scheurer, Global Economics & Strategy
One of our economists, Stefan Scheurer, opened a wide-ranging debate on China by discussing how the Chinese economy has developed over time, and what it might look like in the future.
“China’s rise over the last 20 years has been exceptional. But the rise in debt is alarming, and it is only increasing over time.”
Stefan argued that China tends to think in decades. Historically, before industrialisation began in Europe in the early 1800s, China accounted for over a quarter of global GDP. However, China had been through a period of declining economic relevance, before reawakening in the 1980s. This was achieved by moving from an economy dominated by the agricultural sector, to an export-driven model, focussing on low-cost manufacturing.
China had remarkable success over the last decades using this growth model. China’s economy in 2010 was 17 times larger than in 1980, and 700 million people have been lifted out of poverty as a result. However, Stefan argued that China is now at an inflection point, and in order to continue growing it needs to transform itself into an economy focused on domestic consumption.
Figure 1: Structural Rebalance Continues
Figure 2: Debt-to-GDP 2000-2015
Get rich before they get old
Stefan showed that while the growth of the Chinese economy has slowed over the last 10 years, its use of debt to sustain this has grown. Since the Financial Crisis, the US and other developed nations have deleveraged, but China has continued to create more debt. Debt-to-GDP in China is 119 percentage points higher than in 2000, mainly driven by the corporate sector.
Figure 3: Falling population growth points to slowing GDP growth
Stefan believes that the reason China is using debt to fuel its economy is to ‘get rich before they get old’. China faces an aging population in much the same way that Japan did 20 years ago, which has the potential to drag down productivity.
Stefan expects GDP growth to continue to slow, and estimated it will reach a new trend rate of 3-5% p.a. in the next 10 years.
William Russell, Global Head of Equity Product Specialists
The rapid growth of the Chinese economy could change how we approach investing in the market, claims William Russell, our Global Head of Equity Product Specialists. He believes that we need to start considering China as an asset class in its own right.
Chinese equity markets have continued to grow, and China now has more listed companies than the US. At the same time China has grown to be the second largest equity market as measured by market capitalisation. The story is the same in the bond market – China is the third largest issuer of bonds globally.
Despite representing 18% of global equity markets in market cap, many investors significantly underweight China in their global portfolios, driven by the fact that China only represents 3% of the MSCI AC World Index.
Is China an asset class?
William discussed the reasons why China was a much smaller part of the index than its market cap: China A-Shares (shares issued in mainland China) are excluded from the index, with only H-shares and ADRs (American Depositary Receipts) included.
“Over the least three years we have seen a significant change in the pace of financial reform.”
In China shares fall into two broad categories: China A-Shares and H-Shares. A-Shares are issued on the Shanghai or Shenzhen stock exchange, and trading is restricted to Chinese nationals, with international investors given small quotas. H-shares are issued in Hong Kong, with fewer restrictions on overseas investors. Clients currently access China by investing largely in China H-shares and ADRs.
Figure 4: Listed Companies and Market Cap
Figure 5: The Market Cap/Index Mismatch
Figure 6: Barriers to Entry are falling
But times are changing. William explained how financial reform and the opening up of the economy and currency to overseas investors was making investing in China A-shares easier.
In the future, William expects offshore and onshore equity markets to converge so that clients will invest in ‘Whole of China’. Clients want access to the best Chinese investment opportunities, regardless of where they are listed.
Figure 7: Performance Dispersion in Chinese Equities
Raymond Chan, CIO Equity Asia Pacific
Following the discussion on the development of China as an asset class, Raymond Chan, CIO Equity Asia Pacific, explained how Chinese equity markets are well suited to bottom-up stock picking.
Raymond showed that if we aggregate all the different types of Chinese equities there are 4,207 companies now listed in China, a 1,000+ increase since 2013.
The differences between types of Chinese equities present opportunities for experienced stock-pickers such as Allianz Global Investors.
Raymond explained that A-share markets are locally driven, whereas H-shares and ADRs are determined by foreign sentiment, usually driven by top-down macro opinions.
Knowing your A from your H
Investors should remain aware that A-share and H-share equities have very different risk/return characteristics, which can lead to share prices for the same company diverging across the different markets.
“We are very excited to be on the journey towards providing ‘Whole of China’ strategies for our clients around the world.”
However, Raymond expected that equities will continue to converge in the medium term, making A-shares more attractive to international investors. As a result, ‘Whole of China’ strategies (which combine share classes) will become increasingly popular, and Allianz Global Investors is leading product development in this space.
Raymond also expected that investors will increasingly demand more sophisticated products, such as Multi-Asset and lower volatility strategies.
As financial barriers to entry drop, Chinese equity markets will go from strength to strength.
David Tan, CIO Fixed Income, Asia Pacific & Greg Saichin, CIO Global Emerging Mkt Debt
David Tan, CIO Fixed Income Asia Pacific, and Greg Saichin, CIO Global Emerging Markets Debt, discussed the situation in the Chinese fixed income market. Just as is the case with Chinese equities, fixed income is a large and rapidly growing market that has so far been largely ignored by international investors. China is currently the third largest bond market in the world, and set to grow to $15trn by 2020. David explained how defaults in the Chinese onshore bond market began in 2014.
This has led to increased credit differentiation in China, with spreads increasing since 2014, indicating improved capital allocation, but it is also something investors must be aware of when considering investing in this market.
Figure 8: Chinese Bond Market
Figure 9: RMB Internationalisation Milestones
Is it time to consider Chinese Fixed Income?
Both David and Greg argued that despite the opportunities in Chinese Fixed Income, more progress needs to be made in opening up the market to investors.
Some improvements have already been made. David discussed the process of RMB internationalisation, which has made buying Chinese assets easier for international investors.
However, only 2% of the Chinese bond market is foreign owned currently. Greg argued that inclusion in global bond indexes is crucial for China, and he thought this could start occurring in the second half of 2018.
Inclusion will only happen if China continues on its reform path.
Figure 10: The Road to Global Bond Index inclusion
One of the clear topics of agreement amongst all the attendees was that China has changed the world with its growth over the last 30 years, and that it is now a significant global superpower. However, what is also clear is that the previous model for Chinese growth cannot continue, and this will impact how investors approach the country. In addition to changes in the economy, the changing approach China is taking to capital markets will have an even greater impact for investors.
As equity and fixed income markets open up and warrant greater inclusion in global indices, investors can no longer ignore them. An understanding of the dynamics at play in the domestic debt and equity markets will be crucial for investors, and it is becoming a real possibility that China may soon be an asset class in its own right.
How is disruption changing the way we invest?
Established Ways of
Doing Business are
Gunnar Miller, Global Head of Research
Gunnar Miller, our Global Head of Research, opened a discussion of disruptive technologies by discussing the impact disruption has on asset management. He described how our own industry has been impacted by the rise of indexing and increasing fee compression, along with tougher regulation and declining external resources, which have severely disrupted active investors over the last few years. But Gunnar argued that as well as looking at our own industry we also need to look beyond it. As investors, we are also affected by disruption in all industries, as business models and entire sectors are created and destroyed at an accelerating pace.
Nokia: A cautionary tale
Gunnar used the example of Nokia as an illustration of why investors need to think carefully about disruption. He described how at its peak in 2007, Nokia controlled 41% of the global handset market, and would have been viewed as having below-average disruption risk prior to the iPhone. The share price at the time was €25. By 2012, the share price had fallen 94% to €1.50. With no process in place to flag to investors that the entire mobile telephone market had been disrupted, it became a classic value trap.
“There is probably no industry that is as affected by disruption as the asset management industry.”
What is a Value Trap?
A value trap is a company that appears to be cheap and offering a ‘value’ investment opportunity. Typically this means the stock will be trading on low earnings multiples or price to book value. However, the stock can be a ‘trap’ if it’s actually in structural decline, and despite being cheap the share price never recovers.
Figure 1: Nokia vs. Apple share price 2007-2012
Figure 2: Attribution of US stock market returns
Does disruption make active investing more important?
Gunnar described how the average company lifespan on the S&P 500 has been falling over time. In 1960 the average was 60 years, but by 1990 this was down to 20 years, and currently sits at 12 years.
Gunnar therefore argued that as business disruption accelerates, the importance of stock-picking grows. As Figure 2 shows, all the long-term returns of US equities come from just 20% of stocks. Over the long term, we feel that the best investment approach is to be active and avoid the underperformers, which passive investments cannot offer.
Figure 3: Attribution of US stock market returns
Disruption is being put at the heart of the investment process
Gunnar concluded his talk by introducing our new ‘Disruption Risk Ratings’, which are part of the wider Intrinsic Ratings project at Allianz Global Investors. These new ratings provide every investment professional with a clear and current view of potential business model disruption over a 3-5 year horizon.
He explained how Disruption Risk Ratings are part of our broader Intrinsic Ratings project, where we are centralising our various non-financial valuation thoughts on companies together in one easy-to-find place in Chatter, our propriety platform for sharing investment ideas.
Sebastian Thomas, US Head of Technology Research and PM AI Strategies
Sebastian Thomas, our US Head of Technology Research and Portfolio Manager of our AI strategies, continued the discussion on disruption by discussing Artificial Intelligence (AI), and what it might mean for investors like us. He explained how AI technologies made profound breakthroughs since 2012, such as Google’s Artificial Brain learning to identify cats in YouTube videos with 75% accuracy.
What is AI?
AI is the science and engineering of making intelligent machines, with a focus on intelligent computer programmes. Varying kinds and degrees of intelligence occur in people, many animals and some machines.
Sebastian described how this is part of an ongoing effort to solve “Moravec’s Paradox”: it is paradoxically very easy to make computers complete high-level reasoning tasks like playing chess, but nearly impossible to teach them to complete low-level tasks like walking or recognising people or objects.
Figure 4: Moravec's Paradox
Figure 5: Timeline
Sebastian gave the example of the self-driving car to highlight the progress made in AI. Several leading manufacturers and technology companies are approaching a point where their technology is close to being ready, but the law and society at large is not prepared for the significant changes this could bring. Sebastian also made the point that self-driving cars would not only have an impact on manufacturers in terms of car design and ownership, but also on the insurance industry and the structure of labour markets in the transportation sector. Therefore a portfolio manager needs not only to consider investing in the company providing the self-driving car, but also the profound impact this might have across various areas of the economy.
“AI has developed to the point that it is now disrupting a lot of industries, and is bringing new innovations to the market”
Sebastian also explained how Allianz Global Investors were investing in these new advances in technology through the AI investment teams.
The rise of disruption has some clear implications for investors. It places extra emphasis on underlying investment processes, to ensure portfolios are not exposed to disruption risk.
Disruption is clearly here to stay, and we should expect faster business cycles, and companies being created and destroyed at an accelerating rate. At Allianz Global Investors we have looked at this closely, and are working to ensure that all our teams invest with disruption firmly in mind.
This is about avoiding value traps like Nokia, and also discovering the next big opportunity.
What to Watch: Politics in 2017
More of the same:
Why politics matters
more than ever in
Steven Malin, Senior Investment Strategist, US
2016 was a year where politics was the master of financial markets, and one of the key discussions at the Investment Forum was the likely political risks facing investors in 2017. The political discussions began with a view from the US, as Senior Investment Strategist Steven Malin explored some of the possible developments in the US under President Trump.
“Donald Trump comes into power riding a populist wave, and the policies he espouses are those that confront the biggest issues facing the average American.”
There remains significant uncertainty around what policies President Trump will choose to focus on, but Steven argues that Trump’s “Contract with the American Voter” indicates where his priorities lie. He said that Trump will take action to ‘protect American workers’, including renegotiating NAFTA, withdrawing from the Trans-Pacific Partnership, and redirecting funding away from climate change programs to US infrastructure spending. Additionally, he said that Trump has promised an overhaul of the tax code, which could include a 35% tax cut for the average American family.
The Federal Reserve
Shaking up the Federal Reserve
One of the biggest issues facing investors will be what occurs at the Fed (US Federal Reserve). Steven argued that one of the first items on Trump’s economic agenda will be to fill a number of vacancies on the Federal Reserve’s Board of Governors.
The Board of Governors is the main governing body of the Federal Reserve, and is responsible for overseeing the regional Federal Reserve Banks, and implementing US monetary policy. The seven-person committee is currently chaired by Janet Yellen, and makes up seven of the twelve members of the Federal Open Market Committee, which decides US interest rates and money supply.)
By the middle of 2018, six out of the seven positions could need filling, and Steven reasoned that Trump will likely choose appointees who share his views on the world. This could have far-reaching impacts on interest rates, the central banking system, and banking regulation. Given that the dollar is the world’s reserve currency, and that US Treasury yields have a significant impact on global capitals flows, the approach the Fed takes and its level of independence need to be scrutinised by investors.
By mid-2018, the Board of the Federal Reserve could have six out of seven seats vacant
Trump and Tax
Another key pillar of Trump’s platform is reforming the US tax system. Steven claimed that Trump’s proposed tax changes could represent the single biggest change to the US taxation system in a hundred years. For individuals, Steven showed how Trump would simplify existing tax bands, and reduce average federal taxes for all earners.
For businesses, the corporate tax rate will be reduced from 35 percent to 15 percent, and he would give firms a one-off opportunity to repatriate corporate profits held offshore at a tax rate of 10 percent. However, Steven cautioned that all these changes would need to be passed by Congress, and Republican deficit hawks in the House and Senate may block or water down such proposals.
Figure 1: Federal taxes under Trump's plan
Ingo Mainert, CIO Multi Asset Europe
Donald Trump might be stealing the limelight, but Europe is not short of potential political issues either. Brexit has naturally dominated the political agenda in 2016, and will continue to be the big story in 2017. However, beyond this Ingo Mainert, CIO Multi Asset Europe, believes that the upcoming ‘super election’ cycle in Europe could create some potential flashpoints for investors.
Over the course of 2017 three ‘core’ European countries are holding elections. Ingo argued that we could see an upset in the Netherlands, where the nationalist Gert Wilders is polling better than many expected. In France, much has been made of the rise of Front National, but Ingo contended that the election could be a positive surprise, with moderate Francois Fillon performing well in the polls. Finally, we also have elections in Germany in September, where Angela Merkel will have to fight off the insurgent right wing AfD party. Ingo also warned that we could see another election in Italy, and a referendum in Spain on the future secession of Catalonia.
Italy: The real elephant in the room
However, despite the potential for some positive surprises in Europe, Ingo viewed the Italian economy as potentially the most difficult issue for the Eurozone over the short term. The country continues to suffer from unsolved problems, mainly in the banking sector.
Figure 2: High NPLs put strain on the banking sector
Unfortunately, the government is paralysed and weak, and Ingo discussed the possibility that some of the recent constructive reforms such as changes to labour laws could be revised. Italian governments are notoriously unstable, with a quite extraordinary average government tenure of just 1.1 years since the end of World War II. After the failure of Matteo Renzi to win the referendum on constitutional reform Italy is at a clear crossroads, and investors need to pay close attention to potential flashpoints here.
Where next for Europe?
25 years after the Maastricht Treaty the European project is now at a key juncture, and Ingo argued there are four different potential outcomes.
The chance of an ‘ever closer union’ with greater European integration seems to have declined further than ever before, with individualist nationalist agendas on the rise across Europe.
A possible scenario that Ingo imagined could emerge is a ‘two-speed’ Europe, with ‘Core Europe’ moving towards greater integration, as fringe members break away.
“In 2017 we need a new vision for Europe. The muddling through over the last five years is coming to a crossroads.”
The political landscape ahead is certainly a rocky one, with considerable uncertainty across the world. Investors need firstly to be aware of political developments and their impact on markets, and secondly to remain diversified to cope with any shocks.
The rise of Trump and Brexit have very clearly signposted the beginning of a different era of politics that investors need to take heed of, and 2017 could be a year of significant change in Europe.
Despite volatile markets, investors need to remain active
Neil Dwane closed the Investment Forum by offering highlights of the day’s topics, along with the key takeaways for investors.
Although China is the second largest economy in the world, and represents 18% of total equity market capitalisation, it represents only a fraction of the world’s leading market indices. As China continues to rebalance and reform its economy it will play a larger role in global indices, and therefore investors should consider increasing their exposure to Chinese assets.
Of course China is not without its issues. In particular, investing in China as a non-Chinese citizen is still subject to additional restrictions, which clients should be aware of when investing here. However, these continue to be relaxed by the government, making Chinese assets progressively more attractive to international investors.
Over time disruption is becoming a more and more significant theme, as the pace of technological progress increases. It is an investment topic that impacts practically all companies and industries around the world – including asset managers like AllianzGI. Investors need to find new ways to adapt to and capitalise on disruption, including implementing disruption into the research process on the companies we cover, and developing new products.
For investors, disruption makes earning consistent returns more challenging, as seemingly dominant incumbent companies can quickly lose their competitive advantages. This makes active investing more important than ever – investors need to take active risk and pick the winners of disruption.
Our MC Neil Dwane recalled that as we concluded our last Investment Forum in Hong Kong in January 2016 there was already a change in the political undercurrents, moving away from globalisation and free trade toward populism and protectionism. As we look forward to 2017 Europe will take centre stage, with Brexit negotiations imminent and important elections looming in the Netherlands, France and Germany. The new Trump administration has already shown it can rattle markets with just a few tweets, and exemplifies the adage that ‘uncertainty is the only certainty’.
Investors should be aware that European markets will likely remain mired in political events that will bring further volatility to a region that has suffered numerous political setbacks over the past few years. In the US, equities may have room to run if Trump’s fiscal stimulus and tax cuts come to pass. However, caution is the watchword for investors, who would be well advised to take news from the Trump administration with a degree of scepticism.
Overall, investors need to take risk to earn returns, and to remain active in increasingly volatile markets – a stance that has been validated time and again by the market’s results.
Investing involves risk. The value of an investment and the income from it will fluctuate and investors may not get back the principal invested. Past performance is not indicative of future performance. This is a marketing communication. It is for informational purposes only. Any reference to a security should not be considered investment advice, a recommendation to purchase or sell any particular security or strategy and does not indicate that such security was recommended for any client account.
The views and opinions expressed herein, which are subject to change without notice, are those of the issuer or its affiliated companies at the time of publication. Certain data used are derived from various sources believed to be reliable, but the accuracy or completeness of the data is not guaranteed and no liability is assumed for any direct or consequential losses arising from their use. The duplication, publication, extraction or transmission of the contents, irrespective of the form, is not permitted.
This material has not been reviewed by any regulatory authorities. In mainland China, it is used only as supporting material to the offshore investment products offered by commercial banks under the Qualified Domestic Institutional Investors scheme pursuant to applicable rules and regulations.
This document is being distributed by the following Allianz Global Investors companies: Allianz Global Investors U.S. LLC, an investment adviser registered with the U.S. Securities and Exchange Commission; Allianz Global Investors GmbH, an investment company in Germany, authorized by the German Bundesanstalt für Finanzdienstleistungsaufsicht (BaFin); Allianz Global Investors Asia Pacific Ltd., licensed by the Hong Kong Securities and Futures Commission; Allianz Global Investors Singapore Ltd., regulated by the Monetary Authority of Singapore [Company Registration No. 199907169Z]; Allianz Global Investors Japan Co., Ltd., registered in Japan as a Financial Instruments Business Operator [Registered No. The Director of Kanto Local Finance Bureau (Financial Instruments Business Operator), No. 424, Member of Japan Investment Advisers Association]; Allianz Global Investors Korea Ltd., licensed by the Korea Financial Services Commission; and Allianz Global Investors Taiwan Ltd., licensed by Financial Supervisory Commission in Taiwan.