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Welcome to our 2018
Investment Views

Selectivity is key:
our 2018 outlook

By Philip Saunders

For now, global growth would appear to be sufficiently self-reinforcing to extend what has been one of the longest, if weakest, growth cycles since the 1920s.

The long cycle continues

The global reflation theme which unfolded over 2017 had little to do with President Trump. An end to the energy sector drag on growth in the US, coupled with solid consumer income and spending, led to a recovery there. The European economy finally responded to Draghi’s ‘whatever it takes’ stance. In China, the delayed impact of a dramatic loosening of monetary policy and increased spending on infrastructure caused a reacceleration in growth. Despite the return to globally synchronised growth, inflation and interest rates have remained low and liquidity plentiful.

The global economy appears to have achieved ‘escape velocity’ from the post Global Financial Crisis stagnation (a period of little or no economic growth). Whether this proves enduring or is merely a temporary cyclical respite remains to be seen. For now, global growth appears to be sufficiently self-reinforcing to extend what has been one of the longest, if weakest, growth cycles since the 1920s. Notably recession indicators remain benign, lending more support to this scenario (Figure 1).

Figure 1: Recession probability signal

Source: Investec Asset Management, Bloomberg, May 2017.

Despite a sustained period of unusually low interest rates and unconventional monetary policy in the form of quantitative easing (QE), inflation in the developed world has remained persistently low. Central bank estimates of higher inflation have been repeatedly disappointed, suggesting that powerful changes in labour markets, globalisation and technology are at work. We assume some uptick in inflation rates in key economies will occur, but such changes are still likely to be muted in 2018.

Suggested investment implication

Positive global economic momentum should enable solid revenues and profit growth.

China, moderation not collapse

Chinese growth and liquidity have become critical to the global economy. While we expect the growth rate in China itself to moderate in 2018 in response to the tighter monetary and macro prudential policies already in place, this is likely to be moderate and orderly, with rebalancing in favour of the domestic and service sector continuing.

Although China certainly has challenges, particularly in using its capital productively, it has both the will and the means to address them. Demand management has become noticeably more adept and the consolidation of power in the hands of Party Chairman Xi Jinping is likely to see an intensification of the efforts to reform the supply side of the economy via changes to state owned enterprises. In addition, financial sector reform is likely to continue at its current pace. Local authority finance has been addressed, measures to improve the efficiency of pricing in capital markets are now in place and the focus has shifted to financial regulation more generally and the shadow banking sector in particular.

Suggested investment implication

A positive growth outcome in China, as well as being supportive of Chinese corporate earnings growth, would be a boost for emerging markets more generally.

Commodities continue to enjoy cyclical support

Industrial metals prices were the first to signal an improving cyclical environment in early 2016 and have subsequently enjoyed a further recovery. With the cyclical backdrop set to remain positive industrial metals should remain well supported in 2018. In particular, growth in the use of electric vehicles should continue to boost copper prices.

Demand for oil should continue to enjoy cyclical support and remain firm, but supply will again depend in part on OPEC continuing to manage its own output. Higher prices are likely to be capped by the potential for shale producers in the United States to increase production flexibly.

Gold may benefit from a further bout of US dollar weakness, but we believe that there are other more attractive Defensive assets.

Suggested investment implication

Firm commodity prices should continue to underpin the recovery of natural resource stocks.

Interest rates and monetary conditions set to become less accommodative

The rise in long-term interest rates, particularly in the United States, discounts a meaningful move higher in short-term interest rates. Despite the current cyclical upswing, considerable structural headwinds to growth remain in the form of ageing populations, high levels of debt and poor economic productivity. As such, the normal level of real interest rates (adjusted for inflation) is set to remain more modest than it has in the past. It would appear that US interest rates might only reach 2-2.5% at the cyclical peak of the economy, which is already priced in by the market. Countries like the UK, Canada and Australia in particular will quickly struggle in the face of higher interest rates because of overextended consumer and property markets.

While the US Federal Reserve Board is now in the process of actually shrinking its balance sheet (by putting its QE programme into reverse), the ‘tapering’ of QE has only just begun in the euro zone and Japan. With strong growth in both Europe and Japan, the pace of tapering will likely pick up in 2018 and Chinese monetary policy is unlikely to loosen. Central banks are also reducing support beyond monetary policy – for example, restricting the supply of credit to certain sectors. Hence overall liquidity conditions could become, if not quite restrictive, progressively less supportive.

However, given the nature of these structural issues, the lack of consensus about the impact of tapering unconventional monetary policy and continued low core inflation rates, a gradual withdrawal of support is likely to prevail.

Suggested investment implication

Interest rate normalisation should proceed in an orderly and gradual fashion which should be supportive of Growth assets.

Government bonds – a selective source of defensive exposure

We don’t subscribe to the bond market ‘bubble’ view, believing that the drivers which have caused developed government bond yields to decline over the last 35 years are still largely in place. However, despite disinflationary forces, less central bank bond buying, a modest pick-up in core inflation rates and possible fiscal easing are likely to cause bond yields to rise in some markets. Hence our preference for government bond markets and maturities where we believe interest rate expectations are too high, such as Canada and Australia. In our view, long-dated US Treasuries also continue to offer attractive value as a Defensive asset.

Suggested investment implication

Investors are already pessimistic about prospects for fixed income returns, hence selective allocations to preferred markets and maturities represent an attractive source of defensive returns.

A maturing bull market for Growth assets

Many investors have remained sceptical of the current bull market cycle, missing out on returns for their clients. Beyond the various macro risks outlined above, valuation remains one of the principal concerns. By historical comparison, valuations of most Growth asset classes, and some Defensive assets as well, are now clearly expensive. Although this warrants increasing strategic caution, because high valuations point to lower returns over the longer term, valuation alone has tended to be a relatively poor medium-term indicator. Bull markets typically end just before an economic downturn and after prolonged periods of tighter monetary conditions, neither of which appear to be in place yet. In addition, market price behaviour is still risk seeking (see Figure 2). So given the high passive flows (which are not sensitive to valuation), this could yet cause a final ‘melt up’ in stock prices, as investor scepticism potentially gives way to euphoria late in the business cycle.

Figure 2: Elevated investor sentiment

Source: Ned Davis Research, March 2017. Shows percentage polling by NDR, with highs representing optimism and lows representing pessimism.

Suggested investment implication

Use market strength as an opportunity to add progressively to Defensive exposure and moderate outright exposure to Growth assets.

Equity markets – recovery in cyclical sectors as yet incomplete

From the summer of 2016 there was a distinct change of leadership in equity markets. Until that point leadership was provided by defensive and interest rate sensitive sectors, reflecting enduring investor caution. Since then, growth and cyclical sensitive areas have been more highly priced, supported by strong or improving corporate earnings (see Figure 3). ‘Digital leaders’ such as Facebook and Amazon in the United States and Alibaba and Tencent in China have been in the vanguard of such a change in dynamics. We have also witnessed better performance from financials and, more recently, mining stocks. Cyclical stocks supported by strong earnings growth are likely to gain further investor attention in the year ahead.

Figure 3: Robust corporate earnings

Source: Investec Asset Management, JP Morgan, June 2017.

Better operating performance and growing investor appetite for cyclical risk has also shown up in improving performance of markets outside the United States. From a ‘bottom-up’ perspective, we believe US equities, despite appearing to be relatively expensive, have consistently offered the most attractive fundamentals. With the revival in global growth this has now changed and, in our view, equity markets outside of the United States look increasingly attractive. Asian markets, including Japan, seem to be well placed to benefit from a broader rotation out of the United States.

Finally, after a sustained period of unusually low dispersion between stocks, the current trend towards a more ‘micro’ and less ‘macro’ environment means that the current revival in active returns from fundamental stock picking looks set to continue in 2018. The broadening of an equity bull market previously dominated by the United States also provides scope to benefit from higher alpha potential from structurally less efficient markets.

Suggested investment implication

Continue to emphasise cyclical exposure both in terms of regions and sectors. More specifically via allocations to natural resources, Asian and emerging market equities. Favour ‘active’ versus ‘passive’ exposures to take advantage of an improving environment for stock selection ex-US equities.

Credit markets – caution warranted

Credit markets tend to be sensitive to material shifts in monetary policy. In the past, credit spreads have typically started to widen between 6 and 24 months before a more general equity market peak. The starting point is one of tight credit spreads, supported by improving corporate fundamentals and investor appetite for yield. We are confident in the former, but liquidity could prove to be more challenging and the risks are asymmetric.

Suggested investment implication

This warrants a defensive approach and selectivity in focusing allocations in credits supported by improving fundamentals. Within the spectrum of Growth assets we continue to favour equities, as a source of income, in an environment which should continue to see solid operating performance.

Currencies – a further phase of dollar weakness?

The US dollar weakness which occurred in the first half of 2016 surprised most investors. Previously, the dollar had experienced a six-year bull cycle against the currencies of its major trading partners. A slightly shorter period than its bull cycles in the early 1980s and mid-to-late 1990s. The subsequent recovery has been muted – despite a significant covering of short positions – which suggests to us that a new down leg could unfold in 2018, confirming a medium-term bear market for the US dollar.

Despite its recovery against the euro, the US dollar remains cheap. However, in our estimation the Japanese yen is cheaper still, making it one of the most attractive Defensive exposures. If, as we believe, the Japanese economy continues to perform strongly, the Bank of Japan is likely to continue to moderate its ultra-loose monetary policy. Should market conditions turn more negative in 2018, the Japanese yen has the potential to rally dramatically.

Suggested investment implication

Reduce US dollar exposure into rallies. Among developed market currencies, favour the Japanese yen as a cheap Defensive asset.

Emerging market debt and foreign currencies – selectivity to be rewarded with good returns

Whereas the developed world has been in a long but weak growth cycle since the catharsis of the Global Financial Crisis, with a few exceptions, the recovery of the emerging world is a much more recent affair. Generally speaking, the combination of pent up demand and continued low inflation rates should underpin the relative recovery in emerging market assets already underway. The best opportunities are likely to be found in local currencies and debt markets, provided investors avoid some of the more specific risks within the region. Selectivity will be required to extract returns from a diverse opportunity set supported by improving fundamentals.

Suggested investment implication

Selective exposure to emerging market local currencies and debt are likely to offer attractive income and returns.

ESG – A shift in attitudes can lead to opportunities

A shift in attitudes and regulations is now prompting disruptive change in consumer and corporate behaviour, such as the take up of electric and hybrid vehicles. Slow at first, this is now proceeding more rapidly than most forecasters anticipated.

Professional investor behaviour is changing too. Over the past few years investment processes have increasingly incorporated an analysis of ESG (Environmental, Social and Governance) factors into any investment decision, alongside more traditional factors such as an assessment of valuation and company fundamentals. Increasingly, the evidence is that, if done well, this can help to improve the profile of returns.

Suggested investment implication

It is likely that high ESG standards will increasingly be rewarded by investors. Opportunities are emerging for companies and materials, such as copper, which are beneficiaries of the shift towards environmentally and societally friendly technologies.


An ageing bull

By John Stopford

At a glance

  • The current bull market in Growth assets is intact, but vulnerabilities are increasing
  • We have begun to reduce risk, seeking attractive opportunities from the bottom-up
  • Current positioning:
    • Cyclical and financial equities look relatively attractive
    • Corporate bonds require being cautiously selective
    • Government bonds have supportive long-term drivers but cyclical challenges remain
  • The Japanese yen offers Defensive characteristics and support for the dollar is likely to fade
  • We are closely monitoring the market reaction to the withdrawal of central bank monetary easing

Still intact…

The bull market for Growth assets such as equities and high yield corporate bonds is maturing, with increasingly stretched valuations. While valuations alone rarely cause markets to reverse, they imply lower longer-term returns. Bull markets typically only end just before an economic downturn and after a prolonged period of tighter liquidity conditions, neither of which are yet evident. The risk of recession appears low, monetary conditions are loose and growth momentum is strong.

Market price behaviour is still risk-seeking. Flows from passive investments could even cause a final ‘melt-up’ in stock prices as investor scepticism potentially gives way to late cycle euphoria.

…but vulnerabilities increasing

However, the fundamental backdrop is slowly weakening. Global economic growth has used up much of the spare capacity available for above-trend growth. At the same time, monetary policy looks likely to become steadily less supportive. The Trump tax reduction plan could spark a classic end to the current business cycle, creating a boom followed by a bust. Cutting taxes with unemployment at its current lows would boost growth, but should also push up inflation expectations and risk in the bond market.

Figure 1: G7 GDP growth vs. trend

Source: Investec Asset Management, as at 31.10.17.

Portfolio positioning – Incrementally less risk

The cost of being a little early in getting out of the market is similar historically to being a bit late. Many talented investors have already missed much of this bull market by being bearish too soon, and this could remain the case if the business cycle is extended. We believe the right approach is to run incrementally less risk within our allowed risk budget, but to keep some exposure to Growth assets given the probability of further market strength.

We build portfolios from the bottom-up, which allows us to find securities which offer an attractive combination of yield, sustainable income generation and potential for rising prices.

Equities – Opportunities in cyclicals and financials

Within equities, we are finding interesting opportunities in financial and cyclical stocks, which tend to benefit from an improved economic backdrop and are less sensitive to volatile bond yields. From a regional perspective, valuations and cyclical momentum appear better outside the US, but the US still contains many great companies and may see additional upside if the proposed tax cuts are passed.

Corporate bonds – Cautiously selective

We are cautious towards corporate bonds. However, we do see selective opportunities in emerging markets, which typically offer more value than their developed market peers and are better supported by the higher economic growth. We are still cautious, however, due to a number of idiosyncratic risks – investor flows into the asset class remain lumpy, driving bouts of volatility.

Government bonds – Long-term drivers still in place

The factors that have driven government bond yields down over the last 35 years remain largely in place, particularly inflationary forces and the causes of muted growth. This makes us buyers of long-dated US Treasuries if we see further price weakness.

Figure 2: Global equities vs. US Treasury yields

Source: Bloomberg, as at 30.09.17.

However, we still see the risk of higher yields in the near term, due to less central bank bond buying, a probable pick-up in core inflation next year and the potential for fiscal easing in the US. Any of these factors could push up real and nominal yields, even if slower trend growth and secular disinflationary forces are tending still to pull bond yields in the opposite direction.

We prefer bonds from issuers where the economies are unlikely to be able to tolerate the high interest rates that many investors expect, such as Canada and Australia. We also see value in being short long-dated Japanese government bonds, as a hedge against higher yields globally.

Currencies – Defensive yen, fading the dollar

We own the Japanese yen as a Defensive position. As a global lender, Japan is an exporter of capital. In a crisis, we believe the yen would climb as capital tends to stay at or return home. The currency also appears cheap and would probably rally on any further softening of the Bank of Japan’s expansionary monetary policy.

In our view, the US dollar bull market may be over after six years of real appreciation against major trading partners. Previous up cycles in the currency have lasted slightly longer, but have then been followed by long periods of underperformance. The dollar may, however, stabilise, or recover temporarily in the short term, before resuming a downward trend, given how far sentiment has already shifted in the last year – investors are becoming much more optimistic about Europe than the US.

Risk beyond the bust

The main market risk is always the possibility of recession. However, beyond this our concerns are focused on how well markets, fuelled in part by liquidity, will deal with a reduction of central bank bond buying. We also worry whether or not China can successfully transition to a growth model driven less by debt.

Other important risks are largely geopolitical and include further political instability in Europe, the potential for a hard Brexit, the chance of a follow through on Trump’s protectionist rhetoric, and rising tensions with North Korea and Iran.

Our focus on downside risks suggests we should be aware of and manage the potential consequences of these risks. We will look to quickly scale back exposure if the market environment starts to deteriorate.

One final rally?

With no immediate sign of an economic slowdown, the current market looks like it may have life to it yet. Investors are still seeking risk and the bull market could attract further passive flows and a late-cycle buying spree.

But it is certainly beginning to show its age with valuations looking stretched in places, a global economy with less slack for further above-trend growth and central banks looking to withdraw monetary support. A prudent response is to selectively and incrementally reduce risk in the portfolio.


Structural growth is the key

By Clyde Rossouw

At a glance

  • Investors are becoming increasingly nervous about the outlook for returns
  • Structural, rather than cyclical, growth will be key
  • Valuations appear high, but quality stocks don’t look overly stretched
  • Prudent stock selection will be required to separate the winners from the losers in 2018

Growth strengthening, but risks remain

As ‘the most hated bull market in history’ approaches its tenth year, with the S&P 500 having delivered over 350% total cumulative returns since its post-crisis lows, investors are becoming increasingly nervous about the outlook for returns and dividends.

Global growth appears to be strengthening and becoming more synchronised, and the first tentative steps towards monetary policy ‘normalisation’ have been taken in the US and the UK. However, the outlook remains far from certain. There are a number of risks that could derail this fragile global recovery, ranging from fiscal and monetary policy error to escalating geopolitical tensions, protectionism and ever-increasing debt levels.

Structural growth will be key

Against this uncertain backdrop, and as we look forward to 2018, we believe a focus on structural rather than cyclical growth will be key.

One cannot rely solely on the fortunes of exogenous factors such as commodity prices, interest rates, or the economy to sustain growth. As has been the case in 2017, particularly in the technology sector, we expect the market to again reward quality companies that prove their ability to deliver sustainable growth in earnings and cashflows, and punish companies across the market whose earnings disappoint.

Figure 1: High quality profits (FCF conversion)

Source: Investec Asset Management and FactSet, as at 30.09.17. Investec Global Franchise Strategy re-weighted excluding cash and equivalents, since inception

Figure 2: Sustainability high profitability (ROIC)

Source: Investec Asset Management and FactSet, as at 30.09.17. Investec Global Franchise Strategy re-weighted excluding cash and equivalents, since inception.

We are mindful of the threats that also exist to the future growth of Quality companies. For example in consumer staples disruption from the ‘infinite shelf’ of e-commerce, is lowering barriers to entry and supporting smaller brand and private label penetration, thereby increasing fragmentation across categories. However, the impact of this and other trends will not be felt evenly across companies. In many cases it will likely provide opportunities as well as risks. Careful stock selection will be required.

Valuations not overly stretched

Equity markets have re-rated significantly since the Global Financial Crisis and are no longer cheap. In the context of a low-growth, low-return world, however, we do not believe that the valuations of quality stocks are overly stretched. Relative to longer-term history, we believe the valuations of quality stocks remain attractive, given the quality and growth characteristics one is paying for and the valuations of bonds and other assets. Again, however, stock selection will be key.

In 2017, investors have been rewarded for successfully picking stocks that have delivered growth. However, perhaps more important to investment performance in 2018, will be avoiding the losers rather than picking the winners. This will require careful management of downside risk, including both business and valuation risk. Again, active stock selection will be critical.

Focusing on the ‘quality’ advantage

Overall, while more economically sensitive sectors with global exposure, such as energy and mining, have rallied recently, the sustainability of this rally is uncertain. We believe that carefully selected quality companies, with long-term structural rather than short-term cyclical growth drivers, should be well placed to perform well in 2018.

We will continue to focus on finding these attractively valued quality companies, with demonstrably enduring competitive advantages that are able to continue to grow their cashflows into 2018 and beyond.

Quality not quantity driving Asian markets

By Charlie Linton & Greg Kuhnert

At a glance

  • Asian companies have improved their profitability, efficiency and cashflow, a trend which looks set to continue for long term
  • Despite strong performance in recent years, valuations are not stretched compared to history or developed markets
  • Triggers for further market rallies include both political reforms and structural economic changes that show the region has become a technology centre in its own right, rather than a low-cost manufacturing centre
  • We continue to believe that these opportunities are best captured by a disciplined bottom-up investment process

Improving earnings growth into 2018

Asian markets have had a stellar 2017 and are up over 50% from their lows in 2016. They have outperformed developed markets by around 20% since these lows. As a result, the price to earnings ratio of the MSCI AC Asia ex-Japan Index has risen by 30%. What has driven this outperformance and can it continue?

The performance of Asian indices has largely been driven by four large index heavyweights:

  • Samsung
  • Alibaba
  • Tencent
  • Taiwan Semiconductor.

These stocks have accounted for over half of the index growth this year. While such narrow performance of the index may be concerning, the underlying improvements in the Asia markets recovery are far more broad-based than the stock market movements would suggest.

Asian equities since 2016 lows

Improving profitability for the long term

Unlike developed markets, emerging markets have experienced an earnings recession which only ended in 2016. High debt levels and overcapacity in certain sectors provided investors with good reasons to maintain their underweight to the region. However, in the background low profitability was providing an incentive for companies to address poor working capital, cut capital expenditure and focus on productive growth. This had led to a huge improvement in free cashflow, with every sector except telecoms seeing positive free cashflow growth over the past five years.

In addition to a fall in capital expenditure, which might otherwise imply lower future growth, the free cashflow increase is also being driven by an improvement in margins and capital efficiency. This represents a longer-term improvement in the quality of Asian companies.

High-quality earnings growth into 2018

The quality of earnings growth has been high and has been driven by sales growth and margins, compared to buybacks and acquisitions that have recently prevailed in developed economies (Figure 1). With both sales and margins improving this shows not just good cost control, but also an element of pricing power which suggests we should continue to see improved operating leverage into 2018.

Figure 1: Earnings growth breakdown by region

Source: S&P Dow Jones, Factset. June 2017 is preliminary data.

Valuations still at a discount

The MSCI AC Asia ex-Japan Index has seen an increase in price-to-earnings multiple of 30% from its lows in 2016, yet it still trades at a discount of nearly 20% against the MSCI World, versus its average discount of 11% over the past ten years. Crucially, the free cashflow yield for Asia has increased above that of the USA for the first time since 2005 (Figure 2).

Figure 2: USA vs. Asia ex-Japan free cashflow yield

Note: FY0 FCF data has a three-month reporting lag. Source: CLSA, Factset September 2017.

Could Asian equities bounce in 2018?

Improvement in earnings, growth and/or quality could well provide triggers for Asian markets to fulfil their recovery potential. There are also qualitative reasons for the markets to perform.

Political reforms across the region

One of the key qualitative factors that could spark further market rerating is the political reforms moving ahead across the region.

Following the recent Communist Party Congress in China, Premier Xi Jingping continued to push for reform, with an emphasis on profitable growth and the decline of debt over growth-at-any-cost. In India, Prime Minister Narendra Modi has pushed demonetisation, implemented a Goods and Services Tax and recapitalising the banking sector. South Korea is pursuing improved corporate governance following measures to tackle the strength of the Chaebols (large family conglomerates), which has also coincided with an increase of shareholder returns.

Structural economic changes

Increased spending on automation and the huge increase in the number of patents being filed suggests that Asia has moved on from being a low-cost manufacturing centre to becoming a technological leader (Figures 3).

Figure 3: Spending on robots by market

Source: RBI, Bernstein analysis

Positioning for 2018: unloved sectors, bottom-up investing

Growth stocks have driven performance in 2017, but these opportunities have become more expensive and more crowded as the year has gone on. Our screen and fundamental research are now starting to unearth better opportunities in cheaper, unloved sectors. These are seeing the largest improvement in terms of earnings upgrades and quality improvements and, in the case of state-owned enterprises, signs of reform.

We are cautiously optimistic on the outlook for Asia into 2018 given the improvement in fundamentals. While we would be cautious about announcing that “it’s different this time”, we see good reasons why Asia could continue to outperform, even if the seven-year bull market in developed markets comes to an end. These include:

  • The Chinese economy rising to become a similar size to the US
  • Local economies rebalancing to be driven by domestic demand
  • The China A-share market being included in key benchmarks
  • Global investors remaining underweight.

We continue to believe that these opportunities are best captured by a disciplined bottom-up investment process focusing on return on capital, valuation, improving operating performance and positively trending share prices.

All-China approach: Opportunities and risks

By Greg Kuhnert

At a glance

  • ‘Old’ economy companies (real estate, infrastructure) have begun to recover, driven in part by reform and restructuring
  • A clear push for a better environment also creates interesting ‘new’ investment opportunities in the old economy
  • ‘New’ economy sectors continue to boom, with the service economy now over 50% of China’s total GDP
  • Chinese debt levels remain a potential risk
  • Going into 2018, Chinese equities offer one of the highest revenue, earnings and cashflow growth opportunities globally

Opportunities and risks in 2018

Going into 2018, the Chinese equity market offers a number of investment opportunities in both traditional ‘old’ areas of the economy, as well as ‘new’ economy sectors such as consumer, internet/tech and healthcare. Overall, economic growth is shifting from investment-heavy industries to more sustainable and shareholder-friendly consumer-orientated areas. Of course, investing in China, as with all investing, entails risks, with high indebtedness at the top of the list.

The resurgent ‘old’ economy

Old economy growth rates began declining after 2011, but have started to recover more recently, especially the real estate and infrastructure sectors. In real estate, home mortgage interest rates have been declining since 2014. Together with other easing policies, such as a reduction in the down-payment ratio and a lift of purchase restrictions, we are seeing a strong increase in pent-up demand for housing.

Infrastructure is another area of growth. An example is high-speed rail, where China has some of the best technologies and products globally. While the growth rate of the real estate sector has moderated from high levels, infrastructure spending has helped fill its void.

Another strategic focus by the Chinese government is to improve the environment. This creates several interesting ‘new’ investment opportunities within the old economy, including gas and hydro power companies in the utilities sector, the electric vehicle supply chain and industrial automation in the industrials sector.

Figure 1: Old economy revenue is seeing a significant improvement

Source: Wind, as at 30.06.17.

Within old China, a key investment theme is reform and restructuring, beginning with sectors where returns are improving from cyclical lows and cashflow returns to equity holders are improving. The Chinese government is taking proactive steps to address overcapacity and indebtedness. This results in meaningful improvements in corporate profitability and cashflow.

Coal and steel are two examples where industry capital expenditure has fallen significantly, yet end-demand continues to surprise to the upside. This has created a combination of improving cashflow returns yet cheap valuations, something every equity investor likes to see.

The booming ‘new’ economy

The service sector was more than 50% of China’s GDP as of 2016, from just about 40% a decade ago. This makes the growth more sustainable and shareholder friendly.

Figure 2: New economy contributes more than 50% to GDP

Source: CEIC, December 2016.

We believe that thanks to increasing penetration and high barriers to entry, new economy sectors, such as consumer, technology, internet and healthcare are generating interesting growth opportunities for equity investors going into the new year.

Several sectors are competitive globally. We believe these areas offer the most attractive growth potential, as well as visionary management teams, competitive advantages to the business model, and long-term product and service viability. The superior growth rate and cashflow generation that these sectors deliver over the long term is likely to reward equity holders.

Monitoring indebtedness risk

Despite all the positives, indebtedness remains a risk to the Chinese investment thesis. As the economy transitions from investment to consumption, we are seeing a rise in non-performing loans. China has been taking progressive measures to contain this risk through lowering interest rates, restructuring the debt, and increasing the transparency of the debt market. However, there is much to be done and this is the area where investors need to be wary and constantly assess their risk management processes.

We advocate avoiding those companies with high gearing and large amounts of dollar denominated debt, in preference for those with improving or clean balance sheets, and diversified sales regions.

Looking forward

Going into 2018, Chinese equities offer one of the highest revenue, earnings and cashflow growth opportunities globally. Economic growth is shifting from investment-heavy to more sustainable and shareholder-friendly consumer-orientated areas. Despite a rapidly modernising old economy and a dynamic ‘new’ economy, China still trades at a large discount to developed markets. The international investment community remains extremely underweight Chinese equities, which we think will reverse over time.

A pause or correction may be due in the short term, given how well the market has done this year as some investors may choose to book profits or reduce risk in the light of geopolitical uncertainties. However, we would see that as a buying opportunity. The bottom-up fundamentals of Chinese companies are improving and valuations still look attractive relative to history and other global markets. Corporate profitability is improving due to a broad-based improvement in the economy spanning exports, infrastructure investment, domestic consumption and a pick-up in private investment by corporates. Corporate cashflows are looking stronger and companies are paying down debt.

The government is serious about supply-side reform and this is enhancing returns in the old economy sectors which has been avoided by the market for a long time. The new economy companies continue to grow and thrive as China is moving up the technology curve as it accelerates its investment in research and development. We see the domestic equity market as rich with long-term alpha opportunities, as it is under-researched and is largely driven by domestic retail investors who tend to have a shorter investment time horizon. We believe investors who have a disciplined bottom-up stock selection process and are willing to adopt a longer-term view and stomach the higher volatility will be richly rewarded in the long term.

Important information

This communication discusses general market activity or industry trends and should not be construed as investment advice. The economic and market forecasts presented herein reflect our judgment as at the date shown and are subject to change without notice. These forecasts will be affected by changes in interest rates, general market conditions and other political, social and economic developments. There can be no assurance that these forecasts will be achieved. Past performance should not be taken as a guide to the future, losses may be made. Investment involves risk. Investors are not certain to make profits.

Investec Asset Management and its subsidiaries only provide information about its capabilities, products or services. All of the views expressed about the markets, securities or companies in this communication accurately reflect the personal views of the individual fund manager (or team) named.

The mention of any individual securities / funds should neither constitute nor be construed as a recommendation to purchase or sell securities, and the information provided regarding such individual securities / funds is not a sufficient basis upon which to make an investment decision. All the information contained in this communication is believed to be reliable but may be inaccurate or incomplete. Any opinions stated are honestly held but are not guaranteed and should not be relied upon.

This communication is provided for general information only. It is not an invitation to make an investment nor does it constitute an offer for sale. This is not a buy, sell or hold recommendation for any particular investment.

In Hong Kong, this document is issued by Investec Asset Management Hong Kong Limited and has not been reviewed by the Securities and Futures Commission (SFC). The company website has not been reviewed by the SFC and may contain information with respect to non-SFC authorized funds which are not available to the public of Hong Kong. In Singapore, this document is issued by Investec Asset Management Singapore Pte Limited (company registration number: 201220398M).

Except as otherwise authorised, this information may not be shown, copied, transmitted, or otherwise given to any third party without Investec’s prior written consent. © 2017 Investec Asset Management. All rights reserved. Issued by Investec Asset Management, December 2017.