CIO Report: Q1- Q2 2016 - NZ Funds Management

CIO Report: Q1- Q2 2016 - NZ Funds Management

CIO Report: Q1- Q2 2016 March 2016 disclaimer: please note that this report has been provided for information purposes only. the content of this doc...

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CIO Report: Q1- Q2 2016 March 2016

disclaimer: please note that this report has been provided for information purposes only. the content of this document is not intended as a substitute for specific professional advice on investments, financial planning or any other matter. while the information provided in this document is stated accurately to the best of our knowledge and belief, new zealand funds management limited, its directors, employees and related parties accept no liability or responsibility for any loss, damage, claim or expense suffered or incurred by any party as a result of reliance on the information provided and opinions expressed in these portfolio insights except as required by law. please also note that past performance is not necessarily an indication of future returns. for further information or to request a copy of the nz funds managed portfolio service investment statement or the nz funds kiwisaver scheme investment statement, please contact new zealand funds management limited. nz funds is an active investment manager. accordingly, any securities discussed in this report may or may not be held by the portfolios and strategies at any given point in time.

2

First quarter review Each quarter we include a section on investment returns. This quarter we thought it might be helpful to set out the returns of each portfolio we manage, year by year. Clients’ portfolios are of course made up of a diversified mix of the PIE portfolios set out below. Each client will own a unique blend, specific to (and changing with) their age, risk profile and investment objectives. When comparing our returns with term-deposits, or other sources of investment returns please note all returns are after fees and tax at the highest applicable tax rate*. The returns shown are therefore what clients should receive each year, less any fixed charge for their adviser’s time. Calendar returns to 14 March 2016 after fees and tax NZ Funds Managed Portfolio Service

YTD†

2015

2014

2013

2012

2011

Core Cash Portfolio

0.39%

2.33%

2.28%

1.83%

1.78%

1.82%

26.85%

28 Feb 2008

Core Income Portfolio

1.04%

1.69%

3.89%

2.31%

5.92%

2.82%

31.28%

23 Jul 2008

Global Income Portfolio

1.26%

0.74%

3.04%

1.58%

5.16%

2.21%

24.88%

31 Oct 2008

Core Inflation Portfolio1

-0.98%

0.32%

9.47%

4.12%

9.03%

1.92%

42.44%

31 Oct 2008

Property Inflation Portfolio

-2.00%

7.00%

13.48%

1.92%

17.66%

-5.56%

42.05%

31 Oct 2008

Equity Inflation Portfolio1

-0.18%

6.31%

13.95%

8.89%

6.50%

-0.44%

108.07%

31 Oct 2008

Core Growth Composite Strategy2

-5.68%

2.91%

5.79%

24.85%

13.05%

-9.09%

89.34%

1 May 2003

Global Multi-Asset Growth Portfolio3

-0.69% -20.14% -15.50%

-2.05%

-3.23%

-

-38.16%

7 Nov 2011

Global Equity Growth Composite Strategy2

-7.05%

5.94%

12.60%

22.32%

15.00% -12.51%

121.90%

6 Mar 1996

Dividend and Growth Composite Strategy2

2.16%

12.22%

14.98%

3.63%

18.41% -10.04%

326.94%

2 Dec 1992

-6.86%

3.73%

9.01%

12.47%

20.61%

13.51%

79.94%

23 Jul 2008

NZ Funds KiwiSaver Scheme

YTD†

2015

2014

2013

2012

2011

KiwiSaver Income Strategy

1.24%

1.01%

3.43%

2.01%

5.64%

2.56%

17.02%

31 Oct 2010

KiwiSaver Inflation Strategy

-0.82%

1.29%

10.72%

5.27%

8.66%

-0.27%

26.99%

31 Oct 2010

KiwiSaver Growth Strategy

-7.75%

4.70%

9.88%

26.12%

15.15% -10.61%

37.87%

31 Oct 2010

Term deposit index4

YTD†

2015

2014

2013

2012

2011

Six month term deposit rates

0.46%

2.78%

2.60%

2.65%

2.82%

3.06%

Capital Opportunities Portfolio

Since inception† Inception date

Since inception† Inception date

Since inception† Inception date -

-

* The tax rate applied is either the highest PIE tax rate (28% or 30%) or the highest corporate tax rate (33% or 30%) applicable during each return period. † Year to date and since inception returns are to 14 March 2016. 1 Performance is measured since the launch of the APS platform (now known as NZ Funds Managed Portfolio Service) on 31 October 2008. The post tax since inception returns for the Core Inflation Portfolio and the Equity Inflation Portfolio include the benefit of formation tax losses under the PIE rules. 2 The Composite Strategies are used to illustrate the long-term performance of the investment approach used in managing the Portfolios. They do not represent the historic returns of the Portfolios, nor are they indication of the future returns of the Portfolios. The Composite Strategies are tax-adjusted to remove, as much as possible, the impact of the different tax regimes that applied during the calculation period. 3 The inception date shown is the inception date of the current investment strategy. 4 Source: RBNZ, NZ Funds Calculations. The highest marginal personal tax rate was used in these calculations. Pre tax returns are stated after Portfolio fees and expenses, but before any advisory fees or investor tax. Post tax returns are stated after Portfolio fees and expenses and investor tax at the highest Prescribed Investor Rate (PIR). From 1 October 2008 to 30 September 2010 the highest PIR was 30%. Since 1 October 2010 the highest PIR has been 28%. Past performance is not necessarily an indication of future returns.

3

Investment themes for 2016 Following seven years of economic recovery, financial markets have entered a period of higher volatility. Much, if not all, of the volatility stems from concerns over China’s growth and oil prices. China represents the third wave of the Global Financial Crisis. Unlike many downturns, the Global Financial Crisis is a debt-related crisis. It originated in the United States, through excessive borrowing and aggressive ‘sub-prime’ lending. It was resolved by recapitalising the American banking system in 2009. However, it then spread to Europe in 2011, where successive governments of Portugal, Ireland, Greece and Spain had over borrowed. This led to a period of European Union imposed austerity which saw unemployment rise and countries question the merit of their European Union membership. Throughout this period, in order to maintain its growth rate, China borrowed heavily to build everything from highspeed rail links to entire cities. China’s trading partners, riding on its coat tails, earned nicknames such as ‘the lucky country’ (Australia) and ‘the rock star economy’ (New Zealand). In recent years however, China’s ability to borrow and build productive assets appears to be reaching a natural limit. It is the Party’s hope that as state spending declines, China’s growing middle class will fuel economic growth by embracing small luxuries, like lattes and cinema tickets. Asia - The third wave

$300 United States shares

United States housing crisis

European shares

European sovereign debt crisis

Emerging Market growth crisis

Emerging Market shares

Value of $100 invested

$250

$200

$150

$100

$0

2005

2006

2007

2008

2009

2010

2011

2012

2013

2014

2015

2016

Source: S&P 500, Euro Stoxx 50 Index, MSCI emerging markets index. All values in United States dollars.

We recently travelled to Hong Kong to learn more about the problem first-hand. During the course of the week we spent a day with the management teams of the two largest casino operators in Macau, attended the two-day Global Macro conference along with 2,000 others, and had a series of one-to-one meetings with some of the top local investors. In the first quarter the investment team, overseen by our Investment Committee (which is chaired by NZ Funds Chief Executive, Richard James and attended by senior members of the firm and from time to time our independent director, Greg Horton) began an intensive review process. To date we have reviewed: the universe of specialist managers we work with (earmarking two for redemption and one for inclusion); the weight to each major asset type; and the investment case for each individually held bond and share. We expect the process of discarding investments where the upside potential is limited and reinvesting the proceeds into more of the most compelling investments clients already own, will in time add to client outcomes. The following is a short synopsis of our views following our research trip and internal review process:

4

China China faces slowing growth and rising debt. Over a decade of excessive infrastructure spending and urbanisation has created a property bubble which is now correcting. Economic growth is reported to be approximately 6%, but is estimated to be 1-2% less than reported. Most importantly, growth continues to slow as rising consumption is still insufficient to offset declining infrastructure spending. In the short term, China must also contend with a fixed exchange rate which is too high. If the People’s Bank of China allows the Chinese currency to devalue, it will put pressure on a large number of Chinese companies which have borrowed offshore (it would increase their debt burden). On the other hand, a high exchange rate hurts China’s exporters that are major contributors to GDP. We believe the problems in China are more significant than many think. China needs to reduce its debt by either realising non performing loans and sharply devaluing its currency, or by facing a longer period of weak economic growth, much as Japan did. Either way, in the short term, the risks of further meaningful downside are too high for a long-term allocation to the region. Asia - The great fall of China 16% Reported growth rate

14%

Estimated true growth rate

Annual GDP growth

12% 10% 8% 6% 4% 2% 0%

2002

2004

2006

2008

2010

2012

2014

2016

Source: National Bureau of Statistics of China, NZ Funds estimates.

Asia - How much debt is too much? 300%

250%

Debt to GDP

200%

150%

100%

50%

0% Japan 1990

Thailand 1997

Argentina 2001

Greece 2011

China 2016

Source: National Bureau of Statistics of China, NZ Funds estimates.

5

Japan Japan represents an exception to this rule. Whereas China faces a strong growth hangover, Japan is only now emerging from three decades of price and cost cutting. We think Japanese shares are two or three years into a multi-year period of strong share price appreciation fuelled by rising domestic demand, improving profit margins and shareholder friendly corporate governance reforms. After outperforming many developed markets over the last 12 months, the average Japanese company still only trades on 13x earnings or a 10% premium to book value. In contrast, many American, European and Australasian companies are valued at twice that level or more. No capital gain comes without challenges, and Japan certainly has those. Japan must contend with an aging workforce although it has higher female workforce participation than America, Europe or even New Zealand. It is also vulnerable to a slowdown in China but that is in part mitigated by strong internal consumption that makes up 58% of its GDP. Despite these challenges, we are growing increasingly optimistic about the long-term upside potential in Japanese shares. Governance reforms help drive shareholder returns to record levels ¥25t

6%

Return on shareholders’ equity

5%

¥20t

4% ¥15t 3% ¥10t 2% Dividend payments (rhs)

¥5t

1% Buyback (rhs)

¥0t

0% 2006

2007

2008

2009

2010

2011

2012

2013

2014

2015

2016E

2017E

2018E

Note: Based on TSE1-listed 1,816 firms with consolidated data available from March 2009. For periods prior to March 2009, calculation is based on available data. Source: Toyo Keizai, QUICK, FactSet, Goldman Sachs Global Investment Research and estimates for 2016-2018.

Japan - Largest portfolio holdings

Company

Sector

Forecast Earnings Growth

Forecast Dividend Yield

Expected Return

Fast Retailing

Retail

21.0%

3.8%

24.8%

Nippon Telegraph & Telephone

Telecommunications

10.2%

5.0%

15.2%

FANUC

Industrial Robotics

-5.1%

5.4%

0.3%

SoftBank

Telecommunications

10.0%

3.4%

13.4%

KDDI

Telecommunications

8.0%

5.0%

13.0%

Source: Bloomberg, NZ Funds calculations at 8 March 2016. Includes $31m notional Nikkei 225 futures exposure. All values in New Zealand dollars.

6

New Zealand We believe New Zealand is more vulnerable to a slowdown in China than many would like: we face a flattening in Christchurch rebuild spending; milk prices that are meaningfully below the long-term sustainable price for production; the potential for rising unemployment; and in Auckland, a residential property bubble. Helping to offset this we have low interest rates, a weak exchange rate and strong positive net migration. We have selectively increased our exposure to New Zealand shares favouring large essential spend–orientated blue chip companies with strong dividend yields. We continue to avoid commodity orientated companies without pricing power (such as Fonterra Co-operative Group) and discretionary consumer orientated businesses (such as Sky Network Television). We also own very few small capitalisation companies which are dependent on earnings growth, rather than dividend payments, for delivering shareholder returns. New Zealand - Economy mixed

+65k Immigration at record highs

4.5% Mortgage rates at record lows

-38% Dairy prices below production cost

30% Auckland housing overvalued

5.3% Unemployment lowest since 2009

-23% Weak exchange rate since July 2014

Source: Bloomberg, NZ Funds calculations.

New Zealand - Largest portfolio holdings Client Holdings

Forecast Earnings Growth

Forecast Dividend Yield

Expected Return

Chorus

$34m

2.9%

7.4%

10.3%

Meridian Energy

$29m

3.5%

9.0%

12.5%

Metlifecare

$27m

10.7%

1.3%

12.0%

TrustPower

$12m

4.6%

7.4%

12.0%

Z Energy

$12m

4.7%

6.7%

11.4%

Company

Source: Bloomberg, NZ Funds calculations at 7 March 2016. Forecast Dividend Yields shown gross of imputation credits.

7

United States/Global Economy Despite the weak start to the year we see little wrong with the United States economy, or Europe’s. Economic growth is forecast to be between 2.0 – 2.5% which is in line with the average since 2009. And while market sentiment is sensitive to news on oil and China, most listed American businesses are not. United States corporates generate 65% of their revenue from selling to Americans who currently enjoy rising employment, rising wages and a boost from lower oil prices. Consensus is for around 5% earnings growth from listed American companies, little or no change in margins and a slight contraction in valuations caused by a gradual rise in United States interest rates. This would result in returns in the 5-10% range. Valuations remain of moderate concern; in Europe and America they are generally toward the top end of fair (arguably lower end of expensive), however markets can remain at these levels for many years without “correcting”. We continue to own a long-term index orientated exposure to American and European companies, but given higher than usual valuations we have increased the proportion of clients’ assets managed by experts in the region. Three such specialists are: Kynikos Associates, who adds value by shorting the weakest shares in an index, rather than owning more of the strongest shares in an index; LSV Asset Management, which was founded by three famous academics who decided to manage money based on their research and now oversee US$82 billion using their value approach; and New York based hedge fund, Suvretta Capital Management, which has delivered returns of 8.6% per annum since NZ Funds first invested in October 2014, despite considerable share market volatility. World credit growth = GDP growth 16%

United States Europe Japan

14% 12%

Annual credit growth

10% 8% 6% 4% 2% 0% -2% -4% -6%

2000

2002

2004

2006

2008

2010

2012

2014

Source: International Monetary Fund.

United States/Global - Largest portfolio holdings Client Holdings

Forecast Earnings Growth

Forecast Dividend Yield

Expected Return

Johnson & Johnson

$5m

5.2%

5.1%

10.3%

Microsoft

$4m

4.9%

5.0%

9.9%

Twenty-First Century Fox

$4m

-2.1%

3.1%

1.0%

Total

$4m

-33.0%

8.7%

-24.3%

Pfizer

$3m

3.9%

6.1%

10.0%

Company

Source: Bloomberg, NZ Funds calculations at 31 December 2015. All values in New Zealand dollars.

8

Corporate Bonds Following the Reserve Bank of New Zealand’s surprise interest rate cut it is also worth discussing the merit of corporate bonds. Corporate bonds have been promoted as a handy way to earn a premium over term deposits. And ordinarily this is the case. However, few clients are aware that approximately 50% of the 200 individual bonds on issue in New Zealand yield less than term deposits! We feel owning some of these bonds is like picking up pennies in front of a steam roller. To illustrate how expensive New Zealand bonds have become, clients can purchase investment grade rated bonds issued by some of the largest companies in the world, such as Apple or Verizon Communications, and earn 1 or 2% more in interest per annum after hedging all exchange rate risk out – which is exactly what we have been doing on clients’ behalf in their income orientated portfolios.

United States - How do United States Investment Grade bonds compare? 10% United States corporate bonds hedged into NZD - current average yield 6.3%

9%

United States corporate bonds - current average yield 4.3%

8%

New Zealand corporate bonds - current average yield 3.3%

Interest rates

7% 6% 5% 4% 3% 2% 1% 0%

2003

2004

2005

2006

2007

2008

2009

2010

2011

2012

2013

2014

2015

Source: S&P; NZ Corporate Bond Index; Juli Corporate Bond Index; Bloomberg; NZ Funds estimates.

United States/Global - Largest portfolio holdings Client Holdings

Credit Rating

Bond Expiry Date

New Zealand dollar yield

Apple

$8m

AA+

9 years

4.7%

Oracle

$8m

AA-

9 years

4.7%

Verizon Communications

$7m

BBB+

8 years

5.1%

QBE Capital Funding III

$6m

BBB

25 years

7.1%

Macy’s Retail Holdings

$5m

BBB+

8 years

6.5%

Company

Source: Bloomberg, NZ Funds calculations at 4 March 2016. All values in New Zealand dollars.

9

Themes for 2016 The investment focus for 2016 falls under six themes. First, an increased allocation to strong dividend paying, large market capitalisation New Zealand shares. This underwrites a core level of return in the inflation and growth orientated portfolios, dampening any share market decline, and aiding any share price appreciation. Second and third, clients’ international growth assets are predominately invested in the large developed markets of United States, Europe and Japan and underweight China. Fourth, we have increased clients’ exposure to international investment grade bonds to take advantage of their premium over locally issued bonds. Fifth, we will be actively managing clients’ exposure to the three asset classes we expect above average volatility from: interest rates, foreign currencies, and oil. Finally, we will continue to partner with a range of international specialists, including down-side orientated hedge funds, to seek to capture asset price appreciation and mitigate periods of downside volatility. Investment themes

According to Chinese astrology 2016 is the year of the fire monkey. The fire monkey is ambitious, adventurous, and from time to time irritable. We expect financial markets to be much the same this year. Thank you for investing with us, and for your continued confidence.

Michael Lang, CFA Chief Investment Officer

10

New Zealand Funds Management Limited Auckland Level 16, Zurich House 21 Queen Street Private Bag 92163, Auckland 1142 New Zealand Phone 09 377 2277 [email protected] www.nzfunds.co.nz Follow us on twitter.com/nzfunds Wellington

Christchurch

Timaru

Level 3 Central on Midland Park 40 Johnston Street Wellington 6140

Unit 7a 9 Sir Gil Simpson Dr Burnside Christchurch 8053

Level 1 2 Sefton Street East Timaru

Ph. 04 473 7701 jude.laurenson @nzfunds.co.nz

Ph. 03 366 9088 chris.wasley @nzfunds.co.nz

Ph. 03 683 1989 stephen.mcfarlane @nzfunds.co.nz

Wanaka

Dunedin

Invercargill

Unit 7 12 Frederick Street Wanaka 9305

Level 2 Bracken Court 480 Moray Place Dunedin 9016

98c Yarrow Street Invercargill 9810

Ph. 03 443 2300 andrew.mackenzie @nzfunds.co.nz

Ph. 03 477 4647 peter.ashworth @nzfunds.co.nz

Ph. 03 218 2895 nicki.morsink @nzfunds.co.nz