Churchouse Letter
September 2012        by Peter Churchouse

The Good Get Burned and the Bad Get Bailed.

The Fed and the ECB are Making the Virtuous Pay the Bills.

Inside This Issue:
Further rounds of quantitative easing persist on a low interest rate horizon — real assets and yield are key.
Our case for REITs remains strong, both in terms of recent performance and outlook.
Hong Kong asset prices: upwards pressure in the coming 2-3 years amidst tight supply and extremely low interest rates.
Portwood Portfolio: a quiet month, a small stake in a Singapore-listed software services & solutions provider.

“I accept that invitation to have higher asset prices, so I would go long more the real assets” including real estate. “The central banks are obviously putting a real penalty on holding cash and are trying to incentivize everybody into going into higher assets”. “They want asset prices to inflate”

So speaketh Lloyd Blankfein, CEO of Goldman Sachs (Bloomberg, Sept 19th, 2012)

It is a little over a year since the “Risk off/risk on” mantra became the central sound bite of financial media. Subsequently we have seen successive periods of “mood swings” by investors from one side of the fence to the other, prompted primarily by swings of views about the latest gyrations of the Euro crisis, and slightly less so by perceptions of the health of the US economy. For perhaps the first time the financial world is focusing on the role of China in supporting the global economy. China is on the one hand flattered, but also worried to have the eyes of the world upon it. The flattery element comes from a recognition that China now sits at the top table of the world economic superpowers. The concern comes with the responsibility that such stature brings.

Investor mood has been persistently gloomy over the past year but major markets have staged very significant rallies—on generally low volumes.

Whilst the prevailing mood has been distinctly gloomy over the past year, one could be forgiven, when looking at the charts of key stock indices, for thinking that markets and investor sentiment are truly “in the pink”. For example, the core US market indices are showing increases of approximately 30.8%, 24.7% and 34% since the markets hit a low in the last few days of September 2011 for the S&P 500, the Dow Jones Industrial Average and the NASDAQ Composite respectively. European markets have also enjoyed powerful moves since that time also, with the Euro Stoxx 50 up 27%, the FTSE 100 up 17% and the DAX up 41%.

“Yield” a Central Response to the “Risk-Off” mind-set.

Much has been made of the investor search for yield in an environment of extremely low interest rates and aversion to risk.

A central part of our response to the “risk off the table” environment in which equities moved out of favour has been to increase weights in yield producing vehicles, particularly those with lower risk profiles. With our focus on hard assets, we have made the case for investment in REITs in Asian markets. Our case has been that it is possible to assemble a pool of REITs that would be able to give a blended yield of 6% or higher from within the Asia/Pacific region. But as with any sector, not all REITs are created equal. Asset quality varies as does management, sector exposure, country exposure, legal and policy risk, and financial risk.

Investment in REITs has been a central part of our investment thesis over the past year.

While REITs are in fact listed equities that hold real estate assets, the legal structures that support REITs require them to pay out all (or almost all) of net profits to shareholders as dividends. Their business model, as holders of rental properties, makes for fairly stable and predictable earnings streams, and gearing restrictions in some jurisdictions make for lower financial risk than is often the case with other forms of hard asset vehicles. In a great many instances the beta of individual REITs and REIT indices is substantially less than 1, making these vehicles somewhat less volatile than most other equities.

And now that Mr. Bernanke has told us that zero rates will likely persist well out to 2014, the search for yield is likely to remain a core part of investor thinking.

The case for increasing exposure to yield vehicles is based fundamentally on a view that interest rates are likely to remain low for a considerable time in the current climate of recession in the Euro zone and sluggish, sub-par growth in the US. Pension funds, endowments, insurance companies all need to continue to find cash to meet their current liabilities, and low government bond yields simply do not allow them to meet these needs. Retail investors and retirees are in the same boat. It is this search for yield that has partly been behind strong currencies in Australia, New Zealand and Canada, where government bonds yields look attractive relative to other development markets. The Australian dollar carry trade has long been a favourite of Japanese investors.

The US Fed’s Mr Bernanke has told the world that US rates will stay low for a considerable time in response to subpar recovery in economic growth, and in a way this can be seen as punishing those dependent upon fixed income vehicles and instruments to fund their retirement livelihood. Low rates put such sectors of society at considerable risk, with potentially significant impacts on poverty levels for people dependent on such income.

Similarly, the ECB is embarking on a comparable strategy in Europe – flooding banks with low cost funds, driving interest rates down. While this is great news for borrowers, and all those people who extended beyond their means, it will prove harmful, perhaps devastating for those savers who perhaps did not stretch their financial envelopes.

Around the world REITs have been strong performers over the past year as risk aversion and yield themes have come to the fore.

The good get burned and the bad get bailed – all paid for ultimately by the taxpayer.

Is it any wonder that the German public is balking at being asked to bail out the basket cases in their immediate neighbourhood, when they see themselves as having led a fairly conservative, diligent, financial existence over the past decade or so.

As an aside, and as an indicator of German good sense and abstemiousness, average real wages in Germany have been virtually flat since the inception of the Euro. In countries such as Greece, Italy and Spain, real wages have risen by between 30% and 45% over the same time period. Germany has maintained competitiveness in this environment and increased productivity that has enabled the country to continue as an industrial and export power house. Other major European countries cannot make the same claim.

When all is said and done, despite the potential for mood swings from risk aversion to risk-on amongst the investment community, the reality of low interest rates in Europe and the US is likely to be with us for some time to come. In turn this is likely to produce a continued search for yield on the part of retirement funds, endowments, insurance companies and others with recurrent liabilities to fund.

Despite Apparent Appetite for Yield, Trading Volumes for REITs in Asia, the Most Obvious Higher Yield Vehicles in Public Markets Have Been Quite Subdued.…….But REIT Performance has Been Generally Very Positive in the Past year.

Japan’s REITs are the odd man out in the REIT space in major markets. Here they have underperformed the developer group.

Given the much talked search for yield that investment managers and any number of commentators focus on, I have been a little surprised at the relatively modest buying enthusiasm for REITs in the region. Volumes have not been huge at all. The performance of REIT indices both in the region and elsewhere has been decent over the past year. Since the middle of last year, which was when the “risk off” mantra started to gain currency as the Euro crisis deepened, REITs in Australia and New Zealand have significantly outperformed their respective national broader stock indices. In the case of these two countries perhaps this performance was not just driven by search for yield, but also by some easing of commercial property market concerns, easing of debt concerns for some companies, particularly in Australia , but also some expectation of strong currencies.

Similarly in Singapore and Hong Kong, REIT indices have significantly outperformed both the local broader property stock indices as well as the overall index. Yield does seem to have been a driver of performance of the REITs. However, policy measures to dampen rapid growth in home prices probably helped to dull enthusiasm for the property developer stocks in these markets.

Yields on residential property in Tokyo are very attractive when compared with JGB yields with spreads wider than most developed markets.

In western markets (USA, Canada and UK) REITs have also met favour with investors and have outperformed in each case during this period, in a very compelling way in Canada.

Japan is slightly the odd man out in the broader REIT/yield search story. REITs, although very much less volatile than the overall index, and the broader property stock index, have underperformed the property stock index quite significantly over the past year or so. The yield spread for REITs generally in Japan over the local 10 year bond has been in the range of 3% to 4%. On a bond yield of around 1.3% - 1.5%, this is a very substantial increase in percentage terms. Put in the context of virtually zero interest on the other great savings vehicle in Japan, post office savings accounts, the REIT spread looks even more attractive. And set against the current inflation rate of -0.4% (yes deflation), surely REIT yields in the range of 4% up to 6% should seem very attractive indeed for local investors...

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