A thirst for multi-disciplinary knowledge, plus a balance of critical thinking and humility: these are the keys for investors looking to outperform their peers. That’s according to fixed income portfolio manager Desmond Soon of Western Asset Management Company, a subsidiary of Legg Mason Global Asset Management.
The Singapore-born and -based Soon is a firm disciple of Howard Marks’s ‘second level thinking’. ‘Howard Marks puts it very clearly and insightfully in his newsletters,’ says Soon, who is also head of investment for Asia ex. Japan at Western Asset. ‘You have to think out of the box and you have to think contrarian. But at the same time, you must be mostly right; you can’t be just contrarian and wrong.
‘It is a very difficult skill to acquire. Figure out what other people are thinking, and then the effect on the market via George Soros’s theory of reflexivity, and then ask what if the majority are wrong. That constitutes level-two or level-three thinking, which is rare.’
Relying on such critical thinking, Soon’s Legg Mason WA Asian Opportunities fund has returned 11.34% in US dollar terms in the five years to September, against the average sector manager’s 7.76%.
A philosophical approach
Soon’s portfolio focuses on extracting the highest yield balanced with credit quality.
‘Our highest conviction continues to be an overweight in USD Asia BBB-rated investment grade corporate bonds. For the government bond space, we have been overweight India and Indonesia,’ says the manager, who has more than 20 years’ experience in investing.
‘In the past six months, we have gradually increased our offshore Chinese yuan (CNH) Dim Sum bond holdings to a significant overweight. Contrary to popular belief, we think the yuan will outperform and the 4% yield on short-dated papers is attractive.
'We have been substituting our long-dated Indonesia government bonds allocation with shorter-dated quasi-sovereign Indonesia rupiah bonds given the strong government bond rally.’
Moving forward, Soon says that his team continues to evaluate all eligible bond issues despite the fact that JACI (the JP Morgan Asia Credit Index) market capitalisation has reached $700 billion with 480 issuers. ‘Since we are not benchmarked to credit indices, we can afford to cherry-pick what we would like to analyse and hold,’ Soon says.
Pulling into port
Soon names Indonesia Port Corporations as an example of a bond issuer he is backing. The company is wholly owned by the Indonesian government and is the largest port operator in the country, with 45% market share of container traffic.
Indonesia Port Corporations owns and operates the country’s largest and most strategic port – Tanjung Priok.
'Its solid credit fundamentals are underpinned by its leading market position and high strategic importance as part of Indonesia government’s push for marine infrastructure development,’ Soon says.
‘The firm’s liquidity position was strong with $1 billion of cash on hand versus negligible short-term debt until December 2016.
‘A considerable proportion of revenue is from rental income, which mitigates potential earnings volatility and capital expenditure relating to building new ports.’
Soon also holds other quasi-sovereign Indonesia issuers such as Pertamina Persero PT and Indonesia Eximbank.
When it comes to market outlook, Soon’s base case is for the global economy to recover gradually at a fairly lacklustre pace, as the major central banks gradually move away from ultra-accommodative policies.
The low inflation environment provides central banks with considerable policy latitude, he explains.
‘There will be hiccups – for example, geopolitics and uncertainty over US interest rate policy under the new Federal Reserve chairman Jerome Powell,’ he says.
However, the demand for emerging markets fixed income is likely to remain robust on the back of persistently low yields in developed world bonds.
‘Demand for stable, certain income is likely to grow given ageing demographics in the developed world and benign inflation trends, as we can see from the Japan experience.’
Since tapering, investor flows have been focused on US dollar-denominated bonds, with the expectation that the strong US economy and higher federal funds rate will push the US dollar higher and higher. This year, there has been a rude awakening; despite all the negative rhetoric, total returns from Asia FX have appreciated by between 6% and 9% against the dollar.
Soon attributes this to three key factors. First, he identifies a doubling of the region’s current account surplus due to the drastic fall in oil prices and foreign investor flow into Asia equity markets.
Second, the weakness of the US dollar has also contributed to this, as a result of the fact that Trump’s large tax cuts and huge fiscal stimulus promises have so far failed to materialise.
Finally, Soon points to the failure of macro hedge funds to be effective in FX ‘fundamental’ trades. ‘If this trend continues, next year could be another banner year for Asia FX and bonds.
The renminbi is anchoring Asia FX, and Chinese investors are buying Asia dollar bonds,’ he says. However, Soon is cautious about the potential sources of risk out there. ‘Of course, North Korea is a major uncertainty. In Europe, you have Catalonia trying to break off from Spain, and you could have the elections in Italy throwing up the Five Star Movement, which may try to leave the eurozone. So there are lots of uncertainties out there.’
There has been much talk about the prospect of an interest rate hike from the Federal Reserve in December. Soon points to the fact that the outgoing Fed chair Janet Yellen has indicated that she prefers to raise rates before waiting for inflation to hit 2%.
‘She views her legacy as beginning the unwinding of ultra-accommodative policy in a gradual, non-disruptive manner,’ he says.
Shaking things up
Having come through the Asian crisis of 1997 and the global financial crisis of 2007-2008, Asia’s bond markets have experienced their fair share of upsets. Even now, there are some major trends making waves.
Globalisation and the rise of information technology have given investors instant access to financial news, information and analysis. As Soon points out, macro hedge fund managers have been left asking ‘“What advantage or value do I add, because I’m not the only smart person out there and I’m not the first person to get this piece of news?”
‘There are so many smart people and they are all looking at the same piece of news and analysis.’
Another change is the increasing popularity of ETFs. Due to the growing ETF trend, real money investors like Soon and his peers wonder what will happen to their penchant for detailed stock and credit analysis.
‘I see this ETF phenomenon as still growing. It’s going to push value investing and stock and credit analysis further out of the window,’ Soon says.
However, he adds: ‘That said, there will be a huge opportunity for people who are on the value, fundamental research-driven side to some stage take the contrarian bet against this herd mentality. I think it has been “herd aggregation” via investors
flocking into ETFs, which is yet to be tested in less liquid products such as emerging market debt in a severe market downturn.’
In the 1990s, the US, Japan and Germany were the major markets influencing worldwide trading. However, the rise of China has changed all that. ‘When China sneezes, the world catches a cold,’ Soon says.
What’s more, following the global financial crisis of 2008, major central banks such as the US Federal Reserve, the Bank of Japan and the European Central Bank implemented negative interest rates and conducted quantitative easing programmes to support the fragile recovery.
Today, negative yield government bonds globally exceed $10 trillion and the major central banks hold more than $12 trillion in assets.
As Soon knows all too well, playing a changing world like this certainly requires plenty of second-level thinking.
Soon says he doesn’t think it’s possible to single out a stable approach to investing: otherwise the algorithms could replicate and beat you. ‘Investing is multi-faceted, multi-dimensional and an interactive process where market participants can sometimes change financial reality.
‘You need to toggle between many disciplines, facts and figures. You need to be able to filter out the noise and focus on the key variables,’ he says.
‘Even more important than your analytical skills, you must have the humility to accept new facts, views and reality, and change direction when you have ascertained that you are likely to be wrong.’
This article appeared in the November issue of the Citywire Private Wealth magazine.