July 2023

Insights

The Good: Safe as (Industrial) Houses

The recent pandemic inflicted widespread pain across the economy with listed property not immune. Rentals, the lifeblood of property companies, were significantly reduced for tenants still in business or in many cases, simply went unpaid. Most developed countries extended financial relief to tenants and landlords which ultimately kept property companies on life support. As the worst of the pandemic passed and landlords were replenished with rental income, the life support was withdrawn.

Just as rentals are their lifeblood, vacancies are indicative of a property company’s health. Coming out of the pandemic, inflation spiked as government financial stimulus packages brought the economy back to life. Moderately high levels of inflation are very good for property companies in good health as they can raise rentals commensurately which ultimately leads to higher returns for shareholders. However, the weaker buffalos in the herd with critically high levels of vacancies begin to falter and are unable to command the same rental increases. Just as for most things in life, too much of a good thing regrettably has consequences. Increasing interest rates follow rising inflation which leaves the weakest in the herd vulnerable to elements. Higher rates without increasing rentals lead to lower property values and, for those that were already highly leveraged, the banks begin to demand their pound of flesh as the victims move perilously close to their debt covenant limits. Financial markets begin to value these companies accordingly.

Source: The Independent

As brutal as the seasons can be, they separate the strong from the weak and ensure they have a fighting chance going into the next drought. Office property proved to be the weakest in the herd as demand failed to recover to prior levels as the work-from-home trend gathered momentum. However, industrial property was a net beneficiary as eCommerce and the need to secure supply chains saw a surge in demand leading to significantly higher rentals. In addition, the strongest in the group had fixed their debt at low levels, increased their dividends paid to shareholders and were even able to sell properties above book value and recycle into value enhancing opportunities.

High Street’s property holdings across our funds and products are trading at high, sustainable yields with acceptable levels of leverage given where we are in the cycle. Wounded companies will provide opportunities to continue recycling their portfolios while we patiently wait for the strongest short-term driver of property share prices, the season of declining interest rates.

The Bad: China Disappoints

In the beginning of 2023 investors piled into Chinese equities with high hopes of a rebound in the Chinese economy after the stringent Covid restrictions were lifted. The Hang Seng Index rose 15% in in the first 4 weeks of January with Goldman Sachs making the case that this move was just the beginning.

Strategists believed that Chinese consumer spending would come roaring back, fuelled by savings accumulated during the drawn-out lockdowns. Hopes that the government would step in with large scale stimulus, as they had done so many times in the past, also buoyed optimism. Finally, expectations of an easing in the tensions between the US and China added support to the narrative.

Despite all this, the market rally was short-lived with the Hang Seng falling 20% from its peak in late January, sinking into a bear market at a time when many of the major global markets were creeping towards a bull market. While the Hang Seng has seen a partial recovery in the last week on renewed stimulus hopes, it has significantly lagged most major indices this year.

So why has China been so disappointing? Firstly, the economic data coming out of China has not been positive. The increase in consumer spending has failed to materialise as households appear to be saving more, likely scarred by years of economic disruption due to harsh zero-Covid policies. Secondly, the US-China relations remain strained with the US government downing a suspected Chinese spy balloon in February and recently ramping up restrictions on the export of advanced chips (used for cloud computing, machine learning, artificial intelligence, etc) to China in an effort to hamstring the region’s technological advancement. With this ‘heavy-handed’ export regulation China is at serious risk of falling further behind the US in the AI race, which leads to the next point.

US Big Tech vs China Big Tech has always been interesting. Due to their similarities Chinese tech firms – Baidu (search), Alibaba (retail), Tencent (gaming/social media) and Xiaomi (smart phones) – are often compared to Alphabet, Amazon, Meta Platforms and Apple in the US. Below is a comparison of their returns this year.

Source: Bloomberg & High Street Asset Management

US Tech has massively outperformed China Tech, driven by the AI growth story and in some cases, very effective cost cutting. This comparison also excludes both Microsoft and Nvidia, which have returned 42% and 220% respectively in 2023.

Last year High Street made the decision to implement a phased exit from China. We no longer have any exposure to China across our funds, bar our local balanced fund where we have exposure to Tencent through Naspers/Prosus. The decision has been successful to date with the Hang Seng Index underperforming the S&P 500 Index by 25% since the onset of the phased exit in June last year.

& You Khan’t Stop Tech Mergers

July dealt yet another blow to the US Federal Trade Commission (FTC) after a federal judge in California rejected their bid to block Microsoft’s $69bn acquisition of Activision Blizzard. The deal, the largest ever for a US tech company, had been in the crosshairs of FTC Chair Lina Khan because of its potential to harm competition in the videogame industry. Appointed by President Joe Biden, Khan rose to prominence with her aggressive stance on antitrust issues, particularly with regards to Big Tech’s expansion into other business areas. Her 2019 academic paper, “Amazon’s Antitrust Paradox”, argued that the eCommerce giant’s novel approach to conducting business had left antitrust legislation languishing behind the times.

Source: FT

However, the youngest FTC Chair in history has yet to make her mark on the regulatory landscape, with some major setbacks coming in recent months. The FTC was recently forced to abandon efforts to prevent Meta’s acquisition of virtual reality game company “Within”. They are also battling Illumina’s $7 billion takeover of cancer-screening specialist Grail, a case that was ruled against them last September. Their inability to block Microsoft’s purchase serves as a further roadblock in the way of Khan’s vision of antitrust enforcement. Despite the size of the deal, Judge Jacqueline Scott Corley’s ruled that the FTC failed to demonstrate that the merger “will substantially lessen competition”, particularly since Microsoft will keep blockbuster game “Call of Duty” open to all gaming platforms.

Ironically, some legal experts are hypothesizing that the ferocity of the FTC’s strategy might result in more tech mergers. The string of losses in court may actually embolden companies to pursue acquisitions now that they have been armed with the necessary tools to take on antitrust regulators in the future. As William Kovacic, former FTC Chair, emphasized, “If you want a durable change in policy and doctrine, you have to win cases.” While Khan’s commitment to an aggressive antitrust agenda appears to remain resolute, it is clear that this ruling in particular will have a broad-reaching impact on her efforts reign in Big Tech in the future. High Street funds continue to have a broad exposure to these companies, whose growth and profitability profiles we expect to continue to drive share price performance in the future.