Equities
Nick Grove

Trade wars, Brexit, "the Donald" and his tweets, market volatility – there's a lot going on in the world at the moment. At the Future Generation Investment Forum, Australian Financial Review columnist Tony Boyd sat down to get Hamish Douglass' read on the current situation.

"There's obviously a lot of noise going on and as an investor you have to kind of distinguish between the noise and what's really relevant," Douglass says. "So how do you distinguish between this and what's really going to drive markets and drive economies?"

The Magellan Asset Management chairman argues there are two major issues that he is focused on once he has filtered through the headlines.

Issue 1: The US-China trade war

"We've now got a very large emerging nation who is challenging the United States for economic supremacy and military supremacy in the world, and it’s never faced a foe like this before – the Soviet Union was never an economic foe," Douglass says.

"So, they sort of fought proxy wars in Afghanistan and Vietnam and other places. But now they've actually got a foe that can challenge them economically."

Douglass says that he doesn't think Trump is right about a lot of things but that he is right about the core issue in the trade dispute – and that is China fighting the trade war on unfair terms.

"They have been stealing intellectual property, they’ve been requiring foreign companies who come to participate in their massive market to effectively transfer their intellectual capital as a cost of doing business," he says.

"If they can't get it they go and steal the technology through cyber theft, and they have massive state-owned enterprises who get huge subsidies and they use those subsidies for taking market share on a global scale.

"So, that is a very, very real issue and they're trying to reset that relationship."

Douglass also referenced China's Made in 2025 plan, which outlines a list of industries it wants to dominate in the future.

"And that list of industries is absolutely incredible – it includes autonomous vehicles, AI, quantum computing, 3D manufacturing, aircraft, spacecraft – a fascinating one is deep-sea space stations (?!). I didn't even know there were such things as deep sea space stations! But I guess if you want to own the moon, you might as well own under the rest of the planet here."

"So, they've got very big ambitions, but the big question is: Is Trump just doing this for political purposes, or is he doing it because he really wants to reset the relationship? It appeared up until two weeks ago, it looked like it was just a deal to be done and to protect his stock market," Douglass says.

"It's become a little more uncertain in the past few weeks whether or not this is actually going to be resolved. We could get into a severe sort of trade war, a cold war environment, or we could actually have it settled.

"And it's very difficult to know which way this coin is going to flip. The markets are pricing that Trump is going to do a deal with President Xi – that's what the market environment is. Obviously, it's got a little bit jittery over the past couple of weeks, but still the assessment of markets is a deal is going to be done."

Douglass said Magellan's best assessment is that this is the most likely outcome, but there are political overlays, such as what is going to be the best thing for Trump going into the US presidential election in 2020.

"So that whole issue is taking up a lot of our time and we speak to a lot of experts in Washington and China, and other places, assessing what the pulse is at the moment."

Issue 2: The Fed and the "gravity of markets"

The second big issue that Douglass discusses – which he says is the more important of the two issues – is what's going on with US monetary policy. And the reason he says it's so important is because when you're an investor, you have to make an assessment about where interest rates are going to be in the future, because risk-free interest rates effectively set the discount rate.

"Warren Buffett refers to interest rates as the 'gravity of markets' – when interest rates are low, assets are worth more and when interest rates are high, assets are worth less. And historically, you could normally go to some very liquid bond markets like the US long term Treasuries and the German bunds and it would tell you what that risk-free rate was," he explains.

"You would add a risk premium and you would use 8 or 9% as your sort of discount rate, and all you had to do was try and forecast cash flows between now and Judgement Day – that's not easy by the way!

"But now we've got two moving parts. The market doesn't really know what the discount rate is anymore, because the central banks came in with massive monetary printing exercises known as quantitative easing. (And they have taken these rates in Germany down to 0% - do we really think interest rates are going to be 0% indefinitely?)

"And in the United States long term rates are 2.5% to 3%. And I can tell you if interest rates are 2.5% to 3%, most equities in the world are currently a bargain, but if they go back to where they were sort of were historically, around 5%, most markets are pretty expensive at the moment.

"So, this is why this is such an important topic. And when we went into December last year, the Federal Reserve had a pretty steady program of increasing interest rates and they said there would be more gradual interest rate rises this year and we were factoring that into our thinking.

"And in January they did a backflip and said, 'We're not going to do that anymore.' And a big question you have to ask about the future is: where are inflation and growth going to be, because that's going to factor into this equation.

"So, we spend a lot of time thinking about that and assessing whether markets and assets are attractively priced or not."

The race of the robots is on … and the stakes are high

Boyd then went on to ask Douglass what he thought about a question posed by The Financial Times earlier in the week: Are we going to end up with two separate 'strategic technological silos' in the world, in other words, those supported by the US and those supported by China?

Will we get to a point where investors and countries really have to decide which "silo" they back – or can you back both, sure in the belief that ultimately the most efficient and most powerful capital investor, which Boyd thought was looking to be China, will win?

Douglass was quick to point out that he wasn't sure that China was sure to 'win' at the moment. However, he agreed with Boyd that we were entering a world dominated by two technological silos.

"The Chinese internet has 'the Great Firewall'. So, you can't actually participate in China as a western firm if you're in there and they've banned a lot of players from being in that market – and it's a very, very important market and it's literally a completely separate world."

But Douglass believes the biggest race between the US and China will be the race for ascendancy in two areas of technology, the first of these being in quantum computing and the second being in artificial intelligence.

"Whoever wins the race for quantum computing can effectively decode any cryptography in the world. And that means if you had a nation which had a true quantum computer developed before another nation, they could effectively break in and control the whole nuclear arsenal of the other nation," he says.

"And if you think about the next phases of AI, we've got something now known as narrow artificial intelligence. When you go on Netflix and you get the films recommended to you, what you get recommended and what I get recommended … that's just artificial intelligence. It's just learning what you watch and your habits and knowing things about you. Facebook, what you get in your news feeds, is just narrow artificial intelligence.

"What the next stage is of AI is something called 'artificial general intelligence' and that is some way off in the future, but whichever nation or enterprise who gets there first has such a significant strategic advantage – as in it's astronomical, the advantage it would cause.

"And there is an arms race – China is putting ridiculous amounts of capital behind quantum computing and AI. I think the US is waking up, but they're putting only $1 billion into quantum computing at the moment … there's a very, very big game going on here."

Facebook: still an incredible business

Continuing on the subject of the evolution of these new global tech silos, Boyd put to Douglass that Magellan's top 10 holdings were dominated by US tech firms, and that Boyd saw the biggest threat to these firms being regulation.

And a political pressure mounts on the likes of Google and Facebook given the power that they wield – with Prime Minister Scott Morrison reported to have held a "toxic" meeting with the Australian head honchos of both Google and Facebook in the wake of the Christchurch massacre – Boyd questioned whether these firms were becoming "too arrogant" and were likely to either be broken up or put in a far less favourable commercial position.

Douglass said this was also a topic that he and his team at Magellan spent a lot of time on, reiterating that he spent a lot of time in Washington gathering information.

"We're really trying to stay on the pulse of regulation. We've got some very big positions in Alphabet and Facebook, which I would say are at the front end of this. We've got Microsoft, not quite in the same zone, and Apple, in a slightly different position," Douglass says.

"There's a whole series of regulatory issues that have to be grappled with. One is who is responsible for content on these platforms. At the end of the day, these platforms have billions of users, so there's 2.3 billion monthly active users on Facebook, there's 2 billion users on YouTube. So, they're putting up their content on these platforms, hundreds of millions of posts a day, if not billions depending which platform you're on.

"And therefore, when it gets put up, how do you make the judgement call that what is being put up is what is a real opinion?"

Douglass said a question surrounds whether world governments are going to turn these platforms into publishers, and that they therefore become totally accountable for what's going on.

"As far as we see in any jurisdiction we look at in detail, none of them want to turn them into publishers … but what they want to do is make them accountable to effectively get really bad content off the platform and do it really quickly, and have surveillance technology on their platforms to ensure they're monitoring this."

So, given this issue, in addition to election meddling, competition policy and privacy issues, and the issue of who personal data in fact belongs to, Douglass illustrated how multi-faceted the subject is. Nevertheless, he argues that while two of Magellan's investments are probably at the "pointy end" of these issues, a company like Facebook was still "one of the most incredible businesses of the 21st century".

"These businesses are incredible – it's the regulation you have to look out for. We're there because we know the businesses are fantastic, but we're wary about the regulation."

Boyd noted that Facebook should considered the session's stock tip.

On regrets, achievements and the magic of compounding

Asked by a member of the audience where Douglass hoped to see Magellan in five years, Douglass concluded by saying that he hoped that some of the seeds that the manager had in the ground today were on their journey of growth, aided by "the magic of compound interest."

Quoting US founding father Benjamin Franklin, Douglass quipped: "Money makes money. And the money that money makes, makes more money."

In wrapping up, Boyd snuck in two final questions for his guest.

Douglass' biggest regret? Misreading Tesco and Kraft-Heinz.

His greatest achievement: his family.



Comments

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SR V

"So, we spend a lot of time thinking about that and assessing whether markets and assets are attractively priced or not." So what is his current thinking? That would have been useful to know. I know Warren says markets are still attractive assuming interest rates stay at these levels - the Fed's dovish tilt makes that more likely. Whether they actually do is akin to predicting the future, which is an exercise in futility, so we are back to square one.