On several occasions Arminius has outlined the difficult competitive landscape which Australia's big four banks have had to face since the GFC. Just recently, the most successful bank CEO of the last two decades has given us an update on the main competitive threats to the industry.

Jamie Dimon has been running JP Morgan Chase (JPM:NYQ) since 2004. JPM is the largest bank in the US with a market capitalization of $600bn, or four times the size of CBA, which is Australia's largest bank. During Dimon's tenure, the JPM share price has increased four-fold, comfortably beating the S&P500 accumulation index as well as the US financial sector. In particular, Dimon guided JPM through the GFC without material damage, because he kept its capital ratios high and avoided risky derivative positions.

Every year Dimon writes a letter to shareholders. This year's letter is a record 66,000 words, available here at JP Morgan Chase. Dimon spends five pages on the challenges facing the banking sector, which we summarize as follows:

• Shadow banks provide more credit to the US economy than regulated banks - USD18.4tn versus USD10.5tn. Lack of regulation means that shadow banks enjoy important advantages, such as lower costs, lower capital requirements, and lighter "know your client" and anti-money-laundering obligations.
• The size and strength of unregulated competitors in the banking sector is increasing as the giant tech companies expand into banking functions. For example, Alphabet (Google), Amazon, Apple and Facebook all have cash reserves in the billions as well as market capitalizations in the trillions.
• Fintech start-ups funded by deep-pocketed venture capitalists are trying to build their competitive advantages and capture market share in specific areas of banking services - such as payments, data management, and mortgage origination and approval - by creating products which are faster, cheaper, or intuitively simpler to use.
• Most bank information technology (IT) is based on legacy systems which have been linked together by subsequent patches and fixes, with the result that processes are slow and data cannot easily be shared across platforms. By contrast, modern cloud-based IT systems are cheaper, faster, more efficient and more flexible.
• Over the last twenty years, the importance of US banks as credit providers has steadily diminished due to these competitive disadvantages. Unless there is regulatory change, the market share of US banks will keep on shrinking.

In conclusion, we point out one risk factor which Jamie Dimon did not mention. The world's central banks are planning to introduce their own digital currencies over the next five years. China's central bank is already trialling its digital renminbi with ordinary citizens. In order to encourage individuals to quickly spend any digital renminbi that may be distributed as part of a stimulus package, the Chinese central bank is considering placing a used by ("must be spent by") date on the digital currency. The government can control when it can stop being used in order to encourage immediate consumption increases in the Chinese economy, as opposed to the stimulus recipients "saving" the digital currency. The implications for commercial banks are not yet known, but they are unlikely to be favourable.

What does all this mean for shareholders in the big four Australian banks? When the Australian economy reaches a post-coronavirus "new normal" in late 2021 or early 2022, the banks will still face the type of hostile environment which has kept their share prices below their 2015 peaks. We recommend that bank shareholders stick with the sector for another six months. After that, they should sell down with a view to re-deploying the proceeds into sectors with better growth potential.

Q.E.D.

In the month of March, global markets saw the rise in bond yields as investors worried about unmanageable inflation on the horizon. This has definitely shaken up global equity markets. And while inflation is a genuine concern that should be on the minds of investors, the market has overreacted. While we understand a cyclical economic upturn has just begun, we believe inflation will remain manageable in the short term.

In the video below, I explain why longer term, we have a high degree of confidence that the world will return to its low-growth, low-inflation, low-interest-rate environment.

On the basis that we believe interest rates will remain structurally low over the long-term, we are particularly excited about our holding in REA. There can be no dispute that Australian residential property markets are rebounding strongly, supported by very low interest rates in the context of an improving economy.

In the month of January, REA reported more than 128 million visits to realestate.com.au - and extraordinary feat, given a total Australian population of 25 million (including children).

And the long-term low interest rate environment also stands to benefit our alternative asset managers, Blackstone, KKR and Carlyle Group, as institutional investors outsource their investments to these major global platforms as the need for yield becomes increasingly acute. The structural shift in assets to the world's leading alternative asset managers will drive very strong earnings growth for many years to come.

Whilst inflation is a concern for investors, we believe that with the US still grappling with the COVID-19 pandemic, unemployment and low interest rates, inflation is a manageable concern. Therefore, we are selecting the companies that have a runway of structural growth ahead of them.

Edited transcript

What are your views on the recent surge in bond yields, which has caused some volatility in equity markets?

So, let me just take a step back and look at what's actually happening. We know that the global economy has just started to experience a meaningful cyclical economic rebound, and that will only continue throughout the course of this year and into next year as well as economies open up post-virus. We know that there's still plenty of stimulus about, both on the fiscal side and on the monetary side. So, that's created some degree of speculation that perhaps inflation will take hold and that's resulted in an uptick in bond yields. And so the chart that I've just shown here is a chart of the US 10-year government bond yield going back to about 2016.

You can see that 2016 to 2018 example where yields went up from 1.5% to 3%, and then more recently, yields have gone up from about 0.5% up to 1.5% over the last six months or so. That uptick in bond yields more recently has caused a bit of a stir in equity markets. We've seen some equity prices wobble a little bit. And the question of course is, is this the beginning of a real fly up in bond yields as a result of inflation, which is taking hold, or not? We certainly remain in the camp that that won't be the case. And as a result, we think that the market is really overreacting. Now, we could, of course, be wrong here, but let me tell you why we hold that view, and what I'll do is I'll break it up into a short-term view versus a long-term view.

Short term, it's almost as simple as there are still 10 million Americans out there who are looking for work who can't find it. There are 44 million Americans out there today who are still on food stamps and really struggling to make ends meet. These are not typically the types of conditions that result in really aggressive wage inflation. This analysis is also, for what it's worth, consistent with all the analysis we're seeing out of the major central banks, that the overwhelming consensus view is that this recovery still has a long way to go. So, that's the short-term perspective.

Longer-term, we really just take it back to thinking about some of these big long-term structural drivers, and we think about things like ageing populations, advances in automation, but really the big one is the degree to which governments are indebted, really as a result of funding all of these major fiscal stimulus packages. And that's really important. In our view, that's really going to place a lid on interest rates and stop them from increasing materially.

I'll just give you a simple thought experiment to illustrate this point. So, today, as a result of the gigantic fiscal programmes that the US has undertaken, their federal debt is about US$28 trillion.  Let's say the US 10-year yield increases from 0.5%, a few months ago, all the way up to 3%, right? So, that's an extra 2.5% interest rate, which, of course, drives up the borrowing costs for the federal government. Well, that's an extra US$700 billion that the federal government has to pay to service their debt that is otherwise not being used for fiscal spending.

So, all else being equal, taxes would have to be raised or spending would have to be cut. Both of these things are disinflationary. That's more than a three percentage point GDP negative fiscal stimulus each year for the rest of time. That alone would be enough to push the US back into recession, and frankly, the whole world back into recession. So, our argument, long term, irrespective of what happens in the short term, our argument is, we really struggle to see a world in which interest rates can remain higher for a sustained period of time, given that feedback loop it would have on all of the indebted governments out there who would have to service debt at much higher costs.

Then the final point I'd add is that if we use Japan as an example, the country has seen its interest rates falling from 8% down to zero over a period of 25 years. And I'm just showing that on the chart on the screen, there have been numerous instances over short periods of times where you've seen bond yields tick up sharply, whether it's 50 basis points, whether it's 100 basis points. It's happened a lot, but you zoom back out and the long-term structural trend in Japan, for a lot of the reasons that we've described, around ageing populations and increased government indebtedness, is really kind of a low-growth, low-interest-rate environment. And so that's where we think we're ultimately heading, notwithstanding the cyclical upturn that we're experiencing over the next 12 to 18 months and all the stimulus to go with it.

So, to summarise, interest rates aren't going to be a problem and will remain low for a very long time.

Yes, tht's certainly our long-term view, for sure. And so that's why we think it makes sense to own some of the long-term winners, some of the long-term, high-quality growers out there, like Microsoft,  Alphabet,  Spotify and  Tencent, for example.

But you do also own some names that are benefiting from this short-term cyclical economic rebound?

Yes, we do have some exposure in the portfolio as well. So, names like Visa and MasterCard, still have a wonderful long-term growth story. Obviously, there's still a lot of cash and check transactions that can and will be shifted to cards over time. There's US$18 trillion of that transformation still to happen. So, that's a great long-term growth story, but short-term, they're really going to benefit from the cyclical rebound and particularly the opening up of travel and international tourism, given the extent of the cross-border transactions that are tied to that.

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Disclosure: Montaka owns shares in REA, Blackstone, KKR and Carlyle Group.

As long-term investors in Taiwan we prefer to look at the investment flows by Taiwanese companies into China as an indicator of the state of relations and not media speculation regarding the prospect for military hostilities. If China were going to invade Taiwan it would have happened years ago.  The financial relationship between China and Taiwan is strong and growing. It is that financial relationship which will ultimately guide China and Taiwan to a sensible compromise regarding political differences.As long-term investors in Taiwan we prefer to look at the investment flows by Taiwanese companies into China as an indicator of the state of relations and not media speculation regarding the prospect for military hostilities. If China were going to invade Taiwan it would have happened years ago.  The financial relationship between China and Taiwan is strong and growing. It is that financial relationship which will ultimately guide China and Taiwan to a sensible compromise regarding political differences.

Taiwan has been in the news a lot recently, especially with media headlines highlighting the apparent threat of invasion by China.  In Australia we have seen this being used as a justification for increased military budgets in part to support the defence of Taiwan.  We have been investing in the market in Taiwan since it opened to international investors in the early 1990s.  Taiwan has some world class companies and was recently awarded four of the top one hundred places in the survey of global innovation published by Clarivate, not bad for a small island population of 23.5m people.  We expect to continue to invest in world class companies that are headquartered in Taiwan and prefer to focus on the flow of investment money that takes place between Taiwan and China rather than speculation about imminent invasion. 

April was a month of very mixed performance in the Asian region, by far the strongest market was Taiwan where the small to mid-sized stocks increased by 13.1% bringing the return over one year +75.8%.  The broader measure of market performance in Taiwan for large capitalisation stocks increased by 7.7% during the month of April and +82.3% over one year. This was despite "The Economist" announcing Taiwan as the most dangerous place on Earth.  "The Economist" was highlighting risks of military action by China to seize control of Taiwan.  While China has been increasing incursions into Taiwan's airspace, their way of testing responses, this is not anything new, China has a long history of this behaviour and we do not see this as the move towards an invasion of Taiwan.

In recent months we have seen China objecting to the United States Navy movements through the Taiwan Straits. In February there was tension between China and the United States when the destroyer USS Curtis Wilbur sailed through the Taiwan Strait, with China suggesting that the United States was undermining regional peace and stability.  The United States sends their Navy vessels through the Taiwan Strait on a regular basis in a show of support for Taiwan, this however is a token show of support. The official United States policy of formal defence of Taiwan ended in 1979 when it ceased with recognition of the Republic of China as "China" and started referring to it as "Taiwan". This change of status occurred when the United States recognised the People's Republic of China as "China" and all relations with Taiwan then became informal.  

Late in 2020 Beijing made an explicit warning that independence for Taiwan "means war".  China's Taiwan problem dates back to 1949 when the Communist Party seized control of the Mainland and the displaced Kuomintang (KMT) government relocated to Taiwan.  China has never renounced the use of force to take control of Taiwan, however, overt verbal threats of conflict are rare.  The current ruling party in Taiwan, the DPP previously talked about "independence", however, that word has been quietly removed from the narrative employed by the party. Relations with China tend to worsen when the DPP hold power and improve when the KMT hold power which is somewhat ironic given that the KMT were the original enemy of the Communist Party during the civil war that concluded in 1949.  We can expect better progress towards a form of political accommodation between China and Taiwan the next time the KMT hold office in Taiwan.

A good deal of the recent tension regarding Taiwan can be attributed to the former US Administration under Donald Trump due to increased military equipment sales and US Navy activity through the Taiwan Strait.  We expect the Biden Administration to adopt a lighter touch with respect to Taiwan. We have already seen Vice President Wang Qishan indicating to a delegation of US representatives that common interest outweighs differences with the United States.  A period of relative stability with respect to trade and an end to the arbitrary Trump imposed tariffs will be taken very positively by markets. 

Taiwan's President Tsai Ing-wen responded to "The Economist" headline assuring everyone that the government is fully capable of managing all potential risks and protecting Taiwan from danger. President Tsai went on the speak about responding prudently to regional developments and overcoming the challenges posed by authoritarian expansion in a reference to China without naming China. The equity market in Taiwan was much more interested in the news that the local economy grew by 8.16% in the first quarter, the fastest growth recorded in a decade and well above consensus expectations. The positive growth surprise was driven by stronger domestic manufacturing and demand for exports. Two of Taiwan's major semiconductor manufacturers have recently announced large investment programmes aimed at alleviating the worldwide shortage of semiconductors needed in the automotive industry and consumer products.  Taiwan is expected to achieve economic growth in excess of 5% for the full year of 2021.

The table shows officially sanctioned investment that have taken place by Taiwanese companies investing in China. From the start of 1991 to the end of 2020 there have been 44,400 investments from Taiwan into China totalling USD 192.4 billion.  By way of context, China received a total of USD 141 billion of foreign direct investment in 2019. Typically, "Hong Kong" appears as a major contributor to investment in China and this is usually money from Taiwan that has to be channelled via entities in Hong Kong.  China's official policy position is that Taiwan is a domestic province of China and therefore investment flows sourced from Taiwan should not be treated a foreign source of investment.

Source: Investment Commission, Ministry of Economic Affairs

While the annual flow of aggregate investment funds from Taiwan to China have slowed from the USD 14 billion annual peaks in 2010 and 2011, the figure in 2020 approached USD 6 billion and remains a substantial number.  It is also important to note that the 2020 level showed a substantial uplift from the 2019 number which was a response to the then President Trump's habit of surprise tariff restrictions being applied to China. For a while China was the predominant area of manufacturing investment by Taiwanese companies, the cost savings from manufacturing in China were too tempting to resist.  The rising cost of labour in China and then Trump's trade war prompted a sensible diversification of investments by the Taiwanese to ensure that China did not end up putting their supply chain at risk. The cost savings of manufacturing in China available a decade ago are much less pronounced in the current environment.

An example from our portfolio in Taiwan is Novatek Microelectronics, a leading fabless chip design company specializing in the design and development of a wide range of display driver integrated circuits required for sophisticated flat panel displays and audio/video applications for all digital devices.  We originally acquired our position in Novatek at an average price of TWD 102 in late 2018, those shares recently reached the TWD 600 level. We have taken profits along the journey and remain a happy shareholder in a business that is attractively valued especially versus global peers. We acquired the position on a p/e ratio of 11x, since then profits have expanded from TWD 6 billion in 2018 to more than TWD 20 billion in the current year, putting the company on 14x p/e and a net yield in excess of 4%.  Novatek has eight of their eleven global sales offices located in China, their relationship with China remains crucial to the prospects of the business.  Novatek opened their first office in China ten years ago.  Going forward, the company expects to achieve significant growth in Japan and South Korea in addition to ongoing development of sales in China.  Novatek typically invests the equivalent of 14% of revenues on R&D, a significant and ongoing commitment to the intellectual capital of the business. In the field of display driver integrated circuits, Novatek has global market share of 20%, second only to Samsung at 30%. 

In conclusion, as long-term investors in Taiwan we prefer to look at the investment flows by Taiwanese companies into China as an indicator of the state of relations and not media speculation regarding the prospect for military hostilities. If China were going to invade Taiwan it would have happened years ago.  The financial relationship between China and Taiwan is strong and growing. It is that financial relationship which will ultimately guide China and Taiwan to a sensible compromise regarding political differences.

Insights by Australian Fund Monitors Pty Ltd (AFM) provides investors and advisors with commentary and articles originated and provided by fund managers and other contributors. The views and opinions contained within each Insights article are those of the contributor and do not necessarily reflect those of AFM. www.fundmonitors.com.

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