MARKET COMMENTARY. Horizon Asia Opportunity Q Commentary. February Horizon Kinetics LLC

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1 Horizon Asia Opportunity Q Commentary February Horizon Kinetics LLC

2 In the fourth quarter of 2017, the Horizon Asia Opportunity Institutional Composite (the Strategy ) gained 7.1%, net of fees, compared to the MSCI All Country Asia Index (the Index ), which returned 8.3%. The Strategy s holdings in Macau gaming companies, Japanese blockchain/cryptocurrency companies, and automobile manufacturers in India contributed positively to returns. Tourism and Hotel management companies in Hong Kong detracted from performance was an outstanding year for the global financial markets: Asia was no exception. The MSCI Japan Index was up 19.9%, and the MSCI ex Japan Index rose 41.7% in US dollar terms. It was a perfect environment for financial assets, as economic growth supported positive earnings growth overall but was not strong enough to drive a meaningful spike in inflation or interest rates. In fact, almost all of the asset classes showed significant appreciation, most notably, cryptocurrencies. The backdrop against which financial markets globally have been thriving for decades is going through a major shift. Finally, the long awaited capital investment cycle is commencing in the United States, as a result of new tax regulation that was passed at the end of From the global financial crisis of 2008 until now, US corporations have been hoarding cash and/or using cash to buy back their own stock, at the expense of capital investment. More deregulation is expected from the Trump administration in the coming months, and these new factors are making corporate America more confident about their future; in turn, they are starting to spend on long term capital investment projects. The most recent US economic statistics, such as wages and inflation (in January 2018, the US average hourly wage and CPI grew 2.9% year over year and 2.1% year over year, respectively 1 ) point to accelerating economic growth. The timing of the tax cut may, in fact, have been unfortunate, as it might fuel the fire of the longest economic expansion in history. After the financial crisis of 2008, major central banks employed the very unusual policy of Quantitative Easing (QE) to provide the fragile global financial system with enormous amounts of liquidity (see chart 1). However, starting in , several central banks began the tightening cycle, with the US Federal Reserve Bank acting as the front runner. The Bank of Japan is the only major central bank which has not started tightening. 1 Source: Bloomberg 2018 Horizon Kinetics LLC 1

3 Dec-07 Jun-08 Dec-08 Jun-09 Dec-09 Jun-10 Dec-10 Jun-11 Dec-11 Jun-12 Dec-12 Jun-13 Dec-13 Jun-14 Dec-14 Jun-15 Dec-15 Jun-16 Dec-16 Jun-17 Dec-17 Chart 1: Money Supply (M2) (Dec 2007=1) US Japan ECB Source: Bloomberg These two new Chart 2: US Yield (%) developments renewed growth momentum and 7 major central banks 6 monetary policy shifts might finally jeopardize 5 4 UST 10yr yield US 10yr real yield the US Goldilocks 3 economy, as well as 2 threaten the unusually 1 low nominal and real 0 interest rate environment -1 around the world, which -2 has primarily benefited financial assets ( see Chart -3 2 ). Prior to the financial crisis, the US real interest rate was above 3%. Source: Bloomberg Currently, it has risen from negative 2% in late 2011 to positive 1%. Given the fact that economic growth 2018 Horizon Kinetics LLC 2

4 has been picking up, we expect the real rate to be moving higher. The risk in the global financial markets, therefore, has increased in the form of valuation compression, and the outcome depends on how strong the earnings can grow in the current headwinds. Asian markets are still trading at reasonable valuation levels (see table below) compared to US markets, and the earnings outlook has improved further since the Trump tax cuts for a variety of manufacturing/export businesses. Both Japanese and Chinese corporate earnings grew faster in 2017 than in 2016 (The Tokyo Price Index and CSI 300 Index earnings grew 27.7% and 8.3% respectively 2 ) thanks to a very healthy global economy. The biggest issue facing investors is that rising interest rates should pressure the multiples of earnings for which investors are willing to pay. We believe we are late in the economic cycle; typically, at this point in the cycle, so called late cycle stocks such as natural resource companies begin to outperform globally. In the developed Asia markets such as Japan, Hong Kong and Singapore, there are opportunities in a few natural resource companies, but in the other parts of the region, namely Malaysia and Indonesia, there are some companies that can grow earnings faster in higher inflationary environments. In the coming months, we are planning to incorporate investment opportunities in these areas in our portfolios. Global Valuation Comparison P/E PE P/B EV/EBITDA ROE Div Yield 10yr Bond Yield FY18e FY19e FY18e FY18e FY18e FY18e Current Japan T China Asia ex-japan NA US S Europe S Japanese universe is TSE 1. Chinese universe is MSCI China Index. US universe is S&P 500. European universe is STOXX Europe 600. Asia ex Japan universe is MSCI AC Asia ex-japan Index. As of 02/27/2018 Sources: Bloomberg Analyzing the current long bull market that started in March 2009, and the risks investors might be facing at this juncture, one must examine where excesses have become evident. We can highlight two obvious areas of excess, namely, debts and exchange-traded funds ( ETFs ). Debt level around the world has risen to a level not seen before, which includes emerging market corporate debt, notable ones being Chinese and developed nations sovereign debts (see charts 3 and 4). The low interest rate environment has been a key ingredient for this phenomenon to be sustained; now, since the beginning of 2018, that is changing for the worse. The next area of concern is rapid growth of ETFs (Chart 5), which has become such a big factor in the securities markets that valuations of the underlying securities have become distorted. Our firm s research shows that stocks which are holdings of 2 Source: Bloomberg 2018 Horizon Kinetics LLC 3

5 ETFs trade at much higher valuations than do those that are not in ETFs but which operate in the same industries. Furthermore, ETF investors seem to believe that these funds can be sold at any time without any difficulty the potential issue of liquidity has not yet been tested in a very challenging market environment. Our Asia portfolio holdings are selected by means of a bottoms up analysis and are the result of fundamental research; our active share stands at 98%. This, in our opinion, should provide some protection from unforeseen market disruptions in the new financial market environment which we have entered. Chart 3: Total Credit to Non-financial Corporations as % of GDP Q2017 2Q2017 China Emerging markets (aggregate) G20 (aggregate) Advanced economies (aggregate) Source: Bank for International Settlements 2018 Horizon Kinetics LLC 4

6 USD million 110 Chart 4: Total Credit to the Government Sector as % GDP Q2017 2Q2017 China G20 (aggregate) Emerging markets (aggregate) Advanced economies (aggregate) Source: Bank for International Settlements 5 Chart 5: ETF Assets Under Management Growth Source: Morningstar Direct, EY Global ETF Survey Horizon Kinetics LLC 5

7 DISCLOSURES Past performance is not indicative of future returns. This information should not be used as a general guide to investing or as a source of any specific investment recommendations, and makes no implied or expressed recommendations concerning the manner in which an account should or would be handled, as appropriate investment strategies depend upon specific investment guidelines and objectives. This is not an offer to sell or a solicitation to invest. This information is intended solely to report on the investment strategies of Horizon Kinetics LLC. Opinions and estimates offered constitute our judgment and are subject to change without notice, as are statements of financial market trends, which are based on current market conditions. There are risks associated with purchasing and selling securities and options, and investments can lose money. This commentary references cryptocurrencies. Horizon Kinetics subsidiaries manage products that seek to provide exposure to cryptocurrencies. Cryptocurrencies represent a relatively new asset class and carry substantial risks. Only investors who can appreciate the risks associated with an investment should invest in cryptocurrencies or products that offer cryptocurrency exposure. As with all investments, you may lose money. The MSCI All Countries Asia Index captures large and mid-cap companies represented across 3 Developed Markets countries and 8 Emerging Markets countries in Asia. With 930 constituents, the index covers approximately 85% of the free float-adjusted market capitalization in each country. Note that indices are unmanaged, and the figures shown herein do not reflect any investment management fees or transaction costs. Investors cannot directly invest in an index. References to market or composite indices, benchmarks or other measures of relative market performance (a Benchmark ) over a specific period are provided for your information only. Reference to a benchmark may not reflect the manner in which a portfolio is constructed in relation to expected or achieved returns, portfolio guidelines, correlations, concentrations, volatility, or tracking error targets, all of which are subject to change over time. This strategy is a total return strategy, and the benchmark is provided for illustrative purposes only. It is not our intention to state, indicate or imply in any manner that our future results will be profitable or equal to past results. Horizon Kinetics LLC is the parent company to several US-registered investment advisers, including Horizon Asset Management LLC ( Horizon ) and Kinetics Asset Management LLC ( Kinetics ). Horizon and Kinetics manage separate accounts and pooled products that may hold certain of the securities mentioned herein. Horizon is the investment manager to the strategy referenced herein. For more information on Horizon Kinetics, you may visit our website at No part of this material may be reproduced or distributed, in whole or in part, without Horizon Kinetics prior written consent copyright Horizon Kinetics LLC. All rights reserved Horizon Kinetics LLC 6

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