Powerful secular changes are afoot; seeking a wider palette of opportunity
Let us begin by saying we send our heartfelt thoughts for any client affected by the virus.
On the market side, the quarter so far has been positive for client portfolios, with gains in stock markets eradicating losses experienced during the worst of the pandemic this year. However, given the extraordinary move in markets, we know that investors worry about the degree to which the stock market gains and leadership by technology stocks can continue, particularly given the fragility of the global economy and ongoing uncertainty caused by Covid-19.
In this piece we aim to look forward. We believe powerful secular changes are afoot and we want to examine the possible implications with a longer-term view and investment horizon. While we are not ruling out rolling corrections and market consolidation from here, and are not opining on the valuation of individual shares, we believe that several important trends are coalescing:
- The technology, innovation and digitalisation theme has grown vastly in importance across all industry sectors, as well as public and private markets. The digital revolution – accelerated by the global pandemic – is ushering in an acceptance of all things digital that will fundamentally change the investment landscape.
- The pandemic has dramatically altered the policy mix of governments, from austerity to fiscal and monetary expansion, with an emphasis on keeping rates low for the foreseeable future to aid the recovery, finance widening budgetary deficits and allow inflation to rise, a momentous and ‘risk friendly’ policy shift.
- Investors, companies and governments are increasingly focused on the environment. Green infrastructure and sustainability will be a priority focus of government policy, corporate strategy and investor demand looking forward.
All three are powerful secular trends. In combination, they are likely to have far-reaching investment implications for countries, companies, sectors and asset classes, both positive and negative, for years to come.
While we cannot profess to see all the implications, we believe that the beneficiaries of these tailwinds could see their valuations exceed investor expectations for several reasons:
- There is a winner-take-all phenomenon to disruption and innovation which can turn successful companies into industry behemoths and quasi-monopolies.
- Digital business models have significant data advantages that provide inherent growth optionality, allowing these businesses to scale and grow faster, often beyond the most positive of expectations. Advances in artificial intelligence will only serve to accelerate these advantages.
- Improvements in bandwidth and the roll-out of 5G are likely to increase demand, and further hasten digital adoption.
- Successful digital businesses tend to grow fast, be capital light, are highly profitable and generate high levels of cash.
- Equity ownership represents a perpetual claim on a company’s future cash generation. In a low interest-rate world, long duration growth and cash flow visibility should contribute to higher than average valuations as the discount rate is so low.
Innovation economics has long argued that countries that embrace and encourage innovation and investment in technology and entrepreneurship grow significantly faster than those of countries that do not.
As we have seen, stocks with these characteristics and markets biased towards digitally enabled sectors have had an earnings and outperformance advantage. At no point in time has this been clearer than this year. It will not be lost on governments around the world that the two best performing stock markets this year are the US and China, and within each, the technology sector has led the advance. Last quarter’s earnings seem to justify the move. For example, US earnings results were broadly negative, but exhibited a strong dichotomy between companies with strong digital tailwinds and those more dependent on the more traditional economy. According to JP Morgan:
34% of S&P 500 companies reported higher revenue growth than pre-Covid estimates. Notably, reported results showed significant bifurcation between Nasdaq 100 companies (earnings surprise of 2% and revenue growth of 9%) and cyclically sensitive small caps (earnings surprise of -29% and revenue growth of -42%). Moreover, and unsurprisingly, earnings estimate dispersion reached a new record high (100th percentile), driven by high uncertainty in sectors most impacted by Covid-19.
History has shown us how past periods of innovation and investment, often supported by expansionary fiscal policy and accelerated by periods of war or crisis, can drive both outsized growth and outperformance for corporate winners.
In his book “The Dawn of Innovation”, Charles R. Morris chronicles more than 50 years of innovation in the 19th century as the Industrial Revolution unfolded in the United States, which led to unprecedented economic change that catapulted the US to its leading economic power status.
“There was indeed a distinctly American approach to manufacturing in the 19th century: it was the drive to mass production and mass distribution in every field – from foodstuffs to soap and candles, axes and locomotives, horseshoes, wooden doors, carriage wheels, bedroom furniture, and almost anything else. The nature of the machinery and underlying technologies varied from product to product – soap making was different from steelmaking, and neither had much in common with making guns or clocks. The commonality was that they could all be subject to mass production, organisation and transformation through machinery. Traditional industries like clocks, textiles and shoes could suddenly be produced on a global scale. All industries could now be carried on in large factories, with machinery applied to every process, the extreme subdivision of labour and all reduced to an almost perfect system of manufacture, whose distribution was accelerated by the advent of railroads, roads and the telegraph…..”
Substitute the words digitalisation, innovation, technology for the orange and cyber and digital connectivity for the green (transmission mechanism that made this possible) and the parallels are clear. It was a period of spectacular growth for America, which led the change, but which left other countries behind and many industries in tatters. Wars, especially the Civil War, merely served to accelerate the powerful trend of industrialisation; the US government believed that prosperity was dependent on industrial growth, so government fiscal policies, post-war, favoured industrial development, while also helping to support and retrain displaced workers. One can see eerie similarities emerging from the current pandemic.
This period saw the rise of quasi-monopolies as leading companies that benefited from the transformation became the valued shares of decades, while disrupted businesses literally disappeared.
Similarly, the macroeconomic policies that characterised the period from the end of the Second World War until the late 1960s are somewhat comparable. Enormous fiscal stimulus, supported by unlimited monetary expansion, boosted private consumption and investment and generated above-trend economic growth. Post-war reconstruction created the seeds of economic and global expansion that culminated in the Nifty 50 global stock market leaders.
Today’s changes in macroeconomic policy, combined with increasing acceptance of a new digital order, are fertile ground for a new type of economic regime, one where digital, sustainable and innovation leaders – country or company – may dominate the growth scene for years to come.
What are some of the possible investment implications?
- These changes are market friendly and we remain constructive on the outlook for shares, with a focus on US, Europe and China as the most advantaged markets.
- Active management is likely to grow in importance as returns accrue to those investors able to identify long-term winners and beneficiaries of the change.
- The digital super cycle will continue and companies that use digital enhancements to their advantage will be tomorrow’s industrial winners.
- Whole industries are still likely to be disrupted, with negative implications for companies and shares that fail to change and adapt.
- Shares of leading digital and ‘clean environment’ players can trade at higher valuations as capital moves to sustainable growth and profits.
- A low interest rate world increases the valuation potential of cash rich and ‘in demand’ shares as low discount rates and rising investor focus cause multiples to expand.
- Equity hedge managers benefit as they can identify winners and profit from losers in a world of increasing share price dispersion.
- Private equity will grow in importance as it provides one of the highest returns in our view looking forward, with a wider opportunity set to access these secular themes and with managers who can add strategic and operational value, and where investments may trade at lower multiples to public markets. A faster time to monetisation may be one of the offshoots of increased investor demand.
- Fixed income and the use of fixed income as a diversifier in portfolios will diminish, as inflation risk is increasing and thus weightings globally to bonds are likely to reduce, with positive implications for almost any other asset class that can offer income, diversification and a positive return, such as absolute return strategies and real estate.
- Transitions of this magnitude in both policy and innovation can bring geopolitical tensions, while a world of currency debasement and low interest rates favours gold as a long-term hedge against rising political risks and future inflation.
- Diversification matters: investors able to access the widest opportunity universe to access these themes are likely to experience the best risk-adjusted returns.
This is not to say that we believe in market bubbles or suggest buying technology shares at any price, nor do we think that the market will continue to rise in a linear fashion from here. We recognise that the current largesse of liquidity (US money supply growth at more than 20 per cent) and so-called ‘fear of missing out’ are creating near-term market distortions. Additionally, market concentration is concerning as investors have flocked to similar holdings at almost any price and this will no doubt cause ongoing risk reversals and volatility.
However, in looking at these changes, we aim to move away from the here and now, and the daily noise of markets; we are trying to examine how these secular shifts may change the investment outlook in the next few years and beyond. As long-term investors, we want to focus on enduring strategy changes and opportunities, as this is the best way to support our clients’ positioning with a long-term perspective.
Elaborating on these themes:
The decade of fiscal austerity (and below average economic growth) is likely to be replaced by fiscal stimulus and growth surprise, but with gains and growth that are much more winner specific.
The pandemic will no doubt leave lasting scars – the worst affected industries may only barely recover, while others may not survive. Unemployment levels are still high across the developed world. We still do not know what the longer-term implications of social distancing or more flexible working arrangements mean for business travel, commercial real estate, business city centres and the eco-system of service industry that relies on crowds. Capacity in the worst-hit sectors may now be permanently removed.
The move towards a more digital and sustainable economy will change a wide range of industries, while traditional business models will continue to be disrupted. The pandemic has been a turbo boost for the adoption of technologies that could further displace lower-wage workers. Winner-take- all dynamics tend to squeeze out smaller, more traditional players. Dramatic changes are already underway in sectors such as energy: decarbonisation, storage and grid resilience; electric and autonomous vehicles and telemedicine to name but a few. One has only to look at the current state of the financial service sector to imagine a host of new competitors on the horizon.
See article download for additional graphs.
Governments recognise that they need to continue to support an economic recovery with expansionary fiscal and monetary policy. Over the medium term, we think fiscal policy will shift from income and business subsidy to various forms of infrastructure and recovery investment, with a priority on innovation and sustainable and green investment, while also addressing income inequality for the displaced. This is a hallmark of the European Recovery Fund, of the UK government’s current policy initiative and certain features in Democrat candidate Joe Biden’s campaign platform, with $2 trn earmarked for green infrastructure and investment.
The goal of carbon neutrality by 2050 remains a powerful catalyst for government and private sector investment to be self-reinforcing. Decarbonisation represents a $6trn-plus annual capital requirement today, growing three times that by 2030 (source: Riverstone Holdings & McKinsey). Recent power outages across large parts of the east and west coasts of the US due to extreme weather conditions, sparked in part by global warming and the need to manage intermittency, necessitate the urgency of policy action. Investing with an environmental, social and governance (ESG) focus is now mainstream, with firms overseeing more than $80trn in assets having signed on to the United Nations-backed Principles for Responsible Investment. We believe that sustainable investments and sustainable investing will only grow in focus and importance in the years ahead.
The role of governments may also change as policymakers recognise the need to play a more proactive role in promoting national champions and encouraging research and development (R&D). This is already happening as billions of government money has been allocated to companies working on virus treatment and vaccines. Governments that judiciously use fiscal policy to support innovation and encourage productive ‘technological and sustainable’ investment may fare better. Countries with younger populations where people can be retrained may have an edge.
Change of this magnitude creates winners and losers as the divergence between the emerging winners and structurally challenged incumbents continues to widen. Hence average numbers, whether they are aggregate GDP or aggregate earnings, may be misleading; some areas will grow quickly while others peter out and die and some parts of the global economy will race away, while others experience capacity destruction.
Governments will need to support the transition. As Mario Draghi, former head of the European Central Bank, implored in a recent speech:
“Europe will only fully recover from the economic impact of coronavirus if governments use their vastly increased fiscal support and debts to invest in young people, innovation and research…debt levels may be high for a long time, but they will only be sustainable if good debt is used for productive purposes. We should take inspiration from those who were involved in rebuilding the world in the aftermath of the Second World War and invest in productive areas of innovation, and retraining of workers who have been disproportionately affected by the pandemic’s impact on labour markets.”
US, Europe and Asia/China are favoured
America is still well placed given its culture of entrepreneurship, size of market and availability of capital for newly started businesses; it is still a leader in technology, innovation and venture capital.
Looking forward, Europe could also be increasingly attractive. Capital investment in the European technology eco-system has steadily increased from about $22bn of investment in 2018 and represents 4.3 times the level of investment in 2013*. The nascent beginnings of greater Eurozone integration, combined with government focus on digital and innovation, means that the European market has some promising characteristics in terms of catch-up potential.
See article download for additional graphs.
Europe’s focus on green initiatives may leave it well placed to lead in sustainable investment, favouring companies that benefit from improving the quality of the environment.
China will clearly lead as it continues its strategic and industrial focus on technological supremacy and self-reliance. We believe that investors will be well placed to have exposure to China and Asia, as this region continues to benefit from sheer size of market, strong and digitally skilled workforces, existing digital prowess and significant government support of innovation initiatives.
Hence, we continue to favour the US, Europe and China/Asia as our most significant areas of geographic exposure. Given that these three blocks represent more than 85 per cent of global equities, we remain constructive on the outlook for shares. While corrections are normal, we are staying invested and focusing on these themes. In our view, market sell-offs represent opportunities to add to favoured investments.
Non-Asian parts of the emerging world may look attractively priced; value in general has underperformed growth. However, we are happy to stay with quality and growth as we worry that price may not be a helpful guide for countries and companies fundamentally disrupted by changes wreaked by the pandemic in a digitally transitioning world.
Bottom-up investment and active management will grow in importance
The pandemic has accelerated a tectonic shift toward digitisation and disruption.
In the words of Satya Nadella, Microsoft’s CEO:
“We’ve seen two years’ worth of digital transformation in two months. From remote teamwork and learning, to sales and customer service, to critical cloud infrastructure and security – we are working alongside customers every day to help them adapt and stay open for business in a world of remote everything.”
Hence, companies able to show resilience to, or the ability to unlock the potential of, digital disruptive change will be most highly valued.
Companies that benefit from a combination of:
- Above average organic growth
- Strong balance sheets
- Superior free cash-flow generation
- Higher margins and profitability
- With a positive environmental impact should be more highly valued.
The question is, what multiple of earnings is a fair price to pay? The 30-year historical price-to-earnings average has been 16 times (using the US market by way of example). Given the fall in the cost of equity due to record low interest rates, we believe that companies that display the above characteristics will move to valuations that far exceed long-term averages.
This rapidly changing economic backdrop has the potential to create significant opportunities for alpha-generation. This is a bottom-up market, favouring managers who understand and identify the digitally savvy, sustainable and innovation winners and can assess the degree to which future expectations have already been discounted. Recognising trends early and identifying dominant leaders will help drive outsized returns.
Opportunities for return are not limited to public companies
We expect to see a plethora of opportunities, new business models and technological advancements in almost every sector. While many public companies may lead the charge in some of these areas, we think private markets will be a rich arena to identify new opportunities, new technological trends and new sustainable business models.
We want to be exposed to private equity managers who can transform established businesses through the adoption of digital strategies, as well as venture managers who scour the globe for the leading digital and disruptive corporate models. Investment in new businesses through skilled venture managers can also serve as a hedge to disruption of established businesses in the public markets.
An allocation to private investments, moreover, could offer the highest source of return going forward. The greatest transformations in the world economy invariably have come from entrepreneurs who started private companies, which often trade at cheaper valuations than public equivalents. These companies have the potential to grow more quickly as new technologies and approaches displace the old leaders; manager skill can bring investment and talent to hasten value creation. As companies are floating comparatively late in their development, part of a global trend for companies to stay private for longer, the opportunity to realise the strongest returns often comes during the transition from private to public. Hence, we believe it is paramount to maximise the allocation to private markets within the limits of each client’s illiquidity tolerance.
Resurgence of interest in special-purpose acquisition companies (so-called SPACs), a growing trend in the US, may provide opportunities to access these larger growth private companies within a publicly traded and thus liquid vehicle. Recent changes in direct listing requirements, combined with favourable IPO market dynamics, are leading to an increase in appetite for companies to go public. Time to liquidity and monetisation may shorten as a result.
Equity hedge managers who can perform deep fundamental research to identify long-term disruption and innovation winners, while shorting companies trapped either in technological obsolescence or non-sustainable business models, can also provide compelling returns, with lower risk than a pure long-only strategy.
Diversification across these alternative strategies widens the universe of opportunities and can reduce company and country-specific risk. For clients, this means accessing winners and avoiding losers through the broadest palette of opportunity, in both public and private markets.
Fixed income remains deeply challenged
In a world of greater fiscal expansion and increasing levels of indebtedness at the government level, interest rates will need to remain lower for longer to finance rising deficits. A world of low to negative yields will continue to present a challenge for investors as nominal government fixed income cannot keep pace with inflation. We also see the risk of higher inflation over the medium term. Central banks led by the Federal Reserve are already explicitly signaling a greater tolerance to let inflation rise. Negative supply shocks, deglobalisation and reduced competition (as capacity is eradicated in some areas) could also contribute to increased inflation with a medium-term view. Breakeven rates, a measure of market-based inflation expectations, are already increasing.
Ageing demographics mean that baby boomers, who control about 58 per cent of global wealth, may need to think differently. Many of these investors would normally move into fixed income as they got older in search of a more defensive positioning. Nominal government bonds with no yield and loss potential arguably provide neither. Furthermore, the inverse correlation between bonds and stocks weakens as bond yields are near perceived lower bounds. This reduces bonds’ ballast role, or ability to cushion portfolios against risk asset sell-offs. Pension plans face a similar dilemma with a yawning gap between assets and liabilities. In the US, unfunded pension liabilities could run as high as $6trn. In the UK, the Pension Protection Fund notes a total deficit for defined benefit pension schemes of £200bn.
For many investors, allocations to fixed income will decline, while for others almost disappear. We expect to see outflows in favour of any other asset class that can provide income, diversification and a positive return. A near universal underweighting of fixed income in clients’ portfolios could have significant flow of fund implications. In the US alone, bond markets make up almost $40trn in value, compared to about $20trn for the domestic stock market. This money needs to go somewhere.
The following are candidates for increases in allocation. Within fixed income, we prefer inflation-linked government bonds as well as bond managers who pursue various forms of dynamic credit strategies, with an emphasis on real return, deep research and secure cash flows. But we also see opportunities to preserve capital by diversifying away from bonds in favour of absolute return strategies, where we focus on low beta multi-strategy managers at levels of volatility comparable to fixed income and with low correlation to equity markets. Real estate and infrastructure in quality growth areas and with strong tenant profiles are also favoured to provide income security, a degree of inflation protection and long-term appreciation potential.
We ask ourselves whether technology represents both a growth and defensive investment, the latter due to its high cash generation and low sensitivity to changing rates. This answer remains to be seen, but certainly, cash-rich technology leaders have provided both upside gains during the recent market recovery and a degree of downside resilience during the worst of the correction this year.
We think investors will increasingly use sectors and different company profiles to increase and decrease risk within their portfolios. Sustainability will also be an important return driver as investors seek to overweight ‘green’ companies that could also be resilient in adverse markets. These company-based risk and return assessments should also provide excellent fodder for active and equity hedge-based strategies and managers.
We favour gold
Transitions of this magnitude in both policy and innovation can bring geopolitical tensions; we can see this clearly in recent US-China government relations.
A world of rising levels of indebtedness, with debt to GDP likely to extend beyond 100 per cent in large parts of the developed world, may force investors to search for long-term, tangible value.
We continue to favour gold as an asset class that works well in periods of rising inflation, increased geopolitical risk and currency debasement. Low interest rates mean cost of carry is less of an issue. The asset class is relatively under-owned and supply constrained and, in a world looking to move money from bonds, gold is likely to be the alternative asset class of choice.
Rising demand and limited supply make for an attractive price dynamic, with an asset class that has both elements of ‘protection’ and low correlation characteristics.
Powerful changes are afoot, catalysed by the pandemic. A world of expansionary government fiscal policy, digital transformation and a focus on sustainable investment is likely to have far-reaching investment implications. We may well be entering a decade of secular change where growth is supported due to a proactive Keynesian policy mix, but where investment returns accrue to the innovation, sustainability and disruption winners of this new economic order.
The path of markets will not be smooth and change and disruption will remain constant. But from these changes will emerge significant opportunities (dispersion between the winners and losers) and risks (continued uncertainty and volatility). Our goal for clients going forward will be to take advantage of these opportunities, prudently manage risk and maintain a constructive approach to investment management using the widest palette of opportunity.