In the second of the series we examine what the next five years could hold for equity investors and identify six key themes to watch. From disruption to de-globalisation, just how could these themes impact market leadership from here?
Key points:
- Geopolitics is likely to continue to dominate markets. Whilst the world is now pre-occupied with US-China, more flare-ups are conceivable.
- If the ascendance of protectionism and de-globalisation continues, there will be far reaching implications on markets.
- Given the increasing focus on ESG factors, it seems highly likely that ESG investing will derive a meaningful performance advantage for compliant companies going forward.
1. Growth or value?
The past few years have seen some marked stylistic trends within markets. Notably “value” has significantly lagged “growth”. In fact, over the past five years we have seen the cheapest stocks (on price/earnings ratio) get cheaper and the most highly-rated stocks become dearer. Clearly this is a trend that cannot persist for ever - and reflects both low prevailing interest rates and increasing uncertainty over the direction of economies.
Once again, it may be instructive to look at Japan to see how markets can behave in lower growth periods. Take, for example, the period from 1995 to 2005 (which straddles the technology bubble and avoids the later financial crisis).
Over this period, the Topix 100 Index was essentially flat but there were some very big winners and losers. However, there were no clear sector patterns. “Value” type sectors such as financials, autos and homebuilders had both extreme winners and extreme losers. This emphasises the message that in times of weak growth, it is most important to identify companies that can deliver solid profit growth. This is irrespective of whether they appear to be “value” or “growth” - not forgetting that highly rated stocks often fall further if they fail to deliver according to expectations. In other words, stock selection is key.
Current market conditions are beginning to look more and more like those around 2000 when valuations became even more polarised than they are now and after which “value” had a huge rebound. Having said that, if the next five years have a lower global economic growth background then it will be difficult to see a sustained reversal in favour of “value”.
Our approach is therefore to be specific in our selection of such stocks and apply very disciplined hurdle rates and a thorough risk assessment but to be prepared to step up when we see very high potential returns from “value” situations. As always, investing in equities does involve taking calculated risks.
2. Domestic economic policy
In terms of the control of money supply, central banks have some serious unfinished business. This dates from the financial crisis now more than 10 years ago when emergency levels of interest rates were applied by central banks to stop the system collapsing. Unfortunately, these rates persisted even when it was clear that the immediate danger was over.
Only the US felt strong (and brave) enough to move towards “normalisation” - and even here the direction appears to be reversing somewhat. Meanwhile cheap money everywhere has helped sustain questionable capital projects and increase asset prices, most conspicuously in real estate. This in turn means that most people now entering the workforce despair of ever owning their own house while those older established property owners control a disproportionate amount of the nation’s wealth.
So, given this background, we are likely to see more creative responses from both central banks and governments to any signs of economic downturn. We may see further bouts of quantitative easing on the one hand and creative fiscal stimulus on the other - for example directed towards large infrastructure projects. But governments could also decide to levy new forms of taxation to help level the playing field.
3. Geopolitics and trade issues
The high current level of geopolitical uncertainty looks likely to stay with us over the coming five years. In the case of the US and China, it is clear that there are some issues that will take years to work through.
More flare-ups in various parts of the world are easily conceivable but equally unpredictable, and this uncomfortable environment means that investors should make sure they have adequate geographical diversification over the coming years, while active managers should be prepared to shift when the political environment turns in an unhelpful direction - as has been shown in the case of the UK and its notable underperformance over the past three years.
As for the ongoing question of the UK and Brexit, we will leave fuller discussion of this to another time. But suffice to say the equity and currency markets have very clearly continued to swing more and less negatively with news suggesting a greater or lesser likelihood of a “hard” exit. There seems little reason to disagree with markets on this one.
4. De-globalisation
Leading on from trade issues there is the likely interruption in what has for decades seemed to be an inevitable trend towards increased globalisation. It is not just trade but also increased focus on economic self-sufficiency and the growing ascendance of protectionism in various forms. Furthermore, there is more and more government focus on data and privacy, so we should expect to see more legislation to prevent personal data crossing borders.
All other things being equal, deglobalisation could increase cost on some companies and squeeze margins. We need to be wary of this when we select new stocks for portfolios.
In theory, just as increased globalisation has been deflationary, a backlash against this could be inflationary provided economic growth does not slow too much. Most commentators see very little risk of increased inflation. But most developed economies now have apparently very tight labour markets. If in the next five years see governments deciding to increase borrowing and ramp spending, then inflation could rise. In this case, we should look for the beneficiaries that have true domestic pricing- power.
In general, these forces could tend to favour large companies which offer geographic diversity and greater control of their costs and supply chains. The next five years could be a tricky time for small-cap investors.
5. Disruption
The last five years have seen disruption challenge a large number of sectors, from traditional finance to utilities and of course retail (not to mention specific industries such as restaurants, taxis and many others). This will surely continue in the next five years.
But we should be wary of second order disruption effects. Innovation has happened at such a rapid pace that governments have struggled to keep up. For example, regulators still have not got to grips with new monetary tokens and cryptocurrencies. So, we should expect more government moves to check the untrammelled progress of disrupters who have been taking away parts of the value chain previously occupied by traditional operators and in some cases quickly building quasi-monopolistic positions. In addition, high profile disrupters and innovators could themselves be disrupted (think of perhaps AOL Online, Nokia, Monster.com, TripAdvisor, eBay and Just Eat as examples - there are many more).
So once again this global force is one that we need to consider as a risk factor in most industries we may invest in. And the clear message for those who want to invest in disrupters is to be very wary, particularly when they are valued at a level that implies everlasting superior growth.
6. Climate change and sustainable investing
Finally, and most importantly, is the unstoppable force of sustainable investing. Climate change itself brings huge threats as well as opportunities to companies around the world. Green power is now becoming cost competitive with fossil fuel-based electricity generation. Here, at least we appear to have reached a clear tipping point. The next five years are going to be exciting and transformational as more renewable projects come on line and large users strike contracts for the supply of sustainably generated energy.
With regards to the trend - currently led by European investors - towards sustainable or ESG investing, this too appears to have reached a tipping point. There has been much statistical analysis to examine the question of whether applying an ESG framework to investing in the past would have produced superior returns. In most cases, there was simply too much noise in the data to draw any definitive conclusions.
Regardless, we take the view that we have a duty to our investors to incorporate ESG principles into our consideration of investments in our portfolio. In this regard, we continue to constructively engage with senior management of the companies we invest in to encourage them in their efforts to improve their ESG credentials.
Given the increasing focus on ESG and the weight of money moving in this direction, it seems highly likely that sustainable investing will derive a meaningful performance advantage in the next five years as highly compliant companies see their cost of capital driven down in the markets relative to non-compliant companies.
