Our five conviction calls

 

Consensus point of view

We’re either slowing sharply as shortages hinder economic activity or, if not, central banks and governments will take away the punch bowl, removing a key supporting factor for financial markets.
 

Counterpoint

We’ve now moved past the peak in growth as the boost from reopening is behind us and policy stimulus, while still supportive, becomes less intense. But we’re also moving past Covid-19 and so the level of activity should continue to rise as spare capacity is reabsorbed. We think we will move past peak inflation in 2022, partly because supply is expanding and partly as pent-up demand is now spent. With cyclical acceleration no longer the dominant driver, financial markets may be less well supported in the near term. But with economic expansion continuing and policy remaining easy on the whole, the riskier asset classes such as equities and credit should still outperform safer bonds.

 

Download and listen now: Our Five Conviction Calls - Call 1: Moving past the peak

The tug of war between peaking growth rates and improving activity levels will likely drive asset prices

The investment cycle is likely to be driven by the tension generated in markets as peaking growth clashes with rising activity. The economy’s pace of growth is normalising as pent-up demand following reopening is now spent. But its absolute level is still rising, with remaining spare capacity suggesting there’s still room for further expansion.

We expect this moderation to be gradual and mostly in line with our base case. Some of its causes should eventually be less in the picture, such as the Delta variant and supply bottlenecks, and we see limited scope for abrupt monetary and fiscal tightening – though we forecast some tightening from record levels of policy support.

Not all input shortages are likely to be short-lived and although inflation should ease from high levels, it may stay higher on average than in the past decade.

While the normalisation in demand we envisage should reduce the pressure in some sectors and commodities, if bottlenecks are more protracted than expected, for example in the energy complex, they could cause a more pronounced slowdown.

Against this backdrop, we don’t believe central banks will implement significantly more contractionary policies just yet. Some are tapering or ending their asset purchases, and others are looking to hike rates from record-low levels, while governments’ emergency measures are also set to expire.

Yet our central scenario is more dovish than market prices and foresees a gentler and/or more delayed removal of accommodative policies. Relative to the consensus, we consider policy support for longer an upside risk.
 

 

Some deceleration in the pace of economic growth following reopening is normal. Equities are likely to continue to outperform bonds. However, during periods of cyclical expansion but negative macro surprises, average equity returns tend to be lower.
Within equities, this macro environment has historically implied no clear outperformance by either growth or value stocks. Investors may now need to work harder to find value areas where the dislocation is greatest, and growth areas presenting opportunities combined with some value for that growth.

Within this framework, we expect some residual cyclicality still to be found across several sectors of the economy, from consumer and industrials to commodities, materials and energy. But, in general, we think there’s less room for catching up because the post-lockdown recovery phase is over – when the economy was weak but getting better, asset classes were showing significant dislocation and policy was at its maximum degree of expansion.

We also think the distinction between large and small firms is likely to be less clear. But, on balance, we believe that global companies are best placed to thrive as trade resumes and supply chains are repaired.

Geographical differentiations, too, are likely to be less stark, although laggards in the developed world ex-US and in some emerging markets may come back in vogue at some point.
 

Consensus point of view

We’re set for an imminent and fast rate hiking cycle, as central banks tighten soon and relatively decisively. With bond yields moving higher across the board, currencies look set to remain rangebound.

Counterpoint

To cushion the fallout from Covid-19, central banks deployed unprecedented policy support to cap borrowing costs so governments could spend aggressively. Core sovereign bond yields, which had already been on a secular downtrend, fell further in response to lower policy rates and scaled-up asset purchases. As the world economy recovers more visibly and job creation gradually comes back, central banks are now tapering their asset purchases. The next step is rate hikes. We believe this will happen in a more gradual fashion than market prices suggest. We may be about to see higher, but by no means high, bond yields, as they’re starting to rise from record-low levels. As this happens unevenly across countries and regions, currency markets could become more volatile.

 

Download and listen now: Our Five Conviction Calls - Call 2: Off the lows

As economies learn to live with less policy support, bond yields are set to move gradually higher and currencies may become more volatile 

While the pace of growth has started to slow, the level of activity remains relatively solid and major economies are already above or close to pre-pandemic levels. Meanwhile, inflationary pressures resulting from pandemic-induced imbalances in supply and demand have proven more persistent than initially estimated and, while we expect them to subside as bottlenecks eventually ease, uncertainty remains on how enduring they’ll be. These two factors have pushed several central banks to scale back their support, while remaining accommodative on the whole.

The Bank of England looks set to raise rates, though gradually and from record lows, and should no longer continue with its net asset purchases from next month. The Fed is poised to conclude its own QE taper by the middle of next year or, perhaps, somewhat earlier. We’d expect it to begin to lift rates, also relatively gradually, shortly after.

The ECB will likely remain relatively more accommodative, continuing with some form of asset purchases for a long time, with rate hikes a long way off.

Given some near-term risks, such as the impact of shortages and bottlenecks on activity and inflation, which could be more protracted than expected, plus residual pockets of Covid-19, we envisage the rise in policy rates and yields to be gradual and moderate.

Our expectation is more dovish than market prices suggest. We do see rising bond yields, but also think a mitigating factor is the need for central banks to continue to fund, directly or indirectly, very high government debt levels, which means keeping funding costs affordable. We also think central banks would want to continue to support private incomes and asset prices.
 

 

 

 

Consensus point of view

China is hard to read. An economy this size presents opportunities, but it also looks riskier than other regions. Concerns range from the impact on climate change to vulnerable supply chains and regulatory tightening across key industries.

Counterpoint

We frame any investment in risk-adjusted terms. There’s some extra risk to consider when looking at emerging markets relative to comparable opportunities in developed markets. They include environmental, social and governance (ESG) factors, but also geopolitical issues, especially when it comes to the credibility of promises to address some of these factors. But an economy and capital market as large as China is critical for understanding the global cycle. We think China’s transition promises to create an institutional and regulatory infrastructure to prioritise long-term development, also in terms of achieving its‘net zero’ ambitions, rather than short-term growth. This may present investment angles and market perspectives worth exploring.

There’s plenty more that investors need to look at when investing in emerging markets. Returns matter and high-growth economies are well placed to deliver on this front. But risk-adjusted returns reflect other factors that raise the bar for these types of markets and asset classes to enter portfolios.

Take China, which looks set to become the world’s largest economy. Investors scrutinise its impact on the environment and society, as well as governance standards in both the corporate and public sectors. Tensions with the US are a long-term source of friction and, more recently, the government has tightened regulations in many sectors, including tech, gaming, private education, real estate and commodities.

However, we believe China’s “dual circulation” and “common prosperity” strategy entails rebalancing across three dimensions:

• from an export-led model to one driven by domestic demand;
• from investment to consumer spending;
• from manufacturing to services.

This transition requires an institutional and regulatory infrastructure that makes the key objective long-term development, also in terms of achieving ‘net zero’ ambitions, rather than short-term growth.

While perhaps hard to read at times, these changes may present significant investment angles worth looking at, with direct implications for China but repercussions for Asia, emerging markets, commodities and global financial markets.
 

 

There’s some extra risk to consider when looking at emerging markets relative to comparable opportunities in developed markets. They include ESG factors as well as geopolitical events.

However, when consistent with our asset allocation framework, we think Chinese and Asian stocks and bonds, and selected emerging markets, should feature in portfolios. Structurally, we prefer Asia as we see better reform prospects along with a stronger ability to cope with higher interest rates.

Deleveraging in China’s real estate sector could create extra volatility, but we also recognise that excessively high default rates are priced in, which is why one of our high-conviction tactical calls is that Asia high-yield bonds look attractive over a 12-month horizon.

We also think the shift to build more resilient and domestic capabilities ranging from semiconductors to energy supplies should support the more strategic tech and advanced manufacturing sectors – which could receive a boost from the currency depreciation we project. Services, the end-consumer and other sectors could benefit too.

We believe that pressure on ‘hard’ commodities, such as industrial metals, should slow as China rebalances. However, its energy and technological transition suggests that metals essentials for future technologies are likely to stay well supported.

We also expect demand for oil and natural gas to stay elevated in the near term, as bottlenecks in an already tight market continue and industrial and consumer demand remains solid. While it lasts, this demand should support energy exporters. We think this pressure should diminish at some point as growth normalises towards its long-term average.
 

Consensus point of view

The pandemic has highlighted that global infrastructure requires significant upgrades. While this should stimulate economic growth, marrying sustainability objectives with construction and production isn’t easy.

Counterpoint

Our planet is our home – and it’s the only one we have. Spending on infrastructure looks set to rise. Some of the projects are physical – roads, bridges, railroads and other public projects. Others are in green and digital areas. Policymakers are aware of climate change and the need to support human capital, which suggests to us that the effort to make infrastructure more sustainable is structural. This shift from emergency fiscal support to outright public investment, plus regulatory and sustainability considerations, is likely to be important for other sectors too. The segments of the real estate market that can flexibly adapt to these structural changes may benefit, along with logistics and warehousing.

 

Download and listen now: Our Five Conviction Calls – Call 4: No place like home

 

The need to share the gains from growth and make our planet more resilient will boost sustainable infrastructure.

Infrastructure spending is likely to get a boost – more prominently in the US but also in Europe and other regions around the world as the outcome of the UN Climate Change Conference (COP26) may incentivize further investment in this area. Most of the new US funding coming through in the near term focuses on traditional infrastructure such as roads, bridges, railroads and other public projects.

It is a multi-year effort to “build back better”. Of the US funds that we expect to be disbursed at a later stage, the bulk will probably fund various healthcare and social spending programmes. About a fifth of the total should be allocated to tax incentives and investments in green energy, infrastructure and funding for R&D.

In Europe, the EU recovery fund plans we analysed suggest that 40% of expenditure is earmarked for green investment and around 30% for digital investment.

Private investment tends to follow the economic cycle – it expands when things are good and shrinks when they’re bad. Conversely, government investment as a tool to deliver fiscal stimulus tends to be countercyclical – its growth accelerates when things are bad and slows when they’re good and debts are repaid.

The pandemic has partly altered this dynamic. Even though reopening following the lockdowns has boosted private investment, Covid-19 has highlighted the need to rebuild some physical infrastructure and make it more sustainable.

We believe this is a structural macroeconomic trend. We expect government investment in the US to pick up from here, complementing and magnifying the surge in private investment, and lifting overall economic growth.
 

This long-lasting policy shift supports our view that real assets should stay well supported and benefit further – partly also as inflation hedges, should it prove more enduring than expected.

We regard this as a broad subject, spanning several asset classes. This means that our macroeconomic and investment analysis applies to both public and private markets, especially when there’s a strong overlap between fiscal (using government investment to rebuild the economy) and sustainability aspects (tackling climate change and other key issues).

Among publicly traded companies, when consistent with our stock-picking framework, those operating in sectors of the economy related to the wider infrastructure topic – from traditional to green and digital – could benefit from these long-lasting policy and demand trends. Parts of real estate, just like logistics and warehousing businesses, may benefit too.
 

Certain investments we have been highlighting as potential return enhancers, such as private markets and multi-strategies, should remain well supported. In the near term, with inflation a hot topic in markets, infrastructure assets linked to inflation (through regulation or contracts) could see higher in demand, such as toll roads, and water and electricity assets.

More importantly, over the longer term, the planned infrastructure programmes of governments make infrastructure an even more compelling investment opportunity, with managers starting to adapt their strategies to sustainability factors. We expect to see more fund launches that combine the objective to make a positive impact across several dimensions with an attractive risk-return profile, with high demand from investors.
 

Consensus point of view

It’s easy to be bullish on the technology sector, but what it means in practice and how to pick winners is less clear. Whether innovation can really help address the key global challenges of this age remains to be seen.

Counterpoint

While we agree that choosing the right sectors and companies is key, and for that we think a bottom-up approach like ours is crucial, we also think three key top-down trends are gaining momentum, turbocharged by the pandemic. First, rising R&D spending, especially in disruptive technologies. Second, expanding capital investment, in particular in intellectual property, greener solutions and infrastructure. Third, faster productivity spreading across countries and sectors. We expect public and private firms, as well as investment themes at the intersection of all this innovation, to benefit from these drivers. We regard this as a structural trend spanning many years.

 

Download and listen now: Our Five Conviction Calls – Call 5: Innovation nation

As we come out of the pandemic, technological advances should boost productivity and disrupt all sectors.

Improvements in higher productivity segments supported by automation, digitalisation, artificial- intelligence (AI), e-commerce and remote computing worldwide have the potential to boost overall growth.

This should continue to support job creation for non-routine cognitive roles and tasks. A key factor will be the rising importance of intangible assets. Some intangibles are included in statistics, such as software, data, R&D and content. Many aren’t, such as brands, marketing, design, financial innovation and networks.

Financed by private investments and fiscal programmes, in particular in the US, many sectors should benefit from accelerated digitalisation trends that have been fast-tracked by the pandemic. They include videoconferencing, consumers shifting to e-commerce, digital payments and the ‘internet of things’. AI is displaying progress in many fields, from natural-language recognition and driverless vehicles to broadening the areas of use of the ‘messenger RNA’ approach behind some of the Covid-19 vaccines.

Technological innovation should drive the generation and diffusion of new ideas. While resulting productivity gains may be hard to see at first, they could generate faster structural growth and continue to change the way goods and services are produced and how we consume them.

Since the mid-1990s, R&D spending has been driven by private investment. Now public R&D spending is finally stabilising and even rising again in some countries.

Faster capital accumulation is driving physical and digital capital expenditure, boosting many areas like automation, with the use of robots spreading in factories and warehouses at an increasingly rapid pace.

An asset’s intrinsic value comes from a firm’s earnings power. Valuation approaches relying mainly on company accounts treat many intangibles like ‘expenses’. But if these can generate future cash flows, and are what makes companies what they are in the eyes of their customers, earnings and book value may be understated.

The reason is that markets are volatile as investors constantly re-evaluate asset prices against intrinsic values based on a firm’s earnings power. But this calculation relies mainly on accounting metrics – valuation is based on a multiple of future profits and the book value of assets. So, if a chunk of costs is not current expenses like electricity or rent, but spending on intangibles generating future cash flows – such as advertising or R&D – then valuations based on earnings and book value may both fail to capture the full picture.

There are two key points for investors. First, intangible assets aren’t just about digitalisation and technology, but also about intellectual property, networks, design, relationships and other factors not included in statistics. Second, in today’s service-led economies, what makes companies valuable isn’t physical ownership, but increasingly the value of intangible assets making them unique.

Intangibles can be used repeatedly, and are often characterised by network effects – the more they are used, the more useful and cheaper they become to other customers. Therefore, industries become dominated by big players. Intangibles tend to generate bigger synergies than tangible assets. With increasing economies of scale, a firm that rises quickly will often keep on rising, as ideas multiply in value when they are combined with each other.