Challenges and opportunities for investors as the cycle matures
Our fourth Portfolio Perspectives event in London in late March featured some of the industry’s most successful investors. A total of 16 external speakers from large firms and boutiques presented their views on a range of topics from geopolitics to technology and the psychology of investing. They were joined by former UK Prime Minister Tony Blair and former Italy Finance Minister, Vittorio Grilli, who discussed Europe’s complex past and future.
Portfolio Perspectives is just one example of how the breadth and reach of the J.P. Morgan platform benefits our clients through market-leading intelligence. You can find out more in the session summaries below, or click here to view the full agenda.
Macro investing in the geopolitical recession
This year’s Portfolio Perspectives took place against a background of uncertainty. However, there is also optimism about the outlook for financial markets as the current business cycle reaches its later phases. Following a disappointing 2018, stock markets around the world have delivered decent returns over the first quarter of 2019.
One of the reasons is the recent policy shift by the Federal Reserve (Fed). After three years of raising interest rates, the central bank will keep them steady, at least for this year, slowing the reduction in its balance sheet. The decision suggests a recognition that the US economy is entering a more sluggish period, and could offer continued support for risky assets.
Yet risks remain. They include political uncertainty associated with the upcoming US presidential election campaign and the UK’s Brexit negotiations as well as ongoing trade talks between America and China. There are also concerns about the levels of US corporate debt and whether any further increase in rates could trigger an increase in default rates.
Two correlations in the mind of the Fed are now inexplicably broken: (1) the correlation between employment and wages, and, more importantly, (2) between wages and inflation.
Highlighting the depth of their research capabilities, Mark Holman, TwentyFour Asset Management; Simon Henry, Wellington Management and Alan Breed, Edgewood Management discussed trends they believe offer a source of potentially attractive opportunities for investors.
The rise of electric vehicles (EVs) seems inevitable – they are more environmentally friendly, cheaper to run, more durable and often safer than their non-electric counterparts. Although the US, Germany and Japan are often seen as leaders in the auto industry, China is on track to become a driving force.
China is the largest EV market today, representing about 55% of sales. The government is providing significant capital in the form of subsidies, research and development, grants, tax breaks and various other incentives to develop a world-class EV industry. In particular, the country is developing batteries at an extremely fast rate as it attempts to catch up with other leaders in the field.
You only need to look at the choice of car for James Bond in his next movie. It’s going to be an electric Aston Martin, which shows quite how much times are changing.
Redefining business with technology
Data and technology have become increasingly important for many companies and industries. Although online sales are growing, the potential for some businesses also comes with challenges over protecting their brand. For high-profile companies in particular, the lack of price protection can inhibit their ability to fully embrace an online retail approach. Although online distribution platforms provide valuable opportunities, businesses must continue to invest to make the most of them.
For example, Estée Lauder hired CEO Fabrizio Freda a decade ago to transform its business model. Fabrizio recognised the need to move away from the traditional department store approach, instead occupying more space in travel retail. In addition, 75% of the company’s advertising is now more targeted to consumers. This transition involves more visibility on platforms such as YouTube, where videos about beauty are the second most-viewed category. In the 10 years since Fabrizio’s appointment, his acquisitions have delivered a return on investments of more than 20% a year.
The number one thing people watch on YouTube is music videos and the number two is beauty channels. This influencer market place can have tremendous results on how products are sold.
The view from China
With its high savings rate, large population and higher propensity to reform, the Chinese economy is on course to become two or three times larger than that of the US by 2050. China is making efforts to join the global financial system and increase domestic consumption.
There are ongoing concerns about recent weakness in the Chinese economy, and whether the pace of growth will continue to slow or stabilise. However, as its financial markets become more accessible to foreign investors, the range of investment opportunities is increasing.
For example, the sell-off in growth stocks in 2018 means there are now quality companies available in China at more reasonable valuations. Despite the shift towards monetary easing, some volatility may remain in Chinese equities. Foreign investors own between 2.5% and 3% of the A-shares market, which is today worth around $7 trillion. This figure is set to change as A-shares are now included in the major indices, with MSCI announcing it will add more shares this year.
The outlook for fixed income looks positive. Chinese government bonds are set to join the Bloomberg Aggregate Index in 2019. China should make up around 6% of this index over the next two years, meaning $150 billion of investment will flow into the country. Put in context, outstanding sovereign dollar debt across emerging markets is worth $1.1 trillion and a third of this will go in to the Chinese government bond market.
I’m not so worried about the high debt levels in China because they are financed by high levels of deposits and there’s not a lot of leverage in the banking system.
Mutual funds globally remain underweight Chinese equities relative to MSCI benchmark
The future of Europe
As the five-yearly elections to the European Parliament approach, the region is facing a period of upheaval due to Brexit uncertainty and shifts in the political outlook. There is increasing tension between countries wanting to retain their identity as nation states against the need for greater integration and cooperation.
The rise of populist sentiment in Europe has been demonstrated by the election of Matteo Salvini’s Northern League and Luigo Di Maio’s Five Star Movement in Italy. The government has a fraught relationship with the EU and has introduced strict migration laws since coming to power in 2018. It has also agreed to join China’s Belt and Road Initiative, which is opposed by other member states.
In contrast to Italy, French President Emmanuel Macron continues to be optimistic about Europe’s role and its future. Meanwhile, the relationship between the US and Europe remains complex, but both sides would benefit from a strong, close relationship.
Beyond these issues, one of the major challenges for Europe – and Western economies in general – is likely to be the advent of new technologies. Political differences aside, the impending technological revolution will require cooperation between different countries to ensure no one is left behind.
The British anxieties that gave rise to Brexit are European anxieties and are not just confined to Britain. It’s just that Britain had a referendum.
How does being human impact investing?
The field of behavioural finance examines how our biases affect our financial decisions. One of the longest-established biases is overconfidence – we all tend to overestimate our abilities. In financial markets, this tendency has a variety of consequences that can be used to build a better portfolio. An example of overconfidence responding to the market is called bias self-attribution.
For instance, imagine you have no portfolio management skills and you buy shares from a company. If the share price goes up, you’ll think you’ve made a good decision. If it goes down, you’ll think it’s bad luck. As a result, you’ll increase your trading activity after good outcomes, generating volume patterns. Meanwhile, behavioural finance investors try to take the other side of the trade and take advantage of price movements.
Another bias is the anchoring effect – if you’re shown a number and then asked to estimate an uncertain quantity, your estimate is likely to gravitate towards the number you were shown. For example, a company may announce results that are better than those in its earnings per share forecast. In response, analysts may adjust their forecast upwards, but not enough. As a result, this can create a systematic pattern of underreaction, causing momentum trends within the market.
How can we control behavioural biases when investing? Some systems are designed to avoid human interaction at stressful times, while others focus on a disciplined evidence-based approach. Biases can also provide compelling investment opportunities due to mispricing. Behavioural investors often take advantage of more robust features of the market such as behavioural valuations, quality characteristics and the tendency of asset prices to trend.
People would rather fail conventionally than succeed unconventionally because it's harder to stand away from the crowd.
Corporate engagement: return enhancer or risk reducer?
In the past, shareholders engaged with companies by attending AGMs and through proxy votes. More recently, investors are increasingly embracing environmental, social and governance (ESG) factors as a way to better understand how businesses are managing their risks. It can also help them to identify companies that have the potential to deliver attractive returns for many years to come.
In today’s rapidly changing world, it’s important for shareholders to gain a sense of whether management teams are fit for purpose. For example, it used to be a straightforward decision to invest in companies with strong competitive positions due to brand loyalty. But many of today’s customers demand an emotional connection with the products they buy.
When engaging with businesses as an investor, the issues can vary depending on the sector. For example, drug pricing for pharmaceutical firms was a key topic during the 2016 US presidential election campaign. For manufacturing companies, quality and efficiency can be important factors to explore.
Companies are increasingly vulnerable to stakeholder concerns. For instance, oil firms with a poor reputation on climate change would be wise to change their position in order to recruit engineers. Managing these risks requires management teams that have an open and flexible attitude to dealing with multiple stakeholders.
It’s also important to be patient and be respectful with a company when you are trying to influence its behaviour. Developing a long-term relationship and helping companies understand what they should be reporting on can help, particularly when the information you require is not publicly available.
Income generation: pulling the right levers
What are the prospects for generating an income in today’s environment? Notably, expectations from fixed income markets remain low. Over the past decade yields in both the US and Europe have fallen, and the risk-reward payoff remains challenging. However, in a period of economic and market uncertainty, selective opportunities may likely continue to appear.
The yield curve has recently inverted in the US, which is often an early warning sign that a recession is on the way. As the business cycle matures, many investors have been improving the credit quality of their portfolios as well as extending duration. We believe it’s important to stay invested even in relatively low-yielding assets because they can continue to generate a higher return than cash.
There are concerns about the lowest-quality US investment grade corporate bonds (those with a BBB credit rating), which make up about half of the $7 trillion market. If the economy starts to flirt with a recession and these companies suffer downgrades, then they could overwhelm the high yield market, which is only about $1 trillion in size today.
There are some opportunities in emerging market debt issued by both companies and sovereigns. Many countries are growing positively, tend not to have current account deficits, and are benefiting from both low global growth and a US Federal Reserve that has stopped raising rates.
At a time of low yields from bonds, multi-asset investors can look to take advantage of additional income opportunities by diversifying into equity markets. They include investing in companies that pay high dividend yields but are also able to grow their dividends. They can also find opportunities in specific sectors, such as insurance and infrastructure. Writing options is another strategy investors can use to generate an income.
If you look at the US investment grade market, it’s about $7 trillion in size. About $3.6 trillion of that is now BBB. That’s the largest BBB percentage of the market we’ve ever seen.
An inverted curve
The yield curve tends to flatten towards the end of the cycle, and reducing portfolio risk at this time can be beneficial.
Tech trap or new paradigm?
Over the past 10 years, consumers have led the shift in digital technologies. Instead of calling people on the phone, we now send instant messages. Instead of going out to the shops, we buy online. This trend shows no signs of slowing. Companies are rapidly moving towards digital technologies and the cloud, creating a range of investment opportunities.
There are three themes leading disruption in the tech sector: e-commerce, online food delivery and the traditional advertising market. However, trends take time to establish themselves in the industry. For example, Uber is growing rapidly but only around 1% of the world’s transport is booked online or through apps. Until people transition from owning their own vehicle to ride sharing, Uber is unlikely to penetrate much more of the market.
Innovation is the main driver of tech, but there are risks. They include:
- slowdown of innovation;
- innovative products are too expensive; or
- a significant change in the GDP outlook where businesses scale back tech investment.
The issue of regulation is particularly prevalent in the tech sector. For instance, Facebook is under regulatory scrutiny and has employed around 10,000 people to get rid of fake news on its platform. But as more regulatory burdens are placed on leading companies such as Facebook, it becomes harder for its competitors to penetrate the market.
In China, government policies make it difficult for foreign firms to compete with domestic ones, such as the forced technology transfer. This allows Chinese companies to innovate for a longer period of time while increasing barriers to entry into the country. A key area of focus in trade negotiations is the treatment of US intellectual property in China.
Technology is Being Transformed by the Cloud
AGM Annual general meeting
CEO Chief executive officer
ESG Environmental, social and governance
EU European Union
EV Electric Vehicles
Fed Federal Reserve
MSCI Morgan Stanley Capital International Index
PACE Power Source, Autonomy, Connectivity and Electrification
UK United Kingdom
US United States
The views and information presented in this article are those of the speakers.
All market and economic data as of March 2019 and sourced from Bloomberg and FactSet unless otherwise stated.
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