The elevated economic and market volatility witnessed in 2022 isn’t likely to abate when we turn over the calendar to a new year. With the return of inflation, central banks can no longer afford the endlessly loose monetary policy that served to mute the effects of the economic cycle in the post-GFC period. In fact, as our macro strategist team has argued, central banks will struggle at times to find the right balance between tamping down inflation and propping up growth, and so it seems reasonable to expect a more traditional cycle with distinct and potentially more frequent moves from one phase to the next.
In this new, more volatile regime, we see a case for thematic allocations focused on long-term structural trends. Specifically, we find evidence that thematic investing may help reduce the importance of the economic cycle to portfolio returns.
Defining thematic investing
For context, we define thematic investing as the identification and exploitation of a top-down, innovative, or disruptive trend that has a structural tailwind with the potential to drive above-average returns for companies participating in that theme. Returns to themes cannot be easily explained by traditional country, sector, or style factors.
While thematic investing can be applied to different asset classes, it is often expressed via equities, which is where we have focused our research. Examples of equity themes include fintech, the future of education, energy efficiency and automation. By investing in companies within these themes, investors are assuming that their growth potential is not yet fully appreciated by the market — but will be over time.
Cutting ties with the cycle
If thematic investments generate their returns by exploiting structural change, then including them in a portfolio could make the difficult task of timing the cycle less important, reducing the reliance on strong economic growth to drive strong returns. Thematic allocations could also help increase diversification given how much cyclical exposure is typically found in a portfolio.
To test this argument, we compared the cyclicality of global equity sectors and global equity themes. We used a large universe of single-theme managers, based on thematic mapping work by Broadridge, a data provider that collects and reports AUM and flow data on more than $42 trillion in global fund assets. We defined cyclicality based on the correlation with the OECD’s US cyclical leading indicator (CLI). As indicated by the dashed black lines in Figure 1, we found that themes were, on average, about half as sensitive to the cycle as sectors.