March 2018 | Multiple authors
Last year, the MSCI Emerging Markets Index gained 37% and outperformed developed markets for the first time since 2011.1 With more than 50 investment professionals at the firm focused on EM research and strategies, the investment dialogue is multifaceted and often enlightening. Below is a sampling of our specialists’ perspectives on what may be in store for EM equities.
Several of our EM investment professionals are positive on the prospects for additional equity gains. In their view EMs are, in general, either in early- or mid-cycle stages of their economic recovery. EM inflation remains largely benign. Indeed, some countries are in the process of monetary easing due to sharp declines in inflation. Moreover, many EM real rates are positive (and higher than among developing markets [DMs]), providing a cushion for capital flows and lessening the need for significant tightening. Overall, valuations are not too rich across EM; the MSCI EM Index is still trading below its historical price to book and well below global and US valuations.
Latin America: Positive inflection points
Brazil’s central bank cut its benchmark rate by more than 5% in 2017. Inflation has been trending lower since the start of 2016, commodity prices have stabilized, and private consumption is growing. While the recovery remains tepid, one of our EM portfolio managers (PMs) expects acceleration over the coming quarters. He believes Argentina remains an underappreciated growth story. There, inflation and interest rates have been coming down, and investment and personal consumption are showing signs of strength, notably via robust construction activity and a pickup in auto sales.
China: Innovation and SOE reform have been ramping up
One of our China PMs notes the staggering pace and scale of innovation. China is now home to one of the world’s leading global e-commerce and cloud service providers, the world’s largest gaming company, a global leader of lenses for automotive safety and autonomous systems, and several of the world’s largest security and surveillance system producers. Over the last decade and a half, China’s patent applications have surged and now account for more than 40% of the world’s total applications (Figure 1). The PM also highlights the transition of China’s stock market composition away from state-owned enterprises (SOEs). She notes that the majority of China’s market capitalization is now in private enterprises, and the pace of this transition appears to be accelerating.
India: Attractive in the medium term
One of our India investors acknowledges that structural reforms in India are disrupting established ways of doing business. As a result, he sees reduced economic growth in the near term, but a stronger outlook over the medium term. The recently implemented Goods and Services Tax (GST), which consolidated and simplified the tax code to help unify India as a single market, is causing some pain. The profit margins for many small and rural businesses, whose primary competitive advantage was shirking taxes, are being squeezed. Many small, less-formal enterprises must find ways to adapt, or go out of business. Overall, the GST is benefiting larger companies with stronger, more mature operational models.
Over time, our analysts believe that reforms like the GST and a new bankruptcy law, among others, will ultimately facilitate creative destruction of capital. Businesses are taking advantage of current reforms, which are breaking down regulatory barriers to scale and making India an exciting place to hunt for potential investment opportunities.
One of our thematic portfolio teams sees economic development as a powerful force for structural change in EM. Many thematic investment opportunities enjoy secular tailwinds, yet they tend to be underrepresented in traditional indexes. Areas of focus for the team today include automation, logistics, health care provision, environmental consciousness, and discretionary lifestyles. For example, the teams believe many EM companies that promote freight mobility and provide transportation-related infrastructure including rail, port services, warehousing, and logistics providers are attractive long term.
Read our latest research on structuring EM portfolios, “EM evolution: New paths in portfolio construction.”
The stigma surrounding securitized credit, which was at the heart of the global financial crisis 10 years ago, has clouded this market segment, and in our opinion, created opportunity. Our team of fixed income securitized investors notes that expectations of better collateral performance, improved underwriting standards, enhanced structures, and greater regulatory supervision are all helping to make market participants more comfortable investing in this sector. They believe these factors, along with diversification benefits and relative yield advantages, can support a structural allocation to securitized credit in client portfolios.
The securitized credit market in the US and Europe comprises four distinct segments:
These securities are backed by varied types of assets (e.g., consumer, housing, commercial real estate, etc.), use different structural features, and provide a variety of cash-flow profiles. As a result, it is possible to create portfolios from this universe with customized risk profiles that target tailored return objectives and varying levels of credit quality, liquidity, and duration.
These investments have potential diversification benefits. While tied to the overall health of the economy, securitized assets also have performance drivers that can create distinct return patterns and relatively low correlations relative to one another and to other fixed income credit sectors (Figure 2).
The securitized sector also typically offers a yield or spread advantage relative to corporate credit of comparable risk. Figure 3 shows that investment-grade securitized assets usually offer similar or higher spreads with much lower duration (and weighted-average lives) compared to equivalent credit quality corporate bonds. The vast majority of securitized assets have average lives of under five years, generally leaving these sectors less exposed to a spread-widening event. In fact, today’s duration on the global investment-grade corporate index is higher at over 6.5 years than its long-term range of between five and six years, and the duration on the US corporate index is even longer, at over 7.5 years. Our analysts think this lengthening in duration, combined with a deterioration in average corporate credit quality (average credit quality of the global index has deteriorated with the BBB share more than doubling since the early 2000s), leaves investors especially vulnerable in an economic downturn.
As a result of better market discipline as well as regulatory reforms, underwriting of collateral has improved and structures have sought to become more protective of debtholders. For example, today an AA-rated CLO bond has roughly 25% credit support, equivalent to the credit enhancement of an AAA-rated CLO issued before the financial crisis. Requirements that issuers or sponsors of securitizations retain a portion of the credit risk they originate have also reduced noteholder risk.
The securitized universe is large, but underrepresented in common benchmarks. With securitized assets comprising roughly 2% of the Bloomberg Barclays US Aggregate Index (or about 1% of the Bloomberg Barclays Global Aggregate Index)2 — very small in benchmark terms — most benchmark-oriented strategies offer little to no exposure to these potentially attractive and improving trends in securitized assets. Yet the overall size of the market is in excess of US$2 trillion, representing roughly 10% of the US$20 trillion US Aggregate Index. (As of year-end 2017, the size of the US/European market was approximately US$2.5 trillion or roughly 5% of the US$50 trillion Global Aggregate Index).
For more details, see our paper: “The case for securitized credit as a strategic asset allocation“
Read more about the risks and opportunities associated with CLOs: “CLOs: Still no reason to be scared of the initials”
2Sources: Intex, SIFMA, Bloomberg Barclays, Citi, Wellington Management | Amount outstanding as of 31 December 2017.
Investors are often drawn to trends they consider long-lasting and important, but one secular pattern they appear to be either ignoring or discounting is climate change. The scientific community seems fairly resolute in their view of climate change’s link to weather adversity, yet most investors appear to be paying little attention to climate risk and the near- and longer-term consequences it may have for assets in their portfolios. As those risks start to get repriced, however, the property and casualty (P&C) insurance industry will likely fundamentally adapt, and companies that effectively manage climate risk should be able to weather the storm.
Global temperatures have been rising for decades and now appear to be accelerating — with no sign of mean reversion (Figure 4).
A hotter world generates more climate-related risks. And with a greater concentration of vulnerable physical and economic capital in some of the most climate-susceptible regions, the cost of natural disasters has increased. Figure 5 shows the growing frequency and annual costs in the US of extreme weather events, with storms and floods accounting for the vast majority of weather-related disasters. The risks involved are not related to weather adversity alone. We have seen significant growth in climate-focused regulatory, political, legal, technology, and capital-market pressures.
The growing frequency of extreme weather events underscores the fact that many climate-related risk models are flawed. Within the P&C insurance market, many catastrophic-risk models assess a single weather-related disaster a year at a time, and they assume that the risks are independent of one another across time and location. But extreme weather events, which can be larger and more severe, have multifaceted risks: Intense rain, high winds, and flooding from storm surges during the same hurricane can have different devastating effects.
When climate risks begin to be priced more accurately, insurance coverage will likely become less available, and our analysts believe events that used to be insurance “problems” will become equity “problems.” Almost by definition, insurance exists as a method of hedging a rare occurrence — largely for events that are most often assumed to occur with probabilities of less than 1 in 100. If extreme events become more commonplace and presumed to occur with odds of 1 in 20, then these risks are likely to become uninsurable, with negative effects on equity values of climate-susceptible assets.
Our Global Environmental Opportunities PM believes that long-term asset owners are structurally long climate risk across their investment portfolios, in highly correlated ways. As such, he considers “carbon-advantaged” strategies that focus on companies that help mitigate climate change or adapt to climate risk. In his view, these companies will see strong demand and should enjoy competitive advantages. He seeks to invest in attractively valued companies that can potentially benefit from the sizable investments that will likely be required to design resilient infrastructure, better manage flood risk, rebuild or reengineer new buildings and physical property, and improve security of basic services and goods (e.g., food, water, electricity, and communications).
In this manner, he is aligning his investment process to hedge climate risks aiming to benefit from ongoing secular trends.
Read more about what our climate specialist has to say: “Brewing storm: Are investors discounting climate risks and opportunities?”
Spurred by innovations in batteries, electric vehicles, and autonomous technology, the transportation industry is in the midst of a multidimensional transformation. We convened a roundtable discussion with our automotive, utility, technology, and energy analysts on the topic of electric and autonomous vehicles. A few highlights follow.
A common misconception is that EVs are inferior to internal combustion engine (ICE) vehicles. Several of our auto analysts dispel that idea, noting that EVs can be more powerful, have simpler designs, and are easier and cheaper to maintain. They contend that as more of the population comes to understand these advantages, the EV transition should gain momentum.
One new EV on the market gets 3.3 miles/kilowatt hour (kWh). With electricity rates in the US at 1.1 cent/kWh, this EV costs about 3.33 cents/mile to drive. That’s about 60% less than a traditional gasoline-powered car. (At 30 miles/gallon and US$2.50/gallon for gas, the average cost/mile is around 8.33 cents today.)
Electrification of transport represents a shift of energy delivery from molecules (associated with hydrocarbons) to electrons (from energy in the form of electricity). Grid-based electricity is inherently more efficient than internal combustion engines. As such, one of our analysts believes that if all US light-duty vehicles became electric, electricity demand would rise by only 15% to 20%. He feels that utilities may be uniquely positioned to facilitate EV adoption and the shift to cleaner transport through their networked infrastructure assets.
EVs represent a tiny fraction of auto sales today, but one of our auto analyst’s estimates of EV uptake outpaces those of his internal and external peers; he thinks EVs could grow to 20% of sales by 2025 and 20% of the outstanding auto fleet by 2030. And if we hit 20% of sales, he thinks the move from 20% to 80% could happen quickly.3
Figure 6 shows some of the key variables that may influence oil prices over the next seven years. Oil prices, oil and shale production, and decline rates may have more meaningful impacts on cumulative supply/demand trends than EV adoption.
Oil fields have a natural decline rate. In 2016, approximately US$400 billion was spent on production, and supply stayed flat.4 Capital spending in the energy upstream market has increased substantially, funded primarily by debt and private-equity capital, which may be less plentiful if transportation trends migrate toward EVs. Most of our analysts expect the EV transition to pressure oil prices eventually; however, prices could rise due to investment curtailment in the near to medium term.
The strategic decisions of today’s original equipment manufacturers (OEMs) may well determine their fate in the coming years. One of our analysts thinks the auto industry is saturated and must consolidate to generate long-term value.
While scores of companies may be vying for the lead in autonomous driving, we think many of today’s investment opportunities lie in the automotive supply chain (cameras, sensors, adaptive safety features, and other components). We also see related tailwinds materializing for data centers, semiconductors, and battery storage. Also, if shared and autonomous vehicles drive transport costs down and miles-driven up, tire companies could become more attractive as well.
EV adoption — globally 2%, 5%, or 20% of fleet in 2030
EV adoption + trucking penetration — adds in EV penetration to the trucking fleet with oil demand intensity falling by -1.50%, -2.25%, or -3.00% per year
GDP growth — 2.5%, 3.0%, and 3.5% global real GDP growth
Oil price — US$25, US$50, or US$100 Brent oil prices throughout period. The impact is based on a typical elasticity of 150 thousand barrels per day (kbd) per US$5 change in Brent prices. The model likely overstates impact due to the inherent reflexivity in the market.
ICE efficiency — 0%, -2%, and -4% for annual efficiency gains in ICE fleet
OPEC production — based on bottom-up range of forecasts for 2025, ranging from 30 to 45 mbd in aggregate
US shale production — ranges vary from near flat growth to a high of sustaining near 1 million barrels per day (mbd) of growth per year
Non-OPEC, non-US production — based on bottom-up range of forecasts for 2025
Decline rates — base decline rate of 4% with a range of 3% – 6%
Read our analysts’ full views: “Power on: Five insights on electric and autonomous vehicles”
3Actual results may vary, perhaps significantly, from projections. Projected or forward-looking estimates are based on a number of assumptions. The use of alternative assumptions could yield significantly different results. The views expressed are those of the analyst, are based on available information, and are subject to change without notice.
Historically, enterprise software platforms have evolved gradually from incremental changes in computing architecture. Today, however, significant advances in machine- or deep-learning algorithms are being incorporated directly into software applications. Enhanced functionality is gaining traction across a wide swath of enterprises and could change the way industries and economies operate in significant ways.
Application intelligence refers to user-oriented software that analyzes information, predicts outcomes, or automates user activity and business functions. We think more and more tasks are likely to be enhanced or automated with this functionality, including:
Our software analyst attempted to size the market opportunity for these smarter enterprise software platforms, based in part on the notion of labor replacement. He believes that for many enterprises, the use of deep learning algorithms and embedded intelligence is already starting to deliver returns on investment. As an example, in a customer relationship management system application, intelligence enhancements can prioritize pipelines, evaluate the potential for deals to close, email meeting requests to customers, and update calendars. As such functionality continues to improve and expand, our analyst thinks we will see an increasing share of labor savings shift to spending on software.
As part of his research, he isolated occupations for which software vendors are currently working to deliver application intelligence. He found that in the US alone, the collective compensation of these roles exceeded approximately US$1 trillion (according to 2015 US government data) (Figure 7).
Today, application intelligence generates a relatively small portion of software industry revenues, but the runway for long-term growth appears to be quite long. Our analyst sees ample potential for cross-sector usage, as well as more vertically integrated applications such as for insurance claims, health care administration, and financial fraud detection. During a recent research trip to the US West Coast, he noted that several enterprise software vendors were seeing rising demand for health care-related software aimed at promoting greater levels of efficiency within the US health care system. These firms could benefit from a rise in health care IT spending. Finally, as more companies move workloads to cloud environments in order to capitalize on this new functionality, our analyst expects to see competitive gaps widen and investment opportunities increase.
We think recent concerns about CLOs are overblown. New issuance is subdued, robust structures can buffer a potential rise in bank-loan losses, and there are few signs of outsized leverage...Read more
Given the potential for substantial asset repricing, asset owners may want to consider a proactive approach that seeks to identify companies focused on climate change mitigation and adaptation.Read more
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