By Joseph V. Amato, President and Chief Investment Officer-Equities; & Erik L. Knutzen, CFA, CAIA, Chief Investment Officer-Multi-Asset Class
A decade after the financial crisis, four key trends are helping to fashion the investment landscape for the next 10 years.
The world is undergoing an important series of transformations. Rapid shifts to personal, political and business dynamics are evident on a near-constant basis, affecting our daily lives in ways few would have imagined just decades ago. For investors, a key task is to differentiate truly important changes and consider how to deal with them. In marking the 10th anniversary of the financial crisis, we recently called on portfolio managers and analysts across our firm to identify transformative trends, and together we pinpointed four: the explosion of debt; movement toward a more fractious, multipolar world; a turn toward private assets; and the growing importance of technology. The resulting economic and social changes will be profound, demanding close attention from investors, as explained below.
A Decade's Difference: Key Statistics
|That Was Then||...This Is Now|
|Global Debt1||$116 trillion||$164 trillion|
Federal Reserve, ECB and Bank of Japan balance sheets
|$5.7 trillion||$14.8 trillion|
|Number of AAA bond issuers||6 corporates, 19 sovereigns||2 corporates, 11 sovereigns|
|Value of outstanding U.S. BBB corporate bonds||$760 billion||$2,700 billion|
|U.S. primary dealers' corporate debt net positions||$112 billion||$18 billion|
|World's six biggest companies by market cap2||PetroChina, Exxon Mobil, General Electric, China Mobile, Industrial & Commercial Bank of China, Microsoft||Apple, Alphabet, Microsoft, Amazon, Facebook, Tencent|
|GDP of Brazil, Russia, India and China (current U.S. dollars)3||$9.2 trillion||$16.6 trillion|
|German Bund 10-year yield||4.6%||0.5%|
|New Smartphone shipments worldwide||185 million||1,460 million|
|Global internet penetration (users as a percentage of the population)||24%||49%|
|Number of U.S. private equity-owned companies||4,643||7,265|
Source: International Monetary Fund, Federal Reserve, European Central Bank, Bank of Japan, Standard & Poor's, Federal Reserve Bank of New York, World Bank, Bloomberg, Kleiner Perkins, PitchBook. Data as of 2008 and 2017 unless stated otherwise.
Trend 1: The Debt Explosion and Its Aftermath
The financial crisis of 2008-2009 had initial impacts of historic proportions, triggering a 55% decline in equity markets and an increase in high yield spreads to more than 20 percentage points. U.S. GDP contracted by more than 4% through the second quarter of 2009. Policymakers' response to the crisis was unprecedented. Central banks slashed interest rates and adopted vast quantitative easing programs. Authorities overhauled banking and market regulation and moved debt from the private sector to government balance sheets.
Although such measures probably helped avert a second Great Depression, they are also causing blockages and gaps in the financial system, as banks curtailed some lending and reduced market-making activities. They also led to permanent deficit policies in the developed world and higher sovereign debt levels in the emerging world.
Today, central banks continue to support risk appetite by artificially suppressing the volatility of the economic cycle and distorting the creative destruction of the business cycle and the price of capital. While some individuals and smaller companies have struggled to borrow and raise capital, the corporate sector, in general, has taken advantage of an unusually extended economic cycle and artificially low interest rates to borrow more, leading to huge growth in the corporate bond and loan markets.
As the cycle matures over the next couple of years, we believe growth is likely to slow and interest rates are likely to rise. This, in turn, could put pressure on companies that have exploited a long period of low volatility and low rates by taking on more debt - leading to potential dislocation, but also opportunity for alert investors.
Central Banks Binge on Bonds
Balance Sheet Size ($ Millions)
Source: Federal Reserve, European Central Bank, Bank of Japan. Data through March 2018. For illustrative purposes only. Nothing herein constitutes a prediction or projection of future events or future market or economic behavior. Investing entails risks, including possible loss of principal.
Cyclical Opportunity Looms in Credit
Over the past 20 years, the average rating in the credit markets has fallen from A to BBB as more companies have capitalized on cheap debt, while investors' search for yield has fed exceptional growth in BBB rated bonds as well as high yield loans, European corporate debt, and emerging markets debt.
We believe the credit cycle will turn at some point over the next two to three years, at which point a substantial proportion of the BBB market could be downgraded from investment grade to high yield. As many institutional investors are only able to hold a limited amount of non-investment grade debt (whether because of investment policy or regulation), that could create a wave of forced selling exacerbated by a lack of market makers that traditionally warehoused such securities on their balance sheets.
As a result, we anticipate a major opening for high yield investors in the more stressed parts of the market, beginning as the credit cycle turns in two to three years and lasting for perhaps a year or two thereafter. That could be an opportune time to bolster allocations in those areas.
Investors Rethink Diversification
The financial crisis was an important reminder that fixed income and credit can be subject to major loss events and long periods of weak performance. Indeed, three decades of declining interest rates may have allowed investors to forget that, before the 1980s, the number of long-term periods of poor total returns for bonds was far greater than for equities.
At this point, we believe the disinflationary era of the past 30 years - and related bull market in bonds - may be coming to an end. The depression of bond yields has both reduced their income-generation potential and increased their sensitivity to interest rates, raising questions as to what constitutes a "low-risk" asset and how to balance risk in long-term investment portfolios.
We believe a viable solution for income investors has three elements. First, it involves seeking higher yields from alternative sources of income further out on the risk-return spectrum, whether emerging markets debt, loans, real estate securities, high-dividend equities or options-writing strategies. Second, it involves investors utilizing diversification more broadly to mitigate risk. Finally, in addition to the strategic asset allocation, it involves the use of dynamic tilts to better navigate short-term market challenges.
Trend 2: Shift Toward a Multipolar World
After the collapse of the Soviet Union, a consensus emerged around the benefits of liberal democracy, market capitalism, and free global trade. The emerging world opened to global markets and established orthodox political and financial institutions, while the developed world accepted changes to its own economies in return for access to new, fast-growing markets and cheaper goods and credit.
That consensus has come under strain. China will soon emerge as the world's largest economy and is increasingly a competitor against, as well as a complement to, the developed world's economic and political interests. The emerging world, in general, is likely to leverage its demographic advantages to become the major growth engine (and not just a source of marginal growth) for the world economy.
The spread of markets and economic liberalization, while improving wealth equality across nations has exacerbated inequality at a local level, contributing to a rise in populist and nationalist sentiment, and criticism of global trade.
As traditional east-west and north-south relationships give way to a more complex, multipolar dynamic, investors need to be attuned to the realities of these shifts and how they could affect both portfolio risk and the sources and degree of potential return over time.
The Emerging World Takes Its Share
Share of Global GDP in Current U.S. Dollars
Source: World Bank. Data through 2016. For illustrative purposes only. Nothing herein constitutes a prediction or projection of future events or future market or economic behavior. Investing entails risks, including possible loss of principal.
Emerging Markets Go Mainstream
For all their long-term promise, emerging markets remain underweighted in portfolios, accounting for 40% of global GDP but only 13% of the MSCI All Country World (equity) Index and a quarter of the world's total public and private debt. We believe this imbalance is likely to correct, especially as the clout of the emerging world increases.
Investor engagement is likely to become deeper, too. As private markets grow (see Trend 3), we expect investment in public emerging markets to be complemented by growing allocations to private assets that can provide effective exposure to local economies. Also, active managers' environmental, social and governance (ESG) analysis is likely to penetrate further into securities research in emerging markets, not least because the major emerging countries' stock exchanges often have stricter reporting requirements than those in the U.S.
Over the coming decade, lower return outlooks in the developed world may incentivize allocations to markets with higher growth and return potential, and we believe the current distinction between the developed and emerging worlds will dissolve. Investors are increasingly apt to reject this somewhat arbitrary division in favor of pursuing the best investment opportunities across a multipolar world.
The 'Great Disinflation' Is Likely Over
The financial crisis exacerbated existing disinflationary trends of globalization, technological change, and aging demographics - but we now anticipate something more balanced.
Online deflation is significantly outpacing deflation at large, while the sharing economy (Airbnb (AIRB), Lyft (LYFT)) is also dampening prices. Meanwhile, wages and productivity are rising more slowly due to a rapidly aging and retiring workforce, automation, weaker labor unions, and less capital investment, among other factors.
But there are offsetting trends. Millennials are entering their most productive years and could generate upward pressure on wages. China, which once exported disinflation, is now becoming a more self-sufficient, consumption-led economy, reducing its influence on price trends outside its borders. And the pace of globalization is slowing, exacerbated by populist and nationalist political pressures in the developed world. Related protectionism could move consumer prices upward.
Over the past 10 years, many of us have gotten used to low inflation. While we might not see exploding prices from here, there will likely be more of a "two-way" dynamic, adding to market volatility as investors slowly adapt to this new reality.
Trend 3: Change in Public/Private Asset Balance
The universe of U.S. publicly owned companies has been shrinking since the turn of the century. Fewer companies are choosing to list, and those that are listed have been issuing debt to finance share buybacks at unprecedented levels.
Public markets have also become more fragmented and less liquid. Regulation has made it more capital intensive for investment banks to "warehouse" securities on their balance sheets. Those inventories are used to make markets and provide liquidity to clients as they buy and sell stocks and bonds; as they shrink, the liquidity of the public markets dries up and the potential for gaps in pricing and higher volatility rises.
The opposite trends are evident in private assets. The secondary market in private-asset fund interests has grown and deepened rapidly since the financial crisis, bringing a higher level of liquidity to investors. Meanwhile, as the number of public companies has declined, an increasing number of companies has been going private or staying in private hands indefinitely.
The flow of capital to businesses and individuals is privatizing and fragmenting in other important ways. The dominance of the banking system in credit flows is giving way to capital markets, private debt funds, crowdfunding, and lending-platform technologies, as regulation increases the capital intensiveness of making loans. Meanwhile, the private market ecosystem is expanding to include everything from direct lending and mezzanine financing, to secondaries and co-investment, to investing in the equity of alternative investment firms themselves.
The Private Economy Has Grown in Importance
Number of U.S. Listed Companies and U.S. Private Equity-Owned Companies
Source: World Bank, World Federation of Exchanges, Pitchbook, Credit Suisse. Data as of December 31, 2017, for listed companies and March 31, 2018, for private equity. For illustrative purposes only. Nothing herein constitutes a prediction or projection of future events or future market or economic behavior. Investing entails risks, including possible loss of principal.
Private Equity Offers Flexible Exposure to Growth Potential
Globally, private investments may still account for just 2.5% of the world's market capitalization. However, the number of private companies now exceeds the number of public companies; they are among the world's fastest-growing businesses, and likely to be engaged in the important industries and markets of tomorrow.
With private markets representing a greater proportion of economic activity, where appropriate it increasingly makes sense to seek out such exposure. Private assets have tended to outperform, on average, because private equity investors have deeper access to information, more direct and transparent governance control, and the ability to create value through strategic and operational improvements. Because private equity managers are expected to spend months sourcing and completing investments and can choose between trade sales, sales to other private equity funds and IPOs, they also benefit from flexibility around both their entry into and exit from positions. Finally, private investments are often quite different from public equivalents in the businesses they represent, whether in transitioning industries or at early stages of their growth cycles, potentially adding to their value as diversifiers.
Diminished Banks Create New Opportunities
As regulation and tech-based solutions have reduced the role of banks in lending and providing liquidity, investors are stepping in with financings and to capitalize on market volatility. In particular, private equity managers are increasingly turning to private debt funds both as a reliable source of funds and, when banks are involved, to fill out capital structures so that deals can meet higher regulatory requirements. Private equity investors are also benefiting from the bank disintermediation trend by financing new models such as crowdfunding and non-bank payment systems.
Trend 4: Tech Accelerates Creative Destruction
The world's largest companies today are very different from those of a decade ago. The change reflects the increased importance of technology in the economy. If we include Amazon, for example, the six biggest corporations on the planet are all technology-related businesses. By market cap, the U.S. tech sector alone is larger than the emerging markets, the eurozone and Japan individually.4
Powerful economic forces are fueling this dominance. Since 2007, spending on research and development and capex in the U.S. technology sector has surged by 9% per year, more than twice as fast as any other sector. Moreover, that spending has gone from 13% of revenues to 18% of revenues, and the rate of growth appears to be accelerating.5
Once a concept is proven, it is often adopted faster and more widely than in years past. Television took almost 15 years to be adopted by 50 million households, while Facebook got 50 million users within 12 months.6 Today, a successful internet-based service can cross that threshold in three to six months. The blistering pace of change presents both opportunity and risk to economies, society, and jobs, adding to the pressure on governments to be more interventionist as capital threatens to take an even greater share of growth than labor.
Disruptive technological revolutions are occurring in many sectors, from transport and finance to manufacturing, medicine, and retail. Navigating the tensions between investment opportunities and societal disruption will be an important test for long-term investors and a key challenge for active managers seeking to analyze the true social and political risks associated with their investments.
New Technology Has Been Adopted Increasingly Quickly
Number of Years Until a New Technology Was Used by 25% of the U.S. Population
Source: Ray Kurzweil, singularity.com, U.S. Census Bureau. For illustrative purposes only. Nothing herein constitutes a prediction or projection of future events or future market or economic behavior. Investing entails risks, including possible loss of principal.
Thematic Analysis Gains Traction
The asset management industry is in the early stages of a move away from a sharp division between passive and benchmark-driven active strategies, toward a more considered range of techniques. For genuine bottom-up, fundamental active managers, research will remain crucial and increasingly informed by the development of thematic frameworks, which are likely to gain importance as technological shifts become even more disruptive, far-reaching and frequent.
Thematic investing requires nuance and deep sectoral expertise to help identify not only genuine megatrends but also the truly actionable investment opportunities they are creating. Autonomous driving provides a good example. Picking the winners in the tech-driven race to implement machine-driven transportation could be extremely difficult. However, if you accept that self-driving cars will eventually gain acceptance, you can focus on researching established providers that are likely to benefit, whether (directly) sensor, software, and semiconductor manufacturers or (indirectly) cloud service providers or wireless telecom operators.
In an evolving competitive environment, grasping those differences and capitalizing on them could be a key factor in achieving attractive performance over time.
Big Data Transforms Investing
Active managers are increasingly seeking better ways to gather more granular and timely information about how companies are performing, often in a raw form that can be "sliced and diced" to generate genuinely proprietary insights. This is being achieved through the use of so-called big data, which we believe will be a key battleground for returns in the coming years.
IBM has claimed that human beings, with their new devices, sensors and other technologies, generate 2.5 quintillion bytes of data every day.7 To put it another way, the vast majority of all the data that has been created since the beginning of human history has been created in the past few years. Neuberger Berman's Chief Data Scientist refers to this as our "digital residue."
Insights gleaned from quarterly accounting statements can be dramatically enhanced with the digital residue left - often in real time - by a company, its partners in the supply chain, its customers and the media (both social and otherwise). Properly collected, monitored and analyzed, it can uncover unseen patterns at the macroeconomic, industry and company level.
This ongoing data revolution has already created several waves of quantitative and systematic investment since the 1990s. In our view, the big data "Holy Grail" will be the combination of traditional fundamental analysis and quantitative investment techniques. Enhanced by big data, this "quanta-mental" approach could be a formidable driver of potential investment advantage.
ESG Becomes Integral to Portfolio Management
In our view, the technology revolution will not only require ESG analysis to be more fully integrated into active investment processes but also make that integration possible.
Some of the world's most pressing social challenges, such as rising wealth inequality, have their roots in the automation of our economies. As returns on capital continue to outstrip returns to labor, investors will need to become more sensitive to the potential social disruption of their capital, and mindful of elevated government and regulatory risk. Integrating ESG into research and investment processes can enable managers to fine-tune judgments on impacts, and inform shareholder engagement on key issues. All of this requires judgment, not box-checking. Importantly, it also requires robust and reliable data, which the trend of big data is making possible.
Looking for More From Portfolios
As we've discussed, the economy and markets are undergoing rapid change, driven by trends following the financial crisis and the accelerating technological innovation. At the same time, investors face an array of structural challenges, including high debt levels, low but rising interest rates, and potential for worsening inflation, even as aging demographics and a changing Chinese economy contribute to lower global growth potential. All of these factors suggest that the next decade could be one of lower market return outlooks and higher volatility.
There's no single response to these headwinds. We believe investors should look to a range of markets and strategies, rethink their bond exposures and, where appropriate, consider the use of alternative investments like private equity. Drawing on the skills of experienced portfolio managers, they can seek to capitalize on an array of investment tools, including newer wrinkles such as thematic research and big data. In our view, such a multifaceted approach can provide them with a leg up in seeking to capitalize on opportunities as they strive to achieve their long-term investment objectives.
1 Total private and public debt of 190 countries, as of December 31, 2007, and December 31, 2016.
2 As of December 31, 2007, and December 31, 2017.
3 As of December 31, 2007, and December 31, 2016.
4 Source: BofA Merrill Lynch, MSCI. Data as of June 12, 2018.
5 Source: Internet Trends, Kleiner Perkins.
6 Source: "Capturing Business Value With Social Technologies," McKinsey & Co., November 2012.
7 Source: Industry Insights, IBM, April 24, 2013.
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