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Searching for value in an age of disruption


INVESTMENT STRATEGY

SEPTEMBER 2019

 

Laurent Denize

Laurent Denize,
GLOBAL CO-CIO &
GLOBAL HEAD OF FIXED INCOME

In a word, it is never too early to start thinking about the next disruption.

Few economic booms die of old age. Therefore, many investors and economists are wondering what will end the most recent expansion, that's been going on for 10 years. The prime suspect seems to be Donald Trump.

Sustained support for capital markets…

After boosting investor’s sentiments with a generous tax reform in 2018 Trump’s trade war with China put a strain on their nerves in 2019. As it is hard to imagine that there will be a lasting agreement between China and the U.S. in an election year, the negative consequences of higher trading costs will have to be endured for a while. The first consequences of the increased tariffs are already evident in the manufacturing industry even if the service sector is surprisingly resilient. Also, the central banks on both sides of the Atlantic are doing their best to keep capital markets calm and recession at bay. This may support equities for a while, but at the price of high volatility. While there’s a lot to worry about for investors – from the rise of protectionism to the danger of a hard Brexit to the situation in Hongkong – the global economy is still not in recession. Growth expec-tations must be revised downwards overall, but with good labor markets in the US and Europe consumers will have the confidence to keep up spending.


… at the price of high valuations and volatility

So, despite growing pessimism about the economy, most asset classes performed much better than expected at the beginning of the year. Retail investors were looking for security and moved into bonds and out of equities. Never-theless, equities made gains too - with the help of buyback programs, delisting of an increasing number of companies and some purchases by alternative funds. But as valua-tions for most profitable asset classes are high, the ques-tion arises if there are still attractive investment opportuni-ties to tap.

No alternative to equities and credit

The flight to safe investments at all costs has once again led to an increase in the value of government bonds. Near-ly 30% of all bonds worldwide now have negative yields. With subdued growth and possible contagion from an US economy impaired by higher tariffs it’s hard to predict when rates will again start to rise. Probably we will have to wait a long time for a normalization. In this environment credit is the only game in town. Even if it’s not cheap, valu-ations are far from the extremes seen in the past. Equities too are not overvalued, but risk premiums (measured as the gap between the estimated dividend yield and the 10-year-risk-free-rate) have reached new peaks. Also, the valuation gap between growth and value stocks has not closed but widened in 2019. Normally this should be a strong signal for value investors to start buying. But in a world with stagnating growth we don’t expect a rotation into cyclical stocks. Portfolio managers must therefore practice the art of discovering supposedly expensive stocks that combine pricing power and high visibility of future cash flows.


Thinking about the next disruption

A number of structural trends are reshaping the world we live in: opportunities arise and companies are reinventing themselves to take advantage of these fundamental trends. We believe the acceleration of demographic pres-sure, the depletion of natural resources and the unlimited networking capacity of individuals (digital and AI technolo-gies) embody the core pillars of this change.
Since the first oil crisis in 1973, global energy consumption has doubled. The energy mix is struggling to evolve. In a single figure, the contribution to world energy production from coal and its derivatives represented 30% in 1970... It is also 30% today. This energy transition will require such massive investments that private companies alone will not be able to finance it. Hence, public powers will have to get involved (regulation, tax incentives, budget spending). 

In 2020 “Millennials” will be at equal purchasing power than the Generation X. They have come of age during a time of technological change, globalization and economic disruption, giving them a set of priorities and expectations sharply different from previous generations. Understand-ing their behavior is fundamental to seize upcoming mar-ket opportunities. For example, Tinder, a Millennial-friendly application has reached $15bn market cap in 7 years, an equivalent of Renault’s or Deutsche Bank’s sizes, Spotify leader in music streaming reached 23 bn$ and YY, a Chi-nese video based social networking company reached 4.7bn$ and 300 million users. 

Finally, why is Artificial Intelligence so important? Like electricity or the combustion engine, this is what econo-mists call a "general-purpose technology". Artificial intelli-gence is a silent revolution that will transform all sectors of the society and the economy. Companies that can use AI will be value creators in the long term. It is probably the most powerful "creative destruction" at work since the last industrial revolution.

In a word, it is never too early to start thinking about the next disruption.

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