Guide to Global Equities 2019

Guide to

Global Equities Principal Sponsor

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Can I find portfolio managers who work well independently and even better together?

A distinctive approach to managing money means with Capital Group, I can.

capitalgroup.com/au

FOR PROFESSIONAL INVESTORS ONLY. The value of investments and income from them can go down as well as up, and you may lose some or all of your initial investment. Past results are not a guarantee of future results.

This material is of a general nature, and not intended to provide investment, tax or other advice, or to be a solicitation to buy or sell any securities. In Australia, this communication is issued by Capital Group Investment Management Limited (ACN 164 174 501 AFSL No. 443 118), a member of Capital Group. Š2019 Capital Group. All rights reserved.

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Editorial Global equities – a sector you can’t afford to ignore

T

he runs are on the board over the long haul – global equities exposures have rewarded investors over the past decade.

It has long been accepted that Australian investors tend to be overweight to domestic equities but over the past decade a healthy exposure to international shares would have delivered significant dividends.

As our reporter, Laura Dew, notes elsewhere in this guide, there was a significant benefit in looking at global options over the past 10 years, with global funds outperforming their domestic counterparts over both three and 10-year periods.

Australian equity funds have, of course, been marginally stronger performers over the past 12 months largely due to the uncertainty created by the US/China trade war and the continuing volatility around Brexit.

Over the year to 30 September, 2019, the average global fund returned 7.1% versus returns of 8.8% by ACS Equity – Australia. However, this needs to be weighed against the average global fund returning 42% over three years versus average Australian sector performance of 32%.

Perhaps more importantly, looking at a decade of performance, the ACS Equity – Global sector has returned 169% compared to 101% by the Australia sector.

The question for financial advisers is ultimately going to be how much exposure is appropriate for particular clients given the current uncertainty being driven out of the US and, indeed, a number of the fund managers interviewed for this guide acknowledge the complexity and the challenges.

However, with Australian equities equating to just 2% of the global listed market, global exposures will continue to represent a fundamental part of any well-balanced investment portfolio.

The 10-year performance of global funds suggests that while some uncertainties remain, some astute selection will generate rewards.

Mike Taylor Managing Editor

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Contents 03

Editorial

12

How culture makes a difference to investment outcomes

07

Guiding through the globe 4 | MONEY MANAGEMENT | GUIDE TO GLOBAL EQUITIES

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Contents 15

Exploring equities all over the world 20

Trade tensions begin to bite

25

Natural resources are finite, and so is global economic growth GUIDE TO GLOBAL EQUITIES | MONEY MANAGEMENT | 5

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About the publisher

Launched 32 years ago, Money Management has firmly established itself as the leading source of news and analysis for Australia’s financial services sector.

In this time, Money Management has rapidly evolved from a B2B newspaper into a respected provider of accredited education and training, research, professional support and advocacy as well as thought leadership in the financial services space.

While it remains the most-read print and online publication by financial planners in Australia and is widely recognised as a leading advocate for this profession, Money Management's growing audience is a diverse one that also includes fund managers, accountants, risk advisers and superannuation fund trustees.

Money Management is also the clear publication of choice for finance institutions – both domestic and international – seeking to connect with the high-earning and well-educated professionals working in Australia’s financial services sector.

FE is a financial information and communications company founded in the UK in 1996.

It has offices in Australia, India, Hong Kong, and the Czech Republic. It provides data, software, research, and ratings to help asset managers and financial advisers make better investment decisions.

ACN 618 558 295 www.financialexpress.net © Copyright FE Money Management Pty Ltd, 2019

FE Money Management Pty Ltd Level 10 4 Martin Place, Sydney, 2000 Managing Director: Mika-John Southworth Tel: 0455 553 775 mika-john.southworth @moneymanagement.com.au Managing Editor/Editorial Director: Mike Taylor Tel: 0438 789 214 mike.taylor@moneymanagement.com.au Associate Editor - Research: Oksana Patron Tel: 0439 137 814 oksana.patron@moneymanagement.com.au News Editor: Jassmyn Goh Tel: 0438 957 266 jassmyn.goh@moneymanagement.com.au Senior Journalist: Laura Dew Tel: 0438 836 560 laura.dew@moneymanagement.com.au Journalist: Chris Dastoor Tel: 0439 076 518 chris.dastoor@moneymanagement.com.au Marketing Manager: Odette de Souza Tel: 0404 439 000 odette.desouza@financialexpress.net ADVERTISING Sales Director: Craig Pecar Tel: 0438 905 121 craig.pecar@moneymanagement.com.au Account Manager: Amy Barnett Tel: 0438 879 685 amy.barnett@financialexpress.net Account Manager: Amelia King Tel: 0407 702 765 amelia.king@financialexpress.net PRODUCTION Graphic Design: Henry Blazhevskyi Subscription enquiries: www.moneymanagement.com.au/ subscriptions Money Management is printed by Bluestar Print, Silverwater NSW. Published fortnightly.

All Money Management material is copyright. Reproduction in whole or in part is not allowed without written permission from the editor. © 2019.

Supplied images © 2019 iStock by Getty Images. Opinions expressed in Money Management are not necessarily those of Money Management or FE Money Management Pty Ltd.

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Global funds

Guiding through the globe In an ever-connected world, there’s no questioning the logic behind branching out to all corners of the globe, but Chris Dastoor writes, given the depth of options, you’d be forgiven for feeling overwhelmed.

A

ustralian equities have always provided solid investment options for Australian investors over the last few decades.

However, these domestic options are limited and with major markets in America, Europe and Asia, as well as emerging markets with high potential, there’s good reason to branch out.

The potential to explore the unique opportunities provided by global equities creates

the temptation to try out new markets with qualities lacking domestically.

Charles Stodart, investment specialist for Zurich Investments, said the fundamental quality of global equities was a broader investment universe.

“Australia only makes up about 2% of Continued on page 8

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Global funds Continued from page 7 the global listed market, so including global equities into that space provides a broader universe that means you have access to industries you don’t have access to in Australia,” Stodart said.

The ACS Equity – Global sector has seen returns of 42.9%, over the past three years to 30 September, 2019.

In the same time period, the Zurich Investments Concentrated Global Growth fund has delivered 79.8%.

Zurich has five manager-partners, so they don’t manage money in house, but partner with established investment managers instead. In the case of the Concentrated Global Growth fund, they partnered with a manager called American Century.

“Firstly, we’re looking for an experienced investment team, we also want to understand that the product is differentiated, and it meets a specific portfolio need,” Stodart said.

“We want to see a demonstrated ability to deliver through cycles, so essentially a proven track record.

“Above all, we think investors need to choose a manager that has a long-term investment approach.”

Peter Dymond, executive manager investments at Colonial First State (CFS), said when putting together a multi-asset portfolio it was all about diversification.

“If you think of the opportunities in Australian equities, it’s predominantly banks and resource companies,” Dymond said.

“Whereas if you go overseas you get a much more balanced and different set of exposures than what you could get in

Australia, particularly around tech and healthcare which are probably the two sectors that jump out.”

The CFS Generation Global Share has delivered 73.1% over the past three years to 30 September, 2019, although that fund is no longer open to new investors on their platform.

The CFS FirstChoice Acadian Whole Geared Global Equity has delivered 69.8% over the same time period.

The Acadian fund has taken advantage of the availability of major tech stocks, with interests in Microsoft (4.1%), Amazon (2.9%) and Alphabet (2.3%) being among its highest share of holdings.

Similarly, Zurich’s Concentrated Global Growth fund held 4.7% in Amazon, but also 3.7% in Alibaba, the Chinese online store that competes with Amazon.

Going global creates a different set of economic drivers and opportunity, which not only open up different markets, but different types of markets.

“It’s a far greater opportunity set, Australian equities has only a couple thousand stocks in total,” Dymond said.

“The ASX 300 is a pretty small universe, whereas when you go globally, the indices start off with 1,500 stocks, and there’s probably only a handful of Australian stocks in there.

“The opportunity is massive for managers to ultimately generate returns.

“The other part to keep in mind is the role currency might play in the portfolio construction because currency exposure in itself is a diversifier.”

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Global funds What should advisers look for?

The range of global equities might give ample choice for people looking to invest, but ultimately fees are going to be front of mind for investors’ decision-making process.

“What are their customers’ appetite for fees, that is really a big driver in behaviours today,” Dymond said.

“We’re seeing considerable flows going towards passive management, largely driven by fee sensitivity of advisers or their clients, that’s a starting point.”

But the other part advisers should look out for is how that exposure will fit in with other building blocks they might be using in their portfolio.

“Is it a value versus growth strategy, is it a quantitative strategy, is it a really high conviction strategy that’s really volatile? All those factors can influence it,” Dymond said.

“The other area that might be a factor to some advisers is whether they have some strong philosophical beliefs.”

This could include advisers – or the clients – who have strong sustainability or stewardship beliefs.

Michael Collins, investment specialist at Magellan Asset Management, said advisers should judge global funds on whether or not they are underpinned by a clear investment philosophy.

“They should choose global funds where their objectives align with those of their clients, they should prefer managers that are transparent,” Collins said.

“They should also look for funds that have an impressive history of performance, one

that includes a history of outperforming in falling markets.”

Another factor is the inclusion of emerging markets such as China, Brazil and India in global funds as there is a difference in nature between them and developed markets.

“Some can behave very much like developed markets, whereas others are still very much on the other end of the spectrum, more like a frontier market,” Dymond said.

Whether funds invest in developed or emerging markets is dependent on the mandate of the fund.

Continued on page 10

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Global funds Continued from page 9 “It depends on the benchmark that you’re looking at but ultimately, it’s around identifying companies that exhibit the same criteria,” Stodart said.

“It’s about looking to weight them appropriately, given the geopolitical or macro factors that could be involved with investing in emerging markets.”

Existential threats Although the upside of global equities is the range of unique opportunities, the downside is there isn’t always the same level of stability as you would get in Australia and funds need to take this into account.

Australia has its political and economic challenges, but its market has largely provided a consistent backdrop to develop wealth.

Whereas it has been a challenging time for global equities as the United States deals with the unpredictably of President Trump, particularly his trade war with China. Across the Atlantic, there’s also the uncertainty over Brexit and what a post-Brexit European landscape will look like.

“If you look at the breadth of strategies that might be out there, at one end of the spectrum, you’ve got index funds that don’t take into account those types of threats,” Dymond said.

“Then you have concentrated portfolios or systematic type strategies, once again, they’re reasonably well diversified. It’s only when you start to get into the more skillsbased strategies, that you might see managers focusing on this.”

Dymond said it was probably only a small

percentage of those funds that have an explicit top-down process that might attempt to take in macro components.

“But they are typically big decisions, they can go one or two ways and it’s very easy to get it wrong,” Dymond said.

It is the managers that can navigate threats like Brexit that are the ones who effectively look through the long-term and are comfortable with short-term macro events.

Stodart said the existential threats presented to global markets had created a challenging, complex exercise currently.

“For American Century, their view at the moment is they absolutely acknowledge that global growth is slowing, and corporate earnings growth continues to slow as well,” Stodart said.

“There are always going to be uncertain factors that you have to manage for, their approach is really to look through what’s happening at the index level to uncover individual situations.”

Stodart said they’re looking for secular growth, rather than cyclical growth and the investment team retains a bias for companies that are the beneficiaries of longer lasting secular growth drivers.

Typically, these opportunities are more independent of the overall swing in the macroeconomic cycle and focus on companies with a highly-visible revenue base.

“That provides confidence in terms of the earnings stream going forward and there are always going to be companies which are selfhelping, which they would call idiosyncratic growth drivers,” Stodart said.

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Global funds Chart 1: Top five best performing global equity funds over the last three years to 30 September 2019 vs the ACS Equity – Global sector

Source: FE Analytics

“And these could be companies that may be conducting mergers and acquisitions, they may have bought another company, they may be looking to improve margins within their own company.”

Stodart said there are several examples within the portfolio which lend to that idea and rather than looking at the overall market they acknowledge that it’s a tricky environment which needed to be actively navigated.

“They’re really focused on the fundamental bottom-up research at the companies themselves and that’s one of the benefits of an active approach,” Stodart said.

“If you’re an index investor, you’re very much exposed to the headline slowdown in corporate earnings.

“If you’re an active investor and particularly for funds which hold 30 to 40 stocks, you can express a far higher conviction in the types of companies that you’ve identified for your portfolio.”

Collins said issues such as trade wars and Brexit boost uncertainty, which undermines stocks, helps bonds and increases the risk of an economic slowdown.

“Lower rates in the short to medium-term favour bond-like equities and make companies that are poised to enjoy strong growth more attractive,” Collins said.

“When it comes to judging global managers, heightened uncertainty means planners should assess how good asset managers are at managing risk.”

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Strategies

‘How culture makes a difference to investment outcomes’.

Q&A with Paul Hennessy, Managing Director Australia/New Zealand Capital International, Inc.

I

n the world of financial services, the concept of culture as a competitive advantage is not new. For some time, many companies in this industry around the world have created and committed their organisation to very meaningful and valuable culture programmes.

However, in politically charged environments, cynicism can sometimes prevail regarding culture and particularly, the concept of diversity. Perhaps this is because defining “culture” is not simple. Harnessing its potential is even more challenging.

At Capital Group – one of the world’s largest and oldest fund managers – we have maintained a long and deep commitment to cultivating and preserving what we regard as a culture that enables us to focus on one thing, to the best of our collective ability – deliver long term consistent investment results.

In this Q&A with Capital Group Australia’s Managing Director, Paul Hennessy, he discusses some of the cultural characteristics

of Capital Group, and how it makes a tangible difference to investment outcomes.

Paul, why does Capital Group have such a deep and long-standing commitment to the concept of culture?

The starting point for any discussion around culture is to acknowledge and understand what your primary purpose is. For Capital Group, it is quite simple; to deliver consistent longterm investment results to our clients. In that respect, it is quite right to say that since Capital Group was established in the early 1930s, a fundamental tenet of our culture is a singular focus on the investment management process.

There is no doubt that a positive, supportive and collaborative culture enables people to think and operate at their best. However, there is still some degree of cynicism that some corporate culture programmes and initiatives are window dressing. How does Capital Group approach culture?

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Strategies Knowing what our purpose is enables Capital Group to be very clear on the values, attributes and behaviours that our organisation demonstrates and ascribes to. And to live and breathe them.

So very simply, we ask ourselves: What do we stand for? Everyone within our group perhaps has a different ranking for these attributes but for me, they really revolve around: absolute integrity, in everything we do; client’s needs coming first; the ability to assess, understand and take calculated risks; maintaining a long-term focus – despite frequent and noisy distractions; a commitment to active management; respect for each other and our diverse experiences and backgrounds; and critically, acknowledging that it is individuals who make a difference and are the best decision makers.

It is widely acknowledged that diversity is a key ingredient in creating and sustaining a strong, supportive culture. How does Capital Group approach diversity?

In the funds management world, where decisions are made every day about which companies to invest in, the value of having a diverse culture and pool of resources to draw from is indisputably important.

However, as investment managers, cultural diversity is not enough. Harnessing representational and cultural diversity is needed to reach investment decisions, as well as fostering diversity of thought — otherwise known as cognitive diversity.

A growing body of research on this topic shows that companies with culturally and ethnically diverse leadership are more likely to see above-average profits, with a report from

McKinsey & Company in January 2018 finding that gender diversity correlates with both profitability and value creation in the workplace.

The report showed that “companies in the top-quartile for gender diversity on executive teams were 21% more likely to outperform on profitability and 27% more likely to have superior value creation.”

On these metrics alone, companies with greater executive-level gender diversity would represent a potentially attractive investment.

How does this notion of ‘cognitive diversity’ impact your decision making?

Cognitive diversity relates to having a team of people who provide different perspectives, who may think differently and analyse information in a range of different ways.

A 2018 research report by Deloitte — The diversity and inclusion revolution — showed that high-performing teams are cognitively and demographically diverse, enhancing innovation by 20% and enabling them to spot and reduce risks by up to 30%. The report also showed that a complex problem typically requires input from six different mental frameworks or “approaches”: evidence, options, outcomes, people, process and risk.

Further, as a 2017 report by the Thinking Ahead Institute explored, cognitive diversity can lead to information-processing advantages, greater skills, knowledge and information and, notably, non-consensus views. It also encourages exploration and experimentation.

This ought to prove extremely valuable for enhancing the ability of any fund managers to stay on course, especially during periods of volatility.

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Strategies So what does Capital Group do to encourage cognitive diversity?

Our programmes are based on a simple framework: recruit, engage, advance and lead.

This framework seeks out diverse voices from the next generation in our industry and works toward a more inclusive culture.

This framework instructs our investment approach - what we call the ‘Capital System’.

Rather than relying on the decisions of one or two investment brains, the Capital System taps the intelligence of many, each person acting independently, with conviction and according to their personal experience and insight.

The principles that underpin this system are simple but powerful.

• Diversity. Investing choices are drawn from a collection of inspired, incisive, curious minds. Each individual portfolio manager takes a unique approach to processing and analysing research, bringing the many benefits of cognitive diversity to Capital Group’s investment insights and outcomes.

• Accountability. Each individual portfolio manager is bold and independent in making decisions and held to account as individuals for their results. This ability to act on

well-informed opinion starts with analysts controlling a small stake in each fund, to hone their own investing skills and ideas.

• Ideas. Facilitating an approach that harnesses the natural curiosity and original thinking of multiple leaders, each portfolio manager brings their own style and strengths. They have the license to act on their best ideas, undiluted by consensus and compromise. In essence, to invest with conviction.

Is there proof in the pudding?

Absolutely! Looking at our flagship fund in Australia – the Capital Group New Perspective Fund (AU). The global equity fund is managed by the same experienced investment team and follows the same flexible approach as the New Perspective strategy – one of our most well-known strategies from the US, that has consistently delivered results for 46+ years.

Since March 1973, the strategy has delivered 13.6% p.a. and demonstrated resilience during market declines. It has outpaced the index 100% of the time in rolling three-year down markets, and 92% of the time in up markets.

The strategy has also generated four times more wealth than an investment in the index.

FOR PROFESSIONAL INVESTORS ONLY The value of investments and income from them can go down as well as up and you may lose some or all of your initial investment.

The information provided in this communication is of a general nature and does not take into account your objectives, financial situation or needs. Before acting on any of the information you should consider its appropriateness, having regard to your own objectives, financial situation and needs. While Capital Group uses reasonable efforts to obtain information from third-party sources which it believes to be reliable, Capital Group makes no representation or warranty as to the accuracy, reliability or completeness of the information.

In Australia, this communication and Capital Group New Perspective Fund (AU) (ARSN: 608 698 746) are issued by Capital Group Investment Management Limited (ACN 164 174 501 AFSL No. 443 118), a member of Capital Group. The said fund is offered only by Product Disclosure Statement (PDS), please read the PDS which is available upon request or at capitalgroup.com/au in its entirety before making an investment decision. © 2019 Capital Group. All rights reserved.

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Sector review

Exploring equities all over the world

Laura Dew writes that the global equities sector offers investors exposure to a ranging set of worldwide themes that would be ‘impossible’ to access otherwise.

I

n a world full of opportunities, narrowing down your asset allocation to a few countries can make it tough to select the best options.

Should you opt for the United States to benefit from the tech boom or should you pick Japan to gain from the ageing demographic? The solution

is a global equities fund which invests in all of these areas.

Global equity funds provide a diversified range of investments investing in international Continued on page 16

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Sector review

Continued from page 15 equities, usually both developed and emerging markets. Some may also hold global debt depending on their mandate. The developed market portion of the portfolio provides stability and secure companies while emerging markets represent some of the fastestgrowing economies such as China and offer strong potential for returns from companies such as Chinese technology firm Alibaba.

Some of the funds also include domestic exposure, although investors should make sure they are not duplicating their existing Australian investments.

Adrian Warner, fund manager at Avenir Capital, said the benefit of global funds was they gave investors the ability to gain exposure to other global trends which may not be easy to access from within Australia.

“There are greater opportunities outside of Australia to buy high quality businesses at low prices with greater growth potential. It is challenging to find opportunities in Australia as it is an expensive market, our sectors are dominated by only a few companies and are often priced at high multiples.”

According to FE Analytics, there are more than three hundred funds in the ACS Equity universe – Global sector including 34 which are holding more than $1 billion

in assets under management. The largest fund, Vanguard International Share Index fund, is $17 billion in size and the AMP Capital Enhanced Index International Share fund is more than $13 billion.

Over the year to 30 September, 2019, the average global fund has returned 7.1% versus returns of 8.8% by ACS Equity – Australia while it has returned 42% over three years versus average Australian sector performance of 32%. Looking at a decade of performance, the ACS Equity – Global sector has returned 169% compared to 101% by the Australia sector.

Global index MSCI AC World, the benchmark for the majority of the global funds in the sector, has returned 8.9% over the year to 30 September, 2019, and 52% over three years.

The best-performing fund over one year was the Evan and Partners International fund which saw returns of 27.4% to 30 September, 2019. This fund aims to provide attractive riskadjusted returns over a rolling five to seven year period, half of the fund is invested in North America, according to its most recent factsheet, and a further 28% is invested in EMEA and UK. Over 200 of the funds in the sector had returned more than 1% per cent over one year and

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Sector review

Chart 1: ACS Equity – Global vs ACS Equity – Australia performance over the year to 30 September 2019

Source: FE Analytics

59 had returned more than 10%. Only 20 funds, just 6% of the total sector, saw negative returns.

Nevertheless, global funds are not without the risks, the downside is that investors could be exposed to a broad set of risks from all over the world. These include the US/China trade war affecting Asia and North America, elections in India and the unknowns of Brexit in the UK which is also feeding into Europe.

But, Warner said, the skills of an active manager, which gave it a benefit over a passive fund, meant they should be able to avoid holding too much exposure to any of these risks at any one time.

“If anything, being in a global fund gives investors the opportunity to diversify away from those affected areas. Instead, they can benefit from places like the rising middle class in China which would be impossible to get exposure to in an Australian fund,” he said.

For those investors who are considering investing in a global fund or strategy, they need to check the funds’ track record and whether it has performed consistently over the relevant time period. They should also look at whether the fund’s holdings are just replicating its benchmark and how diversified it is from a geographic perspective.

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We’re being picky

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To find out more visit vanguard.com.au/managerselect or call us on 1300 655 205.

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Trade war

Trade tensions begin to bite Lazard’s Ron Temple explores the various potential US/China trade war scenarios and what they would mean for investment outcomes.

T

rade tensions have escalated substantially in the last year, between the United States and China as well as between the United States and its major trade partners. While it has taken some time, the effects of US-China trade tensions are becoming clearer in both trade and economic data, as is the redirection of US trade patterns from China to other emerging economies.

The policy tools brought to bear on the US-China trade dispute have evolved from a focus on trade deficits, negotiations, and tariffs to measures to address concerns over market access, industrial policies, intellectual property protection, and ultimately national security.

Issues relating to national security could be particularly troublesome, as they are nonnegotiable to a certain degree and hence may preclude a comprehensive resolution.

To the extent a narrow deal is agreed on between the US and China, we also would be highly skeptical of its scope and duration. In the US, the narrative of China as a national security threat and strategic adversary has become embedded on both sides of the political aisle, which adds an element of uncertainty to the economic outlook.

Uncertainty is the enemy of growth and leads

to increased US recession risk in 2020, although a US recession is not our base case scenario.

A multi-faceted trade dispute It is useful to remember that the US is engaged in a multi-faceted trade dispute. It has either threatened or actually implemented tariffs not just on China, but also many other trade partners. In the case of its other trade partners, the US has subsequently reached trade agreements with South Korea and with Mexico and Canada, although the latter has not been ratified by Congress yet. A US-Japan trade agreement is in the final stages of negotiation, while negotiations toward a US-European Union trade agreement is still in early stages.

In the case of China, however, the action so far has come both in the form of tariffs and in the form of more targeted measures, directed against specific entities, such as Huawei and ZTE, or specific issues. Importantly, given the national security implications of the US-China dispute, we should expect more restrictions related to technology equipment and services.

In total, US policies mark a substantial shift away from free trade. Currently, about 45% of US imports from all trade partners are either subject to or threatened by new tariffs.

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Trade war

The annualised run rate now exceeds $80 billion on approximately $400 billion of US imports.

Assuming all the tariffs threatened to date are actually imposed, this figure would more than double to $180 billion per year on approximately $1.07 trillion worth of imports, about $490 billion of which would come from China.

The US’ trading partners have responded with their own tariffs on US exports. So far, retaliatory duties have been smaller, with the global total at a run-rate of just over $20 billion of tariffs on a little more than $90 billion of US exports.

If all threatened retaliatory tariffs are implemented, these figures would rise to $28 billion and $98 billion.

Trade deal scenarios We see four broad outcomes possible for USChina trade talks. However, even if the US and China reach a deal regarding trade, the evolving view of China as a national adversary, rather than just an economic competitor, is critical to keep

in mind. The tension between the US and China is not going to go away, but instead will likely increase in our view.

We consider the chances of a comprehensive deal to be very low, at 5%, in light of the national security stresses in the US. We see better prospects for a narrow deal that involves China purchasing more US commodities, agreeing to intellectual property protections, and improving market access while leaving the tougher issues around national security, technology competition, and industrial policies unresolved, at 25%.

An agreement to pause hostilities is another option, at 30%, but this should be seen as more of a stopgap, not true progress. It would leave US tariffs at current levels rather than raising or eliminating them and would force businesses to deal with ongoing uncertainty over the long-term state of the overall economic relationship and their supply chains.

Continued on page 22

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Continued from page 21 Finally, we believe it most likely that the tension between the US and China escalates, at 40%. This would involve failure to agree on a resolution in October and would lead to increased tariff rates and further retaliation from China.

the number of US student visas issued to Chinese nationals declined by 10%, with anecdotal evidence indicating that tightening access to US universities has accelerated since 2018.

Uncertain outlook

The increasing uncertainty around the USChina trade relationship, not to mention the US’ relationships with its other major trading partners, has increased the risk of recession in 2020.

Recession is not yet our base case scenario, but we believe the risk is at its highest in over a decade.

However, context is important.

Recession need not imply an event of the magnitude of the global financial crisis, but rather two consecutive quarters of negative GDP growth. In fact, there are significant buffers in place against a deep recession today, even if there were to be a nearterm hit to corporate earnings — the unemployment rate is at a 50-year low, and consumer balance sheets are in a much more resilient position than before the crisis. Furthermore, trade-related uncertainty, to the extent it is not resolved in negotiations by year-end, could sustain central bank accommodation well into 2020.

Our broader concern is that additional central

Overall, the outlook is best characterised by uncertainty against a negative backdrop – among other factors, negotiations to date have created bad blood, and recent US commentary has depicted Chinese President Xi Jinping as an adversary. Our negative perspective also stems from US security concerns. Unlike other countries, for which the US delineates between the government and the private sector, Washington sees ‘zero daylight’ between the Chinese government and Chinese companies.

This underlying skepticism regarding China’s motives and long-term intentions are shared across the Republican and Democratic parties. This is a rare case of bipartisanship and should be understood as an ongoing source of tension between the two countries. On the back of these rising suspicions, the broader US-China relationship is suffering.

Chinese foreign direct investment into the US declined by almost 90% from 2017 to 2018. The share of Americans who view China and the US as ‘mostly partners’ declined by 35 percentage points. And

Investment implications

Continued on page 24

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Trade war

e ce es

ers, we

We favour an overweight to equities but prefer de-risking by focusing on companies that can sustain high returns on capital through enduring competitive advantages and strong balance sheets while still trading at attractive valuations.

.

– Ron Temple

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Trade war

Continued from page 22 bank infusions of liquidity, such as the recently announced â‚Ź20 billion ($32.6 billion) per month of securities purchases by the European Central Bank, are likely to continue pushing up the value of financial assets even as economic fundamentals weaken. That implies that if there were to be a recession, valuations could face substantial downside. That said, we must emphasise that recession is not our base case scenario.

Nevertheless, the risks and the economic backdrop make developed markets duration and credit unattractive. With over $15 trillion of government debt in negative yield territory and over $500 billion of corporate debt with negative yields, it makes more sense to invest in US dollar cash balances or emerging markets debt, where real yields are positive and where the currency risk associated with dollar strength has declined in tandem with the Fed’s easing trajectory.

Equities are not cheap, but they are less expensive than debt. We favour an overweight to equities but prefer de-risking by focusing on companies that can sustain high returns on capital through enduring competitive advantages and strong balance sheets while still trading at attractive valuations. Finding attractive valuations

has become more challenging, and this is where security selection and deep, forward-looking fundamental research are critical.

The trade war also makes some sectors especially vulnerable. Some consumer discretionary companies may find it tough to pass through rising prices if tariffs increase.

The technology industry is likely to be the target of non-tariff barriers. Unfortunately, there is little clarity on the form these restrictions might take — they could be narrow and affect specific companies, or they could be wide, affecting semiconductor manufacturers for example.

Beyond these two sectors, a range of companies and industries are likely to be affected as the two largest economies in the world engage in a trade war. To determine the appropriate implications for valuation in this environment, investors need to focus on the actual cash flow implications for the individual company and try to forecast the medium to long-term impacts of the trade situation.

Ron Temple is a portfolio manager/analyst at Lazard Asset Management.

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ESG

Natural resources are finite, and so is global economic growth While fossil-fuel consumption has been successfully overlooked in the past, investment portfolios with direct exposure to fossil fuel-based energy businesses, utilities or the resources sector will struggle to compete as our global economy changes, Hyperion’s Mark Arnold and Jason Orthman write.

W

e believe limits to natural resources, and the effects of climate change may well prove to be the biggest structural headwind the global economy faces, but the sad truth is that most economists and politicians are reluctant to talk about it – because it is the most difficult to solve. Put simply, in a world of finite resources, humanity cannot continue to grow GDP at high exponential rates over the long-term, because key resources are finite, and because we have already significantly and permanently damaged our fragile biosphere. Carbon dioxide (CO2), emissions from fossil fuel use, unsustainable farming practices, water and land degradation,

over-fishing and extinction of species are all contributing to the destruction of our planet.

However, at this time, climate change is the most pressing of the natural resource constraints and is the focus of this thought piece.

A short history on global economic growth Exponential growth results in large, growing numbers over the long-term. The global economy is already very large – the World Bank estimates that global GDP was approximately $US80 trillion ($118.8 trillion) in 2017 – as a result of a compound Continued on page 26

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ESG Continued from page 25 annual growth rate (CAGR) of 3.4% p.a. It is now 2.5 times larger than it was in 1990, has grown approximately seven-fold since 1960 when it was valued at $US11.3 trillion. If we go back still further, global GDP is approximately 80 times larger than it was in 1820, which translates into a CAGR of approximately 2.3% p.a. If the global economy continues to grow at this rate, it will be 200 times bigger than it was in 1950 by the end of this century.

However, it’s important to note that growth in the global economy has not always been so rapid.

Prior to the First Industrial Revolution, the economic growth rates of the world economy were very low.

The CAGR in the world economy from year one to 1820 was approximately 0.1% p.a.

Consumerism – an unintended consequence of growth At present, the global economy is dominated by consumer demand and the rise of consumerism.

This is a result of the virtuous cycle of a growing middle class, growing consumption and productivity growth enabled by cheap energy and better technology. Global economies have grown constantly, and standards of living have improved but looking forward, the constraints on our natural resources, climate change and other headwinds mean that we are unlikely to see the same rates of growth we have been used to.

Fossil fuels and compounding returns A stable and growing economy is reliant on low-cost sources of energy. Inexpensive energy is used to power engines, machines, and other technologies that underpin the modern industrial world. Since the first and second industrial revolutions, consumerism in the global economy

has been satisfied, prima facie, using inexpensive (ignoring externalities) fossil fuel-based energy.

Early on, the industrialising economy was small relative to the abundance of our natural environment and this led to humanity treating natural resources as a ‘free good’.

Looking at the current growth in the global economy, we can see it has been fueled by increasing global energy consumption, and this positive correlation is depicted in chart 1. Fossil fuel demand has grown exponentially over a period of 200 years, during which time it has powered industrial development and the growth of financial capitalism.

The bottom line is that the global economy has grown exponentially on the back of cheap fossil fuel-based energy that has been systematically underpriced by markets, because fossil fuel producers have been able to externalise the longterm costs to society and the environment.

What has been successfully overlooked is that a key problem with fossil fuel-based energy is that when it is used to power the economy it results in large amounts of CO2 related emissions – and these emissions negatively impact the environment. Approximately 85% of the energy that currently powers the global economy is derived from fossil fuels.

The reality is that over the next decade, the global economy will require large levels of sustainable, inexpensive energy to achieve dramatically lower levels of CO2 emissions. And the switch to more renewable energy systems needs to be rapid, if we are to avoid the expensive and potentially catastrophic climate change.

As a result, it is crucial that we correctly price the true long-term cost of depleting scarce

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ESG Chart 1: Global energy consumption and global GDP

Source: BP; Hyperion

natural resources including burning fossil fuels for energy if we are to make the global economy more sustainable and minimise the negative impacts of climate change. The true cost to society of using fossil fuel-based energy needs to be reflected in the market pricing of this energy, through a system of government taxes or related mechanisms.

Climate change and the potential for future compounding returns The scientific evidence is overwhelming that burning fossil fuels causes climate change.

Despite the doubts spread by other individuals or parties, there is little scientific uncertainty that this large amount of atmospheric CO2 is a key cause of the climate crisis the world is facing. Since 1880, average temperatures have increased by approximately 1%.

According to the US Global Change Research Program, observations collected around the world provide significant, clear, and compelling evidence that the global average temperature is much higher, and is rising more rapidly, than anything modern civilisation has experienced.

And the impacts will be widespread. The warming trend observed over the past century can only be explained by human activities and their effect, in particular emissions of greenhouse gases.

The potential disruption from climate change to both the economy and the ecological systems humans rely on, is a real and significant risk. More extreme weather, floods, droughts, heatwaves, super storms and changing weather patterns are likely to adversely affect agricultural production, and reduce productivity levels over time.

Continued on page 28

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ESG Continued from page 27

The negative and far-reaching effects of climate change cannot be overstated It is estimated that climate change will result in significant changes to the geographic distribution of the supply and demand of goods and services, redefining global trade. It is also likely to fundamentally affect migration flows and result in the loss of land and capital infrastructure due to higher sea levels. According to the Stern Review on the Economics of Climate Change (2006), economic models estimate that the overall costs and risks of climate change will be the equivalent to losing at least 5% of global GDP each year, now and forever.

Unfortunately, this greater than 10-yearold estimate by economist Nicholas Stern for the British Government is now considered to be conservative. More recent estimates suggest that limiting global warming to 1.5 degrees Celsius will result in trillions of dollars in savings (through economic cost avoidance) compared with allowing temperatures to rise 2.0 degrees or higher.

If the world accelerates the switch to renewable energy, then the long-term cost to the overall economy and ecological systems will be minimised, but the disruption to the traditional fossil fuel industry and related industries will be massive. The move to renewable energy and actions to halt global warming will have serious consequences for the financial markets as the values of coal, oil and gas assets (worth an estimated $US25 trillion) evaporate. The aggregate demand by humans on natural capital resources is outpacing the rate at which natural resources can be renewed.

Chart 2 illustrates the world has been in a natural resource deficit for an extended period and this deficit has been growing. The biocapacity

equivalent of 1.69 Earths was needed to provide the natural resources and services humanity consumed in 2014 and CO2 production from burning fossil fuels representing 60% of humanity’s ecological footprint.

The importance of identifying companies less vulnerable to climate change Climate change and the growing resource requirements are pushing up against the finite ecological resources of the natural world – which will naturally affect businesses.

In our view, stocks which are well-positioned for the disruption to the economy as society shifts from fossil fuel-based energy to renewables will perform better than those which are not. Traditional assets, networks and utilities based on fossil fuels will eventually be disrupted and replaced by distributed energy systems. For example, the time will come when households have the ability to capture, store and share cheap renewable energy using solar panels and batteries – and their need for fossil fuels will be far less pressing.

The cost of renewable energy has declined dramatically in recent years, making large-scale energy production from wind, solar and hydro feasible. This is good news, as it signals the transition to a phase of decentralisation of energy production and storage In our view, structural disruption due to renewable energy is likely to be far-reaching, initially impacting resource, utility, transport and infrastructure sectors. Further, the finite nature of our natural resources makes unbridled consumerism unsustainable.

As a result, we expect the benefits of compounding returns across the board to be

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ESG Chart 2: Global economy’s ecological footprint (number of earths) since 1961

Source: Global Footprint Network

dampened going forward. Growth will not be as widely spread across the economy but rather limited to the disruptors in certain sectors of the economy or individual businesses. It is our view that capital-heavy, CO2 intensive businesses will struggle to compete going forward, and that it therefore makes sense to limit investment exposure to these industries. On the other hand, if we are able to successfully identify disruptive businesses, these are the companies which have the potential to experience strong growth in a weakened economy.

Conclusion We expect the rate of growth in the global economy to decline over the coming decade and beyond due to several structural headwinds. One of the most challenging of these is the constraints on our natural resources, and the environmental impact of using fossil fuels as our main source of energy.

Long-term investors who ignore the impact of climate change and the imperative to reduce our reliance on fossil fuels will do so at their own peril.

In our view, investment portfolios with direct exposure to fossil fuel-based energy businesses, utilities or the resources sector will struggle to compete with those more attuned to our changing economy and the headwinds it faces.

Disruptive businesses, those with large and growing addressable markets, and which do not rely on economic growth but rather on a strong business proposition to grow their revenues and profits will be in a position to grow at rates well above that of the overall benchmark during periods of subdued economic growth.

Mark Arnold is chief investment officer and Jason Orthman is deputy chief investment officer at Hyperion Asset Management.

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