Global Outlook August

Author

Aymeric Forest, Global Head of Multi-Asset Solutions

Chart Editor

Tzoulianna Leventi, Analyst

Foreword

In this edition of Global Outlook we continue to celebrate our talented colleagues who have recently been nominated for the Investment Week’s Women in Investments Awards. This is the second edition to do so and I hope you found the articles in July both interesting and informative.

As the Inclusion Advisory Group sponsor for Investment and as a sponsor of the Unity Network at ASI, inclusion is naturally very important to me. To be a successful organisation we need to attract and retain the right people. For this purpose, we need to develop colleagues from the broadest possible pool of talent, promote meritocracy and collaboration, ensure new opportunities are accessible, make each of us feel valued for what we bring, and create an inspiring culture.

At ASI we want to build a culture that encourages technical excellence, continuous improvement, and that brings out the best from our people. Diversity of thought, skills, ideas and background is very powerful. This starts with inclusive way of working through frequent and informal interaction, transparency and clarity about our direction of travel, and feedback as we learn from our successes and failures.

In this edition of Global Outlook we start by focusing on idiosyncratic investment opportunities, where secular trends transcend politics and world events. The diversity of these ideas, not only reflect the detailed analytical work from our teams, some thought-provoking, but also highlight our diversity of thoughts within our investment capabilities.

Fiona Manning, an Investment Director in our Emerging Markets Equities team, describes how innovative solutions to age old problems have driven enormous positive social change in Emerging Markets, whilst simultaneously offering those investors able to absorb more risk, outsized returns.

Sticking with the theme of secular trends and idiosyncratic opportunities, Anjli Shah describes the opportunities presented by the seemingly under-analysed and underinvested global mid-cap equity universe.

The team’s distinct investment process allows them to identify investments that offer structural growth by pursing only those companies that fit into their quality, growth and momentum framework.

The impact of COVID-19 continues to dominate economies, and therefore politics, across the globe. Stephanie Kelly, our Political Economist, discusses how the virus has magnified social inequality, and highlighted widening income differentials between low-income households and others, and the life chances of the same. Voter unrest is leading some policy makers to pursue increasingly extreme paths, and this is likely to continue to lead to considerable market volatility now and in the future.

As a result of the coronavirus, and policy makers’ responses, credit markets have been on an epic journey year to date. Having gone from a reasonably benign environment at the beginning of the year, credit spreads widening dramatically in response to the lockdown, and narrowed once again as policy makers stepped in to support the economy. Samantha Lamb takes us through why this recession is affecting companies, and therefore their corporate bonds, differently than other recessions, and how we are responding as investors.

Some countries in Asia are the first to emerge from the coronavirus crisis, having responded to the emergence of the virus in a rapid and effective fashion. This means that there are companies that are already stabilizing and where we anticipate good growth investment opportunities. Flavia Cheong, Head of Asia Pacific Equities, discusses these aspects.

Finally, and perhaps most importantly, Amanda Young, Global Head of Responsible Investment, discusses the climate emergency, inequality, and how to identify and invest in sustainable businesses. Whilst this has been discussed at length over the years, the current health crisis puts the need to address the systemic risks presented by climate change into sharp relief. Amanda discusses how investors are responding.

 

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RISK WARNING

The value of investments, and the income from them, can go down as well as up and you may get back less than the amount invested.
 

Investing in financial inclusion
in emerging markets

Chapter 1

Author

Fiona Manning, Investment Director, Emerging Market Equities

Increasing financial inclusion across emerging markets is creating opportunities for both financial returns and positive social impact.

Access to banking services – the unbanked

The lag in financial inclusion in emerging and frontier markets has been well-documented. World Bank data from 2017 shows that 31% of the global population remained unbanked; this weighs most heavily on developing nations where 58% are excluded from the formal banking network1. However, the last decade has seen financial inclusion rates for individuals improving. This has coincided with a material increase in the number of individuals making electronic transactions.

Investors who were able to identify this opportunity early would have generated a total return in US dollar terms of 521% against the MSCI Emerging Market Index return of 33% over the last 10 years2

This gives a clue to the shift in levers of financial inclusion: where mainstream banks have not met the needs of large segments of the population, innovation and technology have stepped in.

Banks have been unwilling to take the higher credit risk and higher cost of accessing these customers. Disruptive businesses in tech or telcos have used mobile technology to drive more innovative client acquisition and product offerings, targeting this harder to reach segment with fewer issues around ‘trust’ of financial institutions.

The traditional model

The traditional model of micro-lending, based on the provision of small cash loans to community groups to support working capital needs, was initially developed in Bangladesh in the 1970s. This has expanded geographically and evolved over time so that today’s micro-lenders operate in markets as diverse as Indonesia, Mexico and sub-Saharan Africa and offer a range of loans, savings and entry-level insurance products. The group-lending model is a tried and tested way of harnessing both development capital and public markets to generate attractive returns and positive impact. Micro-lenders like ASA International operating in frontier markets, Gentera in Mexico and Bandhan Bank in India have been a source of attractive risk-adjusted returns and high growth, outside of market shocks during the Global Financial Crisis and the global pandemic. As we see the impact of Covid-19 through rising unemployment rates and a resurgence of informal markets, these lending models will continue to provide an important re-entry point to the formal market, supporting recovery.

Growing the opportunity set

In the last decade there has been a technologically driven positiveshift in terms of access to finance. The expansion of mobile phone infrastructure has seen the development of new business models to support micro-enterprises and individuals. In 2007, Vodafone, in partnership with its subsidiary Safaricom in Kenya, seized the commercial opportunity to drive mobile transactional banking through its M-Pesa platform. Like the traditional group-lending model, product innovation now means that a range of insurance and banking products are available, in addition to peer-to-peer and individual-to-business transactions. Investors who were able to identify this opportunity early would have generated a total return in US dollar terms of 521% against the MSCI Emerging Market Index return of 33% over the last 10 years2.

The technological shift continues with mobile money and e-wallets leap-frogging traditional banking in many markets across Latin America and Asia, creating a wealth of investment opportunities. In turn, this has forced banks across our investment universe to invest faster in digital innovation and product offerings to both retail clients and small and medium-sized enterprises (SMEs). This process has been accelerated by the pandemic with many banks in emerging markets reporting a faster pace of adoption of mobile banking services both on the part of clients and the banks themselves. In Mexico, for example, clients historically needed to present their documents in a branch to finalise account opening, whereas local bank Banorte rolled out a fully digital process for client on-boarding3.

Chart 1: Dispersion across US Equity sectors

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SOURCE: WORLD BANK, ABERDEEN STANDARD INVESTMENTS, (AS OF JUNE 2020).

Chart 2: Adults transacting electronically by region

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SOURCE: WORLD BANK, ABERDEEN STANDARD INVESTMENTS, (AS OF JUNE 2020).

Looking forward

The United Nations highlights the importance of SMEs in achieving progress towards the 17 UN Sustainable Development Goals (UNSDGs) which serve to identify the greatest challenges, and opportunities, facing the world today. Working with the International Council for Small Businesses, the UN has identified that micro-enterprises and SMEs “make up 90% of all businesses globally and account on average for 60-70% of total employment and 50% of GDP.”4 Facilitating the profitable growth of SMEs can target SDG 8 – ‘Decent Work and Economic Growth’, and SDG 9 – ‘Industry, Innovation and Infrastructure’. However, it is clear that availability of SME financing remains poor. In Mexico, SME lending accounted for only 20% of business loans in 20165, behind regional peer Brazil and many OECD countries. This represents a huge opportunity for all investors, not only those who are looking to allocate capital in alignment with the UNSDGs.

Following the success of mobile money, mobile operators and fintech businesses are turning to SMEs that represent another poorly tapped pool for financial inclusion. As an engine for future growth, Safaricom has developed a product for merchants leveraging the M-Pesa platform, LipaNa, which grew revenues by at least 30% in 2018. The pool of opportunities is exciting and continues to develop, from e-wallet providers to digital point-of-sale devices offering working capital lending. World Bank data7 showed that small businesses in OECD countries transacted electronically 71% of the time, however, the global figure is only 44%, illustrating the significant runway for growth in emerging economies.

Chart 3: Global Payments by MSMRs, estimated values (2015)

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SOURCE: WORLD BANK GROUP (2016A). B2B PAYMENTS INCLUDE ONLY THOSE FROM THE RETAILERS TO IMMEDIATE SUPPLIERS.

MSMR = micro, small and medium retailers

If you broaden the definition of financial inclusion to businesses driving greater profitability and improved routes to market such as cloud providers enabling faster digitalisation and software companies offering enterprise resource planning (ERP) solutions, you open the door to exciting and profitable investments, such as Douzone Bizon in Korea or Kingdee International in China, have delivered total returns of 239%6 and 342%6 respectively over the last 3 years.

Summary

Prior to the emergence of covid-19, the World Bank estimated that the global unbanked population would fall to 10%7 by 2022 and there are clear opportunities for expansion of SME financial inclusion. The economic set back will likely delay this process but the opportunity for growth and development of innovative business models remains compelling. Identifying these businesses allows investors the opportunity to benefit from attractive relative returns as well as aligning themselves to the UN’s development goals and achieving positive social change.

Company selected for illustrative purposes only and not as an investment recommendation or indication of future performance.


Investors who were able to identify this opportunity early would have generated a total return in US dollar terms of 521% against the MSCI Emerging Market Index return of 33% over the last 10 years2
 

Why global mid-caps deserve
more investor attention

Chapter 2

Author

Anjli Shah, Investment Director, Equities

The Covid pandemic has been highly disruptive and has widespread consequences for companies of all sizes. But attractive risk-reward opportunities can be found by focusing on companies with quality, growth and momentum characteristics within the under-followed global mid-cap equities asset class.

The media has made much of what is happening to the world’s largest companies and to its smallest: many businesses have been forced to stop operations and some have already seen a significant drop in their revenues, but what of those in the middle?

History shows that over the long term, global mid-caps have delivered superior returns to their larger peers, with lower levels of risk than small-caps

The picture is not entirely pessimistic. The pandemic and its lingering effects have been an opportunity for some mid-cap companies to prove their resilience and agility. In certain sectors, particularly those with exposure to structural trends like digitalisation and healthcare, growth and earnings momentum for mid-sized companies is accelerating.

Understanding the mid-cap universe

After small-caps, mid-cap companies represent the next 15% of the MSCI ACWI Index. The index includes 23 developed and 26 emerging markets. What constitutes a mid-sized company by market capitalisation can therefore vary significantly from region to region. As for ways to invest, there are a number of country-specific options. For example, investors currently have around $1 trillion invested in US mid-cap funds. However, there is a distinct lack of global mid-cap funds. History shows that over the long term, global mid-caps have delivered superior returns to their larger peers, with lower levels of risk than small-caps. As a result of this we believe the asset class may appeal to investors who have never invested in small-caps due to concerns over risk, but who still desire the prospect of higher returns than could be found in the large-cap space. Global mid-caps may not be a well-recognised asset class today, but it has the potential to become one in future, just as global small-cap did some years ago.

What drives the performance of mid-cap stocks?

While global small-cap and mid-caps have performed well over a period of 20 years, they have underperformed their large cap counterparts over the year to date. Investors, driven by the view that their larger counterparts are more resilient and liquid, have favoured them over their smaller counterparts

By looking at longer-term performance however, we can isolate the circumstances and drivers that are needed for shares in mid-sized companies to perform well.

First, we should consider that any company that has successfully made the leap from small to mid-cap is likely to have an established business model along with a strong balance sheet and a track record of growth. For example, global mid-cap companies in the healthcare sector often provide essential products and services. Companies which have a subscription or cloud-based model often have a high degree of recurring revenues. By contrast, small-caps companies can often struggle in periods of economic slowdown. With less established businesses, they may have unpredictable revenues and face cashflow or financing issues.

Chart 1: Mid-caps have significantly outperformed over the longer term

SOURCE: LIPPER,USD, 20 YEARS TO 30 APRIL 2020, ABERDEEN STANDARD INVESTMENTS, (AS OF APRIL 2020).

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Companies which are able to dominate their domestic markets and generate positive cash flow are better placed to reinvest back into their businesses to develop new products or services and expand overseas. For mid-sized companies, the scope of the resulting addressable market can provide opportunities for growth. Large-caps companies, on the other hand, tend to be mature, or operate in mature industries. This can mean that their growth opportunities are fewer with growth more tied to the general level of GDP.

Finding quality, growth and momentum characteristics in mid-cap companies

With considerable uncertainty as to what the post-Covid “new normal” looks like, it is important to note that not all global mid-caps are equally placed to thrive.

Investors should focus on those with quality, growth and momentum characteristics. Companies like those described above, with sustainable competitive advantages, resilient business models and robust balance sheets fit the description of quality mid-cap stocks.

Growth should not come at any cost. While some mid-cap companies seemingly have the fastest growth, this can be driven by cyclical or external factors which outside of management’s control. Thus, such growth is unlikely to be sustainable over the long-term. Investors should focus on mid-sized companies whose growth is backed by long-term structural trends. Companies which are encouraging the shift from offline to online or helping their customers to digitalise, have performed particularly strongly during this pandemic and are seeing their growth accelerate.

It is important to note that environmental, social & governance (ESG) factors, which are often framed as risks, can also provide opportunities. For example, companies are helping to address growing healthcare epidemics such as diabetes by reducing the burden of therapy and shifting to value-based outcomes.

Finally, we think of momentum in two ways: pricing (which is tied-in to the concept of running your winners and cutting your losers); and, more importantly, operating (which means consistently growing earnings over time and seeing upward revisions to forecasts).

As one would expect, companies with all three characteristics rarely trade below market valuations. As a result, they tend to underperform in value-led market recoveries. History has shown, however, over multiple economic cycles, that this trend does not persist over the long term. Shares in companies with quality, growth and momentum characteristics often rise sharply when they report their results and analysts upgrade their earnings forecasts.

The relatively under-followed global mid-cap equities asset class offers a differentiated set of investment opportunities. By focusing on mid-cap companies with resilient or recurring revenue profiles and whose growth drivers are structural, thereby allowing for consistent growth in earnings, there is the potential to add value above index level over the long-term. Thus, this asset class and style is deserving of more investor attention.

History shows that over the long term, global mid-caps have delivered superior returns to their larger peers, with lower levels of risk than small-caps
 

Will Covid 19 take
populism viral?

Chapter 3

Author

Stephanie Kelly, Political Economist
With thanks to co-author Nancy Hardie

In these times of uncertainly the coronavirus is likely to further fuel populist narratives and heighten political risk for investors

In the US, the rigid two-party system means that rather than a populist party threatening from the outside, politicians with populist ideals infiltrate the two major parties

The scene is set

Following the GFC, new political actors emerged, offering deceptively simple and often extreme solutions to complex economic and policy questions. Decades of growing income inequality, weak productivity growth and rapid social liberalisation fed discontent among those who felt left behind; the financial crisis created the spark that Covid-19 will likely further fuel.

How populism plays out will, however, depend crucially on the political dynamics and institutions in a country. Emerging markets with weaker institutions are vulnerable to erosion of civil liberties under authoritarian leaders like Orban in Hungary, Erdogan in Turkey, Bolsonaro in Brazil and the Law and Justice government in Poland. Meanwhile, the Chinese regime is using its own comparatively successful crisis management to reinforce rhetoric about the superiority of its political and economic model.

In developed markets, incumbent populist parties and politicians push centrist politicians slightly further towards the extremes to stem voter losses, splitting parties and making elections more frequent and unpredictable for investors. In European parliamentary systems with proportional voting, new parties can emerge and gain support in a relatively short space of time as we have seen with Podemos in Spain, M5S, the Lega in Italy and AfD in Germany to name a few.

In the US, the rigid two-party system means that rather than a populist party threatening from the outside, politicians with populist ideals infiltrate the two major parties. Donald Trump’s Presidency illustrates this on the right while Bernie Sanders’ relative success in 2016 and 2020 exemplifies it on the left. UKIP had a similar effect on the Conservative party in the UK. Despite only holding a few seats, pressure from UKIP on Conservative party unity led to the Brexit referendum and a less constructive stance in negotiations with the EU afterwards.

We had already identified the theme ‘populism persists’ as a constraint on growth and a source of volatility in financial markets over the next decade. The Coronavirus crisis is likely to expedite this theme in three key ways: fuelling dissatisfaction among voters, damaging the credibility of centrist politicians tasked with managing the crisis, and reinforcing populist policies and ideologies.

Inequality gone viral

The novel coronavirus is underscoring the realities of global inequality. Those with lower paying jobs are more likely to be adversely affected during and after lockdown through job loss, lower earnings, erosion of savings and impaired credit access, as well as being at higher risk of becoming infected by the virus with higher mortality rates. This reflects different risks of exposure to the virus as many low paying jobs cannot be done from home; the fact that low income individuals are more prone to chronic health conditions; and that higher income, urban households tend to have greater access to healthcare resources than poorer, rural families.

These relative health and income effects are mutually reinforcing. Moreover, the literature on populism1 is clear that low-income, low-skilled and blue-collar workers are more likely to vote for populist parties than those with higher levels of education and more wealth. The unequal incidence of economic and human pain that the Coronavirus crisis has had on low income voters is the perfect storm for polarised politics and populism to thrive in.

Critically, the trend towards more populist government won’t end when the immediate health crisis does. Although populism is generally associated with difficult economic environments, income inequality often rises during economic recoveries too. The rich tend to own businesses and financial assets, so their initial gains are disproportionately large compared to the rest of the population. And automation and other structural changes to labour markets can also be most rapid during the early phases of recoveries. This means that a rise in populist support from the coronavirus may be delayed but is highly likely in the absence of major policy changes to address the causes of inequality.

Politicians under pressure

While national leaders in France, Germany, Italy, Australia and Canada have enjoyed a ‘rally to the flag’ effect boosting their popularity (see Chart 1), history highlights that this is usually short-lived. Although unprecedented amounts of policy easing have helped support the economy in the short term, these are no panacea to the cleavages running through societies.

Chart 1: A rally effect for some leaders but for how long?

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SOURCE: OVERALL SUPPORT SHOWN ON LHS AXIS. MORNING CONSULT (AS OF MAY 2020).

In the longer term, the economic and human damage from crisis creates large potential pitfalls for politicians. Choices about when and how to end lockdowns, the potential for secondary infection waves, and how to phase out financial support for individuals and corporates, all create risks for mainstream leaders. The corollary is that they create opportunities for populist politicians currently out of power to reinforce messages about establishment politicians being inefficient, ineffective and out of touch.

At the same time, for countries with populists already at the helm, policy mistakes are a clear risk to their own credibility, in part because they tend to favour premature economic re-opening. President Trump’s re-election campaign is already being defined by the crisis while in Brazil a second health minister has resigned as a result of Bolsonaro rushing to re-open gyms and beauty parlours.

More generally, since the crisis began, we have already seen right-wing populists in emerging and developed markets already taking advantage of the virus to reinforce their nativist ideologies, question the value of health evidence and push protectionist policies like localised production, shortened supply chains and immigration controls. In the US, President Trump refers to Covid-19 as the ‘Chinese virus’ and has already accelerated non-tariff aggression to point the finger of blame on China, accelerating the strategic rivalry between the world’s two largest economies. In Hungary, populist leader Orban is already using the crisis to seize power through indefinite right to rule by decree, arrests of dissenters and disputing coronavirus evidence.

It’s not just the economy, stupid

Populist support is not just about the economy, it is also a reaction to deeper social and cultural change, and especially those that threaten the status of working and middle class white men. Ominously, research has found that deaths from the Spanish flu in the late 1910s were positively correlated with the number of votes won by far-right extremists in the following decade,2 even adjusting for factors such as population variation, government spending, and unemployment. There is also evidence that the Spanish Flu had long lasting negative effects on social trust, weighing on economic growth for decades after the pandemic ended. Even further back, research has found that the Black Death reinforced and exacerbated anti-Semitism.3

This pandemic has the potential to unleash similar forces. Populism threatens the outlook most in economies with pre-existing populist tendencies, proportional voting systems, extreme vulnerability to the crisis, and limited policy room for manoeuvre. Italy stands out as the country most at risk of electing a right wing populist-led government in the near-term, presenting existential risks for the Eurozone writ large. However, it bears remembering that many of the populist parties and leaders we know today did not exist before the GFC so new actors may yet appear in response to this crisis in other badly hit economies.

Populism carries clear risks for global political legitimacy, economic transparency and the future of globalisation. Bold supportive policy will be needed to address income inequalities, regional inequalities and social fear at the national and transnational level. However, the risk that policy falls short of this transformation is high, making the themes of fragmentation and polarisation that developed in the post-GFC environment even more influential sources of political risk for investors in the post-coronavirus world.

Polarised fragmented political environments make the outlook for policy more unpredictable and more extreme, creating genuine uncertainty for businesses around supply chain management, tax burdens and regulatory environments. This has resulted in volatility for investors in recent years around issues like US-China tensions, Brexit and major elections. The post-pandemic investment environment will be no different and may even be worse.


In the US, the rigid two-party system means that rather than a populist party threatening from the outside, politicians with populist ideals infiltrate the two major parties
 

Navigating and managing risk
in a heavily distorted slow down

Chapter 4

Author

Samantha Lamb, Head of ESG, Fixed Income

The pandemic and resulting recession have impacted corporate fundamentals differently than in previous recessions. Corporate credit investment analysis has to be forensic as a result.

Traditionally, investors tend to attribute a recession to one or more of only a few causes. It might be triggered by an imbalance caused by an earlier expansionary phase in a particular industry, for example. Or it could be caused by part of the market correcting. The resulting shock might lead to the withdrawal of credit or financing from the real economy, followed by job losses and a retraction in discretionary spending for those who have sadly lost their jobs.

The impact on credit markets has been wide ranging, and traditional credit analysis has been challenged

In addition, those who remain employed often ‘tighten their belts’, as their confidence about future promotions, pay rises and job security founders. They might cancel holidays or dine out less frequently. Such a reduction in ‘extravagant’ spending can turn into a vicious circle: declining demand for business leads to further job losses, which causes demand to fall further.

Eventually, through a rebalancing of prices or government intervention, the retraction stabilises and spending resumes, businesses do better and start hiring and investing again. The sectors hit most by this type of retraction are the ‘cyclicals’, named for their sensitivity to the economic cycle. In a recession we are normally most concerned about the sector whose imbalances triggered the recession, technology in 2001 and banks in 2008, followed by monitoring closely those sectors most sensitive to the economic cycle such as advertising or mining companies.

This time, it’s different

As we would expect to see in a ‘typical’ recession, there have been job losses. What is unlike a typical recession, however, is the nature of the growth disruption facing us as a result of Covid-19. Behaviour has been heavily distorted as everyone has had their movement significantly restricted, with severe knock-on effects. For example, the airline and hotel industries have been very severely impacted, much more so than in other recessions, and credit spreads within these sectors have widened significantly. At the same time, banks and utilities have been well insulated from the effects of the pandemic, and their bonds have performed well.

The impact on credit markets has been wide ranging, and traditional credit analysis has been challenged, as has our traditional playbook for portfolio construction in recessionary environments. For example, as we’ll discuss later, when analysing our automotive exposures, we see that demand for vehicles remains resilient, whilst uncertainty around supply chain management needs careful analysis.

Of course, the basic needs for survival remain. People living and working at home must still have electricity, food and water, as well as connectivity to the outside world. Companies who provide these services are resilient to the collapse in demand, and in fact some have benefitted from the need to remain in the home.

The implications for demand

One of the biggest changes is that people are not moving unless necessary. Demand for some previously essential services, such as transport, has therefore collapsed. Air travel has always been sensitive to a decline in economic activity when there is a drop in tourism and a paring back of business travel. Usually the drop in activity is only modest. This time, however, air travel – whether for business or leisure – has completely stopped for the majority of people. It is also likely to be one of the last industries to return to full strength. From an investment perspective we remain cautious as there is likely to be very little activity or fixed cost investment going forward, which has implications for those supplying or servicing the airline industry.

The role of production

A critical consideration is that unlike in other recessions, the production of goods and services has also been disrupted because it has not been safe for employees to attend their places of work. In a typical recession, car manufacturers are challenged by collapsing demand because people might choose to delay upgrading their car. But in the post-Covid era, they are going to be challenged by extended production shutdowns.

While production has re-started in many regions, challenges remain as global supply chains stutter. A car produced in the US, is reliant on parts from around the world. If another country remains shut down, therefore, it may be that critical components are not being produced. For the auto manufacturers these risks could be manageable, but they will create a drag on earnings and financial strength over the coming months. We are however, monitoring the potential for another full lockdown, which would be significant for these companies.

Extraordinary times, extraordinary measures

Government responses to the crisis have been unprecedented in size and speed, which has helped to maintain consumer confidence. The central banks have also extended extraordinary aid, particularly to the credit markets, without which many companies may have been badly impacted, or in fact bankrupted.

We expect companies to seek to reduce their levels of debt, and focus on only the best investment opportunities. This should lead to credit improvement over the next 12 months, subject to a return to more normal operating and aggregate demand conditions.

The path ahead remains very unclear, however governments must continue to make calculated and unprecedented decisions about the pace and direction of economic re-openings. Until we have a medical solution to manage the virus, the threat of further economic shutdowns remains.

For some industries, demand is resilient and the outlook could be positive. These are extraordinary times, however, with a recession unlike any that we have seen before. We must closely monitor the decisions made by governments, individuals and companies in order to carefully manage our clients’ exposures.

The impact on credit markets has been wide ranging, and traditional credit analysis has been challenged
 

Asian quality a differentiator
amid unsettled outlook

Chapter 5

Author

Flavia Cheong, Head of Equities, Asia Pacific

Many Asian nations are fundamentally better placed to restart their economies than Western peers. With valuations undemanding, long-term quality stocks offer appeal.

Asia benefits from economic orthodoxy, leaving central banks in the region more room to cut rates

The outlook for Asian equity markets appears unsettled amid continued fallout of the coronavirus pandemic, even as nations are easing lockdowns and re-opening their economies.

Strict measures to curb virus transmission have weighed heavily on economic and business activity. The longer the pandemic persists, the more this disruption will stymie recovery in the second half of 2020.

A fresh wave of infections in countries where curbs were lifted too early or insufficient in the first place remains a key risk. Moreover, the flare-up of US-China tensions and run-up to the US presidential election this November presage further volatility.

While sustained stimuli from governments and central banks will offer continued support to markets, investors should remain cautious.

Progression of the pandemic has varied considerably across Asia Pacific. We see risks to the economy and even social stability in countries such as India and Indonesia. At the same time, many Asian governments have proved adept at managing this crisis. They took difficult decisions at an earlier juncture and are now better placed to restart their economies.

China, South Korea, Taiwan, Hong Kong, Australia and New Zealand – which together represent more than 80% of the benchmark MSCI AC Asia Pacific Ex-Japan Index – look set to suffer less damage than many economies due to effective implementation of countermeasures. Nevertheless, renewed waves of infection in parts of China, Hong Kong and Australia serve as vivid reminders that vigilance remains paramount.

But Asia benefits from economic orthodoxy, leaving central banks in the region more room to cut rates than Western peers that have run out of conventional monetary policy firepower.

Most Asian countries also have stronger current accounts, government debt to GDP and individual, bank and company balance sheets. This should offer reassurance to investors as they look ahead.

In addition, structural trends remain in Asia’s favour, notably the consumption power of an increasingly wealthy middle class. The region is home to half the people on the planet and accounts for almost half of global GDP. It’s also at the forefront of technology shifts, including the adoption of 5G, autonomous driving, artificial intelligence and automation.

Discerning winners and losers

We urge investors to focus on two factors in the second half of 2020: which firms are best placed to weather the Covid-19 storm; and what normalised company earnings will look like.

Firstly, investors might differentiate on quality, by which we mean companies with strong balance sheets, low levels of debt and sustainable competitive advantages operating in sectors with structural growth prospects. They tend to be more resilient during downturns.

As financial distress exposes weaker firms, investors will need to assess opportunities stock by stock. It underlines why the second half of this year will be a time for active management. Passive funds can’t avoid weaker companies because they hold everything, good and bad.

Investors will need to study companies’ balance sheets, debt maturities, cash flows and the long-term sustainability of their strategy. Considering risks and opportunities around environment, social and governance (ESG) factors will also remain important.

We have found managements able to discuss key risks and how to mitigate them are the ones that have avoided the blow-ups and created shareholder value. Owning quality remains the best way to mitigate risk, in our view.

Secondly, we expect company earnings to remain under pressure. Many firms have scrapped or deferred dividend payments and cut back on capital expenditure. Cost and operational efficiencies may become differentiating factors to focus on.

Investors might take industry outlooks into account. Consumer discretionary stocks such as autos, retailers, travel and tourism have been hit hard. However, amid a gradual loosening of lockdown measures, we are seeing nascent signs of a recovery in demand in some markets.

Domestic flights have resumed in China, while certain retailers should continue to prosper as consumers stock up on electronics to facilitate working from home. Ecommerce sales are also likely to remain resilient, although not for retailers that have been slow to embrace it.

We continue to like the technology sector, which remains underpinned by structural growth drivers such as cloud computing, data centres, 5G and digital interconnectivity. However, we are mindful that tech is becoming a politically sensitive issue in the run-up to the US election amid disruptive pressure on Huawei and increasing friction between the US and China.

We retain a cautious outlook on banks. However, even as rate cuts eat into margins and banks face pressure to support customers through loan holidays and deferred interest payments, we are drawn to the revenue potential of digital penetration and innovation in payments. We believe digitally enabled franchises are more consumer focused. We favour those with robust capital positions, on the grounds they are better placed to prosper.

Although we see risks on the horizon, the market appears largely to have priced these in. Despite the recent market rebound, Asian equity valuations remain undemanding. On a trailing price-to-book basis as of August 8, the MSCI AC Asia Pacific ex-Japan Index was trading in line with its 20-year average yet offers over a 50% discount to the S&P500.

As valuations diverge across segments, investors might look beyond the short-term noise to identify long-term opportunities. We see the brightest prospects for quality Asian stocks with strong fundamentals in line to benefit from the region’s structural growth. Areas of interest include premium consumption in segments such as health care, wealth management and insurance; adoption of technology services such as the cloud and rollout of 5G; and the region’s growing urbanisation and infrastructure needs.

Asia benefits from economic orthodoxy, leaving central banks in the region more room to cut rates
 

Sustainability as a Global
Investment Opportunity

Chapter 6

Author

Amanda Young, Global Head of Responsible Investment

“At its essence, sustainability means ensuring prosperity and environmental protection without compromising the ability of future generations to meet their needs.”

Ban Ki-Moon, Secretary General, United Nations1

Responsible investing that channels private capital into sustainable investment strategies is no longer something that is just ‘nice to have’

Why is sustainability important?

There are significant challenges facing the world today.

The first is climate change. Many people around the world will have witnessed, or experienced at first hand, the effects of rising temperatures. Societies are counting the human and financial costs of higher sea levels and extreme weather events.

The second is rising social inequality – the growing gap between the world’s haves and have-nots. This has led to widespread anger that, in some cases, has unleashed social and political upheaval.

The third is the fact that we are consuming resources at an unprecedented rate. People are depleting the world’s natural resources which cannot be easily replaced, if these resources can be replaced at all.

These problems will only get worse if we do not act. The Covid-19 pandemic has raised urgent questions about how people interact with nature and how human food production is managed.

Global action

Most countries have acknowledged the need to do something. Multilateral organisations, such as the United Nations (UN), have been at the vanguard of recent efforts. The New York-based body has been promoting research and debate, as well as coordinating an international response.

Chart 1: UN Sustainable Development Goals

SOURCE: UNITED NATIONS, 17 SUSTAINABLE DEVELOPMENT GOALS (SDGS).

UN Sustainable Development Goals

One hundred and ninety three countries adopted the UN Sustainable Development Goals (SDGs) in September 2015. There are 17 SDGs that, collectively, make up 169 individual targets.

These goals provide guidance to governments, companies and civil society on how to identify and pursue sustainable development priorities.

The SDGs will likely guide public policy and private sector capital allocation until at least 2030.

Climate change is covered under Goal No. 7 (affordable and clean energy) and Goal No. 13 (climate action).

Inequality is covered directly by Goal No.10 (reduced inequalities) and indirectly by Goal Nos. 4 and 8 (quality education; decent work and economic growth).

Unsustainable consumption is addressed by Goal 12 (responsible consumption and production).

The UN’s sustainable development goals are ambitious. Estimates of the investment needed range from some US$5 trillion to US$7 trillion per year2.

These goals can only be achieved through partnerships between governments and the private sector. Global asset managers – with more than US$80 trillion of assets under management3 – have an important role to play.

Paris agreement

Most countries accept that decades of burning fossil fuels harmed the environment. Greenhouse gas emissions in the atmosphere, linked to oil and coal consumption, are a major cause of rising temperatures around the world.

Therefore, in 2015, more than 180 countries committed to the ‘Paris agreement’ which was signed at the 21st UN Conference of the Parties (COP 21) in Paris, France.

This is the world’s most significant international climate treaty. Signatories agree on the need to restrict future temperature rises to ‘well below’ 2°C from pre-industrial levels, in order to limit environmental and economic damage.

Individual countries established Nationally Determined Contributions (NDCs). NDCs resulted in more carbon emission reduction targets, as well as an increase in climate change-related policies.

There has been progress. In some regions more than in others. But the level of ambition and urgency to reach the goals of the Paris agreement have fallen short of initial hopes. The cost of too-little-too-late is almost certain to be serious.

In 2018, the Intergovernmental Panel on Climate Change published a special report which compared the implications of warming by 1.5°C, with the effects of a 2°C rise4. The report warned of severe consequences for people, economies and ecosystems if warming exceeds 1.5°C.

Chart 2: Global warming pathways

SOURCE: SPECIAL REPORT ON GLOBAL WARMING OF 1.5°C, IPCC, SEPTEMBER 2018.

UN Principles for Responsible Investment

The Principles for Responsible Investment (PRI) is another United Nations-supported initiative. Asset owners and asset managers around the world have an important role to play in supporting sustainability.

The six principles were designed to promote responsible investment as a way of enhancing returns and better manage risk.

They were developed by an international group of institutional investors which recognised the growing relevance of environmental, social and governance (ESG) issues to investment practices.

ESG analysis is the holistic understanding of how environmental, social and corporate governance issues affect the risks and returns of an investment. At Aberdeen Standard Investments, it is a top-down as well as bottom-up process.

These guiding principles offer practical advice on how to help steer private capital towards supporting sustainable development priorities.

They encourage institutional investors to pursue and demonstrate action across four areas: investments; corporate engagement; investor disclosure; and policy advocacy.

In fact, we have aligned our own investment process with these principles.

Why should investors care?

Responsible investing that channels private capital into sustainable investment strategies is no longer something that is just ‘nice to have’. ESG analysis needs to be an integral part of all investment decisions.

More investors – asset owners and asset managers – need to think about the global trends that are shaping the world we live in.

Many are doing so already. Younger generations of investors don’t want to see society and the environment damaged beyond repair because of their investments. They want to see something that generates a positive outcome, in addition to a financial return.

People with innovative ideas and solutions that can address these big global challenges will be better placed to make money, as well as help society and the environment.

However, finding solutions can’t be left to investors alone. Investors need a clear framework in which to operate. So governments need to think about regulations. Civil society must play a role in challenging practices that are unsustainable.

Technology is a game changer. Social media has raised awareness of environmental issues linked to oil and gas companies, of access-to-medicine issues linked to pharmaceutical firms. Business ethics concerns associated with the banking and finance industry have also been in the social media spotlight.

Attitudes within the investment and corporate worlds are changing. The extent and degree depends on where in the world you look. But there have been encouraging developments:

1. Asset owners are embracing sustainable strategies. Australia is a pioneer of ESG integration into investment decision-making. This was fuelled by the country’s massive superannuation pension funds, also known as ‘super funds’. In Japan, the Government Pension Investment Fund (GPIF) plans to increase allocations in ESG-approved investments to 10% from 3%5. This is an amount equal to some US$29 billion. One of Europe’s most influential managers, Norges Bank Investment Management, plans to sell off its oil and gas exploration assets. It will only retain those oil and gas companies that invest in renewable energy and low-carbon technologies.

2. Companies are under pressure to change. This is to meet the evolving expectations of policymakers, asset owners and public opinion. Clearly the extent of this varies across jurisdictions, but this is most noticeable in more progressive markets. In Canada, many investors are demanding that companies provide reliable ESG data in greater detail and volume. Meanwhile, France requires companies to have good oversight of their operations and supply chains. Firms must comply with health, safety, environmental and human rights obligations.

3. Asset managers are heeding the call. Fund managers around the world have been keen to demonstrate their commitment to ESG tenets. One way to do so is by signing up to internationally recognised agreements such as the United Nations Principles for Responsible Investing (PRI). The PRI has some 2,500 signatories, comprising mostly asset managers. It gained 500 new signatories during 2018/2019. Growth was particularly strong in China -- rising some 64% -- albeit from a low base6.

Chart 3: UN Principles for Responsible Investment

  • Principle 1: We will incorporate ESG issues into investment analysis and decision-making processes.
  • Principle 2: We will be active owners and incorporate ESG issues into our ownership policies and practises.
  • Principle 3: We will seek appropriate disclosure on ESG issues by the entities in which we invest.
  • Principle 4: We will promote acceptance and implementation of the Principles within the investment industry.
  • Principle 5: We will work together to enhance our effectiveness in implementing the Principles.
  • Principle 6: We will each report on our activities and progress towards implementing the Principles.
SOURCE: UNPRI WEBSITE, 2020.

Digging deeper on climate change

Climate change has significant implications for investors. Companies and economies will likely incur major costs during the global transition from fossil fuels to low-carbon energy sources.

In addition, there will be significant costs from increasing physical damage linked to climate change, and considerable investment in adaptation to limit this damage.

Investors need to understand how these changes will affect the value of their investments. This involves gaining an in-depth understanding of how each company is exposed to material issues related to climate change, and what these companies plan to do to tackle these challenges.

That said, there are opportunities as well. The transition to a low-carbon economy will require large amounts of private capital to construct renewable energy infrastructure, low-carbon transport and improve energy efficiency.

Investors will play a critical role by allocating this capital.

Climate change: energy-transition opportunities

The International Energy Agency (IEA) estimates that achieving a Paris-compliant energy transition requires around US$3 trillion in investment every year, mainly in renewables and energy efficiency7.

The opportunities for investing in low-carbon energy sources and technologies are considerable:

1. Renewable energy generation & storage

The growth in renewable energy required to meet the Paris goals is significant. Investment in energy storage and transmission is also needed to address the intermittency issues of renewable energy and to enable a higher percentage of renewables on a power grid.

2. Energy efficiency

Using energy efficiently – in buildings, industry and transportation – is going to be vital. Regulations, such as the Minimum Energy Efficiency Standards (MEES) for buildings in the UK and the fuel efficiency standard regulation in Europe, are in place in many regions. While these rules impose additional costs for some sectors and businesses, they also provide opportunities for others to tap into new energy-efficient technologies and products.

3. Electrification of transport

The shift towards electric cars and other vehicles provides investment opportunities along the whole electric vehicle value chain. This is from the provision of raw materials and the production of components, such as batteries and fuel cells, to the final assembly of electric vehicles.

4. Carbon removal

It’s not just about reducing carbon dioxide emissions (which contribute to global warming). It’s also about removing it altogether. Negative emission technologies, such as carbon capture usage and storage (CCS), are expected to play an important role in Paris-aligned scenarios.

Unfortunately, the rollout of CCS technologies is behind schedule.

Carbon prices are too low to make CCS a commercially viable investment opportunity. This may change in future, depending on the stance that governments take on incentivising carbon removal.

Climate change: adaptation-related opportunities

There is a growing need for investment in adaptation to make businesses, cities and countries more resilient to the effects of climate change. Adaptation commitments are also an important part of the NDCs as part of the Paris agreement.

A number of areas deserve particular attention for adaptation opportunities:

1. Infrastructure – Coastal cities, for example, require engineered protection from sea level rises. A global analysis of 136 coastal cities reported indicative annual adaptation costs of US$350 million per city, or approximately US$50 billion annually in total8.

2. Water and soil management – Investment in water efficiency, restoring the water supply-demand balance and addressing the issue of deteriorating soil quality. This is particularly important in agriculture, but also other water-dependent sectors in water-stressed regions.

3. Technology – Growing demand for certain technologies, existing and new. For example, rising heat in buildings leading to the growing need for cooling equipment. Innovative technologies to reduce water intensity and make water usage more efficient.


1 UNPRI, Investors and the Sustainable Development Goals, October 2017.

2 UNPRI, Investors and the Sustainable Development Goals, October 2017.

3 Aberdeen Standard Investments, Impact Investing – Embracing the UN’s Sustainable Development Goals in Investment, February 2018.

4 Special Report on Global Warming of 1.5°C, IPCC, October 2018.

5 Reuters, Japan’s GPIF to raise ESG allocations, July 2017.

6 UN PRI Annual Report, 2019.

7 International Energy Agency (IEA), World Energy Outlook, 2018.

8 United Nations Adaptation Finance Gap report, May 2016.

Responsible investing that channels private capital into sustainable investment strategies is no longer something that is just ‘nice to have’

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