December Global Outlook

Tactical Asset Allocation (TAA)

We build our TAA funds including bonds, equities, commercial property and other assets looking over a 12-month time horizon. Our decision-making sequence is first to consider the outlook for each asset class (e.g. government bonds), followed by our views within that market (e.g. the US versus Europe). As these funds are broad-based multi-asset portfolios, we can use a number of levers to both take and mitigate risk over the above time horizon. This may result in positions that differ from other internal portfolios which do not have this range of levers and/or time horizon.

TAA Model Allocation - As at 16 November 2018

TAA Model Allocation - As at 16 November 2018

Foreword

Author

Andrew Milligan, Head of Global Strategy

As we look back over 2018 we see several key trends. On top of highly divergent economic growth paths and significant changes in monetary conditions, especially affecting the emerging market economies, there has been a considerable amount of political news, policy announcements and regulatory change. All this has materially affected not only the business environment and the ability of many companies to make decent profits in future, but in particular the resulting ambiguity and uncertainty has affected the willingness of investors to hold riskier assets. Hence financial markets have demonstrated some remarkable behaviour in 2018. The S&P 500 suffered the largest multiple contraction since 2002, while a broad range of global assets have failed to perform better than US inflation for the first time since 1992.

What happens after these episodes of equities and bonds under-performing cash? If the outcome of tightening policy and policy errors is a recession, then the normal downturn playbook comes into effect: government bonds outperform cash, but cash outperforms equities. The dollar typically behaves as a risk-off proxy in such environments. However, if there is any resumption of growth, as indeed we expect, then equities typically outperform both cash and bonds, and bonds usually outperform cash – at least initially.

Of course we must examine these issues in more granular detail. In the Spotlight article in this edition of Global Outlook we examine the economic, corporate and political backdrop before explaining the rationale for the specific equity, credit, government bond, real estate and currency positions which currently make up our tactical asset allocation portfolios.

Elsewhere in Global Outlook, in an important article for portfolio constructors, Arne Staal, Head of Multi-Asset Quant Strategies, examines bond/stock market correlations from a long-term perspective. He warns of a rising risk of simultaneous losses in these two asset classes and considers some solutions from both a tactical and a strategic perspective.

One of the potential responses is to include more private assets in a portfolio. Barry Fricke, Global Head of Private Credit, describes the recent evolution of that particular market, especially the formation of a number of silos over time. He proposes that investing on a more integrated and holistic basis – common oversight across the various sectors in a single portfolio – will prove worthwhile for all but the most sophisticated investors.

Periods of market stress often reveal areas of value. Senior Investment Manager Stewart Methven explains how a combination of bottom up and top down analysis can help with stock picking for a global investor. Our investment process and philosophy aim to use periods of market volatility to invest in strong businesses at attractive valuations.

In addition to economic, political or technological developments, no investor should forget the growing importance of climate change as a factor affecting countries and companies. Sadly progress on efforts to reduce carbon emissions is still far from sufficient to achieve the goals of the Paris agreement. Eva Cairns, ESG investment analyst, warns of the longer-term dangers to an equity portfolio from physical climate risks, and argues that carbon pricing and various technological solutions have a major role to play.

 

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Editor

Andrew Milligan
Head of Global Strategy

Chart Editor

Tzoulianna Leventi

 

A fork in
the road

Chapter 1

Author

Andrew Milligan, Head of Global Strategy

Corporate and economic fundamentals support risk taking in 2019, as long as key policy errors are avoided - and preferably policy decisions support a recovery in economic momentum.

Positive and negative drivers

Occasionally financial markets face a fork in the road. Today, certain drivers, such as valuations and investor positioning, suggest an overweight position in risk assets. Other factors, such as US monetary policy tightening or the growing debt burdens on many countries and companies, suggest that portfolios should become neutral, or even defensive in scope. The balancing factor will be policy decisions, and perhaps even policy errors.

Political uncertainty can quickly feed into investor uncertainty

In this article we present our global outlook for markets in 2019. This combines top-down and bottom-up analysis, from our Research Institute, the Global Strategy team and asset class experts. Our portfolios had a moderate level of risk at the start of the year, and therefore we searched for opportunities to buy oversold assets after the October correction. However, we have become more concerned about fragilities exposed as this investment cycle matures. Unless the tensions between the US and China die down, and indeed China and Europe implement more successful stimulus to revive growth into 2019, then during the course of the year our portfolios will need to be prepared for significant pressure on corporate profits growth in 2020.

Slower economic activity – but no recession

Global economic growth was strong and uniform in 2017, with acceleration across all major blocs. But 2018 has been very different with a divergence between US economic strength, weakening activity in China and stumbling performances in the Eurozone and Japan. Interest rate sensitive areas such as residential property or auto sales, highly indebted countries like Argentina and Turkey, and companies such as General Electric, have come under pressure.

Global industrial production is on course to grow only 1% per annum in Q4 2018, led by Europe, Japan and Asia. It is important to put some of the recent weakness into context. The European economy has suffered from poor auto sales affected by one-off regulatory changes, while Japan was affected by a series of natural disasters. We would expect sales and production to recover into the spring as consumer spending remains supported by lower unemployment and higher wages. On the other hand, the extent of the slowdown in the Chinese economy in 2018 is important to highlight. Trade tariffs are only a minor explanation, with policy induced deleveraging within the shadow banking system being playing a more significant part. The relative weakness of money supply growth in October demonstrates just one of the technical problems that the government has in regard to steering credit towards desirable areas.

2019 is also set to be a divergent year as the US remains supported by fiscal stimulus. Yet the world economy as a whole appears to be stabilising due to slower growth, hampered by political uncertainty affecting business investment, and tariffs bearing down on global trade.

2020 is forecast to be a complicated year. The US economy is set to slow sharply in response to a smaller fiscal stimulus, meaning the financing pressures of a US budget deficit rising to over $1tn a year become more evident. Recession risks are as high as 35% over the next 24 months, though we are not predicting the US economy will fall into recession.

Policy decisions matter

Markets are intensely sensitive to US decisions on monetary policy, rippling through into the US dollar, dollar liquidity and global monetary conditions. This is as well as trade policy, especially vis-a-vis China. We expect the Fed to pause in 2019, with only three moves this year. The key assumption behind this forecast is that underlying inflation remains contained. While wage pressures exist, technological factors and productivity gains restraining unit labour costs are more significant.

The flatter, anchored Phillips curve suggests central banks in most economies have more room to manoeuvre. Indeed, we suggest an obvious pause in Fed policy would be a major signal to investors. Already some Fed governors are concerned about the second round effects from the rising tariffs burden. We forecast another round of US-China tariffs in January 2019 and also on the auto sector, especially between the US and Europe. However, such moves should be put into perspective – for example, tariffs on $800bn of US-China trade compare with total global trade of $17tn. Another key assumption after the recent Xi-Trump meeting at the G20 summit is that the two countries have agreed to continue discussions on trade, even if longer term concerns remain.

Despite the attention placed on US policy decision making, three areas should provide positive tailwinds. The first is a range of Chinese actions – monetary, fiscal, and regulatory - to stimulate its economy, especially key sectors such as consumption, autos and property. The style of China’s response is important. This year US interest rates have risen to 2%, and are on course for 3%, while Chinese 2-year yields have fallen from 3.6% to 2.8%, undermining support for the RMB (see chart 1). Looking ahead, it matters less whether RMB/$ breaks through 7 than its speed when it does so and how well managed this is by the People’s Bank of China.

Chart 1: Mind the rates gap

Source: Refinitiv Datastream, Aberdeen Standard Investments (as of 27 November, 2018)

The second area of support is the swing towards an easier fiscal policy being experienced in Europe - exemplified in Italy, France and the UK. The third is the sharp fall back in oil prices in Q4 2018. We see the recent fall in oil prices as much more a factor of rising supply rather than falling demand. Even if OPEC manages to stabilise prices with production cuts, the sector still faces considerably higher supply in late 2019 when new pipelines allow a wave of shale oil to be exported from the US.

The final player in this scenario is Japan. Peak quantitative easing has shifted to quantitative tightening within 18 months, and therefore further liquidity injections affecting the global economy are dependent on Bank of Japan (BoJ) policy. Although inflation trends do not support a major change in BoJ policy, any surprises could have major implications for the structure of global fixed income.

Profits, Balance Sheets and Valuations

Against this background, we still expect 5-10% global profits growth in 2019. Profit margins are coming under pressure from a mix of factors such as rising labour costs and interest costs, with currency and energy costs as swing factors for individual sectors. Strong profits growth in the US has enabled sizeable share buy backs, on course for $1tn, mirrored to a lesser extent in Europe and Japan. These are adding close to 1% to the traditional dividend yield. The importance of share buy backs also appears in market volatility. February and October’s corrections took place at a time when share buy backs were curtailed by the US earnings season. As well as profits growth, the state of company balance sheets also needs examining. Here the situation is more worrying. The low level of corporate bond spreads reflects reasonable corporate fundamentals, but there are warning signs in higher yielding areas.

Historical analysis shows that it is normal for the S&P500 Price Equity (PE) ratio to decline 10-20% as the Fed tightens. On top of this, investors face a wide array of complex political issues, helping to explain why cash balances are above average as well as why the dollar has been well supported in 2018. However, cross-border capital flows also show that valuations remain an important driver for investors. A positive example is the steady, if modest, inflow into emerging market bonds and equities seen last autumn as investors searched for attractive assets. The PE ratio of many Asian indices has fallen to 9-10x.

But the bubble in some technology stocks has started to puncture. Investors have been reminded of the dangers of stretched valuations by the serious underperformance of technology hardware stocks. This is due to a mix of regulatory worries and the slowdown in the smartphone cycle (Chart 2).

Chart 2: Broad based derating

Source: Refinitiv Datastream, Aberdeen Standard Investments (as of October, 2018)

A balanced portfolio

2018 was an unusual year for portfolio outcomes. The extent of the derating in global equity was significant for a non-recessionary episode. As Chart 3 shows, 2018 was the first year since 1992 where none of the 12 global assets performed better than US inflation. Standard diversification is problematic as correlations between global equity and bond market indices change, both simultaneously stumbling this year. In these circumstances a dynamic approach to portfolio construction is necessary. Our funds bought into emerging market and US equity assets after the October correction. As well as this, a balanced approach is also required. As political risk premia rises, diversification becomes more important. Therefore, our portfolios include higher yielding developed market Australian and US government bonds.

Chart 3: What happened to real returns?

*2 year US Treasuries, 10 year US Treasuries, US Investment Grade Corporate Bonds, US High Yield Corporate Bonds, Global High Yield Corporate Bonds, US aggregate bonds, S&P 500, Russell 2000, US REITS, MSCI Japan, MSCI Emerging Markets, Commodities

Source: Bloomberg, Morgan Stanley (as of 22 November, 2018)

Two other potential diversifiers include US Treasury Inflation-Protected Securities (TIPS) and Japanese yen, providing some protection during those periods where inflation concerns or safe haven fears dominate. Having been largely positioned overweight the US dollar against major currencies, we have reduced this component and are using the Euro to fund emerging market (EM) positions. Turning to income, still important in an environment of historically low interest rates outside of the US, we remain neutral to underweight of investment grade and some high yield credit. However we have been adding to EM debt and European high yield. Spreads have become more attractive as the underlying rate structure has backed up.

Overall, we forecast slower economic growth in 2019, but no recession in the US before 2020, especially if the US administration can encourage more business investment to help activity before the 2020 Presidential election. Valuations and profits growth are attractive for equity assets, but investor uncertainty is understandable. Key triggers include: a noticeable Fed pause, European policy easing, and the style and extent of China’s stimulus.

While political risk premia is expected to remain high markets can cope with individual country issues. Much more dangerous would be a major breakdown in US-China relations or renewed scepticism about the state of the European Union due to Italy’s budget problems. These three large economic blocs comprise almost 60% of global GDP, and the majority of marginal growth in the world economy.

After the decline in experienced by global equities in 2018, we do expect to see a better performance in 2019. But it would be unsurprising if the market volatility continues, for example in the form of a further 10% correction during the course of the year.

 
Markets are intensely sensitive to US decisions on monetary policy
 

Can we count
on diversification?

Chapter 2

Author

Arne Staal, Head of Multi-Asset Quant Strategies

A difficult year for (multi-asset) investors

2018 is proving to be an eventful year for multi-asset investing. Patterns and expectations that have been firmly established in the post-crisis Quantitative Easing (QE)-driven environment are changing as uncertainty is increasing about future central bank policy and interest rates, global growth and inflation, and especially the political and geo-political backdrop.

A generation of investors has become accustomed to viewing government bonds as safe-haven assets

Global equity and bond market indices are simultaneously stumbling this year; at the time of writing, both are delivering negative returns year-to-date. Additionally, as just one symptom of changing financial market dynamics, simultaneous daily sell-offs in US equity and US Treasuries have become more frequent of late. This is unusual; since the late 1990s the statistical correlation between these two asset classes has been consistently negative. As a result, a generation of investors has become accustomed to viewing government bonds as a safe-haven asset, providing relative stability in times of economic or political uncertainty and an effective hedge to portfolios often dominated by equity risk. Such a development is causing investors to question one of the most important assumptions in portfolio asset allocation decision-making.

A historical perspective on bond/stock diversification

When we take a longer term perspective on bond/stock market correlations we find that the relationship is highly dynamic. Chart 1 shows the historical five-year rolling correlation between US equity returns and nominal 10-year US Treasury bond returns from 1873 to 2018. Although today’s investors have become accustomed to a negative correlation between stocks and bonds, such a long path of history tells a very different story. While the average correlation since 2000 has been -0.26, the full-sample historical average is very different at 0.1. In particular, the stock-bond correlation shifted structurally from positive to negative in the late 1990s and has largely remained there but has recently started trending up.

Chart 1: Long term trends

Source: Shiller. Aberdeen Standard Investments (as of October, 2018)

There is no commonly accepted model of bond/stock correlations, the driving forces are complex and change over time. In general though, prices of stocks and bonds reflect the market’s expectations of various common macroeconomic factors such as growth, inflation, and future monetary policy. Asset prices change when realised macroeconomic data is different from consensus expectations.

Macroeconomic surprise indices measure this difference between realised data versus expectation in the aggregate. Charts 2 and 3 show the 5-year rolling correlations between stocks, bonds, economic surprises, which mostly reflect growth shocks, and inflation surprises. We note that the correlation for stocks is consistently positive while the correlation for bonds is consistently negative. We also note that both correlations are insignificant throughout the whole period and they are close to each other.

Chart 2: Growth shocks a greater return driver...

Note: economic surprises refer to changes in Citi US economic
SOURCE: Shiller. Citi. Aberdeen Standard Investments (as of October, 2018)

Chart 3: ... than inflation shocks

Note: economic surprises refer to changes in Citi US inflation
SOURCE: Shiller. Citi. Aberdeen Standard Investments (as of October, 2018)

These results provide some evidence that the observed negative bond/stock correlation could be driven to some extent by opposite effects of growth surprises on both asset classes and a lack of sensitivity to inflation. It is also interesting to note that sensitivity to both growth and inflation shocks for both asset classes declined after the 2008 crisis and the resulting adoption of QE policies by central banks.

In addition to underlying macroeconomic dynamics, the past two decades have seen a global ‘risk-on, risk-off’ paradigm emerge, in which US Treasuries and other high quality government debt have increasingly become safe-haven assets for global equity investors in times of crisis. As a result, equity market shocks have become strongly associated with flight-to-quality (FTQ) effects. Broad shifts in overall risk sentiment have had an unusually large role in determining asset price movements through fast moving global investment flows back and forth between bonds and stocks.

Looking forward

Without structural adverse changes in growth and inflation expectations, we expect stock-bond correlations to remain negative in the foreseeable future, although perhaps less so than in the past decade as markets adjust to a post-QE environment and once again become more valuation-driven and sensitive to macroeconomic drivers. In addition, high quality government bonds are likely to remain a preferred safe-haven asset for global investors in FTQ episodes as long as their expected excess returns over (local) cash alternatives remain sufficiently positive.

Even if we were to experience positive stock-bond correlations going forward, it is important to note that the correlations used in portfolio construction might accurately predict risk in the short term, but not returns in the longer term. To illustrate this, Chart 2 plots the average annualized bond returns experienced in different historical equity market scenarios, ranging from the worst 10% (on the left-hand side) to the best 10% (on the right-hand side) equity market returns realized over both daily and quarterly investment horizons during 1974 to 1996 (a period in which the stock-bond correlation was consistently positive). Over both investment horizons we observe a positive relationship between bond and equity returns (by and large, bonds do better when equities do better, and vice versa). There is an important difference though: despite simultaneous losses in the two asset classes at the daily horizon, bonds provided positive returns during periods of equity losses at the quarterly horizon! It highlights that the stock-bond correlation is an important indicator of the economic environment, but does not by itself provide a full picture of potential future investment outcomes. In the long run the trend in asset class returns will be determined by slow moving underlying macro drivers, correlations will merely determine the movements around these trends.

Chart 4: Average bond returns in different equity scenarios (1974-1996)

US Treasury bond returns in different equity market scenarios (1974-1996) worst 10% to best 10%

SOURCE: Bloomberg. Aberdeen Standard Investments (as of NOVEMBER, 2018)

That said, the risk of simultaneous losses in bonds and equities is rising in our opinion. Valuations for both asset classes are stretched. Pricing relationships are non-linear and the current environment of simultaneously low equity and bond risk premia could amplify the effect of changes in growth and inflation expectations in the future. In particular, when equities are expensive they are more susceptible to negative bond market shocks. A rapid rise in real bond yields that leads to simultaneous losses in equities and bonds is one tangible risk that investors should be aware of.

Preparing for the unexpected

In a multi-asset context, a main driver of diversification is the bond/stock correlation. If this correlation were to become significantly positive, balanced portfolios would certainly become much riskier, and would likely incur unexpectedly large losses if adverse economic shocks occur.

From a strategic allocation perspective, investors could prepare for this by seeking out additional diversifying return streams. Private market assets and liquid alternatives such as market-neutral systematic strategies have the potential to contribute to more stable investment outcomes. From a tactical allocation perspective investors would do well to monitor carefully not only bond and equity return expectations, but also crucially their relationship, and be prepared for dynamic moves into cash.

 
A generation of investors has become accustomed to viewing government bonds as safe-haven assets
 

Private Credit 2.0 - An investment
approach for the next era

Chapter 3

Author

Barry Fricke, Global Head of Private Credit – Product Strategy & Solutions

Investing on an integrated and holistic basis across a range of private credit sectors will have benefits for most investors.

A changing landscape

The private credit landscape has expanded dramatically in the last ten years. Investors who are able to sacrifice liquidity can gain access to higher yields, an improved risk profile and exposure to less-correlated economic drivers. However, as the landscape continues to develop, building a diversified private credit portfolio by incrementally adding sector-specific sleeves is not only inefficient from a portfolio construction perspective, but also limits the opportunity set for all but the most sophisticated institutions. We argue for a new approach to investing in private credit.

The argument for a more integrated approach to investing across a range of sectors is even stronger for private credit

Death by a thousand cuts

Banks have a long history of losing market share. Four millennia of dominance in extending credit was first challenged in the 17th century, when the Bank of England turned to the public with the first official government bond issue and the Dutch East India Company issued the first-ever corporate bond. The process of disintermediation continued with the advent of the high yield bond market in the early 1970s and the creation of the structured credit market in the decades that followed.

Further challenges to banks’ market share then came from private lending based on direct relationships. In the wake of various banking crises – notably the US Savings and Loan Crisis in the 1980s and the Global Financial Crisis in 2008 - financial weakness and increased regulation stripped market share away from banks in favour of institutional investors able to originate loans directly, on a private basis.

Adapting portfolios to changing markets

The evolution of the public bond market led investors to redefine what such a market actually constituted, taking into account the growing breadth of issuer types - and, specifically, their varied investment attributes and performance characteristics. As investors came to recognise that performance across issuers was often driven by common risk factors – chiefly changes in risk-free rates and credit spreads – they began to oversee their bond investments in a more coordinated way, mitigating the proliferation of separate ‘sleeves’.

As with public bonds, the development of the private credit landscape proceeded unevenly, with different areas accessible by institutional investors at different times. But over time, ‘private credit’ came to represent such diverse areas as commercial real estate debt, infrastructure debt and direct lending (mid-market corporate debt), and an extending tail of types of ‘speciality finance’ (Chart 1).

Chart 1: Long term trends

Total UK Market size

Total UK 2017 Issuance

Source: Aberdeen Standard Investments, Bank of America Merrill Lynch, Societe Generale, Private Placement Monitor, Cass Business School, S&P, Deloitte, JP Morgan (as of May, 2018)

Today, as sophisticated institutional investors look to avail themselves of the increasing range of opportunities in private credit, the proliferation of separate investment ‘sleeves’ requiring oversight is becoming unmanageable. It also precludes the application of basic principles of good portfolio management.

Private Credit 2.0

Investors need to break down these ‘silos’ in order to ensure their overall portfolio is properly integrated and positioned to take advantage of the evolving market conditions in each sector. This will ensure that the portfolio is capitalising on the best opportunities at any given time, and efficiently delivering the primary benefits of private credit: illiquidity premia; exposure to hard-to-access economic drivers; better recovery rates; robust covenants; security; and predictable cash flow.

The argument for a more integrated approach to investing across a range of related sectors is even stronger for private credit than it is for public credit. First, investing in private credit requires direct origination of new loans (rather than acquiring assets in the secondary market), and gaining exposure can be ‘lumpy’ as the investor needs to work with the opportunity set that is prevailing at the time. An integrated approach to investing across multiple sectors allows the investor to focus flexibly on those areas that are providing the most attractive relative value and loan flow at the time, and to pivot elsewhere as the environment changes.

The second reason pertains to tactical reallocations among sectors. In the public bond markets, a tactical reallocation among, for example, government bonds and corporate bonds could be easily executed thanks to relatively liquid secondary markets. However, as most areas of private credit have essentially no secondary market, shifts in tactical allocation entail thoughtful reinvestment of maturing assets as they are repaid in the sector that presents the best value, and this requires common oversight across the various sectors in a single portfolio.

There are good reasons some investors might choose to maintain a degree of separation between different areas of private credit. These include more closely controlling the asset allocation among sectors, more tightly defining the permissible investment attributes in each sector (which may be particularly important for certain insurance mandates), and the potential to select specialist investment managers in each sector. However, the internal resourcing and governance requirements for such an approach are typically only available to the largest investors. Those benefits that arise from a more disaggregated approach need to be weighed up against the many advantages that accrue to investing on an integrated and holistic basis.

 
The argument for a more integrated approach to investing across a range of sectors is even stronger for private credit
 

Look for quality
in a changing world

Chapter 4

Author

Stewart Methven, Senior Investment Manager Global Equities

Binding themes across our core equity investment process include diversification, business strength, discipline and focus on risk at the company level

A cautious backdrop

During 2018, we were cautious on many companies in the global equity indices for a number of reasons. One was valuations, which expanded against a backdrop of fairly muted developed-market economic growth. As corporate debt burdens continue to grow in absolute terms, there is a risk that increased funding costs will ultimately lead to additional pressures on profits.

The divergence in performance between developed and EM equities has thrown up a number of interesting valuation opportunities

Meanwhile, trade tensions aggravated sluggish domestic economic conditions. Looking through the headlines, tariffs cause a number of issues. In one meeting we had with a US company its management commented that “it’s chaos, just like Wild Wild West”. Like many, this firm has a fairly evolved supply chain, including a significant proportion of components that are manufactured in China. As tariff deadlines loom, the response by many companies is to build inventories ahead of the event. However, with so many firms attempting to do so at the same time, the result is a scrabble for access and pressure on logistics networks. Senior management teams in many sectors are considering how to address these trade barriers, which are likely to result in lower growth and higher costs.

Through our investment process, we continue to focus on the underlying fundamental quality of the businesses in which we invest on behalf of our clients. As such, we have tended to remain underweight the auto sector and its immediate supply chain due to concerns about lower levels of returns as we move through the economic cycle. That said, the disruption caused by trade concerns has provided opportunities in several strong businesses with longer-term structural drivers. One such company is industrial robotics manufacturer Fanuc. It is benefiting from an extremely well-established market position and, equally important in times of stress, a bulletproof balance sheet.

US financials hold up

The upward move in US interest rates alongside a reduction in dollar liquidity has significantly affected sentiment towards Asian and emerging market (EM) companies. Interestingly, though, while we have seen some monetary tightening in the likes of Mexico and Indonesia, the general policy response has been less pronounced and widespread than it was during 2015. It is significant that the impact of such actions by the US Federal Reserve (Fed) on US financials has been much more muted, with share prices flat for most regional US banks over the year. The reason for this is a classic divergence between market expectation and outcome. In 2017, regional banks were in vogue on the expectation that rising US interest rates would push net interest margins wider. This year, attention has been on the funding side, with the realisation that deposit costs are increasing. There is also the risk that further aggressive tightening by the Fed could prompt a bad debt cycle. Conscious of this shift, we reduced some of our exposure to M&T Bank, a conservative regional lender in the north east of the US. We used the proceeds to initiate a position in First Republic Bank (Chart 1). Its exposure to higher-net-worth individuals has allowed it to fully develop its wealth management capabilities, leading to an extremely strong, long-term credit-quality profile and high customer retention rates.

Chart 1: Switching banks

Source: Bloomberg. Aberdeen Standard Investments (as of NOVEMBER, 2018)

Valuations matter

The divergence in performance between developed and EM equities has thrown-up a number of interesting valuation opportunities. One example is Asian banks. Here, there has been a derating back to levels not seen the aftermath of the global financial crisis. However, this has often been accompanied by a pick-up in lending and asset returns. As a result, we have selectively added to Oversea-Chinese Banking Corporation, the Singapore-listed bank. This is a traditionally conservative lending and wealth management business, with a sound footprint in Asia. It also benefits from being under the umbrella of the Monetary Authority of Singapore, the proactive central bank. Elsewhere within global financials, we have been adding to the better-quality exchange businesses, such as Intercontinental Exchange. In terms of returns, capital generation and competitive advantage, the company’s financial characteristics are strong, while the business should continue to benefit from stock market volatility.

Adding to quality positions

Global equity markets have recorded two noticeable drawdown periods thus far in 2018 – a marked change to the calmer environment of 2017. This reflects a broad array of important factors: the tightening cycle embarked upon by the Fed; technological disruption in many sectors, such as e-commerce; increasing political risk; regulatory oversight and more. During these periods of volatility, we observed a dislocation between share prices and corporate fundamentals. This allowed us to build positions in a number of our favoured companies at a discount. Names to highlight include Estee Lauder, the provider of a range of beauty products, which is leveraging its established brands in a global context; the semiconductor manufacturer Infineon, where the longer-term secular drivers in underlying demand for automation and information in the industrial and automotive sectors are attractive; and India-listed Housing Development and Finance Company, a very conservative and focused lender, which had been under some pressure on account of rising oil prices and the knock-on implication this could have for inflationary pressures in India.

These decisions were led by stock-specific insights, and were in keeping with our investment process and philosophy whereby we aim to use periods of market volatility to invest in strong businesses at attractive valuations.

 
The divergence in performance between developed and EM equities has thrown up a number of interesting valuation opportunities
 

The inevitable policy
response to climate change

Chapter 5

Author

Eva Cairns, ESG Investment Analyst

Successful climate change responses would benefit from higher carbon prices and subsidies. This would create attractive low carbon investment opportunities that are currently not commercially viable.

Not on Track

Global efforts to reduce carbon emissions are still far from sufficient to achieve the goals of the Paris agreement: to keep global temperatures well below 2°C compared with pre-industrial levels. Strong and consistent climate leadership is lacking, particularly in the US – the second largest CO2 emitter – but also in Asia, which is experiencing significant growth of new coal-fired power plants. The Intergovernmental Panel on Climate Change (IPCC) recently published a special report on global warming. It highlighted the significant global damage that is expected if more ambitious action is not urgently taken. The world is already 1°C warmer today and with current policies it will be over 3°C warmer by 2100 – with devastating effects on our planet and society (see chart 1).

A disruptive and forceful policy response is inevitable in order to move the world onto a path that is aligned to the Paris agreement

Chart 1: Global warming pathways

Source: PRI, sourced from Our World in Data

The Inevitable Policy Response

A disruptive and forceful policy response is inevitable in order to move the world onto a path that is aligned to the Paris agreement. This will require a radical shift in climate and energy policies to encourage demand for low carbon technologies and to reduce the use of fossil fuels. Potential policy scenarios and their effects are currently being explored as part of the research commissioned by the Principles for Responsible Investment (PRI). Aberdeen Standard Investments believe that the pressure on governments to act will grow because of the increasingly visible and severe physical effects of climate change, while businesses are demanding more certainty. The next round of country carbon pledges is planned for 2020, which could trigger forceful policy changes ahead of the 2023 Global Stocktake (a five-yearly progress check on mitigation and adoption, which was agreed in Paris).

Policy areas of focus

In our view, two policy areas will be of particular importance. Firstly, carbon pricing – as one of the more important and efficient demand-side policy tools – could be a very effective mechanism for encouraging fuel switching and investment in low carbon technologies. But it has failed to date. Carbon prices have been too low and governments have been too lenient because of worries over competitiveness and carbon leakage in the absence of a global carbon price. Over 51 countries have carbon pricing tools covering 20% of global emissions, but only 13 of these have prices higher than $10/tCO2e.

The High Level Commission on Carbon Prices (co-chaired by Lord Nicholas Stern and Joseph Stiglitz) estimated that a price of $40-$80/tCO2e by 2020 and $50-$100/tCO2e by 2030 is required to be aligned to the goals of the Paris agreement. We expect that forceful action on carbon pricing will happen in the short-to-medium term to move towards these values. Some recent developments are supportive of this: China announced their Emission Trading Scheme (ETS) in December 2017; prices in the EU’s ETS have quadrupled since May 2017; and even some states in the US, such as Washington, have voted recently on carbon taxes – although they are not yet passed. We believe that carbon prices ranging from $40-$100 should be applied for stress testing business plans and for understanding potential implications on asset prices.

In terms of technology solutions, the International Energy Agency (IEA) launched the Tracking Clean Energy Progress initiative in 2018, which assesses the progress of technologies against 2030 targets that are aligned to the IEA Sustainable Development Scenario. Based on a 2017 progress assessment, only four out of 38 technologies were on track: solar photovoltaic (PV), electric vehicles, lighting, and data centres and networks. Some are far behind, such as aviation technologies where a 3% annual decrease in energy intensity is required to meet targets. Progress on carbon capture, utilisation and storage (CCUS) has stalled completely. We expect that policy makers will provide more incentives for adopting clean energy technologies that are required to meet the Paris targets, but are not commercially viable without subsidies.

While the cost of some clean energy technologies – such as solar and wind – can already compete with certain fossil fuels, negative emission technologies– such as CCUS and Direct Air Capture – are still too expensive and not commercially viable on a large scale. However, they are critical for meeting the goals of the Paris agreement. The lack of support for CCUS makes the energy transition difficult for certain sectors, such as heavy industry and fossil fuel power generation. This will increase the risk of stranded assets that will not have a profitable role to play in a low carbon economy. The IEA estimates that China would have to close all its power plants within 30 years if they do not apply CCUS technology.

Someone will have to pay eventually

There is a trade-off between the cost of investing in climate change mitigation and adaptation today, and the cost of severe damages because of the physical risks of climate change in the future. Some research suggests that the potential (extreme) value impairment at risk because of physical climate risks is estimated to be in the range of 3–10% of an equity portfolio.

Ultimately, delaying a forceful policy response will only delay costs, which are likely to be even higher in the future. While a forceful policy response is inevitable, the tools used, the timing, and how they are implemented globally are uncertain and should be explored via scenario analysis. Companies should prepare themselves for stronger policies and understand the potential impact this could have on their business. Having appropriate corporate governance in place to be able to respond quickly to policy changes will be a great advantage.

View the full Global Outlook publication below:
Global Outlook publication

 
A disruptive and forceful policy response is inevitable in order to move the world onto a path that is aligned to the Paris agreement

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