European equities: which style has been in vogue this year?

European shares made a strong advance in the first half of 2019, but the gains were not evenly spread across the market, shows Simon Corcoran, Investment Specialist, UK & European Equities, at Schroders.

Given the headlines over the past six months, it feels a little odd to realise that European equities are up 16% in the same timeframe. From trade wars to slowing economic growth to Brexit, there are plenty of reasons why the market shouldn’t have rallied. But the gains perhaps look less surprising when we dig into the detail behind them.

We looked at the return for the overall index - MSCI Europe – and then for four style factors within this index: growth, quality, high dividend yield and value.

Style factor definitions:

  • Growth companies may currently be growing at a faster rate than the overall market, and/or have higher potential for future growth.
  • Quality is defined by low debt, stable earnings, consistent asset growth, and strong corporate governance.
  • Dividend yield is calculated by dividing the dividend per share by the price per share; a high dividend yield could be a sign a stock is underpriced, or it could be that the stock is under pressure and future dividends may not be so high.
  • Value refers to those stocks that have low prices relative to their fundamental value. This is commonly tracked by metrics such as price to earnings (a company’s share price divided by its profits).

As the table below shows, growth and quality have been the factors in greatest demand in the past six months. Returns from these parts of the market have significantly outpaced returns from value and high dividend yield stocks.

index-style-ytd-return.jpgPast Performance is not a guide to future performance and may not be repeated. 

The uncertain economic backdrop may be one reason why investors have favoured stocks with these growth and quality attributes. After all, this economic cycle has been very long. As we move towards the end of a cycle, investors often look for those businesses with reliable, predictable earnings that can potentially fare better than the rest of the market in a slowdown or recession.

The MSCI Europe Quality and Growth indices have outperformed the Value index by over 10%. Sectors such as industrials, technology, luxury goods and food products form a large weighting within these indices and have led the gains.    

There is considerable overlap between the MSCI Europe Quality and Growth indices. The table below shows eight stocks that are among the top ten constituents by size in both indices, and the returns posted by these stocks in the six months to the end of June. Only AstraZeneca has failed to outperform the broader MSCI Europe index. 

stock-ytd-return-valuation.jpgAny reference to securities are for illustrative purposes only and not a recommendation to buy/and or sell.

As well as offering quality and growth characteristics, large companies such as these are often favoured in times of uncertainty due to their size. Larger companies are often assumed to offer greater stability than small companies, and have usually weathered a number of economic cycles successfully.  

What does this mean for valuations? The chart below shows the forward price-to-earnings ratio for the next 12 months for MSCI Europe Quality relative to MSCI Europe Value. It shows that investors have recently been willing to pay a larger premium than they did previously for quality stocks.

Quality valuations have become elevated


Martin Skanberg, fund manager, says;

“Such a situation can persist for some time, but is unlikely to do so indefinitely. There are signs recently that the quality rally is fading as companies struggle to meet lofty growth expectations. That said, it is impossible to time precisely when the trend might change. As investors, we look for the best trade-off between risk and reward that we can find”.

This information is not an offer, solicitation or recommendation adopt any investment strategy.  If you are unsure as to the suitability of any investment please speak to a independent financial adviser.

For more on the factors driving the market, see why growth stocks look vulnerable.

See our Alpha Equity strategic capability page for further equity insights.

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Bank of Japan officially enters the currency wars

The Bank of Japan’s stance at its July meeting is aimed at stopping the yen appreciating, explains Piya Sachdeva, Economist at Schroders.

The Bank of Japan (BoJ) today signalled readiness to expand stimulus “without hesitation” if downside risks to inflation were to rise.

Until now, the BoJ had acknowledged downside risks to both growth and inflation, but had given little explicit guidance that it would ease policy. It has kept more quiet than the Federal Reserve (Fed) and European Central Bank (ECB).

There were no major changes to the overall monetary policy framework at the BoJ’s July meeting. The short term policy rate was kept on hold at -0.1%, the 10-year government bond yield target kept at “around zero per cent”, alongside an unchanged ¥80tn annual pace of JGB purchases.

In its quarterly Outlook Report that accompanied the announcement, the BoJ yet again revised its inflation forecasts* down to 0.8% year-on-year (y/y) and 1.2% y/y in (fiscal year) 2019 and 2020, respectively. These exclude the effects of the upcoming consumption tax hike.

The growth projection for 2019 was edged down slightly to 0.7% y/y and remain unchanged at 0.9% y/y for 2020.

Ultimately, inflation well below its target is nothing new to the BoJ and its growth projections actually remain fairly healthy by Japanese standards.

Its “ready to act” stance is aimed at stopping the Japanese yen from appreciating against a backdrop of heighted expectations for easing from both the Fed and the ECB. In other words, the BoJ has officially entered the currency wars.

It is well known to investors that the BoJ has little to ease further, given that interest rates are already negative and a full blown asset purchase programme. We believe that the BoJ will be reluctant to ease further, but so far will be quite happy about its ability to keep the yen fairly stable.

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What is “energy transition” and why does it matter to investors?

The switch to renewable energy is gathering pace and is likely to prove hugely disruptive, explains Mark Lacey, Head of Commodities at Schroders.

Renewable energy is well on its way to becoming a core part of our energy mix. In May this year, the UK went a full week without using coal to generate power for the first time since 1882. Clean energy sources are increasingly being used as cost effective and low emission alternatives to coal, oil and gas.

But renewable energy makes up just a small part of the global energy mix at present. This needs to rise substantially if we are to meet climate targets, including the Paris agreement designed to limit temperature rises to 2°C. We therefore need a rapid switch to renewable sources of energy.

There have been two previous transitions to new sources of energy: from traditional biofuels (such as wood) to coal in the late 19th century, and from coal to oil and gas in the mid 20th century. The chart below shows how the global energy mix has changed since 1800.


As the chart shows, renewables are currently just a small part of the picture. But we think they could reach a 30-40% share of the total mix in the next 30 years.

Both of the two previous energy transitions were long-term structural changes that proved hugely disruptive. Use of coal was spurred by the introduction of the steam engine. The transition to oil & gas was driven by the move to the internal combustion engine. These technologies then powered enormous changes in society.

While full adoption of coal took around 70 years and full adoption of oil and gas took around 50 years, we think the full adoption of renewables will take closer to 30 years, essentially happening much more quickly. This is because it will be driven by forced change; the severity of the threat posed by climate change means government policy simply has to support the energy transition to renewables. 

But switching to energy generated by renewables and away from fossil fuels is only one part of the energy transition. Just as crucial is the development of the infrastructure needed to enable the switch. For example, wind and solar farms can generate a huge amount of power when it’s windy or sunny, but this will need to be stored until it’s needed by consumers.

Similarly, there will need to be huge investment in the transmission and distribution networks to support increased demand for electricity rather than other forms of energy. In addition, a significant amount of investment is needed to make the entire system more efficient and this involves a large amount of technology-driven investment. An important part of this demand is the growing popularity of electric vehicles and therefore new, large-scale charging infrastructure for these will be needed.

To sum up, when we talk about energy transition, generating power from renewables is only part of the picture. The mass introduction of electric transport infrastructure, energy storage, improved transmission and distribution networks, coupled with the increased usage of technologies to improve energy efficiency, are all part of the transition too. We expect this to prove hugely disruptive to the energy industry over the next few decades.

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Where next for China A-shares?

by Louisa Lo, Head of Greater China Equities at Schroders.

The rise of China’s A-shares market is a theme that can’t be ignored. Here’s where we’re seeing opportunities in the country.

China’s domestic stock market is on the rise and we think it represents a potentially very attractive long term opportunity for investors.

There is a striking disparity between China’s share of global economic growth and its share of the global stockmarket index. Chinese stocks currently represent just 3.8% of the MSCI All-Country World Index, while China’s share of global GDP is 16%.

With the market opening up to foreign investors, and given MSCI’s recent decision to include China A-shares into its global indices, we expect China’s representation in global portfolios to increase significantly over the coming years..

How investors access Chinese shares

Investors can access Chinese equities through a variety of channels:

  • The companies quoted in Hong Kong (H-shares, red chips and P-chips)
  • The depository receipts quoted on the NASDAQ exchange in the US (these are called American Depositary Receipts and enable access to the likes of tech giants Alibaba or Baidu)
  • The on-shore domestic market (A-shares).

There is still important progress to be made in A-shares, with the on-shore market only recently opening up to international investors through the Shanghai-Hong Kong (2014) and Shenzhen-Hong Kong (2016) Stock Connect programmes.

These programmes allow foreign investors to access domestic Chinese equities (A-shares) through the Hong Kong Stock Exchange. However, only 3% of investors in the domestic market are foreigners.

Retail investor dominance

The A-shares market remains dominated by domestic retail investors who make up 86% of daily trading volume, compared to 35% for the Hong Kong market.

This high proportion of retail investors contributes to the higher volatility of the market relative to more developed exchanges. This is because retail investors typically have shorter investment time horizons and respond more to market events, resulting in more buying and selling of shares and higher market volatility.

That said, the market is attractive for active fund managers who can take advantage of the inefficiencies in the market. Looking across the board, the median China A-shares fund manager has outperformed the MSCI China A Onshore benchmark in four of the last five years.

Market shifts

Over the last few years, investor interest has shifted from "old" China (infrastructure, banks, telecoms) to a greater focus on consumer (staples, food & beverages) and so-called "new economy" stocks (healthcare, consumer discretionary, IT).

This is because the driving force behind Chinese growth is increasingly based on the consumer. We expect this shift to continue.

Another theme we’ve been seeing in China is the push towards automation, given the need for China to improve productivity. This move is also consistent with the need to produce goods with better quality, and to become more self reliant in terms of technological capability.

The A-shares market remains very well balanced in terms of sectors, especially when compared to Hong Kong where technology, banks and commodities still dominate the index. This means it is possible to manage a more diversified portfolio on the A-shares market.

Meanwhile, inflows to the market have been strong since the start of the year, despite constant headlines around US-China trade tensions.

It’s also worth noting that the Chinese market has a low correlation to the other global markets, which can provide diversification benefits. But investors need to remember that this is still an emerging market, with a higher level of volatility.

Which sectors in China A-shares are of interest?

At the moment, we continue to see a number of potentially attractive investment opportunities in the Chinese market.

One of the sectors we are especially interested in is healthcare. There has been a strong trend towards the outsourcing of manufacturing and research & development of drugs by pharmaceutical companies. We expect firms operating in this area to become more prevalent going forward.

Elsewhere, while we remain cautious on real estate companies, insurance companies are of interest to us due to the level of penetration of insurance products in China, which remains low.

Corporate governance catch-up

Finally, from a corporate governance perspective, in many cases companies are still catching up, in terms of the standards generally seen in more developed markets. However, the trend is definitely positive and we think the level of domestic ESG (Environmental Social and Governance) standards will improve going forward, with increased engagement from institutional investors.

The views and opinions contained herein are those of the author and may not necessarily represent views expressed or reflected in other Schroders communications, strategies or funds.

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The case for global small company investing in an era of disruption

The theme of disruption is having a profound effect on how we live and how we invest, explain Matthew Dobbs, Fund Manager, Asian Equities & Head of Global Small Cap, and Kristjan Mee, Strategist, Research and Analytics, both Schroders. There are three factors which we think mean small caps are potentially the best way to tap into the theme.

Smaller companies (small caps) offer the potential for higher returns compared with investing in larger companies, although not without risks. The returns from individual stocks vary a lot and the market is relatively inefficient. This gives active investors greater opportunity to add value.

In addition, investors are increasingly being drawn to the small cap sector due to its ability to profit from the ever-growing theme of disruption.

Over the very long term, US small caps have handsomely outperformed large caps. $100 invested in US small caps in 1966 would be worth $56,232 today compared with $15,576 invested in large caps (Figure 1, left chart). There is also evidence that small caps outperform on a more global basis. Nonetheless, while small caps can outperform over the long run, they can also go through extended periods of underperformance (Figure 1, right chart).

Figure 1: Long-term small-cap performance has been impressive but cyclical

US-small-v-large-cap-disruption-770px.jpgPast performance is not a guide to future performance and may not be repeated.
Source: Credit Suisse, S&P. Data prior to March 2006 is Ibbotson. Data from March 2006 is S&P LargeMidCap vs. SmallCap. Data up to April 1 2019. USD return.

Understandably, such cyclicality might cool investors’ enthusiasm for small-cap investing. However, we believe that there are structural reasons why selective exposure to global smaller companies can potentially yield better returns than a broad market exposure. This belief is based on three key factors: the fundamental attributes of small caps, the relative inefficiency of small-cap equities, and the scale of the opportunity set.

The fundamentals

The fundamental case is based on the fact that small companies have the capacity to grow disproportionately from a relatively low revenue and profits base.

Almost by definition, it is only by investing in small companies that investors can gain effective exposure to a new technology or a market.

They are often the driving force behind disruption, benefiting from this trend rather than being a victim of it. They are less burdened with layers of management and there is less fear of losing sales volume or market share by introducing new products; a major issue for well-established large corporations. Smaller companies who are key players in the fast-growing electric vehicle and artificial intelligence industries are good examples - please see the full paper below for more information and case studies.

The opportunity

The opportunity case is the fact that the small cap market is much larger than the large cap market. For example, there are 6,216 small cap companies in the S&P Developed Benchmark Index, compared with 1,932 large and mid cap companies, according to S&P data as at March 31 2019. Large cap investors are at risk of ignoring the vast majority of the investment universe.

Small caps also tend to be more domestically focused than large caps. This means that, even if the broader global picture is less encouraging, it can be possible to identify companies that are exposed to supportive local growth dynamics. In contrast, large caps are more likely to be buffeted by global trends.

The inefficiency

The inefficiency case rests on the fact that the smaller a company, the less well-followed it is, and therefore the greater likelihood of pricing inefficiencies. This can result in greater opportunities for active managers to add value. Figure 2 illustrates this by showing that the number of broker forecasts declines as companies move further down the size spectrum. This relationship holds across all markets.

Figure 2: Average number of I/B/E/S* estimates per company by size

Company-earnings-estimate-by-size-770px.jpgSource: I/B/E/S, Schroders. Data as at March 31 2019
*Institutional Brokers’ Estimate System – A system that compiles estimates made by analysts on future earnings of publicly traded companies.

The consequence of these inefficiencies is greater opportunity for active small cap managers to outperform. Figure 3 shows the five-year annualized gross and net of fees excess returns of global, US and European active small and large cap funds.

In all regions, the median gross excess return for small caps has been positive, indicating that small cap managers on average do add value. Furthermore, in all regions, small cap funds have performed better than large cap funds.

However, after adjusting for fees, the median net excess returns are negative for global and US small cap funds. Because the cost of small cap funds is generally higher, the excess return must be large enough to cover that cost. Consequently, the fundamental advantages of small-cap stocks and manager skill are two necessary but not sufficient conditions for delivering positive excess returns after fees.

The good news for investors is that the top quartile of small-cap funds have been able to consistently outperform their benchmarks in all regions. This highlights the importance of manager selection to benefit from the inefficiencies in small caps.

Figure 3: Five-year annualized excess returns to end of March 2019

annualised-excess-returns-770px.jpgPast performance is not a guide to future performance and may not be repeated.
Source: Schroders, Morningstar. Data as at March 31 2019.

You can dowload and read the full paper in the link here.

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The downgrade risks facing passive investment grade bondholders

Passive credit investors could be facing significant downgrade losses when the next economic downturn hits. Active managers, however, have the flexibility to manage these risks more efficiently, argues Sean Markowicz, Strategist, Research and Analytics, at Schroders.

Investors have become increasingly worried about the steady increase in the number of lower rated US corporates. The share of BBB-rated bonds, the lowest tier of investment grade (IG) debt, as a proportion of the overall US market has risen to an all-time high of 50% in 2019. In contrast, it stood at only 33% in 2008.

Although, on average, default rates on BBB-rated bonds are very low (0.2% a year1), a more pressing risk for investors is downgrade risk (a deterioration in an issuer’s credit rating). Whenever the next economic downturn arrives, as it inevitably will at some point, corporate fundamentals will weaken. Falling earnings will put pressure on the cushion available to cover interest payments and some measures of leverage will rise.  All else being equal, credit spreads on affected bonds rise and prices fall. Historically, this has also resulted in rating agencies downgrading many borrowers’ credit ratings.

Passive investors risk holding "fallen angels"

BBB-rated bonds are exposed to a particularly acute form of this risk. Because they are on the cusp of IG status, a downgrade would see them relegated to the high yield (HY) market (these are known as fallen angels). This is a problem as, for a variety of reasons, including regulation, many investors are only permitted to hold IG bonds and so would be forced to sell the downgraded bonds.

Additionally, all passive investors would be forced to sell these bonds because they would exit all IG market indices at the next rebalancing date (usually the following month)2. This market segmentation results in a cliff edge in pricing, hanging on whether a bond maintains or loses its IG status. Unfortunately for these investors, the point of downgrade has historically been the worst possible time to sell these bonds.

Given the current large size of the BBB segment, this risk is especially elevated. Fallen angel volumes could be higher than in previous credit cycles and this could weaken portfolio returns. Passive strategies are particularly exposed to this risk, not least because of the sheer increase in passive bond products. Around 28% of all US bond assets under management are now owned by passive index funds, up from 9% in 20083.

Although the exact timing and volume of downgrades from the IG market is hard to predict, we can estimate their potential impact on IG index returns using historical experience. For example, based on the Moody’s 1920-2018 credit migration matrix, 3.2% of the IG market has been on average downgraded to HY each year. If this happened today, $211 billion of bonds would be affected. However, downgrades are typically well above average during economic downturns and this figure could rise to between $275 billion and $557 billion, if the last three downturns are used as a guide. At the overall index level, this could result in a mark-to-market loss of up to 3.5%, or roughly $230 billion in monetary terms.


Being flexible can mitigate against downgrade losses

Whichever scenario occurs, the market is likely to move before the rating agencies act.

Historically, spreads of fallen angels have widened by around 300 basis points, or 3%, ahead of a downgrade to HY. Although they have continued to rise by around another 50 basis points, on average, in the immediate aftermath, most of the pain has already been felt.

In addition, prices tend to partially recover in the months that follow. Selling at the point of downgrade would have been suboptimal, locking in close to the maximum potential loss. Either the ability to sell before a downgrade or hold onto a fallen angel and sell later on, would have generated a better outcome. Neither option is fully open to passive investors. In contrast, active managers have the flexibility to manage fallen angel risk more efficiently because they are not forced sellers and can also discriminate between healthy issuers and those that are more vulnerable.


1) Moody’s Annual Default Study: Corporate Default and Recovery Rates, 1920-2018
2) Most passive investors trade throughout the month as opposed to rebalancing on a single day at month end. This means that they can technically sell bonds before/after a downgrade. However, doing so would increase the tracking error of the index fund so there is an inherent trade-off between tracking the performance of an index and avoiding bonds that may harm the fund’s performance. Seeing as the objective of a passive fund is to track an index, passive investors have very limited, if any, flexibility to manage fallen angel risk.
3) Morningstar Direct Fund Flows Commentary 2018 Global Report

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Are profits no longer required?

The number of loss-making US companies listing on the stock market is close to a record high. Two Schroders experts explain the implications for investors.

The number of loss-making companies listing on the US stock exchange is approaching a 30-year high, according to new research.

Indeed, the average company going through an IPO is now making a loss (IPO stands for initial public offering, the term used when a private company goes public by listing on the stock market).

Perhaps most surprisingly, loss-making companies have beaten the market by around 9% year-to-date, even though historically they have typically underperformed by a similar amount, on average.

Does this paradox mean that profitable companies no longer make for good investments?

Fund manager Frank Thormann doesn’t believe recent performance diminishes the importance of a company’s fundamental strength. However, he does recognise that a new breed of company has changed the way investors think about the stocks they choose.

“I am a strong believer in free cash flow generation as a sign of a strong business model and competitive advantage. There is strong evidence that over a longer horizon, these companies outperform.

“I am not willing to concede that things have changed forever. I consider this current environment as anomalous, and the market has gravitated towards a different kind of company. At the same time, investors should remember that mean reversion is a powerful force. Sentiment could change quickly in favour of profitable and cash-generative companies.”

Percentage of IPOs with negative earnings
1990 until the end of Q1 2019

Percentage_loss_making_companiesSource: Empirical Research Partners Analysis

Operating profits 1991 to end Q1 2019

Operating_profit_marginSource: Empirical Research Partners Analysis

Private equity specialist Schroder Adveq has been involved in IPOs since 1997, and Chief Investment Officer Nils Rode believes that there is a lot of capital chasing these late stage/pre-IPO deals.

Late stage deals are when part of an IPO is placed with private investors (such as private equity or hedge funds) just before the IPO enters the public market.

Investor enthusiasm for such deals has led to a sharp increase in late stage valuations over the past few years. Rode thinks many companies deserve such high valuations, but not all.

“For some of the fastest-growing companies it is normal to be cash flow negative for two reasons:

“Highly successful companies with great upside potential have no problem in raising large amounts of capital that cover their negative cash flows (losses). Companies like this should grow as fast as possible, to lock in market share across regions and across related product categories. This fends off competitors, but requires investment into growth instead of focusing on profitability.

“For some business models, reaching large scale can be a key success factor and requires strong growth, even if this means to be loss-making for some time.

“Nevertheless, it is always possible that some companies burn through too much capital, especially in industries where a significant share of the investor capital goes into marketing or advertising, or even into subsidising product prices.”

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Why growth stocks look vulnerable

The divergence between growth and value parts of the market has been extreme and could be due a turnaround, argues Rory Bateman, Head of Equities at Schroders.

The outperformance of “growth” and “quality” style stocks versus “value” has been a defining feature of markets in recent years. This outperformance was very marked in 2018 and at the start of 2019. In many ways this is to be expected as we move towards the end of this economic cycle.

Value stocks tend to be more tied to the economic cycle and so their earnings are less predictable, especially as the world economy slows. By contrast, growth stocks generally have more visible earnings and the market so far has still been willing to pay up for this in the form of ever-higher share prices.

Given how long this economic cycle has been going on for, growth’s continued outperformance is perhaps unsurprising, as investors wonder if the economy is due a turn for the worse.


However, we think there are other factors at play too. Equity (stock) markets have seen huge inflows of passive money over the last few years. This passive money is essentially forming what is known as a “momentum trade”, meaning the money goes towards those companies that have already performed well and so form a larger weighting of a given index. This momentum trade could become quite worrying in the medium term as money continues to flow into stocks with little regard to their underlying fundamentals.

Despite their more volatile earnings profile, we may be close to the point where value stocks are simply so cheap that they can no longer be ignored. When we reach that point, value should start to perform better.

What value stocks need is for investors to look through the end of this economic cycle. Once we’ve seen clear evidence of slowdown in the underlying economy, investors will start to look towards the next earnings recovery. That’s when the value element of the stock market could really start to recover.

This divergence of value compared to growth and quality is significant in every market in the world, although it’s most acute in Europe. Globally, quality has outperformed value by nearly 5% p.a. over the last five years, so we are at extreme levels in terms of the valuation differential.

This extreme outperformance means growth stocks could look very vulnerable if we were to see a “risk-off” environment. This is where nervy investors shy away from higher risk assets such as equities and move instead towards the relative safety of bonds, for example. We think this risk-off trade would likely be most evident in these highly-rated quality and growth stocks, particularly if these companies were to start missing their earnings forecasts.

Such a risk-off environment would clearly be negative for the overall equity market. But we think the elevated valuations of quality and growth mean these areas could be the most negatively affected, and value could perform better on a relative basis.

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Why ESG matters in value investing

It’s not just the E of ESG that matters – for value investors the S and G are vitally important, explains Kevin Murphy, Fund Manager, Equity Value, at Schroders.

As value investors, we have long taken environmental, social and governance (ESG) considerations into account when investing in stocks. After all, it is our job to weigh up risk and reward and we can only do this competently if we consider all of the potential risks around any investment we might make. ESG has clearly become a hot topic in finance at the moment but there are different ways of looking at it.

For example, lots of people tend to focus predominantly on the E, or environmental side, of ESG. When thinking about that, people tend to be drawn to businesses like wind farms or start-ups offering new battery technology.

The problem with this focus on the environmental side is that it often leads you towards small, microcap, new technology businesses. This can introduce some significant, and unwanted, style biases into your portfolios. Instead, we believe it's worthwhile thinking about the whole of ESG in its totality. The E for environment is important, but so is the social (S) and the governance (G) side.

In the social aspect, we think of the stakeholders. These would be the suppliers to the business, the customers, all the staff, and the regulators it deals with. It's every relationship that a company will have with the entire value chain.

These relationships are of crucial importance when thinking about the sustainability of a company’s profit margins, for example. If a business is paying too low a tax rate, or underpaying its staff, or squeezing its suppliers, then fundamental economics suggests that the associated risks increase. So to us, the stakeholders/social part of ESG is an extraordinarily important and all-encompassing risk to consider when thinking about companies to invest in.

The governance side is equally important because it examines how a company is managed. Questions we ask here would be: are there appropriate staff on the board? Are there appropriate checks and balances? Is there an appropriate incentive structure? Ultimately, we need to consider whether the management team is capable of running the business in the best interest of shareholders.

Of course, as active shareholders, these governance questions are an extraordinarily important part of an investment case for us. If we do not believe a company is acting in the interests of long-term shareholders, we will do all we can to actively engage company management to protect and grow our investment.

Thinking about ESG is fundamentally important to all of our investment decisions and it is a theme that fits in with the value style of investing. Ethical investing is often about trying to achieve long-term change. This chimes with our approach, as investors need to take a long-term view in order to access the best possible returns from a value investment style.

Ultimately, value investing is about buying cheap stocks where we think the potential reward is greater than the risks. In analysing the risk part of that trade-off, we will take into account anything that helps us reach the most considered conclusions and ESG is a crucial part of that.

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How different assets perform in an economic slowdown

It appears that the US is entering the slowdown phase of the economic cycle, argues Martin Arnold, Economist at Schroders. But what might that mean for returns across asset classes? And can a recession be avoided?

For the first time in two years the Schroders US output gap model is signalling a change in the US business cycle. It suggests the economy is moving from “expansion” to “slowdown” (the other two stages in the cycle being “recession” and “recovery”).

The last slowdown period occurred during the Global Financial Crisis and so this should be seen as a warning sign to US policymakers that a recession could be on the horizon.

Is a recession in the offing?

The Schroders output gap model is a way to estimate the difference between the actual and potential output of the economy (GDP). It uses unemployment and capacity utilisation as variables.

Since the model was launched in 1978, there have been six separate instances when it has indicated the US economy was in slowdown mode. Of these six phases, four have been followed by a recession. The two periods of slowdown that did not result in recession and reverted to expansion, occurred in early 1990 (when the slowdown was a false signal) and in the final months of 1998 (when it was a slowdown in the middle – not the end – of the cycle).

In our view, US growth has been supported by accommodative central bank policy and we expect that slowing US growth will force the Federal Reserve’s (Fed) hand in cutting rates in 2020 to bolster activity. Although we feel that the slowdown phase will be prolonged and not end in recession, the balance of our scenario risks indicates that recession is a possibility, especially if policymakers don’t respond to the threat.

What might a slowdown mean for multi-asset performance?

Recession prospects aside, the slowdown phase of the economic cycle has historically had considerable implications for the performance of various asset classes. Of course, past performance is no guide to what will happen in the future and may not be repeated.

The table below shows the average performance of US equities, government bonds, high yield (HY), investment grade bonds (IG) and commodities, over the various stages of the cycle, since February 1978.


During a slowdown phase in the output gap model, equity markets not only perform the worst compared to other phases of the business cycle but exhibit greater volatility. During the slowdown phase, US equities have returned on average less than 5% on an annual basis, with volatility of more than 15%.

Periods of slowdown are historically the only phase when sovereign bonds outperform equities.

Also during slowdowns, sovereign bonds have outperformed investment grade corporate bonds, which in turn have outperformed high yield credit, by around 2% and 4.5%, respectively, on an annual basis. During a recession, performance tends to reverse: high yield credit has outperformed both investment grade and sovereign bonds, by around 2% and 5%, respectively, on average.

This time could be different

The current slowdown phase could be different. The recovery from the Global Financial Crisis was the longest and shallowest in history. With monetary policy remaining accommodative, there is the potential for the Fed to engineer a slowdown phase that is longer than average and which doesn’t end in recession – a period of so called “secular stagnation”.

On the surface, such a period of weak growth appears bad. But arguably, if it doesn’t end in a recession, central bank policy may have finally delivered on an objective it has been trying to achieve for decades: smoothing growth and avoiding the boom and bust cycle of the economy. Indeed, the Fed states that monetary policy works “by spurring or restraining growth of overall demand for goods and services”. In this way, it can “stabilise the economy” and “guide economic activity…to more sustainable levels”.

Time will tell and investors will likely keep their fingers crossed.

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Three reasons why the UK stock market looks compelling

UK equities are unloved, undervalued and high yielding; an ideal scenario for stock pickers, argues Sue Noffke, Head of UK Equities at Schroders.

Whatever the opposite of a sweet spot is, many investors think UK equities are currently in one. With Brexit still unresolved, some have put the market in the “too difficult” basket. While it is understandable to fear uncertainty, as stock pickers we embrace the mis-priced opportunities created by it.

The global nature of the market means that international developments often set the tone for UK equities, and following the trough in the wake of the global financial crisis (GFC) of 2007/08 they’ve had a good run, as have equities generally. However, Brexit has still loomed large and been a drag on returns.

UK equities have underperformed global equities since the EU referendum. As a consequence, relative to global equities they are now the most lowly valued for decades. The market also looks very attractive in absolute terms: its current dividend yield is significantly in excess of the long-term average yield.

1. Unloved

The negativity of international investors towards UK equities is entrenched – global fund managers have been “underweight” the UK for three years, according to the Bank of America Merrill Lynch’s global fund manager survey (see chart, below). Investors are said to be underweight an asset class when they are allocating less capital to it than would normally be the case.


As patient investors, we are often interested in how corporate investors are behaving since we share their long-term mentality. Overseas companies (and private equity) buyers are capitalising on the relative valuation opportunity of UK equities, and sterling weakness.

To cite two recent examples, Coca Cola has acquired the Costa Coffee chain from FTSE 100 group Whitbread, while shareholders in mid-cap speciality pharmaceutical company BTG have approved a bid from Boston Scientific.

Costa Coffee generates the bulk of its profits from the UK, although it has a fast growing international franchise business. In contrast, 90% of BTG’s revenues derive from customers based in the US1. To our minds the bids for these assets underline the indiscriminate negativity towards UK equities – many investors have sold ALL UK equities, both their domestically and internationally focused ones. Remember the UK equity market derives more than two thirds of its revenues from overseas.

Share buybacks2 by companies are another interesting theme. It is, perhaps, no coincidence that Whitbread has proceeded to use the larger part of the the Costa sale proceeds to repurchase stock.

Whitbread has joined a number of other UK quoted companies which have either recently initiated, or extended share buyback programmes, including Standard Chartered and UK-focused peer Lloyds Banking.

It seems to us that many UK corporates see their own shares as undervalued, so are sending another valuable signal.

2. Undervalued

Indeed, valuations reflect the degree to which investors have shunned UK equities. The chart below tracks the market’s valuation discount versus global equities based on the average of three metrics. The metrics used are the price-to-book value (PBV) ratio and price-to-earnings (PE) and price-to-dividends (PD) ratios.

All valuation metrics have their strengths and weaknesses, so combining three reduces the risk of distortions (see the end of the article for a description of these metrics).


Based on this analysis, UK equities are trading at a 30% valuation discount to global peers, close to their 30-year lows. While it is likely to persist until there is some form of clarity over the terms of any Brexit deal, the valuation gap provides an attractive entry point for investors with long time horizons.

Please be aware the value of investments and the income from them may go down as well as up and investors may not get back the amounts originally invested.

The valuation of domestically-focused equities is particularly attractive, and consequently we have been increasing exposures to this area of the market. The uncertainty created by Brexit has driven a slowdown in the UK economy since the EU referendum (albeit, by less than feared), while the global economy has held up well.

Associated UK political uncertainty is further weighing on valuations, and might continue to do so given the relatively high probability of either a leadership election or a UK general election in 2019.

3. Attractive yield

Over the past 30 years the dividend yield of the UK equity market, relative to the rest of the world has only been higher during the 1991 recession and at the peak of the technology media and telecoms (TMT) bubble (see chart, below).

CS11445_Equities_chart_v1_UK_dividend_V2.jpgPast performance is not a guide to future performance and may not be repeated.

In absolute terms, the UK equity market is currently yielding c. 4.5% (MSCI UK index), which compares very favourably to the average dividend yield over the past 30 years of 3.5%. For yields to revert back to their long-term average, either the market has to rise or bad news needs to arrive soon and companies cut payments. They would need to cut by a good margin more than they did following the GFC and ensuing global recession – is this likely?

Following the GFC, UK dividends fell by 15% over two years on a cumulative basis, and that includes the effect of BP suspending its dividend following the Deepwater Horizon disaster in the Gulf of Mexico. We don’t believe we are on the cusp of a recession like the one which followed the GFC. Despite some recent high profile and material dividend cuts from Vodafone and Marks & Spencer, overall we still believe that the market’s dividend payment will continue to rise.

If we do experience a recession in the near term, we would expect it to be local to the UK (possibly the result of  a disordely Brexit) rather than a global one, although we are in the latter stages of the economic cycle. This gives us a degree of comfort that the UK equity market’s yield is sustainable as the large majority of UK stock market dividends derive from overseas.

The charts and data highlighted help put the opportunities within UK equities into a broader context. In light of these conditions it is perhaps unsurprising that our allocation to overseas equities is currently at the lower end of its historical range.

As stock pickers we see plenty of opportunities within the UK – across all parts of the market, large as well as small and mid-sized companies – which could help build portfolios capable of generating superior long-term returns.

Investments concentrated in a limited number of geographical regions can be subjected to  large changes in value which may adversely impact the performance of the fund.

Equity [company] prices fluctuate daily, based on many factors including general, economic, industry or company news.

Please be aware the value of investments and the income from them may go down as well as up and investors may not get back the amounts originally invested.

1) See page 124 of BTG’s 2018 annual report and accounts, at:
2) Share buybacks are where a company repurchases its own shares in the open market. Similar to dividends, it is a way for companies to return cash to shareholders.

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Sink or swim – how less liquid assets could buoy portfolio returns

With public equity markets trading close to all-time highs and low yields available from bonds, interest in private assets like infrastructure and private equity has risen, argues Tim Boole, Head of Product Management at Schroder Adveq Group.

In a climate of lower expected returns, both retail and institutional investors are asking where they can generate the performance needed from their portfolios.

With public equity markets trading close to all-time highs and low yields available from bonds, many are exploring less liquid alternatives to get the returns they require. Consequently, investments such as infrastructure or private equity have all seen strong growth in interest.

Yet even in private assets, a record year for fund raising in 2017 has led to questions on whether historic returns are sustainable.

Tim Boole, Head of Product Management at Schroder Adveq, advises that investors worried about this should remember the differences between public and private markets.

“Investors must keep uppermost in their minds that private assets are long-term commitments, meaning they are almost certain to experience at least one complete business cycle. Investment decisions should be considered with due care. Selecting investments that align with long-term trends in the economy are usually best performing.”

Why diversification is key in private assets

Despite the appeal of private assets though, there are also difficulties and challenges to investing in the asset class, not to mention significant risks. There is a lot of dispersion in private markets. While the best managers do very well, the worst can provide investors with quite a dismal experience.

Heeding this warning, what should investors avoid doing and where within private assets offers the best returns going forward? The key, according to Tim, is to avoid following the herd and instead look for where the future opportunities are.

“For those investors who are relatively new to private asset investing, another important lesson is to target portfolio diversification, both in the traditional sense - such as by sector and region - but also by vintage. The latter is a particular characteristic of closed ended funds whereby investments at a different period of the investment cycle are included in the portfolio. This helps combine investments that are already cash flow positive into a fund that is in its launch phase. Investments at a later point in their investment cycle also tend to be more stable. 

“Within private equity there are some areas that have attracted huge amounts of capital and other areas where the growth has hardly changed. For example, huge amounts have been going into the large and mega buy out funds and late stage venture capital finance, whereas capital into small and medium buy-out funds and early stage venture capital has changed much less in the past 20 years1.

Time is on your side

Tim believes that patience and attention to detail are often overlooked in the rush to commit capital to markets. Given the longer market tenure of private assets, investors can afford to dig deeper into new opportunities.

“Investors want to put a lot of money to work and as a result are chasing the big opportunities. But if you are nimble and can work with those who specialise in smaller buy-outs or in venture capital, the returns may be more attractive. This is because the gap between the valuations of buy-outs at the larger end and those at the smaller end have never been as wide as they are today.

“Given that the main access route to investing in private assets is currently via limited partnership structures or closed-ended funds, at present it is a challenge for intermediaries to get easy access to the asset class.

“One of the things we expect to see a lot over the next five to 10 years are intermediary investors being offered more options for private asset investing. This is a particular focus of Schroders and described as the “democratisation of private assets”. One of the things Schroders is working on this year is creating new products for the intermediary market, which are open-ended with periodic liquidity to provide underlying exposure to the underlying private assets.”

A broad offering

The complexity of the numerous instruments within private assets, as well as the extended time commitment, can make choosing a partner for the investment journey a challenging task. Tim suggests that when selecting a manager for the job, investors consider the length and breadth of their experience before taking the plunge.

“Schroders is more often associated with public market investing but has a far more extensive history and platform for private market investing than many realise. In 1971 it set up a real estate business, which at the end of June 2018 housed just under $20 billion of assets. In 2017 it acquired the Swiss private equity business Adveq which in itself has over 20 years of private equity investing experience and today runs close to $10 billion. Schroders Infrastructure Finance team have executed on 46 transactions in just three years. Schroders Insurance Linked Business (“ILS”) is run by Dirk Lohmann, an early pioneer in the field of insurance securitisation, who placed the world’s first non-life insurance securitization (KOVER) in 1993/94.

“With these capabilities, Schroders is well placed to deliver within all areas in private assets. It has a very broad offering, meaning there is a good perspective on where the opportunities are and can act accordingly. It is specialists in all areas, applying the same levels of thought, care and diligence to our private asset products as we do to our public equity offerings.

Given that investments into private assets are often a 10 to 15 year commitment, investors also need to know their manager will be around for that amount of time. Schroders has been around for 200 years, has the backing of the Schroder family and adopts a long-term time horizon.”

1. Source: Preqin, Pitchbook, Zero2IPO, Schroder Adveq 2018. Late stage/growth capital includes 50% of SoftBank Vision Fund and includes investment activity from non-traditional sources of capital (e.g. corporate investors).

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Why a pick-up in UK growth may prove deceptive

Recent economic data from the UK has improved but signs are that this is due to stockpiling ahead of worries over potential Brexit disruption, argues Azad Zangana, Senior European Economist and Strategist at Schroders.

Brexit continues to dominate news and politics in the UK. Even lowly economists pray for a break from the mundane gridlock and circular arguments. Now that the Brexit deadline has been extended to October (see Is the UK stuck in Brexit limbo), a little breathing room has been created to allow other topics to enter the fray.

The medium to long-term outlook for the economy will be heavily influenced by Brexit. The Bank of England had downgraded its growth forecast for the coming quarters, citing a more negative impact from Brexit uncertainty than it had previously anticipated.

However, recent data has been better than expected. The monthly GDP release for January showed a significant improvement, as GDP growth picked up to 0.5% compared to -0.3% in December.

UK growth seems to be improving

UK-growth-GDP.jpgSource: Thomson DataStream, ONS, Schroders Economics Group. 29 April 2019.

The release for February was more subdued, with 0.2% growth, but even if the economy stalls in March, the quarterly GDP estimate for the first quarter of 2019 would be 0.5%. We suspect it could be even higher. In any case, it will probably prompt many economists to revise up their estimates for 2019. The data is due on Friday 10 May.

An analysis of the contributions to GDP shows that a resurgence in manufacturing has played an important role in the pick-up in activity. This is reflected by recent readings from the Markit purchasing managers' indices (PMI) – a set of private sector surveys that gauge the level of activity in the economy. A balance above 50 implies expansion; below 50 implies contraction. The March UK manufacturing PMI showed activity at 55.1, its highest level since February 2018. This has since slipped to 53.1 in April but it remains substantially above the services level (50.4 in April).

UK manufacturing and services PMI

PMI-manufacturing-services.jpgSource: Markit, Schroders Economics Group, 7 May 2019.

The weakness in services is a concern for the coming months given how much larger the service sector is in terms of its share of the economy.

Delving into the details of the manufacturing PMI survey, we discover a worrying development. The questions that ask about the degree to which companies are building inventories show stocks of both finished goods and of purchases (parts or raw materials) are both are record highs.

UK inventories hit record high ahead of Brexit

Inventories.jpgSource: Thomson DataStream, Markit, Schroders Economics Group, 29 April 2019.

The unusual boost from Brexit

In the run-up to the original 31 March Brexit deadline, there were a number of anecdotal stories of both companies and government entities stockpiling supplies, for example, of medicines by hospitals and pharmacies.

While the manufacturing PMI survey only covers private manufacturers, we suspect it is a good indication of widespread stockpiling. Stockpiling inevitably leads to a slowdown in production at a later point in time. Typically, a large build-up of inventories is involuntary. Companies are usually producing output at a normal pace, when a fall in demand and sales leads to unsold stocks building up.

This time is different as companies are hoarding ahead of possible disruption to output and the ability to import. Regardless of the cause, a slowdown in growth is likely, whether that disruption hits or not.

Once stockpiling ends, GDP growth is likely to slow

For manufacturing activity to continue to enjoy above normal production, further stockpiling would need to occur. Reports of shortages of warehouse space suggest that this is unlikely to continue for much longer. Production levels would have to be wound down to stop any further build-up of inventories.

If demand then disappoints, or if imports are not as restricted as feared in a worst-case scenario, then excess inventories would have to be discounted or destroyed at a cost to producers and retailers.

Imminent rate rise seems unlikely

The Bank of England has stated its ambition to raise interest rates back to more "normal" levels, but we think it is unlikely to follow through given the poor quality of growth the UK is experiencing, set against a backdrop of ongoing Brexit uncertainty.

The government should also take note. Celebrating the forthcoming pick-up in GDP growth for the first quarter could prove to be premature. Indeed, Chancellor Philip Hammond has indicated that he may need to delay the next comprehensive spending review due to the delay in Brexit. Committing to a multi-year spending programme (which is likely to be stimulative) at a time of great uncertainty would be a big gamble.

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Eurozone growth rebounds as temporary headwinds fade

The latest GDP figures show that domestic demand has remained resilient, shows Azad Zangana, Senior European Economist and Strategist at Schroders.

The early estimate for first quarter eurozone GDP growth showed a pick-up to 0.4% quarter-on-quarter (q/q) from 0.1% in the previous quarter – beating consensus expectations of 0.3% growth.

The latest data release suggests that the monetary union has largely sailed through most of the temporary headwinds that it faced in the second half of 2018. Gilets jaunes protests, new car emissions tests, and low water levels of the river Rhine all disrupted activity last year and caused growth to slow sharply.

While there are some residual effects remaining, the latest figures should also put to bed speculation that the eurozone was in recession, and supports the strong performance of European equities so far this year.

Within the member states that have reported so far, France saw activity remaining steady at 0.3% q/q, although it reported better domestic demand growth thanks to a pick-up in household spending. Spain recorded another impressive quarter, as GDP growth picked up from 0.6% to 0.7%, also marginally better than consensus expectations. Finally, Italy saw a moderate rebound, as growth picked up from -0.1% at the end of last year to 0.2% in the first quarter, also beating consensus expectations.  

Overall, we believe these are a good set of growth figures given recent events. External demand is likely to have remained weak as the fallout from the US-China trade war continues. European political uncertainty in the form of the Spanish elections, Brexit and European parliamentary elections probably had a small negative impact, but domestic demand has remained resilient throughout this period.

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Which stock markets look ‘cheap’ after strong performances in the first quarter of 2019?

Following a dramatic rebound for stock markets in the first quarter of 2019, Duncan Lamont, Head of Research and Analytics at Schroders, assesses how market valuations have been affected.

Those who were brave enough to fight the emotional urge to sell during the carnage in markets which brought 2018 to a close have been richly rewarded in the first few months of 2019.

Of the five markets in our regular analysis, even the worst of the bunch (Japan) returned almost 8% so far this year (as of 12 April).

The US was the best with a 13.9% gain, an almost mirror image of the 13.7% it lost in the fourth quarter of 2018 (although this also provides a useful reminder that, because of the way returns compound from one period to the next, a given gain will not be enough to offset a loss of the same magnitude – the return over this six month period was -1.7%). The UK, Europe and emerging markets have all risen close to 10% this year.

Valuations are one of the most powerful indicators of long term returns. Buy when markets are “cheap” and the odds are stacked in your favour. Buy when they are expensive and, although you won’t necessarily lose money, more things have to come right for you to come out on top.

We highlighted in our January update that a combination of robust earnings growth and falling markets had brought stock market valuations around the world close to their cheapest level for several years. Although short term risks were elevated, the longer term case had improved notably.

Although valuations are usually a poor guide to short term performance, markets have clearly rallied sharply from that nadir. However, the strength of performance in the early stages of 2019 means that returns, which were expected to have been earned over the medium to long term, have instead been harvested in barely three months.

This leaves less on the table for the future and the valuation case is now a lot more subdued. Simple models of expected returns linked to either dividend yields or earnings yields suggest that long term expected returns are around 0.3-0.4% lower in all markets than they were at the start of the year.

This more downbeat picture can be seen in our usual valuations table, which has more of a red hue than in January. However, a closer look at the numbers suggests a more nuanced stance is appropriate.

For non-US markets, those valuation indicators which are in expensive territory are pretty close to historic averages, with the exception of cyclically adjusted price to earnings (CAPE). A cautionary note but not something which should keep long term investors awake at night.

Bad performance could of course happen (a restarting of interest rate hikes in the US would be one possible driver) but valuations are unlikely to be the source of the problem. The US continues to be out on a limb. But betting against it has been a fool’s game for years and investors would be wise to maintain a balanced exposure to global stock markets.

Past Performance is not a guide to future performance and may not be repeated.


The pros and cons of stock market valuation measures

When considering stock market valuations, there are many different measures that investors can turn to. Each tells a different story. They all have their benefits and shortcomings so a rounded approach which takes into account their often-conflicting messages is the most likely to bear fruit.

Forward P/E

A common valuation measure is the forward price-to-earnings multiple or forward P/E. We divide a stock market’s value or price by the earnings per share of all the companies over the next 12 months. A low number represents better value.

An obvious drawback of this measure is that it is based on forecasts and no one knows what companies will earn in future. Analysts try to estimate this but frequently get it wrong, largely overestimating and making shares seem cheaper than they really are.

Trailing P/E

This is perhaps an even more common measure. It works similarly to forward P/E but takes the past 12 months’ earnings instead. In contrast to the forward P/E this involves no forecasting. However, the past 12 months may also give a misleading picture.


The cyclically-adjusted price to earnings multiple is another key indicator followed by market watchers, and increasingly so in recent years. It is commonly known as CAPE for short or the Shiller P/E, in deference to the academic who first popularised it, Professor Robert Shiller.

This attempts to overcome the sensitivity that the trailing P/E has to the last 12 months' earnings by instead comparing the price with average earnings over the past 10 years, with those profits adjusted for inflation. This smooths out short-term fluctuations in earnings.

When the Shiller P/E is high, subsequent long term returns are typically poor. One drawback is that it is a dreadful predictor of turning points in markets. The US has been expensively valued on this basis for many years but that has not been any hindrance to it becoming ever more expensive. 


The price-to-book multiple compares the price with the book value or net asset value of the stock market. A high value means a company is expensive relative to the value of assets expressed in its accounts. This could be because higher growth is expected in future.

A low value suggests that the market is valuing it at little more (or possibly even less, if the number is below one) than its accounting value. This link with the underlying asset value of the business is one reason why this approach has been popular with investors most focused on valuation, known as value investors.

However, for technology companies or companies in the services sector, which have little in the way of physical assets, it is largely meaningless. Also, differences in accounting standards can lead to significant variations around the world. 

Dividend yield

The dividend yield, the income paid to investors as a percentage of the price, has been a useful tool to predict future returns. A low yield has been associated with poorer future returns.

However, while this measure still has some use, it has come unstuck over recent decades.

One reason is that “share buybacks” have become an increasingly popular means for companies to return cash to shareholders, as opposed to paying dividends (buying back shares helps push up the share price).

This trend has been most obvious in the US but has also been seen elsewhere. In addition, it fails to account for the large number of high-growth companies that either pay no dividend or a low dividend, instead preferring to re-invest surplus cash in the business to finance future growth.

A few general rules

Investors should beware the temptation to simply compare a valuation metric for one region with that of another. Differences in accounting standards and the makeup of different stock markets mean that some always trade on more expensive valuations than others.

For example, technology stocks are more expensive than some other sectors because of their relatively high growth prospects. A market with sizeable exposure to the technology sector, such as the US, will therefore trade on a more expensive valuation than somewhere like Europe. When assessing value across markets, we need to set a level playing field to overcome this issue.

One way to do this is to assess if each market is more expensive or cheaper than it has been historically.

We have done this in the table above for the valuation metrics set out above, however this information is not to be relied upon and should not be taken as a recommendation to buy/and or sell If you are unsure as to your investments speak to a financial adviser.

Finally, investors should always be mindful that past performance and historic market patterns are not a reliable guide to the future and that your money is at risk, as is this case with any investment.

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China defies the gloom

Chinese industrial production has been stronger than expected, though we see a risk that this could reverse next month, explains Craig Botham, Emerging Markets Economist at Schroders.

First quarter GDP surprised to the upside in China, with real GDP growth unchanged from the end of 2018 at 6.4% year-on-year (y/y). Given the weakness in high frequency data for the first two months of 2019, this came as a surprise to most economists, and it looks like the economy was bailed out by a strong turnaround in March.

If we were to sound a note of caution, it would be to note that GDP was supported by an acceleration in the manufacturing sector, which offset slowdowns elsewhere in the economy. There is a risk that this is a frontloading effect triggered by the April tax cuts and so unwinds next month.

Overall though, this month’s data should still serve to ease fears over China’s impact on the global economy, even if imports are still weak.

Industrial strength is encouraging but difficult to explain

GDP was not the only data to surprise this month; industrial production in particular blew expectations out of the water, growing 8.5% y/y compared to 5.3% for the combined January-February period and the strongest since 2014. Fixed investment also accelerated to 6.5% from 6.1% previously – though despite the pick-up in industrial production, manufacturing investment actually slowed.

Retail sales though slowed in real terms, and while exports bounced back in March they were still weaker for the quarter as a whole and imports are yet to return to expansion.

For us the difficulty lies in reconciling weak domestic demand as evidenced by contracting imports with the story told by surging industrial production. Credit data has been strong but it is too soon to expect it to show up in activity data, particularly as lending to the real economy seemed to slow in January and February and only picked up in March.

Either imports or industrial production must therefore be “wrong” in their signal on domestic demand. For weak imports to be consistent with strong domestic demand this would suggest that China has managed to shift supply chains onshore. While this is an ongoing theme as China moves up the value chain, it seems doubtful that it could prompt such a sudden and dramatic disconnect given that the two were much more closely related until this month.

Brace for whiplash next month

The alternative explanation then is that something is amiss in the industrial production data. It is curious, for example, that industrial production should be so strong and yet manufacturing investment should slow. The implied increase in capacity utilisation would be expected to see capacity expansion under normal circumstances – that it has not suggests manufacturers do not see this as a sustainable increase in production.

Adding to this, we note that the manufacturing purchasing managers’ indices (PMIs) this month pointed to inventory building, with the return to expansion driven by higher stocks of inputs and finished goods. We would suggest two potential triggers for this behaviour; the first is the end of holiday disruptions to production, essentially “catch up” by manufacturers. The 5.3% print for January-February was very weak and so some bounceback seemed inevitable.

The second factor could be the cut to VAT effective at the start of April. This provided manufacturers with an incentive to frontload orders and production, to enable them to offset the older, higher VAT rate as an expense against future profits, taxed at the lower rate.

As may be apparent, we are somewhat sceptical of the sudden spring in China’s step, and see a strong possibility that some of this strength in production is undone next month. All the same, this is a stronger-than-expected GDP print. We still expect the strong credit data to result in a pick-up in growth in the second and third quarters, so there is some upside risk to our expectation of 6.3% growth for 2019.

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The coming squeeze on US profits

We see US profits falling 4% in 2020 as slower growth and higher wage costs hit companies’ profit margins. But we have modelled a range of alternatives - and charted the potential impact, explains Keith Wade, Chief Economist & Strategist at Schroders.

Progress on US-China trade talks has seen investors’ concerns about a trade war fade, and be replaced instead by worries about economic growth and politic risks. The real concern for equity investors, ultimately, is how slower growth will be reflected in company profits.

In 2018 markets were driven by stronger corporate earnings, but share prices still slipped back as interest rate rises caused investors to reappraise valuations. This year looks like being the reverse, as we forecast earnings to slow whilst the central bank stands back.

Lower inflation and rising wages put pressure on profits

One of the key changes in our recent forecasts for slower growth is an update on the inflation outlook. Inflation looks set to be weaker than previously expected and this has fed into a more accommodative monetary policy stance from central banks.

Whilst this can be seen as positive for stock markets (lower interest rates make cash savings relatively less attractive), lower inflation can increase pressure on profit margins. Companies are facing rising wage costs. When higher inflation is accepted, the increased costs of labour can be more easily passed on through higher end prices. When inflation is constrained and producers are unable to pass the additional costs on, then profit margins take the strain. 

One of the key features of the most recent economic expansion has been the elevated level of profit margins enjoyed by companies. For the US market, this is indicated by the high profit share as a percentage of GDP, shown in the chart below.

US profits as a percentage of GDP

us-profits-as-percentage-of-gdp.jpgSource: Thomson Reuters, Schroders, 21 March 2019.
Past performance is not a guide to future performance

The flip side of this of course has been weak wage growth. In many countries, this has translated into dissatisfaction with the economic status quo, stoking the flames of populist politics. Going forward, we think this could change.

US profits set to fall in 2020

We take a top-down approach to forecast the share of profits in GDP via profit margins and capacity utilisation. Capacity utilisation measures the extent to which businesses are using their capacity to produce goods or services. Our forecast for this is driven by GDP growth, while the forecast for profit margins is also affected by growth in labour costs, prices and productivity.

We do not expect a US recession (i.e. two consecutive quarters of negative economic growth) but our forecasting model suggests caution on US earnings would be appropriate. We expect profits to peak in Q3 2019 and to decline in line with a weaker US economy thereafter. Overall, we forecast US profits (excluding financials) to rise by 6% in 2019 but to fall by 4% in 2020.

This is because below-trend economic growth means lower capacity utilisation, putting downward pressure on profits. Moreover, profit margins will be squeezed as labour costs rise, while inflation and productivity decline on the back of weaker growth.

Profits could fall further in alternative scenarios

While the above reflects our base case, we have also modelled a number of alternative scenarios. Unsurprisingly, the share of profits would see a sharper decline should a US recession occur in 2020. In that scenario, profits could fall by 13.5% (see light green line on chart below). When modelling a scenario of a global recession excluding the US, the fall in profits came in at 7.4% in 2020 (dark blue line).

Only two scenarios pointed to profits growth. Either China tries to avert a deeper economic slowdown by stimulating growth and inflation through extra fiscal spending or US growth surprises again through a stronger supply side (purple and red lines).

US economic profits (ex financials) set to peak in Q3 2019

us-profits-in-different-scenarios.jpgSource: Thomson Datastream, Schroders Economics Group. 27 March 2019.

The above is a forecast based on top-down economic factors. Actual profits, or earnings per share (EPS), for the S&P500 (the large cap US equity index) will be more volatile. This is because of the effects of a company’s borrowings and write-offs. However, we would expect the direction of profits to be similar and so we can make an estimate of market EPS.

We estimate that S&P500 operating earnings will rise by 6.8% in 2019, while reported EPS increases by 7.8%. The decline of the profits share in 2020 would reverse these gains; operating earnings would drop by 3.4% and reported EPS by 6.9%.

Operating earnings are profits earned after subtracting from revenues those expenses that are directly associated with operating the business. Reported earnings include non-recurring items (e.g. the one off cost of closing down a factory).

This analysis of profit margins suggests we will see a squeeze on corporate earnings in 2020. Corporate cash flows will come under pressure and this will provoke a reaction. Typically companies would cut jobs and capital spending. The knock-on impact of this could bring the economic cycle to an end, leading to recession. Our model currently puts a 36% probability on a US recession in the next 12 months – the highest probability since 2007.

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The chart that tells the story of value investing’s potential

Value stocks are currently the most out of favour in the history of financial records, explains David Brett, Investment Writer at Schroders. Is now the time for value to make its comeback?

Value stocks are on their longest losing streak versus growth stocks since records began, according to data stretching back to 1936.

Value investing is the art of buying stocks which trade at a significant discount to their intrinsic value. Basically, buying companies which appear undervalued by investors for no justifiable reason.

Growth investors pay less attention to a stock’s price. Even if a company looks expensive they may believe its above average future growth justifies the expensive price tag.

Value’s longest losing streak in history

There have been three periods of dramatic underperformance by value relative to growth since records began: the tail-end of the Great Depression in the late 1930s, the build up to the bursting of the dotcom bubble in the late 1990s and now.

As the chart below shows, value’s underperformance during the late 1930s and 1990s was sharp but also short, lasting around four years and two years respectively. In comparison the current underperformance which began in 2009 is now nearly a decade old.

The good news for value investors is that in the past, value’s bouncebacks were even more dramatic than the underperformance.

Analysis by academics Eugene Fama and Kenneth French has shown that in the five years following its underperformance trough in 1940 value outperformed growth by 138%. Similarly, when value’s two year underperformance troughed in 1999 it outperformed growth by 107%. The question for value investors now is could history repeat itself?

Of course, past performance is not a guide to future returns.

Rolling 10-year total return difference: Fama-French (value vs growth)

Why now for value?

Nick Kirrage, an equity value fund manager at Schroders, explains why now might be a good time to consider value stocks.

“We know we should buy low and sell high. We are looking for investment strategies that are enduring and we want to buy them when they look cheap and attractive.

“Value has been through one of its worst periods in history. Performance has been weak but we continue to have the conviction that value is an enduring investment style.

“When we look across investments in the market today we see a huge bias in investors’ portfolios towards growth-type investments. That presents an opportunity, to diversify and buy into a strategy that has a great long-term success record.

“So why now? Because, we believe, with value stocks at such attractive levels the opportunity has never been greater.”

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14 years of returns: history’s lesson for investors

The graphic shows the best and worst performing assets each year since 2005. Schroders research illustrates why diversifying your investments matters, explains David Brett, Investment Writer at Schroders.

The temptation among investors is to stick to what you know. That is no bad thing. It is a strategy championed by successful investment pioneers such as Warren Buffett, a famous devotee of stocks.

It can work, when the market is rising and you have picked the right asset. However, it’s also important for investors to consider the merits of diversification.

This table underlines the importance of spreading your money around. It can potentially help reduce risk and maybe even improve the long-term performance of your overall portfolio. It shows the returns achieved by some of the main asset classes in each year.

Of course it’s important to note that past performance is not a guide to future performance and may not be repeated.

Stock market performance is measured by the MSCI World Total Return index. Investment grade bonds relates to global government and corporate bonds deemed to be at relatively low risk of default. Property relates to the returns from global real estate markets as measured by Thomson Reuters. More detail on the indices used for each asset can be found at the foot of the table.

Asset class performances 2005-2018

14 years of asset returnsPast performance is not a guide to future performance and may not be repeated. Source: Schroders, Refinitiv data correct as of 01 January 2019.  Stock Market: MSCI World Total Return Index, Property: Thomson Reuters Developed Market Real Estate Total Return Index. Cash: IBA US dollar interbank LIBOR 3 month, High Yield Bonds: BofA Merrill Lynch Global High Yield TR Index, Investment Grade Bonds: ICE BofAML Global Corporate Total Return Index, Commods: Bloomberg Commodity Index, Gold: Gold Bullion LBM $/t oz. All show total return in local currency.

What are the benefits of diversification?

The tables reflects how the fortunes of assets often diverge.

Consider the example of gold. It is often described as the ultimate diversifier because it tends to be uncorrelated with the movement of other assets. In particular, it is perceived as being an asset to hold during times of uncertainty. In 2011, stock markets lost 5% amid the uncertainty of the European debt crisis. But investors who held some money in gold will have had their losses eased thanks to an 11% return for that asset.

The benefits of diversification can be described in various ways:

Managing risk: A crucial imperative for investors is not to lose money. There is risk with every investment - the risk that you receive back less than you put in or the probability that it will deliver less than you had expected. This risk varies by the type of investment. Holding different assets mean this risk can be spread. It could also be managed by you or by a professional, such as financial adviser. Specialist fund managers can also allocate money to help manage risks.

Retaining better access to your money: The ease with which you can enter or exit an investment is important. Selling property can take a long time compared with selling equities, for example. Holding different types of investment that vary in terms of "liquidity" (the ease of buying and selling) means you can still sell some of your investments should you suddenly need money. 

Smoothing the ups and downs: The frequency and magnitude by which your investments rise and fall determines your portfolio’s volatility. Diversifying your investments can give you a greater chance of smoothing out those peaks and troughs.

Johanna Kyrklund, Global Head of Multi-Asset Investments at Schroders, said: “For me, the merits of diversification cannot be emphasised strongly enough. I’ve been a multi-asset investor for more than 20 years and have inevitably faced some pretty turbulent spells for markets. Each time, the ability to nimbly move between different types of assets has better equipped me to navigate those periods.

"Diversification, if carefully and constantly managed, can potentially deliver smoother returns; it’s a key tool to help in balancing the returns achieved versus the risks taken.”

Too much diversification?

There is no fixed rule as to how many assets a diversified portfolio should hold: too few can add risk, but so can holding too many.

Hundreds of holdings across many different types of investment can be hard for an individual investor to manage.

What has been the best and worst performing assets since 2005?

Gold was the best performing asset, bolstering its reputation as a safe haven during times of uncertainty. It’s worth noting that much of the gains were made in the early part of that period before the uncertainty of the financial crisis took hold.

Gold’s strong performance is all the more noteworthy when commodities were found to be the worst performing asset over the 14 years. They alone of the six assets would have lost investors money.

In real terms, $1,000 invested in gold in 2005 would now be worth $2,925 – an 8.3% annual return. $1,000 invested in commodities would now be worth $630 – representing a 2.3% annual loss.

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Global economic outlook: slowdown, not recession

We have cut our global GDP growth forecast again for 2019 but have revised up our prediction for 2020 amid greater optimism on the longer-term outlook, explains the Schroders Economics Team.

We have revised down our forecast for global GDP growth in 2019 to 2.8% from 2.9%, but increased our projection for 2020 to 2.7% (from 2.5%). The downgrade for this year (the fourth in consecutive quarters) is driven by cuts to our forecasts for the eurozone, UK and Japan which offset a small increase to our China forecast.

In 2020, the upward revision is across the board with, for example, the US upgraded to 1.6% (previously 1.3%), Japan to 0.4% (previously 0%) and China nudged up to 6.1% from 6%.

Meanwhile, our inflation forecasts have been reduced for this year and next with reductions across all regions except Europe. US inflation is also lower as a result of a smaller rise in core inflation (i.e. excluding food & energy prices) which we expect to peak at a lower level before declining in 2020.

Longer-term picture looks brighter

Underpinning these forecasts are a number of factors which give us reasons to be more cheerful about the longer-term outlook:

  • Firstly, oil prices are lower. While this is a symptom of weak global demand, it is helping to bring down inflation and boost consumers’ spending power.
  • Second, the US and China are moving closer to a trade deal. President Trump extended the deadline for raising tariffs on $200bn of Chinese imports from 10% to 25% beyond 1 March. This means tariff increases will now be more limited, helping to reduce costs, protect profit margins and contain inflation.
  • Thirdly, monetary policy is easier. This is partly a reflection of lower inflation but it also marks a shift in Federal Reserve (Fed) policymaking where the central bank has become more responsive to financial market conditions.

We now expect the Fed to increase interest rates only once more before they start to fall in 2020 as the boost from tax cuts disappears and monetary tightening feeds through. It seems unlikely that additional fiscal stimulus will be passed by the Democrat-controlled House.

While a trade truce between the US and China could help boost external demand later this year, even as the trade war quietens down the tech war will remain in full swing. We would expect the US to continue to challenge China in this area either through sanctions on Chinese companies or preventing its own companies from exporting key technology items.

Temporary factors have weighed on eurozone growth

We have pushed out rate increases in the UK and eurozone. In the case of the UK, this reflects the growing likelihood that a short delay may be required to facilitate Brexit. Conversely, in Europe, temporary factors have held back growth but we expect the effects to begin dissipating in a few more months.

Among these temporary factors, Germany was impacted by changes to car emissions testing which caused sales of new vehicles to slump sharply from September 2018. Sales have begun recovering. Germany’s woes were compounded by a drought that reduced the river Rhine's water levels so significantly that it led to disruption in raw materials shipments.

In the meantime, in Italy political uncertainty caused financing costs to rise across the economy. In the end, the government’s expected spending splurge was far more modest than feared and the 2019 budget was approved, albeit after a very public battle with the European Commission.  

Given the temporary nature of these shocks, we expect to see an improvement in growth by the summer. Fundamentals are sound in Europe with monetary policy still very loose while most countries have completed their austerity programmes. Following the 8 March European Central Bank meeting, we now forecast a rate rise in March 2020.

VAT increase in focus in Japan

In Asia, we expect the Bank of Japan to leave monetary policy unchanged. Energy and one-off factors should drive a further moderation in inflation before a VAT-led spike in October, as the VAT rate rises to 10% from 8%. We expect a subsequent sharp decline in demand and dissipating inflationary stimulus. On the other hand, more infrastructure spending for disaster prevention should support growth at the end of 2019, and more substantially in 2020.

China is expected to ease further through a lower reserve requirement ratio which is now forecast at 10% by end 2020 (previously 11%). The ratio dictates the amount of cash banks have to hold in reserve, so a lower ratio frees up more capacity for lending.

The main changes for emerging markets come from inflation. Crude oil prices have fallen dramatically since we last updated our numbers. Combined with surprisingly low domestic inflation this sees substantial downward revisions to the inflation outlook for all BRIC economies bar Russia, for whom cheaper oil means a weaker currency and hence more imported inflation.

Turning to currencies, the US dollar is expected to remain firm in the near term, but to weaken later in the year as rates peak in the US whilst monetary policy tightens in the eurozone and UK. Sterling is also boosted by our assumption that a Brexit deal is struck and the UK enters a transition period after 29 March, rather than crashing out of the EU.

Alternative scenarios

These forecasts represent our baseline case, to which we attach a 60% probability. We also model a number of alternative scenarios. One of these is “Recession excluding US”, whereby the outlook in China and Europe deteriorates significantly, while another is “US recession 2020”. These two scenarios would both have a deflationary impact on the world economy and we estimate the probability of these at 17%.

We also model three scenarios that would have a stagflationary impact, i.e. causing persistent inflation and stagnant growth. These are “Trade war: US versus Rest of the World”, “Global inflation surge” and “Italian debt crisis”. We attach a 14% probability to these three scenarios.

We see a lower probability for two reflationary scenarios. In the first of these, “China reopens the spigots”, we assume large scale stimulus from Chinese policymakers. In the second, we model a “US supply side surprise” whereby more people enter the US workforce, therefore containing wages and inflation and extending the economic cycle. 

Table of GDP and inflation forecasts

Source data for table

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Five fintech trends to watch in 2019

Technology is transforming financial services and the way we interact with our money. Charlotte Wood, a fintech expert at Schroders, reveals the trends she's monitoring.

There’s no shortage of stories on how tech breakthroughs will transform financial services, from changing the way we interact with our personal finances to threatening entire banking institutions with disruption.

It can be difficult to predict exactly what this landscape will look like in the next few years, but most seem to agree that the pace of change, with rapid creation and adoption of tech solutions, will not be letting up.

Part of my role involves identifying key innovations which are set to change the financial industry. Here are five trends I’ll be keeping an eye on in 2019.

1. The death of blockchain vanity projects 

Blockchain is the technology sitting behind Bitcoin, the “digital currency” that is separate from any central bank. While cryptocurrencies like Bitcoin have had a lukewarm (at best) response from most banks, the underlying technology has generated much more interest across the industry. Blockchain allows the transfer of digital ownership through a constantly growing chain of time-stamped records called blocks, and the proclaimed impacts of this technology seem endless, being touted as disrupting existing banks in areas such as payments, loans and trading.

Consensus has been gradually emerging that blockchain is an interesting technology that opens up new possibilities. However, it is neither the solution to every challenge nor a replacement to every existing utility, and there are hurdles to implementation, including technical, regulatory and even behavioural barriers.

This year there will be more sophisticated conversations about these limitations. We’ll see fewer experimental proofs of concept (some of which could never become reality at scale and are little more than vanity or PR projects), and more solid examples of how it can help businesses and individuals like you and me.

2. Open banking having an impact after a slow start in 2018

Have you heard of open banking? If not, that is not hugely surprising. It’s been described in the Financial Times as “the quiet digital revolution”.

Many people will be aware of some new apps designed to access and aggregate their financial information - this is a result of the open banking launch just over a year ago, a government-backed initiative which means banks must share customers’ information with other authorised providers on request.

Banks will only share this data if given explicit permission, and it’s up to customers if they wish to do so, to gain new insights into their finances or to get a better deal on financial products. The objective is to make banking fairer and more transparent and encourage new product development, but it’s taking longer than expected to take off.

Although awareness is considered low, and people are rightly cautious about sharing their financial data, the number of people taking advantage of it is increasing. This year we should see banks and fintechs (financial technology start-ups) collaborate better, and communicate the benefits more effectively, hopefully resulting in more people buying into how open banking can help them.

3. The ethics of artificial intelligence (AI)

Artificial intelligence is expected to infiltrate almost every aspect of modern life within a generation. For now development of AI has probably been most widely visible to consumers in the form of ‘smart’ assistants and chatbots, while in the background important questions are being raised on how to ensure we don’t stray into ethically dubious territory. 

In addition to the oft-cited concern of the ‘next industrial revolution’ on employment prospects, a key ethical issue of AI is how we ensure the right parameters are set and data is used so that the machine behaves in the way humans would agree is ‘right’. Just one of the areas this has implications for is financial inclusion, where we need to be able to show why people get turned down for products such as personal loans, mortgages or insurance. An issue being discovered in testing is biases contained in the data so that machines in some cases are essentially trained to be racist, sexist or otherwise discriminatory in this decision making.

In Europe, the European Parliament Committee on Industry, Research and Energy backed plans in January for a comprehensive policy framework on AI and robotics, weeks after ethical concerns in the field were highlighted in an EU report. So we’re likely to see more commentary emerging on these topics, a new area for most organisations to consider.

4. Biometric advances – paying with your face

Starting with fingerprint and facial recognition on smartphones, biometric innovations are now real, and for many people simply normal. Banks in particular are increasingly using voice and imaging technology to verify their customers’ identities, for example KFC in China and the retail giant Alibaba have both tested letting people pay by smiling. Apple has even patented a vein recognition ID scan.

There is potential for this technology to help combat fraud and it’s an area that is rapidly developing, however there are still concerns that fake videos can easily be created.

This has implications for banking security as well as the potential danger of attacks to people’s reputations and use in disinformation campaigns.

5. Continued lowering of the barriers to investing

Roboadvisers in one form or another, like Nutmeg, WealthFront and Acorns, have been around for a while now and have opened up the route to simple investing for many people through technology. (For full disclosure, Schroders has a stake in Nutmeg).

Crowdfunding platforms such as Crowdcube and Funding Circle also offer alternative investment opportunities, where people can purchase equity in small companies, social movements and creative projects

These will become ever more sophisticated and increasingly give people access to new asset classes, based on their interests and values as well as on their desire to invest their cash.

As a couple of examples, Royalty Exchange offers an online marketplace for investors to buy royalties from music artists via auctions, while YieldStreet enables investors to build portfolios across multiple asset classes including real estate and marine assets.

Good for the little guy

This accelerating change is hard to keep up with but it’s not a bad time to be a consumer. These advancements – and many more we haven’t covered - favour customers by giving them more power and increasing transparency of services.

Banks are being forced to innovate in order to give their clients better, differentiated services. In addition, they need to constantly assess the ethical implications of the advances being made.

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Are investors too pessimistic on European shares?

Some European markets seem priced for recession but economists still forecast growth for the region in 2019, explains Emma Stevenson, Investment Writer at Schroders.

European equities had a tough 2018 with the benchmark MSCI Europe index falling 10.6% over the year. Trade wars, reduced support from central banks and slower economic growth were among the factors that saw higher risk assets such as equities fall out of favour.

Despite the difficult global backdrop, the eurozone economy continued to expand in 2018, albeit with quarterly growth slipping to just 0.2% in each of the final two quarters of the year.

However, some European equity valuations have fallen to levels that imply we are already in a recession. The chart below compares the current price-to-earnings (P/E) ratio of the pan-European index, and individual country indices, to their P/E ratios in the last two recessions: the global financial crisis and the sovereign debt crisis.

P/E ratios are a common valuation measure and are calculated by dividing a stock market’s value or price by the earnings per share of all the companies within it. A low number represents better value.

Chart of European equity market valuations

For most countries, and the pan-Europe benchmark, valuations now are above the levels of the two very deep recent recessions, as you would expect. One exception is Italy, where political uncertainty and ever-present worries over the health of the banking sector mean valuations for the FTSE MIB are below the levels reached during the sovereign debt crisis. The other is Germany, where current valuations for the DAX are below those reached in the 2008/09 global financial crisis.

Azad Zangana, Senior European Economist & Strategist at Schroders, says of these recessions:

“The first, the global financial crisis, is probably a once in a century event. The second, the EU sovereign debt crisis, is certainly possible again, although steps have been taken by regulators and the European Central Bank to mitigate a repeat. If Europe is currently in recession, then it is likely to be a shallower and shorter recession than the previous two. Despite this, the P/E of the German DAX is currently at just 12.3, below that of the global financial crisis. This suggests that an extreme negative scenario is priced in to German equities.”

Why would this be? Germany’s export-oriented economy makes it susceptible to worries over trade wars. While the trade war headlines have focused on the US and China, President Trump has threatened tariffs on European goods too. In addition, global supply chains are so intertwined that disruption would be felt far beyond the two main antagonists. Trade wars could impact demand from China, and likewise Brexit could disrupt the UK, another of Germany’s important export markets.

German growth was disappointing in the second half of 2018, with a contraction of -0.2% quarter on quarter in Q3 followed by flat growth in Q4. Azad Zangana says this was mainly due to temporary factors, including “supply disruptions in the autos industry due to the introduction of new car emissions tests, but also low water levels in the river Rhine stopped the shipping of raw materials to factories. We estimate that that the disruption in the autos industry is worth 0.5 percentage points (pp) alone on quarterly growth.”

We can conclude that there are plenty of risks, but does this justify the extremely low valuation levels? Azad Zangana argues not: “We are not forecasting a recession for either Germany or the eurozone in 2019, which prompts us to be more positive on European risk assets than the market.”

The Schroders Economics Team is forecasting growth of 1.6% for the eurozone in 2019 and 1.7% in 2020. For Germany, the forecast is for 1.4% and 1.6%, respectively.

Martin Skanberg, fund manager, European equities at Schroders, says:

“We do not invest on a country basis but, rather, look for stock-specific mispriced opportunities. What is clear is that some parts of the European stock market fell to what we believe to be oversold levels at the end of 2018.

“Some economically-sensitive sectors are trading at very low P/E levels, whereas many defensive shares are at record highs. The share prices of many companies in sectors such as autos and auto parts, or packaging, now appear to be pricing in an extremely pessimistic scenario. As such, these are the areas that we think could potentially perform best if sentiment were to improve.”

As an example, the automobiles & components sector is currently trading on a price-to-earnings ratio of 6.7x. This compares to 22.2x for the beverages sector, which is often perceived as a defensive safe haven for investors when economic times are tough (data source: Thomson Reuters DataStream, as at 14 February 2019).

Skanberg adds that broader economic growth is not the only driver of share prices: “Another driver can be restructuring, whereby companies take self-help measures to deliver growth and/or a share price uplift irrespective of the general market environment. Restructuring stories such as cost cutting, improved returns to shareholders and business simplification can be powerful tools to create shareholder value.”

As ever, even when shares appear very cheap, it’s impossible to say with certainty that the market will start to value them more highly. Immediate attention will now be on Brexit and the trade wars. These and other issues could continue to prove disruptive for equity markets but such disruption may already be factored into prices.

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US small buyouts: Exploiting inefficiencies in the world’s most efficient economy

Schroder Adveq believes the 300,000 small family-owned businesses and corporate divisions dotting the US landscape present a compelling opportunity for investors, explains Ethan Vogelhut, Head of Buyout Investments, Americas, at Schroders.

Schroder Adveq believes that investing in US small buyouts can provide a compelling, high-returning complement to an investor’s large buyout exposures. However, there are a number of hurdles causing some investors to overlook this asset class.

The attractiveness of the US economy has made it one of the most efficient markets globally for private equity and has allowed the asset class to generate strong returns for decades. However, there are still areas of inefficiency to be found, particularly at the smaller end of the private equity market, which can be capitalised on to generate outsized returns.

Inefficiencies still exist

These inefficiencies are structural in nature and exist largely because of the sheer number, geographic dispersion and ownership structure of small US companies. Specifically, there are over 300,000 small family-owned businesses and corporate divisions dotting the US landscape. This vast market lacks the same intermediary coverage that large companies receive and presents transformational opportunities to skilled, operationally-oriented small buyout firms.

There is robust appetite from cash-rich strategic acquirers and larger private equity funds that are willing to pay high multiples for growing and successful businesses. A small buyout firm with a repeatable value creation strategy can help realise these rewarding exit opportunities and in doing so, help you generate attractive returns.

Obstacles to accessing smaller companies

Despite wanting to access US small buyouts, many investors face constraints preventing them from doing so. Some common limitations include:

  • The average investment size that institutional investors want to deploy is too large
  • The diligence and effort required to find, select and commit to multiple small funds is high
  • Inadequate coverage of over 1,000 small US buyout firms

It is a misconception that this segment of the market is therefore out of reach.

Find the right partner

The best way for investors to access these smaller companies is through a partner that is dedicated to US small buyouts. Such a partner will possess a replicable playbook for covering the sizeable landscape of small US buyout firms and have access to the best funds and transactions. Good market coverage requires rigorous organisation, active networking and the use of technology and databases to be effective; a dedicated partner will already have these capabilities in-house.

In constructing a small buyout portfolio, we advocate considering the following factors:

  • Life cycle diversification: Ensure your partner can offer you access to both repeat top performing managers, and high potential emerging managers so that you can diversify your portfolio by firm lifecycle
  • Investment type: To accelerate performance, consider a blend of transactional investments such as direct co-investments and secondary fund commitments, alongside the more traditional primary fund investing, the results of which can take time to develop.

US small buyouts allow investors to acquire companies in a highly inefficient market and, post transformation, reap the benefits of selling into the most efficient exit market in the world. Schroder Adveq believes that investors should capitalise on this opportunity in partnership with a trusted provider committed to constructing performance-oriented portfolios in this attractive investment segment.

Please find the full report as a PDF here.

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Eurozone growth fails to recover as Italy slips into recession

Leading indicators suggest further weakness to come, but European risk assets are already priced for recession, argues Azad Zangana, Senior European Economist and Strategist at Schroders.

The eurozone economy grew by just 0.2% in the final quarter of 2018 according to the flash GDP estimate released this morning. Fourth quarter growth was unchanged compared to the third quarter and matched consensus expectations. For the year of 2018, annual real GDP growth was 1.8%, down from 2.5% in 2017, and the lowest annual growth rate since 2014.

Only a handful of member states have reported their fourth quarter growth rates so far. Both France and Belgium reported sluggish growth of 0.3%, while Italy slipped into recession as the economy contracted by 0.2%, having seen a 0.1% fall in the previous quarter. The recession in Italy is undoubtedly linked to the huge economic uncertainty caused by the populist coalition government’s bickering with the European Commission over its fiscal policy. The negative news flow on the matter has diminished  which should help improve activity, but there are still concerns that we could see a repeat later in the year.

One member state that bucked the trend was Spain which is estimated to have grown by 0.7% compared to 0.6% in the previous quarter. This meant that annual growth was 2.5% in 2018, down from 3% in 2017 but still very respectable.

Looking ahead, leading indicators suggest eurozone activity has weakened further so far this year, prompting fears the monetary union may be in recession. We believe that much of the weakness in recent quarters has been caused by temporary factors, and will pass over the first half of 2019. This should allow the European Central Bank to raise interest rates as its guidance suggests, towards the end of this summer. Moreover, we believe that investors have already priced European risk assets – such as equities - for recession, making them potentially attractive if our forecasts are correct.

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30-year return forecasts: 2019 update

In our latest update of 30-year return forecasts we find that returns on cash are still poor while equities remain the asset class offering the greatest potential for returns, explains Craig Botham, Emerging Markets Economist at Schroders.

Our forecasts suggest that the long run real returns on cash remain poor, with negative returns still on offer in Japan. The US and some Asian markets do offer a positive return, but even risk averse investors might shy away from a maximum return of 0.6% per annum.

We would expect longer dated sovereign debt to outperform cash over thirty years, but returns in real terms are still likely to be disappointing, and Japan still fails to deliver a positive return. The current valuations of bonds considered "safe assets" are unattractive and suggest low returns.

Our forecasts would still suggest credit, property and equities will outperform sovereign bonds, as might be hoped. Equities remain the asset class offering the greatest potential for returns. UK small cap equities, followed by emerging markets and Pacific ex Japan, offer the highest returns.

Emerging market equities, however, are more prone to periods of crisis than their developed peers, and we would expect the more generous potential return to compensate greater volatility and sharper drawdowns. 

Our full analysis can be found as a PDF at the link below.

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Brexit deal defeat triggers huge uncertainty: what next?

Possibility of no deal Brexit is as high as ever, risking a UK recession this year, argue Azad Zangana, Senior European Economist and Strategist, and Remi Olu-Pitan, Multi-asset Fund Manager, both Schroders.

Azad Zangana, Senior European Economist & Strategist, says:

As had been widely expected, parliament has voted against the ratification of the UK’s Withdrawal Agreement with the European Union. Opposition to the agreement was overwhelming, with 432 members of parliament (MPs) voting against, versus 202 for. It is worth noting that 118 Conservative Party MPs voted against their own prime minister (PM), while only four opposition Labour Party members rebelled and backed the deal.

In reaction to the defeat, Prime Minister Theresa May offered parliamentary time to debate whether the government still enjoyed the support of the House of Commons. Labour Party leader Jeremy Corbyn promptly confirmed that his party has tabled a motion of no confidence to the house, and so the debate will commence today (Wednesday 16 January) followed by the vote of no confidence in the government at around 7pm this evening. Assuming MPs vote in line with their parties and the Democratic Unionists Party (DUP) of Northern Ireland backs its coalition partner (as it has suggested), then the government is highly likely to win the vote.

What next?

Assuming the government survives, Theresa May stated that the next step would be to consult cross-party MPs that opposed the deal, to see what changes would be necessary in order to secure their support. The government then plans to put those proposed changes to Brussels in the hope of augmenting the current Withdrawal Agreement.

In order for the EU to be willing to re-open the current agreement, the government must demonstrate that there is sufficient support for the proposed amendments to win a new vote in parliament. Given the multiple issues that parliament is divided on, it seems unlikely that the government can come up with a set of proposals that can change the minds of at least 116 MPs.

If the government persuades parliament to ratify the current or augmented agreement, then the UK will proceed to leave the EU on 29 March, and enter a transition period. During this period, the future relationship including trade, customs arrangements and regulatory alignment should be finalised.

UK recession likely if no deal is reached

In the absence of a deal being ratified, the UK will be leaving the EU without a transition period, and is likely to face significant trade tariffs in accordance with World Trade Organisation (WTO) rules, along with full customs checks, and a number of other important memberships/associations with EU institutions lapsing. Given the fragile state of the UK economy, we would then forecast a recession over 2019.

A delay to Brexit is possible. The UK could request a temporary delay (say three months), but this would require unanimous backing from the 27 EU member states. If the UK has not made progress in securing a majority for a deal, then the EU is unlikely to support a delay without a clear mechanism to break the deadlock in the UK’s parliament. This could come in the form of a second referendum or a general election. As European Parliamentary elections are due in May, the EU is keen not to have the UK’s membership spill over into the new term, unless the UK decides to remain permanently.

If the EU does not grant an extension to the Brexit deadline, then the UK could unilaterally revoke Article 50, only to restart the process again at a later point. This is unlikely and would certainly anger the EU and the public in the UK, especially as it would technically restarts the two-year negotiation process.

High chance of cliff-edge Brexit

In our view, the risk of a “no-deal” or “cliff-edge” Brexit is probably as high as it has ever been. At the same time, the need for a general election or a second referendum to break the deadlock in parliament seems more apparent than ever. Based on the last ten opinion polls of voting intentions, the Conservative Party looks set to retain its position as the single biggest minority party in a general election. However, the Conservatives are projected to lose seats and would therefore need both the DUP and the Liberal Democrats to form a coalition (assuming that both a coalition with Labour and the Scottish National Party is untenable). Moreover, it is worth remembering that opinion polls could shift during a campaign, and we doubt recent events will garner support for the government, even if Theresa May steps down and is replaced by another candidate.

The outlook if a second referendum is called is complicated by the many options possible for such a plebiscite. However, opinion polls that have offered three outcomes: “remain”, “deal” and “no deal” have consistently found that the support for Brexit is split between the latter two, leaving “remain” as the most supported option by a big margin.

Soft Brexit still seems unlikely

We believe that the possibility of a remain result following a second referendum and the prospect of a delay to Brexit have helped boost the pound in recent days against the US dollar and the euro. Markets seem to be pricing in a greater probability of a “soft Brexit”. However, we believe that investors are getting ahead of themselves.

The main uncertainty now is how the Labour party will react if they fail in their bid to trigger a general election. Will Corbyn work constructively with the government to end the deadlock, or will he continue to obstruct the process? The Labour Party’s six tests for Brexit focus on the future relationship, which are irrelevant at this stage of the negotiation. Though not the official position, many in the Labour Party including Shadow Brexit Secretary Keir Starmer and Deputy Leader Tom Watson believe that a second referendum should be the next option.

View from a fund manager

Remi Olu-Pitan, Multi-asset fund manager, says:

You would be forgiven for assuming that financial markets care little for Brexit and the UK political chaos this morning with Asian markets little changed and sterling recovering strongly from yesterday’s close.

This indicates that the defeat came as no surprise and the market expects that the motion of a no confidence vote will fail. The market has moved on to Plan B assigning a much lower probability to a "no deal" outcome. While the plethora of options will keep the pound and UK assets vulnerable to headline risk in both directions, the pound and UK assets are already reflecting a significant Brexit premium.

The immediate reaction by EU member states is critical, support for the PM and scope for concessions and a potential extension of A50 will be supportive for the pound and UK assets

Beyond the near-term volatility, the outlook for UK’s trade relations with the EU remains unclear, this will do nothing to alleviate the risk premium embedded in UK assets.

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Why we see income opportunities emerging in Asian corporate bonds

Market turbulence has produced attractive income opportunities in Asian corporate bonds against a still positive economic backdrop in the region, explains James Molony, Investment Writer at Schroders.

Noise around US-China trade tensions and the moderation of growth in China are among the factors that have caused broad declines in financial asset prices. Asia has come in for harsh treatment with declines in regional equity markets leaving them close to bear market territory, while a number of currencies in the region have been pummelled.

Asian US dollar (USD) denominated corporate bond markets too have felt the hit. This has resulted in one of the most enticing entry points to the market for several years. USD denominated bond yields have reached attractive levels both relative to other markets and particularly in the context of the overall credit quality of the region, both at a country and company level.

The ultra-low rates pervading markets over recent years have often pushed investors to take more risk in order to earn income. Asian USD denominated credit, however, potentially offers the opportunity to access good yield without taking on excessive risk. 

Additionally, the region displays broadly positive economic fundamentals. China’s ongoing growth moderation can often dominate headlines, but Asia as a whole remains one of the highest growth regions in the world, and most of the countries have solid, even enviable public finances.  

Positive valuations

Taking a simple look at valuations, Asian investment grade (IG) corporate bonds in aggregate offer better credit spreads than either US IG or euro IG. As at the end of the 31 December 2018, the spread (the difference between yields of two different bonds or bond markets of similar maturity) on the Asia IG Index was 183 basis points (bps), with duration of 4.8 years. This compared to a spread of 159bps and duration of 6.9 years for the US IG market.

Manu George, senior investment director, Asian fixed income, said: “Given that Asia and US dollar IG have the same average credit rating, these discrepancies in yield, spread and interest rate risk would appear to reflect a degree of mispricing in the market.”

Duration reflects a bond’s sensitivity to changes in interest rates or yields. The level of duration is effectively the percentage change, up or down, in the price of a bond per 1% move in the yield, with prices and yields moving inversely of one another.

Investors can earn greater yield on EM IG corporates, taken as a whole, but for with higher interest rate risk. The average rating on EM credit is below that of Asian credit. A lower rating reflects lower overall fundamental quality and implies a higher risk of default.

These price discrepancies are also pronounced in the high yield (HY) market where Asia yields over 10% (US dollar terms), a spread of 759bps, while US dollar HY, which has the same average credit rating, yields 7.9% for a spread of 533bps. By the same measures, Asian HY is also more attractively valued than EM HY, which yields 8.1%, with a spread of 546bps and 2.1 years duration, though with a similar composite credit rating.

Asian investment grade credit fundamentals continue to improve even through all the noise around the Sino-US trade war with leverage levels in a stronger place than US and euro credit. This should insulate the Asian high grade universe from future shocks and volatile macroeconomic conditions.

Another attractive aspect is the yield on offer on shorter-dated Asian bonds, underlining the relatively low-risk nature of the opportunity. Shorter-dated bonds are seen as lower risk as investing money for a shorter period of time gives the investor greater visibility over the prospect of being repaid and the probability of an unforeseen negative event is reduced.

Asia macro story remains solid

The average credit quality in the Asian bond universe is typically higher than the other EM regions – Asian countries are overall solidly IG-rated by most of the ratings agencies. This is largely because Asian governments have managed their finances in a more prudent fashion following the Asian financial crisis of 1998. As a rule, Asian countries have healthy foreign exchange reserves, policy-makers have tended to try and support economic growth historically and corporate and consumer default rates have tended to be lower than other EM regions.

Given all that, the IG ratings look justified. This means the ratings agencies see lower default risk than in other regions and investors are less likely to suffer capital loss versus investments in other regions which are all mostly non-IG.

Even with the impact of trade tariffs, the Asian region is expected to grow at a faster pace than the rest of the world. However, the growth rate is likely to be slower than 2016 and 2017. This can benefit bond markets as slower growth reduces the need for interest rates to rise, certainly compared to other parts of EM, so investors in Asian credit should remain relatively well insulated from capital losses resulting from market movements.

Risks: Moderating Chinese economy, trade wars, China real estate and default rates

The key headline risks for Asia are signs of slowdown in China and potential for an escalation of trade tensions between China and the US. October brought the news of a larger-than-expected moderation in Chinese GDP growth in the third quarter, to 6.5% from 6.7%. Given that this does not reflect the impact of trade tariffs, which were largely implemented in late-September, there are concerns of further slowing.

A key part of the story and another headline risk is the Chinese real estate sector, which is a substantial component of the Asian corporate bond market, particularly in high yield, and contains some of the most conspicuously low valuations.

With concerns over a slowing housing market and higher levels of debt amongst leveraged Chinese real estate companies, the Chinese authorities have been targeting a moderation in property prices, particularly in the residential market, since 2016.  These efforts seem to have had the effect the authorities wanted. The third quarter data showed a slowdown in mortgage lending, land sales and real estate investment and we are now seeing weaker real estate companies experiencing credit stress.

Overall, a moderate supportive policy response from the central bank seems quite likely, while a moderation in growth is less of a concern for bond investors.

“Default rates in Asia have increased slightly, from a low level, and remain below the global average,” said George. “We expect a moderate increase in 2019, but certainly not enough to justify the current valuation levels.”

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Why oil could bounce back in 2019

Following the recent oil price plunge, Mark Lacey, Head of Commodities at Schroders, looks at the outlook for oil supply and demand in the coming year.

The ~40% fall in crude oil and gasoline prices since September is the sharpest sell-off in more than a decade.

Chart of oil prices since 1999

Although we’d been relatively cautious about the crude complex in recent months, we did not expect prices to fall so far and so fast. However, we expect the supply response to lead to a very strong recovery in 2019.

In summary, our views on oil are:

  • We do not expect demand to collapse in 2019.
  • We think the IEA and OPEC estimates for demand are now too low for 2019. China and India oil demand could surprise on the upside.
  • We do not expect North America to flood the market with oil in 2019.
  • Crude oil inventories are not excessive – we expect them to rise over the next few months and then draw in Q2 and Q3.
  • Total oil and product inventories are normal for this time of the year.
  • Record low oil pricing at hubs in North America (Hardisty, Clearbrook and Midland) will lead to reduced volumes.
  • Iran volumes will still fall to 3.2 million barrels per day (mb/day) in 2019, even with the waivers being applied (which enable some nations to keep importing Iranian oil without running afoul of US sanctions).

What caused the recent sell-off?

As far as we can tell the reasons behind the sell-off are:

  1. Concerns over excess oil supply in 2019 (which we think are over-blown).
  2. Concerns over oil demand collapsing in 2019 (we think demand will soften in 2019, but will still grow at healthy rates).
  3. A concern that North America will flood the oil market in 2019 with too much supply (we think this risk has been greatly reduced by regional hub pricing discounts).
  4. The broader sell-off seen across asset classes.

What’s the outlook for global oil demand in 2019?

Despite what many investors think, oil demand is relatively resilient, even in the event of an economic slowdown. So, to put into context our forecast for 2019 oil demand, it is important to note that oil demand in 2018 will grow at roughly 1.45 mb/day. We are conservatively forecasting demand growth of closer to 1.25 mb/day in 2019. This growth comes almost entirely from non-OECD demand, with OECD demand expected to be roughly flat in 2019.

OPEC and the IEA (after the fall in oil prices) have started to downgrade demand assumptions for 2019, driven by concern for generally weaker global GDP growth. However, we have not yet seen demand weakness coming through in the reported numbers, with recent data showing record high Chinese refinery demand and a recovery in Indian oil demand to record high imports.

We do expect emerging market currency weakness to weigh on oil demand a bit, but this negative impact will be more muted now that oil prices are at lower levels.

We also think that OPEC and IEA are underestimating demand growth from China. Our view differs from theirs because we believe Chinese oil demand growth will be driven mainly by vehicle usage trends, as opposed to industrial activity or economic growth. Personal mobility (both in terms of domestic driving and international travel) continues to be something increasingly sought after, and this means the average Chinese person is starting to use more gasoline and kerosene.

You can find out more, including Schroder's views on supply (OPEC, non-OPEC and North American onshore), inventories, speculative positioning, and Schroder's oil price outlook here.

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Which stock markets look ‘cheap’ as we head into 2019?

As the dust settles on 2018 in turbulent fashion, Duncan Lamont, Head of Research and Analytics at Schroders, assesses how market valuations look as we head into 2019.

2018 was a rumbustious year for stock markets, with things really coming to the fore in the latter stages. With investors having grown accustomed to an unusual oasis of calm over recent years, volatility was back with a bang.

However, as the dust settles, there is a silver lining for stock market investors. Even before the fourth quarter downturn, markets had been cheapening in valuation terms. Improving fundamentals were behind this shift. Profit growth for 2018 is projected to be a hefty 24% for the US market, although this is partly down to the Trump administration’s tax reductions. UK and emerging markets are also both forecast to deliver double-digit earnings growth, while Europe is around mid-single digit levels. Japan is bringing up the rear with only 3% earnings growth, but it has seen its fair share of weather-related troubles this year.

If share prices end the year where they started, investors would be in a stronger position from a fundamental standpoint. In simple terms, they would now benefit from more earnings for each dollar that they have invested.

However, recent events have meant that share prices haven’t been flat, they’ve fallen sharply. That means that not only are earnings higher, but prices are lower. This double-whammy has pushed popular earnings-based measures of stock market valuations close to their cheapest levels for many years.

Relative to consensus earnings forecasts for the next 12 months, US, UK, European, Japanese and emerging market equities are valued at close to their cheapest levels for four to six years. There is a similar story when prices are compared to the previous 12 months’ earnings. Japanese equities have not been cheaper on this basis since the depths of the financial crisis.

Other valuation measures have also cheapened – cyclically-adjusted price earnings and price-to-book multiples have fallen and dividends yields risen – but not to the same extent.

The consequence of these moves is that, from a valuation perspective stock markets are now a much more appealing prospect than before. Whereas, as we entered 2018 our valuation table was a sea of (expensive) red, it is now a field of (cheap) green. With the exception of the US, all other markets are now outright cheap on most valuation measures. Even the US is less expensive than it was. (All of the valuations measures are explained below).

While there are undoubtedly short-term challenges facing markets, not least geopolitics, tightening monetary policy and slowing global growth, investing when valuations are cheap is a sound long term strategy. Valuations are the single biggest determinant of long term returns, although their uselessness at predicting short term market movements should always be borne in mind.

Read more: Why 2019 might be a better year for investors

Stock market valuationsPast Performance is not a guide to future performance and may not be repeated.

The pros and cons of stock market valuation measures

When considering stock market valuations, there are many different measures that investors can turn to. Each tells a different story. They all have their benefits and shortcomings so a rounded approach which takes into account their often-conflicting messages is the most likely to bear fruit.

Forward P/E

A common valuation measure is the forward price-to-earnings multiple or forward P/E. We divide a stock market’s value or price by the earnings per share of all the companies over the next 12 months. A low number represents better value.

An obvious drawback of this measure is that it is based on forecasts and no one knows what companies will earn in future. Analysts try to estimate this but frequently get it wrong, largely overestimating and making shares seem cheaper than they really are.

Trailing P/E

This is perhaps an even more common measure. It works similarly to forward P/E but takes the past 12 months’ earnings instead. In contrast to the forward P/E this involves no forecasting. However, the past 12 months may also give a misleading picture.


The cyclically-adjusted price to earnings multiple is another key indicator followed by market watchers, and increasingly so in recent years. It is commonly known as CAPE for short or the Shiller P/E, in deference to the academic who first popularised it, Professor Robert Shiller.

This attempts to overcome the sensitivity that the trailing P/E has to the last 12 month’s earnings by instead comparing the price with average earnings over the past 10 years, with those profits adjusted for inflation. This smooths out short-term fluctuations in earnings.

When the Shiller P/E is high, subsequent long term returns are typically poor. One drawback is that it is a dreadful predictor of turning points in markets. The US has been expensively valued on this basis for many years but that has not been any hindrance to it becoming ever more expensive.


The price-to-book multiple compares the price with the book value or net asset value of the stock market. A high value means a company is expensive relative to the value of assets expressed in its accounts. This could be because higher growth is expected in future.

A low value suggests that the market is valuing it at little more (or possibly even less, if the number is below one) than its accounting value. This link with the underlying asset value of the business is one reason why this approach has been popular with investors most focused on valuation, known as value investors.

However, for technology companies or companies in the services sector, which have little in the way of physical assets, it is largely meaningless. Also, differences in accounting standards can lead to significant variations around the world.

Dividend yield

The dividend yield, the income paid to investors as a percentage of the price, has been a useful tool to predict future returns. A low yield has been associated with poorer future returns.

However, while this measure still has some use, it has come unstuck over recent decades.

One reason is that “share buybacks” have become an increasingly popular means for companies to return cash to shareholders, as opposed to paying dividends (buying back shares helps push up the share price).

This trend has been most obvious in the US but has also been seen elsewhere. In addition, it fails to account for the large number of high-growth companies that either pay no dividend or a low dividend, instead preferring to re-invest surplus cash in the business to finance future growth.

A few general rules

Investors should beware the temptation to simply compare a valuation metric for one region with that of another. Differences in accounting standards and the makeup of different stock markets mean that some always trade on more expensive valuations than others.

For example, technology stocks are more expensive than some other sectors because of their relatively high growth prospects. A market with sizeable exposure to the technology sector, such as the US, will therefore trade on a more expensive valuation than somewhere like Europe. When assessing value across markets, we need to set a level playing field to overcome this issue.

One way to do this is to assess if each market is more expensive or cheaper than it has been historically.

We have done this in the table above for the valuation metrics set out above, however this information is not to be relied upon and should not be taken as a recommendation to buy/and or sell If you are unsure as to your investments speak to a financial adviser.

Finally, investors should always be mindful that past performance and historic market patterns are not a reliable guide to the future and that your money is at risk, as is this case with any investment.

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Portfolio construction in today's great unknown environment

Over the last few years, investors have benefited from a desirable mix of high returns, low volatility and low correlations. Volatility and correlations are set to rise given a maturing economic cycle, a tightening of global financial conditions and an increased risk of protectionism, believe Remi Olu-Pitan, Multi-asset Fund Manager, and Clement Yong, Multi-asset Analyst, both Schroders.

This combination of factors – some of which form our Inescapable investment truths for the decade ahead – will likely see financial market volatility no longer suppressed and a possible end to low/negative correlations. Against this backdrop, we believe returns are going to be much harder to achieve and will require investors to take on more risk in order to achieve them.

Our framework puts forward several approaches that investors may find useful in navigating this environment. For investors that have the capacity and time horizon to embrace higher risk, we suggest considering:

  • Increasing allocation to laggards such as emerging markets (EM)
    EM can offer a higher premium than developed markets but are generally more volatile and may require a long-term view
  • Increasing allocation to active managers
    This can allow investors to tap into alpha potential, although alpha is not guaranteed and can vary over time
  • Adding leverage
    Leverage can help enhance returns as it magnifies portfolio positions but can lead to excess risk taking

Some investors will be unwilling or unable to take on higher risk. In these cases we propose narrowing the range of potential outcomes and smoothing the path of returns by:

  • Allocating to private assets
    Private assets can be genuine diversifiers given they are less correlated to traditional asset classes. However, they require significant resources and a long-term horizon
  • Adopting a minimum volatility equity strategy
    This strategy involves investing in low volatility stocks. However, it is predicated on one measure of outperformance (volatility) and ignores fundamental variables such as valuations, quality and interest rate sensitivity
  • Using a multi-asset strategy
    Multi-asset strategies which are truly flexible in their approach and balance the trade-off between returns and the range of outcomes well can generate alpha. Strategies that solely target a low to zero correlation to equities are likely to sacrifice returns. One therefore has to be discerning when assessing multi-asset strategies. 

The best sailors are ones that can spot a storm from afar and are also able to navigate their ships accordingly to avoid the worst of the tempest. We believe that this is no different for investors, and it is imperative to accept the uncertain future and begin preparations on how to navigate through it.

Please click on the link to download the full report as a PDF.

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The underperformance of value: a tale of unintended consequences

Our research shows that, given the poor performance of many value-orientated funds, investors would do well to choose their value factor carefully, argue Ashley Lester, Head of Multi-Asset Research, and Steven Sellers, Quantitative Analyst, both Schroders.

Many value investors have struggled over the decade since the financial crisis, and their underperformance has in many cases been even more apparent over recent months.

Taking the performance of the MSCI All Country World Index (ACWI) Value as representative, we apply our proprietary factor attribution methodology to decompose the active returns of the index into underlying factor and signal drivers.

Two key features have driven the underperformance of MSCI ACWI Value, and by extension other value strategies.

Bigger negative impact from momentum and quality

First, as with most single factor approaches, actual performance is not only due to positive exposure to the desired factor, but also by negative and generally uncontrolled exposures to other factors.

In this case, ACWI Value is not just a value strategy; it is also an anti-momentum and anti-quality strategy.

When we broke down the index into five major style factors we found that the value factor accounted for only 0.2% points of annualised underperformance between January 2010 and August 2018. The bigger impact came from momentum and particularly quality. Together, these accounted for around 85% of underperformance over the period.

Greater exposure to underperforming measures of value

Second, as with most factors, there are large performance differences between different measures of “value”. ACWI Value embodies the most widely used measures of value (book-to-price and dividend yield). Unfortunately, and perhaps not coincidentally, these have performed the worst of any of our value measures over the past decade.

The family of signals focused on cashflow measures (operating cashflow yield, free cashflow yield, earnings yield, and buyback yield) have all performed better than the traditional measures and are the measures to which the index is least exposed.

There are at least two possible forces that may have driven the relative performance of these metrics. First, returns to the widely-used value signals may have been arbitraged away over time. Second, in a world in which manufacturing companies are less dominant than in the past, it is possible that a measure such as book-to-price fails to convey meaningful information about expected future cashflows.

We conclude that investors would do well to choose their value factor carefully and to control their exposure to extraneous factors. Investors are likely to make the most of factor investing by forming integrated portfolios of non-commoditised factors.

Please click on the link to download the full report as a PDF.

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The convergence question

by Nicholas Field, Global Emerging Market Equity Strategist at Schroders.

The idea of convergence is a powerful one for many emerging markets investors. But what is it? Why should it happen? What does history tell us about it?

Convergence theory implies that if a poorer country receives access to technology from richer economies, there will be a gap between its old and new production capabilities. This enables higher levels of investment and hence growth.

Convergence: the facts

Emerging countries have a very patchy record of achieving convergence.

  • Latin America: By and large the region has made little progress. The periods of strong uptrends we’ve seen have largely been the consequence of business cycles.
  • Asia: Latin America stands in stark contrast to Asia, where – for example – Korea and Taiwan have converged significantly. In the early 1960s South Korea’s per capita GDP was only about 3% of that in the US. It now stands at 50%. More recently, China - after years of going backwards – has moved from under 2% of relative per capita GDP in the early 1990s to 15% today.
  • Emerging Europe, Middle East and Africa (EMEA): Again, there is not much sign of convergence among the main countries in this region.

It’s clear that countries do not naturally converge. Most emerging markets have made little progress towards US levels of GDP per capita. But there are two noticeable exceptions – South Korea and China. What is it about the economic model in these countries that has allowed convergence?

We can examine the theme through the example of the biggest convergence story of them all in the 1960s and 70s – Japan – and a country that hasn’t converged – Brazil.

  • Japan: In 1960 Japanese people were only about a fifth as rich as their US counterparts, on average. At the height of the Japanese bubble in 1989 they were at parity and at the height of the yen spike in 1995, they were one-and-a-half times richer.
  • Brazil: Not much progress towards convergence and a long history of underinvestment

Convergence: what Japan and Brazil show us

The contrasting fortunes of Japan and Brazil show us that governance and political structures matter. Also hidden in the history is a story of initial conditions. By definition, a less developed country lacks a capital base. To converge you must have a source of capital. Developing that capital internally is a slow process of steadily building up a consumer society in a cycle of investment, leading to a bigger wage base, leading to consumption and more savings, leading back to more investment.

To experience the sort of rapid growth that Japan (and Germany) saw after World War 2 and to secure the political structures, a large capital injection is very helpful. Japan got one via the Korean War and Europe benefited from the Marshall plan. Brazil had no such help.

What does this mean for investors?

Fortunately, emerging markets investing is about so much more than convergence. However, it can help us understand the backdrop and long-term trends that enable us to identify attractive companies.

In a rapidly-changing geopolitical, economic and demographic landscape, more and more world-beating companies are likely to spring up in the emerging world.

Navigating this complex opportunity set is not easy, but the rewards can be extremely attractive if investors are prepared to take a flexible approach to both country allocation and stock selection.

Schroders looks at these topics in greater detail in their full research paper, which is available here.

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Late-cycle investing: Are investors in for a Dickens of a time?

It is the best of times for the US economy, but for investors in high yield bonds and stocks it could become the worst of times, argues Neil Sutherland, Portfolio Manager on the US Multi-Sector Fixed Income Team at Schroders.

“It was the best of times; it was the worst of times…” Charles Dickens’ famous opening sentence from his 19th century novel A Tale of Two Cities neatly encapsulates the current situation in financial markets.

The US economy is booming, unemployment is the lowest since the moon landing and Federal Reserve (Fed) Chair Jerome Powell recently citing a “remarkably positive outlook.” For the US economy, it is the best of times.

The opportunity, value and tailwinds in various fixed income assets, on the other hand, are as challenged today as they have been for a number of years. For those looking to find attractive gains from equities or high yield corporate bonds, it is the worst of times.

Strong economy doesn’t mean strong markets

GDP growth of 4%-plus, full employment and rising bond yields – this would suggest allocating more to risk assets. We think caution is warranted. The easy conditions of suppressed volatility, low term premium (difference between short and long-dated bond yields), yield chasing, and relentless stock buybacks is looking more challenged.

The peak for risk assets often occurs when economic data is strongest. US high yield corporate bond valuations, for instance, have tended to peak with US manufacturing activity (see chart, lower spread equates to higher valuation). It is well to remember that strong earnings and economic data can be better at showing where we have been than where we are going. In 2007 Lehman Brothers’ profits were $4.2 billion on revenues of $19 billion.

High yield corporate bonds peak with PMI

Chart showing HY valuations versus US ISM manufacturing

Since the Global Financial Crisis, financial assets have enjoyed strong returns, partly due to a low starting point, but also an unusually favourable combination of ultra-accommodative monetary policy, low inflation, low yields and zero returns on cash. Each of these is reversing.

Low-risk investments provide a viable alternative to riskier assets once more, with US two-year yields at nearly 3%. The reduction of central bank balance sheets also looks especially pertinent, balance sheet expansion having been a key support to returns for stocks and high yield corporate bonds (see chart).

Central bank largesse has fuelled stellar stock markets

Chart shows G4 central bank balance sheet expansion versus S&P 500

Peak profitability – pendulum swinging back from capital to labour

Building wage inflation is another that things are shifting. Subdued inflation and wages made ultra-accommodative monetary policy possible. It also helped stock markets. Corporate profits have taken up a disproportionate amount of GDP – labour’s share of GDP is close to 60-year lows, but the pendulum may be swinging back (see chart).

Corporate and employee share of profits have diverged from historic norms

Chart showing share of GDP going to capital versus labour

The Atlanta Fed median wage growth tracker is approaching its highest level since the financial crisis, with capacity constraints observable across various industries. Skilled truck drivers can currently command salaries of $100,000 amid an estimated shortage in drivers of 50,000. Amazon recently raised its minimum wage to $15.

A sub-5% US unemployment rate has tended to precede deteriorating returns on the S&P 500. We could start to see rising wages squeeze company margins and earnings.

When will the economic cycle end?

We don’t know, nor does the Fed, who recently admitted as much. Predicting this has proved beyond the powers of most economists; the Fed chair at the time did not spot either of the last two recessions coming.

Inverting yield curves (longer-dated bond yields falling below shorter-dated) and a trough in the unemployment rate are the most reliable indicators, according to the St Louis Federal Reserve, leading a recession by nine and 10 months respectively on average. Today, US unemployment is at a near 50-year low and the difference between two and 10-year US Treasury yields is almost zero.

The current economic expansion is 112 months-long, the second longest since 1854 when recordkeeping began, and eight months shy of the record. It won’t die of old age, but it seems reasonable to ask just how long it can last.

Unemployment troughs, inverted yield curves tend to precede recessions

Chart shows inverted yield curve and trough in unemployment preceding recession

Signs of excess 

Structural problems persist. Notably excessive debt, arguably the main cause of the 2008 financial crisis. Ten years on, global debt is $237 trillion, up from $166 trillion (see chart). Chinese debt is 460% higher. The investment grade corporate bond market has more than doubled in size while credit quality has fallen.

Global debt levels (USD trillions) - still a problem

Chart showing global debt levels in trillions of USD

US pro-cyclical fiscal policy has brought the feel-good factor, but the federal deficit is up 17% over the last year. A rising deficit and falling unemployment in tandem is unusual. The last time the deficit was at these levels, unemployment was 7.5%, yet the market seems unconcerned.

Its is no coincidence that debt-heavy beneficiaries of central bank largesse, corporate bonds and emerging markets, have become more volatile. Additionally, the market will likely have to absorb higher volumes of US Treasuries.

Lower-risk assets to find favour

The US economy remains robust and imminent recession risks appear muted. Riskier financial assets may offer further scope for careful security selection, but face increasing challenges. Tailwinds are fading and/or reversing, valuations offer little margin for error and structural vulnerabilities are abundant.

Increasing volatility and a shifting regime will tend to result in different opportunities emerging. In the US, municipal bonds, short maturity bonds and securitised debt are starting to look attractive. In a broad sense, there now seems much more scope for achieving reasonable returns from a low-risk investment grade portfolio.

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How emerging markets have changed over the past 20 years

Andrew Rymer, Schroders, reviews the evolution of the MSCI Emerging Markets Index and considers the emerging countries to watch for the future.

The transformation of emerging markets has been remarkable. The countries and companies that dominated 20 years ago have changed dramatically, influenced by the major geopolitical, economic and demographic changes that have taken place over this time.

Navigating these changes can be complex, but these developments underline the importance of taking a flexible, active approach and investing in the most attractive opportunities.

Emerging markets (EM) encapsulate a broad range of countries across different geographies. In simple terms, these are generally perceived to be a group of countries with strong potential economic growth and in turn stronger investment returns, albeit subject to greater political, legal, counterparty and operational risk. This is typically underpinned by an expanding middle class and rising wealth, as well as positive demographics and savings trends.

When it comes to investing, major index providers consider a range of factors when determining their definition of an EM. In addition to economic metrics such as GDP per capita, significant emphasis is also placed on market access.

This point is often underappreciated but it is important as it captures investors’ ability to put their money to work, as well as the ease of divesting in the future. The MSCI Emerging Markets is one of the most followed global EM indices.

The relevance of emerging markets continues to rise

As the chart below illustrates, the relevance of emerging markets shares to investors has increased significantly over the past 20 years. The share of EM companies as a percentage of the widely followed MSCI All Country World Index has increased from around 4% in 1998 to 11% today. It should of course be noted that this data immediately follows the Russian financial crisis in August 1998 and the Asian financial crisis in 1997, which had depressed EM asset values somewhat. Nonetheless, the share had previously peaked at just over 8% and in the most recent decade has been as high as almost 14%.

Historical trends are not indicative of future trends.

Breaking down the MSCI Emerging Markets Index

We have focused on the widely followed MSCI Emerging Markets Index. However, a good active manager will often look beyond the companies in this index to identify opportunities. Nonetheless, the index provides a good gauge of the opportunity set.

As at the end of September 2018 the index comprises 24 emerging markets countries. China is the dominant index country, with a weight - its share of the overall index - of almost 31%. Other Asian EM, South Korea and Taiwan are also significant with a weight of close to 15% and 12% respectively.

At the other end of the scale, Pakistan, which was reclassified from frontier markets in 2017, is the smallest index market with a weight of less than 0.1%. Frontier markets are typically less mature than EM on a range of metrics, including market size, liquidity (the ease of buying and selling stocks), foreign investor access and economic development. The precise definition varies by index provider. Egypt and the Czech Republic also have a small weight in the MSCI Emerging Markets Index, at 0.1% and 0.2% each. 

Viewed from a sector perspective, financials and IT are clearly the dominant sectors with respective weights of 23.2% and 26.9%. By contrast, utilities, real estate and health care are the smallest index sectors with a share of 2.4%, 2.8% and 3.0% respectively.  

Index country changes over time

Within EM in particular, a review of index country changes can be illustrative in tracking the evolution of EM over the past 20 years. The chart below provides a snapshot of index country weights at three points in time, the end of September 1998, 2008 and 2018.

Unsurprisingly, the most striking feature is the colossal rise of China from a weight of just 0.8% in 1998 to 31% today. The main driver of this transformation is the addition of Chinese companies to the index; China has performed broadly in line with the MSCI Emerging Markets Index over the past 20 years. This was initially through greater inclusion of Hong Kong-listed companies. Some US-listed Chinese companies were added to the MSCI Emerging Markets Index in 2014. But mainland Chinese companies, known as China-A Shares, were not officially considered for inclusion until 2014. This is one of the largest stock markets in the world and includes over three thousand companies.

The main barrier to inclusion was China’s cautious approach in permitting foreign investors to buy these stocks. Regulation rendered market accessibility unequal and also limited capital mobility. Over time, however, the authorities sought to liberalise and address investor concerns. This included the implementation of the China Stock Connect, which links the Hong Kong Stock Exchange with the mainland Shanghai Stock Exchange. In 2017, MSCI announced the partial inclusion of China-A Shares, which took place earlier this year.  It is likely that more of these stocks are included over time.

South Korea has also seen its weight in the index rise markedly, from 5.5% in 1998 to 9.4% today. In part due to the rise of China, markets such as Mexico, Brazil and South Africa have seen their significance in the index moderate.

Meanwhile Russia, which had a weight of 0.9% in 1998, in the wake of the Russian financial crisis, saw its share rise to 8.4% in 2008, only to fall to 3.7% in 2018. These fluctuations reflect an initial recovery in the economy, crude oil price movements and later, the rise in geopolitical tensions, with the US and European Union implementing sanctions on the country. 

Another notable change was in 2014 when the Middle Eastern markets of the UAE and Qatar were included in the MSCI Emerging Markets Index.

Other countries meanwhile have exited the index altogether. Venezuela, for example, was removed from the index in 2006 and Sri Lanka (which was later added to the MSCI Frontier Markets Index) was removed in 2001. The case of Venezuela highlights the importance of market access in determining EM status. Foreign exchange restrictions, introduced by the government, together with low levels of liquidity were significant obstacles for foreign investors, and were the main triggers for the country’s removal. Jordan, Argentina and Morocco were reclassified to the MSCI Frontier Markets in 2008, 2009 and 2013 respectively.  

Conversely, Israel was reclassified to developed market status in 2010, moving into the MSCI World Index. Greece also entered the MSCI World, following an upgrade in 2001. It was subsequently taken back to emerging markets status in 2013, post the government-debt crisis. 

Index sector changes over time

From a sector standpoint there have also been significant shifts, as indicated in the below chart. 

Most notable is the major increase in the share of the IT sector, which accounted for around 5% of the index in 1998 but is now close to 27%. The emergence and expansion of the internet and subsequently smartphones were major drivers of this shift. It also correlates with the rise in the significance of Asian markets. Over this period, Asia became dominant as a manufacturing hub for technology companies. Meanwhile there was a marked rise home-grown internet and gaming companies, particularly in China but also in South Korea. 

The sectors which have seen a clear reduction in their index weight are telecommunications services and materials, down from 15.8% and 16.4% respectively in 1998 to 4.5% and 7.9% today. In 1998 telecoms offered investors exposure to domestic growth in many EM, but today there are better alternatives with more attractive fundamentals.

Financials meanwhile has maintained a steady weight; it accounted for 21.0% in 1998 and is now 23.2%. Real estate was added as a sector for the first time in 2016. These companies were previously categorised under the financials sector. 

The data for 2008 also shows a pick up in the energy sector. Together with materials, these resource sectors accounted for almost 32% of the index. This was up from below 23% in 1998 and just 16.1% today. 

Top 10 stocks through time

Reviewing the top 10 stocks at the same snapshots in time shows the regional shift that was evident at a country level, with seven out of the top 10 in 1998 all based in Latin America. By contrast, the top 10 stocks today are all effectively in Asia. Naspers, a South African listed stock has a material share holding in Tencent, which accounts for the majority of the value in the stock.

There is also a clear shift in terms of sector representation, in line with the trend discussed above. In 1998, telecoms and utilities stocks had a significant weight. Today there is only one telecoms stock in the top 10.

Interestingly, the top 10 stocks now represent a significantly higher proportion of the index. In 1998 they accounted for 16.7% of the index. This had increased to 21.3% in 2008 and today sits at 24%. The level of concentration has therefore increased. This is despite the total number of stocks actually having increased, rising from 958 in 1998 to 1151 today. 

Where next?

A major driver of revision to EM indices is not typically a dramatic change in an economic indicator such as GDP per capita. It is the removal of restrictions which limit market access. Over the past 20 years, China has been the most significant example of such change, as highlighted earlier. 

Among the scheduled changes to the index are the inclusion of Saudi Arabia and the re-entry of Argentina in May 2019. Saudi Arabia is not currently in MSCI’s emerging or frontier indices. But since 2015, when the country permitted the direct foreign ownership of stocks, Saudi Arabia has undertaken reforms aimed at improving accessibility. Argentina will be reclassified to emerging markets, having been moved to the MSCI Frontier Markets in 2009 following the implementation of capital controls. These have now been removed.  

Meanwhile, Kuwait has been added to the list for review, with a decision expected in May 2019 and inclusion unlikely before 2020. Looking further ahead, there is potential for China’s share of the index to rise further. The liberalisation of the market over the past decade has led to improved access for investors. There are not only further A shares which could be consolidated, in addition to a range of other Chinese companies, such as non-government owned companies which are incorporated outside of China, listed in Hong Kong; often referred to as P-Chips.   

There is the prospect that other markets from the MSCI Frontier Index could be upgraded. Vietnam is an example, although a number of impediments to such a move remain. These include limits on foreign ownership of stocks.

Equally, it may be that in time certain markets are upgraded to developed markets status. Index provider FTSE already classifies South Korea as a developed market for example. This is because is puts greater weight on South Korea’s economic strength. MSCI, by contrast, views technical issues, such as restrictions on currency trading, as hurdles to developed market status. FTSE has recently upgraded Poland to developed market status.

Structural changes in the way people communicate, access media and shop have posed questions over sector categorisation. E-commerce companies for example are currently classified under IT. In light of this, the telecommunication services sector will be renamed as communications services from 3 December. As part of this change, media companies will be re-categorised from consumer discretionary to communication services while internet service companies will move from IT to communication services. Lastly, e-commerce companies switch from IT to consumer discretionary.   

The growth story remains important for investors

There are a number of different factors behind changes in the MSCI Emerging Markets Index. We have highlighted some of these but concede that much time could be spent looking at more detailed changes. What is clear, however, is the dynamism of EM equities, and the structural growth story which these stocks offer. EM equities can have a more important role than ever in helping investors meet their goals.

These changes also draw attention to the fact that active management in emerging markets is vital, as we have highlighted previously. The index is unlikely to remain static and is an element to consider when investing in EM. Those investors with the capability to take off-index or off-benchmark positions can take advantage of these developments. Furthermore, EM equities remain inefficient, providing an opportunity for active investors to exploit. The higher concentration of the index in the top ten stocks also means that simple passive investment does not provide sufficient weight to many attractive investment opportunities.

The value of investments and the income from them may go down as well as up and investors may not get back the amounts originally invested.

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US midterm elections: Is gridlock good?

The US midterms have, as expected, seen the Democrats take the House with the Republicans holding the Senate. Schroders investment experts Keith Wade, Frank Thormann and Frederick Schaefer consider the implications for fiscal policy, trade, and the 2020 presidential election.

Further tax cuts unlikely but will Trump strike a deal on trade?

Keith Wade, Chief Economist & Strategist at Schroders, says:

“The midterm elections restored some faith in opinion polls with the Democrats taking the House of Representatives and the Republicans holding the Senate. Conventional wisdom has it that a gridlocked Congress is good for markets as it prevents politicians from interfering in the economy. However, US markets have received a considerable boost from the president’s tax cuts and deregulation measures.

“Going forward, gridlock means less fiscal support for the economy as Democrats are unlikely to back further tax cuts. This could create a problem for US growth in 2020 when the existing package fades and is not replaced by further measures. It is possible that the president and the Democrats could strike a deal on infrastructure spending, but they may hesitate to take measures that could help get Trump re-elected as president.

“Faced with a potential block on fiscal policy, the president may turn to trade policy and look to strike a deal with China and so prevent a further damaging escalation in the trade war. From an economic perspective, that would be the logical step. However, Trump will have to weigh up whether the economic costs outweigh the political benefits of playing to his base support – many of whom see tariffs as an essential part of putting America first.”

Future policy will require bipartisan support

Frank Thormann, Portfolio Manager, Multi Regional Equity, at Schroders says:

“Two important implications from this election will be stronger presidential oversight and increased political gridlock. Democrats now have a much larger ability to put a check on the president’s power and have promised to intensify investigations into allegations such as the Russian 2016 election interference.

“Because both houses are required to pass legislation, future policy will require much greater bipartisan support, which is a dramatic change from the past two years and is likely to materially alter the remainder of the Trump presidency. One immediate impact of this is a lower likelihood of further monetary stimulus.”

Larger Republican Senate majority is significant

Frederick Schaefer, Head of Equities Management, US Small Cap Product Managers, at Schroders says:

“In a rebuke rather than a rejection of the president, US voters have elected a divided Congress. The Democrats gained control of the House of Representatives after eight years as the minority party.

“In the House, a number of Republican moderates lost or chose not to stand for re-election. This means the Republican House caucus will become more conservative and more Trump-like. The new House Democratic majority will be more challenging to the president on a number of issues. Consider the possibility of a House committee issuing a subpoena for him to release his tax returns.

“On the Republican side, the larger Senate majority is a significant accomplishment. Additionally, Republican gubernatorial candidates fared well, winning races in key states such as Ohio and Florida. As we approach the 2020 elections, these two states are significant prizes in presidential elections.

“In an interview on the eve of the election, Mr Trump conceded that maybe he should have toned down his rhetoric during his first two years. Perhaps this may presage a less bellicose president and less contentious Washington. But don’t count on it.”

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Brazil backs Bolsanaro: what next?

Despite his controversial reputation, Jair Bolsanaro’s victory in the Brazilian election has been greeted with investor optimism. But the real test is yet to come – particularly regarding the crucial topic of pension reform, argue Craig Botham, Emerging Markets Economist, and Pablo Riveroll, Head of Latin American equities, both Schroders.

The will and ability to reform

Financial markets, at least, had been rooting for a defeat of the left-wing candidate Fernando Haddad, successor to former president Lula, on the basis of the very different economic policies espoused by the two candidates. Superficially, this seems odd given that Bolsonaro has repeatedly voted against reform and spoken out against privatisation - he once said former president Fernando Henrique Cardoso should be shot for privatising iron ore miner Vale. However, in his presidential run this is one stance he did moderate, appointing pro-market Paulo Guedes as his economic advisor and now minister. Haddad, meanwhile, remained staunchly anti-reform, anti-privatisation and in favour of more spending.

However, we still have some concerns around Bolsonaro's Damascene conversion to the cause of free markets. Guedes is not the only adviser he has, and others on his team oppose the ultra-liberal stance Guedes takes, particularly on privatisation. Meanwhile, other key figures, including his likely chief of staff and one of his four senators, seem strongly opposed to desperately needed pension reform. 

On top of these internal divisions, Bolsonaro must also contend with a fragmented legislature. This is a cause for concern, given Bolsonaro's limited ability as a political operator; he will need to draw allies with skill in negotiating the legislative process.

The need to reform

Brazil's largest single economic problem at present is its fiscal position. Government debt-to-GDP is remarkably high by emerging markets (EM) standards at 84%, and is set to climb further thanks to sizeable deficits (7.8% of GDP in 2017, including interest payments) with the International Monetary Fund projecting gross debt to hit 95.6% in 2023.

Brazil's debt problem is projected to deteriorate 

Source: IMF, Thomson Datastream, Schroders Economics Group. 24 October 2018

The lion's share of Brazil's budget expenditure is taken up by social security benefits, particularly pensions; a problem which grew notably under Dilma's government. As has been highlighted in The Economist and elsewhere, Brazilian expenditure on pensions is as high as that seen in Europe, despite wildly different incomes and demographics. Pension reform is therefore key to addressing Brazil's dire fiscal outlook. In its recent Article IV consultation, the IMF argued that to stabilise pension spending as a share of GDP, reform would need to increase retirement ages, de-link the minimum pension from the minimum wage, and reduce the generosity of public sector pensions in particular (80% of pension payments currently go to the public sector).

Government spending is large and hard to cut

Source: Thomson Datastream, Schroders Economics Group. 24 October 2018

It would also be helpful to reduce payroll expenditure, simplify the tax code (particularly by reducing exemptions) and tackle the broader problem of mandatory expenditures. Pension reform though is key as being symbolic of intent, as well as the largest single ticket item of expenditure.

Market and macro implications

Bolsonaro's apparent embrace of economic liberalism has been key in changing attitudes from investors. Business confidence in particular has rebounded from its lows this year, which should be positive for investment, while Brazilian assets have seen a resurgence of interest, in part because they offer a rare good news story in a torrid year for EM.

Bolsonaro bolsters Brazilian sentiment

Source: Thomson Datastream, Schroders Economics Group. 25 October 2018

It seems likely that this initial optimism could extend to euphoria for a while. Assuming no unforced errors on the part of Bolsonaro, the first reality check for investors is likely to come in the second quarter of 2019, when a post-Carnival legislature comes to the practicalities of passing tough bills (legislative recess will begin on 22 December and end only on the 4 February, one month before Carnival). Until that point, markets should feed largely on the signals sent by the incoming president. Signs that Guedes is being side-lined (or that the corruption investigation could remove him) or that Bolsonaro is finding it harder than expected to build an allied legislative base, could knock the rally off course. On the other side, should Bolsonaro manage to attract experienced political names, this would further raise the perceived odds of passing tough reforms, given his own limited legislative experience (he has co-authored only two pieces of legislation in a near 30-year long career).

On the macroeconomic side, the sheer relief at having avoided a leftist government should see a lot of deferred investments finally break ground. Currency strength after a period of weakness will also help calm nerves on inflation and the direction of interest rates. We would expect economic growth to begin accelerating, which should also have the effect of boosting Bolsonaro's political capital at a crucial moment.

For now though the Brazilian story seems a good one. We will keep an eye on Bolsonaro for signs of wavering policy intent, or even a preference for prioritising social legislation over fiscal issues. Should he fail to deliver, a sharp unwind seems likely, with particular pain in the fixed income space given the extremely challenging fiscal outlook.

The fund manager view

Pablo Riveroll, Head of Latin American Equities:

“Pension reform and ongoing fiscal discipline is deemed to be critical to medium-term fiscal sustainability in Brazil. The performance of Brazilian assets is likely to depend on the extent to which the Bolsanaro administration delivers appropriate policy measures. Should the government fail to pursue sufficiently conventional economic policies, it is likely that the bond and currency market reaction would pressure the government to consider a more orthodox policy framework. As a result, we have conviction that fiscal sustainability will be addressed in the medium term.

“From an investment perspective, we have a cautiously positive view on Brazilian equities. The market is trading at attractive valuations, with a forward price-to-earnings ratio of around 10x, which is a discount to wider emerging markets and to its history, with above average earnings growth. We believe that pension reform is likely to be approved by the new government. The market may be vulnerable if it does not commit to presenting and passing pension reform at the beginning of its administration. We aim to take advantage of market volatility to add to high quality Brazilian companies at discounted valuations if our base case scenario plays out.”

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Adding return and lowering risk with private assets

Duncan Lamont, Head of Research and Analytics at Schroders, discusses the potential benefits of investing in private assets.

Private assets have been popular with endowments and official institutions, such as sovereign wealth funds and government pension plans, for some time.

However, many  of these investors are looking to expand into new areas and other institutional investors are increasingly drawn to this space, attracted by the potentially for higher returns, lower risk and diversification benefits.

Our survey of 650 global institutional investors found that average allocations to private assets are expected to increase above 13% in 2018, with growth across all major investor types and regions.

As well as the strategic attractions of private assets, our paper on “Adding return and lowering risk with private assets” also addresses current market conditions.

Our in-depth research covers the main categories of private equity and debt, real estate equity and debt, and infrastructure equity and debt, contrasting their characteristics with traditional equity and bond investments.

As well as the return side we also deal with the thorny issue of risk and whether traditional concepts like volatility really have much meaning when it comes to private assets. Our hope is that this paper should serve as a useful companion for both novice and more experienced investors.

Read the full report: Adding return and lowering risk with private assets

Read the summary: Adding return and lowering risk with private assets

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Politics and portfolios: how investors are adapting to a new normal

by Philip Haddon, Head of Investment Communications at Schroders.

Politics is moving markets like never before. So how are fund managers adjusting?

Recently investors have grown accustomed to political issues such as trade wars and Brexit moving markets. But it has not always been this way.

“Fund managers never used to have to think about politics when investing,” said Charles Prideaux, Head of Product and Solutions at Schroders. “That’s changed. We’re seeing political disruption affecting markets and that’s not going away.”

This was a major theme on the agenda at the recent Schroders Investment Conference in Venice, where a panel of fund managers talked about how an active approach can help navigate markets fraught with political risks.

Global equities – Big business is alert to the hostile rhetoric

The panel found that the rise of populism and its consequences are forcing firms to change the way they act.

“Big business is very alert to the fact it is facing increasingly hostile political and media rhetoric. This is raising regulatory risks and the risk of damaging headlines across a range of sectors from big tech to autos,” said global equities fund manager Katherine Davidson.

“It’s creating an environment where companies need to be more aware of being good corporate citizens and of managing their businesses in the interests of a wider group of stakeholders. This may seem at odds with the interests of shareholders in the short-term, but in the longer-term should be mutually reinforcing; a 'corporate karma' that’s beneficial.”

Politics is making this focus on the longer-term essential, Davidson thinks.

“The more volatile the short term becomes, the more important it is to be a long-term shareholder. It becomes challenging or even futile to try to forecast quarterly earnings given the amount of noise, so you need to find companies that can ride out the storm.

“Hence, we’re spending more time thinking about the resilience and durability of business models and companies’ ability to adapt, survive and thrive in a changing environment. We look for management teams who understand this; who are open to disruption and innovation and are appropriately incentivised to think about the long-term.”

China A-shares – Political assistance can see economy emerge stronger

The Chinese market has arguably always been highly driven by domestic politics, given the amount of state control in the economy and the significant presence of state-owned enterprises in the stock market.

Now, amid the escalating trade war with the US, foreign politicians are also having an effect in the country. Indeed, the China A-share market is one of the worst performers within emerging markets this year (down 21% year-to-date as at 3 October), due in large part to the trade dispute with the US.

“We are definitely trying to avoid companies which have a large potential impact from trade with the US,” said Jack Lee, Head of China A-Share Research. “Surprisingly, there aren’t that many companies with a large US export exposure, and past experiences in previous trade conflicts have shown that many such companies would eventually shift production overseas to avoid tariffs.”

“It’s the indirect impact that is harder to calculate and avoid. The loss of business and jobs and the resulting cost escalation that leads to businesses closing would all feed into the economic slowdown and into various parts of the economy.”

Lee thinks that a lot of bad news has already been priced into the China A-share market and that, with some political assistance, the economy can emerge stronger from the current malaise.

“We could expect profound structural reforms coming out from the government to weather this down-cycle,” Lee said.

“After all, China is a large, diverse economy with a huge domestic consumption base and a productive workforce. We are confident that many good companies will continue to prosper over time. Currently, everything has come down in price so it’s an interesting time to pick up companies that we believe have been oversold”.

Please be aware changes in China's political, legal, economic or tax policies could cause losses.

Multi-asset – Fundamentals, not politics

Multi-asset fund manager Alastair Baker predicts that an active and global approach will be beneficial, because there will be “greater dispersion across the performance of companies and countries as they adapt to the breakdown of globalisation.”

It’s best to focus on fundamentals, not politics, Baker believes.

“We would never buy any asset based on a view on politics; we have no edge and can’t predict the electorate,” he said. “But we do analyse the potential range of outcomes. We factor in what we believe to be priced into assets and buy cheap hedges to mitigate against the bad outcomes. Typically we want to invest in areas robust or cheap enough to weather political gyrations. Valuations and fundamentals continue to be our anchor in turbulent waters.”

Baker said that political disruptions have not derailed global growth just yet, although he has been reducing his risk exposure.

“The music is still playing for global growth momentum. We’re dancing closer to the exit, but we’re still dancing.”

The value of investments and the income from them may go down as well as up and investors may not get back the amounts originally invested.

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Further insights covering our capabilities in the areas discussed in this article can be found here: SustainabilityEmerging MarketsMulti-Asset Solutions and Alpha Equity.

Can European equities play catch-up in Q4?

Returns from European equities have lagged the US so far in 2018. But we see signs this could change as we head towards year-end, claims Rory Bateman, Head of UK & European Equities at Schroders.

European equity market returns have been disappointing so far this year and below our expectations. As we enter the fourth quarter, in euro terms the MSCI Europe index is around flat year-to-date on a total return basis (including dividends) versus the US which is up just over 10% in dollars.

Our forecast at the beginning of the year was for the European market to appreciate broadly in-line with earnings growth and, so far, this hasn’t happened.

Trade war fears have weighed on European shares

Part of the reason is that earnings growth has actually been downgraded through the course of the year, from around 10% to the current 5-6%.

Downward revisions to earnings is a familiar theme but this downgrade doesn’t fully explain the modest de-rating we’ve seen in the market which, in our view, is more to do with political factors including the Trump trade war as well as politics in Italy and the emerging markets. 

Our view from here is that while fears of a global trade war have modestly impacted global growth expectations, the US is in good shape and the eurozone consumer continues to push European economic growth. 10-year Treasuries are above 3%, indicating decent activity along with rising inflation expectations. In Europe, the services element of the purchasing managers’ index (PMI) surveys continues to be robust.

Chart of eurozone leading indicators and US treasury yield

It is fair to say that manufacturing PMIs are a little weaker, driven by emerging market demand as international trade digests and absorbs the tariff changes. Our feeling is that sentiment around Trump’s policies is reasonably well priced in, and the momentum within the European economy should be sufficient to drive earnings and market appreciation through the end of the year.

Improved performance from cyclical and value stocks 

We have seen some evidence of this in the last few weeks as cyclicals and value stocks within Europe have begun to perform better. This has closed some of the performance gap between the US and Europe and we expect this to continue.

Our view on a probable continued European equity market recovery is based on the extreme divergence between US and European earnings per share (EPS) growth, driven by the estimated $1 trillion corporate share buyback programme across the pond. These EPS differentials have been driven predominantly by Trump tax cuts and the buybacks which are ultimately responsible for the significant escalation in US corporate debt.

Chart showing US share buybacks

In addition, and perhaps not surprisingly, we have seen dollar strength, some of which has been funded by significant European selling. Estimates of mutual fund redemptions so far this year have totalled EUR 22 billion (source: Morningstar) given superior US earnings growth, concerns around international trade and the usual European political skittishness.

The main uncertainty between now and year-end is of course Brexit “deal” or “no deal”. The outcome is very difficult to call, but at the margin we expect a deal of some sort and a positive UK market reaction. Sentiment for European markets will be impacted by the decision either way but will be relatively short-lived given the economic impact for the overall European economy is minimal.

In summary, we are encouraged by the recent rotation in the market favouring more cyclical value stocks and moving away from expensive defensives.

The overall market valuation remains attractive with the cyclically-adjusted price-to-earnings ratio (CAPE) trading 20% below historical averages. The massive performance differential versus the US has recently begun to close and we expect this to continue.

Markets remain susceptible to volatile periods and we would suggest investors be opportunistic and take advantage of this volatility to buy assets that become mispriced.

Chart of global regional valuations

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Markets react negatively to Italy’s planned fiscal overshoot

The planned fiscal expansion is far smaller than initially feared, suggesting an over-reaction in markets, argues Azad Zangana, Senior European Economist and Strategist at Schroders.

The Italian 2019 budget target was unveiled on 27 September 2018, with the government defying the proposal of Giovanni Tria, Italy's Minister of Economy and Finance. Tria had recommended a deficit of 1.6% of GDP, which would have largely satisfied the European Commission, however, the target has been set at 2.4% of GDP, with additional funds being prepared for pre-election promises.

Italy is now on a collision course with the European Commission, which will assess all member states' budget plans from 15 October. It is very likely that the Commission will instruct Italy to lower its target, although it has little power to force Italy to comply. The Italian government will point to France, which plans to overshoot its previous 2019 target. The European Commission will probably manage to persuade the Italian government to lower its target slightly, but France's behaviour is not helping matters.

Italian equities and bonds slump in reaction to fiscal overshoot

The initial reaction in markets to the news has been negative. The Italian FTSE MIB equity index fell by almost 4% the following morning, with Italian banks suffering the most, as they are large holders of Italian government debt.

The yield spread between the 10-year Italian government bond (BTP) and German 10-year bond rose by around 30 basis points. However, the spread remains well below the peak seen over the summer, when uncertainty over the 2019 budget and rumours over the possible sacking of the more moderate finance minister helped push the spread to highs not seen since 2012.

This period of fear followed the formation of Italy's populist coalition government. The coalition members, the League and Five Star Movement parties, joined forces by agreeing a fiscal programme that, if fully implemented, would likely expand Italy's budget deficit by around 5% of GDP (to around 6.6%) over a two to three-year period. Policies that have been promised include scrapping a planned hike in VAT, the introduction of a flat income tax, a tax amnesty, a minimum citizens' income and an unwind of pension reforms.

Looking ahead, the small expansion of policy (0.8% of GDP) announced in the 2019 budget is by no means a disaster, as with growth and inflation taken into account, Italy should see debt fall as a share of GDP next year. The European Commission will protest over the fiscal slippage in the coming months, but markets are likely to be relieved that the government has only partially followed through with its manifesto promises. Full implementation of those promises could have led to a far higher rise in bond yields, and a quick deterioration in public finances.

Market reaction overdone

In the near term, we expect most investors to warm back up to Italy. Despite all the bluster, the government only plans to loosen fiscal policy slightly, and within the tolerance of markets. Moreover, the yield on offer in Italy will be difficult to ignore, especially when European investors have few places remaining to generate a decent income. We expect the spread between Italian and German bonds to narrow in the coming months, and for the news flow to become more neutral.

A sense of calm is likely to return; however, the elephant is still in the room. Italy's government has not suddenly become a coalition of liberal fiscal conservatives. The political pantomime will probably repeat itself this time next year when setting the 2020 budget. Meanwhile, Italy will remain vulnerable to any hit to growth, be it cyclical or a shock.

In the long term, we are still concerned over the sustainability of Italy's public finances. Poor demographics, a lack of investment and weak productivity growth are likely to cause the economy to stagnate for decades to come. Debt will probably become an issue, and with Italy stuck in a monetary union, Italy lacks the ability to devalue its currency or to manipulate its bonds yields.

Long term concerns will remain, but in the near term, the market appears to have over-reacted.

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What's on investors' minds, in eight polls

by Philip Haddon, Head of Investment Communications at Schroders.

Voting at the Schroders Investment Conference in Venice last week revealed the views of 100 leading fund selectors from around the world on issues such as market risks, sustainability and interest rates.

Trade wars trump other risks

One of the key themes of the event was the huge impact that economic and disruptive forces are set to have on investors in the coming years. Both investment returns and economic growth are predicted to be lower, while political uncertainty remains high and technological advances are set to change the face of many industries.

We asked the gathered audience of global fund selectors in Venice on 20-21 September which issues currently concern them most from an investment viewpoint.

Right now the most pressing concern for 35% of those delegates polled is the impact of the ongoing trade wars between the US and China. This is followed by the end of quantitative easing (24%), political risk (20%) and the prospect of a sustained low growth environment.

Where next for central banks?

Moving to monetary policy, the audience was asked about what lies ahead for interest rates in the US. 55% of the audience predicted four more rate rises from the Federal Reserve (Fed). This is in line with Schroders’ team of economists who expect two more US rate hikes this year and two next year. (The poll was taken prior to the rate hike this week, when the Fed raised interest rates by 25 basis points.)

28% of delegates predicted there would only be two more, however, while 17.5% of those polled thought there would be six or more yet to come.

Looking at Europe, the delegates were asked to predict the identity of the next president of the European Central Bank after incumbent Mario Draghi retires at the end of October 2019.

From the shortlist, the most popular selection (33%) was the current head of the Bundesbank, Jens Weidmann. Second in the polling (and the tip of Schroders’ Chief Economist Keith Wade) was Erkki Liikanen, the former head of the Finnish central bank. Francois Villeroy de Galhau (Head of Banque de France) and Christine Lagarde (Head of the IMF) received 19% and 16% of the votes respectively.

Sussing out sustainability

Sustainable investing is an ever-more prominent theme among investors. Rather than a niche pursuit, it is becoming the new normal.

Indeed, polling showed that 49% of investors in Venice already invest sustainably, with a further 26% considering doing so. However, a third of those polled do not currently invest sustainably and are not considering it yet.

Having a positive impact is not enough; as ever, performance is key for professional investors tasked with getting the best possible returns for their clients.

Indeed, the main reason (cited by 32% of the audience) stopping them from upping their investments in sustainable products is the concern that they may not deliver as good a return as non-sustainable products.

Greater clarity from fund managers on their approach is needed, as 32% of delegates said they are not investing more because of the lack of information on how sustainable fund managers are engaging with the companies they invest in. 

Meanwhile, 23% said they were not investing more in sustainable products because of the limited number available.

Digging a little deeper into company engagement, we asked the audience which areas they think are most important. Climate change came out on top (33%), followed by “pollution from operations” (21%), treatment of workers (18%) and ending bribery & corruption (18%).

You can find out more about Sustainability at Schroders here.

Leaning towards liquid

It’s not just sustainable investing that is moving up investors’ agendas. Liquid alternatives are also an increasingly important part of professional investors’ portfolios. These products are often hedge fund-type strategies which perform differently to traditional investments and aim to provide investors with diversification and downside protection.

Currently, allocations to such strategies among the investors polled in Venice are low. For 71% of attendees, they make up less than 10% of their total portfolios.

However, this is set to change as 57% expect their allocation to increase in the next 12 months.

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Trade wars step up, more to come

As the trade wars escalate we see no sign of agreement between the US and China. Keith Wade, Chief Economist & Strategist at Schroders, assesses the macro impact.

The US has announced tariffs on another $200 billion of imports from China, citing ongoing concerns over the theft of technology and forced transfer of intellectual property. The tariffs take effect next week and are initially set at 10% rising to 25% from 1 January next year. China has yet to respond, but the White House has warned that any retaliation will lead to tariffs on a further $267 billion of additional imports. China may bide its time, but we expect they will follow with tariffs on a further $60 billion of imports from the US.

For some time our assumption has been that we will eventually see tariffs on all the goods traded between China and the US. The red lines on each side are too ideological and entrenched to allow much room for manoeuvre. China sees its trade policies as an essential part of the growth strategy that will allow the economy to hurdle the middle-income trap, in line with its “Made in China 2025” policy. Meanwhile, President Trump came to power promising to put “America first” and he has assembled a team that believes China is a root cause of the decline in parts of the US economy.

Against such a backdrop, we have the makings of a chronic dispute that will go well beyond the mid-term elections in November. Whilst China has less scope to match the scale of goods covered by US tariffs it has plenty of opportunity to apply non-tariff barriers, apply restrictions and make life difficult for US companies operating in China. Those interested need only look at the experience of South Korean companies in the wake of the anti-missile system dispute.

In terms of macro impact, the latest tariffs will slow Chinese export growth to the US. The extent of the impact will depend on the price sensitivity of the goods involved and whether alternative sources of supply can be found. Movements in the exchange rate can also offset tariffs, although we do not expect China to devalue the renminbi in response. Model simulations suggest China’s export growth will be 2-5% weaker. Global growth would also be weaker as international trade slows. However, these effects will take time to come through and in the near term we may actually see a boost to China’s exports as US companies accelerate imports ahead of further tariffs. This will complicate interpretation of the impact and no doubt frustrate the Trump administration’s desire for a smaller bi-lateral deficit. Ultimately though, the effect will be stagflationary, as tariffs slow trade and uncertainty drags on capital investment, whilst the extra cost of imports adds to inflation.

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Have bonds lost their bite?

As markets evolve, Clement Yong, Multi-Asset Analyst at Schroders, explores whether bonds are still able to provide protection in turbulent conditions.

Traditionally, investors have relied on bonds to give them shelter when equity markets dip. But anyone switching from shares into bonds in February’s brief market turmoil would have gained only limited protection. Most types of bond followed equities down during those turbulent days. So have bonds lost their ability to protect portfolios against market squalls? We think not, but investors relying on bonds as an anchor in stormy markets need to be aware of changes in the conditions affecting their behaviour.

Our first chart shows the after-effects of February’s squall. (Bond prices fall as yields rise so we’ve turned our charts upside down to help readers see the direction of capital values as yields change.) The group of bars on the left show that, although short-dated bonds – those due to repay relatively quickly – provided some sanctuary in February, anything with repayment dates beyond two years lost money. And things have got worse since then. The other two groups of bars show that even the shorter end of the bond market has given up its gains, while longer-dated bonds have fallen further.

In technical terms, the yield “curve”, the difference in yield between short, medium and long bonds, has “flattened” – yields over all time periods have tended to equalise. The question for investors is whether all this is just a blip or whether bonds, particularly those in the short and medium part of the spectrum, have lost their effectiveness as a shield in difficult markets?

History can provide some help here. Despite the unsettling experience of February, it is worth remembering that bonds have been an excellent hedge against most of the major equity sell-offs over the past three decades or so, as our chart below shows.

Of course, the last 30 years may not be the best pointer to the future. In the next chart, we have looked back over more than half a century to 1964 to see the shift in the US 10-year yield during weeks when the S&P 500 equity index fell by more than 3%. From this we can calculate that US Treasury bonds, seen by many as one of the safest investments an investor can make, helped to protect against large weekly moves in equities more than 70% of the time.

However, it is also clear that Treasuries were much more reliable protectors in the more recent part of that period. If we cast our eye back to before the 1990s, we can see that longer maturity bonds were often not such a good hedge, only protecting against equity sell-offs 40% of the time. The February sell-off, when the yield on US 10-year Treasury bonds rose by 0.13%, therefore looks more typical of the earlier period. Does this mean then that bond investors should brace themselves for a return to conditions more like the pre-1990s period?

To answer this question it may be helpful to remember the very different economic conditions prevailing before 1990. The 1960s and even more the 1970s were marked by rapidly rising inflation, brought on by soaring oil prices. This runaway inflation was only reined in during the 1980s with rising interest rates and tight control of the money supply. From then on rates fell steadily, spurring the long bull market for bonds which is only now coming to an end as rates start to rise again. Could it be, therefore, that the bond market’s February upheaval is a symptom of a shift in economic conditions which could take the relationship between equities and bonds back 50 years? We looked at some current economic variables to see if they could provide pointers.


The prospects for inflation are a key influence on both equities and bonds through their effect on interest rates. Central banks often use higher rates to combat the causes of inflation, like rising wages or currency weakness leading to higher prices for imports. Until recently inflation (as measured by, for example, the US Consumer Price Index) has been stable at around the 2% level. Lately, however, inflation has been on the rise again and there are fears that pressures are building that will push it higher still. Forces like the retreat of globalisation, political populism and instability in the Middle East are undermining the certainty that once prevailed. Against this cloudier backdrop, bonds seemed like less of a safe haven to investors in February – indeed inflation fears were said to be one of the triggers for the sell-off.

Economic shocks

Financial history is littered with shocks that have had a profound effect on asset prices. The source of major shocks is often either inflation taking off unexpectedly (as in the 1970s) or growth taking a surprise turn down (as in the financial crisis of 2007-2009). Inflation shocks are bad for both equities and bonds, as we have discussed, whereas growth shocks usually hit equities and boost bonds as investors seek less risky assets. The relative stability of inflation has meant that, in general, shocks have been driven more by uncertainty about growth than inflation. The recent sharp increase in trade tensions between the US and China has increased concerns over the impact on global growth, reflected in wobbles in equity markets. However, as we have discussed, inflation fears have also picked up, which is bad news for bonds, at least in the short term. The fallout from current economic shocks could therefore fall on both asset classes, undermining the safe haven status of bonds.

Monetary policy

Central banks’ mass purchasing of bonds through quantitative easing (QE) programmes has artificially depressed bond yields and therefore kept prices high, while also supporting equity prices at levels above where they might otherwise have been. The side effects have included an increased tendency for equity and bond prices to move in opposite directions.

However, in the last few years, quantitative easing has gradually been turning into “quantitative tightening” as central banks slow, stop or even reverse their bond buying programmes. At the same time, interest rates are starting to rise again for the first time since the crisis of 2007-2009. This gradual return to something like “normal” monetary policy is turning what were two tailwinds for bonds into headwinds. This change in climate may also spur a change in the relationship between bonds and equities.

Supply and demand

When seeking a safe haven from market turbulence, US Treasury bonds are often a first port of call, particularly for foreign investors, notably the Chinese. Foreign purchases of Treasuries have indeed risen significantly over time. This increased demand may have had the same effect as QE in exacerbating the negative correlation between equity prices and bond prices. While it is unclear whether foreign holdings will fall significantly in the future, investors need to be aware that this may also have an effect on bond prices.

What next for bonds?

It is unlikely that we will see another 30-year bond rally like the one we enjoyed after 1990. The economic weather has definitely turned chillier. With higher inflation and tighter monetary policy on the horizon, it would not be a surprise to see the relationship between bonds and equities undergoing a change.

With that said, we don’t believe any of these conditions will be fast-moving and, while there are parallels with the pre-1990s period, they are not exact. Most importantly, many of the forces that have suppressed inflation over nearly a generation remain influential. These include the increasing importance of technology in business and commerce, the prevalence of global supply chains and the weak bargaining power of labour. Clearly, some of these forces are under attack, most notably global trade, and the outcome is hard to predict, but we do not expect to see the world reverting to the conditions of the 1960s and 1970s. Moreover, while the price of oil has risen in recent years, there has been nothing like the quadrupling seen in 1973. The future has a tendency to upend forecasts, but at this stage we cannot see any kind of economic shock ahead on the scale of those experienced in the 1970s.

We suspect, therefore, that while the defensive qualities of bonds may start to be chipped away, this process may take some time. Bonds should still provide stability for investors caught up in market upheavals. They may be less reliable than they were, but bonds are likely to retain much of their bite in times of need. That said, those of shorter maturity may start playing a bigger role than those at the longer-end of the maturity spectrum. These longer bonds are more likely to be hit by any worries about growth and inflation, particularly given that lower yields in longer bonds may not price in all the risks.

What this means for investors is that they must continuously evaluate each asset’s role in a portfolio and not take any for granted. And, more than ever, diversification is likely to be a particularly close friend in these uncertain times.

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Ten events that matter to investors in the final quarter of 2018

by Andrew Rymer, Investment Writer at Schroders.

As many northern hemisphere investors get their feet back under their desks after the summer break, we look at the key events and themes likely to be on the agenda for September and the fourth quarter of 2018.

1) Global trade negotiations

The US and China held fresh, and largely fruitless, trade talks in August. The economics team here at Schroders believes that the dispute is likely to be prolonged, and persist beyond the US midterm elections in November.

The US implemented tariffs on $50 billion of Chinese imports in two stages in July and August, and China responded with duties of equal measure.

The US Trade Representative, whose role includes managing US trade relations and negotiating with other countries, recently concluded its hearings on a proposed $200 billion of Chinese goods on which it could apply 25% tariffs. This paves the way for further tit-for-tat tariffs, with Beijing having announced a list of $60 billion in US goods that it would target in retaliation.

There is a limit in the extent to which China could implement reciprocal or retaliatory tariffs, however. This is because China imports less from the US than vice versa. One alternative strategy for Beijing could be to implement non-tariff barriers for US companies which operate in the country. This is an approach which it has previously used against Korean and Japanese companies.

2) Brexit talks

The UK government published in July its long-awaited white paper, outlining plans for exiting the European Union (EU). Since then it has started to outline the measures that it is taking to prepare for the possibility of a “no deal” Brexit. The House of Commons returned from its summer recess on 4 September and soon the political party conference season gets underway, running from 15 September to 3 October.

EU leaders meanwhile are scheduled to meet to discuss Brexit on 20 September. The formal EU summit on 17-18 October is seen as the deadline for a withdrawal agreement. This is to allow sufficient time for both the UK and European parliaments to approve it. Should a deal not be reached in October, the EU has indicated that November is the latest month in which a deal could be agreed. However, another EU summit is timetabled for 13-14 December which on paper would appear to be the final chance for a deal to be agreed. Much uncertainty therefore remains over the timing and nature of any final agreement, or indeed whether an agreement will be reached at all.

View from a fund manager - Alex Breese, UK Equities:

“Despite the uncertainties created by Brexit, quantitative tightening and fears of a trade war, at the sector and stock level we continue to identify pockets of value within the UK market. We continue to focus on these lowly-valued areas in the market where we feel there is potential for positive change in the years ahead.”

3) Federal Reserve policy

The US Federal Reserve’s (Fed) interest rate setting committee, known as the Federal Open Market Committee, is scheduled to convene on 25/26 September, 31 October, 7/8 November and 18/19 December. Current expectations are for a 25 basis points (i.e. 0.25%) increase in policy rates at each of its September and December meetings. However, the focus is shifting to 2019 and at what level the Fed decides to pause.   

Beyond the two additional rate rises expected this year, Schroders’ economics team anticipates that the Fed will increase US interest rates on two more occasions in the first half of 2019, peaking at a level of 3%. This is because it believes the effects of previous interest rate rises are lagged and, combined with a fading of President Trump’s increased spending measures, may slow the economy.

The economist’s view – Keith Wade, Chief Economist and Strategist:

“The Fed is already indicating that it is thinking about how much further interest rates need to rise. Once the peak is in sight markets could shift significantly as the period of dollar strength will draw to a close.

“In this respect it is possible that the Fed will have finished raising rates before the European Central Bank and Bank of Japan have even started.”

4) Japan’s LDP to hold leadership election – 20 September

Prime Minister Abe has recently confirmed that he will stand in his Liberal Democratic Party’s leadership election in September. Should Mr Abe be re-elected leader, it would be his third straight term, making him Japan’s longest serving prime minister. He is expected to comfortably defeat his only challenger, former defence minister Shigeru Ishiba.        

View from a fund manager – Andrew Rose, Japanese Equities:

“After weathering financial scandals earlier this year, Prime Minister Abe now seems to have a reasonably clear path to the LDP leadership election. With a renewed period of policy stability likely after the election, attention will soon focus on the next increase in the consumption tax, scheduled for October 2019. The final decision is likely to be taken around the end of 2018, allowing time for the necessary system updates.

“Despite short-term variations, Japan’s economy still appears to be heading out of a deflationary environment. Wages are showing some signs of responding to the tightness of the labour market and there have been marginal increases in inflation expectations. Although the most recent quarterly results season was good rather than spectacular, the prospect remains for a better revisions cycle in the second half of the fiscal year.”

5) Italian budget announcement – draft likely by end September (talks with EU in October)

Italy’s new government is expected to put forward its budget proposals in the coming months. A small stimulus appears to be the most likely outcome. Should bolder spending plans be included, this would likely trigger a dispute with the EU. This is because its budgetary policy requires member states to avoid excessive government deficits, defined as a deficit in excess of 3%. This is a situation where total government expenditure exceeds total receipts, excluding borrowing.   

6) Brazil general elections – 7 October

It has been a busy few years in Brazilian politics, following the impeachment of second term president Dilma Rousseff in 2016. Former vice-president Michel Temer took the reins but despite some initial success in driving through reforms, these have stalled amid allegations of corruption. President Temer’s approval ratings are in the single digits and he will not run for the office. 

The latest opinion polls reflect much uncertainty, in part due to the fact that the most popular candidate, former president Luiz Inácio Lula da Silva of the Workers’ Party, is prohibited from standing due to his imprisonment for fraud and corruption. Despite being registered as a candidate, he has recently been barred from running by the country’s highest electoral court. Opinion polls without Lula, as he is widely known, show a lead for right-wing candidate Jair Bolsonaro. The highest-polling market-friendly candidate is Geraldo Alckmin of the Brazilian Social Democracy Party. He lags by some margin in the latest surveys, but is expected to benefit from a higher allotment of TV and radio time as the campaigns get underway. 

A two round system is used to elect a president, unless a single candidate receives more than 50% share of the vote in the first round. A second round would take place on 28 October.

7) US second stage sanctions on Iran take effect – 4 November

Following President Trump’s decision to withdraw the US from the 2015 Joint Co-operative Plan of Action (JCPOA) back in May, the US is re-imposing sanctions on Iran in two stages. The first round took effect on 6 August and included measures which prohibit the purchase or acquisition of US dollar banknotes by Iran’s government, as well as trading in commodities such as gold, steel and coal.

The sanctions that the US plans to impose from 4 November include the prohibition of petroleum-related transactions with the National Oil Company among others. Sanctions will also be re-imposed on the port operation and the shipping sector. These measures apply to associated services and businesses engaging with related industries. While many other factors remain uncertain, not least wider geopolitical developments, the impact of these measures would suggest some support to crude oil prices.

8) US midterm elections – 6 November

In November, voters across the US get their first opportunity to show their opinion on President Trump’s administration since his election in 2016. Midterm elections see all of the 435 House of Representatives seats and 34 of the 100 Senate seats come up for election. The president’s Republican Party currently hold a majority in both houses of government but these elections have historically been negative for the ruling president’s party. Nonetheless, the task ahead for the Democrats is not easy, especially in the Senate.

In the House of Representatives, the Democrats would need to gain 24 seats to gain control. In the Senate however, 26 of the 34 seats up for election are currently held by the Democratic Party, suggesting that it may be easier for the Republican Party to maintain control.

9) European Central Bank policy

The European Central Bank’s rate setting committee, the Governing Council, is scheduled to meet on 13 September, 25 October and 13 December. It has previously announced plans to wind down its quantitative easing programme by the end of December. It has also provided guidance for interest rates to remain on hold until the third quarter of 2019, unless there is a major change in economic conditions.

10) Bank of Japan policy

Japan’s central bank will hold interest rate policy meetings on 18/19 September, 30/31 October and 19/20 December. Owing to lower-than-expected inflation, it recently made small tweaks to its policy, contrary to previous speculation that it could effectively tighten policy (i.e. remove some of its stimulus measures). It also stated that the current low rate policy would be maintained for “an extended period of time”, meaning no change to policy is currently expected in the next few months.

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What it takes to be promoted to emerging market status

Sean Markowicz, Strategist at Schroders, highlights the disconnect between an index provider’s definition of emerging markets and what investors think they are getting.

The index provider MSCI recently announced that both Argentina and Saudi Arabia will be promoted to its emerging markets index next year. Although their index weights will be small, this is expected to generate billions of dollars worth of fund inflows into these countries based on the US$1.9 trillion in assets benchmarked to the MSCI Emerging Markets Index1.

The distinction between an emerging market and an emerging economy

Many investors dedicate an allocation of their portfolio to emerging markets to capture their growth potential. You may have heard the rationale many times - young populations with faster-growing economies may deliver strong investment returns, albeit with the potential of more ups and downs along the way. But investors should be careful not to confuse the term emerging market with the term emerging economy.

For example, many countries which feature in MSCI’s emerging and even frontier (the stage below emerging) market indices are advanced in economic terms – see image below. Korea and Taiwan are obvious examples. On some measures (for instance, GDP per capita, a measure of living standards), Taiwan is even more developed than countries such as Canada, the UK, France and Japan2. In addition, the companies within these markets can also be among the global leaders in their fields, such as Samsung Electronics and Taiwan Semiconductor, yet be classified as emerging market companies. 

* Argentina and Saudi Arabia will be promoted to the MSCI EM Index in June 2019.
** The West African Economic and Monetary Union (WAEMU) consists of the following countries: Benin, Burkina Faso, Ivory Coast, Guinea-Bissau, Mali, Niger, Senegal and Togo. Currently the MSCI WAEMU Indices include securities classified in Senegal, Ivory Coast and Burkina Faso.
Source: IMF, MSCI and Schroders. Data as at 30 June 2018. 

This occurs not because MSCI applies especially draconian rules about a country’s stage of economic development. The opposite, in fact. Over half of the 57 countries that make up MSCI’s Emerging and Frontier Markets Index already exceed its minimum economic standards to be included in its developed market indices.

What index inclusion really boils down to…

The reality is that index inclusion boils down to market size, liquidity and accessibility rather than economic status or prospects. In contrast, the IMF ranks countries based on purely economic criteria such as export diversification and the degree of integration into the global financial system. This often under appreciated distinction can have some nuanced effects on index composition, such as those highlighted above.

Among other things, accessibility conditions cover perfectly sensible considerations such as whether there are any restrictions on foreign ownership and the ease at which investors can get their money into and out of a market. It also captures certain operational matters such as the ability to ‘short sell’ a stock (sell a stock that you don’t own, in the hope that you can earn a profit by buying it back at a lower price in future) and the level of sophistication of the regulatory framework governing the financial market.

Most frontier and emerging markets fall down on one or several of these conditions. For instance, one reason Korea and Taiwan are classified as emerging, rather than developed markets, is because their foreign exchange markets are not fully liberalised.

For emerging markets index inclusion, a stock market must have at least three stocks which meet minimum size and liquidity thresholds. For frontier market status, two stocks must meet a more lenient version of these thresholds. But these hurdles often mean that only a handful of companies make it into the index upon the country being promoted – hardly a fair representation of the country’s stock market, let alone the underlying economy.

For instance, the number of constituents in the MSCI Argentina Index is projected to decline from 14 today to 11 when it is promoted from the MSCI Frontier Index to the MSCI Emerging Markets index3. One consequence is that its free float-adjusted market capitalisation would be almost US$2 billion lower as an emerging market than as a frontier market. In a back-to-front logic, promotion will result in MSCI Argentina being a smaller part of MSCI’s global markets indices, not a larger one. Active managers, however, might still choose to invest in stocks listed in Argentina, but not in the MSCI Argentina benchmark.

The effect of reclassification on a country’s index weight

What is also noteworthy is the effect that reclassification can have on a country’s total index weight, as it often means moving from being a big fish in a small pond to a small fish in a big pond. For example, Argentina is currently the second largest member of the MSCI frontier market index, with a benchmark weight of 17%. However, it is only projected to make up 0.5% of the MSCI emerging market index after it is upgraded4.

From an investor’s point of view, this highlights the disconnect between an index provider’s definition of emerging markets and what investors think they are getting. At a minimum it suggests a degree of discretion is warranted when deciding how to invest one’s assets.

1) Source: MSCI. Data as at 31 March 2018.
2) Source; IMF. Data as at 2018. Based on GDP per capita using purchasing power parity (PPP), international dollars.
3) Source: MSCI. Data as at 29 June 2018.
4) Source: MSCI. Data as at 29 June 2018.

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Cyber-risk: how investors can prepare for the unpredictable

Cyber crime continues to create significant costs for companies globally, but understanding the risk means going beyond a formulaic assessment of policies, argues Ovidiu Patrascu, Sustainable Investment Analyst at Schroders.

Digital data has grown exponentially in recent years, spurred by increased penetration of mobile devices and consumption of online services. The rapid expansion in the volume of data companies store, many of which are relatively new to data management and security, has attracted cyber criminals employing increasingly sophisticated tools and techniques. Cyber crime costs global companies around 60% more than it did only five years ago, whilst in the US, that number has risen by over 80% (see Fig 1). No company can afford to ignore the threat, and regulators such as the UK’s Information Commissioner’s Office (ICO) are stepping up enforcement actions. Their response represents the tip of the iceberg the problem represents.

Figure 1: Cyber costs are increasing


Source:, Accenture & Ponemon Institute's 2017 Cost of Cyber Crime Study, Cisco Global Cloud Index

What does cyber risk mean?

Cyber risk is a broad term. For most people, it represents the risk of loss or harm from breaches or attacks on information systems. That loss can take many forms, including direct financial costs, reputational damage or operational continuity. Recent high profile breaches (WannaCry, Petya, Equifax etc.) have served to further raise awareness on the issue, in turn attracting regulatory scrutiny. Data privacy is commonly associated with cyber risk, and is a centrepiece of the EU’s General Data Protection Regulation (GDPR) regulation, which came into force in May 2018. That law has become a defacto global standard; it clarifies and expands upon what sensitive data entails, who has the usage rights, and assigns the responsibility to companies to keep customer data safe, with high fines if they fail to do so.

Why should investors care?

Cyber is an increasingly critical source of business risk, especially for companies with important intangible assets such as brands, customer relationships or technology. The negative impact a data breach can have on a brand link straight to companies’ competitiveness, future revenues and future cash flows. Data breaches often uncover poor governance practices and weak management; changing people or policies is quick but re-establishing market and customer trust take much longer.

An engagement approach

In our view, investors should focus on understanding how well a company prepares for cyber events. The depth of its approach should give confidence that when (not if) a breach occurs, processes and resources are in place to minimise the impact on operations and ability to create value.

Building that understanding means going beyond a formulaic assessment of policies. We believe direct company engagements are the best way to gain insights. We have delved into the topic focusing on a few main areas:

  • Governance: assess how well cyber risk is understood by the board
  • Expertise: does the company have the internal capabilities to manage cyber risk? Is it drawing on specialist skills from outside the organisation?
  • Technological: has the company adopted best practices from a technical standpoint?

Recognising that cyber risk is relevant to many business models, we have engaged with Chief Information Security Officers (CISO) or Data Protection Officers (DPOs) at ten companies Schroders invests in, across sectors such as financial services, technology and telecoms.

Main findings: expertise and board responsibility

Our direct and detailed engagements have allowed us to identify where the material information lies, and to better understand the strength and weakness at a company level. We believe the key areas are:

  • Expertise: it is critical that the company has a well-resourced and specialised cyber security team, managed by a CISO/DPO, reporting preferably to the CEO or the board. The security team should also leverage specialised external expertise on a regular basis to stay on top of new threats and security tools. Internally, the team should have direct ownership of specific technological tasks such as penetration testing, security patches etc.
  • Board level responsibility: the board should have specific expertise to evaluate whether the company has the appropriate operational and managerial resources to mitigate cyber risk.

The analysis of a company’s level of expertise and board responsibility provides our analysts and fund managers with a basis on which to structure their questions of management teams, and to benchmark responses against peers.

In addition, the engagements have changed our understanding of a few areas usually thought of as important, but which most companies disregard.  For instance, our discussions highlighted the weaknesses of focusing on ISO27001 (an IT standard that best-in-class companies implement internally), cyber insurance (current products offer limited coverage) and policies on cyber/data protection (while important for compliance purposes, they appear less helpful in actually managing cyber risk).

Conclusion: targeted engagement

Cyber is an increasingly important risk for every organisation. As investors, we need to gain a deeper understanding into how well companies held in our clients’ portfolios are prepared to manage this risk. We believe targeted company engagement is the most effective way to gain insights into key areas such as top-level risk governance and technical expertise, where investors might be able to identify unsuitable practices before they materialise.

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The data boom in Chinese cities and what it means for real estate investing

by Hugo Machin, Co-Head of Global Real Estate Securities, and Ben Forster, Equity Analyst, Global Real Estate, both Schroders.

China is at the forefront of a technological revolution and the quantity of data it will yield is unprecedented. For investors in companies based in the country’s global cities, this could bring compelling opportunities.

Here on the Global Cities blog, we recently discussed the rise of “meta cities”. These are essentially numerous global cities which combine together to form a single economic area, or “meta city”.

We explained how rapid urbanisation in three Chinese economic hubs, interlinked by transport infrastructure, is concentrating economic activity in China into such areas.

Our view is that the knowledge economy (which relies more on intellectual capital rather than physical inputs) is focused on fewer, more important, global cities. Demand for land increases as economic activity strengthens, which means that owners of real assets have pricing power. This is even more evident in China than other parts of the world, as we saw on a recent visit to two meta-city regions – Beijing (Jing Jin Ji) and Shanghai (Yangtse River Delta).

On this trip we witnessed how the early adoption of 4G – through the provision of network infrastructure of so-called macro towers and small cells – was the catalyst for the increase in data generated in China. We explain how and why 4G has facilitated mobile commerce (also known as m-commerce) in China.

Our view is that Chinese cities are now best-placed globally to transfer to fifth generation (5G) cellular technology, which will enable much faster transmission of vast quantities of data over short distances1. This will be transformational: 5G will allow people living in Chinese cities to control their lives from their mobile device.

The 5G rollout will likely require significant investment in a dense network of miniature cell phone towers (small cells)2. This upgrade is important for two reasons. First, small cells function over short distances, making them most practical in highly populated cities. This adds further to our argument that the data-hungry knowledge economy will only thrive in certain cities, fuelling their economic growth and strength.

Second, 5G will enable new technologies such as the “Internet of Things” (ie the network of every physical thing connected to the internet, particularly those that communicate with each other) practical for the first time, leading to a second boom in data creation.

The opportunity for Global Cities investors is clear; companies that own or operate data centres and network infrastructure (macro towers, small cells, fibre) will see increasingly strong demand and will make their cities more productive.

Why mobile, why China?

Simply put, consumption through handheld devices is higher in China than anywhere else in the world. There is a reason for this. Historically, all forms of commerce were operated and controlled by the state. A lack of customer focus from retailers and from banks meant that when alternatives were introduced, the market was receptive.

The introduction of competition coincided with the rise and adoption of the internet. This meant that companies like Alibaba acted as an online mall for retailers, as well as providing mobile payment facilities. Consumers trusted these emerging companies more than previously run state retailers and banks, hence take-up of m-commerce being more rapid in China than in the West.

This means that Chinese consumers are used to purchasing and paying online. New software allowing them to control other areas of their lives will, we think, be adopted equally quickly.

Once launched, 5G will serve as a foundational technology enabling many new applications to emerge, which are not possible over the existing network. These are likely to include driverless cars, smart city infrastructure and connected factory floors. Collectively, these networks form the Internet of Things mentioned above and they are expected to generate vast amounts of data3.

4G is the backbone of M-Commerce but 5G will be the backbone of the Internet of Things.

Which cities?

We witnessed the momentum behind 5G-enabled technologies at the 2018 Mobile World Congress in Shanghai, where the theme was very much “5G now”. Networks in China are racing to beat US carriers such as Verizon to launch 5G services this year.

Beijing, Shanghai, Tianjin and Shenzhen all make it into the Top 30 of our Global Cities Index, which identifies the world’s most economically vibrant cities.

They are elevated by a unique density of consumers, digital infrastructure and tech-talent from institutions such as Tsinghua University. Coupled with a long-term government vision to lead the world in mobile technology4, we believe these cities are the perfect incubators for new technologies such as 5G.

Digital infrastructure opportunity  

Existing network infrastructure for 5G is more advanced in China than in other markets. This is why the opportunity in Chinese cities and specifically in the areas of data centres and small cell companies is apparent.

One hurdle for 5G adoption is that a city like New York is likely to require 40,000-50,000 cell sites to deliver the service (source: ExteNet). China already has around 2 million macro tower sites, meaning that viral animal clips on Douyin load instantly on demand. This is more than 10x the number of sites owned by the US tower infrastructure leader ‘American Tower’.

To continue funding the denser urban small cells needed for 5G, the three state-owned Chinese telcos are looking to raise capital through an IPO of their jointly-owned network infrastructure, which supplies 97% of the market5. This week saw the $7 billion listing of ‘China Tower’ in Hong Kong, with researchers at consultant Frost & Sullivan expecting wireless data on the network to grow at 39% pa until 2022 (source, China Tower filing).

M-commerce growth

M-commerce is one area of data creation growth that continues to fuel demand for data centres and tower networks. M-commerce has thrived on the back of 4G and applications created by companies such as Alibaba.

More broadly, we do not see a slowdown in Chinese electronic commerce (e-commerce) coming, far from it. We see a long runway of growth representing an enormous number of people yet to adopt e-commerce.

The chart below shows the very rapid and sizeable adoption of the Chinese consumer buying goods electronically. However, this only tells a part of the story. The absolute size of the Chinese population means that the unpenetrated market (80%) has greater depth in numbers than any other market in the world.

We think that m-commerce can still grow rapidly, but creation and adoption of other software and technology represents a new level of growth in data creation and processing. This is why the opportunity that 5G represents is so compelling.


5G represents a critical growth point. Companies that own network infrastructure and data centres will benefit from widespread mobile usage of the Chinese consumers and future adoption of the Internet of Things.

This communication infrastructure has to be located in cities, near to large populations. In particular, the meta cities we have written about that will grow quickly because of government transport projects. These locations will provide outsize economic growth and provide investors with the strongest returns.

We think that there is an inflection point coming in how people control their lives through their devices. We think 5G is the catalyst and 5G can only operate over short distances in dense locations, so it needs Global Cities. We think this makes Global Cities even more important to the world economy, underpinning the value of land in specific locations.

This exciting evolution will increase the gulf between winning cities and the rest. For investors in companies that will benefit from or facilitate 5G, located in Global Cities, the future could be very bright.

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Our global cities team launched the Global Cities blog in 2016, which acts as a resource to track the longer-term trends impacting global real estate. The index uses a number of factors to identify the most economically vibrant cities across the world. You can find out more here.

ESG in passive: let the buyer beware

by Ovidiu Patrascu, Sustainable Investment Analyst at Schroders.

Are investors ignoring the small print in their rush to buy funds incorporating environmental, social and governance (ESG) principles?

There has certainly been no shortage of demand. From what was virtually a standing start 12 years ago, $2.9 billion flowed into these “sustainability” funds in 20171.

It will surprise no-one that at least half of those flows were into exchange traded funds (ETFs). Passive ETFs neatly tick two of the boxes high on investors’ current list of priorities: low fees and meeting ESG concerns. We worry, however, that many passive ETFs and open-ended funds are pitched to exploit investors’ preference for simple, low-cost solutions, rather than providing either the financial or the sustainability outcomes that those same investors expect.

Unlike the more objective measures that typically form the basis of passive ETF construction, such as market capitalisation, sector or domicile, ESG indicators are the result of a series of judgements and analyses that can vary significantly and lead to very different conclusions. Undertaking such analysis is expensive, and often more than low-cost passive products can afford. A cheaper way for passive ETFs is to use the ESG ratings provided by one of a handful of data providers, such as MSCI, Sustainalytics and Thomson Reuters.

In arriving at an ESG score, each data provider synthesises their sustainability analysis into a single measure, akin to the stock recommendations investment banks or credit rating agencies produce. Having several of these diverse views may be valuable for fund managers seeking to better understand a business. However, it would make little sense for them to use a single analyst’s research to form a definitive view of a stock’s attractiveness. All the more so if they had no clear understanding of the analyst’s research process, the basis for their conclusions or the outcomes the recommendations were designed to achieve.

We would argue that this is essentially what investors are signing up for when they buy a passive ESG fund. Despite the perception of transparency, many passive products disclose surprisingly little about how they actually implement ESG factors. The majority of them rely on a single third party ESG rating provider. Their rating methodologies typically emphasise tick-the-box policies and disclosure levels, data points unrelated to investment performance and/or backward-looking negative events with little predictive power. Most of the inputs to these scores relate to policies rather than more tangible measures of performance.

These shortcomings are reflected in the lack of consistency in ESG scores between the main data providers. Using all the MSCI ACWI constituents, we analysed the overlap of ESG scores for each of the three main data providers at the company level, as well as between the three ESG categories, environmental, social and governance.

As can be seen from our first chart, the level of overlap between the scores given by the ratings providers is surprisingly low. It was a similar story when we calculated the correlations across the entire company dataset of E, S and G (second chart).

There’s precious little in common between ESG ratings

This lack of consistency is concerning. As the majority of passive processes eliminate companies with weak ESG scores, portfolios created using different scoring systems are likely to have radically different constituents. By the same token, the widely varying assessments of how strong a company is on environmental, social or governance grounds means investors seeking to allocate to best-in-class companies on ESG grounds will come up with very different answers, depending on which rating provider they use.

Similar problems arise when it comes to stewardship. Many investors buy ESG funds on the basis that their managers will be better stewards of the companies they invest in. Unfortunately, it is very hard to engage effectively with companies and bring about change using mechanical processes that lack the specialist knowledge of both the industry and how individual businesses are likely to be affected by ESG issues.

We would argue that this is less of an issue for an active management firm, where stewardship is an important element of its role and a responsibility of fund managers, analysts and sustainability experts alike. We believe that oversight is made easier by an active investment philosophy, where regular management meetings can be complemented by targeted engagements on specific company, environmental and social issues.

We think it is clear that investors’ expectations of sustainability cannot be truly met by passive funds. In our view, the most effective way to do this is to integrate ESG expertise into active investment solutions. These should be designed to address investment-relevant ESG issues, both at the company-specific level and at the portfolio construction level. The manager of the portfolio should then be able use their expertise to undertake targeted engagements with companies throughout the life of the investment with the aim of improving both returns and capital stewardship for investors.

Please find the full research paper here.

1) Source: 

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Seven surprising facts about tax revenues around the world

by Duncan Lamont, Head of Research and Analytics at Schroders.

New data collated by the OECD compares how governments raise taxes, yielding some notable findings.

Taxes are always a hot topic for the individuals and companies who pay them. It is therefore perhaps unsurprising that an attempt by the OECD, an organisation made up of mostly rich nations, to collate and compare taxation in 35 countries will attract some attention.

Here, we pull out some of the most telling facts:

1. Most economies are taxed more now relative to GDP than at any point since 1990

Around 80% of the countries covered have experienced an increase in taxation between 1990 and 2016. Higher tax income across all major sectors, particularly VAT and corporation tax, has pushed the ratio of tax to GDP to a record high of 34%.

The reasons for this are complex, particularly the sharp rise since the financial crisis of 2008. It isn’t necessarily a result of indebted governments increasing tax rates to raise more money, as we explain below.

 Source: OECD Global Revenue Statistics Database, Schroders. OECD average is for 2015 data.

2. This overall rise in taxation has happened despite corporate tax rates falling by around half since the 1980s

One high-profile story has been the “rates war” on corporation tax. Countries have battled to offer the lowest rates in an attempt to attract companies. To help show that, we’ve pulled in a chart from a recent academic paper. It shows how the average corporate tax rate has experienced a savage decline over an extended period of time. It’s also worth noting that higher pre-tax profits have increased overall corporation tax revenues despite lower tax rates.

3. Corporation taxes are a fairly insignificant source of government revenues

 Source: OECD Global Revenue Statistics Database, Schroders. OECD average is for 2015 data.

This is nothing new. Despite the decline in corporate tax rates, corporate taxes have not fallen at all relative to GDP since 1990. Given its low contribution to overall revenues, cutting corporation tax is a far less directly costly move than cutting income tax, despite growing public opposition. Governments also hope that cutting tax rates for companies encourages them to base or expand their presence in a country, employing people who pay income tax and who buy taxed goods and services.

4. Value-added tax (VAT) and other goods and services taxes (e.g. duties) contribute a far higher amount to the coffers

5. The income tax burden, relative to GDP, hasn’t increased in most countries since 2000. Tax hikes have been slipped in by the back door. 

Less attention-grabbing areas such as VAT and social security contributions have been the major areas the burden has been felt.

Source: OECD Global Revenue Statistics Database, Schroders. All data is to end 2016 other than Australia, Greece, Japan, Mexico and OECD average, which are 2015.

6. The UK consumer’s obsession with house prices is matched by the government’s desire to extract revenues from the sector

Tax revenues derived from property are higher in the UK, as a percentage of GDP, than any other major economy, more than double the OECD average.

Source: OECD Global Revenue Statistics Database, Schroders. All data is to end 2016 other than Australia, Japan and OECD average, which are 2015.

7. Greece and Italy are much criticised but generate more in taxes, as a percentage of GDP, than most other major economies. 

Raising the tax burden much further is not a realistic option. Fiscal health can only be improved by spending cuts (such as a reduction in their very generous benefits) and/or efforts to raise productivity, such as relaxation of employment law. The Italian political climate in particular makes neither an easy option, at least in the near term.


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Why investors are wrong about the role of the dollar

A new theory about the US dollar is challenging the way economists and markets think about currencies. It has particularly important implications for emerging market asset classes, argues Craig Botham, Emerging Markets Economist at Schroders.

It is widely accepted that dollar strength is bad for emerging markets (EM), something that seems to have been confirmed by a very tough 2018 for emerging market assets. However, the traditional reasons why, such as investors’ attitude to risk or prevailing financial conditions, are increasingly being questioned.

A growing body of evidence suggests that it is really the dollar’s role as the dominant "invoice" currency in world trade that explains its impact on emerging markets.

According to this interpretation, a stronger dollar reduces global import demand by simultaneously raising import prices for all countries apart from the US. At the same time, it raises the cost of credit, particularly in economies where dollar-denominated debt is prevalent. A stronger dollar is therefore a clear headwind to EM growth, generating inflationary pressure regardless of what trade-weighted exchange rates may be doing. It means that central banks have a clear incentive to fight depreciation of their currencies against the dollar, given that it offers little benefit to exports, while generating higher inflation.

This holds several lessons for investors. One is that, with emerging markets at least, it may be better to focus on the exchange rate versus the dollar rather than the trade-weighted exchange rate when considering a currency’s valuation, whether a currency adjustment will correct external imbalances and in judging inflationary effects. Reliance on purchasing power parity, real effective exchange rates and other “fair value” measures will not lead to robust investment conclusions.

We may also need to adjust our thinking on how emerging market central banks should react, assigning more of a role to currency stability than inflation and growth. Dollar strength may lead to more policy tightening than normally expected. This has particular implications for bond and currency investors, but should not be ignored by equity investors in emerging markets either, given the role that monetary conditions play in equity markets.

This new dollar invoicing theory is challenging the way economists and markets have previously thought about currencies and their impact on economic and financial variables. We believe it provides a more complete picture of how and why the dollar is so important to emerging markets, and why it has a greater impact on global trade and inflation than is generally appreciated. For investors, this has important implications across all EM asset classes.

The full report can be found on

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Is China’s currency weakness the latest salvo in trade tensions?

Craig Botham, Emerging Markets Economist at Schroders, questions whether China’s currency is being used as a weapon in trade tensions.

China’s currency, the yuan (CNY), has weakened 4-5% relative to the US dollar since June. This has prompted a lot of speculation that the authorities are deliberately weakening the currency in response to tariffs, and that this could mark the beginning of a series of devaluations for China. These fears are vastly overblown.

Official policy targets a basket of currencies, not a peg versus the US dollar 

The first error made in this analysis is the assumption that China targets a peg versus the dollar. It does not. Official policy is to target a basket of currencies (essentially trade weighted) known as the CFETS basket. On this measure, the Chinese currency is only 2.5% weaker since June. 

Not only that, but as is visible from the chart below, this weakness is only reversing the strength seen this year. Since the CFETS basket was established in 2015, it has spent most of its time around the 94 mark. The deviation from currency policy has not happened in the last month and a half, it was the January - June period. 

CNYUSD vs CFETS basket

Recent CNY weakness a reversion to norm 

So in a way, the press and other breathless analysts are right - trade tensions have been dictating Chinese FX policy. Just not in the way that garners headlines. Recent weakness is a reversion to the norm after a period in which the authorities deliberately allowed currency strength, presumably to avoid antagonising the US further at a delicate moment in negotiations. 

…but the currency could still be used to counter the effect of trade tariffs

We would not rule out the use of the currency as a weapon in the trade wars to come, but it remains under tarpaulin in the armoury for now. Should the CFETS pass through the 92 level, there will be more of a case to be made that China is aiming for currency weakness to counter US tariffs.

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An economic slowdown is approaching, but that's no cause for investor alarm

We’re approaching the end of the economic cycle, but markets are not stupid. Investors waiting for a significant collapse in the equity market because the economy is slowing may be in for a long wait, argues Rory Bateman, Head of UK & European Equities at Schroders.

Equity markets are typically quite effective at anticipating the ups and downs of the underlying economy; violent market swings are caused by unexpected moves in activity often brought about by bad policy decisions or unidentified bubbles in the system. 

Investors shouldn’t be alarmed that the cycle is maturing. It’s nearly ten years since the financial crisis and global growth has been resilient for a number of years. The natural course of events is to expect a slowdown because economies can’t grow in perpetuity.

Our belief is that the next slowdown will be shallow in amplitude, which is typical following a severe recession like we saw in 2009.

We think the European situation is somewhat different to the US given the eurozone was later going into recession and, following the eurozone crisis, was much later to emerge from that recession. European equities have not recovered to the same extent and valuations continue to look attractive.

The “super tanker” European economy should continue on a low growth trajectory for the coming year or two but we acknowledge the global backdrop looks more challenging.

Earlier this year we talked about intra-market correlations coming down, paving the way for superior stock selection to be the key differentiator. We continue to believe outstanding bottom-up stock selection will be crucial for alpha generation (i.e. returns superior to the market) in the second half of 2018.

Slowdown expected

It’s been a challenging year so far for global equities in 2018 with negative returns in most markets. The exception is the US, where the S&P 500 has delivered a small 2.7% (in US dollars) gain driven by the strong earnings story for US corporates. Europe has been impacted once again by internal eurozone issues as Italy has failed to form a credible new government.

Chart 1 below shows that the current US economic cycle is already fairly extended compared to history so it shouldn’t be a surprise to investors that economic activity is likely to slow.

Chart 2 shows that the global economic activity indicator has already turned and G7 industrial production has been at elevated levels for some time. 

Chart of US economic expansion

Chart showing leading indicators have peaked


Monetary tightening may squeeze economic activity

The overwhelming theme across all markets, however, has been the tightening of monetary policy. In the US the Federal Reserve (Fed) has been raising interest rates and many investors are concerned about the squeeze that higher rates will have on economic activity.

In Europe, quantitative easing (QE) is coming to an end in an environment where growth remains at a low trajectory. Central banks have significantly expanded their balance sheets through QE over the last ten years, which has probably prevented an extended deflationary cycle.

However, as chart 3 shows, QE becomes QT (quantitative tightening) in most of the major economies in 2018 and 2019 which is likely to be a headwind for growth as liquidity is tightened.

Chart of tightening global liquidity

Politics brings uncertainty, as ever

At the time of writing the Italians are battling with the EU over immigration. This is creating political noise as usual, but we suspect there will be an agreement and the upset to markets will be minimal.

Indeed the situation in Italy is not dissimilar to Germany where Chancellor Angela Merkel has recently avoided the disintegration of her fragile coalition by striking a migration deal with her hostile CSU partners on the formation of transit centres for asylum seekers on the Austrian border.

Meanwhile, the UK has taken another step towards exiting the EU with the government agreeing a proposal for the future UK/EU relationship. The ink was barely dry before some leading pro-Brexit ministers tendered their resignations but so far there has been no challenge to Prime Minister Theresa May’s leadership.

The full white paper detailing the proposal has not yet been published but the information available suggests the government is moving closer to a “soft Brexit”. The proposal still needs to be negotiated with Brussels and there is scope for positions to change as that negotiation takes place.

The UK equity market reaction to these latest developments has been minimal, perhaps because many were already expecting a “softer” Brexit. Looking longer term though, Brexit voters’ ongoing support for the Conservative Party may waver should they be dissatisfied with the type of Brexit that is delivered.

However, the most obvious challenge to equities globally is the ongoing deterioration in trade relations, with US President Trump imposing tariffs on a range of industries and the inevitable reaction from the Chinese and to a lesser extent from Europe.

Given these “tit-for-tat” negotiations are still evolving, it’s very difficult to interpret the impact on trade overall. But sentiment will be impacted if agreements can’t be found soon. 

Valuations still supportive in Europe

There will always be positive or negative surprises for equities, which by definition are unpredictable, but a slowing economy doesn’t necessarily mean weaker markets. Markets are quick to price in slower economic growth and we believe the fundamentals are currently being reflected in global valuations. 

Having said that, eurozone valuations relative to other markets continue to look attractive in our view. Valuations are critical for our understanding of likely future returns and, as chart 4 below shows, the eurozone on a cyclically adjusted price-to-earnings ratio looks favourable at 18.2x versus the long run average of 19.9x.

Chart of regional stockmarket valuations

Stockpicking is key

As we enter a period of slower growth, identifying the most attractive companies becomes even more important for investors seeking to harness returns ahead of the market. Generating alpha - rather than relying on broad, correlated market earnings growth - can make all the difference in the dispersion of returns.

Our expertise in picking undervalued companies through bottom-up fundamental analysis should give investors confidence in our ability to generate superior returns. As we have outlined above, there are numerous cross-currents influencing equity markets and working out what is already priced in is the key to stockpicking success. Our experienced team of sector analysts help us as fund managers to unearth the opportunities that others may miss.

In the context of a potential slowdown of the economic backdrop, it is crucial to identify those companies taking steps to improve their own performance, rather than simply relying on the rising tide of increased economic activity.

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Welche Länder wären bei einem Handelskrieg die Hauptleidtragenden? Antworten auf fünf Fragen

Zunehmende Spannungen zwischen den USA und China könnten einen ausgewachsenen Handelskrieg entfachen. Was würde dies für die Aktienmärkte bedeuten, und wie könnte es die Verbraucherpreise beeinflussen? Antworten von Ökonom Craig Botham, Schroders, auf zentrale Fragen.

Zwischen den USA und China hat es in den vergangenen drei Monaten heftige Wortwechsel gegeben. Beide Seiten haben damit gedroht, Zölle in Milliardenhöhe auf die Waren und Dienstleistungen der Gegenseite zu erheben. Wenn aus diesen Auseinandersetzungen ein ausgewachsener Handelskrieg entsteht, würde dadurch der globale Konjunkturaufschwung gefährdet?

Auch wenn der gegenwärtige Streit der beiden Länder nicht offiziell als Handelskrieg betitelt wird, so ist die Bedrohung doch real.

Ein Handelskrieg herrscht, wenn Länder die Einfuhren anderen Nationen, d. h. Waren und Dienstleistungen, mit Zöllen belegen. Mit diesen Maßnahmen wollen die Länder ihre eigenen Exporte für ausländische Abnehmer attraktiver machen und ihre Handelsbilanz verbessern. Viele Länder, darunter auch die USA, leiden unter einem Handelsdefizit: Die im Ausland gekauften und ins Land eingeführten Güter (Importe) übersteigen die verkauften, aus dem Land ausgeführten Güter (Exporte).


Im Falle der USA und Chinas haben sich die Wortgefechte seit Anfang März 2018 verschärft, als Präsident Donald Trump allgemeine Zölle in Höhe von 25 % auf Stahl- und 10 % auf Aluminiumimporte ankündigte. Sein erklärter Beweggrund war die Senkung des US-amerikanischen Handelsdefizits: Die USA importieren aus Ländern wie China und Mexiko mehr als sie exportieren.

Im April 2018 gingen die USA noch einen Schritt weiter und nahmen gezielt China ins Visier. Sie kündigten geplante Zölle in Höhe von 25 % auf chinesische Importe im Wert von 50 Mrd. US-Dollar an. Diese gelten unter anderem für die Bereiche Luft- und Raumfahrt, Informations- und Kommunikationstechnologie sowie Maschinen, wobei die endgültige Liste am 15. Juni 2018 vorgelegt wurde. China erklärte daraufhin, dass, sollten die Zölle verhängt werden, das Land seinerseits 25 % Zölle auf US-Exporte im Wert von 50 Mrd. US-Dollar erheben würde – angefangen bei Aluminiumschrott bis hin zu Äpfeln. Als Antwort darauf erkundigte sich Präsident Trump beim US-Handelsbeauftragten nach der Möglichkeit, weitere chinesische Produkte im Gesamtwert von 100 Mrd. US-Dollar mit Zöllen zu belegen.

Dies ist nicht das erste Mal, dass die USA sogenannte protektionistische Maßnahmen ergreifen. Am bekanntesten ist wohl der vom Kongress, dem gesetzgebenden Organ der US-Regierung, in den 1930er-Jahren verabschiedete Smoot-Hawley Tariff Act, mit dem die Zölle auf über 20.000 Güter erhöht wurden und der für die Verschärfung der Großen Depression verantwortlich gemacht wurde. Zehn Jahre zuvor wurden jedoch mit dem Fordney-McCumber Tariff von 1922 zum Schutz von Fabriken und Farmen US-Zölle auf viele importierte Güter angehoben. Dies verhinderte nicht den Boom der 20er-Jahre, der letztendlich in der schweren Wirtschaftskrise in den USA endete.

Die Produktlieferkette ist heute wesentlich komplexer als noch im frühen 20. Jahrhundert. Bei vielen Waren und Dienstleistungen ist man auf Outsourcing und ausländische Importe angewiesen, um einen Teil des Herstellungsprozesses zu realisieren. Die Gefahr ist, dass Zölle unbeabsichtigte Folgen nach sich ziehen könnten, indem sie die Preise nach oben treiben und so die Nachfrage nach allen – nicht nur nach importierten – Waren reduzieren.

Viele Länder und Unternehmen außerhalb der USA und Chinas könnten diesem Phänomen aufgrund ihrer untereinander vernetzten Liefer- und Ertragsketten ausgesetzt sein. Somit besteht eine potenzielle Gefahr für das Weltwirtschaftswachstum insgesamt. Nachfolgend steht der Ökonom Craig Botham von Schroders Rede und Antwort zu fünf zentralen Fragen zum Thema Handelskriege.

1.) Welche Länder könnten sich bei einem Handelskrieg zwischen den USA und China als am stärksten gefährdet erweisen?

„Die Schlagzeilen konzentrieren sich für den Fall eines Handelskrieges hauptsächlich auf den Schaden für China, doch auch andere Schwellenländer könnten in fast gleichem Maße leiden. Die Regierungen dieser anderen Volkswirtschaften verfügen unter Umständen nicht über die in Peking vorhandenen Mittel, daher wird der nationale politische Handlungsdruck hier stärker sein.

Manche Volkswirtschaften könnten von den Effekten der ersten Zollrunde zunächst verschont bleiben; die unmittelbaren Auswirkungen konzentrieren sich im Wesentlichen auf die asiatischen Schwellenländer, während sich relativ geschlossene Volkswirtschaften wie Brasilien und Indien als immuner gegen einen breiteren globalen Handelskrieg erweisen dürften.

Es zeigt sich außerdem, dass die Zölle auf chinesische Exporte wesentlich größere Folgen für die Schwellenländer nach sich ziehen werden als diejenigen, die auf Exporte aus den USA erhoben werden, und dass die asiatischen Schwellenländer diese voraussichtlich am stärksten zu spüren bekommen.“

2.) Wie haben die Aktienmärkte auf die Möglichkeit eines bevorstehenden Handelskriegs reagiert, und können wir daraus etwas ableiten?

„Die Marktperformance spiegelt seit der Ankündigung der Stahl- und Aluminiumzölle nur wenig Besorgnis über Handelskonflikte wider, und der globale Index klettert nach oben. Verglichen mit der Entwicklung im Vorjahr sind die diesjährigen Gewinne jedoch im allgemeinen mittelmäßig ausgefallen und waren viel stärkeren Schwankungen unterworfen. Die Märkte sind gegenwärtig vielleicht noch nicht davon überzeugt, dass ein Handelskrieg unausweichlich ist, doch sind sie ebenso wenig sicher, dass er vermieden werden kann.

Natürlich spielen unterschiedliche Faktoren eine Rolle. Die schwachen Ergebnisse an den chinesischen Märkten könnten zum Beispiel auch durch strengere Kreditbedingungen und Sorgen über die Verlangsamung des Wachstums bedingt sein. Auch haben Zweifel in Bezug auf das Tempo der globalen Expansion die Stimmung getrübt.

Dennoch scheinen die handelsbezogenen Bedenken ihren Tribut zu fordern. Bisher scheint der Markt darauf zu setzen, dass ein Handelskrieg zwischen den USA und China vermieden werden kann, doch ein Blick auf die Börse Mexikos verrät uns, dass sich zuspitzende Handelskonflikte deutlich negativ auswirken können.“

3). Können aus einem Handelskrieg Gewinner hervorgehen?

„Es könnte bei sämtlichen Zöllen Gewinner geben. China und die USA müssen ihre Versorgung mit den betroffenen Waren aufgrund der höheren Kosten ersetzen; dies zeigt sich in einem Preisanstieg brasilianischer Sojabohnen, seit China Zölle in Höhe von 25 % auf Importe von Soja aus den USA ankündigte.

Nicht in allen Bereichen besteht Potenzial für bedeutende Zugewinne: Whisky-Exporte aus den USA nach China machten 2016 rund 6 Mio. US-Dollar und damit einen winzigen Bruchteil des BIP aller Länder aus. Dennoch besteht in anderen Bereichen ein erhebliches Potenzial für eine Erhöhung des Marktanteils. Aus Chinas Zöllen auf US-amerikanische Güter werden sich hauptsächlich für entwickelte Volkswirtschaften Chancen ergeben, da sie die USA als wichtiger Lieferant von Rohstoffen mit höherem Mehrwert zu ersetzen versuchen könnten, während andere Volkswirtschaften aus den Schwellenländern darauf hoffen werden, Chinas Platz als Anbieter von Rohmaterialien und Komponenten einzunehmen.”

4). Auf welche Weise könnten sich die Auswirkungen eines Handelskrieges auf die Verbraucher bemerkbar machen?

„Ausgehend von den geplanten Zöllen dürften die unmittelbaren preislichen Auswirkungen auf US-amerikanische Verbraucher begrenzt sein. Die USA haben Konsumgüter im Wesentlichen ausgenommen, sodass sich die Auswirkungen größtenteils aus den höheren Herstellungskosten für US-Unternehmen ergeben werden. Letztendlich scheint die Preismacht von Unternehmen etwas eingeschränkt, sodass Preissteigerungen möglicherweise nur begrenzt weitergegeben werden können.

Eine mögliche Ausnahme hierfür ist die erst kürzlich von Präsident Trump angedrohte Erhebung von Zöllen auf Fahrzeugimporte in Höhe von 25 %, was unmittelbar zu Preiserhöhungen für den Endverbraucher führen würde.

Zusätzlich zu möglichen Preisanstiegen scheinen negative Beeinträchtigungen des Wachstums wahrscheinlich. Zum Beispiel werden Hersteller, die Kostensteigerungen nicht weitergeben können, weniger Gewinn machen und könnten sich daher zu Produktionssenkungen entschließen. Tritt dies in größerem Maßstab auf, könnte das letztendlich zu einem geringeren Lohnzuwachs und niedrigeren Beschäftigungszahlen führen.“

5). Wie nah ist der Ausbruch eines richtigen Handelskrieges, und womit rechnen Sie als nächstes?

„Zum jetzigen Zeitpunkt scheinen die Zölle beiden Seiten dem Aufbau einer Verhandlungsposition zu dienen, mit dem Ziel, im weiteren Verlauf zu einer Einigung zu gelangen. Der 15. Juni 2018 ist ein entscheidendes Datum, da an diesem Tag die endgültige Zoll-Liste vorgelegt wurde.

Sollte es wirklich zu einer Eskalation und damit zu einem Handelskrieg zwischen den USA und China kommen, hat dies klar negative Folgen für die Weltwirtschaft: Das Wirtschaftswachstum dürfte schwächer ausfallen und die Inflation steigen.

Laut unserer Prognose wäre mit stagflationären Konsequenzen (hohe Inflation, Wachstumsverlangsamung und steigende Arbeitslosigkeit) zu rechnen: Im Vergleich zum Basisszenario hätten wir es mit einem um 0,8 % geringeren Wachstum und einer um 0,7 % höheren Inflation zu tun. Für 2018 und 2019 sieht unser Basisszenario derzeit ein kumulatives Wachstum von 6,6 % und eine Inflation von 5,1 % vor.”

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Four reasons for caution on a market in transition

Investors are mostly optimistic and seemingly confident of sizable future gains, in spite of historically unfavourable valuations and a number of other risks that are re-emerging, argue Marcus Brookes and Robin McDonald, both Schroders.

“At its core, investment is about valuation. It’s about purchasing a stream of expected future cash flows at a price that’s low enough to result in desirable total returns, at an acceptable level of risk, as those cash flows are delivered over time. At its core, speculation is about psychology. It’s about waves of optimism and pessimism that drive fluctuations in price, regardless of valuation.” – John Hussman.

The exercise of buying low and selling high is the single most fundamental discipline in investment. Intuitively it makes perfect sense, is theoretically straightforward and has the benefit of working wonderfully well over the long-term. Unfortunately in practice, executing such a discipline is often fraught with difficulty, as in the short-term valuations are frequently overwhelmed by sentiment and momentum.

This quarter’s opening quote captures the essence of today’s market environment perfectly in our view. Reassured by recent gains and the perception of safety and resilience that follows an extended market rise, investors are mostly optimistic and seemingly confident of sizable future gains, in spite of historically unfavourable valuations. This is nothing new. In every cycle investors demonstrate a costly inclination to buy securities at elevated valuations because things feel comfortable, only to sell them again when valuations are depressed and things feel very uncomfortable.

Today’s sense of comfort is the consequence of a nine-year bull market in pretty much everything, underpinned by uber-low or negative interest rates, suppressed volatility, endless rounds of quantitative easing (QE), and central banks having your back at all times. Volatility has picked up since the turn of the year due to the unsustainability of such late-cycle accommodation at a time when capacity constraints in the economy are becoming evermore apparent.

In hindsight, our shift in emphasis towards capital preservation last year was premature.

As many of the risks we on the Schroders Multi-Manager team had safeguarded our portfolios against were put on the backburner, we had to endure much of the market’s advance as outsiders. This year, many of these risks have started to re-emerge, and are briefly discussed below.

1) Central banks are behind the curve

Interest rates are to asset prices what gravity is to the apple. When there are low interest rates, there is a very low gravitational pull on asset prices.” – Warren Buffett.

At 3.76%, the US unemployment rate has just reached its lowest level since 1969, and is now marginally below the Federal Reserve’s (Fed) year-end forecast. It has also been sat below its estimate of the level consistent with a neutral policy setting for well over a year. With inflation also now more or less at its target of 2%, the Fed is in catch-up mode.

As things stand, the funds rate is at least 100 basis points below the Fed’s estimate of neutral, and remains negative in real terms. With Congress and a pro-business president aggravating inflationary pressures by borrowing trillions of dollars to stimulate a late-cycle economy, it’s difficult to see how the Fed can justify suspending its efforts to normalise.

Bond yields have been in a secular downtrend since 1981. For a long time, 10-year Treasuries traded more-or-less in line with nominal GDP growth (4.1% last year). This relationship broke down in 2010 when the Fed began distorting the yield curve through quantitative easing – a policy that is now being unwound.

The combination of higher inflation, rising short-term interest rates, quantitative tightening (QT) and massive new debt issuance leaves the bond market looking cyclically challenged in our view.

In Germany, where QE is still underway and nominal interest rates are still negative, the situation appears even more unstable. 10-year Bunds recently traded as low as 0.25%. These are yields for a fully-employed economy (lowest unemployment rate in 38 years) that has consistently been averaging just over 3.5% GDP growth in recent years.

The bottom line is that the Fed is not done raising rates and we suspect the European Central Bank will not be far behind in removing its titanic footprint from global bond markets. Quantitative tightening (QT) has scarcely begun and the big spike in government borrowing is yet to unfold. Both are going to accelerate together over coming quarters. This amounts to an intensifying withdrawal of liquidity from financial markets and a growing headwind for a highly leveraged global economy.

2) Leverage is once again at a record high

There can be few fields of human endeavour in which history counts for so little as in the world of finance.” – John Kenneth Galbraith.

The main thrust of our argument in recent times has essentially been that the state of the global economy, although not booming, has been sufficiently robust to no longer warrant a monetary policy stance fit for a depression.

Sadly, by waiting so long to recalibrate policy, central banks have once again encouraged record amounts of leverage to build throughout the system, making it more reliant than ever on continued low rates. Consumers have borrowed to boost their insufficient wages, governments run ever-larger fiscal deficits so they can cut corporate taxes and companies pile on cheap debt to fund the buybacks, dividends and M&A activity that has helped take equity valuations close to record highs.

While this all feels very comfortable in the short-term, it has been based on the notion of a prolonged period of low inflation and low rates, which is now changing. As cost-of-capital assumptions increase and credit stress intensifies, risk premiums should rise - which is a polite way of saying asset valuations ought to contract.

Corporate debt has been a chief beneficiary of the QE distortion. It has been the destination for many investors forced out along the risk curve to generate a yield commensurate to what they could previously earn from risk-free securities like T-bills or government bonds. After a long bull market, investors in this asset class now assume a great level of risk for very little reward. Not only has interest rate risk risen, but credit risk also.

Although the corporate default rate ended 2017 at a record low of 3.3%, this is plainly a backward-looking measure of risk. Moody’s recently declared that the number of global non-financial companies rated speculative (or junk) has jumped by 58% since 2009 to the highest proportion in history. Furthermore, the share of leveraged loans considered “covenant-lite” (ie those that lack the usual protective covenants) hit a record-high 82% in April, up from 20% in 2011. This has occurred at a point where the level of US non-financial corporate debt has itself hit a record 45% of GDP.

These three issues are far more relevant when assessing future risks for investors. Sure, they may only become important during the next phase of economic stress, but as Moody’s pointed out, expect a “particularly large” wave of defaults when that does occur.

3) We are late-cycle

I’ve been in the business for over 30 years and not once have I ever found a time when rising oil prices and rising interest rates provided a tonic for a bull market in risk assets.” – David Rosenberg, Gluskin Sheff.

In 2017, investors enjoyed positive surprises for both growth and inflation. This year, the trade-off between the two has deteriorated. The global manufacturing PMI currently sits at a 10-month low, while years of disinflation have given way to a period of moderately higher inflation. Strictly defined, this is a classic case of late-cycle stagflation – a historically unfavourable condition for both stocks and bonds.

Other late-cycle signposts include buybacks, which this quarter hit their highest level since…Q3 2007. And M&A, which has totalled close to $2 trillion globally year-to-date – an increase on last year of about two-thirds. Both are indicative of a perceived lack of organic investment opportunities.

While late-cycle does not necessarily imply end-cycle, it does indicate pressure on profit margins as capacity constraints lift input prices (labour and raw materials) and aggravate generalised inflationary pressures. To prolong the expansion, we ultimately need to see either an eleventh-hour productivity boost or an increase in the supply of skilled labour. Neither appears to be immediately on the cards. Indeed, the latest data suggests capital spending plans are now fading. Maybe Trump should shift the incentive structure for companies and start taxing buybacks!

4) Valuations are generally unattractive

If you run a long-term trend line through a series of completed market cycles, you will find that although it is positively sloped, the fluctuations around the trend can be enormous. In practice, this means that the gains accrued in the later stages of a bull market are only really captured by those who sell. For the rest, these gains are merely transitory.

During a meeting last year, our visitor pronounced that “my valuation work versus anybody else’s is no basis for an investment process.” Of course, in the short-term when valuations often prove frustratingly meaningless, this can often appear correct. In the long-term however, valuations are hugely informative, not only for establishing long-term return expectations, but also the potential vulnerability of an asset class over the balance of a particular cycle.

Share buybacks, while beneficial to shareholders during an expansion, have muddied valuation analysis this cycle and distorted several popular metrics. To quote Chris Cole of Artemis Capital Management LP:

Share buybacks financed by debt issuance are a valuation magic trick. The technique optically reduces the price-to-earnings multiple (Market Value per Share/Earnings per Share) because the denominator doesn’t adjust for the reduced share count. 

"The buyback phenomenon explains why the stock market can look fairly valued by the popular price-to-earnings ratio, while appearing dramatically overvalued by other metrics. Valuation metrics less manipulated by share buybacks (EV/EBITDA, P/S, P/B, Cyclically Adjusted P/E) are at highs achieved before market crashes in 1928, 2000, and 2007.”

To return full-circle to the theme of our initial observations, we think that most investors today not only feel reasonably optimistic about the economy and corporate earnings, but believe valuations are reasonable and that there remains little threat from the bond market.

Our concern is that this is overly complacent, particularly in respect of valuations. Indeed, we judge this to be a window of opportunity where, from a full-cycle perspective, harvesting gains and de-risking portfolios makes generally good sense.

How this all affects our positioning

Change of a long term or secular nature is usually gradual enough that it is obscured by the noise caused by short-term volatility” – Bob Farrell, Merrill Lynch.

Our portfolios currently have three distinct attributes that differentiate them relative to others:

  1. We are overweight cash relative to bonds primarily, but equities also. While the overvaluation of bonds appears pretty unilateral, there are areas of the equity market that offer good long-term value
  2. We are overweight the value style, which has underperformed significantly this cycle, and underweight the outperforming growth and momentum styles
  3. We are well hedged against the late-cycle emergence of inflation

In our view, many major economies - like the US, Japan, Germany and even the UK - are later cycle than the market appears willing to concede. Although globalisation has relieved many of the domestic bottlenecks that historically generated inflationary pressures, we are now two years on from when deflation anxiety peaked, leaving many central banks behind the curve.

The switch in investment leadership that we felt would accompany this fundamental shift from deflation to inflation has - thus far - emerged only intermittently. While frustrating, we ultimately believe the rewards on offer once this shift becomes more apparent will prove worthy of the wait.

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Why Argentina woes shouldn’t detract from positive emerging market debt story

by James Molony, Investment Writer at Schroders.

The recent flare up of risk in Argentina, high and rising inflation, currency weakness, concern over the national finances and monetary policy, bears all the hallmarks of a classic emerging market crisis. Given the improvement in fundamentals which has taken place over recent years, do opportunities remain in emerging market bonds?

Other emerging economies, notably Turkey and to some extent Indonesia, are experiencing similar issues. These developments go against, and perhaps even call into question, what has been a long-term trend of improving fundamentals in emerging economies.

While the Argentinian peso is 20% weaker versus the US dollar in May, the Turkish lira has plummeted, reaching record lows against the dollar. Recent months have seen President Erdogan commenting on monetary policy somewhat unhelpfully, for instance claiming the central bank should lower interest rates in order to bring down inflation. This has contributed to the decline in the lira.

Indonesia too, in the past regarded as externally vulnerable, has seen a slide in its currency though its current account has improved markedly over recent years and it is expected to raise rates. Its current annualised growth rate of 5%, well above global averages, has disappointed some.

These specific situations are raising concerns and questions, but over the last few years, emerging markets (EM) have, through self-help measures and reforms, increased their resilience to external shocks. Most EMs have removed currency controls, “orthodox” monetary policy and central bank independence is more commonplace, financial balances have improved and currency reserves been built up. The image of EMs as routinely debilitated by inflation and currency crises seemed to have been consigned to the past.

Back to square one?

Argentina’s 2001 debt default remains one of the most notorious incidents in recent financial memory, but the country had more recently appeared to turn a corner.

The election of President Mauricio Macri in 2015, on a campaign promising market and business-oriented reforms, was seen as a potential sea change. It ended decades of ‘Peronist’ governments, named after former three-times President Juan Peron, widely seen to have badly mismanaged the economy and caused elevated inflation.

Among Macri’s successes was an agreement to repay holdout creditors from the 2001 default, which enabled Argentina to issue bonds again. Its first subsequent bond issue, in April 2016, was the largest EM sovereign issue to date at that time, raising $16 billion. Among ensuing issues came a 100-year bond; a strong vindication of Argentina’s improvement.

Macri eliminated foreign exchange controls and import and export restrictions and cut the corporate tax rate to 30%. As well as this though, subsidies on public utilities and services were removed, resulting in higher prices, likely contributing to a decline in the president’s approval rating.

In December, the central bank softened its inflation reduction target from 12% to 15%. This prompted a selloff in the peso with the central bank seeming to have acted under the influence of the government.

With rising US Treasury yields prompting a US dollar rally, the old nemesis of EM, burgeoning concerns spilled over with the peso weakening 20% versus the dollar in May.

Turbulence interrupting a smooth flight

The last such meaningful occurrence of EM volatility was during the 2013 “taper tantrum” when the Federal Reserve announced tapering of asset purchases. This bout of volatility saw the “fragile five” moniker coined with reference to a group of EM economies, including Indonesia and Turkey, with financial deficits and vulnerable currencies. Emerging economies have made progress since then and are still on a positive trajectory.

EMs have built stronger buffers to shocks during the recent economic upswing, accumulating foreign exchange reserves and improving current account balances (the balance of imports and exports). Indonesia’s, though still negative, has roughly halved since 2013. Brazil, having seen its current account reach a low at the end of 2014, is almost back to breakeven.

There has also been a concerted and more orthodox response to the current woes. The central bank of Argentina has raised rates quickly while the government has secured support from the International Monetary Fund (IMF).

Indonesia’s central bank is also expected to raise rates to support the currency. Most significantly, following a period of President Erdogan’s interventions in monetary policy, the Turkish central bank managed to halt the lira’s freefall by announcing tightening and promising to simplify its system of interest rates.

Any references to securities, sectors, regions and/or countries are for illustrative purposes only and not a recommendation to buy and/or sell.

The fund manager views

Michael Scott, European Fixed Income Fund Manager:

“The current flare up of volatility is confined to specific situations driven by specific risks at an individual country level. So we don’t see a systemic problem developing.”

“The positive fundamentals and dynamics which have drawn us toward both corporate and sovereign emerging market bonds, particularly in Latin American countries, in recent years remain largely in place.”

“Additionally, these countries are idiosyncratic and will be at different stages of the economic cycle, which makes them very helpful from a portfolio construction perspective. They are moving away from the old image of resource-extraction and low-cost manufacturing and exporting, with services and consumption becoming more significant components of these economies; another encouraging trend.”

James Barrineau, Co-Head of Emerging Market Debt Relative:

“A stronger dollar is never good for EM, but the policy responses in Argentina, Turkey and Indonesia have been prompt. They have not wasted significant reserves defending the currency, and as we saw in 2014-2016, when the smoke clears a more competitive currency can pave the way for better economic growth.”

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Why we are downgrading our global growth predictions

It’s the first time we have lowered our expectations for global growth since 2016. Schroders' Economics Team provides the reasons why.

Although growth remains strong, there are a number of factors that we believe will have a negative impact on global growth in both 2018 and 2019.

As a result, we have downgraded our forecast for the first time in nearly two years: from 3.5% to 3.4% in 2018 and from 3.3% to 3.2% in 2019. Meanwhile, global inflation is expected to be higher and we have raised our forecast for 2018 from 2.4% to 2.7% with implications for monetary policy throughout the world.

A weak start to the year

The year did not get off to a particularly strong start in most economies. In Europe, severe winter weather, a related outbreak of influenza, transportation strikes and the timing of Easter seem to have weighed on growth figures.

Meanwhile, in the US growth also weakened. It had received a one-off boost at the end of last year from post-hurricane rebuilding and replacement spending, but as the impact of this faded, growth pulled back in the first quarter of 2018.

Elsewhere, some of the emerging market economies also saw a softening in first quarter data, notably Russia and Brazil.

While many of these factors should now fade, helping activity to normalise in the current quarter, we are cognisant that leading indicators are providing mixed signals as to whether growth will rebound in Q2. In addition, rising oil prices and trade tensions are likely to contribute to an easing of growth.

Higher oil prices

Oil prices have risen meaningfully this year so far thanks to OPEC production cuts and the likely re-imposition of sanctions on Iran following President Trump’s termination of the nuclear deal. This will have an impact on consumer spending.

In the US, for example, the rise in oil prices will cost the consumer about $60 billion. Of course, consumers are already saving $120 billion thanks to President Trump’s tax cuts, but this means that half of their savings will go toward paying for costlier gasoline. For those in the lowest 20% income bracket, higher gasoline prices more than offset the gain from tax cuts. Overall, real consumer spending is therefore likely to be lower as a result.

The key question will be whether workers can gain some of this back through higher wages. So far wages have remained remarkably subdued but some recent data suggest that this could be changing.

Among the large emerging markets, Indian growth is also expected to suffer in an environment of rising oil prices given its oil import bill while Russia stands to gain, although the benefit will be limited by the impact of US sanctions.

Tense trade talks

As a brief recap, the US and China are currently threatening one another with $50 billion in tariffs. Though a small share of either country's trade, let alone GDP (less than half of one percent for China), the growth impact could be larger as the dispute is unlikely to end with one round of tariffs.

The uncertainty over future trade relations is likely to act as a drag on business decisions to hire and invest, particularly for exporters. This, in combination with certain policy measures, prompts a downgrade to Chinese growth in 2019 (from 6.5% to 6.4%) which in turn accounts for some of the modest lowering of global growth expectations in 2019.

Rising inflation

Higher oil prices will push up inflation on a global basis. Even in the US, we expect core inflation to move higher over the next two years.

In Europe, the combination of higher energy prices and a lower US dollar/euro exchange rate means inflation will rise here too.

In the emerging markets, inflation remains low by historical standards but is beginning to creep upwards in Brazil, India and Russia. 

What does this mean for monetary policy?

In most of the developed world, we expect monetary policy to tighten. In the US, we see the Federal Reserve hiking interest rates three more times this year and two in the next, such that the Fed funds rate reaches 3% by mid-2019.

The European Central Bank (ECB) is expected to end quantitative easing in Q4 this year and raise rates three times in 2019, ending the era of negative policy rates in the eurozone. The Bank of England is likely to remain on hold until November when there should be greater clarity on the outcome of the Brexit negotiations.

In the emerging markets, we expect Brazil’s central bank to avoid further easing and begin a gradual hiking cycle late in 2019. In India we anticipate a slightly faster tightening given the economy’s reliance on oil. We expect two hikes this year, with the first likely in June, to take rates to 6.5%, with two further hikes in 2019.

In contrast, lower inflation and liquidity concerns means that China heads the other way, with the People's Bank of China (PBoC) easing the reserve requirement ratio (RRR). This sets the minimum amount of reserves that must be held by banks in the country and is used by the central bank as a way to fight inflation. A rate cut in China may also be warranted in 2019 as growth slows further amid a drag on sentiment from trade tensions.  

Against this backdrop the US dollar is expected to strengthen further in the near term before weakening in 2019 as central banks outside the US begin to tighten.

Expansion for now, but the forecast takes a stagflationary turn

We continue to expect another year of expansion for the world economy, but at the margin the forecast has moved in more stagflationary direction with more inflation and less growth than before. This is a result of higher oil prices and the increased threat of trade wars.  

This is a summary version of the Schroders Economic and Strategy Viewpoint for June 2018.

1. Market data as at 24/05/2018. Previous forecast refers to February 2018. Consensus inflation numbers for emerging markets is for end of period and not directly comparable. Advanced markets: Australia, Canada, Denmark, Euro area, Israel, New Zealand, Singapore, Sweden, Switzerland, UK, US. Emerging markets: Argentina, Brazil, Chile, Colombia, Mexico, Peru, China, India, Indonesia, Malaysia, Philippines, South Korea, Russia, Czech Republic, Hungary, Poland, Romania, Turkey, Ukraine, Bulgaria, Croatia, Latvia, Lithuania.

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Why Italian politics matters for eurozone banks

Capital strength, margins and the prospects for banking union are among the many issues that may be affected by recent political developments, argues Justin Bisseker, European Banks Analyst at Schroders.

Recent political events in Italy clearly matter to eurozone banks. We are now seeing something of a rebound on the formation of a new government, but eurozone bank shares are still some 10% down in the past two weeks, with Italian banks down 15%.

What is happening in Italy matters – mostly for Italian banks but also with some broader implications for the wider banking sector. Here’s why.

Wider BTP-Bund spreads will impact on capital

At the time of writing (1 June) 10-year Italian sovereign bonds (BTPs) now yield 220 basis points (bps) over German Bunds, down from the week’s high of 280 bps but still some 100 bps wider than end-March levels. Italian banks typically hedge against interest rate movements, but not against movements in spread.

Estimates are complicated by limited disclosure, hedging strategies and the transition to a new accounting standard (IFRS 9) but Italian bank Core Tier 1 capital levels can be expected to see some downward pressure in Q2.

Of course, so long as bonds are held to maturity these capital drags will reverse but for longer-duration books this will take some time and be subject to additional mark-to-market volatility along the way.  That said, sensitivity here should be reasonably limited – typically a c.3% hit to Core Tier 1 capital (40-50 bps off Core Tier 1 ratios) at most for moves to date.

Higher sovereign borrowing costs will impact margins and create a new headwind to fee income growth

Italian bank net interest margins will no doubt come under modest downward pressure as their cost of borrowing on wholesale (and, to a degree, retail) markets rises with that of the sovereign.

This will be a slow-burn drag on margins and over time could be offset by higher lending yields, although this would imply a stronger degree of price discipline than we have seen in recent years from Italy’s banks.

Fee income will also face something of a headwind as retail investors may perhaps choose to invest in higher yielding BTPs than the mutual fund offerings from the banks. These pressures should be modest and therefore should not be overstated but negative earnings revisions tend not to be conducive to positive share price performance.

…As would a potential delay in ECB tightening

The longer-lasting – and sector-wide – impact of ongoing volatility in the Italian sovereign bond market could be a delay in monetary tightening from the European Central Bank (ECB). Rate expectations for 2021 have fallen some 25 bps in the last two weeks (based on three-year Euribor forwards) and expectations are building that the end to the ECB’s Asset Purchase Programme (currently €30 billion per month) could be delayed.

Higher ECB rates would be positive for the sector (our own estimates are that 100 bps higher interest rates would improve pan Europe bank sector earnings by some 18%, with the eurozone subsector benefiting some 17%). Many sell-side analysts have built a large proportion of this benefit into their mid-term earnings forecasts so the absence of this positive would present a downside risk to consensus, especially for more rate-sensitive names.

Balance sheet clean-ups could take longer and be more costly

Despite enhanced efforts to clean up balance sheets in Italy, more needs to be done. The ECB is continuing to apply pressure here (expressed most recently in the March Addendum to the ECB Guidance to Banks on Non-Performing loans).

Government actions which stall improvements in already lengthy collection periods, together with potential increases in borrowing costs and greater uncertainty as to collateral valuation, could all serve to increase the future cost of balance sheet repair.

Fortunately the larger banks have already made significant strides in this regard but for the system as a whole much still needs to be done.

Banking union could stall

In the ECB’s own words “banking union is an important step towards a genuine Economic and Monetary Union.”1 The first key steps on this important project have already been taken with the move to common ECB supervision for the eurozone’s largest banks, as well as the creation of the Single Resolution Mechanism.

The next step is a common deposit guarantee scheme (European Deposit Insurance Scheme, EDIS) to backstop the system. But it seems obvious that enthusiasm for EDIS in the core of Europe is likely to wane in the face of Italian populism.

What next for investors?

Some stability has been restored to markets with the 31 May announcement of a new government in Italy. Much will now hinge on the nature of policies which are implemented and whether a higher risk premium is demanded in Italy as a result. A “snowballing” of Italian sovereign debt clearly presents the greatest medium-term downside risk, but numerous checks and balances should limit the chances of this outcome.

By way of comparison it is worth noting that domestic UK bank earnings have not fallen apart post the 2016 Brexit referendum (indeed, earnings revisions have actually been positive for both Lloyds and RBS over the past year) and yet these banks remain in a “penalty box” with investors whilst uncertainty prevails. For now, Italian banks look set to suffer a similar fate, although in one or two cases the potential rewards for investors look high enough to justify the risk of investing.

For the sector more broadly, many bank valuations look very compelling on sensible base case assumptions. Our approach is to favour banks which can deliver attractive returns whatever the rate environment. If this were to be accompanied by rising interest rates then so much the better.

Could China’s bond market really be within investors' reach?

Chinese equities have become an increasingly large presence in our multi-asset portfolios. In the coming years we're hoping to gain access to the country's onshore bond market too, says Johanna Kyrklund, Global Head of Multi-Asset Investments at Schroders.

Across multi-asset, China’s presence in our portfolios has been increasing, primarily via the equity markets (see our latest asset allocation views here). However, it is today still uncommon to invest in onshore Chinese government bonds owing to access issues and China’s underrepresentation in the key global bond indices.

This is likely to change over the next few years as the authorities are taking aggressive measures to open the onshore debt markets to foreign investors, which we believe is a necessary step in order to meet regulatory and transparency requirements for inclusion in the major indices.

China maintains two bond markets:

  • The Interbank Market (CIBM) is an over-the-counter (OTC) bond market regulated by the People’s Bank of China. 90% of total trading volume is processed via the interbank market.
  • The Exchange Market, referring to the Shanghai and Shenzhen stock exchanges which are regulated by the China Securities Regulatory Commission. Only a small percentage is traded on the exchange.

China’s onshore government bond market is now the third largest bond market in the world at about $1.8 trillion. Foreign investors’ market share is around 4% of the China government bond market.

If China is included in the government bond index (JP Morgan Emerging Market Global Diversified index) then its weighting is expected to be capped at 10% due to diversification rules. Other big markets like Brazil and Mexico are also already treated this way. The possible future make up of the index is shown below.

What are the potential opportunities?

  • Diversification. Volatility-adjusted returns stand out among other major asset classes.  The correlation between Chinese onshore government bonds and major global asset classes has been very low over the past decade. In addition, the more stable Chinese yuan plays a key role in lowering the volatility of Chinese government bonds compared to other emerging market bonds.
  • Liquidity. The huge Chinese onshore bond market offers higher liquidity compared with other EM local bond markets. While the average trading volume of onshore government bonds is still lagging that of major developed bond markets, its corporate-bond trading volume is not far behind that of the US.
  • Attractive yieldChinese onshore bonds may continue to offer higher yields than many other major developed market sovereign bonds thanks to China’s independent monetary cycle.

At present, domestic investors are still dominant in the China onshore market and are the biggest contributors to market liquidity; however, the hope is that before long legislation will change, opening the channels for foreign investors to tap into the Chinese bond market.

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Oil price hits highest level since 2014: what next?

The price of oil hit a three-and-a-half-year high after the US withdrew from a nuclear agreement with Iran. Schroder's experts examine the impact and what might happen next.

The oil price continued its surge towards the $80 a barrel level after President Donald Trump withdrew the US from the nuclear agreement with Iran.

He has also imposed tough sanctions which could prevent Iran from selling its oil to the rest of the world.

West Texas Intermediate (WTI), which is also known as Texas light sweet and is a grade of crude oil used as a benchmark in oil pricing, rose to $71.14 on 9 May 2018, its highest level in three and half years. It has gained more than 13% since the start of 2018 and is up 171% since its low of $26.21 on 11 February 2016.

A perfect storm of strong demand and restricted supply have combined to drive up the oil price. Demand has been particularly boosted by the two key markets of China and India as their economies continue to grow.

The constraints on supplies can be seen in oil inventories, which have fallen below their five-year average.

The limitations on future production have been particularly evident in shale oil, which is one of the fastest-growing areas of the industry. With regard to offshore production, authorised projects have now fallen to their lowest number in eight years.

Outside of this given the Organization of the Petroleum Exporting Countries’ (OPEC) unprecedented discipline the situation in Iran will only add to these supply strains.

Can the oil price rally last and how best to play it?

Mark Lacey, Head of Commodities, said: “The destocking in the second-half 2018 and the lack of sanctioned projects that start in 2019, barring a demand collapse, will leave market supply extremely tight.

“However, much of that supply constraint will now be priced into the market, meaning we could be nearing the top of the current rally, which will continue towards $80 per barrel.

“One way to play the oil rally could be to look at oil explorers and production companies.

“Many have committed to increasing dividends and returning money back to shareholders and most have worked out their budgets at $55-$60 a barrel.

“If the oil price were to remain above those levels, then these companies could have plenty of spare cash which they’ll need to decide what to do with.”

What effect could higher oil prices have on the global economy?

Keith Wade, Chief Economist, said: “In terms of broad economic effects, the rise in energy costs will bite into household incomes leaving less to spend on other goods and services.

“Some of this will be offset by stronger spending from the oil producers and companies linked to the industry, but the net effect is a drag on global spending and growth.”

“This could be a particular problem in the US, the world’s largest economy, where the cost of living has already been rising.

“Raising interest rates could help tackle the issue. However, the Federal Reserve faces a tricky task in tightening policy without triggering a sharp downturn, given the time lag between changes in rates and the effects on the economy.”

How might high oil prices affect emerging economies?

The impact on emerging markets will have differing effects on countries.

In general, those markets which are net oil importers, such as India and Turkey for instance, could face a headwind from higher crude prices.

Those which are net oil exporters, such as the UAE and Russia for instance, are likely to benefit.

Together with the overall balance (or imbalance) in each country's economy, the impact can be magnified. For instance, while Turkey is a net oil importer, its economy also has imbalances, including a large and widening current account deficit. As a result, the Turkish lira has come under pressure, exacerbating the costs of importing oil into the country.

What’s the bigger picture for oil?

The price of oil has enjoyed a period of relative stability in recent years. Ahead of the global financial crisis, a booming global economy helped pushed WTI to a high of $146, reached in July 2008.

It had been as low as $17 a barrel in 2001. The average price since the turn of the century has been $63.

Mark Lacey, Head of Commodities, said: “Aside from the recovery in the last six months, the price of oil has been relatively weak in recent years and this followed a sustained period of very strong oil prices, which stimulated a very high level of investment.

“We estimate that the current levels of investment are not sufficient to deliver enough supply to meet annual demand growth of +1.5 million barrels  per day over the next few years.

“The recent increase in oil prices will stimulate investment, but this will take a few years to hit the market, which means that prices should remain well supported above the average cost of production (see chart below).

“The key driver of oil demand remains transportation.  As a result, China and India remain the key growth areas in the short term, as passenger car sales continue to grow at extremely strong rates.

“Longer term, the impact of electric and hybrid electric vehicles will result in oil demand growth rates slowing and then eventually declining; but given the infrastructure constraints, this is unlikely to have an impact before 2030.”

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Why we expect a capex surge in Europe

Tightening capacity and recent underinvestment are among the factors pointing to a sustained increase in corporate spending, show Martin Skanberg, Fund Manager for European Equities, and Stephen Shields, Research Analyst and Fund Manager for European Equities, both Schroders.

Global capital expenditure (capex) is budgeted to grow by 8.3% in 2018, our analysis shows. This marks a significant turnaround; it follows a 0.1% rise in 2017 and a 8.9% contraction in 2016.

These figures refer to capex by listed companies, so they exclude planned spending by unlisted firms and the state. However, combined with our top-down analysis of the drivers of capex, we are confident that they are directionally correct.

What do we mean by capex?

Capex refers to spending on investments or new projects, for example acquiring or upgrading assets such as equipment or property. The point of such spending is to increase a company’s production capacity. Capex therefore tends to pick up at times when companies are confident there will be growing demand for their products, and so reflects their confidence in the strength of the economy.

Why has capex been weak in recent years?

Capex stagnated in the wake of the global financial crisis (GFC), with companies reluctant to invest at a time when economies worldwide were suffering recession. More recently, the end of the commodity boom was another significant factor causing capex to decline, since oil & gas and mining companies have historically made up a significant proportion of total corporate spending.

Europe in particular has seen a slow recovery from the GFC, with economic expansion only really taking hold in the last 12 months.

The chart below shows our capex model and indicates that the past few years have seen a multi-year downturn in capex – the most protracted for several decades. The 2014-16 peak-to-trough contraction in capex across all the companies in the model was 15.8%, or $450 billion.

Chart showing capex expected to pick up

Our model aggregates consensus capex forecasts for thousands of companies across various different end-markets. The 2018 forecasts, showing an expected 8.3% capex increase, incorporate the guidance released by companies at the full year results. With capital budgets typically set months in advance, these should be reasonably accurate.

European capacity utilisation nearing peak levels

An important part of why capex is expected to pick up this year is that many industries are already close to full capacity. The chart below shows the capacity utilisation rate in Europe. This fell dramatically in the wake of the GFC and then remained at relatively low levels during the eurozone sovereign debt crisis. However, the rate is now close to its all-time high.

This indicates that factories in the eurozone are almost as close to capacity as they have ever been. Companies will therefore need to increase capacity and/or efficiency if they want to increase the amount they produce.

There are other factors at play too which could see capex increase in the coming years:

  • Tighter labour markets: when there is a lot of slack in labour markets companies can hire staff cheaply in order to increase output. However, labour markets are tightening across Europe (i.e unemployment levels are falling). This should encourage more companies to invest in equipment to improve productivity, rather than simply hiring new people.
  • Bringing production back onshore: the offshoring wave of the 2000s saw significant manufacturing capacity move from developed markets to emerging markets. This is now partly reversing. With time-to-market a key consideration, many companies now prefer to locate their factories closer to their end markets.
  • Increased automation: advances in robotics make it cheaper to run a facility in Europe with high levels of automation. The underinvestment in the years since the GFC also means that many plants or factories are in need of modernisation, again pointing to a revival in capex.
  • US tax reforms: the tax cuts enacted in the US are expected to spur greater investment. Some European companies with US exposure will benefit from this too.

A long-term trend

The above are largely factors that we would expect to play out over a period of several years. The pent-up demand from a decade of underinvestment cannot be caught up in an instant. In our view, there is no reason why capex cannot continue to grow in 2019 and 2020, so long as GDP growth remains robust.

We see a capex pick-up as being the next leg in the slow European economic recovery. Greater capital spending by corporates is a sign they are confident that the recovery will be long-lasting. Capex should also help to sustain the recovery, given the prospect that QE could be withdrawn in the fairly near future.

What does this mean for stockpickers?

As active fund managers, it is not enough for us simply to identify general economic or sector trends; we must translate that into selecting specific stocks for our portfolio. We can count on an experienced team of European equity analysts to support this process.

We look for industries where the current investment levels look to be low versus “normalised levels” or where there is a structural reason for capex to increase.

  • Automakers are a clear example of a structural need to invest amid the growth of electric and autonomous cars. Our model indicates strong year-on-year growth in capex by the auto and auto parts sector in 2018.
  • Utilities are also under pressure to invest as demand for power remains high and environmental concerns push wind, solar and hydro power up the agenda.
  • Technology is clearly a fast-growing, high capex sector. Google’s parent company Alphabet announced $7.3 billion of capital spending in Q1 2018 alone, compared to the $13.2 billion the company spent in the whole of 2017. Investment in datacentres and networks is critical for Google to be able to handle heavier use of its services.
  • Similarly, telecommunications is an important sector given the need to invest in 5G networks, and a 9% increase is budgeted for 2018.
  • Oil & gas is an interesting area to consider: since the oil price plunged, the sector has shrunk from representing 30% of total capex spend to just 20%. We do not expect capex here to return to peak levels but nonetheless our model indicates an 8% increase for 2018 as the industry does need to invest in order to grow and the recent upturn in oil prices supports this.

Companies increasing their capex may in the short-term see returns to shareholders drop or plateau, as capex takes priority over dividends. On the other hand, the companies who build the new plants, re-tool the factories, and produce the new equipment or robotics should be the short-term beneficiaries as spending picks up. Our task is to discover the most attractive mispriced opportunities in order to deliver the best returns we can.

Any references to securities, sectors, regions and/or countries are for illustrative purposes only and should not be construed as advice or a recommendation to buy or sell.

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Will UK interest rates rise in May?

Forecasts for rates have suddenly shifted. Azad Zangana, Senior Economist at Schroders, answers five pressing questions about the future of monetary policy.

Rate rises are important to many in the UK, particularly those whose wealth is tied to the value of their homes and the mortgage debt they pay on them. A rate rise could have a substantial impact on both, potentially driving down the value of the home while increasing mortgage costs.

It can also have an impact on markets and certain types of assets, which is explored here.

The next UK interest rate announcement will be made on 10 May 2018. The Bank of England (BoE) is trying to raise interest rates, but with the economy slowing and Brexit on the horizon the chances of rates rising sooner rather than later have fallen significantly.

The market is now pricing in a 17% chance of a rate rise in May, having been at 100% on 29 March 2018, after recent data pointed to a more buoyant economic outlook.

More recently, data from the Office for National Statistics has shown that the UK economy almost stalled in the first quarter of 2018 growing by just 0.1 per cent, the weakest quarterly growth since 2012. Furthermore, inflation fell to 2.5% in March, from 2.7% in February. It was the lowest rate in a year.

If growth had remained solid and inflation high then the decision to raise rates would not have been so complicated.

However, the data surprised many, including the Bank of England’s rate-setting monetary policy committee (MPC). It prompted the Bank’s governor, Mark Carney, to reiterate that he didn’t want to get too focused on the precise timing of a rate increase, more the general path.

The BoE raised interest rates for the first time in a decade in November 2017, taking the headline borrowing rate to 0.5% from 0.25%. Through this period of volatile forecasts, the Schroders Economics Team has maintained its view that November will mark the next rise in rates. It expects only one rise in 2018 and two in 2019, with rates reaching 1.25%.

Given the uncertainty Azad Zangana, Senior European Economist and Strategist, answers some of the most pressing questions.

Why wouldn’t the BoE raise rates in May?

Recent data suggests that the UK economy may not have been as strong as previously thought. Bad weather in February and March probably played a role, but the data suggested that there was something else behind the weakness. Rather than take a risk and hike anyway, the BoE is likely to wait to see whether the data improves in coming months.

What effect would not raising rates in May have?

Very little. A hike would have meant a rise in borrowing costs for mortgage holders, and potentially slightly higher interest rates for savers. However, without the hike, borrowers and savers are unlikely to see any change.

When will UK interest rates rise?

We think the next interest rate rise is likely to happen in November 2018, by 0.25% to 0.75%. By then, economic data should have recovered, and uncertainty over Brexit should be lower.

How quickly do you think rates will rise thereafter?

We think we could see two more (0.25%) rate rises in 2019. The economy is likely to gather momentum, and the UK will have departed from the European Union, albeit into a transition phase. While two more hikes is an acceleration compared to this year and last, it is still a very slow pace of hikes compared to history.

What would be the harm in leaving interest rates as they are?

At the moment, there is little harm. However, as the economy continues to recover, the risk of higher inflation grows. Raising interest rates to more normal levels would help slow the economy to a more stable pace of growth, which should reduce the risk that inflation overshoots the BoE’s target. High inflation not only hurts the purchasing power of households, but it also erodes the value of savings.

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Ein stärkerer Euro ist kein Hindernis für steigende Gewinne in Europa

Das verbesserte Preisumfeld in Europa ist einer von mehreren Faktoren, die den Gegenwind einer stärkeren Währung ausgleichen können, so Martin Skanberg, Fondsmanager für europäische Aktien bei Schroders.

Für einige Marktbeobachter war die Aufwertung des Euro gegenüber dem US-Dollar ein Grund zur Sorge. Sie befürchteten, dass dies die Gewinndynamik in Europa abwürgen könnte.

Wir räumen ein, dass die stärkere Währung für Exporteure eine Belastung darstellt, erkennen aber auch zahlreiche andere Faktoren, die ein fortgesetztes Gewinnwachstum in der Region unterstützen können.

Der Euro steigt seit mehr als einem Jahr

Wie die nachstehende Abbildung 1 unten zeigt, wertet der Euro seit mehr als einem Jahr gegenüber dem US-Dollar auf. Trotzdem sind die Gewinne der europäischen Unternehmen kräftig gewachsen. Wir stellen auch fest, dass es sich 2015 und 2016 genau umgekehrt verhielt, das heißt, der US-Dollar war stark und der Euro schwach, ohne dass die Gewinne der europäischen Unternehmen daraufhin gestiegen wären.

Abbildung 1: Der Euro hat in letzter Zeit gegenüber dem US-Dollar aufgewertet

US-Dollar zum Euro – Wechselkurs

Quelle: Thomson DataStream, Schroders, Stand: 8. März 2018.

Unserer Meinung nach deutet dies darauf hin, dass die Wachstumsrate der Wirtschaft ein wichtigerer Faktor zur Stärkung der Unternehmensgewinne ist als der Wechselkurs.

Die jüngste Stärke des Euro ist ein Signal für eine robustere Wirtschaft, und die zugrunde liegenden Fundamentaldaten der europäischen Wirtschaft sind solide.

Obwohl die Aufwertung des Euro das Wachstumstempo der Gewinne je Aktie in der Eurozone ein wenig bremst, wurden die Schätzungen der Gewinne je Aktie in Kontinentaleuropa für 2017, 2018 und 2019 nach oben korrigiert, wie aus der nachstehenden Abbildung 2 hervorgeht.

Abbildung 2: Aufwärtskorrektur der Prognosen für die Gewinne je Aktie

Gewichteter indexierter Gewinn je Aktie

Quelle: Schroders, Thomson Reuters DataStream, Stand: 20. Februar 2018. Die Grafik zeigt die Gewinnprognosen für den MSCI Europe ex UK Index.

Verbessertes Preisumfeld für die Unternehmen

Was ist die treibende Kraft für diese Aufwärtskorrekturen der Gewinne? Unserer Meinung nach ist dies in erster Linie die Rückkehr des Inflationsdrucks in Europa. Wie Abbildung 3 zeigt, ist der Erzeugerpreisindex der Eurozone aus dem negativen Bereich herausgekommen.

Abbildung 3: Der Erzeugerpreisindex für den Euroraum ist nicht mehr negativ

Veränderung über 12 Monate, in %

Quelle: Thomson Reuters DataStream, Stand: 15. Dezember 2017. Nur zur Veranschaulichung – keine Empfehlung zum Kauf oder Verkauf von Anlagen.

Diese Reflation (höheres Wirtschaftswachstum und höhere Inflation) verbessert die Preisgestaltungskraft der Unternehmen, das heißt, sie können die Preise anheben, ohne dass dies zu Lasten der Nachfrage geht. In unseren Augen fällt der positive Effekt dieses Faktors auf die Gewinnmargen der Unternehmen stärker ins Gewicht als die Belastung durch den stärkeren Euro.

Dieser Inflationsdruck ist die Hauptursache für unsere weiterhin optimistische Einschätzung des Wachstums der Gewinne je Aktie in der Eurozone. Die Inflation dürfte weiter zunehmen, da die Kapazitäten in Europa knapp werden und die Arbeitslosigkeit zurückgeht. Wenn die Kapazitätsgrenzen erreicht werden, müssen die Unternehmen entweder expandieren, um höhere Volumen zu produzieren, oder sie können die Preise anheben. Wenn das Angebot an den Arbeitsmärkten knapper wird, können Arbeitskräfte höhere Löhne fordern.

Wir erwarten jedoch nicht, dass die Inflation außer Kontrolle gerät, und stellen fest, dass sie derzeit immer noch unter der Zielhöhe der Europäischen Zentralbank liegt.

Die Gewinne in der Eurozone sind im Jahresvergleich bereits um 23 % gewachsen, wie nachstehend in Abbildung 4 zu sehen ist. Bemerkenswert ist, dass diese Beschleunigung trotz der Aufwertung des Euro erreicht wurde.

Abbildung 4: Die Gewinndynamik hat sich erheblich verbessert

Gewinnwachstum im Vorjahresvergleich, in %

Quelle: Barclays European Equity Strategy. Am 1. März 2018 gemeldete Daten.

Wenn der US-Dollar wieder stärker würde, möglicherweise weil die US-Notenbank die Zinssätze schneller anhebt, als der Markt derzeit erwartet, würde dies die ohnehin solide Gewinndynamik in Europa vermutlich weiter kräftigen.

Die Gewinndynamik wird durch weitere Faktoren unterstützt

Es gibt aber noch weitere Gründe für die Annahme, dass das Gewinnwachstum im Euroraum seine jüngste Verbesserung fortsetzt. Einer davon ist der boomende Fertigungssektor, denn die Nachfrage bleibt robust, während das kräftigere Wachstum in der Eurozone selbst die Gewinne von binnenorientierten Unternehmen stärken kann.

Ein weiterer Faktor ist, dass viele europäische Unternehmen Aktienrückkäufe in Angriff nehmen. Damit folgen sie einem Trend, der in den USA bereits seit langem im Gange ist. Dies sollte die Gewinne stärken, wenn auch vielleicht nicht so sehr wie bei den US-Aktien.

Vor allem aber ist Europa die Heimat starker Marken. Premiumautos und Luxusgüter aus Deutschland, Italien und Frankreich lassen sich nicht so leicht durch billigere Alternativen aus anderen Regionen ersetzen. Das aktuelle globale Wachstumsumfeld ist ein weiterer positiver Faktor, denn starke internationale Märkte können anziehende Preise besser verkraften als schwache. 

Die Einführung von Zöllen auf Stahl und Aluminium durch die USA bringt ein zusätzliches Element der Unsicherheit ins Spiel. Es ist aber noch unklar, wie sich dies auswirken wird. Dessen ungeachtet rechnen wir mit einer Fortsetzung des globalen Wachstums. Unserer Meinung nach kann dies zusammen mit dem verbesserten Preisumfeld, der robusten Binnennachfrage und den europäischen Marken von Weltformat eine anhaltend positive Gewinndynamik in der Eurozone unterstützen.

Schroders hat in diesem Dokument eigene Ansichten und Meinungen zum Ausdruck gebracht. Diese können sich ändern.

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Is the road to inflation taking us back to the 1960s?

by Keith Wade, Chief Economist & Strategist at Schroders.

The 1960s are remembered for radical social reform, political upheaval and war. Often forgotten is that they were also a time of rising inflation – and in this they may hold disquieting lessons for us today.

One of our key calls for 2018 is that consumer price inflation in the US will become an increasing issue for markets. In a turnaround from 2017, when unexpectedly benign inflation helped create a Goldilocks environment for risk assets (not too hot and not too cold), this year we expect prices to surprise on the upside.

Our conviction has been reinforced by recent rises in the oil price. But we also expect “core” inflation, which excludes food and energy, to increase as pressures late in the economic cycle force up labour costs and allow capacity-constrained firms to increase prices more rapidly. Although historical comparisons are never perfect, there are worrying parallels here with the 1960s, when inflation picked up sharply in the second half of the decade.

As in the 1960s, initially low inflation last year puzzled many as it came against a backdrop of a tight labour market, leading to much debate amongst economists about whether the traditional link between unemployment and inflation had broken. It had been clear for some time that wages were not picking up in response to low unemployment and last year’s experience led some to herald the death of the Phillips curve, which says the two should be correlated.

In our view this apparent disconnection reflected a mix of structural factors, such as globalisation and the increasing impact of technology, along with problems in accurately measuring the amount of slack in the labour market.

For example, on the question of measurement, we recently drew attention to the sharp drop in participation rates in the US which began to reverse as more people came back into the labour force. This meant that the low unemployment rate did not capture the availability of labour. Such analysis still holds, but there are limits to how far the US can keep pulling people back into the labour force, a view supported by surveys which show skill shortages becoming ever more acute (chart 1). 

The comparison with the 1960s seems particularly relevant as it was also a period when inflation appeared to be unresponsive to developments in the economy before taking off sharply.  Unemployment fell steadily in the first half of the decade, from 7% to 3.5% by 1968, with little impact on wages or prices. However, in a warning for today, this changed after 1965, when prices picked up significantly and core inflation accelerated 6% towards the end of the decade (chart 2).

One of the triggers for that shift was fiscal expansion as the US pursued the war in Vietnam and domestic expenditure rose to fund the Great Society programme, a set of unprecedented initiatives launched by President Lyndon Johnson to alleviate poverty and racial discrimination. The extra stimulus pushed unemployment down even further, creating a tipping point where wages and prices began to take off.

We are not seeing the same scale of stimulus today, but we do have the same combination of a significant fiscal expansion meeting a late cycle economy. Following the recent Tax Cuts and Jobs Act and the Bipartisan Budget Act, US government borrowing is headed for 5% of GDP by 2019. This expansion in fiscal policy is set to keep demand rising in the US as the economy faces ever tighter constraints on supply (chart 3). 

Two other factors played a part in the 1960s inflation. First, there was a material pick-up in healthcare inflation due to the introduction of the Medicare and Medicaid schemes, which aimed at bringing medical insurance to the poor, elderly and disabled. The rise in prices was broad-based across the economy, but these new programmes contributed significantly by raising demand for healthcare (particularly doctors’ services), with the result that medical care inflation tripled from 3% to 9% between 1965 and 1967. In recent times, healthcare inflation has slowed as a result of cuts in Medicare payments and has been an important factor in holding back the general rise in prices. The risk today would seem to be less than fifty years ago, unless there were renewed efforts to repeal President Barack Obama’s Affordable Care Act.

Second, in the late sixties, the Federal Reserve (Fed) did not tighten monetary policy rapidly enough to prevent inflation from rising and fuelling expectations of further increases, which in turn fed into a wage-price spiral. Some suggest that the Fed was constrained by political pressure to keep interest rates low as the budget deficit rose so as to reduce the cost of financing the war. Whilst geopolitical tensions have been rising between the US and Russia and with China (over North Korea and trade), this time around there has been no attempt to pressure the Fed to keep rates low for patriotic reasons. 

The control of inflation is a greater priority for the Fed and is more firmly embedded in the framework of the central bank. Nonetheless, the Fed could still fall behind the curve and lose control of inflation for a period.

It is often with the benefit of hindsight that errors are revealed. In the late 1960s there was a belief that the unemployment rate could continue to decline when more recent estimates show that the economy was already operating above capacity. Today’s debate reflects the same uncertainty. Some reassurance can be found in the fact that Janet Yellen, who served as Chair of the Board of Governors of the Fed from 2014–2018, continued to raise rates last year, even as inflation surprised and undershot its target. It remains to be seen though whether the new chair of the Fed, Jerome Powell, can show similar resolve as political pressures to keep policy easy will only intensify as we move toward the mid-term elections and the next presidential election in 2020.

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Which stockmarkets look cheap after the torrid start to 2018?

The start of 2018 has been volatile for stockmarkets. Duncan Lamont, Head of Research at Schroders, explains how it has shifted valuations.

Global stockmarkets have just suffered their first quarterly decline in two years. All major developed markets were in the red.

UK equities shed over 7% while Japan was down almost 5%. Even the previously untouchable US inflicted losses on investors.

Only emerging markets started the year with a spring in their step. Since the end of 2016, they have returned around 40% in US dollar terms, almost double the haul for developed markets over the same period.

As winter draws to a close in the northern hemisphere, households are engaging in their annual spring clean. Given recent market moves, now is a good time to do the same with your equity portfolio.

As we have argued previously, valuations can be a very useful tool when thinking about long-term investment strategy. They are next to useless at predicting short-term market movements but for the medium to longer term investor they are an essential part of the toolkit.

To continue the spring clean metaphor, redecorating your house to be constantly “on trend” is an expensive and time consuming task. Trends are so fickle that you may get it wrong anyway.

But valuations are like investing in classic design. The outcome may not always be flavour of the month but it is likely have a longer shelf-life than the latest fad.

Investors nursing losses from the first quarter of the year can draw some comfort that valuations are now looking less extended than three months ago. This suggests a more favourable environment for the long-term investor. However, we’re not out of the woods yet. Most markets, especially the dominant US (which is over 50% of major global equity benchmarks), continue to be expensively valued in at least some respects.

The table below shows a number of valuation indicators compared with their average (median) of the past 15 years, across five different regional equity markets. A description of each valuation indicator is provided at the end of this document. Figures are shown on a rounded basis and have been shaded dark red if they are more than 10% expensive compared with their 15-year average and dark green if more than 10% cheap, with paler shades for those in between. 

Chart of stockmarket valuations

The US continues to look very expensive on almost all measures. But a combination of positive economic momentum and fiscal stimulus could continue to support returns in the near term.

In contrast, Europe looks fairly valued. It is neither especially cheap nor expensive on any valuation indicator other than CAPE (explained below), which looks on the high side. However even here, the current CAPE is only in line with its 20-year or longer term average so this is not unduly concerning. When considered alongside the robust growth story in Europe, this market continues to have some appeal.

The UK is a mixed bag. Share prices look on the slightly expensive side, though not excessively so, when compared to earnings but cheap compared to book value or dividends. The UK’s high dividend yield has always been part of its appeal to some investors. Income of more than 4% clearly has its attractions in a low-yielding world.

However, a note of caution. UK-listed companies have been struggling to afford those dividends. They have been forced to pay out over two thirds of their recent earnings to do so, a much higher proportion than normal. Analysts are also forecasting the UK to have the worst prospects for dividend growth of all those in our analysis over the next two to three years. There may be value but it is not a time to be an indiscriminate buyer.

Emerging markets continue to look reasonably valued relative to developed markets but their strong performance has pushed prices up and the case is weaker than before.

Japan looks the most obvious buy from a valuation perspective but the export-oriented nature of the stockmarket means that it is also more exposed to the rising tide of protectionism and has a relatively weak outlook for earnings growth as a result.

So what would my valuation-based spring clean look like? It would suggest reallocating away from the US, in favour of emerging markets, Japan and Europe. If income is a priority then selective buying of the UK could also make sense. However, none of these are without risk. Markets that are cheaper are so for a reason. In these instances, maintaining a diversified exposure rather than betting it all on that daring new wallpaper you’ve been eyeing up should allow you to sleep more easily at night.

How to value stockmarkets

When considering equity valuations there are many different measures that investors can turn to. Each tells a different story. They all have their benefits and shortcomings so a rounded approach which takes into account their often-conflicting messages is the most likely to bear fruit.

Forward P/E

A common valuation measure is the forward price-to-earnings multiple or forward P/E. We divide a stockmarket’s value or price by the aggregate earnings per share of all the companies over the next 12 months. A low number represents better value.

An obvious drawback is that no one knows what companies will earn in future. Analysts try to estimate this but frequently get it wrong, largely overestimating and making shares seem cheaper than they really are.

Trailing P/E

This is perhaps an even more common measure. It works similarly to forward P/E but takes the past 12 months’ earnings instead. In contrast to the forward P/E this involves no forecasting. However, the past 12 months may also give a misleading picture.

This is particularly true if earnings have slumped but are expected to rebound. For example, UK equities are very expensive on this measure at present, partly because of past commodity price declines and the UK market’s large commodity exposure.

However, commodity prices have rebounded amid an expectation of a profit rise this year. The UK therefore looks very expensive on a trailing P/E basis but less so on a forward P/E basis.


The cyclically-adjusted price to earnings multiple is another key indicator followed by market watchers, and increasingly so in recent years. It is commonly known as CAPE for short or the Shiller P/E, in deference to the academic who first popularised it, Professor Robert Shiller.

This attempts to overcome the sensitivity that the trailing P/E has to the last 12 month’s earnings by instead comparing the price with average earnings over the past 10 years, with those profits adjusted for inflation. This smooths out short-term fluctuations in earnings.

When the Shiller P/E is high, subsequent long term returns are typically poor. One drawback is that it is a dreadful predictor of turning points in markets. The US has been expensively valued on this basis for many years but that has not been any hindrance to it becoming ever more expensive. 


The price-to-book multiple compares the price with the book value or net asset value of the stockmarket. A high value means a company is expensive relative to the value of assets expressed in its accounts. This could be because higher growth is expected in future.

A low value suggests that the market is valuing it at little more (or possibly even less, if the number is below one) than its accounting value. This link with the underlying asset value of the business is one reason why this approach has been popular with investors most focused on valuation, known as value investors.

However, for technology companies or companies in the services sector, which have little in the way of physical assets, it is largely meaningless. Also, differences in accounting standards can lead to significant variations around the world. 

Dividend yield

The dividend yield, the income paid to investors as a percentage of the price, has been a useful tool to predict future returns.

A low yield has been associated with poorer future returns.

However, while this measure still has some use, it has come unstuck over recent decades.

One reason is that “share buybacks” have become an increasingly popular means for companies to return cash to shareholders, as opposed to paying dividends (buying back shares helps push up the share price).

This trend has been most obvious in the US but has also been seen elsewhere. In addition, it fails to account for the large number of high-growth companies that either pay no dividend or a low dividend, instead preferring to re-invest surplus cash in the business to finance future growth.

A few general rules

Investors should beware the temptation to simply compare a valuation metric for one region with that of another. Differences in accounting standards and the makeup of different stockmarkets mean that some always trade on more expensive valuations than others.

For example, technology stocks are more expensive than some other sectors because of their relatively high growth prospects. A market with sizeable exposure to the technology sector, such as the US, will therefore trade on a more expensive valuation than somewhere like Europe. When assessing value across markets, we need to set a level playing field to overcome this issue.

One way to do this is to assess if each market is more expensive or cheaper than it has been historically.

Finally, investors should always be mindful that past performance and historic market patterns are not a reliable guide to the future.

This article has first been published on

Harnessing the information revolution

by Ben Wicks, Head of Research Innovation, and Mark Ainsworth, Head of Data Insights and Analysis, both Schroders.

Modern fund managers are faced with a flood of data that can be analysed in ways unheard of 30 years ago. If they want to stay ahead of the game, they need to channel this deluge and harness its power to generate alpha in new ways.

There was a time when fund managers only had a limited supply of information to deal with – there were companies’ report and accounts, sell-side research and industry data. Processing power was limited to Excel spreadsheets, but that was all which was required to do the work and make the appropriate judgements about how to apply the data.

Things have changed significantly since, particularly in the last three or four years following exponential growth in the amount of information now confronting the investment industry. These developments pose disruptive challenges at the same time as providing a major opportunity for adaptive, well-structured organisations.

There is a vast amount of previously unavailable data becoming exploitable for stockpicking. Examples are too many to mention, but include: web-traffic data, smartphone-related data, open source government data, massive consumer survey data, mapping data and weather data. The industry really hasn’t moved on and learnt to handle information for itself in a way that others have.

We would argue it would be negligent to ignore these alternative sources of data given the potential alpha to be found within.

Channelling the data deluge

So what is driving this data deluge? Firstly and primarily, it is the ever-pervasive process of digitalisation that is happening. Transactions between consumers and businesses, and from businesses to businesses, are increasingly digitised and visible for subsequent analysis at an aggregated and abstracted level.

Secondly, it is the growing transparency demanded by public markets, especially in the West, but also increasingly across emerging markets. Government to business interactions are subject to increasing disclosure, for example. Thirdly, the increase in computing power is playing a key role as costs for storing and processing the data continue to tumble.

From the perspective of fund managers, it’s no longer sufficient to manage this data without taking a systematic approach and bringing in coding and data engineering skills to create a “Big Data” analytics capability. In our opinion fund managers which invest properly in this area will benefit from an “information edge”.

Far from creating a level playing field, where more readily available information simply leads to greater market efficiency, this information revolution is having the opposite effect.

To be effective, a capability will go beyond that currently available market data, to discover new sources of alternative information that the market may not be collectively aware of. Secondly, it will need to find a way of making sense of the data and serve up insights for fund managers to apply their judgement to. This is not about replacing managers, it’s about enabling them, which is why working in partnership needs to be the third key plank of any capability. Without understanding the questions that the investment teams are seeking to answer, it won’t be possible to know where to apply the data science.

Here at Schroders we’ve set up the Data Insights Unit (DIU) which employs over 20 data scientists from a variety of backgrounds and industries. We have delivered concrete evidence of successfully using Big Data in support of fundamental research.

Practical applications

One early such example related to the merger of UK gaming groups Ladbrokes and Coral. At the time the merger was announced Schroders had a significant holding in Ladbrokes. The key question for the investment team was how many stores would need to be divested for the competition authorities to allow the merger to continue. Initial views from sell-side analysts were between 100 and 1,800 stores out of a combined estate of 4,000 – clearly insufficiently precise for an analyst to recommend to a fund manager what the merger might mean for Ladbrokes.

However, working in collaboration with the investment desk the DIU was able to identify the correct data source which might hold some answers. It was then our job to compute the data to establish how the competition rules might play out for each individual betting shop. That involved calculating the distance of every store to every other store – through 70 million permutations, which is not something you can do on an Excel spreadsheet – and over the course of the day we came to the conclusion that 400 stores would need to be sold. A year later the regulator came out with their initial judgement for the disposal of 350 and 400 stores.

Some of the very large datasets available, such as large samples of web-browsing histories from around the world, would be impossible to combine with legacy analytics technology. They demand the use of newer cloud computing techniques and more agile data querying methods. Sometimes this data can be text, rather than numbers and there is significant demand from our fund managers to bring unstructured, very obtuse data to heal. This might include an analysis of company patents, which are last on their reading list given there are hundreds of thousands issued in large Western countries in each year alone.

Patent data is extremely messy, yet quite important to understand given that companies will typically spend 5% to 10% of their sales on research and development (R&D). Semantic analysis is required to compare the text in every patent with every other patent in order to group them by type, which is relatively quick to do with cloud computing.

The graphic below illustrates the various type of patents launched by an auto manufacturer since 2008 covering five “buckets”, ranging from fuel cell systems to advanced driver assistance systems (ADAS). This cannot be achieved through simple search as raw patents are complex and poorly indexed documents. While not shown here, the real power is comparing this data across a number of auto manufacturers to help identify where they’re focusing their R&D efforts going forward.

Advantages of scale

Other industries have been faster to adapt to this new world than finance which has come to heavily rely on the information provided via their terminals. Fund managers have not learnt to handle things for themselves in a way that the pharmaceuticals sector has, for example, and this is why any new “Big Data” analytics capability will need to draw on expertise outside of the industry.

This should also have the benefit of bringing in new ideas and innovative ways of doing things, plus a network effect – connecting people from diverse industries makes it easier to identify key hires.
In our opinion, the large traditional fund management firms have a significant advantage over both smaller firms and hedge funds when using Big Data to support fundamental research. This is because they already have a large body of well-informed analysts, meaning hypothesis-generation can be better informed and more reliable. Understanding the key question that matters to a particular company at a particular time is complex, and can only really be framed by an analyst with intimate fundamental knowledge of the company or industry. The combination of powerful question-generation with powerful data-exploitation to answer the question is stronger than either aspect alone.

Using Big Data to support fundamental research should increase transparency of an investment process, in our opinion. It should be easier to track whether a hypothesis is failing or working if there is more data available to measure and base the conviction upon.

Certainly there are risks, such as attributing too much certainty to insights from innovative datasets that are not necessarily fully understood. Very large and alternative datasets are often less precise or clean than traditional "market data" because the information may be emanating from organisations or facilities whose primary purpose is not the provision of clean, holistic, data to stockmarket participants. But when appropriate confidence intervals are applied, then the benefit of having additional information to consider is always additive.

Organisations that successfully adapt to this data-heavy world will have a mindset of innovation and collaboration. They will also be large enough and have sufficient technological prowess to compete. Those that do evolve, and that remain agile enough to avoid the pitfalls while embracing continuous change, will be in the best position to offer their clients sustainably differentiated returns.

This article has first been published on

Is a pivotal change in the Chinese economy hiding in plain sight?

With China’s economy quietly entering a new era, there has arguably never been a more exciting time to be a stockpicker in Asia, says Matthew Dobbs, Fund Manager, Asian Equities & Head of Global Small Cap, at Schroders.

Well, just possibly, Liu He is the most important economic policymaker in the world. In a formal sense, he has no more impressive a title than “Economic Adviser” to China’s President Xi Jinping, who has just given himself an open-ended grip on power over the world’s second biggest economy.

He (Mr Lui that is, pardon the pun) may, or may not be the “anonymous person with authority” who wrote an article in the People’s Daily in May 2016 articulating the need for structural reform. But we do know that he was accorded the considerable honour earlier this year of being the only keynote speaker at one of Davos’ main sessions who was not a national leader.

Has China’s change gone unnoticed?

It is often the case that seismic change in China comes without some great declaration from the metaphorical heights of the Forbidden City. A small experimental commune in Chayashan, Henan province, was the early warning of the catastrophic Great Leap Forward. Similarly the obscurely named “May 16 Notification” of 1966 was the harbinger of the Cultural Revolution.

In the late 1970s, few realised that the snappily named “Household-Responsibility System” marked the start of key agricultural reforms that marked the beginning of an astonishing economic transformation of the Middle Kingdom.

We would argue that the evidence suggests the article of 9 May 2016 may well be an equally pivotal moment. Hopefully a harbinger of a benign change in China’s economic direction.

It is perhaps germane to recall the gist of the article, as reported by Reuters.

“China may suffer from a financial crisis and economic recession if the government relies too much on debt-fueled stimulus, the official People’s Daily quoted an “authoritative person” on Monday as saying.

“The People’s Daily, official paper of the ruling Communist party, in a question and answer interview quoted the person as saying excessive credit growth could heighten risks and trigger a financial crisis if not controlled properly.

“Trees cannot grow to the sky. High leverage will inevitably bring about high risks, which could lead to a systemic financial crisis, negative economic growth and even wipe out ordinary people’s savings,” the person, who was not named, said in response to a question on whether stimulus should be used in future economic policy.

“We should completely abandon the illusion of reducing leverage by looser monetary conditions to help accelerate economic growth.”

This time they’re serious

So are these more than pious platitudes to placate the many foreign critics (amongst whom we number ourselves) of China’s credit-fuelled growth model?

It is easy to be cynical, but the hard evidence would suggest that the authorities are serious about rebalancing growth. That is, away from its dependency upon ever larger dollops of mis-priced capital to mobilise resources (ghost towns, roads to nowhere, white elephants) and towards greater productivity, better returns on capital, and more rational pricing of that capital.

In the first place, it is clear that China is steadily tightening monetary conditions, as seen in monetary conditions indices and the recent course of interest rates, leading to a more rational pricing of capital (see Charts 1 and 2 below).