Following the Caritas Guide to Finance article on investment styles last month, Virginie Maisonneuve picks out some key themes for 2011 and beyond
The year 2010 has been one of transition as the developed world painfully rebounds from the abyss and starts to settle into the ‘new normal’ environment. This is a world in which the developed market continues to slowly deleverage and that brings fiscal discipline into an economy with high unemployment and low trend growth. It is also a bipolar world where emerging markets take an increasingly large role in the global economy, supported by global demographic trends.
Focus on long-term structural growth trends
In an uncertain environment, investors must expand their time horizon in order to take advantage of volatility to buy quality companies opportunistically and build strong long-term portfolios. It is important to anticipate the impact that long-term trends will have on companies’ earnings in the future (and, importantly, the sustainability of those earnings) in order to identify growth gaps, or pockets of growth, that will surprise the markets. This allows patient investors to buy targeted companies at attractive valuations.
We believe three key themes continue to mould the global investment environment: the ‘supercycle’, climate change and demographics. The first theme was the most powerful this year, but all three continue to shape the future.
The financial crisis has born witness to the strength of emerging market economies whose strong demand has provided the momentum for a global recovery. Emerging economies represent over 50 per cent of the global economy on a purchasing power parity basis. Moving forward, as they grow stronger, their industrialisation, urbanisation and thirst for oil and resources will become key sources of demand.
China is the world’s biggest importer of raw materials; it now comprises 45-50 per cent of global copper demand and is the main driver of demand growth for this commodity. This provides investors with big opportunities; given that copper supply is restrained, strong Chinese demand is driving copper prices to very high levels.
Some of these large emerging market economies have reached a ‘sweet spot’ in their development where they can increasingly rely on domestic demand to support their economic growth. As a stronger middle class develops, the long term demand for resources, energy and key industrial products will continue. See Figure 1.
Structural adjustment underway?
A potential risk in 2011 is the inflationary impact of the latest round of quantitative easing on emerging markets. For some time now, inflationary pressures in China have built up, which may be structural. Increases in per capita income have spurred diet changes such as eating more meat and vegetables. This has put pressure on food prices at a time when arable land in China, because of continued urbanisation and to some degree climate change, has not grown. This structural food inflation is compensated by other price weaknesses in the economy so we should not yet fear excessive overall inflation. It will, though, continue to worry the Chinese government.
The combination of negative real interest rates in China and the inflow of ‘hot money’ into the country has led it to take a series of rapid moves with interest rates and reserve requirement increases. The potential headwind for the global economy is the fear that China now might over-tighten and ‘ruin the party’.
We believe such fears will bring short term volatility in the markets but that this headwind is likely to be temporary. It will give the opportunity for global investors in search of quality companies with sustainable competitive advantage to buy holdings across the world, including emerging markets, at a good price.
(2) Climate change
Climate change is one of the most important challenges facing the world today and is presenting investors with an abundance of opportunities for the near, medium and long term. We see climate change-related issues as driving the next industrial revolution and believe they will provide a key source of innovation for the global economy.
On the global agenda, climate change has gone relatively quiet for a couple of years but we expect it to re-emerge next year. 2010 brought us highly disruptive weather patterns and record global temperatures: average temperatures in July were the warmest since 1860. Furthermore, disappointing harvests in Europe, Russia, Australia and parts of North America combined to send agricultural commodity prices soaring over the summer.
It should be no surprise then that climate change concern has been increasing globally. What is much more surprising is that concern is now much higher in emerging economies than the developed world, perhaps because of the higher vulnerability of these economies to climate change. See Figure 2.
Low growth for complacent companies
Public concern has been matched with political action. Measures to tackle climate change have been given a significant boost as many of the economic stimulus plans have included significant financial backing for green initiatives. China now accounts for around 25 per cent of global emissions (the equivalent of emissions from the UK, Australia, Spain, the Netherlands, Italy, Germany, France, Brazil and Canada combined) so it is important its government is making significant changes.
Energy efficiency and a shift to low emission energy are key pillars of China’s twelth five-year plan. India and Korea have also introduced major clean energy investment initiatives to drive growth in low carbon industries. Climate change investment has shifted to who will gain most from the rapid global growth in industries such as solar power, LED lighting and electric vehicles.
No one wants to be left behind, including the US, which has subsidised electric vehicle producers by several billion dollars. Companies that are not aligned with this shift can be expected to increasingly experience lower growth and tougher global regulation.Adaptation is also important. Even if the world’s governments and companies are successful in managing the global transition to a low carbon economy, approximately two degrees of global warming seems inevitable.
This will have a negative impact on agricultural yields, potentially pushing up food prices globally. Droughts and flooding around the world are already reducing the amount of arable land globally. Given this trend, we believe there is also an opportunity for companies aiding agricultural productivity, from those supplying irrigation systems to those selling fertiliser and crop protection products.
Combining with the above trends is the rapid shift in global demographics. Many countries are at tipping point. With labour forces in Europe and China peaking in 2010 and 2015 respectively, the case for reforms will continue to increase while emerging market consumption trends will not abate. This might even lead to further social pressure in Europe in 2011 and reinforce China’s goal to promote domestic consumption further.
Population growth over the next 40 years will be huge as the world reaches nine billion people in 2050. Powerful shifts in population growth, ageing and urbanisation provide compelling long term opportunities for companies in a variety of industries. Importantly, the source of growth arising from the global consumer will shift dramatically as marginal income dynamics adjust in accordance with wealth and spending patterns at different stages of life. Overall, although the global population will grow dramatically, the world is getting older at a rate unprecedented in its history. Europe, for example, is currently the world’s oldest continent with a median age of almost 40.
Overall population decline in Europe will begin in the next 10-15 years. For the working population, this could begin as early as 2010. Currently, dependency ratios are relatively similar across the region, but will diverge over the next 40 years, ranging from under 38 per cent in the UK to over 62 per cent in Italy (see Figure 3).
In the absence of major fiscal reform, the impact of ageing on government budgets will be substantial, especially in terms of the cost of public pensions, health and long term care. It also provides opportunities for investors. For instance, as the population ages, the types of goods and services in demand will change: older people will spend more of their income on food and, as they become more health-conscious, nutritious and local produce will win out over fast food or eating out.
Evidence suggests that older people also tend to spend less on clothing, furniture and entertainment, but more on home help, books and utilities. While this section of the population spends less on public transport and buys fewer cars, it is the main consumer of package holidays and cruises.
It perhaps goes without saying that healthcare is the net beneficiary of an ageing population, while education loses out. Our proprietary research suggests that spending on healthcare will grow twice as fast as most other areas from 2010 and will be particularly concentrated in areas such as dialysis, orthopaedics and treatments for age-related disease (heart disease, strokes, dementia and so on). As governments attempt to contain healthcare costs with stricter regulation, demand will shift towards generic drugs.
The financial sector could also stand to benefit from this trend as public pension reforms will necessitate and encourage private saving for retirement. Life insurers, asset managers and financial advisers are all well-placed – especially those targeting older customers by offering annuities and equity release products.
Demographic dynamics within emerging markets
A large portion of the growth in the population worldwide over the next 40 years will be concentrated in some emerging market economies. By 2050, over 85 per cent of the world’s population will live in emerging markets. China and India are, in particular, set to experience dramatic levels of population growth over the next 40 years – a quarter of the growth of the entire world. However, how both of these key countries arrive at these levels – and the opportunities for investors – differs significantly.
India’s population is forecast to continue to grow over the next 40 years, albeit at a gradually slowing rate. By contrast, it is estimated that China’s population growth will peak in 2030 and gently decline thereafter. We predict that healthcare will be the fastest growing sector in China as household spending on health by people over the age of 60 is twice that of consumers in their 20s and 30s.
Meanwhile, India will enjoy a demographic boost during this period as a large group enters the most economically active period of their lives. This will have a profound effect on discretionary spending in India, which is generally unappreciated by today’s investors.
Rapid urbanisation in some of those rapidly growing countries creates clear challenges and opportunities for governments and investors respectively – although these may differ from country to country.
Infrastructure spending will necessarily increase to facilitate the expansion of transport networks and housing. Between now and 2025, China will pave up to five billion square metres of road and add around 28,000km of metro rail. To provide homes and offices for its new 350 million urban inhabitants, China will build almost 40 billion square metres of floor space, adding a number of skyscrapers equivalent to ten New York cities.
Clearly, the way to benefit from such demographic trends is to find companies which have identified the source of marginal income growth and can cater to them. Those companies can equally be based in emerging or developed markets. As global brands become more well known and more affordable in emerging markets economies, some global companies are benefiting very strongly.
Impact of these trends
Understanding how companies’ earnings can be affected by the challenges and opportunities presented by long-term structural trends is essential when analysing their operating environment. Awareness of the potential long term implications of the way our world is evolving helps us distinguish strong leadership and vision in management teams and to find those companies that are best positioned to deliver strong earnings growth in the future.
Virginie Maisonneuve is head of global and international equities at Schroders.
Prior to this she held various fund management positions and was a consultant with the French Ministry of Foreign Affairs in China.
She is a CFA charter holder, has an MBA from the Ecole Superieure Libre des Sciences Commerciales Appliquees (ESLSCA), an MA in Mandarin Chinese and a BA in political economy.Read more articles by this author