A strong policy response to financial stability concerns

Quarterly Investment Forum 1Q 2023

Macro

Macro and markets outlook

Nicole Goldberger, Head of Growth Multi-Asset Portfolios

We are more optimistic on the global economy than consensus. 2022’s headwinds have turned into tailwinds for 2023. Global activity has been accelerating. China is leading the way with its reopening, the end of the tech regulatory campaign, and much more support for the property sector. Europe is rebounding after getting through the winter in a much better position than feared. And the US labor market continues to hold up, with lower gasoline prices providing some support for real consumer spending. While the tightening lending standards from recent bank stress will weigh on growth, we think the strong backdrop for the economy and recent easing of financial conditions will cushion economic activity.

Composite purchasing managers’ indexes are inflecting higher. As recently as November, only 2 of the 14 major economies we track had PMIs above 50 and rising on a three-month basis. In February, that number sits at 12 of 14, pointing to a more synchronized global growth recovery.

This resilient economy is not a good-news story for all asset classes, so we think volatility should persist. We are more optimistic on the economy than we are on stocks at the index level. A solid economy and tight labor market means that inflation will be sticky. This may leave Federal Reserve on track to keep interest rates higher for as long as is necessary to bring about more cooling in wage growth. This will likely weigh on valuations for expensive US large-cap equities, which have a high share of longer-duration growth stocks.

We prefer being invested in equity markets that are cheaper, where policy is easing rather than tightening, where inflation is low, not high, and where growth is rebounding the most strongly. In our view, China is the most attractive macro story, so we are most constructive on Chinese equities as well as broader emerging market stocks. We expect China’s reopening to be primarily service-sector oriented, with some positive spillovers to other emerging markets.

The higher starting yields mean that fixed income is back on the menu as an attractive asset class. In particular, short-term US investment grade corporate credit stands out to us as a way to get a solid coupon with relatively low duration risk and less downside risk than global equities. We also favor emerging market hard-currency debt for its all-in yields.

Investment opportunities

Green spending & reshoring: Investment opportunities

Ellis Eckland, Active Equities
Alex Leung, Infrastructure
Andrew Farnell, Active Equities

Energy transition

The energy transition may be the biggest investment opportunity in history. History shows that energy usage grew rapidly during the 21^st century. But during this period, no energy source was ever replaced – new sources were layered on top of older ones, and grew until they surpassed them. It took 150 years for coal to supplant wood as the most common energy source, and just 50 years for oil to become more dominant than coal.

The energy system of the future calls for use to largely replace oil, gas, and coal in just 30 years, much faster than other transitions. We are in a thirty-year period of massive investment concentrated around the following themes:

Renewable electricity: to build this out, we need to address supply chain constraints. The world needs much more copper, silver, rare earths, lithium, iron, and steel – this is the biggest bottleneck, since building new mines takes a long time.
Advanced biofuels: these may be the future of air transportation.
Hydrogen: industrial processes that require high heat, for instance in making steel or cement, are critical to building out renewable energy sources.
Carbon capture: we are heading to “net” zero, but will still be using fossil fuels. By 2050 we need to capture roughly 25% of what we emit today. There’s been a little investment in this space now; we will need a lot.
Grid stability: a grid system with massive renewables – which are intermittent/unstable sources of energy – will need to be stabilized by the likes of batteries as well as artificial intelligence applications to predict load.

Inflation Reduction Act and implications

The US’ Inflation Reduction Act will help augment this energy transition. This legislation has three key features: First, it covers a 10-year period, which will make it easier to invest compared to the past when tax credits were extended year-by-year in a piecemeal fashion, or not at all. Second, the scale and breadth of tax credits and subsidies, along with a superior financing model, should lead to substantially more clean energy infrastructure investment. Third, it has a heavy element of industrial policy: there is a focus on shoring up the domestic US clean energy supply chain, manufacturing, and onshoring.

For infrastructure investors, a lot of the near-term opportunities will be in traditional renewables like wind and solar. Other technologies may take more years to establish themselves before they receive as much investment – it won’t come overnight, but will come eventually. And as the old adage goes, it can be better to sell a shovel during a gold rush, so we’re also looking at potential adjacent opportunities created by this clean energy boom.

Opportunities in Electrification

Electrification is one of the primary vectors that facilitates decarbonization – electricity needs to go up a lot as a share of the total energy mix.

It’s also important to bear in mind that if electricity is wasted in buildings that have not been modernized, the impact will be much less. The European Commission estimates that the EU renovation rate needs to double, at least, in order to make the building stock more energy efficient. So far, investment in energy efficient buildings is rising globally, but not close to levels that would be consistent with a net zero scenario.

In the EU, harmonized standards are removing barriers to investment. The private sector is recognizing the value of modernized office buildings, as well: there is a rising premium for sites that have had an energy-related renovation.

The alignment of public and private interests makes this a powerful investable theme. In public markets, there are a lot of ways to gain exposure to this dynamic in capital equipment, semiconductors, automation, construction materials, and equipment rental companies.

Behavioral finance

Behavioral biases & how to tackle them

Matthias Uhl, Analytics and Quant Modeling
Sonia Dobosz, Active Equities
Chirag Maru, Fixed Income

Behavioral biases help explain why markets aren’t perfectly rational and efficient. Some common biases that lead to inefficiencies include: Herding (following the crowd, which causes investors to buy at a top and sell at a bottom), loss aversion (a preference for avoiding losses over making gains, which can lead to misjudging risks or not taking risk appropriately), and anchoring (prioritizing old information too much, which can result in holding onto a losing position for too long).

To minimize the impact of behavioral biases, it is important to follow a well-defined investment process with clear rules – and follow those rules no matter what. For instance, this means if markets are in a stressed condition, sticking to the plan for how to deal with an unforeseen situation. In addition, teams can use analytics to identify their propensity for biases and learn from this.

Quantitative indicators add more objectivity to the investment process to avoid biases. These tools are reactive by design – relying on information that is already in the market. This means they have a price, trend, or momentum element, which helps address anchoring and confirmation biases.

This is what we do in Investment Solutions, using our three-pillared approach of macro, valuation, and behavioral factors to make decisions with a consistent process.

We can also drill down into the details of a portfolio manager’s decision-making process to analyze his or her propensity to fall prey to behavioral biases. The value added by a portfolio manager can be explained in terms of three factors: what to buy and when, what to sell and when, and how big to size positions. We can isolate and measure each of these skills. The “sell skill” and “size skill” dimensions are ones in which the biases of anchoring, loss aversion, overconfidence, and regret aversion can creep in – and once identified, can be corrected. Of course, measurement of these skills is a challenge. Data consistency and completeness is critical, and you need to be very careful when assessing one-time, unexpected events that may result in a huge move in portfolios but are not the result of a behavioral bias.