20 Questions for 2020, our convictions, your resolutions.
What does 2020 have in store for us?
This is THE big question you are all asking at the moment. This is also the question we are going to ask 20 of our specialists, throughout the month of December to help you with your investment decisions and share our core convictions with you.
Every day, we shall be presenting a key subject that matters to you.
Every day, we shall provide an answer.
Has calm been restored?
- 2019 was marked by a significant slowdown in global growth.
- Our scenario for 2020: no recession, despite a slowdown in economic activity in the US and in China and sluggish growth in Europe.
- Although there are still grounds for uncertainty, their nature is likely to change: the election year in the US will be watched particularly closely.
- Against this backdrop, our core convictions for our portfolios are as follows:
- Overweight equities vs bonds;
- Profitable investment themes over the coming months: value and cyclical stocks, certain emerging debt segments and gold as a core portfolio holding;
- Mega trends should continue to outperform over the long term.
- Selectivity, conviction and flexibility will be our watchwords throughout the year during 2020
Central Bank Addicts
In its hit track 'Golden Brown', the British rock band 'The Stranglers' reminds us of the obvious: "No need to fight / Never a frown with golden brown." As the year draws to a close, it must be said that the financial markets were unable to withstand the 'golden brown' of central banks. On average, asset classes generated returns approaching 9%, one of the best years since 2012. And all this despite - excuse me for a moment - the economic slowdown, a near-recession in manufacturing, trade in the doldrums, and confused negotiations between Donald Trump and China. In short, such a synchronized performance of asset classes is inexplicable without reference to the massive intervention of central banks.
Never since the Great Financial Crisis have central banks lowered their key rates so quickly. After raising its benchmark rate four times in 2018, the US Federal Reserve made a complete about-face, with three decreases during 2019. The European Central Bank, which was expected to raise rates after the summer, lowered its deposit rate to a record low of -0.50%. The central banks of Australia, New Zealand, Switzerland, China, Mexico, Brazil, Indonesia, Turkey, Russia and even South Africa have all lowered their rates.
And as if this was the previous time, central banks injected massive amounts of liquidity. The Fed halted its balance sheet reduction, launching a monthly T-Bill purchase program of nearly $60 billion during the quarter. The ECB has also relaunched its €20 billion monthly bond purchase programme. After an attempt to overcome the dependency, the brown gold is flowing for the next few months. "Every time, just like the last / ... To distant lands / Takes both my hands / Never a frown with golden brown."
So much liquidity, but to what end? Since the 1970s, the principal mandate of central banks has been to control rising inflation. Since 2008, it has also been a question of controlling deflation. While financial markets have responded well to this monetary easing, inflation rates have remained oblivious. Since 2013, average inflation in the Euro zone has failed to reach 2%. In Japan, inflation rate is near zero. As to inflation expectations, the picture is not much more flattering: 5-year inflation expectations have reached their lowest point in the Euro zone at 1.10%, and 1.80% in the United States.
Should one conclude that central banks are inefficient?
Criticism and reduced independence
These mixed results have subjected central banks to strong criticism. Low rates are already a topic of debate, with the ECB subjected to the strongest criticism. By lowering its deposit rate, the ECB has caused a general decline in interest rates across Europe. Fifty percent of the Euro Aggregate bond index is in negative territory. This is a problematic situation for investors who - like French insurers or Dutch pension funds - have been very critical. This situation could jeopardise the ability of the European financial system to maintain pension levels. Commercial banks are also raising their voices. Caught between increasingly elaborate regulation and negative rates, their profitability is under strain. These effects are all the more worrying because by lowering rates below the psychological threshold of 0%, markets have begun to wonder whether the ECB can ever return to positive territory.
Additional criticism comes from the United States concerns the lack of central bank coordination. In 2018, the Fed was the only one to embark on a tightening cycle. Traditionally, the Fed has been followed by other developed central banks. But the causality has changed. Because the ECB and the BOJ, among others, are extremely accommodative, the Fed's room for manoeuvre has shrunk. The Fed is no longer independent from the rest of the world. All this has led world leaders to voice strong criticism of monetary policy - something not seen in 20 years.
Never give up!
Faced with low inflation, policy criticism, and policy limitations, central banks must reinvent themselves. Some options remain open to them.
First, they could adjust their mandates by making the inflation target either symmetric, or long-term. They could also integrate the management of financial conditions as an objective, which would provide a legal framework for the various quantitative easing programmes and offer more flexibility for their actions.
Another option would be to support governments by using negative rates for budgetary purposes. If France continued to borrow at negative rates (-0.50%) it could reduce its debt ratio by -40% in 30 years. A Maastricht counter-revolution to reach 60% without reducing its deficit!
Finally, the integration of climate risk could alter the situation. By facilitating the financing of virtuous activities, central banks would change their paradigm. The ECB could thus define common criteria for integrating climate risk management in the financial sector. It could also adapt its programme for purchasing financial assets dedicated to green investments, providing substance to the new Commission's stated plan.
"Never give up" was Mario Draghi's last message before leaving the ECB. While central banks seem to have reached their limits, the big question of 2020 is whether they will successfully reinvent themselves and make a comeback in the face of widespread criticism. The question in the coming years is therefore less to predict the general level of rates than to anticipate the evolution of their political mandate. Their future is also our future.
The central banks are dead. Long live the central banks!
Source: Bloomberg, Candriam
Global debt has been on the rise since 2008 -- but EM corporates remain healthy
Global borrowing has risen significantly since the financial crisis. Pre-Lehman global debt stood at $178 trillion; this has grown to around $246 trillion, a staggering 320% of Global GDP.
Breaking this debt into components shows developed markets government borrowing rose from 71% of GDP pre-crisis, to 109% now. The corporate sector has seen an even more rapid growth rate, rising from 70% of global GDP pre-crisis to a record high of 92% of GDP now – and of that, it has been emerging market corporate borrowing which has grown most rapidly.
Post-crisis debt growth mainly from DM Sovereigns and EM Corporates
Source: IIF, BIS ,Candriam
Can this Great Wall of Debt still stand? We see a bright spot in the emerging market corporates. In the post-crisis world of record low interest rates, there has been an almost insatiable demand from investors for yield, generating demand for corporate bonds. With minimal and often negative yields for DM government bonds, EM corporates are of increasing interest.
For corporate borrowers, bond issuance, when possible, can be much more attractive than bank loans. The graphs merely hint at the major change in funding patterns by global corporations. The supply of bank loans has weakened as developed market banks improved their capital ratios following the financial crisis. Figures 1A and 1B show how financials have deleveraged during this decade of rising debt. The bond market now plays a much larger role in corporate funding. Bonds offer clear advantages to corporates relative to bank borrowing, such as fixed rates instead of floating, generally longer maturities, and usually much less restrictive covenants than bank loans.
How should we view these statistics?
Emerging market external corporate debt, excluding financials, reached $1.123 trillion at the end of 2018. If bond issuances of financials are included, the external stock of emerging market corporate bonds stands at $2.7 trillion.
China has dominated this growth in EM debt. Chinese external corporate bond stock excluding financials now stands at $270 billion, or around 25% of total emerging market ex-financials.
But should we perhaps exclude China when we analyse aggregate EM figures? China has a non-bank lending market which rivals that of the US. Including financials, bank loans, domestic debt, China’s non-sovereign debt comes to a whopping $8.3 trillion, or 304% of GDP. Those are developed market types of figures. China's GDP is roughly five times that of India, and more than the GDP of India and the next ten EM nations combined. Even a tiny change in data from China skews overall EM statistics.
Source: IIF, BIS, Candriam
Solid credit metrics in EM corporates
As an asset class that can deliver risk-adjusted returns and diversification for portfolios, we welcome the growth in the emerging markets corporates universe.
Leverage and interest coverage ratios continue to be better for EM corporates than for equivalently-rated DM corporate issuers. We see no evidence of a broad deterioration in credit fundamentals across the larger emerging market corporate issuers, despite the rise in bond issuance. We think EM corporate debt loads ex China are comfortable, especially if rates remain low and markets remain free and open.
Emerging market economies now have better external fundamentals than they did a decade ago. They enjoy improved current accounts, larger foreign exchange reserves, and better macroeconomic buffers to weather storms in the global economy. Of course leverage increases vulnerabilities and may exacerbate downturns. A deep global recession could pressure the most highly indebted companies in both developed and emerging markets, and even create global systemic risks. For emerging market corporate issuers the largest risks would be a serious global economic slowdown, a strong surge in the USD, or a potential increase in risk aversion.
Emerging market corporate issuers have been quite proactive in pre-funding, enhancing their ability to ride out the next downturn. The Bank of International Settlements estimates that 80% of the proceeds of emerging market bond issues remain in cash 12 months post issuance. This demonstrates a prudence amongst issuers, who are building balance sheets in good times, so as not to be overly dependent on future financial market conditions for re-financing.
Currency exposure is also well managed; EM corporate issuers are actively aware of foreign exchange management when borrowing in USD. The majority generate hard currency revenues, producing natural hedges. Of the others, most have at least partial financial hedges in place, while some operate in jurisdictions where pegged currencies limit FX repayment risk.
Overall, the EM credit universe remains firmly investment grade. This is despite the notable growth globally in lower-quality ratings. The often-cited BBB segment, a significant risk in US corporate credit markets, has remained static at 40% of emerging market corporates. The B category has grown in both DM and EM, and we view this area with caution. For EM debt, the change in ratings composition over the last decade has been due to the greater access of emerging market issuers to international markets.
For us, emerging markets outside of China remain a bright spot, even as we view the large buildup of global debt with some caution. Our approach to emerging market credit places a strong emphasis on issuer selection, emphasizing issuers with low refinancing risk, strong asset coverage, and preferably in industries whose geographic revenues provide natural currency hedges.
As 2019 draws to a close, growth in the US will be positive for the 10th year in a row, which is the longest continuous period of expansion recorded since the mid-19th century. Over the past few years, the unusual length of the cycle has regularly instilled fear of an imminent recession among many doomsayers. Their rationale is based on a simple premise, i.e. the longer the period of expansion continues, the higher the risk of it ending. This logic is flawed, however, as Janet Yellen highlighted a few years ago, when she stated that “expansions do not die of old age”.
This year, however, fears of a recession in the US have been fuelled not only by the risk of the cycle running out of steam, but also exacerbated by trade tensions, coupled with a slowdown in economic activity in China and the rest of the world, amid heightened geopolitical uncertainties. These persistent threats, combined with fresh risks arising and the exceptionally long cycle, are highly likely to revive fears of a recession during 2020.
Although traditional macroeconomic analysis pinpoints sources of instability, including widening imbalances and asset price bubbles, and also highlights potential shocks which could tip economies into recession, such as a trade war or restrictive monetary policies, it nonetheless provides no objective gauge of the risk of recession. To remedy this situation, Candriam’s economists and quantitative fund managers have developed a set of proprietary quantitative indicators.
Originally, their construction drew on probit-type models. Probit models, which are derived from linear regression models, are used to assess binary variables. These types of model are used to estimate the probability of one of two different events occurring, in this case the probability of whether a recession will occur over a given timeframe or not. These models have nonetheless been proven to harbour a major default, as models with equivalent statistical properties over past periods can provide recession probability forecasts which differ greatly. The choice of predictor variables plays a key role and also strongly biases forecasts.
Estimations from three probit models based primarily on yield-curve steepness illustrate this inherent default. Whereas, in the past, the yield-curve slope, real short-term rates and monetary policy tightness also proved to be reliable indicators of an imminent recession in the US, signals over the past few years have diverged. Given the difficulty in selecting the “correct” model, i.e. choosing one of these predictor variables, which all adopt similar trends, there is a danger of making an erroneous assessment of the risk of a recession.
CHART 1: The 3 probit models
In order to remedy this difficulty, more sophisticated and more reliable methods can be used. Two key themes underpin the selected methods:
- Applying the “practice-makes-perfect” approach. In other words, there are no assumed certainties and applying these models to a broad variety of sample improves them and enhances their predictive ability.
- Adopting the “wisdom-of-crowds” or collective intelligence approach. A crowd’s diverse independent and aggregated opinions, as opposed to the discretionary choices of one single opinion, are collectively more intelligent than any of the component individual. Transposed onto our case study, the wisdom-of-crowds approach involves privileging aggregated information, provided by a multitude of models, over information from any one particular model. In other words, there is no point in seeking the best model from the past as there is no guarantee that it will remain superior in the future. It is therefore better to combine a widely diversified range of models in order to provide more reliable average information.
The following presentation outlines the results of the two models we have implemented. These models have been developed using a sample of around 100 economic and financial variables which may predict the onset of a recession within the next 12 months.
Method 1: Bayesian probit model averaging
This method is based on the estimates provided by several hundred thousand probit models combining up to four explanatory variables, of which only around 10,000 models are retained, as they are deemed sensible from an economic point of view. In the same way as a surgeon has to make a decision based on the interpretation of an x-ray on the eve of a delicate operation, the models are assessed taking into account uncertainties associated with new circumstances arising. In other words, each model is assessed in probabilistic terms. In applying Bayesian rules, the combination of models provides a recession probability founded on a rationale which also includes uncertainties.
Method 2: Random forest
The random forest method is based on a random collection of decision trees, which split variables into homogenous groups, selecting variables and their level successively, in order to classify events of interest more efficiently, in 2 groups of either: "increasing likelihood of recession within the next 12 months" or "increasing likelihood of recession within the next 12 months.
Unlike probit models, decision tress are non-parametric methods which take greater interaction complexity between variables into account. Their use has nonetheless traditionally been restricted, due to their instability. Any slight modification in data sample leads to highly different decision trees and therefore generates very different predictions.
The combination of the wisdom-of-crowds theme with progress in artificial intelligence, particularly machine learning since the early 2000s, has led to the emergence of an algorithm which remedies this issue, namely random forests. As its name would imply, this approach draws on the aggregate values of a multitude of decision trees (an entire forest) rather than a single tree structure, in order to reduce variance and bias within forecasts.
Variance is also reduced by implementing an algorithmic learning process across sub-periods (this is the “practice-makes-perfect” aspect) and reconciling predictions with observed reality outside of the learning periods.
CHART 2: Random forest and Bayesian averaging
These two methods are currently ascribing a relatively low probability of recession in the US within the next 12 months. The Bayesian averaging result predicting around a 20% probability has risen slightly since the end of 2017. The result provided by random forests is even clearer. After the probability of a recession ascribed by this method increased towards 20% from late 2017 to year-end 2018, it is now close to zero. The quantitative analysis that we have developed therefore substantiates the view held by our economists. Despite the current slowdown, the US economy is unlikely to tip into recession in 2020 (see our 2 December article on 2020 outlook).
The world is a strange place right now. Investors are nervous about the US/China trade war while much of Europe is still struggling to sustain growth. At the same time, securities markets are on a tear. US indices for credit and equities are both heading for double-digit returns this year, with the S&P500 up 25% to end-November. With the exception of a few squalls, investors have enjoyed a bountiful ten years of returns.
The weight of uncertainties in the world thus seems to be balanced by a “weight of money”. On Main Street, trade is sluggish to middling and nationalism is on the rise. Wall Street, meanwhile, is buzzing. To explain the paradox, one has to understand the role of central bankers. After the Great Financial Crisis, central banks in key countries and regions decided to pump into liquidity into financial markets with a hope that their largesse would trickle down into the real economy and alleviate a recession. True, recessions have been short-lived. But robust growth has eluded many countries. For asset owners, on the other hand, the effects are clearer and cheerier: the bankers’ double prongs of big bond purchases and aggressive interest rate cuts have pushed pension funds and insurers into riskier investments such as High-Yield debt, private markets and equities while boosting returns everywhere.
But these ongoing interventions of central banks come at a price. Traditionally safe investments, such as government bonds, now yield next to nothing or less. Lend money to Austria for the best part of a 100 years and you will currently be rewarded with a measly 0.7% for the favour. Across the Alps, the benchmark Swiss and German ten-year bonds will earn you less than you put in, as things stand. Bond buyers are paying to lend on approximately one-quarter of the total bond market globally.
This pertains just to nominal yields. Consider inflation and bondholders are losing even more in terms of real purchasing power. Even the benchmark US 10-year bond is a negative-yielder adjusted for inflation (1).
Existing bondholders have boosted their returns thanks to all this yield compression – the chart below on Austria’s 100 year-bond demonstrates this.
But going forward, issuance itself is occurring at negative rates. This summer, Danish bank Jyske issued a 10-year bond at -0.5%.
Some economists have suggested that this could be the new norm; a consequence of an affluent, ageing society. Generations will pay a wealth tax to keep their money safe and live with the loss of capital that comes with buying bonds at negative rates. But two alternatives come to mind. First, affluent investors park their wealth in a bank account, earning meagre interest but not diminishing value. The second is a bunch of strategies that are altogether less influenced by central bankers’ largesse and less vulnerable to market falls.
Investing for the 'New Normal'
These are established alternatives which not only offer greater returns than highly-rated bonds but which also seek to avoid the heavy drawdowns and volatility of riskier credit and equities. They are absolute return strategies such as equity market neutral, global macro, managed futures, risk arbitrage… Developed in the early 50’s,they came to prominence in the aftermath of the tech bubble, when another long bull run ended painfully and left investors belatedly seeking smarter protection.
Globally there is an estimated $3.4 trillion managed in absolute return and hedge fund strategies. Because they characteristically rely little on the direction of markets, the likes of equity market neutral and global macro can generate returns during bull and bear markets. At this juncture in time, such a feature is valuable to asset owners seeking to lower volatility without foregoing capital appreciation altogether.
Another appealing characteristic of absolute return strategies is that they show low to negative correlation with not only equity and bond markets but also each other. The chart here demonstrates how Candriam’s own range of absolute return strategies relate to each other.
Example of de-correlated strategies
Statisticians regard only correlations of 0.2 or higher as significant. This diversifying power can be increased even further using our active mix of strategies. This has demonstrated over time a return around 3% over cash with limited volatility and drawdowns.
The value of alternatives is that they rely far more on manager skill than market prices. As such, asset owners need to be sure that manager skill is reliable and persistent. In long-only investing, markets account for a far greater portion of returns than manager skill alone. In absolute return, the opposite is true. After a decade of extraordinary spending by central banks has run up the cost of all assets, it is time for a rethink on how much more markets have to give. Allocation to a lowly-correlated variety of proven manager skills in absolute return strategies, on the other hand, seems prudent and worthy of consideration for investors seeking a middle way between negative yields and the late stages of a bull market in credit and equities.
Candriam has been running absolute return since 1996 with a current suite of 12 diversified strategies, including funds of funds. Sparingly integrated, they allow you to boost the potential return on your bond portfolio and consider 2020 with more confidence.
(1) Using yearly per cent change in core CPI
Will the euro zone get stuck in a long period of stagnation? The question is worth exploring at a point where growth is at a standstill in Germany and Italy, while the euro zone as a whole has seen growth drop to under 1%...despite an all-time accommodative monetary policy.
If an economic shock were to hit tomorrow, Europe would have nowhere left to turn. The ECB has already done a lot. Its rates are in negative territory, and its policy is having less and less of an impact on economic activity, whereas the side effects are becoming increasingly clear: by driving real estate and financial prices up, the central bank has taken the risk of seeing bubbles gradually take shape. By hurting the bottom line of insurers and banks alike, it has also weakened the financial system. As for turning to the other pillar of economic policy, i.e. fiscal policy, this particular tool is practically no longer used to stimulate activity: many countries are struggling with high public debt, and the TSCG (Treaty on Stability, Coordination and Governance) signed in 2012 prohibits EU Member States with debt exceeding 60% of GDP from indebting themselves even further. So, unless the treaty is revoked, that avenue basically leads to a dead end...especially since the few countries that do have some wiggle room left are hesitant to use it! Germany, in particular, strongly influenced by ordoliberalism, still sees no emergency, nor even the need for fiscal stimulus. With an unemployment rate barely above 3%, it’s true that its economy is very close to full employment.
So is Europe really doomed to stagnation? Granted, the central bank has few tricks left up its sleeve to drive activity, although newly arrived President Christine Lagarde has stated “there's a bottom to everything, but we're not at that bottom at this point in time.” When it comes to fiscal policy, however, the boundaries are less obvious. In the past Europe has always been able to find room for manoeuvre when needed. As it happens, the need is more urgent than it might appear at first glance. First, because a stagnant economy is a vulnerable economy: any little shock can easily tip it over into recession. Next, because, until Europe has found its way back to sustainable growth, it will have a hard time regaining the support of the people. And, finally, because the euro zone is facing a serious investment deficit: since the early 2000s, capital expenditures have grown three times slower than in the United States and, in the last two decades, government investment net of amortisation has not grown at all!
The new European Commission has a considerable weight on its shoulders. President Ursula von der Leyen has given herself 100 days to put in place a green deal to make Europe “the first climate-neutral continent” by 2050. To that end, she proposes to turn part of the European Investment Bank (EIB) into a Climate Bank and launch a “Sustainable Europe Investment Plan” aimed at raising €1,000 billion during the 2020s. A commendable plan, but it will never happen unless it’s approved by all EU national governments. What’s more, the goal is much less ambitious than it appears. The blueprint is drawn from the Juncker Plan, established in the wake of the sovereign debt crisis. Meant to get the European economy back on its feet, in the last five years it has been funded by just €26 billion in guarantees, taken from the European budget, and only €7.5 billion in capital, contributed by the EIB (i.e. less than 0.1 euro zone GDP point per year!). Furthermore, it isn’t clear that the projects financed by the Juncker plan wouldn’t have been implemented regardless.
The euro zone is currently in a paradoxical situation. Contrary to popular belief, it is not at all living above its means. Just look at its current account surplus for proof: taken altogether, its economic agents (households, corporations and governments) are still spending nearly €400 billion per year less than they earn! However, its self-imposed rules prevent the euro zone from putting that money to work to generate growth. It’s ultimately up to the Member States to assume their responsibilities, together, and invest to prepare for the future.
The surprising election of US President Donald Trump, or the Brexit vote and its continuing saga, make one wonder whether 2016 may have marked the peak of globalization. Nations now seemingly wish to sever multi-national links and treaties and retreat to home markets, potentially heralding a new era of protectionism -- or at least, some “de-globalization”.
Will the return of nationalism end the growth streak for emerging markets?
If we are at the dawn of a new era, what will it look like? For decades, the growth of emerging economies has lifted bourses. Will that be a thing of the past?
Conversely, financial markets are increasingly correlated, as we discovered during the Financial Crisis. Will correlation increase just as growth slows? Is there a two-headed dragon in the cave?
The past: Those were the days….
The end of WW II marked the beginning of extraordinary economic growth around the world, and of unprecedented globalization. From Bretton Woods in 1944, through the the entry of China into the WTO in 2001, history has marked 75 years of extraordinary changes in the interconnections of economies.
The world has been transformed. Global growth has been strong, and income distribution has reached levels of equality unseen in millennia. Billions of workers have been integrated into what is now a global economy, finally enjoying the productivity benefits of 'comparative national advantage' first imagined in the early 19th century. Around the world, affordability of everyday goods was enhanced as the production of goods and services migrated to the lowest-cost geography. Inflation and interest rates declined and stabilized.
Emerging nation populations have benefitted. But while globalization has enhanced the development and income growth of many emerging markets, in the developed nations, the industrial working class saw their jobs migrate to lower-cost countries. The lower middle class in developed nations suffered as labor’s share of economic growth – that is, wages – declined sharply. In the developed nations, economic growth allowed income from capital markets and company profits to soar.
The present: A shift towards services
Wages are converging among developed and emerging nations, becoming a less significant element in global trade. Rising incomes in the EM nations mean that goods once manufactured for export are now also sold and consumed in their country of origin. The ‘trade intensity’ of physical goods is declining.
Services, such as communications and technology, have been growing faster than manufactured goods. The US is running a substantial surplus of traded services. Further, a substantial part of the value of manufactured goods is now contributed by embedded services, such as R&D, design and engineering, and logistics. Technology is also reducing previous EM advantage of cheap labor, and increasing demand for skilled workers, in both emerging and developed countries. Re-shoring production back to the developed world is unlikely to solve the problems of unemployment and stagnant real incomes for its middle class.
These trends, together with the need of shorter time for goods to market and environmental considerations, are forcing companies to 'regionalize' supply chains. Production and consumption of goods and services are speeding up, and moving geographically closer. Competing economic and even geo-political trading blocks, led by the US and China, may be created by trade frictions, creating new winners and losers among nations, but particularly among companies.
The Future: Regionalisation and established local consumers?
If globalization has benefitted global productivity, especially for emerging markets, could the de-globalization and regionalization put these markets into reverse?
We expect emerging nations will continue their progress, each in its own way, but not as a homogenous group. Those that have taken the opportunity to restructure their economies, and now produce higher-value-added products and services, will thrive. They have created their own middle class-driven consumer markets, and have greater means to survive and adapt.
China, for example, is likely to continue to grow, albeit at a slower pace than in the last few decades. We also expect the trade war will force China to become less dependent on the US and Europe, speed up its technological development, stimulate its consumer and services markets, and create regional cooperation with other countries.
Whether other emerging countries will continue to grow and develop will depend on their ability to adapt to the potential creation of a few global competing economic blocks, led by the US and China. This also goes for companies. Either they will grow as domestic players (for example Tencent, HDFC Bank), or they will have to become international leaders, exporting and producing goods and services abroad. Samsung Electronics, Alibaba and others are some of many examples.
For the financial markets, this also means that the trend of synchronization and correlation of emerging financial markets with the developed equity markets, which has increased during the last decade, will likely diminish as a result of economic cycles that will gradually widen again as part of the de-globalization trend.
Performance dispersion between winners and losers should rise within the emerging markets equities class. We expect performance disparities to rise not only between sectors and markets, but even more so between individual companies. Even modest 'de-globalization' is likely to generate growing idiosyncratic differences in development, management quality and ability to adapt.
While this will undeniably bring uncertainty and new challenges for the emerging markets investor, at the same time it will create great opportunities and an additional argument for an active investment approach in managing emerging markets equity portfolios.
Increased stock-picking, and decreased correlation? "The Times, They Are A-Changin' ".
Big numbers. Big, big numbers. For investors, too.
Someone will be producing products, infrastructure, and software services to address the issues related to climate change. Let's find those companies!
In 2013, McKinsey© estimated that upfront capital investment of Euro 530 billion per year would be needed by 2020 to avert climate change. In October 2019, Forbes quoted a report from a major brokerage house that $50 trillion will be required in five key areas of technology by 2050…roughly three times as much investment per year as McKinsey estimated seven years ago.
Nailing down a specific figure is not what matters. When the Intergovernmental Panel on Climate Change, the IPCC, publishes forecasts, the authors stress that their estimates incorporate numerous assumptions. Consensus holds not only that the investment figure required to address the challenges of climate change is large; consensus also holds that the longer investment is delayed, the larger that investment will need to be.
"Climate change is one of the greatest challenges of our time", said the leaders of the G20 in a joint statement in November 2015.
For investors, climate change may also be one of the greatest opportunities of our time.
Climate actions can be of two main types – mitigating potential future climate change, and adapting to climate change problems which have already arisen. The sizes of these markets are inter-related. The more governments delay climate mitigation legislation and investment, the more adaptation spending rises, and the more quickly that market develops.
Certain mitigation businesses immediately spring to mind. Cutting emissions through solar power and other renewable energies, electric cars, and improved mass transport. New technologies, such as new battery and other storage technologies to store solar, wind, and turbo-generated power to use when the sun isn't shining. Agricultural methods which use less water, and emit fewer greenhouse gases (GHGs). Greener buildings. Some companies provide services; for example, collecting data on traffic flows in cities and altering it to reduce congestion, reducing GHGs in the process.
Climate adaptation presents the second huge opportunity category for investors. Climate change is already here. The number of weather-related natural disasters doubled between 1990 and 2018, according to insurance company Munich Re. Assuming an orderly energy transition, we still have to adapt.
Extreme Weather Events are More Frequent
Number of Extreme Weather Events by Type, 1980 to 2016
Adaptation is already in progress. More insulation and vegetative 'green' roofs in areas where temperatures are less comfortable than before. Building codes requiring more energy-efficient homes and offices, and even the return of simple solutions such as working shutters on windows. Seed companies are developing new strains of drought-resistant crops for countries which are suffering from lack of water. Cities such as Copenhagen and Tokyo are building 'sponge' or other flood control, or stadiums on stilts as flood risks rise. These costs may be borne through public funding, but often a company is designing and building this infrastructure.
We have been discussing adaptation under an orderly energy transition. On 5 November, 2019, the United States gave formal notice of intent to withdraw from the 2015 Paris Agreement – the earliest possible day to do so under the terms of the agreement. What if the global energy transition becomes chaotic – a sad state of affairs, but might it result in an even larger investment opportunity in climate adaptation?
Under a chaotic energy transition, more would be spent on adaptation, and more quickly. There could be additional negative impacts on developing nations, through crop failures and water supply problems. In richer countries, homeowners might be expected to invest more in flood control, rebuild with better materials, add air-conditioning or insulation, change their landscaping if water is too expensive, add irrigation to farmlands that were previously naturally supplied with water.
Investment opportunities today
Yes, governments are lagging behind where the IPCC says they need to be. Yes, the biggest figures mentioned always seem to be about 2030, 2040, or 2050. Even so, the size of today's market is considerable. Under one scenario to reach the 2⁰ goal, more than 40% of GHG reductions would be derived from improvements in power production, 20% from transport improvements, and 10% from reduced building emissions.
Today, 26% of global power generation is produced by renewables. That is expected to grow by 1,200 gigawatts, or 50%, in five years – equivalent to the total power capacity of the United States in 2018. That's significant growth of an already-sizeable market. That's a lot of solar panels, wind turbines, design fees… and investment opportunities.
Today, there are an estimated 5.2 million electric vehicles in service globally, as of the end of 2018, and a forecast of almost 20% compound annual growth over the next decade. In the UK, for example, the sales of electric and hybrid vehicles, roughly 7% of the market, grew 28% in the first 7 months of 2019. Meeting environmental goals may be a long way off, but the market for these vehicles is established and growing.
Today, new building codes are being put in place. New builds face new requirements, beginning now. From 2020, EU regulations require new buildings to be 'nearly zero energy'. The UK is currently proposing new building codes, some of them expected for the end of 2020, 12 months from now.
Today, financial market support for carbon-emitting businesses is declining. In November 2019, the European Investment Bank, the EIB, announced it will no longer fund fossil fuel projects, removing $2.2 billion of funding annually for these projects. As throughout history, older technologies are replaced by newer ones.
The future is now. Investments in climate change can present a unique investment opportunity.
 "Market Report Series: Renewables 2019": October 2019, IEA / International Energy Agency, https://www.iea.org/newsroom/news/2019/october/global-solar-pv-market-set-for-spectacular-growth-over-next-5-years.html, accessed 19 November, 2019.
 "Global EV Outlook 2019", IEA, https://www.iea.org/gevo2019/, accessed 20 November, 2019
 "New car market declines in July but pure EV registrations almost triple", August 2019, SMMT, Society of Motor Manufacturers and Traders, https://www.smmt.co.uk/2019/08/new-car-market-declines-in-july-but-pure-ev-registrations-almost-triple/, accessed 19 November 2019, and Candriam analysis.
 "Government reveals plans for emission-reduced homes to reach climate targets", October 2019, Climate Action, climateaction.org, accessed 19 November 2019.
 IEA World Energy Outlook 2017, Candriam Climate Action Fund Review analysis.
 " Pathways to a low-carbon economy: Version 2 of the global greenhouse gas abatement cost curve; McKinsey & Company", September 2013. https://www.mckinsey.com/business-functions/sustainability/our-insights/pathways-to-a-low-carbon-economy
 "Stopping Global Warming Will Cost $50 Trillion: Morgan Stanley Report", Forbes, 25 October, 2019, https://www.forbes.com/sites/sergeiklebnikov/2019/10/24/stopping-global-warming-will-cost-50-trillion-morgan-stanley-report/#498bb5b851e2, accessed 12 November, 2019.
 "G20 Leaders' Communiqué", Antalya Summit, 15-16 November 2015. https://www.consilium.europa.eu/media/23729/g20-antalya-leaders-summit-communique.pdf
1. European returns will improve as the economy recovers
European real estate markets slowed in response to the wider slowdown in the real economy in 2018 and 2019, but rents continue to rise as supply shortage is now acute in a number of major western European cities. Pan-European vacancy rates now average under 5% and in some markets, such as Paris, the supply of new grade A space is below 2%. If European GDP growth picks up into 2021 as expected, real rents should keep increasing given structural and cyclical constraints on credit supply and limits on new construction. As a result, we expect attractive relative returns from real estate in response to rising net income.
2. Global capital flows into real estate look set to continue…but where are they headed?
Source: Bloomberg. Data as at 31.10.19
Since the global financial crisis, flows to private equity real estate have been steadily increasing. We believe that these flows will substantially increase over the next 3 years as the investment community (particularly pensions and insurers) will have to deal with a great wall of fixed income maturities. During 2019, 2020 and 2021, in excess of EUR 1trillion of European sovereign bonds with coupons in excess of 2% will come to maturity. Financial institutions already struggling with solvency will find it hard to reinvest in similar bonds given negative yields. We expect that the majority of this capital will be invested in alternative asset classes with private real estate taking a significant share. These flows will provide a substantive floor for real estate prices, despite relatively low yields for the very best core real estate assets.
3. The rise of risk tolerance
The quid pro quo for high prices and low yields for the best Core buildings is that much of this inbound capital will gravitate to higher risk strategies. We believe this will lift the already significant flows of capital into value-added real estate strategies and fuel demand for strategies such as Core Plus. Equally we expect more risk tolerance and investors reallocating capital away from retail assets, will also add to the appetite for operationally more intensive assets such as multi-family residential, student housing retirement living, self-storage and hotels. Selectively allocating to these sectors ahead of these flows is clearly critical for investors seeking to maximise risk adjusted returns.
 Grade A properties represent the highest quality buildings in their market and area. It is the equivalent of investment grade real estate and refers to offices only
 “Core”, “Core Plus”, “Value Add” and “Opportunistic” are terms used to define the risk and return characteristics of a real estate investment. They range from conservative to aggressive and are defined by both the physical attributes of the property and the amount of debt used to capitalize a project.
In average “Core” investors expect to achieve between a 7% and 10% annualized return and use less than 40% debt to capitalize a transaction.
 In average, “Core Plus” investors tend to use between 40% and 60% leverage and expect to achieve returns between 8% and 12% annually.
In the past: a particularly profitable environment
In recent years, sluggish global growth and low interest rates have encouraged companies to use debt as a means of financing their development. Debt has enabled companies to invest in R&D in order to boost sales or adapt to a new environment and also allowed them to achieve their strategic goals more rapidly through mergers and acquisitions.
As profitability targets expected by shareholders cannot always be reached through growth alone, debt has also been used massively to finance share buybacks and to distribute exceptional dividends.
Optimising the profitability of deployed capital in this way has been largely inspired by the accommodating monetary policy adopted by the central banks and the implementation of non-conventional measures such as quantitative easing (QE) by the European Central Bank (ECB) or quantitative & qualitative easing (QQE) by the Bank of Japan (BoJ).
Broadly lower interest rates have considerably reduced interest servicing charges among companies. This environment has also led to diversification in financing sources for smaller businesses by providing easier access to bond funding for many companies. What has been the result? For certain companies, this has meant a reduced debt burden and a lower chance of bankruptcy, whereas for others it has facilitated development projects.
Present day: a record level of debt?
Has the maximisation of companies’ balance sheet structures through borrowing, rather than building up shareholders’ equity, deteriorated their creditworthiness?
According to the International Finance Institute (IFI), total corporate debt excluding the financial sector currently represents 91.4% of global GDP, i.e. an increase of 20 points over 20 years. This figure should be viewed in perspective, however, as the data relate to gross debt which does not take into account the increase in value of corporate assets.
It is nonetheless a fact that, during the past 8 years, the proportion of BBB-rated issuers in the US market has risen from 40% in 2011 to 50% in 2019, while the European market has seen an increase from 25 to 50% over the same period. What has been the consequence of this increase? BBB-rated debt now represents 5,100 billion dollars globally, which is 6 times more than in 2000.
Overall debt ratings have therefore deteriorated significantly over the past few years. But does this mean that there is a credit market bubble?
Not really. In our opinion, the current high level of credit market dispersion is primarily a reflection of increasing idiosyncratic risk. Specific difficulties encountered among debt securities appear to have a relatively muted knock-on effect on the rest of their particular business sector and only a limited impact on credit spreads. Furthermore, although the ratings agencies estimate that the proportion of potential fallen angels, i.e. companies downgraded from an investment-grade rating (BBB) to high-yield status (BB or lower), should rise to represent over 20% of the total current BBB market, we believe that this risk is overestimated. Abundant liquidity and the high premiums currently paid among private equity acquisitions targeting non-listed companies encourage the divestment of subsidiaries and assets and provide many companies with the opportunity of reducing their debt levels and therefore to maintain their investment grade category ratings.
The future: towards more responsible debt?
This is a fact. The purely financial approach adopted by companies is being brought increasingly into question. Investors now expect companies which are key players in the economy and broader society to integrate environmental, social and governance responsibility (ESG).
The social pressure on companies, coupled with financial performance constraints, obliges them to adapt, despite their huge financing requirements, particularly in terms of energy transition.
The automotive sector can also be considered in this light, with vehicle electrification involving heavy financing requirements for R&D and production line renewal. Similarly, the utilities sector will require high levels of funding for decommissioning coal power stations and the switch to renewable energies.
It would be a mistake to disregard extra-financial factors. Companies neglecting to do so could see investors refusing to finance them or only granting funding at prohibitively high costs which could undermine the profitability of their investments and therefore their long-term viability. On the other hand, financing requirements increase the level of companies’ debt, which is a potential source of ratings downgrades by the agencies.
Looking forward, selectivity is required, including the integration of a rigorous ESG approach. This approach should lead to investments in the winners during the global transformation phase, by avoiding companies with a less certain future. A world of opportunities is opening up to us.
Will the pace of mergers & acquisitions (M&A) run out of steam one day? This is a legitimate question for investors to ask, as the past 5 years have seen a heavy M&A dealflow, which has created significant value. Since 2014, almost 1,300 deals have been launched in the European and US markets, including takeovers of all sizes totalling over 7,700 billion dollars.
Although the scale of these incredible statistics is giddying, the reasons are clearly identified:
- Interest rates are close to zero, which enables companies to borrow at low costs;
- Markets have been bullish, and this gives companies the chance to deploy their shareholders’ equity to fund their transactions;
- The failure of economic growth to trigger stronger earnings momentum has incited companies to expand through bolt-on growth;
- The geopolitical context has been relatively stable despite the Brexit and the trade war between China and the US.
2019 has not proved to be an exception, as at the end of August more than 155 deals had been announced in Europe and the US, representing almost 1,000 billion dollars.
2020: the same causes and effects?
Will the coming year extend this trend? It would appear so, as nothing has changed significantly.
Sources of tension have certainly not been lifted and should therefore lead to continued uncertainty.
- The chaotic Brexit resolution has impacted the number of deals in Europe and driven the UK, traditionally a leader in the European M&A market, towards defensive domestic transactions rather than targeting the continent. This trend appeared to be inverting during the last quarter of 2019, however.
- The trend towards a smaller number of deals in the oil sector, due to tensions in Iran and North Korea, is expected to continue.
- Spreads among certain deals should remain volatile due to the trade war between China and the US. These include Mellanox Technologies, which is being taken over by Nvidia. The spread almost doubled during the summer following a tweet from Donald Trump sparking fears that the Chinese antitrust regulator would block the deal.
Aside from these specific periodic issues, leading M&A indicators are still flashing green.
- The economic and market context is still showing growth, while the cost of borrowing is also still extremely cheap to finance deals, and volatility remains low.
Deal sector breakdown remains highly diversified.
- Although the proportion of financial deals (LBOs, MBOs, private equity) increased sharply during the second half of the year, their weight still remains far below industrial transactions. It should be highlighted that the number of LBOs collapsed in 2007, when credit facilities available in the interbank market suddenly dried up.
- Lastly, although spreads are tight, the deal break ratio remains extremely low, which is reassuring for the coming months.
Several growth drivers
All of the required conditions are in place for corporate managers to feel more confident about acquiring or merging with other companies. This is why negotiators always refer to “boardroom confidence” as a leading indicator for the mergers & acquisitions market. Confidence remains high and we cannot see any reason for that to change in the short term:
Available cash for merger & acquisition deals remains very high;
- Activist shareholders seek returns by continuing to put considerable pressure on companies to undertake mergers or acquisitions and therefore create greater value;
- In choosing between starting a project from scratch or buying a business, the latter option is more rapid and a safer bet, according to pharmaceutical companies, and as illustrated by the recent $5 billion takeover of Spark Therapeutics by Roche and the bid on The Medicines Company by Novartis valued at $9.7bn;
- Lastly, the uberisation of entire segments of the economy is inciting traditional players to plunge into the digital era by taking control of the challengers within the new economy.
A strategy which still makes perfect sense
In other words, all of the catalysts for a strategy aiming to capture value created by merger & acquisition deals are still in place.
Worst-case scenarios can always be imagined, i.e. a recession or a further escalation in the trade war, although Candriam believes neither of these will occur. Meanwhile, the context remains favourable for investors wishing to diversify their portfolios through exposure to M&A.
&2 Deals recorded by the management team in the MAGMA proprietary database.
M. Branet / K. Sourov - Deputy Head of Emerging Markets Debt / Lead ESG Analyst
Magda, isn’t EMD investing all about crunching fiscal numbers? How can Environmental, Social, and Governance factors help with number crunching?
Understanding non-financial risk factors is paramount to understanding sovereign creditworthiness, even more so in emerging markets.
Creditworthiness encompasses both an issuer's ability, and willingness, to repay debt. If ability to pay is greatly influenced by a country’s long term growth potential, willingness to pay is intimately related to issues of governance. We believe that these in turn depend on the way countries access and utilize all the forms of capital available -- social, human, and natural capital in particular, in addition to economic capital.
Kroum, it seems counterintuitive that non-financial elements can contribute to growth -- capitalism is usually associated with “growth at any price”, meaning growth at the expense of the environment for instance. How do you resolve this ?
Going back to the 4 forms of capital- let’s focus on human capital for instance. Education allows a country to generate and absorb new technology, and to diversify its sources of income. Healthcare increases productivity by helping minimize sick days and increase worker productivity. Developing human capital is of the essence when it comes to broadening the camp of resources available to an economy. Another salient example involves Natural Capital – the World Health Organisation estimates that air pollution is responsible for 9 million deaths every year, more than war, malaria, tuberculosis, HIV/AIDS, and murder combined. The vast majority of pollution-related deaths occur in emerging economies. Such topics are increasingly entering the conversation in society, helped by popular media such as the Guardian reporting that in India, for example, pollution is responsible for a quarter of all deaths, a huge drag to the economy.
Magda, governance issues have always been key to investment risk in emerging markets. What can ESG factors add?
The importance of identifying the potential misallocation of state resources through corruption, lack of accountability or mismanagement of public institutions is widely accepted in sovereign analysis. Democratic accountability helps the social and economic systems function more efficiently by minimizing wasteful practices.
Our ESG approach extends that analytical method to a broader range of factors that play into a country’s long term development.. For instance, economic and gender inequality starves the system of consumer purchasing power. Excessive concentration of wealth can impede a healthy middle class, which is the engine of growth. For instance, the IMF estimates that closing the gender gap in countries such as Pakistan and India could add up to 59% to their economic welfare, and up to 21% in the Middle East and North Africa region[i]
Kroum, isn’t environmental protection a rich man’s problem?
On the contrary. Environmental protection is vitally important to the economic growth of emerging nations.
On one hand, many EM countries rely on natural resources for growth. Sustainably managing their natural capital is critical to maintaining long term growth. On the other, emerging nations are major victims of climate-related risks, such as extreme weather events. A flood or a drought in a small, non-diversified economy can significantly disrupt GDP.
Furthermore, environmental preservation is likely to become increasingly embedded in trading relationships – for example, the Mercosur trade deal between Latin American countries and Europe is under threat because of deforestation policies in Amazonia. Going even further, in September 2019, Costa Rica, Fiji, Iceland, New Zealand and Norway launched the Agreement on Climate Change, Trade and Sustainability, which envisages that the countries participating would remove any trade barriers in environmental goods and services, work towards removing fossil fuel subsidies, and encourage eco-labelling schemes
Costa Rica is a particular bright spot, as it has generated almost all its electricity from renewable sources since 2015. It also exports renewable energy in the Central American market. In the UK, renewables generated more energy than fossil fuels for the first time in Q3 of 2019.
Magda and Kroum, how do you compare the integration and exclusion approaches to ESG investing?
Exclusion helps avoid some extreme risks, while integration helps determine whether the return compensates investors for their risks. Exclusion is useful, one might even say necessary, to avoid the most extreme violations of the UN Sustainable Development Goals (SDGs), those which could risk a significant impact on a country’s creditworthiness. Integration ensures that investors are compensated for risks. Considering non-financial factors, including ESG factors, allows for more realistic pricing of risks that are not accounted for by purely "crunching fiscal numbers".
We believe the optimal approach is to combine the two.
[i] IMF Staff Discussion Note- “Economic Gains from Gender Inclusion”, J.D.Ostry et al., October 2018
The 'plastic soup', the several billions of tons of plastic invisibly floating below the surface of the ocean, is a metaphor much less tasteful than it sounds. Most diners fail to realize when ordering fish soup in a restaurant, there is good chance that microplastics are on the menu.
Plastic is the poster child of the pollution problem, and with good reason. At the same time, its numerous benefits must be acknowledged. Proponents of plastic argue that, since it is designed to last, plastic is one of the most durable and sustainable materials, offering a number of advantages.
Can we keep our plastic? Are there sustainable solutions?
Plastic has created an enormous global pollution problem. The oceans will contain more plastic than fish by 2050, according to the World Economic Forum and the Ellen MacArthur Foundation. The constant increase in plastic production, and its incredible lifespan, naturally have something to do with this. To put figures on this, global annual production of plastic has grown from 1.5 million tons in 1950 to 359 million tons in 2018. “Disposable” plastic, as we call it, it is anything but disposal. This will be with us for centuries; the decomposition time of plastic ranges from 450 years for plastic bottles to as long as 1,000 years for other types of plastic waste. Academic research shows the majority of this plastic ocean waste originates in several Asian and African rivers; this does not necessarily mean the plastic was either produced or consumed in these regions.
Benefits of plastic include is strength, light weight, and versatility, and relatively low cost given these advantages. Various types of plastics such as PET, PVC, PP, and others each offer particular properties. This brings us to the major drawback of plastic -- its disposal. Because it is so long-lasting, appropriate disposal is crucial. The solutions we have so far have been woefully inadequate, hence the Earth's unhealthy diet of plastic soup.
Sophisticated use of plastic across a range of industries is proof of the benefits of plastic. In many uses, a better alternative is too expensive or simply has not yet been found. Although some uses of plastic can or should be replaced by other materials, this is far from the case for all. The aircraft and transportation industry benefit from corrosion-resistant, strong and light-weight plastic parts; light plastic saves fuel and reduces greenhouse gas emissions. Safety equipment sector depends heavily on plastic to ensure health and protection in helmets, goggles, and other items. And food wrap? Some benefits; advanced plastic packaging can reduce food waste by extending the food’s shelf life.
Remove or Treat the problem.
To resolve this dilemma, two major paths can be followed; namely, remove the source of the pollution cause or treat its consequences. To remove the source, regulations are being added globally. The most famous is the EU Single Use Plastic Directive, an EU-wide ban of single-use plastic cotton buds, straws, plates, cutlery and other items by 2021. The EU directive is not unique. The United Nations PRI offers a graphical history of single use plastic regulations, which illustrates the rapidly increasing focus on the issue. Corporates take note.. These single-use plastic regulations are treating the pollution cause, a logical start to conquering plastic pollution.
Recycling can help avoid the consequences. There are three main categories of plastic disposal; recycling, incineration and landfill. Unfortunately, today more than 40% of global plastics end up in the landfills. Trash from Western countries destined for landfills, including plastics, have for decades been shipped to poorly-regulated developing countries. Times are changing, and refuse is being refused, notably China’s ban on imported plastic waste. Western waste-exporting countries are facing new circumstances. We can’t export the problem and close our eyes anymore. Now we have to deal with it.
Collection of plastics is crucial for recycling to make a significant impact. This may be hampered by contamination, such as chemicals; or design, as colored plastics are more difficult to recycle. The current collection rate of plastics is insufficient to meet the rising demand of the recycled raw material. This puts pressure on the price. rPET (for recycled PET) plastic is currently up to 40 cents more expensive per pound compared to virgin imported resin, according to IHS Markit. Part of the solution could be bottle and consumer deposit requirements, where a returnable fee charged on sale of products in plastic containers can increase the collection rate to more than 90%, as achieved in Germany and Norway.
Investors, take note. These issues and solutions will inevitably impact the full plastic value chain, representing both risks and opportunities for investors. This starts with oil and gas companies who, while not directly targeted by new regulations, may face slowing petrochemical demand from virgin plastic producers. Chemical companies producing polymers could lose to potential disrupters such as biochemics and chemical recycling. Consumer Goods will likely see the greatest challenge, as companies directly face stricter regulation and growing consumer awareness of issues such as sustainable and recycled packaging. Further along the chain, waste management companies will naturally have their role to play in the plastic life cycle; for instance, recycling and sorting services or take-back initiatives.
Sustainable Development Goals.
Moreover, the issue of managing plastic falls squarely in line with the United Nations SDGs. The increasing attention of world leaders, consumers, and corporates illustrates the sense of Goal no 12, ‘Ensuring sustainable consumption and production patterns’. Planet Earth needs humans to develop a Circular Economy.
Investors can help develop a circular economy by helping finance companies which aim to the most urging challenges of our times and respond to the EU stated objective of implementing its Circular Economy Action Plan. Humans now require the equivalent of 1.7 planets to match their demand on natural resources every year, a number that is expected to increase to 3 by 2050. These issues are not limited to plastics, but plastics exemplify the need for, and markets for, solutions.
Plastic pollution is attracting an enormous increase in media attention while its regulatory landscape and general awareness are undergoing rapid change. The issue is not exaggerated; this is a great challenge, for which revolutionary solutions are required in the near term. To develop workable solutions, we must keep in mind that plastic is not all bad. Plastic can contribute to a more sustainable future. We must reduce its consumption, properly collect the used materials, and recycle and reuse as much as possible.
As a sustainable company, Candriam contributes to the plastic pollution solution through internal 'grass roots' initiatives, many suggested by our employees. For example, we reduce plastic consumption by progressive eliminating plastic bottles in meeting rooms and by providing water coolers directly connected to the water distribution network, rather than bottled water coolers. We share ideas through specific initiatives organized around themes such as The European Week of Waste Reduction and the Sustainable Development Week.
Plastic is designed to last. To continue to enjoy its benefits means recognizing and treating the problems arising from its longevity.
 https://www.ellenmacarthurfoundation.org/news/new-plastics-economy-report-offers-blueprint-to-design-a-circular-future-for-plastics (« New Plastics Economy: Rethinking the future of plastics » by Ellen MacArthur Foundation & World Economic Forum)
 Export of Plastic Debris by Rivers into the Sea, by Christian Schmidt, Tobias Krauth, Stephan Wagner
 Ellen MacArthur Foundation.
What can we expect for the financial markets after a year that saw (at the time of writing) positive performances for asset classes across the board? In 2019, the various asset classes banded together to surprise investors on the upside, with European and US government bonds up by around 8% and Eurozone and US equities up by more than 20%. Of course, 2018 was also an exceptional year ... for all the wrong reasons, with bonds and equities alike losing ground. Ultimately, in the space of two years, the S&P 500 ended up gaining 17%, versus just 5% for the Stoxx 600.
Performance of asset classes since 2004 (orange = negative, blue = positive)
Data at 11/12/2019, source: Bloomberg, Candriam
Right now, it’s hard to say what kind of year 2020 will be. There are several possible scenarios, but most investors are erring on the side of caution. What kind of returns are we expecting for 2020?
Forward-looking analyses are always challenging by nature. It is just as important to understand the projected scenario as it is to come up with a number.
Our central scenario calls for the stabilisation, followed by the gradual recovery, of the manufacturing cycle. It also sees trade tensions easing between the United States and China. This is a reasonable assumption considering that 2020 is a US presidential election year, but then again, has anything been reasonable thus far during Trump’s first term in office? US growth should come in for a soft landing at around 2%, European growth is expected to stabilise at around 1% and EM countries should fare better than 2019. We do not expect to see much more in terms of monetary easing, the Fed is only likely to lower the fed funds rate once in 2020. In Europe, any economic downturn is liable to be offset by fiscal easing, as another rate cut would be unlikely to prove very effective.
In this scenario, rates should stabilise and then pick up slightly once economic indicators improve. Government bonds should thus generate slightly negative performances (factoring in currency hedging for non-European bonds). Projected yields in the credit market are weak, with credit spreads having already significantly tightened in 2019.
Change in equity risk premium in the US and Europe
Data at 29/11/2019, source: Bloomberg, Candriam
The risk premium on equities is still attractive. While bonds are expensive, equities are slightly less so. The projected return for 2020 can be viewed as the sum of EPS growth, dividend yield and the change in equity valuation. EPS growth could end up being somewhat positive, and much lower than the consensus (around 9% for developed country equities). Potential dividend yield is pegged at an attractive 2-3%. The year’s performances will once again depend significantly on how equity valuation multiples evolve. In 2019, the over-20% rally in the US and European equity markets rested solely on an equivalent multiple expansion. As we head into 2020, we expect a potential return of 6-7% on developed country stocks (MSCI World) and just slightly better for emerging markets.
Breakdown of projected dividend yield for developed country equity markets (MSCI World)
A positive equity valuation trend relies first and foremost on how much faith investors have in future growth. Any negative shock in terms of US election results, the resurgence of geopolitical tensions or excessively slow progress on European projects could cause investor fears to come surging back and trigger a drop in equity valuations. For the time being, low interest rates have set a floor level for any potential stock market decline, unless the likelihood of a recession were to increase sharply. Conversely, investors may end up with more nice surprises in store in the event of a positive shock: cancellation of trade tariffs imposed by the US, stronger stimulus in China, a change in perception for Europe with a substantial fiscal stimulus package and strong support for the “green deal”... 2020 is starting off with a little more hope than 2019, and that hope deserves its chance!
 Data MSCI Euro and S&P 500 at 29/11/2019, source: Bloomberg
 Data at 29/11/2019, source: Bloomberg
No need to introduce the FANGs to anyone. You are probably one of the billions of people that use Google Maps©, Instagram©, Netflix© or Amazon© on a daily – or minutely? – basis. Or you may have invested in one of these companies. Without any exception, these have been top investments over the last years, mostly driven by high revenue growth and the prospects of attractive profitability.
The impact of most of these companies on society and on our daily lives has been enormous during the last decade. With them, we feel closer and connected to whomever we want. Just sitting in our chair, we can order almost everything from all over the globe at very competitive prices.
More connection, less privacy
This small device called smartphone has become our window to the world. While this evolution is generally perceived as an enrichment of our quality of life (some would say “comfort consumerism”), one cannot be blind for a number of unwanted side-effects, the lack of privacy being the most important one. You may be sure that searching on the internet for a Christmas holiday destination will be followed by an avalanche of targeted publicity related to potential Christmas holiday destinations on all your internet connected devices. Probably not exactly what you deliberately wanted…
On a much larger scale, there is the well-documented Facebook-Cambridge Analytica case. Back in 2018, Cambridge Analytica had harvested the personal data of millions of Facebook users without their consent and used it for political advertising purposes. Obviously, companies such as Alphabet and Facebook are coming under pressure and a vivid debate on the collection and use of personal data arose. Regulators all over the world started scrutinizing companies that were collecting private data and using them without explicit consent.
Europe was at the forefront in adequately reacting on this privacy issue. GDPR (General Data Protection Regulation) is a regulation in the EU law on data protection and privacy for all individual citizens of the European Union and the European Economic Area. Organizations that are not compliant with this regulation can now face heavy fines.
Enough to jeopardize the hegemony and competitiveness of our mega-quartet in 2020? We don’t think so.
First, even with the scandals on data privacy, people don’t seem like they want to change their habits. Let’s face it: how many of us are aware of their Google or Facebook profile and explicitly change it to keep their own data private? Most of the time, we will simply click on “accept”, without even knowing in detail what we are accepting.
Second, whilst we absolutely agree that individuals must have the complete discretion on if and how their data are used and whilst we absolutely think that this should be regulated and controlled by government instances, we don’t believe that many of FANGs’ users would tolerate the consequences of completely barring access to their private data.
If we can use Google maps or Instagram for free, that’s because of the online advertising that is supporting these apps. This online advertising is mostly based on what these apps know about their users. If users do not let these apps collect and use (part of) their data, they will soon be charged for this. Not sure everyone is ready to pay for such apps, or to renounce the services offered by the use of the data: for example, Amazon proposing its users books that will highly likely please them, based on their history and on history of other customers that have a comparable profile. The same goes for Netflix, Youtube©, Pinterest©…
Apart from the regulation on privacy and the use of data, most of the internet giants are also under fire because of competitive practices.
Facebook©’s competitive practices are under investigation by the U.S. Congress, Department of Justice, FTC and 47 state attorneys general. Google is under antitrust investigation by the Justice Department, the House of Representatives Judiciary Committee and dozens of state attorneys general. Google and Facebook are facing EU antitrust probes as well.
These investigations are very complex and will probably take a lot of time. Internet giants will defend themselves by stating that competition is very intense, and is intensifying at an accelerating pace, and the reason why. Between them of course, but not only.
Let’s take the example of Google search, which is the most used search engine on the Web: 54% of product searches searches (which admittedly are only a minor part of the total search market), are now done on Amazon. The other way around: customers can buy goods directly from their Instagram (Facebook) account or directly from YouTube (Google). Both Amazon, Facebook and Google are offering competing payment facilities.
The bigger threat may come from overseas. In speech technology, autonomous driving, e-commerce and payment systems, Chinese internet giants such as Tencent©, Alibaba© or Baidu© have closed the technological gap already, having made tremendous progress in AI and ML. They are now starting to compete with the western internet moguls on their own home turf... and without the same constraints on the use of private data, a mismatch which may finally result in a major competitive disadvantage against China.
Regulators will continue to scrutinize FANG companies, and as far as it concerns the protection and correct use of private data, this seems appropriate and the FANGs are able to adapt their behavior – Alphabet devoting 20% of its huge resources to R&D – without too much implications for the long term future of their business models.
When it comes to the investigations on competitive practices, the regulator could decide to levy heavy fines or to force companies to split up in different business divisions. This would definitely impact the long term prospects of the targeted companies, but given the complex nature of these investigations, 2020 should not face significant disruption.
 The acronym for Facebook, Amazon, Netflix, Google.
"...Boomers see doing good as separate from investing;
whereas millennials don't see how you could possibly separate the two."
What is Impact Investing, anyway? Impact is the Millenials' way of investing. Within ten years, this generation will be the largest share of workers and leaders. Importantly for both the corporate world and the investment markets, this cohort is expected to inherit $30 trillion in assets from their parents by 2025.
'Investments made with the intention to generate positive, measurable social and environmental impact alongside a financial return.' This definition of Impact Investments, offered by GIIN, the Global Impact Investing Network, is the most widely-accepted definition.
That's a good start. But it is only a start. Traditional investors demand standardisation and comparability of investment results. GIIPS and other globally-accepted performance measurement systems have been developed to satisfy most needs for defining financial performance.
No such standard exists for measuring and comparing the impact of an investment. Some investors are beginning to employ the 17 UN Sustainable Development Goals as a framework for reportable impact measurement. An impact project may be designed with one or more impact goals in mind; any given project usually aims to generate an impact in two or three of the 17 SDGs.
How does Impact Investing differ from ESG Investing?
Both have the dual objective of achieving financial returns and societal or environmental impact for investors. At Candriam it is our conviction that those companies which embrace sustainability-related opportunities and challenges, in concert with their financial opportunities and challenges, are the most likely to generate shareholder value.
For us, the defining characteristic of Impact Investing is intentionality. Because they are conceived and launched with the intention to meaningfully impact society or the environment, these businesses are often private equity or private debt investments. We seek to invest in businesses which are scalable and can increase the magnitude of both their impact and their profit.
Slaying the Dragons
How do we measure the impact?
Measurement of the social and/or environmental impact is critical to the growth and success of Impact Investing as a strategy. Adopting a definition which includes intentionality, as well as key impact performance indicators, can offer investors greater information and confidence in the impact performance reporting. To express impact goals in measurable terms; the UN Sustainable Development Goals are increasingly used as a framework. For example, a 'last-mile' inner-city logistics company could express performance targets using two UN Sustainable Development Goals. SDG 13: Climate Action, to reduce C02 by a set number of kg per km driven versus a pre-set benchmark, and SDG 8: Decent Work, by hiring van drivers without formal education and training a pre-set number of them for management jobs requiring qualifications as the firm expands.
Are impact investments financially competitive?
Yes! Two-thirds of surveyed Impact Investors target risk-adjusted returns at market rates or better. The 2019 GIIN survey showed that almost 90% of respondents met or exceeded their financial expectations.
Certain types of enterprise are missed by the larger financial channels. Impact Investing "is fundamentally about investing where the market would not automatically go.". Businesses which are not on the radar of traditional investors can offer attractive rewards to the early investors. Impact Investors are simply a new type of financial intermediary integrating the non-financial aspect in their long-term results. Impact investors are making resources available to particular sorts of businesses. Think affordable housing, sustainable cities, clean energy, recycling, and 'circular economy' enterprises. What is important to us is to repeat that success, both for impact performance and financial performance. We seek investments which are scalable.
What are the practical considerations of investing in nascent industries?
The investment industry already has the building blocks to manage and measure both impact performance and financial performance. By definition, impact businesses are founded with the intentionality of solving meaningful social and environmental problems in a measurable way, and to produce profit. As a new concept, perhaps ten years old, impact companies are a relatively new investment. Alignment, accountability, and an investment vehicle are among the building blocks already in place which can be incorporated into an Impact Investing structure.
Traditional investment managers may be paid incentive fees for achieving certain financial return targets, to align their incentives with investor goals. Expand the concept to impact investments, managers could create a fee schedule under which incentive fees are paid only if both impact performance targets and financial performance targets are met.
Impact performance results can be measured. Express and quantify the intended impact into metrics and goals; for example, number of gallons of clean water created, number of new jobs created, or number of new schools opened. Monitor these goals and report on them clearly and with the same frequency and detail as financial goals, to increase transparency between investors, portfolio companies and private equity managers.
Private equity Impact managers have companies up and running, many already profitable. These Impact managers often have sector specialisation; hence their funds may lack diversification. Investment vehicles are available to address this lack of diversification. A fund of funds can be designed to increase sector diversification for investors. Experienced multi-managers have the specialized skills to evaluate these private equity managers and build a "fund of funds" portfolio of diversified impact investments.
Investing in impact businesses today means investing in a better tomorrow. We are convinced that Impact Investing will be seen as an attractive and mainstream asset class.
Ok, Millennial! Impact? We can measure it. We can manage it.
 Julia Balandina Jaquier, family advisor and impact investor, quoted in 'The Economist', 25 November 2017
 "How green are your intvestments?", Financial Times, 23 May 2019, quoting JPMorgan Private Bank.
 https://thegiin.org/impact-investing/need-to-know/#what-is-impact-investing, accessed 27 November, 2019.
 Of 266 respondents, 176 indicated they sought market returns or better. https://thegiin.org/research/publication/impinv-survey-2019, Executive Summary, accessed 4 December, 2019.
 Annual Impact Investor Survey, Global Impact Investing Network, Ninth edition, 2019. Of 266 survey respondents, 95% responded to the question of financial performance relative to expectations. Of those who responded, 91% reported financial performance in line with or exceeding expectations.