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.