KNOWLEDGE EXCHANGE ANNUAL INVESTMENT EDUCATION WORKSHOP 2019 2019 EFGAM KNOWLEDGE EXCHANGE Our eighth annual EFGAM Knowledge Exchange took place at the Mayfair Hotel in London on 9-10 January 2019. Technological change and artificial intelligence were two of the important long-term themes which were discussed alongside the outlook for economies and financial markets. Political developments – from Brexit to Italy and Trump – were a key theme, as were China-US trade tensions and the direction of US Fed policy. Jason Jay from our Future Leaders panel looked at the issues involved in implementing a sustainable investment strategy. We hope you enjoy this synopsis of the presentations. Moz Afzal Daniel Murray Global Chief Investment Officer Deputy CIO and Global Head of Research Note: To the extent that this document contains non-independent research, this document should be considered a marketing communication. Such research has not been prepared in accordance with legal requirements designed to promote the independence of investment research and it is not subject to any prohibition on dealing ahead of the dissemination of investment research. 2 | Knowledge Exchange January 2019 NUMEN CAPITAL: INVESTMENT OUTLOOK FOR 2019 Filippo Lanza Numen Capital Filippo Lanza discussed three key aspects of Numen Capital’s The tech winter investment outlook for 2019 and beyond: the ‘debt wall’; the Numen see a ‘tech winter’ coming for almost all industrial coming ‘tech winter’; and merger wars. sectors and banks and insurers alike. That has several key aspects. Cash use is declining: in China, a leader in this trend, The debt wall more than 90% of payments are non-cash. New payments Global debt levels are at historic highs. Debt has been systems are becoming widely adopted. Many banks have too accumulated by governments, banks and corporates but the many employees and legacy IT systems at the same time as nature of this debt has changed. new payments technology is becoming widely adopted by start-up companies with much lower overheads. There are In the eurozone, we now have collective action clauses (CACs) many new entrants to the financial markets putting pressure in many government bonds, which allow a majority of bond on traditional payment, insurance and stockbroking models. holders to trigger a restructuring (these provisions were first Cloud-based software and data analytics are providing a new introduced, retrospectively, for Greek government debt during channel for the assessment of risk and the pricing of insurance. its crisis). The European Stability Mechanism, the bailout fund established in the crisis, has become the “de facto” Merger wars ultimate ruler on European debt restructurings while the ECB In this environment, several big tech companies themselves has emerged as the largest holder of sovereign debt. And are vulnerable: some may well pay too high a price for the concept of a particular class of holders of government mergers and acquisitions; and in some areas, such as media, debt being given preferential treatment in the event of there are many large companies with very similar offerings a restructuring is now a consideration: in the Greek debt competing. Often acquisitions are financed by increased debt restructuring there was no haircut to the value of bonds held issuance, increasing the vulnerabilities of such companies. by national central banks and the ECB. These changes have led to a major loss of sovereignty for eurozone governments. Conclusions For investors, this means that analysis of government balance In credit markets, Numen see opportunities on the short side sheets becomes important, analogous to assessing corporate in sectors where yield spreads are still compressed and the balance sheets when looking at companies’ debt. Filippo macroeconomic situation is deteriorating. In several areas, expressed a concern about the vulnerability of most sovereign equity offers much better value than debt. In some areas, an debt, especially Italian debt, in an environment of potentially over-reaction to bad news is opening excellent entry points in tougher fiscal rules, the end to ECB asset purchases and these stressed and distressed long opportunities. structural changes in government debt markets. For banks, we now have more punitive restructuring and liquidation rules for certain types of their debt, notably Additional Tier 1 (AT1) debt, meaning it is important for investors to assess the entire capital structure. Debt investors can, in extreme cases, see their entire holdings being wiped out overnight (as was the case, for example, with Spanish bank Banco Popular’s restructuring). This change of regime has unfortunately not been complemented by a completion of the banking union with appropriate deposit guarantees schemes. For many companies, leverage ratios have risen sharply and debt maturities have lengthened at the same time as the life cycle of companies has been shortened by extremely competitive markets. Far fewer companies have a competitive ‘moat’ protecting their businesses. Corporate debt is increasingly covenant-lite and has lower coupons and longer maturity than in the past. All these developments make for a more challenging environment in assessing corporate debt. Knowledge Exchange January 2019 | 3 GLOBAL AND ASIAN INVESTMENT STRATEGY Chris Wood CLSA An end to Fed tightening although longer-term the Sino-American relationship will Chris started by commenting that he still thinks that there remain stressed by Washington’s renewed obsession with may be one more increase in the Fed Funds rate to come. ‘strategic rivalry’. This will result in an unhelpful intermingling However, with the American stock market hit in Q418 and US of trade and national security issues. credit spreads rising, the prospects are growing for an end to Fed tightening. Still monetary policy discussion in 2019 will be US tax reform much more about US Fed balance sheet contraction than US tax reform has been hugely significant. US after-tax about interest rates, in Chris’s view. The fact that US 10-year corporate profits, the broadest macro measure of corporate Treasury yields have not broken above the downtrend which profitability, rose by 19.6% year-on-year to a record annualised has been in place since the early 1980s (see Figure 1) is good US$2.08tn in 2018 Q3. US taxes paid by the corporate sector news for asset markets generally. As the 10-year yield follows fell by more than a third in the first three quarters of 2018. US nominal GDP growth, and that is set to weaken, a break out There has been a big repatriation of US companies’ foreign in 10-year yields will be avoided. Some see the Fed’s balance earnings, which has helped share buybacks by S&P 500 sheet contraction as bearish for bonds, but Chris disagrees: companies to reach a new record high of US$720bn (in the 12 that balance sheet contraction is deflationary because it months to end-September). amounts to monetary tightening, and so should keep bond yields low. Higher rates impacting the economy However, there are now signs that higher interest rates are 1. US 10-year Treasury bond yield: long-run downtrend intact starting to impact the economy. For non-financial companies, debt levels have risen, especially for companies in the 16 BBB-rated sector. Household debt, in contrast, has been reduced relative to income. Some claim this will mean that the 8 millennial generation will start to buy houses. However, the income distribution has become more unequal and US e 4 personal interest payments (excluding mortgage payments) reached a record annualised US$348bn in November and are %, log scal up 55% since mid-2013. In that sense, household debt remains 2 an issue. 1 Average hourly earnings are picking up, but Chris does not see 1980 1985 1990 1995 2000 2005 2010 2015 2020 this bringing much higher consumer price inflation – more US 10-year Treasury yield likely it will reduce corporate profits because of pressure on Source: FRED (Federal Reserve Economic Data) and CLSA. Data as at 9 January 2019. record high margins. Core CPI inflation is now peaking. With US M2 growth and bank lending clearly slowing, inflationary However, the US BBB-rated corporate bond spread over pressures look set to remain weak. government bonds rose to almost 200 basis points at the start of January 2019. The price of leveraged loans also fell in ECB 2018 Q4 and Chris thinks there is the potential for redemption The ECB’s narrative will remain one of normalisation, although risk in that market. As a large proportion (70-80%) of Chris sees further longer-term refinancing operations (LTROs) leveraged loans are covenant lite, this is an area where he being introduced to help the Italian banks. European banks sees problems may emerge. have weakened recently along a recognition that there will be no push for further fiscal and monetary integration in the For now, the US Fed’s quantitative tightening programme eurozone. remains on auto pilot, according to Fed Chairman Powell and the Fed would like to continue to normalise policy if the data Chris sees Italy as “openly opposed to the Maastricht Treaty” allow this. although the politics may take some time to play out. Matteo Salvini is by far the most popular politician and Chris sees him Trade deal calling another election after the European parliament Chris thinks a deal on trade will be agreed between America elections in May, with the view to strengthening his position and China within the 90-day “time out” agreed at the start of and putting more pressure on Brussels. Chris thinks any December. This will trigger an equity market rally led by Asia, renewed complacency in the financial markets about Italy cont. 4 | Knowledge Exchange January 2019 GLOBAL AND ASIAN INVESTMENT STRATEGY (cont.) should be used to short the Italian sovereign bond market.