The long-term drivers of return in financial markets and economies
We live in a world that is in a state of constant, and often, rapid change. It can be very difficult to keep up with the sheer pace of change. However, while there are many economic and market level events that unfold on a day-to-day basis fortunately, most change can best be described as ‘short term noise’, which only create small divergences from the underlying secular trends that will affect the world for decades to come. It is therefore important for us not to fixate on the short term but instead focus our attention on the longer-term trends that will drive markets and economies in the future.
Megatrends can be defined as powerful, transformative long-term forces that can change the trajectory of the global economy by shifting the priorities of societies, driving innovation and redefining business models. The most established megatrends are climate change, technological innovation, scarcity of resources, development of emerging markets and demographic change. What is fascinating is that each megatrend encapsulates smaller trends which are all interconnected to each other in some way or another.
Governments and multinational organisations across the world are becoming increasingly aware of the importance of these trends. Rather than reacting to the trends unfolding, policymakers are thinking ahead and are proactively making commitments to address the long-term global challenges which arise from megatrends. In 2016, the UN (United Nations, 2016) published the ‘Sustainable Development Goals blueprint’, highlighting the urgent areas where action needs to be taken.
As investors it is imperative that we do the same and consider not only the investment opportunities but also the threats that will arise from long-term structural change. Successfully separating the short-term noise from the long-term drivers of return will ensure that our portfolios remain robust moving forward.
What are the current long-term megatrends?
Demographic and Social Change:
Demography refers to changes in the composition of a population, based on factors such as age, fertility, mortality, and life expectancy. Changes to demographics have a long-term impact on the human capital of the global economy and future trends in consumer demand. Thanks to the wonders of modern medicine, over the last 60 years, mortality rates have been falling while life expectancy has been increasing (World Bank, 2020). Consequently, the global population is predicted to increase by 1 billion over the next 30 years, with the world’s total population in 2050 expected to be over 8 billion (World Bank, 2020).
However, the pace of the population growth varies significantly by region. Between now and 2050 it is estimated that 97% of the world’s population growth will be from emerging countries (Blackrock, 2019). The remaining 3% will be from advanced economies that are experiencing lower fertility rates. The reason for contrasting population patterns between the two can be attributed to the development stages of their economies. Historical data and studies (World Bank, 2020; Bongaarts, 2009) have shown that populations of developing countries will expand during their development phase and start to reduce once they reach their advanced phase. Countries in Africa and Asia tend to be in the early stages of development and are in their expansion phases and experiencing population growth. Whereas advanced countries in continents such as Europe and North America have been witnessing falling population growth.
This can impact both advanced and emerging economies in different ways. The increase to the population of emerging countries will mean that their labour force will expand, and thus labour productivity will directly benefit economic growth. As this happens workers in emerging countries will start to accumulate wealth, so consumer spending and saving patterns will change. The middle classes in these countries will start to emerge and demand more goods and services abroad aiding globalisation and international trade.
Advanced economies are facing the prospect of higher life expectancy and declining fertility. Meaning that more pressure is being placed on the working population to support the older population. In 2015, there were four working people per retiree in Europe. In 2050, this is projected to halve to 2 working people per retiree (Blackrock 2019) As a result, this will place a great deal of strain on the provision of public services including healthcare and social security for future generations. People who are still working towards their retirement will likely need to work for longer as retiring becomes more expensive. As this becomes the case, many will choose to sell off their financial assets to fund their retirement.
There is a debate as to whether asset prices will fall if there are more sellers than buyers in markets. However, we must remember that we live in a global marketplace, so there is every reason to believe that the wealthy in emerging countries will purchase financial assets from developed markets. We have seen this already with the Chinese government purchasing trillions of dollars’ worth of US Government Bonds. Ultimately, in the long run, demographic trends highlight the importance of diversifying our portfolio holdings across different geographic regions.
Technological Innovation:
Technological development has revolutionised our daily lives to a point where it is now almost impossible for society to function without developments such as satellite navigation or the internet. Future developments in technology such as Artificial Intelligence (AI), robotics, self-driving cars, cyber security will define the next few decades. We live in an information age where market agents have more data at their fingertips than ever before. For many companies, the rise of global e-commerce has disrupted traditional business structures by reducing barriers to trade and increasing the interconnectedness between economies. Small businesses are now able to reach new and obscure markets which they would not have been able to only a couple of decades ago.
The innovation of capital goods (physical assets used in the production of goods and services) have improved long-term productivity by maximising the efficiency of many global industries. As mentioned earlier on, megatrends are connected to each other and a definitive example of this is how Japan is dealing with its demographic crisis. In 2018, the average age in Japan was 53 while the population growth rate was -0.2% (World Bank, 2020); an ongoing trend which has led to a severe shortage in Japan’s labour force. Despite this, the overall productivity of Japan’s economy remains remarkably high due to substantial investments into factory automation systems. Compared to the more expensive option of human intensive production methods, automation means that factories can produce goods at a lower cost, higher capacity, higher quality, greater consistency, and benefit from improved safety. In addition, by investing heavily into these industries, Japan is now the number one producer of industrial robots in the world (Schneider et al. 2018) and the top exporter of robotics equipment. However, many argue that there are some areas in which robotics cannot replace humans. The increasing dependence on automation will reduce the quality of human dependent services such as restaurants, healthcare, education, and governance.
Japan’s case study is particularly relevant to our current situation here in the UK. Since the financial crisis in 2008, productivity has grown at a much slower rate than before the crisis, despite the government investing in skills, industries, and infrastructure. If Brexit brings about tighter immigration controls, the UK’s productivity is likely to continue to stagnate once the pool of economic migrants reduces.
According to a publication by the UK government (House of Commons, 2019), the UK has just 10 robots for every million hours worked compared with Japans 167. This poses the rather tricky question: Could automation be the answer to improve the UK’s sluggish productivity if our labour force declines? The simple answer is that it is hard to say! On the one hand, the UK could try to emulate Japan’s success to improve productivity, but on the other hand, if automation displaces workers there is a strong risk of exacerbating the productivity puzzle the UK faces and creating conditions that are ripe for populist politics to flourish. In a simulation conducted by the IMF across a group of 20 industrialized countries, the results pointed towards the risk of declining labour, income polarization, and rising inequality (Schneider et al. 2018). Ultimately, caution should be taken to manage the risk and rewards that technology can bring to economies. The main headwind to developments in automation is that people do not want to be displaced by machines, instead people want machines to aid them.
We have discussed how technology can benefit global industries but what about the development of the technology industry itself? The technology sector is one of the most fiercely competitive industries – efficiency, growth and invention are key factors which determine the success of technology firms. Within the industry itself, there is a constant technological race between firms as they attempt to leapfrog each other and release the latest products. In general, competition between firms is beneficial as it forces firms to outperform one another, which collectively pushes the entire industry forward. From the consumers perspective, this translates to better value products.
Technology has become such an influential sector that, as of writing, the top four companies in the S&P500 by market capitalisation are digital based (Apple, Microsoft, Amazon, Facebook). Soon it could be likely that almost every large company will be a tech company. Therefore, if businesses do not embrace technological change, it is highly likely that they will suffer. Perhaps the most famous example of this was Blockbuster. Once a well-recognised household name, Blockbuster failed to innovate and ended up losing the entirety of its customers to competitors such as Netflix and other online streamers. More recently, the Coronavirus pandemic has highlighted the importance of technological innovation more than ever, as the crisis forced many firms to adapt and switch to online services at breakneck speed in order to carry on their day-to-day operations.
However, trying to pioneer new technologies is not risk-free and can have its own dangers. Developing new technology can be capital intensive and the rapidly evolving nature of the sector is naturally accompanied by a high percentage of research failure. In addition, there are many concerns around privacy and cyber security which have created headlines in recent times.
Overall, technology is an exciting megatrend which helps to not only drive forward other megatrends but provides us with the solutions in which to fight the unwanted effects of some of the trends such as climate change. In terms of investment opportunities, the high rates of R&D failure make picking the long-term winners of this megatrend extremely difficult in the long run. Furthermore, tech stocks are particularly subject to fashion. What might seem like a sure-fire investment today might not be in a few years’ time as companies’ products can often become outdated almost overnight, as with Blockbuster.
Climate Change:
Climate change is undoubtedly the most frightening megatrend as it affects every one of Earth’s ecosystems, along with the quality of life for Earth’s inhabitants. Global financial institutions are now recognising climate change as a systematic financial risk and the consequences that will arise if we do not address the multitude of environmental problems will be severe. Since 2018, emissions have caused global temperatures to rise by 2˚C above pre-industrial levels and the number of natural disasters has quadrupled. If we continue this trend, by 2030 humanity could pass the point of no return and suffer irreversible damage (United Nations, 2019). Therefore, each of our consumption decisions are under greater scrutiny as we are forced to eke more out of less.
Unsurprisingly, climate change is a by-product of population growth. As the population grows, so does the demand for resources and energy. Trying to meet the demands of a growing population places a significant amount of pressure upon the surrounding environment, causing issues such as air pollution, rising sea-levels and abnormal weather patterns. Therefore, new, and alternative solutions are needed from the energy industry to limit these negative effects. Happily, we are already starting to see the demise of fossil fuels. Only a decade or two ago, oil was the elixir of capitalism which fuelled the world’s energy demand. Since then, we have seen the supply of oil move from extreme shortages and high prices to our current situation where cheap oil is flooding markets.
Global policymakers are taking the centre stage in the fight against climate change, Europe recently introduced a 2030 climate target plan which aims to reduce the EU’s greenhouse gasses to at least 55% below 1990 levels by 2030 and for Europe to become climate neutral by 2050 (European Commission, 2020). As such, the renewable energy sector is continuing to expand at a fast pace, with consumption increasing by 12.2% in 2019 and in 2018, China overtook the US as the world’s top consumer of renewable energy (Forbes, 2020). The consumption of renewable energy is set to increase as more developments in wind, solar, hydroelectricity is being made. In time, increasingly volatile energy prices, adverse health effects of fossil fuel energy production and competitiveness of renewable alternatives will make fossil fuels completely redundant. Just how long this will take will depend on technological R&D success rates among other factors.
Investors are becoming aware of the environmental impact of their investment decisions. There has been a rise in demand for sustainable portfolios among investors that are focused around environmental, social, and corporate governance (ESG). More than 78% of US individual investors surveyed by Morgan Stanley indicated an interest in addressing climate change via their investments (Morgan Stanley, 2019). Given the severity of the climate change crisis, in the very near future, it is likely that ESG will be the main fundamental factor that influences investor decisions.
Emerging Markets:
The importance of emerging nations as key players in the global economy has increased exponentially in the last few decades. Emerging markets are rapidly catching up to advanced countries and economic power is shifting towards emerging markets. For instance, in 1980, emerging economies accounted for 20% of global GDP, while today they represent 40% (World Bank, 2020). Emerging markets are expected to grow at a faster rate than developed economies, driven in large by the so-called ‘BRIC’ (Brazil, Russia, India, China) nations. Most notably China, which has seen itself rise to become a global superpower in just a few short decades. In part the success can be attributed to abundant cheap labour and a manufacturing industry fuelled by substantial levels of capital investment.
Demographic change and the rise in emerging market wealth are intertwined. As emerging markets develop two things happen. Firstly, the wealth level of the emerging countries will grow, as this happens the newly created economic power of these developing regions will allow people to be lifted out of poverty as living standards improve. As this happens, the middle classes will rise and consequently save less and consume more goods and services. This will create a virtuous circle in which there are vast opportunities for investment concentrated around the provision of consumer goods and services.
Secondly, urbanisation will take place as most of the emerging populations move from rural areas to cities in search of more productive and better paid jobs. Investment opportunities will increase around areas such as travel networks, education, healthcare, and other infrastructure needed to support the rapid urbanisation. In addition, as these investments drive forward the development stage of the country it will act as a catalyst and attract additional investment from foreign companies.
Because of its success, many countries are seeing China as an example to emulate. Although the route to rapid growth that was open to China may be closing for other economies. Increasing political instability across the globe means that the risks of investing in emerging markets is higher and they are becoming harder to access. Furthermore, as the middle class grows, so does the cost of investing in that nation’s companies as the higher demand for shares among the middle class pushes share prices up. In addition to this each emerging country has its own challenges and unique properties. For example, China has a substantial debt burden (mostly denominated in foreign currency), India has an extremely poor infrastructure, Indonesia has a wide income gap between the rich and poor, Mexico is heavily reliant on economic ties to the United States, and Nigeria suffers from political unrest.
Emerging markets have incredible long-term growth potential for investment returns. However, the risks mentioned mean that returns from investing in emerging markets can be extremely volatile. Arguably, the smart approach when investing in emerging markets is to invest across a diversified number of emerging countries to minimize country specific risks. Furthermore, investing in indices with a large global exposure such as the FTSE100 will still provide some access to emerging markets as many of the supernational companies listed on the FTSE 100 generate significant revenues from emerging regions.
Investing in long-term trends:
Identifying long-term structural changes will be the key required to make our investment strategy robust in the world of tomorrow. Nevertheless, we must be conscious that while each megatrend has its own upside it does also have its unique downside risks. As with all investments it is crucial that we understand the costs and benefits involved. One way to gain exposure to megatrends would be to invest in a thematic fund. These rely on fund managers being able to pick stocks which they believe will be the long-term winners from a particular trend. This places more emphasis on the ‘abilities’ of the fund manager to make the right calls, which as research suggests, can be a lot harder than it seems.
Just because something is going to be great from a global socio-economic standpoint does not necessarily mean it will be great for investors. For instance, in the early 1900s there were around 2,000 car manufacturers in the USA. Now, only the big three remain (G.M, Ford, and Chrysler). Therefore, the odds of being able to pick successful firms at outset is very small, especially within industries where competition is fierce.
Furthermore, we believe in the efficient markets hypothesis (EMH). Markets efficiently price the shares of companies, and we do not believe that the market consistently provides mispricing opportunities with which fund managers are able to take advantage of. Market agents have a comprehensive level of information available to them and the size of the market will mean that if any arbitrage opportunities arise then market agents will swiftly close them down. For that reason, we believe that as the information on ‘megatrends’ is widely available the market has already processed this information and it is fully reflected in the price of stocks. Therefore, there is no opportunity for investors to expect to achieve higher returns from investing in companies they have identified as being well positioned to benefit for certain trends as the market has priced this in.
So rather than choose ‘thematic’ funds which aim to take advantage of specific trends, our approach is to instead diversify across a wide range of assets and geographies which will naturally benefit from the long-term trends we have identified without trying to pick and choose the companies/sectors which we think may be the winners.
We should ask ourselves the following question: why would we choose to limit our investment opportunities to a handful of thematic sectors when we can invest into an entire market and therefore capture the total returns of the market along with the returns of the multiple trends that impact it?
For example, by investing in an emerging markets fund within our core portfolios allows us broad access to all the trends discussed in this note without having an overexposure to any specific area. A further example of this approach can be seen through our tilt toward the small company risk factor. Logic would suggest that small companies are innovative and flexible enough to respond to issues around climate and demographic change through the introduction of new product and service solutions.
References:
Blackrock (2019). ‘Megatrends’.
Available at: https://www.blackrock.com/ch/individual/en/literature/whitepaper/megatrend-en-emea-whitepaper.pdf
Boongarts, John (2009). ‘Human population growth and the demographic transition’.
Available at: https://www.ncbi.nlm.nih.gov/pmc/articles/PMC2781829/#:~:text=During%20the%20first%20phase%2C%20the,decline%20in%20the%20birth%20rate.
European Commission, (2020). ‘2030 Climate Target Plan’.
Available at: https://ec.europa.eu/clima/policies/eu-climate-action/2030_ctp_en
Houses of Commons Business, Energy and Industrial Strategy Committee’. (2019). ‘Automation and the future of work’.
Available at: https://publications.parliament.uk/pa/cm201719/cmselect/cmbeis/1093/1093.pdf
International Monetary Fund (2018). Finance & Development, June 2018 , Vol.55. ‘Land of the Rising Robots’.
Available Online: https://www.imf.org/external/pubs/ft/fandd/2018/06/japan-labor-force-artificial-intelligence-and-robots/schneider.htm
Forbes, (2020): Renewable Energy Growth Continues At A Blistering Pace
Available at: https://www.forbes.com/sites/rrapier/2020/08/02/renewable-energy-growth-continues-at-a-blistering-pace/
Institute for Sustainable Investing, Morgan Stanley. (2019). ‘Climate Change as an Investment Megatrend.
Available at: https://www.morganstanley.com/ideas/climate-change-investment-megatrend
Todd Schneider, Gee Hee Hong, and Anh Van Le. United Nations, (2016). ‘Take Action for the Sustainable Development Goals’.
Available Online: https://www.un.org/sustainabledevelopment/sustainable-development-goals/
United Nations (2019). “General Assembly Seventy Third Session, High Level Meeting on Climate and Sustainable Development”
Available at: https://www.un.org/press/en/2019/ga12131.doc.htm
World Bank (2020). “Global Indicator Data”.
Available Online: https://data.worldbank.org/indicator/SP.DYN.CDRT.IN
This report is for information only and does not represent personalised financial advice. If you require advice in respect of your financial planning, you should contact us.
Past performance is not a guide to future returns. The value of an investment can fall as well as rise and is not guaranteed – you may get back less than you paid in.
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