Where we are today

If we had known 18 months ago that we would have the Brexit divorce, the Trump victory and the geo-political headache that is the US relationship with North Korea, it is unlikely investors would have predicted that equities would be where they are now. Despite these factors, we have not seen a destabilisation of growth in 2017; rather, we have continued to see the steady global growth of 3-4% that the world has experienced since 2010. It may feel as though we are about to come off the rails, but the reality is that it has not happened yet.

Figure 1: MSCI Index - 31 December 2015 to 30 September 2017

Source: Bloomberg 2017.

During the last decade, there have been periods when the US, Europe, China and the emerging markets have struggled, but generally it has been a benign environment. To my mind, this is because there has not been a huge dislocation in nominal growth, against a backdrop of low inflation and reasonable cost control. It may have felt like a struggle to investors, but the reality is that valuations have incrementally risen, along with corporate earnings, for some years. Then came 2017.

For the first time in many years, we did not see a growth disappointment in Europe at the start of the year. At the same time, investors have become less worried about the renminbi and the degree of devaluation we would see. If anything, the renminbi has gone up in value, while Chinese growth has continued to be strong, but more sustainable; and all of this has had a knock-on effect on emerging markets, which have also been boosted to a certain extent by a marginally weaker dollar.

Pulling all this together, the environment has been constructive for global equity markets in 2017, while some of the perennial laggards such as Europe and emerging markets have performed particularly well. Added to this is the threat of geo-political upheaval not coming to fruition - and we did say at the beginning of this year that the surprise might be that the worst doesn't happen. We were therefore fearful of elections in the Netherlands and France in particular, as well as in Italy, with the potential rise of the Five Star Movement; with good reason, an anti-EU and antiestablishment party would be hugely destabilising for the European Union and for the euro. But if anything the Italian economy has stabilised and the economic situation has not deteriorated, with both the Italian and European banking sectors as a whole performing solidly this year. It might have been a different story four years ago, when we were going through the eurozone crisis, had Italian banks needed rescuing at that time.

So we are further through the cycle and investors have accepted that the worst is less likely to occur and European banks have even outperformed Europe as a whole this year.

Figure 2: MSCI Europe Banks Vs MSCI Europe - 31 December 2015 to 30 September 2017

Source: Bloomberg 2017.

Investment themes

Rapidly-evolving technology

Technology is key to the world we live in today and it is extremely important with regard the changes that are taking place across global economies. However, many of today's technologies are disruptive to existing business models. One of the most obvious would be the retail sector and the degree to which the high street has been disrupted by ecommerce. Going forward it will be the extent to which cars are disrupted as we move from fossil fuel-powered vehicles to electric vehicles (EVs) and, ultimately, autonomous vehicles taking over from people. That may be a pipedream and it may never occur, however, as an investor we need to have a view as to whether it will and who will be the winners and losers if it does.

Our approach is to ask questions such as: what will the value-add in a car be dominated by going forward? Will automobile manufacturers or technology companies provide all the components? In this particular example, we have consistently said for the past 8-10 years, that if you look at the value-add in a car it is less the car company, it is more the car component company. With the advent of Advanced Driver Assistance Systems (ADAS), the amount of electronics you have in a car now is many multiples of what it used to be and that value-add has increasingly been driven by research and development (R&D). This spend has therefore gone to the car component company rather than the car company itself; and as we move forward, we must analyse whether the car component company is likely to be a Continental AG, a Denso or a Delphi - or will it actually be a Google or a Mobileye?

Disruptive technologies are going to disrupt the business models of the traditional companies in which we currently invest but, on the positive side, if we can identify those technology companies which possess the value-add for the next generation, then it's likely they are going to be the winners.

One of the key themes within technology that we have seen over recent years is where you get the gorillas becoming the dominant companies, so it's the like of Amazon and Alibaba, because they dominate ecommerce in the West and China; or it's Google and Baidu because they dominate search engines. These companies have so much power because they are incredibly cashgenerative, which is then reinvested in their own companies or used to acquire new businesses. What can stop them? There are three things: one is that they 'blow up' through bad management; two, they get regulated away; or three, a new technology usurps them.

Figure 3: Cash and marketable securities (last reported as at 30th Sept 2017)

Source: Bloomberg 2017.

The latter point is often dismissed by those who believe the giant technology companies own all the smaller start-ups, and thus the idea of a disruptor itself being disrupted, is not valid. However, any new disruptive technology may be a completely different technology that we haven't even thought of. Turning back the clock, who would have conceived that Google would be in the position they are in now? So, the disruptors can get disrupted. You cannot rule that out.

When we look at technology valuations, we recognise that many of these technology giants are growing quickly and therefore attract a higher valuation. However, if we believe there is a greater risk of disruptive technologies out there, we cannot be sure that the cash flows of these technology giants will be there in five or perhaps ten years' time because we don't know what alternative technologies may exist in the future and we do not know what the regulatory landscape will be.

For example, when Alibaba came to market in China, it was clear that the company's aims tallied with the government's desire to ensure the Chinese economy became more consumptiondriven. Alibaba, through ecommerce, was bringing consumption to areas and regions of the country that were poorly served by 'high street' shops, so consequently they were helping to promote consumption growth. Thus there was little likelihood of regulation preventing Alibaba from achieving its growth targets. But in future, and not just in China, it is impossible to predict where regulation will curtail corporate earnings.

The changing nature of 'defensive'

Utilities are no longer a 'go-to' defensive sector. One example that helps illustrate this is power stations, within the energy sector. We ask ourselves: by 2030, will electricity be generated by existing power stations or by alternative energies such as solar? The traditional valuation method for a utility company is to perform a discounted cash flow analysis going forward ten or more years. Utility companies are regulated, so we know roughly what the returns are going to be and so we can come up with a valuation for the company subject to the regulator rate and discount rate. However, a disruptive technology such as solar changes the picture somewhat. We used to have to subsidise solar power, but the efficiency of this type of energy now threatens traditional power companies because their ability to earn the returns they used to and pay dividends at the same rate is seriously challenged.

In 1999, some analysts suggested that food companies were among the less safe corporates out there and were certainly not defensive. Instead, because the whole world was changing and digitalising, it was the 'new' technology companies that were considered defensive. Consequently, the message was that you shouldn't invest in food companies - maybe their business models were outdated and too risky. Fast forward to today and it is clear that returns for many of these companies have risen, not fallen. We're always going to need to eat food (although perhaps the nature of what we eat will change), but it is clear that those consumer staples are indeed defensive. The telecoms sector, on the other hand, is challenged because the way we communicate is changing rapidly. Regulation once again has played its part: arguably, mobile phone companies should have outperformed to a greater extent than they have given the boom in mobile phone usage, but the regulator aided by the telecoms industry itself (with the likes of 'all-you-can-eat' tariffs) has challenged the business models and hence damaged the environment for these companies.

The future

At some stage over the medium term, there is a concern that an event - whether it is geo-political, a threat to globalisation or of a monetary policy nature - will occur that will disrupt markets. But short term we do not see it happening. That does not mean we do not recognise that potential exogenous events lie in wait on the horizon.

To some extent, it is easy to see rising inflation from here on out, but in a way technology has played its part in keeping inflation low by improving efficiency of production. Indeed, despite traditional measurements that mark productivity as being persistently low, it is difficult to determine the accuracy of these, given that technology has led to a variety of products that were not available ten years ago.

The big question is what will happen when quantitative easing is reversed. Stock markets have been among the primary beneficiaries of money printing; therefore, we are wary of how the global economy will cope as monetary easing is reduced and central banking policy shifts from quantitative easing to quantitative tightening. We have already started that journey in the US but we have yet to start the journey in the UK and Europe.

However, what is encouraging is how central banks are managing the message. In May 2013, Ben Bernanke, then Chairman of the Federal Reserve, made a speech in which he spoke about the Fed tapering and the reaction was extreme - in that quarter alone US 10-year treasury yields went from 1.5% to 3%. But since then, when central bankers talked about tapering, they do so to a much more muted reaction.

China remains a concern, particularly its shadow banking system, bad loans within the banks, and the degree of leverage within China - one or all of these areas could go wrong. However, while the potential 'blow-up' may be bigger now than it was before, we are encouraged that the authorities are doing the correct things to address their issues.

We remain alert to these potential road-blocks and we are constructive about the outlook for global equities going forward. But we are mindful that valuations have edged higher than they were as we continue to climb the wall of worry. However, without that systemic upset to the global economy, that upset to earnings, or an upset to the discount rate, we think valuations are reasonable where they are and even have the potential to move higher from here.

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