Don't be fooled by an Index

We've become accustomed to global equity indices marching in one direction - higher. The S&P 500 is sitting near yet another all-time high and valued at 21x forward earnings, with the index up 23% calendar year to date, you may assume it's been a great year for all US stocks.

As the index has moved higher only 50% of stocks are above their 200 day moving average. In fact, just five stocks - Microsoft, Alphabet, Apple, Nvidia and Tesla - account for 35% of the S&P's year to date return, and more than 50% of the S&P's return since April. The same five stocks account for over 70% of the NASDAQ's 18% return year to date.

Global equity indices are near all-time highs but fewer and fewer stocks are taking us higher. The market is crowding into an increasingly narrow subset of stocks - big cap tech. Reliance on the performance of a handful of names is not a backdrop conducive for markets to continue rising; it's typically associated with market draw downs, as shown below.

                     

Source: Factset, Antipodes

The market is ignoring some major changes taking place in the economy
 

November's headline inflation print of 6.8% brings the 12 month rolling average to 4.2%. Assuming no adverse outcomes from Omicron (find our latest podcast discussion on Omicron here) and supply chain constraints are ultimately alleviated, there's a pipeline of inflationary pressures building via wages, rent and energy prices which can keep inflation above trend over 2022.

Wages in the US are rising 5% p.a., meaningfully higher than the historical average of 3% p.a, and the labour market is tightening. The number of Americans filing for unemployment benefits recently fell to the lowest level in 50 years and the US Federal Reserve (the Fed) forecasts the unemployment rate will fall to 3.5% by the end of next year, which is below the long-term average.

On the ground, the annual increase in asking rents has been running at more than 10% higher for the last few months versus the 3.8% yoy captured in the latest CPI report. This is thanks to the low-interest rate fuelled property boom in the US where house prices are accelerating at the fastest pace in 15 years, which feeds into rent with a lag.

And finally, energy prices remain elevated. European gas prices have been extremely volatile recently reaching $29/unit - a level around three times higher than prior peaks. Europe is facing a once in a multi-decade energy supply crunch. Larger than expected drawdown of inventories with no increase in supply in sight means that demand rationing will likely need to continue throughout the winter. Meanwhile in the US, the gas price has recently corrected by over 30% to under $4/unit on account of warmer weather which has driven down near-term residential demand. But this could easily reverse. Over the longer-term energy prices can remain structurally higher even with decarbonisation because hydrocarbons have seen supply rationed. Companies are investing below replacement cost levels.

Sticky inflation and a tighter labour market has seen the Fed scrap the use of "transitory" in relation to inflation and recently accelerated tapering to $30b per month, meaning the Fed will no longer be buying new issuances of Treasury debt after March 2022. While there's no explicit timing for rate hikes the market has priced in one rate hike by June 2022 and three hikes by the of the year taking the cash rate to 0.75%.

So, what does this mean for bond yields? As conditions tighten, coupled with a relatively resilient outlook for economic growth (even with the pace of growth slowing) is it reasonable for yields and discount rates - the rate used to value a company's future cash flows - to remain at historically low levels? As yields/discount rates have collapsed earnings multiples have risen. Higher yields will be a meaningful headwind to weaker companies that are valued at unsustainably high multiples.

In fact, this may already be playing out. The bottom quartile of the NASDAQ (based on 1 year performance) - arguably the weaker expressions of growth - is around 30% lower than its 1-year highs versus the NASDAQ index itself which is only 6% off its 1-year high.

INTRODUCTION

The focus on ESG, sustainable investing and investment stewardship has dramatically risen in recent times. However, 2020 marked a significant turning point.

Prior to COVID-19, while considerations of ESG and sustainability had become prominent, progress remained slow. However, the emergence of COVID-19 in combination with extreme events triggered by the climate crisis heightened global focus on ESG matters and starkly highlighted the challenge before us all.  A perfect storm had been brewing fueled by habitat destruction, biodiversity loss and social inequality. In addition, as the COVID-19 crisis has unfolded, millions of people crashed down through Maslow's Hierarchy of Needs, revealing the widespread nature of social inequality and insecure work practices.

Given the systemic weaknesses that were unveiled and the broad-based issues facing society, it became rapidly evident (even to the naysayers) that all participants in the investment supply chain have a role to play, including sovereign bond investors.  We need to build in greater levels of system strength and resilience (economically, environmentally, and socially) as we collectively recover from COVID-19.

THE GROWING ESG TREND IN FIXED INCOME - NOT JUST A THEME FOR EQUITIES

Historically, ESG focus has largely been on equities: this was a space where asset managers and asset owners felt comfortable and had clarity around what they could do and how to do it. Attention has also evolved to similar areas of comfort: real assets (property and infrastructure) are asset classes where the what, why and how of ESG is readily understood.  

In the mind of many investors, fixed income tended to be obscured, as it perhaps felt less tangible and therefore more difficult to tackle from an ESG perspective. However, the focus has now duly turned to fixed income.  This is critical, in that when we consider the capital stack, global debt markets (~$281T in size at the end of 2020) are almost triple the size of global equity markets (~$105T), yet almost all ESG focus has been in the listed equity space, leaving a large gap in approach (and potentially outcomes and impact).

In the context of fixed income, greater emphasis has tended to have been placed on corporate debt. The reason being that much of the ESG and investment stewardship knowledge, and practical experience, garnered in and from public equity markets can be transposed into how one approaches ESG in public debt markets - from issuer ESG analysis through to engagement.

Whereas, in the context of sovereign debt, it may have been conceptually overwhelming to know where to focus, e.g.:

• How to engage with a sovereign counterparty or influence change when it comes to ESG.

• Government activities are broad in nature, some of which may be detrimental from an ESG perspective, others which are either neutral or positive.

INTEGRATING ESG INTO SOVEREIGN BOND INVESTMENT  

Notwithstanding, the focus is now turning to sovereign bonds.  This is important given the size of the sovereign debt market which accounts for roughly two thirds of total fixed income market capitalisation.  Further, we all have a role to play in driving positive change and delivering impact on the ground. We also believe that the ESG and investment stewardship lessons learned in public equity markets and listed corporate debt can be elegantly leveraged in a sovereign debt context.

Consideration of ESG factors has long been part of, and an input into, JCB's investment decision making process as a means by which to manage risk, make informed decisions and influence positive change.

We have continued to further refine and develop our approach, which is now centred around three core pillars of focus, namely:

1. ESG research and integration

2. Active ownership

3. Collaboration and information sharing

Sovereign debt investors, JCB included, have utilised ESG research and integrated ESG considerations into their investment analysis and decision-making processes for some time. While ESG factors may not drive the ultimate investment decision, they provide another lens by which to view a prospective investment opportunity. This goes to making well informed investment decisions.

In addition to this, when thinking about ESG integration, ESG factors are not only relevant as an input but can be a key output. The market has witnessed an exponential rise in green, social and sustainable debt issuances. This provides investors with an opportunity to finance impactful activities, projects and programmes at a sovereign and semi government level. Further, such issuances also "serve as a commitment device for politicians".

Government policies and commitments can always be watered down or resiled from, however:

"...when a finance ministry creates a green-bond programme and builds out a "green curve", backing out of specific policies may become harder...Doing so would hurt liquidity and anger investors." ["A wave of green government bonds is flooding markets", The Economist, 9 October 2021].

Anchored to the need for ESG integration and investing in impact, is the opportunity (and some may say obligation) to:

• Engage with issuers and other relevant parties

• Collaborate with others to influence change

Engagement and collaboration, in the context of ESG and investment stewardship, have long been the domain of listed equity investors. However, this is evolving, and sovereign debt investors increasingly recognise that they also have a role to play.

Historically, it has been posited by some that it is not appropriate for sovereign debt investors to utilise their ownership rights and engage on the basis that it may be construed as undue political influence. Our view is that such engagement is incumbent upon us as a responsible market participant, and it provides a constructive tool to:

• Communicate our approach and client expectations

• Share our key focus areas and encourage action

• Communicate our desire to see the development of more sustainable and resilient financial systems

• Maintain ongoing dialogue and conversations regarding ESG related issues

Accordingly, we are in the process of increasing our levels of engagement with issuers, originators, and other market participants as a means by which to stimulate ongoing dialogue and where possible influence for positive change regarding ESG matters. We firmly believe that having conversations can create awareness and drive positive change.

Related to active ownership, we are also seeing that the appetite to collaborate (e.g., via the PRI) has risen.  JCB has recently joined the PRI as a signatory and is actively looking for ways in which to collaborate with others to influence positive change. This will also be an area of ongoing focus.

WHAT ARE THE OPPORTUNITIES FOR INVESTORS?

There are opportunities and benefits for sovereign bond investors who are integrating ESG and focused on participating in the Green Social and Sustainable (GSS) bond space. Specifically, consideration of ESG factors leads to better informed investment decisions, and when combined with the tools of active ownership, it provides such investors with the capacity to influence positive change.

In addition, investing in labelled sovereign GSS issuances enables the delivery of real impact on the ground. In doing so, it also provides the ability to ensure that such Government commitments to positive GSS projects and outcomes are executed on irrespective of the political cycle.

Consideration of ESG factors and investment stewardship practices, combined with participating in GSS issuances also ensures that portfolios are better aligned with client expectations and outcomes, and provides a source of portfolio diversification.

CONCLUSION

We are witnessing a maturation in ESG practices combined with the ever-growing need for capital markets to influence positive change from a social and environmental perspective. Given that sovereign debt constitutes a large part of the capital stack, sovereign investors such as JCB have a role to play in building in economic and ecosystem resilience. Particularly given that against the backdrop of COVID-19 the awareness of the intersectionality between environmental and social issues and capital markets has amplified.  More is now rightly being asked of all capital market participants.

Ultimately, as an active sovereign debt investor, we feel that ESG is both an important input and output of the investment management process.

If you are interested in learning more about how sustainable investing works, view our ESG Approach to investing.

We see plenty of reasons for investors to be positive on the outlook for Asian equities in 2022 now that peak coronavirus appears to have passed and the region's economies are reopening.

Progress in the roll-out of vaccinations allied to improved anti-viral treatments point to a policy transition from zero-Covid tolerance to one of endemic coronavirus management.

We anticipate further easing of mobility restrictions and a resumption in travel. We also expect Asian exports to pick up as demand grows in the US and Europe. This promises to drive consumption and corporate earnings.

A key question globally concerns how transitory inflation really is, and we don't have a crystal ball. But unlike Western markets, we haven't seen much price pressure in Asia so far.

Investors should feel reassured that Asian central banks have more headroom to adjust monetary settings, having been more conservative with state policy tools in recent years.

The Bank of Korea has signalled a potential rate hike soon, but Asian policymakers on the whole continue to prioritise economic support. Asian balance sheets are also in a healthy state, with most of our holdings either meeting or exceeding earnings expectations in recent results.

Economic reopening will help to mitigate inflationary pressures tied to near-term bottlenecks in supply chains. This remains an area we will continue to monitor closely. We urge investors to diversify across markets and sectors and focus on firms with pricing power that can pass on cost pressures to protect their margins. We see many quality businesses doing exactly that.

While Asia experienced an equity market rally in the first half of this year, a regulatory reset in China and the prospect of US tapering led to a correction. Still, corporate Asia is well placed to withstand a cycle of a stronger dollar overall.

We expect China's property sector to remain under pressure, while China's zero-Covid policy approach is likely to stay in place until after it has hosted the winter Olympics at least. Regulatory intervention will likely be at the forefront of investor thinking in the run-up to the Party Congress in November, when President Xi Jinping is expected to secure a third term.

Again, investors can rest assured that Beijing has levers to pull in the event that economic conditions become less stable. Bear in mind, much of China's growth slowdown is self-imposed via restrictions in property and energy sectors and the common prosperity push.

Investors can find quality Chinese businesses on the right side of the policy agenda delivering strong growth.

Investors need to be selective. But look carefully and they can find quality Chinese businesses on the right side of the policy agenda delivering strong growth. Structural drivers behind consumer spending in China remain intact. We predict that rising disposable incomes and increasingly health-conscious citizens will drive demand for healthcare products and services.

Growth in domestic consumption remains a strategic priority for Chinese authorities, so we view quality consumer stocks as well placed to withstand regulatory headwinds.

We believe Southeast Asia will be the biggest beneficiary of economic reopening. Hit hard by Covid, Indonesia and Vietnam are just emerging from the pandemic. They're working through supply-chain indigestion, with cyclical stocks long overdue a meaningful rebound.

India's stock market has been taking a breather of late, having rallied hard this year. But we're confident there's plenty of market upside to come given favourable demographics, low mortgage rates, rising household incomes and improving housing affordability.

After years of subdued economic growth, India looks primed for a rebound that should feed through to earnings. A brightening picture is boosting sentiment and company spending plans.

There's also excitement around India's tech sector. The nation has produced 100 unicorns and counting.¹ Many are listing on exchange, transforming the corporate landscape. Our team has been wading through stacks of IPO information to cherry-pick likely winners.

Foreign direct investment continues to flow into the tech sector. As these businesses grow and harness new technologies, they will invest - creating jobs and lifting incomes. Consumers will also benefit from better products and services.

India's government, too, is reforming the business environment, attracting foreign investment, incentivising companies via tax benefits and raising spending on key infrastructure projects. We expect a broadening of India's entire tech ecosystem, driving more growth in digitisation.

In terms of valuations, Asian stocks look reasonable relative to developed markets. The 12-month forward price-earnings ratio for MSCI AC Asia Pacific ex-Japan Index stands at 15.6x, versus 22.5x for S&P500, 16.2x for MSCI Europe and 20.3x for MSCI World.² Consensus earnings growth for Asia Pacific ex-Japan markets forecast to be in double digits for 2022.

We believe Asia's burgeoning middle class will fuel rising demand for health-care services and wealth management, while the region's urbanisation and infrastructure needs remain vast. At the same time, changes brought about by the pandemic could prove durable and reinforce existing trends - such as increased adoption of cloud computing and 5G networks.

Policymakers globally are also committing to a lower-carbon future and Asia is at the forefront of change. Investors can anticipate tailwinds for companies operating in renewable energy, batteries, electric vehicles, related infrastructure and environmental management.

As an investor we focus on quality firms with strong balance sheets and sustainable earnings prospects best-placed to capitalise on structural growth opportunities in the region. We see market corrections as an opportunity to add to our long-term quality holdings affordably.

In Asia, investors need to think long term. But Asia's attractions remain as bright as ever.

¹ Credit Suisse Equity Research, March 2021     ² Bloomberg, 18 November 2021

Author: James Thom, Senior Investment Director, Asian equities