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Challenges for Investors in a Rocky 2016

Article - March 22, 2016

The IMF global growth forecast cuts for 2016 call for a year of uncertainty. This publication will shed light on the major trends to watch in the markets for the years ahead.

ENERGY UTILITY ASSETS HAVE BEEN THE SUBJECT OF EXTRA ATTENTION SINCE THE PARIS GLOBAL CLIMATE AGREEMENT

In January, the IMF cut its global growth forecasts for the third time in less than a year and warned that recovery from the financial crisis could be jeopardised if key financial challenges are not properly addressed. It projects that world output will be 0.2 points lower than in previous forecasts, and substantiates this new figure with a combination of factors including a generalised slowdown in emerging market economies, China’s rebalancing, lower commodity prices that are putting Brazil, Russia and Saudi Arabia in precarious economic straits, and the gradual exit from extraordinarily accommodative monetary conditions in the United States. The impact of refugees entering Europe was also cited as a potential strain on the job market, and as a buffer, the IMF suggested that central banks continue to boost growth and that finance ministries bolster investment spending wherever possible.

Although economic forecasts vary regionally – the IMF expects the economic output of the US to remain relatively steady at between 2.5%-2.6% over the next two years, to remain constant at 1.7% in Europe, and to slow to 6% in China by 2017 – the overall trend indicates that emerging economies will struggle the most over the coming years. Following a recent increase in interest rates by the US Federal Reserve, for example, emerging Asian economies with currencies not pegged to the US dollar have experienced downward pressure. This is because as US dollar-denominated assets become more attractive as a result of their higher returns comparative to their equivalents in Asia, ensuing money outflows cause the depreciation of local currencies to kick in. While Asian central banks may try and offset these effects by raising interest rates, this also squeezes growth and may dangerously fuel deflationary expectations in a region already facing a deceleration.
 
The aftershocks of shifting monetary policy
For emerging markets with currencies pegged to the dollar such as Kuwait, UAE, Saudi Arabia and Bahrain, increased US interest rates will have a slightly different impact, as they will be forced to tighten credit conditions. When combined with the low oil prices that are already afflicting the region, Gulf currency systems are likely to face significant pressure, especially if forced to continue spending from reserves.

Overall, between the tightening of US monetary policy that is driving countries with currencies pegged to the US dollar to raise interest rates, and the still loose monetary policies of European and Japanese central banks which is harming competitiveness, current economic dynamics make things especially challenging for emerging economies. Even so, the Gulf Cooperation Council (GCC) will remain pegged to the US and also gradually increase interest rates. To mitigate the effects of changes in Europe, Asian central banks are also expected to more closely track the monetary policy of their European counterparts.  

 The uncertainty surrounding global economies has played itself out on the stock market and generated an unexpected effect on treasuries. In fact, as the appetite for a safer, more appealing alternative to stocks grew larger, investors began increasingly putting their money in treasuries. As US, European, and Chinese stocks continued to decline in the summer of 2015 – in some cases to numbers below those in 2007 – investors saw the value of their U.S. government-debt holdings soar by $67 billion.

As James Kochan, chief fixed-income strategist at Wells Fargo Advantage Funds told Bloomberg, “For global investors with large amounts of money seeking a safe haven, it’s Treasuries, Treasuries and Treasuries,” he said, adding, “I can’t think of anything else. “Overall, in a time when aggregate demand around the world has hit new lows which no investors are immune from, the game has clearly changed from bullish investment behaviour to cautious capital preservation – a strategy that also applies to commodities.

After suffering from their worst drop since 2008, industrial commodities in particular are seeing exceptionally high losses, though signs indicate that certain commodities may soon be turning around. Iron ore, platinum, copper and coal suffered the biggest hits and the Bloomberg Commodity Index fell a whopping 25% last year, now standing at its lowest level since 1999. Their drop in value was largely due to decreased demand from China, which has begun to invest and construct less, and instead grow consumption. As this was happening, major miners in Australia and Brazil failed to accordingly ease up on production, which led to a glut of commodities that was only compounded by China’s bid to source more of its own domestic ore. In the wake of this decreased demand, it has become clear that newly emerging countries aren’t big enough to require the same quantities of raw materials. For perspective, in 2000, China consumed 12% of the world’s demand for metal, but now accounts for 50% of total demand. Its demand for steel is larger than that of the US, Russia, India, Japan and Korea combined, and between 1998 and 2008, its demand for iron ore rose by fivefold. By the end of 2014, its share of global consumption was 10% for oil, 45% for copper and zinc, and more than 50% for aluminum and nickel. Yet as China’s demand decreased, the value of the US dollar increased, thereby further complicating matters. Having reached its highest level since 2003, a stronger dollar has added pressure to commodities, which are priced in US dollars. When the value of the dollar rises, it takes fewer dollars to buy commodities, which encourages negative performances.

Blue chips save the day?
In these times of increased market volatility for both stocks and commodities, blue chips may be a promising alternative. Several respected investors have already pointed out that while big ‘rocket’ stocks like Tesla, Netflix, Facebook, Under Armour, Salesforce and Amazon have gotten excess attention, blue-chip dividend stocks have proven to be the most reliable. Nonetheless, the popularity of high-growth stocks often overshadows the security of blue-chips for a variety of reasons, including a tendency for investors to operate with a trader’s mentality and follow momentum rather than investing for the long-term. Some investors also struggle to part with the high-growth stocks that have yielded them huge gains during more bullish times, or want to avoid hefty capital-gains taxes. Still, given a weak global economic backdrop, which offers few opportunities for strong growth, high-quality and defensive blue-chip stocks are proving a safe bet.

Millennial investors bucking investment trends
Despite the increased risks of the traditional stock market, however, there is one group of investors that is becoming increasingly bullish as stocks tumble: Millennials. On August 24th when the stock market tanked over 1,000 points, Robinhood, a stock trading app that is popular with Millennials reported that its number of new accounts doubled. 65% of its customers bought stocks that day, a pattern which was mimicked by Degiro, an online trading platform based in the Netherlands. This was all happening as investors pulled nearly $30 billion from stock funds, or the largest weekly outflow since Bank of America Merrill Lynch began collecting this data. It’s an encouraging sign that Millennials are not as concerned with China’s economic slowdown and its aftershocks on the global economy, nor as disengaged from the stock market as often reported.



Nonetheless, there is still reason to believe that Robinhood and Degiro investors represent a small portion of Millennials, especially when considering that a recent Goldman Sachs survey finds that only 18% of Millennials trusted the stock market as a the best way to save for the future. Over 20% claimed they didn’t know enough about stocks to invest, and yet another 16% deemed the market too volatile or too unwelcoming for small investors. Still, poised to become the most financially important generation in America, Millennials represent an important class of upcoming investors and their investment proclivities are starting to become trends. Unlike their Baby Boomer parents, for instance, Millennial investors are more inclined to put their money into leisure and travel-related stocks such as pubs, airlines, restaurants, live events, online gaming and the sharing economy. They are more interested in experiences, Sarbjit Nahal, head of thematic investing at Bank of America Corp in London told Bloomberg Business, as these help them shape their identity and create memories. They seek alternative roads to satisfaction and tend to favour the stocks of companies they are familiar with. Unsurprisingly, tech stocks like Facebook, Apple, and Netflix are also popular among Millennials because they use and understand the products developed by these companies. Still, larger market trends suggest that tech stocks may be up on harder times than they’ve been in recent, more capital-flush years.

The end of bottomless coffers for tech startups?
Common logic indicates that if big investors begin losing money in the stock market, they might become less keen to invest in companies such as tech startups, which present a higher degree of risk because they are valued on potential more than current profits or dividends. Likewise, startups that have already received one or two rounds of investment and are seeking a third may find themselves with a lower valuation than in previous rounds. Startups might even see a downturn round, and the excessive company evaluations of the past may be corrected by a leaner market. While this is unlikely to make it impossible for entrepreneurs to get more capital, they may have to work harder to convince investors that their companies are indeed worth their valuations.

On the other side of that equation, however, is the silver lining that as a result of a struggling market, big tech companies are now cheaper to buy. If enough investors decide to sink their cash into them, a rebound for the tech sector may even be quicker than expected. For startups still in growth mode, however, things are slightly more complicated. In addition to being harder to attain seed capital under current market conditions, the outlook for going public is not very rosy for the near future.

Since the seemingly bottomless coffers of seed capital for tech startups are starting to become scarce, companies that need more money to keep afloat are not guaranteed an enthusiastic reception when attempting to go public. At present, if their balance sheets allow it, startups are being advised to hold off on an IPO until the market improves.

The threat of climate change – a boon for energy utility assets?
For as much instability as tech startups present, energy utility assets, on the other hand, may benefit from potential stabilisation following increased investor appeals for clean energy sources. Energy utility assets have been the subject of extra attention since the Paris global climate agreement left it clear to the world that every country must be on the path to a low carbon economy. Partially in response to this agreement, according to Bloomberg New Energy Finance, new clean energy investments are up six fold since a decade ago and now amount to 330 billion. The long-term extension of wind and solar federal tax credits in the US is expected to stimulate an additional 73 billion of clean energy investment over the next four years, and a record 42 billion dollars in green bonds were issued last year. Perhaps most impressively, clean energy investments in low-income countries matched investments in the Organisation for Economic Co-operation and Development (OECD) nations.

The real challenge now is finding ways to act quickly and scale up new opportunities. The World Resources Institute reports that the eight largest carbon emitters (Brazil, China, the EU, India, Indonesia, Japan, Mexico, and the United States), will double their renewable energy supplies. In the majority of these countries, ambitious plans are already in place to generate wind and solar power and to increase dependence on fossil fuels while relying less on oil, but for real change, all spheres of the investment community need to be involved. Utility-scale projects such as wind farms, solar parks and biomass plants still only represented 60% of the money invested in clean energy last year. Small-scale projects represented 20% of investments, and less than $6 billion was allocated to clean energy venture capital.

Though encouraging, these numbers still fall extremely short of the trillions that are needed to address climate change with the speed and scope that is necessary.

Financing and fortifying the backbone of world economies
One final pillar of the global economy that must be considered when evaluating the world’s future economic outlook are SMEs. The lifeblood of the economy, SMEs are critical to economies around the world, but their financing options are far from abundant. This is largely because they are considered riskier investments than larger companies, and the heightened regulatory scrutiny that followed the global financial crisis has made banks increasingly sensitive to risk.  

According to a 2015 study by the International Organization of Securities Commissions (IOSCO), roughly 60% of SMEs worldwide rely on bank loans as their primary source of financing. While capital markets could be a viable alternative source of financing for them, IOSCO found that only 25% of SMEs use equity financing as their primary means of raising capital. High regulatory costs, fear of losing ownership of a business and lack of familiarity with capital markets are all cited as reasons for sticking to bank loans over capital markets.

Beyond capital challenges, a number of other obstacles impede SMEs from reaching the full scale of their potential. Cyber-threats continue to be a source of lost business, with cost – equipment, machinery, education and employee training – continuing to be a barrier to innovation. According to Zurich Insurance Group’s third annual global SME survey, it is estimated that small and medium-sized suppliers in the U.K alone are owed $364 billion by their corporate buyers, and that these outstanding payments have either severely strained their accounts, or in some cases, forced them to close.

Fortunately, a variety of new capital markets have been created to meet the funding needs of SMEs, thereby helping them to attain the capital they need and bolstering market integrity. In India, for instance, an “SME Exchange” is a stock exchange for the listing and trading of shares belonging to SMEs that would otherwise not succeed in being listed on a main exchange. The advent of these markets has allowed smaller companies to benefit from capital markets, gain visibility, maximize wealth, scale their operations, and provide new opportunities to investors.

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