Investment Institute: London Forum 2013
The Great Reset
Five years after the global financial crisis, market participants are contemplating a world with decreasing monetary intervention from developed market central banks. While this has ignited fears of major asset price recalibration in the medium term, it also presents significant long-term investment opportunities. This ‘great reset’ in financial markets was the central theme underpinning the discussions at the inaugural London Forum hosted by the Investment Institute at Investec Asset Management. The event, held at the historic Spencer House in London, brought together a small group of distinguished investment professionals to discuss key challenges, opportunities and new frameworks related to global investing.
The discussions highlighted how the reset in financial markets is reflective of much broader structural changes in the global economy. We are at a historic transition point, with a convergence continuing between East and West and significant rebalancing happening within major economies. This, in turn, is causing deep changes in the texture of our economy and society. We believe that this broader reset requires a more multi-disciplinary approach towards investing. It will require new tools and perspectives to grasp the nature of the economic transition and the route through which investors can take advantage of the opportunities.
Emerging Market Growth – Divergent Outcomes and New Lenses Needed: Professor Ricardo Hausmann
Emerging economies underwent an impressive period of growth from 2002 to 2012, and proved to be quite resilient during the global financial crisis. On the back of strong demand from China for commodities, improving fiscal and regulatory environments and youthful demographics, many analysts believed these economies would continue to grow at a significant premium to the developed world.
Upon closer analysis, however, the emerging market growth narrative and future prospects are significantly more nuanced. Over the past decade, many emerging economies grew very quickly in nominal dollar terms, but the ‘real growth’ in their local currencies was significantly less impressive. Much of the economic growth was captured by appreciating exchange rates. For example, the nominal GDP of Brazil increased 348% from 2002-2012. Only 11% of this growth, however, was due to real output, whereas 89% resulted from dollar depreciation over the period. As capital flows and terms of trade, both of which affect exchange rates, are mean reverting, Professor Hausmann, Director of the Center for International Development (CID) and Professor of the Practice of Economic Development at Harvard University, believes we can expect a prolonged slowdown in some of these economies over the next few years. In particular, economies such as Russia, Venezuela, Brazil and Chile may struggle.
The emerging market universe is broad and varied. Investors will need to better understand the differences between these economies to extract market-beating returns. To do so, we believe new analytical tools will be needed to understand the growth prospects of economies, sectors and industries. One such tool is the “Economic Complexity” framework developed by Harvard University’s Center for International Development, research supported by Investec Asset Management. The theory and supporting empirical evidence explains why the accumulation of productive knowledge within a country or region is the key to understanding sustained economic growth. Professor Hausmann asserted how the division of knowledge in modern economies is even more powerful than the division of labour. Using big data and network theory, this research can better help us understand which countries are best poised for growth, how countries can acquire and enhance their productive knowledge and which industries and sectors are likely to appear or disappear over the long term in any given country. Specific examples showed the precise mapping of the development path of Ghana versus Thailand over a forty year period with dramatic results.
Fragility, Unpredictability and Risk in Global Markets: Nassim Taleb
Is the global economy beset with more risks today than before the financial crisis? How should investors think about risk in their own portfolios and more broadly the measurement of unpredictable events? These are important questions central to investing. A key lesson of the crisis was that banks, regulatory bodies, governments and investors had not adequately foreseen the growing risks in the financial system. Market participants need to better understand how to handle risk in their portfolio and whether the systemic risks that caused the financial crisis in the first place have indeed been eliminated.
According to Taleb, essayist, scholar and statistician, rare events are, by their very nature, unpredictable. He suggests that instead of trying to predict these events, we should try to build structures that gain from disorder. This has major implications for portfolio construction. In the S&P 500 Index, for example, approximately 40-70 companies account for 50% of returns. Since a few counters will drive significant returns, portfolios should be constructed in an equal-weighted manner to avoid missing out on the big ideas, after de-selecting the most fragile. Another implication is around risk-modelling. Taleb suggests that as this can never be effectively done, investors should consider adopting a barbell approach to portfolio construction: holding 80%-plus in low risks assets and the rest in more speculative investments. Though these concepts are controversial, they provide food-for-thought for asset owners when constructing a portfolio.
Another key takeaway is that the most successful businesses learn how to turn mistakes into profits – they gain from disorder. Nokia, for example, started off as a paper manufacturing company and eventually became a leader in mobile telephony after attempts of entering industries as diverse as production of paper, bicycle and car tyres, plastics, personal computers and more. Boeing began as a lumber company and eventually became a leader in global aeronautics after various iterations in the industrial sector. A lot of what society knows comes from ‘tinkering’ – an experimental mindset which allows systems to learn, adapt and build technology from the bottom-up rather than having strict structure imposed from the top-down.
Finally, we live in a world where the ‘winner-takes-all effect’ is stronger than ever before. Technology is concentrated, and a few major firms control our use of technology and its benefits. While this effect is strong, it is also true that new technology destroys old technology. Therefore, as large companies become larger, they increase the risk that they can also descend faster.
The Need for Intelligent Risk-Taking: The Global Commodities Industry: Ivan Glasenberg
Industries are experiencing significant transformation, nowhere is this more apparent than in the resources industry. Over the past two decades, the rapid development of the emerging world led to an unprecedented commodity-demand boom. This required a level of risk-taking, entrepreneurship and ingenuity from commodities businesses leaders with significant lessons for the rest of the private sector.
According to Glasenberg, CEO of the mining and trading giant Glencore Xstratra Plc, in the recent past, mining companies prioritised expanding production capacity rather than maximising financial returns to investors. Free cashflow generated was deployed back into the industry to increase the size and scale of production which ultimately had an impact on pricing and profitability. As China’s endless desire for commodity volumes continued, the general sentiment among mining companies was to continue to supply at the expense of dividends and returns for equity investors.
Glencore took another path. Given its origin as a commodities trading company, it had a much stronger knowledge of the markets and prices and was able to leverage both this insight and its global networks to create value in a very different way to the singularly focused mining companies. With this approach, the company grew from a trading house into a global natural resources business with offices in over 50 countries engaged in the mining, oil and agricultural sectors. According to Glasenberg, key to its success has been its ability to attract top talent and its highly entrepreneurial spirit. This allowed it to enter markets where its competitors do not want to be, notably in Africa and buying smaller and often ignored assets recognising the long-term potential of these investments.
With recent executive management changes at almost all the major mining houses, most of these companies appear to have pulled back from their massive capital expenditure expansion drive which should stabilise the industry to a certain degree. Over the long term, Glasenberg believes that the global commodities landscape will continue to be heavily impacted by China, from both supply and demand perspectives. In addition, we are starting to see Chinese companies take direct stakes in production with several recent purchases of large mining assets around the world. However, in our view, China’s ongoing demand, and the country’s transition from government-led to private-led consumption should mean elevated commodities prices for a long period of time, in turn, driving the growth and potential profitability of commodities businesses globally.
This summary of the events and views expressed by the Investment Institute.
The Investment Institute is the insights and strategic engagement platform of Investec Asset Management. Its primary goal is to develop in-depth research and thought leadership that supports our investment teams and the asset allocation decisions of our clients.