Ilga Haubelt

In a constantly changing world, it can be challenging for investors to maintain their focus on long-term trends and opportunities. Fidelity International’s Ilga Haubelt, head of equities, Europe, met with Andrew McCaffery, global co-chief investment officer for fixed income, multi and private assets, and portfolio managers Caroline Shaw and Kris Atkinson to discuss the secular themes that could shape the financial landscape well into the future.

When investment markets go through extended periods of uncertainty, it’s difficult for investors to avoid looking for the next near-term bump in the road rather than focus on the horizon. The world can feel like it’s in a constant state of transition – geopolitically, industrially, and technologically – the pace of which presents us with an operating framework that is increasingly multi-faceted.

For instance, the geopolitical backdrop can generate short-term headlines but has also created scenarios that will likely play out for years. “This is now a multi-polar world, with different drivers, such as onshoring, friendshoring, and the deglobalisation of supply chains, competing for their place on the front pages,” says Haubelt. She adds that emerging markets could benefit from these developments, but the landscape may still be marked by higher inflation and capital expenditure.

As investors, the challenge is to discern the underlying trends and be positioned to tap into the long-term opportunities those themes may offer. Perhaps the most prominent of these is the acceleration of climate change and the accompanying task of building a more sustainable global economy.

Climate risk balanced by developing opportunities

It is apparent now that the impacts of climate change are coming at us far faster than expected. “Investors do face some hazards,” says Atkinson. These include corporate transition challenges, as industries are forced to shift to new business models more quickly than expected. There are also the physical risks that manifest in extreme weather events and their impact on supply chains or insurance payouts. “At Fidelity, we try to understand threats and opportunities, assess how they are priced and where they are insufficiently reflected in asset valuations.”

One of the key opportunities is in the build-out of renewable energy infrastructure as economies attempt to transition away from fossil fuels. Between now and 2050, an estimated USD21 trillion will be needed to install the renewable capacity required to get the energy grid to net zero, including about nine million kilometres of transmission network.1 “We focus on companies designing and manufacturing those elements critical to the grid upgrade,” says Shaw. “There’s also the need to build climate resilience into the grid, so we are looking not just at cabling and transmission parts but also smart-grid infrastructure.”

Indeed, considerable increases in power generation are integral to another secular trend: artificial intelligence (AI).

AI: Beyond the near-term noise

Amid the high valuations and elevated market noise that surround AI, it’s easy to forget that, in essence, we are looking at something as ‘simple’ as a data-processing tool. This tool offers promising long-term opportunities, including in sectors that don’t often make the headlines, like utilities. For instance, the US alone will need to add a forecast 250 terawatt-hours of power generating capacity over the next five years – equivalent to the entire present capacity of Spain – just to run data centres.2 This feeds into the power infrastructure investment theme.

AI’s so-called “second derivative” wave also draws us towards industrial automation. “When we look at the available research, AI applications in the manufacturing sector have potential compound annual growth well above market rates; it’s a sizeable opportunity set,” says Haubelt. This means supply chain optimisation, predictive systems monitoring, customised production, and the prospect of digital twinning – this is where a digital version of a factory floor can be created, allowing any changes or upgrades to be tested before being implemented in the real world.

However, McCaffery warns that the market’s enthusiasm could be dampened over the next year as investors assess the realities of harnessing AI’s potential. “Many people still believe that there will be a significant payoff from AI, but this may be within an unachievable time period, largely because certain companies have still to achieve a significant productivity shift,” he says.

The attractions of smaller companies and fixed income

“Valuations in small and mid-cap equities are at levels we haven’t seen in a long time,” says Haubelt. “Interestingly, that’s happening across geographies, with many of these stocks appearing inexpensive versus history and the market.” Elsewhere, Haubelt says she is considering more defensive holdings and maybe even property-related names that have been somewhat overlooked.

In fixed income, Atkinson says the “attractions are at the front end of the curve, where the risk-adjusted returns look excellent, as opposed to the long end, where valuations are compressed.” From a longer-term perspective, fixed income technicals also look positive. “Yields are high, we’re starting from a good point, and the long-term secular trends suggest fixed income as an important place for a significant asset allocation,” he concludes.

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Andrew Caffery

Fidelity International (“Fidelity”) has announced the launch of its second real estate climate impact fund, the Fidelity Real Estate Logistics Climate Impact Fund (the “LOGICs” fund, the Fund), successfully raising €200m^[1] during its first close, supporting an accelerated energy transition in the real estate sector. Rest Super, one of Australia’s largest profit-to-member superannuation funds, is a cornerstone investor in the Fund and is committing €80m to the Fund at first close, with the intention of committing a further €120m to the Fund over the subsequent closes.

With over 40% of total carbon emissions being emitted from real estate^[2], the asset class plays a pivotal role in the race to net zero. But with 85% of buildings in the EU over 20 years old^[3], there is an urgent and appealing investment opportunity to help turn brown to green.

The LOGICs fund, which will invest solely in the logistics sector across core Western European^[4] markets, will follow a value-add approach of acquiring existing assets with the intention of refurbishing and repositioning to deliver high quality assets that are capable of being operated at net zero carbon. In addition, through the installation of solar panels, occupiers have the opportunity to generate and deliver their own source of green energy.

As a Sustainable Finance Disclosure Regulation (SFDR) Article 9 fund, LOGICs has a comprehensive climate impact framework for the refurbishment of real estate, which seeks to leverage and align with external frameworks and certifications, including the EU taxonomy, to ensure its approach to delivering climate impact is transparent and measurable. Each asset purchased will have an accelerated pathway to net zero carbon emissions through the firm’s refurbishment plans.

According to Fidelity research, brown logistics buildings are currently trading at attractive entry points, 20-30% below peak valuations in 2022. Meanwhile Western Europe is benefiting from multiple demand tailwinds including the continued growth of e-commerce and a post pandemic focus on supply chain resilience. With supply of quality logistics assets constrained, Fidelity anticipates further strong rental growth for well-located, green warehouses. These two factors combined create a rare opportunity to deliver outsized returns for modest risk over the next few years.

The news follows the launch of the Fidelity European Real Estate Climate Impact Fund at the end of 2023.

Andrew McCaffery, Co-Chief Investment Officer, at Fidelity International, comments: “The LOGICs fund launch is a great example of partnering with our clients to jointly develop solutions to meet their evolving investment needs. We are pleased to see strong and growing client interest for our climate impact strategies within real estate, supporting the energy transition in the sector through accelerating purchased assets’ pathway to net zero while offering compelling investment returns to our clients. Following a strong first close, investors will have the opportunity to invest in the Fund’s second close towards the end of the year.

“With approximately €550m of deployable capital within our real estate climate impact strategies, we are excited by the opportunity to take advantage of current market conditions and deliver strong returns as well as tangible carbon reduction within an accelerated timeframe.”

Andrew Lill, Rest’s Chief Investment Officer, comments: ““Rest is pleased to join Fidelity to launch the LOGICs fund as its cornerstone investor. We believe its focus on climate impact offers a fantastic opportunity to benefit Rest’s approximately two million members, including the more than a million who are younger than 30 and will retire into a post-2050 net-zero world.

“With logistics properties trading at attractive rates and demand for energy efficient facilities growing, we believe the LOGICs fund will drive rental yields and property values that should translate into strong financial returns while helping to speed up the path to a carbon neutral economy.”

——–

Notes:
[1] Figure rounded to the nearest €1m.
[2] International Energy Agency, December 2020
[3] EU Commission, October 2020Corr
[4] LOGICs will on Western European countries with a strong bias towards, France, Germany, Netherlands and the UK.

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Andrew Caffery

Markets have proven resilient to the prospect of recession. But that they will continue to do so is far from certain. The final quarter of the year tends to portend what is to come, and with this in mind, Andrew McCaffery, Global CIO, Fidelity International outlines three themes that he believes will determine the path for markets heading into 2024.

1. Diverging signals

“Inflation has fallen during Q3. But beware: the headline data conceal a more nuanced picture.

“There are signs that the transmission of tightening monetary policy has not fed through to the real economy as quickly as central banks would have hoped. Many companies, for example, are earning interest on their deposits but (having agreed multi-year terms) are not yet paying more for the debt they accumulated at ultra-low rates during the pandemic. Ultimately, we believe the transmission mechanism is delayed rather than broken, and the situation could reverse rapidly – especially when corporates begin to refinance their debt next year.

“Fidelity International’s analysts, meanwhile, on average are expecting moderate price rises over the next six months, noting lingering supply chain pressures within sectors such as industrials and communication services. The Federal Reserve has not yet fixed its inflation issue.

2. Higher for longer?

“Central bankers have learned from their mistakes two years ago and do not plan to underestimate inflationary pressures this time. So the message seems clear: rates will remain higher for longer. But it’s a risky strategy, especially with corporate maturity walls coming fast into view. Many of our analysts expect a 15 to 25 per cent increase in interest expenses for companies they cover.

“The situation remains sufficiently uncertain to lead us to believe a recession is still more likely than not. We estimate there is a 60 per cent chance of a cyclical recession, in which unemployment in the US rises to between 4.4 and 6.5 per cent over the next 12 months.

3. China – opportunity amid the uncertainty?

“One impediment to China’s recovery since the pandemic has been a lack of confidence among consumers. This is in part due to the psychological toll dealt by years of lockdowns. But policymakers also recognise the importance on sentiment of key sectors like real estate. Chinese consumers are unlikely to spend while much of their wealth is locked in a declining housing market.

“Beijing has lowered some hurdles to home purchases and mortgages in an effort to revive the sector, although we don’t expect mass stimulus when policymakers are on guard against a debt spiral. But these efforts to boost consumer confidence bode well for the market, as do bright spots such as an outperforming services sector. All the while equities trade at near-historic discounts to global markets. We have taken note.”

Read the Outlook.

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Andrew Caffery

As central banks remain hawkish on the back of persistent inflationary pressure, the likelihood of a soft landing is falling, in contrast to some parts of the market which are moving into overbought territory. With financial markets oscillating between resilience and fragility, investors should consider lowering overall risk appetite while taking both tactical and strategic advantage of undervalued opportunities in the emerging world, according to Fidelity International’s third quarter 2023 investment outlook.

“For the last year, my colleagues and I have been trying to navigate our way through the ‘polycrisis’ – a confluence of pressures which we believe could force central banks into overtightening and trigger sharp recessions”, says Andrew McCaffery, global chief investment officer, Fidelity International. “That polycrisis has now left markets oscillating between resilience and fragility: still abundant liquidity and tight labour markets on the one hand, and the lagged effects of policy and tightening lending standards on the other.”

Andrew McCaffery highlights the three trends expected to dominate the markets as we enter Q3 2023:

Resilience now, fragility later

“The ‘best flagged recession in history’ still isn’t upon us. Excess savings accrued during the pandemic, as well as continued tightness in labour markets, mean that financial conditions are taking longer than expected to bite. But that recession will come when the lagged effects of policies eventually take hold. Resilience now is sowing the seeds for fragility down the line.

“A cyclical recession, in which unemployment in the US rises to around five per cent over the next 12 months, is the most likely outcome. A soft landing now looks highly unlikely, in our view.

“It is time for investors to be more proactive and capture mispriced equity valuations. Some scenarios priced into markets in terms of valuations are extreme. With the US and Europe having already seen strong gains as central banks become more hawkish again, this backdrop looks attractive for parts of the emerging world, particularly in relative value terms.

“From an asset allocation perspective, I think investors should be wary of taking on too much risk at this late stage of the cycle. Here, Investment grade credit provides yield and flexibility.

The long game in China

“After a bumper start, China’s rebound since the end of its zero-Covid policy is underwhelming investors. Earnings estimates are on a downward path, youth unemployment is at record highs, and Chinese consumers haven’t resumed their zeal for spending.

“This does not mean China’s rebound has run its course. It is perhaps no surprise that consumer confidence is muted after three years of severe restrictions. And there are positives elsewhere, including accommodative monetary – which is being eased again – and fiscal policies and an improving regulatory backdrop. Further stimulus measures may arrive soon. Meanwhile, the disconnect between the market’s expectation and the reality of the recovery has left Chinese equities trading at a significant discount.

“While it may feel like China has taken two steps back, the next move could be three forward. This may feel slightly contrarian at present, but it is an attractive entry point, especially as there are some signs of stabilisation in the US/China relationship.

“In Asia more broadly, Japan’s long-term trend of improving governance has been beneficial. Buyback activity has improved and there is now a better focus on return on equity. On a structural basis, the market looks much more interesting than it has been in recent decades, although we are mindful it has also already performed very well so far this year.

Corporate sentiment stabilising

“Our analysts had observed the mood at the companies’ they follow worsening earlier in the year, prompting us to ask whether corporate sentiment was merely resting, or stalling. An uptick in June suggests the former, especially as a full-blown financial sector meltdown seems to have been averted.

“Nevertheless, we view improving corporate management sentiment as a possible sign of complacency given the policy lags. Persistently high wage cost pressures throughout developed markets suggest that central banks are far from done, even if non-labour costs are likely to turn disinflationary this quarter. We will be monitoring closely how the sentiment and price trends, at both input and pass on to customers, evolves in the next few months.”

Read the investment outlook.

By Andrew McCaffery, global chief investment officer

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Andrew Caffery

China’s annual March legislative sessions are likely to reinforce the primacy of ensuring stable economic growth, and we expect the party leadership to back this up with accommodative policy settings.

When it comes to China, the market sometimes has a short memory and an even shorter attention span. Even so, China’s recent bull market probably prompted a few mental U-turns among those who not so long ago were asking “Is China investable?”

I took a different view back in October, when the Communist Party Congress put Xi Jinping on track for an unprecedented third 5-year term in office and Chinese equities plunged. Many investors saw his appointment as anti-growth, and that the tail risks for China had become the baseline. My colleagues and I saw it instead as the start of a new phase; with the domestic politics settled, the leadership could focus more on boosting the economy. We also anticipated the relaxation of China’s zero-Covid policies – even if the speed with which those were abandoned came as a surprise.

For us, the question has never been about China being ‘investable’ – Fidelity has been building our business in Shanghai, Beijing and Dalian for decades – but rather how should investors best take their exposure to China in a way that both aligns with the country’s domestic growth agenda and navigates the geopolitical complexities of the moment.

It’s a pivotal moment. Tensions are flaring as the war in Ukraine enters its second year. The threat of recession still hangs over the US and Europe – especially if central banks overtighten in their quest to stem inflation. All of this amplifies hopes and fears over China’s own political and economic trajectory, as the world’s second-biggest economy emerges from years of pandemic lockdowns.

The new agenda

I think some of these doubts will be eased this month at China’s ‘two sessions’, the annual full meetings of the National People’s Congress (NPC) and the Chinese People’s Political Consultative Conference (CPPCC) that begin 5th March. I expect the meetings will underline economic growth as the country’s top priority for the year ahead, and policymakers will back up these pronouncements in meaningful ways. Specifically, I expect the official GDP growth target to be set close to 2022’s target of around 5.5 per cent, but for actual growth to considerably outperform last year’s 3 per cent reported rate, as economic activity rebounds.

How much fiscal firepower can and will the government deploy to keep growth on track? We see the national budget deficit target coming in at around 3 per cent, up from 2.8 per cent last year, while the quota for local government special bond issuance is also likely to be set modestly higher than last year’s 3.65 trillion renminbi (USD$527 billion at current rates). Along with fiscal support, China’s subdued inflation at home means monetary policy is in play, too. Investors will also be watching closely for any indication that authorities may ramp-up infrastructure investment and ease regulatory restrictions in several areas, including the property sector, providing further stability and potential for momentum in economic recovery for the economy.

The bigger picture

Many see China’s new growth template as marking an inward turn. Promoting domestic consumer spending and homegrown technological innovation will help offset weak external demand and better protect China’s economy from trade disputes, the thinking goes.

But the fact is, China and the US still need each other, and remain extremely important trading partners. US actions to target Chinese industrial development in key sectors like leading-edge semiconductor chips, while blunt, are highly targeted. The same goes for China’s own regulatory actions under its ‘common prosperity’ campaign toward sectors like tech or education: the measures were painful but precise. The market prices in these kinds of new risks accordingly and gets on with it; they shouldn’t fundamentally alter China’s long-term outlook.

And despite all the talk of deglobalisation, China’s economy remains intricately linked to the rest of the world – and especially to its neighbours in the Asia-Pacific. Australia and other regional economies including those of Southeast Asia are likely to enjoy the knock-on effects of China’s current pickup in activity. There are other areas where China’s status as a rising superpower is likely to promote or attract more capital flows.

Longer term, we see scope for more reforms to help to rebalance China’s growth away from investment and more towards consumer demand.

These are the kind of slow sea changes that appear suddenly obvious in retrospect. What’s clear now to me is that the world remains, in aggregate, structurally under-allocated to China across the universe of equities and fixed income, and this will only correct over time as China’s weightings in portfolios catches up with its economic heft on the world stage. I would call that investable.

By Andrew McCaffery, Global CIO, Asset Management

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Andrew McCaffery

With surging inflation and the war in Ukraine dominating global markets through the first half of 2022, central banks have been seeking to strike a balance between reducing inflation and mitigating the impact on economic growth. But is the balance tipping?

Andrew McCaffery, Global CIO, Fidelity International, says: “This quarter could be a turning point for central banks, proving vital in determining the trajectory for markets and economies over the next few years.

“Inflationary pressures have intensified, and supply chains are being redrawn. We see this as the start of “The Great Reset”, in which the Fed leads central banks down a more hawkish path that prioritises managing inflation above a soft landing. As a result, downside risks to global growth have increased substantially. Recession in Europe now looks very likely, while the US too has edged closer to a hard landing scenario.

“In this rapidly changing environment, our focus is on managing risk coupled with mapping the medium-term implications of “the Great Reset”. At the same time, periods of uncertainty create a raft of opportunities for individual companies across a range of sectors, some exposed to long-term trends that were previously overbought, others overlooked in the rush for growth that should come to the fore again as rates rise.”

Mr McCaffery highlights three key themes which he expects to dominate in the third quarter of 2022.

1. Hard or crash landing

“As recently as March, it seemed possible that central banks could engineer a soft landing by front-loading rate hikes and then readjusting mid-course. With inflation edging higher throughout the subsequent quarter, however, the question has become how hard the landing will be.

“This pivot was marked by the Fed’s decision to match its hawkish rhetoric with hawkish action: a 75bps rate hike in June could well be matched by a further 75bps in July. The ECB and BOE are likely to pursue a shallower hiking path, due to their economies’ increased exposure to the war in Ukraine and greater risk of recession. Nevertheless, the risks to global growth are clear. We have increased the likelihood of a hard landing scenario, in which central banks push the economy into a recession (either accidentally or on purpose), from 35% to 60%.

2. China re-emerges from lockdown

“China is an outlier. Navigating a different stage of its economic cycle from most other countries, it’s also pursuing a markedly different Covid strategy. Its Zero-Covid Policy (ZCP) placed many major cities under severe lockdowns, most notably Beijing and Shanghai. These generated a short but sharp economic downturn through April and May.

“China’s re-emergence from the spring lockdowns is a clear positive for its economy, but many indicators suggest caution is still warranted. Primary property sales are well below previous levels1, while unemployment (particularly among the youth) is rising2, causing concern for a government that is focused on social stability. This is particularly important in the run up to its 20th Party Congress.

“Similarly, while China’s fiscal and monetary policy is increasingly supportive, its ultimate effectiveness and the nature of consumer sentiment post-lockdowns remain unknown. It’s also yet to be seen whether China’s economic recovery will be strong enough to offset slowdowns elsewhere in the world. That said, likelihood of China decoupling from the rest of the world in H2 is gathering momentum.

3. The global consumer is put to the test

“The global consumer has a lot on their plate. Many are already feeling the inflationary pinch, with cost-of-living crises and diminishing purchasing power providing major headwinds. Real wages are falling3, and mounting discontent is being reflected in record low consumer confidence indicators across the globe.

“In parts of the world, what consumers are doing is yet to reflect what they’re thinking. Though US consumer sentiment has plunged in recent months, retail sales remain resilient, buoyed by stimulus-laden bank accounts. With mortgage rates rising and affordability metrics plummeting4, it’s likely that low confidence will soon translate visibly into diminishing activity levels.

“The Chinese consumer too faces headwinds, with ZCP restrictions still fresh in the mind and unemployment on the rise. Any further lockdowns would prove a further blow to consumption.

“Ultimately, the resilience of the global consumer in the face of rising costs and tightening financial conditions could prove key in determining the severity of the economic landing.”

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Andrew McCaffery

Fidelity International has outlined its base case macroeconomic assumption of a U-shaped recovery and addressed the new long-term trends that will set the world on a unique course post Covid-19.

In ‘The New Economic Order’, Fidelity forecasts that government intervention, fiscal activism, corporate governance and sustainability, and continued Asian economic strength will become permanent features of the investment landscape, creating investment opportunities out of dislocation.

Andrew McCaffery, Global Chief Investment Officer, discusses ‘The New Economic Order’ and its implications for investors. Please click on the link above to read the full report.

McCaffery comments: “History is littered with examples of large-scale crises ushering in new governmental, economic and social structures. In very recent history, the Global Financial Crisis led to an era of low interest rates and growth, and repeated central bank intervention. Now we think the Covid-19 crisis has the potential to spur its own set of changes.

“How the crisis unfolds largely depends on the trajectory of the virus, the strategies used to exit from lockdowns, and how policymakers respond. As a result, we see three broad economic scenarios developing. The base case, to which we ascribe a 60 per cent probability, is a U-shaped recovery: this entails social distancing for the rest of the year and lockdown restrictions gradually being lifted throughout the summer. Policymakers will provide further support, both on the monetary and fiscal side, but given the scale of the challenges including falling inflation, high unemployment and a deep recession, this could lead to lasting changes in the economy creating a ‘New Economic Order’.

“The New Economic Order will be a world of increased government intervention displacing the free-market policies pursued since the 1980s. Fiscal activism will bear more of the burden and work in conjunction with monetary policy. Corporate governance and sustainability will become widely adopted concepts after proving their worth during the crisis. One area of continuity will be Asia’s enduring role in driving global growth.

“Investors will have to reconcile themselves with an environment of continued low and negative interest rates, debt overhang, unconventional monetary policy tools such as yield curve control, and fiscal spending on a scale we have never seen before. But these challenges create market dislocations that investors can exploit.

“We see emerging opportunities from dislocation from new forms of globalisation including building resilience around supply chains (especially where their importance veers into national security), regional disparities in a return to ‘normal’ after the virus, and differences in demographic profiles. The virus is accelerating the move to online consumption and the best companies are adjusting. Valuation disparities have unlocked rare opportunities to buy quality companies. In fixed income, continued low rates and central bank corporate bond purchase programmes are a boon to risk assets. With ratings in flux, we see attractive opportunities among some fallen angels as well as pitfalls to avoid as the credit cycle plays out.

“For investors, our previous macro assumptions must undergo a major update and finding flexible ways to navigate these changes will be crucial to generating robust, risk-adjusted returns over the longer term.”

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