Kevin Hebner

Investors cannot afford to ignore artificial intelligence (AI), as the market capitalisation of the top global companies is set to leap to new highs – with upcoming IPOs from SpaceX, Anthropic and OpenAI expected to reshape stock market indices, according to Dr Kevin Hebner, managing director and global investment strategist at TD Epoch.

SpaceX is expected to be the largest IPO, raising about US$75 billion. With two more mega IPOs expected to launch in the next six months, all three will enter the indices quickly and change the Mag7 to the Mag10.

“SpaceX is set to be the biggest IPO ever. The company will be raising somewhere in the neighbourhood of US$75 billion, with 30 per cent of funds raised coming from retail markets. It’s going to be massively oversubscribed.

“It is an exciting deal and if it does come out at a valuation around US$1.75 trillion, it will be the sixth or seventh largest global tech company immediately, sitting just below Amazon (NASDAQ: AMZN),” he says.

SpaceX is more than just rockets. “There are three components to SpaceX. There’s the rocket ‘launch’ with Starship Version 3. There’s the communication business, with Starlink satellites, which is growing very rapidly. And then there’s the AI business. That is what most of the value in the IPO is being attributed to.

“Much of the valuation is effectively a call option on space and all the future possibilities that come with that (orbital data centres, a base on the moon or even mars). It is this element of hype or speculation, that adds to the excitement of this IPO,” he says.

Later this year, Anthropic, valued at around US$965 billion, is expected to IPO and following suit will be OpenAI which is expected to be valued at roughly US$850 billion.

“With the addition of these three companies, we will no longer have the Mag7, we will have the Mag10. The market capitalisation of the current Mag7 with the inclusion of these three companies will amount to around US$25-$28 trillion. This is likely to exceed the market capitalisation of all global equities in the world, excluding the US,” says Hebner.

The three companies will be quickly added to the indices, meaning institutional investors will be forced to buy it regardless of their concerns about valuations and volatility.

“Investors may not be interested in the ‘Mag10’ and AI and think it highlight speculative, but the reality is that the market cap for the upcoming Mag10 will be enormous.

“Given how critical it is to market valuations overall, investors will need to pay attention and know a lot about these companies and AI when investing in the market,” says Hebner.

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Kevin Hebner

The investment case for infrastructure has never been stronger, with significant investment in power grids required due to the boom in artificial intelligence (“AI”), the green energy transition and onshoring of manufacturing in many nations, according to Dr Kevin Hebner, global investment strategist with Epoch Investment Partners, Inc. (“TD Epoch”).

Dr Hebner says energy infrastructure companies are likely to outperform in the medium term, after a strong performance in 2024, with US-listed utilities the second-best performing S&P 500 sector year-to-date as of 5 Aug 2024.

“We view the asset class as attractive because it has a relatively low correlation to equities, provides a hedge against inflation, and offers long-term, stable, risk-adjusted returns,” he said.

“In addition, significant investment in power grids is occurring, resulting from the AI boom, the green transition and onshoring, as well as previous underinvestment. The US and many other countries have an enormous need for new infrastructure. Overall, we believe the investment case for infrastructure has never been stronger,” Dr Hebner said.

TD Epoch has developed an Electricity Infrastructure index which is a market-capitalisation weighted index of eight companies: Eaton, Trane Technologies, Quanta Services, Vertiv, nVent, Equinix, Digital Realty Trust, and Amphenol.

“Our index is comprised of companies exposed to electricity infrastructure and has dramatically outperformed the S&P 500 since ChatGPT was released in November 2022. Continued developments in AI could drive electricity demand even higher, resulting in further outperformance for this index,” said Dr Hebner.

The figure below shows the outperformance of Epoch’s index since 2021.

According to Dr Hebner, AI models possess a seemingly insatiable thirst for electricity, which will help to underpin strong performance by electricity infrastructure assets.

“The amount of compute requirements has been increasing exponentially in recent years, with no signs of slowing down. For example, generating images requires more than 1,000 times the energy of texts. The energy demands of sound and video generation will be thousands of times greater still.”

“Data centres are power-hungry beasts, and we expect their overall electricity demand to triple over the next decade. The global data centre market size is set to increase from US$230 billion in 2023 to US$640 billion by 2032, representing a compound annual growth rate (CAGR) of 12.1 per cent,” he said.

Between 2020 and 2022, annual electricity demand from Microsoft, Google, Amazon, and Meta grew 58 per cent to an astonishing 90 terawatt-hours. Most of this surge in energy demand was driven by data centre builds, with Microsoft alone currently adding a new data centre roughly every three days.

According to Dr Hebner, the electricity demand boom will stress existing infrastructure, including generation capacity, transformers, and the transmission and distribution grid. Without massive investment, there is a rising risk that electricity demand races ahead of supply. “This could create a chokepoint that impedes AI progress, with negative consequences for innovation, productivity, national security, and equity markets,” he said.

Across the globe, the International Energy Agency (IEA) expects AI and data centres to represent about half the increase in demand for electricity over the next decade, with the transition to electric vehicles (EVs) and the reshoring of manufacturing facilities accounting for roughly 30 per cent and 20 per cent, respectively.

“The objective of onshoring is to reduce supply chain vulnerabilities, an especially critical ambition for semiconductors. Onshoring is an ongoing secular trend and is an additional factor driving electricity demand growth,” Dr Hebner said.

Demonstrating the importance of having alternatives in a portfolio, the infrastructure sector has experienced exceptional growth in assets under management (AUM) since the global financial crisis (GFC). The COVID-19 pandemic too has reinforced that many alternative assets, including energy infrastructure assets, remained resilient amid the market turmoil, according to Dr Hebner.

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Kevin Hebner

US equity market strength over the past year has been driven by the magnificent seven and artificial intelligence (AI) players, and this trend is set to continue into 2025 and beyond, according to Dr Kevin Hebner, global investment strategist at Epoch Investment Partners, fund manager partner of GSFM.

But he says it is not a trend that can continue indefinitely.

“The consensus expectations for earnings growth this year for the entire S&P 500 is 12 per cent, but that is just an average, and for 493 companies it’s only 5 per cent, roughly in line with nominal GDP growth. For the magnificent seven it is 55 per cent.

“We have this enormous dichotomy that’s being driven by the build out of infrastructure to support AI. These are all the picks and shovels, including the compute, the clouds, and the semiconductors, that make up the operating stack.

“This is going to drive earnings certainly through 2024 and into 2025, but beyond this is less certain,” he says.

Looking more broadly at the magnificent seven, Dr Hebner believes there are three reasons to think we may be in the midst of an AI bubble, similar to the tech bubble in the late 1990s.

“There is enormous concentration in terms of stock market cap for a small number of stocks, valuations are extreme and there is a euphoria of public comment driving prices.

“It’s always the case that there are titans. Titans rise and titans fall and over the past 30 years there has been a lot of movement in the top 25 tech companies, with the exception of Microsoft and maybe Apple.

“With a disruptive technology like AI it is not clear which ones will or will not be able to pivot or adapt, which is why I don’t think it makes sense just to go out and buy the incumbents, particularly now when there are several reasons to believe that we are in the early stages of an AI bubble.

We are only at the beginning of a new age of new technologies for consumers and businesses – and it is a decade-plus long process. Dr Hebner says it’s not yet clear which aspects of AI will actually add economic value to businesses and households, similar to the experience with previous general-purpose technologies (GPTs).

“A decade may sound like a long time. But looking at the experience with previous GPTs – such as the internet or electricity – it did take a long time to see the economic value-add. So investors will need to be patient.”

AI has already seen success in areas including coding and marketing copy, however Dr Hebner believes that healthcare and education are sectors which will benefit the most from AI.

“Healthcare represents about 20 per cent of GDP and is one area where we hope AI will have a substantial impact, even though it is highly institutionalised and resistant to change. We can see positive impacts in areas such as diagnostics or drug discovery.”

“Similarly we see education as another big beneficiary of AI. We are already starting to see these positive impacts.

“We’ve also seen unconventional applications of AI, one of which I like the most is from agricultural equipment company, John Deere. It has made inroads with its combine harvester, a labour saving machine designed to cultivate seeds. The company now has more software engineers than it does mechanical engineers.

“The combines they produce perform numerous tasks across a field such as seeding, fertilising and de-weeding. The combines test the soil by taking samples and access the quality of the soil and what tasks need to be performed. All these tasks are performed using satellite GPS, so drivers aren’t even needed to navigate these machines.

“John Deere is a very interesting case of a traditional company trying to pivot and become an AI company.

“AI augments our abilities, and it is going to make us better. We need to embrace it in the same way that we needed to embrace PCs and the internet and appreciate how they would help us do our job even better.

“Companies that invest in AI to achieve efficiencies and cost savings, are the ones that are on our investment radar,” he says.

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Kevin Hebner

Policymakers face a significant challenge in regulating artificial intelligence (AI) as innovations quickly expand while citizens demand action to ensure AI applications don’t endanger their safety, according to Dr Kevin Hebner, managing director, global investment strategist with Epoch Investment Partners.

Given the market imperative, big technology companies have turbocharged their AI efforts to ensure they are on the front of the wave, more interested in speed than safety. Given the economic imperative to be first, it is not surprising the public wants increased transparency and is supporting increased regulation. However, regulators should not act too quickly to clamp down on AI, according to Dr Hebner.

“The track record of regulation suggests one major risk is a rush to action, without the benefit of rigorous cost-benefit analysis and a firm understanding of how the technology is evolving. As often occurs, regulators would inflict a lot of harm in their vain attempt to do a little good,” Dr Hebner said in a new whitepaper, AI: How to Regulate an Emerging Tech?

“A second risk is strangling innovation, as frequently transpires in Europe, while a third is regulatory capture, which seems likely given the high stakes and dearth of AI expertise in government,” he said.

According to Dr Hebner, a balance needs to be struck between encouraging innovation in AI and ensuring safety for citizens. The US is usually much better at this than Europe, which has stifled innovation through regulation.

“This helps explain why most of the top AI professionals are based in the US or Canada even though they were born abroad. It also clarifies why America captures the lion’s share of private sector investment in AI,” he said.

“Mistakes will be made, and they will have important implications for the evolution of AI, the structure of the industry and the cash flow earned by investors. Implementing a rigid and complex regulatory framework is likely to impose excessive costs but do little to protect society. Unfortunately, such an outcome seems highly likely given the political pressure to act, even though we have little idea what the AI ecosystem is going to look like just a few years down the road,” he said.

The whitepaper notes that populations globally are apprehensive about AI and demanding regulation.

“Regarding the economic impact of AI, most people are concerned it could eventually replace their jobs and result in further concentration and power in the technology sector. On a more positive note, many people are optimistic AI will improve the quality of services they receive, especially in healthcare.”

But caution is needed before laws are made to regulate the unknown. “Nobody possesses a crystal ball and we do not know which start-up companies will become the next titans, and which current superstars will fall. This level of uncertainty means we are regulating what we do not really understand, which is, which governments need to be cautious now about introducing restrictive laws.

When it comes to investing in AI for long term returns, Dr Hebner says only a small number of companies will be winners, and will successfully capture the value inherent in AI.

“Nevertheless, we have previously said we view AI as the fourth wave of digital technology after the PC, internet and mobile phones, and this view hasn’t changed.

“We believe AI will be the key driver of equity markets over the next decade, significantly impacting the labour market, productivity and sector concentration, as well as margins and free cash flow generation,” Dr Hebner says.

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Kevin Hebner

Occupations most likely to be impacted by artificial intelligence (AI) are white-collar jobs, including well paid positions requiring high levels of formal education. On the other hand, the jobs least exposed include manual tasks which AI-enabled robots can’t as easily replicate, according to a new white paper from GSFM fund manager partner Epoch.

Dr Kevin Hebner, managing director, global investment strategist with Epoch, said AI will be highly disruptive to labour markets overall, though it will also bring substantial efficiency gains to companies and economies.

“While jobs are not going to disappear, around 60 per cent of tasks and occupations in the US will be changed materially by AI over the next two decades. We expect overall employment and real wages to rise but that will be accompanied by dramatic shifts across vocations. Furthermore, high wage sectors are the most exposed to AI,” says Dr Hebner.

The white paper finds that occupations most likely to be impacted by AI are those involving cognitive functioning and formal education rather than jobs involving manual work. These occupations include lawyers, post-secondary teachers, real estate brokers, personal finance advisers and content creators such as journalists and computer code writers. In contrast, occupations with low exposure to AI include trade jobs such as painters, plumbers, electricians and welders, as well as cleaners.

“Those with the lowest exposure to AI feature physical skills that will remain beyond the aptitude of AI-enabled robots for the foreseeable future,” the whitepaper reports.

Following from that, workers’ cognitive skills and IQ could become less important as AI replaces these skills and they could become relatively cheap over time. In contrast, soft skills could become more important as AI can’t as easily replace them.

“The key worker skills likely to be beneficiaries of this change could include empathy, relationship skills, artistic creativity, and athletic exceptionalism,” says Dr Hebner.

In contrast, AI will effectively replace the skills of workers involved in technical and repetitive tasks such as content production, customer support, writing and coding, but not perfectly.

“AI will reduce the cost of creating content toward zero. However, truly exceptional code, writing, music, or videos will remain beyond the realm of AI for at least the next decade. In the meantime, prepare to be overwhelmed by mediocre content of every sort,” says Mr Hebner.

For employers, AI is unambiguously positive, as it is increasing opportunities for efficiency gains and innovation. AI is expected to increase US productivity by 20 per cent over the next two decades.

“While this is a very rough guess, we can be more certain that a relatively small share will come from efficiency gains (doing things we already do, but with a bit less labour), with the lion’s share generated by innovative new products and services, many of which will astound and befuddle us all,” the whitepaper finds.

In terms of investment implications, only a small number of companies are expected to capture most of the value created by AI, especially those businesses which develop a dominant position in the provision and application of AI.

“Business strategies for the digital age are capital light, which is positive for margins and shareholder yield. This is especially for true for companies that establish themselves as global champions in the AI era,” says Dr Hebner.

However, he adds we are likely to see increased concentration in most sectors.

“We view AI as the fourth wave of digital technology after the PC, internet and mobile phones, with each stage having a progressively greater impact on the labour market, productivity, sector concentration, and free cash flow (FCF) generation,” the whitepaper says.

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What are the different perspectives on the likelihood of a recession and what this might mean for equity markets and investors?

Since August of 2022 the Bloomberg consensus has placed a probability of 50% or more on a US recession occurring within the next 12 months. However, despite 525 basis points of tightening and a still hawkish Fed, a soft landing appears increasingly likely. This article from GSFM’s investment partner TD Epoch explains what underpins the US economy’s surprising strength.

Epoch believes there are three reasons why US activity has held up better than expected: the lingering impact of the aggressive COVID stimulus packages, the renaissance of industrial policy (which has led to a manufacturing construction boom), and the still accommodative stance of broader financial conditions.

COVID stimulus drove excess savings

The US response to the COVID recession was fast and furious. As a result, personal income and savings immediately soared (figure one). While this stimulus provided a tremendous impulse for consumption over the last three years, it has by now been entirely spent.

Industrial policy renaissance: booming manufacturing construction

The second reason is that industrial policy has returned, after a fifty-plus year hiatus, with the August 2022 passage of both the $280 billion “Chips and Science Act” and the $400 billion “Inflation Reduction Act” (the latter is horrendously misnamed as it primarily incentivises green technology investment).

One direct beneficiary is manufacturing construction, which is up 101% year-on-year, with the electronics sector especially strong (figure two). Moreover, industrial policy spending is likely to remain robust through 2023, as these expenditures have been approved by Congress.

Overall fiscal spending, for which industrial policy is a component, has provided significant oomph for the economy in 2023, contributing roughly three percentage points of GDP. This has offset much of the Fed’s efforts over the last eighteen months, but fiscal expenditures are set to tighten over the next two years. To illustrate, consensus expects government spending growth to slow from three percent this year to one percent in 2024 and 2025^[1]. This implies a significantly negative fiscal impulse coming down the pipeline.

Overall financial conditions vs the Fed Funds Rate (FFR)

Third, while the FFR has skyrocketed, the same can’t be said of broader financial conditions, which are unchanged compared to July of 2022 (figure three).

To illustrate, the 10 year yield is a bit lower than it was last October and the high yield spread is narrower than its level of a year ago (figure four).

The relatively accommodative stance of overall financial conditions helps explain the resilience of both the consumer and corporates. To illustrate, the US household debt service ratio is only 9.6 percent of income (figure five). This ratio is not only below the 1980-2019 average of 11.2 percent, but beneath the lowest rate hit during that period (9.8 percent).

The situation is even more extreme for US businesses (figure six). Moreover, corporate refinancing needs over the next two years are historically low, reflecting their issuance of so many bonds in 2020 and 2021 when rates were rock bottom. In fact, only 16 percent of corporate debt is slated to mature over the next two years.

However, refinanced corporate debt will pay, on average, an additional 1.5 – 2.0 percentage points above existing rates. This will boost interest expense by around two percent in 2024 and five percent in 2025, and likely have a marginally negative impact on capex, hiring, and so on.

The relatively light interest burden facing consumers and businesses helps explain the surprising strength of the US economy. However, the bad news is this means the Fed needs to maintain a hawkish stance until financial conditions tighten enough to tame hiring, services consumption, and wage growth. 

Will we ever get back to target inflation?

Until this year, the bond market expected the Fed to cut twice to a 4.5 percent policy rate by December 2023 after reaching a peak rate above five percent in June 2023. The Fed has consistently insisted that it would not cut rates this year, but the bond market ignored the message. However, after stellar jobs numbers in early 2023, investors had to concede that rate cuts may not happen until 2024. And after several inflation releases that showed “sticky inflation”, investors began to worry that central banks may never again hit their two percent inflation targets and that we should brace for “higher for longer” rates.

Once US regional bank concerns emerged in March, markets went back to pricing in rate cuts for the second half of 2023. However, this time, investors expected four cuts. Then, after some swift, policy assisted regional bank takeovers, concerns over broader financial contagion dissipated and investors, once again, turned their attention to inflation that has defied expectations by normalising at a “slower than expected” pace. So, today, investors are moving back to pricing out 2023 rate cuts as central banks continue to tighten monetary policy, albeit at a slower pace.

Although the global financial system concerns that have emerged since March certainly add another layer of uncertainty around the future path of inflation, the continued tightening in global monetary policy may seem intuitive based on prevailing inflation levels. However, even before banking stresses came to the forefront, continued rate hikes were surprising when we consider that leading economic indicators have been signalling that a recession is coming. But is it?

Three scenarios for the next 12 months

With wage growth still over five percent and core inflation north of four percent, Epoch expects the Fed to retain a tightening bias for at least the next two quarters. While so much tightening, over such a short period, would normally have ensured a recession, nothing about this cycle has been normal. Moreover, forecasting nonlinear events like recessions is a mug’s game. That is why Epoch advocates humility and has adopted a scenario- based framework.

Investors always price in a soft landing (and occasionally they’re correct)

The first scenario calls for a soft landing (50 percent probability), similar to the experiences in 1984 and 1995. This scenario appears to be the current market consensus, which is not unusual as investors always expect a soft landing when the Fed is nearly done tightening.

A soft landing implies sub-trend but positive GDP growth, inflation stuck at three percent, a hawkish pause from the Fed and EPS growing by mid-single digits. This scenario also suggests a choppy S&P500, with “fat and flat” (i.e. choppy but directionless) equity returns. Previous soft landings were terrific for equities, but this time valuations are already quite stretched, which is likely to put a cap on further upside.

The second outcome involves a “short and shallow” recession (40 percent likely), with slightly negative GDP growth, inflation decelerating below three percent, Fed cuts of 200-300 basis points and EPS declining by five-to-ten percent, but recovering quickly, within a couple quarters. For equity markets, this could be similar to the 1990 recession in which the S&P500 declined sharply for two months, but then experienced an impressive V-shaped recovery.

When the Fed hits the brakes, someone almost always goes through the windshield. The third scenario is a hard landing (10 percent chance), in which something breaks, creating a credit event that cascades across financial linkages and results in a freezing of funding markets. This is what happened on a massive scale in 2000-2002 and 2007-2009, although this time the imbalances are much less extreme (figure seven).

In a hard landing, GDP growth would be negative for an extended period of time, and EPS would slump by well over 15 percent. In such an outcome, the Fed would be focused on financial stability rather than inflation and would quickly slash rates (by over 300 basis points). Equity markets could plummet by 15-30 percent, with a relatively slow L-shaped recovery.

While it is extremely difficult to know which of the three scenarios is unfolding, we believe there are four key recession indicators to watch like a hawk:

1. The Fed’s Senior Loan Officer Survey, which is already close to recessionary levels and implies much weaker consumer and commercial and industrial lending, as well as dramatically wider high yield spreads and significantly negative capex growth.
2. The non-performing loans exposure of small banks, which account for 68 percent of commercial real estate loans (but only 38 percent of overall lending).
3. Default rates on high yield and leveraged loans, which have inched up to 2019 levels but aren’t yet anywhere near levels consistent with a recession.
4. Consumer delinquencies, as they are creeping higher, especially for auto loans and credit cards.

Investment implications

The US economy has been much more resilient this year than consensus had expected. However, most of the reasons for this surprising strength are fading. Moreover, the economy’s durability has forced the Fed to maintain a hawkish stance, to ensure inflationary pressures don’t reassert themselves.

It is also critical to keep in mind that monetary policy works with a lag that is famously long and variable. The Fed just started hiking 17 months ago and in previous cycles it has taken considerably longer (typically 21 to 42 months) for the tightening to bite. This suggests the possibility that the current cycle might not be that different, it’s just that the federal funds rate is a crude tool and takes a long time to produce its desired effect.

Epoch believes a short and shallow recession is 40 percent likely and assigns a 10 percent probability to a hard landing. However, it is impossible to have high conviction regarding the timing and depth of an eventual downturn. Rather, the scenario-based approach is preferred, one which favours a cautious stance, focused on quality companies with a demonstrated ability to return capital to shareholders and/or to produce a return on invested capital in excess of their cost of capital.

By William Priest, CFA, Executive Chairman & Co-Chief Investment Officer, and Kevin Hebner, PhD, Managing Director, Global Investment Strategist, Epoch

———

[1] This reflects the 3 June “Fiscal Responsibility Act”, part of the debt limit deal, which sets a cap on federal discretionary spending for 2024 and 2025

Important information: The information included in this article is provided for informational purposes only. The information contained in this article reflects, as of the date of publication, the current opinion of Epoch Investment Partners, Inc (Epoch) and is subject to change without notice. Sources for the material contained in this article are deemed reliable but cannot be guaranteed. We do not represent that this information is accurate and complete, and it should not be relied upon as such. Any opinions expressed in this material reflect our judgment at this date, are subject to change and should not be relied upon as the basis of your investment decisions. All reasonable care has been taken in producing the information set out in this article however subsequent changes in circumstances may occur at any time and may impact on the accuracy of the information. Neither Epoch, GSFM Pty Ltd, their related bodies nor associates gives any warranty nor makes any representation nor accepts responsibility for the accuracy or completeness of the information contained in this article.

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Is modern monetary theory and the saviour of the economy or a pathway to economic damnation?

The following article is authored by two investment luminaries from Epoch Investment Partners: William W. Priest, CFA — Executive Chairman, Co-CIO and Portfolio Manager Kevin Hebner, PhD — Managing Director, Global Investment Strategist. The article explores modern monetary theory and whether it’s the saviour of the economy or a pathway to economic damnation.

Proponents of modern monetary theory (MMT) assert that governments can and should fund their spending simply by printing money. From their perspective there is no limit to government debt issuance, provided two conditions are met:

1. The country controls its own printing presses and currency
2. Inflation remains benign.

Under these circumstances, MMT acolytes envisage a complete convergence of fiscal and monetary policy, which should be used to finance ‘mission-oriented spending goals’.

A key implication of MMT is that, once COVID-19 is finally brought under control, there will be no debt ‘hangover’ and no painful period of austerity. Moreover, we can keep spending and racking up deficits until the unemployment rate falls back to 4% and the output gap has closed.

That sounds awfully enticing, like we’ve finally discovered the philosopher’s stone and are now capable of transforming lead into gold. And it’s easy to see why MMT has become so popular with politicians. What ambitious government wouldn’t want to dodge difficult macro trade-offs and be freed from binding financial constraints?

“We have let our imaginations become far too limited, and it’s holding us back:… There are limits. However, the limits are not in our government’s ability to spend money, or in the deficit, but in inflationary pressures and resources within the real economy. MMT distinguishes the real limits from the delusional and unnecessary self-imposed constraints.”
— Stephanie Kelton, “The Deficit Myth: Modern Monetary Theory and the Birth of the People’s Economy,” June 2020

Before this year’s crisis, this perspective was viewed as quite arcane and eccentric, but it’s important for investors to understand because, while not yet explicitly acknowledged by policymakers, we already live in an MMT world.

Almost to the dollar, the Fed has monetised the unexpected US Treasury issuance resulting from COVID-19. Further, the Fed has adopted a yield curve control policy (so far just implicit, but likely to be made explicit during the next year or two) and is constantly badgering the Trump administration to increase fiscal spending.

One consequence is that MMT expectations have been a key driver of the equity market’s resilience over the last six months. Moreover, investors remain confident that any economic weakness over coming quarters, possibly due to a second wave, will be met with additional fiscal stimulus and an immediate 1:1 ramp up of QE purchases by the Fed.

“Unfortunately, because of the crisis, we have actually taken a number of steps which are heading into new territory—and so we’ve done some version of MMT to some extent to deal with this crisis.”
— Robert Kaplan, President of the Dallas Reserve Bank, June 15, 2020

Monetary policy does not operate in a political vacuum and MMT advocates are well represented on both sides of the aisle, with the pandemic creating a natural catalyst for ambitious fiscal policies to be embraced. For example, Joe Biden has campaigned on promises of greater public spending on education, health care, the environment and infrastructure, while President Trump is calling for additional fiscal stimulus and yet another round of tax cuts.

Whoever wins on November 3, we can be confident in predicting more deficits, more debt, and more monetisation, which raises the question of when the bill will come due and who will pay for it. Given this year’s extraordinary and unprecedented policy response, the consensus view has evolved and now conjectures the answer is nobody, so that we can keep enjoying this proverbial ‘free lunch’ ad infinitum. Could it really be that simple?

Managing inflation risks: the critical challenge

MMT advocates, such as Kelton, do acknowledge one practical limit on their spending plans, acceding that every economy has a ‘speed limit’ where the output gap is closed, the labour market becomes too tight and inflation begins to accelerate. From there, MMT bravely assumes that the inflationary consequences of fiscal policies can be forecasted accurately and that, well before the economy reaches the inflation tipping point, our wise and benevolent policymakers will proactively hike taxes, by the exact right amount and at the exact right time, to pull us back from the brink.

Unfortunately, there are a multitude of ways this could go wrong including:

1. Reasonable people could disagree on the size of the output gap and the risk of inflation accelerating, especially given there is no one, universally agreed upon model of the economy
2. Given that policy lags are famously long and variable, it is easy to misjudge and either hike taxes by too little, thereby allowing inflation to soar, or too aggressively, and with that inducing a severe recession
3. Partisan differences could well come into play, providing incentives to delay policy tightening, especially if there is a pet project under consideration or an election on the horizon.

Moreover, the historical track record of countercyclical tax policy should provide us with little to no confidence that this would work. Rather, it is more likely that bond markets would take fright as they see the fiasco unfolding, pushing the economy into a painful and prolonged recession. The role of bond vigilantes is especially critical, and perilous, given the record-high levels of government and corporate debt that already exist and would assuredly become even more extreme in an MMT world.

A short, medium and long-term view on inflation

Regardless of our skepticism and apprehension, MMT is already in play, which means investors need to understand its implications and risks. As Kelton emphasizes, “Managing the inflation risk is the critical challenge. More than any other economic approach MMT places inflation at the center of the debate.” Given that entirely appropriate frame of reference, we now provide three different perspectives on the inflation outlook.

Starting with the short term, the pandemic has accelerated the digitisation of the economy. All five digital trends are inherently disinflationary, but so far, we only have anecdotal evidence regarding telehealth, e-fitness, work from home and ed-tech.

Fortunately, the fifth example, e-commerce has been around for much longer, so that we now have hard data on its disinflationary impact (Figure 1). Of the 18 different categories represented in the overall Digital Price Index, all but two (groceries and flowers & related gifts) have exhibited negative price trends since the series’ inception in 2014. By contrast, the conventional Consumer Price Index has risen by 10% during this period^[1].

Next, turning to the medium term, there has been a clear decline in inflation over the last four decades (Figure 2). Moreover, forward-looking metrics tell the same story, with inflation expected to remain benign for the foreseeable future, with only a small probability of a breakout above and beyond 2%.

While there are a number of factors behind this secular trend, including demographics, globalisation and the success of inflation-targeting central banks, we believe the most important reason is the rising prominence of digital technologies that, as discussed above, are inherently and profoundly disinflationary.

Figures one and two help us to understand why MMT has become the new orthodoxy, embraced by policymakers and politicians from both sides of the aisle. Rising inflation is the Achilles heel of MMT, but it has been tame for decades now, and our base case features benign inflation, lower for longer interest rates and an enduring world of yield starvation.

That said, it strikes us as ahistorical and dangerously naïve for policymakers to willfully dismiss the risk of an inflationary spike. Taking a longer-term perspective, it is clear that inflation shocks are a regular, if infrequent, occurrence (Figure 3). Moreover, in such a scenario, the damage inflicted on an economy that has followed the tenets of MMT and maxed out on debt would be severe indeed.

Conclusion and investment implications

While not yet explicitly acknowledged by policy makers, we already live in an MMT world. One consequence is that expectations of government debt monetisation have been a key driver of the equity market’s resilience over the last six months. Moreover, investors remain confident that any economic weakness over coming quarters will be met with additional fiscal largess and an immediate 1:1 ramp up of QE purchases by the Fed.

Moreover, we can be confident that, regardless of who wins on November 3, there will be more deficits, more debt and more monetisation by the Fed.

Rising inflation is the Achilles heel of MMT, but it has been tame for decades now, partially because of the rising prominence of digital technologies which are inherently and profoundly disinflationary. Consequently, our base case features benign inflation, lower for longer interest rates and a continued world of yield starvation.

There are numerous implications for investors, but we will just conclude with two here.

First, turbo charged by lower for longer interest rates, we expect long duration digital platforms to comprise the vast majority of S&P 500 market cap by the end of the decade, with tech, health care and communications the most promising sectors.

Second, in a world of yield starvation, with central banks holding policy rates at or close to zero for the foreseeable future, the best — really, the only — alternative for investors who seek income is a diversified portfolio of high-quality equities paying attractive, growing dividends supported by underlying, growing cash flow.

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[1] Although, the DPI and CPI are not directly comparable because the DPI’s scope is narrower, excluding items such as energy, transportation and rent.

Important information: The information included in this article is provided for informational purposes only. The information contained in this article reflects, as of the date of publication, the current opinion of Epoch Investment Partners, Inc (Epoch) and is subject to change without notice. Sources for the material contained in this article are deemed reliable but cannot be guaranteed. We do not represent that this information is accurate and complete, and it should not be relied upon as such. Any opinions expressed in this material reflect our judgment at this date, are subject to change and should not be relied upon as the basis of your investment decisions. All reasonable care has been taken in producing the information set out in this article however subsequent changes in circumstances may occur at any time and may impact on the accuracy of the information. Neither Epoch, GSFM Pty Ltd, their related bodies nor associates gives any warranty nor makes any representation nor accepts responsibility for the accuracy or completeness of the information contained in this article. ©2020 Epoch Investment Partners, Inc.

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Regardless of geography or sector, investors should focus on companies that have an ability to produce FCF on a sustainable basis and possess superior management with a proven track record.

The current hype about two-sided digital platforms, blitzscaling and winner-takes-most markets has fuelled a surge in IPO listings. It is perhaps unsurprising that this exuberance, especially when combined with inordinate liquidity, record levels of VC activity and multiple fundraising rounds, has often produced stratospheric valuations that are difficult to reconcile with free-cash-flow (FCF) fundamentals.

As discussed in this paper from Epoch Investment Partners, penned by CEO and co-CIO Bill Priest and Managing Director of Global Portfolio Management Kevin Hebner, a growing number of commentators suggest we are repeating the excesses of the dot-com boom – are the unequivocal bears right?

One consequence of the high valuations is that there are now over 360 unicorns* globally, with most in tech-related sectors. Given the soaring number of IPOs, it would seem reasonable to expect this list to be shrinking. However, just the opposite is occurring as the pace of business model innovation is intensifying, ensuring an escalating number of promising start-ups. To illustrate, last year delivered a sizeable herd of new unicorns, 96 according to PitchBook, with 2019 on pace to surpass that number and set a new record.

As a result, a rising tide of doomsayers have warned that we are repeating the excesses of the dot-com boom, citing several specific developments to support their alarmist view. For a start, nominal IPO supply is on track to set an all-time high in 2019, finally surpassing the record set in 1999 (Figure 1).

*Unicorn: A start-up, private company, typically in a tech-related sector, valued at over $1 billion. They have been dubbed “unicorns” because, in many cases, their billion-dollar valuations are thought to be purely mythical.

Silicon Valley has become all about applying its magic formula, all bankrolled by slabs of VC money, to as many sectors as possible. However, one must question whether this model of growth at almost any cost is actually magical, allowing investors to take home previously buried pots of gold, or just mythical, like the much sought after, but illusive, unicorn of lore. This is especially a concern given that the clear majority of IPOs are loss-making. In fact, 81% of recent IPOs are for unprofitable firms, a proportion that ties the record set two decades ago (Figure 2). This is a particular concern for tech IPOs where only 15% of firms are profitable and, in some cases, like Lyft and Uber, the pathway to profitability is anything but clear.

Further, VCs now back almost 80% of tech IPOs, up dramatically from the 1980-2010 average of 57%. Reflecting this trend, last year was a banner year for VC investments into start-ups, with 2019 expected to be just slightly lower.

Similar to the tech bubble, VC exit activity is soaring, setting records for the dollar amounts cashed out. According to PitchBook, 2018 set a record of US$126 billion in total exit value for VCs. With a host of major listings still on the horizon, it is all but assured that total VC exit values will smash this record in 2019. This has led us to wonder: Do these savvy and well-apprised private market investors who are rushing to the door know something their public market counterparts don’t?

While the arguments that say history is repeating itself are compelling, we believe unequivocal bears miss three key points:

First, since the dot-com boom the median age of tech IPOs has risen from 4 to 12 years and the median sales of tech IPOs has increased more than threefold. (Figure 3). One could interpret these developments as evidence that it is becoming even more difficult to become free-cash-flow generative. However, in most cases these are real companies that have developed robust, viable and innovative business models and are exhibiting truly impressive sales growth.

Second, most of the oft-cited excesses appear much less worrisome when expressed relative to market cap (which has roughly doubled since the tech bubble) or in constant USD (to eliminate the impact of inflation). Although it is undeniable that some excesses do exist, they are simply not in the same league as those of the late-1990s and certainly do not pose a systemic risk to equity markets.

Third, cynics who take a black-and-white view, risk tarring all unicorns and IPOs with the same brush. This is a mistake as the historical experience and empirical evidence strongly suggests that some of these companies will develop into dominant platforms and become global champions, thus amply rewarding the patience of their investors.

Fake it ‘til you make it

Aside from the “grow fast or die slow” dogma behind the mad rush into platforms, one reason for the increased prevalence of unprofitable IPOs is the burgeoning importance of biotech. While the percentage of total IPOs represented by the tech sector remains close to its historical average of 30%, biotech’s share has soared to 43%, up six fold from the 1980-2010 average of 7% (Figure 4).

This definitely skews the statistics, as very few biotech IPOs have been profitable. In fact, most biotech IPOs haven’t even generated sales, let alone bottom-line earnings. To be more specific, since 2010 only 3% of biotech IPOs have been profitable (down from 23% previously). This is even worse than tech sector IPOs, where a rather dismal average of 27% have been in the black since 2010 (down from the historical mean of 61%).

Moreover, during the last two years the statistics have been even worse. Among tech IPOs, only 17% were profitable in 2017, followed by an even more discouraging 16% in 2018. However, the corresponding numbers for biotech were rock bottom, at 0% and 0%; that is, not a single biotech IPO posted positive earnings during the last two years. This certainly raises questions about the robustness and validity of the funding model behind all these loss-making private companies.

Venture capital: phishing for phools?

“The skill you need most when raising venture capital is the ability to tell a compelling story.” This quote is a key theme of “Secrets of Sand Hill Road: Venture capital and how to get it”, by Scott Kupor of Andreessen Horowitz. He asserts that VC investors are obsessed with technology differentiation, network effects and the potential for juicy margins. This sounds eminently sensible, but he also demonstrates that even the best VCs aren’t terribly good at avoiding failures: in fact, over 50% of VC investments lose money. Rather, he shows that the entire VC business model is based on the 10% to 20% of investments that turn into home runs. Among other things, this helps to explain why the top VCs (such as Sequoia, Kleiner Perkins and Andreessen Horowitz) hold well-diversified portfolios, typically with investments in 25-40 unicorns, spread across sectors.

A second theme of Mr Kupor’s book is that “lemons ripen early.” That is, he contends a portfolio of start-ups will often have early losses as the teams without product/ market fit quickly run out of money early. However, the successful start-ups, the ones that will become dominant platforms, take time to emerge. It can take 5+ years from a company’s founding to understand its likely growth trajectory. As a result, the goal is a J-curve with the start-up initially showing losses, followed by chunky margins and impressive profitability in the later years. This is why VCs are so infatuated with huge TAMs (total addressable market) and frequently declare that few ideas are big enough.

The VC perspective is important to understand, as they backed 79% of tech IPOs in 2018, up dramatically from the 1980- 2010 average of 57%. (The corresponding percentages for all IPOs were 66% and 35%, respectively.) Reflecting this trend, last year was a banner year for VC investments into start-ups, with 2019 expected to be just slightly lower (Figure 5). However, this does raise the question of whether the spike and subsequent collapse of two decades ago will be repeated this time around.

The above trends certainly seem to enable the manic behaviour of start-ups, many of whom appear to be adopting a slightly different mantra, “move quickly and burn money,” sprinting to an IPO before the VC cash runs out. An additional and final cause for concern is the rising number of tech IPOs that are issuing dual class shares, which are typically viewed as a way to raise money but without ceding control. To illustrate, an average of 35% have issued such shares since 2015, up dramatically from the historical mean of 6% (Figure 6).

For most of the modern history of American equity markets the NYSE did not list companies with dual-class voting. However, standards have slipped during recent decades. Popularised by the Google IPO in 2004, weighted voting rights have been featured in the high-profile IPOs of LinkedIn, Groupon, Zynga, Facebook, Fitbit, Blue Apron and Dropbox. Snap took this awkward development to a new level in 2017 when it became the first company since at least 1940 to launch an IPO with shares having zero voting rights. This allowed CEO Evan Spiegel and CTO Robert Murphy to hold a combined 88.5% of the company’s total voting power. More recently, Lyft and Pinterest are among the 2019 listings that have issued dual class shares.

To illustrate why this is a problem, earlier this month 32% of Facebook’s external shareholders voted against the re-election of Mark Zuckerberg to the board, with 67% backing a proposal for the introduction of an independent board chair. However, neither of these moves stood a chance as Zuckerberg holds 58% of the voting power, even though he only owns 13% of the total company shares. Unchallengeable control by one person over such a large and complex firm is troubling, especially considering the multiple controversies the company is currently grappling with. Facebook has become the poster child for governance challenges, with an increasing number of regulators and institutional investors calling for sunset provisions or even outright bans on dual-class structures.

The complexity of voting rights can also make the valuation of VC-backed companies extremely confusing^[1]. After multiple funding rounds, many unicorns end up with convoluted financial structures, which can be confusing and misleading, even for sophisticated insiders. Such complexity is a common feature of asset bubbles (this was particularly the case during the housing market excesses a decade ago), which raises the question of whether the surge in unicorns and IPOs is just the tip of a much larger iceberg.

Is the IPO frenzy just one aspect of a broader e-commerce bubble?

There have been (at least) seven clearly identifiable bubbles over the last 40 years or so (Figure 7). The first bubble is gold, which peaked in 1980 at about 5x its initial price. The most recent candidate is e-commerce, which is up over 8x since mid-2010. Although we are not convinced it’s a bubble, we must admit it shares a lot of the characteristics of one. Such excesses always involve a dislocative event that promises to upend the existing order. The current hype about two-sided digital platforms and blitzscaling, featuring a growth over profits mentality, certainly raises the possibility that e-commerce might be yet another bubble just waiting to be popped.

In addition to a dislocative event, bubbles also require that conventional valuation measures become stretched and untethered from fundamentals. Epoch has always preferred companies with business models that are capable of generating sustainable FCF, if not immediately then in the near future.

On that basis, though, the e-commerce Index appears only slightly extended. The index currently trades on an FCF yield of 4.1%, which is only moderately below the 4.5% yield of the S&P 500. This suggests the index could be marginally overpriced, but not even close to bubble territory. Taking this point further, the remainder of this paper will present evidence that the surge in unicorns and IPOs may indicate a moderate degree of froth, but nothing like what transpired during the dot-com boom and certainly not representing a systemic risk to the equity market.

Investment conclusions

It is crucial to analyse each company individually, based on its own ability to produce FCF on a sustainable basis. Although a number of the key metrics employed for valuing digital platforms are somewhat novel, the FCF principles we have been applying for years are fully relevant to start-ups that have not yet listed on public markets.

This paper has focused on unicorns and IPOs, but Epoch has always believed that, regardless of geography or sector, investors should focus on companies that:

(a) have an ability to produce FCF on a sustainable basis; and (b) possess superior management with a proven track record of allocating capital wisely, including investing today for future value creation.

We are confident that these companies are the most probable winners and the ones most likely to provide investors with the best returns. Crucially, we believe these principles are as relevant to unicorns and IPOs as they are to firms that have traded on public markets for decades.

[1] See “Squaring Venture Capital Valuations with Reality,” UBC and Stanford University, W. Gornall and I. Strebulaev, 2018.

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The information included in this article is provided for informational purposes only. The information contained in this article reflects, as of the date of publication, the current opinion of Epoch Investment Partners, Inc (Epoch) and is subject to change without notice. Sources for the material contained in this article are deemed reliable but cannot be guaranteed. We do not represent that this information is accurate and complete, and it should not be relied upon as such. Any opinions expressed in this material reflect our judgment at this date, are subject to change and should not be relied upon as the basis of your investment decisions. All reasonable care has been taken in producing the information set out in this article however subsequent changes in circumstances may occur at any time and may impact on the accuracy of the information. Neither Epoch, GSFM Pty Ltd, their related bodies nor associates gives any warranty nor makes any representation nor accepts responsibility for the accuracy or completeness of the information contained in this article. ©2019 Epoch Investment Partners, Inc.

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Historically, Americans have been very pro-trade, however, a majority of citizens agree with the US President’s views about moving toward deglobalisation.

China 2025 is perceived as an existential threat to US commercial and technological leadership. This raises the risk that the Trump administration could conclude that its best response is to decouple much of the US supply chain from China.

As discussed in this paper from Epoch Investment Partners, penned by CEO and co-CIO Bill Priest and Managing Director of Global Portfolio Management Kevin Hebner, such a move toward deglobalisation would prove acutely negative for corporate margins and earnings.

US President Trump has been an unabashed trade hawk for decades. He has called for protectionist measures since at least 1989 when he declared “I’m not afraid of a trade war,” presaging his more recent exhortation that “trade wars are good, and easy to win.”

Historically, Americans have been very pro-trade. Today, however, a majority of citizens agree with the US President’s views, especially when it comes to dealing with its new rival, China. It is no longer just about jobs. The US is worried about China’s growing commercial and technological clout, with both sides vying for dominance over new technologies that will determine the economic balance of power in the 21st century.

China has changed the terms of engagement since President Xi’s ascension in 2012. While his predecessors emphasised the slogan “peaceful rise,” President Xi has been far more assertive than anything seen since the days of Mao Zedong.

This “new era,” as Chinese officials have taken to calling it, has celebrated and entrenched the state’s leading role in the modern economy. The key reason why tensions have ramped up recently is “Made in China 2025”, Beijing’s aggressive blueprint for dominating the tech industries of the future, including robotics, biomedicine, renewable energy, aerospace, communications equipment, new materials and artificial intelligence (AI).

Made in China 2025

US policy makers have been startled by the plan’s focus on “indigenous innovation” and the Maoist calls for “self-reliance”, aspiring to achieve self-sufficiency through domestic “secure and controllable” technology and import substitution. Publicly proclaiming the aim of dominating critical high-tech industries has confirmed suspicions in DC that China is not looking for a win-win in trade relations.

It is difficult to understand why Beijing didn’t foresee how hostilely such a massive and pivotal state-led program would be received in America. Made in China 2025 is an ambitious scheme that directs huge state subsidies at key new tech sectors that China wishes to dominate.

From America’s perspective, two aspects of the blueprint are particularly worrisome: first, its reaffirmation of the government’s central role in economic planning; and second, its focus on import substitution.

Made in China 2025 expressly calls for China to achieve 70-80% self-sufficiency in a wide range of critical, tech-heavy industries. Achieving such brazen market share targets clearly requires enormous government support, much of which occurs through a web of opaque subsidies. Firms associated with Made in China 2025 are provided with extensive financial assistance through a multitude of state-directed investment funds.

Although it is challenging to find a comprehensive listing of all sources, it is possible that total support could exceed an eye-popping $1 trillion. The US Chamber of Commerce estimated that the Chinese government plans to spend $161billion by 2025 to develop the semiconductor sector. That is a huge sum of money, and it only refers to one industry.

All ten of the sectors targeted by China 2025 are viewed as key to future economic growth by both China and the US. However, the truly breathtaking innovations are occurring in fields directly affected by AI.

To illustrate, earlier this year both PwC and McKinsey estimated that, by 2030, world GDP could increase by around $15 trillion (or 14%) purely because of AI, with China being the primary beneficiary (receiving about 45% of the total gain). This makes AI the biggest commercial opportunity in today’s dynamic economy and means the stakes are unprecedentedly high.

Mercantilism: a core feature

Mercantilism is a core feature of the Chinese economic system. Imports of manufactured goods from the US represent less than 1% of GDP.

There are also severe restrictions on foreign direct investment. According to the Organization for Economic Cooperation and Development, China maintains one of the most restrictive investment regimes with only a few countries, such as Saudi Arabia, ranking worse. Many sectors have rigid foreign equity restrictions or joint venture requirements. These restrictions either block opportunities, or, in some cases, create a de facto technology transfer requirement to the Chinese partner as a pre-condition for market access.

Data compiled by Global Trade Alert (an independent think-tank based in the UK) demonstrates that China has implemented a distressingly large number of mercantilist measures over the last decade (figure one). While the US and other countries have also exhibited a proclivity toward protectionism, China is in a league of its own among large economies.

Finally, the US has unquestionably been the world leader in the commercialisation of the internet.

However, no US website ranks in the top 25 most visited in China. This is a direct result of China having banned, blocked or placed high restrictions on sites such as Google, YouTube, Facebook, Instagram, WhatsApp, Snapchat, Twitter, Pinterest, Flickr, Tumblr, Dropbox, the New York Times, Bloomberg and the Wall Street Journal.

China’s mercantilist behaviour has undermined political support in the US for free trade and openness. There has been a ramping up of anti-trade rhetoric, the WTO appears increasingly irrelevant, and the US has withdrawn from the Trans-Pacific Partnership process.

If the trend continues, we could end up with a segmented world trading system instead of a global one, an outcome that would be lose-lose.

The US response

During the last couple of decades, America’s approach to China has been founded on a belief in political and economic integration and convergence. However, by celebrating and entrenching the state’s leading role in the industries of the future, President Xi and his “new era” have demonstrated that convergence was never their goal.

The Trump administration has adopted an aggressive stance, demanding three key changes. First, that China jettisons the mercantilist web of rules that have systemically protected and lavishly subsidised companies in numerous sectors throughout the economy.

Next, that China ceases its chronic practice of purloining US companies’ trade secrets (via forced technology transfer, state-sponsored cyber theft, and corporate acquisitions).

Finally, that Beijing fully embrace the principles of reciprocity and full market access for US businesses operating in or exporting to China.

In October, Vice President Pence delivered a remarkable, 40-minute broadside against China that justifiably received an enormous amount of attention. The Financial Times argued this speech was the most important event of 2018. In surprisingly blunt and strident terms, Pence accused China of bullying American companies and stealing their technology and Intellectual Property (IP).

He concluded that it is up to China to avoid a Cold War, demanding concessions on several issues, including its rampant IP theft, forced technology transfer, and restricted access to Chinese markets.

While Pence’s speech has received significant attention, the craftsman behind US trade policy, and chief China critic, is Robert Lighthizer, Trump’s US Trade Representative.

Lighthizer makes a compelling case that China’s economic and political system is fundamentally incompatible with our conception of free trade rules and has been particularly critical of the systemic non-compliance practiced by China for decades.

With forced technology transfer, unfair licensing requirements, corporate acquisitions and government-backed cyber theft as primary sticking points in the ongoing negotiations between Presidents Xi and Trump, one does not have to be a trade lawyer to realise how difficult it will be to obtain a verifiable agreement that both can bring home and declare victory. Effective 24 September 2018, the US imposed tariffs on $200 billion of Chinese imports.

Ongoing negotiations, with a soft deadline of 1 March 2019, will determine if the tariff rate is raised from 10% to 25%, and if tariffs will be applied to additional imports from China.

The global supply chain unravels

It has been just over a decade since Thomas Friedman’s “The World Is Flat” painted globalisation as a seemingly unstoppable trend. It may have marked globalisation’s peak. During the past few years global supply chains have begun to buckle, with the world’s two giant economies clearly de-coupling.

If the global supply-chain does bifurcate, with one part centred around the US and the other around China, which sectors would be most affected?

Ground zero is likely to be all ten sectors that are targeted by China 2025, especially where sensitive technologies are involved. Among the hardest hit industries would be tech hardware, especially semiconductors, with tech software and services being less directly affected. Other exposed industries include capital goods, and possibly autos, as well as certain consumer durables and chemical/commodity sectors.

Still, a full chasm between the two countries seems improbable, with the possibility that energy and agricultural commodities could even become beneficiaries of the new trade architecture.

As trade tensions mount, what countries are most likely to benefit by stepping into the void left by China?

While relatively little would return to the US, it is feasible that some high-end manufacturers could move to Korea, Taiwan, Japan and Singapore, while the low-end manufacturing could shift to ASEAN countries, and possibly Mexico.

Even if a relatively small percentage of existing production were relocated, or if capacity expansions began to favour these destinations, the local impact could be highly significant.

Foreign direct investment (FDI) has been flowing solidly into the ASEAN region over the last decade, even as FDI into China has started to moderate. This suggests that the marginal relocation process is well underway, with Vietnam, Malaysia and Thailand appearing best positioned to attract significant FDI inflows.

Manufacturing margins under pressure in 2019

If global supply chains do in fact bifurcate, what is the likely impact on corporate margins and earnings?

One channel that hasn’t received sufficient attention concerns the impact of overcapacity in China 2025 sectors. Whenever countries undertake overly ambitious central planning exercises, excess capacity inevitability results.

This occurred earlier in China’s development when it built-out its heavy industry capabilities (steel, cement, petrochemicals) and this time around is likely to prove even more wasteful.

Such excess capacity will probably drive down margins and profitability in most China 2025 industries, and not just in China, but globally.

An even more worrisome channel concerns unwinding the decades of progress that has been made with globalisation. International trade accelerated from 1990, following the fall of the Berlin Wall, and was then turbo-charged at the turn of the century when China entered the World Trade Organisation (WTO). A key part of this acceleration was, over a period of many years, putting in place the complex global supply chains that exist today, a process that helped drive a dramatic increase in manufacturing margins (figure two).

This suggests the recent turn toward protectionism is likely to be particularly negative for sectors such as tech hardware, semiconductors, industrial capital goods and some consumer cyclicals

Moreover, the labour cost savings from locating production abroad (largely in China) are estimated to have accounted for about one-fifth of the increase in manufacturing margins since 2000.

However, this factor is likely fully played out and will probably be at least partially reversed during the next couple years. A bifurcation that results in a much less efficient global supply chain would cause additional damage to margins. This is why we believe the peak in manufacturing margins is now well behind us.

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The information included in this article is provided for informational purposes only. The information contained in this article reflects, as of the date of publication, the current opinion of Epoch Investment Partners, Inc (Epoch) and is subject to change without notice. Sources for the material contained in this article are deemed reliable but cannot be guaranteed. We do not represent that this information is accurate and complete, and it should not be relied upon as such. Any opinions expressed in this material reflect our judgment at this date, are subject to change and should not be relied upon as the basis of your investment decisions. All reasonable care has been taken in producing the information set out in this article however subsequent changes in circumstances may occur at any time and may impact on the accuracy of the information. Neither Epoch, Grant Samuel Funds Management, their related bodies nor associates gives any warranty nor makes any representation nor accepts responsibility for the accuracy or completeness of the information contained in this article. ©2019 Epoch Investment Partners, Inc.

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Economic data is put under the microscope. On the other hand, Epoch Investment Partners (Epoch), manager of the Grant Samuel Epoch Global Equity Shareholder Yield Funds, takes a ‘free cash flow lens approach’ across all of its strategies. In this article, Epoch’s CEO and co-CIO Bill Priest, and Managing Director of Global Portfolio Management Kevin Hebner, put Japan under the microscope to determine whether Japan is investable when examined through a free cash flow lens.

In short, the answer is yes. Beneath the surface, and with relatively little fanfare, corporate japan is changing.

Japan has historically scored poorly on corporate governance criteria. However, Prime Minister Abe has made improving corporate governance a priority and the initial indications are encouraging. The June 2015 reforms emphasised shareholders’ rights, increased disclosure and transparency, required the appointment of at least two independent directors, and highlighted the importance of specific return (for example, return on equity, or ROE) targets.

Additionally, 2016 is set to be a record year for buybacks, which will likely continue to increase, given growing cash positions, subdued capex and negative interest rates. Further, the dividend yield for the Tokyo Stock Price Index (TOPIX) is now marginally higher than for the S&P 500 (2.2% vs 2.1%), and dividend per share growth for the TOPIX has averaged 13% per year over the last three years. Other encouraging developments include the boom in outbound M&A and the decline in cross-shareholding ratios.

Japan is the only major market where net cash levels have risen dramatically during recent years, a development that is of particular interest to cash-flow focused investors. One consequence is that over 50% of TOPIX companies are net cash, the highest percentage of any major equity market. This is one reason Epoch expects Japanese companies to continue increasing dividends, buybacks and M&A activity. Further, Japanese equities appear cheap on a price to cash flow (P/CF) basis.

An examination of 20 Tokyo Stock Exchange sectors finds that six appear particularly promising for cash-flow-focused investors: rubber, transportation, air transport, other financials, construction and pharmaceuticals. Surprisingly, telecoms, food and utilities appear uncompelling in Japan, even though they are typically among the most promising sectors for yield-focused investors in other major markets.

However, Epoch does not want to overstate the case for Japan. Policy remains muddled in the face of a formidably challenging macro environment. Corporate governance reforms are just starting to take hold and a majority of sectors appear essentially uninvestable through a cash-flow prism. Investment strategies that require tangible, multi-year evidence that progress is in fact occurring will justifiably demand patience. Still, recent developments suggest toning down one’s cynicism a notch, at least for the minority of sectors identified as promising.

2016 set to be a record year for Japanese buybacks

Buybacks are up 40% year on year among TOPIX stocks according to CLSA, which is doubly impressive given that 2015 was already a record year. Over 280 Tokyo Stock Exchange (TSE) companies have announced share buybacks so far in 2016, with a total announced value of ¥4.8 trillion. Over the last three years, buybacks have represented just under 1% of market capitalisation (Figure 1). More pertinently, the median buyback announcement was for 1.9% of shares, comfortably above the 10-year average of 1.5%.

Buybacks have been well received by investors, with a company’s shares typically outperforming the TOPIX by 3% (within a 2%-to-6% range) in the 20 trading days after an announcement. Also, over the past 12 years, actual buybacks have equalled or exceeded announced buybacks in every year except 2012 (and that miss was quite small). So announcements are a good guide to what is likely to occur. Epoch believe buybacks will probably continue to increase, reflecting growing cash positions at many companies, subdued levels of capex and greater influence from the 2015 corporate governance reforms.

Dividends have increased three-fold since 2000 in Japan

In addition to a rising shareholder yield from buybacks, the dividend yield for the TOPIX is now marginally higher than for the S&P 500 (2.2% vs 2.1%), and dividend-per-share growth for the TOPIX has averaged 13% per year over the last three years. Further, dividends have tripled since 2000 (Figure 2), representing a moderately higher growth rate than that of the S&P 500, and a much stronger growth rate than that experienced in the UK and EU.

Further, the TOPIX payout ratio is a moderate 36%, with significant upside potential. Japanese dividends remain a manageable fraction of all earnings and cash flow measures, suggesting dividend-per-share growth is likely even if earnings shuffle sideways from here. The key risks to this view include:

• a top-line recession
• an acceleration in labour compensation
• a dramatic increase in capex (which appears highly unlikely).

Outbound M&A is booming

Another encouraging development is the ongoing surge in outbound M&A (Figure 4). During the last five years, 65% of Japan’s M&A was outbound (the other two categories are inbound and domestic). This figure is up from 15% during the 2001–2007 period and is about twice the global norm.

Cross-shareholding ratios are declining

As recently as the early 1990s, a majority of Japanese shares were held in cross-holding relationships. This reflected the historically dominant keiretsu model that was centred around the banks, trading companies and heavy industry arms of groups such as Mitsui, Mitsubishi and Sumitomo.

Since then, both broad and narrow definitions of cross-shareholding ratios have declined to new record lows. This is an important development, as it allows for more arms-length transactions, better capital allocation and improved corporate governance. For example, the June 2015 reforms that emphasised shareholders’ rights, increased disclosure and transparency, independent directors and ROE targets, would have been unimaginable in the corporate structure that dominated just two decades ago.

Over 50% of TOPIX companies are net cash

Japan is the only major market where cash ratios have risen dramatically (Figure 6, grey line). This has occurred partly because capex in Japan has declined during six of the last nine quarters and remains well below its 20 year mean. Further, tepid growth in labour compensation has allowed firms to build up cash even in years when earnings growth was sub-par. Epoch expects this cash accumulation to continue to drive strong dividend-per-share growth, more buybacks and further M&A activity.

Six sectors appear particularly promising for cash flow focused investors

Overall, the Tokyo Stock Exchange possesses several positive attributes for cash flow focused investors: a dividend yield of 2.2%, strong dividend-per share growth, record buyback activity, sharply declining net debt and a price to cash flow (P/CF) ratio of only 5.2. Epoch examined 20 TSE sectors and found that six appear particularly promising, exhibiting a high dividend yield, strong dividend growth and supportive cash flow fundamentals. They are: rubber, transportation, air transport, other financials, construction and pharmaceuticals (Table 1).

Six other TSE sectors possess high dividend yields, but appear to be less promising due to their challenging fundamentals: oil, securities firms, banks, wholesale traders, insurance and marine transport. Further, telecoms, food and utilities appear uncompelling from a cash-flow perspective even though they are among the most promising sectors for yield-focused investors in other major markets.

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The information included in this article is provided for informational purposes only. The information contained in this article reflects, as of the date of publication, the current opinion of Epoch Investment Partners, Inc (Epoch) and is subject to change without notice. Sources for the material contained in this article are deemed reliable but cannot be guaranteed. We do not represent that this information is accurate and complete, and it should not be relied upon as such. Any opinions expressed in this material reflect our judgment at this date, are subject to change and should not be relied upon as the basis of your investment decisions. All reasonable care has been taken in producing the information set out in this article however subsequent changes in circumstances may occur at any time and may impact on the accuracy of the information. Neither Epoch, Grant Samuel Funds Management, their related bodies nor associates gives any warranty nor makes any representation nor accepts responsibility for the accuracy or completeness of the information contained in this article. ©2016 Epoch Investment Partners, Inc.

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