Welcome to the Adam & Company Outlook 2021.
At some point in our introduction, we usually reference that we are not trying to make predictions about the future, as it is just too difficult. 2020 was an example of this. Who would have thought, a mere twelve months ago, that our economy and society would have been so profoundly affected by a microscopic bug?
Whilst the initial shocks in the early spring were synchronised and global, as trade collapsed, consumer spending slumped and the labour market wobbled, the recovery from that low has been very uneven. Much of Asia has risen strongly, especially China, whilst the UK and Europe have seen economies opening up and shutting down again. Countries which depend on tourism or oil exports have also suffered disproportionately.
As we wave goodbye to the horrors of 2020 and welcome 2021, we do so to a world which is less global, more digital and more unequal than it was before, with some massive structural changes in the economy. Big cities and offices are largely empty and all the workers and jobs that support them have disappeared. Having been told there is no ‘magic money tree’, governments which can find billions to give us half price meals will surely be under pressure to deliver a whole host of programmes and the principle that household income is underwritten by governments will be hard to loosen.
Many other things have become more important – resilience for example. From company finances to logistics and production plans, it’s no longer about ‘just in time’, but ‘just in case’.
We are of course conscious that when it comes to investing, whilst we need to learn from the past we always need to ‘keep on moving’ and think about what comes next. There’s the hope that vaccines will help us return to a more normal way of life. There’s a new US president whose administration has a very different take on economics and diplomacy. And many of the trends which have driven economies for the past few decades, such as globalisation, have come crashing to a halt – now what?
Looking into 2021, clearly so much has changed, and much remains uncertain about the future. As a result, our portfolios also have to evolve. For those who are patient and can look to the long term, there are surely opportunities. In this issue of Outlook, we discuss the changes we are seeing in such areas, including the world of work, the move to online entertainment and the increasing focus by investors such as ourselves on the sustainability of the companies they invest in.
Whatever happens, we must keep moving and we must never lose our curiosity about the world around us and how it is evolving.
Managing Director, Adam & Company
You have to feel a little sorry for economists. Students of the ‘dismal science’ will have spent years studying theoretical rules and relationships, many of which have turned out to be false.
One such rule is the relationship between unemployment and inflation – the Phillips Curve says that as unemployment falls, the bargaining power of employees rises, wages go up and inflation soon follows.
The world’s central banks have assumed this relationship will hold despite evidence to the contrary over the last 20 years or so. With the orthodoxy being to keep inflation under control, they raised rates in the US and the UK on the basis that inflation was about to pick up.
The world’s most important financial institution, the US Federal Reserve, signalled a huge change in policy in the autumn of 2020. The Fed now wishes to run inflation moderately above their 2% target to make up for the years of sub-optimal economic growth. Despite the breakdown in economic ‘rules’ and the fact they’ve missed targets for years, you have to admire the confidence with which they assumed that they’re now in control and that historic relationships will reassert themselves.
Why the sudden change from worrying about keeping inflation around 2% to hoping it rises? Central banks say they’re concerned about growth, but much of it surely relates to debts. The enormous debts which governments racked up in 2020 relative to the size of their economies can only be dealt with in a few ways. The UK Government debt, for example, has risen to more than £2 trillion or 100% of GDP.
Governments have to repay these debts at some point and they have a few options – they could default of course but that’s never going to happen in a G7 nation like the UK or the US. They could raise more tax (politically toxic, it slows the economy down, and more difficult to raise significant monies than you would think). They could cut spending dramatically (austerity may be more difficult to implement than tax rises). Or finally, the could try to let inflation rise so they pay back less in real terms. This may be the least painful option if you can keep it under control. You grow GDP in nominal terms by raising inflation a little and these debts shrink relatively over decades. This is the idea behind the 100-year bonds issued by countries such as Austria and Mexico.
The problem is that the modern world is very different to that of the 1970s, when many economics lecturers learnt their trade, and passed on to their students in the 80s and 90s. The old world model was of closed economies protected by tariffs, unionised workforces with pricing power over their pay and physical products whose marginal costs could not be reduced.
These days economies are fairly open and workers compete globally. If productivity is poor and wages high, your job may move to a country where the opposite is true. In the internet age, many products and business models are infinitely scalable. For example, it costs no more money to make and distribute 10 million computer games as it does one, as they are just digital copies distributed over the internet. Furthermore, ageing populations, as seen in Japan and Europe, tend to be a deflationary force. Maybe the central banks will not be able to get inflation to help, given these structural forces.
Faced with these, is the idea fanciful? If these structural forces remain, yes. However, the world continues to change and some of the structural forces have been reversing somewhat.
Globalisation has given the world economy a huge boost and lifted a billion and more people out of poverty in the past 30 years. It has also been hugely deflationary as a vast pool of workers – from Eastern Europe to the east coast of China – has joined the global labour force. It has allowed multi-national companies to grow sales and keep wage and production costs down. However, the trade war between the US and China has escalated from a dispute over tariffs to ‘Cold War 2’, and protectionism is on the rise around the world.
Furthermore, the Covid-19 crisis has seen supply chains break down and governments and businesses are concerned about their ability to get their hands on products outsourced to far-off lands from face masks and basic drugs to car parts. Offshoring and lean inventories seem set to fall in favour of onshoring and holding more stock ‘just in case’. These trends are all inflationary.
These will help governments and central banks in coming years on the one hand, though whether they overwhelm the other trends – technological deflation and demographics – remain to be seen and analysed by the next generation of economists.
The events of 2020 have meant a great deal of change, with a lot of rebuilding to be done, and there are increasingly calls to do the rebuilding in the ‘right’ way: to emerge with a stronger focus on equality, resilience, responsibility and environmental awareness, putting sustainability at the core of the way ahead.
Sustainability is about making the right decisions today that will work and be for the benefit of the long term, so a full range of economic, environmental and social factors need to be considered. In terms of companies, sustainability is usually discussed in terms of Environmental, Social & Governance (ESG) credentials.
In the 1990s a company that was seen to focus on ESG ran the risk of being viewed by investors as being distracted from the main business of making money. But since that time there’s been a complete turnaround in attitude and increasingly both companies and investors want to see adherence to ESG principles. Part of this is due to external requirements to act, with increasing government regulations and policies in this area. There was a focus on addressing the ‘G’ with the UK’s introduction of the Combined Code on Corporate Governance in 1998. Standards on ‘S’ have been placed in the spotlight by the 2015 introduction of the UK Modern Slavery Act and gender pay gap reporting rules in 2017. The ‘E’ is receiving ever more attention as the awareness of our impact on the environment grows, and global organisations such as the United Nations have been leading efforts to coordinate a response, with broad global support for the Paris Agreement in 2016, aimed at reducing greenhouse gas emissions, a key milestone.
Research has shown there are sound reasons for companies to be good corporate citizens. There are plenty of studies showing that companies who get it right outperform. A 2015 survey of more than 20,000 companies in 91 countries showed that a 10 percentage point increase in female representation on a board correlates with an increase of 0.7% in net profit margins. A joint UK/US study that paired companies that were measured as having a high regard to sustainability against those with a low regard highlighted both a stock price and financial outperformance of the companies with strong sustainability credentials.
Of course what’s being measured and how it’s interpreted is one of the key problems at the moment. There are a wide variety of measurements and sources of information to choose from, many of which are difficult to standardise across companies, or indeed verify. Then there’s a question of how you combine the ‘E’, the ‘S’ and the ‘G’. How does a company that’s working on developing a very environmentally-friendly product, but with some questionable corporate governance practices, rank against a company that has lower environmental credentials but is working on improving them and has the highest social and governance standards?
At Adam Investments we feel that sustainability, as defined by making the right choices for the long-term, dovetails with our focus on quality companies in structural growth areas. We’ve included our own ESG measures and analysis in our stock research since 2017. However, as with many other investment managers, we are looking to refine and deepen what we do.
On 21st March 2021 the EU Sustainable Finance Disclosure Regulation comes into force. This says that all firms must have a policy on integration of sustainability risks into investment decision-making processes that’s disclosed on the company’s websites. Further to that, it asks companies to assess the principle adverse impacts of their investment decisions on sustainability factors and provides guidance on sustainability factors to be addressed. We plan to continue to make progress through developing our own internal processes and our engagements with companies, and in addressing the new regulations coming into force next year, all of which means you’ll see more on this topic from us as 2021 progresses.
Issued by Adam & Company Investment Management Limited (Adam), which is authorised and regulated by the Financial Conduct Authority. Adam is registered in Scotland number SC102144. Financial Services Firm Reference Number 141831. Registered Office: 6-8 George Street, Edinburgh EH2 2PF.
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