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Next downturn will be active investors’ time to shine

Tom Stevenson

Tom Stevenson - Fidelity Personal Investing

This article first appeared in the Telegraph

Next downturn will be active investors’ time to shine

Investors look at the world around them in one of three ways. Some start with the big economic picture of GDP, interest rates and the like and then decide which investments fit in with that top-down view. Others start at the bottom, investigating individual companies’ prospects; their world view is essentially a sum of the parts. These two approaches are variants of what’s known in the jargon as active investing.

The third group, which within a couple of years will own more than the other two groups combined, doesn’t bother with all this hard, analytical work at all. So-called passive investors just invest in businesses on the basis of how big they are and trust that the lower cost of their approach will offset the fact that they don’t know anything about the companies they are backing.

A study by Moody’s, the rating agency, last week forecast that passive funds would overtake active by 2021 in terms of the amount of money they manage. This is a watershed moment for the investment business, but not altogether surprising. Last year saw the biggest-ever annual outflow from active funds in the US (where this process is most advanced). After ten years in which shares have basically gone up and it has not mattered terribly which funds in an index you actually bought, it has been hard to make the case for employing big teams of highly-intelligent and well-paid researchers to give your investments an edge. Cost has been the key concern.

We shall see how well that argument stands up to the next market downturn. When shares are falling across the board, it might not seem so clever to just buy everything. When that happens, the prospects for individual companies might suddenly seem more relevant. That’s certainly the belief of my investment colleagues here at Fidelity who have just undertaken their annual survey of 16,000 company meetings conducted by 165 analysts last year. Its findings are an interesting - and slightly worrying - snapshot of the outlook for the company profits which ultimately drive the stock market indices that all those trillions of passive investments blindly follow.

There are four key findings this year. The first is that while recession is not expected this year, the next downturn is looming larger on the horizon. The balance of optimists and pessimists has flipped in 12 months with a third of analysts saying their sectors are in a slowdown or recession compared with just 13% a year ago. Only a fifth report expansion against 35% last year. Their pessimism is focused on two areas: lower consumer confidence all around the world and higher costs of doing business as, for example, wages start to rise.

Anecdotal evidence of the end of the economic cycle is increasing, with different stories in different sectors. Financial analysts report an increase in hedge funds and insurers lending on terms that conventional banks would consider too risky. Property companies are reining in purchases of land because it is too expensive. Stitching these threads together, a picture of an increasingly long-in-the-tooth cycle starts to emerge.

The second key observation from this year’s survey is a reversal in sentiment about President Trump’s policies. Businesses were quick to look through bien-pensant negativity about Trump to see the positive impact he might have on their bottom lines via lower taxes, less regulation and more infrastructure spending. That love affair has now soured. Companies, notably in the US and Asia think the positives have run their course with diminishing benefits from tax reform and reduced red tape. Infrastructure spending never really got off the ground and will struggle now to get passed by a divided Government. Meanwhile the impact of tariffs is hitting consumer sectors in particular, with higher import costs giving businesses an unenviable choice between accepting lower margins or passing on the cost to consumers and facing lower demand.

The Trump effect is also being felt in China, where tariffs have built on a pre-existing slowdown as Beijing attempted last year to bear down on excessive borrowings. The Chinese consumer has been one of the key engines of global growth but has more recently started to sit on her hands. This is most noticeable in the car market, the largest in the world at 25 million vehicles a year, which looks like suffering its first decline in a decade. Sales ‘cracked’ in the last four months of 2018, one analyst said. Luxury goods is another area of concern. Around a third of luxury products are bought by Chinese, either at home or on their travels, and the double-digit growth rates of recent years are forecast to grind to a halt this year.

The final key finding this year confirms that the outlook does not simply get better or worse, but it changes too. Environmental, social and governance (ESG) considerations have rocketed up the agenda for the companies followed by Fidelity’s analysts this year. 70% of companies said they were devoting more resources to ESG factors, up from 58% last year. In China, there has been a positive ESG revolution, with 63% of companies reporting a growing focus on sustainability, twice as many as a year ago.

This is partly about greater scrutiny and regulation (things like China’s ‘war on pollution’) but also consumer-led. As end customers have become more demanding, suppliers have had to up their game or risk losing business. Investors no longer see ESG factors as a nice-to-have or niche consideration but a central factor in their assessment of a company’s value.

Perhaps even more so than identifying the growth trends that characterise the first three of this year’s key survey findings, the emergence of sustainability as a crucial input to the investment process makes the strongest case for active management. Maybe 2021 will be passive investment’s high-water mark.

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