Policy support may offer illusory benefits

Iain Stewart, who leads Newton’s Real Return team, examines the reasons for the team’s reluctance to invest in assets that have benefited from the policy actions of the authorities. In contrast, the team’s preference is to concentrate on the fundamental investment attributes of individual holdings as well as focusing on diversification.

The policies that have been used by the authorities to foster growth in the aftermath of the financial crisis run the risk of making matters worse, we fear. Our concern is that once the near-term ‘gains’ from lower debt-servicing costs have been exhausted, vulnerability to unexpected events could even be greater. 

Although the policies put in place to support growth may well have been inspired by good intentions, they could make our economies more fragile and more vulnerable to shocks. Such is our level of concern that we have been less willing to participate in those areas of the market that we judge are particularly dependent on policy support from the authorities. 

As part of the policy support, injecting money into economies has the effect of skewing incentives and creating transfers of resources from one part of the economy to another. Using ever-greater financial incentives to drag future activity into the present can lift activity in the short term but bring forward demand from the future with deflationary consequences. 

Not only does cheap finance enable ‘zombie’ companies to limp along and just survive, it also allows new capacity to be built that would otherwise have failed to meet a required rate of return. The airline industry, for example, is once again challenged by price competition as the ready availability of finance has encouraged rapid fleet capacity expansion. 

Challenges

Unconventional policies have also tended to exacerbate challenging social trends. The deliberate inflation of asset prices has created disparities in wealth and income. It encourages those that do have savings to divert their capital into financial speculation (that proves unproductive for the economy) rather than holding cash that offers no yield. 

How the related distortions ultimately manifest themselves will depend on cultural factors, such as the structure of the economy and who gets most benefit (or is closest) to the new money. Putting cheap money into economies, such as the UK and the US, is much more likely to create a credit expansion that fuels consumption or investment in unproductive assets, particularly real estate. Culturally, this is less likely to be the case in, say, Germany or France. 

China

Globally, cheap money has also created a giant (perhaps the giant) credit expansion in China, which has funded investment in productive capacity and infrastructure. A continuing combination of debt-funded overconsumption in much of the West and debt-funded overcapacity in the emerging world has the potential to be increasingly deflationary. 

High valuations for risk assets, such as equities and high yield credit, need to be validated by increasing growth and profit expectations. The opposite has been the case; long-term growth forecasts, such as those issued by the IMF, have continued to fall. Although imminent 'escape velocity' or the strong reacceleration of growth has remained the dominant narrative, the near-term data releases globally have continued to look anaemic. 

Opportunities

The apparent disconnect between investor confidence that policy is working and faith that policymakers will continue to act as the buttress for any risks market participants may face means that investors should expect more volatility. This does not mean that we view markets as offering no investment opportunities. However, it is likely to require more selectivity in ideas. 

Economies are likely to only be able to sustain nominal growth rates that will continue be a source of disappointment. In such an environment, the positive support for healthcare spending implicit in our investment themes – ‘Healthy demand’ and ‘Population dynamics’ – suggest that the healthcare sector, in both the developed and emerging worlds, is likely to continue to offer attractive investment potential. (Newton identifies global investment themes that it believes represent key forces of observable change and exert a long-term influence on the global economy.) 

Equally, beneficiaries of technology spending should be relatively resistant to cyclical volatility in the economy. Winning companies in this area should benefit as businesses adapt their operations to the technologies that consumers have long since adopted. In turn, consumers in the emerging world are expected to leapfrog the historic patterns of the developed world and move straight to e-commerce on increasingly affordable mobile devices. 

In contrast, many businesses associated with the development of Chinese infrastructure, for example, such as mining companies and local banks, appear on the surface to offer attractive valuations. However, the structural headwinds caused by a prolonged investment boom and the associated accumulation of debt suggest that this is likely to be something of a mirage. 

Maintaining infrastructure exposure through specialist third party funds, can, for instance, offer uncorrelated returns. Such investments can provide strong income streams that come from the public-private partnership projects in which they typically invest.