By Samrat Khosla & Vinay Joseph
The pandemic has driven an acceleration of a variety of investment trends. Investors are also responding to these shifts by allocating higher capital into thematic investments. At the start of 2021, we enlisted six broad investment themes (cyclical and structural) that we believed could capture the underlying acceleration.
Cyclical themes are influenced by changes in the business cycle such as the outlook for economic and earnings growth, valuation and interest rates changes. Cyclical themes have a shorter time horizon of 12-18 months. The three cyclical themes are:
Rotation into value-style equities: The rotation into value-style equities from growth-style equities is likely to sustain as the drivers for outperformance remain in place given, i) A reflationary environment (recovering growth, rising inflation and rising nominal bond yields) supports value-style equities, (ii) A better risk-reward as performance and valuation divergence with growth-style equities is still large and (iii) A favourable sector tilt given dominance of cyclical sectors in value indices amid light investor positioning.
Race for income among bond investors: Our view of a modest rise in nominal bond yields amid a benign policy environment is likely to drive a search for yield among bond investors, supporting an outperformance of high-yield corporate bonds (AA/A). Further, an improving credit cycle, a likely reduction in credit default risk and attractive valuations for AA/A corporate bonds compared to AAA corporate bonds are key supports.
USD to depreciate: The US Dollar downtrend is likely to gain momentum, reducing the US exceptionalism narrative. A weak USD is generally good for broad-based investment returns especially for non-US assets like Europe and emerging markets.
Structural themes intend to have a multi-year investment horizon and are influenced by structural trends, such as demographic shifts, public policies, regulation. The three structural themes are:
In the world of “yield-free” risk: Decadal low bond yields have reduced bond’s ability to act as a buffer against sharp equity drawdowns. Further, equity valuations are much higher compared to past cycles, likely resulting in lower long-term returns. To counter this, investors would need to increase exposure to innovative sources of returns (higher exposure to equities), income (larger allocation to lower quality bonds or longer maturity bonds) and diversification (raise exposure to alternate assets).
Disruptive innovation: We expect adoption of recent technological breakthroughs to accelerate growth in five sectors—fintech, e-gaming, electric vehicles, 5G/IoT and medical technology.
Climate investing: The global acceleration toward “net-zero”, increased corporate disclosures and individual interest in climate-related risks and greater investment and portfolio flows into climate-related areas are key drivers for the performance of climate investments. We see opportunities in the alternative/clean energy transition space, and water scarcity and circular economy plays.
A key question is how best to incorporate thematic investing in asset allocation?
Investors can use three approaches to thematic investing – complement existing core investments with satellite thematic portfolios, substitute some existing exposure with thematics and integrate thematics into one’s core allocation.
In our view, there is no single right approach towards thematic investing.
However, whatever an investor’s approach, thematic investing benefits investors by capturing higher sources of growth, as being on the right side of growth and disruption is critical for long-term returns. Other benefits of thematic investments include the potential for enhanced returns over a full business cycle, mitigating traditional business dynamics and also mitigating downside risks over multi-year time horizons. In our view, as equity returns moderate to a more sustainable pace and the business cycle matures, thematic investing can offer investors a targeted approach.
Khosla is MD & head and Joseph is chief investment strategist, Wealth Manage-ment, India, Standard Chartered Bank