Thematic investing - an update

A number of our investment themes have proved beneficial to performance in recent times. The becalmed and debt & credit themes have been particularly influential in our management of clients' portfolios during the credit crisis which began in the spring of 2007.

The becalmed theme concentrated on financial market behavior, observing that developed world borrowers, lenders and investors had begun to behave as though the economic cycle had been abolished. This gave rise to new excesses in risk taking which pointed strongly to the likelihood that the credit cycle was nearing its peak in the Western world.

The debt & credit theme focused on the unsustainability of the growth in credit witnessed in developed economies in recent years. The structural decline of inflation and interest rates over the last quarter of a century triggered a 'super cycle' of credit growth which boosted economic activity in the West. It extended the economic cycle, but left developed-world households, corporations and administrations increasingly indebted. This contrasted with the developing world, where households and, increasingly, corporations took on significantly less debt.

The becalmed and debt & credit themes have been instrumental in the construction of our clients' portfolios. In the financial sector, the themes have led to our favoring companies with exposure to the developing world. By contrast, we have tended to avoid companies with exposure to indebted consumers in developed countries and those with investment banking operations associated with the explosion of opaque structured products and credit growth. Concerns surrounding the indebtedness of the consumer, especially in the UK and U.S., led us also to be highly cautious about exposure to consumer-related sectors such as house-builders and retailers.

We were uncertain as to the timing of a credit 'crunch', but we were confident that it was an inevitable consequence of the pervasively poor lending practices of Western financial institutions.

Among other established ideas, developing economies and networked world have proved to be important. The former identifies the opportunities inherent in the growing influence of developing economies on patterns of global trade, resource demand and consumption. The latter recognizes the scope for technological networks to continue to transform people's lives.

Elsewhere, Earth matters, which recognizes the additional stresses on resources and the environment from the growth of developing-world economies, has been favorable. The theme has led to our maintaining meaningful exposure to resource stocks and to agricultural companies as pressure to boost stock yields continues to grow. In relation to managing global bonds, the theme has highlighted successfully the rationale for gaining exposure to commodity-related currencies.

Our fire risks theme foresees a likely reversal in the trend of benign disinflation that was driven over the last quarter of a century by globalization and rapid technological change. There are now distinct inflation 'hotspots' in fast-growing and resource-rich economies (owing largely to soaring food and energy prices). The theme has been particularly beneficial in identifying opportunities in the resources sectors.

We are witnessing important changes in the contours of global financial and asset markets. With volatility having returned with a vengeance and credit markets ailing, we have removed becalmed and debt and credit from our list of key themes. The important idea behind these two themes was the unsustainable nature of developed-world debt, and thus the inevitability of some kind of credit crisis. As that crisis has clearly occurred, our attention has turned to the longer-term implications of the crisis for investors.

Recently, we have introduced four new themes.

All change: formalizes our conviction that the crisis in credit markets marks an important turning point in a number of important areas: for example, the growth in credit generally, asset prices, concepts about balance sheet 'efficiency', financial earnings, consumption trends and economic growth. The broad question implied by the theme is what a world with less and more costly credit will look like. We believe this, together with the inflationary threat outlined in our fire risks theme, represent the most important issues facing investors currently.

The 'popping' of the credit bubble appears to have marked an end to the era of rapid growth in debt in the developed world. At the same time, heightened volatility in financial markets appears to herald an end to the benign period of stable economic growth (as described in the becalmed theme) which allowed financial leverage to grow to unsustainable levels. The transition to a more volatile economic setting in which credit is less freely available has profound implications for all asset classes and investment strategies.

As indebtedness is reduced and risk appetites fall, there is the potential for a protracted period of sluggish activity, not least because the end of the era of 'cheap money' is coinciding with an escalation in the global prices of energy and food. Consumption growth is likely to moderate, savings rates should rise and interest in the concept of 'thrift' should increase (not simply in a monetary sense, but also in relation to energy conservation and the reduction of food wastage). Asset prices (especially real estate) and financial earnings are likely to remain under pressure in the medium term.

Despite the obvious challenges, profitable investment opportunities continue to exist. Against the backdrop of tighter credit conditions, we favor stable growth businesses which are capable of generating cash throughout an economic cycle, as well as companies, sectors and geographies in which levels of indebtedness are reasonable. Well-capitalized financial companies may prove to be attractive, and savings companies are also likely to find favor as rates of saving increase in developed economies.

Conversely, we are likely to avoid (or at least to maintain underweight positions) in companies whose recent success has been founded on the unsustainable growth of credit, such as Western banks, investment banks and real estate businesses. Overall, there is significant scope for stock selection to enhance investment returns as balance sheet strength and credit worthiness separate 'winners' from 'losers'.

Uneconomic growth: relates to the distorting effects of currency pegs, price controls and subsidies on key global prices. A significant proportion of global economic activity is currently being distorted by the fixing of key prices (such as exchange rates, energy, food and utility prices) and by the mispricing of others (such as environmental inputs), principally in the developing world. Specifically:

The prevalence of 'uneconomic' growth gives rise to a range of opportunities as well as threats. When taken with rising transportation costs, the theme suggests that some elongated supply chain arrangements (such as outsourcing to China) could come under pressure, benefiting local manufacturers that operate closer to the end consumer.

Currency appreciation may continue to benefit consumer sectors at the expense of exporters in the developing world. Opportunities may exist for companies that produce environmental technologies and infrastructure, as well as for companies in geographic locations that are rich in environmental inputs. Threats include an escalation of protectionist policies globally and thereby the hampering of global trade; and there is a risk also of tighter policy and/or higher inflation in some developing countries.

Construction and reconstruction: highlights the 'megatrend' in global infrastructure. We have been gaining exposure to the growth of infrastructure building in the context of our old economy theme, but we have chosen now to formalize our observations in a distinct investment theme.

Spending on infrastructure in the less-developed economies is already growing rapidly; indeed, such spending over the coming decades may well eclipse anything that the world has experienced in the past. In the developed world, despite a prolonged cycle of prosperity, important areas of infrastructure have been neglected and improvements are long overdue.

We anticipate strong growth in all categories of infrastructure spending (transport, telecoms, utility, social etc). Although the beneficiaries of infrastructure growth are often highly-sensitive to the economic cycle and to the ebb and flow of project funding, we anticipate that they will benefit from strong, secular growth and that demand for a wide range of raw materials will continue to increase.

More government: is concerned with the rising importance of economies operating various forms of managed capitalism. The theme discerns that the current financial crisis in particular will lead to significantly more government intervention.

Unfettered 'market-based' economics appear to be losing their appeal. Having been discredited in earlier decades, state intervention and forms of managed capitalism are gaining influence on a global basis as economies like China and Russia outgrow economies in the West. The crisis in the global financial system, and the recessionary implications of that crisis for some major economies, are likely to add further impetus to this trend and pave the way for further state intervention, regulation and measures which restrain the march of globalization. The 'war on terror', too, means that Western populations are increasingly willing to exchange liberty for security.

The increasing politicization of global economics is likely to have a number of ramifications, among them being heightened protectionist sentiment and a propensity among policymakers for 'resource nationalism'. Among specific measures to tackle more challenging economic conditions, we anticipate the widespread use of currency pegs, tariffs, price caps and trade controls (as illustrated also by our uneconomicgrowth theme).

'More government' is likely to pose risks to global trade and generally to be negative for corporate profits. It is likely also to give rise to unintended consequences as inept economic management increases the risk of policy errors. However, the greater role of politics presents opportunities to investors. Domestically-orientated, stable growth businesses may fare better than those with an external bias, and national 'champions' in key industries may be able to exploit their competitive edge. Companies in the security, surveillance and aerospace and defense sectors in particular are likely to prosper from the more insular approach of governments.