Time to focus on secular trends

• Focusing on long-term, secular investment themes at time of heightened market uncertainty can help investors to overcome their short-term doubts and stay invested in markets. The market of climate-related adverse events, global need for infrastructure spending, and acceleration in digital innovation are three such themes.
• In the first theme, CAT bonds offer fixed income investors an opportunity to own short-duration instruments paying a higher yield, on average, than high yield debt that also help companies deal with climate change risks.
• The number of potential infrastructure investments looks set to mushroom if the world is deliver the $94 trillion in infrastructure investments thought to be needed by 2040 to support global economic growth and start to close infrastructure gaps. The asset class typically provides predictable returns over the medium- to long-term.
• The rise to a more digital world looks inexorable. After explosive growth for many innovative companies in the pandemic, valuations have suffered in recent months. This adjustment may have more legs. But over the longer term, these companies are likely to grow earnings at a far quicker clip than the rest of the market, and be the main powerhouse of market returns.
• The outlook for equities and other risk assets in the medium term still seems promising. It may be some time before this becomes apparent. But for long-term investors, the above investment themes can provide opportunities to focus on secular trends, while diversifying their portfolio, traditionally the best way to deliver long-term growth.

Investors are being barraged by much short-term noise at the moment, as the Ukraine-Russia conflict, inflationary pressures, and recession risks lift market uncertainty. There may be one solution for investors at such times – looking for companies likely to do well from secular changes taking place.

We are upbeat on the outlook for equities and other risk assets in the medium term, though it may be some time before the current fog of uncertainty clears and the medium-term outlook is more visible.

At time when market noise gets too loud, it can be worth taking a step back and focusing on long-term investment themes that we are most confident about. In turn, such themes can help people to overcome their doubts and to build diversified portfolios of assets.

This article explores three such themes: the market of climate-related adverse events, the global need for more infrastructure spending, and the acceleration in digital innovation.

CAT bonds

Climate change is also seeing the number of extreme weather events rise. At the same time, bond investors are being challenged by higher yields and the risk of an economic slowdown worsening default rates.

But what if, instead of trying to predict whether companies will be able to repay their debt, investors took exposure to a different sort of risk? One option could be catastrophe bonds (or “CAT” bonds). The bonds are primarily designed for insurance and reinsurance companies to redistribute risk linked to specific natural catastrophes better.

Getting to grips with the basics

Each CAT instrument covers one event, or a series of them, over a specific period and with well-determined triggers. CAT bonds tend to cover periods of under five years, making them a short duration investment, and often offer some protection against rising yields. Furthermore, this $30 billion market shows low, or even negative, correlation to more traditional segments of the fixed income universe.

As most CAT bonds cover extreme disasters, they are rarely triggered. Indeed, expected losses typically lie between 2.5% and 4.5%, not too dissimilar from expected default rates for high yield bonds.

CAT bonds also often pay a better yield, on average, than that received on US high yield debt, being mid-to-high single digits for the former and below 4% for the latter. As such, they can help to enhance portfolio diversification and returns, especially when macro uncertainty is elevated.

Bricks and mortar investing

According to the G20’s Global Infrastructure Hub, infrastructure investments need to reach $94 trillion by 2040 to support global economic growth and to start to close infrastructure gaps. The total bill would approach $100 trillion to meet the UN Sustainable Development Goals for universal household access to drinking water and electricity by 2030.

While CAT bonds are uncorrelated to global gross domestic product (GDP) growth, infrastructure spending is a determinant of GDP. That means that investments in infrastructure projects may slow when growth decelerates.

Infrastructure is not just about additional water pipes, roads, and sewage systems anymore. It is becoming more digital and sustainable than previously. This, in turn, enlarges the number of potential investment opportunities likely to benefit from future growth, in assets that typically provide predictable returns over the medium- to long-term.

Targeting innovation

The COVID-19 pandemic has been a boon for technology adoption, as how we work and consume is done so online, and as companies find more innovative solutions to meet demand. As lives increasingly show more signs of normality, the move towards a more digital world appears inexorable.

After explosive growth for many high-growth, innovative companies during the pandemic, a gloomier outlook for global growth and higher yields have put pressure on their valuations in recent months. This adjustment is likely to last for a while longer. However, longer term, companies’ ability to boost returns will remain the main driver of stocks’ returns.

Technology companies (in the broadest sense) tend to deliver much stronger long-term growth. For example, earnings per share have jump eightfold in the last 20 years for companies in the MSCI AC World software sub index. This is double the rate of the broader market and exemplifies their inherent innovation, scalability, and asset-light models.

While an active approach to picking winners among innovative companies appeals, given the fast-changing nature of the market, technology companies - and more innovative ones – appear likely to keep growing at a quicker pace than the rest of the market for years to come.