William Blair Economist Olga Bitel and Portfolio Manager Simon Fennell shared their perspectives on today's changing global marketplace and explored the investment opportunities in developed and emerging markets at our 2016 Global Market Outlook.
Summary
There is no question that 2015 was a year of increased market volatility. We saw unrest in the Middle East, tensions in Europe, a slowing Chinese economy, and a guessing game
over what the U.S. Federal Reserve (Fed) would do with interest rates. These factors, among others, put investors on edge.
Amid the noise, five themes dominated the year. These include the proliferation of technology, a change in the hydrocarbon order, and Chinese growth, which are likely to be enduring. In addition, weakness in the emerging markets appears to be cyclical, and the rising U.S. dollar seems transient.
As further detailed in this white paper, we believe:
- The period of rapid U.S. dollar appreciation is behind us. Looking forward we anticipate greater currency stabilization, with a strong but no longer strengthening U.S. dollar.
- From an investment perspective, technology is the most important and enduring theme in the global capital markets, as it is scaling faster and further than it ever has before.
- A change in the hydrocarbon order is clearly upon us as energy moves from being a discussion about extraction into a technology issue.
- China—a tale of two economies, old and new—is likely one of the most enduring stories not just for 2015 and 2016, but for decades to come.
- While the outlook for the emerging markets has been blighted by currency headwinds, there is little scope for this level of magnitude of underperformance moving forward. And since this is a very heterogeneous group of countries, country selection, and even selection within sectors, industries, and companies, is paramount.
As for our 2016 outlook, we believe:
- Global gross domestic product (GDP) growth of 3% is possible.
- There are specific opportunities at the country and company level in the emerging markets. From a broad perspective, we believe that a cyclical emerging market recovery is not unrealistic despite the prevailing doom and gloom.
- Structural disinflation will continue, driven by technology.
- There will be continued uncertainty regarding the exit from unconventional monetary policy outside the United States.
- Volatility in the deleveraging of the commodities complex is likely.
- Risks heading into the new year include wage growth, lower capital expenditures, and corporate taxation policies.
Overview
There is no question that 2015 was a year of increased market volatility given today’s unstable world. We saw unrest in the Middle East, increased fears of terrorism, tensions in Europe, a slowing Chinese economy, a guessing game over what the Fed would do with interest rates, and myriad headlines from U.S. politicians running for president. These factors, among others, made markets edgy and contributed to a low-growth market sentiment that was widely touted by the press.
Specifically, five themes dominated the market’s reassessment of growth prospects in 2015: 1) U.S. dollar strength; 2) the proliferation of new technology; 3) a shift in the established hydrocarbon order; 4) China’s growth; and 5) emerging market malaise. We believe themes two, three, and four will endure beyond 2016. The emerging markets, an area of focus
for William Blair for many years, are clearly out of favor at the moment, but we believe the downturn is cyclical. Lastly, we believe the strength of the U.S. dollar, which was key throughout 2015, is a more transient theme.
Despite this volatility, we believe there are growth opportunities in 2016, many in familiar places: North America, Europe, China, and even the emerging markets. But before we review in depth the themes that dominated 2015 and our outlook for 2016, we will quickly review 2015.
2015: A Year in Search of Direction
The S&P 500 Index has been roughly flat since the beginning of the year, with marked volatility. Global GDP growth has been solid, but at 3%, it is one to two percentage points below the pre-global-financial-crisis level (5.2% in 2007). As a result, it feels slightly anemic.
Meanwhile, inflation, which we talked about in our 2015 Global Market Outlook, has edged even lower, with deflation and disinflation continuing to be major drivers of market sentiment. Commodity prices have been a focal point, with supply growth and a continued demand slowdown responsible for West Texas Intermediate (WTI) hitting $37 a barrel.
Taking a closer look at returns for 2015, we find that the emerging markets have notably underperformed almost all other asset classes (figure 1). That underperformance was largely driven by very weak and declining commodity prices.
Looking at global sector performance, leadership has come from the consumer-related services sectors and technology. Sectors geared more toward energy and materials, and parts of the industrial space supplying those sectors, have underperformed.
Looking at region and country returns, Japan is striking. Over the past several years, we have been focused on the changes in Japan. At the macro level, those changes are ongoing, but the story in Japan this year has been relatively quiet. The focus has shifted to the micro level as companies have improved corporate governance and become more
forward thinking in terms of shareholders and return generation. Essentially, everything we were excited about in 2012 and 2013 is starting to come to fruition, and therefore it is not surprising to see Japan ranking highly in terms of performance. From here on out, we expect Japan to be much more of a micro story of corporate governance and return generation, playing out quietly, away from the headlines.
Theme 1: Most U.S. Dollar Strength Is Behind Us
Over the past 18 months, the U.S. dollar strengthened by 15% to 20% against a broad currency basket (figure 2). Two forces drove this steep rise.
The first force was technology-enabled shale discoveries, which drove the ability to successfully extract oil and gas. As a result, U.S. oil production increased significantly starting in the second half of 2012—so much so that it had a meaningful impact on the U.S. current account deficit. Less than five years ago, the U.S. current account deficit, just from petroleum-based products, averaged around $30 billion a month. Today, that number is less than $10 billion a month and declining. This is a meaningful impact, and has been a significant tailwind for dollar strengthening.
The second force driving U.S. dollar strength has been the debate about monetary policy normalization amid sustained economic growth in the United States. When is the Fed going to hike? June? September? This uncertainty dominated market sentiment amid relatively robust U.S. growth in a global environment in which growth was lackluster or decelerating almost everywhere else.
We believe that these forces are abating, pointing to stabilization of the dollar moving forward. Europe is recovering and European corporates are experiencing a tailwind from the weaker euro at a time when the strong U.S. dollar is beginning to affect U.S. corporate profits. This is a significant reversal. At the same time, global growth is recovering more broadly, such that growth differentials are no longer as dramatic as they were two years ago. Both the Fed and European Central Bank (ECB) are keen to maintain appropriate monetary policies for their respective jurisdictions, reducing the risk of strong currency moves.
All of this suggests that the period of rapid U.S. dollar appreciation is behind us. Looking forward we anticipate greater currency stabilization, with a strong but no longer strengthening U.S. dollar.
Theme 2: Proliferation of New Technology
From an investment perspective, we believe technology is the most important and enduring theme in the global capital markets. Technology is also critical to business processes, as it remains a key driver of corporate performance. In our opinion, there is an inevitability to technology that is clearly demonstrated by Moore’s Law and the impact on the cost curve.
We believe that technology can continue to proliferate because it is scaling faster and further than ever before. We have moved from an environment in which assets were based on hard goods to an environment in which software, data analytics, artificial intelligence, and deep learning dominate. This will continue to radically change return profiles, not just in technology, but in every industry. The scalability of technology will create haves and have nots at both the corporate and geopolitical level.
Reality or Hype?
There is no area more prone to hype and hoax than the technology sector. We saw this clearly in the dot-com era of the late 1990s leading into the crash of 2000. In this era, the Nasdaq Composite Index led the U.S. market and is now leading again. We observe this in terms of returns as well as corporate performance, as technology companies continue to deliver strong operating margins.
Figure 3 shows select U.S. index performance since 1995. In August 1995, Netscape went public, with more than 40 million global online users, which seemed massive. But by the height of the dot-com madness in 2000, that number had grown to 400 million, and the market seemed fully saturated. Today, it is projected that there will be 4 billion global online users by 2020. To put that in perspective, the global population is only 7 billion. So, the world will be nearly completely connected by 2020. More importantly, we will be connected with devices that are at least 300 times more powerful than those used in 1995.
We expect these trends to continue, and we believe they will continue to change the nature of corporate performance.
Cloud Solutions Lead to More Computing Power at a Lower Cost
The venture capital firm Andreessen Horowitz says that software is eating the world in terms of its importance.1 We believe there is truth in this, and we would put mobile
computing in the same realm. As a result, business models continue to evolve, and they are scaling very quickly.
This year has been interesting in terms of growth and scaling. The fastest-growing technology company ever at the enterprise level is a cloud-computing platform that is rapidly growing its top line at 80% and by its own estimates is projected to reach $10 billion next year. Only Google and Facebook, in the consumer space, have matched this level of growth. The significance cannot be overstated as cloud computing is allowing scalability within technology that we have never seen before. This scalability drives a higher growth and return profile not just for the company offering the cloud-computing platform, but more importantly for users more broadly, and it changes the rules of the game. Netflix is the most obvious example of a company using cloud computing, but Goldman Sachs is also a user, and GE has decided to outsource 70% of its computing power to cloud computing. The multiplier effect of technology will be more evident as cloud computing continues to gain share across industries and begins moving across countries.
How does this scalability benefit the individual? In 1995 or 2000, the cost of launching an Internet start-up was about $5 million. Today, using cloud computing, the cost is $5,000—99% less than 15 years ago.
We have seen, and will continue to see, a rapid change in the nature of scaling. WhatsApp, the mobile messaging app, is an interesting example. There are 20 billion SMS messages sent via global telecommunications systems, versus 30 billion sent via WhatsApp. The fact that WhatsApp handles this volume with only 24 employees is remarkable. From an earn-out point of view, the price Facebook paid for WhatsApp is increasing on a daily basis, and the scaling is very impressive.
The beneficiaries of this scalability are not found only in technology. It is almost trite now to talk about what online retailing is doing for consumer convenience, but the impact on consumer prices is also significant. Walmart, which radically changed retail, has 150,000 stock keeping units (SKUs), an enormous number. Amazon has 380 million. That scale has lowered prices, and we have seen decent growth in retail sales volumes—so the impact of technology scalability in retail is extraordinary.
Although technology will continue to be a beneficiary of scalability, it is not all positive. The impact technology is having, though broadly positive, is also clearly negative in parts of the economy. In our opinion, it is no coincidence that for some time we have seen the decline of traditional booksellers, Walmart numbers have been weakening, and Nordstrom’s sales have been decelerating.
Innovation Across Industries
Much of the discussion of technology centers on developed markets—the United States, Europe, Japan, and to some extent Korea. But technology is potentially helping the emerging markets even more.
Consider remittances, and in general, the whole back office of the financial market— payments, clearing, and settlement. The World Bank has recently estimated that the global remittances market is around $580 billion. Migrant workers pay, on average, about 8% to send their hard-earned money to their loved ones, but today’s available online technology can send those payments free, instantaneously, anywhere in the world, without any physical presence required on the other side. All you need is a telephone that is connected to the Internet. That not only disintermediates middlemen, but it also enables a much faster transfer and puts substantial extra money—potentially between $50 billion and $100 billion—into the emerging markets. Importantly, this is not an isolated occurrence, as it affects three to four billion people.
Two other companies that have seen tremendous technological innovation are Uber and Airbnb. To us, they speak to a broader disintermediation within established business models or hierarchies. The speed of disruption is clear, and we believe it will occur across geographies and business models for some time. Where there is old-fashioned economic rent that has been extracted for some time, there will be disruption and the move will be very fast. That is what we mean when we say that technology has its own ambition. At the same time, the complexity of the technology itself is increasing barriers to entry for those that are not technically sophisticated or savvy. The magnitude of the disintermediation possible from an asset-light model provides for a very attractive return profile.
Theme 3: Changing the Established Hydrocarbon Order
A change in the hydrocarbon order is clearly upon us. This time last year, we were observing the reaction of the Middle East, most notably Saudi Arabia, to shale. The big issue was exactly what OPEC would endorse in terms of production. Today, we believe Saudi Arabia is being fairly intelligent in managing its asset base. From our perspective, the most important and enduring issue in energy is the impact of technology. We believe energy may have moved from being an extractive industry to a technology-driven industry. Figure 5 shows when fracking technology came in to play, and figure 6 shows the immediate price reaction. As well costs have declined, so too have oil prices.
How much is that going to change moving forward into 2016? Is $37 per barrel the right number? What we do know from a technology perspective is that Moore’s Law leads to lower marginal costs supporting low prices. As an extractive industry, oil has a naturally increasing marginal cost curve. These two forces are in clear conflict right now, but with WTI at $37 per barrel, it appears that technology is winning the argument.
Theme 4: Chinese Growth
China is one of the most enduring stories, not just for 2015 and 2016, but for decades to come. We can debate whether its growth rate is moving from 10% to 7%, 5%, or 3%, but what is more interesting from our perspective is the nuance and complexity of that growth.
We believe China is a tale of two economies. The first part of the story is the industrial sector, the old growth engine of China. This includes heavy, extractive industry and the industrials that supply it—for example coal, iron ore, steel production, and heavy
machinery. We think this complex is growing at a rate of anywhere between 0% and 3% per year (figure 7). This is much slower than anything we have seen in the recent past, feeding the headlines for a bear case on China.
There has been vast restructuring in China, and a lot of extra capacity still needs to be rationed away, but the industrial complex is not falling into the South China Sea any time soon. There are hundreds of thousands, if not millions, of companies in China that are quietly but steadily moving up the value chain. We see it in the numbers and in observable changes in competitive behavior.
The auto industry is one of our favorite examples because it combines industrials and consumers, and everyone can associate with car ownership. Figure 8 illustrates that in 2000 the quality of cars made by Chinese companies was so poor that almost no one wanted to own them.
In that year, the number of complaints received in the first six months of ownership was so high that it did not matter how cheap these products were; they were just too bad to own. Today the quality differential is almost gone, and it has disappeared at the lower end of the price spectrum. In other words, for the right price, Chinese consumers are willing to entertain the option of buying a locally made car. Many well-established American, European, and Japanese automakers grew accustomed to an underpenetrated or a completely unpenetrated Chinese market with very little competition and considerably outsized profit margins. As figure 9 shows, most had tremendously stronger profit margins in China than almost anywhere else in the world. As Chinese automakers improve, the market dynamics are changing, and it is becoming harder to compete. We hear discussion of demand erosion and destruction, as well as decelerating growth in car sales among the multinationals. Among that rhetoric, there are real competitive threats because the local Chinese automakers are reporting considerably better numbers.
Importantly, this force is occurring in a number of other industries and subsectors. The second part of the story is consumer services, at just over 50% of China’s GDP growth today and growing rapidly.
Headlines of decelerating retail sales growth in China were prevalent in 2015. Figure 10 shows that real retail sales (sales minus inflation) are growing by an average of 10% per year. This is the best consumption story on the planet by a very wide margin. In the United States and Europe, we are excited about retail sales growth picking up to 3% or 4%. In China, the discussion is about deceleration to 10% from a very large base.
Is the marked deceleration of same-store sales growth over the past couple of years due to demand destruction or low wage growth? In China, we believe neither is the case. We do not see demand destruction or tremendous deceleration in consumption in China.
Consumption is well supported with wage growth still averaging around 7% to 8%. Instead, there is a phenomenon of moving up the value chain. Consumers are becoming more selective as local brands offer increasingly better values and opportunities.
We believe that this changing dynamic has more to do with the unexpected proliferation and rapid rise of e-commerce in China. E-commerce did not exist in China in 2008, in that it was not captured in the official retail sales statistics. As a result, no one has paid attention to it. Today, e-commerce is 10% of GDP and 14% of retail sales. Importantly, it is growing by more than 40% per year, which means that it is effectively doubling in size every two and a half years. The proliferation of e-commerce presents an opportunity for small- and micro-cap companies to have a presence in the retail market, reaching millions of people that they would never reach with a purely physical footprint. This is definitely an important and enduring force driving one of the world’s largest economies.
The strength of the Chinese consumer is also increasingly manifesting itself abroad, as figure 11 illustrates.
Chinese tourism is picking up in earnest, and Chinese spending is growing quickly. This is the case not just in Asia but in Europe. Even if we assume modest 4% or 5% growth rates for the Chinese economy moving forward, within 10 years we will have at least another 200 million consumers in the middle class. This is a significant increase in consumers who will have the ability to travel abroad for holidays with their families. This anticipated growth will dwarf the tourism data shown in figure 11.
Lest anyone think that Chinese leaders are behind the times, figure 12 summarizes the areas of growth they have identified in their long-term planning, consistent with their continued focus on rebalancing the economy.
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