Tail risks are higher than usual

In an interview with SKAGEN, Evans talks about returns in equity markets, emerging markets in particular, and how important ESG issues have become now that the spotlight is being shone on climate change.

At BCA Research you think in scenarios. Which three scenarios do you see for equity markets in 2016 and what risks are entailed for each?

Mostly likely scenario (60%): Growth in US, Europe and Japan continues to be positive but below-trend. The lack of inflation pressures means the Fed raises rates only slowly, the Bank of Japan and ECB ease further, and long-term rates are stable. There is no recession, but consumption and capex in DM grow only moderately. Risk assets produce the best returns, but these are not very high. DM equities give a high single-digit return, based on some earnings growth and a small further expansion of multiples. But valuations in most markets are already quite high and so multiple expansion is limited. High-yield debt stabilises as the oil price oscillates around $40. Other commodity prices continue to fall and the USD rises further. EM equites underperform. But six years into an expansion, and with the Fed raising rates in uncertain environment, tail risks are higher than usual. That is the main risk in this scenario. 

Scenario two (bear scenario, 30%): A global industrial recession and bear market in risk assets. The spill-over effects from lower oil and materials prices hurt employment, capex and earnings in DM. The continued slow-down in emerging markets also hurt DM exports. Credit events in EM (perhaps a sharp rise in NPLs and other signs of distress in China) raise levels of risk aversion among investors. Central banks roll out QE again. The Fed stops after one rate rise; the ECB and BoJ do further aggressive QE. Services continue to grow in the US and Europe and so the recession turns out to be mild. Governments, maybe, listen to Larry Summers and start to use fiscal policy (targeting infrastructure spending to take advantage of low interest rates). 10-year US bond yields fall back to 1.5%. Government bonds are the only asset class (along with the USD) that produce positive returns. US equities fall 15-20%.

Scenario three (Disaster, 10%): The world tips into a full-blown recession, driven by the US running out of steam, the Fed making a policy mistake by raising rates too quickly and by a full-blown crisis in EM. Central banks are unable to do much about this, with rates at (or below) zero and the effectiveness of QE increasingly questioned. Politicians balk at the idea of using fiscal policy. Earnings collapse, and global equities enter a full bear market. Only safe-haven assets – CHF, gold, US Treasuries, Bunds – offer any relief.

Emerging markets have seen outflow for many years now. It is clear that the main emerging market China is heading towards a structurally lower level of economic growth. How will emerging markets' stock markets develop in 2016 seen from an investor's point of view? And what is the 5-year outlook, beyond 2016?

It is tempting to think that emerging markets, after five years of underperformance, are good value again. My view is you should avoid such a temptation. The aftermath of excessive credit growth in almost all major EMs in 2009-11 has not fully worked through. Central banks are still having to raise rates to protect currencies, even at the expense of growth. Non-performing loan ratios have only just started to rise. There is a high probability of a major credit event in an EM in 2016 (most likely in Russia or Brazil). A rising USD and Fed rate hikes (both of which I expect to continue next year) are unequivocally bad for emerging markets. Valuations are not particularly cheap (attractive companies, in areas such as consumer services, are very expensive). There has been little structural reform, of the sort that took place in the 1990s and subsequently triggered the bull market in the 2000s in countries such as China and Brazil. In the longer term, once corporate balance-sheets have been cleaned up, return on capital has started to rise again, and EM central banks are proactive about tackling overheating risk (rather than just following the Fed), then the better demographics and catch-up effect on growth can cause the asset class to outperform again. But I don't see this happening over the next two to three years. This doesn't mean there aren't some emerging markets worth buying now: I would point to Mexico, Taiwan and India.

The world climate summit is currently taking place in Paris. How important has ESG become for investors globally?

Environmental, social and governance (ESG) is somewhat of a catch-all term. Most narrowly defined, it is really just Socially Responsible Investment (SRI), which usually means that investors avoid buying securities of companies in industries such as tobacco, armaments and (recently) fossil fuels. These are really moral questions for the wealth owners, and most academic evidence finds that excluding a small segment of the market on moral grounds has little negative effect on investment performance. More broadly defined (as, for example, by the Principles for Responsible Investment), it is something that any professional investment manager, with proper due diligence procedures, would be wise to follow. This is why over 1400 investment firms have signed the PRI Code. I think it is true that portfolio managers are increasingly concerned to check that the listed companies they invest in have proper procedures and corporate governance structures. Scandals this year at a wide range of firms such as Toshiba, Volkswagen and Petrobras, show how important this is. Of course, there is a limit to what investors can do to mitigate these risks, but they increasingly understand they have to have in place procedures to vet firms they invest in. I see more and more large institutions with dedicated departments to monitor such risks.