Bulls look forward to brighter climate

Investors should seek sanctuary in climate change themes, but the prospects for global growth are not as gloomy as some bears predict – particularly as emerging markets develop further.

Before the equity markets took a tumble in late September, the global economy had been expanding vigorously. Growth exceeded 5% for the first half of 2007 with emerging markets, in particular China and Russia, as the key drivers.

This robust growth counterbalanced continued moderate economic expansion in America of about 2.25% in the first half of 2007, according to the International Monetary Fund’s (IMF) World Economic Outlook of October 2007. Indeed, growth in the developed markets of the eurozone and Japan also slowed in the second quarter of 2007, having experienced two strong previous quarters of growth.

Looking into 2008, most economic indicators are pointing towards a slowdown, prompting most forecasters to revise down their estimates for global growth. However, those predicting a significant slowdown to prompt a widespread recession are in the minority. The IMF estimates healthy global growth will continue into 2008, although slowing from an estimated 5.2% in 2007 to about 4.8% in 2008 (and down from the 2006 figure of 5.4%).

With this backdrop of moderating growth, what will be the key investment themes that dominate the investment climate of 2008?

With developed markets’ growth moderating further, most analysts estimate emerging market economies will stay as the primary source of world economic growth. The past five years have seen a substantial rise in optimism towards emerging markets. Strong economic growth and market performance within emerging markets, particularly in the Brics (Brazil, Russia, India and China), have led to a surge in optimism about the prospects of the developing world. This optimism has fuelled theories that emerging markets are decoupling from the American economy and also that these are becoming safe havens for investors.

The fundamentals in emerging markets are robust and are often sounder than those of the developed world. The latest IMF World Economic Outlook shows emerging markets boast lower budget deficits and lower debt-to-GDP levels than the developed markets. Emerging markets also accumulate large current account surpluses, compared with the developing world, which typically has accumulating deficits. International reserves have been built up to a point where emerging markets have become net creditors.

Finally, in a time of slowing growth in the developed world, emerging markets are the only reservoir of growth.

The past few years have seen an increased self-sufficiency to emerging markets growth. Sensitivity to the American economy, as measured by the share of goods and services that emerging markets export to America, has decreased. Europe has become more important and emerging markets are doing more business among themselves.

They not only export more to emerging markets than to developed markets, but domestic consumption within emerging markets has also grown strongly. Overall, the world has become more stable from a growth point of view.

There are more engines of growth than in the past and these are less dependent on each other. This has led to the theories of decoupling: that a recession would have less of an impact on emerging markets than in previous years, with the powerhouses of India and China absorbing much of the slack.

The softening of global growth, and continuing uncertainty surrounding the possibility of a soft or hard landing for developed market economies may sharpen investors’ attitudes to risk and heighten nerves. Such market conditions may exhibit greater volatility as investors’ sentiment responds more sharply to company or economic data.

When facing uncertain circumstances such as these, it is prudent for the longer term investor to consider diversification and position their portfolios across poorly-correlated asset classes and performance sources. The coming market conditions will test the mettle of many a fund manager. Those who can add the most alpha while maintaining a measured risk profile look set to benefit most.

In this type of slowing economic environment, finding conviction investment themes is more difficult than usual. From a strategy perspective, one theme that we have been expecting to emerge is a rotation away from ‘cyclicality’ into ‘growth’. And when you are looking for ‘growth’ themes, companies that are focused on addressing, combating or developing solutions to offset and overcome the effects of climate change looked well placed to benefit. The sector may be viewed as a relative safe haven. Also, a likely slowing economic growth environment may stimulate added interest in the secular growth potential of climate change-related themes.

Some areas will do better than others. Some sectors will go from strength to strength, others may struggle to gain any momentum. In aggregate, we expect climate change related themes to gain further prominence in 2008 and beyond.