Global Equity Observer
  •  
Jun 2019
Journey Into The Unknown
 

Global Equity Observer

Journey Into The Unknown

Journey Into The Unknown

Share Icon

Jun 2019

 
 

It is probably fraught with peril to make any forecasts about U.K. politics, given the turbulence of the last few years. However, it does seem that the room for a compromise deal between the U.K. and the European Union (EU) is closing. The European elections saw the rise of the two ‘extremes’ in the Brexit debate, with the ‘No Deal’ parties dominated by Nigel Farage’s new Brexit Party getting 35% of the vote and the explicit ‘Remain’ parties, led by the Liberal Democrats, scoring 40%. This left less than a quarter of the vote for the two major U.K. parties who were pushing for a compromise deal, with Labour getting 14% and the Conservatives 9%, a collapse versus the combined 82% they accounted for in the General Election only two years ago.

 
 

While Conservative leadership elections are notoriously difficult to forecast, it is looking likely that the next party leader, and thus the next prime minister, will favour No Deal, or at least rule out an extension beyond October 31, which effectively amounts to the same thing, given that the EU will be tied up with selecting the new commission for the next few months. The issue is whether the British parliament will be able to block this outcome, given its current majority against No Deal. This is a journey into the unknown, as the U.K. enters uncharted constitutional waters. Ultimately, it is looking increasingly like a binary choice between No Deal and a decision to Remain, be it via a general election, a referendum or even a revocation of Article 50... unpredictable indeed.

 
 
 
‘‘
While far from optimal for the U.K., the impact on our global portfolios is likely to be relatively minor"
 
 

Without wishing to be accused of participating in ‘Project Fear’, No Deal is likely to be a significant economic shock for the U.K., and also a bump for Continental Europe. The extent of any damage will depend on how long it takes for some sort of accommodation to be reached, i.e. No Deal to be replaced with some kind of deal. There is also likely to be a sharp depreciation of sterling. While far from optimal for the U.K., the impact on our global portfolios is likely to be relatively minor. Optically, there is plenty of exposure, with 19-22% of the portfolios listed in the U.K. But, these U.K.-listed companies are global, meaning that the actual economic exposure is far lower, with only 3-4% of the portfolios’ revenue U.K. exposed. As such, any sterling weakness is likely to be matched by sterling share price appreciation in the U.K. listed stocks, as was the case after the 2016 referendum result. In the case of a British-based multinational tobacco company, it can be argued that any sterling weakness will be positive, as it would effectively reduce the strain from the debt load (40% sterling denominated) and the dividend (100% sterling denominated), helping the company de-lever, and making the company a ‘No Deal hedge’ of sorts! There is a similar argument that a distinctly cheaper sterling will help with GlaxoSmithKline’s U.K.-centric cost base.

The further issue is whether a No Deal outcome would be a general ‘Risk Off’ event. Unlike the aftermath of the 2016 referendum, there is unlikely to be any fears of contagion or a domino effect, as the U.K.’s experience over the last three years has definitely dimmed enthusiasm for similar moves elsewhere in Europe. However, there will be concerns about the impact on U.K. and Continental European growth. Our global portfolios invest in companies with plenty of recurring revenue and pricing power, which should make their economics more robust in any downturn, as both sales and margins tend to be insulated, and history suggests that this is likely to be recognised by the market.

While we are relatively sanguine about the effects of Brexit and/or No Deal on the portfolio, we are less relaxed about political risk in general. The Brexit process can be seen as a symptom of the shift of the global environment away from business-friendly policies; after all, for good or ill, it was far from supported by large corporates. It can be argued that the last few decades have seen governments favour capital over labour, be it around globalisation, workplace regulation, taxation or attitudes to consolidation. This is reflected in corporate profitability, which is at very high levels as a share of gross domestic product, particularly in the U.S., where its share is at around 10% as against the post-war norm of around 6%.

 
US Post Tax Corporate Profits as % GDP
 
9600805-Chart-1
 
 
 

Source: BEA, MSIM Analysis; as of December 31, 2018

 
 

There are three broad and overlapping strands of political threat to the current high levels of profitability: right-wing populism, left-wing populism and the environmental movement. Between them, they are the main structural challenge to the current elevated levels of profitability, as opposed to the cyclical threat from any downturn or recession.

 
 
 
‘‘
There are three strands of political threat to the current levels of profitability: right-wing populism, left-wing populism and the environmental movement."
 
 

Right-wing populism is the one that has already started to bite. Brexit is in this strand, as are the threats to free trade and globalisation. Trump is often seen as the personification of the anti-globalisation backlash, but it has been far broader than that. According to the World Trade Organisation, 2008-2016 saw 1,300 trade restrictive measures introduced globally, even before Trump’s election. Pressure has risen since then. In the absence of the pricing power to pass the incremental costs on to customers, the U.S. tariffs are already hitting profitability, and the uncertainty is not ideal for business investment. Arguably, the potential splitting of global technology value chains into separate U.S.- and China-centric realms could have more serious long-term implications than higher tariffs. There are also rising constraints on international migration, making recruiting more difficult for corporates in countries with tight labour markets and/or skill shortages.

It is notable that right-wing populism has been far more successful than the left since the Global Financial Crisis. In fact, the centre-left has really struggled in most Western countries, seeing its vote fall sharply, or even collapse below 10% in the case of France. This failure is driving more radical policy ideas on the left, notably amongst many of the Democratic candidates for the U.S. presidential election in 2020. Ideas include reforms to the labour markets around higher minimum wages or expanded workers’ rights, a revival of anti-trust policies to fight increased market concentration and even, in the U.K., renationalisation of some industries without full compensation for the current owners. In addition, the rise of unorthodox Modern Monetary Theory is providing some intellectual cover for sharply higher government spending funded by printing money, which may threaten the low inflation that underpins equity valuations. The prospects for the introduction of any of these policies are unclear, but an economic downturn could raise the risks.

The third strand is around environmental pressures. Scientific consensus is that actually delivering the undertakings of the 2016 Paris Agreement to keep the rise in global temperatures less than two degrees centigrade above pre-industrial levels could have severe implications for carbon-intensive industries. What is notable is the increasing traction that environmental parties are having electorally, winning close to 10% of the seats in the recent European elections. The unknown is how fast this electoral progress will translate into policies that constrain corporate action.

It is far from clear that current market valuations fully incorporate these risks to the equity markets. An MSCI World Index trading on close to 15x the forward earnings for the next 12 months does not seem to be pricing in many of these structural threats to corporate profitability, even putting aside any cyclical concerns. Moving down to the portfolio level, these threats emphasise the importance of the Environmental and Social lenses within ESG analysis. These need to be primarily considered at an individual stock or industry level, but there are some general guidelines.

 
 
 
‘‘
Scrutiny of corporates is rising sharply, managements need to be aware of the ESG risks facing their businesses"
 
 

The most important is the existence of pricing power. This is a key characteristic for the compounders in our portfolios, but is particularly important where companies’ cost bases may experience shocks, be it due to tariffs, higher labour costs or more expensive energy. The ability to pass these input costs on to customers is crucial for preserving margins and thus profitability. Amongst the other factors to look for, we would point to the advantage of relatively short and simple supply chains in a world where globalisation is under threat, and the need to avoid dependence on carbon-intensive processes. More broadly, in a world where scrutiny of corporates by both governments and consumers is rising sharply, managements need to be aware of the Environmental and Social risks facing their businesses and proactive in dealing with them. There is clearly no room for complacency in this emerging political environment. However, our view is that our investment process, focussed on compounders with full ESG integration, delivers a portfolio of companies that are relatively well placed to deal with these risks, be it due to their pricing power, their carbon-lightness or the quality of management.

 
 

RISK CONSIDERATIONS

There is no assurance that a portfolio will achieve its investment objective. Portfolios are subject to market risk, which is the possibility that the market value of securities owned by the portfolio will decline. Accordingly, you can lose money investing in this strategy. Please be aware that this strategy may be subject to certain additional risks. Changes in the worldwide economy, consumer spending, competition, demographics and consumer preferences, government regulation and economic conditions may adversely affect global franchise companies and may negatively impact the strategy to a greater extent than if the strategy's assets were invested in a wider variety of companies. In general, equity securities' values also fluctuate in response to activities specific to a company. Investments in foreign markets entail special risks such as currency, political, economic, and market risks. Stocks of small-capitalization companies carry special risks, such as limited product lines, markets and financial resources, and greater market volatility than securities of larger, more established companies. The risks of investing in emerging market countries are greater than risks associated with investments in foreign developed markets. Non-diversified portfolios often invest in a more limited number of issuers. As such, changes in the financial condition or market value of a single issuer may cause greater volatility. Option writing strategy. Writing call options involves the risk that the Portfolio may be required to sell the underlying security or instrument (or settle in cash an amount of equal value) at a disadvantageous price or below the market price of such underlying security or instrument, at the time the option is exercised. As the writer of a call option, the Portfolio forgoes, during the option's life, the opportunity to profit from increases in the market value of the underlying security or instrument covering the option above the sum of the premium and the exercise price, but retains the risk of loss should the price of the underlying security or instrument decline. Additionally, the Portfolio's call option writing strategy may not fully protect it against declines in the value of the market. There are special risks associated with uncovered option writing which expose the Portfolio to potentially significant loss.

 
william.lock
 
Head of International Equity Team
 
bruno.paulson
 
Managing Director
 
dirk.hoffmannbecking
 
Executive Director
 
 

INDEX INFORMATION
The MSCI World Index is a free float adjusted market capitalization weighted index that is designed to measure the global equity market performance of developed markets. The term "free float" represents the portion of shares outstanding that are deemed to be available for purchase in the public equity markets by investors. The performance of the Index is listed in U.S. dollars and assumes reinvestment of net dividends. The index is unmanaged and does not include any expenses, fees or sales charges. It is not possible to invest directly in an index.

DISTRIBUTION
This communication is only intended for and will only be distributed to persons resident in jurisdictions where such distribution or availability would not be contrary to local laws or regulations.

Ireland: Morgan Stanley Investment Management (Ireland) Limited. Registered Office: The Observatory, 7-11 Sir John Rogerson’s, Quay, Dublin 2, Ireland. Registered in Ireland under company number 616662. Regulated by the Central Bank of Ireland. United Kingdom: Morgan Stanley Investment Management Limited is authorised and regulated by the Financial Conduct Authority. Registered in England. Registered No. 1981121. Registered Office: 25 Cabot Square, Canary Wharf, London E14 4QA. Dubai: Morgan Stanley Investment Management Limited (Representative Office, Unit Precinct 3-7th Floor-Unit 701 and 702, Level 7, Gate Precinct Building 3, Dubai International Financial Centre, Dubai, 506501, United Arab Emirates. Telephone: +97 (0)14 709 7158). Germany: Morgan Stanley Investment Management Limited Niederlassung Deutschland Junghofstrasse 13-15 60311 Frankfurt Deutschland (Gattung: Zweigniederlassung (FDI) gem. § 53b KWG). Italy: Morgan Stanley Investment Management Limited, Milan Branch (Sede Secondaria di Milano) is a branch of Morgan Stanley Investment Management Limited, a company registered in the UK, authorised and regulated by the Financial Conduct Authority (FCA), and whose registered office is at 25 Cabot Square, Canary Wharf, London, E14 4QA. Morgan Stanley Investment Management Limited Milan Branch (Sede Secondaria di Milano) with seat in Palazzo Serbelloni Corso Venezia, 16 20121 Milano, Italy, is registered in Italy with company number and VAT number 08829360968. The Netherlands: Morgan Stanley Investment Management, Rembrandt Tower, 11th Floor Amstelplein 1 1096HA, Netherlands. Telephone: 31 2-0462-1300. Morgan Stanley Investment Management is a branch office of Morgan Stanley Investment Management Limited. Morgan Stanley Investment Management Limited is authorised and regulated by the Financial Conduct Authority in the United Kingdom. Switzerland: Morgan Stanley & Co. International plc, London, Zurich Branch Authorised and regulated by the Eidgenössische Finanzmarktaufsicht (“FINMA”). Registered with the Register of Commerce Zurich CHE-115.415.770. Registered Office: Beethovenstrasse 33, 8002 Zurich, Switzerland, Telephone +41 (0) 44 588 1000. Facsimile Fax: +41(0) 44 588 1074.

U.S.
A separately managed account may not be suitable for all investors. Separate accounts managed according to the Strategy include a number of securities and will not necessarily track the performance of any index. Please consider the investment objectives, risks and fees of the Strategy carefully before investing. A minimum asset level is required. For important information about the investment manager, please refer to Form ADV Part 2.

Please consider the investment objectives, risks, charges and expenses of the funds carefully before investing. The prospectuses contain this and other information about the funds. To obtain a prospectus please download one at morganstanley.com/im or call 1-800-548-7786. Please read the prospectus carefully before investing.

Morgan Stanley Distribution, Inc. serves as the distributor for Morgan Stanley funds.

NOT FDIC INSURED |OFFER NO BANK GUARANTEE | MAY LOSE VALUE |NOT INSURED BY ANY FEDERAL GOVERNMENT AGENCY | NOT A DEPOSIT

Hong Kong: This document has been issued by Morgan Stanley Asia Limited for use in Hong Kong and shall only be made available to “professional investors” as defined under the Securities and Futures Ordinance of Hong Kong (Cap 571). The contents of this document have not been reviewed nor approved by any regulatory authority including the Securities and Futures Commission in Hong Kong. Accordingly, save where an exemption is available under the relevant law, this document shall not be issued, circulated, distributed, directed at, or made available to, the public in Hong Kong. Singapore: This document should not be considered to be the subject of an invitation for subscription or purchase, whether directly or indirectly, to the public or any member of the public in Singapore other than (i) to an institutional investor under section 304 of the Securities and Futures Act, Chapter 289 of Singapore (“SFA”); (ii) to a “relevant person” (which includes an accredited investor) pursuant to section 305 of the SFA, and such distribution is in accordance with the conditions specified in section 305 of the SFA; or (iii) otherwise pursuant to, and in accordance with the conditions of, any other applicable provision of the SFA. This material has not been reviewed by the Monetary Authority of Singapore. Australia: This publication is disseminated in Australia by Morgan Stanley Investment Management (Australia) Pty Limited ACN: 122040037, AFSL No. 314182, which accept responsibility for its contents. This publication, and any access to it, is intended only for “wholesale clients” within the meaning of the Australian Corporations Act.

Japan: For professional investors, this document is circulated or distributed for informational purposes only. For those who are not professional investors, this document is provided in relation to Morgan Stanley Investment Management (Japan) Co., Ltd. (“MSIMJ”)’s business with respect to discretionary investment management agreements (“IMA”) and investment advisory agreements (“IAA”). This is not for the purpose of a recommendation or solicitation of transactions or offers any particular financial instruments. Under an IMA, with respect to management of assets of a client, the client prescribes basic management policies in advance and commissions MSIMJ to make all investment decisions based on an analysis of the value, etc. of the securities, and MSIMJ accepts such commission. The client shall delegate to MSIMJ the authorities necessary for making investment. MSIMJ exercises the delegated authorities based on investment decisions of MSIMJ, and the client shall not make individual instructions. All investment profits and losses belong to the clients; principal is not guaranteed. Please consider the investment objectives and nature of risks before investing. As an investment advisory fee for an IAA or an IMA, the amount of assets subject to the contract multiplied by a certain rate (the upper limit is 2.16% per annum (including tax)) shall be incurred in proportion to the contract period. For some strategies, a contingency fee may be incurred in addition to the fee mentioned above. Indirect charges also may be incurred, such as brokerage commissions for incorporated securities. Since these charges and expenses are different depending on a contract and other factors, MSIMJ cannot present the rates, upper limits, etc. in advance. All clients should read the Documents Provided Prior to the Conclusion of a Contract carefully before executing an agreement. This document is disseminated in Japan by MSIMJ, Registered No. 410 (Director of Kanto Local Finance Bureau (Financial Instruments Firms)), Membership: the Japan Securities Dealers Association, The Investment Trusts Association, Japan, the Japan Investment Advisers Association and the Type II Financial Instruments Firms Association.

IMPORTANT INFORMATION
EMEA: This marketing communication has been issued by Morgan Stanley Investment Management (Ireland) Limited (“MSIM Ireland”). Registered Office: The Observatory, 7-11 Sir John Rogerson’s Quay, Dublin 2, Ireland. Registered in Ireland under company number 616662. Regulated by the Central Bank of Ireland.

There is no guarantee that any investment strategy will work under all market conditions, and each investor should evaluate their ability to invest for the long-term, especially during periods of downturn in the market. Prior to investing, investors should carefully review the strategy’s / product’s relevant offering document. There are important differences in how the strategy is carried out in each of the investment vehicles.

A separately managed account may not be suitable for all investors. Separate accounts managed according to the Strategy include a number of securities and will not necessarily track the performance of any index. Please consider the investment objectives, risks and fees of the Strategy carefully before investing.

This material is a general communication, which is not impartial and has been prepared solely for informational and educational purposes and does not constitute an offer or a recommendation to buy or sell any particular security or to adopt any specific investment strategy. The information herein has not been based on a consideration of any individual investor circumstances and is not investment advice, nor should it be construed in any way as tax, accounting, legal or regulatory advice. To that end, investors should seek independent legal and financial advice, including advice as to tax consequences, before making any investment decision.

Except as otherwise indicated herein, the views and opinions expressed herein are those of the portfolio management team, are based on matters as they exist as of the date of preparation and not as of any future date, and will not be updated or otherwise revised to reflect information that subsequently becomes available or circumstances existing, or changes occurring, after the date hereof.

Forecasts and/or estimates provided herein are subject to change and may not actually come to pass. Information regarding expected market returns and market outlooks is based on the research, analysis and opinions of the authors. These conclusions are speculative in nature, may not come to pass and are not intended to predict the future performance of any specific Morgan Stanley Investment Management product.

MSIM has not authorised financial intermediaries to use and to distribute this document, unless such use and distribution is made in accordance with applicable law and regulation. Additionally, financial intermediaries are required to satisfy themselves that the information in this document is suitable for any person to whom they provide this document in view of that person’s circumstances and purpose. MSIM shall not be liable for, and accepts no liability for, the use or misuse of this document by any such financial intermediary.

The whole or any part of this work may not be reproduced, copied or transmitted or any of its contents disclosed to third parties without MSIM’s express written consent.

All information contained herein is proprietary and is protected under copyright law.

 

Check the background of our firm and registered representatives on FINRA's BrokerCheck

It is important that users read the Terms of Use before proceeding as it explains certain legal and regulatory restrictions applicable to the dissemination of information pertaining to Morgan Stanley Investment Management's investment products.

The services described on this website may not be available in all jurisdictions or to all persons. For further details, please see our Terms of Use.

Not FDIC Insured—Offer No Bank Guarantee—May Lose Value
Not Insured By Any Federal Government Agency—Not A Deposit

Privacy & Cookies    •    Terms of Use

©  Morgan Stanley. All rights reserved.

Morgan Stanley Distribution, Inc. Member FINRA/SIPC.