AI could strip emerging markets of their competitive edge, keep inflation low despite QE, cause huge labour market disruption and drive populism according to a new report.
The report – Future proofing your asset allocation in an age of megatrends published by BNY Mellon – shows a huge range of complex challenges facing economies, markets and thus investors from two megatrends – AI and climate change.
To compile the report, Create Research conducted detailed interviews with 45 chief investment officers, investment strategists and portfolio managers among asset owners, asset managers and pension consultants in 16 countries. With AI, investors see four big challenges as follows –
- the shortening of corporate life cycles
- disruption to emerging markets from onshoring
- the blurring of lines between business sectors often used as the basis for investing
- the fact that AI may be enhancing the value of companies in intangible ways making it difficult to measure or understand
AI is seen as a risk and opportunity by 52%, a risk alone by 33% and a pure opportunity by 7%.
With climate change, the investors split into two main groups with 57% viewing climate change as a risk and an opportunity, 36% viewing it as a risk only and 7% seeing it as an opportunity alone.
The report says that investment-specific challenges related to climate change centre on areas that are unknowable, requiring judgemental calls about the future.
- slow progress on carbon pricing –envisaged under the Paris Agreement –is leaving investors guessing at what point draconian governmental action will become inevitable
- a dilemma on the future of stranded assets, with investors weighing up whether to mitigate investment risks now or later at potentially higher costs
- engagement with carbon emitters being more difficult for investors in fixed income than equities
- ·Question marks on whether environmental, social, and governance (ESG)investing is a risk factor now or will be in the future with a view that benefits are already captured with other factors such as quality and low variance
The more optimistic group believe that markets are on the cusp of a once-in-a-generation transformation.
The whole ethos behind environmental, social and governance (ESG) investing is anchored in the belief that healthy markets require stronger economies and stable societies. “Thus, investing has to be about ‘doing well’ and ‘doing good’.”
However, those who fall into the ‘risk only’ group remain unsure about whether markets are pricing in ESG risks to the point where the risk–return trade-off is real. They suggest ultra-loose monetary policies have benefited ESG and believe it is yet to be tested in a significant downturn.
AI – boosting productivity or just making robot owners wealthy?
For all its revolutionary potential, the report suggests that many of the investors interviewed still believe many businesses remain daunted by the required cultural change and shift in mind for AI deployment.
There is also a big battle to attract talent but with the big tech companies essentially ‘vacuuming talent’ from global labour markets.
The report suggests that the most intractable problem is the job-displacing potential of AI across many nations, citing data compiled by the Oxford Martin School.
It also suggests that the AI challenge is more acute in labour-intensive nations, such as China and India, where cheaper labour has long provided a global competitive edge.
It says two competing scenarios emerge from the interviews.
1. A gloomy picture of a mass shake-out of jobs coinciding with increasingly wealthy robot owners
2. Robots helping to boost productivity, new jobs and re-skilling opportunities after the initial disruption.
AI will also be ‘collar-blind’.
It will not only displace low-skilled routine jobs but also hit knowledge-based professions such as law, accountancy and finance, which were previously thought to be immune to the rise of robots.
“Clearly, advances in natural language processing, high-level reasoning, voice recognition and pattern recognition make AI ‘blind to the colour of your collar’.”
In addition, while AI is not replacing jobs on a mass scale yet, in every industry, the people using AI are replacing the people not using AI.
It says this exacerbates the already hollowing out of middle-class jobs and growing market concentration in all economic sectors in the West.
“The resulting rise in inequality and social exclusion have, in turn, revived a long-forgotten phenomenon: populism. Its rise on both sides of the Atlantic has become yet another major unfamiliar risk factor for investors.”
AI is deflationary
Yet among other things, the report suggests that the full force of AI hyper-competition is yet to felt while, more broadly, AI is inherently deflationary.
“By boosting productivity and reducing costs, AI has been one of the reasons why inflation and interest rates have remained subdued in this decade in all the key economies, despite massive monetary stimulus from central banks. Hence as AI’s adoption rises, rates may well remain lower for longer for the foreseeable future,” it says.
It adds that AI has an inherently winner-takes-all dynamic.
“Evidence shows that across 26 countries between 2001 to 2014, profit mark-ups in AI-intensive sectors were higher than in less AI-intensive sectors, with the differential growing rapidly over time.”
The report suggests what is needed are extensive public programmes on education, training and retraining that provide the skills of the future. “The success of the AI revolution critically depends upon whether its fruits are shared more equitably as the future unfolds.”
The four AI investment challenges and investor responses in detail
A. Corporate lifecycles getting shorter
Much of the evidence on this point is indirect and focuses on turnover in the S&P 500 index, as shown by the data compiled by INNOSIGHT, a Boston-based management consultancy.
It shows that the 33-year average tenure of companies in this benchmark index, first recorded in 1965, narrowed to 20 years in 1990 and is forecast to shrink to 14 years by 2026. The implied churn rate means that about half of the constituent companies will be replaced over the next 10 years.
Over the past 10 years, well-known brands have exited the index – such as Eastman Kodak, H.J. Heinz, Safeway and Sprint. Newcomers include Facebook, Level 3 Communications, Netflix and Paypal.”
Adopting a more pragmatic approach to the old adage – ‘time in’ the market matters more than ‘timing’ the market and one or more of three options: greater reliance on passive investing that gives ready liquidity; stronger focus on high conviction investing centred on smaller positions backed by a strong stewardship role.
B. Sectoral boundaries will be blurring
As AI permeates the products and processes of all sectors, traditional sectoral demarcations are weakening. The changing sectoral mix – essential in portfolio rebalancing at different phases in the market cycle – has come under the spotlight. Should electric vehicles be classified: AI or auto manufacturing? Is Amazon a retailer or a cloud service provider?
The report says the questions are not rhetorical. The revisions to the Global Industry Classification Standard (GICS), carried out by S&P Global and MSCI in September 2018, had a dramatic effect on the share prices of what were once classified as ‘tech’ stocks. It notes that they soon lost their glamour with a change in the nomenclature that reclassified them to a newly created ‘communications services’ sector with 23% wiped off Apple’s market value.
Sectoral boundaries will erode with the rise of AI. Walmart sells almost as much online as Apple. Netflix is spending $13 billion on producing its own content in 2019.
Focusing on the idiosyncratic risks of all their actively managed assets to ensure that they are, first and foremost, selected on the basis of their intrinsic worth. Back to basics is the new mantra: “know what you buy and buy what you know”.
C. The future of onshoring is uncertain
Since 1970, the rise of globalisation progressively shifted the global centre of gravity in manufacturing activities from West to East to take advantage of lower unit costs. Now, the rise of AI is set to reverse the trend – at least partially.
The report says the adoption of AI in general and 3D printing in particular is likely to lead to the onshoring of many hitherto offshored activities.
It adds: “Having been the chief beneficiary of globalisation, there are concerns whether emerging markets will be able to retain their favourable growth dynamics. The concerns specifically centre on China, which has been the key swing factor in global growth.” At the same time, China’s home market and investment could alternatively make it an AI superpower.
The key question whether EM assets in general and Chinese ones in particular fall in the buy-and hold bucket or the opportunistic bucket in their current and future asset allocation?
Investors have adopted a twin-track pragmatic approach. The first focuses narrowly on a few companies whose growth prospects look exceptionally favourable and can be accessed via private or public markets.
It is based on the view that dispersions within various EM indices are so big that active stock picking is more rewarding than index investing.
The second track targets theme-based passive funds in the belief that momentum investing can be a powerful driver of returns in the short-term.
D. Intangible assets will become harder to value
A study by Chicago-based, intellectual capital specialists Ocean Tomo concluded that the share of intangible assets in the market value of S&P 500 companies has increased from 17% in 1975 to 68% in 1995 to 84% in 2015.
The time series for other markets are not long enough to discern a similar trend. But in China, Japan and Korea, the current share is in excess of 60%.
The spectacular rise of FAANG (Facebook, Amazon, Apple, Netflix and Google) stocks in this decade confirms the power of intangibles in delivering stellar corporate valuations, while dwarfing the size of their book value.
The report adds: “These tech titans are light on physical assets and strong on intellectual assets, which have been the principal source of mega profits and mounting cash reserves. But there are doubts about the durability of intellectual assets once newcomers offer something better and cheaper than incumbents.”
Investors need to find a realistic measure of intangibles. The respondents said they assess intangibles first by linking them to the present value of future free cash-flows to assess how much money the company is likely to generate over time. To corroborate the results, a raft of other indicators is also used: P/E ratio, price-to-sales, price-to-book, debt-to-equity, pay-out ratio, return on equity, leverage, earnings quality and dividend yield. Big data plays a role in the process. These are duly augmented by judgemental factors including management quality, brand perception, governance structure, and employee retention and motivation.