Thematic investing and the Post-COVID world

In the third in our series of virtual mini-forums, we discussed thematic investing post-COVID in one session and the outlook for oil in another.
June 2020

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In the third in our series of virtual mini-forums, we discussed thematic investing post-COVID in one session and the outlook for oil in another.

In the thematic investing section, we focused on the idea of the pandemic acting as an accelerant of structural trends and behavior changes, which play and increasingly important role in assessing asset valuation.  These include geopolitics and globalization, tech wars, big government, healthcare, and the new consumer. While these are not new themes, they have been accelerated by the pandemic, and against a backdrop of record low interest rates have important implications for our investment decisions.  Readers may recall that our first mini-forum focused on US policy and the potential for regulation in the technology sector. 

The oil session focused on both the 2020 outlook for oil as well as a long-term perspective focused on the rebalancing of supply and demand.  We also compared and contrasted the outlook for US shale, Canadian oil sands and OPEC and the investment implications.

COVID-19 has brought unprecedented levels of uncertainty over the economic outlook. But what is certain is that the pandemic is an accelerant of structural trends and behavioral changes, which play an increasingly important role in assessing asset valuation (see chart). We discuss five megatrends: geopolitics and globalization, tech wars, big government, healthcare, and the new consumer. While these are not new themes, they have been accelerated by the pandemic, and against a backdrop of record low interest rates have important implications for our investment decisions.

We may have seen peak globalization

The U.S.-China trade war marks just the beginning. Today and going forward, the two superpowers are engaged in a war of technology and world domination. The Belt and Road Initiative exemplifies China’s expanding global reach, while Huawei and 5G investment is China’s number one weapon. When it comes to trade, countries across the east and west will have to decide between the U.S. and China. Because of geopolitical pressures, reshoring of production will likely increase.

Tech wars will likely intensify

We have seen this play out with Huawei and U.S. export controls limiting the company’s access to U.S. technology and software. China’s R&D investment has now surpassed U.S. investment and by 2025 will outpace the U.S. by over $300 billion. Trends like this may likely be alarming to U.S. policymakers, who could be pushed toward action.

Big government may only get bigger

Central bank balance sheets and fiscal authorities have stepped in with unprecedented liquidity to fight COVID-19. In addition, we have seen a new social contract emerging—that is, safety over privacy, similar to the response after 9/11, and the trade-off between privacy and data. As of publication, over 30 countries have enacted contact tracing to combat the virus spread.

Health: The new wealth?

Incentives are now even higher to reduce inefficiencies and advance technology in healthcare. Healthcare spend is roughly 10% of global GDP, but 20-30% of these expenditures are generally wasted. A country like the U.S. may rank high on total spending, but low on healthcare outcomes. In addition, one-third of data is in the healthcare industry, which companies will want to leverage. Healthcare is rising in importance as an ESG factor as well. If anything, the virus demonstrates how countries with more equipped healthcare systems can be more resilient.

The new consumer is changing by the day

Gen Z, who grew up in the new tech world, will drive these behavioral changes, likely toward online activities and experiences and away from goods like cars. Their investing habits will likely focus on assets that rank high on ESG scales.  Meanwhile, social distancing measures will pull forward increased adoption across all generations.

What do these trends mean for investing?

When it comes to sectors, no matter the trend, we believe that tech comes out as a big winner. As behavioral changes broaden, key growth areas will likely be food tech, health tech and e-commerce. The most challenged, in our view, will be energy, financials, commercial real estate, traditional retail (brick and mortar) and luxury within consumer discretionary. It may be hard to overturn the decade-long growth-value outperformance.

Investment implications

What could derail this bullish tech narrative? One notable risk for the sector is regulatory changes, such as anti-trust legislation and digital taxation. As we discussed at our U.S. policy mini-forum, tech regulation is likely to increase at some level with bipartisan support. However, political pressures surrounding the U.S.-China rivalry could incentivize governments to ease some restrictions and fund more. U.S. firms can also argue that they are already at a disadvantage with respect to restrictions, such as on data usage.

We also highlight that bigger government and central bank balance sheets, along with reshoring and rising trade barriers, do pose inflationary risks. This could materialize in the short term if infrastructure spending is ramped up. That said, greater tech and infrastructure investment should boost productivity and augment the supply side of the economy. Ultimately, the net effect is more likely to be deflationary because of demographic trends, like aging and rising life expectancy, which could more than offset price pressures.

Intangible assets versus tangible assets

Intangible assets versus tangible assets - chart image

A look at oil

Global oil begins slow recovery

Shortly after a brief spike in early January, global oil prices declined sharply, falling as much as 70% before the unprecedented negative front month futures pricing on April 20. This would serve as the market’s inflection point, with an easing of depressed demand and price compression as a result of the global COVID-19 outbreak. Broad economic activity is the key driver of total global energy demand. Even though there may be a semi-permanent change to the travel habits and gasoline consumption of consumers, and there is a higher than normal level of inventory that will remain to be worked off over the next year, the overall growth rate for oil demand remains positive, albeit slowing. With the shut-in of production that has occurred, future investment will be required to meet this demand, resulting in rising prices, despite the pressure of rising environmental concerns around the world.

While gasoline and airplane fuel have been dramatically impacted by COVID, demand for commercial distillates (e.g., diesel) has remained relatively stable as global manufacturing has been less impacted than consumer use. Even though we have seen an increase in inventories, they remain at manageable levels, and should fall back to normal levels by the beginning of 2021. Following that, we should see a resumption of drilling and extraction activity in 2022, as global demand levels return to 2019’s peak levels.

Supply and demand to rebalance

Globally, there is a strong correlation between the GDP per capita and the aggregate use of oil. In emerging markets, however, we are seeing a sharp difference in that relationship. While certainly growing, the proportionate use of oil to economic output is significantly lower than OECD nations. This is possibly a function of rural versus urban economic activity, and relatively wider and more skewed distribution (i.e., concentrated) of wealth.

Overall, OECD demand will most likely continue to shrink over the next decade, while EM Asia will continue to grow due to its demand for commercial distillates, not only used for fuel but also as basic inputs into plastics and other goods, as industrial output continues to grow at a higher pace than developed nations (see charts).  In developed markets, the trend towards higher sales of EV vehicles is intact but remains too small as a fraction of the total stock of vehicles on a global basis.  In fact, it has been the increased efficiency of gasoline engines due to tighter emissions standards that has been primarily responsible for declining gasoline demand, a trend that should continue, and be compounded by newly refreshed expectations of an acceleration of “work from home” trends.

Oil demands by type and region

Oil demand by type and region - chart image

Source: International Energy Agency, OPEC, BP Statistical Review, BMO Capital Markets.

U.S. shale supply that surged beginning in 2014 is seen to peak in 2026 as the most easily accessible reserves are exhausted. This will be reflected in a need for increased capital expenditures to refresh that depleted supply, as currently sanctioned projects are expected to fall sharply from now into 2025. Without renewed investment, the global supply gap will widen, roughly at a pace of 8% per year after 2021.

Cash costs for ongoing production average $45 per barrel globally, but with a large proportion of that represented by the taxes and royalties collected by governments, which form the base of social spending in key OPEC producing nations like Saudi Arabia and Russia. Low cost producers like Brazil represent cost efficient future opportunity for increased output, but not without significant political risks. By comparison, Canadian Oil sands have some of the lowest cash costs at around $30, even lower than U.S. shale, with very long project lives. However, future project development costs are very high, averaging $65 per barrel globally and slightly higher in the oil sands, suggesting that while oil sands development remains commercially viable for the foreseeable future, Canadian investment may remain constrained pending higher prices.

In Canada, industry challenges are more focused on distribution issues than extraction costs, with limitations on available pipeline capacity having the primary impact on realized prices relative to global benchmarks. At a bare minimum, increasing the use of rail shipments allows for modest increases in capacity over the next five years in the total absence of any pipeline expansion, while the completion of TMX and Enbridge Line 3 would effectively reduce the average $20 (USD) per barrel discount of WCS vs Cushing WTI by 6-8 dollars, having a marked benefit to overall revenues.  The completion of the Keystone XL would all but eliminate this discount, but analyst and industry expectations remain low, with this year’s U.S. election being a coin toss, and Democrat nominee Joe Biden having stated his intention to block the project once again.

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