Five Investment Themes For 2018

The 2017 calendar year delivered the second highest returns for the S&P500 since 2009. Across individual sectors however, return differences have been relatively wide with the gap between the best and worst performing groups at its highest for the post-crisis cycle so far. Looking ahead to 2018, we expect markets linked to our major investment themes to be important sources of performance differentiation relative to the broad equity indices as the cycle continues to mature. Here we highlight some of the key trends that we expect to shape the global economy and markets in 2018.

The Widening Adoption of Automation and Cloud Computing

Information technology was the best performing global equity sector in 2017, and the secular trend toward digitization, automation and embedded computer processing across industries should continue in 2018. Growth in robotics deployment will remain a key theme for both manufacturing and service activity. Global industrial robot deployment has accelerated since the financial crisis, with global unit sales growing at an annualized 15.9% since 2010 compared to 8.9% during the last cycle. Falling system costs, improving functionality and rising wages are increasing the competitiveness of machines relative to humans. And among the key advances in robotic functionality is the growing use of machine learning and artificial intelligence software to build machines that can decipher images and language without being explicitly programmed to do so. Beyond robotics, we expect this technology to be used across a broadening range of applications over the coming years—from autonomous vehicles to drones, medical imaging, online retail, video surveillance and digital assistants in mobile devices—as programmers gain access to more data and high-performance processing chips are more widely adopted. The rise of cloud-based computing services is supporting the development and operation of artificial intelligence systems while reducing the need for companies to invest in their own information technology capability. Instead, firms across a range of industries are subscribing to processing and storage capacity sold by third-party cloud service providers. This is in turn reducing capital expenditure needs on servers, network equipment and storage units, while boosting subscription revenues for providers of cloud computing services. Cisco has projected that 92% of all workloads will be processed in cloud-based data centers by 2020, versus just 8% in traditional in-house data centers. And cloud services are expected to provide 88% of global data center storage capacity by the same year (Exhibit 1).

Exhibit 1: Cloud Services Providing a Growing Share of Computer Processing and Storage.

The Emerging Digital Consumer Class

Alongside the cyclical economic improvement in emerging economies over the past year, we see a continuing structural shift among these populations toward services and consumption in 2018. Many of the emerging countries with the fastest growing per capita incomes are also the most populous, particularly within Asia. Here we would highlight China, India, Indonesia and the Philippines. These four countries alone account for close to 50% of the entire emerging world population and were the only major economies to maintain growth rates of 5% or more throughout 2017. They therefore represent large and fast-expanding addressable markets for consumer-facing firms in areas such as autos, consumer electronics, personal care products, medical devices and international travel. Changing modes of consumption will be an additional feature of the growing emerging market (EM) consumer class, and internet retail in particular stands to be another major beneficiary. Growth in internet penetration, mobile devices, shopping applications, online payment systems and logistics infrastructure (as well as the limited existing physical retail infrastructure in many emerging countries) should allow e-commerce to grow even more quickly than the underlying rate of aggregate consumption. As recently as 2011 for example, online retail in China accounted for less than 5% of Chinese retail sales, but the share has since more than tripled (on a retail sales base that is itself growing at around 10%), overtaking the U.S. in 2014 to stand at around 15% today. It should also be noted that online activity is growing rapidly in service as well as goods demand, particularly in media and entertainment. The share of media consumption devoted to traditional sources such as newspapers, television and radio is declining, while digital media is on the increase. Mobile internet alone now accounts for roughly 40%, with the overall internet share standing at more than half of total media consumption.

Exhibit 2: Chinese Online Activity Expanding in Both Goods and Services.

The Rise of Renewable Energy

The U.S. federal government withdrawal from the landmark United Nations climate accord made headlines in 2017. But one year on from the entry into force of the agreement, we expect the long-term global trend toward de-carbonization to continue in 2018 as renewable energy adoption increases. The falling cost of renewables remains a key driver. The average silicon photovoltaic solar module for example has fallen in price by over 80% since the start of 2010, and by half in just the past three years as rates of energy conversion efficiency have increased. And the falling cost of installation, service and ancillary equipment such as current inverters and mounting are also causing prices to tumble on a fully installed basis. At the same time, economies of scale are driving down the cost of wind power. Larger-scale wind farms are reducing the cost of transporting, installing and servicing turbines, while longer turbine blades mounted on higher towers are better able to capture greater wind speeds to produce more electricity. The U.S. Environmental Protection Agency now has 995 organizations including corporations, universities and state government departments on its 100% Green Power Users list (which counts those using clean energy to meet all of their electricity needs), up from 784 a year ago. And we see a similar trend in place globally, with growth in world consumption of renewable energy dwarfing that of energy sourced from fossil fuels. From 2013 to 2016, global wind power consumption increased at an annualized rate of 14.2%, with solar growing even more quickly at 34.3%. By contrast, natural gas consumption grew at just 1.5%, with coal consumption falling over the same period (Exhibit 3).

Exhibit 3: Wind and Solar Power Growing More Quickly Than Other Energy Sources.

Geopolitical Risk and Rising Defense Spending

Rising security challenges around the world contributed to the outperformance of the defense sector in 2017, and increasing military spending by governments in response to geopolitical challenges should remain a key theme in 2018. In Asia for example, the flip side of the rising risk to regional stability posed by North Korea's ballistic missile capacity has been a greater push to beef up spending on military hardware in and around the Korean Peninsula. A strengthened post-election Prime Minister Abe in Japan is now better-positioned to build a domestic consensus for revising the country's pacifist constitution. And in the nearer-term, the Japanese government is likely to implement a proposed 2018 increase in its stagnant military budget to a record $48 billion, which would include the introduction of a new U.S. missile defense system similar to that recently installed in South Korea. In the Middle East, continuing rivalry between Saudi Arabia, Iran and their proxies may likely motivate all sides to further increase their defense capability. And future budget increases are also likely across the European continent. Foreign and defense ministers from 23 EU countries recently signed a new defense pact to increase their collective levels of spending and cooperation against the backdrop of growing Russian aggression and a more isolationist U.S. administration. All but five NATO countries (mainly EU members) continue to undershoot the 2% of GDP spending target, and a total spending increase of roughly $107 billion would be required for all members to reach the target threshold (Exhibit 4)—equivalent to the entire defense budgets of France and the U.K. combined. After decades of punching below their economic weight in military spending, this all points to a more determined effort by European states to boost their collective defense contribution.

Exhibit 4: Only Five NATO Members Currently Meet the Official Defense Spending Target.

New Treatment Techniques in the Healthcare Sector

Spanning our balanced view of growth and value within equity markets going into 2018, we continue to see long-term support for the healthcare sector. We expect ongoing advances in drug treatment to remain a key growth driver for the sector, both for biotechnology and traditional pharmaceuticals. Most important here has been the rapid decline in the cost of genetic sequencing over recent years—from just under $50,000 for a human-sized genome at the start of 2010 to roughly $1,000 today (Exhibit 5)—which is enabling more research into the links between genetic expression and clinical conditions. This in turn is opening the door to new techniques in drug discovery, particularly in areas such as cancer treatment where genetic variation plays a major role. In 2017, the FDA delivered its first ever approval for an immunotherapy drug—a class of treatments that genetically alter immune system cells to fight leukemia and other cancers. The efficacy of these new immunotherapy approaches should mean that more candidates within this class of treatments are approved over the coming years. This should benefit pharmaceuticals and larger biotechnology firms that develop their own treatments, or that purchase or fund smaller drug developers to expand their pipelines. Designers of next generation sequencing equipment that can make early identifications of developing tumors should also benefit from the continuing decline in sequencing costs. And at an even earlier stage are treatments designed to target inherited diseases by editing gene sequences, with a growing number of clinical trials in their planning phases. To be sure, it remains early days for many of these emerging therapies. And other bottlenecks such as the interpretation of genetic data and the still high cost of sequencing machines remain prohibitive for many research laboratories. But we would expect new advances and further cost declines to bring more widespread adoption into next year and beyond.

Exhibit 5: The Falling Cost of Gene Sequencing Is Enabling New Treatment Techniques.