December 2015
Schroders
Talking Point
Outlook 2016: Global Equities
Alex Tedder, Head of Global Equities
An uncertain macroeconomic backdrop means that the best way to navigate 2016 will be with a focus on
company-specific drivers that can deliver earnings surprises.
In aggregate, the backdrop for equities is challenging and the macroeconomic environment is highly uncertain. Low
interest rates reflect massive quantitative easing by central banks around the world, artificially boosting many asset
prices and creating a potentially dangerous situation when rates start to rise. Significant currency distortion, weak
commodity prices, slowing growth in China and mixed economic data in Europe and the US have added to the
uncertainty. For equities, this has meant low absolute returns and increased volatility.
It is therefore particularly relevant to take a selective approach to investing, focusing on those companies that can
deliver unanticipated earnings growth despite the uncertain environment. We see a number of different dynamics at
play that have the potential to surprise the market in 2016.
Disruptive technology driving rapid change
Technology is evolving at an unprecedented rate and new business models leveraging connectivity, particularly in
the mobile space, are threatening to reshape industry dynamics in a number of different areas. Firms such as
Amazon, Google, Facebook, Alibaba and Tencent are already household names. The revenue and market
capitalisation of these companies already rank amongst the largest in the world.
However, the number of industries facing disruption is increasing rapidly and now extends well beyond the
immediate e-commerce, social media and handset space. Disruptive technology is shaking up traditional industries
such as autos (Tesla, Uber), apparel and food retail (Yoox, Zalando, Just Eat, GrubHub), hospitality (Priceline,
Expedia, TripAdvisor, Airbnb) and recruitment (LinkedIn). Other industries that are about to experience significant
disruption include healthcare and banking. We are focused on finding opportunities where the market has either
overlooked or underestimated companies’ potential to disrupt.
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Service firms preferred for their pricing power
The global economy is likely to be characterised by ongoing deflationary pressure in 2016. A lack of pricing power is
already evident in the traded goods sector where competitive pressures and overcapacity make for a challenging
pricing environment. By contrast, the services sector has been able to maintain pricing power, given a lack of
tradability in many areas. The divergence between manufacturing deflation and services inflation naturally informs a
bias towards service companies in our portfolios heading into 2016.
We still find some attractive opportunities among those manufacturing firms with a substantial component of high
margin recurring revenue, such as maintenance providers and parts suppliers. These types of companies should
prove more resilient to any decline in capital investment spending, particularly in industries that benefited from the
capital spending boom in China over the last 10 years.
Saving profits with “self-help”
We are seeing evidence that companies in challenged sectors, such as industrials, energy and mining, are taking
steps to support earnings and we expect this to be a key feature of 2016. There is an increasing focus on “self-help”,
as companies seek to restructure by reducing costs and strengthening balance sheets in order to weather the
uncertain demand and pricing environment. For example, firms like diversified miner BHP Billiton and oil and gas
major Royal Dutch Shell have committed to substantial cost reductions and lower capital spending in the face of
sharp declines in commodity prices and revenues.
In the industrials sector, earnings have been hurt by the combination of softer economic growth and excess
inventories. However, inventories are now at levels such that even a modest upturn in end demand should translate
into better profitability. Firms that have been able to reduce costs should show significant operating leverage even
with a moderate uptick in revenue. Companies behind the curve in terms of expense management are likely to be
de-rated.
A focus on innovation
Regardless of industry, however, we continue to focus on innovation as a driver of returns in 2016. Our emphasis is
on companies that are committed to finding new, interesting and sustainable ways in which to grow their businesses,
but whose efforts have not yet been fully recognised by the market.
For example, in the healthcare sector, firms continue to gain insight into disease processes and are continuing to
develop a variety of new treatments to improve mortality. Despite a more challenging regulatory backdrop, we
expect the sector to continue to experience strong pricing power for therapeutic innovations.
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Another example is the food and beverage sector where firms have to differentiate their products and services to
command pricing power in a highly competitive industry. Starbucks is a case in point where management is intent on
finding innovative ways to improve the customer experience (such as the introduction of mobile payments) to
sustain customer traffic and support average spend.
Looking for earnings surprise
As we have highlighted, the economic backdrop remains highly uncertain and we cannot predict with any accuracy
what will happen in the global economy, markets, commodities or currencies in 2016. The best approach in our
view, is therefore to focus on developments at the company level, to identify individual companies that can deliver
earnings surprise and outperform in an uncertain and challenging environment.
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