The reflation trade – fate or fad?

While there has been a recent resurgence in some cyclical sectors like mining and energy on the back of the ‘reflation thematic’, we believe the longer-term outlook for economic growth will remain subdued due to various structural headwinds including ageing populations, high debt levels, and increasing environmental constraints on natural resources.

This means that many of the key companies that comprise the major equity indices will struggle to meaningfully grow their underlying earnings. This is especially true for average quality old-world businesses with weak value propositions and legacy technology.

For example, despite a recovery in the spot prices of oil, coal, and other commodities, it is likely that oil and thermal coal businesses will face declining demand over the next decade and beyond as the cost of renewable energy, electric vehicles, and batteries continue to decline.

Equity returns are driven by the few not the many

A low growth world is generally good for our investment style because we invest into a concentrated portfolio of businesses which we have identified as being able to grow revenues and profits organically at double-digit rates for at least the next decade.

To us, it makes long-term economic sense to be selective and manage a concentrated portfolio of stocks and to not be exposed to a wide number of average to below-average quality businesses – ones that comprise most indices and benchmarks.

Beware of the index

For this reason, we believe passive styles of equity investing are likely to produce less attractive returns than they have achieved historically because the vast majority of companies will not be able to deliver returns above the benchmark.

Our base case is for global equities to produce total real returns that average around 1.5% to 2.5% pa (3% to 4% nominal) driven by very low single-digit profit growth.

Why diversify into structurally challenged old-world stocks with declining intrinsic values?

The rise (and fall?) of passive investing

Many active fund managers fail to outperform the relevant benchmark over the long term, particularly after fees. In addition, many active managers have high average rates of portfolio turnover that can result in higher trading-related costs, higher income tax expenses, and higher short-term capital gains tax expense than would be incurred using more long-term styles.

We believe this has greatly contributed to the rise in popularity of passive investing, particularly via exchange-traded funds (ETFs), but as mentioned, we think investors will struggle to achieve above benchmark growth using such strategies.

Active ETFs

So, while investors have pivoted to ETFs and other listed products, we also see a strengthening trend towards active investment strategies over passive due to the reasons mentioned above.

It is no wonder that we are witnessing the proliferation of active ETFs as popular investment vehicles on the ASX, as they offer investors the combined benefits of accessibility and ease-of-use combined with the skills and expertise of professional fund managers.