Sustainability, technology, and the boom-bust cycle

We remain fully invested in equities and high yield bonds at the maximum level allowed across our strategies and funds. Relative to the global benchmarks we have very significant positions in US equities spread across S&P 500, Nasdaq and Russel 2000. While we wait for the global recovery to re-gain traction, we use this edition of the Global Market View publication to look at the role played by SRI, ESG and technology in the economy and across markets. Mega trends like these can last for decades and have very significant positive impacts on people’s lives. As we have seen repeatedly, they also tend to end in bubbles, with severe implications for investors. Recent examples include the Dot-com bubble and the US housing boom crashing into the Great Financial Crisis. Chinese and US railway booms are other notable examples of innovative technology benefiting the world but also ending in bubbles and financial calamity. In 1900 railroad companies were 63% of the US stock market capitalisation1 , significant even compared to today’s tech and pharma giants.

We expect that the wider focus on technology and sustainable investments, and the application of new technologies will both benefit humanity and support the ongoing recovery across investments, employment, and consumption. As enthusiasm gathers pace, this is likely to turn into a very large boom and then, eventually, a bust. To get the sequencing right, we will therefore lay out how we expect the boom to play out and what can be done to protect a portfolio from a typical drawdown associated with bubbles, while still participating in the investments in these areas. In table 1 (on page 6), we highlight the overlap in sectors and companies across Technology, ESG and SRI index weightings. Before we move on to the long-term topics, we note that the US Q4 2020 earnings season is coming in much stronger than expected, with S&P 500 earnings on track for growth year over year, versus a decline of 9-10% expected at the end of 2020. Our algorithms continue to indicate a positive risk-return trade of across equities and sub-investment grade bonds, and we hold the following positions:

➢ Our Systematic Equity Allocation strategies and funds remain fully invested primarily in US equities. After rising 20% in H2 2020, the strategy and the associated ACCI SA fund are up 4%+ year to date. Our Sustainable SEA strategy, with its reduced carbon footprint, is up a similar amount.

➢ In our multi-asset mandates and funds, we maintain a full allocation to equities (50%-60% depending on restrictions) and 30% in high yield bonds. The ACCI Diversified fund is up 2.7%+ year to date after gains of 12% over the last 6 months of 2020. We expect US HY spreads to further tighten 50bps+.

➢ In our Global Fixed Income opportunities mandates, we hold an unchanged allocation of 80% to high yield bonds and 20% to emerging market debt. In the ACCI GFO fund the allocation is now split between 90% high yield bonds and 5% in each of EMBI and CEMBI bonds. The fund is up 7% over the last 7 months.

During the autumn of 2020 we developed our new Sustainability Matrix enabling us to quantify ESG, SRI and Impact measures across portfolios of both traditional mutual funds and ETFs from various providers (please see further below). We also changed our name from Eye Performance to Human Edge Investment Technology. We recognise that this has led to potential confusion and hereby wish to give a short overview of our offering: Over the recent years we have continuously covered five types of investment strategies in this publication:

➢ Global Fixed Income Opportunities: A fixed income strategy allocating between high grade bonds and sub-investment grade bonds seeking to deliver a positive return in line with inflation + real growth.

➢ Systematic Equity Allocation (SEA) strategies: Growth strategies allocating between zero and 100% equities and bonds, seeking to outperform a reference benchmark of 60/40 equity vs bonds.

➢ Diversified strategies: Multi asset wealth preservation strategies where we typically have equity allocations moving in ranges from zero to 50% or 60% targeting inflation +3%.

➢ The Sustainable SEA portfolio is an SEA portfolio only containing ESG and SRI verified instruments taking the CO2 emissions down by more than 50% compared to MSCI World.

➢ The Systematically Enhanced Endowment portfolio is our advisory concept for combining liquid and private market investments in a consistent way securing both liquidity and solid performance.

These strategies share two fundamental goals: limiting the risk and especially drawdowns during periods of sustained and severe market corrections and capturing sustained recoveries. All strategies are available for implementation with 100% ESG and SRI complaint instruments. Last year we had frequent opportunities to discuss risk and we stand ready to reduce risk, by selling both equities and high yield bonds, should the outlook as captured by our algorithms change significantly.

Figure 1: Recent performance of the SEA strategy vs. its 60%/40% equity/ bond benchmark

However, the challenge over recent quarters has been to capture the upside. As illustrated in Figure 1, the Systematic Allocation Strategy had a temporary risk reduction Figure 1: Recent performance of the SEA strategy vs. its 60%/40% equity/ bond benchmark 2 to the "Balanced" stage around the US election but have since been invested at the maximum 100% equities leading to a return of more than 20% in H2 2020 and an additional 3%+ year to date. The Diversified strategy had a similar risk reduction around the US election data, moving from 60% to 30% equities and, after the easing in uncertainty, moved back to 60% equities.

Figure 2: Recent performance of the Diversified strategy vs. its 30%/60% equity/bond reference benchmark

Throughout the period since the middle of last year we have held onto the 30% allocation to high yield bonds in the fund and mandates. With the global recovery expected to strengthen, as outlined in the next section, we expect spreads to tighten further lending support to performance in both the Diversified and the Global Fixed Income strategies, where we hold a 90% allocation to this asset class. As illustrated in the figure below, the US Agg has not given any return in the last 6 months, a strong indication that the bull market in US high grade bonds is now over.

Figure 3: Recent performance of the GFO strategy vs the US Aggregate bond index (ETF).

Conditions for a sustained recovery

The global economic recovery gathered momentum towards the end of 2020 and then slowed on the back of the renewed spike in rates of virus infection and the associated lock down measures, as well as the waves of fear running through society. As so many times before, Europe, with its lackluster domestic growth, is harder hit by the current slowdown than China and the US. In consonance with the same pattern, we expect the US and China to be dragging the rest of the world out of the temporary setback into a continued recovery. The short-term outlook is clouded by lock downs, supply bottlenecks and policy infighting, but the conditions are in place for the recovery to gain traction during 2021. Within our investment framework, we capture these conditions in the business cycle component of our algorithms. Illustrated in Figure 4 below. This aggregate measure signals strong support. This support is driven by last year’s decline in interest rate levels, which work with time lags, commodity prices, industrial production, the strong earnings recovery, and consumption supported by both employment and wealth effects. Via these channels the cyclical forces and the support administered from both fiscal and monetary policy are likely to prevail and lead to a strong recovery through 2021. Should the vaccines prove as effective as hoped, or should the pandemic recede for other reasons, this year’s growth could end up being proportional to last year’s slump. So, even if Beiden's first fiscal package should be watered-down on its way through the system, the US looks set to achieve above trend growth. The Chinese economy finished on a softer note in Q4, but still delivered more than 6% growth year over year in Q4 2020. From here it doesn’t look as though it will be slowing down much. We in any case expect any significant weakness, regional or globally, to be countered by public policy support because politicians across the continents will look for the path of least resistance and resort to further stimulus, based on the argument of unprecedented crisis, while looking to the central banks to provide both the financing and the financial conditions to keep it all affordable.

Figure 4: The business cycle component of our market positioning and risk management algorithm

Looking ahead, a global consensus seems to be forming that the answer to most questions of future growth is "a green future". Such a “green future” will need to be reached through an equally appealing "green transition". From a content point of view, this carries the positive implication of a fight against pollution and degradation in general. From a political point of view, it has the advantage that politicians can express it in any number of different positive goals, ranging from investing in future technology and growth to a more social democratic transition and upgrading of the labour force, leading to better jobs: all leading to a feeling amongst politicians that they have power and drive changes. It is even possible to add a national or nationalistic flavour depending on which country or region they may wish to "Promote " or "Upgrade".

From a market perspective, the policy priorities are likely to lead to continued low financing costs, increasing public investments, and support for private investments, and thereby demand, revenue and profit growth in the corporate sector. Building on an already positive trend, he US earnings season is moving forward and among the first 59% of the S&P companies having reported, 81% have beaten expectations better earnings expectations (vs. a long-term average of 65% positive surprises). Earning for Q4 2020 are now expected to be up year on year. This number was expected to be -9.3% on the 31st of December. Based on our expectations of a nominal and real growth in the US and China revenues and earnings look set for double digit growth through 2021. This is all supportive for our positioning with overweight in equities and high yield and emerging market bonds. Low financing costs and global mega trends are, however, also the ingredients leading to the formation of booms and possible bubbles. In the following section we will therefore take a closer look at the driver of the ongoing SRI, ESG and technology boom.

Sustainability, transformation, and bubbles

As we have repeatedly seen throughout economic and financial history, technological mega trends can last for decades and have very significant positive impacts on people’s lives. They also tend to end, either fully or partially, in excessive booms that transition into bubbles, with severe implications for global investors. Looking at the complete picture, it is not necessarily as bad as it sounds. The benefits of healthy technological developments that run for years and decades can overwhelm the eventual correction. The short-term effect, however, can be painful for societies and devastating for the individual person and investors. In England, Europe and North America, railways played a large and long-lasting role in the industrial revolution and the broader expansion and industrialisation. Of course, this did not entirely justify the fact that railways stocks ended up comprising 63% of the total market cap of the US equity market and close to 50% in the UK market in 1900. Back then, the UK market was 25% of global market cap while the US was 15%2 . This is a good example of a fundamentally beneficial technological development ending up in a bubble and it shows how a "good story" helps building a boom-bust cycle. A similar pattern was seen in US and global housing. After delivering decades of improvement in living standards, the sector went into overdrive (assisted by finance) and imploded into the global financial crises. In the same way, the green transformation of the transport and energy sectors, agriculture, manufacturing, and consumption is set to play a key role both in the ongoing global recovery and eventually in the formation of the next bubble. As the story gets better and the fundamental improvements become tangible, overinvestment is likely to occur and along the path to recovery outright misallocations of smaller and larger pools of capital will happen. In summary, while bubbles have a bad reputation, they are often the extension of a very positive transformation of the economy and often come after good investment based on sound risk return assessments and capital allocations having been made in earlier phases.

Table 1: Top 10 holding across ESG, SRI and Technology indices (and ETFs)

Returning to current markets, we are not in the camp of people who argue with certainty that there is currently a bubble across markets in general. That said, there is also not as much diversification across investment opportunities and positions as there is in the story telling accompanying these opportunities. This is revealed by Table 1 which shown company weights across global and US equity indices. These are some of the broadest definitions of the ESG, SRI and Technology themes we find available, but they are also where most capital is invested. They trade on price earnings ratios of between 25 and 40, which is possibly justified by low interest rates and good prospects, but they are not exactly cheap (though the Nasdaq 100 is well below the broader Nasdaq index of PE ratios of approximately 70). And even the most "differentiated" index MSCI World SRI index has a large concentration in technology and in the same names as the other indices. Using the Nasdaq 100 obviously makes this index stand out and look even more extreme in terms of the weight in specific US technology names. However, for the top-down discussion and risk assessment perspective, it serves the purpose of illustrating that these indices are and will be very correlated.

If public markets are buoyant, so are Private Equity, Venture and "club deals". And most times public markets crash they take with them private markets. In any case, as with public market there is still a strong demand for PE, VC, small and midcap investment, direct involvement via minority stakes and other forms of private markets. The fact that everyone seems to have a view on Musk, Bezos and Zuckerberg and no one seem to worry about the fact that Buffet and Swensen (Yale Endowment) have both underperformed liquid markets over the last 10 Table 1: Top 10 holding across ESG, SRI and Technology indices (and ETFs) 6 years, while running much higher risks both in terms of liquidity and leverage, indicate that also private market are buoyant and global financial markets are running on all engines. In this perspective it is a little bit scary to think of where we can end-up now that Yellen and Powell together seem to be working towards also running the "real economy" hot. The hedge fund and short selling community obviously had their wake-up call in January, but for the rest of us, this could come any time and when that happens one should expect the indices in table 1 with their overlaps of the key names and themes to move down together, taking with them smaller more specialised funds as well as private market, just like in other crises. Our thesis is therefore that there is mutually reinforcing investment behaviour. This is currently working "on the way up" as yield compression continues and growth enthusiasm prevails. This reinforcing tendency is only likely to get stronger on the way down, and when risk premiums increase, risk aversion becomes acute and future growth becomes less valuable, it is not the average correlation but the extreme correlations of which really matter.

Figure 5: Max drawdown of our Sustainable SEA portfolio vs. the static 100% equity benchmark MSCI World

The inclusion of Nasdaq 100 not only serves to highlight the overlap. It is also the index with the lowest CO2 emission per USD turnover, namely 38 tons per USD 1m. The second lowest is MSCI World SRI with 57 tons per USD 1m of revenue. The equivalent number for MSCI World is 143 tons. There are many other matrices of importance to the ESG, SRI and Impact credentials of an investment, but from a top-down point of view we do like to make things quantifiable, and we maintain that not contaminating the air and the atmosphere ranks very high on our priority list. Most ESG and SRI indices and products have limited history, so historic risk analysis based on historic data are difficult to make. However, the correlation of short-term market collapses is well illustrated by the events of 2020. In Figure 5, we therefore present the max drawdowns of MSCI World along with our Sustainable SEA portfolio. The benchmark portfolio represented by the black line in this chart shows the drawdown of our sustainable equity portfolio without the application of our systematic investment process. As shown, the Sustainable portfolio rebounded a bit faster last year. In our view this is not enough to say that there Figure 5: Max drawdown of our Sustainable SEA portfolio vs. the static 100% equity benchmark MSCI World 7 will be a meaningful difference in a longer lasting recession and we therefore advise applying a systematic risk management framework while taking advantage of the future potential across EGS, SRI and Technology investments. As illustrated in the arguably short time span in Figure 6, such risk management can be applied without much loss of return potential even in a persistent bull market. For those who wish to invest without the inclusion of Nasdaq 100, the investment and risk conclusion are relatively unchanged, but it does have the unintended effect of lifting the CO2 emission of the global equity portfolio from 57 tons per USD 1M of revenue to 71 tons.

Figure 6: Performance of our Sustainable SEA portfolio vs MSCI World

Drivers of the boom in ESG, SRI and Technology

In the current situation the very future of our planet is to some extent at stake. We therefore hope for a lasting boom in the ESG and SRI, and that technology will keep playing a key role in overcoming the obstacles we face. As indicated above, we do see this continuing with its inherent risks and opportunities. The newly confirmed policy goal of the Chinese government is to reach environmental neutrality by 2060, a project which according to the latest analysis from one famous global investment bank could lead to investments of the equivalent of 1.7 thousand million. In parallel, one of the first acts of the new US president was to re-join the Paris Treaty, and according to Bloomberg, the world’s largest equity investor (NIB), represented by CEO Nicolai Tangen, "has now made sustainable investing an explicit focus of his strategy", saying that all portfolio managers who work for the fund need to operate with that in mind. A statement which at least in spirit and intention seem aligned to that of Larry Fink, the CEO of the world’s largest asset manager. With a zero-interest rate environment added to these intentions, a lasting investment boom seems assured. One could point out that what we are looking at here is Figure 6: Performance of our Sustainable SEA portfolio vs MSCI World 8 only the large cap indices and the top-down intentions, but in our view the themes run deeper both in markets and in global politics and economics and in a bullet point for one could summarize it as follows:

➢ On the political level, the US, China, Germany and France all want to be at least as socially and environmentally friendly as possible. In Europe, the green transition is one of the few things the north and south agree on, so one can add Italy, Spain, etc., and even if Merkel still doesn't do much in the short term about atmospheric contamination from German industry, she represents well the group of leaders when she argues for co-financing of the future transition both at home and abroad, preferably secured by ECB, EBRD and EIB, rather than directly via the German budget directly.

➢ The political approach is to a large extent replicated and supported across central banks. It should be no surprise to anyone that the PBoC serves the politics of the party. It is the bank's mandate, and noone tries to hide that. The Fed and the ECB are also more open about their political involvement to support the environment than when bailing out governments and countries. One of the ways in which they are making the latter policy publicly popular is by focusing on socially responsible lending.

➢ With regard to private equity and venture capital, growth is being sought and multiples justified by growing through technological innovation and disruption, with an environmental ESG and SRI angle in which the green economy often represents "the future".

The actions of the private equity and venture capital industry in some ways where the publicly traded sector meets the privately held sector and, as such, it plays a significant role in modern capitalism and just like financial market are in general running on full speed across private and public markets, the themes of technology, Sustainability and Social Impact are also playing out across the full capital structure. When we combine our offering of dynamic allocation portfolios with private marketsin a holistic long-term portfolio, we call the concept Systematically Enhanced Endowment Portfolios, a topic we will return to in future editions of this publication.

Best regards,

Mads N. S. Pedersen, Managing Partner & CIO

+ 41 765 878 979

Algorithms

Figure A: The Income-DMP 2.0 algorithm

Figure B: The V1 Algorithm

Figure C: The Income TR algorithm

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