292. Trends, risks, and opportunities in global bonds
This episode covers the interesting dynamics of the past year, including varying economic forecasts,...
The auto industry isn’t very popular right now. Ever since the VW emissions scandal, it’s been under the spotlight and investors are not only worried that profits have peaked and weaker economic growth will mean a fall in demand, but there is also concern that disruption in the form of electric vehicles and autonomous driving could profoundly change the shape of the industry’s future.
However, as James Gautrey, a portfolio manager at Schroders commented recently: “Few investors have considered how the transition might look in practice and if the industry may actually stand to benefit. Controversy always offers opportunity.”
One of the challenges facing the sector is that the public – and increasingly governments – want cleaner air. Fines will soon come into effect in Europe for cars that emit certain levels of CO2 – which could hurt profits. It’s similar here in the UK where cities like London have low emission zones, and Bristol is contemplating banning diesel cars from parts of the town centre. But while zero emission might mean zero fines, fully electric vehicles are currently loss-making for manufacturers due to expensive battery packs and the lack of economies of scale.
So, according to James, some companies are looking at short-term work-arounds while they come up with longer-term solutions.
One such short-term fix, mooted by BMW, is to introduce small batteries to create plug-in hybrid vehicles. Toyota also offers hybrid equivalents of many of its models. James said: “These engines would still primarily rely on an internal combustion engine, but could comfortably avoid fines due to lower emissions. Part of the saving made in avoiding the fine would of course be offset by the cost of the battery pack, electric motor and power convertors. According to our figures, this option would diminish profit margins, but the outcome is still better than the “do nothing, pay the fines” route, which sees profits entirely eradicated.”
Another way of overcoming the problem is, of course, to increase the cost of cars, but will customers be prepared to pay more?
“The running costs of electric vehicles are estimated to be one third of vehicles with internal combustion engines. Proponents say this offsets the higher upfront pricing,” James said. “While this is true, we are sceptical that this will convince most consumers. Human beings are typically poor at weighing cost now versus savings later. That said, higher levels of absolute wealth also enable greater flexibility in thinking long term, so the luxury end should prove more receptive.”
Investors should not under-estimate the importance of the sector to governments when assessing why consumers would bother to convert. James cites figures from the European Automobile Manufacturer’s Association that the European auto industry employs 13 million people – which equates to 6% of the EU workforce. In Germany the importance is even more pronounced: as a proportion of its home economy, the German auto sector is bigger than US tech.
Helen Xiong, an investment manager at Baillie Gifford, is also interested in the disruption in the sector. “We have often spoken of technological change and how the pattern of disruption is broadening out into other sectors of the economy that have been hitherto immune. Nowhere is this more true today than the automotive sector,” she said. “The disruption is underpinned by three structural forces: the shift from internal combustion engines to electric ones, the shift in the economic model of ownership to ‘on-demand’, and the shift from humans behind the wheel to autonomous driving.”
According to Helen, the first shift is inevitable. “As the price of batteries continue to fall, we are at, or close to, the point where electric vehicles make economic sense,” she said. “There is growing consumer acceptance and there is also growing political will, as many governments have committed to phasing out diesel vehicles.”
“The second structural shift, driven by the ride-hailing companies such as Uber and Lyft, is interesting because it’s a classic example of textbook disruption,” Helen added. “Uber and Lyft are not new technologies. The app itself is just the integration of three existing applications – bookings, map, and payment. Yet, by using technology to innovate on the business model and consumer experience, these companies have dramatically expanded the market. In San Francisco, the home market of Uber and Lyft, ride-hailing is four times the size of the taxi market.”
“The third – autonomous driving – is the least developed,” Helen concludes. “But it may have the most profound impact on society. 1.4 million people globally lose their lives on the road every year; the average American driver spends 51 minutes each day commuting (the equivalent to nearly 40 eight-hour working days in a year); millions of elderly and or disabled people have difficulty accessing the transportation they require; and the vitality of urban landscapes are affected by congestion and parking spaces. Autonomy has the potential to solve all these issues, and more. This is made possible by advancements in computing and machine learning.”
Selectivity in this space is obviously key, as few Elite Rated funds have any significant exposure to autos. Scottish Mortgage Investment Trust has the highest allocation, with 4.6% invested in the shares of Tesla and 3% in those of Ferrari*. Manager Tom Slater talked about both in the video and podcast he recorded for us. BlackRock European Dynamic also likes Ferrari with a 3.5% holding**.
M&G Optimal Income has a number of auto bonds – although each are very small positions. Manager Richard Woolnough holds issues from Volkswagen, Daimler and Ford amongst others, but the total sector allocation is only 3.5%***. Fellow M&G manager Jim Leaviss, who runs M&G Global Macro Bond, also holds some of these bonds although to a lesser extent: his allocation is just 1.2%***.
*Source: fund factsheet, 30 September 2019
**Source: fund fact sheet, 31 October 2019
***Source: FE Analytics, last published full portfolio holdings, 31 July 2019
^Source: FE Analytics, last published full portfolio holdings, 30 September 2019