Thematics Outlook The future is green and highly connected“We tell ourselves stories in order to live”, Joan Didion (writer and journalist).
Thematic investing brings this notion to the fore. Avenues of investing aligned with megatrends are inherently predicated on visions of the future. But what makes thematic investing a lot more palatable than prophesising is that certain megatrends are already in motion. Thematic investors, therefore, need only observe the direction of the current and swim with the tide. The stories they tell themselves reveal what places they will witness along the way.
But, of course, timing does matter and the bear market in 2022 has created an attractive entry point for long-term investors. Moreover, the investment industry now offers discerning investors ways to access differentiated themes aligned with unique megatrends.
For investors, this means more stories to choose from and two themes appear especially interesting at the present juncture.
The future is green – the inevitable energy transition
Following 18 months of intense wrangling, the US has passed a $700 billion economic package deemed by many as a monumental step in tackling climate change. The bill includes $369 billion for climate action including tax credits for households to buy electric vehicles and support for renewable energy, carbon sequestration research, hydrogen power, and small-scale nuclear reactors1.
Creating an energy sector that is both sustainable and sufficient will require major investment across all forms of clean energy including renewables, hydrogen, biofuels, hydro, and even nuclear. Most recently, the European parliament has moved to classify future investment in natural gas and, more notably, nuclear power as environmentally sustainable (under certain conditions) in a pivotal shift recognising the need for an ‘all of the above’ approach to phasing out fossil fuels.
Low hanging fruit
The energy sector accounts for around three quarters of global greenhouse gas emissions with road transportation accounting for the largest share at 11.9%2. It therefore makes sense to start where most progress can be made and can have the greatest impact. According to Bloomberg New Energy Finance’s Long Term Electric Vehicle (EV) Outlook 2022, the EV market represents an $82 trillion market opportunity between now and 2050 in a net zero scenario. This is on account of not just the vehicles but the ecosystem of industries surrounding them, which includes battery technology, commodities, charging infrastructure, and recycling to name a few.
No half measures
The electrification of road transportation could create a 27% increase in electricity demand by 20503. It is therefore crucial that the electricity itself is also clean.
Among renewables, offshore wind is all the rage right now - and for good reason. According to Wood Mackenzie, almost $1 trillion is expected to flow into the offshore wind market over the next decade, given its scalability.
But more renewable power will also require more energy storage. Battery technology again comes into play. Lithium-ion batteries, effective for shorter duration storage, will be complemented by emerging longer duration storage technologies. This will ensure the energy supply is not only reliable for a few hours, but days and weeks.
The future is highly connected – the ongoing digital transition
According to Statista, the number of internet of things (IoT) connected devices worldwide rose from 8.6 billion in 2019 to 11.3 billion in 2021 and will likely reach 29.4 billion by 20304. The world is becoming increasingly connected, and there are many facets to it.
Every cloud has a silver lining
The world has shifted quickly from renting cassettes and DVDs to cloud-based streaming services which use artificial intelligence to offer a personalised experience. Video streaming is not just occupying our television screens. It dominates our mobile phone usage as well. According to Ericsson, global mobile data traffic has risen from 10.9 exabytes (EB) in 2017 to 90.4 EB in 2022 and expected to reach 282.8 EB by 2027 with video being the primary driver of this data binging
Gartner forecasts that public cloud end user spending will grow by 20.4% in 2022 to 494.7 billion, up from 410.0 billion in 2021. This number will reach nearly $600 billion in 20235. Now, for end users sitting in their homes streaming content, movies, and TV shows, everything may be in the ‘cloud’. But for YouTube, Netflix, and Spotify this data needs to be physically stored somewhere. The explosion in data usage will require more data centres and ever-increasing internet speeds. For investors looking at cloud computing as a megatrend, the opportunity is not just in the software, but also the real estate that provides the necessary infrastructure.
This megatrend is not optional
If a business hastens to shift to the cloud, collect all the necessary user data to improve its service, but then bungles it all up by falling victim to a cyber-attack, the result could be catastrophic. More connectedness means more points of vulnerability for the nefarious types to exploit. Cybersecurity Ventures expect global annual cybercrime costs to reach $10.5 trillion by 2025, up from $3 trillion in 2015.
As a consumer of any product or service, cybersecurity is something you never want to hear about. If everything is in order, nothing happens. But that is only possible if businesses ensure robust guardrails are in place. Cybersecurity, therefore, is a megatrend that is not optional, but mandatory. It is what makes a connected world sustainably possible.
But what about the risks?
Yes, further hawkishness from central banks could create more turbulence. Nevertheless, monetary policy shouldn’t alter the direction of travel. So, keep an eye on those inflation prints and the response from central banks.
Deglobalisation can also pose a challenge, especially for the energy transition which depends on certain commodities. Supply chains span across the globe and a coordinated effort to tackle climate change would be more fruitful than a fragmented one.
Conclusion
The protagonists will change, the antagonists will change, and there will be unforeseen twists and turns. And for each investor, the plot may thicken somewhat differently. But the stories are underway. And now is an excellent time for investors to not only observe that the world is becoming greener and more connected but help drive the change they want to see.
Sources
1 Source: Financial Times 8 August 2022.
2 Our World in Data based on 2020 figures.
3 Bloomberg New Energy Finance Long Term Electric Vehicle Outlook 2022.
4 Source: Statista in cooperation with Transforma Insights, May 2022.
5 Source: Gartner April 2022.
Thematics
WisdomTree Quarterly Thematic Review: Thematic ETFs holding grouAfter the start of the global value rotation towards the end of 2021, thematic assets in Europe decreased from $371 billion to $276 billion as of 30 June 20221, mainly due to performance. A significant correction in many themes resulted in a slowdown in thematic flows but pointed to the relative resilience of the European thematic exchange traded funds (ETF) market, with thematic ETFs gathering more flows in Q2 than open-ended funds.
Open-ended funds experienced a larger percentage drop in their assets under management (AUM), compared to ETFs2, as they lost around $85 billion, or 26.4%, compared to around $10 billion, or 20%, in ETFs. The impact on AUM from performance year-to-date was similar in both open-ended funds and ETFs. However, exchange-traded vehicles gathered $3.5 billion or around 23% of the total flows they gathered last year when open-ended funds gathered just $7 billion, or 7% of last year's flows.
In Q2, the correction that started originally in the growth space further expanded to broad equity markets amidst higher prospects of more hawkish monetary policy in the United States and fears over ensuing economic slowdown and a potential recession. Many themes extended their drawdowns even further. Resurgence of China-centred themes in June was one of the bright spots within the thematic landscape.
In this quarterly thematic review, we will look at the space and analyse the second quarter as well as the first half of the year through the lens of performance, flows, and new launches. For all of our calculations, we will use the WisdomTree Thematic Classification that we have previously introduced in a series of blogs in which we discussed how to classify and select thematic funds.
Winners and losers
As noted in our research paper on thematic investments, themes tend to rotate in flows and performance over time due to their individual narratives. For example, compared to a rough Q1, China-centered themes were most resilient in Q2. They posted strong returns relative to the global equity benchmark in June, as lockdown policies eased in China and the government expressed readiness to provide stimulus for propping up the economy.
The MSCI ACWI Index lost 15.7% in Q2 and -20.2% year-to-date. Only five themes beat the benchmark year-to-date and seven in the Q2. Overall, most themes posted more negative returns in the Q2 in comparison to the Q1. The major exception were the top 3 themes that benefitted from the rebound of Chinese stocks in June. The performance differential in Q2 vs other themes allowed the China-centered themes to be in the top 5 performing themes year-to-date as well.
Notably, the top performing theme, "China Tech", was the only theme that delivered positive returns in Q2. "HealthTech" was another technological theme in the top 5 that held up better in the Q2, but year-to-date, it has shed -25.7%. Apart from the themes focused on the Chinese market, sustainable energy production was another theme that appeared in the top 5 both in the Q2 and year-to-date. "Sustainable Energy Production" and "Agriculture" might have better resisted the global correction in equity markets year-to-date, as the war in Ukraine brought them into the spotlight.
The bottom of the performance spectrum continues to be composed of technology themes, as growth stocks continued to suffer from the value rotation. For most of the themes, we can note crypto, e-commerce and digital payments as common denominators.
A collapse of UST/LUNA around mid-May, deleveraging in the decentralised finance (DeFi) space, and a general risk-off sentiment in the financial markets contributed to the significant correction in blockchain. Platforms & digital markets and fintech & digitalisation of finance were falling out of favour already earlier in the year amidst the concerns over deceleration in the pandemic-driven growth and broader rotation out of growth stocks. The downward trend continued with new strength into the second quarter as inflation, economic slowdown, and recession fears did not bode well for consumer spending and hence potential revenues for e-commerce and digital payment companies.
Semiconductors and cloud computing were the other two tech themes that suffered amidst the global value rotation. The valuations for many cloud computing companies have seen a steep correction from its peak in November last year, offering entry avenues for investors believing in the long-term growth potential offered by the megatrend. As for semiconductors, the global chip shortages over the past two years incentivised companies to work towards ramping up their production. While increasing inflation and economic slowdown are now contributing to uncertainty on the demand side, putting downward pressures on the revenues and margins in the industry.
Flows were muted but point to resilience in ETFs
Thematic flows significantly slowed down in 2022 as part of the broader risk-off sentiment in the markets, but the slowdown was much more pronounced for the open-ended funds. In the second quarter, flows into ETFs outpaced open-ended funds, $1.8 billion vs $1.7billion, respectively. This greatly contrasts the annual figures in the last five years, where flows into thematic ETFs amounted to 10%-25% of the open-ended funds. Regarding the most popular themes in Europe, climate change and sustainability themes continued to gather the bulk of the flows.
Year-to-date, flows into open-ended funds are still far ahead of ETFs, with $7.5 billion vs. $3.5 billion. Open-ended funds have predominantly suffered from outflows in the technological themes, with $3.6 billion outflows year-to-date and $1.2 billion in Q2 alone. In contrast, to open-ended funds, the tech-focused thematic ETFs were more resilient and continued to gather assets with positive inflows of $177 million in Q2 and $503 million year-to-date. Year-to-date, 4 out of the Bottom 5 themes by flows in both ETFs and open-ended funds were from the technological shifts. However, the picture has slightly changed in Q2, as investors might have found entry opportunities within the tech themes created by the global value rotation.
In contrast to the outflows in open-ended funds, equality, inclusion & diversity was the top gathering theme within ETFs. At the same time, sustainable energy production and agriculture continued to gather significant flows in both wrappers with $1.7 billion and $1.1 billion, respectively. The former theme continued to feature in the top 5 flows from quarter to quarter in the last year, while the agricultural theme entered the top 5 only last quarter potentially on the back of the rally in agricultural commodities amidst the global supply tensions created by the war in Ukraine.
Notably, China tech and the rise of the EM consumer have gathered flows in the second quarter coinciding with the relatively strong performance in both themes.
No sign of deceleration in ETF launches
Huge slowdown in flows within open-ended funds in Europe might have influenced the pace of fund launches in the space. The number of newly introduced funds amounted to 53 compared to 138 for the full 2021 year3. Despite the outflows this year, most of the launches are happening within the technological shifts cluster and such themes as healthtech and metaverse.
In contrast, the thematic ETF providers continue to grow the space with 29 new strategies launched year-to-date and 11 this quarter. Last year the thematic ETF market expanded by 44 products. So, the launches in 2022 are currently on track to overtake that figure. The majority of year-to-date launches in ETFs continue to focus on the "Environmental Pressures" cluster followed by technological shifts. Sustainable energy production andsustainable mobility strategies prevailed in environmental pressures, while technological shifts had a much more diverse mix of launches.
We will continue to closely watch the space in Q3 2022 and we will summarise our findings in the next WisdomTree Quarterly Thematic Review. Stay tuned.
Footnotes
Performance of a theme: For any given theme, we consider each month all the ETFs and open-ended funds classified in that specific theme that have published a monthly return for that month in Morningstar. We then calculate the average of all those monthly returns to compute the average monthly return for that theme. So, the monthly return for January 2020 for the theme may include 19 funds, while the February 2020 return may comprise 21 funds (if two funds classified in that theme have been launched in the meantime). By collating monthly returns for the theme, we get the theme's average historical performance. Therefore, the theme's average historical performance incorporates every ETF, and open-ended fund focused on this theme. The theme's average historical performance is not biased towards surviving funds or successful funds. Every fund alive in a given month is included irrespective of its future survival or success. Investments that try to focus on multiple themes and, therefore, classified either at cluster or sub-cluster level are not included
Sources
1 Source: WisdomTree based on its Thematics Universe and the underlying data on AuM for the funds provided by Morningstar, as of 30 June 2022.
2 Source: WisdomTree based on its Thematics Universe and the underlying data on AuM for the funds provided by Morningstar, as of 30 June 2022.
3 Source: WisdomTree based on its classification of new fund launches reported by Morningstar, Bloomberg
This material is prepared by WisdomTree and its affiliates and is not intended to be relied upon as a forecast, research or investment advice, and is not a recommendation, offer or solicitation to buy or sell any securities or to adopt any investment strategy. The opinions expressed are as of the date of production and may change as subsequent conditions vary. The information and opinions contained in this material are derived from proprietary and non-proprietary sources. As such, no warranty of accuracy or reliability is given and no responsibility arising in any other way for errors and omissions (including responsibility to any person by reason of negligence) is accepted by WisdomTree, nor any affiliate, nor any of their officers, employees or agents. Reliance upon information in this material is at the sole discretion of the reader. Past performance is not a reliable indicator of future performance.
Cloud computing: Beyond the fog of macro2022, so far, has been a year of the value style of investing outperforming the growth style, and few megatrends in recent years have been more growth oriented than cloud computing. Big stories and sales growth went from being in favour during 2020 and 2021 to being completely out of favour in an environment of higher inflation and interest rates.
However, do we risk painting an entire megatrend with too broad a brush? If most cloud computing companies are trading more based on macroeconomic factors, opportunities can be created because the companies where positive things are happening are being pulled downwards along with everything else.
Anyone interested in cloud computing and software-as-a-service (SaaS) businesses would do well to follow Jason Lemkin’s SaaStr blog. Some of the examples that I point out in the text that follows were inspired by his writing, and it’s excellent food for thought in finding positive financial developments in these companies.
Zoom video communications
It’s possible that the biggest value of Zoom is the fact that they are a global brand that everyone knows. There is even such a thing as ‘Zoom fatigue’—meaning the product is used so much that there is common language to describe using it too much.
But, is this just a ‘pandemic darling’ or is this a business that has a significant future outside of the Covid-19 Pandemic?
Customer Cohorts are Changing
Customers that generate more than $100,000 plus in recurring revenue are the engine for future growth. This group of customers, roughly 2,900 in number, are growing 46% year-over-year. This could be Zoom’s ultimate future, but it will be a journey. Even in 2021, 63% of Zoom’s revenue was still from 10 seat or smaller customers1.
Cost Control
I was fascinated and even surprised to see that Zoom’s sales and marketing spending is around 25% of revenue, having grown from 20%. The reason for the expansion of spending is to facilitate Zoom’s transition more towards enterprise customers. The typical Software-as-a-Service company is spending something closer to 50% of revenue on sales and marketing, so Zoom is operating at roughly half the scale of the typical SaaS business, at least on the basis of measuring their expenditure this way. This is a big reason why Zoom is able to generate roughly $2 billion of adjusted free cash flow per year. In the current environment, if these stocks start trading less on macroeconomic factors and more on fundamentals, we believe that the capability to transition from revenues to free cash flows to earnings will be prized, and Zoom is doing this2.
Multi-product Expansion
Zoom has annual recurring revenues of about $4 billion, and the vast majority of this comes from the core product of video communications. However, Zoom’s phone product does have about 3 million users. We can recognise that Zoom attempted to acquire Five9, which didn’t work out, but they are still seeing growth of their phone product. It will just take time for the phone product to get big enough to materially impact the $4 billion in annual recurring revenues.
Sprout Social
Sprout Social is a company that helps increase the impact of brands, people and companies on social media.
Growth Acceleration
Consider these growth rates at different levels of annual recurring revenue3:
$100 million: 30% growth.
$180 million: 34% growth.
$240 million: 41% growth.
We can recognise that this past behaviour doesn’t guarantee any future growth rates, but it’s at least worth continuing to watch Sprout’s results. If they can maintain this trajectory for a time, when cloud computing stocks trade more on fundamentals and less on macroeconomic factors, performance could be quite interesting.
Cost Control
As mentioned with Zoom, the typical SaaS company spends something around 50% of annual recurring revenue on sales and market expenses. Sprout is spending about 39%, which is below a key measure of 40%, which has tended to be associated with better performance on free cash flows. Sprout Social is generating 9% free cash flow at $240 million in annual recurring revenue, which is a level that many SaaS don’t see until $500 million or even $1 billion in annual recurring revenue, speaking to a certain degree of efficiency in the business4.
Box
Box provides a solution that allows for efficient file sharing and data storage.
Operating Margins
Again, we note that the market today cares far less about the ‘story’ and more about the discipline and the execution. I’ll admit that I had to read the following a few times to make sure that I had it right and I wasn’t making a mistake5:
Box had a 1% operating margin in 2020.
Box most recently reported an operating margin of 20%.
That is an incredible display of discipline, helped by the fact that sales and marketing expenses has been driven down to a low of 28% of annual recurring revenues. Box is approaching a level of free cash flow that is almost 20% of revenue, which is a significant figure for a SaaS company.
Conclusion: Remember the Digital Transformation
Cloud computing is certainly a high volatility, high risk megatrend, and we recognise that the first half of 2022 has been tough on the basis of share price performance. However, we were recently asked about how these companies might fare in an environment of rising rates and higher inflation. While there is no guarantee that customers don’t cancel subscriptions—and many cloud companies operate on subscription models—we tend to think about why customers are subscribing in the first place.
Even before the Covid-19 pandemic there was a push toward digital transformation. Companies were largely doing this to increase efficiencies, make better use of data, and run their businesses in a more optimal way. The present environment makes us think that there could be an even greater value on businesses saving costs and finding efficiencies. To the extent that cloud subscription services can actually help businesses continue operating and save costs, we think this is a very interesting space for consideration.
Sources
1 Source: Lemkin, Jason. “5 Interesting Learnings from Zoom at $4.3B in ARR.” SaaStr. 8 June 2022.
2 Source: Lemkin, 8 June 2022.
3 Source: Lemkin, Jason. “5 Interesting Learnings from Sprout Social at $240,000,000 in ARR.” SaaStr. 15 June 2022.
4 Source: Lemkin, 15 June 2022.
5 Source: Lemkin, Jason. “5 Interesting Learnings from Box at $1 Billion in ARR.” SaaStr. 1 June 2022.
This material is prepared by WisdomTree and its affiliates and is not intended to be relied upon as a forecast, research or investment advice, and is not a recommendation, offer or solicitation to buy or sell any securities or to adopt any investment strategy. The opinions expressed are as of the date of production and may change as subsequent conditions vary. The information and opinions contained in this material are derived from proprietary and non-proprietary sources. As such, no warranty of accuracy or reliability is given and no responsibility arising in any other way for errors and omissions (including responsibility to any person by reason of negligence) is accepted by WisdomTree, nor any affiliate, nor any of their officers, employees or agents. Reliance upon information in this material is at the sole discretion of the reader. Past performance is not a reliable indicator of future performance.
EURUSD Macro UpdateThe Euro has sunk and moved in line with our last market update however our models are now signalling signs of greater downside risk than a short/medium risk reversal.
Macro view
Options
- A bearish shift in market sentiment with put options (bearish bets) now claiming the highest premium in nearly four months
- One-month risk reversals (EUR1MRR) (higher volatility put premiums), crossed below zero on the 10th February and fell to -0.425 last Friday, the lowest level seen since 29th October 2019
Futures
- Hedge funds (leveraged funds) substantially increasing EUR short positions
Thematics
- Dollar bid remain supported under risk aversion
Technicals
- Symmetrical swing into 1.07xx institutional floor likely before any meaningful correction
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