RBC Market Analysis

The World Economic Forum estimates the world underinvests in infrastructure each year to the tune of a US$1 trillion. Commuters everywhere will not be surprised.

Infrastructure spending not only improves convenience and safety, but also productivity, as poor roads and delayed flights hold back economic growth. With such obvious benefits, why the underinvestment?

 

Years ago, governments found it far easier to approve infrastructure projects. After WWII a strong public consensus developed everywhere as to the desirability of undertaking large projects that would stimulate growth and put people to work, while modernizing the infrastructure asset base to support a rapidly changing industrial society.

The U.S. Interstate Highway System (built out over 35 years from the late 1950s), high-speed auto routes across Europe, bullet trains in Japan followed by high speed trains in Europe, and massive airports everywhere—these projects were not only sources of national pride, but added substantially to wealth and productivity.

But in today’s world, long development times mean politicians who authorize infrastructure projects often take criticism for massive budgets, possible cost overruns, and disturbance, but seldom remain in power long enough to take any credit for the benefits. In the U.S. and elsewhere, the complexity of infrastructure projects is compounded by the required involvement of regional, local, and national governments, which often have conflicting priorities.

The need to overcome these challenges is clear to all, and the need to boost infrastructure spending is one of the few areas of bipartisan agreement in the U.S. Yet a split Congress may make it difficult for any substantial infrastructure bill to pass.

Breaking gridlock

Tangible plans to increase infrastructure commitments are emerging in other countries, as shown in the box below. We expect more national infrastructure initiatives in the future. Fiscal policy will likely play a larger role in counteracting the next recession, given interest rates are unlikely to have room to fall far enough to lever the economy higher unaided. Central banks could conceivably play a role: the Bank of England, Bank of Japan, or the European Central Bank could buy infrastructure bonds, or bonds issued by a state-controlled infrastructure bank.

The changing face of infrastructure investment

Two big changes have occurred within infrastructure investment over the past 40 years: firstly, the expansion of the private sector’s role; and secondly, the considerable broadening of the asset class.

Faced with the increasing scale, complexity, and financing needs of infrastructure projects, governments have sought more private sector participation. Meanwhile pension funds, sovereign wealth funds, and insurance companies have found long life infrastructure assets often match the long-term liabilities they deal with. Infrastructure projects also offer a reliable cash flow once up and running, often including an inflation adjustment mechanism.

China’s ambitions dwarf others’ plans

Key national infrastructure plans

* PwC estimate, if plan is fully implemented.

Source - RBC Wealth Management

The traditional universe of infrastructure projects—bridges, roads, and power generation—has expanded to include rapid transit systems, high speed rail, airports, electricity transmission grids, harbours, and hospitals. Newcomers include: student housing; assisted living accommodation allowing retirees to live closer to healthcare and hospitals; the build-out of 5G, the fifth generation of mobile internet connectivity bringing greater speed and the ability to connect many more devices simultaneously; construction and maintenance of cell tower arrays; and networks of charging stations for electric vehicles.

Infrastructure investing and the economic cycle

Infrastructure investments should perform relatively well in the economic environment we foresee prevailing over the coming decade. Most infrastructure sectors benefit from economic growth and inflation to some extent, while demand tends to be relatively resilient in downturns.

Higher interest rates may make the investment environment more challenging as infrastructure assets tend to be financed by debt, but the impact will depend on the capital structure and return potential of each project.

A diversification tool

Infrastructure investments can offer valuable diversification benefits. Most deliver an income stream from low-risk, stable assets that would be less affected by an economic downturn. This should mean infrastructure investments will hold up better than the overall market in a downturn.

Transport can benefit most from the current environment

Impact of economic growth and inflation

Source - RBC Wealth Management

How effective a diversification tool they are will depend on the investment. Like all asset classes, infrastructure projects are subject to a broad spectrum of risks. At one end are less risky projects, such as conventional power generation in developed economies where costs can be controlled, demand can be more confidently assessed, and the regulatory environment can be relied upon. At the other extreme are unconventional “greenfield” projects in emerging economies where costs can escalate, contracts can be more difficult to enforce, sponsoring governments can change abruptly, and currency volatility can make returns unpredictable. Riskier infrastructure investments behave more like risky equities, potentially reducing or eliminating the diversification benefits of the asset class.

Investing in infrastructure

Infrastructure investment options include individual stocks, funds, or a combination of both. For single stocks, investors could focus on listed utilities, pipelines, or railways; industrial companies providing equipment, engineering services, or materials for projects; or companies that manage infrastructure assets.

For funds, the most significant benefit is the ability to diversify across industries, geographies, and the risk spectrum. Experienced fund managers are well-placed to assess not only each project’s complexities, but also political, regulatory, and currency risks. Some factors to consider when choosing a fund include:

• What assets is the fund invested in?
  • Long-life assets with stable cash flows, or riskier assets with projects that are less regulated and may be more exposed to demand risks?
  • Listed, or less-liquid unlisted projects located in developed economies, or in emerging ones with higher risk profiles?
  • Physical assets or service providers or raw materials suppliers that may add cyclicality to returns and variability to any income stream?
  • Established projects, or start-ups that may be riskier but offer higher returns?
• Does the fund look to harvest a long-term income stream, or does it buy undervalued assets to capture its returns via capital appreciation over a shorter time frame?

Conclusion

Infrastructure as an investment theme has a long life ahead of it. The demand for repair, replacement, and upgrading of existing infrastructure assets is immense across the developed world. Emerging economies need equally massive infrastructure investment to achieve economic and social goals.

The private sector has become an important source of infrastructure financing. Long-lived assets that provide a predictable stream of income, often inflation-adjusted, offer an attractive alternative for the trillions earning little or nothing in bank accounts ($9T in U.S. bank accounts alone), or for the trillions more that have flowed into lower-quality corporate and emerging market debt in recent years. We expect individual investors will discover the attractions of this asset class to a much greater extent over the coming decade.

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Required disclosures

Research resources

Note: Data in the equity section reflects forward price-to-earnings (P/E) ratios based on Bloomberg consensus earnings forecasts for the next 12 months. Data as of 11/15/18.

Non-U.S. Analyst Disclosure: Christopher Girdler, and Patrick McAllister, employees of RBC Wealth Management USA’s foreign affiliate RBC Dominion Securities Inc.; and Frédérique Carrier, Laura Cooper, and Alastair Whitfield, employees of RBC Wealth Management USA’s foreign affiliate Royal Bank of Canada Investment Management (U.K.) Limited; Jay Roberts, an employee of RBC Investment Services (Asia) Limited; Chun-Him Tam, an employee of Royal Bank of Canada, Singapore Branch; contributed to the preparation of this publication. These individuals are not registered with or qualified as research analysts with the U.S. Financial Industry Regulatory Authority (“FINRA”) and, since they are not associated persons of RBC Wealth Management, they may not be subject to FINRA Rule 2241 governing communications with subject companies, the making of public appearances, and the trading of securities in accounts held by research analysts.

In Quebec, financial planning services are provided by RBC Wealth Management Financial Services Inc. which is licensed as a financial services firm in that province. In the rest of Canada, financial planning services are available through RBC Dominion Securities Inc.

By Iryna Drobysheva & Juan Aronna

Artificial intelligence (AI) has been dominating the headlines—all the way from the transformative opportunities it can bring to society, businesses, and governments, to the science fiction doomsday scenarios. There is a great amount of hype surrounding AI, and the first step to assess the extent of its impact is to remove the mystery and understand what it has to offer.

 

AI is an “umbrella” concept, covering a wide range of disciplines and technologies, including machine learning, deep learning, and cognitive computing, among others.

The “intelligence” aspect of AI is at the root of what the technology can do—intelligence is the capacity to connect comprehension with logic, which results in the ability to draw conclusions from previous experiences. Humans process information like this day in and day out, without even thinking about it. As such, AI can be interpreted as a set of algorithms (logic), programs (instructions to a computer), and statistical models that interact to replicate an output very similar to that of human intelligence.

However, AI is unable to connect insights or understand specifically why something is happening—another key aspect of human thinking. A book published by New Scientist on the topic states that “AI can’t strip us of our jobs, our dignity or our human rights. Only other humans can do that.” This suggests that humans are ultimately responsible for their future. In other words, at this stage it’s humans who control AI, not the other way around.

Subsets of AI

Artificial Intelligence

Any technique that enables computers to mimic human behavior

Machine Learning

Subset of AI. Uses statistical methods to enable machines to learn and improve with experience

Deep Learning

Subset of ML. Makes the computation of multi-layer neural networks feasible

Source - Goodfellow, Ian, Bengio, Yoshua, and Courville, Aaron. Deep Learning. MIT Press, 2016. www.deeplearningbook.org/contents/intro.html.

Revival of AI

While AI might seem like a very 21st century concept, it is not new. The term was coined in 1956 and AI went through alternating phases of early development followed by hibernation. During the 1970s and later in the 1990s, research progress completely stalled for nearly two decades—what became dubbed the “AI winters”—due to unfulfilled promises and lack of funding.

Its revival has been driven by a simultaneous improvement of factors never seen before: the availability of immensely large volumes of data (big data), the advancement of machine learning algorithms, cheap data storage, and increased computing capacity via graphics processing units (GPUs) that meaningfully reduce computation time. AI would not be fully viable without any one of these improvements. For example, consider the dramatic decline in storage costs that enables AI users to store previously unimagined quantities of data, so much data that it is doubling in size every two years. In 1980 one gigabyte of storage cost $437,000; by 2016 the cost had plunged to just under $0.02.

Human + Machine

Even though we can loosely define AI, there is no uniform definition that everyone agrees on. A philosopher would look at it from an existential point of view, but a computer scientist would evaluate a machine’s ability to perform tasks requiring human intelligence and an economist might look at AI’s impact on GDP growth.

In general, most references to AI revolve around three main stages of development: Artificial Narrow Intelligence, Artificial General Intelligence, and Artificial Super Intelligence (defined in the table below). However, it is crucial to recognize that only one, Artificial Narrow Intelligence, is mature today, while the hype about AI taking over the world refers to the other two areas in nascent stages.

Some see the potential for significant leaps in AI, especially related to the human brain. Futurist and Google’s Director of Engineering Ray Kurzweil suggests that for the last 4,000 years the human brain has been “limited by a fixed architecture of enclosure” and AI has the ability to “expand our neocortex”—the part of the brain responsible for higher functions—in quantity and quality. During a TED Talk he said that “if you need some extra neocortex, you’ll be able to connect to it on the cloud directly from your brain. That additional quantity will again be an enabling factor for another qualitative leap in culture and technology.”

Three main stages of AI development

Stage	Applications	Status
Artificial Narrow Intelligence	Restricted to one function, task, or purpose such as: image and speech recognition, data clustering, optimization, prediction, and natural language understanding.	Most mature
Artificial General Intelligence	Not restricted to one field; it includes problem-solving, reasoning, and cognition. It understands why something is happening and draws on many experiences and conceptualizing models to develop actual scenarios (e.g., action plans, projections, etc.).	Not mature
Artificial Super Intelligence	Covers all fields and surpasses human intelligence in many aspects.	Pre-embryonic

Source - RBC Wealth Management

This prospect might be exciting to some and dreadful to others. While it’s intriguing to contemplate future scenarios, it is yet to be seen to what extent far-reaching projections such as these will materialize. Even without massive leaps, today the opportunities for AI are vast and we believe it is evident that human expertise has the potential to be augmented by a combination of human and machine intelligence, which surpasses that of either a human or a machine on a standalone basis.

AI transformation journey has just begun

AI is already beginning to make its mark in a wide variety of industries. For the first time in its decades-long history it has become commercialized. Internet giants use it for search optimization and product recommendation, among other applications, while businesses outside of the technology industry have begun to implement AI for uses such as fraud detection, facial recognition, mapping the customer journey, and much more. It has even made some headway in art and media—a painting created by AI recently sold at a Christie’s auction for $432,500 and the world’s first AI news anchor has gone live in China.

Currently, the global market for AI is estimated to be approximately $7.3B and is forecast to reach some $90B by 2025, based on Statista data. North America is expected to be the biggest consumer in the market with its widening usage of AI applications across numerous business verticals, while Asia Pacific will likely experience the fastest growth in uptake of the new technology, according to Reuters. AI is rapidly emerging as an industry in itself.

Impact of AI on major sectors

Because AI’s commercialization and presence in public equity markets are relatively new, so far AI offers limited opportunities for pure-play investment. The direct beneficiaries are confined to areas like software, where some companies have established a first-mover advantage. As time passes, as happened with previous technological breakthroughs (e.g., the internet), the massive number of private AI startups likely will be reduced to only a comparatively few winners, in our view.

Another approach would be to invest in indirect beneficiaries, companies that would benefit from incorporating AI technologies in their business. In addition to technology and communication services, we expect five industries to benefit in the near future:

Health care

New AI innovations in the health care industry are appearing with great rapidity, making it the most promising industry, in our view, where image recognition has dramatically improved diagnostics—detecting melanoma skin cancer with 95 percent accuracy, for example—adding decision-making support and improved patient monitoring. Big data combined with AI is opening up the possibilities of customized, individual therapies replacing the “one-size-fits-all” protocols that have characterized cancer treatment for decades. Heart disease diagnosis and treatment could benefit in the same way. Deep learning and predictive analytics tools are reducing the costs and time of drug development by predicting the therapeutic use of new drugs, thus driving significant efficiency gains.

Transportation

Industry practitioners expect autonomous vehicles to transform the future of transport along with other AI solutions that will: predict traffic flow and analyze pedestrian patterns to reduce accidents, speed traffic flow and the efficient movement of goods, reduce congestion, air pollution, and energy consumption; not to mention free up valuable land and physical assets currently dedicated to housing and storing autos that are often in use for less than an hour each day.

Manufacturing

AI supports production forecasting and quality control with robotics and sensor technologies. In its 10-year strategic plan, “Made in China 2025,” China is revamping its industrial base, and the International Federation of Robotics expects China to account for 40 percent of the total worldwide sales of robots by 2019.

Retail

AI’s applications in e-commerce include product discovery tools such as visual search, 3D virtual reality, customized product recommendations, targeted marketing, and potentially delivery through AI-powered drones or other self-driving vehicles. Importantly, AI’s predictive analytics could provide, and in some cases already are, the rapid just-in-time inventory management that would permit brick-and-mortar retailers the capacity to compete more effectively against the online threat.

Financials

AI is making strides in the form of virtual assistants, chatbots, speech recognition, alternative data sources, sophisticated trading models, real-time risk assessment, the development of innovative new financial instruments, and much more.

Investments ex machina

We believe AI offers transformative opportunities for society, governments, and businesses, even though the state of the technology still lags the hype. Like other periods of rapid industrial/technological change, we expect AI’s emergence will create a substantial increase in global wealth in the coming decades. However, it is unlikely that increased wealth will be delivered equitably or “fairly.” There will undoubtedly be large dislocations that produce both winners and losers.

What is clear to us is that AI is here to stay. As with the arrival of computers, automation, and the internet, those companies that pursue the opportunities AI presents and understand the competitive threats it may pose, will likely fare better than those who choose to ignore it or fight a rearguard action to forestall it. We believe factoring its impact into investment decisions and choices will rapidly become a “must have” rather than a “nice to have.”

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Required disclosures

Research resources

Non-U.S. Analyst Disclosure: Iryna Drobysheva and Juan Aronna, employees of Royal Bank of Canada, Singapore Branch, contributed to the preparation of this publication. These individuals are not registered with or qualified as research analysts with the U.S. Financial Industry Regulatory Authority (“FINRA”) and, since they are not associated persons of RBC Wealth Management, they may not be subject to FINRA Rule 2241 governing communications with subject companies, the making of public appearances, and the trading of securities in accounts held by research analysts.

In Quebec, financial planning services are provided by RBC Wealth Management Financial Services Inc. which is licensed as a financial services firm in that province. In the rest of Canada, financial planning services are available through RBC Dominion Securities Inc.

By Jay Roberts

When Presidents Donald Trump and Xi Jinping met for the first time at Trump’s Florida golf retreat, Mar-a-Lago, in April 2017, it was all smiles and bonhomie. China’s official Xinhua news agency sounded a note of triumph—even despite Trump informing an unsuspecting Xi that he had just launched 59 missiles at Syria over a “beautiful piece of chocolate cake”—declaring the meeting as positive, fruitful, and a new starting point for the world’s most important bilateral relationship. Trump lauded his friendship with Xi and described the relationship as “outstanding.” Progress indeed from the campaign trail comments in 2016.

Since then, and noted in various Global Insight publications in 2018, the China hawks in the Trump administration have steadily gained the ascendancy. The Trump administration moved quickly from words to actions. To date, this has culminated in five percent–25 percent tariffs on US$250B of goods from China with further increases in tariffs planned for January 2019. China has responded in kind with $160B of its own taxes on U.S. goods, steadfastly underlining its self-belief as a global power that will not kowtow.

U.S. dollar/Chinese yuan exchange rate

Source - RBC Wealth Management, Bloomberg; data through 11/8/18

Chinese equity markets have declined deep into bear market territory, although this is amid a backdrop of Chinese policy aimed at financial deleveraging, a clunky term that simply means tackling riskier areas of lending in the economy. China’s currency has weakened. More recently, it is beginning to dawn on global investors, including in the dominant U.S. market, that what is happening between the U.S. and China goes far beyond political posturing. Something far larger is afoot.

As Trump accused China in September of interfering in the U.S. midterm elections,¹ he offered that President Xi “might not be a friend of mine anymore.” An understatement, perhaps. How things have changed.

Plan B

What is going on is much more than a trade dispute. It is primarily a national security dispute where the key ingredients are: technology leadership; laws, regulations, and behaviours; an overarching accusation of state interference; and ideological differences.

All U.S. presidents are required to produce a National Security Strategy. Trump’s was produced in December 2017 in record time. Of note: “China and Russia challenge American power, influence, and interests, attempting to erode American security and prosperity. They are determined to make economies less free and less fair, to grow their militaries, and to control information and data to repress their societies and expand their influence.”²

The complaints in the U.S. Trade Representative report from March 2018, ordered by Trump in August 2017, revolve around China’s alleged theft of intellectual property, forced technology transfer, limited market access, and state-sponsored cyberattacks.

As such, it is nigh impossible that all will be resolved in a brief meeting and a handshake between Trump and Xi. At most in the short term, there may be some agreement to postpone tariff increases, for example, or agree to rejoin negotiations (currently minimal). But the U.S. has said that it now refuses to negotiate until China presents a concrete plan on technology.³

Moreover, while the dispute has been intensifying over the past year, it has really been many years in the making. The Obama administration discussed similar issues. Even today, with the divide between Republicans and Democrats widening to a chasm, the issue of tackling China is a rarity in that it enjoys unfettered bipartisan support, including some of Trump’s most vocal critics in the Democratic camp.

The U.S. long believed that engagement with China would bring about desired changes over time. That belief is being ditched. Plan B is in operation and it does not only include tariffs.⁴ China has responded by refusing to bend publicly. State media labelled U.S. methods as “extreme blackmail.” Xi Jinping gave a speech at a trade fair in Shanghai on Nov. 5 proclaiming a “new round of high-level opening up.” He also commented that the free trade system is under threat and levelled some thinly veiled criticisms at the U.S.

Crossing the Rubicon

Along the way, there have been a number of public comments made by U.S. officials that underline the seriousness of the situation and the commitment of the U.S. to a new strategy.

The most strident was a speech—history might term it the speech—delivered by Vice President Mike Pence on October 4 in Washington.⁵ Over the course of 40 minutes, Pence delivered a stinging rebuke to China across a wide range of issues that went well beyond trade. The combination of its smorgasbord of complaints and accusations across multiple spheres including commercial affairs, political ideology, military expansion, and human rights; the length of the speech; the entire focus on China; and the fact that it was delivered by the second-highest U.S. official make this a moment in which the U.S. may have finally crossed the Rubicon. For its part, China questions its role in a unipolar world subject to U.S. hegemony.

The nature of the strategic relationship between the U.S. and China is undergoing a generational sea change, in our view. We expect this divergence to continue as both countries work to remove some interdependencies over time. There is growing mistrust on both sides. We believe that the process will be protracted and peppered with bouts of real tension.

Economic implications & market response

The U.S. is primarily a domestic, consumer-driven economy. If economic measures are restricted to tariffs of moderate levels, we believe the impact on the U.S. should be manageable during expansion periods. However, unpredictable secondary actions, such as restricting market access in China or imposing a series of harsh sanctions, would be more damaging to certain companies, in our view. Additionally, the inflationary effects of tariffs are unclear—at a time when U.S. bond yields are pushing higher on Federal Reserve rate hikes and strong economic data.

For China, the impact of a full-blown trade war would be more pronounced, perhaps reducing growth by up to 0.7 percent, according to one estimate by the Chinese government. However, the Chinese economy is also more consumer- and services-oriented than many people might think, in our view.

Equity markets in China, Hong Kong, and to some extent elsewhere in Asia have responded rapidly and negatively since the first tariffs hit. Hong Kong’s Hang Seng Index has declined in eight out of 10 months in 2018. MSCI China Index earnings have been revised downwards for six consecutive months. This trend needs to halt before investors can become more constructive, in our view.

Major Asian equity indexes: 2017 & 2018 year-to-date returns

in U.S. dollars

Indexes shown: Hong Kong Hang Seng Index (HSI), MSCI AC Asia Pacific Index (MXAP), NSE Nifty 50 Index (NIFTY), Jakarta Stock Exchange Composite Index (JCI), Tokyo Stock Exchange Tokyo Price Index (TPX), Straits Times Index (STI), Taiwan Stock Exchange Weighted Index (TWSE), S&P/ASX 200 (As51), Shanghai Composite Index (SHComp), Shenzhen Composite Index (SZComp)

Source - RBC Wealth Management, Bloomberg; data through 11/5/18

Unfortunately for China, the dispute comes at a time of financial deleveraging, which itself is impacting the ability of Chinese companies to tap the domestic capital markets. For example, some Chinese property developers are being forced to offer markedly higher yields on new bond issuances.

We have begun to see Chinese policy support for the equity market. Historically, the actual market has bottomed between one to six months after such support is announced, but every situation is different. While we forecast the Chinese currency to weaken through USDCNY7.00, we believe that authorities would not entertain any disorderly selloff.

The dispute has also meaningfully impacted other Asian equity markets. Some of these markets are approaching levels where valuation may become supportive.

Going forward, a growing divide between the U.S. and China would have ramifications for economic growth rates (although benefits may accrue to other countries depending on the movement of supply chains). However, we believe this is more likely to be an ongoing erosion of growth rather than a shock. For companies, the impact on some will be negligible, for others potentially significant. Investors should consider this when constructing and managing portfolios.

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Required disclosures

Research resources

1. https://www.theguardian.com/us-news/2018/sep/26/trump-china-beijing-election-midterms-interference-claim
2. https://www.whitehouse.gov/wp-content/uploads/2017/12/NSS-Final-12-18-2017-0905.pdf (Page 12)
3. https://www.wsj.com/articles/u-s-wont-resume-trade-talks-without-firm-proposal-from-a-wary-china-1540465201
4. https://www.reuters.com/article/us-usa-trade-china-semiconductors/us-restricts-exports-to-chinese-semiconductor-firm-fujian-jinhua-idUSKCN1N328E
5. https://www.whitehouse.gov/briefings-statements/remarks-vice-president-pence-administrations-policy-toward-china/

Non-U.S. Analyst Disclosure: Jay Roberts, CFA, an employee of RBC Wealth Management USA’s foreign affiliate RBC Dominion Securities Inc., contributed to the preparation of this publication. This individual is not registered with or qualified as a research analyst with the U.S. Financial Industry Regulatory Authority (“FINRA”) and, since he is not an associated persons of RBC Wealth Management, he may not be subject to FINRA Rule 2241 governing communications with subject companies, the making of public appearances, and the trading of securities in accounts held by research analysts.

In Quebec, financial planning services are provided by RBC Wealth Management Financial Services Inc. which is licensed as a financial services firm in that province. In the rest of Canada, financial planning services are available through RBC Dominion Securities Inc.