Economic and Political Monthly Roundup
Investment companies | Monthly | January 2023
A collation of recent insights on markets and economies taken from the comments made by chairs and investment managers of investment companies – have a read and make your own minds up. Please remember that nothing in this note is designed to encourage you to buy or sell any of the companies mentioned.
“Your money is not charity, it’s an investment in the global security and democracy.” – Volodymyr Zelenskyy addressing US Congress
The pace of interest rate rises slowed, but central bankers seemed keen to highlight that more needs to be done to tackle inflation despite a bigger-than-expected fall in the US inflation rate in November. Long bond yields rose (as shown on page 3).
China surprised us by going much further and faster with its abandonment of its zero-COVID policy during December, while trying to pretend that this was not leading to a sharp rise in hospitalisations and deaths. There is thought to have been some impact on the country’s economic output in December.
Japan’s central bank caught markets off-guard when it made an unexpected change to its yield curve control policy (one tool for controlling interest rates). The main effect was a sharp strengthening of the Japanese yen.
China and Russia are said to have been big buyers of gold in recent months, underpinning its price rise. Oil prices were flat over the month.
Markets continue to face considerable risks. These include higher inflation rates fuelling a cost of living crisis, economic recession in major economies, rising interest rates and the Russia/Ukraine conflict showing no resolution in sight. Although markets have adjusted to reflect the likely damage to corporate earnings, there is little good news on the horizon to encourage investors back into the markets. It is encouraging that markets have staged a recovery following the falls witnessed around the year end in September.
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The global economy continues to face many headwinds, which is likely to lead to a deeper and earlier global recession than previously forecast. The UK and EU economies are facing a commodity price induced real income squeeze, amplified by central bank actions. We expect interest rate hikes from the US Federal Reserve, the European Central Bank and the Bank of England, as they seek to control inflation. To a degree, markets have already responded to this uncertainty: equity valuations are cheaper and credit spreads wider than they were at the start of the year – as such, many asset classes look more attractive now on a 5-year view. However, the compounding effects of these various shocks will mean that the investment environment will remain volatile and we may see further weakness across asset classes in the shorter-term.
While fundraising has reduced in the second half of the year, there already exists a high level of cash available to be invested in Private Markets (also known as ‘dry powder’). While we expect a lower level of private equity transactions, there will still be competition for quality assets.
Investor appetite for infrastructure remains stable, especially for social and economic infrastructure where there is potential for long-term, inflation-linked contracts providing yield and inflation protection. In addition, as the world goes through the energy transition, demand for climate and renewable infrastructure is ever increasing, remaining supportive of investment opportunities in this space.
In Private Credit, we believe that there will be opportunities for private financing as companies face a slightly tighter lending environment. However, the quality of deals remains crucial, as company earnings are reduced, the ability to cover interest payments is tested, and default levels increase.
Within real estate, residential markets are expected to come under strain with mortgage burdens weighing on consumers. However, a reduction in mortgage affordability will mean that many people will remain in rented accommodation, to the benefit of the Build To Rent sector.
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Markets have bounced from the lows in September as investors’ expectations, particularly in the bond market, are beginning to discount the peak of inflation. Central Banks have raised interest rates aggressively and the distortions of the pandemic are easing, particularly in the global supply chain. For equities, earnings expectations have yet to catch up with slowing economic growth forecasts into 2023, but looking into the next five years, the economic background will be different from that which prevailed in the last decade of quantitative easing, low inflation and stagnant nominal GDP Growth. Interest rates will be higher offering an alternative to equities for investors and long duration growth stocks will be less attractive. Careful stock selection based on good fundamental analysis of equities and credit opportunities should offer shareholders good returns.
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Looking ahead, the near-term prospects for global economic growth have deteriorated due to the impact of tighter monetary policy. As we have seen recently in the UK, some countries are now having to impose tougher fiscal policies to address their budgetary shortfalls. This is feeding through into a poorer prognosis for company earnings into 2023. It’s unclear at this stage how much further interest rates will need to rise and when inflation will fall back to more normal levels around the world, not least due to the complications of the ongoing war in Ukraine. China’s approach to Covid-19 is continuing to create challenges for global supply chains and the local economy, while at the same time leading to social unrest in the country.
While the underlying background for equities is hardly ideal, this is already well recognised. Many share prices have fallen a long way from their peaks, especially in the more cyclical parts of the markets. We think that there are some good opportunities to take advantage of in this environment. In a period where cost pressures will remain in focus, we will continue to closely monitor how the managements of our holdings are faring in addressing these.
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Investors face the unwelcome combination of a weaker economic outlook combined with elevated valuations in equity markets. A widespread repricing of fixed income markets and a less favourable policy backdrop makes for a more challenging environment for equity investment until greater value is apparent.
When returns are plentiful, as they have been for years, the incremental return from income becomes less prized by investors. In more straitened times it becomes valuable once more. This is especially the case for those with irreplaceable capital and seeking a certain return to cover rising day to day expenses without having to dip into capital at times of stress.
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Past experience suggests the best strategy when markets are depressed and sentiment is low is to stay invested and rely on diversified portfolios to navigate volatile markets. This enables [you] to capture the recovery that will inevitably come, probably beginning when hopes are at their lowest. History shows that investors tend to over-pay for certainty – or at the least the illusion of it – and under-price uncertainty. In other words, taking considered risk is a good thing and indeed essential to making good returns over time.
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Equities are attractive owing to highly depressed valuations and to their inflation-linking. High inflation, interest rates and recession have undermined investor sentiment and equity prices. These forces have depressed most notably UK equities, which have most recently suffered relative to other markets from severe instability in bond markets as a result of government policies.
Appetite for risk capital has fallen sharply. This is most telling from IPO and bond issuance volumes, which have almost entirely dried up. It is also clear from the fall in valuations in early-stage companies and investor sentiment indicators that are close to 2009 lows. Adjusted for inflation, declines have been even greater than they first appear.
The recent series of confusing and negative macro events has diminished the stature of equities, although they have always been and are likely to remain, the best long-term hedge against inflation.
This is because equities are priced in nominal terms and provide owners with a claim on cash flow of productive assets in perpetuity. Over the long-term, this means that the prospective return on equities should be a function of earnings yields (cash generated by the security relative to the price you pay), inflation, and corporate earnings growth, which is a function of real GDP growth.
All crises and recessions are different, but the reaction of asset prices tends to be similar because it is driven by human behaviour which fundamentally does not change. It is at times like these, that it is particularly important to recognise that natural tendencies, such as loss aversion, can be harmful in the field of equity investing. Loss aversion creates a propensity for investors to become more pessimistic in falling markets, even though falling prices mean investing in the future is more attractive.
For all these reasons, we are of the view that prospective returns from equities are very compelling, not only in absolute terms, but especially relative to bonds.
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During 2022, global equity valuations have fallen considerably, and in the case of growth stocks from very elevated levels. Whilst UK equity asset valuations have reflected the global trend, generally they started at more modest levels, so UK valuations overall currently stand at even more attractive levels. During Brexit, UK microcaps tended to be overlooked, and since November 2021 have remained out of the limelight suffering a steady downward trend. As I write, it is a source of some comfort to see glimmers of life in microcap stocks, helped by the recent equity rally, which may or may not turn out to be a bear market bounce. Although our stocks are cheap and some might postulate that they are ripe for takeover, I know that it is the managers’ view that, in general terms, the companies in our universe are too small for larger corporates to be bothered going through a great deal of due diligence that a takeover involves. It is more likely that some of our holdings will be able to pick up distressed assets from the receiver or when those companies are in desperate straits. We would rather not lose companies to takeovers when their valuations are so depressed.
The UK stock market, which has a high proportion of stocks generating a cash surplus, is distinct from most other global markets. With the constraint on capital that comes with inflation, the relative strength of UK quoted company balance sheets should be a considerable advantage, especially compared to those with substantial debt burdens. Furthermore, if economic conditions remain unsettled, quoted companies can often rescue many of the jobs in the over-indebted, but otherwise viable businesses by acquiring them debt-free from the receivers given that this yields the full cash payback on their prior investment.
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During 2022, inflation was persistent and valuations fell considerably. Even prior to this year, with the uncertainties of Brexit, the valuation of UK equities was already relatively undemanding. Following the share price weakness in 2022, UK microcaps have fallen to what we consider to be exceptionally attractive valuations.
As inflationary pressures peak, investors are starting to look forward to a time when asset values stop falling. Indeed, some are starting to look across the recessionary valley in earnings, to an improving trend some quarters hence.
In our view, the prospects for global recovery still range between a recession that may persist for longer than expected to a scenario where inflationary pressures may have been conquered. Either way, with elevated energy prices and the cost of mortgages rising, in our view consumers, governments and corporates will become much more price sensitive in their purchases and moderate their consumption rate. This implies that profit margins will come under pressure which coupled with limited global growth, will hinder earnings growth.
Whilst this period could be challenging for all businesses, those with over-levered balance sheets, or those making persistent losses, will be at risk of bankruptcy. In contrast, quoted companies tend to have relatively strong balance sheets. Better still, they have the potential to acquire overindebted, but otherwise viable businesses from the receiver, debt-free, at distressed valuations. In our view, these transactions will actively improve the potential for these companies to generate surplus cash at a time when most others are short of capital.
Since mainstream stocks will typically be large compared to the scale of any acquisitions, in general they will only deliver incremental improvements. In contrast, the scale of these acquisitions will often be very significant relative to quoted microcaps, and consequently some will have the potential to generate transformational returns.
In short, in terms of the price/book metric, many UK-quoted microcaps are currently standing at unusually low valuations. And yet, even if economic conditions remain challenging, prospects are expected to be superior to many others. Furthermore, if they make acquisitions at distressed valuations, their returns may be substantially better.
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SmallCap and AIM companies
There are a host of factors which have combined to render this part of the UK market out of favour. Reasons for this include:
- The revenue of companies of this size is far more weighted to the UK than in the case of larger companies.
- The UK market as a whole is trading at a significant discount to other developed equity markets (for example, UK equities were trading at a near 40% discount to the MSCI World Index). The UK’s near pariah status has pertained since before Brexit, and has been confirmed by a succession of ‘events’, the most recent being what can fairly be characterised as political chaos.
- The best performers on the UK market have been broadly among the twenty largest companies, often in commodities businesses which have benefitted from the consequences of Putin’s war.
- In times of nervousness smaller companies are often perceived to be inherently risky and sold off indiscriminately.
Despite the UK and other developed economies being blighted by recession and high inflation, we see value in the areas in which we are invested. Investee companies do not generally see downturns in their prospects which would justify their low valuations. While some companies will be hit by unpleasant surprises, by and large we believe that earnings and dividend prospects are not properly priced into the market. It is therefore reasonable, in our view, to look to a recovery in UK valuations and a return to dividend growth.
We are encouraged to see signs of improving sentiment in the mid-cap area, and hopeful that this will permeate down to small-caps.
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Valuations of companies are guided by the cash flows they are expected to achieve over time. When expectations change, share prices will alter. The movement in the share price can then feed on itself – when a stock price falls, sentiment towards the company can deteriorate leading to a downward spiral of pessimism. This may be happening in the UK with the macroeconomic concerns drowning out an appraisal of individual companies’ prospects, leading investors to question the strengths of even the best. Downturns will create opportunities for the better ones to position themselves to prosper in the next upturn.
During this phase of despondency about the UK it is important to remember it is a place to find innovation, world leading companies and strong management teams.
Companies are dealing with changes in consumer behaviour and advances in technology. Some will not keep pace but the belief is many will prosper and grow. We believe there will be substantial share price appreciation when these strengths come to be more recognised.
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The period under review has undoubtedly been a challenging one with sentiment towards the UK deteriorating as global and domestic headwinds strengthened. The prospect of high and sustained inflation, rising interest rates, and a looming recession will undoubtedly present a challenging backdrop at least in the short term for companies, investors, and households looking forwards. Political and policy chaos has only heightened the economic uncertainty. There can be no hiding from the fact that the challenges facing the UK have not been this substantial for many a year. However, out of adversity can come considerable opportunity.
Looking forwards at the prospects for UK mid-caps, there are reasons for optimism despite the turbulent backdrop and recent equity market weakness. Current valuations would suggest that the market has already priced in a lot of the prevailing bad news with small and mid cap stocks having underperformed large caps meaningfully during the period. Valuations remain extremely attractive relative to history.
In addition, M&A activity is likely to continue as overseas firms see opportunity to expand their operations into the UK at extremely attractive valuations with domestically focused mid-caps likely to attract the most attention. Shareholders in many companies will continue to benefit from ongoing share buyback programs as management teams recognise the value in their own shares at current levels and indeed management are also personally buyers of their own company stock.
In short, the Board believes that weakness in the UK mid-cap area over the last twelve months should be seen as presenting attractive investment opportunities over the medium and longer-term.
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There has been no respite this year as a UK mid cap investor. Companies have seen 1970s-style pressure on supply chains and inflation rates in their cost bases. Investors have responded by adopting a risk off approach, moving into the largest capitalised stocks for “safety”. This has had a disproportionate impact on the SMID area of the market as share prices have sold off aggressively.
We note that three types of market participants seem most willing to take advantage of this opportunity. These are private equity and strategic corporate acquirors, particularly North American ones, management teams via share buybacks, and company directors.
Insider share purchases are becoming more frequent and may be considered a significant indicator of management confidence in their business.
Turning back to the UK economy, the big question is where inflation goes from here and whether unfilled job vacancies outnumbering those actively seeking work translates into rising wage growth. Although energy and food inflation are widely anticipated to ease next year, domestically driven inflation remains a concern. It is notable that the Bank of England now appears to be managing down expectations of further significant rate rises. If this comes to pass, it should help to quieten financial markets. Meanwhile, the consumer will be cushioned to some extent by the government’s energy package and residual excess savings.
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There is no doubt that we are facing a combination of economic and political challenges which makes any forward-looking statements precarious. It is probably fair to say that, at the very least, the medium-term outlook is wholly dependent on an early resolution to the war in Ukraine.
The consumer is being squeezed from all angles due to global inflation, supply line shortages and rising prices and there is no simple answer. The Government support packages will help on energy prices, but with the Bank of England anxious to make up lost ground in the fight against inflation, interest rates are likely to continue to rise into 2023. This picture makes it very hard to gauge whether we get a soft or hard landing, and whether company earnings’ expectations for 2023 have bottomed, or whether we have more downgrades to come.
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The global economy is slowing as Central Banks try to control inflation leading to a high risk of recession in the UK and other major countries. This is a challenging backdrop, but we remain confident that we can navigate this environment successfully for the following reasons:
- Broad universe of stocks: As they are starting with high levels of dividend cover, we expect many UK stocks to deliver attractive dividend growth despite the uncertain economic situation. The UK equity market is highly diverse, allowing us to access a wide range of companies with different income drivers. Some companies will struggle in an inflationary environment, but others will thrive. Furthermore, the UK equity market provides exposure to different parts of the world. It seems likely that economic outturns will differ widely in the coming year. For example, the US will be far less affected by the Ukraine war than Germany, as a result of their radically different energy policies
- Tendency of share prices to price in recessions early: Recent research by Stifel has mapped the performance of the S&P 500 index to each US recession post-1945 and found that the stock market bottoms out 4 months before the end of the recession. While it is not possible to know in advance with any certainty when a recession will start or end, this is a reminder that recessions can provide opportunities to buy well-managed companies at attractive valuations.
- Style rotation: Rising interest rates are up-ending stock markets. Loose monetary policy was a boon for highly valued growth stocks, as falling interest rates mechanically drove up their discounted cash flow valuations. As we enter an inflationary era with higher rates, investors are shifting their focus to the cash-generative value stocks that our investment process favours. This is a more favourable environment for us as it enables the delivery of both income and capital growth.
We are aware that the stock market is currently heavily affected by macro drivers and that it is difficult to know how the coming year will play out in that regard. For this reason we have segmented the portfolio into three discrete baskets:
- Inflation Protection: Stocks with inflation hedge characteristics; potentially benefiting from rising prices. We expect inflationary conditions to provide a tailwind to these companies, helping them to grow their cash flows and dividends.
- Mispriced Yield: Stocks whose high yields indicate that the market is pricing in bad news. We believe these stocks are more resilient than their valuation implies.
- Latent Growth: Stocks that are capable of delivering operational progress, driving growth on a medium-term view once the current period of uncertainty abates. This change is being overlooked by the market.
We expect each of these baskets to perform best in different scenarios. Inflation Protection stocks should perform best in an inflationary environment, driven by high commodity prices and rising interest rates. The Mispriced Yield basket should perform best in a rotation out of growth stocks into value stocks. Latent Growth stocks should perform best on any easing in inflationary pressures, perhaps triggered by a resolution to the Ukraine war. We would see the most adverse scenario for the portfolio as a prolonged and synchronised global recession, as this could drive down large swathes of the market. For now we see this as a low probability scenario given the variations in economic conditions around the world.
The UK is a particularly unloved stock market due to a series of political crises since the 2016 Brexit referendum. The scale of the UK’s furlough and energy bill support schemes have caused the UK’s debt/GDP ratio to approach 100%, although it should be noted that this is still the second lowest in the G7. The arrival of Rishi Sunak as the third Prime Minister in as many months heralds an era of more conventional economic policies. This has already calmed the markets, helping to drive a reduction in Gilt yields and a recovery in sterling. Amongst all the political ‘fear and loathing’, it is worth keeping in mind that the UK has many enduring strengths that make it a highly attractive destination for international capital. As has been demonstrated by all the recent M&A activity in our own portfolio, some international investors are coming to the view that UK companies are now attractively priced. It would not take much for broader attitudes to the UK to improve dramatically.
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Recent months have been challenging for financial markets and there are a number of economic dark clouds impacting the investment outlook, with the Bank of England now predicting a “prolonged recession”. While this is certainly a challenging time for equities, there are reasons to be more constructive. Firstly, a recession is now largely expected by financial markets; and secondly many companies are significantly cheaper than they were at the start of the year. In addition, there are reasons to support a view that we are close to the peak of inflation and interest rate fears, and as these factors moderate, valuations can find support. Hence a time of widespread gloom could well be providing investors with attractive opportunities, and we have already seen signs of this with the strong rally across global equity markets since the middle of October.
In the shorter term, there is the likelihood of continued market turbulence. However, for those willing to take a longer-term view, there are strong supportive arguments that UK equity valuations look attractive. The market is on a multi-year high discount to other developed markets and has a record high yield premium. Furthermore, as the majority of company earnings come from overseas, any earnings downgrades will largely be offset by the currency benefit of weak Sterling. Importantly, from an income perspective the Investment Manager does not consider there to be a material risk of dividend cuts, with the UK distribution ratio at a seven year low. That will compress as earnings expectations likely fall, but there is plenty of headroom for most companies to maintain their dividends. That income should be helpful to many investors in these difficult market conditions.
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The immediate economic, domestic political and geopolitical backgrounds look at least as challenging as anything experienced in the last several decades. In this context, investment markets are necessarily forward looking, worried less by the past, but focusing on how the future will develop. Domestic political stability had largely been taken for granted in the UK and it will be necessary in future to avoid further losses in confidence in the UK as a country in which to carry out business.
Inflation, which is driving the cost-of-living crisis, has arisen from a variety of sources, with each of these perhaps starting to be addressed. Some inflation stemmed from the disruption to supply chains caused by the pandemic and this has been easing. Central Banks have been increasing interest rates and the Bank of England has started to implement some Quantitative Tightening as loose monetary policy is unwound. This will help to reduce some inflationary pressure. Additionally, some indices of energy prices are now lower than in the first half of this year; if this trend continues it will be positive for consumers’ disposable income and also reduce inflation.
Valuation is a further indicator of expectations for future investment returns. The UK equity market has not been popular with international investors for a while, leading to the UK market standing at an undemanding valuation, both in absolute terms and when compared with many international markets. On the plus side the relatively low valuation and attractive dividend yield should give some good protection from current and future uncertainties.
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It is difficult to recall a time when the uncertainties permeating global financial markets have been greater or more varied. Yet despite the near-term gloom, Asia’s long-term growth prospects remain bright. With share price valuations now at historical lows in many regional markets, we share the Investment Managers’ excitement about the many opportunities now available to purchase interesting, world-class companies in various sectors across Asia, at particularly attractive prices.
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In our view, the past year’s sharp share price declines mean markets across the region now mostly reflect the deterioration in the economic environment and the many uncertainties and risks ahead. This view is supported by current valuations. The MSCI AC Asia ex Japan Index is trading at a price to book ratio of 1.25x, close to the previous historical lows seen in 2008 and 2016, and looking more deeply into the Index’s geographical constituents, valuations in South Korea, Hong Kong and China are also either close to or below their historical lows in price to book terms. India remains the sole market trading above its ten-year historical average valuation levels.
Despite the myriad of near-term uncertainties underpinning current low valuations in many markets, we stand by our conviction that Asian equities continue to provide attractive long-term investment opportunities. From a top-down perspective, Asian countries have large and growing economies, accounting for roughly 40% of the world’s GDP. Major structural and social changes will ensure the region continues to grow rapidly, with domestic demand supported by the increasing prosperity of Asia’s burgeoning middle class. Furthermore, the region is also home to many innovative and dynamic companies that are leading the world in a wide range of industries, including semiconductor manufacturing, healthcare, renewable energy, next generation automotive production and financials.
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The combination of rising interest rates, the strong US Dollar, currency depreciation and an increasingly fragile global economy will continue to create uncertainty in the months ahead, but Asia is starting from a better position than many developed economies in the West. A number of countries in South-East Asia are recovering after their post-Covid-19 re-opening, which should help to support earnings growth. The resilient performance of the equity markets in India and Indonesia is another source of optimism, and the Investment Manager is also seeing potential signs of recovery in South Korea and Taiwan as the stock markets in those countries recover from significant selling in the technology sector. In China, the economy should benefit from any action taken by the government to address flagging growth, such as further loosening of Covid controls and increasing fiscal support.
Whilst the headwinds experienced in the period are likely to continue to cause market volatility in the short term, it is important to note that this potentially creates some good opportunities to invest at more attractive valuations, and the longer-term advantages of having exposure to growing Asian economies remain very much in place.
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It would be easy to be pessimistic in view of the current uncertainty seen in markets around the world. There is no question that the global repricing of the cost of capital which has followed increased US interest rates continues to be a headwind. It is unclear when these moves will have had the desired effect on inflation but there are signs that we may be nearing the end of this tightening cycle.
In the past few months share prices have continued to adjust and in many cases now reflect the current economic reality and aggregate valuations for the region are trading at or below long-term averages. It is the case now more than ever that Asian markets will continue to provide opportunities for those who can identify the winners.
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Slowing global and weak Chinese growth, elevated geopolitical tensions around Ukraine and Taiwan and rising interest rates, combined with ongoing downward revisions to earnings, mean that headwinds for markets are likely to continue. However, some areas of the markets are starting to look more attractive from a longer term perspective having derated markedly.
Globally, consumption is under pressure as rising prices eat into real incomes. This, allied with the shift away from consumption of goods to consumption of services as the majority of economies open up post-pandemic, has seen the demand for goods falter. This in turn has started to see inventories accumulate across supply chains globally, leading to a fear that we will see a painful period of inventory adjustment on top of an already slowing global economy. From an Asian perspective, this is likely to have an impact on exports and from our portfolio’s perspective is most likely to evidence itself in the technology hardware sector. To an extent, markets have already started to discount this with technology names in both Korea and Taiwan already underperforming despite earnings holding up relatively well for now. In our view, valuations are now starting to factor in a slowdown but not yet a “hard landing” which, although not our base case, is a possibility. In general, the stocks we own in this sector are leaders in their area with high market shares and strong balance sheets on attractive valuations, so in our view should prove to be relatively resilient.
The other trend that the pandemic and Ukraine crisis have reinforced has been the need for increased self sufficiency. The need for diversified supply chains was something that the COVID crisis had highlighted, given the disruption the pandemic caused. With security of supply already a focus in areas such as semiconductor production, thanks to ongoing US-China tensions and the concentration of advanced manufacturing in Taiwan, the Ukraine conflict has also highlighted the vulnerability of nations to energy supply dependency. The recently concluded Party Congress in China saw President Xi mention ‘security’ 91 times in his opening speech (according to Bloomberg) compared with 55 mentions five years ago, reinforcing a view that China will continue to intensify efforts around ‘self sufficiency’ in core technologies and strategic industries. All this will likely lead to further localisation of supply chains and an era of reduced globalisation.
Geopolitics will continue to remain a risk, including surrounding Taiwan as highlighted by the recent visit by Nancy Pelosi to the island, which has resulted in increased tensions between the US and China. Other actions, such as the recent moves by the US to restrict China’s ability to purchase and manufacture high-end semiconductors, combined with the mid-term elections in the US mean it is unlikely we will see any meaningful relaxation in tensions near term and this is likely to continue to weigh on sentiment.
From an Asian perspective the biggest impact on growth is coming from the ‘zero COVID’ policy in China, where the lockdowns have had a severe impact on growth as well as exacerbating the weakness in the property sector. It is not clear how long this policy will remain in place but for now there is unlikely, in our view, to be any major volte-face in the near term. The recent Party Congress gave no indication when the policy might be eased and, whilst vaccination rates in China are high and comparable to most developed nations, a large tranche of the elderly still remain unvaccinated making it difficult for them to open up until this is rectified. Although a wholesale opening up is unlikely near term, it is likely that some more incremental easing measures occur. But in our view, China’s consumption and growth will continue to remain lacklustre as uncertainty over the path of COVID weighs on sentiment.
Given this, we have started to see a number of actions to loosen policy including rate cuts, easing of property purchase restrictions and increases in infrastructure spending and fiscal incentives. We consider it likely that we will see further easing measures but, whilst the ‘zero COVID’ policy remains, their impact for the large part is likely to resemble pushing on a string. Nevertheless, given how poorly the market has performed, together with the move to an easing bias there (whilst most of the rest of the world are tightening), as well as a tentative easing of the severity of lockdowns, there is potential for the market to experience better periods of performance. From our positioning perspective we have been very underweight China for some time and although we continue to look for new opportunities given the falls, we remain so and believe that the challenges that were there for the market remain.
Longer term – although Xi’s confirmation at the Congress as the Party’s General Secretary for his third five year term was not a surprise, the make up of the Politburo Standing Committee (and Politburo) was decidedly one-sided being dominated by Xi loyalists, further cementing his power within the Party. The lack of countervailing voices within the new PSC potentially heightens policy risk and likely means that many of the challenges brought about by increased regulation will persist, with the narrative around areas such as ‘common prosperity’ continuing to weigh on the potential returns of parts of the private sector. All this means one should not necessarily use a mean reversion argument alone when it comes to valuation.
Nearer term, although we are likely to see a stabilisation of the economy, it is hard for it to recover to pre-pandemic growth rates whilst the strict ‘zero COVID’ policy remains in place. The infectious nature of the Omicron variant means it is still likely we will see ongoing rolling restrictions. However, we could start to see a relaxation of some of the ‘zero COVID’ measures after the party congress but these are likely, in our view, to be incremental rather than wholesale. All this continues to mean we look for bottom up stock opportunities in China, consistent with our process, rather than move money into the market on a macro, top-down driven allocation.
India has been one of the best performing markets over the period, due not only to the economy benefiting from a post-COVID recovery, but also to domestic flows into the market in part on optimism about economic prospects following progress on reforms. Whilst on a long term basis the market continues to look attractive, valuations are now at extremes versus the rest of the region, which has led us to temper our position in some of the more domestic orientated names. Historically, the relatively weak external accounts have seen India suffer in a strong US dollar, strong commodity price environment and this could yet see domestic interest rates rise faster than expected, impacting valuations. Given the long term attractions of the market, we would likely use any correction in favoured names to increase positions.
Sector-wise, aside from information technology, financials remain an important overweight. Here banks, in our view, still remain attractive in aggregate on the back of benefits from rising rates and low valuations. However, given the backdrop of rising rates in most markets combined with slowing growth there is a risk that if rates move up faster than expected it could start to impact asset quality, offsetting the benefit of expanding margins, so we remain selective. Underweights are largely found in some of the more ‘defensive’ areas such as utilities, consumer staples and healthcare where valuations are generally, in our view, quite full.
While recent events described above do not paint a particularly optimistic picture, this has in part been reflected in market action with valuations today looking much less frothy than they did a year ago. Nevertheless, the US Federal Reserve being more aggressive on rates near term is clearly a headwind, given its near term impact on growth and earnings. However, this in turn should start to cap long-term inflationary expectations which will pave the way for lower rates at some point in the future. Until then, it is likely that we see further downward revisions to earnings and a period of inventory adjustment amongst companies to reflect the slower growth and hopefully put them in a position to start to grow earnings once more. Given overall aggregate valuations for the region are now trading at or below long-term averages, this does set up a more constructive backdrop for Asian markets next year, barring a global hard landing or a more extreme geopolitical risk event.
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Geopolitical tensions, elevated market volatility, and the fastest pace of central bank tightening in decades are meaningful economic headwinds contributing to an unusually uncertain environment at the moment. In Europe, inflation is being acutely felt as the Russia-Ukraine conflict has pushed gas prices to new highs, triggering a cost of living crisis. It seems probable that equity markets will continue to struggle until higher interest rates appear to be working and bringing inflation under control. Nonetheless, European equities continue to trade at a discount to global peers, providing attractive investment opportunities. It is likely that the macroeconomic environment may remain uncertain over the coming months.
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We started the year believing (like many market participants) that inflation would prove to be transitory. The sad events in the Ukraine and more recently the lockdowns in China make it highly unlikely that the high levels we are currently seeing will quickly revert to Central Bank targets. The positive aspect of equities, unlike bonds, is that there are companies and sectors that can still perform in inflationary environments and those are the companies which we have been increasingly investing in. For instance, companies with high barriers to entry and pricing power should be able to pass on inflation. Certain areas of insurance combine a positive exposure to rising bond yields and defensive business models. Companies who see demand greatly exceeding their potential to supply, such as the high voltage cable manufacturers, or those companies exposed to the electrification theme, should also find themselves well placed to raise their prices.
While it is difficult to predict when the current inflationary environment will end, historically European smaller companies have been one of the best performing asset classes globally, and we do not see the fundamentals that drove this changing. Innovation has powered smaller companies and will continue to do so long into the future.
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War in Europe, an acute energy and cost of living crisis, and lingering Covid-related supply chain disruptions have conspired to stoke the fierce inflationary forces we see today, constituting some of the most difficult operating – and therefore investing – conditions in a generation. The European Central Bank, having sought to protect against the worst of the Covid crisis, has been slow to react with tighter monetary policy but is now doing so, with both higher interest rates and the end of quantitative easing. Unlike a year ago, there is no longer talk of whether inflation is transient or structural – markets are now trying to assess how long it will take to get inflation under control, the length and severity of ensuing recessions, how long it will take to get back to long-term ‘core’ targets, and indeed whether these are even still relevant.
In addition to the macro headwinds, rising bond yields have prompted a fundamental reappraisal of valuations hitherto favouring rapidly growing companies. The style rotation we have seen in the leadership of our markets in the last twelve months has been extreme: from ‘growth’ stocks in the latter part of 2021, to ‘value’ stocks in the first half of calendar 2022, through to those with a ‘quality bias’ now that recessionary fears are rising.
While there are many sources for concern for investors, our Fund Managers make a strong case for a European equity market that has to a large extent already priced in a ‘normal’ recession. In the near term there could well be further tumult, not least as central banks test the resilience of the global financial system by reversing over a decade of loose monetary experimentation. But, on any longer-term horizon – for which the closed-end structure is designed – Europe now abounds with opportunities to invest in quality, cash-generative companies, which are able to pass through the scourge of inflation.
Most importantly, if as we think, the price of money does warrant a return to valuations based on realism rather than euphoria, then these investment opportunities come at attractive valuations.
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The investment landscape does not always develop in the way one, cautiously, argues that it might. Often, it has been our futile lament of the growth style’s dangerous dominance in equity investment; that is, the tendency over the last few years for all things technology, unprofitable and ‘disruptive’ to bulldoze through valuation levels that already made little sense to us. The market saw heroes where we saw literal zeroes. Other times it has been the bemusement at perfectly good companies bestowed with the hallowed ‘bond-proxy’ label, as the market sought a narrative to justify ever-higher multiples. That bemusement has not always been benign, not when it has ultimately forced our hand. Could a style-agnostic, pragmatic, valuation-conscious team of European stock-pickers really own no shares at all in benchmark titans, solely on the basis of valuation? That would be exactly the kind of dogmatic investment approach that we eschew. The pause for reflection then, before once again putting pen to paper, serves to remind us: never dig in.
Inflation is real
This time around we can claim some consistency between what we said last year and what we see today. Inflation has proven to be more durable, as we suspected it might, bringing with it a central bank retreat from the monetary largesse of the past decade. Accordingly, being valuation conscious has served us well relative to a predominantly ‘growthy’ peer group. We believe this should continue to be the case. However, we could not have foreseen the contribution to inflation from Russia’s invasion of Ukraine, nor the aggression with which central banks would then proceed to tighten financials conditions once they finally conceded and retired the ‘transitory’ trope. The global financial system has been forced to go ‘cold turkey’ in monetary rehab, by the very institutions that spent half a generation enabling our growing addiction to cheap money. This combination of factors – representing an unprecedented squeeze on household finances through higher energy, food and finance costs – has largely put paid to the ‘consumer V-shape’ thesis we detailed last year.
People simply will not have the means to let loose in the way we all hoped we would after our long period of enforced confinement.
A responsible reckoning
Most worryingly of all perhaps, ‘ESG by exclusion’ appears to have neglected a primary duty of active management: portfolio construction. The losses inflicted in both bond and equity markets have been severe and highly correlated, such has been the dependence of almost all asset valuations on the continuation of a historically loose and unconventional monetary policy regime. Many ESG-labelled funds have faced a similar performance fate because, in essence, they were ‘growth’ funds with a trendy label. We are not so sure investors were fully aware that such a rate-sensitive risk profile was inherent in their investments. There is also the issue of ‘greenwashing’ – given the regulator’s interest in the activities of many of these funds that purport to be ‘doing good’, we expect this to change. 2022 is therefore likely to prove a pivotal year in the development of responsible investing. We welcome this.
It does not feel excessive to suggest that the war has jolted us all out of this fallacy, whether it is the practitioners who are frantically re-writing their investment policies to allow ownership of oil companies on the basis that they are critical energy enablers (the market-leading share price performance of these stocks in 2022 is surely mere coincidence…), or those passively endorsing the movement because that was simply the way the industry was heading. Asset management is often a fashion industry; growth investing and ESG investing were the future. We take the view that they are now the past, at least in their current guise. Strand 4 of our Investment DNA is ‘believe in cycles’. The cycle that enabled the investing fashions and the many excesses of the last decade – the price of money – has turned.
The era of energy insecurity
We believe there is another profound cycle underway, this one within the oil and gas industry. A lack of upstream investment in oil and gas extraction – for which ESG damnation of these businesses is partially responsible – has tightened the market. OPEC is firmly back in control and its leader, Saudi Arabia, appears committed to protecting a price of $90 per barrel. The European-listed oil companies we hold in size are exceptionally cheap on 15-20% free cash flow yields. This provides us with a significant valuation margin for error, all the more important when the price of money has increased. Of course, this is a sector with a reputation for profligacy. And deservedly so. You don’t have to go back too far in history to find evidence of value-destructive behaviour through misallocations of capital. So, what has changed this time? Through our meetings with the management teams of each of our investee companies, there is a resounding consistency: unwavering capital discipline. Those prodigious free cash flows are largely being delivered directly to shareholders through dividends and buybacks.
The risk of material windfall taxes is limited in our view, as these are globally diversified businesses across many tax jurisdictions. They have little appetite to grow upstream volumes when the stock market doesn’t reward it and when government, media and various climate movements vilify them for doing so. Change is often borne of pain and here we see a strong parallel with the listed mining sector’s transformation over the last six years: near-death experiences, equity raises and dividend cancellations were followed by a period of rapid deleveraging and generous returns to shareholders, a new-found capital discipline that persists even to this day. A cursory glance at the share price chart of any major mining company is sufficient to see just how lucrative that journey has been for shareholders since 2016. Likewise, from the dark days of negative oil prices in 2020 and widespread public condemnation, we believe a new, more disciplined listed oil sector emerges, one which incidentally nurtures globally significant renewable energy portfolios. It is interesting to note that since 2000 the oil sector peaked at almost 14% of the global equity market in 2008, then troughed at 2.5% in 2020. It is currently back to only 5%. As a result of both the monetary cycle and the oil sector cycle, we believe we are in the midst of a multi-year rehabilitation of oil majors within global equity portfolios.
There are more reasons than ever to dismiss Europe as a region worthy of equity investment. And dismissed it is. We have never known it to be more disliked than it is now, which is quite a feat. The constraints to doing business we have referenced since the onset of Covid are now even more acute due to Russian aggression next door. Consumers face a tougher set of disposable income choices than they have for decades, with the further possibility of winter blackouts leaving households without heat and power and our industrial complex compromised.
Added to this, we cannot rule out the potential for an accident in a financial system increasingly under stress due to: 1) the speed of retreat from the free money era, and 2) the multiples of debt now in existence compared to the last time interest rates reached these levels. The tantrum caused in UK gilts and sterling by the fiscal ill-discipline of the uniquely short-lived Truss premiership, may well just be a dress rehearsal for something bigger on other shores. It goes without saying that such an event would be bad news for most assets in the short term.
And so, taking a dispassionate view of what is in front of us today, while acknowledging the many short-term tangible and tail risks, we can only conclude one thing: Europe is too cheap. Not all of it, of course, certainly not many of the darlings of the low interest rate paradigm, where investors appear to be in denial as to just how seismic the shift in the valuation regime really is. Muscle memory exerts strong influence in markets and we expect many investors to keep returning to the familiarity of what made them warm and cosy before. Eventually they will learn new behaviours. Where we see opportunity is in the sectors so brutally jettisoned that they already price in a ‘normal’ recession and worse in some cases: quality, cash generative champions across energy, materials and industrials, with strong management teams and, most importantly, pricing power. This latter point is critical for us since we continue to believe inflation will settle at structurally higher rates than pre-Covid, driven by socio-political and geo-political factors; labour will command a bigger share of the economic pie as the Western world ‘onshores’ critical aspects of industrial supply chains, energy included.
Strand 3 of our Investment DNA is ‘believe in change’. We believe we are seeing profound change: in inflation, in the price of money, in the energy complex and ultimately in asset valuation. Europe is not easy to love, but it is not broken. And it is now exceptionally cheap in pockets. The investment trust structure offers shareholders the perfect vehicle to look through the short-term tumult, to the medium-term value that is increasingly on offer. As your Fund Managers, it is our duty to be resolutely focused on that opportunity, regardless of how tempting it is to become intoxicated by the bleakness of current public discourse.
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We enter the second half of the financial year with domestic demand picking up due to reduced pandemic restrictions and foreign visitor flows booming once more. Inflation is still far lower than other developed markets and there is a growing likelihood of nuclear plant restarting. The Bank of Japan has started the process of monetary policy tightening confirming the end of the depreciation cycle. Against a backdrop of global growth slowing and rates likely to continue to rise for a prolonged period, the Company maintains its focus on growth companies that have a sustainable earnings outlook. Political stability, despite the assassination of the former Prime Minister, Shinzo Abe, has supported continued government focus on the stimulus packages helping drive growth. The Prime Minister, Fumio Kishida, has now been in office for just over a year and continues to focus on the “Kishidanomics” policy of spending on Japan’s digital transformation, domestic infrastructure projects and on tackling the cost-of-living crisis. Pent-up demand is helping to drive consumer spending higher and there have been positive signs of sustained wage price increases filtering through corporate Japan, given the competitive labour recruitment market. Having reopened their economy at a slower pace than other countries, Japan is now seeing a positive impact from inbound tourist and business demand. Whilst the pressures from the 40-year lows on the Japanese yen against the dollar still cause concern, corporate governance changes continue to have a positive effect on driving company share buybacks, rising dividend levels and healthy domestic M&A activity.
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With the latest national headline CPI for September at 3.0% YoY – unchanged from August – headline inflation in Japan has been gradually rising, though remains low compared to other developed economies. Moreover, the GDP deflator – – a measure of general inflation in the domestic economy – remains negative. The Bank of Japan appears to be waiting for a broader confirmation of inflation before looking to raise rates.
We saw inbound tourism start to return after entry restrictions eased on 11 October, which was enough to favourably impact monthly same-store trends at department stores and other retailers. While a full return to pre-COVID tourism levels may depend on the increasingly remote expectations of border reopening in China, the weak currency is clearly having an impact on Japan’s attraction as a destination.
While a shortage of workers in the hospitality industry may constrain capacity in the short term, this does bode well for employment. The September job offers to applicants ratio increased from 1.32x in August to 1.35x, and retail sales (also in September) rose 4.5% YoY compared to the prior month’s 4.1%. The Kishida government has also announced a fresh economic stimulus package worth JPY 39tn to help offset the impact of the weaker yen and rising prices of imports, particularly for energy. We remain encouraged with the outlook for the Japanese domestic economy and corporate earnings.
Although inflation remains the key concern, we note that many commodity prices are now lower than their peak earlier in the year. The recent bounce in markets and in the Japanese yen, triggered by a more moderate print for US inflation, suggests that the weight of market expectations remains to the downside as participants start discounting weak global growth.
Japan’s underlying economic and corporate fundamentals remain attractive. Japanese companies are cash rich, allowing continued improvement in shareholder returns, and have significantly reduced costs and increased operational efficiency during the COVID pandemic. Valuations are also relatively attractive in Japan with the Topix Prime Index forward PER on 13.3x, PBR on 1.15x and an average weighted dividend yield of 2.56% as of 31 October.
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The portfolio is constructed entirely on a stock-by-stock basis as we seek out the best, most attractive companies. Nonetheless, certain themes tend to underpin our investment decisions. In fact, COVID-19 accelerated several tech-based trends in which we were already invested, strengthening the appeal of sectors such as online shopping and gaming and cloud computing. However, Japan remains well behind most other advanced economies in these and many other areas, leaving plenty of scope for such trends to continue developing over the coming years. For example, the penetration of e-commerce within the Japanese retail market is just over 10% and remains much lower than in China, the UK, South Korea or the US.
Standardised cloud-based software for businesses is another digital theme. Historically, many Japanese companies have used internal software solutions, but now that the first generation of software engineers is reaching retirement age, there is an imperative for businesses to switch to standardised software solutions. Japan’s poor demographics will add impetus to this as a structural shift over time.
Deglobalisation is another trend gathering momentum. The pandemic, and subsequent events such as widespread supply chain shortages, the conflict in Ukraine and mounting US/China trade tensions, have increased companies’ desire to move production nearer to end customers. With wage inflation now an issue in the US and other markets, businesses establishing new production plants and warehouses have a stronger incentive to incorporate factory automation into these facilities wherever feasible. Japan is fortunate to be home to some of the world’s leading automation companies.
Even before the outbreak of hostilities in Ukraine, there was already a clear need for Japan, along with many other Asian and European countries, to shift its energy mix away from a heavy reliance on imported fossil fuels. The war only highlighted the need for Japan to speed up its transition to renewable energy sources, and to make faster progress towards realising its commitment to reduce carbon emissions to net zero by 2050.
Japan is only at the beginning of its journey towards digitalisation and renewable energy, but these trends are already spawning many exciting new businesses, especially in the small and mid-cap space. Such growth-oriented companies are set to gather momentum over time and provide resilient, long-term sources of returns for investors.
Japan’s near-term economic outlook has improved since our last report. With the vaccine programme having been rolled out effectively, the Government has recently lifted the last of its Covid restrictions and the country is now fully reopened to foreign tourism. Furthermore, exporters will receive a fillip from the yen’s recent depreciation. The yen/dollar rate was c ¥136.9/$ on l December 2022, thanks to the wide disparity between US and Japanese interest rates. While the US has rapidly increased rates, the Bank of Japan (BoJ) has so far maintained an ultra-loose monetary policy stance.
Conversely, the weak yen makes imports more expensive – a particular problem for Japan as it has almost no natural resources, so it must import energy and other commodities. The weaker yen has increased the cost of these imports, adding to price increases triggered by pandemic-related shortages and the war in Ukraine. As a result, inflation has begun to rise in Japan, but remains lower than in most other developed countries.
Despite a tight labour market, wage growth remains low and there has been no significant increase in property rents. While we do not expect these developments yet to elicit any change in BoJ policy, we continually monitor available data and will reappraise our views if circumstances change. In particular, we are aware that policy may shift with the likely appointment of a new BoJ governor next spring.
Improvements in Japan’s corporate governance continue, with more companies focused on improving shareholder returns. The country is in the process of a major technological transformation that should deliver growth and productivity gains over the medium term. Japanese equity markets are more vibrant than some investors appreciate, with many new and interesting listings on the Tokyo Stock Exchange each year.
Thus, Japan offers a strong environment for the kind of dynamic, quality businesses in which we invest and Japan is an attractive market in which to build a differentiated portfolio. This is particularly true for active, bottom-up investors like us, supported by a large, Tokyo-based team of researchers.
We are optimistic about the long-term prospects of our portfolio holdings and will continue our search for exciting companies ‘at the heart of Japan’s new growth’ and those capable of thriving regardless of the near-term macroeconomic environment. Most importantly, we remain confident that our investment approach will ensure the Company continues to deliver outperformance over the long term.
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Global emerging markets
(compare global emerging markets funds here)
It is likely that economic and market turbulence will continue for some time and the risk of further political and economic shocks remains elevated, not least as Russia’s war on Ukraine continues. The effects of high inflation, the resulting increases in interest rates and strains on currency exchange rates are foremost in many investors’ minds. Uncertainties also continue in China where growth and sentiment are being impacted by the continued zero-COVID policy of the government which is currently resulting in widespread social unrest. We will continue to focus on the Chinese government’s “common prosperity” agenda which has potential effects on the profitability of some companies and on overall economic growth. Geopolitical concerns, and particularly relations between China and United States, also remain a key issue.
At the time of writing the value of the US dollar against a basket of other currencies has moved down from the high levels reached in September and equity markets are showing some signs of recovery. Commentators often say that markets attempt to look 12-18 months into the future and it is possible that they are beginning to reflect an eventual economic recovery. Our aim is to produce attractive returns over the long term. Countries making up the emerging markets currently contribute a large proportion of the world’s economic growth, and this appears likely to continue. The markets in which our Investment Manager seeks opportunities have many advantages, including relatively young and growing populations, growing wealth and expanding economies. Further, many of the companies in which we are able to invest are highly innovative, and in some cases have world leading products and are able to leapfrog their competitors in developed markets. Your Board remains optimistic for emerging market equities over the long term.
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Many of the developed markets are experiencing soaring inflation and the spectre of recession. As governments and central banks grapple with the challenges brought about by the COVID-19 pandemic and the effects of the Russia-Ukraine conflict, our diverse and uncorrelated investment universe looks ever more attractive.
We have long extolled the diversification benefits of the frontier markets. This relative economic stability and, in many cases, countries which are in the growth phase of their economic cycles, in our view further strengthens the investment case for exposing an investment portfolio to the frontier markets. We believe that, collectively, these factors and attributes provide the long-term shareholder with a compelling investment opportunity.
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The world today is a drastically different place from when we last wrote this report. If we gave you two year-on-year inflation figures of 8% and 3% at the start of 2022 and asked you to tag them as Vietnam vs Germany, you would likely laugh at a rather obvious question. Alas, the macro environment today has turned a lot of conventional wisdom and common knowledge on its head. We are seeing most of the developed world edge towards double digit inflation while many emerging and frontier markets generally have trundled along with much more mundane price increases. Whilst the inflation seen across the developed world is the highest in seven decades, the majority of frontier markets are just experiencing a normal economic cycle, a situation that is pretty remarkable.
To understand the impacts of the current high inflation environment, we should split frontier markets into three groups. Firstly, there are a number of countries across frontier markets where inflation remains muted. The meteoric rise in energy prices that we have seen across Europe has not been reflected globally. For many of the countries where we invest, energy prices have seen little change over the past year.
For energy exporting countries, the current boom in energy prices offers them the fiscal resources to support their domestic populations and protect them from the global increases in food and other commodity prices. Inflation in Saudi Arabia is currently at 2.9%, Indonesia at 5.9% and Vietnam at 3.9%. These countries are not currently seeing and are unlikely to see inflation outside their normal expected levels.
Secondly, there are a number of countries which are currently experiencing high inflation. However, in stark contrast to the western world, we have seen governments and central banks take dramatic action to try to bring price levels back under control across these countries. To put this in historical context, in Chile, the policy rate of 10.75% is the highest since 1996 (with the exception of a three month period in 1998). Interest rates in Hungary are at a 19-year high and in Colombia, at a 14-year high. Inflation levels are unprecedented, but so has been the stock market reaction to the extent where we now believe these levels present attractive yield opportunities and could start to drive flows into the region.
There is a third group of countries where inflation is currently very high, policy approaches are either unorthodox or significantly behind the curve and we remain concerned about their future economic trajectory. Luckily these are few and far between within the frontier market universe.
Regionally, the Middle East has been the strongest performer, with Qatar, Saudi Arabia, the United Arab Emirates (UAE) and Kuwait all delivering positive returns. The region has been buoyed by elevated oil prices following Russia’s incursion into Ukraine. The Gulf Cooperation Council region is currently on track to report the highest current account and fiscal account surpluses for nearly a decade.
In contrast, Eastern Europe has had a challenging year. While the year started with optimism about a post COVID-19 recovery and disbursement of EU Recovery funds, Russia’s invasion of Ukraine marked a drastic turn of events for the region. In addition to the tragic loss of life, it has also led to a significant disruption to exports, higher energy prices and import bills, and cast a large cloud of uncertainty over geopolitical stability for the entire continent.
In Southeast Asia, the story is more nuanced. On the one hand, Indonesia and Malaysia have benefited hugely from commodity price strength as well as the accelerating tourism recovery. On the other hand, in Thailand and the Philippines we are concerned that the current high inflation will cause their respective central banks to raise interest rates substantially whilst economic recovery remains relatively weak.
In Latin America, performance has been strong, albeit volatile, given the commodity-heavy nature of the region. Chile has been in the news for constitutional reform for most of this year. It culminated in early September 2022 with voters overwhelmingly rejecting the new changes. We believe this is a positive outcome for the market but expect political noise to continue.
Notes from the road
One of our highlights of the past year was our ability to get back out on the road and meet the management of the companies in which we invest, as well as government officials, economists and other parties with local knowledge.
We travelled to Southeast Asia over the summer. In Indonesia, we see clear activity recovery and a pass-through of higher commodity prices into domestic recovery as well as external accounts. In addition, long-term structural improvements in tax and labour market legislation bolster our positive outlook towards the country. We are also seeing an improvement in foreign direct investment after a long period of underinvestment. In Malaysia, one of the key themes is supply chain recalibration away from China. There is a nascent, but interesting, start-up ecosystem emerging in the country.
On the tourism front, Malaysia has significant room for recovery, particularly if and when China’s borders re-open given China made up 12% of all tourist arrivals in 2019. For Thailand, the outlook has been marred to some degree by inflation, currency weakness, and unorthodox monetary policy. 28% of Thailand’s tourists came from mainland China in 2019 and the lack of recovery has weighed on the country’s economy.
We also travelled to the Middle East, namely Qatar and Kuwait. They continue to be relatively attractive in the current environment of oil price tightness. In August, we travelled far south to Colombia, Peru and Argentina. While we have not had exposure to Argentina for the last few years, we are excited by the work that Argentina is currently undertaking to increase its pipeline capacity for oil exports, seeing a significant increase in export earnings as a game changer for the country.
Most recently, we visited Poland and Hungary. We prefer Hungary on a relative basis. The extent of corrective actions taken by the central bank over the past nine months is unprecedented, with policy rates now a very punchy 18%. We will be watching closely how inflation fares (currently hovering close to 20%) and how they close the fiscal gap. In Poland, valuations are looking very attractive, with the market currently trading at similar levels to where it was in 2003.
We believe that frontier and smaller emerging markets are very well-positioned as global inflation starts to peak out. We have started seeing early lead indicators of this with circa 30%+ decreases in memory chip (DRAM) pricing and shipping freight rates. That said, many countries in the developed world have seen more than two years of excess money creation which is only just starting to drain from the system. That adjustment period still has some ways to go. In contrast, countries in our investment universe have shown commendable fiscal and monetary discipline which creates relative opportunity.
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Equity markets are likely to continue to be volatile over the coming months, as investors pay attention to economic growth data and any signs that inflation may be peaking, whilst central banks remain steadfast in raising rates, even as the global economy slows. Whilst our investment region will undoubtedly be impacted by these global trends, there are reasons to be positive.
High energy prices have significantly strengthened the fiscal backdrop across Middle Eastern economies. Many of these countries are now forecast to experience strong economic growth whilst at the same time benefitting from low inflation, a combination that is extremely rare in the current climate.
Similarly, there are a number of exciting stock specific opportunities in South Africa, particularly amongst companies with a role to play in the energy transition as we move towards a greener planet. Inflationary pressures are less severe in the region than in many other parts of the world, and the monetary policy backdrop is stable.
The outlook in Eastern Europe is understandably less rosy, given the proximity of the region to the ongoing conflict. Stock market valuations are largely reflecting a deterioration in investor sentiment, which, over the medium term, may provide good opportunities.
These factors should help contribute to the increasing attractiveness of emerging EMEA equities.
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Following the events in Ukraine, oil and gas prices have seen significant volatility, with oil rising as high as $120 a barrel before falling back below $100. This has served to push energy security up the agenda, most notably in Europe, which received approximately 40% of its piped natural gas imports from Russia prior to the conflict. This situation has created both areas of concern and opportunity. Eastern European nations reliant on this energy supply are now subject to price pressures in the near term, and face a supply enigma over the medium term as global supply lines are redrawn. We believe this will lead to governments meaningfully reducing their exposure to Russian energy, replacing this supply via significant investment into renewable infrastructure.
Supplying the Green Revolution
Climate change and the need to transition toward a world less dependent on fossil fuels remains one of the most critical issues of our time. While we continue to see an increased demand for electric vehicles and the associated charging infrastructure as the most tangible examples of shifting consumption patterns, what is often overlooked are the commodities required to support this move to a greener society. Furthermore, a lack of investment in supply has led to growing imbalances within critical commodities such as copper, nickel, platinum group metals (PGMs) and aluminium, all of which are projected to hit supply deficits following declines in inventory levels. This is especially relevant given the amount of steel required for an offshore wind farm, which is roughly four to five times greater than that required by an onshore facility with the same gigawatt generation capacity. Electric vehicles are another example, requiring significantly more copper relative to a standard internal combustion engine vehicle. We believe this creates a unique prospect for these commodities, as the increase in investment is set not only to benefit the volume of exports of these metals, but also sustain high prices as the world wrestles with limited supply.
A renewed vigour and focus on renewable energy infrastructure offers a wealth of benefits for global commodity producers. South Africa finds itself in a unique position as an enabler of the energy transition via its access to a broad range of key metals.
Middle East – Emergent Economies
Markets across the Middle East have been some of the strongest performers globally this year, as they have benefitted both from high energy prices and the continued reopening of their economies to the world. This has seen their representation in major indices rise, whilst a burgeoning IPO market is broadening the investment opportunity and deepening local capital markets. The region also benefits from a strong fiscal outlook, low single digit inflation, and a reform agenda, all of which should boost consumer confidence and increase the appeal of its investment case. Furthermore, demand for their exports should not only improve the spending power of its consumers, but also allow for continued investment into infrastructure and diversification of their economies away from oil, helping support long term stability.
Saudi Arabia is centre stage of these developments. Saudi’s “Vision 2030” programme has set out an ambitious agenda to reduce dependence on oil, and diversify its economy. This reform framework is creating a number of exciting opportunities in the privatisation of state assets, alongside a growing domestic base of entrepreneurial companies. More specifically, government initiatives such as “Sakani”, that offers subsidised mortgages for first time buyers to own their first home, and the “Wafi” off-plan sales and rent programme, have driven the demand for affordable homes and have played a key role in facilitating home ownership for Saudi nationals. This has opened unique opportunities within the banking sector for instance, where mortgages have accelerated.
In the short term, markets are likely to remain uncertain as investors closely monitor developments in Ukraine, inflation, and the broader global economic outlook. Looking ahead however, we believe there are a number of compelling opportunities across the emerging markets of Europe, the Middle East and Africa (EMEA).
Markets across the Middle East have been some of the strongest performers globally this year as they have benefitted both from high energy prices, and the continued opening up of their economies. This has seen their representation in major indices rise, whilst a burgeoning IPO market is broadening the investment opportunity. Interestingly, Middle Eastern markets remain significantly underrepresented within investor portfolios, which – in combination with the economic and structural tailwinds mentioned above – help increase demand across the region’s equity markets. The region also benefits from a strong fiscal outlook, low single digit inflation, and a reform agenda, all of which should boost consumer confidence and increase the appeal of the investment case.
South Africa presents another interesting investment opportunity across the EMEA region, primarily because of its access to a broad range of metals. High commodity prices have helped push the current account balance into surplus, and corporate investment has rebounded significantly. This should help provide broader opportunities to invest, as real earnings growth (excluding resources) is still below pre-COVID levels, which suggests there is catch up potential. Whilst we remain vigilant about the potential for social unrest, ongoing structural reforms by the government are encouraging and are likely to support rising private investment and higher employment levels.
Finally, whilst markets across emerging Europe remain most exposed to the war in Ukraine, looking further ahead, we believe opportunities exist as the region pivots away from Russian gas. This is supported by large EU infrastructure projects, such as the European Green Deal and NextGen EU funds that are set to bring billions of euros to EU member states to help transform their energy systems. There is also an opportunity for the region to take advantage of nearshoring trends, where companies are bringing manufacturing closer to customers. Certain EU member states are well placed to provide lower cost skilled labour, strong regulatory protection, and crucially, a lower delivery time for the end consumer due to their closer geographical proximity.
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(compare Chinese funds here)
After hitting lows in October 2022, Chinese stock markets have made up some lost ground, following President Xi’s meeting with President Biden at the G20 session, indications of a gradual relaxation of China’s ‘zero-COVID’ policy, and China’s easing of its monetary and fiscal policies.
As a Board, we believe markets are likely to remain volatile, as long as China’s ‘zero-COVID’ policy is in place, and risks remain of increased COVID cases once this policy ends. Other challenges, ranging from the uncertainties in the Chinese property market and the financial health of the nation’s regional governments to global supply chains and China’s relations with Taiwan and the US, may also impact short-term performance.
Nevertheless, we share our Investment Managers’ optimism about the long-term prospects for the Chinese economy, and the opportunities that this will provide the patient investor.
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The past year has been an especially challenging one for global equity markets for several reasons. Inflation pressures kindled by the COVID-19 pandemic, including supply shortages of electronic components essential to the production of electric vehicles and a wide range of consumer goods, were fuelled by Russia’s invasion of Ukraine, which drove up energy and other commodity prices. The determination of the US Federal Reserve and other central banks to quash inflation with a series of aggressive interest rate increases and hawkish forward guidance raised the spectre of recession and global equity markets fell sharply. The valuations of long-term growth – so-called long duration – stocks in the technology and related sectors were hit especially hard.
The Chinese markets were not immune to these developments, but investor sentiment was further damaged by several other adverse developments unique to China. Key amongst these was the sharp deterioration in China’s growth outlook. China’s GDP is now expected to rise by only 3% in 2022, less than half its growth rate over the past few years, due partially to the government’s pursuit of its ‘zero-COVID’ policy. Unlike most countries, which have opted to live with the virus now vaccines are widely available, China has persevered with strict prevention measures, including lockdowns, to eliminate outbreaks. These actions severely curtailed economic activity in many regions, and it is uncertain when the government’s approach will relent. These actions severely curtailed economic activity in many regions during the review period. More recently, however, the government has relaxed its COVID policies, which should lead to more normalisation in 2023.
The review period has also seen a significant correction in China’s residential property market, sparked by government restrictions on borrowing by developers and home buyers. New home sales have fallen 30% in the past year. This sector accounts for about a quarter of China’s economic output, so this sharp decline is also weighing on near-term growth prospects.
Uncertainties about growth and the near-term prospects of the property sector have been exacerbated by mounting geo-political tensions between China and the West, and by questions about the implications of the expected appointment of President Xi to an unprecedented third term in office. As a result, even though Chinese inflation pressures have been limited, and the authorities are now easing both monetary and fiscal policy, China’s stock market sustained heavy losses over the review period.
We expect a lot of the macro headwinds discussed above, in particular the property sector slowdown and the government’s ‘zero-COVID’ policy, to linger in the short term. However, the Chinese authorities are likely to continue loosening monetary and fiscal policy in an effort to ease pressures on the property sector and to counter the disruptions caused by their stringent COVID policies. These measures will take time to feed through to the real economy, as consumer and business confidence, and activity, will not recover until the COVID restrictions are terminated and some level of normality returns to daily life across the country.
Despite the negative developments over the past year, we remain optimistic about the long-term prospects for the Chinese economy, which will continue to be bolstered by the strong entrepreneurial ethos of China’s private businesses and by growing demand from the country’s burgeoning middle class. Furthermore, the government remains determined to ensure the continued upgrade of Made in China, a government initiative intended to make the manufacturing industry more advanced. It will also continue its pursuit of carbon neutrality and greater self-sufficiency, as mentioned above. These efforts should underpin sustainable growth and productivity improvements over the medium term. As such, in our view, Chinese equities demand a meaningful allocation within any fully diversified global portfolio.
Current depressed valuations suggest to us that the deterioration in China’s economic outlook and other potential risks and uncertainties discussed above are now fully discounted by the market. So now may be a particularly good time to invest in this market in order to benefit from the country’s still positive long-term growth prospects. This view is supported by valuation metrics. Our proprietary, five-year expected return model, as well as familiar measures such as price-to-book (P/B) and Price Earnings (P/E) ratios, have all reached historical lows, suggesting that a sustained recovery in Chinese equity prices is likely soon.
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Given persistent concerns over a global surge in inflationary pressures and mounting fears of a recession, volatility across most asset classes remained elevated – Chinese equities were no exemption. During the reporting period, Chinese economic growth continued to face multiple headwinds; notably the negative impact on demand and activities resulting from the [zero-COVID policy (ZCP)], the lingering weakness in the property sector, despite stimulus measures from the government, and the threat of ongoing geopolitical tensions. Unlike most major economies though, benign inflationary pressures in China have enabled the People’s Bank of China to maintain a more accommodative monetary policy stance versus other central banks. From an economic perspective, China’s policy and earnings cycle is perhaps at least one cycle ahead of other major economies; and I believe this factor, juxtaposed with current undemanding market valuations and the country’s long-term growth drivers, should not be ignored despite the market volatility we have experienced.
We have recently seen extreme market reactions following the conclusion of the 20th Party Congress of the Communist Party. Whilst the market appears disappointed by President Xi not nominating a successor and the make up of the seven members of the Standing Committee of the Politburo, neither outcome should have come as a major surprise to market participants. Additionally, it is difficult to point to any obvious policy changes as a result of this outcome. While national security and social equality are clearly important for Beijing, I believe that economic growth also remains a priority, as laid out in the mid-term economic goals which imply a doubling GDP per capita by 2035 (as mentioned at the 20th National Party Congress on 17 October 2022).
With this backdrop, self-sufficiency and import substitution will continue to be major themes in the coming years. Recent US regulations limiting the sale of advanced semiconductor chips/chipmaking equipment used in Artificial Intelligence and supercomputing to Chinese companies have made headlines globally. I continue to monitor these developments and the impact they could have on various industries and companies. I believe this could accelerate the development of domestic industries and supply chains in China, a trend which is clearly supported by the government. During the same period, the rapid pace of innovation continues, which combined with the domestic substitution trend and market consolidation stories, has driven a significant weighting in industrials in the portfolio.
Meanwhile, I believe the peak of new regulatory reforms, particularly in China’s internet space, is now behind us. The Chinese authorities have now laid out the framework around areas such as anti-monopoly, data protection, data sharing, and cross-selling within an online eco-system. The increasing visibility around the regulatory landscape should result in further clarity around the earnings outlook and add support to valuations in these sectors.
The impact of China’s ZCP has taken a toll on the economy as well as on market sentiment. While China’s new leadership unsurprisingly made no concrete shift from the ZCP, and while we are witnessing targeted lockdowns again, we believe the direction of travel in the ZCP is positive. We are already seeing some nuanced relaxation and improvement in areas such as the shortening of quarantine times and the adoption of a standardised approach across the nation. I do not think we should underestimate the risks from China’s COVID policy and can expect that the short-term outlook for the consumer sector will remain tough; however, if we see gradual tweaks, this could underpin an economic recovery as we have seen in other countries following the loosening of restrictions. Household deposits have grown significantly since the beginning of the pandemic, and this has the potential to be released in increased spending with some normalisation after the relaxation of the ZCP.
Ongoing weakness in the property sector has been another drag on growth for the economy. Year to date property sales through September are down 30%. Some private property developers are in financial difficulty, defaulting on debt and delaying project completions. The mortgage boycott in July 2022 further heightened investors’ concerns over the property sector. We are closely watching the potential systemic risks. While the credit risk potential for mortgages remains quite manageable in my view, we need to keep an eye on the banks’ exposure to private developers. We have increasingly seen supportive policies to tackle these issues, including government funding to complete unfinished projects, tax cuts etc. While we also believe that keeping property prices affordable remains a priority as part of general common prosperity goals, we believe we will see more meaningful supportive measures to stablise the sector. I expect that while private developers will continue to be challenged, the stronger state-owned developers with sound balance sheets are poised to weather this period of uncertainty, and will be able to gain significant market share as the sector consolidates – think of it as a flight to safety to the better managed developers.
In terms of earnings, while revisions, on the whole, continue to be down, we saw some positive signs across several sectors. Fundamentally, when looking at our proprietary research sectoral views for September 2022, we saw downgrades in industries such as jewellery, autos, cosmetics, agriculture, healthcare and building materials as sporadic COVID outbreaks and a weaker macro environment continued to weigh on fundamentals. However, looking at sector performance, key upgrades were in advertising and renewables, with downgrades coming from data centres, cosmetics, agriculture building and materials. So, valuations have become attractive for some sectors whilst others are not yet seeing negatives fully priced in. Near-term fundamentals generally remain tepid, but I believe this is more than factored into what remain very attractive equity valuations. We continue to be very focused on sectors that will benefit from policy support, such as those in renewable energy, semiconductors and infrastructure related sectors. However, these themes are well-known by the market and so often trade at stretched valuations. Therefore, stock picking is key.
Some commentators have suggested that the consolidation of President Xi’s power and the make-up of the Politburo Standing Committee mean policy going forward will focus squarely on social issues, i.e. the focus on “common prosperity” of recent years, and that growth policies and innovation will take a back seat. I believe these concerns are misplaced. It is worth highlighting that, despite the Congress delivering no overall change, policy tweaks are ongoing: from the move away from full city lockdowns to the potential to reassess policy, if the World Health Organisation amends its overarching view on the virus. Hong Kong’s recent change in approach also bodes well for improvement. The significant impact of lockdowns on the economy are clear and should be a strong incentive for change. I remain of the view that economic expansion remains a priority and we will see increasing measures to spur growth both from the authorities’ fiscal and monetary stance. Key economic meetings in the months ahead, starting with the Central Economic Work Conference in December 2022 are going to be closely monitored.
The resilience of Chinese private companies should not be underestimated. I have been encouraged by the pick-up in the number of companies taking themselves private and the record level of share buybacks taking place this year, which attests to the appeal of current undemanding valuations.
As highlighted upfront, current market sentiment is probably the worst I have ever seen it, driving valuations to extreme levels, but I have no doubt this is creating great opportunities to add value on a medium-term view.
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(compare Indian funds here)
As Benjamin Franklin once said, “nothing in life is guaranteed except death and taxes”. As long-term investors in Emerging Markets, we would add volatility to this. However, with every period of volatility comes opportunities and most often it allows you to invest in great franchisees at more attractive valuations. Although we invest in companies, it is also important to consider the environment in which these companies operate. There are many reasons why we believe India will be an attractive and supportive environment over the next decade and beyond. Below we lay out just some of the secular trends which should drive the markets:
- Economic growth – As many economies around the world slow or go into recession, India still has the potential to continue achieving high levels of GDP growth. As dangerous as it is to draw comparisons, if we look at China in 2007 when it had nominal GDP and GDP per capita comparable to India today, over the next four years, we saw China’s GDP as measured by both these metrics more than double. While we don’t expect India to grow as quickly as China over such a short time frame, we do see scope for it to double its nominal GDP and GDP per capita over the next decade, which underpins the long-term market opportunity.
- Rising consumer spending – We have written in the past about how rising GDP per capita will significantly boost consumer spending. India has an aspirational middle class which is increasingly confident and assertive. This, coupled with the second largest population in the world, and one that is still growing relatively rapidly, has the potential to drive demand for discretionary goods such as cars and household appliances. Rising incomes also inspire consumers to spend more on everyday staples, a trend known as premiumisation, which will add an additional impetus to consumer spending.
- Deepening financial penetration – In our view, India will see greater opportunities across the whole financial spectrum as its growing middle classes demand banking, investment and insurance services. We also expect the availability of credit to continue expanding. All these trends will be given further momentum by the rapid digitalisation of financial services, which offers access to a broad range of products to anyone with a mobile phone.
- Increased Offshoring/Manufacturing – The post pandemic world, combined with geopolitical events, have created opportunities on two fronts for India. Firstly, the pandemic proved the efficacy, and popularity, of remote working. So, the decades-long trend towards employing Indian workers to do jobs such as IT services and telemarketing based outside the country, is likely to continue, and support growth in areas such as business process outsourcing, which subcontracts various business operations to remote, third party vendors. Secondly, the recent escalation of geopolitical risks is likely to encourage companies to diversify their manufacturing bases to increase supply-chain resilience. India, again, stands to benefit from this trend, as foreign companies build manufacturing facilities in India and employ Indian workers to operate them.
There are potential risks along the way that may destabilise markets and possibly adversely affect investment cases. They therefore merit close monitoring. Foremost amongst near-term risks for India are the twin headwinds of the war in Ukraine and US monetary policy tightening impacting:
- Inflation – As a large net consumer of commodities, and an energy importer, the Indian economy has always been vulnerable to rising (imported) commodity prices, particularly oil and gas prices. Inflationary pressures will squeeze margins, as many companies lack the pricing power to pass on rising costs. Rising import prices will also widen the current account deficit, weakening the rupee and compounding price pressures.
- Interest rates – the Reserve Bank of India is likely to follow other central banks and continue to raise rates. Bond yields have already started pricing in monetary tightening.
- Growth – Higher inflation and rising interest rates could slow the pace of recovery, and earnings growth, just as momentum was building after the pandemic.
Despite these risks, we remain optimistic. India is an early-stage growth economy, with an annual per capita GDP just exceeding $2,000. As we discussed above, the potential for this to rise further, while also expanding the base of wealth creation, has immense implications. As digitisation spreads and deepens, encouraged by government initiatives, so too will its positive impact on productivity and on the economy.
We agree with Albert Einstein that “compounding is the eighth wonder of the world”. But the benefits of compounding only accrue by staying invested, being patient and holding one’s nerve at times of market turmoil. Nobody knows what the short term will bring, but in our view the Indian equity story remains in its infancy and while there will undeniably be volatility along the way, we see this as an opportunity rather than a risk. In our view volatility is the friend of the patient investor and we believe that at points of maximum volatility, investment opportunities can be at their most attractive.
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A relatively high pool of foreign currency reserves and low levels of public debt leave India’s central bank and its government in a good position to withstand any further macroeconomic shocks. Over the longer term, India’s attractiveness remains intact. As one of the largest consumer markets outside the US and China, India has a predominantly young population. The middle class is expanding, accumulating more wealth and enjoying higher levels of disposable income. Business-friendly policies facilitate opportunities for domestic corporations and multinational companies alike. After performing below its potential over the last decade, due to a multitude of painful but necessary reforms, together with the effect of the pandemic, India is poised for a cyclical rebound.
A promising development is the relocation of manufacturing operations to India by an increasing number of multinational corporations. The country’s desire to become a global manufacturing hub is well-known. This has been promoted by the ‘Make in India’ campaign to incentivise companies to relocate through business-friendly polices such as production-linked incentive schemes, favourable corporate tax rates and the repealing of a controversial retrospective tax law. For example, Apple has decided to manufacture its new iPhone 14 at Foxconn’s Sriperumbudur factory just outside Chennai. Such investments demonstrate important steps along India’s path towards becoming the third-largest economy and stock market in the world by the end of the decade. Insulated more than other countries from prevailing geopolitical complications, this all points to India being on a healthier footing versus other emerging markets.
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India remains one of the fastest-growing countries in the world, and is expected to deliver one of the highest earnings growth stories this year, supported by a pro-growth budget for the 2023 fiscal year. With the Covid-19 pandemic under control, India’s economy is showing signs of recovery: credit growth is accelerating, the real estate market is seeing momentum, infrastructure is being built and consumer spending is gradually improving. Some of the domestic headwinds, including rising inflationary pressure, appear to have moderated slightly in recent months. That said, prices remain above the central bank’s upper tolerance limit, and if interest rates continue to rise, it would eventually have the effect of weighing on the consumption recovery trend. Further, international developments, including the potential onset of a global recession, as well as geopolitical escalations would have an impact and test the resilience of the domestic economy.
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Biotech and healthcare
(compare biotech and healthcare funds here)
Shifting patient volumes away from hospitals to lower-cost outpatient settings such as ambulatory surgical centres (ASCs) and the home are central cogs when it comes to generating much-needed efficiencies in healthcare systems. ASCs are outpatient healthcare facilities that offer same-day surgical services, including diagnostic and preventive services. These facilities offer cost-effective services and are more convenient for consumers than more traditional hospital settings. The number of procedures offered in ASCs is expanding and already includes orthopaedics, ophthalmology, dermatology, urology, gastroenterology and pain management. For context, ASCs perform more than half of all US outpatient surgical procedures and they can expect to see greater volumes as the number of outpatient procedures is expected to increase by an estimated 15% by 2028. Further, over the next 10 years, surgeries are projected to grow 25% at ASCs and 18% at both hospital outpatient departments and physicians’ offices, according to a report published by Sg2, a US-based healthcare and hospital system consultancy. The combination of material cost savings (an average gallbladder surgery costs $12,000 when done at a hospital while the same procedure costs $2,200 at an ASC) and patient convenience underpins the medium-term future for an already accelerating trend.
Home health also adds a critical dimension to the idea that the delivery of healthcare is being disrupted. Home health is usually less expensive, more comfortable for patients and can be just as effective as the care offered by hospitals and skilled nursing facilities. If managed appropriately, home health can also accelerate independence and self-sufficiency. In the US, for example, Medicare covers a number of services including skilled nursing care, physical therapy, social services and medical supplies. Based on a survey of physicians who serve predominantly Medicare fee-for-service (FFS) and Medicare Advantage (MA) patients, it is estimated that up to $265bn of care services for Medicare FFS and MA beneficiaries could shift from traditional facilities to the home by 2025 without a reduction in quality or access. That represents a three to fourfold increase in the quantity of care being delivered at home today for this population.
Value-based care (VBC) rewards healthcare providers for quality of care via payment systems that incentivise high quality of care from clinicians and healthcare organisations alike. The potential benefit to patients comes via improved coordination of care and engagement which in turn can drive more essential diagnostics, reduced hospital readmissions and better outcomes. If successful, the benefits to patients are obvious but there are also benefits to the healthcare systems. An effective VBC model could reduce costly hospital readmissions, improve preventative care and bolster the health of the general population. It all sounds sensible and effective but it is the alignment of incentives that really makes VBC work. Risk‑sharing arrangements are key to ensuring providers reduce waste and work hard to drive better outcomes. Recent deal activity in the US adds even more conviction to this idea that VBC will be an important growth engine for the healthcare industry. In September 2022, UnitedHealth Group agreed a 10-year partnership with Walmart with the specific aim of driving VBC adoption for Walmart’s clinicians. Through the partnership, UnitedHealth Group’s Optum division will assist Walmart clinicians in delivering comprehensive VBC through data analytics and decision support tools. Not only will the initiative improve the provision of care, it will also go some way to addressing the key issue of affordability.
Across the world there is a consensus that there is a growing backlog of patients requiring medical attention, but it is the size of the backlog, for example, and the precise shape of the recovery curve that is tough to predict. The latest NHS figures point to a record 6.84 million people waiting for treatment, with 2.67 million of those having waited more than 18 weeks. Perhaps even more worrying is the hidden backlog with cancer targets continuing to be missed. Looking at the US, according to a study published in the Annals of Surgery, hospitals lost an estimated $22.3bn in revenue between March and May 2020, some of which we believe will likely be, or has already been, recaptured. On a more optimistic note, there is strong evidence to suggest healthcare systems have learnt to adapt and have been able to self-regulate, maintaining surgical procedure volumes even during the COVID-19 surges. That evidence is based on the observation that, despite a 48% drop in surgical procedure volumes in the US immediately after the March 2020 lockdowns, surgical volumes returned to 2019 rates in the vast majority of specialties, a rate maintained during the COVID-19 winter surges.
The healthcare sector operates in the most fragmented of all industries, with consolidation a major long-term driver of efficiencies for companies that operate in different parts of healthcare. Unlike other industries, few subsectors see a small number of companies dominating markets, but the benefits of such scale do matter in healthcare. Consolidation typically drives margin enhancement and often revenue growth, both of which are drivers of shareholder value. The most fragmented part of healthcare is on the services side, particularly within health insurance and all the different types of healthcare provider.
Most recently, M&A activity has been picking up between large-capitalisation pharmaceutical and small/mid-capitalisation biotechnology companies, with the former typically offering significant premiums to acquire the latter. There are several reasons for a pick-up in acquisitions. In 2020-21, following the wider market lows in March 2020, the biotechnology subsector enjoyed a strong run of outperformance and access to capital was easy through IPOs and secondary offerings. As such, small/mid-capitalisation biotechnology companies did not need an exit strategy as they could easily access capital to fund their research programmes. However, with the bursting of the bubble in unprofitable companies, access to funds has become much more challenging, particularly with the market selloff in 2022. The resulting collapse in prices for small/mid capitalisation biotechnology stocks has created a much more attractive environment for the larger companies to consider M&A. Further, large pharmaceutical companies are looking to bolster revenues in the years 2025-30 with patent expiries set to impact growth. In summary, there appears to be a clear rationale for an acceleration in M&A.
Inflation Reduction Act: Is peak policy risk behind us?
On 16 August 2022, the Inflation Reduction Act was signed into law in the US. With regards to healthcare, there were two main areas of focus: drug pricing reform and access to care. As regards drug pricing, the Act includes several provisions to lower prescription drug costs for those with Medicare and reduce drug spending by the federal government:
- Selective drug price negotiation authority for the US Department of Health & Human Services.
- Rebates on drug price increases greater than inflation.
- A $2,000 out-of-pocket cap for Medicare beneficiaries.
The Act also includes a provision to extend health insurance subsidies to reduce monthly premium expenses for the next three years. These subsidies, expanded via the American Rescue Plan Act of 2021, were set to expire at the end of 2022.
So, what are the implications? This Act deals mainly with Medicare, i.e. health insurance for the over 65’s. With regards to drug pricing for Medicare, the planned negotiation beginning in 2026 for a small number of products is only a small negative for the industry as it will impact the value of these products very close to their patent expiry. A positive is the $2,000 out-of-pocket cap which will be a significant tailwind for both patients and the industry given the implications for enhanced affordability and increased volumes.
Focusing on access to care, had the subsidies to reduce monthly insurance premium expenses expired, the Kaiser Family Foundation estimated that 13 million people receiving assistance for their marketplace insurance would have faced significant increases in their monthly premiums. For people who enrolled in the federal marketplace, Healthcare.gov, premiums could have gone up by more than 50%. The decision to extend the subsidies by an additional three years is a clear positive for the healthcare insurance industry plus the facilities and providers.
In summary, the Act is a modest positive for the broader healthcare industry, especially if the drug pricing reforms remain isolated to Medicare and there is no contagion into the wider commercial setting. Further, and potentially more importantly, we believe further legislation is unlikely. In essence, the Act is a clearing event for the sector, potentially removing a significant overhang.
Outlook for healthcare: Macro and micro stars are aligning
The healthcare industry continues to undergo material, structural changes as it looks to use innovative products, technologies and services to meet the ever-growing demands of an ageing global population. It is those structural changes that are creating some exciting and robust growth opportunities. In the near-term, a substantial increase in utilisation could be the catalyst for positive revenue and earnings revisions as healthcare systems globally work their way through ever-growing surgery backlogs. Another positive, near-term dynamic is the disruption of the delivery of healthcare as systems globally look to treat in more cost-effective settings. The adoption of innovative technologies is facilitating the shift of patient volumes from the more traditional and more expensive hospital settings to lower-cost facilities such as ASCs and the home. A trend that inflected during the COVID-19 pandemic, we believe that the momentum will continue for many years to come. Last, but not least, we expect the recent wave of M&A activity to continue as companies look to use their free cashflow and balance sheets to inorganically complement internal assets.
Not only are the industry fundamentals in good health but the macroeconomic and political environments are also very supportive, not just for defensive stocks but also for those that sit higher up the market-capitalisation scale. A combination of rising inflation, slowing economic activity and growing unemployment is creating a constructive backdrop for defensive sectors, none more so than healthcare. Importantly, if inflation persists and we enter a more stagflationary environment, healthcare has shown an ability, historically, to outperform the broader market given the low earnings and share-price beta to economic indicators, the essential nature of its products and services and a relatively broad ability to absorb inflationary pressures given the sector’s high gross and operating margins. Last, but not least, we think the introduction of the Inflation Reduction Act in the US has removed some, if not all, healthcare reform uncertainty offering investors greater clarity on the near and medium-term investment landscape.
Against a background of continued global economic challenges, the outlook for the healthcare sector remains robust. The demand for products and services is growing significantly, innovation continues at a rapid pace and valuations are attractive. The positive fundamental investment drivers are currently matched with a macroeconomic backdrop which is extremely supportive for the sector. The healthcare sector has outperformed the broader market over the last 12 months and with the recent healthcare reform update having passed in the US as part of the Inflation Reduction Act, we are anticipating a period of sustained outperformance for the sector.
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(compare environmental funds here)
The attention of global investors and policymakers continues to focus on the war in Ukraine, its impacts on the global supply of energy, commodities and food and the inflationary consequences borne by business and consumers. The need for environmental solutions to solve the globe’s climate and ecological challenges appears more pressing than ever.
The period featured in this report, covering almost the entire time since Russia’s invasion of Ukraine which catalysed a growing inflationary crisis in global investment markets, was an extremely challenging time. Investors, almost regardless of asset class or region, have faced tumbling equity markets and rising bond yields against a backdrop of geopolitical and monetary policy turmoil.
One of the key routes that price dislocation has fed into overall inflation is through the energy market. The current fossil fuel energy shock highlights how critical energy systems are to everyday life and living standards. Furthermore, that environmental solutions – on both the demand and supply-side of the energy equation – are pivotal to urgently shaping sustainable and resilient energy systems.
The reaction to a similar energy shock in the 1970s saw the first green shoots of the renewable energy industry emerge. Today too there are compelling opportunities over the medium and longer-term, not just in renewable energy generation solutions, but to supporting technologies and infrastructure.
This ‘whole system’ approach is a recurring motif in the environmental solutions universe, as a disparate array of companies combine to navigate the various ecological challenges facing the world and identify meaningful solutions.
Another area that has come under the spotlight as an unfortunate result of soaring inflation is food security, as supply of agricultural commodities from both Russia and Ukraine has been severely disrupted. The security and resilience of agricultural supply chains will surely come under greater scrutiny as issues such as affordability, security and sustainability all continue to challenge the sector. Here, too, the industry is ripe for innovative solutions to solve these sustainability- linked problems through the food supply chain.
This environment is a rich hunting ground for investors in environmental solutions. However, the range of opportunities and the inevitable risks of investing in any asset class mean that taking an active approach based on detailed fundamental analysis and active engagement across multiple themes remains important.
Technology and innovation are key to combating the world’s climate and environmental crisis. These solutions are now setting the pace for policy and regulation – a welcome reversal to the previous relationship. The scale of change required to reverse global warming is creating significant opportunities for investors to support environmental solutions companies, which provide products and services critical to achieving sustainability targets. It is becoming ever more evident that environmental solutions technologies will proliferate to as-yet unpenetrated sectors of the global economy.
Governments are likely to continue to play a major role, in terms of providing incentives for the development of environmental solutions as part of the path to net zero, and through regulating all companies to improve transparency around climate and biodiversity impact.
As attitudes toward addressing climate solutions shift, there is a broadening of the value chain beyond the conventional lens. The opportunities throughout the market that this creates will be plentiful.
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We see the market volatility as presenting opportunities for long-term investors, although we remain cautious on near-term outlooks for companies in a challenging environment for earnings visibility. The US IRA underlines the strong fundamental drivers for environmental solutions investment despite the complex risk picture.
The shock to energy markets is accelerating its reform, with plans to de-couple power prices from the effects of commodity price swings (particularly natural gas) emerging across Europe and the UK, for example. We also see this as likely to be a positive catalyst in the market for solutions across several of our themes.
In all, we believe the long-term growth picture for environmental solutions is stronger than ever, noting the often-overlooked credentials for key ‘green’ solutions in delivering wider benefits than tackling environmental challenges alone, such as delivering energy security and long-term affordability, which serves to underpin a step-change in their growth rates. This is not a dynamic that is restricted to nascent technologies. On the contrary, in many cases this enhances the investment case for technologies that are already well-proven and relatively mature but where – in our opinion – the structural growth opportunity is underappreciated in investment markets.
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(compare technology funds here)
There is little to obviously like about the immediate market outlook: slowing growth, record inflation and central banks embarrassed by how far inflation has surpassed their long-term targets. As discussed during our most recent annual report, the range of potential outcomes, good and bad, looks unusually wide. We cannot know how fast inflation will fall and we continue to believe the Fed and other central banks will prioritise credibility ahead of the economy. Few investors today including us – have experience managing portfolios against a backdrop of persistently high inflation, so market responses and activity could be less predictable – witness the extreme volatility across asset classes around FOMC press conferences and CPI prints. We expect this market volatility to persist as risk is repriced until policymaker and shareholder interests are better aligned. This may result in a more volatile period of performance for the sector.
In terms of downside risks, the most prominent remains inflation should it not come under control. This could be due to service inflation remaining elevated as a function of high unit labour costs, which will not slow without significant productivity improvement or nominal wage growth slowing to 3.5%, even as weaker demand improves goods inflation. There are also more structural issues to contend with relating to a structural shortage of labour in many areas of the market (wage inflation was ticking up before Covid), shortages of production capacity in key commodities and the balkanisation of global supply chains. Second, further energy shocks or the impact of pent-up Chinese demand upon reopening could result in incremental upward pressure. Policymakers may also not have the necessary tools at their disposal to tackle systemic imbalances. For instance, further fiscal stimulus may prove counterproductive while the political will to deliver painful supply-side reform, for example in the flexibility of labour laws or immigration, may not be present.
As such, monetary policy may still surprise to the upside or remain restrictive for longer than markets are currently anticipating. Fed Chair Jerome Powell himself has warned that the nature of the current cycle (strong corporate/consumer balance sheets and a tight labour market, coincident with slower growth) might require a higher terminal fed funds rate and staying there for longer than normal; St Louis Fed Governor James Bullard has argued that various Taylor Rule estimates suggest the fed funds rate may have to reach a minimum of 5% and potentially as high as 7%. Tighter than expected monetary policy could continue to weigh on valuations that, while back at long-term averages, could fall further given the atypical market backdrop. However, negative earnings revisions represent a more likely source of downside risk from here. The investment bank Goldman Sachs (GS) recently lowered its 2023 EPS growth forecast to 0% having previously expected 3% after the S&P 500’s net margins contracted during Q3 for the first time since the pandemic on a y/y basis.
The scale of downward revisions depends on how much monetary pressure is required to becalm inflation and, by extension, whether a US recession can be avoided. While economies in the UK and Europe are already likely contracting, a US recession is not a foregone conclusion. Although a recent Wall Street Journal survey of economic forecasters estimated the probability at 65%, GS believe the chances are nearer 30%. Despite this range of forecasts, the spread between two and 10-year Treasury yields at -62bps is as negative as it has been for at least 40 years. As a reminder, 2yr10yr yield curve inversions have historically presaged recessions. The yield curve today suggests the Fed will start cutting rates in late 2023 or early 2024, which presupposes their actions will likely have had the desired effect (ie dampening inflation) or that a deeper recession will have required a volte-face. According to Ned Davis Research, the median recessionary bear market sees the Dow Jones Industrial Average Index decline by more than 32% as compared to the 21% contraction registered at the October lows. Finally, it would be remiss not to mention the more meaningful risk associated with (investment) regime change: the end of the low inflation, low rate world in favour of a less friendly, less familiar one. The end of the peace dividend, peak globalisation, polarised politics, bigger government would challenge risk assets and, in particular, growth equities as an asset class.
There are also several upside risks that temper our pessimism. Most importantly, we may already be at peak inflation/peak Fed which – after the valuation compression since the Fed Pivot – would set up 2023 very nicely. This view was supported by the October CPI report which came in at 7.7% (compared to a 7.9% forecast) which was greeted with lower nominal and real yields, and the best one-day move in US stocks in two years. While we know one CPI does not make a pivot, there is still a case that the US can avoid a recession as monetary policy could soon be sufficiently restrictive to see inflation trending back down towards 2% with only a modest increase in the unemployment rate. This could occur as the jobs/workers gap closes from roughly six million peak to around four million today, down towards the two million level needed to slow wage growth to a rate compatible with 2% inflation, along with supply side normalising and slowing shelter inflation. Other potential sources of upside include a successful relaxation of China’s zero Covid policy which could be a countervailing force to sagging global demand, US/China relations could thaw as Biden and Xi have shored up their own political positions, and – most important of all – there could be a de-escalation of Russia/Ukraine tensions.
Even if positive surprises are in short supply, strong household and corporate finances can limit the downturn to a mild recession. We could also see more comprehensive central bank/political intervention in FX markets (as per the Japanese Ministry of Finance’s recent support of the yen), bond markets (as per the Bank of England’s emergency gilt buying) to ameliorate the impact of tighter financial conditions. We have already seen widespread willingness on the part of governments to mitigate the near-term impact of higher energy prices on consumers and businesses, although the UK’s experience should remind governments their largesse cannot be limitless. A weaker US dollar would also be good for risk appetite – a 10% appreciation in the trade-weighted dollar delivers the same tightening as a 75bps rate hike per the Fed’s model – even if it could hinder our own NAV given that more than 70% of Trust assets are held in the US. A recent Bank of America fund manager survey revealed that institutional investors are not positioned for a positive change in sentiment, with global equity allocations at all-time lows and cash at 6.1%, a level not seen since 9/11. This is an intriguing set-up given strong year-end and post-mid-term market tendencies.
We are also encouraged that some of the excesses that concerned us last year are being worked off. The sharp correction in cryptocurrencies (bitcoin -70% from November 2021 highs) and the recent collapse of crypto exchange FTX have been sobering, especially for those who hoped bitcoin would prove to be a portfolio diversifier and/or store of wealth. Other digital asset classes such as non-fungible tokens (NFTs) have followed a similar path, while the value of MANA tokens for use in Decentraland (touted as a would-be metaverse) have fallen by more than 90% from their 2021 highs.
The IPO market has also struggled, following a record 2021 that saw $608bn raised globally, +84% y/. To date, this calendar year has been the slowest IPO market in five years with year-to-date proceeds tracking at c30% of 2021 issuance with c60% of deals having been withdrawn. Within technology it has been significantly worse still with 2022, so far, the worst year for issuance since the global financial crisis (GFC). SPAC issuance has also collapsed with just 77 IPOs by the end of September, compared to 613 completed during 2021. Other earlier signs of late-cycle exuberance included investor sentiment which – until recently – had become very negative, having been ebullient last year. Valuations that had been well ahead of long-term averages, have also fallen back to more palatable levels. While the forward P/E for the S&P 500 has bounced back to 17.1x from 15.2x recorded at the end of September, the ratio remains below the five-year average of 18.5 and equal to the 10-year average of 17.1.
As with the broader market, the combination of higher risk-free rates, slowing growth and some margin degradation makes for a more challenging immediate outlook for the technology sector. Inevitably, higher risk-free rates and wider corporate spreads have weighed on sector multiples, but the magnitude of the compression also reflects a sharp reversal in sentiment around the ‘inevitability’ of technology disruption which reached a zenith during the pandemic. This has been most pronounced in speculative areas and/or companies with earlier-stage financials as earlier assumptions about future funding and disruption timelines have been called into question. As in 2015-16, this process appears to have entered something of a self-reinforcing cycle with weaker sentiment and sharply lower share prices weighing on both private company financing, where down-rounds are avoided wherever possible and liquidity with the IPO market all but closed. In that earlier period, this reflexivity ran its course until macroeconomic sentiment improved, and strategic M&A highlighted the upside risk associated with compressed next-generation valuations. We expect the current cycle to follow a similar pattern, although this time stocks also have to contend with inflation and the loss of policymaker support. This process may also be further complicated by an unwind of private holdings held within daily-traded investment vehicles, an approach that gained in popularity last cycle, as some investors sacrificed liquidity and daily pricing to access earlier-stage themes. Companies were able to stay private for longer, in part due to unprecedented access to pre-IPO money from many of the same, non-traditional venture capital investors.
The more challenging economic backdrop, and the stronger US dollar, has weighed on worldwide IT spending this year, which is now expected to grow by only 0.8% y/y in 2022, compared to 4% anticipated in April. This softer outlook has been evident in recent corporate results with the S&P technology sector now expected to deliver revenue and earnings growth of 8.1% and 4% in 2022. Weaker growth this year is expected to translate into a stronger rebound in 2023 with current expectations for IT spending (+5.1%) commensurate with S&P 500 technology revenue and earnings forecasts of 4.1% and 4.6% respectively. As things stand, this would see our sector deliver growth broadly in line with the S&P 500, which is currently forecast to grow at 3.4% and 5.7% respectively. Third-quarter earnings season has reflected this less favourable dynamic with technology companies reporting revenue growth of 5.7% y/y compared to the S&P 500 which delivered 10.8%. Margins remain a key focus, with net margins falling to 23.5% during 3Q22, down from cycle highs. While the decision to de-emphasise growth in favour of profits does not sit easily with technology companies addressing large market opportunities, recent industry cost-cutting announcements are a timely reminder the technology sector is able to support margins when it chooses to. However, it almost always takes longer for growth-centric companies to pivot than it does for investors: through a cycle or more, we suspect this is a very good thing for long-term returns.
While there remains considerable uncertainty regarding growth and technology earnings, this appears partially reflected in sharply lower valuations that – all things being equal – should improve our sector’s medium-term return profile. Having peaked in November 2021 at 28x, the forward P/E of the technology sector has fallen significantly over the past year, and today, the sector trades at 21.3x – below five-year (21.8x) but above 10-year (18.6x) averages. This largely reflects the broader market derating as the sector’s relative rating of 1.1x the market multiple is unchanged with where it stood at year-end and remains within their post-Global Financial Crisis (“GFC”) range of 0.9-1.3x. Although the sector’s near-term relative growth profile appears unexceptional (as other sectors benefit more from inflation and higher energy prices), this is partially explained by technology’s disproportionate exposure to the stronger dollar. We remain excited about a plethora of secular drivers that should support superior growth over the medium and long-term. While sector valuations have clearly been hurt by higher risk-free rates, technology balance sheets remain exceptionally well-capitalised, which should insulate them against refinancing (or even, bankruptcy) risk.
While aggregate valuations remain flattered by ‘cheap’ incumbents such as Cisco, HP and Intel, we no longer have the same concern about next-generation valuations that we did a year ago prior to the Fed pivot. At that time, we expressed our discomfort with “the extraordinary valuation premia enjoyed by a narrow group of high growth, high multiple stocks” which seemed to be “pricing in defiantly optimistic scenarios” that we felt unable to underwrite. The ensuing valuation compression has seen next-generation stocks give up all and more of their pandemic rerating, the reset proving far more brutal than we (and others) had anticipated. A year ago, there were 25 SaaS companies trading at more than 20x forward sales. Today there are none. The highest growth cohort (those growing >40%) recently traded at 11x forward sales versus their 52-week high of 41.1x. Overall, cloud software has recently traded with a median NTM (next 12 months) revenue multiple of just 4.4x versus the 2010-20 pre-Covid multiple of 7.8x. As such (and all things being equal) we see much improved risk/reward in this group of stocks and have been moving the portfolio in this direction, coupled by some cash and Nasdaq puts that reflect the unusually challenging market backdrop.
There are many risks to our constructive medium-term view. Many of these remain macroeconomic (recession; inflation; war) that have been discussed elsewhere. Weaker economic growth is likely to weigh further on future technology spending as we have already seen this year. It may also present risk to cloud spending, as seen during third-quarter earnings season, should companies – especially earlier-stage companies – rationalise their spending. Other macroeconomic risks include cost inflation, as a result of labour market tightness or higher prices for inputs such as energy. While valuations appear less of a risk today given the magnitude of the correction from highs, especially in next-generation stocks, earnings risk looks more pronounced with weaker macroeconomic conditions and sentiment already subdued at semiconductor, and other more cyclically exposed companies. Recent cost-cutting announcements at Meta, Salesforce.com and Amazon suggest technology companies are at least alive to this risk. Regulation remains another risk with uncertainty at elevated levels in China, while in the US we continue to expect a resurgence in regulatory scrutiny post-Covid with a number of key lawsuits slated for 2023. There is also the potential that a new economic and market regime (discussed elsewhere) could increase the value of incumbency which would be a meaningful headwind to our investment approach.
Markets continue to reprice risk against a backdrop of an unusually wide range of outcomes. However, we have not given up on the hope that this period will – in time – be understood as another Covid-related episode where excess liquidity, supply shortages and collective trauma have left demand and supply in a state of disequilibrium. The risk of inflation becoming embedded has left policymakers with little choice, their own credibility and personal legacies dependent on the war against inflation. Until there is more certainty about the outcome of this battle, our interests are likely to remain uncomfortably at odds with policymakers. However, we also know that market narratives can change quickly should macroeconomic headwinds and/or exogenous risks subside. Less than three years ago, we were faced with one of the world’s deadliest pandemics. Technology kept the world spinning while biotechnology and AI developed vaccines that broke the link between Covid cases and deaths. Even if technology stocks have struggled to live up to their pandemic billing, we remain believers in the primacy of technology and excited about humankind’s ability to innovate and reimagine industries. This – above all else – should provide a fertile backdrop against which to invest.
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Despite the volatility, there are significant opportunities in the higher interest rate environment.
The current market conditions have created a dislocation where strongly performing assets are trading at discounted prices. This is partly because AAA and AA-rated ABS proved to be one of the most liquid asset classes for UK pension funds to sell after the mini-budget when liquidity dried up in the corporate bond market. The same selling pressures were not felt in the BB and BBB credits.
During a period of higher rates and a slowing economy, mortgage arrears are likely to rise and there will be some greater pressure in consumer and corporate assets. This always raises questions from investors after their experiences during the global financial crisis. Much has changed since then. The regulatory environment is tighter but so is the stress testing.
Consumers have been cushioned by low unemployment and high savings built up during the pandemic and over the last few years corporates have refinanced borrowings for longer periods of time, at historically low interest rates.
Asset Backed Securities are robust in structure and designed to be able withstand very deep recessions.
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The liquidity-driven sell-off seen in September (which continued into October) differs from periods of weakness seen earlier in the year, which were prompted by macroeconomic or political fears. However, in the wake of the LDI unwinds, the level of liquidity offered by the ABS market proved its resilience in the face of relentless selling. With ABS bonds being floating rate notes, and therefore trading at higher cash prices, the asset class has arguably borne the brunt of the selling that other fixed income markets were simply unable to deal with, and a level of rebalancing going forward will help to restore some equilibrium.
Meanwhile, the elevated volatility in rates markets has increased expectations for where base rates ultimately go to, and so all floating rate ABS bonds have seen a sharp increase in their forward yield to maturity, making them attractive to investors with cash to invest. This has already been seen with new or dormant groups of investors either entering the market or expanding their activities in the wake of the recent sell-off. Bank treasuries in particular have absorbed the bulk of the selling at the top of the capital structure, while further down, some wholesale and hedge funds and private equity players have stepped in (a number of them stating this quite publicly) as they see opportunities to own debt at better yields than the underlying assets themselves.
Moving forward we expect higher rates to start to dent demand for lending. This in turn will limit the funding needs of lenders and constrain ABS issuance globally, a positive technical for investors. It will also slowly have a bearing on consumer and corporate loan performance, though despite scaremongering stories in the more popular press, lending markets have developed under a far stricter regulatory umbrella and with much more conservative lending standards since the financial crisis. Furthermore, almost record low levels of unemployment (by far the largest driver of loan defaults) and strong asset price performance in the last five years provide a far healthier cushion for any downturn in asset performance going forward. At the same time, fiscal plans are being rolled out in core Europe and these have surprised to the upside, which we believe will provide a boost to households feeling more pressure over the coming months.
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During 2022 spreads on CLOs and ABS tranches widened significantly and saw heightened volatility across all types of ratings and asset classes that are eligible investments for the fund. At the close of the financial year for Toro as an example BB rated risk had widened from around 750bps to 1100bps from the start of the calendar year, similarly the loss adjusted yield on equity tranches were around 6-9% higher; the yields have subsequently partially retraced although they remain close to the wide levels for the year. Economic and inflation-based uncertainty is likely to persist throughout 2023 and into the medium term.
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Farming and forestry
(compare faming and forestry funds here)
Shareholders will know only too well the backdrop of the last year, featuring rising interest rates, falling stock markets, global political instability, an energy crisis and currency volatility. Despite these significant headwinds, UK forest property prices have exhibited their historic low correlation to other assets and have held up well. This resilience may not always be the case, particularly if other assets were to continue to deflate in the face of rising interest rates. However, we would highlight the following potential factors that may serve to offset this risk:
- The UK imports 80% of its timber and therefore a weak GBP makes domestic timber more competitive
- Sanctions on Russian and Belarussian timber will have an additional benefit for UK growers
- Historically there has been limited debt involved in UK forestry purchases due to its inheritance tax protected status and it not being a mainstream asset class for banks, meaning less risk of a debt-driven unwind of holdings
- Sustainable timber remains a product in a long-term demand uptrend in the UK and globally
- Government support for new forestry planting across the UK remains significant in both policy and grant terms
- New planting trends are largely unaffected by market volatility
The global decarbonisation agenda continues to accelerate; corporate net zero pledges are becoming increasingly common practice with many looking to achieve this feat between 2030 and 2050.
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After a period of unprecedented demand and high timber pricing due to COVID-19 during 2020 and 2021, the combination of Storm Arwen and the cost-of-living crisis have left UK sawmills with excess stock during 2022 and UK sawlog and medium-sized roundwood prices have fallen accordingly through the year.
Storm Arwen is estimated to have brought forward early supply of 1 million cubic metres of wind-blown timber. However, in a country that imports c.80% per annum, market practitioners are generally of the view that the impact will likely have been fully absorbed by the market by early 2023.
Trees that were wind-blown before reaching prime age for harvesting will only result in a tighter UK timber supply in future years.
Foresight understands that the high inventory levels held as a result of COVID-19 by the sawmills are re-balancing as many UK forest owners have chosen to leave value ‘on the stump’, by postponing harvesting and looking forward to how 2023 order books shape up.
As the financial implications of the COVID-19 pandemic, the outbreak of war in Ukraine and the recent political and financial actions taken by the Bank of England and the UK Government take effect, most forecasters are anticipating a slowing of growth in the UK economy and a period of shallow recession over the next year.
It is likely that such an economic environment will result in decreased demand for UK sustainable timber. The construction products industry currently continues to forecast growth in overall demand during 2022 and 2023 in anticipation that large warehouse and major infrastructure construction projects will go ahead but with downgrades to the previous estimates, driven by an expected slowdown in the private housing and repair, maintenance and improvement (“RM&I”) markets. The UK S&P Global Construction Purchasing Managers Index (“PMI”) has declined approximately 17% from just prior to the Russian invasion of Ukraine (February 2022) to August 2022.
However, a weak GBP makes imported timber relatively less attractive versus home-grown UK timber and the government may choose to boost its ‘build back better’ efforts to offset recessionary pressures, which may partially offset reduced demand elsewhere.
European and global timber market
Inflationary and economic pressures in Europe are not anticipated to increase demand either, with the latest available construction confidence indicators reporting decreases.
In China, new government rules limiting gearing levels for housing development have caused serious debt servicing issues for major property developers and unwanted knock-on effects further down the supply chain. Property makes up a large part of the Chinese economy and the debt restructuring required is dramatic. This has had a substantial negative effect on house prices and construction in China, although the underlying demand for new housing still prevails and it seems likely that the government will take action to stabilise the situation and continue to incentivise infrastructure projects as part of that.
On the supply side there are forces moving in the opposite direction, mainly stemming from Russia’s war in Ukraine, to create shortages of and competition for material.
Russian, Belarusian and Ukrainian timber is all now considered as conflict timber by the FSC and PEFC. With timber from those geographies representing a significant amount of global and European timber demand, this creates an intense supply shortage of certified timber globally.
It is understood that volumes of both certified and uncertified harvested timber have increased elsewhere to make up for some of the shortfall. For instance, Finland is expected to boost harvesting volumes by 3% for each of the next two years, turning Finland’s forests into a net carbon emitter. Another example is Estonia, which has announced a relaxation of its logging restrictions on state-owned land, accounting for roughly half of the country’s forests. As a result, harvesting is expected to increase. Further, satellite imagery of Ukraine illustrates extensive forest fire damage caused by the conflict, further reducing European supplies. This sort of drastic action demonstrates the intensity of the current shortages.
War in Ukraine impacts on UK timber market
In the near term, it is forecast that imports of Russian timber to the UK will have fallen to near zero. Wood pellets, plywood and sawn softwood imports will be the most impacted. According to Forest Research, in 2017, imported Russian wood pellets accounted for 4% of total UK imported wood pellets, Russian plywood accounted for 8% of total UK imported plywood and Russian sawn softwood accounted for 7% of total UK sawn softwood imports. We have now started to observe the tightening supply of timber translate through to imported timber prices, with the TDUK Structural Timber Imported Price Index increasing by c.9% from immediately prior to the Russian invasion to April 2022.
The European energy crisis is also having an impact. With Russia materially reducing gas supplies and Europe keen to quickly become less reliant on Russian energy, parts of Europe have warned of the risk of rolling blackouts and energy rationing this winter. Europe is already the largest consumer of wood pellets, used for bioenergy generation, globally.
Although there is not always uniform consensus regarding the detailed rules and regulations relating to bioenergy generation, the current status in Europe is that wood chips and wood pellets are considered a renewable energy resource. With the combined effects of lower certified timber supply and very high natural gas prices, the value of chipwood, small roundwood and medium roundwood is already experiencing upward pricing pressures in the UK and Foresight believes this is likely to be sustained for at least the rest of 2022 and the first half of 2023. Further, over the medium and longer term, the accelerated harvesting of timber elsewhere is likely to reduce overall supplies, and increase the relative value of standing timber.
Timber market conclusion
With the overall weaker UK and global economic outlook, Foresight’s view is that UK timber demand will reduce in the short term. However, with the effects of Storm Arwen now largely absorbed by the market, mill inventories re-balancing, weak GBP making imports less attractive in relative terms and material supply-side issues as a result of the conflict in Ukraine, the Investment Manager will continue to explore opportunities to achieve good value for the Company’s timber stock in 2023. Given the fundamental structural supply shortages for timber in the UK and globally, Foresight remains of the view that the medium and long-term prospects for UK forest owners are strong
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The drivers for EGL’s [sectors] have been helped this year by the US’s very large renewables-supportive climate bill and a redoubling of efforts across Europe to fast-forward the energy transition with plans for significant additional clean power generation and transmission infrastructure. The long term thesis for superior growth in electricity demand – clean electricity demand in particular – and for major investment globally to modernise infrastructure is stronger than ever.
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Global equity markets had a difficult year adjusting to the end of monetary stimulus in the face of persistent and broadly based price pressures, exacerbated by Russia’s war in Ukraine. As central banks committed to rein in inflation and bond yields returned to more normal levels, often by dramatic moves higher, global growth expectations and investor sentiment deteriorated. Geopolitical relations were strained and financial markets were highly volatile.
Given the resilience of the US economy, which is not experiencing an energy crisis, the US Federal Reserve was at the forefront of policy rate rises and the US dollar was exceptionally strong against most world currencies, rising 17% and 18% against sterling and the Euro, respectively, during the year.
Supply shortages due to natural gas curtailments from Russia, severe droughts in many regions impacting hydroelectricity output, and nuclear outages in France drove power prices radically higher across Europe; US power price increases were more modest but still significant. By 30 September, EGL’s financial year-end, we were seeing a downward trend in power prices in North America and Europe but they remained very elevated by any historical standards and approximately double where they started 2022. This placed energy supply, security and policy at the top of political agendas just about everywhere.
Higher interest rates and risk premia pressured valuations across equity markets, especially for high growth sectors, as economic activity looked set to fade. Corporate earnings estimates for many cyclical or indebted companies were adjusted lower. Over the 12 months to 30 September 2022, the return on global equities, measured by the MSCI World Index, was -19.3% in local currency terms and -2.4% when expressed in sterling terms, due to pronounced weakness from the beginning of 2022.
EGL’s portfolio performed relatively well against this uneasy macro and market backdrop. Most companies in the portfolio reported solid earnings and many increased guidance. Higher power prices continued to lift cashflows for companies with open positions or rolling hedges, and renewables developers reported setting higher long-term power prices as buyers sought predictability. The cost advantage for renewables (versus thermal power) only strengthened as the year progressed, and the urgent need for greater energy diversification and independence pointed squarely to a major scale-up of investment in clean energy generation and the facilitating infrastructure.
Government and regulatory measures to fast-track the energy transition were forthcoming including REPowerEU, which sets the EU on course to generate 69% of electricity from renewables by 2030 and to achieve a net-zero electricity system by 2035, and the US’s landmark climate legislation, the Inflation Reduction Act, which is clear in its objectives to further enhance energy security and combat climate change, notably through supportive measures for renewable energies and nuclear. These were well received, even if Europe’s power utilities’ shares were buffeted by debates about price caps and windfall taxes as policymakers sought to deal with the immediate energy affordability emergency.
Markets are in some turbulence, with investors looking for clues about the course for inflationary pressures and whether equity valuations, which have corrected significantly, have priced in the changes in interest rates and economic momentum. The war in Ukraine continues to present major risks too.
Interest rates are rising to combat sharply higher inflation – the same inflation which should benefit companies in EGL’s portfolio through direct adjustments in regulatory remuneration rates and/ or higher energy commodity prices. Intervention through price regulation and windfall taxes by governments trying to mitigate the impact of higher power prices on consumers is a risk to higher profits and certainly a source of volatility. We believe investors would value clarity in this area. Most European governments are considering taxation of excess electricity generation profits derived from electricity prices which stand well above those of previous years, which would leave plenty of leeway, in our view, to generate attractive returns.
Crucially, decarbonisation ambitions in the power sector keep intensifying, with many portfolio companies leading the way, and energy systems are being overhauled as governments prioritise energy security and affordability. In developed markets coal use is being phased out, perhaps a year or two later than previously planned due to the energy crisis, and clean power generation will have to be built at a vastly more accelerated pace. We are entering a growth era for electricity usage – and therefore for a sector which has seen little demand growth for over a decade – and net-zero scenarios require most of the new generation to come from low carbon technologies.
Renewables development companies report that bottlenecks in the permit approval process are improving, public bodies are swamped with projects requiring interconnection, and that pricing of new power purchase agreements reflects the higher cost of capital. Capital on the scale required for investment in new clean energy generation, transmission infrastructure and grid modernisation requires, and is receiving, government and regulatory support. Decarbonising electricity generation will of course reduce emissions across other areas of the economy too.
Transportation infrastructure (toll road and air) traffic and earnings recovery post-Covid has been stronger than many expected. These businesses are also growing and investing to accomplish vital renewal. This segment of EGL’s essential assets investment universe may be less recession-resistant but companies have the benefit of inflation-linkage in their contracts and regulated returns, and we expect the valuations in the listed segment will continue to be attractive to infrastructure capital in private hands.
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This annual report is published at a critical point for the infrastructure sector. The need to respond to long-term trends including decarbonisation, a growing and ageing population and digitalisation are being balanced with the immediate responses to war in Europe, the Covid-19 pandemic and adapting to the real impacts of climate change. Infrastructure development, maintenance and renewal has a key role to play in these areas. At the same time, the cost of financing infrastructure is rising and supply chains to provide the parts, equipment and labour needed to build and operate new infrastructure are under increasing pressure.
The recent high energy prices and the war in Ukraine have driven a shift in government energy policy from pursuing aggressive decarbonisation pathways to more emphasis on security of supply. The most recent UK energy strategy, published in April 2022, has a clear focus on security of supply, in contrast to the Energy White Paper (December 2020), titled ‘Powering our net zero future’. In my mind, this is reflective of an overdue realisation by policymakers that, whilst we need more wind and solar generation, significant investment in other areas is also required to support decarbonisation whilst also ensuring affordable, reliable energy supplies.
This includes upgrades to the grid infrastructure, low carbon flexible (rather than intermittent) generation, and support for other areas of decarbonisation including heat, transport, industry, agriculture and carbon sequestration. In addition to the contract-for-difference scheme, the Company is closely watching the evolution of other support mechanisms such as the Green Gas Support Scheme and the Net Zero Hydrogen Fund.
UK Government procurement for private sector finance through PPP/PFI mechanisms has largely ceased, with some residual opportunities in the devolved administrations under the mutual investment model scheme. The Board, together with the Investment Adviser, is also closely monitoring the development of the regulated asset base, competitively appointed transmission owner (“CATO”) regime and direct procurement for customers scheme in the water industry that may all provide attractive future opportunities for the Company.
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Infrastructure investments are typically characterised by high upfront capital costs, paid back in consideration for the provision of a service over long asset lives. Asset lives are often longer than political and economic cycles, and therefore investors favour infrastructure as an asset class as it provides services that will be required regardless of such cycles. Infrastructure investment has broad cross-party political backing to support economic, social and fiscal outcomes.
In the last year, there has been a significant increase in political and economic uncertainty driven by the war in Ukraine, the Covid-19 pandemic, high inflation, a cost-of-living crisis, and the rapid change of personnel in Government. This does not provide the stability long-term investors favour. At the same time, infrastructure has a core role in addressing these challenges.
The Covid-19 pandemic has only served to emphasise the role that social infrastructure can play in supporting local communities. Indeed, it is arguably historic underinvestment in infrastructure that has contributed to certain aspects of the current challenges. The UK is at a critical point in its infrastructure journey, with an opportunity to commence correction of its previous underinvestment and to go further and ensure investment in infrastructure that supports the UK’s realigned and future priorities.
In response to an electricity system with a rapidly evolving generation mix and demand profile, the UK Government has announced a fundamental review of the operation of all wholesale electricity markets, as part of the ‘Review of Electricity Market Arrangements (“REMA”)’. This consultation has the potential to result in the introduction of some of the most material market changes since the liberalisation of energy markets in the UK in the 1990s.
Some changes under consideration include:
- separating the wholesale electricity price into ‘on-demand’ and ‘as-available’ prices, based on the short-run marginal cost (as is currently) and long-run marginal cost (applicable to intermittent renewables) respectively;
- locational pricing, either by zone (regional areas) or node (multiple points on the transmission grid) to ensure efficiency in system costs as new demand and generation are developed;
- a reform of the contract-for-difference scheme, with a number of proposals on the table for the mechanics of the strike price, negative pricing and contract tenure; and
- support for low-carbon flexibility, through the capacity mechanism or otherwise.
Certain of these changes have the potential to significantly change the revenues available to existing and new renewable generators. The Investment Adviser and Board are actively monitoring the consultation process and any outcomes. Whilst this does create medium-term uncertainty (the proposals are not expected to be implemented until the mid-2020s), it also points to some clear areas of support for sectors including low-carbon flexible generation.
It remains unclear whether there will be an availability-based, or other, mechanism that attracts private sector finance into the types of asset (such as schools, hospitals and community infrastructure) that PFI and its various derivatives successfully supported. The 2019 Infrastructure Finance Review consulted on possible future alternatives, including the regulated asset base (“RAB”) model that has historically been used to regulate monopoly utilities, and more recently in the finance of the Thames Tideway sewer.
It was further confirmed by the UK Government that PFI/PF2 will not be re-introduced as procurement models and expressed support for the contract‑for‑difference and RAB models, with the potential to apply these to new sectors. A possible alternative is that the UK Government involves the private sector in the delivery of this type of infrastructure but does not require private sector finance in the provision of equity or debt capital to finance these projects.
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(compare leasing funds here)
October saw an improvement in the market post the typical summer holiday lull, but this was stalled by drought conditions in the Mississippi River Basin and zero-Covid policies in China. The non-seasonal softness in the Atlantic has begun to subside and we anticipate some strength to emerge before the end of the calendar year. In the Pacific, rates have shown signs of stabilising in recent weeks as cargo and tonnage become slightly more balanced. In the medium term, recently announced stimulus measures in China are expected to have a positive impact on dry bulk demand, targeting the property and construction sector and are expected to coincide with the supportive gradual easing of zero-Covid policies as the country reopens next year.
From January 2023, gradual lowering of operating speeds to reduce fuel consumption and meet International Maritime Organisation emissions targets is expected to reduce effective supply. Over time, these new regulations and the IMO’s fuel efficiency rules should accelerate scrapping of older, less efficient tonnage – particularly pronounced in the older trading Handysize fleet. This slow down, combined with limited new vessel additions given a historically low orderbook and lack of yard availability should keep earnings above historical averages over the medium term and in turn support firm asset values.
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(compare private equity funds here)
In November, the Bank of England warned that the UK is facing the longest recession since records began, while it raised interest rates from 2.25% to 3%, representing the biggest increase since 1989. Meanwhile, the UK government’s Autumn Statement sought to provide near-term support for the economy, which is likely to already be in recession, while re-assuring financial markets that the government will reduce borrowing over the medium to long-term. In terms of the outlook for the economy, the Office for Budget Responsibility (OBR) has revised up its forecast for growth for 2022 from 3.8% to 4.2% since its last forecast in March but has slashed its 2023 forecast from 1.8% to -1.4%, largely owing to the inflation environment at present. The economy is forecast to return to positive growth of 1.3% in 2024 and 2.6% in 2025. Consumer Price Inflation (CPI) is forecast to average 9.1% in 2022 and 7.4% in 2023, before falling to 0.6% in 2024 and -0.8% in 2025. Meanwhile, the unemployment rate is forecast to peak at 4.9% in 2024, before slowly falling back in subsequent years. The OBR’s analysis suggests that the measures announced in the Autumn Statement reduce the depth and length of the recession this year and next but leave the economy on a similar growth trajectory over the medium term.
Despite the current challenging economic environment, we believe that this represents one of the most opportune times to be an investor, where falling valuations for many businesses do not necessarily reflect underlying positive fundamentals. Indeed, in the small and mid-cap space, history has shown that buying on weakness can offer some of the best long-term returns.
Looking forward in private equity markets more generally, with leverage and rising multiples unlikely to propel returns, there could be a sweet spot for strategies focussed on revenue growth and profit margin improvement. For example, expansion of product lines or geographic footprint, and professionalising management to improve profit margins. This is all easier to do among small and medium-sized companies. At larger companies, which have often been through several rounds of private equity or institutional ownership, it is much harder to add the same value. Buy and build strategies are also positioned to do well, with opportunities to buy smaller companies, expand, improve profitability, and then sell at the valuation premium that larger companies command compared to smaller ones.
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Renewable energy infrastructure
(compare renewable energy infrastructure funds here)
As the world moves away from conventional fuels, which have historically provided capacity and flexibility, in pursuit of a lower‑carbon future, the problem of intermittent generation arises. Energy storage is a key enabler in this energy transition. Wholesale markets and ancillary services are pegged to gas prices, and as volatility impacts this commodity, the rest of the market experiences the knock-on effect. As markets mature, grid operators seek to revolutionise the way grid frequencies are maintained and begin to disconnect gas prices from markets by introducing higher levels of renewables.
Ancillary services facilitate greater renewable penetration, but these markets quickly saturate as battery storage systems are built out. Both providers and procurers of services need to be competitive and flexible as new opportunities emerge and the characteristics of battery storage technology shape frameworks and market mechanisms previously designed for participation from conventional assets.
As the ancillary services market saturates over time with increased capacity build-out, merchant opportunities such as wholesale arbitrage, in which batteries seek to target growing spreads in power markets, are expected to take precedence.
Significant long-term tailwinds are driving national grids to transition towards renewable sources, evidenced by renewables growing to account for 13% of energy generation globally. The increased reliance on renewable energy sources directly propels the deployment of battery energy storage systems, which are expected to grow by 20.2% between 2022-2028. The structural changes required to shift to clean energy sources have been accelerated due to OECD governments passing significant legislation to ensure they remain on track to meet carbon neutrality targets.
The current macroeconomic climate has introduced potential headwinds such as rising short-term inflation, high FX volatility and rising construction costs.
As the EU positions itself as a beacon for renewable deployment, it encourages member states to continue to build out capacity, imposing targets to deliver on milestones. Further, there is an accelerated need to build out renewable projects for certain member states that had been previously more reliant on Russian gas imports.
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(compare royalties funds here)
More people paying more for music streaming services
Reported data from the music industry continues to show growth despite the wider economic challenges. Furthermore, there are regulatory and commercial developments which will directly result in additional revenues for Hipgnosis. For example:
- The market leading global streaming service, Spotify, beat expectations with year-on-year premium subscriber growth of 13% to 195 million and Monthly Active Users up 20% to 456 million, according to their recent Q3 2022 results. Revenues also increased 21% to €3.0 billion.
- Apple Music announced that it would be increasing the monthly price of its individual and family subscriptions by $/£/€1 to $/£/€10.99 and $/£/€2 to $/£/€16.99 respectively in the US, UK and continental Europe.
- Spotify and other DSP’s have indicated they will also increase prices.
- The mid-year revenue statistics disclosed by the RIAA (Recording Industry Association of America) gives us an insight into the recorded music revenues in the US, our largest market. Revenues from streaming music, a broad category including formats such as paid subscription services, ad-supported services, digital and customized radio, grew 10% to $6.5 billion in the first half of 2022. The share of revenues that came from streaming was virtually flat at 84% and paid subscriptions account for 78% of streaming revenue.
We have long believed that music streaming represents exceptional value for money and, as such, believe that the DSPs have significant pricing power despite the current macro-economic conditions. Consequently, in line with many industry commentators, we expect Spotify will follow Apple’s lead and similarly increase its 9.99 individual price point in major markets. Price increases leads to more royalties flowing through to rights holders.
Copyright Royalty Board
During the period there were a number of significant regulatory developments from the Copyright Royalty Board (CRB), which sets royalty rates for the United States.
After a lengthy appeals process, the CRB rejected the appeal of CRB III brought by some streaming companies. As a result, CRB III, which proposed to incrementally increase mechanical streaming royalty rates for songwriters and publishers was confirmed with the “all in” (mechanical and performance) statutory minimum rates for streaming paid in the US was confirmed with the headline rate rising from 10.5% of streaming revenues prior to 2018 to 15.1% in 2022, an overall 44% increase and paid retroactively.
The next CRB IV settlement period begins in 2023. A joint proposal from The National Music Publishers’ Association (NMPA) and Nashville Songwriters Association International (NSAI) and the Digital Media Association (DiMA) has been submitted to the CRB. Should this be ratified, as is almost certain, this would see the headline royalty rate for mechanical streaming in the US rise further from 15.1% to 15.35%, phased in over the five-year term from 2023-27.
While we believe more significant increases are warranted and will come, this agreement will provide the highest royalty rates ever for songwriters in the streaming economy and five years of stability from which to build from. Additionally, the deal also includes a number of changes to other components of the rate, including increases to the per subscriber minimums and the “Total Content Costs (TCC)” calculations which reflect the rates that services pay to record labels and modernizes the treatment of “bundles” of products or services that include music streaming.
The agreement is supported by DiMA member companies, Amazon, Apple, Google, Pandora and Spotify, as well as NSAI’s Board of Directors and the NMPA Board, which is comprised of leading independent and major music publishers.
Separately, we support a 32% uplift in the mechanical rate paid to publishers and songwriters for music purchased as a physical sale from 9.1¢ per track to 12¢ per track from 2023-27 with further annual increases in line with the Consumer Price Index.
The joint proposals for CRB IV are significant as they demonstrate growing acceptance across the industry that artists and songwriters should be fairly remunerated for their work.
Return of Performance Revenues
CISAC – the International Confederation of Societies of Authors and Composers – is the leading network of authors’ societies with 229 member societies in 119 countries. In their recently published 2022 global collections report, which reports data from 2021, CISAC note global collections returned to growth in 2021, increasing by +5.8% to reach €9.58 billion and reversing the previous year’s decline due to the pandemic. Digital collections grew +27.9% to €3.1 billion driven by organic growth in streaming, rising music and video on demand subscriptions (SVOD), and deals with digital platforms. Royalties from live and public performance in 2021 were still 45.8% below 2019 pre-pandemic levels due to lockdown restrictions on concerts, exhibitions and live entertainment, highlighting the long lag in the industry.
This strongly suggests there is considerable opportunity for upside in collections for 2022 and beyond as normal levels of activity resume and the collections agencies distribute revenue to rights holders.
This thesis is supported by statements from Live Nation Entertainment, the world’s leading live entertainment company, which reported in November 2022 that it had delivered the biggest summer concert season in history, with 44 million attendees across 11,000 concerts in 50 countries. As a result, Live Nation Entertainment has said it now expects to transfer over $550 million of additional payments to artists this year and has stated that ticket sales for shows in 2023 are “pacing even stronger than they were heading into 2022, up double-digits year-over-year”.
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Macro-economic and political forces continue to dominate both markets and investors’ perceptions of the future trajectory of the value of all risk assets. Inflation is everyone’s focus as we all grapple with the consequences of the unwinding of the era of cheap capital engineered by the actions of central banks following the Global Financial Crisis. Real estate as a leveraged asset class has been hit hard. As with any market correction, property share prices move fast and take the brunt of this sentiment change, well ahead of the underlying physical transaction market.
There has also been a lack of divergence between the good and the bad. As in all bear markets, forced sellers who require immediate liquidity dictate the marginal price and careful stock selection is overwhelmed in the rush to cash.
Indexation continues to support revenue growth while rising debt costs pull in the opposite direction. Many of our companies have the vast majority of their debt costs fixed or hedged for several years and therefore can confidently look forward to indexation feeding through to the bottom line. Of course, the key issue then is how far vacancy rates and tenant retention will be impacted by the impending recession. We do need to remember that for all tenants rent is a principal business cost. Historically, mild recessions with low levels of corporate failure have resulted in minimal tenant delinquencies.
The quoted sector is in a strong place, relative to many private property enterprises with strong balance sheets, established credit facilities and high-quality portfolios.
Generalist investors are shunning the sector and that is reflected in all property share prices. Share prices still stand at large discounts to our adjusted, real time net asset value calculations. This Autumn’s political events in the UK have been damaging to the UK’s reputation for financial and fiscal prudence. We can only hope that the new Prime Minister is able to restore confidence and deliver the stability which markets crave. It is a tall order but the reduction in the cost of UK Government debt since the last week of October is not only encouraging but crucial for all asset values.
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Both occupiers and investors appear clear on one aspect of office property: they want buildings which are fit for purpose and will stand up to scrutiny on their environmental credentials. The jury remains out on the impact of remote working although certain tenets of corporate behaviour are becoming the new norm. The majority of Continental European cities (bar Paris) have seen a return to pre-pandemic occupancy levels, however the UK, and London in particular, remain well below those levels. Poor infrastructure and length of commute are the clear drivers. A pattern of tenant demand is appearing: the most central and best quality buildings continue to attract demand. Financial tenant focused markets such as the City of London, Canary Wharf and La Defense are suffering elevated void rates and falling rents. CBDs with multiple types of occupier such as London’s West End and Central Paris are seeing rental tension and broad stability. Knight Frank reports that in Q2, Paris CBD saw vacancy fall to 3.3% (close to a record low) with prime rents close to €950 per m2, again closing in on a previous peak. Take up is lower than Q4 2021 but so is the available space. We believe this trend is set to continue in these best placed assets.
Investors still appear attracted to trophy, new builds. The recent deals such as the sale of Deutsche Bank’s new HQ at 21 Moorfields at an initial yield of 4.4% already looks a good deal for the vendor, Landsec, but the index-linked income and very long lease is understandably attractive to its new pension fund owner. Foreign capital is also visible with the German buyer at GPE’s 50 Finsbury Square and the Chinese buyer of TikTok’s HQ built by Helical Bar.
Elsewhere we see rents retrenching. Tenants are back in the ‘wait and see’ mode. Having spent the last 18 months working out what space they need in a hybrid world, they now need to assess the impact of the forthcoming recession (mild or otherwise) on their requirements. Shorter leases and flexibility (which may ultimately be more expensive) are becoming the norm. Landlords have to adapt and investors then need to price in the risk of rental volatility. Improving energy efficiency is now a central part of any office refurbishment and we believe landlords of suburban and regional properties with lower rents (and capital values) are underestimating the costs of these expanding regulatory requirements.
The structural shift to omni-channel continues. The helicopter view remains the same. Retailers will happily pay if the location delivers sales, but the number of such locations continues to fall. Collectively we have too much retail space and the UK remains the worst culprit (compared to Continental Europe). However, retail rents have effectively halved over the last decade and valuations have collapsed. We will therefore see smaller capital value falls in the MSCI/IPD data for shopping centres versus logistics as moving yields from 8% to 9% results in half the capital fall compared to moving from 3% to 4%. Simply put, retail has already been repriced. This statement applies to the UK. Europe is a different playing field where valuers react much more slowly and will remain comforted by rental stability. This stability will be delivered, in the short run, by substantial indexation compensating for rising tenant failures.
Two parts of the retail landscape which continue to outperform are outlet centres and retail warehousing. The former because it offers a more ‘internet-proof’ sales channel and the latter because rents are much lower and they have become an increasingly critical part of the omni-channel sale process. Click and collect from an edge of town, easy access location rather than a regional shopping centre with your car a 10-minute walk from the store. Consumers’ discretionary spend is reducing as energy costs, mortgage rates and rental levels rise. We like the domination of value-focused retailers on the retail warehouse parks.
Supermarkets – fundamentals for food shopping margins remain very resilient when compared to more discretionary spending.
The strong momentum in the logistics market has continued despite the news that Amazon was slowing its take up of space across the globe. Essentially, we see other operators taking advantage of the behemoth’s space indigestion. Whilst European economic growth is going to slow or even enter a recession, the structural tailwinds for this sector persist, particularly the need to re-engineer complex supply chains which invariably result in the need to store more materials, ingredients and parts closer to their end market. Savills reported pan-European take up in H1 2022 of 20million m2, up 12% on the same prior-year period, mainly driven by the UK and Germany. Vacancy rates across Europe have dropped to a record low of 2.9% and led to headline rents increasing by an average of 8% over the past 12 months.
It is no surprise that investors had continued to drive yields lower (and capital values higher) given the expectation of ongoing rental growth and development gains. However, the increases in the cost of borrowing have dramatically reversed this yield tightening cycle. As highlighted earlier, when yields are as low as 3.5%, a 100bps increase to 4.5% reduces the capital value by 22%. Whilst not all logistics property is valued at these historically low levels, the sector’s pricing continues to reflect good rental growth prospects. We remain confident that the structural undersupply of logistics and industrial space in urban markets will continue to drive rents.
The shortage of private sector rental accommodation remains acute. In Germany the regulation of rents (resulting in approx. 20% below market rents) results in tenant turnover being lower than in open market jurisdictions leading to very high occupancy levels with commensurately low payment delinquency. However, the impact of energy costs and the difficulty in forecasting the increased service charge recovery rates has led to a reduction in the expectation of the rate of rental growth.
In markets where the private rented sector is a smaller sector, such as the UK, regulation had already reduced the number of small landlords and this has now been compounded by rising mortgage rates. Large amounts of the private rental sector owned by ‘amateur’ landlords (owning less than 5 units) have been sold to the owner-occupier market. The consequence is inflation busting rental growth in any undersupplied city. London remains top of the list. As house prices begin to fall, we may well see more people choosing to temporarily rent, again adding to demand.
Finally, with historically high levels of employment leading to wage inflation, we see nominal increases in residential rents in open market jurisdictions such as the UK and Finland as sustainable.
Purpose built student accommodation continues to fare relatively well, with rising numbers of students competing for a limited (but growing) number of beds. Rents in the private rented sector also continue to rise, particularly as regulation of HMOs (Houses in Multiple Occupation) continues to squeeze margins for private landlords. According to Bonsard, rents have increased on average by 9.7% in the 2022 academic year. The survey looked at 140 operations across all European countries and the highest rates of growth were in the severely undersupplied Eastern European markets.
Self-storage also continues to confound the sceptics with the Self-Storage Association UK reporting further occupancy growth across its members. We are fully aware that reduced housing transaction volumes should impact turnover but the growth of commercial customers and the growing awareness of the sector remain long-term, systemic trends.
Healthcare continues to be the poor performer in the ‘alternatives’ space whether it is primary or nursing care. Whilst the former has the benefit of direct or indirect NHS rental support, the latter has far greater exposure to private operators. These operators do receive large amounts of their revenue from the government but their operating margins continue to be squeezed through wage inflation and higher energy bills.
Pan-European real estate equity prices are now reflecting very significant corrections in the value of the underlying real estate, across all sectors. These shifts in valuation have been primarily driven by the cost of borrowing and it has been the lowest yielding (and therefore the most highly rated) sectors of our universe which have been impacted the most. The worst performers were industrial/logistics and residential. These are also the two sub-markets with the strongest outlooks based on the ongoing mismatch between demand and supply. These market fundamentals will, at some point, reassert themselves in investors’ decision making. However, in the near-term, markets will continue to be driven by central bank behaviour and equity markets will respond strongly to any indication that the tempo of rate rises is slowing. The question is therefore will the central banks need to see evidence of disinflation or even recession before adjusting their strategies. Clearly this is an unanswerable question and the behaviour of the Bank of England and the ECB may well differ. Either way, we will continue to focus on owning companies which can withstand both higher interest rates and a recessionary backdrop.
It is important to recognise that the downward leg of any property cycle has been driven by an increase in the cost of debt and/or a rental collapse caused by over development in a buoyant upswing. Outside of retail property’s well-rehearsed structural changes we see very few signs of over supply. Our portfolio positioning does reflect our nervousness towards older, lower value (suburban) offices, many of which will fall foul of new energy efficiency requirements. In many markets we see demand for property as an affordable and necessary factor of production offering index-linked income.
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Ediston Property Investment Company
Calum Bruce, investment manager:
Rising inflation, interest rates and energy costs, coupled with political instability, have reduced consumer confidence and put a squeeze on household incomes. Reductions in disposable income could affect the retail market, including retail warehousing. Discretionary spending and the purchasing of ‘big-ticket’ items will be particularly affected. The fact that the company’s portfolio is underpinned by convenience-led tenants, has low average rents and a reduced vacancy rate is important and should help make the portfolio more defensive to these reductions in consumer spending.
If retailers are impacted, there is an increased likelihood of them using Company Voluntary Arrangements (CVAs) and other insolvency processes to reduce costs. The company is in a better position to deal with these challenges than it was during the COVID-19 crisis, which it weathered well in terms of sustaining income.
However, the increase in gilt yields has put all property valuations under downward pressure. The company’s property portfolio reduced in value by 2.5%, on a like-for-like basis, in the quarter to 30 September 2022. Further, larger declines are likely as the property market reprices due to the rise in gilt yields. The expectation is that the property portfolio will fall in value as at 31 December 2022, with the potential for further volatility thereafter.
Despite the more measured short-term outlook, the fundamentals of the retail warehouse sector remain robust. Supply of available space is low, tenant demand is holding up, occupiers are still doing deals and we continue to identify and complete asset management transactions that secure income.
We expect the retail warehouse sector to be the most resilient and flexible part of the retail market, which can adapt to the changing needs of tenants and the integration of their omnichannel strategies. Having sold assets and with cash in the bank, the Company is well placed to capitalise on any investment opportunities that are identified in a re-priced market, but only at the right time and price for the company.
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Robert Orr, chairman:
Following a strong first half for European logistics markets in 2022, the macroeconomic backdrop changed significantly in the second half with the ECB responding to the elevated levels of inflation with a series of aggressive interest rate hikes. The knock-on impact of rising bond yields and debt costs, together with the increased likelihood of European economies experiencing a period of slower growth, has not yet been fully transmitted into real estate markets, with the scale and duration of adjustments to pricing and growth still uncertain.
We believe the structural tailwinds positively impacting the European logistics sector, particularly the growth of internet retail, remain in place and other demand drivers such as the need for supply-chain resilience and buildings that support ESG objectives, will continue to create additional sources of demand. Low vacancy rates and constrained supply of land also serve to underpin occupational market fundamentals.
However, we are cognisant of the recent declines in investment transaction volumes and evidence of a softening in asset pricing and we remain attentive to the potential risk of weaker occupational markets.
In these more uncertain times, the quality of our portfolio together with the strength of our balance sheet combine to provide the company with the resilience and resources to navigate more volatile market conditions. In addition, the embedded indexation, reversion and asset management opportunities in the portfolio provide the ability to grow income and create value throughout the market cycle.
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Civitas Social Housing
Michael Wrobel, chairman:
The past six months have seen many economic challenges in the UK and across the world, including the rapid growth in inflation and the Russia/Ukraine conflict. Within our sector of Specialist Supported Housing, I am pleased to note that our rental income has benefited from some positive inflation linkage. At the same time, we note that inflation is causing significant cost increases for both housing associations and care providers to which local authorities and central Government is being asked to respond. We continue to monitor the position closely, working with our counterparties to help them operate as efficiently and effectively as possible. Our sector is exempt from rent caps, due in large part to the essential nature of the services that are delivered in the properties owned by the Company.
Our sector continues to experience strong demand for quality properties that can provide a long-term stable home for the delivery of community-based care. This is evidenced from our direct engagement with local authorities, care providers and housing associations who are seeking additional provision.
Residential Secure Income
Rob Whiteman, chairman:
The current high inflationary environment is raising the cost of living for citizens across the country at the same time the UK is entering into a recession. Now, more than ever, the Company’s investment thesis is supported by a growing need for affordable housing in the UK, across the age spectrum. The country’s structural housing shortfall continues and most of the population lives in areas where home purchase is unaffordable.
The British Property Federation estimates a need for an extra £34bn per annum of investment into affordable housing over the next decade to start to tackle the shortfall. Housing associations, who have historically been the primary investors in affordable housing, are now dealing with rent caps on their social and affordable rent portfolios in addition to allocating c.£10bn for fire safety and c.£25bn to upgrade the energy efficiency of their stock 2030. These financial pressures reduce their ability to provide new affordable homes, and further support for new long-term investment in the sector.
The government continues to encourage new investment, particularly through its Homes England’s Affordable Homes Programme, which provides total funding of £12.2bn to help subsidise 180,000 new affordable homes by 2026. We remain excited by the opportunity to help housing associations recycle their capital with developers to deliver new affordable homes, helping to meet the critical shortage of affordable homes for independent retirement living and homeownership and in turn delivering inflation-linked income to our investors.
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Paul Arenson, chief executive:
There has seen further significant changes in the macro-economic environment with increasing interest rates, high inflation, and economic and political uncertainty. Against this backdrop, the occupational market in the industrial sector has remained resilient, but the investment market has come under pressure with yields beginning to move out. Accordingly, we took an active decision to pause investment activity.
Asset pricing has not yet found its projected level, which, combined with high interest costs, means that debt does not enhance returns as it has done previously. Investment valuation yields are expected to continue to rise resulting in further reductions in valuations. However, we carry confidence into the second half of the year due to the quality of our estates, continued rental growth driven by a strong occupier market, a low group LTV of 26.5%, and unrestricted cash balances at 30 September 2022 of £21.7m.
This hiatus in investment activity also provides an unexpected period in which we can focus on consolidating operational efficiencies in the platform. Accordingly, when we do re-enter the investment market, we expect that we will have greater operational strength to capitalise on opportunities.
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