One of the most important skills to develop as an investor is simplification. In the same way the genius of Einstein was summed up in E=mc2 and Steve Jobs in the iPhone, both complex ideas made brilliantly simple, the most powerful investment ideas are also the simplest.
Simplification is an idea that has its origins back in the 14th century when William of Ockham (later changed to ‘Occam’), an English Franciscan friar, began to challenge the rather convoluted philosophical and religious explanations of the world around him. This was a time before science as we know it now: as an example, the flight of an arrow from a bow was linked to the wings of angels carrying it.
William began to radically simplify explanations for events around him, to the point he was branded a heretic and nearly burned at the stake on more than one occasion. His lasting idea, which has informed centuries of discovery, was that the simplest explanation is usually the best one. It was given the name ‘Occam’s Razor’ representing a razor shaving away the complexity to reveal the truth. This is a powerful principle when thinking about the current investment environment. In this blog we discuss the issues of the day and try to apply Occam’s razor to today’s markets.
It is a one sector stock market so far this year
Using the S&P 500 – the most used US stock market index – only two sectors have delivered positive year-to-date returns (as of 4/2/22): energy (+24.3%) and financials (+2.5%). All other sectors are down, including information technology (-8.4%) and healthcare (-6.3%). Why is energy, and within it oil, up so strongly?
Well, for the first time in our careers we are seeing a supply-driven, rather than demand-driven, commodity boom. Investment in the oil production industry has been under pressure for several years now. This started with pressure from investors in oil companies to improve the returns they were delivering for shareholders, which have been so poor as to be value destructive. There is also (we think rightly) a desire to develop less carbon-intensive forms of energy that impact the climate less. Finally, the pandemic stalled new investment when demand fell off a cliff as the global economy shut down.
This has happened at a time of heightened geopolitical tensions, with Russia, a major oil & gas producer, threatening to invade Ukraine and restricting oil and gas supplies; and Iran, another major oil producer, embargoed by the US pending nuclear disarmament talks. This lack of supply comes at a time when the global economy has been surprisingly strong, both in the immediate recovery following the pandemic and thereafter.
There is concern that should demand revert to previous pre-pandemic levels (or rise even higher) in the coming months, there may well be a shortage of energy. To resolve this, the oil price needs to be sufficiently high to incentivise more supply to come onstream, either through more expensive sources such as shale oil in the short term, or more renewable energy in the long term.
Our experience of the oil price cycle can be summarised by the adage that nothing cures a high oil price like a high oil price – and there is evidence of higher prices increasing supply, something which should become more apparent as the year progresses. Whether or not oil prices will fall is unclear, but absent a war in Ukraine it seems more likely than not we are at the maximum point of tension with respect to the supply and demand of oil, and the situation should ease from here.
The technology sector is fragmenting
Another sector making the headlines recently has been technology. This has been the key sector for investors to get right over the last decade, and we strongly suspect that this will be the case over the coming decade. So many environmental and social problems are yet to be solved, and technology will be part of the solution. Equally things such as the metaverse will develop in a way few of us can currently comprehend. Technology is a sector that creates emotive reactions in investors, but no one ignores it.
Our simple rule we use for investing in technology is that if we find an exciting area in which to invest, we want to find the dullest way to access it. Think video conferencing is the future? Buy Microsoft, not Zoom. Think immunotherapy will cure cancer? Buy AstraZeneca, not a single-product biotech company. Should the area of excitement turn out to be true, the lowest risk way of investing in it will be plenty rewarding for most; but should it disappoint, there will be much more protection on the downside from their more established and diverse businesses.
The first fragmentation of the technology sector was the demise of speculative, profitless technology companies, whose valuations became detached from the underlying businesses. This part of the technology sector looks increasingly like a bubble which has burst, with it unlikely many of the high-profile speculative names talked so much about last year will reach their previous highs again.
The second fragmentation has come from large, profitable technology companies that are seeing a slowdown in momentum as consumers move gradually back to engaging with the real, rather than virtual, world. Netflix, Facebook and PayPal all noted weaker-than-expected trading towards the end of 2021 and into 2022 (we own PayPal but not Netflix or Facebook). It remains to be seen how quickly this will improve, but these companies have grown rapidly in the last two years so it may just be a case of growing pains.
The third fragmentation has been those technology companies that are powering on. In this cohort are Microsoft and Alphabet, who rather than seeing a slowdown have seen something of an acceleration in their core services, such as cloud computing and information search.
Technology was never a simple one-way bet, although it was sometimes characterised that way by some commentators! There have always been significant qualitative differences between various areas of technology, and the approaches of companies engaged in them. However, as in the period following the bursting of the dotcom bubble in 2001, we seem set for an extended period of investors becoming more discerning and corporates disclosing a broader range of outcomes. This isn’t necessarily a bad thing and may just be a healthy dose of reality and removal of unhealthy, speculative, behaviour.
Negative bond yields are on their way out
Perhaps one headline that didn’t get enough attention last week was the demise of the negative bond yield. There are now no negative bond yields in the major government markets of Europe, Asia and North America. Globally, negative yielding bonds (which includes corporate as well as government debt) now amount to $4.9tn; at the end of 2020 this number was $18.4tn (source: Bloomberg). This decline has been led by rising inflation and recovering economies as the effects of the pandemic have begun to ease.
Of course, some may say it is remarkable there remains nearly $5tn, or that there was over $18tn in the first place: if held to maturity, negative yields guarantee a loss to the investor. This is arguably another bubble slowly deflating in the background, as irrational perhaps as the high prices given to speculative technology companies last year. Maybe the two are connected? Either way, inflation and the removal of central bank stimulus is resulting in a normalisation of the bond market.
Back to Occam’s Razor
What therefore is the simplest explanation as to the behaviour of energy, technology, and bond markets? That the global economy is reverting to pre-pandemic trends and activity! Energy demand is increasing; speculative, stay-at-home, technology bubbles are deflating; and bond yields no longer discount fear. Although the transition back to normality will, for all of us, have its challenges, in the end it surely must be a good thing for markets and for investors.
Past performance is not a guide to future performance. The value of investments and any income from them may go down as well as up and is not guaranteed. Investors may not get back the amount invested. Portfolio holdings are subject to change, for information only and are not investment recommendations. The views expressed are those of the author at the date of publication unless otherwise indicated, which are subject to change, and is not investment advice.
Unless otherwise noted, the information in this document has been derived from sources believed to be accurate as of February 2022. Information derived from sources other than Royal London Asset Management is believed to be reliable; however, we do not independently verify or guarantee its accuracy or validity.
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