In the same spirit as saying economists have correctly predicted seven of the last five recessions, market strategists have a poor track record of forecasting inflection points.
These occur when the tectonic plates of investing collide to change the prevailing direction of markets for a prolonged period. They happen so infrequently, and often for unforecastable reasons, that it can be years before they are understood properly and reflected in asset prices. The three inflection points that I have witnessed in the last 23 years have been:
- China’s entry into the World Trade Organisation, which set the scene for the emerging market and commodity boom of the noughties
- The reaching of scale of large technology companies, which impaired the reversion to the mean and, consequently, the value style of investing as disruption became pervasive
- The introduction of Quantitative easing (QE) after the financial crisis of 2008, which benefited long-duration assets such as growth equities
Each of these, properly understood, gave clear direction as to where investment returns were going to come from on a multi-year period. Are we at a new inflection point today? Possibly.
It is becoming clearer that inflation, unchecked, is going to be a longer-lasting feature of the economic outlook than most of us thought only a few months ago. The transitory argument was based on a view that supply chain issues and commodity shortages would self-correct over the course of this year. After the invasion of Ukraine, it seems likely that both these factors will remain problematic for longer as global supply chains and the availability of commodities adjust. No longer is it wise to have manufacturing where labour is cheapest, given geopolitics and de-globalisation. Equally, as the second largest producer of commodities in the world, Russia is impossible to replace, at least quickly, in the role it has played in keeping oil and a wide range of essential metals and gases at low prices.
These changes are likely to keep inflation higher for longer, which has implications for central bank policy. Inflation is rightly focused on as a key variable for central banks, as once it becomes embedded in an economy it can be hard to reduce due to wage price spirals, among other things. Equally inflation hits those the most who can afford it the least. There is no other choice but to take action to bring inflation back under control. The only tool central banks have to reduce inflation is to slow economies down using interest rates: if there can be no supply-side response to commodity shortages, then the demand side of the economy will have to do the heavy lifting. The track record of central banks in engineering economic slowdowns without creating recessions is not good. Either way, it seems likely the fruitful liquidity environment and good economic growth of recent times look likely to be replaced with shrinking liquidity, higher inflation, and slower growth. This is a very different environment for investors. An inflection point? Maybe.
Sustainability is booming
Although it may seem somewhat contradictory to the underperformance of most sustainable funds this year, and to the need to burn more fossil fuels as we adjust to a world in which Russia has become a pariah, sustainability is booming. We have seen this in the recent corporate results season, where we get to see and discuss the performance of the companies we invest in on your behalf. It has been an unusually good results season, with many companies we invest in exceeding our expectations. The benefits of sustainability are influencing them in the following three ways:
- Cultural – a persistent message we get is that companies with purpose and strong environmental and social performance are more successful in attracting talent to work for them. While some of this is a generational effect, working for a company actively doing good for the environment and society is, alongside more traditional requirements for a role, becoming more important
- Operational – strong environmental and social practices are now seen as making businesses more efficient and effective. Far from being a burden, net zero commitments are a way to making businesses more resource-efficient and saving money. Inclusivity and wellbeing of employees are also correlated with high-performing businesses
- Financial – sustainability is bringing material new business opportunities to many of the companies we invest in, as they themselves help other businesses and consumers to enact their own sustainability goals. More sustainable companies are also able to issue their debt more cheaply, and have their equity valued more highly, as they are seen to be better risk/reward investments
This combination of hiring the best talent, being operationally efficient and effective, and having a greater breadth of opportunity at lower risk is a powerful one. It is also why we believe that any periods of underperformance for sustainable investing could be temporary rather than permanent. We believe that companies with these characteristics are more likely, over time, to be productive investments whatever the overall investment environment, and we own many of them.
The energy conundrum
The three goals of governmental energy policy are as follows:
- Low-cost energy as it is non-discretionary and must be bought by all
- Low carbon to mitigate climate change
- Security of supply must be high, so the lights do not go out
A cursory glance at these three suggests what is known to be true: policy can achieve any two of these goals, but not all three. Want low-carbon, secure energy supplies? You can, but historically that has been too expensive given the price of renewables. Want secure supply and low cost? Burn coal! Somewhere there has had to be a compromise.
These compromises are alive and well in the current energy situation. New security of supply issues in Europe, which has been dependent on Russian gas, meant it needed coal generation to take up more of the burden. This may seem unsatisfactory to those of us who wish to mitigate climate change, however in the short term it is unavoidable.
Just as the energy crisis of the 1970s, when the Middle East stopped supplying oil to the US in retaliation for its support of Israel, was the genesis of the renewable energy industry, recent events will make renewable energy much cheaper than carbon-based. Renewable energy is also the only true energy of freedom, where governments can generate it whichever way the geopolitical wind may be blowing. All three governmental tests can be met! So, we think the crisis in Ukraine will follow the pattern of all crises: disruption (where we are now); adaptation (a reorganisation of the energy complex in the next few years); and thriving (a lower carbon future). So contrary to views that the conflict in Ukraine will create a renaissance in the carbon-based energy industries, we think it is as likely to hasten their downfall rather than reignite them.
Past performance is not a reliable indicator of future results. The value of investments and the income from them is not guaranteed and may go down as well as up and investors may not get back the amount originally invested. Portfolio characteristics and holdings are subject to change without notice. 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.