There have been a lot of headlines in recent days about the inversion of the US yield curve and whether this is an accurate predicter of an impending recession. Whilst a recession is not inevitable in our view, we are increasingly of the view that economic growth is likely to slow materially in coming months, as consumers adjust to rapidly rising costs of human necessities such as food, heat and shelter.
The default response to decelerating growth in recent years has been more liquidity injections by central banks but this looks much less likely this time around with fighting price inflation seen as a more pressing requirement. Federal Reserve Policy Committee members have been lining up to deliver hawkish messages to markets in recent weeks. Whilst it is easy to understand the Fed’s desire to at least be seen to be doing something and rebuild their inflation-fighting credibility in the process, it could well prove easier to “talk the talk” than to “walk the walk” on this one, given elevated debt burdens and the economic impact of increasing the cost of servicing this debt. Furthermore, it is not clear what they can really do to bring down prices quickly. Making borrowing more expensive may dampen speculative demand but will do little to incentivise new food or energy capacity coming onstream. In fact, its effect could be quite the opposite.
The Fed likely has a relatively short window to at least do something. Latest polling data suggests that inflation has become the number one topic that US voters are considering when deciding how to vote in November’s mid-term elections. Raising rates and squeezing standards of living might be OK now, but it will cost the Fed a lot of political capital as we move closer to polling day.
Regardless of the liquidity environment, we will not relax our requirement for rising and sustainable returns. These remain the essential attributes of Future Quality investing. The question is how long do the rising returns have to be sustained for and what does this mean for the areas we should be researching our potential investments? History may point in the right direction, but it is important to be aware of differences that may make historical precedents less insightful.
For instance, unprecedented debt-funded infrastructure investment in China produced a commodity super cycle in the years following 2000 and this (allied to the aftermath of the dotcom bubble) allowed the metals and mining sectors to outperform for seven years. There are certainly similarities today, in terms of the potential structural demand boost for commodities like copper from energy transition and the concentration of equity market performance in the information technology sector in recent years. However, there are some fundamental differences too.
The most major of them are considering how much this pivot to renewable energy will cost (in monetary and resource terms) and—just as importantly—who is going to pay for the necessary investments. Whilst China could effectively fund its spending by issuing debt to itself, such a benign funding mechanism is not obvious for the US or EU after years of quantitative easing and the resultant elevated debt burdens.
Passing the burden onto consumers would be one alternative to state funding, likely via a carbon tax but this too poses some pretty fundamental issues. A World Bank Study confirmed the uncomfortable truth that energy costs a disproportionately high amount to the least affluent in society. Further increasing inequality and fuel poverty would be politically unacceptable in most Western democracies.
The recently launched REPowerEU1 initiative is a good example of the potential disconnect between political ambition and economic reality. The policy’s main ambition is removing European reliance upon Russian energy by 2030. There is little mention, however, of the practical challenges that this entails. How quickly can the new energy infrastructure be planned and delivered? How much additional steel, cement and oil will be needed to build it? How much will it cost? Whilst the glossy Factsheet produced by the EU on this topic has lots of numeric targets for the energy transition that this will necessitate, there is no mention of its resource or financial implications.
1Proposal launched by the EU in March for joint European action for more affordable , secure and sustainable energy and to eliminate dependence on Russian gas.
We are keen to participate in the push towards a less carbon intensive future but want to do so in a balanced fashion, with one eye on the associated risks. One way of doing this is to prioritise more capital-light businesses who are likely to benefit most quickly from the initial preparations for the switch. Companies whose know-how spans several of the technologies (from carbon capture and storage through to hydrogen and renewable energy) that address carbon reduction are also more attractive than more focused options. Engineering and designing the new energy infrastructure required will comfortably pre-date the actual pouring of new concrete or the laying of new copper cable. As such, these industries are less susceptible to any weakening of political support over time.
The portfolio currently offers a blend of companies that will benefit from the strong imperative to reduce reliance upon carbon intensive sources of energy (and the autocratic regimes that own them) and companies that will benefit from long-term demand growth, as a result of other, more well-established multi-year themes. These include the delivery of high-quality, cost-effective healthcare and the ongoing investment in industrial automation and digitisation. Through investing in these areas, we are confident that we will be able to deliver high and rising returns on investment and that this will feed through into attractive long-term returns for our clients, irrespective of near-term macroeconomic developments or central bank policy.
Any references to particular securities are for illustrative purposes only and are as at the date of publication of this material. This is not a recommendation in relation to any named securities and no warranty or guarantee is provided.
Nikko Asset Management New Zealand Limited (Company No. 606057, FSP22562) is the licensed Investment Manager of Nikko AM NZ Investment Scheme, Nikko AM NZ Wholesale Investment Scheme and the Nikko AM KiwiSaver Scheme. This material has been prepared without taking into account a potential investor’s objectives, financial situation or needs and is not intended to constitute personal financial advice, and must not be relied on as such. Recipients of this material, who are not wholesale investors, or the named client, or their duly appointed agent, should consult a Financial Advice Provider (FAP) and the relevant Product Disclosure Statement or Fund Fact Sheet (available on our website www.nikkoam.co.nz). If you are a Financial Advice Provider (FAP) and would like to find out more, please contact our distributions team.