News & Insight • Market Insights

14 April 2023 | Simon King

Thoughts on 2023: Diamonds & Pearls

In all of our recent thought pieces we have commented extensively on the headwinds and difficulties that global economies and markets face in the next decade. However, our last missive in January “Reasons to be cheerful part 3”, outlined why we thought the outlook was more positive than previously.

Although the timing and sequencing of the catalysts we highlighted previously may be slightly different, due to the unintended consequences that we feared, such as the recent banking crises, we have not changed our view. We are clear that the era of cheap money that began post the financial crash of 2008 is now over. Interest rates and inflation will reduce to more normal levels from their current elevated status but not to the low levels of the past fifteen years. This means the outlook for global economic growth will be more subdued. As such, investors will not be able to rely on a rising tide to guarantee investment returns moving forward.

It will therefore be crucial to identify investments that will grow with no help from the general economy. This growth can manifest itself in many forms: from the excitement of a new whizz-bang invention, through companies simply doing things better than their competitors, to longer term secular trends which are beneficial to be exposed to. We tend not to comment on individual stocks in these commentaries but suffice to say that we can find examples of the first two categories right across the globe. If we select the correct ones, then in our experience they tend to become more valuable and sought after in a low growth environment. Therefore, to continue our more positive tone, we thought it would be useful to remind clients of our views on the last category of secular trends. These are the areas and themes that we find attractive and where we believe we can make money for clients. As Prince reminded us in his 1991 song of the above name there are always new opportunities to be discovered.

There has been extensive discussion of the necessity for all economies to transition away from carbon-based energy towards what is commonly known as green energy. We identified this as a theme some time ago but were always extremely nervous about the unbounded enthusiasm that stock markets and investors developed for anything considered environmentally friendly. It simply created over-valuation and unrealistic assumptions. The conflict in Ukraine has unfortunately thrown a major spanner into the works and resulted in increased demand for oil and gas in the short term and a whole new debate around energy security and self-sufficiency. This position will reverse but it will take some time.

In the meantime, the element of the transition we find most attractive is electrification. The move to green energy is one that will result in all major economies becoming more reliant on electricity. The green angle comes from generating and transporting that electricity in a more environmentally friendly manner. The size of the effort to achieve this should not be underestimated. The investment required in both generation and grid infrastructure is simply vast. There are many ways to gain exposure to this value chain and we have identified several interesting investment opportunities. These include manufacturers of generation and switching equipment, developers of new types of technology, eg hydrogen power generation, funds which invest in a wide variety of infrastructure projects, companies that aid connection to grid systems and providers of the cable which connects all of this up. We believe that this group of investments will produce steady and sustained growth over an extended period of time.

Although we are firm believers in the transition to green energy and the eventual demise of the carbon sector, this will only occur over a long and extended period. This provides two major opportunities; Firstly, in the short term there will be a continuing demand for oil and gas due to the ramifications of the Ukraine conflict, and this will continue into the midterm in order to keep the lights on while the difficulties of the green transition are resolved: Secondly, as previously commented on, this transition will necessitate a massive electrification process. We believe that these factors when coupled with continuing economic growth, particularly in China and other developing markets, will lead to increased demand for all basic materials. This will be over a broad range of commodities with the most obvious being oil, gas and iron ore, but will also extend into the precious metals, such as copper, nickel and cobalt, which will be required to facilitate the equipment required to build out the new systems. Although some of these materials are in abundant supply in the ground, there has been a dearth of investment in new extraction capacity across the globe and the lead times and cost of reversing this decline, will mean even a slight increase in demand is likely to Impact on prices with immediate effect. We believe therefore that the current owners of these assets will produce healthy returns for some considerable period of time.

We continue to be attracted to the merits of the wider infrastructure sector. One of the major changes since the financial crash of 2008 has been that all developed economy governments have taken on more debt. This has and will restrict their ability to make the infrastructure investments that are required to both replace existing facilities, but also more importantly to provide the necessary systems and structures to facilitate growth in the future. However, all governments realise that investment must continue and as such will have to increasingly rely on the private sector to fund much of it. We have already seen the US make a huge step forward on this with its mis-named Inflation Reduction Act, which will result in a vast amount of infrastructure spend incentivised by tax cuts but funded by the private sector. When correctly structured and positioned, quoted companies and funds can provide an attractive source of both capital growth and income over an extended period of time. In addition, these investments often offer at least partial protection against inflation over time. This type of investment provides balance and diversification in client portfolios.

We have been clear about our preference for the healthcare sector for some time. Put simply we believe we are going to have to spend a lot more money on healthcare both now and in the future. Developed economies are witnessing a gradual and predictable aging of the population (see later in this piece for our general thoughts on demographics). There is robust evidence to suggest that due to the increased prevalence of diseases, resulting from obesity, eg, diabetes and heart conditions, we are simply less healthy than we once were. This is evidenced by recent reductions in life expectancy for the average 65-year-old in most developed economies. When combined with an increase in chronic conditions in later life, unfortunately we can only forecast a major and sustained increase in demand for healthcare. This will occur in both private and public systems and will ultimately have to be funded by individuals either through taxes or elective surgery. This increasing level of demand will produce many opportunities for the very largest and smaller healthcare providers. Although there will be restrictions on spend due to governments’ ability to fund their healthcare responsibilities, this will focus on trying to reduce increases rather than cut overall budgets. Against this background, there are numerous opportunities to invest in companies with successful major drugs, innovative suppliers of medical products and services, and developers of new drugs and technologies. Some of these will inevitably fail, but the prize for those that succeed will be material.

One of the features of 2022, was a fall in the technology sector. The market took fright at the high ratings many of its constituents had advanced to and listened to the received wisdom that stocks prized for their long-term predictability always fare badly when interest rates rise. We argued at the time that the market was not differentiating between speculative technology and a number of companies, which had developed incredible franchises and financial models. The likes of Microsoft, Alphabet, Nvidia, ASML and Apple have developed into what we like to term the new blue chips ie franchises with above average financial returns. They also possess the ability to invest excess cash flows successfully and profitably into their existing and new businesses. In addition, they achieve growth in a variety of economic and market conditions. The market would appear to have come round to our way of thinking in 2023, with all the major technology companies recovering some or all of their losses. With current economic and financial conditions severely restricting the ability of new players to attract investment and governments losing their appetite for increased regulation, we expect the strong to become even stronger. The  digitisation of the global economy will continue. This will take various shapes and forms as the current hot areas such as cloud computing and digital advertising spend move into new areas such as artificial intelligence. Once again, the prize for both companies and their investors for delivering in this area will be a huge one.

Luxury goods is another area that has surprised many commentators. When economic conditions become more challenging received wisdom is that consumers draw in their horns and spend less on expensive and discretionary products and services. Whilst this is true, there remains a cohort of wealthy individuals and households who are not sensitive to the wider economic situation. Indeed, this group has seen its wealth increase on both an absolute and relative basis during the last 15 years and even more so recently. Although this will appear iniquitous to many, it is a fact. There are several companies that have and continue to execute extraordinarily successful businesses in several luxury areas. Increasing demand for their products comes from developing economies rather than just more developed areas. Many countries are witnessing the emergence of a larger middle-class, which has the aspiration to consume more branded goods and services. The financial returns achieved by the successful companies in this area make them attractive investments. At times they appear expensive but tend to accrete value over the longer term.

One of the tools we use in assessing all our investments is demographics. We are keen students and observers of any demographic data we can acquire. We like it as a tool because of its certainty and predictability. Although its impacts are very long-term, it often has influence on the short-term behaviour of both companies and governments. There are numerous individual sectors demographics can be applied to, such as housing, education, health but it is at the macro level that it is the most powerful. We have previously commented on the declining birth rates being witnessed in most developed countries and the pressure that this is already exerting on primary and social care systems and the ability of working age adults to support retirees. In addition, we are now seeing unprecedented falls in birth-rates in both Asia, and contrary to popular opinion also in Africa. Although these are from very high levels, and to some extent, are counterbalanced by improving levels of health and life expectancy in these areas, they will have a major effect on the global economy much sooner than many are anticipating. We anticipate the hysteria around over-population to subside very quickly and the debate to turn to how the world adapts to a vastly different demographic backdrop. Any period of change creates opportunities.

In a period of more challenging markets, we are acutely aware of our duty to provide returns for our client base. We believe we can continue to identify several investments that will provide capital growth over an extended period. However, we are also conscious that there are many opportunities to gain high levels of income from investments with more limited capital upside. For the first time in fifteen years, cash is now a realistic asset allocation decision. The general rise in interest rates has also led to a number of asset classes offering very high levels of income. The danger in investing in some of these areas is that the income does not compensate for the risk of major capital downside. A high yield should not be used as an excuse to invest in a poor company or asset. The UK market has seen numerous large companies provide major share price reductions and then dividend cuts. We continue to identify several asset-backed investment opportunities where we believe capital downside is limited and current yields are both attractive and sustainable. Our aim when investing in income producing assets continues to be to attempt to diversify exposures by sector and by geography.

Overall we maintain the more positive view we adopted at the beginning of 2023. The world is slowly working through the ramifications and implications of the Ukraine conflict, Covid-19 and the end of cheap money. Importantly it is also dealing with the unintended consequences of policy changes, such as the recent banking crisis, in a robust and decisive manner. This provides much needed confidence to markets, businesses and individuals alike. Although this will not be a smooth path there are enough opportunities in the areas we have highlighted to mean attractive returns are still available.

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