Our Global Equity investor day in the fourth quarter of 2022 was an opportune moment to reflect on an interesting year, and share some views on what lies ahead. Jeremy Richardson gives his thoughts.
Looking back to one year ago, what were you and the team concerned about?
It’s hard to imagine now, but mostly it was the potential threat of Omicron. It wasn’t until it was confirmed that Omicron led to far fewer hospitalisations than previous variants that the ongoing threat of the pandemic receded. This was a key turning point for markets.
The start of 2022 saw a strong rotation in equity markets. The pandemic had suppressed aggregate demand but had also suppressed aggregate supply, with supply chains and storage disrupted. When the threat of Omicron passed, aggregate demand increased but supply chains were slow to respond, leading to inflationary pressures. Financials and energy stocks performed strongly on the back of this, and to a lesser extent, defensive sectors such as consumer staples and utilities also did well.1
A key moment of the year was the Russian invasion of Ukraine on 24th February. From an investment perspective, what are your views on that?
The invasion had a profound effect in a way that the pandemic did not. Obviously, the effects of the pandemic shouldn’t be underestimated, but it might be considered a ‘transitory’ episode in the sense that viruses always become less harmful over time. The war in Europe, however, represented a ‘systemic change’ to the investment landscape. As active investors, we try and capture the benefits of change. Companies change constantly; industries change but less often and at a slower pace. Systems however, be they social, legal or economic, rarely change. Yet the invasion triggered a rare, systemic change.
This change led us re-assess our view of industries and the competitive advantages of individual companies. We reflected on two key points in particular:
- Food and energy disruption: halting Ukrainian grain exports and supply issues with Russian natural gas meant increases in food and energy prices. This inflation ultimately contributed to higher interest rates and put pressure on non-discretionary spending and the finances of households at the lower end of income distribution, in particular.
- Supply chains: the physical impact of the disruption would give a competitive advantage to ‘simple’ businesses with uncomplicated supply chains. Business models of an advertising company or a company focusing on R&D, for example, were unlikely to suffer the same negative impact as that of a car factory which has complex inputs and supply chains.
Since that time, what else has impacted markets?
The general view, early in the summer, was that increased inflation was likely to be ‘transitory’; interest rates would rise but not to a level that would threaten a recession and the U.S. economy would have a soft landing. This environment was more constructive for global equity investors but unfortunately didn’t last. Inflationary pressures remained and the language of central bankers became more hawkish, with talk of continuing interest rates increases until inflation came down.
Going into year end and the start of 2023, the market continues to be in a ‘defensive crouch’. For many investors, the current situation is similar to the economic downturns of 1981 and 2001. In 1981, the downturn was profound and the economy underwent structural changes, whereas in 2001 it was shorter, shallower and with fewer, longer-term consequences. Interestingly, perceptions vary by geography. The situation in Europe is more reminiscent of 1981 and consumers are already changing their behaviour. In the U.S., however, there is a tendency for investors to view the situation as more similar to 2001.
What are your key takeaways from the seismic market events of recent years?
- The pandemic as a cycle: there was a view that pre-existing structural trends, such as the shift from physical retail to e-commerce, would accelerate during the pandemic and create a step change to a new normal. The market initially favoured business models likely to benefit from the bringing forward of this structural growth. However, as the virus has become endemic within society, old established business patterns have re-emerged. Rather than representing a step change, therefore, or ‘no steps back’, investor opinion has faded to ‘two steps forward, one step back’ or even ‘two steps forward, two steps back’. In effect, the pandemic has been its own cycle, with a starting point, a peak and a downturn.
- Energy: higher energy prices after the Russian invasion of Ukraine meant the need for renewable energy became even stronger, due to its benefits of being local, resilient and typically cheaper. However, we have not seen any significant acceleration in the shift to renewables, and there has been a surprising lack of policy from government and regional bodies around the transition.
- Labour: employees in knowledge-based roles typically had more freedom in the pandemic than manual and key workers who generally had much less agency. U.S. data2 shows that employment changes to hospitality and leisure industries have been the most negative, whereas professional and business services performed comparatively well. Employees are now choosing to work in certain industries based upon the quality of work, and good, flexible employers have a significant recruitment advantage.
- Pricing power: in an inflationary world, having the ability to raise prices to protect the bottom line becomes increasingly important, and in particular, managing the trade-off between price increases and volume. Businesses with a strong competitive advantage are more likely to have pricing power. For example, strong contingent assets in the form of branding and customer service are allowing particular consumer products companies to raise prices without negatively impacting volumes.
- Resilient supply chains: several companies, such as Ford, have released major profit warnings recently due to supply chain issues and a shortage of component parts. Supply chain management is acting as a weight on the market and this has been exacerbated by China’s Zero-Covid policies. However, companies are responding by re-shoring and also dual sourcing, so they are not relying on one supplier for a critical part. Although this costs more, it lowers risk and improves the visibility of a business.
And lastly, after an eventful time, where do we go from here?
The current macroeconomic-driven market is characterised by uncertainty and a lack of consensus. This kind of market environment tends to be less helpful for stock pickers as the focus is distracted away from company fundamentals. A stronger degree of consensus would tend to offer a more helpful environment for stock picking alpha.
However, beyond equity markets, great businesses are still doing well and competitive advantage is still resulting in value creation. Our framework of identifying great businesses continues to be relevant. As an analogy, we look at the few years after the Global Financial Crisis; a period which also resulted in a market dislocation. During 2009 and 2010, returns from stock selection were modest, as macroeconomics dominated the investment landscape. However, what is key is that alpha didn’t disappear….it was latent within those companies and sowed the seeds for a rich period of alpha generation when macroeconomic consensus emerged again.
In the longer-term, competition between inflationary and deflationary forces, such as globalisation, energy security, climate change and shifting demographics, to name a few, may mean that equity markets don’t return to their pre-pandemic normal. However we continue to believe that great businesses with strong competitive dynamics will harness the opportunities arising from change and will continue to add value for shareholders and our clients.