As we outline below, we see the complex interplay between geopolitics, economics and capital markets continuing through the year ahead. Despite this, there are some exciting investment opportunities, and we are becoming more enthusiastic about substantially higher expected returns on offer in many asset categories.
Russia’s invasion of Ukraine created the energy crisis in Europe and has also led to higher food prices. European consumers are therefore likely to remain cautious amidst higher living costs while the higher costs of doing business make it difficult for companies to make long-term investment decisions.
We’re keeping a close eye on China where we think the abandonment of its zero-COVID policy is a positive development. As their economic activity normalises, global growth should get a boost. However, China’s ‘reopening’ will create higher energy demand and is likely to have an impact on the energy crisis in Europe.
On another front, the battle for technological supremacy between the US and China means that most Western technology companies will lose access to a major market. Chinese technology companies, on the other hand, will lose access the latest hardware from international suppliers but have gained almost limitless state backing to develop a domestic semiconductor industry.
Inflation and interest rates
We may have shifted from a regime of low and stable inflation to more variable inflation, at a higher level on average. Although disinflationary forces remain (such as disruptive technology), there are now conflicting structural inflationary forces. One example is the shift from globalised “just-in-time” supply chains to a less efficient system with degrees of duplication. Although more resilient, the higher cost is inflationary.
The good news: it’s possible inflation in the US has peaked, with the UK and Europe a few months behind. But with it having been so high for so long, the US Federal Reserve thinks it could take a sustained period of high interest rates to reassert price stability.
Markets disagree and expect rates to fall more swiftly, in part because we are yet to see the full impact of higher interest rates which typically affect economic activity with long and variable lags. With most interest rate increases in the US and UK occurring within the last six months, we believe the initial indications of weakening consumer and corporate activity will multiply. We will get an early steer from corporate earnings reports in the new year but as things stand, it is possible that corporate earnings expectations are too strong.
This combination is a challenge. If the market is right about interest rates falling quickly, it will be because growth has faltered which is not reflected in corporate earnings expectations. Alternatively, if earnings expectations are right, interest rates may well stay higher for longer. Either scenario could cause further market volatility.
On balance, we continue to focus on portfolio resilience with reasonably valued, high quality companies that can weather the economic storm. While looking for signs of change that would make us more optimistic, we continue to be confident about pockets of the equity market represented by long-term themes, such as climate action and healthcare.
While the last several years have seen sustainable investing grow organically, new regulations in the UK, the US, and Europe align with economic policies to turbo-charge the amount of capital driving sustainable development, especially clean energy. For example, the Inflation Reduction Act in the US unlocks over $300 billion in tax cuts and subsidies to incentivise domestic investment in clean energy technology. Combined with the CHIPS and Science Act which was brought into US law earlier in the year, the two form a core pillar of President Biden’s attempt to re-shore key industries that are crucial to global development in the coming years. Other countries are yet to respond with their own packages, but we view this as being highly supportive for the theme.
Advances in healthcare
Advances in healthcare could get a significant boost with the latest developments in artificial intelligence (AI). AlphaFold is an AI system developed by DeepMind (a Google company) that predicts the structure of proteins. This allows scientists to research ideas computationally instead of experimentally, which will speed up the process of finding new and better drugs in healthcare, enzymes for industrial processes and much more.
We continue to face some near-term challenges, but the investment environment should settle down as interest rates stabilise and inflation cools. Being disciplined, patient and keeping our long-term investment objectives in mind has always served investors well and we have no reason to now believe otherwise.
Throughout 2023, we’ll be sharing regular updates to keep you up to date with markets, performance, and our thinking.