While the transition to normalised monetary policy creates uncertainty for the macroeconomic outlook, continued vaccine roll-outs are expected to help underpin growth in 2022. With this backdrop, where can investors turn to during the year ahead to find returns and invest for a better tomorrow?
Hendrik du Toit as well as several of Ninety One’s portfolio managers discuss their outlooks for 2022.
Hendrik du Toit, founder and chief executive
As we look ahead to 2022, Ninety One has its sights set on a date much further into the future – 2050, by when we should reach global net zero. To have any hope of achieving this target, Investors must direct capital towards reducing real-world emissions, rather than focusing on short-term ‘feel-good’ carbon targets
What did you make of COP26?
This was the first COP where the finance sector was present in force. We will only achieve a successful energy transition if finance is involved at scale. At COP26 there was also growing recognition that we need to support the emerging world’s net zero transition, and that it will necessarily be slower. This is important because there is now an honest conversation about how we can build a realistic net zero pathway for the whole world, including emerging markets. I came away from COP26 reasonably optimistic, but there’s a huge amount of work to do to keep global warming below 2-degrees Celsius.
Are asset managers and owners tackling the net zero transition in the right way?
My concern is that the initial drive for net zero focused largely on creating low-carbon portfolios. It’s not difficult for investors – in developed countries especially – to divest from ‘dirty’ industries, most of which are based in emerging markets. But that risks starving the emerging world of the capital it needs to transition and leaving high-carbon assets in the hands of less scrupulous owners with no interest in decarbonisation. Ninety One is arguing strongly for a focus on financing real-world, sustainable emissions reductions, rather than creating low-carbon portfolios.
Can you explain the difference between a low-carbon portfolio and a portfolio that supports real-world decarbonisation?
A tiny number of stocks account for the bulk of emissions. In South Africa, two companies produce almost half of all emissions, namely Eskom, the electricity utility, and Sasol, the energy and chemical company. If an investor divested from a heavy emitter, they would have a lower-carbon portfolio. However, if that emitter is then bought by an unscrupulous investor with no interest in decarbonisation and who is simply aiming to maximise cashflows, the world is no closer to net zero. Responsible ownership will play a key role in the transition to a cleaner greener world.
What are the risks of focusing on reducing emissions at the portfolio level? The risks of focusing on reducing emissions at the portfolio level would mean denying capital to countries with carbon-intensive energy systems, which primarily means emerging markets. That would create a social disaster and likely result in no net zero at all. So it is very important that we don’t leave anyone behind and that the net zero transition is inclusive. As investors, we need to be focused on achieving net zero by 2050, rather than short-term goals that do not support real-world emissions reductions.
How can investors support the net zero transition?
Investors can support the net zero transition in two ways – remain invested in companies and engage with them to support their transitions. The other is to invest in companies whose products and services are enabling or accelerating the transition to net zero. We need to do both, and Ninety One is committed to doing so.
Simon Brazier, co-head of Quality and Portfolio Manager, UK Alpha Fund
Margins are set to come under pressure in 2022, but the key is to pick those businesses still able to grow their profits.
How would you summarise the current environment?
It is one of huge uncertainty, despite the vaccination programme in place and some form of resolution around Brexit. However, I think the biggest uncertainty comes from the future for inflation and, therefore, interest rates and growth. I believe that will determine the investment outcome for the next year – and maybe years – ahead.
What are your expectations for 2022?
If I had my glass half empty hat on, I would say that things could be quite tricky in 2022, particularly economically, as governments are having to tighten their purses, and central banks are unable to help, as we maybe see a tightening cycle on the monetary side. Therefore, I think consumers will be asked to take on quite a bit of that burden and may find themselves quite strained. Having said that, putting the glass half full hat on, if we do see a post-pandemic normalisation with consumers back out spending, then we may see certain areas of the economy, such as leisure and travel, doing much better.
What is the biggest risk facing companies?
Clearly, this is the input cost inflation that we have started to see already; the tightening of supply chains, input cost increases coming through from commodity prices, but also wage increases. The debate as to whether these inflation increases are transitory is still raging and, if we were to see more persistent – particularly wage – increases coming through next year, then that would be more difficult for equities as companies would find it more difficult on the margin front.
How are you positioning UK Alpha?
We are relatively defensively positioned, and still want to own those compounding growth companies that typically are cash-generative, defensive and, come what may next year, will continue to grow their profits and, therefore, their cash flows and be able to reinvest those at good rates of return. On the other hand, I do own cyclicals, particularly around travel and leisure that can potentially normalise their revenue streams into next year. I do think you will start to see airlines, particularly in short haul, fill again and also people back in pubs and restaurants.
Which companies have benefited from the pandemic?
The pandemic has clearly been terrible for most, however, there have been companies where it may have accelerated their growth opportunities. For example, some of the European low-cost airlines have seen their competitors go bust.
On the UK high street, those companies with a very attractive online proposition have prospered, while many competitors have really fallen behind as online shopping has accelerated. Therefore, if you find the right companies in the right areas that are able to benefit from some of the wider trends we are seeing in the economy, then there are some good opportunities ahead.
Deirdre Cooper, co-head of Thematic Equity and Co Portfolio Manager, Global Environment Fund
Rise of the carbon-cutters: investing in climate-solution companies: The intensifying focus on tackling climate change is driving growth for a select group of businesses.
What are your takeaways for investors from COP26?
It was perhaps most telling that attention was already turning to COP27 in Egypt in 2022. The previous pattern was that a major climate summit happened every five years, but now these events are going to be significant each year. That shows how much decarbonisation has risen up the agenda – and consequently why this issue has become so important for investors, from both a return-generation and risk-management perspective.
What should investors in climate-solutions companies keep an eye on next year?
The three key drivers of the structural-growth being fuelled by decarbonisation are regulatory developments, technology advances and changes in consumer preferences. All of them will remain highly relevant in 2022. On the regulatory side, the Build Back Better legislation in the US is expected to pass towards the end of 2021, and we’ll start to see its impacts from next year. Although the stimulus plan has been cut from US$3 trillion to US$1.5 trillion, what remains are essentially all the climate measures. In China, the central bank’s decision to provide subsidised financing for ‘green’ sectors will also fuel growth for select companies in 2022 and beyond.
Where are you seeing technological advances?
The pace of technological development is rapid across many areas linked to tackling climate change, particularly in some sectors that are earlier in their decarbonisation journeys.
For example, we have been adding exposure to software companies that are helping to make buildings more efficient, and to companies developing clean-tech solutions for areas that are difficult to decarbonise, like air transport.
Food has been another focus of our research, given the need to reduce emissions from agriculture and food production. There have been exciting advances in this field too, for example in developing meat-alternative proteins.
What consumer trends are you watching?
One striking aspect of COP26 was how engaged civil society was in the discussions. Addressing climate change is on almost everyone’s agenda, and consequently consumer preferences are shifting further towards sustainable offerings.
We see this as a major opportunity for companies that make the materials for sustainable consumer products, such as ingredients for bio-based shampoos and other household goods, as well as more sustainable food.
What are the key risks to watch out for next year?
Supply-chain disruptions are yet to be resolved. They have pushed up the prices of various components, which is a benefit for some companies but a headwind for others. Some businesses in our universe have seen slower sales because they haven’t been able to access raw materials, as well as lower margins. We expect these issues to dissipate during next year, but they need to be monitored. That said, as long-term investors, we view some of these short-term market dislocations as opportunities to gain exposure to companies we like at appealing prices.
What other big issues are you keeping an eye on?
The energy crisis is clearly one to watch. It’s really two separate issues. In Europe, the energy squeeze is supply-driven, and primarily hinges on the availability of Russian gas. But in China, it’s demand-driven. Chinese power demand is up 20% this year alone. One consequence of more expensive fossil fuels is to make clean energy even cheaper by comparison. The cost of renewables has been falling over time anyway, and in many parts of the world wind is already by far the cheapest way to generate electricity. I think the steep rises in fossil-fuel prices this year will accelerate demand for clean energy in the medium term. That will be a tailwind for a diverse group of companies, from clean-energy utilities to manufacturers of the technologies and components needed to ‘green’ the grid.
How is your portfolio positioned heading into 2022?
We own several companies that we think are well-positioned to benefit from decarbonisation in the US, including clean-energy companies and businesses that make efficient heating and cooling systems. If the Build Back Better legislation makes it through Congress, as we expect, that would significantly increase our forecasts for them. Additionally, we have extensive exposure to electric vehicles (EVs) across the value chain, including via companies that make EV battery components and mobility software.
In October 2021, 23% of new car sales in Europe were electric, which highlights how the switch to electrified transport is accelerating. And we are continuing to explore relatively undiscovered decarbonisation sectors, such as sustainable food and agriculture. Overall, we are maintaining our investment approach, which is to focus on a diverse but very select group of leading companies with competitive advantages, all of which are enabling sustainable decarbonisation.
John Stopford, head of Multi Asset Income and co-portfolio manager, Diversified Income and Global Income Opportunities Funds
We think things could actually turn out better in terms of rate expectations than perhaps the market is beginning to fear.
What is your outlook for 2022?
We would argue valuations within income-generating assets look relatively attractive, both in terms of good quality, high-yielding equities, and elements of the credit market. I think we are getting to a point where some markets are already pricing in a significant normalisation in policy and investors are also pricing in higher inflation. Next year might start with some of the themes that are playing out currently – caution in terms of both growth and policy – but we expect some pretty exciting opportunities for resilient income investors such as ourselves, particularly from the bottom up.
How do you expect this normalisation in policy to play out?
Policymakers are gradually removing super-easy policy, initially through running down their quantitative easing programmes and then, ultimately, we may get higher interest rates. However, the market’s current fixation is the extent to which inflation is likely to be transient or longer lasting. Whilst we think that there are medium-term inflation pressures, we are probably close to peak bottleneck, peak supply pressure, inflation and base effects going into next year could be significant.
There is quite a lot already priced into some markets in terms of higher rates. Additionally, central banks might get away with doing a bit less or being under less pressure if inflation starts to come back down towards target into the middle to second-half of 2022. Therefore, we think things could actually turn out better in terms of rate expectations than perhaps the market is beginning to fear.
Will you add more risk in 2022?
We think that there may be an opportunity to add exposure in areas that are looking a little bit out of favour or distressed, but it is important to be selective. It is not as easy an environment in terms of loose policy and strong growth that we saw in 2020 and early 2021. It is going to be more mixed, but we think we are getting to a point where investors are potentially beginning to price in too much risk in terms of inflation, policy tightening and weak growth, and that should present opportunities.
Jeff Boswell, head of alternative credit and co-portfolio manager, Global Total Return Credit Fund
Prepare for a shift in conditions and increasing dispersion in the performance of companies.
How high are current valuations in credit markets?
Over the past year we’ve seen the phenomenon of ‘a rising tide lifting all boats’ in global credit markets, with spreads and yields approaching historically tight levels in most markets. This means that at the aggregate level credit market valuations appear expensive and some of these markets are looking particularly vulnerable to a price correction. However, look beneath the surface and you find significant differentiation, with some markets still offering compelling valuations for active investors who are able to cast a wide net. US high yield is a good example of where we think both the highest and lowest quality parts of the market are particularly expensive, masking attractively valued opportunities among the middle-rated categories.
How strong is the fundamental outlook?
Offsetting the theme of generically tight valuations is a more constructive outlook for company fundamentals. Default rates – a vital area of concern of credit investors – are exceptionally low across both European and US markets as the global growth backdrop improves. This favourable fundamental outlook arguably justifies tight valuations and favours credit investors who can find those areas of the market that are still attractive from a valuation perspective.
What will be different in 2022?
Returning to the theme of a rising tide lifting all boats and considering what challenges 2022 might hold, credit investors should prepare for a shift in conditions and increasing dispersion in the performance of companies. While all companies benefited from the unprecedented support measures from policymakers in 2021, as that tide of support recedes and new challenges (inflation/supply chain issues/labour shortages) emerge, vulnerabilities will be laid bare.
This will ultimately reveal winners and losers within the corporate landscape. Against this backdrop, credit investors will need to be more selective in their approach, aiming to avoid companies that are most vulnerable and to seek out those with resilience. Investors should also expect increased volatility against this backdrop. As we see a moderation in growth momentum as markets adjust to a new economic normal, investors should not be tempted to buy into credit stories that are heavily reliant on a continued unrealistic economic trajectory, or that are not paying them sufficiently for the associated risk.
Another continuing theme will be the ‘greening’ of credit markets, already demonstrated by the surging issuance of green and sustainability-linked bonds during 2021. Investors will need an increasingly wide lens and new analytical approaches to navigate opportunities arising in that field and, more broadly, to assess ESG risks and opportunities which are increasingly being priced into markets.
How are you positioned?
Given the balance between the market valuation picture and the fundamental strength described above, we would describe our current positioning as cautiously constructive. While the fundamental backdrop is strong, valuations in credit markets limit the potential for further spread compression-driven gains. Our
focus is on earning attractive carry for investors in the parts of the market that still offer value, while the potential for increased dispersion leads us to tilt towards some of the more defensive areas of the market.
2021 was about dynamically allocating across global credit markets to capture the rally that permeated across markets as economies reopened and seeking out companies where we saw strong scope for improvement. 2022 will be more about focusing on the more defensive areas of the market that offer the right balance of yield and downside protection.