SustainAbility: False Fears

New Year Hangover

If December was a party for equity and bond markets, the first week of January feels like the hangover. 2023 turned out to be an excellent year for investors with equity markets offering double digit returns and investment grade corporate bond markets not far off achieving the same.

Much of this return was delivered in the last eight weeks of the year, as a combination of falling inflation and an unexpectedly dovish (favouring lower interest rates) US Federal Reserve gave investors renewed hope that a recession would not be needed to bring global economies back to their stated inflation targets.

Should this be correct, and we now know where interest rates have peaked, I see this as an unqualified positive for economies and markets.

Debt refinancing, both for individuals and corporates, is a process not an event. There is time for all to evolve into a higher interest rate environment, through making cost savings or increasing prices for goods sold, as debt is often ‘termed out’ or spread over many years rather than it all being up for refinancing at a single date. Corporates and consumers can now plan better. Knowing where the peak level of interest rates is, could be more important than what the peak level is.

2024 has however started with a bit of a thud and both equity and debt markets have sold off. In our industry, price drives narrative so there is no shortage of ‘explanations’ for this. Favourites include geopolitics in the Middle East, where the chances of regional escalation with respect to Israel have perhaps increased; and renewed recession concerns as the long and variable lags of higher interest rates finally hit economies.

These concerns are of course valid, but we think the most likely explanation is markets were overbought at the end of last year. Some degree of pull back and consolidation is perhaps inevitable after such a strong run. For context, the S&P 500 is only 3% away from its all-time high at the time of writing. Although the calendar year has changed, not much else has in the last week or so.

False fears and unrecognised growth

At the end of each year, it’s informative to look back on which investments have driven overall performance. Each year ends with individual holdings up 50% or more, and these are the ones which really drive overall performance. Within our sustainable strategies Nvidia, Top Build, Sage and Ferguson would be examples of this in 2023. What can we learn from this when thinking about what may occur in 2024? It comes down to false fears and unrecognised growth.

‘False fears’ is a concept first introduced by Ken Fisher, the US investor and self-made billionaire. His idea is that false fears are always positive for share prices. A false fear is something investors are worried about which turns out to be incorrect. These fears can be at the economic or company level.

The key false fear in 2023 was that of a US recession. That one would occur was perhaps the most consensual view in markets at the start of the year. Far from a recession, the US economy was unusually strong last year, itself a function of a resilient consumer and fiscal deficits (government expenditure) supporting overall economic growth. As investors realised this, key beneficiaries of US economic activity, such as Ferguson and Top Build, performed strongly.

Where could the false fears be in 2024? Perhaps the most consensual fear we see currently is that China is an economy with structural problems. These relate to its imploding property sector and weak demographic profile. Should these fears be proven false shares impacted by them (for example AIA and Prudential which we own) could perform strongly.

There are still some fears of a US recession in 2024, which is unusual as recessions are rare in presidential election years. These concerns are not as prevalent as in 2023, so I think it is unlikely that if this proves to be false it will have as big an impact as in 2023, but we still think it would be positive.

Unrecognised growth is the idea that there are growth drivers for companies that have not been recognised yet. Growth is the elixir of equity investing and is one powerful route to rising share prices.

The big area of unrecognised growth coming into 2023 was generative artificial intelligence (GenAI). This evolution of AI, which allows its application in language and creative based industries, as opposed to just data led, has opened up potential new markets for businesses such as Nvidia and Sage, rerating their share prices in the process.

Our sense is we are still in the early stages of this area of new growth. Although there is much talk about it, like when the first iPhone was launched in 2007, it will take many years – if not decades – to permeate through society and explore all its potential uses. It still seems to us unrecognised growth, even if it is less so than last year.

Are there any new areas of unrecognised growth possible this year? We think emerging markets ex-China could be one. Gavekal, a macro research company we subscribe to, has written extensively on this and their founder Louis Gave has recorded several freely available podcasts on the subject. Their view is that Latin America is booming, taking Mexico for example. As is Asia, which includes India and Indonesia. There are multiple reasons for this which include these countries being beneficiaries of geopolitical tensions, being recently able to buy key commodities such as oil in their own currencies (which they can print) rather than borrowed US dollars, and favourable demographics.

None of this is visible in the performance of emerging market equities over the last decade, but that’s the definition of unrecognised growth! We do have selected investments in these areas, MercadoLibre (Latin America), HDFC Bank (India), Bank Rakyat (Indonesia) and will look for more in the coming years.

In summary, big returns can come from big changes in investors views of the future. A year ago, investors feared a recession in the US which didn’t appear and did not recognise the potential of GenAI. Both these issues may lead to more returns this year, but it is worth looking for other areas too. If China is not the disaster many investors think it currently is, and emerging markets continue to boom, this will result in a significant shift in asset prices related to them. We are not saying this will happen, but it is certainly worth considering.

The story of 2024

Every investment year takes time to build, and what investors believe on 1 January is rarely what they believe on 31 December. Last year was great for investors after a challenging 2022. What will happen this year is subject to future events, the most important of which will not be forecasted (that’s why they are the most important!). We think though 2023 was a useful reminder of the strength of sustainable investing, and long-term investing overall.

Hopefully this year will be more of the same! Happy New Year!

This is a financial promotion and is not investment advice. Past performance is not a guide to future performance. The value of investments and any income from them may go down as well as up and is not guaranteed. Investors may not get back the amount invested. Portfolio characteristics and holdings are subject to change without notice. The views expressed are those of the author at the date of publication unless otherwise indicated, which are subject to change, and is not investment advice.