5 Market Shaping Themes For 2023

Downgrades, net zero, cheap banks and more

I have been writing a lot about conferences recently, but I think they have been worth sharing. Today I’m going to share some insights from the Edelman Smithfield Investor Summit. Edelman Smithfield has an impressive array of 25 asset management clients and there were some notable guest speakers at this small event which I wanted to write about for two reasons:

1            the subject of earnings downgrades came up and it was something I had been discussing over a very cold (outdoors) glass of wine with Russell Napier the previous evening.

2            there was considerable discussion of ESG and this is one of the topics I am going to focus on in 2023, particularly on the podcast (where I have exciting episodes planned) but also here in the newsletter. But it will be ESG with a difference – , much more E, for a start.

The conference was held at the London Stock Exchange on December 13, 2022. Keep reading for a summary of the most interesting debates and insights.

The Macro Outlook for 2023

  • Nigel Bolton, co-CIO of Fundamental Equity, BlackRock
  • Seema Shah, Chief Global Strategist, Principal Asset Management
  • Gurpreet Gill, Macro Strategist, Global Fixed Income, Goldman Sachs Asset Management

Shah suggested that the outlook for markets is mainly dependent on earnings, while Bolton thought that inflation would set the tone and that to stage a further recovery, markets would need to see inflation trending lower. Gill was most optimistic, with a rosy central scenario for a soft landing in the US and China reopening and a decline in inflation to 3% by end-2023. She sees next year as the most attractive year for a decade in fixed income and is focused on high quality short duration investment grade bonds. I should add that Gill’s LinkedIN profile reveals she has been at Goldmans for 9 years after university.

In contrast, Nigel Bolton has been in markets for 37 years and this is his sixth bear market. He  suggested that this is rather different from previous ones because it is occurring in an inflationary period; recent bear markets have all taken place in deflationary environments. Previously, central banks could come to the rescue of markets by cutting rates – he doesn’t believe that will happen this time. I agree with this analysis which suggests that markets may be over-optimistic on the potential for a Fed pivot. Bolton was a client of mine eons ago when I was on the sell-side; he is super smart.

Bolton’s view of the world is quite similar to mine and Russell Napier’s. He thinks that you now need to be active, you can’t just take beta (markets rose significantly in the 2010s and even an index tracker delivered fantastic returns). Valuation will be crucial, given that the cost of capital is higher. He thinks that small caps and EM are interesting, as are Europe and the UK – he highlighted that the UK is on 9.7x earnings! He sees some great businesses in UK mid-caps. But he warned that there are issues around earnings as downgrades are to come – I shall return to this in the appendix for paying subscribers.

Other notable comments included  that the standard US recession is 11 months and Shah and Principal think that is feasible in 2023, as long as the Fed isn’t too aggressive on inflation.

The panel was asked about tail risks which led to discussion of private credit markets. These are opaque and feature some quite cyclical borrowers. This is important because some of these companies will be seeking to refinance debt when they are experiencing a recession and facing an increase of 2x or 3x on their interest cost.

How Material is the S in ESG to Valuations?

Saker Nusseibeh CBE, CEO, Federated Hermes Limited

Nikesh Patel, Managing Director, Head of Client Solutions & CIO, Van Lanschot Kempen

Luis Olguin, Portfolio Manager, William Blair

Nusseibeh is well known as a leading proponent of ESG and made some valid points about why looking after staff was central to a successful business (full disclosure, Federated Hermes is a client). Although some good points were made by all 3 panellists, I came away thinking that the answer to the title question was “not very”. Looking after employees is obviously fundamental to managing a successful; business, but it’s really hard to analyse.

Are we doing enough to meet Net Zero targets?

  • Lord Browne of Madingley, Chairman, Beyond Net Zero
  • Jeremy Taylor, UK CEO, Lazard Asset Management
  • Sarah Williamson, CEO, FCLT Global
  • Stephanie Maier, Global Head, Sustainable & Impact Investment, GAM Investments

The answer to this question was no, but there was a good discussion. Lord Browne is an engineer by training and now chairs a green investing firm. He made a string of good points:

  • Global net investment spend on Net Zero projects has been running at $1tn pa. We need to spend $3tn pa, so we are way behind the curve.
  • He believes in using science-based targets to create real accountability – management must achieve third party set targets. As investors, they demand that their investee companies additionally produce data on targets above what is required to reach net zero.
  • The biggest problem facing many green companies is that they aren’t very scalable.
  • He sees opportunities in the rollout of electric vehicles and related charging infrastructure, materials and control systems for buildings, and areas of the circular economy. In services, there are opportunities in optimising the supply chain to reduce the carbon footprint.
  • The Inflation Reduction Act will divert a lot of green investment to the US and enable the development of new scalable industries.
  • He emphasised the opportunity in small scale nuclear reactors and pointed out that we absolutely need this, just to maintain nuclear output.

It wasn’t all Browne, of course. Maier pointed out that the crucial question to ask a public equity investor was whether their portfolio and engagement had resulted in fewer emissions in the real world – I think this is the right way to think about ESG.

Taylor pointed out that Lazard had been studying and publishing the economics of renewable production for 18 years. It’s only recently that the cost of wind and solar have become competitive with the marginal cost of fossil fuel, hence the IEA prediction that renewables investment in the next 5 years will equal that in the past 20.

Lazard also reckon that as we move to a more sustainable world, 11% of quoted companies’ revenues will deteriorate and only 7% will benefit, although Taylor was vague on the specifics of this very precise estimate. And amid discussion of decarbonisation of portfolios vs real world emissions reduction, Sarah Williamson made the point that there is no point in just throwing trash in your neighbour’s garden – a nice analogy.

I asked them what they thought the “right” carbon price was and the consensus was $100/ton. The European future is not that far away:

Carbon Futures (€/tonne)

Source: Ember

The Trends which will Create Winners and Losers in the Coming Years

  • Laura Cooper, Senior Macro Strategist for iShares EMEA, BlackRock
  • Colm Walsh, Managing Director, ICG
  • Luke Barrs, Global Head of Client Portfolio Management for Fundamental Equity, Goldman Sachs Asset Management

There was much discussion of climate change and inflation and it was the latter which struck me as important. Blackrock’s view is that inflation will be the dominant theme and highlighted three driving forces:

  1. Participation rates have fallen since the pandemic and this is inflationary
  2. The net zero transition will likely be disorderly but is almost certainly inflationary
  3. Geopolitical fragmentation will increase nearshoring which is inflationary

I am more in this camp than the Goldmans speaker who suggested that the Fed will get it down to 3% next year. One commentator at this conference suggested that in developed markets it takes 10 years to get inflation from over 5% to 2%. The truth is that we know very little about inflation.

The chart below shows a study (h/t Joachim Klement) of the impact of an interest rate hike on inflation, judged over 3 different time periods.

The first column is the total sample, 1973-2020. The middle column is mid-1979 to 2012 and the right column is 1988 to 2020. The response is much faster and greater in the latest period – when inflation was higher, rate hikes seemed to have less impact and took longer.

Response to a 25bp monetary policy shock

Y-axis CPI, X-axis months. Shaded regions report bootstrapped 90% standard-error bands.
Source: Bauer and Swanson 2022

The Outlook for Financials in 2023 and Beyond

  • Lloyd Harris, Head of Fixed Income, Premier Miton
  • Jean-Francois Neuez, Head of European Financials, Janus Henderson Investors
  • Sebastiano Pirro, Chief Investment Officer, Algebris Investments

Readers will know that I tend to avoid financials (those who are interested should check out Marc Rubinstein’s Net Interest) and will be surprised that I found this the most interesting and action-oriented panel. Pirro reckons banks have become so cheap because they are now irrelevant to markets after a large decline in profits. At today’s more normal rates, banks can make money again and have a huge opportunity as they have aggressively cut costs.

The consensus on the panel was that loan losses will clearly increase as economies slow but that capital ratios are plenty strong enough and the margin upside from normalised rates outweighs the temporary, cyclical increase in loan loss provisions. If a bank makes 12% RoE and is trading on a 4x P/E, at 0.5x book, there is plenty of upside.

Pirro also likes bank credit which is lower risk and higher income than bank equity.