In our Q4 2022 Angles & Perspectives Regime change in markets: A capital cycle perspective article, we highlighted that "capital cycle analysis is a key pillar of our research process. We focus on the analysis of the supply side of specific sectors (existing capacity and likely changes in future capacity), rather than spending lots of time and effort on forecasting future demand. The excellent and forward-looking data available for supply side analysis (e.g. capex spending plans with long project lead times) contrasts with the difficulties of evaluating future demand, which is often volatile and, if we are honest, unforecastable.

A tight supply side can imply excellent pricing power in the future, and should we be prepared to focus on an appropriately longer time frame, the vagaries of year-to-year demand fluctuations become less important.” We observe that a number of old economy sectors have been starved of capital over the past decade while abundant capital has flowed to new economy sectors, especially tech – refer to the graph below. This should result in sustained pricing power for supply-constrained real assets and higher prices will be required to incentivise investment in future capacity. This situation exists in many capital-intensive old economy sectors, but is particularly acute in energy, materials and infrastructure.

Furthermore, current US Federal Reserve policy is likely to impede future investment spend, as Kevin Cousins explains in his article Arthur Burns, William Miller and learning the right lessons from history. Other factors that constrain future investment are environmental, social and governance (ESG) pressure and shareholder demand for capital discipline.  For example, few firms are prepared to commit to fossil fuel projects with payback periods of more than a decade when longer-dated energy policy is very uncertain. They are currently favouring cash returns to shareholders over investment in new capacity to replace depleting resources.  We conclude that higher prices will be required to incentivise new investments given these risks.  Hence,  medium-term prices are well underpinned in many capital-starved sectors, yet stocks are cheap. Our clients have maintained healthy exposure to a number of likely beneficiaries of improving earnings and share price re-ratings.

However, investing in cyclical industries requires that we accept the volatility that accompanies shorter-term movements in demand and fluctuations in investment sentiment. 

This year has seen a reversal of the strong performance by many supply-constrained industries that outperformed in the weak global equity markets of 2022 after being partially boosted by the disruptions of the war in Ukraine. Commodity prices have been weak this year, as markets have digested a disappointing post-Covid recovery in China. Sentiment has further been impacted negatively by ongoing fears that a US recession is imminent. These conditions highlight the difficulties of predicting short-term demand. Most market participants continue to associate short-term volatility with risk. As sentiment has soured towards old economy sectors, capital has exited. We believe that this situation has created an excellent opportunity for long-term investors.

A capital cycle-led strategy helps one hold the line when short-term macro signals are noisy and confusing 

Most market participants try to time and optimise their positioning in the face of volatile and unpredictable shorter-term developments in economic growth, interest rates and risk appetites. Capital cycle-led investing looks through shorter-term market signals and harnesses long-term opportunities. It significantly increases the odds that the companies we own will have substantial pricing power and a high return on capital in the future, but it is very difficult to predict exactly when that will happen. But, if we buy stocks with favourable capital cycle fundamentals that are priced for mediocre future cash flows, it positions us to generate excellent returns at relatively low levels of risk. This is currently the situation, and explains why we are optimistic about future returns from our portfolios.

South African domestic assets have also been starved of capital

The capital cycle dynamic also plays out in financial markets between different geographies and asset classes. Capital flows to the best performers and out of the underperformers. Inflows push up stock prices while valuations drop when capital exits. The effect of capital flows on stock prices has been exacerbated in recent years by the rise in passive investing and indexation,  price-insensitive investment strategies. As the following graph demonstrates, the past decade has seen material outperformance by the US stock market– it has performed almost three times better than the global ex-US index! And, it has attracted the lion’s share of global capital – the US currently comprises almost 70% of the MSCI World Index, which is now dominated by US mega caps. Notably, the MSCI SA index has lagged the ex-US world index since 2018 in US dollar terms. As we all know, this period has coincided with weak SA economic performance, dismal domestic confidence and a weak rand. 

But it has also been a period of persistent foreign outflows, as well as an aggressive move by local investors to externalise their assets.

A strong contributor to capital flowing out of domestic bonds and equities has been the increase in the regulatory limit for offshore investment by institutional funds to 45% last year. Industry surveys show that local fund managers have been eager to take advantage of this opportunity and average offshore allocations of large balanced funds appear to have exceeded 40%, which suggests that this headwind to local asset prices has nearly run its course. The environment of persistent selling described above has pushed valuations to levels last seen in times of crisis – such as 2008/9 or 2020. As Assistant Portfolio Manager Ané Craig writes in her article Focus on the right factors when navigating a stormy investment environment, opportunities remain despite the currently negative environment. 

Historically, pessimistic pricing like we have seen recently for domestic assets has given rise to strong future returns, and this should again be the case, especially if the headwinds of capital outflows, load shedding and high real rates abate. We have made additional allocations to selected domestic securities in recent months.

Emerging markets are better positioned for the future capital cycle

Emerging markets (EMs) have underperformed for 13 years and capital has flowed elsewhere, especially to the US. We see clear challenges to the performance of the economies and financial markets of the West looming. Very high sovereign debt levels in developed markets and wide twin deficits in the US and the UK have put their economies on an unsustainable trajectory.

Although we expect near-term inflation to subside, we do not expect monetary policy to be effective at sustainably containing inflationary forces. Real yields are barely positive in the US and we have started to witness cracks in the financial system, such as the recent banking crisis. Conversely, emerging markets (EMs) have broadly been fiscally prudent and taken the pain of high real yields in recent years. This has positioned them well to keep a lid on inflation and interest rates are starting to decline in several EMs.

Commodity-rich economies should be particularly well suited to the environment we have described above. Furthermore, most EMs are cheap and underowned. All of this suggests that they should be the beneficiaries of the future capital cycle. South Africa should be relatively well placed in this environment given our resource endowment and very low starting valuations, but only if we can sustain reasonable levels of governance. 

Positioning portfolios for a future that will look very different to the recent past

We expect strong long-term returns from our portfolios. Our confidence has been boosted by our research, which indicates that the likely long-term winners of the future are also the cheapest part of the market. This situation is prevalent within global and domestic stocks. We have leveraged our global investment process to find a diverse set of global opportunities.

Our best global ideas consist of both less-cyclical (idiosyncratic) stock picks that are less exposed to the economic cycle, and cyclicals in capital-starved sectors. These less-cyclical investments include brewers, insurers, precious metals streamers and crop science and pharma industrials. Our global exposure to cyclicals is concentrated in the energy, metals and shipping sectors. Within domestic stocks we have been primarily focusing our attention on the long-term winners. These comprise stocks that we expect to grow profits despite weak SA macro conditions, because they are exposed to pockets of secular growth within the SA economy. Examples of such sectors are infrastructure (renewables and roads), transport, mining, communication and tourism. 

Global financial markets face many future challenges that are likely to contribute to higher levels of volatility and which make shorter-term forecasts dangerous. We believe that it is appropriate to take a long-term view and embrace some volatility to harness long-term opportunities, but simultaneously to build in appropriate levels of portfolio protection. Defences in our portfolios include: very attractive starting valuations and high real yields from domestic assets, globally diversified stock picks including allocation to less-cyclical businesses, a combination of cash and equity hedges (given the very attractive put option pricing available, we currently have significant protection coming from derivatives and less from cash), and gold. Gold stocks are a hedge against ongoing Western fiscal recklessness amidst monetary policy constraints. 

We expect significant benefits to accrue to those that can take a longer-term view and be patient.

The current environment also highlights the importance of partnering with investment managers who are well positioned to take a differentiated perspective on markets, and to identify investments that are likely to fare well in the future environment we have outlined.