Comment on Q3 2021: Revenge of the old economy
One of the standout features of the quarter was the continued rally in commodity prices, particularly in the energy space. While we have seen something of a perfect storm of factors over the last few months, above all in the gas market, we do believe that there are certain structural issues underlying the price strength, caused by a decade of underinvestment. This suggests that high commodity prices are not fully transitory, and are likely to remain going into 2022.
Most eyes have been on gas, where European one-month forward gas prices jumped up 176% in the quarter, with a 736% increase since the start of 2020. The key reasons for this have been falling EU production and last year’s cold winter, combined with record-low winds and weak inventories in both the EU and Russia. And while fundamentals clearly support a price increase, most of the upside has been led by a higher risk premium, to account for the possibility of another cold winter.
Such alarmingly-high prices see few winners; but Russia, up some 28% year-to-date, stands out as the only out-and-out beneficiary, with many appealing investments stories. Natural gas producer Gazprom is a clear example, offering a 13% yield for 2021 and 16% for 2022, but there are also other high-quality commodity names that are often overlooked. Aluminium producer, Rusal, is one of those. It is the lowest carbon-intensity producer globally, and returned 42% in the quarter. We continue to believe that Russia remains an attractive diversification play for investors concerned about inflation and high commodity prices. This is especially true given the country’s incredibly strong fiscal and monetary management, and it will be one of the only major countries globally to print a fiscal surplus this year.
A tough quarter for China
For many other countries, the global energy crisis is having an economic fallout, with some nine UK energy suppliers announcing bankruptcy and China facing a power crunch that has forced factories to scale back production, posing a risk to both the inflation outlook and global supply chain.
China has also seen downside pressure on its equities during the quarter, with the China offshore market declining 18.2%. This is related to both an economic slowdown fuelled by virus containment measures and high energy prices, and a heightened political risk. Since the summer, China has announced a steady flow of regulatory overhauls, led by its focus on “common prosperity,” with broad sector implications, especially towards education and technology. For the former, businesses that provide academic tutoring will be restructured as non-profits in an effort to curb education costs, hopefully making families more prone to having children. For the latter, China is reining in large tech companies that have gained significant market power or data possession, to increase and ensure competition and data security, and to limit social fallout. As part of this effort, China made a pioneering move to regulate algorithms, which may soon not be allowed to “encourage addiction or high consumption”. But even though many of these measures may be well justified, the pace of the tougher regulation has scared investors, and it is still not clear how far reaching this clampdown will be.
Adding to this, China Evergrande, the world’s most indebted real estate developer, is inching closer to a default. This has been well anticipated, and we do not see a systematic risk brewing (some developers have even rallied since Evergrande started catching headlines, possibly anticipating easing measures), but uncertainty on financial implications still exist.
Broad emerging and frontier markets
Looking at broader performance during the third quarter, MSCI Emerging Markets fell 8.1% on the weakness in China, while MSCI Frontier gained 3.4%, thanks to a combination of secular growth and attractive valuation stories. Among individual countries, those with exposure to energy and financials generally did well, with the Czech Republic up 15%, UAE up 13% and Russia gaining 9.4%. Although Brazil defied the trend and fell 19.7% on political uncertainty and spiking inflation. Poland and Turkey delivered softer returns, but outperformed the broader market and gained 1.6% and 1.8% respectively. Asia excluding China saw mixed performance, with India up 13.1% and Indonesia gaining 7.1%, while Taiwan declined 2.5% and South Korea fell 11.2%.
Finding opportunities among uncertainty
This quarter has seen no shortage of eye-catching headlines, and we face uncertainties as we transition to the later stage of the recovery. In particular, persistent bottlenecks in the supply chain and elevated energy prices continue to add to inflation pressure, at a time when global growth momentum is slowing and the US central bank is about to scale back asset purchases, increasing the risk of higher rates, and potentially “stagflation”. Thankfully, emerging and frontier countries have significantly improved their financial resilience compared to the 2013 “taper tantrum,” and the underlying growth should continue to support earnings and favour our active approach to allocation and stock selection. Energy prices may also help speed up the transition to renewable energy names favoured in many of our strategies, though in the shorter-term they will really benefit Russia.
Code Red for Humanity
An important event in the quarter was the long-awaited report from the first working group of the Intergovernmental Panel on Climate Change. It made for pretty sobering reading; essentially highlighting that we are very close to breaching the internationally-agreed 1.5C warming level, above which we will see a significant acceleration of the kinds of physical risks (floods/fires etc) that we are seeing at the moment. As such, it is vital that we see rapid and highly-disruptive policy change from governments, and an acceleration of climate change adaptation measures from companies. We believe this policy shift will happen to some extent, and hence a big part of our engagement efforts involve making sure our portfolio companies are sufficiently prepared for this.
We started to see these policy announcements in the run up to COP26 in Glasgow. The most major was the EU’s “Fit for 55” package. This will include a widely-discussed carbon border tax and a highly-ambitious increase in renewable energy consumption, from 20% of the energy mix to 40% by 2030. China also announced they would stop funding for coal power plants overseas, which is significant because over 70% of coal power plants built today rely on Chinese money. We also sent out our annual CIO letter to all our portfolio companies – you will find the full letter here. This year we chose to highlight the highly-disruptive impact that we expect global decarbonisation to have on our portfolio companies, and what we expect our companies to do about it, including robust scenario analysis and science-based target setting.
We also raised the important issue of biodiversity. While it is more difficult to quantify (which is why we are looking forward to the first draft of the TNFD), the science is unequivocal – the equivalent of “net zero by 2050” for biodiversity is no further biodiversity loss from this point forward.
