In this edition of the EdenTree CIO View, Charlie Thomas considers some of the key themes that are shaping market expectations for 2023 and discusses the boom in solar, a sector that has witnessed another stellar year of growth.
- Markets start to price peak inflation and policy pivots
- Geopolitics becomes a known unknown, hastening localised trade and energy security policies
- The green revolution is gathering pace: total global installed solar capacity eclipsed 1 terawatt for the first time in 2022
- We remain risk-aware, but also alive to a more constructive environment for our active, fundamental approach to responsible and sustainable investing
Markets in brief
Global stock and bond markets rebounded strongly in the final quarter of 2022. The FTSE World Index rose 1.4% in sterling terms but was up 10.3% in local currency terms. Currency movements once again played an outsized role in returns of offshore markets
in sterling terms. The FTSE All-Share ended the quarter up 8.9%, while the FTSE World Europe ex UK climbed 11.6%. The mood in the US, however, was less rapturous. The S&P500 Index ended the quarter down 1.1% in sterling terms (+7.6% in local currency),
while the NASDAQ returned -8.7% (-0.8% in local currency).
An easing of Covid restrictions in China drove a cautious lift in the Hang Seng and Shanghai indices late in the quarter. Meanwhile, Japan’s Topix Index returned 4.9% during the quarter. Bond markets were less turbulent than Q3, especially in the
UK where the political backdrop settled following the change of Prime Minister and Chancellor of the Exchequer in October. Overall, the conditions felt like a relief rally, driven in part by short covering, rather than a more meaningful risk-on episode.
The themes shaping expectations for 2023
- Peak inflation, policy pivots and recession risk
Inflation and interest rate policy continued to dominate broader market activity during the quarter and will be key themes in 2023. There is a hardening view in the market that inflation has peaked and that the terminal policy rate for the Fed will be
in the region of 5.5%, with slightly lower policy rates for the Bank of England and ECB, which had policy rates of 3.5% and 2.5% respectively at the end of the year, although with a slightly more protracted tightening cycle.
Recession risk remained front of mind for investors. Some of the more upbeat forecasts suggest the US will narrowly avoid recession next year due to the strength of its labour market, in contrast to tougher conditions in the UK and Europe. A recent headline
in the FT cited Kristalina Georgieva of the IMF suggesting “recession will hit a third of the world this year”1 and indicators in the UK and Europe – for example, manufacturing and services PMI data – already suggest
both are in recession, with the cost-of-living crisis crimping confidence and demand.
Rebasing will start having a greater effect in coming months in bringing inflation down. However, as highlighted by David Katimbo-Mugwanya in his outlook for the year (available on our website), inflation is unlikely to fall to 2% anytime soon. Many now
expect inflation to revert to a level closer to 4%, and the risk is that policy rates rise higher than expected and remain high for longer.
The key question for investors is how the combination of higher rates and lower demand will impact profitability and indeed corporate financing. Earnings forecasts of S&P500 companies is indicative of a looming recession, while default rates are expected
to rise. During the Q3 earnings season, many companies were reluctant to provide significantly changed outlook statements but we expect the Q4 earnings season will provide a stronger impression of the economic environment on the ground.
- Politics and geopolitics, localised trade and energy security
In the context of the year overall, the last quarter has been relatively sanguine on the political front. However, for investors it remains a heightened risk factor. Following the change in premiership the UK is hopefully now looking forward to a year
during which politics is less in the foreground, although there is a great deal to work through in terms of addressing deeply negative real wages which has prompted rolling strikes in many sectors. Moreover, the Conservative Party continues to be
weakened by infighting and resignations, which are not constructive for a properly functioning government.
China’s handling of Covid-19 has been another chapter in an increasingly fraught domestic agenda, with the economy still overshadowed by slowing growth and vulnerably in its outsized property sector. A relatively low immunity rate means the health
risk for the local population is likely to remain high for some time yet, with knock-on effects in terms of the domestic, and therefore global, economy.
Meanwhile, domestic politics in the US also remains challenging, with the election of Republican Kevin McCarthy as House Speaker coming at a significant political price. The fiscal pledges he was effectively forced to give to the hard-right of the Republican
Party will potentially make heavy weather of the debt ceiling negotiations expected in the second half of this year – with associated volatility in bond and stock markets.
And no one is under any illusion about the year we have witnessed in geopolitics. Unfortunately, the war in Ukraine has gone from being a black swan event to a known unknown, with Europe rapidly adjusting to life without Russian gas and core pressures
around food and energy generally abating, in part due to wider economic weakness. There is a risk Russia will drag Belarus into the conflict, which would mark a disturbing escalation of the conflict. Equally, concerns remain about a potential escalation
of China’s ambitions for Taiwan.
For investors this backdrop means closer monitoring of geopolitical risk, further deglobalisation of supply chains with “on-shoring” and “friend-shoring” continuing apace. This in itself is creating new opportunities for investment
and should ultimately build greater economic resilience, with potential environmental benefits too in terms of shorter supply chains and better visibility in the value chain.
Cyber-security will also remain a major theme of the new era of geopolitics. Similarly, the drive towards localised and secure sources of energy will continue to be a further impetus for the clean energy transition, which I expand upon below.
- The Green Revolution continues
The quarter saw two important COP summits. In November, UN climate talks in Sharm el-Sheikh (COP27) agreed to create a new fund for “loss and damage”, which was seen as a breakthrough moment for small island states and other vulnerable counties.
However, the hosts ignored calls for the phased down of fossil fuels – mooted by India – to be included in the final agreement and little progress was made to bridge the gap between existing pledges and the 1.5oC goal.
The UN biodiversity summit in Montreal (COP15), meanwhile, produced something of a landmark agreement with the memorable “30x30” goal of conserving 30% of the world’s land and ocean by 2030. This came with a $30bn funding commitment
from developed to developing countries by 2030. However, its ambition level was somewhat muted, with many decisions pushed to future discussions. The delayed completion of COP15 by two years due to Covid means there are only seven years left to deliver
on its goals with the next talks (COP16) slated for 2024.
It is worth reiterating a point I raised in an article following the COP27 conference that the quality of the agreements struck at each COP will be judged cumulatively
over years and decades. Both climate and biodiversity conferences this quarter were fractious, tension-filled affair which made important headway that needs to be backed-up and hopefully exceeded at the country level.
And while the COP27 headlines might have underwhelmed, we continue to be impressed by the massive uplift in demand for solar since COP26 in Glasgow is cause for optimism. Net zero pledges, combined with energy security concerns, have resulted in a near-doubling
in the annual pace of installations globally with between 2020 and 2022, with new solar capacity nudging 270 gigawatts (GW) in 2022. For context, capacity for the entire UK power grid is around 76 GW.
Although China continues to dominate the market for renewables (including solar), demand has increased globally, effectively ending the longstanding dynamic of excess supply pushing prices lower. Supply bottlenecks and higher commodity prices have certainly
contributed to market tightness, but net-zero-driven demand has been the key contributor of rising solar prices (and unsustainable margins in some cases). Total global installed capacity rose above 1 terawatt (TW) in 2022. According to BNEF,2 total capacity is expected to climb to 4.5TW by 2030, with an estimated 515 GW installed in that year alone. However, forecasts have historically been much more conservative than what has been achieved and simple maths suggest we could witness a 1TW
year of additional capacity as soon as 2027-28, given the market is effectively doubling every two years. The solar boom is also driving innovation and is making it easier to bring new cell technology to market.
And rightly, the sector has come under greater ESG scrutiny. Investors and companies want assurance about labour conditions in the supply chain, concerns about which prompted Enel to move the manufacture of its solar panels to Sicily and the US, which
is expected to supply all its needs throughout Europe by 2024. As part of our engagement programme in 2023 we at EdenTree will continue to engage with renewable energy infrastructure holdings to ensure they have a robust approach to respect for human
Manufacturing capacity is also expected to balloon in the US – a laggard in the solar space – due to bans on imports from China and the positive impact of the $369bn Inflation Reduction Act. Indeed, South Korean firm Hanwha Q Cells has unveiled
$2.5bn investment in US solar power equipment production which will help localise the supply chain. Moreover, Germany has demonstrated its ability to rapidly build energy infrastructure with the development of its first floating LNG terminal, a model
for rapid development that Chancellor Scholz hopes will continue, which should in theory support the faster expansion of the burgeoning renewables sector.
The other side of the coin is energy efficiency, and there has been a sharp rise in global investment in this area this year due to increased concern about energy security, continuing a pattern that started during Covid. The IEA estimates that roughly
US$1 trillion has been mobilised since 2020 targeting areas such as building efficiency, public transport, infrastructure and electric vehicles.3
- Sustainability regulations continue to evolve
The FCA has unveiled proposals for three sustainable fund labels (“focus”, “improvers” and “impact”) as part of its final consultation on new Sustainability Disclosure Requirements (SDR). While the intentions behind
the regulation – to stamp out greenwashing and improve consumer understanding – are welcome, many in the industry have rightly questioned the efficacy of the proposed labels. They potentially impose counterproductive restrictions of fund
structures and could unduly add friction to the allocation of capital to sustainable companies and projects. Issues also remain around the wider regulatory mismatch that is emerging between the EU (Sustainable Finance Disclosure Regulation “SFDR”), the UK (“SDR”) and
US (“climate disclosure regulations”). It is a topic we will discuss further as events evolve.
At the start of the 2023, the prognosis for the global economy is relatively gloomy, with recession looming and hawkish interest rate policy expected to challenge indebted corporations and consumers for some time yet. A rise in corporate defaults is likely
and higher mortgage repayments have contributed to wider cost-of-living pressures. With labour markets still relatively tight, especially in the US, investors should remain alive to a sustained period of hawkishness from central banks. And the geopolitical
must be watched closely.
That said, markets have adjusted significantly this year to a wide set of risks and possible outcomes. As an investment team we have started to lean into the prevailing sense of market uncertainty, which favours our bottom-up, fundamental approach to
investing. The green revolution is gathering pace, supply chains are adjusting to a new normal and we as a team are pursuing resilient businesses that have been sold down on short-term macro concerns, whose longer-term prospects remain intact. While
there are reasons to remain cautious, this should be a constructive period for active investors, such as ourselves, who approach the market with a robust approach to responsible and sustainable investing.
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- Bloomberg New Energy Finance