How Value Can Benefit from a New Investment Cycle

We have seen a changing of the guard in terms of the value versus growth debate. This has been attributed to the post-pandemic recovery, decade-high inflation, and aggressive monetary tightening. Supply chain problems (emanating from the pandemic) have also seen a more general retreat from globalization. The resultant rapid rise in inflation and monetary tightening in response has seen investors favour value areas of the market. However, as bottom-up investors, we are also excited about the potential for a new capital investment cycle forming after many years of under-investment. For value investors, this is an exciting development as increased spending can be a significant source of investment opportunities. It also makes the case for a new investment cycle.

Since the global financial crisis (GFC) in 2008, we have seen large-scale under- investment from both corporates and governments. Both policymakers and corporates have focused on repairing balance sheets. Many industries have invested only at ‘maintenance capex levels,’ rather than investing to improve productivity or expansion. We believe many industries are now long overdue investment after many years of neglect.

We have also heard phrases like ‘build back better’ and ‘leveling up’ as governments seek to recover after the pandemic. However, we have seen a chronic lack of investment at a top-down level ever since the GFC, despite an era of ultralow financing costs. There are a number of interrelated reasons for this, but a major one has been the anemic economic rebound we witnessed after the financial crisis. In previous economic cycles, economic recoveries were much stronger, but any recovery in recent years has frequently undershot expectations. Meanwhile, at a corporate level, the lack of demand anticipated by companies could be a reason for past lack of spending. Businesses that aren’t predicting higher demand are less likely to invest.

Looking forward, with the cost of everything going up (including wages), this inflationary environment is one of the catalysts that can drive increased spending and awaken entrepreneurial spirits (at both a company and government level). In total, we have identified four main reasons why a capex boom could be on the horizon:

Drivers of Potential Increase in Capital Expenditure

Near Term

Inflation ‒ Inflation at below one per cent offered little incentive to invest, but with inflation at current levels we expect spending to accelerate.

Increased fiscal spending/infrastructure investment ‒ Investment to support economies as we move through a difficult part of the economic cycle. ‘Build back better’-style policies to refresh public infrastructure.

Long Term

Deglobalization/supply chain independence ‒ Countries are securing access to essential components and materials, making them independent of global sup- ply chains, but with inflationary repercussions.

Net-zero and the green transition ‒ Large-scale investment needed to drive renewable energy requirements to meet net zero targets.

►           Inflation

Returning demand after the pandemic met with disrupted supply chains, whether that be through China’s zero-COVID policy (periodically closing important manufacturing hubs) or Russia’s invasion of Ukraine (sending energy and agriculture prices sharply higher). Although inflation has shown signs of weakening, it is likely, in our view, to settle back at higher levels than experienced in the post-GFC environment.

A major factor of this will be what we call ‘geopolitical inflation.’ We believe it is unlikely that the conflict in Ukraine will be resolved quickly, while geopolitical tensions have also risen between China and Taiwan and, subsequently, China and the U.S. This heightened geo- political friction is likely to prove inflationary as tensions remain elevated and supply chains disrupted. However, these inflationary pressures have the potential to encourage firms and governments to invest sooner, given that delaying would mean higher costs in the future.

►           Increased fiscal spending/infrastructure investment

We expect greater fiscal spending and investment to support economies, especially if economies move into a recessionary period. That is likely to come in the form of increased handouts to consumers (tax cuts, energy caps) and greater spending on infrastructure projects to help drive growth. Both are inflationary unless they are managed in a fiscally neutral way.

Infrastructure is very much the backbone of any economy and helps to provide the framework for both economic growth and modernization. However, infrastructure investment globally has been neglected for many years. Historically, expenditure on infrastructure has been the primary responsibility of governments or policymakers, but governments are increasingly entering into public-private partnerships with companies.

Importantly, the inelastic demand, high barriers to entry, and monopoly-like characteristics of many infrastructure and utility assets mean that their financial performance is not as sensitive to economic cycles as others. These companies also tend to offer higher pricing power and, therefore, inflation protection.

►           Deglobalization/supply chain independence

Deglobalization is already underway. We first heard about the potential in 2018 when the U.S.-China trade war ignited, but concerns increased with the onset of the Russia-Ukraine conflict and supply chain disruptions stemming from the pandemic. This has focused policymakers’ minds on securing supply chain independence. With companies struggling to manufacture and deliver products through the pandemic, many companies are now telling us of their plans to regionalize ‒ or onshore ‒ their supply chains, despite the potential economic ramifications.

►           Net-zero and the green transition

Many countries have set ambitious carbon reduction targets but achieving them will require huge levels of investment. China is a great example, being the world’s largest fossil fuel emitter. Currently, China imports 73 per cent of its oil and 42 per cent of its gas needs. However, it has plans to make greater use of renewable energy that will allow it to become much more self-sufficient. With China having spent around US$12 trillion during its supercycle from 2000 to 2010 (building roads, bridges, airports, and other infrastructure projects), it is now forecast to spend almost US$16 carbon neutrality goal by 2060.

Looking forward, market turbulence of the last several years has contributed to desensitizing investors to ensuing risks. Risk management does not only have to rely on sophisticated modelling; it can take different forms including a simple discussion among trustees or committee members, drawing on the insights of investment managers and consultants, and fine tuning the asset strategy and portfolio diversification. In early 2023, take time to formally review your portfolio to identify any uncertainties which may elevate the risk of not delivering on your goals.

We believe these factors will help drive a new capex/investment cycle, which should, in turn, support earnings growth, particularly in areas like utilities and industrials. Meanwhile, with inflation higher than in the past, we expect interest rates to remain elevated, benefiting financials. With these sectors making up large parts of the value investment universe, the backdrop for value stocks should remain favourable.

Ernest Yeung is Portfolio Manager, Emerging Markets Discovery Equity Strategy at T. Rowe Price.