192. Why energy prices could remain high

5 May 2022 (pre-recorded 27 March 2022)

Below is a transcript of the episode, modified for your reading pleasure. Please check the corresponding audio before quoting in print, as it may contain small errors. Please remember we’ve been discussing individual companies to bring investing to life for you. It’s not a recommendation to buy or sell. The fund may or may not still hold these companies at your time of listening. For more information on the people and ideas in the episode, see the links at the bottom of the post.

[INTRODUCTION] 

Staci West (SW): Welcome back to the Investing on the go podcast, brought to you by FundCalibre. Every year, European companies source more and more of their revenues from outside the continent. This week, we’re looking at sustainability, how the global consumer impacts European equities, and whether high energy prices could be here to stay.

Ryan Lightfoot-Aminoff (RLA): I’m Ryan Lightfoot-Aminoff and today I’m joined by Niall Gallagher, Elite Rated manager of the GAM Star Continental European Equity fund. Niall, thank you very much for your time today.

Niall Gallagher (NG): Thank you Ryan.

[INTERVIEW]

RLA: Now, your fund gives investors exposure to some sort of big global trends. At the moment it’s the rise of sort of the Asian middle class, the move from offline to online, and decarbonisation. Can you take us through each of these and tell me why you think you’re able to do that with the European companies and how they’re best positioned to do that?

NG: Yeah, one of the misnomers or I guess, misconceptions about European equities is that when you invest in a European equity fund, whether it’s an active or a passive, that you are investing in Europe and increasingly as time has gone on, that has become less the case. As I speak now, the portion of revenues in a European equity fund like ours, that come from outside of Europe are over half. So, in a sense, the exposure to Europe within the fund is less than half. And that’s been a thing that’s built over the last 25 or 30 years, as globalisation has taken shape. The European equity market is very globally exposed and there are some big drivers of that. 

One of the big drivers has been the growth in Asia ex Japan, of which obviously China is very large. And within that, what we are seeing, is the emergence of a gigantic middle class in Asia. China has led the way, but we expect also countries like India, Indonesia, the Philippines, Bangladesh, Vietnam, more from Southeast Asia, to also add significant numbers of middle class consumers over the next decade or so. And these are countries of very large populations. So even if a small proportion of the population of India or Indonesia, or the Philippines, end up hitting middle income status, that’s still in total, a very large number. 

So, basically the kind of forecast we that we think there’ll be about an additional billion middle class consumers added to global consumption, or to middle class population globally, which will mean that by the end of this decade, Asia will account for about two thirds of consumption. And that’s a really big powerful shift. So, for us, as investors in European equities, the obvious questions are what are the companies that are very well exposed to this?

And we have a bunch that are very well exposed. There are the obvious names like a Nestle, some of the sporting goods companies like Adidas for example, but we think some of the really good exposures are some of the luxury companies. Companies like LVMH, companies like Montclair, because these are the businesses that are less likely to be disrupted by the emergence of local brands. The brands like Louis Vuitton, you know, again, I guess some of the spirits brands within LVMH as well, such as, Hennessy Conacs or Moet Champagnes, these are brands with fantastic heritage, and they also resonate greatly with investors in Asia, too. In fact, for a given level of income, their propensity to consume high end luxury in Asia is higher than it is in Europe. So, for that reason, we see these companies as being very exposed to that kind of growth.

And then in addition, one of the things we’re seeing too is obviously the US is doing very well as well. There’s low unemployment, a lot of wealth creation, and we’re seeing significant growth in demand for luxury too, which is a partly function of rising income and wealth, but also changing tastes over time in that market as well. So for that reason, you know, we think that the luxury stocks are very interesting in terms of some of the exposures. 

Another great theme that we’re exposed to, European equities are exposed to, is decarbonisation. Obviously, the transition to net zero and the desire to hit net zero by 2050, if we can, certainly in power economies in the West. And perhaps slightly later in some of the more emerging economies, is also a very, very significant trend and there’s a whole load of different types of exposures one can think of to decarbonisation. 

Now there are companies that are exposed to building renewable energy and actually within here, some of the big oil and gas companies like a BP or a Shell or a Total are very well exposed. They’re investing very large amounts of money in decarbonisation. Then you’ve also got companies exposed to helping decarbonise buildings. So, people who supply insulation or other building components that will help a building, either a new building or an existing building, reduce its energy consumption. So there are companies there like Kingspan or Saint-Gobain, or Sika. 

Then there are also companies involved in mobility – and that’s not just the car companies themselves, it’s also companies that supply components into cars. So, things like Infineon on which make power semiconductors – it’s very exposed – companies exposed to new automotive CapEx like a Hexagon are exposed, or an Atlas Copco. So, what we see is right across different parts of the market in Europe, companies that will see a big rise over time in the demand for their products and services, as the world really begins to focus heavily on decarbonisation, particularly in this part of the world.

RLA: Thank you. I know we’ve spoken in the past, in different forums, about this move to decarbonisation and the effect that that’s going to have on sort of inflation and things like that. So, you’ve got some quite interesting views, I think, on the world going forward and this higher inflation coming through because of that. So perhaps you can maybe talk through that and what you’ve done in the portfolio with it.

NG: Yeah, we think unequivocally, and this has been a non-consensual view, but we are more convinced than ever. We believe that the move to net zero is going to be inflationary. This is something that I think central bankers at first didn’t see, but they’re now beginning to see more clearly, and there’s a few reasons for it. 

So, the first and the most obvious is that over the last five to seven years, there’s been a big drop in investment in oil and gas. That’s been for a whole load of reasons, but one of the reasons is oil and gas companies not wanting to end up with stranded assets or perhaps being pressured not to invest in new oil and gas. And the issue there is that the supply of oil and gas is falling more quickly or will fall more quickly, than the demand for oil and gas.

And we must remember that the demand for oil and gas at the margin is not driven by developed markets, it’s driven by emerging markets. So, what we think we are seeing right now, in terms of higher oil and gas prices, is not really just a function of the Russian invasion of the Ukraine. It’s also a function of fundamental supply/demand mismatches. So that’s the first reason why if like decarbonisation, the deemphasis on trying to extract new hydrocarbons, is leading to inflationary outcomes. 

The second is that the newer energy sources themselves are going to be a lot more expensive. A lot of focus is on the fact that wind is in theory free because the wind blows and you don’t pay for that. But that ignores the fact that you have to build a lot of offshore or onshore wind infrastructure. You have to build grid connections to those new generating assets. You need a lot more of them because they are intermittent, so you can’t get the same kind of load, if you like, out of offshore wind, as you might out of a coal plant. You have to build backup or storage. You may have to change local grids as well as the transmission grids. So ,the amount of investment required is very significant indeed. And that’s likely to push up prices for energy, which will then knock on through a whole range of other things, which will also be inflationary too. 

And then the final one, which I think is, again, something where the penny’s only just beginning to drop. If we are going to decarbonise and electrify as one of the means of decarbonisation, that’s going to require lots of copper. It’s going to require lots of other materials as well. Things like lithium, it’s going to require more nickel. We’re going to need aluminum for the wind turbines. We’re going to need oil-based materials to go into the wind turbines, the blades themselves. So, all of these kind of things are going to put a lot of pressure on the supply chain, and the supply chain is also underinvested. So, I think the kind of rises we’re seeing in material prices is also function of increased demand for those types of materials to help decarbonisation, but there’s been a lack of investment. So ,for all those reasons, we think the inflationary impulses we’re seeing will remain with us for quite some time.

RLA: And do you think maybe that this inflationary effect will sort of slow the approach towards decarbonisation and the big impacts going on there? And if so, what sort of companies are you avoiding in the portfolio? What are you adding to? 

I know Europe’s been incredibly good about building out wind farms that we talked about with the likes of Orsted, does that mean you’re going to avoid the likes of those and look towards maybe supply chains or what are you going to do with that?

NG: I think it certainly means one has to be quite cautious on what you invest in. Now we are big believers in decarbonisation, and it will provide great investment opportunities, but you have to be selective. 

So, in terms of your first question, do I think that the rate of decarbonisation or the willingness to decarbonise will go away or decline? I don’t think so. I mean, certainly I think the Russian invasion of the Ukraine has also brought energy security back onto the radar as well. And actually you can kind of combine an argument as to why you might want to invest for decarbonisation and have more energy security, by potentially having more renewable energy, particularly if you are a country like Germany with very low or very little by the way of fossil fuels. So, I don’t think we’re going to see reduced demand for decarbonisation. 

In terms of what inflation may do in the supply chain, I think we have to be really quite cautious there. So the names that we’ve been avoiding have been some of the wind turbine makers, so companies like Vestas Wind Systems, Siemens Gamesa, we had results from GE a couple of days back, and they talked about you know, very significant negative margins in their wind turbine business, because what’s happening for the wind generators is they’re locked into supply contracts where they have to provide machinery at a certain price, but the actual cost to the manufacturer have gone up. So, we are kind of quite cautious on parts of the market there where you don’t have the ability to pass on pricing. 

As regards things like Orsted themselves, it’s an interesting business, we owned it for quite some time ,particularly through its transition to being almost a pure play generator. We thought the stock got very, very overvalued, particularly towards the end of 2020 when there was a bit of a green bubble. It’s still an interesting business. There is obviously a lot of CapEx that’s going to go into offshore wind. When we look at a stock like that, it’ll be really a function of, what are the returns you’re going to make? What are the kind of risks? And the risks aren’t always cost inputs, they’re sometimes political.

So, in Spain last year there was some windfall taxes which were planned or announced to be applied to some of the generators which used renewable energy, because the government saw electricity prices going up driven by higher gas prices, but not actually by higher input costs for renewables. And they proposed a windfall tax, which was very negative. So again, we also have to be careful of the politics in an era when utility bills are going up a lot for consumers.

RLA: And when you are looking at the portfolio and you’re sort of assessing risk, ESG is obviously one of the areas that you do look at and you look at sort of the financial and technology-driven risk. Maybe if you can just talk through it, about how you apply those risks to the portfolio when you’re looking at companies.

NG: Yeah, the ESG risks are the ones that take up, you know, quite lot of our thinking and time, and it’s probably worth breaking it into each of the E, S and G. So, the E bit is pretty kind of two-sided. First of all, if we’re looking at a new company, or an existing company in the portfolio, what is the risk that some of the products or services will have to either stop or materially change over the course of the next decade, decade and a half? And is there a risk that that will materially damage the prospects for the business? So that’s kind of one area where we’re focused. 

Now I mentioned it’s two-sided because we also have quite a few companies where the need to decarbonise, the need to have more efficient buildings or more electric cars, or more investment in renewable energy will benefit. So, we also look to the positive as well, but that kind of focus on who will benefit and who won’t, is a key one. 

And then obviously we look at what companies are doing to decarbonise their own operations as well. So how are companies seeing reduced carbon intensity? What are they doing? We have some pretty interesting conversations, so we’ve had some great conversations with Ryanair on what they’re looking to do to decarbonise in the short and medium term, or to reduce the carbon impact, but also kind of medium/long term thinking about sustainable or even synthetic aviation fuel and what that might do. So, we’ve a lot of conversations with companies on what they’re doing, how they’re positioned, and then we look for companies to have hard targets in place to reduce their carbon impact. So that’s on the, if you like, the E. 

On the S, the S covers a whole range of things. So ,when we’re investing in companies like Pernod Ricard or Diageo, for example, there’s a whole range of S, sustainable issues. So, first of all, starting with the crops that they may use to produce their spirits, the relationships they have with the farmers in terms of good husbandry of agriculture. And then also, things like water stress, what are they doing? Potentially, if they’re using crops that are produced in areas of water stress, and then you go beyond that to then look at things like responsible promotion of alcohol and what are they doing to make sure that newer alcohol consumers, so the younger people coming into consumption for the first time, are encouraged to consume responsibly. And then of course, what are they doing to make sure they’re not targeting minors as well?

So, a whole range of things there, and then, you know, over and beyond it goes into almost every business that has some either touch of the consumer or some element of regulation. What are they doing? Are they being proactive? Are they taking the right kind of initiatives to kind of be responsible businesses? 

And then G. G is an area where I think most managers are engaged, have been engaged for a long time. So, we spend time talking to our companies around E issues and S issues, but then also about things like board representation, what are they doing to make sure that they have a diverse board? And diverse is not just for us, it’s not just about gender and ethnicity, but also we like to see the boards of the companies that we invest in be fairly multinational. If you’re a multinational business with operations in many different countries. We’d rather that the board didn’t come exclusively from the home market, which is something that we kind of push on companies to do. Then there are issues around compensation and pay where we sometimes have a different opinion and have a dialogue with the company and sometimes will vote against the resolutions. So, the ESG aspect to risk, but also opportunity, is a big part of the analysis that we do.

RLA: And then maybe finally, the younger consumer is something we’ve touched on a couple of times, both ESG and with the emerging Asian middle class as well. Some of those companies are paying particular attention to the young consumer, they’re going to be their future customers and the aspirational type they’re looking for. Do they have more of a focus on sustainability and things like that? How is that affecting how those companies operate, what’s changing in their strategies and their partnerships that’s helping them embrace this change?

NG: Yeah, well, look, I think the view of most companies would be that if your younger customers are much more focused on this, you know, sometime down the line, they’re going to be the bulk of your consumer base as of course they age. So, it certainly accelerates the focus on sustainability issues and that doesn’t really change the kind of things I’ve just talked about, but it sort of reinforces the importance of focusing on sustainability issues, environmental issues. I mean, certainly the evidence is that younger consumers are much more interested in environmental issues than potentially older consumers. Certainly, they’re also more interested in sustainability issues being perhaps around supply chains, particularly in ensuring ethical supply chains. So, it’s definitely an accelerant, but I wouldn’t say that it means that some companies are more focused than others. Most companies recognise that if this is where your younger consumers are, then in time, that’s where the bulk of the consumer base will be.

RLA: And just one more actually. Despite you being a European manager, we’ve actually spoken a lot about consumers from Asia and the US. What’s happening with the European consumer? Obviously it’s a huge array of different countries, different backgrounds, different people. But they are one area that looks particularly under stress. Is that a concern for you in the portfolio or are those overseas earnings going to offset that with the sort of industry global leaders that you’ve got in the portfolio?

NG: I would say that we are modestly concerned, rather than very concerned. So obviously, as I mentioned, the more global nature of European equities certainly helps. Within Europe itself, you know, there are markets in, the UK will be one of them too, where consumers, particularly consumers in the lower income deciles are stressed by rising energy prices. I would say we don’t have a lot of exposure to this area, but it does increase the risk that you have a growth slowdown. 

One of the things that I would say that potentially concerns us long term is that Europe, as a whole – and again, I would include the UK in this – Europe, as a whole, has to make sure that it doesn’t lock itself into very expensive energy in the long term. So obviously we’re going down a root of wind in the UK, offshore wind is quite expensive, not just in terms of the turbines, but also the connections you need to get it there on the grid, the amount of storage you require, backup, all that kind of stuff. And the same is true of many other European countries.

We don’t want to end up in a situation where we are locking ourselves into very high energy costs. And particularly when you compare us to other parts of the world where maybe they’re using more nuclear, or where they may have opportunities for much lower cost renewable energy. So, it’s kind of ironic that some of the parts of the world that have very good fossil fuels also have fantastic energy resources for renewables. So, a place like Saudi Arabia, places like Australia, but also the US, the US has got very good onshore wind resources in the middle, it’s got offshore resources as well. And then also it’s got fantastic solar. So, we don’t want to end up in a situation where we lock ourselves into very high energy costs on a relative basis, which disadvantages the region, but also places consumers under a bit more pressure.

But in terms of the where and now of where we are, I would say that yes, there’s a lot of focus on rising gas prices for consumers and rising oil prices. But also we mustn’t forget that we went through the pandemic, consumers during the pandemic typically saved because they weren’t going out as much. So, the state of consumer bank account balances is pretty healthy. Unemployment is low relative to history, unemployment is low in most European countries or certainly falling. We’re seeing reasonable wage growth. It’s not as high as current inflation, but it’s still pretty decent. 

So, I don’t think we want to overstate the negative in terms of the impact on the consumer. There’s a little bit of loss of consumer income, real income growth, I guess it’ll be negative this year, but we shouldn’t overstate it you know, given the overall state of the European consumer

RLA: Well as expected Niall, it’s been really interesting. Thank you very much for your time today.

NG: Brilliant. Well, thank you very much to you Ryan. It’s been great talking to you and we’ll chat again.

SW: GAM Star Continental European Equity invests in large companies, preferring those the team believes will grow faster than the index. The manager looks to buy stocks at the point where they are either out-of-favour or where growth prospects are believed not to be fully reflected in the share price. To learn more about the GAM Star Continental European Equity fund visit fundcalibre.com – and don’t forget to subscribe to the Investing on the go podcast, available wherever you get your podcasts.

Please remember, we’ve been discussing individual companies to bring investing to life for you. It’s not a recommendation to buy or sell. The fund may or may not still hold these companies at the time of listening. Elite Ratings are based on FundCalibre’s research methodology and are the opinion of FundCalibre’s research team only.