Article 24 October, 2022

Cleansing capitalism’s karma

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Analyst: “[H]ow much flexibility do you see within your capex overall? Normally, in a down cycle, we see sustaining capex come down. We see … growth projects … moderate and so on. But how should we think about your capex in this cycle?”

Jackob Stausholm, Rio Tinto CEO: “[L]ook this is actually really fundamental. If we start adjusting our capex program because we think there is a recession in the next six months, we have lost it. We are in for the long haul here.”[1]

Capitalism’s karma, according to the strategy team at BNP Paribas Exane, is that “every cycle we end up paying for the sins of the previous cycle”. 2010-20 saw consumers deleverage household balance sheets while governments engaged in austerity to try and balance their own books. With a consequent lack of nominal growth, corporates shunned re-investment in capital expenditure (‘capex’) and embraced buybacks as a superior use of cash. We believe this has set up an investable opportunity today due to 3 converging elements: [1] today’s inflationary pressures are a symptom of last cycle’s underspend and a need for upgraded manufacturing bases (‘smart industrial’) and infrastructure is joined by decarbonisation, supply chain resilience or ‘near-shoring’, and energy security as critical investment priorities for the near, medium and long term[2]; [2] investor mindsets are conditioned by the past decade to expect that capex will undershoot expectations, particularly as macro expectations and cyclical companies’ earnings expectations roll over; [3] we have evidence that capex forecasts are proving more resilient than earnings forecasts, while market falls have made the risk-reward for companies exposed to this opportunity particularly attractive today.

How did we get here? Examining some key periods from the past two decades, we can make the following observations:

  • Pre-GFC (2003-08): capex grew at an average rate of ~19% in the pre-GFC “golden era” (‘03-08). This wasn’t just driven by extractive industries – despite mining and oil & gas leading growth, industrial capex (i.e., ex-extractive industries) still grew at a healthy ~15% rate.
  • Post-GFC recovery (2009-13): while companies cut spending in ’09 (global capex down ~15%, or ~20% excluding extractive industries), good growth in 2010-13 (+7%) led by extractive industries meant that capex had recovered to ’08 levels by 2013 (though capex outside extractive industries was still some 7% below pre GFC levels).
  • Extractive industry capex unwinds (2014-21): the mining capex unwind came first (2013) then a year or two later came oil & gas. This capex reduction in extractive industries pulled down global capex to a 1% decline per annum on average. Excluding extractive industries, capex growth was ~4% over this period but was heavily influenced by semiconductors and technology (e.g., datacentres); excluding these industries, the balance grew at a ~2% rate.
  • Where are we today: global capex is still 3% below its 2008 peak in dollar terms. Extractive industries have been a major drag but excluding these and semis & tech, core industrial capex is only 1% above the ’08 peak.

Global capex growth year-on-year (2004-2024e)

Source: BNP Paribas Exane

Global capex excluding Mining and Oil & Gas (indexed to 2003 =100)

Source: BNP Paribas Exane

But this is only part of the story. What we see in the charts above is the outcome (the actual capex dollars spent) which misses another critical element involved in the movement of equity prices – how expectations change. Below we show the capex forecasts for some major spenders between 2014-2018. Consistent moves down in expectations were the defining feature and our assessment is that this is embedded in investor memory and the mental shortcuts they consequently apply.

Capex forecasts 2014-2018 for ExxonMobil, TSMC, Rio Tinto and Ford (Y axis = $ millions, forecasts shown as negative figure)

Source: Bloomberg Finance LP, River and Mercantile Asset Management LLP.

“The inflationary pressures we’re experiencing today are a symptom of last cycle’s underspend – the requirement to upgrade manufacturing bases (‘smart industrial’) and infrastructure is joined by decarbonisation, supply chain resilience or ‘near-shoring’, and energy security as critical investment priorities for the near, medium, and long term.”

This is important context for the dynamics we are witnessing today. Forecast revisions for cyclical sectors have weakened relative to defensive sectors, notably since the middle of 2022, leading to broad-based share price underperformance for economically sensitive companies.

Forecast revisions for cyclical sectors relative to defensive sectors

Source: Redburn

Despite this, unlike 2009, capex forecasts are proving more resilient than earnings forecasts. We have aggregated the bottom-up analyst forecasts for capex in 2022, 2023 and 2024 for every company in the MSCI ACWI index to look at how these have moved over the past year. For 2023, for example, the aggregate level is +7% higher versus a year ago and the levels for all have hardly budged in US dollar terms since the end of Q1 2022 despite softening macro and the strong dollar. 2024 spend is expected to be higher than 2023, which in turn is higher than 2022.

MSCI ACWI Aggregate CAPEX forecasts 2023e (L) and 2024e (R) since 31 March 2022

Source: MSCI, Bloomberg Finance LP, River and Mercantile Asset Management LLP. Data to 21 September 2022.

When we drill down to a handful of key sectors and sub-sectors (below), the growth figures are like previous capex cycles while there is also a clear logic and narrative behind the current spend. The inflationary pressures we’re experiencing today are a symptom of last cycle’s underspend – the requirement to upgrade manufacturing bases (‘smart industrial’) and infrastructure is joined by decarbonisation, supply chain resilience or ‘near-shoring’, and energy security as critical investment priorities for the near, medium, and long term. Returning to the Rio Tinto CEO’s quotation at the top, “this is actually really fundamental” – rapid payback investments[3], helping build business resilience, or giving companies a licence to do business for the decades to come if we consider energy transition investments for oil & gas companies or investment in electric vehicle platforms for autos. Or as Morgan Stanley puts it, “Even if we were to dip into a recession, we are of the view that these investments still need to take place as the problems do not get resolved with a moderating demand environment. In other words, the capex investments we envision and believe are necessary are incremental and largely cycle/capacity addition agnostic.”

Source: MSCI, Bloomberg Finance LP, River and Mercantile Asset Management LLP. Data to 21 September 2022.

The numbers involved are large. Morgan Stanley forecasts the following:

  • ~7.5% manufacturing capex CAGR over the next 3-5 years vs historical levels ~4%, and within this automation growing at ~10%
  • Retrofit to enable EV infrastructure, onsite power generation and storage, and grid modernisation providing a 20-year runway of ~6% growth in electrical markets, incremental to industrial production growth and accelerating from 2025-30 (~$45bn opportunity between now and 2030)
  • $350bn spending over the next 15 years to modernise the commercial building installed base, an additional $140bn over status quo investment requirements
  • ~$39bn from the CHIPS Act to bolster domestic US semiconductor manufacturing (plus $13bn for R&D) versus a current ~$200bn manufacturing capex base
  • ~$370bn earmarked for Energy Security and Climate Change investments within the US government’s Inflation Reduction Act to incentivise the transition to greener energy sources
  • ~€200 billion by 2026 from the German government for investments in decarbonisation and energy dependence.

Some of the major investment opportunities come in what we might consider ‘derivative spend’. For example, we know that spend on renewable energy generation is ramping fast (captured above in Energy’s +23% increase in 2023 forecasts over the past year). A future grid with 20-30% solar is considered optimal, which requires a 3-5x acceleration in the pace of annual solar deployments. However less well known is that solar output typically flickers downwards by over 10% around 100 times per day[4] and building out power grids and inter-connectors is considered the best means of helping to resolve both short- and long-term variability in output. Thunder Said Energy estimates that power network investment can rise from an average $280bn per annum in 2015-20[5] to $600bn by the end of the decade, equivalent to all upstream oil & gas capex in 2015[6]. Portfolio holding NKT is well placed to benefit from demand for its high-voltage cable solutions.

Global power network capex 2020-2050e

Source: Thunder Said Energy

Anticipation of a global recession has made accessing this long-term growth very cheap, with the prospect that for the select cyclicals that are beneficiaries, near-term earnings also look set to be more resilient than analysts are forecasting or share prices are embedding. Below are the price/earnings multiples (based on consensus earnings 1 year ahead) for a handful of companies held in the portfolio which are positively exposed to the trends mentioned:


Source: Bloomberg Finance LP, River and Mercantile Asset Management LLP. Data to 4 October 2022.

And from a timing perspective, using the broad Capital Goods industry group as a proxy, capex beneficiaries have underperformed the bear market, but investors have nascently begun to differentiate their outlook versus other cyclical sectors. This suggests the idiosyncratic outperformance is in its early innings.

Capital Goods relative performance year-to-date (indexed to 31/12/2021 = 100)

Source: MSCI, Bloomberg Finance LP, River and Mercantile Asset Management LLP. Data to 30 September 2022.

This entry point offers a positively skewed risk-reward: “heads we win, tails we don’t lose too much.” Nonetheless, it’s worth considering where we could be wrong. Firstly, and most obviously, monetary policy works with a lag – that’s to say, the capex cuts are coming, we just haven’t seen them yet. Do companies have the capacity to make the investments, even if they want to? Current analysis is relatively comforting on this point. Goldman Sachs “see the ability for public companies to spend $1.0 trillion in additional Green Capex without stretching balance sheets while still retaining 30%+ of operating cash flow.” The impact of rising interest rates is nuanced. For an announced project already underway and financed, corporates will likely have visibility on cost of debt for the coming 3-5 years; preparation for this spend is no doubt partly behind the reduction of short-term borrowing in Europe from 30% to 20%. Long-term lending (over 5-years maturity) is holding up well – it picked up slightly in August and is still above the pre-pandemic average growth rate. The broad observation is that although the bond market has repriced up sharply, banks have been happy to step in and so the true price shock for corporate borrowing is more moderate than bond yields suggest. Governments are clearly also stepping in with tax benefits and other incentives which reduces the bill that corporates will foot and shortens the payback on the spend they do.

We certainly don’t expect there to be no cuts, and indeed some have already emerged. Semiconductor company Micron recently cut its 2023 capex guidance by 30%, or $8 billion. Putting this in context, TSMC alone is still expected to spend $37 billion in each of the next 2 years and most of the semi capex cuts have so far been in memory, which was anticipated by many industry analysts given pricing trends there (logic and foundry are expected to be more resilient).

Eurozone credit growth (%, year-on-year)

Source: ECB, BNP Paribas Exane estimates

The long-term requirements for investment are relatively well-established by now, but we detect nervousness among investors about how a combination of tightening financial conditions, demand weakness, inflation and earnings forecast reductions will feed into an ‘air pocket’ and capex cuts during 2023 and 2024. We expect this is conditioned by the experience of the previous cycle, but the evidence is currently incontrovertible that we’ve entered a different regime. Many companies can’t afford not to invest today. Cleansing capitalism’s karma – or fixing the ‘sins’ of the last cycle – suggests casting off the ‘lower for longer’ playbook of 2010-2020 and instead looking to the 1970s for inspiration. Then, as now, inflation was the ‘disease’ and investing in the cure – the capex winners – was a profitable strategy.

[1] Rio Tinto 2022 Interims earnings call, 27 July 2022.
[2] We introduced these ideas in our Q1 2021 investor letter.
[3] According to surveys, the key factors limiting Eurozone production currently are equipment followed by labour; until 2021 this was demand.
[4] Source: Thunder Said Energy
[5] Of which one-third was transmission, two-thirds distribution
[6] Thunder Said estimates $1 trillion annual spend by 2045 assuming wind and solar at just 20-25% of all global energy in 2050. 'Aggressive' renewables scenarios can require $2-3 trillion p.a. of power grid spending.

 

This information has been prepared and issued by River and Mercantile Asset Management LLP (trading as “River and Mercantile” and “River and Mercantile Asset Management”). River and Mercantile Asset Management LLP is authorised and regulated by the Financial Conduct Authority (Firm Reference Number 453087).
The value of investments and any income generated may go down as well as up and is not guaranteed. An investor may not get back the amount originally invested. Past performance is not a reliable guide to future results. Changes in exchange rates may have an adverse effect on the value, price or income of investments.
Please note that individual securities named in this article may be held by the Portfolio Manager or persons closely associated with them and/or other members of the Investment Team personally for their own accounts. The interests of clients are protected by operation of a conflicts of interest policy and associated systems and controls which prevent personal dealing in situations which would lead to any detriment to a client

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