SustainAbility: Reality check

The start of the year has been busy with client meetings as they review performance from 2023 and look forward to 2024.

In these meetings there have been common themes and discussions as investors try to understand what the reality of markets and economies are today. Here are our views on some key areas of debate.

Is sustainability fading away?

Generally, we’ve noted investor surprise at how well our sustainable funds performed this last year. In part, this is due to a difficult year in 2022 for most growth-orientated and oil-shy funds, including sustainable ones. A narrative had been building that the trend towards sustainability has come to an end. It is also down to there being a large disparity between the best and worst performing sustainable funds in recent years.

2023 was a positive year for investors as inflation began to fall, interest rates peaked, and the much-feared recession did not appear. This resulted in strong returns from most major asset classes. Within this, the dominant investment trends were digitisation/AI, electrification as a function of the desire to decarbonise, and healthcare relating to the impact of obesity drugs. These three areas have pushed markets forward from the bottom up, at the same time as top-down macro influences have become more positive. This has been a potent combination and one highly beneficial for those sustainable funds which looked for investments in these areas. These positive bottom-up and top-down trends have largely continued into 2024 thus far.

If we accept digitisation, decarbonisation, and healthcare as three of the most powerful and durable long-term societal and investment trends, and we also accept these are a core part of sustainable investing, then we would argue one logical conclusion is that sustainability and sustainable investing is far from ending, it is getting stronger.

Are equity markets in a bubble?

Another area of debate we see is if equity markets are in something of a bubble. This idea comes from their strength with the US stock market up around 40% from its lows of October 2022, and the view that much of what is driving them is hype around AI rather than fundamentals.

As it is often noted, the main difference between a bull market and a bubble is if you are invested in it! For those owners of Nvidia shares, they will argue that the rapid adoption of AI in society has and will continue to result in an explosion of demand for their advanced semi-conductors. For those on the sidelines, they will point to the rapid rise in Nvidia’s share price and draw comparisons to the technology boom of the late 1990s when the excitement was about the roll out of the internet.

In my own experience of markets, the term ‘bubble’ has been used too often. Bubbles do occur in asset prices, but infrequently. In my view, a bubble implies extreme over valuation which could lead to a major and permanent loss of capital for investors. In hindsight, there was clearly a bubble in 1999 in technology share prices, and again in 2007 in residential home prices, but outside of those two occasions markets have oscillated between reasonable levels of under and over valuation. It is the former, the internet-led technology bubble, where most comparisons to today are made.

As someone who saw and worked through the technology bust of the late 1990s, some of the comparisons to today seem accurate and some do not. The accurate comparison is the adoption of a pervasive technology that has the potential to transform society in ways we cannot yet comprehend. In 1999 it was the internet, today it is artificial intelligence. Those in the bubble camp will note that the internet did indeed transform society but from an investment perspective there were very few winners and many losers, as investors in lastminute.com will attest. The hype around AI today certainly is reminiscent of the hype (and subsequent reality) of the internet.

Those not in the bubble camp will note many companies that fuelled the internet bubble were unprofitable, speculative businesses. Today nobody doubts the profitability and competitive advantage of large AI beneficiaries such as Microsoft, Nvidia, Amazon and Alphabet. Equally the valuations of these companies and other AI beneficiaries, whilst clearly not cheap, are nowhere near the levels ascribed to technology companies in the late 1990s.

Bubbles are only obvious in hindsight. No one can say for sure if we are in a technology-led bubble today, but the evidence does not clearly support this conclusion. We are entering a period of innovation which will result in societal changes very few can comprehend. It seems just as likely to us that this is the more likely rational driver of markets than any pockets of euphoria that can be found.

Recession is just around the corner

The final area for debate and discussion has been the health of the global economy. Many investors were surprised at the strength of the global economy in 2023. Indeed, the now infamous headline in January of last year from Bloomberg that there was a ‘100% probability’ of a recession in the US lives long in the memory.

The idea that there must be a recession, due to higher interest rates and inflation, is a hard one to let go. Long and variable lags in policy making do exist, and it is possible we haven’t seen the true impact of higher interest rates yet. Equally though, we must acknowledge the corporate and consumer components of the economy have dealt with higher interest rates much better than expected, in part as employment has remained high but also as many had extended the length of their loans in a lower rate environment, providing protection as rates have increased. This is especially true in the US consumer sector, where the most popular mortgage is a 30-year fixed rate.

There is a saying in investing, that more money has been lost in waiting for recessions than in recessions themselves. It is worth bearing in mind. Recessions are rare and fleeting. Economic growth is the norm. Investing with a recession in mind defies the odds of one occurring, and risks missing out on investment returns which are gathered in more normal times.

Finally, recessions are rare in US presidential election years, the last being 2008 when the financial crisis was in full swing. The reason for this is no mystery – often the government in power will seek to stimulate the economy ahead of the election to increase their chances of being re-elected. We can see this happening already here in the UK, and in the US. It seems to me that the risk that most investors are not managing is that the global economy could once again, and like in 2023, be stronger than expected.

In summary

In my view, sustainability, and the investable trends within it, is a strengthening wind not a weakening one. Equity markets have done well but there are powerful and rational reasons for this. Economies are strong and may remain so, at least for the foreseeable future. These to me are reasonable assertions, but they don’t as yet seem to be reflected in the minds of investors.

This is a financial promotion and is not investment advice. Past performance is not a guide to future performance. The value of investments and any income from them may go down as well as up and is not guaranteed. Investors may not get back the amount invested. Portfolio characteristics and holdings are subject to change without notice. The views expressed are those of the author at the date of publication unless otherwise indicated, which are subject to change, and is not investment advice.