Quarterly Equities and Multi Asset Outlook – Q1 2024

⁸ Data through 2 January 2024.
⁹ Source: Bloomberg New Energy Finance or ‘BNEF’, December 2023.
¹⁰ Source: Bloomberg New Energy Finance or ‘BNEF’, December 2023.
¹¹ Source: Bloomberg New Energy Finance or ‘BNEF’, December 2023 – includes BEVs and PHEVs.

Off-grid is independent of the main grid and typically used in remote areas for mining, agriculture and remote communities. In Australia, mining alone is 41.3% of off-grid demand¹³.

Mining transitioning from diesel is important given the industry is responsible for 4-7% of global greenhouse gas emissions (Scope 1 and 2 basis)¹⁴. Diesel is key to this. For example, the Australian Renewable Energy Agency (ARENA) suggests diesel accounts for 41% of mining energy consumption¹⁵ from electricity and fuel (equipment, haulage, rail and port operations).

Australian mining company BHP (the world’s largest by market capitalisation) suggests electrification is their preferred pathway to eliminate diesel¹⁶. We expect companies to look to existing utilities rather than seeking in-house solutions given the expertise required, high capital costs and risk, and synergy benefits from sharing grid assets across mining regions.

A recent Australian transaction hints that the off-grid mining renewables opportunity could be big. In November 2023, Australian energy infrastructure business APA acquired Alinta Energy Pilbara. Alinta has renewable generation, storage and transmission assets in the Pilbara, Australia’s premier mining region. What excites us are the electricity projections behind this transaction.

The Pilbara is forecast to nearly triple off-grid capacity to 7.6GW by 2040, replacing 2.5 billion litres of annual diesel demand. The investment required is estimated at US$10 billion¹⁷. Extrapolating this globally is difficult given the range of variables – for example, estimating global mining diesel consumption and noting Australia is more diesel intensive than, say, North America with less gas infrastructure. However, Alinta could imply that 330GW in renewables (and US$450 billion in investment) is needed globally if we assume 10% of global diesel demand is mining related.

Major utility companies are investing in this opportunity. Italian utility ENEL, for example, is commencing a 75MW wind project for BHP’s Western Australian nickel operations in 2024. ENEL is active globally with infrastructure projects ranging from a 50MW Spanish solar facility for Atalaya Mining to Chilean E-bus charging infrastructure for Anglo-American. US utility AES is, likewise, active in Chile contracting in 2023 to supply copper company Codelco the equivalent of 980MW of renewable energy.

Opportunities for infrastructure enablers and services companies

Besides benefiting utilities, we expect these trends to also support the growth of related infrastructure enablers and infrastructure services companies. Infrastructure enablers such as Alfen (which manufactures smart grid and energy storage equipment and sells EV charging equipment to infrastructure owners) and Vestas Wind Systems (which manufactures and sells wind turbines to utilities and renewables developers) provide products and solutions to support infrastructure owners and operators. Other key players that support utilities are companies like Japanese Toray (via subsidiary Zoltek) which provides 50% of the global composite material used to manufacture wind blades, and France’s Nexans, one of the dominant three high voltage cable manufacturers in Europe. High voltage cables and investment in the electricity grid are widely acknowledged as one of the key bottlenecks in the energy transition. With utilities and renewables developers scrambling to secure orders, we expect pricing power to be very much in the hands of the cable manufacturers.

For enablers, the manufacturing of products and the development of solutions drives value. Infrastructure services companies, on the other hand, provide services to asset owners and operators as well as to enablers. For these companies, human capital, expertise and intellectual property tends to drive value.

Undoubtedly, there are challenges ahead. For one, questions remain around whether electrification alone, or in tandem with hydrogen for example, is the solution to decarbonise mining. Regardless, we believe that energy transition will underpin significant growth in infrastructure over the next decade. Some of the most compelling investment opportunities are not always immediately evident. Taking a research-driven, active approach and drilling down to fully understand the industry dynamics and company level exposures can help to uncover significant upside opportunities.

¹³ Source: Australian Department of Climate Change, Energy, the Environment and Water Australian Energy Update 2023 | energy.gov.au; Open NEM (Australian electricity consumption data source) OpenNEM: NEM
¹⁴ Source: S&P Global: Commodity Insights Mining faces pressure for net-zero targets as demand rises for clean energy raw materials | S&P Global Commodity Insights (spglobal.com)
¹⁵ Source: Australian Renewable Energy Agency (ARENA). Renewable Energy in the Australian Mining Sector (White Paper) Page 3. Renewable Energy in the Australian Mining Sector – Australian Renewable Energy Agency (ARENA)
¹⁶ Source: BHP. Operational decarbonisation investor briefing June 2023 (Investor Presentation) Operational Decarbonisation Investor Presentation (bhp.com)
¹⁷ Source: M&G Investments, APA. Acquisition of Alinta Energy Pilbara and Equity Raising August 2023 (Investor Presentation) Acquisition of Alinta Energy Pilbara and $750 million equity raising | APA Group

As we have discussed many times, we believe Japanese equities represent a compelling long-term opportunity in a global context. We continue to believe that structural earnings growth, principally derived from corporate self-help, will be a strong driver of market returns. Taking into consideration a strong dividend and buyback story in Japan, it’s not unrealistic to expect the Japanese equity asset class to deliver a mid-teen total compound return in the decade ahead, even without an uplift in valuations. Compared to the underlying risk of ownership, this feels attractive to us.

Japanese firms well placed for energy transition

When it comes to energy transition, Japan is perhaps something of an overlooked market. We estimate that approximately one-third of the large-cap benchmark in Japan, excluding financials, has energy transition as a key underlying business thematic. As it happens, in 2023, this cohort of stocks outperformed the broader market, on average, by around 600 basis points²⁰.

We are invested in names such as Hitachi, Orix and Toyota; all companies with important roles to play in energy-transition. For its part, Hitachi is a technology leader when it comes to power grids and is well placed to accelerate the clean energy transition globally. Orix is one of Japan’s largest investors in renewable energy assets, notably solar and wind related. Toyota, on the other hand, is leading the global technology race toward solid-state-batteries, which should drive broader adoption of EVs in the years ahead.

These companies are of course not alone. Japan boasts leading Intellectual Property in several areas that will be critical to the global energy transition. Lightweighting²¹ of various products is unlikely to happen without the involvement of Japanese materials science companies like Toray. Japanese heavy industrial companies have their fingerprints all over various aspects of the hydrogen economy and, in the start-up innovation space, Japan occupies essential positions in nuclear fusion technologies. As businesses pursue the means with which to contribute, and adapt, to energy transition, Japanese companies across a range of industries are providing opportunities for active investors to take advantage of the innovation and technologies being developed.

²⁰ Performance differential based on proprietary analysis of companies in the Topix 150 Index that we believe have significant exposure to the energy transition versus the broader Topix 150 Index performance.
²¹ Lightweighting is the process of removing weight from a component or assembly to improve performance and expand functionality while reducing material volumes and waste. As manufacturers attempt to create both greener and more economical products, lightweighting has become increasingly relevant.

Very encouragingly, the world’s largest emitter China, in 2020 pledged a net-zero goal by 2060. The end result of this pledge has been truly staggering as China now leads the world in both the installation of wind and – especially – solar energy²². It is also the world leader in existing installed EV fleet and production. Ironically, after an initial wave of positive flows in Chinese, and for that matter Asian, energy transition stocks, this portion of the equity market has become increasingly treacherous. Huge increases in capacity for commodity renewable items like polysilicon has ultimately outstripped demand and led to falling prices, and an incredibly competitive environment where only the fittest survive, and returns on invested capital have been crushed lower. 

Navigating the current environment

Against such a backdrop, we are adopting three broad approaches to navigate this difficult environment, while still identifying stocks that should benefit structurally from the energy transition megatrend.

The first is in identifying those parts of the renewable supply chain that enjoy high barriers to entry, either through technology or regulation. We own stocks in this category which are well-positioned to benefit from decent top-line growth, while maintaining steady margins. A good example is Jiangsu Zhongtian, a niche cable maker listed in the Chinese A share market. Zhongtian specialises in both making the cables and then providing the engineering services, which connect offshore wind farms to the onshore power grid. The service it provides is both complex and critical in nature and, as a result, there are only three certified players in China, of which Zhongtian is one. The scale of the offshore build out in Chinese wind farms mean that these three cable and engineering companies are the largest in the world, which is allowing them to win lucrative export orders in an industry that is increasingly facing ever tougher capacity constraints on a global basis.

The second approach focuses on those more commodity-based producers that either have the scale, vertical integration (supply their own key components at a low cost) or both, and thus have a structurally competitive cost advantage, which will allow them to remain profitable through this period of intense competition. Importantly, with general negative sentiment towards all things China at present, both groups of stocks can be bought at undemanding valuation levels.

The final approach is to identify sectors or industries that will benefit tangentially from the energy transition. Shipping and shipbuilding are two such sectors. Shipping is a cyclical sector that experienced 10 very lean years from 2010, as a boom turned to bust, with ships ordered in peak demand years arriving in a depressed market sometime later. Looking forward, shipping (especially bulk shipping) now has a much healthier demand supply balance. Importantly, due to uncertainty about what will be the new climate-friendly fuel standard – methanol, ammonia or hydrogen – ship owners have been reluctant to order new ships fearing any deliveries may become obsolete before their 20 years’ useful life has expired. This is instilling an enforced supply discipline in bulk shipping that we have not seen in the past.

Similarly, ship yards are also benefiting from energy transition. During the last decade, many yards were forced to close due to a lack of orders. This has reduced both physical and human capacity for building ships. As a result, remaining yards are in a strong position to cherry pick the most lucrative of orders, given full order books out to late 2026 or even 2027. With literally thousands and thousands of ships that need to transition in the next 20 years, it is very plausible that an historically-cyclical industry like shipbuilding will resemble, for a prolonged period, a structural growth story. In the shipping and shipbuilding stocks that we own, such a positive, structural outcome is by no means discounted by current valuations.

²² Source: BloombergNEF (BNEF), 2023

In fact, across EM, we find attractive investment opportunities beyond China’s renewable supply chain. For example, we see many legacy utility operators, especially those with large renewable operations, in a good position to benefit from such exposures as the cost of carbon inevitably rises via taxation or other policy measures. Such companies also avoid the risk of stranded assets, for example in Romania and Brazil.

Along the same lines, we see opportunities in businesses that are the ‘picks and shovels’ for large energy transition projects – for example, construction companies and mining companies with positive asset exposure to green metals like copper and nickel. The flipside of the coin is that there is still a bill to be paid by many other industrial segments to decarbonise – such as pulp and paper, and chemicals manufacturing. As such, we remain wary of these areas.

The priorities and actions driven by a global focus on climate change investments also have a broader impact as some countries have to shift their entire economic model. This is particularly prevalent in the Middle East with, for example, Saudi Arabia’s hugely ambitious Vision 2030 plan focused on diversifying the economy away from dependence on oilfields and into new economic areas. These go beyond new energy sources and include the service industry such as leisure and tourism, potentially providing further investment opportunities.

Overall, the investment winners and losers from the energy transition are neither obvious nor static. We take a multi-disciplinary approach across the Equities team globally to find ideas for investment where energy transition has the potential to bring opportunity and positive economic impact for us as shareholders.

Microsoft has significantly increased its quarterly capital expenditure (capex) since its investment in OpenAI in early 2023. Undoubtedly, the increase in capex is related to increased AI capacity in Microsoft’s Azure Cloud.

Microsoft believes that in its fiscal year (FY) 2022 ending June, it consumed 18,153,454MWh of electricity, up 33% versus FY 2021²⁴. While the company has not yet disclosed its electricity consumption for FY 2023, we do believe the growth in Generative AI computing will continue to accelerate the rise in electricity consumption.

Fig 4. Microsoft quarterly capex spending

Likewise, Oracle is also increasing capacity for AI-related workloads. On a recent earnings call, Oracle said that it currently has 66 datacentres, for which it plans to increase capacity, while also looking to create an additional 100 datacentres to build out capacity for AI.

The capability of AI increases as datasets used to train AI systems increase. Training capacity increases with more processors, computer memory, data storage and high-speed networking. As these training systems become more powerful, AI becomes more powerful. For example, Tesla believes that increased training capacity is the key to developing fully self-driving cars and, while it has developed its own AI training processor called Dojo, it remains a customer of Nvidia for training because they need as much capacity as they can get. Tesla’s approach to developing software for fully self-driving cars is to feed the system an extreme amount of training data that is primarily video to ‘teach’ the neural network how to drive like a human. As more data is sent to the system for training, the performance improves. The power consumption of a single Dojo system is two megawatts which is approximately 8x more power than a Tesla Supercharger.

Hardware and semiconductor companies believe Generative AI will be a tremendous tailwind over the next decade. For example, Cisco mentioned on a recent quarterly earnings call that it has “line of sight to over $1 billion in orders for AI infrastructure from major cloud providers in fiscal year 2025”. While Micron also gave very bullish commentary, calling Generative AI its biggest demand driver: “We are in the very early stages of a multi-year growth phase catalysed and driven by Generative AI, and this disruptive technology will eventually transform every aspect of business and society”.

Efficiency improvements from AI offset AI energy consumption

While we expect AI to be a significant driver of electricity consumption over the next decades, we believe it will also play a key role in managing the supply and demand of electricity. As electricity generation moves to renewable sources from carbon-based ones, the supply of electricity will become more fragmented, distributed and less predictable. Homes are likely to become local sources of solar energy, power may come from long distances where there is wind, sun, or hydroelectric power, and storage of excess power will require stationary or mobile (including EVs) batteries.

However, wind and solar energy is not always available, either because of the time of day or the weather. AI will be needed to balance electricity consumption with production. For example, based on weather predictions, and hence available power, non-critical electrical loads can be ‘shifted’ to more favourable times. AI can recommend reducing power consumption and storing excess power in batteries ahead of adverse weather that could reduce available power. Companies such as Schneider Electric and Microsoft are working together to transform grid management with the goal of maintaining grid reliability and accelerating customer adoption of distributed energy storage resources, including EVs and rooftop solar²⁵.

AI can also be used to reduce energy consumption. Today, data from trucks is analysed and used to optimise drivers’ habits. Data such as idle time, throttle position, and speed is being used to train drivers to minimise fuel consumption. In the future, autonomous transportation with fully electric vehicles will help minimise energy consumption because of optimised routing, reduced traffic, and better asset utilisation. While AI will increase datacentre energy consumption, the capabilities of AI will be needed to manage the transition to fully renewable electricity sources.

²³ Source: Nvidia, company earnings reports, 2023
²⁴ Microsoft, 2022 Environmental Sustainability Report, 2022 Factsheet
²⁵ Source: Schneider Electric capital markets day

For the ‘core’ renewables and their enablers/suppliers, there is a mix of established firms with good credit quality along with some fledging, new-technology firms with unproven business models, high capex needs and intense cash burn. As such, they average high implied spreads of c.800-910 basis points (bps) and high volatility in the 36-43% range, with notable differences between the more established and the newer business models.

By contrast, and unsurprisingly, traditional utilities are generally good-quality investment grade businesses with low volatility, high dividend yields (often 4-5%), and mid-single digit dividend growth. They necessitate large amounts of capex to gradually decarbonise their installed base and to meet growing demand. Favourable market and regulatory dynamics ensure adequate returns for the investments needed, but the structure of most bonds (relatively short-dated, no dividend passthrough for the existing dividend yield, deltas on the low side, and high effective conversion premia) offers slim chances of conversion and leads to a reliance on coupon income for returns. As a consequence, we do not currently find attractive investment opportunities in this segment.

The final segment, independent EV makers, are mostly new standalone companies with immense capex and cash burn plans, limited scale, and sometimes with little more than a prototype to their name. As very high-risk operations, they imply an average of c.2,070 bps credit-spread and c.53% volatility. It is worth noting that Tesla, the poster child of EVs, used to be a prolific convertible bond issuer but is no longer in the convertibles market, while the more successful Chinese EV makers (eg BYD) are not convertible issuers either.

Fig 5. Energy transition segments: implied spreads and volatility

Over the longer term, meaningfully reducing the reliance on fossil fuel energy might lead to lower and less volatile inflation, while the expected reduced cost of solar and wind energy might suggest higher household disposable income potentially leading to an increase in consumption. While the macroeconomic effects of the energy transition are difficult to predict and might vary over time, they are certainly something investors and asset allocators need to be aware of: as the last few years have demonstrated, increased volatility in macroeconomic fundamentals can lead to increased volatility in financial markets.

Inflation and rates variability remained a key focus for investors in 2023, leading to elevated volatility in bonds. In particular, the last quarter of the year saw significant shifts in investors’ beliefs regarding the path of interest rates, as represented by the extreme price shifts in sovereign bonds markets which provided attractive opportunities for tactical asset allocation. For example, 30-year German bund yields moved from 3.2% to 2.2% generating a capital gain close to +25% in just a few weeks.

Fig 6. 30-year sovereign bond yields

Looking ahead, monetary policy is likely to remain centre stage. However, with inflation numbers now looking more benign, investors might start to focus more on the growth environment. In equities, we maintain a preference for more attractively-valued markets such as Europe, within our current neutral stance. European companies are also, in our opinion, more competitively-positioned towards decarbonisation, with more advanced frameworks in place for the measuring, monitoring and targeting of carbon emission intensity. We also find opportunities globally in companies exposed to the energy transition, an area that struggled in 2023 in an environment of higher rates and continued supply-chain driven cost pressure, but where we are starting to see these headwinds abating.

In fixed income, we might continue to see higher-than-normal volatility bringing opportunities for tactical asset allocation. However, current levels of yields are attractive on a longer-term basis, in our view, especially if growth was to decelerate in the coming months. More recently, we have found renewed opportunities in developed market sovereign bonds and taken exposure via different instruments, including use-of-proceeds green bonds of Italy, the UK and Germany, bringing together asset allocation and sustainable investing.

In 2024, macroeconomic events and price behaviour are likely to continue to surprise investors and provide tactical asset allocation opportunities. Current elevated real yields across asset classes should be supportive for Multi Asset investors as a potential source of longer-term returns (capital appreciation and income) and improved diversification characteristics in risk-off environments. Investors with longer time horizons might also choose to take advantage of specific allocations related to longer-term themes such as the transition to a low-carbon ecosystem, areas benefiting from structural tailwinds and where we expect capital to continue to flow. The road to make the COP 28 agreement a reality is still long but we believe opportunities are set to arise along the way.