GAM Investments’ Niall Gallagher explains why he believes investors must adapt to a new global post-deflation environment, highlights how he aims to capitalise on opportunities in the new era of higher inflation and the challenging energy transition, and states his long-term positive view on the luxury sector.
For the last three years or so I have taken the view that investment markets are entering a whole new era; it has been clear to me for some time that the age of deflationary and low-but-stable economic growth is well and truly over.
The deflationary forces that dominated from 2008 to 2021 have faded, and, in my view, they are not coming back any time soon. The end of both deleveraging and the era of cheap energy, coupled with the reversal of demographic tailwinds, means that investors will have to adjust to the new realities.
With global central banks now having to push against inflation – rather than deflation – interest rates are likely to stay higher for longer. In my view, neither inflation nor higher interest rates are transitory, so I do not anticipate anything close to zero interest rates for a very long time.
Europe’s banks are in the money
The return to historically normal interest rates and yields is of immense significance to the banking sector, which is highly geared to rising interest rates. European bank valuations, which have been pressured to some extent by poor sentiment towards weaker US regional banks earlier this year, are now very cheap, both versus history on both absolute and market-relative terms, and have yet to reflect this new era of higher rates.
Europe’s banks are very geared to the old industry model of collecting customer deposits and making loans. So during the near-zero interest rate period since the Global Financial Crisis of 2008, through various eurozone mini-crises, until 2021, European banks’ core deposit franchise was largely loss-making. Yet with eurozone interest rates back up to 4%, the core model is now firmly back in the money. In fact, the return on equity in the banking system has more than doubled. What is more, after a decade and a half of deleveraging across the sector – the end of which removes a deflationary impulse – banks are in great shape, in our view; deposit-rich, and, thanks to conservative lending standards, with high provisions for bad loans. Yet with loan books showing few signs of non-performing loans, our view is that banks will not need to make much more by way of provisions. Hence, with balance sheets robust and lending growth at healthy levels, banks look set to continue generating large amounts of cash, and most of the excess can be returned to shareholders.
The bumpy road to the energy transition
A major driver of the new inflation reality has been energy policies over the last decade or so. Energy costs, particularly in Europe where the energy transition has been badly flawed, will be significantly higher. Capital expenditure (capex) will be vastly higher, with huge implications not just for economies and investors but for society as a whole. Last week UK Prime Minister Rishi Sunak, facing a general election next year and trailing badly in the polls, took the pragmatic decision to slow the pace of the rush to net zero, aligning with the EU on delaying the ban on sales of petrol and diesel-powered vehicles from 2030 to 2035. This followed his German counterpart’s decision to press ahead with unpopular laws mandating the use of heat pumps, even as his party hits near-record low poll ratings. This underlines the point that the energy transition, however well intentioned, is both difficult and expensive; politicians have been evasive at best on the costs of it all, and the implications have gradually been dawning on investors.
Opportunities to plug the energy supply shortfall
For various reasons, principally ESG pressures and over-optimism over the short/medium-term potential for new cleaner energy supplies, the oil & gas sector has suffered from a lack of investment over the last decade or so. Given the ongoing push for decarbonisation, that is not going to change now. The result is that today’s structurally tight oil & gas market is here to stay, something that is true across the range of industry products. Anyone driving a diesel car in Europe nowadays knows only too well that diesel is expensive, largely a result of the lack of diesel refining capacity in Europe. And whether the ban on sales of new petrol/diesel cars takes effect in 2030 or 2035, nobody is going to invest in a new diesel refinery given the short payback period in the era of the energy transition.
Even before the upturn in energy prices over recent weeks is factored in, oil & gas prices are driving profits across the energy sector, and higher margins across much of their product range. And with capex low given the lack of investment in new hydrocarbon plants over recent years, much like in the banking sector, most of the energy sector’s profits will continue to flow back to shareholders. Across oil & gas companies, free cashflow yields are strong and therefore capital returns are very high. Of course, over the short term, we can expect oil prices to fluctuate, plus there will doubtless be further talk of windfall taxes across the sector. But, notwithstanding the politics, we are in no doubt that, much like the banking sector, the energy sector looks set for highly attractive dividends and big share buybacks coming down the line.
It is clear to see that over the long term the luxury sector outperforms. If you bought and held the sector 25 years ago, you could have made an excellent return.
The luxury sector has had a huge acceleration over the last four to five years, particularly since 2019. During this period, we had the pandemic where consumers were unable to spend, followed by ‘revenge spending’ with the cash accumulated during the lockdowns. To give an idea of how big this acceleration has been, the value of sales in the US and Europe are up between 80%-100% since 2019; a very material luxury boom.
The market has since been bullish on China since Chinese luxury spend is below 2019 levels, so the hope had been that while spending in Europe and the US might flatten, China would pick up the baton. However, so far, we have seen a more cautious Chinese consumer.
Given the size of the luxury boom in the US and Europe, it would be fair to assume we might see some flattening of spending. However, medium- and long-term support for the sector remains given its exposure to Asia, the tendency of Generation Z to ‘buy less, buy better’ and the growing number of millionaires and billionaires who will boost the sector.
Not only has the sector experienced strong growth in sales but profit margins are also at an all-time high; LVMH’s profit margins hit 26% EBIT margins, the highest ever. Given the high revenues and high profit margins, our expectation would be for growth to moderate in the near term as it is a cyclical industry.
In terms of valuations, the price/earnings of LVMH, a proxy for the luxury sector, relative to the European market traded at a 35%-40% premium between 2001 and 2019. That rose to a 120% premium in 2021. This year it has fallen back to a 63% premium, which is lower than it was but still relatively highly valued versus its own history.
Our long-term view on the sector is positive but we do need to be cognisant of shorter-term operating fundamentals, as well as valuations.
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