The US Federal Reserve (Fed) recently cut interest rates by 50 basis points. What does this mean for thematic investing?
Alex Tedder: It was more than I was expecting as I don’t think the US economy is in a bad place, it’s probably a lot stronger than many people think. But the labour market has certainly been cooling and inflation has come down a long way. So, the Fed is clearly trying to keep everything in the “Goldilocks” place and this cut is a good step in that direction. It’s definitely supportive for markets: good for markets in the short term; pretty encouraging overall. Typically this type of range of 1-3% inflation with interest rates coming down is the sweet spot for equities and that’s why we can be quite optimistic for markets, despite fairly high valuations.
Ailsa Craig: Biotechnology is highly affected by interest rates. The sector’s performance has a strong inverse correlation with rates. Biotechnology is usually hit hard when rates rise and then, when rates fall, the sector tends to outperform. So, in October last year, we saw a bottoming of the biotech sector when the US yield hit 5% and since then we have seen a recovery, so further cuts to interest rates means a positive environment for biotech investing. The biotech sector is seeing accelerating innovation, rising demand for its products and a good flow of merger & acquisition (M&A) deals so it is good that the macro backdrop is now in a more supportive place.
Tom Walker: I’ve been waiting for this moment for a long time. 2022 was the start of a dark period for the real estate sector. We saw the largest decrease in our sector since the global financial crisis, and what always staggered me was that this was taking place when all the research trips and management meetings we were having were telling us that real estate markets were in a really strong position. But you had this change in the discount rate and this absolutely smashed us. So, we’re relieved that people want to speak to us again. We’ve seen a huge change in client appetite with regard to talking about our strategy.
Is the trend of urbanisation still important?
Tom Walker: Nothing has changed in the fundamentals of people moving to areas where there are clusters of expertise and fun things to do. Urbanisation is as strong today as it was many years ago. But there were so many violent things happening in the markets, people’s attention was distracted by Covid, and then rates rising, that people just stood back and forgot about what the long-time direction is here. When we look at the demand for things such as data centres, senior housing, residential, those are incredibly strong now, as they were two years ago.
What forces have been driving the markets?
Alex Tedder: What has happened in markets this year is that they have been dominated by a small number of companies. This has been a global trend, but has been particularly pronounced in the US, with the technology and AI phenomenon particularly powerful in that market for obvious reasons. More than half of the returns from the S&P 500 in the first half of the year came from five companies and those have been directly linked to AI. The theme has captured investors’ imagination and for good reason because the earnings growth of the S&P 500 so far this year has also been driven by these companies.
So that kind of progression has been very logical, but also very narrow. And what we saw in July was a little bit of a reassessment. Maybe the whole technology thing got a little ahead of itself in terms of expectations. But also, maybe the dynamic in the economy was beginning to shift and maybe it’s time to look at areas that have been out of favour and have become really attractive from a valuation standpoint and are potentially really interesting in this environment of lower inflation and lower interest rates.
Is AI still an important investment theme?
Alex Tedder: We have been very positive on AI and still are. This has been a theme for us for some time. But here’s the problem; you’ve got the three biggest hyperscalers who will probably spend triple-digit billions on AI-related capex this year. And if you look at the consensus revenue increments for the next two to three years that are expected to be generated by that AI investment, it’s double-digit billion at best. So, it means that underlying profitability is falling and return on capital is coming down.
The question we now need to think about is this: if we look further out, are they going to get paid back on that massive amount of AI investment or are they just doing it because they are worried about being left out of the race. Of course they can afford it, but are they ultimately wasting shareholder’s money? That’s the question that the market now needs to address.
Ailsa Craig: There are lots of advantages of AI that can be exploited by the healthcare industry. Over time there has been a large reduction in costs for things such as DNA sequencing. The first genome that was sequenced cost $3 billion, but now you can do that for $300. What we are seeing with research and development (R&D) is the inverse of that. Over time it’s become more expensive and less productive to find and develop new drugs. So, because of this downward trend in R&D productivity, that’s one of the areas that people think AI could make more efficient and change.
In terms of AI, there are various different stages in the drug development process where AI could be helpful and save costs. One such area is data analysis. Once you have had a clinical trial and you get all the data, that process could be revolutionised by AI. Another area is diagnostics. A doctor can look at a tumour and take a view, but AI can do that exponentially better. But in terms of speeding up the overall process of clinical trials, nothing can replace or accelerate the process of putting a potential drug into humans and seeing if it is effective over time and whether side effects develop over time.
What about the US presidential election?
Alex Tedder: When Trump was elected in 2016, we had a “Trump bump” that was pretty material. That was a short, but powerful change in the market direction, when a lot of areas that were perceived to be beneficiaries of Trump’s protectionist policies did extremely well. If Trump is re-elected, I don’t think we are going to see another “Trump bump” because I think the market is seeing through that right now. Both candidates don’t have a lot of room to manoeuvre from a policy standpoint. Fiscal constraints are pretty substantial. Protectionism, if applied by Trump, would be a tax on consumers and massively regressive. I think whoever is elected will not do a whole lot fiscally and just let monetary policy do the job.
Final thoughts
Alex Tedder: I’m reasonably constructive on equities; valuations are high, but I think they are supported by earnings. And the move by the Fed goes to support that. The one caveat is geopolitics. It’s a wildcard that we can’t predict.
Ailsa Craig: We are very constructive on biotechnology where conversely we are not seeing high valuations among listed equities. We are in a sweet spot where long-term trends – an older, sicker, richer society, plus the interest rate cycle moving in a favourable direction – means that we are optimistic for a period of positive outcomes for the biotechnology sector.
Tom Walker: We are clearly moving from a headwind to a tailwind. The discounts in the listed sector, which is still pessimistically priced and the evidence of M&A increasing, shows that there is value, and so we are constructive on listed real estate too.
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