Video: What's the outlook for the energy transition sector in 2024?

What has caused the recent sell-off in the energy transition market?

The recent capitulation in energy transition equities has been extremely painful, with all sub-sectors across the universe experiencing severe pressures over the last few weeks.

The cause of this weakness has been the continued impact of various cyclical headwinds on the space. Valuation pressures from tightening monetary conditions; and earnings pressures from both the consequences of this monetary tightening on company operations, and prolonged inflationary pressures and supply chain disruptions in certain sectors; have weighed heavily on share prices across the entire energy transition value chain.

When adding all this to recent persistent outflows from sustainable energy ETFs, you can understand the recent collapse in sentiment towards the energy transition space.

It is important to stress that we believe these headwinds are short-term and cyclical in nature, and not factors that would challenge the significant structural investment potential of energy transition equities over the longer term.

But in the near-term, there will always be parts of the sector that will be exposed to cyclical downturns in activity, supply chain challenges, or tighter financial conditions – and this is exactly what we are seeing in the energy transition market today.

What could change this trend and what’s your outlook for 2024?

In order for this recent downward trend to change, we need to see two key things: attractive valuations and earnings inflections.

Since the start of 2023, we have felt valuations on a two-year forward earnings basis have looked reasonably attractive, and they are even more so now as they start to price out a lot of expected future growth. The sector is now trading at a discount to the wider equity market, when accounting for expected earnings growth in future years.

We also believe that potential earnings inflections are getting slowly closer. As supply chain headwinds further ease and as consumers and businesses adjust to higher interest rates, all while technology costs continue to fall, the structural demand for energy transition technologies will once again come through.

However, these earnings inflections will not necessarily come in the next six months. We anticipate a broader economic slowdown as we enter 2024, and we remain cautious about potential inflationary and interest rate threats that could further impact valuations in the short-run too. But we believe an improved earnings outlook could start to more materially come through towards the second half of 2024 and into 2025.

How has the portfolio been affected by the downturn?

With all sub-sectors underperforming over the past quarter, there were very few places to hide.

Companies exposed to renewable generation, renewable equipment, and hydrogen saw particular pressures, but very few parts of the universe and portfolio were able to deliver positive returns.

It is important to highlight that our relative underperformance compared to the broader equity market relates to our pure-play approach to investing in this space. This year many parts of the equity universe that we cannot invest in, such as traditional energy, industrial gases, or diversified semiconductors, have been particularly strong.

While we know recent performance has been challenging – and that it may not be fully over yet - we continue to believe the market leaders in under pressure energy transition sectors will be able to deliver strong earnings growth going forward, as the energy transition unfolds.

The long-term fundamentals of these businesses has not materially changed and so we’ll continue to invest in these areas.

How are you positioned for the months to come?

We continue to take a balanced approach to portfolio construction across the sub-sectors, looking for companies with strong and structural earnings and cash flow potential; reasonable value; strong returns and pricing power; sustainable business models and balance sheets.

We also continue to incrementally deploy cash into the market given the increasingly attractive risk-reward we see today. Although our move to deploy cash in the summer proved early, we continue to feel that this is the right time to do so for the strategy, in a managed and disciplined way, as pressures on the sector continues.