Perspective

Video: how the macroeconomic backdrop is affecting energy transition equities


Q2 once again saw significant volatility across energy transition markets, along with risk assets more broadly, as investors grapple with rising economic threats. As we've been outlining since the start of the year, investors and broader society are currently facing two economic monsters.

The first of these relates to supply chain pressures and inflation, which continues to surge to near 40-year highs. This inflation has had two effects on companies across the energy transition space.

The first is from an earnings perspective where companies have seen their profitability decline as their costs have increased.

The second is from a valuation perspective, as the higher interest rates required to tame that inflation have decreased the value of future cashflow growth.

It's with respect to this threat that companies in some of those higher growth markets, such as renewable energy, energy storage, and hydrogen, have felt the most pain given the value of their earnings is far further out in time, and they've also been more exposed to some of these supply chain shocks.

While a lot of this inflation has been caused by Covid-19 lockdowns, it’s also been caused by the war in Ukraine, the return to a more de-globalised world and structural under investment of key markets such as energy and agriculture. As a result, we do believe that this inflation could remain with us for some time to come.

The second economic consequence is the real risk of a recession, and this has been particularly in focus since the start of June. Interest rates have increased as supply chain pressures have acted as a ‘tax’ on the consumer. There are now concerns that economic growth is starting to slow and could put pressure on the near terms earnings of companies in the more cyclical parts of the energy transition space, such as electrical equipment and autos.

Energy transition equities remain attractive for investors

While the current macroeconomic landscape is clearly challenging, the positive news is that energy transition equities are often the solution to some of the problems that the world is facing today.

With energy prices one of the main causes of inflation that is causing the potential recession too, bringing on more energy supply to the system is going to be absolutely vital.

Given the speed at which we can increase renewables compared to some of the conventional forms of energy, that certainly plays into the structural opportunity behind the energy transition space. We are going to need lots more renewables, lots more storage and event hydrogen to solve the energy crisis that we have, particularly in Europe, today.

How are we navigating the current environment?

Within the complex and broad energy transition market, trying to navigate these economic threats is certainly difficult. We're really looking for three key characteristics from companies.

The first is strong structural growth to manage some of those threats of a potential economic slowdown, and this is where companies in that renewable space, energy storage, and hydrogen should potentially fare best.

The second is strong pricing power and margins to manage some of those supply chain shortages and pressures on profitability, and that's also where things like electrical equipment and utilities start to come in given their robust business models, in general.

And finally, we're also looking to make sure that we're paying for companies at a reasonable value and not over-expensive levels. This is where despite their cyclicality, sectors such as electoral equipment and autos generally stand to fare a little bit better.

Few companies within the energy transition universe have all three elements, as well as the strong sustainability profiles that we’re also looking for in companies. We are focused on taking a balanced approach when looking for companies across the energy transition space to ensure that our overall strategy maps towards these three characteristics.

What do we expect from energy transition equities going forward?

Given the current macroeconomic uncertainties, we do expect volatility across energy transition equities to continue for some time. But we also think it's important to take a step back and remember that the long-term opportunity behind energy transition equities hasn't changed at all, and if anything, has only become stronger in light of our new energy security goals.

We're still going to need lots more renewables, storage, and hydrogen, as well as all the electrical equipment to tie those technologies up to the grid.

Moreover, as valuations have pulled back, we're starting to see interesting entry points for some of these companies when taking a longer-term view and particularly those that can manage some of those nearer-term threats.

Our conviction around energy transition equities remains as strong as ever. So too is our view that capital discipline and finding companies with robust balance sheets, sustainable business models and an exciting long-term growth profile has never been more important. That is what we are looking for across the energy transition space.

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