Real Return Archives

Will the global economy experience a hard or soft landing, or a rebound?

We need to be careful when talking about the global economy as different regions have been operating at different speeds. For example, China has been particularly sluggish, with the consumer exhibiting pronounced weakness, although the export side of the economy has been more resilient. Europe has suffered from the contagion effect from China, as manufacturing had been reliant on Chinese demand, while consumers are still experiencing the aftermath of the inflationary wave.

The US has demonstrated continued exceptionalism and has topped the league table of the major economic blocks in terms of resilience. While the consensus is for a soft landing, the resurgence of inflation is a growing risk as the new political regime is likely to deploy fiscal stimulus as a key tool and the agenda is decidedly pro-growth.

In our view, the bigger risk for the US is in fact ‘no landing’, with the possibility of inflation overshooting. Interest rates are likely to stay higher for longer, and markets have already priced out a number of rate cuts that had previously been pencilled in for 2025. This could impede a recovery in the US housing market. On balance, however, we still think that the US economy is likely to remain buoyant and would attribute a low probability to a recession at this juncture.

What is the impact of the US election? Is US equity market leadership set to continue?

For the time being, the US is the only show in town, while China and Europe are decidedly out of favour and mired with challenges.

In terms of equity market leadership, technology has been relatively unchallenged at the top of the league table, but this could change if artificial intelligence (AI) hopes disappoint, or should the sector come under pressure from rising bond yields. We could see a broad range of sectors among the future winners, with areas such as domestic cyclicals, financials and small caps playing catch-up. US-dollar strength could also be a drag on technology stocks, as well as negatively affecting the performance of areas such as health care, which tends to be dominated by those companies deriving their earnings from overseas.

Is China investable again? Will stimulus revive the economy?

The Chinese economy has struggled for the last few years on the back of government intervention, which was perceived by markets as unhelpful, as well as distress in the real-estate sector as a result of excessive investment. The Chinese government had not been active on the stimulus front throughout 2023 and in the first half of 2024, but with the announcement of stimulus plans in September, it does seem to have pulled some levers to kick-start the economy.

Although there are tentative signs that the consumer is stabilising, the stimulus currently appears insufficient to engineer a full-blown recovery. We may see some drip-feeding of further stimulus which could be positive at the margin, but the significant structural issues in the real-estate market are unlikely to be resolved overnight.

China enjoys the biggest trade surplus it has ever had, giving rise to pockets of optimism. A potential recovery is, however, difficult to play from an investment perspective, and we have sought to gain exposure to the more positive sentiment on a tactical basis.

AI-related spending: will the investment pay off?

AI has remained a key focus for investors in 2024 and there has been huge excitement around its potential to increase productivity following decades of scant progress on this front. Companies can be more intelligent in the way they manage their businesses in areas such as supply-chain management and identification of consumer trends.

We are now getting to the ‘show me’ phase: considerable investment has been deployed and there is a desire to monetise it. There is a genuine risk that the market has got ahead of itself in terms of expectations, as reflected in lofty price earnings multiples, and there is the potential for a hangover if disappointment ensues. The gold-rush mentality of upping the investment ante has set some companies up for a fall if an increase in demand does not justify the scale of the investment made.

We remain alert to the broadening out of the AI trend and there are a range of companies in peripheral areas that could partially benefit from related productivity gains.

We continue to have significant investment in this theme in the strategy. Exposure is skewed towards the ‘picks and shovels’ through semiconductor names. While we believe in the long-term trend, we are mindful that we could see some pullbacks along the way. We also remain alert to the broadening out of the AI trend and there are a range of companies in peripheral areas that could partially benefit from related productivity gains.

Do you see fixed income returning to its role as a diversifier?

Bonds will have a role, but they are unlikely to be as dominant as they have been in the past.

Bonds have typically acted as a ‘flight-to-safety’ asset, as well as cushioning against growth shocks. They have also had the benefit of positive carry (when the benefit of holding the asset exceeds the costs). As a result of the more inflationary environment inherent in this new market regime where fiscal policy plays a more dominant role, bonds may no longer be as consistent a hedging tool and there will be a need to further diversify. The new regime appears more fragile, and the shocks of tomorrow are likely to look very different in terms of frequency, intensity, origin and their ability to spread across the system.

A portfolio’s ‘stabilising’ assets will need to be different from those used previously and could include alternative risk premia and other alternative return streams. In our view, the fact that bond insurance appeared to be ‘free’ was an anomaly, and a product of the distorted policy regime that allowed yield curves to steepen.

What is the outlook for commodities – gold/silver/oil/copper?

Gold seems to have got ahead of itself, sensing that expansionary fiscal policy was on the cards with a likely Trump victory in the US presidential election. We still like gold and consider it to be a useful diversifier, but we have reduced exposure for the time being.

We are selective about the weighting to commodities, mindful that a strong US dollar in the short-term will not be a positive for the commodity complex. Copper is an area that we still favour, as it is a beneficiary of the green transition, playing into the electric-vehicle theme, as well as being used for data centres, a key element of the AI build-out.

Elsewhere, silver is a precious metal that we like, owing to the attraction of both its industrial use and the fact that it is playing catch-up with gold from a valuation perspective. It is, however, a higher-beta commodity and does not have the same safe-haven attributes as gold. We have reduced the strategy’s oil exposure on the equity front in the expectation that the new US administration will encourage a higher level of drilling activity or may even lean on OPEC to increase supply.

Your capital may be at risk. The value of investments and the income from them can fall as well as rise and investors may not get back the original amount invested.

Will the global economy experience a hard or soft landing, or a rebound?

In our view, the bigger risk for the US is in fact ‘no landing,’ with the possibility of inflation overshooting. Interest rates are likely to stay higher for longer, and markets have already priced out a number of rate cuts that had previously been penciled in for 2025. This could impede a recovery in the US housing market. On balance, however, we still think that the US economy is likely to remain buoyant and would attribute a low probability to a recession at this juncture.

What is the impact of the US election? Is US equity market leadership set to continue?

For the time being, the US is the only show in town, while China and Europe are decidedly out of favor and mired with challenges.

In terms of equity market leadership, technology has been relatively unchallenged at the top of the league table, but this could change if artificial intelligence (AI) hopes disappoint, or should the sector come under pressure from rising bond yields. We could see a broad range of sectors among the future winners, with areas such as domestic cyclicals, financials and small caps playing catch-up. US-dollar strength could also be a drag on technology stocks, as well as negatively affect the performance of areas such as health care, which tends to be dominated by those companies deriving their earnings from overseas.

Is China investable again? Will stimulus revive the economy?

The Chinese economy has struggled for the last few years owing to government intervention, which was perceived by markets as unhelpful, as well as distress in the real-estate sector as a result of excessive investment. The Chinese government had not been active on the stimulus front throughout 2023 and in the first half of 2024, but with the announcement of stimulus plans in September, it does seem to have pulled some levers to kick-start the economy.

Although there are tentative signs that the consumer is stabilizing, the stimulus currently appears insufficient to engineer a full-blown recovery. We may see some drip-feeding of further stimulus which could be positive at the margin, but the significant structural issues in the real-estate market are unlikely to be resolved overnight.

AI-related spending: will the investment pay off?

We are now getting to the ‘show me’ phase: considerable investment has been deployed and there is a desire to monetize it. There is a genuine risk that the market has got ahead of itself in terms of expectations, as reflected in lofty price earnings multiples, and there is the potential for a hangover if disappointment ensues. The gold-rush mentality of upping the investment ante has set some companies up for a fall if an increase in demand does not justify the scale of the investment made.

We remain alert to the broadening out of the AI trend, and there are a range of companies in peripheral areas that could partially benefit from related productivity gains.

We continue to have significant investment in this theme in the strategy. Exposure is skewed toward the ‘picks and shovels’ through semiconductor names. While we believe in the long-term trend, we are mindful that we could see some pullbacks along the way. We also remain alert to the broadening out of the AI trend, and there are a range of companies in peripheral areas that could partially benefit from related productivity gains.

Do you see fixed income returning to its role as a diversifier?

Bonds will have a role, but they are unlikely to be as dominant as they have been in the past.

Bonds have typically acted as a ‘flight-to-safety’ asset, as well as cushioning against growth shocks. They have also had the benefit of positive carry (when the benefit of holding the asset exceeds the costs). As a result of the more inflationary environment inherent in this new market regime where fiscal policy plays a more dominant role, bonds may no longer be as consistent a hedging tool, and there will be a need to further diversify. The new regime appears more fragile, and the shocks of tomorrow are likely to look very different in terms of frequency, intensity, origin and their ability to spread across the system.

A portfolio’s ‘stabilizing’ assets will need to be different from those used previously and could include alternative risk premia and other alternative return streams. In our view, the fact that bond insurance appeared to be ‘free’ was an anomaly and a product of the distorted policy regime that allowed yield curves to steepen.

What is the outlook for commodities – gold/silver/oil/copper?

We are selective about the weighting to commodities, mindful that a strong US dollar in the short-term will not be a positive for the commodity complex. Copper is an area that we still favor, as it is a beneficiary of the green transition, playing into the electric-vehicle theme, as well as being used for data centers, a key element of the AI build-out.

Will the global economy experience a hard or soft landing, or a rebound?

What is the impact of the US election? Is US equity market leadership set to continue?

For the time being, the US is the only show in town, while China and Europe are decidedly out of favour and mired with challenges.

Is China investable again? Will stimulus revive the economy?

AI-related spending: will the investment pay off?

We remain alert to the broadening out of the AI trend and there are a range of companies in peripheral areas that could partially benefit from related productivity gains.

Do you see fixed income returning to its role as a diversifier?

Bonds will have a role, but they are unlikely to be as dominant as they have been in the past.

What is the outlook for commodities – gold/silver/oil/copper?

Amid price instability, heightened geopolitical risks and volatility, investment opportunities remain.

Last year was a transition year – and a painful one at that. The end of the Cold War, the break-up of Russia, and the advancement of China had driven inflation and interest rates lower for decades, creating a benign environment for risk assets. However, the 2020 Covid-19 pandemic led to unprecedented spending and assistance – with global central banks spending the equivalent of nearly US$800m every hour for 18 months. This was bound to have an inflationary impact, with the subsequent environment seeing the fastest, most aggressive interest rate-hiking cycle in decades.

In the context of this transition, 2022 was a difficult year across all asset classes, disrupting the negative correlations that have supported the traditional 60/40 equity/bond asset-allocation model in recent years. Against this backdrop, we believe bonds may no longer be the best way to stabilise portfolios. While it appears unlikely that we will return to the c.15% interest-rate levels experienced by past generations, a return to zero interest rates also looks improbable any time soon. This is why we believe it is important to start considering a broader set of alternative investments.

I would highlight the attractiveness of a few such alternatives, such as carbon. In 2005, carbon emissions trading schemes were initiated, allowing companies to sell on unused credits which bigger polluters can buy. Europe has become the largest carbon trading market in the world. Today, with the increased global focus on emissions and lowering targets, each year the supply of unused credits is becoming constricted.

Another area of alternatives relates to continuing electrification, which is driving greater demand for commodities. Such is the growing demand for commodities that we may eventually see governments start to hoard supply in anticipation of future shortages – such as in copper. Other aspects of the energy transition, like wind farms and solar panels, have other attractive qualities, such as somewhat predictable cash flows thanks to implicit and explicit government support.

Another potential area where alternatives can offer diversifying effects is volatility itself. Volatility can be seen as an asset class, and some of the instruments in this area can offer the prospect of equity-like returns with roughly half the volatility.

Reflecting this view, allocations within our Real Return strategy have increasingly favoured alternatives in recent years. As of the end of April 2023, just under 20% of the strategy was invested in alternatives such as infrastructure, music royalties, energy storage, commodities and risk premia.

We also favour consumer companies with pricing power as well as domestic producers (companies that do not have to worry about foreign-exchange issues), commodities and health care. The latter has been an unloved area thanks to worries over patent expiries. However, post Covid, the health-care industry is trying to catch up on procedures that were delayed, while innovation in drugs has become an exciting area that could save governments billions in health-care provision, particularly in areas like Alzheimer’s and obesity.

Elsewhere, we see opportunities in China’s reopening, and while we find select individual Chinese/Hong Kong securities attractive, we believe index futures can be a liquid and efficient way for a diversified, multi-asset strategy to gain exposure to the reopening story. Liquidity is key for us in this market as we want to be able to exit quickly should it be necessary.

While we value alternatives’ attractive diversification and return potential, we believe there is still a place for risk assets. Although we are cautious, we view the use of alternatives as providing an opportunity to be more dynamic. If we are to learn from times such as the high-inflation, rising-rate environment of the 1970s, we must remember that such periods also saw aggressive equity rallies, in spite of the challenging economic backdrop. It is therefore important to be adaptable.

We do expect volatility to rise, and we believe that the way in which an investment strategy manages that eventuality is likely to become increasingly important. Volatility does create opportunities and dispersion of performance between different securities, sectors and asset classes, which we believe favours active stock selection.

We share our key learnings from a recent visit to a vertical farm.

Key Points

We believe that vertical farming has a credible role to play in future food production and the potential to address a number of challenges faced by modern agriculture.
The ability to control growing conditions allows for improved crop yields at the same time as reducing negative externalities.
Environmental benefits include removing the need for pesticides, reducing the use of fertilizer and eliminating the environmental damage from runoff into waterways, as well as reducing water consumption.
Dedicated renewable energy generation is essential to making this a sustainable food proposition.

When people think about vertical farming, often what comes to mind is the image of a wall of lettuce leaves in a hip city-center location, or perhaps an efficient warehouse that can supply directly to retailers without the environmental impacts associated with transporting produce across the world. It was therefore somewhat surprising when I arrived at a new UK-based vertical farming facility and found myself on a farm, in an area with no observable space constraints. The concept, it turns out, has less to do with the proximity to the end consumer, and more to do with controlling the growing environment. We believe that agriculture and food systems are key areas that we need to address to start living within safe environmental boundaries on Earth. The opportunity to learn about what innovations are being worked on to solve the food system challenge was the motivation for inspecting a vertical farm in person.

What Does a Vertical Farm Look Like?

In order to enter the farm, there is a two-stage airlock procedure: first, an initial room to remove outdoor clothing and shoes, and then a second room to put on a white suit, boots and a hair net, to prevent insects from getting into the farm. A key advantage of indoor farming is that there is no need for pesticides, which can cause significant harm to the environment. Pesticide use has been linked to drops of more than 70% of insect biomass in Germany, the halving of farmland bird populations in Europe, and global declines in pollinators.¹

By growing agricultural produce in a controlled environment, and eliminating the use of these chemicals, there are clear environmental benefits, and, in addition, the crops do not need to be washed. Conventionally grown salad is washed in chlorine baths, deteriorating the leaves and diminishing the shelf life. Moreover, on a typical farm, produce can be left wilting on the back of a tractor for up to 45 minutes, whereas in a vertical farm, the time from cutting to transferring the produce to dry cold storage is only a couple of minutes. The combination of these two factors means that vertically grown produce can last up to 14 days; this is a game changer for bagged salad, which typically has a shelf life of two to three days in the consumer’s home, but when vertically farmed, can last up to seven days.

Photo above shows the conventional washing process which is not required in a vertical farm.

The layout inside the farm that I visited consists of two rows on either side of the room, reaching approximately 15 meters tall, and there is enough space down the center for a robotic lifting mechanism to maneuver and handle the crops. There are 1,000 trays of produce in the building, each with its own LED lighting, as well as a dedicated water supply. Each factor that affects the plants, including air temperature, humidity and nutrient content of the water, is controllable within this environment.

When a tray (approximately four meters by two meters in size) is ready for harvesting, which is around 28 days from the time of planting for rocket leaves, the robotic lifting equipment removes the tray from the rack and lowers it so that the leaves can be trimmed. The tray can then be put back on the rack to regrow up to about five times, or if the roots have become too established (and therefore the flavor is too strong), the tray is moved to a separate re-seeding room. A robot empties the tray and then a hopper sorts the clay bedding granules from the roots, washes the equipment and re-seeds the tray. The new seeds sit on a water-soluble paper and are then sprayed with mist to initiate the growth process and help the root formation to occur. After this, the seeds are watered and the soluble paper dissolves, leaving the roots to attach to the clay granules.

Water

Freshwater availability is becoming a major global issue. Agriculture accounts for roughly 70% of global freshwater withdrawals and is the primary source of nutrient runoff from farm fields.^2,3 Groundwater contributes to 44% of irrigated food production worldwide and, globally, an estimated 14% to 17% of food produced with use of groundwater relies on unsustainable mining of groundwater resources.⁴ To put this into perspective, Lake Mead, a Colorado River reservoir, is roughly 143 feet below its normal capacity, a deficit that is about the height of the Statue of Liberty.⁵ The production of one kilogram of tomatoes in a field in southern Europe uses between 60 and 200 liters of water, whereas in a vertical farm, producing the same amount of tomatoes requires only two to four liters of water.⁶

The amount of water used in conventional farming is not the only issue; the surface runoff of nutrients back into waterways has caused large-scale eutrophication (the nutrient over-enrichment of freshwater and coastal ecosystems). This is an issue that affects 97% of the Baltic Sea, owing to excessive past and present inputs of nitrogen and phosphorus.⁷

In the indoor controlled environment, 96% of water goes directly into growing the produce, with minimal wastage, and there is no runoff of nutrients, thereby ensuring that the nutrient content of food can be managed. The Haber-Bosch process, which is used to produce nitrogen, produces about 1% of global CO2 emissions,⁸ and more than 50% of human-caused nitrous oxide emissions come from agriculture – the main driver of which is nitrogen fertilisers.⁹ Minimizing nutrient runoff and reducing the need for fertilizer could potentially contribute towards reduced greenhouse-gas emissions.

Why Is the Farm Vertical?

The obvious advantage of vertical farms is space efficiency; however, more importantly, this structure enables optimum air circulation and automation efficiency. At the farm that I visited, the plan is for the next version to use smaller individual modules, rather than to scale up in one vast warehouse – the reason being that the air circulation is easier to control in smaller units, as is limiting issues such as insects entering the facility. A four-acre vertical farm operation is equivalent to 1,000 acres of British farmland, and to satisfy the current bagged salad market in the UK, it would take just 46 vertical farming sites. In fact, the total global bagged salad market supply could be produced by only 1,436 sites.¹⁰

Cost Competitive

Produce that is domestically produced is generally valued by consumers, and for a retailer to be able to demonstrate that 100% of its bagged salad is vertically farmed would also help build its environmental credentials. Weather instability is increasingly an issue for retailers and customers when it comes to securing supplies, and offtake agreements for crops tend to be short in nature; given that vertical farming is not exposed to the same weather risks, there is the potential to enter into multi-year agreements where many of the costs of key variables are fixed.

The cost base for a vertical farm is approximately 80% electricity, 15% labor and 5% inputs.¹¹ If the electrical component can be secured off-grid through a combination of renewables and storage, a large proportion of the cost can be fixed. Way et al, from the Smith School of Enterprise and the Environment at Oxford University, suggest that current consensus expectations for the cost declines in solar photovoltaics (PV) could be too conservative when modelling for the rate of innovation.¹² If this is the case, the main cost component of vertical farming may continue to fall, making vertical farming increasingly cost competitive over time.

Where Is Vertical Farming Likely to Take off First?

One of the key ingredients for a vertical farming operation is abundant zero-carbon electricity generation; there must be access to off-grid wind, solar and battery storage to ensure a low fixed-cost supply of power. At the farm that I visited, for every square kilometerof vertical farming site, two hectares of off-grid solar power are required, so an urban location is not an option for this type of farm.

Given that clean energy is a key criterion, France would be well positioned, as it has a large nuclear generation fleet combined with strong renewable penetration in the south, as well as geographical access to the central European consumer market. Elsewhere, Quebec has the lowest-cost grid electricity in the world, provided by hydro power, and it is also well-located to supply the north-east of the US, and take share from Californian production which is increasingly climate-challenged. North Africa would also be a beneficiary of this technology; however, political instability in the region is likely to make attracting the required investment more difficult, and it is instead likely to be the Arab states that see investment in vertical farming first.

What Is the Future for Vertical Farming?

It is clear from the facility that I visited, which at the time was the largest in the UK, that the market is nascent and there is significant scope for scientific innovation. Vertical farming is currently focused on high-value salad crops, and this is expected to expand to fruits next, but ultimately it has the potential to broaden to wheat, soy and even rice. The UK is one of the only countries that currently permits gene editing of crops, which has attracted global investment to the John Innes Centre, which specializes in plant science, genetics and microbiology. With increased investment in agriculture, we expect to see greater funding to advance vertical farming, as well as the development of crop strains that are perfectly suited to this type of farming.

Many of the resiliencies that need to be built into the seeds used in conventional farming to protect plants from challenging conditions such as wind, drought and floods are not necessary in a controlled environment, so there is significant potential to enhance yields. Picture a rice stalk, which in a traditional farm setting needs to have the strength to take the weight of the rice and withstand adverse weather conditions. In a vertical farm environment, the plant could be edited to have a far higher density and a shorter stalk.

Is Vertical Farming the Answer?

Vertical farming is still in its infancy and is unlikely to replace land farming on any time horizon; however, it is likely to play an increasingly important role in the innovation of agriculture and contribute towards the decarbonization of the food industry. The graph below shows that, according to the World Resources Institute, half of the reduction in greenhouse-gas emissions from agriculture will need to come from productivity gains, which vertical farming could be well positioned to provide.¹³

Source: World Resources Report: Creating a Sustainable Food Future (Final Report). 2019.

We believe that vertical farming will play a role in future food production as we expect it will become more economically viable and address a number of challenges faced by modern agriculture; however, it is likely to be only a small part of a sustainable food system. There are many crops that would not be suitable for vertical farming, such as tall plants, trees or those with large roots. Transporting food across the world is not necessarily the wrong thing to do; energy used to move food by sea is relatively low, and in return we obtain important nutrients from produce grown in countries with the right natural conditions. We also recognize that, done correctly, agriculture can enrich soil and improve its carbon storage. Vertical farming has scope for significant investment opportunities over the coming decades, as does land-based agriculture, if we are to move to a sustainable food system.

Sources:

We share our key learnings from a recent visit to a vertical farm.

Key points

We believe that vertical farming has a credible role to play in future food production and the potential to address a number of challenges faced by modern agriculture.
The ability to control growing conditions allows for improved crop yields at the same time as reducing negative externalities.
Environmental benefits include removing the need for pesticides, reducing the use of fertiliser and eliminating the environmental damage from runoff into waterways, as well as reducing water consumption.
Dedicated renewable energy generation is essential to making this a sustainable food proposition.

When people think about vertical farming, often what comes to mind is the image of a wall of lettuce leaves in a hip city-centre location, or perhaps an efficient warehouse that can supply directly to retailers without the environmental impacts associated with transporting produce across the world. It was therefore somewhat surprising when I arrived at a new UK-based vertical farming facility and found myself on a farm, in an area with no observable space constraints. The concept, it turns out, has less to do with the proximity to the end consumer, and more to do with controlling the growing environment. We believe that agriculture and food systems are key areas that we need to address to start living within safe environmental boundaries on Earth. The opportunity to learn about what innovations are being worked on to solve the food system challenge was the motivation for inspecting a vertical farm in person.

What does a vertical farm look like?

In order to enter the farm, there is a two-stage airlock procedure: first, an initial room to remove outdoor clothing and shoes, and then a second room to put on a white suit, wellies and a hair net, to prevent insects from getting into the farm. A key advantage of indoor farming is that there is no need for pesticides, which can cause significant harm to the environment. Pesticide use has been linked to drops of more than 70% of insect biomass in Germany, the halving of farmland bird populations in Europe, and global declines in pollinators.¹

Photo above shows the conventional washing process which is not required in a vertical farm.

The layout inside the farm that I visited has two rows on either side of the room, reaching approximately 15 metres tall, and there is enough space down the centre for a robotic lifting mechanism to manoeuvre and handle the crops. There are 1,000 trays of produce in the building, each with its own LED lighting, as well as a dedicated water supply. Each factor that affects the plants, including air temperature, humidity and nutrient content of the water, is controllable within this environment.

When a tray (approximately four metres by two metres in size) is ready for harvesting, which is around 28 days from the time of planting for rocket leaves, the robotic lifting equipment removes the tray from the rack and lowers it so that the leaves can be trimmed. The tray can then be put back on the rack to regrow up to about five times, or if the roots have become too established (and therefore the flavour is too strong), the tray is moved to a separate re-seeding room. A robot empties the tray and then a hopper sorts the clay bedding granules from the roots, washes the equipment and re-seeds the tray. The new seeds sit on a water-soluble paper and are then sprayed with mist to initiate the growth process and to help the root formation to occur. After this, the seeds are watered and the soluble paper dissolves, leaving the roots to attach to the clay granules.

Water

Freshwater availability is becoming a major global issue. Agriculture accounts for roughly 70% of global freshwater withdrawals and is the primary source of nutrient runoff from farm fields.^2,3 Groundwater contributes to 44% of irrigated food production worldwide and, globally, an estimated 14% to 17% of food produced with use of groundwater relies on unsustainable mining of groundwater resources.⁴ To put this into perspective, Lake Mead, a Colorado River reservoir, is roughly 143 feet (44 metres) below its normal capacity, a deficit that is about the height of the Statue of Liberty.⁵ The production of one kilogram of tomatoes in a field in southern Europe uses between 60 and 200 litres of water, whereas in a vertical farm, producing the same amount of tomatoes requires only two to four litres of water.⁶

In the indoor controlled environment, 96% of water goes directly into growing the produce, with minimal wastage, and there is no runoff of nutrients, thereby ensuring that the nutrient content of food can be managed. The Haber-Bosch process, which is used to produce nitrogen, produces about 1% of global CO2 emissions,⁸ and more than 50% of human-caused nitrous oxide emissions come from agriculture – the main driver of which is nitrogen fertilisers.⁹ Therefore, by minimising nutrient runoff and reducing the need for fertiliser, this could potentially contribute towards reduced greenhouse-gas emissions.

Why is the farm vertical?

Cost competitive

In the UK, produce that is domestically produced is valued by consumers, and for a retailer to be able to claim 100% vertically farmed bagged salad, for example, would help build its environmental credentials. Weather instability is increasingly an issue for retailers and customers when it comes to securing supplies, and offtake agreements for crops tend to be short in nature; however, given that vertical farming is not exposed to the same weather risks, there is the potential to enter into multi-year agreements where many of the costs of key variables are fixed.

The cost base for a vertical farm is approximately 80% electricity, 15% labour and 5% inputs.¹¹ If the electrical component can be secured off-grid through a combination of renewables and storage, a large proportion of the cost can be fixed. Way et al, from the Smith School of Enterprise and the Environment at Oxford University, suggest that current consensus expectations for the cost declines in solar photovoltaics (PV) could be too conservative when modelling for the rate of innovation.¹² If this is the case, the main cost component of vertical farming may continue to fall, making vertical farming increasingly cost competitive over time.

Where is vertical farming likely to take off first?

One of the key ingredients for a vertical farming operation is abundant zero-carbon electricity generation; there must be access to off-grid wind, solar and battery storage to ensure a low fixed-cost supply of power. At the farm that I visited, for every 1km²of vertical farming site, two hectares of off-grid solar power are required, so an urban location is not an option for this type of farm.

Given that clean energy is a key criterion, France would be well positioned, as it has a large nuclear generation fleet combined with strong renewable penetration in the south, as well as geographical access to the central European consumer market. In addition, Quebec has the lowest cost grid electricity in the world, provided by hydro power, and it is also well-located to supply the north-east of the US, and take share from Californian production which is increasingly climate-challenged. North Africa would also be a beneficiary of this technology; however, political instability in the region is likely to make attracting the required investment more difficult, and it is instead likely to be the Arab states that see investment in vertical farming first.

What is the future for vertical farming?

It is clear from the facility that I visited, which at the time was the largest in the UK, that the market is nascent and there is significant scope for scientific innovation. Vertical farming is currently focused on high-value salad crops, and this is expected to expand to fruits next, but ultimately it has the potential to broaden to wheat, soy and even rice. The UK is one of the only countries that currently permits gene editing of crops, attracting global investment to the John Innes Centre, which specialises in plant science, genetics and microbiology. With increased investment into agriculture, we expect to see greater funding to advance vertical farming, as well as the development of crop strains that are perfectly suited to this type of farming.

Is vertical farming the answer?

Vertical farming is still in its infancy and will be unlikely to replace land farming on any time horizon, however it is likely to play an increasingly important role in the innovation of agriculture and contribute towards the decarbonisation of the food industry. The graph below shows that, according to the World Resources Institute, half of the reduction in greenhouse-gas emissions from agriculture will need to come from productivity gains, which vertical farming would be well positioned to provide.¹³

Source: World Resources Report: Creating a Sustainable Food Future (Final Report). 2019.

We believe that vertical farming will play a role in future food production as it will become more economically viable and address a number of challenges faced by modern agriculture; however it is likely to only be a small part of a sustainable food system. There are many crops that would not be suitable for vertical farming, such as tall plants, trees or those with large roots. Transporting food across the world is not necessarily the wrong thing to do; energy used to move food by sea is relatively low, and in return we obtain important nutrients from produce grown in countries with the right natural conditions. We also recognise that, done correctly, agriculture can enrich soil and improve its carbon storage. Vertical farming has scope for significant investment opportunities over the coming decades, as does land-based agriculture, if we are to transition to a sustainable food system.

Sources:

We examine the conditions that have led to increasingly high levels of inflation.

Key Points

Since the 2008 global financial crisis, the West has demonstrated greater concern for national self-interest, and frictions between nations have been rising, leading to a more fragmented world.
Russia’s invasion of Ukraine has presented a more definitive end to globalization, given the financial sanctions imposed by the West and the halting of trade.
There has been a clear shift towards a greater role for fiscal policy, in an attempt to reduce inequality and ease inflationary pressures.
The combination of these factors is leading to higher interest rates, lower leverage and more challenging financial markets, but we believe that active investment will benefit in this environment.

Defining Inflation

Before understanding how inflation reached this point, it is first useful to define inflation. Prices can rise or fall owing to ‘shocks’ to the system – a bad corn harvest, a pandemic that disrupts global production, or the closure of the Straits of Hormuz are examples of supply-side shocks. In the case of demand-side disruptions, such as the 1997 Asian financial crisis, prices may decline and remain depressed, despite aggressive monetary-policy easing. These resulting price shocks are often considered inflationary or deflationary, though in our view they are ultimately not, given that they tend to mean-revert.

It is important to distinguish between changes to price brought about by these ‘shocks,’ and those that stem from inflationary (or deflationary) policy. We believe that inflationary conditions, characterized by a sustained acceleration of price increases, are a function of a government adopting policies that expressly try to lower the value of money, and a currency’s value will keep falling until the central bank changes its stance. As Milton Friedman argued, “inflation is always and everywhere a monetary phenomenon in the sense that it is and can be produced only by a more rapid increase in the quantity of money than in output.”

We believe that consumer price index (CPI) measures are residuals – the more important question is: why is this happening? If CPI measures of inflation peak out, it does not mean the underlying causes of inflation have necessarily gone away, and these can have a greater impact on asset prices.

Deglobalization

Prior to the 2008 global financial crisis, globalization was generally considered to be a positive force, in which free trade and the free movement of capital, labor and knowledge resulted in a more efficient world that was generally judged to be mutually beneficial. This narrative in Western populations has steadily changed since then, as persistently weak economic growth in the West contributed to growing skepticism around whether globalization really is in their best interests. This has been exhibited by a spark of populist politics: Donald Trump was elected as US President with his ‘America First’ vision, and the UK left the European Union following a referendum. A similar theme has also played out throughout Europe and China.

As the West has demonstrated greater concern for national self-interest, frictions between nations have also been rising, most notably between the US and China. Both countries have implemented restrictions on the other for the import and export of goods, in particular in the technology sector. The extent to which the West relies on China’s manufacturing base, especially for strategically important components, has raised fears, and is encouraging nations to become increasingly self-sufficient.

Russia and Ukraine

While this trend of deglobalization started long before Russia’s invasion of Ukraine, we believe that the subsequent financial sanctions imposed by the West and the halting of trade with Russia and its allies has presented a more definitive end to globalization.

Russia’s invasion of Ukraine has revealed the heavy reliance of Europe on Russian energy, and the associated risks. The European Commission has announced that the EU’s dependency on Russian gas will be cut by two-thirds by the end of 2022, and the UK has shared plans to phase out imports of Russian oil in the same time frame.¹ In addition, the US has completely banned Russian oil, gas and coal imports.² The situation in Ukraine is therefore likely to encourage Western governments to invest in the onshoring of manufacturing and the rebuilding of their industrial base and strategic industries, particularly where there are concerns about national security.

Whatever views the West might hold regarding globalization, it seems that its result has been a more efficient global system. In a world where fewer goods, capital and ideas cross borders, we believe that the outcome will inevitably be lower productivity growth and higher costs of production.

Shift in Policy

Since the onset of the Covid pandemic, there has been a clear shift away from dominant monetary and recessive fiscal policy, towards a greater role for fiscal policy. A balkanized world is likely a less efficient one, and with higher prices and pressure on the cost of living comes increased fiscal stimulus. The US Congress has been considering rebates of USD 100 for Americans, given the soaring gas prices,³ and in the UK the government is providing a council tax rebate of GBP 150 to approximately 20 million households, to ease the impact of the increase in energy costs.⁴ The unintended result of this, however, is that this fiscal stimulus is monetized – by giving people more money, the underlying price pressures could be exacerbated.

While the inequality that has been felt over the last 30 years in mature economies may decline through the use of fiscal policy, it could in fact rise between developed and developing nations. Countries with weaker institutions that are not part of the global order may be unable to use fiscal policy in the same way to help ease inflationary pressures.

What Next?

We believe that all of these factors in combination are not only leading to higher inflation, but also to a higher interest-rate environment than we have been accustomed to in recent times. Over the last 40 years, we have witnessed lower highs and lower lows in terms of rates, and this is likely to have come to an end. Along with higher interest rates come lower levels of leverage, which until now have been accommodated by monetary policy. Generally, against this backdrop, a significant portion of returns has come from capital appreciation rather than from income. However, we believe that is likely to change – we expect to see a greater focus on income from now on.

One example of where we see potential opportunity in this environment is commodities. As countries continue to reduce their trade linkages and focus on domestic production, there may be a requirement to build more infrastructure, in particular as governments seek to ‘green’ the economy and onshore their renewable energy resources. Commodities that constitute the raw materials of production processes have historically had a more reliable relationship with inflation.

Investing in a disinflationary world has been a relatively straightforward affair. Both equities and bonds have been in structural bull markets for 40 years. We think that financial markets will be more challenging to navigate from now on, and we believe that the ‘beta wave’ that carried bonds and equities for a long time is over. It is in this environment that we suggest active investment has a particular opportunity to demonstrate its purpose.

Sources:

We examine the conditions that have led to increasingly high levels of inflation.

Key points

Since the 2008 global financial crisis, the West has demonstrated greater concern for national self-interest, and frictions between nations have been rising, leading to a more fragmented world.
Russia’s invasion of Ukraine has presented a more definitive end to globalisation, given the financial sanctions imposed by the West and the halting of trade.
There has been a clear shift towards a greater role for fiscal policy, in an attempt to reduce inequality and ease inflationary pressures.
The combination of these factors is leading to higher interest rates, lower leverage and more challenging financial markets, but we believe that active investment will benefit in this environment.

Defining inflation

It is important to distinguish between changes to price brought about by these ‘shocks’, and those that stem from inflationary (or deflationary) policy. We believe that inflationary conditions, characterised by a sustained acceleration of price increases, are a function of a government adopting policies that expressly try to lower the value of money, and a currency’s value will keep falling until the central bank changes its stance. As Milton Friedman argued, “inflation is always and everywhere a monetary phenomenon in the sense that it is and can be produced only by a more rapid increase in the quantity of money than in output”.

Deglobalisation

Prior to the 2008 global financial crisis, globalisation was generally considered to be a positive force, in which free trade and the free movement of capital, labour and knowledge resulted in a more efficient world that was generally judged to be mutually beneficial. This narrative in Western populations has steadily changed since then, as persistently weak economic growth in the West contributed to growing scepticism around whether globalisation really is in their best interests. This has been exhibited by a spark of populist politics: Donald Trump was elected as US President with his ‘America First’ vision, and the UK left the European Union following a referendum. A similar theme has also played out throughout Europe and China.

Russia and Ukraine

While this trend of deglobalisation started long before Russia’s invasion of Ukraine, we believe that the subsequent financial sanctions imposed by the West and the halting of trade with Russia and its allies has presented a more definitive end to globalisation.

Whatever views the West might hold regarding globalisation, its result is a more efficient global system. In a world where fewer goods, capital and ideas cross borders, we believe that the outcome will inevitably be lower productivity growth and higher costs of production.

Shift in policy

Since the onset of the Covid pandemic, there has been a clear shift away from dominant monetary and recessive fiscal policy, towards a greater role for fiscal policy. A balkanised world is a less efficient one, and with higher prices and pressure on the cost of living comes increased fiscal stimulus. The US Congress has been considering rebates of USD $100 for Americans, given the soaring gas prices,³ and in the UK the government is providing a council tax rebate of £150 to approximately 20 million households, to ease the impact of the increase in energy costs.⁴ The unintended result of this, however, is that this fiscal stimulus is monetised – by giving people more money, the underlying price pressures will only be exacerbated.

While the inequality that has been felt over the last 30 years in mature economies may decline through the use of fiscal policy, it could in fact rise between developed and developing nations. Countries with weaker institutions that are not part of the global order are unable to use fiscal policy in the same way to help ease inflationary pressures.

What next?

All of these factors in combination are not only leading to higher inflation, but also to a higher interest-rate environment than we have been accustomed to in recent times. Over the last 40 years, we have witnessed lower highs and lower lows in terms of rates, and this is likely to have come to an end. Along with higher interest rates come lower levels of leverage, which until now have been accommodated by monetary policy. Generally, against this backdrop, a significant portion of returns has come from capital appreciation rather than from income. However, we believe that is likely to change – we expect to see a greater focus on income from now on.

One example of where we see opportunity in this environment is commodities. As countries continue to reduce their trade linkages and focus on domestic production, there will be a requirement to build more infrastructure, in particular as governments seek to ‘green’ the economy and onshore their renewable energy resources. Commodities that constitute the raw materials of production processes have historically had a more reliable relationship with inflation.

Investing in a disinflationary world has been a relatively straightforward affair. Both equities and bonds have been in structural bull markets for 40 years. We think that financial markets will be more challenging to navigate from now on, and we believe that the ‘beta wave’ that carried bonds and equities for a long time is over. It is in this environment that active investment has a particular opportunity to demonstrate its purpose.

Sources:

With financial markets remaining turbulent, which sectors and asset classes could present opportunities for an unconstrained multi-asset strategy?

Key Points

Rising interest rates, global growth concerns and a less accommodative monetary-policy backdrop highlight the need for careful consideration not just of individual companies but also of thematic trends.
We are placing greater emphasis on more defensive businesses, including pharmaceuticals.
Other areas of interest from a thematic perspective include renewables and infrastructure, although it is vital to consider valuations carefully.
Select commodities also hold appeal as near-term beneficiaries of supply constraints, while copper is an area of secular growth.

Rising interest rates, global growth concerns and a less accommodative monetary-policy backdrop do not optically create a positive cocktail for global equity markets. Indeed, rising bond yields over the last six months have already caused significant collateral damage, with many of the former Covid beneficiaries in the large-cap technology area falling precipitously from their heady heights, feeding through to a wave of cost-cutting. The ripple effects have spread wider, with the spotlight further cast on those companies that are yet to turn a profit, erstwhile dependent on their rising stock prices to fund operations and growth, as well as to attract talent from a tight labor market pool.

While it is not our base case that we will experience a full-scale liquidity event, such developments in the tech sector are concerning. They put the spotlight on the need for a discerning approach to stock picking and the requirement for careful consideration not just of individual companies but also of thematic trends. This marries a full understanding of a business’s fundamentals and stock characteristics with long-term thematic trends such as an ageing population and the influence of big government.

A global thematic approach has been espoused by Newton Investment Management Limited¹ since its foundation in 1978, and themes are viewed as providing a more meaningful lens to consider opportunities than traditional sectors. Similarly, a crude geographic classification based on where a company is quoted can be misleading in terms of understanding where the true risk exposure of holdings lies. For instance, while at first glance the European exposure of the equity portion of our Real Return portfolios may appear substantial, the picture looks quite different on a revenue basis, evidencing the limitations of traditional methods of ‘slicing and dicing’ portfolios.

Turning back to themes, while the common thread of these tends to be the ability to capture long-term trends, their relevance over discrete periods is undoubtedly influenced by shorter-term forces and the market cycle itself. For example, we are currently experiencing a period of heightened volatility in markets, exacerbated by geopolitical turmoil, intense inflationary pressures, and the decision of central banks to rein back easy monetary conditions by initiating quantitative tightening (reducing their balance sheets by selling assets).

Equities: A Different Tilt

We believe this ‘regime change’ necessitates a different tilt to equity positioning, with increased emphasis placed on more defensive businesses and a pivot away from long-duration stocks which are vulnerable to rising bond yields. We favor sectors such as health care, including traditional pharmaceutical companies focused on addressing long-term conditions such as cancer, Alzheimer’s and diabetes. There is also recovery potential in areas such as cardiac and eye surgery, given the reduction in the number of elective procedures during the Covid-19 pandemic.

Other areas of interest from a thematic perspective include renewables and infrastructure which, as well as displaying steady, predictable cash flows, have the added role of gaining exposure to long-term projects where cash flows are inflation-linked. We are mindful that there has been a rush to invest in those assets which offer strong ‘green’ credentials, so it is vital to consider valuations carefully.

Considering Commodities

Commodities also hold appeal, but here we believe it is important to be highly selective. While the travails of the major oil companies have been well-publicized, and their transition plans to champion greener energy sources are in the spotlight, we acknowledge that it is likely to be a bumpy ride as scrutiny intensifies around the speed with which they embark on a net-zero path. There is scope for their inclusion in Real Return portfolios as near-term beneficiaries of oil-price buoyancy, aided by the supply constraints created by Russian oil embargoes, although we would want to see meaningful progress made towards energy transition over the longer term, and indeed society is increasingly likely to demand this.

Elsewhere within the commodity spectrum, copper is an area of secular growth, underpinned by near-term supply shortages and the move towards the deployment of renewable generation, the adoption of electric vehicles (the metal is an essential component), and the migration to 5G mobile networks.

In summary, despite the challenges of the febrile backdrop, characterized by short-lived equity market rallies giving way to a resumption of a risk-off tone in markets, we contend that this remains fertile ground to fine-tune portfolios as we seek to ensure they are well-placed for the next phase of markets. Ranking securities by their risk contribution is revealing in this regard, to help ensure that the amount of risk taken is commensurate with our level of conviction.

We maintain a wish list of securities and remain ready to try to take advantage of thematic drivers such as a growth in capital expenditure by companies as the economy emerges from the pandemic, combined with an increase in consumer experiences as activities such as travel resume. While we remain in cautious mode at this juncture, we are deploying our analytical resources to the full to try to take advantage both of valuation opportunities and the varying fortunes of disparate business models.

Newton Investment Management North America (“NIMNA”) was established in 2021. NIMNA is part of the group of affiliated companies that individually or collectively provide investment advisory services under the brand “Newton” or “Newton Investment Management” (“Newton”). Newton currently includes NIMNA and Newton Investment Management Ltd. (“Newton Limited”).

With financial markets remaining turbulent, which sectors and asset classes present opportunities for an unconstrained multi-asset strategy?

Rising interest rates, global growth concerns and a less accommodative monetary-policy backdrop highlight the need for careful consideration not just of individual companies but also of thematic trends.
We are placing greater emphasis on more defensive businesses, including pharmaceuticals.
Other areas of interest from a thematic perspective include renewables and infrastructure, although it is vital to consider valuations carefully.
Select commodities also hold appeal as near-term beneficiaries of supply constraints, while copper is an area of secular growth.

A global thematic approach has been espoused by Newton since its foundation in 1978, and themes are viewed as providing a more meaningful lens to consider opportunities than traditional sectors. Similarly, a crude geographic classification based on where a company is quoted can be misleading in terms of understanding where the true risk exposure of holdings lies. For instance, while at first glance the European exposure of the equity portion of our Real Return portfolios may appear substantial, the picture looks quite different on a revenue basis, evidencing the limitations of traditional methods of ‘slicing and dicing’ portfolios.

Equities: a different tilt

We believe this ‘regime change’ necessitates a different tilt to equity positioning, with increased emphasis placed on more defensive businesses and a pivot away from long-duration stocks which are vulnerable to rising bond yields. We favour sectors such as health care, including traditional pharmaceutical companies focused on addressing long-term conditions such as cancer, Alzheimer’s and diabetes. There is also recovery potential in areas such as cardiac and eye surgery, given the reduction in the number of elective procedures during the Covid-19 pandemic.

Considering commodities

Commodities also hold appeal, but here we believe it is important to be highly selective. While the travails of the major oil companies have been well-publicised, and their transition plans to champion greener energy sources are in the spotlight, we acknowledge that it is likely to be a bumpy ride as scrutiny intensifies around the speed with which they embark on a net-zero path. There is scope for their inclusion in Real Return portfolios as near-term beneficiaries of oil-price buoyancy, aided by the supply constraints created by Russian oil embargoes, although we would want to see meaningful progress made towards energy transition over the longer term, and indeed society is increasingly likely to demand this.

In summary, despite the challenges of the febrile backdrop, characterised by short-lived equity market rallies giving way to a resumption of a risk-off tone in markets, we contend that this remains fertile ground to fine-tune portfolios as we seek to ensure they are well-placed for the next phase of markets. Ranking securities by their risk contribution is revealing in this regard, to help ensure that the amount of risk taken is commensurate with our level of conviction.

We maintain a wish list of securities and remain ready to try to take advantage of thematic drivers such as a growth in capital expenditure by companies as the economy emerges from the pandemic, combined with an increase in consumer experiences as activities such as travel resume. While we remain in cautious mode at this juncture, we are deploying our analytical resources to the full to take advantage both of valuation opportunities and the varying fortunes of disparate business models.