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In recent weeks, the speed of the post-pandemic recovery, combined with ongoing fiscal and monetary stimulus, has raised expectations for a period of price inflation. For some, the surge in commodity prices since the start of the year may be a harbinger of things to come.
According to Paul Loudon, investment manager at Walter Scott, investors are now pondering whether this is the start of a systemic rise in inflationary pressures, or simply a more short-term phenomenon driven by Covid-induced supply and demand imbalances.
Already, central banks have begun to respond. The US Federal Reserve, for instance, raised its inflation forecasts in June, based on its preferred metric, the personal consumption expenditure (PCE) price index, to an annual rate of 3.4% in 2021, well above its 2% goal. This was coupled with a rise in expectations that its first interest rate hike, after cutting to zero at the start of the pandemic, may come in 2023.1
“If we see a situation where inflation really does come rushing back, we think companies that have pricing power will be able to better withstand inflationary costs.” says Loudon.
This is because high-quality companies with greater pricing power could potentially pass on rising input costs to consumers, allowing them to protect margins, Loudon says. Quality companies of this nature would have a return on capital in excess of their cost of capital, which could provide a buffer in the case of inflationary pressure, enabling them to continue to invest in growth.
The ability of companies to take advantage of a wide range of macroeconomic shifts or global trends can present intriguing, long-term investment opportunities, according to the team at Walter Scott. For instance, aging demographics and shrinking labor forces have become particularly problematic in Asia Pacific manufacturing hubs. One possible solution, according to Loudon, is automation.
“We think factory automation still has a massive growth runway ahead of it,” he says. “Some of the leading players that are enabling this include a world-class sensor company and an industrial robotics company, both located in Japan.”
Both companies have global revenue streams, which allow them to benefit from prevalent trends outside of Japan as well as less exposure to country-specific risks. Some regions of Japan, for instance, have had to grapple with renewed Covid-19 outbreaks.2 Additionally, there has been an uneven economic recovery with emerging market countries lagging behind developed markets, largely due to vaccine availability.3 However, high-quality companies with global revenue streams are not reliant on the economic situation in one particular country or region. The Japan-based robotics company Loudon mentions fields roughly three quarters of its sales from outside of Japan.4
That aside, the global smart manufacturing market, comprised of companies that enable the adoption of automated systems in industrial processes, is forecasted to grow at a compound annual growth rate (CAGR) of 12.4% over the next seven years.5 Pandemic or not, this is a trend that is expected to permeate through global supply chains at a promising pace due to secular demographic trends, according to Loudon.
In line with this vision of an increasingly automated world, Loudon highlights the importance of semiconductors, particularly those at the heart of IoT (Internet of Things) hardware like smart sensors and robotics.
“We think the proliferation of chips that fuel the electrification of all sorts of industries is a massive megatrend,” he says.
A key process of semiconductor manufacturing is a technique called photolithography. This consists of taking complex circuit patterns, which are drawn on large glass plates, and reducing and exposing them onto semiconductor wafers, or a round pieces of silicon. Those same wafers are then used in integrated circuits, consisting of a combination of electronic components synthesized to work together and perform a specific tasks.6
While semiconductor companies have long been an area of interest for investors, there is a Dutch company with sizable market share of the lithography industry, according to Loudon.
“We like the suppliers to the semiconductor fabrication plants. And while there are some exceptional US semiconductor companies, we believe there are some high-quality global companies in that space, which play a key role in the semiconductor value chain,” Loudon says.
The semiconductor sector is forecasted to grow at a CAGR of 8.6% over the next seven years. Specifically, DUV (deep ultraviolet) lithography is expected to grow at a CAGR of 8.4% through 2025, while EUV (extreme ultraviolet) lithography is forecasted at a 12% CAGR through 2027.7
Diamonds are forever
While the luxury goods sector is not a beneficiary of secular technological trends or aging demographics necessarily, the investment team at Walter Scott has other reasons to be excited about its future. Within the space, the corporate characteristics they like remains the same: high-quality companies with pricing power, a large market share and a global revenue stream.
Although the team views prospects through a long-term lens and—in most cases—holds companies for years, there may be cyclical tailwinds at work as well. For instance, the reopening of economies that bore the brunt of the lockdowns in the early days of the pandemic, as well as pent-up consumer demand for experiences, could lead to increased spending on luxury goods. The global luxury goods market, which saw its biggest annual decline on record in 2020, now has a chance at fully recovering to pre-pandemic levels of US$340bn in sales by the end of this year.8
Loudon believes this bodes well for certain ex-US players: “France and Italy are home to some of the most dominant players in the luxury goods market,” Loudon says. “One of these companies gets 72% of its sales from outside of Europe, granting it exposure to global megatrends like the rising middle class in China and the consumer rebound in the US.”
“In our view, there are dozens of world-class companies internationally, of which it can be worth having exposure,” he concludes.
1 US News: Fed raises inflation and economic forecast, hints at first rate hike in 2023. June 16, 2021.
2 Reuters: Japan extends COVID-19 state of emergency ahead of Games. May 28, 2021.
3 Brookings Institute: The global economy’s uneven recovery. April 7, 2021.
4 Walter Scott & Partners research. June 2021.
5 Grand View Research: Smart Manufacturing Market Size… by end use and segment forecasts. May 2021.
6 WaferWorld: Everything you need to know about silicon wafer manufacturing. July 31, 2020.
7 Seeking Alpha: ASML – The market could be underestimating its potential. June 17, 2021.
8 Nasdaq: Luxury Goods Sales Projected to Recover to 2019 Levels This Year. May 30, 2021.
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