Introduction: Robert M. Almeida is a Global Investment Strategist at MFS Investment Management. James Gruber interviewed Robert after his appearance on a panel at Morningstar's Investor Conference in May.
---
James Gruber: Robert, you talk about a new paradigm, a higher cost environment that might be with us for a while. Is that structural or cyclical in your view?
Robert Almeida: I think it's structural. So what ended was an era of suppressed costs [and] interest rate suppression, but also globalization. I think what's changed now is while central banks may cut rates because inflation's coming down, what you're going to see is longer rates where companies and households borrow at. I think that's going to be higher than it was last cycle.
And globalization hasn't ended, but it's shifting. So as companies have to shift supply chains, that requires capital, that requires spending, that requires people. We're in a world now where costs, I would argue, are a bit more normal. That's going to have a different effect on P&Ls than what you had in a suppressed cost environment. So I think it's structural.
Gruber: A longer term theme, though, rather than a short term one? Or do you think it's already starting to play out as we speak?
Almeida: It's playing out now, but not in financial markets. I don't think risk assets have discounted that because what risk assets tend to do, as you know, is they focus on what has happened and then look out the next, say, three to six months. But when we think about this being a structural and longer term thing, once financial markets start discounting it, you're going to get a very different behavior pattern. But I don't think it's in asset prices yet.
Gruber: Which sectors do you believe will benefit from this?
Almeida: Capital goods. Throughout the 2010s, the reason it was such a low growth, low inflation environment is people weren't spending, whether that's households or companies. So we didn't build enough infrastructure. If you think about some of these mega trends, the reshoring that we mentioned, but also artificial intelligence, it requires a lot of equipment. So companies tethered to that. Companies that supply parts, goods, equipment to go into an EV factory or gigafactory. Or [companies that] support AI hyperscalers or the building of manufacturing plants outside of China. Capital goods, industrial companies, electric equipment makers, they're in the midst of that.
Gruber: And I imagine also those that have the ability to raise prices in that higher cost environment.
Almeida: Yeah. Every company has fixed costs that they have to absorb. So a dollar in has to go to some level of fixed costs. The last customer is always the most profitable because once fixed costs get absorbed, each new dollar is incremental profitability. But now as we enter into a higher cost world, the differentiator in financial markets will be those companies who have something that people want that's in relatively short supply. They'll be able to raise prices to offset those other higher structural costs. Conversely, those companies that can't, or don't because their product isn't good enough or there's just too much competition or the business just can't support those higher costs, those companies are going to have a very different financial outcome.
Gruber: Which sectors are the most at risk in this new environment?
Almeida: Coming out of the global financial crisis, obviously banks and households were deleveraging their balance sheets. Then what happened was sectors across technology, staples, industrials, et cetera were using cheap financing and globalisation to drive high profitability. In the 90s we built too much IT hardware and it was the technology sector that was at risk. In the 2000s we built unproductive homes, particularly in the United States. So it was the consumer and financials and banks providing the financing that were at risk. This time it's more ubiquitous. I think businesses that are offering a product or a good that can be commoditised or copied by others [are most at risk] and I think that risk exists across a lot of sectors. It's a lot harder to pinpoint versus prior cycles.
Gruber: How does AI fit in? I imagine that It is sucking in a lot of capital, yet there's a fair bit of growth in the meantime?
Almeida: I think about AI through few different lenses. So if you think about the hyperscalers today, they are spending a tremendous amount of money. If we take them at their word, those capital investments could be US$700 billion, US$800 billion over the next four or five years. How many other technology companies have the financial firepower to be able to keep up with that? Not a lot. So to maybe go back to your earlier question, software companies that sold code, AI will do it for free. Those companies that don't have the firepower to keep up are the assets most at risk. Then on the other side, a lot of investors are making this assumption that all companies are going to be more productive. I think there's something to that. However, the flip side to that coin is companies we've never heard of or maybe don't even exist today. AI allows them to enter the marketplace. That increases competition, increases commoditisation risk. So I think it's a two-edged sword.
Gruber: How does geopolitics fit into all this? What are the risks there? They seem to be increasing.
Almeida: I think about it from wants and ability. What a politician wants to do might be different from what they're able to do. In my country [the US] we have a very important election coming up later this year. It is hard to underwrite both the outcome and what whoever wins will want to do. What will matter is the balance of Congress relative to who wins and what they're able to do. I guess whether it's President Biden or Donald Trump, each of them want to stimulate. A lot of politicians love fiscal stimulus. They saw how much it worked. I'd argue it was more of a short-term thing but they saw how much it worked and they're going to want to stimulate. But what's their ability to stimulate now with yields elevated, deficits elevated? Bond investors need to be compensated for that. So that's a different environment. It's hard to underwrite what those outcomes will be but I think wants and ability are going to be more constrained than they have been.
Gruber: Final question, commodities, where do they fit into the picture of a higher-cost environment?
Almeida: Commodities are beneficiaries and you're seeing that in commodity prices today. As we go from a single polar world where the U.S. was providing safe shipping lanes to a world with more conflict and at the same time increasing protectionism, demand for resources grows. There's ultimately just less sharing and more demand for those goods. Particularly we just have a lot of stuff we need to build to support those mega trends and stuff that we need to build just for a greener world of less pollution. That requires resources and I'm not sure we have enough.
For more articles featuring Robert M. Almeida, please see MFS Investment Management's sponsor page.