Capital Ideas^TM

Hello, I'm Matt Reynolds and this is Capital Ideas, your connection with the minds and insights helping shape the world of investments. Recently, three of our investment professionals put out a short article with the title, What’s right with the world? I like the title and the direction, and some investors don't really ask often enough what can or is going to go right.

Now there's no doubt, a daily diet of negative news can lead even the most experienced investors to lose conviction in their long-term investment plans. Bad news often overshadows more favourable events. Even after the US avoided recession and the inflation picture brightened in 2023, many investors remained downbeat about the economy and markets. So, I've channelled the thoughts of Jared Franz, one of our economists, Jeff Garcia, an equity analyst, and Carl Kawaja, an equity portfolio manager at Capital Group into this podcast to reflect on what can go right.

Now I'd like to also be balanced and not diminish some of the very obvious anxieties at the moment. Wars in the Ukraine and the Middle East, simmering US-China tensions and a contentious US presidential campaign under way. These are all areas that can impact investors' views of the prospects and convictions and their views in investing.

But today I'm going to focus on the positive trends across technology, healthcare, and other areas that are transforming lives and driving opportunity for companies and patient long-term investors. So here are five reasons we're feeling confident about the future.

Number one, while the US economy may be stronger than you think, investors spent 2023 bracing for a recession that never materialized. In the face of elevated inflation and rising interest rates, GDP actually, expanded at a stunning 3.3% annualized rate in the fourth quarter. Indeed, the US may be even stronger than this and why is that?

Well, the American consumer sector continues to flex its muscles. In January, the economy added 353,000 jobs and wages increased 4.5% year on year, a robust pace that is likely to slow. That said, continued, albeit more moderate labour and income gains can continue to support continued strong consumer spending growth. Moderating inflation should also bolster real income growth, particularly amongst the lower income workers.

What's more, the US housing market appears to be recovering as mortgage rates ease, and there are early signs that manufacturing is heating up as businesses begin to restock inventories. Now many of you will have seen our chart showing the US federal government has committed $1.4 trillion for capital projects, including the construction of manufacturing facilities as American companies seek to diversify supply chains.

The Federal Reserve's efforts to achieve the soft landing for the economy, bringing down inflation while maintaining growth, have so far seemed quite successful. Even though inflation remains above the Fed's 2% target, and there has been quite a change in the expectations about when the central bank may begin to lower rates. The central bank may have actually laid the groundwork for an extended period of economic expansion.

Okay. Second reason. The AI productivity boom is just beginning. Now there's no doubt that the introduction of ChatGPT and other artificial intelligence tools has garnered wide attention for the technology's potential to drive vast gains in productivity across industries, reducing costs and potentially creating efficiencies for companies and consumers.

Of course, investors, let's call it the market overall, often overestimate a new technology's impact in the short-term, also at the same time underestimated its impact over the longer-term. The key for investors is to distinguish between what is hype and what represents tangible investment opportunity. That said, little more than a year since ChatGPT was released, it is no longer just a buzzword. Companies in the health care, financial services and retail sectors have already begun to harness its potential to automate complex tasks, streamline workflow and accelerate technological advancements.

For example, MasterCard is using generative AI to streamline its employee recruiting process and use it for the detection of payment fraud across its networks. Online retailer Amazon, which has long used a form of AI for its product listings and recommendations, is using AI at its Amazon Go physical locations. This enables consumers to take items home and pay from the Amazon app while avoiding the checkout lines. In health care, AI is being adopted by hospitals and medical providers to streamline documentation and other administrative tasks. This is helping to reduce the number of patient visits that require physician notes and also being used to address staff shortages. The total addressable market in the words of one of the PMs is almost unknowably large. One only has to recall the expansion of the total addressable market seen in the last three major technological paradigms being smartphones, digital payments and cloud or software as a service and attempt for these markets is still expanding.

Reason number three, more stocks could be poised to join this market rally. So, stock markets defied investor expectations last year and delivered surprisingly robust returns. The S&P 500 was up 26.3% in 2023. And in contrast, the MSCI All Country World Index (ACWI), when you exclude the USA index, advanced only 15.6%. Now, both of these numbers are in US dollar terms, of course.

But for investors who think they've missed the market rally, they may want to take a deeper look. The Magnificent 7 - Apple, Meta, Microsoft, NVIDIA, Amazon, Alphabet and Tesla - they accounted for an overwhelming proportion of the market's total return in 2023. In fact, a look at returns over the past two years reveals the returns for the other 493 companies in the S&P 500 and more than 2,900 other stocks in the MSCI ACWI were generally flat. Observers can detect a similar pattern across international markets.

The brighter economic backdrop in the US is providing tailwinds for corporate earnings across a broader range of companies. In fact, Wall Street analysts expect earnings growth across major markets this year. The stunning success of the Magnificent 7 may have been warranted. These companies have been responsible for creating a great deal of economic value add and continue to be on the cutting edge of AI and other innovations.

But broadly, innovators can be found across markets and industries that are adopting strategies to grow their businesses. In the US, air conditioner maker Carrier Global has seen demand for its energy efficient system soar amid record temperatures in regions around the world. Irish insulation maker Kingspan has designed synthetic siding panels to help improve the energy efficiency of buildings. And a third example would be in Japan, where SMC is a leader in factory automation components.

Okay, reason number four to feel optimistic. Emerging markets are emerging as global trade evolves. So, two major developments in recent years prompted governments and companies to rethink the contours of global trade.

Firstly, escalating tensions between the US and China triggered tariffs and trade restrictions that adversely impacted the flow of goods around the world. Second, this was amplified by the COVID-19 pandemic, which exposed serious vulnerabilities in supply chains as shutdowns and labour shortages led to bottlenecks and delays.

But global trade isn't dead, it's just transforming. To reduce the risk of overdependence on a single global supply chain, Governments and companies are developing more trade relationships, many of them regional.

Increasingly, American companies have turned to neighbouring Mexico as an alternative trade partner. There are several reasons Mexico can be an appealing trade partner for US companies. Labour costs are attractive relative to China and other major manufacturing regions. The country has ample natural resources and its proximity to the US limits logistical challenges. The relationship also helps boost the regional economy overall.

Indeed, Mexico recently surpassed China as the top trade partner with the US. Even as China's economy slows and its relations with the US cool, infrastructure growth, improved government balance sheets, and global supply chain shifts are generating opportunities across other emerging markets, including India, as well as Thailand, Indonesia, Singapore, as well as other economies.

Okay, fifth and final reason, the ongoing breakthroughs in healthcare. I've left my favourite to last. In my view, pharmaceutical and biotechnology companies have entered a golden age of drug discovery in the last few years, advancing therapies for a wide range of major diseases and extending and improving lives.

Perhaps the most widely talked about advancement has been the introduction of drugs developed by Novo Nordisk, Eli Lilly and others to tackle obesity. Life-threatening health problems linked to obesity include cardiovascular disease, diabetes and kidney failure to name a few.

Several treatments have been introduced in recent years to treat and manage diabetes. In decades past, diabetics had to self-test several times a day to test blood sugar levels and determine whether they needed to inject themselves with insulin. More recently, however, medical device companies like Abbott Labs and Dexcom have developed continuous glucose monitors that track blood sugar and actually deliver insulin through a pump. Even more recently, Boston biotech firm Vertex Pharmaceuticals, which has developed a therapy for the treatment of cystic fibrosis, today is working on developing a cure for Type 1 diabetes.

Other examples of recent breakthroughs are also numerous. For example, advances in genetic sequencing have allowed innovative biopharmaceutical companies to develop gene and cell therapy cancer treatments to compete with more traditional treatments like radiation therapy. Japanese pharmaceutical Daiichi Sankyo has been developing a class of cancer therapies called antibody-drug conjugates (ADCs), genetically engineered to target cancer cells while leaving healthy cells alone.

Now clearly in this sector, not all innovations will succeed. And so, investors must consider other factors, including the potential for a company's overall pipeline of developments, the quality of its management, and the potential adjustable market for its therapies.

Okay, I'll end there, but with one final comment. Stay focused on what matters. Distractions and discouraging news are always around us. There are challenges we are aware of and unknown setbacks that will inevitably occur throughout the year. Bad news can drive market volatility in the near term, but company fundamentals are what drives value longer term. Investors who remain focused on their financial objectives, we better position to participate in long-term investment opportunities when they arise.

We're always trying to get better. So, if you have any feedback, including topics you'd like to see addressed in future episodes, send us an email at Capital Ideas Podcasts Australia at capgroup.com. And if you like what you've heard today, please follow us on your favourite podcast platform for Capital Ideas. This is Matt Reynolds reminding you that the most valuable asset is a long-term perspective.

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