Richard Saldanha, Senior Portfolio Manager
In this article, Richard Saldanha takes a look at four megatrends that are likely to transform companies and markets over the coming years, and how they might create opportunities for equity investors.
Read this article to understand:
- The long-term, secular themes likely to create opportunities for income investors over the years to come
- How these megatrends can help drive growth in income for companies whose business models are aligned with the themes
- Why investors should expand their reach to sectors where dividend-payers have traditionally been more scarce
Economists call it “regime change”.
In the wake of the Russian invasion of Ukraine and supply-chain issues that followed the COVID-19 pandemic, the global economic picture abruptly shifted in 2022. Inflation spiked and central banks sharply raised interest rates to try to bring it under control, prompting fears major economies would be tipped into recession. The era of ultra-low interest rates that followed the Global Financial Crisis (GFC) was decisively brought to an end.
Two years on, the chances of a “hard landing” for the global economy appear to have receded. Nevertheless, inflation remains sticky – core US CPI rose 3.5 per cent in March 2024 – and markets have repeatedly pushed back their expectations for rate cuts. It looks increasingly likely we are facing a new paradigm in which rates stay higher for longer.
In this environment, equity income strategies that can identify companies that pay recurring dividends – and, perhaps as importantly, those that can grow their dividend payouts over time – are worth considering. Dividends can, and often do, rise when inflation does, unlike income from bonds and other investments that pay a predetermined rate of interest. A company’s long-term dividend growth, when combined with other characteristics such as competitive advantages and pricing power, can therefore offer protection in a higher-rate, higher-inflation environment.
But looking beyond the current macroeconomic conditions, we also see longer-term themes that are likely to create opportunities for income-seeking investors over the years to come, especially those who can expand their reach to include companies from sectors where dividend-payers have traditionally been more scarce, such as technology and industrials. In this environment, it can also help to implement strategies that encompass both value and growth.
Predictability, protection, upside
A more diversified portfolio can provide greater scope to identify companies that look well positioned to benefit from secular growth trends of the future. The three key elements to building a diversified portfolio are predictability, protection and upside.
Companies that offer a high degree of predictability in their cashflows have the potential to provide resilient income throughout market cycles. Mature businesses with defensive characteristics and good business models can offer downside protection against volatility, and companies in industries with strong secular growth drivers, often resulting in high cashflow growth, can allow investors to benefit from the upside that equity markets provide over the long term – namely, income and capital growth potential.
By seeking the right balance across these three elements, portfolios can not only offer capital protection in falling markets but also enable investors to take advantage of the longer-term megatrends shaping the future.
In this article, we pick out four of these megatrends (see Figure 1), consider how they will reshape the corporate landscape and identify the key investment implications.
Figure 1: Four major megatrends reshaping the future
The electrification of everything
The demand for electric solutions is set to grow over the next decade and beyond.
Many elements of the world around us are becoming increasingly electrified, from the cars we drive, to the infrastructure of the buildings we live and work in, to the demand for electrical equipment to power usage.
Climate change mitigation and adaptation
Climate change is leading to more extreme-weather events with serious financial consequences across the world.
Measures to mitigate emissions and adapt to climate impacts are opening up a myriad of new revenue streams for businesses, both old and new.
The artificial intelligence (AI) boom
AI is likely to play a growing role in our daily lives.
A vital component in autonomous vehicles, aiding diagnosis and drug development in healthcare, automating factories, improving agricultural practices to make food systems more efficient and allow adaptation to different weather conditions: these are just a few ways in which AI can transform human life.
Rising demand for healthcare
There are structural trends that suggest demand for healthcare will keep on rising over the coming decades.
Innovation in the healthcare industry is accelerating at an unprecedented scale. Spurred by advances in AI and gene editing, algorithms and machine learning are being used in detecting, diagnosing and treating diseases. Healthcare is also finding its way into homes and communities away from hospitals.
Source: Aviva Investors, April 2024.
1. The electrification of everything
Many elements of the world around us are becoming increasingly electrified, from the cars we drive to the infrastructure of the buildings we live and work in. As the shift away from traditional fossil fuels to renewables continues apace, this will put even greater focus on the need for the distribution and management of electricity networks. The underlying grid will have to meet escalating requirements from both a supply and a demand standpoint.
Whether it derives from increasing usage of electric vehicles (EVs) and heat pumps or grid modernisation, demand for electrical equipment is set to increase materially over the next decade and beyond. In September 2021, research from Morgan Stanley concluded that the electrical sector could grow at an annual compound growth rate of six per cent over the next 20 years, or nearly double historical industry rates.1
Spending on chargers and electrical upgrades is expected to rise, as well as on-site power generation and storage. Residential, commercial and government entities will need to revamp their outdated systems in order to charge EVs, store solar energy (solar power continues to be one of the largest contributors to new electricity generation) and modernise power grids.2
Government targets are also playing a role in the electrification theme. For instance, the European Union (EU) has a goal of 30 million EVs on its roads by 2030 and an additional 60 million heat pumps by the end of the decade. Such targets are dependent on a functioning and efficient electricity network. The International Energy Agency estimates investment in so-called smart grids needs to more than double (to over $600 billion per annum) through to 2030 to be on track with targets for net-zero emissions by 2050.3
What this means for equity income investors
Companies in more traditional income sectors, such as utilities, may receive tailwinds from this theme. The likes of National Grid and Enel could benefit from increased government investment in grid infrastructure as policymakers seek to accelerate the energy transition to meet net-zero commitments.
But these trends will also create opportunities for companies in the technology and industrials sectors. While these sectors are not usually associated with dividend payments, those companies that do make shareholder payouts tend to be able to grow them over time (see Figure 2), and including them in income portfolios can allow investors to capture capital growth as well as the resilience associated with stocks with more “defensive” characteristics.
In Europe, companies that are helping with grid digitalisation include Schneider Electric and Siemens. These firms manufacture both hardware and software that is helping address some of the key challenges from an operational standpoint and ensuring grids are working as efficiently as possible. Meanwhile, US-based Hubbell sells electrical equipment that is mission-critical when it comes to making grids more robust and enabling them to deal with increased climate-related events such as forest fires or storms.
Figure 2: Dividend growth over the five years to June 2023 (per cent)
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Past performance is not a reliable guide to future performance.
Note: Levels of income growth across sectors for the strategy. Based on MSCI All Country World Gross TR Index using 5-year dividend growth.
Source: Aviva Investors, Aladdin, Explore – Blackrock Solutions. Data as of March 31, 2024.
2. Climate change mitigation and adaptation
This brings us to a related megatrend – climate change and its impacts on businesses and communities. Climate change is leading to more extreme weather events. Droughts are increasing in frequency and severity. A series of devastating hurricanes in recent years have caused severe damage and slowed economic development in and around the Caribbean, and searing heatwaves have caused deadly wildfires across all continents. Such hazards had serious financial consequences across the world.
But along with risks come opportunities to create solutions. Measures to mitigate emissions and adapt to climate impacts are opening up a myriad of new revenue streams for businesses, both old and new.
Climate mitigation efforts are boosting the fortunes of several sectors including EVs, specialists in solar and wind power, and providers of parts and services across infrastructure supply chains. Adaptation efforts should also provide a tailwind to many sectors including insurance/reinsurance, infrastructure, construction and engineering.
What this means for equity income investors
There is a significant gap in protection for climate-related events (see Figure 3) – according to the European Insurance and Occupational Pensions Authority, just 56 per cent of damage caused by meteorological events in Europe is currently insured. For hydrological events (floods, landslides), coverage falls to 28 per cent and to seven per cent for climatological events (wildfires, droughts).4
Reducing the insurance protection gap would provide substantial welfare benefits and help reduce the social and economic impact of catastrophes, and reinsurance companies can help in terms of providing coverage to address this gap. From an income standpoint, these companies tend to offer relatively attractive dividend yields given their more defensive business profile.
In the automotive industry, we are seeing increased focus on fuel efficiency as well as reducing emissions via the adoption of EVs. Companies that supply semiconductors for the next generation of vehicles are participants in these trends. While conventional vehicles contain on average $330 of semiconductor content, hybrid electric vehicles can contain upwards of $1,000 of such content.5 These structural growth drivers are leading to higher levels of cashflow as well as dividend growth and hence have an important role to play for income investors.
Figure 3: Total climate-related damages and those covered by insurance, 2000-2022
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Source: Environmental Research, June 28, 2022.6
3. The AI boom
Generative AI is creating huge opportunities for both hardware providers and application builders. Since 2022, tech innovators have unveiled an impressive range of products that have astounded businesses and consumers alike – ChatGPT, OpenAI’s generative AI language model, attracted one million users in just five days.
By comparison, Apple needed over two months to attract the same level for its iPhones, Facebook waited ten months, and Netflix more than three years to build the same user base (see Figure 4). (Meta’s Twitter-like messaging platform, Threads, broke this record in July 2023, reaching 100 million users in even less time, but the number of active users fell sharply thereafter.)
AI is likely to play a growing role in our daily lives. It is a vital component in autonomous vehicles. In healthcare it is being used to analyse large volumes of data and spot patterns, aiding in diagnosis and drug development. Factories are becoming increasingly automated. AI also presents the prospect of improving agricultural practices through making food systems more efficient, and minimising the use of fertilisers, while allowing adaptation to different weather conditions.
Figure 4: Time taken for ChatGPT to reach one million users
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Note: Refers to one million backers (Kickstarter), nights booked (Airbnb), downloads (Instagram/Foursquare). Threads = two million signups in two hours. Data from company announcements via Business Insider/LinkedIn.
Source: Aviva Investors, Statista. Data as of April 2024.
What this means for equity income investors
More technology firms that stand to benefit from AI have recently started regular shareholder payouts: for instance, US tech giants Meta and Salesforce both announced their first dividends in February 2024 and were followed by Google’s parent Alphabet in April, creating opportunities for income investors to participate in this growth trend.
But we also see ways for income-focused investors to participate in the broader AI value chain. Given the massive need for increased computing power requirements, the semiconductor industry is a key driver. We have seen a surge in demand from the big hyper-scalers (such as Microsoft, Alphabet, Meta) for high-performance computing chips that can handle AI’s complexity and increased power requirements.7
Companies such as Broadcom that supply customised chips to hyperscalers, drawing on wafers made by the likes of Taiwan Semiconductor Manufacturing Company (TSMC), could be well-placed to capture this demand. These kinds of firms also tend to pay a healthy level of dividends and boast an exceptional track record of income growth.
There are also likely to be increased requirements in terms of data centres, which are part of the critical infrastructure needed to take advantage of high-power computing chips. Again, companies such as Schneider Electric have a key role to play, both in terms of meeting the electrical needs and making sure data centres run as efficiently as possible.
Given the power consumption for AI data centres can be as much as three times that of traditional data centres, being able to manage the additional demands from an energy-efficiency standpoint is vital. This demand will likely lead to a more predictable revenue stream for companies involved in data centres, which in turn should support future income growth.
4. Rising demand for healthcare
There are more than 7,000 rare diseases around the world, only five per cent of which currently have treatments.8 In spite of this, the number of newly approved drugs has halved every nine years since the 1950s.9 This decline in research and development (R&D) returns has made pharmaceutical companies more risk-averse and less inclined to look for treatments of rare diseases.
The good news is that innovation in the healthcare industry is accelerating, and at an unprecedented scale, according to the World Health Organisation (WHO), particularly in the digital space. Helped by advances such as AI and gene editing, the way diseases are detected and treated is seeing a massive transformation. The COVID-19 pandemic saw an acceleration in terms of the timeframes it would usually take to bring drugs through to the market.
Pharmaceutical companies are now using genetic information to develop customised therapies, tailored to the individual needs of each patient. New drugs are being developed with mass-market appeal, such as anti-obesity drugs. Innovations in AI and technology are revolutionising cancer treatment and care. The use of algorithms and machine learning in detecting, diagnosing and treating disease has become a significant area of life sciences.
Driven by the rise of new technologies, healthcare is also finding its way into homes and communities away from hospitals. Devices are being used for remote monitoring of vital signs, conditions and compliance with treatment plans.
There are also structural trends that suggest demand for healthcare will keep on rising over the coming decades. The dominant demographic trend of the 21st century is the rapid ageing of populations, mostly in advanced economies.
The proportion of those aged 65 years and over globally is rising steadily as people live longer (see Figure 5). Beyond healthcare, ageing demographics are likely to lead to a significant increase in demand for income; this weight of capital, searching for investments that generate the highest levels of returns, is likely to spur changes across many industries.
Figure 5: The ageing of the global population (billion)
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Note: World population by age group. Historic estimates from 1950 to 2021 and projected to 2100 based on the UN medium-fertility scenario. UN projection scenarios: the UN's World Population Prospects provides a range of projected scenarios of population change. These rely on different assumptions in fertility, mortality and/or migration patterns to explore different demographic futures.
Source: Aviva Investors, Our World in Data: United Nations, World Population Prospects (2022). Data as of April 2024.
What this means for equity income investors
In terms of healthcare innovation, a number of pharmaceutical companies are participating in these trends. Take Swiss pharma company Novartis. It supplies drugs and medicines to over a quarter of a billion patients worldwide, in treatment areas ranging from cardiovascular, renal, neuroscience and oncology. The company has a number of upcoming pipeline launches over the next couple of years, following successful phase III readouts.
We are seeing further breakthroughs in areas such as breast and prostate cancer (especially when it comes to early diagnosis) that should help provide access to treatments in a more timely manner.
We also see a big shift towards value-based care offerings, particularly in the US, where healthcare expenditure remains a significant portion of government spending. By incentivising healthcare companies to focus more on quality and patient outcomes, health insurers are set to play a central role in managing these costs over the next decade. US-based companies with strong value-based care offerings can help address this.
In general, these types of businesses tend to be quite resilient over the economic cycle and offer investors a stable and growing source of income.
5. Embracing the megatrends
We believe value-orientated companies with proven free cashflow generation and sustained returns on capital have the potential to deliver in a high interest-rate environment such as the one we are currently living through.
However, given the likelihood that inflation will be more persistent going forward, there will also be a need to look for companies that can grow their income, and at a higher rate than inflation. That means paying close attention to megatrends and the companies whose business models are aligned with these themes.
Some of the megatrends we have explored in this article should help drive growth in income for companies and therefore create opportunities for equity income investors with a global focus and the ability to range across a broad spectrum of sectors. Predictability, protection and upside will continue to be the key watchwords for equity investors as these dynamics transform economies, societies and our everyday lives.
References
- “Plugging into the electrification megatrend”, Morgan Stanley, September 16, 2021.
- “Renewables 2022”, IEA, December 2022.
- “Smart grids”, IEA, July 11, 2023.
- “Climate change, catastrophes and the macroeconomic benefits of insurance”, European Insurance and Occupational Pensions Authority, July 6, 2021.
- “Executive briefings on trade: The automotive semiconductor market – key determinants of U.S. firm competitiveness”, U.S. International Trade Commission (USITC), May 2019.
- Ben Clarke, et al., “Extreme weather impacts and of climate change: an attribution perspective”, Environmental Research, June 28, 2022.
- A hyperscale company (hyperscaler), is an organisation that operates massive-scale data centres and cloud infrastructure to support their business operations. These are large cloud service providers, that can provide services such as computing and storage at enterprise scale.
- “Rare disease: Pioneering the science of breakthroughs”, Pfizer, 2024.
- Known as Eroom’s law in the pharmaceutical industry, the number of new drugs approved, per billion dollars spent on research and development (R&D) has halved roughly every nine years since the 1950s. (This is the opposite of Moore’s Law, which states that the number of transistors that can be housed on a given area of silicon doubles every two years).
