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What does the current volatility mean for energy transition investing?

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The driving forces behind the energy transition remain as strong as ever and the current market volatility has only enhanced these trends.

There is a lot going on in the financial markets right now. Meaningful inflation has returned for the first time in decades. Supply chains everywhere continue to be disrupted. Geopolitical and social tensions around the world are heightened, most notably with respect to Russia’s invasion of Ukraine.

All this amounts to a challenging cocktail of risks for investors to navigate.

The world is experiencing multiple macroeconomic ‘crises’ at once, which will impact both short-term and longer-term investment trends.

And at a time of such heightened market volatility, it is of vital importance to take a balanced and disciplined approach. Detailed below are answers to some of the questions faced by investors in energy transition equities.

How long will the current macroeconomic environment last and what are the biggest risks facing investors?

Stepping back from the specific issues mentioned above, we think investors are concerned about the risk of a systemic shift in the predominant macroeconomic regime. That is, with higher inflation and a slowdown in economic growth, now more likely than not.

Our current baseline expectation is that while inflation will likely ease over time from the extended levels today, there is a very real risk that it could take more time than expected to ease, remain higher than before and be more volatile in the time to come. Although we are still some way from heading back to a 1970s-style inflationary regime, we do think a potential inflationary regime shift may have started to occur. We are concerned that this inflation could also result in a slowdown in growth – creating a more stagflationary environment where supply chain pressures on earnings may remain for a period.

What are the main risks facing energy transition equities?

We see three headwinds associated with the shifting macroeconomic regime: (1) persistent supply chain pressures; (2) the threat of rising interest rates; and (3) the risks from a slowdown in economic growth.

From a risk perspective, we are more concerned about the earnings risk from prolonged inflation and supply chain constraints than a slowdown in economic growth, given the structural nature of the energy transition theme. While certain sections would be significantly exposed to weaker economic growth (for examples, autos, electrical equipment, etc.), most companies are in structurally growing markets which offer a very attractive growth profile compared to other parts of the listed equity space. The positive long-term support provided by our decarbonisation, and now energy security goals, should ensure this is the case.

Discover more by visiting Schroders’ insights or click the links below:
– Read: Will the gold price surge continue?
– Listen: Lessons from history: how we beat inflation in the 1970s – now can we do it again?
– Watch: How the energy transition sector is faring so far in 2022

Does the current environment offer any opportunities?

Despite the clear risks associated with the current environment, we strongly believe that there are substantial opportunities too. We must also not forget the enormous investment opportunity behind the energy transition or the potential for energy transition technologies to help solve many of the issues facing the world today.

The renewed interest in energy security (in addition to our broad decarbonisation goals), further supports the need for the build-out of local, abundant, cheap, clean energy supplies around the world. The driving forces behind the energy transition remain as strong as ever and the current market environment has only enhanced these long-term structural trends.

Over the next 30 years, we expect more than $100 trillion to be spent on achieving the transition to a more sustainable energy system, with even more to be spent on making the economy more sustainable. This spending will create the potential for a significant and structural 30-year increase in earnings growth for companies across the energy transition sector.

This structural growth could be quite attractive during an economic slowdown. Moreover, if a more persistent inflationary regime were to emerge, the size and sustainability of potential earnings growth over time may outweigh any valuation de-rating when considering wealth preservation over the long run.

Finally, cheap, clean, abundant renewable energy could be a very powerful solution to reducing energy dependence on Russia, creating an opportunity to remove one of Russia’s more powerful diplomatic threats. By accelerating the uptake of renewables, and particularly wind and solar which are produced using resources that are available in every country, there is a real tool to drive higher energy equality and perhaps help to reduce inflationary pressures too. Indeed, the wider realisation of this opportunity has fuelled the recent surge in valuations in the space.  

There are lots of positives about energy transition equities in the current market environment, which should not be overlooked by being overly focused on the threats.

Given the very strong long-term opportunities, is now a sensible time to invest?

Although we still see risks to the earnings and valuations of energy transition stocks in the current environment, we also firmly believe there are also exciting opportunities for stronger structural growth too. Valuations have also clearly re-set quite substantially from the Q4 2020 highs – and are now back to mid-2020 levels.

Energy transition shares aren’t cheap yet (they are still sat just above the three-year trailing mean), but they are certainly much more fairly priced than they were at the start of 2021. Given that the valuations are fair (and not necessarily cheap yet), there is of course scope that valuations fall further.

We cannot predict when performance will turn around – and there are definitely near-term threats that we must be aware of. However, the long-term picture remains very robust and exciting (and has not really changed over the last year) and so we do think now is a good time to at least be looking at the sector again given the long-term opportunity ahead.

In the short-term, there is certainly a material risk of de-rating across most parts of the energy transition space. Equities across the wider market, including some in the energy transition space, remain richly valued on most measures compared to their historic range, and with central banks tightening, the era of cheap money may be coming to an end. However, for those investors willing to hold-on through the near-term pain and use weakness as an opportunity to further build exposure in this structurally growing space, the longer-term returns projection may look very appealing indeed.

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