High conviction opportunities 2024
From the equipment makers helping to power generative AI to the normalization of the US yield curve, these are the shorter-term opportunities we feel strongly about heading into 2024.
HIGH CONVICTION INVESTMENT APPROACH
1. Semiconductor equipment makers
2. Cybersecurity shares
3. Western energy producers, equipment, and distributors
4. Copper miner equities/clean energy infrastructure
5. Medical technology & tools companies
6. Defense contractors
7. Private capital asset management firms
8. The Japanese yen and yen-denominated Japan tech, financial shares
9. Private credit and structured debt securities
10. Normalization of the US yield curve
At Citi Global Wealth, we have long viewed the wealth management process as a combination of “core” and “opportunistic” investments. Core carries most of the weight, both in terms of the amount of a client’s portfolio allocated to the assets, and in getting clients to their long-term strategic destinations. We make “core” allocations to benchmarked asset classes, based on a client’s risk profile and investment objectives and our rolling 10-year Strategic Return Estimates (SRE)1. As the SREs and other parameters shift, we periodically make minor adjustments. Core investments are the bedrock of every client’s portfolio. Their role is to keep the portfolio steady and generally moving in the right direction.
At the same time, we recognize that some clients seek returns over shorter time horizons. So, we are continually looking for ways to identify timely, investible opportunities that may benefit from their present undervaluation, a likely change in market perception or faster growth than is expected, especially over the nearer (call it two-year) time frame.
These opportunities are almost by definition high-conviction and are thoughtfully executed without putting a client’s long-term strategic objectives at risk. If we were to attach rough percentages to the two – it might be 85% to core, 15% to these various side investments and areas of emphasis. Potential opportunities like the 10 that follow are therefore incremental, quite interesting and should be considered according to investor risk profile and investment objectives.
As we were putting together this year’s Wealth Outlook, we identified an assortment of high-conviction opportunities.
2023 has been a year of conflicting signals about markets and the economy. In the second half, however, some of the major questions around interest rates and inflation pressures have begun to resolve. As we triangulate these current developments with the larger, longer-term (i.e. decade-plus) trends that guide our strategic thinking, we have become more convinced that the 10 ideas presented herein have merit.
1. Semiconductor equipment makers
In the past year, two major dynamic shifts took hold across our economy: 1) technical leaps in artificial intelligence efficacy and an associated 2) infrastructure spend in the sector from artificial intelligence (AI) service providers2.
As we discuss elsewhere we believe AI could do more to boost economic output and labor productivity than any technology the global economy has seen in decades.
Competition is coming into the field of AI chip design. Some of the generative AI products might be a commercial failure or competitive laggard. But all the work requires advanced semiconductor equipment. As Figure 1 shows, the market cap of the top 10 semiconductor equipment makers has suddenly fallen behind the surging market cap of the semiconductor producers. In essence, there is less optimism for the “picks and shovels” than for the “silicon gold miners.” That makes little sense to us given that the barriers to entry for the makers of these sophisticated machines and materials tend to be at least as high as for the advanced chipmakers themselves.
But there is more to this story. As Figure 2 shows, the US government and its trade allies are offering industrial subsidies to diversify the highly concentrated semiconductor supply chain. Whatever the success of this diversification effort, it points to a strong prospective spending on semiconductor equipment (and battery technology). To date, this has largely only impacted a narrow segment of US construction spending. But in the next coming couple of years, this will be followed by capital equipment outlays.
FIGURE 1: Market capitalization of semiconductor designers versus equipment and fabricators
Source: Haver Analytics as of September 30, 2023.
Figure 2: US semiconductor imports from Taiwan and private construction spending on US manufacturing
Source: Haver Analytics as of November 15, 2023. Indices are unmanaged. An investor cannot invest directly in an index. They are shown for illustrative purposes only and do not represent the performance of any specific investment. Index returns do not include any expenses, fees or sales charges, which would lower performance. Past performance is no guarantee of future results. Real results may vary.
2. Cybersecurity shares
With geopolitical risk already heightened, the world will see heightened manipulation of news, data and images as critical 2024 elections get underway across the US, Europe, India and elsewhere. Hacks and attempts to infiltrate the devices and files of political candidates have been a key tool for opposition research and malicious actors to add chaos to these democratic rituals. The continued growth of AI will bring with it ever-more sophisticated tools to be weaponized for pattern recognition and decryption. Thankfully, these technologies are also available for the “good guys,” with AI being deployed to improve cyber threat detection and prevention.
Citi Research’s survey of Chief Technology Officers3 at large US firms continues to indicate that spending on cybersecurity remains a top item in information technology budgets (Figure 3). When choosing the right solution for combating cyber threats, companies increasingly choose to contract with outside vendors to substantially augment in-house capabilities. The Nasdaq CTA Cybersecurity delivered 14% earnings growth as October 31, 2023 (versus -0.4% for the S&P 500 as a whole). That’s on top of a 36% increase in earnings per share (EPS) in 2022.4
Cybersecurity shares have failed to keep pace with this consistent, market-beating earnings growth. Valuations are hovering near early pandemic lows (Figure 4). As we look to 2024, we see cybersecurity shares rerating to be a source for reliable profits growth in an otherwise uncertain world.
Figure 3: Firm spending on cybersecurity Is growing rapidly.
Source: Haver Analytics as of October 15, 2023. All forecasts are expressions of opinion and are subject to change without notice and are not intended to be a guarantee of future events.
Figure 4: Cyber shares have rarely been cheaper despite double-digit EPS growth.
Source: Haver Analytics as of November 3, 2023. Using Nasdaq Cybersecurity Index. All forecasts are expressions of opinion and are subject to change without notice and are not intended to be a guarantee of future events. Indices are unmanaged. An investor cannot invest directly in an index. They are shown for illustrative purposes only and do not represent the performance of any specific investment. Index returns do not include any expenses, fees or sales charges, which would lower performance. Past performance is no guarantee of future results. Real results may vary.
3. Western energy producers, equipment, and distributors
Russia’s invasion of Ukraine forever realigned energy supply chains, with Europe turning to gas suppliers from the US and the Mideast. Recent conflict in Israel and the Gaza Strip further underscores that world petroleum supplies have both “concentration risk” and substantial political/geopolitical risk. (Russia and Iran together account for 20% of world crude oil production.5)
OPEC’s decision to lower crude oil production preemptively in a slowing world economy – to maintain high prices even at the expense of lost market share to alternatives – should be considered a “gift” to non-OPEC suppliers and the clean energy value chain alike (Figure 5). The competitive economics of energy supplies with oil at $80 per barrel are markedly different for producers than at $24, the trough price for Brent reached on average following the last four US recessions (Figure 6). Higher oil prices also enhance the value of its competition from green alternatives.
A transition away from fossil fuels requires redundant energy supplies to avoid economic disruption. Geopolitical considerations also argue for redundancy. The relatively low valuation of most oil and gas producers, pipelines and equipment makers make them worthy portfolio components to consider. Their equities and bonds have reclaimed their traditional role as a potential source of income while also seeking a direct if partial hedge against shocks and inflation (Figure 7).
Figure 5: Saudi production cuts benefit Non-OPEC producers.
Source: Haver Analytics through November 3, 2023.
Figure 6: Benefits show up in creating a floor under US crude prices...
Source: Haver Analytics through October 31, 2023.
Figure 7: ...and in producers’ high free cash flow yield.
Source: Bloomberg and Haver Analytics as of November 22, 2023. All forecasts are expressions of opinion and are subject to change without notice and are not intended to be a guarantee of future events. Indices are unmanaged. An investor cannot invest directly in an index. They are shown for illustrative purposes only and do not represent the performance of any specific investment. Index returns do not include any expenses, fees or sales charges, which would lower performance. Past performance is no guarantee of future results. Real results may vary.
4. Copper miner equities/clean energy infrastructure
The transition to clean energy involves extensive investment and experimentation with new technologies. Some will prove uneconomic, while others will shape the grid of the future. The prospect of large capital outlays without immediate profit drove shares of clean energy producers lower during most of the past two years as US Federal Reserve (Fed) tightening rationed credit for unprofitable firms. China has supplied much of the world with solar panels at price levels that are ruinous for global competitors, but still helpful for reducing global emissions. In other areas like hydrogen, potential producers and users are waiting for breakthroughs in technologies that are yet unproven.
Green tech – and related areas such as clean water infrastructure – involves a range of investments with differing risk/reward characteristics. One component where we see high future demand, restrained supply, and no substitution is copper. Beyond the impact of near-term economic weakness, Citi Research forecasts6 copper prices being pushed higher by the relatively low level of investment, but lengthy time required, by the companies sitting atop the world’s major copper reserves to bring on new supply (Figure 8).
Battery technology can change and bring surprising volatility to commodities such as lithium. But until new “super-conductor” materials are discovered, the electrification of infrastructure and almost every part of an electric vehicle will require large quantities of copper.
No single commodity should comprise a very large portfolio stake, but profitable copper producers may be one of the lower-risk components of the energy transition, with a strong correlation to global growth once it improves.
Figure 8: Historical and Citi Research-forecast copper miner equity and spot copper prices through 2025
Source: Bloomberg as of November 15, 2023 using Solactive Global Copper Miners Index, Citi Research as of November 15, 2023. All forecasts are expressions of opinion and are subject to change without notice and are not intended to be a guarantee of future events. Indices are unmanaged. An investor cannot invest directly in an index. They are shown for illustrative purposes only and do not represent the performance of any specific investment. Index returns do not include any expenses, fees or sales charges, which would lower performance. Past performance is no guarantee of future results. Real results may vary.
5. Medical technology & tools companies
Healthcare, a sector for which ever-rising medical spending typically lifts most boats, saw one of its widest performance dispersions in recent memory this year. While a handful of large companies with blockbuster new drugs experienced explosive share gains, many others struggled. Loss-making early-stage biotech firms straining under rising financing costs, insurers facing new US regulatory headwinds, pandemic vaccine makers and teledoc providers were among the subsectors that fell out of favor.
But the performance of another category makes no sense to us. With the advancement of AI, the methods for drug discovery and testing are about to accelerate and become more productive. (Think of AI-enabled drug research as Healthcare’s answer to the semiconductor equipment makers.) After valuations had gotten rich during the low-rate, peak-COVID medtech euphoria of a couple years ago, the abrupt switch to fast-rising discount rates led many companies to suffer severe share price declines that have overshot the mark, in our view (Figure 9).
As credit costs stabilize over the coming two years, and regulatory changes force more best-selling drugs off patent, we expect merger and acquisition activity to pick up as pharma and larger biotechs acquire small earlier-stage firms with promising candidates to replenish the larger firms’ pipelines. This should lead to the next leg in the biotech innovation investment supercycle. We also believe that cheaply valued tech and tools could be among the broadest beneficiaries.
Figure 9: S&P pharmaceuticals total return versus S&P healthcare equipment
Source: Haver Analytics through November 22, 2023. All forecasts are expressions of opinion and are subject to change without notice and are not intended to be a guarantee of future events. Indices are unmanaged. An investor cannot invest directly in an index. They are shown for illustrative purposes only and do not represent the performance of any specific investment. Index returns do not include any expenses, fees or sales charges, which would lower performance. Past performance is no guarantee of future results. Real results may vary.
6. Defense contractors
The tragedies unfolding in Ukraine and the Middle East see history repeating as simmering, longstanding conflicts explode into major wars once again, sowing further tensions between the major powers lining up in the shadows on either side. The division of the world again into “Western” and “Eastern” Cold War blocks has dangerous precedent. However, the arms race of the 1980s showed that deterrents work. NATO nations see no choice but to increase defense spending to avoid a larger conflict.
These two wars have strained the capacity of US and European defense equipment and arms producers. Their share prices appear to reflect worries about government funding and the stress they are under as shipments of defense goods have fallen behind demand (Figure 10).
While buyer power is always a wild card in this unique segment of the market – with literally just a handful of taxpayer-supported customers around the world setting prices and all the rules – it’s hard to imagine Western defense agencies not doing almost whatever it takes to ensure these companies are able to catch up.
Figure 10: Share prices of US aerospace and defense contractors feeling the strains on their capacity.
Source: Haver Analytics as of November 22, 2023. All forecasts are expressions of opinion and are subject to change without notice and are not intended to be a guarantee of future events. Indices are unmanaged. An investor cannot invest directly in an index. They are shown for illustrative purposes only and do not represent the performance of any specific investment. Index returns do not include any expenses, fees or sales charges, which would lower performance. Past performance is no guarantee of future results. Real results may vary.
7. Private capital asset management firms
Equities of US banks have returned -6% in 20237. Their return relative to the S&P 500 matches a 35-year low (Figure 11). In core portfolios, we have effectively overweighted US bank preferred shares with an average yield near 7.6%8 on capital securities, but not their common shares.
There are many explanations for the deep under-performance of bank common shares. However, the most compelling explanation is the desire by regulators to force large, regulated banks to bolster balance sheets by issuing more long-term debt at a higher cost than deposits (Figure 12) and raising the capital requirements for certain banking activities. Though the economics of banking should have improved with higher yields, regulatory uncertainty is effectively preventing the big systemic banks from fully participating.
This creates a potential opportunity for firms that provide alternative sources of financing, such as the private capital managers that oversee private credit and other types of private equity funds. One of the ways to access this potential opportunity is to own the asset managers themselves that are seeking to take advantage of the regulatory burdens being placed on the banks. This can be done either by simply buying stock in the managers (for those that are publicly listed) or through other vehicles available in the alternatives markets for qualified investors.
Figure 11: The underperformance of US bank shares matches a 35-year low.
Source: Haver Analytics as of November 22, 2023. Ratio of S&P 500 Banks Index to S&P 500 Index. Gray areas are recessions An investor cannot invest directly in an index. They are shown for illustrative purposes only and do not represent the performance of any specific investment. Index returns do not include any expenses, fees or sales charges, which would lower performance. Past performance is no guarantee of future results. Real results may vary.
Figure 12: Regulators’ insistence on shoring up bank balance sheets with long-term debt instead of deposits will potentially be very costly for banks.
Source: Haver Analytics as of November 22, 2023. Index information from ICE BofA Merrill Lynch Corporate Bonds: Financials: 5 to 10 years yield to maturity. Indices are unmanaged. An investor cannot invest directly in an index. They are shown for illustrative purposes only and do not represent the performance of any specific investment. Index returns do not include any expenses, fees or sales charges, which would lower performance. Past performance is no guarantee of future results. Real results may vary.
8. The Japanese yen and yen-denominated Japan tech, financial shares
Once the strongest currency in the world during its decades of deflation, the Japanese yen has more recently been among the developed world’s weakest. From January 1, 2022 until October 31, 2022, the Japanese yen fell 23% against the US dollar since the Fed’s first rate-hike eight months earlier.9 However, now Japan’s policymakers seem to feel that their stubbornly dovish monetary policies have achieved their mission in helping to finally reinvigorate the Japanese economy (and the data suggests they’re probably right). That sets up the likelihood of a reversal in 2024.
Japan could hardly have taken a more different approach than the world’s other major central banks to the inflation spike of 2021-2022. After having kept its short-term policy rates near zero or below for more than a dozen years, the Bank of Japan determined to keep going even as inflation in Japan rose. In contrast, the Fed raised its policy rates by 525 basis points. Over that time, Japan has merely allowed its longer-term yield targets to drift higher while keeping short rates negative.
Ironically, it’s the Fed that may now soon need to swerve from a monetary policy path that could ultimately prove deflationary, while we see Japan swerving from its inflationary one. Japan’s headline consumer price index inflation has averaged 3.6% for the past two years – a major victory. We can’t imagine policymakers will press their luck much longer and based on Figure 13 above, the market seems to agree with us.
Aside from investing directly in the currency, investors can gain exposure through investing in the Japanese banks that may benefit from the monetary policy tightening we expect to help drive the strengthening. To the extent a stronger yen is a sign of continuing economic strength, another play are strong Japanese assets that might generate positive returns even if the currency does not boost returns further. Japanese tech firms providing semiconductor equipment, battery technology, robotics and automation are globally competitive in growing industries.
Figure 13: What goes up … US/Japanese policy rate differential and USD/yen exchange rate headed for an inflection point?
Source: Bloomberg as of November 15, 2023. All forecasts are expressions of opinion and are subject to change without notice and are not intended to be a guarantee of future events. For illustrative purposes only. Past performance is no guarantee of future results. Real results may vary.
9. Private credit and structured debt securities
Private debt is a rapidly growing asset class among institutional investors and has continued to prove its value in 2023. The Cliffwater Direct Lending Index reports annualized return to loan maturity returns 9.69% as of June 30, 2023 (primarily attributable to senior debt). Uncertainty has continued to limit the availability of syndicated loans to the largest, near-investment grade offerings, and banks have also largely remained on the sidelines with the prospect of expected stricter liquidity and capital requirements, particularly in the middle-market and in certain sectors such as technology.
As a result, direct lenders are in high demand by private equity managers, driving new channels in the industry through nontraded business development companies, interval funds and tender offer funds.10
For fixed income investors looking for more liquid public market opportunities, another asset class used heavily by qualified institutional investors (and for other suitable investors can also be accessed via a managed fund) is structured credit. With US mortgage rates jumping 7-8% for various maturities, it is possible for structured debt funds holding prime mortgage-backed securities to yield 6.5-7.5% with short- to intermediate holdings. Yields have risen even more widely for investment grade commercial mortgage- and asset-backed securities. The pipeline of new loans becoming securitized at higher rates points to higher yields for suitable institutional and retail investors alike (Figures 14-15).
Figure 14: Behind the rise in US mortgage-backed securities (MBS) yields, a sharp rise in mortgage rates.
Source: Bloomberg as of November 22, 2023. Indices are unmanaged. An investor cannot invest directly in an index. They are shown for illustrative purposes only and do not represent the performance of any specific investment. Index returns do not include any expenses, fees or sales charges, which would lower performance. Past performance is no guarantee of future results. Real results may vary.
Figure 15: Securitized credit yields higher than those for IG corporates.
Source: Bloomberg, ICE BofA Indices as of November 22, 2023. Index used is the Bloomberg US Corporate Bond 1-5 Year Index. Indices are unmanaged. An investor cannot invest directly in an index. They are shown for illustrative purposes only and do not represent the performance of any specific investment. Index returns do not include any expenses, fees or sales charges, which would lower performance. Past performance is no guarantee of future results. Real results may vary.
10. Normalization of the US yield curve
The US Treasury 1-year/10-year yield curve has been positively sloped in 82% of all months during the past 60 years. It can steepen on higher long-term rates and/or lower short rates. The longest period of an inverted US yield curve has been 20 months. The 10s/1s US Treasury curve has already been inverted for 15 months (Figure 16).
Strategies with a duration of two-years can be constructed and can potentially earn a high current cash yield Using similar tools, market opportunities could enhance current Treasury yields or tailor investments for higher-yielding entry points.
Some of the conditions that might steepen the curve – either a recession or an acceleration in inflation would likely be adverse for equities markets. For suitable clients, rate strategies may also serve as a risk hedge for equities or credit. The risk of implementing such a rate strategy is that the curve remains inverted or does not steepen sufficiently beyond the initial entry point of the strategy to result in a favorable gain, and so the investment in the strategy is reduced in value.
Figure 16: Already close to a record-long inversion – US Treasury yield “curve” showing the % spread between 10- and 1-year Treasury yields
Source: Bloomberg as of November 22, 2023. Indices are unmanaged. An investor cannot invest directly in an index. They are shown for illustrative purposes only and do not represent the performance of any specific investment. Index returns do not include any expenses, fees or sales charges, which would lower performance. Past performance is no guarantee of future results. Real results may vary.
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