With a career spanning over two decades in the world of finance, Matt Dennis has established himself as a seasoned investor and astute portfolio manager. Having spent the majority of his career managing international equity portfolios for INVESCO, Matt recently embarked on a new chapter, founding S5 Capital, an investment firm based in Austin, Texas.
During his tenure at INVESCO, Matt’s keen eye for opportunities and meticulous approach to managing multiple mandates led to remarkable success. He skillfully grew institutional and retail client portfolios to surpass $30 billion, all while maintaining a deliberate and organized daily routine.
Matt’s journey as an investor and his steadfast commitment to productivity serve as the foundation for the insightful interview that follows. As we delve into the current investment landscape and explore emerging opportunities, Matt’s expertise and balanced perspective offer valuable insights to investors seeking to navigate the complexities of today’s ever-changing financial world.
What are you seeing in the current investment landscape?
The current investment landscape is marked by a multitude of contemporaneous risks that experienced investors should take seriously. These risks include the fastest pace of monetary tightening by the Federal Reserve in four decades, still high and potentially sticky inflation, deteriorating growth indicators, and historic debt levels. Worrying corporate and sovereign credit risks arise as loans mature and are refinanced at materially higher rates.
In addition to these economic risks, there is also a deterioration in geopolitical relationships, particularly between China and the West. Furthermore, there is a reversal in the trend towards globalization and rising trade protectionism, along with the unavoidable math of demographic curves. To add to the challenges, there is a rising probability of a recession in the US, contrasted with the prospect of a delayed but potentially robust recovery in China’s economic prospects.
The most relevant factor that investors must acknowledge today is the likelihood that the four-decade-plus decline in interest rates and the positive support it has lent to asset returns is over.
While each of the threats in the current investment landscape is manageable on its own, together, they introduce a level of complexity that can be difficult for many investors to navigate. The risks pose significant threats to investment returns and introduce the prospect of above-average volatility.
Despite the decline in equities and the rise in bond yields throughout most of last year, recent moves in bond and equity prices suggest that the market continues to take a relatively optimistic view of the probable outcomes and the ability of the economy, monetary and fiscal authorities to manage through these challenges effectively. However, the investment landscape remains rife with risks, and the risk premium embedded in the price of many assets is inadequate, representing a clear threat to investment returns.
Amidst the likely volatility in the investment landscape, thoughtful investors who can combine an appropriate degree of composure, a robust assessment of value, and an adequate time horizon should be able to take advantage of the significant upside opportunities that will emerge. This can be achieved with a degree of downside protection that has been absent for more than a decade.
What other risks are you focused on?
Two additional factors to consider are the corporate bond refinancing risk and the ballooning US fiscal burden. The increase in borrowing costs over the past year has left a significant portion of the corporate bond market vulnerable and poses a ticking time bomb for fiscal budgets.
Approximately $2 trillion in corporate bonds are set to mature in the next 12 months, with a cumulative $6-7 trillion scheduled to mature over the next 36 months. All of this debt is likely to be refinanced at much higher interest rates, which will further pressure corporate profits.
What’s even more concerning is that a significant amount of the debt coming due by 2025 is rated “BBB-” (dangerously close to non-investment grade status). A credit downgrade to a “BBB-” rated bond would place it in the junk category, with ominous implications for investors and potentially employees in these businesses.
The reckless spending by the US government over the past decade is a major concern, but it seems that the mathematical realities facing fiscal decision-makers have not been fully grasped by investors. Politicians have been spending without restraint, and we are now $31 trillion in debt, with that figure expected to rise significantly in the coming decade due to rising entitlement spending and growing budget deficits. This will only be exacerbated by the burden of higher interest expense.
The arithmetic looks like a bad dream, and unless our elected officials change their spending habits, we can expect more money printing and higher tax burdens to be imposed.
The current cycle will bring about winners and losers, and the good news is that this will result in a new wave of opportunities. The rise in capital costs will make many investments uneconomical for businesses, leading to the decline and even the demise of many others with business models reliant on cheap capital. At the same time, incumbents that took advantage of cheap credit to make substantial investments may find it harder for new entrants to challenge their positions. The potential winners will be those with stable cash flows, excess capital, and liquidity to seize opportunities presented by distressed situations. Investors should focus on businesses with pricing power, low capital intensity, robust balance sheets, and healthy cash generation that are better placed to survive and even thrive in the current environment. High-quality corporate bonds, treasuries, and cash are also viable options.
What opportunities do you see if the deglobalization trend we are seeing prevails?
It’s not surprising to see an increase in geopolitical and trade tensions, as governments and businesses are forced to reevaluate their interests in the wake of pandemic-related disruptions and structural vulnerabilities. This has led to a rapid restructuring of global supply chains, with a focus on reshoring to increase resilience. This transformation will require significant investment and will stress long-standing trade relationships while cultivating new ones. Latin America and Asia, excluding China, are well-positioned to benefit from the US supply chain transformation, provided they offer secure and stable production and resources. Domestic politics and trade pressure from China will be primary factors determining the success of this initiative. The construction, data, industrial, and transport sectors should all benefit from the reshoring momentum.
How do emerging markets rank on your investment list today, particularly given what sounds like a slightly bearish view on the dollar?
The relationship between the dollar and emerging market (EM) returns is a good question to consider. A weaker dollar, the end of Federal Reserve tightening, and the potential for a Chinese economic recovery would all be beneficial for EM performance. Additionally, there may be a shift in thinking among EM investors regarding the safety of their capital investments in the US, especially after witnessing how the US and the West dealt with Russia and Putin over Ukraine. This suggests that EM savings that have funded US deficits for decades could also have peaked, with more money staying local and supporting investment, consumption, and growth.
Moreover, the West’s attempts to isolate Russian energy exports have led to a situation where many energy-dependent economies are paying for Russian, Iranian, and Saudi oil and gas imports with local currencies, thereby reducing the demand for US dollars. All of this is relevant to the ongoing debate about expected US dollar returns and the potential for a period of EM asset outperformance, particularly since US investors remain underweight in non-US investments in general after a decade or more of US outperformance.
You mentioned demographics earlier. How are you factoring this into your investment strategy?
Demographic considerations are becoming increasingly important, as labor forces in many countries are shrinking. The baby boomer generation was already reaching retirement age, but the pandemic has accelerated retirement decisions for many individuals. Although people are working longer, we are now at a point on the age curve where demographic factors are playing a more significant role in many countries, including the US and China. These factors range from the cost of social programs to the demand for healthcare products and services.
Europe has been grappling with demographic challenges for some time, providing a useful roadmap for how growth and domestic policy priorities might evolve elsewhere. As such, demographic considerations are likely to have a significant impact on investment strategies and opportunities, as well as broader economic trends, in the years to come.
It is widely acknowledged that the cost of entitlement programs in the US far exceeds the available assets to pay for them, given the steadily aging population and years of creative accounting. How this situation will play out in the future is uncertain, but all options are likely to be considered, including means testing, delayed retirement age thresholds, and higher taxes. Meanwhile, new and powerful trends are already emerging, such as hospital efficiency solutions and gene-based technologies for testing and products. As a result, healthcare exposure is expected to benefit from structural tailwinds, creating new winners and losers in the industry over the next decade.
How do you see artificial intelligence impacting the investment landscape?
Artificial Intelligence (AI) and Automation are critical productivity levers for the economy, and the recent arrival of ChatGPT and other competitors in the AI arms race could represent an inflection point. AI is expected to drive innovation and facilitate processes that were previously unimaginable. Furthermore, the significant investment in new greenfield capacity and brownfield restructurings as supply chains are reconfigured will feature a higher mix of automation and AI-supported software investment.
At present, it is challenging to identify clear winners and losers in the AI space. However, companies with strong incumbent positions in the industrial/automation space are well-positioned to benefit from this multi-year investment trend. Some examples of such companies include ABB, GE, Schneider, Siemens, Emerson, Rockwell, and others. As the use of AI and automation continues to grow, these companies stand to benefit from their expertise and experience in these areas.
How constructive are you on the green energy theme?
There is a growing alignment between government, industry, and consumers seeking to shift towards green energy solutions, which is stronger than ever before. This has significant implications for the cost of energy going forward, following several decades of sometimes volatile but generally inexpensive energy. Today, Western government energy policy is inflationary, as the production of fossil fuels is discouraged, and investment in green energy is encouraged to pursue long-term climate policy objectives. As a result, the energy transition is likely to be inflationary.
The Inflation Reduction Act and tax and fiscal support will be significant in the US, with other nations likely to respond in a similar fashion to support green energy solutions. US funding is expected to become more meaningful from 2024 and last for several years, supporting infrastructure investment in areas such as grid, transport, energy storage, producers of electrical components, software solutions to manage energy production vs demand, renewables (including carbon-free solutions), electric vehicle proliferation, and more.
In short, the energy transition, energy security, and supply chain reshoring will all lead to more investment in energy solutions (both fossil and green) and should be high on investors’ radar for opportunities.
Green energy solutions are moving closer to becoming a reality, but we are still several years away from completely moving away from carbon-based energy sources. The pace of consumer adoption of green energy solutions remains uncertain, with most of the progress to date driven by fiscal policy incentives rather than consumer demand.
Early adoption of green energy solutions is more likely to occur in the industrial sector, driven by tax incentives and the potential for energy productivity improvements. However, fossil fuel producers are becoming more disciplined in their capital allocation, and if energy prices remain firm or rise, they should generate significant cash flow to support dividends and equity returns for businesses focused on traditional energy sources.
In the near term, declining consumer and industrial demand due to a recession represents a headwind for traditional energy firms. However, if inflation remains sticky and structurally higher going forward, these businesses and other commodities can serve as a useful portfolio hedge. Any near-term weakness in their equity prices should be seen as a buying opportunity for long-term investors.
Rather than choosing between green and fossil fuel energy sources, it is wise to focus on an “and” approach for the time being, recognizing the potential opportunities in both areas.
Learn more about Matt Dennis of Austin,Texas on his website.
