Quarterly Report 2Q2021

Review

The question of whether there will be a return to more inflationary times came increasingly to the forefront of investors’ minds during the quarter. While nominal benchmark bond yields stayed rangebound consistent with central banks’ still-consensus view that the phenomenon is of transitory nature, corporate managers in virtually any business and region have been mentioning a worrisome rise in a variety of input prices paid, as well as certain difficulties in obtaining specific raw materials, components, or qualified labor. Concerning the former, the way government bond yields behave we can neither control nor forecast. Instead, we deem it worthwhile to focus our attention on the latter issue, i.e., how companies deal with their cost structure, how easily they can pass any increases along to their customers, as well as how they manage any resource shortages and delivery bottlenecks within their respective supply chains.

Outlook, thoughts and issues

Structural changes that favor pricing power in the “old economy”

It has been a rather long time—we would argue going back all the way to the post-WWII rebuilding and prosperity phase during the 1950s and ‘60s—since the industrial, “tangible” complex of the world economy enjoyed sustainable pricing power. During that time, high-quality manufactured goods and well-managed infrastructure projects by and large commanded strong profit margins; rising input prices such as raw materials, manufacturing and labor could reliably be passed on to buyers.

We can envision a constellation finally forming in the world economy that could lead to a return to such a forgotten environment. While infrastructure spending has always represented a prominent slice of fiscal policy in the Far-East (notably in their two largest economies China and Japan since the 1980s and the 1950s, respectively), the West (led by the US and select members of the EU, notably Italy) now also seems seriously determined to start revamping the basic physical backbone of their economies encompassing the likes of roads, railways, ports and bridges.

Moreover, another type of infrastructure spending that goes beyond restoring the ageing core systems is coming into focus worldwide. Specifically, to meet climate goals by mid-century as set forth by the Paris Accord, vast new projects will have to be launched in wind, solar, hydroelectric, hydrogen, nuclear and other carbon-reducing energy technologies, including the necessary electric transmission, storage and distribution systems, to try to reach or at least approach those targets.

Firmer pricing power will not only become a factor due to higher demand and stronger growth in order books and revenues, but also due to the rising underlying input cost pressure (e.g., labor, raw materials, logistics) that will—with a time lag—be passed on to supply chain buyers and the ultimate end users downstream.

We believe that our portfolio would strongly benefit from such forces because a big part of the Fund is structurally tied to companies that focus on these business areas—either directly or indirectly. Directly by means of being active in industrial sectors such as materials, capital goods, construction and manufacturing and indirectly through the provision of ancillary functions like trading, transportation, engineering and utilities. In addition, other crucial services such as custom-tailored loan and debt arrangements as a core commercial banking activity will regain more pricing power compared to the recent past, according to our estimation. After all, many ultra-complex, capital-intensive infrastructure projects will be realizable by means of public-private-partnership structures only, where extensive know-how in credit facilitation and intermediation is essential.

In conclusion, we are extremely excited about the long-term positioning of the Fund’s holdings in the areas mentioned above. The prospect of higher pricing power would ultimately promise improved profit margins. These dynamics in turn may signal the real possibility of a gradual but perceptible strategic rejig in investment style taking hold among asset allocators, eventually representing an earnest alternative or at least a complement to the index-heavy “go-to” stocks that have gotten all the headline-grabbing attention over the last few decades, i.e., sectors such as consumer staples, healthcare, high-tech and new media.

Sincerely,

Gregor Trachsel,
Chief Investment Officer SG Value Partners AG