Elections and stocks: A surprising non-story

In a recent weekly update, we discussed how 2024 is an important election year worldwide. As it relates to US elections and stock returns, the data shows limited impact. Although markets can be volatile in election years, the political party in the White House has historically had minimal effect on returns. Since 1936, the 10-year annualized return of US stocks (as measured by the S&P 500 Index) at the start of an election year is 11.2% for a Democratic win and 10.5% for a Republican win. Sector performance, however, can be affected by short-term policy planning headlines.

Election rhetoric and the real story of healthcare stocks

For example, the healthcare sector often underperforms during a US election year due to the attention on drug and medical cost control. The global impact is significant, as the US is a major driver of healthcare economics. For 2024, the effect on healthcare may be less pronounced. The Biden administration’s measures for drug price control as part of the 2022 Inflation Reduction Act have already been implemented, but with only 10 high-profile drugs priced by the government under the reform, the economic impact has been muted. The pace of implementation could slow further under a Republican administration, potentially leading to positive earnings surprises.

Our Global portfolio includes a pure-play drug manufacturer, ANI Pharmaceuticals (ANIP:US), which owns a large facility in Minnesota where it produces a wide range of specialty and generic drugs and has a rapidly growing immune therapy franchise. None of its drugs have been targeted by US authorities for price negotiations.

From tariffs to technology

Recent protectionism, particularly new tariffs in sectors like semi equipment initiated during the Trump administration, may extend to medical devices and biotechnology. Don’t be alarmed if more are implemented. It’s our job to identify the tailwinds. Medical devices and biotechnology companies are likely to be the next tariff targets, especially those involving China. Over the past decade, Chinese productivity and quality have risen sharply in the fields of biotechnology, drug and device development.

Two proposed bills: the Biosecure Act and the Prohibiting Foreign Access to American Genetic Information Act of 2024 enjoy bipartisan support, with a 60% China tariff on healthcare goods proposed by Republicans in the event of their victory. This could create positive competitive tailwinds for North American and European contract drug manufacturers.

Evotec’s leap forward

Global Alpha owns Evotec SE (EVT:GR), a rapidly growing biological drug manufacturing contractor with technologies for low-cost and fast scaling of drug production. Evotec also has potential for numerous drug development partnerships and is developing a new stem cell medical device system for diabetes treatment.

Medical devices as the market’s quiet titans

The medical device industry, known for its high barriers to entry and advanced technology, appears well-positioned for profitable growth. It tends to be less scrutinized by policymakers and therefore less affected by elections. In the last three decades, the industry has outpaced the S&P 500 by almost 15 percentage points, with stellar performance in the early 1990s, mid-2000s and late 2010s. Yet value creation has become more difficult in the past five years, especially for large, diversified companies. The top-30 largest medical device companies have underperformed the S&P 500 over one-, three- and five-year periods.

Our focus is on smaller, nimble names like Globus Medical Inc. (GMED:US), now an orthopedic powerhouse after acquiring its competitor, NuVasive. This acquisition has broadened its portfolio and enhanced its geographic reach. Globus’s expanded sales force will also support its fast-growing robotics business, a relatively new area. These robots improve the efficiency and output of orthopedic surgeons during back surgeries. Globus has also recently initiated a trauma product line that has successfully penetrated the market, further benefiting from its increased sales force. The orthopedic market is very large, valued at USD$72.3 billion and growing at a 5.3% rate.

Seeing clearly: The vision market’s rapid growth

Medical devices target a broad range of very large markets. For example, the global vision care market is projected to reach USD$192.85 billion by 2026, with a CAGR of 5.6%.

Global Alpha owns Menicon Co. Ltd. (7780:JT), Japan’s first and largest contact lens manufacturer, which now has a presence in over 80 countries. The company offers a comprehensive product lineup including disposables (daily, 2 weeks, 1 month, >3 months, silicone hydrogel), other soft contact lenses and RGP (Rigid Gas Permeable) lenses.

In China alone, myopia affects 146 million people. The condition is especially prevalent among children, creating a strong demand for corrective devices. Orthokeratology, a technique using contact lenses to reshape the cornea for long-lasting effects, had a global market value of $2.5 billion in 2023 and is expected to grow at a CAGR of 6.1% beyond 2026. Market penetration in China is only 2.0%. Menicon ranks as the second-leading company in this space.

The true power of legislative winds

To sum up, it seems ineffective to predict the direction of the US stock market based on political party forecasting. However, it is important to monitor the progression of legislation from announcement through to funding and implementation. This is because bills go through phases of hype, disillusionment and reality, similar to many other events that can influence the economy.

Contrary to the market’s expectations of a robust post-pandemic economic recovery, China’s rebound has been underwhelming. Although its 2023 GDP growth surpassed the official “around 5%” target, key indicators point to a struggling economy in the post-COVID era. This situation reveals three primary challenges: debt, deflation and demographics (collectively termed the 3Ds), reminiscent of Japan in the 1990s. China is arguably in a stronger position, with potential for higher growth, lower asset-price inflation and more effective currency management. Nevertheless, addressing these problems is complex. While debt and deflation could be mitigated through proactive government policies and a shift to a consumption-driven economy, demographic trends are less malleable.

The one-child policy legacy

For the second year in a row, China’s population decreased by 2.08 million people in 2023 after losing 850,000 in 2022. The longstanding one-child policy, only lifted in 2016, has had a lasting impact. Government initiatives to encourage marriage and parenthood have been insufficient. Educational and employment gains have empowered women to have more control over reproductive choices, contributing to a lower fertility rate. This demographic shift threatens China’s economic prosperity by reducing the labour force and consumer spending.

Balancing the productivity and social welfare equation

Globally, countries like Sweden, Japan, South Korea and Russia have tried various strategies to tackle similar demographic dilemmas, including financial incentives, and housing and childcare assistance, yet a sustainable solution remains elusive. For instance, Japan anticipates a shortfall of 11 million workers by 2040. However, this does not render these countries, including China, less attractive for investment. To adapt, China must improve its existing workforce’s productivity.

In 2022, household consumption in China constituted 37% of its GDP, lower than in Japan (55%) and the US (68%). This may be primarily due to the lack of a strong social safety net, leading to a high savings rate for healthcare, education and retirement. Enhancing these supports could unlock significant consumer spending. China’s government is transitioning the economy towards consumption, but pension, healthcare and unemployment reforms face political and fiscal hurdles. We believe improving social welfare is also essential for China’s economy.

Sector opportunities

Meanwhile, China’s equity market appears historically undervalued and relative to its emerging markets peers. After losing more than US$6 trillion in market capitalization since early 2021, it risks becoming a value trap if fundamental issues aren’t resolved. At the same time, certain sectors, like electric vehicles, renewable energy, robotics, healthcare, services and tourism, may enjoy strong tailwinds.

Fu Shou Yuan: A case study in market potential

An example is Fu Shou Yuan (1448 HK), a leading private provider of deathcare services that we hold in our Emerging Markets Small Cap Fund. Operating in 46 cities across 19 provinces, the company targets the premium market in a highly fragmented and regulated industry forecasted to grow at a 9% CAGR and reach US$56 billion by 2026, according to Goldman Sachs. Fu Shou Yuan’s extensive land bank, expertise and reputation position it to continue consolidating the market through tuck-in acquisitions and public-private partnerships.

China’s future amid the 3Ds

In the short term, investors in China are anticipating more impactful stimulus measures. We believe that for it to achieve sustainable growth, the country must simultaneously deal with its core structural issues and revive flagging consumer confidence.

Last week, the January edition of the BofA Global Fund Manager Survey was released. It featured 256 panelists who manage a combined US$669 billion in assets. The survey revealed a growing optimism about rate cuts and a macroeconomic “soft landing” despite increasing bearishness with respect to China. Among the many interesting findings, a few are particularly relevant to our focus:

• For the first time since June 2021, there’s a marked preference for small caps over large caps.
• A strong preference for high-quality investments.
• Overweight in countries compared to the average positioning of the past 20 years: notably the US and Japan.
• Overweight in sectors relative to the average positioning in the past two decades: predominantly in consumer staples, healthcare and technology.

While our last commentary covered global small caps in general, this week let’s take a closer look at Japan specifically. The positive sentiment towards Japan in the survey is in line with market trends. The Nikkei 225 Index was up 28% in 2023 and recently reached its highest level in 34 years, approaching a new record.

Factors driving this rally include a weaker yen, the end of deflation, wage growth and improved corporate governance. A decade ago, few companies had independent directors, but today almost all have at least a third of their board as independents. Institutional investors are increasingly voting down poison pills and supporting activism.

Source: GMO.

In 2024, we expect continuing financial reforms to attract more investors. Here are some new initiatives:

• January: Introduction of the revamped Nippon Individual Savings Account (NISA). Under Prime Minister Kishida’s new capitalism scheme, the NISA aims to boost household wealth through investment. The contribution limit has been raised and the tax-exempt period extended, allowing an annual contribution of up to ¥3.6 million (US$24,300) per person and a combined total balance of ¥18 million to be permanently tax exempt. As of June 2023, there were 19.4 million NISA accounts, a modest number considering Japan’s population. In contrast, Japanese households held a record ¥2,115 trillion in financial assets, with more than half of this amount in cash.
• January 15: Companies on the Tokyo Stock Exchange (TSE) began disclosing their capital efficiency plans. Thus far, 40% of firms listed in the TSE’s prime section have done so.
• April: Enhanced segment earnings reporting. In addition to quarterly earnings reports, listed companies will now only need to submit more detailed financial reports semiannually rather than quarterly. This change emphasizes segment reporting. The TSE will mandate that companies disclose earnings and cashflow for each business segment to improve transparency.
• November 5: The TSE will extend trading hours by 30 minutes to increase liquidity.

How have Japanese small caps been performing?

Since 2000, Japanese small caps have substantially outperformed large caps.

However, in 2023, they underperformed, with value stocks outperforming growth stocks. This trend was influenced by the TSE’s March 2023 initiative for sustainable growth and enhanced corporate value, leading to a renewed interest in large caps and companies with a price/book value below 1x.

Looking ahead, we believe strong fundamentals and valuations are likely to favour Japanese small caps over large caps due to:

1. Faster earnings growth: Bloomberg data predicts +20% EPS growth for the MSCI Japan Small Cap Index in the next 12 months compared to +8% for the MSCI Japan Index. EPS growth for the following 12 months is +12% for the MSCI Japan Small Cap Index and +10% for the MSCI Japan Index.
2. Cheaper valuations: The P/E multiple discount for Japanese small caps compared to large caps widened in 2023 to a sizable 3.6%, suggesting a potential mean reversion.
   
3. Reduced FX volatility: We expect the JPY to appreciate against the USD in 2024 in response to monetary policy in the US and Japan. Japanese small caps, which are more exposed to the stable domestic economy than large caps, should be less affected by currency fluctuations and may even benefit from a stronger yen via imports.

We believe the shift towards Japanese markets and small-cap stocks hints at something deeper than market fluctuations and could be indicative of structural changes and a broader reassessment of risk and opportunity. Moving forward, investors may need to view traditional powerhouses through a new lens and consider how different markets and different asset classes can offer new avenues for growth in a world where economic certainties are increasingly hard to come by.

Last week, the New York Times identified some pivotal themes set to shape 2024: elections, antitrust and shadow banking, painting a vivid tableau of the global investment landscape. Against this backdrop, over half the world’s population across more than 50 countries will choose their governments in 2024. The US is probably the most significant, but Taiwan’s on January 13 was also noteworthy in the context of the country’s tense relationship with China and its crucial role in the global technology sector and semiconductor manufacturing.

In antitrust, recent weeks have seen cancellations of deals such as Illumina and Adobe and losses in important cases for Google and Apple (with appeals underway). Many antitrust cases are expected to reach courts in both Europe and the US in 2024.

The shadow banking sector is also at the forefront, with prominent figures like Jamie Dimon of J.P. Morgan highlighting private credit as a potential harbinger of the next financial crisis.

Listen to Robert’s audio commentary:  

 

Small caps in 2024

Turning to our universe of global small-cap equities, our outlook for 2024 builds on our December 2023 comment. As you may recall, 2023 was marked by the dominance of US large-cap equities, particularly the “Magnificent Seven” technology stocks. To help provide a well-informed outlook for this year, I reviewed our previous commentaries, all of which are available on our website from the time our firm was established. They offer valuable context and background and I invite you to browse them for a fuller picture of our thinking over time.

Despite the incredible returns of the Nasdaq-100 Index and, consequently, the S&P 500 Index due to unprecedented concentration, these large-cap indices have not significantly outperformed small caps since 2000, even in the face of various global upheavals, including the tech crash, the Great Financial Crisis and the COVID-19 pandemic.

Defying expectations: Large-cap vs. small-cap performance since 2000

Source: Bloomberg.

2024’s market moods

Understanding market psychology is a good starting point for thinking about the year ahead. So, where do we stand today?

We view the Nasdaq 100 and, by extension, the S&P 500 as being in the “New Paradigm” phase. Meanwhile, small-cap, international and emerging markets equities are approaching the “Despair” phase. Question is, when and what will trigger a return to the mean?

The concentration conundrum

The S&P 500 is at its highest concentration ever, with the top-10 stocks comprising 31%. This is in contrast to the 35-year average of 20% and even exceeds the 25% peak during the tech bubble. A look back at the performance of US large caps following the era of the Nifty Fifty, which dominated the markets in the 1960s, these stocks subsequently underperformed from 1973 to 1982, realigning their multiples with the broader market.

From 2000 to 2010, US large caps lagged most other indices by a wide margin.

Another perspective to consider is that the US’s weight in the MSCI World Index is at an all-time high of 70%, far exceeding its 25% contribution to global GDP. This is a stark increase from approximately 38% at the end of 2000.

According to the Buffett Indicator, which measures the total market cap over GDP, we are currently at 174%, another record high.

Now that we have scared you about the US large-cap market, the question remains: why do we anticipate a return to the mean in 2024?

Unprecedented global events: a four-year retrospective

The last four years have been extraordinary. In 2020, we had the COVID-19 pandemic, followed by a global lockdown, things we had never seen before. 2021 was the year of the reopening, although a few countries like China reopened in 2022. We also saw the rise of inflation. Not so transitory as it turned out, although the supply chain shocks were. 2022 was the year of the great interest rate resets around the world and the end of free money. Rates were no longer zero. We also saw the war between Russia and Ukraine break out last February. 2023 could have been a more normal year, maybe marked by a slowdown or recession caused by the rapid rise in interest rates. Instead, the economy continued to be strong.

The overlooked factors of government spending and consumer behaviour

What did we miss? First, we missed the fact that governments around the world continued to spend enormously, while running huge deficits. The US, for example, ran a deficit for fiscal 2023 (October) of $1.7 trillion, $320 billion (23%) more than in 2022 and 6.3% of its GDP.

Second, we did not think Americans would spend all the excess savings they had built up during COVID-19.

Source of excess savings

Source: Federal Reserve.

Third, we did not anticipate the frenzy brought by the launch of ChatGPT and the narrative around generative AI.

Fourth, we did not anticipate such an aggressive Fed pivot while inflation is still running hot. Is the Fed seeing a market slowdown ahead?

Navigating new normals

So, what do we think is in store for 2024?

• The pandemic is over. Although COVID-19 persists, it is no longer seen as a flu variant. No more lockdowns. And companies in 2024 will stop the references to 2019.
• Interest rates have more or less reached a peak. Will they come down fast? We do not think so unless we experience a deep recession and even then, they will not go back to 0. That experiment failed and the central banks admit it. Will they go from 5% to 10% as they did from 0 to 5%? We believe absolutely not.
• Supply chain shocks have subsided. There are always supply chain snags, but what we saw in 2021 and 2022 is now behind us.
• The easy comparison for inflation is now over. Comparing 2023 prices to 2022 showed a big decline. Comparing 2024 to 2023 will not be so straightforward. We will realize that inflation is stickier. How central banks will react remains to be seen. See air freight rates as an example:

Source: Xeneta.

• The return of the bond vigilante: Those government deficits are unsustainable and the amount of government debt to be refinanced in 2024 is staggering. Governments will have to go back to austerity, possibly at the worst possible time if the economy slows down. We will also see income taxes rise, particularly for companies with high profitability and aggressive tax strategies.

• The lagging impact of interest rate increases: It takes about 18 months to see the full impact of interest increases. So, we will see the impact of increases for another year, even if rates come down quickly.

• A return to investment fundamentals: 2023 was brutal for many fundamental investors, us included. Dividend-paying companies underperformed non-dividend payers by the largest margin since 1983. Companies with strong balance sheets underperformed the weakest. Companies with low valuations underperformed those with high valuations.

• Emphasis on revenue and EPS growth: In 2023, steady revenue and earnings growth gave way to momentum and liquidity. A good example is Apple, which saw its share price increase 49% in 2023 despite a 3% revenue decline in FY 2023 (September) and no earnings growth. That share price increase was equivalent to close to a trillion dollars, the market cap of Australia’s, South Korea’s or Stockholm’s stock exchanges. We anticipate a different trend this year, with a focus on solid balance sheets to withstand shocks and higher interest rates and to take advantage of consolidation opportunities.

• There will be more M&A, both from strategic investors as well as private equity funds. A more stable operational and funding environment will be conducive to transactions.

• We may also see a return of individual investors in Japan now that the Nikkei Index is back to where it was in 1990 and the government is trying to unlock US$14 trillion of household savings by expanding the tax-exempt Nippon Individual Savings Account (NISA), allowing investors to buy up to $24,170 per year in stocks. Japanese households keep 54% of their assets in cash versus 35% in the euro area and 13% in the US.

Building trust through market cycles

For our clients who started investing with us between 2019 and March 2020, you will have experienced mediocre performance, even worse if you invested with us in spring 2020 or since March 2022. But likely satisfactory if you invested with us outside these periods.

Should you keep your trust in us? We believe you should.

Our portfolio management team remains the same. The five partners who manage our one portfolio as one team have been together for over 15 years.

We have added to our bench strength with five more analysts joining our developed market portfolio management team since 2018 and three more covering emerging markets.

Upholding our investment philosophy

Our philosophy remains the same. We believe:

1. Earnings growth drives stock prices.
2. Secular trends will support superior and longer-term growth.
3. A long-term investment horizon is key.

Our investment process is solid:

1. Add excellent investment ideas that meet all our criteria, including valuation and expected return, to an approved list.
2. Use the approve list to build a portfolio that meets client expectations and constraints.

The chart below shows some style factors since 2008. Our worst two years since inception have been 2020 and 2023. Unfortunately, this has impacted our one to four-year performance. As illustrated, those two years coincided with size (larger), beta (higher) and ETFs (passive flows) outperforming.

You will also notice that the number of years these factors underperformed greatly surpass the number of times they outperformed, forming another reason for our optimism.

Calendar year style factor returns

Source: Omega Point.

As we reflect on these trends and look ahead, it’s clear that the markets are in flux. We remain committed to adapting to these changes, always with an eye on long-term growth.

With this perspective, I want to wish you an excellent 2024. May the year bring health, peace and happiness to you, your families and your friends and colleagues!

Robert Beauregard

President, Co-Founder and Chief Investment Officer

*This communication may contain forward-looking statements (within the meaning of applicable securities laws) relating to the business of our funds and the overall financial environment in which they operate. Forward-looking statements are identified by words such as “believe”, “in our opinion”, “anticipate”, “project”, “expect”, “predict”, “intend”, “plan”, “will”, “may”, “estimate” and other similar expressions. These statements are based on our expectations, estimates, forecasts and projections and include, without limitation, statements regarding decreased fund portfolio risk and future investment opportunities. The forward-looking statements in this communication are based on certain assumptions; they are not guarantees of future performance and involve risks and uncertainties that are difficult to control or predict. A number of factors could cause actual results to differ materially from the results discussed in the forward-looking statements. There can be no assurance that forward-looking statements will prove to be accurate as actual outcomes and results may differ materially from those expressed in these forward-looking statements. Readers, therefore, should not place undue reliance on any such forward-looking statements. Further, these forward-looking statements are made as of the date of this communication and, except as expressly required by applicable law, we assume no obligation to publicly update or revise any forward-looking statement, whether as a result of new information, future events or otherwise.

As winter approaches, homeowners are confronted with the need to turn on their heating systems and the higher costs of additional heating. This winter, many US consumers will likely pay even more to heat their homes because of surging fuel prices and colder weather forecasts.

The National Energy Assistance Directors Association predicts increased winter heating expenditures across the board, with electricity up 1.2%, propane 4.2% and heating oil 8.7%. Natural gas is expected to be down 7.8%. Air conditioning and heating are by far the biggest sources of home energy use, comprising 51% of household energy bills. A main reason energy bills spike in winter is due to inadequate insulation.

This is where Installed Building Products (IBP) comes in – and why we’ve invested in this company. This week, we’ll share insights into our investment process and approach to selecting companies like IBP that we believe are poised to generate shareholder value.

Who is Installed Building Products (IBP)?

Founded in 1977 and based in Columbus, Ohio, IBP is one of the largest insulation installers in the US. In the late 1990s, the company embarked on an ambitious acquisition strategy to expand its reach nationally. IBP went public in 2014, at which point it was generating $432 million in revenue with earnings of 2 cents a share. Last year, its revenue reached $2.6 billion with adjusted earnings of $8.95 per share.

Besides insulation, which makes up 60% of its revenue, IBP has diversified into complementary building products (waterproofing, fireproofing, garage doors, rain gutters and more) for both the residential and commercial construction markets.

Target market

• Combined single family and multifamily insulation market has a ~$6 billion total addressable market (TAM).
• Complementary products add another $4 billion TAM ($1.4 billion for garage doors, $1.1 billion for shower shelving and mirrors, $800 million for window blinds and $700 million for gutters).
• Amount of insulation per home is increasing due to a greater focus on energy efficiency and stricter energy codes.
• IBP’s largest competitor is TopBuild (they each rank #1 or #2 in different markets).

IBP has a cost advantage

Industry suppliers lack power. The fiberglass insulation manufacturing industry is highly consolidated, with four players accounting for all sales (Owens Cornings 40%, CertainTeed 20%, Knauf 20%, Johns Manville 20%). While the supplier concentration would suggest high pricing power, insulation manufacturing is a capital-intensive business with high fixed costs. Ovens cannot be easily shut on and off. As a result, manufacturers are incentivized to run their lines at high capacity to cover their fixed costs and get leverage. This makes the industry more competitive despite its concentration. Given IBP’s scale, it can buy insulation foam at a larger discount than smaller competitors and save big on costs.

IBP’s growth strategy

• Organic growth is achieved through increasing penetration in developing markets.
• On average, an established IBP branch generates ~$4,400 per residential permit versus $2,200 for a new developing branch.
• Inorganic – M&A is part of IBP’s expansion story and it aims to acquire ~$100 million of revenue annually.

Strengths

• Leading positions in insulation installation, with a 28% market share up from 5% in 2005.
• M&A has been a part of its growth strategy since 1990.
• Scale = ability to buy product cheaper than smaller competitors.

Weaknesses

• Distribution arm is relatively small when compared to peer TopBuild.
• No centralized ERP = branches could be competing for the same business.
• Complementary products have lower margin due to current lack of scale.

Opportunities

• Complementary products.
• Capacity to penetrate developing markets.
• Increasing residential building codes = higher revenue per unit.

Threats

• Weakness in US residential markets.
• Current supply constraints cap organic growth.
• Supply shortage (COVID-19 period) or explosion/fire at a supplier plant (2018) can temporarily increase cost of raw material.

IBP management

IBP’s management, led by CEO Jeff Edwards since 2004, is a key part of the business’s success. Edwards, who joined the company in 1994 and became chairman in 1999, is one of its largest shareholders.

When we first spoke to Jeff and he walked us through how he built the business, we quickly realized he was a visionary leader with a solid plan for future growth.

He told us how he saw potential in the niche sideline of foam insulation. His rational was simple: every home, every building, needs insulation. He was not looking to reinvent the industry, but rather focused on delivering the best service to builders while acquiring successful businesses in various cities. The sales pitch to targets was also simple: being part of IBP means they can do what they like and not be bogged down by functions that aren’t core to their business, like insurance, human resources, accounting and payroll.

In 1994, IBP made its first acquisition with Freedom Construction in Columbus, Ohio, followed by several more in the ensuing years. The rest as they say is history.

Unseen value beyond the walls

Investment potential often lies hidden in plain sight, like the insulation in our walls. IBP has all the characteristics we look for in an investment: a small-cap company with what we believe to be tremendous growth potential with low debt, rapid revenue and earnings growth compared to its industry, and strong management.

Insulation may not be exciting, but not only does it conserve energy and reduce bills, it also represents a notable sector in our investment landscape. How often do investors overlook the potential in the ordinary and what opportunities might we uncover by paying closer attention to what others may miss?

2024 is shaping up to be a historically significant year for elections, with around half of the world’s population having the opportunity to vote. An estimated 76 countries will hold elections in 2024, including eight of the 10 most populated (Bangladesh, Brazil, India, Indonesia, Mexico, Pakistan, Russia and the US). Europe will witness the most election activity, with 37 countries voting, followed by Africa with 18.

US elections: The world watches

The US election in November, when voters will choose the next president, the entire House of Representatives and a third of the Senate, is expected to dominate headlines. The most likely scenario is a rematch between President Joe Biden and Donald Trump.

The shifting focus of Europe’s political landscape

The European Parliament elections are in June and the topic of migration will likely be at the forefront of debates. If current trends persist, the EU could see the highest number of asylum applications since the 2015-16 refugee crisis. Once thought of as a solution to labour shortages, migrants are increasingly being viewed by some European politicians as a security threat, despite ongoing worker shortages. This could lead to a meaningful political shift toward stricter immigration controls.

Dutch elections: A sign of the times?

The Netherlands’ snap elections on November 22 were perhaps a glimpse of what is to come, with the far-right Freedom Party led by Geert Wilders winning unexpectedly. No party achieved more than 25% of the vote, necessitating coalition talks that could stretch well into 2024. In addition to a strict stance on immigration, the Freedom Party campaign included higher taxes on banks, which negatively impacted Dutch bank stocks the following day. However, the Amsterdam Stock Exchange remained stable after the election due to the pending coalition formation.

Poland’s election results as a market catalyst

Poland’s October elections saw a major upheaval, with the long-ruling nationalist party being replaced by pro-Europe parties, lifting Polish markets the following day.

From voting booths to market trends

That is not to say all elections wield the same influence. Russia’s elections are unlikely to challenge Vladimir Putin’s stronghold. Brazil and Turkey will hold local or municipal elections, while the EU will elect its next parliament.

India, the world’s largest democracy, is likely to see Modi’s party re-elected in May despite some recent discontent. Indonesia will also hold elections early in the new year.

Taiwan’s January elections, important for their geopolitical implications, are expected to see the pro-independence party maintain control. It remains to be seen how the country’s relationship with China will develop from there.

Understanding the election effect on markets

US Bank reports that the S&P 500 Index typically experiences lower returns due to investor uncertainty before US presidential elections, with stronger returns in the following year regardless of the election outcome. Notably, returns tend to be higher when an incumbent party is re-elected and when one party wins decisively, suggesting larger policy changes.

Investing smart in election years

We believe our diversified portfolio is especially critical in periods of uncertainty. Election outcomes can heavily influence economic policies, affecting taxation, regulations and economic reforms. These changes have the power to shape various sectors and industries in profound ways. Safeguarding your investments by diversifying across different securities and industries is a wise strategy.

The role of quality companies

Quality companies that demonstrate enduring strength, guided by capable management and driven by long-term secular trends are well-equipped to weather the market’s ups and downs. Their resilience and adaptability often become key to their sustained success, offering a more grounded perspective for investors looking beyond the immediate horizon of shifting politics.

The US commercial real estate (CRE) sector is experiencing heightened concerns due to increasing interest rates and diminishing credit availability. In the third quarter, US banks faced challenges from the CRE loans in their portfolios. For instance, Morgan Stanley allocated an additional $134 million for credit losses, in addition to the $161 million provisioned in the previous quarter, attributing this to worsening conditions in the CRE sector. Bank of America saw its nonperforming loans surge by $707 million, reaching $4.8 billion in the third quarter, driven primarily by CRE.

While it might seem like the entire sector is facing turmoil, it is important to note that CRE includes a wide range of assets. Segments like industrial, retail and hotels remain relatively stable, whereas offices spaces are facing substantial difficulties.

JLL reports that the US office vacancy rate has soared to 21%, a peak not seen in over 25 years as of Q3 2023. The imbalance between supply and demand is reflected in the 18.3 million square feet of negative net absorption, contributing to an annual total occupancy loss of 51 million square feet, although the vacancy rate differs significantly between the high-quality segment of the office market and the more obsolete ones.

Furthermore, the Trepp CMBS Special Servicing Rates for offices, which tracks the share of loans at risk of default, surged to over 8%, the highest since May 2017. This increase suggests more challenges ahead.

The sector also faces a huge refinancing hurdle. From 2023 to 2025, nearly $1.36 trillion in CRE loans will mature, a quarter of which are collateralized by office properties. Even with prevailing rates, new lending rates are likely to be 3.5 to 4.5 percentage points higher than existing mortgages.

The combination of high vacancy rates and rising interest rates complicates refinancing efforts. Lenders and CMBS investors have significantly tightened underwriting standards, pushing the loan-to-value (LTV) ratio to around 53%, the lowest in 23 years, and well below the historical average of around 65%.

This shift and higher financing costs could devalue office properties by around 20% for prime buildings and over 60% for lower-quality ones. While public market valuations are resetting, the private market has been slower to respond. A narrowing valuation gap between these markets is expected as risks persist.

The increase in office landlords defaulting on loans is concerning, with some properties falling below their mortgage values, prompting landlords to surrender properties to lenders. Even leading office owners like Pacific Investment Management Co. and Brookfield defaulted on their mortgages earlier this year. Most landlords have managed to maintain their mortgages due to typically long-term office leases, but as more mortgages come up for renewal, we expect an increase in defaults.

The typical capital structure in CRE is around 30% to 40% equity and 60% to 70% debt, with banks owning around 60% of the loans. Therefore, there is concern that the challenges in the CRE, especially the office sector, may trigger another banking crisis.

The basic problem is an oversupply of office space. Solutions like converting office spaces to residential use are being discussed, but only 10% to 15% of US offices are suitable for residential conversion. Government support may be necessary to incentivize and facilitate these conversions. Cities like Boston, New York, Washington DC, Chicago, Portland, Los Angeles and the Bay Area have already started incentivizing office conversions since the pandemic.

In our portfolios, we hold a few positions with exposure to commercial real estate:

IWG, which we talked about in a recent commentary, is the world’s largest provider of workspace solutions. While the growth outlook for traditional offices is in question, demand for flexible workspace has been growing, driven by the structural growth in flexible and hybrid working. Higher vacancy rates at office buildings also allow IWG to negotiate better lease terms with landlords. With a major competitor WeWork fading out of the landscape, IWG is well-positioned to expand its network.

Savills, established in 1855, is a leading global real estate advisor with expertise in various segments including residential, office, industrial, retail, leisure, healthcare, rural and hotel property, and mixed-use development schemes. Its revenue is diversified, with 40% from transaction advisory (30% commercial, 10% residential), and 60% from stable segments like investment management and property management. Despite a decline in transaction advisory business in the first half of the year, revenue growth in property management has kept its business relatively stable. Savills generates over 85% of its revenue from the UK, Asia Pacific, Continental Europe and the Middle East, with less than 15% from North America. Office occupancy rates are higher in Asia Pacific (79%) and Europe (75%) compared to the Americas (50%), suggesting less distress in these regions. Savills has a strong balance sheet to weather the current turbulent times.

The hotel sector, while hit hard during the pandemic, is recovering faster than offices. With international borders reopening and a surge in travel demand, hotel occupancies, especially in cities like London, New York and Tokyo, are improving and contributing to a strong investment outlook supported by fundamental performance.

Melia Hotels, a major holding in our strategies, is seeing strong bookings and improvements in occupancies and RevPAR. The company operates 350 hotels, with nearly 92,000 rooms globally. Despite its quality assets, it is trading at a significant discount to its net asset value, but increasing transaction volumes in the industry at higher multiples may reduce this discount.

We recently initiated a position in Hoshino Resorts REITs (HRR). Sponsored by Hoshino Resort, HRR has an extensive hotel portfolio, including upscale resorts and city hotels. Its flagship hotels managed by Hoshino Resorts show a strong recovery, with RevPAR 20% above pre-pandemic levels.

Despite ongoing challenges in the CRE industry, we believe the resilient business models and strong balance sheets of the companies in our portfolios will help them navigate these difficulties.

Within the emerging market universe, plenty of ink has been spilt on extreme pessimism regarding China and over-the-top optimism around India. Yet, as the following chart shows, small-cap stocks in Mexico have quietly been a top performer in the post-pandemic period.

Mexico’s unforeseen rise 

Growing tension between China and the US has positioned Mexico as an unintended beneficiary due to its geography and the trend among companies to shock-proof their supply chains through nearshoring.

Will this time be different? 

As noted in an earlier weekly, we recently met with companies across various sectors in Mexico and most of the executives we spoke to seemed convinced that the nearshoring wave was sustainable while also being realistic about the challenges ahead.

They have good reason to be pragmatic. The last time the economic stars aligned for Mexico via NAFTA (North American Free Trade Agreement) in 1994, the country delivered mediocre growth of around 2% and watched on the sidelines as China took full advantage of a shift in manufacturing from the West. The question now is if the outcome will be any different this time. 

The nearshoring challenge trifecta 

Mexico’s ascent as a key supplier to the US can be traced to three key events: Trump’s tariffs on China in 2018, the US-Mexico-Canada Agreement (USMCA) that raised the bar for North American product content requirements and pandemic-induced supply chain disruptions. These factors, coupled with deteriorating US-China relations, have led to Mexico surpassing China as a supplier to the US this year.

However, as emerging market investors, we know that structural tailwinds that are attractive and advantageous today don’t preordain good outcomes. Our conversations with Mexican executives at the recent LatAm conference gave us a good reality check on the constraints they face on the ground, from infrastructure and water supply to the political climate. 

Electric dreams, grounded realities

While Mexico generates sufficient power, it struggles with inadequate transmission infrastructure in its north that hinders industrial growth. We spoke to two industrial REIT developers that had to build their own power systems, passing those costs to customers. For perspective, Mexico’s state utility, CFE, built 150 kms of transmission lines in 2022 compared to Brazil’s Electrobras’ 8,679 kms. 

Parched prospects

Water availability is another constraint, especially in Nuevo Leon, home to the populous city of Monterrey and the large, water-hungry beverage industry that includes Heineken and Arca Continental, one of Latam’s largest Coke bottlers that extracts billions of gallons of water under federal concessions. As recently as 2022, Mexico had declared a drought in the state of Nuevo Leon and yet Tesla plans to open a factory there.

The political maze 

The final speed breaker to the nearshoring story could be politics and a volatile security situation by the US border. On the political front, Mexico’s President recently demanded that airport operators in Mexico reduce their tariffs even though they were bound by law via a concession system instituted in 1998. In terms of security concerns, the cities of Juarez and Tijuana, while strategically located across the border from California and Texas, have a history of gang violence and cartels profiting from piracy and counterfeiting.

Mexico’s unique competitive edge 

Despite these hurdles, Mexico offers several advantages, including lower labour costs compared to China, a younger workforce and significant investment in GDP, particularly in nearshoring and public infrastructure projects. 

Unlocking nearshoring potential 

With plenty of natural resources, a faster lead time and shorter distance to market, we think Mexico can continue to benefit from current trends with some policy support. Our Mexican holdings offer three different ways to access the nearshoring theme. 

Grupo Cementos de Chihuahua (GCC MM) – Primarily selling cement in the US, GCC also operates in Chihuahua. It benefits from strong volume demand generated by the region’s growing industrial sector, particularly maquiladoras and warehouses near the Texas border. Recently, GCC expanded its Samalayuca plant and now supplies cement to about 85 projects in Northern Mexico, serving clients like Foxconn, Wistron and Pegatron.

Regional SAB de CV (RA MM) – Known as “Banregio,” this Mexican bank specializes in lending to small and medium enterprises, with a strong focus in Neuvo Leon, its home state and a big beneficiary of the nearshoring trend. With about 45% of its assets in the region, Banregio is poised to benefit from the growth of industries supporting multinational corporations relocating to Mexico, thanks to low credit penetration and an expected easing cycle.

Grupo Aeroportuario Del Centro Norte (OMAB MM) – OMA, managing 13 airports in Central and Northern Mexico, sees its largest traffic accounting for nearly half of its total at Monterrey Airport. Despite recent concerns about tariff cuts, we remain positive on OMA both for its exposure to nearshoring and potential for growth in its commercial business. The company operates six airports closely tied to nearshoring, covering 33.5 million square metres of industrial gross leasable area, about 35% of Mexico’s total.

A crucial crossroads 

The real intrigue lies not in what Mexico has already achieved, but in what it could accomplish moving forward. Will it leverage its current position to create a more diversified, resilient economy, or will it repeat the patterns of the past? As global dynamics continue to shift, Mexico could be a big winner and serve as a blueprint for other emerging markets navigating the balance between risk and opportunity.