The Capital Call

David Stevenson is an experienced investment commentator and writer, with a passion for media and technology. David writes for a number of leading publications including The Financial Times, where he is a columnist, the Investors Chronicle, Money Management and trade newspaper Investment Week, where he’s the contrarian columnist.

Dusting off the 2022 crystal ball

January 4, 2022

Now that Christmas is out of the way and 2022 is heaving into view, the inevitable temptation is to dust off that crystal ball and start to wonder out loud about what might happen in the coming year which is exactly the time at which I usually tend to run a mile, largely because my ability to predict the future is utterly lamentable. But what we can, with some caution, anticipate are the big debates that will continue to echo through into the new year.

I suppose one must start with the question of what will happen to rates – inflation and interest rates. Talk to any market observer and I’m sure they’ll have a view on inflation rates which are currently surging across the Anglo-Saxon world. I was in Team Transitory but it’s clear we were wrong, and the US and the UK have a much bigger problem with inflation than we first thought. But I wouldn’t get too carried away with the seductive argument that we’re about to return to some 1970s inflationary nightmare.

A large part of the surge in retail prices is based on energy prices and at least as regards this surge there’s an arithmetic iron law about to emerge. As UK-based strategist Joachim Klement at investment bank Liberum observes “to keep energy inflation at current levels we would have to see Brent crude oil prices rise to all-time highs in September 2022. Even if crude oil prices remain above $100/bbl. for the coming year, energy price inflation would half from 9.3 percent today to less than five percent while headline inflation would drop to 2.1 percent.”

As for wage pressure pushing up inflation expectations, I’d also be a tad cautious. We are in an entirely new world of collective wage bargaining compared to the 1970s, when governments anxiously watched national wage negotiations as they fuelled a surge in wages as a result of collective bargaining deals. Most of these deals in the private sector have long gone and the unions are a pale shadow of their former selves.

As The Economist’s Duncan Weldon has pointed out, borrowing on a note by US Federal Reserve researcher Jeremy Rudd, “outside of a few unionized industries (which now account for only about six percent of employment), a formal wage bargain—in the sense of a structured negotiation over pay rates for the coming year—doesn’t really exist anymore in the United States. In a world where most employment is “at will,” changes in the cost of living will enter nominal wages as part of an employer’s attempt to retain workers: if employers pay their workers a wage that falls too far behind the cost of living, they will start to see more quits, which will in turn force them to raise the wages they pay to existing workers (and those they offer to new hires). But there is no real scope for direct negotiation”. My guess is that these structural developments will significantly blunt any wage inflation spiral and thus help moderate inflation expectations as we head towards 2023.

What’s rather more predictable is that interest rates in the US and the UK will rise. If I had to wave a finger in the (cold) air, I’d suggest we’ll see US interest rates at 1.5 percent by the end of 2022/mid 2023 with the UK probably at between one to 1.5 percent. More to the point I think the chances of interest rates in either country moving above two to 2.5 percent are next to zero, that is unless we do feel the full force of the much-hyped inflationary wage spiral.

My logic is based on simple macro-economic observations: governments cannot afford to pay too much on their debt and central bank finances would be on thin ice if rates rose too fast; globalisation is far from over and is still, along with technology, exerting a downward pressure over the long term on prices; and last but by no means least, there’s still a glut of excess savings globally which needs to find a home in ‘safe’ currencies such as the dollar.

Of course, many will disagree with this analysis, but I think if you accept that we are still in a low rates environment – by central bank design – then I also think you need to accept that the central economics underpinning the current bull equity market trend are still in place. Put simply, low interest rates inflate the equity risk premium, and make equities an attractive asset class. Markets may wobble and blow up every once in a while, but I currently see no real alternative to equities as a home for risk capital. That will underpin market valuations. The old ‘average’ price to earnings ratio of between 15 to 20 is now 20 to 25, while growth stocks can be regarded as fair value if their PEs are between 25 and 40. That, I think, underpins the surge in interest in digital infrastructure stocks.

Moving beyond the gyrations of financial markets, I’d pick out three structural developments worth watching in the digital infra space: measures of carbon intensity; the battle over the last mile; and cybersecurity for critical digital infrastructure.

The US government may be struggling to get all its carbon reduction plans through the Senate but Europe is racing ahead aggressively. The new German government will be at the forefront of an intensive push to measure carbon emissions and attach those numbers to an increasing array of corporate ESG benchmarks which will turn be regulated by state mandate. The centre piece will be a series of carbon emissions per share/carbon emissions per business unit measures on their way through the statute book.

The logic behind these changes is laudable – voluntary disclosures of carbon emissions are patchy and ESG measures vary wildly by data provider. Legislation mandating benchmarks will standardise these measures. But the underlying agenda is much more radical. Rather than measure direct emissions, the real intent is to see through the business product cycle to measure the true sustainability of a product or service over its life span. This move will catch the digital infrastructure space and especially the data centre providers – they’ll be forced to measure and publish the true impact of their services on the environment with carbon taxes as one likely long term imposition based on these impact measures. This will, in turn, fuel ever more demand for data centres to invest in energy efficiency and renewable power sources.

The good news for these data centres – as well as tower co providers and alt nets – is that demand for their services will keep exponentially increasing because of all the new technologies coming along the track. I’m inclined to skate over the grand technological claims offered up by enthusiasts for 5G and the metaverse. I don’t doubt that big changes are coming for both, but I sense that 2022 is yet another of steady development with no big headline developments – unless of course Apple finally reveals those augmented reality glasses.

No, I think the more interesting story is last mile fibre and broadband solutions. The move to work from home isn’t going away and that places a spotlight on those last mile technologies – arguably at the expense of building ever fatter, faster inner-city connections. In this regard I think that the current suspense around the fate of UK based BT Group is fascinating, with big, acquisitive European shareholders prowling the share register.

BT is I think a test case for how a boring, stodgy old fashioned fixed telco can turn itself into a digital infrastructure asset by investing huge amounts of money – at the expense of its shareholders – into last mile fibre solutions. After much derision, BT is really making progress at connecting up the suburbs and exurbs – my own home, which is a good few miles from the nearest suburban exchange, has just been linked to fibre to the home (at speeds much faster than my son at university in a big city, much to his horror). In parallel, BT looks like it’s still trying to jettison previous projects such as its Sports TV channel, thus giving greater clarity to its move back into infrastructure. On this score I think Charter Communications is the telco leviathan to watch in 2022.

The US government’s digital access policies will increasingly echo those of the UK – increasing public investment in the last mile. Next up, I’d expect the new centre left German government to lean in heavily into the digital divide and last mile policies – broadband connections in Germany are surprisingly dreadful. Stepping back from the detail, I think we can see a big capital push to invest even more money into the last mile across the developed world, aided by governments, but funded largely by private capital. Private equity won’t be far behind, and we should expect the pace of PE deals in alt net land to increase.

My last prediction is arguably the most obvious – that ever more scrutiny will be placed on essential digital infrastructure and its national security implications. The driver for this may be one of the existing rogue states. A zero Covid policy in several states has resulted in some regimes becoming more desperate to a) make news and b) make money by carefully selected cyber-attacks. My money would be on a carefully staged attack on a key piece of digital infrastructure in the West, designed to register BELOW the level of military threat but big enough to cause a fuss and make money for the hackers. For me that spells taking down a key piece of digital infrastructure for a short period of time. The bottom line though is that providers of key infrastructure will need to spend ever more money to protect these increasingly strategic assets.

Previous Columns from David Stevenson