AI, energy innovation and the UK stock market

David: This is FTSE Russell Convenes. In this episode we're going to talk about AI, energy, innovation and the UK stock market. I'm David Sol, your host and joining me today are Professor Constantine Yannelis, Janeway Professor of Financial Economics, Cambridge University, and Senior Investment Director from Aberdeen Investments, Thomas Moore. Welcome, gentlemen. Constantine, can I call you Constantine rather than professor? Constantine: Absolutely. David: OK, let's kick off with you. Can you tell us a bit about your work at the university what you teach and your field of interest? Constantine: Absolutely. I'm the Janeway Professor of Financial Economics at the University of Cambridge. I'm also a fellow at Pembroke College. My research mainly focuses on how government policy affects credit markets. In a world with no information frictions and perfect competition the government can only do harm to the economy. Of course, we don't live in that world so there is a role for the government to step in and provide support both to businesses and individuals to help fix these information problems and competition problems. I focus particularly on when why and how the government should intervene in credit markets, particularly consumer and small business loan markets. I'm particularly interested in financing human capital. The biggest driver of economic growth today globally is innovation and human knowledge. I'm particularly interested in how the government should support financing education and the development of new ideas. David: Tom, you are a very experienced portfolio manager. We've known each other for more than 15 years. What do you do precisely at Aberdeen? Tom: Good to be here, David. I work in equities. We're active investors which means that we take positions based on our views. We have conviction in every position we take whether that's a big overweight position in the index or whether we're actually underweight a position we have views on everything. So that's what active investing means. It means taking conviction. We have over €50 billion in active equities at Aberdeen Investments. I'm part of a team of 110 people. We conduct 6,000 meetings every year. So we're taking views on each company in the index. David: And our index just to interrupt, that is the FTSE All-Share. So that's your benchmark. You use that as a reference rate and relative to that benchmark you'll go overweight or underweight depending on your conviction. Tom: Exactly. So that's important for us because our clients want to be able to judge us at the end of each time period whether it's one year or three years or five years how much value we are adding. Of course, we have different outcomes for different types of investors. We like to think client first. We like to think about how we can add value for the end client. This can include performance relative to the index but it can also include other outcomes such as income. I manage an equity income product myself. It's a listed investment trust, Aberdeen Equity Income. This is a product that achieves a high level of income. We look to achieve high levels of dividend growth over time as well. This is an outcome which can fit a particular type of client. We have other products such as small and mid-cap sustainable products and quality products. So you see we are thinking about the end client when we're putting a product together. By doing that we're looking to achieve some sort of outcome that will allow us to justify the fees we charge our clients. David: Constantine, you're going to talk about energy, innovation and AI. Why are these three points particularly important? Constantine: Today I want to focus on threats to the global economy and threats and opportunities in the global economy. I want to begin by talking about something a bit gloomy. What keeps me up at night in terms of the global economy and the number one thing in the short term is what we're all probably aware of. Unless you've woken up from a deep sleep for the past couple of years you've heard that the United States and Israel attacked Iran recently and this led to a large spike in global energy prices. Brent crude peaked at 138 dollars per barrel recently. This has the potential to throw the global economy into a recession. Higher energy prices could operate in a fashion similar to a tax lowering consumption and lowering consumer demand. We've had events like this in the past there was the great oil shock in the 1970s. We've had major recessions recently such as the great financial crisis and, more recently, the recession during the Covid-19 pandemic. Is this just run-of-the-mill nothing to worry about? I'm worried that this time is different and different in a very bad way. What makes today different from the past couple of recessions is governments' balance sheets in this country and indeed in many developed economies. In the past couple of recessions governments effectively have been playing the Keynesian stimulus playbook. I should mention Keynes, of course, was at Cambridge and is most closely affiliated with King's College where he spent most of his career. But he actually started at my college, Pembroke where he was the first director of studies in economics. He really started the study of economics at Pembroke. So it's big shoes to fill. The Keynesian playbook has been fine over the past couple of decades because governments had spare fiscal capacity but they just don't right now. According to the IMF, in the United States the debt-to-GDP ratio is 125%. It's around 100% in the United Kingdom. This might be OK if this was on a declining trajectory but it's not now. The IMF also projected that the deficit as a size of the economy would be 7.5% in the United States and 3.5% in the UK. If we're running these large deficits during good times we just don't have spare capacity. If there's a major recession and the economy shrinks these numbers will increase. Bond yields could spike, throwing us into a major recession. The other area where high energy prices are a major threat to the global economy is in throwing a wrench into this artificial intelligence boom that we're currently in that markets seem to think that we're in. We've seen that in the United States there has been massive growth in equity markets. Most of this has been driven by technology companies. The “Magnificent Seven” companies these technology companies like Nvidia, Meta and Google today account for more than 35% of the market capitalisation in the US markets. This is mainly based on the idea that AI is going to lead to massive productivity gains. This may or may not happen. You can talk to my colleagues in computer science who will know far more than an economist about the technology. But what I do know is that AI is tremendously energy intensive in terms of energy for computing power. I was recently talking to a hedge fund manager and they bought a single data centre in the United States that used more energy than the city of Birmingham. The estimates I've seen suggest that about 6% of all electricity in the US is now being used for AI compute, and that's projected to rise much further if we are indeed in this boom and companies like OpenAI and Anthropic grow very rapidly. Also, chip making is very energy intensive and relies on materials like oil for many of the components. So high energy prices threaten this major boom that we're seeing today. This is a real barrier to building in AI and also other industries like chip making or bringing manufacturing back to Britain. I was talking to a colleague of mine at the college Dame Clare Grey who is the founder of Nyobolt which I believe is the latest unicorn in the United Kingdom. It's a company with a valuation of over a billion that's producing battery technology. Essentially, this is a brilliant chemist at Cambridge who developed new and better technology for batteries. She mentioned that high energy prices are the single biggest barrier to growth for UK companies. A lot of that has to do with the electricity pricing system which links marginal pricing to natural gas in this country. David: How do you think we can lower energy prices? Constantine: A difficult question. This is particularly a problem in the UK which not only has higher energy prices than the United States but also continental Europe, and high energy prices in the UK really stem from the economics. It's not about renewables or the source. There's a system in the UK for pricing electricity that relies on natural gas for marginal pricing. When Russia invaded Ukraine in 2022 this led to a massive spike in electricity prices. This is really a tremendous problem if we think about bringing things to the UK like AI compute, chip making or trying to reshore manufacturing. Oil and natural gas prices are also very high in the UK. There's a view that I think is an economic fallacy, that preventing drilling in the North Sea will somehow be good for the environment. Actually, if we import oil and natural gas from the Persian Gulf or other parts of the world and consume that rather than domestic natural gas It’s actually worse in terms of emissions because we have to pay all of these transportation costs. We're just doing damage to the economy and doing damage to the environment by importing natural gas. If we want to lower emissions what we have to do is lower demand by making prices higher for consumers. Of course, that's very politically unpopular. So instead, there's a focus on banning drilling, which does nothing for emissions and is deeply harmful for the economy. David: Tom, what's your perspective on how capital markets can help with that transition? Tom: Part of the answer as well is about the network. The network of energy generation here in the UK hasn't been fully developed. There's a huge CapEx programme led by National Grid. National Grid is a stock listed here in London. It's the key network transmission mechanism for the UK and over in the US as well. It's about 50/50 between the UK and the US. How do capital markets play a role in all of this? Since we're here at the LSE, I thought it's actually a very important rights issue that National Grid did back in May 2024. I took part in this myself as did many of my colleagues. It was one of the largest rights issues of the past decade. Seven billion is a huge amount of money to raise. They have a CapEx programme over the next five years of 60 billion. This is a key part of the funding for that CapEx. What that CapEx will do is it will fast-track this investment that's absolutely necessary because if we're generating lots of renewable energy in Scotland, for example. In Scotland we have a lot of wind turbines. We can't consume all of that energy that's generated in Scotland. There's a mismatch between generation and consumption. So that needs to flow down to where consumption is taking place which is typically London and the south-east of England. That transmission network improving over the next five years will be key to becoming less reliant upon oil and gas, which is a key political ambition for Ed Miliband, for the government and previous governments. It's not really a party political issue. This is a key ambition to decarbonise the system. At the same time, if we could in tandem lower the cost of oil and gas and help the economy by allowing more domestic consumption and production to take place, this would be helpful as well. So really, if you look at other countries where energy sources are much more varied, such as China, and the success they're having in keeping energy costs down it’s because they've got multiple different sources of energy generation. I was pleased to take part in the National Grid rights issue. For me, this was a great advertisement for capital markets. What can we do to help the UK move forward and be part of this AI revolution? David: You're an investor in UK companies the theme is energy. How do you look at this from a portfolio management perspective? Tom: It's a key theme and we can think about it directly. In fact, if you're running a global equity mandate you have to be on top of the big US stocks because the US is about two thirds of the global equity market. Clearly, within the US market there are famously seven stocks – in fact, I think it's a few more than that now. I think it's ten stocks, many of which are now reaching this enormous market capitalisation. some of them have got to one trillion dollars of market cap which is enormous. Now of course in the UK we don't have that same penetration of technology companies in our index but we have stocks that will power this AI revolution. For me it's not so much about being an expert on technology companies but it’s thinking about the second derivative. It's thinking about which companies will enable this revolution to take place. There are lots of those companies. You have to think a little bit tangentially. You have to think about joining the dots. Which companies will allow this to proceed here in the UK and here in Europe? This throws up all sorts of questions. To what extent is this CapEx boom sustainable? There's a new thrust this year. People had doubts last year about sustainability because there are a lot of assumptions on what kind of revenue growth these companies will achieve and also how much cash they will generate. Typically people will feed a CapEx boom but at some point they want to see what the return on all that investment is So we're having to take a view on that as well. This will be a key driver of how sustainable this trend is. In the UK, unlike in the US it's more of a the companies that are the picks and shovels of the AI boom. David: You invest in dividend stocks you have income funds. What type of companies or sectors do you look for that fit in this story for income producing stocks? Tom: Income-generating stocks typically are more established names. London has been the home of many companies over decades. In fact it's got a rich history as the UK as a trading nation partly why we are home to so many interesting companies from all around the world. If you think about the mining sector what's interesting to me is the number of mining companies now that are popping up on screens of stocks which are part of this AI revolution. Of course that makes sense because in order to manufacture the chips we are going to need the physical commodities that will power that. Interestingly we're seeing not just earnings growth but we’re seeing evaluations the multiples that people are willing to pay for mining stocks is also increasing. that is one sector which is a key beneficiary. It's a big sector here in London. We also have energy companies meaning not just oil and gas which is a separate part of that system but also energy companies, meaning electricity companies. The companies that generate electricity the companies that transmit the electricity through networks all of this is part of the important revolution we're now seeing. David: Constantine, one of the points you're making is that there needs to be closer cooperation between the world of academics and the corporate world to foster innovation. What's the thinking behind that? I absolutely agree and picking up where Tom left off you have all of these companies that he mentioned many of them came out of top universities in the UK particularly Cambridge. You just mentioned energy for example Octopus Energy. That was another company to come out of my college, Pembroke which you usually think of utilities as being boring and not that profitable. But these entrepreneurs built a company creating money by doing good lowering bills for consumers and lowering emissions. Talking about AI, there was a wave which rather than using hard-coded rules it’s using artificial intelligence in creating programmes for self-driving cars. This was founded by Alex Kendall and Amar Shah who are Cambridge graduates and the company was set up in London. This has the potential to scale self-driving without going through a lot of rigorous grunt work in terms of developing rules and the like. So I think there's a lot that can be done In the United States about two thirds of venture capital goes to the San Francisco Bay Area. This is because of Silicon Valley. and Silicon Valley has benefited tremendously from two great universities there. I did my PhD at Stanford and my brother-in-law went to Berkeley. So it pains me to say it's also a great university. Just as it's painful for me to say that Oxford is a wonderful university. But I think that in Europe the Oxford–Cambridge corridor is the natural place to replicate Silicon Valley. A lot is needed for that One, better transportation links and building rail between Oxford and Cambridge. Two, deepening capital markets and providing more support for companies to scale. I think AI is a perfect example of this. Where did AI really start? Again Cambridge, Alan Turing. If we think of the first private company to try to take AI to the market it was DeepMind founded by Demis Hassabis who went to Queens' College, Cambridge and then did postgraduate work at Imperial. DeepMind is now Google and it was sold for a paltry half a billion. Whereas today Anthropic and OpenAI have evaluations near or even above a trillion. I agree, there are many great companies in the UK but as Tom said they're producing the picks and the shovels where they could have really been leading this. I was reading about the acquisition of DeepMind. What happened was that Meta and Google figured out that this was going to be the next big innovation and they started throwing money at DeepMind engineers. Perhaps if they had more access to capital Hassabis and the management team could have responded rather than being acquired. David: This has been a fantastic discussion about AI innovation and linking the world of portfolio management with that of academia. I'd like to thank you. Thank you, Constantine. Constantine: Thank you David: And thank you, Tom for this fantastic discussion.