Have you ever stopped to imagine what would happen if the world's central banks spent just over a decade pouring USD 25 trillion of liquidity into the economy, with more than 60% of that liquidity created in the last two years?  If you are like the overwhelming majority of people, the answer is almost certainly no. The good news is you don't have to imagine as this is precisely the situation we are in today.  In this article, we assess what has happened and provide some thoughts around how investors should navigate the next phase of the greatest financial experiment of all time.

USD 25 trillion is almost an unimaginable amount of money so what has happened to all of this liquidity?  Well, rather inevitably, a lot of it has found its way into asset markets.  The value of almost everything has gone up - considerably.  From wine to whisky, growth stocks to digital gold, the returns to asset owners have been extraordinary since the depths of the financial crisis in 2009.  Younger generations have gone from occupying Wall Street to trading Bitcoin on margin and buying meme stocks on trading platforms as if it were a video game.  Old people "just don't get it" and lack the imagination to see just how enormous the returns will be.

Make no mistake, there are many aspects of this that have the trappings of a bubble.  This is nothing new.  In late 1636 in the Netherlands, the Viceroy tulip bulb sold for four fat oxen, eight pigs or 12 fat sheep.  As many bulbs flowered in 1637, prices crashed and by early 1638, the government decreed that tulip contracts should be annulled in return for the payment of 3.5% of the original price.

There are many examples of financial speculation littered throughout history and interestingly several of these are also linked to technological innovation.  Investors in railway bonds in the 19th century enabled the construction of vast networks in Europe and the US which enhanced productivity and had a huge impact on the way people lived and worked.  Investors in railroads typically made little profit however, and most of the long-term gains were arguably made by the businesses and people in cities which grew up as a result of their newly connected status.

The dot-com internet bubble of the late 1990s had a very similar story at its heart.  Investors in the companies who built the internet networks and operated them thereafter either lost everything or made very poor long-term returns.  The real beneficiaries of the networks created in the bubble were businesses like Apple, Google, Facebook, Netflix, and Amazon*, who used those networks to sell us the products and services that meant we got the most out of them.  They were effectively the hotel at the end of the railway line which stood to gain the most from the passengers arriving on the newly constructed network.

Is there a bubble today and if so, where is it and how can we expect things to pan out from here?  The first thing that strikes us is investors' have very long-time horizons and the second is the sheer number of companies that are forecast to make significant losses for the foreseeable future.  This is dangerous.  The future is highly unpredictable, and far more things can happen than actually will happen.  For example, if you were asked in 1969 what would be the greatest innovation in 40 years' time, you'd be forgiven for answering that humans would have colonised space and we would all be going on holiday to Mars (given Neil Armstrong had just set foot on the moon).  Instead, the reality in 2009 was that the Apple iPhone was being rolled out which effectively placed the sum of all human knowledge in your pocket.  We should be wary of people selling us a version of the future based on science fiction rather than practical and applicable facts.

This unpredictability makes today's stock market dangerous. If a company asks investors to think 20 to 30 years out to generate a profit, and forecasts losses and cash flow burn for the foreseeable future, then be careful.  The dramatic unwind playing out in markets is the first phase of these time horizons shortening as central banks withdraw the liquidity which has fuelled this excess.

Given the dangerous nature of these speculative businesses experiencing heavy losses and cash burn, what should we do from here?  For us, understanding the drivers of cash flows and the returns on investment made by the companies we invest in is critical to the long-term health of our portfolio.  By investing in businesses with strong competitive advantages who remain disciplined around capital allocation, we aim to find the next set of 'hotels at the end of the railway line' that will benefit from the new activities created by this latest bout of speculative excess.

If lesson one is to avoid loss-making, cash-burning businesses chasing a pipe dream of market share, what next?  In our opinion, lesson two is "beware the wolf of cyclicality wrapped up in the sheep's clothing of growth".  The journey from a growth stock to a value stock can be damaging to your financial health.  It strikes us that in industries such as digital advertising, investors may be mistaking a maturing industry that has seen a pull- forward of demand for one which still offers enormous secular growth.  The pandemic saw an enormous amount of liquidity added to the system, and many speculative businesses received funding and/or very high valuations which they may not have otherwise.  It's worth noting that a number of these new companies' costs (after generous option packages for senior staff) are spent on IT infrastructure and services, as well as digital advertising to gain market share.  When you add in the pull forward of time spent at home/online for consumers in the pandemic, and inflationary pressures, it is perhaps no surprise that digital advertising in all its forms may face a more challenging outlook over the next few years.

Navigating choppy waters

If we have established a few things to avoid, the obvious question remains around where are the opportunities?  In our opinion, there are many businesses that have been left behind from the speculative excess of the last two years because their businesses have been negatively impacted by the pandemic which offer opportunities.  In the provision of home nursing care and patient rehabilitation for example, companies such as LHC group and Encompass Health have suffered from dramatically rising costs due to a shortage of nurses exacerbated by the need for staff to quarantine following exposure to COVID-19.  As the pandemic ebbs, the staffing situation is expected to normalise, and we see these companies benefitting from improving pricing as the Centers for Medicare and Medicaid Services (CMS), a US federal agency that administers the Medicare programme, has affirmed reimbursement rates which begin to take account of these near-term challenges.  This should position these companies for a better 2022 while many in the digital advertising industry may face exactly the opposite scenario.

Another area we feel remains underappreciated is in the provision of contract catering.  Punished by stringent lockdowns and a shift away from office-based working, many of these businesses were forced to raise capital and adapt quickly to a very new reality in the pandemic.  As healthcare providers, schools and universities grapple with rising costs and labour shortages, they are now outsourcing their catering operations at a record pace and the pipeline of new business for a company like Compass has never been better.  Also, consumption at stadiums where the firm has many concessions is booming as people make the most of attending live sports and cultural events.  These businesses are reinvesting for structural growth, but many investors perceive them to be too old hat to be interesting.  'Boring' improvements in return on capital might be just the menu item investors should choose in what may continue to be a challenging 2022.

Valuation rationality and margin for safety

We have highlighted that we have been experiencing some speculative excesses within parts of the equity markets for some time, and there have been some clear parallels to historical bubbles. Our philosophy is focused on compounding clients' capital over time rather than being a slave to the shorter-term gyrations of the market. We focus on the following:

• Investing only in companies that can grow and sustain high returns on invested capital is the best source of long-term superior returns. The path of sustaining, or even better improving, returns on capital tends to be dictated mostly by an individual company's unique franchise and its management team. In most cases our Future Quality investment case is not dependent on shorter-term economic cycles.
• Valuation is one of our key pillars, as the pricing of future growth can sometimes swing notably towards high pessimism or optimism and therefore justify either larger weightings or the exit of a position in favour of better ideas.

The latter point has been more relevant for portfolios in the last 12-18 months, as we have been in a period where easy monetary policy has encouraged investors to price future growth very generously. This has resulted in reductions in some holdings or a complete exit on valuation grounds, with the proceeds recycled into Future Quality companies that have better valuation support. We are comfortable paying a premium for companies that deliver better and more consistent growth, can attain, and sustain high returns on invested capital and have strong balance sheets - but that premium needs to be appropriate and fair. The following history from style analytics confirms that we have stuck to that discipline.

Chart 1: Cash Flow Yield

Source: Style Analytics as at 31 December 2021

We believe we have entered  an unknown period of tightening liquidity, with the evolution of supply-related inflationary inputs and central bank responses remaining the dominant drivers for returns from and within equities as an asset class. History would suggest that following an unwind from periods of excess, the prior winners typically don't regain leadership again. Given the lack of profitability of many companies that some have described as 'concept finance', this makes sense, as over the long term the delivery of cash flow and growth is the key determinant on share prices.

Chart 2: Group Median Market Implied Yield (MIY) Spread vs Market

Source: Credit Suisse HOLT, Data date 2/4/2022. Universe: Top 2000 Global companies by TTM Market cap. Market Implied Yields for Financial firms on the HOLT CFROE model are trimmed by 150 bps throughout this analysis to preserve comparability.

Chart 2 highlights that the growth versus value debate dominating many conversations is becoming less important for most companies. except for those with very high growth expectations. The path of future growth and profitability will likely soon start to dominate again as the driver for individual share prices once the current period of unwinding and rotation has exhausted. We believe our portfolio of Future Quality stock picks should be well placed when that time arrives.

*Reference to individual stocks is for illustration purpose only and does not guarantee their continued inclusion in the strategy's portfolio, nor constitute a recommendation to buy or sell.

Author: Iain Fulton (Portfolio Manager) and Will Low (Head of Global Equities), Nikko AM, Yarra Capital Management's global partner

Disclaimer

This material has been prepared by Nikko Asset Management Europe Ltd (NAM Europe) which is authorised and regulated in the United Kingdom by the FCA. This material is issued in Australia by Yara Capital Management Limited (formerly Nikko AM Limited) ABN 99 003 376 252, AFSL 237563. To the extent that any statement in this material constitutes general advice under Australian law, the advice is provided by Yarra Capital Management Limited. NAM Europe does not hold an AFS Licence.

Effective 12 April 2021, Yarra Capital Management Limited became part of the Yarra Capital Management Group. The information contained in this material is of a general nature only and does not constitute personal advice, nor does it constitute an offer of any financial product. It is for the use of researchers, licensed financial advisers and their authorised representatives, and does not take into account the objectives, financial situation or needs of any individual. For this reason, you should, before acting on this material, consider the appropriateness of the material, having regard to your objectives, financial situation and needs. The information in this material has been prepared from what is considered to be reliable information, but the accuracy and integrity of the information is not guaranteed. Figures, charts, opinions and other data, including statistics, in this material are current as at the date of publication, unless stated otherwise. The graphs and figures contained in this material include either past or backdated data and make no promise of future investment returns. Past performance is not an indicator of future performance. Any economic or market forecasts are not guaranteed. Any references to particular securities or sectors are for illustrative purposes only and are as at the date of publication of this material. This is not a recommendation in relation to any named securities or sectors and no warranty or guarantee is provided.

Portfolio holdings may not be representative of current or future investments. The securities discussed may not represent all of the portfolio's holdings and may represent only a small percentage of the strategy's portfolio holdings. Future portfolio holdings may not be profitable. Any mention of an investment decision is intended only to illustrate our investment approach or strategy and is not indicative of the performance of our strategy as a whole. Any such illustration is not necessarily representative of other investment decisions.

Portfolio holdings may change by the time you receive this.

Any reference to a specific company or security does not constitute a recommendation to buy, sell, hold, or directly invest in the company or its securities. The information set out has been prepared in good faith and while Yarra Capital Management Limited and its related bodies corporate (together, the "Yarra Capital Management Group") reasonably believe the information and opinions to be current, accurate, or reasonably held at the time of publication, to the maximum extent permitted by law, the Yarra Capital Management Group: (a) makes no warranty as to the content's accuracy or reliability; and (b) accepts no liability for any direct or indirect loss or damage arising from any errors, omissions, or information that is not up to date.

Yarra Capital Management. Copyright 2022.

Whilst we focused on this exciting megatrend and Accenture last year, things are moving even faster than forecast and so a revisit is timely.

Accenture is a prime holding for this megatrend and thus remains in the Insync portfolio. In their recent earnings call, they announced a very strong demand environment. This has induced double-digit growth in all parts of their business and also across all their markets, industries and services.

Many of their clients are embarking upon bold transformation programs, often spanning multiple parts of their enterprise in an accelerated time frame. Macro-economics have little impact on these companies spend on digitisation. These clients recognize the need to transform almost all of their businesses, meshing technology, data and AI and with new ways of working and delivering their product or service to market.

Current market gyrations have not changed the trajectory of our identified megatrends (including this one) in the Insync portfolio. Our companies such as Accenture continue to grow profitably at multiples many times that of GDP.

Insync's intense focus on the fundamentals, investing in businesses like Accenture that are compounding their earnings at high rates, gives us confidence that the portfolio is well positioned to deliver strong returns as volatility in markets subside.

Stocks held by Insync possess:

• Far lower than market debt to equity,

• Excellent interest coverage,

• 4x the ROIC of the market average,

• Not dependent on new capital for growth,

• Margin and/or pricing power

Finland's forests, which cover more than 70% of the country, are the subject of a continent-wide debate on how to halve EU carbon emissions by 2030. Policymakers, environmentalists, companies and the public are arguing over whether the forests should remain untouched, and thus absorb carbon, or be used as biomaterial.[1]

Environmentalists want the woodlands in Europe's most-forested country to remain pristine carbon 'sinks'. Finland's government, companies, especially the ones that help forestry products generate 20% of the country's exports, and much of the public want to find commercially viable solutions that alleviate warming risks. That an EU proposal released in mid-2021 favoured the carbon-sink option only intensified the debate.

Perhaps the European Central Bank could sort it out? During the dispute over the forests in the euro-member Finland, the ECB declared mitigating climate change was a priority. The central bank said it will embed environmental goals within monetary policy because wild and warmer weather can affect "inflation, output, employment, interest rates, investment and productivity; financial stability; and the transmission of monetary policy".[2]

The Bank of England,[3] the Bank of Japan,[4] the Federal Reserve[5] and Sweden's Riksbank[6] are among central banks to mix sustainability and monetary goals to different extents. They are among the 83-member Central Banks and Supervisors Network for Greening the Financial System that seeks to "mobilise mainstream finance to support the transition toward a sustainable economy".

As part of their green focus, central bankers are calling for net-zero-emissions targets. As they warn of climate systemic risks, central bankers are seeking to use their regulatory powers to enforce climate-risk-based capital standards on banks, conduct climate-change stress tests on financial institutions and force companies to disclose carbon risks. They are under pressure to 'green' the corporate-bond portfolios they have amassed under quantitative-easing programs.[7]

To propel the sustainable shift, governments are appointing climate-aware people to central-bank leadership roles. US President Joe Biden this year, to cite a prominent example, nominated former Fed governor Sarah Raskin to be the Fed's vice chair of supervision of the board of governors.[8] In 2020, Raskin slammed the Fed for giving emergency pandemic relief to "dying" fossil-fuel companies.[9] In 2021, she urged financial regulators to exercise their "existing powers" to mitigate climate change.[10] (Such comments appeared to prompt the Senate in March to block her appointment.)

Many ask whether it's wise for central banks, which style themselves as above politics, to charge into an issue that governments are struggling to solve because, while the science is not contentious, the politics are. Amid such discussions, two questions stand out.

The first is: Will central banks accomplish anything? Those who advocate that central banks consider climate risks say standardising climate-related disclosures and making them mandatory could improve the pricing of climate risks. They say central banks highlighting the long-term financial risks of climate change can only help the public swing behind a solution towards net-zero emissions. They say that central banks can embolden the stability of the financial system over the long term by limiting banking crises caused by a sustained change in weather patterns. Advocates say central banks elevating climate risks would make commercial banks more wary of adding to (and they might even reduce) the US$3.8 trillion major banks have committed to the fossil-fuel industry.[11]

Some factors, however, suggest central banks might achieve less than they hope. First, it can be argued that climate change poses little risk to financial stability. Bushfires, droughts, heat waves, rising and warmer oceans, storms and the like have never in modern times triggered a systemic financial crisis.[12] The industries that lose from the shift to a low-carbon economy (so-called stranded assets) are unlikely to imperil the financial system either. It's usually the next big things that bubble to the point of threatening financial stability.[13] A study of financial crises, This time is different by Carmen Reinhard and Kenneth Rogoff, found one common theme behind eight centuries of financial folly; "excessive debt accumulation".[14]

The second, perhaps surprising, reason central banks might make little headway for the environment is that banks don't appear to have been threatened by climate change and they seem capable of judging such risks for themselves. A 2021 Fed Bank of New York study of declared US disasters from 1995 to 2018 found US banks have learnt to manage climate risks and they gain from calamities. The study found that banks are adept at avoiding loans for, say, homes in harm's way and benefit from lending for rebuilding, "which actually boosts profits at larger banks". The study noted its findings "are generally consistent" with other studies on bank stability and disasters, even one conducted on banks in the hurricane-prone Caribbean.[15] The results, however, might be different if the world experiences a watershed increase in temperature.

Third, central banks elevating the consideration of climate risks is unlikely to be a telling blow to fossil-fuel companies. If commercial banks were to restrict lending to or increase interest-rate charges for fossil-fuel companies, private financial firms are likely to buy these businesses cheaply, especially in the absence of a price on carbon. The Economist estimates that private equity firms have swooped on US$60 billion of dirty assets in the past two years.[16]

Fourth, central banks have little legal basis on which to act on green lines.[17] Central banks lack authority to direct bank lending. Parliaments could give central banks these capabilities but it's likely such efforts would be as stillborn as most political efforts to mitigate the climate emergency. In the meantime, central banks can only target net-zero emissions - almost indirectly - by using their regulatory powers to highlight financial-stability risks. Last, there appears to be no link between interest-rate settings and a long-term meteorological event. "When it comes to saving the planet, central banks do not have a magic wand," says Jens Weidmann, former head of the Bundesbank (2011-2021).[18]

The other overarching question with central banks going green is: What are the risks? The first is that central-bank climate risk management could clash with their mandates to keep inflation tame over the short and long term. The shift to a net-zero-emissions world stirs what economists call 'greenflation'. This is the term for when fossil-fuel prices jump because investment in climate-harming energy has fallen but demand for dirty power hasn't. Greenflation is already rife in Europe, especially the UK.

The second hazard is that central banks might be adopting an explicit role of capital allocation, which breaches their principle of 'market neutrality'. Their climate stress tests, for example, might force banks to pull back from fossil-fuel assets. They are toying with tilting their asset-buying towards sustainable assets - something a Bank of England paper says defies calibration.[19] While central banks control the quantity of money, the allocation of money is a political choice for governments. Smudge the role of central banks and politicians and central-bank credibility and independence could be lost.

A theoretical risk is that central banks might encourage a green investment bubble on that could metastasise into a systemic threat - think of it as a central-bank 'green put', even if there is no sign of one emerging. A fourth concern is that central banks might be in danger of 'mission creep', at the cost of their focus on inflation. What, for instance, is stopping central banks pursuing other worthy social goals such as reducing inequality (which is made worse by their quantitative easing)?

Setting aside the debate about what central banks might accomplish, the risks show the use of public regulatory powers is a poor substitute for political solutions, even when none are appearing. The problem arising when government institutions step in because politicians can't sort out competing rights is that these bodies become politically tainted. It is best that central banks don't let climate-change priorities get in the way of their traditional tasks, which are hard enough to get right.

To be sure, central banks recognise that governments and parliaments have "primary responsibility" to act on climate change.[20] Central banks certainly have a role in managing the short-term costs of combating climate change, especially greenflation. Government policies to mitigate the climate emergency could hurt the economy to the point of creating financial instability. But that's different from saying changed weather and stranded assets could. Central-bank stress testing demands higher capital requirements for credit cards and auto loans than for home loans or the highest-rated companies. It thus could be argued that central banks are already allocating capital and all they seek to do is extend those responsibilities to mitigating the impact of climate risks on the banking system. Plenty of studies, such as one in 2021 from the US's Financial Stability Oversight Council, warn that climate change poses "an emerging and increasing threat" to financial stability.[21]

What is more certain is the solutions to achieving net-zero emissions need to come from the political process - where they are being thrashed out for Finland's forests.

The conflict of interest

UK Prime Minister Boris Johnson this year has faced the threat of a leadership challenge as fellow Conservative MPs (and the public) sickened of endless scandals. These outrages included that Downing Street partied at the height of the pandemic while enforcing strict social restrictions that even prevented relatives being with the dying. They included allegations that Johnson approved the evacuation of zoo animals from Afghanistan while UK nationals were left behind when the Taliban last July took control of the country.

The issue, however, commentators said, shaping as the most damaging blow for Johnson is economic. In February, the energy regulator told UK households their electricity and natural-gas bills could soar 54% come April when regulatory price caps are adjusted for prevailing prices. The average household's annual utility bill is forecast to jump by 700 pounds to about 2,000 pounds.[22]

Energy prices are surging in the UK because the net-zero-emissions Johnson administration has deterred investment in fossil-fuel energies and renewable-energy companies are struggling to produce enough power to make up for the shortfall in climate-damaging-generated power. (One mishap was that an unusual lack of wind failed to power wind farms while Russia's invasion of Ukraine has only added to energy costs.)

The higher power bills come with another blow for UK household budgets. The other battering is higher interest rates. In March, the Bank of England raised its key rate for the third consecutive month. The central bank in March lifted its benchmark rate by 25 basis points to 0.75% because it expects higher energy prices, exacerbated by Russia's invasion of Ukraine, to drive annual inflation above 8% within months. The most recent report shows that steeper energy costs boosted UK inflation to 6.2% in the 12 months to February, a 30-year high and more than triple the Bank of England's 2% inflation ceiling.

This situation encapsulates the greatest quandary for central banks. Policies such as carbon pricing to reduce the production and usage of fossil fuels are likely to boost inflationary pressures (even if it only shows up directly as a one-off jump in inflation gauges). The greatest contribution central banks might make in the quest to mitigate climate change could be to ensure their economies flourish in a low-inflationary way over the longer term, while ensuring financial stability. That would create the most favourable milieu for the political process to tackle climate change, as messy, protracted and contentious as that method might be. See the debate over Finland's forests.

Author: Michael Collins, Investment Specialist