Conventional wisdom suggests that 'time in the market' is a less risky strategy than 'timing the market'. Boom and gloom provide attractive entry and exit points but only if the timing is right. Accurately identifying market peaks and troughs is notoriously difficult. In our experience, gradually allocating more to markets during times of market distress and less when 'everything is awesome' is a preferable approach.

Small caps, and in particular, industrials, present an opportunity for investors at current levels. The Small Ordinaries benchmark has underperformed the ASX100 since November 2021. Notably, industrials have underperformed resources, which have been supported by thematics such as energy security, battery materials, and gold. In addition, adjusting to tighter monetary policy has weighed on small industrials. The recent underperformance presents a chance for investors to incrementally allocate to the sector.

Falling liquidity signals capitulation

Investors' willingness to trade reveals their confidence, or lack thereof, in the market. Rising liquidity can create a virtuous circle during a bull market, when abundant liquidity entices more capital into markets (attracted by lower trading costs). Yet when liquidity falls and markets are falling, the cycle works in reverse. Capital ceases to flow to (or exits) the market due to illiquidity concerns.

Since November 2021, liquidity in the small industrials sector has dropped meaningfully. Thus far in 2023, the daily average value of turnover for small industrials has been $704m, down a third (from $1,070m) during the same period in 2021. The decline in liquidity indicates that a lower amount of new money is being put to work in Small Caps. Contrarian investors have a better chance of picking up a bargain now, relative to last year.

Microcaps have been hit harder

Not surprisingly the decline in liquidity has been most pronounced for the smallest of small caps. 74% of the smaller small industrials (with a market capitalisation of less than $1 billion) had lower turnover in the last 12 months relative to the previous year. Adjusting for stocks which benefited from index inclusion, 85% of companies saw turnover decline. The impact on liquidity has been lower for the larger small companies, 63% had lower turnover (or 69% adjusting for index changes). Unsurprisingly, 37% of 'larger' small caps (market cap >$1bn) outperformed the benchmark relative to a mere 14% of the 'smallest' companies.

One of our holdings Quantum Intellectual Property Ltd, provides a case study of the current dynamic in microcaps. Quantum has a meaningful and growing share of the Australian Patent, Trade Mark and IP Legal Services market. Over the last year their share price has fallen by 19%, materially under-performing the small cap benchmark. On our estimates, the company trades on an attractive discount to earnings and yield metrics relative to the broader market, however its share turnover is 23% lower than the previous year. In a recent market update, the company reaffirmed expectations for organic growth, improving margins and further consolidation opportunities. The decline in liquidity merely reflects that the stock has fallen off the market's radar in our view, creating an investment opportunity. Quantum is just one example of similar opportunities arising in the current market environment.  

Different exposures than large caps

The Australian stock market is heavily weighted towards highly profitable bank and resources stocks. The smaller end of the market has a wider range of exposures, from resource exploration stocks and retailers to fast growing technology businesses. The composition of the small caps benchmark evolves over time.  Furthermore, industrial companies are less risky than three years ago. We estimate that loss making companies are now only 5% of the small industrials' universe, down from over 30% before the pandemic. The current small cap market has a lower exposure to risky, early stage or loss-making companies.

Following the recent underperformance of small caps, we see attractively priced opportunities relative to the large cap universe.  For example, Domain Holdings offers faster growth than REA Group (as it increases market penetration), yet it trades at a discount.  At the same time, small cap building materials companies in markets with high barriers to entry, trade at through cycle earnings multiples in the mid-teens, despite having more favourable industry structures relative to than their historical averages.

Smaller Companies have traditionally been more volatile and sensitive to the economic environment, which is expected to be challenging. There are valid reasons to be cautious. However, the small industrials benchmark is comprised of more robust businesses post the 2022 market correction.  Their underperformance relative to large caps and the withdrawal of liquidity suggests the market is already fearful. This presents us with an opportunity to increase our exposure to quality, but overlooked, businesses.

Author: Sinclair Currie, Principal and Co-Portfolio Manager

The Australian housing market continues to bounce back despite further interest rate rises, with CoreLogic's national Home Value Index rising by 1.2% in May.

The capitals and the regions both performed strongly, with all capital cities recording a month-on-month increase, and only regional Victoria decreasing.

Once again, the capital cities performed well with Sydney leading the way with a 1.8% increase, followed by Brisbane (1.4%), Perth (1.3%), Melbourne (0.9%), Adelaide (0.9%), Tasmania (0.5%), Darwin (0.4%) and Canberra (0.4%).

Performance across regional areas was also largely positive, with only Victoria experiencing a reduction in values (-0.5%). The Northern Territory and ACT, maintained values, whilst New South Wales (0.5%), Western Australia (0.5%), Tasmania (0.7%), Queensland (0.8%) and South Australia (0.9%) all experienced growth.

The property market continues to experience a lack of supply, with the last weekend of May holding just 1912 auctions, well below the 3226 that occurred on the same weekend in 2022. This lack of supply is likely the factor propping up property prices.

Melbourne (858) and Sydney (708) led the way with significantly more auctions taking place than the rest of the country with Brisbane (140), Adelaide (117), Canberra (72) and Perth (17) all well below previous year figures.

Whilst the total auctions were down considerably, clearance rates were exceptionally high, with a weighted average of 75.9% across the capital cities, well above the 59.3% last year. Adelaide had the highest clearance rate across the country, with 81.8% (up from 73.6% last year). Sydney and Melbourne also performed strongly with 78.5% and 77.1% respectively, well above the 56.4% and 60.4% last year. Canberra recorded 67.8% (64.4% last year) with Brisbane also outperforming last year, with 60.3% (51.2% last year). Perth was the weakest performance of the cities, with only a 27.3% clearance rate, down from 42.1% last year.

Clearance Rates & Auctions 22^nd - 25^th of May 2023

Property Values as at 1^st of June 2023

Median Dwelling Values as at 1^st of June 2023

Quick Insights

Clover Moore, Closing the Door

The National Housing Finance and Investment Corporation estimates that there is a shortfall of 400,000 houses nationwide. The Sydney basin represents nearly half of this amount, and over the next decade that shortfall will worsen by another 160,000 houses.

Rising house prices have been routinely blamed on negative gearing policies, when in reality it is the inaction and onerous requirements laid on developers in the inner cities that has exacerbated the issue.

Developers have been unable to provide supply due to the conditions city bureaucrats have placed upon them.

Source: Australian Financial Review

Paperwork & Supply

National Australia Bank boss Ross McEwan has spoken out about the housing supply saying, "Housing supply is a major issue at present and without clear moves to significantly increase supply, demand will inevitably push up prices further and faster."

Mr McEwan was backed up by Lendlease's Dale Connor, Mirvac's Campbell Hanan and Charter Hall's David Harrison - who agreed that improving planning processes was the first area to target.

Mr Harrison said that, "State governments have to take more control over the planning process to create more densification."

"It's got nothing to do with negative gearing or the demand side of things - it's all about a chronic undersupply of housing stock."

Source: Australian Financial Review

Hot Terraces

In defiance of the RBA's then coming increase in rates, 8 out of 10 Sydney terrace homes put up for auction last weekend sold, the strongest result in 19 months.

As mentioned in our Market Update this was followed by a 77.2% clearance rate across the combined capital cities, the third consecutive week of robust increases.

Independent Sydney-based auctioneer Clarence White said, "Even one-bedders are selling quite well nowadays, such as the one I sold on the northern beaches last week, where we had five registered bidders. I wouldn't have seen that six months ago."

Source: Australian Financial Review

Author: Filippo Sciacca, Director - Investor Relations, Asset Management and Compliance

Equity markets were mixed in May. In the US, the S&P 500 rose +0.3%, the Nasdaq rebounded sharply +5.8%, whilst in the UK, the FTSE 100 declined by -5.4%. In Australia, the All Ordinaries Accumulation index fell -2.6%, driven by ongoing investor caution around the impact of interest rate hikes by the Reserve Bank of Australia. The technology sector was the top performing sector, as investor sentiment continues to recover after materially underperforming in 2022. Consumer discretionary was the worst performer, with multiple ASX listed stocks flagging consumer spending is weakening due to rising interest rates and cost of living pressures. Gold stocks also underperformed in the month. 

Small cap stocks significantly underperformed as investor funds moved to the perceived safety of larger cap stocks. As an example, on the ASX, the Emerging Companies index fell -6.4%, whilst the Small Ordinaries Accumulation index declined -3.3%. 

In bond markets, the US 10 year bond yield rose +20bp to close at 3.66%, whilst the Australian 10 year bond rate increased +26bp to 3.60%. Both movements were due to increased inflation expectations. In currency markets, the A$/US$ declined -2% to close at US$0.65. Commodities were broadly weaker in May. Brent crude oil declined -8.6%, copper -6.5%, iron ore -5.0%, whilst gold -1.2%. Thermal coal fell sharply, down -27.3%. 

The numerous interest rate hikes implemented by the Reserve Bank over the past 12 months are clearly having an impact on consumer spending, as evidenced by multiple ASX listed retailers announcing profit downgrades in recent weeks. Whilst some components of the CPI basket are declining (eg. Commodities), other parts such as power prices and wages are still rising (eg. Recent 5.75% award wage increase which commences on 1 July). Services inflation in particular, continues to be too high, as businesses across the board increase prices. With regards to interest rates, given inflation is proving more difficult to reduce to the Reserve Bank's targeted band of 2%-3%, it now appears likely that the RBA will need to lift rates 2-3 more times in this cycle. 

One theme that continues to impact the fund's relative performance versus benchmark is the underperformance of small/mid cap stocks on the ASX, noting the fund has a strong skew to this part of the market. Whilst this has been negative for the performance of the fund in recent months, we strongly believe this focus will produce some outstanding buying opportunities for longer term focussed investors over the next 6-12 months. The Fund continues to see numerous attractively valued stocks across a wide range of sectors and is well capitalised to take advantage of this current short term investor bearishness. 

Australia has been delivered another rate hike in an attempt to "quash" inflation. This month Darren debates with special guest Tim Toohey, Head of Macro and Strategy, the risks posed by rising wages and weak productivity growth, and why the RBA continue to change its goalposts to drive down inflation.

Low fertility is a problem for countries. Many developed markets (DMs) are starting to struggle with ageing populations and their associated social and economic issues.

Meanwhile, it could be a problem even for emerging markets (EMs), which face a slowdown in the growth of their 'working-age' populations over the next 30 years.

Last year, we published two papers - Emerging market demographics 'in focus' - implications for growth and the rise of the global middle class and Emerging market demographics 'in focus' - implications for equilibrium real interest rates - that examined the issues in developing economies.

Our latest on the topic, Towards the peak: How the rise and fall of populations affects economic growth, seeks to advance the discussion by looking at things from a global perspective and asking what this may mean for investors.

Population divergence

The world's population is expected to grow by a further 1.7 billion people to reach 9.7 billion by 2050, according to the latest United Nations data.

However, these numbers hide big differences between and within EMs and DMs. For example, the US' population is expected to increase by some 37 million by 2050, while Germany's could fall by some 4 million over the same period. Lower fertility in some European countries could be partially alleviated by immigration.

Meanwhile, the number of people in developing economies is expected to continue growing, driven mainly by countries in Africa and developing Asia. That said, the population of the largest emerging market, China, began shrinking in 2022.

Its impact on growth...

EMs will drive global economic growth - accounting for some 75% -- in the coming decades. China and developing Asia alone will be responsible for some 60% of that. Despite their own demographic challenges, EMs will likely grow between two and 2.5 times faster than DMs (see Chart 1).

Chart 1: Global GDP increasingly driven by Asia

Source: Haver, abrdn, as at February 2023

India and Indonesia are set to join China among the world's top seven largest economies by 2050. What's more, Nigeria will be just outside the top ten (No. 11), while the Philippines, Pakistan and Vietnam will occupy places within the top 25.

India and Indonesia are set to join China among the world's top seven largest economies by 2050

On the other hand, big oil producers - Russia, Saudi Arabia and Norway - will slip down the rankings as the world transitions to low-carbon energy sources.

We found in our two previous papers that, while the percentage of 15-64-year-olds in EMs (often used as a proxy for the working-age population) is shrinking, the impact on growth isn't as bad as feared because social changes mean that people start and stop work later.

What's more, there's a lot of scope for human capital - the economic value of a worker's skills and experience - to grow in EMs as more people attain higher education levels.

That said, the next three decades will see labour playing a less important role in potential growth, as demographics hold back capital-stock growth. This means potential growth could fall close to zero in the Eurozone and Japan by 2050. But China's ability to improve the quality of its workforce could help offset the effects of its ageing population.

...and impact on productivity

Productivity has been in gentle decline for many economies since the 2007/08 global financial crisis and we don't see much hope for a return to the boom years of the 2000s. Commodity-exporting countries have experienced productivity decline for years, while institutional weakness and political instability pose risks in EMs.

The potential for demographics to create negative feedback loops, including for productivity, could result in additional risks. Ageing populations can strain the sustainability of social welfare models and public debt, which could reduce public spending in other areas and spur emigration. These risks are greatest in the ageing societies of China, Thailand and developed Asia. Other at-risk regions include Latin America (excluding Argentina, Mexico and Peru), central and eastern Europe, Japan and the Eurozone area.

Only a few markets could see productivity improve if a feedback loop operates between demographics and growth. Pakistan, the Philippines, Israel, Nigeria and South Africa are among these as they benefit from improving dependency ratios - due to relatively youthful populations and falling birth rates.

What this means for investors

Here are five things for investors to consider:

1. As emerging markets develop and the ranks of the middle class expand, the share of economic growth dedicated to consumption will rise, leading to notable changes in the relative size of consumer markets around the world.
2. The outlook for Europe and developed Asia looks less promising, with slowing growth set to limit the scope for consumption to rise.
3. Consumer preferences will change. As salaries rise in low-income countries, people will spend less money as a proportion of income on food and clothing; more on housing, healthcare, transport and personal care.
4. Ageing populations everywhere will increasingly skew consumption towards the 'silver economy', amplifying these trends.

Author: Robert Gilhooly, Senior Emerging Markets Research Economist and Michael Langham, Emerging Markets Analyst