As we summarized in our September quarter note, there was a time post the Fukushima disaster when it appeared that nuclear energy was too risky and would be bypassed entirely in favour of renewables. Coal was to be phased out and wind and solar, as well as more marginal technologies like biomass, would increasingly play a central role in keeping the lights on. Zero carbon will eventually disrupt the transition fuels too (a polite term for gas) so that come 2050, the energy transition will be complete.

This is a neat narrative but it's looking increasingly likely that the scale of the transition may just be too great to reach net zero in less than 30 years. After all, the global population continues to grow and there is a very strong correlation between population size and energy demand - we all require energy for life's basics and per capita consumption continues to rise. The inequalities of energy consumption apparently don't matter; wealthy countries with low population growth consume far more power per capita than poorer ones. We can either try to grow a bigger pie, or be fairer with the one we have, and if it's a bigger pie we need, then the scale of transition is extremely daunting.

Excessive demand can lead to many problems, and we will need to walk a fine line between environmental preservation and deprivation. The Australian Broadcasting Corporation recently featured an article entitled, "How can we support the transitions to renewables without further damaging the environment?", which highlighted the 'dark side' of the rush to electrification - pollution and degradation.

An example is the controversy surrounding the Upper Burdekin Wind Farm in Queensland. Windlab, a company associated with Andrew Forrest and at one time had the support of Apple, has been criticized for the scale of land clearing and endangerment of several threatened species including koalas and rock wallabies. It's an odd circularity akin to that infamous line from the Vietnam War era, "we had to destroy that village in order to save it".

Where does nuclear fit in? Besides being a low-carbon source of power, it offers several other advantages over most other renewables: long life; high reliability/efficiency; competitive life-time cost; less intensive use of raw materials; and lower physical footprint. In this piece, we focus on the small footprint that nuclear power generates relative to other power sources. Coal has been a foundation for modern economies, providing 'safe', stable baseload power. Nuclear has the same ability and can do so in a uniquely small area for its potential.

In an article published on OurWorldInData.org in 2022, author Hannah Ritchie detailed the relative land use intensity of different methods of power generation.1 The lifecycle assessment, i.e., complete land use including mining, found that nuclear power at 0.3m2/MWh is the most efficient form of power, including renewables (Figure 1).

Onshore wind is almost as efficient at 0.4m2/MWh if only the land used by the windmill is counted and not the entire wind farm. This is because land in between windmills can have other uses, such as agricultural production or grazing. The total area needed can be very large and may require the clearing of vegetation, hence the large range. As the Burdekin project shows, this can disturb the natural state of a large area although it would be hard to argue that the land is completely sterilised.

As turbines grow in size and technology advances, there is likely to be some improvement in m2/MWh though vary through a wide range.

Figure 1: Relative efficiency of power generation relative to land use

Offshore wind offers several advantages over onshore installations, namely an ability to install larger and more efficient turbines, and land use ceases to be an issue (ex the need for raw materials). The limiting factors for offshore wind tend to centre on finding suitable wind resources, seabed condition, locations near population centres, visual impacts, access to fisheries and impediments to marine navigation and aircraft. There has been some controversy regarding the potential impact on whales, and while this issue has recently been a hot topic in the US, to date there is no evidence that connects offshore wind farms to the injury or death of whales.

Nevertheless, these utilities are enormous, sprawling structures, where for example, the proposed Illawarra (4.2GW) and Hunter (5GW) projects offshore NSW cover areas of 1,461km2 and 1,854km2, respectively (Department of Climate Change, Energy, the Environment & Water, DCCEEW). To give some context, that is roughly the same size as Fraser Island (K'gari), the world's largest sand island. Another way to look at the scale is to consider that the Illawarra project would stretch over about 50km of the coast and the Hunter up to 90km, or a combined 6.5% of the state's coastline (Figure 2). The windmills themselves will be around 270m high and at 15MW each, around 600 would be needed to meet the stated capacity of the combined area.

Figure 2: Proposed area for the Hunter (top) Illawarra (bottom) offshore wind projects

Solar PV's great advantage is that for the most part, it uses existing infrastructure (rooftops). The Australian PV Institute states that there are over 3.6m PV installations in Australia totalling more than 32.9GW of capacity with most systems between 6.5kW and 9.5kW, i.e., suburban roof tops. Our basic analysis indicates that the area used by all PV solar in the country is only about 146km2 and 2m2/MWh assuming a somewhat generous average of 400W panels and no secondary impacts from mining. On a life-cycle basis, Ritchie estimates that number to be 3m2/MWh for rooftops but 19m2/MWh for on-ground commercial facilities.

On-ground commercial solar arrays don't piggyback on existing structures, so their land-use is real. Hence, they are amongst the least efficient forms of power generation in terms of their footprint. The largest proposed solar PV facility in Australia is Sun Cable in the Northern Territory. At 20GW, it would cover 120km2, almost as much area as all other PV installations in Australia, but be located on pastural leases used to graze cattle. Large as it is, Sun Cable is remote and is almost meaningless in a country the size of Australia.

The area of installed solar PV in Australia is just one-tenth that of the Illawarra wind project yet has almost 8 times the installed capacity. Naturally there are other things to consider, such as the higher capacity factor of offshore wind (e.g., ability to generate at night) that make installed capacity an overly simplistic measure. Using average global capacity factors for offshore wind of 40% (35-45% range over 2010-2022) and 12% for rooftop solar in Australia (i.e., non-commercial), solar PV would still have 2 times the capacity of the Illawarra project - 4GW vs 2GW - for the same operational life.

At the other end of the spectrum are hydro systems, mainly due to the mining footprint and the flooding of valleys for water storage. A slightly unusual system is solar that uses mirrors to concentrate solar energy on a tower to create heat. Land use is very intense, averaging 22m2/MWh, which suggest that these systems are somewhat extravagant and that better alternatives exist.

Nuclear suffers from very few of the problems discussed above. Firstly, the raw size of the nuclear power plant itself is relatively small and the move to Small Modular Reactors should enhance this feature. A 1GW nuclear power plant covers approximately 3.5km2 while a coal plant of the same size is almost twice that. Neither can compete with gas, however, at 0.5km2. Pity about the CO2. There is a case to make that the sites of shuttered coal-fired power plants would make good sites for new nuclear ones in that grid infrastructure is in place and further land clearing is unnecessary.

Secondly, the mining of uranium does not take much space relative to the output of a nuclear power plant and hence m2/MWh is miniscule. Land disturbance for coal mining is famously large and ash disposal contributes to land use. The scale of coal consumption depends on plant design, efficiency and the rated calorific value of the target fuel, so there is no rule of thumb. However, the World Coal Institute estimates that at 38% efficiency and 75% availability, a 1GW coal plant would burn 2.5Mtpa bituminous coal and 6.5Mtpa brown coal. Compare this to a nuclear power plant of the same size, which uses about 27tpa uranium, requiring perhaps 0.5Mlbs U308 and ore input of maybe 400ktpa depending on grade and recovery. Mining for silica, aluminium, copper and zinc contribute negatively to solar and wind.

Thirdly, nuclear power plants are highly efficient, with plant availability of more than 90% over long life spans. These are key factors in life cycle analysis because they result in nuclear power plants producing many more TWh of power over time than other power plants, i.e., a bigger denominator.

All this is underscored by the COP28 meeting held in the UAE at beginning of December, which again highlighted the role nuclear power could play in the drive to decarbonize. More than 20 countries signed a declaration to triple nuclear capacity by 2050. It included major economies such as the US, Japan, South Korea, France and the UK, though not Germany (nor Australia for that matter). This represents a stunning turnaround for the nuclear industry and is reflected in the surging uranium spot price, which is now US$87/lb. We continue to believe that nuclear energy will play an increasingly important role in providing the world with clean power and maintain significant positions in near-term uranium producers, Boss Energy and Paladin Energy.

Author: David Haddad, Principal and Portfolio Manager

Globally equity markets performed strongly in January. In the US, the S&P 500 increased +1.6%, the Nasdaq rose +1.0%, whilst in the UK, the FTSE100 declined -1.3%.

In Australia, the ASX All Ordinaries Accumulation Index rose +1.1%. Energy and Financials were the best performing sectors, whilst resources was the weakest performer, as sentiment towards the Chinese economy weakened.

Inflation data both domestically and offshore continues to moderate, which in our view indicates the bulk of the heavy lifting by central banks in terms of interest rate hikes has now been done. The US economy appears to be ahead of Australia in terms of getting on top of inflation, hence we expect the US will see interest rate cuts before Australia over the next 12-18 months. In bond markets, following two months of very material declines in bond yields, January saw a slight increase as economic data pointed to a still strong global economy (despite the aggressive tightening by central banks). In the US, the 10-year bond rate climbed +17 basis points (bp) to close at 4.01%, whilst in Australia the 10-year bond rate rose +6 bp to also finish at 4.01%.

As always, February is a very busy month with the vast majority of the fund's holdings reporting results for the six months to 31 December 2023. The upcoming reporting season will provide visibility into how the companies are performing operationally. Whilst we have seen a recovery in equity markets in recent months, we continue to be very optimistic about the outlook for small/mid cap stocks on the ASX given their cheap valuations and material underperformance over the last two years.

To reiterate, our focus in 2024 will be identifying quality businesses trading on attractive valuations, where we believe material earnings upside exists.

CY2023 Review

Stocks on higher multiples did better than those in "value" territory as investors chased "quality" (if you define that as top quartile return on capital or companies paying dividends) but the most clear cut divide in ASX listings in CY2023 was simply size as investors shunned the perceived heightened risk of micro caps. Below we analyse CY2023 performance of our ASX "FIT" (Financials, Industrials & Technology) micro-to-mid cap universe, alongside the S&P/ASX benchmarks. All FIT returns presented are averages of the stocks that meet the relevant criteria.

CY2023 Sector & Industry Review

The Materials sector, covering chemicals, packaging and paper, was the most beaten-down in CY2023 with an average decline of 10% and a median decline of 15%. Health was an interesting space, where the average return was -1% but the median was -17% as the median biotech, pharmaceutical and health care stock fell by more than 20% BUT one stock surged 214%. Interesting to note that Consumer Discretionary stocks strongly outperformed Consumer Staples.

Returns by Size - Broader International Perspective

On an equal-weighted basis, the smallest 10% of stocks by market cap have outperformed the larger 90% in North America and in Asia Pacific ex-Japan (Australia, Hong Kong, NZ & Singapore) over the past 30+ years. But returns over CY2022 and 2023 have favoured the largest and most profitable businesses.

We began tracking the dispersion of trailing (historical) EV/EBITDA multiples when we launched the weekly "Small Talk" publication in 2020. There has been a tangible shift downwards in multiples, with 51% of companies on 10x or less in 2022 and 2023, compared to just 39% at the end of 2020.

What's in store for private assets?

Resilient growth and moderating inflation in the US reflect positive supply shocks that are almost exhausted. A slowdown followed by a mild recession in 2024 is the most likely scenario. European economies are already weak and we expect them to remain so until the middle of next year - although positive real income growth should limit the size of the downturn. Most central banks have finished hiking rates and should begin cutting in 2024, as inflation fades further. Chinese policy easing is now stabilising activity, but there are long-term headwinds. Emerging markets are benefiting from moderating inflation and they are entering a policy-easing cycle. As we analyse the private markets landscape, it is important to consider the latest trends in key sectors and to address the evolving macro backdrop. 

Private equity

In a high-interest-rate environment, persistent inflation continues to draw down deal appetite in both Europe and the Americas, particularly regarding exit strategies. Many General Partners continue to extend out their exit horizons, avoiding lower valuations in anticipation of better market conditions in the future.

The latest third-quarter valuation multiples suggested that valuations are correcting at a modest pace across North America and Europe. In terms of sectors, financials and consumers have suffered the worst peak-to-trough declines while energy valuations are still rising. Technology multiples held up well heading into 2023 but have been hit since. However, they are still at a premium relative to other sectors.

We continue to see mid-market companies in Europe and the Americas contributing to consumption growth in urban centres. Therefore, we will focus on opportunities to invest in recession-proof industries like healthcare and information technology that capture global long-term trends. It is crucial to focus on upper-quartile managers who have a proven track record of unlocking value in portfolio companies' balance sheets.

Private credit

Demand for private credit continues to remain robust as traditional lenders pull back. Given the elevated returns, expanded spreads, and protection from a low correlation to gross domestic product, the risk-return dynamics of private credit have become extremely appealing. Careful deal selection for assets with downside risk remains crucial.

Default rates remain low by historical standards, but they are anticipated to rise in private credit as many private credit managers have not been fully tested since the Global Financial Crisis (GFC). In addition, the market dynamics are fundamentally different from the previous cycle.

Dislocation in the market is creating good opportunities, and lenders are in a position to demand stronger covenants and to execute deals at attractive risk-adjusted returns. Selectivity remains key. And with signs of distress and increasing default rates, high-quality deals are vital.

Infrastructure

Global infrastructure markets grappled with several shock factors over the year. These stemmed from macro and micro drivers, with a slower fundraising environment, increased financing costs, geopolitical risks, and valuation pressures (to name a few).

Despite facing volatility, core private infrastructure assets showed resilience. They provided inflation protection, cost pass-through mechanisms, and robust cashflow generation. The energy transition sectors, for example, continued to grow and large deals still closed. The US Inflation Reduction Act (IRA) provides a strong tailwind for investing in infrastructure spending. For example, technologies such as hydrogen, carbon capture and transport are attractive structural opportunities. Europe is positioning itself to increase domestic commodity supply and energy autonomy by expanding investments in renewable energy. Globally, digital and telecom infrastructure continues to ride a long boom, bolstered by macro headwinds and rising opportunities in digitisation.

Real estate

The global real estate market is progressing steadily through this current downturn. Capital markets (yields) have been recalibrating in response to higher interest rates and higher debt costs, which have been much faster than the correction following the GFC. In most regions, values have fallen between 15% and 30% in just two-to-three quarters, but we believe this revaluation phase is close to the end.

Real estate yield spreads remain tight versus the risk-free benchmark, but spreads are improving slowly - although they have yet to offer enough illiquidity premia.

In Europe, logistics have repriced most aggressively but with more to go for secondary offices. In North America, we are observing cap-rate expansion starting to slow down across sectors. Office defaults are becoming more visible in the US and several high-profile valuations are bringing expectations down to more realistic levels. Meanwhile, across industrials and logistics, renewal activity has remained robust, hence values have held up with a strong macro backdrop.

In Asia-Pacific, yields in most markets have barely moved since end-2021. As such, we think there are likely more outward yield shifts that need to take place in the next year. While logistics properties in many markets will likely see higher yields, the negative impact on capital values is expected to be mitigated by further rental upside.

Natural resources

Activity across natural resources is heavily driven by the global energy market. Energy prices continue to be the driving force of investment across the asset class, which is set to continue. The recent conflict in the Middle East has caused further uncertainties, which had started to fall in June. As the renewable energy transition continues to play out, metal and mining strategies have also seen increasing demand, given some metals are also essential in generating renewable energy.

While growth in renewables fundraising continued, it is a multi-year push toward decarbonisation. Interestingly, investment flows in North America renewables seem to be catching up with Europe. This can be largely explained by the IRA. In Europe, government infrastructure spending is expected to increase to reflect its transition to a low-carbon economy.

Going into 2024, it's likely that the demand for energy will be sustained, but there is uncertainty about how long this could last. However, investment opportunities across natural resources will continue, with the emergence of low-cost renewable power and the growth of carbon markets. This includes the role of timber in the global transition to net zero and lower emissions. 

Author: Lulu Wang, Portfolio Strategist, Private Markets
Nicole Reid, Research Analyst, Private Market Solutions

Bonds finished 2023 strongly following the market categorically rejecting the 5.00% level in US and Australian 10-year bonds in October. This has provided a solid base for bonds in 2024 following the global peak in yields and the end to the global central bank hiking cycle. The market was comforted with the lower inflation readings and the weaker set of economic data. Bond supply dynamics also played a part when the narrative of increasing government deficits was alleviated with US Treasury projections in the order of 100 billion less than the market was expecting.

Markets have moved to more aggressively price in easing from the US Federal Reserve (US Fed), Bank of England and European Central Bank given declining inflation with goods inflation the driver. While time will tell whether November's cash rate hike from the Reserve Bank of Australia (RBA) was the last in the cycle, our view is that we are either at, or at least very near, the peak in cash rates.

If history is a guide, cash rates tend to remain on hold at the peak for an average of eight months.  While this is certainly not an exact science, based on what we currently know about the economic outlook and market pricing, we anticipate that the RBA will start to loosen monetary policy in 2024 following in the slipstream of its global central bank counterparts. Predicated on this view, any back up in yields will provide a decent opportunity to increase duration exposure, particularly in the 3-to-5-year sector where historically the curve steepens as markets approach their first rate cut.

The monetary tightening has pushed the global credit impulse to its weakest level since the Global Financial Crisis, which implies weaker demand growth moving forward placing pressure on the jobs market. High delinquency rates and credit card balances currently support anemic consumer confidence and may begin testing both consumer resilience and the ability of employers to maintain employment with margins under pressure. The job market in 2024 will be the main determinant of whether we travel down the path of a 'hard landing' with the commensurate aggressive easing of short-term interest rates and much higher bond prices with the recent rally into year-end just an entrée to what can be served up.

MARKET OUTLOOK: ARE RECESSIONARY SIGNAL LIGHTS STILL FLASHING RED?

US recessionary indicators are all signaling a code red alert. An inverted yield curve persisting for 18 months, coupled with a 19-month sequential decline in the Leading Indicator Index, has an infallible record in predicting a US recession. In a soft-landing scenario, the US Fed will need to make approximately a 300 basis points cut just to reach a neutral rate setting. However, in the event of a full-blown recession, we are anticipating a need for around 500 basis points of easing.

The December US Fed meeting validated the end of the hiking cycle in short term rates with US Fed Chairman, Powell commenting that "you want to cut rates well before inflation is at 2%" otherwise it would be too restrictive. The US Fed also downgraded its inflation forecast and alluded to three cuts in 2024 as Powell showed concern over keeping rates too high for too long.

The inflation trajectory continues a downward path and heading into 2024 this is expected to persist - we still have some hefty inflation prints dropping out of the index so we should get inflation falling on a year-on-year basis for the first five months of the year if we continue to print similar numbers that have been recorded lately. Continued weakness in energy prices and lower wage growth through a deteriorating employment market would also be supportive of the slowing inflation period. The picture in Australia is also encouraging with the inflation story lagging the global softening prices thematic.  Given the transmission mechanism of Australian interest rates, we would anticipate this to play catch up in the first quarter of next year.

As the new year commences, 2024 is ripe for geopolitical developments with 40 national elections on the calendar from Taiwan at the start of the year through to the US presidential election in November. The potential for a changing of the guard in foreign policy heightens the chances of an escalation or aggravation amongst countries and should fly in the face of the complacency that currently prevails in risk markets and encourage a flight-to-quality demand for sovereign bonds.

After an extended period of ultra-low bond yields, followed by some painful years of adjustment higher, bonds are arguably in better shape now than they have been in several years, offering a sense of stability and optimism for investors in the current financial landscape.