Markets always present a multitude of opportunities and obstacles.  However at any given point in time there are only a select few, around which traders coalesce.  Commentary and action align to these few factors, which then powerfully drive markets. Recognising this, and the rationale for it, or indication of a pivot in market trends helps identify and reprioritise risk. In this way, issues which the market has long ignored can suddenly seem to be the only thing that matters.

During the GFC, the market seemed only to care about balance sheets. In recent years it has been pre-occupied with innovation and disruption. Today, we are grappling with the most fundamental changes to international relations since the end of the Cold War. These risks have always been present, yet the reprioritisation of these risks is changing the flow of funds, between nations, between asset classes, and within the underlying sectors of asset classes.   

Small cap investing: Top down has become paramount

A trend of the last decade has been the grouping of stocks into ever more diverse 'baskets' (often known as an index). Today these 'baskets' are sold by securities dealers as a product. Stocks can be grouped by industry, quantitative factors or thematic association. In the past, the profit motivation behind these classifications formed part of a two-step process.

1. Identify companies exposed to sectors and factors expected to benefit from ongoing or forecasted tailwinds.
2. Assess the actual and prospective performance of these companies relative to expectations and peers and select the best stocks.

When investors purchase a basket from a dealer, they are de-emphasising stock selection.  

In recent years we have observed a shift in Australian Small Companies market dynamics. Increasingly, money is deployed with a greater emphasis on macro-strategy (i.e. step one above); yet seemingly without significant focus applied to the fundamental performance of the underlying businesses (step two).

The outcome is a growing number of companies exhibiting a divergence between their share price performance and operational performance. The most obvious demonstration of this has been the increasing correlation of stocks within certain baskets. For example, the correlation of Australian Technology stocks to the US NASDAQ index. This correlation ignores the fact that each Australian tech stock has its own fundamental and operational opportunities and challenges distinct from the success of Nvidia, Facebook, Netflix or Tesla.

In contemporary markets, it seems that share price performance depends on being allocated to the 'right' group of stocks rather than actual business performance. This has been particularly evident in the last two reporting seasons. We saw many companies fail to deliver on expectations.  Yet their share price performance was more powerfully explained by broader market trends than their underlying performance. It is important to note that this relates not only to profit but outcomes have also been skewed for looser metrics, such as revenue.

The willingness of markets to overlook operational performance of individual stocks is not sustainable.  However we do not dictate how the market chooses to reward speculation. Markets are expressions of emotions as well as logic and we cannot expect them to be rational. What we can look for is catalysts which might change sentiment and behaviour. At this point in time, there are several. None of these are new, yet suddenly they have become relevant.

Looking ahead

We believe identifying and responding to change faster than the market is key to successful investing.

So much has changed since March 2020 and the market is still adapting.  The assumption that markets will resume their pre-covid trajectory ignores the profound changes that have occurred.  The following trends are reshaping market dynamics in our view.

1. Demographics

The ageing global population has been apparent for a long time however its adverse impact has been offset by globalisation and trade, which delivered to enterprises the gift of a huge increase in the pool of available labour. While its sustainability has always been questionable (particularly due to the ageing population in China) it has not registered as a concern for markets. The escalation of tensions in global markets brings the challenges of a shrinking workforce into sharper focus.

2. ESG

Awareness of Environmental, Social and Governance issues is challenging the status quo. For example, the current US Trade Representative Katherine Tai has been vocal in raising ESG issues at the World Trade Organisation, arguing that trade policy must take the environment and workers' rights into account. Whilst coming from a different angle, this approach is a continuation of the more assertive trade policy adopted by the previous US administration. Trade frictions will not only impact labour markets but will also alter the flow of capital through financial markets. When President Trump first pushed back against free trade the market seemed less concerned. Now it is clear that scrutiny of trade relationships is bipartisan. The market must now reprioritise this risk.

3. Geopolitics

Relationships between the world's great powers were evolving prior to the pandemic. Tensions were evident due to conflicts in Syria and Crimea. Since the shocking invasion of Ukraine there has been a call to action. Today global leaders are not only worried about the equitable distribution of the benefits of trade, but also the security and resilience of their economies. Our own Prime Minister has recently committed to support development of 'Just in Case' rather than 'Just in Time' models for critical supply chains.

Aligning national security with industrial development is a significant contrast to decades of globalisation. It will require substantial investment and impact trade relationships, labour markets and capital markets. The weaknesses of globalisation have always been obvious. The sudden need to address these weaknesses has become a priority which is rapidly changing the investment landscape.

4. Market structure

The pandemic forced economic change at a scale and breadth almost unimaginable to contemporary financial markets. GFC-era measures were enhanced and expanded to ensure the resilience of financial markets. There was also increased validation for the role of Government in the economy. The US Federal Reserve has put in place massive backstops to ensure the liquidity of the market for US Treasuries and the core banking system. Yet today, with extra ordinary guard rails around banking and risk-free assets, there may be scope for a lower strike of the famous "Fed Put" on markets.

5. Experience

The current cohort of market leaders have enjoyed their dominant position for an extended period. Software as a Service and the Cloud are no longer new concepts and markets have had time to become more discriminating about which companies they are going to support. After a period of time, all start-ups progress from 'promising' to having a demonstrated track record. Good or bad. The incipient pivot from judging the best known and loved start-ups of the last decade on what they promise to deliver relative to what they have delivered is inevitable yet will seem sudden.   

In summary, plenty has changed…

These five themes will force markets to reprioritise their risk assessments. None of these risks are obscure or unknown, however changing events is triggering a reassessment. The market tends to focus on a relatively small number of issues.  So when these change, price movements can seem extraordinary.

Therefore, we adapt

There are important implications for investors in Australian Small Companies. Over the last half decade investors converged around a growth thematic supported by the theory that low inflation, low interest rates and market-friendly central banks would remain enduring features. As a result, investing in baskets of stocks aligned to this theme became as important if not more so than  understanding the actual performance of underlying businesses.

Changes in the inflation and monetary outlook also challenge the significant weight of money aligned with the established macro-strategic positioning. Investors can adapt by re-evaluating the outlook for the businesses they are invested in on a case-by-case basis, then refocusing on those businesses which they consider enduring or alternatively finding new investments which can be beneficiaries of change. 

Author: Sinclair Currie, NovaPort Principal and Co-Portfolio Manager

For decades Australian investors have been encouraged to look beyond their backyard for investment opportunities.  Holding an overweight exposure to the Australian market leads to an unintended skew towards the financial and mining sectors, which together comprise 53.41 per cent of a highly concentrated market as shown in Table 1 below. An allocation to international markets broadens a portfolio's exposure to global leading companies in the IT and Healthcare sectors, which are underrepresented in Australia.

Table 1: Index Weightings

Source:  https://www.spglobal.com/spdji/en/ as at 28 February 2022

This is a sound long-term strategic approach. 

However, at this juncture and after a decade of low interest rates across developed economies, we are now starting to see indications of a turn in the market cycle. Higher inflation and normalising interest rates are expected to remain a feature for the short to medium term. For several reasons outlined below, these factors are aligning to make Australian shares a compelling tactical investment opportunity on a relative basis in the medium term.

1. Relative valuation

Despite the 8.22 per cent fall in the S&P 500 since the beginning of 2022 and after a decade of outperformance relative to global equities more broadly, US equities are still trading at P/E multiples close to their historical averages. The S&P 500 for example, has a forward P/E of 18.5 times, down from 22x at the start of the year and now in line with its long-term average of 18.6x. The derating is most apparent in the tech sector with mega caps such as Amazon, Alphabet, and other FANG+ stocks which were responsible for much of the index return over the past decade. 

As the US market surged over this period, the Australian market lagged on a relative basis. Based on a Global Fund Management survey (Chart 1 below) it appears that global fund managers are repositioning away from US equities with a preference for more attractively priced investment opportunities.

Chart 1: Absolute net% OW positioning by investors

2. Longer path to higher rates

Annual inflation rate in the US accelerated to 7.9 per cent in February of 2022, the highest in 40 years. Energy remained the biggest contributor (25.6 per cent versus 27 per cent in January), with gasoline prices surging 38 per cent (40 per cent in January). Other countries including the UK and Eurozone are not far behind. As a result, in many jurisdictions, bond markets have priced in a path of interest rate hikes particularly over the short term to temper the spike in the cost of goods and services. Higher interest rates will push up borrowing costs for businesses and households and slow economic growth. 

According to the Reserve Bank of Australia (RBA), a divergent path in Australia looks likely with inflation barely within their 2 to 3 per cent target band and wage inflation modest. Australia is also less impacted - but not immune - to rising energy costs as we are a net exporter of gas. China, our largest trading partner, is also seeing lower price growth with annual CPI at 1.5 per cent. Also, in contrast to other markets, China is taking a stimulatory approach to their economy adding liquidity rather than withdrawing Quantitative Easing. This should be a net positive for commodity producers.

Chart 2

Source: Bloomberg as at 28 February 2022

3. Sector composition

The dominance of banks and mining stocks in the Australian market could present opportunities for stock pickers at this point in the cycle. Concerns over rising interest rates over the medium term could increase banks' net interest margins as the gap between lending rates and deposit rates widens allowing greater scope to increase margins. Rising rates also reflects a stronger economic environment which leads to greater demand for credit and lower bad debts. Insurance companies also benefit as they can invest in bonds with higher yields. Australian Banks are well capitalised and are expected to maintain their dividend payout ratios, which are high relative to other companies in the market.

As a major commodity producer, Australia is a beneficiary of rising gas prices, higher demand from reopening economies as well as higher agricultural prices. Commodities often have a positive correlation to inflation and play a safe haven role in inflationary environments and a hedge against falls in equity markets. Compounding the problem is the conflict in Ukraine which is impacting the supply of energy and other metals. A rise in demand combined with a reduction in supply could lead to a commodities super cycle.

4. Dividends and franking

Australia's imputation system lends itself to higher payout ratios than global peers. Companies are incentivised to return capital to shareholders when there isn't a compelling opportunity to reinvest earnings. This reduces the risk of management teams pursuing capital-intensive projects that may not be in the best interest of shareholders. The average dividend yield for the ASX 200 is 4 per cent which is significantly higher than the 1.3 per cent average of the S&P 500. If stock market gains are more muted in 2022, with lower capital returns than we have experienced over the past decade, a higher franked dividend could prove attractive given the lower risk profile than growth focused stocks. 

Summary

The big winners of the past decade have been long duration global growth stocks. Much of their returns have been driven by higher earnings expectations, due to the pull forward in demand caused by the COVID pandemic. Contrast this to banks or commodity-related companies where long-term growth rates are not be expected to be materially different to the current rate. In a climate of higher interest rate expectations, it is these higher growth stocks who are expected to suffer on a relative basis as the earnings outlook for other sectors improves. 

Despite the expectation of monetary policy tightening in Australia, inflation is relatively controlled thus far and short-term interest rates are generally favourable due to a slower than expected interest rate hiking cycle relative to other global markets.

Travel. Remember that? Long plane flights, new places, new people, new ways, new sounds. Whilst many of us look forward to travel once more, is it time to invest in travel? At Insync we believe yes but...... it all depends on how and where.

The Experience Megatrend, of which travel is a component, is one of 16 megatrends in the Insync portfolio. Like a giant tidal wave, megatrends tend to be very large, long lived and unstoppable. Therefore, it is unusual for us to sell out of stocks benefitting from megatrends. However, after an extended period of lockdowns and travel restrictions from a one-off global event reaching into the very heart of travel, it had become clear to us that the nature of travel was going to change in the post Covid world. We sold out of the pure play travel companies and studied deeper into what was probable in the years to come in travel. 

The extent of the fall in travel has been unprecedented as seen in this next chart. Destinations worldwide lost a staggering 1 billion fewer international arrivals in 2020 than in 2019. This compares with the 4% decline recorded during the 2009 global economic crisis (GFC).

Unquestionably, an individual's deep desire to travel is hardwired into human DNA- a developed and privileged means of human wandering. Whilst we cannot know how long the pandemic will last, we are certain that when it is once again safe to travel, people's desire to travel will boom once again. 

However, the pandemic has changed the playing field around traveller behaviour and habits, and this impacts the businesses involved with travel in a myriad of ways.

New expectations have emerged, prompting travel providers to take heed and reassess how they cater to those shifting demands. Therefore, the winners - those that can deliver high ROIC and sustainable growth, in travel post-covid, are not yet clear.

Some recent trends in travel habits we have been observing include:

• Closer - Domestic tourism has shown positive travel uplift. Travellers go for 'staycations' or vacations close to home. How much this will endure once international travel reopens fully remains to be seen. 
• New concerns - Health & Safety measures, getting home in a lockdown, along with cancellation policies are consumers' main concerns. Businesses are however adapting. 
• Get away - Nature, Rural Tourism and Road Trips have emerged as popular travel choices due to geographical restrictions and the quest for open-air experiences.
• Last minute - Last-minute bookings have increased due to volatility of pandemic-related events and the travel restrictions.

The one area that is highly likely to change structurally, and in a negative way, is corporate travel. As many businesses have now transitioned into a hybrid work environment, with remote working and meeting tools normalising, there's no question that businesses will look to lower costs and travel risks. 

Mckinsey estimate that business travel will recover to only around 80% of pre-pandemic levels by 2024. This is important to businesses such as airlines and hotels et al, as business travellers represent a large and profitable part of the travel sector.

Notwithstanding the human desire to travel, we will see fundamental changes in travel patterns compared to the pre-Covid world. Cruise ships, airlines and hotels might seem like the obvious way to invest in a travel rebound. However, these companies are the higher risk, higher reward options and are a lot less profitable through the cycle. They are capital intensive and highly leveraged by nature. For travel booking engines the future remains unclear. Should a new deadlier viral variant emerge post the delta variant, the recovery would be pushed out again with 'pure' travel stocks facing a sudden price setback.

Insync is focused on identifying profitable winners in the travel megatrend in the post Covid world. Sometimes the winning companies are the less obvious ones. Estee Lauder and Walt Disney represent two examples of highly profitable businesses in the Insync portfolio that are beneficiaries of the recovery and long-term resumption of secular growth in experiences and travel. 

Estee Lauder is a highly profitable company benefiting from the wellness and beautification global megatrend. The pandemic with its restrictions and uncertainties has not slowed Estee's rise. Premium skin care continues to grow at multiples of global GDP with the online channel representing circa 40% of their sales in key markets. 

Travel retail represents 25% of Estee's sales, and this is during the pandemic. In places where travel has resumed, such as China, sales have also recovered quickly. What is remarkable is that despite the collapse in global airline travel consumption the travel channel for Estee has been resilient, declining in only one out of the past six quarters through the pandemic. 

Walt Disney's global entertainment focus has produced a variety of interwoven income streams that has seen it do well during the pandemic, and importantly for the recovery, things look even brighter. 

Walt Disney is also a major beneficiary of the Streaming Megatrend, building as many subscribers in 2 years that Netflix took 10 years to achieve.

It is also a major beneficiary of a rebound in the Experiences Megatrend. Disney has a loyal following of customers with parents trusting the brand to provide clean, safe entertainment for their children. Families can plan a vacation at a Disney theme park as their ideal getaway. As a result, Disney has a history of raising prices with no slowdown in customer demand. By example, a Disney World Magic Kingdom Park ticket has more than tripled in price since 2001 (well above inflation), yet every year attendance has continuously increased with the exception of 2020/21 coronavirus lockdown. This trend is highly likely to resume as lockdowns ease. 
Disney also provides a much lower risk way from a recovery in cruising, it is a small and integrated part of their overall offer on experiences. A lot of people that are booking Disney cruises are also booking vacations to Walt Disney World as part of a package. 

For professional investors and advisers only

The road to net zero emissions has the potential to set in place the conditions for a commodity super-cycle which has significant implications for emerging and frontier markets. Governments and authorities made many pledges following the two-week COP26 meeting in November 2021. More than 100 countries, including Brazil and Russia, agreed to end deforestation by 2030. Another 80, led by the US and the EU, pledged to cut methane emissions by at least 30% by 2030 while over 40 countries made new commitments to phase out coal power despite China, US, India and Australia holding back. These widespread commitments to achieve carbon neutrality are likely to intensify electrification and renewable energy efforts, creating multi-decade support for relevant industries. Solar is set to play a more important role while producers of "green wave" materials like copper, uranium and lithium may also be key beneficiaries of this trend.

INVESTING IN CLIMATE CHANGE

An estimated $56tn in incremental infrastructure investment should be needed to achieve net zero carbon emissions by 2050. This implies an average annual investment of $1.9tn in decarbonization worldwide. If politicians commit a fraction of the capital which they have talked about we believe that copper, aluminium, nickel, cobalt and lithium prices could increase significantly as supply and demand dynamics may create serious bottlenecks. The majority of these commodities is located in emerging markets. The economies which are net exporters of these metals should be beneficiaries of higher prices as the contribution of exports to GDP increases rapidly.

We see equity outperformance from companies that produce commodities related to the electrification of the global economy and businesses involved in the respective supply chains (e.g. copper/lithium, electricity transmission, energy storage). The Redwheel Emerging and Frontier Markets team has identified several key themes that look set to benefit from this long-term secular growth opportunity: Sustainable Energy, New Auto Tech and Copper.

SUSTAINABLE ENERGY

The International Energy Agency (IEA) estimates that global electricity demand could double by 2050 under a net zero scenario.¹ We believe that demand has the potential to grow more than that. As the world continues to focus on decarbonization, the majority of the new sources of electricity will have to be generated sustainably. We identify and invest in companies that are actively involved at any point in the supply chain of low carbon energy. The target of sustainable energy is to produce affordable and reliable energy for extended periods of time, while at the same time helping to combat climate change with the lowest possible emission of CO2 and other greenhouse or polluting gases. We have key portfolio holdings across different sectors such as solar power and nuclear energy.

SOLAR POWER

The development of solar power will be crucial in phasing out fossil fuels. Solar PV² is becoming the lowest-cost option for electricity generation in most of the world leading to significant investment in the coming years and strong growth for solar power manufacturers.

In the solar sector, after years of expansion and consolidation, Chinese suppliers now represent more than 80% of the effective capacity in most segments across the solar supply chain.³ Chinese solar suppliers started to expand their capacity in 2019 on the back of stronger visibility on future demand. The robust performance of these companies in the equity market has enabled them to raise capital and further accelerate their expansion plans.

LONGi is the largest mono-silicon wafer producer in the world and is set to be a key enabler of the shift to solar power. We expect ongoing vertical integration (from wafer to cell and module) to potentially further boost LONGi's market share in the global module markets. Additionally, LONGi believes the distributed solar market in China, especially commercial and industrial, should see strong demand in 2022 driven by government policies. In 2021, distributed solar modules accounted for 15-20% of LONGi's total module shipment, which may increase to 35-40% in 2022. LONGi believes the distributed solar market has higher module price affordability than solar farms, leading to higher margins.

URANIUM

Nuclear energy has been brought back into the spotlight due to its low cost and high energy efficiency. Nuclear capacity is increasing in countries such as China and India due to the constant search for more sustainable forms of energy. This is offsetting the decommissioning and decline of nuclear as a source of electricity generation in Western countries. However, we believe that nuclear power will regain political support in the US and parts of Europe which will drive life extensions of existing reactors and positively impact medium term demand. Additionally, supply curtailments by key industry players such as Cameco and Kazatomprom could continue to drive uranium prices higher, benefitting low cost uranium miners.

Kazatomprom is the world's largest uranium producer commanding a direct share of 45% of the world's production. Its mines operating in Kazakhstan are also the lowest cost uranium producer globally. This uranium miner will be a key beneficiary from the expected rise in uranium prices.⁴

COPPER

We have been bullish on the role of copper in the drive for global decarbonization for several years. Copper is one of the key metals and beneficiaries of the electrification of the global economy, whether through the production of electric vehicles or the electrification of industries and is crucial in the construction and build out of renewable energy. For example, electric vehicles use seven times more copper per car than vehicles powered by internal combustion engines while wind power is five times as copper intensive as thermal power stations. A wholesale switch would require the copper supply to almost double from today's levels.⁵

On the supply side, large existing copper producers are struggling to maintain copper production at current levels as higher cost underground mines are replacing above ground open pit mines. Ore grades have decreased substantially, and our research suggests new copper greenfield projects are only viable at sustainable prices of over $3.50 per pound of copper. These supply issues, combined with secular growth in demand, suggests that the outlook for the base metal is positive over the coming years.

Emerging markets account for over 60% of the copper supply globally, therefore we see several emerging markets benefitting from the robust long-term supply-demand dynamics of copper.

In Zambia, First Quantum Minerals operates one of the largest copper mines globally. The company is set to benefit from an appreciation in the copper price over the next decade due to robust demand and subdued supply.

NEW AUTO TECHNOLOGY

There is currently a dramatic change taking place in the world's transportation sector. New Energy Vehicles (NEVs) are replacing vehicles with internal combustion engines (ICEs). NEVs require different materials for construction and operation which lead to a new set of beneficiaries within the automobile supply chain.

We believe there is a considerable growth opportunity within the upstream segment of the NEV value chain. Demand for commodities such as lithium, nickel, cobalt, copper and platinum group metals should rise exponentially as the penetration of NEVs increases worldwide.  The supply dynamics of many of these commodities are strained which will likely lead to higher and more stable prices over the medium to long term.  

Electric vehicles are the main driver of future lithium demand, accounting for c30% of total lithium demand currently and potentially rising to over 60% by 2025e⁶. As a result, lithium demand is expected to grow 20-25% annually in the medium term. We expect lithium prices to be supported over the next decade by strong demand and lagging supply leading to deficits.

SQM operates one of the world largest lithium mines in Chile and is well positioned to take advantage of this price environment. The company should see robust production growth through the end of the decade, while its projects have attractive positions on the cost curve. Additionally, SQM has a solid balance sheet to fund this growth and has significant leverage to lithium prices.

WHAT HAPPENS TO FOSSIL FUELS?

The global economy will remain heavily reliant on fossil fuels for several decades to come despite the transition to a green economy. Even if all the currently announced climate pledges were fully implemented, oil demand in 2050 would still be 75m barrels per day, down only 25% from current levels (source: IEA, 13/10/2021). However, capex in the sector is down 50% from its peak in 2014. Thus, it is quite possible that the supply of fossil fuels will decline more than demand as the development of low carbon alternatives may not be adequate to keep the market balanced. Underinvestment in the hydrocarbons sector amid green transition efforts and changing government regulations could lead to growing energy scarcity.

This structural underinvestment in high carbon sectors is likely to drive hydrocarbon prices higher over the medium-to-longer term, raising affordability concerns, but also increasing the innovation of decarbonization technologies.

CONCLUSION

In conclusion, as the momentum behind the 'E' of ESG grows stronger, we will continue to see an increasing demand for greener materials and we believe Emerging Markets are set to benefit.  However, unless more investment comes through, mined raw materials may become a bottleneck to tackling climate change.

The French presidential election is underway, with a first-round vote on Sunday 10 April and the run-off between the top two candidates on Sunday 24 April.

In a likely replay of 2017, the polls suggest incumbent President Emmanuel Macron will face far-right candidate Marine Le Pen in the run-off.

In this piece we consider some of the key issues at play and the implications for us as infrastructure investors.

Meet the candidates

From far-left to far-right, there are 12 official candidates for the election.

As of 2 April, opinion polls are placing Emmanuel Macron ahead with 24% to 33% of vote intentions, with the other candidates fighting for the runner-up position.

Key policy positions

The table below summarises the key policy positions of the four leading candidates and how they may impact the current and potential future infrastructure investment environment.

Impact on infrastructure investment

In terms of sector specifics, energy/climate policies have dominated the campaign with all candidates expressing a view - albeit quite different ones - around need, support, funding and timing of the energy transition. These policies represent potential head and tail winds for the infrastructure sub-sectors exposed, but overall it means significant investment in the sector, potentially creating many future private sector investment opportunities.

Outside the energy space, the argument of private versus public ownership of the transport sector has again come into play and could have ramifications for those stocks exposed, such as Vinci, Atlantia and ADP.

A second Macron term

A Macron win would not alter the fundamental outlook for the infrastructure sector relative to today. However, it will cement a positive infrastructure investment cycle with more than €10bn of investment towards energy transition and Russian gas independence.

The pace to renewable energy as base load power could also accelerate and benefit renewable operators such as Neoen, Voltalia, Orsted. We would expect further integration with Europe in terms of security of energy supply benefiting the integrated players.

We have also seen a shift in thinking around nuclear. We expect Macron, in a second term, to revive what had been an out-of-favour sector with important investment packages to both extend the life of existing plants and develop new generation reactors (to the benefit of Engie, EDF or Vinci).

Outside the energy sector, we believe the current motorway network concessions could be extended in exchange for capital expenditure commitments, supporting improved motorway efficiency and growth profiles of the key players such as Vinci or Atlantia.

A Le Pen win

Le Pen has dropped her controversial proposal to exit the euro, which we believe reduces the risk to the overall French economy relative to 2017.

Due to the extreme nature of her economic positions, a Le Pen victory would lead to clear winners and losers in the infrastructure space.

The biggest threat from a Le Pen victory would be the nationalisation of assets of listed entities with toll roads and airports clear targets, which would be detrimental to domestic listed players such as ADP and Vinci as well as foreign players with exposure to French infrastructure. Regardless of whether nationalisation is a serious threat (legally or otherwise), it would be a clear overhang for the sector - much like a potential Jeremy Corbyn victory was for the UK in 2019. Even without nationalisation, in a Le Pen victory the infrastructure sector will likely experience stricter sector regulation (as far as it is possible within the concession construct).

Positively, Le Pen has expressed a willingness to pursue the energy transition. However, certain sectors are definitely not in favour (wind), and she would push for limitation of the EU influence on French energy policy.

Conclusion

We are expecting a Macron/Le Pen run off with Macron ultimately re-elected for a second term. However, unless Macron can also win a majority in the parliament, we could see a fragmented legislature with increased difficulty in policy execution stalling reforms. Regardless of who wins, we see continued positive momentum in energy transition and investment as all parties work towards this common goal, and more of a status quo for the transport names with existing earnings underpinned by long-term concessions. Should Le Pen win, we would revisit our transport exposure in the near term.

Key Portfolio Construction Trade-Offs

Dr. Laura Ryan and Tamar Hamlyn are joined by Dr. Nigel Wilkin-Smith to discuss the importance of currency management for AUD investors, along with the backdrop created by the regulatory environment in superannuation, particularly the YFYS performance test.

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.

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