January saw property prices fall nationally by 1%, which was less than December and the smallest month to month decline since mid last year according to CoreLogic's national Home Value Index.

Prices fell across all capitals by an average of 1.1%, however regional housing values continued to record a milder rate of decline at -0.8%. Hobart saw the largest reduction (-1.7%), followed by Brisbane (-1.4%), Sydney (-1.2%), Melbourne (-1.1%), Canberra (-1.0%), Adelaide (-0.8%) while the falls in Perth and Darwin were less significant at (-0.3%) and (-0.1%) respectively.

The quarterly trend however is pointing to a reduction of the in the pace of decline, and despite the falls every capital city and region is still recording home values above pre-pandemic levels.

Contributing to the reduction of dwelling values, is the fall in demand. Capital city dwelling sales were down -29.4% on previous year figures, with listings -22.2% below the same time last year meaning that most home owners who are considering selling are sitting things out with no pressure to sell into this market.

Weekly auction activity has begun to increase in 2023, with 706 auctions taking place across capital cities last weekend achieving a 67.9% clearance rate which we consider positive. Melbourne recorded the most auctions with 259 auctions taking place at a clearance rate of

68.3% (67.5% last year), followed by Sydney with 202 auctions and a strong clearance rate of 71.6% (66.3% last year). Adelaide achieved the best clearance rate for the weekend with 76.8% (81.8% last year) for their 105 auctions whilst Brisbane and Canberra were lower with clearance rates of 59.6% (80.1% last year) and 52.2% (85.5% last year) respectively.

Whilst property prices will undoubtedly be linked to the movement in interest rates we do believe we are nearing the end of the rate rise cycle, with some banks already beginning to reduce the fixed rates for 3 and 5 year terms.

The resurgence in overseas student migration will also see the rental market remain tight and help support yields across the residential property market. As a result we do believe housing values will stabilise over the coming months as some level of confidence returns to the market. 

Quick Insights

The Return of Students  Demand is set to strengthen in inner-city suburbs across Australia as the Chinese government directs its students to return to university campuses worldwide. Almost 50,000 Chinese students are expected to flood back into Australian capitals looking for rental accommodation as they return to in-person study. This injection of demand is likely to raise rental yields by at least 5%

Extra Eastern Income  Demand for rentals in Sydney's affluent eastern suburbs never waned throughout last year even as the supply of suitable housing dried up. As a result, an additional $19,812 in rental income was delivered to some landlords throughout 2022. Across the country, houses and units across 195 suburbs made at least $5200 a year in extra rent during the same period.

Apartments Continue to Rise  In addition to the rental apartment frenzy in Melbourne and Sydney, property prices among apartments have also risen. In particular, Adelaide, and Brisbane have seen unit values jump by significant amounts. 76 suburbs across Queensland and South Australia, broke record-high prices in December. Adelaide's Mitchell Park alone rose by more than 30%. Tim Lawless of CoreLogic has explained that, "...with borrowing capacity reducing as interest rates rise, it's likely the lower price points of unit values have become more broadly appealing."

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As we look forward to the year ahead, we have been reflecting on where we are likely to see the most prominent sustainability issues (sometimes called 'ESG' or environmental, social and governance issues) surface for companies in the year ahead.

Our predictions include continuing to see the big issues, such as climate change, remain centre stage but shift from a conversation about disclosures and targets to issues of quality and substance. Alongside climate, we will see companies scrambling to make sense of an expanding environmental mandate to include understanding their implications on nature and biodiversity more broadly.

We see a big year ahead for social topics, including industrial relations and labour rights, as well as a resurgence of issues pertaining to social license to operate. And, as ever, good governance will continue to be a key driver of value, particularly with the continuing rise of cybersecurity issues and companies having to navigate an increasingly complex landscape of material issues.

Our predictions for the big battleground ESG issues for the year ahead are:

Environment

1. Climate change issues are evolving towards quality:

• Move toward the improved transparency, rigour, feasibility and quality of emissions reductions strategies, including a focus on more science-based targets and disclosures for scope 3 emissions.
• Push for reducing greenwashing and more scrutiny around credibility of targets and claims, as supported by the Treasurer recently putting greenwashing penalties into focus, and signals from ASIC and APRA over the last year that guidelines are moving toward increasing regulation and penalties. This is also supported by the establishment of the Australian Sustainable Finance Institute and their move to publish an Australian Sustainable Finance taxonomy.
• Negative emissions - taking carbon out of the atmosphere, not just avoidance and abatement-will become a hot topic.

2. Nature, food and water security and biodiversity will be the newest everywhere topic:

• 2023 will be a year of companies trying to establish their liabilities and obligations with the growth in nature-related disclosures.
• Beyond 2023, clearer standards and expectations will emerge in relation to the way companies are impacting vital resources, like water, soil and air, biodiversity. This will be underpinned by tightening Federal legislation (e.g. Our Nature Positive Plan) and increasing disclosure frameworks (e.g. TNFD (Taskforce for Nature Related Financial Disclosures)).
• We can expect more focus on water stress and food security, including on equity and pricing which will have implications on how companies consume, price and manage water assets. The tension between water as a commodity versus a resource as well as issues of access, affordability and sustainability across food supply chains will become increasingly apparent.

Social

3. Industrial relations and labour rights and conditions will become increasingly material:

• Workplace issues will continue to make headlines, including companies that are failing to engage in appropriate cultural shifts to account for demands for diverse, fair and inclusive workplaces.
• Industrial Relations reforms (e.g. Secure Jobs, Better Pay 2022) have put rights for collective bargaining, flexible work, gender equity and zero tolerance on sexual harassment into the spotlight. We see increasing risks for companies with either no EBA (enterprise bargaining agreement) or an EBA set to expire, a low-paid workforce and high union membership, as well as companies with poor track records responding to inappropriate workplace incidents at risk.
• Best places to work studies starting to show that companies that rate highly are driving alpha.

4. Social license to operate makes a 'comeback':

• Greater regulatory pressure and scrutiny on social license when evaluating new approvals. Evidence is particularly prevalent in the mining, materials and energy sectors, with material financial impacts. We are also seeing companies with track records of breaches experiencing regulatory approval issues compared to peers (e.g. RIO v. BHP and FMG).
• Industries and companies with shaky license to operate are more at risk of stakeholder outrage and penalties, NGO engagement, increased scrutiny, regulatory intervention, litigation, and accountability on stakeholder management issues. Socially controversial sectors are likely to see more stakeholder backlash incidents in the years ahead.
• We are also likely to see this issue intersect with issues of equity, access and affordability. As rising cost of living fuels pressures on quality of life, there will be focus on accessibility and affordability as the socioeconomic divide widens, particularly for products and services that are considered 'rights' (e.g. pharma).

Governance

5. Data security and privacy evolves to include issues of data sovereignty:

• The conversation around privacy and data security will continue to escalate, alongside more sensitive data leaks and cyber security attacks. Reports of cybercrime were up 13% in 2022 led by the highest reporting sectors of government (healthcare, IT, and education and training).
• There will likely be pushes toward data sovereignty and people demanding ownership rights over their own data.
• With the rise of AI (Artificial Intelligence), a new suite of digital security challenges such as how data use is intersecting with issues of human rights is quickly surfacing. This is giving rise digital sovereignty issues, where companies will have to navigate geopolitical boundaries to comply with new regulations about data privacy and regulations.

6. The 'G' factor will drive corporate responses to an evolving landscape of material issues:

• While corporate governance has been the most steadfast in the ESG conversation, we will see the 'G' factors continue to be seen as critical (perhaps the most critical) in this evolving landscape of complex and material E and S challenges. How a company responds to any material issue always comes back to its governance.

Beyond the E, S, and G

Beyond the individual issues surfacing under the E, S, and G banners, we also see trends toward positive investment opportunities, including:

7. Scale will be the focus for the new wave of purpose driven capital:

• Purpose driven capital will move toward opportunities at scale commensurate with the size of the social and environmental challenges and the urgency and timelines of these challenges. Offshore wind, hydrogen, nuclear-what are the game changers that are going to help address the scale and urgency of the problems we are facing? This is where the ideal moves toward the pragmatic and money will follow, which is why we are seeing labelling shifts in the EU Taxonomy to allow for gas and nuclear.
• We will see the theme of 'transitions' extend beyond energy and climate. The trend of moving away from 'divestment' toward active engagement will start extending to other sectors including waste and toxic chemicals. This provides opportunities to look at positive screens and ESG improvers and leaders across all sectors, particularly those companies with entrenched social/environmental issues but which are societally necessary or difficult to replace.
• Collective action and collaborative engagement will be a feature for engaging in these strategies. We expect to see new innovative approaches toward collective action in the year ahead.

8. Sustainability, ESG and Impact are no longer distinct approaches to investing:

• Investors across all shades of responsible investment have been looking for the win-win solutions to back for decades, opportunities that deliver alpha and support the narrative of addressing our world's most pressing social and environmental challenges. Investors now seeking to align a values overlay with value considerations have to look beyond the thematic to the nuance of how companies are operating. This is forcing a "coming together" of ESG considerations with positive screens, thematic investing and impact investing. This is, in part, because value is not just driven by what a company produces but also by how it operates. This means that a lot of our distinct responsible investment approaches are blurring together, creating a greater need to help investors interrogate the different strategies of how managers are integrating these responsible investment considerations into investment decisions. This intersects with the moves toward a taxonomy, scrutiny around greenwashing, and greater requirements for transparency, disclosures, and language that helps investors understand the quality of disclosures and strategies.

Author: Dr Erin Kuo, Yarra's Chief Sustainability Officer

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The changing seasons are nature's way of reminding us that time moves on. And it is the same in the Russell household, where my youngest is approaching 18 and his late weekend nights are his way of telling me change is arriving in our home too. There is a dawning that I am heading into a new stage of life. It is exciting, but after 20 years of bringing up a family, I also admit to being a little scared of what the next chapter will bring. In markets we often get obsessed with short-term changes but it can be the slow structural moves—such as a child leaving the home—which can have a more profound longer-term impact.

Bear markets exist for a purpose. They expose the heavy misallocation of capital that in this bear market happened because finance was too easy. While capital is now more rationed, energy too can no longer be taken for granted. Of course management teams of energy companies have been aware of this for some time, as they have witnessed their own cost of capital rise as the shale revolution unwound and climate change took hold.

In bear markets time horizons are compressed and dreams are often shelved as rising costs force management teams to make difficult choices. These choices impact different stakeholders, often over different time horizons, which explains why companies adopting a stakeholder approach with purpose could be better equipped to navigate their way through difficult times and eventually, when the next bull market begins, may be better placed to solve the significant challenges facing society over the coming decades.

Choice One: Energy affordability versus long-term energy transition

Energy markets and policies have changed as a result of Russia's invasion of Ukraine, not just for the time being, but likely for decades to come. The environmental case for clean energy needed no reinforcement, but the economic arguments in favour of cost-competitive and affordable clean technologies are now stronger—and so too is the energy security case. But solving for clean, secure and affordable energy is not straight forward.

Energy is an input to making substantively everything in the modern world. So when we have shortages—as we do now—the rising costs of everything acts like a tax on consumption. Primary energy costs at the start of the last century were about 4% of the global GDP. Today, primary energy accounts for about 12% of total GDP, which is similar to that achieved in the two oil shocks in the 1970s.¹

Direct energy makes up about 45% of European inflation (Chart 1). However, we also know that 10%-15% of all primary energy goes into making food for the world's population—which adds to the inflationary pressure. If other associated links to energy are added, we can estimate that approximately 75%² of inflation is driven directly and indirectly by energy costs. Our current energy crisis is a core element of today's inflation and until we solve energy's supply problems, we expect inflation to remain stubbornly above most central banks' 2% targets.

Chart 1: Headline inflation rate with component contributions - Eurozone

Source: Aurora Energy Research, GOV.UK, Eurostat, U.S. Bureau of Labor Statistics, MarketWatch

Today, for every US dollar (USD) spent globally on fossil fuels, USD 1.5 is spent on clean energy technologies. But by 2030, under the net-zero emissions by 2050 scenario, every dollar spent on fossil fuels will be outmatched by USD 5 on clean energy supply and another USD 4 on efficiency and end-uses.³

If clean energy investment does not accelerate, higher investment in oil and gas will be needed to avoid further fuel price volatility, while also putting the 1.5 degrees Celsius goal in jeopardy. But if we accelerate clean energy today at the expense of fossil fuels, we will only exacerbate our energy shortages, given the short-term draw on valuable energy sources made by solar and wind. These are long-term versus short-term choices that even the experts have difficulty reconciling (Exhibit 1):

Exhibit 1: IEA illustrates the challenge between short-term affordability and long-term energy transition

International Energy Agency (IEA) executive director Fatih Birol: "If governments are serious about the climate crisis, there can be no new investments in oil, gas and coal, from now - from this year". ("No new oil, gas or coal development if world is to reach net zero by 2050, says world energy body", The Guardian, 18 May 2021)

IEA's 2022 outlook: "Ahuge increase inenergy investmentis essentialto reducethe risksoffutureprice spikes and volatility, and to get on track for net zero emissions by 2050… an average of almost USD 650 billion per year 'will be' spent on upstream oil and natural gas investment to 2030, a rise of more than 50% compared with recent years". (IEA "World Energy Outlook 2022", November 2022)

The most suitable near-term solutions include projects with short lead times that bring oil and gas to market quickly, but also includes areas such as capturing some of the 260 billion cubic metres of gas that is wasted each year through flaring and methane leaks⁴ to the atmosphere—a key driver of our investment in Emerson.

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.

¹Thunder Said Energy, "Energy Shortage: fear in a handful of dust?", November 2022
²Nikko AM estimates
³IEA, "World Energy Outlook 2022", November 2022
⁴IEA, "World Energy Outlook 2022", November 2022

Demand efficiency and productivity could also be key and in this field, there has been significant progress. A recent German IFO survey suggested that most companies—in this case 75% of those that use gas as a primary energy source in their production—have found ways to reduce gas usage in the last six months while still meeting production targets (Chart 2).

Chart 2: Reduction of natural gas consumption in the production process (%)

Source: IFO Business survey, October 2022

In fact energy efficiency is the number one place to look for solutions to this energy crisis. While energy costs soar, CEOs are expected to look at ways to make their businesses more resilient and reduce their energy burden. Paybacks on energy efficient investments will be very high, in our view, and are unlikely to be shelved if and when a recession starts. We see this providing tailwinds for long-term holding companies such as Schneider and opportunities within the energy services companies, where cash flow returns could accelerate to double-digit levels. This is certainly a significant part of the reason for our more recent investments in Worley & Schlumberger

Choice two: ESG recession versus stakeholder capitalism

Recent market history suggests that commodity prices will correct with a recession and if central banks have their way, a recession is exactly what we may get. Our own experience tells us that we should prepare for where the cuts might be. Some are obvious—such as advertising and marketing. These cuts have already started as can be seen by the demise of Google or Meta. For many others their earnings recession is just starting.

Corporates are also expected to cut capital projects and the following June 2022 Gartner poll provides some insight into where these might be (Chart 3). The results are not surprising—but significant reductions in investment for improved sustainability and environmental impact is worth raising.

Chart 3: Investment categories to be cut first—surveys

Source: Gartner, July 2022

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.

While corporates may sharpen the knife on sustainability, what is surprising to many is the backbone behind policy changes in Europe and the US (among others) which instead of accelerating fossil energy supply, are expanding incentives and targets for alternatives, such as wind, solar and hydrogen. The REPowerEU Plan was launched by the European Commission earlier in 2022 to reduce the European Union's (EU) dependence on Russian fossil fuels in a direct response to the Ukraine invasion. The plan calls for the EU to consume 20 million tonnes (mT) of hydrogen by 2030, instead of the 5mT target previously quoted in the Fit For 55 policy announced just a few months before, as an example. If we feared a clash between decarbonisation and short-term energy needs, decarbonisation seems to remain society's number one target.

The bull market for ESG data and integration has been stratospheric. Changing demographics, rising inequality, the rise in the importance of externalities such as nature and increased influence of the state through regulation all have a part to play. But as was the case in prior recessions, we should expect ESG to be less of a focus for management teams as they divert their attention to short-term challenges or for some simply staying afloat (Chart 4). In our view, expensive virtue signalling does not perform well during recessions (e.g. Tesla).

Chart 4: Long-term bull market for ESG—with a few blips

Source: Bernstein research and Bloomberg, October 2022

In terms of energy shortages, we may play out the 1970s again. We also appear to have returned to that decade to question the role of shareholder primacy, with both business leaders and politicians (e.g. business round tables and the Davos Manifesto), suggesting we are on the verge of a fundamental reshaping of society. This slow, structural change is of course not new and ESG is a key cog if stakeholder capitalism is to work.

Given the shift to stakeholder capitalism is such an ideological shift, it shouldn't surprise anyone that we are now seeing an ESG backlash, the most vigorous of which is targeted at greenwashing. Survey evidence around sustainability suggests trust is low. For example, three out of four institutional investors do not trust companies to achieve their sustainability targets and commitments.⁵ And of course, the measurement of ESG data is fraught with difficulty; while credit ratings correlate 99%, the correlation of external ESG ratings ranges between 38% and 71%.⁶ For some, ESG is leading to a significant misallocation of capital and is morally bankrupt. ^7 8The situation has prompted some regulators, such those in the predominantly Republican US states, to try and alter the direction of travel and ban ESG investing altogether.

Yet, many companies today are making major decisions, such as discontinuing operations in Russia and protecting employees in at-risk countries. They also continue to commit to science-based targets and to define and execute plans for realising these commitments. This indicates that ESG considerations are becoming more—not less— important in companies' long term decision making.

In fact, at Nikko Asset Management we believe companies should adopt a stakeholder approach. Companies must approach externalities as a core strategic challenge, not only to help future-proof their organisations but to deliver meaningful impact over the long term. Some companies that have already built purpose into their business models and are demonstrating they benefit multiple stakeholders are already showing success, such as Microsoft or lesser known companies, such as Compass Group.

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.

⁵Edelman, "2021 Trust Barometer Special report: Institutional investors", November 2021
⁶Florian Berg, Julian Kölbel and Roberto Rigobon, "Aggregate confusion: The divergence of ESG ratings", Review of Finance, forthcoming, updated 26 April 2022
⁷Bérengère Sim, "Ukraine war 'bankrupts' ESG case, says BlackRock's former sustainable investing boss", Financial News, 14 March 2022
⁸Steve Johnson, "ESG outperformance narrative 'is flawed,' new research shows", Financial Times, 3 May 2021

In recent years, boards of directors have become increasingly focused on corporate purpose. This is partly driven by a sense that purpose drives corporate culture, helps attract and retain talent and is increasingly a differentiator when it comes to customers and suppliers.

External pressure on corporate boards to define purpose better has come from investors, who are themselves being asked to justify their own investments on the basis of ESG as well as financial considerations.

A single, clearly marked path that every business should follow does not exist. Strong corporate leaders recognise that social expectations constantly evolve and we believe that it is the company's purpose that guides management, fund managers and owners through difficult times.

A recent Mckinsey study developed a framework for summarising key ESG approaches. This highlights characteristics of those at the forefront of stakeholder capitalism, fully integrating ESG into strategy and operations—listed as "Next Level Practices". Companies adopting stakeholder capitalism are seen to be enhancing their company's competitive positioning. They have purpose and can articulate why stakeholder capitalism is creating a competitive edge (Exhibit 2).

Exhibit 2: Corporate approach to ESG and stakeholder capitalism

Source: "How to Make ESG Real", McKinsey, August 2022

They are a more attractive place to work for their employees—retention rates are higher than peers—successfully fighting the war for talent, while some are discovering new solutions needed to solve many of our current problems, such as climate change.

We can already see success in many of our own holdings—such as Danaher, Sony or John Deere to name a few. These companies are creating their very own superpowers, enhancing their franchise and management qualities and creating value (Exhibit 3).

Exhibit 3: Examples of Future Quality purpose statement

"Helping realize life's potential" (Danaher)

"Fill the world with emotion, through the power of creativity and technology". (Sony)

"We must act with urgency today to make the lives of our customers, workforce, and all those we serve better tomorrow". (John Deere)

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.

Our own experience is supported by academic research. Work by Ariel Babcock et al. titled "Walking the Talk: Valuing a multi-stakeholder strategy" links the importance of stakeholders and stronger operating performance across a number of metrics.⁹

These management teams are committed, empathetic and demonstrate with full and transparent disclosure of data that they are on a journey of continuous improvement. They invest with a long term investment horizon and are prepared to make difficult decisions, some with potential trade-offs across different time periods. But when backed by a clear purpose statement that creates value for all key stakeholders, these management teams can "walk the talk".

Remuneration and incentive schemes are linked to measurable ESG targets and integrated reporting—such as diversity targets or emission reduction targets. And they are preparing themselves for further regulation such as the introduction of separate ESG reporting under what is known as "Double Materiality".

Conclusion

In conclusion clean, secure and affordable energy is likely to be one of the major challenges of this decade. Given we need abundant energy to complete the energy transition, we believe fossil fuel companies that are actively enabling transition to low carbon society can be part of the solution. They often understand how to deliver global energy at scale and have the balance sheets capable of enabling the transition to clean energy.

We also believe companies adopting a stakeholder approach will be better equipped to solve the significant challenges facing society over the coming years, and that a clearly defined purpose will help guide management teams through the challenges and choices they will have to make.

After all, it is the choices made today that will define the Future Quality returns of tomorrow.

⁹Ariel Babcock et al., "Walking the talk: Valuing a multi-stakeholder strategy", FCLTGlobal, 17 January 2022

Author: Johnny Russell, Investment Director, Global Equity 

Important disclaimer information
Please note that much of the content which appears on this page is intended for the use of professional investors only.

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Last year was terrible for equities. A war in Ukraine, soaring inflation, higher interest rates and weak economic growth all weighed on sentiment. Globally, both small and large caps were firmly in negative territory. Large-cap indices like the S&P 500 were dragged down as technology companies (such as Meta and Tesla) and stocks with high valuations sold off. Meanwhile, risk-averse investors shunned small caps as economic conditions deteriorated.

And what about the future? Given the gloomy backdrop, investors are likely to avoid smaller companies for much of 2023. On the surface, this decision seems understandable. History shows that smaller companies tend to underperform larger ones during economic downturns. But dig a little deeper and a surprising conclusion presents itself: the time to start allocating capital to small caps might be sooner than investors think.

Small caps outperform earlier than expected

There are widely agreed assumptions about the performance of smaller and larger companies in different economic scenarios. Chart 1 shows the relative average performance of US small caps versus large caps, before, during and after recessions (dating back to the 1980s). Of course, each recession is different, with different mechanisms at play. Nonetheless, three factors stand out.

Chart 1

Source: Bloomberg, William Blair Equity, December 2022

Firstly, larger companies tend to outperform their smaller rivals before, and at the start of, recessions. This makes sense. In economic slumps, risk-averse investors typically favour safer assets. In the equities space, this means more mature, well-established larger companies. Their markets are often less volatile and earnings more stable. By contrast, investors view smaller companies as riskier investments. Many businesses aren't as entrenched as bigger firms. Earnings and profit margins can therefore come under pressure in times of upheaval.

Secondly, these factors are turned on their head when we exit a recession. In recovery periods, smaller companies usually outperform their larger rivals. By their very nature, small caps are nimbler and able to react faster than large caps to changes in the business environment. Smaller firms can therefore take advantage of the new opportunities a growing economy offers. The consequent rise in investor risk appetite also helps smaller companies.

So far, so predictable. But the third point is not widely known: smaller companies have historically started outperforming large caps soon after a recession starts. As you can see from Chart 1, this rebound can begin as early as three-to-six months into a recession. That's because the market tends to price in an economic recovery before it happens. Yet this phenomenon is not part of the traditional small/large-cap narrative. We believe this disconnect creates opportunities for active investors.

A potentially attractive entry point

Smaller companies trailed their larger peers in 2022. In Europe, it was the worst relative year since comparative data began (see Chart 2). This has had a knock-on effect on valuations. Historically, European smaller companies have traded at an average premium valuation of 21%¹ above that of larger peers, thanks to superior small cap growth and earnings potential. However, at the close of last year, this difference dropped significantly and is currently at 9%. Given the potential rebound as we exit recession, this could represent an attractive entry point for long-term investors.

Chart 2

A similar dynamic is at play in the US. Here, the valuation discount of small caps relative to large caps is as wide as it has been in more than 40 years (Chart 3). We believe this creates excellent long-term opportunities. Indeed, after US small caps reached a similar level of 'cheapness' in early 2001, small-cap stocks materially outperformed larger caps over the subsequent three-, five- and 10-year periods¹.

Chart 3

What about today's high inflation, high interest-rate environment?

As we highlighted, every downturn has its own characteristics - and this time is no different. Today, elevated inflation is a major factor (although it remains benign in much of Asia). Developed market central banks have responded by aggressively hiking rates. The medicine appears to be working. Eurozone and US inflation has retreated from summer highs, recording 9.2% and 6.5% in December, respectively¹. Nonetheless, it will take time for inflation to reach pre-pandemic levels.

But we believe high inflation shouldn't worry small-cap investors too much. Many smaller companies operate in niche industries or areas of the market with few players. They're also often a critical link in complex supply chains or wider manufacturing processes. As a result, they can dictate higher prices despite their size, allowing them to pass on costs to protect their margins. They also have the agility to change where they source goods and materials, further helping to control costs.

What about elevated interest rates? Many assume that higher rates hurt small caps more than larger caps. That's because many small caps are starting out and have weaker balance sheets and lower profit margins. This is the case for some businesses. However, as anyone watching the headlines knows, several larger companies have also been found wanting in the world of higher interest rates. In short, durability frequently comes down to the quality of the company.

The importance of quality

That's why we focus on high-quality firms, irrespective of the macroeconomic backdrop. That is, those with low leverage, strong profitability and consistent earnings. True, quality has underperformed in 2022 as many investors rotated into value stocks. But with the economy deteriorating, we believe investors will increasingly favour companies with robust business models, pricing power, healthy balance sheets and unique growth drivers.

Final thoughts…

So is now a good time to start considering smaller companies? The traditional answer would be a resounding 'no'. The world economy is forecast to slow further in 2023, with a recession possible in the first half of the year. However, as we have shown, smaller companies might be more resilient in the current inflationary climate than many assume. Using history as a guide, we can also see that smaller companies start to rebound quicker during economic downturns than is widely assumed. With valuations depressed, investors could therefore potentially pick up great long-term opportunities at a discount.

Author: Anjli Shah, Investment Director, Smaller Companies Team, Equities

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If there was a year in investment markets where swearing was justifiable, 2022 would be a great candidate. The FT shows us swearing reached new heights on company conference calls. Maybe swearing in 2023 will find a new peak as the feeling of greater uncertainty remains - just look at the IMF's plot. Gartner's estimate of a 28.5% year-on-year decline in global PC sales may cause a few to swear, at least privately. Net flows into tech, as charted by JP Morgan, were hammered right through to the end of 2022. Of course it was the unprofitable segment of tech that Charles Schwab's @LizAnnSonders shows taking the most heat. We can also see that pain in the price/sales multiple contractions highlighted by The Macro Compass' @MacroAlf. There can be no doubt the cost of capital has jumped - Professor Damodaran's expected equity return estimate has increased >4% while Bloomberg's negative yield bond chart lost its last member. Two different schools of thought fight it out over what the Fed needs to do to curb inflation - CLSA shows that when US inflation has spiked above 5%, the Fed had to lift rates to "within spitting distance" of the inflation peak; but DoubleLine is backing the bond market's lower implied rates over the Fed's expectations. Economist @C_Barraud picked up on the decline in Australian house prices as borrowing costs surge. Credit card rates are surging too, as per FRED data, and re: venture consulting sounded the alarm on personal savings in the US diving. The cost of debt is also a growing problem for governments, @CharlieBilello highlights. Looking forward to reporting season, Bespoke sees market expectations in the US have been pulled back across almost all sectors. FactSet's aggregate of S&P 500 earnings estimates shows a 3.9% decline is now the consensus for the December quarter - but the actual earnings growth rate has exceeded the estimated earnings growth rate at the end of the quarter in 38 of the past 40 quarters. Finally, some good news - chart brought to our attention the progressive healing of the ozone layer.

Bull market in swearing - frequency of swearing on conference calls

 

Source: AlphaSense, Financial Times

 

World Uncertainty Index - Ukraine invasion spike in red

 

Source: IMF

Global PC shipments in December quarter of CY2022

 

Source: Gartner

Thematic net flows split (excluding ETFs)

  

Source: JP Morgan, @wallstjesus

Performance of non-profitable tech stocks (US)

 

Source: Charles Schwab's @LizAnnSonders, Bloomberg

Price-to-sales for VC-backed IPOs (US)

  

Source: Pitchbook, Morningstar, @macroalf

US Equity Risk Premium

 

Source: Aswath Damodaran

The last of the negative yielders

 

Source: Bloomberg

When US inflation has spiked above 5%, Fed Funds Effective Rate has had to follow

 

Source: CLSA via @nomad_cap

Fed Funds Rate - Market Expectations v Fed Projections

Source: DoubleLine

 

Australian home prices slide as borrowing costs surge

Source: CoreLogic, RBA, @C_Barraud

 

US credit card interest rates surge 

Source: FRED, Blockworks

US personal savings rate hit the lowest level on record in late 2022

  

Source: re:venture consulting

Interest expense on US public debt outstanding

 

Source: @CharlieBilello

 

US S&P 1500 EPS revisions by sector - the sptread between positive and negative

 Source: Bespoke Investment Group

S&P 500 quarterly earnings growth - estimates and actuals

 

Source: FactSet

The ozone layer is healing

  

Source: Hegglin et al, Chartr

 

January Edition

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For professional investors and advisers only

Edward Chancellor was already the author of two books in my top ten investment books list; Devil Take the Hindmost: A History of Financial Speculation and Capital Returns (the latter is a compendium of investment letters written by Marathon Asset Management and edited by Chancellor) and I would now add a third to that list. The Price of Time: The Real Story of Interest is an extraordinary book which illustrates the problems created by setting interest rates too low and by the rapid expansion of credit through the use of historical examples ranging from John Law's Mississippi Scheme to the Wall Street Crash and Japanese bubble of the nineteen eighties. Interest rates are the anchor for the valuation of asset prices and once they reach zero, any valuation can usually be justified, and bubbles occur. These bubbles have ALWAYS burst with enormous economic costs but that is only part of the damage wrought by low interest rates. As Chancellor notes today's ultra-low interest rates have contributed "to many of our woes, whether the collapse of productivity growth, unaffordable housing, rising inequality, the loss of market competition or financial fragility. Ultra-low rates also seemed to play some role in the resurgence of populism". As much as mainstream media would like you to believe that all of the UK's economic woes can be pinned on Liz Truss's mini budget, Chancellor explains that these issues have been years in the making and can be mostly traced back to the faulty economic thinking of the central banks.

In the first half of the book, he examines many of the previous ill-fated bubbles which were inflated by low interest rates, and I found myself repeatedly writing "just like today" in the margin. It would appear, however, that many of our current economic thought leaders do not regard the study of interest rates history as worthwhile. According to their website, the US Federal Reserve employs over 400 economics PhD's and yet it would appear that they don't employ any financial historians since all their recent errors occurred previously. In my opinion, Chancellor is rightly critical of the current cadre of central bankers and their predecessors for their failure to observe historical misjudgements as well as their failure to learn from their own mistakes (Ben Bernanke rightly attracts criticism despite the fact that he has just received a Nobel prize). In the last few years, our monetary mandarins have inflated what some have described as 'the everything bubble'. At the same time, we saw the average price of a home in Vancouver reach $1.6m, Tesla valued at more than Toyota which produces twenty times the number of cars as Elon Musk's firm, cryptocurrencies like Bitcoin rise by 1200% in a year and 150 unicorns (start-up firms valued at more than $1bn). The collapse of companies such as Theranos, WeWork and FTX is also reminiscent of how most bubbles end and the enormous damage that they create.

This book should be required reading for anyone involved in financial policy making from politicians to treasury officials and to central bankers. If I thought they would read it, I would willingly buy a copy for Andrew Bailey and the rest of the Monetary Policy Committee but I suspect they have little interest in reading anything which conflicts with the current economic orthodoxy no matter how wrong it has been.

Author: Ian Lance, Fund Manager

Global equity markets were weaker in December. In the US, the S&P 500 fell -5.9%, the Nasdaq declined -8.7%, whilst the FTSE 100 (UK) outperformed (given its lower tech and growth exposure), falling just -1.6%. The driver of the declines was persistent inflation and hawkish commentary from central banks, which disappointed investors hoping for an end to the interest rate rises that have been the key headwind for equities in 2022. The ASX All Ordinaries accumulation index fell -3.3% in December. Whilst all sectors produced negative returns, mining was again the best performer boosted by expectations that the re-opening of China's economy will lift demand for commodities. Consumer discretionary, IT and REIT's all underperformed. In bond markets, the key US 10-year bond rate rose +10 basis points to close at 3.83%, whilst in Australia, the 10-year bond rate rose more materially, up +52bp to close at 4.05%. The

A$/US$ was flat at US$0.68. 

Review of global stock market indices in 2022 

The table below shows how some of the relevant equity indices performed in 2022.

Some of the key takeaways:  

• Growth stocks, in particular technology stocks, underperformed materially given the sharp rise in bond yields and (for many stocks at the start of 2022) over valuation following several years of very strong stock price performance  

• Indices with a heavy weighting to resources (eg. ASX and FTSE) outperformed 

• Small caps significantly underperformed large caps on the ASX, as investor sentiment became very bearish, investor funds flowed into the perceived safety of large caps 

Looking forward to 2023, our view is that having underperformed materially in 2022, small/mid cap stocks on the ASX in particular, are poised to provide some excellent opportunities given historically this part of the ASX has been a very profitable segment, due to small/mid-caps typically having superior earnings growth prospects vs large caps. In terms of the growth and technology sectors, we believe that whilst much of the sell off of highly priced stocks has likely played out, given our preference for established business generating profits and cashflow, we remain cautious on this part of the market.