Federal Reserve Chair Jerome Powell appeared on March 3 before the Senate Banking Committee and vowed the US central bank would quell inflation running at four-decade highs. "We are going to use our tools," he said. Then came a pointed question. Would the Fed be prepared to harm the economy to tame inflation?

To show his intent to smother inflation that has surged to 8.5% (12 months to March), Powell answered "yes" by invoking the last Fed chief to induce a recession to rein in price rises. The Jimmy Carter-appointed Paul Volcker, who was Fed chair from 1979 to 1987, raised the key rate so much - to 20% in 1981 - he triggered two recessions; a fleeting one in 1980 and the slump of 1981-1982 when the jobless rate peaked at a then-post-Depression high of 10.8%.[1] "I knew Paul Volcker," Powell said. "I think he was one of the great public servants of the era."[2]

Volcker was probably the most hated.[3] As the economy slumped, the Fed was subject to protests that still rate the greatest in its history. In-debt farmers on tractors besieged Fed headquarters while car dealers sent coffins full of unsold car keys.[4] Volcker was assigned bodyguards,[5] especially as a man angry at high rates and armed with a sawed-off shotgun burst into Fed HQ.[6]

While Volcker was scorned by industry, the public and politicians (but not the media - why Ronald Reagan reappointed Volcker in 1983), historians have been kind. "Volcker was Jimmy Carter's gift to Reagan," one Reagan biographer wrote. Volcker "squeezed the inflationary expectations out of the economy and put it on the path to solid growth".[7]

Powell says he can achieve the same feat without the Volcker recession(s). He'd better. Though Volcker was on the Fed leadership team from 1975, he bore little responsibility for how inflation was running at 13% when he became Fed chair. (It peaked at 14.8% in early 1980.) Powell, however, is to blame for much of today's inflation for two reasons.

The first is Powell loosened the Fed's inflation guidelines. The Fed in 2020 scrapped a 2% inflation ceiling that had been in place unofficially then since 2012 officially for two decades in favour of an average target of 2%. The change means the Fed will let inflation exceed 2% "for some time" if it has undershot that figure. The move signalled the Fed would refrain from taking pre-emptive steps against inflation. It makes inflationary expectations prone to leaps.[8]  

Powell's other error - one he admits to[9] - was to misdiagnose today's inflation as fleeting.[10] Even though inflation has topped 5% since mid-last year by when unemployment had fallen below 6%, the Fed left untouched a record low US cash rate and persisted with its asset purchases until March this year. The Fed was even purchasing mortgage-backed securities when home prices, which eventually feed into inflation gauges, were soaring at a 20% clip.[11]

Powell's major fightback against inflation kicked off on March 16 when the Fed raised the cash rate by 25 basis points to a range of 0.25% to 0.5%. Powell's other anti-inflation tool is to shrink the Fed's US$8.9 trillion balance sheets swollen by quantitative easing. Such asset sales would boost longer-term bond yields. Powell's third weapon is to talk tough, as he did on March 21 when he said the Fed would raise the key rate "by more than 25 basis points at a meeting or meetings" to beat inflation.[12]

On the day the Fed raised the cash rate, Fed policy-setting board member 'projections' showed they expect to authorise another 11 rate increases of 25 basis points by the end of 2023 that would lift the key rate to 2.8%. Such an outcome would mean the key rate would be below the Fed's inflation projections until the end of 2023.[13] The Fed thus thinks it can douse inflation with negative real rates while the economy will "flourish" in Powell's words[14] and unemployment stays at generational lows. The jobless rate stood at 3.8% in February.

Such thinking contradicts how the Fed's economic models assume a trade-off between inflation and employment. Michael Feroli, chief US economist at J.P.Morgan, ridiculed the Fed's forecasts as "magical, immaculate disinflation".[15]

The models on which the Fed bases policy decisions are Keynesian-based ones[16] where policymakers seek to manipulate demand to influence inflation, employment and economic growth.[17] Powell's biggest problem is the US economy is not just overheating due to excessive demand (due to fiscal and monetary stimulus). The economy is suffering from 'supply shocks' beyond the reach of monetary policy that fan inflation while denting growth.

Count these shudders. Russia's attack on Ukraine has boosted energy, food and metal prices and reduced consumer spending on other items. The West's sanctions against Russia will hasten the reversal of the globalisation that exploited cheap foreign labour to reduce the cost of goods. China's recent lockdown is just the latest to constrain the output of 'the world's factory' and elsewhere. The pandemic-inspired 'reshoring' of production since 2020 has caused shortages. Lockdown populations, deprived of services but flush with fiscal stimulus, bought goods in such quantities that ports, ships, trains and trucks couldn't cope. Populations detained at home boosted demand for technology so much a shortage of microchips is hobbling the production of many goods. A shift to renewable energy is causing 'greenflation', the term for when the supply of fossil fuels falls but demand doesn't. Pandemic-inspired resignations and the decline of working-age populations tied to falling birth rates are pushing up wages (by 6% in the US).[18]

Powell's best hope is the supply shocks ease and inflation recedes without the Fed needing to raise rates. This is the "soft landing" of the Fed projections that Powell says the Fed pulled off in 1965, 1984 and 1994.[19] Next best, Powell might permit moderate inflation and hope to avoid a cost-of-living blowout that would result in stagflation. An option if inflation persists? Powell might have to crush the economy. Ultimately, a credible Fed chair must mimic Volcker.

To be sure, some excess demand the Fed can stifle is boosting US inflation. But how to remove surplus demand without strangling an economy recovering from the covid-19 blows? Hard to calibrate. How much demand would need to be eliminated to tame inflation boosted by supply constraints? Too much. The soft landings Powell cited aren't much solace because in these cases the Fed stopped inflation accelerating, rather than hauled it in.[20] The US economy could enter a downturn irrespective of what the Fed does, if events were to so turn (due to, say, Russian cyberattacks, a sovereign debt crisis in the eurozone or the developing world or covid-22). In an era of record debt and bloated asset markets, Powell need not raise the US cash rate to the level Volcker did to slow economic growth.[21]

But Powell surely needs to do more than the Fed projections suggest. In the balance between aiming for price stability and full employment, the Fed seeking to hold its authority and independence will eventually need to prioritise fighting inflation to keep the trust that Volcker earned against much hostility.

Sidelined central bankers

Charles Goodhart (born 1936) is a UK economist who has split much of his career between the Bank of England and the London School of Economics.[22] Last year, Goodhart predicted that by 2021 higher inflation would become entrenched. Why? Low birth rates and the consequential decline in working-age populations are ending the era of cheap labour and affordable goods. A future of faster inflation (3% to 4% compared with 1.5%) beckons. In the meantime, Goodhart predicted labour shortages, fiscal stimulus and the post-pandemic recovery meant inflation would hit "between 5% and 10% in 2021 - and stay high."[23] Which is what's happened in the eurozone (inflation at 5.9%), the UK (6.2%) and the US.

Goodhart, co-author of The great demographic reversal book released in 2020, is correct that the labour pool in many countries (from China to Germany) is shrinking as the world heads towards its first voluntary depopulation. Whether such a wage-boosting shift is driving today's inflation is arguable. What is clearer is that monetary policy is largely powerless to tackle such inflation, short of a Volcker-destroy-the-economy setting that no one wishes to seek.

Same goes for greenflation. Global efforts to curb the use of fossil fuels, such as Biden's decisions to halt fracking on federal land and block a key oil pipeline from Canada to the US, have helped propel benchmark oil and gas prices. Central banks struggle to ease greenflationary pressures without inducing a downturn that, among other harm, could slow the investment in renewables they seek to promote.

The end of the second great era of globalisation will probably be dated to when the pandemic struck in 2020. Shortages of emergency goods prompted governments to order home the manufacturing of essential medicines and supplies. Lockdowns, especially those in China, that interrupted the production of everything from microchips to car parts motivated firms to rejig supply lines. Russia's invasion of Ukraine in February only further prioritised national security and self-reliance over economic efficiency. The sanctions imposed on Russia, the strictest ever inflicted on a large economy, are inspiring Moscow to seek revenge (the closing of a key oil pipeline and demands European countries pay in rubles for gas), which further boosts energy prices.[24] The sanctions could come with unintended blows for the global economy and, longer term, might encourage autocracies to become less reliant on the US-led financial order. What can monetary policy do to help alleviate inflationary pressures as ties between blocs fade? Not much. Higher interest rates could even be harmful if they slow investment that could relieve shortages.

Wars usually cause inflation because production is interrupted, transport is disrupted, resources are diverted, young workers are deployed to the military and many are killed and maimed, civilians are killed and become refugees as they flee battlegrounds, and capital goods are destroyed.[25] The OECD in March said the war in Ukraine is likely to lop more than 1 percentage point from global economic growth this year while lifting world inflation by 2.5 percentage points.[26] (Late 2021, the OECD predicted the global economy would expand by 4.5% this year while consumer prices would rise by 4.2%.) Successful peace talks would dampen inflation pressure far more than any action central bankers could take.

China's latest lockdown has only added to policymaker angst about hampered supply. How can central banks tackle inflation stemming from health restrictions without damaging the economy? They can't.

In a world where supply constraints are driving up prices, central banks must choose between inflation and growth (especially in the absence of politically led appropriate solutions to supply-side inflation such as using fiscal policy instruments (taxes and transfers), microeconomic reforms, industry policy, trade policy and diplomacy (in the case of the Ukraine war, and a better health response in the case of China and covid-19). Two big differences between Volcker's world and that of today are the mammoth increase in debt (government, corporate and household) and the financialisation of the global economy that means asset markets hold larger sway over the economy. The marginal impact of each increase in interest rates is greater, especially if asset prices are stretched.

In any Powell blitz against inflation, the cash rate won't have to increase as much as some people might think to trigger a Volcker-like bludgeoning of the economy.

Author: Michael Collins, Investment Specialist

The story driving equity markets (S&P500 -8.8% for example) through April was more of the same: higher inflation, higher commodity prices, higher interest rates and lower valuations ascribed to growth companies. Whilst we understand the optimal portfolio positioning for such an environment has been to own commodities, cyclicals and value stocks, we also understand that playing this game profitably requires an ability to dance close to the door as macro-economic variables can change quickly. If we were to bet the portfolio based on a guess of the future economic environment, we would do so with the knowledge that we are likely to be right as often as we are wrong. Instead, we focus on where we have an edge.

Our edge is in identifying durable businesses that can grow their cash flows through the full economic cycle. Over a long enough time-horizon, we are likely to experience the full spectrum of economic environments. Similarly, over a long enough time horizon, highly durable growth companies will be worth multiples of the low return, cyclically-driven companies we seek to avoid.

Unsurprisingly, attribution was characterised by some of our growth companies moving lower: Tyro, IDP Education, Block & Aristocrat. We did experience an offset from our short positions however, most of which contributed positively this month. The shorts are doing their job of cushioning the damage caused by the longs. This will help the fund recover from a higher base when, eventually, a recovery does dome. Special mentions for our short contributors go to the speculative, cash burning companies, many of which have no revenue. Covid winners that are now covid sinners such as e-commerce and healthcare companies also contributed to performance on the short side.

In terms of future opportunity, there are two key areas forefront of our minds.

The first is the businesses that exhibit all of the ingredients for superior long-term shareholder returns (i.e. high ROIC, durable business models with proven execution) are getting cheaper and therefore implying higher future returns. We feel the sting of having many of these already represented in the portfolio but nonetheless are enthusiastic to accumulate more shares in these companies at increasingly attractive prices.

The second area of opportunity are also companies that have seen recent share-price weakness but are distinct from the first group in that there is little to no fundamental value to support their valuations. These companies are often biotechs, aspiring resource producers or technology developers that lack a clear link between their cash burn and incremental revenue growth. Not only do these stocks do poorly when market sentiment becomes cautious, but they tend not to recover when sentiment returns due to a lack of execution and an investor base that has already moved on to the next shiny thing. Years of bullish share market conditions have presented a plethora of these opportunities and we continue to add them to our short portfolio.

The most obvious area of market speculation currently is in battery minerals. There is no shortage of these names on the ASX, however few are likely to have commercial operations. Unproven mining methods, chemical processes and or spicy jurisdictions that have never produced lithium before all loom as potential headwinds for these projects. Meanwhile, a lot of optimism has been built into projects that have a material chance of disappointing. Selectively and within risk tolerances, we have taken a short position in some of these names which worked in April.

As I have discussed in recent blogs, US ten-year treasury bonds have risen from approximately 0.5 per cent in mid-2020 and are now approaching 3.0 per cent. At the beginning of 2022, they were 1.5 per cent - and have effectively doubled in four months - as the concept of "transitory inflation" was reduced to rubble from the war in Ukraine pushing up commodity prices, continued supply bottlenecks and the general tightness of the labour markets as many economies exit COVID-19.

In many Western World economies, the rate of inflation is hitting between 30-to-40-year highs and examples include New Zealand at 6.9 per cent; the UK at 7.0 per cent; Germany at 7.3 per cent and the US at 8.5 per cent. Most Central Banks have moved very late in their tightening cycle and cash rates of around 1.0 to 1.5 per cent are still very low by historical standards. Australia's record low cash rate at 0.10 per cent compares, for example, with the "Emergency Low" cash rate of 3.0 per cent implemented on the back of the Global Financial Crisis over 13 years ago.

Much of the Western World adult population have enjoyed an enormous bull market for their prime asset - their house. But with house prices and household debt at record levels relative to household disposable income, indebted households will be sweating rising interest rates, and this could have a knock-on effect.

In the US, for example, 30-year fixed mortgages have hit 5.35 per cent, a 12-year high. Given they were under 3.0 per cent not so long ago, this has added around one-third to monthly mortgage payments on a standard 30-year repayment mortgage. And for those Americans buying today, post the 20 per cent year-on-year increase for the average house, this means they are now paying around 50 per cent more on the mortgage than they would have been a little over a year ago.

Buyers who fixed in a high proportion of their mortgage for some years will be less affected by rising interest rates. In the past I have pointed out that early in 2021, a four-year fixed loan in Australia was sub 2.0 per cent. Today, that rate is closer to 4.5 per cent. What this means is that today's housing buyers are taking out variable loans at closer to 2.3 per cent but are vulnerable to the RBA moving late with the interest rate tightening cycle.

No matter how you cut it, the psychological boost and wealth effect enjoyed from strongly rising house prices will likely be missing in the foreseeable future and this means indebted households are more vulnerable to Central Bank tightening late in this inflationary cycle.

Author:  David Buckland, Chief Executive Officer

Is the RBA risking a recession to solve inflation?

The RBA hikes rates by 25bps, with more set to come in 2022 as Australia's central bank attempts to keep a grip on inflation.

With oil and commodity prices set to continue to be at elevated levels due to Russia's war with Ukraine, could a series of rapid rate hikes rates push the Australian economy into recession??

Tune in to hear Darren and Chris discuss this in episode 27 of The Rate Debate.

The small and mid-cap universe offers the potential to invest in tomorrow's large companies today. In this article, we'll look at ways to navigate this huge global market while balancing the opportunities and risks.

Given a backdrop of conflict in Ukraine and a lingering pandemic, investors face a lot of uncertainty at the moment.

Due to concerns about inflation, interest rate rises and tightening monetary policy in early 2022, investors in small and mid-cap equities have been favouring "value" stocks with lower price-earnings (P/E) valuations over higher P/E "quality" companies recently.

We also saw small and mid-caps underperform large caps in 2021, based on the (not always accurate) perception that big equals safer.

There is now an opportunity to invest in quality small and mid-cap companies…at compelling valuations

All this means there is now an opportunity to invest in quality small and mid-cap companies with the potential to weather economic cycles.

These companies are available at compelling valuations. But in today's unpredictable environment, is it possible for investors to buy tomorrow's potential large caps without taking high risks?

Narrowing the search

The global small and mid-cap equity investable universe is vast. Two thirds of the world's listed corporates are small or mid-cap companies. That's 7850 stocks.1

Very few analysts cover the sector, which means experienced investors can exploit market inefficiencies.

With such a huge opportunity set, where do investors begin to look? At abrdn our starting point since the late 90s has been our stock screening matrix. Our information feeds measure the quality, growth, momentum and valuation factors that our continuous backtesting has found to be predictive of share price performance.

The above illustration shows the select companies we look for; those with strong quality, growth and momentum characteristics.

Our screening matrix highlights a shortlist of companies which look attractive from a quantitative perspective. Small and mid-cap specialists carry out rigorous fundamental research on these top-scoring companies, including meeting with senior management, financial analysis, an assessment of ESG risks and opportunities, as well as a peer review process.

The result is a 'best ideas list' which comprises of regional analysts' highest conviction names. Each list typically contains 15-20 stocks.

Our portfolios have high weights to these strongest conviction companies, while ensuring a sufficient level of diversification as well as clear, deliberate and persistent style tilts to quality, growth and momentum.

Factors in focus

We've talked about the factors that we believe are important when selecting companies with the potential to enlarge their market capitalisation over the long term. But what are the key indicators of these three characteristics?

Growth 

In our view, it's important to look for companies with profitable, sustainable, growth. Small and mid-cap businesses with supportive end markets, as well as the ability to gain market share and expand profit margins, have the greatest potential to become tomorrow's large caps.

Momentum

We also look for signs that companies are exhibiting momentum, such as seeing upward earnings revisions and a history of consistently beating earnings forecasts.

Growth and momentum characteristics have the potential to be sustained for many years, which partly explains why small caps have outperformed large caps over the long term.2

Quality

The graphic below shows what we believe are the key indicators of company quality:

Measures such as balance sheet strength, management pedigree and sustainable competitive advantage allow companies to successfully navigate changing economic cycles. Of course, investing in quality is also about avoiding loss-making, blue sky or highly leveraged businesses, as well as those with extremely cyclical earnings or a history of dividend cuts. Because of this, we believe, 'quality' companies have the potential to deliver higher returns over the long term with less volatility. This results in a more favourable risk-return profile. 

ESG - a key indicator of quality

One indicator shown above is ESG (environmental, social and governance). For us, ESG factors are financially material and can affect any company's performance both positively and negatively. A strong record on ESG issues is a key sign of company quality and can potentially help to reduce risk. Therefore, in our view, understanding ESG risks and opportunities should be an intrinsic part of any small and mid-cap research process, alongside other financial metrics.

We also think informed and constructive engagement with company leaders can help investment managers to encourage and share positive ESG practices - potentially protecting and enhancing the value of investments for years to come.

Well-resourced investment managers have the confidence to rely on their own ESG research, investing in companies which meet their own criteria, even when not covered by external ratings agencies. You can read more about The Importance of ESG in Small Cap Investing in our recent article.

Risk and opportunity

Looking forward, the outlook for higher interest rates, potentially sustained high inflation, and a lower growth environment suggest uncertain times are ahead.

Companies selected using a quality, growth and momentum process combined with ESG analysis are potentially well-placed to weather economic downturns. Far from being dependent on externally-driven cycles, these companies are likely to expand in a predictable, sustainable way.

They are also more likely to be market leaders able to pass on inflationary costs in the form of higher prices, as well as having strong margins and robust balance sheets. Furthermore, portfolios constructed in this way are more likely to be diversified across products, markets and geographies.

We also believe that in a changing world, smaller, nimble, well managed companies that can pivot their businesses more quickly than mega caps are well placed to take advantage of evolving opportunities.

Final thoughts

Many high quality small and mid-cap companies with the potential to expand and grow are currently available at attractive valuations. In today's uncertain world, we believe a robust, repeatable investment process focusing on quality, growth and momentum can help investors select the large cap leaders of the future with favourable risk-return profiles.

Author: Alexandra Popa, Macro ESG Research, Abrdn Research Institute

On Wednesday, April 27, Laureola Advisors shared an update on Q1 2022. 

Request for the recording now!

ABOUT LAUREOLA ADVISORS
Laureola Advisors was founded with the belief that investors deserve access to the unique benefits of Life Settlements, with the advantages of a specialist and focused asset manager. 

The best feature of the asset class is the genuine non-correlation with stocks, bonds, real estate, or hedge funds. Life Settlement investors will make money when others can't.

Like many asset classes, Life Settlements provides experienced and competent boutique managers like Laureola with significant advantages over larger institutional players.  In Life Settlements, the boutique manager can identify and close more opportunities in a cost effective manner, can move quickly when necessary, and can instantly adapt when opportunities dry up in one segment but appear in another. Larger investors are restricted not only by their size and natural inertia, but by self-imposed rules and criteria, which are typically designed by committees.

The Laureola Advisors team has transacted over $1 billion (US dollars) in face value of life insurance policies.

March witnessed the third month of the fear-based swing to stocks perceived as short-term winners from the Ukraine invasion and Covid related supply chain issues. Think: materials and economically sensitive stocks. These same events also precipitated a knee-jerk move away from stocks viewed as 'growth' related at the same time. The ensuing impact on inflation from both of the above events added to fear-based motivations.

Consider this: Most stocks receiving current price lifts (commodities, energy & banking) tend to possess various combinations of low PEs, a history of business underperformance, low returns on invested capital, high Credit Default Swap prices, low sales growth, and lesser margin control. Few successful fund managers have enriched investors built around these factors. In the last few months these stocks outperformed by a large margin those that are; highly profitable, with strong margins and price control, long run earnings growth, lower debt, and not as reliant on macro factors (like inflation). It's interesting to note that many leading "value-managers', have also posted negative returns. Banking, industrial cyclicals, and housing related stocks generally trade on low P/E ratios, yet they too had their prices weaken recently. This is principally due to the 'supply side' commodity price shock at a time when macro-economic growth is weakening. This is not the environment for a rising tide to lifting all value stocks.

In our minds, this swing represents the same but opposing side of the unjustifiable prices that many tech/disruption stocks enjoyed until recently. Neither group are worthy of serious, risk aware and longer-term investment. It's why we invest in companies that can sustainably deliver strong above average Earnings Growth. Their stock prices tend to always follow (Barr the odd event-based, short-lived exception like the one we are experiencing now).

Are the businesses enjoying stock price rises today also the winners of tomorrow?

Lately we are all experiencing one tectonic event after the next. Foundations of the political and economic framework that have dominated much of the world since the 1980s are now being challenged; the impacts on globalisation, the questioning of the USD central role, and previously deeply embedded structural relationships in the energy markets to name a few.

Regular readers of our newsletter know that our approach is far less dependent than our peers are on these issues, including inflation and interest rates. The jury is still out on whether inflation will be a temporary or a longer-term phenomenon.

Covid and the tragic invasion of Ukraine have created significant commodity, energy, and labour mobility pressures. Companies that:

• can raise prices are clearly better placed than those that do not.
• enjoy high margins and operating leverage are better protected than low margin businesses with high marginal costs and no pricing power.
• possess high incremental return on capital may be able to not just defend their profitability but actually see it expand!

These are the required factors for a business to continue delivering healthy returns in real terms and are thus the same attributes Insync seeks.

Most companies are not able to do this. Those companies possessing the most levers to pull going into an inflationary period are also the most likely to protect and even thrive for their investors. There will likely be tougher times ahead, quality growth investors should find themselves better positioned than most to weather the storm and come out substantially ahead.

Why earnings power is crucial

A shy, humble investor living on a suburban street in a small mid-western US city is often cited for his quips.

"In the short-term markets are a voting machine. In the long-term it's a weighing machine"

Over shorter periods sentiment in markets can shift wildly depending on the narrative of the day. This is driven by perceptions of investors trying to gauge where we are in the economic cycle, the path of inflation and interest rates, the impact of a geopolitical crisis, and what style of investing will be best equipped for the future. These are impossible to predict with any degree of certainty or to do so consistently.

The one thing that is more certain over time is that in the long-term, share prices follow the consistent growth in the earnings of a business.

We know that the most profitable companies remain profitable even ten years later fuelled by the enduring, large megatrends.

Megatrends are so predictable you can set your watch by them. This is whether it is the rising importance of the Gen Z'ers, the acceleration in the number of people aged 70+, GDP+ growth in spending on skin and beauty, or the insatiable desire to spend on experiences. A portfolio of the most profitable companies tied to megatrends provides consistency in earnings leading to strong stock price returns. They are also mostly impervious to interest rate settings, the state of the economy or current commodity prices.

3 portfolio examples of why Earnings Growth is good for investors

The evidence shows it all. Here are 3 companies in our portfolio. The coloured line in each graph is the path of earnings over the past 10 years. The white line is the share price performance.

Observe the strong correlation between the earnings growth and share price performance. From time to time the two lines deviate based on an 'event', as is the case now. Obviously, present prices present an outstanding opportunity to invest.

These highly profitable businesses benefitting from Insync's identified megatrends have become even more attractive due to recent price falls. This is because their ongoing and established earnings power remains intact. Such excellent buying opportunities do not often present themselves.

The 'coiled Spring' phenomenon continues to gain energy. 

In this episode, CIO Steve Johnson is joined by whisky-naysayer (and Senior Analyst) Chloe Stokes to discuss the bid for Twitter, social media monetisation, and control in volatile markets. Chloe also shares her experience as a younger investor and reveals the stocks (and burgers) currently on her watchlist.  

"As shareholders, we can't help but be disappointed. We bought [Twitter] because we thought the platform had a lot of potential," Chloe tells Steve. "It's obvious that we think it's worth more than the bid, because we held it through periods where it was trading much higher and still thought it was worth more than those higher prices. So, we are definitely not happy from a price perspective, but on the other hand, we can't stop talking about it."

Timestamps

02.30 Start
07.15 Is Twitter offer the right price?
11.12 What is causing concern in the social media ecosytem?
19.02 Meta price in distress
26.26 Stock to watch
32.00: Whisky tasting - Suntory Toki

Whenever stranded assets are mentioned we are likely to conjure the image of a dilapidated oil terminal that no longer has any value attached to it due to alternate fuels or costly environmental regulations. Commercial real estate rarely enters our consciousness and as a result the REIT sector has never had the intense ESG spotlight shone on it by the public or the wider investor base.

How is ESG impacting investing?

ESG focused investing has really ramped up in recent history and has gradually shifted from just the direct operations of a company to now analyzing the impact of all its organs. As a result, firms will have to reflect and act on every part of their operations - whether that includes a manufacturer assessing the carbon intensity of its HQ, a pharmaceutical trying to lessen water usage at its distribution centre or a tech company maximizing the air quality on its campuses. Thus, the real estate occupied by those firms will become increasingly scrutinized and assets that cannot be adapted to the tenant's growing requirements risk becoming obsolete and costly for its owners to hold.

While there are many prisms to look at commercial property from an environmental perspective, the NABERS (National Australian Built Environment Rating System) Energy rating guide is arguably the most comprehensive in its coverage, especially for Australian office assets. Buildings are given a rating on their energy efficiency using a 1 - 6 star system on a relative basis compared to their peers.

While there are similar NABERS ratings on water, indoor air and waste, energy has grown to be the most prolific due to legislative requirements. Under the current system all commercial offices over 1000sqm that wish to advertise for leasing or selling purposes must disclose their NABERS energy rating. Furthermore, in order to attract the government as a tenant the base building requires a minimum 4.5 star NABERS rating. As a result, NABERS has become the leading benchmark for assessing the 'green-ness' of a property.

What can businesses expect to see?

The current landscape in the Australian market is that of institutional investors leading the pack and commandeering more of the higher star rating assets. Morgan Stanley research found that the three biggest listed office landlords had a significantly high performing portfolio with Mirvac (MGR), Dexus (DXS), and GPT achieving a portfolio average rating of 5.5, 5, and 5 respectively for their office assets. This has largely been the result of an active development pipeline helping refresh the age of the portfolio as well as conscious decisions to refurbish older assets to meet modern environmental standards.

Employees are also increasingly expecting their employers to be environmentally conscious - a survey by HR resource company ELMO found that 71% of Generation Z workers would refuse to work for a company that was not seriously dealing with climate change. Furthermore, ambience and aesthetics are also rising in importance with a future workplace wellness study found that 31% of employees lose the equivalent of 60 minutes of productivity if the environmental wellness of their environment such as air quality and other factors were not satisfactory. Increasingly the mental health of employees is being brought to the fore thanks to the pandemic and companies who wish to be seen as socially responsible will need to accommodate this. Employers are taking note - JLL reported that 73% of their APAC based tenants surveyed saying they will be retrofitting assets by 2025 to meet these requirements such as achieving net zero and ensuring the office is a pleasant location to be.

The COVID pandemic has shaken up the office sector in various ways. Vacancies in CBDs have ballooned, with Sydney climbing from 4% pre-pandemic to 13% currently. Companies are re-assessing their space requirements which will certainly be influenced on how successfully they are able to persuade staff to return to the office. With widespread reports of labour shortages, it looks that the balance of power has shifted towards the employees. Employers in a post-COVID world will face the dual challenges of keeping their staff by aligning their actions with the staff's ESG values as well as also providing enticements to lure them back into the offices - no doubt challenges landlords will have a stake in. 

It has become clear that for employers to retain talent and encourage employees back to their offices for physical collaboration, they will need to ensure their assets and workspaces are up to scratch. Feedback from asset owners and leasing agents are that expectations from tenants are shifting to asset owners providing the amenities required by their employees such as coffee shops or breakout areas whereas previously the landlord was only responsible for the capital to ensure the base building was environmentally friendly. The costs of these amenities historically would be recouped through higher rents or lower incentives however the supply/demand dynamics in this market means tenants have effectively externalized a portion of their costs to meet environmental and social expectations to landlords.   

Where are we seeing vacancies?

If history is any guide, the current over-supply situation (highlighted by elevated vacancies) will  result in lower rental price growth and higher incentives (in the form of fit out contributions or rent-free periods) which negatively impact the cashflow of the landlords. While this trend was observed in 2020-2021, our channel checks have found that the performance of assets have become increasingly bifurcated. Prime grade assets (Premium & A grade) continue to hold onto higher rents and lower vacancy while the declines in rents has mostly been felt in B grade assets and below. One asset owner has even stated that they are seeing further bifurcation with A grade starting to lose some of its lustre leading to a 'Premium vs everything else' situation. This trend has been accelerated post-COVID with a common theme in the Feb-2022 reporting season being an acute sense of 'flight to quality'. For example Mirvac called out 80% of their vacancies were located in their lower tier assets.

This is not surprising given higher-grade assets predominately have 5-6 star ratings further enhanced with numerous amenities to maintain tenants and their increasingly demanding staff. The Australian listed market and other large institutional owners have been acutely aware of this and have largely been successful in ensuring their portfolios are at the higher end of the NABERS spectrum. Conversely, B-grade assets and below are mostly held by private owners. Typically such owners have less access to capital and as such may struggle to make the necessary investment to upgrade the asset ratings. Refurbishments required to drive an increase in the NABERS ratings require significant capital and often involve asset downtime (from 1 - 2 years). Activities such as replacing the cladding of a building has shown to potentially cost >10% of the asset value itself. As such, we expect more and more assets becoming more obsolete as the capital costs to upgrade older assets are prohibitive especially for non-institutional investors.

Additionally, debt markets are also starting to differentially price ESG factors. In 2021 GPT issued their inaugural Green Bond of $250m and we expect this to be the first of many. Whilst this has not translated to lower cost of debt for green assets yet, expectations are that liquidity pools will become more discerning around ESG which over time should translate to higher cost of debt for ESG-poor assets.

Ultimately while we are concerned about the current oversupply in the market and the uncertainty in the sector's vacancy outlook due to COVID and increased working from home, we are somewhat comforted by the fact that the Australian listed players have positioned themselves relatively well in regards to the sustainability of their asset portfolios. This should partially offset future structural uncertainties as we believe not all the competing supply in the market is fit for purpose and given ESG requirements on buildings are only getting more stringent, we expect the pool of 'ESG-ready' assets to shrink further.