2022 is shaping up as potentially another challenging year, with the combined effects of the ongoing COVID crisis together with evolving inflationary pressures presenting governments and central banks around the world with some challenging policy decisions.

In this article, Sarah Shaw (4D's Global PM & CIO) and Greg Goodsell (4D's Global Equity Strategist) examine these near-term issues.

2022 outlook
While the pandemic in all its forms will prevail longer than was initially hoped, the effective development and deployment of vaccines and treatments means the world will increasingly move to an environment of living with and managing the virus - reverting from a pandemic to an endemic. We continue to believe that the global economy will ultimately emerge stronger for the experience. The huge amount of fiscal and monetary stimulus is still to be fully deployed in economic terms with, of course, much of that spending focused on badly needed infrastructure investment around the globe. All this investment will be a strong positive for the global economy over coming years, improving efficiency, productivity and output. In addition, many of the changes that have been forced on businesses by the pandemic will, we believe, lead to a stronger, more efficient economic environment post the virus. As such, we remain generally positive on the economic outlook for 2022 and beyond.

However, the two key factors dominating economic discussions and providing some near-term threat to a generally robust outlook as we enter 2022 are COVID-19 (again) and evolving inflationary pressures.

COVID-19/Omicron variant
 We believe the global economic recovery is continuing, although the Omicron wave has likely pushed out the timing of the full recovery. However, once we move to a more stable environment where we learn to live with the virus, infrastructure in all its forms remains integral to a sustained economic recovery and returning society to 'situation normal'. We have consistently maintained that there is no global growth recovery without roads, railways, pipelines, power transmission networks, communication infrastructure, ports and airports.

While the ongoing COVID saga keeps pressure on equity markets, we continue to believe it represents a unique buying opportunity for infrastructure investors. The infrastructure investment thematic has not been derailed by COVID, but rather has been enhanced by the pandemic - huge government stimulus programs are fast-tracking infrastructure investment (in particular the energy transition), increasingly stretched government balance sheets will see a greater reliance on private sector capital to build much-needed infrastructure, and the interest rate environment remains supportive of infrastructure investment and valuations.

Global inflationary forces
Over recent months, global inflation has been emerging as a key economic risk. In the US in December 2021, consumer prices accelerated at the fastest pace since 1982, hitting 7% (annualised), bolstering expectations that the Fed will increase rates in March. The US is not alone, with inflation picking up around the world and seeing interest rates already on the move (Brazil, UK) or with expectations of moves in 2022. 

Broadly, the price increases are being driven by a combination of supply chain disruptions, causing critical supply shortages of key items (such as computer chips), together with the huge global monetary stimulus pushing up the amount of money in the global economy, with inflationary forces being the consequence (e.g. Australian house prices). Importantly, we are also seeing real wage pressure in certain industries and markets as a result of the combination of COVID disruptions and job rotations as stimulus flows through. This is compounding near-term inflationary pressure.

Central banks are already beginning to tighten monetary policy in an attempt to curtail these inflationary forces. After its January 2022 Fed meeting, Chair Jerome Powell said the Fed is ready to raise rates in 2 months. He spoke after the FOMC communicating that it would hike 'soon' and then shrink its bond holdings. Mr Powell declined to rule out tightening at every meeting this year, said officials may have to move sooner and faster on shrinking the central bank's US$8.9 trillion balance sheet, and warned there's a risk of a prolonged period of surging prices.

The risk now is that if the Omicron variant continues to spread, this may itself lead to a crimping of global growth just as central banks take their feet of the stimulus pedal, compounding the slowdown.

Ultimately, we believe central banks will act prudently and cautiously in easing policy. We are also of the belief that they may let inflation run somewhat ahead of target over the short to medium term to assist in the reduction of headline nominal government debt to GDP levels.

But just at the present, uncertainty prevails and caution is warranted. In this regard, infrastructure is an asset class that can do well in an inflationary environment and we believe it is a sensible portfolio allocation at the current stage of the economic cycle. As discussed in a number of our previous Global Matters articles, many infrastructure stocks have built-in inflation protection, either directly linked to tariffs or indirectly through their regulatory construct.

As such, in an inflationary scenario some parts of the infrastructure universe, namely User Pays, may enjoy the perfect storm over the short/medium term -interest rates supportive of future growth, economic activity flowing through to volumes, and explicit inflation hedges through their tariff mechanisms to combat any inflationary pressure they may experience.

In contrast, Regulated Utilities can be more immediately adversely impacted by rising interest rates/inflation because of the regulated nature of their business. The flow-through of inflation is dictated by whether the Utility's return profile is 'real' or 'nominal'. If the Utility operates under a real return model, inflation is passed through into tariffs much like a User Pay asset. This model is more prevalent in parts of Europe and Brazil, for example, and limits the immediate impact of inflationary pressure - and in fact can positively boost near-term earnings. In contrast, if the Utility is operating under a nominal return model, it must bear the inflationary uptick reflected in certain costs until it has a regulatory reset, when the changing inflationary environment is acknowledged by the regulator and approved to be incorporated in new tariff/revenue assumptions. This nominal model is the standard model for the US Utility sector. As such, those Utilities in a real model will weather inflationary spikes a little better than their nominal peers.

However, in terms of interest rates shifts, the issues for both real and nominal models are consistent. For a Regulated Utility to recover the cost of higher interest costs, it must first go through its regulatory review process. While a regulator is required to have regard for the changing cost environment the Utility faces, the process of submission, review and approval can take some time or can be dictated by a set regulatory period of anywhere between 1-5 years. In addition, the whole environment surrounding costs, household rates and utility profitability can be highly politically charged. As a result, both the regulatory review process and the final outcome can be quite unpredictable.

The differences between User Pay and Regulated Utility assets should see certain sub-sets fundamentally outperform during a rising inflation/interest rate period due to a more immediate and direct inflation hedge. At 4D we remain overweight User Pay assets and, within the Regulated Utility sector, favour those with real returns. However, should the market overreact to the economic outlook we would use it as a buying opportunity across all sectors.

Key ongoing macro themes
While COVID/Omicron and inflation expectations dominate current day-to-day equity market discussions, there are a number of other important investment thematics in play that will impact decisions for decades to come. Many of these themes are long-term positives for infrastructure investment. Over the past 6 years 4D has addressed a range of such issues and we revisit a number of them in the Annexure so as to provide more detail on our current portfolio thinking and positioning.

However, in summary, current investment forces that we at 4D find particularly interesting include the:

• re-opening trade - capturing the stimulus and pent-up consumption around the world;
• global need for infrastructure investment;
• emerging middle class, which offers a huge opportunity with infrastructure both a driver and a first beneficiary of improved living standards;
• global population growth but with changing demographics - the West is getting older, but much of the East younger;
• active positioning for inflation/interest rates - with current overweights to the inflation trade;
• emerging markets - the recent underperformance of emerging market infrastructure equities is not warranted given the attractive earnings fundamentals and long-term sector dynamics; and
• energy transition - environmental and climatic challenges underpins the need for even more spend on infrastructure.

What could derail our outlook?
While we are generally optimistic regarding 2022 and beyond, there is no doubt that we have had a couple of tumultuous years. There are a number of residual factors that could adversely affect our view, including:

• whether COVID-19 vaccines are effectively deployed globally and in a timely manner, delivering the expected health benefits and leading to subsequent economic recovery;
• governments and central banks prematurely taking their feet off the 'go' pedal before the global economy has the opportunity to properly get back on its feet;
• the actual shape of the economic recovery, which is crucial, remains to be fully seen (V, U, L or W);
• President Biden is unable to make diplomatic progress and we see renewed Chinese/US tensions on a variety of issues: trade, Hong Kong, South China Sea, COVID-19 origins;
• the current standoff with Russia and the Ukraine could deteriorate further, dragging in Europe and potentially NATO involvement;
• longer-term, how all the massive global fiscal stimulus (much of which will be sourced from central banks) is paid for;
• the question of whether 'Modern Monetary Theory' will earn its stripes; or will too many dollars chasing too few goods see currencies devalue and inflation escalate ('Monetarism' and Milton Friedman's economic theories)?;
• whether inflation comes back faster than anticipated, forcing central banks to act ahead of plans via interest rate increases; and
• if so, these rate increases could place pressure on borrowers of all types who, given recent history, would be very unaccustomed to a rising interest rate environment.

We continue to monitor the near and long-term trends and will actively position accordingly as events unfold.

Conclusion
In terms of investment opportunities, we're still spoilt for choice, with significant value having emerged across the entire infrastructure universe as a result of the ongoing pandemic and increasing macro concerns. Despite the near-term concerns, we remain generally optimistic about the global recovery story. Our portfolio remains diversified, with a strong bias to attractively valued, high quality names with solid balance sheets and superior management teams. We remain overweight User Pay and real return Utilities in the current inflationary environment, while capitalising on significant long-term thematics across the portfolio.

2021 was an exciting year for initial public offerings (IPOs) and placements. 55 companies with an offer price greater than A$20 million made their debut on the ASX during the year. Up a staggering 62% from the year before! Secondary placements experienced a more modest increase, up 6% from 2020.

Most equity capital market (ECM) activity took place in the small cap end of the market. Providing a material opportunity for institutional small cap managers like Firetrail to add value for their investors.

In this article, we analyse the success of small cap IPOs and placements in 2021, provide key takeaways for investors, and what to expect in capital markets in 2022. We conclude that corporate activity will remain elevated in small companies throughout 2022. Creating meaningful opportunities for investment managers willing to do the work to identify the best opportunities.

IPOs and placements outperformed in 2021

It wasn't just the sheer number of IPOs and placements that broke records in 2021. Together, new ASX-listings raised a total of A$12 billion! Among them were a record number of billion-dollar floats, such as APM, SiteMinder and PEXA.

On the first day of trading, these IPO companies outperformed the market by an average of 20%. However, we did see this outperformance moderate by the end of the year.

We saw the inverse occur in the market for secondary offerings. Average day one performance hovered around 10.1%. While calendar year performance rose to 15.4%! The total amount raised by secondary offers was A$37.7 billion.

But that doesn't seem like an accurate reflection of performance from a market perspective.

Careful stock selection is critical

If we adjust for the size of the raise, the story changes. We see big declines for first day and calendar year performance for both IPOs and secondary placements. Suggesting that the relative performance is skewed by a handful of big winners.

In the IPO space, performance was dominated by a few key players. DGL, a chemical manufacturing and storage group, and Trajan, an analytical science and devices company, experienced greater than 100% returns in the calendar year.

To account for this asymmetry, we took the median performance for the calendar year. The median return for IPO stocks was just -4%. Providing a more accurate reflection of capital market performance.

Clearly, an ability to pick winners is key to harnessing value from corporate activity. The chart below compares the relative performance of IPOs that raised more than $50 million. While average performance was strong, there were more losers than winners.

Through deep fundamental analysis, Firetrail were able to pick the winners this year. The median return from our IPO participation was 18% for the 2021 calendar year (shaded in grey in Figure 1).

Careful selection is also key for managers trying to maximise returns from secondary placements. In 2021, we saw a wide dispersion in results.

The best returning secondary issuances were in companies in need of balance sheet repair. The average placement in this category delivered 33% excess. In many instances we observed that the 'raise' was already priced in by the market. Hence recapitalisation was the catalyst to refocus the market on business fundamentals.

The market also rewarded companies raising capital to grow organically far more than M&A. Raisings for growth dominated the market (Figure 3). In contrast, there were few M&A bargains in 2021 due to intense competition for assets. Many companies were willing to pay listed multiples for strategic acquisitions.

Opportunities will remain elevated in small caps in 2022

ECM events are a consistent source of opportunity and strong returns for small cap investors. Access to these opportunities is key, and the Firetrail team have a strong track record of leveraging our corporate relationships and fundamental expertise to access attractive corporate opportunities for our investors. Since the inception of the Firetrail Team's Small Companies strategy in 1998, previously the Macquarie Australian Small Companies Fund, these events have contributed an average 20% of the total excess returns, or ~3% p.a.

Looking ahead to 2022, low interest rates and high valuations will continue to encourage companies to raise capital. We expect ECM activity to remain elevated and to continue delivering material opportunities for small cap investors like Firetrail.

Conclusion

2021 was a year of frantic ECM activity and we see no sign of this abating as we move through 2022. As small cap investors, we are excited by the opportunity and potential returns offered by IPOs and secondary placements in the coming year. Our experience shows that meaningful returns are out there if managers are willing to do the work to find them!

Funds operated by this manager:

Firetrail Absolute Return Fund, Firetrail Australian High Conviction Fund

In 1997, Jeff Sprecher of the US, who had spent years developing power plants, decided to provide transparent pricing to the US power market. Well before electronic trading of financial securities became the norm, Sprecher paid US$1 for a tech start-up so he could build a web-based trading platform.

For three years, Sprecher and his team met oil, natural-gas and power companies to learn what people sought in a trading platform. Some of the innovations that resulted included pre-trade credit limits, counterparty credit filters and electronic trade confirmations - novelties taken for granted now. By 2000, the trading platform was set for launch. Sprecher renamed the shell company Intercontinental Exchange to highlight the trading platform's ability to cross oceans, let alone borders.

In 2001, the International Petroleum Exchange of London wanted to evolve from floor to electronic trading. At the time, the exchange was a regional one that offered oil futures contracts and had less than 25% share of the global oil futures market. Intercontinental Exchange, which promotes itself as ICE, saw an opportunity to branch into energy futures and clearing and purchased the exchange. Thanks to the ability of ICE's platform to increase price transparency, handle high volumes efficiently and lower transaction costs, the volume of oil futures traded on what is now called ICE Futures Europe swelled. A regional exchange grew into a global one.

From 2007, the year ICE listed (with the ticker ICE), the company went on a buying spree of exchanges. The company snared the New York Board of Trade, which barters commodities such as cocoa, coffee and cotton, ChemConnect, which trades chemicals, and the Winnipeg Commodity Exchange, now ICE Futures Canada that mainly trades canola. A sign of ICE's ambitions was the company's failed bid that year for the commodities-based Chicago Board of Trade.

Undaunted, the ICE takeover quest continued such that ICE, which earned US$6.6 billion in revenue in fiscal 2020, owns an exchange arm that boasts 12 global exchanges and six clearing houses that service the energy, agricultural and financial sectors. The haul includes the purchase in 2013 of the New York Stock Exchange, the world's biggest by volume. Among feats, ICE hosts nearly 66% of the world's traded oil futures contracts and is the world's leading clearer in energy and credit defaults. On top of that, ICE's exchange arm manages key global benchmark contracts. This list includes Brent oil, Euribor, natural gas, sterling short and long rates and sugar barometers of performance.

In recent years, ICE has branched out such that the exchange business, which brought in 55% of ICE revenue in fiscal 2020, is one of three divisions. The second arm, responsible for 27% of revenue in fiscal 2020, is the fixed income and data services business that sells data and technology to help investors make and execute decisions. ICE assess prices for roughly three million fixed-income securities spanning about 150 countries in 73 currencies, as well as providing advanced analytics and indexes for fixed-income markets.

ICE's other business is mortgage technology, which pulled in the remaining 18% of revenue in fiscal 2020. This arm has digitalised the mortgage process to reduce costs and increase efficiencies. The ICE mortgage business is the largest to automate the entire process, is the industry's leading platform with more than 3,000 customers, partners and investors, and the industry's only loan registry. This platform offers significant growth potential as more US mortgage originators are expected to turn to ICE's digitised offering.

ICE is a promising investment in three ways. The first is that the exchanges and other businesses possess sustainable competitive advantages that form a daunting 'moat' for the parent company - where moat is a colloquial way to say a company is protected from competition. Most of ICE's earnings are derived from trading and clearing fees from the exchange businesses and linked data. These businesses are moated because they enjoy economies of scale, network effects and industry structure that intimidate would-be competitors. Another moat for ICE is that when it comes to derivatives and listing, there are limited substitutes. The holder of benchmark contracts is favoured in negotiations, even if others are seeking to undercut on price.

A second advantage ICE enjoys is that the company is vertically integrated - it controls the execution and clearing of contracts. This enables the company to exert pricing power, attract volumes, and improve counterparty and systemic risk management.

The other advantage that makes ICE an attractive investment is the company is well managed. While ICE has a history of disrupting others, the Sprecher-led team has prevented ICE being disrupted. Management has steered the business towards attractive industry structures (derivatives exchanges), unique data sources and value-add analytics. As important, the team has largely directed ICE away from equities exchanges, where regulation and technology have upended the pricing power and volumes over the past 15 years. All up, ICE is well placed to provide compounded returns for its investors for the foreseeable future.

ICE, as do all businesses, faces risks. One is that the company's revenue is tied to trading volumes over which it has little influence. The fact that trading volumes often increase in turbulent and falling markets means that ICE is well placed to weather a market slump that falls short of a prolonged 'bear market' where trading was light. ICE's other risk is that its business is exposed to adverse changes to regulations. Moves by regulators to separate execution and clearing, and actions that might reduce trading volumes, would disrupt ICE's revenue. ICE is protected to some extent in this regard because regulators are aware that such moves against exchanges, especially ones that feature large derivatives trading, would boost trading costs, hamper innovation and, possibly, increase systemic risks.

ICE, thus, is well placed in a world where Sprecher's vision has helped electronic trading become the norm.

Sources: Company filings and website.

Apparently, Confucius did not say "One Picture is Worth Ten Thousand Words" after all. It was an advertisement in a 1920s trade journal for the use of images in advertisements on the sides of streetcars. Even without the credibility of Confucius behind it, we think this saying has merit. Each month we share a few charts or images we consider noteworthy.

You may have noticed that the tech sector has been under pressure lately. Bank of America's monthly fund manager survey shows allocations to the sector are at the lowest point since 2006 - yet in the unlisted world CB Insights has tallied up a surge in "unicorns" to 1,000! Totus Capital made a great point on the significant dispersion between different tech companies' accounting treatment of R&D spend. And ASX-listed fintech Douugh's "accumulated revenue" chart, as highlighted by  @lukewinchester9, was definitely an innovative approach to presenting financials. On the COVID-19 front, Bloomberg shows global air traffic is still less than half pre-pandemic levels, while The Economist shows most countries trending back towards "normalcy" - with China a notable exception.

Tech net allocation at lowest level since 2006

Source: Bank of America (via @daniburgz)

Now there are 1,000 unicorns

Source: CB Insights

Huge differences in how ASX software companies account for R&D spend

Source: Totus, livewiremarkets

Accumulated revenue chart by ASX-listed Douugh (DOU)

Source: Douugh Limited, @lukewinchester9

Global air traffic less than half pre-COVID level

Source: Bloomberg

The Economist's "Normalcy Index"

Source: The Economist

It was all about "chips" - semiconductors - in 2021and likely also in 2022. We (internally) break down our portfolio into three categories - those that produce the tools that enable disruption ("tools"), those enabled by these tools ("enablers") and a group of more downstream beneficiaries ("beneficiaries"). It's not the only way the portfolio is split, but it is a useful way to understand how value in disruption can be tracked.

This understanding resulted in a significant weighting toward the "tools" companies during the year, including semiconductor designers, makers and suppliers such as Qualcomm, Nvidia, AMD, Marvell, Taiwan Semiconductor Manufacturing Company (TSMC), Samsung and ASML.These companies are the equivalent of pick and shovel makers in a goldrush. They may not perform as strongly as the best miners, but they do produce a steadily-growing and valuable cashflow stream. And they are not as subject to failure if a particular "mine" (social media platform maybe, or app) doesn't work.

It's an area in which most investors do not participate. However, it is correct to say that the new disruptive business models which have created so much value for shareholders would simply not have emerged but for the increasing sophistication and sheer grunt of the chips on which they run.

Earlier this week, for example, the agricultural machinery company John Deere debuted a new autonomous tractor with attached tillage equipment at the CES trade show in Las Vegas. Deere's director of emerging technologies stated the tractor can run fully driverless at all times while tilling, saving significant time and labour. The company has stated it intends to expand the technology to include planting and weed control.

The scope of this is enormous. The feed from cameras, radar and possibly lidar (light detection and ranging) must be fused into a single moving picture - although it is not a picture, since every element of it must be 'interpreted' (and so involves graphics processing units, or GPU's, tied in to the central processing units, or CPU's). All of this intelligence is then used to drive the actuators which steer, till and spray across the mapped field. This is automation writ large.

The essential tools for these use cases are GPU's by the likes of companies Nvidia and AMD (which together generated +4.1 percentage points of return for Loftus Peak investors in 2021).

Companies such as these have created interlocking value loops with each other. A Google-map search for directions may take place on a Samsung phone, using a Qualcomm processor, to then be stored in a Microsoft Cloud.                                                                                                    

Semiconductor companies are powering disruption across all industries

Need to create recommendation engines for everything from movies to restaurants to clothing, or crank up machine learning systems to remove spam from millions of inboxes? Find the quickest way home? Play a game in smooth 4K? Conjure the metaverse itself?

Electric cars? These cannot run without power semiconductors from ON Semiconductor and Infineon. Ditto the home solar roof panels which require inverters and rectifiers to turn the DC current to AC, on which almost all appliances run. Even excluding battery electric vehicles, the silicon content of cars is set to triple in the next three years as drivers demand better safety features such as lane departure and school zone warnings, not to mention ever more sophisticated in-car displays and entertainment/navigation systems.

Indeed, the reason that used car prices have skyrocketed is because new cars are not available pending the required chips to finish them. Semiconductors are now critical in areas as diverse as shipping logistics, vaccine development and power grid management.

The Loftus Peak portfolio does not include semiconductor companies because it is a technology investor, trying to pick winners from a commoditised group of companies making low value-add components for computers. They are there because of their critical role in powering the cutting edge of disruptive businesses in all parts of the economy.

Where next for semiconductors?

The revenue limitations for semiconductor companies are not related to demand, but supply. Because of supply chain mayhem caused by COVID-19 coupled with an endless thirst for compute cycles required by advanced applications, there is simply not enough capacity in the world's major chipmakers to satisfy the demand. It's the reason that TSMC has allocated US$100b over the next three years to additional manufacturing capacity, more than double the normal sum. Virtually the entire company's production in 2022 is already sold, and the situation seems likely to continue into 2023.

The Economist magazine recently referred to data as the new oil - true enough - and it is the semiconductors that are producing, storing and generating value from it. There is no sensible reason for any fully engaged market participant to miss this trend. Investors should look to their own portfolios to ensure adequate, well-priced exposure.