Globally equity markets in August were broadly weaker. In the US, the S&P 500 fell -1.8%, whilst the Nasdaq declined -2.2%. In the UK, the FTSE 100 fell -3.4%. Impacting investor sentiment was weaker than expected Chinese economic data (eg. Industrial output and credit growth), which saw commodity prices fall during the month.

In Australia, the All Ordinaries Accumulation index fell -0.7%. Consumer discretionary was the top performing sector (driven by better than feared results), whilst utilities and staples (ie. more defensive sectors) underperformed. August saw the majority of listed companies report their results for the six months to 30 June, which provided an excellent health check on how these companies are trading in the current economic environment.

In terms of the macro environment, data in August pointed to a continued reduction in inflationary pressures both in Australia and overseas. This in turn, should mean the bulk of heavy lifting in terms of interest rate rises needed to bring inflation down to targeted levels, has now been done.

We viewed the August reporting season on the ASX as broadly better than had been feared. Many companies are seeing significant cost pressures (eg. wages, energy, rent, interest expense), however these issues were well known going into reporting season. Interestingly, the consumer discretionary sector performed well despite bearish expectations by investors. Whilst economic conditions remain challenging, it is important to remember the stock market is forward looking, hence we continue to believe the correct approach is invest in quality businesses and take a medium-term view, particularly given inflation data is now pointing to a clear decline from the very high levels of 6-12 months ago.

"Hottest on record" is on repeat

In scenes now repeated every summer, not a day seems to go by without headlines of record-high heat somewhere on the planet, whether in Europe, Asia, Africa or North America. The World Meteorological Organization said it was "extremely likely" that July 2023 will be the hottest on record¹. As temperatures climb, news images of raging wild fires have become all too common, along with other hallmarks of extreme weather such as violent storms and destructive flooding.

We have been spared the worst of extreme weather patterns here in Tokyo. Nevertheless, we have acutely felt the impact of climate change. In Tokyo this August the mercury rose above 30 degrees Celsius every day of the month for the first time since records started being kept in 1875. As the country becomes more tropical in climate, long-standing traditions are being challenged. An example is in baseball, Japan's national pastime. The sport is usually played without any breaks. However, a "cooling time" rest period was introduced for the first time at the 105th edition of the National High School Baseball Championship, a nationwide tournament held annually in August. This break with tradition caused a national debate, with many of us wondering if children in the future will even be able to enjoy pastimes long associated with the summer in this country such as tennis, soccer and rugby?

It is no secret that greenhouse gas (GHG) emissions play a role in global warming. Yet, despite pledges by governments around the world to reduce GHG output, global emissions have been increasing steadily (Chart 1). Our tendency to ignore a looming catastrophe was satirized in the 2021 movie Don't Look Up. Two astronomers played by Leonardo DiCaprio and Jennifer Lawrence discover a comet hurtling towards earth and warn the world of the impending disaster, but to no avail. In desperation, the two scientists beg the world via social media to just look up, but the US president, portrayed by Meryl Streep, advises to do just the opposite, telling people "don't look up".

Chart 1: Global GHG emissions and corresponding temperature change

World total GHG: Total greenhouse gas emissions including land-use change and forestry, measured in million tonnes of CO2-equivalents.World temperature change from GHG: Change in global mean surface temperature (in °C) caused by greenhouse gas emissions.

Source: Out World in Data material compiled by Nikko AM

Japan: a major GHG emitter with room for improvement

Unlike fictional characters in a movie, in reality we have no option but to look up and consider what is driving climate change. Let us take our home market of Japan as an example. The country was the seventh largest GHG emitter in 2021 (Chart 2). Japan's significant emissions are a result of its heavy reliance on fossil fuels to generate power, having slashed its dependency on nuclear power plants following the earthquake and tsunami-induced nuclear disaster in 2011.

Chart 2: The world's top GHG emitters

Source: Our World in Data material compiled by Nikko AM

Seen from a different perspective, being a large GHG emitter means there is plenty of room for Japan to improve its environmental standing. In 2020, the country made an ambitious pledge to reach carbon neutrality by 2050, and in 2021, it set a goal to cut GHG emissions 46% by 2030 from 2013 levels. The share of renewable energy that generates Japan's electricity has risen to 22.4% in 2021 from 12.1% in 2014, according to the Institute for Sustainable Energy Policies².

There are other concrete signs that Japan is indeed improving its standing, in particular among its private sector. As Chart 3 shows, Japan has the highest number of companies that support the Task Force on Climate-Related Financial Disclosures (TCFD). Upon request by G20 central bankers and finance ministers, the Financial Stability Board established the TCFD in 2015 to help the financial sector assess and price climate-related risks as well as opportunities. The TCFD Recommendations were released in 2017 and widely credited with shaping the voluntary climate-related financial disclosure landscape. However, whilst support for the TCFD is encouraging, the quality of disclosures still has room for improvement.

Chart 3: TCFD-supporting institutions by country as at July 2023

Source: TCFD Consortium material compiled by Nikko AM

Awareness towards sustainability within Japanese society is expected to increase, with companies taking a more proactive role in promoting it. Interest towards ESG investment is also rising among individual investors, led by those of the younger generation. According to a survey by Japanese news provider QUICK's ESG Research Center, 48% of respondents in their 20s were interested in ESG investment, compared to 44% in their 30s and 42% in their 40s³ .

Equity strategy focused on climate change

In addition to Japanese companies and individuals, awareness towards sustainability is also increasing among the country's financial institutions and investors. Until recently, only a few financial institutions disclosed their financed emissions, which are GHG emissions linked to investment and lending activities. However, more such institutions are now hiring sustainability specialists to estimate their financed GHG emissions, and their disclosure is seen gathering pace going forward. Against such a background, we expect increased demand among investors to reduce GHG emissions linked to their investments. One strategy asset managers use to meet such demand for portfolios with lower GHG emissions focuses on urging companies to accelerate decarbonisation efforts via stewardship activities. Nikko AM's climate change-focused Japanese equity strategy takes such an approach (Exhibit 1).

Exhibit 1: Climate change-focused Japanese equity strategy's objectives

Source: Nikko AM

The strategy covers all sectors to construct a low-GHG portfolio, providing exposure to Japanese stocks that is similar to the TOPIX while simultaneously aiming to limit financed emissions. As at end-July 2023, the portfolio's estimated tracking error versus the benchmark TOPIX was 0.34%, of which the estimated risk attributed to industry allocation was a modest 0.13%. GHG emissions and intensity are maintained approximately below 50% of those of the benchmark TOPIX (Exhibit 2); GHG emissions by companies are based on publicly disclosed information as well as estimates calculated using an in-house model.

Exhibit 2: Portfolio-wide GHG restrictions and targets⁴ (KPIs)

Source: Nikko AM

A key feature is the utilisation of in-house GHG emission estimates, which enable us to expand our coverage significantly from approximately 600 companies to the entire TOPIX universe of roughly 2,100; the weight coverage has also increased from 82% to 100%. We are able to cover almost the entire TOPIX on a market cap basis through the use of our own estimates as well as actual reported results.

In addition to such a quantitative approach, another important feature is engagement with the investee companies. The quantitative data obtained is utilised in engagement undertaken by Nikko AM's Sustainable Investment Department. This interaction encourages companies to operate in a more environmentally conscious manner and disclose relevant information (Exhibit 3). The department's on-the-ground stewardship specialists are well positioned to leverage Nikko AM's influence on investee companies. Their well-established relationships with local companies give Nikko AM an advantage over foreign peers. In addition, our stewardship activities in all global regions follow the highest international standards, with the firm having been recognised in 2023 for the second consecutive year by the UK's Financial Reporting Council as a signatory to the UK Stewardship Code. Nikko AM was the first Japanese asset manager accepted to the Code based on a global, firm-wide application.

Exhibit 3: Driving decarbonisation initiatives through engagement

Source: Nikko AM

Engagement example: a major Japanese steel company

• Engagement: The company initially aimed for an 18% reduction of CO2 emissions by FY2024 from FY2013 levels. Considering the company's standing as a major emitter, we conveyed the need for a more ambitious target by first using existing technology. We also encouraged the company to actively seek government support in its emissions reduction efforts.

• Company response: The company revised its CO2 reduction plan and now aims to reduce its emissions by 30% by FY2030. It explained that the plan would be achievable through the introduction of new procedures, mainly the effective use of raw materials; practical utilisation of digital transformation within the production process is also expected to play a role in reducing emissions.

• Assessment: This is an example of successful engagement as the company responded by proposing concrete measures.

• Future approach: We intend to monitor the progress of the revised plan and encourage the company to further accelerate its emissions reduction efforts, including where required through measures such CO2 capture and storage from 2030 onwards, which would require cooperation with players in other industries.

Summary

The climate change crisis we are witnessing presents both challenges and opportunities. Focusing on the latter from an investment perspective, in our view asset managers are in a position to help facilitate society's goals of reducing GHG emissions and decarbonising. An important way of meeting investors' needs for portfolios with a lower carbon footprint is through direct engagement with investee companies. Japan is currently a major GHG emitter but the country's ambitious plan to become carbon neutral by 2050 has made it necessary for companies to ramp up decarbonisation efforts. The intent is not in short supply as Japan has the highest number of companies that support the TCFD and they are increasing the quality of their data disclosures. We believe strategies focused on climate change-related initiatives in Japan are uniquely placed to help with the construction of a greener portfolio while assisting society as a whole in its decarbonisation efforts.

Author: Masayuki Teraguchi, Head of Investment Technology Fund Management Department

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• 0:46 - The impact of high rates on REITs
• 4:01 - Quay's view on bank values and the risks across sectors
• 7:33 - The mismatch between supply and demand in the real estate market
• 8:51 - The opportunities for REITs in the USA, UK and Europe
• 11:11 - ... and how Quay is capitalising on these opportunities
• 11:58 - The team's long-term earnings outlook

Since Chat GPT3 crashed onto the scene at the end of 2022, the world has been swept up in (generative) Artificial Intelligence (AI) euphoria.  AI related stocks have all rallied, companies have expanded their capital plans and gone to great lengths to explain how and why they use AI, and analysts have sharpened their bull case scenarios for future growth opportunities.

We've seen similar transformative technology breakthrough exuberance rise and fall in the past, such as Web 3, the metaverse and crypto architecture last year.  Is AI just another tech bubble about to implode? Or something much more substantive? The answer is yes to both.

In this note, we expand on why we remain excited about the use cases and subsequent earnings potential that can be built off the back of AI in the future and why we believe this technology shift, and the value that it can create, is real.  Investors however need to be very selective as the monetisation potential of AI will flow through different elements of the chain at various levels an at different times. Two clear early winners in our view are Microsoft and Nvidia.

The AI induced rally

The release of Chat GPT did bring the technology sector heavily back into focus in the first half of the year with the Mega (or profitable) Tech index rallying 64% to the end of July. But this reborn tech euphoria also dragged the Unprofitable Tech stocks 37% higher, to outperform the broader US market by more than 40% and 15% respectively.

AI enthused rally has boosted profitable and unprofitable tech stocks YTD  

There is undoubtedly an element of AI froth that has come into the technology sector, as some companies have seen AI potential wash into their share prices before a clear articulation of how the earnings that will back these valuations will emerge. And we have seen the downside of this where companies such as Data Dog and Palantir have had solid falls after earnings disappointments, while some of the air has also come out of other companies such as MongoDB, Snowflake and Salesforce.

We expect the market to become more discerning in terms of wanting to see a clearer monetisation path to determine who the key winners will be as opposed to the broad lifting of almost all boats even tangentially brushing up against the AI theme that we have seen so far this year.

Use cases of generative AI

In terms of winners in the AI space, it is all about a clear identification of use cases. AI is not a new theme. The difference now is generative AI developments expand these technological capabilities and put them within the reach of hundreds of millions of new users each month.  The IDC estimates the global AI market will see 19% compound annual growth between now and 2026 to reach US$900bn while Goldman Sachs predicts generative AI alone could drive 7% or an almost $7trn increase in annual global GDP growth over the coming decade.

There are various elements of the tech ecosystem where value will emerge to varying degrees. At the front end you have the key enablers such as semiconductor designers like Nvidia that will benefit along with foundry businesses like TSMC and Samsung and the semiconductor equipment players such as ASML, Applied Materials and Lam Research who supply them. Then you shift towards the infrastructure names such as networks businesses like Arista, and the cloud players that span Microsofts Azure, Amazons AWS and Googles GCP.

But the really exciting opportunities should emerge beyond the initial enablers and infrastructure players and be in those businesses that can create applications based on AI. Established businesses such as ServiceNow, Workday and Salesforce are working to embed AI within their current offering, but the real opportunity is likely to be in the emergence of a business that applies AI to a deep revenue pool and owns that vertical. Whether that be in healthcare, finance or customer service, there is potential for an AI leader to emerge that could be the next big tech name in 5yrs.

AI offers a plethora of investment opportunities, but not all created equal

Source:  Alphinity, 31 July 2023

Two clear early winners currently - Microsoft & Nvidia

Investing in AI is like investing in any other idea for Alphinity; find the investment ideas that are showing earnings leadership, come wrapped in a quality business, and are bound by a reasonable valuation. In AI it comes down to identifying a tangible use case and the monetisation potential that flows off the back of this to driving earnings outperformance, exceptional returns and valuation upside. Microsoft and Nvidia are two clear early winners in AI that display these characteristics.

Microsoft (MSFT) - Well positioned for broad secular trends in technology and a leader in AI

Microsoft has multiple legs of opportunity flowing from AI. At the front end, it has announced pricing for its AI infused M365 co-pilot product at $30per user per month. Applying this pricing to Microsoft's 250m commercial users of it's higher value products, we estimate Co-pilot can drive an extra $27bn in revenue, or 13%, over a 3-5yr period, assuming a conservative 30% penetration rate. There is also the uplift in consumption that will run through Microsofts cloud business Azure, a potentially simpler Ai product for the extra 200m commercial users on simple product sets, plus incremental gains from any shift in search traffic from Google to Bing.

Wrap this together and while the Microsoft share price has risen in 1H23, investors are currently paying 30x Price to Earnings for a business that can grow mid-teens over the next 3 with multiple growth drivers.

MSFT offers tangible AI monetisation

Source:  Alphinity, Bloomberg, 31 July 2023

Nvidia (NVDA) - Global leader in Graphics Processing Units with generative AI a gamechanger

Nvidia is the other key initial beneficiary from AI, with their most recent result generating an almost unprecedented upgrade in earnings expectations for a business of its scale. Generative Ai is all about GPU's given their ability to run calculations and simulations in parallel; the key tasks for AI. And Nvidia sits front and centre as the leader in terms of GPU performance coupled with a powerful software capability making their GPU's flexible and programmable.

The key to the Nvidia investment case is ensuring that the current demand is not just a flash in the pan. To our mind, there is sustainability to this demand given that generative AI has triggered a shift in data centre infrastructure from CPU's towards GPU's. With around $1tr of datacentre infrastructure installed, and this infrastructure turning over around every 4 years, this provides rich structural tailwinds that should drive Nvidia earnings for years to come.

On our estimates, NVDA should generate around $30bn in datacentre revenue this year (2/3rds of total revenue). If we push the shift from CPU to GPU through our discounted cashflow model, we estimate that datacentre revenues can increase to $80bn CY27. Investors are paying c40x FY24 Price/Earnings, with what looks like growth to come for the years ahead.

Revenue & margin uplifts driving unprecedented EPS upgrades over next two years

Source:  Alphinity, Bloomberg, 31 July 2023

In summary, AI is an exciting investment opportunity, with many growth tangents still to be discovered.  But like any investment, investors need to be able to have a line of sight to the earnings potential and be disciplined in terms of what they pay for these companies to ensure that they are not riding a bubble that may eventually pop.

Authors: Elfreda Jonker, Client Portfolio Manager & Investment Specialist and Trent Masters, Global Portfolio Manager

Amidst ongoing economic uncertainties, the RBA has seen fit to keep rates on hold for a consecutive month and wait to see how the lagging effects of 12 rate hikes play out.

While inflation is decelerating, uncertainty abounds over consumer spending, falling productivity and wage growth. Will the central bank's aim to deliver a soft landing make it harder to get inflation back to target, meaning that this pause is short-lived?

Darren is joined by special guest Phil Strano, Senior Portfolio Manager in charge of credit research, to explore this and more in episode 41 of The Rate Debate.

At the same time as we are seeing global policy initiatives seeking to further accelerate the uptake of electric vehicles (EVs), corporate activity in the fuel and convenience retailing sector has stepped up. If the common belief that EVs will displace the need for Fuel Retailers, why are industry players increasing their capital allocation to the sector? We investigate the outlook for Fuel Retailers against the commonly held perception that they will ultimately be stranded assets.

With the transport sector accounting for 14% of global carbon emissions (refer Figure 1), internal combustion engines (ICEs) are directly in the firing line of governments seeking to meet reductions targets. Further, the development of cost-competitive alternative technologies means that the transition to cleaner transport is not only achievable but now gathering significant momentum around the world.

Figure 1: Global Greenhouse Gas Emissions by Economic Sector

Source: US Environmental Protection Agency

The consequence is that ICEs are likely to go the way of the steam engine over time. This begs the question - will service stations become stranded assets? What are the prospects for these sunset industries?

Three years ago the answer to these questions was largely speculative. However, the COVID-19 period has created an ideal test environment in which the impact of a reduction in fuel volumes can be readily examined. This paper reviews the data and the risk that service stations become stranded assets.

It is beyond debate that over the next two decades the vast majority of Australia's passenger vehicle fleet will transition to cleaner fuels. Car manufacturers are moving rapidly towards EVs, recognising the mega trend and the cost comparability. Governments around the world have varying incentives to assist in the transition, with adoption of EVs having increased rapidly as price-competitive and range issues have been overcome.

Australia lags but won't forever

While adoption of EV's in Australia has been relatively slow to date, it would be naïve to consider that this will remain the case.

Norway is the country most advanced in electric vehicle penetration of new car sales. This has come on the back of significant government incentives for the electric vehicles and support for infrastructure development. While EVs were only 1% of new car sales in 2011, the Norwegian Office of Vehicle Statistics reports that in the nine months to September 2022, EVs represented 77.8% of new car sales (refer Figure 2).

Figure 2: Electric Vehicle Share of New Car Sales - Norway

Source: Road Traffic Information Council (OFV); Electric Vehicle Association (Elbil). *Year to date September 2022.

What would this adoption rate mean for Australian fuel volumes?

We have modelled the implications of an adoption rate as rapid as Norway's for the Australian market, allowing us to map out the potential impact on retail fuel demand as the energy transition proceeds. We have also assumed that the uptake of hybrid vehicles accelerates from recent trend rates, as more models become available. Combined these assumptions indicate that ICE vehicles will be a rapidly declining proportion of new car sales, to the point that they are all but eliminated by 2033. Notably this is faster than the proposed legislated goal of ending ICE vehicle sales in the UK and EU by 2035 and close to the recent Biden Administration proposal to phase out ICE vehicles by 2032.

Figure 3: Composition of New Car Sales (Australia)

Source: VFACTS, Tyndall estimates

While the composition of new car sales changes rapidly in a decade, the impact on the vehicle fleet (refer Figure 4) is a much slower process. Under this scenario, hybrids and electric vehicles will represent only one-third of the total fleet by 2033.

Figure 4: Australia's Vehicle Fleet Mix

Source: VFACTS, Tyndall estimates

What is evident from this analysis is that the impact on volumes from the transition to electric vehicles is extraordinarily protracted (Refer Figure 5). Retail volumes are not forecast to decline from 2019 levels until 2029. And even then, the decline is only 1.3ppts. The impact does accelerate quite significantly during the following decade, with 2040 volumes forecast to be c33.5% lower than 2019 levels.

Figure 5: Fuel Volumes (Indexed to 2019)

Source: ABS, Tyndall estimates

A longer-term volume contraction is only half the story

While significant and at face value perhaps alarming, a significant decline in fuel volume is only half the story. The other relevant variable of course is price, and the COVID-19 experience has demonstrated the ability of the fuel retailing industry to maintain dollar gross margin in the face of falling volumes. This rational industry response perhaps benefited from the recent memory of unprofitable discounting that occurred during calendar 2018.

Chart 6 shows the trends in gasoline volumes and retail gasoline margins over the recent past - capturing the period of COVID disruption. As the chart shows, Fuel Retailers responded to lower volumes with price increases, such that dollar gross margins expanded.

Figure 6: Retail Gasoline Margins and Volumes

Source: Australian Petroleum Statistics, Department of Energy; Australia Institute of Petroleum; Tyndall

In the June 2020 quarter, which includes the early part of the pandemic and national lockdowns, fuel volumes fell ~45%. Retail margins in that period averaged 18.3 cents/litre, ~46% above the 2019 average.

Following the partial recovery in the ensuring quarters, over the two years to October 2022 volumes have been ~9% below 2019 levels while retail margins have been ~18% higher.

Due to the price inelasticity of fuel and a rational response in a relatively concentrated industry, retailers have been able to maintain gross profit in the face of weaker volumes.

Looking further ahead to the ~40% declines in volumes by 2040, the price increases required to offset the lower volumes are not prohibitively high. At the time of writing, retail fuel prices at $1.88/L for gasoline and $1.96/L for diesel. Retail margins for these base products were in the order of $0.20/L. Maintaining gross margin for a 40% decline that occurs over a 10-year period (plus allowing for the underlying inflation in a retailer's cost base) would require that this retail margin increases by an average 2.7 cents/litre p.a. On the total cost of fuel this increase represents an increase of 1-2% p.a. Given the inelasticity, this is easily achievable.

Preparing for the future

As highlighted above, the medium-term outlook for Fuel Retailers is sound, with the impacts of the fleet conversion to electric vehicles a very slow burn that will not materially impact volumes for a decade. That said, the longer-term outlook does point to significant erosion of fuel volumes. While pricing offsets to combat this have been proven possible through the COVID experience and at face value are not unaffordable, the very long-term scenario is that retail fuel volumes go to zero.

In the very long term, therefore, Fuel Retailers will need to rely entirely on their shop sales. Presently the industry relies heavily on the profitability of fuel to underpin the combined fuel and shop offering. For example, ~70% of the earnings of Viva Energy's Convenience and Mobility business currently comes from fuel. The Fuel Retailers have been increasing their attention to non-fuel income, recognising the long-term need to replace fuel earnings. This is a work in process but the global consumer trend in favour of convenience is a strong tailwind to harness.

We are watching this area closely and observing how the listed participants are progressing their strategies. Both Viva Energy and Ampol have de-risked their businesses by selling service station properties but with long-term options that provide ongoing control over the site.

Ampol has extended its relationship with Woolworths with the Metro offering, which is suitable for some of its network. In sites not well-suited to the Metro offering, the company has progressed its own "Foodary" brand, which has a "food on the go" style of offering.

Viva Energy is also refreshing its strategy. The acquisition of Coles Express accelerates its opportunity to progress a more contemporary and potentially more lucrative strategy. The recent acquisition of the "On the Run" network now adds a high performing offering and a scalable delivery platform. Alongside Viva Energy's complete control of its national network, we see this combination of offering platform and network as compelling. We will continue monitoring the execution of the rollout with great interest.

Author: Tim Johnston, Portfolio Manager