As the tidal impact of higher interest rates and tighter lending standards takes hold, we have seen little to dissuade us that we are living through a period of decisive change.

Australian small caps is a volatile asset class and one for the long-term investor. With recent offshore bank failures and some concerns creeping into credit markets globally, balance sheets and cashflow come into focus, especially at the smaller end of the market where many companies still require funding for growth plans. While we don’t make macroeconomic calls and are by no means suggesting that there will be further issues to come, it is worthwhile exploring how Australian small cap companies are positioned if there is to be another banking crisis, by examining lessons from the Global Financial Crisis (GFC) in 2008.

For any student of economic history, it’s self-evident that economies and markets move in cycles. While this reality appears obvious, the elongated cycle that endured over the past decade may have caught investors in an illusion that this decade may revert back to the ‘good times’ – that market price weakness is short, temporary and likely to see another elongated bull market ensue. We remain cautious on retailers but nonetheless find opportunities in select consumer names with a favourable customer base that is, for the most part, insulated from the effect of interest rate increases.

Our recent meetings with the management teams of Australia’s large iron ore producers have allowed us to gain insights into the fascinating dilemma emerging in the global iron ore market. Right now, market forces remain finely balanced. On one hand, China’s abrupt change in COVID policy sets the stage for a substantial pickup in steel demand. Will China kick-start an economy slowed by recent lockdowns in the same way they have in the past – through steel-intensive infrastructure spending? Or will they be more resolute around their longer-term desire to transition the economy to one based more on services, allowing primary industries like steel to slow?

Over the past decade, several structural (higher leverage) and transient factors (rising asset prices and a widening valuation gap) have benefited the performance of unlisted infrastructure relative to listed. We believe It is unlikely these tailwinds will persist but rather that they will reverse, providing a headwind to unlisted returns.

Asset markets remain volatile, but there are early signs that inflation recently peaked and real interest rates have come off their recent highs. In our view, the inflation protection in many infrastructure assets, such as toll roads that can pass inflation on via toll rates to motorists or regulated utility networks that have their asset base increased by inflation each year, should be protected from further increases in inflation. Read about the outlook for global listed infrastructure in 2023.

Despite recent market strength which has seen the Australian market back close to all-time highs, and in particular the recovery in the prices of some of the hardest hit tech and growth stocks, we remain firmly of the view that valuation ultimately determines the direction of share prices.

Listed infrastructure investors must pay attention to political lobbying disclosures and policies when researching environmental and social factors, especially in light of E, S, and G linkages. The governance pillar is the bedrock of all ESG and sustainability progress, and, as past controversies have shown, a company’s environmental and social attributes can become irrelevant when things go wrong.

We believe 2023 will be a challenging year with several areas potentially surprising investors, namely uncertainty around corporate earnings, the duration of elevated commodity prices and a possible reversal of US stock market outperformance.