The common theme of market strategists over the past 6 months – basically since the Credit Suisse and Silicon Valley Bank events in March – is that the global economy will face a credit crunch that causes a recession. Even though this has been subsequently and self-evidently shown to be an incorrect forecast, the same strategists are still clinging to their strategic approach of switching from assets that are traded with daily liquidity; like equities, senior debt, and major bank subordinate debt, into “alternative asset class” investments; like private equity, and private debt. It is important to understand what is meant by “alternative asset class” investments. These market strategists are switching into alternative asset class investments because:
– The assets are not marked to market. If there is an equity market or credit/bond market sell off sometime in the next 6 months at a total asset level investors will not see a change in value. This helps advisors maintain their asset-based fees… in the short term.
– They are claiming that this will broaden and diversify the investment risk and at the same time provide a higher return.
– It is apparently some sort of “magic pudding”?
So we feel compelled to point out that:
– There is no “magic pudding”.
– The market strategists and advisory groups recommending alternative asset class investments are receiving high fees, sufficient to compensate them for the lack of liquidity, that are not passed onto the investors and often not disclosed sufficiently. The high fees require higher risk with investment into higher risk assets.
– While it is true that investing in private equity and private debt does broaden out the investment universe, it comes with a considerably higher risk and a lack of liquidity that many investors in equities and repo-eligible bonds may not fully comprehend. The actual value of private debt or equity funds may not be truly revealed until the debt matures and the funds are repaid. Until then, investors have an opaque black box on their balance sheets.
The mistake that these strategists are making is that they are assuming that any equity or credit market sell off will be a short-term event and not a signal of a recession. Here again, they are clinging to the history, since the GFC, where the central banks have rushed to the rescue with Quantitative Easing (QE) at the first sign of asset price weakness, and there has been no recession. In an Australian context there has not been a recession since 1992. Very few remember and even fewer understand the economic implications of a recession in an Australian context, where we have a household debt to income ratio of 190% (Italy is at 88%) and combined federal and state debt to GDP ratio above 80% (although the perilous position of the Victorian state’s debt to income outcome actually is a risk to all of Australia and is unsustainable), the true debt position needs to then also include Commonwealth and state-owned entities so may in fact be much higher again.
Firstly, it needs to be understood and acknowledged that central banks got away with QE (really Modern Monetary Theory) since the GFC only because we had stable prices – no inflation – and this miracle was because we were successfully exporting our industrial production to China and more recently SE Asia. Now that inflation has returned the central bank “put” option for all those households, businesses and government with high levels of gearing is dead.
Secondly, “when” not “if” a recession occurs, it will not be mild, it will not be short, but it will be severe and prolonged because of the extreme levels of debt held by government, households and corporates. In a recession, investors in the opaque private equity/debt funds and investments will see large losses from these higher risk investments because they are far more reliant on an ongoing economic expansion than the more liquid listed market traded securities. Alternative assets may avoid a short-term fall in market prices, but only if a recession does not occur.
Given that the investment risks are currently rising, all investors should remember that Goldilocks and The Magic Pudding are just fairy tales. Inflation will not be brought under control without an economic contraction – no Goldilocks outcome – and investors cannot just move into alternative assets and expect a Magic Pudding outcome. Now is the time to move towards investments that are low credit risk and liquid, or fund managers that understand and have room within their mandates to avoid the rising inflation risks and the risks of a recession. Cash is King! Private equity and private debt are very poor investments in a recession because they are exposed to smaller companies (85% of PE funds are invested in companies with fewer than 500 employees) that don’t have the balance sheet strength to survive a recession, or the market power to pass inflation onto customers.
One of the more disturbing forms of private debt we have seen being marketed to retail investors as “secure” but with very high mid-teen returns, has been from funds that lend to property developers of residential real estate. Australia has an unsustainable level of household debt linked to ownership of residential real estate assets. One way to see the extent of this risk is to compare Australia in the graph below (blue line with left hand axis showing 190% debt to income) with the US and EU countries on the right. Australian households must remain fully employed just to service this debt level, let alone one day repay it. Not the lucky country for much longer?
Last week there was a very good piece written by Jonathon Shapiro for the AFR about the APRA discussion paper about Australian bank Tier 1 hybrids that inspired our Weekly thoughts. This is worth reading: Bank hybrids are pitting APRA and ASIC against one another (afr.com).
Last week we had the Euro Area inflation readings coming in lower than the expected oil price rise-impacted numbers, but still not good readings when you consider that it will take some time for the increased oil price to flow into logistics and then into final goods prices. Still, the lower than expected Euro inflation data triggered a much-needed end of month rally in the bond market. One can be and should be skeptical of this rally on the last day of the month, but even more so when you consider that the Italian-German 10-year yield spread was nudging 199bps just before the data on Friday. The ECB policy of a 200bps cap on the Italian-German 10-year spread has been under pressure in September for several reasons:
- The Italian budget deficit was revised up to 5.3% from 4.5% despite stronger growth assumptions and is in breach of the Euro Commission rules that are due to be reimposed next year after the pandemic.
- Italy will need to begin shortly issuing more debt to service its outstanding debt now that interest rates have risen since the pandemic lockdowns. ECB President Lagarde, at the ECB summit in Portugal in June, pointed out that some Euro Area members with high debt levels will be impacted by the costs of rolling over the bonds issued during the pandemic period. Portugal, Greece, Ireland and Spain have previously also been at risk of a bond yield blowout, but it is Italy that is currently in focus because its conservative government will struggle to deploy Euro Commission pandemic recovery funds in the way the Euro Commission wants them deployed.
- Italy has enjoyed a huge tourism boost over the past summer from post-pandemic travellers, but this will not be maintained and, going into winter with energy prices rising, the economy may contract sharply.
Interest Rates
The rise in US treasuries continues with a new set of factors for contemplation: a looming government shutdown, some moderation in US and a surging USD. However, on Friday rate rises paused after Eurozone inflation fell to a 2-year low. Next week will test if inflation or other factors such as the US government debt pile are driving rates.
Australian gov. bond rates continue to surge higher across the curve. In particular the 10-year rate rose by 0.15% last week to be at 4.513%, a 12-year high, driven by an inflation reading spike, surging oil and the global trend to higher rates. The monthly August CPI reading showed an acceleration to an annual rate of 5.2% from 4.9% in July, the reacceleration due to the sharp rise in fuel prices. Services inflation was also sticky.
A Reuters poll of economists has no RBA rate rise at the next October meeting but a 0.25% rise by year-end (17/35 polled).
Major Credit Markets
Spreads of investment grade issues rose slightly from the week before as the market looked for direction given the consistent rise in long-term bond rates. IG investors are grappling with how recent inflation data and the looming government shutdown will impact corporate balance sheets and hence credit spreads. Since mid-September, IG credit has spiked 0.10% in the US.
Despite Australian IG credit being 0.04% weaker for the week after a rise of 0.10% the week before, new issuance was strong. ANZ issued USD senior notes, Bendigo Bank a EURO-covered bond, Westconnex a 7-year fixed rate bond, NBN USD notes, RBC Kangaroo bond and Mineral Resource a large USD senior bond.
Forward Interest Indicators
Australian rates
- The gap between bill rates and swap rates continues to widen.
- Swap rates:
– 10-year swap 4.74%
– 7-year swap 4.58%
– 5-year swap 4.45%
– 1-month BBSW 4.15%
High Yield Markets
US high yield (HY) markets were weak with the average HY spread moving 6 points wider, continuing a trend from the previous week. The recent inflows to HY funds has suddenly reversed with a large weekly HY funds outflow of USD2.41billion.
Hybrids rallied strongly over the week with the major bank average hybrid margin falling 0.19% to a 2-month low of 2.24%. Leading the falls were short-term hybrids AN3PG, CBAPH and WBCPI. The rest of the curve was also firm with a graduated effect – longer-dated issues showing the least effect. Much of the buying support may have come from the $950m NABPE redemption which was repaid at the end of the prior week. Volumes were 10% above average from the redemption day Sept 20 to Sept 25, then 10% below average for the rest of the week.
Listed Hybrid Market
Most of September was characterised by a recovery in hybrid margins post the recent $1.25 billion NAB hybrid IPO in August. The average major bank hybrid margin contracted nearly 0.50% in September to finish at 2.24%. However, towards month end APRA released a paper calling for submissions, for a review it will be conducting, into the role of hybrids (AT1 capital) in its role as providing capital support in banking crises. This review announcement has no immediate impact on secondary pricing except for currently unknown outcomes on which some participants of the market may be speculating, albeit way too early. Of note is the contraction in margins in the week after the announcement. Of the 0.49% September contraction mentioned above, 0.19% occurred in the past week. Whether this was due to the APRA release or the $950m of NABPE redemption funds moving back into the market is unknown (see above).
The following chart shows the ratio of hybrid margins to the iTraxx index has reversed in recent weeks, that is, hybrids are moving back into expensive territory versus general credit. The chart shows this trend can evolve further given the range this ratio displayed from March 2022 – March 2023. In September 2022 the ratio traded well under 2. Also shown in the chart are the individual time series components of this ratio. The iTraxx index in September 2022 traded well above 1% for many weeks with hybrid margins contracting. The point of this is to show that the opposite of what is expected to occur can prevail, usually driven by liquidity issues. Hence unless it’s a violent move in credit wider, the iTraxx margin can rise and hybrids maintain their level.
Arculus Funds Management is an Australian asset manager of both public and private mandates.
They manage two retail public unit funds for DDH Graham:
- The Arculus Preferred Income Fund, formerly the DDH Preferred Income Fund.
- The Arculus Fixed Income Fund, formerly the GCI Australian Capital Stable Fund
Platform Availability: BT Wrap / BT Panorama / Macquarie / Netwealth / Hub24 / Praemium / OneVue / Australian Money Markets / Ausmaq
