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Insights

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Buying umbrellas in Summer

It has been a stellar year to date for most asset classes around the world, except for Chinese equity and real estate. Merricks Capital noted several months ago that China was the only place in the world where we could identify slowing credit/liquidity.

  • It could be argued that markets are demonstrating elements of mispricing due to the peak in excess liquidity, monetary and fiscal conditions. However, the quantum of this and the path to normalisation is clouded by the fact that these conditions have coincided with peak economic and earnings growth momentum.
  • In the absence of a renewed shock or credit-based recession, economic and market cycles tend to continue until central banks signal a tightening bias or there is a tightening in macro-prudential policy in real estate.

Whilst our portfolio of loans is underpinned by a direct mortgage on hard assets, we use credit markets to hedge against a macro-led downturn in the value of our collateral. The cost of this insurance continues to be extremely cheap and sacrificing 0.4-0.5% per year in performance seems prudent when predicting the path forward, locally and globally is a challenge.

Importantly, credit markets tend to lead at major turning points and recently we have seen only a very mild widening in spreads. The exception has been the Asian High Yield market, where spreads have widened by more than 120 points since the start of June. While this may be considered “junk” credit, 40% of it is in Chinese Real Estate issuers and the major source of demand for Australia’s raw materials in commodities including iron ore and copper.

Even the Asian Investment Grade Credit Default Swap (CDS) spread has diverged or widened relative to the Australian ITRAXX benchmark which has been more resilient, shown in the chart below.

Meanwhile, with the macro cycle transitioning to mid-cycle, asset pricing in equities, credit and real estate is moving toward “late cycle” valuations. This suggests any further narrowing in credit spreads should be limited and a more likely scenario is for credit spreads to widen, increasing the value of the portfolio “insurance”.

The CDS portfolio insurance is an economic way to provide investment flexibility. It allows our investment team to pursue attractive opportunities within a carefully and actively managed risk framework. It ensures those investments, and investors in the Partners Fund, are protected from the negative impact of an external macro or credit shock.

Merricks Capital believe high single digit returns from mortgaging quality commercial real estate assets, whilst hedging the macro risk of a potential decline in property prices at a cost of less than 0.5% continues to be a good investment.

Partners Fund Portfolio Update

This week Merricks Capital settled on a new $35m residual stock facility secured against the unsold stock in a 49-level mixed-use tower in Melbourne’s CBD which includes 229 apartments, offices, and retail spaces. This is a two-year loan which will provide investors in the Partners Fund an IRR of ~8%.

 

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