Productivity Matters – the implications of Australia’s falling productivity on hard asset private credit.

Declining productivity in Australia is impacting the lending environment and outlook. In 2023, productivity output fell by 3.7% (Productivity Commission) despite the number of hours worked increasing by a record 6.9%. A higher productive output allows wages to outpace inflation and stabilise prices, while falling productivity narrows the RBA’s path to achieving its inflation target (2-3%).
Today, we look at the opportunities and challenges that a lower productivity environment creates for private credit.

There has been a lot of conjecture about productivity from different sides of the political spectrum, but the numbers are now in and Australia is tracking the worst performance in the Western world. What does this mean for our strategy?

• Our stated position in December was that the market was too optimistic about rate cuts and a stable unchanged rate environment for 2024 was likely. With the latest inflation and productivity numbers at hand we believe unchanged rates continue to be the base case.
• For a hard asset lending strategy this backdrop continues to support ever-increasing replacement costs. The country’s workforce cannot deliver homes, infrastructure, commercial real estate and food production at lower costs.
• The rising replacement cost does not solve the affordability issues. Just because something costs more does not necessarily mean the users can generate the income to afford this inflation.
• However, we can predict with a high degree of certainty that it means there will be less production of new hard assets.
• Unlike the financial crisis of 2008 where “easy credit” fueled asset construction beyond demand, this cycle highlights an income crisis that could end with extremely tight supply/demand for assets.
• In the short term, it feels sentiment will swing to being too pessimistic, as it was too optimistic only five months ago.
• With this backdrop, we reiterate our core focus on senior secured debt as this year may be characterised by a “sideways grind” and the risk vs return balance continues to support being in the lowest risk part of the capital stack.

Our 2024 outlook considered the market-implied view that reserve banks worldwide would aggressively cut rates as a best-case scenario; we have been preparing our portfolios for a more likely higher for longer rate environment by taking more asset protection on new and existing investments (the Merricks Capital Partners Fund has an average weighted LVR (Loan to Value Ratio) of 60%, down from 63% 18 months ago, and 78% of the portfolio on floating rates) . Based on the current level of potential borrower demand for purchasing assets, we expect real estate transaction volumes to bounce back from 2023 extremely low level as purchasers hunt for value in a subdued commercial real estate market where lower productivity will see asset replacement costs continue to rise.

Source: https://www.pc.gov.au/ongoing/productivity-insights/bulletins/bulletin-2024/productivity-bulletin-2024.pdf