July 31, 2020

Senior secured loans well protected amongst uncertain inflation expectations!


The stark contrast of gold hitting all-time highs and the lowest Australian inflation numbers in a century highlights extreme dispersion between measured deflation and the markets fear of stagflation. In other words data is suggesting central bank money printing, massive government fiscal deficits, COVID induced disruption to global supply chains and growth is causing deflation but the market is in fear that hyperinflation is coming. The job of all investment managers has become even more challenging as we need to generate returns but also follow the golden rule of preserving capital in real terms. Our strategy is well suited to this task as our loans are lowly geared which should protect against price falls and conversely backed by real assets that should rise with inflation.

Weak Demand vs Restricted Supply

Australian CPI fell 1.9% in the June quarter, giving an annual change of -0.3%. While this was the largest quarterly fall in the 72-year history of the index, there were a number of one-off factors (free child-care, fuel and education) which resulted in the underlying measures of inflation being broadly flat. The one-off factors assume that there will of course be some answer to COVID-19 in the not too distant future.

Until recently, rising inflation and the timing of potential central bank rate rises have loomed as a key investment risk. The economic uncertainty created by the COVID-19 pandemic has now switched the focus to deflation. A shift in the demand curve due to social distancing, lockdown measures and rising unemployment, has resulted in lower levels of demand and spending generally, putting downward pressure on prices.

Supply on the other hand is not surging as is usual at the end of an economic cycle but rather the supply curve has also shifted down due to lockdown measures, with lower production of certain goods and many services. Other factors, including a potential reversal in globalisation trends, political tensions and moves away from “just in time” inventory management, may also results in upward pressure on prices.

But the “elephant in the room” will be the massive fiscal and monetary policy response from central banks and governments, which will potentially have lasting effects well after the pandemic is gone. The oversupply of money relative to the level of productive output in the economy will be with us for the foreseeable future. Some economists are even pointing to the potential return of “stagflation”, where the economic scars of COVID-19 limit meaningful recovery while prices still rise due to governments printing money.

What does this all mean for senior secured real estate loans?

The key question then becomes whether the risk for investors is rising or falling rates of inflation, and are there any major implications for senior secured loans held by the Partners Fund. We have been considering these inflation risk by breaking down the components of our loan book as follows.

Interest rate risk

Inflation impact on property prices as the collateral of our loans

Our most obvious protection against an inflationary shock is low LVRs which require prices to decline by 30% before we begin to be concerned with loan impairment, however beyond this buffer our ongoing stress tests include assessments of the following:

The tug of war being waged by central banks and governments with inflation and growth have an incredibly complex interaction with all asset prices including real estate. In analysing this dynamic we remain comfortable that senior secured lending will maintain an inbuilt buffer (borrower equity) against major inflation shocks. The potential for either inflation or deflation has never been greater and we are constantly questioning how we can best balance our book to buffer a dramatic price shock. Our portfolio is currently well balanced between residential, commercial and agricultural exposure which will enhance the already defensive nature of senior secured loans.

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