The Australian Dollar has made lower highs and higher lows and is approaching the thin edge of the wedge. Despite the headlines, the market is effectively becoming more comfortable with a very tight trading range. The reality of a wedge pattern as shown in Chart 1, is that eventually the range becomes so tight a breakout to the upside or downside occurs, setting a new trend.
We feel the “AUD wedging” is symptomatic of the backdrop for many macroeconomic factors that will impact markets, and importantly for our portfolios, via the performance of hard asset backed credit.
Despite the recent market volatility experienced at the beginning of the month things have settled down surprising quickly. This suggests many asset classes are contained in a wedge pattern.
Several observations this week relevant to our portfolio are:
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- The spike in the value of our CDS hedge (insurance) has reverted to tight levels reflecting the ongoing flood of capital into fixed income markets.
- One of our borrowers who is in the final stages of an office development is receiving multiple term sheets for refinancing at robust leverage levels. This potential refinance in the next two months demonstrates the market is still open for well positioned assets.
- The 10yr AUD Government Bond is trading back down to 3.9% suggesting commercial real estate yields (cap rates) could stabilise at 5.5-6%.
Chart 1: AUDUSD since the onset of the COVID pandemic
Source: Bloomberg
- Despite some positive trends, we have been suggesting for some time that the coming quarter could set the lows in commercial real estate. There is simply an ongoing need for some property owners to find a clear price and sell. It is possible that a small number of our borrowers could find themselves in this predicament.
- The financial press has shown increasing interest in the growth of private credit, suggesting there is some mystery to what is going on.
- Of all the asset classes we have traded in over the last three decades, we believe that senior direct lending is in fact the simplest to understand. We finance real property and generally hold security via a senior mortgage like a bank, however we lend from a pool of unlevered capital i.e. equity unlike a bank.
- The ability to earn higher interest rates than a bank is because our unlevered capital allows us to take more liquidity risk than a bank and provide borrowers with a solution that APRA does not allow the complicated balance sheets of banks to participate in.
- The growing provision of alternate capital in Australia and New Zealand is an important solution for the ongoing growth of our economy. The higher returns are important because they attract capital to this emerging asset class and create an eco-system that can facilitate nation building.
- Investing in private credit is considered to be lower risk than investing in equity markets or buying real property, however it is far from riskless. The returns have generally been as good as investing in equities over the last decade and we believe that this will persist for some time.
- In particular, a portfolio of mortgages averaging a loan to value ratio of 60-65% is potentially highly unlikely to experience an impairment of capital, whereas equity markets in almost every cycle will experience a significant decline in capital values for some period.
As we approach the “thin edge of the wedge” of many macro trends during the second half of 2024 we believe that a trend change from what we have experienced over the last five years will emerge. In particular, more benign inflation and softer rates will set a very positive trend for hard asset collateral values; conversely if the normalisation does not arrive in time, we believe that it could trigger a number of borrowers having to sell assets at a loss to repay debt.
