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
- Our loans are all short duration and significantly higher returning than general fixed income. As such the value of the underlying loans will not be materially affected by a shift in real bond rates in any significant manner
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:
- Is real property an inflation hedge – Conventional wisdom suggest property prices rise with inflation and may lose value in a deflationary environment. No doubt the cost of materials and labour imbedded in a building will rise in value but does the land value rise? This link between property prices and rising inflation seems a little simplistic as property prices have greatly benefited by a steady decline in inflation and interest rates over 30 years. Ongoing muted inflation and near zero interest rates for a prolonged period are probably the best outcome, it is only if we start to see prolonged deflation such as Japan has experienced, where land values fell for 20 years, that we have any concern. If stagflation was to emerge, on the other hand, we are grappling with the concept that property prices will rise in the face of rising interest rates which would unwind the cap rate compression that has driven markets for decades. Replacement cost of buildings could certainly surge if materials and wages increase but ultimately the income/ serviceability generated from real estate would need to rise faster than interest rates to create an offset in valuation.
- Residential Real Estate – higher inflation and interest rates would impact mortgage serviceability and we think this might be the most vulnerable sector as wage increases are unlikely to rise as fast as mortgage payments. Simply home owners can pay less for a house at higher rates, whereas a deflationary world would see no wage growth but still allow servicing of low mortgage rates sustaining house prices.
- Commercial Real Estate – most quality commercial leases have CPI linked increases in the annual rent review. This protection against inflation will hold in the early stages of inflation, as rising product prices will generally be positive for a tenant’s underlying business. The broad business sector has struggled for pricing power over the last decade and some inflation is certainly sought after by central banks and other policy setters. While deflation is probably synonymous with poor performing tenants and increasing vacancy rates, the demise of tenants will be a slow bleed offset by near zero interest rates.
- Agricultural Real Estate – this is probably the one sector that will clearly benefit from stagflation as commodity prices will rise faster than interest rates. Unlike commercial real estate, deflation in this sector could see tenants suffer quickly as commodity prices collapse. The major banks have increased their focus on income versus asset value in this sector during the recent cycle and a declining revenue line in agriculture could have more impact sector- wide than experienced during recent commodity cycles.
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.
