ROADNIGHT MUSING – JULY 2024
WHAT CAN WE LEARN FROM THE US?
The Australian economy does not operate in a vacuum. Rather, it is connected via travel, global markets and trade to the rest of the world (which in practice is primarily the US, EU, China and Japan).
As we saw during the GFC, the performance of subprime housing in the US ended up impacting Australian banks and the share market. As a result, it is necessary to keep an eye on what is happening in other financial markets and use these insights in planning for the future and which risks require keeping an eye on.
What we are seeing:
Sticky inflation and depressed consumer demand impacting loan performance on consumer loan and auto loan portfolios.
Distressed real estate sectors - For the first time since the financial crisis, investors in top-rated bonds backed by US commercial real estate debt are getting hit with losses
Redemption illiquidity - US credit funds specialising in property, and listed REITs have been facing significant redemption calls, resulting in short term liquidity issues and in most cases an inability to meet calls. We are hearing about similar situations in Australia
Risk of stagflation - Jamie Diamond of JP Morgan is concerned with the return of the 1970’s phenomenon of stagflation and is scenario planning for this risk
The inverted yield curve (where short-term yields are higher than long-term yields) that has been in place since early July 2022, and is almost always a predictor of recession, tells us that rates will eventually crack parts of the economy.
Continuation of massive fiscal spending in the lead up to the US presidential election. The bond markets have demonstrated revolts against fiscal excess, for example when bond yields went to 5 per cent in the September quarter and stocks fell sharply.
Private Equity dry powder, or the amount of money committed to private credit funds that has yet to be deployed, is at a record. This is offset by PE funds unable to monetise assets.
Stock market valuation – Warren Buffett’s time tested stock market valuation indicator comprising total market capitalisation of all US stocks relative to GDP reached an all-time high of 200% last week. If the ratio approaches 200% - as it did in 1999 and part of 2000 - it is a strong warning signal to stretched values.
There is the old saying “When the US markets catch a sneeze, Australia catches a cold.” So what is this telling us?
As an investor - It is evident investors will continue to face an element of uncertainty in generating the same historical returns from the share market as the past 6 months, and value could be up or down in the bond markets over the near future given the expected fiscal spending in the lead up to the US elections. Diversifying investment portfolios through reweighting towards other less volatile asset classes could be considered.
As a fund manager, it is evident we need to trust in our rigorous assessment processes and stay focused on our pursuit of quality counterparts. The task of a private debt fund manager is complicated by many of the observable market trends in the USA also playing out here in Australia, albeit at a slower or diminished pace.
For example, the NAB Monthly Business Survey dated May and June 2024 shows business confidence is low and inflation remains sticky.
At the same time, private investment flow into private debt funds has never been higher. Fund managers face the dual responsibilities of effective and responsible stewardship of investors money and generating strong risk adjusted returns.
The culture of a successful funds management firm must have risk embedded as part of the DNA, more commonly known as “the way of doing things around here”. The structural components of good corporate risk governance are a given but it is the behaviour of the firms employees on a day-to-day basis that will govern the effectiveness of their responses to changes in the global and domestic markets. In such times, the Kranz Dictum is front of mind : that is,
Focusing on singular accountability in performance, and the hard line taken against incompetence and irresponsibility. At Roadnight Capital, we will be singularly focused on seeking strong risk adjusted returns generated from quality investments that Roadnight Capital has structured, and negotiated the terms and conditions of the facility in a direct relationship with the borrower.
RNC will not be involved in Syndicated and Club lending arrangements where typically the structure, terms and conditions are negotiated by the lead lender.
For the moment, we will not invest in real estate private credit. Australia is one of the most competitive real estate markets in the world, and we do not believe we can generate a return premium.
We will withdraw from capital raising processes that involve a “race to the bottom’ among bidding private credit managers.
Our mantra are the dual virtues of tough and competent – tough means forever accountable and strong enough to say to no. Competent means we will never be found short in our knowledge and our skills.