ROADNIGHT MUSING – MAY 2025
MARKETS ARE NEVER BORING!
There doesn’t seem to be a day go by where we are not reading about a new major global or political event that gives us pause for thought. While we are not a macro investor, we do run a range of scenarios to stress test the credit worthiness of our borrowers.
Not surprisingly, we have recently been asked on several occasions whether the turmoil and prospect of tariff increases has the potential to impact the businesses we fund. While it is hard to be definitive, and there will be negative flow-on impacts, we do not believe the damage of US tariffs on Australia will be consequential enough to cause any credit quality issues for our borrowers or portfolio.
A few thoughts on the sectors and businesses we fund:
Agriculture:
The free-floating exchange rate will likely result in currency falls offsetting some of the tariff impact. Since Trump was elected in November 2024, the Australian dollar depreciated 10% from US67c to US60c, (hitting a low of US59c in recent weeks), and has recovered to 64c. While there are many moving parts, any AUD weakness will offset the 10% tariff on the landed price of Australian goods into the US leaving the end consumer no worse off.
Australian exports to the US are largely comprised of high-quality agricultural products (and minerals). They will either continue to be purchased by the US at a higher cost or sold elsewhere. A good example is Australian beef, which was singled out by Trump. Before the tariffs were announced, 300 abattoirs in the USA didn’t have their licences renewed to export beef into China, and Australia has been filling the gap with Australian grain fed beef exports ramping up in February and March by 40%.
The free trade agreement between the European Union and Australia was almost finalised in 2024, with talks abandoned by the Australian side due to some impasses. Since the US tariffs were announced, it appears free trade discussions with the EU have recommenced and there is optimism that an agreement could be concluded in 2025.
The farming sector has a long history of dealing with both geo-political and shorter-term weather and commodity price volatility, and remains focused on long-term fundamentals rather than short-term noise (look through the cycle perspective).
Corporate Australia:
Market consensus appears to be that tariffs will have inflationary implications for the US economy in the short term as higher import prices unavoidably feed into the supply chain. This inflation will be diminished by free floating currencies while China will also look to devalue its fixed exchange rate to offset the impact.
The costs to both the US and China economy will impact growth in the short-to-medium term. Longer term the diversified US industrial base can substitute the imports with domestic production, but this is unlikely to be as efficient an outcome so it will have some inflationary implications.
We are maintaining a watching brief on any flow on effects to the Australian economy. Whilst the Australia dollar has already fallen to equalise some of the tariff impact, Australia does have a reliance on imports and inflation is persistent. Three areas we are watching:
Concerns around persistent inflation are reflected in the interest rate yield curve (forward rates 2 year to 20 year):
The recent volatility has pushed credit margins wider from historically tight levels as investors demand compensation for increased risk. The costs will flow through to borrowers.
Severe economic contraction in China (without stimulus measures) that reduces demand for our key exports. This is probably the biggest potential knock-on effect for Australia from the trade war, and there is still uncertainty on how China will respond.
Looking at our portfolio, we have 2 borrowers with US exposure, albeit comprises < 30% of their total revenue. Their recent operating performance has been strong and both businesses continue to grow. It is too early to determine the scale of any negative impacts on their product demand from rising US inflation, if any, and we will continue to monitor their performance each month.
About 40% of the portfolio is invested in Non-Bank Financial Institutions that are primarily focused on consumer and business lending in Australia and have very limited US exposure. Their business models will marginally be impacted from credit margins moving wider, however their capacity to pass on increased costs onto the underlying borrower and extremely strong net interest margins leaves them well placed to withstand a widening in credit margins. At the present time, we have not seen any uptick in arrears rates in the underlying consumer or business loan pools.
The greatest challenges borrowers have faced in the current environment have been more idiosyncratic factors and own goals rather than broader macro factors. Several businesses have over invested in their operations in anticipation of growth which has not eventuated, and consequently cashflows have been impacted. We have two such businesses that remain fundamentally sound but are needing to right size their cost base to reflect the slower operating environment.
With higher volatility and uncertainty flowing into funding markets, private debt continues to increasingly provide a viable alternative for small to medium sized businesses as risk aversion lifts. While the risks around the current trade war are not immaterial, we are seeing the fall out from a credit risk perspective as manageable when looking across our portfolio and borrowers.