Troubled times ahead? Ardea Investment Management April 2024 The saying that all good things must come to an end is a bittersweet reflection of reality. Sadly, too many of us fail to appreciate those good times, often focusing on what could or might go wrong. Perhaps this is understandable given the potential for higher interest rates to stifle economic growth and an increasingly complex geopolitical environment. However, financial markets have delivered investors a stellar twelve months of performance. The Dow Jones Industrial Average and S&P 500 have both reached record highs in the US, as did the Stoxx 600 in Europe and Japan's Nikkei 225. Corporate bonds have also performed well, with the spread over similarly dated government bonds approaching historically tight levels in both the investment grade and high yield markets. Can the good times continue? It is looking increasingly likely that forecast aggressive interest rate cuts are no longer on the way.  In fact, "higher for longer" appears to be the base case for a growing number of central banks with inflation remaining stubbornly above the average 2% target. US inflation, which has become a bellwether for market expectations unexpectedly rose from 3.1% to 3.2% in February, while core inflation which excludes volatile food and energy prices remained closer to 4%.  A similar trend is evident in other developed market economies such as the United Kingdom, Australia, and the Eurozone where central banks are now forecast to begin trimming interest rates in May or June - far later than previously forecast. Higher interest rates are already impacting the corporate sector, and this is where we could see the first cracks of a financial market correction. In many industries, the combination of higher input and financing costs mean that capital expenditure has been curtailed and cash stockpiles are low. Debt finance which was readily available and cheap is now falling due with nearly $1.5 trillion of high-yield debt, including loans, maturing globally through the end of 2026, of which $882 billion is U.S. debt, according to S&P Global. Bonds account for some $338 billion of that total with $53.8 billion maturing this year, $125.5 billion next year, and $158.6 billion in 2026. Refinancing that debt presents a challenge on two fronts, with the first being affordability. Interest rates have risen very significantly in recent years meaning the cost of refinancing these bonds will have also risen and for some corporates these higher rates will be unaffordable. The second challenge is one of demand. The spread over supposedly low risk government debt has narrowed, limiting the upside of corporate debt for investors, and shining a bright light on current valuations. Defaults have been surprisingly resilient, but that could change and the impact on demand will be immediate. Furthermore, the process of quantitative tightening has sapped liquidity from the financial system. Inflows into the US Federal Reserve's overnight reverse repo facility, a proxy for excess cash in the financial system, have been falling sharply for over twelve months. Once cash drains from the reverse repo facility, bank reserves at the Fed are likely to fall, further tightening financial system liquidity, and potentially hitting demand for corporate debt as well as equities. The high cost of debt finance, lofty valuations and a rapidly approaching wall of maturing bonds at a time where economic growth is forecast to slow are all reasons for investors, particularly those in the corporate bond market to be cautious. Yet, flows into the corporate sector remain strong and this we believe is purely a function of forecast interest rate cuts later in the year. Should those interest rate cuts fail to materialise and concerns around corporate debt come to fruition, many investors could be over exposed to rapidly falling asset class. Unlike traditional bond investment managers, our relative value approach is duration neutral and excludes credit. Investment performance is independent of the level of bond yields, the direction of interest rates and macro-economic variables. Consequently, relative value portfolios are excellent diversifiers of traditional fixed income and equity market risk, often appreciating when these asset classes are in retreat. The economic outlook remains uncertain and as such, the outlook for financial markets is also uncertain.  We believe now more than ever it is important for fixed income investors to look past the consensus view when structuring their portfolios, adding assets that are able to weather a wider variety of economic and financial market conditions.

Funds operated by this manager: Ardea Australian Inflation Linked Bond Fund, Ardea Real Outcome Fund

Important Information This material has been prepared by Ardea Investment Management Pty Limited (ABN 50 132 902 722 AFSL 329 828) (Ardea IM) for wholesale investors only. It is general information only and is not intended to provide you with financial advice or take into account your objectives, financial situation or needs. To the extent permitted by law, no liability is accepted for any loss or damage as a result of any reliance on this information. Any projections are based on assumptions which we believe are reasonable but are subject to change and should not be relied upon. Past performance is not a reliable indicator of future performance. Neither any particular rate of return nor capital invested are guaranteed.

Sovereign debt market demands clear transition to renewables Ardea Investment Management August 2023 Governments that perform poorly in managing climate change transition may encounter difficulty finding investors to buy their sovereign debt, that is the finding of a research paper by global bond managers Ardea Investment Management and Fortlake Asset Management, along with academic researchers at the University of Technology, Sydney. While the integration of climate change considerations in equity investing is today quite mature, the sovereign debt market has lagged considerably. However, the authors predict the reduction in carbon emissions and increased take up of renewable energy will become ever more important risk indicators for government bond investors. The paper, Climate Transition Risk in Sovereign Bond Markets, shows carbon dioxide emissions, natural resources rents, and renewable energy adoption statistically impact sovereign bond yields and spread. It aims to give fixed income investors and policymakers a way to assess country transition risk that is aligned directly with the United Nations Sustainable Development Goals. Commenting on the paper, Dr Laura Ryan, Head of Research at Ardea Investment Management, said, "Given the threat climate change poses to the global economy and the rapid rise of transition risk, we advocate that climate transition risk factors are determinants in sovereign bond markets. "Carbon dioxide emissions and natural resources rents not only negatively affect the environment and inhibit progression toward climate goals but also increase a country's cost to borrow in debt markets. "Importantly, the adoption of renewable energy was found to be an economically and statistically significant mitigation strategy, as the supply and consumption of clean fuel sources could drive economic growth, counteracting any short-term financial losses from the non-renewable energy sector," Dr Ryan said. Developed versus Developing Markets Assessing the transition risk factors, macroeconomic fundamentals and sovereign yield spreads across 39 countries between 1999 to 2021, the research found a strong positive association between carbon dioxide emissions and sovereign yields and spreads across advanced and developing countries. In developed markets, natural resources rents have a strong positive association, while renewable energy has a negative association with yields and spreads. Cheaper financing may counteract any short-term losses that industries may face from reevaluating assets. Further, the savings made on funding could be invested into renewable technologies and transitioned away from sectors in decline, such as the fossil fuel industry. Fortlake Asset Management's Deputy Chief Investment Officer, Kylie-Anne Richards, added, "This research shows that prioritising renewable energy supply and consumption, while forgoing the short-term opportunity cost of decreased revenue from natural resources, would benefit from lowering the cost of borrowing in the sovereign debt market." In contrast, in developing markets, while yields tend to rise when carbon emissions increase, they are expected to fall when earnings from natural resources rise, and perversely, yields rise when renewable energy consumption increases. This suggests that investors in developing country debt prioritise the pursuit of economic growth and profits from natural resources over climate transition goals. "Developing economies are less likely to have the resources needed to facilitate a transition from fossil fuel reliance to renewables, and thus they seem not to prioritise climate change targets," Dr Richards said. "While investors seem to focus instead on short-term factors, such as a developing country's ability to repay debt and the fact that the profits from high natural resources rents may be higher than the uncertain payoff of transition." A warning for policymakers While estimates vary in terms of reducing net carbon emissions to zero, it is projected that to achieve the goals set out by the Paris Agreement by 2050, spending of $50 trillion will be required. This expenditure will be largely financed by governments, with a sizable proportion of this spending allocated to renewable technology. The evidence presented in this paper has clear implications for policymakers given sovereign bond markets are the benchmark from which every other asset class is priced. "The sovereign debt market is one of the largest asset classes globally and has significant exposure to the full gambit of climate risks. However, unlike equities and even corporate debt markets, the integration of climate change considerations into the investment process has lagged significantly," Dr Richards said. The paper provides a clear argument to request greater government transparency on specific climate risks, strategies and policies that are inherently linked to the bonds they issue. For example, Dr Ryan and Dr Richards believe the Australian government should be more open about the direct link between our borrowing costs and climate change. "It is undeniable that governments are exposed to transition risk. Whether it is considered through the channel of directly or indirectly influencing yields via macroeconomic variables such as GDP, investors are already starting to penalise advanced countries with poor prospects of transitioning away from fossil fuels," Dr Ryan said.

Funds operated by this manager: Ardea Australian Inflation Linked Bond Fund, Ardea Real Outcome Fund

Important Information This material has been prepared by Ardea Investment Management Pty Limited (Ardea) (ABN 50 132 902 722). Ardea is the holder of an Australian financial services licence AFSL 329 828 and is regulated under the laws of Australia. This document does not relate to any financial or investment product or service and does not constitute or form part of any offer to sell, or any solicitation of any offer to subscribe or interests and the information provided is intended to be general in nature only. This should not form the basis of, or be relied upon for the purpose of, any investment decision. This document is not available to retail investors as defined under local laws. This document has been prepared without taking into account any person's objectives, financial situation or needs. Any person receiving the information in this document should consider the appropriateness of the information, in light of their own objectives, financial situation or needs before acting. This document is provided to you on the basis that it should not be relied upon for any purpose other than information and discussion. The document has not been independently verified. No reliance may be placed for any purpose on the document or its accuracy, fairness, correctness, or completeness. Neither Ardea nor any of its related bodies corporates, associates and employees shall have any liability whatsoever (in negligence or otherwise) for any loss howsoever arising from any use of the document or otherwise in connection with the presentation.