Financial markets have dealt with a large volume of economic data and communication from central bankers in recent weeks. Despite some overly sensationalised media coverage and short-term predictions, we believe that the central banks' messaging has remained consistent across jurisdictions.  

The US Federal Reserve (US Fed), the global leader in setting market trends, and the Reserves Bank of Australia (RBA) domestically, have both cautioned patience with monetary policy, as already restrictive settings continue to work through the system, lowering growth and demand whilst bringing inflation back towards target. This process is frustrating in the day to day, in that inflation data doesn't move in straight lines - seasonal factors, annual price increases, one-off adjustments, flash sales, and other variables create a bumpy, unpredictable, and somewhat volatile path. Even well-resourced teams of economists at major investment banks consistently get their estimations markedly wrong, reflecting the inherent volatility in this process.

Take the latest CPI quarterly release in Australia, which was widely predicted to be 0.8%. When the actual figure came in at 0.96% (rounded up to 1.0%), the unexpected result triggered a significant market reaction, leading to the removal of any expectations of a rate cut from the RBA.

What makes this even more galling for forecasters is that with a monthly inflation series, they already have about two thirds of the dataset before the quarterly figures are released. This makes forecasting errors even more surprising and exacerbates the market's reaction when a when a relatively small portion of new data has an outsized impact.

This may be more detail than you require as you read this over your morning coffee. Of course, forecasting errors can also work in reverse, as we have seen some large undershoots versus expectation over time. Yet the sequencing of these dataset surprises drives market sentiment, and sadly, central bankers are now wedded to react to a 'data dependent' approach, risking falling behind the curve.

The key takeaway here is that while inflation in Australia peaked at 7.8% in the fourth quarter of 2022, it has since steadily fallen to 7.0%, 6.0%, 5.4%, 4.1% and now 3.6% over the preceding quarters. This downward trend, though slightly slower than the RBA forecasts, has been the direction of travel for 18 months. The fight against inflation is not yet over, but it is well advanced, whilst the battle rages on under restrictive interest rate settings.

The US economy, which has long been the 'exception' in a souring global macroeconomic story, has suddenly slowed significantly.  Whilst the incoming numbers remain solid, they are markedly weaker than we had received previously, with a shock miss on components like GDP, the employment report (Non-Farm Payrolls), initial unemployment claims and a host of second-tier manufacturing and activity data.  This has taken the US "economic surprise" index to a negative reading. Markets are now focused on how the interplay of slower growth will affect prices (and inflation) in the coming quarters, trying to calibrate the timing of central banks that have become unashamedly 'data dependent'. The significant failure of models used to calibrate policy through the COVID-19 period has made central bankers highly reactive, no longer willing to back their judgements on years of policy learnings and economic theory to move policy ahead of the cycle.

Ordinarily, as growth slowed, central bank policy levers would already be in motion to address the slowdown and expected cooling inflation outcomes associated with weaker demand, acknowledging that policy works with long lag times. Now, as data dependency is 'policy de jour', the danger is that economies may slow more than necessary before central banks act to curb a downturn. This delay could lead to more severe corrective measures, as central banks struggle to address a substantial loss of economic momentum.

We have heard various terms to describe economic trajectories, such as 'hard,' 'soft' and 'no' landing.  If, like an aircraft, the economy hits stall speed, the pilots' attempts at recovery will be a lot more severe than if they'd simply eased up a little ahead of time.  Central bankers are often criticized for waiting until ''something breaks'' before taking decisive action. This was evident during the Global Financial Crisis (GFC) over a decade ago when rates were held at similar levels to today until a catastrophic episode was unavoidable, prompting rates to be slashed by more than 5% to jump start economies and reverse the damage caused by overly restrictive rates from the pre-2008 period.

With this concept in mind, our baseline position at the start of the year was that central bankers would aim for a non-stimulatory rate cutting cycle in the back half of 2024. This was expected to be led by Europe or the US, commencing around the middle of the year. Such a strategy could help smooth the economic cycle, offer some relief to consumers and borrowers, and ideally avoid the negative consequences of keeping rates too high for too long.  That is still seemingly on track for Europe, with the European Central Bank (ECB) likely leading the way, followed by Canada, the UK and New Zealand. However, the expected timing for the US to lead the rate-cutting cycle has shifted further out.  

An interesting development is Sweden's Riksbank, which just leapfrogged the pack by cutting rates from 4.00% to 3.75%, whilst observing similar economic outcomes to our own domestic data, weak growth, deeply negative retail sales and cooling (though still above mandate) inflation. Perhaps some central bankers are still moving ahead of the curve.

In the US, the trend has slightly reversed, with inflation moving from a low of 3.1% up to 3.5% over the last five months. Despite this uptick, the US Fed retained its easing bias and reduced the scope of its Quantitative Tightening program during its May meeting, helping solidify expectations around bond yields. A short covering rally followed thereafter, which all asset markets have enjoyed, lifting bonds and equities alike.

From prior communications, the US Fed indicated its intent to cut rates, retaining an easing bias. However, the slight increase in inflation has complicated the process, delaying market expectations for rate cuts to later in the year.  While monetary policy is fighting the good fight against inflation with restrictive policy settings, US fiscal policy remains highly stimulatory, with public spending running at around ~6% of GDP.  Much of the economic growth in the US has been fueled by this large public sector spend, which has been exceptional against other jurisdictions and looks to continue in an election year. As a result, this continued fiscal stimulus could create some friction in achieving normalisation of inflation.  

The RBA has found that recent surprises in our own inflation were predominantly due to education and insurance, which we think has heavy seasonal annual reset, and is unlikely to be repeated in following quarters. Calling the near-term inflation pathways remains difficult. Plenty of things can work sequentially against further progress in the near term, like a stimulatory federal budget, larger fair work outcomes on minimum wages, geopolitical flare ups driving energy prices higher or global shipping disruptions to name a few. On the other hand, there are reasons for optimism.  Oil prices are well off their highs despite recent geopolitical tensions involving Israel and Iran. Slowing economic activity has tempered discretionary spending, as evidenced by deeply negative retail sales. We've also seen declines or stabilisations in rent and used car prices. In the 10 years prior to COVID-19, Australia's average quarterly inflation rate was 0.52%. If we assume that the next few quarters are much higher at 0.8%, inflation could fall to 3.2% by the end of the third quarter, against the RBA estimate of 3.8% by year end.  

These contrasting forces create a complex landscape for policymakers, and while there is room for inflation to fall below the RBA's forecasts, data dependency will continue to drive monetary policy decisions. The uncertainty surrounding these various factors suggests that flexibility and careful analysis will remain critical as the RBA navigates the path ahead.

Author: Charlie Jamieson, Chief Investment Officer

The Oxford Word of the Year 2023 was "rizz". An abbreviation of charisma it is used to refer to an individual who has a lot of style and is attractive to others, albeit not just in their appearance. As Dennis Denuto said in the classic Australian film, The Castle, "it's the vibe." Suffice to say that Dennis didn't have much "rizz" and neither do I, a point which was made clear to me by my kids when I tried to use "rizz" in a sentence.  

If you aren't a Gen Z-er but are a keen observer of financial markets, it would not be a surprise if your word of the year was "private credit". A quick Google Trends search shows the dramatic increase in interest in private credit that started in 2020 and ramped up considerably in 2022 and 2023. Notably Australia has lagged the United States with interest only peaking in late 2023.

The level of interest in private credit inevitably raises the question of whether it has peaked. In the United States there have been a number of recent data points which suggest the private credit opportunity may not be what it once was.

Firstly, funds raised by private credit funds slowed in the first quarter of 2024.

According to Preqin, private debt managers raised US$30.6 billion in Q1 taking total funds under management to US$1.7 trillion. This is the lowest Q1 figure since 2018. Interest rates and inflation were the top two concerns for investors. The fourth quarter of 2023 was also slow with only US$42 billion raised, the slowest end to the year since 2018. The terms of the funds are typically 6-8 years and dry powder (capital raised but not yet invested) was estimated at US$400 billion in September 2023 implying there is still plenty of capital available even if fund raising continues to slow.

Secondly, returns in private credit are moderating.

With so much capital flowing into the sector it was inevitable that returns would slow. Cliffwater now expects a long term illiquidity premium (measured as the difference between the expected return on the CDLI index unleveraged after fees and losses to the return on the Morningstar LSTA Lev Loan index after losses) of 2.25% per annum. This compares to an excess return of 4.2% p.a. in the ten years prior.

Thirdly, the growth of the private lending market might have outpaced the supply of private lending opportunities.

In other words, we may have reached a point whereby private lenders are competing with public markets and banks for new deals. In 2023 private credit lenders provided a US$5.3 billion loan package to Finastra Group, refinancing existing syndicated debt raising the question of what the private lenders were providing that public markets couldn't.

The sharp contraction in credit spreads seems to have reversed this trend in 2024. As shown below public leveraged loan issuance levels have picked up from 2022/23 levels. According to Pitchbook, in 2023 around US$20 billion in publicly syndicated loans was taken out by private direct loans. In 2024 through April, over US$13 billion of private direct loans have been refinanced by publicly syndicated loans.

And in another important data point, Bloomberg reported in May that a large US private lender, HPS Investment Partners actually capped inflows into one of it funds to manage the imbalance between demand for private credit and the supply of opportunities.

Of course, there are two interpretations of the supply argument. One is that public markets are lacking discipline and pricing risk too low. The other is that private lenders have become too large and are now competing directly with public markets rather than filling the gaps around them. Both are probably true to some extent.

Our conclusion is that we have probably hit the peak in private credit in the United States.

That's not to say that it is a poor investment now but perhaps not the slam dunk it was 5-10 years ago. An illiquidity premium of greater than 2% per annum is good, but maybe doesn't have the rizz it had a few years back. But how about Australia? Are we past the peak in Australian private credit?

In assessing this question, the first thing to note is that until recently Australian private credit definitely didn't have the same amount of rizz as US private markets. This is consistent with the Google Trends data and the level of understanding from investors and advisors who had barely scratched the surface of these markets before COVID.

Data on funds raised in Australian private credit markets is hard to come by but anecdotally there has been exponential growth the number of private credit managers claiming to be active in Australia. According to E&Y's annual survey the growth in Australian private credit has outpaced the growth US private credit markets but only if you include CRE debt as we show below.

So, growth in Australian private credit is really about growth in commercial real estate lending. Non-CRE lending has grown at a more moderate place which aligns with our lived experience.

Australian markets are also less transparent than the United States when it comes to returns. Our anecdotal view is that illiquidity premiums were never as large in Australia as they were in the United States and haven't compressed nearly as much and we continue to guide investors to expect an excess return of around 2% per annum.

Supply-wise the Australian market has never competed with public high yield markets for the simple reason that Australia has never had much of a public high yield bond market. In Australia, the main competition for private lenders is banks for whom non-financial corporate loan exposure growth slowed to around 6% in the 12 months to March 2024. Looking at major bank Pillar 3 disclosures it seems as though loan growth for sub-investment grade corporate credit exposure was around 8% over the past 12 months. This implies that banks were actively but not aggressively competing in corporate direct lending markets in Australia, consistent with our experience.

So, while there may not be as much rizz in the US private lending opportunity, we think there is probably still some left in Australia. Indeed, if there is a credit cycle down under, the opportunity for alternative lenders to fill the gaps left by the banks could be significant, especially in non-CRE lending which has experienced less growth. Watch this space!

<

Man-made hazardous byproducts have long been an issue for our health and the environment. Many people understand the deadly impact of products such as asbestos, a once common material in many building products. In addition to the devastating health impacts of asbestos, the financial impacts have been nothing short of astronomical. It is estimated by the World Health Organisation that the annual financial cost of the health effects from asbestos is around US$2.4-3.9bn, excluding the additional costs of pain, suffering and welfare losses.

The emerging risks of 'forever' chemicals and a little Australian company trying to make a difference

Drawing parallels to the asbestos industry, our research on per- and poly-fluoroalkyl substances (PFAS) indicates that the risk with PFAS can potentially be just as great as the now well-understood risk with asbestos.

PFAS are a group of over 4,000 man-made chemicals that have been used in a variety of industries and consumer products due to their unique properties. Given their stain and water-resistant properties, PFAS is most commonly found in clothing, cookware and fire-fighting foam.

Despite the obvious appeal of non-stick and water and grease-resistant properties, the production and use of PFAS have led to widespread environmental contamination and raised significant concerns about their potential risks to human health. PFAS has been described as "forever chemicals" because they do not degrade naturally in the environment.

Studies on laboratory animals have shown the adverse effects of chronic PFAS exposure on the liver, gastrointestinal tract, and thyroid hormones. While studies of the impact of PFAS on humans have been more limited, the link between PFAS and a variety of health problems (e.g. liver, immune system damage and some cancers) has been strong enough for the USA's Environmental Protection Agency to propose strict limits on two types of common PFAS, namely Perfluorooctanoic acid and Perfluorooctane sulfonate. In addition, the European Union's Restriction of Hazardous Substances Directive restricts the use of certain PFAS, and similar regulations are either being considered or implemented worldwide.

Given the heightened scrutiny around the adverse impacts of PFAS on human health, 3M, a Fortune 500 chemicals manufacturer based in the US, has recently announced a US$10.3bn settlement with the US Public Water Suppliers. The settlement is to help fund the monitoring and treatment or filtering of drinking water for a large portion of the US population that is currently exposed to high PFAS levels within their potable water. This settlement follows the US$1.18bn settlement in June 2023 between DuPont de Nemours Inc, Chemours Co, and Corteva Inc and a group of 300 drinking water providers in the US over the treatment of PFAS in drinking water.

With growing scientific evidence highlighting the dangers of PFAS exposure, the implicit admission of PFAS manufacturers to the harm posed by PFAS and the need for both treatments and finding a solution is becoming increasingly critical.

The Environmental Group and its role in addressing PFAS

The Environmental Group (ASX: EGL) is an Australian environmental engineering company that provides products and engineering services to industries to improve environmental outcomes. This includes providing solutions such as dust extraction systems, odour capturing solutions, and noise abatement solutions. The business has been in operation for almost 100 years, servicing a diverse group of customers, from resource companies to manufacturers, waste management companies and healthcare operators. Key products include exhaust silencers, industrial steam boilers, medical waste autoclaves, and dry and wet scrubbers.

Over the past five years, through the establishment of its Water division, EGL has looked to expand its capabilities into water management solutions and, in particular, the treatment of PFAS in water and soil. As part of this process, for the past three years, EGL has been working with Victoria University to develop technology focused on the removal of PFAS from contaminated waste streams. As a result of this collaboration, EGL has developed a gas foam fractionation process to treat the presence of PFAS in water, soils and biosolids. In its simplest explanation, gas foam fractionation involves bubbling gases through the contaminated material, which in turn lifts the PFAS particles to the top of the surface, with the PFAS material removed by gently vacuuming the particles. Successful trials have been conducted, demonstrating that the treatment reduced PFAS to undetectable levels. Trial study results published by EGL indicate that the process was able to extract 99.9% of PFAS from a sample of highly contaminated leachate processed (first pass), and 99.94% of PFAS from a sample of highly contaminated wash water (first pass).

As the PFAS is separated and compacted to just 1% of the initial volume, the storage of PFAS becomes less of an issue, reducing facility, operational and risk costs.  In addition, the processing unit does not require human interaction, with the unit being operated from a control station. This reduces the OH&S risk by minimising employee interaction with contaminated materials.

EGL's gas foam fractionation process received patent approval in May 2023, with a 20-year patent timeframe. The company has an operational plant in Melbourne, with all documentation having been submitted to the Environmental Protection Agency to obtain the required licence to start operations. EGL expects approval to be granted in the next 3-6 months, which could be a catalyst for the company to expedite the roll out of this offering. EGL estimates that the total addressable market for this product is in the billions of dollars globally, which appears to be a reasonable estimate given the extent of PFAS contamination, and the settlements so far from PFAS manufacturers. 

The Tyndall Small Companies Fund is an investor in EGL, recognising that the company possesses many of the attributes that we look for in an investment. EGL is a business that has been listed for over 30 years with proven technology. One key issue was that the company was formally run by engineers, with little financial acumen to extract value from the technology. Enter current CEO Jason Dixon in Feb-2021, a highly regarded executive with extensive waste management experience, having run and developed Tox Free for a decade before it was acquired by Cleanaway.

We can readily see what capable management can do to a business's financials. In 30 years of listed life, EGL barely made a profit. In a little over three years, Jason and his team have been able to take the business from a $34m revenue, $1.4m EBITDA enterprise to an FY24 estimated $99m revenue and $10m EBITDA business. Another attribute we like is the industry structure EGL operates in, with structural tailwinds for environmental waste management. Trading on 9-times EV/EBITDA, the business is trading on a reasonable valuation and screens as very cheap assuming it continues to execute as it has done in the past three years, delivering +20% p.a. revenue and earnings growth in its core business.

While the PFAS problem has the potential to be detrimental to the scale of disasters such as asbestos, in The Environmental Group, we believe we have found a company that can potentially deliver a solution that helps address a significant portion of the problem. That said, our investment thesis in The Environmental Group is not predicated on the success of the Water Management/PFAS solution. The PFAS opportunity to us is free optionality and one with a very large potential upside. In our view, backing current management to execute their plans is an extremely attractive risk reward proposition, while also delivering a solution to a global problem that has had devastating health and environmental impacts.

Author: James Nguyen, Portfolio Manager