Australian Secure Capital Fund - Market Update

Australian Secure Capital Fund

March 2025

Funds operated by this manager:

ASCF High Yield Fund, ASCF Premium Capital Fund, ASCF Select Income Fund

Chris Gosselin, CEO of FundMonitors.com, speaks with Winston Sammut, Property Director at Euree Asset Management.

They discuss the global market reaction to Donald Trump's tariff announcements, as investors shift to safer assets amid rising uncertainty, falling interest rates, and fears of a trade war, with flow-on effects for REIT valuations and broader market sentiment.

Hedge Clippings | 04 April 2025

It's difficult to add anything new to the commentary about Donald Trump's "Liberation Day" that hasn't already been said or written. Outside his immediate circle of acolytes, seemingly led by Commerce Secretary Howard Lutnick, we have struggled to find any positive commentary from any corner of the world, (including the economic powerhouse of Norfolk Island) or in any language that supports Trump's upending of the world's economy.

Except two: Russia and North Korea. Go figure? Ronald Reagan and every other US president since WWII would be turning in their grave.

To be fair, although Norfolk Island was singled out in Trump's Rose Garden ramble, by the time the official list was released, someone had realised there's stupid, and then there's plain dumb, and thus Fletcher Christian's descendants were spared - yet again.

One assumes that in due course the results of Trump's "genius" (his words, not ours nor it seems anyone else's) will come back to bite him where it hurts most - his ego and the ballot box. Unfortunately his self esteem/adoration is such that he probably won't notice when it does, and in spite of his best efforts, a third term seems out of reach. Not that the US constitution will stop him from trying.

So Australia, and the rest of the world, (except as above, Russia and North Korea) are left to try to decide how to respond to the US directly, and, at the same time, try to fathom how every other country's response will change the overall global economic landscape.

One factor to consider is that Trump is obsessed with the trade of goods, where the US operates a deficit. In today's technological and service orientated world, the US has a services trade surplus - admittedly not sufficient to even the score, but he's quiet on that front.

Trump will try to pick off individual targets. Maybe the world's best reaction is to coordinate their responses? It worked in 1939 (just, after a shaky start) when dealing with another predictably self-obsessed adversary, even if it did take the US a couple of years to join the fray, and only then when they had no other option, or possibly saw the tide turning.

In the meantime, everyone else - along with the RBA - is left to ponder their reaction in uncertain times. For the record, if you can remember as far back as last Tuesday, the newly formulated board left rates on hold on April Fool's Day, just before Trump's Liberation Day. However, they did mention "uncertain" no less than five times, as well as devoting more than 50% of their media release to a section on the "Uncertain Outlook", before returning to the more familiar ground of "returning inflation to target" being the priority.

Markets, and as a result, many fund performances, were negative in February and March, and April is certainly heading that way. We spoke with Euree Asset Management's Winston Sammut just before going to press, (see video below) and it is fair to say that with all his experience, he views the immediate outcome as "uncertain" (that word again) but not overly positive.

News & Insights

Manager Insights | Euree Asset Management

Making sense of the banking sector | Airlie Funds Management

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Spurious Correlations

Yarra Capital Management

March 2025

Funds operated by this manager:

Trumponomics: What tariffs could mean for small caps

abrdn

March 2025

Funds operated by this manager:

abrdn Sustainable Asian Opportunities Fund, abrdn Emerging Opportunities Fund, abrdn Global Corporate Bond Fund (Class A), abrdn International Equity Fund, abrdn Multi-Asset Income Fund, abrdn Multi-Asset Real Return Fund, abrdn Sustainable International Equities Fund

Making sense of the banking sector

Airlie Funds Management

March 2025

How long will the extraordinary rally continue?

The banking sector enjoyed an extraordinary rally in 2024, with the Big Four Banks delivering an average TSR of 33%. As recently as February, Commonwealth Bank (CBA), for instance, enjoyed a price to earnings multiple of 26x- a 60% premium to its historical average. This raises an important question: are these valuations justified for a sector that has not grown its overall earnings per share over the last 10 years?

To look at this in another way, you can see in the chart below that the collective earnings of the Big Four are only today back to where they were in 2018. Yet if we add up the cumulative share prices of the banks, you're paying $233 in total for all four banks versus $157 in 2018 for the same level of earnings. And this is after the recent share price rout; at the banks' peak in February, you would have paid a cumulative $276 for these earnings.

Are banks really making more money? The net interest margin story

At its core, banking profitability hinges largely on a single key metric: Net Interest Margin (NIM). This is the difference between what a bank earns on loans and what it pays on deposits. The higher the margin, the more profitable the bank.

However, over the past few decades, this margin has been steadily shrinking. This decline has been driven by three key structural changes in the industry:

1. Mortgage brokers

Over the past decade, the share of mortgage broker-originated loans has surged from ~50% to 75%, significantly squeezing bank margins. Banks pay the broker a large upfront commission of ~0.65% of the loan value ($6.5k for every $1m lent) and a trailing commission of 0.15% per year. Moreover, because brokers focus on securing the lowest possible rate for customers, mortgages have become increasingly price-driven, reducing banks' ability to charge more favourable rates. Since brokers earn their largest commission when writing a new loan, they have an incentive to refinance customers regularly, which further erodes bank margins. The Commonwealth Bank estimates that the broker channel is 20-30% less profitable than a loan originated through a bank's proprietary channel. 

2. Entrance of Macquarie

Over the last decade, Macquarie Group has entered the banking sector, employing a digital, broker-led model where it can operate a lean model without the tech debt and branch costs of its traditional competitors. The company has successfully grown its share to ~5% and its ease of use has made it popular with brokers. Unlike the major banks, Macquarie doesn't need to maintain a constant presence in the mortgage market. It has entered when risk and pricing are attractive and exited when margins tighten, making it a highly agile competitor. This dynamic prevents periods of excess profitability for the Big Four, as Macquarie re-enters the market whenever rates become too favourable for banks.

3. Exit from broader business lines

In the past, banks operated in higher-margin businesses such as wealth management and insurance. While these divisions may have distracted them from mortgage competition, they also provided additional profitability. With banks now exiting these areas, mortgage lending has become their primary battleground, intensifying competition and further pressuring margins.

Bad debts are low but can this last?

One of the biggest risks for any bank is loan defaults, which result in bad debt expenses; that is, the losses banks take when borrowers can't repay their loans. Historically, Australian banks have averaged bad debt expenses of ~0.15% to 0.20% of gross loans and acceptances.

In FY24, this figure was just 0.08% - about half the long-term average. While this looks like a positive for bank earnings, the key question is: is this sustainable?

Why are bad debts so low right now?

There are three key reasons bad debt expenses remain unusually low:

1. Favourable economic conditions. Strong employment and rising house prices mean most borrowers can still meet their repayments. Even if someone loses their job, they can often sell their home at a premium, allowing the bank to recover the loan without taking a loss.
2. Covid-era provisions act as a buffer. During the pandemic, banks set aside large provisions for expected loan losses that never fully materialised. These reserves have been gradually released, reducing reported bad debt expenses in recent years.
3. Shift towards lower-risk lending. Some argue that historical bad debt levels aren't as relevant today because banks now focus more on residential mortgages rather than riskier business lending, which traditionally had higher default rates.

The real risk: Are banks underestimating future loan losses?

While bad debts are currently low, history suggests this won't last forever. Since current bank earnings are inflated by unusually low bad debt expenses, it's reasonable to assume:

• Future earnings may be overstated at today's valuations.
• A normalisation of bad debts could reduce bank profitability more than expected.

Bottom line? The current low levels of bad debts make bank earnings look better than they likely are in the long run, suggesting investors should be cautious about assuming today's profits are sustainable. To pick on ANZ as an example - and we chose ANZ because it has the lowest level of provisioning for bad debts - if the bad debts expense were to normalise to ~0.20% of gross loans and acceptances (the pre-covid FY16-19 average) from 0.05% in FY24, its EPS would have been ~13% lower.
 

Expenses

One area where banks could justify a higher valuation is through improved efficiency. However, the track record here is mixed. While banks have closed physical branches and pushed digital banking, these savings have been offset by rising IT spending, cybersecurity costs and regulatory compliance. Additionally, employee expenses account for ~70% of a bank's cost base and wage pressures remain high. The net result? Banking cost bases have proven resilient, making it difficult for them to structurally improve profitability through expense reduction.

Since FY16, bank expenses have grown at ~1.7% p.a. compared to income growth of just 0.9% p.a.
 

This means that despite cost-cutting efforts, banks struggle to convert these savings into higher profits because any efficiency gains are competed away in lower prices for customers. As a result, cost-cutting alone is unlikely to drive meaningful margin expansion at the sector level.

Over time cost efficiencies (lower cost-to-income (CTI) ratio) have been reinvested back in the customer
 

Source: JP Morgan

Are bank valuations justified?

The 2024 banking rally may suggest a thriving sector but the fundamentals tell a different story:

• Net interest margins remain under pressure as mortgage brokers dominate the market and Macquarie intensifies competition.
• Bad debt expenses are at historic lows but history suggests they will normalise over time, reducing earnings.
• Cost-cutting has failed to translate into sustained profitability, with banks reinvesting savings into lower prices to stay competitive.
• Volume growth will remain moderate, given Australia has one of the highest household debt-to-GDP ratios globally.

Given these challenges, the current high bank valuations appear disconnected from long-term earnings potential.

By Jack McNally, Investment Analyst

Funds operated by this manager:

Airlie Australian Share Fund, Airlie Small Companies Fund

Important Information: 

This material has been delivered to you by Magellan Asset Management Limited ABN 31 120 593 946 AFS Licence No. 304 301 trading as Airlie Funds Management ('Airlie') and has been prepared for general information purposes only and must not be construed as investment advice or as an investment recommendation.  This material does not take into account your investment objectives, financial situation or particular needs. This material does not constitute an offer or inducement to engage in an investment activity nor does it form part of any offer documentation, offer or invitation to purchase, sell or subscribe for interests in any type of investment product or service. You should obtain and consider the relevant Product Disclosure Statement ('PDS') and Target Market Determination ('TMD') and consider obtaining professional investment advice tailored to your specific circumstances before making a decision about whether to acquire, or continue to hold, the relevant financial product. A copy of the relevant PDS and TMD relating to an Airlie financial product or service may be obtained by calling +61 2 9235 4760 or by visiting www.airliefundsmanagement.com.au.

Past performance is not necessarily indicative of future results and no person guarantees the future performance of any financial product or service, the amount or timing of any return from it, that asset allocations will be met, that it will be able to implement its investment strategy or that its investment objectives will be achieved. This material may contain 'forward-looking statements'. Actual events or results or the actual performance of an Airlie financial product or service may differ materially from those reflected or contemplated in such forward-looking statements.

This material may include data, research and other information from third party sources. Airlie makes no guarantee that such information is accurate, complete or timely and does not provide any warranties regarding results obtained from its use. This information is subject to change at any time and no person has any responsibility to update any of the information provided in this material. Statements contained in this material that are not historical facts are based on current expectations, estimates, projections, opinions and beliefs of Airlie. Such statements involve known and unknown risks, uncertainties and other factors, and undue reliance should not be placed thereon. No representation or warranty is made with respect to the accuracy or completeness of any of the information contained in this material. Airlie will not be responsible or liable for any losses arising from your use or reliance upon any part of the information contained in this material.

Any third party trademarks contained herein are the property of their respective owners and Airlie claims no ownership in, nor any affiliation with, such trademarks.   Any third party trademarks that appear in this material are used for information purposes and only to identify the company names or brands of their respective owners. No affiliation, sponsorship or endorsement should be inferred from the use of these trademarks.  This material and the information contained within it may not be reproduced, or disclosed, in whole or in part, without the prior written consent of Airlie.

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Chris Gosselin, CEO of FundMonitors.com, speaks with Benjamin Harrison, Chief Investment Officer at Altor Capital. 

Ben discussed the growing investment opportunities within the global sports industry, highlighting its diverse revenue streams and Altor's strategic focus on both team ownership and related support sectors. The conversation underscored the potential for meaningful investor involvement beyond just elite-level teams, particularly within Australia's mid-market sports landscape.

Funds operated by this manager: Altor AltFi Income Fund, Altor Emerging Growth Fund