Rethinking risk in time of war
Asia-Pacific Private Credit Newsletter
For LPs, this conflict necessitates a near term focus on risk mitigation. Portfolios must be triaged to assess the impact that the war has brought to existing investments. Most of the thematic risks we documented in our 2022 outlook have been impacted by the changes in the geopolitical and monetary landscapes over the last month:
In this Newsletter we discuss:
1. Thematic focus - The impact of the Russian invasion of the Ukraine on private credit risk
ESG – shades of brown through to green
Reading other investment firms’ memos is always instructive, especially when there is a meaningful shift in tone.
In his latest Letter to Shareholders, Larry Fink emphasises that he believes the conflict will, “actually accelerate the shift toward greener sources of energy in many parts of the world.” But this year he spends an equal amount of time discussing the need for a more gradated energy transition, which includes, “continuing to work with hydrocarbon companies who play an essential role in the economy today and will in any successful transition […]. He concludes this part of his letter by acknowledging that, “we will need to pass through many shades of brown to shades of green.”
Source: Zerobridge Partners as of 29 March 2022.
Exhibit 6: Pipeline by Industry
Source: European Commission Price Dashboard, February 2022 edition
The Rest is Politics
Larry Fink's Letter
Global Fertilizer Crisis
The Pendulum in International Affairs
Taking sides on the Ukraine-Russia war
Ukraine impact: more united Europe, but what about Southeast Asia?
Spike in Commodity Prices
Australia Position on Ukraine
Zelenskyy address to the European Council
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"Mass destruction, mass disease;
We thank thee, Lord, upon our knees
That we were born in times like these."
"2020: start of a global pandemic
2021: jan 6, taliban retakes afghanistan
2022: russia invades ukraine, biggest attack by one state against another in europe since wwii
i’m not loving this decade geopolitically"
We'd planned to write about something different for our ninth newsletter, but the world changed on 24 February. It's impossible to ignore the fact that Europe is experiencing its largest land war since 1944. Our first thoughts must always be with the innocent victims of the conflict, primarily the people of Ukraine.
We don’t claim to have an edge in understanding the complex geostrategic ramifications of this war. But we do have some reflections on what this pivotal moment may mean for credit risk in APAC and elsewhere. Please note that we’re trying to cover a lot of ground quickly in this Newsletter – we’ll be returning to examine these areas in more depth in coming months.
1. The recovery is now being led by the West, not the East
Stagflation is a real risk for Europe, given the energy supply shock and higher prices resulting from the region’s heavy reliance on Russian gas.
While we expect many developed Central Banks to tolerate higher inflation for longer given the risk of growth shock from the war, this stance will continue to have negative implications for real rates. There is also heightened risk of policy error as the Fed’s stance on inflation becomes more hawkish in tone – this leads us back to our recovery assumption and the risk of stagflation/recession.
2. Inflation is persistent but can it be tamed?
3. The search for real yield continues
4. ESG and “ESXi”
As we said in our November newsletter, the progression of US monetary policy offers US dollar-based fixed income investors a choice of unpleasant scenarios between real yields staying lower for longer as inflation is tolerated or the Fed slamming on the brakes and bonds losing value as a result, especially those with lower coupons and/or longer tenors.
Energy security is taking short term priority over energy transition, although Putin’s invasion represents a historical moment for both. The geopolitical implications of this conflict for China are yet unclear and it will take a braver author than this one to speculate here. But it is broadly fair to say that sanctions risk is heightened for some Chinese enterprises and that China’s own energy and food security is probably top of mind for Beijing policymakers right now. And COVID-19 has yet to be brought to zero, dynamically or otherwise.
Higher energy prices: Europe's wicked dilemma
It is now over 30 years since the demise of the USSR and over 20 since Vladimir Putin was first elected Russian President on a “reform” mandate, with intentions to bring the country into the global economic order. Today, as Western economic sanctions begin to mount, the world’s largest country by land mass is becoming, as some commentators have put it, “Tehran on the Volga”.
To the EU, NATO and the US, the desire to punish Putin for the invasion is strong but also complicated by Europe’s reliance on Russia for its energy – half of the region’s coal, 45% of its imported gas and around one third of its oil. Current sanctions include exemptions for energy commodities – Russia’s largest source of hard currency.
Europe – and especially the German industrial powerhouse at its centre - is therefore faced with a wicked dilemma between substantial economic sacrifice and the ongoing funding of an unconscionable war that threatens to undo an 80-year continental peace. While Chancellor Scholz has demonstrated plenty of resolve in turning many longstanding German policies 180 degrees in the last month, he has yet to switch off Russian gas:
"Greece, I believe, stands with us. Germany… a little later," - Volodymyr Zelenskyy, President of Ukraine, Address to the European Council delivered (24 March 2022, Kyiv, Ukraine)
Rising input costs have become a significant risk for a wide variety of European companies because of the war. Doing the right thing will be expensive and not all companies will be able to pass these costs on to customers. Ultimately the war will impact the creditworthiness of many European corporate borrowers.
Higher commodity prices are a global issue
The war has only increased the global supply chain stresses caused by the pandemic and weather extremes linked to La Nina, all of which contribute to current elevated commodity prices.While APAC overall trades much less with Russia and Ukraine than Europe, the conflict creates further uncertainty for commodity producers and consumers in the region.
Russia and Ukraine account for 30% of annual wheat exports. European wheat prices rallied over 60% from US$300/mt to 488/mt within the first seven days of the invasion. Exports have been affected by both the logistics of the war as well as sanctions imposed on Belarus and Russia, including bans from the world’s three largest shippers. In addition, Russia has substantial market share in a variety of fertiliser compounds.
Exhibit 1: Cereals/bread and cereals based product: EU agricultural market and consumer price developments (January 2000 until February 2022, 2000=100)
At the same time, higher food prices are negative for the already pressurised travel and leisure sectors. For emerging markets in the region, such pressures can generate significant political risk, heightened further by tighter global financing conditions and potentially reducing refinancing options in public markets. While dependent on investor sentiment, this may produce further opportunities for private credit to step in as an alternative to bank lenders and public bond markets
Our pipeline shows financing needs from several energy opportunities, weighted heavily towards renewables, as well as some enterprises involved in “old energy”, where we believe we can influence better environmental outcomes in the near term. As we emphasized last month, a nations’ energy mix is heavily influenced by geopolitics – China has understood this for some time, while Germany is just waking up.
More localised supply chains?
Oaktree’s Howard Marks also reflects on nations’ future energy mixes. He sees a common thread between Germany’s reliance on Russian fuel and US companies’ foreign (Asian) sourcing as two of the critical trade-offs in early 21st century economics:
“The recognition of these negative aspects of globalisation has now caused the pendulum to swing back toward local sourcing. Rather than the cheapest, easiest, and greenest sources, there’ll probably be more of a pendulum put on the safest and the surest.”
The end of globalisation?
Fink and Marks both identify the Russian invasion of Ukraine as a significant moment in globalisation.
Marks evokes a cyclical historiography, where the “pendulum” of globalisation swings back to surety over profit maximisation. Fink reaches for something seemingly more cataclysmic, pronouncing, “an end to the globalization we have experienced over the last three decades.”
In our view, it’s premature to call time on globalisation in full – but this war certainly changes the future complexion of the trend, and this has potential implications for our region and asset class.
Call it deglobalisation or “slowbalisation” - some countries and companies will benefit from these changes, just as others will lose. These changes will take time to manifest. Macroeconomic and geopolitical policy positioning across APAC will be important.
Emerging Asia may benefit from its geopolitical ambiguity
It’s too early to draw to any conclusions around the impact of the war regarding geopolitical alignment but here are some initial thoughts.
China’s show of unity with Russia prior to the Winter Olympics and subsequent abstention from condemning the war at the UN certainly caught the imagination of Australian Prime Minister Scott Morrison, who spoke at the Lowy Institute on 7 March and unveiled a new foreign policy catchphrase: “A new arc of autocracy is instinctively aligning itself to challenge and reset the world order in their own image.” Long term Scott-watchers will recognise the PM’s longstanding love of a snappy line.
But the reality is much more nuanced than this. India also abstained from the UN vote for its own very specific set of priorities. The world’s largest liberal democracy, China’s neighbour and sometime adversary, is also on the verge of reaching a free trade deal with Australia. While a member of the Quad, India has concluded that, for the time being at least, there is no benefit in choosing sides explicitly – this war is not directly about APAC security.
We expect smaller countries in the region – especially within ASEAN – to maintain similarly nuanced stances. It is clear that – with the notable exception of Singapore – the region wishes to remain geopolitically ambiguous for now. Most of emerging Asia is supportive of the rules-based international order but they also rely on Russia for commodities, export revenues and (in the case of Vietnam) weapons.
It is impossible for emerging Asian economies to remain untouched by the war. However, we believe their collectively ambiguous position will likely serve them well. As Fink’s letter notes, developed nations may reconsider their supply chain dependencies and large corporations may reorient some operations to the region because of this conflict.
Shift in risk premia assumptions between APAC and European private credit asset classes?
The current era of globalisation began in the 1990s. As fully paid-up Gen-Xers, the three principals of our firm all started our careers during this era, in different corners of the City of London, before making our journeys to the East.
Having all worked in both Europe and APAC, we are keenly aware of both the similarities and differences in complexities between the two regions. And despite the dramatic changes and events of the following two decades, we believe that certain risk assumptions have ossified in investors’ minds, in terms of private credit at least. Specifically, the notion that APAC is generally “riskier” than Europe.
We think that this goes back to the late 90s, when credit spreads were tightening, driven by the "convergence trade" ahead of the introduction of the single European currency. Currencies like the escudo, the peseta and the punt were transitioning into the euro and their respective bond yields were moving towards the bund. Europe was enjoying the fruits of the post-Cold War “peace dividend” (which sowed the seeds of today’s wicked dilemma). That's not to ignore the Balkans, or Checnya, which contributed to Russia's 1998 default, but the presumption of convergence leading to a lower risk premium was strong.
Asia was a hot mess by comparison. I started work the day the Thai Baht devalued. Within a few weeks the Indonesian stock market was pretty much worthless, and the rest of the region was engulfed in a series of rolling devaluations as foreign investors and domestic savers pulled their money out of these currencies, back into safer havens.
There are much better eye witnesses to the Asian Financial Crisis (AFC) than me who, only a few days before, was more concerned about rumours that Oasis’ third album was going to be a self-indulgent disappointment. Instead I’d particularly recommend this book by a fellow countryman who probably had the best seat in the house. In many ways, the AFC set the stage for the era to come and the perception of an Asian “risk premium” continues to linger, despite evidence to the contrary.
APAC for portfolio resilience?
As global investors triage their portfolios, we hope that they will consider APAC private credit as part of their efforts to enhance diversification. This is not as contrarian a view as it may first seem.
For longer term investors that can trade liquidity for higher returns, we believe private credit, funded from public fixed income, still offers stronger covenants and better downside mitigation than public market equivalents. On a whole portfolio level, the ability to access higher returns from debt is diversifying and takes some of the “heavy lifting” away from equity/growth assets.
From a risk standpoint, we are cautiously optimistic that the current environment will strengthen APAC’s relative appeal. Higher financing and input costs will put pressure on borrowers' creditworthiness globally, but investors should consider that APAC is in a much stronger starting place to weather any coming storms.
APAC offers higher IRRs (15+% gross, unlevered) than US or European direct lending. With similar default, LGD and recovery rates to other regions, APAC investors are arguably well-compensated in risk-reward terms for the additional complexity of the region. Deals tend to be shorter tenor and – unlike the US and Europe – there is not the problem of too much capital chasing too few deals, so APAC covenants and structuring tend to be stronger. Most deals are not PE sponsor-backed.
As pan-APAC investors, we will try to maintain a balanced portfolio in terms of country allocation and are currently seeing interesting deals across Australia, ASEAN and India as well as some offshore Chinese opportunities. In terms of industry themes we continue to see opportunities in renewables and companies positioned to benefit from energy transition, as well as ASEAN tourism, where well-managed businesses should see positive earnings impact from operational leverage as customers return.
Exhibit 2: Exporters and Importers of Fertilizers (2020)
Source: The Observatory of Economic Complexity (OEC) as of 2020
Exhibit 3: Wheat futures prices (Comparison CBT vs. EUR)
Source: Bloomberg as of 1 April 2022
On the producer side, Australian businesses should benefit from tight conditions in both agricultural and energy markets, which in turn leads to non-bank funding opportunities in the export supply chain.
Exhibit 4: Rising fuel costs hurt most APAC economies, which are energy net importers
Source: S&P APAC Q2 2022 Outlook, 6 April 2022
Exhibit 5: Energy prices and currency movements
Source: S&P APAC Q2 2022 Outlook, 6 April 2022
Zerobridge Partners Asset Management Limited is focused on giving institutional & high net worth investors globally access to APAC alternative credit opportunities. The strategy seeks to take advantage of the less developed banking and capital markets in the APAC region and capitalize on our strong proprietary deal flow.
Zerobridge Partners Advisory Limited is a debt advisory firm focusing on raising new capital, creditor negotiations and debt restructuring for companies in Asia-Pacific. We come with deep investment banking experience and a strong track record across multiple credit cycles in Asia.
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