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Inflation, Rates Start To Bite Corporate Australia

Corporate Australia has held up well against a tide of inflation and rising interest rates. Companies have generally been able to pass through cost increases, supported by a robust labor market and willing consumers. However, S&P Global Ratings sees signs that consumers are tightening their belts as higher interest rates erode purchasing power. We expect that companies' ability to pass through higher wages and other costs--thus preserving earnings margins--will diminish in the next 12-18 months.

Downside credit pressure is most apparent among REITs, where cyclical and structural challenges are buffeting the sector. More than 40% of our rated office REITs are on negative outlook. We have also noted the default of Genesis Care Pty Ltd. in recent months, highlighting the risks of aggressive, debt-funded offshore expansion and a less accommodative and higher cost speculative-grade capital market.

Investor Redemptions Pile Credit Pressures On REITs

Rising interest rates are so far having their greatest credit hit on the REIT sector. Devaluations, rising vacancies, higher debt costs, and structural challenges are straining a range of commercial property segments, particularly the office sector.

Wholesale property funds are feeling most of the credit pressure, with investors seeking redemptions to cut commercial real estate exposure or rotate their capital into the heavily discounted listed sector. We expect these redemption-funding challenges to persist. They will continue until valuations more closely reflect strains from higher interest rates and subdued rental growth, driven by elevated supply in some markets and the work-from-home trend. More transactions would help price discovery.

Chart 1


We have more than 40% of our office focused REITs on negative outlook (see chart 1). Mirvac Wholesale Office Fund (A-/Negative/--) and Australian Prime Property Fund Commercial (A-/Negative/--) both face large redemptions and elevated capital expenditure at a time of rising vacancies and higher debt costs. Accordingly, they rely on capital management initiatives, such as asset sales or equity raisings, to alleviate pressure on credit quality. While some asset sellers such as Dexus have been willing to accept significant discounts to book value, others will need to adapt their pricing expectations to meet this new environment, particularly for assets over A$300 million.

Outside of the office sector, we have about one-quarter of REITs on negative outlook. Some, such as Dexus Wholesale Shopping Centre Fund (A/Negative/--), are facing similar redemption challenges to their office counterparts. Others, such as The GPT Group, are facing significantly higher interest costs and a large debt burden that it incurred when making a sizable acquisition.

The broader retail property sector continues to recover from the pandemic, recording strong growth in foot traffic and cashflows. Leading shopping centers are adapting well to the pressures of online competition. We expect large, well-located shopping centers to remain a key social gathering point for communities, and to continue to adapt their tenant mix to meet consumer demands.

Industrial property continues to be the standout asset class in the commercial property sector, driven by strong e-commerce-driven demand, and seemingly insatiable appetite for data centers from hyper-scalers and other data-hungry users. These favorable demand trends, together with limited supply and record-low vacancies, are driving strong and ongoing rental growth across the sector. This helps owners such as Goodman Group and its stable of industrial funds.

Consumers Are Tightening Their Belts

While inflation has moderated somewhat in recent months, we expect inflationary pressures to persist. Price rises have so far provided margin protection against increased input costs. However, we expect that this may become more challenging as consumer demand eases and competition intensifies in the next 12-18 months.

Coles Group Ltd. and Woolworths Group Ltd. exemplify the cost and pricing challenges facing businesses, even at the nondiscretionary end of the spectrum. As businesses negotiate wage agreements, the retailers are incorporating their higher wage bill into their cost of doing business. Coles saw its EBIT margin contract over the past six months primarily due to higher costs. Consumers across Coles and Woolworths are trading down to lower price points, and similar trends are driving strong sales for discount retailers such as Kmart. Discretionary retailers are facing the brunt of these trends, with Harvey Norman flagging declining sales, higher costs and a challenging outlook.

The travel sector appears to be weathering higher airfares but it remains to be seen for how long. Domestic air travel is still growing albeit at slowing rates, with recovery in both inbound and outbound travel exceeding industry expectations. Higher operating costs, project costs, and wage increases will delay operating margins getting back to pre-COVID levels. Ports are also seeing some softening in trade due to lower consumer demand.

Operators with regulated or legislated pricing power will be protected from--and sometimes benefit from--inflation-linked prices. This group includes rated regulated utilities and toll road operator, Transurban. Rail entities can pass through cost increases, but face overall pricing pressure due to competition.

Cost Focus To Intensify as Demand Slows

As companies' ability to pass through price rises to support margins abates, costs are likely to come more into focus. Coles, Woolworths, Telstra Group Ltd., Amcor PLC, Wesfarmers Ltd. and others are continuing to pursue aggressive cost-out programs that should provide some margin protection.

Wage rises, which have been a laggard to date in broader cost pressures, are gaining momentum. Woolworths, for example, is flagging wage rises of about 5.5% in fiscal 2024. We are also seeing wage pressures in the commodity sector with strike actions in the gas and coal sectors. These trends could see companies try to reduce labor costs and accelerate automation across their business as they seek to protect earnings and margins in a weaker consumer environment.

Commodity Companies Are Well Positioned For Moderating Prices

Pricing conditions for Australian commodity exporters generally remain strong, despite price-softening in the past 12 months (see chart 2).

Woodside Energy Group Ltd., South32 Ltd., Santos Ltd., and Fortescue Metals Group Ltd. have all benefited from strong cashflows over the past two years. This has positioned their balance sheets well for large capital expenditure programs and should help them navigate ongoing cost inflation and capital-execution risks.

China's economic outlook is a key risk for some commodity prices at a time when major capital projects are being undertaken. Environmental approvals are also posing roadblocks for some major projects, such as Santos' Barossa gas project and renewal of Alumina Ltd.'s (BBB-/Watch Neg/--) bauxite mine plans in Western Australia.

We expect mergers and acquisitions (M&A) to continue in the commodities space despite higher interest rates. This will likely be driven by portfolio rotation toward "new metals" that support the energy transition, or consolidation to gain scale efficiencies. The strong gold price is supporting consolidation in the gold sector, with Newmont expected to complete its takeover of Newcrest Mining Ltd. (BBB/Watch Pos/--) in the coming months.

Chart 2


Energy Transition Drives Strategic Growth And Capital Expenditure

Energy transition (both organic and inorganic) drives activity in the energy sector as companies prepare for a clean energy future. Service providers such as Worley Ltd. are well positioned to benefit from these trends.

Fortescue continues with its plan to spend about US$6 billion to decarbonize scope one and two emissions in its iron ore business. Its recent revision to its capital allocation framework also provides scope to deploy greater capital to its Fortescue Energy division. That said, the group has substantial capacity at the current rating to fund investment.

APA Group Ltd.'s A$1.8 billion acquisition of Alinta Energy Pilbara continues its push into the electricity space as it seeks to slowly diversify away from its predominant gas pipelines business. Such opportunistic M&A is likely to continue in the utilities sector bringing a focus to balance sheet management.

Santos' capital expenditure program reflects investment in cleaner fuels and decarbonization such as its Moomba carbon capture and storage project.

Speculative-Grade Markets Remain Tough

Highly levered borrowers will continue to face challenging refinancing conditions in the next one to two years. This follows several years of ample and cheap liquidity. Most of our speculative-grade borrowers are on a stable credit footing, benefiting from long-dated debt maturities and growing cash flows.

Genesis Care's Chapter 11 filing in June highlighted the unsustainability of its capital structure and the risks of aggressive debt-funded offshore expansion.

Recycle and Resource Operations Pty Ltd. (B/Negative/--) continues to suffer from weaker construction activity, rising costs and elevated leverage. Accordingly, the company will be reliant on price increases, strong execution and continued satisfactory end-user demand to reduce leverage and stabilize credit quality in the coming months.

We expect the resilience of the Australian economy to be tested in the next 12-18 months. The Reserve Bank of Australia is walking a narrow path to deliver a soft landing for the economy. Companies with pricing power, strong brands, low-cost structures and balance sheet capacity remain well positioned for this environment, and may use the opportunity to take market share from weaker competitors.

Editor: Jasper Moiseiwitsch

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