A few weeks ago, a house was listed for sale in Sydney's famous Bondi at $3.8 million. (There were no water views, unlike for the $20.1 million penthouse apartment that set the Australian record last week). [1] The house went to auction, with opening bids at $4 million. It sold for $6.1 million.

In an environment of rock-bottom interest rates, locked in for years to come by central bank policymakers, asset prices are continuing their appreciation. In the case of many Australian property markets, these price movements have been fierce.

We are witnessing a sharp acceleration in inequality. In the US last year, the wealthiest one percent of households increased their wealth by US$4 trillion - equivalent to about 35% of the extra wealth generated nationwide. [2] The bottom 50% of households shared in only four percent of the gains.

We believe inequality will only become more extreme, with Covid-19 accelerating a number of the dynamics in our economic system that give rise to inequality. And growing inequality will feedback into our economic system in two key ways: more grievances and more debts.

More grievances

When inequality is high, democratic systems face a fundamental question: how can a political system that gives the ballot to all coexist with an economic system that concentrates wealth in the hands of the few?

As well articulated by political scientists Jacob Hacker and Paul Pierson in their new book, Let Them Eat Tweets: "Extremely unequal societies have a hard time finding that delicate balance between protecting ordinary citizens and reassuring the privileged few. The authors study the historical record to uncover a clear pattern of behaviour by those political parties on the right facing this Conservative Dilemma: "Whenever economic elites have grossly disproportionate power and come to see their economic interests as opposed to those of ordinary citizens, they are likely to promote social divisions."

Furthermore, in a recent study of 450 political parties in 41 democracies between 1945 and 2010, it was found that when inequality was higher, parties on the right ramped up their emphasis on divisive noneconomic issues, especially those surrounding race, ethnicity, religion and immigration. This might sound somewhat familiar to observers of the US political environment over the last four years - and particularly in the lead up to the recent 2020 general election.

This is, perhaps, one important reason why large-scale reversals of income inequality within the context of democracies have not happened orderly, historically. Not only do plutocrats fight to retain their power but, in order to do so, tend to resort to outrage-stoking, thereby exacerbating political instability.

More debts

It is easily understood that, while most people spend close to everything they earn on goods and services, the very wealthy do not. If you give a wealthy person one extra dollar, it will most likely be saved (i.e. invested in assets, including property), not spent.

This means the world's spending is increasingly being supported by consumers in the lowest-wealth cohorts who need to borrow to fund their expenditures. (Perhaps this partially explains the booming buy-now-pay-later space).

In their excellent book Trade Wars are Class Wars, Matthew Klein and Michael Pettis explain that: "For the world as a whole, rising inequality means the value of those assets is necessarily contingent on continued increases in spending by people who have progressively lower shares of national income. The only way to make this work is rising debt."

And this is exactly what we have seen in the world's largest economy, particularly over the last 40 years - the period during which income inequality increased significantly in the US.

Going "long" inequality

For those not holding their breath for a large-scale reversal of these trends any time soon, one interesting way to benefit is to own the world's leading alternative asset managers. Montaka owns Blackstone, KKR and The Carlyle Group, for example, on the basis that these global trends (like them or not) are driving asset owners to own more assets, at increasing valuations. And these assets are increasingly being managed by the world's highest-quality and largest-scale investment platforms in return for fee-income streams that are indexed to their value. The result is a sustainably growing profit stream for shareholders. And this, of course, is particularly valuable in a low interest rate environment.

A long-term marshmallow test for capitalism

We observe that the economic system which has evolved and delivered great benefits to so many is at risk of being undermined over the long-term by the very side-effects the system itself creates - particularly inequality.

Ironically, the price of preserving the overarching structure of this economic system is perhaps making it work more beneficially and equitably for the broader population. It perhaps represents the mother of all marshmallow tests for the preservation of capitalism as it was originally intended.

This article is based on a new in-depth Montaka research paper titled Covid-19: accelerating our journey to inequality

Risk, opportunity, and responsbility in the new ESG climate

Have ESG-related structural factors created an insurmountable obstacle to investing within some sectors?

That's the key question raised by a recent, finely detailed, Aurizon Operations case study, outlined below.

Certainly, it appears that integrating environmental, social & governance (ESG) factors into investment process is now unavoidable from a practical standpoint, and, with buyers of assets within certain sectors shrinking, there has arisen a fair expectation from credit market participants that these risks need to be compensated.

In the article below we explore whether the case study is a one-off, or an increasingly common example of when market prices dislocate due to ESG concerns, and ask whether these risks (or opportunities) are likely to continue to present themselves as the renewable energy transition evolves.

Earlier this month, Aurizon Operations Ltd, the above rail operations of Aurizon Holdings Ltd issued its inaugural debt capital market bond: a A$500 million 7-year senior unsecured medium term note at a fixed-rate of 3% (comprising of a margin of 180 basis points over asset-swap).

In an ultra-low interest rate environment, the Aurizon Operations deal priced at more than 60 basis points wider (i.e. cheaper) than initially expected by sell-side brokers.

Not surprisingly, sister company Aurizon Network - the below rail operator/owner of the regulated Central Queensland Coal Network - was negatively impacted as its bonds sold-off by more than 20 basis points (approx. -1.0 % to -1.5%) following the deal's official launch. In the end, the new Aurizon Operations bond priced about 40 basis points cheaper than the Aurizon Network secondary bond curve.

For context, this pricing level is 50 basis points wider than the prevailing BBB-curve, 50 basis points wider than one-notch lower rated Origin Energy Ltd (rated BBB/Baa2) and slightly cheaper still than two-notch lower rated Lend Lease Corp Ltd (rated Baa3/BBB-).

So, while Aurizon Operations was still able to borrow at a historically favourable interest rate, the pricing outcome shows investment managers are now demanding a premium to take on coal exposure risk and are looking beyond credit ratings when dealing with these securities.

A question of volatility

As above, the question that the case study brings to the fore is whether these ESG related structural factors significantly impede investing within these sectors?

We believe asset-volatility holds a clue as it can often be very instructive in inferring the level of uncertainty around a company's outlook. In the case of Aurizon Holdings, its prevailing rolling 1-year volatility sits at a historically high level of 34%, which is well above the long-term average of 24%.

While some of this increase is a function of general market volatility, it still begs the question of whether the outlook over the next 10 years is more uncertain that the last 10 years, and if so, will this likely result in Aurizon's long-term volatility continuing to rise? 

The question of volatility is particularly important when assessing a company's probability of default. A higher implied volatility infers that credit quality can deteriorate "faster" and should result in credit investors being better compensated for the risk.

Using a range of volatility assumptions, we can extrapolate an output around the fair value for the debt of Aurizon (the X-axis relates to the term and Y-axis relates to the fair value for default risk). For example, using the rolling 1-year average volatility assumption of 34% requires a much higher level of compensation for default risk than using the long-term average or current volatility (which is closer to 24%).

The equity market's view around Aurizon's enterprise value also tells an interesting story; while there has been some cyclical volatility, the reality is that enterprise value sits at 2013 levels. Meanwhile, in Price-to-EBITDA terms, the market is now valuing the cash-flow of this business to be well below the long-term average.

Is the equity market making a forward-looking statement about the increasing uncertainty around the business's long-term ability to generate cash-flows, and what does this mean for enterprise value?

From a credit investor's perspective, the key factors relate to the security of the lend and whether the level of compensation is adequate in capturing these concerns around rising uncertainty.

It seems that both enterprise value and volatility of the underlying equity do reflect environmental concerns relating to coal. These concerns are well documented and front of mind, which should give investors greater certainty that they are in the price.

In addition, in the case of Aurizon Operations, the company's credit outlook is supported by its long-term take-or-pay coal contracts with large global mining companies, which provides some cash flow certainty. The strong performance of its growing bulk commodities business should also provide some diversity away from coal, while the company's plan to transition its fleet of locomotives to electric power will further reduce its carbon footprint. Aurizon also benefits from a sound corporate governance structure and conservative financial policy which will provide some financial buffer in times of stress.

Conclusion

In conclusion, the Aurizon case study is a good example of when market prices change due to ESG concerns. These risks (or opportunities) are likely to continue to present themselves as the renewable energy transition evolves.

The key challenge for investors is how to determine the appropriate level of compensation for the additional risks taken. Indeed, various investors (rightly or wrongly) are increasingly applying negative ESG screens to certain sectors, deeming them un-investable.

This is not consistent with our ESG policy, which values the role we play as investors in a sustainable energy transition and in supporting ESG aware companies, such as Aurizon, through their carbon reduction efforts.

Funds operated by this manager:

Realm High Income Fund (Wholesale), Realm High Income Fund (Retail)