Corporate Australia's hopes for a soft landing remain on track. Companies have, for the most part, taken higher interest rates and persistent inflation in their stride. But it won't be a smooth ride for all. We anticipate a margin squeeze for retailers amid falling demand, as well as sluggish conditions for major ports. Other sectors face material credit hurdles. Most at risk are rate-sensitive office REITs and the structurally declining postal sector.

REITs: Asset Sales Will Be Critical

Slowing inflation, moderating seller expectations, and improving confidence that interest rates have peaked should support a pickup in real estate transactions later this year. Office REITs increasingly rely on asset sales to support credit quality as investor redemptions and development expenditure increase debt and valuations decline. This comes at a time when rising office vacancies and higher interest costs are squeezing cash flows. REITs have struggled to sell assets in the past 18 months as most buyers remained on the sidelines.

Buyers are likely to be spoilt for choice this year, given the amount of planned asset sales, particularly in the office sector. This may exacerbate price declines and dampen the enthusiasm of sellers. Reducing portfolio diversity following asset sales could also add to credit strain.

We downgraded GPT Group to 'A-/A-2' with a stable outlook in December 2023, partly due to its difficulty in selling assets to reduce leverage assumed from prior acquisitions.

Further, about 40% of our rated office REITs remain on negative outlook, reflecting stretched balance sheets. This includes Australian Prime Property Fund Commercial, Investa Commercial Property Fund, and Mirvac Wholesale Office Fund.

Structural demand risks from hybrid working also hinder the office REIT sector. We continue to see a so-called flight to quality as a key support to the occupancy and credit quality of our rated REITs. For secondary assets, weaker demand and new high-quality supply will likely drive higher vacancies and weaker rents.

Chart 1

Outside the office sector, shopping center performance has continued its post-COVID recovery. Further, tailwinds remain strong for industrial, healthcare, data centers and, retirement living assets. That's because tenant demand remains robust and investors are seeking to increase their exposure in these growing subsectors. Goodman Group, for example, is aggressively expanding its data center development pipeline, supported by its 4 gigawatt powerbank and robust balance sheet.

Commodities: Demand-Supply Imbalances Pressure New Minerals

Appreciable capital flows have supported strong supply growth in the burgeoning lithium, nickel, and cobalt markets over the past 18 months. Even though these new or repurposed minerals play a crucial role in the shift to cleaner energy, their prices are weak because new supply is coinciding with volatile demand (see chart 2).

While the five-year outlook for electric vehicle (EV) demand remains robust, volatility in growth rates for EV sales over the next 18 months is adding to demand and supply imbalances of battery minerals.

Chart 2

Price volatility will persist as these markets develop and strive to achieve a demand-and-supply balance against rapidly growing end-user markets. We do, however, project pricing conditions in some markets (such as lithium) to gain support as the input price shock of very high recent prices abates. This will in turn ease the strain on battery prices and underpin a recovery in demand. Government support for local producers may also provide relief.

The credit quality of rated players, such as South32 Ltd., with exposure to these new minerals will benefit from their commodity diversity across new and traditional minerals. Prices of traditional commodities such as oil, gas, metallurgical coal, and gold continues to trade at robust levels amid persistent demand and patchy supply.

Construction cost inflation also remains a key risk factor for the commodities sector, given the large capital expenditure plans of many operators. However, several years of buoyant commodity prices have positioned rated players such as Woodside Energy Group Ltd., Santos Ltd., and the large mining houses to accommodate moderate cost overruns within rating tolerances.

Retail: Margin Squeeze Likely To Intensify As Demand Slows

The resilience of Australian consumers has allowed large corporates to pass-through higher raw material, fuel, and labor costs and protect margins. Although we expected cost pressures to moderate in 2024, we anticipate inflation will remain elevated. The ability of companies to pass on higher prices will become more acute as demand slows, particularly in sectors with strong competition.

Possible regulatory intervention in sectors such as food retailing is adding to margin pressures for operators such as Coles Group Ltd. and Woolworths Group Ltd.

Consumers have also benefited from continued wage increases over the past 12 months and tax cuts are coming from July.

However, as the economy slows wage growth will moderate, in our view. Consequently, consumers will likely seek to spend less, which will continue to propel the strong performance for value-focused operators such as Wesfarmers Ltd., and its subsidiary Kmart.

Chart 3

Companies will prioritize cost efficiencies to maintain margins and improve lackluster productivity. Many companies, such as Telstra Group Ltd. and the major retailers, are pursuing use cases for AI, particularly around customer relationship management and information efficiency.

Transportation: Postal Operators In A Race to Cut Costs

Australian Postal Corp. and other postal operators globally need to cut costs and increase parcel profitability to offset structurally eroding mail volumes. While we expect government owners to support this process, the rapid pace of mail declines and the complexity and timing of cost-reduction programs mean profitability and credit risks remain weighted to the downside.

Infrastructure: Inflation-linked Pricing Is A Cushion

Inflation-linked pricing and a high level of interest rate hedging will offset higher labor and interest costs across most infrastructure entities. Most entities have also redefined their capex plans and dividend payments to maintain their metrics amid uncertain consumer demand. Liquidity remains adequate in the sector, with entities showing proactive refinancing strategies to cover maturing debt and annual capex.

Airports and toll roads remain resilient

Total airport traffic has recovered strongly (see chart 4). Domestic traffic has faced hurdles, given airline capacity issues, higher fares, and weaker business travel. The normalization of these factors will be gradual.

We retain our forecast of total traffic not returning to pre-pandemic levels before 2025. Weaker container volumes and work-from-home trends may manifest in slower growth in traffic for toll roads. Toll pricing will more than offset this.

Chart 4

Ports: Sluggish import container volumes may persist

Lower container volumes may affect rail entities Aurizon Holdings Ltd. and Pacific National Holdings Pty Ltd., which are competing fiercely to retain their intermodal market share. Operating efficiency and retention of market share in the coal business will be crucial for rating headroom.

Overall, ports' earnings will meet our expectation due to their strong margins and solid property income.

Regulated Utilities: Capitalizing On Large Energy Transition Investments

Regulation will support the utilities' efforts to enhance their electricity networks or undertake network projects in their franchise areas. Most rated utilities derive nearly 90%-95% of their cash flows from the regulated segment. We see some appetite among utilities to pursue contracted smaller projects, but not at the risk of hurting their balance sheet.

Among the rated entities, we expect APA Group to continue expanding into the electricity space--network build or renewable generation--to diversify away from gas. But it will likely be cautious in its approach and ensure it has an appropriate funding structure.

Investment-Grade Corporates To Increase Capital Market Funding In 2024

In our view, investment-grade industrial corporates will increase their capital market borrowings over the next 12 months as they seek to lengthen debt maturity profiles.

Many issuers have increased their exposure to bank financing over the past 18 months because of capital market volatility, basis-point spreads that were wider than average, and uncertainty about interest rates. This has shortened the debt maturity profiles and funding diversity of some issuers.

Longer-dated capital markets issuance would alleviate these inherent risks. However, we anticipate that highly rated REITs will continue to rely more heavily on bank funding, given the favorable pricing differential.

In the high-yield capital markets, we project cost and availability of capital to remain constrained. Most of our rated speculative-grade issuers have a remaining tenor of three to five years on their existing facilities (see chart 5), providing some time and flexibility to deleverage ahead of refinancing. Private credit will be a growing source of funding for these issuers, in our view.

Chart 5

Companies are coping with higher rates and slowing consumer demand. But inflation, elevated interest rates, rising unemployment and geopolitics may throw some off course. For certain sectors, such as office REITs and postal operators, the landing is already bumpier than most.

Editor: Lex Hall

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