Public or Private? A Strategic Question
- We prefer private to public credit long term on better return potential. It’s the mirror image in equity: We prefer public stocks as risks fade in the medium term.
- U.S. stocks hit 2023 highs on hopes for a debt ceiling deal. Yields climbed on odds of another rate hike versus a pause or cuts. We don’t see rate cuts this year.
- U.S. PCE this week will help gauge inflation’s persistence. We see wage pressure from worker shortages keeping inflation above policy targets for some time.
The banking tumult has reshaped opportunities for income: We now favor private over public credit on a strategic horizon of five years and longer. We think private credit could help fill a void left by banks pulling back on some lending and offer potentially attractive yields to investors. We see a mirror image in equity, strategically preferring public to private: Public stocks have repriced more than markets like private equity, and we see risks fading over a medium-term horizon.
Investing in private markets takes time. So we see the repricing in private credit as an opportunity to be nimble with our strategic views and tap into our expectation that private credit can help fill a lending gap left by banks after the recent turmoil. Yields in direct lending, a subset of private credit, have risen (dark orange line in chart). These higher yields may better compensate investors for the risks we see ahead – even after factoring in lower credit quality. U.S. high yield and investment grade (IG) credit yields have faded from highs (yellow and pink lines), but we think they will rise eventually. We go overweight private credit as a result and move to neutral on global IG. Private markets overall are complex, with high risk and volatility, and aren’t suitable for all investors.
The fallout from the banking sector troubles and further tightening of credit conditions adds to the pressure on public credit but could be a potential boon for private credit, in our view. We think the rising interest rate environment and increased competition for deposits will put pressure on banks – and cause them to pull back some lending. We see this making room for non-bank lending and private credit to play a greater role
Private credit refers to a wide range of investments, from direct lending to infrastructure and venture debt. We’re focused on direct lending – financing that is typically negotiated directly between a non-bank lender and a borrower, often a small to mid-sized company. This private credit is mostly made up of floating rate debt that adjusts with policy rates that we see staying high. We think there are potential benefits from a borrower’s perspective in seeking out non-bank lending. Dealing with one private lender could be easier than with a broad group of banks in public markets. The private nature could also help avoid spooking financial markets, such as with the risks that come with tapping funds from public markets at inopportune times. This demand from borrowers creates an investment opportunity for lenders, in our view: more attractive pricing and deal terms than would have been the case before. But we think seeking out quality borrowers is key: That means a keen eye on deal terms and lending standards. We have had a conservative view on our assumptions about private credit default losses in our strategic views for some time because private credit is not immune to the credit risk from an economic downturn. Yet even after allowing for these more prudent assumptions that would be a drag on returns, the wider set of opportunities for private lenders in the wake of the banking fallout, coupled with the divergence between private and public credit yields is enough to spur an upgrade.
Our strategic view on equities is the mirror image of credit: We prefer public to private. We’re still strategically overweight developed market (DM) equities but underweight on a six- to 12-month tactical horizon because a strategic investor can look past some of the near-term pain. And the pressure from tighter credit conditions is also likely to have relented down the road. We remain strategically underweight growth in private markets such as private equity. Private equity has started to reprice the tougher macro environment but not as much as publicly traded equities.
Bottom line: We see the appeal of income in the new regime of greater macro and market volatility and favor private over public credit on a strategic horizon. We see a mirror image in equity, strategically preferring public to private.
U.S. stocks hit 2023 highs last week on hopes for a debt ceiling solution. Yields climbed on expectations the Federal Reserve could hike rates again instead of pausing at its next meeting. First-quarter earnings contracted for the second-straight quarter – but less than expected. Inflation helped revenue and margins as firms passed on higher prices to a still-strong consumer. We think higher financing costs and dwindling savings could start to bite: Earnings expectations look too rosy.
Most developed markets are grappling with a shared problem. Core inflation – or inflation excluding more volatile food and energy prices – is proving more stubborn than expected and remains well above the central bank’s 2% targets. See the chart. The cause is persistent production constraints, especially worker shortages. That is making it difficult to comfortably meet demand. Worker shortages are driving up wages, including in Japan, where wage inflation is at its highest rate since the late 1990s. We think that means central banks can’t undo any of their inflation-fighting rate hikes any time soon, even if financial markets think the Federal Reserve will start cutting rates before the end of the year. We see the Fed simply taking a breather for now, while it assesses how much economic damage is still to come from the hikes already done. We see a recession ahead. But unlike in the past when central banks would cut rates to stimulate a struggling economy, we think the unresolved inflation problem makes that unlikely this time.
1 Pricing in the damage
- Recession is foretold as central banks try to bring inflation back down to policy targets. It’s the opposite of past recessions: Rate cuts are not on the way to help support risk assets, in our view.
- That’s why the old playbook of simply “buying the dip” doesn’t apply in this regime of sharper trade-offs and greater macro volatility. The new playbook calls for a continuous reassessment of how much of the economic damage being generated by central banks is in the price.
- In the U.S., it’s now evident in the financial cracks emerging from higher interest rates on top of rate-sensitive sectors. Higher mortgage rates have hurt sales of new homes. We also see other warning signs, such as deteriorating CEO confidence, delayed capital spending plans, and consumers' depleting savings.
- The ultimate economic damage depends on how far central banks go to get inflation down. The Federal Reserve signaled a pause after hiking rates in May. But it also reiterated that persistent inflation means no rate cuts this year. We see the European Central Bank going full steam ahead with rate hikes to get inflation to target – regardless of the damage that entails.
- Investment implication: We’re tactically underweight DM equities. They’re not pricing the recession we see ahead.
2 Rethinking bonds
- Fixed income finally offers “income” after yields surged globally. This has boosted the allure of bonds after investors were starved for yield for years. We take a granular investment approach to capitalize on this, rather than taking broad, aggregate exposures.
- Very short-term government paper looks more attractive for income at current yields, and we like their ability to preserve capital. Tighter credit and financial conditions reduce the appeal of credit.
- In the old playbook, long-term government bonds would be part of the package as they historically have shielded portfolios from recession. Not this time, we think. The negative correlation between stock and bond returns has already flipped, meaning they can both go down at the same time. Why? Central banks are unlikely to come to the rescue with rapid rate cuts in recessions they engineered to bring down inflation to policy targets. If anything, policy rates may stay higher for longer than the market is expecting. Investors also will increasingly ask for more compensation to hold long-term government bonds – or term premiums – amid high debt levels, rising supply, and higher inflation.
- Investment implication: We prefer very short-term government paper over long-term government bonds.
3 Living with inflation
- High inflation has sparked cost-of-living crises, putting pressure on central banks to tame inflation with whatever it takes. Yet there has been little debate about the damage to growth and jobs. We think the “politics of inflation” narrative is on the cusp of changing. The Fed’s rapid rate hikes will stop without inflation being back on track to return fully to 2% targets, in our view. We think we are going to be living with inflation. We do see inflation cooling as spending patterns normalize and energy prices relent – but we see it persisting above policy targets in coming years.
- Beyond Covid-related supply disruptions, we see three long-term constraints keeping the new regime in place and inflation above pre-pandemic levels: aging populations, geopolitical fragmentation, and the transition to a lower carbon world.
- Investment implication: We’re overweight inflation-linked bonds on a tactical and strategic horizon.
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