Like the popular Mark Twain misquote “reports of my death are greatly exaggerated,” the U.S. economy has yet to show the weakness that many observers had predicted to arrive by the midpoint of 2023. That is not to say the economy will not dip into contractionary territory at some point, while the Federal Reserve remains on the brake pedal. However, so far, the recessionary calls have been premature at best. Q1 ended with a regional banking crisis and considerable uncertainty about the magnitude of its impact on the country. While regional bank stocks prices remain depressed at the end of Q2 and lending is reportedly more constrained, the severe fallout that many predicted has failed to materialize. The markets luckily appear confident that the damage has been contained. From a market perspective, the rest of the quarter reflects some good news (the first Fed pause after 10 straight hikes, for example) and quite a bit of no-news-is-good-news sentiment (Ukraine and China situations haven’t worsened, U.S. labor market is stable, inflation is still high but not rising, earnings announcements better than feared, etc.).
History would indicate that the U.S. economy should have dipped into recessionary territory already, given the advanced nature of the Fed’s tightening program and consistent yield curve inversion (typically a strong indicator of downturns). So, why does it seem to be different this time? There are many opinions out there, however, we found that Apollo’s chief economist, Torsten Slok, provided one of the most succinct (and credible) explanations:
- High savings in the household sector, and post-Covid strong demand for air travel, hotels, and restaurants.
- During the pandemic, HY and IG corporates extended the maturity of their loans, making them less vulnerable to higher interest rates.
- US households have 30-year fixed mortgages and are therefore less sensitive to Fed hikes. Higher mortgage rates for homebuyers are holding back the supply of homes.
- A growing share of capex spending is on intangibles (i.e., software, R&D) which generally are less sensitive to Fed hikes.
- IRA and CHIPS Act are creating a boom in energy transition and manufacturing.
We’re not sure what the odds would have been on January 1 that the S&P 500’s total return for the first half of 2023 would be the second strongest first half since 2000 (2019 was the best by a nose), but they would have been very long for sure. It would have been a winning bet, though, as the S&P had its best start in 23 years. That said, the index’s performance was not shared equally among its constituents, and the lofty 19x forward earnings multiple also was not equally-distributed. The largest seven companies by market capitalization comprise almost 30% of the S&P, had a weighted year-to-date return of around 70% and are currently valued at over 35x their one-year forward earnings. It is remarkable to consider that, today, Apple’s market cap alone is larger than that of the entire Russell 2000. Among the other 493 names comprising the rest of the index, performance was mixed, but it was generally positive.
Looking ahead, earnings expectations seem relatively optimistic with analysts projecting 20% growth over the next twelve months. This projected earnings growth is widely-distributed, reflecting optimism that extends beyond just the top seven stocks into the broader equity market. The combination of multiple expansion plus earnings optimism is concerning to us, though, as a still hawkish Fed (a policy stance designed to reduce demand and, therefore, earnings) and generally weak forward economic sentiment indicators should provide at least a yellow light for equity investors at the current price levels.
The bond market appears to be done fighting the Fed for now, as the structure of U.S. interest rates currently aligns more closely with the expected Fed path for short term rates. The U.S. Treasury yield curve has been persistently inverted, as bond investors continue to believe that short-term rates will begin falling sooner than has been communicated by Fed officials. However, the degree of inversion has varied considerably. For example, the two-year Treasury Note was as much as 1.25% below the Fed Funds rate in the wake of the SVB failure in early April. Whereas, that gap was only around 0.4% on June 30. We have viewed the more severe inversions as inconsistent with both the actions and the communicated intentions of the Fed. Today’s modest inversion represents close alignment, as both the bond market and the Fed are broadly forecasting the easing of the Fed Funds rate mid-2024 and into 2025.
While risk free Treasury rates may be more aligned with Fed, credit spreads more closely map the equity market’s pricing insofar as they do not reflect substantial risks to the economy or credit quality. While the “maturity wall” risk in corporate credits has been well managed with limited near-term refinancing needs, the reality is that all borrowers face higher financing costs, which are likely to continue for some time. Borrowing is no longer nearly free, and those participants with greater leverage will face greater changes to their cost structure as higher rates filter through refinancing. Any increase in costs without an offsetting revenue increase is mathematically adverse to credit quality, so the unanswered question is which sectors and companies may face more material cost increases than others. This will become more apparent as we head into late 2024 and 2025 when the pace of maturities picks up.
Three of the most significant assumptions in real estate investing are cap rate (the income generated by a property divided by the value of the property), financing costs and rent growth. The latter factor has been positive in many sectors, as inflation over the last two years has allowed for more aggressive rent increases. The first two factors, on the other hand, are working decidedly against real estate investors and represent greater sources of risk for transactions executed under more aggressive assumptions. Many real estate sectors exhibit strong demand fundamentals (multi-family, hospitality, industrial and logistics, for example), but, even with stable occupancy, investors will still require sharper pencils to generate adequate returns because of the higher rate environment. Additionally, the U.S. office market remains under extraordinary pressure from the evaporation of demand post-COVID. We believe the dislocation in the office market will be a multi-year challenge and worth observing, as the more skilled underwriters in the real estate market identify attractive solutions.
Private Equity and Private Credit
The last 18 months have been an interesting period for the private markets, as the modern era of private equity and debt had not yet been tested with such a dramatic change in interest rates. The prolonged period of low rates provided private equity markets with both low financing costs for portfolio investments and demand from investors earning very little return in traditional cash and fixed income. This dynamic also buoyed public equity markets, which further benefitted the private equity sector as the strong appetite for IPOs provided reliable exit windows for investments.
These worked just as effectively in reverse, unfortunately, as the private equity markets were given little time to adjust to the pace and magnitude of the interest rate changes. Higher financing costs have a punitive effect on equity returns, investors have more income generating alternatives and the exit windows are much narrower today. We are in a period of transition for private equity and venture capital during which the strong managers with well-underwritten investments will have to be patient but are still likely to achieve their objectives. On the other hand, weaker players and poorly-underwritten investments may struggle.
All that said, the valuation decline in private markets should offer a better opportunity set for skilled investors in the near and intermediate-term. Fundraising challenges also mean that there should be less “dry powder” competing for transactions, as well, which works to the benefit of skilled managers who are reluctant to overpay for investments.
While private equity participants may have reefed their sails and battened the hatches, the private credit side appears to be putting out the spinnakers. The sector has benefitted from the combination of substantially-higher interest rates and the contraction in bank lending, which was underway even before SVB and the regional bank issues (and accelerated thereafter). Essentially, private credit investors are experiencing a surge in demand even as they raise their prices. Credit has its own set of risks though, and the potential for losses in certain sectors and/or with bad underwriting requires careful consideration. The higher rates paid for private credit come directly from a borrower’s profits, so borrowers are inherently more vulnerable in the event of a weakening in their revenues. And of course, the Fed’s hawkish policy is intended to do just that by reducing aggregate demand in the economy.
This is a bullish period for private credit, and we believe that strong managers are well-positioned to benefit from it through conservative underwriting, strong covenant negotiation and thoughtful portfolio construction. While attractive overall, private credit’s limited tax efficiency must always be considered, as the returns typically come with a high degree of ordinary income.