2Q 2023 Quarterly Investment Forum

During this session we explored how bank disintermediation is affecting private credit and commercial real estate, as well as the broader influence of recent banking stress. This discussion sat alongside our usual macro outlook.

Market Updates 09 Jun 2023 9 min read

Authors

Evan Brown Tiffany Gherlone Baxter Wasson Andy Strommen

Macro Outlook

Evan Brown, Head of Multi-Asset Strategy and Portfolio Manager

Bottom line: We continue to be of the view there will not be an imminent recession – but, as such, we expect inflation to remain sticky and elevated. While central bank tightening cycles are not done, they are slowing down. This should mean a decline in bond volatility, such that further rate hikes will have less of an impact on risky assets.

We are starting to see a shift in economic momentum towards the US as of late, and away from Europe and China. In our view, there is scope for more cyclically oriented US equities to bounce back.

There are two main differences between this business cycle and others: fortress private sector balance sheets (reinforced by large fiscal stimulus) and the divergence between goods and services spending. Coming out of COVID, we had a surge of demand in goods due to low mobility. Following a proper reopening, there was a switch to services that is still carrying through.

Normally in the business cycle, the goods sector is a key leading indicator for the broader economy but given we had this abnormal, pandemic-catalyzed boom in goods, the roll off of it hasn’t been a harbinger of recession.

Money is being spent in services, in areas where the labor market is still really tight. Initial and continuing jobless claims, which were rising last year, have stabilized. That is key for consumption to stay resilient.

We are seeing some green shoots in other areas of the economy. Housing, the most rate-sensitive part of the economy, got crushed last year amid surging interest rates, but homebuilder sentiment has rebounded, construction employment is rising, and there is structural demand from millennials while rate-locked households don’t want to move.

There have been a series of rolling recessions in different sectors, but not all at once. First was tech/crypto/VC, then housing, and now manufacturing is stalling. Later this year, there will likely be pressure on services but as that is weakening, we could see housing and manufacturing pick up again.

The main risk we see right now is a sharp tightening of lending standards. The question is how much bank stress will drive standards even tighter. At least for now, there appear to be few signs of a seizing up of credit, and broad financial conditions broadly are fairly easy. The Senior Loan Officer Survey showed recent bank tightening in lending was driven by concerns about the economic backdrop in general, rather than a lack of liquidity or capital adequacy.

In our view, the condition of credit markets, the Federal Reserve, and earnings will be the key drivers of risky assets. Treasury bill issuance following the debt ceiling deal may well reduce bank reserves, but we are still in an ample reserve position, in aggregate.

For inflation, we have made a lot of progress in getting headline price pressures down with the decline in energy prices and supply chain issues resolving. Now, shelter prices are coming off. But the Federal Reserve is most focused on core services ex-housing. This is the type of inflation that tends to get sticky and is tied to the labor market. It is still pretty elevated, and not close to the Fed’s target. Investors need to think about a soft landing versus no landing – no landing being a continuation of sticky services inflation as growth stays resilient. In that environment, the Fed probably has to continue hiking – possibly eventually causing a more severe recession.

In Europe, we have strong services and consumption, a tight labor market, but poor manufacturing. That is especially a negative for Europe because the continent is much more manufacturing-intensive and export driven compared to the US. We expect relative softness from European stocks, which had outperformed substantially from the end of September 2022 to May, particularly when the currency appreciation is taken into account.

A good chunk of that European economic weakness is related to China. The reopening bounce has faded, and youth unemployment has skyrocketed. China is going to need more policy support to revive their sagging economy.

In markets, this is a solid backdrop for balanced portfolios. We may be breaking out of the S&P 500’s year-long range; a lot of this comes down to overly pessimistic expectations, low positioning, a solid economy, and bond volatility stabilizing. Globally, there is plenty of breadth. International developed market equities have outperformed. The DAX Index is at an all-time high, the Nikkei is at a 30-year high, while emerging markets are the laggard because China has underwhelmed.

The S&P 500’s forward P/E has expanded recently – the market is by no means cheap. But there is plenty of room for US stocks to re-price higher beyond mega-cap tech. We see a broadening of the equity market rally.

The Federal Reserve is trying to convince the market to price out rate cuts, and the market now finally believes them. The risk-reward in duration is more balanced. The Fed is likely to skip in June, and this should weigh on bond volatility. Meanwhile, credit is priced for a gentle default cycle. At about 9% at the index level, high yield is attractive considering the last decade and beyond of low coupons. If we are wrong on our optimistic economic view, we think the better way to position is to be long duration rather than short high yield.

State of Banks, Real Estate, Private Credit, and Bank Disintermediation

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Andy Strommen, Senior Investment Analyst in Active Equities

For US regional banks, funding cost pressures are the focus of investors. Those have been driving negative revisions and are likely to continue doing so.

Deposit betas are likely to rise, with quantitative tightening adding to pressures on deposits. Credit costs are rising, loan growth is slowing, funding stresses have emerged, fee income trends are mixed, and buybacks are curtailed. There is an elevated risk of further stresses to regional banks. Loan to deposit ratios have risen a lot, and firms also may have to realize losses to meet outflows.

Tougher regulatory requirements are going to be pushed upon the regionals, so they will need to build capital, hold more liquid assets, and have more long-term debt on the funding side. In our view this may lead to 200 to 300 basis points of compression in return on equity for regionals, which could be more severe if cyclical factors take a turn for the worse.

Tiffany Gherlone, Head of Real Estate Research

The slowdown we have seen in the economy is also evident in real estate. But since it has been a ‘slow’ slowdown, that has bought us some time. In private real estate, the numbers are not as bad as some might think. Rents are growing in all sectors except office, which is really struggling. Vacancies are up in all sectors, and while there has been some slowdown in demand, elevated supply is the real problem (excluding retail).

In private real estate, prices are down about 6 to 7% over the past year – far better than publicly traded REITs. Roughly half of that is offset by income. But the pain has arrived in the past two quarters, and there is more to come in 2023 – particularly in offices.

Pension funds and other institutions already have a decent amount of this sector in their portfolios. We do not believe office conversions to multifamily will be a big theme. There are a lot of risks in execution, since you need municipality cooperation, and these conversions can be difficult and expensive.

There are huge opportunities for private funds, which can afford to be picky. We think there will be attractive options in industrials and residentials, as well as from diversifying into niche centers like cold storage. We are also really interested in partnering with tech-enabled companies – start-ups that have technology but not capital – so that we can enhance our capabilities in this area.

John Popp, Global Head and CIO of the Credit Investments Group at Credit Suisse Asset Management

Loans are an inherently risk-averse asset class. They are senior secured and floating rate, so they hedge against rising rate environments and have had particularly good relative performance over the past year. Typically, this lower-volatility, diversifying, income-generating asset delivers a positive annual total return – in the past 20 years, it has only been down in three (2008, 2015, and 2022).

The asset class also has an asymmetric risk profile – it is about what you don’t own as much as what you do. The trailing default rate is about 2.7%, and one big name accounts for 40 basis points.

Presently, the credit premium in loans is about 130 basis points wide to high yield, so there may be some relative value there, more potential return in addition to the capital structure benefits. Banks were fine with being disintermediated in the early stages of the syndicated loan market, and happy to trade loans. Since 2016, private equity capital market activities have caused a convergence between syndicated loans and private debt. As private markets scale, the banks are trying to figure out where lost revenues will be made up. They likely won’t be able to do it fully through lending to the private lending community. A lot of money is also moving into direct lending, which will be a challenge for banks and syndicated managers who now need to step up on the private side.

Baxter Wasson, Co-Head of O’Connor Capital Solutions

We focus on making loans to family/founder-owned companies at the lower end of the middle market, and are excited by the opportunity set ahead of us and tailwinds for our business. The dynamics we are seeing these days, with regional banks having to pull back from lending, really reminds me of those supply/demand imbalances that accelerated growth in private credit from 2010 onwards.

We are seeing a tightening in credit, but not yet a credit crunch. And that is important because in aggregate the markets served by regional and mid-sized banks are huge. US middle-market corporates on a standalone basis would be the third-largest economy in the world, and much of that cohort is served by those lenders.

So the credit crunch is less severe compared to the GFC, and the imbalance is being created in a more fragmented market. Most private credit funds are not organized to capitalize on this opportunity set, because they have been moving towards larger deals. A small pullback from regionals creates thousands of opportunities to lend to smaller companies that need to grow or refinance debt. You need the right network to capture that deal flow, with strong connectivity, as well as the right skillset and mandate. Family/founder-owned companies tend to be a bit different to private equity-owned companies. When you negotiate, the dynamic is also very different, as these deals tend to be less heavily competed and more lender-friendly.