Industry Insights

Inflation, recession fears, and the case for private credit

Private Credit
Burkhard Niewoehner
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2022 has been a year of superlatives across the rates markets. In June, the Federal Reserve undertook its largest rate hike in 28 years when it raised its benchmark rate by three-quarters of a percentage point – the biggest hike since 1994 (and a step since repeated twice). In September, the European Central Bank (ECB) lifted all 3 of its policy rates by an unprecedented 75 basis points, in what was the largest hike yet in the institution’s history. Also in September, the Bank of England (BOE)’s key interest rate was raised to its highest level in 14 years, in what was the BOEs seventh consecutive rate hike. A recent Deutsche Bank report now expects the Fed’s terminal rate to be 4.9%, reached in the first quarter of 2023 – a far cry from the historical March 1080 high of 20% but nevertheless the highest level yet in the post-GFC financial landscape which was characterised by cheap liquidity and anemic inflation.   

Central banks prioritise price stability over the economy, fuelling recession fears

While the hike in key global benchmark rates sent bond markets tumbling, the accompanying rhetoric and economic forward guidance from central bank chiefs has been weighing heavily on public equity markets. During the post-meeting conference on 21 September conference, Fed Chair Jerome Powell gave this clearest signal yet that he is willing to tolerate a recession as the necessary trade-off for regaining control of inflation, quashing hopes for a soft landing. To be clear, Fed officials are not (yet) explicitly predicting a recession. But Powell’s rhetoric as to the FED’s commitment to combat inflation through rate hikes even at the expense of hurting workers and businesses has gotten progressively sharper in recent months:

The chances of a soft landing,” Powell said, “are likely to diminish… We have got to get inflation behind us,” “I wish there were a painless way to do that. There isn’t.””

Echoing the commitment of her US counterpart to hiking rates as the preferred means to combat inflation, ECB president Christine Lagarde stated in October that "the traditional interest rate... under the current circumstances is the most effective, the most appropriate and based on the proportionality assessment that we conduct in choosing from the toolbox is the one that actually works best,"

In terms of clouding the economic outlook, an extenuating factor is the fact that inflation prints have remained stubbornly high despite the unprecedented monetary tightening. US Inflation, as measured by the Consumer Price Index (CPI), rose 0.4% in September (up 0.1% August gain), and up by 8.2% in September versus a year earlier. Euro zone inflation zoomed past forecasts to hit 10.0% in September, a new record high that will reinforce expectations for another jumbo interest rate hike next month from the European Central Bank. Price growth in the 19 countries sharing the euro accelerated from August's 9.1%, data from Eurostat showed on Friday, beating expectations for a reading of 9.7%, with some eurozone members experiencing the fastest price growth since the time of the Korean War 70 years ago.

These hotter-than-expected consumer inflation reading further undermined hopes for a slowdown in the tightening path undertaken by the Fed and the ECB, and fomented fears of sky-high inflation becoming entrenched for a prolonged period. Indeed, the persistently high inflation in the face of, and despite, progressive monetary tightening has prompted growing scepticism over the effectiveness of monetary tightening to curb an inflation which appears not demand or labour driven, but rather a combination of food & gas shortage brought on by geopolitical events, supply-demand shortages, and corporate opportunism: 

“The price drops aren’t materialising because current inflation largely isn’t demand- or labour-driven as it often is during inflationary periods”, said Claudia Sahm, a former Fed economist and founder of Sahm Consulting.

“Raising interest rates isn’t working, and the Fed’s overly aggressive actions are shoving our economy to the brink of a devastating recession,” said Rakeen Mabud, chief economist at the progressive Groundwork Collaborative thinktank. “Supply chain bottlenecks, a volatile global energy market and rampant corporate profiteering can’t be solved by additional rate hikes.”

Growing fears of recession amidst rate aggressive tightening drives bonds and equities lower

Indeed, Lael Brainard, Federal Reserve Board vice chair, even acknowledged the roles of pricing and supply chain disruptions during a September speech before the National Association for Business Economics. Retail profit margins have increased 20% since the pandemic’s onset, Brainard noted, roughly doubling the 9% increase in average hourly earnings by the sector’s employees.

An underlying concern here is that the two most impactful central banks are driving 180kmh in the wrong lane – forcing the economy (& markets) onto its knee through an uncompromising rate hike agenda in pursuit of fighting an inflation brought about by factors that are impervious to rate hikes, forcing Powell’s and Lagarde’s hands to stronger tightening. The shadow of stagflation starts to loom – a recession-inflation scenario whereby inflation & therefore interest rates are high or increasing (hitting the bond market) and economic growth languishes (driving down equity valuations).

Recent downward adjustments to economic projections seem to substantiate such concerns.  In September, Goldman Sachs cut its forecast for 2023 U.S. GDP as it projects a more aggressive Fed tightening policy through the rest of this year, and sees that pushing the jobless rate higher than it previously projected. Goldman said in a note released 16 September that it now sees GDP growth of 1.1% next year, down from its prior call for 1.5% growth from the fourth quarter of 2022 to the end of 2023. Likewise, the latest projections released by the ECB in September paint a gloomy outlook, albeit steering clear from predicting a recession. Eurozone inflation is now forecast to average 8.1% in 2022 (increased from 6.8%), 5.5% in 2023 (previously 3.5%) and 2.3% in 2024 (previously 2.1%). At the same time, the ECB’s GDP growth forecast has been cut for 2023 to 0.9% from 2.1%, and to 1.9% for 2024 (previously 2.1%).  

The impact is seen (and felt) across the global equity and bond markets. S&P 500 and Euro Stoxx 50 are in deep bear market territory, recording YTD performance of -21% and -19%, respectively. The Bloomberg Global Aggregate Total Return Index – widely established benchmark index for global bond markets – is down 22% over the past 12 months. According to Bloomberg, global stocks and bonds have lost a record  US $36 trillion in value in the first nine months of 2022.

Alternative assets prove resilient, private credit emerges as (un)likely beneficiary 

How has the current macro uncertainty impacted private assets? Through much of the past decade, the emergence and growth of private markets were driven by the promise of quick outsized yields and returns in a cross-asset bull-market environment fuelled by historically low yields. Risk considerations were frequently an afterthought. 2022 has proven the resilience of alternative assets.  With pricing in private markets being relatively less frequent and transparent, the impact on the private equity side may be more evident through the size, structure and frequency of deals rather than valuations. As far as private equity is concerned, a study by M&A law firm found that while 2022 saw some contraction vs blockbuster year 2021, 2022 remains on track to be the second best year in historical terms   “In line with overall M&A activity, US PE dealmaking in H1 lagged behind 2021 in terms of both value and volume. Total deal value of US$415 billion during the first half of the year represents a 28 percent fall year-on-year, though it adds that “yet this level of activity looks on track to reach the second-highest annual deal value in Merger market’s history (since 2006), after the record-topping 2021” going on to state that “A deal volume of 1,727, while 20 percent below the 2021 total, is still firmly ahead of pre-2020 activity levels.”  In the same spirit, JP AM found that while public markets are grappling with the prospects of higher rates, higher inflation and a slower growth outlook,  “the counterparts in private equity and credit appear to be holding up and may even benefit from the volatility in the public markets”.

Private credit may emerge as an unexpected beneficiary, as it stands to benefit from the developments in public debt and private equity markets. With GPs unwilling to accept down rounds, private credit presents a logical alternative to raise capital without undermining valuations or dilution. According to Dealstreetasia,

Demand is increasing as fund managers such as buyout funds look for private credit to support their valuations, and start-ups and unicorns look for fundraising alternatives to avoid a down round”.

For fixed income investors, private credit, at least certain segments, could present a viable alternative to the beaten bond markets as focus shifts to portfolio de-risking and volatility mitigation. A key observation is that higher yields in the private credit space are not always, and necessarily, due to  higher credit risk – as common credit pricing theory would hold.  Instead, they are reflective of inefficient and unequal access to debt capital in certain (mainly emerging market) regions, which essentially prohibits or deters size-able segments of SMEs in the relevant jurisdictions from accessing bank lending or capital markets, creating borrowing demand from otherwise solid corporates which are unable to tap the mainstream sources of  lending capital. Such systemically imposed credit supply bottlenecks create unique value opportunities enabling alpha through carefully selected, well-structured private credit investments while at the same time benefiting from customised risk mitigation in the form of (over-) collateralisation/security, covenants, and short duration.  

While private assets are not a panacea and public securities will continue to form a cornerstone in any investment portfolio, the resilience of alternative investments in the light of this year’s broad-based public markets sell-off underscores its value proposition as a real-return accretive, effective portfolio diversifier, calling for a potential re-thinking of established portfolio allocation paradigms from (public) equity vs bonds on to public vs private assets. Such re-assessment of established portfolio allocation strategies toward privates assets was also called for in a recent note by GIC and MSCI:

We are witnessing the rise of private assets to the core of many asset allocations from a peripheral ‘alternative,’ and we have entered a new period of heightened macro uncertainty,” according to a paper published by the two organisations in October. “Both could require a fundamental evolution of the asset-allocation process.

Stay tuned. Stay nimble.

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