Macro
The US economy handled higher interest rates better than anyone anticipated despite multiple issues affecting the global economy. Although some restrictive monetary policy effects remain to be seen, the US remains an attractive destination for investors’ capital. The focus of the weekly update is more tactical, but it is worth acknowledging a few strategic changes that helped the US equity market to dominate the returns of any other region over the last decade.
- Technology – The US became a global leader in software development and digital technologies and played a pivotal role in developing the Internet’s infrastructure. Over time, this made other global economies more interlinked with the US and dependent on services provided by US mega-tech firms. Dominance in those high margins and growth was possible thanks to the robust venture capital ecosystem and culture focus on celebrating innovation and entrepreneurship. US companies are now at the forefront of technologies that will shape the future, including artificial intelligence, machine learning, and cloud computing.
- Energy Security – Another is gaining greater control over its energy supplies and reducing reliance on foreign energy sources due to dramatically increasing domestic oil and natural gas production, thanks to the shale revolution (primarily through hydraulic fracturing – fracking). Although the US is not completely energy independent, it has significantly increased the fraction of renewable energy, diversified its energy sources, and shifted from a net importer of oil and natural gas to a net exporter.
- Structure – the US has a relatively stable political system, predictable legal system, and well-established rule of law. It has a highly skilled workforce with the world’s leading universities and research institutions and a large and affluent consumer base. Over time, a higher proportion of household income is spent on less cyclical services (COVID has flipped that towards goods). In 100 years, there’ve only been 13 quarters of negative growth in services, and the US is now a 75% services-based economy.
Despite a strong economy, the US Dollar remains weak. We have ‘everything rally’, except for the US dollar. The build-up of the inventory, improving logistics, and the global supply chain have caused the inflation of US goods to subside. Core PCE is expected to hit 2% by January. Service level inflation is still a bit sticky, but the averages are coming down. Continuous wage pressures, healthcare and auto insurance premiums, and shelter costs drive service-level inflation. 85% of all the excess inflation in the US since 2019 was driven by housing and cars.
Rates
The FED wants to keep the business cycle healthy, which leads to rate-cut expectations and makes it difficult to maintain its quantitative tightening efforts. At the peak in April 2022, the FED balance sheet held about $9t in assets, which has declined by over $1t but still has about $3.7t above its pre-pandemic level.
With maturities piling up in 2024/25, there is growing concern about borrowers’ inability to stomach higher borrowing costs, which puts further pressure to cut rates. According to Bloomberg Economic Forecast (composition of estimates from prestigious universities, brokerage firms, and major money centres), 90% of economists predict that 10Y will be lower next year.
Credit
Many investors consider investment grade attractive because, while the treasury yield curve is inverted, the investment grade yield curve is slightly upward-sloping.
We see a disconnect between the bankruptcy filings (12 MMA) and the high yield spreads (3M Lead). Some investors argue this is a good setup for credit arbitrageurs to take a spread trade to go long IG and short HY. This will give put optionality, which can become more valuable if default increases or the recession is more severe than expected, although a more selective approach through careful fundamental analysis is required. Investors need to be cautious when judging the credit market through a historical lens, as the structure of the credit market has changed significantly due to improvements in the quality of the credit market since the GFC.
As the wall of maturities approaches, distressed debt financiers will have a significant opportunity. Over the next three years, over $1t of debt is due, the highest amount in decades. There is also the continuous expansion of the private credit space, fueled by the demand from the PE sponsors to get a solution to help their capital structure recycle their capital and make new transactions. The leveraged loan high-yield market has reached $3t, and the private credit market has reached $1.5t. However, if we compare it with the size of the dry powder of the PE firms and the volume of deals they do annually, there is much room for further growth.
Equities
Mega Cap tech is still leaving the market and for the right reason. They had a positive earnings revision in a year when most companies had a negative earnings revision. However, this remaining relative earnings revision will be challenging to maintain next year, and market performance will be more reliant on the performance of S&P 493.
It’s also interesting to see how the trend is shaping out in the private markets, as deal-making has significantly slowed in 2022 but has started to pick up again. Valuations tend to lag public markets (general partners tend to mark down their valuations less quickly in falling markets), and as public markets bottomed in October 2022, the private market only recently started to recover. BlackRock estimates the Prive Equity industry ‘dry powder’ has reached $4t. That is more than the market capitalization of the entire UK (6th biggest equity market, $3.2T cap as of October 2023) and almost as large as Hong Kong (5th biggest market, $4.3t cap). Although not all committed capital is readily available at any moment, it is planned to be eventually deployed. And with recovery that has just begun, investors should position themselves ahead of the trend.
Source: Black Rock’s 2024 Private Markets Outlook.
Private Equity can offer more flexible and faster financing even in challenging market conditions. It also places more emphasis on long-term growth than the public markets, with more control over investors. In addition to those benefits, abundant funding potential is why companies now tend to stay private longer. In addition, there is a surge in the secondary market with over half of transactions. In 2023, the secondary market saw signs of discounts narrowing from their multi-year highs, indicating a rebound in pricing but offering attractive discounts to reference NAV compared with the historical averages. However, those discounts may be misleading when valuations are in flux, primarily due to ongoing adjustments to the new macroeconomic reality of monetary tightening.
Given the current stage in the cycle, and with valuations way below those in 2021 in addition to healthy NAV discounts, secondaries present an attractive opportunity.