MACRO
This week we had many headlines about risk of more sticky inflation caused by continuous wage growth. Investors are slowly loosing hope for return to easy monetary policy maintained for over a decade and start to see past years as an anomaly. Higher costs of capital becoming a new norm, and requiring companies to operate more efficiently. This can separate companies which are more productive and are able to cut costs and manage their capital more effectively. In such environment fundamental analysis will become more important as it will allow to select those firms which are able to perform above higher effective hurdle rate.
RATES
Last year we were in the rate-shock environment, where companies were trying to access shorter-term borrowing to bridge themselves to expected return of a lower interest rates environment. Now companies CFOs and treasurers are getting more convinced with the view that we are in the higher for longer interest rate environment and few are forecasting materially lower rates before the end of 2024. This shift in view makes companies more comfortable with accessing long-term borrowing, even at higher rate. Companies are now wondering if we have seen the peak rates, to find a best time to increase capex, lever up balance sheet or to refinance debt.
CREDIT
We are seeing outflows from a public credit, but this effect is offset by a large credit liquidity flowing from a private credit direct lenders. Private Credit market has grew significantly in recent years, and it’s now approaching size of a High Yield market itself.
Current spreads are 120 bps on IG and 370 bps on HY. By comparing to historical level during slowing economic growth, IG is 10 to 20 bps overpriced for soft-landing scenario and about 80 to 100 bps overpriced in recessionary scenario. For HY we are 75 to 150 bps overpriced for a soft-landing scenario and 300 to 450 bps overpriced for a recessionary scenario.
Although spreads remains tight, the all-in costs of lending increased drastically due to higher rates. Companies with floating rate coupons have seen their interest expense double over the past 12 months, which pose heighten risk in the current condition of slowing economic growth and tightening profit margins. Pressure on issuers is not only from the floating rates, but also from maturing fixed coupons which are up for refinancing and we see some of the shortest maturities on record. The average maturity of the outstanding high yield debt declining from roughly 6.5 years at the end of 2021, to 5 years now, with the refinancing volume expected to pick up drastically in 2024 and 2025.
We are still in the transition period to the higher costs of capital environment. It’s a powerful transition and there is tail risk of potential aftershocks to liquidity, lending conditions and pricing of credit.
EQUITIES
So far this year, the small and mid caps underperformed large caps, which reached long-cycle highs in terms of the relative performance. Furthermore US market performance was mostly driven by technology stocks, while US tech has substantially outperformed the global tech. Both of those drivers lead to current concentration in the US mega-cap tech. In fact mega-cap tech weight in hedge fund long US equity portfolio has been largest in over a decades. Many investors are concerned about over-concentration in those names and are looking for the broadening out of the overall equity market, which strongly depends on the economic outlook, which remains uncertain.
There are good reasons for mega-cap tech concentration. They include: strengths in fundamentals, long history of robust growth, ability to consistently generate high free cash-flow, healthy profit margins and very strong balance sheets. However all those good reasons lead to the high relative valuation. The prospective earnings yield on NASDAQ 100 index is just over 3%, while money market funds and short term treasuries are paying over 5%. Meaning that investors are so confident about mega-cap tech that they no longer require premium for taking equity risk.