The inflationary environment and private credit investing

Transcript

As we saw, really no more recently in the 1970s into the Volcker tightening of inflation, it's hard to actually put a damper on it. Now, there are a few reasons for this. Wages, which tend to be a source of further inflation, do tend to go up. People feel the pinch, you know, in their spending. There's usually a tight labor market associated so they can demand more cash because they need to meet rising expenses. Of course, that then increases their budgets, which can further increase inflation.

This is why it's so hard to really effect a true soft landing. We want one. We'd love to see the Fed pull that off. And in many ways, this is about as soft as you could imagine. But what you're left with is a little bit of persistent inflation to really curb the problem of too many dollars going after too few things, which is just inflation: price divided by quantity. You need the dollars chasing it to go down, and you need a contraction in spending, or you need to significantly increase production. With a landing that's too soft you're not really going to curb demand. You're not going to curb the dollar flowing in. And it takes a long time to ramp up production. Especially at these higher interest rates, it's actually harder to increase production today. If I were to go out and say, "I'm going to build a new factory," I'd face a much higher lending regime.

And so, we're stuck with a situation where it's obviously much lower than it was. We seem to be out of the acute phase, but how do we get back down to the Fed target is a much harder question. We haven't really broken the demand side yet. People are still reaching for credit. Credit card utilization is near multi-decade highs. That's just one form of consumer credit creation. But the dollars aren't slowing down yet, which many people see as good growth has been a positive surprise to the economy.

But because you can't turn production on overnight and you're less incentivized to grow production at high interest rates, it does leave us with a persistent inflation that looks set to stay above the Fed's interest rate target barring a material downturn. Now this creates opportunities as well as risks for investors. And so when I look out at the equity price earnings and what that implies about the forward path of earnings versus the bond yield, one of those has to give either we're going to break the back of inflation and the Fed can lower rates.

Now we've had a bit of an adjustment in expectations. Ten-year bond yields have drifted back up signaling a higher and longer path of interest rates but still implying a rate cut with an inverted yield curve. Contrast this with fairly dramatic expectations for growth and earnings. And you say, "Well, where's that falling inflation going to come from?" If companies are earning more despite a slowdown in China, despite trade tensions, despite global conflict, despite election uncertainty that has to be cut because of a strong U.S. consumer or strong U.S. business investment. Both things contribute to that demand, that pours into inflation. And so as we see it, you don't have to have a strong view on either. You just have to recognize the tension and recognize that you may get more correlation between stocks and bonds than you'd like if things go up and only get protection in the event of a high recession risk event.

While these are short term forces that will continue to evolve over the course of this year, especially given the upcoming election, it's still worth considering how this plays with longer-term views and private markets. And so one place we remain consistently excited is in the niche side of private credit. And the reason for that is in the loans, if you segment all loans made into larger than 200 million and smaller, on that smaller side, these tend to be entirely floating rate. And so you're sort of agnostic to where the Fed goes from here. And by proxy where inflation goes, if the short rate goes up so far will go up. Your underlying rate will go up and you will continue to earn commensurate with that higher rate. And if it goes down, yes, you will earn less high of a rate. But often that coincides with spreads contracting because capital got easier. And so you'll still experience positive performance in many cases despite that slightly lower current pay yield.

So we like private credit as a hedge against duration risk in a world like this where bond pricing still looks aggressive, it can still deliver pretty consistent income to investors, well not overloading on risk. The flip side of that is we are pretty wary of the large loan space. There's a mix; they're floating and fixed, but more often it's fixed and floating. And so you have the same duration risk yet in public bonds. And when we look at the year, the spreads, that's the spread over what I can earn on a risk-free bond. You know, it's 4 or 5 maximum, 6%. And when we look at the balance sheets of those companies, how geared are they to growth factors like sales, like margins which can get hit by inflation. And we back into a risk number. It looks a lot like we're getting 5 to 6% excess return for 15 to 17% risk. That's just an equity. But I don't get equity like upside in these loans. The best that can happen is I get paid back and no one defaults.

And so, entering more uncertain times macroeconomically, it's really important to think about how to build multiple ways to win, which is why we really like breaking private credit into segments that have truly different aspects as it relates to how they're going to perform next to public market asset classes over the next 18 months.