US Elections: Weighing the Options

The U.S. stock market is rising to new highs, but investors should still try to minimize risk in their portfolios. Our analysts list a few key strategies to navigate this dynamic.----- Transcript -----Stephan Kessler: Welcome to Thoughts on the Market. I'm Stefan Kessler, Morgan Stanley's Global Head of Quantitative Investment Strategies Research, QIS Research in short.Aris Tentes: And I am Aris Tentes, also from the QIS research team.Stephan Kessler: Along with our colleagues bringing you a variety of perspectives, today we'll discuss different strategies to hedge equity portfolios.It's Monday, the 4th of March at 10am in London.The US equity market has been climbing to record levels, and it seems that long only investors -- and especially investors with long time horizons -- are inclined to keep their positions. But even in the current market environment, it still makes sense to take some risk off the table. With this in mind, we took a closer look at some of the potential hedging strategies for high conviction calls with a quantitative lens. Long only portfolios of high conviction names of opportunities for excess returns, or alpha; but also of exposures to broad market risk, or beta, embedded in these names.While investors are keen to access the idiosyncratic excess return in individual stocks, they often overlook the systematic market and risk factors that come with owning stocks. Rather than treating these risks as uncontrolled noise, it makes sense to think about hedging such risks.Aris, let me pass over to you for some popular approaches to hedging such risk exposures.Aris Tentes: Yes, thank you, Stefan.Today, investors can use a range of approaches to remove systematic risk exposures. The first one, and maybe the most established approach, is to hedge out broad market risks by shorting equity index futures. Now, this has the benefit of being a low-cost implementation due to the high liquidity of a futures contract.Second, a more refined approach, is to hedge risks by focusing on specific characteristics of these stocks, or so-called factors, such as market capitalization, growth, or value. Now this strategy is a way to hedge a specific risk driver without affecting the other characteristics of the portfolio. However, a downside of both approaches is that the hedges might interfere with the long alpha names, some of which might end up being effectively shorted.Stephan Kessler: Okay, so, so these are two interesting approaches. Now you mentioned that there is a potential challenge in which shorting out specific parts of the portfolio and removing risks, we effectively end up shorting individual equities. Can you tell us some approaches which can be used to overcome this issue?Aris Tentes: Oh, yes. Actually, we suggest an approach based on quantitative tools, which may be the most refined way of overcoming the issues with the other approaches I talked about. Now, this one can hedge risk without interfering with the long alpha positions. And another benefit is that it provides the flexibility of customization.Stephan Kessler: Aris, maybe it's worth actually mentioning why better hedges are important.Aris Tentes: So actually, better hedges can make the portfolio more resilient to factor and sector rotations. With optimized hedges, a one percentile style or sector rotation shock leads to only minor losses of no more than a tenth of a percentage point. As a result, risk adjusted returns increase noticeably.Stephan Kessler: That makes sense. Overall, hedging with factor portfolios gives the most balanced results for diversified, high conviction portfolios. One exception would be portfolios with a small number of names, where the universe remaining for the optimized hedge portfolio is broad enough to construct a robust hedge. This can lead to returns that are stronger than for the other approaches.However, if the portfolio has many names, the task becomes harder and the factor hedging approach becomes the most attractive way to hedge. Having discussed the benefits of factor hedging, I think we also should talk about the implementation side. Shorting outright futures to remove market beta is rather straightforward. However, it leaves many other sectors and factor risks uncontrolled. To remove such risks, pure factor portfolios are readily available in the marketplace.Investors can buy or sell those pure factor portfolios to remove or target factor and sector risk exposures as they deem adequate. Pure factor portfolios are constructed in a way that investment in them does not affect other factor orsector exposures. Hence, we refer to them as “pure.” Running a tailored hedge rather than using factor hedging building blocks can be beneficial in some situations -- but comes, of course, at a substantially increased complexity.Those are some key considerations we have around performance enhancement through thoughtful hedging approaches.Aris, thank you so much for helping outline these ideas with me.Aris Tentes: Great speaking with you, Stefan.Stephan Kessler: And thanks for listening. If you enjoy Thoughts on the Market, please leave us a review on Apple Podcasts and share the podcast with a friend or colleague today.

4 Mars 20245min

Our head of Corporate Credit Research explains why the Purchasing Manager’s Index is a key indicator for investors to get a read on the economic outlook.----- Transcript -----Welcome to Thoughts on the Market. I'm Andrew Sheets, head of Corporate Credit Research at Morgan Stanley. Along with my colleagues bringing you a variety of perspectives, I'll be talking about trends across the global investment landscape, and how we put those ideas together.It's Friday, March 1st at 2pm in London.A perennial problem investors face is the tendency of markets to lead the economic data. We’re always on the lookout for indicators that can be more useful, and especially more useful at identifying turning points. And so today, I want to give special attention to one of our favorite economic indicators for doing this: the Purchasing Manager Indices, or PMIs. And how they help with the challenge that economic data can sometimes give us.PMIs works by surveying individuals working in the manufacturing and services sector – and asking them how they’re viewing current conditions across a variety of metrics: how much are they producing? How many orders are they seeing? Are prices going up or down? These sorts of surveys have been around for a while: the Institute of Supply Management has been running the most famous version of the manufacturing PMI since 1948.But these PMIs have some intriguing properties that are especially helpful for investors looking to get an edge on the economic outlook.First, the nature of manufacturing makes the sector cyclical and more sensitive to subtle turns of the economy. If we’re looking for something at the leading edge of the broader economic outlook, manufacturing PMI may just be that thing. And that’s a property that we think still applies -- even as manufacturing over time has become a much smaller part of the overall economic pie. Second, the nature of the PMI survey and how it’s conducted – which asks questions whether conditions are improving or deteriorating – helps address that all important rate of change. In other words, PMIs can help give us insight into the overall strength of manufacturing activity, whether that activity is improving or deteriorating, and whether that improvement or deterioration is accelerating. For anyone getting flashbacks to calculus, yes, it potentially can show us both a first and a second derivative.Why should investors care so much about PMIs?For markets, historically, Manufacturing PMIs tend to be most supportive for credit when they have been recently weak but starting to improve. Our explanation for this is that recent weakness often means there is still some economic uncertainty out there; and investors aren’t as positive as they otherwise could be. And then improving means the conditions likely are headed to a better place. In both the US and Europe, currently, Manufacturings are in this “recently weak, but improving” regime – an otherwise supported backdrop for credit.If you’re wondering why I’m mentioning PMI now – the latest readings of PMI were released today; they tend to be released on the 1st of each month. In the Eurozone, they suggest activity remains weak-but-improving, and they were a little bit better than expected. In the US, recent data was weaker than expected, although still showing a trend of improvement since last summer.PMIs are one of many data points investors may be considering. But in Credit, where turning points are especially important, it’s one of our favorites. Thanks for listening. Subscribe to Thoughts on the Market on Apple Podcasts, or wherever you listen, and leave us a review. We’d love to hear from you.

1 Mars 20243min

Our Global Macro Strategist explains the complex nature of recent U.S. economic reports, and which figures should matter most to investors.----- Transcript -----Welcome to Thoughts on the Market. I’m Matthew Hornbach, Morgan Stanley’s Global Head of Macro Strategy. Along with my colleagues bringing you a variety of perspectives, today I'll talk about what investors should take away from recent economic data. It's Thursday, February 29, at 4pm in New York.There’s been a string of confusing US inflation reports recently, and macro markets have reacted with vigor to the significant upside surprises in the data. Before these inflation reports, our economists thought that January Personal Consumption Expenditures inflation, or PCE inflation, would come at 0.23 per cent for the month. On the back of the Consumer Price Index inflation report for January, our economists increased their PCE inflation forecast to 0.29 per cent month-over-month. Then after the Producers’ Price Index, or PPI inflation report, they revised that forecast even higher – to 0.43 per cent month-over-month. Today, core PCE inflation actually printed at 0.42 per cent - very close to our economists’ revised forecast.That means the economy produced nearly twice as much inflation in January as our economists thought it would originally. The January CPI and PPI inflation reports seem to suggest that while inflation is off the record peaks it had reached, the path down is not going to be smooth and easy. Now, the question is: How much weight should investors put on this data? The answer depends on how much weight Federal Open Market Committee participants place on it. After all, the way in which FOMC participants reacted to activity data in the third quarter of 2023 – which was to hold rates steady despite encouraging inflation data – sent US Treasury yields sharply higher.Sometimes data is irrational. So we would take the recent inflation data with a grain of salt. Let me give you an example of the divergence in recent data that’s just that – an outlying number that investors should treat with some skepticism. The Bureau of Labor Statistics, or BLS, calculates two measures of rent for the CPI index: Owner’s equivalent rent, or OER, and rents for primary residences. Both measures use very similar underlying rent data. But the BLS weights different aspects of that rent data differently for OER than for rents.OER increased by 0.56 per cent month-over-month in January, while primary residence rents increased 0.36 per cent month-over-month. This is extremely rare. If the BLS were to release the inflation data every day of the year, this type of discrepancy would occur only twice in a lifetime – or every 43 years.The confusing nature of recent economic data suggests to us that investors should interpret the data as the Fed would. Our economists don't think that recent data changed the views of FOMC participants and they still expect a first rate cut at the June FOMC meeting. All in all, we suggest that investors move to a neutral stance on the US treasury market while the irrationality of the data passes by.Thanks for listening. If you enjoy Thoughts on the Market, please take a moment to rate and review us on the Apple Podcasts app. It helps more people to find the show.

1 Mars 20243min

As the deadline to fund the government rapidly approaches, Michael Zezas explains what economic effect a possible shutdown could have and whether investors should be concerned. ----- Transcript -----Welcome to Thoughts on the Market. I'm Michael Zezas, Morgan Stanley's Global Head of Fixed Income and Thematic Research. Along with my colleagues bringing you a variety of perspectives, today I'll be talking about the market impacts of a potential US government shutdown.It's Wednesday, February 28th at 2pm in New York.Here we go again. The big effort in Washington D.C. this week is about avoiding a government shutdown. The deadline to pass funding bills to avoid this outcome is this weekend. And while many investors tell us they’re fatigued thinking about this issue, others still see the headlines and understandably have concerns about what this could mean for financial markets. Here’s our quick take on it, specifically why investors need not view this as a markets’ catalyst. At least not yet.In the short term, a shutdown is not a major economic catalyst. Our economists have previously estimated that a shutdown shaves only about .05 percentage points off GDP growth per week, and the current shutdown risk would only affect a part of the government. So, it's difficult to say that this shutdown would mean a heck of a lot for the US growth trajectory or perhaps put the Fed on a more dovish path – boosting performance of bonds relative to stocks. A longer-term shutdown could have that kind of impact as the effects of less government money being spent and government employees missing paychecks can compound over time. But shutdowns beyond a few days are uncommon.Another important distinction for investors is that a government shutdown is not the same as failing to raise the debt ceiling. So, it doesn’t create risk of missed payments on Treasuries. On the latter, the government is legally constrained as to raising money to pay its bills. But in the case of a shutdown, the government can still issue bonds to raise money and repay debt, it just has limited authority to spend money on typical government services. So then should investors just simply shrug and move on with their business if the government shuts down? Well, it's not quite that simple. The frequency of shutdown risks in recent years underscores the challenge of political polarization in the U.S. That theme continues to drive some important takeaways for investors, particularly when it comes to the upcoming US election. In short, unless one party takes control of both Congress and the White House, there’s little domestic policy change on the horizon that directly impacts investors. But one party taking control can put some meaningful policies into play. For example, a Republican sweep increases the chances of repealing the inflation reduction act – a challenge to the clean tech sector. It also increases the chances of extending tax cuts, which could benefit small caps and domestic-focused sectors. And it also increases the chances of foreign policies that might interfere with current trends in global trade through the levying of tariffs and rethinking geopolitical alliances. That in turn creates incentive for on and near-shoring…an incremental cost challenge to multinationals.So, we’ll keep watching and keep you in the loop if our thinking changes. Thanks for listening. Subscribe to Thoughts on the Market on Apple Podcasts, or wherever you listen, and leave us a review. We’d love to hear from you.

28 Feb 20243min

As grocery and dining costs continue to increase, our analysts break down how this has affected consumers and when food prices may stabilize.----- Transcript -----Sarah Wolfe: Welcome to Thoughts on the Market. I'm Sarah Wolfe from the US economics team.Simeon Gutman: And I'm Simeon Gutman; Hardlines, Broadlines, and Food Retail Analyst.Sarah Wolfe: Today on the podcast, we'll discuss what's happening with food prices and how that's affecting the US consumer. It's Tuesday, February 27th at 10am in New York.It was almost exactly a year ago when I came on this podcast to talk about why eggs cost so much at the start of 2023. Here we are. It's a year later and food in the US still costs more. The overall inflation basket and personal consumption expenditures inflation was 2.6 per cent year over year in December; but dining out prices are still up 5.2 per cent. I'd like to admit that grocery prices are a little bit better. They're just a tad over 1 per cent. So we've seen a little bit more disinflation there. But overall food is still up and it's still expensive.Simeon, can you give us a little bit more color on what's actually going on here?Simeon Gutman: Yeah, so food prices measured by the CPI, as you mentioned, up about a per cent. The good news, Sarah, is that your eggs are actually deflating by about 30 per cent at the moment; so maybe you can buy a couple more eggs. But in general, we're following this descent that we started -- about almost two years ago where food prices were up double digits. A year ago, we were up mid single digits. And now we're down to this one per cent level. Looks like they're gonna hold. But so prices are coming in; but not necessarily deflating, but dis-inflating.Sarah Wolfe: Can you help me understand that a little bit better? You mentioned that some commodity prices are coming down, like food prices. So why is overall inflation for food still rising? And dining out, grocery stores, both of them are still seeing price increases.Simeon Gutman: Well, commodity prices, which is the most visible input to a lot of food items -- that's coming down in a lot of cases, and I'll mention some that haven't. But there's many other components into food pricing, besides the pure commodity. That's labor; you have freight; you have transportation. Those costs -- there's still some inflation running through the system -- and those costs make up a decent chunk of the total product costs. And that's why we're still seeing prices higher year over year on average for the entire group of products.Sarah Wolfe: How are grocery sales actually performing though? Are we seeing demand destruction from the higher pricing? Or has unit growth actually been holding up well?Simeon Gutman: First of all, total grocery sales are just slightly negative. We saw a little ray of hope in January, positive for the month; but likely driven by some stocking up ahead of weather events that happened in the country. So we were barely positive. It looked like we were getting out of the negative territory; but the first few weeks of February, we're back into the negative territory. Negative one, negative two per cent.Units are negative. Negative three to four per cent. If we look at CPI as sort of a proxy for the product categories that are doing better than others: dairy and fruit units, those are up mid to high single digits. And as I mentioned, we're seeing egg prices down significantly. We're also seeing a lot of deflation with fish and seafood as well as meat.So, and if you use that as a way to think about the various product categories that consumers are demanding, but overall industry sales are flat to slightly negative; and we think this negative cadence continues going forward.Sarah, let me turn it to you. You monitor the U. S. consumer closely. How big a bite of the US wallet is food right now? Groceries, eating out at restaurants, etc., and how does that compare to prior periods?Sarah Wolfe: Let's start high level with essential spending, which I consider to be groceries, energy and shelter. That typically averages about 40 per cent of household disposable income pre-COVID. And now if you add on all the price increases we've seen across all three categories, it's an additional 5 per cent of disposable income today.And this matters a lot when you're a lower income household and already over 90 per cent of your disposable income was going towards these essential categories pre-COVID. If I look at grocery prices alone, they're up 20 per cent on average since the start of the pandemic. And prior to COVID on a per household basis, they were spending $4,600 a year on groceries. And now that's $5,700 a year. More than a thousand dollars more each year on groceries.The last time we saw such extreme food inflation was the 1980s. Granted, I have to mention that we've also seen a really notable rise in disposable income too. So if you look at grocery spending as a share of disposable income, it's only marginally higher than it was pre-COVID. It was six and a half per cent, now it's seven per cent.What's really driving higher wallet share towards food is this dining out category -- and it's a price and unit story. On the pricing side, we have high labor costs, high food prices still. And on the unit side, there's still a much more notable preference to dine out to enjoy services.And so you mentioned that unit growth has been a lot weaker for groceries. That's not what we're seeing in the dining out space. And overall, it's been driving total food spend as a share of disposable income to high since the early 1990s.Simeon Gutman: So food spending is up a lot. But the situation is somewhat confusing. You have US inflation data and forecasts seem to be suggesting that food prices should be coming down. That doesn't seem to be happening. We're still looking for inflation. Can you talk about the macro factors behind these persistently high food prices?Sarah Wolfe: So as you mentioned, we have seen disinflation, right? So grocery prices are down from 12 per cent year over year in the summer of 2022 to about 1.5 per cent today. Dining out is down from 8 per cent to about 5 per cent. So there's a bit of progress on inflation growth. But price levels are not coming down. They're still rising and that definitely does not feel good to households.The reason we're still seeing a rise in prices, as you've mentioned, are supply chain disruptions, there was an avian flu, and we see very high labor costs. Some of the forward-looking indicators are pointing to more progress on inflation for food, so we know that labor costs are starting to moderate as supply demand imbalances in the labor market are getting a bit better. We know that supply chain disruptions have been unwinding. But all these things together are not pointing to price deflation. Only disinflation. So growth, but at a slower pace.Simeon Gutman: Yeah, so some of this backdrop continues. When can the US consumer expect some kind of relief, and then what data and indicators are you watching closely?Sarah Wolfe: Unfortunately, prices are still going up in our forecast, but they're going to stabilize around one to one and a half per cent year over year for grocery. So kind of where we are right now, that's what we expect for the next year and a half or so. But the price levels are going to remain elevated.As I mentioned in the last response. We know we're watching the supply chain indicators to see if commodity prices start to come up again. If freight costs start to come up again because of geopolitical tensions. We're not seeing any notable rise there yet but we're watching it very closely. And we're also watching what happens with the labor market. Do we continue to see slack in the labor market that'll bring down wages and bring down labor costs? Or do we continue to run a very tight labor market.Simeon, thanks for taking the time to talk.Simeon Gutman: Great speaking with you, Sarah.Sarah Wolfe: And thanks for listening. If you enjoy Thoughts on the Market, please leave us a review on Apple podcasts and share the podcast with a friend or colleague today.

27 Feb 20247min

Our Chief U.S. Equity Strategist reviews how the unusual mix of loose fiscal policy and tight monetary policy has benefited a small number of companies – and why investors should still look beyond the top five stocks.----- Transcript -----Welcome to Thoughts on the Market. I'm Mike Wilson, Morgan Stanley’s CIO and Chief US Equity Strategist. Along with my colleagues bringing you a variety of perspectives, today I'll be talking about the investment implications of the unusual policy mix we face.It's Monday, February 26th at 12pm in New York. So let’s get after it.Four years ago, I wrote a note entitled, The Other 1 Percenters, in which I discussed the ever-growing divide between the haves and have-nots. This divide was not limited to consumers but also included corporates as well. Fast forward to today, and it appears this gap has only gotten wider.Real GDP growth is similar to back then, while nominal GDP growth is about 100 basis points higher due to inflation. Nevertheless, the earnings headwinds are just as strong despite higher nominal GDP – as many companies find it harder to pass along higher costs without damaging volumes. As a result, market performance is historically narrow. With the top five stocks accounting for a much higher percentage of the S&P 500 market cap than they did back in early 2020. In short, the equity market understands that this economy is not that great for the average company or consumer but is working very well for the top 1 per cent. In my view, the narrowness is also due to a very unusual mix of loose fiscal and tight monetary policy. Since the pandemic, the fiscal support for the economy has run very hot. Despite the fact we are operating in an extremely tight labor market, significant fiscal spending has continued.In many ways, this hefty government spending may be working against the Fed. And could explain why the economy has been slow to respond to generationally aggressive interest rate hikes. Most importantly, the government’s heavy hand appears to be crowding out the private economy and making it difficult for many companies and individuals. Hence the very narrow performance in stocks and the challenges facing the average consumer. The other policy variable at work is the massive liquidity being provided by various funding facilities – like the reverse repo to pay for these deficits. Since the end of 2022, the reverse repo has fallen by over $2 trillion. It’s another reason that financial conditions have loosened to levels not seen since the federal funds rate was closer to 1 per cent. This funding mechanism is part of the policy mix that may be making it challenging for the Fed’s rate hikes to do their intended work on the labor market and inflation. It may also help explain why the Fed continues to walk back market expectations about the timing of the first cut and perhaps the number of cuts that are likely to continue this year. Higher interest rates are having a dampening effect on interest-rate-sensitive businesses like housing and autos as well as low to middle income consumers. This is exacerbating the 1 percenter phenomena and helps explain why the market’s performance remains so stratified. For many businesses and consumers, rates remain too high. However, the recent hotter than expected inflation reports suggest the Fed may not be able to deliver the necessary rate cuts for the markets to broaden out – at least until the government curtails its deficits and stops crowding out the private economy. Parenthetically, the funding of fiscal deficits may be called into question by the bond market when the reverse repo runs out later this year. Bottom line: despite investors' desire for the equity market to broaden out, we continue to recommend investors focus on high-quality growth and operational efficiency factors when looking for stocks outside of the top five which appear to be fully priced. Thanks for listening. Subscribe to Thoughts on the Market on Apple Podcasts, or wherever you listen, and leave us a review. We’d love to hear from you.

26 Feb 20243min

The valuations of stocks and corporate bonds, which have been driven largely by macroeconomic factors since 2020, are finally starting to reflect companies’ underlying performance. Our Head of Corporate Credit Research explains what that means for active investors.----- Transcript -----Welcome to Thoughts on the Market. I'm Andrew Sheets, head of Corporate Credit Research at Morgan Stanley. Along with my colleagues bringing you a variety of perspectives, today I'll be talking about trends across the global investment landscape – and how we put those ideas together.It's Friday, February 23rd at 2pm in London.In theory, investing in corporate securities like stocks or corporate bonds should be about, well, the performance of those companies. But since the outbreak of COVID in 2020, financial markets have often felt driven by other, higher powers. The last several years have seen a number of big picture questions in focus: How fast could the economy recover? How much quantitative easing or quantitative tightening would we see? Would high inflation eventually moderate? And, more recently, when would central banks stop hiking rates, and start to cut.All of these are important, big picture questions. But you can see where a self-styled investor may feel a little frustrated. None of those debates, really, concerns the underlying performance of a company, and the factors that might distinguish a good operator from a bad one.If you’ve shared this frustration, we have some good news. While these big-picture debates may still dominate the headlines, underlying performance is starting to tell a different story. We’re seeing an unusual amount of dispersion between individual equities and credits. It is becoming a market of many.We see this in so-called pairwise correlation, or the average correlation between any two stocks in an equity index. Globally, that’s been unusually low relative to the last 15 years. Notably options markets are implying that this remains the case. We see this in credit, where solid overall performance has occurred along-side significant dispersion by sector, maturity, and individual issuer, especially in telecom, media and technology.We see this within equities, where my colleague Mike Wilson, Morgan Stanley’s CIO and Chief US Equity Strategist, notes that the S&P 500 and global stocks more broadly have decoupled from Federal Reserve rate expectations.And we see this in performance. More dispersion between stocks and credit would, in theory, create a better environment for Active Managers, who attempt to pick those winners and losers. And that’s what we’ve seen. Per my colleagues in Morgan Stanley Investment Management, January 2024 was the best month for active management since 2007.The post-COVID period has often felt dominated by large, macro debates. But more recently, things have been changing. Individual securities are diverging from one another, and moving with unusual independence. That creates its own challenges, of course. But it also suggests a market where picking the right names can be rewarded. And we think that will be music to many investors' ears.Thanks for listening. Subscribe to Thoughts on the Market on Apple Podcasts, or wherever you listen, and leave us a review. We’d love to hear from you.

23 Feb 20243min

As traditional financial institutions tightened their lending standards last year, private credit stepped in to fill some of the gaps. But with rates now falling, public lenders are poised to compete again on the terrain that private credit has transformed.----- Transcript -----Vishy Tirupattur: Welcome to Thoughts on the Market. I am Vishy Tirupattur, Morgan Stanley’s Chief Fixed Income Strategist. Along with my colleagues bringing you a variety of perspectives, today we’ll have a conversation with Joyce Jiang, our US leveraged finance strategist, on the topic of private credit.It's Thursday, February 22nd at noon in New York.Joyce, thank you for joining. Private credit is all over the news. Let’s first understand – what is private credit. Can you define it for us?Joyce Jiang: There isn't a consensus on the definition of private credit. But broadly speaking, private credit is a form of lending extended by non-bank lenders. It's negotiated privately on a bilateral basis or with a small number of lenders, bypassing the syndication process which is standard with public credit.This is a rather broad definition and various types of debt can fall under this umbrella term; such as infrastructure, real estate, or asset-backed financing. But what's most relevant to leveraged finance – is direct lending loans to corporate borrowers.Private credit lenders typically hold deals until maturity, and these loans aren't traded in the secondary market. So, funding costs in private credit tend to be higher as investors need to be compensated for the illiquidity risk. For example, between 2017 and now, the average spread premium of direct lending loans is 250 basis points higher compared to single B public loans.Vishy Tirupattur: That’s very helpful Joyce. The size of the private credit market has indeed attracted significant attention due to its rapid growth. You often see estimates in the media of [the] size being around $1.5 to $1.7 trillion. Some market participants expect the market to reach $2.7 trillion by 2027. Joyce, is this how we should think about the market? Especially in the context of public corporate credit market?Joyce Jiang: I've seen these numbers as well. But to be clear, they reflect assets under management of global private debt funds. So not directly comparable to the market size of high yield bonds or broadly syndicated loans.In our estimate, the total outstanding amount of US direct lending loans is in the range of $630-710 billion. So, we see the direct lending space as roughly half the size of the high yield bonds or broadly syndicated loan markets in the US.Vishy Tirupattur: Understood. Can you provide some color on the nature of private credit borrowers and their credit quality in the private credit space?Joyce Jiang: Traditionally, private credit targets small and medium-sized companies that do not have access to the public credit market. Their EBITDA is typically one-tenth the size of the companies with broadly syndicated loans. However, this is not representative of every direct lending fund because some funds may focus on upper middle-market companies, while others target smaller entities.Based on the data that’s available to us, total leverage and EBITDA coverage in private credit are comparable to a single B to CCC profile in the public space. Additionally, factors such as smaller size, less diversified business profiles, and limited funding access may also weigh on credit quality.Given this lower quality skew and smaller size, there have been concerns around how these companies can navigate the 500 basis point of rate hikes. However, based on available data, two years into the hiking cycle, coverage has deteriorated – mainly due to the floating-rate heavy nature of these capital structures. But on the bright side, leverage generally remained stable. Similar to what we’ve seen in public credit.Now let me turn it around to you, Vishy. What about defaults in private credit and how do they compare to public credit markets?Vishy Tirupattur: So when it comes to defaults, unlike in the public markets, data that cover the entire private credit market is not really there. We have to depend on the experience of sample portfolios from a variety of sources. These data tend to vary a lot, given the differences in defining what a default is and how to calculate default rates, and so on. So, all of this is a little bit tricky. We should also keep in mind that the data we do have on private credit is over the last few years only. So, we should be careful about generalizing too much.That said, based on available data we can say that the private credit defaults have remained broadly in the same range as the public credit. In other words, not substantially higher default rates in the private credit markets compared to the public credit defaults.A few things we should keep in mind as we consider this relatively benign default picture. What contributes to this?First, private credit deals have stronger lender protections. This is in contrast to the broadly syndicated loan market – which is, as you know, predominantly covenant-lite market. Maintenance covenants in private credit can really act as circuit breakers, reining in borrower behavior before things deteriorate a lot. Second, private credit deals usually involve only a very small number of lenders. So it’s easier to negotiate a restructuring or a workout plan. All of this contributes to the default experience we’ve observed in private credit markets.Joyce Jiang: And finally, what are your thoughts on the future of private credit?Vishy Tirupattur: The rapid growth of private credit is really reshaping the landscape of leveraged finance on the whole. Last year, as banks retreated, private credit stepped in and filled the gap – attracting many borrowers, especially those without access to the public market. Now, as rate cuts come into view, we see public credit regaining some of the lost ground. So how private credit adapts to this changing environment is something we’ll be monitoring closely. With substantial dry powder ready to be deployed, the competition between public and private credit is likely to intensify, potentially impacting the overall market.Joyce, let's wrap it up here, Thanks for coming on the podcast.Joyce Jiang: Thanks for having me.Vishy Tirupattur: Thank you all for listening. If you enjoy the show, please leave us a review on Apple Podcasts and share Thoughts on the Market with a friend or colleague today.

22 Feb 20246min