Is American Market Dominance Over?

Our Head of Thematic Research in Europe previews the possible next phase of the AI revolution, and what investors should be monitoring as the technology gains adoption.----- Transcript -----Welcome to Thoughts on the Market. I’m Edward Stanley, Morgan Stanley’s Head of Thematic Research in Europe. Along with my colleagues bringing you a variety of perspectives, today I’ll discuss the latest developments around AI Adopters. It’s Tuesday, February the 20th, at 2pm in London.The current technology shift driven by AI is progressing faster than any tech shift that came before it. I came on the show at the beginning of the year to present our thesis – while 2023 was the “Year of the Enablers,” those first line hardware and software companies; 2024 is going to be the “Year of the Adopters,” companies leveraging the Enablers’ hardware and software to better use and monetize their own data for this generative AI world.And the market is still sort of treating this as a “show me” story. Enablers are still driving returns. Around half of the S&P’s performance this year can be attributed to three Enabler stocks. Yet, be it Consumer or – more importantly – Enterprise adoption, monthly data we’re tracking suggests AI adoption is continuing at a rapid pace.So let me paint a picture of what we’re actually seeing so far this year.There has been a widening array of consumer-facing chatbots. Some better for general purpose questions; some better at dealing with maths or travel itineraries; others specialized for creating images or videos for influencers or content creators. But those proving to be the stickiest, or more importantly leading to major behavioral day-to-day changes, are coding assistants, where the productivity upside is now a well-documented greater than 50 per cent efficiency gain.From a more enterprise perspective, open-source models are interesting to track. And we do, almost daily, to see what’s going on. The people and companies downloading these models are likely to be using them as a starting point – for fine-tuning their own models.Within that, text models which form the backbone of most chatbots you will have interacted with, now account for less than 50 per cent of all models openly available for download. What’s gaining popularity in its place is multi-modal models. This is: models capable of ingesting and outputting a combination of text, image, audio or video.Their applications can range from disruption within the music industry, personalized beauty advice, applications in autonomous driving, or machine vision in healthcare. The list goes on and on. The speed of AI diffusion into non-tech sectors is really bewildering.Despite all these data points, suggesting consumer and enterprise adoption is progressing at a rapid clip, Adopter stocks continue to underperform those picks-and-shovels Enablers I mentioned. The Adopters have re-rated modestly in the first month and a half of the year – but not the whole group. Of course, this is a rapidly changing landscape. And many companies have yet to report their outlook for the year ahead. We’ll continue to keep you informed of the newest developments as the years progress.Thanks for listening. If you enjoy the show, please leave a review on Apple Podcasts and share Thoughts on the Market with a friend or a colleague today.

20 Feb 20243min

Our Fixed Income Strategist outlines commercial real estate’s post-pandemic challenges, which could make regional bank lenders vulnerable. ----- Transcript -----Welcome to Thoughts on the Market, I’m Vishy Tirupattur, Morgan Stanley’s Chief Fixed Income Strategist. Along with my colleagues bringing you a variety of perspectives, I'll be talking about the challenges of the commercial real estate markets. It's Friday, Feb 16th at 3 pm in New York.Commercial real estate – CRE in short – is back in the spotlight in the aftermath of the loan losses and dividend cuts announced by New York Community Bancorp. Lenders and investors in Japan, Germany, and Canada have also reported sizable credit losses or write-downs related to US commercial real estate. The challenges in CRE have been on a slow burn for several quarters. In our view, the CRE issues should be scrutinized through the lenses of both lenders and property types. We see meaningful challenges in both of them.From the lenders’ perspective, we now estimate that about a trillion and a half of commercial real estate debt matures by the end of 2025 and needs to be refinanced; about half of this sits on bank balance sheets.The regulatory landscape for regional banks is changing dramatically. While the timeline for implementing these changes is not finalized, the proposed changes could raise the cost of regional bank liabilities and limit their ability to deploy capital; thereby pressuring margins and profitability. This suggests that the largest commercial real estate lender – the regional banking sector – might be the most vulnerable.Office as a property type is confronting a secular challenge. The pandemic brought meaningful changes to workplace practice. Hybrid work has now evolved into the norm, with most workers coming into the office only a few days a week, even as other outdoor activities such as air travel or dining out have returned to their pre-Covid patterns. This means that property valuations, leasing arrangements, and financing structures must adjust to the post-pandemic realities of office work. This shift has already begun and there is more to come.It goes without saying, therefore, that regional banks with office predominant in their CRE exposures will face even more challenges.Where do we go from here? Property valuations will take time to adjust to shifts in demand, and repurposing office properties for other uses is far from straightforward. Upgrading older buildings turns out to be expensive, especially in the context of energy efficiency improvements that both tenants and authorities now demand. The bottom line is that the CRE challenges should persist, and a quick resolution is very unlikely.Is it systemic? We get this question a lot. Whether or not CRE challenge escalates to a broader system-wide stress depends really on one’s definition of what systemic risk is. In our view, this risk is unlikely to be systemic along the lines of the global financial crisis of 2008. That said, strong linkages between the regional banks and CRE may impair these banks’ ability to lend to households and small businesses. This, in turn, could lead to lower credit formation, with the potential to weigh on economic growth over the longer term.Thanks 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.

16 Feb 20243min

Michael Zezas, Global Head of Fixed Income and Thematic Research, gives his take on how the U.S. election may influence European policy on national security, with implications for the defense and cybersecurity sectors.----- 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 impact of the US election on global security and markets. It's Thursday, February 15th at 3pm in New York.Last week I was in London, spending time with clients who – understandably – are starting to plan for the potential impacts of the US election. A common question was how much could change around current partnerships between the US and Europe on national security and trade ties, in the event that Republicans win the White House. The concern is fed by a raft of media attention to the statements of Republican candidate, Former President Trump, that are skeptical of some of the multinational institutions that the US is involved in – such as the North Atlantic Treaty Organization, or NATO. Investors are naturally concerned about whether a new Trump administration could meaningfully change the US-Europe relationship. In short, the answer is yes. But there’s some important context to keep in mind before jumping to major investment conclusions.For example, Congress passed a law last year requiring a two-thirds vote to affirm any exit from NATO, which we think is too high a hurdle to clear given the bipartisan consensus favoring NATO membership. So, a chaotic outcome for global security caused by the dissolution of NATO isn’t likely, in our view.That said, an outcome where Europe and other US allies increasingly feel as if they have to chart their own course on defense is plausible even if the US doesn’t leave NATO. A combination of President Trump’s rhetoric on NATO, a possible shift in the US’s approach to the Russia-Ukraine conflict, and the very real threat of levying tariffs could influence European policymakers to move in a more self-reliant direction. While it's not the chaotic shift that might have been caused by a dissolution of NATO, it still adds up over time to a more multipolar world. For investors, such an outcome could create more regular volatility across markets. But we could also see markets reflect this higher geopolitical uncertainty with outperformance of sectors most impacted by the need to spend on all types of security – that includes traditional suppliers of military equipment as well companies providing cyber security. 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.

15 Feb 20242min

Key developments in China and the U.S. will impact global trade and the growth outlook for Asia in 2024.----- Transcript -----Welcome to Thoughts on the Market. I’m Chetan Ahya, Morgan Stanley’s Chief Asia Economist. Along with my colleagues bringing you a variety of perspectives, today I’ll discuss the risk of re-emerging trade tensions and how this might impact the growth outlook for Asia. It’s Thursday, Feb 15, at 9 AM in Hong Kong.Trade tensions took a back seat during the pandemic when supply-chain disruptions led to a mismatch in the supply-demand of goods and created inflationary pressures around the world. However, these inflationary pressures are now receding and, in addition, there are two developments that we think may cause trade tensions to emerge once again.First is China’s over-investment and excess capacity. China continues to expand manufacturing capacity at a time when domestic demand is weakening and its producers are continuing to push excess supply to the rest of the world.China’s role as a large end-market and sizeable competitor means it holds significant influence over pricing power in other parts of the world. This is especially the case in sectors where China’s exports represent significant market share.For instance, China is already a formidable competitor in traditional, lower value-added segments like household appliances, furniture, and clothing. But it has also emerged as a leading competitor in new strategic sectors where it is competing head-on with the Developed Market economies. Take sectors related to energy transition.China has already begun cutting prices for key manufactured goods, such as cars, solar cells, lithium batteries and older-generation semiconductors over the last two quarters.The second development is the upcoming US presidential election. The media is reporting that if reelected, former President Trump would consider trade policy options, such as imposing additional tariffs on imports from China, or taking 10 per cent across-the-board tariffs on imports from around the world, including China.Drawing on our previous work and experience from 2018, we believe the adverse impact on corporate confidence and capital expenditure will be more damaging than the direct effects of tariffs. The uncertainty around trade policy may reduce the incentive for the corporate sector to invest. Moreover, this time around, the starting point of growth is weaker than was the case in 2018, suggesting that there are fewer buffers to absorb the effects of this potential downside.Will supply chain diversification efforts help provide an offset? To some extent yes, in a scenario where the US imposes tariffs on just China. The acceleration of friend-shoring would help; but ultimately the lower demand from China would still be a net negative. However, in the event that the US imposes symmetric tariffs on all imports from all economies, the effects would likely be worse.Bottom line, if trade tensions do re-emerge, we think it will detract from Asia’s growth outlook.Thanks 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 a colleague today.

15 Feb 20243min

Our expert panel discusses how the Red Sea situation is affecting the global economy and equity markets, as well as key sectors and the shipping industry.----- Transcript -----Jens Eisenschmidt: Welcome to Thoughts on the Market. I am Jens Eisenschmidt, Morgan Stanley's Chief Europe Economist.Marina Zavolock: And I'm Marina Zavolock, Chief European Equity Strategist.Cedar Ekblom: And I'm Cedar Ekblom, Shipping and Logistics Analyst.Jens Eisenschmidt: And on this special episode of the podcast, we will discuss the ongoing Red Sea disruptions and the various markets and economic dislocations caused by it. It's Tuesday, February 13th, 6pm in Frankfurt.Marina Zavolock: And 5pm in London.Marina Zavolock: 12 per cent of global trade and 30 per cent of container trade passes through the Suez Canal in Egypt, which connects the Mediterranean Sea and the Red Sea. Safety concerns stemming from the recent attacks on commercial ships in the Red Sea have driven the majority of container liners to divert trade around the Cape of Good Hope, pushing up container freight rates more than 200 per cent versus December of last year on the Asia to Europe route.Last week, our colleague Michael Zezas touched briefly on the situation in the Red Sea. Now we'd like to dig deeper and examine this from three key lenses. The European economy, the impact on equity markets and industries, as well as on global container shipping in particular.Marina Zavolock: So Cedar, let's start with you. You’ve had a high conviction call since freight rates peaked in the middle of January – that container shipping rates overshot and were likely to decline. We've started to see the decline. How do you see this developing from here?Cedar Ekblom: Thanks, Marina. Well, if we take a step back and we think about how far container rates have come from the peak, we're about 15 per cent lower than where we were in the middle of January. But we're still nearly 200 per cent ahead of where we were on the 1st of December before the disruption started.Cedar Ekblom: The reason why we're so convicted that freight rates are heading lower from here really comes down to the supply demand backdrop in container shipping. We have an outlook of significant excess supply playing out in [20]24 and extending into [20]25. During the COVID boom, container companies enjoyed very high freight rates and generated a lot of cash as a result. And they've put that cash to use in ordering new ships. All of this supply is starting to hit the market. So ultimately, we have a situation of too much supply relative to container demand.Another thing that we've noticed is that ships are speeding up. We have great data on this. And since boats have been diverted around the Cape of Good Hope, we've seen an increase in sailing speeds, which ultimately blunts the supply impact from those ships being diverted.And then finally, if we look at the amount of containers actually moving through the Suez Canal, this is down nearly 80 per cent year over year.Sure, we're not at zero yet, and there is ultimately [a] downside to no ships moving through the canal. But we think we are pretty close to the point of maximum supply side tension. That gives us conviction that freight rates are going lower from here.Jens Eisenschmidt: Thank you, Cedar, for this clear overview of the outlook for the container shippers. Marina, let's widen our lens and talk about the broader impact of the Red Sea situation. What are the ripple effects to other sectors and industries and are they in any way comparable to supply chain disruptions we saw as a result of the COVID pandemic?Marina Zavolock: So what we've done in equity strategy is we've worked with over 10 different sector analyst teams where we've seen the most prominent impacts from the situation in the Red Sea. We've worked as well with our commodity strategy team. And what we were interested in is finding the dislocations in stock moves related to the Red Sea disruptions in light of Cedar's high conviction and differentiated view.And what we found is that if you take the stocks that are pricing in the most earnings upside, and you look at them on a ratio basis versus the stocks that have priced in the most earnings downside. That performance along with container freight rates peaked sometime in January and has been declining. But there's more to go in light of Cedar's view in that decline.We believe that these moves will continue to fade and the bottom group, the European retailers that are most exposed. They have fully priced in the bear case of Red Sea disruptions continuing and also that the freight rate levels more importantly stay at these recent peaks. So we believe that ratio will continue to fade on both sides.The second point is you have some sectors, like European Airlines, where there's also been an impact. Air freight yields have risen by 25 per cent in Europe. And we believe that there is the potential for more persistent spillover in demand for certain customers that look to speed up delivery times.The third point is that in case of an escalation scenario in the Red Sea, we believe that it's less the container shipping companies at this point that would be impacted and we actually see the European refiners as most exposed to any kind of escalation scenario.And lastly, and I think this is going to tie into Jens’ economics.We see a fairly idiosyncratic and broadly limited impact on Europe overall. Yes, Europe is the most exposed region of developed market regions globally – but this is nowhere near a COVID 2.0 style supply chain disruption in our view.Marina Zavolock: And Jens, if I could turn it back to you, how do you estimate the impact of these Red Sea disruptions on the European economy?Jens Eisenschmidt: That's indeed one thing we were sort of getting busy on and trying to find a way to get a handle on what has happened there and what would be the implications. And of course, the typical thing, what you do is you go back in time and look [at] what has happened last time. We were seeing changes to say delivery time. So basically disruptions in supply chains.And of course, the big COVID induced supply chain disruptions had [a] significant impact on both inflation and output. And so, it's of course a normal thing to ask yourself, could this be again happening and what would we need to see?And of course, we have to be careful here because that essentially is assuming that the underlying structure of the shock is similar to the one we have seen in the past, which of course it's not the case.But you know, again, it's instructive at least to see what the current level of supply chain disruptions as measurable in these PMI sub-indices. What they translate to in inflation? And so we get a very muted impact so far. We have 10 basis points for the EU area, 15 basis points for the UK. But again, that's probably an upper bound estimate because the situation is slightly different than it was back then.Back then under COVID, there was clearly a limit to demand. So demand was actually pushing hard against the limits of good supply. And so that has to be more inflationary than in the current situation where actually demand, if anything, is weakened by [the] central bank chasing inflation targets and also weak global backdrop.So, essentially we would say, yes, there could be some small uptick in inflation, but it's really limited. And that's talking about here, core goods inflation. The other point that you could sort of be worried about is commodity prices and here in particular energy commodities.But so far the price action here is very, very limited.If anything, so far, TTF prices are, you know, going in the other direction. So all, all in all, we don't really see a risk here for commodity prices, at least. If the tensions in the Red Sea are not persisting longer and intensify further – and here really, this chimes very well in the analysis of Cedar and also with Marina – what you just mentioned.That doesn't really look like any supply chain disruption we have seen on the COVID. And it also doesn't really look like that it would, sort of, last for so long. And we have the backdrop of a oversupply of containers. So all in all, we think the impact is pretty limited. But let's sort of play the devil's advocate and say, what would happen to inflation if this were to persist?And again, the backdrop would be similar to COVID. Then we could think of 70 basis points, both in the Euro area and the UK added to inflation. And of course that's sizable. And that's precisely why you have central bankers around the world, not particularly concerned about it – but certainly mentioning it in their public statements that this is a development to watch.Marina Zavolock: Thank you Jens, and thank you Cedar for taking the time to talk.Cedar Ekblom: Great speaking with you both.Jens Eisenschmidt: 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.

14 Feb 20249min

Despite a likely softening of the labor market, U.S. consumer spending should remain healthy for 2024.----- Transcript -----Welcome to Thoughts on the Market. I’m Sarah Wolfe from the US Economics Team. Along with my colleagues bringing you a variety of perspectives; today I’ll give you an update on the US consumer. It’s Monday, February 12, at 10 AM in New York.Lately, there's been a lot of mixed data on the health of the US consumer. We saw a very strong holiday spending in November and December; very strong jobs reports in recent months. But we’re forecasting somewhat softer data in January for retail sales. And we know that delinquencies have been rising for households.When we look towards the rest of 2024, we're still expecting a healthy US consumer based on three key factors. The first is the labor market. Obviously, the labor market has been holding up very well and we’ve actually been seeing a reacceleration in payrolls in the last few months. What this means is that real disposable income has been stronger, and it’s going to remain solid in our forecast horizon. We do overall expect some cooling in disposable income though, as the labor market softens. Overall, this is the most important thing though for consumer spending. If people have jobs, they spend money.The second is interest rates. This has actually been one of the key calls for why we did not expect the US consumer to be in a recession two and half years ago, when the Fed started raising interest rates. There’s a substantial amount of fixed rate debt, and as a result less sensitivity to debt service obligations. We estimate that 90 per cent of household debt is locked in at a fixed rate. So over the last couple of years, as the Fed has been raising interest rates, we’ve seen just that: less sensitivity to higher interest rates. Right now, debt service costs are still below their 2019 levels. We’re expecting to see a little upward pressure here over the course of this year – as rates are higher for longer, as housing activity picks up a bit; but we expect there will be a cap on it.The last thing is what’s happening on the wealth side. We’ve seen a 50 percent accumulation in real estate wealth since the start of the pandemic. And we’re expecting to see very little deterioration in housing wealth this year. So people are still feeling pretty good; still have a lot of home equity in their homes. So overall, good for consumer spending. Good for household sentiment.So to sum it up, this year, we’re seeing a slowing in the US consumer, but still relatively strong. And the fundamentals are still looking good.Thanks 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.

12 Feb 20242min

Investors in credit markets pay close attention to the latest economic data. Our head of Corporate Credit Research explains why they should be less focused on the newest numbers and more focused on whether and how those numbers are changing.--------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, February 9th at 2pm in London.Almost every week, investors are confronted with a host of economic data. A perennial question hovers over each release: should we focus more on the level of that particular economic indicator; or its rate of change. In many cases, we find that the rate of change is more important for credit. If so, recent data has brought some encouraging developments with surveys of US Manufacturing, as well as bank lending.I’m mindful that the concept of “economic data” is about as abstract as you can get. So let’s dig into those specific manufacturing and lending releases. Every quarter, the Federal Reserve conducts what is known as their Senior Loan Officer [Opinion] Survey, where they ask senior loan officers – at banks – about how they’re doing their lending. The most recent release showed that more officers are tightening their lending standards than easing them. But the balance between the two is actually getting a little better, or looser, than last quarter. So, should we care more about the fact that lending standards are tight? Or that they’re getting a little less tight than before?Or consider the Purchasing Managers Index, or PMI, from the Institute of Supply Management. This is a survey of purchasing managers at American manufacturers, asking them about business conditions. The latest readings show conditions are still weaker than normal. But things are getting better, and have improved over the last six months.In both cases, if we look back at history, the rate of change of the indicator has mattered more. As a credit investor, you’ve preferred tight credit conditions that are getting better versus easy credit that’s getting worse. You’ve preferred weaker manufacturing activity that’s inflecting higher instead of strong conditions that are softening. In that sense, at least for credit, recent readings of both of these indicators are a good thing – all else equal.But why do we get this result? Why, in many cases, does the rate of change matter more than the level?There are many different possibilities, and we’d stress this is far from an iron rule. But one explanation could be that markets tend to be quite aware of conditions and forward looking. In that sense, the level of the data at any given point in time is more widely expected; less of a surprise, and less likely to move the market.But the rate of change can – and we’d stress can – offer some insight into where the data might be headed. That future is less known. And thus anything that gives a hint of where things are headed is more likely to not already be reflected in current prices. No rule applies in all situations. But for credit, when in doubt, root for a positive rate of change.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.

9 Feb 20243min

Our credit experts from Research and Investment Management give their overview of private and public credit markets, comparing their strengths and weaknesses following two years of rate hikes.----- Transcript -----Vishy Tirupattur: Welcome to Thoughts on the Market. I am Vishy Tirupattur, Chief Fixed Income Strategist in Morgan Stanley Research.David Miller: And I'm David Miller, Head of Global Private Credit and Equity for Morgan Stanley Investment Management.Vishy Tirupattur: And on this special edition of the podcast, we'll be taking a deep dive into the 2024 credit landscape, both from a private credit and public credit perspective.Vishy Tirupattur: So, David, you and I come at credit from two different avenues and roles. I cover credit, and other areas of fixed income, from a sell side research perspective. And you work for our investment management division, covering both private credit and private equity. Just to set the table for our listeners, maybe we could start off by you telling listeners how private credit investing differs from public credit.David Miller: Great. The main differences are: First, privately negotiated loans between lenders and borrowers. They're typically closely held versus widely distributed in public credit. The loans are typically held to maturity and those strategies are typically has that long duration, sort of look. Private credit -- really -- has three things of why their borrowers are valuing it. Certainty, that's committed capital; certainty of pricing. There's speed. There's no ratings -- fewer parties, working on deals. And then flexibility -- structures can be created to meet the needs of borrowers versus more highly standardized parts of the public credit spectrum. Lastly and importantly, you typically get an illiquidity premium in private credit for that holding to maturity and not being able to trade.Vishy Tirupattur: So, as we look forward to 2024, from your perspective, David, what would you say are some of the trends in private credit?David Miller: So private credit, broadly speaking, continues to grow -- because of bank regulations, volatility in capital markets. And it is taking some share over the past couple of years from the broadly syndicated markets. The deal structures are quite strong, with large equity contributions -- given rates have gone up and leverage has come down. Higher quality businesses typically are represented, simply as private equity is the main driver here and there tend to be selling their better businesses. And default rates remain reasonably low. Although we're clearly seeing some pressure, on interest coverage, overall. But volumes are starting to pick up and we're seeing pipelines grow into [20]24 here.Vishy Tirupattur: So obviously, it's interesting, David, that you brought up, interest rates. You know, it's a big conversation right now about the timing of the potential interest rate cuts. But then we also have to keep in mind that we have come through nearly two years of interest rate hikes. How have these 550 basis points of rate hikes impacted the private credit market?David Miller: The rate hikes have generally been positive. But there are some caveats to that. Obviously, the absolute return in the asset class has gone up significantly. So that's a strong positive, for the new deals. The flip side is -- transaction volumes have come down in the private credit market. Still okay but not at peak levels. Now older deals, right, particularly ones from 2021 when rates were very low -- you're seeing some pressure there, no doubt. The last thing I will say, what's noteworthy from the increase in rates is a much bigger demand for what I'll call capital solutions. And that's junior capital, any type of security that has pick or structure to alleviate some of that pressure. And we're quite excited about that opportunity.Vishy Tirupattur: David, what sectors and businesses do you particularly like for private credit? And conversely, what are the sectors and businesses you'd like to avoid?David Miller: Firstly, we really like recurring or re-occurring revenue businesses with stable and growing cash flows through the cycle, low capital intensity, and often in consolidating industries. That allows us to grow with our borrowers over time. You know, certain sectors we continue to like: insurance brokerage, residential services, high quality software businesses that have recurring contracts, and some parts of the healthcare spectrum that really focus on reducing costs and increasing efficiency. The flip side, cyclicals. Any type of retail, restaurants, energy, materials, that are deeply cyclical, capital intensive and have limited pricing power and high concentration of customers.So, now I get to ask some questions. So, Vishy, I'd love to turn it to you. How do returns, spreads, and yields in private credit compare to the public credit markets?Vishy Tirupattur: So, David, yields and spreads in private credit markets have been consistently higher relative to the broadly syndicated loan market for the last six or seven years -- for which we have decent data on. You know, likely reflecting, as you mentioned earlier, illiquidity premia and perhaps potentially investor perception of the underlying credit quality. The basis in yields and spreads between the two markets has narrowed somewhat over the last couple of years. Between 2014 and the first half of 2023, private credit, on average, generated higher returns and recorded less volatility relative to the broadly syndicated loan market. For example, since the third quarter of 2014, the private credit market realized negative total returns just in one quarter. And you compare that to eight quarters of negative returns on the broadly syndicated loan market.David Miller: Something we both encounter is the idea of covenants -- which simply put, are additional terms on lending agreements around cash flow, leverage, liquidity. How do covenants help investors of private credit?Vishy Tirupattur: Over the last several years, the one thing that stands out in the public credit markets -- especially in the leveraged loan market -- is the loosening of the covenant protection to lenders. Cov-Lite, which means, nearly no maintenance covenants, has effectively become the norm in the broadly syndicated loan market. This is one place that I think private credit markets really stand out. In our view, covenant quality is meaningfully better in private credit. This is mainly because given the much smaller number of lenders in typical private credit deals, private credit has demonstrably stronger loan documentation and creditor protections. Maintenance covenants are typically included. And to a great extent, these covenant breaches could act potentially as circuit breakers to better manage outcomes, you know, as credit gets weaker.David, we also hear a lot about the risk of defaults, in private credit markets. How much concern do you have around defaults?David Miller: We are watching, obviously stress on credits and the default rates overall, and they are at historically quite low levels. We do expect them to tick up over time. But there are some reasons why we clearly like private credit from that perspective. First, as mentioned, the covenant protections typically are a little better. If you look historically, depending on the data, private credit, default rates have been, somewhat lower than public leveraged credit and its been quite a resilient asset class, for a number of reasons. We like the amount of private equity dry powder that sits waiting to support some of the companies that are underperforming. And it's important to remember that private credit lenders typically have an easier time resolving some of these stresses and workouts given that they're quite bilateral or a very small group, to make decisions and reach those negotiated settlements. So overall, we feel like there will be a category of businesses that are underperforming and are in structural decline and that will default. But that number will be still very low relative to the universe of overall private credit.Vishy Tirupattur: So David, it’s been great speaking with you.David Miller: Thanks for having me on the podcast, Vishy.Vishy Tirupattur: As a reminder, if you enjoy Thoughts on the Market, please take a moment to rate and review us on Apple Podcasts app. It helps more people find the show.

8 Feb 20248min