Is private credit the next domino?

There was an article in the Wall Street Journal this week discussing the private credit markets and whether or not they could be the next domino to fall in the banking crisis that began last month. This market is referred to as “shadow banking” because it provides loans to companies that are not able to get financing from banks. The industry has grown aggressively since the Global Financial Crisis, and now manages $1.5 trillion in assets, larger than both the High Yield and Leveraged Loan market.

• After the financial crisis regulators cracked down on lending standards at the banks
• Private credit firms stepped into the void, offering loans to companies that the banks would not lend to
• In a very low yield environment, investment firms pitched this strategy to investors as a “yield alternative”
• They use investor capital to make the loans, and distribute the interest to their investors
• Many also use leverage to make the returns higher
• This is the first time this industry is facing an economic cycle
• Given most of the loans are floating rate (they fluctuate based on the general level of interest rates), companies that took loans from private credit firms are now facing higher interest costs
• Combined with weaker financial results given the economic environment, some companies could fall into financial distress (not have ability to make interest payments)
• Combined with leverage that the private credit firms add to their funds (to juice returns), this could put pressure on some of the more aggressive private credit managers
• However, there is also a fair amount of dry powder in distressed funds that would be there to take some of these problem loans off their hands for pennies on the dollar
• It seems to us, similar to the banking crisis, this will likely affect certain firms with the weakest underwriting standards and/or over exposure to industries that may come under relatively more pressure if the economy weakens
• Similar to the banks, at least today, this does not have the makings of a systemic issue

Earnings hang in there, for now

Coming into this year, many expected the S&P to hit last October lows or worse driven by a collapse in earnings. About halfway through the earnings season, we have yet to witness this. 79% of companies that have reported have beat by an average of 6.8%. Areas such as consumer staples, large money center banks, medical devices, pharma, homebuilders, certain technology companies have all outperformed expectations. It is important to remember that earnings are nominal (including inflation). With inflation still running hot it means nominal growth will hold up. The first half of the year is expected to be the worst of the earnings, before they accelerate in the second half into 2024.

• Most on Wall St. expected an earnings collapse this year leading to new lows in the S&P
• Earnings have held so far. Earnings are nominal, meaning inflation helps top-line growth
• Investors will soon turn their attention to 2024, when earnings are expected to be up double-digits
• A weaker dollar, down 12% since September, will be a major tailwind for earnings
• China re-opening and GDP numbers coming in better will also serve as a tailwind for global businesses
• If the earnings collapse doesn’t materialize and the Fed pauses, that could help stabilize the equity markets

Recipe for conflict in Asia?

We have discussed geopolitical risk as one of the main macroeconomic risks in today's environment that is worth paying attention to. We came across this great graphic on Twitter that we thought worth sharing. While the military always exercises in various parts of the world, the activity in this area seems more and more common with potential for unintentional (or intentional) conflict. Credit: @ianellisjones

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