Global interest rates are near zero and, with massive amounts of quantitative easing by central banks, interest rates are poised to remain low for a sustained period of time. The downward force on interest rates looks to be sustained by continued efforts by central banks, a lack of consumer and business demand in a COVID-19 recovering economy, followed by a demographic trend similar to that of Japan from the 1990’s onward. The implications for traditional fixed income investments may mean very meager or negative returns unless alternatives are found.
The North American economy has experienced a prolonged expansion since the last US contraction during the Great Financial Crisis (“GFC”). After more than 10 years of expansion, COVID-19 has tipped the credit and economic cycle into contraction. As the second time in the last 10 years that we’ve seen zero interest rate policies from central banks, the economy may be in a debt trap which may take longer to recover from. Banks are focusing on existing customers, and these customers should take advantage of current liquidity provided by governments and banks while still available. New borrowing customers may have to rely on alternative lenders now and when banks retrench, existing banking customers may need to focus alternative lenders should additional capital be required.
In the shadow of a global pandemic with 20.5 million people sidelined at the end of April 2020, the U.S. Labor Department reported a record 14.7% jobless rate, the European Commission released projections of Europe’s worst recession in history, India’s unemployed topped 120 million and yet the S&P is close to all-time highs. Wow! Experience from the Global Financial Crisis (GFC) of 2008 gives a sense of what’s to come. How long will the contraction phase last? How will fiscal and monetary policies cohabit? Will the risk-free rate be negative? Will there be a vaccine? What will happen with trade between the US and China? Is a pension crisis looming?
It’s a perfect storm for pension funds as it translates to deteriorating funded status. Strategic asset allocation matters. The returns from public markets will be marginal, volatile and risky. Private capital and its illiquidity premium will outperform at this point in the cycle. A high allocation to a defensive alternative income-oriented portfolio achieved with rotation into assets like private credit and infrastructure will outperform other asset classes.
Many of the traditional monetary and fiscal tools used during the 2008 Global Financial Crisis (“GFC”), have been dulled and will not be as effective in the current pandemic. Europe and the rest of the world will struggle to bounce back as fast as the U.S. from a recession unless China launches a 2009-style stimulus effort. Chinese stimulus looks unlikely as policymakers in Beijing worry that opening up the flow of credit could add to financial instability. The Fed with a traditional monetary response has cut its benchmark interest rate to zero and signaled that rates will remain low or negative until we return to full employment and a 2% inflation rate. Even with the US Government bringing an unprecedented fiscal response by printing trillions in deficit funded stimulus, a 2% inflation rate is likely years away due to demographics and disinflation. The possibility of an extended contraction period or an even longer duration double dip recession is high. Only time will tell if and when we will recover back to pre-crisis economic activity. Will we experience a 95% recession with a U or W shape, or experience an 80% recovery (near depression with an L shape)? Jerome Powell, Chairman of the US Fed has already stated “a V shaped recovery seems unlikely”. For context, the last time the U.S. economy contracted on an annual basis was during the GFC in 2009, when it shrank by 2.5%. The last time it shrank by more than 10% was in 1946 at the end of World War II. Prior to that the U.S. economy shrank by 12.9% in 1932, at the height of the Great Depression. Oxford Economics puts the 2020 Covid-19 Global Pandemic decline at 12% and the loss of 1 million jobs. Capital Economics sees a 10% decline in GDP, TS Lombard 8.4% and Nationwide 8%.
With competition for assets from central banks traditional fixed income investing will be challenged. It’s a perfect storm for pension funds as lower returns translate to deteriorating funded status as liability growth remains consistent while investment returns diminish. The spread between US investment grade yields and those of emerging markets is the widest since 2002 and far wider than during the GFC as investors flee risk. In a low-interest-rate low risk environment, yield will be a more important component of total return for pension funds, foundations and life insurance companies. The average yield on investment grade debt is now sub 4% and declining with similar trends in blue chip public equities. Where should a long-term investor turn to? Below is an example of what a liability hedging defensive strategic allocation might look like to keep fully funded through a contraction.
The repercussions for insurers and pension funds having to endure up to 10 more years of low interest rates may be harsh for their balance sheets. By allocating traditional fixed income to private credit, capital is preserved through the downturn and as the market recovers an experienced manager will protect real returns for investors having incorporated floating interest rate facilities. In the last two major cycles, funds raised in and around economic downturns performed the best according to Preqin (see chart below).
Source: Preqin
Private credit has been an attractive asset class through several cycles as Preqin has shown and particularly attractive in an economic downturn. As public investments get crowded, the large alternative managers will attract larger and larger buckets of capital requiring them to do larger and larger private market deals and crowding out the upper end of private markets and reducing returns invested therein. Demand will exceed supply as large managers will be in competition with pension funds, insurance companies, actors retrenching from emerging markets and central bank fiscal policy. This will force institutional investors to look to smaller asset managers who work in smaller and less liquid markets.
There’s more market volatility to come. If history teaches us anything, it is that periods of crisis can present opportunities for success. There will be winners and some companies will not survive. Although the long-term impacts of this global pandemic remain to be seen, fund managers and investors that are diligent and agile are likely to emerge from this crisis in a position of strength and poised for future success.
Private credit offers an all-weather source of yield with capital preservation.
About Bond Capital
Bond Capital is an award-winning provider of structured business debt and equity to successful business owners and management teams wishing to capitalize for growth, acquisitions, or buyouts. Since 2002, Bond Capital has provided funding and advice to later stage companies with strong management teams and EBITDA between $2 million and $50 million. Bond Capital has been named by Preqin as a top global performer by a private debt fund for each of 2015, 2016, 2017 and 2020. Bond Capital is located in Vancouver, Canada.
Extending is Pretending in 2020 Trying to extend the longest U.S. expansion in 150 years without much economic capacity left to go will be stressful. The global debt-to-GDP ratio recently hit an all-time high at 322%. Total global debt sits at US$253 trillion, according to a report released by the Institute of International Finance (IIF). “The 2020’s will see a greater incidence of debt distress and restructuring,” according to S. Gibbs, an MD at IFF. Erwan Pirou, CIO, AON notes that there is a “[r]isk of a double-whammy.” Pirou went on to state it’s equally concerning that “Lower yields from (ineffective) monetary easing could raise [pension fund] liabilities, while risk-asset returns might fail to provide a counterbalance if they fall victim to slowing economic growth.”
Investing with a Cycle Approach Investment strategy needs to accommodate changes across both economic and credit cycles. At the beginning of an Economic Expansion, senior credit will generally be available and can be supplemented with more junior capital and equity (see Figure 1). In Late-Stage Expansion, senior credit availability will increasingly crowd into junior credit stratums and reduce required equity. During a Contraction, less senior debt will be available leaving junior debt and or distressed debt to fill the gap that gets created. Finally, during Early Expansion, junior capital will start to replace distressed debt until senior debt becomes more readily available. Investing successfully across the credit and business cycles requires presence, consistency, discipline and experience to understand the dynamics at hand.
Preparing for Recession The 2020’s may not be a typical economic cycle with short-term credit availability being the wild card. In addition, some investors posit that this time around we will see up to five longer cycles arrive concurrently at the intersection of economic cycle change : a greying demographic; income inequality; long-term credit; energy source transition; and geopolitical power transition or multipolarity which, when combined, may result in a deflationary debt cycle. Today the financial condition of major developed economies is better off than the last economic cycle Contraction that occurred in 2008. However, in the deflationary debt cycle case, capital markets will lock up, prolonging economic Contraction and the Early Expansion portions of a typical economic cycle (Figure 1). As senior debt contracts into an extended deflationary debt cycle, a larger than normal opportunity set will occur for continued growth in the private credit asset class. Traditional fixed income is not well positioned for this cycle change. This is because refuge in negative-yielding global debt (valued at over $13 trillion) and the prospect of further lowering of rates by central banks may not be feasible for most investors. In September 2019 the Dutch government criticized the European Central Bank’s latest wave of monetary easing, fearing damage to their domestic pension funds. Negative yields impact pension fund and insurance company solvency and increase risk by making asset and liability matching more difficult. While the eve of cycle change is nigh (see Figure 2 that indicates growth is slowing), time remains to seek out non-correlated all-weather strategies like private credit. Current evidence indicates private credit will be the best alternative for investors as it is even less correlated to equities than traditional fixed income. Afterall, interest is meant to be earned not paid.
Investment Implications Stay calm, think long-term and seek out alternative assets to become fully diversified. Complementing the business cycle approach with additional non-correlated strategies will generate attractive risk adjusted returns over time. Every business cycle is different yet similar. During the global financial crisis in 2008, private credit in particular proved its ability to weather steep market declines. Empirical evidence indicates that private credit, through its features of non-correlation, illiquidity and absolute return, is well positioned for the next cycle’s downturn. For those not requiring immediate liquidity, private credit will also offset public market volatility, making it an attractive substitute for high-quality liquid bonds. Finally, private credit managers with full business cycle experience can help asset allocators thrive during a capital dislocation event caused by a cycle change. Recession 2021 here we come! Will we deflate asset prices right back to where we started from?
Interest rates have been declining for nearly 40 years. There are many factors driving the current low interest rate environment: central banks trying to stimulate their economies and or stave off recession; muted inflation; weak global growth; protectionism; ongoing geopolitical uncertainty; aging populations; and the demand for traditional fixed income outstripping supply.
