Deborah Cunningham
After years of ultra-low interest rates, the Federal Reserve’s aggressive rate-hiking campaign has been a nirvana for money market investors. Many have found that spreading their clients’ cash across multiple liquidity vehicles – including money market funds – and time horizons, such as apportioning non-operating cash to higher yielding products, to be a sound strategy. But as inflation continues to fall and the remarkably strong labour market cools, is the blissful environment over as we move to 2024?
We don’t think so. Throughout the tightening cycle, U.S. monetary policymakers have made clear they will not repeat the past mistakes when they assumed inflation had rolled over, only to have it reverse course. When the U.S. Labor Department reported lower-than-expected consumer price index (CPI) data for October, the markets responded with gleeful rallies. But the Fed likely viewed it warily, lest it be just another “head fake,” as Fed Chair Jerome Powell colorfully described inflation’s behavior over the last two years.
Even if inflation truly is falling, it is not where the Fed wants it.
Even if inflation truly is falling, it is not where the Fed wants it. CPI and the personal consumption expenditures index (PCE), the Fed’s preferred measure, still sit above the central bank’s 2% target. If the Federal Open Market Committee meeting opts to hold rates in the 5.25-5.50% range at its December meeting, which we expect, the game is not over.
We think the Fed has entered a ‘higher for longer’ period that will likely extend to at least the second half of 2024. It behoves policymakers to let the lagging impact of monetary policy be fully felt before easing. Plus, Powell would like nothing more than to guide the economy to a soft landing. He has never given up hope that the U.S. could avoid a recession, and his legacy would be boosted if he can pull it off.
This scenario should keep cash managers on cloud nine, even as some investors extend duration to other asset classes. Most liquidity products should continue to mirror the target range with attractive yields. And when the Fed finally starts to reverse course, the broad sector likely will attract asset flows if yields decline slower than other cash options, as has been the case in previous periods of easing.
Inflation: The worst is over?
Global bonds on a tear
Fraser Lundie, CFA
The evidence is mounting up that interest rates have reached their peak. Central Banks are now hellbent on maintaining a ‘higher for longer’ narrative that they hope will regain lost credibility, having underestimated the scale of the tightening job that has been required. Images of Cape Town’s Tabletop Mountain as sighted by Huw Pill of the Bank of England are designed to prepare the market for a long, flat top, ensuring complacency does not allow a re-emergence of problematic inflation. This will likely remain a push-and-pull, cat-and-mouse game in 2024.
A false step will see the bond market punish fiscal profligacy – as Liz Truss found out to her cost last year.
The economy has been surprisingly resilient, but cash buffers built up through the pandemic are now winding down, locked-in low rates are rolling off and, while yields may be lowered by Central Bank cuts, it remains much more uncertain whether spreads at the lower end of the spectrum will be able to come in too. It’s hard to see help coming in the form of top line growth with consumers tightening their belts, facing higher loan payments, greater rewards for saving, and the ill feeling of house prices continuing to adjust downwards. To add further complication, structural economic trends may cause some inflation to be stickier than we would like – climate transition, an aging population and the related greying of the developed market workforce, as well as increased defence spending, all point to lofty fiscal spend. Governments will have their hands full balancing public debts that are rising rapidly with a higher proportion of spending on interest payments. A false step will see the bond market punish fiscal profligacy – as Liz Truss found out to her cost last year. But cutting public services or raising taxes can be politically toxic, particularly in election years. And it’s not just voter confidence that is required – markets are going to be asked to digest a lot of Sovereign new issuance at a time when Central Banks are also attempting to unwind bloated balance sheets.
Hidden pockets of leverage will continue to emerge, although the flip side to this is that higher interest rates may return some discipline to markets – a reminder that you can pay a dividend, but you must pay a coupon. The new regime of higher rates will feel strange and uncomfortable, but really it was the prior time of ultra-low rates and QE infinity that was the abnormality.
Patrick Marshall
After nearly two decades in a low interest rate environment in both the UK and in Europe, the direct lending market is adjusting to a period of higher-for-longer.
Transaction flow is expected to remain subdued in 2024. As we have seen in 2023, low enterprise valuations, exacerbated by higher interest rates, will force private equity investors to hold onto assets for longer in order to make their target returns. This will lead to increased focus on the financing of buy and build strategies, adopted by private equity to grow the value of their existing assets by bolting on small acquisitions to portfolio companies. Furthermore, with a higher cost of debt, focus will be on cost rather than flexibility in loan terms. This should benefit the bank lenders over the unitranche lenders, who have higher return targets. This means that senior secured lending will continue to gain market share over unitranche products in the European loan market.
The sustained higher interest rate environment will benefit investors who have backed conservative direct lending funds. As loans are floating rate assets, investors will benefit from the rise in base rates on loans. However, companies burdened with high levels of financial leverage will continue to struggle under the increased cost of debt. This will put pressure on their debt service coverage covenants and will cause increases in defaults. As a result, restructurings will increase, especially for those direct lending funds that have lent with aggressive loan structures to cyclical companies. Fund raising will be difficult for these funds as investors will continue backing more conservative direct lending strategies.
Some companies will struggle to find liquidity to refinance their loans as they approach maturity.
Some companies will struggle to find liquidity to refinance their loans as they approach maturity. This means that only the strongest and most stable companies will be able to access the market, and companies will have to pay a premium to borrow. This should lead to increased yields on loans and better documentation and protection rights for lenders.
2024 will likely be a great year for direct lenders who have been disciplined in their lending approach, and therefore not dealing with restructurings.
Vincent Nobel
The interest rate rises we have seen have been a direct benefit to floating rate debt investors, such as those invested in real estate debt. The relative volatility in the underlying real estate market has caused bank lenders in particular to reduce their lending appetite, which has helped the margins that non-bank lenders can charge on new loans. For new investments, lenders have seen both rates and margins rise, showing the relative value the asset class can deliver.
With rates now closer to long-term normal levels, we have seen the real value that real estate debt can have in an investor’s portfolio. Senior real estate debt portfolios continue to deliver income in line with underwriting, albeit with collateral that has lost some of its realisable value since those loans were made. However, with many senior loans having been made at modest leverage, the expectations are that impairments on senior loans should be minimal.
As a senior lender, our strategy is specifically designed to work in “all seasons”, which means that the question of where rates go next year should be less relevant to us. The portfolio should perform in all scenarios. A reduction in rates will typically help the asset values of the properties that serve as collateral for our loans. Rates rises will increase the returns on our existing loans. Higher rates do, however, add refinancing pressure for our borrowers, who will have to repay our loans in due course with more expensive debt. This is not a problem when rates movements are modest, but the moves we have seen in recent times have not been modest.
2024 will likely be a great year for direct lenders who have been disciplined in their lending approach, and therefore not dealing with restructurings.
Some companies will struggle to find liquidity to refinance their loans as they approach maturity. This means that only the strongest and most stable companies will be able to access the market, and companies will have to pay a premium to borrow. This should lead to increased yields on loans and better documentation and protection rights for lenders. 2024 will likely be a great year for direct lenders who have been disciplined in their lending approach, and therefore not dealing with restructurings.
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