The Credit Sun Also Rises

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It would be an understatement to say that the second quarter’s volatility left global investors on the edge of their seats. Rising rates continued to rock the equity and credit cages as the risk-off sentiment persisted, driving spreads and yields wider and stunting the primary markets. We continue to live in an ever-evolving market and dare we say, one that feels a bit aimless. The economic outlook has rapidly narrowed as we continue to combat historic levels of inflation paired with the reality of an ensuing recession and slowing growth. Market volatility has evolved from the initial January jitters that focused on high-valuation, high-multiple growth companies recalibrating downward, to the reality of rising rates and the end of cheap money. The market’s oscillating direction of travel has created an environment that can feel manic at times; however, we do continue to believe that amidst the volatility and as we now enter the back half of the year, the public markets have priced in much of the risk in the system to date, and the private markets have also begun to adjust.

As global central banks continued onward with their hawkish moves, the pulse of the market began to hone in on the resulting economic implications. The market grew more defensive when, despite a strong labor market, the quarter cemented no growth, and consumer sentiment echoed a negative tone globally. Indeed, the past quarter was a stark reminder of how hard it is to price uncertainty. And we were all reminded how much the market dislikes uncertainty. We witnessed that sentiment unfold through the scaled pricing pressure downward and volatility, which often times did not connect back to core fundamentals.

As we reflected on the second quarter we were reminded of Hemingway’s timeless 1926 novel The Sun Also Rises. Jake Barnes, the protagonist, yearns for direction while embarking on the exhilarating, but chaotic, running of the bulls in Pamplona, Spain. Hemingway’s renowned novel captures the common struggle of being uncomfortable. We all navigated significant turbulence in 2020, and yet, today’s volatility is creating a new level of discomfort. Why? The post-war world in which disenfranchised expatriate Jake yearns for meaning has uncanny similarities with the one we are operating in today. It also resembles what we feel to be a “leaderless” market, where the lack of consensus, depth of capital and conviction on the go-forward investment sentiment has manifested into chaos. We continue to yearn for stability in the aftermath of the pandemic, but the implications born from the 2020 drawdown continue to ripple through the financial ecosystem. As investors and market participants look to find their footing in this market, we look to Hemingway’s masterful prose in an effort to distill this market’s bull run of an existential journey.

The starting jolt to the year prompted us to look to Jack London in our first quarter note, Call of the Market Wild, which reminded us to embrace and learn how to thrive in the market’s wild. The second quarter’s persistent volatility and macroeconomic headwinds only confirmed our thesis that it is critical to have an expansive credit toolkit to thrive and navigate the market’s twists and turns. It also affirmed our view that having an agile, multi-strategy and interdisciplinary approach to investing, originating and structuring capital solutions and credit opportunities is more relevant now than ever. Although this approach to portfolio management has not fully proven itself out to date, we continue to believe it is the optimal long-term positioning strategy for both public and private credit markets. 2022 has already introduced new headwinds that few could have predicted and has also underscored the interconnectedness of global markets. Meanwhile, the elevated and sharp declines in public debt and equity markets have raised concerns about the structural bifurcation between public and private credit markets.

We have seen this dynamic play out with liquidity needs and broader asset allocation decisions and models. For example, in the liquid markets increasing redemptions on the basis of asset allocation rebalancing contributed to downward price pressure. With few new flows coming in, lack of CLO creation and an anemic forward pipeline, volatility was exacerbated. On the other hand, in private markets, where capital is locked up for longer periods, there was a less immediate and noticeable mark-to-market (“MTM”) impact as the risk-off sentiment permeated the markets. The private credit markets appear to be in better shape, albeit are starting to adjust now post the public market drawdown, and have experienced less volatility, in part as there is less of an ability to force sell assets. More importantly, the private markets continue to exhibit steady leadership. As we think about dispersion between public and private markets, it has become more apparent that there has been a structural breakdown in public markets, and as a result, they have experienced the brunt of this market’s wrath.

Drawdowns of High Yield over History

We believe the whipsaw will persist for the near-term. It appears inevitable that the U.S. economy has already entered a technical recession and, most of Europe is already in a recession. Thus growth will remain challenged. The current environment highlights the complexity of the central banks double-edged sword predicament. Ultimately, the central banks will have no choice but to continue to keep rates higher for longer, but a deep recession may provoke a more dovish response going forward. So, amidst the fog and slog of this market, we are cautious, but also feel conviction that there are now attractive entry points into both public and private credit. The market may appear directionless as we continue to go through the motions of day-to-day combat, but as Hemingway demonstrates to us, this is our time to get in the ring with the bulls. We are relying on our regimented approach to credit investing and selection to give us a clear perspective against the market’s visceral and bull-like behavior, similar to the calm of mind Jake achieved on a fishing trip in the Spanish countryside. Having a disciplined approach to deploying and investing capital is paramount in this environment. This frenetic market requires not only the traditional playbook but also patience, ingenuity and discipline of process.

Key Themes

As we look across the blurred edges of this market, we highlight the following themes:

  1. Structural bifurcation of leadership between public and private markets
  2. Volatility continues to be predominantly disconnected from fundamentals
  3. Why Credit Now