The Economic cycle and the implications for private debt strategies
Regardless of where we are in the economic cycle, the most important observation is that there appears to be no imminent bad news out there. This absence of bad news is a key reason why we believe that risk assets likely will continue to perform well despite stretched valuations. But there are risks on the horizon, both economic and political, with the latter being difficult to forecast and less meaningful than the former.
At the macro level, the uncertainties are more likely to lead to short-term volatility than to meltdown. Nonetheless, debt cycles are influenced heavily by micro considerations, for example the supply of and demand for debt, debt servicing metrics, specific industry cycles, debt pricing and downside protection.
The U.S. recovery has been long and slow. At the time of writing, the consensus view is that the economic cycle is transitioning from a stage where the economic recovery has strengthened and policy makers have begun the process of policy normalization to a later cycle stage whereby the pace of recovery has slowed somewhat and interest rate increases are beginning to weigh on growth. The U.S. recovery is showing some peaky characteristics, such as high overall asset valuations, record corporate debt levels and record private market fund raising. Standards for corporate lending have declined, accompanied by a continuing huge appetite for risk. The U.S. is at full employment and the Fed keeps on raising rates. However, corporations are well able to service their debt at current interest rate levels, and default rates remain low (for the time being, at least).
The Eurozone is earlier in its recovery and there is more to come, although growth seems to be stalling at present. The recovery was originally above expectations, but has been more problematic recently. Still, corporate profits are up in major countries, including Spain and Italy. Corporate valuations also seem to have further space to grow. The excess of bad loans is declining gradually such as in Spain where government action has been pronounced, and also more recently in Italy, in spite of recent political machinations. There remains uncertainty about what the ECB will do in the current environment, but growth is stalling somewhat and there remains much more work to be done in both sovereign and corporate debt. The ECB has been in no rush to tighten, but its bond purchase programme is likely to taper down in the third quarter. However, the Eurozone will remain predominantly a low or negative interest rate zone, with extremely yield-hungry investors.
What are the implications for private debt strategies?
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