Quarterly Market Outlook
Q4 2024
Author
Chief Investment Officer
Household balance sheets, once bolstered by Federal stimulus during COVID, are trending back to pre-COVID levels. Excess savings have been widely depleted, and we are beginning to see cracks in the consumer sector as inflationary pressures have outpaced wage growth. While the consumer has shown resilience thus far, we anticipate further challenges in discretionary spending and overall consumer demand, which could be exacerbated by potential economic headwinds.
Much of the household and mortgage debt currently in the market were originated at significantly lower interest rates. As the Fed has begun its easing cycle, the current environment suggests that any meaningful shift in refinancing activity will be slower to materialize compared to past cycles, absent a significant and swift reduction in the Fed Funds Rate. We believe that any Fed easing will take time to have a meaningful impact on households.
Certain segments of the private credit market, such as direct lending, may be more significantly impacted by lower base rates. Direct lending tends to be more exposed to lower base rates as these loans are usually floating rate in nature with low floors. In addition, we continue to observe slight spread-to-quality deterioration in direct lending due to increased competition, also limiting lenders’ ability to compensate for lower base rates.
Private credit returns may not be meaningfully impacted by the Feds initial lowering of base rates. We believe certain sub-markets within asset-based lending and real estate lending are less competitive and can compensate for lower base rates via spread widening. We continue to see attractive asset-based and real estate opportunities, where spreads remain more aligned with conditions we have observed over the past 9 to 12 months.
Stagflation concerns have surfaced in light of the Fed’s most recent actions to lower base rates. The challenge now lies in the Fed’s attempt to balance growth with inflationary risks. Inflation has only recently begun to moderate after running high for several quarters. If the Fed eases too quickly to stave off a recession, we could see inflationary pressures re-emerge. Moreover, external factors, such as geopolitical events and international policy, remain outside the Fed’s control and could impact the inflation-growth dynamic.
- The Lower Middle Market (the non-sponsored segment in particular) has generally exhibited less spread tightening relative to the sponsor-backed Upper Middle Market.
- While recent default rates are slightly elevated relative to the lows of the cycle in corporate direct lending, they remain at modest levels. Overall, private credit has generally offered compelling loss metrics when compared to high yield bonds and leveraged loans (predominantly due to the lenders ability to work with borrowers towards more efficient solutions), and we believe private credit continues to offer attractive risk-adjusted returns relative to equity strategies.
- Commercial real estate (CRE) transaction volumes continue to be suppressed from high interest rates and valuation uncertainties. However, the forward rates outlook suggest a potential rise in transaction volumes.
- A considerable amount of debt from high quality properties is maturing in the upcoming 12-24 months, creating the potential for an attractive opportunity set in bridge lending.
- Residential real estate continues to hold substantial equity value supported by property appreciation and limited supply. Tighter underwriting standards have further strengthened the asset class.
- Rates relative to the post-2008 accommodative Fed policy remain high. Despite initial cuts, some consumers are strained.
- The consumer balance sheet and household waterfall (individual priority of debt payments) needs to be closely monitored in order to reasonably underwrite potential downside scenarios as macroeconomics conditions change (savings, employment, borrowing).
The views expressed in this chart are those of the Investment Team of Nomura Capital Management LLC and are based on the Investment Team’s forward-looking assessment of credit markets as of the date referenced above. The views expressed herein are subject to change at any time following the publication of this report. The arrows in the chart reflect the change in the Investment Team’s outlook of each credit market since its prior quarterly market commentary. This chart is provided for informational purposes only and is not intended to represent a recommendation from Nomura Capital Management LLC to invest in, or divest from, the credit market asset classes referenced herein.
The views expressed in this chart are those of the Investment Team of Nomura Capital Management LLC and are based on the Investment Team’s forward-looking assessment of the general macro-economic environment as of the date of this report. The Bull/Base/Bear Market (“Market Scenarios”) outcome probabilities noted in this report reflect the Investment Team’s forward-looking estimate of the probability of each Market Scenario occurring within the next 12-18 months from the date of this report. The market metrics noted within this report (Growth, Inflation, Unemployment, Risk Assets, Base Rates and Volatility) represent the Investment Team’s forward-looking estimate of each market metric resulting from the corresponding Market Scenario. All views and estimates contained within this report are as of the date of this report and are subject to change at any time following the publication of this report.
Data sourced from Bloomberg
CPI = The Consumer Price Index; PCE = Personal consumption expenditures; Cleveland Fed NTRR = Federal Reserve Bank of Cleveland New Tenants Repeat Rent Index; CPI OER = Consumer Price Index Owners’ Equivalent Rent
Data sourced from Bloomberg
Data sourced from Bloomberg
C&I Large = Commercial & Industrial Large Energy Users; C&I Small = Commercial & Industrial Small Energy Users
Some aspects of consumer inflation, such as insurance costs and geo-political turbulence, cannot be controlled by monetary or fiscal policy.
Chart from Federal Reserve Bank of New York / Equifax Consumer Credit Panel and authors’ calculations
Delinquency is defined as credit card debt that is 30 days or more past due
Consumer spending has remained strong but the stress is starting to show.
Data sourced from Federal Reserve Bank of San Francisco
- We noted in our last quarterly outlook the contraction in the number of FDIC-insured commercial banks from the 1980s to present day. We believe this has contributed to a more difficult environment for small-to-medium enterprises (SMEs) to secure loans from the traditional banking sector.
- Another chart that illustrates the more difficult environment for borrowers to secure loans is net corporate credit creation. The chart below shows net corporate credit creation encompassing investment grade, high yield, broadly syndicated loans, private credit and bank commercial & industrial loans slowing throughout 2024.
1 Data from research report “Credit Growth M.I.A High Yield Strategy” published by Bank of America dated 08.16.2024
In the 5-year period ending 2019 (the “pre-covid period”) global buyout net distributions averaged $71mm per year. Beginning 2020 through 2023 (the “post covid period”) global buyout net distributions have averaged $8mm (i.e. 1/9th of what they were).
These delayed monetizations are creating the need for liquidity solutions such as secondaries, NAV loans, and capital solutions on existing assets and portfolios to enable private equity owners to return capital to LPs.
Chart from Preqin’s database (figures are in billions)
Represents capital called and distributed to LPs across global buyout strategies
- While the current macro environment may suggest various tailwinds for the consumer in the near term given the recent rate cut, we believe that higher unemployment, depleted savings, and lower disposable income might continue to pressure borrowers – especially those with inflated credit scores.
- Although it’s still too early to tell, the 2024 vintage losses in auto loans seem to be tracking 2022/2023 vintages1, which were the worst performing vintages since COVID. Conversely, 2024 vintage losses in unsecured consumer seem to be more contained, most likely attributed to a shift in underwriting style.
Source: JPMorgan Research as of September 3, 2024, focusing only on publicly available US securitization data.
The end point of the 2024 vintage may change in the future as the vintage further seasons, and more data points are contributed over time.
- Large U.S. banks are actively retreating from commercial real estate lending, while small U.S. banks are still over-exposed and decreasing loan growth. As of Q2 2024, 480+ regional banks are exceeding regulator guidance on CRE, equivalent to $340B+ CRE loans exceeding regulator thresholds. The trend of bank retrenchment gives rise to an immediate and growing opportunity in CRE lending for alternative lenders.
Source: Board of Governors of the Federal Reserve System (US)
These materials reflect the opinion of NCM on the date of production. Opinions and statements of financial market trends that are based on current market conditions constitute our judgement and are subject to change without notice. Past performance does not guarantee future results. Where data is presented that is prepared by third parties, such information will be cited, and these sources have been deemed to be reliable. However, NCM does not independently verify or otherwise warrant the accuracy of this information. All investments are subject to risks, including the risk of loss of principal.