QQQ - Public Or Private? A Strategic Question

2023-05-22 11:30:00 ET

Summary

• We prefer private to public credit long term on better return potential. It’s the mirror image in equity: we prefer public stocks as risks fade in the medium term.
• U.S. stocks hit 2023 highs on hopes for a debt ceiling deal. Yields climbed on odds of another rate hike versus a pause or cuts. We don’t see rate cuts this year.
• U.S. PCE this week will help gauge inflation’s persistence. We see wage pressure from worker shortages keeping inflation above policy targets for some time.

Transcript

The recent banking tumult has reshaped opportunities for income as we navigate a volatile regime.

We now prefer private over public credit long term. We see a mirror image in equity, strategically preferring public to private.

1) We favor private credit

Some private market assets are starting to reprice. We see opportunity in direct lending where yields have increased.

Private credit is not immune to a growth slowdown or tighter credit conditions, but we think higher yields better compensate investors for the risks we see ahead, given the natural implementation lag for investing in this asset class. And that’s after factoring in the risk of worsening credit quality.

The floating rates nature of the asset is an additional benefit in the current rate environment.

2) We see reduced bank lending

The fallout from recent banking tumult is also likely to lead to reduced bank lending.

We think that adds to pressure on public credit spreads but could be a boon for private credit as companies look beyond banks or public markets for financing. Still, we prefer to be up in quality within private credit, with eyes on deal terms and lending standards. We look for quality within private credit.

3) We see a mirror image in equites

Our strategic view on equities is the opposite of credit: We prefer public to private.

We think listed stocks have repriced relatively more, and for those who can look through near-term dislocation, the allocation to public equities should start from an overweight.

Private markets overall are complex, with high risk and volatility, and aren’t suitable for all investors.

We go overweight income private markets and move to neutral on global investment-grade credit. We’re still strategically overweight developed market equities and underweight growth private markets.

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The banking tumult has reshaped opportunities for income: We now favor private over public credit on a strategic horizon of five years and longer. We think private credit could help fill a void left by banks pulling back on some lending and offer potentially attractive yields to investors. We see a mirror image in equity, strategically preferring public to private: public stocks have repriced more than markets like private equity, and we see risks fading over a medium-term horizon.

Yield appeal

Notes: The chart shows yields for direct lending, U.S. high yield debt, U.S. investment-grade credit. The indexes used are: Lincoln Senior Debt (based on valuation data from 2017-2022), Bloomberg U.S. Corporate High Yield 2% Issuer Capped Index and Bloomberg U.S. Credit Index. Indexes are unmanaged and do not account for fees. It is not possible to invest directly in an index.

Investing in private markets takes time. So, we see the repricing in private credit as an opportunity to be nimble with our strategic views and tap into our expectation that private credit can help fill a lending gap left by banks after the recent turmoil. Yields in direct lending, a subset of private credit, have risen (dark orange line in chart). These higher yields may better compensate investors for the risks we see ahead - even after factoring in lower credit quality. U.S. high yield and investment-grade ((IG)) credit yields have faded from highs (yellow and pink lines), but we think they will rise eventually. We go overweight private credit as a result and move to neutral on global IG. Private markets overall are complex, with high risk and volatility, and aren’t suitable for all investors.

The fallout from the banking sector troubles and further tightening of credit conditions adds to the pressure on public credit but could be a potential boon for private credit, in our view. We think the rising interest rate environment and increased competition for deposits will put pressure on banks - and cause them to pull back some lending. We see this making room for non-bank lending and private credit to play a greater role.

Private credit appeal

Private credit refers to a wide range of investments, from direct lending to infrastructure and venture debt. We’re focused on direct lending - financing that is typically negotiated directly between a non-bank lender and a borrower, often a small to mid-sized company. This private credit is mostly made up of floating-rate debt that adjusts with policy rates that we see staying high. We think there are potential benefits from a borrower’s perspective in seeking out non-bank lending. Dealing with one private lender could be easier than a broad group of banks as in public markets. The private nature could also help avoid spooking financial markets, such as with the risks that come with tapping funds from public markets at inopportune times. This demand from borrowers creates an investment opportunity for lenders, in our view: more attractive pricing and deal terms than would have been the case before.

But we think seeking out quality borrowers is key: that means a keen eye on deal terms and lending standards. We have had a conservative view on our assumptions about private credit default losses in our strategic views for some time because private credit is not immune to the credit risk from an economic downturn. Yet, even after allowing for these more prudent assumptions that would be a drag on returns, the wider set of opportunities for private lenders in the wake of the banking fallout, coupled with the divergence between private and public credit yields, is enough to spur an upgrade.

Our strategic view on equities is the mirror image of credit: we prefer public to private. We’re still strategically overweight developed market ((DM)) equities but underweight on a six- to 12-month tactical horizon because a strategic investor can look past some of the near-term pain. And the pressure from tighter credit conditions is also likely to have relented down the road. We remain strategically underweight growth private markets such as private equity. Private equity has started to reprice the tougher macro environment but not as much as publicly traded equities.

Our bottom line

We see the appeal of income in the new regime of greater macro and market volatility and favor private over public credit on a strategic horizon. We see a mirror image in equity, strategically preferring public to private.

Market backdrop

U.S. stocks hit 2023 highs last week on hopes for a debt ceiling solution. Yields climbed on expectations the Federal Reserve could hike rates again instead of pausing at its next meeting. First-quarter earnings contracted for the second straight quarter, but less than expected. Inflation helped revenue and margins as firms passed on higher prices to a still-strong consumer. We think higher financing costs and dwindling savings could start to bite: Earnings expectations look too rosy.

We’re watching U.S. PCE closely this week, the preferred inflation gauge of the Federal Reserve. We expect inflation to remain above 2% policy targets for some time - that’s why we don’t see the Fed cutting rates this year. Global PMIs will help us gauge how much interest rate hikes are hitting economic activity in developed markets.

This post originally appeared on the iShares Market Insights.

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