The advent of costly capital calls for a progressive solution
The market volatility that followed the abrupt end to a decade of ultra-low interest rates has made it clear that interest rates are a major driver of equity market performance. Having been forced to adjust their valuations and growth expectations over the past year, investors need to assess how a structurally higher cost of capital will affect their portfolio strategies in the longer term.
With US interest rates at their highest for 16 years after a rapid succession of hikes, the billion-dollar question for equity investors is how the battle against persistently high inflation will affect corporate earnings and economic growth around the world.
Nearly two-thirds of investors see inflation and interest rates as the macroeconomic factors with the greatest bearing on stock market performance over the next 18 months, according to a new study commissioned by EquitiesFirst and carried out by Institutional Investor. The general consensus is that rate rises are at or close to peaking, but there is certainly room for more surprises.
While markets are looking for cuts to support a slowing economy, policymakers in the US and Europe have warned that interest rates are likely to remain elevated until at least 2024, given that inflation is still well above their target range.
The longer rates remain high, the more business and household borrowers will feel the squeeze from higher borrowing costs. This credit tightening has accelerated in recent months as lenders turn more cautious ahead of an expected recession and look to conserve their own liquidity. More than US$1.1 trillion of deposits have flowed out of US banks since the Fed began its hiking cycle in March 2022.
Defaults on the rise
The EquitiesFirst study – which polled some 300 investment decision-makers across asset management firms, foundations, pension schemes and endowments – shows that the higher cost of capital is casting a cloud over investor sentiment.
Indeed, it could very well trigger the recession that the market has been predicting. Analysts at Deutsche Bank at the start of June argued that a wave of credit defaults is imminent, now that the combination of higher interest rates and tighter lending standards has put an end to a two-decade lending boom fueled by ultra-cheap money. US high-yield bond defaults have risen to 2.1% from 1.1% last year, and loan defaults are up to 3.1% from 1.4% last year. The investment bank sees these peaking at 9% and 11.3%, respectively.
When interest rates were close to zero, even financially stressed firms were able to raise debt and equity capital to continue operating. Now these companies – along with those that are relatively healthy but highly leveraged – may be unable to refinance maturing debt. Accordingly, the number of US businesses filing for bankruptcy is rising fast.
The housing market, meanwhile, could be another casualty of the sharp rise in capital costs, with home prices tipped by some to fall as much as 10-15% this year. Pricier mortgages mean not only that property owners may struggle to repay their debt but also have less disposable income to spend on other things.
All this could wreak havoc on financial markets, especially if leveraged positions need to be unwound quickly, giving investors plenty to think about for the rest of 2023.
Those who choose to stay invested in public markets are also facing higher margin costs and persistent volatility, while bargain-hunters will find it harder to access the capital they need to fund their purchases.
Tackling the capital crunch
With traditional lenders beating a hasty retreat, many borrowers are turning to private credit –financing from non-bank institutions such as asset managers or pension funds.
As investors have been increasing their allocations to private markets generally in recent years, private credit has become one of the fastest-growing asset classes. Private credit assets under management globally surged from US$342 billion in 2011 to US$1.4 trillion last year and are expected to reach US$2.3 trillion by 2027.
Among the various forms of private credit, securities-backed financing is particularly well suited to today’s more volatile and uncertain market conditions. It typically offers lower borrowing costs than unsecured borrowing, and it is flexible, as virtually any asset – from stocks to cryptocurrencies to real estate – can serve as collateral for funding.
Although loans need to be structured carefully, in general risks are limited by the ability of lenders to recover their collateral, allowing them to offer highly competitive terms and rates.
EquitiesFirst has a 20-year track record in providing such financing – which we call ‘progressive capital’. As partners to long-term shareholders, we offer low-cost, flexible funding to help investors pursue new opportunities while maintaining the upside potential from their underlying holdings.
There are no clear answers to the big questions now facing equity investors, but there are clear opportunities for those who can act decisively in uncertain times and are willing to explore pioneering financing solutions.
 MAS, citing Preqin Pro: https://www.mas.gov.sg/news/speeches/2023/private-credit-the-next-key-driver-of-growth-in-private-markets
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