Since the Federal Reserve’s historic rate hike campaign and yield curve inversion in late 2022, we have now been waiting for an economic downturn. We have not seen one yet, and that has economists in every single place baffled. The lingering impact of the COVID pandemic has actually made this cycle unique. But there are other forces at work, moving more slowly but potentially longer-lasting, that designate the divergence between the economy and traditional economic indicators.
First, the means of lending has modified dramatically in a comparatively short time frame, representing a hidden but powerful force on the broader economy. Private capital markets – including enterprise capital, private equity, real estate, infrastructure and personal credit, in addition to other asset classes – have greater than tripled in only 10 years to almost $15 trillion today. While this is barely a fraction of the $50.8 trillion public stock market, the general public market increasingly includes investment vehicles comparable to ETFs and is more focused on large corporations that will not be representative of the general economy.
The appeal of personal markets
The banking crises and public market volatility have allowed private capital markets to achieve market share by offering more stable capital to borrowers and providing their investors with above-average returns through higher rates of interest on longer-term capital. Investors in search of to maximise their Sharpe ratios in a zero-interest-rate world over the past decade found that the perfect approach to achieve this was to tie up their capital with managers who could generate uncorrelated and above-market returns. An unintended consequence of this, nevertheless, has been the weakening of the causal chain between traditional economic indicators comparable to the yield curve, an indicator of bank profitability, and the true economy, as banks and other traditional providers of capital are not any longer the first source of capital for the economy.
This shift has increased the variety of capital providers but in addition fragmented capital markets. Borrowers today have more options but in addition face the challenge of finding the proper capital provider for his or her business. This significantly increases the worth of the lending process that brings lenders and borrowers together within the capital markets and is traditionally carried out by Wall Street firms.
After the repeal of the Glass-Stegall Act in 1999, large banks and broker-dealers began acquiring one another or merging. The reason for these mergers was to attempt to grab low cost capital from depositors and use it within the higher-margin brokerage business. This ultimately led to an excessive amount of volatility within the economy, as seen through the global financial crisis, and regulations comparable to the Dodd-Frank Act were put in place to guard depositors from the risks of the brokerage business. Wall Street firms are notoriously insular, and increased regulation only complicated the flexibility of those firms to work across business lines and supply efficient capital solutions to their clients. This created space for personal equity firms, that are also less regulated, to steal clients from traditional Wall Street firms by offering more progressive and versatile capital solutions.
The compromise
Investors’ demand for uncorrelated and low-volatility returns has necessitated a shift to less liquid investment instruments within the private capital markets. Because managers of those instruments can lock in investors’ capital for the long run, they can provide more stable capital solutions to their portfolio corporations and are less vulnerable to the vagaries of the general public markets. This longer time horizon allows managers to supply their portfolio corporations more flexibility and even delay the conclusion of losses.
This signifies that the implied volatility and rates of interest measured in the general public market are less informative of the broader real economy, as they only represent the worth of capital and liquidity of short-term entities comparable to hedge funds, retail investors and asset managers. The cost of capital of entities with real money comparable to pension funds, endowments and insurance firms is best reflected in private capital markets.
The result’s that, as a result of the expansion of personal capital markets, we have now replaced credit risk with liquidity risk in the broader economy. When rates of interest are low, the longer term value of a dollar is higher than the current value of that very same dollar. This lowers the natural demand for liquidity and increases the capability for credit risk, delaying the last word realization of intrinsic value. In these environments, narratives dominate investment fundamentals.
The changing playbook
This changes the sport for corporations by way of how they finance and grow their businesses. Companies can stay private longer as they increasingly find long-term investors within the private markets and will not be subject to the upper costs and restrictions of the general public markets.
Source: @LizAnnSonders
The rules of the sport for mergers and acquisitions have modified, the variety of publicly traded corporations that might be taken private has shrunk and the marketplace for financing these transactions has modified. In the past, a Wall Street bank might offer a bridge loan for an acquisition, followed by a everlasting capital placement. Today, buyers can work with hedge funds, private equity and family offices to acquire each short-term and long-term capital, making a type of one-stop shop for corporate financing.
As private markets change into more popular, there’ll inevitably be a democratization of access to those attractive investments in the longer term. However, to get the masses to speculate in these sophisticated strategies, their liquidity will must be increased, which in turn will impact managers’ ability to allocate long-term capital and delay fundamental realization events. This will result in a reversal of the recently observed trade-off between credit and liquidity risks and ultimately restore the link between traditional public market-based economic indicators and the true economy.
