Q3 Outlook & Beyond

Since the inception of our quarterly update reports, we have consistently maintained a forward-looking perspective that emphasizes the significance of public equities and fixed income. However, we recognize that the average allocation of Kinsted clients to public equities is less than 25%, with no exposure to traditional fixed-income securities. In fact, public equities represent only approximately 20% or less of the expected contribution to a client's overall long-term performance. While maintaining our economic outlook's relevance to traditional assets, we are shifting our focus toward unique asset strategies. We aim to offer clients a deeper understanding of why and when we favor specific asset classes and how they can help achieve investment objectives with reduced volatility. Recognizing that traditional public equities alone do not fully capture long-term performance potential; we are committed to providing insights that showcase opportunities beyond the confines of public markets.

In this issue, we will discuss Private Credit, an asset that we are highly optimistic about in the coming years. Following the financial crisis in 2008-2009, banks came under severe regulatory constraints that governed their lending activities. These regulations limited the amount of lending banks could undertake while imposing certain restrictions on the types of loans they could make. Given private debt often involves higher risk or non-traditional lending structures, many of these loans no longer fit within the regulatory boundaries for banks. As a result, traditional banks exited the business, leaving a vacuum that was filled by non-bank financial institutions, such as private credit funds, specialty finance companies, and asset managers.

While banks exited (for the most part) the space, the demand for private credit continues to soar. Private equity sponsors and companies that are already highly leveraged are competing for increasingly scarce and expensive capital. Private lenders are filling the void at more favorable terms for themselves. The current combination of high-interest rates and stricter credit conditions has led to borrowers paying significantly higher costs for debt financing. For instance, by the end of 2022, first-lien private credit deals offered attractive coupons of 12.4%, which is considerably higher than returns from traditional fixed-income investments. One advantage private credit investors enjoy over traditional fixed-income securities is that the interest on private credit is typically floating. Unlike traditional bonds with fixed interest rates throughout the loan term, the interest rate on floating-rate private debt fluctuates based on prevailing rates.

To illustrate, consider the example of a private credit investment paying 8.5% last year. That same investment is now providing the investor with 13.5%. During times of increasing interest rates, private credit tends to perform well, while traditional fixed-income instruments usually lose value. Consequently, private credit has delivered significant returns and diversification benefits to client portfolios, given the environment of the past year.

Moreover, we believe these loans carry less risk because lenders can negotiate stronger covenants. These covenants function as protective measures for lenders, ensuring that borrowers adhere to certain financial and operational guidelines. Strengthening the covenants provides additional security for private credit investors, reducing the overall risk associated with these loans. Overall, we believe the opportunity in the private lending space is currently very attractive.

Howard Marks, a co-founder of Oaktree Capital, recently said the following about private credit, "In my 53 years in the investment world, I've seen several economic cycles, pendulum swings, manias and panics, bubbles and crashes, but I remember only two real sea changes. I think we may be in the midst of a third one today."

Our perspective remains unchanged regarding the current economic environment and its impact on public equities. We believe a recession will begin within the coming quarters due to significant tightening in monetary policy (unprecedented in the past 50 years), along with the reduction of quantitative easing and a notable decline in money supply growth, coupled with banks implementing stricter lending standards. It is important to note that a bear market in stocks has accompanied every past recession.

"Most private asset classes not only provided superior returns versus global equities in bull markets, but also provided more downside protection in bear markets."

From our perspective, the only way to maintain a positive outlook on the equity markets is to believe that "this time it's different" and that all the factors mentioned earlier are no longer relevant. However, it is essential to heed the words of Sir John Templeton, who warned that the phrase "this time it's different" can be perilous. If this phrase becomes increasingly common, it should raise concerns.

In conclusion, our perspective remains unchanged, as we anticipate that the existing economic conditions are poised to result in an impending recession. Historical patterns suggest that such a downturn would likely impact the stock market as well. Therefore, it becomes crucial to possess a diversified portfolio that extends beyond conventional assets in order to mitigate potential risks.