Markets Weekly podcast - 20 February 2023

Henk Potts (HP): Hello. It’s Monday, 20th February and welcome to the Barclays Private Bank Markets Weekly podcast, the recording that will guide you through the turmoil of the global economy and financial markets. 

My name is Henk Potts, Market Strategist with Barclays Private Bank. Each week I’ll be joined by guests to discuss both risks and opportunities for investors. Firstly, I’ll analyse the events that moved the markets and grabbed the headlines over the course of the past week. We’ll then consider the outlook for private credit. Finally, I’ll conclude by previewing the major events and data releases that are likely to shape the week ahead.

Investor sentiment was primarily driven by the macroenvironment last week, as investors faced up to the conflicting forces of robust consumer demand and elevated inflation prints which may require higher peak interest rates versus resilient economic data that is increasingly pointing to a softer economic landing.

In terms of equity performance in Europe, the STOXX 600 rose four out of the five trading sessions last week. The index was up 1.4%, its best week since the week commencing 8th January. It hit its highest level in a year on Thursday. Not such a bright picture on Wall Street. The S&P 500 climbed three-tenths of 1% over the week. The benchmark is now 12%, below its 52-week high on 29th March last year but is still 17% above its low in the middle of October.

Speculation of a 50-basis point hike at the Fed meeting in March pushed Treasury yields higher and strengthened the dollar. The ten-year yield was 3.83% on Friday, the second highest this year. Yields have risen for four consecutive weeks, the longest winning streak since 21st October last year.

Gold prices were under pressure last week and have fallen for a third straight week as the precious metal faced competition from rising bond yields and the stronger US dollar. Gold fell 1.6% last week and is $1,845 an ounce this morning. 

The US inflation report was billed as the headline grabber last week with traders hoping it would confirm the moderation in price pressure is continuing. The print came in slightly higher than expected, suggesting, actually, the easing of price pressures may take a little longer. January CPI rose half of 1% month-on-month and 6.4% year-on-year.

Energy prices picked up and food inflation rose more than expected. At the core level, the services component continues to be driven by shelter and medical, and goods provided a positive contribution again with a pickup in apparel, household furnishings and medical-care commodities. 

While still more than three times the targeted level, we should recognise that year-on-year inflation has decelerated for seven consecutive months, is now back to its lowest level since October 2021, and considerably more digestible than that four-decade peak of 9% that we saw in the summer last year.

In terms of the inflation outlook in the United States, housing price pressures, which are a lagging indicator, should ease as the year progresses. Core goods should remain in deflation due to high retail inventory levels, improving supply chains and increased capacity.

We project that February CPI will rise three-tenths of 1% and the annual rate will slow to 6% year-on-year. As we look further out, we expect that trend to continue. So, we’ve got CPI slowing to 2.9% year-on-year in December, decelerating further through the course of 2024 to finish next year at 2.4%.

The US consumers’ ferocious appetite for goods and services appeared to have diminished at the end of last year, with declines in retail sales in both November and December. However, demand bounced back in January with the value of retail purchases increasing by 3%. That compared to a consensus expectation of around 1.9%.

The recovery in demand was broad-based, with all 13 retail categories registering gains, led by cars, furniture and a 7% surge in restaurants and bars. Demand is clearly being supported by historically low levels of unemployment, high wage growth and excess savings, although we should note these figures are not adjusted for inflation and enthusiasm over the surge in demand should be tempered by potential hangover effects from the exceptionally cold weather at the end of last year, which infringed upon consumption.

Consumption growth during the course of this year is expected to be tempered, given the fact that you’ve got the ongoing pressures on disposable incomes, the weakening economic outlook and our projected moderate increase in terms of unemployment.

So, what does the market deduce from the recent strong labour market figures, the elevated inflation report, the jump that we saw in terms of retail sales? Well, the answer is further pressure on the Federal Reserve. Based on the medium forecast, Fed officials in December pointed to a peak interest rate of 5.1% this year. Traders are now betting that the Fed funds rate will rise to 5.24% in July.

What’s our view? Well, we think the hiking cycle could be extended into June suggesting three more 25 basis point increases in the terminal rate of 5.25% to 5.5% for this cycle.

The other big inflation release of the week, of course, came in the UK. Headline CPI came in at 10.5% for January year-on-year, which represents a third consecutive monthly deceleration and is more palatable than that four-decade high 11.1% that was registered in October. But, CPI still remains in double-digit territory in the UK and five times the Bank of England target level.

In terms of the breakdown, the easing was driven by softer transport, restaurants and hotel prices, which offsets strength in alcoholic beverages and tobacco. Services inflation dropped 80 basis points to 6% year-on-year. Core inflation retreated to 5.8% from 6.3% year-on-year in December, which certainly will come as a relief to the Bank of England.

But it’s probably way too early for the MPC to declare victory over inflation because, number one, part of the improvement was due to a change in the composition of the inflation basket. 

Number two, UK inflation is still elevated compared to the US and Europe, and forecast to moderate at a slower pace than elsewhere, partly due to the ongoing disruption to the supply of labour and goods because of Brexit. We still see UK inflation averaging 7.3% during the course of this year. 

And thirdly, labour markets remain very tight. The unemployment rate in the UK in the fourth quarter was 3.7%, close to the lowest that we saw in the early 1970s. If you look at average pay growth, well, it came in at 6.7% and 7.3% for the private sector, and we should remember that wage growth inflation tends to be stickier than other forms of price pressures.

In terms of the policy impact, the MPC has indicated they are data dependent but despite the recession playing out and rates already deeply into restrictive territory, we do see one further hike, a 25-basis point increase in March, with rates then on hold at 4.25% through the course of this year.

So, that was the global economy and financial markets last week. Fixed income markets have been gathering a lot of attention amongst investors over the past few months. Information on private credit is relatively harder to come by, so we thought we’d go into some more detail today, including looking at the asset class, the current state of the market environment and the outlook for the upcoming year.

In order to do that, I’m pleased to be joined by Ted Goldthorpe. He’s a partner at BC Partners. Ted, great to have you with us today. Can you start by explaining what private credit is and how the market has grown over the course of the past decade?

Ted Goldthorpe (TG): Sure. Well, thank you so much for having me. So, private credit is largely providing debt to either sponsors or companies for their various needs, and it’s all privately negotiated. So, unlike, you know, traditional fixed income markets where the debt is placed amongst many, many different lenders, and done through investment banks, this is all done directly with a counterparty and, typically, involves much fewer counterparties.

So, the market has grown immensely over the last 10 years, and really the big theme is that it’s replacing the banks. So, in the United States, banks had a 94% market share in this space in 2005, and today it’s below 4%.

In the fourth quarter of last year, there were 50 leveraged buyouts done in the US and of the 50 that were done, 48 were done by private credit. So, it’s a large theme that’s been going on for over 10 years, which is largely the alternative asset-management sector really replacing the banks. And this is all corporate lending.

HP: Well, thanks. It’s great to get an understanding of the size of the market and some of the developments that we have been seeing. Now, many investors have experience of traditional fixed income markets over the years so have an idea of what to expect there. How does private credit differ?

TG: Yeah, there are some big differences between private credit and the syndicated markets. Number one is there’s less liquidity. So, a private credit loan you can’t sell versus when you buy bonds, you can buy and sell them, so the underwriting becomes very, very critical. 

Basically, all of private credit is floating-rate debt. So, to the extent that interest rates go up or down, you don’t have these wild swings in your bond prices, like traditional fixed income. And so, this last 12 or 18 months, obviously rising rates have been incredibly good for private credit returns. 

And then the last couple of things are that we typically get covenants in our deals. So, what that means is there’s provisions in the documents that companies must comply with. Largely speaking, the syndicated markets don’t have covenants anymore and so it allows for discussions to happen to the extent that, you know, companies are underperforming. 

And the last thing, you know, the reason the market’s really moved this way is it’s one-stop shopping. So, when a sponsor is buying a company, to buy it, they need committed financing. When they go to a bank, a bank is largely distributing that debt to other people, and it’s distributed broadly amongst many different people. 

In private credit, we call it one-stop shopping. They can come to us, we can provide them with the loan directly, they only negotiate with us, and we can provide them with a lot more certainty. So, in markets like this, which are highly uncertain, one-stop shopping and certainty is a big advantage. Those are really the big differences between traditional fixed income and private credit.

HP: OK. Let’s pick up on one of those major themes that you mentioned, the changes that we’ve been seeing in terms of policy rates. How has pricing in the private credit markets moved over the course of the past 12 months, given the fact that we have seen multiple central bank rate hikes?

TG: Yeah, so all of our private credit in all of the sector is floating-rate risk, and we’re levered not so much to long-term rates, but very, very levered to short-term rates. And so, when the central banks raise rates, they’re really raising short-term rates. So, this has been a massive tailwind for our space. The biggest fear a year ago, was that many private credit providers were going to start cutting spread. So, they would tighten spread just because LIBOR or SOFR was higher and that hasn’t happened, the reverse has happened.

SOFR has gone from 30 basis points to close to 5% and our spreads on a traditional unitranche deal have gone from a 525 spread to more like 700. We really haven’t seen a big deterioration in credit and so it’s been a really, really great thing for our sector.

HP: So, given the fact that you’ve already seen a strong performance, the next obvious question is where do we go from here? So, what’s your outlook for credit markets and where do you see the opportunities in today’s environment?

TG: Yeah, so the big question is we’ve obviously had this tailwind from SOFR, so that’s been a big driver of returns. The number-one issue in our business, in private credit, but also for broad fixed income markets, is credit quality. And so the big question is where are defaults going? 

Companies have done a really, really good job of paying down debt. Coming into 2020, the high yield index, which is just a benchmark for overall leverage, had been deleveraging for a couple of years and interest coverage was at all-time highs. So, even though growth has slowed, companies and corporate balance sheets are still in very good shape. 

And so really if we’re going to see a deterioration in credit, you’re not going to see it for 12 to 18 months, because there’s a lag effect to that. So, I would expect credit markets to become more challenged over the next 12 to 18 months as we go into an inevitable slowdown in growth or a potential recession. 

So, you pull all that together and, you know, I think the outlook is actually very positive, despite the fact that the overall economic environment’s destined to get worse.

HP: Well, OK, let’s pick up on that difficult economic backdrop in some more detail, Ted, if we may. We know all investments carry risks. So, what are the main challenges that could infringe upon the performance of private credit in the coming months and, indeed, over the coming years?

TG: Yeah, so I would say a couple of things. One is definitely defaults, and we talked about that a little bit earlier on this podcast. So, you know, as defaults go up that, obviously, is bad for private credit. Again, we don’t see that happening. There’s very little in the way of near-term maturities, and there’s very little in the way of, you know, companies who are doing materially worse. So, there has been a little bit of challenge on growth. 

There has been some margin compression for all the reasons that are obvious, you know, labour, inflation, supply-chain issues, but again a lot of the headwinds that we saw 18 months ago are now tailwinds. So, supply chains are getting fixed, people are obviously back in the office, so, you know, some of the COVID shutdowns and everything else are now behind us. So, there’s some tailwinds, as well as headwinds to the market. 

The other challenges are twofold and they’re kind of tied together. One is it’s very, very hard in today’s environment to refinance your debt. So, the syndicated markets have largely been closed for over 12 months now, and what that means is if you need to refinance your debt, it’s not as easy as what it was 18 months ago. 

And then the second challenge, which kind of ties into this refinancing challenge, is private credit is obviously a growing space and we have a lot of capital. The liquid fixed income markets, or traditional fixed income markets, dwarf private credit. So, we’ve largely stepped in to basically replace the traditional fixed income markets, but most of us are out of money. 

So, fundraising has slowed down and then because refis have slowed down, we’re not getting a lot of money back and they’re all tied together. So, there seems to be less capital around for debt today and, you know, refinancing of debt is a challenge. So, all of that is an opportunity but also a challenge and, again, they’re all kind of tied together at the end of the day.

HP: Well, Ted, thank you for sharing your insights today. As we’ve discussed in the face of the economic slowdown and rising rates, companies are certainly finding it tougher to access traditional sources of funding. Private credit can fill the gap and help provide borrowers access to a more transparent source of debt, while offering investors the chance to diversify portfolios and, potentially, boost returns for little extra risk. So, certainly an asset class that’s worth monitoring.

OK, let’s move on to the week ahead where the focus in the United States will be on the FOMC minutes on Wednesday. We expect the minutes of the February meeting to provide more detailed information about the FOMC’s assessment of the state of the economy at the time of the meeting, as well as the extent of support for a downshift in the pace of rate increases to 25 basis points.

While the participants’ assessment has likely changed since the meeting, given the fact we have seen that strong dataflow coming through, the minutes should provide more colour around participants’ endorsement of the December summary of economic projections and, in particular, a 5.1% medium dot for 2023.

Also in the US, Friday’s January personal income release will give estimates of household income, consumer spending and the FOMC’s favoured inflation indicator, PCE price inflation.

Considering the retail sales estimate, we expect real personal consumption expenditures to be up 1.1% month-on-month. After folding in the strong income gains from the January employment report, along with the boost to social security income from January’s cost-of-living adjustment, we expect personal income to post a solid 0.9% month on month gain.

Our translation of the CPI and PPI estimates points to a half of 1% increase in both the headline and core measures of PCE prices. 

Moving on to Europe, where on Tuesday we get the purchasing managers’ report for both Europe and, actually, the UK, we expect euro area PMIs to edge slightly higher to 50.5, from 50.3 in January, but remain close to that 50 threshold which would signal no growth. Sentiment may improve in both the manufacturing and services sector, as industry as well as consumers benefit from lower energy prices.

In the UK, we expect February services PMI to move sideways at sub-50 levels, as squeezed disposable incomes from high energy bills and mortgage rates are likely to continue to curtail spending. We expect headline manufacturing to pick up slightly, albeit to stay comfortably in contraction territory. The easing of supply-chain pressures likely acted as a tailwind to output. This would bring the composite PMI to 48.6, which would be consistent with our view of a small contraction in the first-quarter GDP for the UK economy.

And with that, I’d like to thank you once again for joining us. I hope you’ve found this update interesting. We will, of course, be back next week with our next instalment. But, for now, may I wish you every success in the trading week ahead.