The U.S. Federal Reserve’s surprise decision at the last FOMC meeting to delay reduction of its program of quantitative easing (QE) has, at least for now, left room for interest rates to fall or remain at historically low levels. The Fed has repeatedly stressed that any withdrawal of monetary stimulus would be data dependent, and its decision to maintain the current pace of asset purchases seems to be an acknowledgement that signs of economic growth are still inconsistent. Sentiment indicators, which tend to lead the hard data, show a more optimistic outlook: the U.S. homebuilders’ index, ISM new orders index, and the Conference Board’s metric for consumer confidence are at the highest levels in five years. We have been sanguine about the U.S. economy since the beginning of the year, and believe the last FOMC decision was partly an acknowledgement of the fiscal drag from the recent Washington gridlock, which according to Standard & Poor’s will reduce fourth-quarter GDP growth from 3% to 2.4%. However, the primary impetus for the Fed’s surprise was most likely the frightening rise in capital outflows from emerging market countries. In India, for example, the rupee fell close to 25% since the Fed first announced intentions to “taper” (see “Unleashing the Taper” from our Q2-2013 Investor Letter) as investors feared rising rates in the U.S. would lead to money leaving India and other emerging markets. Over a similar period, the Brazilian real fell to a 4 ½ year low. In order to halt the capital exodus, India, Brazil, and other countries were forced to raise rates and impose capital controls. India even announced that it would subsidize the cost of hedging against fx risks in foreign currency loans, and encouraged banks to solicit high-interest bearing deposits from non-resident Indians living abroad! By postponing its decision to taper, the Fed helped avert a potential destabilization of emerging market economies. The IMF recently warned that the Fed’s exit will need to be carefully managed by emerging market countries, which are struggling with structural problems and will be at most risk of capital flight and sky-rocketing yields. The implication here is that the Fed may maintain its loose monetary policies longer than justified by fundamentals in the U.S. economy alone, and thereby increase long-term inflation expectations. An inflationary tail risk is the biggest threat facing investors over the next few years, in our opinion, and many assumptions about asset class returns during changes in inflation will be untenable. A protracted period of unconventional policy measures has sowed the seeds for a different kind of capital flight than the one the Fed is currently trying to reverse.
The combination of stronger growth and accommodative policy continues to favour risk assets, but not in a straight line as evidenced by the mini riot in credit markets when the Fed signaled its exit from QE. The search for yield is certainly pushing investors further out on the risk curve, increasing the volatility within fixed-income, a sector traditionally considered to be a refuge from choppy markets. Cash as an investment will guarantee losses in real terms. Government bonds in the US and Canada offer 2.5% returns at best. Spread products, such as investment grade and high yield, are only 0.5-3.0% better. With fading interest rate expectations, investors are repositioning for yield rather than capital preservation, and because concerns about company defaults are more muted when rates are lows, the riskiest grades within high-yield are attracting the greatest flows. The lack of yield-bearing investment alternatives is also causing more investors to sell liquidity in exchange for a return premium, and this is a worrisome trend at a time when inflation expectations are greatly underestimated. The price of liquidity will increase dramatically under an inflation surprise, and investors will be more concerned about the return of their capital than the return ontheir capital.
Private credit does derive part of its excess returns from a liquidity premium but unlike in high yield, firm specific risks can be influenced through active management. Embedded in all of our investments are explicit access rights – to information, to management, and to assets, especially cash. Senior liens, controls, and covenants, including a dynamic link between borrowing availability and collateral, reduce agency conflicts and loss of capital. Perhaps private credit’s most important contribution to investor portfolios in the next few years is its inflation fighting properties: short duration loans with minimum coupons that rise with market rates and are overcollateralized by critical assets with values measured in real terms. Private credit is a sanctuary for any capital fleeing the dangers of volatility and inflation.