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A Tale of Two Outcomes
Mid-Year 2024 Reflections


With this mid-year letter, I will take stock of what’s happened so far in 2024, evaluate my predictions from the start of the year, evaluate new concerns that have emerged, and look ahead to the rest of the year. As many of you know, I have been hawkish on inflation, anticipating that it would take longer than predicted to come down and the Fed would not begin to lower rates until the end of the year. I remain confident in these predictions and like many of my peers anticipate that we may see interest rates come down by the end of 2024, or in early 2025.

The big question in my view, however, isn’t when rates will come down but rather what condition the economy will be in when they do. I see two potential outcomes, which serve as the lens through which I’m analyzing current market behaviors. In the first outcome, the economy accelerates and grows, which allows credit conditions to improve. The second possible outcome is that we enter a recession, which could be a proximate reason for why inflation is declining.

It’s a tough call as to which outcome is more likely, but the probability of a recession is increasing as inflation is finally capitulating, yet rates are being kept higher for longer which continues to decrease growth. This has resulted in raising the bar for consumers and companies that are currently stretched from a borrowing point of view.

Until the Fed makes a definitive signal to investors by cutting rates, many remain wary of taking on additional risk. In this state of suspense, big tech companies in the equity world continue to attract capital as they are seen as safe bets. Meanwhile, small caps even in this scenario underperformed in the first half of this year. However, during the month of July, we have begun to see a significant uptick in small cap performance versus large caps and the Mag 7. The Fed has been clear about its data dependency, and the data has begun to reflect a more benign inflation backdrop. In our view, these stocks were previously significantly undervalued in the market, and we believe they will continue to hold significant upside for investors who can weather the uncertainty over the next few months. I believe that were a recession to occur, it won’t be deep, meaning that even in this scenario small caps will still offer attractive risk adjusted returns.

Credit markets are a bit more complex. Right now, investors are willing to own credit because the probability of a recession is still low enough. In liquid markets, default risk is still fairly muted, (the exception being structured credit real estate). Using my lens of two outcomes we can see a true divergence in credit. In scenario one, where the economy accelerates, credit spreads will tighten and there won’t be any significant increase in defaults. People will continue to profit from their existing positions. If, however, there is a recession then credit markets will be stretched, and we may see an uptick in defaults.

Investors continue to buy private credit notwithstanding that is potentially the riskiest part of the credit market right now. This signals that the credit investor is placing their bet on the acceleration outcome and why not? CCCs have rallied and spreads remain tight. As I mentioned above, the only place in the credit market where we continue to see stress is in commercial real estate. Despite, the challenges the next few months may bring in private credit we believe there is still upside in unique and underserved areas experiencing a fundamental mismatch of capital allocation like legal specialty finance.


What Matters Globally

I founded Aperture just 18- months before COVID began, and while the world today feels less tumultuous than it did just a few years ago, there are still two significant wars happening with no end in sight for either. Unfortunately, when it comes to the market - rightly or wrongly - no one seems to care very much. Do I believe that a background of exogenous conflicts could accelerate and make markets unappealing? Perhaps. But investors don’t seem to invest or not based on these ongoing conflicts.

The larger point globally goes back to the big tech companies I mentioned before. It’s well-documented that a small number of mega cap stocks have dominated the S&P (~25-30% of capitalization). Given that risk concentration, investors should still consider whether they want to be overweight to the US market.

Historically, the US market has performed better than any other market in the world, yet so far this year, Europe has outperformed the US. Competitive companies that are exposed to the massive opportunities in AI and GLP-1 have recently emerged in Europe. These companies have the potential to drive the EU market to a rate of return similar to that of the US market. Overall, the EU looks attractive over time as faster growing companies make up a larger percentage of the European ecosystem.


Keep an Eye on Default Rates…if You Can

Over the past few months, I have been keeping a close watch on liability management transactions and liquidity management exchanges. Traditionally, a default rate is based on the percentage of outstanding bonds that default. But this is becoming more challenging to track as private credit continues to grow in size and popularity amongst investors, allowing for more private debt exchange transactions and negotiated resolutions.

In most scenarios private credit workouts do not take the form of a traditional default and look more like a restructuring. These transactions aren’t captured in the overall default rate, making this an incredibly murky metric to understand across liquid and private credit. We would assume this situation would create uncertainty in investors’ minds and increase spreads, but to- date, we have not seen that occur. It seems investors have looked past the fact that they aren’t dealing with the most accurate data.

There is no easy way to explain this situation. Investors may believe that extensions are buying companies enough time to recover through a recession (if there is one), and that interest rates will have come down before the debt has to be refinanced. This can be a dangerous game in my view. You’re increasing the interest expense on the equity owners of the company, and, although you’re buying more time, you are sacrificing flexibility.

In a scenario where a company doesn’t want to refinance it has two options: raise more equity and dilute shareholders or take on loans, in this case through private credit, extend the maturity, and pay more in interest. Those are both acceptable options, but if you choose scenario number two, at the end of that extension you either have to refinance or take more dilution. If you choose the first option, and valuations do not increase enough to offset the cost of additional interest payments, or in the worst-case scenario the risk of bankruptcy increases. The options get fewer in number as the layers in your credit stack increase. As we saw in the recent case of Altice France, complex credit stacks are susceptible to these kinds of transactions, but they materially impair existing creditors’ positions. It can get messy and yet the market seems to be tolerating the opacity.


Past Peak PE Observation

The last two years have been ones of low activity in the M&A market, which has resulted in low levels of distributions in private equity. While I believe that activity will likely pick up in 2025 and create some liquidity in that space as a result, it may also include greater losses or sales at losses in the event of a recession. The result of which will be dwindling returns across the asset class in conjunction to the liquidity challenges that the private fund model creates. As a result, I think we may be past peak private equity allocation and can perhaps expect to see an increased reallocation to more liquid asset classes.


In Conclusion 

Growth or a recession, that is the question. As I posited at the beginning of this letter, a recession is looking more likely, but I don’t anticipate it will be deep or persistent. For now, I think the balance of outcomes is only slightly better than 50% for growth accelerating with inflation receding. Given the volume of elections taking place globally, including the US presidential election later this year, uncertainty in the markets will remain. Surely by the end of the year investors will have clarity on which path the economy will take in 2025. The question for investors today is have they allocated enough capital to risk assets to benefit from the growth, lower rates and lower inflation will engender, even if at first there is a modest recession.

We look forward to continuing to work with our investors to navigate the financial markets throughout the remainder of 2024.

Peter Kraus
Aperture Investors, Founder and CEO



IMPORTANT INFORMATION
_{This letter is for information purposes only and does not provide any professional investment, legal, accounting nor tax advice. All information and opinions contained in this note represent the judgment of Aperture Investors, LLC (“Aperture”) at the time of publication and are subject to change without notice. For more information about costs, risks and conditions in relation to an investment or a service, please always read the relevant legal documents. This note may not be reproduced (in whole or in part), transmitted, modified, or used for any public or commercial purpose without the prior written permission of Aperture. Recipients of this information are deemed to be investment professionals and/or qualified investors that have employed appropriately qualified individuals to manage their financial assets and/or are appropriately informed and experienced as to understand the associated risks of investment. To the extent that any opinions or forecasts are provided, they are as of the dates indicated, are subject to change without notice and may not be revised, may not be accurate and do not represent a recommendation or offer of any investment. Although all reasonable care and attention has been given to the data provided, no liability is accepted for any omissions or errors. Data contained herein should not be relied upon as the basis for any investment decision.}