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06.15.2023

Aperture Investors Mid-Year Letter 2023

Rising Rates, Banks in Stress, and Slowing Growth (It Could Be Worse)
Mid-Year 2023 Reflections 


Summer here in New York City is very much upon us. In the middle of the year, I typically like to pause and take stock of the prior six months. Events that have occurred this half were in some cases predictable, and in some cases unexpected.  In some cases, the changes are merely flashes in the pan, yet others may prove persistent. In reflecting on the first half of the year, some of my views about which I wrote at the outset of 2023 remain consistent, and some of my outstanding questions have been answered.  

Up, Up, and Away?
My first outstanding question was how long will inflation last and rates remain elevated? Though inflation in the developed world has reached levels not seen in decades, the Fed has since indicated they won’t increase rates dramatically relative to what they have to date. Powell recently said not to expect 2% targets until 2025, which aligns with what I’ve been saying since 2021 - it’s going to take longer than you think. In 2021, we reached an inflection point from the prior 10-year trends. And at that point, I thought it would take roughly four years to tame inflation. Between now and 2025 though? I believe investors should expect rates to come down in the latter part of 2024.

Another question that loomed large earlier this year was around China’s re-opening after it ended its zero-COVID policy. I believe that China has been crystal clear on what they’re going to do. They’re embracing technology – including Artificial Intelligence, or “AI” (more on that later), they’re going to continue to stabilize the property market without overstimulating it (no small feat), and they’re going to work to convince the world that they love foreign investors. While it may take a long time to win back the trust of foreign investors (and I anticipate their success in that area will be less than what they want), I think it will be an improvement from the situation today.

It was unclear in January if nominal growth rate could surpass declines in unit volumes caused by the Federal Reserve’s restrictive monetary policy actions. The answer we now know to be “no”; earnings are going to be lower (or at least grow less quickly). The consumer has been resilient but is showing signs of fatigue. Price increases can’t bail out the lack of unit volume growth. As an example, General Mills recently announced their earnings and future earnings expectations with slower growth as management is not forecasting meaningful price or unit volumes increases, with the latter having already declined.

I predicted a temporary equity market decline would occur in the first half of the year, and the equity markets are, in fact, higher. While the broader market was up in the first half, it was driven by the “The Magnificent Seven” and AI-focused companies. NVIDIA, Microsoft, Amazon, Google, Apple, Meta, and Tesla. It was a “skinny bull market” that lacked breadth for most of the rally. These same companies were also some of last year’s biggest losers because of their higher multiples and concerns over long-term growth. Investors change their outlook on these companies quickly, and AI provided the next “growth wave” for investors to drive the stock prices back up. My hypothesis is that the nominal growth effect merely had a longer impact, so my prediction could hold (just take a bit longer to materialize). Excluding the rally in the “magnificent seven”, the rest of the stock market performed in-line with my expectations. As is always the case when we discuss broader market trends and viewpoints, the challenge is figuring out what the transmission mechanism in the market is and the timing of it.

As companies forecast slower growth over time and anticipate lower earnings in the coming quarters, we’re simultaneously entering increased default risk territory – especially for companies that are highly levered within this current interest rate environment and face refinancing risk. According to the latest market intelligence data from S&P Global[1], there have been more than 230 corporate bankruptcy filings in the United States in 2023. This is more than double the number of filings in the same period in 2022, and the highest number of filings since 2010. Anyone that can’t afford to refinance today or in the coming year will face increased challenges. It could be that there aren’t going to be many companies that can’t refinance, but we can check back on that fact in another six months’ time.

Restrictive Monetary Policy, coupled with the recent regional bank crisis, has caused most banks to increase their lending standards, thus reducing liquidity. The private markets have stepped in to fill the liquidity void. At the same time, private debt also faces an interesting refinancing cycle. How private credit performs over the next few years will determine its long-term future growth trajectory. Since the meteoric rise in this activity engendered by the Great Financial Crisis (“GFC”) and regulatory actions affecting bank lending, there has not been a proper credit cycle. There has been no demonstrative credit cycle since the end of the GFC. As a result, there is no reliable data on credit defaults and on losses for this period. Previously, private credit was much smaller and, frankly, a different business and borrower, so using prior history could be tricky. While some regional banks have chosen to reduce lending, other commercial banks may move to reclaim some of this market segment, such as JP Morgan (which has announced its intention to do so). 

Who’s Stressed Now?

One thing that no one truly predicted happening in H1 was what I’ll call “regional bank stress” that was conditioned on transformational risk or assets being priced at a time different from the liabilities. Cost of liabilities went up and asset values declined - that was the primary cause. Much of this transformational risk was due to asset mismatching that went unattended by management and some cases were exacerbated by the implosion of the crypto ecosystem. However, the primary culprit really was the decline in asset values precipitated by fast-rising rates, where those assets were funded by short-term deposits, whose costs were rising rapidly.

While the stress on our regional banks shouldn’t be ignored, it was not a structural event, was quickly contained, and better described as multiple idiosyncratic events which developed concurrently. Unless rates were to go up another 500 basis points, which no one is expecting, an event like this is unlikely to recur. A potential source of future stress may reside in banks that are overexposed to commercial real estate and commercial lending. These credit issues could be more pervasive as many banks have this risk.

At the end of the day, the Fed is fighting inflation, which is a bigger problem than the idiosyncratic effect of higher base rates on certain companies or banks. I believe it’s Buffett who said, “only when the tide goes out do you discover who’s been swimming naked” - there were some less traditional banks that got caught. 

Another aspect that wasn’t anticipated - and is also contributing to the resiliency of the equity market - is the impact of AI. The explosion of enthusiasm around artificial intelligence has allowed investors to get even more aggressive on technology opportunities, and the megacap tech stocks are continuing to drive the market. By my math, as 30% of the market, and up 60%, these seven or so stocks comprise roughly 85% of the reason why the market’s up from early January. Nvidia alone has risen from ~$143 in early January to ~$420 as of the end of the first week of July - these companies and a growing cadre of competitors are encouraging investors to continue doubling down. Even if the market does go down in H2 by 10%, the S&P 500 would end at the ~ 4,000 level - still up from the beginning of the year.

New Questions Arise

As always, with new information and the passage of time come new unknowns. Today, I find myself curious about the scale of the economic slowdown to come. Right now, unemployment remains at historically low levels as the labor market remains tight, and the consumer has been resilient, but we expect to naturally get tired. If/when the unemployment rate increases, consumer behavior is expected to change with more job losses across the economy. I find myself wondering to what level unemployment could rise, which ties back in some ways to the rise of AI.

If you trust every article you read, you might believe that, on an individual basis, a worker could lose their job to AI. It seems far more likely to me that much of AI remains a process that still has to be managed. This might mean hiring different people, but it preserves the net number of jobs filled. The timing is what remains unknown; it could be that the market loses jobs before they’re regained, or vice versa. In the short-term, I expect AI to be more of a productivity enhancement for workers than an outright replacement while it remains in its nascent stage. The megacap tech companies building the hardware and infrastructure to support AI at the application level have already seen significant price gains, while simultaneously reducing headcount.  

Additionally, I expect we’re going to see some unintended consequences from the Fed’s “Zero Interest Rate Policy” (“ZIRP”) hurting investors which reached for yield during the low-rate environment for the past decade and a half.  Earlier this year, I gave a speech in which I said that in the last 5-7 years, there’s been a lack of institutional investor interest in liquid fixed income securities replaced by illiquid private credit opportunities. With higher base rates, I think the growth of private credit and private equity is going to slow. I don’t think it’s going to go negative, but it may slow materially. It’s yet to be determined by investors what their real returns look like because they own assets in these private credit vehicles that are not marked to market. They may like that because they don’t have the perceived volatility, but it is illusory as it’s impossible for the bond market to go down 22% and for private credit assets to remain unchanged. That makes no sense to me, but I’m curious today about the extent to which the growth in these categories will slow.

In Summary, It’s Less Gloomy

I believe rates are likely to be higher versus lower, and stay elevated, while long-persistent negative real rates will fade away. I also believe equity returns driven particularly by megacap tech are likely to be more muted. I feel many portfolios today are generally short liquidity and long duration in both private and public debt assets. 

I anticipate liquidity will eventually have to come back in portfolios as allocators adjust to a more effective balance between liquidity and a willingness to lock up capital for lengthy periods. Private credit, high yield, CLOs, and bank-driven lending will coexist, but which of these will lead to growth remains unclear.

What Is Our Industry to Do?

I anticipate a sustained expansion in niche asset management businesses specializing in specific areas and capable of accumulating between $10 to $30 billion in assets. These businesses will prioritize performance-based fees rather than asset size, and their steady expansion will make a substantial contribution to the overall growth of the asset management industry.

Some larger organizations will undergo a transition from performance-based business models to becoming asset accumulation engines and adopting client service-oriented models. These organizations will focus on building their franchise value through elements such as brand recognition, distribution capabilities, cost efficiencies, and exceptional client service. In essence, they will resemble wealth management, service-based, or solution-based entities rather than being solely focused on generating alpha.

Despite the myriad of unknowns in the macro-economic environment, the asset management industry is poised for ongoing growth as individuals ramp up their savings, developed economies expand, inflation remains stable, and equity markets demonstrate a long-term upward trajectory — an undeniable principle.

To attain returns surpassing market indices, allocators must be open to allocating resources to managers who face capacity constraints but possess strong financial incentives to deliver superior performance.

We look forward to continuing to build our partnership with investors in the coming years.

 

Best regards,

Peter Kraus
Founder & 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. Past performance is no guarantee of future results.

 

[1] Source: https://www.spglobal.com/marketintelligence/en/news-insights/latest-news-headlines/april-adds-54-more-us-corporate-bankruptcies-2023-filings-highest-since-2010-75543160

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