Executive summary
- Priced for perfection—Public markets rallied in 2H23, driven by the expectation of early monetary easing. This momentum extended into early 2024, particularly in equity markets, reflecting investor optimism for continued economic resilience and growth. However, this optimism may be prematurely pricing a near-perfect macroeconomic scenario for 2024, potentially vulnerable to geopolitical tensions, persistently high inflation and sustained high interest rates.
- Spreads & lending terms—Direct lending showcased strong returns and stable yields through 2023, supported by higher base rates and favorable lending terms. While spreads slightly compressed at the end of the year, total leverage and interest coverage ratios seem to have stabilized. Middle-market companies exhibited strong earnings, especially toward year end, suggesting resilience despite macroeconomic uncertainties.
- Transaction activity—Despite a slowdown in private equity activity due to macroeconomic challenges, late 2023 saw an uptick in transactions for direct lending loans towards LBOs, likely driven by the need for private equity firms to deploy capital. This resurgence aligns with increased M&A activity observed early in 2024, offering promising deployment opportunities for direct lenders going forward.
- US exceptionalism—The US economy’s resilience contrasts with Europe’s minimal growth, underpinning regional disparities. Inflation has decreased faster than anticipated for most regions, leading to revised interest rate expectations. Central banks are now expected to cut rates in 2024, reflecting a more dovish monetary policy outlook. At the same time, however, the number of rate cuts from Fed have been continuously lowered since the start of 2024, likely correlating with the unexpected strength of the US economy.
- Relative value—While the rally in public markets signals investor optimism for 2024, it carries the potential for significant risks around overly optimistic valuations. By comparison, direct lending presents a compelling investment opportunity, underscored by attractive risk-adjusted returns. Direct lending usually performs better than many asset classes in times of financial stress while still offering attractive returns in normal times.
Public markets
Strong rally driven by potentially overly optimistic sentiment
The second half of 2023 began rather muted for public markets, but the dynamic reversed significantly with a strong rally in the last two months across all asset classes, likely spurred by the anticipation of earlier-than-expected monetary easing. This shift in market dynamics suggested a growing optimism among investors about the potential for cheaper borrowing costs to stimulate growth. This enthusiasm has continued through the start of 2024 as most asset classes built further on their gains, especially in the equity markets. Buoyed by expectations of continued positive economic and financial conditions, investors appear ready to embrace higher risks in pursuit of greater returns (Figure 1).
Figure 1 | 2023 total returns across asset classes
Sources: Leveraged loans: LCD Morningstar Leveraged Loans Indices; High yield: Bloomberg High Yield Indices; Investment grade: Bloomberg High Yield indices; Equity: S&P 500 and MSCI Europe, as of March 2024.
A “priced for perfection” situation in public markets in early 2024
However, the recent rally in public markets may carry significant risks for investors as markets are expecting a near-perfect macroeconomic landscape in 2024. This sentiment is directly related to the assumption that developed economies will achieve a “soft landing,” where growth stays resilient and inflation decreases towards central banks’ targets. While there is certainly potential for a cycle of monetary easing, the recent rally in public markets may be vulnerable to geopolitical and inflationary risks. For instance, central banks may be forced to maintain high interest rates for a longer period, in turn pressuring company earnings and financial health. Put simply, a “soft landing” leaves little room for error, with adverse shocks potentially leading to material losses as possibly too low risk compensations are priced in.
An early indicator of those potentially too optimistic market expectations is the current level of spreads in the public debt markets. As of March 2024, the spreads are even lower than their long-term average (Figure 2). However, the uncertainty has not disappeared, and unexpected economic shocks could still upset the macroeconomic environment. With the market potentially underestimating the possibility for downside risks, it may be too soon to drive spreads below their long-term average.
Figure 2 | Secondary spreads across asset classes
Sources: Leveraged loans: LCD Morningstar Leveraged Loans Indices; High yield: Bloomberg High Yield Indices; Investment grade: Bloomberg Investment Grade indices; Equity: S&P 500 and MSCI Europe, as of March 2024.
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