John P. Bryson

Hello, everyone, and welcome to the Portfolio Intelligence Podcast. I'm your host, John Bryson, head of investment consulting and education savings here at John Hancock Investment Management. And today we're going to talk about alternative investments and, specifically, private credit. In September of 2024, Preqin, one of the largest industry providers of alternative asset data tools and insights, published its Future of Alternative 2029 report.

In it, Preqin forecasts the Global Alternatives industry to reach$29.2 trillion in assets under management by 2029. And an exciting and rapidly growing part of that space is private credit. So to help us learn more about the private credit market and the opportunities there, I've invited Alex Catterick to the podcast. Alex is the global head of alternative investment solutions at Manulife Investment Management.

He is responsible for defining the private markets globally for high net-worth strategies and managing and developing and launching those strategies and new products for the high net-worth investor space. Alex has more than two decades of experience in alternative investments, wealth management, and capital markets. Before joining Manulife, he served as the regional head of alternative investments at HSBC, where he led alternative investment distribution, product management, and strategy across the wealth management and private banking platforms in the Americas. Alex, welcome to the podcast.

Alex C. Catterick

Hey John, thanks so much. I'm so happy to be here.

John P. Bryson

You got it. We're really excited to kind of pick your brain and leverage your expertise. So, I kind of want to start with a 101 and talk about private credit in layman's terms. At a high level, how do you describe private credit?

Alex C. Catterick

So I think in … in its simplest terms, what you have is a tailored financing solution that's made directly to a company. And that tailored solution is coming from a private credit firm, as opposed to going through a traditional bank lender, or through public credit markets. So you think about who that might be. These are small and mid-sized private companies, you know, across the United States and, you know, presumably around the world, that is seeking funding, for any, any number of things: growth capital, business expansion, and acquisition, even just funding regular corporate operations.

Sometimes it's for a restructuring or a liquidity event. You know, but these are the uses that private companies, you know, where they need capital for some reason and traditional bank lending sources, you know, are less and less available for these types of loans. And again, typically, if they're private companies, they're not going to go through the public credit markets.

And then if I think of it from the view of the actual, you know, credit provider. You know, they're looking to structure a loan based on their ability to figure out whether the company can repay. So if you think in public credit scenarios, you know, you've got where you've got public markets and you've got, publicly available, financial statements, you've got rating agencies, you've got a lot of regulations around the way that, you know, public credit is structured and these loans that go out. In the private space, it’s negotiated one to one.

So it's much more direct. You know, typically there's a little more complexity to it. And, and that is … maybe the last thing I would say is that it's a huge part of the market. Right? If you think of the number of private companies that exist out there and compare it to the number of publicly-traded companies, you know, it's a … it's a large multiple of private credit firms that need to be able to access this type of capital.

John P. Bryson

Got it. So, companies need a loan. They can go through the public space … through a traditional bank, or they can now go through the private space. And that loan can be used for whatever companies use loans for, right? You know, grow their company … acquisitions, whatever it may be. So it's not as complicated sometimes as we make it, you know, thinking through the alternative space. So let's go further. How do you break down the private credit universe?

Alex C. Catterick

Yeah. So that it's funny when people think of private credit. I think what they're thinking about is traditional direct lending. And, and I think the reason why that's the case is the majority of solutions that have come to the market are traditionally direct lending. And direct lending is, you know, again, this is … this is a non-bank lender.

They're giving a loan to a company that seeks some sort of financing. These are usually senior-secured loans, typically, you know, four-to-seven-year term. You think of the way these loans are structured. They might have high-single to low-double digit yields, you know, attached to them. You know, typically a reference rate like SFOR, plus a spread, I think … I think spreads right now in the private credit space or, you know, maybe around 500 basis points which is, I think, higher than what you might see from traditional, you know, high-yield or leveraged loans.

And, you know, that's kind of bread-and-butter type, you know, just … just regular way business in the direct-lending space. And that's, you know, the vast majority of what the market is. But the private credit universe is expanding, and it's expanding in that there are different flavors of private credit that are out there. What we're seeing, increasingly, is asset-backed financing.

So these are also, you know, typically senior loans, but oftentimes they're going to be secured by a specific asset or a specific asset package or pool of assets. So now you've got, you know, contractual rights to the cash flows. You've got a claim on the underlying asset specifically. So that's different than just, you know, traditional corporate lending.

And then additionally, in the private credit space, you know, you've got subordinated debt, and you know, junior or mezzanine loans, which typically come with a little bit of risk because you're further down in the capital stack, but you do get paid a little more for that. The returns are higher. And then additionally, in private credit, you can see distressed or special-situation lending.

And that's where a lender might, you know, come in to a financially distressed company that might be going through a bankruptcy, and maybe they're looking to recapitalize the balance sheet or looking for catalyst down the road. But this is typically a little more complicated. It might be going through a reorganization or liquidation. And this tends to be, you know, riskier. You might … you might see returns of, you know, 15% or above.

This feels a little more like equity. But again, it does come with that risk. I think you could probably continue to kind of cut up the private credit market, but I think of those as kind of the four main buckets.

John P. Bryson

Gotcha. And if I were to think about an equivalent that our market … places that we’re very comfortable with, it's the public fixed-income space. And the correlations in my head, at least, are … you've got investment-grade bonds or corporate bonds … so private direct lending is similar except it's got a floating rate. Then you've got asset-backed securities in the public market … there, maybe, mortgage-backed securities or other types of asset-backed. Again, with asset-backed private credit, you've got this similarity where there's some collateral that goes along with it. And then you've got the higher yielding in bank-loan space in the public markets. You've got the subordinated debt, distressed debt situation. The other kind of more aggressive spaces is in the private market. So there's equivalence on the public side in the private side. Is that a healthy way or a good way to think about it?

Alex C. Catterick

That's exactly right. That … that's the right way that that folks should be thinking about the private space and comparing it to, you know what?

Folks are more maybe more familiar with, in traditional, you know, public fixed income.

John P. Bryson

Okay. Awesome. So, let's keep going. Why is private credit becoming so popular right now?

Alex C. Catterick

Yeah, I think of this as kind of … with two different lenses, if you will. Part of it is the private credit market itself has experienced a lot of growth over the past, you know, decade, decade and a half. And there's some reasons for that that I'll speak about. And then secondly, is the adoption or the use of it, right? So, as the market itself has grown, you know, investors have increasingly moved into the space. So again, if I look at it from, you know, the growth of the market, a couple of things happened.

You know, we had … we have … we've seen bank retrenchment. So banks have actually pulled back from issuing these types of loans. And part of that is due to regulatory and capital requirements that came into effect after the … the financial crisis in 2008, 2009. And then additionally, what we've seen is, you know, we've had this low interest-rate environment that we had for, you know, all of the 2010s. And that, you know, changed the dynamics for borrowers, right?

You know, companies were willing to chase more debt because they were trying to grow. And we did have a strong economic growth throughout the 2010s. So with the banks pulling back, with the low interest-rate environment, and then you had these private equity companies coming in and recognizing the opportunity, and they started building out these private credit arms to satisfy the demand and the need for this … You know, the ever-growing kind of debt, you know, debt expansion. On the other side of it, you know, the use case has been that with that low interest-rate environment, you know, investors were looking for higher yields. So, you know, through all the 2010s where we had this … this race to zero in terms of, you know, central bank movements on … on interest rates, you know, folks were starved to find yield.

So if I could take a step into the private markets and boost my yield to something … more accustomed to what I would have in my fixed-income portfolios, I was willing to do that. And then finally, I think there's been structural changes to the way that investors can access, you know, this asset class. Historically, this was really reserved for institutional investors.

So large pension funds would work with a private equity manager, they would go into a large, you know … you know, drawdown fund. They would have their money locked up for, you know, five, eight, maybe even 10 years. And that private equity firm would go out and issue these loans. As we've seen in the past, six or seven or eight years, we've seen semi-liquid evergreen solutions come to market.

So it's a structural change into the underlying fund, where the underlying exposure is to this type of lending activity. But the structure, you know, permits investors to have, you know, better access to liquidity over time. So you put all those things together, you know, the growth of the market, you know, the entry of the private equity firms, the low interest-rate environment, investors access.

And it's gotten to the point now, where this is becoming, you know, a very, very popular, you know, if I can call it an asset class. And ultimately, what we're going to end up seeing is that, if you look at the private credit market in 2018, 2010, it was around $300 million. Today, that private credit market is, you know, upwards of $2 trillion today. It’s had significant growth.

John P. Bryson

Wow. That's impressive. So, you mentioned structure a little bit there. And knowing what I do know about the private space, they are different than some of the structures that people are familiar with. Mutual funds and ETFs would be the ones that I think are most popular right now. What are some of the key features you need to think about when investing in these products that might be new to people that are new to private credit?

Alex C. Catterick

Yeah, I think there's a couple things here. So, structure we mentioned, and I'll talk about structure in a second. Understanding the manager, as you would with any investment, right. Whether it's a mutual fund or an ETF, you know, understanding that … that the manager that's behind, you know, that that structure or that fund, is someone you're comfortable with. Additionally, you know, sector or segment focus, right?

Understanding, you know, again, is it direct lending? Is it asset-based lending? You know, is it something that might be, you know, kind of riskier? So, understanding that part. And then really digging into the fact that, you know, I mentioned that the way your structures are set up and I did say I'll come back to that is that they're more liquid, right?

But we all need to remember that the underlying, you know, investments in these funds are illiquid themselves. So as much as the structure can be developed to provide liquidity, there are points in time when liquidity may not be available. So investors need to understand that … that illiquid nature of the investment, and that the reason that they might be able to access higher yields and higher returns is because they're giving up some of their liquidity, and that changes the risk profile.

And then I keep saying and come back and talk about structure one second, but two other things is just asset allocation and position sizing. So, the same way that when you build a fixed-income portfolio and you think about how much investment-grade I want to have and how much high yield I want to have, when we're building out a private credit allocation, you need to think about what's my bite size, you know, how do I want this to relate to the rest of my fixed-income portfolio?

How much liquidity can I bear in my portfolio? So that asset allocation and position sizing is very important. And this is, you know, typically why, you know, folks want to work with advisors to help them think through those … those types of decisions. And then the other thing in these funds is leverage … is that when you're looking at private credit funds, you know, the manager might be using leverage within the fund, and that leverage can help, you know, juice the returns, if you will.

But it also increases the, you know, the downside risk in the event of a default or, you know, if the economy deteriorates. So, you know, being … being mindful of the leverage that's implicit in these vehicles. So, I want to come back and talk about structure, specifically for a second. But John, anything …anything on those points that, that you think I should, also elaborate on?

John P. Bryson

You know, what I think I'd ask is, the way I think about it again is people are familiar with mutual funds and ETFs the same way they're familiar with stocks and bonds in the public space. And then in the private space, like you had mentioned, the traditional true private, you got to expect to lock up your assets from 7 to 10 years. Right. And these are one-to-one contracts, if you will, or you're part of a group of investors. But the evolution is this space in the middle where we're … we're getting more liquidity, making it more available for high net-worth investors.

It's a little bit of the best of both worlds. But along with that is some of the requirements that you need to be aware of … that underlying investments aren't as liquid, so you have to be comfortable with that. The structure which you'll talk about is a little bit different. So there is some kind of working knowledge to understand, but the parts that are familiar is you want to get onboard with a good manager that really knows this space is really well in their specific area. And has had a track record of delivering results. Is that a is that a good summary of what you've covered so far?

Alex C. Catterick

Yeah, that's exactly right. Diligence in getting a manager. You're going to follow the same approach. And, you know, you want to make sure you understand, that they know, you know, how are they sourcing these loans?

How are they working with these, you know, sponsors and structuring them? What are their historic returns? How do you think about loss rates? You know, how do you think about what a manager is going to do in the event of a default? You know, all the questions you would ask if you were looking at any manager. You know that's … that's important.

But on that structure, John, you know, and so I'm sorry to throw some, you know, nomenclature at folks, but the structures that have emerged … So the one that we see is the most popular in the private credit space is a business development company. So a BDC, and a BDC is structured in a way that it allows the manager to go out and actually, you know, source and invest in these loans.

And typically the the way that investors get in these … These funds are typically designed to have monthly, or sometimes quarterly subscription processes. So you're not … It doesn't trade the way that an ETF or a mutual fund or stock or a bond does. You subscribe into the fund. You know, you typically fill out a form, you get admitted into the fund, and now you're an investor in the fund.

A lot of times these funds are designed to have a lockup. So in traditional private credit or private equity where you're locked up for, say, you know, 7, 8, 10, 12 years, the lockup in these semi-liquid evergreens is typically just one year. So you come in, you know, you can't ask for your money back for a year.

If you do want your money back inside a year, typically you're able to get it put at a haircut. So a discount to what you put it in at. And the idea is, you know, that's helpful to the manager to know that they have the ability to deploy that capital on your and the other investors in the fund’s behalf as they build out the portfolio.

After that year is up, typically you can redeem from the fund, but it's typically quarterly. So on a quarterly basis you can get your money back. And that's how a lot of these funds have been designed. In addition to BDCs, you might hear the term, you know, tender-offer funds or interval funds, and in the real estate space with REITs. You know, these are all the structures, but the way I just described … kind of the way you get in and get out, is fairly consistent across … across these funds. The other thing that's really important to note is that the portfolio itself, typically about 80% of the invested capital is going to go into traditional private credit, and then 20% is going to sit in ... I would just call it a liquidity bucket.

It's going to sit in public securities, or it could be ETFs … kind of a kind of a managed credit sleeve. And the reason that … that 20% buffer exists is to satisfy the redemption requests as they come in. So, you know, investors are essentially getting 80% of their portfolio into private credit. The other 20% is more liquid. And that also should factor into the way that folks think about this from an investment and an asset allocation perspective.

John P. Bryson

That is super insightful and helpful as we think about this for our audience as they're getting more comfortable with it. There are some new things, terminology, structures that you need to get familiar with it, but it' s… it's well worth it. So let's pivot to that.

Alex C. Catterick

Hey, John, you know, John, I'm so sorry. One thing I didn't say, and this is maybe the maybe the most important part: The manager can say no. They can … they can gate your redemption request. Typically, the fund is structured so that up to 5% of the value of the fund can come out in any given redemption period. And if their redemption requests exceed that 5% limit, you know, the manager can say, you know, you're going to have to wait for another quarter. And the reason for this is it actually saves the investors in the fund from forcing the manager to exit positions for, you know, an uneconomic reason, right? For selling when they don't want to sell something. So understanding, you know, that that gating or queuing mechanism, on … on the redemption part is … is important part to …to mention as well. I should have said that in the outset.

John P. Bryson

I'm glad you did, because that goes back to your point where people need to understand that these new structures are becoming more liquid with monthly liquidity or quarterly liquidity, but the underlying investments are illiquid. Therefore, the manager needs some discrepancy on saying no. They need to do that to protect the portfolio so that they are doing what's best for all investors, not just one investor that says, I planned on being in this for the long term, but I need to get my money out a little bit earlier. So I'm glad. I'm glad you mentioned that.

So we talk about it. We're clear up front because we want people who go in and invest in these products to go in eyes wide open. We think there's excellent opportunity to diversify your portfolio with alternatives, but you have to go in with eyes wide open. And that's why we cover this up front. But let's also talk about what some of the benefits are of investing in private credit.

Alex C. Catterick

Yeah. So the first thing I always mentioned is, you know, your yields are higher, right? By design, the … the … these private loans come with … premium yields as a result of the illiquid nature of the underlying loans that are being issued. So the benefit to investors is adding, you know, that additional income, that additional yield to their portfolio. And, I’d like to say in some cases, you could argue that there's less risk with the private credit space as long as you're willing to give up that liquidity. If you look over time, loss ratios in the private credit space have actually been lower than what you've seen in traditional, high yield, and in the broadly syndicated loan market.

So from a law standpoint, you know, you tend to have, a little better protection and then recovery rates in the event of loss tend to be higher in the private credit space. So, if you can argue that you're getting better returns with, you know, lower risk, despite the fact that this is less liquid, you know, that's the reason why you want to be able to invest in private credit. And that's the reason why institutional investors have had this as a large allocation for, you know, a number of years.

John P. Bryson

Yeah. There it is right there that trade off. If you're willing to accept some of the illiquidity, you can get some premium in terms of lower risk and higher return. That's what we've seen in the past. Institutional investors recognize that.

Alex C. Catterick

And then the other thing is I would say … diversification is that, I said at the outset that, you know, these loans are going to small- and mid-sized private companies and that the … the private … the number of private companies in the United States dwarfs the number of public companies. So by having exposure to private credit and having exposure to these private companies, you know, you're really participating in a broad part of the economy that maybe isn't in your portfolio right now.

And then, you know, if you're just extrapolate that across, you know, folks, just think of the number of private businesses that are out there that are, you know, I don't know … service providers and, you know, technology companies and manufacturing companies that are up and down the value chain of a lot of the public companies we're all familiar with.

But they're providing really important services. And, you know, being able to actually access this part of the market, I think is important. And again, is underrepresented in, you know, the vast majority of individual investment portfolios today.

John P. Bryson

Yeah, we definitely see that. We see … and I research a lot of institutional investors, up to 50%. In alternative individual investors is much, much smaller … We're pushing for people to think of an allocation between 10% and 30%. I think most are probably under 5%, but more and more are growing that. Hey, let me let me ask a different question, because we've talked about a lot of the benefits for investors in private credit. What's the benefit for the companies to stay in the private space? You mentioned that they might not have access because banks have limited how much they're lending, but what other benefits are there for the companies to stay in the private space?

Alex C. Catterick

In terms of the … in terms of the private equity and private credit firms that are issuing the loans?

John P. Bryson

No, the actual end company that's … that's getting the loan, you know, what’s the benefit there?

Alex C. Catterick

Oh. Yeah. I mean, in a lot of cases, you know, these smaller mid-size private companies can't access the credit markets as directly. Right? So, they need to work with these private lenders in order to have the capital to do some of the things that I mentioned, like, you know, business expansion and so on. But also, in general, a lot of companies, you know, don't want to become public companies.

Right? And you don't necessarily want to have to do quarterly regulatory filings. And, you know, there's a lot of, time and effort and expense that private … that private companies don't want to necessarily go through in order to become public companies. So, it's a great way for them to access capital, it's a great way for them to continue to, you know, grow and expand their business.

Typically, they have, you know, good working relationships with the lender. Often times these lenders can help provide, you know, capital solutions and, you know, maybe give some guidance around the business. They can make introductions to other companies. So, there's a lot of benefit for working with, you know, these … these private equity sponsors. And that's why I think companies are continuing to, to, to go down this path.

John P. Bryson

Got it. That makes a lot of sense. Okay. So let's turn our focus now and talk about are there any areas in the private credit market that are particularly compelling to you right now.

Alex C. Catterick

Yeah. So, traditional direct lending has been the first step out of fixed income for folks that are trying to build out the alternative credit category and that … that traditional direct lending is, again, as I said, a senior secured, it's … you know, loans that are issued to companies that, you know, they're looking for, again, that kind of growth capital.

You know, typically the, you know, the lender is basing it on, you know, the general corporate cash flow of the company. And that's great. It's great that, that … that is a market that exists as a market that it's grown. But we tend to think that, you know, the better part of, I shouldn't say better. We tend to think that investors should start to look beyond traditional direct lending.

And I would say the next step, in terms of that journey … journey would be into asset-based lending. So I've mentioned previously that when we look at the asset-based lending market, you know, that includes things like, you know, loans that are structured against a pool of assets or an individual asset. So you think of, you know, the use case here would be for, you know, airlines could issue a loan and have the engines of an airplane as collateral.

You see this happen in the marine and shipping businesses. Typically, real estate can be used to secure, you know, loans or packages of loans. You can see the same thing with receivables. Or inventories. And this is a little more of a specialty-lending area where you probably are seeing higher returns even beyond what we talked about in the direct-lending space, because not only is there an illiquidity premium, there's a complexity premium because the manager really needs to understand these industries.

They need to understand these assets. And this is a … this is a growing space in the market. And we think that there's a great opportunity for investors to broaden out their private credit exposure, by looking at the asset-based lending space.

John P. Bryson

So, Alex, we've covered a lot of different topics quickly in the alternative space and the private credit space can you summarize for me, high level, talking to an end investor, what are the key things they need to be thinking about when exploring private credit?

Alex C. Catterick

So I would say I would say three things. I would say the first is that, investors should start thinking about private credit as an extension of their fixed-income portfolio, and they should think about it in terms of, if I'm going to have a portfolio, you know, am I ever really going to take it to 100% cash? And I think the answer you're going to find to that is almost always no. So, if you know that you have, a portfolio that's going to remain invested, then you should have the ability to bear some illiquidity. And, you know, that illiquidity, you know, should possibly be allocated to private credit where you're able to get higher yields. And those higher yields can complement the rest of that, you know, fixed-income portfolio.

The second thing I would say is that folks need to be super aware of the structures in the managers that are active in this space. And the reason I say that it comes back to our discussion before that, it's different to what investors maybe they are familiar with. And we should still make sure that we're kind of super focused on the restrictions that come with something that we're saying is a more liquid version of private credit.

And then we also want to be really super aware of who the underlying manager is. And you know why … why we want to work with them and why we trust them. And then finally, I would say that, you know, this is just a growing opportunity set and that, you know, if we look at traditional direct lending, that has been the first step. I almost think of that, you know … you know, if you're trying to build out a portfolio and you want to have beta in your portfolio, if I think of it in the equity market terms, you know, you can own the S&P or you can own the triple Qs. But in the private credit space, as we see this growth, you're going to see different underlying exposures or exposures like I mentioned in the asset-based lending space.

You're going to see funds that emerge that are going to be sector-focused or geography-focused. You're going to see funds that are, you know, less risky or more risky based on, you know, what it is that they're investing in. And I think that this market is going to evolve the same way that, you know, investment markets evolve generally.

Again, you can … you can have data in your portfolio or you can have other flavors that can help you design the types of, you know, risk and return profiles that you're trying to achieve. And as the space grows, I think, you know, investors and advisors need to stay educated, and knowledgeable on the topic. And, you know, that's why, you know, we like to make ourselves available, and speak about these topics.

John P. Bryson

Alex, this is exactly what I was looking for. The point of the Portfolio Intelligence podcast is to help our advisors or financial professionals build better outcomes for their clients and build a better business. And we think the alternative space can do exactly that.

I want to thank you for joining the call today! Folks, it is an exciting landscape. It's a complicated landscape, but I encourage you to reach out to your local business consultant or financial professional to really understand this space. And if you want to hear more, I would love you to subscribe to the Portfolio Intelligence podcast on iTunes or your favorite, podcast location.As always, thanks so much for listening to the show. Have a great day.

John P. Bryson

This podcast is being brought to you by John Hancock Investment Management Distributors LLC, member of FINRA, SIPC. The views and opinions expressed in this podcast are those of the speaker, are subject to change as market and economic conditions warrant, and do not constitute investment advice or recommendation regarding any specific product or security. There’s no guarantee that any investment strategy discussed will be successful or achieve any level of results. Any market or economic performance information is historical and is not indicative of future results, and no forecasts are guaranteed. Investing involves risk, including the potential loss of principal.

The Secure Overnight Financing Rate, SOFR, is a benchmark interest rate for dollar-denominated derivatives and loans that replaced the London Interbank Offer Rate, LIBOR. Beta measures the sensitivity of a fund to its benchmark. The beta of the market, as represented by the benchmark, is 1.00. Accordingly, a fund with a 1.10 beta is expected to have 10% more volatility than the market. The S&P 500 Index tracks the performance of 500 of the largest publicly traded companies in the United States. The NASDAQ 100 Index is a large-cap growth index that tracks the 100 top domestic and international non-financial companies based on market cap. It is not possible to directly invest in an index.

John P. Bryson

Hello, everyone, and welcome to the Portfolio Intelligence Podcast. I'm your host, John Bryson, head of investment consulting and education savings here at John Hancock Investment Management. Today is September 23, 2024. And we've started fall. So I've invited Emily Rowland and Matt Miskin, our co chief investment strategists here at John Hancock Investment Management, to the podcast to talk to us about what's going on in the economies around the world and markets as well.

Matt. Emily, welcome.

Emily R. Roland

Hey, John.

Matthew D. Miskin

Thanks for having us.

John P. Bryson

You got it. Hey. Exciting week last week. the Fed met and they cut 50 basis points. Walk us through the reasoning and the market reaction, if you could, Emily.

Emily R. Roland

Yeah, sure. So that was probably the most anticipated Fed meeting that I could remember in recent history, and it was pretty notable. We actually didn't know what the Fed was going to do. The bond market was oscillating between pricing in 25 basis points versus 50. But over the days leading up to the meeting, 50 became the base case. And that’s what the Fed came through with. And really, I think the idea behind the 50 basis-point cut is that the risk has really moved away from higher inflation and more towards the risk of a further weakening in the labor market. So, core PCE, which is the Fed's preferred measure of inflation, was as high as about 5.5% at its peak. And it’s now down to about 2.6% year over year. So not quite back down to the Fed's 2% target but going there … they're moving in the right direction as inflation kind of fades into their rearview mirror here as the key risk. And meanwhile, we're starting to see more cracks in the labor market. We've seen a couple of months of weaker nonfarm payroll report.

The unemployment rate has been rising and is now sitting at 4.2%. So, the Fed really wanted to preempt any further weakening in the labor market by doing this 50 basis-point cut. I mean, in terms of the market reaction, markets loved it. It was a “risk on” reaction, really. Some of the most notable things that we saw was a steepening in the yield curve. So the 10-year Treasury yield went up. And really, the idea is that by lowering the Fed Funds rate by a significant amount, the theory or the idea is that, you know, perhaps that staves off the likelihood of a recession. So more of a “risk on” perspective there. You also see that, in … in areas like Bitcoin, which was up 9%, the momentum factor and sort of junk … or less profitable companies, doing really well.

Small caps, one of the leaders across equity markets, reflecting that more cyclical rotation “risk on” view. And then you saw high-yield bond spreads went below 3%. That's incredibly tight. The 20-year average is 500 basis points. So that's the credit market telling you there's not a lot of concern about any type of liquidity event, financial accident, even recession.

And then you also saw the equity market reaching a new all-time high. So I think, you know, certainly markets loved it. And we want to be mindful here. There's a lot of good news that's being priced into to riskier assets. And I know we'll talk about how we want to think about positioning from here. But broadly, we would sort of fade this rotation into lower quality parts of the market and think about notching up on quality, both from an equity and a fixed-income perspective.

John P. Bryson

Okay. That's really helpful. We're going to certainly dig into that. I got to kind of put this under the, “shows what I know” category. I was surprised by the 50 basis-point cut. I was thinking more 25 when we look at economic data for August. Matt, it wasn't that bad. Were you surprised by the 50 basis-point cut?

Matthew D. Miskin

Yeah. A week before the … the meeting, actually, 25 basis points was the consensus. And then if you asked economists of … you know, the consensus of economists, almost all said 25. And I think from an economist standpoint, that's what you would have thought. Initial jobless claims fell to 219,000 last week. That is at the lower end of the last year’s range, industrial production improved, retail sales beat. So what we're seeing is this strong data and then S&P 500 hits all-time highs. Amidst this, you know, a lot of things looking actually pretty positive. And so, you know, I think this … the economic backdrop, the key is the inflation piece. And really, the Fed has two mandates: one is to have full employment and the other is to have stable prices.

The … the stable prices piece is no longer as big of a deal to them, and inflation is coming down. And so they are really, you know, restrictive here at five before when they were 5.5%, Fed funds rate and inflation was down to 2.6% or so. So that's in our view why they went for it. But the thing that, you know, we look at this as … is that it's incrementally positive for the economy and risk assets.

But it's pulling forward that dry powder. This is something they could have used when things got a lot worse and they're using it now, you know. You could make, you know, you could make the argument that that makes sense. But it is something that's going to not be around later. And in our view, as Emily said, you know, because of this, you got this “risk on” pop.

And we think it's pulling forward this, you know, positive view on risk assets. And we think actually that gives you an opportunity to, you know, trim some of that and redeploy into … whether it's intermediate-term bonds that have cheapened up a little bit here, or some other parts in the higher-quality, mid-cap … mid-cap space that have underperformed lower-quality small cap. So it gives you an opportunity to make a little bit of a shift in the portfolio. And we welcome that opportunity.

John P. Bryson

That's great to hear. So, both of you had mentioned the kind of strong “risk on” rally that this has prompted. If we look back though, at past 50 basis-point cuts, they have often preceded … preceded a recession. What's the network … and your take on that possibility right now? Emily?

Emily R. Roland

Yeah. I mean, right now markets are pricing in a soft-landing scenario. And I think, you know, that's not the typical scenario. There's been one kind of official soft landing, which was in 1995, when the Fed really got ahead of the cutting cycle and started that early. So you're sort of not playing the odds if you're betting on a soft landing.

But one thing that may kind of help that narrative is that we have seen an incredible amount of fiscal spending. So we've really, you know … government officials have really, really extended this cycle by increasing the size of the deficit to the tune of almost 7% of GDP. So we're essentially paying for a lot of the economic growth that we're getting, which has left us in this sort of never ending late-cycle environment where the lagged impact of all of this tightening in the system just hasn't tipped us into recession.

So that could last for some time although that fiscal support is fading. And we would really be looking at a three … sort of three key things to embrace .. these things need to essentially happen in order for a soft landing to play out. And one is …  the bond … the Fed's got to deliver and what the bond market is expecting.

So the bond market’s pricing in another total of 2% of cuts over the next 12 to 16 months. And if the Fed cuts less than that, essentially they're tightening monetary policy, which could create a “risk off” environment. So, you know, we need to see the Fed deliver. The other thing is the jobs market needs to hold steady.

And Powell has made it clear that the Fed does not welcome any further deterioration here in the labor market. So, you know, typically in a hard landing, the unemployment rate is has gone to about 5.1%. As we talked about earlier, right now we're at 4.2%. One thing we watch really closely are initial jobless claims on Thursday mornings.

And we're going … so far so good. We're sitting here in the low 200,000s. We've been there for … for weeks and weeks at this point. You know, if we saw initial claims, you know, jumping up to somewhere around 300,000, that would be a bit more cause for concern. But we're just not there. And then we just cannot see liquidity conditions drying … drying up here.

I talked earlier about high-yield bond spreads. If you look at the borrowing costs for these lower-quality companies that have been rallying from their low, the overall high-yield corporate bond yield right now is about 7.3%. That's the lowest level since mid-2022. We talked about spreads relative to Treasuries being around 300 basis points. So we're seeing this really favorable credit backdrop that can change really quickly.

If investors lose confidence, if we do see some type of, you know, credit event or exogenous shock, or just a typical economic contraction playing out … You know …  but for now, these credit conditions are really helping the economy, stay … stay, you know, stable. So, and again, those are the things we'd be looking at to sort of check the boxes for this soft landing to … to actually play out.

John P. Bryson

All right. I want to pivot from the economic conversation to kind of the … investor behavior conversation. Matt, you've done some, work around money market flows, drain rate, current environments. What does that data tell you going forward?

Matthew D. Miskin

Yeah. So we were looking at, you know, after the Fed starts a rate-cutting cycle, how do investors usually allocate capital after that? And we look back through the 90s to today and what we found was that actually, investors allocate to money markets right through the end of the rate-cutting cycle. So they basically see the biggest inflows across asset is … is money markets as the Fed is cutting rates. And they wait all the way till the rates hit the lowest point of the cycle and then they start going to bonds. So taxable bonds, according to Morningstar data, gets inflows after money markets … get a massive amount of inflows in the cutting cycle. And as you know we think about markets, this is of course not what you want to do. Because what you're doing is you're actually taking on the short end of the curve, you're positioning right where the Fed is going to be cutting.

So you're getting a lower and lower yield as the Fed's cutting. And you're not getting any benefit for the lower rates, which the bond market does. The bond market has interest-rate sensitivity. So as those interest rates go down, the bonds rally … at least the Treasury bonds rally and that duration can be a tailwind. And then also, if you allocate capital to bonds instead of money markets, your yield doesn't change. You're locking in a yield because you're having a longer maturity bond. So you can have the yields at the peak of the Fed hiking cycle for the next five to seven years instead of getting … you're not locking it in for more than maybe a month or two, because every time the Fed cuts, your yield goes down. You know, investors psychology has historically found that investors they … they chase returns.

And this would suggest similar because cash usually looks … or money markets look better … at usually the peak of a Fed cutting cycle relative to bonds. But they don't … but investors don't think about, well, on a forward-looking basis. Bonds can make that recovery. They can lock in the yield. And then finally, equities are usually the last … so equities wait in a cycle until Fed rates are all the way down.

They've already allocated to bonds, and then they look to stocks after that. We're not even there yet. But for us it's about that allocation. Thinking about fixed income today versus money markets, where we are in the cutting cycle.

John P. Bryson

Yeah I mean we've been having that conversation about people have cash in the sidelines and when are they going to move. They should lock in higher rates now. I mean now's the time. If you continue to wait, it's … it's a big mistake. So, for the investment professionals out there, certainly keep that in mind … that behavior is not going to pivot on a dime … we're going to have to encourage people.

Hey, Emily, when we think through these changes that are going on, and we think through the rate-environment dynamic, and we think through the market highs, has your outlook for investors changed going forward? And what would be your key takeaways for the rest of the year?

Emily R. Roland

Yeah, John, we continued to be positioned for this late-cycle environment where we really want to look underneath the hood to figure out what areas are potentially mispriced here or should expect to see leadership trends continue. And I think, you know, Matt really hit the nail on the head talking about the elevated income that's now available and high-quality bonds … getting that cash on the sidelines. Embracing a core or core-plus type bond strategy that's going to allow investors to lock in, you know, an elevated income stream here for years rather than sitting in cash or CDs or money market funds.

So I do think that, you know, in our view, that bonds can do some more heavy lifting in portfolios heading into the back half of the year and into 2025. It can happen quickly. So we … we always want to think about kind of, you know, repairing the roof while the sun is still shining. And so we really want to think about making those shifts within fixed-income portfolios.

You know, credit is just not really offering you a huge advantage relative to the potential risks that are there. On the equity side, we want to continue emphasizing higher-quality stocks. They do tend to do well as a factor in rate-cutting environments. So these are companies with lots of cash, great balance sheets, stable profit margins.

You know, we find a lot of quality in the U.S. technology space. We like that. There are some valuation concerns there … so … so we're really looking at where we can find quality at a reasonable price. Areas like mid-cap equities that Matt mentioned have cheapened up. We think that offers a nice opportunity  especially given some of the trends we're seeing around fiscal spending and onshoring activity that's leading to a really industrial renaissance in the U.S. midwest.

We think embracing mid-cap industrials, can really help us play that trend and do it at a reasonable price. So really thinking about quality, looking at the U.S. over international equities as we're doing slightly better from an economic growth and earnings growth perspective. And really just being mindful of risks. There is a lot of, you know, risk taking happening going on.

You know, and I think the Fed cutting 50 basis points has sort of added to that mood in the markets. Don't get me wrong. We want to be fully invested here. We just don't want to go over our skis and taking risks. So quality U.S mid-caps … and looking at high-quality bonds … we think is a good formula as we head into what's probably going to be a bit of volatility into the back half of the year and then into next year.

John P. Bryson

Yep. Makes sense. I think a lot of people wait till the beginning of the year to make allocation changes. Now is a great time to grab a pumpkin spice latte, grab your pencil, sharpen up your allocations. Extend, grab that higher yield and fixed income, upgrade the quality in a portfolio. Awesome. Awesome info folks. The markets are always changing and very dynamic.

If you follow Matt and Emily on LinkedIn, you can get their most recent updates. I highly recommend you do it. Emily, is at Emily R Roland and Matt is at Matthew underscore Miskin. You can keep up to speed. At the end of the quarter, they'll be updating a very popular market intelligence piece so keep an eye out for that.

And as always, if you want to hear more, please subscribe to the Portfolio Intelligence podcast on wherever you subscribe, or check out our website JH investments.com to stay up to speed on all the great business-building ideas and market commentary that we have for you. As always, thanks so much for listening to the show.