First Eagle over time has deliberately sought to nurture an investment-led culture supported by a set of core investment tenets that encourages philosophical autonomy among our portfolio management teams in pursuit of client goals. While our four investment teams operate independently, we strongly believe each can benefit from the disciplined, unconventional thinking the others bring to bear in their areas of expertise. To share such insights broadly across the organization, we periodically assemble the senior members of our investment teams; below is an overview of some of the key issues raised at our midyear 2023 gathering.
Matt McLennan
Co-Head of Global Value Team
Looking at a variety of market indicators, it might be easy to get the impression that the world returned to normal during the first half of 2023. The S&P 500 Index was up nearly 17%, implied stock market volatility receded
to pre-Covid levels, bond yields moderated and inflation expectations continued to ease.1 Ironically, the signs of cyclical improvements in US inflation data that have supported these sanguine developments may also be distracting markets from the emergence of more-worrying secular concerns—perhaps most notably, rising sovereign risk due to an erosion of the country’s fiscal position.
It’s possible that the regional bank failures we saw earlier in the year were the proverbial canaries in the coal mine warning us of hazardous conditions. Though each failure was idiosyncratic in nature, they all appeared to grow from a common root: the massive fiscal stimulus rolled out in response to the disruptions from Covid-19.
The expansion of the US money supply—M2 grew by about 40% from March 2020 to its peak in April 2022—led to a surge in commercial bank deposits.2 With loan activity off its peaks and interest rates near zero, banks sought profitable applications for these deposits. Many tried to scratch out marginal yield by increasing exposure to long-dated Treasuries. Given the government’s ability to print money, the risk of credit losses on US Treasuries is minimal; as such, bank capital guidelines assign US government securities a risk weighting of zero, meaning that banks are not required to hold a multiple of capital against these exposures as they are with risk assets. And though the duration risk of these Treasuries was no secret, many banks likely deemed the risk/reward acceptable given the 40-year downtrend in interest rates. They were wrong, of course, and paid dearly. Treasury yields picked up in late 2021 as inflation prints continued to rise, and the onset of aggressive Fed tightening—which came at a lag given the average inflation-targeting policy framework adopted by the central bank in 2020—acceler-ated their move higher.
So where did this unexpectedly strong surge in inflation come from? Economist John Cochrane has posited a theory of inflation that to me seems particularly well aligned with today’s dynamics. His “fiscal theory of the price level” states that “inflation adjusts so that the real value of government debt equals the present value of primary surpluses.” In essence, fiat money only has value because it’s required for the payment of taxes; thus, a govern-ment bond denominated in fiat only has real value if there is an expectation that there will be sufficient budget surpluses in the future such that the bond can be repaid in real terms. If such surpluses fail to materialize, addi-tional bonds must be issued—which for existing holders of sovereign paper act as the equivalent of a share split. He goes on to point out that debt and deficits are not necessarily highly correlated with inflation if government credibility remains intact. If investors lose faith in the government’s ability to generate the necessary surpluses to repay the outstanding deficit, however, new debt can be inflationary. 3
Exhibit 1 depicts the US government’s cyclically adjusted primary fiscal balance—the difference between federal non-interest spending and receipts—going back to World War II. Until about 2000, the government tended to run a small surplus on average, suggesting credibility as an issuer. Since then, however, there has been a meaningful erosion in the country’s fiscal picture, as crises have been met with deeper and deeper deficits while produc-tivity improvements lag. At some point, it’s possible that market participants perceive the resumption of fiscal surpluses to be further into the future than had been typical in the twentieth century, leading to persistently above-target price increases amid sluggish economic growth—i.e., stagflation.
The emergence of stagflationary conditions likely would have significant implications for asset markets. For those who don’t remember the 1970s, it may be helpful to briefly highlight some of the high-level dynamics that emerged during our most recent period of stagflation. The US equity market traded sideways while the price of real assets like oil and gold surged. Pressure on the dollar helped international equities outperform US stocks during the period, as did a normalization of the outsized relative valuations that had developed during the US growth stock boom of the late 1960s. Finally, value outperformed growth, as stocks with shorter-duration cash flow streams outperformed amid high inflation. Furthermore, by the end of the 1970s, equity multiples were about half of what they are currently while fixed income yields were about double; although past performance does not guarantee future results, we could be in for a long period of adjustment were a similar pattern to emerge in the mid-2020s.
Jon Dorfman
Chief Investment Officer, Napier Park
Since the financial crisis, credit as an asset class has been pretty dull to anyone but natural credit investors. We appear to be at an inflection point, however, as credit markets seem to be consistently offering investors equity-like returns—something we haven’t seen for decades. The Fed’s hiking cycle has spawned seismic shifts in the credit market, and absolute yield relative to risk appears to be more attractive than it has been since the early 2000s, for a few specific reasons that I can see:
- There has been an enormous reduction in global liquidity, as persistently high inflation forced central banks to pivot toward restrictive policies after years of very easy money.
- These tighter financial conditions have resulted in a dramatic increase in the cost of capital for companies, consumers and real estate investments.
- Investors that built significant private market exposures over the years as an alternative to very low public market yields may face liquidity issues as distributions from these private investments wind down. Many rely on these distributions to fund capital calls on other unrelated private commitments. It’s likely the liquidity challenges that emerge when these distributions stop will exacerbate existing issues around the availability and cost of credit for borrowers.
Despite credit’s attractive pricing, I think there are still some challenges that have not yet been fully priced into markets—something that fundamentally driven investors such as ourselves should be able to navigate.
Bank lending standards historically have been highly correlated to defaults, and they are an indicator the team pays keen attention to. Banks began tightening their standards about 18 months ago—before the Fed began hiking rates in 2022 and prior to this year’s regional bank failures. Though the cost of credit has been higher for some time, default rates have been slow to react; rising interest rates and inflation generally have a lagged impact on the real economy, and strong corporate balance sheets also have helped insulate against short-term deterioration.
We think defaults will continue to rise over time, especially relative to what market participants have become accustomed to over the past 10-plus years; however, we do expect defaults to be sector- or asset-specific rather than systemic. This is counter to what we observe in credit markets, as spreads within many sectors are uniformly pricing in a near-term recession and more elevated level of default. We regard this as a potential opportunity, one that is likely to be durable given the time it will take for the economic picture to become truly clear.
The environment of restricted capital and restricted liquidity has resulted in higher credit volatility and greater credit spread dispersion. Combined with falling trading volumes and tepid new issuance, these dynamics should continue to promote disparate changes in spreads across credit markets; as shown in Exhibit 2, this has been particularly true among the complex, structured instruments that are our areas of focus, such as US and European collateralized loan obligations (CLOs), consumer asset-backed securities (ABS) and residential mortgage creditÂ-risk transfer (CRT) securities. In my view, these conditions should favor active credit managers.
Securitized and structured credit markets are pricing in extreme economic outcomes, to a much greater degree than other credit markets and US equities. Spreads on structured credits currently rank in the top decile to 15th percentile of their 10-year ranges, while spreads on more-liquid assets like high yield bonds and leveraged loans are closer to the 50th percentile.4 Given historically wide credit spreads and a much higher and continually rising base rate, overall yields are now at equity-like levels that we view as highly attractive. With losses on securitized credit highly likely to run well below the rate currently priced into the market, in our view, these assets may represent the kind of secular opportunity that lures non-credit investors into the credit space for the first time in 20 years.
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