Will Cost of Capital Go Higher or Lower?
Everyone I speak with wants to talk about the stock market. Why won’t it go down? Why doesn’t it reflect the economy? What’s happening?
My response back is… I don’t really know.
Maybe the stock market only captures large companies less impacted by the economy. Or maybe allocators need to fill their equity bucket, and prices are being driven by equity re-balancing rather than speculation. Or maybe it’s bullish investors predicting an early recovery. Or maybe equity markets are so weighted towards tech stocks, it’s not reflective of the plight of traditional industry.
But high yield doesn’t make much sense, in this environment, to me either. Buying high yield risk (like an airline!) at mid-single digits make no sense… unless (i) investors are being forced into high yield because rates have been pushed so low and (ii) because investors are buying these bonds with the assumption that they are “quasi-government backed.” Because investors believe the government has more or less said “these assets can’t fail.” Not explicitly… but kinda explicitly. The spread is that treasuries are definitely backed by the government, whereas high yield is probably backed by the government. The government has shown they are just going to keep funding stuff, buying stuff, and supporting stuff such that anything in public credit markets, even stuff that isn’t super quality, is going to be supported.
So what does that mean? It means investors are buying stuff not based on the quality of the security, but the belief that they have to put their money somewhere, and that the government won’t let it fail.
And how long will this keep happening? It could be forever. It could be that even if the government pulls back, investors assume that they can keep buying risky stuff, because when things get bad they’ll be saved. And if rates stay low (which they may for a long time), investors will keep being forced into these high risk assets. Again… because there’s nothing else to buy and “there’s nothing to lose.” Or at least… it’s hard to lose.
So then what does that mean for private credit? Private credit, for now, is a safe haven of ration… kinda. Except, who knows. Would you want to own private commercial real estate? Or loans that have levered up private equity deals with thin debt to income ratios? Or residential real estate?
Maybe… but if the government isn’t there to help clean up your mistakes, maybe not. Or… at the very least, there will be some deals people say no to.
And so maybe private lending becomes a safe haven for investors who still feel like it’s a place where they can “invest based on risk” rather than “allocate based on hoping the government doesn’t change it’s mind.” But then that too will push more capital into private credit, not away from it.
And this whole time, when we thought the world was going to show us higher yields because the cost of capital was supposed to go up, the government may have shown us that they are going to keep pushing returns down forever.
This could be frustrating. The rational investor may think: “but what the hell should I be investing in, then, if the whole world is irrational and based on some crazy ‘can’t lose, fake capitalism’ scheme?”
Well, in investing you can buy or sell. And maybe the move is to sell risk into this government-subsidized wonderland of cheap credit. Maybe… the next 5–10 years will be about uncovering reasonable risk in private markets that has sorta low returns and selling that risk into public markets with even more offensively low returns. Maybe it’s just better to be an originator/seller for a while, since owning risk is just one big speculation on the government’s policy and emotions… not based on the risk itself. Or at least selling that risk into big old pools of stuff the government can easily spot and support.
Maybe investing will be about finding one dumb, irrational place to invest, and buying assets there, and selling them into a dumber, even more irrational place to invest, like high yield credit markets drunk with a “we can’t lose” mentality.
I don’t know.
Maybe I’m wrong.