The great rotation

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We focus on senior secured direct lending strategies with short durations that offer stable and attractive returns, protection and liquidity.

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Financial markets are hard to predict. After a difficult year with a lot of volatility and uncertainties around the Covid-19 crisis, the outlook for 2021 appears positive. The speed at which vaccines have been developed and distributed has been undeniably impressive and fortunately, there is a relatively high share of the population with some sort of immunity, probably coming from contacts with previous coronaviruses. More importantly, only a relatively small part of the population is at high risk of having a severe course of the disease. These are older people (that is people over 60 years old); and those with underlying medical conditions (such as cardiovascular disease, diabetes, chronic respiratory disease, and cancer). This means that with the ambitious vaccination process, starting with these vulnerable groups, we should have significant relief for hospitals soon, especially the intensive care units (ICUs) that in some regions and cities were at the verge of collapse during last year’s peaks.

Source: Bloomberg

Therefore, economists have become very hopeful that the drastic lockdowns and other unprecedented, inhuman measures can be gradually lifted throughout 2021 – not to say that there are great doubts, to say the least, that these measures have been successful in the first place -. In any case, the gradual exit from lockdowns should lead to an economic recovery globally, with a notable advantage in developed countries such as Israel, the UK, Europe and the United States. The Asia Pacific Region has been much less affected, generally thanks to better health and high levels of pre-existing immunities against coronaviruses (it goes without saying that the lockdowns cannot explain a mortality rate per capita 30 times lower than in Western countries).

Typically, the economic recovery phase is very supportive for stock markets. Investors might be surprised though that the major indices are barely positive this year, due to a massive underperformance of some bluechips. Nevertheless, there are also some sectors that have had an excellent start of the year. In the United States, the best examples are the energy sector (+31%), transportation (+24%), the financial sector (+17%), followed by small- and mid-caps (+15%). On the other hand, defensive sectors such as consumer staples (-2%) and utilities (-1%) are amongst the losers.

This obviously makes a lot of sense. It is normal for investors to prefer cyclical companies that benefit most from the economic recovery. What is perhaps less intuitive is the underperformance of the technology sector (at the time of writing, the Nasdaq 100 was slightly negative year-to-date), which is traditionally categorized as a cyclical sector. This time, however, the economic recovery does not favor technology. In fact, many Nasdaq companies were amongst the main beneficiaries during the lockdowns for obvious reasons, as people spent more time on video calls, online shopping, social networks, movie streaming services etc.

In other words, the technology sector in the broadest sense was a defensive sector during the crisis, and has therefore lost appeal during the recovery. This “defensive” feature explains that some giants like Amazon, Apple, Walmart, Coca-Cola and Procter & Gamble all lost between 7% and 10% so far this year. In our opinion, this rotation from defensive to cyclical sectors may well last a few more weeks, but it is a matter of time until the winners of megatrends like 5G, cloud, big data, artificial intelligence, just to name a few, will return to the center of attention.

In our opinion, the biggest challenges for investors remain in the fixed income area. The increase in bond yields is another consequence of the anticipated economic recovery, especially in long-dated US treasuries. For example, the 10-year US Treasury yield has risen from 0.9% in December to more than 1.7% today, and the 30-year US Treasury yield has risen from 1.6% to almost 2.5% since the beginning of the year. We are seeing a steepening of the yield curve that is quite typical for the economic recovery phase, coupled with an increase in inflation expectations. This year we are seeing an excellent reminder of the most basic equation in fixed income, which is the inverse relationship between interest rates and bond prices. In other words, when interest rates rise, bond price decrease, and vice versa. Therefore, it is not surprising that major fixed income indices are suffering. The investment grade corporate bond index lost 7%, emerging market hard currency bonds are down 6% and the 20+ year treasury bond index even fell 15% this year, causing heavy losses for conservative investors.

Of course, it is never recommendable that investors abandon their risk profiles by allocating too much into equities and other risky asset classes, just because bond funds are temporarily struggling. Even though many economists and strategists have a positive view, there is no such thing as a crystal ball and there are always unknown uncertainties and tail risks that might trigger a major correction. Last year’s sell-off showed that this can go very fast – too fast for many investors. Instead of allocating more capital into risky assets, such as stocks and industrial commodities, we believe investors should rather explore new, alternative areas of conservative investments. On the credit side, the yield premiums of private investments (private debt, private credit, alternative credit) versus listed fixed income areas remains remarkable, as traditional fixed income markets remain inflated after the massive monetary stimulus over the last couple of years. We thus continue to recommend to overweight private debt areas, especially the most conservative ones in the senior-secured direct lending space, such as real estate bridge loans.