CIO recommends investing in core assets that enjoy robust, predictable, and inflation-linked cash flows that are less exposed to cyclical pressures and have manageable levels of debt. (ddp)

Investors will look to this week’s data highlight—the release of US June CPI on Wednesday—for clues on how the Federal Reserve is navigating this balancing act. The consensus forecasts a 0.3% month-over-month gain in both headline and core measures, which would lead to a 3.1% year-over-year headline inflation rate and a 5.0% core rate. The latter would still be uncomfortably high for Fed Chair Jerome Powell, in our view.

The potential for further US policy tightening ahead is just one reason why we foresee more muted equity returns, higher uncertainty, and a rise in cross-asset volatility in the second half.

And with the risk that macroeconomic uncertainty pushes the equity-bond correlation into positive territory (reducing the diversification power of holding fixed income), we believe that private market investments could play an important role in portfolios in the second half.

Private debt can offer compelling current income, with robust fundamentals. In an environment of higher rates, we see favorable risk-adjusted income opportunities in private credit. Private credit can benefit from stronger covenant protection amid slowing economic growth. As banks tighten lending standards, direct lenders are filling the void. Their improved negotiation position has helped secure higher yields with JPMorgan data showing new loans yielding a coupon of close to 12.5% per annum. Newer deals are also marked by less leverage and more equity.

But with increasing cost of debt and deepening economic worries, selectivity and diversification will be key. Default rates in private credit markets have started to pick up, and we see them rising to historical averages in 2023. Yet, we expect investors’ total returns to remain positive in the mid-single-digit range, driven by high income generation.

Private equity can take advantage of current valuation dispersions. We think today’s market dynamics, especially bigger performance differences between strong and weak companies, offer good entry points in private equity.

Widening valuation dispersion should offer opportunities for managers to acquire assets at compelling valuations. And while elevated rates pose a risk for private equity managers as they impact cost and availability of debt financing, we think operational performance can be insulated thanks to sponsors’ active management.

As companies streamline costs and focus on raising liquidity, we observe increased activity in add-on deals, carveouts, and divestitures. We note that these deals also require less leverage and are generally better priced. To take advantage of these opportunities, we prefer exposure to value-oriented buyout strategies. We also think secondaries offer good value in the current climate, with average pricing declining to 81% in 2022, compared to 92%at the end of 2021.

Real assets may benefit if second-half inflation is stickier—but be selective. In a potential environment of stickier inflation, allocations to infrastructure and select core real estate could help with near-term income generation and diversification, while shielding wealth from long-term inflation erosion.

But we advocate a selective approach in real estate and recommend remaining invested in line with benchmark allocations. In the current environment, we maintain a focus on quality and resilience and favor properties with strong market fundamentals in robust sectors, like logistics. We remain cautious on suburban offices and shopping centers given near-term supply-demand imbalances.

Infrastructure assets have shown resilience to the current macroeconomic pressures, while benefiting from policy and structural tailwinds. We recommend investing in core assets that enjoy robust, predictable, and inflation-linked cash flows that are less exposed to cyclical pressures and have manageable levels of debt.

Beyond balancing traditional portfolios with an allocation to private markets, we also believe hedge funds should enable investors to navigate and seize dislocations through the economic and policy uncertainty of the second half.

Main contributors - Solita Marcelli, Mark Haefele, Matthew Carter, Antoinette Zuidweg, Jon Gordon

Content is a product of the Chief Investment Office (CIO).

Original report - US CPI uncertainty supports private markets exposure, 10 July 2023.