Daryl Boxall: From a valuation perspective, I'm concerned about the deviation between private and public markets. There is significantly more volatility in public markets, which isn’t observed in private markets. That's to be expected somewhat from the method and frequency that many private market assets are valued, but it's unclear as to whether it is a feature or a bug – different investors have different views on that. In my experience, where there's a market downturn combined with a lack of transparency - people tend to fear for the worst, so I worry about a correction in private credit/equity valuations relative to their public counterparts.
"Corporate insolvencies are close to 2008 financial crisis highs at the moment. However, investment grade credit spreads are quite tight, historically."
From a pricing perspective, we've come out of a prolonged period of low interest rates, where there has been an element where ‘a rising tide lifts all boats’. Rising interest rates is not new-news to anyone – but it does mean it is no longer a case of following asset class flows – you need to have trust and conviction in your underwriting process and the skill to weed out the good from the bad within an asset class. Some of that strict discipline around risk pricing has been relaxed in past years when rates were low, and investors chased yield.
When I consider ratings – looking at the UK Insolvency Service statistics – corporate insolvencies are close to 2008 financial crisis highs at the moment. However, investment grade credit spreads are quite tight, historically as well.
That, to me, warrants asking the question of whether investment grade markets are under-pricing default and downgrade risks. We're at the point in the cycle where central banks have made herculean efforts to combat inflation, and they've done a good job – and understandably markets are taking comfort from that. But, on balance, there’s some sensitivity lurking – we’re in a place where it won’t take too much to spook markets into a correction.
Daryl: If you look at the macroeconomic picture, UK employment is not far off all-time lows, GDP was positive in Q1 2024. It seems to me that insolvency is mainly caused by companies struggling with their own costs because interest rates have gone up, and they’ve been dealing with persistent high inflation as well.
It’s possible that those conditions have reached their peak and will improve. The consensus view is that the Bank of England will reduce the base rate, so the prospect of further rate rises is diminishing, and inflation is largely back down to central bank targets now.
Daryl: It will probably be reinforced as time goes on – it takes time for underlying risks and weaknesses to crystallise. Companies where that vulnerability is closer to the surface and more obvious will come under pressure faster. There will also be some companies that are less obviously badly positioned, where the issues will take longer to crystallise, and the real pain won’t be felt until further through the cycle.
We all have a recency bias to some extent. If we start observing an uptick in investment grade defaults and downgrades that focus minds on underwriting discipline.
Daryl: The short answer is: look everywhere. Political risk is high on people's agenda in 2024, as it’s the election year. 50% of the world's population are voting for new governments, so political risk is elevated, and this has captured people's attention. If I look in the market, though, to try and see how it has captured people's attention it seems to be stuck in the ‘awareness and understanding’ phase as opposed to a ‘taking action’ phase – people are grappling with how to translate the implications of elevated political risk into portfolio positioning or risk mitigation actions.
"The big challenges that the world faces – climate change, mass migration, conflict, inequality – they’re structural, multifaceted, and human-related."
It's genuinely tricky – if you think about the big, thematic challenges that the world faces at the moment – climate change, mass migration, escalating conflict, inequality – they’re deeply structural, multifaceted, and human-related. Resolving them is not a simple case of small domestic policy changes. They will require coordinated global action to address this.
With my cynical hat on, when you have problems of that nature you reach the tipping point for coordinated action when the consequences of not doing so are unavoidable. I’m still an optimist and think that when we do get to that point we can come together and resolve it.
When you think back to Covid; the early consensus on vaccines focused on having never mobilised a vaccine in a quicker time than four or five years – however, there was sufficient motivation, focus of hearts and minds, and coordinated global action and it was achieved much faster.
Daryl: In all business, especially in the risk sector, relationships are critical.
Because risk is such a multi-discipline area, it's impossible for one person to be on top of all the detail, nuance, and complexity across all the areas you need to be, to do the job well.
In a sense, you are only as good as your supporting team, network, and the relationships that bind those together. That’s your source of information and insights, and if you don't have relationships that build and maintain that then you're going to be at a disadvantage.
To get sizeable investments deployed in new asset classes, you need to use those relationships – no one works in isolation – you need to rely on colleagues or advisors in risk, accounting, legal, and modelling – to come together and deliver.
"We make a huge effort to build a two-way relationship with our
first-line colleagues, based on credibility and mutual respect."
Within risk, we often see part of our role in those relationships as being the people who take a step back and think about the bigger picture – if you have been in the weeds of developing an investment proposition, or due diligence on an asset class, it is very easy to miss the wood for the trees.
We make a huge effort to build a two-way relationship with our first-line colleagues, based on credibility and mutual respect. Quite frankly – it’s easy to list all the possible ways that an investment can go wrong. That's not adding any value. To be a high-performing risk team, the conversation needs to flow both ways, with risk providing productive ideas back to the first line. Instead of saying “no” you say, “maybe not, but how about …”. Having that open and honest challenge enhances the view of risk as trusted partners to the business.
Daryl: The private market space is broad and encompasses a large amount of individual asset classes and risk profiles. As a fixed income investor through our Matching Adjustment portfolio, we focus primarily on private debt, but do have some venture/private equity holdings too.
Private debt spans from the more vanilla end of the spectrum; lending directly to corporates that aren’t too dissimilar to publicly issued debt, all the way to highly bespoke lending secured by calls on underlying property or other asset types.
The key thing to be cognisant of right now is expertise. I’ve seen estimates of c.$500 billion of dry powder available to private debt markets, so you have to be wary of following a big wall of capital into that market, in terms of supply and demand dynamics.
In those conditions, you have to ensure that you are allocating capital where you have, or can access, a genuine edge where other people don't. That edge may come from a number of places, e.g., being able to take more liquidity risk than others due to the illiquid nature of your liabilities, having access to a best-in-class origination team for a particular asset class, or understanding and pricing certain risks better than others.
"On the overhyped angle - at the risk of appearing contrarian
for the sake of it, I would put AI in that category."
As I said earlier – I worry about the risk of correction in valuations in private markets. In the long low-rates environment we have been through, there was pressure all around to relax risk protections to chase yield – a good example is convenient-lite loans. You do not want to find yourself in those types of assets, unless your managers have diligent underwriting, and an understanding and experience of things going south in their asset class.
On the overhyped angle - at the risk of appearing contrarian for the sake of it, I would put Artificial Intelligence (AI) in that category. So many people are animated about the potential use cases, and of all the different ways that AI could transform the world. There's a model for new technology called the Gartner Hype Cycle, and I’d place AI right around the peak of inflated expectations at the moment. Call me a Luddite, but I don’t buy the extreme concerns of AI picking off huge swathes of human jobs – it’s more likely to be a tool that helps people be more efficient – like Excel compared to a calculator.
Daryl: There is a lot of regulatory activity around liquidity at the moment – both in the UK and internationally. This is my view, which has been mainly driven by two things; firstly, and the more UK-specific is around taking lessons from the mini-budget crisis. Secondly – a recognition that non-bank financial institutions, like insurers, now occupy a significant place in private markets.
"The mini-budget crisis was better weathered by annuity insurers relative to pension funds. That raised some interesting questions for regulators."
For many years, banks have been subject to stringent regulatory liquidity testing, which the non-bank sector hasn’t been. By stepping into the banks' shoes as lenders in private markets, there are calls that those entities, like insurers, should be subject to more scrutiny on liquidity risks.
The mini-budget crisis was better weathered by annuity insurers relative to pension funds. That raised some interesting questions for regulators; you have two industries, with the same liabilities, adopting roughly the same asset-liability matching principles using similar assets, but one struggled and the other didn’t – how does that work? We’re helping flesh that out as an industry through various market-wide initiatives.
