Brave new world

The following is an extract from our latest CIO outlook.

Our central case remains a recession for the US, Europe and UK in the first half of 2024, as Tim Drayson outlines. What does this mean for real assets?

Weaker GDP growth is likely to lead to lower demand for cyclical businesses and the more economically sensitive areas of real estate and infrastructure, such as offices and transportation, in our view. Conversely, residential property, utilities and social infrastructure are relatively uncorrelated to the economic cycle.

The flipside of higher rates is attractive debt returns. With interest rates at their highest levels for more than a decade, public credit yields are currently trading around the 80-90th percentile versus their 20-year histories; we can see a similar pattern in private credit. In real estate and infrastructure, debt yields are higher than valuation-based asset yields in several markets.

We think the lower-rated segment of the private credit market (B rated or below) will come under increasing debt servicing pressure. Recent research by Moody’s showed that, assuming a federal funds rate of 5.25%- 5.50%, the proportion of North American B3-rated issuers where EBITDA no longer covers interest cost would jump from 29% at the end of 2022 to 62% at the end of 2023.[1]

A further year of weak earnings growth and continued high funding costs is likely to push coverage ratios down further; pressure on credit metrics is likely to ripple up the sub-investment grade end of the rating scale.

As such, we expect rising defaults, restructurings and writedowns (although not a GFC-style crisis). From a debt investor’s perspective, we continue to believe that the tactical opportunity lies in the investment grade and resilient BB space, where returns are driven by interest rates more than as compensation for credit risk.

Capital structures created in a very different interest rate environment could be challenged by refinancing schedules. This is particularly the case in commercial real estate, where lending is typically shorter-term than most corporate or infrastructure lending.

There is an estimated $1.4 trillion of commercial mortgages maturing in the US during 2024-26.[2] Even for assets where cashflows have remained stable or grown, the material increase in rates since many of these loans were originated means that many loans cannot be refinanced on terms acceptable to lenders without injections of fresh equity. We believe this is likely to drive asset disposals from borrowers without access to equity, as well as demand for preferred equity to bridge. Either avenue could open opportunities for long-term investors with flexible capital.

These opportunities will need to be assessed with a robust approach to underwriting long-term free cash flows. A number of areas of real estate, with offices the most prominent example, are experiencing both changing occupier requirements and high future capital expenditure liabilities, including those associated with energy efficiency.

Conversely, residential and industrial assets are seeing more consistent demand with less risk on future capital liabilities. Those investing fresh equity, or originating new loans, need asset profiles and business plans that support long-term investment performance.

The above is an extract from our latest CIO outlook.

For those readers looking for more detailed insights, our full 2024 Real Assets outlook is also available. 

[1] Source: Moody’s, July 2023

[2] Source: MSCI as at 27 October 2023