Higher For Longer Still Intact

The Federal Reserve elected for an aggressive start to its first easing campaign in four years, reducing the benchmark rate by 50 bps at its September meeting. In our view, while the magnitude of the cut may have surprised certain market participants, the Fed’s policy adjustment was already reflected in what market expectations for interest rates were in August. With the median dot plot for 2025 currently at 3.375% (vs. 4.125% in June), the Fed is now more aligned with the forward SOFR curve, which still shows a gradual path for easing toward a terminal floor of 2.75-3% in 2026.1 (Figure 1) Also worth noting, the Fed did not change its 2025 GDP forecast and slightly revised unemployment projections higher by just a fraction, from 4.2% to 4.4%.

However, while we remain positive on the U.S. economic outlook, as investors pivot their focus from inflation to the downside growth tail, volatility across markets is likely to increase. Historically, in each of the prior easing cycles since 1989, there was a notable increase in equity market volatility in the period following the first interest rate cut.3 (Figure 3) While equities may ultimately respond positively to easier monetary policy alongside reduced recession risk, the slowing growth dynamic is likely to lead to higher volatility across financial markets. Equity investors must contend with lofty valuations as the consensus S&P 500 bottoms-up P/E multiple is at 21×4 , limiting the scope for multiple expansion.

So, for prices to move higher corporate earnings for large cap companies, which are sensitive to the economic cycle, will have to continue to meet expected growth targets. With the S&P 500 currently trading at ~5700 as of the time of writing (vs. median analyst consensus 2024 YE forecast of 56005) price appreciation may be limited. Furthermore, with fixed income’s correlation to equites hovering at its highest level

in a decade, (.78 vs. average of .16 over the last 10 years) we think investors looking for fixed income to provide portfolio diversification may be disappointed.6 This may prompt investors to consider tilting asset class exposure towards investments like direct lending that, in a diversified portfolio, can help provide a buffer against higher volatility.

• St. Louis Fed FRED database. Financial conditions track indicators across money markets, credit and equity markets, and the banking system
• Antares Research, St. Louis Fed FRED database and Bloomberg
• Yardeni Research as of September 17, 2024
• Bloomberg
• Fixed income represented by Bloomberg Aggregate Bond Index and equities by the S&P 500

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Direct lending tailwinds to strengthen

Over the first three quarters of 2024, credit trends have remained broadly stable. While certain subsectors face idiosyncratic headwinds, the positive economic backdrop continues to support portfolio performance and remains favorable for overall credit performance. As interest rates fall, borrowers will begin to experience less interest cost burden and revenue and EBITDA growth is expected to continue, albeit at a slower rate granted a soft-landing scenario.

With non-accruals at benign levels and interest coverage ratios stabilizing and positioned to improve, we believe the environment remains constructive for future direct lending performance. All-in yields, which are currently ~11%7, should move lower as base rates decline, but a prospective increase in spreads could partially offset the decline. On balance, direct lending appears likely to continue to offer high single to low double-digit returns (depending on the use of leverage) as interest rates normalize, which we believe remains compelling on a risk-adjusted basis.

Historically, credit spreads tend to widen as base rates fall which should relieve some of the pricing pressure for first lien term loans.8 (Figure 4) Certain market dynamics that drove spreads tighter have modestly abated in 3Q24. On the demand side, CLO issuance has slowed slightly (though still tracking for a very strong year) and in 2Q24 private credit has recaptured share from the syndicated market for refinancings, although the market remains highly competitive.9 We think this trend will continue as syndicated market activity is subject to periods of dislocation and does not offer sponsors the same certainty of execution that private credit can provide. We witnessed this in August, when the short-lived volatility in equities led to the shelving of some BSL transactions.

On the supply side, lower interest rates should facilitate the long-awaited rebound in M&A activity. Signs of a pickup emerged over the summer, with M&A activity showing improvement.

According to the Boston Consulting Group, in July there were 196 M&A deals valued at more than $100 million, the highest level of 2024 and their proprietary M&A sentiment index shows positive momentum.9 (Figure 5) Anecdotally, many of our investment banking relationships have conveyed that during the remainder of the year, they plan to launch more deals from their extensive pipelines compared to 2023. With more than 30% of private equity portfolio companies being held for more than five years (vs. the typical 3-4 years), sponsors are likely to increase transaction activity to return capital to LPs.10

As markets contend with an uneven pace of rate cuts, slowdown in growth and the upcoming U.S. election, there will be no shortage of catalysts for increased volatility. In our opinion, the contractual income and enhanced downside protection that senior secured first lien loans offer represents a compelling opportunity for investors in the current investment climate.

• Cliffwater LLC as of August 13th, 2024
• Cliffwater LLC as of August 13th,2024
• Boston Consulting Group BCG’s M&A Sentiment Index: Monthly Market Insights | BCG
• Pitchbook LCD

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Disclosures

The materials presented herein are provided to you solely for informational purposes and unless otherwise indicated herein, has been prepared using, and is based on, information obtained by Antares Capital (“Antares”) from publicly available sources. It does not constitute an agreement, or an offer, commitment to offer, or agreement to sell any loans, securities or other assets including interests in any fund or vehicle. The materials contained herein are not intended, nor should they be construed or implied, to be a recommendation or advice of any kind. The information set forth herein has been compiled as of the date(s) noted, is preliminary and subject to change. There is no obligation on the part of Antares to update the information provided herein after the date hereof. Neither Antares nor any affiliate thereof represents or warrants the accuracy, completeness or reliability of any of the materials contained herein, either expressly or impliedly, for any particular purpose, and shall have no duty to update or correct any such information. Without in any way limiting the generality of the foregoing, you understand that certain of the information provided herein is based on information provided by third parties, and neither Antares nor any affiliate thereof makes any representation or warranty regarding the accuracy, completeness or reliability of any such information. In no event will Antares be liable for any losses or damages arising from or as a result of the use of the information or the materials contained herein.

Certain information contained herein concerning economic trends and performance is based on or derived from information provided by independent third-party sources. Antares believes that such information is accurate and that the sources from which it has been obtained are reliable; however, none of Antares nor any of its affiliates or agents can guarantee the accuracy of such information and they have not independently verified and are not responsible for any inaccuracies, omissions and outdated information contained in such third-party information or the assumptions on which such information is based. Certain other information regarding market analysis and conclusions could be based on opinions or assumptions (including those of Antares) that Antares considers reasonable. Unless otherwise indicated, such market analysis and conclusions represent the subjective views or beliefs of Antares.

The materials presented herein may include certain projections, forecasts and estimates that are forward-looking statements. Any such forward looking statements are based on certain assumptions about future events and are subject to various risks and uncertainties. Forward-looking statements are necessarily speculative in nature and it should be expected that some or all of the assumptions underlying them will not materialize or will vary significantly from actual results. Accordingly, actual results will vary from the projections, and such variations may be material. Some important factors that could cause actual results to differ materially from those in any forward-looking statements contained in these materials include, without limitation, changes in interest rates, default and recovery rates, market, financial or legal uncertainties, the timing of acquisitions of loans, the types of loans acquired, differences in the actual allocation of loans from those assumed mismatches between the time of accrual and receipt of interest proceeds from the loans and whether or not and how loan investments may be leveraged.

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