AQS Performance and Perspective

AQS Performance and Perspective - July 2023

June Employment and Inflation Data - Pointing Toward Soft Landing?

Unemployment Rate (BLS report): Lower 3.6% vs 3.7% prior; range: 3.4% - 3.7% since March 2022.

Nonfarm payrolls: increased 209,000; May revised down to 306k vs 339 prior estimate.

June CPI headline: 0.2% MoM / 3.0% YoY; Ex-Food & Energy (Core): 0.2% / 4.8%

(12-month plot w/ drill-down) (20-year trend, select categories)

June PPI: 0.1% MoM / 0.1% YoY; Ex-Food & Energy (Core): 0.0% / 2.8%

(12-month plot w/ drill-down); (12-year plot, YoY; peak March 22: 11.7%)

Will the Fed Read the Signs? Not likely.

World Interest Rate Probability suggests a 93.6% chance of another 25 basis point increase.

This Month

China's Balance Sheet Recession. What IS a balance sheet recession?
Private Credit - Going Small. More yield in smaller packages. But it takes more work.
Commercial Lending - Also Where the Yield Is. Collateral too.

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China - Balance Sheet Recession?

In 1990, Japan's Great Recession began what many now call the country's "lost decades" - a period when economic growth was routinely well below the average for developed nations and deflation was a constant threat.

Enter the Dragon

When China abandoned its lockdown-heavy "COVID zero" policy in December 2022, it was widely predicted (sorry, pay-wall Fortune but the headline remains) the nation's economy would boom as trade and travel returned to normal. But largely due to confusion and 'expert's reversals', consumer spending has been anemic. The property market continues to struggle after years of overbuilding. Home sales are weak, price growth has cooled and new housing starts have continued to drop. Excess leverage and overbuilding by developers has led to debt stress in the sector and empty buildings in many cities. Adding to the stress is $23 trillion in local government debt and rising youth unemployment. And if that isn't enough, exports fell the most in three years (12.4%) following a drop of 7.5% in May. All this after a reasonably robust first quarter when the economy grew 4.5%.

A Balance Sheet Recession

According to Richard Koo, chief economist at Nomura Research Institute, "China is entering a balance sheet recession...people are no longer borrowing money". He defines a balance sheet recession as a period when consumers and businesses put more of their money toward paying down debt instead of spending or investing. Koo maintains that when businesses turn from the goal of profit maximization to debt minimization, it can slow growth to a standstill. The latest China Beige Book survey indicates national borrowing in the country fell to its lowest level since 2010.

Treasury Secretary Yellen: But Not Here

While she acknowledged that China's problems could slow other parts of the world, a strong U.S. labor market suggested the U.S. could avoid a recession.

“Many countries do depend on strong Chinese growth to promote growth in their own economies, particularly countries in Asia — and slow growth in China can have some negative spillovers for the United States,” Yellen told Bloomberg Television in an interview Monday.

“[U.S. economic] growth has slowed, but our labor market continues to be quite strong — I don’t expect a recession,” Yellen added, expressing confidence that the economy is on a “good path” to curb inflation without significantly weakening the “strong” labor market.

Private Credit - Going Small

Private credit is structurally similar to what most investors know to be a 'corporate bond'. Private and public credit have other key differences as well.

Private Credit

Borrower and lender negotiate directly.
Does not require securities registration.
Accredited Investors (AI) and Qualified Institutional Buyers (QIBs) only.
Covenants negotiated by purchasers include a number of provisions not found in public issues.
Typically less than index eligible size
Depending on size, less liquid.

Public Credit

Borrower negotiates with securities dealer.
Registered at issuance.
Available to the public.
Frequently omit certain covenants; seldom require a rating be maintained. 'Covenant light'.
Typically but not always larger issues in excess of $300mm (index eligible).
Depending on size, more liquid.

Where the Yield Is

If you've never heard of Houlihan Lokey Inc., you are not alone. Nonetheless, HL pointed out recently that loans to smaller companies generate higher returns than those to bigger businesses. Smaller borrowers as measured by earnings, consistently pay the highest returns. HL's Private Performing Credit Index shows the dispersion between returns is growing in favor of the smaller bracket. Fund managers face a simple decision between higher returns and more time spent on due diligence.

AQS Has Been Involved Since 2018

AQS realized 5 years ago that smaller deals, though more due-diligence intensive, produced more yield. These returns are part of the reason the AQS Trailing Reinvestment has consistently remained at the top of our sector. Why don't larger managers get involved? It simply doesn't 'move the needle' in the context of hundreds of billions under management. Should your portfolio suffer because your manager is large?

Commercial Lending - Also Where the Yield Is. Collateral too.

AQS has created a structure in which clients are super-senior, first lien and the sponsor/underwriter has 'skin in the game'. Insurance friendly, pledged collateral, great rates, short maturities. Avoid the CMBS 'mill'.

The following is just one of the loans in which AQS has successfully invested and exited.