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Previously, I talked about the last popular Bridgewater item that made the rounds. They are out with another similar note today on their prediction that we are headed for stagflation.

The note generally updates their prior call for current implied financial conditions, namely how markets are predicting that the Fed Funds rate will go up to somewhere in the mid-high 3s by next year and then cuts will start. Bridgewater thinks that this will not be enough and political forces may keep the Fed from breaking the back of the economy to truly tame inflation, potentially causing a second tightening cycle. They note:

Thus, the degree and duration of the tightening must be strong enough and long-lasting enough to bring credit growth down by enough (roughly by half ) for long enough—to bring spending down by enough for long enough—to weaken labor markets by enough—to bring wages down by enough—that NGDP growth falls by enough and stays there—to bring inflation down to 2.5%. Historically, the average lead time of a decline in labor markets to a decline in wages is about two years, with a wide range around that average.

As mentioned, we doubt the scenario that is now discounted in the markets and think that the odds of a protracted stagflation are much higher. Our systems suggest the same for the near term which now doubt the degree of near-term tightening that is discounted, the 2.5% terminal inflation rate that is now priced in, and the future level of earnings that is now priced in, reflecting instead the growing vulnerability of the dollar should those doubts prove true.

Basically Bridgewater says that the Fed needs to do major damage to credit, to do major damage to spending, to damage wages, to blunt overall growth and thus inflation. I do feel like we may be at some sort of crossroads, with one direction supported by fear mongers like Bridgewater and the other being that the market is right. But “feeling” something isn’t actionable.

As an investor just focused on staying in the game, none of this really matters as an input. Sticking with a process that is conservative and just keeps one in the game, is indeed what matters.

I previously investigated the publicly traded BDC, Apollo Investment Corporation (AINV), Apollo’s middle market publicly traded direct lending vehicle here and here.

The general conclusion was that AINV was heading towards being a 100% first lien, 100% co-invested with MidCap vehicle – versus one that trafficked in MidCap levered loans / ABLs along with aircraft and a pile of legacy non-core loans. Today the company made a number of strategic announcements:

• Rebranding under the MidCap banner, detaching from confusing Apollo Investment Corporation name
• Reducing fee structure, enabling investments in lower yield / higher quality loans
• ~3% post-close equity investment in AINV at NAV, which is ~35-40% higher than yesterday’s trading price, and validating existing NAV

AINV will head towards being one of, if not the only, 100% first lien middle market publicly traded loan vehicle. In my opinion, an attractive cut of loans given MidCap’s track record.

The big question in my mind is would Apollo wind down the vehicle given growth is dependent on being able to issue equity at or above NAV, a long way from where it was yesterday.

I was able, for the first time, to get airtime with management on AINV’s earnings call this morning. And the answers to my questions made future ambitions clear. Apollo plans to support the vehicle and aims to grow it based on issuing equity when / if that window opens.

As such, what does this mean today? As of right now, AINV is trading up 1-2%, so the market reaction is muted / non-existent. I believe that purchasing MidCap loans at a 25% discount, or at a look through LTV of 45%, is attractive. Not to mention the dividend was increased as a part of the above strategic announcement and continues to remain depressed as it rolls off its aircraft and non-core investments.

All told, following AINV has been a fun experience in thinking through strategy and pulled on other research I had done on credit markets and Apollo’s equity. We’ll see how the story continues to play out.

Disclosure: We own shares of AINV. This is not investment advice, do your own work.

I’ve written previously about my interest in grocery-anchored shopping centers. Retail has been an ugly duckling among the real estate landscape for a long time. Big name retailers have had a tough time finding their spot versus e-commerce competition for about a decade. Look no further than GAP letting go its CEO after a short tenure (and its prior CEO was similarly canned).

Our investments in grocery anchored (or shadow anchored) shopping centers have done remarkably well, despite investing the majority of the capital mere months before the pandemic started. A number of the investments are printing mid-teens cash-on-cash returns, stunningly higher than what I personally expected.

We recently invested in a shopping center deal that placed debt around ~4.75% and has a cap rate (unlevered yield) of about ~7.25%, so a spread of 2.5% between debt and unlevered yield. That’s about my line in the sand on how much spread I need for real estate investments. This deal’s spread should widen as outparcels (e.g., Starbucks pads, etc.) are sold off, returning capital and increasing the unlevered yield on the remaining capital invested to between 9-11%.

That said, the door on investing in grocery anchored shopping centers appears to be closing or is closed going forward. Rates on debt have climbed since this deal was signed and cap rates haven’t yet moved. Thus the spread between debt and unlevered yield is collapsing, reducing potential investor returns. Furthermore, the asset class has seen a material change in investor sentiment. One of our investment managers recently commented:

Our original thesis led us to take advantage of mispriced, stabilized assets due to the public perception of retail in general. That perception has changed drastically the last 12 months and grocery anchored retail is quickly becoming (or has become) one of the most desired asset classes for public and private investors.

To that end, it appears that the only asset class within real estate that I know of with an “icky” factor is office, given the major lack of consensus in transitory / permanent nature of work from home trends. I haven’t seen a strong actionable thesis yet that is investable, but presume that will materialize as the pandemic recedes from memory and business practices find some level of normal.

Neel Kashkari of ’08 Great Financial Crisis fame (Paulson’s assistant at Treasury), is out in the NYT throwing shade on the consensus Fed rate expectations.

Currently, September futures imply a peak Fed funds rate in the 3s early next year and then cuts later in the year. Kashkari had something else to say about that:

“I don’t know what the bond market is looking at in reaching that conclusion,” Mr. Kashkari said, adding that the bar would be “very, very high” to lower rates.

He went further to reaffirm the commitment to blunt inflation:

“The committee is united in our determination to get inflation back down to 2 percent, and I think we’re going to continue to do what we need to do until we are convinced that inflation is well on its way back down to 2 percent — and we are a long way away from that.”

That said, while it is fun to follow the Fed drama, the back and forth has direct implications on what is likely to be a muted investment environment given uncertainty breeds caution.

Ares reported earnings this week. As usual, there are a few market related pieces of commentary that were helpful to know.

On spreads today:

So — but order of magnitude, if you were to look at the market today, factoring in OID and credit spread adjustment and the new SOFR environment, first lien loans in the middle market are probably somewhere in the [500 to 550] range with [90 to 95] OID. So kind of pricing 7% to [875] all-in for first lien piece of paper. That’s significantly wider than we saw coming into the beginning of the year.

On risk / return in direct lending:

Ladder Capital also reported this week and had interesting comments about real estate and the credit part of the stack which is their primary business. On credit spreads:

…I know that we talked about how credit spreads got really wide, especially in the CLO business. I think that was a function of a technical, and I think we’ve talked about this, where the 2 year was just galloping higher and LIBOR wasn’t moving. I know at the end of the day, the 2 year at 286 and 3-month LIBOR that 78. So all those spread widening, I think, that you saw, which (inaudible) technical reasons, they would see too far low the 2 years, I think you’re going to see a sharp reversal and the tightening spreads here.

On where BB corporate bonds are trading (and repurchasing their own debt):

The short bond that is due in ’25 for us. We’re purchasing that between 91% and 92%. The 2027 was around 82%. And the 2029 was actually around 78%. There was a follow of 2029 trading in the low 70s at one point. And these weren’t trading at those discounts because anybody thinks that the companies are having it from, that’s just where BBs are trading with 8 years of duration or 7 or 8 years left on them.

Transactional debt financing is largely on pause right now – especially anything below investment grade, which is largely where financials sponsors play. Moelis reported earnings yesterday but more interesting than its earnings were Ken Moelis’ comments on the transactional debt markets. These are my highlights from the call:

“…the debt market is not fully operational due to significant transactional loans that are mispriced for the current market and need to move through the system. As a result, the market conditions that existed in Q2 have continued into the beginning of Q3.”

“The debt markets are just not functioning right now. And I think that’s a function of, there’s a bunch of loans that are being marked down. It’s a little bit like the retailers are doing. I think the product that was put on the shelves 3, 4, 5 months ago isn’t appropriate for the market today. It’s going to be discounted and cleared that will happen quickly. And then I think I believe we’ll be back to a new financing market. But right now, I think the sponsor community wants to transact. They just can’t transact in the capitalizations that they want to.”

“The banks are strong. The nonbank market is strong. But right now, the nonbank market is focused on transactional loans that the banks have and they’re being offered at the clearance aisle, 10%, 20% off. And I just think that’s just a natural, yes, I think that those are going to get cleared out because they’re onetime, and then we will reset and the banks will be in business.”

It’s in the 90s where I’m at but the elevation and / or breeze is making it feel positively delightful. Nothing like a morning “hike” with a cool breeze.

The Fed did some hiking of its own today by moving the benchmark range up by 75bps to a 2.25-2.5% target.

Blackstone released its July commentary recently. I found a few sound bytes to be interesting:

We maintain our view that inflation is going to remain persistently elevated, with “sticky” forms of inflation, including shelter pricesand labor costs, potentially hindering a quick return to lower inflation. It may be easy to go from 9% inflation to 5%, but going from 5% to 2% may take longer than many expect.

…despite souring consumer sentiment amid biting inflation levels, consumption has remained steady. Finally, and perhaps most significantly, there is still a significant cushion of excess savings and elevated levels of liquid financial assets on household balance sheets.

Markets are pricing in a terminal rate of 3.5% for this Fed hiking cycle, but the Fed may very well need to raise rates much higher than that. A Fed Funds rate of 5% is a real possibility. For the Fed to feel that it has really licked inflation, the central bank will want to see lower levels with its own eyes.

Plenty of cross currents in markets today that cause volatility, but still remains what I personally believe to be a decent market to invest into – as a good measure of the excess in speculation has left the system and most everyone anticipates a poor economic environment going forward.

On vacay but couldn’t help but be a little ticked by the following:

Kraken, one of the world's largest crypto exchanges, is under investigation by the US Treasury Department for potentially violating sanctions by allowing accounts in Iran and other countries to buy and sell crypto. Latest w/ @yaffebellany: https://t.co/BixJm2lm9g

— Ryan Mac 🙃 (@RMac18) July 26, 2022

$COIN shares plummeted 8% shortly after opening bell. The #cryptocurrency exchange platform is facing an SEC probe into whether it improperly let Americans trade digital assets that should have been registered as securities.https://t.co/PiFwNUduIE pic.twitter.com/j4gLLqL9bT

— Yahoo Finance Plus (@yfinanceplus) July 26, 2022

Josh Friedman, one of the co-founders of Canyon, was on Capital Allocators recently.

He’s one of the Drexel diaspora, of particular interest to me right now as a I re-read the book Den of Thieves. In the podcast he goes over some of the mistakes made in setting up an alternatives firm and the differences in his path vs. some of today’s mega-cap alternatives firms. Of note, it was interesting hearing him outline how he had many of the investing strategies that others had (e.g., risk arb, distressed, high yield, etc.), but co-mingled them rather than keeping them as separate products – which made it much harder for potential limited partners to allocate to them.

Separately, he discussed opportunities in today’s market from a credit investor’s point of view. A few notables he pointed out included fixed rate liquid credit and lower rated tranches of unsecured consumer loans. He outlined that while lower grade fixed rate bonds have declined rapidly in price, and should represent some measure of value today – investors that hold them often dump them because they have declined in price. Therefore the forced selling is pushing certain fixed rate bonds into highly investable opportunities. He also outlined that consumer unsecured loans, specifically those related to home improvement and at the lower end of the securitized tranches, have gapped out about 4x (on a spread basis), representing a wholesale major repricing in return expectations.

All told, it was an interesting interview that was an easy listen and I recommend it.

As the Fed put the brakes on the excess in the marketplace under the cover of inflation, it was obvious that housing was going to be tip of the spear. Affordability has dropped dramatically as mortgage pricing has soared relative to the rock bottom levels of the past.

There’s a lot of speculation out there on the extent to which housing will suffer. Sometimes its good to just use common sense and look at the data.

Enter Bend, Oregon. This resort town saw a similar boom to other resort towns such as Park City, Lake Tahoe, Breckenridge, etc.

Here’s a luxury home, 4 bedroom / 4 bath brand new construction on the west side of town (a desirable part):

And here’s what they builder is going through. You will have to read upwards from the bottom of the two pictures below.

Ouch. Talk about desperation. A 27% cumulative price cut from the initial listing.

That said, this home would likely have sold for far lower in 2018 let alone 2012. All is to say, in some pockets, the excess is quickly flowing back out to sea. How far we will go in the other direction is anybody’s guess.