Higher for Longer: The CIOs’ Way In

Brad Tank, Co-Chief Investment Officer and Global Head of Fixed Income

While this year’s inflation and rates environment has disappointed many, we see it as a bump in the road that has created opportunity in several markets.

Midway through 2024, it’s pretty clear what the story of the year has been so far: stickier inflation and higher rates for longer than many investors wanted or expected.

That was the topic of the opening Chief Investment Officers’ discussion at Neuberger Berman’s Investment Leaders’ Summit last Wednesday. How have the fixed income, equity and private markets been affected by the shift to higher rates? And how disruptive has the unexpected persistence of the peak in rates been?

All of us reiterated that it is the destination for rates that is more important, not the journey . But we also concluded that the adjustment to the new environment has been largely orderly and generated plenty of investment opportunity, even though the journey has been bumpier than anticipated.

Upside

I kicked things off with the fixed income perspective.

It has been notable that, even with this year’s inflation disappointments, there have been fewer central-bank headlines and lower market volatility than when rates were on the way up. Moreover, this has been the case even though the central banks that have cut rates—including the European Central Bank and those of Canada, Switzerland and Sweden—have also cast doubt on when the next cuts will come.

That is more important than many recognize: When rates are going up, the destination is troublingly uncertain; on the way down, for all the ebb and flow, we know the end point is somewhere between zero and where we are now.

This has informed one of our key themes for the year: favoring the short and intermediate points on yield curves. Because policy-rate expectations are the main determinant of yields here, at peak rates the downside is effectively capped, income is unusually high, and upside is highly likely—even if the journey to get there takes longer and is more volatile than expected.

Further out on the curve, income is the same or even lower. At the same time, a range of other factors, from debt-sustainability concerns to uncertainty about growth trends or the term premium, make upside and downside risk more symmetrical.

In credit, while it is fair to say that spreads have been tight and risk fully valued for the broad market, higher rates for longer have caused stresses for some overstretched issuers and sectors, giving active managers opportunity to generate alpha.

Dispersion

Our Equities CIO, Joe Amato, continued that theme of quality as a determinant of this year’s often extreme dispersion of performance in stock markets, and how that relates to the higher-rates environment.

Companies with high free-cash-flow generation and little or no debt, often issued with long tenors back when yields were low, have been largely immune to the change in interest-rate regime. Some have earned more interest on their cash this past year than they have paid to service their debt.

These forces have also contributed to the dispersion between large- and small-cap markets over the past year. There are a lot of poor-quality smaller companies, but even higher-quality small and mid-caps tend to be more leveraged and need more access to lending markets than their equivalent large caps. As policy rates decline, we think some relief is on the way for those stronger firms, and some potential convergence of performance.

Transactions

In private markets, Jonathan Shofet, our Global Head of Private Investment Portfolios and Co-Investments, explained how a general shortage of debt financing, as well as the higher cost of what is available, has contributed to a marked slowdown in private equity transactions. The impact of higher rates on valuation multiples has further disincentivized exits, which ran at around half the long-term average rate last year.

As a result, General Partners (GPs) have been holding onto assets for longer while also facing pressure to send capital back to Limited Partners (LPs). This has created significant opportunity for investors willing to provide the liquidity GPs need , whether via traditional secondaries, GP secondaries or the burgeoning market in mid-life co-investments. From an average of around a third of our co-investments business, Jonathan revealed that mid-life transactions have accounted for more than half over the past year.

As rates come down, valuations recover and the pressure to sell assets grows, we think the primary buyout market will revive at some point over the next six to 12 months. But Jonathan noted that the business will have changed now that zero rates are in the past; GPs will need to contribute genuine operational value-add to their portfolio companies rather than relying on leverage to amplify multiple expansion.

Discount

One asset class that has not adjusted painlessly to the new environment is real estate. Valuation declines in 2022 and 2023 were so brutal that the Green Street Commercial Property Price Index is barely any higher today than it was a decade ago. However, as Matt Kaplan, Head of our Almanac real estate team put it, that is why now is such an opportune time to invest.

He warned that, in his view, the huge uncertainty around work-from-home and artificial intelligence trends makes offices “uninvestable,” but elsewhere value opportunities abound.

While valuations are virtually flat to where they were 10 years ago, construction costs have risen by 52%, which means that assets are available at a 20 – 30% discount to what it would cost to build them anew. New supply is down precisely because of those forbidding costs, but demand from a robust economy is strong, as current rental inflation suggests.

Opportunities

The overall message from our discussion was that, yes, the shift from zero to 5% has been rapid and challenging, but the economy and the financial markets have shown resilience in their adjustment. Moreover, that adjustment has given investors a whole new set of opportunities to focus on as the rate cycle turns and the destination becomes clearer.

In bonds, we have income and the potential for meaningful capital appreciation for the first time in years. In equities, we have substantial dispersion of valuation and performance providing renewed alpha opportunity. In private markets, liquidity providers have been in high demand and skillful GPs now have an environment in which to prove their worth. And in real estate, high-quality assets are trading at once-in-a-generation valuations.