The UK’s budget squeeze, good news is bad for the stock market, and the IMF investigates private credit

Welcome to this week’s Market Pulse, your 5-minute update on key market news and events, with takeaways and insights from the Sidekick Investment Team.

Today, we’re looking at what the gilt sell-off means for the UK economy, why stock investors should embrace higher US rates, and the hidden dangers lurking in private credit.

But first, our number of the week…

$14.4 billion

That’s the amount of money that flowed into the most popular equal-weight S&P 500 ETF in the second half of 2024, a new record. It’s a sign that investors are getting nervous about the top-heaviness of the S&P 500, with the largest five companies now making up more than a quarter of the index.

Sidekick takeaway: We’d never discourage diversification, but investors should remember why Big Tech is such a big part of the index. Not only do these companies earn a ton of money today, their earnings growth forecasts are also much higher than peers.

Now to our main stories…

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It’s important to note that the content of this Market Pulse is based on current public information which we consider to be reliable and accurate. It represents Sidekick’s view only and does not represent investment advice - investors should not take decisions to trade based on this information.

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1) Pound the Alarm: Gilt Sell-Off Could Hurt the UK Economy

Investors have been dumping UK government bonds over the past few weeks, driving prices lower and yields higher. The 10-year gilt yield recently hit its highest level since 2008.

Notably, this trend doesn’t seem specific to the UK. Investors have been selling government bonds around the world and gilt-Treasury spreads haven’t moved much.

Still, this sell-off could have unintended consequences for the UK economy. When market yields spike, the government needs to offer a higher interest rate on new debt to entice investors, which drives borrowing costs up.

Here’s why this matters…

• Chancellor Reeves has promised to balance the UK budget, ensuring that revenue equals day-to-day spending.
• Higher borrowing costs will make that much more challenging to achieve. Analysts estimate that Reeves may have already lost ￡6 billion of the original ￡10 billion of fiscal headroom she had.
• To prevent breaching the government’s self-imposed rules, Reeves may have to cut spending, having previously ruled out additional tax increases.

Unfortunately, these spending cuts could come at exactly the wrong time for the UK.?

Amidst stagnant growth, the government’s budget was supposed to help kickstart the economy with spending on public infrastructure and investments. The Chancellor’s budget rules may turn out to be much more expensive than originally planned.

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2) Bad Good News: Strong US Jobs Data

On the surface, the US economy received excellent news last week. Thanks to an unexpected acceleration in job growth, America’s unemployment rate dipped to 4.1%.

To stock investors, however, the resiliency of the US labour market might seem like a mixed blessing. Strong jobs data means that the Fed is likely to slow the pace of coming rate cuts. In response to the news, the 10-year Treasury yield surged to new highs.

When rates are high, stocks tend to look less attractive compared to bonds, which can depress valuations. So, is all this good news actually bad news for equities?

Investors shouldn’t fear a strong economy…

Not quite. Missing from this analysis is the impact that a strong economy can have on corporate earnings growth.?

When people have jobs and money to spend, corporate earnings tend to rise. Even if rates are high, this growth can help power strong stock market performance.

In 2024, for instance, the S&P 500 had estimated earnings growth of 9.4%. While rates were above 5% for much of the year, that growth helped power the index to a nearly 25% gain.

In the short term, stocks may wobble as markets digest how economic data will impact rates. A longer term view, however, is the right approach for investors, and good news really is good news for equity markets.

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3) PIK Your Poison: IMF Warns on Payment-in-Kind

The International Monetary Fund is planning a deeper review of ‘payment-in-kind’ debt, a type of lending popular amongst private credit funds. While the IMF’s analysis is focused on financial stability concerns, their concerns are instructive for any potential private credit investor.

What is Payment-in-Kind?

Under a typical debt structure, companies owe their interest payments in cash. A PIK structure, however, allows companies to make interest payments in the form of additional debt.

For instance, imagine a company owes ￡1 million in interest on a PIK loan. Rather than demand this amount in cash, the lender can essentially mark up the company’s outstanding debt by an extra ￡1 million to cover the difference.?

For companies, this comes with significant tradeoffs:

• In the short run, PIK payments can give indebted companies more time to come up with cash to pay their debts and prevent default.
• In the long run, however, issuing additional debt can make a company’s cash flow problems even worse.

PIK lending is increasingly popular at private credit funds, which typically account for these payments as regular income. According to Bloomberg data, PIK payments now comprise about 20% of income at private credit funds, up six points from last year.

While PIK lending can have a place in private credit, this increase could mask underlying risks, which is why the IMF is investigating. For investors in these funds, it’s crucial to understand how much income is actually being paid in cash.?

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Notices

Please remember, investing should be viewed as longer term. Your capital is at risk — the value of investments can go up and down, and you may get back less than you put in.

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