U.S. Exceptionalism, Reality Check, and Illiquidity Premium.

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Welcome, market participants, to another 3 Things in Credit. I’m Van Hesser, Chief Strategist at KBRA. Each week we bring you 3 Things impacting credit markets that we think you should know about.

A quick post for an upcoming event. As you know, KBRA is the leader in rating U.S. banks, a sector that is getting a lot of interest as we look ahead post the election. This November 20, we are hosting a particularly timely one-day bank symposium in Washington, D.C. at the Willard Hotel, featuring relevant content, not company presentations. We’ll have members of Congress, top regulators, and market participants weigh in on what’s ahead for banks in 2025. And we’ll hear the perspective of one of the most insightful and engaging D.C. pundits, Jim VandeHei of Axios fame, to give us his post-election (at least I hope it’s post-election) thoughts. One day, November 20, at the Willard Hotel in Washington. Sign up on our website, KBRA.com, under the Events tab.

Alright then.

This week, our 3 Things are:

1. U.S. exceptionalism. What’s driving it?
2. Reality check. We’ll check in on two broad-based barometers of economic growth.
3. Illiquidity premium. Here’s how Blackstone sees it.

Alright, let’s dig a bit deeper.

U.S. exceptionalism.

“America’s breathtaking economy.” So says The Economist newspaper. And, as if on cue, the IMF intimated the same thing at its Autumn soiree, which just wrapped up in Washington this week, where it released its latest World Economic Outlook. The IMF upgraded its 2024 economic growth forecast for the U.S. to 2.5%, half a percentage point higher than its July estimate, and better than any other developed world economy. Driving growth in the U.S. is higher nonresidential, i.e., business, investment and stronger consumer spending, which is being supported by rising real wages, according to the Fund.

The investment piece is the interesting one. That is expected to grow 4.5% year-over-year in the U.S., more than triple the rate for all advanced economies. Anyone watching the stock market understands this. Over the past decade, investment in technology came to be seen by U.S. business managers as no longer a nice to have, but a must have. And we see it today in the productivity numbers.

Which brings us to this point: U.S. exceptionalism has been driven in no small part by what are, in our opinion, the world’s most effective capital markets. The U.S. financial system, decentralized and markets based, stands in contrast to what we see elsewhere. It gets capital and funding to its most productive use better than any other system. It allows startups to get off the ground, growing businesses to find the capital they need to grow, and mature businesses to find a path to lower their overall cost of capital. And here’s a factoid from the IMF: “In the last two decades, U.S.-listed firms have issued about twice as much equity relative to their size as their European counterparts. Equity is crucial to finance intangible investments like patents or trademarks that can’t be pledged as collateral for bank credit, and to protect these investments against short-term economic fluctuations.”?

And the U.S. financial system, by its very nature, is dynamic, allowing for innovation and change to continually meet changing preferences of investors and firms. One of the most noteworthy developments illustrating this point is the growth of private capital. As policymakers set out to de-risk banking systems post the GFC, alternative asset managers were able to step in with a better mousetrap: funding longer-duration assets with longer-term capital. Investors able to absorb illiquidity found superior yields and borrowers found ease and certainty of execution. And policymakers gained a better market shock absorber in the form of a thousand institutional investors as opposed to a dozen global banks and their unpredictable regulators.

The U.S. financial system—public markets, private markets, banks, and nonbanks—is a big part of what sets the U.S. apart.

Alright, on to our second Thing—Reality check.

Notwithstanding all of the talk on U.S. exceptionalism, U.S. economic growth is forecast to slow in 2025, from an estimated 2.6% in 2024 to 1.8%, according to Bloomberg consensus. The IMF has it slowing from an estimated 2.8% to 2.2%. And the Fed, for what it’s worth, is looking at growth flattening out, 2% this year, 2% next. My guess is that 2% forecast for 2024, given in September as part of its Summary of Economic Projections, is light. But you get the picture. We’re normalizing back toward trend. And I would remind you that the better-than-expected growth we’ve experienced has been fueled in part by extraordinary, but fading, fiscal stimulus that has created massive peacetime deficits. Just a reminder.

Two reports out this week are consistent with that expectation: the Fed’s latest Beige Book, and the Chicago Fed’s National Activity Index. These two matter. Jay Powell often refers to the Beige Book and the sentiment expressed therein from among “real world” citizens, and the weak report in September set in motion the 50-bp rate cut, while the Chicago NAI tracks some 85 economic indicators across the country. The latest reports from both came in soft.

The Beige Book was actually a tad better than the September report where nine of the Fed’s 12 districts saw economic activity that was flat or declining. In the most recent report, 10 districts reported flat economic activity while two saw modest growth. Consumer spending was mixed, with the trend of trading down to cheaper alternatives noted in some districts. Manufacturing activity was in decline in most districts. Employment increased slightly over the period, although demand for workers eased, and improvements in the supply of labor is slowing the pace of wage pressures. And that figures to lean on consumer spending.

The three-month moving average for the Chicago Fed’s National Activity Index came in modestly negative for the 23rd consecutive month. A zero value for the Index has been associated with the national economy expanding at its historical trend (or average) rate of growth; negative values correspond with below-average growth. That seemingly ominous trend has taken place as the economy has normalized, so it is to be expected, but the persistence of negative readings into the post-stimulus environment is a bit worrisome. All the broad categories—Production and Income, Employment, Personal Consumption and Housing, and Sales, Orders and Inventories—made negative contributions in September.?Of the 85 indicators, 47 made a negative contribution to the Index in September, four more than August. Not good.

So, a reminder that we continue to slow consistent with 2025 forecasts. And, of course, for those looking for that November/December rate cuts, these reports won’t hurt.

Alright, on to our third Thing—Illiquidity premium.

Third-quarter earnings from Blackstone revealed a number of interesting updates, at a time, to quote Steve Schwarzman, “of profound transformation across the economy and markets, as well as geopolitically.” That says a lot, but I’m not sure it’s hyperbole. There’s a lot going on.

What we’re interested in, of course, is what’s happening in private credit. Blackstone provided some interesting color. Jon Gray spoke of four key developments at the firm, as it emerges from the “high cost of capital environment.” One of those developments is the secular rise of private credit. The others, for those keeping score, are well-timed deployment of capital ahead of the turn; the recovery underway in commercial real estate; and momentum in tapping into private wealth. But I digress.

In private credit, Blackstone sits atop the largest third-party private credit business in the world—$432 billion across corporate and real estate credit. Inflows over the past year across the platform of direct lending, CLOs, real estate debt, and private investment-grade credit were north of $100 billion.

Blackstone’s experience reveals the appeal of private credit. In the non-IG arena, Blackstone Private Credit Fund (BCRED) has delivered 700 bps over base rates since its inception. In private IG (think asset-based credit), returns were nearly 17% over the past year. But this datapoint caught my attention. Year-to-date, the firm placed or originated $38 billion of single-A rated credits that generated 185 bps of excess spread over comparably rated public credits. That’s the premium investors that can take the illiquidity book. That’s compelling.

In an environment of falling base rates and very tight credit spreads, a reasonable question would be how durable is that illiquidity premium? Mr. Gray acknowledges that while this new environment will naturally pressure absolute returns, he believes that relative returns—that premium—can endure. This is all still early days in terms of penetration of IG markets, but the appeal to longer-term investors seems clear.

So, there you have it, 3 Things in Credit:

1. U.S. exceptionalism. The world’s best capital markets get capital to its most productive use.
2. Reality check. We are slowing, let’s see if the Fed stays on top of this.
3. Illiquidity premium. For longer-term investors, there is reward for the risk.

As always, thanks for joining. Don’t forget to check in on KBRA.com for our ratings reports and our latest research. If you’re interested in banks, you’ll want to find your way to Washington on November 20 for our Bank Symposium. Find out how to sign up on our website under the Events tab. Hope to see you there. On the podcast, we’ll see you next week.

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