Why US lenders are striking a cautious note

Managers speaking publicly and on the sidelines at this week’s PDI Forum in New York say deal making is slowing as lenders assess conflicting market signals.

Public market volatility has US private lenders spooked – and with good reason. 

As Golub Capital’s David Golub reminded everyone at PDI’s second annual New York Forum this week: “One of the best leading indicators of a turn in credit markets has been a sharp drop in stock prices.”

There’s been no shortage of that lately. As of 1 October, year-to-date returns from the S&P 500 were down 7.45 percent. Meanwhile, the FTSE 100 just recorded its worst quarter since 2011, ending Q3 down more than 10 percent. And in China, the Shanghai Composite fell almost 25 percent over the third quarter, bringing its nine month performance to -5.62 percent.  

Equity volatility combined with slowing growth in China, ongoing conflict in the Middle East and historically high valuations are all feeding into the growing caution among lenders, Sankaty Advisors’ Jeff Hawkins said at the Forum on Wednesday. 

Those issues have policymakers concerned, too; notably the Fed last month demurred from raising rates, saying international markets and an emerging market slowdown threatened US growth. 

That today’s valuations are frothy, most private equity, never mind debt managers agree. And last month Deutsche Bank published a comprehensive report aggregating equity, bond and real estate valuations from developed markets going back two centuries that showed valuations are close to hitting a 200-year historic high. 

That said, there are other data points that justify some hesitation before fully battening down the hatches. Public market twitchiness bears no relation to solid, if not vibrant, economic data points. 

For example, after a slow first quarter, the US reported second quarter GDP growth of 3.9 percent, while the country’s unemployment rate continues to fall and stood at 5.1 percent in August. 

And crucially, credit managers tell PDI they are not seeing underlying weakness in the earnings of portfolio companies. Golub Capital’s mid-market report, which aggregates the financials of the firm’s 150 or so borrowers, showed second quarter earnings up 7 percent year-on-year, with revenues up more than 9 percent – a greater acceleration than in 2014.

Certain sectors – oil and gas foremost among them – have issues, but the average mid-market corporate is not exposed to slowing Chinese growth. They have domestic bases and serve a recovering US economy where consumer spending continues to rise. 

So debt managers face a bit of conundrum: which indicators should they pay attention to?

With principal preservation in mind, most of the US managers at this year’s event said they were playing it safe, getting choosier about their deals and turning down a greater number of transactions.

AllianceBernstein’s Brent Humphries predicted during an early panel that losses would be higher than historic averages in the next downturn. And – remarkably, for a diverse set of experts with different views on the market – when asked, eight out of eight speakers on two different panels agreed with him. 

On that basis alone, the more cautious approach is probably justified.