With the ‘Great Accommodation’ ending, the nature of collateral becomes more important for private credit

As investors enter 2023 there is a very real prospect that the longer-term dynamics that financial markets have become accustomed to over the last 20+ years reverse. In turn, these evolving dynamics will impact on businesses and asset values differently increasing the level of dispersion evidenced within and between markets. For investors in private credit this increased level of dispersion will impact on the relative attraction of not just the sectors they lend to but also the type of collateral they accept against loans.

The period post-2000 has been characterised by two main and interrelated dynamics operating within markets. The first was an increasingly complementary relationship between the production-driven East (particularly China) and the consumption-led West. The rapid growth of the productive capacity of the East, driven by its large pool of low-cost labour and associated outsourcing of production by the Western companies, was one of the key dynamics. This resulted in a prolonged period of lower inflationary pressures as the supply of both products and labour outstripped demand. 

In turn, the benign inflationary backdrop allowed central banks globally, but particularly the US Federal Reserve, to adopt and maintain a highly accommodative stance to monetary policy in the face of a series of demand-side shocks starting with the bursting of the Technology Bubble in 2000. 

The magnitude of the highly accommodative stance to monetary policy adopted in the post-2000 period can be seen by the real cash rate averaging around -1% over this period. To put this in perspective in the decade preceding 2000, where inflation averaged just under 3% compared to 2.5% in the post 2000 period, the real cash rate averaged around +2%. This shift in monetary policy dynamics, so that over a multi-decade period negative real cash rates became the norm, has resulted in some referring to the post-2000 period as the ‘Great Accommodation’.

To put this in perspective, so significant was this shift in monetary policy dynamics that nearly an entire generation of investors and corporate managers has been brought up experiencing negative real cash rates as the norm while viewing positive real cash rates as being largely transitory in nature.

Unfortunately, there are reasons to believe that the underlying dynamics that defined the post-2000 period are experiencing a major change. This change in dynamics becomes increasingly relevant as, though the recent spike in inflation will subside, they will ultimately define the extent to which inflation will subside; i.e. at what level inflation will eventually settle. The key driver of this less benign inflation backdrop going forward is the breakdown in the complementary relationship which has underpinned the lower inflation environment of the last 20 years. This change in dynamics has occurred at multiple levels. 

At one level, the large pool of cheap labour available from Eastern countries has declined as the population demographics and labour overhang in countries such as China become less favourable. But more importantly, changing global geopolitics has undermined the once complementary relationship between East and West. 

Most notably, the increasing assertion of China as a global political and military counterbalance to the West, and more specifically the US, has irrevocably altered the dynamics between East and West. Against such a backdrop, the ongoing outsourcing of production by Western companies to lower-cost countries such as China is taking on a more sensitive political dimension. Bringing these factors together the assertion that supply will continue to outstrip demand over the longer term becomes increasingly problematic.

This change in the availability of excess supply to maintain downward pressure on inflation is itself likely to alter the dynamics of monetary policy. A less benign inflation backdrop will inevitably make it more difficult for the US Federal Reserve to get inflation rates back to the 2% target rate they have set for themselves. Indeed, the US Federal Reserve’s target of 2% for the inflation may prove as unsustainable as the disinflationary period from which they were spawned[1]. In turn this reduces the potential for the US Federal Reserve to maintain the biases towards negative real cash rates set during the ‘Great Accommodation’. As the US Federal Reserve aims to push inflation back towards its target a return to the positive real rate environment seen before 2000 is increasingly likely. It is this risk of a return to an extended period of positive real interest rates which the markets appear to be largely discounting given the experience of the last 20+ years.

For investors in private credit, the return to an environment of sustained positive real cash rates is not simply a matter of technical interest. ‘The Great Accommodation’, by maintaining negative real cash rates, has not only inflated asset values but also the Free Cash Flows generated by corporations. Under such a monetary policy regime, investors could afford to be relatively indifferent to the sectors lent to and the form of collateral chosen. 

A return to an environment of positive real cash rates will, however, remove one of the key pillars supporting some of the forms of collateral often utilised to support private loans. It is the removal of this key support that will make it increasingly important that investors not only choose the right sectors but also the appropriate quality/class of collateral to maximise the returns from investing in global private credit markets going forward.