First Eagle over time has deliberately sought to nurture an investment-led culture supported by a set of core investment tenets that encourages philosophical autonomy among our portfolio management teams in pursuit of client goals. While our five investment teams operate independently, we strongly believe each can benefit from the disciplined, unconventional thinking the others bring to bear in their areas of expertise. To share such insights broadly across the organization, we periodically assemble the senior members of our investment teams; below is an overview of some of the key issues raised at our mid-July gathering.
Matt McLennan
Co-Head of Global Value Team
Risk appetites continued to fuel financial markets in the first half of 2024. Credit spreads have narrowed as implied volatility has declined and equity multiples have increased. Styles factors have largely remained unchanged as large-cap US growth stocks—fueled by the “narrative economics” surrounding developments like artificial intelligence and GLP-1 agonists—accounted for most of the gains, while value names and non-US markets lagged. More recently, easing inflation and a softening labor market have rekindled expectations for interest rate cuts, albeit with a greater sense of urgency. Are current conditions pointing toward the much-anticipated soft landing of the economy? Or are strong financial markets just a mirage that has obscured the true risks and uncertainties of the environment?
The personal consumer expenditures (PCE) price index has inched closer to the Federal Reserve's target goal of 2.0%.1 But we think it's worth noting that one of the primary drivers of disinflation has been something originating from outside of the US: deflationary forces from Chinese manufacturers. As shown in Exhibit 1, the price of Chinese exports peaked in 2022 and began to experience year-over-year declines in 2023 as post-Covid inflationary pressures eased. We believe the impact of this tailwind will eventually abate as the prices of US imports from China have already plateaued. Without this benefit, inflation may remain stubbornly mired just above the Fed's target; should export prices begin to tick up, inflation may follow suit.
Exhibit 1. Falling Chinese Export Prices Have Been a Deflationary Force
Prices of U.S. Imports from China, January 2003 through July 2024
Source: Federal Reserve Bank of St. Louis, US Bureau of Labor Statistics, First Eagle Investment (Trades, Portfolio)s; data as of August 15, 2024.
On the other hand, labor markets have largely absorbed the structural changes brought on by the pandemic, and we are seeing a return to normalized labor dynamics even as wage inflation remains above levels supportive of 2% inflation.2 Wage growth has declined below nominal interest rates, a phenomenon that historically has occurred at the end of economic growth cycles. This puts pressure on households, whose borrowing rates are now meaningfully higher than their wage growth, and the decline of the personal savings rate to levels well below Covid-era highs adds to the readings that hint at a weakening consumer.3
The disappointing July jobs report prompted market prognosticators to speculate whether the Fed has waited too long to cut interest rates and sparked a violent market response. The unemployment rate has increased from its trough of 3.4% to 4.3%, though we have seen an increase in labor-force participation.4 Reviewing most US recessions since World War II, we've noticed that the unemployment rate has tended to inch higher early into the slowdown before accelerating sharply into recession. It remains to be seen if we are on the cusp of a recession, but with PCE and wage inflation still above target rates, there is a risk that the much-anticipated Fed rate cuts may trigger an unwelcome asymmetric inflationary response.
More troubling are fiscal conditions in many developed economies, including the US. The swell of public debt outstanding in advanced economies combined with a general lack of fiscal discipline has made sovereign paper an increasingly risky proposition as interest expenses increase as lower-yielding bonds mature and are refinanced with bonds at current rates. Deficits also work against central bank efforts to cool an overheated economy. Worryingly, fiscal discipline is not a concept associated with either major US political party today, and the prospects for improvement in the foreseeable future are dim regardless of the result of November's elections.
Increased concerns about the potential for currency debasement given massive government debt levels worldwide has been supportive of gold, whose price reached new nominal record highs in 2024 even as interest rates increased.5 Global central banks have been a key source of support for the metal's price in the face of traditional headwinds. Net purchases of gold by central banks in 2022 and 2023 were the highest on record by far, and 2024 has gotten off to a good start.6 Gold's history as a perceived “safe haven” often attracts buyers of all stripes during periods when perceived risks are high, and it's perhaps not surprising that global central banks have sought to diversify their reserves through additional gold holdings.
Jon Dorfman
Chief Investment Officer, Napier Park
In the years following the global financial crisis, highly accommodative monetary policy rewarded businesses and individuals for taking on a significant amount of debt. Two years into a monetary regime with positive real interest rates, we have begun to see visible signs of economic fade as well as greater risk to credit investing. The US services sector—which comprises more than 70% of the economy—has been alternating between expansion and contraction for the past few months, while manufacturing in July posted its weakest level of activity in 2024.7 Consumer spending has also begun to wane, and the disappointing July employment report underscored the flagging momentum.8
The impact of this softness can be seen on consumers and businesses at the bottom of the credit market. Credit card delinquencies have begun to increase, with the largest increase among consumers in the lowest income bracket.9 While issues with household balance sheets don't appear serious enough to be systemic at this stage, the weakness is likely to result in greater delinquencies and defaults. We are also seeing weakness in corporate fundamentals, particularly among highly leveraged businesses who have experienced declines in interest coverage, as well as an increase in distressed exchange volumes.10 As with previous late-cycle stages, defaults likely will remain elevated until all of the weakest players get shaken out.
Despite the slowing economy being only one of a range of risks facing investors, credit spreads in traditional non-investment grade markets remain tight. We attribute some of this behavior to investors targeting gross yields rather than spreads; the potential for falling interest rates may create some stress in the spread markets. More complex structured credit assets, however, currently offer meaningfully wider spreads than high yield bonds and loans, as shown in Exhibit 2. Combined with relatively high base rates, we believe yields on certain structured credit instruments appear enticing.11
Exhibit 2. Structured Credit Assets Historically Have Offered Wider Spreads than Traditional Fixed Income
Comparison of Percentile Rank of Spreads, July 2014 through July 2024
Source: JPMorgan; data as of July 29, 2024.
Though the yield differential between structured and traditional credit currently is wider than typical, the existence of such a gap is far from novel; structured credit instruments historically have offered an attractive yield pickup relative to traditional fixed income investments.12 This premium also tends to persist over the cycle, during periods of both calm and volatility such as we are experiencing as we write this in early August. While there are a number of valid reasons for the structured credit yield premium—including greater complexity, reduced liquidity and pronounced price volatility—greater credit risk is not one of them, in our view. In fact, certain structured products historically have realized significantly lower defaults than their like-rated traditional counterparts—including, in many cases, no defaults at all.13
For investors, structured credit offers the potential for enhanced returns, portfolio diversification and tailored credit-risk exposure. Success in these specialty credit segments has historically featured a higher barrier to entry in terms of experience, expertise and technology, however. Further, we believe the flexibility to actively allocate among the disparate opportunities across credit—both public and private, and both single name and structured—best supports efforts to generate meaningful incremental yield with manageable incremental risk while promoting potential diversification benefits in multi-asset portfolios.
Jim Fellows
Chief Investment Officer, First Eagle Alternative Credit
Robust demand and limited new supply continue to dominate the narrative in leveraged credit, and spreads in broadly syndicated loans and private credit remain very tight. Though we believe investors remain inadequately compensated for credit risk, we expect to see continued demand for floating-rate credit, from both fixed income investors and potentially from equity investors seeking equity-like returns that have the potential for reduced risk.
New-loan issuance surged to record levels in the first half of 2024 but continued to be dominated by repricings and refinancings; net loan supply remained elusive, as higher-for-longer rates and a murky economic outlook continued to weigh on mergers and acquisition (M&A) activity. Demand, meanwhile, is trending very strongly—especially from collateralized loan obligation (CLO) creation, which accounts for the vast majority of loan demand.
In the secondary market, higher-risk issuers, particularly those with negative headline exposure, have been under pressure of late; the risk-off posturing was especially notable among CLOs, given their limited risk budgets and ratings sensitivity.
Spreads across leveraged credit have narrowed in general in response to supply and demand dynamics, but the imbalance appears particularly acute in private credit. As a result, pricing in direct lending appears to be slowly converging with that of broadly syndicated loans. For example, as shown in Exhibit 3, the 200 basis point premium new-issue private credit offered over broadly syndicated loans in early 2023 has been cut in almost half. That said, the lower middle market—which is our focus—appears to have a more balanced supply/demand dynamic overall, as rising private company valuations over the years prompted private equity sponsors to look toward the smaller end of the middle market for more cost-effective platform opportunities.
Exhibit 3. Private Credit Spreads Have Compressed on Strong Demand and Limited New Supply
New Issue Spreads on Acquisition-Related Transactions by Private Equity Companies, January 2023 through April 2024
Source: Pitchbook | LCD; data as of April 15, 2024
Default rates are running above the historical average, but not significantly so thanks to still-strong corporate fundamentals. While revenue and earnings growth have normalized following strong post-Covid levels, margins have remained healthy, enabling issuers to reduce leverage and borrowing costs. Beyond fundamentals, while the great wave of M&A activity many are anticipating has yet to materialize, direct lending volumes to finance buyouts in 2024 remain higher than they were during the period of Fed rate hikes. The relatively benign maturity schedule and open access to capital via both the syndicated and private credit markets should also help keep defaults in check, barring a major breakdown in the economy. This is particularly true in the sponsor-backed middle market segment, in our view, given these borrowers' more conservative capital structures. However, we continue to monitor stress factors in the system.
It's worth noting that despite an only moderate default rate, we are seeing lower recovery rates on defaults, especially in the broadly syndicated loan market. This may reflect the absence of covenants, which basically have been stripped from broadly syndicated loans over the years. Covenants both enforce and encourage communication between borrower and lender, especially in periods of distress, and can help dampen defaults and enhance recoveries. Unfortunately, there is a similar erosion of structural protections happening in the upper end of private credit as these two financing options converge. Though they sometimes include covenants per se, larger direct deals already are falling prey to financial engineering and aggressive restructurings—including liability-management exercises (LME)—in which distressed borrowers exploit ultra-loose covenants at the expense of certain lenders.
Despite ever-changing dynamics and a still cloudy economic outlook, we remain constructive on the long-term outlook for credit, though selectivity, perhaps now more than ever, is key. With increased risk aversion and risk premia already fairly tight—and covenants sometimes “lite” at best—we remain focused on better-quality issuers with limited appetite for higher-stress situations. Should the market exert what seems to us unwarranted pressure on highly levered issuers, however, buying opportunities could emerge.
More broadly, we value our flexibility to migrate between public and private markets in pursuit of attractive risk-adjusted returns. Within direct lending, we currently find sponsored, lower/middle-market transactions a sweet spot, providing reasonable debt levels, structure and information flow. Across markets—both broadly syndicated and direct—we have found specific opportunities within healthcare, as labor-cost pressures continue to abate, and in technology, especially as interest rates decline.
Bill Hench
Head of Small Cap Team
While we're in the midst of the longest period of small cap underperformance I can recall in my 24 years of investing in this space, shorter chunks of time have been similarly disappointing. Higher interest rates have hurt, but relatively slower earnings growth may be a stronger constraint, at least at the index level. Good companies with strong businesses and solid earnings have languished alongside weaker operations. But, as we have seen from time to time, market perceptions of value can change quickly.
July proved to be one of those times, as investors appeared to shift focus away from recessionary concerns and toward the prospect of Federal Reserve rate cuts. As a result, small caps broke free from the protracted run of underperformance illustrated in Exhibit 4, and the Russell 2000 outperformed the S&P 500 Index 10.2% to 1.2%.14 While potentially only a mini-burst within a long slog of relative weakness, this 9,000 basis point bump in relative performance is a good reminder of how decisively markets can respond once investor perceptions—for whatever reason—finally shift. Surges of this magnitude sometimes reflect nothing more than short covering or even a cessation in selling. In the final analysis, though, consistent buying interest among market participants perceiving the same bargain pricing we do is needed for opportunities to be fully realized.
Exhibit 4. Small Caps Have Lagged Large Caps Considerably for the Past 10 Years
Trailing Returns, January 2014 through July 2024
Source: Bloomberg: data as of July 31, 2024
Past performance does not guarantee future results.
Higher interest rates arguably have restrained durable outperformance for small caps. And yes, small caps—which tend to have higher debt levels and greater exposure to floating-rate debt—are more vulnerable to higher rates than large cap companies. But lower interest rates may be less of a linchpin than generally perceived. In our experience, investors will look beyond interest-rate levels so long as a company grows its earnings. But earnings growth is key. And, quite simply, small caps—at least at the index level—have not grown earnings as quickly overall as large caps. This slower aggregate growth reflects, at least partially, the proliferation of companies within the Russell 2000 that aren't currently and perhaps never will be profitable; non-earners comprised more than 40% of the index at the end of the second quarter.15
On the other hand, we think that small cap “pick and shovel” suppliers to the artificial intelligence behemoths of tomorrow appear poised to deliver compelling earnings growth, just as small cap providers to future internet giants like Google, Amazon and Facebook/Meta did in the early 2000s. Following the dot-com implosion that troughed in 2002, small companies with robust end markets grew rapidly and performed well; abundant capital fueled vigorous initial public offering (IPO) activity, and small caps outperformed large by more than 7,000 basis points over the next ten years.16
M&A can also aid in price discovery. Distorted valuations historically have been arbitraged away by M&A activity by sophisticated market participants like private equity sponsors and strategic buyers. Strategic buyers, in particular, tend to target companies that have rationalized their cost structures, survived difficult times and may be well positioned for the future, with sound business models and responsible balance sheets. Strategic buyers often pay attractive premiums for these companies, beyond which they expect to generate additional solid returns.
Perhaps validating the conclusions of our own wide-ranging proprietary research, we have observed an uptick in takeout activity within the small cap universe during 2024, and we are hopeful that persistent interest from sophisticated buyers may call greater attention to the latent value we see in this market. In the meantime, we remain focused on what we as investors can control: namely, the stocks we invest in and the price we pay for them.
John Miller
Head and Chief Investment Officer of High Yield Municipal Credit Team
In a volatile interest rate environment not terribly supportive of fixed-rate assets, municipal bonds in general comported themselves well year to date while high yield munis have surged thanks to higher base rates and spread tightening.
While fundamentals usually win out over time, performance of the muni bond market can be highly technical in the short run. Demand trends thus far in 2024 have been supportive, with muni fund inflows solidly positive year to date after two years of heavy outflows.17 On the supply side, relative stability in interest rates was enough to encourage issuers to bring new bonds to the market, and 2024 has gotten off to a robust start after two years of declining net supply.18 Note that these volumes, while strong, reflect a return to trends in place before the Fed began tightening its policy rate rather than a secular break higher.
That said, we think this issuance trend has the potential to persist. This is especially true if interest rates remain contained; the volatile rate environment that characterized most of 2022 and 2023 was among the disincentives to municipal issuance, along with well-stocked local coffers following years of federal-level support and a post-pandemic tax-revenue windfall. The supply/demand imbalance has helped support muni bond prices in recent years, but we think there is sufficient pent-up demand to absorb any uptick in issuance—particularly with both absolute and tax-equivalent yields at such high levels, as shown in Exhibit 5. Moreover, falling interest rates could inspire greater inflows into munis as the yields on cash-equivalent investments lose their appeal.
Exhibit 5. Muni Yields Are Near Levels Not Seen in Many Years
Bloomberg US Municipal Bond Index Yield to Worst, January 2023 through July 2024
Source: Bloomberg; data as of July 31, 2024.
Fundamentally, the municipal market remains robust. Unlike the US federal government, the fiscal positions of state and local governments are strong overall. Total financial assets for state and local governments ended 2023 at an all-time nominal high, and expenditures, while above trend, have begun to moderate.19 Municipal bond defaults are far less common than defaults by corporate issuers—muni issuers have multiple levers that can be pulled to help service their debt, including tax increases, spending cuts and drawing on reserves—and current fiscal dynamics should support historically low default rates as well as high recovery rates in the event of default. Most of the defaults we have seen this year have been idiosyncratic in nature.
We believe current conditions in the municipal bond market—marked by elevated yields, favorable technicals and healthy fundamentals—support putting money to work in fixed-rate, tax-exempt bonds.20 Longer-dated issues may be particularly attractive at the moment, offering the opportunity to lock in yields not seen in many years, especially as potential federal funds rate cuts loom.
While we are constructive on the municipal market as a whole, we believe there are a number of unloved, overlooked or contrarian sectors in which fundamental, research-driven managers can uncover particularly attractive investment opportunities. With about $4 trillion distributed across more than one million distinct municipal bonds and 50,000 issuers, the municipal bond market is large but highly fragmented, which historically has resulted in pricing inefficiencies and opportunities for skilled active investors to add value in certain corners of the market.21 Currently, we believe this may include healthcare, where issuers continue to rebound from the dislocations of Covid-19 at differing paces; charter schools, where opportunities are emerging as federal funding winds down; and unrated bonds in general, which offer attractive yield premia for greater complexity and information risk.
1. Source: US Bureau of Economic Analysis; data as of July 26, 2024.
2. Source: US Bureau of Labor Statistics; data as of July 31, 2024.
3. Source: US Bureau of Economic Analysis; data as of July 26, 2024.
4. Source: US Bureau of Labor Statistics; data as of August 2, 2024.
5. Source: Bloomberg; data as of July 31, 2024.
6. Source: World Gold Council; data as of July 30, 2024.
7. Source: Institute for Supply Management; data as of July 3, 2024.
8. Source: US Census Bureau; data as of July 16, 2024.
9. Source: Federal Reserve Bank of New York; data as of May 14, 2024.
10. Source: Bank of America, JP Morgan, Pitchbook; data as of June 30, 2024.
11. Source: JPMorgan; data as of June 10, 2024.
12. Source: JPMorgan, Bloomberg; data as of June 26, 2024.
13. Source: BofA Global Research, Moody's Investors Services; data as of June 30, 2024.
14. Source: FactSet; data as of July 31, 2024.
15. Source: FactSet, data as of July 31, 2024.
16. Source: FactSet; data as of July 31, 2024.
17. Source: Investment Company Institute; data as of July 31, 2024.
18. Source: JPMorgan; data as of July 2, 2024.
19. Source: Federal Reserve; data as of December 31, 2023.
20. Source: CME Group; data as of March 20, 2024.
21. Source: Securities Industry and Financial Markets Association; data as of March 30, 2023.
The opinions expressed are not necessarily those of the firm. These materials are provided for informational purposes only. These opinions are not intended to be a forecast of future events, a guarantee of future results or investment advice. Any statistics contained herein have been obtained from sources believed to be reliable, but the accuracy of this information cannot be guaranteed. The views expressed herein may change at any time subsequent to the date of issue hereof. The information provided is not to be construed as a recommendation to buy, hold or sell or the solicitation or an offer to buy or sell any fund or security.
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