Long the Strong

October 1, 2023

5 minute read

by Niall O’Sullivan, Chief Investment Officer, Multi Asset Strategies – EMEA, Neuberger Berman

The prolonged adjustment to higher rates is just beginning, and we think it will likely be more painful for some than others.

“The strong do what they can and the weak suffer what they must.”

When, in his account of the Siege of Melos, the ancient historian Thucydides put this hardheaded ultimatum into the mouths of the Athenian negotiators, he inaugurated the realist school of history. Human affairs were not decided by the whims of the gods, but by naked interest and the often-brutal assertion of the balance of power.

Today, when we look across many asset classes and think about how to invest, we think a realist would recognize that relative strength, and “quality” characteristics, will be key factors.

There is a top-down deus ex machina at work in the economy, in the form of inflation and the wave of central bank rate hikes implemented to contain it. The European Central Bank hiked again at its last meeting, the pause by the U.S. Federal Reserve last week was framed in notably “hawkish” language, and markets pushed their expectations for the first rate cuts of the next cycle deeper into 2024. Furthermore, this policy tightening can also be thought of as a tourniquet. Each hike represents a further twist, but the previous twists also have a cumulative constrictive effect on blood flow.

However, while the painful adjustment to this shock is just beginning, we think it will likely be more painful for some than others. At this stage in a cycle, more than any other, the strong are defined by their flexibility to do what they can, despite the macroeconomic headwinds, while the weak, defined by their lack of options, suffer what they must.

We think it is important to be selective in this environment, to try to ensure exposure to stronger over weaker companies. It is also the time to be opportunistic, in our view—because a price can be gained for helping some of the weak to survive.

Margins

Who are the strong in this context?

First, those with relatively low and stable costs. That means asset-light businesses that do not need a lot of manufactured or raw-commodity inputs. It means people-light businesses with modest operational leverage, where wage bills are not spiraling upward. It means cash-generating businesses that can invest in growth with little or no financial leverage, and therefore low and stable interest costs. Some companies with large cash balances have even seen their net interest expense decline as rates have gone up.

Second, those with competitive “moats”: providers of essential products or services with dominance in their markets. These businesses can absorb the inevitable rise in their costs by passing them onto customers, thereby maintaining or even continuing to grow their margins.

These characteristics are often said to define “quality” companies, and at the moment, they also come with some sectoral and even regional implications.

As the U.S. auto-sector strike is likely to demonstrate, in some competitive industries it may be difficult to pass rising costs onto customers without losing critical market share. Last week’s Purchasing Managers’ Index releases remind us that manufacturers in general are struggling more than the services sectors, which is also one reason the U.S. is coping better than Europe and China. And, eventually, countries with high levels of debt and rising interest costs, among both developed and emerging market sovereigns, are likely to find the “kindness of strangers” running low.

Operational Flexibility

That said, strength and quality are not found exclusively in, say, large caps rather than small caps, investment-grade rather than high-yield borrowers, or public rather than private companies.

For example, our Fixed Income team’s bottom-up analyses anticipate rising defaults and credit stresses among high-yield issuers. Due to the idiosyncratic nature of these stresses, however, they do not anticipate the kind of broad widening of spreads that was seen in 2007 – 8, 2015 – 16 or 2020. Similarly, our Direct Lending team is happy to help a very select group of private companies refinance with senior debt at double-digit rates because it is confident those firms can grow their margins to more than cover those rates.

More than 170 investors at our recent Private Markets Annual General Meeting (AGM) in London heard Tony Tutrone, our Global Head of Alternatives, explain how buyout deals based on financial engineering won’t thrive in conditions where borrowing costs are much higher. Rather, a focus on stronger companies and management that can achieve results through operating excellence is more likely to be rewarded.

Today, it’s all about the quality of the business, the quality of management and the operational flexibility to “do what they can.”

Disruption, Reconstruction and Reorganization

And the weak?

What they must suffer will depend on their circumstances. For some, it will merely be tighter margins. Others will incur losses. Some will lose market share, some will be forced to restructure, many may not survive.

Still others will become takeover targets for the stronger companies in their sectors: Event-driven investment strategies could be a way to get opportunistic exposure to this period of disruption, reconstruction and reorganization.

There may also be some businesses, especially in the private markets, that are fundamentally strong but whose balance sheets have become an Achilles’ heel of weakness in the current environment. These companies should be investing in their growth or be out there making acquisitions, but they cannot afford to borrow more to do so. Here, providers of specialist capital solutions can provide solutions such as preferred or structured equity to these businesses, which effectively means equity-like contractual returns despite having, on average, a 50% value cushion of common equity below them in the capital structure. These can often be attractive equity investment opportunities for our Co-Investment teams, too.

The Weak Falter

Investing is not as brutal as ancient history. It is not always wise to be long the strong. When rates are low and stable, and cycles are smooth, the market is apt to reward companies that move a bit too fast and take a bit too much risk.

That’s not where we are today. Now is the time to be very selective, in our view, focusing on quality businesses that can sustain their margins. But it is also the time to provide capital and liquidity opportunistically when you see the weak falter—as we believe they surely will.

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What to Watch For

- Tuesday, September 26:
  - U.S. Consumer Confidence
  - U.S. New Home Sales
  - S&P Case-Shiller Home Price Index
- Wednesday, September 27:
  - U.S. Durable Orders
- Thursday, September 28:
  - U.S. Q2 GDP (Final)
- Friday, September 29:
  - U.S. Personal Income & Outlays
  - Eurozone Consumer Price Index