Aptus Quarterly Market Update: Q1 2026

Browse the Recap and Outlook’s 3 Minute Executive Summary Here.

 

Full Transcript

Derek

Welcome. We’ll give people a couple of minutes, maybe a minute, to get in and we’ll get started. All right. Now the first hundred, we might as well kick it off. So we got enough people. We got a quorum here, so let’s roll with it. Welcome. First day of the quarter, and it’s been pretty wild to finish off the end of Q1. It was obviously some fireworks there going into the end and then yesterday. But we do this every quarter where Chief Investment Officer, JD Gardner comes on, Head of Equities, Dave Wagner’s on here, Head of Fixed Income, John Luke Tyner. Just talk through some of the stuff that’s going on. A lot of it is noise. Let’s be honest. There’s a lot of stuff coming through that clients are definitely seeing and wondering about and worrying about. And you can see markets have obviously had some emotions attached to them, but we just want to get through some of the facts, data, help with talking points and things to talk about with clients.

So guys, thanks for coming on. I’ll do our little disclosure. The opinions expressed during this call are those of the Aptus Capital Advisors Investment Committee and are subject to change without notice. This material is not financial advice or an offer to sell any product. Forward-looking statements are not guaranteed. Aptus reserves the right to modify its current investment strategies and techniques based on changing market dynamics or client needs. More information about Aptus’s investment advisory services can be found in its form, ADV part two, which is available upon request. Also, we got Easter weekend ahead and we’re going to do another webinar next week. It’ll be a little bit different, but we had an exciting fund launch today. So we’ll talk through some of that and how that fits into the whole portfolio setup, but we’ll be sure to send those out. That’s going to be Tuesday after the close, same time. So anyway, I’ll let the smart guys talk. So thanks for coming on guys.

JD

Yeah. Thanks, D. Hern, and thanks everybody for being here. What a good turnout. I think the turnout’s probably an indicator that people are interested to hear what we think about what’s going on. So I would say just a quick on Tuesday’s webinar, we can’t discuss a lot of the content of that webinar, but I think it’s worth it to put that on the radar because we’ll be talking about more of the defined outcome stuff. And there’s been some really interesting setups that this market’s given us and it’s well worth being aware of that. But I’ll kick us off. And again, thank you. I know it’s April 1st. We don’t let the grass grow under our feet when it comes to quarter end stuff. Dave’s notorious for getting things out the door quickly. So we like to do this as quick as we can.

Hopefully this will be 30 minutes or so of time really well spent. If you’ve got questions, feel free to ping us. I’m going to let Dave and JL walk through more of the data and more of the facts. But one thing that I’d say, and y’all can blame me for being the optimist in the room, but I still think the story of, “Hey, we want to own more stocks. We’d like to be less dependent on bonds because we think some of the assumptions there are incorrect. And we’d like to do that in a way where we neutralize drawdown as much as possible.” I think that story is still going to resonate when you consider the backdrop, especially what is going to be the reaction to bad things that happen, good things that happen, the debt needs that are coming down the pipe, all of those things.

I think it leads to a very difficult environment for fixed income to preserve purchasing power for the next 5, 6, 10 years. And it tilts the odds in equities favor, just like it has over the last 15 years. So I’m bullish on equities. I think long term, I think there’s going to be some bumps in the road for sure, but I think hopefully that’s some of the piece we bring today is it might not be… There’s some terrible stuff happening all over the place, but I think when you consider hard-earned wealth and how do you steward that well, and how do you protect it? How do you grow it? How do you improve purchasing power? I think we have some insights into that that will be helpful to think through. So JL or Dave, whoever’s kicking us off, rock with it.

Dave

Yeah, I’ll take it. And I want to elaborate on what JD was talking about there because it’s these exact times right now, whether it’s emotional volatility or actual volatility, that’s where Aptus shines. This is exactly what this firm was built for from a fund perspective, from a services perspective, but more importantly, our consistent messaging perspective. So definitely reach out if you want to talk markets, if you want to talk really anything related, this is what we’re built for and we’re ready for any type of conversation that we can have or any direction that this market can take. And as many of y’all know, we’re very competitive people here. The firm was basically built on college and professional basketball players. Obviously that does not pertain to John Luke and I, but we still have that competitive nature. We’d love to get this quarterly data out on day one.

We tend to like to beat one of our largest competitors out there, JP Morgan from their guide to markets perspective, are getting our slide deck out there, which was sent out about noon. So please take a look at it. And alongside that quarterly chartbook, we also sent out our newsletter. And for people that have read our stuff for quite some time, y’all know we’re very thematic. And this quarter’s newsletter definitely probably hit the nail on the head of being very thematic. The theme this quarter was South Park. It didn’t have any pretend to any of the main characters. It actually pretended to one of their newer characteristics. His name was PC Principal. And what we recognize in markets, whether it’s emotional volatility or actual volatility, I’m actually a firm believer we see more emotional volatility here and it’s somewhat probably stemmed from the geopolitical problems out in the Middle East or even some of the political issues here more domestically speaking.

We thought this PC Principal and the PC stands for Politically Correct principle. We thought it was probably the best way to attack a market narrative from a fun perspective where we’re either making fun of no one with this newsletter or making fun of everyone with this newsletter. So hopefully we kept it within the guardrails of that PC world because right now, again, as I said, emotions from what I’ve seen personally, or at least anecdotally, emotions are pretty high right now. So let’s do our best messaging and talk through what we’re talking to clients about, and more importantly, how to explain that. And that’s actually why I kept putting these two slides in here. I’m not going to walk through it because there’s a lot of verbiage on these slides, but the two favorite slides that I have in the slide deck, this first one being, why has the market been so resilient? And then more importantly, how do I explain this current market to clients? So two really, really good slides that y’all can utilize.

And as we always say here at Aptus, a good artists create, better artists steal. So definitely steal away on some of these slides. But I’m going to show you my favorite chart that we had. Actually, it’s my second favorite chart that we had this past quarter, and it’s going to be on the top here. At Aptus we always try to make things as simplified as we possibly can, whether it’s from an investment standpoint or a marketing standpoint. And one of those things that we do that combines those two is that we always talk about where do returns come from. It’s either going to be to yield, it’s going to be growth or it’s going to be valuation expansion or contraction. And what this top chart is showing you here, what was the composition of returns, what came from yield, what came from earnings growth, and what came from valuation expansion or contraction. And what you’ll see here is that the largest detractor of performance during this quarter where the S&P 500 was down 4.35%, it was virtually all valuation compression.

And the valuation compression was basically the contribution from that was that one, we had some volatility from a geopolitical standpoint, but I think there’s a second aspect too that caused the markets multiple to actually pull back, more specifically in the tech sector. And it all entailed that AI disintermediation story, specifically within software or just within jobs themselves. So I always love showing these types of charts because I think it gives you a good position on what many investors are thinking right now. And so this is showing that, hey, you know what, investors, they’re pretty pessimistic right now, but let’s walk through each one of those parts. We won’t talk about yield that’s obviously more static than the more dynamic nature of earnings growth and valuation, but let’s walk through valuation first. I think we’ve been a pretty big firm believer at Aptus as a whole that we’re not worried about valuation right now.

We think many advisors and investors themselves, they haven’t seen the forest or the trees on how this market has evolved over longer periods of time to become more of a technological hub or more importantly, an asset light type of allocation or asset cost, where it should yield a higher valuation. Yeah, there’s been a lot of people out there talking, “Hey, you know what? Markets are expansive. We need to see valuations pull back to get more comfortable.” Well, that’s exactly what happened this quarter. You had valuations pulled back by almost 9%, the forward next 12 months P/E for the S&P 500, it’s actually sub 20 now. It’s at 19.7. And what each one of these three charts are showing you, I wish I could overlap some one, but more, I wanted to show them from a side load perspective. Let’s look at the valuation of large caps to the S&P 500. Let’s look at the valuation of the NASDAQ, which is going to be more of the tech focused area of the domestic markets.

But also let’s look at the MSCI EAFE from a valuation perspective so we can at least know where we currently stand from a sentiment perspective. And what these charts are showing is the current P/E ratio, but it’s also going to be comparing it versus the 5 year and the 10 year. And what you’re seeing is that the more dollar denominated indices, so the S&P 500 and the NASDAQ, their valuation’s looking a lot more palatable than what most investors probably perceive. This data’s only going back five years. So it will show you that the more international benchmarks given last year’s run, which is pretty much all valuation driven that maybe international might be looking a little bit expansive right now, but my takeaway from here is that this is a reason to be optimistic. Price is what you pay, value is what you get. I think the market is trading at a pretty good valuation right now, given a lot of the emotional volatility out there and the negative bear sentiment.

But the next part of where yield comes from, it’s going to be from earnings. And we know that when the market has some type of pullback, it’s trying to figure out, is this going to be a growth pullback or is this an exogenous event pullback that we’re witnessing? And I put a piece out maybe a year ago and just try to bifurcate that to understand where we can find a bottom in the market. And what we came to find out was when the market has a pullback, it’s either growth related or not growth related. But when the market has a pullback and it’s not growth related, the average peak to trough pullback of the market, it’s about 8, 9%. But when you do have a growth scale, a company with a pullback, you tend to see the S&P 500 pullback peak to trough about 16 or 17%. And what I look at right now in this market, the fundamentals are very strong. I don’t see this as a growth scare whatsoever. I think there’s a lot of Twitter charlatans out there that would argue with me on this point.

And I would actually like to debunk that here in a second, but growth is actually unbelievably strong. And what I want to show you is two different charts showing where earnings were. One back on March 12th and one more recently here at end of quarter on March 31st. And what you’ll see is back just about two and a half, three weeks ago, the 2026 ETS growth rate for the S&P 500 was about 15%. As of yesterday, it was closer to 17%. Thus, we saw a rerating and earnings growth of 2%. And all of that 2% expected future growth, it actually came from the energy sector. We all know what’s going on with oil right now. It did just close below $100 today, but Wall Street analysts, when they come up with their EPS expectations for the S&P 500, it’s really easy to plug into their calculation, their analysis, “Hey, this is where oil is. We think that the energy sector can see now X or Y amount of growth during this period of time.” So it’s very easy to plug in what energy’s future earnings per growth is.

Obviously the main cornerstone of that is energy. So all this 2% increase that we saw in ETS expectations was from energy. That is still real earnings. It does tend to be a little bit more volatile, and I see that as a positive. What most people give me a kickback here for is like, “Well, Dave, you are correct that these energy companies are going to be making more money because energy prices are higher,” but there’s a second derivative and a third derivative nature to this. And it’s that, yeah, energy prices are higher, that’s good for energy companies, but that’s bad for manufacturers, that’s bad for companies that have a lot of input costs that pertain to oil or diesel or something along those lines. Or think about food. The increased price of fertilizer right now obviously is going to have some type of ramification for companies that sell food. And we all know that it’s much more difficult to figure out what input costs are going to be, or at least the headwind from energy.

And I think we’re going to get a little bit better of a picture of that moving forward into the future as we start to get and garner Q1 guidance or some management commentary. But I don’t think it’s that big of a deal because the market, yes, expected to grow earnings by 17% in 2026. That’s already kicking well above its historical norm. So if we have some type of haircut on earnings per share growth from energy input costs, it’s going to be very, very palatable because we know historical growth rates for the market’s about 9% or it’s 17%. I can tell you that input costs aren’t going to degradate all 17% earnings growth that we’re going to have this year. I’ve actually read a few studies here more lately, and they all point to the same north star that if you average $90 of oil for an entire year, it’s about a 5% headwind through earnings per share for the S&P 500. So I think I do math for a living, so I should be pretty good at math.

But if you take that 17% earnings per share growth of the S&P 500, subtract 5%, that’s 12%. That’s still pretty good earnings. That’s still double-digit earnings. And that’s still just on the back of us just having our fifth straight double-digit earnings per share growth for the S&P 500, which is a record. So I’m okay. I’m not worried about that input cost scare that a lot of charlatans are speaking to or these ultra bears are speaking to because one thing I like to talk about when talking about this is, I love keeping things in perspective because I think a lot of the bear sentiment that’s coming from the geopolitics over in the Middle East specifically with Iran, it obviously has to do with the Strait of Hormuz, and that’s directly tied to world global consumption of oil. We know that 20% of the world’s oil comes through the Strait of Hormuz, and if that’s shut down, that’s going to create some type of bottleneck. We also know the ramifications of some of the bombings that have affected or altered the infrastructure within the region that could have longer term ramifications.

But at the end of the day, the market, to be honest, is very used to and accustomed to, one, with oil volatility, but two, also with the price of gas being this high. I mean, we did see the largest spike in oil probably on record, but we were starting off at a very low base. What I like to show is, to keep things into the proper perspective is this chart on the left-hand side here. It talks about over the last eight or nine years, what is the average cost per gallon of gas? Obviously that’s what affects consumers the most is gas prices here. We’re still pretty much right in the realm with average. Year to date, the average cost per gallon is $3.34. The average over the last eight, nine years is about $3.1 to $3.10. So we’re not outside the realm of something crazy right now. But even if we want to make it more political, again, this theme that we had a South Park of PC Principal, I’m trying to hit on both sides here.

Let’s look at different presidential regimes and the number of days that that specific presidential regime was associated with gas price, departing oil barrel prices over $100. And right now, Trump 2.0, he’s at 24 days. If you go back to the four years of Biden, he witnessed 168 days of oil above 100. Trump 1.0 was at zero. Obama was at 410. Granted, that was over eight years, not just four years, but even Bush over an eight-year span throughout obviously all the stuff going on in Iraq and Desert Storm, he still had 225 days where he saw in his presidency oil over $100. So the market can digest and get used to these so called higher energy prices. Obviously, we know that the Strait of Hormuz is going to be probably closed for a while and there’s going to be ramifications there. We talked about the duration of this war, but I think that this market rate now, it can handle that increase of input cost. And before, John, I turned it over to you. I want to say one last thing. And it was the theme of the newsletter outside of South Park.

And it’s when markets get chaotic, when markets feel like they’re in turmoil, the best things that we can do as an investor is to get back to the basics. And the basics right now, they’re very simple and very strong. The basis are the growth for markets, but also the profitability for markets. And right now, the growth of the S&P 500, whether you look at corporate earnings growing at 17% year-over-year, or if you look at GDP, which has comprised 71% of consumer spending, so both the consumer and corporations, they’re spending a lot of money and they’re growing. So that’s very, very healthy. The last point on profitability, profitability is still very strong here domestically speaking, where you can bifurcate it between the market cap weighted S&P 500 benchmark, which is seeing operating margin hit almost 19%, which is an all time high. But also on the equal weighted S&P 500 benchmark, you’re starting to see operating margins inflect to just over 13%. They’re not hitting all time highs just yet, but they’re still inflecting and going higher.

And it’s always great to remember that it’s very difficult for the market to get into trouble when margins are staying static or they’re increasing. So that’s why I say, if you’re a firm believer that there’s some type of growth scare out there, the best thing you can do as an investor is to go find where the growth is. And that growth is still here in the United States. That’s why our outlook heading into this year was based off of the 2001 movie American Psycho because we want to be psycho about American assets because the fundamental backdrop for US equities, especially from an opportunity cost, I still believe is second to none. So Derek just brought up a poll question here. It’s talking about for the rest of the year, what do you think the S&P 500’s performance is going to be? Is it going to be down 5% or more, flat, up five to 15%, or up 20% or more? We’ll take a moment for y’all to answer on in here.

Derek

Always good when you got a crowd to take the temperature of the room. So this’ll give us some decent feedback on where sentiment is, because I know, Dave, you love soft data.

Dave

You know how to get me going. So we have our results here right now. The majority of our participants from here believe that the market’s going to be up 5 to 15% coming in, tied for second is going to be flattish or up 20. But I think the big takeaway here is that only about 5% of those that voted said that the market’s going to be down 5% or more from here. So it feels like a lot of people believe that that bear sentiment is somewhat behind us and it’s time maybe to become a rational optimist.

John Luke

The 5% should tune in on Tuesday for the defined outcome webinar. I think that’d be helpful. I mean, it’s pretty wild. It’s just add onto the list. So since 2022, we’ve had Russia’s invasion of Ukraine, 9% inflation, 550 basis points of rate hikes by the Fed, the third and fourth-largest bank failure ever, tariffs, now the war or conflict in the Middle East. And yet over that period since ’22, stocks are up 50%. And so I think it goes back to a lot of what you said about just the resilience of corporate earnings, stimulus, and AI CapEx. And I think as long as that continues to drive, there’s a lot of stuff that can continue to build up underneath the economy and grow earnings. But when you look at this chart and you look at the rate environment, it was a pretty chaotic first quarter for bonds. I think we can probably all agree that the 40-year bull market in rates that started in ’81 and ended in August of 2020 is probably over. We’ve seen rates definitely get back to more normalized levels, especially compared to just nominal GDP growth.

But what you continue to see is bonds not be great insulators for portfolios. So if you look at the ag for the quarter, it was down about five bps, offering minimal support to stocks being down. And if you look at credit spreads and things to that extent, they widened out a little bit and were a little bit less impactful as well. The story coming into the year was really a steeper yield curve. Everyone was expecting the front end to come down with two or three rate cuts this year by the Fed, and then the long end to stay stickier just because growth was remaining elevated. At the top, the spread between the two year and the 10 year was about 70 basis points. And it got down into the low 40s and high 30s last week, and now it’s about 50 basis points. So still a positive spread there. I think the biggest thing that you saw was the spread between the two-year treasury and the three-month treasury changed drastically, where you actually saw the two-year treasury rise above the three month. Which typically only happens whenever the Fed’s actually hiking interest rates.

And what that told us was the market was really getting ahead of the oil crisis and the potential of future inflation from higher oil prices, and actually pricing in rate hikes for the Feds. So if you look at where we started the year at about two and a half to three cuts for 2026, at where we actually started pricing in a small chance of a hike later this year. So you can see on the chart here on the left, global bond yields have basically risen in response to all of the geopolitical turmoil. And I think the market was a little bit unfounded, at least in the US perspective of thinking that the Fed’s going to hike rates into an energy crisis, a supply constrained energy crisis, which they really haven’t done that in the past. They tend to look through it. But if you look at other central banks across the world, they don’t have the same mandate that our Fed has. Our Fed mandate is inflation and labor market, and it teeters and totters back and forth based on the environment for both of those.

But many of the other central banks have a central mandate of inflation. And where you’re seeing markets price in is a lot of other countries are definitely not as resilient or independent for energy as we are here in the US, and you’re seeing their markets respond. So I think the first comment that I would make on that is, if any central bank hikes into a supply constrained energy related price increase, it’s probably a mistake. And so I would expect that as soon as we get more clarity, and there’s been so much back and forth between the Trump administration, tweets, tweets from the Iranian administration that have moved the market two, three, 400 basis points in a heartbeat. But as soon as we do get past this, I would really expect that oil prices, and if you look at futures, they’re not offering a huge worry of prices higher in the future. And so I think you could start to see the market catch a little bit of momentum as the Fed and the market starts to price back in some of the rate cuts back onto the table.

And so the chart really on the right just shows that. It shows what the Fed’s communicated from their dots, which is the blue line, where we started before the conflict, which is the green line, and then the red line was yesterday. And you can just see that a lot of the rate cuts have been priced out. And if you look actually at the interest rate probabilities, there’s no rate cuts priced in as of today out for like 18 months, which is a little bit outlandish to me. Dave, go back to the credit spreads. I think we’ll just briefly touch on this. Credit spreads obviously widened for the quarter, both investment grade and high yield, but we’re back at the average levels over the last six years. So it’s really nothing overly alarming. I think it probably got a little bit overdone, which we have made that call for a while. We were a little early. But spreads are back to normal levels. This isn’t anything that points to recessionary dynamics or anything overly concerning. And of course we’re watching it. And Dave, I guess go to that last one on the breakevens.

Yeah. So the chart on the right just shows the breakeven levels. And this is essentially saying where the market is pricing future inflation. So you can look at it on a shorter term basis, like a one or two year, and then you can look at it on a longer term basis. And this is where real market money is going in terms of future inflation expectations. It’s a little small, but the bright blue is the one line that’s spiked up. So the market’s pricing in higher inflation in the front end from energy, but it’s really saying that it’s anchored further out. The longer we go out, the less problems with inflation. And I think a lot of it points back to the other chart on the left that you tend to see big moves in response to geopolitical events or different type of mini crisis. But what you tend to see is after the initial 10-day move, it oftentimes turns back in the other direction and gets a little bit of sanity baked into it. So what you see is a shoot first, ask questions later, type of environment.

And I think it’ll be a similar backdrop from here. So Dave, you really had the more fun quarter in terms of what was going on on the equity side, given the amount of volatility. There was quite a bit in bonds when you look at the move index, which is the VIX for treasury bonds. It saw a nice spike. A lot of that’s come down since the capitulation yesterday, but I think as we set up, and as I turn it over to JD, I’ll leave with this comment. So over the next 12 months, the US government has 33% of our treasuries outstanding that are maturing, so they have to be refinanced. We’ve got another two trillion of treasuries that will need to be financed because of our deficits. And then you’ve got roughly half a trillion to a trillion in AI, CapEx, debt financing that’s going to occur, and some of that’s already happened throughout this year. And so you’re in a backdrop where that’s 13 plus trillion dollars of debt that’s going to have to be refinanced into a backdrop of, we already have over 38.5, roughly trillion in US debt outstanding.

It’s a big number. And so it all points back to this chart that we focused on and we’ll continue to focus on. We can’t spend and cut our way out of this. We can’t likely grow our way out of this. I think there’s going to be a big focus on deregulation as well as productivity throughout the next years of history, but it doesn’t happen overnight. The ultimate way out is that you debase the currency and you inflate your way out. And the real return for bond holders is very likely to be very poor, especially after you pay tax on it and obviously the purchasing power is eroded from inflation. So the backdrop continues to really favor risk assets. And I think when you put those stats in your head, it’s a little bit humbling to think about. But when you do think about what the solutions are for clients’ portfolios, there are some rosy topics to talk about and there are ways to preserve your wealth and how that we can invest their capital to give ourselves the best opportunity to win. JD?

JD

Yeah. I would just reiterate the amount of debt that is going to be needed and will come to market. Every new issue of debt equals new money in the system. And if you look at money supply over the last 50 years, whatever it is, 7, 8% compounded rate, well, there’s a reason your purchasing power was a dollar when we went off the gold standard and you’ve lost 90 something percent of that purchasing power. We expect that environment to continue. And if you think about it, like the productivity piece, AI, productivity, all of that should be a deflationary pressure, but that does not coincide with the amount of debt that we need. Deficits, what’s maturing, CapEx spending, all the things JL just mentioned. So the reason for that, if that is what is forecasted, then we’re really convicted that allocations need to recognize that. The risk in the equity markets when you do add additional equity is obviously left tail concern. And I think that’s why defined outcome is so interesting. That’s why hedged equity, obviously talking our book a little bit there, but that’s why we’re excited about our business over the next decade.

Because I think we give a path towards the ownership of more of the risk assets and the flawed assumptions of thinking bonds are positive carry vehicles and can protect your equities. We can break the chains of those assumptions, which every other asset manager may say some of the things we say, but their way out of it is just to buckle up and deal with the volatility. And that’s not, to Dave’s point, to start the call emotionally and behaviorally, that’s an issue, especially… Everybody has that client. We’ve seen this, especially with the software stocks, a client’s got a big piece of their wealth in a software stock and they’re real convicted in it. We’re good. 2% pullback, we’re good. A 6% pullback and it’s like, “Oh gosh, what do we got to do?” Much less a 40% pullback. So we know how quick behavior can change when you’re dealing with drawdowns. So that’s where we’re excited. So I’ll shut up. But Dave, you got anything to wrap us or D. Hern or whoever?

Dave

I did say that the top chart was my second favorite chart. JD, you just hit on my favorite chart here. It was actually put out by one of our favorite CFAs, Brad Rapking, and he created this because what we always try to do great here at Aptus is not just have great qualitative stories and analogies of what we’re talking about. For me, because I’m not that smart, I’m the equity guy, I’m not smart like John Luke, the bond people are always smarter, but I need a picture book when it comes to talking options or talking analogies. And this is just my favorite chart right now. I mean, we recently had a slew of new scenes out there talking about Aptus’ two pinnacle investment philosophies, pardon me, that we had out there. And it was like, “Hey, focus on structure, but also focus doing better in the tails.” And to reiterate JD’s point is, most other people’s plan out there is like, “Hey, you know what? Buckle up for the ride. Markets go up over longer periods of time. It just creates a disconnect on cognitive behaviors and actual volatility.”

This chart just shows you what our competitive edge is here at Aptus, is that we don’t have to rely on commodities. We don’t have to rely on gold. More importantly, we don’t have to rely on fixed income to be that insulatory nature, that buffer that we have in portfolios to make sure we protect on the downside. And what the chart’s basically showing is there’s a Mendoza line of zero here. And when you’re above that Mendoza line of zero, you have higher correlation amongst assets for that given asset class. If it’s below zero, and you have lower correlation, meaning that you get better, more consistent protection, if that’s what you’re trying to do, to be negatively correlated. And what you see on this bottom line is just that blue line of long hedge. You just get a lot more consistency out of that protection. And that’s what we’re trying to do. We want to control the controllables because there’s a lot of controllables out there that we cannot control. Obviously the geopolitics going on. But what we can always do is make sure that we have these hedges in place to protect against the unknown.

Derek

Couple questions coming in and I want to open it up so other people will throw them in. Any thoughts on if the private credit redemptions will have a spillover effect? We haven’t really talked about that here, but I know it’s been in the headlines.

John Luke

Yeah, I’ll take the first.

Dave

Yeah, John Luke, go for it and I’ll finish it.

John Luke

Yeah. Well, I mean, it’s certainly an asset class that’s had a lot of interest the last few years where investors chased it with the low rate environment and because it wasn’t marked to market every day, had some allure with higher yields and no volatility. Although when it’s not priced, that’s part of it. I think there’s a couple different ways to look at it. You had an illiquid product that was stuffed into a semi-liquid wrapper that was sold to retail clients that we know have the tendency to be fearful and sell at the wrong time. And so I think part of that is the backdrop from a marketing perspective, and it was funny to hear the Blue Owl CEO actually admit that. But when you think about what the structure looks like, really they have gates for a reason. The reason these products are gated is because they have an advantage of not being like First Republic Bank or Silicon Valley Bank, where when the client goes to the bank, the bank has to be able to provide their deposits back.

That’s a liability to them. Well, the private credit investors signed up knowing that the asset manager for their protection could gate the liquidity. And what you’re seeing is that play out, where if everyone’s having to sell illiquid assets into a fire cell, it’s not a great opportunity or it’s not a great situation for clients or for the managers. And so I think by putting up the gates, it is putting some form of protection. But as Joseph Sikora has said for the last several years, “When you stuff stuff into a black box and you don’t really have a great idea of what it is, it can be tough to value.” And so are there some problems out there with assets? I’d say so. But also, are there investments that are really influential and important to the infrastructure growth, the build out of the economy, real assets with real estate, with data centers that a lot of the private credit has exposure to? I’d say you bet.

And so I think that they can protect themselves with the gates long enough to buy some time for things to chill out a little bit. But if you did have an environment or a situation where somehow regulators forced them to sell, which I don’t see that as very likely, but I guess it is possible, then that could be problematic. But really, when you signed your money up for this structure, this is what could happen. And so I think really for clients that have invested in this and have some problems, I think it points out that you don’t need too much size in your portfolio because there can be lack of liquidity when you want it or need it most. But if you do own some of this and you can get out at NAV, from what I’ve talked with Joseph, he would recommend trying to get out at par value if that’s possible. So it’s a bit of an ugly picture, but the other side too, and then Dave, you can run with it.

From the default perspective, you haven’t seen a real degradation in defaults happening. And so I think that’s also important and it really goes back to these products have the scope of everything, from consumer loans to real estate projects, to everything in between. And when you look at the backdrop of where the consumer sits from an asset to liability perspective, it’s one of the better positions that we’ve been in for a long time. As Dave puts out that net worth update, I think every month or every quarter, where you update the net worth of the US in general across the corporate side, across the personal balance sheet side, you’ve seen drastic improvements in that. And I think that can help cushion where you’ve actually got equity capital available to cushion some of the ugly.

Dave

Dave is 30 seconds here, which is like a minute. I’ll start off by saying that I don’t think there’s a systematic risk at the current moment for private credit, but that doesn’t mean I’m advocating for the asset class. I think there’s so many better opportunities to get alternative exposure with daily liquidity and consistency of performance, better than what you can get in private credit. Brian Jacobs, CFA on our team, he had a great blog post out talking about this. Everyone loved the illiquidity premium on the way up, but they hate the illiquidity discount on the way down because there’s this theater effect is that everyone’s trying to get out of the movie theater on one small door and it’s very hard to do. So if you look at our quarterly newsletter, the one obviously that’s on the South Park theme, there’s a whole page actually talking about where our current thoughts are from a numerical standpoint on private credit. The private credit’s only about a $2.5 trillion asset class. Obviously it has grown a ton, but 90% of those assets, they’re institutional assets.

The other 10% where you’re getting a lot of this exuberance, it’s on the retail side. Institutional investors tend to be more rational and they tend to have a longer time horizon than the irrational, shorter time horizon of the retail universe. So a lot of the flows you’re seeing right now coming out of private credit, creating this bank run-on type of worry, it’s coming from the retail side of things right now. And if you believe that what Goldman Sachs and us are saying, you’re going to get at a default rate of 8% to 12% here, which is totally fine. That’s only losses of 200 to 300 million. It’s not terrible. It’s an injury, but it’s not systemic because it’s not risky loans that drives this. It’s the leverage that really drives this. And what you’re seeing from a leverage standpoint in private credit, you’re getting loan to values of 40 to 50%, and interest coverage ratios of 2X. So it’s not that the leverage isn’t there yet, I think, in my opinion, to create more of a systemic problem, but obviously let’s keep our head on a swivel.

Derek

We could probably take another one or two. This one here, clients still ask about the best way to benefit from AI. Any ideas?

JD

Yeah.

John Luke

Yes.

JD

I can be brief on this, D. Hern. To bring it back to the asset allocation piece. So I do think AI is a productivity boost. I think anybody that runs a business or is involved, you should probably consider using AI tools to help drive productivity. Our business, multiple other businesses that we know well, it’s a testament to that. So the issue is, what does that do to jobs long-term? That’s an unknown, and I think it will continue to be an unknown. It’s going to have an impact. But if you think about the best way to get exposure to AI. Well, at the higher level, the asset allocation level, what matters? Who benefits from AI productivity? Does owning equity interest in a business or owning fixed income? We would argue the equity interest in the business is going to benefit. Every company out there is exploring and spending resources into how can they leverage these new tools, and you’re going to get…

So as boring of an answer as this is, own equity beta, own the S&P, own indices, you’re going to get exposure, you’re going to get exposed to that productivity increase. We don’t have this and maybe we should do… We wrote about this last month, but the opportunity cost of holding cash or holding bonds is not just the inflationary pressure that is inevitable. It’s also the lack of productivity gains that you feel. So you are compounding your opportunity cost by both. You get eaten alive by inflationary pressure and you do not benefit from productivity gains. Whereas in equity, you own equity interest in a business, you benefit from their productivity increases, and you benefit from their ability to fight inflationary pressure. So if you want exposure to AI, own equities.

Derek

That’s 45 minutes, gentlemen. That’s probably a good place to cut it. Awesome. Appreciate you coming in. Like JD said at the beginning, Dave just killed it to get stuff done by today. So you’ll see if you’re a client, you’re going to see a bunch of content coming through, charts, commentary, things that you can turn around and share with clients. But hit us up if you have anything specific, any custom needs or anything that you see that we send your way, just let us know. We’ll brand it up, we’ll tweak it up, whatever we can do for you. I don’t know if anybody else has anything to add, but-

JD

Tuesday webinar. Tuesday webinar, be on the lookout. It’s going to be a good one.

Derek

Same time on Tuesday.

JD

Yep. Thank you everybody for the time.

Dave

God bless y’all.