Middle East Tensions | Credit Fund Runs | Portfolio Defense

In this debut episode of Forthlane’s Off the Charts, Andrew Sarna and Vanessa Hui unpack three recent headlines impacting markets: escalating Middle East tensions, mounting concerns in private credit, and a challenging March for traditional portfolios.

Despite geopolitical chaos, equities remain surprisingly resilient, leaving investors questioning whether markets are underpricing risk or simply conditioned to ignore it. . 

The key takeaways: the war is difficult to handicap and markets remain resilient; private credit headlines are more about liquidity than fundamentals; and portfolio construction matters more than ever when traditional diversification breaks down.

WHAT TO LISTEN FOR

:26 Middle East Conflict & Market Resilience
5:38 Private Credit & Liquidity Concerns
9:38 Traditional Portfolios Struggle in March

CONNECT WITH ANDREW SARNA

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CONNECT WITH VANESSA HUI

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This podcast is for informational purposes only and does not constitute investment advice. Views expressed are those of the speakers and should not be relied upon for investment decisions. 

Transcript

Andrew Sarna (00:04):
Welcome to Forthlane's Off the Charts podcast, where every two weeks we cover three market headlines that matter. I'm Andrew Sarna, portfolio manager.

Vanessa Hui (00:11):
And I'm Vanessa Hui, senior client advisor.

Andrew Sarna (00:14):
And today we will cover the conflict in the Middle East, recent headlines regarding private credit and what March's price action means for portfolio construction. There's a lot to unpack, so let's jump right in.

Vanessa Hui (00:26):
Andrew, let's start with the conflict in the Middle East. Markets have been surprisingly resilient despite escalating headlines. From your perspective, what's actually going on here?

Andrew Sarna (00:37):
Frankly, it's been incredibly hard to understand what's actually happening. Every Sunday, Trump seems to pump the market ahead of the open by suggesting negotiations are progressing or that the U.S. is going to wrap up their operation. Then a couple hours later, Iran denies it. I mean, it's been incredibly effective at propping up equity markets and ensuring that we don't open up down 2%, but it's really hard to understand what's going on. There's a lot of propaganda and censorship out there. It's difficult to know what's real, who's winning, the damage done, et cetera. As an example, for a couple weeks, the U.S. was claiming a laundry room fire on one of their aircraft carriers. It wasn't till a Trump press conference that the truth seemed to be revealed that it was actually drones attacking the ship. Investors have been conditioned to fade geopolitical events. Investors have been rewarded for buying the headline, fading the bad news.

(01:47):
 None of this ever escalated into World War III and equity markets marched on. At the same time, if this does escalate a couple more weeks, we're going to see real demand destruction. We're going to see shortages, and we're already seeing flights being canceled in some of the regions where fuel supplies are a little tighter. I also always thought Trump couldn't afford a war going into midterms, but there's parts of me that now feel that he might be trapped. Bottom line is really tough to have edge here. I don't think either party wants the war to drag on, but at this point, it seems like a resolution could be far away. And at the end of the day, in all these investment scenarios, you always ask yourself, "What's my edge?" And it's very difficult to have an edge over the market in this scenario. And speaking of edge, Citrini, a research provider, actually sent boots on the ground to the Strait of Hormuz, and their findings were pretty fascinating.

(02:52):
 They actually found that the strait is acting more like a toll booth rather than a full blockade. Traffic is actually increasing even as tensions escalate. Shipping data is underestimating real traffic through the channel. The real bottleneck isn't insurance. It's safety and sanction risk, and infrastructure damage seems to be underestimated. So this isn't a simple open or closed scenario. It's messy, it's evolving. And remember, the S&P 500 is off like 5% from where it entered this conflict. So equity markets are still not a screaming bargain.

Vanessa Hui (03:29):
Given all of this uncertainty, how should investors be thinking about positioning right now?

Andrew Sarna (03:34):
A few things stand out. Energy has obviously been the best hedge, but at this point it's becoming more of a binary bet on resolution. So if the conflict drags on, energy price or energy stocks could still go up. If there is resolution, energy prices fall and energy stocks suffer. And then you also have risks that, one, the U.S. could put export controls on their energy, which would diminish energy company profits. And then, I mean, looking at the Europeans, there could be windfall taxes, so it's not that straightforward. There's also an interesting dynamic between U.S. and rest of the world equities. You could argue the U.S. is most insulated from the war. It's a more service based economy and less reliant on energy relative to the size of their GDP. Meanwhile, Europe and parts of HR are more manufacturing heavy and more energy dependent on other regions.

(04:32):
 So shortages are going to impact them more than a country like the U.S. But there's another angle. The U.S. is also the most crowded and most liquid market. If investors need to raise cash, they typically sell what they can, not what they want, and the U.S. could be exposed to that similar to what we saw in gold last month. Longer dated oil futures also look interesting as their pricing and normalization with Brent crude futures trading at $75 a year from now, which seems optimistic and seems that that price is in a scenario where there's no permanent damage. And then of course, gold. This war is essentially setting money on fire and fragmenting the world order, which should be a good thing for gold, but force selling can suppress price in the short term. Ultimately, we're looking for asymmetric return profiles where if the war escalates, you're not going to be hurt too bad, but if there is resolution, you're not going to be down 10%.

Vanessa Hui (05:38):
Let's shift to private credit now. Blue Owl recently capped redemptions across two of their major funds after a surge in withdrawal requests. There's been a lot of concern in the market when it comes to private credit. What's your take on this?

Andrew Sarna (05:52):
Yeah, super interesting headline last week where we saw two private Blue Owl BDCs receive $5.4 billion in redemptions, which represent 21% and 40% of total capital, which is honestly shocking. I am getting tired of these private credit headlines, but here we are again. And when you see redemption requests that high, you know it matters. I think it's important to also differentiate what's happening. Is this fundamental impairment of the loans or is it just a run on the bank? Right now, it's just speculation that software loans are impaired. The concern is around terminal values and who the next buyer of these software loans is going to be, but it's speculation. Fundamentals still look okay. Meanwhile, mainstream media has latched onto the narrative. Investors are rushing for the exits and they're looking for liquidity in a liquid asset class. I actually don't think this is a crisis.

(06:55):
 These vehicles were structured thoughtfully. They have redemption gates. They have protection. We saw this happen in the pandemic with BREIT, which is Blackstone's real estate investment vehicle. Investor redemptions surged, but BREIT survived. So what you're going to see is ultimately investors might not be able to get their capital back immediately. We don't know how long these redemption queues are going to get, but I wouldn't call it a crisis. But here's the real issue. There's very little incentive for investors to stay. If you can redeem at par from a private BDC and buy the public version at a 15 to 20% discount, which you can right now, that's a completely rational thing to do. There isn't really any upside in waiting around. If these funds are forced to sell assets, they sell the good stuff first. If redemptions continue, you're left holding the worst loan. So in a bank run, if you're going to panic, you kind of want to be the first to panic.

(07:54):
 That said, I actually think the loans are probably fundamentally stronger than the headlines make it seem, but these investment vehicles structurally create the incentives for investors to redeem. So these stories are probably just getting going and I imagine we're going to see these private BDCs hit their gate thresholds for the next few quarters at least.

Vanessa Hui (08:19):
So does this change how investors should think about private credit more broadly?

Andrew Sarna (08:23):
I think it reinforces some of the things we've been saying for a while. One, these were sold to retail investors as non risky investments. To be frank, these are risky loans. So there's no such thing as a free lunch. And the reality is these are risky loans. Two, liquidity matters. So in recent years, evergreen alternative vehicles have proliferated, but there's a clear liquidity mismatch. And you know what? It's important to go in eyes wide open and understand that you're going to be able to get your money out when the sun is shining, but in the event of a period of risk off, you might not be able to get your money back. Next, it's going to call credit marks into question. You know what? I don't think it's egregious what's going on, but there are certainly some mismarked and some poor incentives for some loans to not be marked properly.

(09:16):
 Investors also need to understand the investor base. Is it long term institutional capital or is it retail hot money? In this instance of the Blue Owl headlines where you see 40% redemptions, it seems like it's hot money. And you know what? If you're investor in those funds, it could be a long time before you get your money back.

Vanessa Hui (09:38):
Okay. Now for our third topic, March was a difficult month for traditional diversification. What stood out to you when you think about portfolio construction? Yeah,

Andrew Sarna (09:48):
I feel bad for investors who are restricted to sort of public markets and traditional investments. March was extremely difficult. Equities, the equity was down almost 8%, bonds were down, so those are your two traditional asset classes, both down. And then on top of that, gold didn't work. Gold had its worst month since the global financial crisis. So in recent years, investors, if they had diversified away from a traditional 60 / 40 portfolio, typically it was something like gold that they added to their portfolio. The only thing that really worked was energy and commodities. So it was almost like a repeat of 2022. There were very few places to hide. And on top of that, you had the aforementioned issues around private credit. So those investors who did stray from traditional portfolios, well, one of the things being pitched to them was private credit, and that clearly isn't a sole replacement for bond portfolios.

(10:47):
 The higher returns meant more risks, so the narrative is beginning to crack.

Vanessa Hui (10:52):
And so what are the key lessons?

Andrew Sarna (10:54):
A few things stand out. First, your annual reminder that equities don't only go up. Second, in hindsight, energy probably should have been a larger allocation in portfolios. In recent years, it has had a negative correlation to many traditional portfolios like look at tech and even look at bonds. And then I would also argue that the new reaction function from governments in these periods of crisis seems to be money printing, which should bode well for energy. You can clip the dividend, and in the event of a geopolitical super spike, you get some additional portfolio protection. Of course, energy has downside in a recession, so you can't replace all defensive holdings. That's why a basket approach makes sense on the downside. Things like gold, energy, commodities, bonds, infrastructure, hedge funds. You can't just rely on a single holding, and you need to take a basket approach. So in the event that one of these things fail, you have a diversified approach that they shouldn't all fail at the same time.

(12:01):
 Sophisticated investors build diversified defensive exposure rather than relying on a single asset.

Vanessa Hui (12:07):
So to summarize our three headlines for today, one, the conflict in the Middle East is difficult to handicap and markets remain surprisingly resilient. Two, private credit headlines are more about liquidity than fundamentals. And three, portfolio construction matters more than ever, especially as we look at March when traditional diversification breaks down.

Andrew Sarna (12:31):
Thanks for joining us for the first episode of Forthlane Off the Charts. We'll be back every two weeks. Thanks for listening.