The top strategist for $2.5 trillion investment giant State Street breaks down a growing threat to the market that's lurking in the shadows, even as stocks soar
- The swelling private-equity and debt markets are looming as possible threats as possible threats to investors once interest rates rise and financial conditions tighten, according to Michael Arone of State Street Global Advisors.
- Arone says that market is likely to keep growing for now. But since the market lacks transparency compared to the stock market, investors may not understand the risks they're taking.
- Other experts are also saying the rapid growth in leveraged loans and other private debts in the past decade might become dangerous in a downturn.
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Stocks have surged to record highs as investors feel the Federal Reserve is ready to pull the economy back from the brink. But there are still dangers lurking just the same.
Michael Arone, chief investment strategist for State Street Global Advisors - which manages $2.5 trillion - says trouble may be brewing in the enormous private equity and debt markets. While investors have clamored to get into those areas in the last decade, Arone argues that many of them are taking bigger risks than they realize.
"Private equity markets could be the source of your next challenge when interest rates and financial conditions tighten," he told Business Insider.
And, to add insult to injury, Arone thinks the very factors that are helping the market today could give the risks in the private market more time to build up.
Trillions have flowed into private markets in recent years as banks were hesitant to take risks after the global financial crisis, while private lenders were eager to step in. Companies have taken on more and more debt, something that's worrying some experts.
"There continues to be a surge in debt," Arone told Business Insider. "It's been happening in direct lending, leveraged loans, private credit markets, peer to peer lending (and) crowdfunding."
That surge seems set to continue as long as interest rates remain low. But Arone isn't only worried about the debt loads themselves. He notes that it's harder to evaluate private spaces compares to the stock and bond markets, to the point that he calls the private options "opaque."
"Who owes what to whom and when, and under what covenants and conditions, is really kind of vague and difficult to determine," he said.
That makes it difficult to determine how risky an investment really is.
The private market is far smaller than public markets despite the recent growth. But much of that market is just barely investment grade, meaning it's vulnerable to an economic downturn. And it's much harder to sell those private investments when their value drops, so big losses there could push investors to dump other assets like stocks.
Arone said he sees signs that investors are taking bigger risks as demand goes up and returns start to slip, as private market debts are packaged into collateralized loan obligations and other instruments, reducing transparency further, and getting more aggressive in seeking new investors.
"They're even packaging these things up and offering them to the financial advisor market, who then sells it to the high net worth clientele," he said. "That's kind of a red flag."
While the risks in the private market may be rising, Arone acknowledges they're not likely to predominate over more immediate concerns. But he says investors should prepare themselves by watching not just the Fed, but real interest rates, which are adjusted for inflation.
They've mostly been negative, but the market reacted violently in September when the situation briefly changed.
"The global economy couldn't tolerate it, the stock market couldn't tolerate it, credit spreads widened, lots of challenges become evident," Arone said. "That is the mechanism through which we'll see problems begin to unfold."