Dear Investors,

One of the things I like to do when I am not working is surf. In many regards, surfing is analogous to my work life – exhilarating, exacting, unpredictable, and deeply gratifying. Much like the markets, the ocean is never the same. Each day offers something new and challenging to absorb and adapt to. Surfing, like investing, requires conviction – when a large set wave comes in, you must process multiple pieces of information, make a decision to “go”, and then commit to that decision. Doing this over and over hones a different kind of response to chaos, a reflex to use the fleeting calmness between the waves to position yourself for the next one. As we set up for the 2024 wave in the markets, I thought I would reflect on some of what we saw in 2023, discuss what we are seeing on the horizon, and outline where we have conviction to “go”.

Real assets, such as real estate, faced formidable headwinds in 2023 as central banks took aggressive measures, hiking interest rates to arrest accelerating inflation. Higher borrowing costs weighed, stifling dealmaking and fundraising – a dramatic shift from 2022 – and exacerbating uncertainty surrounding valuations. Interestingly, rising interest rates did little to dent demand for private debt, which saw increased investor interest as fundraising outperformed most other private capital strategies (e.g. private equity). Broadly speaking, investors favored experienced managers to navigate them safely through uncharted waters as first-time funds struggled to raise capital.

If 2023 marked a challenging year for Alternatives asset managers, it was a downright atrocious one for economists.

Gross Domestic Product (GDP) growth was more robust than expected, driven primarily by wage increases and resilient consumer demand, despite the combination of high inflation and interest rates. At the same time, there is growing recognition that inflation has fallen faster than expected in many markets. Economic pressure from high debt servicing costs is proving painful. A low-growth environment is forecast in 2024, with the specter of recession in the U.S., U.K., and some European markets remaining. We are forecasting cuts to policy rates starting in Q2 or Q3 2024, but the timing is far from certain as central banks have remained stalwart.

• Private credit remains a strong value proposition, but we believe positioning is more important than ever. The strong relative and absolute return potential of private credit is, rightfully, highly prized in today's world of persistent macro and geopolitical volatility and, even more so, as liquid credit has become more expensive. Surplus cash flow, stronger claims to the underlying assets (senior positioning), comprehensive lender protections, and reduced interest rate sensitivity evidenced by near-zero interest rate duration can all offer important insulation from volatility and loss. However, as the asset class has grown rapidly, competition to lend has followed. So, while we see compelling value in direct lending (privately negotiated loans), we have the most positive view on loans that are senior, unlevered, and well-geographically diversified and believe that managers with multiple origination channels, especially with direct connectivity to lower mid-market (medium-sized) borrowers, are best positioned to deliver value for investors.
• Market conditions are creating a unique short- and medium-term opportunity for Real Estate debt across the risk-return spectrum. Lender pullback due to higher rates and lower property valuations when more than $2 trillion in U.S. commercial real estate loans is maturing before 2028 are impacting borrowers’ ability to refinance loans - private capital can help fill this funding gap. In real estate, we believe the logistics and residential sectors still offer the most attractive risk-adjusted returns for both senior and junior debt, although offices and retail could also offer interesting lending opportunities on a more selective basis.
• The opportunities in Infrastructure remain compelling, with the European Energy Transformation continuing to offer significant scope for infrastructure investors to deploy capital over the coming years, particularly as Europe looks to shore up its energy independence, a commitment backed by strong regulatory policies. While deal-making slowed sharply in 2023, investment in areas like digitalization and decarbonizing power production and transportation have continued to rise steadily and substantially over the last decade, and Europe has seen momentum building since Q3 2023 when the decline in activity reversed. We are reinforcing our existing strengths in private infrastructure equity and debt to meet these evolving needs.
• 2024 should provide an attractive entry point to capitalize on the coming real estate cycle. History has shown us that the years after a major price correction have tended to be some of the best milestone years for capital investment (vintage). Lower values and rising cash flows are pushing income returns to their highest level in more than a decade. Property fundamentals, with the exception of office, are essentially sound, and supply shortages may propel strong rent growth over the next several years. Signals from the listed real estate markets are supportive, and if interest rates ease further, cap rates could follow suit, adding further support to capital appreciation. While we believe U.S. office will continue to struggle in the short-term with low post-COVID utilization, metros with an expanding technology and life science presence and strong population growth, as well as a tightening market for higher-end space, are offering cause for cautious optimism in select markets as the sector marches toward longer-term recovery. Elsewhere, fresh capital can seek to capitalize on ample emerging opportunities across residential as well as industrial and retail, which are supported by longer-term structural tailwinds such as e-commerce, population growth, and migration trends.
• Individual investors are interested in the Alternatives opportunity set. Different client segments are at different places along their Alternatives investment journey. For the retail/wealth channel, it is just beginning. Historical barriers to entry have eased and Alternatives can offer the same set of attractive investment characteristics – the potential for increased diversification, stability, and enhanced total return – to individual investors. In our view, thoughtfulness around capital migration into this sector will be crucial. We are excited about our recent DWS’ iCapital partnership, which will further enable U.S.-based wealth managers and high-net-worth investors to access the return and diversification opportunities offered by DWS Alternatives solutions. Importantly, DWS has a proud legacy of innovating to meet a wide range of client needs in the real assets space, including offering a suite of liquid real assets solutions that provide a variety of access points and can be utilized to expand the alternatives opportunity set, meet liquidity needs, and afford transparency in valuation, complementing our private solutions offering.

Entering 2024, as we pursue opportunity in a challenging market environment, we take a moment to recognize that investing is the act of executing where you have conviction and renew our longstanding commitment to work tirelessly to earn your trust. It is a tremendous source of pride for us to serve as the Alternatives asset manager of choice for our clients. The money we manage and the future we strive to prepare for belongs to you. To be relied upon to chart a safe course in the face of uncertainty is both motivating and humbling. We cannot eliminate the risk – the noise – but we can process it, manage it, and thereby exploit it with confidence in pursuit of outstanding risk-adjusted returns for our clients. We will continue to offer perspective that matters, innovate relentlessly, and place our clients at the heart of what we do.

Sincerely,

Paul Kelly
Global Head of Alternatives