The Economy

The first estimate of second quarter U.S. GDP growth shows that U.S. GDP expanded at a quarter-over-quarter annualized rate of 2.4%, an acceleration from the 2.0% growth rate reported in first quarter 2023. The acceleration in U.S. GDP growth from the prior quarter was primarily driven by an increase in nonresidential fixed investment and consumer spending.

Driven by consumer spending on services, the personal consumption expenditure (PCE) component of GDP – which drives 70% of GDP over the long run – advanced 1.6%. Consumer spending on durable and nondurable goods also contributed to second quarter GDP growth. Offsetting this advance was housing, which contributes between 15% and 18% to GDP, as it fell 4.2%, its ninth consecutive quarter of declines.

Meanwhile, the Kansas City Fed Financial Stress Index, which tracks overall conditions in the country’s financial industry, continues to trend above the pre-COVID-19 period as three FDIC-insured banks failed over March and April, resulting in elevated deposit outflows.

We anticipate small- and medium-sized banks (that is, banks with less than $250 billion in assets) to focus more on liquidity and to tighten lending standards, as discussed further in the Credit Market section, which may continue to add stress to the financial system.

Switching to forward-looking indicators, we believe that The Conference Board’s index of 10 leading economic indicators (LEI) provides the most balanced, forward-looking gauge of economic activity. While many economic indicators display more noise than signal, the LEI has proved to be a valuable forecasting tool over multiple economic cycles.

In the prior three recessions (excluding the COVID-19-induced recession in 2020) that started in 1990, 2001, and 2007, the LEI began declining between 12 and 22 months prior to the start of the recession. As of June 2023, the LEI has declined for 15 consecutive months since peaking in March 2022.

Given the narrowing in positive breadth of the LEI’s subcomponents, it is possible to see further downside for the index for the remainder of 2023. Momentum reversals have been swift in the past, but nothing about today’s backdrop is suggestive of a near-term trough in leading indicators. There is no guarantee the LEI will prove to be as good a forward-looking indicator this time around, but given its history and the broad base of data it includes, we still believe this index is worth consulting.

Concerning monetary policy, after holding the fed funds rate steady in June, the Federal Open Market Committee (FOMC) raised rates by 25 basis points (bps) in July, in line with expectations, to bring the targeted range to 5.25% to 5.50%, the highest since March 2001. As of July 27, the fed funds futures curve is pricing in that the fed funds rate peaks in November 2023 at 5.43%, implying a target range of 5.25% to 5.5%, below the Fed’s terminal rate guidance of 5.6% (implying a target range of 5.50% to 5.75%), and for the Fed to begin cutting rates by March 2024. 

The FOMC has emphasized that decisions regarding the normalization of monetary policy will be data dependent. However, data dependency is sometimes misinterpreted as meaning decisions are based on data released just before an FOMC meeting. While there will be two inflation reports and two nonfarm payroll reports released prior to the FOMC’s next meeting in September, both of which are likely to move both equity and fixed income markets, lower-than-consensus figures for each may not signal that the FOMC is done with its interest rate hiking cycle.

Fed funds rate expectations have risen sharply since the regional banking crisis in early March as core PCE services ex housing, which is Fed Chairman Jerome Powell’s preferred measure of inflation, continue to show signs of stickiness, and nonfarm payroll numbers show signs of economic growth and improvement.

Should this measure of inflation continue to be range bound – as it has been over the past nine months – and should nonfarm payroll numbers continue to show signs of strength, Powell will likely continue to reiterate that the FOMC would not consider cutting rates until it is confident inflation is declining to 2% in a sustained way.

Given the sharp rise in short-term rates, the Treasury yield curve is extremely inverted: The spread between two- and 10-year Treasury yields stands at -97 bps, while the spread between the three-month and 10-year Treasury yields is -150 bps, its most inverted level in 40 years.    

The inverted yield curve largely reflects rising recessionary and global growth risks. These concerns are due to global central banks’ commitment to raising rates to tame high inflation and its future impact on consumer spending, along with uncertainty on how the banking turmoil may affect economic activity as it relates to lending.      

However, in the U.S., signs suggest that inflation may have peaked in June 2022, as the headline consumer price index (CPI) has declined for 12 consecutive months on a year-over-year basis. Given the lagged economic impact of higher rates and tighter financial conditions, the market is pricing in below-trend U.S. GDP growth of 1.5% in 2023 and 0.6% in 2024.

There is much underway as we progress through the second half of 2023 – balance sheet runoff and potential recession, to name just a few – and we will be watching developments in global growth and inflation closely.

The Credit Market
Tighter Fit: Trimming Down Bank Lending

The persistent rise in inflation, recent bank failures, and the rising risk of a global economic slowdown have been key determinants of the middle-market lending environment in 2023. The credit market has tightened substantially over the past year, and 11 hikes to the federal funds rate since March 2022 have left interest rates at their highest mark in 22 years. While the pace of rate increases has slowed in the short term, the potential for further increases remains as the FOMC stays committed to achieving its long-run inflation rate objective of 2% vs. the current 3% level.

Concurrently, deposit outflows following three of the largest bank failures in U.S. history have led to increased conservatism among smaller lenders, which lost deposits to larger institutions. Although these events have had a limited impact on the broader economy to date, the resulting decrease in access to capital, tightening standards, and increased interest rates to middle-market companies will continue to slow the growth of the U.S. economy and heighten the likelihood of a recession in 2024.

Net tightening of lending standards began in third quarter 2022 – even prior to the recent bank failures unfolding – transitioning from a borrower-friendly to a lender-friendly environment in late 2022. The nearby graph shows commercial and industrial (C&I) loans outstanding to U.S. companies overlaid with the net percentage of U.S. banks tightening or loosening credit standards for C&I loans to large and middle-market firms.

Per the Fed’s quarterly “Senior Loan Officer Opinion Survey on Bank Lending Practices,” a net 46% of domestic banks continued to tighten standards in the first quarter, up slightly from 45% in fourth quarter 2022, and approaching levels that historically precede a recession – 58% in July 2008 and 42% in April 2020.

In the first quarter, a net 62% of banks increased the cost of credit lines by widening the spreads of loan rates over the costs of funds and increasing premiums for riskier loans, similar to trends seen from 2008 to 2010 and in 2020. A significant portion also tightened loan covenants, maximum facility sizes, maturity, and collateralization requirements. Banks that reported tightening standards on C&I loans cited a lower tolerance of risk, decreased liquidity in the secondary market, and deterioration in their current or expected liquidity position following the deposit migration as motivators.

Brown Brothers Harriman (BBH) Senior Vice President and Fixed Income Product Specialist John Ackler advised that “while the threat of a more widespread banking crisis appears to have abated for now, profitability for small and mid-sized banks will likely remain challenged.”

This will act as a mechanism for further monetary tightening. In the meantime, as elevated interest rates reduce corporate profitability and weaken their ability to service their debt burdens, banks have shifted focus from issuing new credit facilities to maintaining existing loan portfolios and minimizing potential losses with their borrowers.

In instances where banks are making new loans, most are requiring deposits or participation in ancillary services from borrowers to bolster their security position and risk-adjusted returns. Loan interest revenue alone generally is no longer sufficient in the current economic climate.

BBH Senior Vice President Phil Ross said that “we’re seeing banks act with flexibility for their best borrowers, including increasing interest rates on deposits to prevent those from going into money market accounts elsewhere and requiring deposits and ancillary services for qualified new borrowers,” further speaking to banks’ increasing demand for liquidity security. BBH bankers have witnessed an increasing number of peer lenders declining new business altogether, causing syndicated transactions to take longer and requiring greater numbers and a more diverse set of banks to ensure transaction closure. In discussions among our BBH bankers and regional banks around the country, we have heard:

“We are not underwriting loans to new companies without also receiving all their deposit business.”

“Our bank is not making any new loans right now.”

“While we are underwriting new loans to our existing customers, we will not partake in any new syndicated bank loans.”

However, the limited capital outflow to middle-market companies has been partially offset by a decline in demand for new credit facilities and existing line increases. Companies may choose to wait out the current market environment and may have less need for working capital financing, given moderating input prices and M&A activity in the slowing economic environment.

In the near term, private debt may be more attainable to mid-size borrowers (those with a $10 million trailing-12-month EBITDA at minimum), who had historically been too small to access this source of funding – notably for leveraged and M&A transactions. 

As a result of the current bank lending mood, institutional investors have rushed to raise new private debt funds to meet lending demand unmet by banks, albeit at disadvantageous pricing for the borrowers. Nonbank lenders typically provide higher cost but more flexible loan terms, including lower annual amortization rates and more lenient covenant structures than banks.

However, borrowers should expect increased equity requirements from both nonbank and bank lenders to offset reduced facility sizes for M&A and dividend recapitalization transactions. Lenders now expect equity contribution of 50%, vs. 20% to 25% on average in 2022, with a preference for new cash equity over rollover equity and seller notes. Asset-backed facilities may be advantageous for both lenders and borrowers in the upcoming period as interest rate ambiguity dilutes cash flow reliability.

While not directly comparable to the spread of loan rates over the cost of funds, corporate spreads provide information on how the market values risk and credit quality through the additional return required for providing capital to incrementally riskier borrowers. At the onset of the COVID-19 pandemic, spreads for high-yield, BBB, and A bonds peaked at 11%, 3.4%, and 2.6%, respectively. This is similar to patterns shown during the Great Recession when these rates peaked in 2008 at 20%, 8%, and 6.5%, respectively.

Higher spreads increase the cost to borrow in order to purchase risk assets as well as the rate at which future cash flows from risk assets are discounted, emphasizing the market’s shift to a more risk-averse credit stance. More recently, due to the quick and accommodative monetary and fiscal policy responses and a recovering economy, spreads declined over 2020 and 2021, and were 2.6% (high yield), 1.2% (BBB), and 0.8% (A) at the start of 2022. As of July 25, 2023, spreads for high-yield, BBB, and A bonds were 4.5%, 1.7%, and 1.2%, respectively, modestly below their respective 25-year historical daily averages of approximately 5.5%, 2.0%, and 1.3%, suggesting the bond market is cautiously optimistic about the prospects of corporate borrowers in this economy.

Although the market’s credit stance has tightened and become less risk tolerant during 2023, loan activity has not yet been acutely affected. Over the first half of 2023, total C&I loans outstanding decreased just 2.7% from $2.8 billion to $2.7 billion. Likewise, the effect on the U.S. economy at large has been modest, with annualized real GDP growth slowing from 2.6% in fourth quarter 2022 to 2.0% in first quarter 2023, and economists are forecasting second quarter 2023 growth between 1% and 2%.

As banks continue tightening their belts, the lag on the economic impact shortens, and companies look to cut expenses, it will be important to monitor the unemployment rate and the resulting consequence on consumer spending, which represents almost 70% of U.S. GDP, as discussed in the Economy section. BBH recommends that this may be a good time to review the financial health of your bank and revisit your corporate lending relationship.

The Private Equity and Mergers and Acquisitions Markets

The first half of 2023 will be remembered for the myriad of catastrophic bank failures. The demise of First Republic Bank, Silicon Valley Bank, and Signature Bank represent the second, third, and fourth largest bank failures in U.S. history. Credit Suisse, one of the world’s largest 30 banks with assets exceeding $500 billion, had to be rescued by UBS in March. While these bank failures more conspicuously wreaked havoc on the public equity and fixed income markets, PE and M&A firms also had to rapidly adapt to a more limited financing environment.

Second quarter 2023 U.S. PE deal activity declined by 15.8% from the first quarter. In fact, dealmaking has declined in four of the last six quarters and has yet to stabilize. Since peaking in fourth quarter 2021, quarterly volumes are now down 24.0% by deal count and 49.2% by deal value. However, deal count is still well ahead of pre-COVID-19 levels by 56.3% but only slightly ahead by dollar value.¹ In a survey conducted by S&P Global Market Intelligence, PE executives reported that volatility in financial markets and subsequent fluctuations in valuations presented the biggest challenges in closing deals over the past 12 months.² However, it should be noted that market reversals and periods of excess volatility oftentimes breed innovation, potentially leading to future tailwinds in the asset class.³

PE managers have had to make adjustments to their playbook in order to keep deploying capital. As smaller deals are more digestible and easier to finance, add-ons have taken on a greater importance in recent quarters. Add-ons, as a share of all buyouts, increased by almost four percentage points between 2021 and 2022 – from 72.5% to 76.5% – before adding another 1.5% in the first half of 2023 to stand at 78.0% currently.⁴

After three consecutive quarters of decline, U.S. PE exit activity bounced back slightly in second quarter 2023; 289 PE-backed companies exited with a cumulative exit value of $87.3 billion during the second quarter, increasing by 3.7% and 66.9%, quarter over quarter, respectively. Exit value experienced the first quarter of growth in the trailing 12 months; however, both exit value and count remain well below pre-COVID-19 averages, and the second quarter’s exit value was bolstered by a few mega-sized transactions.⁵

This “new normal” of slow exit activity is a result of prolonged inflation and unfavorable valuation adjustments. General partners (GPs) have continued holding on to their portfolio companies instead of exiting them at lower valuations.⁶ In addition, there has been a limited appetite from corporate acquirers, an initial public offering (IPO) market that has essentially closed, and continued general caution among potential PE buyers.⁷

PE fundraising activity in the first half of 2023 is 15% to 25% slower than last year’s pace based on the number of funds closed and final amounts of those closed funds. This slowdown was widely expected due to 2022’s record fundraising numbers. A persistent denominator effect and a lack of distributions from GPs have left limited partners (LPs) capital constrained.⁸

GPs are bracing for a challenging fundraising environment for the foreseeable future. According to an S&P Global survey, compared with last year sentiment has shifted from cautious optimism to a more cautious outlook, with 45% of GPs believing that fundraising conditions will deteriorate – a significant increase from just 12% last year.⁹

While global M&A faltered in the first quarter, M&A activity in North America remained steady, with an estimated 4,492 deals closed or announced for a combined value of $503.2 billion. Despite continued market volatility, quarterly M&A value is back to pre-pandemic levels (down 22.1% in count and 35.9% in value from the fourth quarter 2021 peak). As a direct result of the bank failures during the quarter, first quarter M&A deal value dropped 5.5% quarter over quarter, and deal count fell 10.1%.¹⁰

Conclusion

Overall, there is much underway in the business environment as we progress through 2023, amid rising inflation, historic bank failures, and increasing risks of a slowdown in the global economy. The Kansas City Fed Financial Stress Index shows higher levels than normal, and inverted Treasury yield curves reflect the rising recessionary and global growth risks.

In the credit market, the current tightening cycle seen by lending standards are motivated by lower risk tolerance and decreased liquidity in the secondary market, among other factors; however, loan activity has not yet been acutely affected. Finally, PE exit activity and fundraising got off to a slow start, but despite market volatility, quarterly M&A value is back to pre-pandemic levels, presenting a silver lining amid an otherwise murky environment.