In each issue of Owner to Owner, we review aspects of the business environment on three fronts: the overall economy, the credit markets, and the private equity (PE) and mergers and acquisitions (M&A) markets. The following article addresses economic conditions and factors we are watching as we enter 2023, a shift to a lender-friendly environment in domestic commercial and industrial (C&I) loan lending, and the challenging PE environment.
The “second” estimate for U.S. GDP growth in fourth quarter 2022 indicates that the economy expanded at a 2.7% quarter-over-quarter annualized rate, an increase from -1.6% in the first quarter and -0.6% in the second quarter, but down slightly from the 3.2% reported in the third quarter. The headline growth figure of 2.7% is a sharp reversal from the decline during the first half of 2022 as the rate of change in the personal consumption expenditure (PCE) component of GDP – which drives 70% of GDP over the long run – advanced 1.4%, following a 2.3% growth rate in third quarter 2022, driven by consumer spending on services. However, offsetting the advance was housing, which contributes between 15% and 18% to GDP, as it declined 25.9%, its seventh consecutive quarter of declines. Meanwhile, the ISM Manufacturing PMI, one of the better leading growth indicators, stood at 47.7 in February, its fourth monthly reading below 50. As the ISM Manufacturing PMI is a diffusion index, readings below 50 signal contraction and are consistent with weak global growth.
Chart showing the ISM Manufacturing PMI from 1984 to February 28, 2023. The ISM Manufacturing PMI, one of the better leading growth indicators, stood at 47.7 in February 2023. If you are in need of the data behind this chart, please contact us at BBHPrivateBanking@bbh.com.
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 began in 1990, 2001, and 2007, the LEI started declining between 12 months and 22 months prior to the start of the recession. As of February 2023, the LEI has declined for 11 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 into at least the first half 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.
Chart showing The Conference Board’s Leading Economic Indicators again economic recessions from 1984 to February 28, 2023. If you are in need of the data behind this chart, please contact us at BBHPrivateBanking@bbh.com.
Turning to monetary policy, the Federal Reserve raised the fed funds rate by 25 basis points (bps) on March 22, bringing the target range to between 4.75% and 5.0%. As of March 22, market pricing of fed funds futures contracts implies a 49% probability of a 25-bp rate hike at the Fed’s May 2023 meeting, which would bring the target range for the fed funds rate to between 5.0% and 5.25%, its highest since August 2007 and in line with the Fed’s terminal rate forecast of 5.1% (which implies a target range of 5.0% to 5.25%). 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 -51 bps, while the spread between the three-month and 10-year Treasury yields is -131 bps, its most inverted level in 40 years. In large part, the inverted yield curve reflects rising recessionary and global growth risks due to global central banks’ commitment to raise rates to tame inflation and its future impact on consumer spending, along with uncertainty on how the banking turmoil may affect economic activity. 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 eight 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 0.9% in 2023 and 1.2% in 2024. There is much underway as we progress through 2023 – balance sheet runoff and potential recession, to name just a few – and we will be watching inflation and global growth developments closely.
The Credit Market
The Federal Reserve appears to be steadfast in its directive for the near term, with the Federal Open Market Committee (FOMC) continuing to prioritize both maximum employment and a stable long-run inflation rate of 2%. The FOMC has aggressively raised the fed funds rate over the past six consecutive quarters as headline monthly inflation numbers, though somewhat eased, continue to exceed the long-run targets. With the growth of the inflationary trend moderating toward year-end 2022, the FOMC slowed the rate of increase to 50 bps in the fourth quarter, following 75-bp hikes in the second and third quarters. Committee members stress that this is not a sign of a loosening policy and made 75 bps of additional interest rate increases in first quarter 2023. Unemployment rates remain at a 50-year low, at 3.6%, as the U.S. economy improves, and both job gains and consumer spending increased in the first quarter. Though short-run inflation appears to have peaked, it remains above the Federal Reserve’s 2% goal. As such, the FOMC has indicated it will continue to increase the federal funds rate, albeit at a slower pace, to stabilize pricing while remaining highly attentive to pressures caused by Russia’s invasion of Ukraine, recent banking developments, and the delay in which the cumulative tightening of its monetary policy affects the economy.
While the FOMC sets short-term risk-free borrowing rates through its federal funds rate, it influences long-term rates through the purchase and sale of Treasury and mortgage bonds. The Federal Reserve began shrinking its holdings of Treasury and mortgage bonds in June 2022 in an effort to cut down its approximately $9 trillion balance sheet and will continue to do so in first quarter 2023 by $95 billion monthly. Similar to increasing short-term borrowing costs with the federal funds rate, these actions have increased long-term risk-free rates, which can curtail inflation. The FOMC will continue to monitor the implications of its decisions and the economy’s outlook in assessing its monetary policy going forward, adjusting as appropriate if public health conditions, labor markets, international developments, and inflation expectations pose a risk to the Fed’s long-term goals for the U.S. economy.
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. As shown in the nearby chart, at the onset of the COVID-19 pandemic in March 2020, spreads for high-yield (CCC-rated and below), BBB, and A bonds peaked at 11%, 3.4%, and 2.6%, respectively, similar to patterns shown during the Great Recession of 2008-09 (albeit high-yield, BBB, and A rates peaked at 20%, 8%, and 6.5%, respectively, in 2008). Given quick and accommodative monetary and fiscal policy responses and a recovering economy, spreads declined throughout 2020 and 2021 and were 2.6%, 1.2%, and 0.8%, respectively, at the start of 2022, relatively close to respective pre-pandemic spreads of 3.3%, 1.2%, and 0.8%. However, during 2022, spreads increased due to geopolitical turmoil, slowing economic growth, and a rising risk of recession, which increases the cost to borrow to purchase risk assets as well as the rate at which future cash flows from risk assets are discounted. Fourth quarter 2022 spreads were 5.1%, 1.9%, and 1.2%, respectively – modestly above pre-pandemic spreads, though substantially below the March 2020 peaks. Despite the increase in 2022, high-yield, BBB, and A-rated bond spreads are near their respective 25-year historical daily averages of approximately 5.5%, 2.0%, and 1.3%.
The nearby graph shows C&I loans outstanding to U.S. companies overlaid by the net percentage of U.S. banks tightening or loosening credit standards for C&I loans to large and middle-market firms. The net percentage data is based on the Fed’s quarterly “Senior Loan Officer Opinion Survey on Bank Lending Practices.” As of fourth quarter 2022, 44.8% of domestic banks tightened standards vs. 39.1% in third quarter 2022, suggesting domestic C&I lending has transitioned to a lender-friendly environment. Most banks increased the cost of credit lines through widening the spreads of loan rates over the costs of funds to firms of all sizes and increasing premiums for riskier loans, while a significant portion also tightened loan covenants and collateralization requirements for firms of all sizes. A moderate share of banks reported having tightened the maximum size of credit lines to firms of all sizes and tightening of the maximum maturity of loans and credits lines to large and middle-market firms.
A majority of banks that reported tightening standards or terms on C&I loans cited a less favorable or more uncertain economic outlook and reduced tolerance of risk as important reasons for doing so. Banks also mentioned decreased liquidity in the secondary market for C&I loans, less aggressive competition from other banks, and deterioration in their current or expected liquidity position as motivators for tightening lending standards. The survey reported weaker demand for C&I loans from firms of all sizes due to decreased customer need for financing inventory and accounts receivables, investment in property or equipment, and mergers or acquisitions. Despite these trends, the overall amount of C&I loans outstanding continued to grow with the economy.
The Private Equity and Mergers and Acquisitions Markets
Private equity took a step back in 2022 after a record-breaking 2021. Deal, exit, and fundraising activity were all affected by the confluence of economic headwinds.
After 2021’s remarkable deal activity levels, the past 12 months have been more challenging for private equity. Spiraling inflation, supply chain shocks, conflict overseas, pullback of the debt markets, and fears of a recession have all had an impact on the asset class. While dealmaking slowed, it remained quite strong. Deal value ($1 trillion) and deal count (8,897) were higher than any previous annual amount on record with the exception of 2021. In the fourth quarter, total U.S. PE deal count and value declined by 23.4% and 41.8%, respectively, from the peak recorded one year earlier. Year over year, deal value was down 2.4%, and deal count was down 19.5%.1
While still extremely abundant, PE dry powder shrank by 10.9% in 2022, the first down year since 2008. This decrease was a result of the record deployment in 2021. GPs still found themselves looking for more creative ways of deploying capital, such as minority investments, all-equity deals, add-ons, and private placement of debt. These strategies will facilitate capital deployment as PE funds wait for a more general market normalization. Current market disruptions have placed a renewed focus on long-term value creation drivers, such as digital capabilities, talent, and environmental, social, and governance (ESG) factors.2
|U.S. Private Equity Activity Deal Flow by Year|
|Deal Value ($B)||Deal Count|
As with deal activity, U.S. private equity exit activity slowed in 2022 as potential sellers chose to hold portfolio companies for a longer period amid the aforementioned headwinds. While exit activity waned in comparison to the record-breaking levels seen in 2021, exits remained relatively healthy compared with historical standards. In 2022, PE firms exited 1,274 U.S. companies for a cumulative value of $295.8 billion, a year-over-year decline of 28.3% and 66.3%, respectively.3 Private equity-backed IPOs sharply decreased in 2022 as steep declines in public markets essentially eliminated that exit path for many firms. In addition, secondary sales posted the lowest annual figure for private equity-backed secondary sales since at least 2018.4
|U.S. Private Equity Exits by Year|
|Exit Value ($B)||Exit Count|
After record levels of fundraising in 2021, private equity firms are tempering their expectations against a more challenging backdrop that arose in 2022. A majority of institutional limited partners (LPs) have allocated all of their capital for the year as of the end of the third quarter. In addition, many LPs are reconsidering their allocations to private markets due to the “denominator effect.” The phenomenon occurs when slow-to-adjust valuations in the private market allocation of an investor’s portfolio are compared against falling returns in the rest of the portfolio, namely from sinking public stocks. What may have been an under-allocation to private equity at the start of the year has turned into an overallocation, with public stocks significantly falling in 2022.5 However, general partners (GPs) remain fairly optimistic. According to Investec’s 12th annual “GP Trends” report, 20% of GPs expected the size of their next fund to exceed its predecessor by between 50% and 100%, and 46% anticipated their next fund would be between 25% and 50% larger than their current vehicle. The remaining 33% of respondents were preparing for flat fundraises the next time they go to market.
|U.S. Private Equity Fundraising by Year|
|Capital Raised ($B)||Fund Count|
Global M&A activity continued to decline for three consecutive quarters as of third quarter 2022, falling 29.8% in deal value from the peak seen in fourth quarter 2021. However, deal value is on track to surpass the pace of deals set prior to the COVID-19 pandemic. Deal count is a similar story; 10,118 global M&A deals are estimated for the third quarter, which is nearly 33% higher than the quarterly average between 2015 and 2019. However, as announcements are more of a lead indicator, cracks are beginning to show. Compared with the second quarter of the year, third quarter announcements slowed both in terms of deal count and deal value by 7.4% and 26.3%, respectively.6
|Global M&A Activity|
|Deal Value ($B)||Deal Count|
Overall, recent economic data for the U.S. paints a bleak picture. With much underway as we progress through 2023 – balance sheet runoff and potential recession, to name just a few – we are watching inflation and global growth developments closely. In the credit markets, spreads increased in 2022 due to geopolitical turmoil, slowing economic growth, and a rising risk of recession, increasing the cost to borrow to purchase risk assets as well as the rate at which future cash flows from risk assets are discounted. At the same time, the domestic C&I lending space appears to have switched to a lender-friendly environment, with more banks reporting tightening standards than loosening them. And in the PE market, deal, exit, and fundraising activity were all affected by the confluence of economic headwinds in 2022, while global M&A activity also continues to slow.
2 “Private Equity: US Deals 2023 Outlook.” PricewaterhouseCoopers.
4 S&P Global.
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