In each issue of Owner to Owner, we review aspects of the business environment on three fronts:

• Overall economy
• Credit markets
• Private equity (PE) and mergers and acquisitions (M&A) markets

The following article examines the state of the economy as the recession speculation that characterized much of 2023 continues into first quarter 2024. Thus far, the Fed's effort to curb inflation through monetary policy shows incremental progress, while domestic banks continue to tighten their lending standards and private equity fund managers battle headwinds as a result of ongoing market volatility and high inflation.

The Economy

Entering 2023, investors worried that the Federal Reserve’s interest rate hiking cycle might trigger a recession. Instead, inflation subsided and despite regional banking instability, the U.S. economy remained solid. According to the “advance” estimate by the Bureau of Economic Analysis, U.S. GDP expanded at a quarter-over-quarter annualized rate of 3.3% in fourth quarter 2023, above the 2.0% consensus estimate. The increase in real GDP reflected increases in consumer spending, federal government spending, exports, and nonresidential fixed investment. The personal consumption expenditure (PCE) component of GDP – which drives 70% of GDP over the long run – advanced 2.8% with increases in both services and goods.

Meanwhile, despite the U.S. unemployment rate remaining near its lowest levels since the 1950s, job openings continue to trend downward and are now 25% below the all-time high recorded in March 2022. While the stock market is forward-looking, job openings often reflect current economic conditions and signal a potential slowdown in growth expectations.

For 2024 and 2025, the Fed estimates real GDP growth of 1.5% and 1.8%, respectively, down from the 2.5% GDP growth rate in 2023.

Turning 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.

While the declining LEI continues to signal headwinds to economic activity, for the first time in the past two years, six out of its ten components were positive contributors over the past six-month period (ending in January 2024). As a result, the leading index currently does not signal a recession ahead, despite declining for 23 consecutive months since peaking in March 2022.

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.

In line with expectations and after maintaining the fed funds rate target range in December, the Federal Open Market Committee (FOMC) held rates steady and maintained its target range of 5.25% to 5.50% during its January 2024 meeting.  As of January 31, the fed funds futures curve is pricing in that the fed funds rate ends 2024 at 3.9%. This implies a target range of 3.75% to 4.0%, which is more ambitious than the Fed’s terminal rate guidance of 4.6% (implying a target range of 4.50% to 4.75%) estimated in its December 2023 Economic Projections release.

The difference in the number of potential rate cuts in 2024 between the Fed and investors may result in elevated volatility in the near-term and may impact equity prices, as real interest rates are likely to stay higher for longer than what is currently priced (equity multiples share an inverse relationship with real interest rates).  

During the month of January, medium-to-long-term treasury yields across the yield curve advanced slightly despite encouraging U.S. core inflation, which continues to show signs of disinflation. The 10-year Treasury yield advanced to a monthly high of 4.17% (an increase of 30 basis points from the end of December) as investors processed stronger-than-anticipated economic data, such as the initial estimate of fourth quarter U.S. GDP growth of 3.3% (vs. the consensus estimate of 2%). However, the 10-year Treasury yield exited the month only three basis points higher from the end of December and down sharply from its monthly high after ADP jobs data showed the labor market is slowing down.

There is much underway as we progress through 2024 – balance sheet runoff, the timing of a Fed pivot, and a U.S. presidential election, to name just a few – and we will be watching inflation and global growth developments closely.

The Credit Market

For 2024, the Federal Reserve remains committed to achieving a stable long-run inflation rate of 2.0%. During its fourth quarter 2023 meetings, the FOMC voted to maintain an upper federal funds target of 5.50%; economic data will determine any additional policy adjustments.

According to a survey of December FOMC meeting attendees, a majority anticipate the Federal Funds rate to be between 4.25% and 5% by year-end 2024, with only a few expecting rates to remain above 5% or fall to between 3.75% and 4%. In 2023, the FOMC implemented four rate increases at the start of the year totaling 1.0%, but has left the rate unchanged since its July 2023 meeting. This was a slower pace compared to seven increases totaling 4.5% in 2022.

The Fed’s effort to curb inflation through monetary policy shows incremental progress, with core inflation easing from a high of 6.6% in September 2022 to 3.9% by December 2023, though still above its 2% target. On a positive note, the Fed’s second mandate of promoting maximum employment has not been impeded by its rate hikes, with U.S. employment rates remaining near record lows at 3.7% as of December 2023.

Through quantitative tightening, the Fed is gradually reducing its balance sheet, allowing around $100 billion worth of debt (mainly treasury and mortgage bonds) to mature monthly without reinvesting the cash. During 2023, the Fed reduced its balance sheet by just over $1 trillion, from a peak of $8.7 trillion on March 22^nd to $7.7 trillion on December 27^th.

According to Fed Chair Jerome Powell, in 2024 the Fed intends to “slow and then stop the decline in the size of the balance sheet when reserve balances are somewhat above the level judged to be consistent with ample reserves.”

While there is uncertainly around the timing and size of this reduction, general consensus from primary dealers (firms with which the Fed trades directly) is that the Fed will begin slowing the reduction process towards the end of this year and finish in the middle of 2025, allowing the balance sheet to decline and remain between $6 and $7 trillion thereafter.

The FOMC will continue to monitor the implication of its decisions and the economic outlook as it assesses its monetary policy moving forward; however, market expectations of future growth and inflation often have a more significant impact on longer term Treasury interest rates.

As inflation continued to ease through the end of 2023, an increased market demand for higher coupon Treasury notes and bonds decreased medium to long-term risk-free rates by 12/31/23. Medium to long-term rates increased for a time in 2023, most notably in Q3, as investors processed the slowing U.S. GDP and Consumer Price Index (CPI) growth data alongside meaningful exogenous events like the regional banking crisis and Hamas’ attack of Israel.

The overall impact of elevated but slowing inflation is shown in the nearby chart, where the U.S. five- and seven-year Treasury yields shifted downwards by approximately 0.75% during fourth quarter 2023, and by 0.12% over the entire fiscal year. This offset the impact of the Fed’s balance sheet tightening, although short-dated Treasury bills continued to be influenced by the increased federal funds rate.

Corporate spreads reflect how the market assesses risk and credit quality by measuring the additional return demanded for investing in riskier borrowers. Throughout 2023, spreads for corporate bonds across various rating classes narrowed: As of 12/29/23, spreads for high-yield, BBB, and A bonds were 3.7%, 1.3%, and 0.9%, respectively. All were below their respective 20-year historical averages of 4.8%, 1.9%, and 1.3%. The nearby chart indicates that the bond market is cautiously optimistic about the economic prospects of corporate borrowers.

Fourth quarter 2023 marked the seventh consecutive quarter of domestic banks tightening their standards, matched with continued easing of loan demand across all major segments. The nearby graph illustrates the trend of C&I loans outstanding to U.S. companies alongside the net percentage of U.S. banks adjusting their credit standards for loans to large and middle-market firms.

The net percentage data is derived from the Fed’s quarterly “Senior Loan Officer Opinion Survey on Bank Lending Practices” (SLOOS). In fourth quarter 2023, a net 15% of domestic banks tightened standards for commercial and industrial (C&I) loans to firms of all sizes, compared to 34% in the third quarter and 51% in second quarter 2023 – the latter of which may likely be the peak of increasing bank lending conservatism following the recent banking crisis. Although fewer banks tightened their credit standards in fourth quarter 2023, the majority of lenders are proceeding cautiously to reduce risk-taking. Overall, the share of banks reporting tightening lending standards remains at elevated levels.

A less borrower-friendly environment is typically associated with a recession, or the preamble to and aftermath of one, as demonstrated by the SLOOS completed in the first quarter of 2008. As the U.S. economy entered the Global Financial Crisis, a net of 32% of banks tightened standards for business loans to large firms, 30% to small firms (versus 19% in the most recent SLOOS), and 80% for commercial real estate (CRE) loans (versus 41% in the most recent SLOOS).

In the most recent SLOOS (January 2024), most banks noted increasing premiums charged on riskier loans and raising the cost of credit lines by widening the loan spreads above the costs of funds. Additionally, a significant portion tightened loan covenants and collateral requirements. Banks also reported that they expect demand for loans to strengthen but quality to weaken, across all categories. While the U.S. economy remains resilient, the forward-looking aspect of the latest survey suggests continued credit tightening.

Unsurprisingly, the cumulative effect of tougher standards over the past 18 months has resulted in a 1.3% decline in the amount of C&I loans through December 2023. BBH bankers have commented that the market for middle market loans remains tighter, with spreads increasing marginally for all but the soundest credits. Other trends from fourth quarter 2023 include:

• Regional banks focusing on the all-in return on their banking relationships, often requiring significant deposit accounts or ancillary business in order for them to join or remain in a relationship.
• Middle-market borrowers increasingly turning to the private debt markets as a viable path for funding, albeit at a higher cost than traditional bank loans, driven by a range of factors including tighter bank lending standards.

Nonetheless, certain banks, such as BBH, remain active in growing their corporate loan portfolios. 

The Private Equity and Mergers and Acquisitions Markets

The fourth quarter of 2023 was more of the same for PE and M&A. Fund managers continued to battle headwinds as a result of ongoing market volatility and high inflation. Dealmaking, exits, and fundraising all remained excessively competitive. Going forward, General Partners (GPs) will need to be highly adaptable, embrace technology and artificial intelligence (AI), and move quickly in this ever-evolving market environment.

Year-over-year (YoY) deal count declined by 7.3% to 8,115 in 2023 and marked the U.S. PE market’s worst year in deal activity since 2016. Deal value declined by 29.5% to $645.3 billion, its lowest point since 2017 (excluding the COVID-19-pandemic-induced period in early 2020). Of all deal types, platform deals fared the worst (down 36.5% from 2022 and 51.8% from 2021) due to their dependence on leverage. Leverage ratios have decreased significantly since the beginning of 2023, thus inhibiting larger leveraged buyouts (LBOs), which platform deals tend to be.¹

The slowdown in deal activity lends itself to PE firms leveraging technologies and operational efficiencies to find deals. In particular, generative AI is showing potential to transform and accelerate deal activity. Generative AI-powered tools can summarize vast amounts of data to help select the right deals more quickly. They can develop alpha-generating resources such as deal sourcing maps, outreach strategies in just minutes, and expand narrow or niche lists to include similar acquisition targets.²

U.S. PE exit activity continued to decline through the end of 2023 as GPs struggled with prolonged inflation and unfavorable valuation trends. 1,121 companies were exited for a value of $234.1 billion, which is 17.7% and 33.4% below pre-pandemic averages, respectively. Exit activity in fourth quarter 2023 was the weakest for the year, with 256 companies exited for $44.7 billion in aggregate. This represents a decrease of 3.2% and 21.5% quarter-over-quarter (QoQ), respectively.³

While most portfolio companies are either nearing or have passed the average five-year timeframe for PE exits, there is optimism that exits will start to see a rebound in 2024. However, the slowdown has created a shift in focus toward value creation across existing portfolios.

In 2024, GPs will take a more hands-on approach as they look for ways to cut costs, optimize capital structures to drive greater cashflows, and enhance the unique properties of each asset for greater market penetration.⁴ Generative AI will also be deployed as a value driver in the portfolio, accelerating traditional levers like cost takeout, top-line transformation and revenue growth.⁵ This will likely put many PE firms in a stronger position as exit opportunities eventually make a comeback.

2023 proved to be a more difficult fundraising environment than in previous years. A sluggish exit market postponed a return of capital from older funds to LPs. The lack of available capital extended fundraising timelines and pushed GPs to explore diverse avenues for fundraising.

Despite these headwinds, the total capital raised throughout the year amounted to $374.8 billion across 381 funds, on par with the record-setting figures of 2021 and 2022. This indicates LPs’ sustained commitment to the asset class, which is buoyed by its robust long-term prospects and a history of resilient returns in economically volatile periods.⁶

For the full year of 2023, the M&A market was subdued. The total deal value reached $1,691.8 billion, down 13.4% YoY. The total number of transactions (16,391) also marked a significant decline of 11.0% YoY. This continued downward trend can be attributed to higher interest rates, a widening gap in valuation expectations between buyers and sellers, and heightened geopolitical tensions—all of which have collectively impeded the pace of dealmaking. Still, these headwinds appear to be moderating somewhat as inflation is fading and interest rates are now expected to decline in 2024.⁷

According to Goldman Sachs, key themes for strategic M&A in 2024 include:

• An elevated focus on M&A as a strategic lever
• Amplified activity across growth sectors
• Continued simplification of business models
• Increased activity outside of the U.S. and reemergence of cross-border activity
• Return of sponsor dealmaking, including on the sell-side
• Growth of AI-driven M&A
• Continued volume surge in resources, energy transition, and infrastructure 

Conclusion

As we progress further into 2024, we continue to watch inflation and global growth developments closely, while also monitoring for the impacts of balance sheet runoff, a potential Fed pivot, and the U.S. presidential election. The difference in projected rate cuts between the Fed and investors may also result in heightened volatility in the near-term and may impact equity prices.

In the credit market, the general consensus from primary dealers is for the Fed to begin the rate and balance sheet reduction process toward the end of 2024 and finish in the middle of 2025; moving forward, we remain on the lookout for any additional policy adjustments as determined by economic data. After narrowing throughout 2023, spreads for corporate bonds across various rating classes ended the year below their respective 20-year historical averages. The bond market is cautiously optimistic about the economic prospects of corporate borrowers. Meanwhile, fourth quarter 2023 marked the seventh consecutive quarter of domestic banks tightening their standards and we are watchful of this potential indicator of a recession.

Amid slowdowns in PE dealmaking firms have leveraged technologies and operational efficiencies to find deals, in some cases turning to generative AI which has a potential to transform and accelerate deal activity. There is optimism that PE exits could see a rebound in 2024; however, the slowdown in exit activity has shifted focus toward value creation across existing portfolios. Finally, headwinds impeding the pace of M&A dealmaking in 2023 appear to be moderating now that inflation is fading and interest rates are expected to decline in 2024.