In each quarter’s 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 mixed U.S. economic performance in 2018, accommodative lending conditions and strong competition in the PE space.
Over the course of 2018, global manufacturing Purchasing Managers’ Indices (PMIs), one of the better leading indicators of economic growth, declined. As opposed to the 2016 to 2017 period, which was characterized by a synchronized acceleration in global PMIs and growth, 2018 was more mixed. In comparison to many other parts of the world, however, the U.S. remains a relative bright spot. Many of today’s global macroeconomic issues, such as the U.S.-China trade war, Brexit, political turmoil in Europe and the recent fall in oil prices, affect other parts of the world more than the U.S. In the U.S., exports account for a mere 8% of GDP, and oil plays a much smaller role in our economy than it did 30 to 40 years ago, when an abrupt drop in oil prices alone was capable of triggering a recession. In contrast, many emerging market countries, where most of global GDP growth comes from today, are enormously dependent on oil prices and Chinese economic growth.
Many parts of the U.S. economy remain quite strong, chief among them the labor market. In January, the country added 304,000 jobs, and while the unemployment rate ticked up slightly to 4.0%, overall it remains extremely low. There has also been a recent resurgence in Americans joining the labor force, which is positive for our economy. In addition, wages continue growing at above a 3.0% clip, another sign of a healthy, competitive labor market.
Despite this clear strength in the U.S. economy, there are some signs of weakness. U.S. manufacturing PMIs – again, a leading indicator of growth – fell over the second half of 2018. The current manufacturing PMI level of 56.6 is still consistent with U.S. economic growth but at a lower level than we saw last year. January was a good example of the dichotomy in the trends of U.S. vs. global growth, with manufacturing PMIs in the U.S. rebounding strongly and global PMIs continuing to fall further. In addition, leading indicators, which have risen consistently for several years, took a pause and were flat in the fourth quarter. Other indicators, such as vehicle sales, vehicle production, pending home sales, home prices and lending conditions, have weakened as well. It is also clear that financial conditions have tightened recently. Equity values, which help drive the wealth effect, have declined, while the Federal Reserve’s “Senior Loan Officer Opinion Survey on Bank Lending Practices” indicates that lending standards have tightened. Overall, equity prices remain just 5% to 6% off all-time highs, and credit conditions, as we discuss in the next section, are still accommodative, but at the margin there has been some deterioration in financial conditions since the fall.
Despite these isolated pockets of weakness that emerged at year-end, 2018 was a strong year overall for the economy. On many measures, economists believe that the U.S. has been operating above its long-term sustainable growth rate. Yet while such growth might typically result in rising inflationary pressures, inflation is still benign. Some measures, such as the core Consumer Price Index, are running just above 2.0%, while the core personal consumption expenditure index is just under 2.0%, and long-term inflation expectations remain well anchored. Economists do not yet seem to have a good model to explain the lack of inflationary pressures this far into a business cycle, but it is surely something they will continue to study.
With the lack of inflation and tightening of financial conditions, the Federal Reserve has recently grown more dovish. After hiking the federal funds rate four times in 2018, the indication is that in 2019 the Fed will be more deliberate in its pace of hikes. This slower anticipated pace of rate increases also caused two-year Treasury yields to fall from 2.9% in October to 2.5% as of this writing in mid-February. In addition, 10-year U.S. Treasury yields, which peaked at over 3.2% in October, have dropped to 2.7%.
In hindsight, the strong economic growth in 2018 may prove to be an aberration, as it was certainly fueled to an extent by the tax cuts that took effect at the start of last year. Because tax cuts are not a permanent source of economic growth, it would not be surprising to see economic activity moderate in 2019. While there are certainly pockets of weakness domestically, overall the preponderance of evidence points to a strong U.S. economy, both in an absolute sense and especially relative to the rest of the world.
The Credit Markets
Despite pressure to curtail rate hikes, the Federal Open Market Committee (FOMC) voted to raise the fed funds target range by another 25 basis points (bps), from between 2.00% and 2.25% to 2.25% and 2.50%, at its December meeting. This was the fourth 25 bps rate increase of 2018, meaning floating-rate debt holders saw a 1.00% rise in borrowing costs throughout the year. The fourth hike was not entirely unexpected given positive economic indicators, but signs of slower GDP growth, equity market volatility and a newly inverted yield curve are precarious signs that raise the question, “Is it time for tightening monetary policy to slow down?”
Rising short-term rates and declining long-term rates caused the short end of the yield curve to invert in December 2018 for the first time in more than a decade, suggesting that investors are less optimistic about the short-term economic outlook. Today, the yield curve remains inverted, with a slightly negative spread (-3 bps as of February 12, 2019) between the one- and five-year Treasury yields. An inverted two- to 10-year yield curve, however, is historically a more predictive measure of an impending recession. The two- to 10-year yield curve has not inverted, though it continues to flatten. As of February 13, 2019, the two- to 10-year spread had decreased from 0.90% a year ago to 0.15%, creating an opportune time for borrowers to consider fixing rates at favorable levels for the long term.
The current state of the yield curve has created a delicate situation for the FOMC to navigate, and dovish undertones in the December 19, 2018, post-meeting statement suggest the Fed will proceed with caution over the next year, continuing to focus on fundamental data to direct policy. This is supported by the nearby chart, which shows the progression of FOMC member expectations for 2019 interest rates over the past year, providing some insight into their expected trajectory for rates. After trending upward through 2018, the median projection decreased from 3.125% (suggesting three rate hikes) at the September meeting to 2.875% (just two rate hikes) at the December meeting. Interestingly, the market indicates a more dovish outlook. According to fed funds futures, the market expects the Fed to hold rates steady in 2019 and has even priced in a small probability of a rate cut by year-end, further suggesting that tightening monetary policy will slow in 2019.
Despite the potential for rising rates, abundant capital has created a competitive landscape for banks seeking new loan opportunities such that creditworthy borrowers can still access inexpensive financing in the current lending environment. The considerable growth in outstanding commercial and industrial (C&I) loans over the past year demonstrates this ample supply of capital. From December 1, 2017, to December 1, 2018, the amount of C&I loans in the market increased 9.7% to $2.3 trillion, with a 4.1% lift in fourth quarter 2018 alone. As a measure of how difficult it is for businesses to obtain credit, the Fed conducts a quarterly survey asking banks if they are tightening or loosening credit standards. A net 2.8% of banks reported tightening standards in January 2019, but this small net positive comes after seven consecutive quarters of banks reporting loosening standards, meaning the lending environment remains favorable for potential borrowers.
Consistent with evidence of tightening credit standards among banks, corporate spreads widened at the end of 2018, indicating lower risk tolerance from investors. Most notably, high-yield corporate spreads jumped in fourth quarter 2018 from 3.1% to 5.3% after market volatility and a drop in oil prices caused investors to flee to safe 10-year Treasuries. As energy producers currently make up a large portion of the high-yield bond market, spreads are influenced by major movements in oil prices. Nonetheless, the recent spike was small and short-lived compared with historical variations, and thus is unlikely to materially affect the overall credit market.
The overall lending environment continues to lean in favor of creditworthy borrowers. Short-term rates have increased nine times over the past three years, but looking forward, evidence suggests the Fed will be less active in raising interest rates in 2019. Current rates remain relatively favorable for borrowers, especially if fixing for the long term, and abundant capital has created an environment with relatively relaxed bank lending standards.
The Private Equity and Mergers and Acquisitions Markets
According to Forbes, the average PE fund appreciated 8.2% in 2018, while almost all major public market indices experienced double-digit annual declines. As PE assets are actively managed, they have less exposure to extreme stock market swings, and returns typically outperform public equities during times of volatility. The economic and geopolitical concerns that led to volatility in 2018 have continued into 2019. As a result, optimism for the asset class and record dry powder will continue to foster fierce competition within the PE market.1
2018 U.S. PE deal activity represented the highest deal count and second-highest deal value on record. In all, 5,050 deals worth a combined $803.5 billion represents year-over-year increases of 32.1% and 11.0%, respectively. The highest deal value on record – $272.7 million – posted in the fourth quarter of the year as several mega-deals closed during this timeframe. For most of 2018, PE firms continued enjoying easy access to affordable debt financing with favorable terms due to the market’s appetite for high-yield bonds and leveraged loans. However, recent months have seen a dramatic turnaround, with outflows from leveraged loan funds occurring at the fastest pace on record.2 It remains to been seen whether this will dampen overall dealmaking in 2019.
Global PE dry powder reached an all-time high of $1.14 trillion as of October 2018.3 As such, general partners (GPs) continue to feel internal and external pressure to put this uninvested capital to work. However, competition for attractive assets remains fierce as purchase price multiples stay elevated. 2018 marked the sixth consecutive year with double-digit purchase price multiples, and the proportion of deals priced above 10.0x – 61.4% – hit the highest rate on record in 2018.
2018 PE exit activity remained robust as fund managers sought to take advantage of high purchase price multiples. While exit count fell, the value of those transactions rose as median exit size climbed to the largest on record – $330 million. The proportion of exits completed via secondary buyouts also reached record levels in 2018, at 52.0%. PE-backed IPOs saw the highest activity level since the 2014 record.4
Fundraising in 2018 slowed both in terms of dollars raised and fund closings. However, the fundraising figure still compares favorably to annual totals over the past decade. The $166.4 billion raised across 186 funds in 2018 were down 25.9% and 20.9%, respectively, over 2017. This decline is almost entirely due to fewer mega-funds closing during the year. However, several $10 billion-plus vehicles are slated to close in 2019. In addition, PitchBook’s “2018 Annual Institutional Investors Survey” found that limited partners expected to increase allocations to private market strategies from 30.9% to 32.5% over the next 24 months. Another conversation around the current fundraising environment is how quickly new funds are going to market. GPs are waiting, on average, less than three years between vintages, vs. four-year waits or more between 2010 and 2014.
Tax legislation and a looser regulatory environment helped keep M&A activity strong in 2018. Announced transaction volumes reached $4.1 trillion, the third-highest year ever. This activity was largely driven by mega-deals, defined as deals greater than $10 billion in size. Activity was robust across all deal types, domestic and international deals and strategic and private equity, as well as across all sectors, with technology (17%) and healthcare (12%) representing the largest contributors to global volume during the year.5 There is concern, though, that economic forces, tariffs or other legislative and administrative activity in Washington, D.C., may curb deal activity in the short term. However, in a recent survey conducted by Deloitte, 76% of M&A executives at U.S.-headquartered corporations and 87% of M&A leaders at domestic PE firms expected the number of deals they would close over the next year to increase. Seventy percent of these respondants anticipate these transactions will be larger than the ones closed in 2018.6
Despite pockets of weakness, such as falling manufacturing PMIs and tightening financial conditions, the U.S. economy is on solid footing overall, with the labor market in particular a shining star. Much of this growth was likely fueled by the tax cuts that took effect at the beginning of 2018, so slowing economic activity in 2019 would not be a surprise. In the credit markets, it continues to be a good time to be a borrower. Capital is still abundant, and while data indicates that standards may be tightening, for now banks remain accommodative. Finally, in the PE market, deal activity hit the highest count and second-highest value on record last year, and high multiples persist. With optimism surrounding the asset class and dry powder at a record high, fierce competition will remain a theme in the space.
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1 Forbes. February 1, 2019.
2 S&P/LSTA U.S. Leveraged Loan 100 Index.
3 Preqin Private Equity.
5 J.P. Morgan. “2019 M&A Global Outlook.”
6 Deloitte. “M&A Trends Report 2019.”