In each quarter’s issue of Owner to Owner, we review aspects of the business environment on three consistent fronts: the overall economy, the credit markets and the private equity (PE) and mergers and acquisitions (M&A) markets. The following article addresses recent GDP weakness, shifts in sentiment among lenders regarding commercial and industrial (C&I) loans and the slowdown in middle-market M&A and PE transactions, among other topics.
The second estimate for U.S. GDP growth in first quarter 2016 indicates that the economy expanded at a 0.8% quarter-over-quarter annualized rate, a decrease from 1.4% growth in fourth quarter 2015. While this headline growth number is lackluster, the rate of change in the personal consumption expenditure (PCE) component of GDP – which drives 70% of GDP over the long run – declined a lesser amount, from 2.4% to 1.9%. Additionally, there has been a seasonal weakness in first-quarter GDP over the past five years, while a sharp bounceback has characterized the second quarter. Looking ahead, the ISM Manufacturing PMI, one of the better leading growth indicators, declined from 51.8 to 50.8 in April. Despite the decline, at this level the PMI is still consistent with continued growth in both the manufacturing sector and overall economy.
Digging deeper into the data, much of the GDP weakness is a result of trends that have been in place for some time. More specifically, while the trade-weighted value of the U.S. dollar has declined since peaking in January, it is still high compared with its value from the past few years, which has put pressure on exports. Additionally, falling oil and gas prices have pushed energy investment off a cliff. Bureau of Economic Analysis data on private investment in mining shafts and wells – a direct component of GDP – and the Baker Hughes oil and gas rig count have both declined precipitously. In an economic environment where companies seem reluctant to reinvest in their businesses, and where consumers have been reluctant to spend their windfall from energy savings, energy sector weakness has had a more negative near-term effect on the economy than expected.
Despite relatively subdued growth in the U.S., both the labor market and inflation have continued to move forward. While April’s jobs report showed weaker headline growth of 160,000 jobs, we attribute this mostly to an economy running near full employment. Similarly, the unemployment rate, while an imperfect measure of labor market health, remains near recent lows and within the range of the Federal Reserve’s long-term projections for unemployment. Furthermore, while headline inflation is still noticeably below the Fed’s 2% target, the year-over-year change in core CPI now stands at 2.2%, compared with 1.6% for core PCE. Based on a basic assessment of inflation and unemployment vs. their respective long-term targets, the fed funds rate appears artificially low. The Fed has seemed worried about spooking markets and is content to let monetary policy normalize at a snail’s pace.
Somewhat troublingly, the Federal Open Market Committee is now explicitly taking account of a broader range of measures in deciding when to normalize policy, such as equity prices, credit conditions and volatility from global financial markets. However, these markets themselves are in large part discounting future outcomes that depend on the evolution of Fed policy. By paying specific attention to financial markets, we believe the Fed has made its job harder, and we are uncertain whether it will be possible to meet all of its goals simultaneously. Notably, despite a 25-basis-point rate hike in December, long-term interest rates in the U.S. are currently below early-2013 levels before the “taper tantrum” and talk of monetary policy normalization began.
Commodity markets also received a good deal of attention in the first four months of 2016 as prices rebounded across the board following an 18-month decline. Much has been made of the tight inverse linkage between the dollar and commodity prices; however, this is slightly overblown. While there has been a meaningful inverse correlation between the dollar and commodity prices for some time, there has been almost no change in this relationship since commodity prices started declining in 2014.1 In fact, we do not believe that the most likely explanation for these movements has anything to do with a direct causal relationship. Additionally, we would note that the magnitude of swings in commodity prices is far greater than that of the dollar. In reality, changes in the outlook for global growth likely have the largest impact on both the dollar and commodities.
The Credit Market
For the most part, the commodity market rebound began in mid-February. Its effect rippled throughout financial markets, and most risk instruments joined for the ride. The first quarter of 2016 was a tale of two credit markets, with taxable credit a standout in terms of volatility. Corporate credit started the year posting miserable performance that troughed alongside crude oil before abruptly turning course on February 11 with a rally that continued through quarter-end. Municipal credit proved itself relatively immune from the commodity effect and provided investors with a traditional safe haven from market volatility. Within taxable domestic credit, sector returns varied widely. Investment grade metals and mining credits led the way during the second half of the quarter, producing an excess return of 7.6% but still finishing the quarter at spreads elevated relative to historical averages. More broadly, high yield generated the strongest sector performance, posting an excess return of 1.8% over Treasuries.
A stream of U.S. economic data showing slow, but consistent, growth in the domestic labor market supported the first-quarter bounceback in corporate spreads. An increasingly dovish Fed helped the rebound in risk assets. Credit investors started the year expecting a series of between three and four 25-basis-point rate hikes to be announced during 2016. By March 31, market expectations reverted to a single hike of 25 basis points for the year. Rates have accordingly fallen across the curve year to date, with sentiment pointing toward a “lower for longer” outlook. We expect rate volatility to continue through 2016 as credit investors digest the interplay between fundamental global economic stresses and policy responses from central bankers.
Turning to private credit markets, the Federal Reserve Board conducts quarterly surveys on bank lending practices. Late April marked the release of its first 2016 survey, where respondents included 70 domestic banks and 22 U.S. branches of foreign banks. Credit to the middle market has been accommodative: A majority of banks reported loosening lending standards in 22 of the 26 quarterly surveys conducted since the Great Recession ended. That sentiment among lenders is starting to shift, though, as the three most recent surveys have indicated that a majority of senior loan officers are now tightening lending standards for large and middle-market borrowers. A majority of respondents are also now reporting contracting loan demand.
Since the Fed began surveying C&I loan demand in the early 1990s, there have been two time periods when senior loan officers have consecutively reported both contracting loan demand and tightening lending standards. The first emerged during the first, second and third quarters of 2000; the U.S. economy went into a brief, shallow recession in March 2001 that lasted for eight months. The second period was in the third and fourth quarters of 2007 into the first quarter of 2008; the U.S. economy entered a recession in December 2007 that lasted for one year, six months. While the Fed survey appears to send an ominous signal on the overall flow of middle-market credit, underlying sector distress has been heavily concentrated in commodity industries. We do not see the survey results as a canary in a coal mine for the U.S. economy’s health. Nor apparently does the Federal Reserve, who in early May pivoted commentary toward a more hawkish tone that has led market participants to price in a June rate hike of 25 basis points. So while the canary’s tune has changed, it is still singing – albeit in a more muted tone. Credit continues to flow at a healthy pace to most economic sectors, and we are witnessing required supply adjustments take place in the oilfield.
The Private Equity and Mergers and Acquisitions Markets
The middle market is finally starting to see a slowdown in M&A and PE transactions as questions about the availability of debt financing have begun to cause sellers to question bringing their companies to market. First-quarter 2016 numbers are consistent with some of the anecdotal conclusions from the second half of 2015. Leverage multiples for middle-market transactions declined from an average of 5.3x in 2015 to an average of 4.4x in the first quarter, according to data from Standard & Poor’s. Similarly, buyers have started to demonstrate more discipline in their investment underwriting standards due to the decreasing availability of debt financing, and as a result, purchase price multiples fell from an average of 10.7x in 2015 to an average of 8.3x in first quarter 2016. We still believe that the market remains accommodative to sellers of high-quality businesses relative to historical averages, but we are finally beginning to see M&A activity cooling off.
Although it is possible to view this as a single data point, as we have pointed out over the past few M&A and PE market updates, the changes in the debt markets really started early last summer, and this trend has continued. The drop in oil prices, which led to a significant uptick in distressed oil and gas borrowers, combined with the impact of increasing bank regulations caused banks to pull back from some of the more leveraged loans that were being used to support leveraged buyout transactions and leveraged dividend recaps. We also highlighted the decreasing equity issuances by business development companies as their valuations started to trade below book value. Another source of debt financing that seems to be drying up are bank loan mutual funds and collateralized loan obligations (CLOs). Since the end of August 2015, there have been just three weeks with positive flows into these bank loan mutual funds. Similarly, CLO new issuance fell from $30 billion in first quarter 2015 to below $7 billion in first quarter 2016, according to Leveraged Commentary & Data. We believe these trends will likely continue as the Federal Reserve considers further interest rate increases, and this will remain a headwind for the M&A market.
While we still believe that this market is incredibly accommodative for high-quality businesses due to the growing overhang of PE dollars, the softening valuation environment has slowed down the stampede of sellers looking for liquidity in historically accommodative markets. If the first quarter is any indication, 2016 transaction volume will likely be off vs. last year.
One beneficiary of the pullback in the debt market are buyers who are more conservative in their use of leverage for M&A transactions. The past few years have made it difficult for them to compete with buyers who look to aggressively finance their acquisitions with debt.
While the first quarter of 2016 saw GDP weakness, historical data suggests a likely rebound in the second quarter. In addition, though growth in the U.S. has been subdued, the labor market and inflation each continue to make strides. The credit markets exhibited significant volatility in the first quarter, specifically in taxable credit. Additionally, market attitudes point toward a “lower for longer” outlook regarding interest rates. In private credit markets, which have been accommodative, sentiment among senior loan officers is starting to shift, as a plurality are reporting both contracting loan demand and tightening lending standards. In line with this, M&A and PE volume in the middle market appears to finally be slowing, with questions around leverage availability causing sellers to step back from bringing their businesses to market. As a result of the softening valuation environment, we expect lower transaction volume in 2016.
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© Brown Brothers Harriman & Co. 2016. All rights reserved. 2016.
1 Source: Bloomberg. Based on weekly correlation between the U.S. Trade-Weighted Broad Dollar Index and the S&P GSCI Spot Commodity Index from 1/1/00 to 6/20/14 (-0.44) vs. 6/20/14 to 5/4/16 (-0.43).