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 the anticipated tightening of the Federal Reserve’s balance sheet, the positive lending market for borrowers and the effects of high valuations on the PE market, among other topics.
The U.S. economy performed solidly in the second quarter, with the advance GDP estimate indicating real growth of 2.6% quarter over quarter, up from 1.2% in the first quarter. Encouragingly, most of the increase came from a rebound in consumption. In July, the U.S. and Global Manufacturing PMI were each down; however, both remain firmly in expansion territory, which continues to bode well for future growth. Second-quarter earnings season in the U.S. is roughly two-thirds complete, and S&P 500 operating earnings are estimated to have risen 19% year over year, driven by top-line gains and margin expansion.1 The U.S. dollar also continued to decline last quarter and year to date has fallen by 7% against a broad basket of U.S. trading partners and over 8% vs. other major currencies. In a reversal from most of 2014 to 2015, the dollar’s decrease has helped propel earnings for U.S. companies.
The labor market is also healthy and, with the unemployment rate at 4.3%, is near full employment. The economy added 209,000 jobs in July and over the past six months has averaged 176,000 new jobs monthly, just slightly below recent averages. Wage inflation remains modest as average hourly earnings have risen at a 2.5% clip over the past year. The lack of wage and price inflation is one of the more vexing economic questions today, and a surge in inflation pressures would likely have a dramatic impact on markets and the real economy.
With this backdrop, the Federal Reserve raised rates in March and June, its third and fourth hikes of the cycle; however, longer-term Treasury yields declined, with the 10-year ending July at 2.3% despite spending substantial time above 2.6% in March. The market-implied odds of an additional rate hike in 2017 are roughly 1-in-3, though the Fed appears likely to begin normalizing the size of its balance sheet later this year. While the runoff will be gradual (limited to $10 billion per month at first), the removal of a large, price-insensitive buyer from the market bears watching. In a benign market, this may prove to be a nonevent, but the market now likely has less of a shock absorber to deal with volatility in an orderly way. While the Fed may announce more concrete plans, current estimates call for a reduction in its balance sheet to $2 trillion – a $2.5 trillion decrease from today. Before the financial crisis, the balance sheet stood at roughly $900 billion, so the Fed would still have absorbed over $1 trillion of securities.
The yield curve seems particularly sensitive to inflation currently. First, higher inflation readings would cause the Fed to tighten its policy rate at a faster pace than anticipated by the market, which would lift longer-term rates through expectations about future short rates. Further, nominal Treasuries respond particularly poorly to inflation, as investors demand higher term premiums for holding long-term bonds in times of rising inflation. Today’s two- to 10-year Treasury yield spread, which is well below 1%, is low by historical standards, leaving plenty of room for a steeper yield curve if inflation readings should begin rising.
Policy-wise, it appears the U.S. will continue living with substantial uncertainty. The Trump administration and the Republican Congress have been unable to form a consensus on their key policy initiatives such as tax reform and healthcare, so they have struggled to push through any meaningful legislation. Tax reform looks to be a priority in the second half of the year, and the House has already started watering down earlier versions of its blueprint, such as the border-adjusted tax.
The Credit Market
The Federal Reserve’s June decision to raise the federal funds rate another 25 basis points (bps) caught almost no one by surprise, as the futures market immediately ahead of the announcement showed a 93% chance of a hike. As noted in the previous section, market pricing implies only a 1-in-3 chance of another rate hike this year; any increase is expected to be another 25 bps. Since the beginning of the year, short-term rates have risen a half point, but longer rates have actually declined slightly.
The Fed’s indication that it will likely begin reducing the longer-term securities on its balance sheet later this year shows confidence in continuing moderate economic growth. In addition to signaling this comfort, reducing the balance sheet, with a potential concurrent rise in longer-term rates, gives the Fed the option of reversing course in the future should the economy begin to falter. Once the reduction begins, payments on securities will be reinvested only when they exceed $6 billion in a month, increasing gradually to $30 billion – a small fraction of the overall portfolio.
Borrowing costs are beginning to creep up, with somewhat higher rates on the short end. This particularly affects consumers and businesses that borrow on a floating rate basis or for fixed terms less than five years. That said, credit spreads remain low, and banks’ willingness to lend continues to be evident.
Last year’s ramp-up in spreads for higher risk credits, sparked by additional stress in the energy sector, is fading from memory. By the end of the year, risk premiums for lower-quality borrowers had declined again to near post-crisis lows – and have remained low, though with some volatility, so far in 2017. Lenders continue to stretch quality in order to gain yield when reaching on maturity gives only modest rate increases. That being said, the overall level of commercial and industrial loans has remained quite flat for the past four quarters.
The modest pace of increase does not appear tied to banks’ credit standards. The second-quarter report from Phoenix-Hecht’s survey of commercial lenders showed banks have loosened leverage standards at the very top end. The percentage of respondents that indicated they would consider lending at debt-to-EBITDA ratios above 3.5x increased from 23% in the first quarter to 41% in the second quarter. As in other markets, there is an abundance of capital available, and terms are favorable for those who need it.
Over the past four quarters, the Federal Reserve’s reports have confirmed the continued ease of credit. In line with the declining trend in spreads for higher risk borrowers, banks continue to report a slight loosening in standards after a brief period of tightening last year. Rates remain low, and terms are flexible – business owners and consumers continue to benefit from the lending environment. It is a good time to be a borrower.
The Private Equity and Mergers and Acquisitions Markets
The current PE landscape has been described as “a tale of two markets.” Fundraising continues to soar, while valuations remain sky-high, and the number of PE-backed exits continues to decline. Through the first half of 2017, U.S. PE firms are on pace to compete with or surpass the record-breaking fundraising statistics recorded 10 years ago (in terms of capital raised). This momentum has been propelled by strong distributions over the past few years and increased private equity allocations by limited partners as a result of the asset class’s impressive returns relative to others. General partners are raising larger funds and at a faster pace than any period over the previous decade. In addition, a higher percentage of funds are hitting or exceeding their initial fundraising targets – 93% in 2017 vs. 69% in 2007. 2
Valuations through the second quarter remained elevated at 10.5x, although slightly lower than last year’s post-crisis high of 10.7x. Continued normalization in the credit markets, limited attractive opportunities and possible corporate tax cuts have kept valuations well above historical norms. The combination of significant amounts of strategic cash on balance sheets, high public equity valuations and record PE dry powder will likely keep valuations raised for the remainder of 2017. These dynamics have created an intensely competitive environment for attractive businesses. PE firms are having difficulty finding assets at a fair price and extracting value. Buyers are more selective in choosing attractive opportunities and are willing to stretch for more appealing businesses. There is a premium on direct deal sourcing models, exclusive industry segment insight and other clear points of differentiation.
Armed with a record amount of dry powder ($545.5 billion), PE firms continue to deploy capital despite this competitive market.3 Deal flow through the first half of 2017 remained steady, albeit below the past few years. Anecdotally, the number of investment opportunities reviewed by BBH Capital Partners in the first half of 2017 was 42% above the second half of 2016.
Once predominantly the target of venture capital firms, the technology sector is seeing heavy investment from buyout and growth funds. The industry has become increasingly active over the past few quarters, representing 19% of U.S. buyout deals through June 2017.4 There are many new opportunities in the sector, particularly in areas such as virtual reality, cybersecurity, autonomous vehicles, machine learning and big data. In addition, PE investments in the healthcare space seem unfazed by the political turmoil surrounding the industry as fund managers remain bullish in the sector. Through the first half of 2017, the combined value of PE-backed U.S. healthcare deals was on pace to surpass 2016.5 However, it is likely that healthcare sectors dependent on Medicaid will be more heavily diligenced.
The U.S. M&A market overall has remained relatively strong over the past six quarters, following a sharp decline in both deal volume and count from the last quarter of 2015 to the first quarter of 2016. M&A revenues reached a new year-to-date record with $6 billion so far in 2017, up 6% year over year. Similar to the PE market, technology led the U.S. M&A sector in revenues for the second consecutive year.6
Second-quarter PE exit activity was slightly greater than that of the first quarter. However, volume is still down 26% year over year, and exit value is on track to be down 46.5% for the full year.7 Most pre-2008 investments have been exited, and the majority of current portfolio inventory purchased between 2014 and 2016 is not yet ready for sale.
While there are many concerns over what is occurring in the political arena, the PE and M&A markets remain healthy. However, it remains to be seen how long this “Trump bump” will last.
Overall, the U.S. economy is performing solidly. Last quarter’s advance GDP estimate indicates quarterly growth higher than that in the first quarter, second-quarter earnings are positive, and the labor market is healthy. In the coming months, two top areas to watch will be the Fed’s expected normalizing of its balance sheet and policy reform efforts by the Trump administration and Republican Congress. In the credit market, which also has its eye on the Fed’s actions, the lending environment is bright for borrowers as low rates persist and standards loosen. Finally, the M&A and PE markets remain healthy. Though high valuations have fueled competition, PE firms continue to deploy capital thanks to a record amount of dry powder. In the M&A space, activity is strong, with deal volume and revenues both up. In these markets, too, changes in the political arena are a key event to watch.
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© Brown Brothers Harriman & Co. 2017. All rights reserved. 2017.
PB-2017-08-17-1629 Expires 08/31/2019
1 Operating earnings include income from product (goods and services) and exclude corporate (M&A, financing, layoffs) and unusual items.
2 Source: PitchBook.
6 Source: Dealogic.
7 Source: PitchBook.