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 both positive and negative economic data as of late, the continued accommodative lending environment and the fiercely competitive PE market.
Economic data in the past few months paints a slightly mixed picture of the U.S. economy. Most coincident and lagging economic indicators point to the U.S. economy still being on solid footing; however, various leading indicators are less positive. In addition, several global macro risks continue to loom. Based on its concern for the economic outlook, muted inflation, weak global growth and trade policy uncertainty, and perhaps out of an abundance of caution, the Federal Open Market Committee (FOMC) decided to lower the federal funds rate by 25 basis points (bps) to a range of 2.00% to 2.25% at its July meeting. This came on the heels of eight rate hikes from December 2015 to December 2018 and was the first rate cut in over 10 years, dating back to when the FOMC lowered rates to zero in 2009 in the wake of the financial crisis.
Weak global economic growth, particularly in the manufacturing sector, is one of the primary risks concerning the Federal Reserve. In July, the J.P. Morgan Global Manufacturing PMI declined 0.1 to 49.3 and has fallen 18 of the past 19 months. At levels below 50, the index is consistent with contraction in the global manufacturing sector. While U.S. data is slightly more positive, the ISM Manufacturing Index declined from 51.7 to 51.2, its lowest level since September 2016 and consistent with low levels of manufacturing sector growth. Though manufacturing makes up a lower percentage of U.S. output than it does in the global economy, a turn in the sector is still a risk worth watching. Notably, the U.S. ISM bottomed at 48.0 in January 2016, and the U.S. escaped without a single negative quarter of GDP growth.
Further complicating matters is a continued escalation of the trade dispute between the U.S. and China. Just over a day after the Trump administration reported a “constructive” dialogue in high-level talks with China, President Trump announced another 10% tariff on the remaining $300 billion of Chinese imports to the U.S. This most recent announcement has followed the general pattern of truces and productive talks followed by repeated escalation. In the round of tariffs that went into effect on September 1, there is a greater share of finished consumer goods, ranging from electronics to mobile phones to apparel (The Wall Street Journal reports this could increase the import cost of an iPhone XS by $40). The expectation is that these tariffs will take effect, and it is not difficult to envision a flat 25% tariff on all Chinese imports in the near future. While China’s ability to retaliate directly with tariffs is restricted due to the relatively limited volume of U.S. exports to China, the bigger risk to the economy in this trade spat is a reduction to either U.S. personal incomes and/or corporate profits brought on by U.S. tariffs.
U.S. policymakers face the difficult task of balancing weaker global growth and trade policy uncertainty against domestic data that is not as alarming. In July, the U.S. added a solid 164,000 jobs, and the unemployment rate held steady at 3.7%. At the same time, the trailing six-month average of job gains, which smooths out some of the month-to-month noise in the data, fell to a seven-year low of 140,000. Elsewhere in the jobs report, though, average hourly earnings grew 0.3% month over month, and year-over-year wage gains, at 3.2%, still appear to be trending up. GDP growth also fell from 3.1% in the first quarter to 2.1% in the second quarter; however, the contribution from personal consumption, arguably the better barometer for the health of the U.S. economy, increased from 0.9% to 2.9%. On a forward-looking basis, we have already noted the decline in the ISM Index; however, The Conference Board’s index of 10 leading economic indicators (LEIs) has also flattened out. The LEIs have been relatively flat for the past 10 months, and the annualized six-month rate of change stands at just 0.4%. Overall, we certainly do not believe the data indicates that economic growth is trending up, but it also seems premature to prognosticate about the nature of the next economic slowdown. As the nearby chart shows, the six-month rate of change in the LEIs has fallen to zero four times in the past eight to nine years, with no such instance resulting in a U.S. economic recession.
The Credit Market
All eyes have been on the Federal Reserve as of late, where Chairman Jerome Powell and the FOMC continue to weigh mixed economic data while determining how to appropriately adjust monetary policy through the remainder of 2019. The Fed’s July decision to decrease the fed funds target range by 25 bps was not a surprise to markets. Prior to the decision, the CME Group reported financial markets had already priced in a 100% chance of a rate cut, with a further 56% probability of two more reductions before year-end. As expressed in the nearby chart, this is quite a dramatic shift in interest rate expectations from the beginning of the year. At the Fed’s last meeting of 2018 in December, FOMC voters’ expectations for interest rates at year-end 2019 averaged 2.875% (representing two rate hikes).
As noted, unemployment remains low, at 3.7% as of June. Conventional thought, therefore, would suggest price pressures would ultimately rise and produce inflation closer to the Federal Reserve’s target of 2%. However, core inflation, the Fed’s preferred measure, which adjusts for volatile energy and food prices, remained below 2% through June, at 1.6%. This could suggest that there is more room for unemployment to fall before the U.S. economy starts to see prices pick up more substantially. Modest levels of inflation are attractive for fixed-rate borrowers, as higher inflation makes debt repayment relatively cheaper. In addition to more favorable borrowing rates, sustained lower interest rates allow inflation the opportunity to rise. Powell noted in his July press conference that a faster return of inflation was a factor in the FOMC’s decision to cut rates.
As shown in the nearby chart, Treasury yields have continued to fall significantly during 2019, particularly among securities maturing in the two- to 30-year range. While segments of the yield curve remain inverted – and the 10-year briefly dipped below the two-year Treasury yield in August – the relevance of this signal and its ability to time an impending recession continues to be debated.
The first rate cut since the Great Recession should further propel the already robust credit market, which remains attractive for borrowers. Bank commercial and industrial lending to corporations continues to grow, reaching $2.3 trillion as of June 2019, up 6.8% from $2.2 trillion in June 2018. At the same time, loan standards are at historical lows. In the Federal Reserve’s July 2019 “Senior Loan Officer Opinion Survey on Bank Lending Practices,” banking standards remained unchanged from the prior three-month survey. The survey noted continued increased credit lines, eased covenants and lowered spreads for large and middle-market clients. Despite the shift and relative uncertainty in monetary policy that has persisted throughout 2019, it continues to appear like an opportune time for borrowers to take advantage of lower interest rates.
The Private Equity and Mergers and Acquisitions Markets
The economic and geopolitical concerns that led to volatility in 2018 have continued well into 2019. While the U.S. stock market performed extremely well in the first half of the year, U.S.-China trade aggressions and fears over falling global government bond yields have resulted in third-quarter market volatility. With less exposure to the extreme swings of the stock market, PE continues to be at center stage for active investors, and fierce competition for quality assets remains.
Despite a sluggish first quarter, the first half of this year was generally in line with the high level of PE activity seen in the first half of last year in terms of deal count and deal value. Thanks to a second-quarter activity uptick due to a recovery in the leveraged loan market and relative public market stability, 2,142 deals closed in the first half of 2019, totaling $297.1 billion.1 However, in order to match 2018’s full-year record-breaking numbers, activity levels in the latter half of the year will need to pick up the pace. The technology/IT sector continues to drive these high activity levels. Technology accounted for 28% of all deal value in the second quarter, and there continues to be a surge in deals where technology overlaps with other industries, such as healthcare and financial services. Certain technology subsectors (such as software and payments) will likely remain strong due to their recurring revenue models, which are favored by PE firms.2
At the end of June, global PE dry powder rose to a new high of $1.54 trillion.3 The level of dry powder and current cheap debt financing will likely keep EV/EBITDA multiples above 12.0x for the remainder of the year. As a result, through June, the median U.S. PE deal size jumped to $275.7 million, up from $190.0 million in 2018, an increase of 45.1%. In addition, add-ons – which comprised 70% of all U.S.-based buyouts in the second quarter – have also swelled in size.4 Investors and fund managers will continue to need more sophisticated strategies to succeed in this fiercely competitive market.
Second-quarter U.S. PE exit activity was above first-quarter levels but below historical averages, with 168 exits for a total value of $62.0 billion. Deals over $2.5 billion accounted for 58.4% of second-quarter exit value. This larger exit value is likely due to IPO activity, as the second-quarter IPO value is the highest in five years.5
Fundraising activity remained elevated in the second quarter, with $48.8 billion raised across 39 funds. Fundraising value declined in the second quarter compared with the first quarter, but the number of funds closed was higher. Once again, mega-funds ($5 billion and larger) continued to drive strong fundraising numbers. At the current rate, it is likely that the amount of capital raised in 2019 will surpass that of 2018, especially due to the fact that several mega-funds are expected to close by year-end.6
North American M&A activity remained high in the first half of 2019, with 4,754 deals worth $849.7 billion closing. While 2019 M&A activity came in at a slower pace than in 2018, an abundance of mega-deals have recently been announced, and it is expected that this will result in a strong second half. This prolonged period of heightened M&A activity is likely in response to a strong U.S. stock market through the first half of the year.7 However, the continued threat of a trade war with China and falling global government bond yields have led to more market volatility in the beginning of the third quarter. It remains to be seen if these recent market fluctuations will affect the high level of expected second-half M&A activity.
Data around the U.S. economy has been varied over the past few months. Various leading indicators, such as weak global growth, along with macro risks, including a U.S.-China trade war, have people on edge; however, domestic data paints a rosier picture. While the data certainly does not show that economic growth is trending up, we believe it is too early to predict an economic slowdown. In the credit markets, it remains a good time to be a borrower, with banks reporting increased lending and a loosening of standards. In addition, the July fed funds cut should propel the robust credit market further. Finally, the PE market remains competitive, with global PE dry powder at a new all-time high and swelling deal sizes. In the M&A space, expectations for second-half activity are high, though recent market volatility could affect this.
Brown Brothers Harriman & Co. (“BBH”) may be used as a generic term to reference the company as a whole and/or its various subsidiaries generally. This material and any products or services may be issued or provided in multiple jurisdictions by duly authorized and regulated subsidiaries.
This material is for general information and reference purposes only and does not constitute legal, tax or investment advice and is not intended as an offer to sell, or a solicitation to buy securities, services or investment products.
Any reference to tax matters is not intended to be used, and may not be used, for purposes of avoiding penalties under the U.S. Internal Revenue Code, or other applicable tax regimes, or for promotion, marketing or recommendation to third parties.
All information has been obtained from sources believed to be reliable, but accuracy is not guaranteed, and reliance should not be placed on the information presented. This material may not be reproduced, copied or transmitted, or any of the content disclosed to third parties, without the permission of BBH.
All trademarks and service marks included are the property of BBH or their respective owners.
© Brown Brothers Harriman & Co. 2019. All rights reserved.
2 “Private Equity Deals Insights Q2 2019.” PricewaterhouseCoopers.
3 Institutional Investor.