The U.S. economy continues to hold up quite well despite ongoing macroeconomic headwinds. On balance, economic data leading up to fourth quarter 2019 has been positive, equity prices rose to all-time highs and fixed income markets appear more “normal” with an upward sloping yield curve.
At the end of October, the Federal Open Market Committee (FOMC) lowered the federal funds rate for the third time since July, seemingly completing the Fed’s 75 bps “mid-cycle adjustment,” bringing overnight interest rates to a range of 1.50-1.75%. With this adjustment, the yield curve returned to its normal upward-sloping shape, and fears of a yield-curve induced economic slowdown were quelled.
Economic data has been relatively positive. The economy added 128,000 jobs in October, which is impressive considering upward revisions to prior months, as well as the striking of 46,000 GM workers that reduced monthly job gains. As of October, the trailing six-month average of payroll gains stands at a healthy 156,000, and the unemployment rate, at 3.6%, is just 0.1% above its recent low. The last time the unemployment rate dropped this low was in the late 1960s. Beyond just payroll gains, wages have been climbing at a healthy clip as well, helping to drive growth in personal incomes. Heading into the fourth quarter, the year-over-year increase in average hourly earnings has been at or above 3.0% for 15 months.
In addition to employment figures, GDP growth was more positive than expected with the economy growing at a 1.9% annual clip in the third quarter vs. an expectation of 1.6%. In line with the positive data on employment and wages, GDP growth in the prior two quarters has been almost entirely driven by personal consumption. Personal consumption, which we believe is a more durable form of growth than investment, net exports or government expenditures, contributed 3.0% to GDP in the second quarter and 1.9% in the third quarter.
While the economy appears on solid footing overall, the manufacturing sector is under more stress. The ISM Manufacturing PMI rebounded slightly from a decade low of 47.8 in September to 48.3 in October. However, the ISM is a diffusion index and levels below 50 are consistent with contraction in the manufacturing sector. The weakness in the manufacturing sector is consistent with weak global growth and lingering trade uncertainty.
As discussed in the third quarter of 2019, we believe that the Conference Board’s index of 10 Leading Indicators (LEI) provides the most balanced, forward-looking gauge of economic activity. While many economic indicators display more noise than signal, the LEI’s 10 components (shown in the nearby table) have proven to be a valuable forecasting tool over multiple economic cycles. In the past three recessions that began in 1990, 2001 and 2007, the LEI began declining between 12 and 22 months prior to the start of the recession. As of September 2019, the LEI has been relatively flat, up 0.4% year over year. 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.
Credit Market Update Q4
The Federal Reserve’s October decision to decrease its fed funds target range by 25 bps for a third time in 2019, represents an unexpected shift in interest rate expectations from the beginning of the year. As shown in the nearby chart, the Fed’s last meeting of 2018 had FOMC voters’ expectations for interest rates ending 2019 at an average rate of 2.875% (representing only two rate hikes). However, as the year progressed, expectations for interest rates took a more dovish tone as rate cuts were viewed as a more appropriate course of action by FOMC members, given economic data uncertainty.
Fed officials have largely cited three reasons for trimming rates in 2019: weakening global growth, trade-policy uncertainty and muted inflation. Meanwhile, this is juxtaposed with both a strong labor market, with unemployment at a near historic low of 3.5% in November and modest levels of economic growth, with 1.9% growth in the third quarter. The contradicting data points create some uncertainty as to the overall strength of the U.S. economy, and therefore, uncertainty in how monetary policy will be conducted in 2020. Although the mixed economic data persists, changes to policy statements made after the October Fed meeting do indicate that the hurdle has been raised for an additional rate cut in the succeeding year.
As shown in the following chart, Treasury yields have fallen significantly during 2019, particularly Treasuries maturing in the two-to-ten-year range. This eventually resulted in an inversion of the yield curve at various points, which sparked fears of an impending recession. As of October, the yield curve had returned to a more positive curvature, though the reasoning for which remains to be debated—some point to the potential of a breakthrough “Brexit” deal, the U.S. and China trade war drawing closer to an agreement or the Federal Reserve’s announcement in October that they intend to buy $60 billion of T-bills every month. Nonetheless, the recent, relatively flat yield curve presents an opportune time for fixed rate borrowers to secure low rates on loans with longer-term maturities.
While bank, commercial and industrial lending to companies shows growth year over year ($2.4 trillion as of October 2019, up 4.8% from $2.2 trillion at the same time last year), total outstandings have flattened over the past few months, as shown in the below chart. Each quarter, the Federal Reserve conducts and publishes their Senior Loan Officer Opinion Survey on Bank Lending Practices. As of October, while credit standards continued to remain at relatively low levels, a net 4.4% of banks reported somewhat tightening loan standards, versus the previous three-month period. When asked the reasoning for tightening standards, notable rationale included increasing concerns about potential legislative changes and a more uncertain economic outlook. At the same time, several banks reported slightly weaker demand for loans. Their explanations included an increase to internally generated funds at companies, reduced investment in plant or equipment and customer borrowing shifting to other sources of credit (such as nonbank institutions). While the slight increase in credit standards paired with a dip in demand for loans represent the first signs of hesitancy in the bank credit market in some time, the majority of cited motives indicate both lenders and borrowers remain uncertain of the political and monetary policy landscape as we enter 2020. Nonetheless, the low interest rate environment for both short- and long-term borrowings coupled with still accommodative lending standards continues to make it an attractive time to seek debt capital.
The Private Equity and Mergers and Acquisitions Markets
As mentioned previously, U.S. economic activity slowed in the third quarter, as GDP growth dipped below 2.0% for the first time since the end of 2018.1 However, the overall economy remains relatively strong as heightened consumer activity partially offsets the effects of ongoing trade disputes. At the beginning of the fourth quarter, several stock market indices reached record levels, though the market has become more volatile over the years according to some sources that measure market fluctuations.2 With less exposure to the extreme swings of the stock market, private equity continues to be at center stage for active investors, and fierce competition for quality assets remains.
U.S. Private Equity (PE) deal activity continued at a strong pace through the third quarter of the year with 3,883 deals closed, totaling $501.2 billion.3 This pace is expected to continue due to the record levels of PE capital being raised, several large deals that were set to close in the fourth quarter of 2019 and lower interest rates due to a third Fed rate cut in 2019. The B2B and technology industries continue to be a key focus for PE, representing 38% and 19% of deal volume through the third quarter of 2019, respectively. While the technology sector used to be dominated by venture capital, PE firms are also attracted to innovations with the potential to transform industries. More recent growth may be partly attributable to investors looking to protect their downside by deploying capital in “recession-resistant” industries such as technology and healthcare, which have seen an increase in average deal size through the third quarter 2019, by 50% and 10%, respectively.4
At the end of September, global private equity dry powder rose to a new high of $1.7 trillion.5 Extremely high levels of dry powder, relatively inexpensive debt financing and a larger variety of PE investors (sovereign wealth funds, family offices and pensions) competing for deals will likely keep EV/EBITDA multiples elevated for the foreseeable future. Through September, the median U.S. PE deal multiple reached a record high of 12.9x. As such, add-ons, which are typically lower multiple acquisitions, continue to be a rising portion of U.S. PE buyouts, accounting for 68% of all U.S.-based buyouts year to date through September.6
In addition to high purchase price multiples, economic and political uncertainty continued to drive down the number and value of exits in the third quarter (248 exits valued at $67.2 billion). Through September 2019, year-over-year exit count and exit value are down 29.6% and 19.5%, respectively, and full-year 2019 numbers are poised to be well below 2018 totals. There was, however, an increase in median exit size, which is likely due to a rise in PE-backed IPO activity.7
The amount of PE capital raised through third quarter 2019 ($191 billion) nearly matched the full-year 2018 figure of $196 billion. This pace will likely continue into the fourth quarter, as several mega-funds ($5.0 billion+) were set to close by year end. This heightened fundraising activity is likely driven by: (i) LPs looking to allocate to GPs who employ strategies that have historically outperformed the public market and (ii) GPs’ sense of urgency to raise funds before a potential economic downturn. Conversely, the number of funds raised has continued to decrease. The general shift toward mega-funds has allowed large LPs to cull the number of GP relationships they maintain and allocate more capital to a few select managers.8
North American M&A activity in the third quarter of 2019 was robust with over $600 billion in total value, though much of the deal flow was attributable to a few exceptionally large transactions.9 According to Ernst & Young's Capital Confidence Barometer survey, published in mid-October, approximately 96% of the nearly 600 U.S. C-suite executives surveyed anticipate domestic economic growth, and 83% expect the U.S. M&A market to improve in the next year. However, deal intentions slipped below the 50% mark for the first time in two years, with just 46% of U.S. respondents saying they intend to actively pursue M&A in the next 12 months.
Overall, the U.S. economy appears to be on solid footing despite continuous macroeconomic headwinds during the third quarter of 2019. Following the third federal funds rate cut since July, the yield curve returned to its upward-sloping shape, unemployment rates continue to stay low and GDP was more positive than previously expected, despite its slowing rate. LEI also suggests an optimistic future, as it has yet to decline going into fourth quarter. In the credit markets, accommodating lending standards and a low interest rate environment provide an attractive market for debt capital. Finally, the PE and M&A space also appears strong as dry powder reached a new record high and M&A activity is robust due to a few exceptionally large deals.
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