In each 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 bleak U.S. economic data over the past few months, increasing spreads and tightening lending standards, and slowing PE and M&A activity.
Economic data in the past few months paints a negative picture for the U.S. economy. While most lagging indicators, such as non-farm payrolls and wage growth, point to the U.S. economy still being on solid footing, various leading indicators are less positive. In addition, several global macro risks continue to loom, ranging from an energy crisis in Europe to a sharp deterioration in China’s property sector to consumer sentiment at all-time lows. Within the U.S., the main risk continues to be elevated levels of inflation, which advanced 8.2% in September, while core inflation advanced 6.6% year over year. Despite the macro risks, the Federal Open Market Committee (FOMC) has hiked rates aggressively throughout 2022; the current targeted range is 3.75% to 4.0%, the highest since fourth quarter 2007, and up from 0.0% to 0.25% in January 2022. As of November 3, current fed funds futures estimate that rates may peak at 5.18% in June 2023 and stay above 4.8% for all of 2023, suggesting multiple rate hikes throughout the first half of 2023.
U.S. policymakers face a difficult task of balancing weaker domestic growth (consensus estimates call for 2023 U.S. GDP growth of 0.40%) against hiking interest rates to a level that reduces inflation without tipping the U.S. economy into a recession. In October, the S&P Global U.S. Composite PMI, which tracks business trends from both manufacturing and service sectors (60% from manufacturing and 40% from services), declined to 48.2, down from 49.5 in September, extending its trend below 50 to four consecutive months. At levels below 50, the index is consistent with economic contraction within the manufacturing and services sectors. Notably, as the U.S. Composite PMI trended into contraction territory, U.S. real GDP decreased at an annual rate of 0.6% in second quarter 2022, its second consecutive quarter of negative real GDP growth. While the advance estimate of third quarter 2022 GDP showed 2.6% growth from the preceding quarter, the increase was driven by an upturn in government spending and an acceleration in nonresidential fixed investment that was partly offset by a larger decrease in residential fixed investment and a deceleration in consumer spending. Recent U.S. Composite PMI data coincides with the Conference Board Leading Economic Index, which declined 2.8% over the six-month period between March and September 2022, a reversal from its 1.4% growth over the previous six months, signaling a slowdown in growth ahead and potentially a recession.
Chart showing U.S. Composite PMI vs. Real GDP quarter-over-quarter growth from 2014 to 2022. The most recent figure for the Composite PMI is 48.2 (October 2022), and the most recent figure for quarter-over-quarter GDP growth is 2.6% (September 2022). If you are in need of the data found in this graph, please contact BBHPrivateBanking@bbh.com.
The impact of higher rates is beginning to affect the housing market, which contributes between 15% and 18% to GDP. U.S. homebuilder sentiment declined for 10 consecutive months through October – its longest stretch of declines on record – while single-family building permits (a more forward-looking indicator for single-family housing starts) has declined for seven consecutive months and is at the lowest level since June 2020. The decline of the U.S. housing market has both disinflationary and inflationary tendencies. It lowers demand for building materials and associated durable goods (disinflationary), but it pushes consumers to the rental market, which provides upward pressure on the owners’ equivalent rent measure, which holds about 24% weight within the housing component of the Consumer Price Index (CPI). However, we do not know what the impact to overall inflation will be, as CPI is made up of eight components with different weights.
|Other Goods and Services||3%|
|Education and Communication||6%|
|Food and Beverages||14%|
Further complicating matters is a continued escalation of the trade dispute between the U.S. and China. Recently, the U.S. Department of Commerce formalized new rules prohibiting (without a license) the shipment of chipmaking equipment to Chinese factories that produce advanced semiconductors, which affects data centers, artificial intelligence systems, and other equipment that requires highly advanced chips. While China’s ability to retaliate is limited at the moment, the bigger risk to the U.S. economy is a reduction of durable goods or continued supply chain disruptions should the supply of chips begin to decline. However, longer term, the risk of low supply should lessen, as the Biden administration recently signed the CHIPS and Science Act of 2022, a law that provides an over $50 billion investment to increase domestic semiconductor manufacturing capabilities and catalyze research and development (R&D) to restore U.S. leadership in advanced technologies.
In hindsight, the strong economic growth in 2021 may prove to be an aberration, as it was certainly fueled to an extent by the record amount of stimulus and liquidity injected into the economy post-COVID-19. Current data points, such as hiring pauses and layoffs, retailer profit warnings due to the impact of rising prices, and an inverted yield curve, could suggest that growth may be starting to roll over.
The Credit Markets
The FOMC is assessing the stance of its monetary policy while prioritizing both maximum employment and a stable long-run inflation rate of 2%. As mentioned in The Economy section, as headline monthly inflation numbers continue to exceed the long-run targets, the FOMC has aggressively raised the fed funds rate this year in order to curb this ongoing inflationary trend. Unemployment rates remain low as the U.S. economy improves. However, “inflation remains elevated, reflecting supply and demand imbalances related to the pandemic, higher food and energy prices and broader price pressures,” as stated in the FOMC’s September 21, 2022, statement. As short-run inflation remains above the Federal Reserve’s 2% goal, the FOMC will continue to moderate its accommodative policy to stabilize pricing while remaining highly attentive to pressures caused by Russia’s war against Ukraine.
The Federal Reserve will continue shrinking its holdings of Treasury and mortgage bonds in the fourth quarter and will continue reducing the portfolio by $95 billion monthly in an effort to cut down its approximately $9 trillion balance sheet and curtail inflation. The FOMC will continue to monitor implications of the economy’s outlook in assessing its monetary policy going forward, adjusting as appropriate if public health conditions, labor markets, international developments, and inflation expectations pose a risk to the Fed’s long-term goals for the U.S. economy.
Corporate spreads provide information on how the market values risk and credit quality through the additional return required for providing capital to incrementally riskier borrowers. As shown in the nearby chart, at the onset of the COVID-19 pandemic in March 2020, spreads for high-yield (CCC-rated and below), BBB, and A bonds peaked at near 11%, 5%, and 3.25%, respectively, similar to patterns shown during the Great Recession of 2008-09 (albeit high-yield, BBB, and A rates peaked at 20%, 8%, and 6.5% in 2008). Given quick and accommodative monetary and fiscal policy responses and a recovering economy, spreads declined throughout 2020 and 2021. However, spreads have increased since the start of 2022 due to the geopolitical turmoil and rising risk-free interest rates, which increases the cost to borrow to purchase risk assets as well as the rate at which future cash flows from risk assets are discounted. Despite the increase in 2022, high-yield, BBB, and A-rated bond spreads are at or near their 25-year historical daily average of approximately 5.5%, 2.0%, and 1.3%, respectively.
The nearby graph shows commercial and industrial (C&I) loans outstanding to U.S. companies overlaid by the net percentage of U.S. banks tightening or loosening credit standards for C&I loans to large and middle-market firms. The net percentage data is based on the Fed’s quarterly “Senior Loan Officer Opinion Survey on Bank Lending Practices.” As of the second quarter, 24.2% of domestic banks tightened standards, after five straight quarters of loosened lending standards, suggesting domestic C&I lending has transitioned to a lender-friendly environment. A moderate share of banks increased the cost of credit lines and widened the spreads of loan rates over the costs of funds to firms of all sizes, while a moderate portion also increased collateralization requirements for large and middle-market firms.
A majority of banks that reported tightening standards or terms on C&I loans cited a less favorable or more uncertain economic outlook, the worsening of industry-specific issues, and reduced tolerance of risk as important reasons for doing so. Significant net shares of banks also mentioned decreased liquidity in the secondary market for C&I loans, increased concerns about the effects of legislative changes, changes in accounting standards, and less aggressive competition from other banks as motivators for tightening lending standards. The survey reported strong demand for C&I loans across all firm sizes due to increased customer need for financing inventory, accounts receivable, and increased precautionary demand for cash and liquidity.
The Private Equity and Mergers and Acquisitions Markets
A confluence of economic factors, such growing inflation, interest rate hikes, supply chain concerns, and lingering effects of COVID-19, have slowed PE and M&A activity from the unprecedented levels seen in 2021. However, it must be noted that recent figures are comparable to historical norms. Fund managers report being cautiously optimistic but will need to be proactive in order to find ways to keep deploying their dry powder.
Despite macroeconomic headwinds, PE dealmaking has remained strong thus far in 2022. Deal value ($819 billion) and deal count (6,530) in the first three quarters of the year were already higher than any previous annual amount on record with the exception of 2021. However, it should be noted that interest rate hikes have started to impact the leveraged buyout (LBO) market. Federal Reserve rate increases also drove the Secured Overnight Financing Rate and other benchmarks used to determine the floating rates for LBOs to increase. Floating rates for loans on LBOs averaged 4.8% in February before doubling to 9.8% in September. While deal volumes remained strong through the first seven months of the year, they significantly slowed in August and September.1 Private equity managers have reported that they expect to face some difficult economic conditions in the next 12 months. In Investec’s 2022 “GP Trends” survey, 71% of respondents said they expected rising inflation and interest rates to dampen the availability of financing for deals, and 55% expected more covenant breaches in the next 12 months. As such, PE managers have been pivoting toward more “defensive” sectors, such as healthcare and business services.
The current economic landscape and the need to deploy a massive amount of dry powder has resulted in PE firms giving more attention to take-private deals and add-on acquisitions. Lower corporate valuations have made it easier for PE funds to lure away business from the stock market at bargain prices.2 Take-private transactions are expected to reach $100 billion in deal value for a second consecutive year, a first for the industry in over a decade. In addition, as of September 2022, the number of add-ons as a percentage of buyout deals reached a new record of 78%. Compared to large-scale acquisitions, add-ons are a more conservative strategy that allows PE firms to scale up in the current environment.3
|U.S. Private Equity Activity Deal Flow by Year|
|Deal Value ($B)||Deal Count|
As with deal activity, U.S. private equity exit activity slowed in comparison to the record-breaking levels seen in 2021 but remained relatively healthy compared to historical standards. During the third quarter, 337 PE-backed companies were exited, for a cumulative value of $89.0 billion. One reason for the decline in exit activity is the drop in the number of companies exited via initial public offerings, which accounted for roughly one-third of exit value in the past two years.4
|U.S. Private Equity Exits by Year|
|Exit Value ($B)||Exit Count|
Through the first three quarters of 2022, U.S. PE firms raised $258.8 billion across 296 funds, which is comparable to 2021 figures. However, this pace of fundraising activity is not projected to continue into the fourth quarter as it did in in the year prior. As a record amount of capital was deployed in 2021, GPs have been seeking re-ups from their investors throughout the year, and as a result, many LPs have already hit their allocation targets for the year.5 However, according to Investec’s 2022 “GP Trends” survey, PE investors are cautiously optimistic: 46% of respondents expected the size of their next fund to exceed its predecessor by 25% to 50% in size, and 20% expected their next fund to beat their previous fund in size by 50% to 100%.
|U.S. Private Equity Fundraising by Year|
|Capital Raised ($B)||Fund Count|
Due to strong headwinds from a combination of geopolitical tension, inflation, and pandemic-related supply chain issues, North American M&A continued its decline in deal value and volume through the first half of 2022. In the second quarter, approximately 4,571 deals closed with a combined value of $547.7 billion, representing a decline of 30.2% and 37.6%, respectively, from fourth quarter 2021.6 However, it should be noted that the 2022 figures are comparable to healthy, pre-pandemic levels. This slower pace can be seen as an opportunity to revisit and refresh the fundamentals after the nonstop action seen at the end of 2021.7
|North American M&A Activity|
|Deal Value ($B)||Deal Count|
Overall, recent U.S. economic data paints a bleak picture for the U.S., with various leading indicators suggesting a negative outlook. While growth in 2021 was strong, the tide may be turning, as suggested by current data points, such as hiring pauses and layoffs, profit warnings from retailers, and an inverted yield curve. In the credit markets, spreads have increased since the start of 2022 due to the geopolitical turmoil and rising risk-free interest rates, but it is important to note that they are at or near their 25-year historical daily average. And it appears the tide is turning in the C&I loan space, as domestic banks reported tightening standards after five straight quarters of loosened lending standards, and demand for C&I loans is on the rise. Meanwhile, activity has slowed in the PE and M&A markets due to a combination of economic factors; however, recent figures are comparable to historical norms, and fund managers remain optimistic while also getting creative to identify new opportunities in which to deploy their dry powder.
6 “Global M&A Report.” PitchBook.
7 McKinsey & Co.
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