Chart tracking the fluctuation of U.S. job openings against the S&P 500 from 2001 to 2023. As of August 2023, job openings were at roughly 8.8 million, 20% below the all-time high of roughly 12 million in March 2022. If you are in need of the data behind this chart, please contact us at BBHPrivateBanking@bbh.com.
In each issue of Owner to Owner, we review aspects of the business environment on three fronts:
- Overall economy
- Credit markets
- Private equity (PE) and mergers and acquisitions (M&A) markets
The following article examines the state of the economy amid signs of potential slowdowns in growth expectations and un-inverted yield curves, a temporary pause in rate hikes, and declines in PE dealmaking, exit activity, and M&A activity.
U.S. GDP expanded at a quarter-over-quarter annualized rate of 2.1% in second quarter 2023, a slight deceleration from the revised 2.2% reported in first quarter 2023. The headline growth figure of 2.1% was driven by a deceleration in consumer spending, a downturn in exports, and a deceleration in federal government spending. These factors were partially offset by business investment, an acceleration in nonresidential fixed investment, and a smaller decrease in residential investment, resulting in an overall fairly solid pace of growth.
The personal consumption expenditure (PCE) component of GDP – which drives 70% of GDP over the long run – advanced 0.8%, following a 3.8% growth rate in the first quarter. Compounding this deceleration was housing, which contributes between 15% and 18% to GDP, as it fell 2.2%, its ninth consecutive quarter of declines. For the remainder of 2023, there are several factors on the horizon that may affect fourth quarter GDP, such as the resumption of student loan payments and reduced auto production due to the ongoing United Auto Workers (UAW) strike.
Meanwhile, the number of U.S. job openings continues to trend downward: It is now 20% below its all-time high recorded in March 2022, although it remains roughly 34% above the pre-pandemic levels of January 2020. While the stock market is forward-looking, job openings often reflect current economic conditions and signal a potential slowdown in growth expectations.
Switching to forward-looking indicators, we believe that The Conference Board’s index of 10 leading economic indicators (LEI) provides the most balanced, forward-looking gauge of economic activity. While many economic indicators display more noise than signal, the LEI has proved to be a valuable forecasting tool over multiple economic cycles. In the prior three recessions (excluding the COVID-19-induced recession in 2020) that started in 1990, 2001, and 2007, the LEI began declining between 12 and 22 months prior to the start of the recession. As of August 2023, the LEI has declined for 17 consecutive months since peaking in March 2022. Given the narrowing in positive breadth of the LEI’s subcomponents, it is possible to see further downside for the index into at least fourth quarter 2023. Momentum reversals have been swift in the past, but nothing about today’s backdrop is suggestive of a near-term trough in leading indicators. 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.
Chart showing The Conference Board’s Leading Economic Indicators (LEI) against economic recessions from 1985 to August 31, 2023. The latest figure is 105.4. If you are in need of the data behind this chart, please contact us at BBHPrivateBanking@bbh.com.
Concerning monetary policy, the fed funds futures curve is pricing a 68% probability that the Federal Open Market Committee (FOMC) maintains the fed funds target range of 5.25% to 5.50% at its November meeting and for rates to remain at this target range for the remainder of 2023. This, however, is below the Fed’s latest terminal rate guidance, which suggests that investors are underpricing the risk of the target range increasing to between 5.5% and 5.75%. The fed funds futures curve is also pricing in fed funds rate cuts to begin in July 2024, which is a pushback from the March 2024 estimate made at the end of July. In a hawkish move, the FOMC raised its fed funds target range in 2024 to between 5% and 5.25%, up from between 4.5% and 4.75%, effectively removing the expectation of two rate cuts.
While the fed funds futures curve suggests that rates will remain in the current target range, Treasury yields across the Treasury curve increased as the FOMC stated a possibility of one additional fed funds rate hike during the remainder of 2023 and an increase in its terminal fed funds rate projection for 2024. This, in turn, led to the 10-year Treasury yield to advance 46 basis points (bps) to 4.57%, breaching 4.6% at one point in September 2023 – its highest level since October 2007. Compared with 10‐year Treasuries, most yield spreads are inverted – particularly the closely watched two‐year/10‐year yield spread (-47 bps), which has been inverted since July 2022 but has steepened significantly from its July 2023 low of -108 bps.
While an inverted yield curve is seen as a recession signal, we find the un-inversion of an inverted yield curve to be a more reliable signal that a recession is underway. There is much happening as we progress through the end of 2023 and head into 2024 – balance sheet runoff and potential recession, to name just a few – and we will be watching inflation and global growth developments closely. In addition, we are monitoring how the Israel-Gaza conflict might impact oil, the economic outlook, and the risk of any potential escalation provoking a market response.
Chart showing the un-inversion of two-year/10-year yield spreads before the recession periods of 1980, 1990, 2001, 2007, and 2020. 2023 shows a slight un-inversion, which according to this pattern could indicate a possible future recession. The latest figure is -0.47. If you are in need of the data behind this chart, please contact us at BBHPrivateBanking@bbh.com.
The Credit Market
As 2023 draws to a close, the Federal Reserve continues to prioritize achieving a stable long-run inflation rate of 2.0%, and while the FOMC voted to maintain an upper federal funds target of 5.50% during its September meeting, economic data will determine whether the pause in rate hikes is temporary. Among September FOMC meeting attendees surveyed, seven believe no further rate increases will be required in 2023, while 12 anticipate one additional upward adjustment of 0.25%.
Thus far during 2023, the FOMC has instituted four rate increases totaling 1.0%, moderating its pace from 4.5% during 2022. The Fed’s efforts to curtail inflation through monetary policy appear to be succeeding, though progressing incrementally. Core inflation (which excludes volatile food and energy prices) has eased from a high of 6.6% in September 2022 to 4.3% as of August 2023 – still higher than its 2% target. Positively, the Fed’s second objective of its dual mandate is being achieved, with U.S. unemployment rates remaining near record lows at 3.8% as of August 2023.
|Yield Curves Over Time|
While the FOMC sets short-term risk-free borrowing rates through the federal funds target, it influences long-term rates via the purchase and sale of Treasury and mortgage bonds; however, market expectations of future growth and inflation tends to be more influential. The Fed continues to shrink its holdings of Treasury and mortgage bonds in an effort to reduce its approximately $8 trillion balance sheet. As of September, the Fed has successfully trimmed nearly $500 billion this year. These actions, along with shifting market expectations, have increased long-term risk-free rates, as shown in the nearby chart. U.S. 30-year Treasury yields have shifted upward by 75 bps between June 30, 2023, and September 26, 2023. The FOMC will continue to monitor the implications of its decisions and the economy’s outlook in assessing its monetary policy going forward.
Chart showing spreads for corporate bonds across rating classes: high-yield, BBB, and A bonds. The latest figures are 4.3%, 1.7%, and 1.1%, respectively. If you are in need of the data behind this chart, please contact us at BBHPrivateBanking@bbh.com.
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. Spreads for corporate bonds across rating classes have eased during 2023. As of September 29, 2023, spreads for high-yield, BBB, and A bonds were up 4.3%, 1.7%, and 1.1%, respectively. This is below their respective 25-year historical averages of 5.5%, 2.0%, and 1.3%, suggesting the bond market is cautiously optimistic about the prospects of corporate borrowers in this economy.
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 loans to large and middle-market firms. Second quarter 2023 was the fifth consecutive quarter where domestic banks tightened standards.
Chart showing the amount of commercial and industrial (C&I) loans outstanding to U.S. companies versus the net percentage of U.S. banks’ credit standards. The latest figure is $2,755.99 billion. If you are in need of the data behind this chart, please contact us at BBHPrivateBanking@bbh.com.
The net percentage data is based on the Fed’s quarterly “Senior Loan Officer Opinion Survey on Bank Lending Practices.” Additional highlights as of the second quarter include:
- A net 51% of domestic banks tightened standards vs. 24% during the same period last year, suggesting that domestic C&I lending has transitioned to a less borrower-friendly environment.
- Most banks reported increasing the cost of credit lines through widening the spreads of loan rates over the costs of funds (68%) and increasing premiums for riskier loans (62%).
- A significant portion also tightened loan covenants (33%) and collateralization requirements (25%).
- A moderate share of banks reported having tightened the maximum size of credit lines to companies and shortening the maturity of loans.
Almost all banks that reported tightening standards or terms on C&I loans cited a less favorable or more uncertain economic outlook and reduced tolerance of risk as important reasons for doing so. Among all banks, 59% cited a deterioration in a bank’s current or expected liquidity position as a somewhat or very important factor in tightening credit standards or loan terms. Additionally, 54% reported increased concerns about legislative changes, supervisory actions, or changes in accounting standards when making lending decisions.
Unsurprisingly, the aforementioned concerns resulted in a 2.6% decline in the amount of C&I loans during 2023 through August. While many U.S. banks pull back their exposure, borrowers are turning toward additional debt capital providers. Private debt funds continue to attract investors, with an estimated $200 billion of new capital anticipated to be raised during 2023. Nonetheless, certain banks, such as Brown Brothers Harriman, remain active in growing their corporate loan portfolios.
The PE and M&A markets continued to struggle through third quarter 2023. Investment managers continue to be met with a persistent inflationary environment, continued pressure on public equities, bank failures and government interventions, rising geopolitical tensions across the globe, and a number of complex and burdensome new laws and regulatory proposals. These conditions have made dealmaking and fundraising exceedingly competitive, and general partners (GPs) are battling these headwinds in the search for allocations from investors who are struggling with the denominator effect and a lack of liquidity across their portfolios.1
U.S. private equity dealmaking continued its slowdown through third quarter 2023. For the first time since COVID-19, deal value fell below $200 billion. Quarterly deal flow has now been flat to down for six of the last seven quarters, including a 7.2% and 18.1% decline by count and value, respectively, in the latest quarter.2 Nonetheless, with creativity and persistence, deals are getting done. Lenders are adjusting their balance sheet exposures. Direct lending, co-investments, and innovative deal structures have helped the financing gaps caused by the pullback in syndicated debt financings.3
|U.S. Private Equity Activity Deal Flow by Year|
|Deal Value ($B)||Deal Count|
Platform opportunities have taken the greatest hit due to their greater dependency on leverage. Platform deals declined 20.6% in value from the prior quarter and 42.9% year to date. While the pace of add-ons has leveled off, they are still at a near-record high share of all PE buyouts at 76.1% year to date. Add-ons have been essential to keeping the cogs turning while credit has been tight, as they allow PE sponsors to continue deploying capital while taking down deal size and biding time until lending markets can support larger platform buyouts.4
During the third quarter, U.S. private equity firms exited 275 portfolio companies worth $44.1 billion, representing a decrease of 6.9% and 40.7% quarter over quarter, respectively. The third quarter exit value marks the lowest recorded figure over 10 years (excluding second quarter 2020 during the onset of COVID-19 lockdowns).5
Exit activity is arguably the most important link in the PE chain of capital formation and a lead indicator of industry growth. Its cash flows recycle into fundraising that feeds into dry powder, fund deployment, and ultimately fund performance.6
|U.S. Private Equity Exits by Year|
|Exit Value ($B)||Exit Count|
PE fundraising through the first three quarters of the year is down approximately 13% from the prior year comparable period; however, this figure is better than anticipated, especially since 2022 was a record fundraising year for private equity. The average amount of time to close PE funds has risen to 15.6 months, the highest point since 2011. Middle-market funds seem to have taken advantage of the slowdown in megafund fundraising activity: The middle market’s share of all PE fund closings has reached its highest level since 2009, standing at 58.7% through third quarter 2023.7
|U.S. Private Equity Fundraising by Year|
|Capital Raised ($B)||Fund Count|
M&A activity in North America continued its slowdown through second quarter 2023. An estimated 4,276 deals closed or were announced for a combined value of $466.5 billion, representing quarter-over-quarter decreases of 4.5% and 5.5%, respectively. The tally from the first half of 2023 of $960.0 billion is below the levels in the first half of 2022 by 28.5% and below the pre-pandemic average from the same timeframe by 16.2%. Major factors dampening deal activity include the disconnect between buyer and seller valuation expectations, higher financing costs, and tighter credit availability relative to the same period in 2022.8
However, a lot has changed since the beginning of 2023: Inflation is slowing down, interest rates may be near their peak, many banks have failed, and the U.S. debt ceiling crisis has been averted. The buzz swirling around artificial intelligence (AI) may create opportunities and the right conditions for a more active M&A market in the near future.9
|Global M&A Activity|
|Deal Value ($B)||Deal Count|
As we near the end of 2023, we remain on the lookout for a potential recession while also monitoring fed funds rate cuts and the un-inversion of inverted Treasury yield spreads. The full effects of the resumption of student loan payments and ongoing UAW strike also have yet to be seen, while the downward trend of U.S. job openings further signals potential slowdowns in growth expectations.
In the credit market, the Fed continues to shrink its holdings of Treasury and mortgage bonds to reduce its balance sheet and as of September has trimmed nearly $500 billion from $8 trillion this year. Several banks continue to tighten lending standards, citing less favorable or more uncertain economic outlooks and reduced risk tolerance, and borrowers are turning toward additional debt capital providers. Meanwhile, third quarter 2023 saw slowdowns in PE dealmaking, exit activity, and fundraising. However, changing conditions – including slowing inflation, peaking interest rates, and buzz around AI opportunities – indicate potential for a more active M&A market in the future.
1 Debevoise & Plimpton.
3 Debevoise & Plimpton.
9 “Global M&A Industry Trends: 2023 Mid-Year Update.” PwC.
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