Volatility and it's impact on markets, the economy, IPOs and M&A

I?wanted to expand on my recent thoughts around recent economic news and market volatility, and the potential for a correction.? My best guess is that if a correction is to happen, it will start to happen before year-end, but it is too early to tell.? The depth of the correction will be determined, as always, by the health of the credit markets and the ability to avert real breakage in riskier asset classes.? At this time, I believe those risks are reasonably small (unlike in the GFC) and we should pay careful attention to news coming out of the global commercial banking and private credit systems (not just here in the US).??

The Good News: While IPO and M&A activity could slow temporarily during a period of heightened volatility, there is huge pent-up supply of quality businesses and a huge amount of dry powder in private and public markets.? In all likelihood, PE, Growth Equity and VC firms will dramatically accelerate exits even before the dust has settled, having been bitten by waiting too long in 2023 and 2024 as valuations contracted.? IPO markets may benefit the most, as sellers seek any exit, and declining interest rates will cause valuations to increase, probably beyond what the late-stage private markets are willing to pay (especially for companies growing quickly but still not meaningfully profitable) in 2025-2026.

Backdrop:? Markets have returned to health. Significant dry powder exists in all markets.? Rate cuts will lower the cost of capital. However, public debt and equity markets appear overly complacent given the shifting sands in the economy

• IPO and M&A markets have started to improve in 2024 as the spread between bid and ask has narrowed from the lofty expectations that sellers had in 2022 and 2023
• Equity markets have performed well since October 2023 but it has largely been concentrated in large cap tech.??
• The Companies that have gone public in 2024 have been well received by investors and have traded well
• Stock market volatility has been low, and credit spreads have remained tight (High Yield vs IG).? This has worried market strategists as the economy enters a less certain phase.
• Private company valuations have declined anywhere from 20-60% for companies funded between 2018-2023 putting significant strain on PE, growth equity and Venture funds who are under increasing pressure to return money to LPs forcing many PE funds to use debt secured by GP to return capital
• According to Goldman Sachs there is significant dry powder for PE ($1.2T) and Private Credit ($443B) which is bullish for M&A
• The Fed is signaling that rate cuts are forthcoming
• Inflation has moderated but job growth should slow, and the unemployment rate should continue to rise

Markets and the Economy:? If we do not get a bear market or recession post-pause, it would be an anomaly.? Job growth and unemployment are rising and spending is slowing. Recent volatility is unwelcome as it often forces irrational investor behavior if it persists. I expect volatility to continue to be elevated at least through the election, where bad news in the economy and geo-politics will cause outsized moves to the downside.

• When it comes to the Fed versus the Economy in a divergence knife fight, the economy almost always wins and that determines the health of the markets in the near and medium term.
• Bear markets and recessions almost always occur AFTER the Fed pauses a material tightening program.? The reason for the tightening - exceptionally strong consumer spending from COVID free money coupled with unrestrained price hikes for food, energy, housing, transportation etc - may also be the reason for a recession as the global economy cools and consumers pull meaningfully back.? The only instance where a bear market/recession did not occur after meaningful tightening was in 1995 when the Fed under Greenspan acted proactively and decisively.?

• In the last 2 weeks, three things happened that rattled the markets: 1) the Fed did not cut rates at their July meeting.? They do not meet again until September 17-18; 2) the July jobs number came in much weaker than expected; and 3) Japan raised rates and signaled further tightening, which caused significant unraveling of the Yen Carry Trade, causing losses at banks and funds, and worrying economists that Asian economies will slow.
• June quarter earnings reports were largely ok (except for energy, healthcare and consumer discretionary), but overall guidance for September earnings was more muted than expected
• In tech, there have been rumblings that software spending may slow as companies try to figure out how AI will ultimately impact their tech stack.? However, as AI enhanced applications become enterprise-ready, a spending cycle not seen since the advent of the internet is likely to ensue
• Warnings from the likes of Disney, AirBnB, Amazon and others about the growing cautiousness of their customers
• As a result of the above, the stock market, which had not had an up or down 2% day in 346 trading days has had?three?in the last two weeks, and volatility in the public markets swung sharply higher
• In general rising volatility is not good for the stock market, the equity issuance market, or the M&A market

• Historically, market pain has occurred most prominently in September and October while the best months have been July and April
• Some strategists have made the case that there is a strong likelihood?that this time may be different.?
• Reasons include: Unlike past Fed tightening cycles where Net Interest Payments paid by the Corporate and Household sectors rise dramatically, over the last 2 years Net Interest Expense has actually declined meaningfully.? This is probably due to Corporates locking in very low-cost medium and long-term debt during the 0-interest rate period, and households locking in low rate 30 year mortgages during COVID.? This makes debt service easier and leaves plenty of continued room for CapEx and Consumption.? In addition, the jobs and unemployment number may be skewed by high immigration in the last two years causing a rise in the effective labor supply. Wage growth has remained strong.?
• However, as Mohamed El-Erien and John Authers point out, there is more stress in the revolving credit markets such as credit card and auto loans, which could be a canary in the coal mine.

• The last few weeks of heightened volatility and market sell-off by no means represents the beginning of a trend, but it is a yellow flag, especially given recent economic reports and earnings call commentary from some very large companies

Markets are merely the sum of investor emotional response to events, past, present, and anticipated:? So, what should we expect over the next few months which could alter investor, corporate and consumer behavior?

• Having been through five economic cycles in my career, I have seen this movie before. Tremors are just tremors and do not automatically portend an earthquake.? However, tremors tend to be more pronounced in the periods between August and November and investors tend to want to take gains and losses during this period, which can exacerbate market moves
• Tremors can also start to alter corporate and consumer behavior.? Public companies can be more cautious on their earnings calls in October/November.? Budgeting can tighten a bit.? Sales cycles can extend heading into year-end. Payables can extend and cash preservation becomes more of a focus, especially in small to medium sized businesses that are more likely to see strain early.
• Conviction can get rattled
• And, as I have said in the?past, there is more likelihood that bad news is interpreted as bad for the markets, as opposed to bad news being deemed good for the economy and hastening Fed action

Potential Systemic Risks in a Slowing Economy: Are bank balance sheets the elephant in the room? While there is no evidence that the system is stressed enough to become a problem, it bears watching

• During COVID, banks stopped extending credit.? Immediately afterwards, banks opened the spigots and ballooned their balance sheets.? Many critics have commented that underwriting standards since 2022 have been weaker than past periods as the Fed has encouraged banks to prop up the economy.? As the Fed tightened, banks reduced lending
• Commercial real estate is perhaps the biggest exogenous risk as the labor market has meaningfully shifted from full time office work to hybrid or work-from-home, while retail storefronts continue to evaporate due to eCommerce.? During COVID banks allowed many CRE borrowers to extend maturities out 3-5 years and those loans are now coming due from 2024-2027 which will certainly set a record for defaults
• Banks also hold record amounts of unrealized losses in Investment Securities (which helped bury SVB) and asset prices could fall in a slowdown, creating even more losses?
• Similar to past economic expansions, loan loss reserve ratios have stayed at the low end of historical norms.? Banks will often contribute to creating a recession during and after a period of tightening as they pull back on lending (in favor of risk-free treasuries) that fuels consumption and capital investment, and then dramatically pull back further as loan losses mount
• The combination of the ballooning in consumer credit post-COVID, a huge CRE burden, complacent loss provisioning, and a slowdown in the economy, makes the banking system vulnerable in the next two years

Look forward to your thoughts!