As we walk the back nine of 2024 (and from the play on the front nine, the 19th hole cannot come fast enough), there are a few things that are certain at this time:
rate cuts have not happened (as of August 8, 2024), even though most economists thought we would have had a 150 bps reduction in the terminal rate (R*) by the end of Q2 (and unless there is a full meltdown in the economy, I do not see rate cuts of more than 25 bps per quarter will happen this close to a presidential election—in fact (not to play conspiracy theory guy), if a significant rate cut happens and Trump is elected, every member of the Federal Reserve (the “Fed”) will be searching for a new job, while if Harris is elected, every member of the Fed will have to explain why rate cuts weren’t more than 25 bps per quarter);
inflation has not been transitory (even if CPI print comes in at less than 3 percent);
the M&A environment has not recovered (most pundits believed that 2024 would be a great year for M&A, but that has not transpired…more on that below); and
anything connected to artificial intelligence (“AI”) carries with it an equity/enterprise multiple last seen when Netscape[1] was waging a war on Microsoft for internet browser domination.
As many of my peers in the middle-market M&A space can attest, the deal flurry that once looked so promising heading into 2024 has stalled to a crawl. While there have been a number of large deals announced thus far in 2024, the middle market remains mostly unchanged from 2023. Some pundits and colleagues attribute the lack of activity to higher interest rates, others attribute it to the mismatch of the bid-ask spreads between buyers and sellers (i.e., valuation), and yet others say it is because the fundraising environment is generally poor.
Admittedly, it is likely all of the above; however, in the end (at least until AI takes control of every aspect of our lives), it is sentiment that controls how we react, interact and transact. For example, a great question that is asked and answered by corresponding data collected is Direction of the Country (Wrong Track/Right Direction). As of August 8, 2024, polling has indicated that 67% of people believe the country is headed on the wrong track, more then 2/3rds of people polled—that is meaningful.[2]
Sellers do not transact if they believe the market is at the bottom for one simple reason—it’s anathema to capitalism (even in a Bizzaro World, no one looks to buy high and sell low). Simply put, there is a disconnect between the bid-ask spread between seller and buyer. Buyers do not transact if they believe the market (i.e., valuation) has more room to fall; in other words, no one wants to catch a falling knife, and, clearly, buyers believe that sellers need a mental valuation correction.
If one “buys” the sentiment theory, then the next question is: How does sentiment turn positive? Admittedly, if I really knew the answer to the foregoing I’d be a very wealthy man. The answer is likely similar to (and directionally different from) Hemmingway’s quip on bankruptcy in the “Sun Also Rises:”
“How did you go bankrupt?” Bill asked.
“Two ways,” Mike Campbell said. “Gradually and then suddenly.”
“What brought it on?”
“Friends,” said Mike. “I had a lot of friends. False friends. Then I had creditors, too. Probably had more creditors than anybody in England.”
How do you tell when sentiment is moving in a positive direction? Two ways: first, friends/peers are talking about doing deals, traveling to look at deals and asking you about deals, and talking about missing out on deals; second, banks and private credit funds are accommodative. If/when banks (both commercial bank or “non-bank” banks) are competing over your transaction and lowering the barriers to enter into a loan (e.g., by lowering the LTV, agreeing to covenant-light terms, finalizing and issuing a term sheet within hours rather than days or weeks), then sentiment is moving in a positive direction.
To wit, I have not seen much of any of the foregoing; however, with the number of private credit funds now looking at deals, competition to lend may heat up.
Free Fallin
The billion-dollar question is: Will rates start falling, and if so, when? And once rates do start falling, will the cost of capital for borrowers decrease, or will lenders keep rates close to where rates are now?
The equity market is addicted to a “5-card Monte”/parlor game that generally predicts whether rates will increase, decrease, or remain the same. The government loves this “addiction” because it puts its policies front and center of everything, including controlling the animal spirits that power our economic capitalistic engine. It is a mutual co-dependence. Let’s be clear: the government (left/right/center/Democrat/Republican/Libertarian, etc.) loves being the most important thing in your life because…well, it is the most important thing in your life (like every organism, the federal government—heck any government wants to exist and be relevant).
Since 1977, the Fed has adhered to three (3) key mandates: (i) to effectively promote the goals of maximum employment; (ii) to stabilize prices and to moderate long-term interest rates (what is now commonly referred to as the Fed’s “dual mandate[3]” even though there are three components. For our purposes we are going to break up the last leg of the dual mandate into two separate components).
Thinking about the dual mandate, it would appear that the Fed has some wood to chop as it relates to two of its three main purposes. Can you guess which ones? I will give you a hint: the second largest population cohort in the modern history of the USA (the Baby Boomers, which were the largest, until the Millennials came around) is almost fully retired, while the smallest cohort (i.e., Gen X) is filling the upper management gap. However, the number of Gen Xers is not nearly big enough to fill the gap left open by the Baby Boomers, and the Millennials are not yet ready to fill those positions. The foregoing will result in labor shortages or tight labor markets for (likely) the next 10-15 years—and that is hoping that the Millennials even form “traditional” homes and/or have children. Accordingly, while there could be job loss (and indications from the May jobs report appear to support this), long-term structural unemployment does not seem to be an issue for the U.S. economy—unless of course AI teams up with robotics and we are all replaced by the T-1000 or Uniblab (email me if you know the reference and you’ll get a shout out in the next Earnout).
The other two mandates (i.e., the dual mandates) of stable prices and moderate long-term interest rates are more difficult because: (i) pricing dynamic is a complex indicator but is generally driven by demand and scarcity—both of which are greatly affected by consumer wealth (e.g., I have extra money and I want that new car) and scarcity (e.g., think back to the cabbage patch kids of the 1980s); and (ii) moderate long-term rates are not easy to achieve—in fact, good luck with that due to the record debt-to-GDP ratio, cash spent on entitlement programs, and helicopter money pushed by the government’s and the Fed’s monetary policy (thank you, Milton Friedman).[4]
Here are some other relevant stats (courtesy of Clinton Investments[5]):