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September 2024
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Jerome Powell was more than crystal clear for once in his speech delivered at the annual meeting of central bank officials in Jackson Hole. He said that the time had come to lower interest rates because inflation is on a sustainable path toward 2% and downward risks to the employment market have increased. The kickoff of a US rate-cutting cycle on September 18 is now clearly preordained and is likely to happen in the form of a small 25-basis-point step. A bigger rate cut is not warranted by the current macro data and would only needlessly inflame the rhetoric in the final stage of the US presidential election race.
Volatility event
The correction on stock markets that began in July accelerated at first in August. An unexpected interest-rate hike by the Bank of Japan and a poor US labor market report caused the VIX volatility index to spike to above 60 in a flash. That panicky volatility reading was quite outsized in relation to the drawdown in the S&P 500 index, which came to “only” 10% at its trough point. The explanation for this latest volatility event thus owes more to technical market factors. However, the shakeout of investors’ previous extreme positionings is desirable for the longevity of the equity bull market. At the same time, it could mark the kickoff of a sustained rotation in the equity market.
Performance trouble spot: Private equity
The machinery of private equity has been sputtering ever since zero and negative interest-rate policies came to an end. While fund managers are increasingly coming under pressure to deliver their promised performance not just on paper but also in the form of capital distributions to investors, institutional investors are asking themselves whether they need to tweak their portfolio allocations. The private equity industry, as always, is very creative in its efforts to live up to its reputation of consistently churning out high returns, with attendant risks and side effects – as well as opportunities for private investors.
People who were on a well-earned summer vacation in August (and were able to take their eyes off the stock market ticker) may likely think that they didn’t miss anything while they were away. But if they didn’t find out before, at the latest they learned from their office colleagues that their presumption is way off the mark – things were indeed very volatile in the interim. The intraday high in the VIX index on August 5 stood at above 60, joining the ranks of other historical volatility events like the great financial crisis in 2008, the euro crisis in 2011, Volmageddon in 2018, and the outbreak of the COVID-19 pandemic in 2020. But what exactly happened this time? Just a small interest-rate hike by the Bank of Japan and a weak US labor market report. The disproportion between cause and effect has a number of different reasons: persistent elevated macro uncertainty in the post-pandemic economic cycle, investors reading too much into almost every data point of (medium) importance in an effort to deduce the corresponding central-bank policy, herd behavior on the part of investors, the increasing use of derivatives, and the growing prevalence of systematic trading strategies.
Jerome Powell was more than crystal clear for once in his speech delivered at the annual meeting of central bank officials in Jackson Hole.
Chart
Source: Bloomberg
Macro Radar
Taking the pulse of economic activity
Time for interest-rate cuts
Jerome Powell was more than crystal clear for once in his speech delivered at the annual meeting of central bank officials in Jackson Hole. He said that the time had come to lower interest rates because inflation is on a sustainable path toward 2%. Now that the US Federal Reserve is thus well on the way to fulfilling its price stability mandate, the central bank’s second target objective – achieving full employment in the labor market – is now moving into the spotlight. The employment market has cooled down substantially in recent months, even if the August revision of the number of new jobs created over the 12 months ending in March 2024 (–818,000) possibly paints an overly negative picture. The kickoff of a US rate-cutting cycle on September 18 is now clearly preordained and is likely to happen in the form of a small 25-basis-point step. A bigger rate cut is not warranted by the current macro data and would only needlessly inflame the rhetoric in the final stage of the US presidential election race.
Fine-tuning of recession expectations
The health status of the US employment market is also vitally important to a long-burning question among economists: Does a recession loom in the USA next year? The research department at Goldman Sachs has recently been especially active in fine-tuning its recession expectations. After its analysts raised the probability of a recession to 25% in early August in view of a weak labor market report, better data on retail sales
and a drop in initial unemployment claims prompted them to lower their estimate to 20% just two weeks later. There’s good reason for the uncertainty. Recession indicators that were reliable in the past have failed completely in the current cycle (Conference Board index of leading indicators) or have long since passed their signaling half-life (inverted yield curve). Even the Sahm Rule, which heretofore had worked unfailingly, has to be viewed with caution these days (see “Ask the experts” on page 15).
Olympics euphoria obscures weaknesses
The Olympic Games fueled optimism among service-sector businesses in France, causing the corresponding purchasing managers’ index to jump from 50.1 to 55 points in July. However, it was the only glimmer of light – and probably a short-lived one at that – in the otherwise dismal European macro data lately. Meanwhile, sentiment in the French manufacturing sector fell back to its lowest level in three years and is unable to decouple from the persistently weak economic condition of neighboring Germany. The European Central Bank will take the continued stagnation in the largest Eurozone countries into account in its monetary policy and looks set to implement another interest-rate cut on September 12. Switzerland, in contrast, has been able to decouple since the COVID-19 pandemic. So, a further rate cut by the Swiss National Bank on September 26 would have a different motive – not overly weak economic activity, but an overly strong currency.
A French summer fairy tale | Buoyant sentiment, but for how long? Purchasing managers’ indices
The correction on equity markets that began in July accelerated at first in August.
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Equities: Volatility event
Asset Allocation
Notes from the Investment Committee
• The correction on equity markets that began in July accelerated at first in August. An unexpected interest-rate hike by the Bank of Japan and a disappointing US labor market report caused the VIX volatility index to spike to above 60 in a flash. That panicky volatility reading was quite outsized in relation to the drawdown in the S&P 500 index, which came to “only” 10% at its trough point. The explanation for this latest volatility event thus owes more to technical market factors such as investors’ one-sided positioning in Big Tech stocks, generally overly bullish investor sentiment, and the increased prevalence of systematic trading strategies. The risks portending the momentum crash that occurred had been latent for months and erupted in the form of a summer thunderstorm.
• The shakeout of extant extreme positions is basically desirable for the longevity of the equity bull market. At the same time, it could mark the kickoff of a sustained rotation in the equity market because the shift that began in July into stocks that theretofore had tended to be neglected by investors has continued in recent weeks. Meanwhile, market breadth has widened lately. For example, the equal-weighted S&P 500 index already hit a new high in August while its better-known capitalization-weighted counterpart was still off its peak. Yet it remains to be seen how long this trend will continue because
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there have already been several rotation false starts over the past few quarters. Fundamentally, however, the “rest of the market” catching up to the “Magnificent 7” wouldn’t be unjustified. In Q2 of this year, the other 493 companies in the US blue-chip index contributed to earnings growth for the first time in five quarters. Moreover, analysts’ forecasts project a further acceleration of earnings growth at smaller companies versus Big Tech in the quarters ahead.
• During the midsummer weeks, heavy downward pressure particularly weighed on the equity market in Japan, where the Topix index intermittently plummeted by 25% in veritable crash style. However, the extent to which (foreign) investors were affected depended on whether they had exposure to the yen or were invested with a currency hedge. For those who eschewed currency hedging, the nightmare was quickly over because the Japanese stock market has recently climbed back to close to a new all-time high in US dollar terms. Refraining from
currency hedging would seem the thing to do also in the months ahead. The monetary-policy divergence between the Bank of Japan and the other central banks suggests that the yen’s protracted phase of weakness may be over.
Fixed income: Portfolio parachute
• (Long-term) government bonds acted as a parachute for well-diversified investors’ portfolios during the summer correction on the equity market. A pullback in yields to as low as 3.7% on 10-year US Treasury notes and to 2.1% on German Bunds of the same tenor went hand in hand with tidy price gains. However, at these levels, the risk-reward tradeoff on government debt securities is now no better than balanced because this means that a good portion of upcoming interest-rate cutting by the US Federal Reserve (and the European Central Bank) is already priced in. Further price gains and yield declines would only be in the cards in the event of a doomsday scenario of an impending recession. The probability of this worst case occurring, though, is currently still well below 50%. Investors should wait for a higher yield level to top up a position in government bonds as an implicit portfolio hedge against an economic downturn.
• Credit spreads on high-yield bonds are also showing few signs of an imminent recession. In the past they have regularly signaled a certain degree of stress beneath the surface. However, in the latest market episode, they rapidly recovered just like the equity market did and were already back close to their year-to-date lows at last look. High-yield bonds are an unattractive asset class at the moment for new investments. Insurance-linked bonds, in contrast, continue to beckon with higher return potential, and we would prefer them in comparison.
Alternative assets: Rollercoaster ride for trend-following strategies
• Trend-following strategies (CTAs) ranked among the biggest winners in the early months of 2024. They benefited from clear directional trends in the prices of commodities, bonds, stocks, and several currencies. At the end of April, the SG Trend Index was up almost 15% for the year. However, a number of breaks in the trends in a variety of asset classes since then have caused the benchmark index to shed quite a few feathers. The recent summer thunderstorm on financial markets caught CTAs with long positions in stocks and short positions in the Japanese yen on the wrong foot once more. In August, the SG Trend Index’s year-to-date gains were entirely erased for a while. Up-and-down markets and momentum crashes are the worst possible environment for systematic trend-following strategies. At the same
time, they separate the wheat from the chaff in the CTA universe. Even in the wake of the turbulence in recent weeks, there are some products that are still up by double digits year-to-date. The mission for investors is to ferret out those gold nuggets through comprehensive due diligence.
• Speaking of gold, the yellow precious metal hit yet another new high in August at a price above USD 2,500 per ounce. The very weak US dollar lately and the pullback in bond yields (which lowers the opportunity cost of holding gold) place the path of least resistance for bullion clearly on the upside. Investors see it the same way – a resumption of continual net inflows into gold ETFs has been observable since June for the first time in a long while. So, now a third group of buyers has joined central banks and the Asian middle class in driving the gold bull run.
Currencies: EUR/USD cross at year-to-date high
• EUR/USD: The euro has held up very robustly against the US dollar throughout the entire year thus far in spite of anemic European economic data. After the poor US labor market report in early August, the euro’s resilience conclusively turned into overt strength. The upcoming Fed pivot caused market interest-rate differentials to narrow in advance in favor of the euro. At an exchange rate in the area of 1.12 against the USD at last look, the euro now already has last year’s high in its sights. That is likely to restrain the euro rally of the past few weeks for the time being. A sustained breakout above last year’s high would be a strong buy signal.
• GBP/USD: The GBP/USD exchange rate already vaulted past its 2023 high in August, once again reflecting the high-beta nature of the British pound, which benefits more than average from switches back to risk-on mode on the equity market. But UK economic data also argue in favor of the pound at the moment. In contrast to the Eurozone, sentiment surveys on the UK economy have surprised on the upside lately. This suggests that the Bank of England will not outpace other central banks in the global rate-cutting cycle.
• EUR/CHF: The turbulent unwinding of the yen carry trade had repercussions also for the Swiss franc. It, too, appreciated substantially as a result of the closing of short positions and briefly hit a new record high against the euro. The available data give reason to suspect that the Swiss National Bank intervened in the currency market at that point, causing the EUR/CHF exchange rate to briefly lurch back to the middle of this year’s trading range. However, the force of gravity has already taken hold again lately. The strength of the Swiss franc makes another interest-rate cut by the SNB likely in September.
Credit spreads on highyield bonds are also showing few signs of an imminent recession.
Yields on Chinese government bonds have known only one direction in recent months: down. That sends a sign of slumping economic growth and lurking deflation to economists and has bestowed pleasing price gains on investors, but in the eyes of the People’s Bank of China (PBoC), it presents a risk that must be combated. Chinese authorities see a bubble and are warning about the risk to financial stability. Their concern is that banks’ speculation in government bonds could backfire if the interest-rate trend reverses someday, similar to what happened to Silicon Valley Bank with its holdings of US Treasury bonds last year. They seem willing to resort to even unconventional means to prevent that from occurring. An official investigation of four small banks in a neighboring province of Shanghai came to light at the start of August. They were accused of manipulating prices of government bonds on the secondary market. Their offense evidently consisted of having snapped up bonds when larger state-run banks were selling them. Finally, at the end of August, the PBoC started stress testing banks. As long as the underlying economic conditions do not change, it is doubtful that Chinese regulatory authorities will be successful in their efforts.
Chart in the Spotlight
Theme in Focus
Performance trouble spot: Private equity
The machinery of private equity has been sputtering ever since zero and negative interest-rate policies came to an end. While fund managers are increasingly coming under pressure to deliver their promised performance not just on paper but also in the form of capital distributions to investors, institutional investors are asking themselves whether they need to tweak their portfolio allocations. The private equity industry, as always, is very creative in its efforts to live up to its reputation of consistently churning out high returns, with attendant risks and side effects – as well as opportunities for retail investors.
Are the good times over?
The job of a private equity manager used to be easier than it is these days. The last two years have proven to be extremely difficult for the industry. The combination of a precarious macroeconomic climate, heightened geopolitical risks, temporarily overshooting inflation, and massively increased market interest rates has thrown a lot of sand in the gears of the deal machinery of the private equity industry. The number of transactions in 2023 was around one-third lower, and the transaction volume 60% lower, than in the peak year 2021. Exits – i.e. sales of portfolio companies that produce a profitable ka-ching for investors (by allowing capital to flow back to them) – actually even decreased by 70% compared to 2021 in volume terms and were the lowest on record since 2013. The steep plunge was caused by a veritable blockage of traditional private equity exit routes. In prospective sales to other private equity managers, bid and ask prices were often (too) far apart – while sellers were still gunning for valuations that prevailed in the era of ultralow interest rates, valuations of that kind often were no longer thinkable for buyers in the face of increased interest rates and the resulting altered financial arithmetic. Only the very best assets were sellable. Strategic buyers wishing to strengthen themselves by taking over a small competitor also tended to exercise restraint last year. And the third option – the classic initial public offering (IPO) –likewise was hardly practicable up until a few months ago due to insufficient investor appetite. The IPO volume in 2023 was 90% lower than in 2021.
The deal carousel spins on…
At the start of 2024, the private equity industry was looking ahead to the year with calculated optimism. After all, inflation by now is indeed no longer an issue. Moreover, (US) economic activity has stayed robust to date, and the mergers-and-acquisitions (M&A) market has recently picked up. However, hopes for a series of interest-rate cuts by the tone-setting US Federal Reserve have not been fulfilled thus far. So, buyout activity
Stabilization… | …at a lower level
Volume of buyout transactions worldwide (in USD billion)*
Source: Dealogic (*2024 estimated based on data January to June)
has normalized at a lower level than before. If one extrapolates the transaction data from the first half of 2024 to the full year, the volume of new deals and exits is likely to turn out only slightly higher than last year on the bottom line. The IPO space illustrates just how challenging the climate remains. Alongside successful exits via the stock market such as in the case of Swiss skincare specialist Galderma in March, in which private equity manager EQT was one of the players on board, there have also been recurring mishaps. The managers at Permira, for example, pulled the emergency brake on their planned initial public offering of shares in Italian luxury sneaker manufacturer Golden Goose at the proverbial last minute in mid-June (after a 10-month preparation) to avert a debacle like the last Permira IPO, which resulted in shoemaker Dr. Martens now trading at just one-fifth of its original value three years after having gone public.
The fundraising scene also provides evidence that the auspices for the private equity industry have changed. Many a manager these days is finding it hard to reach the planned target sizes for new fund vehicles and oftentimes has to postpone the final closing date. The
At the start of 2024, the private equity industry was looking ahead to the year with calculated optimism.
more than 14,500 private equity managers worldwide by now make competition in the sector extremely fierce. Moreover, in a (monetary) climate that has become more difficult, investors are differentiating between them more and more critically, seeking mainly managers with proven expertise and a long track record of success. As a result of this, a few megafunds are splitting the largest slice of the pie of newly raised money among themselves. Although the number of new funds decreased again year-on-year in 2023 by 38%, the average fund size actually increased by a good 80%, resulting in the raising of a record total of almost USD 500 billion of fresh capital. The 20 largest funds alone took in more than half of all new capital commitments, with European private equity titan CVC setting a new record for the biggest buyout fund (EUR 26 billion). The indications from the first half of 2024 thus far bespeak a continuation of the trend toward an ever narrower concentration of assets between the largest private equity managers. In the first six months of this year, the 10 largest funds scooped up 64% of all the new money.
Increasing concentration | Brand-name managers are attracting more and more money
…because it must
The amount of dry powder accumulated in the industry as a result of the continual raising of capital has swelled to more than USD 1.2 trillion at last look for classic buyouts alone (excluding growth and venture capital). A good quarter of that capital has been sitting idle for more than four years now because private equity funds have not called it from their investors yet. In cases of this kind, managers slowly run out of time to find suitable investment candidates because private equity funds typically have an investment holding period of five to six years. The same can be seen on the sell side. Around half of all companies currently owned by private equity firms have been in their hands for more than four years already (median age: 6.1 years). Meanwhile, the intended holding period upon acquisition usually is four to six years. The invested private equity universe (buyouts) currently consists of a total of 28,000 companies with a combined market value amounting to a good USD 3.2 trillion. The pressure on private equity managers is slowly but steadily mounting. The “traffic jam” that has arisen must be unsnarled, and the performance machinery must be put back into motion, not least also because investors are increasingly growing impatient. Since most private equity funds in recent years have called more capital than they have returned in distributions, investors increasingly lack the financial means to make capital commitments to new funds and to keep their private equity portfolios rotating. As a result of the muted exit activity, around three-quarters of all investor portfolios were cash-flow negative last year. The last time the disparity between capital calls and distributions to investors was as wide as it is today was back in 2008 (in the midst of the Great Financial Crisis). The cash-flow problem is being exacerbated more and more by “zombie funds,” which have extended far beyond their standard 10- to 12-year lifespan and are sitting on (evidently) unsellable assets. Many (new) investors in private equity have likely received a rude awakening over the last two years because the hidden liquidity risks of classic private equity funds are now becoming visible in tough times.
Creativity is called for…
Private equity managers have no shortage of creative ways to keep the deal carousel spinning. They employ a variety of sometimes questionable strategies to maintain an ability to return capital to investors:
• GP-led secondaries: General partner (GP)-led secondaries are one increasingly popular exit option. Under this strategy, a private equity manager retains ownership of one or multiple companies instead of selling them to an external buyer. The portfolio companies are simply shifted from one fund wrapper to another, enabling old investors to be paid off this way. Normally, however, managers can only execute transactions of this kind with their star companies. So, in this sense, this type of “creativity” is the one least worthy of criticism. On the contrary, in fact,
Source: Preqin
The 20 largest funds alone took in more than half of all new capital commitments.
GP-led secondaries frequently present good opportunities for new investors and enable them to participate in the future growth potential of a manager’s best assets.
• Dividend recapitalizations: Dividend recapitalizations are another way of returning capital to investors. Under this strategy, a private equity manager encumbers its portfolio company with additional debt for the sole purpose of using the money raised to pay out a dividend. This maneuver, of course, further increases the leverage ratio of companies that are often already loaded with debt as is. Dividend recapitalizations nonetheless are very much in vogue right now, in large part because investors have a big appetite for debt at the moment and credit conditions have become a bit cheaper lately. In the first half of this year alone, USD 36 billion worth of leveraged loans were raised worldwide to fund dividends. This strategy was carried to an extreme by private equity manager 3i with its portfolio company Action. After investing (just) EUR 130 million in the Netherlands-based discount store chain in 2011, 3i has since paid out several billion euros to investors via a total of eight dividend recapitalizations.
• NAV loans: A related variant is net asset value (NAV) credit facilities under which private equity managers take out loans that are secured by an entire portfolio of companies. This, too, enables managers to return capital to their cash-hungry investors without having to sell assets at a potentially bad price. But NAV loans are not necessarily inexpensive, and they diminish investors’ end return in any event because they indirectly have to pay the interest expenses themselves.
However, when faced with private equity’s performance problem, institutional investors like pension funds, sovereign wealth funds, and foundations do not have to depend solely on managers’ hacks and tricks. They can practically obtain liquidity on their own by selling part of their respective private equity portfolios on the secondary market. The market for LP-led secondaries of this kind has grown rapidly in recent years. The motives of the sellers vary here. Many an investor just would like to reduce the number of managers in its portfolio while others would like to tactically shift portfolio weightings or bring their portfolios back in line with their strategic asset allocation. Unlike in the early days of secondaries, financial difficulties in servicing capital calls are no longer the most frequent motive for selling. Nevertheless, sellers tend to have scant bargaining power, which is why private equity portfolios usually come onto the secondary market at a discount price. In most cases, buyers not only get an attractive price, but frequently can also cherry-pick from the portfolio put up for sale.
…and so is handcraft Strategies for dealing with the cash-flow problem are just one aspect. Another matter at least equally as important for investors is performance. Private equity
Only with a discount | Buyers are at an advantage in an illiquid market
Secondary market prices for buyout and venture capital portfolios
managers have had to do some rethinking here as well ever since, if not before, central banks’ zero and negative interest-rate policies came to an end. After a decade in which the high returns in the industry were driven primarily by revenue growth and valuation expansion, the focus in the future must be concentrated much more on operational improvements and profit-margin growth. The days of financial engineering and valuation arbitrage are likely over for a long time because a return to the monetary policy environment that prevailed prior to the pandemic is not in sight anytime soon. Industry spokesmen see it the same way, or at least most of them do. The CEO of private equity firm New Mountain Capital aptly put it this way: “I preach against the old private equity model of 40 years ago where people think you borrow as much as you can, go play golf, and see if it all worked out in five years.” Private equity managers focused on a specific sector are particularly likely to be at an advantage in the future. They seem to be the ones most capable of using a proven playbook to guide their portfolio companies on a path to success.
Performance prospects for retail investors
Whereas the current environment is challenging for managers and institutional investors in equal measure, private equity presents great opportunities for retail
Easy was yesterday | Margin growth looks set to gain importance Value drivers in global buyout transactions (2013–2023)
Private equity managers focused on a specific sector are particularly likely to be at an advantage in the future.
Source: Bain & Company
Source: Jefferies
Private equity underperformed the booming (US) stock market last year.
investors. Innovative products enable them to tap this asset class these days with smaller investment amounts and low administrative expenses without having to put up with typical pitfalls. The liquidity problem particularly can be bypassed with evergreen funds. These semi-liquid vehicles enable not just a full investment of capital in a timely manner through monthly or quarterly subscriptions, but also enable divestments if so desired within a reasonable time frame (usually three to 18 months).
The number of evergreen funds on the market has increased considerably over the last three years, in large part because big private equity managers like Blackstone, KKR, EQT, and their peers by now have discovered the retail wealth channel as a new source of money for themselves. For retail investors, simply having access to private equity is no longer all that’s important; so
is having a selection of (the best) products within the ever-expanding universe of semi-liquid private equity funds. Fee structure, portfolio composition, underlying substrategies, and the toolboxes employed by managers are examples of key criteria that make the difference between mediocre and good investment products.
Private equity underperformed the booming (US) stock market last year. Despite the challenges, though, the industry nonetheless continued to generate solid double-digit percent returns in 2023. Private equity remains out in front in a long-term return comparison over five and ten years. We are operating on the assumption that investors can continue to earn a return pickup of 200 to 300 basis points per annum with private equity in the years ahead, provided that comprehensive due diligence is performed and good selection choices are made.
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