We are in market utopia centuries in the making. Not hyperbole, I swear.
Aggregate government indebtedness has never been higher. Cheap capital has never been as abundant. Fiat currencies have never been more debased. US stocks have rarely enjoyed such a smooth, unbroken push to record highs. The unemployment rate has fallen to dot-com bubble lows. And private markets are enjoying an overplus of dry powder, high deal multiples, more unicorns, and a “reach for yield” dynamic with LPs hungry for more.
And it all could be on the verge of ending with interest rates set to move higher, potentially upending the 25-year bull market in bonds and challenging many of the assumptions that have underpinned the financial markets in the modern era. Not only could this increase the risk of another recession, but it raises the risk of another financial crisis as well.
Rates are on the move.
US Treasury yields have been drifting higher off of the lows set in early September, with the 10-year returning on Tuesday to levels not seen since March. As seen above, the two-year yield, after a tepid auction, has pushed to highs not seen since 2008 at 1.6%, a 10-fold increase from the low of 0.16% set in 2011.
This is a consequence of the Federal Reserve’s policy tightening cycle—”Don’t fight the Fed,” and all that—which started back in December 2015 and accelerated this month as policymakers started the process of rolling back their bloated $4-trillion-plus balance sheet. Also, a creeping sense inflation is about to jump higher driven by tight labor market conditions and steady GDP growth.
Bank of America Merrill Lynch economist Ethan S. Harris outlines a number of reasons to expect higher inflation, and thus higher interest rates, in a recent note to clients:
- Job openings as a share of the labor force is a metric that has continued to rise and is now at the highest level in the 17-year history of the data series.
- The output gap—the measure of the economy’s output vs. its full potential—continues to shrink, according to estimates from the Congressional Budget Office, the International Monetary Fund, and the Organization for Economic Co-operation and Development.
- Rental vacancy rates are near the lowest in more than 20 years.
- Industrial sector capacity utilization is rising as supplier deliveries are at the slowest since 2004.
But why would higher inflation and higher interest rates be worry? Deutsche Bank strategist Jim Reid, in the bank’s latest long-term asset return study, warns it could trigger not just a typical recession but a new crisis, given the dangerous connection between higher government debt and more frequent financial shocks.
This comes at a time of extreme valuation highs in both equities and bonds, as shown below. Possible triggers for a crisis include:
- Central bank stimulus unwinding after developed market central banks increased their balance sheets from $4 trillion to $14 trillion since 2008
- Aging economic expansion, with the US expansion already the second longest in history
- Demographic pressures from a peak in the Chinese labor force, which could turn the recent era of secular disinflation on its head
Reid warns: “With inflation naturally creeping up, it will become more difficult to control economic cycles and asset prices.”
Percentile Valuations of 15 DM Bond and Equity Markets
The last bout of higher interest rates, public market turbulence and economic weakness in the 2007-2009 period hit PE funds particularly hard. The two-year Treasury yield increased from a low of 1.1% in 2003 to a high of 5.3% in mid-2006—breaking the back of the housing bubble, kicking off the recession in December 2007 and pushing rates down to a low of 0.7% in late 2008 in the midst of the financial crisis.
As rates rose during the last economic expansion and the bull market matured, median global PE IRR more than halved from a median of 16.9% for the 2003 vintage to 7.9% for 2006 vintage funds. PitchBook analysts note that this coincided with increased competition for deals and higher deal multiples enabled by cheap capital; a dynamic that is in play again right now.
Then the recession hit.
US PE deal count more than halved to a low of 415 in 2Q 2009 while deal value fell from a high of $292 billion in 4Q 2007 to a low of $29 billion in 3Q 2009. Buyout activity, median deal size and deal multiples all contracted; despite the fact the industry held nearly $460 billion in dry powder during the recession.
Fundraising took a hit as well, as capital raised in the US fell from $269 billion in 2007 (into 309 funds) to just $72 billion in 2010 (into 160 funds).
Overall, the bottoming of interest rates in 2003 into the peak of 2006 and the recession of 2007 that followed ushered in the start of nearly decade of lukewarm relative returns for the PE industry compared to public markets. A consequence of diminished IRRs and the roaring post-recession performance of the stock market.
Is a repeat on order? Perhaps.
Although much of the post-crisis excess suggests 2007-2009 was a mere prelude to what comes next. The combination of massive debt, high bond prices and extended asset prices valuations—what’s enabled this easy status quo in markets—has been quelled by a singular factor: Ultra-low yields.
Once that changes, the ground will shift in ways sure to catch everyone by surprise. My advice, wrapped in a metaphor: Widen your stance.
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Article by Anthony Mirhaydari, PitchBook