01 Feb Q1 Economic & Market Outlook
The Deal Window is Open:
After an explosive equity rally in Q4 of 2023, investor confidence is running high across most asset classes. This confidence has resulted in higher asset prices, fund flows into risk assets, and increased consumer spending. At the same time, the Federal Reserve (FED) jaw-boned down interest rates and the markets began expecting significant interest rate cuts in early 2024.
This optimism around lower interest rates helped supercharge equity and bond market returns. In December, interest rates were down almost 100 basis points (bps) across the entire yield curve. The lower yield environment, higher consumer confidence, and risk on mindset has created an excellent environment to get M&A deals done through early Q2. The window is open for deal flow in the first half of 2024.
Interest Rates: We believe the market has exaggerated expectations for lower interest rates in 2024, and we expect rates to drift back up 25-50bps in early Q1 as the market recognizes their optimism for rate cuts was too aggressive. In addition, US Treasury debt issuance will accelerate in 2024 as the government continues to run large deficits, requiring the bond market to absorb more supply (at likely higher rates).
As we get through this Q1 rate pressure, expect rates to drift lower as the consumer reaches spending exhaustion- as credit limits are maxed out. However, this push/pull on rates will end up with rates staying relatively stable, allowing for stability in risk assets. Lower interest rates likely need to wait until early Q3 2024, and when it becomes clear they will resume a downward trajectory there will be some short-term pop in risk asset markets.
VIX/Volatility: After a tumultuous 2023 (2 wars), we will see another year of elevated volatility as we approach the 2024 election. Normally, election years are positive for risk assets, however, 2024 will likely be different given the lack of serious GOP challengers to Trump and Democratic challengers to Biden. Markets are familiar with both these candidates and will expect more of the same from either. Expect continued escalation in the Mideast, translating to more volatility in the oil markets. Overall, factors will generally balance out volatility in early Q1-Q2, resulting in stability in risk markets.
Liquidity: The FED will continue quantitative tightening (QT) through Q1, putting funding stress on bank lending markets. However, after many years of excess bank reserves throughout the banking system this will only impact lending on the margin.
We do expect lending standards to remain higher, but not tighten significantly until mid-Q2. There remains significant cash on the sidelines available to be invested, if the risk/return profile is appropriate. However, as election rhetoric heats up in Q3/Q4, and lower summer liquidity kicks in, September/October could get dicey.
Deal Flow (Supply/Demand): After almost three years of a sellers’ market, we expect deal leverage to move towards buyers. We expect sellers who had been waiting on the sidelines to enter the market with the recognition that they have missed the top and do not want to run the business through the next downcycle. This will increase the supply of technology firms available.
On the demand side, we expect the market to see some new strategic entrants, as they finally see reasonable values and return profiles. We continue to see cashflow as king, over revenue growth in Q1/Q2 of 2024, however, as rates fall in H2- look for this to begin shifting back to revenue growth.
As interest rates remain elevated through Q2, we expect PE firms to remain on the sidelines. Overall, we think the market will come into balance, resulting in more pressure on sellers and lower EV values/prices. We do not expect significant price dislocation in Q1/Q2, but are concerned about late summer into Q3.
Predictions Risks: Soft Landing through Q2
“No Landing”- The upside risk to the economy is associated with moderating economic growth, in line with a slow and predictable decline in interest rates. The economy would likely downshift from high-gear to a lower-gear while still moving forward. Lower inflation and interest rates, with solid growth and margins would create a foundation for higher risk asset valuations and increase the likelihood of additional lending/leverage being brought to the marketplace as rates slowly decline in Q2-Q3. Animal spirits might re-enter the market as the all-clear sign is sounded for risk assets.
Energy shock- Downside risk could come from an accelerating rise in oil prices (lower production vs demand, expanded wars, tanker spill, China GDP growth) which prevents the FED from moving forward on multiple rates cuts. The increase in cost of living could result in lowered consumer confidence and spending, setting off an unemployment cycle which could ravage GDP/earnings. We do not expect this would materialize until late summer, as energy supplies/stocks remain solid given the warmer than expected winter to date and slower Chinese economic recovery.
Maxxed Out- The US consumer hits a spending wall, as they approach credit limits across their credit facilities. This could lead to a very precipitous drop in spending and consumer confidence. This would set off an unemployment wave as businesses look to protect earnings. This would get aggressive in the September/November timeframe.
Get off the fence, get in the market, and get deals done in the first half of 2024. The window is open to get deals done at reasonable prices and high returns. If you’re considering a merger or acquisition, let’s talk.