With 10 weeks to go in 2024, it’s time to make investment decisions. While the outlook remains uncertain and the market’s predictions on the exact path of interest rates continues to shift, rates are starting to head lower. The U.S. Federal Reserve cut 50 basis points two weeks ago, and the European Central Bank (ECB) cut rates a second time this year in September; contrastingly, the U.K. remains more cautious on cutting again. For now, 200 bps of additional cuts are priced in the U.S., and the U.K. and Europe expect 157 bps and 159 bps, respectively. Key trends in Asia remain more nuanced by country, with India, China, Japan and Australia all facing different tailwinds and challenges to their economic outlook. Globally, all eyes are on the next big data prints, starting with the U.S. jobs report in early October. Stepping back, the critical question is whether the world’s economies are actually heading towards a soft landing (the big hope) as opposed to a recession or one of many other scenarios.
Summer in the northern hemisphere is long gone, and the last few weeks have been active in credit markets, with continued liquidity supporting corporate borrowers that are mostly performing well. Geopolitics and elections continue to dominate headlines, but the two key questions we are focused on are:
- What is next for M&A?
- What do the next 12 months look like for the financial health of companies and consumers?
Ever-impending M&A Wave
The wave is starting to build as evidenced by everyone’s favorite legal document and a necessary hurdle for any business sale or M&A process: the Non-Disclosure Agreement (NDA). The legal firm Ontra, which works with some of the largest private equity firms globally, saw the strongest quarterly NDA volume for new transactions in eight quarters at the end of June 2024. Even still, M&A activity is slow to recover, likely due to the impact from rising interest rates. Debt—which companies need to fund new projects and M&A—now costs more and requires projects to earn a material premium to the rate of borrowing. Think about it this way: today a person with a floating rate mortgage or personal loan needs to carefully assess how best to spend their limited available cash on opportunities that can provide incremental value. According to Preqin, the differential in yield between the current U.S. risk-free rate and the three-year horizon returns for private equity is at the tightest level—outside of major market shocks—in the last 20 years.
Movement in Equity & Debt Returns vs M&A Volumes
With base rates now decreasing, companies are expected to have more flexibility and be more active in pursuing M&A and other corporate actions—all of which would likely result in higher equity returns, broadly consistent with how this trend has played out historically. To try and quantify the level of increased financial flexibility for companies, we looked at a recent analysis from Bank of America Global Research on 1,300 public and private issuers across leveraged loans and high yield bonds, with an eye to how a 100, 200 and 300 bps reduction in U.S. base rates would impact Interest Coverage Ratio (ICR) multiples. For floating rate/loan-only borrowers with B1 or B2 credit ratings, the 100-300 bps base rate reduction would increase the average ICR by 0.3-1.3x (assuming no change to financial performance and outlook, both of which are not a given). That level would provide substantial additional free cash flow and provide companies greater flexibility to largely debt fund the acquisition of smaller competitors, a trend we expect to accelerate over the next 12 months.
Impact of Rate Cuts on Interest Cover Ratio (ICR)
Consumer & Corporate Checkup
Despite this backdrop, corporates have largely remained resilient. As an example, Ares’ U.S. direct lending portfolio companies experienced their second straight quarter of improving organic EBITDA growth through the end of June, reaching 11% year over year. The portfolio’s loan to value ratio remained in the low 40%-range—well below historical average market levels. Portfolio company leverage multiples are also a half turn lower than the prior year and loan non-accruals declined from previous quarters.
Consumers have also been largely resilient to date, but further tests lie ahead. Of the over $4.5 trillion of excess savings globally since the start of 2020, the vast majority has been spent, with current elevated rates expected to be a real test going forward. Housing debt in the U.S. has increased $2.7 trillion in the last four years, but perhaps more important is the increased credit card and auto loan debt with 30-day delinquencies, now at 9.1% and 8.0% respectively. These levels have increased markedly in the last two quarters and match levels last seen at the end of the Global Financial Crisis in 2012.
Delinquency (30+ Days) by Loan Type in the US
U.S.
The U.S. Federal Reserve lowered the Fed Funds rate by 50 bps to a target range of 4.75%–5%, marking the first rate cut since 2020. The move was considered to be a "Hawkish 50" because of the below-market forward guidance (25 bps on each of the upcoming 11/7 and 12/18 meetings) and one Federal Open Market Committee member dissenting for a 25-bps cut. The decision was driven by continued economic growth, slowing job gains, and further progress toward the 2% inflation goal. Even prior to The U.S. Federal Reserve cut, macro-economic data drove markets in the third quarter, notably after July’s non-farm payroll report triggered the “Sahm Rule” (a historically accurate predictor of a recession), causing spreads to spike temporarily and decline again following stronger prints in Services PMI, Jobless Claims and Retail Sales.
Focus for the U.S. Federal Reserve has shifted from inflation to employment, as Core Personal Consumption Expenditures (PCE) remained at 2.7%, with the three-month trend falling to 2.1%, which will continue to benefit from lagged housing-related components. Despite the Sahm Rule being triggered, economist projections and the U.S. Federal Reserve’s GDPNow model still predict positive growth over the upcoming quarters. In the U.S., the biggest concerns relate to job growth revisions and leading indicators that show a decline in openings and hiring rates. So far this has put the labor market back in balance from COVID-era supply/demand mismatches, but further deterioration would lead to an uptick in unemployment. While we can’t know the number of rate cuts, the U.S. Federal Reserve will be attentive to every data point and ready to adjust policy accordingly, giving comfort to markets in the event of growth falling below projections. As stated by Jerome Powell in Jackson Hole this August, "the time has come for policy to adjust".
Europe
Market activity across the region has elevated in the third quarter, as the ECB continues to lead the charge with rate cuts that prompt borrowers into refinancing activity and begin to spur M&A in the region. Year-to-date issuance in the loan and high yield markets rivals the record volumes witnessed in 2021, although 70% of that volume involves refinancing and recapitalizations (vs. a 10-year average of 45%). Amend & Extend volumes in the loan market have reached €35 billion year-to-date, only outpaced in volume by 2023, demonstrating that companies are focused on pushing out maturities and maintaining spreads as close to prior levels as possible. Growth is mixed across the EU in particular, with Germany still struggling to break out of its recent run of form, while Spain grows quickly, keeping broader eurozone growth modest but positive. With defaults remaining very low across the markets, rates softening and CLO formation and investor demand staying strong, credit is attractive—even at these tighter spread levels.
APAC
Activity across the region has remained varied, with Japan, India and Australia/New Zealand still the most active areas. Overall, the region’s M&A activity fell to 17% of global activity in the first half of the year, which is the lowest relative level for the region in over 10 years; debt financing has dropped as result of this dip. However, momentum has shifted in the last couple of months, with a number of large-scale financings completed or signed. And, the final quarter of the year tends to be the most active, which aligns with what market participants have been saying in recent weeks across the region. One material difference when comparing APAC with the U.S. and Europe is that refinancing and recapitalizations are likely to remain a higher proportion of activity going forward, as that activity was less pronounced earlier in the year.
Conclusion
Base rates are coming down—though how low and how fast remains to be seen—and companies are likely to have more flexibility to execute their strategic plans going forward. As a result, we expect increased activity and credit investment opportunities globally through the end of 2024 and into 2025. Base rates are unlikely to return to the historically low levels from two years ago, unless global economies severely deteriorate. Companies and consumers have remained resilient over the last two years despite the material step-up in interest rates, but real tests lie ahead. Now more than ever, asset selection will be critical, given bifurcation between winners and losers across and within all asset classes. As always, the report cards on performance won’t come out for a while.