Yogi Berra, the iconic American baseball catcher, famously said: "Make a game plan and stick to it. Unless it's not working."
US Federal Reserve Chair Jerome Powell may have had this quote in mind when he delivered his 'Jackson Hole' speech on August 26th, as the world's Central bankers gathered in Wyoming for their first in-person economic symposium for some years.
In contrast to his more optimistic and discursive 2021 effort (promoting maximum employment and transitory inflation), Chair Powell was short and direct, taking just 8 minutes and 49 seconds to deliver his speech. The price stability imperative and the burden of high inflation falling on those least equipped to deal with it were front and centre.
The Chair promised to forcefully use the Federal Reserve tools to bring demand and supply into better balance, aiming to bring inflation back down to the Fed's 2% goal. The consequences were spelt out in stark terms; the medicine would be unpleasant, it may be needed for some time, and households and businesses would feel the pain.
This stark and unusually pointed language from a Central banker more accustomed to providing markets with subtle cues through a light touch on the tiller, clearly indicates how difficult it will be to unravel the Gordian inflationary knot.
To quote Chair Powell's own words:
If the public expects that inflation will remain low and stable over time, then, absent major shocks, it likely will. Unfortunately, the same is true of expectations of high and volatile inflation. During the 1970s, as inflation climbed, the anticipation of high inflation became entrenched in the economic decision-making of households and businesses. The more inflation rose, the more people came to expect it to remain high, and they built that belief into wage and pricing decisions. As former Chairman Paul Volcker put it at the height of the Great Inflation in 1979, "Inflation feeds in part on itself, so part of the job of returning to a more stable and more productive economy must be to break the grip of inflationary expectations."
What does this all mean for private capital?
The US dollar and US Treasuries remain two of the most important financial instruments in the world, they set the tone and benchmark for global interest rates. The ripple effects of any substantive change in US policy are felt everywhere. And the Federal Reserve remains the 'Daddy' of all Central banks.
In a high inflation environment, Central bankers have two essential policy tools to achieve the goal of low, stable prices. The first is interest rates, and the second is quantitative tightening.
Both lead to higher borrowing costs for businesses and individuals leaving less disposable income to chase discretionary purchases in supply-constrained developed economies experiencing high employment rates.
The effect the Central banks are hoping for is a moderation in price increases and wage demands as the economy 'cools', hoping all the while they can do this without triggering a substantive recession.
The strength of language used by Chair Powell implies that choking off inflation before it becomes intractable is the critical goal and that higher unemployment and a recession may be the price that has to be paid. Headwinds are building.
Public markets reacted decisively, with US Treasury yields and the dollar moving higher in anticipation of further rate increases and all three US equity benchmarks declining by more than 3%.
The most likely effect of this level of uncertainty is to slow M&A activity, at least for a time, as price fluctuations in the public markets start to bleed across to private companies. The nettle of falling revenue projections and increased wage costs will have to be grasped at some stage, with buyers looking to reappraise target prices and owner-managed companies understandably reluctant to give up on the heady valuations of recent years.
A period of adjustment will be needed with every fresh piece of economic data rigorously scrutinised. The FOMC meeting 20th and 21st of September will carefully weigh the non-farm payroll numbers due September 2nd, and we will likely see another .75bps rate rise with .25/50bps increments following November 12th and December 13th.
The recent Debevoise & Plimpton 2022 Private Equity Mid-Year Review and Outlook provide insight into how Private markets are dealing with this economic turbulence. The report chronicles the drag effect from continuing geopolitical and economic uncertainties with an even more competitive fund-raising climate for the year's second half. The use of warehousing vehicles, active participation by funds of funds and continuation funds are all expected to feature.
Continuation funds provide a valuable means to address market timing issues, providing the opportunity to safeguard high-performing trophy assets from untimely disposal. Tainted initially by the stigma of assets spending time in the recovery ward, they have progressed to become a valuable portfolio management tool allowing companies to grow to their full potential. Liquidity can be created for the limited partner if desired, but in volatile times, many prefer the ability to remain invested in a familiar and proven-performing asset.
And, of course, for those with committed but undrawn capital, the opportunity for contrarian investment into targets with more attractive valuations and inflation-busting characteristics will support selective deal activity. Investment in energy transition, food security, infrastructure and the re-mapping of supply chains will all see significantnew commitments. And whilst banks may be more demanding on terms and covenants, this will open new space for private credit to occupy.
As Yogi Berra also famously said: "Its tough to make predictions, especially about the future"
There can be little doubt that headwinds are building, and choppy waters lay ahead. Still, the Global Private Equity industry will adjust its sails and navigate successfully through the coming challenges.
Next time: Private Capital and Regulation
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