Economic Data Watch and Market Outlook
Global equity markets surged for the week with MSCI World Index rising 5.58%. Bonds also jumped with the Bloomberg US Aggregate Bond Index up 1.31%. The US government borrowed longer term debt during the week, but the increase was less than expected causing the 10 year to drop to 4.557%.
Source: WSJ
Despite the drop, the yield curve still remains inverted with one month rates just below 5.50%.
Source: WSJ 11/5/2023
For the second meeting in a row, the Fed left rates unchanged at 5.50% on Wednesday and signaled they may be done increasing for the foreseeable future. The Bank of England also left rates unchanged after 14 consecutive hikes.
October Nonfarm Payrolls were released on Friday, slightly lower than anticipated (150K versus 180K estimate). The prior two months worth of gains were revised downward by 101K. Most of last months gains came from private education and healthcare, up 89K, government, up 51K, construction, up 23K, and leisure/hospitality, up 19K. Manufacturing saw the greatest decline, down 35K. The labor force participation rate declined slightly from 62.8% to 62.7%.
On Tuesday, the yen fell to a 33-year low as the Bank of Japan appears to be loosening their cap on the 1% 10-year government bond. Further the Bank of Japan did not support yen-buying which lead to uncertainty by traders.
South Korea’s Financial Services Commission has banned short-selling of Kospi 200 Index and Kosdaq 150 Index starting Monday until June 2024 as the country’s regulatory agency overseeing market activity will review the rules. The Commission has stated that illegal short-selling has affected price information and impacted market confidence. Meanwhile, the Philippines will begin to allow short-selling of 52 equities and one ETF on Monday after a 27-year hiatus.
The People’s Bank of China is expected to inject significant liquidity to stabilize money market rates after a sharp increase in interest rates, which a central bank insider attributed to certain financial institutions’ risky financing practices. This intervention follows a tight liquidity situation where interbank borrowing costs for some institutions soared to 20% annualized. State media has downplayed the impact, stating these practices affect a small portion of the market. Amidst a backdrop of tight liquidity and challenging economic data, economists predict the central bank will continue to add liquidity, possibly through a reduction in the reserve requirement ratio for banks.
Equities
US equities saw the biggest gain since November of 2022 as the S&P 500 posted its strongest weekly performance in nearly a year. This comes following signs of a slowing economy and dovish comments from the Fed leading to longer term bond yields decreasing. Gains were broad based but small caps posted their best weekly gain since October of 2022 gaining 7.6%. It was the second busiest week regarding earnings but most of the focus was on the Fed as they kept rates unchanged on Wednesday.
For the week, the Dow Jones Industrial Average gained 5.1%, the S&P 500 rose 5.9%, and the tech heavy Nasdaq jumped 6.6%. Gains were seen across every sector, but REITs were the leader as symbol XLRE, The Real Estate Select Sector SPDR Fund, was up 8.5% followed by strong performance in financials, consumer discretionary, and consumer services sectors. Growth outperformed value during the week for large cap stocks but the opposite was true in small cap companies. The Russell 1000 Growth Index posted a 6.3% gain versus the Russell 1000 Value Index which gained 5.7% and the Russell 2000 Growth Index rose 6.7% while the Russell 2000 Value Index rose 8.5%. International markets also saw gains but developed markets outperformed emerging slightly as the MSCI EAFE Index, which tracks developed markets outside the US and Canada, posted a 4.4% gain and the MSCI Emerging Markets Index rose 3.1%.
In Europe, the Euro STOXX 600 Index posted gains, rebounding off last week’s decline, jumping 3.4% on the week. Italy’s FTSE MIB jumped 5.1%, France’s CAC 40 Index gained 3.7%, Germany’s DAX improved 3.4%, and the UK’s FTSE 100 Index increased 1.7%. Overall, indices were higher in Europe during the week as expectations that interest rates may have peaked added some positive steam to markets in the region.
In Asia, Japan’s stock market posted gains on the week as both the Nikkei 225 Index and the TOPIX Index returned roughly 3%. These gains follow moves by Japan’s central bank to tweak its yield curve control framework. The bank’s dovish stance impacted the yen which briefly fell below the 151 level versus the US dollar. In China, stocks were positive as speculation that the US interest rates may have peaked distracted investors from the country’s slowing growth. The Shanghai Composite Index gained 0.4%, the CSI 300 jumped 0.6%, and the Hang Seng Index rose 1.5%.
Fixed Income
November began with the Federal Reserve’s decision to hold rates steady in the target range of 5.25%-5.50% where it has sat since July. This is the second consecutive pause on rates since we saw 11 straight rate increases throughout 2022 and 2023. The decision to keep rates steady was widely expected and included an upgrade to the FOMC’s general assessment of the economy. Jerome Powell went on to say that the FOMC is not considering or discussing cutting rates but did say that the risks around the Fed doing too much or too little are becoming less. Key factors for the continued pause include the US labor market coming into balance with slowing job gains, increasing labor force participation and a rebound in immigration. Ultimately yields fell this week with the 2-year Treasury yield falling 16 bps, the 10-year Treasury yield falling 27 bps, and the 30-year Treasury yield fell 26 bps. Major bond indices climbed with the Bloomberg US Aggregate Bond Index climbing 1.31%, the Bloomberg US Corporate High Yield Index jumped 1.88%, and the Bloomberg US MBS Index climbed 1.74%.
The Bank of England left rates unchanged causing a rally in bond markets which saw their best day in over a month. Yields on the benchmark 10-year UK bonds, otherwise known as Gilts, fell as low as 4.318% and closed Thursday down 2 bps from before the BoE’s decision. The BoE left rates unchanged at 5.25% and released a forecast stating the UK is likely to bypass a recession but will flat-line over the next several years.
A $69 billion debt maturity wall is inching closer as companies face debt maturities through 2026. Many companies that were extremely popular during the pandemic issued a combined $58B of securities in 2021 alone, an increase of 1,100% from two years earlier. Now the cheap debt which was once seen as attractive is becoming a burden for many beaten down growth stocks. Geir Lode, the head of global equities at Federated Hermes Ltd. believed that the market has not fully appreciated the impact that higher interest rates and refinancing issues will create. Much of the debt purchased is now trading below 80 cents on the dollar, a level typically considered distressed.
Hedge Funds as of Thursday, November 2nd
Hedge Funds (HFs) closed out the month of October this week with the average global HF ending the month down -1% (vs. MSCI World -2.9%), while the average US long short (L/S) equity fund ended down -2.1%, in line with the S&P 500, making October the most challenging month for this group YTD. Performance continued to be challenging through the first two days of November, as the average global HF captured under 20% of the upside as they gained 33 bps (vs. MSCI +1.93). Similarly, the average US L/S equity fund gained 56 bps for the two days vs. the S&P up 1.9%. The largest attributor to the challenging performance would be the top 50 crowded shorts gaining +5.2% this week, while the top 50 crowded longs only gained +4.7%.
North American (NA) equities entirely led the buying of global equities this week as all other regions tilted towards being sold in smaller amounts. While the beginning of the week was quiet on the flows side as positioning stayed relatively stable across both longs and shorts, HFs began to cover shorts in outsized amounts through Wednesday and Thursday, with Thursday posting as one of the largest days of short covering YTD. This came as the S&P gained nearly 2% and pockets of short concentration rallied. As a result of the capital cleaned up from the short side, US L/S net leverage rose 7% in the last 7 days, which represents the 99th percentile of 7-day moves in net leverage dating back to 2005. However, while short leverage has fallen much of the move lower was driven by activity at the index level as ETFs accounted for ~ 80% of the net flows last week and the largest in 16 weeks. At the single-name sector level, there was smaller levels of short covering in tech (largely unprofitable tech) and consumer discretionary, though ultimately short positioning continues to remain extended across consumer cyclical themes (leisure travel, apparel/footwear) and small-caps (where HFs continued adding to shorts on Thursday). HFs were net sellers of consumer staples, energy and materials on the week which was led by integrated oil & gas, refining & marketing, beverages and construction materials. European equities were net sold in the 2nd largest amount seen YTD driven largely by selling on both sides of the book across cyclical sectors. Particularly, HFs were sellers of consumer discretionary and energy where short exposure sits in the upper decile in the last 12 months, as well as materials where long exposure also sits relatively low. HFs were net buyers of defensive real estate and utilities via retail REITs, electric utilities and multi-utilities. In Japan, each day this week was about in line with the largest trading days from a volume perspective seen YTD. At the sector level, HFs were sellers of healthcare, industrials/materials, real estate and energy, while buyers of TMT-related names, consumer staples and index-level products. Flows were quieter in AxJ relatively, though HFs continued to sell China (13 of 14 weeks), Taiwan and India. Regarding the China flows, consumer discretionary names made up the bulk of what was sold, while HFs were sellers of tech and materials in Taiwan.
Private Equity
The syndicated loan market for corporate leveraged buyouts (LBOs) in 2023 has witnessed a significant shift in equity contributions and leverage ratios, primarily due to high borrowing costs. Equity contributions to LBOs have exceeded 50% for the first time on record, reflecting concerns about the strain on leveraged balance sheets. Despite amplified credit risk, M&A and LBO activity surged to a 17-month high in September, indicating optimism in the dealmaking funding market.
In 2023, yields on new LBO loans reached a record high of 11% while corporate buyout leverage has fallen to an 11-year low and cash interest coverage on M&A debt is at an all-time low. Leverage ratios for large corporate borrowers have fallen to 4.71x, the lowest since 2012, resulting in an average year-to-date leverage of 5.18x for LBO loans, the most conservative since 2010.
Cash interest coverage on debt backing LBO transactions in Q3 decreased to 2.24x, compared to 2.87x in Q2. This metric was significantly higher at 3.72x in the first quarter of 2022, before the Federal Reserve initiated interest rate hikes.
In the broader context of M&A activity, the average leverage ratio increased slightly to 4.87x in Q3, reaching a five-quarter high. Year-to-date, the debt/EBITDA ratio for newly issued M&A debt is 4.89x, down from 5.73x in 2022. The shift in risk tolerance is evident in the changing ratings profiles of LBO borrowers, with only 11% carrying a B-minus rating in 2023 compared to 52% in 2021 and 41% in 2022.
High debt costs have led to lower purchase price multiples for US LBOs in the third quarter, with an average of 9.3x, below all full-year readings since 2013.
Equity contributions for LBO transactions have risen to 51% through September 30, marking the first time in LCD’s history of tracking this metric since 1997. This increase is attributed to the impact of high borrowing costs on purchasing power.
LBO loan pricing has experienced a dramatic increase in the average yield to maturity, reaching above 11% in the third quarter, a record high. The average yield for the first three quarters of the year is 10.7%.
Overall, the high borrowing costs and increased equity contributions are reshaping the landscape of corporate LBOs, causing a shift in leverage ratios and raising concerns about credit risk and interest coverage. Despite these challenges, M&A and LBO activity remains robust, driven by optimism in the dealmaking funding market.
Authors:
Jon Chesshire, Managing Director, Head of Research
Elisa Mailman, Managing Director, Head of Alternatives
Katie Fox, Managing Director
Michael McNamara, Analyst
Sam Morris, Analyst
Josh Friedberg, Fall Associate
Data Source: Apollo, Barron’s, Bloomberg, BBC, Charles Schwab, CNBC, the Daily Shot HFR (returns have a two-day lag), Goldman Sachs, Jim Bianco Research, J.P. Morgan, Market Watch, Morningstar, Morgan Stanley. Pitchbook, Standard & Poor’s and the Wall Street Journal.
