What the Venture Capital Market is Telling Us: In early July, Crunchbase, a business information platform, released their quarterly report on global venture capital. The highlights showed a mixed state of affairs for venture capital broadly. While the number of deals has remained stable, the dollar volume of deals has dropped significantly since the fourth quarter of 2018. Dollar volume has also declined significantly year-over-year as well. Dollar volume declines have come mostly from later stage companies not raising, or not being able to raise, additional growth capital. This makes sense as later stage rounds tend to be orders of magnitude larger than earlier rounds. There are, however, good (bullish) signs coming from seed and early stage deal volume with both segments showing some growth which could be expected to feed the later stage pipeline in the years to come. Where things really become uncertain are in the options for exit opportunities. Acquisitions of VC backed companies have essentially remained steady over the last few quarters. The IPO market, which has long been promoted as the ideal ending to any company’s VC backed story, has been very slow. The last few quarters have showed some improvement with headline IPOs of large VC backed firms such as Zoom, Beyond Meat, and Lyft, but the public market has received these companies with very mixed results.
Our Takeaways: It is a little too early to make definitive determinations about the health of the U.S. economy solely based on the venture capital community, but we see a few markers that help frame the overall context of today’s markets. The most obvious is that the private capital markets have a ton of cash in them right now. Probably the only thing more impressive than the amount of private funding companies are receiving is the amount of dry powder venture capital and private equity firms have at their disposal while they are simultaneously raising larger and larger funds for future investments. This is likely driven by the difficulty in finding competitive returns in just about any other corner of the world, so at least for the time being, it appears that we should expect to see more capital inflows to these types of investments. This transitions to the next point of valuations and how these relate to exit opportunities. With so much capital chasing so few good ideas, the valuations of the most prominent venture backed companies have become astronomical. This is of course a byproduct of flooding a system that was not really designed to handle and has never had to handle such a volume of cash. This availability of funding has made it possible for companies to stay private much longer than has been typical, but at the same time it has created an echochamber for valuations since, at least by the standards of Silicon Valley, it logically follows that a company is worth more each and every round. When everyone on the capitalization table is incentivized to show higher and higher paper valuations each time new money is put in and since those not on the table do not get a say in the company’s valuation (i.e. there is no price discovery like in the public markets) this misalignment of incentives, more often than not, leads to higher and higher numbers - on paper. This is all fine and good until it isn’t. Past a certain point, the valuation no longer becomes credible in the eyes of the public market, thus eliminating, or dramatically worsening, the opportunities for a successful public offering. This is the point where we find ourselves today as the number of publicly listed U.S. companies has steadily declined from 8,090 in 1996 to 4,397 in 2018, however we still need a little more time to see if this is going to be a longer term paradigm shift in terms of how capital is allocated between public and private markets or if this trend will end in the exuberance seen during the dot-com era with the subsequent pull back causing investors to reconsider their allocation decisions.
It’s a Negative Rate Bond World: In Europe, over a dozen companies with below investment grade ratings, commonly referred to as “junk,” have seen yields on their publicly traded bonds go negative. It has become commonplace to see yields of government and highly rated corporate bonds trade, or even be issued, with negative yields, but this latest development has many analysts pointing to it as a sign of increasingly stretched financial conditions in Europe. Leading the charge in pushing rates negative has been the European Central Bank (ECB) which currently has its benchmark rate negative and has signaled further cuts ahead. Currently, only 2% of the European high yield market is trading with negative yields, but it is estimated that a mere 40 basis point reduction in spreads between government and junk bond yields could take that number to over 10%.
Our Takeaways: The thing we find important to understand about this development, and negative yielding bonds in general, is what the economic rationale for paying someone to lend them money entails. Upon analyzing this further, a few answers arise: 1) currency speculation, 2) expectations of deflation, 3) expectations of further declines in yields (i.e. bond price appreciation), and 4) because of structural mandate (i.e. because you have to). Currency speculation is probably the least contributing factor of the four explanations since the fewest number of buyers would be interested in European debt, particularly corporate debt, for these purposes. The second and third explanations are similar in the fact they explain negative yields as a function of market participants expectations about other factors - namely rates of inflation/deflation and bond prices. Both also appear to pass the legitimate and relevant tests since there is nothing unusual about investors expressing expectations about future states of inflation/deflation and bond prices (the only thing unusual is the extremes which this has gone), and because some of the largest buyers of European debts (European pension and debt funds) should be evaluating and managing the risks around these two factors in the normal course of their investment processes. The final explanation is likely the one to frustrate efficient market proponents the most. The vast majority of the aforementioned buyers of European debt have certain mandated constraints when it comes to their investment and allocation decisions. For example, a particular pension fund may be obligated to remain 90% to 95% invested at all times with no more than a 40% allocation to equities or alternatives. With just two constraints, they would have to, at a minimum, allocate 50% of their assets (60% non-equity/alternative portion less the 10% that could be held in cash) to debt instruments. Taking all of this into account, the emergence of negative yielding junk bonds is not all that surprising. Furthermore, it is likely to continue if the ECB continues pressing rates further negative causing everyone to chase them on the way down.
U.S. Housing, Consumer Updates: Leading the headlines for housing and consumers in the U.S. are record low home mortgage rates and a (seemingly) stellar retail sales report for the month of June. Helping to lower mortgage rates has been the Fed which cut rates for the first time since the 2008 financial crisis. This in turn has led to record levels of mortgage applications which should translate into strong demand for housing, however, the opposite seems to be the case as housing starts and building permits have begun to drop at a high rate. Also indicative of slowing demand for future housing supply are construction input prices which had been increasing at a strong pace given the huge demand in recent years that are now not only slowing, but have even started to show year-over-year decreases. Turning to retail, headline reports showed that U.S. retail sales grew at a faster than expected pace in June. This makes the 4th straight month of retail sales growth, but below the surface, the report was not as bullish as the headline would suggest. It should not come as a surprise at this point that most of the growth in retail is coming from what is categorized as nonstore retailers (i.e. online), but June’s report showed this all important category is beginning to cool off. Online retail sales have gone from a 5%-6% year-over-year growth rate as recently as the end of 2018 to mid-3% range for this year. While slowing growth as anything gets to scale is to be expected, many analysts did not expect online sales growth trends would go this way so soon since, at least with respect to the overall retail sales picture, it is still a relatively small portion at about 10% of total retail sales.
Our Takeaways: The current situation in the housing market makes a lot of sense. Mortgage applications are at record levels, but if there is a disconnect between the amount of mortgages being applied for and the amount getting approved, then that likely means we have met an edge condition (i.e. there are marginally less qualified applicants) and that the system is functioning correctly (i.e. banks are not loaning money to people who should not be getting loans). Recent trends in real income (which has showed little to no growth in decades compared to rapidly rising housing prices) has been a cause for concern with many economists, however, at least in the short run, it appears that markets are capable of showing a healthy amount of push back. In the long run, the health of the consumer still remains the key factor for the housing market. As evidenced by the latest retail sales report, conditions are still improving, but are definitely slowing. However, a recent Wall Street Journal article titled “Families Go Deep in Debt to Stay in the Middle Class” says it all. High levels of debt resulting from the ever increasing big ticket investments/purchases such as education, housing, transportation, and healthcare are making savings and additional consumptive expenditures more and more difficult for an ever growing population of people. As with businesses, higher costs, whether they be higher costs of goods/services and/or higher costs of debt service, have a crowding out effect that ultimately limits long term growth.
Germany on the Decline, Leads the Rest of the Eurozone Down: As we have alluded to in previous commentaries, the state of the German economy, much like Europe in general, has been flashing warning signals for a few months now. After recovering at a modest pace from the recession in ‘08/’09, manufacturing output in Germany reached a peak at the end of 2017. Since then, it has been rapidly decelerating to the point where, at the start of this year, the sector began to contract. The importance of Germany, and in particular its manufacturing sector, really cannot be understated when it comes to a discussion of the economic health of Europe. In percentage terms, roughly 21% of its entire economy is manufacturing making it the number one European nation in terms of manufacturing activity to total economic output. Even more importantly is how this translates into dollar terms. Germany has the largest economy of any European nation which is projected to be $4.2 trillion for 2019. This puts its manufacturing sector at roughly $882 billion which would rank it 8th out of 40 European nations. While Germany provides a nice bellwether, signs of slow downs are popping up all over Europe. This has prompted the European Central Bank (ECB) to aggressively signal it will be going back into its policy toolbox and is prepared to “ease the monetary policy stance further by adjusting all if its instruments.” If history is any indicator of possible actions, rate cuts would be the beginning of such measures with expanded bond buying programs not too far behind. Several factors are proving to be helpful to both Germany and a number of European countries. First, the service sector of the economy in both Germany and Eurozone has shown solid, albeit not stellar, growth for the past several years. This has likely been the primary reason why unemployment in the Eurozone has dropped by nearly 38% since 2014 from 12% to about 7.5%. Lower unemployment has translated to both business and consumer sentiment seemingly being at odds with the data coming from the manufacturing sector and in spite of the geopolitical turmoil stemming from forthcoming events such as Brexit. The ECB’s current path seems to be a clear signal that Europe’s top policymakers think the continent is either on the brink of, or already in, a recession, but the mix of hard and soft data is less convincing.
Our Takeaways: As mentioned above, signals are flashing red all over Europe. Bexit looks like more of a reality than ever, which is very problematic given the strength the United Kingdom generally provides to the European financial picture. Germany appears to be getting hit the hardest, which is not necessarily surprising given the huge portion of the economy that is reliant on exports. With the citizens of other European nations in an increasingly less favorable position to purchase German goods, the German manufacturing sector is understandably suffering. What is particularly puzzling is the divergence in sentiment data. Businesses are understandably less enthusiastic about the future of their financial situations and the economy in general, however, individuals surveyed have a very favorable view of the future of their households financial future, but share the less enthusiastic view of the future of the economy. This is somewhat explainable by two factors - the low, and declining, unemployment rate and the general noise about the European economy. If, on an individual level, people are employed and see people around them employed at a high rate, then that tends to make them feel even better about their personal financial prospects. However, if the media is constantly emphasizing the negative aspects of the economy, then most people’s thinking will generally be easily influenced by that. The real test now will be if the efforts of policy makers can outpace a possible change in sentiment. Put another way, it is possible the European economy could limp itself away from a recession as long as its population continues to be good consumers. However, if sentiment regarding future financial conditions deteriorates and causes Europeans to reign in spending, then that would undoubtedly cause a crisis for the economy. Another possible bright spot is that while Germany has been forced to weather some tough times recently, its government has not overextended itself and actually sits in a great position to respond with accommodative economic policy if needed. Unlike many countries around the world, including our own, who have run increasing deficits and racked up huge debts with little to show for it, Germany has done the opposite. Many policymakers throughout Europe have been urging the German government to do more, but at least for now they appear willing to wait until there is clear and present economic danger to act.
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