After years of cheap money helping fuel the rise of speculative investing and profitless business models in the US over the past decade, stubborn inflation has forced the Federal Reserve to raise interest rates faster than ever in 2022. Now we are entering a new era of higher borrowing costs and more cautious lenders – coupled with slowing growth and recession fears – have frozen once red-hot segments of the US economy.
The initial public offering (IPO) market is essentially closed; Tech companies are laying off employees and halting hiring; the housing market is experiencing a “reset” after years of booming growth; and venture capital (VC) has slowed dramatically, with private market valuations collapsing.
But despite freezing in key sectors — and consistent doomsday predictions from Wall Street — the economy as a whole has continued to grow alongside the resilient labor market. In the fourth quarter of last year, US gross domestic product (GDP) grew an annualized 2.9%, beating analysts’ forecasts. And the unemployment rate hit near its pre-pandemic low of 3.5% in December.
Many economists assume that this will change this year. Morgan Stanley’s chief US economist, Ellen Zentner, said this week that annualized first-quarter GDP growth will slow to just 0.2%, while Wells Fargo expects a slowdown to 0.4%. And some CEOs, billionaire investors and investment banks believe an outright recession is looming.
It’s still unclear whether key frozen aspects of the economy will eventually collapse under the weight of rising interest rates – triggering a recession – or whether the freeze will thaw and allow for slow but positive growth. But credit markets may hold the answer.
“When credit markets pull back and you can’t get financing for transactions or investments, things freeze,” Jim Cahn, chief investments and business development officer at Wealth Enhancement Group, an asset management firm, told Fortune. “Credit is the secret. It is the fuel of growth. And it has always been the engine of growth since credit markets developed at the dawn of the industrial revolution 400 years ago.”
Freezing and frozen segments of the economy
A new era of higher interest rates, inflation and recession fears have caused various segments of the US economy to slow dramatically over the past year.
The VC space, for example, has been boosted during the pandemic. In 2021, global VC funding volume reached a record $681 billion, more than double the 2019 figures.
“[A] “Growth at any cost” mentality, fueled by cheap capital in 2020 and 2021, and exploding investor interest caused by fear of missing out (FOMO), led to large investments in startups at all stages,” explained Alex Warfel , a PitchBook analyst in a Friday note.
But in 2022, as rates rose, there was a 35% decline in VC investing to $445 billion, according to Crunchbase. Warfel said the days of “sky-high valuations for startups and easy fundraising opportunities” are over, sentiment in the VC space is “crushed” and capital is drying up. According to PitchBook data, the estimated amount of capital requested by US startups exceeded the amount provided by $42.8 billion in the fourth quarter.
Logan Allin, founder of Fin Capital, a fintech-focused VC and private equity firm, told Fortune that he doesn’t see the VC space fully recovering until 2024, in part due to the credit crunch, and he argued that 2023 could be a particularly challenging year for tech startups.
“In our view, 2023 will continue to be a year of very acute pain, and actually more painful than 2022, both from a private markets perspective and from a public tech stock perspective,” he said.
Allin added that the sharp downturn in the market should be a “small wake-up call” for VC investors who have developed irresponsible habits during the pandemic and have not scrutinized their investments with due diligence. He gave the example of now-defunct crypto exchange FTX, which he “passed on” for failing to get beyond basic “checklist items” in the due diligence process, including not allowing an independent auditor to view its finances. But other venture capitalists poured millions into the company without even looking at its books.
“They asked for financial data and the team at FTX sent them Excel spreadsheets,” he said. “It was just absurd.”
Sam Bankman-Fried leaves court in New York on January 3, 2023.
Fatih Aktas – Anadolu Agency/Getty Images
But now, with interest rates rising and many smaller VCs going out of business, Allin believes the market will return to a more rigorous investment approach.
“I think it’s going to be a much healthier, more sustainable venture capital environment now because we’re investing in meaningful valuations and multiples that allow the company to grow into them much better,” he said. “It’s a real return to basics. It’s a refocusing on real diligence.”
When US interest rates were near zero and consumers were awash with cash from stimulus checks during the pandemic, the IPO market experienced a similar upswing as the VC space.
In 2021 alone, the U.S. saw a record 1,033 new IPOs, but in 2022 — with interest rates rising and the S&P 500 down about 20% — the number of IPOs fell by 50% by comparison, the company said EY Global IPO 2022 trend report. And in America, the decline was even more pronounced: IPOs fell 86% last year from 2021, while total proceeds fell 96% over the same period.
“Transaction activity and volume fell precipitously throughout 2022. IPOs have been halted entirely,” Allin said. “There was very little appetite in the public market, even for companies that were potentially profitable.”
This year, Allin said he sees only a “sliver of an IPO window” and only for companies that can demonstrate their ability to make money.
“Otherwise, they will trade significantly lower, as did all companies that went public last year or in 2021,” he said. “We still have inflation, high interest rates, geopolitical uncertainty and significant volatility, and that’s not creating a warm market for IPOs.”
US home prices surged over 45% between the second quarter of 2020 and the third quarter of last year as low interest rates and home-working trends fueled a boom in the housing market. But rising interest rates have pushed the average 30-year fixed-rate mortgage rate — the most common type in the US — from 3.45% in February 2020 to just over 6.1% today.
Higher borrowing costs and high home prices have led to an affordability crisis and a major housing “reboot”. Applications to buy a mortgage fell 39% last week from a year earlier.
According to Jay Hatfield, founder and CEO of investment management firm Infrastructure Capital Advisors, it’s not just prospective homeowners who feel left out – institutional real estate investors are also feeling the pain of rising interest rates. Higher interest rates and recession fears have caused bank lending to “dry up,” he told Fortune, making acquiring new real estate — and/or businesses in the real estate sector — challenging.
“There is some private lending, but on terms that are too onerous for LBOs [leveraged buyouts] more,” he said, referring to when a company tries to buy another company with borrowed money. “And then also the companies that were buyers, like Blackstone. They are now sellers rather than buyers. So M&A activity has dried up.”
Cahn of the Wealth Enhancement Group says that not only are lenders offering much higher interest rates, they also do a lot more underwriting — or research and risk assessment — before lending money to avoid the risk of default. He noted that this is another example of how the current stalemate in some sectors of the economy is all “a reflection of what’s going on in the credit markets.”
“In 2021 and 18 months before that, people were throwing money at everything as fast as they could because there was so much cash, but in 2022 credit markets are basically frozen,” he pointed out. “And that’s why you’re seeing these industries freeze.”
The frozen economy on the brink of collapse?
Is the economy thawing and avoiding a recession, or are rising interest rates and high inflation cracking? That depends on who you ask.
Cahn said his “guess” is that we’re going to have “a recession sometime in the back half of 2023. “I think it’s really, you know, maybe 2024 before we go back to business as usual,” he said.
He’s not the only one with a pessimistic attitude. Many top investment banks are forecasting a “mild recession” for this year, and some forecasters have argued that a “severe recession” or even “another variant of the Great Depression” could be on the way.
“From an economic and macro perspective, we’re definitely going to enter an increasingly difficult phase, which can be a recession with a capital ‘R’ or a small ‘r’, but it’s going to be bad,” Allin said.
While many experts believe a recession is imminent, some argue it won’t be as devastating as previous downturns, and frozen sectors of the economy will begin to thaw by late 2023 and into 2024. Infrastructure Capital Advisors’ Hatfield said that in the second half of this year we will “have a more normal IPO market and a recovering M&A and equity market.”
He argued that the “post-pandemic tailwind” has kept the job market healthy — particularly in the service sector, where so many companies have struggled to find workers during the pandemic — and without widespread layoffs that weigh on consumer spending, it’s unlikely that there is a serious downturn in the economy. He also noted that despite the rapid rise in interest rates over the past year, housing stocks are near an all-time low, which he believes will allow this sector to thaw throughout the year.
“We need a Fed break [interest rate hikes] though,” he said. “And we might get a negative quarter or two [of GDP]but we don’t think we’re going to have a significant recession.”
Comments are closed.