Is it Time to Consider a Recession?
We’ve enjoyed the third longest period of economic growth in U.S. history at 103 months. We’ve also enjoyed nine years of positive performance by the S&P 500, matched only once before from 1991-1999.
So, the question that comes to mind is: how much longer will it last? Considering the answer to this question now will help you to be ready before the market turns.
Where the Evidence Points
Volatility Has Returned
In January, we saw the first evidence of economic volatility when equity markets dropped ten percent from their recent highs.
Research from Goldman Sachs (see chart below) shows that average returns from the S&P 500 in the year prior to a bear market are very similar to what we are experiencing now (see chart below). In 2017, the S&P saw a return of 21.8 percent and the January 2018 drop was ten percent.
Evidence of an impending recession in the economy at large is outlined in KKR’s recently released economic forecast, which predicts a 100 percent chance of a recession by 2020.
The forecast points to the weakening of the U.S. dollar, likely accelerated inflation, planned Fed rate hikes, increasing labor costs, and an expected drop in both consumer confidence and housing market confidence as primary factors that will weigh the economy down.
Near-Term Growth Should Continue
These signals don’t mean that 2018 is the year we will see a recession take hold. The recent tax reform legislation is undoubtedly providing the economy a boost and the various factors KKR refers to in their report are unlikely to have a broad effect until the end of 2019.
However, after almost a decade of ever-rising equity markets and economic strength, these indications are perhaps evidence that we are reaching the apex of this economic cycle.
The Effect on M&A
M&A activity through the end of 2017 was strong and is expected to continue through this year as investors look to take advantage of continued growth. Sellers are the biggest winners in this high-demand market, as they’re able to take advantage of very high valuations.
However, if commodity prices, import prices, labor costs, and/or the price of debt increases as KKR projects, current valuation multiples will not be sustainable. Rising interests rates alone will put downward pressure on the prices buyers are able to pay. Combine rate increases with decreasing revenues, as businesses face challenges in a slowing economy, the high valuations and seller favorable terms we are currently seeing will start to disappear.
While private markets are relatively insulated from the volatility we are starting to see in public markets, it is imprudent to ignore the possibility that the M&A market’s current strength will not last.
What Should You Do About It
After asking that first and most obvious question of how long economic growth will last, the next question is what you should do about it?
In our experience, this pre-recession period is when both investors and business owners make the costliest mistakes. So, getting the answer to this question right is essential.
Insatiability often overcomes rationality at the top of market cycles. It’s common for Investors to buy assets that later prove to be overpriced, while business owners decline objectively good investment or acquisition offers believing that ever-higher offers are waiting down the road.
To avoid taking losses or missing out on good offers, it’s best to make every effort to remain objective and to make prudent decisions early.
If you’re considering taking on an outside investor or selling outright in the next one to three years, now might be the time to take action. If you’d like to discuss your options in the current market and going forward please feel free to contact me.