Fed Keeps Interest Rate Unchanged at 22-Year High But Signals Cuts Next Year By DICCON HYATT Updated December 13, 2023

Assessing the Implications of Potential Federal Reserve Policy Shifts on M&A Activity and Capital Cost Dynamics in 2024

The market seems to believe that the Federal Reserve Chairman, Jerome Powell, will announce a series of interest rate cuts in the upcoming months of 2024. This belief has been driving the market up with little signs of these market-driving rate cuts. However, based on the current bank earnings and other relevant facts, our firm holds a different opinion than the market. We believe that there is a possibility of only one 25 basis point rate cut in Q4 of 2024. If the Federal Reserve does decide to cut rates this year, it is possible that equity markets may continue to rise, providing a favorable environment for retail investors. However, there are some major negative factors that could potentially impact the market in the near future. As a result, we believe that there may be a market correction this year.

There are some important economic events scheduled for Q1 of 2024 which will help us understand where interest rates will end up. This is critical because it will affect the lower and middle market M&A services, as well as the success rates of deals. "Cost of Capital" is a term used in finance that is impacted by high-interest rates. When underwriting debt, a commercial bank or private equity debt fund will typically be using SOFR (previously LIBOR) with a spread. For instance, in the lower and middle markets, according to CME Group’s latest current data on January 12, 2024, the current average term of 1-month SOFR is 5.346 percent. A hypothetical risk premium of approximately 350 (3.50%) basis points would be added on top of this, resulting in a transaction lending rate of around 8.846 percent on a term loan. It is important to note that the term loan is the first lien over subordinated debts in the capital stack. In many private equity transactions, uni-tranched debt vehicles are utilized. In such cases, mezzanine and other methods of transaction "bridge" debt or working capital interest rates can be as high as 20%, with an additional equity kicker that further elaborates on the return that mezzanine and other private lending firms articulate.

A.J. Arenburg Financial Equity Research Division

Source: CME Group

Let's take a look at some concerns related to the anticipated 2-3x rate cuts in the markets. We believe that these cuts will happen in 2025 rather than 2024. Instead of relying on economic models and speculative opinions, it's important to consider what the FED is looking at. There are some issues that have started to raise concerns in the financial sector, and we have access to information that can help us understand the situation better.

Bank earnings are a crucial indicator of the health of reporting entities. However, as you begin to understand how the markets work, you realize that the financial sector can provide a much deeper insight into the economy. This is because banks provide services that involve consumer deposits, reserves, lending volumes, and diversification in revenue channels, all of which can indicate overall economic health.

Banks generate a lot of their free cash flow from net interest income from lending and other interest-bearing financial products. We have taken a deeper look at net interest income and the financial sector ahead of the CPI and PPI assumptions in our blog called "THE AMERICAN MARKETS ~ Future Movement Possibilities" on January 10, 2024. This blog provides further elaboration on CPI and other inflationary metrics we may encounter. It also provides opinions and insights ahead of the Q4 2024 bank earnings and forecasts outlooks, along with some hedging strategies.

Below we will provide a few factors to consider as the flow reveals itself throughout 2024.

INFRASTRUCTURE, RIA, AND GREEN RECOVERY ACT

The massive infrastructure package was put together by a bipartisan group of 10 senators. J. Scott Applewhite/AP

In the current fiscal landscape, the U.S. is grappling with a $2 trillion deficit, a complex issue shaped by strategic economic policies and spending decisions. President Biden's economic growth strategy, focused on stimulating the economy from the bottom up and middle out, necessitates substantial fiscal spending, which contributes significantly to this deficit. Similarly, the 2024 National Defense Authorization Act underscores a hefty commitment to defense expenditure, another major contributor to government spending. Meanwhile, there is an acknowledgment of the potential drag on growth due to current fiscal policies, highlighting the delicate balance required in government spending to avoid negative impacts on economic stability. This scenario is further complicated by the IRS's inflation adjustments, which align the tax system with the economic context but also influence government revenues and spending. Despite these challenges, there remains optimism for a soft economic landing, contingent on effective management of fiscal policies and spending, which is crucial for maintaining economic growth and stability in the face of a substantial deficit.

The evolving economic landscape, influenced significantly by policies such as the RIA Act, the Infrastructure Act, and the Green Recovery Act, appears to be shaping the U.S. Federal Reserve's decisions on interest rate cuts, a topic that is increasingly relevant in 2024. Recent data indicates that the Bank of England is expected to implement more aggressive rate cuts, between 100bps to 125bps, beginning around May or June 2024, a notable increase from earlier predictions of only two rate cuts. In the U.S., the likelihood of a March rate reduction by the Federal Reserve seems diminished, affecting forecasts not only in the U.S. but also abroad.

Wall Street has adjusted its 2024 interest rate predictions in response to the Federal Reserve's dovish stance, with Bank of America Corp suggesting a 90% chance of a Fed rate cut by March 2024. These anticipated rate cuts could ease financing costs in various sectors, including auto loans, with expectations of reduced rates for new and used car loans. However, tighter credit and higher interest rates may persist for borrowers with weaker credit.

These developments are particularly relevant in the context of the Infrastructure and RIA Acts and the focus on the green economy. While specific data on the impact of these acts on the transactional cost of capital in lower and middle market M&A is not immediately available, it is plausible that reduced interest rates could lower capital costs. This could foster investment and expansion in these sectors, potentially stimulating M&A activity due to more favorable financing conditions.

It's crucial to acknowledge that economic forecasts are inherently variable, influenced by factors like geopolitical events, consumer behavior shifts, and unforeseen circumstances. Therefore, while current trends suggest a certain trajectory, businesses, and investors should remain vigilant and adaptable to the ever-changing economic environment.

In the public markets, retail investors are inflating share prices, such as in the case of NVDA, due to a lack of knowledge of where to invest their money. The semiconductor industry, particularly Nvidia, is predicted to experience a significant correction, despite the company's repeated earnings growth. Nvidia's almost 250% year-to-date increase in stock is not justified, making it a potential short waiting to happen. Investors are advised to take risk mitigation measures in anticipation of the impending correction.

Additionally, what does not help are some clowns claiming to be experts in the media outlandishly calling for six interest rate cuts starting this year and then proceeding to carry on and boldly forecast two years out what the rate cuts will be. For example, according to a recent article in December of 2023 from Morningstar, Preston Caldwell predicts a total of six interest rate cuts by the Federal Reserve in 2024, starting with the first cut in March. This series of rate cuts is expected to reduce the federal funds rate from its current range of 5.25% to 5.50% down to a target range of 3.75%-4.00% by the end of 2024, amounting to a 150-basis-point reduction. Further cuts are anticipated in 2025, bringing the rate down to 2.25% and potentially as low as 1.75% in 2026. This forecast is based on the belief that the economy can achieve a 'soft landing' without a recession, as improvements in the supply side of the economy, including labor markets and global manufacturing, have helped in reducing inflation. Caldwell notes that avoiding a downturn in the economy requires appropriately calibrated monetary policy, considering that the current federal funds rate is above the Fed's normal range, which is believed to be around 2% to 3%.

A new Taiwan Semiconductor Manufacturing Co. plant under construction in Kikuyo, Kumamoto Prefecture, in January | KYODO

The recent election in Taiwan has received significant attention due to the island's strategic importance, particularly in the semiconductor industry. The newly elected President of Taiwan, Lai Ching-te, has pledged to defend the island against any form of intimidation from China. During his campaign, he was positioned as a protector of Taiwan's democratic values. The election results, which saw Lai securing a third consecutive term for the Democratic Progressive Party (DPP), were closely monitored by both Beijing and Washington, given the tense geopolitical climate. Despite Lai's victory, China has reiterated its position on Taiwan, claiming it as part of its territory and not ruling out the use of force for "unification". The semiconductor industry, a critical sector in which Taiwan holds a dominant position globally, has been a focal point in these developments. Taiwan produces about 60% of the world's semiconductors and 90% of the most advanced chips, making it a crucial player in the global technology and artificial intelligence sectors. The country's largest company in this sector, Taiwan Semiconductor Manufacturing Co (TSMC), has been central to the election discussions. The company's global investments and the potential impact of geopolitical tensions on its operations were debated extensively.

The recent election results have raised concerns about their impact on global markets and the semiconductor industry. While some experts anticipate short-term market reactions, the long-term effects will largely depend on the new government's strategic policies, particularly in balancing relations with China and the U.S. The situation in Taiwan is of particular interest to global semiconductor companies and investors due to its significant role in the global supply chain. The geopolitical tensions in the Taiwan Strait are a source of concern, as any escalation could disrupt the semiconductor supply chain and have a significant impact on global technology sectors. For more information, reports from Reuters, POLITICO, Asia Financial, and Yahoo News can be referenced.

Exploring the Complex Relationship Between Militarization and Economic Growth: Impacts on Capital Cost and M&A Activity

Several studies collectively suggest that militarization can have varying impacts on economic growth, depending on the context, the extent of militarization, and other socio-economic factors. The research ranges from examining the direct impact of defense spending on growth to exploring the broader effects of militarization on the economic and social fabric of nations. It's important to consider that the relationship between militarization and economic growth is not linear and can be influenced by a multitude of variables, including the political, social, and economic context of a country. For example, war increases fiscal spending when the United States provides aid to its allies, such as Ukraine and Israel. When this happens, defense contractors profit in the United States, but the rest of the economy and many small businesses suffer due to commodity volatility, such as oil prices, caused by several Biden regime executive orders, one being the “all stop” on the Keystone pipeline, immediately impacting the United States consumer not only on the road but in almost every aspect of our daily lives.

Source: Boeing

The impact of militarization on the cost of capital and lower and middle market M&A transactions is another critical aspect to consider. Increased defense spending and broader militarization efforts, particularly in times of conflict or heightened military readiness, can lead to significant shifts in a nation's fiscal policy. This often results in increased government borrowing, which can drive up interest rates and, subsequently, the cost of capital. An example is the increase in bond auctions under the Biden Administration to support the massive spending bills pertaining to aid. The substantial military spending under President Joe Biden's administration, including the monumental $886 billion defense policy bill for fiscal 2024, is highlighted as a catalyst for economic ramifications, particularly influencing the cost of capital and mergers and acquisitions (M&A). This administration's defense spending trajectory has been consistently expansive, evidenced by the $858 billion budget for fiscal 2023, surpassing the $752.9 billion requested in fiscal 2022, which included $715 billion for the Department of Defense. Notably, this upward trend was further accentuated by the U.S. House of Representatives Armed Services Committee's proposal to augment the defense budget by an additional $37 billion, potentially escalating it to over $810 billion.

These significant defense allocations, encompassing aid for Ukraine, measures against China in the Indo-Pacific, and investments in the U.S. nuclear triad, stealth bombers, nuclear-powered submarines, and hypersonic weapons, bear extensive economic impacts. Primarily, the need for increased government borrowing to fund these expenditures could propel interest rates upward, thereby escalating the cost of capital. This escalation directly influences the financial strategies and decisions surrounding M&A activities.

In sectors closely aligned with defense and technology, for example, Raytheon, Lockheed Martin, and Boeing (FAA has completed their inspections), the surge in government spending may enhance company valuations, rendering them more appealing for M&A pursuits. However, the broader economic effect, particularly the tightening of credit markets due to elevated interest rates, could temper M&A activities in other sectors. This is primarily due to the augmented costs associated with financing these acquisitions.

Conclusively, the Biden administration's commitment to national security through robust defense spending not only underscores its strategic priorities but also significantly molds the economic landscape. This has a nuanced effect on the dynamics of the cost of capital and M&A transactions, impacting a diverse range of sectors.

Market Dynamics and M&A Prospects Amid Rising Capital Costs and Geopolitical Uncertainty in 2024

For businesses, especially in the lower and middle market sectors, this means accessing capital for expansion, mergers, and acquisitions becomes more expensive. With this being said, it would be plausible to consider the claims of 2024 being a good M&A year seem to be diminishing, at least in the lower and middle markets where the entity's balance sheet has tangible asset values typically are not existent and mainly consist of goodwill, may continue to see issues with securing transaction leverage as the entities debt and interest coverage ratios do not support conventional term loans.

Furthermore, the economic uncertainty and commodity volatility, exacerbated by militarization and related policy decisions, can lead to a more cautious investment climate. Investors and financial institutions may perceive higher risks in financing projects or acquisitions, particularly in sectors sensitive to such volatility. For instance, industries reliant on oil and energy might see fluctuating costs and unpredictable demand, affecting their valuation and attractiveness in M&A transactions. This uncertainty can lead to a slowdown in M&A activities as buyers and sellers grapple with valuation challenges and the unpredictability of future cash flows and market conditions. Additionally, for small businesses, the increased cost of capital and economic uncertainty can limit their growth opportunities and ability to compete, potentially leading to a consolidation of market power in the hands of larger, more financially robust companies.

In a publication, “Guns and Butter? The Effect Of Militarization On Economic And Social Development In The Third World,” by Brad Bullock and Glenn Firebaugh, quoting, “Militarization will be positive only to the extent that it represents investments in people rather than in weapons. Based on this argument, we distinguish social militarization (more soldiers) from economic militarization (more spending) and hypothesize that other things being equal, social militarization promotes development while economic militarization hinders it.” This quote provides a good way of deciphering the difference between positive and negative militarization of the world and that the militarization of third-world countries for economic benefits will only create more frivolous spending and drive uncertainty in the financial markets, whereas the militarization of social benefits.

The restructuring of Diamond Sports, the largest owner of regional sports networks operating under the Bally Sports banner, marks a significant shift in the sports broadcasting landscape, particularly influencing the cost of capital in lower and middle market M&A in 2024. Suffering from a debt of $8.67 billion and having filed for Chapter 11 bankruptcy protection in March last year, Diamond Sports' agreement with Amazon and its largest creditors is pivotal. This deal allows Diamond to emerge from bankruptcy and continue operations, averting a total collapse of the regional sports network system, which would have required intervention from major sports leagues like the NBA, NHL, and MLB. Previously, MLB had to assume control over the production and distribution of teams like the San Diego Padres and Arizona Diamondbacks due to Diamond’s financial struggles.

The essence of this restructuring lies in Amazon's minority investment in Diamond and a commercial arrangement to stream Diamond’s content via Prime Video. This move will enable customers to access their local team's games on Prime Video channels, where Diamond holds broadcasting rights, with further details on pricing and availability to be announced later. Additionally, Diamond retains the ability to broadcast regional sports content on traditional cable and satellite providers. This agreement is a continuation of Amazon's foray into sports broadcasting, following their existing arrangement to air some New York Yankees and Brooklyn Nets games. The deal also includes a settlement with Sinclair Broadcast Group, from whom Diamond was separated last year as a result of creditor agreements. Sinclair will contribute $495 million to support Diamond’s reorganization, demonstrating the evolving nature of the sports broadcasting industry amid challenges like cord-cutting and declining advertising revenues.

Recently, the potential merger between Spirit Airlines and JetBlue was prevented due to concerns about consumer ticket pricing inflation and an oligopoly in the airline industry. The financial markets are impacted by various driving forces, such as remilitarization and restructuring of trade. However, with the uncertainty surrounding the interest rate cut assumptions, geopolitical issues, and the upcoming US Presidential election, the market is expected to be more volatile. There may be a significant correction in the near future as inflation is predicted to rise, with a possible recession in the second half of the year, and the S&P 500 may hit the 3000s again.

About A.J. Arenburg Financial

A.J. Arenburg Financial, headquartered in Jacksonville, Florida, specializes in investment banking and advisory services, focusing on the industrials, manufacturing, and AI-enhanced sectors. Our firm caters to a distinguished clientele, including premier boutique private equity firms, family offices, and entities with substantial annual revenues exceeding $10 million. We are adept at guiding family-owned and multi-generational businesses through sophisticated exit strategies, offering indispensable support for retiring owner-operators lacking succession plans.

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Sources

https://www.morningstar.com/economy/we-predict-6-interest-rate-cuts-2024

https://epsjournal.org.uk/index.php/EPSJ/article/view/366

https://www.jstor.org/stable/45293553#:~:text=URL%3A%20https%3A%2F%2Fwww.jstor.org%2Fstable%2F45293553%0A

https://www.reuters.com/markets/us-treasury-increases-size-most-its-debt-auctions-2023-11-01/

https://www.reuters.com/world/us/biden-signs-886-billion-us-defense-policy-bill-into-law-2023-12-22/

https://news.yahoo.com/biden-prepares-largest-defense-budget-234639885.html?guccounter=1

https://www.wfaa.com/article/sports/amazon-bally-sports-diamond-sports-agreement/287-216be67d-1fa7-49c8-a575-8fbcc51ae801?utm_source=ground.news&utm_medium=referral

https://www.4029tv.com/article/the-jetblue-spirit-airlines-merger-was-blocked-what-you-need-to-know/46415257

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