Markets Weekly podcast – 12 June 2023

Henk Potts (HP): Hello. It’s Monday, 12th June and welcome to the Barclays Private Bank Markets Weekly podcast, the recording that will guide you through the turmoil of the global economy and financial markets. 

My name is Henk Potts, Market Strategist with Barclays Private Bank. Each week I’ll be joined by guests to discuss both risks and opportunities for investors. 

Firstly, I’ll analyse the events that moved the markets and grabbed the headlines over the course of the past week. We’ll then consider the risks and benefits of investing in the venture capital space. Finally, I’ll conclude by previewing the major events and data releases that are likely to shape the week ahead.

Today, I’ll take a step back, actually, from the melees of the markets to focus on our mid-year economic outlook, where we reflect upon the projections that we made at the start of the year and offer updated forecasts for the rest of 2023 and beyond. We’ll analyse how well policymakers have been doing with the battle against inflation and averting the risk of recession. Then, we’ll go through some of the major regions from a growth, inflation and path-of-policy perspective.

Coming into 2023, we always thought it would be a challenging year for the global economy against the backdrop of heightened geopolitical tensions, the ongoing impact of elevated levels of inflation on consumption, and the tightening of financial conditions, as interest rates have been ratcheted up.

We also felt that stressed international relations could infringe upon activity with risks around an escalation of the war in Ukraine and an intensification of trade wars playing out. But, actually, the political backdrop has been a little bit more stable than we anticipated and economic activity has proved to be more resilient, helped by robust labour markets. We know consumers have had excess savings, built up during the course of the pandemic, that has been cushioning demand. The service sector has been recovering, and we’re also seeing the benefits of China reopening.

But I think we have to be realistic. Many of those tailwinds are starting to fade. It looks like a bumpy landing for the global economy in the second half of the year. Given our expectations that we will see a shallow recession in the US, there is a risk of a contraction in the UK, and only anaemic economic growth in Europe. We think advanced economies will struggle to generate meaningful growth during the course of this year. In fact, we’ve got just 0.9% pencilled in for 2023 and 0.2% growth for 2024 in advanced economies.

Now, on a global basis we expect growth of 2.7%. That’s actually an upgrade from the 2.4% projection we made back in January, as China recovers from a depressed 2022 and India looks like it’s fulfilling its promise as being the fastest growing major economy, with growth of around 6%. Though, we should remember growth at 2.7% would be the fifth weakest outturn for the global economy in the past three decades, outside of the contractions we saw in 2009 and in 2020.

We knew the inflation trajectory would be a big driver of activity, sentiment and policy during the course of this year. We expected price pressures to moderate and there has been some evidence of that, but progress has certainly been slower than expected due to the impact of higher food prices, elevated energy bills and, of course, rising wage growth.

Nevertheless, we do believe that we have passed the point of peak price pressures. We expect prints to become increasingly digestible in the coming months, and actually descend back towards central banks’ targeted levels during the course of 2024.

Now, to put some numbers around that, we expect global consumer prices to average 3.7% in the third quarter of this year, 3.4% in Q4 and 3.1% during the course of 2024, much better than that 7.1% surge that was registered during the course of 2022.

In terms of rates, well, stickier inflation, labour-market strength and resilient activity has kept pressure up on central bankers and resulted in higher peak interest rates than we were previously projecting. We think the hiking cycle will now be extended into the second half of the year, although we do think that much of the heavy interest-rate lifting has now been achieved, we’re only one or two increases away from the steepest hiking cycle since the 1980s being closed out in many of the major regions.

Whilst markets are getting excited about the possibility of cuts, we think that’s going to be more of a 2024 story and skewed towards the second half of next year.

In terms of the regions, starting with America, where growth is expected to come under pressure in the second half of this year and through the course of 2024 in the face of tightening financial conditions, easing domestic demand growth and a prolonged slowdown in manufacturing activity.

The economy is forecast to grow by 1.2% during the course of 2023, but we think it will shrink for three consecutive quarters from the fourth quarter of this year, resulting in a 0.3% contraction during the course of 2024. 

We think that US inflation will continue to moderate. We’ve got CPI slowing to 2.5% year-on-year in December, averaging 2.3% during the course of next year.

In terms of rates, well, a hike this week looks like a very close call, but we do expect the FOMC to deliver two additional 25-basis point rate hikes by September, pushing the target range up to 5.5% to 5.75%.

The Fed is expected to flip to an easing stance during the course of 2024, in fact, delivering 150-basis points of cuts with the fed funds target range forecast to finish 2024 at 4% to 4.25%.

In terms of China, well, its recovery in services consumption, stimulus measures and, of course, the healthy infrastructure investment should help to drive growth up to 5.3% during the course of this year.

However, recent data suggests that the recovery has been losing momentum and a number of challenges still persist. After the near collapse in the Chinese property market last year, officials have introduced a range of measures to try and alleviate the stress. These have helped to address the liquidity crisis for property developers, but buyer sentiment still remains weak and the sector is expected to remain a drag on growth prospects during the course of this year.

Overall, when you’re looking at slowing consumption growth, the weak property market and low levels of inflation, that all points to a pronounced policy response being played out. We anticipate the People’s Bank of China will cut policy rates between 10 and 25 basis points. We expect 25- to 50-basis point cuts in the reserve requirement ratio, and an increase in the lending programme in an effort to try and aid infrastructure investment.

In terms of Europe, well, despite some dire predictions around the length and depth of the contraction, the region is likely to avoid a prolonged recession during the course of this year. This, however, should not mask the significant challenges the continent faces. It still has to deal with energy concerns, lacklustre household consumption, stalling manufacturing recovery. 

Consequently, at best, European growth can be described as anaemic. We are forecasting an expansion of 0.5% during the course of this year and 0.4% in 2024.

We expect inflation in the eurozone will moderate, in fact, averaging 2.8% in the fourth quarter of this year, decelerating down to 2% by the time that we get to the end of 2024. 

We continue to expect two more 25-basis point hikes, one this week and one at the July meeting. We think the tightening cycle will end in July, with the deposit rate at 3.75%. We then anticipate the European Central Bank will remain on hold till the second half of 2024, after which we expect it to cut policy rates cumulatively by 100 basis points over the follow six months, to return to a more neutral level.

Finishing off with the UK, where activity has been supported by resilient global growth, lower energy prices and the fiscal support that was offered in the spring budget. However, there’s no escaping the impact of the aggressive rate hikes, the squeeze on consumer spending and the medium-term fiscal tightening.

As such, the UK economy is predicted to grow by just 0.1% during the course of this year, skirting a recession, and deliver only a tepid recovery in 2024 with inflation adjusted GDP up by 0.4%.

In terms of base rates, well, we think they’ll be nudged up by another quarter point at both the June and July meetings, the latter probably being the last in terms of the current rate-hiking cycle, taking the terminal bank rate to 5%.

So that was the global economy and financial markets last week. The venture capital space has seen an increasing level of curiosity, particularly in light of more recent market events in the VC ecosystem.

In today’s session, we are looking to get insight on the venture capital market from experts in the field, including Matt Spence from Barclays Investment Bank, who’s our Global Head of Venture Capital Banking, and Hunter Somerville, who’s a partner at StepStone Group. Our guests today have operated and continue to operate in the venture capital space quite actively, so we’re looking forward to hearing their thoughts on the topic.

Gentlemen, it’s a pleasure to have you both here today. Perhaps we’ll start with you, Hunter. Given you are interacting with VC firms and companies on a daily basis, not all our listeners will be familiar with venture capital, as the space is fairly hard to access. Can you give us a quick explanation on what venture capital is, as well as the types of companies and entrepreneurs which would fall into this category?

Hunter Somerville (HS): Sure, happy to. Yeah, so venture capital is effectively a way to provide financing to younger start-up businesses that are just getting going. Many just have a business plan or a concept or an idea, and are looking to execute upon that and build out a team and rapidly scale and grow.

So, they would go to a venture capital investor who would provide them with that cash and capital and, in return, the venture capital investor would be getting an ownership percentage in that business on a go-forward basis.

Early-stage investors would focus at the very beginning doing seed and Series A, and then growth investors would come along later, once the business is 10 million or more of ARR or forward repetitive, continuing to support that business. And then the eventual goal is that those companies will become scaled public businesses through an IPO or a potential acquisition candidate for strategics or for financial buyers.

HP: Hunter, when people hear of early-stage companies, one of the first questions that likely comes to mind is, will this company actually make it? From your experience, what are the main factors that define whether these early-stage companies succeed or fail?

HS: Yeah, so when you’re investing at the early stage of seed or Series A, most of these businesses are just a team and a business plan. They may have early beta customers or strategic partners that they’re working with, but there’s very little to sink your teeth into around quantitative metrics or anything in terms of overall traction.

So, really what you’re betting on, and what will make or break the business as it starts to scale and grow, is it’s the quality of the team, whether they’ve the technical expertise to build a great product, whether they have the ability to sell and build an effective go to market engine, the team is really of the most importance. 

The market opportunity in the segment that they play in is also important, but it’s oftentimes hard to project the overall size of some of these market opportunities because they’re new or they’re creating the market opportunity itself and it’s easy to underestimate what some of these categories can become, given time. So, really betting on great teams with that combination of expertise is what’s important.

HP: Thank you for those thoughts. Matt, let me bring you in at this stage. What is your view of the venture capital market? How has it evolved over the course of the last decade and, most importantly I suppose at this point in time, how does it look?

Matt Spence (MS): It’s a really interesting market and I think it’s evolved pretty significantly over the last 10 years. I mean, if you looked at 10 years ago, I think two big things were different, 1) the cheque-size of investments tended to be a lot smaller. So, venture capital, as Hunter was saying, tends to adopt small cheque sizes much earlier in a company’s capital journey. At that time, it’s really risky capital, so you would see a seed round, which is very early in a company’s development. They might have a team, probably now have a client, and that would be maybe a few hundred thousand dollars.

A seed round, now, can be $2 million to $5 million. In some firms it’s called mango seeds, because mangoes have large seeds. A seed round used to be maybe between $5 million to $10 million. Now, it starts at $2 million. Series A round would be between $5 million to $10 million. 

Now, you regularly see Series A rounds of $20 million to $25 million, and that’s when a client is there, you’re already scaling. And a Series B round, which, again, used to be what a Series A was, now can be up to $100 million. 

So, the size of capital going into companies has increased dramatically, and also the size of funds, as a result, has increased. Some venture capital firms now have several billion dollars under management, and when you look at that, that means they’re investing in a lot more companies and they invest in larger amounts. That’s one big difference.

And then another major difference is where venture capital is investing and what really qualifies as technology. So, again, if we look 10, 15 years ago, the major investment for venture capital firms made were often things that we think of as regular tech, Google, Apple, Meta, Netscape, things that were maybe eCommerce, media, internet. Now, you’re really seeing a lot of investments at the intersection of technology and something else.

So, industrial technology, the interaction of aerospace to defence and technology companies like Shield, which apply artificial intelligence to traditional defence problems. And also, you’re seeing a lot of investments in sustainability companies. 

These are start-ups that are working on everything from carbon patches to electric vehicles to batteries. And a lot of those types of industries require to make things, build things and take more capital than software equipment, for example. So, you’re really starting to see venture capital firms taking chances on types of companies that they might not have in the past.

HP: Thank you for talking about some of those opportunities. Matt, given the fact that you speak to a great deal of these companies and entrepreneurs on a regular basis, what are you seeing from them in terms of their business needs?

MS: From talking to great founders and entrepreneurs and VCs, I mean really many dozens every week, there are a few things that are top of mind. One big issue is how do these companies scale? So, getting seed funding or Series A funding is hard, but it’s really not the biggest challenge for a lot of companies. It’s take a risk on an idea. 

What a lot of these companies really need is to find the type of capital to really take them to the next level. You can extend your sales team, you can extend your product team when you have the fuel to take advantage of customer opportunities, and these companies probably aren’t ready for the major growth ramps that private equity investors or public investors that cross over into the private markets do. So, they use VCs to really get them across the hump as they continue to scale up.

And then the second piece that really they need is often venture capital funding, that doesn’t just provide money, but provides the colour of money that could be helpful to them. 

So, to give you an example, it would be a VC investor who has had experience running software companies in the past, so that person has experience understanding price, or they would want someone on their board who has had experience selling into maybe the government, which is becoming an increasingly large customer for a number of these new companies, or really selling into a significant enterprise. So, it’s both getting capital for the seller of your business and also finding investors who can provide more insights and support that gets the dollars.

HP: Thank you. It’s interesting to see what the needs of the companies are as well as the investors. Hunter, a lot of your interaction is with venture capital firms in addition to talking directly to early-stage companies. Where are you seeing VC firms flourish in the market, and what’s been driving that?

HS: Yeah, from a stage standpoint, I’d say where you’re seeing the most activity, right now, is at seed, and small series A, B, C, D round type opportunities are much less frequent. A lot of that is because pricing on those opportunities was fairly frothy over the past few years, and, therefore, the businesses need to grow into those valuations and above them, and that obviously takes time.

So, where the most activity is, is mostly, like I said, in seed and Series A. More folks are looking to make new bets and capitalise on innovation trends that, some of which Matt mentioned earlier, around sustainability, artificial intelligence and machine learning, generative AI, next-generation cybersecurity. I think defence, as Matt outlined as well, and its intersection with government customers, is an area people are spending more time. 

So, when you’re investing at an earlier stage, these businesses haven’t raised from other people or have raised very little capital, so you’re not saddled with a price that is now considered to be too high or with too much invested capital already put to work. And so, that’s where most people are spending time in this market and in this current macrocycle.

MS: One thing I might add to what Hunter was saying, is it really is an interesting environment given this fundraising market, because, as Hunter said, a number of these companies raised rounds in the last few years that had some pretty significant valuations that a lot of people took a look at and said, right, that is something we’d like some significant growth to be in. 

What we’re seeing, now, is as those same companies who raised capital, capital is not as readily available, and they’re facing some difficult trade-offs between we’ll raise capital at a lower valuation, which we call a down round, which obviously reduces the value of the equity, or, when they raise capital, do we put these types of structures into return sheets, which give different investors different preferences and have different return thresholds, and in some other cases they have different types of covenants, in terms of debt, and that can be complicated when the companies raise other pieces.

So, for a lot of the companies, they’re entering a more challenging phase right now that really requires some real skilful advice, both for the companies and for the funds, frankly, as they think about what’s the right way to deploy capital.

HP: It’s very good to get your thoughts on that. OK, a final question which I’d love to hear both of you answer. What would you say are the main opportunities and risks surrounding the venture capital market at this point in time? Matt, let’s start with you.

MS: Maybe I’d start with risk. So, obviously some of the risks are that valuations still remain high, and investors should ask themselves how much can they actually exit. The issue with venture firms is, unlike a hedge fund or a private equity investor, is the return timeline of how long you will hold the company until they’ve had an exit event is a lot longer. So, six, seven, eight, often 10 years. 

And what really matters, at the end of the day, is that limited partners and the venture capital firms themselves ultimately want returns. And one of the risks now is, as the IPO market has been largely closed, as the monetisation of exit events has been pushed out, it might put some pressure on the VCs to make some judgements, which of our companies are going to have large exits and really return the funds, or which are the ones that may stay here that rather than find a player for making an IPO, which would have 10 times the return of the investment. 

Some VCs are now starting to talk about whether they want to engage in mergers and acquisitions that maybe have less of an exit than some companies. So that’s a risk that just changes that dynamic. 

I think on the opportunity side, though, there are a tremendous amount of opportunities within this market. Of course, artificial intelligence creates a huge opportunity now for AI and other pieces and that really applies to a whole range of things, as Hunter was saying. 

And then I think the other piece, really, is looking at the traditional industries that we don’t think of as tech industries, and they are looking to the intersection with technology, so technology and automotive, technology and transportation, technology and industrials, and this is really combining two very different pieces and creating some real ambitious opportunities, which has the downside of requiring a certain amount of capital, but gives some great companies and great itineraries and some funds that really mix well, which I think is a very interesting area to go to.

HP: Hunter, your thoughts on the current risks and opportunities?

HS: On the risk side, fundamentally, venture capital investors are pursuing businesses that are profitable. So, runway becomes an ever important consideration, and in an environment where being able to get future financing is tougher, the bar that needs to be met in terms of year-over-year operational growth and the ability to grow efficiently becomes a really important consideration.

So, for companies that have not established a business model for efficient growth, it’s going to be a harder fundraising environment and runway will be diminished putting you at risk for down rounds if you are a growth investment.

So, all of that needs to be thoughtfully considered and really an increased focus on margin profile and efficient growth is what the market is looking for. Even if you’re not yet close to profitability, just showing that you can acquire new customers in an efficient way is really important.

On the opportunity side, I would say I would play off of actually Matt’s risk. With diminished liquidity options and with closed IPO window it does create opportunities on the venture secondary side because people do need to find ways to get liquidity, and if you don’t have strategics and corporates buying and you don’t have the open IPO window, the next logical places to consider are selling through secondary mechanisms or pursuing financial buyers in private equity. And so, that creates an interesting opportunity where secondary investors can come in and buy at discounts or find preferential pricing.

So, both a risk and an opportunity depending on whose vantage point you’re looking at it from.

HP: Well, gentlemen, thank you for your insight today. You’ve certainly provided a great overview of the role of venture capital, the key factors to focus on, and why it might be of interest to investors.

So, let’s move on to the week ahead where on Tuesday we get the inflation report for May in the United States, where we expect a moderation in core goods inflation, while we anticipate services inflation to have maintained its momentum.

Overall, we expect headline CPI to continue to ease, forecast a 0.1% month-on-month and 4% year-on-year increase. That would represent the eleventh consecutive monthly deceleration.

The FOMC rate decision on Wednesday, we think will be a close call, as I said. That could be determined, actually, by Tuesday’s inflation print. We expect the summary of economic projection to show that activity and inflation is not slowing in line with the FOMC’s higher expectation for the median participant outlook for core PCE price inflation, and output in 2023 higher than in March.

With inflation likely surpassing the forecast set out in March, and evidence that tightening in lending conditions has underwhelmed prior expectations, we expect the median dot to show an additional 50 basis points in hikes for 2023 and a higher trajectory throughout.

In terms of Europe, well, we expect the European Central Bank to continue its tightening cycle on Thursday, hiking rates by 25 basis points up to 3.5%. We think the monetary policy statement will provide guidance that policy rates are closer though not yet at peak but the Governing Council will remain non-committal.

In particular, we believe the majority of the Governing Council members consider the current pricing would see the final 25-basis point hike in July as broadly appropriate. So, they will not deliberately, I think, attempt to steer markets in a more hawkish or dovish direction.

So, lots to get through during the course of this week. But with that, I’d like you to thank you once again for joining us. I hope you’ve found this update interesting. We will, of course, be back next week with our next instalment but, for now, may I wish you every success in the trading week ahead.