Markets Weekly podcast – 19 June 2023

Henk Potts (HP): Hello. It’s Monday 19th 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 will then add to our discussion from the previous week around opportunities in the venture capital space by looking at secondaries. And, finally, I’ll conclude by previewing the major events and data releases that are likely to shape the week ahead.

Risk assets notched up an impressive rally last week, as investors continued to buy into the concept of a technology revolution driven by AI. Sentiment is also getting a boost from expectations the steepest hiking cycle since the 1980s in the US will be closed out in the coming months. And Chinese policymakers will boost both monetary and fiscal support to aid the recovery.

The S&P 500 topped the 4,400 level. The benchmark index rose for six straight sessions before paring gains on Friday. It was up 2.6% last week. The Dow Jones is up nearly 20% from September lows. And the Nasdaq hit its highest level since March 2022.

In Europe, stocks rose 1.5%, their biggest weekly advance since April. We think, given the strong performance, remember, the S&P 500 was up round about 15% year to date and the still challenging economic backdrop, we would remain cautious about the sustainability of this rally. Investors, I think, should consider using hedges and structures to try and limit possible short-term downside risks.

On the macro side, in the US the focus was on the inflation report, the Fed meeting, and retail sales numbers. The inflation print continued to show that price pressures have been moderating. Headline CPI rose just 0.1% in May. The annual rate decelerated to 4%. Inflationary pressures have now eased for 11 consecutive months. That’s their lowest level since March 2021. 

In terms of the breakdown, energy was a drag, while food inflation showed a moderate increase, although there was a less comforting picture, it has to be said, emerging from the core inflation profile, which accelerated 0.4% for a third straight month, driven by a rebound in used car prices and hotel prices, although these pressures are expected to be transitory.

In terms of the outlook, we think future inflation prints should continue to moderate. In June, base effects will be particularly prevalent in the year-on-year comparison given the strong rise a year ago. This should help lower annual CPI to 3.1%. We put the US CPI print at 2.8% in December this year, and averaging 2.3% during the course of 2024.

The inflation report and concerns over the tightening of financial conditions caused by the banking crisis helped the Fed to deliver on its pause pledge. So, after 10 consecutive increases that have seen rates rise by a full five percentage points since March 2022, the FOMC decided to keep rates on hold, but resilient inflation, consumption and labour market data still encouraged the Committee to signal two additional 25 basis point increases by year-end.

Twelve of the 18 policymakers pencilled in rates at or above the median range of 5.5% to 5.75% and none of the participants anticipate a rate cut this year.

What do we expect? Well, the hiking cycle, we think, will resume in July, followed by a further quarter-point increase in September, although it’s possible this could be delayed until November. This still suggests a terminal rate of 5.5% to 5.75%. We then expect rates to be hold until June 2024, after which we expect a series of rate cuts, with Fed Funds finishing next year around 4.25%.

Finally, on US household consumption, retail sales continued to show robust demand, sales rising three-tenths of 1%. That’s on top of that 0.4% increase we saw in April. The tailwind of excess savings and strong labour markets, we think, will fade in the coming months with a mixture of economic uncertainty, pressure on disposable incomes from higher interest rates and the moderate increase in unemployment should result in a sharp slowdown in private consumption growth.

We have just 0.3% private consumption growth pencilled in for next year and given, of course, consumer spending accounts for 70% of activity, it will inevitably weigh on US growth prospects.

Moving on to Europe where the European Central Bank, as expected, lifted interest rates by a quarter-point, and refused to announce a ceasefire on its battle with inflation. The Governing Council raised the deposit rate up to 3.5%. Remember, that’s the highest that we’ve seen in two decades, and pledged that future decisions will ensure that rates will be brought to levels that are sufficiently restrictive to achieve a timely return of inflation back to that 2% target level.

The guidance appears to lock in a further 25 basis point increase at the July meeting, but President Lagarde refused to offer any commitment beyond July. We maintain a view that the July increase will, indeed, be the last of this hiking cycle with a terminal rate of 3.75%. That’s based on a lower growth trajectory than the European Central Bank is currently projecting, and further evidence that monetary policy is transmitting to the real economy.

In terms of China, we should remember the economy did produce some pretty robust growth at the start of the year, driven by pent-up consumer demand as restrictions were abandoned, but recent data highlights that household demand’s been losing some impetus, the recovery in industrial production has been slowing, and the housing market continues to be a significant drag.

Retail sales in May slowed to 12.7%, from 18.4% in April. Industrial production rose just 3.5%. Home sales slumped 10% year-on-year in May. The slowing momentum, coupled with slumping exports and derisory levels of inflation, has encouraged policymakers to ramp up stimulus. The People’s Bank of China has already started to cut rates and we expect further easing in the coming months.

We also look for the reserve requirement ratio to be cut by 25 basis points in both the third quarter of this year and Q1 2024. We now look for a 60 to 80 basis point cut to mortgage rates. Alongside that, we think the lending programme will also be increased to support infrastructure investment.

We believe the Chinese economy, when it comes to growth this year, will be somewhere round about 5.3%, which is actually below its potential but comfortably above its official 5% target. Remember, that was set at the National People’s Congress back in March.

So that was the global economy and financial markets last week. Following on from our discussion on last week’s podcast where we discussed the venture capital market, we’re delighted to be re-joined by Hunter Somerville who’s a partner at StepStone Group to delve deeper into the venture capital secondaries space, which appears to be a growing area of interest for investors.

Secondaries have been especially topical this year for investors seeking liquidity and looking to the secondary market to provide this. Today, we’ll discuss what exactly is driving the secondaries market, and how venture capital fits into this.

So, Hunter, thanks for joining us once again. It’s a pleasure to have you. Investors often hear of secondary strategies but find it hard to get under the surface of what this actually means. Can you explain the concept of secondaries, and why the market exists?

Hunter Somerville (HS): Sure. Yeah, the easiest type of secondary to probably start with is an LP interest sale. So, someone decides to invest in a venture capital fund. At some point in time, years later, after they’ve made that commitment, they decide that they want to get out of it. And since it’s an illiquid asset class, the way that you would do that is to find a buyer on the other side, who would come in and take over that interest.

They would offer you a price and that price would be based off of the prior quarter NAV, with some discount attached to that, because they would be buying from you and would expect that it would transact at a discount, due to the illiquidity or due to where the fund is in its overall lifecycle.

After you agree on that price, they would assume ownership of that interest and play out the remaining exposure until its eventual end conclusion. Businesses within a fund, you know, can get liquidity through an IPO, through a strategic M&A event, or a sale to a financial buyer, and once you become the owner of that, you’re waiting for the remaining value, driving assets, to eventually be realised.

So, at a high level that would be an example of an LP interest sale.

HP: Thanks for that explanation. Let’s get into a little bit more detail on that, though. What types of secondary opportunities are there, and how do they work?

HS: Yeah, so what I just detailed is an LP interest sale. It’s generally a foundation, endowment, pension fund, high-net-worth family office, whoever that may be, deciding to sell interests in funds that they no longer want or where they need liquidity.

Another type of secondary would be a direct secondary within a company. In that example, you could have an employee within a company, a departed employee within a company, a friends-and-family investor, a family office that’s been an investor in a company for a long period of time, and they decide to sell their ownership shares within that company directly to a buyer. So, instead of it being an LP interest or a fund, this would be a direct secondary in a company, and someone would come in and take over ownership of the shares within the business itself.

And then a third category, we refer to as a sort of GP strategic solutions. Those could include tender offers, continuation funds, strip sales. Effectively, there, a buyer would be taking out a number of investors all at once. So, they would offer a discount to an entire limited-partnership LP base, they would be creating a new structure to allow people to roll over or sell, or they’d be buying a strip of an entire portfolio in partnership with the general partner.

So, all of these are different types of ways you can do secondaries, not just in venture but more holistically.

HP: So we spoke about venture capital on our podcast last week, so I’m interested to know if, and how, venture capital fits into this. Do secondary opportunities exist in that space?

HS: Yeah, in venture it’s really an important component, because venture investments take the longest to eventually get realised. It’s a longer hold period than you’d typically see in buyouts in private equity, and particularly if you’re coming into the business at the very beginning at an earlier stage, like seed or Series A, or you’re an employee that’s been with the company for a long period of time. 

It oftentimes takes eight to 10 years for a company to eventually become public or be acquired, and for some people that’s simply too long to hold, you know, exposure within a company or a fund. So, they would seek out potentially getting full or partial liquidity on the secondary side, in order to mitigate that duration concern that is very specific to venture only.

HP: How do you see the market for venture capital secondaries evolve, and what are the opportunities and risks that you see coming in the future?

HS: Yeah, so certainly in a macro environment like right now the discounts that are achievable in venture secondaries are much deeper than we’ve seen over a longer period of time. You can look at a variety of industry data and venture secondaries are, you know, on average right now trading at around 30% discounts, according to a number of different sources that are out there. That’s very different than the prior few years, where they became much more compressed, you know, versus historical averages. 

And so, the opportunity is that there’s a lot of supply on the secondary side due to people being over allocated or due to the denominator effect, and, therefore, they’re seeking liquidity at a higher rate but, because of the macro conditions and the dynamics we find ourselves in, the discounts that buyers are able to achieve are much deeper on that increased level of supply. So, it’s a really interesting time in the market, and opportunity set specific to venture overall that’s occurring on the secondary side.

The risks are that, once again, these businesses aren’t profitable. Runway can be a real key consideration. So, you could buy a position in a fund or in a company. Suddenly, that business needs to raise money and, even if you bought it at a discount that seemed deep at one point, there could do a down round or raise at a much lower level that basically erodes or removes your discount entirely.

So, the key is to select the best-quality assets that are showing really good operational performance and that have runway flexibility, so they don’t have to come back to market until they’ve achieved a price that’s above what they raised at before, and ascribing a discount on top of that to sweeten the arbitrage for the buyer.

So, there’s a lot of nuance to that. You need to understand the underlying companies quite well. You need to get granularity on the financials, on the runway, the performance, really, to pick appropriately and not just get to seduced by deep discounts.

HP: Well, thank you, Hunter, for sharing your knowledge and expertise on the venture capital market and, specifically, on secondaries today. We know there is a great deal of interest from investors on this topic. You’ve clearly identified the broad range of factors that people should be considering.

Let’s move on to the week ahead where the focus will be on the Bank of England’s interest rate decision on Thursday, where we expect a 25-basis-point increase to 4.75%. We think we’ll get some pretty hawkish guidance. Resilient UK growth, a tight labour market and sticky inflation point to a heightened risk of inflation becoming embedded and suggest a longer tightening cycle. 

As such, we expect three 25-basis-point hikes in the second half of this year and the terminal rate for this cycle is now expected to be 5.5% in November. So markets will be watching those numbers very carefully, but I think the commentary will also be incredibly important.

With that, I’d like to thank you once again for joining us. I hope that 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.