In this interview hosted by the Hispanic Heritage Foundation on June 8, 2022, Elizabeth Grier of Cap Table Coalition discusses the state of capital markets in 2022 with East Los Capital’s co-founding partner, Anthony Valencia. Under the theme of “Economic and Capital Markets Outlook”, Anthony analyzes the Federal Reserve’s strategy towards managing inflationary and recession risks, the role of the COVID-19 pandemic on the economy and financial markets, and discusses some outlook scenarios for the next 6-12 months in the private equity space.
[0:48, Elizabeth Grier, hereafter EG]
- Thank you so much for having me here, I’m really excited to talk about the state of the markets. A lot of us have a lot of opinions on where things are going.
- We have seen a number of challenges that are showing up in the capital markets and the economy, and of course, the front facing risk is inflation. Managing those inflationary risks with potential recession, trying to manage a soft landing.
- Anthony, I know that you have significant experience in investing in both the public markets and the private markets. I would love to hear your thoughts on what is going on out there in the capital markets and the economy, where you think things are going to be at the end of this year. I’d also love to hear your thoughts on how the Fed is going to manage the inflationary risks and downside risks to the economy.
[1:44, Anthony Valencia, hereafter AV]
- Thanks, Elizabeth, it’s nice to be here and to see everybody virtually again. You alluded to a lot of the issues that I think are generally well-understood, which isn’t always the case unfortunately it is because it is so front and center in everyone’s lives these days.
- The Federal Reserve finds itself in a very difficult position, arguably somewhat due to their own making as they stayed overly accommodative, too loose for too long, developed a false sense of security, staying around the zero bound pre-pandemic. Then they were faced with the pandemic issue, and everything that has spun forth from there.
- They are faced with bad choices and less bad choices, and investors are holding out the hope that there is still the possibility for safe landing or soft landing.
- Just to touch on some of the points you mentioned, everybody is aware of the inflation situation right now. The last CPI print in April looking back over the previous 12 months was right in that kind of mid 8.3 or 8.5% range which is significantly higher than what we’ve seen in the last decade or since the Great Recession.
- We have the situation with the oil shock so to speak, with very high oil and gasoline prices. We have a real estate market that is at an all-time high, and is probably the next asset class to start to roll over. There’s beginning to be preliminary signs of that.
- You have recession risks brought on by the need for the federal reserve to try to fight this very, very strong inflation, so none of this is good. If you were to make a list of all the bad things going on in the economy, not to sound doom and gloom, the list is quite long, and if you were to make a list of the things that are going well, and you would probably consist of the fact that just the economy still is plugging along pretty well as of today despite all of the things that on the list that would be bad.
- There’s been a number of false starts in the past with respect to federal reserve saying that they were going to raise rates, most famously in the last few years is in the 4th quarter of 2018 when Chairman Powell essentially had started to raise rates and tighten and then was forced by the markets to pivot and back off and become accommodative again.
- We also have now as of this month QT, which is basically the Fed shrinking their balance sheet, which isn’t something that gets quite the headline press with respect to rate increases- is the Fed going to raise rates by 50 basis points or 75 basis points? But that’s equally destructive potentially to markets and liquidity in the same manner as raising rates are, but is something that needs to be done.
- Maybe let me pause there, and we can dig down into any of the specific areas that you initially mentioned.
- I’d love to hear your thoughts on whether the Fed right on just now starting to raise rates; also, how powerful do you think the Fed is in terms of really combating inflation, if you’re looking at more sticky areas such as wage growth and rents for example?
- You can’t necessarily just decrease rents overnight. How optimistic are you on the Fed actually being able to really tame inflation?
- Many people have pointed out in the past that inflation is like that genie, that once it gets out of the bottle, it is really hard to put it back in, and that’s one of the primary dangers of letting it get out of hand, because it feeds on itself.
- The Fed is a very powerful institution, but that power also has to be wielded with their will to actually do it. We saw this with Chairman Volcker, the last time we had this kind of inflation issue, because it will make a lot of people unhappy if they are as firm as they need to be (and when I say unhappy I mean from the perspective of investors and consumers) to a certain extent because it’s tough. It’s tough on everybody, which goes to your other question, which was did the Fed wait too long.
- That was an easy answer in my mind, pre-pandemic the answer was undoubtedly yes: we were on zero bound for way too long, it was an emergency measure because of the Great Recession, and there was a time when they should have begun raising rates. There were plenty of opportunities and they didn’t.
- Now they were thrown a curveball with the pandemic and then there’s other discussions about was the pandemic related stimulus still too much, were the most recent ones that we’ve had too much when things seemed to be well.
- Chairwoman Yellen came out recently and kind of alluded to that, maybe the last stimulus shouldn’t have been as big and what not. The Fed can be very effective, but they need to create some demand destruction, which is having consumers stop spending so much.
- One of the dual mandates of the Fed is employment, but quite frankly if employment were to not be as good, then that puts some pressure on inflation, which in the long run would be good.
- What we don’t want to see is an extended period like we saw in the 70s, ending in the early 80s with inflation just going on and on, until finally the Fed says enough is enough, and we’re going to do whatever we need to do to tame inflation.
- I’d like to just touch on the point of the strength of the consumer. There is a lot of talk out there, amongst the optimists, saying just look at the resilience of the consumer who are still going out and spending. I know that one can argue that with the target earnings recently that you’re seeing just a bit of pullback from there, but in general, there’s a lot of talk about a number of trillions of dollars that are still cash savings in the household and that with the strong jobs market and the significant wage growth that they’re still going out and spending. They are saying one thing, doing another. I’d love to hear your views on that.
- Everything has a limit, because people’s incomes are finite for the majority of Americans. If you were to look at the most recent consumer credit statistics, they’re starting to dramatically increase over the past several quarters, which means that people are starting to rely more on credit cards, which would kill the argument that personal balance sheets are so great.
- I think one of the factoids that we’ve all heard over the years, is that the average consumer doesn’t have a very large rainy-day fund and doesn’t have the resources for an emergency auto or home repair-that sort of thing.
- Many people, actually at all income levels are living paycheck to paycheck. So quite frankly, I’ve never understood this “ the consumer’s balance sheet is stronger than ever”, argument especially in view of the number of people that pre-pandemic and concurrent with the pandemic have dropped out of the workforce.
- I think that the consumer is strong is a little bit of a myth that we’re going to see quickly come crumbling down if inflation stays where it is these days
- Thank you so much for that point. I do agree with you, but I think that’s just really important that we go see both sides. On the private markets, what do you see over there, and how do you think that the public markets turmoil and how that’s going to be seeping through the private markets in the next say, 6-12 months?
- It all flows downhill, it’s just more obvious in the public markets because we see those prices mark to market every day and we turn on CNBC or read the Wall Street Journal, it’s kind of in your face. So you see that wow, there are SaaS companies that have come down 80% since November, whereas you don’t have that instant price discovery on a daily basis in private markets.
- But there are people in the private equity world like myself, or in the venture world like yourself Elizabeth, you see it in different ways. You see founders suddenly inundating your inbox as they need to raise money. From your perspective, I’m sure you’re saying that gee, that valuations that looked pretty attractive 12 months ago, doesn’t quite look as attractive [now]. On the PE side, we are seeing things similar to that, we’re also seeing less exits because the IPO market is dead.
- In the first quarter of this year, 65% of the exits in PE-land were sponsor to sponsor, which just means one private equity firm selling their asset to another private equity firm. And the numbers have come down, it was $95 billion in the first quarter of this year, and the last quarter it was $150 billion every quarter, more or less.
- You’re seeing the weakening, on the private equity side there’s still a trillion dollars in dry powder, and that dry powder has been out there for a long time because people were hesitant on the private equity side due to valuations to get too aggressive, now is the opportunity. But of course, there’s a dual-edge sword to that, as you presumably may be able to get more attractive valuations but you’re also going to be buying companies at a time when the economy is challenged and limits your use of debt, so on and so forth.
- For me, trying to focus on the upside here, as I know we can easily look bearish these days, but absolutely: I think a lot of what we’re seeing is very cyclical and maybe some of the younger generation might not be as comfortable with what they’re seeing but for me, having live through a number of recessions already, the positive is it is very cyclical. I do think that it will be great to see some of the valuations go back down to earth.
- You might actually have some value out there, yes, it could be trickier on the financing side, but I think we could just see more of a healthier, balanced market.
- Agreed, absolutely.
- I’m just going to take a pause here and see if there are any questions.
- Luis Dominguez asks: do you think the Fed will continue to raise rates until it reaches parity with inflation, and do you see the chance of Volcker-like rate hikes, as it’s tough for the Fed to fight the supply side inflation.
- One of my former colleagues, Jeffrey Gundlach, said a few years ago, I think it even pre-pandemic, that the Fed will raise rates until they break something, and I think that’s just the perfect way to look at it.
- I think if you look at the history of the Fed, since the Great Recession, it would argue that at some point they’re going to reverse themselves. It may only be at one Fed meeting, it may be a pause, people in the investment community are debating whether or not they will pause in September.
- I think there’s a high probability at some point, if the breaking of things gets too painful, that you’ll see some cold feet on the part of the Fed. Whether it’s a temporary or sustained pivot, I think the idea that they will just continue to raise rates meeting after meeting to get to the point that the questioner had asked, is probably unlikely.
- My next favorite topic is the housing market. I’d love to hear your views and where you see things heading in the next 6-12 months.
- The housing market is obviously one of the most illiquid markets, the price discovery to a certain extent takes a little bit longer to flow through the price discovery channels. I think we’re already starting to see things with respect to mortgage applications slowing, to a certain extent people buy a payment, so they go out and say what can I afford, and then the price falls from that calculation, which is why we saw the great housing prices increase so much over the past decade plus.
- It’s also because rates were low and people were saying wow, I can afford this payment, that much higher priced house than I thought I could afford previously, but so be it, I can afford it. So I think with rates going up, it’s just axiomatic that the housing prices will at some point need to go down
- Yes we had some supply issues and shortages and do on and so forth, but to a certain extent you’re going to see the housing market roll over. Even back in the great financial crisis when everybody was focused on mortgage-backed securities, a lot of the publicly traded homebuilders fell right away even before we really got to the depths of the Great Recession.
- A lot of buy side firms piled into some of these names, these are the Pultes of the world because they were still down appreciably. I remember thinking the real estate market itself hasn’t really begun to roll over, and even recently I am seeing the same type of conversations on the financial news networks, and people are buying the homebuilders, and yet we have not even really seen major cracks in the housing market.
- So yes, I think the housing market will roll over, it won’t be as bad as during the great financial crisis because we have the mortgage issue there and the banking issues. But yes, it is going to get much softer.
- [Question from the audience] – Are there any areas in the public and private markets that are attractive for investments. We have mentioned SaaS and growth stocks, perhaps oil higher for longer.
- The way I look at things is that it is a valuation issue. It’s not so much that I’m going through all the different S&P sectors and saying today healthcare looks more attractive than software. To me, it’s looking for good solid companies that are going to have a commanding presence in their respective vertical that I can buy at an attractive valuation today, that I could not have done 12 or 24 months ago.
- Yes, there’s been great destruction in the SaaS marketplace, and some of those look very attractive. There are things in the private market that will look very attractive as valuations come down. But for me, it’s really valuation-driven.
- That makes perfect sense. Thank you so much Anthony, I really enjoyed speaking with you. It’s just been going on in the markets and economies, I find it hugely fascinating, some turmoil but we are going to see things through, and things are going to look very different at the end of this year.
- Thank you, we will get through it as we always do.