A Common Sense Guide to Lower Interest Rates

Dear Clients, Jefferies Teammates, and Friends of Jefferies,

When it became clear that interest rates were going to rise materially for the first time in 15 years after a prolonged period of intense stimulus and free money (correct response to the global financial crisis and COVID-19), we shared three notes about what we “Boomers” learned to expect from rising interest rates.  We did this because we recognized that many people at Jefferies (even senior leaders) had never experienced the full power and force of the U.S. Federal Reserve.  If interested, here are the links to those notes (Chapter 1, Chapter 2, Chapter 3) that proffered a perspective that is consistent with the reality that played out.  In a nutshell, we recognized that the uncertainty of rapidly rising rates would cause capital formation to dramatically slow (and in some cases, cease).  As is the Jefferies way, we generally use these more challenging periods to play offense because, let’s face it, our business is all about quality people and they are most readily available when their respective firms are playing defense and contracting.  As a result, over the past few years, Jefferies has hired roughly 2,000 new employee-partners around the globe and we could not be more excited or better positioned to serve all our clients in the next phase of market cycles.

This is now all ancient news, so the real question before us today is: What do we make of the Fed’s bold 50 bp cut and what will the potentially increasingly lower interest rate regime bring?  Every cycle is different, and few things thus far have played out in our careers as we have expected.  That said, there are certain themes that have found their way into our collective consciousness that we would like to share with all of you.  Again, these are just thoughts from two guys who have been doing this for a fair bit and have been humbled repeatedly by getting it wrong.

1. Capital Formation.  It isn’t an immediate on/off switch, but more of a dimmer that allows people to begin to deploy cash, move out on the risk curve and properly assess relative values in an increasingly wider range of asset classes.  There is currently a very nice riskless rate of return on cash, but the expectations are that these returns will not be as attractive as equities on a risk adjusted basis.  We foreshadowed a bit of this in August with our note regarding the feedback we, and our teams, were seeing from clients who were starting to ask about the IPO market.  We expect that there will be increasing momentum over time with IPOs, equity add-ons, take privates, and mergers and acquisitions.  As is always the case, it will not be linear, but it is clear to us that investors are actively looking for alpha and relative value, and they feel the current backdrop is conducive to slowly moving out on the risk curve.
2. Greater Breadth in the Stock Market.  The initial and anticipated further moves downward in rates have broadened out the positive performance in the equity markets.  While there are still a handful of mega tech companies that outdistance themselves from the others, there is finally broader participation from a more expansive group of companies that are so important to the U.S. and global economies.  Broad positive public valuations bring solid comps for private companies, and none of us should forget there is significant pressure from LPs around the world to get back their (hopefully) gains from their chosen private equity GPs.  The pressure has grown particularly since there was so little capital formation during the rising interest rate periods and, of course, the stakeholders want their cash so they can rebalance, reinvest or spend.  Fortunately, in addition to the now “fully functioning” capital markets, there is also an incredible amount of dry powder within the private equity community, even after they return older invested funds.  Strategics are also more optimistic and looking to invest in growing their businesses and market shares.  Time for everyone to get to work.
3. M&A is Likely to Surge.  M&A activity is building up and is likely to continue to do so into the next few years.  Public companies are seeking growth and more total addressable market through M&A.  Private equity sponsors have a pent-up need to pursue liquidity for their portfolios and capital returns to LPs.  Time can heal value, and more and more sponsors are making the decision to proceed with sales of businesses that have performed reasonably or outperformed.  We are optimistic that the M&A market will be active and healthy for the next several years, supported by public market values.
4. Don’t Get Too Comfortable.  Things can happen.  If you just look at the indexes for equities and bonds and block out all other data points, you’d think: “Happy days are here again.”  However, inflation is not cured.  Geopolitics are at the top of everyone’s mind with serious conflicts potentially escalating.  The U.S. election is imminent.  There is this little item called the deficit that nobody really understands or talks about.  We could go on. The point is the most important lesson we have learned is that nothing in life is black and white.  In fact, we’ve found that when the environment feels the best, like today’s does in terms of capital formation, it has the potential to be the most dangerous.  Let’s not forget that excessive cheap capital (or even anticipating it) has caused more damage to investors, companies and economies than almost anything else.  During good and robust times, we can all get arrogant, sloppy, further out on the risk curve, complacent or distracted.  We personally do not feel the Fed needs to be super aggressive here because the general economy is pretty darn good, except for some specific areas like commercial real estate.  We would prefer to see a more measured reduction so that we can all save our collective stimulus bullets for the next time we are all truly in the soup.  But we have no vote on the timing and amount of the cuts, so instead we will just focus on executing for our clients, building our culture with our incredible Jefferies teammates, and keeping our eyes wide open for trouble and opportunities.

We cannot thank our clients enough for standing by our firm and so loyally and consistently trusting us with their most important challenges and opportunities.  We both feel that Jefferies has never been better positioned to assist our clients on a truly global basis.  We are heading into the home stretch of fiscal and calendar year 2024 and, as is everyone else at Jefferies, we stand ready to serve you in real time and at a moment’s notice.

Enjoying the 50 bps with each of you,

Rich and Brian