The second quarter of 2023 was certainly a surprising one for the financial markets from many pundits and investor expectations to start the year. Despite the continuing war in Ukraine weighing on sentiment, and stubbornly high interest rates, financial markets particularly equity markets continued to rally.
A bevy of cross currents in the markets and economy during the second quarter have led many to question where we are and where we are going in the economic cycle. The recent cooling of headline inflation numbers has been cheered by investors despite pronouncements from the Federal Reserve that interest rate hikes may resume as early as July despite the encouraging data. Employment remains resilient though daily headlines of impending technology layoffs add to the uncertainty of the economy’s future state. The U.S. economy continued to grow in the second quarter, and corporate earnings remained strong in spite of economic data from Europe and China that has been far less encouraging
The S&P 500 index rallied by 8.7% in the second quarter and the Nasdaq Composite index gained 13.1%, one of its best quarterly performances ever.
The rally in stocks while impressive, was driven largely by large-cap technology-related companies. The Volatility Index (or VIX) has returned to lows not seen since prior to the onset of the pandemic. The breadth of the equity markets remained muted with several sectors including energy, utilities, staples, and REITs finishing the quarter in the red or slightly positive. Lingering concerns about the impact of the recent regional banking crisis and its effects on Real Estate lending have resulted in subdued performance for many smaller banks, financial institutions, and commercial RE-exposed equities.
Bonds also experienced significant volatility in the second quarter. The yield on the 10-year Treasury note closed the quarter at 3.85% while the two-year settled in nearly 100 basis points higher at 4.90%
The interest rate volatility was driven by investor perceptions and reactions to the potential Federal Reserve’s plans to stay their current policy of increasing interest rates. A pause in the Feds cycle tightening in June occurred, but recent Fed language and futures market behaviors argue for a potential hike in July.
The second quarter of 2023 was certainly a unique one for the financial markets. Surging equity prices took many investors by surprise and the Federal Reserve has remained vigilant in its mandate to keep inflation in check. Spillover from the recent regional banking crisis remains a concern while international economies diverge further from the US path. Continuing geopolitical factors only add to the potent mix of issues facing investors today and as they look out to the balance of 2023 and into 2024. We believe that the financial markets will remain volatile for the remainder of the year, but we are optimistic about the long-term outlook.
Outlook for the Remainder of 2023
The outlook for the financial markets in the remainder of 2023 is uncertain. The Federal Reserve’s hawkish stance, concerns about the global economy, and regional banking crisis contagion are all major risk factors that could weigh on the markets. However, there are also some positive factors that could support the markets, such as the continued growth of the U.S. economy and the strong performance of corporate earnings.
Regional Banking Crisis
The failures and takeovers of SVB, Signature, and First Republic in the second quarter, while unsettling and frightening for shareholders and depositors appear, to have been contained at least for the time being. There are many analysts and pundits that believe there may be another shoe to drop in the banking crisis given the mark-to-mark issues of many bank’s underlying investment portfolios. Critical attention should be paid to any signs of additional issues percolating through the banking system.
The Federal Reserve’s Tightening Cycle
The Federal Reserve is expected to continue to raise interest rates in the remainder of 2023. This is a positive development for the long-term health of the economy, but it could also weigh on the markets in the short term if the market deems they have gone too far Higher interest rates make it more expensive for businesses to borrow money, which could lead to slower economic growth. Currently, the market action conveys a bet by market participants the Fed can engineer a soft landing.
Despite the risks, there are also some positive factors that could support the markets in the remainder of 2023. The U.S. economy is still growing, and corporate earnings are expected to remain strong. This could provide support for the markets, even if there is some volatility.
Despite these risks, we believe that the financial markets will ultimately recover in the long term. The U.S. economy is still strong, and corporate earnings are expected to remain healthy. In addition, the Federal Reserve is likely to take a measured approach to raising interest rates, which should help to avoid a recession.
We are optimistic about the long-term outlook for the financial markets and believe that the markets will continue to grow in the years to come. However, we also believe that there will be some volatility in the near term. Investors should be prepared for this volatility and focus on investing in high-quality assets, diversifying their portfolios to include more than just stocks and bonds.
What does this mean for Merchant Cash Advances (MCAs)?
The merchant cash advance (MCA) industry is a growing one, and the current economic cycle has only enhanced its growth prospects. The MCA industry is growing for a number of reasons.
First, the number of small businesses is increasing, and these businesses often need access to quick and easy financing. Finsyn reports that the MCA market was worth an estimated $125 billion in 2022 and is projected to grow to $200 billion by 2025.
Second, the MCA industry is becoming more regulated and transparent, which is making it more attractive to investors. A recent Schwab report stated that the MCA industry is becoming more regulated, with the Federal Trade Commission (FTC) issuing guidelines for MCA providers.
Third, the current banking crisis has only increased the necessity for businesses to seek MCA capital as their local and regional banks have severely curtailed their lending because of deposit flight and balance sheet deteriorations.
The outlook for investors in the MCA industry is positive. The industry is growing, and there are a number of attractive investment opportunities available. However, investors should carefully consider the risks before investing in MCAs.
Many of the current economic factors from the second quarter detailed above, chief among them the regional banking “mini-crisis,” have had a positive impact on the makeup of Supervest’s MCA portfolio 2023 to date when compared to its composition from the previous two years. As a result, the pool of investments has moved notably “upstream,” which projects to improved performance and reduced volatility across the board. While there is some sacrifice in pricing and turnover of the underlying advances, the reduction in delinquency and defaults far outweighs any drop in spread.
At the beginning of 2021, coming out of the COVID freeze across the MCA space, the majority of advances were generated by a pocket of smaller, high-risk funding companies seeking to recharge their business after an extended period of diminished revenues. What resulted was an extension of high-rate, short-term advances to small businesses with minimal and inconsistent track records operating during and post-COVID or to industries that had previously been heavily restricted (i.e.trucking/transportation), but now seemed more viable for approval after the shakeup to US commerce. On one side, there were MCA companies with underperforming portfolios seeking to make up for losses by extending high-risk advances with sizeable fees, and on the other small businesses in need of capital to re-enter their relative marketplace or previously unapprovable in the MCA space, both willing to accept high rates to attain capital.
The initial outcome from this volatile pool of advances was high turnover at attractive rates and terms, quickly undercut by dips in performance due to a lack of affordability for the underlying customers. For 2021 and much of 2022, this extension of approvals from overly aggressive Funders and acceptance of high-rate, short terms offers by their customer base, drove the high-risk portion of MCA portfolios far higher than in previous years.
In reality, the larger, more risk-averse Funding groups waited out much of 2021 before reopening to a wider customer base – most of them relying on refinancing and modifying existing advances to keep the majority of their pre-COVID portfolios repaying. Having observed the MCA landscape and performance outcomes for as many as 18 months, identifying what portions of the economy had stabilized, allowing them to better assess risk and price for it accordingly, dramatically increased funding output from these style funders
Over the past 12 months, Supervest has seen an influx in upstream deal flow and investor offerings as we’ve sought to increase portfolio exposure to higher-end, low-risk Funders. These targeted groups deal almost exclusively in affordable advance rates to a bankable customer base, and the results of their increased funding capacity have a demonstrable impact across the SV portfolio. When comparing 2023 to date to the first half of 2022, Supervest’s underlying portfolio has seen the average advance size and underlying business revenues almost triple during that time span. Additionally, the average owner FICO score ranges have increased dramatically, where over 90% of the portfolio is considered higher end within MCA (650+), compared to just 50% the year prior. The two main factors driving this steady increase in quality offerings are the reintroduction of Funding Partners with more acute pricing and formidable underwriting into the Supervest portfolio that had stayed somewhat dormant in 2021 and the 1H of 2022, and the influx of bankable customers into the MCA space as a direct result of the reduction of available credit from regional banks.
With a laser focus on affordability and sustainable repayments, this relative seachange in advance offerings through SV’s network of Funding partners bodes well for performance in the 2H of 2023 into 2024. While the overall rates will reduce as a result, with higher quality customers accepting more responsible repayment terms, the outlook on improved performance far outweighs the reduced spread, setting up investors with the opportunity to significantly expand investment into less volatile, longer-term paper as a prudent balance to the higher risk/reward paper that has been prevalent in many portfolios from prior years.
In conclusion, we believe that the financial markets will remain volatile for the remainder of the year. However, we are optimistic about the long-term outlook. The U.S. economy is still strong, and corporate earnings are expected to remain healthy. In addition, the Federal Reserve is expected to continue to raise interest rates, which should help to bring inflation under control.
We are also bullish on the outlook for MCAs. We believe that MCAs will continue to grow given the tailwinds afforded to them by the baking industry’s tightening standards. Small businesses are the lifeblood of the economy and those businesses need working capital, the MCA industry will likely be filling a funding void left by the banks. We believe the MCA asset class is poised for a fertile period in popularity for both merchants and investors alike through the remainder of the year.