Note: This is a distillation of recent market observations. The info is based on the sources cited herein, chats with portfolio cos and other funds & Brighteye team members beliefs. It is in no way meant as investment advice and should not be taken as such.
I) Current macro situation / public markets
📝 Tl;dr While the long term opportunities inherent in technology remain strong, in 2022-23 interest rates will be higher, economic growth slower, capital more expensive and public equity valuation multiples lower than was true in recent years, and there is potential for longer-term headwinds if macro conditions deteriorate further.
- Inflation has hit 30+ year highs across the US (8.3%), UK(9%) and Europe (7.5%). At the onset of the pandemic, many governments lowered interest rates and raised spending and liquidity, creating an increase in spending power, i.e. more demand. At the same time, pandemic related disruptions meant that labor, goods and services were less available, i.e. less supply. Increased demand combined with decreased supply meant prices began rising across the board beginning ~18 months ago. As supply disruptions have continued, exacerbated by the war in Ukraine, lockdowns in China, Brexit, etc, prices have continued to rise.
- Central banks are raising interest rates in response. The US Federal Reserve (central bank) has already begun raising interest rates (anticipated to reach 2-3%) as has the Bank of England and European central banks are expected to follow suit (details here). Raising interest rates is meant to bring prices down, but will also slow economic growth, even as governments scale back spending, further slowing economic activity.
- Higher interest rates decreased valuations of public stocks, particularly high growth stocks. As of May 12, the US S&P 500 was down 18% from all time high reached in early January, while median public company software valuations have dropped from 12x forward revenue to 5x or less since highs in October 2021. Public stocks are typically valued by discounting anticipated future cash flows. Discount rates are indexed to interest rates so raising interest rates increases the discount rate and lowers stock valuations. Because high growth companies have a higher proportion of their cash flows in the future, growth stock valuations are more impacted by rate rises.
- From here, different macro scenarios are possible, ranging from mild slow down (”soft landing”) to recession to stagflation (Pitchbook breakdown here) generally, the longer inflation stays high, the higher interest rates will go, the more the economy will slow. For what it’s worth, while Pitchbook does not view a US recession as likely (20% chance) they do believe that rates will remain high and therefore valuation multiples will stay low, “We do not see a quick reversal in asset valuations. Private market investors should prepare for valuations to be marked down in the coming quarters, especially in VC.”