Pushmi-Pullyu

Pushmi-Pullyu
Conflicting narratives continue to drag markets hither and thither. Increasing levels of M&A highlight increasing corporate confidence, buoyed again by improving growth figures. However, the Ukraine-Russia conflict and dashed Q1 earnings expectations add uncertainty and disappointment. It all adds up to a volatile, but not inflammatory mix since the quest for yield continues to triumph over most doubts. Russian companies and banks are the clear exception, as sanctions and investor nerves make it harder to attract even the most return-starved investors. However, the market is still hoovering up whatever yields it can in the rest of Europe. The Fed’s monetary largess is still shining on the markets and, after previous minute dissections of each Yellen syllable , this week it’s likely to just blandly play down the imminence of the first rate rise with its $10bn taper. The dancing continues.

Mega Monday!
Deal speculation, reaching a weekend crescendo followed by a Monday announcement…this is no longer the stuff of misty-eyed nostalgia. Pfizer’s confirmed offer for AstraZeneca could reach more than $100 billion, making it one of the pharmaceutical industry’s biggest acquisitions on record, and the biggest foreign acquisition of a UK company. This announcement follows on from around $1 trillion of announced deals so far in 2014 – only the third time since records began in 1980 that activity has hit this level so early in the year. Welcome back to ‘Mega Mondays’!

Deals and especially healthcare deals are certainly grabbing the headlines. Before Pfizer’s announcement, Dealogic had recorded $148.7 billion of Healthcare M&A in 2014, up 37% on the same period in 2013. However, the actual volume of deals is much smaller at 641, down by almost a fifth from last year. This follows a clear trend for fewer, but larger transformational deals highlighted in EY’s 10th Capital Confidence Barometer. Companies are more prepared to take big bets. However, with strong focus on the bottom line, a volatile recovery and increasingly vocal shareholders, they are looking for quality over quantity.

Within this trend is a strong emphasis on rationalising the portfolio, but not necessarily through traditional means. The GSK-Novartis asset swap is a potential game changer in the Pharma sector and beyond. Given the likely rise in the cost of capital and fresh memories of unrewarding deals, it seems likely that we’ll see more companies at least investigating swaps as a means to lower M&A risk. This could leave financial buyers somewhat out of the loop, given the closed and precise nature of this format, which will throw up fewer auctions and post-deal sales of superfluous assets.

We’re going on a yield hunt…
Every day brings new tales of investors’ increasingly inventive hunt for yield in market savannah parched by wafer-thin interest rates and bank deleveraging. The most eyebrow-raising item this week is the rush into coco bonds – “contingent convertible” capital – with news that European banks issued $9.4 billion in Q1 versus a record $15.2 billion in the whole of 2013. Analysts expect about €50 billion in coco issuance by European banks this year, a more than tenfold increase on 2011.

This rapid rise is due to an opportune meeting of need and demand. Regulators created the coco in the aftermath of the financial crisis to absorb bank losses. They are Tier 1 capital that acts like conventional bonds – so long as the bank stays above its pre-agreed capital threshold. The cocos then either convert into shares or are subject to write down. Their key attraction for investors is their yield. For banks, cocos are also a relatively cheap and non-dilutive way of raising regulatory capital – compared to equity. There are already signs that banks will need to raise capital to meet the demand of the Asset Quality Review (AQR) and banks are understandably acting now – when demand is high and before any adverse stress tests results.

The concern is that some investors may treat cocos like a bond. They’re not. For that reason, there was a broad expectation that this untested asset class would largely attract specialists. However, due to the shortage of alternative assets, investor demand is broad and stronger than expected, pushing down yields. Hence, rising regulatory and ratings agency concern that investors are mispricing this and many other risks.

Some may argue that these are still well calculated risks, rather than hubris. If so, calculators are busy. Numericable has launched the largest junk bond sale in history. The spread between US Treasuries and US junk is at its lowest since October 2007. The yield on Portugal’s 5YR benchmark is lower than Tesco’s 2019 bond.

QE or not to QE
Investor enthusiasm isn’t the only factor driving down Eurozone sovereign debt yields. The spectre of deflation and potential for quantative easing are playing their part too. There isn’t a QE promise on the table, but a hint of QE can be almost as good as the deed – or at least provide breathing space. Perhaps enough to wait to the end of summer, when bank stress tests are well under way and the ECB has more data to assess the recovery.

The ECB is cautious and mindful of the vulnerabilities of low inflation, but also of its perpetual problem of wide variation. German inflation is 1% – the lowest rate since 2010, but still well above the five Eurozone countries reporting deflation. Output gaps are never an exact science, but there’s a stark contrast between the reported amounts of economic slack in Spain, versus Germany. German house prices are also climbing rapidly as ultra-low interest rates encourage buying over renting. One interest rate won’t work for all in this recovery, as it didn’t in the boom. It’s going to create problems – and opportunities – whichever way the ECB moves.

You’re hot then you’re cold….
Consensus expectations for UK companies’ earnings growth have once again proved over-optimistic. EY’s analysis shows UK profit warnings hitting their highest first quarter level since 2011, despite the economic recovery, whilst the average earnings estimate for the UK MSCI index also fell 7% in the three months to the end of March. This is the fastest drop since the credit crisis and a faster pace of earnings forecast downgrades than the US and Eurozone.

This fall in UK earnings estimates and rise in UK profit warnings reflects some element of analyst over-bullishness – the last three years have started in similar fashion – as well as unexpectedly tough pressure on company earnings. Pricing tensions remain – especially for consumer facing businesses. Meanwhile, many companies have pegged back forecasts in response to weaker emerging markets and stronger currency headwinds. Companies in the FTSE 100, significantly exposed on both counts, issued more profit warnings in Q1 2014 than at the height of the financial crisis.


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