Rich in contradictions
It has been an eventful week, typical of this recovery. Mixed economic news and full of the type of contrary market data that can make the recovery look both brittle and well set at the same time. Of course, opposing market forces can be healthy. Collective, unrestrained market exuberance didn’t exactly end well last time. Although, current contrary conditions stem in large part from ‘looser’ noises coming from central banks, which stem in turn from their growth and ‘lowflation’ concerns. Economies are still weak – hence the move to safety; however, all this spare cheap cash generated by loose policy needs spending somewhere on yielding assets. Part of the problem is also figuring out what levels are sustainable, from UK house prices, to buyout multiples – it’s been all or nothing for so long.
Eurozone trips on fundamentals
Eurozone GDP data certainly put the cat amongst the pigeons this week. Q2 growth was just 0.2%, well below expectations and only dragged into positive territory by the improving performance of Germany and Spain. Elsewhere, the figures were terrible, in sharp contrast to recent falls in sovereign debt yields– although these were as much about hopes of ECB action as of recovery. Yields rose at first, but have recovered somewhat, suggesting some punt on central bank action.
‘Well placed sources’ indicate action is indeed likely at June’s meeting – the magnitude of concern being highlighted by the inflation-absorbed Bundesbank support of looser policy. These sources suggest that the ECB is ready to lower interest rates to negative levels for the first time and to use a further LTRO to push Eurozone banks into lending more to small businesses. Given the extent of the GDP disappointment and barely there inflation – this may only be enough for an opening salvo. The IMF believes there is now a 25% chance of deflation in the Eurozone by the end of 2015, a frightening prospect when debt to GDP stands at over 90% – barely falling in 2015. Fiscal policy prescriptions aren’t working fast enough; with interest continuing to compound, some form of debt monetisation may be the only serious option.
There’s also more uncertainty in the mix due to this week’s EU elections and the rise of anti-establishment parties across much of the EU. Greece is of particular interest. Last week’s local elections bruised the coalition; a poor result in the EU elections could tear apart this fragile relationship along with any lingering consensus around Greece’s austerity programme.
On the wings of a dove
Meanwhile, UK and US central banks have been at pains to stress that they won’t be raising rates any time soon. Last week’s Quarterly Bank of England Inflation report stressed the lack of inflationary pressure in the UK economy and its reluctance to use interest rates to cool the overheating housing market. The Governor was even more dovish in the accompanying press conference, which suggests Q2 15 as the preferred/expected date for the first rate rise – possibly even later. Given the difficulties of measuring the slack in the UK economy, there is a fair amount of guesswork involved – hence the broad spread of forecasts in the Bank’s infamous fan diagrams. This dovish talk has helped to cool sterling a little, although the fact that major central banks are trying to ‘out-dove’ each other makes it hard to cool investors’ sterling ardour.
The Fed is also trying to push back US interest rate expectations. Chair Janet Yellen recently warned that the protracted housing market slowdown remains a significant risk to the US recovery.
Well did you ever!
All of which helps to explain some recent market contradictions. Why investors are piling into Bunds and Treasuries and flattening yield curves, whilst others are dashing into riskier areas. It is certainly a strange time when Bunds and Treasury yields hit twelve and seven month lows, whilst investors continue to pursue their “dash for trash”. The expected rotation out of bonds in 2014 is still, well…. ‘expected’… despite evidence of recovery.
Concern over growth, low inflation, assertions from central banks that they will keep rates at low-limits for a long time yet is inspiring the move to safety. Yet, there is a sense of not wanting to miss out of recovery, the desperate need to put a huge pile of QE-boosted cash to work and the scarcity of yield-offering assets, driving investors out into riskier areas. Moreover, the clock is ticking. No one wants an IPO, M&A or debt deal pending across the long European break – not when so much has gone awry in recent summers.
Hence, we move onto what’s becoming a regular feature – did you see the price/multiple of? Figures from S&P show that European private equity groups have paid an average price equivalent to 10.4 times EBITDA for companies this year. This compares with 8.7 times last year, and 9.7 times in 2007. The issue here is abundance and shortage. Reloaded buyout funds are competing for a small pool of large assets. Preqin figures show buyout funds “dry powder” has risen 11% to $380bn in 2014, whilst buyout volumes of deals over $500m are falling – down by 35% to $55bn compared with the same period in 2013. The secondary market is especially sparse due to the popularity and lucrativeness of IPOs.
China property crisis?
A difficult economic week also for China, topped off by worrying figures showing a significant drop in real estate volumes and prices. China obviously needs to rebalance. However, there are growing fears that a combination of falling prices, property overhang and exceptional leverage could spiral into a crash that would ripple through the global economy – from luxury goods to commodities.
Official stress tests have played down Chinese bank’s exposure to real estate. However, it’s clearly a major economic driver with banks heavily reliant on its fortunes. Direct lending to real estate only accounts for a quarter of Chinese banks balance sheets. However, indirect exposure is much larger via shadow banking and through loans to companies, like railway builders and shipping companies, which have large real estate arms. Leverage is also larger than officially indicated due to developer promotions and consumers’ use of other credit sources to cover the large down payments required for residential mortgages. Beijing could prop up the real estate market. However, it has so far been reluctant to take any strong action that would undermine its rebalancing efforts.
Commodity sectors will be watchful. They’ve perked up of late, but junior oil & gas companies, in particular, still trade at significant discounts to net assets. A key barrier to consolidation has been unrealistic valuation expectations, but recent activity suggests these are finally breaking down as growth expectations adjust to new levels. However, there’s a big difference between “adjust” and “crash”.