New term, new challenges.
There’s a ‘back to school’ feeling this week with excitement and trepidation obvious in the markets. Activity is picking up after the summer break; however, the recent escalation in geopolitical tension and conflict demands a measure of caution. Meanwhile, we’re moving directly into the uncharted territory of an extraordinary countdown to an extraordinary wind down of an extraordinary level of central bank support. Plus, there’s an independence vote for Scotland that’s looking a mite closer than it did a few weeks back.
Rush before the crush?
The return of the IPO was the talk of the markets in H1 2014 and we look set to pick up where we left off. There’s talk of around £7b of UK IPOs this month, with the pace set to remain high for the rest of 2014. Enthusiasm did appear to wane just before the summer break. However, that was largely due to increasing investor discrimination – hardly surprising given the several trees worth of flotation documents weighing down desks. In the UK, 61 IPOs in H1 2014 represents almost as many as the whole of 2013. Globally the first half saw a sizeable 60% increase in listings and 67% increase in capital raised compared with the same period in 2013.
The sheer volume of deals and greater global uncertainties will make standing out from the crowd challenging and even more vital in this next round. The troubled geopolitical backdrop, slower growth across the Eurozone and the oncoming tightening will further focus investor mind on quality – as will some of less successful stories from H1. Companies lacking strong governance, a credible management team and a compelling growth story could easily get lost in the throng.
Faced with a more discerning market, more companies may choose the M&A route over IPO – as we noted here previously, sometimes in novel and discreet ways. Global M&A volumes strengthened in H1, picking up to their highest level since the financial crisis. UK levels dipped in Q2, partly due to IPO’s enthral and a number of cancelled deals – although that itself suggests appetite for transactions. There remain compelling reasons to make transformative acquisitions – not least to combat sluggish growth in many markets. Global tensions and the ticking liquidity clock clouds this outlook and will temper activity. Although, central banks seem unlikely to risk half a decade of careful market management with a bout of rash tightening, especially if the global picture darkens.
The end of QE might also inspire unexpected consequences….
Bye bye buybacks
US buybacks have fallen out of fashion, so what will drive earnings now? Debt prices are rising in the (almost) post-QE era and the higher stock prices have made purchases less attractive, even for companies sitting on cash. Analysis from Andrew Lapthorne of Societe Generale shows buybacks fell 20% in Q2 2014, versus the previous quarter, with levels falling below those recorded in Q2 2013. Total and net debt levels also froze in Q2.
“Perhaps as we suggested, US corporates are indeed reaching the limits of what their balance sheets will allow. Without QE facilitating the extra debt, buybacks will have to be scaled back, undermining a key support to the equity bull market.” Andrew Lapthorne, Societe Generale
The bull case for equities is that companies, having gained earnings altitude, will now buy, improve and invest to keep earnings growing – the investment part being music to the US Government’s ears. The bear case points to the difficulties companies have had maintaining earnings growth without free-flowing central bank assistance in the past. The alternative ‘bull’ case is that central banks, faced with stalling earnings and stock markets, won’t turn off the tap – although we can see how that transforms into a ‘bear’ scenario…
Either way, there’s an opportunity for companies to get ahead of the competition by quickly establishing their earnings credentials in the post-buyback era. Companies will need to show their earnings mettle through ‘traditional’ means, through operational improvement and through increasing sales and market share – both organically and through acquisitions. QE has indirectly kept the earnings tide in for a many years. To steal Warren Buffet’s analogy, we’re going to see who’s been swimming naked!
This week’s PMI manufacturing figures continue the theme of driving earnings in difficult markets. The UK slipped to a 14-month low, raising familiar concerns about the balance of the recovery. An early peek at the Q3 UK profit warning data similarly shows a spike in manufacturing earnings misses. Eurozone manufacturing PMI figures also reached a 13-month low. It’s important to note that in both cases, the manufacturing index figures show growth – 52.5 in the UK and 50.7 in the Eurozone – above the 50 line that separates expansion from contraction. However, it’s still the wrong direction of travel.
Falling demand, adverse exchange rates and the blowback from Russian sanctions is hurting across Europe in varying degrees. Discussions around Russia’s access to the SWIFT banking transaction system may not progress, but they show how far European leaders’ deliberations are ranging and wide the impact of sanctions might be. Germany is certainly feeling the strain, as recent drops in activity and confidence highlight. However, the Baltic states, look more vulnerable, particularly with relation to food imports. Lithuania, Latvia and Estonia have the largest share of EU agricultural trade with Russia as a percentage of GDP. Between 70-80% of Latvia’s trucks are used to transport goods to and from Russia. Estonia ships about 10% of its overall exports and almost 20% of its food exports to Russia. Russia also accounts for 10% of Finland’s exports. A Finish Chamber of Commerce survey, shows 6% of companies suffering a direct impact from sanctions and 41% an indirect impact – of those, 25% said the effect is significant.
The ECB, mindful of the global backdrop – and the need to do something to attack deflation expectations – will take action following their scheduled meeting this week. Moving ahead with the ABS purchase programme and perhaps a small cut in rates are the most likely options. QE is likely to remain as a discussion topic for now.
It will be interesting to see if Northern European attitudes soften to QE and austerity as the impact of sanctions and embargos bite.