All change! UK break-up & HY wake-up ?

Risk off

Markets are in ‘risk-off’ mode. Weak surveys highlight the continuing struggles of the Eurozone to grow at all and of China to grow enough to meet its targets without blowing bubbles. Meanwhile, Eurozone banks have largely eschewed the ECB’s offer of cheap cash for lending for now – they may pick up more after the AQR. The Fed has also thrown a spanner into the works after hints of faster rate rises. But, above all, it’s the geopolitical uncertainties that are troubling markets and investors. And that list of uncertainties now includes the UK.

‘No’ vote doesn’t mean no change

So, Scotland voted ‘No’. Except, by last Thursday, a vote for ‘No’ was effectively a vote for ‘devo-max’ – and therein lies the rub. As we highlighted last week, a ‘No’ vote isn’t a vote for the status quo, but a potential trigger for major and rapid change to the UK body politic. Late campaign promises of greater devolution – beyond the bounds of The Scotland Act 2012 – have intensified the ‘West Lothian debate’ and posed new conundrums over which UK politicians can vote for what and where. Tough negotiations over the constitution of the new-look UK start here.

It’s a debate that’s already running beyond ‘home nation’ divides. Newspapers representing the north of England have already called for Northern devolution. The debate raises the prospect of a federal system, variations of which are a strength in Germany, a weakness for Spain and an ostensible success for the US – if you ignore the weight of federal debt, bankrupt states and the fact that around 1-in-4 Americans want their state to secede.

What is apparent from these examples is it that devolved success takes a great deal of financial discipline and unity. Any transition to greater regional control in the UK will involve major upheaval and uncertainty in the run into the upcoming election in 2015 and the possible referendum on EU membership in two years’ time. Attracting investment in such a period will require a balance between finding a durable solution and finding it fast. Sterling stuttered and drooped on Friday, in part because investors had pretty much priced in a ‘No’, but also because they were grasping and absorbing the implications and uncertainties ahead.

Of course the ‘No’ outcome helps remove some uncertainty for Scottish businesses, although there are still questions to answer in financial services, in energy and especially in renewables. Scotland’s fiscal and tax landscape is obviously changing, no matter what the outcome for the rest of the UK. The Scotland Act 2012, which comes into force in 2015 and 2016, will represent the largest transfer of fiscal power since the Act of Union, more than 300 years ago.

To hear what the Scottish Referendum result means for Scottish businesses, register for EY’s webinar today at 3pm.

A little reminder

Capital markets hit geopolitical potholes in July, fund outflows eased in August as volumes dropped and now, in September, confidence is picking up again – but with signs of greater discernment. Monetary conditions remain easy, so investors still have cash to splash and yield to chase. However, the rapid fall of Phones 4U, along with a still troubled international backdrop and a more hawkish Fed, are focusing minds on asset quality and the future.

Moody’s Investor Service commented last week that Phones 4U’s demise, although primarily due to a ‘failed business model”, provides a “timely reminder that highly leveraged companies have little tolerance to event risk”. The company’s near-term liquidity profile was solid, it had significant cash on its balance sheet, but this couldn’t mitigate against the loss of suppliers.

It’s a case that highlights two points. The first is the vulnerability of highly leveraged companies, something almost forgotten during years of accommodating markets. However, in August Moody’s European ratings downgrades exceeded upgrades and the ratings agency expects their numbers to be more balanced for the rest of the year as the Eurozone economy splutters and investors look ahead to tighter conditions.

The second is the way that technology is breaking down barriers and reforming the relationships between manufacturers, service providers, retailers and consumers. In the mobile market, smart phone saturation is accelerating and driving this trend, compelling direct interactions between network operators and manufacturers and their consumers. Across so many sectors, but especially those relating to the consumer, the rules of the game are being changed by technological disintermediation and the struggle to drive profitable demand in crowded markets.

Rewarding discernment

The rise in M&A volumes isn’t the stand out feature of recent quarters, according to a new report from Barclays, it’s the positive market reaction to the acquirer. Over the last four years, the share prices of acquirers have risen in the days following a deal’s announcement, in stark contrast to previous years, when the price generally dropped or remained static. Barclays attributes the shift to acquirers paying reasonable prices using attractive debt financing and otherwise idle cash. Our research also shows that companies are also focusing on quality rather than quantity when it comes to deal making, partly in response to shareholder influence. This  ‘fewer and bigger’ trend is likely to continue as companies navigate geopolitical challenges, modest economic growth and the next stage of the monetary cycle.

Deciphering the Fed

And so it seems here, as elsewhere, all roads lead back to the Fed. Last week’s much anticipated statement made no change to the phrase that the rate rises will come a ‘considerable time’ after QE is tapered in October. However, the supporting dot charts provided showed members think rates rises are more imminent. Instead of an interest rate of 1 – 1.25% at the end of 2015, the FOMC now expects a rate of 1.25 – 1.5%. This implies five rate rises from the current level of 0 – 0.25%. There are eight meetings in 2015, so the Fed would have to start raising rates by June 2015 and at every meeting after that to reach that level, i.e. more aggressive than previous forecasts. This is by no means a one way street; but there are constant reminders now of how this extraordinary period of extraordinary low interest rates will be soon drawing to a close.

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