Deflating times

Takeaways: Deflation risks in spotlight. Eurozone forecasts dip further. Saudi action pushes oil price even lower. Bank of Japan hits the QE (panic) button (again) – raising the stakes in the currency markets.  Strong corporate balance sheets provide opportunities to counter growth/deflation risks with acquisitions – despite the October M&A pause, pipelines look strong.  Investor concern will focus again on highly leveraged companies in a deflation scenario – and on weak spots in the Eurozone, especially where capital protection is also weak.

Oil on troubled waters?

S&P Dow Jones Indices reports 37 out of 48 markets fell in October, despite the last minute QE huzzah from Japan. Investors certainly have found more food for thought of late: the US-Japan QE hokey-cokey, growth worries, geopolitical instability, Ebola, fears of US political impasse and the rapid fall in oil prices. West Texas Intermediate and Brent Crude prices now stand at a four-year low, the latter falling by 29% since mid-June. The most obvious causes for the fall are the strong dollar and a global supply glut caused by OPEC competition and weaker global demand. In the last week, there’s been further speculation that Saudi Arabia – in further lowering the price it charges US customers – is taking fight to US shale.

Regional currency, tax and feedstock variations create a complex picture of winners and losers if the oil price sticks within this low band. The impact on Russian oil company profit is being partially offset by the rouble’s decline and a progressive tax regime.  However, sustained low prices will force producers to reconsider capex spending yet again – a further blow to beleaguered service and equipment companies.   A pullback in US shale oil and associated natural gas production will have negative implications for the US petrochemical industry, which has benefited significantly from cheaper feedstock –potentially giving a competitive boost elsewhere.  US coal miners could benefit from a fall in shale production, as utilities switch electricity generation back from gas to coal.

Falling oil prices have the potential to boost the global economy; but such a rapid fall in an era of weak demand and deflationary forces isn’t necessarily an economic balm. The ubiquity of oil means any fall in price should ease producer and transport prices, plumping up consumer wallets. However, if households don’t feel confident enough to spend this windfall, the fall feeds into deflationary pressures.  Oil exporting nations, used to windfalls, will face falling dollar incomes for the first time in many years. This in turn means less petro-dollars finding their way back onto world markets for the first time in almost two decades, according to BNP Paribas. They estimate that this year oil producers will effectively import capital amounting to $7.6b against an export of $60b in 2013 and $248b in 2012. Small beer in terms of global liquidity, but it’s still going the ‘wrong’ way.


Talking of deflation….The Fed had barely left the building before the BoJ, global pioneer of the loose monetary arts, stormed the QE stage for yet another encore.  This wasn’t a total surprise – Japan is way off its 2% inflation and nominal 5% GDP target– but the BoJ’s decisiveness and largesse caught everyone on the hop and sent global markets soaring last Friday. The increasing troubles of the world’s third largest economy are asset positive when they come with more QE –central banks are still the principal players on this stage.

Chief aim for Japan is to reduce its debt to GDP ratio of 240% via stronger growth and lower budget deficit – giving a kick to inflation on the way. Arguably QE’s main contribution will be to produce an even weaker Yen to boost exports. However, this latest currency-crusher is hardly likely to unchallenged by Japan’s neighbours and economic rivals. The Yen has already fallen 40% against the dollar, euro and Korean won since mid-2012, and 50% against the Chinese yuan.  This stirs memories of 1998 and raises the spectre of currency skirmishes in the region and beyond. Over to you ECB….

 Feeling Japanese?

Awe or Envy? What was the primary emotion in the ECB as it watched the BoJ – albeit with some internal dissent – throw the switch on the presses without loud protests about debt monetisation, with willing domestic buyers and without domestic unrest.  Since the Eurozone professes none of these advantages, it cannot afford to fall into this kind of deflation scenario – but it’s looking mighty close. This week, the European Commission cut its Eurozone forecasts, predicting growth of just 0.8% this year, and 1.1% in 2015, down from 1.7% forecast just six months ago.  They predict CPI of just 0.5% this year and 0.8% next for the region, leaving some countries more than flirting with deflation.

The ECB has stuck with its AQR to ABS plan again today. It arguably can and should do more to grow its balance sheet – although this last week brought another reminder that this isn’t the be-all and end-all of the region’s problem. The importance of efforts at an EU and national level to harmonise and improve insolvency proceedings is highlighted by The World Bank’s annual “Doing Business” report, which shows Greece with the lowest insolvency recovery rate amongst OECD ‘high income’ nations.  Investors  are more likely to commit if they can count on a quick and predictable outcome if the worst happens.

An article this week from Reuters, looks at the increasing interest from CLOs in S&P recovery ratings – the percentage recovery if a credit defaults – an interest that obviously then extends to banks structuring European leveraged loans.  It’s not a binary assessment – ‘default or not’ – but ‘what will I get back’ if default happens. A sign we’re moving back into more ‘normal’ assessments of risk?

Gathering strength

Our latest analysis of global M&A shows companies took a breather in October in response to market concerns. However,  year –to-date activity is already ahead of 2013 and there is every reason to think activity will pick up again.  Deflation and low growth create a strong imperative to do deals, whilst strong credit markets and strong balance sheets provide the means.

Market worries may occasionally moderate appetites, but M&A is now providing one of the best routes to growth as well as an avenue to new technologies.  Spin-offs, in particular, could be a major driver for M&A in the near-term, as part of the increasing drive to portfolio optimisation. This could set the stage for the next wave of M&A as the newly independent companies pursue acquisitions to grow or become targets themselves.

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