Divergent – the opportunities and risks of diverging fortunes

Takeaway Monetary policies are polarising as fortunes diverge. Balancing the opportunities and risks will be easier for companies able to buy in areas of growth, access cheap debt markets in areas of stress and ride the currency waves. However, for those stuck on the wrong side of the currency equation or the growth and deflation divide, there’s a rougher ride ahead – especially if central banks create currency maelstrom in a race to devalue. Warning lights are indeed flashing. The need to combat slow growth and overcapacity should drive deals. Low prices are giving an extra push in oil. The AQR results and a fitful recovery should increase distressed debt sales in Italy – although its structures makes it more challenging than other active markets.

I’ve got the growth; you’ve got the yields…

European companies have buying more businesses in the faster growing US. US companies have been selling more debt in low-yield euro-bonds. For companies and investors able to cherry pick their way around the global economy, there are obvious opportunities.

In the first 10 months of 2014, the total value of acquisitions by EMEA companies reached $788bn, according to Moody’s, the most since 2008, with about a fifth of that directed toward US targets. Excluding acquisitions within EMEA, about 70% of M&A spending has been on North American businesses – mostly in the US – compared with about half in the previous five years.  For the first time in a decade, North America has overtaken Europe as the primary destination for German M&A activity.  The reason for the switch is obvious: growth. Sentiment may be picking up in Germany and the US might be facing monetary tightening and its partisan demons; but the bottom line is the IMF expects the US economy to grow by 2.2% this year and 3.1% next, compared to just 0.8% and 1.3% respectively for the Eurozone.

Will this attraction last? The dollar’s rise against the euro will make US acquisitions more costly, but balanced against this is cheaper energy costs, a flexible labour market and the ability to raise cheap cash in euros as the ECB loosens.  Hence why, in debt raising terms, the Eurozone is getting hotter as it economy cools. Apple grabbed the headlines with its euro bonds, but it’s not alone in spotting the potential. US companies have sold €51.5bn of euro-denominated debt so far this year, the most at this point since 2008, according to Dealogic.  Euro debt also has the advantage of a loosening bank behind it, one which is making increasing hints that it could start buying company bonds next year. It doesn’t look as if the corporate debt market needs much help – at least not in investment grade. However, the ECB will struggle to increase its balance sheet without expanding its purchase range and sovereign debt is clearly still a no-no for the Bundesbank, despite Mario’s hints. The potential to avoid re-shoring profits offers additional benefits – which become more attractive as inversion deals become less compelling.

That’s the opportunity bit of the picture, but it’s tough to avoid the glaring flashing warning lights and risks associated with the reasons behind such cheap Eurozone debt and the increasing Japanese stimulus – not to mention the problems for those who can’t arbitrage. The ‘every central bank for themselves’ approach isn’t new. Janet Yellen sent out a clear signal last February that the Fed was making making monetary for the US alone. However, recent strong divergence of policy has highlighted the worrying increasing disparity in fortunes and the risk of a deflationary currency war between central banks racing to devalue and improve their export levels in a zero-sum game.  IMF warned this week of “peak trade”, since for the first time in decades, world trade has expanded more slowly than the global economy.

Capacity for change

The UK’s biggest supermarkets are facing a toxic mix of falling sales and too much space – or at least, the wrong type of space. For the first time since it began collecting data in 1994, Kantar Worldpanel has reported a decline in UK grocery sales by price. A report from Goldman Sachs forecasts that sales in large out-of-town supermarkets will fall by 3% every year until 2020. This equates to sales in larger stores falling by 18% over the next six years. Hence Goldman Sachs’ assessment that major UK supermarkets will need to shut 20% of their stores to get back to growth and comments along the same lines from Waitrose boss Mark Price. However, switching to residential use will likely require substantial write-downs. If supermarkets scale significantly back on space, there is also a broader impact for jobs, for food producers – not to mention for football clubs looking to relocate…..

The shape of this recovery, in particular low levels of insolvency, has many sectors with overcapacity. It’s one of the reasons we expect M&A levels to rise in 2015, as companies seek increasing efficiency through consolidation. It’s not a route open to all due to anti-trust issues. But, there are strong catalysts and opportunities for deals in many sectors such as automotive and consumer products, where there is an increasing focus on efficiency in the face of strong margin pressure. In commodity sectors, low prices provide an additional driver. Oil & Gas M&A volumes have never been higher, with the $38bn Halliburton-Baker Hughes deal bringing total sector M&A volumes to $369bn so far in 2014, according to Thomson Reuters. That’s almost twice the level of the same period last year and the highest since its records began in the 1970s. The fall in the oil price has not only increased pressure on companies to increase margins, but also exposed weaknesses proving opportunities for distressed acquisitions.

Presto Pronto

Recession should provide Italy with a further imperative – if any is needed – to address its banking weaknesses. Italy received the weakest report card from the ECB following its comprehensive assessment of European banks released last month. Nine of the 25 banks with capital shortfalls were in Italy, including its third- and fourth-biggest lenders. Italian banks also had the lion’s share of the additional loan provisions – €12.1bn out of the total of €42.9bn – required across the region. Official figures out this week show bad loans increasing by 22% in the year to September to reach €177bn. This all suggests that we should be seeing higher levels of distressed debt sales; however it’s not that simple.

Micro companies dominate Italy, making up 95% of all enterprises, compared with 83% in Germany. The Italian banking system is also fragmented with only a handful of major banks. Therefore, whilst, there has been a steep level of growth in non-performing loans, there are also limited opportunities in single names. This makes the market less attractive for buyers. Moreover, Italian banks haven’t felt the same imperative to sell in areas like real estate, which have been so active elsewhere, due to the absence of a property crash. In turn, the Italian authorities haven’t felt the need to create a bad bank to pool loans– as in Ireland and Spain – and banks have felt able to wait out the storm, creating a significant pricing gap between banks and potential investors.

The focus of the AQR on NPL and forbearance – and the rapid increase in bad loans due to Italy’s economic woes – should provide the strong catalyst thus far lacking to bring bank and investors closer together. Single names are still relatively rare in the distressed market, but we’re starting to see more portfolios of loans for sale. In April, KKR & Co. signed a deal with UniCredit and Intesa Sanpaolo SpA to manage a vehicle that will pool their bad debts. The expected consolidation of the small to medium size banks should also improve the health of the banking sector and open up more distressed opportunities as critical mass allows banks to structure larger portfolios of non-performing loans and attract a wider range of buyers.