All I want for Christmas…
I’m not sure Santa will be able to deliver everything on central bankers’ lists this year. Mario must be wondering if he’s made the ‘naughty’ list as Eurozone inflation expectations dip again. Haruhiko got an early present in the form of an Abe election win – a green light for stimulus – and more inflation will be on his list. Meanwhile, Janet might be asking for a crystal ball – and a loudhailer. The Fed has a tricky year ahead, where timing will be everything and, troublingly, it doesn’t look like the bond markets are on the same page. It could be a rollercoaster ride if expectations don’t converge – or for different reasons, if Russia troubles continue to deepen. Moscow’s woes highlight again how the previously coupled emerging markets have diverse wants and needs. No-one is hoarding food and dollars on the streets of Shanghai. Indeed, our research shows that China’s executives have more in common with their US counterparts than the rest of the ‘BRICS’. All this adds up to ‘risk-off’ as we move into 2015. Next year might bring more growth, but increasing volatility will keep self-help measures – including a prudent approach to M&A – high up corporate agendas.
In the bleak midwinter
Spain’s 1.8% 10yr bond yield doesn’t signal ‘bleak’, but it’s hard to take this at face value when markets already have QE inked in. The latest Reuters poll shows that 25 of 27 economists believe the ECB will begin buying sovereign bonds within a few months. We believe the decision is more finely balanced. Not because we think action isn’t necessary; but because implementation remains a thorny issue. The waters have clearly been muddied further by Greece’s stumble towards a general election.
The case for radical action did become more acute this week as inflation expectations took another dive. The five-year, five-year forward swap rate of inflation –the average expected inflation rate over five years, starting in five years – slipped below 170bp, a new record low. When Mario Draghi spoke at Jackson Hole in August promising to use “all available tools” to stave off deflation, the 5Y5Y was around 185bp. QE might be part of the solution, but as we’ve said many times before, the Eurozone’s chief issue isn’t the availability or the price of credit – not with yields this low. The biggest issue remains the amount of debt on the region’s balance sheet. Companies and households simply do not have significant appetite for more, which means US and UK style QE can do little to improve demand. It should help to weaken the Euro. For that reason, it’s probably worth trying and it’s hard to see how they reverse expectations now – but we keep coming back to the debts.
A Standard & Poor’s report out this week shows that Italy, Greece, Portugal and Spain will owe a total of €1.85tn to external creditors by the end of this year – more than double the €875bn owed a decade ago. The Eurozone is home to nine out of the 15 most externally leveraged economies in the world. The region will remain a thorn in the global recovery’s side in 2015. Those with the means are engaging in increasing amounts of outbound M&A (see below). Another year of low growth and the slide towards deflation could test the patience of stakeholders and public next year.
Do you hear what I hear?
The ECB can only dream of the problems facing the Federal Open Market Committee as it meets this week. The US recovery, whilst fragile in places, is moving on a pace. There is speculation the FOMC will do more after this meeting to prep the US – and the global economy – for their first rise in interest rates since 2006. Market forecasts clearly lag Fed expectations by some chalk. The FOMC dot charts show the Fed fund rate at around 1.25% by the end of 2015, whilst Fed fund futures show 0.5% at the same point.
This disconnect is hardly surprising given the vast gap between expectation and reality in 2014. However, interest rates have to go up some time and there is another chorus of concern over the gap and a potential ‘bloodbath’ in 2015 (on 1994 lines) if the Fed raises rates rapidly. There are mitigating factors that should prevent a shock across the whole asset class. The possibility of full-blown QE in the Eurozone, the benign global inflation outlook and continuing slow growth should prevent a mass bond exodus. It also seems unlikely also that the FOMC will raise rates aggressively ahead of market expectations.
However, asset price dislocation and the potential for a crush at the high yield corporate and emerging market exit is something we’ve been wary of for a while. We’ve highlighted elsewhere the current problems of using risk free rates in valuations. The market’s need to re-price risk is clearly recognized –it’s just the timing and steepness of the curve that’s the issue.
Investors were already applying more discretion in HY corporate debt post Phones4U and before the latest Russian twists. According to research from Barclays, the yield gap between B and BB-rated credit European bonds is at its widest since the financial crisis at 2.2x having drifted around 1.6x to 1.8x for the last five years. Companies refinancing with weak ratings and a patchy track records could find markets less accommodating in 2015. As we highlighted last week, emerging nations exposed to dollar-denominated debt – especially those who haven’t taken steps since the ‘taper tantrum’ to build resilience – look exposed if investors pull back from risk.
On the first day of Christmas, my true love gave to me…
…a BT bid for EE. A deal that epitomizes current M&A trends: a transformational, cross-border deal with a clear rationale in technological convergence. Unsurprisingly, it comes with unequivocal shareholder endorsement.
After five years of almost permanent crisis, 2014 saw the first signs of smoke clearing and an early look at the post-crisis M&A landscape. Our global analysis through November shows a very clear preference for buying lower risk assets, with nearly 50% of all value being allocated to US based targets. China, the UK, France and Canada make up the rest of the top five. Russia is the notable faller in 2014 – dropping from US$74bn of assets acquired to US28bn in 2014. In global term, this represented a fall from 5th place in 2013 to 17th place this year. The drop is even more dramatic if you consider that in 2007, the value of assets acquired was US$156bn. Russia is clearly loosing investor interest.
Cross-border deals are the other big story. Again, this is a tale of lower risk options. Brazil is the only non-developed market to make the top 10. However, buying abroad has its appeal when growth is slow at home. China has slipped to 6th in terms of acquiring outbound. It is not that they have spent less in 2014; it is that others have invested more. Germany is a notable riser, spending US$97bn on overseas assets compared to just US$14bn last year. Deal making in the UK is only up slightly by 5.3% on last year overall, but overseas acquisitions have increased considerably – up by 16% in value and 60% in volume. This surge has catapulted the UK to the second most active overseas acquirer, second only to the US. The UK is clearly punching above its weight. Those sectors that are particularly active include: Telcos looking to grow global revenues steal a march in the race for technology convergence; life science companies taking advantage of the benefits offered by tax inversions and the need for the next blockbuster drug; and consumer products companies seeking defense against low growth at home.
A winter’s tale
It’s been noted before how the patterns of M&A in China are changing, with a shift from inbound acquisitions by foreign investors to an almost total domination by local based participants and an increase in outbound purchases. This reflects the growing strength and confidence of Chinese companies and this is highlighted in a comparison of China to the other BRIC nations based on EY’s own Capital Confidence Barometer. What we clearly see is a divergence of outlook between Chinese executives and those from Brazil, Russia and India. In fact, the group that Chinese executives most resemble now is their peers from…..the US.
This is our last blog of 2014. We hope that all of you who are celebrating have a wonderful and restful holiday season and we look forward to some interesting times in 2015! We’ll be back in the second week of January.