Takeaways: In the next week we could have a new UK government and significant policy change…or maybe in the next month. With so many permutations, the current focus is on the impact of uncertainty rather than policy. It’s certainly a (another) big month for Greece, with the endgame surely close now. Arguably it’s still a pretty big year for this recovery – it’s still not entirely clear how we progress from here. Companies are responding to current conditions with a heady wave of M&A – but will it hold into 2016?
Let me introduce myself. My name is Michel Driessen, EY’s new TAS Markets Leader for UK&I, taking over from John Van Rossen as of now. I have over 27 years of transaction, industry and consulting experience focused on large, complex and multinational diligence, post-merger integration, restructuring and carve-outs for both corporates and Private Equity. Prior to EY I held executive roles in Accenture, Rabobank, Visa and Fujitsu.
A pivotal week for the UK
The UK has gone to the polls today, with a plethora of likely outcomes and policy formulations still possible. As of Thursday evening, bookmakers are still stumped. They give a roughly a 50-50 chance that we still won’t know the outcome a week from now – and a one-in-four chance of a new election in 2015. So unsurprisingly, much of the focus has been on the potential impact of a prolonged government hiatus – longer than the five days of 2010. The electorate may surprise us overnight; but the maths looks much closer than last time and surely Mondrian didn’t draw so many lines. Compromise will be hard won.
Pre-election uncertainty hit construction – as PMI data confirmed this week. Unsurprisingly, since it has sat in the crosshairs. However, the service sector continued to motor in April, with new business the primary driver of activity. That said, if the Scottish Referendum taught us anything, it is that this is a noisy world. Companies, investors and markets don’t tend to worry until problems loom large in their mirrors. This does appear to be happening in gilt and currency markets – albeit with some Eurozone volatility thrown in. Yields on 10-year gilts are at a six month high and the pound is at its most volatile since mid-2010. We may see more dramatic election-related capital outflows and more currency volatility if negotiations drag – but may-be only if prospects look better elsewhere.
UK equities currently have looked more insulated – especially in the FTSE 100, where two-thirds revenues are international. However, once we move from uncertainty to actual policy there will be an impact on domestically oriented healthcare, support services, banking property, betting and energy shares – either relief or concern – with a broader impact if referendums are on the table. However, curiously, volatility measures show waters calming three months out. Perhaps a hope that after the initial horse-trading, the resulting compromises will limit change to the status quo. That old Wall Street adage: ‘gridlock is good’? However, the campaign alone has widened the UK’s national and political fault lines. There’s not been much ‘better together” recently. And, if just some of those red lines hold, there will be some pretty major decisions made about the future of the UK in the next week…or possibly month….
A pivotal month (or two) for Greece
It was a fairly big week for Greece. However, it managed to find money to pay the IMF and its pensioners by looking down the back of the municipal sofa and cutting costs. So the saga rolls on….
Greece was “on the brink” when the UK last went the polls. But this time it’s (probably) different. Debts are higher, patience is thinner and there are more lines here too. The FT reports that Greece is so far off course on bailout programme that the IMF won’t release its share of the next €7.2bn tranche unless European finance ministers write-off significant amounts of its sovereign debt. This isn’t all that surprising given Greece’s deepening debt spiral. Brussels has cut its Greek growth forecast from 2.5% to 0.5% for 2015. This bleak figure assumes Greece receives its bailout funding by June, but even under this scenario, it’s now on course for a primary deficit of 1.5% and for debt/GDP to rise to 180.2% versus the decline to 170.2% predicted in February.
Debt restructuring arguably might be the best way of anyone getting some money back; but for Eurozone powers, this isn’t so much a ‘red line’ as the Rubicon. Especially since Greece isn’t just refusing to introduce new austerity measures, it is rolling back some of the old ones. The next major meeting is 11 May. More debts are due in June, when the next bailout money is due. Crunch time.
A pivotal time for the global economy?
Admittedly, the waters have been muddied by yet another mixed bag of US macroeconomic data, but we’re still somewhere on the road to US monetary tightening – probably still in 2015. And, when we take those first steps, we’ll really get to test the strength of our recovery’s foundations.
Whilst monetary conditions have been so abnormal, how can we judge? where we are Signs of recovery in the capital markets in particular have blurred into over exuberance and potentially systemic risk. This week the Joint Committee of the European Supervisory Authorities added their voice of concern. Janet Yellen noted last night that shares are “high” and that debt market investors are taking some excessive risks. Sometimes it’s hard to work out what is rational or not. Is the recent rise in German bonds yields a rational reaction to impending recovery and rising inflation, an irrational stampede – or a bit of both? Crowded trades amplify the impact of herd behaviour.
The recent M&A boom highlights this blurring between rational and irrational responses to normal and abnormal conditions. Obviously, the Eurozone economy has been boosted by some extraordinary ECB support; but the recovery would appear to predate this and seems rational for companies to take full advantage of this upturn and the QE-inspired fall in the euro. In a low interest rate environment, there is also an obvious incentive to either borrow or spend existing cash and buy up capacity of weaker rivals. Partly due to opportunity cost, partly because the market wants it. M&A is being rewarded.
But what happens when these loose monetary conditions unwind? There is growing concern over overcapacity in many areas. Valuations are also starting to raise eyebrows. It’s obviously tricky to value assets with zero nominal or negative real rates. The vast amount of money flowing into equities in pursuit of higher returns has raised sellers’ expectations. Buyers, justifying their already high valuations, are more willing to pay higher multiples aided by their large cash piles and cheap debt.
At a global level, M&A multiples look merely warm, but in key countries we can see some hot-spots building up, e.g. Germany, China, US. And in sectors too, e.g. Aerospace and Life Sciences. We’re not ready to call the end of the M&A upturn: 2015 could well be the highest year on record, beating 2007. However, 2016 doesn’t look so hot. Interest rate hikes inevitably drag on equities and that great unwinding is still the great uncertainty.