Takeaways: We wouldn’t be so presumptuous as to say these are the biggest questions out there, but they’ve been exercising our minds these week and we’d welcome your views. We’re still waiting on Greece’s fate, whilst we ponder the bond sell off, ask where oil is going, wonder about corporate cash piles, and reflect on the potential impact of the now upcoming UK EU Referendum. There isn’t an easy answer to any of these. So, above all, we’re thinking about how companies can navigate these known unknowns – which in turn may help with the unknown unknowns and any other Rumsfeldian permutations the rest of 2015 throws up. The outlook looks hazy, rather than gloomy. However, with multiple scenarios on offer, it makes sense for companies to think about their capital, market, operational and stakeholder resilience. We said 2015 would be ‘interesting’.
1. What next for Greece…and does GREXIT still matter?
The finance minister meeting mood looked convivial, the ECB is still on board and Greece is still running a surplus. However, Greece still paid their latest chunk of IMF debt out of its IMF emergency reserves. The coffers are empty. Therefore it still comes down a stark choice for Greece: a face-losing deal to secure the next tranche of the bailout or default when the repayment schedule intensifies in June/July. The odds look finely balanced, but we still make ‘deal’ the narrow favourite. Compromise is still possible. Relations haven’t broken down. Although Greece’s arguably is on the road to bailout 3.0 given its deteriorating economic outlook.
If Greece does default, there is less reason to fear a deep, global crisis than 2010. Greece’s economy was always small in Eurozone terms – let alone global; but now its debts are also ‘contained’ within domestic and EU institutions and the financial system is theoretically more robust. Default might not automatically equal ‘GREXIT’. However, the danger is that this will be the first thing on investors’ minds, creating immediate concerns over the euro’s integrity. If one nation leaves, all can leave. If a euro in Greece can change to a drachma overnight – what about a euro in Portugal? It’s hard to run a fiat currency on this basis. The ECB will need to step in on a massive scale if investors lose faith.
Companies with Greek operations will obviously be scenario planning. The recent up-tick in periphery yields is small fry compared with earlier in the crisis, but there is the potential for at least a moment of paralysis if the situation deteriorates whilst the ECB shores up the euro – along with significant currency fluctuations.
2. Where’s oil going?
The multi-trillion dollar global question that lies behind so many other questions, from inflation to geopolitical tensions. Brent Crude is almost $70 a barrel from $45 in January. A much as we can assign cause and effect, possible reasons include stronger demand, strong hedge fund buying and a fall in the dollar.
However, there are a few voices suggesting that prices have gone too far. A Goldman Sachs note this week points to a continuing US supply overhang due to “limited rig curtailment” and the potential for producers to increase activity at $60/barrel, given improved returns and lower costs. It’s a message echoed by the IEA, who say it’s “premature” to assume that OPEC has won its battle for market share with US shale, the market as a whole still looks “relatively loose” and non-OPEC supply has “defied expectations”. In other words, the oil keeps flowing from Russia and Brazil.
So the market might not be moving back into balance and perhaps a lack of pressure from debt and equity markets could be part of this. To return to last week’s overcapacity theme for a moment, does excess capital equal excess oil? When capital is easy and cheap, how much do companies need to worry about returns or excess capacity? An assertion that could apply to more than just the oil sector.
Low oil prices should benefit the economy, but volatility and customer expectations of cheaper products could limit the boost to margins. Even if the heat isn’t on now, companies in the oil sector need to drive efficiency and flexibility into their cost base and strengthen their working capital position– this capital environment/price rise might not last. A dip back to $50/barrel could create significant opportunities for opportunistic purchasers.
3. What’s up with bonds?
The strengthening oil price and expectations of higher inflation is one possible reason why developed market bond yields have sprung back in recent weeks. The ten-year German bond yield has moved from a record low of 0.08% on April 20 to 0.62%. UK and US sovereign bonds have seen similar, albeit smaller, moves. It might be that yields were just getting too low for comfort and this is just a normal correction. That’s one way to look at it – a sudden moment of sanity. But it is this suddenness that rings alarm bells.
Nine-day losing streaks in Germany Bunds and three week sell-offs in US T-bills aren’t normal. The fact that the market moved so quickly without much provocation feels like some kind of portent. Crowded trades amplify herd behaviour and price movements. A combination of credit downgrades, austerity and QE means that ‘safe’ assets are in short supply and high demand. Investors will often move in on mass and, if large groups are in the same trade, any collective dash for the exit naturally creates a limited pool of buyers. The crushed yield curve has also encouraged investors into riskier areas, where the exit doors have been made smaller by bank regulation.
Markets have recovered slightly this week. But, like last year’s US flash crash, this feels like a warning that debt re-pricing in these markets can be swift and material – even in the good times. So, what happens when we have some real news? Discretion is likely to move higher up investors’ agendas as market volatility increases.
4. What’s happening with corporate cash piles?
Moody’s data has put cash back in the spotlight. Their data shows $1.73tn cash being held by US groups – a quarter of this by just five companies and 64% overseas. Recent figures for the UK show FTSE 350 non-financials held cash of £139.5bn at the start of March.
Why so much and what next? In our experience, cash holding and generation continues to be a priority for many companies in order to facilitate transactions, protect against takeover and to prove the quality of their earnings – especially if growth rates remain low or uncertain. There’s still an element of credit crunch hangover. With debt so cheap, companies are also making good use of low interest rates – even lower for those with strong balance sheets. The changing nature of industry, investment and work also affects cash holdings. Technology companies can generate increasing revenue without a significant increase in capex.
Moody’s research also shows that US corporate cash growth has slowed to 4%. M&A is playing its role in making a dent in cash piles. Verizon spent $4.4bn this week on AOL and US interest in European acquisitions will make use of overseas cash. It’s hard to imagine that governments and activists will sit idly by, whilst cash keeps piling up on the balance sheet. Shareholders will want action. M&A is still being rewarded by markets, but for highly consolidated sectors, competition regulation may leave limited options beyond buybacks and dividends.
5. EU Referendum – the next big challenge?
No dramas in the General Election, but the result sets up another big vote in the form of an EU Referendum – possibly by the end of 2016. On a micro level, this is obviously something companies need to begin scenario planning for right now. But what about the market and macro implications?
Logic dictates that uncertainty signals trouble in UK markets, however the impact isn’t that clear cut. The Scottish Referendum showed investors were able to exercise mindfulness and push worry aside until the vote was imminent. Our UK Country Attractiveness survey, to be released in late May, also shows 45% of the 400 foreign investors we spoke to were unaware of any possibility of an In/Out referendum. Moreover, it seems very likely that although there would be a short-term cost in lost investment, the longer-term impact is harder to call. A significant number of investors, especially outside of Western Europe, are open to the benefits of a looser political relationship between the UK and the EU, provided access to the Single Market can be retained. It’s obviously a topic that we’ll be returning to, as the terms of the referendum and the shape of the debate becomes clearer.
So a challenge, yes – and one companies need to factor into their plans..However, arguably the biggest immediate challenge remains low productivity, as highlighted by the Bank of England.