Takeaways: It’s a week that’s pushed US and UK rate expectations back, brought ECB buying forward and dragged all three currencies, but especially the euro down. The UK’s brush with negative inflation added to the ‘loose’ narrative – just don’t call it deflation or get complacent. All this has helped steady bond markets, but it’s an uneasy peace. Meanwhile, news of an early-July ‘Budget’ will focus attention on outsourcing opportunities – but any search for efficiencies will extend to the contracts themselves
The minute waltz
It was billed as a big week for central bank minutes, but economic data and after dinner speeches set much of the agenda. The ECB announcement that it would front-load its summer bond buying inspired the second biggest one-day fall in the single currency in three and a half years. Chasing the Euro down was sterling, after negative UK CPI data pushed tightening expectations back again. The US picture was more confused, with so-so economic data denting the dollar before strong house prices pushed it up again and the minutes dragged it down. That’s currency volatility remaining high up corporate agendas…..
Where are we now with rate expectations? As much as you can pin amorphous monetary expectations down, markets and minutes suggest September 2015 for the first US rate increase. FOMC minutes show members increasing doubts over the strength of the US recovery, which seem unlikely to ease entirely before June. There is just too much ‘noise’ from the port strike and cold weather to get a clear fix on the economy. The absence of any inflationary pressures probably puts the UK on the path to a spring 2016 rise.
The MPC minutes don’t suggest any immediate inclination to move. And you have to wonder when investors will become ‘immune’ to warnings of monetary tightening. The date always seems 6-9 months away. When inflation gets stuck in a low range it also risks damaging central banks’ credibility, which can make it harder to move prices. Apparently, Chopin got the inspiration for his minute waltz as he was watching a small dog chase its tail…
Negative inflation Some might call April’s CPI read ‘deflation’ – and the dictionary might allow it – but deflation has too much economic baggage to use in this context. It normally refers to a persistent drop in prices linked to a low level of activity and falling wages. The difference between UK’s April’s -0.1% and March’s 0% CPI was due to a late Easter and cheaper airfares– hardly Japanification.
On this basis, April’s reading is much the same as March. A temporary fall in prices, largely inspired by falling import prices and transitory effects, can be a good thing if it helps to boost consumer spending power. What is starting to raise concern, however, is the persistence of low inflation in major economies and a 14-year low in UK core inflation, which has been on a downward path for a year.
The Bank of England believes the fall in UK core inflation is due to low wages. Its recent Quarterly Inflation Report recognized the danger of a vicious circle, where low wages leads to low prices, which leads to low wage demands etc. The 2.2% annual wage rise in the quarter to March provides some comfort that the UK can break out of this cycle; but this wage momentum could wane without some resolution to the productivity conundrum. All roads still lead here.
Never mind the quality…feel the yield
All these monetary and inflation machinations have confused the picture enough to steady bond markets. Given Greece’s precarious fiscal position, the ECB’s appetite, changeable oil prices and shifting monetary policy expectations this is an uneasy market peace, but it’s allowed Ireland and Portugal to sell 6-month debt at a negative yield. Although, the bond market selloff was always more about Bunds than periphery in the Eurozone. Supply-demand imbalances meant Bunds had risen further – and had further to fall.
Meanwhile, the fall in Eurozone peripheral yields was less dramatic, but significant enough to encourage sovereigns to increase supply. The European high yield bond market has also proved more immune to recent volatility than its investment grade cousin. No way of really knowing if this is because investors couldn’t get out (liquidity), didn’t want to get out (comfort with HY risk) or didn’t have anywhere else to go (lack of yield). We might not know the answer until the market hits a bigger bump in the road.
Meanwhile, hybrid bonds are becoming increasingly popular. According to S&P, hybrid issues in 2015 are running at the same level as 2014, which saw a 42% increase on 2013 and an eight-fold rise on 2012. Hybrid bonds attraction to companies stems from the buffer can they can provide in volatile markets, with features like subordination to senior creditors and payment deferrals. This ability to absorb losses protects senior creditors and therefore allows companies to raise capital whilst also protecting their credit rating.
Investors are obviously attracted to the yield premium, although that yield comes with risks attached. These risks had confined issues to the top end of the ratings scale. However, S&P notes that in 2014, companies rated ‘BBB+’ and ‘BBB’ began to make up a larger percentage of the companies tapping the hybrid capital market. Another marriage of convenience? Enthusiasm will be tested first by instruments issued in 2005-2010 approaching their first call dates in 2015.
Outsourcing: challenge & opportunity
News that the Chancellor has called a ‘Budget’ for early July inevitably focuses attention on government spending. Outsourcers’ shares rallied on the decisive election result, which promises to deliver a significant push towards greater central and local government efficiency. However, this search for efficiency will also extend to their contracts. Government agencies have become more sophisticated, cost conscious and commercially savvy buyers. Increasing transparency measures, more competitive procurement practices and use of complex ‘payment by results’ processes are becoming the norm. The government is also moving to centralised procurement, bringing a harder commercial edge.
This leaves outsourcers well placed to benefit from a rise in activity, but in a highly competitive market, with increasingly complicated procurement processes and tightening balance between risk and reward. The sector’s lengthy contracts are inherently vulnerable to changes in circumstances, with wage increases an increasing risk if current trends continue. Companies will need to think about their ability to manage multiple contracts across their lifecycles, from risk management to effective planning and forecasting (including cash, capex and WCAP visibility) and cost base flexibility.
High profile failures have often been triggered by a limited number of rogue contracts that were misjudged at inception and mishandled in execution. These examples highlight the need to rigorously apply best practice and constant vigilance for underperforming contracts. The implications of failure are often significant – from loss of contract to reputational damage. It’s vital that companies do all they can to mitigate against failure – and a have a ‘Plan B’ for when things go wrong.