Takeways: In some areas of the market it might feel a bit, well 2006-7. The rise in M&A ‘mega deals’, for instance, which could drive overall deal values to record highs in 2015. However, this M&A cycle differs in one vital respect: financial discipline. It’s a somewhat notable trait given the highly tempting yields on offer from lenders. Indeed, arguably the imbalance between limited supply and veracious demand is the foundation for recent debt market volatility.
The next stage of recovery is adjusting to normality – and it’s often a bumpy ride. Watch for more volatility and growing pains – most obviously in emerging markets, hitting areas like luxury and capital goods suppliers. Slower emergers might keep a lid on commodity prices and inflation – but El Niño is back the great unknown in everyone’s 2015-6 equations.
As I mentioned last week, 2015 looks set to be the highest M&A year by value – or at least not far behind. Volumes will probably fall just short of previous highs – mainly due to fewer smaller deals – but overall the market is booming. We do have a question mark over 2016. But for now, rising confidence and (just as importantly) a need to meet new challenges is providing a strong impetus. Deals beget deals and rumours and fantastical ideas are flying about, making all feel a bit 2006-7.
However, before we get too carried away, it’s worth noting that (for now) this time is different. The vast majority of deals are company rather than PE led and there is a distinct lack of leveraged activity. Yes, US debt volumes are exceptionally high: June is expected to be the fifth month running that US corporate bond sales will exceed $100bn. However, part of that is just simple maths – more deals, more debt. In fact, most deals have been relatively conservatively structured by companies and financed by less debt and cash than in past M&A booms. In Europe, M&A loan volumes were up year-on-year in Q1, but only by 15% and barely more than a sixth of the volume seen in Q1 2006.
So, if we’re looking for late stage warnings similar to previous credit cycles, it’s still rather a confusing picture. Yes to mega deals, low defaults, tight spreads, but no to highly leveraged deals and slumping credit profiles. All in all, M&A isn’t giving cause to raise the red flag yet, as Invesco noted in their latest risk-reward report:
“In a critical departure from the past, we have seen a smaller use of cash (and less debt) than in past deals, despite very low interest rates….We believe most deals have been strategically beneficial and responsible in terms of higher profit margins, earnings and cash flow. A large set of acquirers appears to be focused on external growth strategies to preserve pricing power and market share, and rebalancing business portfolios. This may be especially true where prospects for organic growth are weak.”
In other words, most companies are making ‘sensible’ deals, even though debt is available at rock bottom prices. Of course, there is a difference between virtuous self-discipline and imposed restraint. It’s hard to say which is in operation here. In the US, regulators have made it hard for banks to underwrite deals with leverage in excess of six times earnings. The Bank of England has a watchful, rather than regulated stance – but with an implied warning. Buyers and lenders do tend to find ways around restrictions and things might not be as rosy as they seem, due an increasing use of hybrid debt. Cycles can pivot almost on a single deal into hubris.
Although, perhaps the risk horizon looks too complex for companies to run ahead – 2016 does look more hazardous and corporate debt markets look less friendly if sovereign debt continue their wilder ride. Hence why some companies are raising funds well before deals complete.
A European loans P.S.
Just to illustrate where we are with loans, EMEA values were flat year-on-year in Q1 – up 15% in M&A, down 9% in refinancing – companies have been busy locking in low rates for the last two years. So although, M&A loan volumes are up, overall the market is pretty sluggish. In April EMEA loan volume fell to its lowest for 13 years – down 76% on last year. May was more active, but June needs to see significant activity to catch up. This really isn’t 2007 in a volume sense. However, idle money, significant competition and pricing pressures almost inevitably leds to more risks taken (or fewer controls) in the search for deals and margin. It underlines the difficult post-crisis transition for banks, also contending with rising levies, fines, implied uncertainty of government support….
Unruly summer markets
Inadvertently discipline – corporate, PE and fiscal – has laid the foundation for the recent yield yo-yo. The ECB’s €1.1tn bond buying spree created a shortage of investment grade assets, pushing yields into the negative. However, the ECB are using the bond market to stimulate growth and inflation. The Eurozone revival actually pre-dates QE, but whatever its positive impact we’re now seeing the effect of rising growth and prices on bonds, with that lack of liquidity amplifying moves…and how!
- Germany’s 10-year bond yields jumping from virtually zero in April to over 1%
- Switzerland selling 10-year bonds at auction with a positive yield for the first time in months.
- US 10-year Treasury yield close to 2.5%, a nine month high.
Arguably, these levels aren’t indicating stress, but normality and dare we say…confidence. Yields did fall too far. And yet, this drama looks set for further acts. Even without further Greek escalation, it’ll be an interesting summer. Volumes are normally slim, so even with th ECB will rowing back on purchasing, the region could see negative issuance and yields falling again. Add in renewed Fed speculation – which could spark a sell off – and this could be an especially bumpy summer, particularly if investors have misjudged the signs.
Perhaps there have been too many cries of ‘wolf’, but there is now a wide gap between Fed signals and market forecasts. The Fed is implying rates of 0.5% by year end, the market 0.35%. Deflation isn’t off the table either. When Mario Draghi spoke at Jackson Hole in August promising to use “all available tools” to stave off deflation, the 5Y5Y swap rate (the inflation indicator of choice) was around 185bp –as it is today.
Meanwhile, equity markets aren’t anywhere near as volatile. They are subject to a related growth conflict of interest – good news helps earnings, but also could cut QE. This can produce some contrary reactions – see last week’s US payroll numbers. But this is nowhere near as severe as the tug of war in bonds, where central bank purchases have created unbalanced markets. That said, equities are never totally immune – it can just take a while for the signal to reach.
In one area, investors do seem to be taking the dollar threat seriously – prompted further by more signs of a slowdown. According to the IMF, investors are moving more money out of emerging markets than at any time since the 2013 ‘taper tantrum’. Changes in US Federal Reserve policy could stem capital flows to emerging markets by as much as 80%, according to research by the World Bank, who yesterday forecast a long period of “structural slowdown” for developing nations. According to Oxford Economics, emerging markets turned from contributors to global trade growth to detractors for the first time since 2009 in the first quarter.
If emerging markets are no-longer the global growth engine, this puts US, Japan and the Eurozone in the driving seat. And there’s one great unknown that could add salt into emerging market wounds. Leading meteorological agencies have warned of a longer and stronger than expected El Niño phenomenon. The severity of the 1997 event had a significant impact across many countries – including the US – pushing commodity markets and inflation higher..
Please note that we won’t be publishing the blog next week, but will be back week commencing 22 June.