Takeaway: Of course Greece isn’t out of the woods. We remain convinced that the only sustainable way forward is through debt reconstruction. It’s not off the table, but it’s not on it either. So, whilst this debate remains parked on a hostess trolley in Brussels, we’re going to ask a few questions to help take stock of the broader picture. Altogether, it looks like a continued rebound with that clichéd phase: “challenges ahead”. This is why we’re really focused on capital allocation as a key differentiator. And – as recent transactions show – many companies are too.
1. Confidence, paralysis or the ‘doldrums’?
VIX – the ‘fear index’ – dipped below 12 on 17 July. This level doesn’t happen very often and could be read as a vote of post crisis confidence. Or just markets treading water? Interest US rate rises are coming, but they’ve been a long time coming. We might as well have been waiting for Godot. Long waits encourage investor paralysis. Summer is also the traditional time for market ‘doldrums’. Like sailors without winds, investor without news will sit on their hands. It’s not that we’ve had nothing to think about, but the continual Eurozone crisis has rather inured many investors.
The thing about VIX -and equity indices in general – is that they’re blunt predictive tools. VIX was bobbing around below 11 in early 2007. Vix has come back up in recent days on China/commodity concerns, but remains relatively low for now. So, best to take low VIX at face value: i.e. good news for deal values and volumes whilst it lasts. Low volatility helps build confidence and equity prices, the foundation of much of the recent burst in M&A activity. It is one reason why we think 2015 will be a record year, but are more cautious on 2016.
2. Time to race against the Fed?
The long wait could be over soon. Putting cynicism aside, with macro clouds clearing and some domestic indicators starting to flash, the Fed could move in September. It will be on a gradual trajectory. However, after so long at the low bound and with the trajectory expected to be one way for some time, it is a significant moment. Capital will shift and no-one really knows how much, how quickly and at what cost – other than it’s hardly likely to be cheaper!
We sense no panic, but certainly some urgency. According to Dealogic, companies have sold more “jumbo” bond deals ($10bn+) since January than the previous five years combined. A whole convoy of European bond deals have also begun their road shows. But could this be as much about the market coming out of its Greek purgatory and a race to get M&A fuelled deals done before the summer slowdown as much as a pre-Fed rush? Companies have effectively been in a race to refinance for many years. About one-half of outstanding debt in S&P’s database was issued after 2012 – the point where borrower terms turned real friendly. The non-financial peak is now pushed out to 2019.
The environment might not change dramatically at investment grade – not whilst the ECB, BoJ are still ‘supportive’. But, companies have never had it so good and may not again. We expect more companies to move soon to secure capital, with a risk of crowding if a US rise is signalled strongly.
3. Why is HY debt so popular?
The reason is simple: high yield bonds have returned 2.74% this year, according to Barclays Indices, outpacing corporate bonds and the much distorted sovereign debt market. Moreover, it did this with a downturn in the energy sector and global economy instability. In a recent survey by Fitch, investors made this their most favoured asset class. What’s not to like? Well, you’d need a pretty short memory to have forgotten previous swings out of HY, when monetary tightening moved onto the menu. But this is somewhere where investors could keep dancing until the music stops.
Again, we’d be very cautious about using current enthusiasm to extrapolate a long-term trend. As we’ve seen before, sentiment can turn very quickly. Refinancing at this end of the market will also be complicated by tighter Basel III rules that will limit banks’ appetite for leverage exposure. Companies will be testing the appetites of alternative lenders.
4. What’s up with gold…oil, copper?
Gold is approaching a five and a half year low, but there’s no mystery behind the fall. Gold usually moves inversely to the strengthening dollar. Add in weak Asian buying (with China’s market woes adding to concerns) and what might be termed ‘pre-crisis fatigue’ and you have good reasons for gold to drop. The speed is dramatic, but capital is going to move fast in the coming months.
Looking more broadly, the Bloomberg commodity price index recently fell to its lowest level since March 2002. Brent Crude is well under $55/barrel. Copper is at its lowest since 2009. Mining bond yields are rising, shares falling. Commodity companies across the board are retrenching by cutting jobs and costs and delaying projects.
None of the major commodity price deflators – strong dollar, weak Chinese demand (with fears rising after further dramatic stock market falls) and oversupply – look set to reverse significantly in the near future. In oil, suppliers of equipment and services have arguably been hit hardest. Expect more pain as price falls become entrenched and capex cuts continue.
5. Where’s the growth?
As the IMF recently noted, there is a broad global swing back to developed markets. The Eurozone recovery story is still just about intact – albeit with debt & reform caveats. The US is emerging from its winter freeze. Emergers are still growing quicker overall, but not quick enough to balance out the risk for many investors.
· 46% investors thought emerging market corporates faced the greatest refinancing risk.
· Only 15% would consider buying Russian debt
· 76% picked Brazil as the biggest EM contagion risk – 38% Russia and 36%
(China arguably could be the bigger threat, but it still has big levers to use)
Many emerging markets obviously have vulnerability to cheaper commodities, stuttering Chinese demand, more expensive dollar/credit and capital shifts – which are already happening in some areas. But, beware using a broad brush. Some countries – like India – tend to benefit from commodity price falls. Its road to reform is long; but if travelled, offers significant opportunity. Meanwhile, the Bank of Canada has cut interest rates to a five-year low of 0.5%, whilst trying to avoid talk of recession. Falling milk prices are hurting New Zealand, now in rate cutting mode.
The recent earnings season has highlighted softening demand in a number of markets – especially China & Brazil – ahead of any US monetary tightening. But this isn’t simple equation. The global trade map is being redrawn and investors are likely to differentiate their approach to emerging markets, preferring countries with reforming agendas or new momentum, e.g. Cuba & Iran.
6. Where are earnings heading?
Our latest research shows UK profit warnings fell dramatically in Q2 15, down by 26% on the previous quarter, thus bringing an end to the run of ‘most since the financial crisis’ periods. It seems like expectations have reset, but they can often overreach at this point – as they over correct at others.
Both companies and analysts have struggled to forecast through this recovery. Part of the reason may be that macro is a diminished part of the story. Whatever the economic winds, many companies are also still contending with change within their own sector, as disruptive entrants and technologies continue to challenge pricing and old models. On the other hand, many companies are also running leaner. Cost cutting cannot last forever, but it will continue to boost earnings for some time yet.
The upward trajectory looks like continuing, but may be shallower. The UK consumer in particular will come under additional pressure from 2016 – hitting sectors already struggling to cut prices and invest in new channels.
7. So where are companies placing their bets?
The recent rise in M&A is based on rising boardroom confidence, with its foundation in supportive equity and debt markets. But, it’s also linked to companies thinking more and smarter about their capital allocation. Divestment can make companies more profitable. Disruption – especially technological disruption – can offer new opportunities in mature markets to reinvigorate the product or service. Two recently announced deals exemplify these trends in smarter capital allocation
Volkswagen’s offer to buy Nokia maps.
The maps will power their navigation systems now, but have obvious potential in the development of autonomous vehicles. It exemplifies the trend for mature sectors to buy in new technologies to meet increasing consumer demands for connectivity.
Pearson’s disposal of The Financial Times/Economist Stake.
In its statement, Pearson acknowledged an “an inflection point in media” and that the best way to ensure the FT’s success was through a sale to a company better able to invest to meet new industry challenges. Meanwhile, Pearson is using its proceeds to invest in its core global education business – a sector that is also changing rapidly and needs additional investment. We expect to see more companies selling businesses – not because they are unsuccessful; but because they do not have the capital or expertise to develop them and capital could be better deployed elsewhere.
We may see more conservative capital allocation from companies in terms of geographical reach – although like investors, we expect companies to treat each emerging market on a case by case basis. However, we also expect more transformational and imaginative moves as companies adapt to rapid changes in their sector, united with the ongoing need to consolidate and cut costs in many industries.