Takeaways: The 2015 rollercoaster continues. Markets raced back up in October for some good and some more speculative reasons. ‘Payroll Friday’ brought another twist and another lurch. Managing currency risk, raising capital and picking commodity prices will be tougher going in the rest of 2015.
These are perplexing times, but this shouldn’t stop smart deal making. Companies have shown their ability to see beyond the turmoil to the bigger picture and are still on track for record levels of M&A in 2015. News of this cycle’s death has been greatly exaggerated.
What a difference a month makes…
The latest asset chart comparing performance in Q3 and the start of Q4 tells quite a story. At the close of markets last Thursday, the S&P 500 had made up all of its Q3 losses and the STOXX Europe 600 was most of the way there. Shanghai had clawed back almost 50% and emerging market equities staged an equal recovery as commodities stabilised.
Some of this recovery is due to recent release of data and earnings, which has brought some perspective to the reality-checks of summer. Although Q3 growth undoubtedly looks softer, manufacturing data has come in a touch better than expected. Earnings also showed some resilience. Nevertheless, the really major market moves were strongly aligned to hints of continuing loose or looser monetary policy. The Draghi bounce was the real game changer in European markets in October. S&P recently noted that Italy has benefited most from looser ECB policy and 10YR bonds yielded just 1.5% at the end of October, compared to 2.3% at the start of the third quarter.
….and a day makes…
Which brings is to last week’s monetary about-face. Markets do seem to be increasingly geared to big consensus bets – especially on interest rates. The herd gathers and, when the consensus is overturned, the herd stampedes. Markets lurched again at the end of last week when, in the space of just over 24 hours, the Bank of England swung to the dove-side and US non-farm payroll numbers came in vastly better than expected. Even after a week of FOMC members pushing a December theme, the dollar shot up by almost 1.5% against the euro and 1% against the pound. European stocks rose sharply on hopes that they would now outstrip US counterparts.
Divergence on! But who’d bet against a further twist? Europe is certainly on a different path to the US. The ECB sent some mixed messages last week, but any move now will be to loosen. The Monetary Policy Committee voted 8-1 to hold again; but an accompanying Bank of England report said UK inflation won’t ‘need’ higher interest rates in 2016. A strong dollar could keep commodity prices low in 2016 – if global demand remains tepid. Certainly the oil taps remain on for now. But a year is really long time in oil markets and monetary policy. And, before we ink in a US rate hike on 16 December, it is worth noting that ‘strong’ October payrolls were actually only the same as the 2014 average and they follow two very weak months, with more than a month of data to go. See above for how much can change! The FOMC will also be well aware that raising rates in this looser environment risks huge inflows of capital, a much stronger dollar and pressure on exports. It won’t do this lightly. It’s a probable, but not certain raise.
In many ways – as the FT pointed out last week – the current depth of consensus in this and many other areas is curious, given the lack of certainty and 2015’s track record. Just look at central banks’ differing takes. Last week, The Bank of England indicated that they were more worried about the global economy – just as the FOMC played down the risks. Perhaps such deep uncertainty is actually driving consensus, with investors seeking safety in numbers? Consensus driven less by certainty than by fear.
What did low commodity prices ever do for us?
European Q3 earnings look set to fall 12% from a year ago, according to Thomson Reuters StarMine’s “blend” estimates, which takes into account reported results and forecasts. Not great, but not as disastrous as feared. More companies hit, rather than missed expectations – just. Of course, commodity-reliant company earnings remain under pressure. In recent weeks we’ve seen more second round warnings from businesses who thought they could hold out for better times and those coming back for their second or third profit warning as expectations drop again. This might help to explain why UK aggregate earnings expectations have come under so much pressure, given their commodity bias.
We could look at figures that discount the impact of commodity stocks – but should we then also discount stocks that have benefited from lower energy and material costs? Of course it’s not that simple and it’s increasingly obvious that this benefit is being limited by rising costs elsewhere and the difficulties of passing these on in a highly competitive environment. The investment cost of keeping up with the digital Jones’ and rising operational costs are recurring themes in Q4.
We’ve recently examined <here> how UK companies should approach the wider implications of the national living wage. Companies also face increasing cost of regulation and assurance and – again in the UK – the impact of this November’s spending review. How well companies deal with these challenges – and take any opportunities – will further bifurcate companies’ earnings.
Alive and kicking
According to our analysis, the total value of M&A in October was the fourth highest on record – or the fifth highest if you exclude real estate. This may yet be upgraded as details of smaller deals are added in. The data can initially make it look like it’s all about the mega deals, but in the final reckoning we expect October’s picture to remain as it has for the whole of 2015 – ahead of 2007 and broad- based in terms of geography, size and sector.
So we’re not calling the end to this cycle yet. Of course, the environment is changing and this may temper the pace as we move into 2016. Companies are digesting the absolute feast of deals completed in the last year and they are increasingly testing regulatory barriers. They may be more focused on completing smaller deals that emerge as part of the shakedown. Exceptionally accommodating markets are also becoming a more discerning – with an eye to potential events in December. Average acquirer premium has fallen. There is some indigestion in the loan market due to the sheer volume of debt banks are trying to sell.
Thus, riskier plays in unloved sectors risk being squeezed out. But, good, well-argued deals with a strong rational are still getting market support. And the deal imperative remains strong. Companies need to find growth in low growth markets and they need to protect their existing market share from disruptive competitors and M&A is their weapon of choice.
Cyber-security is rising up the corporate agenda in this busy deal and integration context. In our recent Capital Confidence Barometer, 56% of respondents said they always performed cybersecurity due diligence in their transactions. A strong process for mitigating cyber threats is vital for all companies – as recent high profile examples demonstrate. The M&A process creates a particular vulnerability, since it typically involves centralising an organisation’s strategy and information in one repository. Companies’ systems could be hacked or compromised with the intent to gaining insider information to manipulate stock price or gain competitive information. Understanding the motivation of potential attackers is the first step to managing the risk and taking preventative steps.