What a start to 2016! Bear markets, $28 oil and talk of further easing and even US recession! Markets are probably over-reacting, but – as we’ve said before – this is what happens when investors wander along the yield curve to unfamiliar places. They get spooked when it gets dark and make monsters out of shadows. Of course there’s plenty to worry about – it’s just a matter of proportion. There are still enough buffers in place and enough positives for us to stay out of the bunker for now – albeit with an eye on the canned food supply. No doubt there are pockets of stress in this environment and we’re not complacent.. But, to illustrate the more nuanced picture, we’re going to take a look at our 2016 outlook for credit, share insight from the audience of our latest UK retail webcast and preview our latest profit warning report.
Markets woke up after New Year with a sore head and – brief rallies aside – it hasn’t been pretty. Last week the FTSE 100 retreated into bear territory (20%+ fall from the peak) and at one point about 60% of the S&P 500 sat in this category. This has inspired loose talk of an upcoming US recession, which is a bit melodramatic, not least since the S&P is far more energy and export exposed than the broader economy. Much of this turmoil is due to the oil price, which can’t summon enough momentum to reach much over $30 a barrel. As the IEA put it last week: the market is at risk of drowning in oversupply and demand is a sideshow. It is impossible to say when this will reverse, since much of this oversupply is a function of a conflicted OPEC, but we know that all this feeds into the weak global economy narrative, led by emerging market concerns. China’s 6.9% GDP growth isn’t really enough to calm nerves.
Then again, let’s come back to $30 oil and consequent low inflation, which has promoted looser talk from the Eurozone and UK central banks and left the consumer in a pretty good place in 2016. Pretty big buffers, even before we throw in lower dollar debt than the last emerging market crisis and the fact that some nations are benefiting from cheaper currency and commodities – as per 7%+ growth in India. None of this is without complication. There is only so much more demand cheaper oil can generate, whilst the impact on the sector, markets, capex etc is large and tangible now. Another year of low interest rates also is another year of investors chasing along the yield curve. One of the reasons why we think reactions are so extreme is this misallocation of capital. Investors are in unfamiliar places and far from safety when problems arise. We believe that there is enough momentum and protection to keep this recovery on the road – but there are inherent dangers when drivers are this nervous and there is so much imbalance in the system.
Caution, markets reversing…
Given all the advantages still in play in 2016, credit markets should hold their nerve – albeit with more caution, discretion and volatility than they’ve shown when the going was uncomplicatedly good. As EY’s latest Credit Markets report reflects, last year was particularly good for European investment grade issuers, who reaped the benefits of high liquidity and near record low interest rates on the back of the ECB’s foray into quantitative easing. Leverage loan markets were a little more subdued than 2014; but European high-yield bond markets blossomed and the alternative lending market experienced significant growth.
There were – and still are – strong sector variations. All but the strongest credits struggled to issue debt in the oil and gas and mining and metals sector. Problems here also drove default rates to their highest since 2009. These complications have run into 2016, turned up a notch in a post Fed-hike world as the oil price falls and political and economic uncertainty increases. It’s by no means a tight market overall. Ample liquidity is still generating competition in many areas. For deals of €150m and above (outside of pressured sectors), the market is rich in liquidity, with banks, alternative lenders and high-yield investors all competing. Issuers in demand can keep their options open. But, it will be a more volatile and difficult year, especially for companies at the tougher end of high-yield and in those pressured commodity exposed sectors.
The last retail hurrah?
We’re also still expecting a reasonable year for the UK economy – despite tougher global markets – aided by the extension of the UK’s interest rate-inflation buffer. The EY ITEM Club has upgraded its 2016 GDP growth forecast to 2.6%, primarily due to consumer spending growth continuing at 2.8%. What is a concern is how this is – or isn’t – translating into retail sales and profits on the ground. BRC and official figures show no growth at Christmas and our figures show the highest number of Q4 FTSE General Retail profit warnings since 2011.
Why isn’t this rosy consumer picture translating into an improved performance at the tills? We asked attendees at our annual retail webcast – <replay here> – their views on retailers’ main challenges in 2016. The overwhelming majority gave one of three answers: discounting & deflation; maintaining profitability as more sales move online; and the impact of the National Living Wage. Effectively, UK retailers are in a margin vice in what we’ve termed a “discountvenience” market. Loyalty is scarce, price rules, disruptors are muscling in and consumer’s expectations are rising – at a rising price to the retailers who are striving to fulfil them. It also looks like 2017 will be tougher as the vice closes, not just on retailers’ margins, but also on consumers’ disposable income. This is set to be another year of rapid change and retailers will need to be bold in their moves to embrace new trends to come out the other side in a stronger position.
It’s interesting this context to note that over a third of attendees thought distress deals would be the main driver of retail M&A activity in 2016. This isn’t the kind of market to trigger a clutch of post-Christmas administrations, but the margin vice is tightening and it could squeeze a few companies to breaking point in the next 12 months. Low polling for trade deals – 23% – reflects a low incidence in reality and real-estate complications. Most high street retailers are trying to trim their estate, although the quest for better use of space might drive more M&A activity here. The bigger 25% vote for overseas deals highlights the UK market’s on-going popularity. It’s tough out there, but that doesn’t mean there aren’t ‘turnaround’ or market leading opportunities and companies everywhere are trying to spread geographical exposure. More surprising, is the low expectations for IPO exits, at just 2%. This might reflect the mixed performance of 2014-5 vintage IPOs and market conditions – and we do expect PE funds to keep their exit options open in 2016.
Retailers aren’t the only sector struggling under the mantle of disruption, uncertainty and change. EY analysis shows that UK quoted companies issued 100 profit warnings in the final quarter of 2015 – the highest total since Q1 2009, while the 7.3% of quoted companies warning is the highest proportion since Q4 2001. This is an exceptionally high number and, although a fifth of warnings cite a fall in commodity prices, that’s clearly not the only factor. Not when warnings from such diverse industries populate our top 10 in 2015. It’s oil, but it’s also the weather, and emerging markets and competition and sterling and…well in this volatile climate there is always something.
It is tough to account for every eventuality, but in this more uncertain climate, companies need to be better prepared for the unexpected with a more robust assessment of their business and their forecasts. And underlying this is the impact of digital disruption. EY research shows that only 70% of today’s major global corporations will even attempt to reinvent themselves digitally – with 40% of these failing, and only one-third will survive the next 25 year. This sense of rapid change only adds to the confusion amongst investors. There are obviously areas of stress, but there are also companies, industries and economies doing well. The problem in 2016 will be how much they are heard over the noise.