I don’t think we need to hype this up; June could herald fundamental changes to our capital landscape. There is already a great deal to digest from last week’s ECB and OPEC meetings and even more to anticipate from pivotal votes on US interest rates (14-15th) and the UK’s EU membership (23rd) – in case you needed reminding. Then again, we’d caution against zooming in too closely on specific events. Outwith both of these votes, the world keeps turning and presenting challenges and opportunities….there’s plenty more to see here.
What we know…
It’s a relief for a moment to focus on what we do know. The ECB is extending its QE programme into investment grade corporate bonds this month, which will help propel its balance sheet beyond the Federal Reserve & Bank of Japan – that’s a whole other post just in there….. But back to the bond buying and the details out last week, in which the ECB confirmed that:
- It will only buy at investment grade– but won’t be forced to sell if debt is downgraded to ‘junk’
- It will be “mindful” of the impact on market liquidity.
- It won’t buy bank bonds, but will buy from issuers with “internal banks” e.g. carmakers
- It will buy bonds with negative yields – so long the yield is above the deposit rate (currently at -0.4%)
- It will only allow counterparties to tell clients the sector and maturity of bonds purchased – not the amounts, name or country!
To say the ECB’s move into the corporate bond market has been much anticipated would be somewhat of an understatement. The amount of investment-grade corporate debt sold in Europe jumped from €22.5b in February – before the March 10 announcement – to €43.25b in May, according to Dealogic. Yields have fallen by more than a fifth as demand has risen in anticipation. More than 60% of investment grade bonds now yield less than 1%, with 10% yielding below zero, according to JP Morgan Asset Management. You get the picture.
But what will the impact be in terms of transactions and investment? It’s worth noting at this point that US companies accounted for over 20% euro-denominated bond issuance in 2015. Fitch recently commented that US companies issued euro-bonds worth €32b in the five months to May, just over half the record total seen in 2015, and that their share is likely to rise in coming months. With the US seemingly on a rate hiking path again, we’re potentially back into late-2014 divergence territory in terms of euro-bond attraction, especially if the region’s growth picks up. Markets are still betting that the Fed will hold rates on June 15th – especially after weak non-farm payroll numbers – but the fact that the topic is back on the agenda creates a new dynamic and paradigm for any positive data and further hints.
As for European companies, obviously lower debt yields will ease the burden on companies as they refinance. Goldman Sachs has recently highlighted the potential for a trickledown effect into the small caps as falling yields at investment grade “incentivise credit investors to rotate into ‘yieldier bonds”. But it’s not like borrowing costs were really high before, so I wonder how much of more of an incentive even lower borrowing costs will provide. Even lower yields might provide a little nudge, but what’s really going to drive companies to action is what we’ve been talking about for some time: weak growth, excess capacity and disruptive competition. The ECB has upgraded its growth outlook for 2016 to a lesser variation of slow – 1.6% from 1.4% – 2017 stays at 1.7% and 2018 drops 0.1% to 1.7%. Organic growth is still going to be hard to come by.
And what we don’t…
Of course forecasting the rest of 2016 is somewhat difficult with so much up in the air. In the UK, the focus of concern has been the impact of referendum-related uncertainty; but I think it’s important to put this within a global context. Mario Draghi warned last week that activity in Q2 has been softer in the Eurozone, with PMI survey data showing a similar picture across Asia and the Americas. The OECD also cautioned that the global economy will meander along at its slowest pace since the financial crisis for a second year in a row in 2016, ensnared in a “low-growth trap”.
UK company statements and industry surveys suggest that uncertainty leading into the vote on June 23 could be having an additional effect. Markit’s latest PMI data shows the UK service sector picking up a little in May after activity hit a 38-month low in April, but the rate of growth was still one of the weakest in the last three years. In the construction sector new orders fell in May for the first time since April 2013, with output hovering near three-year lows. Tim Moore, senior economist at Markit, commented:
Survey respondents noted that the forthcoming EU referendum has disrupted new order flows and the timing of client decision making in particular. Heightened uncertainty and subdued general economic conditions in turn contributed to the first outright fall in new work received by construction firms for just over three years.
But the picture is complex. Construction hiring levels in May were their fastest since the beginning of the year, which suggests companies are banking on temporary second quarter weakness. Meanwhile, the UK manufacturing PMI survey showed an improvement in output for May following a plunge in April – although Markit cautioned that uncertainty was weighing on investment spending.
Overall, Markit believe that UK GDP growth could fall to 0.2% in Q2, but – as Kristen Forbes of the Bank of England Monetary Policy Committee commented last week – we don’t really know how much of the apparent Q2 slowdown in UK activity is referendum related. Therefore, by extension, it’s even tougher to forecast what happens in July and beyond.
In this environment, the natural reaction could be to sit back and wait and see. But, what we see in the market isn’t so much paralysis as preparation. We know companies and banks have been tremendously busy back stage – something that that won’t necessarily be picked up on surveys and market data. Operational and capital optimisation also continues regardless. They know the world will still be turning in July. They don’t know exactly what it will look like, but they need to be ready to meet it – and the many other challenges and opportunities that will endure beyond June. As we’ve said before, this just isn’t the kind of global economic environment where companies can sit on their hands.