Five summer themes

When was the last quiet summer? Perhaps it was the same year as the last hot one? The pace of events might slacken in August –but let’s not bet on it. Still, it feels like a good time to take stock.  So much is up in the air, but we’re starting to get a better idea not only of BREXIT’s initial impact but also the official reaction and implications for M&A.

In this blog, I want to pull all this together, pulling out five broad themes that are shaping the capital agenda.  A BREXIT thread runs through this tapestry, but it’s not the only strand – and it’s not where we start.

1.      The “left behind” reshape the debate

“We [believe] that we are entering the age of de-globalization, as societies demand (and get) greater protection from competition & immigration as well as greater support for local industries and employment.” – Macquarie Research.

To understand the current political and economic debate you need to take a step back and look at changing attitudes to globalisation. Surveys show that free trade is now a vote loser on both sides of the US political divide. Anti-globalisation and anti-establishment feeling is moving into the mainstream across Europe and the US. This is exemplified by the BREXIT vote and rise of “populist” movements – but governments are also closing the trade doors, according to CEPR.

It’s not all about growth. The US, UK (pre-BREXIT) and parts of Europe have been growing well. But this hasn’t translated into increases in wages and wealth for the many, whose jobs have become more precarious. According Macquarie, 40%-45% of the US labour force is in “contingent and least-paid occupations”. There are around 22m contingent workers in Europe – mainly in Turkey, Italy and the UK. OECD data shows average real wages in the UK have fallen by about 10% since 2008.

Why follow mainstream politics when you’ve fallen out of the mainstream economy? In the US, death rates predict whether people vote for Donald Trump. In the UK, BREXIT votes correlate with areas where wages had been depressed for some time. Some argue this is more about cultural anxiety than economics. Either way, their concerns are now reshaping the political debate.

 2.      Comeback for fiscal stimulus
“This fear that one could suddenly lose everything is not well captured by average numbers….Missing upward social mobility is not the problem. Growing downward mobility is.” – Martin Sandbu, Financial Times

The Bank of England acted as expected: an interest rate cut of 0.25% – the first for seven years, a QE extension – including corporate bonds , a potential £100b pound loan program for banks  to help get this into the ‘real’ economy’  and the hint of more to come.  This represents a significant structural shift, with the UK now on a looser path than the US and a similar trajectory to the Eurozone. This has had an immediate impact on the pound – no doubt part of the thinking on economic stimulus. But the Governor has also handed the baton to the Chancellor – who has already signalled his intension to do what it takes from his side.

The return of fiscal stimulus has the potential to be the biggest game changer for the UK economy – and it is part of a much bigger global trend that includes measures in Japan, more relaxed attitudes to fiscal breaches in the Eurozone and promises from both US presidential candidates on infrastructure spending.

Why now? Monetary stimulus is a useful tool, but a blunt one – indeed S&P has shown how it has exacerbated wealth inequality in the UK. The UK government is likely to use fiscal stimulus not just to plug the economic gap left as uncertain companies reign in investment spending, but also to promote more inclusive growth and address some of the UK’s economic imbalances exposed by the EU Referendum vote. Returning to the idea of the “left behind”, London was the only English region to vote for remain.

Moreover, there’s growing concerns about the shape of capital markets as the yield on more debt turns negative. According to Callan Associates, in 1995 investors could achieve a return of 7.5% with a portfolio entirely made up of bonds and the likelihood that returns could vary by about 6%. To make a 7.5% return in 2015, investors needed three-quarter of their portfolio in private equity and stocks and returns would vary by more than 17%.  Imagine what this looks like now with around $13t in negative-yielding debt in global markets!

It’s not just about the drift along the yield curve. Weak companies limping on, inefficient use of capital and problems for pension schemes and banks – the negative list is growing. Clearly Italian banks have problems beyond low interest rates, but it’s a concern popping up in trading statements across the financial sector.

3.      The end of old certainties, the start of a new era?

“The U.K.’s decision to leave the EU has been a salutary reminder that risks considered serious but unlikely can indeed crystallize, with significant credit implications.” – Standard & Poor’s

I think this year has really brought home that we’re in a new industrial revolution, one that has created an entirely new work dynamic, which needs new skills and fewer workers – at least on a constant basis. Somewhat contradictory to this, there’s also falling productivity – a measure perhaps of the overcapacity that still exists in many sectors and a lack of investment linked to uncertainty and cheap labour. 

Governments might recognise the issue, but will struggle to square this circle. As in the last industrial revolution, technological change could eventually bring about improvements in productivity and this will change the game again – but not in the short term. Governments will also be distracted by a litany of other challenges: terrorism, conflict, banking crises, constitutional referendums, elections, US interest rate rises…BREXIT isn’t the only worry, but it exemplifies the uncertainties of the current age.

The global economy is finally gaining velocity according to Fulcrum’s monthly report of underlying activity. The risk of global recession now stands at almost zero.  But – the Fed hasn’t yet managed to raise the US rate rises without creating tumult in the markets. Something has to give and just maybe it’s this year?

4.      BREXIT – a (long) work in progress

“We took these steps because the economic outlook has changed markedly,” – Mark Carney, Governor of the Bank of England

All of which will shape progress on BREXIT – now shaping up in three phases.

1) To the end of 2016 – to include the initial market, monetary and fiscal responses

2) The negotiation period – from 2017 to maybe 2019 or beyond – on immigration, trade & regulation

3) The period beyond, with a reshaped economy

The initial impact has been tough – the biggest one month dip in PMI surveys recorded since record began in 1996 – and the Bank of England now expects growth of just 0.8% in 2017. Forecasters generally agree on the amount that growth will reduce in 2016-7 – around 40% – what they don’t agree on is if this will come as part of a sharp shock or a slow burn, which in turn depends on the shape and success of stimulus.

The market is picking up on some nuances after their initial blunter downgrades. Companies with little UK exposure and potential for export boosts are looking more attractive to investors as sterling falls. Those exposed to cyclical UK demand and sterling via rising import costs are lagging. If there is significant fiscal stimulus, infrastructure companies and related ancillary services should benefit.  Support for consumer or housing could change the dynamic again.

 As for the longer term, we can take perverse heart that BREXIT is coming up on earnings calls across the globe. The UK’s position as the 4th largest consumer economy, the 5th largest overall suggests it has much to bring to the table in negotiations, although we have no doubt that these could be prolonged and it probably will be easier to do deals on goods than services, given the relative deficits. There will be more twists and changes in investor priorities as the negotiations play out.

5.      A more nuanced deal environment

” I decided for the viewing the paradigm shift as the opportunity, this is the beginning of IoT. I would have made this decision at this time regardless if Brexit happened or did not happen,” Masayoshi Son, chairman and chief executive of SoftBank on the acquisition of ARM Holdings

Uncertainty has slowed the deal market well beyond the normal summer slowdown. We are seeing pulled deals, delayed refinancing and obviously quiet IPO markets. But this isn’t a total cessation of activity. Some sectors are and will show resilience.

‘Large cap’ companies with a broad geographical spread and sectors that aren’t heavily correlated to riskier areas – i.e. cyclical UK demand – remain active. We expect to see carve-outs continue when they still have strong commercial logic. Private equity activity continues. There is a sense that there are significant opportunities where markets have downgraded on mass, creating some attractive individual valuations.  Some companies will also want to reposition their businesses post-BREXIT – and this will require some deal activity. Activists remain supportive. Interesting IP trumps everything.

But confidence has been eroded. We won’t really know by how much until the current deal pipeline plays out in the next six months or so. IPOs have clearly stopped and it will probably take a successful deal to open the market again – the usual Catch-22.  Much also depends on the financing environment. UK deals in the £100m-£300m range are currently struggling to get away – although the Bank of England is clearly trying to loosen the market again.

It is incredibly tough to act when so much is unknown. Recent trading statements are full of uncertainties, but also action based on what companies know and can do now to mitigate or exploit. They know sterling is weak and will remain so. They know demand has fallen in many areas. They know financing could be tricky and there are greater risks.  Companies are also planning for the coming years of uncertainty, but also opportunities from exports and potentially from further government spending. There are areas were companies can only wait for clarity, but we don’t see many standing still.

 The blog and I will be taking a sort break and will be back later in August. 


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