Animal spirits trump uncertainty

We said it wouldn’t be a quiet year! This week we’re focusing on two phenomena: what looks set to be a record January for global M&A – surpassing even 2007 – and record equity market performances in the wake of the Dow going through 20K. The dollar looks “interesting” too. As do high-yield bonds – even energy ones. So much for uncertainty damping activity. I keep hearing about “animal spirits” driving this – but is it sustainable?

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So far so good with our 2017 predictions, although I have to admit that I’m scratching my head a bit. Global growth is picking up – as per improved IMF forecasts. There are great hopes for US growth in particular – and other markets can ride off the coat-tails. But it’s the surety with which investors have recently bet on the positive narrative, without it seems much attention to the risks, that’s got my attention. What’s happening?

Uncertainty…what uncertainty?

We’ve seen the Dow Jones hit 20,000 for the first time and the S&P 500 criss-cross 2,300.  Elsewhere, we’ve seen the difference between short and longer dated US Treasuries rise to the  highest level of 2017 – a further signal that investors expect more US growth and inflation. High-yield bonds have also rallied, with yields falling below the broader high-yield index. The dollar index dipped then rose again – with less certainty and enthusiasm – and dipped again. A bit like the pound in the UK, it’s more likely to read between the lines – perhaps due to a lack of QE-influence.

It’s all go in M&A as well. Last year was the fourth highest for M&A values on record. Surely 2017 can’t top this? Well, our figures show global M&A in January 2017 ready to surpass 2015 and 2007!  Of course, there’s those growth prospects. Pipelines take some time to empty. PE still has a significant war chest – as do many companies. There may be some aspect of investors trying to get ahead of political and market change. As we’ve discussed before, we’ve turned a corner in monetary policy in 2017. Progress may be slow, but almost all major economies seem to be on a stable-to-tightening track.

But can even this explain such an exceptional level of activity? Does uncertainty count for nothing these days?

Animal spirits?

“Animal spirits” has arisen in the last few week as an explanation. We’re not going to take you back to school, but it’s worth reminding ourselves what Keynes meant when he coined this term, given that it’s being bandied about. He said that conventional economics confined to rational quantifiable facts – and behaviours. “Animal spirits” refers to  what might be termed a gut reaction.

“Most, probably, of our decisions to do something positive, the full consequences of which will be drawn out over many days to come, can only be taken as the result of animal spirits—a spontaneous urge to action rather than inaction, and not as the outcome of a weighted average of quantitative benefits multiplied by quantitative probabilities.

Thus “animal spirits” can be a force for good, a means by which we take action and don’t rest on our laurels – even in challenging times. Arguably, this response isn’t surprising and some of it is logical. BREXIT was a popular choice in the UK, so why shouldn’t we expect consumers to react confidently – aided of course by a cut in interest rates. Trump won and, mixed in with the unorthodox and controversial policies, are measures that could stimulate further growth – not forgetting that the US was on a growth track anyway.

Risks & Realities

But how sustainable is this “urge for action”. What happens when risks become realities . EY ITEM Club have written in the last week about the changing and slowing UK economy. There are similar concerns in the markets. Bank of America Merrill Lynch said this week that it believes that: “positioning, profits and policy are consistent with one last melt-up in risky assets.”

They expect the market rally to come to an end this summer, when the reality of tighter monetary policy and protectionism pinch consumers’ pockets around the world. 

It’s the reversal of the interest rate/inflation holiday that helped sustain earnings and helped riskier assets raise capital. There’s also the extra element of trade and policy uncertainty to dampen those spirits. The new US administration is likely to say more on trade and be more active in its interest in the location of operations. We can also expect more attempts to cool the dollar – given the potential for this to hit trade and earnings – although this might not be consistent with dollar-boosting policy elsewhere. Interesting also to see the cooling in the US house market – again linked into expectations of US rate rises.

So markets may stumble. And – even if they find their footing again – our expectation is that investors will start to differentiate companies more. That’s primarily because there is so much more to differentiate on due to the radical changes in growth, trade, currency and technology landscapes to name but a few. We’ll explore this topic soon in the context of discussing our Quarterly Profit Warning Paper for Q4 16 – released on Sunday.  We’ll be watching reactions to  profit warnings in 2017 with interest. We’ve previously said that muted reactions may be caused by a lack of alternative in a low-yield, undifferentiated environment – but what happens when there clearly better places to invest?

 M&A keeps on keepin’ on….

When we turn to M&A, we think animal spirits might just be more sustainable – and useful – for three primary reasons. The first two are the ones that we’ve expounded for a number of years and they still hold – arguably more than ever. Growth is still relatively slow and technology continues to disrupt our world, whatever the economic backdrop. Companies cannot afford to stand still. Their business model might not be viable in five years’ time…or less. We said that companies would need to be bold in 2017. And in this case, making bold, informed decisions about where to invest – be that through deals, JVs or alliances – will continue to be a differentiator.

The additional reason is one we’ve talked about before – and then some. It’s the need to react to the changing political backdrop. Politics are going to be a much bigger part of decision making than we’ve seen for a long time. Companies will need to rapidly reconsidering trade, production and supply routes; rethink what deals governments and regulators will block – or promote; think about labour markets; and consider the potential for greater fiscal stimulus and other incentives. It makes sense that they’ll be reviewing their portfolio.  This means companies need to act despite and because of this uncertainty and change. This is why we think they’ll continue to transact.

The elephant in the room is the capital markets. Debt markets have also had an incredibly buoyant start to 2017 and they should continue to offer access – but with some of that differentiation creeping in and of course a chance that uncertainty and change becomes too much. It is a riskier world – we need to acknowledge that and a more extreme backdrop may stymie activity. But for now, we expect companies to keep dancing.

 


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