On paper there’s some testing events coming up, from the French election to some potentially pivotal monetary policy meetings and on-going debates around BREXIT and US policy. Geopolitical tensions are also heightened. But, we’ve been through difficult quarters before without there being much discernible change on the ground in terms of investor sentiment and corporate attitudes to deals. So will anything trigger a change this quarter?
Not quite more of the same…
We’re just over a week into the second quarter and in many ways it feels different to what came before. We’re now finding out a bit more about what BREXIT means after the trigger of Article 50 and the setting out of both sides’ positions. UK survey data is also starting to reflect some post-BREXIT effects, most notably the sharp rise in input prices driven by the fall in sterling. The new US administration has hit its first policy hurdle, which is periodically inspiring concern about much the vaunted stimulus hopes. Through minutes and speeches, the Federal Reserve is clearly preparing the ground for a reduction in the size of its balance sheet later this year – if the US economy stays on track. We’re getting into the meat of potentially pivotal French election, with the debates beginning in earnest. Geopolitical tensions are rising.
…but what does it mean?
So, we’re not on the same track; but that doesn’t necessarily signal a dramatic change in market dynamics. A high level of change, risk and uncertainty is arguably ‘normal’. This time last year, we saw the ECB dive deeper into the world of negative interest rates as deflation threatened – before the surprises of BREXIT and a Trump victory. Uncertainty abounded. And yet, companies and investors seemed unfazed. Last year was one of the highest years on record for M&A – which has continued into this; we saw a grand slam in equity markets – since surpassed; and debt markets continued to quietly remain loose and positive.
There is still a question mark about how much of this is driven by sentiment. A recent Morgan Stanley report notes that the gap between quantifiable data (e.g. GDP) and reports based on sentiment (business surveys) has never been so wide in the US – a move that has prompted a sharp divergence in Q1 expectations. The Atlanta Federal Reserve’s GDPNow running forecast for Q1 US economic growth suggests the weakest pace in three years. A Financial Times article has pointed to a similar phenomenon in the UK.
In the past, this divergence has been a negative signal for equities. Markets do seem to be ‘priced for perfection’ – as they say. But, as I wrote last week, narrative can be a powerful force in capital markets. And, the improvement in sentiment is backed up to some extent by improving corporate earnings in the US and Europe. The UK economy is changing and adapting – as our latest EY ITEM Club reports today. On the other hand, this clearly isn’t, as Bank of America Merrill Lynch also recently reminded us, a ‘normal’ cycle. The road back to whatever ‘normal is won’t be easy and we can’t expect it to always be smooth.
Normalization” from a 5,000-year low in rates, 70-year low in G7 fiscal stimulus, 35-year high in the US-German rate differential, an all-time high US stocks vs. [the rest of the world], a 75-year low in bank stocks is unlikely to be peaceful; long gold in anticipation of potential manias, panics, crashes.”
All of which leaves me torn between that on-going worry that we’re in the midst of a capital market dislocation that must surely see bring reckoning at some point…and my continuing hope that the resilience we’ve seen so far from economies, companies and markets will continue!
So, coming back to those Q2 risks…
It’s a debate that no doubt we’ll continue. There could be trouble ahead if investors are seriously rattled, but what about this quarter?
Talking to my colleagues in EY, the consensus is that capital markets still have enough positive sentiment, resilience – and central bank support – to withstand some pretty hefty blows. The second quarter has the potential to land such a blow; but at the moment we’re working on the assumption that we won’t see any manias, panics or crashes baring a significant shock or policy misstep. There’s a long road between a Le Pen victory and France leaving the EU and returning to the franc. President Trump may get bogged down domestically, but markets are generally happy if politicians don’t interfere. BREXIT negotiations have a long way to run and recent pronouncements suggest that the UK government will do what it can to avoid a cliff edge in trade and labour.
None of which says that we won’t see markets jump around in Q2 if sentiment wavers. There’s likely to be greater volatility in exposed areas – like the spread between French and German sovereign debt, which will get wider if investor concern is raised. The pound has been the primary BREXIT-o-meter and most exposed areas are those vulnerable to rising prices driven by weaker sterling. The recent run of UK retail administrations is testament to the rising pressures – which are exacerbated by increasing labour costs. The will-they-won’t-they Fed discussions will feed into markets. US policy direction is still tough to call. As the Financial Times points out, the flattening US yield curve is now effectively discounting Trumpflation. Oil has traded in a tight range for most of 2017, but a rise in geopolitical tensions has pushed prices higher.
Of course, given the volatile, geopolitical situation there are variables that are hard to factor into any forecasts – and which may yet force us to rethink. It’s this reality that companies are constantly dealing with – but the reaction so far has confounded expectations.
…but companies are ‘dealing’ with it!
It’s not that companies are immune or inured to all of this risk and uncertainty, but – as we’ve said many times – companies have adapted out of necessity. If they want to get or stay ahead, they just can’t stand still…and so, and the deals continue. There were US$734b of deals announced in the first quarter – ahead of 2016, but behind 2015 – with a big pick up in the Eurozone, just to underline the recovery there. The UK was also still third in terms of target country and fourth in terms of acquirer country. Our global IPO survey also shows a brisk start – albeit less so in the UK. Again, as I’ve said elsewhere, it isn’t business as usual in M&A either, with transactions facing greater challenge and scrutiny. But, still the deals keep flowing. We’ll find out more about corporate sentiment in our upcoming 16th Global Capital Confidence Barometer, out on 24 April.
- EY ITEM Club Spring forecast considers how the UK economy is transforming post BREXIT.
- Register <here> for EY’s webcast asking ‘What’s next for business?’ 11 April, 15:00