How will we know if the cycle is turning?

Hello, I’m Adrian Browne and very pleased to be taking over from Michel Driessen,  both as UKI TAS Markets Leader and as chief editor of this blog.

I want to start my blog career by posing a question that I think we’ll be coming back to many times.  Markets are losing momentum, but how much can we read into this? It seems so much harder to get a read on the markets these days. Not that it was ever easy. What’s that old joke? Economists have predicted nine of the last five recessions! And, investors are no better – see every bubble and crisis, from tulips to subprime. So, what chance have we of calling the top of this cycle?

The US$1.5t ‘problem’

It is ten years this week since the last UK interest rate rise. A decade with only falling or statically low interest rates is by any measure abnormal. Add to this that since the financial crisis trillions have been pumped into the market via QE – US$1.5t since the start of 2017 alone! That’s going to have some impact.

Central Bank Asset buys

That’s not to say that this extraordinary support wasn’t warranted in many respects, but it has undoubtedly created a new set of capital market dynamics. Increasing risk should increase bond yields. But, ‘bad’ economic news can become ‘good’ news for bond markets, lowering yields  if it creates an expectation of increasing – or at least a continuation – of central bank support. If risk perceptions and thus yield dynamics have changed, can we assume that a flattening yield curve still signals danger – as it has in the past? In mid-2017 it’s doing just that –as it did last year with no ill-effect. Can we take it at face value this time? Will the current normalisation of policy in the US – and growth – normalise reactions?

US yield curves

Abundant liquidity also makes it difficult to call the top of the equity market. It’s not just that normal relationship between bond and equity prices has broken down. Given low returns and still low growth in the economy, do we need to re-evaluate what is ‘expensive’? As reported in the FT this week, the MSCI World index currently trades at a price-to-earnings ratio of 21.5 times – as it did in March 2004, when it went on to rise by a further 70% in the next three years. Although, as Société Générale points out, sales growth in those years was 13%,  against 4% today – even if we generously include the recent energy revival. Then again, can we really call equities expensive given the low returns available elsewhere – certainly compared to that 2004-7 era? Where else will the capital go?

MSCI World Nov 16-Jul 17

There is something going on – as Michel pointed out – the flat calm of markets has been disturbed. Momentum is waning, volatility is back – relatively. But calling the turn with this amount of liquidity (and in some cases a shortage of assets) is still a tough call. The ECB – unless it tapers – will be buying €60b of assets each month. This figure far exceeds the total set to be issued by Eurozone sovereigns this year.

Dealing with it

The deal cycle has arguably also behaved unusually in recent year. Conventional wisdom says that an uncertain political and economic climate stalls deals; but although activity has been slower in patches, volumes have been robust in the last year as companies’ need for innovation and growth appears to override uncertainty.

In H1 17, headline global deal value fell by 4% year-on-year, according to our analysis of Dealogic data. So are we losing momentum? Maybe not. Mega deals are down 16%, but deals in the US$1b-$US10b range are on a par to 2016. PE spending rose 14% YoY – albeit still at just over a quarter of 2007 level. Western Europe continues its comeback, deals up 21% YoY in H1. Again well down on H1 2007, but with the potential arguably to push on. So, is activity just reshaping?

PE firms currently have nearly US$570b in capital available for new deals, far surpassing the US$478b they had in 2007-2008. If corporate activity – and maybe even multiples slip, PE is ready to get back in the game. If companies find it harder to access funds, perhaps we’ll see more companies selling or floating assets. Our data already shows that 2017 global IPO activity is set to outpace 2016. The year has seen a strong start for IPOs globally, with equity indices trending upward and low volatility enabling transaction windows to remain open. Greater stability in the UK market has also helped – although this pick up came before the election.

A sentimental journey

I’m not going to say straight out: “this time is different”, because it almost never is – not totally. There are different dynamics, but we’re the same people. It’s why sentiment – that so far to watch and define signal – is going to be so important to watch and I think will be our chief signal. Yes, some realities will intrude into the capital environment and change behaviour as central banks tighten – or threaten to – as they start to think about wriggle room for the next downturn. And this downturn will come – as it always does – but it will come sooner if sentiment slips, or if we see serious policy misstep or harmful event. We can scarcely discount a black swan event in this environment.

But, the biggest changes in our market are often driven by how companies and their stakeholders react. Given the imperatives to combat slow growth and meet the digital challenge, it may be that those stakeholders continue to acquiesce in supporting deals longer than previous cycles. Or it may be than a heavy reliance on loose monetary policy amplifies reactions – as per previous taper tantrums. Speaking to my colleagues attending this week’s Mergermarket European Corporate Development Summit, it seems that the consensus is that it is still a strong sellers’ market and the amount of sheer amount of liquidity  – even with some tightening – makes it unlikely that we’ll see a serious slowdown in the next year….but the global economy is expected to hit the rocks again in 2019-20.

Over to you…

Although I wonder if when we reach this consensus how much it becomes a self-fulfilling prophesy? I’d welcome your thoughts on this –  and anything else here –  and look forward to seeing whatever comes next.


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