Season of contrasts

As we move into autumn I’m struck by growing contrasts. Heightened geopolitical tensions are hard to miss and financial risks are moving back in the spotlight. But, there are also many positives, including improving earnings and Eurozone story. This week we highlight some of the themes we think exemplify this contradictory outlook – and think about how companies might adapt. Watchfully active? Mindfully acquisitive?

Reading the newspapers these days, it’s certainly possible to believe we’re both doomed and recovering before breakfast. To illustrate, we’ve picked out just a few of the risks and opportunities that exemplify the contrasting themes that emerged or strengthened this summer…although sometimes the lines between them are blurred

 Geopolitical risk: Entrenchment

I’m not sure I need to spell this one out. From the threat of war to the Brexit impasse to internal strife and the looming US debt ceiling, opposing sides have dug in further and ramped up the rhetoric over the summer – with varying levels of consequence should any side miscalculate.

Entrenchment and escalation have inspired periodic flights to haven assets, but not with any conviction. This might be rational judgement of the risks, or just the sheer weight of market liquidity. Still, there seems to be greater volatility and risk aversion. UK companies issuing profit warnings in summer 2017 have seen the highest average drop in share price on the day of warning since 2011 – in midst of the Eurozone crisis.

PW SP Fall

Financial risk: CDO 2.0

Perhaps it’s because we’re a decade on from the credit crisis or perhaps it’s just because the risks are increasing, but there is certainly a growing focus on financial risks. Re-leveraging is raising concerns as is the increasing risks being taken in the search for yield.

A few weeks ago, the Financial Times reported on a comeback for CDOs:

“The market for “bespoke tranches” — bundles of credit default swaps that are tied to the risk of corporate defaults — has more than doubled in the first seven months of 2017.” 

The FT notes that since these products are not graded by the rating agencies they have a limited investor base – i.e. there is less systemic risk than CDO 1.0. Banks say that they are being more cautious this time. Default rates are exceptionally low. But, such benign conditions cannot last forever and the move exemplifies the increasingly risky behaviour being taken by investors as demand – driven by QE and spurred by aging populations–  far outstrips the falling supply of safer assets. It’s a big and fundamental issue with potential seeds of the next crisis.

Capital opportunities: Lower for even longer?

This is where the line between risk and opportunity blurs. UK interest rates now look set to stay on hold until late 2018, maybe even early 2019. There’s some doubt now over the US interest rate rise that’s long been pencilled in for later this year. Where there’s increasing talk of tightening is the Eurozone, although the ECB have played this down as the Euro inconveniently strengthens.

So, there’s still time for companies to make hay in terms of refinancing and new deals. As Bloomberg reports, there is significant amount of fresh supply in high-yield markets this autumn, with new issuance at near 10 billion euros in the next couple of months. Greater supply could give investors the chance to be more selective and demand more documentation. But – to quote BofA Merrill –  asset bubbles are getting ‘more bubbly’ –

“What we mean by this is that post the financial-crisis, the largesse of central banks appears to be inducing quicker and steeper price gains in assets compared to the case historically.”

Economic opportunities: Eurozone leads the way

Of course, what we really need is growth and improving earnings and, in the last week, Moody’s said it expects “above-potential growth this year and next“ in the Eurozone. They’re less positive about the US, which is being weighed down lower expectations of rate rises and legislative progress. Still, US Q2 GDP was recently revised up to 3% and Moody’s said it expected 2% growth in advanced economies and more than 5% in emerging markets, with potential for upside. This growth is reflected in earnings, with a blended growth rate of 10.3% for the S&P 500 in Q2, whilst European second quarter earnings are expected to increase 16% year-on-year.

In the UK, there’s growth – maybe around 0.3% in Q3 – but the summer has brought somewhat of a reality check. This week’s round of PMI surveys shows a slowdown in the key services sector offsetting manufacturing confidence. The figures suggest modest growth in an economy – in the words of Howard Archer, Chief Economic Advisor to the EY ITEM Club:

 “still struggling markedly to get out of a low gear, as activity is hampered by squeezed consumers and economic, political and Brexit uncertainties.”

Deal opportunities: Disruption 2.0

Deals continue at a slightly lower average price than before, but still at high volumes. As we’ve said before, most of the major challenges facing companies are driving deals including slow growth, geopolitical and technological disruption. Companies also have the capital and shareholder support to keep on transacting.  PE too, with fundraising on pace to surpass the amount raised last year and ‘dry powder ‘ at an estimated US$601.1b.

It’s logical that the disruptors themselves will face new challengers and challengers, unless they adapt and remain agile – a big incentive for them to transact . That doesn’t necessarily mean making new acquisitions at the cutting edge of technology. It’s about content, channels and making sure customers stick. See Neflix’s acquisition of Millarworld, an independent comic publishing company and Amazon’s purchase of Whole Foods.

In the UK, Reckitt Benckiser’s $17.9b takeover of US baby milk manufacturer Mead Johnson largely accounted for the steep rise in outbound and overall deal value of £30b of in Q2 shown in official figures.  But underlying trends do show a drift away from the UK. Just 44 inward deals were completed during the period, worth £2.9b – the lowest level recorded since 2014. The second quarter of the year also marked the first time since 2002 that overseas owners become net sellers of British firms. It won’t all be Brexit related, but surveys suggest a growing wait and see approach when it comes to UK investment.

No sudden moves

I’m not sure we can make many definitive predictions as to how this contradictory picture resolves given the unpredictable factors and actors in the global narrative. On the whole, I think the rising number of scenarios is a reason to feel more cautious, but not to panic or make sudden moves. On Brexit, for example, companies need to adapt to short-term issues and plan for a variety of long term outcomes; but there’s a long road ahead with increasing twists and turns. It’s impossible to react to every nuance in negotiation or policy option.

Therefore, I think it’s important that companies remain agile and watchful of both risks and opportunities – and stand ready to react thoughtfully to both. This isn’t being passive. The world is moving too fast for that. Perhaps we could describe it as watchfully active or mindfully acquisitive! Whatever we call it, it feels like change is in the air…even if we’re not sure what.


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