What happened in 2018?

This week’s Capital Agenda Blog comes from Adrian Browne, UK&I Transaction Advisory Services Markets Leader, and Kirsten Tompkins, UK&I Transaction Advisory Services Lead Content Editor.

What stands out most from our 2018 word cloud is ‘More’. We clearly used that word a lot! This last year had more volatility, more uncertainty, and more disruption – but also more deals. More seemed to happen, but without giving us much more certainty about what comes next.

In this week’s blog, we’re going to pick the bones out of 2018 and think about what might lie ahead in 2019.

Below is a visual representation of 2018’s Capital Agenda Blogs in a very more-ish word cloud. But, what was there more of?

CAB 2018.png

More uncertainty

We now live in such uncertain times, it’s hard to say what uncertainties we’ll face tomorrow.

We’ve been through bigger crises, but events generally followed well-worn scripts. The result of the 2016 EU Referendum and US election were highly unexpected, but life carried on as normal for a while. The last 12 months haven’t followed any recognisable script, creating a wealth of uncertainties, from US-China trade relations to Italian debts and almost unfathomable Brexit flowcharts.

As Mohamed El-Erian, Chief Economic Advisor at Allianz said this week:

“…five knowledgeable observers of Europe and the UK converged on five — yes, five — possible outcomes. And all agreed that none of these five commanded a high enough probability to constitute a baseline scenario.”

It’s this utter unpredictability that make it so hard for businesses to plan and invest. Forecasts need to be constantly revisited. Vulnerable businesses need to be prepared for protracted Brexit uncertainty, by identifying vulnerable areas and ensuring they have the operational and financial flexibility and resilience to cope. The ‘no regrets’ approach.

But, there may be limits to what businesses can physically do – or afford. As The Financial Times noted this week, warehouse space is limited and rapidly increasing in price.

More volatility

All things are relative. This isn’t 2008. But, as the Wall Street Journal wrote this week…

“…investors are struggling to pivot from years of calm, gently rising markets to a new period marked by sudden, big lurches in asset prices.”  

According to JPMorgan Chase & Co, major derivatives contracts have seen price moves that exceeded margin limits at least 49 times this year. That means the money traders put up to cover loses was insufficient – another area to watch.

Risk is back on the agenda and markets are reacting to every nuance of uncertainty – which inevitably feeds volatility. Concern over technology earnings triggered falls in US indices. Equities with links to China are moving on every trade-war plot twist. The Turkish Lira has become a proxy for the strength of the US dollar.

Further volatility for emerging markets awaits in 2019. But, the currency rollercoaster isn’t limited to emerging markets. Traders are talking about the difficulties of trading sterling, now a proxy for UK uncertainty.

Sterling's 2018 rollercoaster

“Sterling traded options volatility levels are now higher than those seen in September for a basket of emerging market currencies — quite some going given the type of pressure EM currencies were under this summer, e.g. Turkey, Argentina”.

Chris Turner, Head of Currencies strategy at ING

More tightening

‘Rate’ and ‘Rise’ feature prominently in our word cloud, representing a year when monetary policies moved firmly into tightening mode. There was a further rate rise in the UK, after the first in over a decade in late 2017. Next week, The Federal Reserve is likely to raise rates by 0.25% for the fourth time in 2018. ECB asset purchases are due to end in 2018.

That said, expectations for further tightening have diminished in recent weeks as growth concerns rise. The flattening US yield curve signals trouble ahead. Investor concern has tightened leveraged markets, irrespective of Fed actions, with prices falling, deals being pulled and outflows increasing. UK public debt markets are increasingly hamstrung by Brexit fears.

European secondary market bid levels1

Opportunistic borrowers can wait, but those that need to move now are paying the price.

November in leverage loans….

Five transactions pulled

17 upward price flexes

48% month-on-month fall in issuance

Record fund outflows in w/e 5 December

Source: Leverage Loan Monthly, Refinitiv

But let’s not forget how the year started. Taking 2018 as a whole, 73% of 2018 LBOs have been levered 6x or higher while 41% are 7x or higher, both all-time highs according to Refinitiv. There was a great deal of activity. The question is now how well these deals will play out in changing economic circumstances.

More stress

It’s important to say at this point that we’ve seen GDP growth continue in 2018 across most major economies, albeit at a slightly slower and slowing rate in recent months. And it’s this easing– combined with other structural forces, has put some companies and sectors under pressure.

In the UK, rising pressure on consumers, uncertainties, costs, regulatory change and structural change – including technological – has led to more companies issuing profit warnings in 2018 than 2017.

PW sector table infographic

The sectors searched for most often on our Profit Warning Console reflect those stresses, with consumer sectors like retail and restaurants under greatest pressure in 2018 – joined increasingly by their landlords. In addition, sectors vulnerable to contract delay, like construction and support services, increasingly feature along with those vulnerable to regulatory and trade issues – such as automotive.

More disruption

Much of this structural pressure comes back to technological change. In 2018, we launched our EY Disruption Index™  to track the speed at which disruptive technology is being deployed across global sectors – and to help us understand what technologies are disrupting major industry groups.

It’s interesting to note that the sharp rise in FTSE Travel & Leisure profit warnings in 2018 coincides with the sector showing high levels of disruption in our Index – especially from Artificial Intelligence. Technologies allow companies to take great leaps forward, but they also create significant structural challenge and change and companies need the capital and wherewithal to adapt.

More deals

Which brings us to one of our most read blogs this year, which asked if companies needed to take more calculated risks in their M&A strategies. Clearly the need to meet the twin challenges of disruption and slower growth head on is one reason why global M&A is still set to reach its third highest total on record and why ‘Busy’ and ‘Deal’ appear so prominently in our blogs in 2018.

Deals, Jan - NovIncreasingly linked to this drive to keep up, is a need to divest and rationalise portfolios. Companies need time and capital to create their future states. The second half of 2018 was notable for a slowdown in mega deals and a rise in the sale/spin-offs of non-core, assets – a trend we expect to continue into 2019. The low market value of many conglomerates against a sum-of-the-parts valuation is hasn’t gone unnoticed by activists or private equity.

We also noted in 2018 how PE was increasingly going back to its carve-out roots, picking up these non-core assets. We also looked at the search for greater resilience that was leading PE to look at life sciences and education assets.

Uncertainty is unlikely to totally stop deals when the drivers are so strong; but it will shape activity.

More division

If there is one underlying story in 2018 its growing division, be that between ‘Brexit’ and remain; between the US and China; between the Eurozone and Italy. A ten-year bull-run hasn’t created widespread prosperity, whilst widening social divisions have polarised views and made it harder to create political consensus.

Now that bull-run is at risk of ending, there is a risk that volatility will spill over into the ‘real economy’ with the fallout from these divisions – Brexit uncertainty, trade wars, and a new Eurozone crisis – feeding into this slowdown and hurting growth.

Which is not to say that we’re set to fall into recession in 2019. Interest rates are low. Momentum remains. But recessions happen because vulnerabilities build, confidence fails and activity stops and localised problems can quickly spill over. The mood has palpably changed in the last few weeks and its notable how more of those pieces have moved into place.