Equity markets have had a torrid time of late, buffeted by the headwinds of slowing economic growth, and the ongoing worries about the Eurozone sovereign debt crisis. However, amongst all the gloom there are still some bright spots, says Willem Sels, UK Head of Investment Strategy at HSBC Private Bank…
Lower valuations, healthy balance sheets, and low financing costs have enabled the M&A cycle to continue. High profile deals announced in recent weeks are evidence that every threat presents an opportunity. In our view the conditions remain in place for M&A activity to continue, which should be beneficial for markets over the long-term.
Equity market volatility has focused on the outlook for the global economy, the lack of global leadership, the risk scenarios for the economy and the potential for liquidity squeeze.
We believe it is too early to make a recession call for the global – or even the US – economy. Furthermore, we think it unlikely that we are on the verge of another apocalyptic failure of a financial institution. There are growing signs of tightening credit conditions, but they are still far from the levels witnessed back in 2008.
As always there are two sides to every story, and what the corporate sector seems to be telling us through M&A activity is that future may be a bit brighter than what markets are pricing in.
Mergers and Acquisitions (M&A) activity has been recovering steadily from the low levels touched at the nadir of the 2008/9 financial crisis. Even though we have seen a sharp fall in risk appetite over the summer months, the corporate sector has held its nerve and M&A volumes have held up relatively well.
Are the recent trends in M&A likely to be sustained? In our view the foundations look solid for the corporate sector to continue to make acquisitions.
Many factors are responsible for explaining the M&A cycle but they can be grouped into three broad categories – 1) the strategic merits of a deal, which tends to be a function of the business cycle; 2) the ability of the acquirer to finance the deal, 3) the price of the target company.
Starting with the first of these drivers, the strategic merits of the deal, this tends to be the hardest factor to quantify. Companies typically look to M&A in order to acquire growth when organic expansion of their core business is slowing. Another driver of M&A related to this can be the desire for vertical or horizontal integration to gain a better control over supply chains.
The outlook for the global economy is challenging which makes the decision for companies as to whether they invest and expand much harder. This has been the case for some time, which has led to a large amount of underinvestment so far in this cycle. Our central case scenario is that the major western economies avoid a recession and enter a period of sluggish growth. Under such a scenario, we
believe that the corporate sector may pick up somewhat from the current low levels, as, at a minimum, companies will wish to maintain their market share within their industry. Once a more meaningful recovery takes hold, most companies may wish to grow and a meaningful amount of this is likely to come in the form of M&A as companies seek to buy revenue expansion.
Another driver of M&A is likely to come from the corporate sector reversing some of the outsourcing of supply chains that took place prior to the recession. The recent recession, and more recently the Japanese earthquake have shown how manufacturing production can be affected when the supply chain freezes. Going forward we expect that a lot of the large manufacturing and industrial companies will look to ensure such disruptions occur less frequently in the future. This in itself should lead to consolidation in a number of industries.
The corporate sector may have the desire to embark on M&A, but does it have the means? We believe so. Profitability is close to previous highs, cash generation is high, and the corporate sector (excluding financial service companies) has significantly reduced balance sheet leverage, as can be seen in the chart below.
Furthermore, more profitable companies have had little trouble raising finance in the capital markets. The yields at which companies can borrow remains at historically low levels: in spite of credit spread widening, yields have fallen as a result of the rally in government bond markets. Strong corporate balance sheets and low funding costs should benefit M&A in the absence of a credit freeze. Companies that do not have access to the bond market and are more reliant on bank financing may find it more difficult to obtain the necessary funds.
Turning to the final driver of M&A, valuations across most equity markets are at, or close to, all time lows. The chart above shows the 12-month forward PE ratio for the S&P 500 which has only been on a lower valuation multiple for 4% of the time since 1987. Thus valuations should look as compelling to potential acquirers.
The positive outlook for M&A matters because a strong M&A cycle has historically been good for equity market returns.
When companies are investing and making acquisitions, it can send a powerful signal to investors as to mood of the corporate sector. CEOs can often be better at identifying cheap opportunities than the average investor. That the M&A cycle has held up well so far during the recent market nervousness, should bode well for equity market returns in the medium term, in our view.
The M&A cycle has recovered well from the “Great Recession”, and has held up well in the recent market turmoil with a number of large deals announced in recent weeks.
The pillars are in place for the cycle to continue, assuming that the major western economies avoid a recession over the next few quarters. Business sentiment is currently fragile, but companies who wish to grow will look to the long-term opportunities that current equity market valuations offer. Over time, this should be supportive for equity market returns.