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NEWS & VIEWS

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A surprise, no matter what

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3 rd November 2016
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Given the frequency with which market upheavals seem to take place in the autumn months, October 2016 has been notable mainly for its calm continuation of the trends which prevailed throughout the summer.

Equity markets have either remained broadly flat or edged a little lower, the dollar is still strengthening against most major currencies despite the obvious risks associated with the upcoming US presidential election, and yield curves have continued on their upward climb in spite of a general lack of hawkish noises from central banks. Oil also seems to have stuck to its tentatively established trading range of $40 to $50, putting to bed (for now at least) the turbulence seen earlier in the year.

Consensus has it that we are in a seller’s market for equities. This is true despite the fact that, depending on the index you choose, listed equities have not seen new highs for four to eight weeks. News regarding IPOs are piecemeal of any finance page on a daily basis.

However, while there are plenty of success stories, there are good reasons to be a little concerned for the near future. A handful of well-known IPOs have been pulled (Misys and Pure Gym) on the basis of weak support from institutional investors. On top of this, in the private market, quality businesses – the few justifying high valuations – are changing hands at ever higher multiples, some having motored above 14 times EBITDA. Moreover, the leverage necessary to make these purchases worthwhile for many private equity houses is now five to six times on senior debt, maybe 10 to 12 times on junior debt - not far from leverage levels seen just before the last financial crisis.

This is a point of concern for a number of GPs who are staying away from full blown auction processes. Yet the deal flow has been strong this October, and it is good news for investors that bank club deals are now extending their leverage offer on senior facilities in a bid to win over private debt funds, which on their side have plenty of dry powder. That said, there is always a limit to the amount of leverage that a can be loaded onto a firm’s book before it becomes very exposed to an economic downturn.

Looking to November, it is difficult to believe that this tranquility can carry on for long. It is true that the market does not expect changes to monetary policy in the announcements of the US Federal Reserve and the Bank of England scheduled for this week. And yet, interbank lending curves for the major world currencies are showing more volatility than we have seen for some time. In the UK, the steepening of the LIBOR curve is largely driven by the soaring inflation expectations which have accompanied sterling’s weakness: a forecast released by the National Institute for Economic and Social Research (NIESR) on Wednesday morning saw inflation rising to 4% by the end of 2017. Elsewhere, the drivers of the yield curve volatility are less obvious. The past few years should give pause to anyone attempting to call a bottom for Euribor, but it may well be that the comments currently coming from the European Central Bank – that their considerations have been limited to extending rather than expanding the QE program – at last mark a turning point.

An obvious consequence of this steepening is that firms may need to revisit the borrowing costs in their business models. If a turning point really has been reached in the interbank lending markets, there is no sugar coating the fact that rates modelled on the experience of the last eight years may soon become unachievable. Even if all we are seeing is a bout of increased volatility rather than the start of a directional trend, it is hard to imagine that this volatility will disappear any time soon. This is especially true given the geopolitical events we know will occur in the coming year – from the US election to those across Europe, and the torturous process of the UK beginning to extract itself from the EU. For the foreseeable future, so-called ‘headline risk’ is here to stay. What we have seen as a consequence, is renewed divergence for interest rate cap premiums across hedging banks, some being substantially less competitive (or more cautious) than others, and requiring specific attention to timing and auction processes.

The past few months have provided a number of reminders that the sensitivity of FX markets to such events is stronger still. In spite of sterling hitting multi-year lows against the euro, it is not at all clear whether the cross has reached the bottom, in discounting a ’hard Brexit’, or if there is further volatility to be seen. As mentioned already, the next few months will give reasons for both sterling and the euro to move around. In this sense, while the cost of purchasing options to increase flexibility could seem too high, allowing hedging strategies to provide some upside would be wise. However, this should not be interpreted as support for structured products in general. It is absolutely not the time for firms to engage in ‘hedging’ using leveraged or barrier products which show improved rates in return for the risk of significant losses should the market move beyond a pre-set level. The example of Sport Direct’s recent £15 million loss due to such products is instructive, and they are unlikely to be the only firm suffering from hedging strategies structured to sell market volatility.

In the last week of the US election, uncertainty has maxed out as latest polls showed Trump trailing Clinton by just one percentage point. In similar fashion to the latest UK elections and referendum, the results will be a surprise either way.

The real news for Europe is the proposal by Sigmar Gabriel, Germany’s economics minister and deputy chancellor, to expand the government power to deny M&A approval for foreign takeovers of EU companies if they involve “…key technologies that are of particular importance for further industrial progress”.

Germany’s initiative against non-EU investors can and should be linked to the social distress evidenced by the rise of support for right wing parties seen in recent elections. It could also be argued that the issue is just one of reciprocity, and the impossibility for EU investors to complete successful takeovers of worthy foreign businesses.

For the average individual this would be a risible problem.  The reality has more to do with a growing need across Europe’s leading political parties to demonstrate the will to implement forms of protectionism that guard against perceived colonisation by ‘foreigners’.

All views expressed here are the author’s own and are based on information available at the time of writing.

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