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Episode 36

The Fiscal Crater

Published on: July 09, 2020 • Duration: 19 minutes

This week on Real Vision Louisa Bojesen uses Refinitiv's best-in-class data to look at how the UK government might attempt to get out of the £300 billion economic crater, created by the fiscal response to the COVID pandemic. With Oil and Gas exploration and production companies likely to lose $1 trillion in revenue in 2020, how will governments try to cover for this loss in tax income? The Chatter looks at the disconnect between the deteriorating fundamentals in developed economies and the rising asset prices. In The Whisper, we take a look at the data behind the data for the M&A market.

  • With the coronavirus causing a severe economic drop, how will the U.K. government get out of a 300 billion pound Covid crater? That is this week's Big Conversation. 

    Hi, everybody. I'm Louisa Bojesen, and welcome to this week's The Big Conversation. Before we start thought sharing, I just want to say that from my almost 20 years as a live on-air financial news anchor, interviewing thousands of people and close to covering market moves and politics, recoveries typically start before recessions end. Just remember that, we tend to see recoveries before the end of a recession. Now on top of that, so much of everything has to do with human psychology and managing behavior. Having said that, many of the big conversations today are about a possible second Corona virus wave, especially given the soaring U.S. cases and the market disconnect, so asset prices heading north. Putting these overarching themes to one side let's look instead at the big fiscal conversation, namely the current Corona environment from a fiscal perspective. Economic activity has been shrinking. So that means less revenues for corporates, which means less corporate taxes for the government. Unemployment is high, which means less income taxes for the government. And if the economy is unstable, which many would say it is, that means that people they'll be consuming less, which means less VAT for the government. Now, on top of that certain tax beneficial sectors to the government like oil and energy, for an example, they've been suffering due to lower demand and weaker prices. The Covid impact on Nymex, some Brent-crude has been big, both down somewhere in the region of 35 percent year to date due to demand dropping - Brent at its lowest level in more than 20 years - but spending cuts have really been announced across the board by the energy producers. Exxon cutting capital spend globally by 30 percent, Shell, BP, Saudi Aramco, Chevron, they're all cutting by 20 to 25 percent globally. And the countries that really rely on oil taxes for government income like Saudi Arabia, Russia, Libya, Venezuela, Iraq, the list goes on, they're really hurting. So oil and gas exploration and production companies, they stand to lose an astounding one trillion dollars in revenues in 2020. A trillion dollars. That's a 40 percent drop year on year. And that's according to Rystad Energy on CNBC. So income taxes for governments are shrinking on all levels. Now, governments, they need to keep the welfare state going. So you have this situation where government spend remains very high or at least stable, is not dropping right, but tax collections they are substantially going down. This warrants thinking about for many, a strong and healthy government means a strong and healthy society. How do governments get out of this situation, particularly if it's ongoing? Well, here in the U.K., with the U.K. Treasury looking at how to cope with a deficit expected to billow to more than 300 billion pounds in the current financial year, well a leaked Treasury document is revealing that the U.K. government has indeed been studying options for tax increases or cuts in public spending. Now, one of the suggestions is to reduce VAT to stimulate spending, remember VAT accounts for almost a fifth of tax revenues, so it is significant. Rishi Sunak, the U.K. chancellor is considering a temporary cut in VAT to encourage spending and boost the economy. Incidentally, since 2011, VAT has been at 20 percent, its highest rate since being introduced back in '73. But as in life, timing is everything. Would a cut to VAT actually help? Well, according to the IFRS, the Institute for Fiscal Studies, a temporary cut to VAT would be most effective as spending stimulus when certain conditions are met. One - we're certain that social distancing measures will continue to be eased. Two -  when supply no longer is limited because of social distancing. Three -  when companies affected by a VAT cut can both accommodate more demand and pass on the VAT cut to prices. Four -  when the fear of Covid has dampened so consumers feel more comfortable spending again. And five, if demand remains low. If a VAT cut is introduced too early, while consumer products are unavailable for an example and uncertainty still is too high, then the IFRS says that there would be a limited beneficial effect. On top of that, the government still has other stimulus tools it could apply to get the economy moving again, including investing in training and infrastructure to create jobs and lift productivity. In other words, and as the IFRS concludes, the jury is still out on a temporary cut to VAT and whether it might be better at a later date. Now, in looking at the idea of a windfall tax, well more than half of the UK public they would support a windfall tax levied on the industries currently experiencing above average profits as a result of Covid-19. And that's according to a YouGov survey. In addition, 61 percent of those polled, they would approve of a wealth tax for people with assets of over seven hundred fifty thousand pounds. As an example of windfall taxing, the U.K. government has already brought in a new digital services tax, imposed at two percent of online revenues for large Internet companies, including Amazon. Online retailers and supermarkets, they've flourished through the Corona lockdown, and according to the ONS, the Office for National Statistics, March food sales, they were,the strongest on record. They were actually stronger than what's usually seen over Christmas. In contrast to that, incidentally, many non-food retailers, they've seen weakness with physical shops having been closed, but the food retailers, though, they're arguing that they've had to hire thousands of new staff members, they've had to install social distancing equipment and massively increase their home delivery services. Tesco, Sainsbury's, WM Morrisson, they've all said that regardless of reduced business rates on their stores, the extra costs that they've had will cancel out any benefits. Now, the UK Debt Management Office, the DMO in charge of selling gilts - so UK government bonds -has been working overtime to bridge the gap between government spend and what it takes in via taxes. The DMO recently announced plans to sell a record 275 billion pounds worth of government debt. They're doing that between April and August, so all in the first five months of this financial year, in reaction to Covid so more than double what it borrowed the entire year before and a 50 billion pound increase on previous estimates. And investor appetite for gilts has been healthy. With a rundown of solid offerings expected to continue the DMO, they've already raised more than 181 billion pounds and bond sales since April. But if the economy takes longer to recover the current three hundred billion pounds that the government needs to balance the books could turn into a figure north of 500 billion, according to the worst case Treasury estimates. Gerard Lyons, a senior fellow at the think tank Policy Exchange and past economic adviser to Boris Johnson when he was mayor of London, he's been quoted in the media saying that a repeat austerity program would be a mistake. Now, the thinking here would be that if you do anything too drastic, then you'd be killing off the buds of a recovery, as was done during the financial crisis in 2010. Lyons doesn't think that the government should be cutting spending or raising taxes. Instead, the Bank of England should be focused on fine tuning its gilts market activity to ensure that the government can carry on borrowing cheaply. And this could be done if the Bank of England buys gilts that mature in the future. So say, in 50 years. So in other words, reducing the interest rate, the yield on the long term borrowing. So instead of tackling the debt immediately, the debt racked up during the Corona virus would be paid off over a longer period. The mood today is very different in the bond markets than what it was during the financial crisis. With no signs of yields being driven up by worried investors, in fact, bond yields remain at record lows, and not just in the UK. The U.K. also did just sell its first negative yielding government bond, which caused a rally in bond markets immediately afterwards, with yields on the twos and the fives dropping to record lows. The yield on the five year gilt went negative for the first time ever, which also means that negative rates from the Bank of England can't be ruled out any longer. Now, it will probably be a mixture of things that happen as you don't just dig your way out of a 300 to 500 billion pound hole overnight, but regardless of the solution, patience will be required. 

    [00:08:38] Now, as mentioned, there are really two overriding big themes right now. Soaring Corona virus cases in the U.S. and a possible second wave for everyone, and all of the central bank stimulus. The real issue we have in attempting to move forward is a conundrum. On one hand, we want to believe a recovery can and is happening. But on the other hand, we have all these U.S. Covid- 19 cases. Many are questioning the disconnect between fundamentals having deteriorated in developed economies, and asset prices continuing to shoot up. And even with the odd better than expected economic data point, the disconnect is big. Will 'don't fight the Fed' lead to tears? Because in riding on the coat-tails of the Fed and following the smart money, the trade playing field isn't necessarily fair. The market logic applied is the same as that applied to a teenager with a ton of debt. First, convince the market, the teen, that they're in good credit, then convince the market, again the teen, that they'll be able to pay back whatever is borrowed. So interest rates should be at zero. It's like saying don't believe the policymakers, believe your central bank instead. They will buy the bonds. The difference though, is that the central banks are printing their own money to buy the banks, and you, for example, a pension fund, you're using the money of savers. One of the players is paying with printed money. The other is forced to go in with their life savings. And if that trade sours, the pain will be bad for those who aren't printing money. Now, there's a lot of talk at the moment about how sustainable growth is overvalue. Take a look at a chart of MSCI World Growth over MSCI World Value. The spread has widened beyond that of the dot com bubble, which peaked back in 2000. And the strength of the current trend has been on course for around the last five years, although widening for the last 10 years, plus. Whether from a global or regional perspective, many would argue that it clearly looks like we're in bubble territory in terms of the relative performance between the two. Keep in mind, growth investment properties are defined using five variables - the long term forward earnings per share growth rate, the short term forward earnings per share growth rate, the current internal growth rate, the long term historical earnings per share growth trend, and the long term historical sales per share growth trend, as well as the value investment traits. On the other hand, are book value to price, 12 month forward earnings to price, and the dividend yield. Now the MSCI country weightings still overwhelmingly are geared towards the US and Japan. Also, the prominent sectors in growth are IT, around 33 percent, followed by health care and consumer discretionary is both around 15 percent. In value we see financials dominating at 22 percent, followed by healthcare and industrials both around 12 percent. Now, while oscillations are normal, we've never had a situation where growth has outperformed value to this extent. That last acceleration seen on the chart, is that the last push up? Are we heading into an environment where you want to roll over growth stocks and start buying value? I mentioned Japan. Stephen Macklow-Smith, a fund manager at J.P. Morgan and Alexander Fitzalan Howard, a portfolio manager, also at J.P. Morgan, they made the point that if you examine markets where you've seen economic challenges like Japan, quote unquote, "value investing has actually done very well in the last three decades. And specifically, between 1995 and 2008, it was value which led the market rather than growth or momentum." Now, the S&P 500, NASDAQ, the Dow, they're all somewhere around peak highs, and while the buying has been broad, the sectors leading those lofty gains are precisely the information technology companies and consumer discretionaries, digital economy stocks, including the FAANGS, they've been flying during the entire Covid months. In Europe however, pan-European stocks 600, while just closing out its strongest quarter in five years, it's still down around 15 percent from its all time peak in February. Compared to the U.S.. Europe is full of old world type companies. Granted, they're slowly but surely being disrupted, but as one money manager told me, tell me which European company is as strong as any of the FAANGS. Sure, you have companies like ASML or SAP, but aside from a very small handful, Europe is full of Old-World companies compared to the US. From an index perspective why would I want to own these, especially in the absence of policy support? Still, many investors they'd argue that the main reason to invest in Europe right now is precisely because Europe isn't the U.S. Invest in Europe because of the soaring U.S. Corona virus cases, the political uncertainties there and underperformance relative to the U.S. not because you no longer believe in Amazon or Apple. There will always be a place for U.S. digital economy companies and big tech, but the current storm is a lot bigger in so many ways than what we went through back in 2008. And back to that MSCI growth over value chart, as it turns out, according to the JP Morgan fund managers from the earlier mentioned interview, quote, "The divide between cheap and expensive stocks is at historic highs within as well as across sectors." So in other words, the spread between growth and value has actually widened equally as much on an industry neutral basis, which implies the bigger growth occurrence isn't just because of growth sectors like technology. Value is much cheaper today relative to growth companies. And given that we're in this situation of great uncertainty and low growth, and given that we've seen a phenomenal appetite to push the markets higher and higher to these lofty peak levels, it might just be that the next move is where the value of value starts to emerge. 

    In this section, we look at some of the trends or themes that we can glean from the data on the data. M&A activity came to a grinding halt in the early part of 2020 with Refinitiv's Director of Deal Intelligence Matt Toole, pointing out that in March we'd seen the first week in 16 years without a one billion dollar M&A deal taking place. A few nimble companies with dry powder were able to take advantage of the dislocations, but overall, it was a very slow period, even if there were deals to be made. It was hard work lining up the lawyers while capital markets were focused on emergency funding to keep corporates afloat rather than the luxury of M&A dealmaking. Going into the second half of 2020, things have stabilized. But does that mean a pickup in activity for this sector? Some technology companies certainly have large war chests, having been the clear winners from the dislocations of the last couple of months, but overall sentiment appears to be subdued. I asked David Craig, the CEO of Refinitiv, if the M&A market has been put on ice for now, and if it has, what does the data on the data say about the underlying levels of activity? 

    And what do you think could be motivating this pickup in activity? 

    Well our headline data from Refinitiv last week indicated the global M&A market was basically in hibernation. Seems like a six year bonanza is over. Value of M&A deals fell over 40 percent in the first half and Q2 was the lowest quarter since 2009. And the number of deals has been flat since April, and as Morgan Stanley's James Gorman said recently, the market is basically dead for Q2. Investment banks are instead concentrating on capital raising, for some periods in April or May we've seen more global bond offerings than announced mergers first time in decades that that's happened. However, our usage data shows that maybe the animal spirits are returning. The number of Refinitiv customers pulling information on mergers, on acquisitions and takeovers, has rebounded sharply since May's lows, and was up 45 percent month on month in June. And across a two month period hits on news related to rumours in M&A was up over 50 percent. So we asked ourself what's motivating this pickup? And it's very natural that there's some sort of return to normal or at least an emergence from the worst of the crisis. People are starting to be bolder about making longer term bets and braver about making valuations maybe. We're also seeing some bankers go back into the offices, and M&A as we know traditionally is a very in person face to face activity. So maybe there's some human side to it. But does the data usage really hinted a revival in Q3? Maybe it's too early to tell. As with anything, a lot will depend on the course of the virus in major markets, especially in the U.S. But regardless, it will take some time for confidence levels to return as dealmakers assess post-covid business models and valuations. But at the same time, we're seeing a bit of a change in mentality. Companies are being more opportunistic, particularly where targets have seen a dramatic hit to demand and valuations are well down. And the other dynamic, of course, that will play out is deals are motivated by underlying structural changes to the global economy. Buyers looking to increase their exposure to sectors such as technology, or sellers looking to shed physical retail travel or other sectors which may struggle for some time, or simply put, companies looking to accelerate a strategy in digital through using M&A and acquisitions. 

    While the M&A market does indeed remain sluggish, there has been a clear pickup in the demand for data within the sector. Capital markets have in many cases normalized with huge volumes going through the corporate bond space. Most service industries, such as lawyers, have quickly adapted to the use of remote communication technologies, and both these have helped remove some of the impediments to doing business. But perhaps the biggest driver of demand has been the acceleration and concentration of businesses, especially within technology that took place during the Covid crisis. The demand for digital in particular, is likely to drive a new wave of M&A consolidation, while companies that have seen businesses expand during the lockdown may now want to increase their reach into other sectors, the data on the data is certainly suggesting that activity in the sector is now quickly picking up, even if this hasn't yet translated into increased volumes of deal-making.