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The Big Conversation

Episode 82: Which markets are vulnerable to this mid-cycle slowdown?

This week we look at the signs that a mid-cycle slowdown is already underway. Small caps continue to underperform and there are more signs that the reflation trade is under pressure. Emerging markets look particularly vulnerable on a relative basis because they didn’t reap the usual rewards of the cyclical upturn. In The Chatter this week, Cornelia Andersson, Head of M&A and Capital Raising at Refinitiv, discusses the record volumes in the M&A space and the key role that private equity has played in this process, and the potential for these firms to be priced out as corporate activity starts to pick up.

  • Roger [00:00:00] Are the markets vulnerable to mid-cycle slowdown? There are many signs from US asset prices that we're already at that stage. The ratio of small caps versus large caps has recently taken a new leg lower as sector and style rotations gather pace. The outlook for emerging markets looks particularly tricky, having seen very few of the usual early cycle benefits that would accrue from reflation. In this Big Conversation, we look at the areas which are most vulnerable to a drift in growth.

    Roger [00:00:30] It may seem too early to be looking for a mid-cycle slowdown, but the impact of the Covid pandemic and its policy response have accelerated those usual cycles. Bond yields had already peaked at the end of March, the highs coinciding with the end of selling by Japanese asset allocators for the end of their financial year. Although many cite the slightly hawkish tone from the Fed at the June FOMC, yields had been falling for many weeks by then. Market breadth has also been declining, with fewer and fewer stocks joining in the rally to new highs. According to Lohman Econometrics, the S&P500 recently had four days when it made a new high with less than 50 per cent of its companies above their 50 day moving average. The previous occasions that happened were in the run-up to the 2000 peak. Usually, during a mid-cycle slowdown, we can expect a few runaway leaders to lose some of their energy as investors start to rotate out of the early cyclicals. The US market has generally been conforming to this pattern, even though the reflationary outperformance has been relatively short, having only gained momentum after the US election and the first vaccine rollout announcements. But we shouldn't be surprised that the cycles have been concentrated into a shorter time frame. The policy response in terms of speed and scale is very impressive. That momentum will be impossible to maintain, however, because it would require ever-increasing intervention. US personal income is now drifting back to trend. In the same way that base effects have had a positive impact on the year-on-year change in commodity prices and inflation, so base effects are having a negative effect on last year's stimulus. For the last two months, the change in the growth of personal income has been the lowest for seven years. Absent another immediate fiscal boost, it would make sense that spending patterns will wane in and they will also change as consumption shifts from goods towards services when the economy start to reopen. But perhaps the biggest anomaly during the early cycle recovery is how concentrated this was. Many global reflationary assets didn't party as hard as the US. An early cycle reflationary recovery should see strong participation from emerging markets. The German DAX, which usually benefits from global growth because of exports, has also significantly underperformed when viewed through that reflationary prism. Now that doesn't mean that we've seen these assets perform badly in absolute terms, but their relative performance is surprising. The dollar has been on the back foot for much of the last 12 months, but that weakness was mainly strength in the euro, which makes up 50 per cent of the DXI and strength in the Chinese Yuan. The broader-based emerging market currency index has significantly lagged. Yes there's been strength versus the dollar, but it's not been inspiring. At the same time, we can see that the relative performance of emerging market equities has also been underwhelming. The ratio of the S&P500 versus the MSCI Emerging Market Index has reached its highest level since 2002. This is a massive disconnect with the performance of the US dollar. Emerging market equities should have been outperforming, given the tailwind of dollar weakness. It would appear that the weaker dollar has not conferred the usual benefits on emerging markets. Part of this is due to the clampdown by Chinese policymakers on their internet stocks. Both technology and Chinese equities have become an increasingly important part within emerging market equities, and these shares have significantly underperformed the tech-heavy Nasdaq this year, negating many of the benefits of a weaker U.S. dollar. Additionally, the weaker dollar has seen inflationary elements pick up, such as commodity prices, but if prices rise, but volumes remain relatively stagnant, then many countries and corporates will experience margin compression. Global oil demand has rebounded from the lows, but at the end of Q1 2021, it was still well below pre-pandemic highs. Whilst that will have rebounded further in Q2, the pattern is repeated across many commodity markets. Prices have increased due to supply chain issues rather than demand. Institutional investors often use the DAX as an emerging market proxy within developed markets because emerging markets were customers for German exports. In absolute terms, the DAX has performed well. But again, in relative terms to the S&P500, it's close to the recent lows. Perhaps more surprising is how the DAX has failed to take off with last year's reflationary impulse. When the US yield curve was flattening, the DAX generally underperformed because the lower, longer-dated yields were reflective of slowing growth. Last year however, when the US yield curve sharply steepened, German equities failed to take their cue to outperform. Again this suggests that the reflationary impulse was not a global event, but something very much centred around the US rather than global policy. Again, volumes have significantly lagged price. Copper prices soared and the belief that where copper goes, so goes the economy, helped create the impression that the global economy was in great shape. Obviously, we've seen a powerful rebound off the lows, but we have not yet rebounded into a new paradigm of stronger growth. We've run into a number of inflationary bottlenecks that could kerb growth before it ever really takes off. So if all the outperformance has been mainly amongst US assets, is that where we should focus our attention for a mid-cycle breather? Well, probably not, because resilience in the US equity market has been held by a broader mix of sectors. When yields were flying there are many US beneficiaries of the cyclical upturn. The stronger move higher in US bond yields and the steepening of the US curve allowed US banks to outperform other regions such as Europe. This was aided by a rebound in capital market activity. So even as higher yields were undermining the performance of the US tech sector, other sectors were able to step into the breach and keep the S&P500 on its upward trajectory. We can now see that with the fall in bond yields, U.S. banks had been underperforming. If we expect US 10-year yields to fall back to one per cent, then US banks should underperform Europe again. But at the same time, the tech sector will take over and benefit from those lower yields. The US will see rotations, but that should keep the broadest index level out of trouble. U.S. yields would need to significantly overtake the 2021 highs of 1.75 per cent to pose a bigger problem for the market. For now, the dollar remains the most obvious risk. The dollar index has been testing the neckline of a technical formation. The euro, which is the largest component of the DXY, therefore has a similar pattern. If this is successfully breached, we can target 1.09. The dollar poses an asymmetric risk for emerging markets and the German DAX. If the dollar falls, these markets aren't receiving the usual benefits because China is no longer playing the same growth game, whilst the inflationary impact of the weaker dollar becomes a headwind. If the dollar rises, then high levels of dollar-denominated debt, the negative impact on commodities and the urge for dollar-based investors to unwind their overseas holdings, means that means a stronger dollar is still a significant issue. We have to note, however, that it's not the absolute level of the dollar that matters, it's the speed and the direction of change. If the dollar index surged to 99, then it would be a problem. If it grinds there over a matter of months, then most economies and markets can adjust. A mid-cycle slowdown is therefore not about recessions, it's about rotations. Reflation expectations have reached fever pitch and that alone will remove some of the urgency for an additional policy response. Rotations in the US market have held the S&P grind higher, even when there is significant sector turbulence beneath the bonnet. The dollar poses the greatest risk for global markets. But as we've seen before, it looks like policymakers prefer a dollar that's range-bound rather than one that is inflationary when it falls or causes tightening conditions when it strengthens. And the astonishing rate of M&A activity is also another indication that the usual cycles have been distorted. Record volumes are usually a late-cycle sign. Refinitiv's Cornelia Andersson outlines the biggest trends in this space.

    Roger [00:07:59] M&A volumes of this magnitude are unusual at this stage of the business cycle. Many of the drivers do look set to continue though leadership, maybe about to shift.

    Cornelia [00:08:08] M&A has had its strongest period since records began, and in the last quarter, we've seen deal values over one and a half trillion dollars. And in fact it is the fourth consecutive quarter where we've talked a trillion dollars, which is really quite astounding. So the recovery that we saw last year is continuing ahead full steam. M&A is largely a confidence game and the removal of many of the factors that created a lot of uncertainty, presidential elections in the US as well as the pandemic crisis, has resulted in an environment where dealmakers are largely much more comfortable pursuing the M&A agenda again. Capital markets are very strong, the interest rate environment continues to be favourable. Private equity is a very big driver for deal activity and to some extent SPACs as well. So what we're really looking at here is a situation where we are likely to continue to see elevated deal activity going into the second half of the year. Private equity or financial sponsor-backed M&A activity continues to really drive the numbers up here. So we saw about half a trillion dollars worth of deal activity in the latest period. And the markets have been very favourable for private equity. Private equity continues to raise record amounts of capital from limited partners, meaning that they continue to drive deals in the next half of the year. But what I'm going to predict, which is perhaps a little bit against the grain here, is that we are going to enter an environment where private equity will find itself increasingly squeezed. So as corporate deal-makers are getting more comfortable with the M&A agenda again, and they're really going to enter the fray here, we're going to see a situation where prices are pushed up. We're already seeing an increase in valuations where multiples of deals is approaching 17X, which is a steady upward trajectory. And what will happen here is as corporates continue to pay a premium for assets, private equity will increasingly get squeezed. Obviously we talked a lot about SPACs during the last year. So Special Purpose Acquisition Companies are obviously the blank check vehicles that take private companies public through a reverse merger. Now these vehicles obviously have a lot of criticism in terms of higher, higher risk and some uncertainty, lack of transparency, some, but also a lot of proponents, and whilst SPAC activity has dropped off a little in the latest quarter, it's down to 14 per cent now. 14 per cent of deal activity is still a very significant part, and interestingly we are starting to see SPACs looking at cross-border transactions. So expanding outside the US, which was the original home of the SPAC, so to speak, and now looking increasingly at international targets. So technology M&A continues to be the highest sector here. So we see an awful lot of activity in technology, both in the high tech and other technology sectors. We also see a lot of activity in financial services as well as energy and power. Now, what's really interesting and what I think will continue to drive technology as a top sector going forward, is the fact this is expanding beyond our high tech firms. Right so we are now also seeing a lot of tech M&A activity from more traditional businesses. And the reason for this is that traditional firms, whether they are industrial or perhaps retail or other types of services, they are under pressure to innovate right. And what this really means is increasingly to go digital. We're in an environment where there are very high expectations, both in terms of growth and returns from investors. So just taking a look at the equity markets will tell you this, right, they're trading very highly. So companies therefore are under pressure to meet these return expectations from investors, and M&A often becomes a good solution to achieve those targets. And with that background, I'm sure that we're going to continue to see a lot of M&A activity as companies continue to expand their businesses and to meet those return expectations from investors. In the second half of the year, we're going to continue to see record M&A as well as capital markets activity.

    Roger [00:12:20] If leadership in the M&A space shift to corporates, we may well see another burst of activity from private equity before valuations get really out of reach. The size of these war chests suggest that global equities should reap the rewards for at least the rest of this year.