The Big Conversation
Episode 94: The stagflation specter? No time to cry
This week we look at the stagflation that many people feel is stalking the economy, from fuel price surges to empty shelves at supermarkets. Is this a rerun of the 1970s? There is a quantum of solace in that the similarities stop with the surge in prices. It’s the supply chain issues, rather than a demand surge, that’s driving people to tears today. In the Chatter, Cornelia Andersson, Refinitiv’s Head of Banking and Capital Markets, looks at the record-breaking value and volumes across the M&A sector, which sectors are leading the charge, and which participants are driving the activity.
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Roger [00:00:00] Searches on social media for the word stagflation have hit record levels in recent days. Now, for many people of a certain generation, stagflation harks back to the 1970s, an era in which stock markets across the world surged and then collapsed, there were regular fuel shortages, and in the United Kingdom, a 'Winter of Discontent'. Many investors are wondering is stagflation is making a comeback? And that's this week's Big Conversation.
[00:00:26] Is today's demand in excess of supply? Well, in many cases, yes, it is, and hence the higher prices. But is today's demand in excess of pre-pandemic levels? Well in most cases in that, no it isn't. If we take crude oil as a proxy for overall activity, then global demand for oil is still well short of its pre-pandemic levels. The shortfall has not been offset by alternative energy sources, which is one of the reasons why many regions today are facing an acute shortage. As a result, oil production remains subdued, with OPEC in particular trying to manage supply in favour of price rather than volume. Demand remains weak, but prices have risen. We are in the midst of an enormous supply-side distortion rather than experiencing a surge in demand, and this is a key distinction between today and the 1970s. The 1970s were the culmination of years of labour market distortions. A rate of change of population growth that was reaching its peak into which OPEC restrictions then shook up a narrowly sourced energy market. Surging demand beyond previous levels was back then a major factor. Although inflation did create significant price distortions, the backdrop in the 1970s was one of strong growth interspersed with regular recessions. If we get higher prices today due to supply- side distortions, then we'll also see an impact on margins which have recently been rising. There's just not the same sustainable growth in demand today. If we get margin contraction, then companies paying higher wages will soon be cutting jobs in order to offset those higher costs. Furthermore, whilst wages are rising today, they are doing so at a slower pace than inflation. This will put downward pressure on consumer demand, which will become a headwind for growth. Bottlenecks today are a problem, but we've seen these before. Record rises in many commodities have subsequently been crashing down back to Earth. Many of the key components for cars are struggling, such as palladium. Now there's obviously a slowdown in car production because of a shortage of chips, which is another supply chain issue. US total light vehicle sales have collapsed, partly due to a lack of semiconductors, but that's not the only reason. Higher prices have seen a collapse in demand for all large-sized durable goods, not just autos. Second-hand car prices remain elevated. High second-hand car prices are not a benefit for the economy, and we've see many other elevated prices eventually go into reverse. Many of these, such as lumber, are nothing to do with automakers or semiconductor supply chains. The European and Asian issues around natural gas are primarily a story of depleted storage and supply uncertainty. Asia is competing with Europe because many energy substitutes have failed to provide security. Storage levels had already dropped at the end of last year. And despite today's headlines, this is not an issue that's appeared out of nowhere. Natural gas prices stateside have not moved in the same direction as fast. The differential had taken the spread between the US and European gas to the top of its range, prompting many traders to put on positions that would take advantage of a mean reversion in the price differential. That mean reversion trade had worked for more than a decade, but this time it didn't. The demand-supply imbalance is therefore being exacerbated by a short squeeze on the European leg of that spread. These higher energy prices are probably going to have an adverse impact on GDP growth. Prior to 2014, higher energy prices led to higher levels of capex and also jobs growth. Since 2014, however, energy transition policies have led to chronic underinvestment in the sector. There's no capex or jobs growth with higher energy prices today. As a result, higher energy prices today are a drag on growth. Whereas 20 years ago, they were a major tailwind for investment. The post-pandemic reopening is therefore now giving way to debilitating shortages and price squeezes across many essential items. And many of the issues that are being faced in places like the UK, such as driver shortages, are being faced in other regions such as the US. Now, much of this is due to the retirement of existing drivers and a lack of newly trained replacements. The UK has also struggled to attract short-term replacements from the EU. As of Tuesday this week, fewer than 200 people have taken advantage of a new visa scheme for truck drivers. The UK army is providing 500 squaddies to help fill the gap, but some estimate that the shortfall in drivers across trucks and tankers is as high as 100,000. Combine these issues with the fiscal cliff, particularly a benefits cliff, which will occur as the base effects of government spending and subsidies goes into negative territory, then we have a recipe for a significant shortfall in consumption versus earlier expectations of economic growth. And as we've regularly observed in the Big Conversation since 2019, the nature of the Chinese economy has also shifted away from supporting global growth. Base effects and bottlenecks aside, the long-term employment picture remains structurally deficient. Job openings often double count the actual demand for jobs because companies may post multiple listings. The actual labour force participation rate remains well below pre-pandemic levels, having recently fallen again. One thing's for sure, if companies are faced with margin compression, they're unlikely to convert adverts from job openings into an actual hiring spree. Now, as a result of these margin concerns, equity analysts have been marching down their earnings expectations whilst those stagflation fears continue to build momentum. But should this matter for equities? That question largely depends on whether you're focussed on just US equities or global equities, and these are, of course, very different beasts. In the US we are once again seeing a call for a top. But if that's based on fundamentals, then it's based on factors which just haven't worked for pretty much five years now. The US has been driven by buybacks, pension flows and the ongoing switch from active to passive management. And that framework is very unlikely to change unless inflation can meaningfully push up bond yields. And the Fed will be very reluctant to let bond yields move meaningfully higher. Even at current levels above 1.5 percent, we've started to see the stock market hit a few early air pockets. Now prior to this year, you needed yields in excess of 3 percent to cause problems. It will be much lower today. The US equity market may be more vulnerable today because of an influx of retail investors who can certainly drag markets down if they head for the exit at the same time. But so far, they've still shown a greater propensity for buying the dips, especially through the use of short-dated out of the money call options in which losses are limited to the premium paid. Many institutional investors have already got tail hedges in place. Skew was recently at an all-time high, indicating a demand for deep out of the money puts, which pushed up their volatility to much higher levels than the equivalent out of the money calls. Skew has now normalised, partly because investors have taken advantage of this small pullback to sell their long puts for a small profit. They are effectively buying the dips via this strategy. If however, the market heads properly lower, then the automatic, stabilisers will kick back in. Bond yields will fall and falling bond yields would again be supportive of the tech sector. Rotations would be more likely than a full-on bear market if there was indeed a wobble. Bond yields have failed to move meaningfully higher so far despite the move in inflation because growth has fallen well short of expectations and continues to get downgraded. Whilst current inflation is the tide that will impair rather than reflect future growth. If, however, investors are genuinely worried that yields might spike higher before the Fed can react with more rather than less QE, then one hedge they could employ would be puts on the bond market or on the TLT, which is the ETF on the long bond. Now for the TLT, they would look at strikes around the neckline of a potential head and shoulders top, though that's quite a long way down from here. This shouldn't be the base case, because yields should fall, not rise given the current outlook for growth, but a sudden surge in yields could destabilise stock markets globally. And if you want to watch a tech bellwether for true change in sentiment then Amazon is approaching its own key support levels. A break here would suggest a move to 2017. So stagflation is a concern today, but inflation is not as structural as it was in the 1970s. A policy response to a stock market wobble is always just around the corner. And despite all of these concerns, the corporate sector remains extremely positive. This has been another great quarter for M&A, with tech again taking the lead. In the next section, Refinitiv's Cornelia Andersson outlines a record breaking year for deals that shows no sign of pausing for breath.
Roger [00:08:35] The first half of the year saw M&A volumes closing in on a number of records, and those volumes have just kept on coming. Many of the old records have already fallen with both the volume and the value of deals at impressive levels. And that's with a quarter of the year still to go.
Cornelia [00:08:49] It's another quarter and it's another record. So we've had this conversation several times this year, but this time the markets have hit new heights. M&A is double compared to last year, and in the last nine months, we've hit the all- time full year record with volumes over four point five trillion dollars in the first nine months of the year. And it's also the fifth quarter in a row of M&A hitting more than one trillion in that particular quarter. So despite what onlookers may have thought 18 months ago, the pandemic has not put a stop to M&A activity, but instead we're seeing a supercharged environment. And interestingly, it's not just of value, so it's not just ever- increasing deal sizes, but it's also the number of deals. And with over forty four thousand deals done to date, it's a very active market.
Roger [00:09:35] Through most of this year, the tech and internet sectors were leading the charge within the M&A space. And this pattern has continued through Q3. This year has also been notable for the geographical split of the deals.
Cornelia [00:09:46] So in terms of sectors, technology leads the race, so about 20 percent of all M&A deals are tech deals this year, and that's an all-time high. So financials are also going strong, as well as industrials and energy and power. And if we were to look at regions the geographic split across the world, cross-border deals are doubled compared to last year. The US saw the strongest growth, followed by Europe and then Asia. We might see some differentiating impacts of the pandemic here, so several markets in Asia have been back to lockdown this year, which probably had a slowing impact on dealmaking in Asia.
Roger [00:10:20] This has also been a year in which there's been a wide variety of participants, with private equity and SPACs continuing to play a major role in supplementing the volumes of the corporate sector.
Cornelia [00:10:28] So there's a couple of key factors that are driving M&A activity. So there's a friendly financing environment, so plenty of access to cheap debt as seen in the boom in the capital markets issuance, interest rates continue to be very low globally, corporates are relatively cash-rich with healthy balance sheets. Sentiment, of course, so dealmakers and C-suite executives are very comfortable with the new normal, and in a comparatively low-growth environment, M&A is one of the ways to ensure growth both your business and investors. Private equity absolutely continues to drive a good chunk of M&A activity, and we saw some record numbers there as well. So PE now accounts for about 20 percent of all deal activity. And the reason for that, of course, is that as asset allocation increases to alternative assets and public markets are really high valuations, private equity is more and more attractive, and that capital flowing into PE funds needs to be put to work. SPACs, which was sort of the phenomenon that everyone was talking about a couple of quarters ago, they are still there absolutely. Things have slowed down a little, but SPACs still continue to account for about 13 percent of all deals. Another driving factor is the US. So 2021 has been a year of making up for some lost time, and there's been a very strong recovery there. So we're also seeing a lot of activity around large deals. We've never had so many deals over $1 billion before, and we've never had so many mega deals, so deals over five billion. So deal sizes starting to continue to go up there. And lastly, and this is quite interesting, we also see international deals with cross-border deals, driving activity. So cross-border M&A is on the up, and certain markets like the UK have had a big influx of foreign buyers snapping up UK assets. That's not a bad thing, right? And perhaps it's just what the UK needs to get out to the post-Brexit and pandemic slump.
Roger [00:12:22] Although this has already been a record year, Cornelia doesn't expect the volumes and value of deals to slow down. In fact, the momentum is expected to extend into 2022
Cornelia [00:12:31] Certainly for the remainder of the year and probably the next couple of quarters, I would expect more of the same. We are in a supercharged M&A cycle and it shows no signs of stopping anytime soon. So I predict that Q4 will be another record quarter, taking 2021 one to an all-time high in the books. But I think, you know, the big question is not so much of how know how this is going to continue? The big question is when and how will we see a slowdown? Is it going to be a gentle tapering off and slowing down, or are we going to see the markets come to an abrupt stop? That I think the jury's still out on and very much depends on what happens in the broader economic environment around interest rates and access to financing and so on. But look, I think we're certainly in for the next couple of quarters for continued booming activity and a very strong outlook for both M&A and capital markets.
Roger [00:13:27] The environment of easy access to cheap capital, at least for the bigger players in the market, has helped supercharge this M&A cycle. And whilst there's talk of taper, which will no doubt lead to further discussions about a rate hike, these are still some way off. Before then, there's still many good months in which M&A activity can continue at full speed. And as always, if you have any questions about anything in this episode or about the economy or financial markets, please put your questions in the comments section or send them to TBC@Refinitiv dot com.
Episode 93: Can stocks rally if yields rise?