US monetary policy influence on an increasingly globalised economy

US monetary policy influence on an increasingly globalised economy

From Quantitative Easing to Tightening Policies

On Tuesday 16th December 2008, following the recession, the Federal Reserve lowered its benchmark interest rate to a range of 0 – 0.25%. The central bank also implemented the Quantitative Easing, which consists in purchasing US Treasuries and mortgage-backed securities to increase liquidity and stimulate the economy with new printed money.

In December 2015, based upon a better economic backdrop, Janet Yellen as Chair of the Fed, began a tightening policy. Since then, the Fed has raised the interest rates by 25 basis points 9 times, rising from 0 – 0.25% to a range of 2.5 – 2.75% in only 3 years. Since Jerome Powell succeeded to Yellen as Chairman of the Fed, his increasing confidence in the US economy, based upon accelerating inflation and a solid economic backdrop, allowed the Fed to raise the interest rates 4 times in 2018. While the Fed had signaled it would probably raise rates twice in 2019 and twice in 2020 to finally reach 3.5-3.75% in 2020, a dovish January Fed meeting changed expectations as it seemed the central bank would be more patient than expected regarding a future rate increase.

Figure 1: Federal Reserve’s funds rates increasing over time

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   Source: Macro Trends

Borrowers taking cautious stances

Since the tightening policy began in December 2015, signs of rising inflation, pushed the central bank into a more hawkish direction, raising the rates by 2.25% in 3 years. A moderate rising inflation is indeed an indicator that the economy is doing well, and it paves the way for salary increases but also interest hikes. Higher rates allow a better yield for savers, but it also means consumers and business will face higher costs when they want to access credit. Even more worrying, with US incomes still relatively flat, higher interest rates mean many homeowners with flexible-rate mortgages may be unable to repay their loans. This was one of the causes for the subprime crises: people took on mortgage debt at a very low interest rate thinking they would be able to reimburse it, but when the rates increased, they found themselves with not enough liquidity to pay back their interests on debt and lost a major part of their savings. And not only…

Bond holders see their prices fall…

A tightening monetary policy is a negative news for investors who see the price of their bonds fall. Interest rates and bond prices have an inverse relationship; meaning if one goes up, the other goes down. Therefore, if the interest rates increase, the value of a bond will decrease. The reason for this is that new bonds can now be issued at a higher yield and will therefore give a higher return than the bonds which are already on the secondary market pushing the demand for the existing bonds down together with their price.

“If the Fed is buying Treasuries, investors have to go further out the risk spectrum in search of returns,” said Subadra Rajappa, head of US interest rate strategy at Société Générale. “So, if the Fed is unwinding QE then the reverse should be happening. It should be negative for credit spreads and equities”.

…and so do equity holders

It seems the market wasn’t prepared to switch to quantitative tightening as US stocks had their worst December since 1931. The S&P 500 Index fell 15.7% between December 3rd and December 24th, when it reached its lowest point of the month. The Dow Jones Industrial Average fell 15.6% entering the correction zone.

Equities usually underperform during tight monetary policy periods. The higher the interest rates, the easier for investors to find low risks investment with high yields, such as bonds. As risk appetite is restricted, equities sell-off drives stock markets prices lower. On the other hand, higher interest rates environment impacts investor confidence that the economy is growing strongly enough for the corporations to offset the impact of higher borrowing costs.

Figure 2: S&P 500 (blue) and Dow Jones (red) Indexes falling for the month of December2

The impact on the Yield Curve

The Yield Curve is a graphic representation of the interest rates at different maturities for a given credit quality. The most common yield curve compares different maturities of the U.S. Treasuries. The tightening policy of the Fed controls short-term interest rates but has very little impact on the long-term. Therefore, the Fed monetary policy has a crucial impact on the Yield Curve. As shown on the graph below, as short-term interest rates rise, the spread between the short-term and long-term maturities diminishes, which causes a flattening of the yield curve over the years. Concerns rose around the flattening of the yield curve as it means investors do not expect to get a higher yield for long-term investments than for short-term investments even though long-term ones are riskier. In other words, it means investors expect an economic slowdown in the future.

Figure 3: US Treasury Yield Curve

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Source : Guru Focus

The flattening Treasury yield curve has also raised concerns as it paves the way for a future inversion. An inverted yield curve is an interest rate environment in which long-term debt securities have a lower yield than short-term debt securities. It means that investors expect their return to slow down in the future, hence, an inverted yield curve has often been seen as an anticipator of a recession, as it has been historically observed twice and both times it was the case. The Fed takes into account inflation, economic growth and unemployment when voting for a rate hike, however it may also take into account the yield curve and pause hikes if it were to flatten further or possibly inverts.

Figure 4: The visual representation on the inverted and the normal yield curves

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Source : Forbes

The impact on Emerging markets

Fed’s U-turn from Quantitative Easing (QE) to Quantitative Tightening (QT) is pretty significant for emerging markets (EMs).

As already said above, following the financial crisis, the Fed injected liquidity into the market aiming to ease financial conditions and borrowing costs by increasing demand for relatively safe assets. As a consequence, prices rose, and interest rates fell (this is the supposed effect of a QE).

Central banks across EMs followed suit, to allow non-financial corporations to get cheaper debt, consequently, private credit across EMs ballooned. Now that central banks are holding their current portfolios of bonds until maturity and selling the assets on their balance sheets to the market (QT), that private credit has started to shrink (Figure 5). Given that “credit creation has been the most important driver of asset prices for decades” as credit creation has pulled back, economies have tumbled.

Figure 5: Private sector credit creation started falling

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Source : National Central Banks

EMs have strongly been affected by this unwinding for two main reasons:

  1. They binged the most on the giant pool of cheap money in the years since the crisis
  2. As the Fed started shrinking its balance sheet, as observable on the appendix 1, the supply of global dollars will also shrink making it more expensive. The dollar rally in 2018 worsened currency crises in the economies with large dollar-denominated debt (Appendix 2).
  3. Higher interest rates in US means higher returns for dollar-denominated banking accounts that increase investors’ demand for dollars consequently making the USD more expensive vs other currencies (Appendix 3). 

Appendix 1: Fed’s balance sheet, showing a steep increase after the 2008 crisis and now starting to decrease

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Source : Bloomberg

Appendix 2: the huge evolution of the Chinese debt in US dollars value, representative on the EMs debt trend

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Source : IMF data, Tradingview representation

Appendix 3:  Balance sheet roll off is supportive for the Dollar

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Source : CitiFX, Bloomberg

Authors: Noa Lachkar, Greta Pontiglio

Supervisor: Lorenzo Bracco

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Small investment bank boutiques cash in on mega M&A deals

Small investment bank boutiques cash in on mega M&A deals
(On the right side is Simon Warshaw and on the left side is Michael Zaoui)

 

While it’s normal that big name players take mega deals in M&A market, small investment bank boutiques in London have shared a bigger slice of the pie than ever before, and, many times, some of them are beating big names.

Robey Warshaw, a Mayfair based investment bank boutique with merely 13 members, had a market share of 20.4% and an announced deal volume of about $65.6 billion through 1H2018 in the UK M&A market, according to the Bloomberg Global M&A Market Review 1H2018, overcoming giants such as Bank of America Merrill Lynch ( UK market share19.1%, deal volume: $61.6 billion), Goldman Sachs (UK market share: 18.8%, deal volume: $60.6 billion) and Rothschild (UK market share: 18.4%, deal volume: $59.2 billion) etc.. Interestingly, Robey Warshaw had only 3 deals to achieve a deal volume as high as $65.6 billion, comparing to an average of approximately 30 deals for other top-10 investment banks on this list (as shown in the table). With an average deal size of $21.9 billion,Robey Warshaw beat almost every company on this criterion.

 

Finance 1

Finance 2

 

Another mega-deal investment bank kiosk is Zaoui & Co. Established in 2013 by Morocco-born brothers, Michael Zaoui and Yoël Zaoui, Zaoui & Co had 12 employees in 2015, of which only 7 were bankers. It is worth noting that both brothers held a senior role in major investment banks: Michael was the head of M&A division at Morgan Stanley and Yoël at Goldman Sachs. Although the company was not on the top 20 deal-maker list in the 1H2018 report, which is mainly due to a lack of large deals and a nearly 60% shrink in French M&A market, according to Michael Zaoui’s interview with Financial News, it showed a strong performance in 2014 and 2015, only two years after it was incorporated. In 2014, the company advised GlaxoSmithKline PLC (“GSK”) to acquire 36.5% of stake in Consumer Healthcare Joint Venture of Novartis AG (“Novartis”) for $13 billion. There are other transactions involved which push the total amount to $57 billion. The deal was closed on 1st June 2018. In the same year, Zaoui brothers also advised a major merger in the manufacturing industry, helping Lafarge and Holcim to form LafargeHolcim, now the industry’s biggest player. The transaction involved is about €40 billion. Different from Robey Warshaw, which mainly puts its focus on the UK M&A market, Zaoui & Co. has broader geographical coverage. It has been developing its market in France, Italy, and Switzerland and also working on deals in Israel, according to the Financial News.

 

Comparing to the similar size UK kiosk advisors (another name often used for investment bank boutiques), which often have deals with transaction volume between $10-300 million, these two investment bank boutiques had an eye-catching performance, often with multi-billion deals. Reason? Their owners were superstars in big-name investment banks long before building their own businesses. Robey Warshaw has a team with Sir Simon Robey, Philip Apostolides, and Simon Warshaw. Sir Simon Robey was the former co-head of global M&A at Morgan Stanley, while Mr. Apostolides also held a senior investment banking role at the same bank. Mr. Warshaw was the former head of investment banking at UBS, according to FT source. Michael Zaoui was a colleague of Simon Robey in Morgan Stanley for many years; even now, their offices in Mayfair are merely a few hundred meters away. While both were co-head of global M&A in Morgan Stanley, Simon Robey focused more on the UK deals while Michael on continental European ones. This is correspondent to the different geographical exposure and strategies of Robey Warshaw and Zaoui & Co now. The former did the most of deals in the UK while the latter focuses primarily on continental Europe. Yoël Zaoui had spent about 25 years in Goldman Sachs and left as the head of the global M&A before founding the company with his brother in 2013. There is “fantasy football team” of London’s leading merger & acquisition advisers on the wall in Zaoui & Co’s boardroom, drawn up by a financial journal, according to EveningStandard. In goal is Karen Cook. The right full-back is Simon Robey. At right center is Richard Gnodde. Occupying the two striking positions are Michael and Yoel Zaoui. When all-star players team up, no wonder they can hit the goal that even big banks cannot.

 

Robey Warshaw and Zaoui & Co. are just two typical examples of investment bank kiosks. LionTree Advisors LLP (example transaction: Liberty Global’s acquisition of Virgin Media, $23.3 billion) and many others are advising multi-billion deals with just a few bankers in the office. Nonetheless, M&A advisory was never a labor-intensive industry. Thanks to their structure, top tier boutiques can generate an incredible amount of profits with small teams. Zaoui & Co, for example, earned an approximate £17.3 million turnover and an £8.6 profit. Between these two numbers is an administrative expense of £6.4 million, and employee cost was more than £5.3 million for a total of 13 staffs. In conclusion, with a strong network of the top management and an experienced team loaded with talents who worked for big banks, these firms have proven the ability to win the trust from big clients and play a leading role in the most relevant deals in the market.

 

Autor: Yintao Hu

Sources:

 

 

 

 

 

US-China Trade War Effect on the EU

US-China Trade War Effect on the EU

Back in March we introduced and briefly discussed Trump’s intention to impose tariffs on steel and aluminum goods. In less than a year those trade disputes escalated in a trade war, impacting not only the two involved countries but also other trading partners, including the EU. The disaffection versus international institutions has been driven by their inability to include the weakest parts of the population from feeling the benefits of the globalization process. While globalization has triggered economic growth and substantial real income growth in developing countries, the middle class of developed nations has not experienced the same benefits, leading to a decrease in purchasing power and a rise in protectionist sentiment.

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The main idea behind Trump’s rhetoric was to reduce the large trade surplus China has with the United States. Trump previously described the widening deficit, which Washington has said is around $100 billion wider than Beijing reported, as “embarrassing” and “horrible”. China and the EU were among those expressing their concerns regarding steel and aluminum tariffs and have threatened the US with applying a number of countermeasures. Jean-Claude Juncker, President of the European Commission, announced that the union will engage in a collective response with other countries affected by American measures and expressed EU’s intention to draft a list of retaliation tariffs amounting to $3 billion.

Since then, Trump’s actions have shaken the very foundations of global trade, with billions of dollars worth of goods from the EU, China, Mexico and Canada. The protectionist measures imposed by the American president have escalated into a full-fledged trade war between China and the US. An economic showdown between world’s largest economies does not look great for anyone and the EU’s manufacturing and industrial sectors are largely affected. Clearly, those sectors are monumental for Germany – the world’s fourth largest industrial nation.

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Potential Paradigm Shift?

As the US is escalating the trade war, it will be more difficult for China to accommodate American demands. There are few effective ways for China to retaliate without hurting its long-term development. An alternative would be to open up to the world’s largest economy to the EU. Thus, there is an expectation of a possible collaboration between China and the EU, given that China accepts the longstanding demands of the EU on better market access and give-and-take approach. Within this scenario we would observe a paradigm shift in terms of US-China economic relations. The EU Commission currently maintains a neutral stance towards Chinese exports. So, the result would largely depend on whether EU chooses to align with the US to protect its market from the Chinese market or maintain the neutral policies. By maintaining the neutral stance, EU could substitute the US and China in each other’s markets to an extent. Given that US does not hit the EU directly and EU maintains a neutral stance, potential gains for EU industries are relevant for the motor vehicles and aircraft sectors as well as other sectors combining over $200 billion altogether.

Germany’s GDP Growth

In the third quarter of 2018, German output contacted for the first time since 2015 and this helped push the euro zone growth down to just 0.2%. This weakness is expected to continue in 2019, with the German GDP Growth rate revised down from 1.8% to 1% due to the global economic slowdown. Furthermore, the euro zone does not have the economic backdrop to increase rates, since the ECB ended its net asset purchases in December. Therefore, the benchmark rate is likely to remain the same, making it harder for the EU to offset the effects brought about by the trade war.

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The main factor contributing to this contraction is the German auto industry. German car production decreased by 7.4% quarterly and this subtracted 1% from expansion in the industrial production and 0.3% from Germany’s GDP growth. The reason for this decrease comes partially from the new environmental standards for passenger cars, as producers could not make the vehicles as quickly as they desired.

Another reason for the Germany’s GDP slump might be China’s economic slowdown as China is one of Germany’s largest trading partners. China is facing economic issues arising domestically due to financial instability and externally given the trade tensions with the US. In October, China’s financial team went into overdrive with ten meetings within two months and Vice-Premier Liu He’s team was under pressure to resolve problems caused by the trade war that slowed the country’s growth. China’s economy officially grew only 6.4% on YoY basis in the fourth quarter, its slowest rate since the global financial crisis. A lack of growth in investments and consumption is the main driver of this lackluster performance.

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Weakness In The Car Industry

Back in June, Germany’s Daimler cut its 2018 profit forecast, while BMW stated it was looking at “strategic options” because of the trade war. Thus, the companies sparked fears of earnings downgrades in the auto industry. Daimler stated that import tariffs on cars exported from the United States to China would hurt sales of its Mercedes-Benz cars, resulting in slightly lower EBIT for the year. Morgan Stanley’s analysts added that Daimler will not likely be the only Original Equipment Manufacturer (OEM) to reduce its guidance. Other OEMs are exposed to similar trends in various degrees.

Daimler’s rival BMW, which also exports from the United States to China and Europe reaffirmed the profit forecasts, adding that these would largely depend on unchanged global political conditions.

 “Within the context of the current discussion concerning additional tariffs on international trade, the company is evaluating various scenarios and possible strategic options”.

European Central Bank’s Hard Work

Mr. Draghi of the ECB and Mr. Weidmann of the Bundesbank seem to agree that the policy should be normalized without delay. This suggests that the ECB remains determined to end net asset purchases by the end of 2018. Still, German exporters are vulnerable to the slowdown in external demand and the risk of trade tensions between Europe and the United States.

So, what should the ECB focus on? The Quantitative Easing program launched in 2015 with the intention to reduce the risk of deflation has come to an end last December. The key EU Inflation Rate rose above the ECB’s target of close to but below 2% for 2018, making it harder to justify an extension of the QE program.

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The ECB held its benchmark refinancing rate at 0 percent on October 25th and said it would stop to make net purchases under the asset purchase programme at the end December 2018.

This situation has changed in the past months as the effects of the Trade War have been felt on both the real economy and financial markets globally. The sharp slump in energy prices, a contraction in Exports and finally Consumer Sentiment drifting lower from high levels have consistently reduced Inflation and GDP Growth expectations for the EU Area. As a result, it is highly improbable that Mario Draghi will be able to follow through on ECB plans towards normalization in the short term. The continued reinvestment of the proceeds from bond redemptions will be necessary to provide stimulus to the European economy for the years to come. Moreover, ECB should use the forward guidance to thrust back market expectations over the key interest rate rise – something which would weaken the euro and further loosen the financial conditions. The ECB’s next moves largely depend on the upcoming levels of inflation and economic activity, which are linked to politicians’ ability to solve trade disputes and restore confidence.

Trade War Detente

China and the US have agreed to not impose new tariffs up until March, when a definitive agreement is expected to be reached. Furthermore, China’s Ministry of Finance removed the 25% tariffs on American-made cars and 5% on specific car parts for three months. This shows the willingness of both sides to cooperate and work towards a larger trade deal, but only time will tell whether this willingness will convert into a desirable outcome. As commentators pointed out, any positive cooperation including negotiation or even talking would help settle the markets, while continuing tensions will instigate investors to withhold their money.

Even if according to the United States Trade Representative several outstanding issues remain, the possibility of an expedited trade deal has helped stabilize the markets in the last weeks.

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 The Dow Jones Industrial Average gained 163.08 points (0.7% increase) to 24,370.24 – its highest level since December 13.

The upcoming elections of 2020 in the US oblige Trump to find an agreement in order to maintain his electoral base and increase his probability of reelection. According to reports from various sources, US officials are willing to grant China sizeable concessions in further negotiation rounds to reach an agreement before the deadline. It is unknown if this is enough to restore confidence in the system and the first test is expected in few months on the other side of the Atlantic Ocean. In May there will be the elections for the European Parliament, with Eurosceptic Parties gaining ground thanks to the widespread economic malaise exacerbated by the Trade War. The March meeting proves to be essential for all the parties involved, making extremely hard to forecast future upcoming events.

Authors: Nikita Borzunov, Mario Stopponi

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