Alternative investments will hit record $14 trillion AUM in 2023. What about PE?

Alternative investments will hit record $14 trillion AUM in 2023.

What about PE?

The popularity of the alternative investments space does not come as a novelty in a period in which investors increasingly seek to shy away from the less attractive returns of traditional asset classes. The news is however, that forecasts see the industry hitting a record $14tn AUM mark in 2023, growing by +59% (i.e. c.8% CAGR) from the $8.8tn recorded at the end of 2017. If we think that, merely ten years ago, assets managed by alternative investors stood just north of $3tn, growth has already been outstanding.

Key drivers for growth in alternative investments include investors’ need for yield, the long-term outperformance of private capital compared to public markets, the growing appetite for alternatives from institutional and private investors, and strong growth in emerging markets.

“Fourteen trillion dollars may sound like an overly ambitious prediction for the alternative assets industry, but it is lower than the average growth rate we’ve seen in the past decade, hence extremely likely to happen” comments Preqin’s CEO Mark O’Hare. According to the latter, other trends shaping the alternative’s industry besides the proven long-term performance, are the growing opportunities in private debt and the rise of emerging markets in which alternative funds are already entrenched.

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The asset class claiming the largest share within alternatives is obviously Private Equity, with an expected increase of +58% (i.e. c.12% CAGR) over the next five years from $3.1tn to $4.9tn AUM overtaking hedge funds that instead will grow by +31% (i.e. c.7% CAGR) from $3.6tn to $4.7tn. More interestingly, the rise of private debt will see the market for this asset double in size (e.g. expected at $1.8tn in FY2023) growing organically thanks to allocator interest no longer for traditional bank lending but for private capital. Real assets instead, although representing a smaller portion of the alternative investment universe at this moment (i.e. c.8% according of the total according to Preqin), are expected to be the fastest growing set of assets over the next five years.

Anna Gervasoni (Director General of AIFI – Italian Private Equity, Venture Capital and Private Debt Association and board member of Fondo Italiano d’Investimento) emphasizes this positive trend claiming that: “private capital and private equity will become more convincingly part of institutional investors’ asset allocations in the coming years”.

Performances have their say in this. According to Preqin, buyout funds have recorded performance of 5 ppts greater than those recorded by the S&P500 since 2000 and better than any other institutional asset class. Performance-based metrics remain a key driver in asset allocation towards alternatives says Michael Murphy (Managing Director and Private Equity Global Co-head at Credit Suisse):“I expect to see this trend rise even more leading to a more mature secondary market that will reduce the perception of illiquidity of these assets”.

But where does this growth come from? The most important sources of the incremental flows to alternative investments will be family offices, sovereign wealth funds and pension funds. These funds are starting to believe they can run their own money, rather than outsourcing to large asset management companies because they now “manage more capital, are more sophisticated and have greater expertise in-house than was the case prior to the global financial crisis” comments Michael Stirling, CEO of Stirling Infrastructure.

There are expected to be way more fund managers available for LPs to choose from in 2023, bringing the total number of alternative investment funds to a staggering 34,000! At that point, the ability of picking the right guy (fund) will be crucial, even more than today.

 

Sources:

Il Sole24Ore, https://www.ilsole24ore.com/art/finanza-e-mercati/2018-10-31/fondi-alternativi-l-industria-arrivera-14mila-miliardi-dollari-2023-131834_PRV.shtml?uuid=AEj7ojYG

Institutional Investor, https://www.institutionalinvestor.com/article/b1bg5lknj62d7l/Report-Alternative-Investment-Industry-Will-Hit-14-Trillion-By-2023

Preqin report “The Future of Alternatives”, https://www.preqin.com/insights/special-reports-and-factsheets/the-future-of-alternatives/23610

Bebeez, https://bebeez.it/files/2018/11/Alternative-Timeline.pdf

 

Consolidation in the luxury industry: acquisition of Versace by Michael Kors

Authors: Alessandro Babbaro, Riccardo Lizzi

Michael Kors Holdings Limited announced the acquisition of Versace for $2.12bn, on September 25th. Upon completion of the deal, which is expected to be during Q4 2019, the group will rebrand as Capri Holdings with combined annual revenues of $6bn. This deal follows the £896m acquisition of Jimmy Choo, dated one year ago. The American company is trying to create a US rival to conglomerates such as LVMH and Kering.

Companies overview

Michael Kors, formally known as Michael Kors Holdings Limited, is a global fashion brand founded in 1981 with executive offices in London and operational headquarters in New York. The company sells accessories, footwear, and apparel with a presence in more than 100 countries.

Michael Kors went public in December 2011, raising $944m through the sale of 47.2 million shares. Through the IPO, the company reached a market value of $1.18bn. Seven years later, the market capitalization climbed to $8.7bn, with the shares trading at $57, as of November 6th. During FY 2018 (ended in March 2018), the company generated $4.71bn Sales Revenue, showing a 5% increase from the previous year. In terms of profitability, the company reported a $592.1m Net Income, which represents a 7.4% increase from FY 2017.

Versace is an Italian luxury fashion company founded by in 1978 by Gianni Versace in Milan as Gianni Versace Spa. The Versace family retains 80% of the ownership, with the remaining 20% held by Blackstone since 2014. The American PE Fund is expected to exit this investment with a €156m capital gain.

Upon completion of the deal, the Versace family will retain a €150m equity stake in the combined entity. According to The Financial Times, the company in 2017 generated $680m in revenues and roughly $15m in profits. Revenues are expected to climb to $850m next year. Versace, as opposed to Michael Kors, generates the majority of its revenues from the clothing business line. This transaction comes after Versace had delayed its plans to launch an IPO due to unfavorable market conditions. Indeed, in January, the CEO told Reuters that they were in “no rush” to list on the stock market.

Industry overview

The structure of the luxury fashion retail industry is not going to change significantly, but recent notable mergers & acquisitions have further shaped the industry landscape since certain brands are looking for opportunities to expand. The reasons behind the willingness of luxury fashion houses to expand are attributable to several factors. Firstly, it is important to mention the disruption brought by the e-commerce, which has greatly affected the bottom lines of brick-and-mortar stores. As more and more consumers are buying online, as it is possible to see from the graph below, retail sales have declined. In fact, there has been a noticeable decrease in the number of consumers willing to buy in shopping centers and department stores in North America.

MK 1

Another reason that has created a shift toward mergers and acquisitions is the change in consumer preferences. Until a few years ago, customers gravitated more towards luxury brands that fell in the middle range in terms of price and style, which are also referred to as “middle market luxury brands”. Now, consumers are going toward the opposite ends of the spectrum and seem to be split into two groups, one that is loyal to high-end luxury brands and another that prefers more affordable fashion retailers. Some high-end luxury brands are using M&A to fight changing environmental factors in the industry for years, by merging into “luxury brand super groups” or a “family of brands”. LVMH, one of the largest luxury brand conglomerates in the world, is composed of 70 brands with reach in six different industries, ranging from fashion and leather goods to wines and spirits. Even though consolidation in the luxury retail sector will likely increase, some heritage brands, such as Chanel and Hermès, are resisting the trend of M&A. One reason why heritage luxury brands would resist attempts to be taken over is that these brands have historically been associated with their founding fashion designers. In relation to this deal, Mr. John Idol, Chairman and CEO at Michael Kors, said the Versace brand had been “terribly under-developed” and that Capri would invest in 100 new stores as well as take ownership and invest in its own factory base to control production. Michael Kors is seeking to become a “luxury brand supergroup”, like LVMH and others, and for this reason Versace can take the opportunity of this acquisitions in order to develop synergies with Michael Kors and expand in Europe, Korea and Japan. The latter is a market that represents hundreds of millions of dollars a year in sales for Michael Kors, while Versace brand has not penetrated the market yet.

Deal rationale

Michael Kors has taken an additional step towards becoming a luxury conglomerate with the acquisitions of Jimmy Choo first and then Versace.  This move will make the company compete with the likes of LVMH and Kering.

Michael Kors believes that this transaction represents an opportunity to reach the long-term goal of $8 billion in sales. In addition, the deal diversifies the geographic presence of the group with forecasted sales in Americas representing 57% (from 66%), Europe 23% (from 24%) and Asia 11% (from 19%). Japan, for instance, represents a real opportunity for the group as the CEO of Michael Kors said that Versace’s business was insignificant in that area. Michael Kors has a strong presence in the Americas while Versace next year is expected to generate 46% of sales from Asia. As reported by Erinn E. Murphy, a managing director and senior research analyst at Piper Jaffray covering global fashion and lifestyle brands, there is room to grow in the American market for the Italian fashion brand. Interestingly, Versace generates $58 per follower while Michael Kors a much higher $357 per follower. As part of the $8bn goal the company expects Versace’s sales to climb to $2bn (2.5 times current level), increase the number of stores globally from 200 to 300, focus on online and omnichannel sales, and accessories and footwear to represent 60% of revenues. In terms of the long-term revenue breakdown by brand, Michael Kors would generate c. 62.5% of them, followed by Versace at c.25% and Jimmy Choo at c.12.5%.

Deal Structure

It was reported on the 24th of November 2018 that Michael Kors Holdings may acquire Versace in a deal valued at €2bn, and an official announcement could be made during that week. Just one day after, on the 25th of November, the US luxury group announced that has reached an agreement to acquire Versace at an enterprise value of €1.83bn. Michael Kors has acquired Versace, the luxury fashion designer clothing manufacturer from GiVi Holding SpA, which holds an 80% stake in the target, and The Blackstone Group LP which holds the remaining 20%. The cash for the deal will be financed from the acquirer’s cash resources, existing bank facilities, new bank facilities from J.P. Morgan and Barclays. Michael Kors will also pay €150m in Capri Holdings Ltd shares, which will be the acquirer’s new name upon completion of the acquisition. Based on Michael Kors closing share price of $66.71 on 24th September, it can be calculated that approximately 2,649,378 shares will be sold. Based on the acquirer’s 149,321,694 shares outstanding, the consideration shares represent a stake of 1.774% in Michael Kors. GiVi Holding will retain a minority stake in Versace. The deal is expected to be completed during the 4th quarter of 2018. Upon closing, Michael Kors will start trading under the name Capri Holdings Ltd and it will have a combined annual sales of $6bn. A value that Mr. John Idol hopes to bolster 33% to $8bn across the three brands, according to his recent presentation to investors. Donatella Versace together with her brother Santo and daughter Allegra own 80% of the fashion house, they will retain a €150m equity stake as part of the deal. The remaining 20 percent is owned by the US private equity firm Blackstone that is selling its holding. Mr. Idol did not rule out other acquisitions but he said that there could be a “seamless integration” of Versace, they want to invest a great amount of money into the family-owned ”Milanese” fashion house. In conclusion, this is a crucial deal in the luxury industry and Versace family’s decision to sell follows disposals by other long fiercely guarded independent brands. Donatella Versace pointed out that as shareholders in the newly renamed Capri, the family remains committed to the business also thanks to the structure of the deal where GiVi Holding will retain a minority stake.

Sources:

Second act! Cinven & Bain launched their final tender offer on the remaining listed shares of Stada, a leading German-based drugmaker, finally valuing the business at over €6bn

By Ricardo Mühle, Felix Paul Schäfer and Massimiliano Marchisio

Date October 1st 2018
Type of transaction Public delisting tender offer
Valuation 15-15.5x LTM 2018 June EBITDA of c. €410m
Bidder Cinven-Bain Capital consortium
Target company (sector)

Financials

STADA AG, “STADA” (Medical – Pharmaceuticals)

FY17 Rev. / EBITDA: €2.3bn / €0.4bn (17.4% margin)

Advisors (first bid)
Advisors (second bid)
Evercore, PWP, Deutsche Bank (sell-side)

JP Morgan, Jefferies, Barclays, Rothschild, UBS (buy-side)

JP Morgan (buy-side)

Rationale STADA has a leading position in the pharmaceuticals space with potential for value appreciation via organisational changes, operational efficiencies, M&A build-ups and concentration of product portfolio

August 16th 2017 – Cinven and Bain jointly announced the successful takeover of 63.87% of STADA, initially valuing the German drug maker at €5.3bn, making it the largest buyout in this sector in over four years. One year after, the two PE giants acquired a further 13.5% stake in the company and in October 2018 decided to launch a final public tender offer on Stada’s remaining shares.

HOW IT ALL STARTED? – THE FIRST ACT AND BIDDING WAR

  • May 2016 – the starting points for the STADA acquisition were the “informal” talks between STADA, the London-based private equity firm CVC Capital Partners and the activist investor, Active Ownership Capital.
  • February 2017 – these talks led to the start of a competitive process and two non-binding offers were received from Cinven/Bain and Advent International/Permira.
  • April 2017 – the Cinven-Bain consortium emerged as the winner of the bidding war with an offer worth €66.00 per share (€65.28 +  €0.72 dividends per share). However, by June 2017 the Cinven-Bain offer did not reach the minimum acceptance threshold and eventually expired.  
  • August 2017 – Cinven/Bain reinitiated the voluntary public takeover, increasing the offer price by €0.25 to €66.25, leading to the acquisition of 63.87% of STADA for €5.3bn (2.4x FY17A Revenue, 13.0x FY17A EBITDA).

THE SECOND ACT: SUCCESSFUL BIDS AND DELISTING

The offer on the remaining outstanding shares was an all-cash bid equal to €81.83 per STADA share, representing a premium of approximately 24% on the offer price per STADA share during the successful takeover offer in 2017 and a premium of 0.3% over STADA closing share price of €81.12, one day prior to announcement (28 September 2018). Simultaneously, Elliott Management, the famous activist hedge fund, agreed to sell its stake in the company. The combined offers value the entire business between €6-6.5bn (15-15.5x June 2018 LTM EBITDA).

DEAL RATIONALE

Private equity firms are typically not interested in participating in a firm’s administration for a very long time. However, this won’t be a touch-and-go operation.

Both PE firms have a consistent track record of growing companies through their global networks, having successfully invested in businesses for over 30 years and have expanded many of these through buy-and-build strategies.

Mr. Weidenfels – STADA’s CEO – in June 2016, outlined two key objectives for the company: “commit to a more focused strategy of concentrating the product portfolio on performing branded and generic drugs with clear growth potential. He also underlined the importance of focusing on costs reduction, particularly with regards to COGS, as well as simplifying group and operating structures”.

A private equity ownership could now accelerate the reaching of those goals. Moreover, Bain and Cinven share the strategic objective to strengthen STADA’s position as a global healthcare company and could support investments in new products, organic expansion and, more likely, accelerating its growth through bolt-on acquisitions.

What’s certain, is that the implementation of their strategy will take time, efforts and additional capital to realize STADA’s full potential. But, if the business model works, volume growth and consequent economies of scale would reward both the company and its investors.

ESCP PE – TEAM VIEW:

The STADA deal is very attractive due to its “uniqueness”. Private equity firms tend to be reluctant to invest in pure drug makers pharmaceutical companies due to the very high structural valuation of the sector and extremely strong competition potentially arising from strategic buyers. This successful story on the one hand is a clear indicator of the increasing attractiveness for drug makers (stable and recurring cash flows; favourable industry trends; multiple areas to create value and high margins), while on the other hand, is an indicator for the massive amount of dry powder private equity firms hold in their pockets (see graph 2) and lack of outstanding assets available on the market. The tender offer made by the Cinven and Bain a year after the acquisition of 63.87% is a logical step, needed to take the company private and becoming the sole shareholder. Being the sole majority shareholder was a necessary step for Cinven and Bain to have full control over the business, exploit operational efficiencies and implement the proposed growth plan to be able to generate an attractive return for its LPs.

An obvious risk in the STADA buyout is the high price Cinven and Bain decided to pay (around 15x based on LTM 2018 June EBITDA of c. €410m), which could potentially lower returns at exit, especially in a downturn macroeconomic scenario. However, with multiples continuing to rise and the opportunity for STADA to strengthen its position as a global player (STADA is expected to grow organically but also through acquiring complementing businesses) the deal seems promising. For comparative purposes, larger generics listed companies like Teva, Mylan and Aspen Pharmaceuticals are trading at multiples around 9x-10x EBITDA, and, earlier this year, Zentiva was acquired by Advent at 12-12.5x.

Img1_Stada

Graph 1: Healthcare & Pharmaceuticals – Trading multiples over the last 12 quarters (Source: PWC eValuation 2018).

Img2_Stada.png

Graph 2: Increase of Dry power of GPs (Source: McKinsey Global Private Markets Review (2018). The rise and rise of private markets.

About STADA Arzneimittel AG is a Germany-based pharmaceutical company engaged in development and commercialization generic and branded of pharmaceutical products. Its best-selling products are generic Viagra and Grippostad C.

About Cinven Partners LLP, founded 1988, is a London-based private equity firm focused on building European and global companies. Its funds invest in six key sectors: Healthcare, Business Services, Consumer, Financial Services, Industrials, and Technology, Media and Telecommunications (TMT). Today, Cinven has over €15.0bn in AuM.

About Bain Capital Private Equity, LP, founded 1984, is a leading international private equity and alternative investment firm, investing across asset classes including credit, private equity, public equity, venture capital and real estate. Its funds invest in industries including healthcare, consumer, financial & business services, industrials and technology. Today, Bain Capital has over €91.0bn in AuM.

SOURCES

Our view on 2019

What’s up buddy?

At the beginning of 2018, the VIX, an instrument which tracks the volatility of the S&P500, surged dramatically showing a comeback of fear among investors (Figure 1) following a period of extreme calm started after the financial crisis.

Figure 1: Higher VIX since February 2018

Figure 1

Source: Bloomberg

February’s spike in volatility led to further speculations about a coming correction or bear market as the end of the bull market started in 2009. Through 2018, we saw an increasing number of headlines on the coming bear market but, on the contrary, the main US equity indices kept reaching new highs without giving any signal of a downturn. However, during the week starting on October 8, the main US equity indices fell raising concerns about the beginning of a correction. On October 10, the S&P 500 swept 4% from its all-time high with the 60% of the stocks composing the index down >10% from the 52-week high, therefore in correction’s territory. Over 130 components fell at least 20%, level at which a bear market is recognised. Why did that happen?

We believe that the main drivers of the market downturn were:

  • The tightening monetary policy in the US and expectations on the ECB’s interest rates hikes starting from mid-2019;
  • Rise in fixed income products’ yield shifting capital allocation from stocks to less-risky assets (e.g. bonds);
  • Slowing inflation around the globe giving signal of a slowdown of the global economy;
  • Emerging markets’ downturn due to political instability (e.g. Venezuela) and higher oil price (e.g. India);
  • A stronger dollar causing weaker currencies around the world, especially in emerging markets;
  • Concerns over the trade war between USA and China and other political crises fuelling uncertainty in financial markets (e.g. Italy, Venezuela, Turkey, Iran);
  • Higher oil price increasing companies’ expenditures hence lowering margins;

On top of these drivers, on October 9, the IMF lowered its guidance on 2018 global economy growth to 3.7%, down 0.2% from April estimates. We believe that the combination of these factors together with the negative sentiment fuelled by the newsflow, triggered last week investors’ sell-off which led the main US indices down, as observable in Figure 2.

Figure 2: S&P 500 (white), NASDAQ 100 (green) and Dow Jones (orange) LTM %change

Figure 2

Source : Bloomberg

So, given the current situation, what should you expect for 2019?

Main topics

We believe that 2019 will be a turning-point year for investors with the main focus being on the following topics:

  1. Monetary policy
  2. Inflation
  3. Trade war
  4. Oil price

Monetary policy

After the beginning of the latest financial crisis, central banks pumped liquidity into financial markets and lowered interest rates in order to sustain the real economy suffering from a troubled financial system. The Asset Purchase Program (APP), also known as Quantitative Easing, was first started by the Federal Reserve (FED) in November 2008 and officially ended in January 2014. However, the FED waited until the end of 2015 to hike interest rates when it brought the US FED Funds Rate from the historical low of 0.25% to 0.50%. In September 2018, Jerome Powell announced the third interest hike in 2018 bringing the US central bank’s benchmark rate to the range of 2.00-2.25% (Figure 3).

Figure 3: Increasing US Funds Rate starting from the end of 2015

Figure 3

Source : Federal Reserve

The comeback of higher interest rates was triggered by the concerns around rising inflation and a potential overheating of the American economy. However, apart from making financing more expensive, the tightening monetary policy impacted the bond market, particularly increasing the 2-year US treasury bill’s yield to 2.85% from the 1.92% at the beginning of 2018 (Figure 4).

 Figure 4: 2-year US yield curve rose 48% YTD

Figure 4

Source : Bloomberg

As a rule of thumb, when the yield of government bonds surges, more risk-adverse investors shift their money from stocks to bonds as they can earn a decent return carrying the risk-free US Treasury bill. This shift of capitals from shares to fixed-income products generated a selling pressure on the stock market contributing to the above-shown downturn of the main US equity indices (S&P500, Dow Jones, NASDAQ). Looking ahead, we see the shift in capital allocation likely to continue as bonds’ yields increase due to the execution of the planned interest rates hikes announced by the FED. We see Powell’s schedule to be respected with 1 more hike in 2018, 2 in 2019 and 1 in 2020, leading the US FED Funds Rate to a potential 3.00-3.25% interest rate by the end of 2020 vs 40-year average of 5.72%. On top of that, the European Central Bank (ECB) announced the end of its APP to come in by the end of 2018 and consensus expects a first interest rates hike coming in in the second half of 2019. Albeit the political tension coming from Italy, we are aligned with consensus and believe that the ECB is set to hike the current -0.25% reference rate starting from mid-2019. An increase in European interest rates is likely to fuel the shift effect, leading to further sell-offs in the European stock market.

Inflation

US economy seems to be on the verge of the cool-off. Annual inflation showed a slowdown to 2.3% in September 2018, down from the 2.7% in August (Figure 5) and a miss vs expectations at 2.4%. It is the lowest rate since February and likely to be attributable to a sharp slowdown in gas prices. Since 1914, inflation averaged 3.27% reaching the high of 23.70% in June 1920 and the low of -15.80% in the same period one year later.

Figure 5: US inflation rate evolution since the beginning of 2018

Figure 5

Source : US Bureau of Labor Statistics

On October 15, US Commerce Department released data on US retail sales showing almost-flat growth with motor vehicle spending being offset by the biggest drop in spending at restaurants and bars in nearly two years. Retail sales rose 0.1% mom, 0.5% below expectations but up 4.7% yoy. Consumer spending accounts for more than two thirds of US economic activity. Despite historical low unemployment rate at 3.7% in September 2018 and 3Q18 expected 3.5% annualized growth in consumer spending, we see a slowdown in US macroeconomic data in 2019 and 3Q18 US GDP growth around 3.00%, down 1.2% from 2Q18. Adding to this, we see Trump’s rhetoric against the FED supported by investors’ that are losing confidence in Jerome Powell. JP Morgan recently published a report showing that the market reacted negatively to all the speeches given by Powell since the beginning of his mandate, quantifying the effect of his words in a US$1.5tn wiping away effect. This shows that investors are concerned about the speed at which the FED is executing its hiking plan as the expectations on US inflation are slowing down (Figure 6) putting investors on a wake-up call.

Figure 6: US annual inflation rate down in 2019-23E

Figure 6

Source : Statista.com

Trade War

On July 6 of this year, the US imposed 25% tariffs on US$34bn of imported Chinese goods in the beginning of what escalated to a proper trade war between China and US. On September 24, Trump’s administration imposed 10% more tariffs on US$200bn Chinese goods and China retaliated on US$60bn of US goods.

In this scenario, investors were scared of the potential effects that the neo-protectionist policies might have on their portfolio. In order to get a sense of how the trade war impacts companies, we looked at the luxury goods industry. Chinese authorities are implementing strict controls on travellers with the objective to look after imports over the duty-free allowance of CNY 5,000  (US$730). Chinese customers represent c.40% of the revenues for brands such as Louis Vuitton (LVMH) and Gucci (KERING) and a drop in purchases from Chinese customers would have a significant negative impact on the top-line of luxury brands. No wonder why on October 10, LVMH plunged 7.14% despite the company published strong results. We believe that investors reacted to the sentence of the head of Investors Relations at LVMH, Chris Holly, stating that the company is “subject to important risks and uncertainties that could cause actual results to differ materially” from previous forecasts. The entire luxury goods industry lost ground since the beginning of October, showing a more marked drop than other industries (Figure 7).

Figure 7: MSCI luxury good index (orange) down more than MSCI Technology (white) and MSCI Emerging Market (blue) since the beginning of October.

Figure 7

Source : Bloomberg

The example of the luxury industry gives a general understanding on how the trade war is already impacting equities and gives also a taste of the potential consequences that further escalations might have on the global stock market. We see the tensions between China and US to continue through 2019 leading to more industries being negatively impacted and a downward pressure on the global equity market.

Oil price

In October 2018, Brent oil – the main benchmark for oil price – was up 50% from the same period last year, reaching US$85.16 per barrel on October 9.

Figure 8: Brent spot price rose 50% since October 2017

Figure 8

Source : YCharts

The spike in oil price was mainly driven by the sanction imposed by the US government on Iran that lowered the OPEC’s member oil production to 3.4mbd (million barrels per day), down c.400,000 bpd from August 2018. Oil price is very sensitive to changes in supply/demand shifts and such a drop in supply makes oil scarcer hence increasing its value, therefore price, in the market. Higher oil price means rising energy costs for companies which will have to deal with increasing expenditures to keep the business going. This puts companies’ margins under pressure and translates into lower expected earnings per share (EPS). Therefore, investors see their expectations on dividends per share – computed as portion of EPS – decreasing and the equities’ bottom line shrinking. We see the oil price continue to rise in 4Q18 on the widening of supply/demand gap due to the uncertainty coming from Saudi capacity to cover the Iranian production wiped away by US sanction.  Also, we think it is worth to keep an eye on the development of the latest scandal on the US-based journalist disappeared in the Saudi consulate in Turkey since potential sanctions on Saudi Arabia from western countries would put further upward pressure on the oil price.

Food for thought

The last two weeks were characterized by the sell-off, but also by the US investment banks’ 3Q earnings releases. In the 3rd quarter of 2018, US banking sector’s results were overall positive with an improvement of the Net Interest Margin (NIM) – difference between interest income and interest expenses – thanks to the rising interest rates environment in the US. However, the IB – Global Markets divisions did not show much improvement. Indeed, results from the Sales & Trading departments of the biggest US investment banks (e.g. JP Morgan, Goldman Sachs and Morgan Stanley) delivered an overall performance below expectations. Therefore, one might draw the conclusion that investors are not exchanging their stocks for other financial products at higher frequency than last year, otherwise the level of fees should have been higher. Indeed, it seems that investors are selling their holdings without replacing those with other financial products, lowering the trade volumes hence commissions for the IB trading floors. From this perspective, one might argue that investors are taking out money from the market and building their cash piles in order to prepare for the worst-case scenario. As a corroborating factor of this thesis, BlackRock, the world biggest asset manager, had inflows below expectations in the last quarter showing a lowering investors’ appetite to put money in financial markets rather than under their mattress.

We believe that financial markets are impacted by a collection of reasons which go beyond the “Main topics” illustrated in this report. We are convinced that psychological, irrational and behavioral variables drive the market on daily basis together with financial, rational and economic factors. Therefore, we urge the reader to explore as many alternative explanations as possible when looking for reasons to justify markets’ moves.

Authors: Alessandro Sicilia, Lorenzo Bracco

The website and the information contained herein is not intended to be a source of advice or credit analysis with respect to the material presented, and the information and/or documents contained in this website do not constitute investment advice.

 

 

The Retaliation of Tech

Long we have been used to tech stocks trading at price multiples (price/earnings) at more than the industry standard has been comfortable with for decades. Benjamin Graham’s ideal PE is between 10 and 15 dollars. The Dow Industrial is trading at 25 PE, the S&P 500 is trading at 25 PE. If you thought that the Dow and the S&P 500 are overvalued by Graham’s standards, here’s a look at the tech industry valuations. Amazons PE is trading at 316, Netflix is trading at 206 PE, Dropbox has a negative PE. However, what was evident this past two weeks is that these tech stocks are more correlated than initially thought. When one tech stock sneezes, the entire market catches a cold.

Facebook has fallen 14% since 16 March when the news of privacy breach by Cambridge Analytica has spread. This caused Apple to fall more than 5%, Alphabet and Amazon have fallen more than 8%, and last but not least Twitter fell more than 19%.

However, one knows that a cold eventually ends, and with these company’s being sugar-coated with net margins of more than 20%, and growth potential, innovation and barriers to entry, it is important to keep watch for those companies. They are more likely than not that they are trading at a discount. Most of these tech companies have very strong balance sheets. This means they are relatively low leveraged. A hawkish fed of increasing interest rates has lesser of an effect on their valuation extended to the end of 2018.

However, as a kid knows exactly when to catch an ice cream truck, a good trader knows when to enter a stock. Technical analysis 101 serves a good purpose. Many mistakes made by students these days are getting excited very fast, being scared to fast, and not admitting one’s own mistake like a toddler refusing to get out of a car.

As long as markets are trading above 50-day moving average, the trader should be thinking “buy the dip”, many do the mistake of directly entering the trade once the stock price has fallen, however the truth is to better forgo some profit for a safety margin to allow one’s self to be confident that the stock is actually reverting. The 100-day moving average, this line provides the support between the 50 days and 200 days. If it does not hold support, there is a high probability that the 200-day moving average is the next stop, this is the deeper pullback in bull markets. 200-day moving average, this is an indicator telling you which side a trader should be one, either a bull or a bear market.

It is important to know that moving averages are not the Holy Grail of trading they are tools to help the trader capture a trend in their own time frame.

The point is will tech stocks retaliate and gain back valuation and return to their highs? Or will they descend even further? Either way, liquidate and hold 100% cash and wait and watch for those moving averages, because at this level they have attractive risk/reward ratio.

 

Author:

Bassem Mneimne

2018 EU-US Outlook: Where do we come from? What are we? Where are we going?

As the first quarter of the year is headed to the end and new challenges lay ahead for international financial markets, frame the actual situation is necessary to adapt to future changes.

2017 has been a record year both in terms of returns and volatility. Looking at historic data, seems obvious the past year represents an outstanding exception, may have the markets gone too exuberant? Economic and business data do not suggest so, with results exceeding expectations consistently.

 

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European Union: Renaissance

The year that just ended has proven the comeback of growth in the economies in Europe. The expansion in GDP and the steady decline in unemployment from the record level of 2011 has spread to Mediterranean countries and gathers speed. France, Spain and Italy have inverted their road joining Germany and northern countries in what can be compared to a renaissance of European Economy.

 

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As over 62% of EU countries’ total trade is done with other EU countries, the interdependency across EU economies has risen to levels which make necessary a harmonized growth to attain lasting results. Moreover, the strong reliance on exports, as testified by the fall in imports between 2012 and 2016 while exports grew in that period, has proven to be beneficial given the harmonized global growth. The EU accounts for 15% of global imports and exports approximately, making it the second world player and a necessary participant to global expansion. Which comes first, global growth or European expansion? The answer is irrelevant, as they influence and reinforce each other in a benign loop. The high levels of unemployment from which Europe started the recovery in 2012 leave space for further expansion, accompanied by low inflation rates which are consistent with an early stage recovery.

 

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Fiscal and monetary policies do not represent a threat, at least now. Governments around Europe share similar electoral programmes centred on the reduction of fiscal pressure and the enhancement of investments. The policy makers at ECB do not want to break the toy by acting too fast deleveraging their balance sheet, but the market is anticipating the end of QE and the beginning of the tightening cycle by end of 2018, beginning of 2019. Low interest rates are here to stay as Mario Draghi said, so the extremely favourable economic environment is going to support Equities through the year. The effects of improved stability can be seen inside Europe, with outstanding levels of consumer and business confidence, and outside Europe, with the Euro-Dollar Exchange Rate moving consistently with the strengthening of European Economies. The strengthening cycle of Euro started in 2017 will continue with the economic recovery, until Euro strength weights too much on exports. At least in the foreseeable future, this is not the case.

 

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Attractive valuations in European Equity offer long term opportunity for investors looking to take advantage of the economic environment. On the other hand, the extreme intervention of ECB in the Bond Market has created distortions in prices with risks skewed to the downside. This means that investors will be exposed to volatility, both in Equity and Debt Markets, once the normalization of interest rates begins in the following years.

 

United Kingdom: Uncertainty

A big question mark is represented by the United Kingdom: after the Brexit the outlook for UK economy has darkened leaving big gaps of uncertainty. Those gaps will be filled only after the conclusion of the negotiations with EU representatives with the deadline to negotiations fixed in October 2018. The IMF has already cut economic growth forecast for UK, expecting 2018 growth of 1.6%, down from previously forecasted 1.7%, followed by a further slowdown next year to 1.5%. The effects of uncertainty cited by Christine Lagarde, IMF Chief, are the delay in investments and the loss in spending power, caused by rising inflation, falling pound and stagnant wages.

 

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As a result, the UK will live the global expansion only vicariously losing relative strength and power in respect to other countries which offer better opportunities. On the other hand, the UK government will have to counterbalance the possible losses in the financial industry, approximately high net worth 100.000 jobs in the City with cascade effects on housing market, leisure industry and most importantly on tax revenue. The possibilities of actions range from a tax cut to a more generic business friendly environment, with Equities resulting as the most beneficiaries of the situation. Government bonds on the other hand are not as attractive, given the deficit that the UK government will incur to support fiscal policies. The uncertainty already weighting on the Pound will continue until businesses will have clear investment plans to adapt to the changing environment and markets will have enough information to take positions.

 

United States: Goldilocks

The expansionary cycle started in the US after the Great Financial Crisis does not seem to have stopped, as testified by the healthy 2.3% annual GDP growth for 2017, the steady decline in unemployment rate to 4.1% and the inflation rate of 2.1%.

 

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These are numbers of a country which have abandoned early stages of recovery and has entered the late stage cycle of economic expansion. In this environment fiscal and monetary policies diverge. The Federal Reserve has started the unwind of monetary policies in Q4 2017, by deleveraging the balance sheet from the record level of $4.5 trillion at a rate of $50 billion per month targeting a drop below $3 trillion by 2020. Moreover, the FED plans three rate hikes for 2018 as the normalization process continues, but the threat of inflation picking up at wages level is creating questions whether the FED is already behind the curve. Given the 2% inflation rate target, the FED may be forced to accelerate the hikes before expected from the market, causing turbulence to the new chair Jerome Powell.

 

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In this context, the Tax Plan approved at the beginning of the year by the Congress represents the fiscal lever to counterbalance the monetary contraction. Cutting the corporate tax rate to 15%, President Trump aims to stimulate the economy enhancing job creation, wage growth and investments. The slash of the repatriation tax rate on corporate cash held overseas, from 35% to 10%, is the second major incentive for investments in the country. With $2.5 trillion in cash held by US-owned corporations overseas, it is rational to expect a big portion of it to be reinvested in the US in the form of dividends, buybacks and M&A operations. As the economy is moving closer to full employment, the benefits of fiscal stimulus will likely be constrained because the economy is already operating at near full capacity. Nevertheless, GDP growth is expected to reach 2.5 percent in 2018 and then to moderate to an average of 2.1 percent in 2019-20. US listed companies will see the benefits of the Tax Plan on their balance sheets starting from 2018. According to the most recent estimates by UBS analysts, S&P500 companies will post an increase in earnings of 18% for 2018: nearly half of it, 8.5%, will come from pretax income growth, while the tax cuts for corporations, M&A and buybacks will provide a 9.7% growth.

How much of this positive outlook is already priced in by the market? The S&P500 delivered a 21.7% return in 2017, with no negative months across the year and extremely low levels of volatility, while the first quarter of 2018 has been characterized by spikes in volatility and dispersed returns.

 

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Valuations look stretched here: the Price to Earnings Ratio is above 25 and the Cyclically Adjusted Price Earnings, which takes into account the adjustment for the average inflation from the previous 10 years, is around 32. This does not mean that the market is going to crash, but that returns in the future are expected to be lower as the market is already pricing them in the valuations. The US market has historically been more expensive than the global markets, as it offers both the biggest companies and the highest diversification by sectors. Moreover, the US are the first global superpower by GDP, GDP per capita and international influence, which means that they will always attract more investments and will sell at a higher premium than other countries.

 

Two major factors to further consider are the Dollar and the Government Bond yield. The 10 Year Bond yield is approaching 2.9%, the first time since 2014, as the market is pricing in the widening budget deficit coming from the Tax Reform and the $1.5 trillion spending of the Infrastructure Plan proposed by Trump in February 2018. The Yield curve, represented by the difference between 10Y and 2Y yields, is downward sloping and consistent with late stage cycle expansion, the Goldilocks period before the end of the expansionary cycle.

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The last factor to take into account is the Dollar. Uncle Ben’s currency has started a weakening cycle from the highs of 2017, providing support both to overseas earnings of US stocks and to the FED in reaching the inflation target. As the global economy strengthens, risk-off currencies like the Dollar and the Yen should weaken as capitals flow to riskier countries which provide higher returns.

 

 

 

Author:

Mario Stopponi

The return of megadeals: Blackstone buys Thomson Reuters’ data unit for $17bn

On 30.01.2018, Blackstone announced to buy a majority stake in the data business of Thomson Reuters, the world’s second largest financial information provider. It’s the private equity group’s biggest purchase since the financial crisis, pitting the firepower and network of Stephen Schwarzman, who oversees $387bn in Blackstone funds, against fellow billionaire and former New York mayor Michael Bloomberg, who dominates Wall Street’s financial information industry.

 

When Blackstone announced to buy a majority stake in Thomson Reuters’ data unit, there was a lot of excitement among investors, pushing Thomson Reuters’s share price to new highs at announcement date. The $17.3bn transaction is Blackstone’s largest deal by enterprise value since the firm’s $26bn buyout of Hilton Worldwide Holdings Inc, in 2007. Under the terms of the deal, Blackstone will acquire a 55% majority stake in Thomson Reuters’ financial and risk division, which will then be carved out into a new company, with Thomson Reuters owning the remainder. CPPIB(1) and GIC(2), will co-invest alongside Blackstone. According to the Financial Times, the deal will not include Thomson Reuters’ newsgathering operation or its businesses serving the legal, tax and accounting communities.

 

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The deal volume of $17bn consists of a $3bn equity investment from the Blackstone-led group and $14bn in debt and preferred equity. Bank of America Merrill Lynch, Citigroup and JPMorgan Chase will provide debt financing for the deal, most likely including leveraged loans and high-yield bonds. Canson Capital Partners, Bank of America, Citigroup and JPMorgan were financial advisers to the Blackstone-led consortium, whereas Guggenheim Securities, TD Securities and Centerview Partners advised the sell-side.

The deal will make the Blackstone-led entity the major competitor of the financial information industries’ global market leader, Bloomberg. Blackstone sees attractive growth in the Thomson Reuters unit’s data feed, its foreign exchange and treasury trading platforms, as well as its risk and compliance business, according to industry experts. In addition, the division would also be able to improve operations more quickly than a private company, highly critical in a turn-around.

The market for financial data and information is only weakly fragmented with Bloomberg and Thomson Reuters accounting for c. 56% of total revenues in 2016. In 2017, global spending on information/analysis increased by 3.6% to $28.5bn, for the largest YoY growth since 2011. When looking at the historic development of the market, Thomson Reuters has been the leading player ahead of Bloomberg until 2011 with regards to market share. Since then, Bloomberg has largely evolved as the dominant player in the financial information market and successfully defended its strong position. However, with increasing competition from new players such as Goldman Sachs-backed company Symphony, the market could undertake a major re-organization and threaten Bloomberg’s dominant position, which offers significant growth opportunities for the new company.

The market reacted with a 9.5% increase in Thomson Reuters’ stock price, immediately after the acquisition plans were published, whereas the share price of Blackstone fell by 2% due to increased uncertainty among investors. A carve-out by a private equity firm could lead to a turnaround that Thomson would have struggled to achieve on its own ague analysts in favor of the deal. However, there are also concerns with regard to the feasibility of the turnaround. According to Bloomberg, there is a plateau problem regarding the earnings of the unit. To achieve private equity-style returns, Blackstone will need to boost the unit’s average earnings, which are flat around $1.6bn since 2012, a task that has proved difficult for Thomson Reuters in the past. Finally, the question remains whether a deal of this size is an outlier, or the start of a new wave of megadeals in the private equity industry to deploy record sums of dry powder. “There is undoubtedly a lot of dry powder in the market at the moment,” said Andrew Adams, chief executive officer at Quayle Munro, a U.K.-based M&A advisory firm.

 

Thomson Reuters Corporation is a Canadian media and information firm with revenues of c. $11bn in 2016. As of 2018, they employ around 45,000 people across the four divisions, financial & risk, Reuters news, legal and tax & accounting. In 2018, the financial & risk division accounted for over half of the company’s revenue.

The Blackstone Group L.P. is an American multinational private equity, alternative asset management and financial services firm based in New York City. As the largest alternative investment firm in the world. Blackstone specializes in private equity, credit and hedge fund investment strategies. As of December 31, 2017, Blackstone had $434bn in assets under management.

 

Sources:

For Illustration 1: Thompson Reuters Revenue by Segment. Retrieved from: The Wallstreet Journal (2018): https://www.wsj.com/articles/thomson-reuters-chairman-criticized-its-17-billion-deal-with-blackstone-1518692400

Spotify goes public, not through an IPO

Spotify will go public before the end of the first half of 2018 and has already filed confidentially with U.S. regulators for an initial public offering. Morgan Stanley, Goldman Sachs and Allen & Co to advise on the listing, acting as commission brokers that will only help selling the shares.

Spotify, the privately held Swedish music company, last valued at $20 billion,  will not be selling its shares and raise any capital through a standard IPO process but it will be the first large company to go public via an unusual direct listing on the NYSE.

Spotify is the biggest global music streaming service with 70 million paying subscribers as of January 2018 (compared with Apple Music’s 30 million), over 140 million active users worldwide and 30 million songs available to stream straight from the internet.

While Spotify’s losses are mounting – the company experienced net losses over the last 5 years and saw losses more than double in 2016 to 556.7 million euros – its revenues increased by 52.1 percent in 2016 and by 39% in 2017.

One of the reasons behind this unusual choice might be found in that the company had raised $1bn (£740m) in a debt deal with private equity companies in 2016. The deal provided that the debt interest rate would increase by 1% every half of a year until the company went public.

Moreover, Spotify’s listing would benefit not only its CEO Daniel Ek who controls 25% of the company and Martin Lorentzon, co-founder and director and former chairman, owning 13% of the company, but also Sony Music Entertainment International, Technology Crossover Ventures, Investor Tiger Global and Tencent which are the major investors of Spotify.

Company founders will retain control of the company by holding onto a separate class of shares, so-called dual-class, with enhanced voting power. The “dual-share” structure, employed previously also by Facebook and Alphabet, is not the only feature that sets this listing apart.

 

What is unusual about this

First, when a company decides to go public it does so by issuing new shares and increasing capital. However, Spotify decided not to go for the traditional route and thanks to the direct listing the private company will sell their shares on the market by bypassing the underwriting process by directly selling shares to investors at a price determined by the company without any help from investment banks.

Second, direct listings have occurred mostly in biotech and life sciences and have been limited to small-cap companies, Ovascience (market cap: $55 million) and BioLine Rx (market cap: $83 million) being two examples.

Third, when a company decides to go public it needs to register with exchanges, which are usually NASDAQ and the OTC market.  However, Spotify has asked NYSE to change rules, and for the first time it will go public via a direct listing on the NYSE.

 

The Process

The process for going public is very similar to the IPO. In fact, the business presentation, due diligence, prospectus preparation, and forms required are the same as for an IPO but with an exception. What is different is that a direct listing does not require the 2 week roadshow.

You will ask, is a roadshow really needed? Usually it is carried out in order to setting up meetings and interviews, so that the investment bank will increase demand. However, being Spotify a large company, with an established brand and a knowledgeable customer base, a roadshow is not really needed.

Direct listings can be compared to the opening of a shop and hoping people will just drop by. The store is open, but you do not have anyone marketing or setting up meetings.” says Kathleen Smith. Private shares will become legally tradable and therefore whoever owns Spotify stock will have the chance to offer it on the public market and slowly Spotify’s stock will begin trading like any stock.

However, since there will be no agreed ‘starting’ price it is unclear what will happen at  start of trading if the demand will be higher than the supply, hence we could see huge volatility (more than in an underwritten IPO) of Spotify’s share price.

 

Advantages of a direct listing

A direct listing will leave less money on the table as people will not sell their shares at a lower price. Moreover, since no new share will be issued there will be no dilution for existing shareholders.

In addition, investors can sell their shares more quickly as there is no lock-up period that prevents insiders from selling shares in the months following a listing. Finally, a direct listing requires no underwriters and  therefore is cheaper because of no fees.

To sum up, in three words,  direct listing is faster, easier, cheaper.

 

However, there are some disadvantages

Since there is theoretically no need for an investment bank, the company will not benefit from a professional support from investment banks (especially in terms of demand generation and liquidity support). Moreover, it will not have buffers against volatility (especially on the first day where volatility is usually high), and will not take advantage of presentation support from advisors (important for small to medium companies). In addition, its price will purely be determined by demand and supply and Spotify will not have any control over it.

Lastly, the company will be less likely to have long term investors, usually gained during the roadshow process.

 

Conclusion

Spotify’s unusual way of going public could change not only the way that large technology companies go public in the future especially those who do not need capital and would like to go public like Uber and Airbnb but could also impact investment banks’ business model as they would not be able to collect many underwriting fees. However, if Spotify, falls below the valued amount, it would probably not like a successful roadmap to follow.

Are We on the Verge of a Trade War?

Many of us have been asking ourselves this question after President Trump announced his intention to impose 25% and 10% tariffs on steel and aluminium imports, respectively. Trump’s announcement might be challenging the GATT (General Agreement on Tariffs and Trade) which despite evolving throughout time, have remained the WTO’s foundation since its establishment after World War II.

Globalisation has triggered global economic expansion and development, leading to substantial real income growth. However, developed countries’ middle class has not experienced such an increase on their real income. A decrease in their purchasing power has lead them to blame globalisation and free trade agreements for this.

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This sentiment has triggered an increase in protectionism, being Brexit and Trump’s election two illustrations of this anti-globalisation movement. Trump’s potential tariff imposition is therefore another protectionist measure founding his campaign’s slogan: “Make America great again”. Previous protectionist tariffs, such as those imposed by George W. Bush in 2002, resulted in a loss of 200,000 jobs. Will it be any different this time?

Despite affecting other countries, such as Canada or Mexico, in a more devastating way, when Trump talks trade, he talks China. Decreasing China’s record high trade surplus with the US is one of Trump’s main targets, which he has emphasized throughout his mandate.

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China, the EU and other countries have expressed their concern regarding steel and aluminium tariffs and have threatened to apply several countermeasures.

CHINA– China is one of the leading US export car markets as well as being one of the top tourist and technology-purchasing markets. Additionally, China holds over $1tn of US debt. Some likely countermeasures could be industry-specific, such as restricting automobile, semiconductor or agricultural imports from the US. Examples of firm-specific measures include restricting iPhone sales or substituting Boeing for Airbus aircrafts. Other counteractions might include discouraging travel to the US (more than 100 million Chinese people travel around the world every year) or limiting the number of Chinese students in the US. The Chinese Government, however, remains cautious in attempt to restrain a potential trade war.

CANADA– Canada would probably be Trump’s most sound victim if these tariffs are actually applied. Prime Minister Justin Trudeau classified them as “absolutely unacceptable” and expressed Canada’s intention to respond to them by targeting two symbolically-valuable industries: manufacturing and agriculture. Trump, however, announced that Canada and Mexico could be exempted from these tariffs if NAFTA were to be renegotiated.

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EU– The European Commission president, Jean-Claude Juncker announced that the EU’s will engage in a collective response with other countries affected by these measures. Additionally, Juncker expressed EU’s intention to prepare a list of potential retaliation tariffs which would most likely add up to almost $3 billion. These tariffs would target a list of products including clothing, cosmetics, motorbikes, boats, agricultural products and industrial products.

UK– Despite being the US one of the UK’s most important trade partners and even though a possible US-UK post-Brexit free trade deal had been rumoured, Theresa May has expressed her “deep concerns” regarding new tariffs and confirmed that “while the UK remains part of the European Union, any action would come as part of an EU-wide response.” [1]

According to the WTO, Mexico, Japan, Australia, India and South Korea are also “very concerned” with Trump’s potential tariffs and have announced their intentions to apply countermeasures.

 

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Despite easing trade war likelihood, the application of such tariffs would have a remarkable global impact if it escalated to a trade war. Some possible long-term consequences would include:

  • Global economic expansion slowdown triggered by decrease in global output
  • Gross job loss
  • Worldwide inflation driven by increase in product prices because of tariffs
  • Equity market sell-off driven by lower corporate earnings expectations
  • Decrease in risk appetite, increased demand for safe havens
  • FX fluctuations
  • US Tech sector decline

 

CONCLUSION –Imposing these tariffs on aluminium and steel may seem insignificant at first, however, this would most likely result in a series of retaliatory measures which would in the end lead to a trade war. “Protecting” these metals, mostly input goods, would have a negative impact on other aluminium and steel-consuming industries. Assuming no retaliatory measures are applied, negative consequences would still escalate to other countries, in a world where globalised supply-chain dependency is a reality. For a country that accounts for 13.9% of the world’s imports and 9.1% of the world’s exports a trade war definitely does not sound like the best solution.

 

Author

Carmen Álvarez Álvarez

 

Sources

Mifid II: what about the markets?

3rd of January 2018, while the markets started well their year and were keeping a bullish direction before the recent increase in volatility, something else started. Yes, it’s the new European Union Markets in Financial Instruments Directive known also as MiFID II.

Most people talked a lot about it during the last quarter of 2017 and were trying to understand the possible opportunities and threatens related to this topic. But first, let’s see what it is about.

 

The Directive

The aim of this big EU directive (more than 7000 pages) is to protect investors and make sure they receive “fair” deals when dealing with Fund and Asset Managers and so try to make Financial Institutions more transparent. This happens thanks to reports filled within 15 minutes from the transaction so that the regulators can spot abuses in all existing asset classes (Bonds, Stocks and Derivatives) and consequently become more diligent.

A major related change is for Bonds and Derivatives as they will not be any more phones involved in those processes, but everything will be done electronically. In this way, the EU wants to push back a lot of trades to public exchanges so that they can be monitored.

On the Equity side, EU was pushing for stricter limits regarding dark trading but at the last minute it was set back, probably to broaden this aspect, making still possible to trade more than 600 stocks on dark pools. The dark pools are basically private exchanges or forums for trading securities not accessible by the investing public. In those exchanges there is no transparency at all and are mainly used by institutional investors who do not wish to impact the markets. This is confirmed by Trista Keller’s (Bloomberg) statement which says: “For a lot of people MiFID II has still not happened, at list on the equity market”.

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With this little, simple and effective table published by Bloomberg, we can have an overview of the rules that the European regulator introduced and the result that should therefore arise.

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The implications

Let’s now look at the implications of this directive. First, different studies showed a decrease for Research inside banks, both in budgets and in people. Therefore, many professionals of the sector decided to leave earlier to create their own firm. This because an increasingly large number of leading asset managers already announced they will internalise the cost of research in their P&L instead of charging it separately to investors via Research Payment Accounts which are accounts exclusively created for the clients to put funds in to pay for research and directly managed by the financial institutions and banks. A McKinsey report estimated a 10-30% reduction in buy side’s external payment for research over the next three years and a S&P survey indicates that, asset managers’ EBIT may decline by 15%/ 30% because of the shift to P&L accounting for external research expenses.

From the following chart, the first impression is that big banks need a lot of information and their demand seems very fragmented. However, 20 banks account for 64%. Therefore, according to 80:20 Pareto’s rule, one can dominate the market by providing reports of Equity Research to a small number of big players.

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Moreover, the impressive decrease in European Research budgets both in terms of advisory and brokers, could lead to a big change in banks demand.

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Another big effect is on Sales&Trading which last year has seen a declining number of traders together with an introduction of electronic trading engineers. Indeed, specific data compiled by McKinsey on the Equity segment of the top 9 investment banks show the overall Sales&Trading headcount declined three times faster than Research since 2011. For example, Goldman Sachs’ US cash equity business moved from 600 traders in year 2000 to only 2 traders in 2016.

In fact, with MiFID II will cause lot of job loosing but at the same time many have been, are and will be created. For example, the number of job adverts on LinkedIn for MiFID-related roles has more than quadrupled in the last year in a sign of how companies have been trying to be well prepared for the far-reaching European regulation. Banks, asset managers, consultancy and law firms have all embarked on a hiring spree ahead of the introduction of the second instalment of the Markets in Financial Instruments Directive.

This is quite a revolution happening in banking which is also related to Fintech and Robo-advisory recent success among investors. Indeed, this disruptive companies are recently receiving large funding from high-profile investors and hiring new talents to take advantage of growth momentum.

 

Winners

Until now, MiFID II has created some advantages that benefited some players such as:

  • Pension funds and family offices will be advantaged as they will be more aware of the fees payed for researches and so increase their bargaining power. Regarding the price, also big money managers such as BlackRock and Vanguard Group will benefit.
  • Platforms in general will benefit from this directive and particularly in hedge funds where they will ease compliance and reduce again costs.
  • Individual investors will be more aware of the fees and this might lead to a big shift from funds to ETFs due to their lower cost. Indeed, they are forecasted to surge from 725 billion dollars to more than $1 trillion in next 1 to 3 years.
  • Big Investment Banks will be able to compete on prices for research eventually building a new revenues stream.

Losers

As any other piece of legislation, MiFID also created some “losers”:

  • Smaller companies with lower budgets will encounter higher prices for obtaining information and may charge higher expenses to clients which could cause a negative impact on business. The same goes for smaller investment banks and boutiques that cannot afford a war price on their research products.
  • Hedge funds will have to insert reports within 1 minute for the equity side and 15 for the fixed income products. This will probably impact their transaction volumes and costs in terms of time and money.
  • Research teams will shrink and so their effort higher or the output poorer. Are unexperienced investors ready to independently search for stocks without being able to rely on recommendations? Will they take the risk or miss the opportunity? What would happen to the relatively unknown small cap? Would the capital run towards big firms leaving the small ones illiquid? As trades would not be any more done over the phone but via platforms, who will now loose his voice and go to the doctor? And what about the already declining fixed phone business?

 

 

Authors

Lorenzo Bracco