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

1

   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

3

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

4.png

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

5

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

6

Source : Bloomberg

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

7

Source : IMF data, Tradingview representation

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

8

Source : CitiFX, Bloomberg

Authors: Noa Lachkar, Greta Pontiglio

Supervisor: Lorenzo Bracco

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

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.

1

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.

2

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.

3.png
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.

4

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.

5

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.

6

 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

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 Race has started for European PE firms to join the $100bn Club!

By Ascanio Rossini

The race to become Europe’s first $100bn private-equity firm is accelerating as the recent fundraising boom shows. Europe’s largest investment firms, including Ardian, Partners Group and CVC Capital Partners, are closing in on $100bn in AuM after raising some of their largest-ever funds in recent years and launching new investment strategies in areas such as infrastructure, credit and real estate. Their rapid growth from single-fund PE shops to multi-strategy asset managers comes as the asset class has matured from a cottage industry 20 years ago to one attracting hundreds of billions of dollars annually from some of the world’s largest institutional investors.

Keeping Pace

The rapid growth of these firms also raises questions about whether firms are expanding their teams and building out the infrastructure sufficiently to keep pace with their growing assets. Money flooding into the asset class in Europe is concentrating in the hands of fewer firms, much like the U.S. market. New York-based Blackstone, for example, manages nearly $500bn, ranking it as the largest firm by assets.

Paris-based Ardian, established in 1996 as the captive private-equity arm of French insurance conglomerate AXA, leads the pack of European managers closing in on the $100bn mark.

Ardian now manages $82bn on behalf of its investors (more than double of what it managed in 2013), but is seeking an additional $25bn in new cash across its various investment strategies, including a flagship buyout fund and a global secondary fund, as well as vehicles focused on North American buyouts, private debt and European infrastructure.

Meanwhile, Ardian’s Swiss rival Partners Group, Europe’s largest listed private-equity firm, has turned itself into a fundraising machine after switching its investment focus a decade ago from backing private-equity funds to making direct investments. The Swiss firm now manages $78bn.

London-based CVC, the former owner of Formula One, is another candidate that could join the $100bn club, although perhaps a bit later than the others. The firm managed some $69bn in assets as of Sept. 30 after collecting €16bn in 2017 for the largest buyout fund ever raised by a European private-equity manager.

Increasing assets under management by moving into new markets means PE firms stand to enrich themselves by boosting the fees they receive from investors. Buyout shops typically make cash by taking a slice of profits from successful investments as well as by charging a 2% fee on the money they manage. The decision to move into different investment strategies has prompted a mixed reaction from some investors. Some see it as an opportunity to put large sums of money to work with a manager they know and trust; others as an excuse to increase the money they make in fees.

Increasing Staff

To keep pace with the growth in assets, many of the largest European firms are expanding into new geographies and ramping up the number of staff they employ. Partners Group for example, employs more than 1,000 executives globally; nearly double the 560 workers Ardian has on its payroll.

Investment firms, including Neuberger Berman’s Dyal Capital Partners and Goldman Sachs’ Petershill unit, buy stakes to gain a cut of the fees firms charge and the profits from their deals.

Bridgepoint, which has recently moved into credit and manages small-cap funds, became one of the first major buyout shops in Europe to strike such a deal when it sold a chunk of itself to Dyal Capital in August.

The continuing flood of capital flowing toward Europe’s buyout giants comes with a risk. Firms will have to be careful to ensure they don’t raise more money than they can prudently spend, as dry powder in Europe reached a record of €220bn as of Q4 2018, pushing asset prices up to an all-time high in 2018.

“This is the kind of environment—marked by too much money chasing too few deals – in which investors should emphasise caution” said Howard Marks (OakTree Capital co-founder).

Sources:

PE Newshttps://www.penews.com/articles/the-race-is-on-for-europes-firms-to-join-the-100-billion-club20190121

PE Insightshttps://pe-insights.org/the-race-to-be-europes-first-100bn-private-equity-firm/

FN Newshttps://www.fnlondon.com/articles/the-race-to-be-europes-first-100bn-private-equity-firm-20190122

ALL TIME CLASSIC! KKR’s first leveraged buyout battle ($25bn). The fall of RJR Nabisco. Yes! Barbarians are really at the gate.

Authors: Qitong Sun and Massimiliano Marchisio

Date 30 November 1988
Type of transaction Leveraged Buyout
Valuation 7.5-8.0x FY 1988 EBITDA of c. $3.1bn
Bidder KKR
Target company (sector)

Financials

RJR Nabisco (Tobacco & Food)

FY1988 Rev./EBITDA $16.9bn/$3.1bn (margin c.18.3%)

Rationale

RJR Nabisco’s operations exhibited moderate and consistent growth, required little capital investment and carried low debt levels.  All these features made it a particularly attractive LBO candidate. Though it had problems of declining ROA and falling inventory turnover, they appeared fixable.

On November 24th, 1988, the board of RJR Nabisco finally announced its acceptance of a revised proposal from KKR, with $25bn ($109 per share). KKR won the competitive process for the ownership and control of RJR Nabisco, a victory that resulted in the largest corporate control transaction in the US, opening the road for large corporate buyouts.

History of the RJR Nabisco takeover

  • 1985 – RJR Nabisco was formed in 1985 when Nabisco merged with RJ Reynolds tobacco. The CEO F.Ross Johnson, originally from Canada, was known for a risky, bold decision making process inside the boardroom.
  • 20th October 1988 – Johnson decided to take the company private and proposed a $17bn LBO. Company shares rose sharply on the news. Sherson Lehman Hutton announced they would take the company private at $75/share.
  • 26th October 1988 – KKR & Co. made an offer $20.4bn, but the deal was rejected. Salomon Brothers, Forstmann Little, Shearson Lehman Hutton, Goldman Sachs, First Boston, Merrill Lynch, Morgan Stanley, and more are all trying to get in on the action. A few days later, RJR Nabisco gave KKR confidential financial data about its operations.
  • 2nd November 1988 – KKR and RJR Nabisco tentatively agreed to join forces, but just after one day, the agreement failed. After that, RJR Nabisco upped the ante by making a $92/share offer (i.e. $20.9bn).
  • 18th November 1988 – Fist Boston put together a deal. Working with the Pritzker family in Chicago, offering between $23.8bn and $26.bn.
  • 29th November 1988 – Management offered $22.9bn, KKR offered $24bn and First Boston offered $23.38 to $26.1bn. The stock price jumped to $90.88.

30th November 1988 – Finally, the company went to KKR for $24.9bn or $109 a share. Mr Johnson received $53m from the buyout, $23m after taxes.

kkr pic1

The RJR Nabisco transaction warrants particular attention. Not only is it the largest LBO on record, but it also features a particularly wide range of sophisticated players, a complex set of innovative financial instruments, and a challenging valuation process.

Successful LBOs are generally characterized by both low business risk and moderate growth. RJR’s unlevered beta was 0.69, which means the firm was relatively insensitive to market-wide fluctuations. Although the growth rates of tobacco and food were 9.8% and 3.5% respectively, most analysts had forecast a slower long-term growth rate in both units. Together with the firm’s little capital investment requirement and low debt levels, RJR Nabisco was a particularly attractive LBO candidate.

ESCP PE-Team View

How did KKR win if its offer was low?

By traditional standards, RJR management should have won the bidding war. Its offer, $112 a share, was higher than KKR’s by nearly $700m, its cash portion of the offer (i.e. $84) was higher than KKR’s ($81), its members were all industry experts with an intimate knowledge of the company and management was on good terms with the board members. Nevertheless, when the bidding ended, traditional factors did not determine the winner. The management group lost.

Why?

Here the following factors had led to the success of KKR’s lower bid:

  • The break-up factor – KKR promised to keep the tobacco and most of the food business intact, which matched the board’s will to keep the company as intact as possible. While KKR promised to keep the tobacco and most of the food business intact, the management group planned to keep only the tobacco business. Indeed, KKR specified that it would sell only $5bn-$6bn of RJR assets in the near future, while the management group planned to sell the whole food business (estimated at $13bn).

To sum up: Better negotiations carried out by Henry Kravis and George Roberts (co-founders of KKR). The reality is the KKR kept its options open, not disclosing its long-term pans.

  • The equity factor: The board’s five person committee wanted to provide existing share-holders with an option to participate in the buyout and thus share in any future KKR profits from the transaction. The desire was to leave some portion of the company’s stock in public hands. While KKR proposed to distribute 25% of the equity in the future company to existing shareholders, the management grup offer included only 15%.

To sum up: Better terms and proposal deriving from a higher expertise in meeting boards’ requests.

  • Financing structure: Based on an analysis performed by the advisors to the board’s committee, KKR was offering $500m more equity than the management group, which again accommodated the board’s objective of maximizing current shareholders’ participation in future profits.

To sum up: Better understanding of businesses’ capital structures and again higher expertise in meeting boards’ requests.

  • Post-LBO leadership: The intensive bidding war affected all parties involved (including management, employees, communities and the bidders themselves). During the bidding period, the uncertainty was high and business was affected. In the interest of restoring stability, the board’s special committee assessed each offer in terms of its effects on RJR’s identity and culture. KKR quickly read the board’s mind and announced its plan to install J. Paul Sticht as the new CEO (vs. management which proposed Johnson to continue as CEO). For various reasons (i.e. most expensive fleet of corporate jets and poor public relation) the board associated MR. Johnson’s group with greed, lavish spending and insensitivity to employee and community needs.

To sum up: Again KKR demonstrated higher expertise vs management in meeting boards’ requests.

The board assessed each offer in terms of its effects on RJR’s identity and culture, and finally placed more preference on KKR. KKR was able to recognise that financial factors, as well as the acquiring group’s goodwill, would play a decisive role in the game.

About RJR Nabisco – was an American conglomerate, selling tobacco and food products, headquartered in the Calyon Building in Midtown Manhattan, New York City. RJR Nabisco stopped operating as a single entity in 1999; however, both RJR (as R.J. Reynolds Tobacco Company) and Nabisco (now part of Mondelēz International) still exist.

 About KKR & Co. – is a global investment firm that manages multiple alternative asset classes, including private equity (corporate buyouts, infrastructure and real estate), credit, and through its strategic partners, hedge funds. As of September 30, 2018, Assets under Management were $195 billion.

SOURCES

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.

Articolo.png

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