There is widespread discussion around the world on the possibility of a severe economic contraction in 2023 across most of the developed world. This time round the severe economic contraction is coupled with record high inflation numbers. Yes, we are indeed living in a world of growing stagflation risk.
The pandemic induced liquidity boost led central banks around the world pumping enormous liquidity into their economies to boost economic activity. However, when you print such large sums of money, expect collateral damage! The risk of a severe economic reset, coupled with spike in bond yields points to some tough economic conditions ahead of us.
However, not all is doom and gloom out there. The recently concluded World Economic Forum at Davos, Switzerland, where the world’s capitalists and economic influencers gather for their annual pow-wow, failed to unanimously agree on the impending economic gloom in 2023. Labor markets for the most part remain buoyant and resilient; capital availability remains high; and consumer demand has yet to go on strike! All the above, perhaps explains some of the optimism.
The recent data out of US, shows over 517,000 (non-farm) jobs were added in the month of January 2023; taking the unemployment rate to a 53-year low! Despite the successive rounds of interest rates hikes since March 2022, the job market remains hot and the economy not showing any major signs of slowing down. All the above points to inflation remaining a concern (for policy makers) despite it showing some signs of cooling off and the Federal Reserve’s recent sanguine comments on near-term inflation outlook for the US economy.
In this article we have looked at the conditions as to how severe is this likely economic correction to be; as well as how does this impact the outlook for M&A across the world. We believe there are grounds for optimism.
The Role of Monetary Policy
While we can argue about the severity of the recession that is expected to hit US and Europe in 2023, one cannot argue about the fact that economic slowdown/contraction is well and truly underway in most OECD countries. The UK is grappling with the sharpest slowdown, driven by high inflation and perhaps some of the knock-on effects of Brexit.
The pandemic-induced significant monetary easing and the massive liquidity injections into the economies around the world created demand bubbles in many areas and bloated asset prices. All the above in varied ways has contributed to rising prices; not to mention the supply side shocks that have exacerbated the situation.
The figure below is useful illustration of what factors have largely contributed to recessions in the US, in the post WWII era. The last time we experienced a hyper-inflation induced monetary policy tightening was in 1990.
Figure 1: Key Contributors to US Recessions over the Years
“11 out of the last 14 monetary tightening episodes in the US, since the end of WWII; have led to a recession within 2 years of the first round of interest rate hikes.”
Monetary policy, via interest rate hikes has limited ability to curb inflationary pressures, especially when supply side shocks and geopolitical risk factors dominate the global landscape and its resulting domino effect on inflation. However, if the past is a good guide of the future, our economic history suggests that 11 out of the last 14 monetary tightening episodes in the US (since World War II) led to a recession in the US within 2 years of the first round of rate hikes.
Undoubtedly corporate spending will tread carefully, given that backdrop, and the need to shore up defenses to weather the adverse impact from a potential decline in consumer demand and its resulting impact on earnings outlook and balance sheet strength.
Figure 2: US Interest Rates & Bond Yields
The above graph is quite telling; cheap debt for years provided the US economy with the fuel to keep powering and holding up consumer spending and demand. However, the spikes in rates across the spectrum of credits (driven by runaway inflation) has spooked investors and consumers alike; making a compelling case for a “hard landing” in the US a real possibility.
US Rates still playing catch up with Inflation?
Central banks are generally always behind the curve when it comes to addressing inflation risk in the economy. They tighten too little in the run up to inflation ravaging the economy (fearing a disproportionate adverse impact on consumer demand), and when the damage is done, they go overboard (on the tightening) and further magnify the demand contraction crisis.
The December 2022 data on US inflation leaves grounds for some optimism with the easing trend giving policy makers some relief on the outlook for inflation. Although the inflation bogey remains a real threat and clearly a policy concern, any worsening will be a negative hit on consumer confidence and cause the next round of contraction to be acute; and any easing trend will boost confidence and lower the monetary policy tightening exercise and boost consumer confidence.
Figure 3: US Federal Funds Rate and Inflation
Impact of Stagflation on a Business
In a classical sense when you have inflation or stagflation risk, you can expect the following scenario to play out:
- Growth slows down (or contracts) as consumer demand takes a hit!
- Cost of financing (borrowing) goes up making capital scare and a rise in borrowing costs reduces demand for credit to power economic activities.
- As a business owner or manager, you find your margins come under pressure as you lack pricing power in the market and input cost pressures refuse to subside.
- Rise in risk aversion leads to private capital providers (i.e., PE/VCs) seeking higher return thresholds.
- Companies go out of business as they fail to sustain operations, or their balance sheets are too weak to tide over the tough times. Such incidents may trigger M&A as way to remain in business; while it offers acquirers to either gain a competitive edge via M&A in a geographic expansion move or shore up their competitiveness via an expansion up (or down) their value chain.
Recession and Impact on M&A Volumes
In the normal course, when we go through economic recessions, it leads to a dramatic contraction in M&A activities both in terms of transaction volumes as well as transaction value. Investor appetite for risk as well as capital availability are both essential elements to drive M&A activities. The rise in risk aversion coupled with drying up of capital sources tends to drive down M&A activities severely in tough economic environments.
We believe this time round the contraction in M&A activity may not be severe on account of the following factors:
- Capital markets have corrected sharply over the last 6 months in the US and Europe; but liquidity availability remains high (relative to historical periods when one rolls into a recession).
- Consumer demand is yet to see any major contraction in most economies (relative to past numbers).
- While interest rates are at a 30-year historic high in the developed world, corporate balance sheets remain flushed with cash for the most part.
- Geo-political shifts, driven partially by the COVID-19 crisis, is getting companies to relook at their supply chains to remain competitive on a global scale.
- There is a huge technology driven disruption underway, in turn driven by climate change, impact of artificial intelligence and robotics, and the world of web 3.0 and its application to traditional businesses.
One will, however, list the Russia-Ukraine crisis as one that could go either way – it can further add to the supply side induced energy crisis if there is further escalation of the conflict; or be a significant boost to investor and economic sentiments if the conflict de-escalates and commodity prices deflate and lower inflation outlook globally.
Large cash holdings on Corporate Balance Sheets
Unlike public finances (i.e., government balance sheets) that have witnessed significant deterioration over the pandemic years, corporate balance sheets at an aggregated level remain extremely healthy and robust with large cash piles in place. This is true for the US as well as for a large part of Europe.
Figure 4: Large Cash Piles in the US
“In the US, there is US$12. trillion of corporate cash, sitting on the side lines; seeking opportunities.”
The US corporates coupled with the gigantic availability of cash for high grade borrowers in the US, points to an active global consolidation and tactical positioning by many US players looking to build dominant market positions or create a global footprint. There is close to US$ 12 trillion out of the US that is seeking investment opportunities when you look at the PE, Debt raised by non-financial companies and net cash on corporate balance sheets in the US.
This level of cash is unprecedented compared to previous bouts of economic recession and stagflation risk. Additionally, US corporate tax rates at 21% are at a historical low level in almost 100 years! The Federal Reserve in the US expect interest rates to top off at around the 5-5.25% level; we are presently at 4.75% with the recent 25 bps hike on 1 February 2023. An increase that is less than previously estimated back in Sept-Oct 2022.
The figure below on the Top 12 European corporates highlights an over Euro 200 bn cash pile across these companies; a figure that is an historic high by all measures.
Figure 5: Top 12 Corporates in Europe and their Growing Cash Positions
Technology Disruptions and Global Supply Chain Re-alignments
Globalization may take a different course in terms of managing risks around supply chains, and this will undoubtedly spur M&A activities around the world as global footprints get re-configured and re-aligned.
Additionally, the world is going through a level of tech disruption and innovation driven by climate change, healthcare delivery, the role of artificial intelligence, the surge of Web 3.0 applications to drive greater social and financial inclusion. Such disruptions give rise to enormous opportunities for start ups and established players to acquire capabilities to transform their long-term outlook.
Strength of the US Dollar – Compelling argument for M&A
The US Dollar has seen unprecedented appreciation against all major currencies around the world over 2022. This has made foreign assets cheap for US acquirers. The rising interest rate environment has added to the challenge for corporate treasury functions to ensure their low-risk corporate cash investments do not expose them to the wrong side of the interest rate upswing (i.e., exposure to bonds may lead to capital losses in the near term).
Add to that the equity market corrections, US corporates with large cash balances have limited choices ahead of them. They primarily include:
- Pay a higher dividend to their shareholders (given the bleak treasury outlook).
- Undertake larger than planned share buy-back schemes.
- Look at M&A to boldly reset their long-term growth and competitive outlook.
We have already seen some large stock buy-back announcements in the US; expect more leading up to the middle of the year. We believe, while there has been slowdown in M&A activities, we do not expect the contraction to be of the same magnitude as has been in the past recessions.