15/02/2007
Global Liquidity and the M&A Boom in 2007
Equity markets performed well in second half of 2006 and into early 2007, despite concerns about a US economic slowdown, moderating earnings growth, and higher interest rates in many parts of the world. One explanation put forward for this strong performance is 'excess liquidity' pushing risky assets ever higher. Does such an explanation hold water, and could such liquidity quickly be withdrawn?
Global liquidity is a much used phrase, but one which is subject to considerable uncertainty. Does it simply mean more buyers than sellers? A classic example would be a small emerging market, say Vietnam, with a limited amount of stocks and only a small daily turnover. Overseas investors might be attracted by buoyant economic or profits growth. A wave of liquidity into such a market can overwhelm the normal trading conditions and cause a sharp share price reaction. Not only small markets can be affected in this way. On our analysis of cross-border capital flows, as discussed in more detail in our August edition of Global Insight, we monitored overseas investor interest in the Japanese equity market, which historically has been an important driver. In addition, flows into China's and India's stock markets in 2006 have been a key, albeit not the sole, driver behind their out-performance – a surge which caused their central banks publicly to worry about bubbles!
How can excess liquidity be measured? This is the crux of the problem. There are a variety of methods, most of which suffer from serious drawbacks. One option is to examine the growth of foreign exchange reserves over time, drawn from the International Monetary Fund's statistics. However, taking account of movements in the value of the US dollar can prove rather problematical. Another is to calculate excess money supply growth over and above that required for normal consumer spending or industrial activity. However, credit availability can now take many forms, rather than solely some broad monetary aggregate. Some measures of excess liquidity are more related to the cost of money, but price need not give a useful steer about the availability of credit. A problem with many of these approaches is the delay in publishing the necessary data.
We do measure global liquidity at Standard Life Investments. The methodology processes an array of data provided by an independent research consultancy, which we aggregate with in-house analysis. The model weights various components according to their predictive power. Three main sections cover market indicators, such as inflation adjusted interest rates, policy indicators such as central bank purchases, and credit indicators such as banking sector liquidity ratios. The important point is that in each case the measures are optimised against actual bond and equity market performance, to ensure that there is predictive power in the relationship. The results are cross-referenced against more mainstream analysis, especially changes in the shape of the yield curve and currency movements. These are transmission mechanisms whereby monetary policy in one country can have an impact on others. The result of our work is a global measure of monetary conditions or credit creation.
What are the results? Liquidity was plentiful in 2003 and 2004. This is not a surprise, as central bankers were dealing with the after effects of the worst equity bear market for 30 years. Since then, global liquidity has become steadily less plentiful. This can easily be seen in the form of flatter yield curves across a variety of major economies. At present, monetary conditions are their tightest since 2002, but not yet unduly tight. This has informed our House View, which still has Heavy positions in the more defensive equity markets as well as a number of bond markets, positioning our funds for potential volatility ahead.
If global liquidity is not as plentiful as many commentators suggest, is the recent rally underpinned? One way we can answer such a question is to examine not only new credit creation but also its transfer, how liquidity is put to work. This enables us to consider a key issue driving markets higher, namely the strength of corporate activity such as M&A or management buy outs. Across the world, there were over 15,000 M&A deals in 2006, worth almost $2.5tn. This matches the previous peak seen in 2000. Small and medium sized firms have been the major targets, helping to explain the under-performance of big cap stocks against their smaller bretheren. However, the deal size is beginning to rise, especially as more leveraged projects appear. Private equity now accounts for about one quarter of all M&A activity.
Is such consolidation amongst companies a sign of excess liquidity? There are some warning signs which need to be monitored. However, the underlying drivers of M&A activity are well understood. In recent years, companies have generated significant profits – US earnings are running about 10% above their level a year ago. Cash balances have built up and the quality of balance sheets improved, with free cash flow yields 6% in the UK and over 4% in the US. If CEOs expect a soft landing for the world economy in 2007, then M&A becomes more attractive as companies try to enhance profits growth through acquisition. At the same time, cash flows into private equity funds have been strong as more pension schemes diversify into alternative assets, and current low financing rates enables leveraging up of such funds.
We would expect such strong corporate activity to continue into the first half of 2007. Individual deals are looking expensive, but en masse the bid premiums paid in 2006 were no higher than the average seen over the previous decade. Earnings growth will slow significantly into 2007, and we expect debt servicing costs to rise moderately, but neither will have a quick impact. Nevertheless, the degree of leverage starting to be seen in some markets is a cause for concern. Irrespective of any further moves in short term interest rates by the main central banks in 2006, we will monitor our measures of global liquidity closely into 2007, to assess whether they are giving more warning signs that investors should prefer more defensive assets or alternatively whether attitudes towards greater risk seeking are justified.
Andrew Milligan, Head of Global Strategy, Standard Life Investments
First published in Professional Adviser on 15 February 2007.
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