Monday digest

Posted 12 July 2021

Overview: Investor vertigo an entirely natural response
Global equities have been on a pretty rapid ascent since the start of the year, but as the second quarter ended, investors have been dealing with a mild attack of vertigo. In its June meeting, the Fed signalled that a strong economy might allow it to move away from its emergency monetary support, with a rate rise coming possibly as early as 2022 – but more likely in 2023. This is sooner than markets had been expecting, and the news caused shorter-term US bond yields to rise while longer-term bond yields fell late in the quarter.

The result has been a fickle mood in capital markets. We seem to be flip-flopping between the supposed ‘Great Reflation Trade’ and a return to the slow-but-steady outlook of the pre-pandemic world. The former favours cyclical assets, emerging markets and value stocks, while the latter favours bonds, growth stocks and the US tech giants. This indecisiveness has carried over into the second half of the year, and sentiment could quickly shift over the coming months.

On the positive side, the return of dividend pay-outs is a welcome sign along the road back to normal – giving positivity to the banking sector in particular. The early rally in commodities was another signal of normalisation in Q2, but this later fell back after China’s efforts to curb what it sees as excessive speculation. Interestingly, the calming of reflation hopes seems not to have affected oil prices, which continued to rally throughout the quarter.

The rise of the Delta variant remains the main public scare story, threatening the promised end to the pandemic. Fortunately, as the recent spike in British cases has shown, Delta outbreaks look much less worrying for countries with high vaccination rates. But developing countries, which have received far less of the vaccine stockpile than richer nations, are rightfully concerned. Emerging markets have subsequently underperformed, hit with a double whammy of virus pessimism and tightening conditions in China. This is perhaps another factor in the dampening of reflation hopes. In all, though, the outlook from here looks positive. Economic indicators are still high, albeit not at the astronomical levels we have seen before. Things are rolling over, but that – after all – is what normalisation is about.

The mini liquidity trap in US money markets
It is hard to overstate the importance of central bank support throughout the pandemic, and the US Federal Reserve has led the line in this regard – pinning down interest rates and buying assets at historic levels for a year and a half now. But in the last two months, liquidity in money markets has come from another source: the Treasury General Account. This is the US government’s own bank account with the Fed, and it had been filled with cash from bond sales that the Treasury has since been unleashing to fund its fiscal programmes. In short, the system is awash with liquidity – and currently has more cash than anyone knows what to do with.

The cash situation is so comfortable that interest rates in money markets – markets for interbank lending and cash instruments – have recently fallen close to 0%. Excess cash might sound like a positive for the health of the financial system, but it creates a problem for central bankers. With no returns on offer, the danger is that money market funds will dry up, posing a serious risk to financial stability. The Fed’s solution to this problem is to raise rates slightly. Banks now get 0.15% (up from 0.1%) on their deposits with the Fed, while money market funds now make 0.05% (up from 0%) on reverse repurchase operations – where an asset is bought with the agreement of selling it back in the future. Isn’t raising rates the precise thing the Fed was only recently reassuring markets it wouldn’t do?

This situation is different, as the Fed is giving money markets the funds to keep them afloat and avoid the zero lower bound. Higher repurchase rates mean money market funds are depositing more cash with the Fed. Effectively, then, the Fed is just soaking up the same excess liquidity that it created. In other words, it pushed out more cash than was needed to keep interest rates low and create demand for higher yielding assets; so to avoid an overload, that money is cycling back round to the Fed and is thereby sterilised. This is a fairly common practice for central banks when conducting foreign exchange interventions – central banks intend to influence the price of their currency, but do not want more liquidity being channelled into their economy.

Judging by market moves last week, the Fed’s technical move has been interpreted as tightening by some. But unlike a genuine policy tightening, there is no effect on the underlying economy at this point. Rather, what we are seeing is a limit to the effectiveness of the Fed’s liquidity pump. The money that policymakers are pushing out is ending up back with them, not because of any policy decision, but because there is not enough demand to soak it up. It is a classic example of a liquidity trap: supply side changes from the central bank start being ineffective. Over the next few weeks, with summer holidays and potentially thin trading volumes, this might cause some teething issues in markets, particularly if the economy continues to cool to a simmer.

Further ahead, the Fed will likely have to do more to convince markets that financial conditions will stay loose until the economy reaches full employment. When that happens, and the public become more certain of their long-term job prospects, we should expect consumers to stop saving and start borrowing – which will be good news for policymakers.

Why private equity is keen to buy British
After weeks of courtship, and a protracted bidding war, supermarket chain Wm Morrison has at last picked a suitor. A private equity consortium led by Fortress will pay 252p (a share along with a 2p special dividend), valuing Morrisons’ equity at £6.3 billion. The price was a 42% mark-up from the company’s share price before the takeover bidding began. It begs the question of why private equity investors are so interested in the supermarket chain and, more importantly, why they are interested now?

Coming out of the pandemic, Britain and the wider world are on the cusp of strong growth and inflation. Meanwhile, central banks are still pinning down interest rates and pumping out liquidity at historic levels. Money is cheap and growth prospects are high – but for how long no one is sure. For US private equity buyers, there is a particular sense of urgency. Anxieties around when and how the Fed will change its course are encouraging firms to take money while they can. More pressingly, Joe Biden’s proposed tax changes mean such deals are likely to be less profitable for financiers in the near future.

So, Britain’s businesses represent a unique – and possibly fleeting – opportunity. Brexit uncertainties and subsequent sterling volatility have weighed down UK assets – particularly domestically-focused ones – for half a decade. The pandemic only compounded these issues, with Britain one of the worst hit nations in the world in both health and economic terms. Investors’ reluctance to buy anything with a pound sign has left UK plc looking mighty cheap compared to global peers. The FTSE 250 is currently trading at around 16.1 times next year’s earnings expectations, while that figure is at 20.4 for the S&P 500 and 18.9 for the MSCI World Index. Private equity firms see the stock market’s loss as their gain.

Private equity groups have a unique ability to cherry-pick when it comes to undervalued businesses, and UK plc has many that look ripe for picking. The UK has cheap companies and some of the highest medium-term growth expectations in the developed world. A total of 345 buyout bids have already been launched for British businesses this year, 13 of them for listed companies. By gobbling them up they have an opportunity to restructure and profit away from the spotlight of public markets. To be sure, politicians and public investors have many legitimate gripes with how they do so, and the effect it has on industry. It would therefore be no surprise if regulatory changes limited private equity’s purchasing power in the future. But for now, this will only increase the urge to buyout British companies. We should expect more offers where Morrisons’ came from.

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