6 reasons US M&A activity will see strong growth this year

US M&A activity is picking up steam. Deal volume in the first quarter of this year was the highest since 2007 (in dollar terms). The total of $278bn of transactions includes high profile deals such as Time Warner, Forest Laboratories, and WhatsApp.

Moreover, M&A transaction volume growth for both large and middle market firms is poised to accelerate this year. Here are some reasons:

1. US corporations currently hold record amounts of cash (see story) and shareholders want to see action. While dividends and stock buybacks have been popular recently, many firms are looking toward growth strategies.

2. The market has recently rewarded companies that are doing deals by giving them higher valuations (Facebook was an exception), encouraging CEOs to be more aggressive with acquisitions.

3. Financing costs are still quite attractive. US high yield spreads for example hit another post-2007 low last week as fixed income investors (including "shadow" banking participants) look to buy corporate paper. This allows for more leveraged buyouts even at higher valuation multiples.

HY spread to treasuries

4. Private equity funds, particularly some of the larger ones are having a fairly impressive start this year with their fund raising efforts (see example). The first quarter has been the strongest since 2008 according to Preqin with some $95bn raised. This capital has to go somewhere.

5. A great deal of near-term fiscal and monetary policy uncertainty has been removed from the market (see post). The macroeconomic environment in the US should support M&A activity.

6. The US stock market strength, while making target companies more expensive, is providing more buying power for strategic acquisitions. Companies will be using their (sometimes overvalued) shares as "currency" to do deals.

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Jumbos still cheaper than conforming mortgages

For years mortgage rates on "jumbo" loans (definition) have been higher than for traditional (conforming) mortgages (definition). Since jumbo loans were larger than the upper limit permitted to be packaged and sold to Fannie and Freddie, banks would typically charge a premium for "illiquidity" on these products. But starting last year conforming mortgages became more expensive for borrowers than jumbo loans.

Source: Barchart

This distortion persists today and is directly related to the Fed's quantitative easing program. Since conforming loans are funded via agency MBS (bonds that Fannie and Freddie sell to fund purchasers of pools of conforming loans from banks), the pricing on these loans is directly linked to MBS yields. And as discussed last year (see post) the Fed has been dominating the MBS market via QE3. As the Fed's taper expectations took hold (after Bernanke's May 22nd speech), MBS yields rose sharply. With that, conforming mortgage rates also increased.

Jumbo mortgage rates on the other hand rose more slowly because these loans tend to stay on banks' balance sheets and are not funded with MBS. Moreover banks are happy to get paid a lower rate on loans to these higher net-worth creditworthy clients. Banks fund themselves with near-free deposits and charge jumbo clients 4.25%, keeping the spread. And unlike conforming loans that get sold at "market" levels, banks don't have to mark jumbo loans to market (banking book accounting treatment is based on accruals unless there is an impairment). The dynamics of conforming mortgages being more directly tied to MBS pricing (which is impacted by the Fed's securities purchases) and different accounting treatment have resulted in 30-year jumbos being some 20 basis points cheaper than standard mortgages.

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Why is the ECB hesitating on monetary easing?

The Eurozone's unemployment rate is at 12% and holding while the area's youth unemployment is at staggering 24%. Private lending is still contracting (see post) and disinflationary pressures persist even within the "core" states (see chart). The price stability situation in the "periphery" is starting to look outright deflationary - see chart.  The euro is still at mulit-year highs, putting pressure on the area's export businesses. At the same time monetary conditions continue to tighten as the area's central banking system balance sheet approaches pre-LTRO levels.

unit = mm € (source: ECB)

Given the situation, most central bankers would take action. A simple policy change for example could be to suspend the sterilization of securities already held by Eurosystem - see post. But the ECB is hesitating. Why? Here are some reasons:

1. This may upset some folks but the reality is that the ECB is notoriously indecisive as it is pulled into various directions by the member states. Many forget that the institution is relatively new (just over 15 years in existence) and the shock of the recent crisis had left the organization a bit paralyzed. It rarely takes a decisive action unless it's forced by the markets to do so. The decision to "save the euro" only arose as Spain approached the point of "no return".

2. The ECB is also somewhat distracted as it prepares to take on the massive task of regulating the area's banking system - a responsibility that was not initially part of the central bank's charter.

3. The ECB does not have the dual mandate of the Fed and is only focused on price stability. The central bank views the area's horrible unemployment problem as being outside of its "jurisdiction". While technically correct, many central bankers would regard this narrow interpretation of the rules as shortsighted.

4. The hawks at the ECB continue to view the disinflationary pressures in the euro area as transient.

Reuters: - The ECB is running official interest rates at a record low but unlike other major central banks has resisted calls to follow that move with outright "quantitative easing" to pump more money into the economy.

[Bundesbank President Jens] Weidmann said that about two thirds of the falloff in euro zone inflation to 0.7 percent, the lowest since the economy was deep in recession in 2009, could be attributed to falls in energy and food prices.

"Monetary policy should respond to such factors only in the event of second round effects," he told a conference in Berlin, saying he would not talk about current monetary policy ahead of the ECB's monthly policy meeting next Thursday.

"With regard to the rate of inflation at the moment, the euro area is not in a self-enforcing downward spiral of price decreases, which is nominally the definition of deflation," he said.

5. The ECB has been heavily focused on the recent improvements in corporate growth, particularly the PMI indicators. Markit indices for example show a steady recovery from the 2012 lows.

Mario Draghi has been speaking about these improvements lately but he continues to ignore some warning signs hidden in these numbers.

Markit: - Policymakers will be encouraged by the survey in terms of the signs of sustained recovery. However, concerns will persist regarding the deflationary forces, especially in the periphery. With prices charged by manufacturers and service providers both falling again in March, there remains an argument for further stimulus, especially if the rate of growth of activity cools again in April.

6. The central bank is also hanging its hat on improving sentiment surveys in the euro area - see Twitter post. The thought is that if consumers and businesses are happy, credit growth will somehow stabilize. Perhaps. But the mood of these crisis-weary survey participants can easily turn if the area's labor markets do not heal soon.

7. The policymakers are also betting on the fact that the rapidly falling long-term rates in the Eurozone periphery will provide some "natural" stimulus to the area's economy. Indeed, as the markets perceive lower risks of default, the yield declines on longer-dated periphery sovereign paper have been quite spectacular. The OMT backstop provided by the ECB has certainly helped.

Source: Investing.com

The reason behind these recent sharp declines in yield however has to do with bets on disinflationary pressures and a subsequent easing action by the ECB.

Reuters: - Spanish, Italian and Portuguese bond yields hit multi-year lows on Thursday, with speculation about further European Central Bank monetary policy easing prompting investors to seek the bigger returns offered by lower-rated assets.

Should the ECB fail to act, these yields will inevitably rise. It is also important to note that low government borrowing costs are no guarantee of stimulus to the private sector. The private sector can not or is unwilling to borrow, reducing the impact of lower benchmark rates.

Ultimately the ECB could be right and some day, as the banking system is "restructured", the Eurozone's economy will heal itself. But that was also the attitude in Japan years ago when the nation undertook its banking reform. Yet deflation in Japan persisted for years since then, becoming heavily entrenched in the economy. Is the ECB now willing to take that chance?

Update: More CPI results from the Eurozone are out this morning.

a. Here is the latest aggregate euro area CPI result.
b. Below is the CPI measure for Italy:

Source: Investing.com

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US benefiting from reduced policy uncertainty

It is becoming increasingly clear that the Fed's taper, the slowdown in the central bank's balance sheet growth (chart below), is unlikely to damage credit expansion in the US.

Fed's balance sheet (YoY)

In fact - and many economists find this counterintuitive - the certainty of taper trajectory (which is effectively on autopilot) seems to be stimulating loan growth. In the post-financial-crisis world, periods of shifting government policy (both fiscal and monetary) had been quite damaging for the economy. The reduction in nearterm uncertainty with respect to the US fiscal impasse (see story on federal budget and on debt ceiling) is likely to be helping the situation as well. Loan growth acceleration in recent weeks has been quite pronounced.

Total loans in the US banking system (YoY)

This stabilization stands in sharp contrast to what is taking place in the Eurozone (see post) and seems to be fairly broad based. Small US banks, where credit growth had slowed materially in the wake of the US government shutdown, are now showing improvements in non-cash asset growth, especially corporate loans.

To be sure, much of this sudden recovery has less to do with banks suddenly easing credit and more to do with improving demand, especially in the corporate sector. That's because banks typically don't turn on a dime - they loosen credit policies far more gradually as a whole. This trend is therefore more indicative of bank credit facilities being drawn, particularly for working capital. Having said that, the Fed's senior credit officer survey does indicate lending standards easing in Q4 of 2013.

The data on loan growth is supported by high frequency survey results. Last week's ISI Bank Loan Survey index rose to the highest level since 2008. It is increasingly likely that the US economy will not only be able to withstand the gradual conclusion of QE3 but may actually benefit from the reduced monetary policy uncertainty.

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Eurozone's credit contraction continues

Private loan balances in the euro area continue to decline. Last month's drop of 2.2% from the previous year was worse than had been expected by economists.

Source: Investing.com

The area's banks are undergoing a sharp deleveraging exercise with balance sheets shrinking due to both loan write-downs and extraordinarily weak lending. Maturing loans are not being fully replaced with new credit. Pressure from the ECB's 2014 stress testing of banks (similar to what the Fed just completed) is also discouraging credit expansion.

Reuters: - Lending to households and firms in the euro zone shrank further in February and money supply growth remained subdued, adding to the European Central Bank's list of concerns ahead of its policy meeting next week.
...
The ECB's health check of the euro zone's largest banks' balance sheets before it takes over banking supervision in November is exacerbating the situation, with lenders reluctant to take on more risk and trying to slim their loan books instead.

Bank balance sheets declined by around 20 percentage points of gross domestic product last year, partly in anticipation of the health check, ECB President Mario Draghi said on Tuesday.

And more is to come this year.

UniCredit, for example, posted a record 14 billion-euro loss this month due to huge writedowns on bad loans and past acquisitions as it moved to clean up its balance sheet.

The ECB welcomed the move and encouraged other banks to not to wait with any corrective measures until the review's results are released in October.

Some have pointed to a "glimmer of hope" in the household lending balances which showed a small uptick in credit expansion.

Eurozone household loan growth (YoY); Source: ECB

The increase however came from a slightly slower decline in consumer credit (credit cards, auto loans, etc.), which continues to fall (year-on-year change is firmly in the red). This contraction to a large extent is driven by weak demand.

Eurozone consumer credit growth (YoY); Source: ECB (apologies for the different time scale)

Furthermore, growth in mortgage loans remains anemic, making this household lending uptick less of a reason to celebrate.

Eurozone mortgage loan growth (YoY); Source: ECB

Moreover, the area's corporate loan balances are continuing to see sharp declines - down 3.1% from the same time last year. Weak demand remains the culprit here as well.

Eurozone corporate loan growth (YoY); Source: ECB

In February Mario Draghi blamed credit weakness on banks' "window dressing" exercise of trimming balance sheets before year-end financial reporting.

Draghi: - "One would not rule out a certain behavior by the banks that would like to present their best data by the end of 2013, which means that this is going to affect credit flows, which means that we may have different figures in the coming weeks ..."

It would be interesting to see what Mr. Draghi will come up with this time to explain the ongoing contraction in euro area's private credit.

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5-year treasury cheapest in years after selloff

The five-year treasury yield hit a multi-year high relative to the average of the two- and the ten-year rates (the 5-year treasury is cheap on a relative basis). The chart below shows a measure of how "concave" the treasury curve has been over time (negative indicates the curve is convex).

2 x (5yr yield) - (10yr yield) - (2yr yield) 

Given that the five-year tenor is sensitive to the trajectory of the Fed's rate policy in the intermediate term, this is where we should see quite a bit of volatility (see post).  We've come a long way from the days when the 5-year treasury was highly overpriced relative to the rest of the curve (see story from 2012) and the market was pricing in "perpetual" QE.

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France vs. Germany - a Eurozone puzzle

Here is a puzzle. We are seeing an unexpected divergence in private sector activity indicators for Germany and France. The manufacturing report for France came in materially better than was forecast by economists while the one for Germany was worse.

Source: Investing.com & Markit

The services sector PMI measures show a similar divergence to those for manufacturing. What's particularly puzzling is how broad based this divergence has been.

• Markit (France): - Expansion was broad-based across the service and manufacturing sectors. Services activity increased for the first time in five months during March. Growth was at a 26-month high, albeit modest overall. Manufacturers reported a solid rise in output that was the sharpest since May 2011. [ - see story]

• Markit (Germany): - The easing in the rate of activity growth was broad-based, with both manufacturers and service providers indicating weaker expansions than seen in February. Companies in the goods producing sector reported the slowest rise in output since November, while growth in the service sector eased to a two-month low. [- see story]

Thoughts, comments?

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The changing face of commercial property lenders

US commercial real estate prices have firmed up recently although the recovery remains uneven across the various sectors.

Source: Real Capital Analytics

Improvements in pricing are giving rise to higher deal volumes as investors chase yield-generating assets. Anecdotal evidence suggests that commercial property transaction volume remains robust for the current quarter. Commercial real estate investing is popular once again.

Source: Real Capital Analytics (note: the big pop in Q4 of 2012 was tax-related)

On the other hand, the amount of commercial real estate mortgage backed securities (CMBS) outstanding is still declining after peaking in 2008. Total balances are now at the lowest levels in seven years.

Source: SIFMA

Something is off. We know that property purchases are almost always leveraged (very few buy commercial properties with cash - the rental yield is just too low). So who is providing the mortgage financing? In the past many of the large banks would arrange these loans, pool them across multiple properties, and then sell them as CMBS. The securities would be sold in tranches, with cash from mortgage payments following a predetermined "waterfall" (senior tranche would get paid first and so on). It seems that in recent years the use of CMBS as a financing tool has become far less prevalent even as commercial property deal volumes pick up.

Bloomberg: - ... sales of commercial-mortgage backed bonds are falling short of predictions for the best year since 2007: Issuance slumped to $14.6 billion from $20 billion in the same period last year, according to data compiled by Bloomberg. Bank of America Corp. cut its forecast last week for deals tied to single loans, typically backed by the higher-quality properties that insurers target, as sales plunged 66 percent from last year’s record $9.1 billion.

Part of the trend has to do with securitization being out of favor in general. Banks for example can't hold material amounts of CMBS on their books for regulatory reasons but can on the other hand hold a portfolio of real estate loans. It's the same type of risk but the "optics" are different.

Another reason is competition for direct loan assets. Many institutional investors have been getting into direct investing and direct lending. Insurance firms for example often act like bankers these days: competing for rates, arranging loans, charging fees, etc. Except they are funding assets with premiums from insurance sales rather than with deposits. And many of these institutions are so hungry for yield that they undercut banks on pricing. Great for property buyers, bad for the CMBS market.

Bloomberg: - Insurers are offering 10-year loans with interest rates as low as about 4 percent, compared with 4.9 percent on new debt that will be packaged into bonds, according to Alan Todd, a debt analyst at Bank of America. Insurers are increasing those investments because they performed well for them during the credit crisis and its aftermath, Woodwell said.
...
MetLife, the largest U.S. life insurer, has increasingly turned to real estate to bolster profits and support long-term obligations as the Federal Reserve holds interest rates close to zero for more than five years. Last year, MetLife boosted lending for commercial properties 19 percent to a record $11.5 billion, funding loans including $450 million to Shops at Columbus Circle in the Time Warner Center in Manhattan and $500 million against its own New York headquarters at 1095 Avenue of the America.

Even some pensions are moving into direct lending as this "shadow banking" market picks up steam. So if you are looking for a mortgage to fund your commercial property purchase, these days your banker won't necessarily be a bank.

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