Investors appear skeptical about whether AT&T’s $85 billion takeover Time Warner will get antitrust approval.
At $107.50 per share, AT&T’s offer represents a 36% premium over Time Warner’s most recent closing price. However, as of Friday’s close Time Warner shares were trading at just $87.47, an 18% discount to the offer price. Still, merger arbitrage hedge funds want no part of betting on the deal. AT&T is also taking steps to protect itself in case the deal doesn’t get consummated. The $500 million anti-trust breakup fee, which represents 0.59% of the deal’s value, is abnormally low; the average breakup fee for deals greater than $1 billion is 4%. AT&T has been burned by a failed merger before, having been forced to pay Deutsche Telekom $4 billion after antitrust regulators nixed its takeover of T-Mobile USA. The deal is also structured to discourage competing bids, with Time Warner required to pay AT&T $1.73 billion if it accepts a higher offer.
The market thinks Qualcomm’s $47 billion deal to buy NXP Semiconductors is a steal. Last week sources reported the two parties were in final negotiations on a deal valuing NXP between $110-120 per share. The announced deal was for $110 per share, at the low end of the range. As a result, the acquirer, Qualcomm, saw its stock rise nearly 5%, doubling the gains of the seller, NXP. An all-cash offer sweetened the pot.
Resurgent Global Growth Sends Government Bonds Tumbling
Global economic growth is picking up, and as a result we could be witnessing the beginning of a bloodbath for safe-haven bondholders.
To review: investors have been gorging themselves on developed-nation sovereign bonds for the last several years amid expectations for persistent low growth and central bank intervention. As short-term yields in Europe and Japan plunged below zero, buyers were forced to buy long-dated securities to meet actuarial return goals.
Governments, meanwhile, have been more than happy to shore up funding gaps by issuing longer-term debt. Belgium in April sold 100-year bonds, while Austria is said to be exploring the possibility of offering 70-year notes. In fact, worldwide government debt due in 10 years or more has grown by a record $733 billion this year and more than doubled since 2009 to about $6 trillion, according to Bank of America. Effective duration in the global government bond index has this year reached record levels of 8.23, up from 5 in 1997. The U.S., Europe and Japan have all set individual records of 5.9, 7.2 and 8.8 respectively.
Duration risk has swelled to the point that a 1% increase in interest rates – which has happened 10 times during a calendar year in the past four decades – would trigger $2.1 trillion in losses for global bond investors. Ten-year term premium, a metric reflecting the extra compensation investors demand to hold longer-maturity debt in lieu of successive short-term securities, also returned to pre-Brexit highs.
Global growth is still far from stellar, but long-term government bonds became so expensive even the slightest whiff of inflation sends them into a tailspin, which is exactly what happened in October. The Barclays Global Aggregate Bond Index lost 2.5% during the month, its largest decline since September 2014.
The impetus for further bond market losses this week was additional stronger-than-expected economic data in Europe and the United States, which reduced expectations for further monetary policy accommodation.
Britain’s economy showed resilience to Brexit, growing more than expected (0.5% actual vs. 0.3% forecast) in the third quarter, the first reporting period since the referendum. The report pushed 10-year gilt yields briefly above 1.30% to their highest level since late June. The Bank of England (BOE) has been in a tough spot, wanting to support the economy without putting further downward pressure on the pound, which has fallen 17% against the dollar since the referendum. The encouraging GDP print basically eliminated market expectations for further BOE rate cuts through the end of 2017. As we discussed in last week’s SkyBrief, the spread between inflation expectations and gilt yields could portend an even sharper sell-off for British government debt.
German bunds also fell sharply this week to cap off their worst month since 2013 after a report showed consumer prices rising at the fastest annual pace in two years. Yield on 10-year bunds rose 29 basis points in October to finish last week at 0.17%. Bond yields across developed Europe climbed as well.
Perhaps the only silver lining for bondholders is following the recent bond sell-off there are now more securities eligible for the European Central Bank’s (ECB) quantitative easing (QE) program. The ECB was running into a scarcity problem given rules barring it from buying securities yielding less than the deposit rate (-0.4%), causing President Mario Draghi to reportedly discuss tapering the central bank’s asset purchases. However, Draghi now has greater flexibility leading up the end of the current stimulus package next March.
The final blow to bondholders came Friday as the U.S. reported better than expected GDP growth of 2.9% (vs. consensus expectations of 2.5%). U.S. 10-year treasury yields surged six basis points to 1.85% following the report to their highest level since before Brexit. Fed Funds Futures are now pricing in a 73% chance the Fed raises interest rates by year-end, up from a 68% a week ago. This isn’t the first time global bonds have been roiled by expectations of Federal Reserve tightening. Sovereign debt markets plummeted in early summer 2013 when then-Fed Chairman Ben Bernanke suggested the central bank would begin winding down its QE program. The market’s hypersensitive reaction to his comments became known as the “taper tantrum.”
Developed-nation government bonds have traditionally served to protect principal and dampen volatility within a portfolio. However, “safe-haven” debt reached such grossly expensive levels post-Brexit as to become extremely risky. Given the fact global equity multiples are also at the high end of their historical range, they don’t deserve an outsized portion of your asset allocation, either. So where can investors turn for portfolio stability? Allianz chief economic adviser Mohamed El-Erian, among others, recommends an old-fashioned solution: cash.
Exports, Inventory Buildup Drive Better Than Expected U.S. GDP Growth
More on the aforementioned U.S. GDP report: the U.S. economy’s 2.9% growth rate in Q3 was the fastest growth in two years, helping to make up for last quarter’s anemic 1.4% expansion. Economists had expected growth of around 2.5%. Increased exports, especially of soybeans, and inventory buildup, a leading indicator of business sentiment, were largely responsible for the acceleration in economic activity, adding 0.83% and 0.61% to the GDP total, respectively. They made up for a deceleration in consumer spending growth.
The current economic expansion, averaging annual growth of around 2%, remains the weakest on record since World War II. While the Q3 GDP print puts 2016 on track to perhaps slightly exceed that average, it’s likely to fall short of 2015’s 2.6% growth rate. Job gains remain a bright spot during the current recovery, but they have been offset by falling worker productivity, which decreased for the third straight quarter.
Deutsche, Monte dei Paschi Duke It Out for Most Dysfunctional
Global bank earnings continue to exceed expectations, even at the most troubled European financial institutions.
Deutsche Bank posted a surprise profit of $279 million in the third quarter, much better than consensus analyst estimates of a $433 million loss. Like American banks already reporting this season, Deutsche owed the beat to higher trading revenue (as well as cost cuts).
UBS Group profits climbed 11% to $883 million, triggering a modest rally in company shares, while Royal Bank of Scotland handily topped estimates but saw its stock fall. Barclays profits surged 35% also thanks to higher fixed-income trading revenue, triggering the biggest rally the stock had seen since July. Nomura net income rose 31%, owing largely to – you guessed it – higher-than-expected trading income.
For Deutsche Bank, though, better-than-expected earnings were only half the story. Deutsche shares traded sharply lower Tuesday morning after news a recent verdict by a California judge exposed the firm to fresh legal liabilities relating to the sale of mortgage-backed securities. Also likely tempering employee enthusiasm over earnings was news the German bank would seek to pay bonuses in company stock rather than cash. Will Deutsche’s workforce be amenable to such an arrangement? That depends on how much they believe in CEO John Cryan’s defiant defense of the company’s financial position on the post-earnings conference call.
Not to be outdone, Europe’s most-stressed lender, Monte dei Paschi di Siena (MPS), also had an eventful week. MPS shares took a staggering round-trip Monday after CEO Marco Morelli unveiled the latest details of the bank’s recapitalization plan. The stock swung from a gain of around 14% to a loss of roughly 13% within a 20-minute span, not the type of volatility typically reflective of market confidence. MPS announced it was cutting 2,500 jobs in a bid to slash staff costs by 10%, closing 500 of its 2,000 branches, selling additional assets and undertaking a voluntary debt-to-equity swap sure to be met with the greatest demand since Tickle-Me-Elmo. Existing shareholders holding on to hope of an Italian renaissance will be offered additional units, while the company will court potential “cornerstone investors,” including Middle Eastern sovereign wealth funds, to take large new stakes in the bank. The stock settled lower due to skepticism over the viability of the plan, whose numbers rely on aggressive assumptions regarding future growth.
The Bank of England (BOE) isn’t waiting for the other shoe to drop, already seeking details of large U.K. lenders’ exposure to Deutsche and Italian banks.
Uncertain Leadership at BOE Heaps Further Pressure on Pound
Brexiteers continue to shoot themselves in the foot.
While U.K. GDP surprised to the upside in the third quarter, investors are betting the worst is yet to come. Hedging costs for Britain’s FTSE 100 are at their highest since early June as well-respected Bank of England (BOE) Governor Mark Carney dropped subtle hints this week he could walk away from the job.
Two weeks ago British Prime Minister Theresa May criticized the bad side effects of loose monetary policy in a Tory party stump speech. The comments apparently didn’t sit well with Carney, whose steady hand has cushioned the blow of Brexit. May reportedly apologized in private for the “clumsy” remarks, insisting she wants Carney to stay on, but this week signs pointed to him having one foot out the door.
When questioned over the central bank’s long-term policy path, Carney said: “I don’t want to bind … (long pause) … the Bank of England two years’ hence … Like everyone, I have personal circumstances which I have to manage. This is a role that requires total attention, devotion and I intend to give it for as long as I can.”
Carney appeared to stop himself from saying he didn’t want to bind his successor, and his greatest concern is the long-term effect of attacks on the BOE’s independence, which he says have contributed to the pound’s persistent weakness. “If it were to be called into question, one would expect to see a risk premium for U.K. assets … Markets have taken note of the comments,” Carney said. The British currency fell to a fresh 31-year low this week, with Goldman Sachs saying it thinks the pound is still 10% overvalued.
Also contributing to further pound weakness this week was a surprise admission from key Brexit minister Mark Garnier that London banks are likely to lose their passporting rights as part of Britain’s departure from the EU. Passporting rights allow businesses to use their local licenses across the EU. Although European officials have made it clear they will not allow the U.K. to both dictate immigration terms and maintain passporting, it’s the first public acknowledgement of that likely outcome from a U.K. government official. A U.K. regulator estimates there are 5,500 firms with a combined 9 billion pounds of annual revenue who rely on passporting rights.