International economic forecasts for 1987
1987 - Year of the shrinking market?
The major sovereign, supranational and corporate borrowers will not be taking as much from the international markets next year, a Euromoney research project shows.
The causes: a sluggish rate of economic growth around the world (compounded, in the case of Japan, by deflation) and the expectation that interest rate levels will remain fairly static. Furthermore, the majority of prime corporate names do not need cash, and capital investment is at a low ebb.
But investment bankers do have the resource of ingenuity. There will be a vigorous scramble in 1987 to generate fee-earning business through the development of new markets.
The bankers are also hoping that the fashion for corporate restructuring in its various forms will continue.
In dozens of interviews with the major users of the international markets--detailed reports on these borrowers begin on page 44 --Euromoney heard the same story. Among European companies, borrowing requirements next year will be relatively small, for example.
"Faced with the prospect of low economic growth, companies tend to work with what they have rather than invest in capital stock,' said Anthony Thomas, economist at Kleinwort Benson.
David Kern, chief economist at National Westminster, said: "UK companies are at present very profitable. They can expand from their own cash flows.'
In Spain, Javier Monzon, Telefonica's deputy general manager of finance, foresaw his company generating 70% of its funding requirements for 1987 internally.
And Jean Michel Tomas, economist at Barclays in Paris, added: "There is a lot of cash around; everyone is looking for new investments.'
US corporations have been heavy debt sellers in international markets during 1986. Nicholas Sargen, a senior analyst with Salomon Brothers, estimated that, for 1986, net private foreign debt investment in US corporate instruments will total something like $50 billion, with around $40 billion of that bought in the Euromarkets. That figure is up markedly from the 1985 total of around $45 billion, and it helps offset the fall in overseas investor purchases of US Treasury bonds; down to $15 billion from the 1984 peak of $24 billion. Sargen added that the 1986 figures would show a more dramatic increase in the volume of foreign purchases of US corporate equities--up from $5 billion to roughly $20 billion.
But the pace of new issue activity by US debt raisers is slowing. "From the investment demand side, I see reasons why the rate of issuance should slow from the record highs we've reached,' Sargen said, "We've reached the point where yields are down dramatically and spreads between dollar and non-dollar securities are at their lowest.'
Because foreign investors have less incentive to buy the dollar, the amount of US corporate debt sold overseas may remain static at the 1986 level, Sargen estimated. The bulk of that will still be raised in the Eurobond market, where swaps, above all else, enhance the market's flexibility.
Only the Japanese might change this prospect. Always hungry for yield, Japanese institutional investors might lower their investment criteria in order to improve portfolio performance. This would mean a new international appetite for issues rated Aminus or even below. Any decline in the Tokyo stock market would propel Japanese funds into overseas stock markets.
Meanwhile the refinancing boom is virtually over. There are few borrowers which still have dollar debt sold five or six years ago with high coupons.
US corporates now have a somewhat tarnished image with international debt buyers. Almost a third of Standard and Poor's rating changes over the past year have been related to M&A activity, and most changes have been downwards. "US corporate industrials now have a greater credit risk than they used to,' said Gail Hessol, a senior vice president at Standard and Poor's in New York.
In Europe, debt is not much used to finance acquisitions. Equity funding is traditionally considered the most appropriate for what, after all, is equity risk, and the junk bond market remains the preserve of Manhattan. But Nicholas Aylwin, of PaineWebber International in London, suggested: "There is a new type of acquirer developing in the European market who feels more comfortable with debt.'
By financing its attempted acquisition of Allied Lyons with a debt package, Elders IXL may have raised a new signpost for the aggressive bidder.
"In the United States, acquisitions are often driven by purely financial, as opposed to industrial and commercial motives,' Aylwin added. "This is a trend which has also begun to develop over here.'
David Reed, head of corporate finance at County NatWest Investment Bank, declared: "Banks have got to be more proactive than reactive. In that context we've got to do more dealmaking and put ourselves at risk.' Corporate restructuring is the crucial area for Reed, who saw the City of London's Big Bang eroding the prejudice against managers making money. "We are determined to achieve one or two major leveraged buyouts, US-style, on the scale of hundreds of millions of pounds next year,' said Reed.
The tendency of US corporates to leverage themselves, and make more money through borrowing more money, may catch on in Europe. "The UK clearers have become more aggressive in lending to leveraged companies,' said John Fordham, the director in charge of M&A at Hill Samuel. "And as a community we'll be doing more business with more adventurous people than we'd have considered doing two years ago. It's the only way of keeping market share.'
Fordham predicted the use of more internationally placed equity, or equity hybrids such as convertible Eurobonds, to facilitate M&A business. But initial bank loan financing will still be needed. "We see sustained activity on the takeover market,' Fordham added. "There has been a tail-off in the number of mega-deals being done, partly because of the strength of defensive strategies being used, but it will only take a couple of major transactions to get the market moving forward again.'
In the UK there is no shortage of takeover candidates: Pilkington, Hawker Siddeley, Grand Metropolitan, and Pearson are names the analysts mention.
M&A specialists are also concentrating on the Scandinavian countries, and on France, where they believe the climate is becoming conducive to their business. But the specialists agree that, if the stock exchanges flag, so will M&A.
International bankers have for some time been resigned to competing for market share, rather than participating in a larger market. The great hope is that, if borrowers' funding requirements fall in 1987, financial engineering will interest corporations more.
John Hepburn, head of European coverage at Morgan Stanley International in London, suggested that competitive pressures would accentuate the advantages for companies of a low cost of capital, and generate a demand for financial innovations of all types.
Morgan Stanley International's M&A team has grown from three to 19 in six months. "The decision to buy dictates the need for financing,' said Hepburn. "More block trades, vendor placings and international equity deals.' The cross-border acquisition requires not just funding, but a range of other investment banking products, designed, for example, to protect the buyer against interest rate and currency exposure.
US investment banks are building up their M&A divisions in Europe, and hope to add to the volume of business. At PaineWebber, Aylwin said: "M&A client loyalties can be won over by creative and persistent marketing. Most British and other European companies welcome innovative ideas from whatever investment banking source.'
One good reason for the push into Europe is that corporate restructuring activity in the United States is levelling off. Up to the third quarter of 1986, total corporate restructuring in the US (corporate repos, mergers and acquisitions, divestitures and leveraged buyouts) totalled $206 billion. The total for 1985 was $235 billion. Wall Street's insider dealing scandals may affect next year's M&A business.
The new US tax laws which take effect from January 1 1987 will also alter M&A activity by limiting tax breaks. Ira Shapiro, a tax accountant with Price Waterhouse in Washington, explained:
"Tax policy does not drive mergers and acquisitions activity, but it has a big influcence in some cases on the economics of the transaction and its structure, so some of the changes in tax reform will have an impact.'
Capital gains tax is rising from 20 to 28%, and M&A professionals expect to see higher prices to cover that tax, as well as a revision that limits write-offs. Also, because of the higher capital gains tax on individual shareholders, there may be a trend towards the equity transaction as a way to pay for a target company.
Hostile deals will be more difficult, because companies and shareholders face bigger tax liabilities.
The US banks, because they lack the long-established client relationships of their European competitors, will have to work hard at stimulating the market, in order to generate financings. Companies are usually far more conservative about their choice of house for equity deals than they are about their choice for debt financings. But this may change; Fisons, the UK pharmaceuticals company, chose Morgan Stanley International to lead-manage its convertible Eurobond issue earlier this year. Like Elders', that deal was M&A-related.
The decline of the dollar in 1986 has left a number of US corporations looking like cheap buys, especially to the Japanese, who have an added incentive. If they have production plants inside the US, they need not worry about protectionist measures.
The US tax reforms may enhance the attactiveness of US acquisitions. "I see more demand for American companies as the most important implication of tax reform,' said Robert Metz, an analyst with Oppenheimer. "Now the US has the lowest tax rate effective anywhere in the world. I look to foreign companies to allocate more capital here. That should help the dollar to stabilise, and it could last for years.'
Michael Quinn, a managing director at Merrill Lynch in New York, suggested that the focus might switch to a new market for taxable municipal bonds (the tax-free municipal market having been curtailed to the reform) with foreign currency Yankee bonds and commodity indexed bonds also becoming important over the coming year. Merrill Lynch also suggested that asset-backed financings might grow to account for some 20% of the domestic US market in 1987. It's an opinion shared by Laurence Fink, managing director in charge of First Boston's mortgage and asset-based securities.
"The Ginnie Mae 9s have $100 to 200 billion outstanding,' remarked Fink. "We estimate that turnover in the market is $10 to 15 billion a day. It's a far more liquid long-term market than Treasuries.'
Fink pointed to other asset-based securities. First Boston has already set up a subsidiary to trade securitised car loans. "So far the market for other asset-based securities is small,' Fink said. "Only about $4 billion have been issued. But over the next couple of years I expect that to grow to $25 billion.' Along with car loans, credit cards will provide most of the raw material.
But the great hope of investment banking is the rise of the corporate treasurer. "Corporates may not be raising as much new money,' said David Lough, head of County NatWest Investment Bank's capital markets division. "But they are more involved in active management of existing liabilities and rate risk management; in identifying the main risks to their profit and loss account.'
Japanese corporations, with their present passion for zaiteku (financial engineering), are probably setting a worldwide fashion.
In its lengthy study of zaiteku, "Further Relaxation of Financial Conditions and Structural Changes in Corporate Finance', the Bank of Japan said that the funds available to Japanese corporations last year amounted to 29 trillion ($180 billion) and that only 12% of this was being invested in plant and equipment. The remaining 88% was going to zaiteku.
If the Japanese have been more extreme in their reaction than the industrialists of other countries, it may be because deflation has hit them harder.
Nothing like it has happened to them since the Second World War. To find their currency so strong that their exports are undersold everywhere by those of poorer countries, to find their imports (including oil) so cheap that all prices are going down (88.3% of what they were in 1980) and, then, even as they sack their workers, to discover that they are enormously rich-- these are unsettling experiences.
Some of the money can be used to pay outstanding debt. Mitsui repaid 300 billion ($1.9 billion) in nine months, ending in September 1986. The interest rate was only 5%, but Mitsui regarded this as "quite heavy' because the general fall in prices made the real rate higher.
Some money goes to assets inside Japan. The BoJ report pointed out that, while the retail price index is falling, the prices of equities and land continue to rise. It concluded that this is connected with corporate investment.
But there is not enough land in Japan, or enough equities, for so much investment. Zaiteku has to be worldwide. The BoJ pointed out the benefits of zaiteku, in keeping the export-oriented industries alive through the depression caused by the yen's excessive strength. However, it predicted that these industries would not be able to survive a further rise of the yen to March 1987.
Already some petrochemical companies are matching their capital expenditure to the price of naphtha, now at one third of its peak. "It is necessary to curb capital spending to the same extent as the fall in selling prices of products devalued by deflation,' said the spokesman of a petrochemical company.
If this idea catches on in the rest of the world, there will be very little scope for bank lending. Just how little becomes evident in our detailed reports in the following pages.