Corporate Financing Analysis - The Short-Term Attraction Of UK Inbound M&A - 17 APR 2017
With local currency weakness expected to continue in the near term, we note that the window for UK-targeted M&A activity remains wide open in 2017. The rally in announced takeover deals only has a finite amount of time to run, however, and we predict that activity will begin to slow across the course of H217. We highlight longer-term strengthening of the currency, rising inflation due to sterling's continued weakness, and elevated levels of political risk surrounding the UK's withdrawal from the EU now that Article 50 of the Lisbon Treaty has officially been triggered as the catalysts to this trend. However, the recent numbers for announced dealmaking have shown resilience since the UK's decision to leave the EU. Indeed, they appear to show that rather than shying away from the UK, strategic acquirers have instead accelerated their focus on striking deals in the nation to take advantage of cheaper valuations caused by the ongoing weakness of the pound. According to Thomson Reuters data, Britain has been 'open for business' during Q117 with deals valued at a combined USD39.96bn targeting the UK having been announced across the first three months of the year, a decline of just 2.5% y-o-y from the first quarter of 2016 ( see ' Global M&A Rally To Sustain Across 2017 ' , March 29 2017). While stable, we note that UK M&A activity has underperformed dealmaking in the broader European arena, where activity has risen by 16% y-o-y during Q117 to tally a level of USD215.3bn - a tally which makes it the busiest first quarter for deals across the continent since the onset of the global financial crisis.
|Set To Slow Before It Grows|
|UK Real GDP Growth, %|
|f = forecast. Source: BMI|
Sterling: Short-Term Pain, Long-Term Gain
In the aftermath of the UK's Brexit referendum vote, the strength of the pound dropped dramatically, hitting a 31-year low in October 2016. As of the end of the first quarter of 2017, the currency has since recovered some ground but remains down by around 11% against the euro and around 15% against the US dollar.
In our view, the proliferation of M&A activity in the UK is good news for the pound over the longer term. Indeed, our UK analyst believes that depressed valuations will serve to boost the attractiveness of UK assets in the context of a relatively resilient post-Brexit growth outlook (we see real GDP growth coming in at 1.3% in 2017, before contracting to 1.2% next year, but then accelerating again to a rate of 1.3% in 2018). In turn, this will lend further support for the pound through stronger export competitiveness, an increase in the domestic savings rate as import spending declines, and a narrowing current account deficit. In addition, one of the most compelling factors which serves to underpin our view that the pound has bottomed is the unit's historically cheap valuations. In October 2016, the pound's trade weighted index (TWI) held long-term support corresponding to the 1993 and 2008 bottoms at 21% below the 2015 peak and we do not expect it to drop more than this.
The decline in the currency, however, has started to drive up inflation in Britain and increased the risk of interest rate rises, even though funding costs remain relatively low for now and liquidity is high. With ongoing uncertainty surrounding the UK's economic outlook during the upcoming two years of Brexit negotiations and after it exits the EU, we are projecting an increase in UK inflation in 2017 to a level of 2.8% by year-end, compared to 1.0% as of the end of 2016.
The Brexit Risk
In our view, a lot of the bad news for the UK economy surrounding Brexit has already been priced into the pound, with the UK government clearly signalling its willingness to pursue a 'hard' exit. In this context, we continue to believe that the bulk of pound depreciation is now behind us, consequently implying more potential upside than downside stemming from political developments going forward over the next two years (the timeframe for the UK's to leave the EU). However, we caution that a lot of uncertainty remains over the terms of the UK exit and any unexpected political moves may well dent investors' confidence, market trends, or the strength of the currency. One major potential point of uncertainty, which has the capacity to cause both political and economic shockwaves, for example, is the UK's membership of the single market. While the UK government has made no secret of its willingness to leave the EU single market in exchange for full control of the UK's borders, details of this process have yet to be outlined, or put into motion.
While such factors have at most played a minor role in the withdrawal of two major UK based M&A deals this year - namely Anglo-Dutch consumer behemoth Unilever's proposed USD143bn bid for Kraft Heinz, and the London Stock Exchange's attempted tie-up with its German equivalent, the Deutsche Boerse ( see ' LSE-Deutsche Boerse Marriage Is Off ' , April 5 2017) - they have the potential to have a considerable bearing on activity levels going forward, with the risk in this instance stacked to the downside.