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Global economic expansion could be starting to slow down despite major M&A activity

Global activity (M&A, leveraged buyouts, and other corporate actions) announced in the first quarter totalled $923bn – almost 38 per cent more than in the comparable period in 2005.

Deal volumes, increasing for some time, have only recently turned into visible drivers of sector returns. Recent equity market price movements indicate some signs of a momentum market that is increasingly focused on merger-induced returns.

Recent corporate buyout activity has been broadly-based, including proposed takeovers among European utilities – Endesa of Spain by E.ON of Germany, and Gaz de France by Suez, a French counterpart, while in Germany’s pharmaceutical industry, Merck KGaA launched a hostile bid for rival Schering. This was followed by a friendly offer from Bayer. These three deals were among the top five announced in the first quarter – the latter illustrating an emerging feature of M&A in Europe – bidding wars.

In the telecommunications sector, Vodafone Group announced the sell-off of its phone business in Japan to Softbank. We are aware that substantial corporate liquidity globally could lead to the enhanced risk of overpaying for acquisition assets and we have continued to monitor this issue very closely.

Europe has seen the most M&A activity. In Europe, cross-border deals have been the strongest in six years, enough to cause a backlash of political protectionism. Corporations, however, have been opportunistically positioning themselves for the next leg of global competition.

The timing seems appropriate. Balance sheets are in the best shape in years, and profits and cashflow have risen significantly. Since 2003, profits are up 120 per cent for companies in France’s CAC-40 index and 130 per cent for those in Germany’s Dax index. Free cashflow yield – a company’s free cashflow per share divided by its share price – is at a record high in the eurozone. This explains why many deals have been structured with cash as the main or sole component.

Global economic expansion is maturing but the timing of a slowing or retrenchment in growth is elusive. Robust growth could continue to be underpinned by high levels of liquidity, productivity gains, a solid labour market, and strong (albeit slower) corporate profit growth. But, the negative effect of rising rates, expensive energy and other raw materials on corporate profitability and a cooling in the US housing market and consumer spending could presage a global slowdown.

Corporate profitability and levels of cashflow are at historically high levels but pressures on costs are becoming more visible.

M&A is likely to continue but we may be nearing a high point in corporate activity. Sectors such as industrials and utilities, where speculation has been intense, already command valuations that discount much of the potential upside from takeover activity and balance sheet recapitalisation. There is a surplus of both corporate and investor liquidity searching for a home and multiples have been bid up in many sectors to a point where even highly leveraged buyouts and the ensuing tax benefits are becoming hard to justify.

Because of unattractive valuations, we are wary of stocks and sectors with a defensive bent. Many of these companies are in mature businesses with relatively stable cashflow that are appealing to debt-financed predatory players. By contrast, media, telecom, and healthcare – also less cyclical – are areas where we have been identifying stocks that look undervalued on a long-term basis. But from our bottom-up perspective, rising input prices such as energy, raw materials and labour may eventually squeeze companies’ profitability.

Many manufacturers and retailers today are not fully able to pass on increasing costs through volume gains or output prices, which suggests strongly that the current high profitability enjoyed by corporations is set to wane. We are concerned about the risks of relying on profitability that is at all-time highs. We will continue to pick stocks that are less exposed to rising cost pressures and whose valuations are very supportive, even if profits were to retreat.

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