2018 could be a banner year for US M&A — and bond investors are nervous


US mergers and acquisitions activity fell off a cliff in 2017. The value of deals this year has been about half what it was in 2015 and 2016, and about a third lower than 2014. Chart from CreditSights:

Some of this was to be expected. We’re told that executives tend to be cautious in the first year of a new administration because they want to get a feel for how regulations and antitrust enforcement might change. (You can’t see that clearly on this chart because 2009 coincided with the cyclical nadir of the US economy and financial markets…) This was likely exacerbated by heightened uncertainty over trade and tax policy.

Barring a few notable exceptions, however, the US government seems to be just as accommodating to the desires of big business as the Obama administration. Analysts at CreditSights think this means the backlog of deals postponed in 2017 will be cleared next year. In addition, the dwindling fear of antitrust may be inspiring deals that might not have been considered before, such as CVS/Aetna and Disney/Fox.

CreditSights looked at some of the biggest potential deals — Bristol-Myers Squibb/Gilead, Qualcomm/Broadcom, something involving Kraft Heinz — and added them up. These 11 deals alone would be worth over $800 billion in value, compared to around $200 billion for the 11 biggest actual deals of 2017:

Assume (unreasonably) that the total value of deals in a given year is a constant function of the 11 largest transactions and you end up thinking there could be about $2.4 trillion in US M&A next year. That would be about the same as the total value of deals in 2015 and 2016 combined.

Pent-up demand would not be a sufficient explanation this huge number, but CreditSights identified two additional reasons to justify it.

First, the combination of corporate tax cuts and the inducements to repatriate funds parked in offshore subsidiaries will increase businesses’ purchasing power. The two biggest potential deals listed in the chart above are in tech and pharma — the two sectors that exploit the tax code’s existing provisions on offshore deferrals most effectively. Companies will probably use most of their tax savings to improve their “shareholder rewards programmes”, but some of that money could find its way into M&A.

(It’s unlikely that lower taxes on profits would do much to boost real investment. Companies spend when their sales are rising and they are coming up against capacity constraints. Consumption in the US remains weak and the investment-heavy sectors remain burdened with a massive overhang of excess capacity, so the outlook for an investment surge would be poor regardless of the tax code.)

Second, there is the flattening yield curve. Normally this is just an effect rather than a cause of anything: the difference between longer-term and shorter-term interest rates reflects market expectations for monetary policy, which in turn can provide clues about an economy’s position in the business cycle. (The slope of the curve may also affect the profitability of financial institutions, although the size of the impact may have shrunk as lenders increasingly hedge their fixed rate exposure or simply lend at floating rates.)

But one CreditSights strategist argued the rise in short-term interest rates up to the level of long-term rates could also influence corporate behaviour. Interest rates are the cost of money. A flat curve just means that money ten years from now costs the same, or close to the same, as money today. In that situation it would be reasonable for executives to be more willing to borrow to do big deals.

Anecdotally, this fits what happened in both the mid-2000s and the late 1990s. The apparent tightening of monetary policy could therefore be considered a cause of increased M&A in those earlier periods, as well as more recently.

Put it all together and more than $2 trillion in deals starts to seem more plausible.

The risk, according to CreditSights, is that this M&A boom will be funded largely with debt, and much of that debt will be issued by companies willing to move down a few notches in ratings as long as they can stay above junk. Several large companies — most notably Kraft Heinz — have shown there may be not be much point in holding onto a high credit rating if that prevents you from gobbling up the competition and inflicting “synergies” on your acquisition targets.

That might not have a macro or financial stability impact, but it could mean that some investment-grade bonds will lose out to the bankers rejoicing at the resurgence in fees.

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