Volatility Is About to Return as Central Banks Taper
Volatility Is About to Return as Central Banks Taper
(Bloomberg View) -- A global cyclical recovery is putting pressure on central banks to accelerate the tapering of quantitative easing. As they do so, look for volatility in three areas where a prolonged period of easy money has resulted in the most blatant misallocation of resources: credit markets, M&A activity and the insurance market.
Start with the credit market. Historically low interest rates have had the unintended consequence of keeping 'zombie' companies afloat, as the OECD and others have noted. But leverage has also increased across the board. According to the Bank of International Settlements, advanced economies now have total debt in excess of 250 percent of their combined GDP, up from around 100 percent at the end of 2007.
Thanks to the monetary environment, corporate credit spreads -- the difference between what governments and corporations have to pay in interest when they borrow -- have remained historically low, encouraging increasingly risky bets from debt holders. Investment company Morningstar summarized it bluntly: "Not only are credit spreads tighter now than in much of the recent past, the average credit quality of the Morningstar Corporate Bond Index is lower than it was much of the time." As the credit market rediscovers its ability to differentiate credit quality, which will be a natural consequence of tighter money, companies with impaired credit will face higher spreads, making more bankruptcies likely.
Among the credit that could be most affected are overleveraged M&A deals. With access to more and cheaper debt, companies across many sectors -- from technology stocks to pharmaceuticals -- have embarked on an M&A spending spree. They have acquired ever-higher valuations, with multiples of enterprise values on Ebitda now similar to those observed just before the financial crisis.
Low interest rates have also tilted the field more toward "growth" than "value" M&A targets, inducing more deals in steadily overpriced infrastructure and technology sectors rather than in traditional corporate restructuring. Higher spreads will not only reduce M&A activity, but it's likely that many of the deals recently concluded will prove value subtracting (though infrastructure will likely benefit from government spending intended to replace monetary stimulus).
Similarly, private equity firms have registered record inflows of yield-hungry investors. They have built up the largest stocks of "dry powder" on record, in excess of half a trillion dollars. The consulting firm BCG notes "an increasingly challenging environment for private equity buyers as they face both record-high target multiples and more competition from cash-rich corporate acquirers." With higher prices paid and more difficult restructuring, private equity investors are bound to face disappointment.
Finally consider the often overlooked yet critical insurance market, struck in 2017 with the largest losses on record, which could well exceed $300 billion, due notably to a particularly virulent hurricane season. That would historically lead to higher premiums, enabling insurers to rebuild their capital reserves while simultaneously allowing for stricter selection of the insured risks. Instead, after a brief period at the end of last year when rates rose (so-called cat bond spreads, which measure the cost of insuring catastrophes, widened), the market quickly returned to historical lows.
Why? Because there was plenty of liquidity to be found. "Reinsurance pricing has moved up in lines and territories most affected by recent losses, but we expect this trend to be relatively short-lived, given the amount of new capital entering the sector," wrote Aon Benfield, a major insurance broker, in its annual report. Continued low premiums have increased the ability of higher-risk buyers to take under-priced insurance, while insurance companies are unable to replenish their reserves, a potentially explosive mix should another round of natural catastrophes occur before finances stabilize.
Wherever you look, the period of easy money and low rates appears to have created "rational exuberance," in some cases reminiscent of the dot-com bubble. The recent bout of volatility was an early indication: As the tapering of QE gathers speed, the most extravagantly funded markets will be the first to be exposed.
This column does not necessarily reflect the opinion of the editorial board or Bloomberg LP and its owners.
Jean-Michel Paul is founder and chief executive of Acheron Capital in London and faculty member at the Solvay Brussels School of Economics and Management.
To contact the editor responsible for this story: Therese Raphael at traphael4@bloomberg.net.
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