A pickup in merger and acquisition activity, higher oil prices and changes in leadership resulting from shifts in interest rates could unlock new opportunities for active equity managers in 2018.
Merger & acquisition activity could drive performance
Capital deployment has been flat this year due to political uncertainty keeping companies on the sidelines. We believe, however, that the likely passage of some version of tax reform will cause uncertainty to fade and unlock abundant cash to fund consolidation. This could make M&A activity a significant driver of returns in 2018. Corporate cash balances are at historical highs and the potential for repatriation of taxable overseas cash – a scenario that could occur even if broad tax reform fails – represents another $900 billion to $1 trillion in dry powder for deal making. In today’s slow growth economy, buying growth by acquiring competitors and stripping out costs is often a better and quicker option than capital spending geared to organic growth.
M&A activity historically picks up at the end of a market cycle. The last big M&A periods occurred in 1999/2000 and 2007. At eight and a half years into the current bull market, we are at a relatively mature point in the cycle. That is not to say the market won’t move higher from here, but it may require a catalyst that a series of accretive acquisitions could create. Several sectors are well positioned to benefit from consolidation, including health care, where biotechnology stocks offer innovation and growth potential in their pipelines that is attractive to would-be acquirers in the large cap pharmaceutical space. Health care also maintains the highest percentage of foreign earnings among S&P 500 companies that could benefit from repatriation. Valuable assets exist in the energy and media sectors that could jumpstart activity while the potential cash windfall from repatriation could also drive deals in technology.
Normalizing of volatility and dispersion favors active managers
Many investors are concerned about the narrowing of the market. This fear is justified as a market led by only a handful of names usually indicates a top. If the market is being held up by only a select few names, when they finally top, the market can no longer mask the weakness below the surface and the index drops as buying fatigue sets in. Today, the media will focus on the glamour FAANG stocks plus Microsoft and even Tesla. But we aren’t even close to the levels of narrow leadership where we should be concerned. If you look at the largest 10 names of the S&P 500 today compared to the previous two years, breadth has actually widened substantially. In 2015, the largest 10 stocks made up 208% of the market’s return. The number has risen from 2016 levels - year-to-date through September the return contribution of the largest 10 stocks was just 30% of the market’s return - but we are not close to an inflection point from a breadth standpoint.
Market breadth is important because it provides active investors a wider set of opportunities to add value. Active and passive investment styles outperform in cycles, with passive maintaining leadership since the global financial crisis. But a broadening of markets, as well as a normalizing of volatility levels, creates the conditions that favor active management: lower correlations among stocks and a higher dispersion of returns across the market – in other words, more winners and losers.
A major reason why we could see a change in leadership is interest rates. We expect rates to move higher globally as the Fed continues to unwind accommodation and the ECB tapers its bond buying. While quantitative easing acted as a pacifier of volatility, we view quantitative tightening as an accelerant. Firming of inflation, which is expected to hit the Fed’s 2.0% target by the end of 2018, a tighter labor market and stable U.S. growth should also contribute to higher rates. These factors should initially cause higher volatility in fixed income markets and eventually cause volatility to rise among equities. Equity volatility tends to lag changes in the yield curve by 30 months. A steepening of the yield curve over the past several years also portends a period of higher volatility
Trajectory of oil prices signals opportunities in energy
Crude oil prices have rallied over 20% from a mid-June trough but remain in a range between $40 and $60 per barrel. For the last two years, increasing U.S. shale production has offset production cuts by OPEC. But U.S. production began to slow in the third quarter, with rig counts declining for the first time since May 2016. This calls into question the near-term role of the U.S. as the swing producer in global oil markets, ready to open the fracking spigot to overcome shortfalls elsewhere. Services inflation, newer and less efficient workers in the field and a lack of high-yielding new wells to drill will make it more difficult for U.S. producers to quickly fill any supply-demand imbalances. Global demand projections are also picking up, which should be supportive of higher commodity prices. Demand growth hit its highest rate in a decade in 2015 and 2016, according to the Energy Information Administration, and is expected to surpass its long-term trend in 2017 as synchronized global economic growth has taken hold. We also view the threat of electric vehicles to oil demand as overblown and premature. Taken together, we expect the global market will move from an oversupply to an undersupply situation by 2019 or 2020, with the U.S. expected to assume greater production over the long term.
For years, exploration & production companies were rewarded for increasing production regardless of cash flow. Sentiment has shifted from a “growth at any cost” mentality as investors no longer react positively to companies that don’t operate within their means. We are starting to see companies temper growth forecasts, which should be a positive for higher prices and free cash flow. Investors are now recognizing energy stocks that exercise balance sheet discipline and are positioned to do well without relying on oil prices. We favor exploration & production companies that have driven down the cost of extraction by concentrating on high-quality assets in areas like the Permian Basin. Meanwhile, services and equipment providers are gaining pricing power as drillers work through a $300 billion backlog of deferred projects.