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August 8 2022

Commercial News Round-up: Banks, Bonds and Busts

Industry Insights

Jacob Darcy

Jacob Darcy

Jacob Darcy of Flex Legal smiles warmly, ready to offer you comprehensive commercial update news. Behind him, Time Magazine and the Flex Legal branding is seen.

Welcome to the latest Flex commercial update. A slightly longer read than usual as there’s a lot to cover! I hope you find it useful, remember that as application season and the academic year winds down, keeping your commercial knowledge sharp is a full time job!

Recession on the horizon and the need for restrained optimism

‘The economy isn’t in great shape’, a strong contender for understatement of the year. Writing these updates, I think I’ve said this a lot to you, and it looks like this ubiquitous and fast moving topic is set to remain. Most recently, the conversation around a recession is now taking the form of ‘when’, rather than ‘if’. More and more companies are planning for a recession, so let’s look at the causes, coping strategies, and how the Bank of England might tackle it. The Bank of England has just raised interest rates by 50 basis points. A basis point equals 0.01% and they are used to measure change in financial instruments where the percentage seems small despite the significance of a change. They have also predicted a recession to be declared in Q4 and have gloomily predicted inflation to peak at over 13% later in the year before returning to the 2% target in 2025.

The root causes are fairly straightforward and we’ve discussed a few of them before. The war in Ukraine, the supply chain disruption caused in part by China’s bullish approach to managing Covid, the cost of living crisis, and inflation. They are all linked of course. The war in Ukraine has been particularly impactful on food and fuel prices. The ‘Bread Basket of Europe’ nickname is no misnomer given Ukraine’s previously huge grain and wheat exports, currently sullied by the Russian invasion and quasi-blockade of Ukrainian exports. The standoff with Russia, with their wealth of natural resources, especially gas, has led to rising energy costs for consumers and businesses alike. Consumers have also been impacted by a global supply chain and component crisis, caused by a toxic mixture of labour shortages and varying approaches to containing the Omicron Covid variant. China’s manufacturing has been severely undermined by various lockdowns across cities with spiking Covid rates, causing rising costs throughout the supply chain which in turn is passed on to consumers.

Supply side shocks have damaged consumer confidence, and hard choices are being made by households with stricter budgets. Less disposable income means less purchases, meaning less revenue for businesses, meaning less confidence in jobs, meaning the cycle continues as inflation prices force consumers out.

At this point, you may be thinking back to 2008 and quaking with fear when you consider the economic evisceration it caused. However, whilst a recession is never really good news (unless you’re planning on qualifying into restructuring and insolvency) there are some small comforts that the situation is far from the disaster of the credit crunch.

First, the labour market is healthy in terms of job vacancies. Unemployment is low and job casualties of the current economy are mitigated by the availability of work. The ‘great resignation’ and the rethinking of our relationship between personal and professional lives has put those who sell their labour in a relatively good position.

Second, several sectors are retaining strengths and are becoming more cyclically resilient. We’ve discussed the (often surprising) resilience of M&A in the face of tremendous difficulties. Latest analysis over the first half of 2022 suggests M&A activity emulates levels of 2019, a very strong showing considering the strong performance seen in 2021 and current geopolitical and economic uncertainty. Private equity continues to grow, with 50% of all deal value covered and capital raised reaching $2.3 trillion according to PWC. The housing market has also so far resisted any worrisome slump. These trends though appear to be declining, with investment banking reporting showing a slump in earnings from the world of corporate transactions.

Third, whilst today a looming recession would most likely be inflation driven, 2008 was credit driven. The latter is typically more damaging and takes longer to be absorbed by the economy.

What does all this mean for law firms? Well, first, plenty of advisory work is on the horizon. Clients will need to think about the various ways the downturn will play out, and proactively identify strategies to manage their way through. Restructuring debts, employment models, shedding/acquiring assets, raising funds; these are examples of topics firms will need to cover when thinking of how they will manage the challenging economic difficulties faced today. Second, whilst an upcoming recession is not predicted to be as damaging as previous recessions, casualties are inevitable. This means aforementioned restructuring and insolvency work is likely to grow in demand, and when considering the health of transactional work there is reason to be optimistic. Third, contentious work typically becomes resilient during troubled times. Disputes and investigatory work are hardy to market cycles.

👉 Financial Times: Is the global economy headed for recession?

👉 PWC: Prime time for private markets

Dollar surge creates problems for the US manufacturers and the battle to rein in inflation

When we think of how ‘strong’ or ‘weak’ a currency is, we are often tempted to think of ‘strong’ always being better than ‘weak’. However, the globalisation of trade now means that how ideal a currency’s strength is largely depends on its strength relative to other currencies, particularly with close trading partners.

Recently, the value of the dollar has surged against sterling and euro, and against multiple currencies of key trading partners with the US. What does this mean in practical terms?

Let’s start by thinking about an American buyer wanting to buy a car in the UK. The American buyer will first have to convert their dollars to sterling to buy the car because, simply, dollars can’t be used in the UK. Assuming the price of the car is fixed, a stronger dollar means the American buyer can get more sterling for the same amount of dollars. On a macro level the same logic applies. When a currency appreciates (gets stronger), imports in real terms become cheaper ceteris paribus.

The same is true in reverse. Imagine instead a British buyer looking to buy a car in the US. If the dollar surges, the British buyer has to spend more of his pounds to buy enough dollars to carry out the transaction. As such, US car manufacturers will see a fall in demand from international buyers as the dollar surge prices them out of the automotive market.

The logic of our example is currently in action in the real world. Sales carried out by US firms in different currencies to the dollar decrease in value when converted to dollars, meaning less real term revenue and profits, and increasing costs. International competitors become stronger as imports become cheaper relative to domestic goods.

So why has this happened? Well the simple answer is the Federal Reserve (the central bank of the US, their equivalent to our Bank of England) is hiking interest rates in a bid to cool inflation. Increasing interest rates incentivises banks to move money out of circulation, thereby reducing demand in order to force prices down. The logic of supply and demand tells us that as increased interest rates cause an increased scarcity in the dollar, the price of the dollar goes up.

Similarly in Europe, interest rates being hiked have come as a slight relief to banks selling leveraged financial products in particular. Since 2008, stimulation efforts have led to loans and credit being sold at low (and sometimes negative) interest rates. As interest rates go up at central bank level, retail and commercial banks can in turn charge more to sell leverage. The impact caused by Covid on public finances may though result in calls to levy any surging profits made in the banking sector by increased interest rates.

👉 Financial Times: European banks set to benefit from rising interest rates

👉 Bloomberg: Stocks Swoon as Treasuries Sound Recession Alarm - Markets Wrap

JD Sports sells off Footasylum - CMA shows its teeth

The fashion-conscious readers among you may have been following the standoff between CMA and JD Sports over the latter’s acquisition of Footasylum. JD bought Footasylum in 2019 for £90m, however the two businesses were instructed to operate separately whilst the CMA investigated the merger. Secret meetings between the chair of JD Sports and the chair of Footasylum were recorded in a car park exchanging commercially sensitive information, for which both sides received a multi-million pound fine. JD was forced to sell Footasylum following the CMA’s investigation, in the end selling Footasylum for £37.5 million to a private equity house. 

Remember that competition law is based on the orthodox understanding of free markets. If a single competitor has a large share of the market for particular goods, in this case sportswear and sports shoes, they can use their market share to become resistant to market forces. Monopolistic (where one dominates) and oligopolistic (where multiple larger firms dominate) markets tend to mean higher prices for consumers owing to high barriers to entry for challenger firms. M&A activity that may undermine competition will be leapt upon by affected competition authorities, and given the wide scope of powers such authorities tend to have it’s often the case that competition teams seek to build positive relationships with them. Often, when a merger is due to take place that may be of interest to the CMA, lawyers will issue a merger notification. S.96 of the Enterprise Act 2002 sets out the statutory framework for the issuance of such notifications if you want to delve deeper.

👉 The Guardian: JD Sports and Footasylum fined almost £5m for breaching CMA order

👉 Drapers: Painful fallout from JD Sports’ Footasylum saga

Bond market feels the effect of inflation

The bond market is suffering the effects of counter-inflationary measures, creating headaches for investors, fund managers, and yes… also the lawyers. 

Before we go further, let’s clarify what a bond is. A bond is a bit like an IOU with interest. It is a financial product used to raise capital. Say for example the government wants to build a new bridge, the outward expense and duration of such a project means a significant amount of capital needs to be sunk into the project with the benefits a long way into the future. Such benefits, though low in risk, being a long way off creates a headache for funding. The government will ask the bond buyer to lend them X, the government intends to repay X in say five years. The buyer, in exchange for lending the government the money, receives interest payments (usually twice a year) until the agreed date in which the government pays the buyer back X. 

So how does inflation come into this? Well a healthy bond market needs liquidity, liquidity of course meaning the availability of cash. The increased interest rates in many central banks, especially the Federal Reserve and more recently the Bank of England, have aimed to reduce liquidity in a bid to slow down inflation. By contrast, when governments around the world attempted to kick the economy into action in the wake of Covid, the lowering of interest rates created high levels of liquidity and therefore boosted the bond market. The antagonistic relationship with bonds and central interest rates is useful to understand if you’re interested in corporate finance or even personal finance, owing to bonds being more predictable and less volatile in value relative to other investments such as stocks.

A bond’s price changes daily according to supply and demand, and remember that whilst in our simple example the bond buyer waited to maturity, bondholders may wish to sell on their bond. An increased interest rate makes the bond less valuable, as new bonds will be issued with the higher interest rate, meaning that the value of the bond agreed with lower interest rates loses value owing to the increased supply of higher value bonds. This is why the bond market is in disarray now, as the increased interest rates to fight inflation are causing pre-existing bonds to diminish in value and therefore cause a reduction in demand in the bond market. There is now greater incentive for bond holders to stop selling until interest rates decrease, which is not likely until the next year as inflation is yet to peak.

👉 Bloomberg: Chaos in Bond Market Is Dangerous Side Effect of Inflation Fight

👉 Investopedia: Bonds

👉 City AM: Record £300bn wiped off UK bonds and gilts as investors flee in biggest market collapse in decades

That’s all for this round-up! Remember to have a broad array of sources for your commercial news. A little bit a day keeps you up to date and ready to smash your commercial awareness!       

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