Perspectives

Snakes and ladders: the outlook for corporate treasury in 2017

Published: Sep 2016

Old style board game of snakes and ladders

What will be the big issues for corporate treasurers in the year ahead? We examine a number of key economic, regulatory and market trends and consider how each of these might influence treasurers’ decisions around raising finance, risk management and short-term investments in the future.

Christine Lagarde, the IMF’s Managing Director, rather succinctly summed up the economic predicament we now find ourselves in during a speech earlier this year in Germany. “The good news,” she told the audience, “is that the recovery continues; we have growth; we are not in a crisis. The not-so-good news is that the recovery remains slow, too fragile, and risks to its durability are increasing.”

Some of those risks alluded to by Lagarde certainly became manifest over the summer of 2016. Economic sentiment, which had been on a moderate upward trend earlier in the year, ground to a halt in nearly all regions as concerns over the UK’s vote to leave the European Union (EU) and the slowdown in Asia weighed on international markets. Overall, confidence in the global economic outlook is now at its lowest level in three years, according to an August 2016 survey by the Munich-based Ifo Institute.

One small comfort to corporate treasurers as they begin planning for 2017 might be that not every economist believes the cloudy post-Brexit economic outlook will necessarily prove long-lasting. The US economy, still the world’s largest in nominal terms, continues to grow steadily. Concerns that the US might be nearing a downturn have now abated after a string of positive economic data. “Before the good job numbers came out I was quite worried about the outlook for the global economy,” Mike Bell, Global Market Strategist at J.P. Morgan, tells Treasury Today. “Profits were weak, and typically when there’s weak profit growth companies will look to cut back on hiring. But with the numbers we saw in June, it looks like the US economy is still in a relatively healthy condition. That gives me a lot of confidence that – in the short term – the global economy is not going to be in too bad shape.”

Over the other side of the Atlantic, the consensus is that the UK vote to leave the EU should not derail the Eurozone’s economic recovery. Indeed, it would appear that the slow economic recovery has at least weathered the initial shock of the Brexit vote, with recent data showing business activity reaching its highest level in seven months. “It is likely to shave up to half a percent off European GDP, which will take growth down to about 1.3%,” says Bell. “That’s pretty weak, but it’s not a recession.”

But the Brexit negotiations will certainly be headwind for the EU economy in the years ahead, even if the near-term and medium-term macroeconomic impacts are largely contained. The UK is the EU’s single largest export market in goods, if we treat the UK as if it were already outside the union. Any post-Brexit downturn in the UK will inevitably have consequences for the EU and UK economic outlook, therefore. But Bell believes the business impact will not be as severe as some commentators fear. “Our view is that the uncertainty around Brexit is going to hit the UK economy quite hard, and that in turn will affect European growth via the trade channel,” says Bell. “It doesn’t necessarily play too bad for large cap corporates however. If you look at the FTSE 100, many of those companies earn a majority of their revenues outside of the UK, and they could even benefit if we see sterling fall further.”

Of course, the revenues those companies are earning outside of the UK might come under pressure too. Brexit has brought a fresh spell of economic turmoil about, not only in Europe, but throughout the world. China, where a downturn raises the prospect of much weaker growth across the world, is no exception. The Shanghai Stock Exchange Composite Index fell and the Chinese yuan depreciated against the US dollar in the immediate aftermath of the UK referendum result. But while Brexit certainly presents an additional headwind for an economy already slowing down, treasurers will be relieved to hear that Bell believes the gloom around the prospects for China has been overdone somewhat.

The Chinese economy, he says, has stabilised in 2016. If anything, growth and other economic figures have actually surprised on the upside. “That is the result of the stimulus: the government is spending to support the economy and that, combined with interest rate cuts, has helped to stabilise the economy,” says Bell. “But since that stimulus is likely to be pulled back slightly now, China GDP may be a bit weaker over the next few months. Nevertheless, the growth we expect to see – around 6% – is nowhere near the scare scenarios some would have you believe.”

Lower for longer

That the global economy appears to still be recovering at a steady pace does not mean markets are expecting any imminent changes in monetary policy. With the fragility of the recovery and the risks to its durability that Lagarde spoke of, it would appear unlikely the world’s central banks will opt to take a radically new course in the immediate future.

In the US, the benign price pressures that have allowed the Federal Reserve to postpone a further rate rise all year remain unchanged. In July, the Consumer Price Index came in at 0.8% on a non-seasonally adjusted basis, still some way off the level that would precipitate a further rate rise from the Fed. However, Bell’s view is that inflation could pick up sufficiently in the fourth quarter to put a rate hike by the end of the year on the cards, albeit a very cautious rise. “We think inflation is going to start to pick up, almost on a national basis. So long as the dollar doesn’t strengthen dramatically, then the fact that the oil price is up from its $28 should translate into higher inflation. At that point, if the labour market is still looking healthy, then the Fed starts to run out of excuses.”

Chart 1: US inflation rate

Chart 1: US inflation rate

Source: www.tradingeconomics.com | US Bureau of Labor Statistics

Elsewhere, however, ‘lower for longer’ seems likely. Following its historic decision in August 2016 to lower rates to 0.25%, the Bank of England (BoE) is expected to cut interest rates again this year. Alongside the first interest rate cut in seven years, the BoE also unveiled a package of other stimulus measures, including restarting its quantitative easing programme to buy government and corporate debt. Policymakers at the central bank have signalled that this could be just the beginning. “If the economy proves to have turned down in line with the initial survey signals, I believe that more easing is likely to be required, but that can easily be delivered in the coming months,” Ian McCafferty, an external member of the BoE’s Monetary Policy Committee wrote in an Op-Ed for The Times newspaper in August 2016.

The BoE’s decision to cut UK interest rates to a record low has put the European Central Bank (ECB) under pressure to follow suit with more monetary easing of its own. Yet many economists are of the view that the ECB has much monetary policy firepower left to bring inflation back to its target level. Although ECB President Mario Draghi has hinted that the bank is ready to ease policy again if needed, the consensus that emerged from a recent Reuters poll of economists is that the negative policy rate will remain unchanged until the end of 2017. Only a handful of the economists surveyed said they were expecting a further cut into negative territory. However, the central bank is widely expected to extend its monthly asset purchases programme beyond its original termination date of March 2017.

Financing outlook

Given that it is likely to be a very long time before we see interest rates approaching anywhere near the pre-crisis levels, financing conditions for most corporates – especially investment-grade – should remain fairly benign over the course of the medium term at least.

That is perhaps just as well when one considers the size of the maturity wall coming further down the line. In the US, a record $947bn of high-yield debt is scheduled to mature in the next five years, a recent report by Moody’s estimates. Of that total, $400bn is set to come due in 2020 alone, the highest amount of rated debt to ever mature in a single year in the history of the credit markets. The telecommunications, technology and media sectors are currently carrying the heaviest debt burdens. However, the recent collapse in oil prices has damaged the refinancing prospects of companies across the energy sector, especially upstream exploration and production companies. Energy-related issuers in the Baa3 band – just one notch above junk – are of particular concern to the ratings agency, and are said to have around $34bn in debt maturing in the next five years.

European borrowers are facing their own enormous maturity wall. There is currently €345bn worth of European leveraged loans and high-yield bonds up for refinancing between now and 2022. Although much has been made of previous maturity walls which have subsequently been overcome through amend and extend, some market experts believe that is unlikely to happen this time around given the volatility we are seeing in the market. “We still expect some borrowers may end up requiring a more fundamental restructuring given the level of leverage, which has been perpetuated by the benign credit conditions of the last few years,” PwC wrote in a recent research note.

Diverging monetary policy could make the ‘reverse Yankee’ – a US company issuing euro-denominated debt – yet more attractive for companies that require financing. American companies have already flocked to Europe’s bond markets to borrow at rock bottom rates, and with the ECB now engaged in the purchase of corporate bonds, pulling down costs even more, others may yet join them. A stronger dollar does add, of course, some cost to converting euros back to dollars. But companies with significant euro denominated cash flows have a natural hedge against such unfavourable exchange rate movements. No wonder, then, that foreign companies have been the biggest issuers of euro-denominated corporate bonds, with a 21.3% share, according to data from Dealogic.

Corporate bond issuance is also surging in sterling following the BoE’s recent stimulus package. Since the stimulus was unveiled, sterling corporate bond yields have fallen to a record low of 2.06%, according to Bank of America Merrill Lynch indices. This has led to a flurry of companies – including the likes of Vodafone, BP and BMW – to issue in the currency given the reduction we have seen in the sterling premium over euro-denominated investment grade corporate credit since the EU referendum.

Foreign exchange outlook

Currency strategists drawing up their predictions of the year ahead largely agree on some broad themes – the US dollar will get stronger, emerging market currencies will – despite recent gains – remain fragile, and the sterling exchange rate will continue to be very volatile as the Brexit negotiations proceed.

On the latter, Sam Hewson, MD and Northern Europe Head of Corporate FX sales at CitiFX, notes that amid all the current macroeconomic and political uncertainty, a top priority for corporates will be mitigating the impact of sterling volatility on the predictability of their cash flows. Switching hedging instruments used for sterling exposures might be helpful in that respect.

“We have seen an increasing use of options,” Hewson says. “There is a lot of uncertainty around the future trade deal that the UK is going to negotiate with the EU. That is going to have implications for a lot of corporates cash flows from an export and import perspective. So you are going to have some degree of uncertainty of cash flow and, if you have uncertainty of cash flows, then forwards become less favourable as a hedging tool. Treasurers could end up in a situation – as per 2008 – when they are having to unwind forwards at significant cost against a cash flow that never occurred.”

Hewson says options strategies might also be useful for hedgers at risk of exhausting their maximum available credit lines with their banks as exposures increase. “Options don’t require any credit,” he says. “So for treasurers who are having challenges from a credit line perspective, options are a way they can continue their hedging. We have definitely seen more of that.”

Chart 2: EUR/USD and GBP/USD implied volatility

Chart 2: EUR/USD and GBP/USD implied volatility

Source: Citi

Although CitiFX was engaged in many discussions with clients in the run up to the referendum, FX activity on the actual day of the vote was rather muted. Many treasurers proactively moved settlements so that they would not be executing in an illiquid market close to the date of the referendum. But while that proved a very effective strategy for some, more fundamental changes may need to be made given that market conditions are expected to remain challenging for the foreseeable future.

“We are talking to our clients about their hedge ratios and asking them to consider whether their risk management policies are fit for purpose in this volatile environment,” Hewson adds. “Liquidity is low right now, so we are also encouraging treasurers to look at their execution methodologies. We regularly have these types of discussions with clients, but they have been brought to the fore more since the referendum, given the magnitude of the move we saw.”

Investment outlook

Industry experts believe that conditions in liquidity markets will remain challenged in the year ahead, for both regulatory and market reasons. In the US, reforms to Rule 2a-7, approved in 2014, mean that come October 2016 prime institutional MMFs must abandon the practice of fixing share prices to $1 and move to a variable net asset value (VNAV) model, be subject to liquidity gates and redemption fees at the Board’s discretion. Government funds, meanwhile, will be able to continue using a stable net asset value (CNAV) model.

With the new rules due to take effect in October, there has been much speculation on the small matter of whether corporate treasurers – many of whom prefer CNAV MMFs – will opt to abandon prime MMFs in favour of government CNAV MMFs. That is not a baseless claim. Indeed, all the latest survey data, together with what we are already seeing in the market, suggests many treasurers are planning – and indeed doing – exactly that.

A majority of the finance professionals (62%) recently surveyed in the AFP 2016 Liquidity Survey, for instance, said they are anticipating their organisations to make significant changes in their approach to investing as a result of the new rules, with nearly half (47%) expecting their companies to discontinue or reduce holdings in prime funds. The exodus appears to already be underway. In June Moody’s observed signs of a spike in outflows from MMFs driven, it says, by investors “voting with their feet”. It is a trend that they expect to continue between now and the October deadline for funds to comply with the new SEC rules.

But Bob Stark, Vice President of Strategy at treasury software providers Kyriba is not convinced that this shift away from prime to government funds will be especially long-lived. Stark points out that the two most commonly cited priorities for institutional investors in MMFs – security and liquidity – should not be materially affected by the new rules. Although prime MMFs will henceforth be subject to redemption fees and liquidity gates he thinks it is doubtful that we will ever see these implemented.

“Many fund providers argue that gates temporarily halting fund redemptions would not have been required in 2008,” he says. “If there was a time in recent history that one would expect to see such behaviour it would have been during the onset of the credit crisis.”

The security element of the value proposition for prime MMFs will not be diminished as a result of the reforms. Actually, we could see the opposite. “The composition of prime funds won’t suddenly become riskier on 15th October than the days leading up to it,” he says. “In fact, an argument could be made that fund companies may choose even more conservative underlying assets to smooth the movement of the fund’s net asset value.”

Uncertainties around Brexit and the lack of comparable investment alternatives have kept investors in money market funds. Lower investor confidence and higher risk aversion could cause corporate investments to be postponed, leading to inflows into low-risk, highly liquid assets such as MMFs.

Vanessa Robert, Senior Credit Officer, Moody’s

Though the EU began drafting its new rules at broadly the same time as the SEC, procedural differences between the two regulators has meant that progress in Europe has been less expedient than in the US. In June 2016, the Council of the EU agreed its position on MMF regulation, building upon both the original proposal of European Commission (EC), and the position of the European Parliament (EP). This latest text retained some notable aspects of the EP’s position. The text proposes that CNAV MMFs can continue to operate only by investing in public debt or – as proposed by the EP – by converting to a new, still hypothetical product, called a low volatility (LVNAV) MMF. Whereas the EP’s text included a five-year ‘sunset clause’ for LVNAV MMFs, the Council instead proposed an open-ended review of the product within five years. Also in accordance with the EP, the Council chose not to back the EC’s widely criticised proposal of a 3% capital buffer for CNAV MMFs.

The other tectonic force affecting the MMF industry in Europe at the moment is the rate environment. Accommodative monetary policies pursued by central banks – not least the ECB – have pushed down yields on the short-term debt instruments that MMFs purchase, making it increasingly difficult for fund managers to generate positive returns for their investors. With no directional change in policy at the ECB appearing to be on the cards in the near future, and still more central banks like the BoE now believed to be considering following suit, it would seem that negative yields are here to stay.

The risk of large redemptions by corporate treasurers unwilling to stomach ‘paying’ a fund to hold their assets would appear to be minimal though. “Uncertainties around Brexit and the lack of comparable investment alternatives have kept investors in money market funds,” says Vanessa Robert, Senior Credit Officer at Moody’s. “Lower investor confidence and higher risk aversion could cause corporate investments to be postponed, leading to inflows into low-risk, highly liquid assets such as MMFs.”

More of the same?

Many corporate finance departments are likely to continue to be challenged by the rapidly evolving macroeconomic climate in the year ahead. Beyond the reaction to the Fed’s expected rate decision later this year, there are a host of external developments that will continue to shape the world that treasurers have to operate in over the coming years.

While corporate treasurers can draw some comfort from the fact that the recovery is continuing, they should also be wary of the fact that it remains, as the IMF’s Christine Lagarde highlighted in her speech, in an extremely ‘fragile’ condition. Lagarde spoke that day of how the “risks to [the recovery’s] durability are increasing” and, indeed, since then we have seen just how vulnerable the economic outlook currently is to political shocks such as the Brexit vote.

For corporate treasurers, that most probably means they can expect more of the same in terms of an ultra-low to negative interest rate environment. On the one hand, then, the favourable borrowing conditions treasurers have enjoyed through the post-crisis years will continue. But on the other, a difficult short-term investment climate characterised by a dearth of yield will also persist. “For every snake, there is a ladder,” as Salman Rushdie once wrote, and “for every ladder, a snake.”

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