Bloomberg Television talks to Jan Hatzius, chief economist at Goldman Sachs and Gregg Lemkau, co-head of global M&A at Goldman Sachs at the Goldman Sachs Leveraged Finance Conference in Rancho Palos Verdes, CA.
Jan Hatzius discusses the risks associated with the Federal Reserve overshooting full employment, why he’s not worried about a U.S. recession, and corporate America’s constructive view of the U.S. economy.
- “I’m not very worried about a recession. I think the risk of recession — if I look at the indicators that seem to predict recessions the best –“
- “I think high yield spreads are obviously things that you want to monitor because you want to know what the market is saying, but I think, when I look at the risk of recession, I look at things like credit growth, where you are relative to full employment, and while we’re approaching it, I don’t think we’ve overshot it yet.”
Gregg Lemkau calls M&A pipeline for rest of year “good.”
Michael Mauboussin: Here’s what active managers can do
- Lemkau says regulatory headwinds affecting big deals
“…and we’ve seen real regulatory headwinds, so the government has been a lot more active blocking transactions for both anti-trust and then for tax reasons, and I think in particular, as a risk to the largest transactions, that’s what’s chilled activity to a degree.”
- Biggest M&A concern is risk of antitrust
“If the deal is going to happen, everything’s great, and I think what we’re seeing now in a world where the anti-trust bodies are a lot more stringent on transactions is companies that are thinking about a deal where there might be a risk of anti-trust not approving it are going to think twice or think three times before they go out and do it, and I think that’s really what’s chilled some of the activity on a big, big scale.”
- Seeing “massive” pickup in China outbound deals, with most of them “interloping” other deals
“So we’ve seen a massive pickup in outbound M&A from China, so 26 percent of volumes –“
- Says volatility affects CEO confidence for deals
“…the one great qualitative factor that drives M&A is CEO confidence, and it’s hard to measure… even though the markets have recovered, I think the anxiety at the CEO level and in the board rooms is still there and they’re a little bit more cautious about going out and taking on some kind of external growth via M&A than they would have been a year ago”
Jan Hatzius: I’m Not Very Worried About a Recession
Goldman’s Gregg Lemkau on Mergers and Acquisitions
Jan Hatzius Transcript:
Alix Steel, Bloomberg Anchor: Jan, great to see you. I want to get to your overall take on the economy, but first, I want to get to the data that we saw today. I mean, we got (ph) umish last week, retail sales holding up pretty well, core CPI also rose. At what point does it become harder for the Fed to not hike rates if this data keeps coming in positive?
Jan Hatzius, Chief Economist, Goldman Sachs: I mean I do think it’s supportive of most of what we see, not everything. Empire yesterday was on the softer side but generally it’s supportive of the idea that we will see some rate hikes this year and we are getting that story from the Fed, people like Williams. But also, if you look at what Fed president Dudley said on Monday last week, it’s certainly supportive of the idea that we will get some hikes. At what point they come? I think that’s still a little more uncertain. June seems less likely now but I do think we’ll see some hikes.
Alix Steel: But at some point, the data dependent — when the data actually comes in better, means they should be hiking, to some extent. Do you think data dependent is real or it’s just lip service?
Jan Hatzius: No, I think it is real, and I do think that markets underestimating their willingness to follow through on what they say now. I mean, if you are approaching full employment, and I think we’ll be at full employment sometime late this year, you’re approaching it with an average of 200,000 jobs per month being created, more than twice the long-term trend. I think you will want to see a little bit of a slowdown in that, in the direction of 100,000, so that you don’t overshoot full employment by too much, because it’s risky. It’s risky to overshoot full employment and then have to ultimately bring the unemployment rate up and achieve a soft landing from below. That’s very difficult to do, historically.
Alix Steel: And you recently downgraded your rate hike forecast to two this year, but it was almost kicking and screaming, like you really didn’t want to do it.
Jan Hatzius: Well, we didn’t want to do it because we — I think the fundamental case for them to normalize is still pretty strong. At the same time, we forecast what we think is the most likely case and June has gone to a less likely case. Partly because the data had been a little weaker, including the last (inaudible) report, partly because some of the Fed commentary has become a little more non-committal about the immanent case for rate hikes and partly also because, if you look at market pricing, the hurdle for them to basically generate pricing that’s consistent with the hikes is pretty high now. So what I mean by that is that we’ve never had a hike that was priced as low in the bond market, 30 days ahead, as this one. So that makes it a little less likely.
Alix Steel: The market’s really behind the curve in that sense. We’ve also seen the yield curve really flatten here. When you look at that, at any point, are you worried about a recession?
Jan Hatzius: I’m not very worried about a recession. I think the risk of recession — if I look at the indicators that seem to predict recessions the best —
Alix Steel: So yield curve is not one of them?
Jan Hatzius: I think the yield curve is a financial indicator that’s obviously important. I think high yield spreads are obviously things that you want to monitor because you want to know what the market is saying, but I think, when I look at the risk of recession, I look at things like credit growth, where you are relative to full employment, and while we’re approaching it, I don’t think we’ve overshot it yet. If we had already overshot full employment by a significant amount, I’d be a lot more concerned because again, it is very difficult to achieve a soft landing from below. There’s never been an increase in the unemployment rate of more than a third of a percentage point that wasn’t associated with a recession. So if that was the case, I’d be more concerned, but right now, the indicators to me just don’t look that concerning.
Alix Steel: Which kind of brings me to what David Solomon had (inaudible) here at Goldman Sachs was just telling me, that on one had, you have investors who are still relatively cautious, but on the corporate side, CEO’s seem relatively constructive. They don’t think growth is going down the tubes. They feel OK. Do you feel like you’re seeing this push and pull as well?
Jan Hatzius: Yes, I can probably relate a little more to the message from the corporate side. I think if I look at the real economy and I look at the prospects for the real economy, I feel a little more optimistic than much of what I hear from investors, which is of course also reflective in the pricing of it, at least some assets. Maybe not so much equities or even credit after the rally that we’ve seen, but certainly if you look at where the yield curve is priced, how little normalization of monetary policy is discounted, that’s very striking.
Alix Steel: Because it does seem like investors assume that Fed chair Yellen will overshoot inflation over the two percent target in order to really stoke some kind of growth, but you don’t really agree with that thesis?
Jan Hatzius: Well, I don’t disagree with the idea that you can have some overshooting. I do think it’s a symmetric inflation target, and so that means you should expect to be above it as much as you are below it, so I do agree with that. What I don’t agree with is the idea that they are going to engineer a deliberate overshooting and I certainly don’t agree with the idea that if inflation were to overshoot two percent, I’m talking about core PCE here, that they would just sit on their hands and not normalize policy. I think that they’d tolerate an increase. They wouldn’t go ballistic with rate hikes if you overshot two percent, but I think they still would want to take that into account and raise the funds rate a little more than they otherwise would have done.
Alix Steel: And the market’s not getting that? At some point, I mean, the market’s being too pessimistic.
Jan Hatzius: Yes, there’s a combination, I think, of the market thinking that an overshoot is very unlikely, and the market’s saying that, if you did get an overshoot, the Fed might not respond. I think it’s probably more the former, that many people in the market just don’t think you really can get an overshoot. To be clear, we’re not forecasting an overshoot. Our forecast is one which core PCE inflation gradually returns to two percent but doesn’t really go above. But of course, a forecast is a forecast, and reality could be that you go above.
Alix Steel: OK, Jan, good to see you. Thank you very much. A much more measured look on the economy from Jan Hatzius.
Gregg Lemkau Transcript:
Alix Steel, Bloomberg Anchor: Gregg, good to see you. Last time you were on Bloomberg in November, you saw a pretty robust 2015 M&A pipeline. That was true, and then first quarter 2016 really fall off a cliff. What’s your pipeline now?
Gregg Lemkau, Co-head Of Global M&A, Goldman Sachs: So the pipeline continues to be strong. So the M&A environment is quite good, although it’s down somewhat from the 2015 record levels. We’ve seen about $1 trillion of activity announced year to date, which is down 20 percent from this same period last year, which probably understates the drop off. If you look at the average weekly announced volume for last year versus this year, it’s down more like 35 percent, and the real difference is just the lack of very big transactions. The deals over $10 billion were about half the same level we were at the same point in time last year.
Alix Steel: So what does your pipeline look for the rest of the year?
Gregg Lemkau: The pipeline is good. I think it still doesn’t have as many big deals as we did this time last year, but the flows are quite strong, and I think we’ll see good activity in the back half of the year, and it’s really across all sectors that the healthcare sector continues to be active, the pharma-biotech trade, we saw another one earlier this week will continue. We’ve seen a lot of pickup in activity in consumer, and then a real pickup in activity across the technology sector, so I think we’re bullish about the pipeline. It’s really the lack of the mega transactions that embodied the pickup last year that we haven’t seen as much.
Alix Steel: And what do you make of that? Why?
Gregg Lemkau: I think it’s a couple of factors. The fundamental drivers of the activity last year still are there, which is limited organic growth opportunities for the biggest companies, and lots of available capital at cheap rates. So they can go out and drive growth, top line and bottom line, via M&A quite easily. So that still persists, which gives us reasons for hope. I think the challenge, there’s greater headwinds in 2016 than we saw last year. There’s not the same positive shareholder receptivity towards deals that we saw last year. That’s abated somewhat and reverted to historical means, and we’ve seen real regulatory headwinds, so the government has been a lot more active blocking transactions for both anti-trust and then for tax reasons, and I think in particular, as a risk to the largest transactions, that’s what’s chilled activity to a degree.
Alix Steel: So let’s distill those two. So starting off with jus the big leverage buyout deals, at what point do you think that will come back into the market?
Gregg Lemkau: I think it has to come back, and I would say it probably comes back in the second half of this year. There’s so much private equity dry powder on the sidelines that needs to get put to work, and so it’s at massive record levels, and there’s also additional sources of capital from sovereign wealth funds to big pension funds to big insurance funds, all desperate to put to work. The capital markets are quite available. There’s some limitation in terms of the amount of leverage you can get and it’s hard to make the math work for big leverage buyouts with limitations on the amount of leverage and the multiples we see today. Having said that, I think there may have to be a reversion of returns required by private equity because they’re going to need to put this capital to work, and so I think we see that coming up sometime in the back half of this year.
Alix Steel: Do you feel like there’s a trigger for that, or it’s literally just the clock counting down for PE where their clients say, guys, show me something?
Gregg Lemkau: Well, there’s two elements. One is they’re going to put the money to work. Traditionally, you either invest the money or you return it and I think they’re more likely to invest it and get paid fees and drive returns for their investors than to return it, and the second thing has been the leverage finance market to a degree, so when we started the year, there was a big backlog on the balance sheets of the investment banks, of leverage finance commitments from last year that had to be sold down for this year. A lot of that has come through. (ph) Dell’s in the middle of the market, and I think as you see a lot of those commitments come off the balance sheets of banks, you’ll see new commitments get written and that should be what spurs a big pickup in private equity activity.
Alix Steel: So then in terms of the regulatory issue, it seems like tax inversions was the way to help sell M&A for so many years. Take that off the table now, what is it?
Gregg Lemkau: So it’s interesting. So the tax inversion, I’d say it got a lot of headlines and some of the biggest transactions, or attempted transactions were tax inversions, but it was actually only about five percent of volumes. It was big — so in terms of overall activity for 2014 and 2015, five percent of it was driven by tax inversions. So I think with that off the table, you’ll see a drop off to a degree, but it wasn’t the biggest driver of activity. I think what the bigger challenge is, some of the anti-trust regulations that have gone out and stopped some of the transactions.
Alix Steel: Right, like Halliburton/Baker Hughes, for example. How many more of those kind of deals do you think are going to blow up?
Gregg Lemkau: So that’s the real challenge. I think you’ve got a very active government right now and the biggest concern for companies and boards when you enter into a transaction, Baker Hughes/Halliburton is a great example, the deal was announced in 2014, so that was out there for almost 18 months before they had resolution, and to be in limbo for that long a period of time, two companies who can’t really make their own independent strategic decisions, that’s a long time if the deal isn’t going to happen. If the deal is going to happen, everything’s great, and I think what we’re seeing now in a world where the anti-trust bodies are a lot more stringent on transactions is companies that are thinking about a deal where there might be a risk of anti-trust not approving it are going to think twice or think three times before they go out and do it, and I think that’s really what’s chilled some of the activity on a big, big scale.
Alix Steel: All right, so does that mean we see sort of more asset sales and sort of one off versus the big leverage buyout, billions of dollar merger, in part due to the regulatory overhang?
Gregg Lemkau: I think so, and I think that’s really what’s chilled some of the activity to date. I think — it’s interesting. Companies are still having the discussion. So if we look at the pipeline, the companies are still thinking, what are the big transactions? How can we either pull out cost and drive bottom line growth or how can we diversify ourselves to drive top line growth? But as they look at doing it with the regulatory environment, I would say in a different environment, they’d probably say, you know what, why don’t we just wait? Let’s let this administration move on and get to the next administration, see if things are better. In this current political environment, I think people are even more anxious about what comes next, and so people are actually willing to think about doing things even if there’s some regulatory risk in this environment.
Alix Steel: Ah, so now rather than later, because really, who knows what’s going to happen in 2017?
Gregg Lemkau: Really, who knows?
Alix Steel: Interesting. Part of the — dealing with the tax inversions was U.S. companies basically buying European targets. Do you see that dying then?
Gregg Lemkau: No, I don’t think so. I think ultimately, the tax inversion was probably a little bit of fuel to the fire of transaction that made strategic sense, so there weren’t many of them that were done solely for tax reasons. I think the tax benefits and the synergy allowed these deals to be a lot more accretive and allowed there to be more flexibility in terms of how you could pay a premium and get a transaction done. So I think with that out of the system, it just makes it harder for the math to work on a lot of these deals, but I think the strategic rationale of combining a lot of these companies will still make sense and if they can make the math work, they’ll continue to try to do them.
Alix Steel: And the other sort of region that you’re really looking at is China. You’re actually headed to China today. What’s the trend there?
Gregg Lemkau: So we’ve seen a massive pickup in outbound M&A from China, so 26 percent of volumes —
Alix Steel: So Chinese companies looking elsewhere to buy —
Gregg Lemkau: Chinese companies buying into Europe, buying into the U.S., buying anywhere outside of China. And it feels like, to us, that it is centrally driven. It looks like a mission from the top to say, let’s diversify capital outside of China into different countries and let’s take advantage while we have it with a relatively attractive currency and start to buy things, and so almost a quarter of volumes in the global M&A market have been Chinese companies buying companies outside of China, which if you went back four or five years would be less than ten percent. So it’s a meaningful pickup, and it’s fascinating, if you look at the actual nature of the activity, more than half of the big deals have been interloping on other announced transactions or buying assets that were about to be sold that they’ve come in, and as you think about these Chinese companies who are relatively new to M&A, I think what they’re doing is they’re saying, all right, here’s something that’s actual. I know it’s for sale because they’ve announced the transaction with somebody else. I know what the price is, so all I have to do is pay a slightly higher price, and I know that someone has come along and done due diligence on the asset, so it must be clean, and it’s interesting, they’re really targeting those deals.
Alix Steel: But I feel like sometimes what we’ve heard is they come in, they announce a better deal after another deal was already announced, and they pull out like a week later.
Gregg Lemkau: There was a high profile situation where that did take place, and I think a lot of these companies are still learning how to do M&A, and one of the reasons I’m heading over to China today, we’re going to sit down with over 100 clients over the next three days in Beijing with our internal team to talk about, how do you do outbound M&A? How do you make sure your financing is in place? How do you make sure you’re going to get the regulatory approvals that you need? And have you transacted with Western companies that are going to be generally a little bit more skeptical on your ability to get a transaction done given the track record?
Alix Steel: So we’ve got regulatory, anti-trust, we’ve also got concerns in the leverage market. What about market volatility? How is that impacting CEO’s M&A decisions?
Gregg Lemkau: I think it impacts confidence to a degree, and the one great qualitative factor that drives M&A is CEO confidence, and it’s hard to measure, but when we started this year with the great momentum coming in to the end of last year, the markets were really choppy early, and from the first month or probably the first six weeks of the year, it was choppy out there, and companies were anxious, and even though the markets have recovered, I think the anxiety at the CEO level and in the board rooms is still there and they’re a little bit more cautious about going out and taking on some kind of external growth via M&A than they would have been a year ago.
Alix Steel: Gregg, such a pleasure to talk to you. Thank you very much. Great perspective. That’s Gregg Lemkau, Co-Head of M&A here at Goldman Sachs.