Improving economic fundamentals in the U.S. will likely provide a catalyst for the Fed to unwind its balance sheet and increase rates. As in previous tightening cycles, we expect a gradual increase in rates and a flatter yield curve. Corporate fundamentals are becoming more important drivers of equity valuations as the Fed unwinds its balance sheet, gradually removing the support global equity markets have enjoyed in recent years. Equity valuations today are also driven more by growth prospects than at any time since the global financial crisis.
Investors’ greater focus on growth, strong corporate fundamentals, and low funding costs will encourage the pursuit of M&A. Global M&A volumes reached $3.7 trillion in 2017 and acquisition multiples hit all-time highs. Although often justified by the target’s higher growth prospects, high acquisition multiples are nonetheless being challenged by activists. We expect activist interference in M&A to be a recurring theme in 2018. Activists will continue to influence highly strategic decisions involving M&A, break-ups, and management and board control. In many instances, executives and directors are being questioned, and often replaced.
U.S. tax reform will require companies across the globe to rethink their M&A, capital allocation, and financial policies. Repatriated foreign cash will provide flexibility for M&A, and changes to the taxation of U.S. companies’ foreign earnings could help U.S. corporations compete for foreign assets. A lower tax rate will make asset sales significantly more attractive for sellers while also raising the returns for some financial sponsors. For cash-rich U.S. multinationals, tax reform could trigger a wave of share repurchases. Moreover, immediate expensing of capital expenditures could spur an increase in new investments.
Firms must proactively react to technological disruption with both organic and inorganic investments, as the pace of change will continue to accelerate in 2018. Corporates will, therefore, need to revisit capital allocation, both to position for faster growth and to enhance returns on capital. Preserving incremental capacity for funding capital investments and acquisitions may prove more rewarding going forward, especially since the market response to shareholder distributions is noticeably smaller today.
As capital gravitates from active to passive management, corporates and investors should pay close attention to the impact on price discovery, trading liquidity, and market valuations. We find that high levels of passive ownership may lead valuations to deviate further from fundamental value. Firms in 2018 must understand passive shareholders’ investment objectives, anticipate their response to strategic transactions and activist campaigns, and adjust their shareholder communication strategy accordingly.
Proactively managing cyber risk is becoming a key imperative. As many companies have recently experienced first-hand, security breaches often result in severe financial consequences. Firms need to re-examine their cybersecurity investment priorities and establish an incident response plan to tackle this growing risk.
Simpler hedge accounting rules will facilitate more corporate hedging activity in 2018. These new rules can lower earnings volatility both by eliminating mark-to-market noise and by encouraging firms to increase their hedging activities. In light of hedging-friendly accounting rules and the positive valuation impact associated with lower earnings volatility, a reassessment of various market risks is warranted in 2018.