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Monday November 13, 2006 - 12:20:47 GMT
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Economics Weekly: Robust economic growth in 2007 to boost UK mergers and acquisitions

Economics Weekly 13 November 2006

Robust economic growth in 2007 to boost UK mergers and

Faster economic growth and buoyant liquidity will boost mergers and acquisition activity in 2007
Economic growth in the UK has been estimated at 2.8% in the 12 months to Q3 2006 - this compares with growth of just 1.9% during 2005 as a whole. A buoyant world economy, a stronger housing market, positive real earnings growth, rising employment and relatively low short and long term interest rates seem to be the main factors that account for the pick up in UK economic activity. Our 2007 UK outlook is for a continuation of this economic performance, with manufacturing output boosting growth and helping to rebalance the economy away from its reliance on consumer and government spending. With companies sitting on around £70bn of cash and equity markets and bond markets still buoyant, how will the economic recovery impact on mergers and acquisitions activity in 2007?

UK mergers and acquisitions are already rising strongly
We think that higher short term interest rates are unlikely to dent the boom in mergers and acquisitions that is currently underway, both in the UK and globally. Table 1 shows that the number of companies acquired in the UK by UK companies last year was 769, well up from 430 in 2002. UK firms bought 365 companies overseas last year and 242 companies in the UK were purchased by firms from abroad. This makes a total of 1,376 company acquisitions involving the UK last year. Our estimate suggests that this figure will be matched or surpassed this year, and in 2007. It is worth noting that this total figure of 1,376 acquisitions last year was last beaten in 1998, ahead of the peak in the stock market boom in 1999. Table 2 shows that in value terms the picture is similar, with £25bn spent by UK firms in 2005 and an estimated £30bn this year. We expect over £40bn to be spent in the UK next year. The pattern has changed for inflows involving UK firms and foreign firms in terms of value, however, with an outflow from the UK of £33bn last year set against the inflow of £50bn. Clearly, this implies that the UK is a magnet for foreign investment at present. The total of £108bn last year and estimated £143bn this year is the highest since 2000. Chart a shows the number and value of these transactions. Chart b shows that the activity in the UK is increasingly in cash, perhaps reflecting the large cash holding of UK companies. But with equity markets now rising, perhaps 2007 will see a greater share of this category. Fixed interest funding remains low, as shown in the chart. Chart c and d show that the UK buys more companies in the EU than anywhere else in the world and that the EU reciprocates, overtaking US firms last year for the first time since 2002.

What is boosting this activity?
Even though short term interest rates are rising long term interest rates are still low, so overall debt financing for companies is still relatively cheap. Indeed, the rate of UK economic growth that we are expecting next year, in particular the contribution from growth in the manufacturing sector and in- creased investment spending, could lead to even stronger activity in the acquisitions market than this year. Moreover, broad money growth in the UK was up by 14.5% in the year to September 2006, a 16 year high, suggesting there is plenty of liquidity around in the economy. In addition and as mentioned above, UK companies cash reserves are standing at around $70bn, nearly 6% of the value of annual output of the economy and the highest surplus on record. Interestingly, takeovers have been one of the key factors driving up UK and European equity markets in 2006, and the high level of liquidity available to companies is not just a UK phenomena but a European and global one as well. With stronger equity markets, finance becomes even cheaper and acquisitions even more attractive for companies. With so much cash around, it is not surprising that a large proportion of the take-overs in the UK have been in cash, see chart b. Finally, with UK company investment spending projected to rise by 4% next year, some of that investment is likely to involve mergers and acquisitions as well as spending on new plant and machinery.

With very narrow spreads between corporate bonds and risk free cash - government bonds - there is cheap finance available for acquisitions. However, as chart b shows, companies are not issuing fixed income debt to fund acquisitions, preferring cash and equity finance instead. Of course, all good things must come to an end and this boom cannot continue unabated forever, but over view is that it can continue for at least the next fifteen months. And we look for 2007 to be even more buoyant than 2006, as equity markets rise and UK economic growth accelerates.
Trevor Williams, Chief Economist

Commentary on economic data in the week

Key inflation data will add to the debate about the likely direction of interest rates in the major economies

• Focus this week returns to inflation data in the UK, the US and the eurozone. UK and US inflation in October may have accelerated, whereas final eurozone inflation could be revised downward.

• Following last week’s 0.25% rise in UK interest rates to 5%, financial markets may be disappointed if clear indication of another 0.25% increase to 5.25% is absent from the Bank of England’s quarterly Inflation Report published Wednesday.

• The dust should settle following last week’s victory for the democrats in the US mid-term elections, but over the coming months, concerns of policy deadlock could negatively affect the dollar.

• Despite growing speculation that Japanese policy makers are gearing up to increasing interest rates, we expect rates to be left on hold at 0.25% at the Bank of Japan’s policy making meeting on Thursday.

Financial markets disliked the Bank of England’s neutral tone regarding the future direction of interest rates in its policy statement after raising rates on Thursday, but sterling mostly stayed above the key $1.90 level and was heading towards $1.92 at the end of the week, as the dollar weakened. The question has to be whether the two increases in base rates so far will cool the economy sufficiently to bring inflation back down to the 2% target or below over the 2 years of the forecast horizon. The quarterly Inflation Report published Wednesday may help clarify whether or not the market is correct in pricing this into sterling futures contracts, while this week’s data has the potential to re-assert concern over inflation expectations. On Monday, October producer price data could show a continuation of the decline in raw-material input prices, but factory gate prices may have increased in the month. In addition, the key core producer output price inflation, excluding food, drink and tobacco could accelerate to 2.1% in October from 2% in September. Tuesday’s publication of October CPI is expected to show a faster rise in all measures of inflation; the RPI index will be closely watched for indications of upward pressure on forthcoming wage negotiations. The UK labour market report on Wednesday could show that average 3-month earnings rose by 4.2% in September, well below the 4.5% rate judged critical by the MPC, but sharply rising RPI could be increasing the risk that this threshold could be breached next year. Retail sales, published on Thursday, may have stayed at the same level in October as in September, similar to the BRC like-for-like sales, which were just a touch higher in the month. Given the very weak CBI distributive trades’ survey in October, the risk to retail sales may be on the downside.

There is a mixed bag of US data publications scheduled for this week; Tuesday and Thursday are particularly heavy days for data releases. On Tuesday, headline producer prices may be weak, but on Thursday, consumer prices could be strong, to rise to 2.2% on the year compared with 2.1% in September. Also on Tuesday, retail sales for October could weaken by 0.5%, although excluding autos sales may have grown 0.2% in the month. Industrial production in October, published Thursday, may have strengthened, while capacity utilisation is expected to remain high, at around 82%. The Empire manufacturing survey and the Philadelphia Fed surveys could surprise on the upside this week, while housing market statistics published Friday should confirm extended weakness in this sector of the economy.

Hawkish comments by ECB members have increased the probability of a 25bp increase in interest rates to 3.5% next month. This week’s data include the Q3 GDP result , published Tuesday, which could show growth of 2.5%, only a touch down from 2.7% in Q2 and final October CPI, which could ease off a touch to 1.6% from 1.7% in the earlier release.
Lloyds TSB Bank,
Financial Markets
Faryners House,
25 Monument,
London EC3R 8BQ
0207 283 - 1000

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