The global corporate sector is entering 2019 on the heels of episodic turbulence in 2018 and with mixed signals for the year ahead. On the one hand, current corporate and macroeconomic fundamentals remain sound, with continued GDP growth, low unemployment, and healthy corporate balance sheets. On the other hand, some financial market indicators, such as a flat U.S. yield curve, higher equity volatility, and rising credit spreads, point to increasing risks. Rising U.S. interest rates may also continue to exert upward pressure on the dollar with increasing risks for emerging markets. Against this backdrop, we see equity markets rewarding firms for maintaining financial flexibility.
As GDP growth momentum slows and becomes less balanced across the globe, developing a robust growth strategy becomes a key priority for companies in all sectors. We find that investors historically preferred organic growth, evidenced by higher shareholder returns for firms that mainly grew organically. However, companies will need to use acquisitions to overcome a lack of organic growth opportunities; those that have historically done so performed noticeably better than those who abstained from large acquisitions despite lagging growth.
On a positive note, firms are entering 2019 with significant capital deployment firepower. A large share of the firepower is held by a handful of technology titans, who have expanded aggressively and successfully beyond their sector boundaries. These titans now account for an unprecedented share of total equity market value and growth expectations. In 2019, the pressure on companies across wide swaths of the global economy to effectively fight these titans will only intensify. Those companies most at risk will need to use their firepower judiciously to defend their competitive positions.
As firms evaluate transformative M&A, they must pay attention to growing execution risks. Regulatory headwinds, along with valuation disagreements and activist pressures, have impacted the M&A environment in recent years, resulting in an increase in withdrawn deals. Nonetheless, failed attempts at large acquisitions were not penalized by investors. Hence, management and boards should focus on managing the risks surrounding large transactions rather than delaying their strategic plans.
A strong M&A market in 2018, U.S. tax reform, shareholder activism, and increased appetite from private equity will likely drive divestiture and LBO activity in 2019. Proactive and tax-efficient pruning that improves the rate of return on capital is particularly rewarded by investors. LBO activity in 2019 will increasingly focus on larger, whole-company buyouts, driven by a shift towards more focused firms and market volatility potentially slowing the pace of M&A. The larger deal size may give rise to more consortium deals, expanding the universe of buyout candidates and requiring the participation of new partners to traditional private equity.
Activism will likely continue its role in corporate boardrooms in 2019, following a strong year of campaign activity in 2018. Public campaigns are, however, only part of the story since investors of all kinds now engage more actively with their portfolio companies. Therefore, the challenge for executives and directors in 2019 is to proactively mitigate the broader risk of investor discontent before it gives rise to a disruptive campaign. This approach should involve enhanced investor relations, analytics to better understand and anticipate investor sentiment and behavior, as well as active cultivation of a supportive long-term investor base.
Mounting trade-related tensions will remain a key risk in 2019. Earnings estimates have already been significantly lowered for both U.S. companies with exposure to China and Chinese firms with exposure to the U.S. These trade tensions should prompt a re-evaluation of global supply chains and production locations. They also merit revisiting risk management policies, as policy uncertainty may continue to spill into the broader macroeconomic environment. Trade tensions and slowing growth present a particular challenge in emerging markets, but these markets still offer attractive long-term growth prospects, especially when taking into account currently depressed equity valuations.
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