A confluence of factors including the Russian-Ukrainian conflict, COVID-19 related supply chain issues and global fiscal stimulus is contributing to high inflation rates in Australia and around the world. In Australia, the trimmed mean gauge of inflation rose to 4.9% in the April-June 2022 period, accelerating from 3.7% in the previous three months. This is far in excess of the RBA’s stated target inflation range of 2 – 3%.
The RBA and central banks across the globe are reacting to elevated inflation levels by raising interest rates to reduce consumer demand and dampen economic activity. At its most recent board meeting in August, the RBA raised the cash rate by a further 50 basis points to 1.85%. It follows similar moves by central banks around the world, including the Fed, BoE and the ECB.
Against this backdrop of increasing inflation and interest rates, Nash Advisory has been ruminating over the following questions:
- What next for inflation levels and interest rates?
- What might the near-term implications be for corporate M&A activity?
- What does this mean for corporate M&A valuations?
What next for inflation levels and interest rates?
The honest answer is that we don’t know (and we don’t think anybody really knows). Where we go from here will depend in large part on:
- Whether currently elevated inflation levels are temporary or structural;
- the extent to which the RBA and other central banks will continue to raise interest rates to bring inflation under control; and
- whether doing so will produce a soft landing or a hard landing for the economy.
Depending on the views adopted by market participants with respect to the above factors, one of two potential near-term economic scenarios will generally be ascribed to:
Scenario 1 – Soft Landing
Current inflation levels are temporary. Supply chain issues will dissipate and minimally impact overall price developments. Interest rates and inflation will soon return to pre-pandemic levels. Companies and investors will continue focusing on capital growth and business expansion.
Scenario 2 – Hard Landing
Inflation stays highly elevated for an extended period. Interest rates rise globally, leading to a severe reduction in aggregate demand. Supply chains remain stretched as production costs continue to rise. Companies and investors will look to focus on capital preservation and cost savings to weather the fall-out.
Only time will tell which of these scenarios ultimately plays out.
What might the near-term implications be for corporate M&A activity?
The good news is that Nash Advisory does not believe that the current economic uncertainty will meaningfully dampen near-term M&A activity. History suggests that during all stages of the economic cycle, there will be companies and investors who consider it to be a good time to buy (or invest), as well as companies and investors who consider it to be a good time to sell (or raise capital).
In fact, the existence of economic uncertainty is the very thing which drives market participants to hold differing views of the future, ultimately enabling buyers and sellers (holding these differing views) to be able to arrive at an agreed position and consummate an M&A transaction.
Nash Advisory is seeing this continuation of robust M&A activity play out in real time, having completed 9 Australian M&A and principal investment transactions in FY22, and remaining actively involved in over 12 live M&A situations at present.
What does this mean for corporate M&A valuations?
In general, rising inflation and interest rates tend to influence corporate M&A valuations in two key (and countervailing) ways:
- Downward impact on M&A valuations from higher cost of debt and equity funding; offset by
- Upward impact on M&A valuations from market participants “buying” growth in a low growth market.
On balance, rising inflation and interest rates will tend to impact valuations negatively; market valuations have fallen by around 10% to date from peak levels in early 2022.
However, this general fall in market valuation levels is by no means universal, with significant variation in valuation outcomes being observed at an industry and company level.