Monster Deals, Big Questions

A surge in M&A can be a sign the economy is sputtering.

Photographer: Gallery Stock

On Nov. 23, when drugmaking giants Pfizer and Allergan agreed to combine, in a deal worth $183.7 billion, 2015 gained the distinction of becoming a record year for mergers and acquisitions. The Big Pharma deal, by far the year’s largest, pushed 2015 past the $3.4 trillion mark in global M&A value set in 2007, just before the financial crisis. That beat the previous record, set in 2000, which also came right before the economy fell into recession, pulled down by the dot-com collapse.

A flurry of corporate dealmaking is “a classic late-cycle development,” says David Rosenberg, chief economist at Gluskin Sheff, a Toronto money manager. “When companies embark on peak M&A activity, it is more often than not coinciding with a peak in the stock market and, dare I say, a peak in the business cycle. Companies are telling us they can no longer grow organically.” The dollar value of deals in 2015 through Dec. 21 was $3.8 trillion.

During six and a half years of expansion, the U.S. economy has averaged only 2.2 percent annual growth. With interest rates near zero and corporate balance sheets flush with cash, the easiest way for executives to boost share prices has often been to increase dividends and buy back stock.

That strategy worked to a degree. Even with lackluster economic growth, the stock market has almost tripled since its March 2009 low. Yet corporate profits peaked in the summer of 2014. With consumer demand still weak around the world, sales growth remains elusive. Rather than trying to generate revenue themselves, companies have been buying growth instead, acquiring rivals at an unprecedented pace.

The near-term impact of a merger boom tends to be negative for the economy, Rosenberg says. The watchwords of corporate M&A—cost-cutting and synergies—usually translate into people losing jobs. “The idea is to take capacity out of the system and generate better returns for shareholders,” he says. “I don’t think I’ve ever seen a merger that didn’t involve job losses.”

Judging the longer-term impact of all these deals is trickier. Some will invariably turn out to be mistakes. “In a world where borrowing money is virtually free, you’re probably doing more of these deals than you should,” says Jim Paulsen, chief investment strategist at Wells Capital Management.

But a surplus of deals doesn’t mean a recession is lurking nearby. Given how bizarre this recovery has been—almost seven years of weak growth despite record-low interest rates—“I’m not sure the same lessons apply this time around,” Paulsen says.

For one, the current flood of deals is more U.S.-centric than previous ones. So far this year, mergers and acquisitions made by U.S. companies have accounted for almost $2 trillion in deals, more than half the global total. European targets made up the smallest share of global acquisitions in 17 years, 21 percent, or only $785 billion. That gives many corporate watchers confidence that M&A isn’t overheating, because it’s mostly focused on the world’s strongest economy.

This year’s rush is also noteworthy for the number of transactions valued at more than $10 billion, says Russell Thomson, who leads Deloitte & Touche’s U.S. M&A practice. By his calculation, it’s about double the number of high-priced mergers during the previous peaks of the past 15 years. “That is quite staggering,” says Thomson, who points out that this year’s crop is more evenly spread across the various parts of the economy, “instead of being concentrated in one or two industries.”

Earlier recessions were preceded by ever-riskier dealmaking in single industries. Such focus led to financial imbalances as too much money poured into one part of the economy. Think of the dot-com bubble that burst in 2000 or the 2008 crisis that devastated households, homebuilders, and banks. This time the lack of dealmaking focused on one industry lowers the chance of a recession. The average expansion since World War II has lasted less than five years. Joseph LaVorgna, chief U.S. economist at Deutsche Bank Securities, rejects the idea that recoveries “die of old age. They die of imbalances, and right now I’m not seeing a lot of imbalances.”

Every recession is different, but they all tend to have the same main ingredient: inflation. Despite an abnormally long recovery and rates near zero, inflation is very low. So is growth. The average forecast among economists surveyed by Bloomberg is for the U.S. economy to expand 2.5 percent in 2016. That makes LaVorgna nervous: “I’m more worried over the inability to generate decent economic growth than I am over what this M&A boom is signaling.”

From a corporate standpoint, with so much cash flooding the system, acquisitions have become less risky given most companies’ lower cost of capital, says Stephen Morrissette, who teaches M&A strategy at the University of Chicago Booth School of Business. “You really have to overpay for something, for a deal not to end up adding value.”

Rather than a warning of weaker growth, some economists see the record M&A activity as the opposite. “I think it’s a sign of strength in the U.S.,” says Torsten Slok, chief international economist at Deutsche Bank. “Corporate America’s appetite for risk is finally beginning to thaw. Even if activity slows down next year, I think we are still two or three years away from a recession,” he says. Allen Sinai, chief global economist of Decision Economics, agrees. “If anything, this is a sign of maturation. It’s as if this recovery is just reaching puberty. Chronologically, it’s old, but functionally, it’s still very young.”

The bottom line: An M&A wave can signal an economic downturn, but this record-breaking cycle may not follow the script.

Raising the Bar: Why Was There So Much M&A This Year?
Before it's here, it's on the Bloomberg Terminal. LEARN MORE