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What matters is not whether the world will be well managed but whether calamity will be avoided

There is a great deal of ruin in a nation. Thus did the wise Adam Smith rebuke a correspondent’s worry that ruin was bound to follow reversals in the war against the North American colonists. If there is a great deal of ruin in an individual country, there is even more ruin in the world economy. Somehow, it keeps on going.

Measured at purchasing power parity, the world economy has grown in every year since 1946, even (albeit barely) in 2009, in the wake of the global financial crisis. The period between 1900 and 1946 was more unstable than the era of managed capitalism that succeeded it. Even so, the world economy grew in all but nine of those years.

The innovation-driven economy that emerged in the late 18th and 19th centuries and spread across the globe in the 20th and 21st just grows. That is the most important fact about it. It does not grow across the world at all evenly — far from it. It does not share its benefits among people at all equally — again, far from it. But it grows. It grew last year. Much the most plausible assumption is that it will grow again this year.

The world economy will not grow forever. But it will only stop when the economics of Thomas Malthus overwhelm those of Joseph Schumpeter — that is, when resource constraints offset innovation. We are certainly not there yet.

Since 1900, the world’s output has grown at a rate of just over 3 per cent a year. Such is the power of compound interest that world output has expanded more than 30-fold over this period. Output grew relatively slowly in the early part of the 20th century and relatively fast between 1947 and the early 1970s. Intriguingly, it grew a bit faster under postwar Keynesian economics than under the conservative revival launched by Margaret Thatcher and Ronald Reagan in the 1980s.

Now consider the pattern of volatility. The marked volatility between 1914 and 1919 was due to the first world war; that of the 1930s to the Great Depression; and that of the 1940s to the second world war. The instability of the 1970s and early 1980s was due to the oil shocks, triggered (or augmented) by war (the Yom Kippur war of 1973 and Iraq’s 1980 invasion of Iran). Inflationary financing of the Vietnam war generated the inflationary backdrop to the instability. Ultimately, that led to disinflation by the Federal Reserve, under Paul Volcker.

The slowdown in 1990 and 1991 was again due to disinflation and the first Gulf war, which followed Saddam Hussein’s invasion of Kuwait. The slowdown in 1998 was triggered by the Asian financial crisis, that in 2001 by the bursting of a huge stock market bubble and that in 2009 by the western financial crisis.

This picture of the past indicates the kind of events one should worry about. In brief, there seem to be three: wars; inflation shocks (perhaps linked to wars or jumps in commodity prices); and financial crises. These phenomena can be linked: wars will trigger inflation if their finance is by inflationary means.

In this light, let us consider current risks. Some analysts have been convinced for years that high inflation must result from the expansion of central-bank balance sheets. They are wrong. It is quite possible for central banks to control the effects of their policies upon the expansion in credit and money.

A second set of risks, again ceaselessly promoted, is that of financial crisis. The biggest risks seem to be in emerging economies. But these risks are likely to be contained or prove manageable at the global level. If the worst came to the worst, the results are likely to be more like those of 1998 than of 2009.

The third set of risks is that of geopolitical upheaval and conflict. We can identify a daunting list of worries: the massive overloading of the EU’s capacity to act; the possible exit of the UK from the EU; the hollowing out of the western alliance; the rise of populist pressures in high-income countries, shown in the success of Marine Le Pen and the rise of “Trumpism”; uncertainty about China’s economic and even political future; the rise of global jihadism, and particularly of Isis, the “world’s most powerful terrorist organisation”; Russian revanchism; disputes among great powers, notably between Russia and the US and China and the US; friction in the Middle East, notably between Iran and Saudi Arabia; state failure; floods of refugees; and US retreat from its hegemonic role.

Beyond this is a decline in the legitimacy and effectiveness of many high-income democracies, the fragile self-importance of many other powers and the chaos in large parts of the world. Yet all this comes at the same time as a need for effective global governance in an integrated and interdependent world.

If one wants to worry, there is plenty to worry about. Yet, from the economic viewpoint, what matters is not so much whether the world will be well managed: it will not be. What matters more is whether a disaster will be avoided.

What would such an event look like? A war among great powers could be one. Election of a bellicose ignoramus to the US presidency could be another. A war between Iran and Saudi Arabia would be a disaster. The replacement of the Saudi regime by Isis would be another. A nuclear war between India and Pakistan would be another. Collapse of the EU could prove yet another.

The cumulative chance that at least one of all such disasters will occur is greater than the chance that any one of them will do so. Nevertheless, the likelihood that none of them will occur is surely bigger. Remember: there is a great deal of ruin in the world economy.

The luxury goods industry grows in “waves”, expanding from region to region. It moved from Europe to the USA in the 70s; it conquered Japan in the 80s; it moved into Russia in the 90s; and in the most recent 15 years it rode on the back of massive Chinese development. Understanding how these waves work – especially those appearing in EMs – is of vital importance when it comes to assessing the future shape of luxury demand.

In a rising tide, income inequality fuels luxury demand. Newly rich – starting at the top of the social pyramid – race to fill their wardrobes. They progressively sophisticate, moving to more complex product categories and services. Eventually, they come of age and normalise their spend/ capita. This is what is going on in China at the moment. The bulk of luxury growth is driven by middle class consumers, with shallower pockets and higher attention to price gaps. Besides, the undertow of more muted macro-economic growth hits the rich too.

The outlook for luxury goods is difficult in the near term. Structural moderation by the Chinese – one of the largest “waves” luxury goods have enjoyed in their modern history – compounds a subdued global macro-economic environment

It seems wise to seek cover and to lean on the side of prudence when it comes to luxury goods exposure, as long as the environment stays this difficult – and as long as the industry hasn’t fully adjusted to a “new normal” of more moderate growth. We think the preferred option is to invest in self-help stories with high probability of success and only partial market appreciation: 

1) Kering is our top pick; 

2) Hugo Boss is cheap, but has so far underwhelmed; hopes hinge on digital; 

3) Burberry is probably the most intriguing of our Neutralrated names at the moment. 

Betting that high quality is cheap enough (CFR) may require mediumterm patience.

- Countries that raised oil production when sanctions on Iran were mposed should cut output to stabilize market

(HOME.L; £1.25; 2) in November 2015 – The offer comprised shares and cash but

has not been quantified. The initial approach was rejected by Home Retail Group’s

Board of Directors and Sainsbury now has until 2 February 2016 to announce either

a firm intention to make an offer or that it does not intend to make an offer.

* Rationale - Sainsbury’s has stated that it believes the combination of Home Retail

group and Sainsbury’s is an opportunity to bring together two of the UK’s leading

retail businesses to create an attractive proposition for both customers and

shareholders. The Board of Sainsbury’s believes the combination will, amongst

other things: create choice for customers, deliver profitable sales growth, bring

together multi-channel capabilities and delivery networks, optimise use of combined

retail space, deliver revenue and cost synergies. There has as yet been no

response from Home Retail.

* Our view - Whilst our view will be contingent on the price of any subsequent M&A

and the synergies from the combined business plan we would adopt a cautious

stance with regard to JS acquiring Home. Specifically, 1) Whilst Sainsbury has

performed relatively well the backdrop for UK food retail remains challenging as the

industry seeks to slow the advance of the discounters. We think JS's shareholders

might be better served by focusing management's time on the task in hand. 2) JS

already has a strong non-food offer. The rationale for acquiring an electricals

focused retailer in Argos and DIY in Homebase is not clear, in our view. 3) JS has

acknowledged that it is overspaced. Whilst we applaud JS's use of Argos

concessions, the deal would acquire yet more space. In short it is not clear why JS

needs to buy the whole of Home to leverage Argos's brand, buying scale, category

expertise or delivery assets.

* View from Citi General Retail Team - Given the low valuation of Home Retail

Group (it was trading at c5.0x 2016E EV/EBIT, almost a 50% discount to the

general retail sector) we are unsurprised at the quantum of the share price move

(+32%) today. The rationale however seems to focus around leveraging the c750

Argos stores in the UK where the average lease length is still 5 years and its owned

home delivery network with nationwide coverage. However it is difficult to see how

this could be leveraged cost effectively to fulfil both grocery and non-food at scale

together. Additionally question marks would exist on where this would leave the

Homebase business given the large level of buying synergies which exist between

the two divisions. With the shares now trading at an EV/EBIT of 8.2x it could be

harder for Sainsbury to justify paying such a premium when it is already benefiting

from Argos concessions and has a decent non-food offer (note that c50% of Argos

sales are electricals).

Retail Group plc in November, in the form of Sainsbury’s shares and cash. The

offer has been rejected and Sainsbury’s is now considering its position. It has

until 2nd Feb to make another offer.

Home Retail Group is a £5.8bn of sales UK retailer, consisting of two banners.

Argos, a catalogue and online general merchandise retailer with >800 stores,

accounts for £4.2bn of sales and the majority of the group’s c.£100m of EBIT.

Homebase is a £1.5bn DIY retailer with 260 stores. Financial services accounts

for c.£150m sales and just under £10m of EBIT.

Our view is that food retail margins will remain slim. Hence, we see a

combination of retail businesses with real synergy potential as worth exploring.

Sainsbury’s statement mentions opportunities in multi-channel, financial

services and the ability to become the retailer of choice for food and non-food.

Three areas of cost synergies are identified 1) property rationalization (rents) 2)

scale (purchasing) and 3) operational efficiencies (central costs).

Home’s share price closed today at 139p. We expect any further offer to be at

a meaningful premium to this, hence we assume a min. 25% premium,

implying a 175p per share offer. Assuming a 50% equity/cash mix and our

midpoint view of c.£125m of synergies, we think this deal would be broadly

neutral to Sainsbury’s financial leverage (adj. net debt/EBITDAR at c.4x) and

c.20% accretive to EPS.

Ultimately, we think optimizing and rationalizing store portfolios is inevitable in

both grocery and non-food and Sainsbury’s experienced management team is

well equipped for the task. However, the time and effort being directed at

such a major undertaking would need to be well rewarded, given the risk.

We base our 265p PT on a DCF, using a normalised 2.2% EBIT margin, 2.8%

capex/sales, a terminal growth rate of 0% and a WACC of 6.0%. Upside risks

include a property-based bid, food inflation, more cost cutting or less price

investment than expected. Downside risks include deterioration in profit than

expected due to negative operating leverage or price investment.

received an approach from Sainsbury in the form of cash and shares back

in November, which HR rejected. In accordance with the City Code on

Takeovers and Mergers, the deadline to announce a firm offer is less than

a month from now, on 2 Feb at 5pm to be precise, and, therefore,

Sainsbury’s could decide to formally bid at a higher price in the coming

weeks (HR +41% yesterday to 139p). In general, we are of the view that

merging two businesses that are structurally challenged (Sainsbury by the

discounters and the excess capacity in the food retail industry and HR by

Amazon and by perhaps even more exacerbated industry capacity issues)

would not necessarily make the resulting entity more competitive. At a

time when, in our view, the worst is still to come in food retail (gross

margin investment at Tesco and Asda triggering further price competition

across the board, ongoing net space closure at the Big 4, online becoming

more competitive), we believe that, should the deal materialize, there

could be some distraction at Sainsbury’s, the one among the Big 4 that has

executed best up until now, in the short term.

Terms of the deal and potential financial impact. The price and split

between shares and cash of Sainsbury's approach to HR are unknown.

HR has stated that the board rejected the approach because it

‘undervalued HR and its long-term prospects’. We would be inclined to

think that any potential firm offer from Sainsbury’s would consist mainly

of shares given its B/S constraints (4x LA ND/EBITDAR on margins

that face downside risk, in our view) and muted cash generation. For

illustrative purposes only, in the event that Sainsbury's decided to offer a

20% premium to yesterday's HR share price close (c£1.3bn), structured

30/70 split between cash and shares, it would cost the company c£400mn

(c9% of its current market cap) plus the equity. For sensitivity purposes

only, assuming £100mn synergies, 5% cost of debt and £100mn PBT for

Home Retail we get to a c10% EPS accretive deal for Sainsbury’s. LA

Net Debt/ EBITDAR would go up from c4x to 4.5x (adding £115mn of

pension liabilities and c£2.5bn of capitalized leases).

HR brief description: HR operates c840 Argos outlets and c270

Homebase stores. Of HR’s retail sales 41% is made up of electricals

(consumer electronics and domestic appliances), 45% home

enhancement (ie housewares, DIY and other home/garden furniture) and

14% other general merchandise products such as jewellery, toys and

leisure equipment. At Argos, internet orders represent c46% of all sales,

versus online sales participation of c8% at Homebase.