Attractive investment opportunities The IT services sector is characterised by recurring business models and high levels of growth in recent years, both of which make it an appealing area for investment. After an initial dip in revenues, the Covid-19 pandemic accelerated the adoption of digital products and services. While these effects do appear to be fading, the sector is still reaping the benefits as the demand for the outsourcing of IT services, IT infrastructure and software subscriptions remains high. The move to the cloud, data centres, and the development of new IT services such as data and cyber security have also led to extra demand for Dutch IT. As a result, the sector has shown sustained revenue growth, totalling 9% YoY in 2022. The recent contraction we've seen was mainly driven by a decline in investment in IT equipment, and therefore shouldn't deal too much of a blow to the bigger picture.   The IT services sector displays sustained revenue growth after the pandemic     Private equity contributions Given its attractiveness to investors, it's no surprise that the sector is one in which private equity is very active. So much so that from 2020 to 2022, 52% of deals were backed by a private equity fund. Private equity-backed companies tend to follow one of two M&A strategies: integration and buy-and-build. The strategy followed partially depends on the investment horizon of the private equity fund in question.   In an integration strategy, not only are the back-end systems of the acquiring and target companies combined, but their processes and operations are also incorporated into one company following one strategic direction and brand. This strategy is followed by Arcus IT, Hallo and Rapid Circle. In the short term, integration takes more time and effort and consumes more resources from companies involved in the deal. However, in the long term, it makes it easier for companies to maximise their service proposition towards clients using cross and upselling.   In a buy-and-build strategy, only the back-end systems tend to be integrated while the different brands and company names are kept, bundling the knowledge and expertise from various companies under a business group. This is the case for Interstellar Group, Total Specific Hosting and Broad Horizon. Through this strategy, firms take advantage of the market tendency of assigning higher valuations to larger companies and benefit from multiple arbitrage*, without making many material changes.   *Multiple arbitrage means that multiples are higher for larger companies than for smaller ones when acquired. For instance, larger company A can acquire smaller company B at 5x EBITDA, but when A is then acquired by even larger company C, it is sold for 7x EBITDA. The EBITDA gained by A from the acquisition of B is an additional profit.

Consolidation in Dutch IT services: Slowing but not stopping M&A activity in the Dutch IT services sector has soared in recent years. Investment opportunities, financing conditions, and an increase in optimal scale have all been key drivers of this trend. As interest rates continue to rise, consolidation will slow but remain resilient.   The Dutch IT services sector is consolidating quickly M&A activity in the Dutch IT services sector has more than doubled in the past six years. This increase was driven by three main developments.   1 Client demand An increase in optimal scale for both small and large companies. Client demand has increased the minimum viable scale for smaller companies and further incentivised larger corporations to become a one-stop shop for their customers.   2 Elevated growth Second, the sector has shown high growth and is characterised by recurring business models which make it an attractive sector to investors.   3 Lower interest rates Third, lower interest rates made it an attractive time for M&A due to relatively low financing costs and high multiples. As financing conditions tighten, M&A activity in the sector will not continue to grow at the same pace as the past years, but consolidation will continue.   The Dutch IT services sector has become increasingly engaged in M&A in recent years. From 2017 to 2022, the number of M&A deals in the sector increased from 290 to 620, resulting in an annual growth rate of roughly 16.5%. The Dutch economy as a whole experienced a 12.5% year-on-year growth rate of M&A in the same period.   Low interest rates caused high multiples, which made for interesting sales – and coupled with the fact that many IT entrepreneurs started their companies in the 1990s, many saw this period as a good time to sell. The increase in M&A activity within the sector is partially driven by lower interest rates, but also by the attractiveness of the sector to investors and increases in required scale. We delve into this in more detail below.   M&A deals in IT services increased significantly over the last 6 years    

Metals – China steel production extends decline The latest numbers from the National Bureau of Statistics (NBS) show that monthly crude steel production in China fell by 7.3% year-on-year and 2.7% month-on-month for a second consecutive month to 90.1mt in May 2023 as domestic steel producers continue to curb output amid falling margins.   Meanwhile, cumulative output rose by 1.6% YoY to 444.6mt over the first five months of the year – overall growth was impacted by the lower production numbers in the April and May months. Among other metals, Chinese primary aluminium production rose by 1.1% YoY to 3.42mt in May 2023. Cumulatively, output rose almost 3.4% YoY to a total of 16.7mt over the first five months of the year. Chinese primary aluminium production might pick up in the coming months given the recent plans of Yunnan to bring back about 1mt of capacity from the end of next month.   Meanwhile, spot gold prices extended the downward rally for a fifth straight session and were trading marginally down this morning, following the latest comments from the Federal Reserve that more rate hikes are possible as the risks to inflation are still on the upside. At its latest meeting, the Fed kept interest rates steady at 5-5.25%.   Looking at the ETF holdings, gold ETFs reported outflows of 12.9koz yesterday, (the 12th consecutive session of outflow) taking the total known gold ETF holding to 93.8mz as of yesterday, the lowest level since 8 May.       Agriculture – Coffee quality premium continues to fall The spread between Robusta and higher-quality Arabica coffee dropped to around US¢59.7/lb this week (the lowest since December 2020), following the diverging fundamentals between the two types of coffee. Robusta coffee inventories in major producing regions such as Vietnam, Indonesia, and India are shrinking given the increased demand. Moreover, concerns about the potential impact of El Nino weather on crops in the nations near the Pacific have also been supporting robusta prices. The USDA projected a 5% YoY decrease in Brazil's Robusta coffee output for the season to 21.7m bags due to poor weather conditions. On the other hand, Arabica coffee prices have been under pressure due to the prospects of a massive crop from Brazil and weaker global demand. The commencement of harvest in Brazil for the season, following two years of lower production due to bad weather, has added to the downward pressure on Arabica prices.

The Commodities Feed: US crude oil inventory increases sharply It was a mixed set of data for the oil market yesterday. The IEA report was fairly neutral with both supply and demand growth estimates increasing by 0.2MMbbls/d. The weekly report from the EIA was soft as US crude oil inventory increased by a huge 7.9MMbbls for the week.   Energy – The IEA revises higher both supply and demand growth estimates The International Energy Agency (IEA) released its latest monthly oil market report yesterday and its longer-term forecasts. The agency revised higher its demand growth estimates by 0.2MMbbls/d for 2023 and now expects global crude oil demand to increase by 2.4MMbbls/d to 102.3MMbbls/d. The agency estimates demand growth to slow down to 0.9MMbbls/d in 2024 as the switch to cleaner energy accelerates and overall energy demand stabilises. On the supply side, the IEA revised higher global supply estimates by around 0.2MMbbls/d for 2023 with global oil supply estimated to increase by 1.4MMbbls/d to 101.3MMbbls/d for the year. Most of the production growth comes from non-OPEC countries led by the US and Latin America. Global oil supply growth is expected to slow down to 1MMbbls/d in 2024.   For the longer term, the IEA estimates global demand growth to slow down significantly to less than 0.5% per year by 2027/28 as electric vehicles replace the demand for gasoline and distillates. By 2027/28, the IEA estimates oil demand growth to come only from LPG, ethane, or naphtha products (where substitution is limited) while demand for gasoline and diesel could fall. The IEA expects global major oil producers to maintain plans to build further capacity which will help keep the market well supplied in the longer term.   The weekly report from the Energy Information Administration (EIA) shows that US commercial crude oil inventories in the US jumped by 7.9MMbbls over the week to 467.1MMbbls. The market was anticipating a drawdown of 1.11MMbbls whilst the API reported a build of around 1MMbbls for the week. When factoring in the Strategic Petroleum Reserve (SPR) releases, total US crude oil inventories increased by around 6MMbbls as the SPR stocks fell by 1.9MMbbls for the second straight week.   Meanwhile, oil inventories at Cushing, Oklahoma rose by 1.6MMbbls to 42.1MMbbls, the highest level since 2021. EIA said that US crude oil production was unchanged at 12.4MMbbls/d last week. As for refined product inventories, gasoline inventories rose by 2.1MMbbls, against a forecast for a build of 1MMbbls. Meanwhile, distillate stockpiles rose by 2.1MMbbls last week, quite in line with expectations for a build of 2MMbbls.    

Outlook for bond yields and the AUD It has been a volatile 12 months for the Australian dollar, which dropped as low as 0.617 intraday against the US dollar in September 2022 and reached as high as 0.716 in February this year. Currently, the AUD is sitting in the upper half of this range. Further volatility is probable. The combination of a turn in global central bank rates, a pick-up in risk sentiment, and China’s reopening, all point to a stronger AUD in the medium term. Still, the long-awaited weakening of the USD is proving very elusive. Global risk sentiment, as proxied by the Nasdaq, which is up more than 25% year-to-date hardly needs any further encouragement and may be due a re-think if analysts’ earnings forecasts finally start to price in recession. And China’s reopening story may prove to be a case of the dog that didn’t bark. That makes the argument for further volatility seem a stronger one than our directional preference.     We feel on stronger ground on bond yields. Australian government Treasury yields track US Treasuries closely, so the broad direction is likely to be driven by those, with local factors (RBA policy, Australian inflation etc) of second-order importance though still useful for considering the direction of spreads. And right now, with US Treasury yields up at around 3.80%, the balance of risks for lower bond yields certainly feels better than it does for higher yields. The current spread of Australian government bond yields over US Treasuries is about 20bp, and this could widen as we think the US inflation story will improve quicker than that in Australia, resulting in a more rapid return to easing in the US.       Summary forecast table

Is the labour market turning? It is not at all clear The labour market is also remaining remarkably (and unhelpfully) firm, with May data showing an unexpected rise in full-time employment and a drop in the unemployment rate. Viewed against long-run trends, the unemployment rate remains extremely low and doesn't seem consistent with slower inflation. And then there is wage growth, which is also still heading higher, though is very lagging, so we don’t really know what is going on here in real time.    So, despite the slowdown in overall economic growth, there are a number of indicators that still look like reasons for more tightening, rather than either easing or pauses, though we suspect these are not yet showing the full extent of the effects of earlier monetary easing.     Also, the RBA has at times seemed keen not to overtighten given the lags involved in the monetary transmission mechanism. Time is likely to be a helpful ally for rate doves allowing the slowdown to work through the economy more fully. This is certainly true of the lagging labour market.  What happens in other central banks, most notably the US Federal Reserve may also play a role. It will be far easier for the RBA to hold fire if that is also what the Fed is doing. Though this also remains a tight call and the current guidance from the Fed is for another 50bp of tightening, even though we don't think that they will ultimately deliver.    All things considered, the case for believing that the cash rate may have already peaked is weakening, if not entirely dead. So while this remains the base forecast, it will not take much for us to jettison it in favour of further hikes. That said, the market expectation for a further 50bp of tightening does feel too high, and we would limit any further increase to 25bp. It would certainly help our current call a lot if activity and labour data both swung our way in the coming months, to bolster the message from lower inflation, on which we feel a much stronger conviction. We have, however, ditched our view that rates will be cut as soon as 4Q23, and have pushed this out into 2024.   AUD/USD outlook

The case for rates having already peaked is weakening We started by noting that markets seem confused by recent events and their pricing may reflect this. Cash rate futures point to rates rising to over 4.6% - a further 50bp of hikes. Our view is that this is too much and that the current cash rate of 4.1% could be the peak, though this view has certainly been damaged by the latest labour report.  Our principal argument for a more moderate rate outlook is that we do expect to see inflation coming down over the coming months, and consequently, the pressure for the RBA to keep hiking will lessen substantially – especially as they aren’t expecting inflation to come down much over the coming quarters, so the hurdle for surprises on the downside is quite a low one. Still, this isn’t likely to be plain sailing. What was once mainly a supply-side shock affecting energy and food prices has widened out to a much broader inflationary issue, with virtually all components of the CPI basket rising at a rate in excess of the RBA’s target range, and the annualised run-rate of inflation (currently about 4%) still inconsistent with getting inflation back to trend.     Further complicating the picture is the fact that despite the RBA’s tightening, house prices, which had been falling, ticked up in 1Q23. If the RBA’s tightening were sufficient to slow the economy, we would expect this to show up in housing - one of the most interest-sensitive parts of the economy. If it isn’t, then it is probably unlikely that we will see less sensitive areas, such as consumer spending dip as much as will be required for inflation to ease. That said, the house price increase seems at odds with sharply lower consumer confidence and so for now, our best guess is that the housing bump in 1Q23 was more of a blip than a concrete turn in prices. Nevertheless, a rapidly rising population, spurred by strong net inward migration as well as low housing supply could keep house prices and rents under further upward pressure. This area certainly bears close watching.     Conversely, the RBA has little interest in causing more hardship than needed in the residential property market, and will likely also be cautious about the outlook for commercial real estate should it squeeze growth too hard. Banking sector metrics look extremely solid, and delinquent and past-due loans aren’t flashing any warning signs. But as we’ve learned recently in other jurisdictions, even well-regulated financial markets are not immune to adjustment problems that are associated with monetary tightening of the scale we have seen in markets like the US, the EU, or Australia. And this, perhaps, also supports a more cautious outlook on rates than that currently priced in by markets.   Unemployment and wages (%)

Inflation is falling, just not in a straight line Australia introduced a monthly inflation series early this year, though many analysts still seem mistrustful of the data and even the RBA still tends to refer to the quarterly figures when talking about inflation. Like the US, Australian inflation ticked up slightly in April, and almost exclusively because the year-on-year comparison was an unfavourable one. Changes in the CPI index on a monthly basis were little different from previous months. This uptick was as predictable as it was irrelevant. Inflation will fall more rapidly in the coming months as it is unlikely that we will see the large monthly increases that characterised global prices in the aftermath of the Russian invasion of Ukraine.     The three-month annualised rate of inflation is a little over 4%, which equates to an average monthly increase of between 0.3% and 0.4%. Last year’s CPI index rose at a faster rate than this. So even if there is no further reduction in the current trend increases in prices, we should see inflation falling by just under one percentage point over the coming three months. That would take headline inflation down to about 5.8-5.9%. Progress after this could be a little more pedestrian for a while. But absent a repeat of the weather/energy supply shocks of last year, inflation should decelerate forcefully again at the end of 2023 and could slow around a further 1.5pp. This should happen even without assuming any further deceleration in the current trend increase in monthly prices and would take inflation down to the mid-4% level, from which a further decline towards the top end of the RBA’s 2-3% inflation target would be in sight.   Real and nominal cash rates (%)