Almost Daily Grant's

Almost Daily…on vacation

Grant’s is taking its summer break. 

Almost Daily Grant’s will resume on August 24^th.

Almost Daily…on vacation

Grant’s is taking its summer break. 

Almost Daily Grant’s will resume on August 24^th.

* * *

Grant’s Interest Rate Observer . . . Thinking required™

Rounding error

Loss making Uber Technologies, Inc. (Grant’s, January 27) wants to grow.

Rounding error

Loss making Uber Technologies, Inc. (Grant’s, January 27) wants to grow.  Getting more of its drivers on the road is one logical route to that end.  So the ride-sharing Unicorn devised a plan: contractors (not to be confused with employees) who wanted to drive but lacked a vehicle could lease one from the company.  So far, so good.

There was one small problem.  As reported this morning by the Wall Street Journal’s Greg Bensinger, Uber’s subprime auto lending unit (titled the Xchange Leasing Program) sported an average loss per vehicle of roughly $9,000, 18 times the company’s own estimated loss of $500 per vehicle.

So, the Xchange Leasing program, with 500 employees (roughly 3% of Uber’s workforce) and an inventory pegged at around 40,000 vehicles, will soon be no more.  This latest setback follows the late-May bulletin from the New York Times alleging that Uber had been stealthily deducting its commission from drivers’ pre-tax revenue in New York, thus sticking its contractors with the full tax bill in addition to the wear and tear accrued on their automobile.

Side-hustle, indeed.

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The buck stops here

Will the last U.S. dollar bull to leave kindly turn out the lights?  To say the least, 2017 has not been kind to the greenback.  Amidst a continually soggy post-crisis recovery, low measured inflation and political sea change in the form of President Trump (described as “the avatar of tail risk” by Grant’s last fall), the dollar index has declined in each month of calendar 2017 and sits lower by nearly 10% year-to-date.  Of the six currency pairs which comprise the Dollar Index in 2017, so far only the Swiss Franc (with a gain of 4.8%) has failed to advance by more than 5% against the dollar this year. 

Even beyond those sovereign blue chippers, it is difficult to find a currency weaker against the dollar in 2017.  Sanctioned-anew Russia has seen the ruble tick higher by more than 2% year-to-date despite the continued struggle in energy prices, while the Brazilian real is up by nearly 5% in 2017 despite yet another corruption scandal, this time involving President Michel Temer.  Amidst an escalation of the bellicose threats from its neighbor to the north (featuring demonstrated technological advances in recent ballistic missile tests), Korea’s won has advanced by roughly 7% against the dollar year-to-date.

If recent data are any guide, market participants are overwhelmingly positioned for the bloodletting to continue.  The August 1 Commitment of Traders Report from the Commodity Futures Trading Commission reported a net $7.87 billion worth of contracts short the dollar,  the largest imbalance since early 2013 according to the Wall Street Journal (the DXY subsequently rallied by 6.5% from February to May 2013).  Bianco Research meanwhile relays data from Consensus, Inc.’s July 28 survey of market participants: only 38% of respondents were bullish on the greenback, the smallest contingent in over three years.

Meanwhile, second quarter Advance GDP growth of 2.6% marked the fourth reading above 2% in the last five quarters.  As for the third quarter, early estimates from the Atlanta Fed’s GDPNow forecast (which, to be fair, are frequently reduced as the quarter progresses) peg the third quarter growth rate at a robust 3.7%. So too, does the dovish Fed look less dovish when graded on a curve:  the U.S. overnight lending rate of 1.25% is higher than each nation in the G-10, with the exception of Australia at 1.5% and New Zealand at 1.75%.

As a wise frog once said: It ain’t easy being green.  It might soon get easier.

Headline of the day

Courtesy of The Durango Herald:

Bear breaks into SUV, then takes it for a short drive. 

From the article:

La Plata County Sheriff’s Office deputies determined a bear was to blame.

It also ripped up the interior of the vehicle. It pulled the steering wheel straight off the shaft, ripped the radio out of the dash and busted out the back window.

“It would have taken a human being hours to do what this bear did in a couple minutes,” he said.

At least one bear is accomplishing its goals in 2017!

Recap August 8

“Fire and fury,” and a 30 basis point decline.  President Trump’s in-kind response to the North Koreans this afternoon spurred a modest drop in the S&P 500 that felt like a crash compared to the remarkable recent inertia in the major indices.  Treasury yields generally ticked a bit higher with the long end underperforming, and commodities finished little changed as a metals bid offset weakness in energy. 

- Philip Grant

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Whipping Post

St. Louis-based Post Holdings, Inc. is striking while the iron is – or rather, remains – hot.

Whipping Post

St. Louis-based Post Holdings, Inc. is striking while the iron is – or rather, remains – hot.  Taking advantage of today’s forgiving market conditions, the acquisitive purveyor of breakfast cereals has priced an upsized add-on of $750 million in 5.75% senior unsecured notes due 2027 to an existing $750 million issue.  The new securities were priced at 105 ½ to yield 4.87%. Proceeds are earmarked for general corporate purposes, including acquisitions.  

Moody’s gave the all-clear to the news, affirming Post’s B2 Corporate Family Rating with its food industry analyst Brian Weddington commenting that “Although acquisitions have maintained the company’s high exposure to the slowly declining ready-to-eat cereal category, they have also greatly expanded the company’s scale and cash flow.”

The numerous acquisitions (14 by our count) completed by Post since its 2012 spinoff from Ralcorp Holdings have successfully burnished its top line over the past few years. Fiscal year 2016 revenues were north of $5 billion, compared to a sub-$1 billion footing in 2012.  The spring victory over competing bidders for England’s Weetabix Ltd. for about $1.8 billion in cash (at nearly 13 times trailing EBITDA, compared to an industry average of 7.55 times according to Bloomberg) promises to deliver a further jolt to the top line.

To the victor go the spoils:

Mr. Market has enthusiastically approved: Post shares have rallied by more than 160% from their fall 2014 interim nadir to current highs – up about 8% from a September 16, Grant’s analysis (“From hunger, click here to read) --  while each of its 10 corporate bond issues (all issued at par) currently trade north of 100 cents on the dollar.  Backed by the formidable reputation of board Chairman William Stirlitz, Post commands a trailing price/earnings multiple of 34 times, which dwarfs large cap peers General Mills Inc. at 18 times and Kellogg’s Co. at 17 times.

The Grant’s story summed up the company’s charmed run thusly:

Bulls, viewing Post as a kind of public LBO with lots of embedded optionality, are hopeful that Stirlitz will continue to work his capital-allocation magic, even within the lackluster private brands division.

True believers are evidently still widespread (seven of the 10 sell side analysts listed by Bloomberg rate POST a buy, three judge it a hold, none say “sell”), but Post’s burgeoning revenues and penthouse-dwelling stock price obscure an increasingly precarious capital structure.  Against total debt of $7.3 billion (soon to be $8.05 billion), the company generated free cash flow in 2016 of just $380 million, while 2016 interest expense topped $300 million.  Not just for acquisitions does Post deploy its currently-readily accessible cash pile. The company announced in early June an authorization to buy back $250 million of its own stock.  A $300 million buyback unveiled in February 2016 was still ongoing, with roughly $48 million remaining, at the time of the June announcement.

Meanwhile, growth-by-acquisition has been the only game in town in the cold cereal business, which has been an especially troubled component of the struggling consumer packaged foods realm.   Research firm IBISWorld pegged total U.S. sales of cold and hot cereals at $10.6 billion last year, down 17% from the $12.7 billion logged in 2009.  For its part, Post reported a 1.7% year-on-year sales decline in its consumer brands division in the fiscal third quarter ending June 30 on a 1.1% drop-off in volume.  Its newest crown jewel Weetabix logged GBP 410 million in revenues over its most recent annual period, down more than 3.5% from the prior twelve month total of GBP 425 million. 

A positive outcome in the house of Stirlitz, featuring a revival in the cereal business and ongoing accommodation from the credit markets, will reward buyers of today’s bond offering with 5.75% on top of full repayment of their principal.  We wonder about other contingencies.

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Recap August 7

Closing at the top of a remarkably narrow 20 basis point range was enough to push the broad S&P 500 to another record high.  Treasurys barely budged, and the dollar index resumed its downward trajectory after Friday’s bounce.  The VIX found single digits again, after closing above 10 in each of the prior seven trading sessions. 

- Philip Grant

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Tape delay

A common economic thread today links a handful of nations across North America, Europe and the Land Down Under.

Tape delay

A common economic thread today links a handful of nations across North America, Europe and the Land Down Under. Lucky or prudent enough to largely avoid the housing crisis and Great Recession, they are now burdened with over leveraged consumers and vulnerable (or teetering) housing markets.

Still riding the tailwinds of the Chinese commodity boom of the mid-aughts, the Aussie home price index managed a 7.5% advance in the two years ending March 2009.  That resilience presaged a golden decade of price appreciation amidst Reserve Bank of Australia rate cuts to 1.5% from above 7% and an influx of Chinese buyers, as a near 50% advance in Aussie home prices since 2012 has left the smallest continent by land mass sporting a household financial debt to income ratio of more than 190% as of March 31^st, per the RBA.  

Nordic neighbors Sweden and Norway likewise feature housing markets on the boil, with their home price indices jumping by 56% since 2011 and 63% since 2014, respectively. Norway’s heavy reliance on the oil industry makes the persistent updraft in housing all the more striking, but momentum appears to be abating. Year-on-year price gains slowed to 4.8% in July from 6.3% in June, while inventory for sale rose by 14% from its 2016 footing.  Although still ongoing (second quarter prices saw a 10% year-on-year uptick), Sweden’s own housing boom spurred its central bank to issue this warning on May 24:

Households’ high and rising indebtedness form a serious threat to financial and macroeconomic stability . . . There are also vulnerabilities in the Swedish banking system and its resilience therefore needs to be reinforced.

Closer to home, the heretofore-relentless Canadian housing boom may finally be flagging under the weight of higher interest rates and a 15% foreign-buyers tax in Toronto, which has of late been the epicenter of appreciation (a similar regulatory remedy cooled down frenzied activity in Vancouver last year).  Canada’s financial hub saw total housing transactions plummet by more than 40% year-on-year in July, while the C $746,220 average selling price in Toronto in July represented a drop-off of 19% from its April peak.  That prices still sit higher by 5% from July 2016 indicate the extent of euphoria seen through the fall, winter and spring.

Blow-off top, anyone?

The precipitous drop in housing fortunes was addressed (kind of) on this morning’s quarterly conference call by Canadian subprime mortgage lender Home Capital Group, Inc., which is a recipient of Warren Buffett’s imprimatur via a 19.99% equity stake. Under new CEO Yousry Bissada, the third top executive since the May 2016 departure of Gerald M. Soloway, management argued that the sharp reversal in fortunes won’t necessarily augur wider trouble. 

We welcome what we see right now.  From a lender’s standpoint, there’s nothing better than a nice, controlled, levelling off of the real estate market.

We don’t normally see people defaulting because the price of their home has declined, usually the driver is employment issues, like they just don’t have the income . . . Home prices don’t typically drive defaults.

Longtime attendees of the Grant’s conference may recall a presenter in the spring of 2006 similarly arguing that positive employment trends would underpin ongoing strength in mortgage lending and the housing market, despite high prices and growing debt.  In the last cycle, at least, it did not turn out that way.

The Canadian economy is particularly reliant on the real estate industry.  CBC news reported on July 31 that real estate commissions, land transfer taxes, legal costs and fees for inspecting and surveying homes accounted for 1.9% of total Canadian GDP in 2016. That’s a bigger contribution to output than agriculture, forestry, fishing and hunting, and far more than the 1.5% of share of U.S. GDP claimed by the real estate business in 2007.

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Tech sightings

Free broadcast television can be yours – all you need is some sort of apparatus to convert electric power to radio waves.  What are these space-age devices called?  Antennas. 

Utah MBA student Dan Sisco, who just shelled out $20 for one, expressed his wonderment to the Wall Street Journal:  “I was just kind of surprised that this is technology that exists. It's been awesome. It doesn't log out and it doesn't skip.”

The future is bright!

Recap August 3

A late spasm of risk aversion followed news that Special Counsel Robert Mueller has convened a Grand Jury as his investigation of Russian interference in the 2016 elections, but as is recent custom the bulls quickly regained control to push the averages back into the green by day’s end. The S&P 500 closed within a 30 basis point range for an eleventh straight session, while the Dow Jones Industrial Average logged a closing record high for the seventh straight time.

- Philip Grant

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Paid to wait

This year’s emphatic advance in stocks has been accompanied by equally agreeable price action in credit. 

Paid to wait

This year’s emphatic advance in stocks has been accompanied by equally agreeable price action in credit. The S&P/LSTA Leveraged Loan Total Return Index currently sits at a record high, up by nearly 25% in the last five years. Vincent Ingato, senior portfolio manager at ZAIS Group assessed current conditions thusly:  "This is a very strong leveraged finance market, a lot more buyers of loans than sellers.” 

Perhaps due to unusually-smooth sailing that featured exactly zero defaults from issuers within the S&P/LSTA Leveraged Loan Index in July, S&P Global Market Intelligence Leveraged Commentary and Data (LCD) calculates a 1.36% default rate in that basket of loans, its lowest level since January of 2016.  

Across the credit spectrum, borrowers are calling the shots. According to Bloomberg, this upcoming fall will see more than $250 billion worth of term loans become eligible for repricing,  which will avail debtors further opportunity to obtain better spreads (lower rates) from pliable lenders.  The Barclays U.S. Corporate High Yield to Worst-10 Year Treasury spread (yield gap between high yield corporate bonds and Treasurys) currently stands at just 3.1%, down from the roughly 8.4% nadir seen in February 2016 amidst the energy shakeout. The 20-year average stands at 5.3%. 

Beyond lower rates, issuers have acted on their advantageous positioning.  The share of “covenant lite” loans (those without certain creditor protections restricting additional debt or certain use of proceeds) in the S&P/LSTA index reached a record high of 72.5% in the second quarter, compared to just 18% in 2007, per S&P’s LCD unit.  It seems fair to wonder what default recoveries will be like when the cycle turns. 

However, skeptical types (sad!) waiting for the comeuppance may have to find a comfortable chair. LCD notes that “there are relatively few corporate leveraged loans coming due this year and next, though the ‘maturity wall’ ramps up quickly in 2019”.

Over in China, the balance of power rests on the other side of the scale, as a high proportion of borrowers sold debt containing put options, which bestows on lenders the right to sell the bonds back if they so choose.  Bloomberg explains further:

(Chinese) businesses sold about 65 percent of all corporate bonds with put options worldwide, at 3.9 trillion yuan ($580 billion). Creditors holding some 2 trillion yuan of mainland notes will be able to exercise those options in the next two years, forcing issuers to either increase interest payments or redeem the debt early.

Visible upward pressure on Chinese interest rates in 2017 undoubtedly has some borrowers lamenting the insertion of a put option; the Chinese 10-year note currently fetches almost 3.65%, its average yield through calendar 2016 was less than 2.9%.  A June 28 report from Fitch Ratings pegs the percentage of local bonds with such options currently “in the money” (for lenders to put them back to the issuer) at 82%.  Data from Bloomberg indicates that the “the peak in property bond put dates (is) coming in 2018 and 2019.”

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Visa approves

The Australian “Black Economy Taskforce” has some proposed remedies in their fight against something or other, beyond potentially implanting hi-tech nano chips in AUD $50 and AUD $100 notes.  Take it away, former global head of accounting at KPMG and Taskforce chair Michael Andrew:

We intend to examine the merits of consumer focused sanctions, including the loss of consumer protections, warranties and legal rights for people who make cash payments without obtaining a valid receipt. This is not simply of (sic) matter of imposing new penalties, but part of a wider cultural change agenda.

Oh, there’s an agenda all right.

Recap August 2

Stocks recovered from a harrowing 40 basis point decline in the S&P 500 to finish at the unchanged line, near their closing high water mark.  Treasury yields ticked a bit higher across the curve with the exception of the long bond, and the U.S. dollar index made another new 2017 closing low.

 - Philip Grant

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In reverse

The 2017 auto market has gone from limousine to lemon.  

In reverse

The 2017 auto market has gone from limousine to lemon.  Detroit’s “big three”- General Motors, Ford and Chrysler - all reported light vehicle sales for July that fell far short of analyst consensus, including a double digit aggregate sales decline from the year ago period and the seventh straight monthly drop from 2016.  The pain was far from confined to the domestic producers, as high-end imports Mercedes-Benz and BMW saw year-on-year declines of around 10% and 14%, respectively. Down-market, Hyundai reported a sales drop of nearly 28% from a year ago.

Overall, the annualized pace of 16.9 million (according to estimates from GM) logged in July falls well short of the 17.9 million annualized clip from July of last year.  The monthly data make for an especially sharp contrast with the buoyant activity seen in July 2016, which at the time led WardsAuto to upgrade its projection of seasonally adjusted annual sales by 6.5% from its June 2016 level.

Signs of trouble abound beyond the headline numbers.  Increasingly broad based weakness includes a 7.5% year-on-year decline in Ford’s truck sales in July.  Larger vehicles had previously held up much better than sedans or compact cars amidst the post-2014 drop in gasoline prices.  Laurence Dixon, the director of market intelligence for the National Automobile Dealers Association, told Grant’s earlier this year that while car demand was weak, “for trucks, pricing has been so exceptionally strong that there is the temptation to believe that strength will continue on for the next several years.” He then noted an incoming supply glut and concluded that “we expect pretty significant declines in prices relative to where they’ve been for those segments.”

Dealers are increasingly obliged to resort to generous price concessions to move inventory, and July was no different.  According to estimates from J.D. Power and Associates, average vehicle incentive spending jumped by 7.7% from July 2016 (projection is based on the first 18 days of the month).  The average retail price of just under $31,000 per unit was barely changed from its year ago levels, pushing the average dealer incentive spending above 12.5% of transaction prices in July.

So far those concessions have not moved the needle in whittling down the dealers excess inventory levels.  Ford disclosed that it held 77 days of inventory at the end of July, unchanged from its prior year levels.  GM’s unsold dealer stocks amounted to about 874,000 units, (or 104 days of supply), up by 28% year-on-year. It has pledged to reduce that number to 70 days’ supply by year end, through a combination of curtailed production and (it hopes) a sales uptick in the third and fourth quarters.

The pronounced struggles of rental agencies such as Hertz are exacerbating the problem.  Ford’s fleet sales fell by more than 26% from their prior year levels, while GM’s plunged by 81%.  Last Friday evening Hertz announced it was abandoning plans to redeem a bond issue that is set to mature in 2019. Investors sent both its debt and equity lower as they pondered such unpleasant scenarios as a far weaker than expected second quarter, or a cash crunch that could potentially lead to covenant violations (HTZ is due to report a week from today).

Grant’s Feb. 24 analysis (“Disabled vehicles”, click here to read) chronicled the increasingly prominent role in rising used-vehicle prices to underpin residual values and spur new auto sales, as well as extended financing activity in same. Both cornerstones have been eroding.  Since the spring, the J.D. Power Used Vehicle Price Index has remained stuck at levels not seen since 2010, the early stages of the autos bull market.  Meanwhile, leasing as a percentage of total sales declined to 31.1% from 32% in 2016, according to Edmunds.  Manheim’s numbers pegged leasing activity at just above 30% of sales last year, compared to 19.1% in 2010.  

Coincidence?  Probably not. 

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Paging the Festrunk brothers

Wild and crazy news abounds! 

Yesterday, Uber announced plans to produce, in partnership with Barclays, its own credit card later this year. 

Online travel marketplace Airbnb has produced its own magazine in concert with Hearst, announcing today that it has arrived at newsstands. CEO Brian Chesky adeptly described the merits of print to the Wall Street Journal: “It isn’t ephemeral, as opposed to content on a feed that expires.”  Ephemeral is a relative term however: The travel site’s prior attempt at glossy magazines, 2014’s Pineapple, was aborted after one issue.

What’s next, Tesla producing a profit?

Recap August 1

Stocks wiggled higher, with the S&P 500 remaining within a 1% peak/trough range for a hard-to-fathom tenth straight day.  Treasurys were bid in bull flattening fashion, and energy prices dipped from their recent charge higher in tandem with a bounce in the U.S. dollar index (DXY). 

 - Philip Grant

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Negative rates, positive carry

That quasi-public entity known as the Swiss National Bank released its operating results for the first half of 2017 this morning, earning a reported profit of CHF 1.2 billion ($1.24 billion) through June 30.  

Negative rates, positive carry

That quasi-public entity known as the Swiss National Bank released its operating results for the second quarter and first half of 2017 this morning, earning a reported profit of CHF 1.2 billion ($1.24 billion) through June 30.  The bank mostly kept steady its proportional holdings, allocating 20% of its portfolio to equities and 68% to government bonds.  The gnomes did slightly dial up their risk appetite, raising their holdings of A-rated bonds to 12% from 11% while trimming double-A-rated fixed income holdings to 24% from 25%.

As for the income statement, interest and dividend income (CHF 4.4 billion and CHF 1.8 billion, respectively), gains in their equity portfolio (CHF 9.4 billion) and a small profit in their foreign-currency book (CHF 100 million) helped the bank’s bottom line, offsetting exchange rate-related losses of CHF 11.8 billion.   A markup in the valuation of their gold holdings chipped in CHF 300 million.

The line item which perhaps best captures our current era was modest relative to most of the above quantities: a CHF 900 million gain on “Swiss franc positions.”  Separate and distinct from the foreign currency and exchange rate components, that ledger entry, as the SNB explains, is “largely comprised of negative interest charged on sight deposit account balances.”   

The Swiss have been especially enthusiastic practitioners of the heretofore unprecedented experiment of negative interest rates, holding their deposit rate at negative 75 basis points since January 2015.  So far, the confiscatory rate has yet to deter wealthy savers.  To the contrary, local bank deposits at the SNB have jumped by 40% year on year through June 30, according to Reuters.

The outsize risk aversion implied here contrasts markedly with the solid, if relatively unspectacular performance of local equities (the Swiss market index has gained by about 12% over the last 52 weeks, compared to 14% or so in the MSCI world index). By contrast, the global uptick in interest rates has manifested itself in slightly less negative yields in the mountainous confederation.  The Swiss two-year yield, which approached negative 1% in February, now stands at negative 0.76%, near the highest level seen since the SNB surprised markets by removing its peg to the euro in the winter of 2015.

Still less than cash. Swiss two-year yield (source: The Bloomberg): 

What is more desirable (or less undesirable): Guaranteed capital shrinkage in negative rate bank deposits or virtually guaranteed capital depreciation in tandem with interest rate risk in negative yielding sovereign debt? 

The Swiss are voting with their wallets.

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Your broker on line two

Like the central bankers, the ETF promoters never seem to take a day off.  The latest study in innovation comes from WisdomTree Investments, which has evidently determined that buying historically low-beta equities is not the only way to profit from the seemingly no-volatility world in which we currently live.   The WisdomTree CBOE Russell 2000 PutWrite Strategy Fund is soon to make its debut.  The company described the fund’s objective in its registration statement with the SEC:

The Index tracks the value of a cash-secured (i.e., collateralized) put option sales strategy, which consists of selling (or “writing”) Russell 2000 Index put options (“RUT Puts”) and investing the sale proceeds in one-month Treasury bills. By selling a RUT Put, the Fund receives a premium from the option buyer, which increases the Fund’s return if the option is not exercised and expires worthless. If, however, the value of the Russell 2000 Index falls below the RUT Put’s strike price, the option finishes “in-the-money” and the Fund pays the buyer the difference between the strike price and the value of the Russell 2000 Index. 

Operating expenses for the fund, including management fees, have yet to be announced, but one thing's for sure.  We've come a long way from the SPY. 

Recap July 31^st

Stocks eked out small gains, with the S&P 500 rising to within a few points of last week’s high water mark, while Treasurys finished little changed.  WTI crude oil crossed the $50/bbl benchmark for the first time since April, thanks in no small part to the weakening greenback.  The DXY dollar index is down by nearly 10% from its mid-December interim highs.

 - Philip Grant

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Runs runs Rudolph

Europe is enjoying solid economic conditions and pleasant asset price action amidst the loving embrace of Mario Draghi and Co.  So why are bank runs on the minds of the regulators? 

Runs runs Rudolph

Europe is enjoying solid economic conditions and pleasant asset price action amidst the loving embrace of Mario Draghi and Co.  So why are bank runs on the minds of the regulators? The latest dispatch comes today from Reuters, which reports that “European Union states are considering measures which would allow them to temporarily stop people withdrawing money from their accounts to prevent bank runs.”

According to Reuters, the plan under consideration would bestow upon regulators the authority to block depositor withdrawals for a period of five working days, which could be extended as far as 20 business days under “exceptional circumstances.”  The E.U. working paper cited in the report refers to this idea as a “feasible option.”

Feasible to the bureaucrats, perhaps.  Then again, European depositors are used to treatment which would likely spur far more outcry elsewhere.  Consider the “bail-in” conducted in Cyprus in 2013, in which some savers absorbed steep haircuts to make whole the losses borne by senior creditors following the failure of local banks. 

Exceptional circumstances:

More recently, the early-June failure of Spain’s Banco Popular contained some fraught moments before the regulators managed to broker a nominal €1 takeover by stronger local peer Banco Santander.   ECB vice president Vítor Constânciowas quoted in The Financial Times on the near-miss. “There was a bank run. It was not a matter of assessing the developments of solvency as such, but the liquidity issue.”  Depositors emerged from that episode unscathed.

Considering the tailwinds of economic growth and rising asset prices, the plainly shaky state of the European banking system is remarkable.  Perhaps more remarkable is the phlegmatic reception to the mandarins trial balloon.

Charlie Bannister of the bank lobbying group the Association for Financial Markets in Europe was not so phlegmatic, telling Reuters that "We strongly believe that this would incentivize depositors to run from a bank at an early stage."

Indeed.  If one were trying to start a bank run, would this announcement not be a good way to begin?

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Garlic, mirrors and sunlight

It has already been a week to forget for the market-leading FAANG contingent, with components Google (Alphabet, Inc.) and Amazon.com Inc. each trading lower after earnings releases which left something to be desired.

A more significant setback may prove to be in store, if some foreboding commentary from Procter & Gamble on the efficacy of digital advertising becomes broadly accepted.  As reported by The Wall Street Journal, the consumer goods giant not only cut its digital marketing budget by over $100 million, but CEO David Taylor also made plain his dim view of the digital medium on the company’s Thirsday conference call:

We got some data that said either it was in a bad place or it was not effective.  And we shut it down and said, ‘We’re not going to follow a formula of how much you spend or share of voice.’ We want every dollar to add value for the consumer or add value for our stakeholders

CFO John Moeller added his 2 cents:

Either we were serving bots as opposed to human beings or . . . the placement of ads was not facilitating the equity of our brands. After cutting back on certain digital ads, we didn’t see a reduction in the growth rate. What that tells me is that the spending we cut was largely ineffective.

Google and Facebook are expected to capture between them more than 60% of the $83 billion U.S. internet advertising market this year, according to estimates from research firm eMarketer.  Better for their sake if other corporate executives read the FT today instead.

Recap July 28^th

A North Korean missile test showing increased range was no match for the summer Friday doldrums, as equities lost some ground early then gradually rebounded to leave the S&P 500 virtually flat for the week.  U.S. Treasurys were bid across the curve, with the three-month bill continuing its recovery from the multi-year yield highs above 1.17% reached on Monday.  Energy continued its bull run, with WTI crude approaching $50/bbl for the first time since late May.

 - Philip Grant

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Bid quarry

What’s going on in the formerly-moribund large cap gold mining realm?

Bid quarry

What’s going on in the formerly-moribund large cap gold mining realm?  Despite little help from the underlying precious metals market, the past 24 hours have seen stronger than expected earnings from mainstays Barrick Gold Corp., Agnico Eagle Mining Ltd. and long-time Grant’s favorite Newmont Mining Corp.   Enhanced corporate efficiency, as opposed to the rising tide of a gold bull market, looks to explain the performance uptick. Andrew Kaip of BMO Capital Markets told Bloomberg that “their optimization programs are continuing to deliver.”

Most recent quarterly numbers bear out Kaip’s assertion. Newmont rode a roughly 13.4% year-on-year rise in production and a 3.2% drop in sustaining costs per oz. to post earnings per share well in excess of consensus, while CEO Gary Goldberg made reference to a potential dividend hike in the future. Barrick managed a 6.7% uptick in production from its 2016 levels, while trimming all-in sustaining costs by over 9%. Agnico Eagle churned out 4.6% more gold than their prior year level in tandem with a 7.4% downtick in costs.

Mr. Market gave the trio its due, with Newmont shares rising by about 7.5% from the Tuesday earnings release, while Barrick and Agnico Eagle have rallied by about 3% and 4%, respectively.  For long-time observers of these mining securities, price movement based on operating results is a rare treat, somewhat on the order of a lunar eclipse. 

The price of gold has historically been the primary fulcrum: A 10-year monthly price correlation between each of the three miners and XAU yields positive correlations of between 0.71 and 0.76, categorized by Bloomberg as “most statistically significant”.  The trio also trade with one another at similar or even stronger rates of correlation.

Bill Fleckenstein, eponym and president of Fleckenstein Capital, relays to Grant’s that there is another, perhaps even more influential factor on these securities; the whims of the ETF’s which purport to track them.  Consider the primary vehicle for one-stop shopping gold miner exposure, the Van Eck Vectors Gold Miners ETF (GDX).  Against assets under management of $7.6 billion, GDX has traded an average of just over 67 million shares per day in the past 52 weeks, for a total daily volume of around $1.6 billion.  Roughly 21% of the fund is turned over in a given trading day.

Then, too, the leveraged vehicles present liquidity profiles that currently far exceed the securities they are purported to track.  The Direxion Daily 3X Bull Gold Miners ETF (NUGT), which sports an expense ratio of 95 basis points, has averaged more than $500 million in daily trading volume over the past year, against assets under management of less than $1.5 billion.  

By comparison, Barrick and Newmont (each valued over $19 billion in market cap) have averaged daily turnover of $268 million and $236 million, respectively in the past year. Agnico Eagle has turned over just $85 million worth per trading day in the past 52 weeks, less than 1% of its $11 billion market cap.

With liquidity gaps like those and the historically lockstep trading profile of the miners, who can blame investors for opting to just pile into the ETFs? 

Also, who will be surprised if this increasingly prominent “tail wags the dog” regime culminates in unexpected price action and perhaps unwelcome surprises for those who went the synthetic route? 

Not we.

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Bezal-gazing

The Grant’s in-house team of Wealth Editors have been apprised that Jeff Bezos this morning surpassed Bill Gates to become the world’s richest man, with a current net worth estimated at $90 billion.  The self-made CEO of Amazon.com now has treasures that exceed the 2017 estimated GDP (per IMF forecasts) of Croatia, Iceland, Mongolia and Fiji, combined. 

Unfortunately, Amazon’s after-market earnings release failed to reach the sky-scraping heights that Wall Street had expected, pushing Bezos back to second place. 

Gates is safe, for now  

Recap July 27^th

Another round of calm summer trading was interrupted in the early afternoon by a volatility spike and FAANG-led decline in the Nasdaq.  Dip-buyers emerged to pare the losses into the close,  before Amazon’s earnings miss leaves the behemoth weaker by 2% in after hours trading and presumably gives the bears a fighting chance tomorrow.

Despite giving back most of its early afternoon gains, the VIX held on to close above 10 for the first time in over two weeks. 

 - Philip Grant

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Best Ally

Price match: It’s not just for flat-screen TV’s anymore. 

Best Ally

Price match: It’s not just for flat-screen TV’s anymore.  Former General Motors financing arm Ally Financial, Inc., which just re-entered the mortgage lending market last year via its Ally Home unit, announced today a Price Match Guarantee program “to give borrowers the peace of mind and assurance they will get the best possible mortgage rate whether they are taking out a loan for a new residence of refinancing an existing home.”

The increasingly shaky state of the auto market following years of rising sales built on expanding credit likely informs Ally’s search for greener pastures.   Mortgage lending has, however, remained surprisingly limp of late.

Despite flat-to rising new and existing home sales, both the MBA FHA Mortgage Applications Index and the MBA Refinancing Index have remained stuck near multi-year lows since the spring.  That stalling in credit comes in spite of the decline in the Bankrate.com US Home Mortgage 30 Year Fixed National Average to 3.82% as of yesterday, down from nearly 4.2% in March.

Perhaps a Loan Officer Geek Squad will help grease the wheels?

Approved!

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Bills lose again

Some unusual sightings of late in the short end of the money market:

Three-month Treasury bill yields have positively soared higher of late, well outpacing the upward trajectory in other government securities to now exceed the yield on offer from the six-month bill.  The inversion is almost certainly a function of the government’s imminent encounter with the statutory debt ceiling (likely to occur in early-to-mid October according to estimates from the Congressional Budget Office), and the prospect of selective default if Congress is unable to reach agreement on raising the limit.

Further out on the Treasury curve, the spread between the two-year and 10-year notes currently sits near 10-year lows around 93 basis points (the differential exceeded 250 basis points in early 2014).  According to last week’s Commitments of Traders report from the Commodity Futures Trading Commission, speculative positioning is heavily weighted toward more convergence.  Net short positions in two-year note futures stood at 274,213 contracts, an “unprecedented” imbalance according to Bloomberg.  By contrast, speculators held net a long position of 282,329 contracts in 10-year note futures. 

The kicker:  short positioning in two-year note futures has built up in tandem with declining expectations of further Fed rate hikes for the balance of the year (one catalyst for higher two-year yields).  According to Bloomberg, the odds of one more rate hike in 2017 currently sit at 45%, down from 62% on July 7th.  

Chinese food for thought

It seems that nowhere in the world do economic fortunes vacillate so quickly between potential disaster and euphoria as the Middle Kingdom.  Today’s balance of news pointed to the latter.

Property developer and subject of a wary Grant’s analysis (“Ever higher”, June 2) China Evergrande Group predicted that profits in the back half of the year will triple from their 2016 levels, thanks to rising property prices and transactions, as well as redemption of its RMB 113 billion in perpetual securities.  This actively shorted and highly leveraged barometer of the country’s animal spirits has seen its share price rise by 136% since early May, an annualized pace of 1,000%.

U.S. construction behemoth Caterpillar, Inc. managed to outpace second quarter consensus earnings forecasts while also hiking its full-year earnings forecast well beyond both consensus expectation and its own prior guidance.  CEO Jim Umpleby cited robust Chinese construction activity in his commentary, as shares jumped to a record high this morning.

Iron ore stockpiles at Chinese ports have meanwhile ballooned. The most recent reading over the weekend of the Steelhome Port Inventory Index ticked to 140.45 million tons, nearly double the levels logged two summers ago and nearly 50% north of the gauge’s trailing five-year average.

Recap July 25^th

Strength in the financials and resources offset heavy trading in health care amidst the procedural vote toward repeal of the Affordable Care Act to push the S&P 500 to another closing high.  Treasury yields jumped higher in bear steepening formation, and WTI crude approached $48/bbl for the first time since early June. 

 - Philip Grant

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Soirée temps

A few dispatches from across the Atlantic and beyond:

Soirée temps

A few dispatches from across the Atlantic and beyond:

Greece announced today its plans to return to the sovereign debt market for the first time since 2014, with sell-side estimates pegging the size of its 5-year note offering at around €3 billion.  In tandem, the financial problem child will launch a cash tender offer for its outstanding 4.75% notes due in 2019 north of par value.  Prime Minister Alexis Tsipras proclaimed to The Guardian that “The worst is clearly behind us.”

The universe of emerging market debt trading at distressed levels (defined as yielding more than 10 percent versus Treasurys) is the slimmest pickings in ten years, according to data compiled by Bloomberg and J.P. Morgan.  Diego Ferro, co-chief investment officer at Greylock Capital Management, commented that: “There is too much money coming into emerging markets, so leverage is increasing and investors are piling on certain trades of dubious quality.”

Amidst microscopic yields and dwindling supply as the ECB continues to Hoover up as much as 33% of investment grade corporate and sovereign debt across the eurozone, local investors have poured capital abroad.  Data from the ECB show that euro-area investors have been buying at an annualized clip of between €300 billion and €500 billion in foreign long term debt instruments since 2015. ECB executive board member Benoît Cœuré discussed the trend in a speech on July 11:

At their peak around the middle of 2016, net capital outflows – measured here in terms of 12-month moving sums – reached nearly 5% of euro area GDP. Never before in the history of the euro area have capital flows been so high.

Have passport, will travel:

The current zeitgeist is perhaps most in evidence in real estate.  German publishing company Axel Springer recently struck a deal to divest some of its Berlin properties to Norway’s sovereign wealth fund and Blackstone for total considerations of €755 million, a figure that Forbes termed “unthinkable.” Axel Springer CFO Dr. Julian Deutz put it more diplomatically in a prepared statement: “The realized purchase price significantly exceeds our initial expectations.”

A July 12 piece in the Financial Times highlights the frothy conditions in French open-end property funds, noting that annual fund flows have more than doubled to €5.6 billion in the three years to 2016. The acceleration has caught the wary eye of Adrian Benedict, investment director of real estate at Fidelity International, who describes the situation thusly:

Small investors who are hungry for yield are piling into property funds, displacing large international investors, pushing up prices and depressing yields to unsustainable levels that no longer compensate for the risk involved.

With apologies to former Citigroup CEO Chuck Prince: The music is still playing, and investors in the Old Continent are still dancing.

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Why didn’t we think of that last time?

Headline of the day, via Reuters:
 

China's Politburo pledges to prevent 'systemic' financial risks: Xinhua

Recap July 25^th

A slow summer Monday featured sideways action in the major indices, while a headline earnings beat from Google after the bell was met rudely, to the tune of an initial 3% share price decline.  Treasury yields ticked higher across the board, with the 3 month bill yield now topping 1.16% compared to around 0.50% in February.

 - Philip Grant

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Rich in Fibra

Mexican REIT Fibra Uno reported in-line earnings this morning, eliciting little more than shrugs. 

Rich in Fibra

Mexican REIT Fibra Uno reported in-line earnings this morning, eliciting little more than shrugs. Revenues jumped by 12% year-on-year and total occupancy rate ticked to 93.7%, 30 basis points above first quarter levels. The quarterly distribution of just over 0.51 pesos/share equated to a 6.0% annualized yield, and the company’s operating margin footed to 72.8%. The low velocity reaction in the stock through midday offered little hint of an operational update.

For the bulls, no news is good news.  Riding a rebound in the peso against the dollar amidst abating fears of a big, beautiful border wall and new 52 week lows on the broad DXY index, Fibra shares have enjoyed gains north of 32% in dollar terms since late January.   Strip out the substantial influence of currency gyration, and Fibra’s near-11% advance from the end of January tops the 8.7% peso-denominated gain in the benchmark S&P/BMV IPC index.

The January 27 bullish analysis in Grant’s (“REIT numero uno”) made note of Fibra’s sound, experienced management team, diversified operations and relatively (grading on a curve is necessary these days) undemanding valuation.  Speaking to Evan Lorenz, vice president of investor relations Jorge Humberto Pigeon Solorzano described Fibra’s strategic rationale thusly:

‘This is a cyclical business. How do you protect yourself? Having affordable rents. Having good locations. Having prudent leverage.’ And, Pigeon adds, by having undrawn credit facilities with 7.1 billion pesos ($330 million) and $410 million of capacity.  ‘It is completely unused precisely to take advantage of opportunities if they present themselves in times of crisis.’

Crisis has seemingly abated, if the rebound in the peso/dollar exchange rate is any guide.  It will in time re-emerge (as is its wont) and Fibra’s seasoned management team is prepared.  CEO Andre El-Mann Arazi noted last fall that they “were able to weather the storms of the 1980s and 1990s, and we managed to grow during those crises.”  The severity of those disruptions puts that accomplishment into relief: 1981 to 1986 saw a 49% contraction in dollar-denominated Mexican GDP, with a 32% drop logged between 1993 and 1995.

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Wild wild east

Chinese retail investors are demonstrably risk-tolerant: Just note the proliferation of wealth management products, financing stocks, bonds, commodities and all other manner of assets.  Risk-tolerance does not equate to loss-tolerance however, as the Financial Times today recounts a peculiar incident at the Shanghai office of currency broker Union Standard Group Forex. 

According to the FT, “USGFX said that up to 50 investors entered their offices Wednesday afternoon, initially taking 20 staff hostage. Most staff were let go but three staff from China and Taiwan continued to be held in the offices as of Friday.”   The paper goes on to summarize the Middle Kingdom’s investor zeitgeist: “Chinese retail investors have a penchant for get-rich-quick schemes and to fight back when things go badly.”

Viewed in this context, the Chinese government’s various exertions to maintain financial stability are certainly understandable.  Referring to the USGFX incident, Peking University Economics professor Christopher Balding observed on Twitter: “This is why China cannot allow any large scale asset price decline, especially real estate.”

Or perhaps the question should be, what will Mr. Market command? 

Points for creativity

Disgusted by the prospect of a ketchup-slathered hot dog? The combination has long elicited something less than mouthwatering anticipation from a large swath of the grilling ranks. 

Instead of timidly accepting this widely held ketchup and hotdog-aversion lying down, Kraft-Heinz has a plan: a new topping called Chicago dog sauce, which, according to USA Today, “is a new condiment that looks like ketchup, tastes like ketchup, and also is ketchup.” 

A visit to the product’s home page reveals the “dog sauce” is sold out.  With this level of innovation, who needs zero based budgeting?

Not ketchup

July 21^st recap

Monthly options expiration did little to spice up the recent index-level inertia, with the broad S&P 500 logging a narrow pullback from the most recent highs logged yesterday.  Treasurys were mostly bid, but the sharp recent sell off in the three-month bill continues apace.  A three month yield now fetches above 1.16%, compared to 1.34% in the two-year note. 

 - Philip Grant

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IPO blues

A strange sighting on the wires this morning:  On the day its shares were scheduled to price, prospective public concern Yogaworks announced it was pulling the plug on its scheduled initial public offering.  “Market conditions” was the company’s announced rationale.  

IPO blues

A strange sighting on the wires this morning:  On the day its shares were scheduled to price, prospective public concern Yogaworks announced it was pulling the plug on its scheduled initial public offering.  “Market conditions” was the company’s announced rationale. 

What market conditions might they refer to?  Not only are the major indices continuing to grind to new highs on a near-daily basis, but the IPO market itself has enjoyed outsize success this year, on aggregate. The Renaissance IPO Index has jumped by nearly 25% year-to-date, more than double the roughly 11% advance on the S&P 500. 

Perhaps the high-profile struggles of a pair of recent offerings, Snap Inc. and Blue Apron Holdings Inc., are the deterrent.  Like Yogaworks, both of those trendy, millennial-friendly companies operate at a loss.  Both have seen their shares struggle mightily, APRN’s having declined in nearly straight-line formation by nearly 35% from its late June debut.  SNAP is off by more than 45% from its March 3^rd highs; it listed on March 1.  

A story meanwhile in that investment bible known as the New York Post’s Page Six detailed the complaints of “incensed” SNAP shareholders as CEO Evan Spiegel lounges on a yacht off the Mediterranean with his supermodel wife, Miranda Kerr.

Still smiling:

Other, uh, unconventional companies appear undeterred by the market conditions which halted Yogaworks’ public ambitions.  Earlier this week came the S-1 filing for Chicken Soup for the Soul Entertainment, which intends to offer 900,000 class-A shares (carrying 1/10 the voting power of the class-B shares largely held by the Chairman and CEO) at an offering price of $12 per share.   

The company is filing its offering under the 2012 Jumpstart Our Business Startups (JOBS) Act, which allows businesses designated as “emerging growth companies” to exempt themselves from disclosure and reporting requirements previously mandated by the S.E.C. There is, however, still a section in the filing on corporate risk factors. It includes the following:

All of our assets are pledged to secure existing indebtedness.

Certain conflicts of interest may arise between us and our affiliated companies and we have waived certain rights with respect thereto.

Our exclusive license to use the Chicken Soup for the Soul brand could be terminated in certain circumstances.

You will experience immediate and substantial dilution.

Nasdaq may, after listing, delist our Class A common stock from quotation on its exchange, which could limit investors’ ability to sell and purchase our shares and subject us to additional trading restrictions.

And, last but not least:

The determination for the offering price of our shares is more arbitrary compared with the pricing of securities for an established operating company.

How about, Chicken Soup for the Wallet?

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One from the vault

Near 30 years ago, the late-July 1987 edition of Grant’s (“Perpetual motion”, click here to read) documented investment banks’ increasing emphasis on merchant banking. Era mainstays such as First Boston Corp. made their push into a business line that Grant’s described as “lending to a leveraged company in expectation that the loan will be repaid through the issuance of junk-grade debt.” This was in the teeth of that late-80’s bull market in junk bonds, stoked by financial celebrities such as Michael Milken and his firm, Drexel Burnham Lambert.

Economic conditions were strengthening 30 summers ago; real GDP growth, which had averaged “just” 3.4% in the four quarters ending in June 1987 (what would policymakers give for those numbers today?), was about to accelerate to 4.6% in the four quarters to come.  Corporate bond upgrades nearly caught up to downgrades after lagging far behind during the prior two years. Asset prices were on the upswing, and with it the government’s finances. “The nation’s composite, mark-to-market balance sheet has strengthened,” judged Grant’s.

Financial markets, then as now, featured a bull market in common stocks and compressing high yield spreads, and forecasts of continued good times were not hard to come by. Researchers at First Boston (now part of Credit Suisse Group) led by James L. Freeman proclaimed that continued corporate alchemy would do the trick: “The real [fuel] for higher prices comes from mergers and acquisition, restructuring and (stock) repurchases. So the question is not if the markets are going up, but how soon and how much.”

Indeed, the Dow Jones Industrial Average soon tacked on an additional 9.5% gain from late July to late August before stalling.  Soon to follow was Black Monday, which featured a harrowing 22.6% swan dive in the Dow on October 19, 1987.  Nevertheless, the Dow was able to scrape out a 2.2% advance for calendar 1987 despite the autumn’s historic setback.  

The summer of 1987 featured a few cracks in the credit façade, most notably an uptick in bank failures in what would become the savings-and-loan crisis. A total of 96 banks shuttered in by mid-1987, nearly 50% higher than the 66 seen by the middle of 1986.  

The survivors were increasingly extending themselves in search of volume: “A lot of higher-risk loans are being made that ought not to be made,” said Malcolm T. Murray Jr. president of Robert Morrison Associates (a financial services industry organization which now goes by Risk Management Associates). “Over the longer term, it’s almost certain to snowball into a problem.”

Grant’s asked three decades ago: “If the nation is going to play ducks and drakes with balance sheets, won’t credit risk intensify?” In the due passage of time, those mid/late-1980’s excesses in credit did come home to roost.

Recap July 20^th

Stocks consolidated their most recent advance, with the S&P managing to eke out a new closing high, while Treasurys flattened a bit after yesterday’s curve-steepening sell off.  The spike in 3 month bill yields continued, with that short term paper jumping another 3 basis points to 1.13%. The yield spread between the three month and two-year note is now just over 20 basis points, well below the average 50 basis point gap in those two instruments over the past year.

 - Philip Grant

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What a Wonderful Whirl

Now unfolds an update on a pair of conservatively-financed, venerable American companies with business models that (we contend) are at risk of competitive disruption: 

What a Wonderful Whirl

Now unfolds an update on a pair of conservatively-financed, venerable American companies with business models that (we contend) are at risk of competitive disruption: W.W. Grainger, Inc. and Whirlpool Corp. Each was the subject of a bearish Grant’s analysis earlier this year. One has made prophets of us. The other is less obliging.

Bad news (for the shorts) first.  Burnished by a 7.8% year-on-year gain in the June AHAM-6 (Association of Home Appliance Manufacturers) delivery index and by well-received results from European competitor Electrolux AB, Whirlpool shares reached a new 52-week high. They sit higher by about 13.5% from the time of Grant’s Feb-10 piece (“Spin cycle”), compared to a 6.8% gain in the S&P 500 in that period. 

Fellow appliance operator Electrolux raised its outlook for sales growth in North America (Whirlpool’s biggest, and most profitable region), although CEO Jonas Samuelson did cite particular strength in Electrolux’s air conditioners unit, a business in which Whirlpool is not as strong.  North American operating margins ticked to 8.4% for the Swedish appliance maker, well above the 6.5% logged in the year-ago period. Readers of the Grant’s analysis may recall that Whirlpool’s puffy North American margins helped form the backdrop for the bear case. Deputy Editor Evan Lorenz observed:

8.3% is the 20-year average margin of the North American division. If Whirlpool had earned that average margin, rather than the 11.5% it did report in 2016, company-wide operating income would have plunged by 26%.

Whirlpool has so far defied our anticipated contraction, first quarter operating margins in North America footing to 11.2%, compared to 10.4% in the first quarter of 2016.

A more immediately lucrative Grant’s bear call was the May 5th appraisal of W.W. Grainger (“In the Bezos bullseye”), which has since seen its share price decline by nearly 16% compared to a 3.5% advance in the S&P 500.  The bulk of that decline took place today, following second quarter earnings that featured inline revenue growth and a reiterated fiscal year outlook for adjusted earnings-per-share (headline EPS was well-below consensus on account of store closing costs). 

Increasing price pressure is at the heart of the bulls’ agita; U.S. pricing declined by 4% in the second quarter compared to the 2016 period, while CEO D.G. Macpherson said there is more work to be done on the conference call.

Well, when your prices are – when your visible prices are much higher than the competition, and you do things like digital marketing, you don’t get the returns that you get (sic) . . . It’s been 25 to 35% (of stock keeping units) have been re-priced (since) the beginning of the year . . . and that will be all of them soon.

Macpherson also stated on the call he expects the pricing decline to accelerate towards 6% for the balance of the year.

The springtime Grant’s piece focused on Grainger’s eroding pricing power, making note of 2016 deposition of Amazon Business vice president Prentis Wilson related to the now-scuttled merger between Staples and Office Depot:

It (Amazon) regards Grainger as a “primary competitor,” in fact, the only distributor that Wilson named in deposition. Pure and simple, Grainger is wearing a Bezos bullseye.

He’ll be back

So it is (say we), the common thread between these two long-standing American businesses:  Unsustainably high margins that are ripe for attrition.  Mr. Market terms us half right, so far.

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Sand castles in the desert

Those who thought that not-early stage bull markets were a time for shorts to complain about manipulative managements and an easy Fed might be forgiven for some cyclical confusion.  Last month, NYSE President Tom Farley described short selling as “Icky” and “un-American,” while today senior biotech lobbyist John Blake told Congress: “we strongly believe that the current lack of transparency related to short positions is enabling trading behaviors that unfairly harm growing companies, long-term investors, and, most importantly, patients.” 

Whatever happened to the schoolyard athletics taunt: Score-board?

In any event, bulls may have good reason for a nervous disposition.  Yesterday the same Tom Farley lobbied congress to repeal the Sarbanes-Oxley Act, which, in the wake of the early-aughts accounting scandals, prescribed criminal penalties for senior executives who sign fraudulent statements.  The roll-back of sensible, if burdensome regulatory apparatus in good times calls to mind the 1999 repeal of the Glass-Steagall Act.

Meanwhile, the uninterrupted march of higher prices (the Wall Street Journal notes that this is the farthest into a calendar year the major averages have gone without a 5% correction in 24 years) is evidently built on less than solid bedrock. 

Bloomberg today relays data from Novus Partners, which analyzed liquidity conditions using their in-house “30 day liquidity” metric to judge how ably hedge funds could exit their positions if required.  Novus finds that “the market could absorb only about 12 percent of the industry’s total holdings in a month right now.”  That metric sits near its lowest recorded levels, and compares to its long-term average of 29% going back to 1999.

Recap July 19^th

A powerful leg higher left the S&P at its best intraday levels at the close, as all eleven sector groups finished in the green with leadership in the resources (energy and materials) despite a bounce in the U.S. Dollar index.  Treasury yields ticked modestly higher across the curve, but there was nothing modest about the move in the 3-month Treasury bill which saw its yield jump by five basis points to 1.08%. The Congressional Budget Office estimates that the government will be forced to default on its debts sometime in October if it does not raise the statutory debt ceiling. 

 - Philip Grant

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Green tea leaves

The Bank of Japan has been hard at work.  

Green tea leaves

The Bank of Japan has been hard at work.  Buying ETFs at a ¥6 trillion ($53 billion) annual clip in its quest to foment 2% consumer price inflation, the BoJ now holds upwards of 71% of domestic ETF assets according to a report from Bloomberg.  The central bank’s outsize position is beginning to inspire unease among some unnamed BoJ members; apparently 70% ownership is the threshold for stoking concern over potential distortion.    

A prospective public outcry over the practice is one risk factor. In paraphrasing the BoJ officials, Bloomberg notes that “The timing of any such change would depend on a range of conditions, including . . . the extent of public criticism of its ETF buying, they said.”

The Financial Services Agency (Japan’s own S.E.C) is likewise “paying close attention” to the central bank’s ETF extravaganza, according to the report.  Perhaps most tellingly, some higher-ups in politics and banking circles are starting to get nervous.

Nobuyuki Nakahara, the erstwhile CEO of Japan’s largest bank (Mitsubishi UFJ Financial Group, Inc.) and a confidante of Prime Minister Shinzo Abe, publicly lamented an “artificial rise in stock prices” that accompanied the ETF purchase program.  His successor as CEO of Mitsubishi, Nobuyuki Hirano, likewise expressed “issues with the size” of the central bank’s ETF cache last week according to Bloomberg.

Growing criticism of radical monetary policy from the financial sector is not confined to the Far East.  As noted in the June 30 edition of Grant’s (‘A dangerous situation’), Deutsche Bank CEO John Cryan identified a prominent side effect to the European Central Bank’s own €60 billion monthly bond buying regime: “There has been absolutely no price discovery now in corporate bonds, so we don’t really know the price of credit, which is a very dangerous situation.”

Stateside, it is Congress more than the banking system which is applying heat to the stewards of monetary policy. In last week’s Humphrey Hawkins hearing, Rep. Bill Posey (R-FL) scolded Janet Yellen over the Fed’s reluctance to submit to an audit, dismissing the Chair’s assertion that providing the Government Accountability Office access to meeting transcripts (among other proposed remedies) would bring undue political pressure on the strictly data-dependent central bankers.

As for the Bank of Japan, their persistent accumulation of public equity through the ETF purchase program is producing some uneven results.  Fast Retailing Co., (9983 JP) the largest component of Japan’s Nikkei 225 index and accordingly the biggest theoretical beneficiary of the BoJ’s money-printing largesse, has seen its share price decline by nearly 25% since December despite steady buying from the BoJ. 

Nikkei estimated at the end of June that the Japanese central bank held about 15% of Fast Retailing’s shares outstanding (nearly half of which are already held by insiders). Last August the BoJ held just over 10%, according to Bloomberg.  If one were to assume an average holding of 12% from the time of that December peak, the BoJ would be sitting on an unrealized loss of at least ¥129.8 billion ($1.14 billion) on this one position. While certainly manageable considering the BoJ holds roughly ¥8 trillion in equity on its balance sheet, the downdraft in Fast Retailing could be instructive if and when a proper bear market were to get underway.  It is not so hard to imagine the potential for accidents here.

The printing press is overrated.  BOJ share price since 2013 (source: The Bloomberg):

No wonder the publicly traded BoJ shares (8301 JP) have had trouble catching a bid of their own in recent years.  Any activist shareholders looking for a new muse?

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Bull sightings

Courtesy of today’s Wall Street Journal: the old-school, tried-and-true (to its proponents) “Dow Theory” is signaling higher equity prices.  The theory, which holds that new highs in the Dow Jones Industrial Average should be confirmed by corresponding highs in the Dow Transports in order to portend a healthy bull market,  has flashed a yellow light to investors through the spring as the broad Industrial average repeatedly made new highs without confirmation from the Transports.  With the latter group riding an 11% advance from mid-May, both indices notched fresh highs on Friday.

File it under: For what it’s worth.

Recap July 18^th

Netflix-mania sparked a strong rally in the FAANG contingent and was enough to help nudge the S&P 500 to another nominal closing high amidst generally lackluster action away from tech.  Treasurys saw the biggest bull-flattening price rally in more than a month amidst some large block trades in the 10-year note futures.  Commodities were generally well bid, as the U.S. Dollar index approached fresh one-year lows. 

 - Philip Grant

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Is this your homework Larry?

BlackRock, Inc. is out with second quarter earning’s report this morning:

Is this your homework Larry?

BlackRock, Inc. is out with second quarter earning’s report this morning: Gangbusters growth in assets under management (a 16% year-on-year uptick) included a 32.3% jump in ETF assets; and ho-hum revenue growth of just 5.7%.  Growth in expenses virtually kept pace with the top-line, rising by 5.6% year-over-year and resulting in an earnings miss.  Larry Fink, a progenitor of the movement toward indexation and passive management, appears be a victim of its success. 

Nowhere is fee compression more in evidence than in the house that Fink built.  Last October, BlackRock cut its fees on more than a dozen ETF’s, and followed that up with a discount to six smart-beta ETF products in December.  Last week, BLK slashed its take on the iShares mortgage-backed securities ETF to nine basis points, one third of the 27 basis points it had charged previously.

Dwindling fees can be offset by sufficient volume growth, but “sufficient” is a daunting word for a behemoth such as BlackRock.  Thus, last week’s news that the company was actively encouraging consumer lenders such as Capital One to increase their deal volume in order to populate BlackRock’s soon to be launched iShares Consumer Asset-Backed Securities ETF (Almost Daily Grant’s, July 13^th) begs the question of the nature of BLK’s future growth. 

What level of profitability is sustainable?  How will apparently goal-seeking, “tail wag-the-dog” ETF’s such as the aforementioned ABS product fare when market conditions inevitably change? The September 2016 Grant’s analysis of BlackRock (“House of Fads”, click here to read), contained the observation that: “Self-evidently bad ideas don’t cause financial panics. It’s the good ideas turned bad – pushed beyond their reasonable limits - that do the damage.”

Sporting an enterprise value of more than six times trailing revenues, BlackRock appears priced for no such interruption of the good times.  

Source: The Bloomberg. Hat tip to Kevin Duffy, Bearing Asset Management

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A tale of two kingdoms

Happy days are here for China, sort of.  Monday brought word that GDP growth in the Middle Kingdom was a brisk 6.9% in the second quarter, with broad-based gains in industrial output (7.6%), fixed-asset investment (8.6%) and retail sales (11%) from their comparable 2016 levels.   According to the country’s statistics bureau, production of steel and aluminum reached record highs in June.  Bloomberg terms the Chinese steel mills to be in “a sweet spot, with larger suppliers ramping up output after a crackdown . . . triggered a shortage of some products, raising prices.”

Contrast that evident euphoria with the moribund price action in China’s ChiNext 100 index of small cap equities.  After a 5.1% selloff on Monday, the ChiNext now sits at its lowest level since January 2015, down by more than 15% year-to-date and nearly 27% over the last 52 weeks. 

Similarly, the ongoing saga of China’s heretofore high-flying conglomerates strikes a disparate chord.   The government has put the screws to the Dalian Wanda Group Co. in response to the company making a series of overseas acquisitions, cutting off financing from local banks and blocking Wanda from divesting those assets to any other Chinese company.  Evidently, Wanda’s international deployment of cash is what drew the government’s ire. 

Keith Pogson of Ernst & Young tells the Wall Street Journal that regulators, “are sending a clear message to the market that they’re going to make it difficult for companies to finance overseas deals.” Castor Pang of Core-Pacific Yamaichi HK notes the broader implications: “Not only Wanda, every Chinese company won’t find it easy anymore to acquire assets overseas. Stabilizing the yuan is the top priority for Beijing now.”

Volatility M.I.A

Since its 1990 inception, the CBOE SPX Volatility Index (VIX) has averaged just below 20.  It has closed below 10 on 19 occasions over that 27-plus year period; 10 of those have taken place since May of this year.

Meanwhile, those who rode the low-volatility wave have achieved some extraordinary results. The VelocityShares Daily Inverse VIX Short-Term ETN (XIV) finished the day trading above 90, a 209% gain from its July 16, 2016 closing level.  That product carries a hearty 1.35% expense ratio, but it’s doubtful that many holders mind too much these days.

Recap July 17^th

Modest early strength in the S&P 500 was reversed to an unchanged finish by the close, although a bullish reaction to Netflix earnings (+10% in the aftermarket) gives the bulls a leg up for tomorrow.  Treasurys were likewise little changed,  while gold saw a second straight green finish to inch to its best levels since the end of June near $1,233/oz.

 - Philip Grant

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Buffed with a fine chamois

It’s been quite a year for equity holders of Restoration Hardware Holdings, Inc.  

Buffed with a fine chamois

It’s been quite a year for equity holders of Restoration Hardware Holdings, Inc.  Riding a 20.22 million share company stock buyback that has eliminated virtually half of the shares outstanding, RH has burned the substantial (13 million shares as of last check) contingent of short sellers with a near 120% share price advance year-to-date.

Grant’s was on the scene with a bearish recommendation back on January 23, 2015 (“House of Mirrors”, click here to read). Quoting from CEO Gary Friedman on the fiscal third quarter 2015 conference call:

‘We see a clear path to $4 billion to $5 billion in North American sales, mid-teens operating margin and significant free cash flow.’ For perspective, the company is currently producing $2 billion in annual revenue, a 9% operating margin and negative free cash flow.

A look at Restoration Hardware’s most recent financials indicates that precious little progress has been made toward Friedman’s goals.  Trailing 12-month revenues register $2.24 billion, with the operating margin shrinking to 4.7%.  Free cash flow of $185 million was burnished by a decline in capital expenditures as the company has slowed its expansion of stores,  first quarter capex of $13.5 million was a fraction of the near $49 million in the prior year period.

Nearly half of its $106.8 million in trailing 12-month operating income was allocated to interest expense, as the company has financed its share repurchase with $1.12 billion in new debt, encompassing term loans, revolving credit agreements and the issuance of zero coupon convertible notes due in 2019 and 2020.

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Mama mia

Debt levels are rising the world over, but the Italian Republic seems to be contributing more than its fair share of the tally. Bloomberg reports today that Italian public debt rose to a fresh record high in May of €2.28 trillion, which equates to 136% of 2016 GDP of €1.67 trillion as tabulated by the International Monetary Fund, the second highest ratio in the eurozone after Greece. 

In tandem with an encumbered public sector is a frail banking system. In late June, the Italian government bailed out Venice-area banks Banca Popolare di Vicenza and Veneto Banca after the European Central Bank termed them as “failing or likely to fail.” More broadly, Reuters estimates that the proportion of nonperforming loans across the country exceed more than threefold the European average of roughly 5% of GDP.

A time traveler unversed in the epic bond bull market and the ECB’s current €60 billion monthly QE undertakings might guess that Italy would be obliged to pay a dear interest rate to finance itself considering its tenuous fiscal position.  Ten-year Italian debt is currently priced to yield 2.29%, below the 2.32% fetched by 10-year U.S. Treasurys.   That convergence is even more striking in light of the fact that the U.S. total public debt to 2016 GDP ratio was a far more manageable 86%, while the domestic banking system has suffered few setbacks in the past eight years.

It is not easy to make U.S. government debt look like an compelling investment following 35 years of persistent price appreciation and yield shrinkage, but next to Italian debt the obligations of Uncle Sam look downright attractive.

Sinking feeling

Have we got a deal for you, San Francisco-area home buyers! For an asking price of $850,000, a four bedroom, 3 bath ranch style home in the Lafayette neighborhood with a clear view of Mount Diablo can be yours.  The catch? The house is currently lacking a backyard, as the winter rains spurred a landslide that has left it at the edge of a steep, 20 foot cliff.

Where does the grill go?

A sign on the front door reads: “This structure has been seriously damaged and is unsafe. Do not enter. Entry may result in death or injury.”

Potential buyers are apparently undaunted.  With the home on the market for just a week, listing agent Valerie Crowell claims she has received 10 inquiries so far, with one offer in. 

Hats off to de facto listing agent Janet Yellen.

Recap July 14^th

The S&P 500 shook off a downbeat reaction to earnings releases from money center banks J.P. Morgan, Citigroup and Wells Fargo to advance to a fresh closing high amidst sturdy price action in technology and the consumer realm.  Commodities finished broadly higher amidst the weakest close in the US Dollar Index since September of 2016,  and U.S. Treasury yields dipped across the board.

- Philip Grant

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Creditor prey

Heady days for corporate borrowers: From consumer loans to structured credit and junk bonds, debtors are up in the driver’s seat.  

Creditor prey

Heady days for corporate borrowers: From consumer loans to structured credit and junk bonds, debtors are up in the driver’s seat.  Some dispatches from the fixed-income motor speedway:

The June 23 edition of Asset-Backed Alert contains a pair of illuminating stories.  A front page article “BlackRock Summons Issuers for ETF Plan” details the asset manager’s efforts to cajole consumer credit issuers to step up their deal volumes. Why? Because the soon-to-be-floated iShares Consumer Asset-Backed Securities ETF needs to buy something. The following piece “Income Verifications Catch Eye of Regulator,” notes an SEC investigation of multiple originators for potential “unverified or incorrect” representation of borrower incomes.  An unnamed source tells Asset-Backed Alert: 

They collect loan information and income, and even if it’s significantly different, some of these firms are going with the original decision they made on the loan grade.

Structured credit holders were dealt a rude surprise earlier this month, when trustee Wells Fargo announced it would “divert” $91 million out of the $540 million called from holders of Residential Mortgage Backed Securities to help cover its potential legal liabilities.   Fitch Ratings subsequently placed a number of other RMBS products on review for downgrade, after determining they were also at risk for similar diversion of funds.  This practice is becoming more widespread, as the Fitch report notes that:

J.P. Morgan's research team has identified four transactions where three trustees other than Wells Fargo (U.S. Bank, Bank of New York Mellon and HSBC) withheld funds on called transactions.

High-yield corporate borrowers have it especially good these days.  According to an analysis by Moody’s, bonds issued across North America in June featured the weakest covenant quality since at least spring 2011 (when the ratings agency began tabulating the metric), with a record 60% of June issuance and 47% in the Moody’s index carrying the dreaded “High-yield-lite” designation.  Alexandra Scaggs of FT Alphaville explains:

High-yield-lite bonds automatically earn Moody’s worst CQ (covenant quality) score, because they lack the usual high-yield covenants that limit activities like taking on more debt, or making dividend payments.

Moody’s sounds the alarm:

The Alphaville piece goes on to identify a mid-June offering from Tenet Healthcare Corp. that managed to secure those easy-breezy terms, despite a well-below investment grade CCC-plus rating (the $500 million offering, priced at par with a 7.00% coupon, continues to trade near that level).  

Tenet carries a debt load in excess of $15 billion, against GAAP pre-tax income of less than $150 million in the trailing 12-month period.  Nearly half of trailing 12-month EBITDA of around $2 billion was allocated to interest expense.  Free cash flow in the past year registered negative $268 million.

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Fightin’ words

National Beverage Corp. (NYSE: FIZZ) CEO Nick Caporella is known for a particularly, uh, enthusiastic management style, so perhaps the company’s press release this morning touting its recent operating performance came as no surprise to his happy stockholders (FIZZ shares have nearly doubled year to date). It began thusly: 

The release of our year-end financial statements certified that FY 2017 was the best year in the history of National Beverage – absolutely!

In reference to the company’s hefty contingent of disbelievers (Bloomberg shows a short interest in excess of 18% of the float), Caporella asserted that their fiscal year results exceeded the expectations of not only their fans but also their “cash poor detractors.” 

With surging profits and a percolating stock price, Caporella’s evident euphoria is understandable, but nevertheless the shorts have a bit of extra change in their pockets.  FIZZ shares reversed their early gains and finished weaker by 8.5%, near the lows of the session.

Recap July 13^th

A strong bid in biotech and the financials helped push the broad S&P 500 back within a few basis points of its closing high water market. 

Treasurys finished weaker across the curve in bear-steepening formation as this afternoon’s long bond auction yield priced higher than expected. Energy continued its rebound with WTI crude back near two week highs above $46/barrel. 

- Philip Grant

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Greater grains

A dispatch from a Pennsylvania farmer: 

Greater grains

A dispatch from a Pennsylvania farmer: “There seems to be a bull market developing in the grains…  We just took in 400 acres of wheat, storing some and capitalizing the big move in prices with others.  One more crop failure in either Europe or Russia or China would make harvest time in October, November and December in the U.S. a big moment.”

If our friend is on the beam, Mr. Market has yet to take notice.  The PowerShares Deutsche Bank Agriculture Fund (NYSE: DBA) continues to hover around 10-year lows, roughly 25% below its average price over that time.   A recent 20% jump in the price of wheat still leaves that staple about 17% below its own average price over the past 10 years.

Kindness of strangers

A recent report from the Bank for International Settlements adds statistical weight to the intuitive relationship between microscopic interest rates and the increasingly rare capitalist feature of creative destruction.  According to the BIS, the proportion of so-called zombie firms, defined as those with interest expense in excess of earnings before interest and taxes, nearly doubled in the 2007-2015 epoch, to account for more than 10% of the median corporate universe across the developed world.   Outside funding is essentially required to keep the lights on for these encumbered businesses.

Having stumbled upon a revelatory fact, the BIS report then strains to avoid identifying the obvious cause.  “Indeed, the share of zombie firms…has increased significantly despite unusually low levels of interest rates.” 

Despite?  Easy money necessarily forestalls corporate failure, and the continued operation of businesses that should have exited stage-left necessarily hinders the ability of potentially better ones to take their place.

Later, the BIS identifies a critical feature of this dwindling dynamism:

Post-crisis investment weakness, coupled with resource misallocations, has no doubt contributed to the further deceleration of productivity growth.

No word from the bank on the root cause of this malinvestment.  We have a few theories, and observe that Japan has remained in economic torpor since its own 1989 real-estate bubble collapse amidst widespread government intervention on behalf of teetering corporate concerns.

In his 1942 book Capitalism, Socialism and Democracy, economist Joseph Schumpeter laid bare the essence of Adam Smith’s brainchild. Free enterprise “incessantly revolutionizes the economic structure from within, incessantly destroying the old one, incessantly creating a new one. This process of Creative Destruction is the essential fact about capitalism.”

Government-administered interest rates may help delay job loss and other forms of short term pain, but true capitalism it is not.  

Counterpoint

YUM China’s KFC brand and Chinese electronics brand Huawei have teamed up to soon release a limited edition smartphone,  which will feature the fried chicken joint’s logo as well as a new music app that “allows users to choose the music that plays in KFC restaurants,” according to online magazine Shanghaiist. The smartphone complements previous KFC initiatives in China, which included the debut last year of “edible nail polishes that purport to capture the flavor of KFC's secret recipe chicken in two variations: Original and Hot and Spicy.”

Take heart, Joseph Schumpeter.

Certainly creative

Recap July 11^th

A steep mid-day drop in equity prices was promptly reversed, leaving the SPX back in summer consolidation mode roughly one-percent below its closing high water mark.  Treasurys and corporate bonds both held steady, while the Dollar index continued to hover near its lowest levels since the fall. 

- Philip Grant

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Tales from the crypto

Crypto-currencies, the corner of the capital markets which perhaps most resemble the Wild West, took another tumble today.

Tales from the crypto

Crypto-currencies, the corner of the capital markets which perhaps most resembles the Wild West, took another tumble today.

Bitcoin, the elder statesman of this nascent asset class, sank by about 5% and is off by nearly a third from its mid-June peak.  Peer ethereum saw losses on the order of 10%, and has given back roughly 42% from its high water mark reached June 12. 

No one should be shedding a tear for the longs, at least those who got in early. Even with this recent correction the price of bitcoin is higher by about 150% year to date.  Ethereum has soared by more than 27-fold in 2017 so far.

With such gaudy appreciation naturally comes wider attention, as well as new expressions of the sincerest form of flattery.  Friday came word that U.S. regulators have approved “fully-collateralized, physically settled” options trading in bitcoin via the LedgerX platform.   

Physical bitcoin?

This weekend The Wall Street Journal highlighted the exponential growth in “Initial Coin Offerings,” an unregulated crypto-based cousin to the more traditional fund raising techniques long employed by corporations.  The Journal’s Paul Vigna explains:

In a coin offering, the coins being sold are similar to bitcoin and ether[eum]. Investors purchase a coin, or digital token, that they can use in the future to buy a product or service a company plans to offer.

The coins usually don’t confer any ownership in a company. Rather, investors hope they will rise in value over time if a company’s product or service is popular.

Three such offerings have each raised over $100 million, while aggregate “ICO” proceeds have topped $1.1 billion this year, more than 10-times the 2016 level.

In a May 19 analysis (“I own tulips at 40 cents a bulb”) of bitcoin and its role in the so-very modern monetary regime, Grant’s paraphrased the words of Horizon Kinetics CEO and bitcoin bull Murray Stahl, who termed the alt-currency a “store of value…a monetary asset that’s winning its place in the hearts and minds of the world’s financially repressed.”

We wonder if the law of diminishing returns might apply to the growing ranks of the burgeoning crypto-currency asset class. Buyers of these Johnny-come-lately’s should consider the Warren Buffett quote: “What the wise man does in the beginning, the fool does in the end.”

Pull the lever

An eye-catching dichotomy has emerged in the realm of consumer borrowings, as flagging credit creation for goods and services contrasts with robust loan growth in service of financial speculation. 

Aggregate consumer credit growth in the first five months of 2017 has slowed by nearly 15% from the comparable period a year ago.  Over the same period, margin debt as tabulated by the New York Stock Exchange has jumped by more than 19% from its 2016 levels.

Wealth effect, here we come!

Recap July 10^th

A bounce in tech helped push the S&P 500 back to the middle of its narrow one-month trading range, as outperformance from the FAANG contingent helped push those stocks back within 4.4% of their respective highs, on average, compared to the Nasdaq 100 which is about 3% off its peak and 1% on the S&P 500.  Snapchat, Inc. was a notable absentee from the party with a 1.5% decline taking that loss-making company back below its $17/share IPO price.

U.S. Treasurys were bid modestly across the curve after last week’s sell-off and ahead of $56 billion in fresh supply later this week in three & ten-year notes and 30-year bonds. 

- Philip Grant

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Rate & roll

This morning’s release of June non-farm payrolls brought a measured dose of relief for those worried about a slowing economy:

Rate & roll

This morning’s release of June non-farm payrolls brought a measured dose of relief for those worried about a slowing economy: Headline job growth of 221,000 easily topped consensus, while net payroll revisions to the prior two readings added an additional 47,000 tallies to push total private employment to record high levels, using both the establishment and household surveys.  Wage growth of 2.5% annualized was below the 2.6% consensus, but still represented the 16^th straight reading of 2.5% or higher year-on-year earnings growth, exempting the 2.4% gain seen in May.

One constituency who caught no such relief is U.S. Treasury longs. The complex sold off yet again in bear steepening fashion, pushing the 10-year yield to near 2.4% from the sub-2.15% level at the close of business two weeks ago.  The sharp springtime rally in bond prices has been emphatically halted:  that benchmark 10-year yield now sits about 20 basis points from the 52 week highs logged in March.

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Bit wit

The march of financial technology stops for no man, woman or child.  Yesterday the U.S.  Commodity Futures Trading Commission announced a registration order for LedgerX, an options trading platform for bitcoin.  The approval bestows on LedgerX status as the first federally regulated bitcoin exchange and clearing house to list “fully collateralized, physically settled” options in the crypto-currency.

Finally, the staid and traditional bitcoin exchange marketplace can be supplemented with derivatives: A tradition as American as apple pie.

Now, maybe the Winklevoss twins can put that whole Facebook thing behind them.

Silo, sell high

What happens when low prices and solid demand meet vast supply?  The agricultural commodity market is currently providing watchers with such a case study, as robust worldwide appetite for soybeans and corn has run into record inventory in those grains. 

Amidst the recent emergence of Brazil as a major source of production, worldwide soybean reserves are poised to jump by 21% from the prior year to a record 93.2 million tons, according to estimates from the USDA.  World corn ending stocks reached a record 212.5 million metric tons in June, roughly 47% higher than the ten year average reading of 144.9 million metric tons.   

Abundant supply is putting the squeeze to Brazilian farmers who have played no small role in the expanded production of recent years: Brazil is today the world’s number one soybean exporter, while its corn crop is expected this season to surpass 100 million tons for the first time. 

Brazilian farmer Nelson Antonini, who sits on the board of farm cooperative Copasul, tells Bloomberg that “Warehouses are still full of soybeans while farmers start the winter-corn harvest.” Federico Azevedo, a manager at farmer’s group Aprosoja, reports that “we’ve seen a great number of farmers ordering silo bags to store corn.” 

No room here:

Demand has not been the problem. Worldwide domestic “crush” usage (grinding the beans into oil, its predominant usage) is forecast at 301.5 million metric tons in 2017-18 in the June WASDE report, a 3.7% year-on-year increase.  2017-18 worldwide corn usage for domestic feed is forecast to rise by 2.5% over its prior season levels, per WASDE.  China has been a prime contributor to demand growth; Chinese soybean imports in May registered a record 9.59 million tons, nearly 26% higher than their prior year levels and 55% above those seen in 2015.  

The laws of economic gravity may be putting a halt to the beans influx sooner than later: Reuters this week reported that ships carrying as much as 700,000 tons of soybeans are parked along the Chinese coast, waiting for space to offload their wares.  An anonymous trader summed it up to Reuters: “The beans can't be discharged because they don't have enough warehouses.”

Back in Brazil, inventory-laden farmers are faced with a decision as existing soybean stocks will soon compete for space with the imminently-arriving winter corn harvest.  Agricultural analyst Luiz Fernando Roque of Safras & Mercado advises: “If they had to choose between saving the soy or corn, they’re likely to prioritize corn sales and hoard the beans. Farmer’s don’t want to sell at current prices.”

Mark Twain is purported to have once said: “Buy land, they’re not making it anymore.”  Then again, Rick Perry recently offered:  "Here’s a little economics lesson: supply and demand. You put the supply out there and the demand will follow."

That more contemporary counsel has evidently not been lost on farmers around the world. 

- Philip Grant

Grant’s Interest Rate Observer . . . Thinking required™

Yield of dreams

Interest rate risk still exists, after all.   

Yield of dreams

Interest rate risk still exists, after all.   Sovereign yields have spiked in Europe of late, with regional economic champion Germany seeing its 10-year yield jumping nearly 10 basis points today to 0.562%, its highest since January of 2016. Just last week the same paper was priced to yield 0.24%.   With a coupon of 0.25% on the current 10-year note, the recent downtick in face value from north of 100 to just above 97 cents on the Euro represents a loss equivalent nearly 12 years of coupon payments (more than the life of the bond). 

 No margin of safety here. German 10 year yield:

Neighboring France has seen yields on its 10-year note move to 0.92% from sub 0.60% last Monday, while BBB-plus rated Spain has seen its 10-year yield rise to 1.68% from 1.37% in that same period.  

The selloff is all the more remarkable as the European Central Bank is in the midst of a €60 billion-per-month QE program.  Amidst self-imposed mechanical restrictions such as the “capital key” rule dictating that sovereign bond purchases be proportional to the size of the country issuing them, as well as its limit of 33% ownership in any particular bond issue,  the ECB is finding itself increasingly constrained on what it can buy, according to Kim Liu of ABN Amro:

The recent data reveals that the ECB is forced to de facto taper its core-country buys even before the QE program’s potential deadline of December 2017…the constraints are becoming more visible and will intensity.

However, upward pressure on sovereign borrowing rates has not been confined to Europe. The even more central bank-dominated-Japanese bond market has also sold off, its benchmark 10-year yield reaching a near five month high of 0.104% from 0.047% last Tuesday.  Bloomberg reminds us that “after the yield jumped to 0.15% on Feb. 3, the (Bank of Japan) held a fixed-rate operation to buy an unlimited amount of the securities to bring yields back down.”

Virtually zero-yielding 10-year debt is a BoJ policy in service of its policy goal of measured 2% inflation. The demonstrated efficacy of low rates in this regard has been wanting:  Over the past 20 years, the 10-year Japanese Government Bond yield has averaged 1.176%. During that time, Japanese annualized CPI has registered above 2% in only 21 months, or under 9% of the time.  One hundred twenty-six monthly readings in that period has CPI been in contraction year-on-year, more than 52% of the time.  Perhaps one day the widely held presupposition that zero or negative nominal interest rates necessarily stimulate consumer inflation will come under closer inspection.

Up the credit risk-river, emerging market sovereign bonds have also seen their yields lurch higher, all but closing a valuation gap with emerging market corporate debt.  Bloomberg today reports that the yield spread between the USD Emerging Markets Sovereign Index and the corporate index has dropped to just four basis points,  the lowest level on record.  As recently as January of 2016, the yield gap between those two indices was as wide as 168 basis points.

The selloff in government bond yields of all stripes has not spared the Argentine Republic, a nation that has defaulted eight times in its history but recently returned to investors’ good graces following the 2015 election of Mauricio Macri as president.  Argentina has since fully availed itself of the now-accommodative capital markets, raising more than $10 billion in USD-denominated debt so far in 2017, well beyond the $7 billion on dollar bonds that the government planned to issue this year as of January.

If not a direct catalyst for the reversal, the mid-June sale of 100-year Argentinian bonds (Almost Daily Grant’s, June 19) at a yield to worst of 7.917% roughly coincided with the interim highs in sovereign debt prices. Issued at 90 cents on the dollar, the century bonds initially rallied to as high as 93 before reversing.  Today they traded to their lowest level in their brief existence, dropping below 89 cents on the dollar on an intraday basis.

On the bright side, investors only have to wait 99 years, 11 months and two weeks until principal repayment. Time flies when you’re having fun.

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Say’s who?

Department of Energy secretary Rick Perry, at a West Virginia coal plant earlier today, as quoted by Taylor Kuykendall of S&P:

"Here’s a little economics lesson: supply and demand. You put the supply out there and the demand will follow."

Recap July 6^th

Simultaneous selling pressure in equities and U.S. Treasurys made this session an unpleasant one for practitioners of risk parity.   A late extension to the downside pushed the S&P 500 through the low end of its tight recent trading range to its lowest close since May 24^th.

Bear-steepening in the Treasury curve pushed the spread between five and 30 year yields wider off the more than eight year lows reached yesterday. 

- Philip Grant

Grant’s Interest Rate Observer . . . Thinking required™

Amazon warrior

News items over the lengthy July 4 weekend offered no succor for the beleaguered retail realm.

Amazon warrior

News items over the lengthy July 4 weekend offered no succor for the beleaguered retail realm.  Jeans and denim purveyor True Religion Apparel, Inc. filed a pre-packaged Chapter 11 bankruptcy for relief of $350 million in debts. 

This morning, auto parts retailer O’Reilly Automotive, Inc. saw its shares clubbed after June comparable store sales came in far below the company’s’ prior guidance.  CEO Greg Henslee cited “a more challenging environment than expected” for the shortfall and “overall weak consumer demand.” Henslee also lamented the whims of Mother Nature, particularly the mild winter just passed.  Left unsaid was any potential role of Jeff Bezos and Co. in the shortfall.  Judging by today’s near-19% share price decline, ORLY holders appear disinclined to wait for a snowy winter.  

The specter of disruption-Amazon style likewise looms in no subtle way over the mall business.  Bloomberg today relays that many operators are pouring investment into their properties in order to keep customers coming through their doors instead of logging on to find their wares.

Rent payments from eateries are never going to recoup the renovation costs, but for landlord Time Equities, Inc. that’s not the point. The point is survival.

(Mall owners) are turning to everything from restaurants and bars to mini-golf courses and rock-climbing gyms to  draw in customers who appear more interested in being entertained during a trip to the mall than they are in buying clothes and electronics.

There is good reason for the apparent strategy shift: data from Cushman & Wakefield and Moody’s Analytics points to an imminent jump in U.S. store closures, with almost 10,000 expected in 2017 from the roughly 4,000 annual run rate in the prior three years.  In 2018, closures are expected to jump to near 12,000.

The mall REIT industry has of late been struggling amidst these dynamics, with class ‘A’ mall operators GGP, Inc. and Simon Property Group, Inc, seeing their shares weaker by 7.5% and 11% year to date, respectively. 

Pennsylvania REIT, which is leveraged to now-struggling J.C. Penney, Macy’s and Sears (together representing more than 33% of gross leasable area as of February) and the subject of a March 22, 2013 bearish feature in Grant’s (“Just looking”, click here to read), has had it far worse with a-more than 40% stock price decline year to date.  Management laid bare their troubles in the most recent form 10-K:

Changes in the patterns of consumer spending have led to decreased operating performance of and bankruptcy or similar filings by several retailer tenants, which has led to store closings, delays or deferred decisions regarding lease renewals and the openings of new retail stores at our properties, and has in some cases affected the ability of our current tenants to meet their obligations to us. 

The (perhaps rhetorical) question at hand:  how much of the pain in brick & mortar can be attributed to the business acumen of Jeff Bezos,  and how much to a consumer that doesn’t seem to be acting the way one might expect amidst record high asset prices and a B.L.S.-measured 4.3% rate of unemployment?    

A bit of both, it appears to us.

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3G cookin’

What hath a cost-cutting corporate culture wrought?  Feast your eyes on the new Burger King Cheddar and Bacon Grill Dog. 

http://boingboing.net/2017/07/05/burger-king-cheddar-and-bacon.html

Priced at 79 cents, one could argue you’re getting your money’s worth? 

In any event, Burger King comparable store sales declined by 0.1% in the first quarter from 2016.  We may be holding our noses, but are not holding our breath for a turnaround in the second quarter.

Recap July 5^th

With equities and U.S. Treasurys confined to a tight range, action today was concentrated in the energy patch as comments from the Russian oil minister implying reluctance toward further production cuts spurred a 4.5% sell-off in Brent crude. 

For 2017, the S&P energy index is down by roughly 14%, while the Van Eck Oil Services ETF (OIH) is weaker by nearly 26%.

- Philip Grant

Grant’s Interest Rate Observer . . . Thinking required™

Defensive driving

They grow up so fast.

Defensive driving

They grow up so fast.  Spin-off real estate investment trust Parkway, Inc. wasn’t long for the public securities market after its September 2016 trading debut, agreeing today to a $1.2 billion takeover offer from the Canadian Pension Plan Investment Board comprised of $19.05 per share in cash and a $4 per share special dividend. 

That prospective deal price of $23.05 a share represents an approximately 13% premium to yesterday’s closing price of $20.38 a share. A fairly concentrated investor base (Vanguard, Blackrock and TPG Capital together hold more than 37% of the share count) should simplify the shareholder approval process; the deal is expected to close in the fourth quarter.

Parkway, an operator of 19 Class A designated (meaning premier) office properties in Houston, Texas, announced in its first quarter results a slightly upsized fiscal year earnings outlook, now expecting full year funds from operations at $1.42 per share using the midpoint of its range, from $1.39 expected this year as of its fourth quarter 2016 results.  That modestly improved outlook hasn’t translated to stock-market riches; prior to the deal announcement shares had slumped by about 9% year to date against a 3.8% gain in the iShares U.S. Real Estate ETF. 

Proximate cause of Mr. Market’s stinginess?  Likely the less-than delirious conditions in Houston’s real estate market, colored by the ongoing struggles in the energy business.  According to Colliers’ First Quarter Houston Office Market Report, Class A vacancies in the Central Business District jumped to 17% from 11.8% in the first quarter of 2016.  Parkway has evidently managed this exodus just fine; its first quarter occupancy came to 85.9%, and was 87.5% including leases which have been signed but yet to commence.  Each represents an improvement of 10 basis points over levels seen in the prior quarter.

In a November 25, 2016 write-up in Grant’s (“Redheaded stepchild REIT”, click here to read), former colleague Alexander Hess made note of Parkway’s relatively high quality asset portfolio, solid balance sheet footing and undemanding valuation using both FFO and net operating income metrics.  Its relatively strong cash generation continued in the first quarter: NOI of $41 million compared to full year 2016 NOI of around $155 million, and implies a meaty 9% cap rate.  

Now come the Canadians, and with them the likelihood that Parkway’s brief time as a public company is drawing nigh. In light of the relatively skinny deal premium and Parkway’s evidently strong operating performance, it is fair to wonder if the prospective buyers are getting these assets too cheaply.  Grant’s attempted to reach the company by phone and email this morning to inquire over its rationale, but received no response by publication time.

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Keep calm and carry on

Now more than ever, households in the United Kingdom are feeling the pinch.  Today’s data from the Office of National Statistics found that the savings rate among British consumers drooped to a record low of just 1.7% in the first quarter, a paucity compared to the 5.5% of personal income pocketed by Americans in the most recent May data.

On the whole, aggregate real disposable income saw its third straight sequential contraction, the first time that’s happened since the economically unhappy 1970’s.  Bloomberg notes that the consumer data “means households have little in reserve as they are forced to spend more and more simply to maintain the same standard of living.”

The evidently tapped out U.K consumer can expect no help from his or her central bankers. Bank of England President Mark Carney promised on Wednesday an imminent “removal of monetary stimulus” and suggested that the time for rate hikes is drawing near. 

Borrowing costs are snapping higher in response, albeit from a very low base. U.K. two year bond yields have risen this week to around 36 basis points from less than 10 basis points in the middle of June.   

Société Générale strategist Guy Stear subsequently observed: “It has become fashionable to be hawkish on the MPC (monetary policy committee).” Carney himself offered some ominous words to the encumbered on a BBC appearance:“Borrowers should consider adverse scenarios as well as positive scenarios.” Now they tell us.  

Recap June 30^th

A late downdraft all but erased solid gains for equities, leaving the broad S&P 500 weaker by 0.60% for the week. With the second quarter now in the books, the S&P stands higher by 8.2% in 2017 so far.  

Another round of upward pressure on interest rates left the 10 year Treasury yield above 2.3% from last week’s 2.14%, while the 2 and 10 year spread widened to near 92 basis points from below 80 basis points a week ago.   Finally, an extension of the recent energy bid pushed WTI crude back above $46/barrel; nearly 10% above the intraday lows logged last week. 

- Philip Grant

Grant’s Interest Rate Observer . . . Thinking required™

Preaching to the choir

The House Financial Services Committee yesterday held a hearing on “The Federal Reserve’s Impact on Main Street, Retirees, and Savings”

Preaching to the choir

The House Financial Services Committee yesterday held a hearing on “The Federal Reserve’s Impact on Main Street, Retirees, and Savings”, featuring a panel of four economists from Washington, D.C. think tanks.  For nearly three hours, the committee and panelists shone a light on monetary policy in the post-crisis era. Numerous moments in the hearing might have elicited uncomfortable seat-shifting from any listener in the Mariner Eccles Building. 

Norbert J. Michel of the Heritage Foundation found that CPI inflation has averaged 3.35% since 1913, compared to 0.22% in the preceding 123 years (for more see “Cheer up Charlie”, Almost Daily Grant’s, June 21).  Following the adoption of the price stability mandate in 1977, CPI inflation averaged 3.74% during the 1979-2013 period.   Michel further commented:

Consequently, the long-term purchasing power of the dollar has dramatically declined. Anyone not lucky enough to receive an automatic raise every year as the CPI crept up probably does not view the reduc­tion in variability as a great improvement, no matter what macroeconomists think.

Federal Reserve offi­cials also seem to be thrilled with the idea of stamping out the good type of deflation that a growing capitalist economy would normally produce. Though virtually everyone in Main Street America understands exact­ly why the Wal-Mart business model benefits them, the Fed appears bent on stamping out Wal-Mart’s low prices. For the Fed, deflation has become synon­ymous with depression, even though the empirical evidence suggests otherwise.

Paul H. Kupiec of the American Enterprise Institute offered a tangible suggestion for enhancing Congressional oversight of the central bank:  releasing the Fed chair’s written semi-annual Humphrey Hawkins testimony well in advance of the hearing date, which would allow for non-Fed experts to offer detailed feedback that could inform more robust questioning from Congress.

An intriguing idea from our perch at 2 Wall Street, likely less so at Eccles.

Perhaps the most effective salvos of all were landed by Alex J. Pollock of the R Street Institute, who calculated that monetary policy since 2008 has led to a net $2.4 trillion wealth transfer away from savers.  Pollock then went for the knockout blow, challenging the premise of the Fed’s raison d’etre:

There can be no doubt that taking $2.4 trillion from some people and giving it to others is a political decision and a political act.  As a clearly political act, it should be openly and clearly discussed with the congress…analyzing the economic and social implications.

If you believed that the Federal Reserve had superior knowledge and insight into the economic and financial future, you could plausibly conclude that it should act as a group of philosopher-kings and enjoy independent power over the country. But no one should believe this. It is obvious that the Fed is just as bad at economic and financial forecasting as everyone else is. It is unable to consistently predict the results of its own actions. There is no evidence that it has any special insight. That is in spite of (or perhaps because of) the fact that it employs hundreds of Ph.D. economists.

Moreover, the notion of philosopher-kings is distinctly contradictory to the genius of the American constitutional design. Seen in a broader perspective, the Federal Reserve is an ongoing attempt at price fixing and central planning by committee. Like all such efforts, naturally it is doomed to recurring failure.

Had the denizens of Grant’s been in attendance, perhaps a standing ovation would have interrupted Pollock’s remarks.  As it happens, we and the ranks of Fed-skeptics everywhere shouldn’t get too excited just yet.  The hearing looked to draw just about half a dozen attendees seated behind the panelists, most of whom appearing to be staff.

Well, as a wise baseball fan once said: there’s always next year.

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Risk comes at you fast

See tranquility in the future?  Forget selling volatility, there’s a new way to profit from the absence of “sub-optimal” outcomes.  The Financial Times notes that the World Bank yesterday sold $322 million in debt that carries an eye-catching name: pandemic bonds. 

The bonds will pay investors a regular coupon, in exchange for which they lose some income or capital if a catastrophic infectious disease takes hold…One of the new bonds, priced at 6.5 per cent over six-month US Libor, will cover pandemic influenza and coronaviruses such as SARS, while the other, priced at 11.1 per cent over US Libor, will cover filoviruses such as Ebola, and several types of fever. 

Tail-risk can take many forms.  The Congressional Budget Office today announced it expects the Treasury department to run out of cash by early or mid-October as the Federal government rapidly approaches its statutory debt limit.  With the Republicans in charge of the executive branch and both houses of congress, passing legislation should be a relative cinch.

Investors may not be totally convinced; the spot VIX volatility index jumped by as much as 50% intraday.

June 29^th Recap

Stocks and bonds came under pressure in tandem,  with the former beset by another round of underperformance in the Nasdaq 100 (down by 1.75% vs 0.85% in the S&P 500).  Unquestioned leaders of this bull market, the FAANG group has lately resembled a millstone on the neck of Mr. Market, down 6% from their recent highs on average compared to 4% off in the Nasdaq 100 and just 1.4% in the S&P 500. 

The buy-the-dip reflex is still in vogue however; that mid-day VIX surge was largely reversed by day’s end (it finished higher by 14%), allowing the indices to recoup a chunk of their losses this afternoon. 

- Philip Grant

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Well, you have cooties

NYSE President Tom Farley launched a verbal broadside at short sellers this morning, 

Well, you have cooties

NYSE President Tom Farley launched a verbal broadside at short sellers this morning, in testimony before at the House Financial Services Committee: “It feels kind of icky and un-American, betting against a company.”

We hope the well-reasoned rejoinder in the above headline will help Farley reconsider his opinion.

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Sheepskin shuffle

That walk to the graduation podium is set to get a little more expensive.  Beginning on Saturday, July 1^st, interest rates on new student loans will be set higher, to 4.45% on ten year debt from the 3.76% rate seen this year for undergraduate students, according to CNBC.  Graduate lending rates are also moving north, to 6% as of July 1^st from the prior year’s 5.31%.  

The upward rate reset, which was established by the May 10 auction of 10-year U.S. Treasury notes, corresponds to a similarly higher yield in the 10-year compared to last year.  Legislation signed in the 2013 Student Loan Fairness act tied interest rates to that 10 year Treasury.  Christine DiGangi of credit.com explains the details:

Every year, the undergraduate loan rates are calculated by adding 2.05 percentage points to the high yield of the 10-year note at the last auction prior to June 1. Add 3.6 percentage points to the high yield to determine unsubsidized graduate loan rates, and for PLUS loans, add 4.6 percentage points.

That the sting of higher borrowing costs will be felt by a growing membership is a now-self-evident fact; according to data from the New York Fed’s consumer panel, total student loan debt has risen to $1.34 trillion in the first quarter, representing about 10.5% of total consumer liabilities.  That compares to $663 billion in student loan debt as of the first quarter 2009 equating to 5.3% of total household borrowings.

Overall, average Federal debt load per student reached $30,200 in the first quarter, up from $20,500 in the first quarter of 2009, according to the National Student Loan Data System.

Not only has student debt grown significantly, but it has done so in near lockstep. In each quarterly period going back to at least the beginning of 2003 (when the New York Fed begins its data series) has total student loan debt grown on both a sequential and year-on-year basis.  

From the end of 2008 to 2016, total student debt outstanding has risen by more than 105%, far outpacing both GDP growth of 26% and personal income growth of 31%.  As for personal income, we have seen a pronounced downward reversal since it made its recent highs of 4.5% year-on-year growth in the fourth quarter of 2014.  After trending lower through the last two years, it grew by just 1.8% year-on-year in the first quarter of 2017.

Student loan and refinancing marketplace LendEDU recently conducted a poll of 544 millennials in early June, asking whether the “$1.4 trillion student loan crisis” or the threat of conflict with North Korea was a bigger problem facing the United States.  Nearly 70% of respondents opted for the former.  One feature shared by those dual menaces foreign and domestic:  neither can be relieved with bankruptcy (exempting the notoriously difficult-to-invoke “undue hardship” clause in Federal student debt).

Rising student debt loads (soon to be overlaid with higher interest rates), falling disposable income growth and stalling inflation data feature prominently in the current economic backdrop. They might even be somewhat related.

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The other guys

For an ongoing demonstration of the creative forces perpetually unleashed by the brainchild of Adam Smith, look no further than today’s Financial Times and its documentation of recently debuted, “thematic” ETF’s. 

Ranging from the Obesity ETF, the Millennials Thematic ETF, to the SPDR Gender Diversity Index ETF (which was the recipient of a $250 million anchor investment from the California State Teachers Retirement System) these increasingly, uh, specialized segments of the equity market are available for one-stop shopping needs, at the cost of between 20 and 50 basis points in expense ratio. 

Who says modern capitalism has lost its dynamism? 

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Recap June 27

A recurrence of the tech-centric selling pressure previously seen in the middle of June left the broad indices at session lows at day’s end.  The Nasdaq 100 caught the worst of it, more than doubling the S&P 500’s 0.80% selloff to close below its 50 day moving average for the first time this year.  The FAANG (Facebook, Apple, Amazon, Netflix, and Google) stocks fell by an average of 2.3%.

Energy prices continued their rebound with a fourth straight green showing, and the crypto-currencies managed to steady themselves after yesterday’s selloff with a 5% bounce in bitcoin. 

- Philip Grant

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We must protect this house!

Under Armor CEO Kevin Plank’s nine minute appearance Sunday on NBC’s Today featured no shortage of notable quotables. 

We must protect this house!

Under Armor CEO Kevin Plank’s nine minute appearance Sunday on NBC’s Today featured no shortage of notable quotables. Discussing chief competitor Nike, Plank spoke of his respect for the sportswear incumbent, before lamenting the advantages that their scale confers: "They don't fight fair. Big companies do what big companies do. They've got more money. When we run a commercial, we've got one shot. The person has to be great. It has to hit."

The interview laid bare Plank’s fixation on his Beaverton, Oregon, based rival: each year, Plank sends Nike CEO Phil Knight a Christmas card with the vaguely menacing inscription: “You will know our name.”  It was unclear what Knight sends Plank.

As for more mundane concerns, including fourth quarter results featuring net revenues and gross margin far below consensus estimates as well as a departing CFO, Plank commented: "I think we found that there's a bit of a shifting market that has happened in the marketplace where, you know, the obligation of brands is to make sure that first of all, freshness and newness, whoever makes the best product, is going to win, and there are all these things converging at one moment in time."  Alright.

In a bearish feature on Under Armor in the summer of 2015 (“Under analyzed”, Grant’s June 12, 2015, click here to read), Deputy Editor Evan Lorenz rhetorically asked: “What does it take for a once excellent brand to become merely good?”  Plank’s brainchild has been spinning its wheels.  Adjusted net income for fiscal 2016 totaled just over $212 million, virtually on par with 2014’s haul of $208 million despite some 60% growth in top line revenues over that time.  Meanwhile, inventory growth has outpaced the advance in revenues, with the $917.5 million in fiscal 2016 representing a gain of some 70% from its levels two years prior.

The disappointing turn in business conditions has coincided with a steep downward lurch in its share price; a small dose of reassurance to those who wonder just how much fundamentals matter these days.  Under Armor’s class C shares are down 21% year to date and nearly 52% from last March, when the company debuted its dual class share structure.

The Mr. Market-sponsored half off sale has yet to yield an optically cheap company.  Under Armor’s near $10 billion enterprise value compares to trailing 12-month adjusted EBITDA of $569 million, for a ratio of over 17 times.  The ratio of price to trailing 12-month GAAP earnings stands at just over 51 times, and total debt of $861 million compares to free cash flow of $65 million over the past twelve months. 

The object of Kevin Plank’s Christmastime attention by contrast sports an enterprise value-to-EBITDA ratio of 16 times and price-to-earnings ratio of around 22 times, on a substantially higher operating margin (12% for Nike compared to less than 4% for Under Armor).  Last week, Bloomberg reported that Nike had entered into an agreement with Amazon.com to directly sell its merchandise, bypassing traditional retail destinations such as Foot Locker.  Goldman Sachs analysts estimate the move could add $300 to $500 million in wholesale revenues for Nike.

A familiar brand is likewise reasserting itself on the American scene.  European footwear company Adidas AG has seemingly awoken from a multi-year slumber, posting 31% year-on-year revenue growth in North America in the first quarter amidst strong demand for its classic “Superstar” brand shoe.

The competitive environment isn’t getting any less intense; Plank may have to crank out a few extra cards this Christmas.

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Honor system

Regulators in China’s National Audit Office found that 18 state-owned enterprises inflated their revenues by over RMB 200 billion ($29.2 billion), according to a weekend report from Xinhua News.  Earnings were likewise overstated by about RMB 20 billion ($2.92 billion), representing 0.8% and 1.7% of their totals, respectively.

Today, the Financial Times warned the local debt situation in China is growing increasingly unstable, writing:

We see growing credit-related risk to companies directly or indirectly backed by local governments. Once unthinkable, a default by a local government financing vehicle (LGFV) looks increasingly possible, despite expectations that the government will intervene and back off from its tightening campaign.

For now, borrowers and lenders continue to trust one another.  There may be no other option.

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Recap June 26th

An early (+0.50%) rally on the S&P 500 had the broad index testing its closing highs before those gains were erased in the afternoon.  Energy was green with WTI crude making its third straight move higher after reaching a 52 week nadir last Wednesday, and the U.S. Treasury curve continued to flatten amidst strength in the long end.  The spread between the 5 year and 30 year yields now sits below 94 basis points; it had reached 140 basis points in the aftermath of the fall 2016 elections. 

- Philip Grant

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Capital call

“‘System risk’ alert rocks Chinese companies that gorged overseas”, blared this morning’s Financial Times headline. 

Capital call

“‘System risk’ alert rocks Chinese companies that gorged overseas”, blared this morning’s Financial Times headline. Banking regulators are cracking down on the large contingent of property, insurance and financial companies across China that have gobbled up marquee assets around the world in recent years.  Keith Pogson of Ernst & Young did not mince words, advising the FT that: “This is a game changer for Chinese M&A and could pretty much stop all outbound deal making in its tracks.”

Regular readers might already be familiar with some of these deal-makers, China Evergrande Group, Anbang Insurance Group, and Fosun International among them.  Each has received a star-turn in Grant’s highlighting less than-transparent corporate structures, business models and accounting practices. 

The first two have been recently discussed in relative depth, whereas the last was featured in the September 30, 2016 issue (“One-stock ETF”, click here to read). Fosun is a veritable jack-of-all-trades, engaged in such wide-ranging undertakings as steel manufacturing, pharmaceuticals, property management, retail, financial services and metals mining.  A high debt burden is, at cursory glance, supported by a robust bottom line.  There is evidently more to the story.  From the aforementioned Grant’s piece:

Fosun’s EBITDA includes not only operating income but also gains on the sale of corporate assets.  By this reckoning, EBITDA amounted to RMB 25.2 billion over the 12 months through June (2016)…Gains on sale contributed no less than 19.7 billion…Exclude these items (investment mark-ups, fair value adjustments, other income and gains on sale), and EBITDA over the past 12 months shrinks to RMB 1.9 billion. Using this measure, net debt amounts to 42 times EBITDA, which in turn covers less than half of the trailing-12 month net interest expense.

Since publication date, Fosun (whose share price has remained near its fall 2016 levels) has continued its free-wheeling ways.  A look at corporate actions in Bloomberg reveals 17 separate acquisitions and five divestitures since the fall of 2016, although at least three announced acquisitions have been withdrawn by the company since the beginning of April.  Another three are still pending.

Beyond the implications for this trio of black-box conglomerates, the news appears significant from a macro perspective. The FT further noted that:

The companies are affiliated with a range of political factions, suggesting a broad crackdown by Beijing and underlining the Communist Party’s resolve to tackle stability risk posed by unconventional financing tactics.

Why is China cracking down on outflows?  A central bank can only control two of the following three:  A fixed exchange rate (China pegs its renmimbi to the dollar), independent monetary policy (the PBoC did not hike following the Fed’s tightening in June), or free capital movement.  This is known as the ‘impossible trinity’ in economics. 

The impact of those tighter capital controls are already being felt overseas. Wednesday’s Wall Street Journal noted data from listing site Juwai.com show that Chinese inquires for foreign real estate dropped by 31% from the year-ago period in the first quarter.

As for our “black-box” three, one of the group managed to secure some fresh funds, perhaps just in time.  On Wednesday Evergrande placed $3.8 billion in additional B-minus rated debt, the biggest dollar-denominated corporate junk bond sale in Chinese history, per Bloomberg.  The early price action was foreboding; the bonds “dropped as much as 5 cents on the dollar – a stunning move in a market where newly issued securities typically rise on the first day of trading.”   More from Bloomberg:

Evergrande managers appear “to be trying to get as much money as they can,” said Charles Macgregor, head of emerging markets at Lucror Analytics in Singapore.  “We expect that other high-yield borrowers could also be desperate for funds…and this could mean poor performance for following deals.”

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Alien covenant

Questionable debt deals are far from confined to the far-east.  Financially strapped car rental company Hertz recently placed $1.25 billion in par value five-year notes now sporting an 8.19% yield to worst, far above the 5.66% yield to worst currently quoted in the Bloomberg Barclays High Yield Corporate Bond Index.

The higher borrowing costs can be attributed to the companies precarious debt load and deteriorating operating performance; a sharp year-on-year earnings decline pushed the company’s debt-EBITDA ratio to 5.6 times,  putting Hertz out of compliance with the 4.75 times limit in the revolving loan covenant according to Debtwire.  

In spite of that red flag, the newest borrowing contains an absence of routine clauses designed to protect lenders.  A Moody’s report today detailed the unusually borrower-friendly terms, via Bloomberg:

Terms of Hertz’s $1.25 billion junk-bond sale allow the company to skirt typical restrictions on how it spends money raised from asset sales, Moody’s Investors Service analyst Evan Friedman wrote in a note Friday. That means Hertz could use proceeds to reward shareholders with dividends if it meets certain leverage targets. Such moves could ding bondholders by leaving the company with less cash to repay its debts.

When junk issuers sell bonds, they’re typically expected to use proceeds from asset sales to pay down debt or reinvest in their business. But recent bond offerings by Hertz and oilfield servicer Brand Energy, Inc. contain language that would effectively eliminate that requirement, according to Moody’s.

A demonstrably shaky borrower in a contracting business getting special terms? File this one into the 2017 time capsule.

- Philip Grant

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Altice falcon

In the second largest IPO of the year, Altice USA, Inc. raised roughly $2 billion in its trading debut

Altice falcon

In the second largest IPO of the year, Altice USA, Inc. raised roughly $2 billion in its trading debut.  Altice USA is the leveraged U.S. holdings (mostly comprised of Cablevision Systems Corp. which it acquired in 2015) of Dutch telecom conglomerate Altice N.V. It being a bull market, shares naturally spent the morning in a lather, rising by an additional 7%.

Simply looking at the company’s income statement in its S-1 SEC filing, an analyst might assume Altice USA was a hot tech stock or a cash-hemorrhaging electric vehicle maker.  A price to earnings valuation ratio yields no positive integer, as the company reported a fiscal 2016 net loss of $721 million (pro-forma) on revenue of $9.1 billion.  By way of comparison, domestic satellite television operator DISH Network earned roughly $1.45 billion in GAAP net income against slightly more than $15 billion in top line revenues during 2016.

Leverage ratios look daunting.  For fiscal 2016, Altice USA reported $598 million in operating income, while interest expense for the year was just under $1.76 billion.  Net debt totals just over $21 billion, supported by $3.35 billion in 2016 pro-forma, adjusted EBITDA, and a market capitalization of roughly $7.9 billion. Nor is growth exactly pulsating.  First quarter revenues rose by a modest 1.4% from their comparable 2016 levels.

The Netherlands-based parent carries a similarly stretched financial profile.  A wave of acquisitions in recent years has taken its net debt levels to just under €58.9 billion as of the first quarter of 2017, from €47.1 billion in fiscal 2015 and €21.4 billion in 2014.  Those net borrowings compare to a market capitalization of €34.8 billion at the end of the first quarter 2017, trailing twelve month adjusted EBITDA of €8.5 billion and free cash flow of negative €254 million. 

Writing about Altice N.V. and U.S. peer Frontier Communications Corp. in the fall of 2015 (“Frontiers of junk”, click here to read),  Grant’s noted the high risk appetite of Altice chairman Patrick Drahi and asked: “Are the creditors quite sure they are willing to bear the risks that the intrepid management is willing to take?”

So far, the answer has been yes, in the case of Altice N.V. at least. 

Its stock has risen by about 12% since publication of that analysis (tracking the Euro Stoxx 600 index), while its 6.25 notes due in 2025 have appreciated from just under 90 cents on the Euro to north of 109.5 today for a yield-to-worst of 3.54%.  Rated B-plus by Moody’s, Altice N.V.’s junk credit rating is insufficient to quality for the ECB’s corporate bond buying spree, but no matter.  The Bloomberg Barclays Pan-European High Yield Total Return Index has gained more than 10% in the last year to now sport a yield-to-worst of just 3.46%.  The Stoxx 600 equity index carries a nearly matching dividend yield of 3.29%.

Frontier Communications has not been so fortunate.  Since October 2015, its shares have dropped by more than 70%, while its 11s of 2015 have dropped below 92 cents on the dollar from near 110 last summer.  Sizing up the challenging business environment and sometimes-clashing business objectives of the telecom and cable industries, Grant’s wrote:

“These firms,” observes a friend of this publication who asks to go nameless, “have tried to straddle a line of providing high current income to shareholders while trying to hold on to their subscribers and keep their revenue streams from declining…and they are having to maintain fairly high levels of capex in order to provide services that are competitive with cable providers and other combatants, or else risk watching their customers defect. That’s a combo that doesn’t bode well for shareholder payouts generally.”

Mr. Market has since cast a wary eye on Frontier’s business model and re-rated it accordingly.  We patiently wait for the Altice pair to come under the same scrutiny.

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You get a car! And you, and you, and you!

Brooklyn dwelling subway straphanger Evan Lorenz was the recipient of a most generous proposition this morning.  Via the solicitations of Chase Bank, luxury automobile brand Maserati is offering some eye-catching bargains on five separate 2017 models.

From an average MSRP of $80,000, Chase is advertising a 7% discount on Maserati’s Ghibli sedan, plus dealer incentives of $5,000 to bring the prospective sale price to $69,400 for a 13.25% discount.  The new Levante SUV, Quattroporte, GranTurismo and GranTurismo Convertible are also on offer for that 7% discount plus unspecified dealer incentives.

To belabor the point, Maserati represents the ultra-high end luxury market for autos, and the offer is for 2017 models.  Maybe too many cars? Or not enough millionaires?

- Philip Grant

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Stairs up,

Preliminary home price data in the formerly hot Toronto housing market is little short of shocking.  

Stairs up,

Preliminary home price data in the formerly hot Toronto housing market is little short of shocking.  According to the Toronto Real Estate Board, the average transaction for the first half of June dropped below CAD $809,000, from CAD $863,910 in May and CAD $919,614 in April.   The reversal coincides with the introduction of a 15% foreign buyer’s tax at the end of April.

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Cheer up, Charlie

Chicago Fed President Charles Evans is on the lookout for lower prices.  Not for his own shopping needs, mind you.  Instead, the specter of the monetary boogeyman known as deflation evidently haunts the Federal Open Market Committee voting member.  In a CNBC interview yesterday, Evans noted the stubbornly low level of measured inflation in recent years, stating:

We’ve said that 2% [annual inflation] is our objective, [and] that it’s symmetric, and I think we need to follow through on that.  So I think we need to average 2% for a long enough period of time…The most recent inflation data, makes me a little nervous.

Evans went on to identify a likely culprit for this-too slow pace of inflation:  technological progress.  Citing the recently announced Amazon acquisition of Whole Foods Market, he said:

We know that technology is disruptive. It’s changing a number of business models that used to be very successful, and you have to wonder if certain economic actors can continue to maintain their price margins, or if they are under threat from additional competition. And that could be an undercurrent for holding back inflation.

If sub-2% inflation makes Evans and Co. shudder, we wonder what emotional scars the experience of the late 19^th Century would have visited on a hypothetical FOMC (the Fed was still decades away from existence). According to economists Nathan S. Balke and Robert J. Gordon, the years 1866-1899 saw only two annual periods of positive inflation (1880 and 1887);  five times in that period did the price index decline by more than 4%, twice by more than 6%.  

Then, as now, technological advance figured prominently.  That era included the invention of the telephone, typewriter, dishwasher, internal combustion engine, paper-strip photographic film, steam turbine, barbed wire, wearable contact lenses and traffic lights, among many other features of modern life.

With greater productivity came lower prices, and with lower prices came a higher standard of living.  David Ames Wells’ 1890 book “Recent Economic Changes - And Their Effect on the Production and Distribution of Wealth and the Well-Being of Society” notes that:

In the United States the daily wages paid, or the daily earning capacity of a healthy adult worker, in even the most poorly remunerated employments, is more than sufficient, if properly expended, to far remove the recipient from anything like absolute want, suffering or starvation.

It is no understatement to say that the 1913 founding of the Federal Reserve was a seminal turning point in the economic history of the United States.  According to the Westegg inflation calculator found online (with data derived from the 1975 Historical Statistics of the United States), goods and services which cost $100 in 1800 would have cost only $58.10 in 1913.  By contrast, the Bureau of Labor Statistics’ own CPI inflation calculator (which only goes back to 1913) calculates that what would cost $100 in 1913 would now command $2,497.65 today. 

So have no fear, Charles Evans. The dollar is but a piece of paper. The Fed holds the lit match. 

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Better early than never

In this golden era of indexation, the September 10, 2004 Grant’s piece “The coming fee famine”  (click here to read) paints an instructive contrast to the bygone boom times of the 2-and-20 (or higher) hedge fund compensation model.  Some excerpts of that essay follow:

At first glance, the hedge fund boom would seem to provide a pricing umbrella for any and every branch of the money management business.  We see no such umbrella, only an echo of the bubble years.

“I view index funds as a commodity,” Jeff Carney, president of Fidelity’s retail group, tells The Boston Globe, “and we need to offer a competitive price in order to attract the kind of flows we’d like to see.” If index funds are a commodity, what should we call equity mutual funds?

The runaway popularity of the hedge fund model supports the most basic truth of Wall Street.  We mean that professional investors will believe just about anything.

After years of retreat, the hedge fund industry finally steadied in the first quarter.  Although the average management fee of 1.47% represented a 1 basis point decline from its comparable 2016 level, the number of new fund launches jumped to 189 from 153 in the fourth quarter of last year.  Fund liquidations declined to 259 from 273 in the prior quarterly period.

- Philip Grant

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Party like it’s 1999

Having barely escaped the economic grim reaper in 2007, retail trading platform E*TRADE is alive and well these days

Party like it’s 1999

Having barely escaped the economic grim reaper in 2007, retail trading platform E*TRADE is alive and well these days, regularly churning out the cutesy television advertisements which have long been its corporate calling card.  Recently, one spot channeled the zeitgeist of the dot-com bubble, depicting a newly-rich Joe Sixpack type (dubbed “the dumbest guy in high school” by the ad) cavorting on his yacht and encouraging the potentially envious viewer: “Don’t get mad, get E*TRADE.” 

https://www.youtube.com/watch?v=cLSecfkulqs

Multi-cycle television aficionados may recall a similar spot run by competitor Ameritrade (now TD Ameritrade) in 1999, featuring the face-photocopying intern Stewart convincing his boss to buy 100 shares of Kmart. 

https://www.youtube.com/watch?v=e2LSyiYjbcg

We hope the fictional boss was using a short time horizon for his trade, as Kmart filed for bankruptcy protection in 2002 before eventually merging with Sears under the auspices of Edward Lampert in 2004. 

For a perhaps-more germane allegory to that era,  Charlie Bilello, director of research at Pension Partners, reports that the Nasdaq 100 ETF (QQQ) has closed above its 50 day moving average in every session back to December 6^th of last year,  which is the longest such streak since its creation in 1998. 

As for Stewart the intern (real name Matthew Marrona)?  A 1999 profile in the Wall Street Journal noted the actor:

Has long let an outside money manager handle his finances. All Mr. Maronna knows is that he's in mutual funds -- "and that I'm doing well," he adds.

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CoCo crisp

German regional bank Bremer Landesbank announced today that it will be unable to pay the scheduled June 29^th coupon on a pair of contingent convertible notes (otherwise known as CoCo bonds, referenced by Grant’s in the February 12, 2016 “Big sick puppy”). 

Issued in 2015, the notes carry a combined face value of around €150 million.  As for the source of trouble, Bloomberg relays: “Bremer has suffered an increase in bad loans because of a shipping-market slump, which prompted parent Norddeutsche Landesbank to inject funds and buy out other shareholders.”

Readers may recall that this is the second financial accident involving Coco debt in less than two weeks.  On June 7^th, Spain’s Banco Popular was acquired under duress for a nominal fee (think Bear Stearns) by Santander, and the value of its CoCo bonds (which are the most subordinated bonds in the credit capital structure) virtually disappeared in two trading sessions. 

Trouble is mounting elsewhere.  Italian banks Veneto Banca SpA and Banca Popolare di Vicenza SpA are in negotiation with the government over a proposed €11 billion bailout as bad loans and dwindling liquidity have pushed both to the brink.

With Eurozone manufacturing PMI its strongest since 2011, asset prices levitating and Mario Draghi’s QE program in full swing, the sight of multiple banks either fighting for survival or failing to make scheduled interest payments is an odd one indeed.    

For its part, the ECB’s bond buying is currently restricted to sovereign and investment grade corporate issues.  Operating at a current, tapered monthly pace of €60 billion (it had been €80 billion until April), Frankfurt’s balance sheet currently foots to €4.2 trillion, a whopping 39.4% of 2016 Eurozone GDP.  By comparison, the Fed holds the equivalent of “just” 24% of 2016 US GDP in assets.  Last fall, Deutsche Bank CEO John Cryan observed a worrying unintended consequences of this heavy handed activity, via Bloomberg:

The impact of buying up corporate bonds is that we see, in our bank, bond-trading volumes down something like three-quarters. And there has absolutely been no price discovery now in corporate bonds, so we don’t really know the price of credit, which is a dangerous situation.

The epilogue to this story has yet to be written.  What good can come of a quasi-government agency holding a substantial portion of the region’s higher quality bonds while leaving the rest for the private sector?  Not much, we judge. 

- Philip Grant

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‘Tine marches on

Argentina to issue 100 year sovereign bonds? A drowsy early morning headline reader may have wondered if he or she was still dreaming.  

‘Tine marches on

Argentina to issue 100 year sovereign bonds? A drowsy early morning headline reader may have wondered if he or she was still dreaming.  It is all too real.  The “Land of Silver” is indeed planning on tapping the ultra-long term sovereign lending market for U.S. dollar bonds.

Eight times in its 194 year financial history has Argentina defaulted on its borrowings, most recently in 2014 amidst its dispute with creditors from its prior episode of financial ruin in 2001. At its historical pace, the soon to be-issued 7.125s of 2117 (priced at $90 to yield around 7.92%) will default more than four times over before that so very-distant prospective maturity date.

From banking crises, to political dysfunction, to depression-level economic contractions and hyperinflation, Argentines (and their creditors) have seen it all, usually more than once.  Among their unhappier economic episodes include the Baring Bank Crisis in 1890-91,  an event that included default amidst three separate bank runs, the last leaving Argentina’s largest private banks holding a cash-to-deposit ratio of just 22% and forcing the country into a painful fiscal realignment (not to mention major losses absorbed by foreign investors).  In a 2001 postmortem, the National Bureau of Economic Research identified the symbiotic dysfunction at the heart of the trouble:

(National and local) governments had no incentive to control the lending procedures of the banks of issue since the governments were major beneficiaries of the banks’ lending function as fiscal agents of the state.

Another instructive period for prospective debt buyers was the hyperinflationary epoch seen in the late 1970’s and 1980’s.  According to the NBER, monthly CPI inflation registered 5% or higher in most every quarterly period from 1975-1990. The council notes that 6% monthly inflation equates to around 100% on an annualized basis. That pace of debasement was the norm for well over a decade.

Capital controls, unchecked money printing, and, eventually, the replacement of the Argentine peso with a currency unit known as the austral were ineffectual in preventing the skyward price spiral: Wholesale prices in 1989 rose by 5,400% from the prior year.

Their 2002 default was perhaps the most spectacular of all, one of the largest sovereign defaults in history at over $82 billion according to Moody’s. Most creditors accepted a 70% haircut, with some holdouts seeking and obtaining  better terms from a U.S. court. That decision helped push Argentina back into default in 2014.

Proximate cause of that early-aughts meltdown was largely more of the same, including high public debt and fiscal mismanagement, including an eventually deleterious currency peg to the dollar.  According to the IMF’s 2003 paper, “Lessons from the Crisis in Argentina”, the seeds of that crisis were sown in the preceding boom:

There was little sense of urgency to address these vulnerabilities at that time, given the widespread eagerness to interpret the (1990’s) boom as the onset of an era of permanently higher growth founded on structural reforms and sound macroeconomic policies.

Back in the present day,  the 2015 election of business-friendly Mauricio Macri has been well received by investors, the MSCI Argentina index has gained more than 47% from its interim lows last December,  while the Argentine 10 year dollar bond yield has declined to around 6.15% from north of 7.5% at the end of last year.

Fundamental indicators have yet to confirm Mr. Market’s bull whims. Real GDP fell by 2.3% in 2016 for its third annual decline in the past five years, and the Argentine peso continues to trade near a 52 week low of around 16.15 per dollar, compared to a five year average of roughly 9.5. Perhaps most importantly for potential debt holders, its fiscal situation looks again to be deteriorating.  In the fourth quarter of 2016 (the most recently available data point in this series), the Argentine budget deficit exceeded 1.5% of GDP, roughly double the fourth quarter levels over the prior three years and easily the biggest shortfall going back to 2002.   

If one was inclined to take a flier on Macri and Co. why not the 10 year U.S. dollar bonds yielding around 6.15%?  Those extra 177 basis points or so found in the 100 year bonds may look like meager compensation indeed if the Land of Silver reverts to its regular past form and finds it has none to pay its debts.

- Philip Grant

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Price check

Undisputed retail heavyweight champion Amazon.com 

Price check
 

Undisputed retail heavyweight champion Amazon.com is making a full force foray into the grocery business via an all-cash acquisition of upscale purveyor Whole Foods Markets, Inc.  

Understandably, the announced transaction (which is still subject to federal anti-trust review) visited a seismic impact on the rest of the industry, with stock prices of any and all competitors to the prospective tandem re-marked to the downside.  After 20 years of near-uninterrupted operating success, the reputation of Jeff Bezos precedes him.  Woe betide the high margin business model targeted by Amazon.

It is difficult to find a less-high margin business model than that of groceries in 2017. Yesterday, longtime domestic operator Kroger Co. announced that its first quarter operating margin fell to a meager 1.7% from 3.5% in the prior year period, while also trimming its fiscal year profit forecast owing to “competitive factors”. 

Likewise, the domestic expansion and arrival (respectively) of twin German low cost operators ALDI and Lidl has made waves: Jefferies analyst Christopher Mandeville recently performed an industry pricing comparison using a basket of 20 common items, finding that ALDI managed to price its basket at 5.5% below that of domestic price leader Wal-Mart.  Lidl bested the American incumbents by 9.1%. Amazon itself was already a large and fast-growing presence in the industry with its Amazon Prime and Amazon Pantry services.

Amidst the onslaught, Kroger shares have taken a dive, down a cool 26% over the past two days to their lowest level since April 2014. It’s new, snack-sized market capitalization of roughly $20 billion compares to just under $2 billion in net earnings for fiscal 2016. That trailing 12 month price/earnings ratio of around ten times compares to nearly 23 times in the S&P consumer staples index. 

The factors which helped push Kroger’s valuation downward were no secret; the dual German price-dicers (both already established and formidable players in Europe) announced their plans to expand stateside months ago.  Jeff Bezos and Amazon have long been rumored to be expanding into brick and mortar retail. So, too, were Wal-Mart’s new ultra-aggressive pricing strategies known to investors in February (Reuters had the story).  For its part, Grant’s noted this trend in the March 24^th piece “Price war for Warren Buffet”.

It’s almost enough to give hope to the conscientious active manager, whose ranks have plainly thinned amidst the encroaching popularity of low cost indexation and exchange traded funds. J.P. Morgan estimates that only 10% of stock market trades are currently conducted by traditional, “discretionary” money managers.

Nowadays, few people even bother to read company filings.  A study by University of Notre Dame economists Bill McDonald and Tim Loughran (via the Wall Street Journal) found that the average 10-K annual report gets downloaded from the SEC’s website fewer than 30 times between the day it is filed and the next.

Here’s to inefficient markets, and those who prosper therein. 

- Philip Grant

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Who insures the insurers?

Behold the multi-act saga currently unfolding in Red China. 

Who insures the insurers?

Behold the multi-act saga currently unfolding in Red China.  In April, former chairman of the country’s Insurance Regulatory Commission Xiang Junbo was removed from his post amidst a corruption investigation.  The agency has continued to operate sans-top leadership as no replacement to Xiang has yet been named.

Next, the authorities put the screws to Anbang Insurance Group, a privately held investment conglomerate that owns New York’s Waldorf Astoria hotel and whose chairman is an in-law to longtime former leader Deng Xiaoping.   That chairman has been detained by police, and authorities have since instructed banks to stop doing business with Anbang, according to Bloomberg.  

Anbang’s life-insurance unit sold 115 billion yuan ($17 billion) of policies through banks last year, double the amount in 2015 and accounting for 88 percent of total premiums, according to its annual report.

“It’s like having your legs broken,” said Grace Zhou, a Hong Kong-based analyst at ICBC International, referring to the reported block on Anbang’s bank channels. “It’s their main source of revenue.”

As is typically the case in China (and may exist to a greater extent than many believe), the knee bone is very much connected to the thigh bone.  The Financial Times relays that “Anbang ranked among the top 10 shareholders in 18 mainland-listed companies at the end of March, with its stakes worth a combined RMB 1.06 trillion ($155 billion).”  Anbang’s total assets currently foot to RMB 1.97 trillion, according to the company website.

There are plenty of loose threads in the sweater of Chinese finance on which curious fingers might pull.  As for recent Grant’s pick-to-not-click Evergrande Group (“Ever higher”, June 2^nd), it has seen its latest euphoric advance reversed to the tune of a 14% drop this week.

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Taken Ill

The state of Illinois has suffered more than its share of indignities of late, between feeble economic growth (the Illinois Policy Institute calculates an aggregate 4% gain in economic activity since 2007, a slower pace than the decade of the Great Depression), persistent population outflows and a potentially imminent downgrade to junk status by S&P on account of its shameful fiscal situation (Almost Daily Grant’s, June 9).

The latest dishonor may be the most cutting of all. The Multi-State Lottery Association, which administers games such as Powerball and Mega Millions, has warned it will drop the Land of Lincoln at the end of the month if a budget is not in place, according to the Chicago Sun-Times.  That outcome is certainly not unrealistic considering state lawmakers have failed to agree on a budget since 2015. 

Albany and Hartford are veritable paragons of virtuous municipal stewardship by comparison.

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Damn the torpedoes!

Today the spread between the 5 and 30 year Treasury yield hit 102 basis points (1.02%), its flattest since 2007.  This afternoon, Citigroup reported its May credit card write offs at 2.94%, up from 2.34% in April, to join Capital One, Synchrony Financial and (auto lender) Santander Consumer as reporting a recent rise in late payment or outright welching. 

Mr. Market can’t talk, but perhaps can impart hints on those who would bend an ear.  Yesterday the Fed hiked rates for the third time since December, and introduced detailed plans for selling down assets from its balance sheet. The best laid plans…  

- Philip Grant

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Imagination at work

The news dropped early yesterday. 

Imagination at work

The news dropped early yesterday. After 16 years at the helm, General Electric CEO Jeffrey Immelt is out as of Aug. 1.  Taking his place will be longtime GE employee John Flannery. Internal succession it may be, but the news marked the end of an era. Jack Welch’s magical management epoch is finis.

Once widely lauded as the crème de la crème of U.S. corporate executive stewardship (Warren Buffett referred to Welch as the “Tiger Woods of management”), Welch’s reign has lost some reputational luster as the years have passed.  For the five year period ending in 1999, GE stock skyrocketed by over 500%, not only trouncing the S&P 500 over that period (up by a mere 220%) but also the Nasdaq (higher by 441%), which was of course the epicenter of the era’s tech bubble. 

The secret to such spectacular performance?  Making the numbers, no matter what, every single time.  “Beginning in 1995 and continuing through the filing of form 10-K for the period ended December 31, 2004, GE met or exceeded final consensus analyst earnings per share expectations every quarter.”

The above quote came from the SEC, from their 2009 announced settlement with GE in which the company agreed to pay $50 million in fines, but did not admit to any wrongdoing, over alleged book-cooking and earnings manipulation. That settlement covered accounting misdeeds that the regulators assert took place from 2001 to 2005, which covered the beginning of the Jeff Immelt era.  However, the “tone at the top” at GE was very well established when Immelt took command.

Grant’s was on the scene years before, observing (as is our wont) in the thick of the 1990’s bacchanal (“One in 50 billion”, July 17 1998. Click here to read):

For the past 20 quarters, the (analyst) consensus was within 2.37% of the mark (in predicting GE’s earnings per share).  The odds of such a display of clairvoyance on Wall Street, according to (author and statistician David) Dreman, are 1 in 50 billion.  Who says that bull markets make you stupid?

No need to speculate on potential chicanery.  Welch explained the GE approach in his 2001 autobiography/business how-to “Straight from the gut”, in a manner perhaps more illuminating than the author intended. When the company was suddenly faced with the prospect of a large write-down following revelations of fraud in the newly acquired Kidder Peabody unit in 1994, his underlings rode to the rescue:

The response of our business leaders to the crisis was typical of the GE culture. Even though the books had closed on the quarter, many immediately offered to pitch in to cover the Kidder gap. Some said they could find an extra $10 million, $20 million and even $30 million from their businesses to offset the surprise.

Old habits die hard.  Welch publically scolded his successor in an April 2008 CNBC interview, after the company had failed to deliver quarterly results that its erstwhile chairman (to say nothing of Wall Street) had been expecting.   “I’d be shocked beyond belief, and I’d get a gun out and shoot him if he doesn’t make what he promised now. Just deliver the earnings. Tell them you’re going to grow 12 percent and deliver 12 percent.”

Whether due to a lack of adherence to the Six Sigma management techniques championed by his predecessor, a more conservative accounting style in the wake of that SEC settlement, or some combination therein, Immelt wasn’t able to “deliver” often enough. 

With a 10% year to date share price decline against a 9% advance in the S&P 500, GE stock currently sits about 63% below its August 28, 2000 high water mark.  By comparison, the Nasdaq has managed to exceed its March 10, 2000 blow-off highs by more than 20%. 

As for those bygone glory days of quarterly performance you could set a timer to? You can’t go home again.

Goldilocks with Chinese characteristics

An excerpt from today’s edition of the Wall Street Journal:

In an article published Saturday, the central bank’s flagship newspaper, Financial News, said that the severe credit crunch four years ago won’t repeat itself this month because the central bank will keep liquidity conditions “not too loose but also not too tight.”

Good to know. 

What goes up,

Barclay’s analysts issued an upgrade on energy pipeline name SemGroup Corp. this morning.  After realizing a calculation error that erroneously inflated their calculated price target, those analysts pulled an about-face and returned the company to its equal-weight perch. 

What did Mr. Market make of this?  After a brief dive back to unchanged, SemGroup rallied anew this afternoon to finish higher by more than 2%, well above the day’s volume-weighted average price. 

Yep, it’s a bull market all right.

- Philip Grant

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Fed ahead

By all accounts, we will soon see the Funds Rate exceed 1% for the first time since 2008.  

Fed ahead

By all accounts, we will soon see the Funds Rate exceed 1% for the first time since 2008.  In the past week, the likelihood of a 25 basis point rate hike at Wednesday’s FOMC meeting rose to almost 98% from the 90.6% logged last Monday, according to interest rate futures.  Multiple upticks in the Federal Funds Rate are also increasingly expected; the odds of an additional 25 basis point rate hike by September rose to about 32% from 26% one week ago. 

With higher rates a seeming fait accompli, no small irony can be found in the fact that economic conditions appear to be less supportive of tighter monetary policy than at any time since the brief but sharp winter 2016 deep freeze.

According to the latest data from the St. Louis Fed, commercial and industrial loan growth has halted. Aggregate loans outstanding have remained virtually unchanged over the last seven months, hovering just below $2.1 trillion.  By contrast, the series grew by 49% between May 2012 and May 2016. 

A standstill would represent a major improvement in the market for used cars.  The J.D. Power Used Vehicle Price Index for May tumbled to its lowest reading since May of 2010, down by a meaty 7.6% from its year ago-levels.

On the other side of the policy ledger, the measured inflation uptick seen in the early stages of this year appears to be abating. Headline CPI and core PCE (the Fed’s stated indicator of choice) have declined in tandem in the past two months, with the former growing by 2.2% year-on-year in April from 2.7% in February, and the latter seeing a 1.5% annual uptick in April, down from 1.8% in February. 

Consumer inflation expectations have likewise reversed “noticeably”, according to the New York Fed’s May 2017 Survey of Consumer Expectations.  Median one-year expectations dropped to about 2.6% in May from 2.9% in April and roughly 3% at the beginning of the year.  Longer term expectations saw a steeper decline, with the three-year median sinking below 2.5% from 2.9% in April for its second lowest reading in the four year history of the series (January 2016 was the nadir).

Respondents to the survey also anticipated lower earnings growth and a higher overall unemployment rate in the next 12 months, while the households’ financial situation component, which measures both current status relative to a year ago and a forward one year expectation, also deteriorated from the prior reading.

But while the economy hardly resembles one in need of rate hikes, financial markets are a different story.  A dispatch from today’s Wall Street Journal:

Broad financial conditions are as accommodative now as they were in early 2015, the point of maximum Fed stimulus according to a closely watched Goldman Sachs index, which measures the combined impact of movements in interest rates, stock prices and the value of the dollar.

The action in rates is particularly interesting; the persistent bid in U.S. Treasurys seems to run counter to intuitive price action during a tightening cycle. Today’s $24 billion auction of three year notes was met with outsized demand; the 3.0 bid-to-cover ratio was well above the 2.75 average over the past six auctions and its highest since late 2015.

In the past three months, the three year U.S. Treasury yield has dropped to 1.49% from 1.68%. In that time, the odds of a pair of Fed rate hikes by June has more than doubled to 97% from 45.5% (the Fed did hike once in March).  In the 2004-2006 tightening cycle, short yields moved higher with the Fed Funds rate while long rates barely budged. 

For the Federal Open Market Committee, this week’s choice is now to divert from clearly established market expectations or to tighten into slowing economic conditions and declining inflationary pressures. 

For its part, America’s neighbor to the north is making similar noises.  Today, Bank of Canada Senior Deputy Governor Carolyn Wilkes seemed to hint at withdrawing some of their own policy accommodations, commenting in a Winnipeg speech:    

As growth continues and, ideally, broadens further, Governing Council will be assessing whether all of the considerable monetary policy stimulus presently in place is still required. At present, there is significant monetary policy stimulus in the system.

Those remarks helped spur a 1% rally in the Canadian dollar against the greenback peer this afternoon.  Meanwhile, the formerly breakneck Toronto housing market has suddenly hit the skids: May sales in the city fell by 20% from their year-ago levels.  New listings in May jumped by 49% on a sequential basis, while unadjusted home prices fell by 6.1% from their prior month levels.

Your move, central bankers of the upper reaches of the North American continent.  

- Philip Grant

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Chicago dog

Things are going from bad to worse for the state of Illinois.  

Chicago dog

Things are going from bad to worse for the state of Illinois.  Already rated on the brink of junk, the Land of Lincoln absorbed another blow late Wednesday when a federal judge ruled that the state must supply additional funds to Medicaid providers. 

Additional funds they do not have.  Illinois’ projected $6.2 billion deficit in the fiscal year ending June 30 (“more than the checks Springfield wrote for higher education, public safety and government services combined” per WGN) is the fruit of many bad seeds, political dysfunction being one; there has been no state budget in place since fiscal year 2015. Republican Governor Bruce Rauner and Democrat Speaker of the House Michael Madigan blamed one another in less than statesman-like language following Moody’s and S&P’s most recent downgrades on June 1.

Wednesday’s ruling jolted the normally narcoleptic muni market into semi-consciousness. Illinois General Obligation 5s of 2041, issued in October near 106 cents on the dollar to yield 4.27%, sliced to a new closing low yesterday near 95 cents on the dollar for a yield to worst of 5.36%.  For its part, S&P promises another downgrade in the next few weeks if the politicians can’t get their act together.

Debt holders of other fiscally challenged states such as Connecticut (Almost Daily Grant’s, June 1^st), may draw comfort—well, false comfort—from the fact that Illinois munis had seemed bullet-proof.  As recently as June 2^nd, Bloomberg reported that Illinois ranked second and first in year-to-date performance in the S&P municipal indexes and Bloomberg Barclays indexes, respectively.

More than half a dozen states defaulted on their bonded debt in the early 1840s, Illinois among them. In 1842, The Times of London, quoting a Philadelphia newspaper, let the defaulters have it:  “There are crimes which, in the moral daring which they evince, secure for themselves a sort of shuddering respect, but this `repudiation’ is not relieved by any such exhibitions of depraved courage. It is all low, skulking and scandalous, without a solitary trait to qualify reproach or mitigate execration.”

Let’s keep those ringing phrases handy, just in case.  

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Choose your own adventure

What is the true state of the U.S. consumer? 

On the one hand, record high asset prices, bottom scraping unemployment and jobless claims figures, and a largely brisk housing market indicate good economic times.  On the other, rising credit card defaults, a widely struggling retail realm and the slump in auto sales suggest another kind of macro trend.   

How to square these opposing realities?  Consumers are deleveraging, yet depend on asset values to maintain their standard of living.

The ratio of household debt to GDP has declined from its highs above 99 percent in the first quarter of 2008 to around 80 percent in the fourth quarter of 2016.  Yesterday’s Fed Flow of Funds Report shows that the ratio of household net worth to disposable personal income set a post-World War II high in the first quarter of 6.62, its quarterly average back to 1946 being just under 5.3. 

That pleasant appreciation in stock portfolios and house prices is largely responsible. Of the $2.3 trillion sequential advance seen in Q1, $1.3 trillion can be attributed to rising equity values, with gains in the housing market chipping in another $499 billion,  according to the Fed report. 

Wage growth has failed to keep pace with the S&P, as annual average hourly earnings growth has yet to exceed 2.8% in any monthly period during this expansion; the series topped 3.5% in both 2007 and 2009.  

Was this what Ben S. Bernanke, author of the idea that rising stock prices would produce rising consumption—the “wealth effect”—had in mind?

The tail wags the dog (sort of), and the Great Ph.D. Monetary Experiment continues apace.

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Play dough

Dublin-based Endo International PLC absorbed another disappointment late yesterday, disclosing that the FDA has requested that it pull its opioid based-Orpana pain reliever off the market on account of its potential for abuse.  At $158.9 million, Orpana sales totaled just under 4% of total revenues last year.

The company earned about $150 million in adjusted net income in the last twelve months. It carries long-term debt of more than $8 billion, while its near-90% stock price decline since 2015 has left a market capitalization of roughly $2.5 billion.  For a flashback to the good old days of 2015 (for tax-escaping pharma roll-ups), click here to read the Grant’s piece “Wire pullers of the 21^st century.” 

- Philip Grant

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Three wishes

This year, BABA’s no black sheep.  China e-commerce giant Alibaba Group Holding Ltd. announced 

Three wishes

This year, BABA’s no black sheep.  China e-commerce giant Alibaba Group Holding Ltd. announced today it expects revenue growth of as much as 49% this year, spurring a 13% share price advance today that brings its year to date gain to 62%. That leaves each component of the celebrated FAANG (Facebook, Apple, Amazon, Netflix, and Google) stable in the dust.

The brisk sales forecast “elicit(ed) gasps of ‘wow’ and loud clapping from investors at the ecommerce group’s Hangzhou headquarters” according to the Financial Times. The ample bear contingent is likewise gasping; Factset calculates that 4.7% of shares outstanding were sold short in the middle of May.

Listed on the New York Stock Exchange, headquartered in Hangzhou, China and incorporated in the Cayman Islands, Alibaba is a modern day corporate citizen of the world. It is also something of a black hole for investors trying to make sense of its business model, a holding company that contains hundreds of operating subsidiaries which frequently transact with one another.  

As a result of its massive reported growth in revenues, the company “now lays claim to over 15% of ALL retail sales in China”, according to Anne Stevenson-Yang, co-founder of J Capital Research (emphasis hers).  Moreover, that retail sales figure includes categories that Alibaba does not sell, including autos, food at restaurants, gasoline and groceries.

In the not-so distant days of May 2016, the company disclosed it was under investigation by the SEC over potential securities law violations. An early November piece in the New York Post reported that a whistleblower “high up” in the company was working with the SEC and had helped them initiate the investigation. 

The company denied the claim on a subsequent earnings call, with Executive Vice President Joseph Tsai assuring listeners that “when we have real news we will update everyone.” Seven months later, we are still waiting.  Mum’s the word from both company and regulator.  

In early April, Scott Kessler of CFRA Research was quoted in Barron’s wondering about the SEC’s radio silence, writing: “I find it unusual that substantive updates have not been provided by the SEC or Alibaba. I would have expected something at this point.”  Kessler also made note of this salient fact: recently appointed SEC Chairman Jay Clayton had worked on Alibaba’s $25 billion initial public offering in 2014.

Others cast a wary eye at strangely circular dealings involving Alibaba, beyond the SEC’s stated interest in related party transactions.  At the Grant’s spring 2016 conference, Stevenson-Yang noted one such curiosity: “as when they purchased half of a football team from Evergrande, then listed the football team with Evergrande and Evergrande bought some Alibaba assets. It is kind of a peculiar deal.”

Evergrande (mentioned in the June 2^nd issue of Grant’s and the June 5^th Almost Daily Grant’s) is a very, very diversified property developer. It shares with Alibaba not only a demonstrated affinity for burning short sellers (shares are up 120% since May 5^th) but also a distinct lack of operational transparency.

More broadly, China-related equities are suddenly on the march. The mainland Shanghai composite index has gained nearly 2% this week, continuing to recoup the losses seen in late April and early May. Last Wednesday, a group of seven companies debuted an incentive program for employees to buy their shares, promising to insure them against any potential losses. Meanwhile, ever so quietly, the Chinese sovereign yield curve is approaching total inversion. One year government debt yields 3.66%, with ten year paper fetching 3.64%.

Alibaba and Evergrande have successfully squeezed the shorts.  Now what?

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Forage for porridge

In these lean times for bears, sometimes it’s best to take a break and get away from it all.  A headline in last week’s Denver Post broke the news: 

Bear caught on video raiding Vail apartment, playing piano

Luckily, video footage of the incident was captured for our review (click here to view).   As the jazz great Thelonius Monk once said: “The piano ain’t got no wrong notes.” 

- Philip Grant

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CoCo-nut

A multi-billion dollar bank failure in the midst of a rip roaring bull market and growing economy?  An odd sighting indeed.  

CoCo-nut

A multi-billion dollar bank failure in the midst of a rip roaring bull market and growing economy?  An odd sighting to be sure.

Today’s announcement that Banco Popular Espanol SA will be absorbed by the sounder Banco Santander under the auspices of the European Central Bank for considerations of €1 harkens back to March 2008, Bear Stearns and J.P. Morgan. 

Such opportunities for wistful bearish reminiscence are rare these days. In the U.S., a total of five banks failed in 2016 compared to 140 in 2009, according to the Federal Deposit Insurance Corporation. Total cost to the government’s Deposit Insurance Fund in 2016 totaled $9.6 million, according to estimates from Bankrate.com.  In 2009, such failures cost taxpayers more than $38 billion.  

Much unlike the tense days of that Bear Stearns and J.P. Morgan shotgun wedding, asset prices and economic growth are on the upswing.  Riding a 13% advance in the past year, the Stoxx 600 Index now sports a dividend yield of 3.29%. Amazingly, the Bloomberg EUR High Yield Corporate Bond Index has rallied to yield a paltry 2.24%. 

GDP growth in Spain (the home nation of both banks) has matched or exceeded 3% in each of the last eight quarters.  Germany saw its IFO (Institute of Economic Conditions) Business Climate Index rise to the highest level on record in May, reflecting “euphoric” sentiment according to the group’s president.

Fueling these evident good times is a central bank that is most determined to generate inflation in the price level, via negative nominal interest rates and undertaking €80 billion in monthly asset purchases.

Today, Bloomberg reported the ECB has lowered its forecasted level of CPI inflation through 2019, ahead of a policy decision tomorrow. The article paraphrased the bank’s thinking: “they must be extremely cautious in communicating and implementing any exit from monetary stimulus.” (Some member nations are taking a less than gracious view of the generosity cum largesse from Brussels, for more see “Sturm und Draghi” from the May 11^th Almost Daily Grant’s).

Amidst those calm seas, Banco Popular has managed to run the ship aground. In order to shore up their sickly balance sheet, the acquiring Santander will issue a €7 billion rights offering to shareholders. Banco Popular’s equity and junior debt are wiped out, to the tune of €3.3 billion.

Among the securities being zeroed out are the Banco Popular contingent convertible bonds.  One issue of those so-called CoCo securities, carrying an 11.5% coupon and perpetual maturity, changed hands around 53 cents on the euro yesterday, and above 93 cents on the euro less than a month ago (May 10).  Today it fetched just under three cents on the euro, for a yield to worst of 404.22%.

That harsh outcome has generated little consternation for other holders of these complex debt/equity hybrids.

Bavarian behemoth Deutsche Bank’s 7.125 coupon CoCo debt (featured in Grant’s, February 12 2016; click here to read) securities have barely budged off their highs, finishing today at 101.4 cents on the euro from the 102.3 highs reached in mid-May.  Recall that in early 2016, Deutsche Bank shares sold off sharply amidst fears it would be forced to write down its CoCo bonds to help recapitalize its balance sheet. Banco Popular realizing that worst-case outcome was no problem for Deutsche Bank hybrid holders this time.

Likewise, the Markit iBoxx EUR Contingent Convertible Liquid Developed Markets AT1 Index has also shown little reaction, finishing today weaker by 0.06 to 130.39. The index has rallied by about 26% from its June 2016 interim lows and sits within a rounding error of its high water mark reached on May 29^th.  By comparison, the Stoxx banks equity index has retreated by more than 7% from its early May highs. 

More such workouts may be coming down the pike; local and EU regulators are considering liquidation options for Italian banks Banca Popolare di Vicenza SpA and Veneto Banca SpA, according to the local newspaper Corriere della Sera.

“Debt with equity characteristics” is one title frequently bestowed upon convertible securities.  For us, less is sometimes more. 

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Why, indeed

The aptly named Chinese loan guarantor Wins Financial is putting bitcoin to shame.  The actively shorted special purpose acquisition vehicle (SPAC, for short) jumped higher by as much as 180% today on no apparent news, continuing its exponential advance that has now exceeded a 10-fold price increase in lss than a week.

Reached for comment by Bloomberg news, investor relations representative David Rudnick demurred:  “We really don’t know what’s going on.”  Rudnick also noted that he spoke with the Nasdaq Market Intelligence desk, who suggested the move could be the result of a technical buy signal, among other potential causes.

As for the company itself, a Bloomberg piece in March following another inexplicable share price surge detailed their repeated efforts to arrange an interview with company executives (click here).  The extraordinary tale includes a visit from reporters to Wins’ U.S. headquarters in Times Square, which turned out to be occupied by another company that was itself founded by a Wins board member.

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Paging Mortimer Duke

The worst performing commodity of 2017 thus far?  Orange juice is the dubious winner, with its contracts for future delivery sinking by more than 33% year to date.  

- Philip Grant

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Polishing cloth

“The desire for gold is the most universal and deeply rooted commercial instinct of the human race.”  So said Gerald M. Loeb, founding partner of Wall Street brokerage E.F. Hutton & Co. and “the most quoted man on Wall Street” according to Forbes, in his 1935 book The Battle for Investment Survival.

Polishing cloth

“The desire for gold is the most universal and deeply rooted commercial instinct of the human race.”  So said Gerald M. Loeb, founding partner of Wall Street brokerage E.F. Hutton & Co. and “the most quoted man on Wall Street” according to Forbes, in his 1935 book The Battle for Investment Survival.

Investors seem to agree, of late; spot gold today rose to its highest levels since November near $1,295 per ounce, good for a 13% gain so far in 2017.  

In so doing, the yellow metal broke a technical downtrend that has been in place since its September 2011 peak of $1,900 per ounce, according to Sheba Jafari of Goldman Sachs.  Still, true believers don’t have too much to be excited about as yet, gold’s weekly average price over the past five years of about $1,314 per ounce is 1.5% higher than current levels.

The pep in the yellow metal may be evidence of market fear rather than reflationary exuberance. The Chinese Gold and Silver Society Exchange expects 2017 mainland gold imports to increase by 50% from the prior year, amidst increased safe haven demand.  Likewise, the Japanese yen sits at its strongest level against the greenback in nearly six weeks in another sign of retrenching risk appetite.

Stateside, the spread between two- and ten-year U.S. Treasury note yields has narrowed to around 85 basis points, its lowest since September: Steepness, or lack thereof in the Treasury curve, has historically signified market expectations for economic growth.

Simultaneous weakness in the dollar and commodity prices that has included eight month lows in the DXY U.S. Dollar Index in tandem with a near one year nadir in the Thompson Reuters/CoreCommodity CRB index could be another cause for concern.

Not much concern is evident in the equity or derivatives markets. The CBOE VIX Volatility index has been stuck near 10 for the past six weeks, a level roughly half of its average back to 1997, with the last tick of 20 or higher occurring prior to Election Day. 

The major equity indices have in turn fluttered higher. Spurred by surges ranging from 25%-33% from the FAANG (Facebook, Apple, Amazon, Netflix and Google) group, the S&P 500 has tacked on nearly 9% and the Nasdaq 100 nearly 21% for 2017 so far.  As a result of their strength, those five names now represent nearly 12% of the SPDR S&P 500 ETF and more than 33% of the Powershares QQQ Nasdaq 100 ETF.

While the virtuous cycle of outperformance and increased weightings in those market capitalization-based indices has proven a boon for owners of the FAANG stocks, we can’t help but notice that the circus tent of this current bull market is currently being held up by relatively few poles.

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Full speed ahead

The auto market may be sputtering, with industry sales seeing a fifth straight annual contraction in May and inventories piling up at their fastest pace since 2009, but new formats for selling vehicles, and equity to the public, abound. 

Online listing platform Cars.com recently debuted on the New York Stock Exchange, currently sporting a roughly $2 billion market capitalization against 2016 pro-forma revenues of about $663 million.  In its S-1 registration,  the company advises that it is classified as an “emerging growth company” according to the 2012 JOBS Act, and as such: “is eligible to take advantage of certain exemptions from various reporting requirements that apply to other public companies, including, but not limited to, scaled disclosure provisions with respect to financial information and executive compensation.”

Meanwhile, reporting today for the first time as a public company is Carvana Co. The Phoenix based spin-off of DriveTime Automotive Group, Inc. is a purveyor of used automobiles, described as “Amazon-like” by an analyst on the sell side.  Their method of distribution?  Seven-story glass-sheeted vending machines. 

Longtime readers of Grant’s may recall the colorful back story. As Bloomberg today disclosed (you didn’t see it in the S-1), Ernest Garcia II, the controlling shareholder and father of CEO Ernest Garcia III, was convicted of securities fraud in 1990 related to the failure of the Lincoln Savings & Loan, featuring a scandal that implicated five U.S. Senators—“the Keating Five.” From the New York Times 2014 obituary of former Lincoln Savings and Loan CEO Charles H. Keating Jr.:

In three years, Lincoln’s assets soared to $3.9 billion, from $1 billion, and Mr. Keating was using the business as his personal cash machine, taking $34 million for himself and his family and $1.3 million more for political contributions, prosecutors said.

The Federal Home Loan Bank Board, fearing wide collapses in a shaky industry, finally imposed a 10 percent limit on risky S.&L. investments. By 1987, its investigators found that Lincoln had $135 million in unreported losses and was more than $600 million over the risky-investment ceiling. Soon, the F.B.I., the Securities and Exchange Commission and other agencies were homing in.

Mr. Keating hired Alan Greenspan, soon to be chairman of the Federal Reserve, who compiled a report saying Lincoln’s depositors faced “no foreseeable risk” and praising a “seasoned and expert” management. Mr. Keating soon called on five senators who had been recipients of his campaign largess — Alan Cranston of California, Donald W. Riegle Jr. of Michigan, John Glenn of Ohio and Dennis DeConcini and John McCain of Arizona — to pressure the bank board to relax its rules and kill its investigation.

“A `thrift’ for our time” was the headline over the Grant’s story of May 13, 1988 which flagged trouble at American Continental Corp., holding company of Lincoln Savings & Loan (CLICK HERE TO READ). We nominated the American Continental 9 ½% and 10 ½% debentures for the title of the worst investment extant. Certainly, they proved to be strong contenders.

- Philip Grant

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With a side of clams

Restaurant Brands International just had its annual shareholder meeting, as scheduled. CEO Daniel Schwartz spoke to attendees, as scheduled.  

With a side of clams

Restaurant Brands International—the Warren Buffett, Bill Ackman, 3G juggernaut—just had its annual shareholder meeting, as scheduled. CEO Daniel Schwartz spoke to attendees, as scheduled. 

There was one change of note:  the company skipped the normal Q&A with audience members, which included representatives of aggrieved Tim Horton’s franchisees.  John James Hoey of the Great White North Franchisee Association told the Toronto Globe and Mail that he was “astounded” at the lack of opportunity to air his grievances. 

What’s his beef, exactly?  For much, much more, see the current issue of Grant’s (“Rumblings from the great white north”).

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Good news, bad news

Active management is staging a mini-comeback.  Per David Kostin of Goldman Sachs, more than half large cap mutual funds have exceeded their respective benchmarks through May 18^th of this year.   The secret to their recent success? 

You guessed it:  Overweight holdings of the usual technology suspects.  Amazon, Google and Facebook are ubiquitous holdings in growth manager portfolios, while value mangers hold Apple and Microsoft shares in bulk.

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My baby ‘grande

The Chinese banking system is a monetary science project remarkable even by today’s standards of negative nominal rates, QE and yack-yack “forward guidance.” Now tightening financial conditions, upward pressure on interest rates and a sovereign debt downgrade are putting China—and maybe the rest of us, too—to the test.

Today’s Wall Street Journal featured a piece noting the  increasing shift in banking assets away from traditionally sound household deposits; the WSJ calculates that around RMB 1.2 trillion ($176 billion) were withdrawn from the banking system in May. 

In place of banks, companies are turning to more expensive and more opaque investment trusts to secure funding. These murky forms of structured finance have seen a breakneck pace of growth this year, with new trust loans in the first four months of 2017 exceeding RMB 882 billion, more than five times its comparable 2016 pace.  More broadly, Chinese total business and consumer credit outstanding rose to RMB 8.3 trillion in the first four months of this year, 11.4% above its 2016 levels.

What, exactly, is an investment trust? That inoffensive branding belies some eyebrow raising features.  The Wall Street Journal’s Chao Deng and Lingling Wei explain:

Trust firms, which often charge borrowers higher rates than banks, occupy a middle ground between banking and asset management. They are licensed and loosely regulated by China’s banking watchdog, but they lack some of banks’ protections, such as government deposit insurance, and they have more flexibility to invest in risky areas than banks do.

Daye Trust Co. is helping Qingzhou City Construction raise 200 million yuan through a two-year product that offers investors returns of 6.5% a year. The firm would pay Daye a rate of about 8%, which is still less than it was expecting to pay for bonds, these people say. Qingzhou City Construction intends to use the proceeds to finance a water-treatment project.

One area of concern for authorities as they tackle soaring Chinese debt—a factor in Moody’s Investors Service’s downgrade of China’s sovereign debt last month—is loans that banks disguise as investments. A shift to trust lending would make it even harder to gauge the true extent of credit in the system.

This suddenly burgeoning product recalls the lightly regulated, fast growing and implicitly guaranteed Wealth Management Products which have underpinned this cycle’s credit expansion.  The April 7, 2017 Grant’s piece “Tightness on tap” contains a primer on that investment black box.  

The replacement of relatively sticky deposit funding with that of investment trusts necessarily places China’s financial footing on shakier ground. But if the Chinese have proven anything in their management of financial affairs, it’s that short sellers there shouldn’t get too comfortable.

Last week the People’s Bank of China helped steer the offshore overnight deposit rate to as high as 23 percent, spurring a scramble for renminbi that pushed the local currency higher by 0.70% against the greenback.  

At the corporate level, Hong Kong property developer cum black box Evergrande (Grant’s, June 2^nd) propelled higher by 11.3% Monday amidst a Credit Suisse upward revision to its price target.  Bulls were apparently unconcerned that the bank’s positive relative appraisal included a price target of HKD 8.60, while shares finished the session fetching HKD 15.90 each. (Wait a minute: Is Credit Suisse trying to tell us it’s actually bearish?) For the year, Evergrande’s stock price is higher by a cool 229%.

Short squeezes, no matter how expertly administered, are a remedy for only the symptoms of financial trouble rather than the problem itself.  To that end, Caixin media reported today that as of September 1 all Chinese banks will be required to file daily reports of all cash withdrawals from overseas ATMs above 1,000 yuan (about $147).  The story contained an instructive anecdote.

A manager with a foreign bank told Caixin that some shops in Macau allow visitors from the mainland to buy watches and jewelry using their bank cards and then repurchase the goods for cash. Another practice, known as ‘ants moving their house’, involves individuals making multiple ATM withdrawals overseas to transfer large amounts of money offshore.

Capital outflows, a weaker currency, tightening credit screws and lower asset prices are four prospective unhappy outcomes which could await the Chinese.  The future is a closed book, but we will take the over. 

-- Philip Grant

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Disco(unt) inferno

Shares of aspirational home-furnishings retailer Restoration Hardware went into reverse today, retreating to the tune of 25% after the company’s first quarter results included a downward revision to its forecast for adjusted earnings per share in the fiscal year. 

Disco(unt) inferno

Shares of aspirational home-furnishings retailer Restoration Hardware went into reverse today, retreating to the tune of 25% after the company’s first quarter results included a downward revision to its forecast for adjusted earnings per share in the fiscal year.

In contrast, management revised higher its revenue growth forecasts over the same period.   As one might infer from that pair of trends, increased promotional activity is a decisive factor. CEO Gary G. Friedman noted as much on the conference call, disclosing that he expects the heavier discounting will continue for at least the next two quarters:

We may, as we're doing in the second quarter and fiscal year outlook, accelerate the rationalization of our product offer to enable us to move more quickly…we're seeing that we can optimize the offer, we can reduce the offer somewhat more. And we are moving through those goods more quickly. So we're taking more aggressive markdowns.

And today, as we look at the quarterly cadence, we believe it will still impact Q3 meaningfully and to a much lesser extent Q4, and we will be in a really good position in 2018 to re-architect the back-end.

In a bearish analysis penned about two and a half years ago (“House of Mirrors”, January 23, 2015), Grant’s contended that the high flying boutique would be unable to maintain its outsized growth rate in the fragmented home furnishings market, while its then-skyscraping valuations implied plenty of downside if things didn’t go according to plan.  Since then, shares have declined by about 55% while the S&P 500 rose by 18.5%.

As for the future?  Friedman’s ambitious plans far exceed simple upscale retail, as the press release emphasized his “RH Hospitality” vision, which would marry existing galleries (stores) to coffee bars, wineries and cafes. 

Such big thinking doesn’t come cheap.  Friedman is undeterred, wrapping up his prepared remarks with the following:

Our most valuable asset is not what we've done, but rather who we've become. We've become a team of people who don't know what can't be done. A team that is driven by our values and beliefs. A team that is willing to march into hell, as we did last year, for a heavenly cause.

One thing that hasn’t been done, at least in any year back to 2010, is the generation of positive free cash flow. Despite today’s disappointment, hope springs eternal for the sell side.  Consensus is for $125 million in free cash flow for fiscal 2018.

The investment heavy/cash flow lite business model will soon have another public entry in the form of meal-kit purveyor Blue Apron Holdings, Ltd. The silicon-valley startup yesterday filed its form S-1 with the Securities and Exchange Commission, a move which usually precedes an initial public equity offering. 

Revenues at Blue Apron are fast-growing, as are its operating losses.  With the top line ballooning to around $800 million in 2016 from $80 million two years prior, its 2016 net loss of $55 million was nearly double the $31 million shortfall seen in 2014. 

In its demonstrated lack of operating leverage and scale, Blue Apron recalls many a technology “Unicorn”, Uber Technologies among them (“Tell us what you really think”, Almost Daily Grant’s from May 24).   

Likewise, the path to profitability is muddled, at best.   The company saw its marketing expenses more than double year-over-year in the first quarter of 2017, to $60.6 million from $25.4 million.  At the same time, average revenue per-existing customer fell to $236 in the first quarter from $264 in the comparable period in 2016, a 10.6% annual drop.   

“You realize,” Friedman concluded in RH’s first quarter press release, “what we are building is extremely rare in contrast to today’s retail landscape.”

We beg to differ.

-- Philip Grant

Grant’s Interest Rate Observer . . . Thinking required™

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March of the mansion-dwellers

“You can’t give away a house in Greenwich.”  Such was the blunt assessment at a CNBC-sponsored conference last fall from Starwood Capital CEO Barry Sternlicht, a former resident of the Constitution state who has since moved to Florida. 

March of the mansion-dwellers

“You can’t give away a house in Greenwich.”  Such was the blunt assessment at a CNBC-sponsored conference last fall from Starwood Capital CEO Barry Sternlicht, a former resident of the Constitution state who has since moved to Florida.

Well, the point survives the exaggeration. A piece in today’s Wall Street Journal notes the sluggish state of the ultra-high end luxury housing market in Greenwich, Connecticut.

The well-manicured suburb 28 miles from New York City saw only five transactions at more than $10 million in each of 2015 and 2016. The 38 such properties currently on the market represent more than seven years of supply at the current pace of sales.   By way of comparison, absorption period (average time a unit spends on the market prior to sale) for all houses in the region averaged just under one year in the fourth quarter, according to broker Douglass Elliman.

An observer may note that this development seems inconsistent with record high asset prices.  Then, again, it’s entirely consistent with fee compression and investment underperformance in the once-thriving industry of 2% and 20%. As politics are to the Washington, D.C. economy, so is buying low and selling high to the Greenwich economy.

(A illustrative depiction of better days in Fairfield County; Grant’s, April 21 2006)

Things are hardly much better below the ultra-high end of the market. Elliman tabulated 114 total residential sales in Greenwich in the fourth quarter, a 40% sequential decline and a 5.8% year-on-year drop. Average days on the market rose to 168, a 12.8% jump from the third quarter and 3.7% from the prior year, and the median sales price of about $1.59 million represented a decline of 7.7% sequentially and 0.8% year-on-year.

The bearish reversal of fortunes in real estate is part and parcel to growing fiscal problems, as government measures to shore up its revenue base have backfired. 

Despite a pair of hikes to state income tax rates since 2011 under the auspices of Governor Dannel P. Malloy, revenues have recently dwindled, especially at that top end. Amidst the flight of some wealthy residents and lower reported income from others, 2016 collections from the state’s top 100 taxpayers dropped by a staggering 45% from the year prior.   

That shortfall is estimated to add an additional $200 million to Connecticut’s budget deficit, which the Connecticut Mirror projects will total more than $5 billion over the next two years. 

For context, the state’s general spending fund totaled just over $18 billion in 2016 and is projected at around $18.9 billion for 2017.  With fiscal 2018 set to begin on July 1^st, state budget negotiations have reached a stalemate.

You would suppose that the dicey fiscal position, negative demographic trends (2016 saw a 0.40% loss in total state population from the year prior) and slumbering housing market would be reflected in municipal bond prices. 

No such distress is evident.  Quite the opposite, in fact, as the federal and state tax-exempt Connecticut general obligation 4’s of 2037 (rated A1 at Moody’s and A+ at S&P) saw the strongest closing price in its brief existence yesterday, finishing at 103.45 on the dollar for a yield-to-worst of 3.578%. Nearby Pennsylvania last year issued some GO paper of its own, and despite credit ratings of Aa3 at Moody’s and AA- at S&P (one notch higher than Connecticut) its 3s of 2036 currently trade below par, with a yield to worst of 3.645%.

Now, Pennsylvania’s top personal income tax rate, at 3.07%, is less than half of Connecticut’s 6.99%. Still, the creditworthiness of the issuer counts for something, does it not?

One from the vault:

For a survey of Greenwich real estate in the aftermath of the 1987 “Black Monday” stock market crash and a timely observation that Japan’s then ferocious asset bubble appeared to be potentially listing, click here for a PDF copy of Grant’s “Greenwich around the bend,” dated January 25, 1988.

-Philip Grant

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Cheaper by the dozen

It’s never been more convenient to be average. 

Cheaper by the dozen

It’s never been more convenient to be average. Passive investment strategies via indexation and exchange traded funds have seen exponential growth during this cycle, and investors can now pay next to nothing for the privilege of tracking the market. 

Part of the fad can be attributed to widespread underperformance from active managers (the HFRX Global Hedge Fund Index has appreciated by a measly 9.5% since June of 2012, compared to about 83% for the S&P 500 not including dividends) amidst the top-heavy, FAANG stocks-led bull market.  A growing focus on cost from institutional investors plays no small part as well.

Just as it is said that revolutions eat their children, the increasing primacy of low and lower fees is now pressuring the very architects of the indexation movement. 

The Financial Times on May 24^th documented efforts by ETF makers to cut costs by creating their own stock market indices for the funds to track; they currently pay a fixed licensing fee to the likes of MSCI and S&P that create the indices. This represents a rising proportion of their costs as fees to investors dwindle amidst intense competition.

Today, the FT reports that the State Street SPDR S&P 500 ETF has seen more than $10 billion in outflows this year (roughly 4.3% of its total assets), while rival funds from Vanguard and iShares have seen their assets grow by $14 billion and $7 billion, respectively.  Vanguard and iShares charge an expense ratio of four basis points, compared to nine for the State Street vehicle.

It certainly seems fair to wonder about eventual unintended consequences of such a widespread focus on low fees.  The astronaut John Glenn, when asked to describe his state of mind when climbing into an Atlas rocket, purportedly quipped:

I felt exactly how you would feel if you were getting ready to launch and knew you were sitting on top of 2 million parts — all built by the lowest bidder on a government contract.

What might go wrong?

In the not so-distant days of August 2015, a surprise Chinese currency devaluation spurred a mini-financial panic that led to a widespread dislocation of numerous domestic ETF’s from their net asset values  (for more, see the September 30 Grant’s “House of fads”). On Monday, August 24^th 2015, the Guggenheim S&P 500 equal weight ETF (NYSE: RSP) briefly traded as low as $50 per share versus a net asset value of about $71 a share, before recovering. 

Similarly, the Powershares S&P 500 Low Volatility Portfolio (NYSE: SPLV) finished the prior Friday at $36.90 a share.  It opened at $35.52 per share on August 24^th before falling as low as $20 per share a few minutes later.  By 10:30AM Eastern, it was above $36/share. Low volatility can mean different things to different people.

Speaking of China, something unusual is afoot. 

The curiously buoyant price action in its currency relative to other domestic assets noted here last week has continued apace; Bloomberg relays that the 0.90% four day rally in the offshore yuan to dollar exchange rate and “surging” yuan borrowing costs in Hong Kong have pushed implied volatility in the CNY to its fastest rate of growth since that memorable August 2015. Recall that Moody’s cut its rating on Chinese debt last week, the first such move in three decades according to Bloomberg.

-Philip Grant

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Here, take two of these:

It’s been so gradual and free of unpleasant effect you may have hardly noticed: bank-to-bank lending rates as measured by LIBOR (London Interbank Offered Rate) have virtually doubled since the summer of last year, 

Here, take two of these:

It’s been so gradual and free of unpleasant effect you may have hardly noticed: bank-to-bank lending rates as measured by LIBOR (London Interbank Offered Rate) have virtually doubled since the summer of last year, today reaching fresh eight year highs on a one and three month basis, near 1.05% and above 1.20%, respectively.  In turn, the three month Treasury bill yield has risen to 0.92%, from less than 0.20% in the fall of 2016.

Of course, during this time the U.S. Federal Reserve has undertaken a campaign to tighten monetary policy by hiking its overnight Fed Funds Rate (interest rate futures forecast a 100% chance of a rate hike at the upcoming June meeting), and measured economic growth appears to be on a decent footing. 

Today, first quarter GDP growth was revised higher, to 1.2% from the advance reading of 0.7%. For the second quarter, the Atlanta Fed forecasts real GDP growth at a robust 3.7%, which would be the highest since 2014.  A growing economy and rising interest rates would seemingly provide a ready explanation for the tightening financial conditions.

Despite the apparent bullishness, interest rate futures continue to place less than 50% odds of two additional rate hikes by the end of the year (recall that one in June is an apparent lock).  The bond market is also signaling a less than sanguine growth outlook.

Upward momentum in Treasury yields has been confined to the very front end of the curve.  It costs almost as much to procure unsecured funding for three months on the interbank market as it does for Uncle Sam to borrow for twenty-four months (about 1.29%).

Those two year Treasury notes have seen their yields decline from about 1.37% in mid-March.  Five, seven and ten year note yields have reversed even faster, with each between 30-40 basis points lower than their respective March highs.  The spread between two and five year government yields is fast undoing its post-election lurch steeper:

(Reflation fizzles)

Considering that a material source of bank earnings derives from the spread between short term borrowing and long term lending (known as the net interest margin), this yield curve compression is none too-welcome.  So, too, does the lending environment suddenly look a little dicey.  From a May 25 note on CFO.com, U.S. Banks See Slower Loan Growth, Higher Charge-Offs:

Total loans and leases fell by $8.1 billion, or 0.1% year-over-year, in the three months ended March 31, led by credit card loans, which posted a seasonal decline of $43.7 billion, or 5.5%. In its Quarterly Banking Profile, released on Wednesday, the FDIC attributed the decline to cardholders paying down outstanding balances, but residential mortgages also fell, by 0.5%. Credit to businesses offset some of the decline, with commercial and industrial loans up 1.3% and commercial real estate loans rising 1.7%.

Failed consumer loans also dinged banks’ balance sheets. Banks charged off $11.5 billion of loans in total in the first quarter, an increase of 13.4%. Net credit card charge-offs rose 22.1%, while auto loan charge-offs increased nearly 28%. Charge-offs of “other loans to individuals” increased a whopping 66.4%.

We can safely reach three conclusions.  Banks are charging one another far more for capital than has been seen through this cycle, they are seeing an uptick in non-performing loans across a couple of different categories, and are faced with a flattening Treasury curve that may crimp net interest income.  Since enjoying its sharp post-election rally into year-end; the XLF large-cap bank ETF (largest holdings Berkshire Hathaway, Inc., J.P. Morgan & Co. and Wells Fargo & Co.) has consolidated its gains, settling into a narrow trading range in the past two months.  Some of its key inputs are moving.

As for the Federal Reserve, the assets held on its balance sheet have been self-labeled as the System Open Market Account, or SOMA for short.   That term may be familiar to some fans of dystopian science fiction literature: “Soma” was the name of the narcotic instrument of public control featured in Aldous Huxley’s 1932 novel “Brave New World”. Coincidence? Probably. 

-Philip Grant

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Recency bias

Baubles merchant-cum consumer finance dispenser Signet Jewelers, Inc. is having another tough day.  

Recency bias

Baubles merchant-cum consumer finance dispenser Signet Jewelers, Inc. is having another tough day.  The Akron, Ohio based retailer badly missed sell-side expectations in its first quarter earnings release: net income and operating cash flows declined by 46.5% and 50%, respectively from the levels seen a year ago. Comparable-store sales (open for at least a year) saw a steep 11.5% year-on-year decline.  In response, the stock has fallen to its lowest levels since the spring of 2013.

Management maintained its full year guidance estimate despite the shortfall, and creatively cited the timing of Mother’s Day (which annually takes place on the second Sunday in May here in the U.S.) while explaining the weak first quarter performance.  Signet’s fiscal first quarter ended on April 29^th, last year it ended on April 30^th.

Beyond the results themselves, investors were keen for an update on the company’s efforts to sell its credit portfolio; an asset which has drawn more than its share of scrutiny from skeptics (Grant’s included).  Sure enough, they indeed found a buyer, in the form of Alliance Data Corp., $1 billion of customer accounts receivable at par value. 

The only problem? It was their prime book, featuring higher average customer credit scores and lower default probabilities, as opposed to the subprime accounts receivable that Signet has been so far unsuccessfully shopping. They retained Goldman Sachs a year ago in hopes of selling the entire portfolio, not just the best part. 

In light of the sharp sales retrenchment and defensive strategic moves from management, it is perhaps fair to wonder about the true shape of Signet’s balance sheet.

As noted in Grant’s bearish analysis in June of last year (available here) for which we are indebted to Marc Cohodes and Zander Rosenbluth,  Signet uses so-called recency accounting to monitor its credit performance,  an unusual technique that counts customers making smaller “qualifying payments” as being current on their debts.  The more standard contractual accounting method makes no such accommodation for partial payments.  

A loan book of subprime borrowers making partial payments which are counted as current is not such an attractive proposition, it turns out. With the proceeds of the sale of its prime receivables, Signet announced plans to pay down some $600 million in debt and potentially repurchase shares, depending on market conditions. 

This would not be their first buyback. As noted in their most recent form 10-K, in fiscal 2017 (last year) the company repurchased 11.2 million shares at an average price of $89.10, for a total consideration of just under $1 billion.  After a near 50% decline in its share price from its levels in early December, Signet finished today’s trading at $50.30 per share, with a market capitalization of around $3.43 billion.

Epilogue:

The SEC has responded to a request under the Freedom of Information Act from John Gavin, CEO and founder of Probes Reporter (@probesreporter on twitter) by confirming that a previously undisclosed investigation of Signet is currently underway. The agency provided no other details, stating that: “releasing the withheld information could reasonably be expected to interfere with on-going enforcement proceedings.” 

-Philip Grant

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Now is a great time to…

It sure isn’t 2007, but the mini-boom seen in the U.S. housing market in recent years looks to be abating.  April new home sales of single family units (not seasonally adjusted) saw a sharp 11% decline on a sequential basis.  

Now is a great time to…

It sure isn’t 2007, but the mini-boom seen in the U.S. housing market in recent years looks to be abating.  April new home sales of single family units (not seasonally adjusted) saw a sharp 11% decline on a sequential basis.  

That compares to spring seasonal trends which have included flat or stronger monthly sales in April in every year going back to 2006, with an average gain of 4.3% over those ten years. Slowing activity was met with lower prices, as the median price for existing homes dropped by 3% from March and by 3.8% from April of last year.  One month of data (albeit in two metrics) does not a trend make, but suddenly slothful conditions in residential real estate are not confined to the U.S. 

The formerly white-hot London market has likewise cooled off, at least in terms of financing activity.  Home loan applications dropped by 19% in the first quarter from a year ago according to the Council of Mortgage Lenders. Total loan value of £5.4 billion shrank by an even wider 22% from its 2016 level, indicating a more pronounced reversal at the high end of the market. 

It is no breaking news that the Canadian housing market has in recent years enjoyed a major bull run.  The Canadian Real Estate Association tabulated an average home price of C$559,317 in April transactions (equivalent to about $416,000), a nosebleed level considering that benchmark prices only broke through C$500,000 for the first time last year and C$400,000 for the first time in 2014. By comparison, the April median home price on existing sales in the U.S was only about $245,000 according to the National Association of Realtors.   

With that breakneck pace of growth in mind, a Bloomberg article from today (“Toronto Bidding Wars Turn to Homebuyers’ Remorse as Market Slows”) contained an ominous quote.  Whether on account of a new foreign buyer’s tax, or the funding troubles at Home Capital Group, Inc. (see “Score one for Mark Cohodes”, April 20^th) something seems to have recently changed:

“We are seeing people who paid those crazy prices over the last few months walking away from their deposits,” said Carissa Turnbull, a Royal LePage broker in the Toronto suburb of Oakville, who didn’t get a single visitor to an open house on the weekend. “They don’t want to close anymore.”

Canada can ill afford a swift turn in its housing fortunes, it appears.  The ratio of household debt to adjusted household disposable income topped 167% in the fourth quarter. By comparison, U.S. household debt to disposable income peaked at 132.7% in the fourth quarter of 2007 and logged 103.4% in the fourth quarter of 2016.

But as for daredevil balance sheet living, one Nordic nation has the Canadians soundly beaten.  Swedish household debt to disposable income ratios currently top 180% and are projected to reach nearly 200% by the middle of 2020, according to a semi-annual report released this week by the Swedish Riksbank. 

As a point of reference, overnight lending rates in the U.K., Canada and Sweden are 0.25%, 0.50% and negatve 0.70%, respectively.

Tell us what you really think

Australian investor Hamish Douglass is evidently not a fan of Uber Technologies, Inc.  He is quoted in an interview with Bloomberg issuing the following salvos:

 I see Uber as one of the stupidest businesses in history. The probability of this business not going bankrupt in a decade is like 1 per cent.

They've got no advantage over anyone else when it comes to autonomous driving technology. They tried to steal it from Google, they've ended up in court. That whole side of the business is falling apart. It's constantly losing money and its capital-raising strategy is a Ponzi scheme.

All they do is keep increasing their private market valuation and someone always says, 'I'll put some money up, because next time they raise, it'll be at a higher price.

We can imagine that Mr. Douglass was likewise none too impressed by the piece in this morning’s New York Times announcing Uber had disclosed an error in its favor when computing the commissions it pays to its independent contractor (don't call them employees ) drivers.  The ride-share company had been incorrectly taking its cut from pre-tax fares, as opposed to the lower after-tax percentage.

“We are committed to paying every driver every penny they are owed – plus interest – as quickly as possible.” Rachel Holt, the company’s regional general manager for the United States and Canada, said in a statement.

Monetary Mission Creep

The ECB is a large organization, with over 2,500 employees across Europe working for their sole mandate of price stability (stability defined as 2 percent annual inflation).  As such, some degree of inter-organizational disagreement is to be expected.  A pair of Bloomberg headlines today indicate a more fundamental policy divide within the central bank:

ECB Warns of Dangers of `Ripple Effect' From House Price Boom

Draghi Sees No Reason to Deviate From ECB Policy Guidance

Quantitative easing continues apace in the Eurozone, with the ECB’s current €60 billion in monthly asset purchases scheduled to continue through December.  Their balance sheet footings recently surpassed that of the Federal Reserve for the first time since the spring of 2013.

Meanwhile, the German Institute for Economic Research (IFO) business climate index today rose to a record high level; the data set goes back to 1991 and the end of the Cold War.  The Institute’s President, Clemens Feust, described business sentiment there as “euphoric.”

-Philip Grant

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Yuan love

A cross-asset tug of war is underway in the Middle Kingdom, as an apparent revival of risk aversion in Chinese equity and credit markets stands in increasing contrast to calm waters in the yuan/dollar exchange rate. 

Yuan love

A cross-asset tug of war is underway in the Middle Kingdom, as an apparent revival of risk aversion in Chinese equity and credit markets stands in increasing contrast to calm waters in the yuan/dollar exchange rate.

After beginning the year on a bullish note, the Shanghai Composite Index has shed nearly 7% from its mid-March interim highs and now sits lower for 2017, in tandem with soft recent price action in industrial commodities such as iron ore and copper.  

Slowing growth is likewise evident in the ongoing inversion between its 5 and 10 year government bonds (the five year note now yields 3.71%, the ten year yields 3.67%; healthy economies normally feature higher yields in longer dated debt). Likewise, China’s loan market has been turned on its head: it is now cheaper for corporations to borrow from banks (the 1-year prime rate is 4.30%) than it is for banks to borrow from one another (the 1-year Shibor rate is 4.3024%).

The currency market is signaling no such trouble. Instead, the Chinese yuan sits higher by about 1% vs the greenback so far this year. Bloomberg has covered this contrast with a pair of recent stories, noting today (“China’s Yuan is Locked in a Tussle Between PBOC and Traders”) that their People’s Bank of China has marked the yuan higher vs the USD in eight of the last nine sessions, only to see the CNY finish below that so-called reference rate in all but one of those instances.

While China may or may not have a viable strategy to ward off financial mishap amidst a leverage-soaked banking system and evidently slowing growth prospects, Chinese listed companies in Hong Kong have a battle plan.

Yesterdays announced formation of the “anti-malicious short selling alliance’’ will allow affiliated management teams to pool P.R. resources and potentially buy each other’s equity, as they battle nay-sayers such as Muddy Waters and Glaucus Research.

For those with a long memory, this move echoed an undertaking from the Hong Kong Monetary Authority in the fraught days following the Asian currency crisis in 1998.  The Financial Times tells the story:

Donald Tsang and Anthony Yam, the two senior officials running economic policy in Hong Kong at the time, hatched an audacious plan to buy 11 per cent of the Hang Seng (index), paying for the move by drawing on foreign exchange reserves. They conducted the purchases within 10 days, starting on 14 August 1998.

The stock market rose rapidly, and never looked back. Furthermore, short positions against the Hong Kong dollar were effectively squeezed out, and the peg survived against all the odds. The (yuan) was not devalued, and Asia recovered. The HK move was initially greeted by derision from the hedge fund community and from international financial officials, led vociferously by Alan Greenspan. It was not until a decade later that Mr. Greenspan publicly admitted that the intervention had been a major success.

Unlike in 1998, however, there is no George Soros attacking the HKMA’s peg to the greenback, so the monetary authority is unlikely to spend its funds buying stocks. Nor should Hong-Kong listed Chinese companies expect much help from the People’s Bank. Printing redbacks to buy stocks on the Hong Kong Stock Exchange would undermine the bank’s efforts to hold up the currency exchange rate.

Pick your poison, PBOC.

What’s Gold is new again

Behold, three seemingly unrelated, but perhaps very much related, headlines from this year:

In Volatility Lull, Stocks Became Bonds—Is It Over Now? (Wall Street Journal, May 19^th)

Franklin Templeton's Zahn says he is buying Government bonds as a "store of cash" (Reuters, May 12^th)

Bitcoin is 'a great hedge against the system' and could be the new gold (Business Insider, January 29^th)

Perhaps by this logic, bars of gold are the new stocks? If so, count us as bull jockeys. 

-Philip Grant

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Leap of faith     

Subprime auto lender Santander Consumer, Inc. has an unusual element in its underwriting process; trust in the borrower.

Leap of faith     

Subprime auto lender Santander Consumer, Inc. has an unusual element in its underwriting process: trust in the borrower. According to a recent report from Moody’s, the company verified income on only 8% of the loans it securitized in 2016, a far cry from the 64% of borrowers vetted by peer AmeriCredit (a unit of General Motors).

In addition, extensions of credit featuring no income verification, no co-signer or a low or non-existent credit score comprised about 9% of Santander’s total portfolio, compared to less than 1% at AmeriCredit.  In light of those facts, it is perhaps little surprise that things are apparently heading south. As noted here last week, the Santander unit saw total delinquencies jump higher in April, reaching 13.01% of its book from 11.87% in the year ago period. CEO Jason Kulas explained his philosophy on the company’s recent first quarter conference call:

It’s taking what the market gives us. We always want to maximize our capture with all the applications that we get…There are certain pockets of what we originated in 2015 that we are no longer originating…we saw the same thing, by the way, when we went through 2006 and 2007.  When you go through those types of situations, you learn from them…some things you never do again. Some things, you just make sure you’re priced for. And for us, it’s a little bit of both.

In the eternally cyclical world of credit, behavior that can earn market share and profitable origination business in good times can look not-so prudent when conditions inevitably change.

(A vehicular metaphor for the recent trends in auto sales and credit)

Inflation conflation

The line between moderate and high inflation can be very thin indeed. Core CPI has declined to 1.9% year-on-year in April, from 2.3% in January. Half of that decline, according to Paul Ashworth of Capital Economics (via the Wall Street Journal), can be attributed to hedonic adjustments in wireless telephone services.  Hedonic adjustments are economist assumptions that tweak the price index for changes in the quality of goods and services.

The proliferation of unlimited data plans offered by the likes of T-Mobile appears to be a primary culprit, with Ashworth noting “the price war that has broken out among cell-phone service providers, with all the big providers now offering unlimited data plans at cheaper rates.” As for its impact on measured inflation, Bianco Research calculates that the 12.91% year-on-year decline in cellular telephone services (as measured by the B.L.S.) equates to a 24 basis point (0.24%) decline in the core CPI reading for April, which came in at 1.9%. Considering the Fed’s price-stability mandate of 2% inflation, that hedonic adjustment represented the difference between a below target and above target reading for the April period, at least according to the CPI.

It’s enough to make you wonder about the data which underpins our data-dependent monetary policy.  The March 10, 2017 issue of Grant’s (“Scraping up inflation”) quoted the economist Oskar Morgenstern from his 1963 work, On the Accuracy of Economic Observations:

The idea that as complex a phenomenon as the change in a ‘price level,’ itself a heroic theoretical abstraction, could at present be measured to such a degree of accuracy is nevertheless simply absurd.

The faux-precision on which Morgenstern heaped such articulate scorn is on full display in this instance; meanwhile market expectations of Fed policy can be as capricious as the Committee itself. Amidst the latest recovery in risk assets, odds for a policy hike at the June 14 meeting have returned to near 100%, according to interest rate futures markets.  After the stock market sell-off seen last Wednesday, those odds temporarily dropped to just over 80%.  But expectations for two hikes or more have gone the other way, futures currently price less than 50% odds of a funds rate of 1.375% or higher by year end, down from around 62% on May 9^th (the effective Fed funds rate is currently 0.91% according to Bloomberg).

Meanwhile, interbank lending rates continue to move higher, with three month LIBOR making a fresh eight year high today above 1.18%.  A two year Treasury bill yields less than 10 basis points more, roughly 1.27%.

-Philip Grant

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Pack em’ in

In some of the nation’s biggest and most expensive cities, the balance of power in commercial real estate is swinging to the buyers. 

Pack em’ in

In some of the nation’s biggest and most expensive cities, the balance of power in commercial real estate is swinging to the renters. Consulting firm Trepp LLC this week flagged data from tenant representative Savillis Studley noting that so-called effective rents (which include landlord concessions and other incentives to rent) as well as landlord rental income have softened in New York, San Francisco and Washington, D.C.  

Landlord concessions figure heavily:  Midtown Manhattan saw a 10.2% annual rise in such givebacks during 2016, while upfront concessions in San Francisco surged by 22.4% in 2016, in the context of an 11.6% rise in rents, according to the San Francisco Business Journal.  It puts us in mind of the auto market, in which a 14% jump in selling concessions was necessary to move the iron in 2016, according to ALG Group (Almost Daily Grant’s, “Buckle up, auto bulls!” May 5).

Turning back to Gotham, Green Street Research has identified an interesting potential source of drag apart from growing supply.  Office density, as in jamming more employees into fewer square feet, is on the rise; Green Street calculates that “Manhattan offices are ~10% more dense today than in 2010 on average.”

This trend, they judge, would be even more pronounced but for relatively longer lease terms (8-10 years on average) that keep tenants in one spot longer than they might like. “In reality, the average lease signed today is likely 20-30% more space-efficient than a comparable deal 10-15 years ago.” 

A similar phenomenon exists in D.C., where, the National Real Estate Investor observes: “Since 2010, D.C. office occupiers relocating to other parts of the market have shed an average 18 percent of space with each move.”

With this impressive, and landlord-flummoxing, trend of increasing efficiency comes the latest reminder: The march of human progress is apparently bringing us closer together. Literally.

Leaning tower of money

Asset prices have displayed some familiar resilience in the days following Wednesday’s harrowing (on a relative basis) sell-off, with the broad S&P 500 since recouping the majority of its near 2% decline.  As usual, we can thank (?) our ever-so-generous central bankers for this prompt turnaround. 

While comments from Jim Bullard of the St. Louis Fed ruminating on a potential fourth iteration of Quantitative Easing made headlines, a perhaps more concrete factor is the herculean pace of asset purchases currently being undertaken by the European Central Bank. Since the program got underway at the end of 2014, the ECB has seen its assets rise to above €4.1 trillion from just over €2 trillion; good for a breakneck pace of nearly 35% annualized growth. 

By comparison, America’s central bank has been a laggard, with Federal Reserve assets rising at a mere 26% annualized pace during Ben Bernanke’s QE3 program, which ran from the fall of 2012 to fall of 2014.  Since these grand monetary experiments began in late 2008, Fed balance sheet growth has tallied at an annualized rate of just over 21%.  

At its current, “tapered” €60 billion monthly pace of acquisition, the ECB will surpass the currently status-quo Fed’s balance sheet footings by the programs scheduled conclusion at the end of the year.  Even leaving aside the monetary gymnastics being undertaken by the Swiss National Bank and the Bank of Japan, it seems that Jim Bullard and co. have little reason to worry.

Newly minted fiat currency chasing assets? There’s more where that came from. 

-Philip Grant

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Foresea-able

China’s Foresea Life Insurance Group has a problem, and is not shy about it.

Foresea-able

China’s Foresea Life Insurance Group has a problem, and is not shy about it.

As reported by the Financial Times, the subsidiary of the Baoneng Group conglomerate sent a letter to its regulator asking to be allowed to once again sell its investment-linked insurance products. The Chinese Insurance Regulator Commission has barred them  from doing so since December, with its chairman Yao Zhenhua receiving a 10 year ban from the industry, for ‘violat(ing) insurance regulations and provid(ing) false information for its capital increase.’ The letter apparently contained an extraordinary passage. Take it away, FT:

In the letter dated April 28, Foresea asks the CIRC to resume new product approvals ‘in order to avoid inciting mass incidents by clients and localized and systemic risks, producing greater damage to the industry.’ The term ‘mass incidents’ is commonly used in China to describe demonstrations, protests and riots.

Foresea warned in its letter of RMB 60 billion (about $8.7 billion) in projected redemptions this year, and apparently needs the cash from new originations to help meet those redemptions. Its premium revenues increased more than threefold last year to RMB 100 billion from RMB 32 billion in 2014.

In describing the financing of its parent Baoneng Groujp, the FT describes its policies as “essentially investment vehicles offering high yields and guaranteed payouts on maturities.”  So, the fund needs cash to make whole implicitly guaranteed payouts on prior investments.  Where have we heard that before?

From the New York Times, on December 11, 2008:

The Madoff funds attracted investors with the promise of high returns and low fees. One of Mr. Madoff’s more prominent funds, the Fairfield Sentry fund, reported having $7.3 billion in assets in October and claimed to have paid more than 11 percent interest each year through its 15-year track record.

From Barron’s, way back in May 2001:

These private accounts, have produced compound average annual returns of 15% for more than a decade. Remarkably, some of the larger, billion-dollar Madoff-run funds have never had a down year.

When Barron's asked Madoff how he accomplishes this, he says, "It's a proprietary strategy. I can't go into it in great detail."

Nor were the firms that market Madoff's funds forthcoming. "It's a private fund. And so our inclination has been not to discuss its returns," says Jeffrey Tucker, partner and co-founder of Fairfield Greenwich, a New York City-based hedge-fund marketer. "Why Barron's would have any interest in this fund I don't know."

Back in the present day, the Chinese public appears to be blissfully unaware of the risks these products carry.  A recent Bloomberg piece summarized the uncanny recent success of Wealth Management Products, another quasi-guaranteed investment vehicle:

Despite investing in volatile assets from corporate bonds to stocks and real estate, WMPs have produced remarkably steady returns. Among the more than 181,000 products that matured in 2015, just 44 suffered a loss, most of which were sold by foreign banks.

“Only after a WMP defaults in a high-profile way will investors start worrying about their money,” says Hao Hong, a Hong Kong-based strategist at Bocom International Holdings Co. who’s known for his prescient calls on Chinese markets.

Investors, as a collective, aren’t worried.  Investors, as a collective, might soon be worried. What do they say about things that are too good to be true?

Brazil, ETFs and you

For a change, the source of this morning’s most destabilizing political news wasn’t Washington, D.C.

Revelations of apparent graft by Brazilian President Michel Temer, who himself was vaulted into power last year following a corruption-induced impeachment of his predecessor Dilma Rousseff, sent the iBovespa index down by nearly 9% in local terms (and triggering a 30 minute trading halt this morning), while the Brazilian Real shed just over 7.5% against the dollar. 

Stateside, the iShares MSCI Brazil ETF (which carries an expense ratio of 62 basis points) tracked those losses with a roughly 16% decline, while three times levered Direxion Daily Bull Brazil ETF (which carries an expense ratio of 95 basis points) was accordingly weaker by about 48%.  Remarkably, the leveraged product saw trading volume today of over 14.5 million shares, which equates to more than eight trades per each of the 1.8 million shares outstanding.  Mission accomplished, sort of, for iShares and Direxion. 

-Philip Grant

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Shhh—the market is sleeping

Staying home with the curtains drawn and the pillows fluffed is the new going out on the town. At least, the hot demand for so-called low volatility ETF products would seem to suggest as much.

Shhh—the market is sleeping

Staying home with the curtains drawn and the pillows fluffed is the new going out on the town. At least, the hot demand for so-called low volatility ETF products would seem to suggest as much. 

Bloomberg today reports that inflows to the iShares Edge MSCI Min Vol USA ETF rose to $238 million last month (its highest since July), continuing its accumulation that has seen positive inflows in six of the past seven weeks. That has helped maintain valuations to treetop levels.  Bloomberg’s Oliver Renick writes:

A basket of low volatility stocks tracked by Leuthold Group traded at a median price to earnings ratio of 23.1, a “totally bananas” level, according to a May 5 note to clients by the firm’s chief investment officer, Doug Ramsey.

One cannot say that these gimmicks have failed to perform their stated function of late. A look at recent price trends in the PowerShares S&P 500 low volatility ETF is a study in inertia: the product has seen exactly zero daily moves of 1% or greater in the past six months (its last bout of outsized motion was a 1.14% decline on December 14 of last year), while closing within 1% of $43.50 per share on every day but one since the beginning of March. 

The popularity of low volatility strategies has coincided with extremely low realized volatility in equities.  For the S&P 500, realized volatility has compressed from 6.78 over the past 6 months, to 6.66 over the past three months, to 6.60 over the past month.  In that context, the 10.5 reading in spot VIX (roughly half its long term average) seems downright cautious.  Deutsche Bank’s Rocky Fishman explained this phenomenon, as quoted in Barron’s:

“Low intra-SPX correlation, decent economic growth, a still-accommodative Fed and…positioning from dealers all contribute to the low realized vol… As dealers delta hedge these positions, they can dampen moves in both directions.”  Fishman also warns that VIX exchange-traded products rebalancing on a spike in volatility poses a higher technical risk to markets than vol control funds or commodity trading advisor or CTA positioning. 

What, if anything, could disrupt the widespread slumber? Perhaps the apparent deterioration in the auto market and a subsequent downturn in consumer credit may eventually play a role.  Amidst the first four month contraction in auto sales since 2009, rental car company Hertz is evidently choking on its bloated inventory levels.  CMA calculates that five year credit default swaps are currently pricing in 62% odds that the borrower will fail to repay its creditors in full.  This morning the Wall Street Journal reported that Ford plans to reduce its global workforce by 10%, which implies around 20,000 job cuts (half of its workers call North America home).  Auto financer Santander Consumer reported a surprise jump in total delinquencies in April, with the metric rising to 13.01% from 11.87% year-on-year.  April Master Trust data saw net charge-offs rise year-on-year at American Express, Capital One, Discover Financial, and J.P. Morgan (Citi’s declined from 2016 and Bank of America’s were unchanged from a year ago).

Undaunted by these figures, the broader indices are making some history of their own.  Robin Wigglesworth of the Financial Times relays that volatility in emerging markets is near its lowest level since 1997, while today marks the 15^th straight time the S&P 500 has failed to move at least 0.50% in either direction, the longest such streak since 1969 according to CNBC.  Considering the eventual outcome in both of those instances, here’s hoping that this time is different.  

-Philip Grant

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Bad breadth

US equities made their first high of the cycle in over two months, with the broad S&P 500 finally eclipsing its March 1 peak after ten weeks of sideways drift in a narrow range.  While not necessarily breaking news on its own, the component behavior driving this latest move higher is definitely worth noting.

Bad breadth

US equities made their first high of the cycle in over two months, with the broad S&P 500 finally eclipsing its March 1 peak after ten weeks of sideways drift in a narrow range.  While not necessarily breaking news on its own, the component behavior driving this latest move higher is definitely worth noting. 

In particular, the hot-money “FAANG” group comprising Facebook, Apple, Amazon, Netflix and Google has rode a near constant bid to drive the broad indices higher by their virtual lonesome,  with each rising between 11-14% from their respective March 1 levels (adding an aggregate $325 billion in value),  compared to a 1.6% uptick on the S&P 500.

In so doing, these mega-cap bastions of bullish sentiment have captured an ever-growing proportion of the domestic equity universe; those five names now account for more than 37% of the market capitalization in the Nasdaq 100 index, 26.3% of the broader Nasdaq Composite and 11.2% of the S&P 500.

One does not have to strain in order to find fundamental justifications for the red-hot performance from this realm; each has more than quadrupled its annual revenues since 2009, for instance, with Facebook and Netflix growing orders of magnitude faster than that.  Each, with the exception of Netflix, has likewise managed to generate significant free cash flow, while continuing to capture the imagination of investors pressed for growth in a plodding GDP, ZIRP-ish environment.  

A more compelling explanation may be the seemingly universal rush toward indexation and passive management. For the largest components of the market-cap weighted SPX and NDX, an apparent virtuous cycle of outperformance and increasing allocations is seemingly in effect.  According to Bloomberg, the five “FAANG” stocks belong to 781 indices in total. 

Amidst their synchronized march, these chosen five have become all things to all people. Take Apple;  the WisdomTree Dividend Index, WisdomTree Low P-E Index, Russell 3000 Value Index, Russell 3000 Growth Index, S&P 500 Buyback Index and, perhaps most perplexingly of all, the S&P Industrials Index, all call the Cupertino, CA based electronics maker as one of their own.

Noting a similar top-heaviness across the ETF industry at the Grant’s Fall Conference in 2015,  Stephen Bregman, President and co-founder of Horizon Kinetics cautioned:  “the formulaic pursuit of diversification creates a new form of idiosyncratic risk” (the slides from that talk can be accessed here). 

As for the market itself, the increasingly narrow leadership is a fact which should concern equity bulls, both for its logical implications and anecdotal history. Here was Reuters at the turn of the last cycle, releasing a prescient warning in the fall of 2007:

At a glance, the U.S. stock market appears to have muscled through the often-treacherous month of October.

Yet last month's gains -- 1.5 percent for the Standard & Poor's 500 and 5.8 percent for Nasdaq -- belie a trend of withering leadership, where a handful of technology shares are doing the heavy lifting while the rest of the market stalls or fades.

Equity analysts worry that a rally underpinned by a declining number of stocks tends to be more fickle and prone to messier pull-backs.

Back to the present day. If this latest upturn in prices is to have legs, it would be best if others joined the raucous but lightly attended party.

Pension play dough

New Jersey has a new plan to deal with its unfunded liabilities. No, not cuts in spending or tax hikes. Instead, the Garden State will convert its lottery into an asset of its pension fund for the next 30 years, allowing the $13.5 billion valuation afforded to the sweepstakes to be applied to a partial narrowing of its yawning unfunded liability.  As a result of this maneuver, the pension system’s funding level will rise from 44.7% to 58.9%, according to Samantha Marcus at NJ.com.

Credit to the governor for at least attempting to stem the tide of runaway unfunded pension liabilities; a recent Grant’s piece (“Financier Chris Christie”, April 7, 2017) noted the exponential growth in its net pension and other post-employment obligations between 2010 and 2016.  Last year alone, pension debt in New Jersey rose to $49.1 billion, from $43.8 billion at the end of 2015.  

The state constitution does not appear to be a hindrance, as it specifies only that proceeds of the lottery be used for “State institutions and State aid for education”; public employee pensions apparently qualify.

But what goes in one pocket comes out of another, and the $965 million which the lottery is forecast to bring in this year will go to the teachers and public employees (mostly the teachers; 78% is earmarked thusly according to the plan) instead of other purposes.  That sum represents just under 2.8% of the $34.4 billion in appropriations called for in the governor’s 2017 state budget.  

-Philip Grant

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Retailer reflux

April was another fine month for the consumer economy, and another mixed period for consumer retail.  Advance retail sales for the month, although short of analyst consensus, logged a respectable 0.4% sequential gain to leave the year-on-year reading higher by 4.5%.  That continued a relatively torrid start to 2017 for this metric, with average monthly growth of 4.9% towering over the comparable first four months for 2016 and 2015 (both advancing by around 2.9% per).

Retailer reflux

April was another fine month for the consumer economy, and another mixed period for consumer retail.  Advance retail sales for the month, although short of analyst consensus, logged a respectable 0.4% sequential gain to leave the year-on-year reading higher by 4.5%.  That continued a relatively torrid start to 2017 for this metric, with average monthly growth of 4.9% towering over the comparable first four months for 2016 and 2015 (both advancing by around 2.9% per).

Two constants have underpinned the 2017 expansion:  an upward reversal in gasoline station sales, which after seeing double digit year-on-year contraction in early 2016 has seen reciprocal percentage gains to begin this year, and an acceleration in e-commerce activity via the non-store retailers component.  That metric has leapt higher by an average of 10.9% compared to 2016 in the first four months of the year, dwarfing the 6.8% average annual gains seen in the comparable period last year.

It’s tougher sledding, of course, for the rest of the industry.  Beyond government data, anecdotal evidence of hard times for consumer discretionary is not hard to find.  Restaurants saw their third consecutive month of negative same-store sales in April, leaving 2017 comps weaker by 1.5% so far this year according to analytics group TDn2k.com.

Macy’s reported a 7.5% year-on-year revenue decline and 38% drop in profits in its first quarter earnings release Thursday, sending the stock to its lowest since August 2011 (incidentally, the last time the S&P 500 fell 20% from its highs).  Finally, the have-nots have been increasingly visited by the economic Grim Reaper; store closings across the U.S. have leapt skyward, with researchers at strategy firm Fung Global tabulating 3,296 such announcements so far in 2017, a 97% increase from a year ago. By comparison, new openings rose by a relatively modest 20%, to 2,573 locations.

Mr. Market has gotten the memo, it seems.  The Bloomberg Mall REIT index (heavily weighted towards components Simon Property Group and GGP Inc.) has declined by 14% so far this year and 32% from its cycle highs reached in July of 2016 amidst this tenant retreat. As for Simon, it was featured in a January 2015  Grant’s piece (“Follow that Trend!”) which called attention to its then-nosebleed valuation (implied cap rate below 5%) and contention from its CEO that the business was largely Amazon-proof.  One apparent lesson from recent years:  underestimate Jeff Bezos at your own peril.

Noble less-oblige

Hong-Kong based commodity trading firm Noble Group Ltd. disappointed investors this week, issuing a profit warning that included a delay in its projected return to profitability until at least 2018-2019 (2015 saw the last positive annual net income line, while the company was last free cash flow positive in 2011).  Mr. Market’s response was severe enough to make observers pay attention, particularly in its bonds.  The 8^3/4s  of 2022 which the company just issued in March, closed Tuesday near 98 cents on the dollar; by Friday they traded to 52.5, for a yield to maturity of near 27%. 

Noble’s suddenly-precarious footing could act as a further weight on the suddenly-faltering industrial metals complex; a Citigroup note earlier this week assessed the recent selloff in iron ore thusly: “We suspect that a good number of physical traders that are financially leveraged up to five times have been forced to destock due to rising short-term borrowing costs and the recent sharp price corrections.”  The growth of opaque-by-design Wealth Management Products has to some extent facilitated that financial leverage; Reuters recently reported that such WMP’s outstanding topped 30 trillion yuan at the end of April ($4.35 trillion, roughly equivalent to the size of the Fed’s balance sheet); up from 26.2 trillion yuan on June 30th of 2016.  

Lending ties among financial institutions have grown increasingly complex in China, with lenders issuing certificates of deposit to some banks to buy high-yielding wealth management products from others. Issuers of such products then entrust the funds to third-party asset managers such as trusts, insurers and fund companies. 

As for those borrowing costs, the steep rise in the short end has left the Chinese yield curve inverted for the first time on record (going back to only 2010), which is traditionally a signal of financial trouble or economic recession.  The five year yield has risen from 2.42% last October to 3.67%, now exceeding the 3.65% available in 10 year notes.  All is not well in the world’s second largest economy.

Inmates run the asylum

A counterintuitive milestone has been reached, Bloomberg announced today: “There are now more indexes than stocks”.  The proliferation of ETF’s designed to slice and dice the asset universe for “exposure” seeking investors is one contributor, as is the simultaneously dwindling universe of equities (down 42% from the mid-1994) amidst corporate consolidation in this lengthy regime of low interest rates. One thing’s for sure, we’ve come a long way from the 1975 debut of the Vanguard Index Fund. 

-Philip Grant

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Sturm und Draghi

“Super Mario” ran into a less than receptive audience as he explained ECB policies to a group of Dutch parliamentarians yesterday.  An excerpt of one brusque exchange (conducted in English) with MP Thierry Baudet follows:

Sturm und Draghi

“Super Mario” ran into a less than receptive audience as he explained ECB policies to a group of Dutch parliamentarians yesterday.  An excerpt of one brusque exchange (conducted in English) with MP Thierry Baudet follows:

TB: Clearly we, we can disagree about the merits of the Euro currency, and my view is that in non-Euro countries the economic system is significantly better. But just one point, you said you didn’t want to speculate about the possibility of the Euro zone falling apart, but isn’t that precisely what you did in January when you were saying, ‘if Italy leaves, it will have to settle the bill.’  You were actually speculating about the breaking apart of the Euro zone, and wouldn’t it be intellectually fair to have the same principals if the Netherlands decides to leave (Baudet had previously noted that the Netherlands holds a €100 billion surplus under the TARGET-2 system for large intra-bloc payments).

MD: I, um, in European parliament I was asked the same question about that. I said one can have technical answers of all kinds, but the point is, the Euro is irreversible and I’m not going to speculate on hypotheses that have no ground whatsoever.

TB: We’ll see about that then.

MD: We’ll see about that.

Another verbal haymaker was landed by the Party for the Animals’ Lammert van Raan, who observed:

"You look remarkably calm for someone who issues EUR2.5 trillion out of thin air, especially when your chief economist says there is no Plan B.”

Draghi attempted to ward off the multi-front rhetorical assault by claiming, among other things, that his policies were responsible for the creation of 4.5 million jobs, a non-provable claim that falters against the truism that correlation is not causation. Total Euro zone employment rose to 153.9 million in the fourth quarter of 2016, 1.2% above its year-end 2015 levels and its highest since 2008.

At the close of the cantankerous colloquy, MPs provided the ECB chair with a “gift” in the form of a tulip, an apparent reminder of speculative manias past and a seemingly less than subtle commentary on current affairs.   As relayed by the Financial Times:

“We want you to look at this tulip before your meetings,” said Pieter Duisenberg, the head of the finance committee — and son of Wim Duisenberg, the ECB’s first president.

Luckily for Draghi, the ECB’s explicit political independence should continue to largely insulate him from these less-than glowing reviews, as long as the Euro bloc remains intact.  The Chairman defiantly signaled he plans to continue apace his QE and negative rate policies, in the face of distinct apparent improvement in the economy (for more, see ADG from May 9^th).  On the face of it, the Dutch have no reason to grumble; measured unemployment in the Netherlands was a mere 5.1% in March from near 8% in early 2014, while GDP growth in the fourth quarter of 2016 was a decent 2.5%.

One piece of free advice from 2 Wall Street: If such a rude reception greeted the chairman in apparently solid economic conditions, perhaps he should consider skipping any future symposium convened in a true recession.

Car and driver  

Ride sharing app Uber caught a tough break this week, as the European Court of Justice’s advocate general ruled that the company “must be classified as a service in the field of transport”.  Readers may wonder: What else could possibly describe the outfit?

Uber itself had argued that it was a provider of “Information provider services”, as in, merely a technology-based intermediary between riders and the contractor drivers that are, importantly, not its employees.  The ruling is non-binding, but advice from the advocate general is “typically” followed by the high courts per the U.K. Telegraph. 

Uber could have used some good news. Beyond the raft of recent bad publicity (including the late April New York Times profile of CEO Travis Kalanick, which noted his tenets of management including: “be super pumped” and “always be hustlin’”), the company lost around $2.8 billion on $6.5 billion in net revenue in 2016.

From a $69 billion private valuation referenced in a January 13^th skeptical review in Grant’s (“Not Joseph Schumpeter”), CNBC reported in late April that transactions on the secondary market valued the company closer to $50 billion.  

-Philip Grant

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Not so great grains

The world agricultural commodity market is creaking under the weight of outsized inventories. Sound familiar?  

Farmers’ supply stocks have ballooned, with corn, wheat and soybeans rising to least 50% above their respective 20 year averages prior to today’s release of USDA supply and demand estimates for May.   Over the past three years, prices have accordingly withered on the stalk, with corn dropping by about 25%, wheat by 39% and soybeans by 15% in that period.

Not so great grains

The world agricultural commodity market is creaking under the weight of outsized inventories. Sound familiar?  

Farmers’ supply stocks have ballooned, with corn, wheat and soybeans rising to least 50% above their respective 20 year averages prior to today’s release of USDA supply and demand estimates for May.   Over the past three years, prices have accordingly withered on the stalk, with corn dropping by about 25%, wheat by 39% and soybeans by 15% in that period.  A brief weather-induced rally in the ags was turned back earlier this month, leading Richard Feltes of RJ O’Brien & Associates to reflect to Bloomberg: “The take-away…is that even small disruptions in production will not produce significant rallies. The grain and soybean markets are saddled with huge carryover inventory cushions.”

Some relief from the invisible hand may be imminent, as today’s WASDE report for May showed significant declines in the department’s stockpile forecasts for 2018 in corn and wheat (not so for soybeans). However, as recently noted in Grant’s (“Bots buy beans”, April 21^st, 2017) that downdraft in prices has not been severe enough to spur a more substantial correction of the imbalance between supply and demand.  In the case of corn, the excess supply has been at least partly tucked away in hopes of better prices later. The USDA allows farmers to pledge their wares as collateral for a loan, with the current going rate of $2.14 per bushel of corn versus the market price of around $3.74. The USDA commodity loan report from April 30 reported that 634 million bushels of corn had been pledged as credit, a sum 23.5% higher than that seen a year ago.

What’s so similar about agricultural commodities, the energy complex and automobiles?  Not much, in terms of their fundamental uses.  But we can readily identify one similarity in this age of central (bank) planning; each saw a binge of activity in response to too-good-to-be-true interest rates, and in tandem with new marketplace developments (the emergence of mega farms in Brazil, U.S. shale oil and the proliferation of sub-prime auto credit extension among them) saw new supply come on line at a pace that far exceeded demand.  Now, whether a farmer, OPEC member or Hertz shareholder, various economic actors are paying a different kind of price for the monetary experiments now going on 10 years old.

Crime doesn’t pay, either

No front page news is the fact that the auto finance boom is now long in the tooth. However, even close observers may be forgiven for doing a double take at a Bloomberg report this morning that fraud in the auto loan market, as a percent of total activity, has reached levels “achieved” in the mortgage realm at the end of the last cycle.  Data analytics firm Point Predictive estimated $12 billion investor losses from unsavory behavior in 2016, double the prior year level and roughly on par with the near 1% fraud related losses seen in the mortgage market in 2009. The auto market does pale in size relative to housing ($10.3 trillion in residential mortgages and $1.1 trillion in car loans at year end 2016), but the gap is closing.  The auto finance market has more than doubled since the end of 2010, per Bloomberg. By comparison, nominal U.S. GDP has risen from near $15 trillion in 2010 to around $18.6 trillion, an uptick of only 24%.   

 One possible explanation

Mark Mobius of Templeton Advisors has a theory.  The historical run of market calm that has been discussed on seemingly every news and investment forum (including Grant’s) under the sun? Blame it on social media, said the long-tenured and well respected fund manager.  Said Mobius to Bloomberg, “It’s creating confusion with a lot of false news,” he said. “You’re getting a situation where a lot of information is discounted immediately because people are afraid that maybe the information they’re getting is not true.”

Leaving aside the scourge of Very Fake News, we postulate a different hypothesis.  Low volatility can be thought to resemble a beach ball held underwater.  Whose hands are suppressing the ball?  We point no fingers, Janet Yellen. 

- Philip Grant

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Anchors aweigh

The European economic engine is revving up.  Staffing firm Adecco Group AG provided the latest example of brisk activity, as their first quarter results featured strong hiring growth across the continent. Improving conditions were evident from France, which contributed a 9% year-on-year revenue gain in the run-up to the Presidential election just concluded, to Italy, which saw top line performance leap higher by 26%. Even erstwhile EU member-non grata the U.K. managed general staffing growth of 16% from 2016 levels, per Adecco.

Anchors aweigh

The European economic engine is revving up.  Staffing firm Adecco Group AG provided the latest example of brisk activity, as their first quarter results featured strong hiring growth across the continent. Improving conditions were evident from France, which contributed a 9% year-on-year revenue gain in the run-up to the Presidential election just concluded, to Italy, which saw top line performance leap higher by 26%. Even erstwhile EU member-non grata the U.K. managed general staffing growth of 16% from 2016 levels, per Adecco.

Recent economic data largely dovetails with this bullish turn.  Dutch industrial sales today accelerated to a 12.1% year-over-year gain in March, its fastest pace since September of 2011.  German industry has also outpaced expectation of late, with both imports and exports topping their respective economist forecasts in March. The IHS Markit April manufacturing purchasing manager index for the Eurozone also accelerated to its best reading since 2011, helped in part by a better FX regime as EUR/USD has spent the last year hovering near 1.09, versus its five year average north of 1.21.

Inflation, too, is stirring.  CPI for April as measured by Eurostat reached 1.9% year-on-year, the fourth straight reading at or above 1.5% following a 41 month period spent below that mark.  Although the rebound in energy prices was a factor, so-called “core” CPI likewise moved to a post-2013 high in April.

Plainly does it appear that the Old Continent is seeing a broad based and substantial turn in its economic fortunes.  It is equally obvious that the region’s central bank and sovereign debt markets are unprepared for such an outcome. Mario Draghi and his cohorts at the ECB have opted to maintain its key deposit rate at negative 40 basis points for the past 14 months (a level of ease that not even the intrepid Ben Bernanke did approach), while undertaking €60 billion in monthly QE scheduled to run until year end (that USD equivalent of roughly $66 billion compares to the $40 billion in monthly asset purchases undertaken in the 2012-2013 QE3 stateside.) 

Amidst, or perhaps on account of, this monetary tipping of the scales, European sovereign yields look (even more than usual) like so many typographical errors.  For the privilege of lending to the German government at two years, you, the lender, pay 67 basis points on your principal per annum; extend to ten years, and the yield turns positive; you earn the munificent sum of 43 basis points per year.  France, which just last week saw a potential currency redenomination beaten back with Emmanuel Macron’s election victory, could borrow now, if it chose, at negative nominal yields all the way to five years.  For those willing to extend credit risk, 10-year Italian debt is available at 2.28%, well inside the current 10-year U.S. Treasury at 2.41%.  The Italians will soon have their own confrontation with political populism, as elections are scheduled at or before spring of next year. The anti-EU 5 Star movement enjoys “a growing lead” per Reuters.

As for the U.S. economy, the Atlanta Fed just slashed its second quarter GDP Now estimate from 4.3% to 3.6%, continuing the trend seen regularly in the first quarter (and one borne out by the formal data last time).

If you had to be long government debt, what’s wrong with America’s?

Wet blankets

As China attempts to contend with widening credit spreads and falling commodity prices, their regulators have positioned themselves in between the ridiculous and the sublime.  As spotted and translated by Tom Orlick of Bloomberg, local watchdog CBRC recently released updated guidelines for interbank lending, including the provision that collateral accepted by banks “must actually exist.”

On the other hand…

The SEC has certainly had its share of bad press since the events of 2007-09, but this is one news cycle that has yet to turn.  The self-regulating regulator today announced it is charging a former employee with improper conduct, alleging that staffer David R. Humphrey engaged in prohibited options trading for his personal account during his 16 year stint with the agency, then misrepresented his offense to the inspector general who was investigating.  The philosophically (and ancient language)-minded may inquire; Quis custodiet ipsos custodes?  Who will guard the guards themselves?

-Philip Grant

“The interesting people read Grant’s.” ---Wall Street proverb

Click here to join this thoughtful remnant.

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Global energy supply:  push and pull

Consider a pair of news items, as the oil patch digests a steep 12% decline in WTI crude over the past month to approach its 52-week low.

Global energy supply:  push and pull

Consider a pair of news items, as the oil patch digests a steep 12% decline in WTI crude over the past month to approach its 52-week low. 

Saudi Arabia's oil minister said on Monday that oil producers would "do whatever it takes" to rebalance the market and that he expected a global deal on cutting crude output to be extended to the end of 2017 or possibly longer.

While the Saudis were channeling Mario Draghi circa 2011, ConocoPhillips CEO Ryan Lance spoke at a conference in Kuala Lampur, Maylasia.  According to Bloomberg, he said:

Many shale plays are profitable with oil at $30-$40/bbl.

The wild card of the Far East might have the last word; Chinese oil imports averaged 8.4 million barrels per day in April, an 11% sequential decline from the record levels seen in March. 

Volatility au revoir

The CBOE options volatility-index continues to plumb the depths. Following the victory from establishment-friendly Emmanuel Macron in this weekend’s French presidential elections, the local CAC 40 index fell by just under 1%. The S&P 500 likewise struggled to gain its footing, retreating from the closing highs reached on Friday. The VIX index, in this not-so-euphoric trading day?  Down a hefty 7.4% in the forward contract, for a minus-30% showing year to date and reaching its lowest close since 1993.  The low volatility regime appears to be setting up for a culmination of spectacular inertia.  With respect to the post-election action, colleague Evan Lorenz quips:  “buy the rumor, sell (puts on) the news.”

Sohn cold

At today’s non-Grant’s investor conference in Manhattan, Social Capital’s Chamath Palihapitiya discussed his bullish outlook on Tesla Inc, recommending a long position in its convertible notes, which he judges are "guaranteed not to lose money as long as Tesla's worth $15 billion (current market cap is over $50 billion).... More importantly while our downside is protected, if this guy manages to pull it off, we get 95% of the upside." 

Palihapitiya enumerated a couple of less than tangible arguments in defense of his position, suggesting a Tesla investment allows for the chance: “To stand shoulder to shoulder with the guy we think is our generation’s Thomas Edison," and be, “on the right side of history."  Then, too, he declared, the company, “is completely unmodelable.”

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And the 2017 "King of carry" is . . .

Bloomberg News anointed the winner this morning. Take a bow, Turkish lira. Of all the currencies in all the waste places (AKA “developing markets”), you are the favorite of income-deprived monetary shoppers, so Bloomberg reports.  Does it matter that the Republic of Turkey is beset by sui generis, regional and who knows how many other varieties of trouble? Not to today’s rugged yield-seeking investors.  They are as intrepid as the volatility-sellers.

And the 2017 "King of carry" is . . .

Bloomberg News anointed the winner this morning. Take a bow, Turkish lira. Of all the currencies in all the waste places (AKA “developing markets”), you are the favorite of income-deprived monetary shoppers, so Bloomberg reports.  Does it matter that the Republic of Turkey is beset by sui generis, regional and who knows how many other varieties of trouble? Not to today’s rugged yield-seeking investors.  They are as intrepid as the volatility-sellers.  

Since the beginning of the year and a bullish mid-January appraisal in Grant’s (“Horrible to bad, January 13^th), Recep Erdogan’s sovereign playground has seen its currency appreciate by about 5.5% against the U.S. Dollar, while its ten-year yield has dropped to 10.24% from 11.16% since we went to press.  A basket of equities featured in Grant’s (thanks to Istanbul investor Haydar Acun) has returned an average of 16.5% in U.S. Dollar terms, compared to a 9% gain in the iShares MSCI Emerging Market ETF (EEM).  Clearly, the gateway from Europe to Asia has seen its financial fortunes improve in 2017, or so judges Mr. Market. 

Mr. Macroeconomics has another take on the situation.  Inflation has percolated of late, with measured CPI leaping from 8.5% year-on-year in December, to 10.1% in February, to 11.9% in April. Foreign currency reserves have symmetrically plummeted, falling below $85 billion for the first time since 2012 on April 28th (they were above $100 billion as recently as year-end 2016).   Three weeks ago, the Turks voted sweeping new powers for President Erdogan, including the right to appoint and remove senior government officials without approval from parliament; the opposition party plans to challenge those results in EU court.  

As for our formerly bullish Turkish stock picker, Acun relays that his view on the Turkish market is “negative now,” in the light of dearer valuations, a more expensive currency, growing fiscal risks and the combustible geopolitical situation.

Farther east, Thailand earlier in April amended its constitution to allow its military junta the power to appoint members of the Senate.  Investors have barely even shrugged at this seemingly impactful development, as the Thai Bhat has gained just under 4% against the greenback this year while its SET equity index has drifted higher by 1.7% in distinctly tight-range trading.   The lesson in all this may be that those anxiously awaiting catalysts like the French election results can relax for the time being; whether a democracy, despotic autocracy or somewhere in the middle, Mr. Market doesn’t seem to care too much.

100% confident

This morning’s reading of April payrolls data from the Bureau of Labor Services was remarkable in its conformity; the 211,000 headline increase virtually matched the 213,800 monthly average of the past two years, while average weekly hours worked came to exactly 34.4, the tenth instance of that reading in the past 14 months. Labor force participation declined to 62.9%, from its prior reading of 63%, which also represents its five year monthly average (by comparison, this metric remained north of 65% from the mid-1980’s up until 2008).

One area of note is employment as a percent of the population, which has broken out of its recent trend line, to the upside.  The 60.2% reading seen in April was its best since the end of the financial crisis of 2009, and well above the five year average of 59.1%. 

The financial market has made up its mind, interest rate futures now price in a 100% odds of policy tightening on June 14, up from 70% on Tuesday.  This is despite a status-quo FOMC meeting Wednesday with nary a direct hint of imminent action; Bloomberg noted the press release carried “no concrete commitment to the timing of the next rate increase.”  With a Fed so demonstrably averse to disappointing investors, it is perhaps ironic that the path of least resistance is now for tighter policy.  A hall of mirrors, indeed.

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A little trouble in little China

Money rates up, commodities down, IMF abashed.

Limit down plunged iron ore futures on the Dalian Commodity Exchange overnight—curious, given alleged healthy Chinese economic growth. Curious, too, is the weakness in steel rebar and copper, down 6.3% and 5.7%, respectively,  in the past three sessions. Or maybe not so curious. “Sell a non sequitur.,” said the page-one analysis in the Jan. 13 issue of Grant’s, which laid out a bearish case for industrial metals in the context of the long-unfolding Chinese credit debacle. Since its multi-year peak in February, iron ore has fallen by 30%.

A little trouble in little China

Money rates up, commodities down, IMF abashed.

Limit down plunged iron ore futures on the Dalian Commodity Exchange overnight—curious, given alleged healthy Chinese economic growth. Curious, too, is the weakness in steel rebar and copper, down 6.3% and 5.7%, respectively,  in the past three sessions. Or maybe not so curious. “Sell a non sequitur.,” said the page-one analysis in the Jan. 13 issue of Grant’s, which laid out a bearish case for industrial metals in the context of the long-unfolding Chinese credit debacle. Since its multi-year peak in February, iron ore has fallen by 30%.

Whatever happened to reflation? Too much supply, perhaps—iron-ore shipments from Australia’s Port Hedland reached their third highest level on record in April, up nearly 20% from February. And too little demand, perhaps--the Caixin Manufacturing Purchasing Manager Index for April registered its lowest reading since September.  

But fundamentals per se bear only so much of the blame for the deflationary commodity price action. Speculation with borrowed money is the magic elixir. Think “wealth management products,” think a gigantic government-induced credit impulse and, yes, think donkeys.  Bloomberg reports that 2016 trading volume across the Shanghai Futures Exchange, Dalian Commodity Exchange and Zhengzhou Commodity Exchange reached a record 177 trillion yuan (about $25 trillion), an astronomical sum that dwarfs Chinese GDP of just over $11 trillion and compares to world GDP of just over $75 trillion. That virtuous cycle (or not-so virtuous party) appears to have ended for now.

Judging by recent public comments, senior management at firms leveraged to these markets aren’t particularly concerned. Fortescue Metals Group CEO Neville J Power recently told CNBC: "Longer-term, China is looking good in terms of economic development, so we see consistent steel demand and therefore consistent demand for iron ore going forward." Jean-Sebastian Jacques, chief executive of London’s Rio Tinto plc and a five time visitor to China in the last nine months (five more than anyone at Grant’s in that period, to be fair), was even more direct:  “Are we concerned about the Chinese economic health?” He asked. “The answer is no.”

We are.  That 2016 commodity rally may prove to have been an illusion backed by powerful but fleeting speculative forces. China has greased its breakneck economic expansion with a highly leveraged financial system, one rife with implicit guarantees of sometimes-dubious origin, and one that, we believe, is an accident waiting to happen.  

No country is an island as far as financial markets are concerned, not least China as the world’s largest commodity consumer.   The IMF, in its World Economic Outlook for 2017, relays that emerging markets now account for more than 75% of global economic growth.  The fund guesstimates that global growth in 2017 will accelerate to 3.5% from the 3.1% logged a year ago, with emerging markets to perform much of the heavy lifting.  Their crystal ball reveals the following: “Activity is projected to pick up markedly in emerging market and developing economies…supported by the partial recovery in commodity prices, while growth is projected to remain strong in China and many other commodity importers.”

With that in mind, the fact that the commodity sell-off is occurring in tandem with tightening liquidity and funding conditions is an instructive one.  In China, repurchase rates for overnight debt, interbank lending rates and one-year interest rate swaps have all risen sharply this week and sit at their highest levels in about two years, while the one-year government bill yield has followed suit with a move to its highest since April of 2015. 

You’d never know it by looking at the S&P 500 or options volatility, but financial conditions have tightened stateside, as well.  Three-month LIBOR has continued to advance, now pricing north of 1.17%.  A two-year loan to the U.S. Treasury yields just 1.3%.  

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In/de-flation In-decision

Is the U.S. economy accelerating, or slowing down? While the travails of the auto-manufacturers, commodity producers and reflationista Treasury bond bears have been well documented of late, a comparably broad swath of commercial activity appears to be positively vigorous. 

In/de-flation In-decision

Is the U.S. economy accelerating, or slowing down? While the travails of the auto-manufacturers, commodity producers and reflationista Treasury bond bears have been well documented of late, a comparably broad swath of commercial activity appears to be positively vigorous. 

Shipping activity, for instance, is on the hop.  The Port of Houston saw total container volumes increase by 21.7% in March from a year ago, bringing its total first quarter uptick to 11%.  On the left coast, the Port of Los Angeles saw an almost identical advance, with a 29% year-on-year surge in March pushing its aggregate first quarter higher by 10.3% from a year ago and a steep 23% above its monthly average going back to the beginning of 1999.  Importantly, the West Coast shipping destination is more leveraged to the consumer and Asian economic activity, as opposed to energy-focused Texas. 

That brisk maritime activity is being corroborated by an uptick in Federal tax receipts.  As recently tabulated by Investors Business Daily: “Over the past 10 weeks through April 26, withheld taxes have surged 7.9% from a year ago.” IBD also identified recent commentary from a diverse array of industries including banks (J.P. Morgan), airlines (American Airlines), restaurants (Dave & Busters) and rail operators (Union Pacific) where management has either noted upward wage pressure or announced plans to increase their own employees’ pay.  The Institute for Supply Management’s non-manufacturing (services) index for April showed its 88^th consecutive monthly expansion, with the headline reading exceeding its monthly average going back to 1997 in each of its past eight months. 

How, exactly, does one square this distinct divergence in fortunes?  It can seem that we are living in two separate economic climates simultaneously; perhaps that is the case to some extent.  One common thread which connects bullish and bearish soundings is a central bank-abetted distortion of supply.  Persistently negligible interest rates seemingly fomented production far beyond actual economic demand from the automobile assembly line to the commodity complex.

Imagine, if you will, a world with less-accommodative rate policy on the heels of the financial crisis.  A (temporarily-more painful) clearing of malinvestment and unproductive debt could have paved the way for a sustained economic boom whereby the expansion in shipping activity, tax receipts and services was the rule as opposed to the exception. 

Instead, our central bank has acted as a crutch for asset prices, with its promised rate “normalization” at the start of each year quickly forgotten at the sight of bad economic data or a market hiccup.  Today’s status-quo FOMC statement noted a sturdy labor market amidst a general slowing of economic conditions, which the board described as “transitory”.   Mr. Market remains convinced of imminent monetary tightening, as futures markets are priced to imply a near certain rate hike in June and the likelihood of another by year end.

With the so-called third mandate of financial stability clearly taken seriously by the mandarins at the Eccles Building (financial conditions were twice mentioned in today’s concise press release), it is no small chore to try and anticipate whether inflationary or deflationary conditions will prevail in the near and medium-term.  We would color option C; “all of the above.”

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Buckle up, auto bulls!

April’s round of vehicle sales was a strikingly poor one. Each major U.S. automaker cleanly missed its estimate for the period, putting the industry on track for its first annual decline since 2009.  Was there not one shaft of sunlight in the gloom?  Ford vice president of U.S. marketing, sales and service Mark LaNeve found it. “I’m not discouraged by the number,” he said, referring to Ford’s 7.1% year-over-year sales decline, worst among the majors. “In this kind of industry, there’s going to be these kind of months.”

Buckle up, auto bulls!

April’s round of vehicle sales was a strikingly poor one. Each major U.S. automaker cleanly missed its estimate for the period, putting the industry on track for its first annual decline since 2009.  Was there not one shaft of sunlight in the gloom?  Ford vice president of U.S. marketing, sales and service Mark LaNeve found it. “I’m not discouraged by the number,” he said, referring to Ford’s 7.1% year-over-year sales decline, worst among the majors. “In this kind of industry, there’s going to be these kind of months.”

Evidence is mounting that this bearish reversal may represent more than a cyclical hiccup.  As argued in “Disabled Vehicles” (Grant’s, February 24^th), the recent success of the auto industry has been underpinned by EZ credit and similarly accommodative behavior from the major producers who are eager to maintain market share.  The beneficial impact from these tailwinds seems to be eroding.  Today brought news that inventory accumulation has accelerated, headlined by GM which saw its stockpiles surge to nearly 100 days sales from about 70 a year ago, making its biggest backlog since late 2007.  Jessica Caldwell of Edmunds sounded the alarm to Automotive News:  “We’re seeing a dramatic lag in the 2016-model year selldown. In April, 8 percent of vehicles sold were 2016 models, up from only 3 percent five years ago. Inventory buildup is a top concern of automakers.”

Incentive spending has climbed with inventories. ALG Inc. tabulated a 14% year-on-year rise in such enticements across the industry.  That is especially problematic in the context of stagnant overall pricing. Compared to a year ago, average car prices are little changed at around $25,500 and SUV’s cheaper by 2% at just under $33,200, according to J.D. Power and Associates.  Source of the problem is clear enough; an abundance of credit helped lift sales beyond a sustainable long-term level, while OEM’s unwisely ramped up production in anticipation of those elevated sales continuing beyond the apparent cyclical peak of around 17.5 million units in 2016.  Jeff Schuster of LMC automotive summarized the daunting challenge now facing Detroit:  “They will have to balance with natural demand at some point relatively soon or the industry will be heading into potentially troubled waters and unhealthy habits.”

Where is that critical but undefined ‘natural demand?’  Jeff Dyke, the executive vice president at Sonic Automotive, ventured a guess on their recent first quarter call:  “It’s going to be a hell of a lot lower than it is today… in its natural state, it’s probably a 15 million SAAR (seasonally adjusted annual rate), a 14 million SAAR, who knows?” Maybe we should ask Ben Bernanke.

Speaking of the former Fed Chairman, he couldn’t resist lobbing a few barbs at his critics in a CNBC appearance yesterday. In defending his response to the Great Financial Crisis and weak subsequent recovery, Bernanke said: “So far so good. You know, it wasn’t too long ago when people on shows like this were saying we were going to be having hyperinflation and huge stock market bubbles, and dollar collapse, and all kinds of terrible things to come, but in fact, it’s gone pretty smoothly. The Fed is in the process of exiting from easy money, the economy is doing pretty well, the unemployment rate is 4.5%, inflation is close to the Fed’s target. All those things are on track.”

So far, so good for Wall Street, as the Shiller price/earnings gauge has ballooned from sub-22 in early 2013 to just above 29 today, for a valuation that has only been surpassed in 1929 and the late stages of the dot-com boom.  The Fed, according to recent speeches, intends to soon shrink its $4.5 trillion balance sheet and raise rates, without toppling those richly valued asset markets and the economy.  Indeed the epilogue from the housing bust and subsequent asset-friendly policy response has yet to be written.  Let’s hope history is as kind to Bernanke as he was to himself in his 2015 memoir, The Courage to Act.

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Now what, Chair Yellen?

What are we bid for eight bedrooms, seven baths and 700 square feet of the rarest of outdoor Manhattan living space? Including eight wood-burning fireplaces and a paneled library? And not forgetting a 107-year history and a gold-plated Beekman Place address (No. 29)?

Now what, Chair Yellen?

What are we bid for eight bedrooms, seven baths and 700 square feet of the rarest of outdoor Manhattan living space? Including eight wood-burning fireplaces and a paneled library? And not forgetting a 107-year history and a gold-plated Beekman Place address (No. 29)?

Time will tell. We know more about the offer. It started at $50 million in 2014. It came down to $37.6 million in 2015. And it’s just dropped to $28 million.

Earlier this year, broker Douglas Elliman noted a broad decline in rental rates for all apartment sizes in Manhattan, including a 2.6% year-on-year median rental decline for studio apartments in February. One-bedroom median rates dropped by 1.3% from the prior year, and two bedrooms by a steep 5.2%.

The commercial market appears to likewise be reversing from the euphoric strength seen in recent years. CBRE reports that Manhattan retail rents declined by 2.7% over the prior 12 months ending on March 31 after increasing by a gaudy 90% between 2012 and 2014, which roughly coincided with the Fed’s $40 billion of monthly mortgage-backed securities purchases known as QE3 (the sequel is never as good as the original it seems). Cushman & Wakefield tabulates a 32.8% vacancy rate at the prized midtown corridor of 5^th Avenue between 42^nd and 49^th streets, up from 31% a year ago.

As the saying goes: the cure for high prices, is high prices.  Exhibit A would be the gallop higher in retail rental rates and subsequent cooling.  Likewise, the formerly buoyant residential market naturally attracted additional supply, with Elliman calculating a 12% year-on-year increase in apartments available for rent at the end of February.

A reversal from brisk absolute levels may be nothing to write home about, but evidence of a less-than-stellar economic picture continues to build.  Friday’s advance reading of first quarter GDP came in at a feeble 0.7%, which would be its worst quarterly showing in an even three years. Today brought weaker than expected readings of personal income and personal spending for March, while the March PCE deflator (the Fed’s preferred inflation gauge) dropped to 1.8% from 2.1% in February, for its biggest sequential decline since December 2014.

Curiously, speculators are steadfast in expecting imminent policy tightening amidst this backdrop.  Futures markets anticipate a roughly 68% probability of a rate hike at the June 14-15 FOMC meeting, well higher than the 50% chance priced in two weeks ago.

With President Trump seemingly extending a lifeline to Chair Yellen for an additional term should she walk the party line; (“I like her, I respect her…I do like a low interest rate policy, I must be honest with you.” He told the Wall Street Journal last month) both the balance of economic data and the political winds seem to be tilting in an easy money direction. 

As for the two additional hikes this year forecasted by Fed vice president Stanley Fisher on April 21?  We will take the under.  

Take a load off Fannie

In response to our survey of conditions across real estate, auto and credit card lending arenas on Thursday, Aleksandrs Rosens and Jonathan Lawless of Fannie Mae followed up to defend their organization’s new policies, which are designed to facilitate the pay-downs of student debt via cash-out refinance, debt sponsorship from others (such as parents) and relaxation of debt-to-income calculations. Rosens stressed that relatively low loan-to-value ratios and higher average borrower FICO scores form a sounder foundation for credit extension than that which was seen in the prior cycle. Then, too, said Lawless, Fannie’s in-house “comping analysis” found that those cash-out refi’s, when undertaken for repayment of student debt, outperformed not only other cash-out refi’s but the traditionally sounder rate-term refi’s as well.  The cycle may or may not be turning, but Fannie appears determined to avoid the type of mistakes which factored into the events of 2007-2009. 

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But it rhymes

Those who recall the financial chaos of 2007-09 might shift in their seat uncomfortably upon seeing the phrase “innovative solutions for borrowers” in a press release headline. Wire-watchers were treated to that informative sight earlier this week, as the government sponsored enterprise Fannie Mae announced a plan to help those burdened with student loan debt qualify for a mortgage.

But it rhymes

Those who recall the financial chaos of 2007-09 might shift in their seat uncomfortably upon seeing the phrase “innovative solutions for borrowers” in a press release headline. Wire-watchers were treated to that informative sight earlier this week, as the government sponsored enterprise Fannie Mae announced a plan to help those burdened with student loan debt qualify for a mortgage.

The mechanisms for this borrower relief?  Offering the option of a cash out mortgage refinance to pay down student debt, excluding “other” forms of debt (including auto loans and credit cards from a borrower’s credit profile when paid by a third party (i.e. mom and dad), and relaxing underwriting by utilizing more forgiving calculation of debt-to-income. Reached for comment, vice president of underwriting, pricing and capital markets at Fannie Mae Jonathan Lawless estimates that the debt-to-income adjustment and cash out refi changes may provide upwards of an additional 13 million borrowers with access to mortgage credit.

(Could a stimulus in the form of a student-debt jubilee be so far off?)

This slackening of terms could be arriving at an inopportune time.  Last week, Sam Khater of CoreLogic released a paper asking the simple and essential question: “Is the credit cycle turning?” He notes that of the four primary loan types (agricultural, business, personal consumer and real estate), the first three have seen a downturn in performance over the past year.

The bullish hold-out has been real estate, but as Khater reports in a subsequent analysis of loans broken out by year: “the 2016 vintage was the first year in which the serious delinquency (defined as more than 90 days behind) rate after 10 months was worse than the prior.” So far, the reversal has been mild, with 2016 serious delinquencies coming in well below those from 2010-2014 (2015 set a two decade low rate of just 0.13% through 10 months, whereas 2016 ticked to 0.17% for the comparable period). However, any change in the credit cycle warrants attention, as trends here not only exert a strong influence on economic performance, but also tend to persist for a period of years.

Evidence of an unwelcome turn has also appeared in a pair of first quarter earnings releases this week.  Capital One Financial Corp. and Discover Financial Services both disappointed relative to sell-side consensus, with provisions for loan-losses leaping by 30.5% and 38%, respectively, from their levels of a year ago.  Finally, Bloomberg this morning reported that banks, including Wells Fargo & Company and J.P. Morgan & Co., have grown increasingly hesitant to extend new subprime auto loans as serious delinquencies have risen to their highest levels since 2008.  

Equity markets enjoy a near constant bid and options-based volatility is all but extinguished:  six month VIX futures are trading at their lowest levels since June 2007, shortly before Bear Stearns disclosed problems with two in-house credit funds. Credit seems to be gradually pivoting, in the wrong direction.

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Tech goes to heaven

The eyes of Silicon Valley have turned increasingly skyward.  Industry “rock stars” have seemingly broken into near-simultaneous competition to break technological barriers long considered to be far from human reach.  Last fall, Elon Musk announced plans to colonize Mars via his SpaceX company, only to be beaten to the publicity punch by Amazon’s Jeff Bezos, whose Blue Origin days before (according to Digital Trends) “detailed a new series of rockets…that will have much more lifting capacity and orbital capability.” Richard Branson’s Virgin Galactic also has its eye on the red planet.

Tech goes to heaven

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A short story in six lines

Consider the following headlines, all from Bloomberg news, this morning:

China’s Hidden Debt Stirs Investor Angst as Defaults Rise

China Markets Reel as $1.7 Trillion in Shadow Funds Unwind

China Pledges Support for Economy, Stressing Need to Avoid Risk

Hong Kong Dollar Weakens to 14-Month Low as Rate Spread Widens

Iron Ore Seen Slumping for Years After Hitting February Peak

China Helps Make Caterpillar Great Again as Outlook Improves

A short story in six lines

Consider the following headlines, all from Bloomberg news, this morning:

China’s Hidden Debt Stirs Investor Angst as Defaults Rise

China Markets Reel as $1.7 Trillion in Shadow Funds Unwind

China Pledges Support for Economy, Stressing Need to Avoid Risk

Hong Kong Dollar Weakens to 14-Month Low as Rate Spread Widens

Iron Ore Seen Slumping for Years After Hitting February Peak

China Helps Make Caterpillar Great Again as Outlook Improves

As the lyricists of Sesame Street once taught us:  One of these things is not like the others.

Meanwhile China’s domestic Shanghai Composite has quietly slipped to a three month low.  At the same time, the NASDAQ composite index rose to its first finish above the 6,000 level, to mark a record close in nominal terms.

^{Trump Tweets Trudeau tweaks}

In the past 24 hours, President Trump has fired a pair of salvos at America’s neighbor to the north. Yesterday, our Commander-in-Chief announced retroactive (to 90 days) tariffs on Canadian lumber imports ranging from three to 24 percent.  This morning, Mr. Trump dashed off a twitter message complaining that Canada “has made business for our dairy farmers…very difficult” and threatening that “We will not stand for this.  Watch!”   In response, Prime Minister Justin Trudeau politely noted, “The U.S. has a $400 million dairy surplus with Canada so it’s not Canada that’s the challenge here.”

At least in the case of lumber, the cross-border dispute has been percolating for years and was seemingly anticipated by the commodities market, as CME lumber prices jumped 25% from early November to April 7 before leveling off (they finished weaker today).   For its part, the loonie is testing a 52 week low against the greenback this afternoon.

Contrast this with Trump’s treatment of China, the U.S.’s largest trade partner and a country that he promised to crack down on during last year’s campaign.  The Congressional Research Service writes in a recent paper that China “continues to maintain (or has recently imposed) a number of state-directed policies that appear to distort trade and investment flows.” But the President has remained firmly accommodative thus far, offering a metaphorical carrot to his counterpart in a recent Wall Street Journal interview.  He recounted telling President Xi Jinping: “‘[Y]ou want to make a great deal? Solve the problem in North Korea.’ That’s worth having deficits. And that’s worth having not as good a trade deal as I would normally be able to make.”

Perhaps Trump is attacking Canada in order to provide political cover for inaction on China.  America’s other traditional allies may wish to take note.

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Grant’s Interest Rate Observer . . . Thinking required™

Apres Macron, le deluge?

Apres Macron, le deluge?  Yesterday’s first round elections in France looked to produce a favorable result for the status quo, as the May 7 runoff between establishment candidate Emmanuel Macron and nationalist Marine Le Pen will likely vault the former into power, or so say the can’t miss polls. That result would sit well with Brussels, as Ms. Le Pen had vowed to exit the union and recommission the franc...

Apres Macron, le deluge?

Apres Macron, le deluge?  Yesterday’s first round elections in France looked to produce a favorable result for the status quo, as the May 7 runoff between establishment candidate Emmanuel Macron and nationalist Marine Le Pen will likely vault the former into power, or so say the can’t miss polls. That result would sit well with Brussels, as Ms. Le Pen had vowed to exit the union and recommission the franc, a re-denomination that would constitute technical default under existing French debt covenants.  Accordingly, French sovereign debt saw a screaming rally, with the ten-year shaving 10 basis points to yield 83 basis points (compare to 2.27% for the 10 year U.S. Treasury, a security with no apparent re-denomination risk), and two year yields dropping by 15 basis points to a head-scratching negative 44 basis points. The VIX collapsed, with the spot reading dropping more than 24% to under 11 while contracts out through August sit below 15 as participants assess our new, apparently risk free world.

Amidst today’s global bid for risk assets and squashed options volatility, it is perhaps worthwhile to ponder the yawning disconnect between giddy asset prices and unmistakable voter dissatisfaction across the Western hemisphere.  In aggregate, French voters who selected a far right or far left candidate virtually matched those who opted for the pro-EU “centrists” including Macron, Francois Fillon and Benoit Hamon.  Stateside, a piece in the Wall Street Journal highlighting the President’s poor approval ratings contained a survey showing a striking trend; respondents who feel that government “should do more to solve problems and meet people’s needs” reached a record high of 57% in April, while those believing “government is doing too many things better left to businesses and individuals” was a mere 39%.  Since the survey began in 1995, only in the fall of 2008 did the discrepancy tilt so heavily, a period that certainly stands in contrast to the levitating equity markets, steady payrolls growth and a 4.5% measured unemployment rate seen today.

What gives?  Markets have increasingly become tools of public policy, their historical reflection of economic vitality seemingly dwindled. Consider a note from Deutsche Bank over the weekend, which tabulated $200 billion in global QE per month currently being undertaken among the Fed, ECB, BoJ and BoE. The Swiss National bank reported more than $63 billion in U.S. equity positions in their 13-F filing dated December 31, 2016 compared to $41 billion in the prior year, representing a bid backed by dollars and francs created at the tap of a computer button.  Meanwhile, U.S. Federal debt as a percentage of GDP has virtually doubled from its spring 2001 interim lows.

These machinations have evidently failed to impress Joe, Alistair or Jacques six-pack, as evidenced by the election of Donald Trump, Brexit and yesterday’s 49%-plus French vote for far right and far left candidates.  Governments around the world opted to “save” the financial system in the wake of the 2008 market cataclysm, and in doing so have further enriched asset holders while leaving the rest behind. The St. Louis Fed relays that real median household income has declined by 2.4% since 1999, marking nearly 20 years of stagnation.  World central banks appear inclined to double down on their support for asset prices, but an extension of the political unrest that emerged last summer could put the brakes on this eight-year and counting multiple expansion party.

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Grant’s Interest Rate Observer . . . Thinking required™

Score one for Marc Cohodes. Canadian regulators dealt a blow to Toronto-based Home Capital Group, Inc., accusing the mortgage finance company of making “material misleading statements” over its response to the origination fraud which the company disclosed to the public in 2015.

Score one for Marc Cohodes. Canadian regulators dealt a blow to Toronto-based Home Capital Group, Inc., accusing the mortgage finance company of making “material misleading statements” over its response to the origination fraud which the company disclosed to the public in 2015.

Individuals named in the complaint included former CEO’s Gerald Soloway and Martin Reid, as well as current CFO Robert Morton. With its stock trading around C$17.5 per share from above C$39 a year ago despite relentless strength in the Toronto housing market, investors have clearly voted with their feet amidst high executive turnover and less than transparent disclosure, now underscored by yesterday’s rebuke from the Ontario Securities Commission.

Cohodes delivered a memorable presentation at the Grant’s fall conference in 2016, which included a frank analysis of the red flags he spotted at Home Cap and the unusual behavior of management. Two weeks back, he regaled podcast listeners with tales of his less than pleasant interaction with a process server dispatched by another one of his targets (specialty pharmaceuticals name Concordia International Corp.) who had opted to sue him for libel. Click below for the slides from his talk, as well as the podcast interview.

Click here for slides from  Marc Cohodes presentation on Oct 4, 2016

Podcast episode 7:  Free speech for bears

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Ever seen the 2010 film Inception?  The “dream within a dream” concept developed there now has a real-life doppelganger. It will soon arrive in the form of an ETF designed to track the ETF industry itself. Brought to life by Toroso Investments, this nascent second derivative will allow investors to gain “exposure” to an array of companies involved in the burgeoning ETF business.  $200 million is the minimum market cap for potential components.

It was over a decade ago and for many it surely feels far longer, but the hedge fund business once commanded a level of popularity that seemingly necessitated the invention of fund of funds. Then came: the fund of funds of funds.  As documented by Grant’s in the spring of 2004, the arrival of that three-tiered management-hydra turned out to bode not-well for the traditional two and twenty business model.  We can only observe that the enthusiastic clamor for ETF products is approaching a similar fever pitch.

Click here for Grant’s:  Fees and fees on funds of funds of funds, April 9, 2004

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The carry trade is alive and well, but not where you might expect to find it.  With the JPY/USD pair remaining well off its December highs (near 109.5 from 118 five months ago), it is Russia of all places that has emerged as the preferred vehicle for speculators to capture sovereign funding spreads from the chronically low rates available in the west. 

Bloomberg reports that inflows into Ruble-denominated debt hit a record high in March at $2.8 billion, underpinning a steep 15% Ruble rally over the past year versus the greenback, in a period where the DXY index has managed a 5.5% advance of its own. 

While a relief bounce in the energy complex and balanced-budget initiative has seemingly formed the fundamental basis for the bullish reversal in Russia’s finances, the striking intensity of speculative interest (Wednesday’s tender of ruble notes due in 2019 and 2033 were swamped with bids, covering the offer size by ratios of 3.18 and 3.70, respectively) serves as the latest example: If there is positive news to be had in this ZIRP-ish world, you can be sure that growth and yield starved investors will not forego the chance to participate.  Risk today is missing the trade. 

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Risk appetite was the name of the game, as the second S&P 500 levitation in four days left the broad average higher by +1.3% for the week and back within 2% of the closing highs reached on March 1.  U.S. Treasury yields ticked a bit higher in tandem to leave the curve little changed, while gold managed to stay flat despite the highest JPY/USD in more than a week. 

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Grant’s Interest Rate Observer . . . Thinking required™

A significant positive data point arrived this morning in the form of the Cass Freight Index for March.  Standing in contrast to some recent harbingers of weakness, this tabulation of North American shipping activity showed a third straight month of year-over-year gains in both the shipments and expenditures components (higher by .9% and 3.0%, respectively), maintaining the upward trajectory which began in October.

A significant positive data point arrived this morning in the form of the Cass Freight Index for March.  Standing in contrast to some recent harbingers of weakness, this tabulation of North American shipping activity showed a third straight month of year-over-year gains in both the shipments and expenditures components (higher by .9% and 3.0%, respectively), maintaining the upward trajectory which began in October. 

The domestic rebound in activity can be primarily attributed to two factors:  a reversal of fortunes in the rail business related to recovering energy prices from their 2016 nadir (the Association of American Railroads saw commodity carloads grow by 7.4% year-over-year in March), and strength in domestic shipping volumes.  Perhaps unsurprisingly, author David Broughton ascribes the latter trend to e-commerce and its “outstanding” growth rate.  

Perhaps more importantly, air freight has been strengthening in both the Asia Pacific and Europe Atlantic lanes, with the proprietary index created by Avondale Partners showing year-over year growth of 17.1% and 3.4% in February, marking the fifth straight month of improvement in each corridor from its 2016 levels. 

While U.S. rails and e-commerce names have certainly not been overlooked by the bull crowd, (Amazon sits higher by 19% over the past 52 weeks, and the Dow Transports index by 14.3% compared to a 7.8% advance in the S&P 500), UPS has been conspicuously absent from the party. Amidst ongoing attempts at disintermediation from key customer Amazon, its shares have lost just over 5% in the last year and more than 8% in 2017 so far, while the trailing price/earnings ratio has been whittled to 17.8 compared to around 21.5 for the S&P 500.

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Reporters at Bloomberg provided readers with a pertinent and at times very funny (for non-investors) update on the San Francisco based tech “unicorn” known as Juicero, a company described as a “stealth-mode juicing startup” on its Bloomberg profile page. Offering an intersection of traits near and dear to many a west-coaster including sustainable, organic cuisine and high-tech gadgetry, Juicero has managed to raise around $120 million in funding in recent years. Founder Doug Evans described his machine thus in an interview with Recode:  “There are 400 custom parts in here. There’s a scanner; there’s a microprocessor; there’s a wireless chip, wireless antenna.”

The problem for the makers of the $399 (marked down from an original $700) press machine and its wide array of venture capitalist financial backers?  Its end-product can be squeezed by hand at roughly equivalent efficiency, accounting for time and juice “yield”.  Most investors, who quite understandably demurred on being quoted for the record to reporters Ellen Huet and Olivia Zaleski, were nonplussed by the revelation.  One who bought in lamented “that their venture firm wouldn’t have met with Evans if he were hawking bags of juice that didn’t require high-priced hardware”, per Huet and Zaleski.

One investor did speak up, and remained steadfast in his support.  Doug Chertok of Vast Ventures claimed he’s “still a huge fan” in spite of the revelations, terming the machine a “platform” for a new medium of food delivery. Evans, for his part, used just such a term in a 2016 interview with the New York Times. He also mused: “Not all juice is equal. How do you measure life force? How do you measure chi?”

We certainly cannot answer those questions, nor can we ascertain the fortunes of this heretofore technology/organic food “platform” that now more closely resembles, well, a juice company. We can observe that in the right speculative conditions engendered by the “right” kind of interest rates, fad products with a dubious business model and marginal prospects can endure far longer than might otherwise be expected.

                                                            ******

Stocks caught an early bid but were unable to hold it, fluttering lower through the session to finish near the day’s worst levels with a ~.75% peak-to-trough decline on the S&P 500.  Declines were lead by energy as the weekly inventory report continued to show stubbornly high levels, confounding (for now) Grant’s anticipation of easing stockpiles this spring.  The U.S. Treasury curve ticked wider, helping the long end ease off the 2017 low yields logged this week, while a test of 109 in JPY/USD coincided with weakness in gold as the precious metal retreated to a one week low after notching its best close of 2017 yesterday.  

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Grant’s Interest Rate Observer . . . Thinking required™

Following their surprise (or non-surprise, for Grant’s readers) currency devaluation in December 1994, Mexico was forced to contend with a number of necessary evils, apart from Larry Summers. Hyperinflation reared its head in the form of a 43% rate of CPI growth at publication time in the fall of 1995, on its way to 52% at year end. Following a series of rate hikes, GDP went into freefall...

Following their surprise (or non-surprise, for Grant’s readers) currency devaluation in December 1994, Mexico was forced to contend with a number of necessary evils, apart from Larry Summers. Hyperinflation reared its head in the form of a 43% rate of CPI growth at publication time in the fall of 1995, on its way to 52% at year end. Following a series of rate hikes, GDP went into freefall, sinking by as much as 8.1% year-over-year in the summer of 1995, before recovering in early 1996. The peso, however, made no such comeback; trading at just over six to the dollar in mid-1995, it broke eight to the dollar in early 1997 and has become weaker ever since.  As Grant’s remarked, presciently, sort of, those types of conditions in this country “might cause J.P. Morgan & Co. to finance a Bernie Sanders presidential campaign.”

Credit markets were more than happy to forgive and forget. While the Mexicans scrounged to repay their bailout, Colombia managed to borrow an upsized $225 million in October 1995, at a mere 1.25% over wholesale dollar deposits. Other sub-triple-A borrowers stateside, including RJR Nabisco and Orange County, were likewise quickly “re-accomodated” (not in the United Airlines sense either).  Mr. Market was telling us something: What followed, of course, were four-plus years of broad asset appreciation, interrupted only briefly by the Asian Contagion in the summer of 1998.   

(original piece is linked below)

Grant’s, October 13, 1995: “Same country, same currency, new plot”

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Diversified industrial-equipment supplier W.W. Grainger is seizing up. Notwithstanding an already skeptical analyst cohort (Bloomberg tabulates three buy ratings compared with 15 holds and four sells among the sell side, prior to today), a reported first-quarter combination of weaker than expected net sales, pricing deterioration, contracting margins and an accompanying EPS shortfall in both the quarterly results and fiscal-year outlook was enough to spur some acute pain for longs.

Today’s 11.4% drop left its shares 23.5% below its February peak and under the interim lows logged last fall, prior to the presidential election and subsequent spate of optimism over the economy. The gradual encroachment of retail bogeyman Amazon.com is a factor (mentioned by Grant’s in our bearish analysis of peer Fastenal dated February 7, 2014) that can partially explain this steep erosion in business, but in any event the market reaction indicates surprise at the intensity of decline. One by one, the post-election expansions in risk appetite have largely or fully reversed themselves. The primary exception?  Banks and financials, as the XLF product still sits roughly 16% above its closing price on November 7. Steve Mnuchin and Gary Cohn may be doing God’s Work, but they aren’t miracle workers. 

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Grant’s Interest Rate Observer . . . Thinking required™

The non-eruption of a new Korean war over the weekend helped spur a solid bounce for equities, with a .77% upswing for the S&P 500 erasing the bulk of last week’s decline. U.S. Treasury spreads widened a bit as the long end reversed its early strength, while losses in the energy patch helped keep the CRB commodity index in the red. 

The non-eruption of a new Korean war over the weekend helped spur a solid bounce for equities, with a .77% upswing for the S&P 500 erasing the bulk of last week’s decline. U.S. Treasury spreads widened a bit as the long end reversed its early strength, while losses in the energy patch helped keep the CRB commodity index in the red.  Seventeen components of the S&P 500 are scheduled to report earnings tomorrow according to Bloomberg,

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When is a margin loan not a margin loan?  Thanks to Alexander Hamilton’s old newspaper, we now have the answer.  Securities based lending is that not-quite margin debt, and it is plainly on the rise according to the New York Post’s Kevin Dugan.  It is also lightly publicized, fast growing and all but unregulated.

As with traditional margin debt, securities-based loans are extended against the value of an investment portfolio, but the similarities end there.  Proceeds of an SBL may be used for any purpose other than investment securities; think yachts, starter mansions or that Major League Baseball franchise you’ve always had your eye on.

Naturally, these products generate significant fees for the brokerages that offer them. For instance, Wells Fargo advertises a base rate of 6.25%, further adjusted according to the borrowers debit balance and household assets under management at the firm.  Lenders are mostly mum about the scope of this product. Morgan Stanley, one brokerage which does break out its SBL exposure, reports that outstandings grew to $36 billion as of December 31^st 2016, from $28.6 billion in the prior year and $22 billion in 2014. By point of comparison, their book equity at calendar year-end 2016 stood at just over $77 billion.

Today’s Post story highlights details which should send shudders down the spines of those who remember previous leveraged-induced mishaps.  As Dugan reports:  “Unlike most other loans, SBLs typically have no term limits and don’t require monthly payments, even as interest compounds. Because the bank can sell off their securities at any time, borrowers aren’t required to chip away at their debt.”  An un-named former Morgan Stanley broker tells Dugan that some customers are using proceeds for the one purpose that is expressly prohibited. “What they’ll do is have another account, wire the money out of [the SBL account] to a bank, and then have that bank wire to pay off margin. I have seen that.”  As for the regulators, there has been little apparent push-back, with Susan Axelrod of FINRA telling The Wall Street Journal in August of 2015: “These loans are a really great option for (obtaining) extra capital if the market is producing returns.  But customers have to be aware that a market downswing…would make these products less attractive.” 

Dugan relates via his sources that aggregate SBLs outstanding fall somewhere within the $100 billion to $250 billion range. Meanwhile, conventional margin debt reached a new record at the end of February of just over $528 billion, a +21.2% leap from February of 2016.  On April 7th, the Mortgage Bankers Association reported that the average loan size of a home purchase reached a new record high of just under $319,000 compared to around $257,000 at the peak of the last cycle logged at the end of 2007, an advance of 24%. 

Past performance may be no guarantee of future results,  but heavy borrowing against highly priced equities pretty much ensures trouble.
 

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Grant’s Interest Rate Observer . . . Thinking required™

A late spasm of selling pressure left the S&P 500 at its lowest close in an even two months, as equity markets are perhaps paying heed to the risk aversion signals recently emanating from the JPY/USD pair, industrial metals complex and US Treasury curve...

A late spasm of selling pressure left the S&P 500 at its lowest close in an even two months, as equity markets are perhaps paying heed to the risk aversion signals recently emanating from the JPY/USD pair, industrial metals complex and US Treasury curve.   Spot VIX continued its steady ascent with its first closing test of the 16 level since the election, while the energy group suffered a -1.83% decline (despite sideways action in the underlying complex) for the worst showing among S&P sector components.

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Speaking of which, balance of news in the energy sector has turned positive of late beyond the un-attributable mumbles from OPEC members suggesting an extension to the existing 1.2 million barrel per day supply cuts currently in force through July 1st. The International Energy Agency reckons that the cuts are, in fact, being implemented (the agency calculates 104% aggregate compliance with the cartel’s agreement), but the ongoing realignments between supply and demand, longs and shorts, could prove to be more significant.

Both the American Petroleum Institute and Department of Energy reported big inventory depletions this week. The latter measure, which is generally more likely to influence prices, saw its first significant draw of 2017 with declines in crude, gasoline and distillate double or triple their respective consensus estimate. Run-off of apparent stockpiling by OPEC members ahead of the Jan. 1 start date seems a likely factor behind the reversal, tempered by continuing recovery in U.S. production.    

As noted by Grant’s in our recent survey of the energy market (Laddered Oil Play, March 10), U.S. shale producers can undertake new projects in a fraction of the time required by majors. Accordingly the DoE has marked a pickup in domestic output (just over 9.2mbpd, up 9.6% from the July interim lows) to back within range of the 2015 high water mark, as prices have recovered from their early 2016 nadir below $40/bbl. 

While the nimbleness of domestic players in responding to increased prices seemingly counts as a bearish feature, bulls can take comfort in a pair of positive developments:

DoE implied demand has seen a corresponding uptick to 17.4mbpd, the highest since September and +12.7% from the late fall lows. Finally, the listing speculative imbalance that saw CFTC spec-longs reach a record high of 556,607 net contracts in mid-February of 2017 has eased considerably.  That net long position ticked to 408,382 contracts last week, a relatively prompt decline of just over 36%.  While far from a certainty, the path to a higher oil price does appear to be clearing somewhat.

-Philip Grant

Quote . . . unquote

Chandler Howard, CEO of Liberty Bank, Middletown, Conn., in today’s Financial Times on the speculative tone of present-day commercial real-estate lending:
     “When we’re trying to compete, we see term sheets coming through with interest-only transactions, terms going out longer and longer, some loosening of guarantees.” 

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Grant’s Interest Rate Observer . . . Thinking required™

The so-called Trump trade saw its latest round of unwinding, as the first sub-110 close in the JPY/USD pair since November accompanied reciprocal post-election highs in the price of gold.  Rates likewise continue to augur something other than reflation, as the benchmark 10-year yield crept below 2.28% for the first time since November 17 while the Treasury curve has pancaked to its flattest in the past five months.

The so-called Trump trade saw its latest round of unwinding, as the first sub-110 close in the JPY/USD pair since November accompanied reciprocal post-election highs in the price of gold.  Rates likewise continue to augur something other than reflation, as the benchmark 10-year yield crept below 2.28% for the first time since November 17 while the Treasury curve has pancaked to its flattest in the past five months.  As for President Trump, the campaign-trail hard-money man, he roiled markets this afternoon by hinting he may reappoint Fed Chair Yellen, after all, that he likes low interest rates and the dollar is getting too strong, “and partially that’s my fault, because people have confidence in me. [Uneasy lies the head that wears the crown.—ed.]

“Look,” the president added, “there’s some very good things about a strong dollar, but usually speaking the best thing about it is that it sounds good.”

Click here to read, or reread, the Jan. 13 Grant’s front page that foretold this Trumpian monetary switcheroo.

Among the array of indicators signaling waning risk appetite,  the recent downside acceleration in industrial metals prices carries the potential to inflict particular mayhem on financial conditions.  The conduit of such hypothetical strife would be China, the United Nations member state that most closely resembles a margin account.

As every Grant’s reader is aware (see, for instance, “Sell a non-sequitur” in the January 13 issue), the state of Chinese speculative finance appears to be a decisive factor in the euphoric price action of those metals in 2016 (steel rebar for instance saw a +138% move from its mid-2016 trough to the recent highs), especially considering the largely unfavorable fundamental conditions which persisted throughout that rally.  Now the metaphorical worm seems to be turning, as evidenced by the swift reversal across iron ore, steel and copper. They now sit 28%, 16% and 9% below their respective recent highs after an overnight tumble. 

There is nothing necessarily remarkable about that development on its own, particularly as each of those commodities still resides near the middle of its individual 52-week trading range.   However, the highly leveraged and financially interconnected nature of the Chinese economy could prove the catalyst for a more extended sell-off in these products (which undoubtedly act as collateral for many an encumbered speculator).   Market participants are to some extent wise to these risks, as Bloomberg reports that Chinese financials are trading at their largest discount on a price/book basis since 2004.

Meanwhile, a piece in today’s Wall Street Journal makes note of tightening conditions in the Chinese corporate lending market, with a pair of rate hikes from the PBoC not helping matters.  The Journal tabulates a 38.5% year-on-year decline in corporate bond issuance for the first quarter, while nearly Rmb. 120 billion worth  ($17.4 billion) of issuance was delayed or scrapped entirely, a near three-fold increase over levels of re-accommodated* deals seen two years ago. If the base-metals market continues to sink, the PBoC may be forced to backpedal from its policy tightening sooner rather than later.  Who knows?  Maybe the Fed, too.

*copyright, United Airlines

Quote . . . unquote

“`We’re not seeing much interest on the buy side, everyone is nervous that the bottom is falling out’, said a commodities trader in Perth, Australia, who closely monitors activity on China’s Dalian and Shanghai Futures Exhanges for overseas clients.” (Reuters)

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Grant’s Interest Rate Observer . . . Thinking required™

In spring-like fashion, the volatility freeze that has defined 2017 so far is showing increasing signs of thaw. Indicators such as the VIX index, JPY/USD pair and price of gold have all retraced their “reflation” moves following the November elections, joining the US Treasury curve which initially widened sharply following Donald Trump’s surprise victory but has since fully reversed flatter across the 2/10 and 5/30 spreads. 

In spring-like fashion, the volatility freeze that has defined 2017 so far is showing increasing signs of thaw. Indicators such as the VIX index, JPY/USD pair and price of gold have all retraced their “reflation” moves following the November elections, joining the US Treasury curve which initially widened sharply following Donald Trump’s surprise victory but has since fully reversed flatter across the 2/10 and 5/30 spreads.  

Equities temporarily followed suit, with an intraday decline of 80 basis points in the S&P 500 shaking the broad average from its recent trading band.  Dip-buyers then performed their customary afternoon “magic” to push that SPX back above its 50 day moving average by the bell, but risk appetite does appears to be plainly abating with first quarter earnings season set to begin in force next week.

The Mortgage Bankers Association reported a potentially significant reversal in commercial real estate finance; total lending volume in 2016 saw a 3% yearly decline, and squares with the broad stalling-out seen in the C&I lending market since late last year.  That pullback comes after a lengthy and virtuous run of growing issuance and shrinking loan delinquencies, as 2016 still marked the third highest volume on record (behind 2015 and 2007).  Delinquencies exceeding 90 days reached a microscopic .59% from just over 4.2% in 2010. 

It seems that end buyers have collectively exhausted themselves amidst these ultra-benign conditions and accompanying rise in prices (The St. Louis Fed CRE price index tabulated year-over-year growth above of 10% for 11 straight quarters through the end of 2015), as evidenced by a steep decline in property transactions.  The $493.7 billion in deal value for 2016 represented a 10% yearly drop (compare to the smaller change in lending volume), while the early stages of 2017 have delivered even weaker results: $50.3 billion in transaction value through March 1 compared to $80.1 billion in the like period in 2015 (a 37.2% yearly drop). 

In light of the intensifying reversal in buyer appetite and the simple laws of gravity, one may think that banks and other lenders would take a hint, but that has not transpired.  Indeed, yield-famished investors are still clamoring for new deals, according to Craig Bender of ING real estate, who bluntly told the Wall Street Journal:  “The banks are hungry.  The life insurance groups are hungry”.   

A lengthy run of success in this asset class and paltry yields across the Treasury and corporate debt markets are seemingly a ZIRP-induced incentive to stick around for longer than prudent. As for ING itself, the Journal notes that the bank just reopened its real estate unit two years ago after shuttering it following the real estate collapse in 2008. 

 Quote…unquote

            “Duration has never been this long in my career,” says Jeffrey Gundlach, chief executive of Los Angeles based DoubleLine Capital.  “With rates near the lowest levels ever and duration at literally the highest level ever, it is the worst possible set-up versus history.  You are [taking] more risk and getting less reward.”

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Grant’s Interest Rate Observer . . . Thinking required™

The BBC reports that, according to a newly discovered tape, the Bank of England directed money-center banks to set Libor below the prevailing market rate during the chaotic days of October 2008.  The news is bombshell and dud, rolled up into one.

The BBC reports that, according to a newly discovered tape, the Bank of England directed money-center banks to set Libor below the prevailing market rate during the chaotic days of October 2008.  The news is bombshell and dud, rolled up into one.

Do as the central banks do, and you may face jail time. The central banks conjure currency out of the digital ether—you can’t. They manipulate interest rates—you do so at your peril. They muscle around asset prices—retain a good securities lawyer before you try it yourself.

Central banks and fine-levying regulatory authorities have become giant governmental profit centers. The Council on Foreign Relations relates that more than 20 individuals face,  or have faced, criminal prosecution in the U.S. and the U.K. under the heading of interest-rate manipulation since 2015. To settle such cases, financial institutions have paid fines in excess of $9 billion.

No doubt, the Bank of England believed itself to be acting in the national interest when it made its directive to Barclays and presumably to others. We wonder about the integrity of prices and the rule of law. Be that as it may, the monetary giants continue to tromp around the world’s financial markets. As of December 2016 the Bank of Japan owned more than 60% of domestic ETF shares per the FT, while the Swiss National Bank owned nearly $67 billion of American equities at year end according to its 13-F filing. Compare and contrast the $60.7 billion equity portfolio of the California Public Employees Retirement System.

Here’s a question for a smart lawyer: define “manipulation.” 

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Grant’s Interest Rate Observer . . . Thinking required™

Rounding Error

Loss making Uber Technologies, Inc. (Grant’s, January 27) wants to grow.  Getting more of its drivers on the road is one logical route to that end.  So the ride-sharing Unicorn devised a plan: contractors (not to be confused with employees) who wanted to drive but lacked a vehicle could lease one from the company.  So far, so good.

There was one small problem.  As reported this morning by the Wall Street Journal’s Greg Bensinger, Uber’s subprime auto lending unit (titled the Xchange Leasing Program) sported an average loss per vehicle of roughly $9,000, 18 times the company’s own estimated loss of $500 per vehicle.

So, the Xchange Leasing program, with 500 employees (roughly 3% of Uber’s workforce) and an inventory pegged at around 40,000 vehicles, will soon be no more.  This latest setback follows the late-May bulletin from the New York Times alleging that Uber had been stealthily deducting its commission from drivers’ pre-tax revenue in New York, thus sticking its contractors with the full tax bill in addition to the wear and tear accrued on their automobile.

Side-hustle, indeed.

The buck stops here

Will the last U.S. dollar bull to leave kindly turn out the lights?  To say the least, 2017 has not been kind to the greenback.  Amidst a continually soggy post-crisis recovery, low measured inflation and political sea change in the form of President Trump (described as “the avatar of tail risk” by Grant’s last fall), the dollar index has declined in each month of calendar 2017 and sits lower by nearly 10% year-to-date.  Of the six currency pairs which comprise the Dollar Index in 2017, so far only the Swiss Franc (with a gain of 4.8%) has failed to advance by more than 5% against the dollar this year. 

Even beyond those sovereign blue chippers, it is difficult to find a currency weaker against the dollar in 2017.  Sanctioned-anew Russia has seen the ruble tick higher by more than 2% year-to-date despite the continued struggle in energy prices, while the Brazilian real is up by nearly 5% in 2017 despite yet another corruption scandal, this time involving President Michel Temer.  Amidst an escalation of the bellicose threats from its neighbor to the north (featuring demonstrated technological advances in recent ballistic missile tests), Korea’s won has advanced by roughly 7% against the dollar year-to-date.

If recent data are any guide, market participants are overwhelmingly positioned for the bloodletting to continue.  The August 1 Commitment of Traders Report from the Commodity Futures Trading Commission reported a net $7.87 billion worth of contracts short the dollar,  the largest imbalance since early 2013 according to the Wall Street Journal (the DXY subsequently rallied by 6.5% from February to May 2013).  Bianco Research meanwhile relays data from Consensus, Inc.’s July 28 survey of market participants: only 38% of respondents were bullish on the greenback, the smallest contingent in over three years.

Meanwhile, second quarter Advance GDP growth of 2.6% marked the fourth reading above 2% in the last five quarters.  As for the third quarter, early estimates from the Atlanta Fed’s GDPNow forecast (which, to be fair, are frequently reduced as the quarter progresses) peg the third quarter growth rate at a robust 3.7%. So too, does the dovish Fed look less dovish when graded on a curve:  the U.S. overnight lending rate of 1.25% is higher than each nation in the G-10, with the exception of Australia at 1.5% and New Zealand at 1.75%.

As a wise frog once said: It ain’t easy being green.  It might soon get easier.