Ten weeks after the historic trip into negative territory for WTI crude, price signals are working their magic. From The Wall Street Journal:

Weekly U.S. output recently fell to 10.5 million barrels a day, down from a near-record of 13 million barrels a day in late March, government data show. 

The good times continue to roll for the exchange traded fund industry, with record inflows of more than $18 billion into credit-based ETFs in June according to Bloomberg. Overall, U.S. fixed income ETFs have enjoyed $96.5 billion in inflows year-to-date according to data from ETF.com, equivalent to 11% of total assets under management.  Over the same period, equity ETFs have attracted $72 billion in fresh capital, or just under 3% of that category’s AUM.  

Perhaps encouraged by the Fed’s springtime foray into the market via the Secondary Market Corporate Credit Facility, new converts abound. “There is increased interest from a lot of investors, particularly dedicated fixed-income investors, who wouldn’t necessarily have been thinking about fixed-income ETFs three months ago, six months ago, given that ETFs are an equity instrument that trade on equity pipes and plumbing,” Rory Tobin, global head of State Street’s SPDR ETF business, told Bloomberg in June. “But we’ve certainly started to see doors being opened, conversations being started with entities that might not have been very ETF-friendly in the past.”

Even credit bears can avail themselves of a new vehicle to express their view. London-based Tabula Investment Management on Tuesday debuted the Tabula North American CDX High Yield Credit Short UCITS ETF (ticker: TABS). The Europe-listed fund aims to provide negative exposure to around 100 sub-investment grade bonds at an equal weighting, utilizing credit derivatives to offer, in Tabula’s words, "high yield credit risk without exposure to the interest rate risk inherent in high yield bonds.” 

While the Fed’s pandemic-response measures may have amplified interest in credit-based ETF strategies, the broad asset class has long been the apple of Wall Street’s eye, reaching $6.1 trillion in total global assets at year-end according to Statista, up from $1.3 trillion in 2010.  Last December, analysts at Bank of America forecast that total ETF assets would grow to $50 trillion by 2030.  

Yet mushrooming growth into more esoteric investment strategies may amplify risks inherent within the ETF structure.  An April 2019 paper from University of Calgary Faculty of Law assistant professor Ryan Clements investigated so-called interaction risks within the burgeoning ETF category. The paper concluded that:

ETFs have significant potential to destabilize markets, despite their benefits. As the case studies show, Wall Street will occasionally create new financial products that rely on discretionary actors in intermediated structures to provide perpetual liquidity. 

These products may combine leverage, complexity, and structural opacity to further decrease financial stability, while simultaneously generating procyclical market accelerations because of the complex interactions of market participants in a crisis. 

Despite the calming voices from the ETF industry, history illustrates that ETFs are likely not immune to this phenomenon; discretionary liquidity and arbitrage reliance is not always there when you need it.

Real world experience bolsters that academic conclusion. Recall that on August 24, 2015, a surprise Chinese currency devaluation spurred a mini-financial panic that led to a widespread dislocation of numerous domestic ETFs from their net asset values. For instance, the Guggenheim S&P 500 equal weight ETF (NYSE: RSP) briefly traded as low as $50 per share on August 24, 2015, versus a net asset value of about $71 a share, before recovering. 

Similarly, the Invesco S&P 500 Low Volatility Portfolio (NYSE: SPLV) finished the prior session at $36.90 a share. It opened at $35.52 per share on August 24th before falling as low as $20 per share a few minutes later.  By 10:30AM Eastern, it bounced back above $36/share. 

Evidently, low volatility is a relative term.

Stocks fell to the tune of a 1% decline on the S&P 500 to break a five session winning streak for the broad average, while Treasurys caught a strong bid as a record-size $46 billion three-year UST auction priced at a record low 0.19% this afternoon. 

Gold jumped to $1,808 an ounce, its first foray north of $1,800 since September 2011.  WTI crude edged lower to $40.3 a barrel, and the VIX rose 5% to 29.5. 

- Philip Grant

From Reuters:

Starved of the travel experience during the coronavirus lockdown? One Taiwanese airport has the solution – a fake itinerary where you check in, go through passport control and security and even board the aircraft. You just never leave.

Around 7,000 people applied to take part, the winners chosen by random. More fake flight experiences will take place in coming weeks.

For those not lucky enough to win that lotto, might we suggest a stop at the local DMV.

Bloomberg reported yesterday that Citigroup is reversing plans to reopen its offices in 13 states on account of rising coronavirus cases across much of the U.S. 

Citigroup management signaled their flexibility last week. “None of the jobs need to be back right away,” president Jane Fraser said at a Bloomberg conference. Employees “will largely decide for themselves whether they want to stay at home, how they feel about their commute, what’s going to happen with childcare.”  

As that anecdote suggests, the emergence of work-from-home promises to usher in major changes for both the residential and commercial property markets. A May 31 report from Green Street Advisors crystalized the problem: 

Even if most workers continue to work fulltime in the office, plausible projections for increased remote work should put a sizable dent in long-term [office] demand. That is highly unwelcome for a sector that was already facing challenging fundamentals and lofty valuations.

Green Street noted an internal Facebook, Inc. employee poll showing that 40% of respondents found their work-from-home setup to be appealing, and three-quarters of that group “might [or] will move to another place.” The pandemic-spurred migration to remote work is making an impact in one of the world’s most expensive markets. Listing service Zumper reports that rental rates for a one-bedroom apartment in San Francisco are down 12% from a year ago, while apartment vacancies jumped to 6.2% in June from 3.9% in March, according to data from RealPage. 

Needless to say, that potential migration is no good news for already strapped municipalities like New York City. George Sweeting, deputy director of the city Independent Budget Office, told Bloomberg last week that if 5% of the 162,000 NYC taxpayers making over $250,000 a year left the city, it would equate to $360 million in lost tax revenue.  Sweeting anticipates a $1.5 billion budget deficit this year, on its way to as much as $6 billion in 2022. 

E.J. McMahon, research director at the Empire Center for Public Policy, notes that, based on official estimates, New York state tax receipts won’t reach 2019’s level until 2024.  NYC mayor Bill de Blasio said Wednesday that the fiscal 2021 budget now stands at $87 billion, down from a projected $95 billion in January. De Blasio warned last week that the city is considering furloughs and layoffs of 22,000 employees to save $1 billion. 

With city coffers far from flush, the real estate industry may struggle to find much assistance.  A May 31 analysis from The Wall Street Journal found that property tax assessments will rise by $1.65 billion, or 5.7% from a year ago, as that annual appraisal was conducted in the pre-pandemic days of early January. A mayoral spokesperson told the Journal that, although the government is sympathetic to the plight of the real estate industry, “we must balance the very real needs of the city, which relies on property taxes to fund essential city services like hospitals and our first responders.” 

And so, the cash-strapped city will attempt to collect from cash-strapped landlords.  A survey by the Community Housing Improvement Program found that 39% of property owners will only be able to make partial property tax payments this year, while 6% report they won’t be able to pay anything at all.  That stress is working its way up the food chain, as delinquency rates on commercial mortgage backed securities rose to 10.32% in June according to Trepp, up 317 basis points from May and within a whisker of the 10.34% all-time high set in July 2012. 

For a way to potentially profit off this looming sea change, see the June 12 edition of Grant’s. 

Your correspondent had to leave early, but we can report that the YRC Worldwide, Inc. term loan fell to 78 cents on the dollar yesterday from 87 on June 30, after the Treasury Department announced it will lend the company $700 million in coronavirus stimulus funds. Go figure. 

- Philip Grant

Here’s Rich Greenfield, media analyst and partner at LightShed Partners, on Twitter: 

Just spoke to union leaders representing Walt Disney World cast members in Orlando - Confirmed that Disney is NOT testing employees before they return to work next week, including stage performers who can't wear masks – testing is employees' responsibility, not Disney’s.

Supermarket sweep, 2020 edition.  From May 19 to June 16, the Federal Reserve bought $5.1 billion in corporate credit ETFs under its Secondary Market Corporate Credit Facility according to Bank of America. That shopping spree was enough to push the central bank towards the top of the holders list in a number of the biggest such ETF products, including the third largest in the $54 billion iShares iBoxx USD Investment Grade Corporate Bond ETF (ticker: LQD), as well as the second- and fifth-largest holders in the $29 billion Vanguard Short-Term Corporate Bond ETF (ticker: VCSH) and the $36 billion Vanguard Intermediate-Term Corporate Bond ETF (ticker: VCIT), respectively.

There is plenty of in-house appetite for more. Fed chair Jerome Powell declared yesterday that: “The path forward for the economy is extraordinarily uncertain and will depend in large part on our success in containing the virus. . . [recovery] will also depend on the policy actions taken at all levels of government to provide relief and to support the recovery for as long as needed.” 

Mr. Market anticipated that message, as junk bond issuance in the first half of the year came to a record $180 billion, according to Dealogic. Investment-grade corporate bond issuance for the first six months footed to a monster $840 billion, nearly double the previous half-year issuance record set in 2016.  Kevin Foley, head of global debt capital markets at J.P. Morgan, summed up the prevailing mentality to The Wall Street Journal: “It’s been ‘take the money and run.’” 

Musical chairs in food delivery.  Various press outlets report that Uber Technologies, Inc. is cooking up a formal bid – The Wall Street Journal pegs the likely price at $2.6 billion – for the food delivery service Postmates to pair with its Uber Eats business. Time is of the essence for Uber, relays the Financial Times, “because a private equity buyer was also competing to buy Postmates.”  The latest merger efforts follow European rival Just Eat Takeaway plc.’s $7.3 billion, all-stock deal with Grubhub on June 10, which beat back Uber’s reported approach. 

That determination to size up its Uber Eats division comes as the ride-share giant looks to retrench from other non-core businesses to save money.  Bloomberg reported that CEO Dara Khosrowshahi told staff in an email last Thursday that Uber will “deprioritize” a number of finance-related projects, a decision which coincided with Uber Money head Peter Hazelhurst’s decision to step down from his role.  That follows announced layoffs last month totaling 25% of the total workforce. 

Of course, the core ride-share business is no great shakes. Since the start of the pandemic, ridership dropped some 70% from a year ago, Khosrowshahi announced earlier in June.  Then again, the status quo wasn’t exactly lucrative, as Uber posted adjusted Ebitda of negative $7.3 billion last year, compared to a $2 billion adjusted Ebitda loss in 2018. 

Meanwhile, regulators and politicians look to do a little disrupting of their own. Last week, California Attorney General Xavier Becerra said he will seek a court order immediately to enforce Assembly Bill 5, the legislation passed in 2019 to require so-called gig economy companies to classify their workers as employees instead of independent contractors (thus putting the employers on the hook for healthcare expenses along with Social Security and Medicare taxes).  By way of response, Uber spokesperson Julie Wood told the press: “Trying to force drivers to give up their independence 100 days before the election threatens to put a million more people out of work at the worst possible time.”

While politics and the pandemic play their roles, structural deficiencies may be the ultimate hindrance for the industry and their investors.  Addressing the Grant’s fall 2019 conference audience from the podium at the Plaza Hotel, noted transportation consultant-turned ride-share authority Hubert Horan didn’t mince words in providing his assessment:

Uber has no hope of sustainable profits in competitive markets. A company with $20 billion in losses in years six through ten is not rapidly growing into profitability like Facebook or Amazon. Uber’s economics are totally uncompetitive. They are actually a higher-cost, less efficient producer than your traditional yellow-cab company.

All of Uber’s popularity and growth has been the result of massive, predatory subsidies that were used to drive out the more efficient operators. The market shows no willingness to pay the true cost of Uber’s services. Reversing these losses would be one of the biggest turnarounds in corporate history, and Uber doesn’t have a profitable core to restructure around.

Another green day for stocks left the S&P 500 down by less than 5% year-to-date at the mid-way point for 2020, up a cool 38% from its March 23 low.  Treasurys reversed early gains in bear steepening price action, with the 30-year yield rising above 1.41%, while gold jumped nearly 1% to $1,798 an ounce, after climbing above $1,800 intraday for the first time since 2011.  The VIX closed south of 31 for a three-week low. 

- Philip Grant

What a pile of junk.  June has been a month to remember for high-yield bonds, as new supply of $50.6 billion tops the prior record of $46.4 billion set in September 2013 with days to spare.  Year-to-date issuance foots to $205 billion, up a cool 71% from the same time last year. 

That’s not to say that all junk issuers are created equal, as the Financial Times notes today that the recent supply surge has been concentrated in the upper echelons of the credit spectrum. Thus, data from Refinitiv show that 57% of the $140 billion in issuance over the past 14 weeks has been double-B-rated credits, up from 42% in the first two months of the year. At the same time, the share of debt issued by single-B-minus rated companies fell to 3% since March, compared to roughly 10% in January and February.

The enthusiasm for the upper crust of sub investment-grade bonds is also reflected in price action.  On the one hand, the double-B-rated segment of the market has lost a mere 0.61% year-to-date.  Triple-C’s, on the other hand, are down by 12.2%.

Ratings may be dictating the proceedings, but there are exceptions.  On Wednesday, American Airlines, Inc. priced a $2.5 billion first-lien 11 3/4% notes due 2025.  Issued at 99 cents on the dollar, the double-B-minus-rated securities have since fallen to 96.4 cents, for a 1,242 basis point spread over Treasurys.  For context, the triple-C-portion of the Bloomberg Barclays High Yield Index sports a 1,165 basis point option-adjusted spread. 

The Wall Street Journal reports that higher-ups at Credit Suisse are examining a handful of structured investment vehicles with exposure to Wirecard A.G, which has filed for bankruptcy following revelations of an accounting scandal including fictitious cash balances. Of particular focus: The multiple investment roles that SoftBank Group Corp. played in transacting the complex securities, and associated potential conflicts of interest. 

It wasn’t supposed to be this way, as SoftBank managed quickly to recoup its €900 million ($1.01 billion) convertible bond investment in Wirecard last year while maintaining potential upside in the German fintech company through call options. Recall that last September, an unnamed senior executive at SoftBank told the Financial Times that the move “was inspired by Warren Buffett, who has a record of making highly structured investments in seemingly troubled companies that then benefit from his reputation” (Almost Daily Grant’s, June 19). 

Instead, the unfolding reputational fallout comes as SoftBank looks to make wholesale changes to its portfolio structure following a $13 billion operating loss over the 12 months through March 31.  Earlier this week, the firm sold $14.8 billion worth of shares in T-Mobile U.S., Inc., equivalent to roughly half its position in the carrier (SoftBank intends to sell a total of $20 billion worth of TMUS).  

Even formerly sacred cows are up for veterinary reappraisal. SoftBank famously acquired a 25% stake in Alibaba Group Holding Ltd. for $20 million in 2000; today that investment is worth $150 billion. Last month SoftBank CEO Masayoshi Son indicated he may sell up to $11.5 billion worth of BABA shares.  Something appears afoot on that score, as Son yesterday announced he would leave the Alibaba board of directors after a 15-year stint, a month after Alibaba CEO Jack Ma departed the SoftBank board. 

Son is not using all of the sales proceeds to improve balance sheet quality, however. Yesterday, SoftBank announced a fresh ¥500 billion ($4.7 billion) share repurchase program.  That’s equivalent to 5.7% of shares outstanding and is the third such buyback authorization in the last two months. 

Some are less than impressed with the wheeling and dealing. Earlier today, Moody’s Investors Service cut its outlook on SoftBank to negative, citing “the potential for substantial changes in its credit profile as a result of its large recapitalization plan,” along with “thin” interest coverage and SoftBank’s “aggressive financial policy and associated governance concerns.” 

By way of response, SoftBank issued a statement declaring that: “SBG has provided no information to Moody’s since withdrawing from its rating service on March 25, 2020. Therefore, it is unclear what Moody's intention is to comment on SBG, nor what information it uses to understand SBG's situation and assess our creditworthiness.”

The negative outlook is apparently mutual. 

Stocks fell bigly, with the S&P 500 losing 2.4% to finish the week nearly 3% in the red, while a bull-flattening Treasury rally left the 2-, 10- and 30-year yields at 0.17%, 0.64% and 1.37%, respectively. WTI crude slipped to $38 a barrel, gold reached another post-2012 high at $1,771 an ounce and the VIX closed just above 35. 

- Philip Grant

More anything? More everything!  As the monetary response to pandemic-related pain has far outstripped that of previous crises, central bankers can look with satisfaction at evidence of their successes: Namely, a 40% S&P 500 rally off the March 23 low and retracement of high-yield credit spreads to 600 basis points over Treasurys from a high of 1,100 basis points on that same grim day.  Yet policymakers past and present, along with other constituencies, are expecting more to come. 

While Fed chairman Jerome Powell has repeatedly played down the prospect of negative rates in the U.S., Mr. Market isn’t so sure: This morning the January 2022 Fed Fund futures contract traded above 100, implying that overnight interest rates will be set slightly below zero on that future date (thank you, Alex Manzara). Anecdotal indicators are also apparent, as the Financial Times reported June 15 that the Bloomberg data service told users to consider switching the standard dollar-denominated interest rate options pricing model to one incorporating the possibility of a sub-zero funds rate, “as a preventative measure.” 

As for so-called yield curve control (or committing to purchase sufficient quantities of government bonds to keep rates pegged at desired levels), public statements suggest more approval from the monetary mandarins. New York Fed president John Williams appeared to jawbone for the policy last month, telling reporters on May 27 that the central bank is “thinking very hard about rolling it out.”  

For his part, the Fed chair has hedged his bets. Powell told Congress last week that the idea had come up in a recent meeting of the Board of Governors, but “it’s not something we’ve all decided to do.”  

To be sure, yield curve control, which had its 21st century debut at the Bank of Japan in fall 2016, has its limitations. In a study published Monday, the New York Fed concluded: “Has yield curve control been a success? Seemingly not on the inflation front.”  But financial markets are more pliable: “Under the new policy, the BoJ has been able to exert fairly close control over the term structure of interest rates without resorting to large-scale interventions in the Japanese government bond market.”

Stateside, the prospect of overtly capped Treasury yields is a bullish siren song. “It depends on the form and the price but broadly speaking it’s the green light to carry on with the QE trade – buy everything regardless of valuation,” James Athey, senior investment manager at Aberdeen Standard Investments, told Bloomberg. 

While “buy everything” has been a perfectly successful mantra post-March 23, “buy deep junk” has fared even better, as Marty Fridson, chief investment officer of Lehmann Livian Fridson Advisors, LLC, concluded in a June 17 analysis for S&P’s LCD division.  From the March 23 lows to June 8, a sample of 30 companies rated single-B-plus and below (i.e., the junkier end of junk) racked up average gains of 108.5%, topping the 74.6% gain in the double-B-plus to double-B-minus ratings bucket. In addition, 11 of the 30 selected stocks within the “extra junk” group doubled and four tripled over that ten week period, while six out of 30 for the higher-rated sample doubled and none tripled. 

The tidal wave of liquidity that coincided with the historic spring rally has abated, for now at least. Weekly sequential growth in Reserve Bank credit (meaning total interest-bearing assets on the Fed’s balance sheet) has remained below 1% since late May and declined outright last week for the first time since February.  By contrast, Reserve Bank credit grew by a combined 25% in the two weeks ended April 1. 

Lest anyone be concerned about a suddenly passive Fed, former New York Fed president William Dudley wrote in a Bloomberg Opinion column Monday that the balance sheet could “conceivably” top $10 trillion by the end of the year. That compares to a bit more than $7 trillion currently and just over $4 trillion when the bug bit.  Dudley expounds:

By reducing the supply of safe assets and increasing the amount of deposits that the private sector must hold, the Fed generates a demand by the private sector for more risky assets. The result is a rise in financial-asset valuations and an easing of financial conditions. The Fed’s asset purchases change the mix of assets available to be held by private investors and this influences asset valuations.   

Forget Instagram, and behold the real influencers. 

Stocks finished off their best levels of the day, but early gains were enough to leave the S&P 500 less than 8% from its February high-water mark, while the Nasdaq 100 ascended to a fresh record close of its own. The Treasury curve steepened a bit thanks to modest weakness at the long end, as the 30-year bond yield rose to 1.49%.  Gold rolled higher again to $1,770 an ounce,  WTI crude pulled back to $40 a barrel and the VIX held near 31.  

- Philip Grant

A total of 742 banks across the Old Continent borrowed €1.31 trillion ($1.46 trillion) from the European Central Bank at interest rates as low as minus 1%, the ECB announced yesterday.  The debt sale marks the debut of the so-called dual-rate system, in which banks enjoy favorable borrowing costs compared to the administered overnight repo rate, currently set at minus 50 basis points. 

Lenders eagerly availed themselves of the ECB’s generosity. Total loan size from the refinancing facility was more than double the prior high-water mark of €530 billion, set in March 2012 as the eurozone sovereign-debt crisis raged.  

The banks will use those funds to repay maturing loans, as well as to increase their holdings of government debt. “Increased sovereign exposure by banks has typically been seen as a negative in recent years,” analysts at Jefferies wrote in a recent report. “However, the policy stance is shifting and with government debt levels set to rise, it may make sense for banks to channel excess liquidity in this direction.” 

One thing is for sure:  There will be plenty of new supply to soak up that extra cash.  In its biannual financial stability review issued May 26, the ECB estimates that government borrowings across the eurozone will jump above 100% of GDP in 2020 from last year’s 86%, as budget deficits will average a projected 8% of GDP, with output declines ranging from 5% to 12%.  At the same time, some European banks are heavily exposed to their own country’s fiscal fortunes, with Italian financial institutions holding some €425 billion in Italian debt, more than 10% of the outstanding total. 

Then, too, E.U. member states face some imminent heavy lifting in terms of rolling over existing obligations, with more than 10% of total debt of France, Spain, Belgium, Finland and Portugal each coming due in the next year, while upwards of 15% of Italy’s borrowings will need to be refinanced by mid-2021. 

If the current slump persists, the ECB warns, “overvalued asset prices, low bank profitability, high sovereign indebtedness and increased liquidity and credit risks in the non-bank sector . . . [risk creating]  negative feedback loops arising from sovereign or bank rating downgrades.” 

The spectacular meltdown of German fintech giant Wirecard A.G. (WDI on the Frankfurt Stock Exchange) leaves plenty of damage in its wake.  The stock has fallen 75% in the past two trading sessions after auditor Ernst & Young declared that a stated cash balance of €1.9 billion may not exist, while CEO Markus Braun resigned with immediate effect this morning.

Others involved in the fiasco face less quantifiable harm.  Last spring, SoftBank Group Corp. announced that it would invest €900 million in Wirecard via convertible debt instruments.  Instead, the deal was financed by SoftBank employees, along with the Mubadala sovereign wealth fund, and subsequently sold to investors through structured notes arranged by Credit Suisse.  

At the time of the transaction, an unnamed senior executive at SoftBank told the Financial Times that the move “was inspired by Warren Buffett, who has a record of making highly structured investments in seemingly troubled companies that then benefit from his reputation.” Subsequent events color those remarks, as the securities changed hands this morning at less than 12 cents on the euro. 

“Everything about that deal is not what you would call textbook corporate governance,” Justin Tang, head of Asian Research at United First Partners, told Bloomberg. “This is the last thing that [SoftBank CEO Masayoshi] Son needs right now as he deals with the fallout from Vision Fund losses.” 

Others are processing the news in their own way.  As the FT’s Robert Smith observes, Akshay Naheta, the managing partner at SoftBank’s Vision Fund who spearheaded the deal, took to Twitter yesterday to publicly complain that Ernst & Young had “displayed a lack of competence and responsibility.”  The executive continued: “As an organization that is meant to protect all stakeholders – creditors and shareholders – in companies, both public and private, they have failed in their fiduciary duties.”   Subsequently, Naheta locked his account. 

Stocks saw modest declines on this quadruple-witching options expiration day (covering expiration of single-stocks, single-stock futures, stock-index options and stock-futures), with the S&P 500 pulling back 50 basis points to wrap up the week 2% in the green. A third straight strong showing in Treasurys left the 10- and 30-year yields at 0.69% and 1.46%, respectively, while WTI crude rose to near $40 a barrel and gold jumped to $1,742 an ounce, within range of a fresh eight-year high.  The VIX finished at 32.5, slightly lower on the day.  

- Philip Grant

Yesterday’s semi-annual Congressional appearance by Fed chairman Jerome Powell was a memorable one. The central banker provided no shortage of quotable comments in explaining the recent myriad of expanded monetary exertions, which have included the upsizing of Reserve Bank credit (meaning the sum total of interest bearing assets on the Fed’s balance sheet) at an annualized pace of 726% over the past three months.  Let’s review the current state of play. 

Near-zero interest rates are, of course, a fundamental component of the chairman’s economic medicine, “until we are confident that the economy has weathered recent events and is on track to achieving our maximum-employment and price stability goals.”  In other words, the Fed is “not even thinking about thinking about raising rates.” 

Abundant purchases of Treasury debt and mortgage-backed securities are another pillar of 2008-era monetary policy dusted off for another go, as Powell promised the Fed will increase its holdings at “at least the current pace” in the coming months. 

Those purchases have helped the market digest Uncle Sam’s mammoth financing needs, which have included $2.6 trillion in fresh borrowings over the three months ended June 11.  For comparison, federal debt remained largely unchanged from mid-March to mid-June of last year. The Fed’s portfolio of Treasurys has risen by $1.62 trillion from March 11 through June 11, accounting for 63% of the net debt expansion over that period (updated figures will be published tomorrow). 

Asked about so-called yield curve control, the chairman revealed that the Fed discussed the strategy at a recent meeting of the Board of Governors:  "We briefed people up on the history of it and how it works, so people understand the technology. . . The concept of using yield curve control at the Fed is at an early stage."

Perhaps unsurprisingly, Monday’s announcement that the Fed is set to begin outright corporate bond purchases took center stage in yesterday’s testimony, as such a program is uncharted territory for the 107 year-old institution. 

That move to buy corporate bonds, the former Carlyle Group partner said, was made “out of an excess of caution” in order to maintain functioning markets.  “I don’t see us wanting to run through the bond market like an elephant snuffing out price signals and things like that,” Powell assured Congress. While the epic snap-back in credit spreads seemingly mitigated the need for such direct support, market credibility was front of mind for the chairman: “We feel we need to follow through and do what we said we would do.” 

The corporate credit markets have been counting on it.  According to S&P’s LCD unit, the first 12 days of June have featured fresh junk bond issuance of $24 billion, the second-heaviest monthly pace on record.  Year-to-date supply of domestic high-yield debt stands at $181 billion, or 61% ahead of this time last year, while $1.1 trillion in new investment-grade supply stands 73% above that of 2019. 

Not that balance sheets were too conservative before COVID-19 barged onto the scene. According to data from CreditSights, corporate liabilities stood near a record-high 135% of GDP as the calendar turned to 2020, up from 105% in 2007. 

Despite the extraordinarily EZ-monetary policy, Powell indicated little concern over an awakening of the sleeping inflation giant: 

There’s [been] downward pressure on inflation around the world for a couple of decades. And so, what the models would have called for with big deficits, they would have called for higher inflation, would have called for higher interest rates. We don’t see either of those things. So, I think we’re not working under the hypothesis that higher inflation is a likely outcome. 

While that view may enjoy plenty of support at the Fed and other central banks, a pair of establishment economists beg to differ. A March 27 essay from Charles Goodhart, emeritus professor at the London School of Economics and a former external member of the Bank of England’s Monetary Policy Committee, and Manoj Pradhan, founder of Talking Heads Macro and former economist at Morgan Stanley, makes the dissenting case:

Inflation will rise considerably above the level of nominal interest rates that our political masters can tolerate. The excessive debt amongst non-financial corporates and governments will get inflated away. The negative real interest rates that may well be necessary to equilibrate the system, as real growth slows in the face of a reversal of globalization and falling working populations, will happen. 

Even if central banks feel uncomfortable with such higher inflation, they will be aware that the continuing high levels of debt make our economies still very fragile. And if they try to raise interest rates in such a context, they will face political ire to a point that might threaten their “independence.” Only when indebtedness has been restored to viable levels can an assault on inflation be mounted.

Perhaps a topic to be revisited in the future. 

A late downtick left the S&P 500 slightly below unchanged, the first red showing since last Thursday’s 6% swan-dive. Treasurys caught a bid across the curve, headlined by a strong 20-year note auction this afternoon.  WTI crude fell back below $38 a barrel, gold remained rangebound with a close near $1,729 an ounce and the VIX finished at 33.5.  

- Philip Grant

One giant leap for central banks.  This afternoon, the Fed announced it will commence individual corporate bond purchases tomorrow, under the Primary and Secondary Market Corporate Credit Facilities unveiled on March 23. 

In the frequently asked questions addendum to the announcement, the Federal Reserve Bank of New York noted it will “not purchase bonds of issuers that have filed for bankruptcy protection or bonds of issuers that no longer meet the facility’s minimum rating or other requirements.”

In other words, Robin Hooders, Hertz is all yours. 

Dialing up a Hail Mary.  The $400 billion California Public Employees' Retirement System (CalPERS),  the nation’s largest, announced it will enhance leverage and boost allocations to private equity managers in an attempt to goose returns.  “Given the current low-yield environment, there are only a few asset classes with a long-term expected return clearing the 7% hurdle,” chief investment officer Ben Meng told the fund’s board of directors today. “Private assets clearly stand out. Leverage will increase the volatility of returns but Calpers can tolerate this.”

“We will have to live with the possibility of market drawdowns as the price for increasing the probability of achieving our ambitious rate of return,” Meng continued. “There is no alternative.” 

The status quo is lacking, to be sure. The fund lost 4% in the nine months through March, while an internal study conducted last year placed the odds of achieving that 7% annual return over the next decade at just 39%. Self-inflicted wounds compound that daunting challenge as CalPERS opted to unwind tail-risk hedging strategies in January, a move which cost the fund an estimated $1 billion payout when markets went into spin cycle two months later. 

***

As the pension fund bellwether looks to ratchet up its risk profile, private equity basks in the glow of both flush fundraising (a record $361 billion last year) and increasingly friendly treatment from regulators. 

On June 4, the Department of Labor issued guidelines stating that private equity is an appropriate investment for retirement plans such as 401(k)s, while the Securities and Exchange Commission last year advocated relaxing the rules limiting p.e. to so-called accredited investors (those with at least $1 million in assets or $200,000 in annual income), in order to  “expand investment opportunities while maintaining appropriate investor protections and to promote capital formation.” 

The influx of new capital shines the spotlight anew on curious performance discrepancies.  For instance, the largest U.S. p.e. operators reported an average 15.8% drawdown in their buyout portfolios in the first quarter, while single-B-rated companies in the S&P 500  (which generally represents the upper end of the credit ratings spectrum for p.e.-backed portfolio companies) fell by roughly 50%. 

Then, too, the proliferation of so-called friendly adjustments such as earnings add-backs, or credit for hypothetical future cost savings, figure prominently in the p.e. miracle. According to the Coller Capital Global Private Equity Barometer survey of 107 investors released today, 67% of respondents said they were “very concerned” about the quality of reported Ebitda metrics.  Yet 52% of limited partners who participated in the survey say they are not inclined to ask their managers to utilize independent third party valuation sources.

Thanks to the record breaking post-2009 bull market, buoyant asset prices (before the bug bit, anyway) rendered investment bargains few and far between. According to Bain & Company’s 2020 Global Private Equity Report, 55% of U.S. buyout deals featured enterprise values in excess of 11 times Ebitda.  For comparison, only about 20% of such transactions carried an EV/Ebitda ratio above 11 in 2007.   With rising price tags come more aggressive capital structures. Bain reports that nearly 75% of buyout deals last year featured net debt in excess of six times (reported) Ebitda, up from about 60% in 2007.  Adjusted for add-backs, those leverage figures are likely higher still. 

Yet those advantages have not translated into observed excess return. Data compiled by Ludovic Phalippou, professor of finance at Oxford Said Business School, show that p.e. has generated annualized returns of roughly 11% from 2006 to 2015 after accounting for fees, broadly matching that of the broad stock market.   

Investors may not be coming out ahead, but that’s not to say there are no winners from the great p.e. migration. “This wealth transfer from several hundred million pension scheme members to a few thousand people working in private equity might be one of the largest in the history of modern finance,” Phalippou tells the Financial Times.

For more on the great private equity migration, along with the bear case on a key cog in the p.e. machine, see the May 29 edition of Grant’s.  

A rip-roaring rebound in stocks helped S&P 500 futures erase overnight losses of more than 3%, as the broad index finished nearly 1% higher by the end of cash trading.  Treasury yields finished little changed, but implied investment grade and high-yield credit spreads both tightened substantially (according to their respective CDX indices) following the Fed’s announcement this afternoon.  WTI crude rose back above $37 a barrel, gold ticked slightly lower to $1,724 an ounce, and the VIX fell 5% to 34. 

- Philip Grant