The relentless recent rally in government bonds reached a new crescendo today as the 10-year Treasury yield slipped to 1.15%, near a six-month low. With inflation remaining on the boil, that price represents an historic anomaly.   The real 10-year yield, as measured by the nominal one less headline CPI, reached minus 424 basis points as of early afternoon.  For context, Treasury investors have received average post-inflation compensation of positive 98 basis points over the last 20 years, while that CPI-adjusted yield only briefly dipped below minus 200 basis points during the 2008 financial crisis and sharp summer 2011 selloff. 

It’s a similar story across the pond.  Today the nominal 30-year German bund yield tumbled to a fresh six-month low of minus 1.2 basis points.  That comes as German headline CPI posted a 3.8% year-over-year advance for July, the highest reading since 1993.  In early February, the last time that the German 30-year slipped into negative territory, CPI was running at a 1% annual clip.

Lucky borrowers in the eternally developing markets likewise have their moment in the sun. Bloomberg notes today that caa3/single-B-minus rated Ecuador, which defaulted on $17 billion in debt last year, stands as the best sovereign performer of 2021 with a 28% average return on its bonds this year. 

Environmental, social and governance-related “issues” abound at DWS Group, a former employee alleges.  Desiree Fixler, who served as sustainability officer at the Deutsche Bank-affiliated asset management firm until March, tells The Wall Street Journal today that the firm’s ESG-related investing acumen lags far behind the lofty rhetoric used to impress investors. DWS’ 2020 annual report, which was released in March, claimed that some €459 billion ($546 billion) of assets, representing more than half its total holdings under management, had been through a self-described “ESG integration process,” and declared that “we have placed ESG at the heart of everything we do.”   

Instead, an internal audit of DWS’ bona fides conducted a month earlier concluded that “only a small fraction” of its portfolio had been through the ESG rigmarole. “As we are already quite late to the game, we need to set our ambition now and start the transformational process,” ESG product head Oliver Plein urged in a Feb. 1 email accompanying the in-house report.  

DWS fired the whistle-blower on March 11, one day before the annual report went to press, asserting that she herself failed to implement tangible improvements. Fixler, who has filed an unfair dismal claim in German labor court, told the Journal that “posturing with big statements on climate action and inclusion without the goods to back it up is really quite harmful as it prevents money and action from flowing to the right place.” 

Temptation to burnish one’s ESG credentials is certainly understandable, considering the spigots of capital gushing towards those pursuing green investing strategies.  U.S. assets allocated so-called sustainable funds (or those highlighting ESG-related factors in their prospectuses or other regulatory filings) reached $304 billion as of June 30 per Morningstar, nearly double the $159 billion categorized as such at the halfway point of 2020. 

 
“Sustainable” inflows by quarter.  Source: Morningstar

DWS’ dust-up presents a risk to the credibility of the bourgeoning ESG craze, as a recent survey from U.K.-based wealth management service Quilter found that such alleged “greenwashing” was the biggest concern among respondents, topping concerns over investment fees and performance.  Yet a more fundamental problem of quantifying the inherently murky criteria remains.  For instance, MSCI evaluates companies’ ESG bona-fides with 37 separate metrics, while peers Sustainalytics (a subsidiary of Morningstar) and Refinitiv utilize 155 and 178 categories, respectively.  Then, too, the trio hold differing views over whether to consider the industry in which a corporate candidate operates in its assessment.  

The hodgepodge of benchmarks can, of course, invite spirited disagreement. German utility RWE A.G., which derives about a quarter of its revenue from coal-generated power, received a 33.1 ESG rating from Sustainalytics in April (a lower score is better), indicating “a high level of risk.”  Yet that downbeat assessment overlooks the company’s ongoing green pivot, the benefits of which may ultimately accrue to shareholders. 

Will Thompson, founder and managing partner at Massif Capital, told Grant’s Interest Rate Observer on July 23 that RWE plans to whittle its coal exposure to a single plant by 2030 and predicts a complete divestment soon thereafter, concluding that RWE’s “future and the future of the stock price are all dependent on how they build out and continue to monetize their renewables pipeline, not the coal assets.” In other words, Mr. Market, rather than the ESG gatekeepers, will render the ultimate judgement on RWE’s progress.

For more from Thompson on the opportunities and risks inherent in the large-scale ESG migration, tune in or join us live at the Grant’s fall conference in New York on October 19 (advt).

An early rally didn’t last as the S&P 500 lost ground throughout the day to finish marginally in the red, while Treasurys maintained their early advance with the long bond yield declining to 1.85%.   WTI fell back to $71.5 a barrel after approaching its post 2018 highs on Friday, Gold held at $1,817 an ounce, and the VIX rose 6% to log a fresh two-week peak near 19.5. 

- Philip Grant

Let’s talk it out. The China Securities Regulatory Commission held an overnight conference call with BlackRock, Goldman Sachs and other Wall Street heavyweights to assuage concerns over the Communist Party’s series of heavy-handed punishments against U.S.-listed local enterprises (Almost Daily Grant’s, July 23). Those moves have proven painful for foreign investors:  From its mid-February peak through Tuesday, The Nasdaq Golden Dragon China Index sank by 48%.

Reports of that powwow, in tandem with the People’s Bank of China’s upsized RMB 30 billion ($4.6 billion) liquidity injection into the financial system, helped that Golden Dragon gauge stabilize some 10% above Tuesday’s low.  That’s not to say that Beijing’s broadside has run its course. “These policies are not coming from the CSRC, they’re coming from much higher up,” cautions one anonymous source to the Financial Times. “It’s clear there will be more to come, that’s obvious to everyone.” 

One target of the CCP’s wrath aims to please both its capital base and political masters.  Ride-share firm Didi Chuxing is mulling a return to privately owned status, The Wall Street Journal reports today, “in order to placate authorities in China and compensate investors” for their losses as shares swiftly turned south following Didi’s June 30 debut on the NYSE.  That may not be enough to sooth ruffled feathers stateside: “Numerous” law firms representing shareholders have filed class-action suits against Didi and its investment banking underwriters, the Journal notes. 

Didi’s predicament shines a spotlight on the unusual ownership structures which predominate in U.S.-listed, China-domiciled enterprises.  Didi, as do many prominent Chinese companies, utilizes a variable interest entity (VIE) format, which allows foreign investors to accumulate an economic interest via Cayman Islands-domiciled shell companies without running afoul of Chinese laws limiting foreign ownership in certain key sectors. Some $1.6 trillion worth of Chinese VIE businesses listed on U.S. exchanges utilize this structure, Nikkei Asia calculated on July 14. 

Of course, the VIE workaround is rife with potential pitfalls. A 2019 paper from GMT Research put it this way:

Companies that use the VIE structure tell two inconsistent stories. To Chinese regulators they say that the business is owned by Chinese and not by foreigners. Yet, to foreign investors they claim that foreigners own the business.

China expert Anne Stevenson-Yang underscored that point in a July 11 opinion piece in Swiss publication The Market, writing that the contracts that underpin foreign investors’ claims to Chinese profit streams “are legally iffy.” 

For now, at least, the VIE structure serves the CCP’s geopolitical ends, Stevenson-Yang argues: 

China's door is closing to inbound traffic - internet content and other forms of media, other channels of cultural influence, many kinds of inbound travelers, and many imports. . .  For capital, the inbound door remains wide open, but the way out is increasingly shut.

Policies around IPO approvals, VIEs, internet control, anti-monopoly regulation, and investment policy have everything to do with capturing and holding on to hard currency.

Past experience on that score is not reassuring. Indeed, foreign investors remain exposed to a reprise of a 1998 bait-and-switch in which the government allowed telecom firm China Unicom to list in Hong Kong using a structure similar to the VIE, and then deemed foreign ownership within that sector to be illegal, after it had gathered requisite foreign capital and technology.  “This is likely to be ultimately the fate of Chinese VIEs,” Stevenson-Yang concludes. 

Any disruption to the VIE status quo could spell trouble for SoftBank Group Corp., the tech-focused conglomerate dubbed “the epitome of the cycle” by Grant’s Interest Rate Observer in December 2017. The CCP’s recent pressure campaign is already beginning to sting. This morning, SoftBank unloaded a 45 million share block of Uber Technologies, Inc. to help cover recent losses incurred in Didi’s post-IPO plunge, CNBC reports.  

SoftBank, which famously invested $20 million in Caymans-domiciled Alibaba Group Holding (BABA on the NYSE) back in 2000 and has seen its 24.8% stake balloon to $134 billion on paper, took out a $10 billion margin loan backed by its holdings in Alibaba in early June, following a similar $8 billion Alibaba-backed margin loan in spring 2018.  Thanks to a 34% pullback in BABA shares from its October peak coinciding with the ongoing house arrest of co-founder Jack Ma, those loans appear slightly underwater as shares in the e-commerce giant now sit about 10% below their early June levels and near those from April 2018.  The market is expressing some concern, as SoftBank’s own shares have shed 34% over the last five-plus months. 

Epitome of the cycle?  The bulls hope not. 

A weak seven-year auction catalyzed some modest pressure on the Treasury complex, as the 10- and 30-year yields rose to 1.26% and 1.91%, respectively, while stocks cruised higher with the S&P 500 advancing 40 basis points to slip into positive territory for the week. Gold ripped to $1,833 an ounce, breaking out of its tight recent range to log a six-week closing high, WTI rallied to near $73.5 a barrel and the VIX slipped back below 18.   

- Philip Grant

Senate negotiations over the proposed $1 trillion infrastructure bill lasted through the night and currently continue, as a cohort of 10 lawmakers haggle over the details of the package beyond a self-imposed Monday evening deadline. 

“We have reached a critical moment. The bipartisan group of senators has had nearly five weeks of negotiation,” majority leader Chuck Schumer (D-New York) told the press yesterday afternoon, adding that the talks will continue into the weekend’s scheduled commencement of summer vacation if the group fails to come to terms.  White House spokesperson Jen Psaki added that the administration remained “confident” over the bill’s prospects but also observed that “time is not endless.”

Any agreement will serve to further deepen gaping budget holes.  The Congressional Budget Office estimated last week that, based on current laws governing taxes and spending, the federal deficit will foot to $3 trillion over the fiscal year ending in September. That’s four times greater than the $747 billion gap logged in 2019, while the projected 13.4% deficit as a percentage of GDP would trail only last year’s 14.9% figure for the biggest since World War II.

While Congress works to hammer out its latest spending bill, the Biden administration looks for other ways to enact worker-friendly initiatives without requiring legislative assent. As The Wall Street Journal notes today, the executive branch is investigating a variety of regulatory tweaks designed to enhance employee wages and benefits, including a federal minimum wage increase and relaxed rules governing union organization. That follows last week’s announcement from the Department of Labor that it will begin to implement a January executive order hiking the minimum wage for federal contractors to $15 an hour from the current $10.95 by the beginning 2022, with further annual adjustments based on the course of measured inflation, a move that would provide a raise to some 327,000 contract-based employees. 

Another proposed rule would limit employers’ ability to utilize the so-called tipped minimum wage, or an hourly rate of as low as $2.13 for workers who derive enough in tips to reach the established minimum remuneration.  Such new regulations could boost effective wages for large swaths of the 11 million Americans who work at bars and restaurants. 

Though the ultimate outcome of those D.C.-machinations remains uncertain, a perhaps more impactful trend is taking shape in regional halls of power.  A Moody’s analysis published yesterday found that state and local governments are set to significantly increase their infrastructure spending. That would represent a marked change from the belt-tightening seen in the wake of 2007 to 2009, as such capital investment declined on a nominal basis from 2008 to 2014 per the Census Bureau and remains well below pre-2008 levels relative to total government spending.  The rating agency estimates that capital assets on local government balance sheets were 46% depreciated in 2019 on average, up from 39% in 2008.  

The worm may finally be turning, as state and local debt issuance during the first half of the year was 29% higher than the same period in 2019 without adjusting for inflation.  Moody’s concludes that “if issuance continues at this robust pace, it will support an improvement in capital asset conditions.”  

Might spendthrift governments help support the CPI as well? 

Stocks took a dip ahead of tomorrow’s FOMC rate decision, as the S&P 500 and Nasdaq 100 pulled back by 50 and 110 basis points, respectively, though each finished well off their worst levels of the day following an overnight liquidation in Chinese equities.  Treasurys caught a bid with the long bond yield sinking to just 1.89%, while WTI crude remained near $72 a barrel and gold finished near $1,800 for a fifth straight session.  The VIX advanced to 19.4, up 10% on the day.         

- Philip Grant                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                  

Once is happenstance, twice is coincidence and the third time it’s enemy action.  Reports that regulators are considering forcing for-profit education firms to migrate towards a not-for-profit structure hammered Chinese schooling stocks today, with shares of the New Oriental Education & Technology Group (EDU on the NYSE) enduring a 54% swan-dive.  

That follows Beijing’s ongoing broadside against Didi Chuxing (which includes a Bloomberg report yesterday claiming “unprecedented penalties” may be forthcoming) over alleged data collection abuses following the ride share giant’s celebrated June 30 listing on the NYSE and last fall’s salvo against Alibaba after co-founder Jack Ma dared to publicly criticize the Chinese Communist Party.  Foreign investors have taken the hint. Since logging its peak in mid-February, the Nasdaq Golden Dragon China Index, composed of American Depository Receipts tracking local businesses, is off a hefty 41%. 

Euthanasia of the renters? The National Multifamily Housing Council’s quarterly survey, released today, shows the tightest market conditions on record going back to at least 2006. A reading above 50 indicates that supply conditions are shifting in landlords’ favor, and vice versa. 

 
Source: The National Multifamily Housing Council

With activity on the hop and availability historically limited, tenants may be forced to pay up for some time.  “We calculate the market won’t be fully in balance until 2023 or 2024,” Ali Wolf, chief economist at real estate advisory firm Zonda, told the Financial Times Wednesday. “Assuming the economy continues to improve, and we continue to see the job growth numbers get better, I do think there will continue to be some upward pressure on rents.”  That trend could wield no small influence on broader inflation expectations.  “People don’t buy a used car every month whereas many pay rent every month,” Oregon University professor Tim Duy added.

The housing market has likewise gone into hyperdrive, in short order reverting to the sonic boom-like conditions that rival the headiest days of the mid-aughts.  Data released yesterday by the National Association of Realtors showed that the median “existing” home price reached $363,300 in June. That’s up a cool 23.4% from a year ago and 57.7% above the housing bubble peak logged in July 2007. 

Shelter, both for sale and for rent, is of course a lynchpin for the future course of inflation. The owners’ equivalent rent (OER) metric, which attempts to capture the change in a homeowners estimated proceeds from renting his or her dwelling, represents 23.7% of the Consumer Price Index.  Rent of primary residence, which measures contracted rental and prices, accounts for an additional 7.6% of the CPI.  Overall, the shelter component registered a modest 2.6% year-over-year advance in June, up from 1.5% in February but well below the 3% to 3.6% run-rate seen from 2016 to 2019, let alone the 5.4% advance in headline CPI.  

As rental contracts typically last one year and inflation indices capture prices on currently occupied domiciles as opposed to asking prices on vacant units, it takes about five quarters for trend changes in measured home or rental prices to appear in the CPI data, a June 9 analysis from Fannie Mae economist Eric Brescia finds. That suggests that last year’s deep freeze is still working its way through the system and will soon abate. 

Meanwhile, a dearth of affordable housing supply complements the ultra-tight rental conditions identified by the NHMC. Citing data from Freddie Mac, The Wall Street Journal relayed Wednesday that the annual construction pace of homes sized 1,400 square feet or less (a category typically denoting starter homes for first-time buyers) has remained stuck between 55,000 and 65,000 units per annum in recent years, compared to more than 400,000 new units in the late 1970s. 

“What was really striking to me was the consistently of the decline. . .irrespective of geography,” Sam Khater, chief economist and head of Freddie Mac's Economic and Housing Research division, told the Journal. “It’s all over the U.S. It doesn’t matter where.” 
Indeed, today’s heady conditions set the stage for persistently elevated inflation tomorrow.

Utilizing data from Zillow and Apartment List, Ben Breitholtz, data scientist at Arbor Research, predicts that OER will accelerate to between 4.8% and 6.3% year-over-year by December, equivalent to as many as 1.5 percentage points CPI from that 23.7%-weighted component alone.  

Fannie Mae’s Brescia comes to a similar conclusion. Under the economist’s baseline scenario, the shelter component will add 1.9 percentage points to the index by the second quarter of 2022, nearly accounting for the Federal Reserve’s entire 2% annual inflation target before the other two-thirds of the CPI come into play.   

Then, too, the lagging effects visible in the inflation data can work in the other direction once the boom runs its course.  Thus, while the S&P CoreLogic Case-Shiller 20-City Composite Index rose 105% from January 2000 to April 2006, OER rose only 20.3% over that period.  Over the following six years, the Case Shiller gauge declined by 33.9%, but OER registered an 11.7% increase. 

Transitory is a relative term.   

Stock jockeys enjoyed another euphoric day, as the S&P 500 managed another 100 basis point rally to complete a 3.6% four-day rally to emphatically erase Monday’s large decline and leave the broad index higher by 17.5% year-to-date. Treasurys settled down from their recent volatility with the 10- and 30-year yields holding at 1.28% and 1.92%, respectively. Gold slipped to $1,802 an ounce, WTI rose above $72 a barrel and the VIX pulled back by a modest 3% to finish just above 17. 

- Philip Grant

“Inflation is expected to follow a volatile course in the short term due to various supply and demand factors,” the Central Bank of the Republic of Turkey wrote after last Wednesday’s meeting. The CBRT, which kept rates unchanged for a fourth consecutive month, has endured heavy staff turnover in recent years under the auspices of strongman president and easy money advocate Recep Erdogan, culminating in the March 20 termination of Governor Naci Agbal two days after hiking the key rate to 19% from 17%. Perhaps dissuaded against further tightening, the CBRT last week promised that the future course of inflation “will be monitored closely.” 

There is lots to monitor.  Turkish CPI advanced at a 17.5% annual clip in June, the highest since the bug bit but well below the 25.2% local peak logged in 2018. Meanwhile, inflation has bounded higher at a 13.5% average annual rate since Erdogan tightened his grip on power following a failed coup d’état five years ago, compared to an average 8.1% over the five years through July 2016.  The foreign exchange market takes a dim view of the politically-hobbled CBRT’s ability to tamp down those raging price pressures, as the lira vs. dollar pair remains stuck near a record low exchange rate of 8.57 to the buck. 

The world’s largest miner takes a pause.  This morning, BHP Group announced that it will hold production steady over the next year, projecting between 278 and 288 million tons of iron ore output.  That compares to the 284 million tons of production over the 12 months through June 30 and is slightly below the company’s long-term target of 290 million tons per annum.

A sparse longer-term pipeline further colors that decision, as The Wall Street Journal notes that the company has just two major projects in development and is a minority partner to BP in one of those.  During the commodity price boom of a decade ago, BHP had 18 such ventures in the hopper. 

“Chasing production does not really make sense,” CEO Mike Henry told analysts in March. “The industry has a great track record of being quite pro-cyclical and that has ended in tears all too often.”  That discipline is paying off industrywide, as the world’s top 40 miners will earn $118 billion in net profit this year, nearly double that of 2019, if estimates from PricewaterhouseCoopers are on point.

A similar dynamic is underway among stateside energy majors. In April, Exxon reiterated full-year capex guidance at $16 billion to $19 billion for 2021, down from $21.4 billion last year and some $31 billion in 2019. The oil giant expects that figure to remain at between $20 billion and $25 billion from 2022 to 2025, down from a pre-virus projection of $30 billion to $35 billion in annual capital spending over that period.  Rival Chevron now targets $14 billion to $16 billion in capex through 2025, which is less than half of its spending levels in 2014 when WTI crude hovered near $100 a barrel. 

That belt tightening from major resource producers represents an increasingly stark contrast with other areas of the economy. Callum Thomas, head of research at Topdown Charts, noted in a June 15 blog post that capex among the energy and materials components of the S&P 500 have reached a record low relative to the index as a whole.  At the same time, the tech sector accounted for some 40% of S&P 500 capex, its highest share since at least 1981. 

 
That slimmed-down spending regime from energy and materials producers, Thomas believes, “helps sow the seeds for a sustained bull market in commodity prices.” At the same time, “one can’t help but notice how the record high capex by tech companies seems to echo the same pattern seen during the peak of the dot com bubble.”

The hair-raising rally in Treasurys was dramatically interrupted, as the benchmark 10-year yield turned tail from an intraday low near 1.13% to finish at 1.23%, while the long bond rose to 1.88% from 1.81% yesterday.  Stocks enjoyed a 1.5% gain for the S&P 500 to all but erase yesterday’s losses, while the VIX settled near 20, compared to 18.5 as of Friday’s close.  WTI crude rebounded nearly 2% to $67.5 a barrel, and gold remained in a tight range at $1,811 an ounce. 

- Philip Grant

The Department of Justice has opened a formal investigation into electric truck startup Lordstown Motors Corp. (RIDE on the Nasdaq), the company disclosed in a filing yesterday.  That inquiry follows a pair of subpoenas from the SEC pertaining to its October merger with special purpose acquisition company DiamondPeak Holdings Corp. 

Confusing corporate communications color that development. Back on June 8, Lordstown warned in an amended form 10-K that it was running out of cash and its status as a going concern was increasingly in question. 

Evidently attempting to calm nervous investors, Lordstown president Rich Schmidt declared one week later that the company had an order book that would cover its output for 2021 and 2022, adding that: “I don’t know the exact facts of the legal aspect of that, but they are basically binding orders that are committed here in the last two weeks, reconfirmed orders. They’re pretty solid, and I think that’s on the light side or conservative side.”  Two days later, Lordstown “clarified” in a filing that existing orders “do not represent binding purchase orders or other firm purchase commitments.” RIDE shares are down 57% year-to-date, leaving the pre-revenue firm’s enterprise value at $900 million. 

For more on Lordstown, and the other nine SPAC-related picks-to-not-click comprising the analysis “Short this index,” see the Dec. 25 edition of Grant’s Interest Rate Observer.

A new escalation in China’s crackdown on newly public Didi Chuxing (DIDI on the NYSE):  This morning, seven separate government departments paid the rideshare giant a visit to conduct a cybersecurity review, including the police, primary antitrust regulator and Ministry of State Security. That comes days after the Cyberspace Administration of China accused Didi of improperly collecting user data and two weeks after authorities barred the company from signing up new members and delisted its app. Shares traded lower by 4% in immediate reaction to that bulletin and remain 34% below the intraday peak on its June 30 IPO date.

Of course, today’s developments represent the latest instance of Beijing publicly asserting its dominance over China’s domestic technology champions, a phenomenon which began last fall with a crackdown on Alibaba after co-founder Jack Ma publicly criticized the Communist Party. 

That broadside is making some on Wall Street a little nervous. Goldman Sachs CEO David Solomon lamented in a Tuesday CNBC interview that “a large number of companies that have been planning to come [public in] the U.S. . . [but] because of the actions the Chinese government has taken, I think some of those companies will not come to the market at this point in time. . . I was surprised that this played out the way it did.” 

Lingering Sino-American tensions further complicate the calculus.  The Biden administration yesterday warned U.S. investors that doing business in Hong Kong is an increasingly risky endeavor, as mainland China continues to tighten its grip on the long independent city. “The situation in Hong Kong is deteriorating, and the Chinese government is not keeping its commitment that it made, how it would deal with Hong Kong,” Biden declared at a press conference ahead of the advisory.  

That follows China’s diplomatic snub earlier this week, as the Financial Times reported yesterday that Beijing refused a meeting with deputy secretary of state Wendy Sherman. That would have been the highest level powwow since the two sides endured a frosty summit in Alaska earlier this year. “China’s move is a dangerous one,” Georgetown professor Evan Medeiros told the FT. “It increases distrust, tension and risk of miscalculation during an already-fraught period.”

Investors in the 244 U.S.-listed Chinese American Depository Receipts are perhaps experiencing similar sentiments.  As Bloomberg’s Francis Chan noted Wednesday, those certificates tracking the price of Chinese stocks are off by 30% from their mid-February levels on average. Wall Street pros have taken notice, as China-related fears led investors to “sharply” curtail their exposure to emerging market equities as a category, Bank of America’s Global Fund Manager Survey for July finds. Even some die hard bulls are heading for the hills, as fund manager Cathie Wood cut the allocation to Chinese stocks in her ARK Innovation ETF to less than 1% from 8% five months ago. “From a valuation point of view, these stocks have come down and again from a valuation point of view, probably will remain down,” Wood told to Bloomberg Tuesday.

Yet those developments are of little concern to the throngs of emboldened retail punters. Instead, as animal spirits reign supreme, dip-buyers arrive en masse.  Bloomberg notes that the KraneShares CSI China Internet Fund (KWEB on the NYSE Arca), which is off by 40% from its mid-February highs, attracted a hefty $631 million worth of inflows over the first four days of the week, equivalent to more than 10% of the fund’s total assets. Meanwhile, the number of outstanding call options reached a record high last week, more than double that of puts. “Between all the call buying last Friday and all the inflows this week, it certainly seems like investors are trying to pick a bottom,” noted Chris Murphy, co-head of derivatives strategy at Susquehanna. “Maybe Cathie Wood getting out was the final contra sentiment indicator those investors needed.”

Stocks came under late pressure, with the S&P 500 and Nasdaq 100 each finishing near session lows to wrap up the week with a 1% loss, while Treasurys consolidated their impressive recent gains as the 10- and 30-year yields finished at 1.29% and 1.92%, respectively. The VIX jumped 8% to 18.4, gold pulled back to $1,812 an ounce and WTI crude held near $71 per barrel. 

- Philip Grant

Markets make opinions, crypto edition. Last week, Guggenheim chief investment officer Scott Minerd told CNBC that he believes bitcoin is undergoing a “crash” that could take the price to as low as $15,000.  That’s a stark reversal from late last year, when the digital ducats broke to a then-record high near $21,000 and Minerd concluded that “our fundamental work shows that bitcoin should be worth about $400,000.”

Other Wall Street luminaries are similarly rethinking the digital revolution. For instance, consider the below headline from Decrypt on April 15, two days after bitcoin logged its high-water mark near $63,000:

BlackRock CEO Sings Bitcoin’s Praises as Future ‘Great Asset Class’

That was then. A headline from CoinDesk today, with the price cut nearly in half from three months ago, strikes a different tone: 

BlackRock CEO Larry Fink Says There’s ‘Very Little’ Demand for Crypto

All aboard in the Middle Kingdom:  Foreign investors around the world hold a record $806 billion worth of Chinese assets, the Financial Times reports today. That’s up more than 40% from a year ago.  Bond holdings account for nearly three-quarters of that sizable sum. 

A dovish policy pivot colors that capital influx into the world’s second-largest economy. Last Friday, the People’s Bank of China slashed the reserve ratio requirement, or the amount of cash that banks must hold for a rainy day, by 50 basis points, unleashing some $154 billion in previously dormant cash into the financial system. The PBoC’s move follows months of softer-than expected loan growth and a relatively sluggish pace of money supply expansion. A further 50-basis-point cut is forthcoming later this year, economists surveyed by Reuters yesterday predict. 

“It is a signal, it’s a higher profile message I think, that the authorities are paying attention and alert to the possibility of downside risks,” Andrew Tilton, chief Asia economist at Goldman Sachs, told CNBC Monday. 

Rising distress in the local credit market represents one such pitfall. Some RMB 99 billion ($15.3 billion) worth of onshore bonds defaulted over the first six months of the year, a 35% increase from last year’s pandemic-addled total.  “We expect the number of defaults to jump in the next few months,” Wang Feng, chairman of Shanghai-based Ye Lang Capital, tells the South China Morning Post today. “Real estate companies and some debt-ridden state-owned enterprises are grappling with difficulties in managing their cash flows and are being closely watched.”

Property developer China Evergrande (3333 on the Hang Seng), Asia’s largest issuer of junk bonds and the world’s most-encumbered real estate firm, has earned no small dose of scrutiny. Higher-ups at China’s Financial Stability and Development Committee “urged” Evergrande founder and chairman Hui Ka Yan to “solve his company’s debt problems as quickly as possible,” Bloomberg relayed last week.  The discussed remedies include bringing strategic investors on board to help fortify the company’s shaky financials.   Net debt footed to RMB 570 billion in late June, which is down from RMB 717 billion at year-end but still equivalent to nearly seven times consensus 2021 adjusted Ebitda. The company hopes to trim that burden to RMB 350 billion by mid-2023, as it attempts to reach compliance with regulators’ three red line restrictions governing property sector balance sheets. 

Asset sales represent another avenue toward that goal, though the developer seems less than eager to embrace this strategy.  Evergrande yesterday responded to Chinese social media reports that it will sell property worth billions of dollars to rival firms by telling English language news service Yicai Global that it “reserves the right to hold such rumor spreaders legally accountable.”

Financial engineering, on the other hand, is front and center in the corporate “toolkit.” Bloomberg noted last week that Evergrande has turned to short-term commercial bills (which are not classified as debt securities) to finance itself, with its primary onshore subsidiary owing some $32 billion of those IOU’s as of December. “The amount of Evergrande’s outstanding commercial bills is massive,” Dong Ma, partner at BG Capital, observed. “It has apparently become a vital fundraising channel.”  B2/single-B-plus-rated Evergrande’s dollar-pay, senior-secured 8 3/4% notes due 2025 changed hands today near 65 cents, for a 2,191 basis point spread over Treasurys. A 1,000 basis point pickup typically connotes distress. 

The key question for the bulging ranks of China’s foreign creditors: might Beijing ride to the rescue if Evergrande proved unable to pay its debts?  Last week, a development fund led by the Jiangsu provincial government purchased a 16% stake in e-commerce outfit Suning.com, a subsidiary of conglomerate Suning Appliance.  Suning fell into distress after now deposed co-founder Zhang Jindong waived an RMB 20 billion payment due from Evergrande in September, a move that helped “his friend and Evergrande chairman Hui Ka Yan save his own company,” Bloomberg noted last month.

The transaction is an ominous development, some observers believe. A report from CreditSights last Wednesday argued that, rather than a bailout of existing debt-holders, capital injections of that nature serve to allow “local governments with good financial resources to acquire strategic investments at bargain prices. . . it is worth noting that the Jiangsu government did not directly inject capital into Suning Appliance but only invested in the crown jewel of the company, Suning.com.”  CreditSights also offered the following caveat: “government-backed liquidity assistance typically emerges in the debt restructuring process and might not be timely enough to avoid bond defaults.”

Treasurys continue to evince little concern over recent inflation data, as a strong rally across the curve left the long bond yield at 1.98%, while stocks gave back early gains to finish little changed. Gold rose to a near one-month high at $1,829 an ounce, WTI crude slipped below $73 a barrel and the VIX pulled back to near 16. 

- Philip Grant

“Welcome to the dawn of a new space age,” tweeted Richard Branson yesterday.  The British billionaire’s successful foray into suborbital space yesterday duly stirred animal spirits, as shares in his Virgin Galactic Holdings, Inc. (SPCE on the NYSE) touched a record $59.99 in the pre-market, up more than 150% year-to-date. 

SPCE’s voyage represents a “massive marketing coup,” writes Canaccord Genuity analyst Ken Herbert, a triumph which the company wasted no time in attempting to monetize. Virgin announced in a filing this morning that it will sell up to $500 million worth of common equity through a trio of investment banks, catalyzing a sharp reversal to leave shares south of $41 at the bell, down 18% from Friday’s close.  

Intraday roller-coaster aside, Virgin Galactic, which was at the vanguard of the recent special purpose acquisition company boom with a stock market debut back in October 2019, remains the apple of Mr. Market’s eye. Pre-revenue SPCE, which burned through $240 million of cash over the 12 months through March 31, currently commands a $9.5 billion enterprise value, equivalent to 17 times consensus 2025 revenue and 65 times adjusted Ebitda four years from now. 

Meanwhile, a fellow would-be space explorer and stock promotion expert provided his imprimatur.  The Wall Street Journal reports today that Tesla CEO Elon Musk has purchased a ticket on a future Virgin Galactic voyage. Branson may reciprocate, telling London’s Sunday Times that “Elon’s a friend and maybe I’ll travel on one of his ships one day.” 

High hopes abound as second quarter earnings season gets underway this week.  S&P 500 components will grow their bottom lines by a cool 63.6% from last year’s pandemic-depressed levels, if estimates from FactSet are on point.  That would mark the fastest pace of year-over-year earnings growth since the end of the financial crisis in 2009.  

During the second quarter, Wall Street analysts bumped up their aggregated earnings estimates across the S&P 500 to $45.03 a share from $41.97.  That 7.3% bottom-up estimate increase is the highest since FactSet began tracking the metric in 2002.  On average, analysts have trimmed their bottom-up earnings projections by 4% during each quarter over the past 10 years.  Early indications on that front are validating today’s atypical optimism:  66 S&P 500 companies issued positive earnings guidance relative to expectations this quarter as of July 2, marking the highest such proportion going back to at least 2006. 

Of course, that prospective windfall looks to be thoroughly discounted by eager investors, as the broad equity index has enjoyed a 17% year-to-date advance and sits at nearly double its March 2020 nadir.  The S&P 500 trades at nearly 22 times forward earnings, FactSet notes, well above the five- and 10-year averages of 18.1 and 16.1 times, respectively. 

Recent earnings boom aside, today’s fancy valuations are increasingly divorced from traditional fundamental underpinnings. As Bloomberg’s Cameron Crise has observed, equities derive their value from their net assets and future earnings prospects, as well as a third, vaguer component encompassing the expectations of a better tomorrow. To that point, a chart prepared by Bianco Research president and eponym Jim Bianco last week shows that just 36% of the S&P 500 valuation can be attributed to the index’s current book value and net present value of earnings estimates over the next three years.  The surplus 64% “hopes and dreams” component represents the highest proportion of the S&P 500’s value since 2000. 

 
That Y2K-era analogue should give investors pause, considering the dismal epoch which followed.  Jill Mislinski, research director at Advisor Perspectives, notes today that once the worm turned following the early 2000 market peak, it took the S&P 500 until mid-2007 to briefly reclaim its nominal peak price level. Of course, the financial crisis followed soon thereafter, and the broad index failed to reclaim its 2000 bull market crest again until early 2013.  The tech-heavy Nasdaq didn’t manage to match its March 2000 high water mark until 2015.  Adjusted for inflation, as measured by the CPI, the S&P and Nasdaq remained underwater for 15 and 18 years, respectively, after the tech bubble burst.

Smooth three- and 10-year Treasury auctions headlined a day of gently rising yields, as the 10-year note finished the day at 1.37%, while stocks enjoyed a modest bid with the S&P 500 cruising higher by 35 basis points to log another fresh high.  Gold and WTI crude each edged lower to $1,806 an ounce and $74 a barrel, respectively, and the VIX gave back an early 8% advance to remains near 16 at day’s end. 

- Philip Grant

Keeping the band together: With Fed chair Jay Powell’s four-year term set to expire in less than eight months, a former colleague and Biden administration bigwig likes what she sees. Treasury Secretary Janet Yellen “has told those close to her that she has a good relationship with Powell, and is pleased with how he has steered monetary policy through the pandemic-induced crisis,” Bloomberg reported yesterday.  That support could be crucial for Powell’s prospects of renomination, as alternative candidates more closely “aligned with administration priorities such as inequality and tighter banking regulations” remain under consideration.

While palace intrigue takes center stage in D.C., a seismic policy shift quietly continues as the monetary mandarins reverse one element of the unprecedented stimulus measures launched during last year’s depths.  The New York Fed noted in a statement this morning that it will begin “gradual and orderly” sales from its corporate bond portfolio held under the Secondary Market Corporate Credit Facility, beginning Monday. 

The SMCCF, established on March 23, 2020, accumulated a relatively modest $13.8 billion in corporate bonds and ETFs before the Fed announced the beginning of ETF sales last month (sometimes, it’s the thought that counts). The central bank has set a Dec. 31 deadline for full liquidation of the portfolio. 

Cryptos and blank check firms: a match made in heaven? Fintech concern Circle Internet Financial, Inc., issuer of the USD Coin (USDC), will go public via a merger with Concord Acquisition Corp., Circle announced today.  The entity will be listed on the NYSE under the ticker CRCL upon completion of the deal, at a $4.5 billion valuation.  

Circle, which offers a high-minded mission of “raising global economic prosperity through the frictionless exchange of financial value,” has lofty aspirations to match. The company, issuer of the second-largest stablecoin, or digital currency purportedly backed one-for-one by U.S. dollars, cites a total addressable market of $165 trillion, composed of $130 trillion in global M2 money supply and $35 trillion in global payments.

Of course, pie-in-the-sky financial projections from SPAC-affiliated companies are old hat, a phenomenon that has recently drawn the attention of key regulators (Almost Daily Grant’s, May 19). Circle predicted that assets under management will soar to $190 billion by the end of 2023 from $25.9 billion today. Total revenue will foot to $886 million in 2023, a 177% compound annual growth rate from this year’s projected $115 million top line, while active accounts will jump to above 30,000 in 2023 from 2,786 accounts expected this year, if management projections are on point. 

That breakneck pace of growth will likely translate to a modest bump in its gussied-up bottom line, as adjusted Ebitda would foot to $76 million in 2023, compared to an expected $76 million adjusted Ebitda loss this year. Favorable external forces, rather than rapid growth, may be the ticket to corporate prosprity.  A simultaneous 200 basis point jump in the yield curve next year would equal $940 million in incremental interest income, the company reckons. Such a move in 2023 would spell a $2.22 billion windfall. 

Yet unwelcome regulatory attention could serve to disrupt that stairway to financial Valhalla.  The Internal Revenue Service seeks documentation of customers who have undertaken crypto transactions equivalent to $20,000 or more on the venue between 2016 and 2020, the Department of Justice announced in April.   U.S. District Judge Richard Stearns acceded to the IRS summons, writing that “there is a reasonable basis for believing that cryptocurrency users may have failed to comply with federal tax laws.” 

Legal scrutiny has also served to exacerbate missteps from the c-suite. The company disclosed today that it took a $156.8 million loss stemming from its ill-fated acquisition of crypto exchange Poloniex in early 2018, near the first peak of crypto prices. Beyond a realized loss on the subsequent resale of Poloniex for $33.2 million in 2019, Circle also noted that it has accrued a $10.4 million contingent liability for a Securities and Exchange Commission complaint against Poloniex “with regards to the trading of cryptocurrencies that may be characterized as securities.” Furthermore, Circle estimates that a pair of subpoenas from the Treasury Department’s Office of Foreign Assets Control and an “Iranian government agency” concerning potential sanctions violations will result in further penalties of up to $2.8 million.

Meanwhile, a familiar problem stalks USDC: questions over the composition of assets backing the world’s second-largest stablecoin, just as with its larger peer Tether. CoinDesk columnist JD Koning noted Tuesday, that, as recently as Feb. 28, 2020, Circle held all customer accounts at U.S. banks under the auspices of the Federal Deposit Insurance Corp. In a subsequent attestation a month later, Circle added the category “approved investments,” suggesting that it was branching out into less secure collateral in hopes of generating income as short-term yields collapsed.  That is a particularly significant change considering that USDC issuance has mushroomed by more than 50-fold from the $400 million outstanding in early 2020. Then, too, Koning notes, different state laws allow for sometimes drastically divergent standards in terms of what constitutes approved investment products, leaving outside observers guessing as Circle declines to disclose which state guidelines it follows.

See the brand new edition of Grant’s Interest Rate Observer dated July 9 for more curious doings in crypto. 

The feverish rally in Treasurys put the crimps on stocks today, as the S&P 500 lost nearly 1% to erase its gains for the week as the 10-year yield fell to 1.29% and the long bond to 1.92%.  The VIX advanced to 19, extending to a 26% three-day gain after logging a fresh virus-era low on Friday, while WTI crude bounced back above $73 a barrel and gold held just over $1,800 an ounce.  

- Philip Grant