Almost Daily Grant's
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Saturday, March 23, 2019
Still the smartest guys in the room
From The Wall Street Journal:
From The Wall Street Journal:
Salt in the wound
It’s been a smooth ride for third world debtors,
It’s been a smooth ride for third world debtors,
Recap March 22
Still the smartest guys in the room
From The Wall Street Journal:
Former Enron Corp. Chief Executive Jeffrey Skilling is looking to get back into the energy business, with a little help from his friends.
Just weeks after serving more than 12 years in federal custody on fraud, conspiracy and insider-trading convictions following Enron’s fall, Mr. Skilling has been holding meetings with former Enron executives and others, hoping to win backing for a new energy venture, people familiar with the matter said.
At least one former colleague has agreed to support Mr. Skilling’s comeback attempt: Lou L. Pai, the onetime head of Enron’s energy-services unit, has pledged to invest in the venture and indicated to others he is involved with Mr. Skilling, the people said.
Mr. Skilling has met with individuals who specialize in cryptocurrency, blockchain and software development in recent weeks, two of the people said.
Salt in the wound
It’s been a smooth ride for third world debtors, as the iShares J.P. Morgan U.S. Dollar Bond ETF reached a 10-month high Wednesday despite the Dollar Index remaining in the upper end of its 52-week range. Yet Turkey and Argentina, the largest and sixth-largest weightings in the index, respectively, are back in the soup.
Yesterday’s reading of Argentina’s fourth quarter GDP registered an alarming 6.2% year-over-year decline; the worst reading since 2009. As output goes into reverse, inflation accelerates. February CPI rose a whopping 51.28% year-over-year, more than double the 25.44% CPI reading logged in February 2018.
Those grim figures are spurring the government into action. Yesterday, the Central Bank of Argentina raised the policy rate by 87 basis points to 65.76%. On Wednesday, Bloomberg reported that the central bank asked Argentinian bank treasurers to raise their deposit rates, as the 30-day Badlar savings rate of 42.06% lags well behind both the overnight rate and the measured rate of inflation.
Meanwhile, the Argentina single-B-rated, dollar-pay 7 1/8 century bonds due 2117 trade at 75 cents on the dollar (they were issued at 90 cents), for a yield-to-worst of 9.52%. That’s off from the 80 cents seen in early February but above the sub-70 cent lows logged in December.
A relatively strong FX reserve position burnishes the bull case. Argentina’s central bank reported $68.2 billion in international reserves as of yesterday, the highest in at least five years and compared to less than $50 billion three months ago, while the country reached an agreement with the IMF Monday for an additional $10.9 billion in funding. The inviting yield and bountiful reserves aside, history isn’t exactly on the side of the creditors: The Land of Silver has defaulted on its international obligations on eight separate occasions in less than 200 years of modern history (Almost Daily Grant’s, June 19, 2017).
Trouble is likewise reappearing in Turkey. As the lira came under heavy pressure against the dollar this morning, the Central Bank of the Republic of Turkey announced that “considering the developments in financial markets,” it will suspend one-week lira repurchase auctions “for a period of time.” That move did little to stem the lira rout, as the Turkish currency fell more than 6% against the dollar to 5.81, the weakest level since October.
The developments in Turkey’s economy have likewise been grim. Inflation is heating up, with CPI rising 18.7% year-over-year in February, while GDP contracted 3% year-over-year in the fourth quarter. Turkish citizens are hoarding dollars, with central bank data showing that foreign currency holdings among residents rose to a record $175.8 billion as of March 15, up $4 billion in a week.
That rush out of liras is taking a toll. The Turkish central bank reported yesterday that international reserves fell to $28.5 billion as of March 15, down $6.3 billion in the first two weeks of the month. Henrik Gullberg, strategist at Nomura plc. in London, told Bloomberg that there’s only one reasonable explanation for that decline: “Since external debt payments can’t explain the decline in reserves, markets are assuming there is intervention going on.”
The lira’s sharp slide is putting the squeeze to those who borrowed in dollars. The Turkish government dollar-pay 5 3/4s of 2047, issued in May 2017 at 98.25, traded at 77.86 at midday for a yield-to-worst of 7.66%. On the corporate front, Bloomberg reported Wednesday that Turkish conglomerate Dogus Holding A.S., owner of the Nusr-Et steakhouses featuring celebrity chef Nusret Gökce (a.k.a. “Salt Bae”) is struggling to repay its obligations despite restructuring $2.5 billion in debt in December. The company, which has been selling assets, reported TRY 28.6 billion ($4.92) in liabilities at year-end, up 17% year-over-year.
Thanks, but do you have any pepper? “Salt bae” in action.
Two emerging market mainstays may be on the rocks, but hope springs eternal. Today, the Financial Times reports that single-B-rated Ghana’s $3 billion debt sale attracted a whopping $21 billion order book, allowing the West African nation to cut the yield on its 31-year bond to 8.95% from an expected 9.5%. After the rousing success of that sale, Ghana’s deputy finance minister Charles Adu Boahen is thinking big: “I think right now a 50-year bond is very possible but the question is at what price. This is a market-sounding exercise and there’s encouraging appetite.”
Recap March 22
Risk off, bigly. The three-month vs. 10-year Treasury spread inverted today for the first time since 2007, sending a historically unmistakable recession signal (if the inversion remains for 10 days, that is), and triggering a massive rally across the yield curve as the 10-year fell 10 basis points to 2.41%.
Stocks were hammered, with the S&P 500 losing 1.7% and the small-cap Russell 2000 suffering a 3.6% swan-dive. The VIX raced higher by 23% to 16.75, the most elevated weekly close since January. Gold bucked largely bearish commodity action to edge higher by $4 to $1,313 an ounce.
- Philip Grant
Thursday, March 21, 2019
You're un-fired
Yesterday’s Fed meeting featured a dovish trifecta.
Yesterday’s Fed meeting featured a dovish trifecta.
Canada goosed
Things are no great shakes in the Great White North.
Things are no great shakes in the Great White North.
QT Progress report
Recap March 21
You're un-fired
Yesterday’s Fed meeting featured a dovish trifecta. The central bank cut its view of 2019 U.S. economic growth, announced the end to “QT” balance sheet runoff in September and suggested that the tightening cycle underway since late 2015 would be put on ice “for some time,” leaving the overnight Fed Funds Rate in a 2.25% to 2.5% range.
This is a big shift from just three months ago when Chairman Jerome Powell proclaimed that “we have a strong forecast for 2019” and to expect “some further gradual [rate] increases” this year. Of QT, Powell remarked: “I think that the runoff of the balance sheet has been smooth and has served its purpose and I don’t see us changing that.” Two days later, Bloomberg reported that President Trump “has discussed firing” the Fed chairman. We can surmise that those discussions have abated in the interim.
Anyway, interest rates swiftly adjusted to the Fed’s new tack. Yields dove across the curve, with the seven-year note trading as low as 2.38% this morning, well below the 2.41% effective Fed funds rate. In addition, the gap between the three-month Treasury bill and the 10-year note flattened to as little as three basis points this morning, the narrowest differential in nearly 12 years.
The spread between the 10-year and three-month yields is an important indicator, James Bianco, president and eponym of Bianco Research LLC notes today. On six occasions over the past 50 years when the three-month yield exceeded that of the 10-year, economic recession invariably followed, commencing an average of 311 days after the initial signal. Bianco concludes that the market, like Trump, believes that the current Funds rate isn’t low enough:
While Powell stressed over and over that the Fed is at “neutral,” . . . the market is saying the rate hike cycle ended last December and the economy will weaken enough for the Fed to see a reason to cut in less than a year.
Canada goosed
Things are no great shakes in the Great White North. After reviewing the latest fiscal budget released yesterday, Fitch Ratings this morning commented that Canada’s gross government debt load “is higher than other triple-A-rated sovereigns, excepting the U.S., and remains close to a level that is incompatible with triple-A status.”
As a spendthrift government spurs rating agency-angst, the Canadian yield curve augurs a different kind of trouble. Today, the Canadian 10-year yield trades at 1.68%, down from 2.6% in the fall and well below the Bank of Canada’s 1.75% overnight funds rate.
Meanwhile, the correction in Canada’s long-running housing bubble continues apace: Statistics Canada reported last week that the new home price index saw its first year-over-year decline since 2009 in January (see the March 5 Almost Daily Grant’s for more).
That news augurs poorly, according to Steve Eisman, portfolio manager at Neuberger Berman who famously shorted mortgage-backed securities in the run-up to the U.S. housing bust and financial crisis. In an interview today in the Financial Times, Eisman reiterated he is short various Canadian banks. While not calling for an outright housing collapse, the manager believes that “a simple normalization of credit that hasn’t happened in 20 years” is nigh.
QT Progress report
An $8.2 sequential decline in mortgage-backed securities left the Fed’s portfolio of securities held outright at $3.78 trillion. That’s down $13.1 billion from the trailing four-week average.
Since the Oct. 1, 2017 onset of QT, total balance sheet assets are down by 11.1%, a 7.6% simple annualized pace.
Recap March 21
No slowdown here. Stocks ripped higher with the S&P 500 gaining more than 1% to finish at its best level since Oct. 10, as tech led the way with a 2.5% advance and a 3.5% gain in the Philadelphia Semiconductor Index to a record close. Treasury yields finished mostly higher after yesterday’s aggressive rally, though the long bond rallied to leave the 30-year yield at 2.96%.
The greenback staged a nice recovery, as the Dollar Index jumped nearly 1% to recoup all of yesterday’s losses. Commodities held up pretty well considering, with the CRB Index losing only 0.1% while gold and WTI crude held near $1,310 an ounce and $60 a barrel, respectively.
- Philip Grant
Tuesday, March 19, 2019
Lyfted
From Reuters:
Lyft, Inc.’s initial public offering is oversubscribed based on commitments made so far by investors, making it more likely that the ride-hailing startup will fetch or even exceed the $23 billion valuation it is seeking, people familiar with the matter said on Tuesday.
The roadshow began yesterday.
Our man in Rio
“Waste places” no more? Emerging market equities have fared well of late, with the MSCI Emerging Market Index rising 14% from its late October lows as the Fed has backed off its rate hike regime and hinted at an imminent end to the QT balance sheet runoff program.
If market expectations are on the beam, more good tidings could be on the way for EMs. According to the latest Bank of America Merrill Lynch Investor Survey, a net 50% of respondents believe the dollar is overvalued, a 16-year high. A weaker greenback of course allows smaller countries to more easily service their largely dollar-denominated debt loads.
Brazil, the fifth-largest constituent in the MSCI gauge, has been at the forefront of the recent bull move. After suffering a 28% dollar-denominated decline from January to September of last year, the benchmark Ibovespa Index has since risen by 48% in dollar terms (when now-President Jair Bolsonaro pulled into the campaign lead shortly after being stabbed), taking the benchmark index above the 100,000 level for the first time yesterday.
There’s more where that came from, according to Bernd Berg, strategist at Woodman Asset Management who anticipated both the real (Brazil’s local currency) selloff of 2015 and asset price rally last fall: “The Brazilian stock rally should accelerate this summer. Pension reform would be a major boost and fresh impetus for a second leg of gains.” Berg sees the Ibovespa rising to 150,000 by the end of next year.
Beyond the possibility of pension reform, bulls can point to the relatively low cost of money, as the benchmark SELIC interest rate remains at a record-low 6.5%, down from 13.75% as recently as January 2017 (the Brazilian Central Bank is expected to leave rates unchanged at tomorrow’s meeting). Inflation remains relatively subdued despite a recent uptick, with the CPI up 3.89% year-over-year in February, well below the 6.17% five-year average reading.
Meanwhile, Brazil looks to solidify economic ties with world powers. Bolsonaro is in the U.S. to meet with Donald Trump today after visiting CIA headquarters on Monday, while economy minister Paulo Guedes told reporters that commerce secretary Wilbur Ross has agreed to visit Brazil, the first such trip in 10 years. That’s not to say the Brazilians are putting all their eggs in a red, white and blue basket. The University of Chicago-educated Guedes said of economic ties with the world’s second-largest economy: “We are dancing with the Chinese, and they dance well.”
But faltering growth presents a risk to the bull case. Yesterday’s release of the IBC-Br Economic Activity Index fell 0.41% on a sequential basis, far worse than the expected 0.1% decline and the third month-over-month drop in the last five readings. On Friday, analysts surveyed by the central bank cut their 2019 GDP growth forecast to 2.01% from 2.28% on March 8 and 2.49% one month ago, while local brokerage XP Securities LLC slashed its own estimated growth level to 1.5% from 2%, noting that “it’s entirely plausible to see 2019 GDP below that” lowered 1.5% figure. Hopes for a growth pickup are abating, says XP, “as cries of a confidence-led expansion get drowned in a sea of poor economic data this quarter.” Declining GDP expectations match last year’s pattern, when the Central Bank-surveyed analysts predicted 2.6% real growth at the outset of the year. Actual 2018 output growth footed to 1.1%.
Then there’s pension reform, crucial to both stabilizing Brazil’s shaky fiscal position as well as bulls’ hopes for higher asset prices. A report from Fitch Ratings on Thursday argues that the measures “will face significant legislative hurdles and is likely to under-deliver on market expectations for long-term fiscal savings.” Analysts at XP also argue that passage will be more drawn out than investors might hope:
Success in the House will not depend on just one vote session, but on successive rounds in which, after the basic text, re¬presentatives will vote on the so-called highlights, themes that will be separated from the rest of the proposal, so they can be voted on individually. This series of voting sessions will be the most critical moments, real tests of strength and en-durance for the negotiating skills of Bol¬sonaro’s government.
It is for this exact reason that we assert that this short proceeding heralded by the government is too optimistic.
An analysis in the Jan. 12, 2018 edition of Grant’s contended that the strong post-2016 rally in Brazilian asset prices, in tandem with rising deficits and limited political will for pension reform, left both local equities and the real vulnerable to a tumble.
An Oct. 5 follow-up said of Bolsonaro and socialist opponent Fernando Haddad: “The question is not, ‘Which of the two candidates is more bullish?’ but rather, ‘Who’s the less bearish?’” One thing’s for sure, policy success is more priced-in than it was six months ago.
Recap March 19
Stocks gave back early gains to leave the S&P 500 unchanged on the day, while Treasury yields ticked slightly higher across the board with the 10-year settling at 2.61%. Modest dollar weakness helped the CRB Index edge into the green, and the VIX closed at 13.56, a one-week high.
- Philip Grant
Monday, March 18, 2019
If you build it they will come?
From The Wall Street Journal:
From The Wall Street Journal:
Racing to a red light
This morning, Lyft, Inc. took another step
This morning, Lyft, Inc. took another step
Recap March 18
If you build it they will come?
From The Wall Street Journal:
The first U.S. exchange company to launch bitcoin futures has pulled the plug on them, the latest sign that mainstream financial firms are losing their enthusiasm for cryptocurrencies.
Cboe Global Markets, Inc. said in a notice to traders last week that it “does not currently intend to list additional XBT futures contracts for trading.” XBT is the symbol for the bitcoin futures listed by Cboe.
Racing to a red light
This morning, Lyft, Inc. took another step towards an initial public offering, disclosing in an amended SEC form S-1 that it will offer 30.8 million shares at a price of between $62 and $68 per share. If priced at the high end of that range, Lyft will garner a total valuation of between $21 billion and $23 billion, according to a Bloomberg report citing a company source.
Projected to debut in the second quarter, Lyft is on pace to beat its fellow ride-share unicorn Uber Technologies, Inc. to the public markets, with Uber expected to file its own IPO paperwork some time in April according to Bloomberg. As Reuters noted on Thursday, being first to market is important to Lyft, as Uber is expected to garner a valuation of as much as $120 billion according to investment bankers, potentially crowding out its smaller rival.
Upstart Lyft’s brisk domestic growth will underpin its marketing strategy to investors, as U.S. market share rose to 39% at year-end 2018, up from 22% in 2016. The company will also emphasize its profile as a pure play on the ride share market, in contrast with Uber, which “plans to portray itself as a global logistics and mobility platform, and will spend less time on metrics specific to its core ride-hailing business,” per Reuters. Back in the fall, Uber CEO Dara Khosrowshahi drew a parallel between his company and Jeff Bezos’ behemoth, telling the Financial Times that “[C]ars are to us what books were to Amazon.” On that score, Khosrowshahi has his work cut out for him.
The Nov. 2 edition of Grant’s included an analysis of just why Uber’s Amazonian ambitions seem far-fetched: Primarily, a lack of profits. Last year, as Lyft’s revenues doubled to $2.2 billion from $1.1 billion, net losses on an adjusted EBITDA basis grew by 36% to $943 million. Uber, which last year generated 43% year-over-year revenue growth and an $11.3 billion top line, reported negative $1.8 billion in adjusted EBITDA, an improvement from the $2.2 billion adjusted EBITDA shortfall in 2017.
Might the passage of time allow the pair to eventually transition into the black? Writing in the Naked Capitalism blog on March 5 following the release of Lyft’s original S-1 filing, transportation expert Hubert Horan concludes that the filing documents provide little comfort:
Lyft’s prospectus provides absolutely no data demonstrating that it has the ability to profitably raise prices over time, increase operational efficiency or win significantly greater market share. It cites “growing the rider base” as the first plank of its future growth strategy, but provides no data showing what it thinks its current share of the market is, no estimates of future aggregate market growth, no evidence of what might drive that growth, and no explanation of what its future growth potential might be. Lyft makes no attempt to lay out a possible path to future profitability, or even a timeline as to when breakeven might be achieved.
With profitability a far-flung hope, the ride-share companies are getting creative. Lyft’s S-1 notes that the company utilizes a bespoke metric called “contribution.” Yes, contribution. Contribution is intended “to evaluate the effectiveness of our business strategies, and to communicate with our board of directors concerning our financial performance.” Unsurprisingly, the results are flattering. The contribution line-item showed a $920 million gain last year, compared to the $943 million adjusted EBITDA loss.
In a Breakingviews post Friday, columnist Richard Beales wrote of that newfound accounting innovation: “It’s a metric that’s supposed to represent a steady-state level of profitability, excluding the costs associated with growth.” But, of course, growth is what investors are paying for. The prospective valuation represents “the kind of eye-watering multiple of sales that only rapidly expanding companies attract. Switching off growth in the foreseeable future, even in return for profit, would knock that down sharply."
As the pair’s IPO preparations continue, one major Uber investor is looking to ensure that things go smoothly. On Wednesday, The Wall Street Journal reported that a SoftBank Group-led consortium “is in late-stage talks to invest $1 billion or more into Uber’s self-driving unit. . . a move that would help the ride-hailing firm bolster its pitch to investors.” Lyft looks to be following a similar script in hopes of showing a good top line this quarter. Recently, some users have received email promotions offering discounts of as much as 50% for 10 rides.
Recap March 18
Another solid day for stocks saw the S&P 500 extend its year-to-date-gains to 13%, as a 1% rip in the Dow Transport Index helped offset a red finish in the tech-heavy NYSE FANG+ Index. Commodities remained strong with the CRB Index making its best close since late November and WTI crude rising to $59 a barrel. Treasury yields rose across the curve with the 10-year ticking back above 2.6%.
- Philip Grant
Friday, March 15, 2019
There's one for you, 19 for me
On Tuesday evening, beauty products company Coty, Inc. (COTY on the NYSE)
On Tuesday evening, beauty products company Coty, Inc. (COTY on the NYSE)
Patch work
The Organization of the Petroleum Exporting Countries struck a vigilant
The Organization of the Petroleum Exporting Countries struck a vigilant
Recap March 15
There's one for you, 19 for me
On Tuesday evening, beauty products company Coty, Inc. (COTY on the NYSE) issued an alarming press release: “After a periodic review of our tax books and records, Coty now estimates that our pending March 15, 2019 dividend will be classified as a taxable dividend.” What’s more, six prior quarterly dividends paid out since Sept. 14, 2017 that had been designated as tax-free returns of capital have been reclassified as taxable dividends.
COTY shareholders have been inconvenienced but may not mind too much. Shares rose by 1% the day after the disclosure, and are up a cool 67% year-to-date. The short interest stands at just over 15% of the float, according to Bloomberg.
Patch work
The Organization of the Petroleum Exporting Countries struck a vigilant tone in its monthly report released yesterday. Noting a combination of softer-than expected global demand and an uptick in anticipated non-OPEC supply, the cartel urged its members to stick to their quotas: “This highlights the continued shared responsibility of all participating producing countries to avoid a relapse of the imbalance and continue to support oil-market stability in 2019.”
Recent fundamental trends help explain the producers’ concern. The International Energy Agency estimates world oil demand at 99.8 million barrels per day (mbpd) as of Jan. 31, up from 98.8 million year-over-year. Supply growth has outpaced that, reaching 100.4 mbpd at the end of January, up from 97.6 million in the first month of 2018.
Yet energy prices have enjoyed a solid rebound, recouping nearly half of the plunge seen in the fourth quarter with West Texas Intermediate crude rising 27% this year to $58 a barrel.
The OPEC (and Russian) supply cuts agreed to in December, in tandem with involuntary, politically-driven Venezuelan export declines, have already made an impact. Total OPEC production footed to 30.5 mbpd as of Feb. 28, down from over 33 mbpd as recently as November. Stateside, production growth continues apace, standing at a near-record 12 mbpd as of March 8, according to the Department of Energy. But the increased production hasn’t translated into much excess supply: U.S. inventories stand at 44.9 million barrels, just over the five-year average of 43.9 million.
Meanwhile, the Kingdom of Saudi Arabia, OPEC’s biggest swing producer, has slashed production to 10.1 mbpd in February from 11.1 mbpd three months ago. The Saudis were whipsawed last fall by President Trump’s decision to issue broad waivers to previously announced Iranian sanctions, leaving the market in oversupply. Mohammad Darwazah, director at Medley Global Advisors, tells Bloomberg that the Saudis are now less inclined to listen to Trump’s exhortations for lower prices: “We’re going to see quite a different Saudi Arabia maybe than what we saw in the fall. I don’t think they’re going to be as accommodative.”
Domestic demand has been solid. Colin Fenton, managing partner at BlackLight Research LLC, notes in a report Monday that the crucial PADD 3 region covering the U.S. Gulf Coast saw runs (meaning refiner demand) at 8.6 mbpd in the week ending March 1, “916,000 bpd above the cyclical average, by our math.” The Midwest PADD 2 region saw 3.5 mbpd that same week, 54,000 bpd above Blacklight’s cyclical average.
More broadly, there is good reason to expect that the IEA’s demand forecast of 100.6 mbpd in 2019 will be upgraded. “Please remember that the IEA has now revised its demand projection higher in seven of the last eight years, by 1.2 mbpd on average,” notes Leigh Goehring and Adam Rozencwajg, the eponyms of natural resource investment firm Goehring and Rozencwajg Associates. The pair “don’t expect 2019 to be any different.”
Grant’s, continuing to cast our analytical lot with BlackLight, Goehring and Rozencwajg in a bullish stance on energy prices, last fall identified a quartet of cheap companies that, we believe, offer attractive investment propositions. For more, see the Nov. 30 issue.
Recap March 15
Another strong day in stocks wrapped up a great week for the bulls, as the S&P 500 rose nearly 3% to close to within 4% of the all-time highs reached Sept. 20. By comparison, the tech- and momentum-heavy NYSE FANG+ Index sits 15% below its June high water mark.
Elsewhere, a weaker dollar helped commodities erase early losses, while Treasurys rallied again with the 10-year yield falling to 2.58%, its lowest in ten weeks. The VIX fell for a fourth time in five tries for its first sub-13 finish since October.
- Philip Grant
Thursday, March 14, 2019
All politics are local
From the New York Post:
From the New York Post:
Tethered to what again?
A report today from Frances Coppola of Forbes identifies a subtle,
A report today from Frances Coppola of Forbes identifies a subtle,
QT Progress report
Recap March 14
All politics are local
From the New York Post:
The new honorary mayor of Fair Haven, Vermont — a 3-year-old goat named Lincoln — was officially sworn into office this week. Lincoln was dressed in a sash reading “Mayor” for the Tuesday ceremony at the Fair Haven town offices.
Fair Haven, a town of about 2,500 along the border with New York just west of Rutland, does not have an actual mayor. Town Manager Joseph Gunter says the honorary pet mayor idea was conceived as a fundraiser for a playground, but it turned into a civics lesson for kids.
On the way out of the office, the honorary mayor defecated on the floor — leaving clean-up to the police chief and other attendees.
Tethered to what again?
A report today from Frances Coppola of Forbes identifies a subtle, yet significant, development in the Tether cryptocurrency saga. Tether, which has long claimed to be backed on a one-for-one basis with U.S. dollars, is a crucial mechanism for the easy conversion of fiat currency to cryptos and back again, as digital exchanges do not have access to the U.S. banking system. The purportedly dollar-backed crypto was part of a skeptical Grant’s analysis in the Sept. 8, 2017 edition subheadlined: “Tethered to what?”
As noted by Coppola, seemingly minor recent changes to language on the Tether website could carry major implications for the crypto realm. Whereas the front page had claimed that the company’s reserves were “subject to frequent professional audits,” that language was subsequently switched to “professional verifications.” A second revision removed any reference to outside oversight, instead telling website visitors that “reserve holdings are published daily” and that “all tethers in circulation always match our reserves.”
In addition, the site had claimed that tethers were “always backed one-to-one, by traditional currency held in our reserves.” An addendum, which appeared to take place on Feb. 26 (found using the Internet Archive’s “Wayback Machine”), now broadens the definition of “100% backed” to cover not only currency and cash equivalents but potentially also “other assets and receivables from loans made by Tether to third parties, which may include affiliated entities.”
As Tether gives itself rhetorical breathing room, a Silicon Valley heavyweight lurks. In December, Bloomberg reported that Facebook, Inc. (FB on the Nasdaq) is working to launch its own “stablecoin,” or dollar-backed crypto, that will allow users to transfer funds via the WhatsApp encrypted messaging service.
That potential development is rife with possibility. Barclays analyst Ross Sandler estimated in a report Monday that such a foray into payments could translate into as much as $19 billion in revenue, with a $3 billion top-line boost as the base case (for reference, FB reported $55.8 billion in revenue for 2018). Sandler believes that “merely establishing this revenue stream starts to change the story for Facebook shares in our view.”
One potential problem with this scenario: Cryptos are something of a regulatory black hole, with anti-money laundering and “know your customer” regulations likely factoring in to Wells Fargo’s spring 2017 decision to cut ties with exchange Bitfinex and Tether (the two companies share a management team). Such stablecoins present even greater risk, as the dollar link provides regulators even more incentive to investigate potential violations. Were such “Facebookcoins” (or, perhaps, “Zuckerbucks”) found to be used for nefarious purposes such as terrorism, money laundering or disguised campaign funding, the political target on Facebook’s back would grow even larger.
QT Progress report
No change this week, as the Fed’s portfolio of securities outright holds at $3.786 trillion, with Treasurys accounting for just under 58% of the total, unchanged from six weeks ago.
Since the Oct. 1, 2017 commencement of QT, the Fed’s total balance sheet assets are down by 10.9%, for a 7.6% simple annualized pace of decline.
Recap March 14
Stocks drifted sideways, with the S&P 500 consolidating its steep rally to remain in the green by 2.5% for the week. The dollar caught a bid and commodities finished flat, with WTI crude advancing to $58.50 a barrel while gold tumbled back below $1,300 an ounce. Treasury yields generally finished little changed, though strength at the front end and softness in longer issues left the curve a bit steeper. The VIX fell to 13.27, its lowest close since Oct. 3.
After the close, Facebook announced that Christopher Cox, chief product officer since 2014 is leaving the company. FB shares ticked lower by 1.7% in extended hours trading.
- Philip Grant
Wednesday, March 13, 2019
Patent pending
A new chapter in financial innovation.
A new chapter in financial innovation.
Arc of the covenant
An analysis from S&P’s LCD unit yesterday calculated
An analysis from S&P’s LCD unit yesterday calculated
Recap March 13
Patent pending
A new chapter in financial innovation. From Barron’s yesterday:
Salt Financial, an exchange-traded fund shop with less than two years under its belt, filed on Tuesday to launch an ETF that will actually pay investors for investing in it, at least at the start. The negative-fee ETF is finally here, making online lender Social Financial or SoFi’s zero-fee ETFs old news.
Like SoFi’s zero-fee ETFs, Salt’s ETF will effectively zero out the cost and then some via what is called a management fee waiver. Salt’s investment advisor has pledged to add 0.05% [five basis points] of assets to the ETF, but only on the first $100 million in assets or until April 30, 2020. Once the ETF crosses that level or hits that date, it will charge its true fee of 29 basis points.
Negative-fee investment products may be the hot new thing, but a more familiar, if equally confounding, phenomenon persists: Lenders paying borrowers for taking their money. After falling below $6 trillion last year, the Bloomberg Barclays Global Aggregate Negative Yielding Debt Index has seen its market capitalization jump back above $9 trillion. On the authority of Sidney Homer and Richard Sylla, negative interest rates had not been seen in substantial size during 3,000 years of financial history prior to this cycle.
Market cap of the Bloomberg Barclays Global Aggregate Negative Yielding Debt Index. Source: The Bloomberg
Arc of the covenant
An analysis from S&P’s LCD unit yesterday calculated that the trailing 12-month default rate for leveraged loans has fallen to just 0.93%, down from 1.62% in February and from a long-term average of 3.1%. The sharp sequential decline is the result of iHeartMedia, Inc., which defaulted last March, being removed from the trailing 12-month calculation.
The low default rate provides another enticement to lend and borrow. LCD reports that institutional loans outstanding in the U.S. now total a record $1.17 trillion, up from $1 trillion last May. Across the U.S. and Europe, total term loans outstanding have doubled in the last 10 years to $2.65 trillion, according to the Bank for International Settlements.
That breakneck growth pace is making regulators nervous. Last Thursday, the Financial Times reported that the Financial Stability Board is investigating components of the leveraged loan market, particularly the practice of bundling loans into collateralized loan obligations (according to LCD, CLOs now account for 50% to 60% of U.S. leveraged loans). On Feb. 28, Bloomberg reported that Japan’s Financial Services Agency has been questioning local lenders about their CLO concentration, particularly Norinchukin Bank, which itself holds a nearly $62 billion CLO portfolio (roughly 9% of global supply) and bought one-third of all U.S. and European issuance in the fourth quarter (Almost Daily Grant’s, Feb. 21).
A Sept. 7 cautionary Grant’s CLO analysis, noting that the securities are divided into tranches based on risk profile and recovery potential, called attention to the acute cyclical risks that reside in the lower-rated and higher-yielding tranches:
It’s not quite true that a CLO is only as good as its loans. What is true is that a portion of a CLO is only as good as its loans, that portion being the junior one, equity and mezzanine debt. Deterioration in the quality of late-boom debt puts those segments at risk.
Late-boom conditions are on full display. Yesterday brought word that Moody’s covenant quality indicator reached a record-worst in February, eclipsing the prior nadir set in August 2015. The deterioration is comprehensive, as the agency notes that “weak covenant packages are clearing the market in all rating categories.”
Meanwhile, high profile deals continue to push the envelope. Yesterday, Bloomberg reported that a $10 billion loan and bond syndication financing Brookfield Asset Management, Inc. and Caisse de dépôt et placement du Québec’s leveraged buyout of Johnson Controls International plc is attracting strong bidding interest, “even after Xtract Research categorized its covenants, terms that protect investors, as some of the weakest and ‘most aggressive’ the firm’s analysts have seen.” Yield indications are now below initial guidance, even though some investors “had balked in particular at terms related to how easily the company can pay itself dividends.”
Recap March 13
Another solid rally in stocks pushed the S&P 500 to its best close since Nov. 7, up 12% year-to-date. Commodities fared even better, with the broad CRB ripping more than 1.1%, as WTI crude and gold rose to finish above $58 a barrel and $1,310 an ounce, respectively. Treasury yields rose slightly to snap the recent rally, while high yield was bid with equities and investment grade trading a bit lower with rates.
- Philip Grant
Tuesday, March 12, 2019
Drumroll
Confusion reigns down Mexico way. This morning, deputy finance minister Arturo Herrera told the Financial Times that the MXN 48 billion ($2.5 billion) Dos Bocas oil refinery project would be put on hold, instead using those funds to help state-owned Petroleos Mexicanos (Pemex) burnish its long-flagging oil production. But president Andrés Manuel López Obrador (AMLO for short) contradicted that assertion just hours later, stating that the refinery project will move ahead as planned. That proclamation helped spur a whipsaw in the Mexican peso, which had rallied nearly 1% against the greenback following Herrera’s claim in the FT.
Communication breakdowns aside, the Mexican government has loosened the purse strings to aid Pemex. On Feb. 15, AMLO announced a MXN 107 billion ($5.5 billion) bailout package, including tax relief and $1.3 billion in direct recapitalization to the state-owned enterprise, promising that “if more is needed, we’ll allocate more funds.” More state monies are likely on the way, according to remarks from finance minister Carlos Urzua on Friday, although he noted the timeline remains fluid: “I think in March. We still don’t know exactly.”
One thing’s for sure – Pemex can use the help. Between 2008 and 2017, the company spent $77.4 billion more on capital expenditures than it generated in cash flow from operations (non-Spanish speakers looking for full 2018 results are hindered by the non-working condition of the company’s English-language website). Meanwhile, production remains in persistent decline, with output falling to a record low 1.62 million barrels per day in January, less than half of the 3.4 million barrels per day peak achieved in 2004.
While production shrinks and losses mount, the debt pile keeps growing, with total borrowings at $106 billion on top of $66 billion in pension liabilities. The rating agencies are concerned: Fitch issued a two-notch ratings downgrade, to triple-B-minus (one notch above junk) on Jan. 29. S&P cited the oil giant’s precarious finances as rationale for lowering Mexico’s sovereign rating outlook to negative on March 1, noting the “added burden” placed on Pemex by AMLOs populist energy policies that include the planned Dos Bocas refinery discussed today. In a Feb. 29 report, Moody’s called attention to the implications of Pemex’s struggles on Mexico’s sovereign credit profile: “If market sentiment does not improve, Pemex will require additional sovereign support in 2020 and beyond, further eroding government finances.”
By way of response, the president placed the blame on past administrations, complaining that the rating agencies “are punishing the country for the neoliberal policies implemented over the last 36 years, which were a total failure. Especially the last few years [predecessor Enrique Peña Nieto opened the oil and gas industry to private exploration in 2014].” On the bright side, AMLO continues to enjoy popular support, with a Reforma poll of 1,500 adults conducted between Feb. 28 and March 6 finding that 78% of respondents approve his performance.
But will investors share that enthusiasm? Following the February bailout, Fitch noted that that $5.5 billion bailout falls well short of the agencies’ estimated $12 billion to $17 billion of annual cash requirements needed to arrest production declines and pay down debt. Shamaila Khan, head of emerging markets at AllianceBernstein tells the FT that: “I don’t think Pemex can cling to investment grade much longer unless the government takes drastic action – and the government thinks it is taking drastic action. That’s what’s concerning.”
Grant’s issued its own bearish verdict on Pemex and Mexican sovereign credit in the March 23, 2018 edition, noting the not-insubstantial risk that the flagging oil company’s debts may one day become the liabilities of the government. That analysis included a blunt assessment from John Padilla, partner and managing director of energy consulting firm IPD Latin America: “Pemex, in any private sector context, would absolutely be considered bankrupt.”
The bond market is still optimistic, as the senior unsecured 4 7/8% notes due 2024 trade at 97.25 cents on the dollar to yield 5.53% a 312 basis point premium over Treasurys. That’s down from 101 to yield 4.7% and 199 basis point pickup last year, but well above the recent trading lows of 92 cents on the dollar reached last fall. Longer-term credits have reacted a bit more, with the senior unsecured 6 3/4% notes of 2047 now trading just below 91 cents on the dollar, down from 99 last March.
Recap March 12
Stocks built off yesterday’s strong rally with the S&P 500 extending the week’s gains to nearly 2% and come within a few ticks of the 2019 closing high, while a softer greenback helped commodities as gold pushed back above $1,300 an ounce.
Treasurys were likewise strongly bid as yields fell across the curve, with a brisk 10-year auction this afternoon helping the benchmark rate close at 2.61%, breaking out of a narrow six-week trading range. The VIX finished below 14 for the first time in more than a week.
- Philip Grant
Monday, March 11, 2019
To everything there is a season
Bag of chips
This morning, Nvidia Corp. (NVDA on the Nasdaq) announced it will buy
This morning, Nvidia Corp. (NVDA on the Nasdaq) announced it will buy
Recap March 11
To everything there is a season
From KDKA in Pittsburgh:
A man is behind bars at the Allegheny County Jail after accusations that he choked another man for singing Christmas songs [this morning].
Bag of chips
This morning, Nvidia Corp. (NVDA on the Nasdaq) announced it will buy peer Mellanox Technologies Ltd. (MLNX on the Nasdaq) for $6.34 billion in cash. Mellanox, a chipmaker specializing in data center transmission and storage, has been a hot commodity, as a bidding war began in late January with a reported $5.5 billion approach from Intel Corp. Investors approved, with NVDA shares jumping 7%.
To bag its prize, Nvidia will pay just under six times trailing revenue and 57 times trailing adjusted EBITDA, though Mellanox’s EBITDA is expected to rise to $488 million this year, nearly double 2018’s $251 million figure. The $125 per share bid represents a 53% premium to MLNX’s Jan. 29 close. The deal is subject to regulatory approval in China, which famously helped scuttle the planned $44 billion 2018 combination between Qualcomm, Inc. and NXP Semiconductors N.V.
For Nvidia, the target offers the welcome prospect of diversification. The company’s core business has faltered of late, as the crypto boom that generated brisk demand for NVDA’s graphics-processing units (GPUs) has gone the way of the dodo. Analyst William Stein of SunTrust Robinson Humphrey writes today that “investors may view [the deal] as a defensive mechanism to offset current weakness in both gaming and datacenter sales,” while Rosenblatt Securities’ Hans Mosesmann notes that competitive factors loomed large: “Nvidia may have calculated that Mellanox as part of Intel would have hindered Nvidia’s long term growth rate.”
After more than doubling revenues and nearly quadrupling adjusted EBITDA (to $11.7 billion and $4.1 billion, respectively) in the three years ended Jan. 27, Nvidia has seen a sharp reversal in its fortunes. This year, sales and adjusted EBITDA are currently projected to decline to $11.2 billion and $3.5 billion, as the company has twice been forced to cut guidance since November. Mr. Market has reacted accordingly, with NVDA shares falling by 32% since June 29, compared to a 2% gain from the Nasdaq 100 Index.
NVDA five-year price chart. Source: The Bloomberg
A bearish June 29 Nvidia analysis in the pages of Grant’s argued that the bursting of the crypto bubble would deliver operating disappointment well beyond market expectation, while the virtuous cycle seen through 2017 of rising crypto prices and strong demand for high-end GPU’s from digital miners would be replaced by reciprocal weakness.
Before the crypto bubble, the demand for high-performance memory boards varied with the quality of new video game releases. Perhaps it will again. Falling crypto prices, by denting the returns to digital mining, have also dampened the demand for high-end GPUs.
The crypto bust has left Nvidia with a surplus of product. Inventories footed to $1.58 billion as of Jan. 27, nearly doubling year-over-year from $796 million. According to a report last Wednesday from Monica Chen and Joseph Tsai of Digitimes, liquidation efforts are now underway:
With the dissipation of the cryptocurrency mining fad, graphics card players have begun cutting product prices in a bid to clear out excess inventory at the expense of profitability, according to industry sources.
Although Nvidia, AMD and graphics card vendors are expected to see rising revenues, profits will be unsatisfactory and may even be halved from previous high levels. The inventory digestion process may not end until mid- to late-2019, the sources noted.
Recap March 11
It was a big day for the bulls, as stocks ripped to the tune of a 1.5% gain in the S&P 500, a near 2% advance in the Dow Transports and small cap Russell 2000 indices, and a 3% rip in the tech-heavy NYSE FANG+ Index to erase the bulk of last week’s declines. Commodities finished generally higher with WTI crude settling at $57 a barrel, and the VIX fell more than 10% to finish below 14.5.
Treasury yields ticked slightly higher across the curve, continuing the recently rangebound trading in rates. Since late January, the 10-year yield has remained between 2.76% and 2.63%, closing today at 2.64%.
- Philip Grant
Friday, March 8, 2019
Blues brothers, 2019 edition
Set your DVR’s. From The Hill:
Set your DVR’s. From The Hill:
China check
Choose your own adventure
Blues brothers, 2019 edition
Set your DVR’s. From The Hill:
Federal Reserve Chairman Jerome Powell will appear on Sunday’s episode of “60 Minutes” for an interview on interest rates, the outlook for the U.S. economy and financial system cybersecurity risks, CBS announced Thursday. Powell was interviewed by Scott Pelley in Washington, D.C., this week, CBS said, and will appear beside his predecessors, former Fed chairs Ben Bernanke and Janet Yellen.
They’re on a mission alright.
China check
Earlier today, the Shanghai Composite Index plunged by 4.4%, the biggest one-day loss since November, as CITIC Securities Co.’s application of a rarely-seen “sell” rating on People’s Insurance Company (Group) of China Ltd. “was widely interpreted as a sign that the government wants [the recent] surge in Chinese stocks to slow down,” according to Bloomberg.
Perhaps more ominously for both China and the rest of the world, February exports from the Middle Kingdom were horrible, falling 20.7% year-over-year, compared to an expected 5% decline. It’s not just exports, as February auto sales crumbled by 18.5% from a year ago to 1.19 million units, the eighth consecutive drop.
Choose your own adventure
A pair of earnings releases you don’t see every day:
Fort Lauderdale, Fla.-based National Beverage Corp. (FIZZ on the Nasdaq), producer of the popular LaCroix soft drinks, reported fiscal third quarter results well short of expectations on both the top and bottom line. Shares fell by 20% at midday to extend the post-August decline to 53%.
CEO Nick A. Caporella broke the news to investors in style at least, via a press release titled: ‘”We Just Love our LaCroix,’ Consumers Chant.” Caporella went on to expound:
We are truly sorry for these results stated above. Negligence nor mismanagement nor woeful acts of God were not the reasons – much of this was the result of injustice!
Managing a brand is not so different from caring for someone who becomes handicapped. Brands do not see or hear, so they are at the mercy of their owners or care providers who must preserve the dignity and special character that the brand exemplifies. It is important that LaCroix’s true character is not devalued intentionally − in any way.
National Beverage Corp. is and will remain the preeminent innovator that adds zest and authenticity to the ‘sparkling water’ phenomenon in North America.
Meanwhile, Camping World Holdings, Inc. (CWH on the NYSE), which counts television personality Marcus Lemonis as CEO, issued its own fiscal fourth quarter figures yesterday. The press release was a study in suspenseful delivery, as the fourth bullet point on page one read:
Adjusted EBITDA was $312.5 million; and
We can fill in the blank: “down 21.7% year-over-year.” CWH shares lost more than 5% in early trading today.
That pair of notable releases follows Monday’s effort from Anheuser-Busch InBev S.A./N.V., (ABI:BB and BUD on the NYSE) which, though relatively lacking in entertainment value, did provide a study in confusion.
While dollar denominated revenues and “normalized” operating earnings fell year-over-year, the company reported “organic” growth figures of 5.3% and 12.4%, respectively, for those line items. A 100 basis point contraction in gross margins was reported as a 40 basis point shrinkage on an “organic” basis.
Drink organic: AB InBev fourth quarter press release
Thursday, March 7, 2019
Bottoms up
This morning, the European Central Bank cut its guesstimate
This morning, the European Central Bank cut its guesstimate
Product 19
A paper today from the Brookings Institution
A paper today from the Brookings Institution
Les Miz'
Yesterday, Japan’s Mizuho Financial Group, Inc. surprised investors
Yesterday, Japan’s Mizuho Financial Group, Inc. surprised investors
QT Progress report
Recap March 7
Bottoms up
This morning, the European Central Bank cut its guesstimate for 2019 GDP growth to 1.1% from 1.7%. In response to the bleaker expected growth, ECB president Mario Draghi once again pivoted towards easier monetary policy, reviving the “Targeted Longer-Term Refinancing Operations,” a lending program with favorable interest rates designed to prop up the Old Continent’s frail banking system, less than three months after wrapping up an aggressive asset purchase program (Almost Daily Grant’s, Feb. 28). “Super Mario” also made it known that the negative 40 basis point deposit rate which has been in place since March 2016 isn’t to blame, stating that negative rates “have been very successful for the ECB and were a powerful instrument in fostering a recovery.”
Instead, Draghi ascribed the latest bout of economic pain to outside forces, particularly “the persistence of uncertainties related to geopolitical factors, the threat of protectionism and vulnerabilities in emerging markets.” With introspection in short supply in Frankfurt, Mr. Market picked up the slack, as the Stoxx E.U. Banks Index sank by 3.3% in reaction. The Index trades at 0.59 book value, less than half of the 1.26 times book value commanded by the KBW U.S. Banking Index.
Monetary policy, Homer Simpson style
The beatings will continue until morale improves.
Product 19
A paper today from the Brookings Institution put widely-held skepticism over China’s gross domestic product figures into quantitative terms. Researchers from the Chinese University of Hong Kong and the University of Chicago re-estimated The Middle Kingdom’s output growth from 2008 to 2016 using “several local economic indicators that are less likely to be manipulated by local governments to measure local and aggregate GDP.”
The analysis concluded that actual GDP growth over that period lagged officially reported statistics by 1.7% per annum. If the Brookings researchers are on the beam, that would reduce China’s year-end 2016 GDP by some 16%. Continuing to extrapolate a 1.7% GDP shortfall through 2018 leaves last year’s Chinese GDP at RMB 71.7 trillion, far below the RMB 90 trillion reported.
While China’s output is under question, the debt remains. The ratio of total banking assets to reported GDP stood at 297% in 2018. Under the Brookings-tabulated GDP methodology, that ratio expands to 374%. By comparison, U.S. banking assets stood at $17.9 trillion at year-end, or 86% of GDP.
Les Miz'
Yesterday, Japan’s Mizuho Financial Group, Inc. surprised investors with JPY 680 billion ($6.1 billion) worth of charges related to business restructurings in its securities portfolio, including losses on “past investments in foreign bonds.” The write-offs led the bank to cut its full-year net income forecast by 86%. Mizuho CEO Tatsufumi Sakai, who will forfeit performance-related pay as a result of the losses, told investors that the bank has subsequently cut “negative carry” exposure on its portfolio of overseas credits.
Mizuho’s pain is instructive. As the Bank of Japan continues its long-running experiment with negative interest rates, Japanese institutions went abroad in search of income. Tokyo-based Morningstar, Inc. analyst Michael Makdad explains:
There are lots and lots of deposits and not enough loans, so Japanese banks have had the incentive to go outside. Certainly the BoJ policy in place now for many years to keep rates extremely low – absolutely it’s a contribution.
Indeed, Makdad reports that Japanese lenders hold an aggregate of JPY 142 trillion in foreign bonds, up from JPY 48 trillion in March 2009. That’s an 11.8% compound annual growth rate.
Meanwhile, the BoJ plans its next monetary machinations. On Feb. 22, BoJ governor Haruhiko Kuroda told the Asahi newspaper that the central bank would “of course” consider additional stimulus should inflation continue to disappoint relative to the central bank’s 2% target. In January, CPI grew by 0.2% year-over-year.
QT Progress report
A $6.7 billion sequential decline left the Fed’s portfolio of securities held outright at $3.785 trillion, with Treasury securities accounting for all of this week’s portfolio runoff. Today’s figure is $27.3 billion below the trailing four-week moving average.
Since the Oct. 1, 2017 commencement of QT, total balance sheet assets are down by 10.92%, at a 7.7% simple annualized pace.
Recap March 7
Risk is creeping back into the picture, as the S&P 500 fell for a fourth straight day to leave the broad index red by nearly 2% for the week. Treasurys were sharply bid across the curve as the 10-year yield fell to 2.65%, and the Dollar Index spiked to its highest finish since June 2017.
Commodities managed to hold up pretty well considering, as the CRB Index fell modestly while WTI crude inched higher to $56.50 and gold held at $1,285 an ounce. The VIX rose above 16.5.
- Philip Grant
Tuesday, March 5, 2019
Deep freeze
Yesterday, the Real Estate Board of Greater Vancouver reported February results that could be classified as ghastly, with residential home sales plummeting 32.8% year-over-year to 1,484 units. That’s the lowest February sales total since 1985 and 42.5% below the 10-year average. Prices have also broken lower, with the composite index sinking by 6.1% year-over-year. In addition, inventories have jumped, with total listings in metro Vancouver up to 11,590 homes at month end. That’s up 48.2% from February 2018.
Toronto, Canada’s largest city, has held up better, with February prices rising 1.6% year-over-year, while new listings dropped 6.2% to outpace the 2.4% decline in sales. Nevertheless, TREB president Gurcharan Bhaura asked for regulatory relief from the mortgage stress test mandated by the Office of the Superintendent of Financial Institutions. These subject borrowers to the greater of the five-year benchmark rate or the contracted mortgage rate plus 200 basis points (Almost Daily Grant’s, May 31):
The OSFI mandated mortgage stress test has left some buyers on the sidelines who have struggled to qualify for the type of home they want to buy. The stress test should be reviewed and consideration should be given to bringing back 30 year amortizations for federally insured mortgages. There is a federal budget and election on the horizon. It will be interesting to see what policy measures are announced to help with home ownership affordability.
On the score of home affordability, there is certainly room for improvement. According to Demographia’s International Affordability Survey for 2019, Toronto ranked 294th out of 309 metropolitan housing markets, with a median house price of 8.3 times median annual gross pre-tax household income, up from 7.9 times year-over-year. For context, the United States national median multiple registers at 3.5 times, while the organization designates anything beyond 5.1 times to be “severely unaffordable.” Vancouver puts Toronto in the shade, ranked second to last by Demographia (only Hong Kong is more expensive) with a median multiple of 12.6 times.
As Canada’s long-running housing bull market teeters, economic data continue to disappoint. Friday’s release of fourth quarter GDP showed annualized growth of just 0.4%, well below the 2% third quarter reading and the 1% consensus expectation, while December retail sales fell by 0.5% ex-automobiles, also worse than the expected 0.3% decline. M2 money supply growth registered 4.99% in December, down from 5.83% year-over-year and 8.65% in the final month of 2016.
Perhaps most importantly, total residential mortgage growth fell to just 3.1% year-over-year in December, the worst monthly reading since May 2001. That last data point may be especially concerning for Canada’s banks: Craig Fehr, investment strategist at Edward Jones & Co., told Bloomberg that the mortgages are, “in many cases, the largest and most profitable and steady of the businesses that these banks operate.” Fehr concludes: “The bread and butter of profitability for Canadian banks – is going to have a little less butter on the bread.”
Early indications bear that out, as a trio (the Bank of Nova Scotia, Toronto-Dominion Bank and Canadian Imperial Bank of Commerce, or CIBC) of Canada’s five largest banks reported earnings shortfalls in the quarter ended Jan. 31. Increased credit losses figured in two of those reports, with Toronto-Dominion raising its loan loss provision to C$850 million ($645 million), up 23% year-over-year. CIBC’s provision for credit losses jumped to C$338 million, more than double last year’s C$153 million and well above the expected C$258.5 million.
CIBC CFO Kevin Glass told Bloomberg that “three big” non-performing loans across different sectors hurt the bank’s credit portfolio, while asserting that the jump “is certainly not representative of any sign of underlying problem.”
Glass may not be worried, but an extended housing downturn may cause CIBC particular discomfort. For more, see the Feb. 9, 2018 edition of Grant’s.
In other news from formerly-booming housing markets, yesterday The Australian reported that Queensland-based bank Suncorp Group Ltd. warned that some investors in an A$120 million ($85 million) residential mortgage bond may not be repaid. The problem: An increase in borrowers at least 60 days past due on their mortgages to above 3% of the loan pool has triggered a clause prioritizing senior claims holders, potentially diverting principal repayment from those farther down the creditor food chain.
Meanwhile, Australian new auto sales fell by 9.3% year-over-year in February, the eleventh straight decline. On Feb. 21, Fitch Ratings reported that Australian prime auto loan asset-backed securities in arrears rose to a record high in the fourth quarter, with loans past due more than 30 and 60 days rising to 2.05% and 1.03%, respectively. That compares to a five year net loss rate of 0.51%.
Recap March 5
Stocks mostly cruised sideways with the S&P 500 remaining in a tight range, though the Dow Transports Index broke lower late in the session to finish red for an eighth straight day. Nevertheless, the transport index is up 12.5% year-to-date, topping the S&P’s 11% gain for 2019 so far.
Treasury yields finished little changed, though the long end was modestly bid and short yields ticked a bit higher to leave the curve flatter. The VIX remained at 15, and gold managed to inch higher and snap a four-session losing streak.
- Philip Grant
Monday, March 4, 2019
Head for the mountains
On Thursday, global beer behemoth Anheuser-Busch InBev S.A.
On Thursday, global beer behemoth Anheuser-Busch InBev S.A.
Recap March 4
Head for the mountains
On Thursday, global beer behemoth Anheuser-Busch InBev S.A. (ABI:BB in Brussels and BUD on the NYSE) reported solid fourth quarter results. Bullish highlights included 5.3% and 10% year-over-year growth in revenues and EBITDA, respectively (those figures are self-reported “organic growth” across a range of currencies; in U.S. dollar terms, sales and EBITDA both fell), as strong pricing growth helped burnish a meager 0.3% uptick in volumes. In addition, company management pledged to continue paying down a hefty debt burden, with CEO Carlos Brito reiterating his expectation of a leverage ratio below four times by the end of 2019, compared to 4.6 times, by management’s reckoning, as of Dec. 31.
Mr. Market approved, as ABI shares jumped by nearly 5%. But strong fourth quarter aside, its been no picnic, as shares have fallen by 21% since Feb. 9, 2018 (the S&P 500 has gained 8% over that period) while the 3.65% dollar pay bonds due 2026 have seen their spread over Treasurys widen to 120 basis points from 75.
Reaction among the sell-side tended towards relief more than exuberance, with last week’s disastrous earnings report from fellow 3G Capital, Inc. investee Kraft Heinz Co. weighing on sentiment. James Edwardes Jones of RBC notes that North American operations were “less bad than expected,” while Citi’s Simon Hales wrote that while the fourth quarter did “not demonstrate a material improvement in volume growth. . . it should mark the inflection point after a prolonged period of downgrades.” Yet overall analyst expectations for 2019 continue to march lower:
Down and to the right. Chart of 2019 adjusted EPS consensus. Source: The Bloomberg
Ample leverage and 3G ownership are not the only similarities between AB InBev and Kraft Heinz. Secular difficulties in the form of changing consumer tastes is another, unwelcome roadblock for the pair. A Friday report from Bloomberg, citing data from IWSR, noted that American beer consumption has declined by 2.8% since 2015, despite a near 15% uptick in craft beer sales during that period. The increasing prominence of cannabis as an alternative intoxicant also presents a risk: A study conducted by professors in the U.S. and Peru found that between 2006 and 2015, overall alcohol sales declined by nearly 15% in states that have legalized medical marijuana.
Secular pressures aside, much of ABI’s current predicament is traceable to the October 2016 acquisition of SABMiller plc. for $65 billion, at a princely 18 times EBTIDA. The resulting influx of debt led to the company cutting its dividend by 50% on Oct. 25. Moody’s downgraded Anheuser-Busch’s credit rating to Baa1 from A3 in December. Even so, ABI’s leverage ratio towers above the 2.5 times EBITDA carried by (also Baa1 rated) global peer Heineken N.V.
At the same time, there is little to show for that expensive SAB deal thus far. Free cash flow is expected to register at $10.9 billion this year, hardly improved from 2012’s $10 billion, while net debt has ballooned to $110 billion from $35 billion during that period.
Even ABI management’s current reckoning appears optimistic, as the 4.6 times leverage ratio cited on the conference call omits a $12 billion working capital deficit. For instance, vendor financing remains on the upswing: Accounts payable footed to 274 days of turnover at year-end, up from 180 days in 2012. By comparison, Heineken’s balance sheet shows 216 days’ worth of payables.
Grant’s Feb. 9, 2018 bearish analysis of Anheuser-Busch argued that the company’s heavy debt load and struggles with changing consumer tastes presented problems not yet reflected in the company’s bonds:
As for us, we judge that there is a good chance of operational disappointment, therefore of ratings disappointment. As the market is seemingly willing to admit no possibilities but happy ones, downside risks are palpable.
Recap March 4
A sharp mid-day decline shook stocks from their recent inertia, though a late rebound narrowed the S&P 500’s loss to 0.4% and left the broad index just above its Dec. 3 close.
Treasurys were bid with the long end outperforming to push the curve flatter, as the 10-year yield settled at 2.73%. WTI crude rallied back to $56.5 a barrel while gold continued its slide, settling at $1,286 an ounce to extend its post-Feb. 19 selloff to 4%. The VIX jumped as high as 17 intraday, before finishing at 14.5.
- Philip Grant
Friday, March 1, 2019
Property tax
Everything must go. Yesterday, Chinese state media website The Paper quoted Hui Ka Yan, chairman of real estate developer China Evergrande Group (3333 on the Hong Kong exchange), urging his employees to ramp up efforts to sell homes, authorizing 10% price discounts on all properties to do so.
That’s one way to do it: Analysts are expecting Evergrande to generate RMB 574 billion ($85 billion) in revenues this year, nearly double 2017’s RMB 311 billion top line. Meanwhile, the company’s contract sales in January fell to RMB 43.2 billion, down 33% year-over-year (Grant’s, June 2, 2017).
Cooking with gas
On Wednesday, kitchen equipment producer Middleby Corp. (MIDD on the Nasdaq) reported year-over-year net sales and EPS growth of 21% and 26%, respectively, in the fourth quarter, easily beating consensus expectations. The company also announced it will acquire the Cooking Solutions Group from Standex Corp. (SXI on the NYSE) for $105 million. Shares rallied 5% in response, but it’s been tougher going of late for a stock that managed a 1,260% appreciation from year-end 2008 to mid-2016. Since a bearish Grant’s analysis on June 17, 2016, MIDD shares are up 6%, compared to a 30% rise in the S&P 500.
Acquisitions have helped fuel the growth spurt. Unrated MIDD has made 24 deals since the beginning of 2015 (more than one per quarter, on average), headlined by the $1 billion cash purchase of equipment concern the Taylor Company in May.
The add-ons drove top-line growth (revenue decreased 0.8% year-over-year when backing out acquisitions and currency swings) but have also helped push Middleby’s leverage ratio to over three times consensus 2019 EBITDA, from less than 1.5 times at year-end 2016. At the same time, the company is increasingly dependent on the restaurant industry, as the commercial foodservice unit chipped in 63.5% of 2018 sales. That’s up from 59.2% and 55.9% in 2017 and 2016, respectively. The food processing and residential kitchen divisions accounted for 14.3% and 22.2% of total revenues.
Restaurant sales have been soft, with research firm TDn2K reporting a 1.12% industry traffic decline in the three months ended Jan. 31, while the franchisees that purchase MIDD’s wares face declining profits and rising labor costs, as well as franchisor demands to undertake expensive store remodels. Nevertheless, Elgin, Ill.-based Middleby (founded in 1888), has thrived. The company has grown revenues and adjusted EBITDA to $2.7 billion and $563 million, respectively, in 2018, up from $1.8 billion and $392 million in 2015. The sell-side expects more of the same, with six buy ratings, three holds and zero sells. With that bullishness comes high expectations: projected 2019 free cash flow is expected to jump to $433 million from $333 million a year ago.
Meanwhile, margins are under pressure, with gross profits representing 36.9% of sales in 2018, down from 39.1% year-over-year and 42.1% in 2016. Asked about the waning profitability, brand new CEO Timothy FitzGerald, replacement for longtime boss Selim Bassoul (who retired, effective immediately, on Feb. 19) struck a hopeful tone noting that integrating a host of new businesses presents its problems:
I don't know off the top of my head exactly how many acquisitions, but we've had quite a few in the last two to three years. So certainly, there's a lot of heavy lifting that happens in year one but then there's continued fine tuning that happens in second and third years, as you kind of really move into higher fruit on the tree. So we do expect. . . that we’ll move the margins for the businesses forward as we go through the year.
Middleby’s roll-up business model presents other pitfalls for investors beyond rising debt and shrinking margins. The June 2016 Grant’s analysis zeroed in on the company’s use of so-called purchase accounting, noting the potential for results to appear stronger than they actually are:
Under the rules of purchase accounting, acquirers may apportion the assets of their acquirees as they wish for 12 long months after the transaction closes. Middleby has tended to tag those assets “goodwill and other intangibles” (GOI). Most assets so designated need not be amortized. And as they are not amortized, they do not impair the optics of reported GAAP earnings.
Sure enough, the “goodwill and other intangibles” line-item continues to bulge, reaching a balance of $1.74 billion at year-end 2018. That’s up from $1.26 billion year-over-year, and $1.09 billion in 2016.
Recap March 1
Stocks caught a bid, with the S&P 500 rising 0.7% to finish the week in positive territory, as the energy sector led the way higher despite pressure on prices as WTI crude slipped back below $56 a barrel. Commodities traded broadly lower with gold sinking to $1,291 an ounce, while the Dollar Index rose.
Treasurys continued their recent weakness as yields jumped across the curve, leaving the 10-year at 2.74% and the long bond at 3.14%, its highest since mid-December. The VIX took another tumble, falling to 13.5 and testing its lowest since the early-October stock market break.
- Philip Grant
Thursday, February 28, 2019
Hundred Dollar General
From CNBC:
From CNBC:
Trudge report
“Eurozone slowdown helps keep Draghi’s dissenters in line,” declares a headline in today’s Financial Times
“Eurozone slowdown helps keep Draghi’s dissenters in line,” declares a headline in today’s Financial Times
QT Progress report
Recap Feb. 28
Hundred Dollar General
From CNBC:
The amount of $100 bills in circulation is surging. And it’s leaving some economists scratching their heads. The number of outstanding U.S. $100 bills has doubled since the financial crisis, with more than 12 billion of them across the world, according to the latest data from the Federal Reserve.
C-notes have passed $1 bills in circulation, Deutsche Bank chief international economist Torsten Slok said in a note to clients this week.
Trudge report
“Eurozone slowdown helps keep Draghi’s dissenters in line,” declares a headline in today’s Financial Times. The catalyst: Recent comments from Bundesbank president and European Central Bank governing council member Jens Weidmann acknowledging ongoing economic softness in Europe’s largest economy. No need to lift those rates, notes the FT, which breathes a journalistic sigh of relief for Mario Draghi, who has to spend so much of his precious time “trying to curtail sniping from the sidelines by policy hawks.”
So it goes on the Old Continent, where Draghi’s balance sheet has grown to 39% of GDP, twice the relative size of the Fed’s, and where the overnight rate rests at negative 0.4% (it first settled there in March 2016); the benchmark rate has remained below zero since June 2014.
Weak data points, including flat sequential German fourth quarter GDP, a surprise contraction in December factory orders and eight straight months of declining economic sentiment across the eurozone, plausibly argue for the status quo. Other factors do too: Succession at the ECB is unclear as Draghi’s term ends on Oct. 31, while political risk is on the upswing, evidenced by growing discord between Italy and other member states as well as popular discontent movements like France’s Gilets Jaunes.
Thus, the negative-rate epoch drags on and on. According to analysts at Bank of America, some $11 trillion worth of sovereign debt is priced to yield less than zero, up 21% from October and not so far off the $13 trillion peak logged in 2016.
The resurgence of such financial anomalies (historians Sidney Homer and Richard Sylla find that substantial volumes of negative-yielding notes had never been seen in 3,000 years of financial history prior to this cycle) has even some members of the ECB concerned. Of those negative yields, governing council member Francois Villeroy de Galhau was quoted as saying on Wednesday:
If maintained for too long, they could weigh negatively on the profitability of financial intermediation with possible adverse consequences for the smooth transmission of monetary policy.
Four years and counting aren’t long enough, apparently. An analysis in the April 6, 2018 edition of Grant’s (“Let the ECB pay you”) noted the realistic potential for the central bank to enter the next recession with rates already in negative territory. But how can investors, deprived of income by these monetary machinations, profit from the ECB’s demonstrated willingness to do “whatever it takes”, for however long it takes?
Deputy editor Evan Lorenz identified interbank lending rates as a potentially attractive investment proposition. In particular, the three-month Euribor futures contract expiring on March 2020 then traded at 99.88, implying a future rate of positive 0.12%. That compared to the negative 0.33% Euribor rate on offer at publication time, as expectations of so-called policy normalization were then widespread.
Lorenz observed that if Euribor remained unchanged through that March 20 expiration, the 100.125 strike call option would deliver a 183% return, with additional upside possible were the ECB forced to further cut rates during that period. Since publication time, that contract has rallied to 100.21, or an imputed negative 0.21% Euribor rate in March of next year. That compares to negative 0.31% currently.
March 2020 three-month Euribor futures, one-year chart. Source: The Bloomberg
QT Progress report
The Fed’s portfolio of securities held outright registered at $3.792 trillion this week, down $6.7 billion from a week ago. Mortgage-backed securities accounted for almost all of the sequential decline, while Treasurys represented roughly two-thirds of the $33.6 billion drop compared to the trailing four-week average.
Since the Oct. 1, 2017 commencement of QT, total balance sheet assets are down by 10.8%, for a simple annualized pace of 7.74%.
Recap Feb. 28
Stocks turned a bit lower, snapping three days of consolidation as the S&P 500 finished at a one-week low. Treasury yields ticked higher across the board with the belly (middle) of the curve seeing additional pressure, leaving the 10-year yield at 2.72%.
Commodities finished slightly weaker with gold retreating to $1,312 an ounce, and the VIX remained below 15.
- Philip Grant
Wednesday, February 27, 2019
T-leaves
The moment of truth draws closer for Sprint Corp. (S on the NYSE) and
The moment of truth draws closer for Sprint Corp. (S on the NYSE) and
Recap Feb. 27
T-leaves
The moment of truth draws closer for Sprint Corp. (S on the NYSE) and T-Mobile US, Inc. (TMUS on the Nasdaq). The pair, America’s fourth- and third-largest wireless carriers, respectively, agreed to merge on April 29, 2018 and now await regulatory approval with an initial projected closing date just over four months away.
The credit markets have already given the deal a thumbs up. S&P’s LCD unit reported yesterday that Sprint managed to raise a $900 million term loan, upsized from an initial $400 million, at a smaller-than-expected issuer discount. Meanwhile, the Sprint 6 7/8s senior notes of 2028 have lifted above 99 cents on the dollar from 94.5 in early April (both the bonds and stock rallied into the deal announcement) narrowing the spread over Treasurys to 439 basis points from 510. During that period, the spread on the Bloomberg Barclays High Yield Index has widened to 387 basis points from just under 350.
Classically, bond investors, who stand to gain nothing more than the return of their principal with interest, are a conservative bunch, ever-cognizant of risk. Benjamin Graham and David Dodd’s Security Analysis notes that “bond selection is primarily a negative art. It is a process of exclusion and rejection, rather than of search and acceptance.”
Anyway, for single-B-rated Sprint, which is saddled with an extensive debt load as well as stagnant revenue growth and persistently negative free cash flow (Grant’s, Dec. 23, 2016), the stakes are high indeed. Deal approval could mean a nice payoff for creditors, with analysts at Bloomberg Intelligence estimating that those 6 7/8 senior notes would see nearly 200 basis points of spread tightening in the event of a green light from Uncle Sam.
The stock market is also optimistic, as market-implied odds of deal approval sit just above 50% based on the respective trading levels of each stock, under the assumption that Sprint shares would return to their early-April price of $5.18 a share if the merger is scuttled (Sprint trades at $6.35 a share, while T-Mobile’s all-stock bid is currently worth $7.40). Based on T-Mobile’s current share price, approval would likewise suggest a 17% gain for Sprint shareholders.
The CEOs of both companies have utilized differing tactics with an eye toward swaying regulators. Sprint boss Michel Combes painted a grim picture of his company’s standalone prospects on the most recent earnings call (Almost Daily Grant’s, Feb. 1), while T-Mobile CEO John Legere maintained his typically upbeat persona in a blog post Friday:
We have had some amazing discussions and the regulators we’ve talked with continue to impress me. Their process is thorough, and that is great news for us – because we have a lot to share!
The great news is things are moving forward positively! We now have approval from 16 of the 19 needed state utility commissions, which is a huge step forward. . . Despite what others may want you to think, we’ve made steady progress – and we remain confident that we’re going to see regulatory approval, as planned, in the first half of this year!
Some observers are less than sanguine, however. On Monday, The Capitol Forum reported that T-Mobile and Sprint’s pro-approval arguments “have yet to win over the staffs of competition enforcers and telecommunications regulators.” The prospective decline in national carriers to three from four, an absence of tangible consumer benefits like improved service prior to 2021 and the likelihood of higher prices count among the regulators “grave” concerns. The Forum notes that “time is running out for T-Mobile and Sprint to persuade Justice Department staff, which is preparing a recommendation for senior department officials.”
Even a green light from Washington wouldn’t mean the merger is in the clear. In a note Sunday, New Street Research relayed that state attorneys general have hired an unnamed “leading antitrust economist” to help conduct an investigation of the proposed tie-up, a development which is “certainly cause for concern” for deal advocates. More broadly, the state AGs present a “material risk” to the deal’s closing, per New Street.
A thumbs down from federal or state regulators could deal significant pain to Sprint investors beyond a reversal to early April prices, as a Jan. 31 analysis from MoffettNathanson, LLC concluded that if the deal is rejected, Sprint’s debt “will likely have to be restructured.” Investors in SoftBank Group Corp., (Grant’s, Nov. 30) which owns 84.5% of Sprint’s equity, are likewise exposed to regulatory whim: A return to the early 2016 trading levels for S shares would equate to a loss of roughly 12% of SoftBank’s total market capitalization.
Recap Feb. 27
Consolidation continues, as stocks shook off early losses to finish unchanged for a third straight day on the S&P 500 to leave the broad index near the highs for the year. Commodities caught a strong bid, with WTI crude pushing back to $57 a barrel while gold bucked the bullish trend to finish at $1,320 per ounce.
Treasury yields rose with another round of widening seen at the back end of the curve; the 30-year long bond finished the day at 3.07%, a one-month high.
- Philip Grant
Tuesday, February 26, 2019
Tip your waitress
A trio of Sonic Corp. restaurants in central Ohio closed abruptly
A trio of Sonic Corp. restaurants in central Ohio closed abruptly
Climate change
It’s not just U.S. equities that have enjoyed a blistering start to 2019.
It’s not just U.S. equities that have enjoyed a blistering start to 2019.
Recap Feb. 26
Tip your waitress
A trio of Sonic Corp. restaurants in central Ohio closed abruptly over the weekend after employees quit en masse. At each location, the departing staff displayed some less-than polite messages for management on their way out the door.
What spurred the worker walkout? Local news site the Scioto Post reports:
One anonymous source close to management stated: “Circleville, Lancaster, and Grove City crews have all walked out and quit after the franchise was bought out by corporate. The regional director, two district managers and four general managers have all been let go. All of which have been working for the company in management for 7+ years.”
According to sources close to the situation, part of the dispute stems from pay cuts forced onto employees who saw wages reduced from at or near-minimum wage to a tipped employee wages at approximately $4.00/hr.
In December, Inspire Brands, Inc., a division of private-equity firm Roark Capital Group, acquired Sonic for $2.3 billion, or more than 15 times trailing EBITDA.
For a wide-ranging look at the troubles plaguing the restaurant industry, see the Feb. 8 edition of Grant’s.
Climate change
It’s not just U.S. equities that have enjoyed a blistering start to 2019. China’s broad CSI 300 Index ripped higher by 5.8% on Monday, which marks the biggest one-day gain in three years and brings the year-to-date advance to 22%. Mr. Market displayed particular enthusiasm towards the financial sector: Bloomberg notes that all 30 Shanghai- and Shenzhen-listed stocks that feature the word “securities” in their corporate title finished higher by the 10% daily limit yesterday.
The recent bull stampede can be chalked up to “substantial progress” on trade according to both Donald Trump and Xinhua News Agency, as well as to a friendly policy turn from Beijing. On Saturday, President-for-life Xi Jinping called for “strengthening the countercyclical adjustment of fiscal policy and monetary policy [to ensure] that the economy operates in a reasonable range.” Yesterday, Wang Zhaoxing, vice chairman of China’s Banking Regulatory Commission, declared that the Middle Kingdom’s deleveraging campaign has already achieved its goals.
With deleveraging apparently complete, re-leveraging begins anew. Thus, the People’s Bank of China reports that new aggregate financing footed to RMB 4.6 trillion in January, up 51% year-over-year. Meanwhile, Chinese margin debt outstanding has jumped by more than 8% in the last two weeks, according to the China Securities Finance Corporation, while research firm PY Standard reports that local banks increased issuance in so-called wealth-management products by 22% year-over-year in January.
The latest round of stimulus is having an impact, but will it be enough? Many corporations are already listing under the unwelcome combination of a pronounced economic slowdown (last year saw the slowest pace of real GDP growth since 1990) in tandem with stifling debt burdens. A Jan. 23 report from UBS Group A.G. found that work-out investors acquired RMB 1.75 trillion in bad debt last year, the busiest for distressed debt in two decades.
Back in December, Yu Liang, chairman of China Vanke Co. (the country’s second largest real estate developer) told employees that China’s housing market faces the prospect of an extended slump, commenting that “we need to ensure survival first, and then quality development,” according to a speech released yesterday on the company’s WeChat page.
In a Feb. 18 commentary, Anne Stevenson-Yang, co-founder of J Capital Research, wrote that while Beijing’s recent exertions have helped the banks, the reflation efforts seen in January are insufficient to stem the broad deterioration in financial conditions. If the powers-that-be hope to avoid a painful (and perhaps politically perilous) economic reckoning, they will be forced to double down:
It will take much more: The culture at Chinese banks has changed, and, if authorities really want bankers to lend, they must change incentives. Thus far, they have been unwilling to do that.
The structural problem, Stevenson-Yang relates, is that banks are obliged to increase financing efforts, while simultaneously facing scrutiny of their loan quality.
That means that China’s economy will likely continue in decline, until the tide of corporate and financial defaults swells to the point where authorities feel they have no choice but to launch a truly gargantuan stimulus, greater than the RMB 6.4 trillion in stimulus monies issued in 2016.
Recap Feb. 26
Stocks drifted sideways to finish virtually unchanged, with the VIX also cruising through a low-key session to again settle just below 15. Commodities and the dollar both ticked slightly lower.
Treasury yields traded lower across the curve, but recent moves have been far from lockstep. While the spread between five- and 30-year bonds has widened to 56 basis points from about 20 basis points in July, the short end remains inverted with the two-year yield residing four basis points above the five-year. Back in July, the two- and five-year spread also stood at (positive) 20 basis points.
- Philip Grant
Monday, February 25, 2019
Musical chairs
This morning, Barrick Gold Corp. (ABX on the TSX) announced it will launch a $17.8 billion all-stock bid for Colorado-based rival Newmont Mining Corp. (NEM on the NYSE), continuing the 2019 mining merger wave. Recall on Jan. 2, Barrick completed a no-premium, $5.4 billion takeover of South Africa’s Rangold Resources Ltd. Two weeks later, Newmont bid $12.6 billion in cash and stock for peer Goldcorp, Inc., which was 16% above the target’s closing price (Almost Daily Grant’s, Jan. 14).
The proposed Barrick-Newmont tie-up, which would take place in lieu of Newmont’s Goldcorp bid, would create the world’s largest gold miner by far, but Mr. Market wasn’t particularly impressed. NEM shares traded lower by 1%, while ABX sank by 3%.
Unsurprisingly, Newmont management is reluctant to accept Barrick’s terms, which were offered “at the market” and implied a slight discount to NEM’s closing price on Friday. NEM issued a press release this morning arguing that the planned Goldcorp merger offers superior value creation for its shareholders, noting that a prior internal analysis of Barrick “determined that Barrick’s risk and return profile is inferior on many fronts, including factoring Barrick’s comparatively ineffective operating model, poor track record on delivering shareholder returns and unfavorable jurisdictional risk.”
In an interview on Friday, after Barrick had publicly expressed interest in a deal, Newmont CEO Gary Goldberg pulled no punches: “It’s a desperate and bizarre attempt to muddle up our [Goldcorp] deal. And it’s certainly not the sort of behavior that will appeal to investors who want to invest in serious, well-run companies.”
Mark Bristow, former CEO of Rangold and current Barrick boss, shared his perspective in a Jan. 2 interview with Bloomberg: “[The] industry, if it had carried on the way it was, was going to become irrelevant, [with] too few assets with too many management teams and it needs reorganization.”
The matter at hand for investors: Will a wave of corporate consolidation help streamline production, increase operational efficiency and pave the way for higher share prices? Or do the low- or zero-premium prices being bid for these large mining assets foreshadow more disappointing days ahead?
Grant’s today put the question to John Hathaway, the co-manager of the Tocqueville Gold Fund, who anticipated a wave of industry consolidation at the Spring 2018 Grant’s conference. Hathaway believes that the proposed Barrick-Newmont combo faces an uphill battle, as “its hard to see where the value creation is coming from” in a $42 billion merger of equals while “the gold mining industry doesn’t necessarily lend itself to that kind of scale.”
Indeed, the longtime gold investor sees a substantial valuation gap between the mega players and smaller, sometimes single-asset miners. To that end Hathaway has co-founded a new investment venture named the Sprott Hathaway Special Situations Fund, designed to capitalize on the sudden thirst for deal-making.
Hathaway notes that the current market price of gold is about 35% below the cost to discover and extract the yellow metal, making it cheaper to mine for gold assets on Wall Street than underground. The fund will be a concentrated one, with position sizes of as much as 10% of total assets, while the new venture will have some attractive options from which to choose. Hathaway relays that some potential targets are currently valued at as little as three times (growing) EBITDA. The Sprott Hathaway fund will target smaller operators (i.e., no Barricks or Newmonts to be found), some of which do business in less-than ideal geographical jurisdictions. Nevertheless, that political risk can be more readily absorbed in an acquirer’s larger asset portfolio.
Recap Feb. 25
Stocks gave back the bulk of early gains but still managed a green finish on the S&P 500, leaving the broad index at 2019 closing highs for a second straight session and within 5% of the record finish logged on Sept. 20. That late selloff did coincide with a 10% spike in the VIX to leave the volatility indicator just under 15.
Elsewhere, a Trump tweet from this morning complaining about high oil prices helped send the energy complex sharply lower with WTI crude finishing near $55 a barrel, while Treasury yields ticked slightly higher across the curve.
- Philip Grant
Friday, February 22, 2019
Smothered
Cleanup in aisle four. Yesterday evening, longtime Grant’s pick-not-to-click Kraft Heinz Co. (KHC on the Nasdaq) reported fourth quarter results that could safely be described as calamitous. Net sales grew by a feeble 0.7% year-over-year, while EBITDA collapsed by 13.9%. Management guidance of another double digit slide in EBITDA in the first quarter adds to KHC’s woes, as does newly-revealed regulatory scrutiny and asset impairment charges. In response, shares suffered a 28% swan-dive to an all-time low, dragging down the S&P Packaged Foods Index to the tune of 4.5%.
With revenue stagnating, profitability on the wane and a hefty debt load of 4.5 times consensus 2019 adjusted EBITDA, balance sheet remedies are now in order. KHC announced a 36% dividend cut, to 40 cents a share per quarter, while CEO Bernardo Vieira Hees suggested the company will pursue additional asset sales after having disposed of its Heinz India and Canadian cheese businesses in the fall of 2018. Nevertheless, Standard and Poor’s placed triple-B-rated Kraft Heinz on negative watch today.
But poor operating results were just part of the problem. The company disclosed receipt of a subpoena from the SEC in October related to “an investigation into. . . the Company’s accounting policies, procedures and internal controls related to its procurement function.” Kraft Heinz took a $25 million charge for the period as a result, a figure management deemed immaterial both in the press release and subsequent conference call. So immaterial, in fact, that the C-suite declined to make note of the subpoena in either its Nov. 1 third-quarter press release or in the form 10-Q released the next day.
Perhaps the most significant problem: A $15.4 billion noncash write-down of goodwill assets related to domestic and Canadian business lines, as well as intangible assets such as the Kraft and Oscar Meyer trademarks. The writedowns are not important by themselves; they are, of course, non-cash. Rather, they tell us about management’s expectations about future profits, i.e., they will be lower. This was confirmed by CFO David Knopf on Thursday’s call.
KHC price chart from spring 2016. Source: The Bloomberg
To say the least, the Kraft Heinz business model of industry consolidation, ferocious cost cutting and focus on delivering high margins has reaped some less than welcome side effects. As growth in the packaged-foods industry remains anemic at best, KHC’s focus on maintaining “industry-leading margins” (a phrase repeated frequently during yesterday’s call) has manifested in brand erosion.
Grant’s produced its first analysis of KHC on March 25, 2016 (“Sell big food,” available here), followed by an equally bearish judgement on March 24, 2017 (“Price War for Warren Buffett,” available here). In a Feb. 23, 2018 follow-up, deputy editor Evan Lorenz noted that the company’s prioritizing of certain brands at the expense of others presented the potential for unwelcome surprises:
So, how should we assess Kraft Heinz’s ability to manage an operating business, apart from slashing its costs. “[T]he Heinz brand in the United States is now 17% bigger than it was in 2015,” CEO Bernardo Vieira Hees not¬ed of a key success on the Feb. 16 call, “which is a good example of the process we are going through with each cat¬egory.” The growth in the Heinz brand is part of KHC’s focus on big bets—on concentrating ad and innovation dollars on a few brands and product categories that management believes hold the most promise.
To put Heinz’s growth in context, overall organic sales in the United States fell by 0.3% in 2016 and by 1.5% in 2017. This implies that non-Heinz-branded sales contracted substantially over the past two years. Kraft Heinz owns 33 brands that reap $100 million or more in revenues. By focusing on a few designated winners rather than the overall portfolio, the company runs the risk of eroding the equity of its smaller brands. Neglected, the step-children may disappoint.
Whither the roll-up strategy? While Hees indicated that asset sales are on tap during the call, the CEO told the Financial Times just two days ago that industry valuations “are much more attractive than before.” On the call, Hees once again displayed an acquisitive mindset, stating that divestitures would merely set the stage for the next corporate shopping spree:
Our decision here is to execute the strategy on deleveraging faster, so we can better position the company for future consolidation.
The recent plunge begs the question of how KHC’s A-list investor roster will respond. Brazilian private equity shop 3G Capital and Berkshire Hathaway, Inc. bought H.J. Heinz Co. in 2013 and Kraft Foods Group, Inc. two years later. Last August, 3G sold 20.6 million shares of KHC (just under 2% of current shares outstanding), lowering their stake to 22%.
Might Warren Buffett ride to the rescue? Yesterday, The Wall Street Journal noted that Berkshire Hathaway, which already owns 27% of Kraft Heinz, boasted a cash balance of $103.6 billion as of Sept. 30 and has not completed a major acquisition since buying Precision Castparts Corp. for $32 billion in early 2016. Beleaguered KHC bulls won’t have to wait long for hints at the Oracle of Omaha’s next move: The annual Berkshire Hathaway letter is set to be released tomorrow.
Recap Feb. 22
Another equity bid pushed the S&P 500 back to a 2019 closing high, up 0.6% for the holiday-shortened week. Gold and oil both managed to finish a bit higher with a flat greenback, and Treasurys were stronger across the board to leave the 10-year yield at 2.65%.
It wasn’t just KHC that suffered rude treatment in a rising market. Stamps.com, Inc. (STMP on the Nasdaq) was shellacked by 58% after the company disclosed the termination of its partnership with the United States Postal Service. For a detailed rundown of the bear case in STMP, see the April 6, 2017 edition of the Grant’s Current Yield podcast with short seller extraordinaire Marc Cohodes.
- Philip Grant
Thursday, February 21, 2019
Loan ranger
On Tuesday, both the Financial Times and The Wall Street Journal ran stories highlighting the prominent presence of Japan’s Norinchukin Bank in the market for collateralized loan obligations, or CLOs. The Journal notes that the bank (Nochu for short), which was founded in 1923 as a collective for farmers and fisherman, holds a $62 billion CLO portfolio, nearly 9% of the roughly $700 billion in global outstanding supply. Nochu (whose English-language website prominently features the phrase “dedicated to sustaining all life”) added some $10 billion, roughly one-third of all U.S. and European issuance during the fourth quarter.
The FT reports that Nochu almost exclusively purchases triple-A-rated CLO tranches (in contrast to lower rated and higher yielding tranches), while also adhering to strict limits on accumulating so-called covenant-light debt, which carries limited legal protection for investors if trouble strikes. Nochu’s constrained appetite for covenant-light debt can lead to its own difficulties, as reporters Robert Smith and Leo Lewis note that “as nearly every new loan is ‘covenant-light’. . . Nochu’s stipulation can force CLO managers to buy the very riskiest loans, which still have covenants.”
Anyway, Nochu’s outsize CLO foray shines a light on an obscure but crucial asset class, one that has enjoyed a strong historical track record: No triple-A-rated CLOs have ever suffered a default, while the asset class came through the 2008-era trials largely intact on a credit basis, unlike other types of collateralized debt obligations which famously faltered.
Comprised of floating-rate leveraged loans, an attractive option for those concerned with rising interest rates, the CLO market has boomed of late. Analysts at Citigroup report that the aggregate market size has nearly doubled over the last four years. That growth in turn provides a ready source of demand for leveraged loans (roughly half of all syndicated loans have been packaged into CLOs).
As 2019 has ushered in an asset price thaw after the brutal fourth-quarter, some issuers are stepping back into the fray. Thus, Commercial Mortgage Alert reported on Feb. 15 that the real estate-CLO market is heating back up from a December freeze, with three new obligations issued so far this year with at least five more set to debut by quarter-end. The publication predicts that “issuance is expected to climb substantially this year, aided by the fact that the volatility that swept through fixed-income markets in December proved to be short lived.”
Prices have mostly recovered, with the LSTA/Leveraged Loan Index rising back to 96.4, from 93.8 on Dec. 28 to recoup more than half of the decline from 98.7 in early October. Analysts at Goldman Sachs are expecting the rebound to continue, and a continued pick-up in CLO issuance, writing that “we still see more room to run.”
But a recent report from Fitch Ratings on domestic life insurers should give the bulls pause. Noting that aggregate corporate credit quality is below the levels seen in 2007, the ratings agency zeroes in on CLOs:
CLOs are a particular point of focus for us, given the market’s rapid growth and signs that leveraged loan underwriting standards and covenants have deteriorated. We believe CLO exposure could represent a significant risk if investor protections weaken late in the credit cycle.
Grant’s, concurring with the judgement of Fitch, had this to say at the outset of an in-depth analysis of the loan and CLO market in the Sept. 7 edition:
On Wall Street, success begets failure. Take a good idea, emulate it and embellish it, drive it into the ground like a tomato stake. Voilà: It’s a bad idea.
QT progress report
The Fed’s portfolio of securities held outright registered at $3.799 trillion this week, down a chunky $31.2 billion from last week’s reading for the second-largest sequential decline so far. Treasury securities accounted for about three-quarters of this week’s runoff, as well as the $40 billion decline relative to the trailing four-week average.
Since the Oct. 1, 2017 onset of QT, total assets on the Fed’s balance sheet are down by 10.6%, at a 7.7% simple annualized pace.
Recap Feb. 21
Stocks ticked a bit lower, taking the S&P 500 off the year-to-date highs reached yesterday and leaving the broad index green by just under 11% for 2019 so far. Corporate credit also traded weaker, while gold and oil fell despite a flat showing from the CRB Index to finish near $57 a barrel and $1,320 an ounce, respectively.
Perhaps the most interesting action lately has taken place in Treasurys, which saw yields jump across the board, particularly the 30-year long bond. As of now, the spread between the two- and 10-year yields remains near a 52-week low, while the spread between the five- and 30-year yields approaches a 52-week high. Go figure.
- Philip Grant
Tuesday, February 19, 2019
Art of the deal
Deficit reduction, outside the box.
Deficit reduction, outside the box.
Credit check
The bull run in junk bonds continues apace,
The bull run in junk bonds continues apace,
Recap Feb. 19
Art of the deal
Deficit reduction, outside the box. From a petition circulating on Change.org:
Sell Montana to Canada for $1 Trillion to eliminate the national debt.
We have too much debt and Montana is useless. Just tell them it has beavers or something.
So far, more than 8,700 people have signed the petition.
Credit check
The bull run in junk bonds continues apace, as the Bloomberg Barclays High-Yield Index is up 5.4% year-to-date, the best showing since 2009 and well ahead of the 2.56% and 3.26% logged by the Bloomberg Barclays Investment Grade and S&P/LSTA’s Leveraged Loan Indices, respectively. The bottom of the ratings heap has fared even better, with the triple-C component of high yield rising by 6.1% since 2019 began, for its best start since 2003.
On the other end of the high-yield spectrum, the double-B-rated index has seen its spread over investment grade-triple-B issues narrow to 87 basis points, down from 166 basis points at year end. Overall, the rally in speculative-grade debt has narrowed the option-adjusted spread to 402 basis points over Treasurys, down from 537 basis points on Jan. 3 and within 100 basis points of the post-crisis low reached on Oct. 3.
The rip in junk bonds has been spurred by a trio factors, including the prospect of easier monetary policy as elucidated by Fed chairman Jay Powell on Jan. 30. In addition, corporate performance continues to be solid, with the Moody’s speculative -grade default rate registering at 2.6% for the U.S. and 2.1% globally in January, down from 2.8% and 2.3% at the end of 2018 and the lowest rates in four years.
Meanwhile, new supply remains low. In total, 38 deals have priced this year for an aggregate $28.7 billion, down from 51 new issues totaling $30.9 billion at this time in 2018 and 66 deals for $35.7 billion through mid-February 2017. That relative lack of supply, coupled with recent strength, has forced investors into the secondary market. Last Wednesday saw $12.7 billion worth of high-yield debt change hands according to data from TRACE, the busiest session in almost a year.
But a pair of indicators created by Moody’s imply that things may not be so rosy. The agency’s Liquidity Stress Indicator ticked to a 21-month high of 4% in January, suggesting “that default risks are edging higher, albeit to a still-low level.” In addition, Moody’s Covenant Quality Indicator deteriorated back into the “weakest level” category in January, and sits just a hair away from the record-worst reading reached in August 2015.
At the same time, risks to the 116-month and counting economic expansion (it would become the longest on record if continued through July) are growing. A January survey of economists conducted by The Wall Street Journal found that the median expectation of recession in the next 12 months stands at 25%, the highest level since October 2011 and almost double the January 2018 guess. Retail sales in December sank by 1.2% sequentially, the largest one-month decline since August 2009, while January auto sales at a 16.6 million seasonally-adjusted annual rate were far below the expected 17.2 million.
In an analysis last Tuesday for S&P’s LCD, Marty Fridson, chief investment officer of Lehmann Livian Fridson Advisors, LLC, calculates that the rally in junk bonds has left that asset class implying 12-month recession odds of just 10%. The Dean of High Yield cautions that junk bond investors might not be receiving adequate compensation, considering the evident risks:
Based on the historical relationship between economic forecasters’ estimate of the probability of a U.S. recession within one year and the high-yield spread-versus-Treasuries, the spread is currently 248 basis points too tight. That is the biggest gap since the Great Recession.
Fridson goes on to suggest a way to potentially profit from the sanguine spreads currently on offer in high-yield, via a pairs trade in tandem with other economically-sensitive assets:
If you are not willing to stake your performance on economists’ opinion of recession probability, you could look for another asset that you do find to be reflecting a 25% one-year probability of recession. Possible candidates could include industrial commodities, either individually or in baskets. The implied strategy would be to short high-yield bonds and go long the asset class that is priced to incorporate the economists’ recession probability estimate.
Recap Feb. 19
Stocks rose again, with the S&P 500 finishing green for a sixth time in seven tries to extend its 2019 gains to near 11%, while the small cap Russell 2000 now sits higher by nearly 17% year-to-date.
Elsewhere, commodities caught another bid with the CRB Index notching its best close in more than two months, with WTI crude and gold settling at $56 a barrel and $1,340 an ounce, respectively. Treasurys also rallied with the 10-year yield falling to 2.63%, toward the low end of its 52-week range, and the VIX traded sideways to end the day below 15.
- Philip Grant
Thursday, February 14, 2019
Halt, and catch fire?
On a Monday earnings call, Rachelle Girard, Cameco Corp. (CCJ on the NYSE)
On a Monday earnings call, Rachelle Girard, Cameco Corp. (CCJ on the NYSE)
QT progress report
Recap Feb. 14
Halt, and catch fire?
On a Monday earnings call, Rachelle Girard, Cameco Corp. (CCJ on the NYSE) vice president of investor relations, told listeners in that the blue-chip uranium producer will be keeping production idled in hopes of higher prices. It was not a hard decision:
While we are seeing some positive developments, we have not yet seen the type of response needed from the uranium market to restart. Unfortunately, today's prices are still nowhere near, not even close, to the levels needed. There's plenty of idle tier-one production and tier-one expansion capability, as well as tier-two production and expansion capability.
We were unwilling to risk having to sell those pounds into an oversupplied spot market at some point in the future. And we were unwilling to tie up our financial capacity and create an overhang in the market by producing only to place the pounds in inventory.
As might be surmised from that commentary, it’s been tough sledding for the world uranium market, as a 30% rebound in prices in the last 10 months to $29 per pound still leaves the compound scientifically known as U3O8 (Triuranium octoxide) far below its $136-per-pound peak in 2007 and a $73 interim top in 2011, before the Fukushima disaster spurred a broad revulsion toward nuclear power and faltering demand for the mineral.
Those post 2011 doldrums can at least be partially explained by the particular quirks of the commodity itself. The market for so-called yellowcake is a peculiar one, with thin liquidity, limited transparency and long cycles as utilities frequently lock in multi-year contracts with their providers.
There are reasons to think the difficult conditions will continue. In late January, Germany announced a plan to phase out all coal and nuclear power plants by 2038, as it looks to move off fossil fuel consumption (though nuclear is, of course, not a fossil fuel). Despite a production halt from Cameco and curtailment from other large producers like Kazakhstan’s Kazatomprom in 2017, global inventories remain elevated. Nicolas Carter, executive vice president of Ux Consulting Co., LLC, estimates in a Jan. 25 interview with The Northern Miner that the U.S. and Europe currently hold 2.7 and 3 years’ worth of supply, respectively. Carter, who expects the price of uranium to enjoy a gradual rise in the next few years, nevertheless notes that supply considerations can change rapidly, and unfavorably, for the bulls:
Between [Cameco’s] McArthur River mine, which is on standby, and excess capacity at operating low-cost Kazakh. . . mines, upwards of 35 million pounds [about 19% of total world supply, by his reckoning] of U3O8 can be brought back to the market relatively quickly.
Bulky inventory levels and the rise of renewable energy haven’t dulled the bull case. At a Cape Town industry conference in early February, Daniel Major, CEO of small-cap GoviEx Uranium, took a more sanguine view of both demand and supply, noting positive changes on each side of the equation while downplaying the risks of inventory oversupply:
The first thing is strong demand. Nuclear generation is now at the same level that it was pre-Fukushima. On the supply side you have a lot of projects closing down and you have the Kazatomprom and Cameco shutdowns which have effectively put the market into a deficit.
There was also an inventory overhang but now you have people like Yellow Cake (Yellow Cake plc., a specialist company buying and storing uranium) sucking metal out of the market as well. So you have a massive tightening of inventory; demand growth and big supply cuts.
The bigger fish concur with Major’s assessment. A press release from Kazatomprom (the world’s largest producer) last fall included the following assessment:
The Company believes that the supply side of the uranium market is undergoing a structural shift, following a prolonged period of depressed spot prices and oversupply, underpinned by the prevalence of legacy long-term contracts, the majority of which were concluded in the period between years 2005 and 2012.
As a significant portion of such contracts are set to expire in early 2020s, many utilities are likely to return to the market in the near-to medium-term to begin covering their future fuel needs through entering into medium- and long-term contracts.
Grant’s, likewise expecting better days ahead for the so-called heavy metal, reiterated a bullish analysis of Cameco on June 1, followed by approving assessments of Yellow Cake (YCA on the LSE) and Toronto-based Uranium Participation Corp. (U on the TSX) in the June 15 edition. Shares in each are up between 15% and 20% from publication.
QT progress report
The Fed’s portfolio of securities held outright registered at $3.83 trillion this week, unchanged from last week’s reading and following the $14.3 billion, Treasury-driven decline from Jan. 30.
Since the Oct. 1, 2017 commencement of QT, the Fed’s total balance sheet assets are down by 9.6%, a 7% simple annualized pace.
Recap Feb. 14
A relatively quiet day in the markets saw the S&P 500 cruise sideways to consolidate recent gains, while Treasurys rallied across the curve to leave the 10-year yield at 2.66%. Commodities were mostly flat but energy caught a bid to push WTI crude to near $55 a barrel, within about 50 cents of its 2019 highs, and the VIX settled below 16.
- Philip Grant
Wednesday, February 13, 2019
I thought you were pre-med?
This morning,
This morning,
Print and frame
Today,
Today,
Capital punishment
Call waiting.
Call waiting.
Recap Feb. 14
I thought you were pre-med?
This morning, microcap stock Auris Medical Holding A.G. (EARS on the Nasdaq) spiked by as much as 58%, as traders rushed to take a position in the company ahead of an announced takeover by Johnson & Johnson.
The only problem: JNJ is actually acquiring privately-held Auris Health, Inc. for $3.4 billion in cash. By contrast, the market capitalization of EARS currently stands at $12 million.
Print and frame
Today, the Swiss National Bank released its form 13-F for the fourth quarter, revealing that the central bank’s portfolio of 2,536 U.S. equities totaled $78 billion, a 13% decline for the quarter. That compares to a 14% drop in the S&P 500.
The SNB may be an uneconomic actor in the traditional sense (the bank conjures francs out of thin air, sells them to buy euros to prevent unwanted currency appreciation, then diversifies into other assets like U.S. equities), but the gnomes know how to buy the dip. The SNB’s fourth quarter filing shows 30 new positions, while the bank upsized positions in Microsoft Corp., Sprint Corp. and Amazon.com, Inc., (to pick just three) by 376,200, 99,700 and 31,200 shares, respectively.
Capital punishment
Call waiting. Holders of Banco Santander S.A.’s €1.5 billion ($1.7 billion) contingent convertible bonds (CoCos, for short) received an unpleasant surprise yesterday, when the Madrid-based bank announced it would not call (repay) the bonds, as had been hoped. The bonds traded as low as 97.5 cents on the euro in immediate response, down from 99.4 at the open on Monday.
A Santander spokesperson explained their rationale in a press statement: “When making call judgements we have an obligation to assess the economics and balance the interest of all investors.” Indeed, not calling the bonds allows the bank to convert those notes to a floating-rate structure next month with a coupon of roughly 5.53%, down from a fixed-rate of 6.25% prior to the call date.
Those who got the short end of the stick were understandably miffed, with Timothée Pubellier, portfolio manager at Financière de LA Cité S.A.S. proclaiming to Bloomberg: “The handling of the situation was truly disastrous. Credit investors will need some serious new issue premium to touch that name again.”
Santander issued a similar €1.2 billion in 7.5% contingent convertible notes one week ago, leading many observers to believe that the proceeds from that offering would be used to redeem the 6.25% securities. One unnamed banker who worked on that recent deal was less than sympathetic, telling Robert Smith of the Financial Times: “I think holders of the existing euro bond put two and two together and got five, to be honest.”
The episode shines a light on these CoCo bonds, which sit at the bottom of the credit capital structure and feature unique (and counterintuitive) characteristics. Instead of traditional convertible debt, which is eligible for call as the issuers share price rises, CoCos are converted in times of trouble to bolster the issuer’s balance sheet. Acting as a sort of financial failsafe, CoCos are designated “Tier 1” equity capital, the primary bulwark against credit losses.
Blessed by the regulators and favored by banks, the European CoCo market has grown rapidly in recent years, to €200 billion from €80 billion in the summer of 2014. Investors, squeezed by the European Central Bank’s negative interest-rate regime, have likewise thrived in the CoCo patch. The Bloomberg Barclays European Banks CoCo Tier 1 Total Return Index has jumped by 42% since July 2014, lapping the 16% gain in the Bloomberg Barclays Pan-European High Yield Index during that period.
But dangers in the CoCo market extend far beyond Santander’s maneuver yesterday. The July 11, 2014 edition of Grant’s argued that these securities present particularly acute contagion risks:
CoCos, indeed, pose potential risks to the whole world of leveraged finance, we think. Conversions or write-downs, when they’re finally forced, won’t take place under wraps. The news will start a highly focused reassessment of the creditworthiness of the stricken CoCo issuer or issuers. Providers of short-dated liabilities—certificates of deposit, uninsured deposits, commercial paper—are likely to arrive at the same conclusion more or less simultaneously.
For a timelier analysis of these CoCo contraptions, see the Jan. 11 edition of Grant’s.
Recap Feb. 14
Stocks rose for a fourth straight day, pushing the S&P 500 well above its 200-day moving average, while the VIX remained near four month lows and Treasury yields ticked higher with the short end catching the bulk of the selling.
The energy patch caught a solid bid, with WTI crude rising to $54 a barrel despite a larger-than-expected weekly inventory build. This morning’s data brought a whiff of inflation as the Bureau of Labor Statistics reports that January Core CPI grew 2.2% year-over-year, above the consensus 2.1%, while real average weekly earnings rose 1.9% year-over-year, the fastest growth rate since October 2015.
- Philip Grant
Tuesday, February 12, 2019
Funny how time slips awaty
Private equity to the rescue. This morning, mortgage service provider Ellie Mae, Inc. (ELLI on the NYSE) announced that p.e. firm Thoma Bravo, LLC is buying the company in an all-cash deal for $99 a share, or $3.7 billion.
The deal price represents a 49% premium to Ellie Mae’s average closing price in the 60-trading days ended Feb. 1 and includes a 35-day “go shop” period in which the target can solicit competing bids. In response, ELLI shares jumped 21% and for a time traded above that bid, indicating investors believe there is a chance they will indeed be able to find a better price. The deal confounds a hefty contingent of shorts (just over 21% of the float, according to Bloomberg), as well as a bearish assessment of Ellie Mae in the April 6, 2018 issue of Grant’s. Thanks to their recent surge, ELLI shares are up 6% from our publication, matching the 6% rise from the S&P 500.
Around and around. ELLI one-year price chart. Source: The Bloomberg
Ellie Mae, which provides software for the mortgage-finance industry, is the progenitor of the widely-used Encompass, used to close more than one-third of all U.S.-originated mortgages in 2017. The post-financial crisis regulatory regime, particularly the Dodd-Frank Act of 2010, has been a boon for ELLI, as small lenders, in particular, have rushed to tick regulatory boxes. According to data from the Home Mortgage Disclosure Act, non-bank lenders accounted for 56% of mortgage originations in 2017, up from just 26% in 2011. In tandem, the company grew revenues at a 38% compound annual rate from 2010 to 2017. In the third quarter, revenues grew 15% year-over-year.
From the buyer’s perspective, the deal appears to anticipate a return to the good old days. Yet, in a note published on Feb. 6, analysts at J.P. Morgan argued that Ellie’s recent performance made a takeover difficult to justify, even at its then-price of $81 a share:
[Ellie Mae’s] trailing four-quarter adjusted EBITDA is $87 million, and at $81, the enterprise value is $2.7 billion, so at a 5-6 times leverage level that is only $435 to $522 million borrowing capacity. That would make for a ~80%/20% split of equity/debt in a transaction at these current levels and we typically do not see private equity contributing above 60% equity in a transaction (and that tends to involve multiple private equity firms partnering in what is known as a club deal).
Thus, at that premium $3.7 billion ($99 a share) deal price, Ellie Mae’s theorized borrowing capacity covers about 13% of the total consideration.
Then, too, Ellie Mae’s business prospects may be dimmer than the bulls believe. That April 6 analysis in Grant’s argued that as most banks had already adopted Dodd-Frank-compliant mortgage underwriting systems, further growth for ELLI, with its 35% market share, will be harder to come by. Beyond the financial gravity of the law of large numbers, Ellie needs to contend with another immutable fact: Mortgages are a cyclical business, and Ellie’s customers skew to smaller, less well-financed lenders.
To that end, an article in the Institutional Risk Analyst on Sunday noted the sharp recent slowdown in mortgage lending activity. Citing data from The Securities Industry and Financial Markets Association, IRA publisher Christopher Whalen writes that issuance has plunged, and some industry players are hurting:
The U.S. has seen a ~ 40% decrease in issuance of mortgage backed securities since the end of September 2018, certainly reason for alarm in our book. The U.S. residential mortgage industry is looking at doing a lot less than $1.5 trillion in new mortgage origination volumes in 2018.
Market factors aside, the slump in residential lending volumes is more of the same, premium pricing for loans killing profitability for aggregators and banks, which are bidding points through the curve to buy larger jumbo assets for portfolio. Smaller retail lenders are dying due to high origination and funding costs. And even though rates have fallen since December, better yielding refinancing volumes are not yet returning.
But hope remains: Several operators in mortgage land tell The IRA that January will be a great month.
ELLI’s prospective backers surely hope that the fourth-quarter slowdown was just a blip and January’s evident revival the status quo. Regardless, the regulatory tide might be turning. On Jan. 29, The Real Deal reported that Ginnie Mae (the government-backed entity that guarantees mortgages, no relation to ELLI) has stepped up its scrutiny of nonbank lenders, which have risen to 61% of Ginnie Mae’s outstanding service volume from 34% in 2014. The Real Deal’s Kevin Sun wrote:
For the first time in years, the agency has asked a number of these lenders to improve financial metrics before receiving full approval to continue issuing Ginnie-backed mortgage bonds. . . The agency has also conducted its first ever stress tests of business partners, to see how well their monthly cash-flow obligations would hold up under reduced loan production and increased delinquencies.
Recap Feb. 12
The bulls remain firmly in control, as stocks ripped higher to leave the S&P 500 green by 9.5% year-to-date, while the NYSE FANG+ Index, Dow Transports and small-cap Russell 2000 have gained between 13% and 14% so far in 2019.
A dollar selloff helped commodities catch a bid with WTI crude ticking back above $53 a barrel, while Treasury yields rose for a second day to leave the 10-year at 2.68%, just below its simple 30-day average of 2.7%. The VIX fell to just above 15, its lowest close since October 5.
- Philip Grant
Monday, February 11, 2019
Snap-chat
The streak lives on. Industrial tools and diagnostics manufacturer Snap-on, Inc. (SNA on the NYSE) reported fourth quarter earnings featuring adjusted earnings per share of $3.03, edging past the consensus $3.02 to extend the company’s bottom-line “beat” streak to a 40th consecutive quarter. Figures beyond the headline were less impressive, as revenues were light of consensus across each of the company’s three business lines (commercial & industrial, tools and repair systems & information), while operating profit margins in the tools division (the largest) saw a 240 basis point decrease year-over-year, to 14%. Shares fell by 8% in response, and are down 5% since June 3, 2016, compared to a 29% rise in the S&P 500 over that period.
Snap-on, founded in 1920, has thrived in recent years despite a sluggish sales environment. While full-year 2018 revenues of $3.74 billion represent a 2.9% compound annual growth rate over the past five years, adjusted net income has leapt higher to over $680 million as compared to 2013’s $343 million, for a compound annual growth rate of 14.7%.
The company’s balance sheet is shipshape. On Dec. 21, Fitch Ratings reiterated its single-A rating for Snap-on, citing the firm’s “conservative financial management and consistent free cash flow generation.” Indeed, net debt stands at just $1 billion, while the Street expects SNA to generate just under $1.1 billion in adjusted EBITDA for 2019. Operating earnings of $956 million easily cover interest expense of just $50 million. The contrast between Snap-on’s sturdy credit profile and that of its customers is stark: On Thursday’s conference call, senior vice president Aldo Pagliari noted that the average yield in the financing division stood at 17.7%, “reflective of the credit quality of customers originating loans.” I.e., most borrowers are subprime.
Meanwhile, financing accounts for the bulk of that disproportionately-fattening bottom line. Thus, operating earnings from the financial services unit totaled $230 million last year, a 12.8% compound annual growth rate from the $126 million booked in 2013. Long-term net financing receivables (customer loans) footed to $1.07 billion at year-end compared to $561 million in 2013, a 13.8% compound annual growth rate.
The question before the house: How might Snap-on’s credit-centric business model fare in a less hospitable economic climate? A Jan. 16 survey from Bankrate.com finds that only 40% of respondents would be able to pay an unexpected $1,000 expense from savings on hand, with 34% needing to finance such an expense and an additional 10% unsure about how to proceed in such a scenario. Last month’s reading of consumer confidence showed a record negative disparity between the “present situations” and “future expectations” components, suggesting that Joe six pack is expecting tough times ahead.
A bearish analysis of SNA in the June 3, 2016 edition of Grant’s noted the contrast between then-strong sales growth with lackluster expansion in mechanical and automotive repair work that generates demand for Snap-on products. It argued that the company’s franchise dealer system understates credit risk and drew attention to the company’s exposure to the once-booming, now cooling, automobile market. According to WARD’s Automotive Group, January sales clocked in at a 16.6 million seasonally-adjusted annual rate, down from 17.07 million year-over-year and a 17.34 million reading in the opening month of 2017. Secular changes also present a problem, as increasingly complex and computerized cars often need to be repaired at licensed dealerships, as opposed to independent auto repair operations which are Snap-on’s bread and butter.
Bret D. Jordan, analyst at Jefferies Group, LLC, likewise noted that lengthy replacement cycles boded ill for Snap-on’s top-line growth, asking Grant's: “They are selling a product that is super premium and lasts forever. Once a guy buys a socket-wrench set from Snap-on – unless he is losing his sockets – he will never need to buy another one. How do you sustain that growth rate?”
Snap-on shares have attracted many a short-seller recently, as short interest currently stands at 12.7% of the float, according to Bloomberg. That’s up from just 3.8% in June 2016. Snap-on management seems to think the bears have a point. On Dec. 21, CEO Nicholas Pinchuk sold 22,433 shares into the open market, cashing out $3.2 million. Last year, directors made 13 open market sales, while the most recent open-market insider purchase came from former director Ruth Ann Gillis, for 265 shares, in August 2017.
Recap Feb.11
Stocks went nowhere, with the S&P 500 drifting sideways for a second straight session to remain higher by 8% year-to-date and about 7% below its early October levels, while the VIX held at 16 and Treasury yields ticked higher across the board.
The greenback caught a sharp bid, with the Dollar Index closing above 97 for the first time in six weeks, helping to pressure commodities with WTI crude finishing at $52.50 a barrel and gold closing at $1,308 per ounce. Emerging market equities and dollar-denominated debt also turned lower.
- Philip Grant
Friday, February 8, 2019
Xi student
The trade war grinds on. Yesterday, The Wall Street Journal reported that American business luminaries have been lobbying the Trump administration to break its trade-stalemate with China, with Blackstone Group boss Stephen Schwarzman arguing that “failure to strike a deal will undermine the economy and roil markets, which are anticipating an end to U.S.-China hostilities.”
So far, those efforts have been for naught, as Trump told reporters “no” yesterday when asked if he would meet with Chinese counterpart Xi Jinping by the March 1 conclusion of the 90-day trade truce agreed to in the fall. Bloomberg, citing an unnamed senior official, reported that the absence of high-level talks “should not be read as a sign that talks are breaking down.” Mr. Market appears to be more skeptical, as stocks immediately turned lower once Trump’s comments hit the wires yesterday.
While the two powers continue to posture, the U.S. is turning up the rhetorical heat. On Wednesday, the U.S. ambassador to Europe made some extraordinary comments in an interview with Politico:
We should. . . combine our mutual energies — we have a $40 trillion combined GDP, there is nothing on the planet that is more powerful than that — to meet China and check China in multiple respects: economically, from an intelligence standpoint, militarily.
As the Sino-American confrontation continues to unfold, Chinese authorities look to ease the burden on domestic business. Thus, on Jan. 23, the People’s Bank of China rolled out its so-called targeted medium-term lending facility, a mechanism aimed “at encouraging commercial banks to provide credit support to private and small firms,” according to the South China Morning Post.
One day later, the PBoC rolled out another contraption, termed the central bank bills swap, which allows owners of renminbi-denominated perpetual capital bonds to swap them for PBoC paper. One anonymous European investor described the arrangement as “very weird” to the Financial Times, noting that “nothing even remotely looking like it [exists] in any of the ECB rules today.” When Mario Draghi thinks your policies are unconventional…
Anyway, the central bank’s machinations come as economic indicators continue to point southward. Official GDP is expected to grow at 6% to 6.5% this year, the lowest growth rate since 1990. Last week’s release of the January Caixin China General Manufacturing PMI registered at 48.3, down from 49.7 in December and the weakest reading since the February 2016 deep freeze.
Meanwhile, public discontent appears to be on the upswing as companies tighten their belts. The New York Times reported yesterday that “thousands of Chinese workers are holding small-scale protests and strikes to fight efforts by businesses to withhold compensation and cut hours.” The Times cites data from the Hong Kong-based China Labor Bulletin, which found 1,700 labor disputes in 2018 compared to 1,200 the year prior, noting that “those figures represent only a fraction of disputes across China, since many conflicts go unreported and Mr. Xi has increased censorship.”
An extended economic downshift would be particularly unwelcome for China’s amply-leveraged real estate industry. Yesterday, real estate blog Curbed provided an update on the partially completed, now stalled $1 billion Los Angeles multi-use project developed by China’s Oceanwide Holdings Co., Ltd. (Almost Daily Grant’s, Jan. 29). Curbed reports that six subcontractors have recorded liens on the property totaling $62.5 million, with Webcor Construction claiming the developer still owes them $52.8 million, according to a lawsuit filed yesterday in Los Angeles County Superior Court. In addition, “a second Oceanwide subcontractor said it has been partially paid but was still owed about $550,000 – more than half the amount of its $877,471 lien.”
More broadly, the Middle Kingdom’s three largest mainland property developers, Country Garden Holdings Co., Ltd., China Evergrande Group and China Vanke Co., Ltd., saw year-over-year declines in housing contract sales of 52.2%, 32.9% and 28.1%, respectively, in January. Reuters’ BreakingViews notes today that Country Garden and Evergrande have issued $7.7 billion in offshore debt so far this year, nearly triple the $2.8 billion non-renminbi issuance in January 2018.
Overseas borrowers (the unhedged ones at least) may be in for a rude surprise. At the fall 2018 Grant’s conference, Logan Wright, director at the Rhodium Group, LLC, told the assembled that slowing economic growth, in tandem with China’s massive debt load, will eventually leave Beijing with little choice but to allow the renminbi to weaken:
Basically, in order to service this debt burden. . . Beijing is going to need interest rates lower, they are going to need to start to adjust credit conditions overall.
So, discussing the currency in more detail here, the key insight is that the severity of the domestic financial stress makes external adjustment a far easier path. . . They have a $27 trillion money supply growing at $2 – 2.5 trillion per year.
We would argue this leads to a faster path of yuan depreciation rather than a sustained defense. . . particularly if the trade conflict is not going particularly well for Beijing, given the severity of domestic stress that is underway.
Recap Feb. 8
A strong late rebound in stocks left the S&P 500 little changed both for the day and for the week, while commodities likewise traded sideways as the Dollar Index ticked to a five-week high. Treasurys were bid again, with the 10-year yield dropping below 2.64% for its lowest weekly close since January of 2018, and the VIX fell to 16, its lowest weekly close since the onset of market volatility in early October.
- Philip Grant
Thursday, February 7, 2019
Bottom of the barrel
Explosive growth in U.S. crude production continues apace,
Explosive growth in U.S. crude production continues apace,
Recap Feb. 7
Bottom of the barrel
Explosive growth in U.S. crude production continues apace, reaching a fresh record high of 11.9 million barrels per day (mbpd) at the end of November, according to the Department of Energy. That’s a record high, and up from less than 10 mbpd as recently as January 2018.
According to the U.S. Energy Information Administration, the U.S. will become a net exporter of oil by 2020 (the EIA expects production to grow to 14 mbpd by 2030), while the Financial Times noted Tuesday that the U.S. has become the United Kingdom’s largest supplier of oil for the first time since the Suez crisis of 1956. Yesterday, the FT reported on the corporate scramble to build out infrastructure in the Gulf of Mexico that can accommodate the sharp expected uptick in oil exports to the world: “The prize is the ability to fully load a Very Large Crude Carrier, a supertanker big enough to transport oil profitably to Asia.”
The supply surge has helped keep a lid on prices, as a barrel of West Texas Intermediate has fallen to $52 from $76 in early October, albeit off the late December lows of $43 per barrel. Meanwhile, President Trump’s surprise decision to issue wide-ranging waivers to the Iran sanctions allowed a greater than expected proportion of Iranian crude to hit the market and caught the Organization of the Petroleum Exporting Countries, which had already increased production to offset the expected shortfall, flat-footed. Instead, the world oil market tipped into oversupply after having drawn down on global inventories in the first half of 2018.
OPEC is not just sitting idly by as prices fall. Thus, S&P Global’s Platts Energy unit reported yesterday that the cartel pumped 30.86 mbpd in January, the lowest output since March 2015, while the 970,000 barrel sequential decline exceeds the 812,000 b/d supply cut agreed to in October (Russia and nine other non-OPEC countries are to supply the balance of the agreed 1.2 mbpd cut) and marks the biggest one-month drop off since December 2016. Swing producer Saudi Arabia slashed its January production to 10.21 mbpd, down from a record-high 11.1 mbpd in November and below the 10.31 mbpd quota agreed to by OPEC.
Then, too, the cuts are likely to remain in force for some time. Azerbaijan energy minister Parviz Shahbazov told Bloomberg that “it’s realistic [to expect] that the decision might have to be extended.” Shahbazov favors price stability, pegging the “$60 to $70 corridor” for Brent crude (currently trading at $62) as the “best price for producers and consumers.” Mr. Market is also expecting status quo for now, as John Kemp of Reuters notes that the Brent crude futures curve has returned to nearly flat from backwardation (meaning future prices fall below spot, a bearish signal) in that fourth-quarter selloff, “suggesting traders currently see the oil market close to balance this year.”
Might the oil market be girding for a renewed bull run instead? Commodity investors Leigh Goehring and Adam Rozencwajg think so. In their fourth-quarter investor letter, Goehring and Rozencwajg argue that declining output from the rest of the world will more than offset the U.S. production surge, while global demand is stronger than expected. The pair draw the historical analogy between current conditions and the 2001-2003 period, when energy prices retrenched towards their 1999 lows, before setting the stage for massive gains:
In many ways we are again in the same position as 2002. Because of the temporary imbalance in global oil markets, prices pulled back, and have now stabilized some 60-65% above their 2016 cycle-lows, (just as they did in 2001). Because of the US Federal Reserve’s quantitative tightening, Trump trade wars, and worries over potential debt problems in China, investors and energy market commenters believe we will see significant downward revisions in 2019 and 2020 global oil demand (also similar to 2001). Finally, we believe we’re going to see a significant overestimate of future non-OPEC oil supply, just as we did back in 2001.
As 2019 starts, we believe we are under¬estimating the forces that are driving global demand in the coming years as well as the forces that are driving conventional non-OPEC supply—a situation not dissimilar to what happened when oil prices bottomed at $17 per barrel in Q4 of 2001. We are repeating the trajectory of oil prices that started 20 years ago. It won’t be long before the financial press returns to talking of $100 oil.
Eighteen years ago, energy investors incorrectly judged the future of both demand and supply and we believe the same dynamic is playing out today. We are more convinced than ever that global oil markets have entered a multi-year bull market and that the 35% pullback in oil in the last three months has created another superb buying opportunity.
Grant’s, bullish on oil since March 2017, presented subscribers an analysis of a quartet of “very cheap” energy-related stocks in the Nov. 30 issue.
Recap Feb. 7
Stocks came under pressure with the S&P 500 falling nearly 1%, while commodities sold off sharply as the dollar enjoyed modest strength. The VIX rose by 6% to finish back above 16.
Perhaps the most interesting price action was in rates, as Treasury yields fell across the curve while three-month Libor plummeted by more than four basis points, its biggest one-day move since May 2009.
- Philip Grant
Tuesday, February 5, 2019
Crocodile done deed
A crackdown in the Lucky Country? Yesterday, the Australian Royal Commission released its highly-anticipated final report on alleged misconduct in the country’s financial services industry. Much to the delight of stock bulls, the Commission stopped short of proposing drastic structural changes such as a break-up of the big banks. In response, the S&P/ASX Index rose 2% for its biggest one-day gain since 2016, while the ASX Financials Index ripped higher by 4.5% for its best showing in more than five years.
But that’s not to say the Commission gave the banks and brokers a pass. The report refers more than 20 institutions and individuals for potential criminal or civil prosecution, while detailing scandalous alleged behavior such as charging fees for services not provided (including to the deceased) and deploying aggressive sales tactics toward a young man afflicted with Down syndrome. Commissioner Kenneth Hayne offered a particularly scathing assessment of National Australia Bank Ltd.:
I thought it telling that in the very week that NAB’s CEO and chair were to give evidence before the commission, one of its staff should be emailing banks urging them to sell at least five mortgages each before Christmas. Overall, my fear – that there may be a wide gap between the public face NAB looks to show and what it does in practice – remains.
The Commission’s report comes as Australia maintains a remarkable 27 years-and-counting string of uninterrupted economic growth (the last year-over-year decline in GDP took place in the fourth quarter of 1991). However, the housing boom that had long accompanied that growth streak is now firmly in reverse, as CoreLogic reported a 1% sequential drop in national dwelling values in January, extending the pullback in prices to 6.1% off their October 2017 peak.
While prices retrench, homeowners fall deeper into hock: The Australian Bureau of Statistics finds that household debt as a percentage of income rose to 188.6% in the third quarter (the most recent reading), up from 185.9% year-over-year, while the Home Price Index fell 1.9% over the same period.
The auction clearance rate, a key gauge as auctions are a primary mechanism for selling houses in Australia, has suffered a protracted decline to less than 48%, down from 70% early last year and 84% in spring 2015. Activity is likewise on the wane: CoreLogic also reports that 526 homes were put up for auction in the seven major “Capital Cities” during the first weekend in February (a busy one, coming right after the Australia Day holiday), down from 790 a year ago.
CoreLogic Australia auction clearance rate, five-year chart. Source: The Bloomberg
Whether a simple gravity-driven pullback, the result of political heat or some combination therein, lenders are tapping the brakes. Thus, Digital Finance Analytics reports that 40% of mortgage applications were rejected in December, down from 48% in November but still far above the 8% which didn’t make the cut in December 2017. In a Dec. 14 Grant’s Aussie analysis, deputy editor Evan Lorenz identified the unwelcome implications of that trend:
The rise in mortgage rejections comes at a particularly difficult time for borrowers. At the end of 2015, nearly two-fifths of mortgages were interest-only (IO). The typical Aussie IO starts amortizing after five years, at which point monthly payments increase by 30%-40%. The Reserve Bank estimates that around A$120 billion ($86.3 billion) of IOs will reset annually in 2018 through 2020. ‘About one-third of that won’t get refinanced,’ says Martin North, the principal of Digital Finance Analytics.
Will the Royal Commission report and potential regulatory crackdown, accelerate the housing market’s slide and expose the Australian banks to losses? Grant’s man on the scene, Roland Nelson of South Perth, forecasts an emphatic “yes” to that question:
The mortgage application systems of all the banks were intentionally designed to not look at incomes or expenses. Not merely not verify, not look. To accept borrowed deposits as unencumbered assets. Because they thought house prices always rose, and that this increase (which would improve the security of the loan) was occurring independently of their lending.
After yesterday’s announcements it will be extremely hard to return to faith-based mortgage credit checks. The stock of collateral on the banks balance sheet is worth what a future (less easily financed) buyer can afford.
Nelson draws a key distinction between the American experience of 2007-2009 and the current situation Down Under:
Australian Banks are NOT securitizing and selling their toxic near-NINJA [no income, no job or assets] mortgages. They are keeping them on their balance sheets. As safe assets, with minimal risk weights.
Recap Feb. 5
Another day, another green close for stocks as the S&P 500 rose for a fifth day to push the broad index higher by more than 9% year-to-date, while bonds were bid with Treasury yields dropping across the board and both investment grade and high yield corporates also faring well.
A rallying greenback pushed the Dollar Index back above its six-month range and pressured the energy patch, as WTI crude fell back below $54 a barrel. Interbank lending costs rose, with three-month Libor advancing for the second time in three sessions after ticking lower through much of January.
- Philip Grant
Monday, February 4, 2019
Drop a 'Digm
The junk-bond revival continues apace. The Bloomberg Barclays High Yield Total Return Index gained a whopping 4.52% in January, easily topping the 2.6% advance in the S&P/LSTA Leveraged Loan Index and marking the best one-month performance for high-yield in seven years, according to Bloomberg. Cellar-dwelling issues have fared even better, as the iBoxx U.S. Triple-C-rated Index has ripped higher by 6.6% year-to-date.
That swift recovery in prices has naturally spurred renewed deal activity: Last week saw $8 billion in fresh high-yield supply, the busiest week since August, according to Bloomberg. S&P’s LCD unit likewise notes that since Jan. 10, speculative-grade companies have raised $50 billion across both leveraged loans and high yield debt; that compares to just $29 billion during November and December.
That bulge in issuance includes some notables. On Friday, aircraft component manufacturer TransDigm Group, Inc. priced $550 million in senior unsecured 7.5% notes due 2027 and $200 million in 6.25% senior secured notes due 2026, with the secured tranche a follow-on offering to a $3.8 billion sale announced just two days earlier. That $4 billion in total size will likely place TDG’s 6.25% issue as the third-largest within the U.S. high-yield index, according to Bloomberg Intelligence. TransDigm will use the proceeds to retire the outstanding 5.5% senior unsecured notes maturing next year, as well as to fund the purchase of Esterline Technologies Corp., a $4 billion cash deal announced in October at a 41% premium to where Esterline shares traded prior to reports of TDG interest.
The Esterline deal is the biggest in TransDigm’s history, no small feat for a company that has made some 22 separate acquisitions since 2012. As is frequently the case with such roll-ups, debt figures prominently in the capital structure. Fitch Ratings calculates that TDG’s “adjusted” (to include restructuring costs, a recurring line item for the serial acquirer) leverage ratio is set to jump to 8.2-times EBITDA by year-end, up from 7.1 times in 2018, following the completion of the Esterline purchase. Indeed, the junk-bond thaw comes not a moment too soon for the company, as research firm CreditSights summed things up: “TransDigm is striking while the iron is hot.”
Issuers have gotten a reprieve. What about investors? In a note on Thursday explaining their decision to cut TransDigm’s senior subordinated notes to triple-C-plus, Fitch cited both “a material increase” in first lien debt “in excess” of the rating agency’s assumptions, as well as “weaker potential recovery” in the event of default.
The actions of TDG management betray no particular concern for creditors: In August 2017, the company issued stockholders a special dividend of $22 a share, with a $1.2 billion total payout compared to $717 million in 2017 free cash flow. That followed a $24 per share disbursement, at a total cost of $1.4 billion, made to shareholders in October 2016.
An analysis in the March 10, 2017 edition of Grant’s inspected the plight of corporate creditors in the context of asymmetric opportunity. The editorial verdict: With a best case scenario of the return of principal with interest, creditorsare not sufficiently compensated for the real risk of severe impairment should things go wrong. Of TransDigm, Grant’s wrote:
If the bears are wrong, the bondholders will earn their 6.33% yield to a 2020 call. If it’s the bulls who miscalculate, the creditors may suffer equity-like losses. In a bankruptcy, the lenders would probably secure recoveries no higher than 30% of par, according to the range of ratings-agency estimates (S&P calculated in May 2015 a recovery of zero, but allowed for a range of up to 10%).
A follow-up survey of unappealing corporate bonds on April 6, 2018 summarized the plight of corporate lenders in an analysis headlined: “Doormats of Wall Street:”
Creditors are the loneliest corporate stakeholders. Management disdains them. The Fed debases them. Give them this, at least (it’s a kind of virtue, anyway): They never complain.
Recap Feb. 4
The bull parade continues, as stocks rallied again with the S&P 500 rising for a fourth straight session to finish 16% above its interim lows less than six weeks ago. Meanwhile, another lurch lower in the VIX pushed the volatility gauge below 16, its lowest close since early October when the indices remained near their closing highs.
Treasury yields rose in near lockstep, with the 10-year settling at 2.72%, and WTI crude fell back below $55 a barrel. After the bell, Alphabet, Inc. (née Google) reported fourth quarter results featuring narrower-than expected margins, sending shares lower by 3% in immediate reaction.
- Philip Grant
Friday, February 1, 2019
Lockedchain
The downsides of digital security. From CoinDesk:
The downsides of digital security. From CoinDesk:
Pocket dial
Yesterday, Sprint Corp. (S on the NYSE) reported better-than-expected third quarter figures,
Yesterday, Sprint Corp. (S on the NYSE) reported better-than-expected third quarter figures,
Recap Feb. 1
Lockedchain
The downsides of digital security. From CoinDesk:
Troubled Canadian crypto exchange QuadrigaCX owes its customers $190 million and cannot access most of the funds, according to a court filing obtained by CoinDesk.
The problem: The exchange kept its digital ducats in a so-called cold wallet, which is not connected to the internet and accessible only by private key. Following the death of co-founder Gerald Cotton, investors were left with no way to access their cryptos.
In a sworn affidavit filed Jan. 31 with the Nova Scotia Supreme Court, Jennifer Robertson, identified as the widow of QuadrigaCX co-founder Gerald Cotten, said the exchange owes its customers roughly $250 million CAD ($190 million) in both cryptocurrency and fiat.
She later added that she has no business records whatsoever for QuadrigaCX or its affiliated companies. While she does have Cotten’s laptop, the device is encrypted, and she does not have its password or recovery key. While a consultant has been retained to try and recover the laptop’s contents, he has had limited success to date.
Pocket dial
Yesterday, Sprint Corp. (S on the NYSE) reported better-than-expected third quarter figures, with operating revenues of $8.6 billion and adjusted EBITDA of $3.1 billion topping the expected $8.38 billion and $2.89 billion, respectively. The wireless carrier also maintained its full-year adjusted EBITDA forecast and reiterated that it will roll out next-generation 5G wireless networks in the first half of 2019.
In response, Sprint shares rallied by 4% and remain in the upper end of their 52-week range, while creditors are also feeling their oats, as single-B-rated Sprint’s 7 7/8 notes of 2023 currently change hands at 107 cents on the dollar for a 358 basis point spread over Treasurys. That’s well below the 423 basis point pickup currently fetched by the Bloomberg Barclays High Yield Index.
But commentary from CEO Michel Combes belied those pleasing headline results. After detailing the company’s various accomplishments during the conference call, Combes then painted a grim picture of Sprint’s prospects should the company’s pending merger with T-Mobile US, Inc., (TMUS on the Nasdaq) fail to meet with regulatory approval:
We’re hopeful to complete our merger with T-Mobile which is the only path to delivering the breadth and depth of spectrum which will allow us to provide a truly consistent national-wide 5G experience to Americans.
As a stand-alone company, we lack the scale to keep pace with the bigger carriers, AT&T and Verizon, in sustained capital investments, and without additional low-band spectrum we will face challenges to provide customers with coverage comparable to that of the big two carriers.
It was a notable change in tone from a year ago, when Sprint chairman and current chief operating officer of SoftBank Group Corp. (which owns 84.5% of Sprint) Marcelo Claure had this to say, in discussing the 2019 arrival of 5G technology:
This latest development will put Sprint at the forefront of technology and innovation on par with other leading carriers around the world. . . While our network is much improved, we believe our Next-Gen Network will truly differentiate Sprint over the next couple of years due to our strong spectrum assets that enable Sprint to be the leader in the true mobile 5G.
From a lobbying point of view at least, Combes’ downbeat rhetoric is understandable. On Monday, Democratic leadership in the House of Representatives announced that Congress will hold a hearing on the merger on Feb. 13, and the ultimate outcome remains anyone’s guess. Reading the political tea leaves today, The Capitol Forum sees the market-implied odds of approval at 60%, identifying President Trump’s friendly rapport with SoftBank CEO Masayoshi Son as one factor that could help. Assistant attorney general Makan Delrahim’s recent comment that he sees no “magic number” of U.S. wireless carriers could also be construed positively, as the potential consolidation into three carriers from the current four is a popular talking point among deal opponents.
Then again, The Capitol Forum reported on Jan. 10 that Justice Department staff have been coordinating their review with skeptical state regulators in New York and California, “a setback” for the would-be merger, while the DoJ’s plans to depose third-party cable company executives is potentially “an ominous sign.”
Craig Moffett, co-founder and one-half eponym of firm MoffettNathanson, LLC likewise sees things as coming down to the wire, handicapping 50% odds of the deal closing. In a note yesterday, Moffett writes that Sprint management faces a daunting task: Convincing regulators that Sprint cannot go it alone as a viable company (see Combes’ rhetoric above), while at the same time projecting confidence to the bond market that the company can survive without T-Mobile, if need be.
Ultimately, Moffett concurs with Combes’ assessment, putting it bluntly: “If the merger is approved, the stock will go up. If it is rejected, [Sprint’s debt] will likely have to be restructured.”
A thumbs down from regulators would be bad news indeed for Masa Son, as even a return to Sprint’s early-2016 price (roughly 50% below current levels) would equate to a loss of approximately 15% of the parent’s market capitalization (Grant’s, Nov. 30). Regardless of the outcome, the SoftBank boss is keeping it all in the family: Bloomberg reports today that Son is preparing to tap Claure as head of a new Latin America-focused investment fund, which, though separate from SoftBank’s gargantuan in-house V.C. arm the Vision Fund, “could reach several billion dollars in size.”
Recap Feb. 1
Stocks finished little changed, shaking off a near-6% post-earning selloff in Amazon.com, Inc. to leave the broad S&P 500 up 1.5% for the week. A red-hot reading of January non-farm payrolls pushed Treasury yields sharply higher, erasing a chunk of this week’s rally, while energy prices caught another bid with WTI crude closing above $55 a barrel for its best finish in more than two months. The VIX fluttered to just above 16, its lowest close since early October.
- Philip Grant
Thursday, January 31, 2019
T Pain
Yesterday was a big day for monetary policy, as the first Fed meeting of 2019 featured a sharp dovish pivot, with chairman Jerome Powell suggesting not only a halt to the hiking cycle but also a sooner-than expected end to the “QT” balance sheet runoff. With monetary-traffic signals now blinking green, investors responded by bidding up equity prices, while interest rate futures went from pricing net 15% odds of a rate hike by the December meeting to pricing a net 17% chance of a cut in December. Analysts likewise cheered the move, with BofA Merrill Lynch releasing a note headlined: “The Fed is on your side.”
But a less discussed, yet potentially more impactful, long-term policy event also took place yesterday: The Treasury Borrowing Advisory Committee presented its quarterly recommendations to help tackle Uncle Sam’s ever-expanding financing needs.
The board estimates Treasury’s borrowing needs at more than $12 trillion for the next decade, assuming no recessions during that stretch (that $1.2 trillion annual average compares to an average $875 billion during the eight, recession-free years from 2010 to 2017, a 38% increase). The current business expansion stands at 115 months and counting, the second-longest in history behind the 120 months logged between 1991 and 2001. When the music stops, we can expect issuance to ratchet even further: TBAC notes that recessions typically increase the size of the deficit by between two and five percent of GDP.
Growth fluctuations aside, TBAC predicts that a greater proportion of U.S. debt will need to be placed domestically, noting that the portion of world FX reserves denominated in dollars has steadily declined, to a current 62% share from 72% in 2000. Over the five years ended in November, the total supply of Treasurys outstanding has grown at a compound annual rate of 4.9%, while foreign ownership has grown by just 1.7% compounded annually.
Among the TBAC’s suggestions:
- Targeting “pockets of savings” in the economy, from banks, pensions, insurance companies, corporations and asset managers.
- Broadening the types of debt issued to include perpetual and zero-coupon bonds, as well as expanding the usage of floating-rate and inflation-protected debt. The board also recommends increasing longer-dated issues, particularly 15-20 year maturities.
- Increasing the use of re-openings [providing additional supply] for popular issues, as well as of buybacks of issues that are trading cheaply to reduce interest costs.
The facts and ideas presented by TBAC have caused no great concern in the bond market. Indeed, Treasury prices have jumped across the board during the past two days, not just at the particularly policy-sensitive short end. That continues a strong rally that has seen the 10-year yield fall to 2.63% from 3.23% in November.
The contrast between falling borrowing costs while Treasury supply bounds higher shines a light on the interaction of these dual monetary and fiscal policy pillars. On May 18, Grant’s produced a mock prospectus for the U.S. Treasury, the sixth in a series going back to 1985. Among listed risk factors: the temptation of debt-soaked Uncle Sam to reduce the real weight of his burden through inflation. It has happened before:
As a substantial net borrower, the Government may be predisposed to conduct a monetary policy that reduces the real burden of its debt. The Government may pursue such a policy through the Federal Reserve, the senior officials of which the executive branch of the Government appoints.
The Government has conducted inflationary policies in the past. Thus, in 1933–34, the Government devalued the dollar to 1/35th of an ounce of gold from 1/20.67th of an ounce of gold. In affirming this policy, Congress voted to abrogate pre-existing public and private contracts denominated in gold coin, including contracts bearing on U.S. Treasury securities; in 1935, the Supreme Court upheld that Congressional action. In 1971, the Government rescinded its pledge to exchange dollars for gold at the fixed rate of 1/35th of an ounce of gold. Federal courts have held that the Government may do what it will with the nature and value of the dollar.
But the post-Bretton Woods monetary system confers extraordinary privileges on the dollar, and by extension, the U.S. government; benefits that have perhaps helped keep borrowing costs earthbound while debt piles higher. The editor’s foreword addresses that topic, arguing that those perceived advantages may not be all they’re cracked up to be:
As to the dollar-printing franchise and the reserve-currency privilege, commonly regarded as assets, we hold that they are either liabilities or traps. If the U.S. Government manages finally not to overprint the currency despite a pliable central bank, and not to overborrow despite the temptations presented by the dollar’s exalted status as a reserve asset, history will immortalize Washington, D.C. as the seat of the political wisdom of the ages.
What do you want to bet?
QT progress report
A $7.2 billion sequential decline left the Fed’s portfolio of securities held outright at $3.84 trillion. That’s down by $13.5 billion compared to the trailing four-week average, with mortgage-backed securities accounting for most of the drop.
Since the commencement of QT on Oct. 1, 2017, total balance sheet assets are down by 9.3%, at a simple annualized pace of 7%.
Recap Jan. 31
Another equity bid wrapped up a stellar January, with the Dow Jones Industrial Average, S&P 500 and Nasdaq 100 Indices rising by 7%, 8% and 9%, respectively, for the first month of the year. After the bell, Amazon.com, Inc. reported fourth quarter figures, topping consensus on the top and bottom line but offering lighter than expected first quarter revenue guidance, sending shares lower by 2% in immediate reaction.
Elsewhere, Treasurys continued their rally with slight outperformance from the short end leaving the curve a bit steeper, while commodities gave back early gains with WTI crude settling at $54 a barrel. The VIX dropped below 17 for its lowest close since Dec. 3.
- Philip Grant
Wednesday, January 30, 2019
Dancing in the Streets
New data from the European Central Bank comes to an interesting conclusion
New data from the European Central Bank comes to an interesting conclusion
Zuck Tales
The hits keep coming for Facebook, Inc. (FB on the Nasdaq).
The hits keep coming for Facebook, Inc. (FB on the Nasdaq).
Recap Jan. 30
Dancing in the Streets
New data from the European Central Bank comes to an interesting conclusion about the strenuous monetary stimulus undertaken in recent years. From the ECB Twitter account:
ECB asset purchases have reduced inequality in the eurozone, our research shows. They have especially benefited low-income households, which suffer the most from unemployment.
The proof is in the pudding: French citizens have been celebrating the ECB’s successes in the streets of Paris for weeks on end.
Zuck Tales
The hits keep coming for Facebook, Inc. (FB on the Nasdaq). Yesterday, TechCrunch reported that the social media behemoth “has been secretly paying people to install a ‘Facebook Research’ [app] that lets the company suck in all of a user’s phone and web activity.”
That is a violation of the rules that Apple, Inc. sets for its app store. In response, Apple this morning revoked Facebook’s app development credentials, a move which blocks FB employees from accessing both in-development “beta test” app projects as well as internal company apps used to organize lunch orders and transportation. According to tech website The Verge, Apple’s move is considered “a critical problem” for Facebook employees.
It’s the latest P.R. black eye for Mark Zuckerberg’s creation, which has recently endured data privacy scandals, political heat and unflattering press coverage such as the revelation from Rolling Stone that the Facebook boss slaughtered a goat with a “laser gun and then a knife” to eat at a dinner with Twitter, Inc. CEO Jack Dorsey (he's a real bleating heart). Meanwhile, insiders continue to aggressively sell stock in the open market. Zuckerberg halted his near-daily sales at the end August, but chief operating officer Sheryl Sandberg continues to forge ahead with sales of 55,000 shares twice per month, cashing out some $15.8 million of stock in January.
After ripping by 475% in the five years ended August 2017, FB stock has since fallen by 2% (Grant’s offered a bearish analysis at that time), compared to a 16% gain from the Nasdaq 100 Index. The pullback leaves FB shares priced at less than 18 times full-year 2019 consensus adjusted earnings per share, while the Street expects revenues to jump more than 23% this year from 2018. Today, the company reported fourth quarter figures (pleasant ones by Mr. Markets reckoning, as FB gained 9% after-hours), including daily active users of 186 million and monthly active users of 242 million in the U.S. and Canada, Facebook’s most profitable regions.
However, bulls must consider a potentially uncomfortable question: Is Facebook’s user engagement, which drives the advertising dollars that have propelled the stocks dizzying rise, what the company says it is? An in-depth report from investigative website Plainsite (available on the web here) on Jan. 24 summarized its findings thusly:
Facebook has been lying to the public about the scale of its problem with fake accounts, which likely exceed 50% of its network [vs. a company estimate of three to four percent of the total in 2017]. Its official metrics—many of which it has stopped reporting quarterly—are self-contradictory and even farcical. The company has lost control of its own product.
While Plainsite author Aaron Greenspan has long claimed to be the true inventor of “the Face Book” while at Harvard and may have an axe to grind, a September 2017 report from Pivotal Research analyst Brian Wieser (who has long carried a “sell” rating on FB shares, one of four to do so out of 53 tracked by Bloomberg) casts further doubt on the company’s claims:
Through Facebook’s Ads Managers we can see that Facebook claims a potential reach within the U.S. of 41 million 18-24 year-olds, 60 million 25-34 year-olds and 61 million 35-49 year-olds. By contrast, U.S. Census data indicates that last year there are a total of 31 million 18-24 year-olds, 45 million 25-34 year-olds and 61 million 35-49 year-olds. Nielsen estimates for the 2017-2018 season are close to the 2016 U.S. Census figures, with 31 million 18-24 year-olds, 43 million 25-34 year-olds and 61 million 35-49 year-olds.
A year later, a study from Pew Research reported that 42% of respondents had recently taken a “multiweek break” from the social network and 26% had outright deleted the Facebook app from their phones during the fallout from the Cambridge Analytica data-selling scandal. Yet the company reported curiously stable engagement during the course of 2018, with daily active users remaining at 185 million in the first, second and third quarters in North America.
Even taking the company’s figures at face value would imply growth potential that may disappoint the still well-represented bull crowd (41 analysts carry a buy rating on FB). North American daily active users and monthly users reported by Facebook today represent 80% and 105%, respectively, of the 231.2 million total population aged 15-64 in the U.S. and Canada as of December (comprising much of Facebook’s target demographic as users must be at least 13 years old), according to the Organization for Economic Co-operation and Development.
Recap Jan. 30
A dovish turn from the Fed: Language from chairman Jerome Powell suggesting the pace of rate hikes will slow and the “QT” balance sheet runoff may be near its end was just what the bulls wanted to hear, as the S&P 500 gained more than 1.5% while the NYSE FANG+ Index ripped by 4%, leaving those gauges in the green by 7% and 10%, respectively, for the year.
A sharp dollar downdraft paved the way for another commodity rally, with WTI crude finishing above $54 a barrel and gold approaching $1,320 an ounce, while Treasury yields fell across the board with the short-end outperforming to leave the curve steeper. The VIX fell below 18.
- Philip Grant
Tuesday, January 29, 2019
Scoreboard watching
Let’s take a look at the early returns for fourth quarter earnings season:
Let’s take a look at the early returns for fourth quarter earnings season:
All groan up
One defining feature of the ongoing earnings rush: Un-bullish tidings from the Middle Kingdom.
One defining feature of the ongoing earnings rush: Un-bullish tidings from the Middle Kingdom.
Recap Jan. 29
Scoreboard watching
Let’s take a look at the early returns for fourth quarter earnings season: In a note published yesterday, analysts at Bernstein find that with 21% of S&P 500 companies reporting through Jan. 24, 77% have managed to beat the bottom-line consensus estimate. That’s a pleasant-enough looking figure, but still “the lowest beat ratio since 2014, despite aggressive estimate cuts by analysts going into earnings season.”
Meanwhile, ambitions for 2019 have been scaled back significantly. While Wall Street consensus currently calls for aggregate 9.5% year-over-year earnings growth in the fourth quarter, bottom line growth is forecast to fall to 1.6% year-over-year in the first quarter. The primary source of slashed expectations? “Companies with the largest share of revenues coming from outside the U.S. are experiencing the most severe [forecast] cuts.”
While analysts lower the bar, Mr. Market remains in a charitable mood, the Bernstein team finds: “Companies who beat or met estimates outperformed the market by 1.5%, and those who missed estimates were able to outperform the [S&P 500] slightly by 0.6% within the five-day window [two days prior to two days after] surrounding the report date.”
All groan up
One defining feature of the ongoing earnings rush: Un-bullish tidings from the Middle Kingdom. This month, an array of companies has noted unexpected economic weakness in China, including the large-cap tech trio of Apple, Inc., Nvidia Corp. and Intel Corp. On the industrial side of things, tool maker Stanley Black & Decker, Inc. made note of a Chinese slowdown, glue manufacturer H.B. Fuller Co. CEO James Owens termed the deterioration “worse than expected,” and yesterday Caterpillar, Inc. CEO Donald Jim Umpleby forecast a “roughly” flat showing in the world’s second-largest economy, following back-to-back years of “significant growth.”
At the same time, Chinese companies continue to retrench. On Friday, Bloomberg reported that formerly-acquisitive conglomerate Anbang Insurance Group Co. “is looking to sell the Manhattan office building which houses its U.S. headquarters.” Yesterday, the Los Angeles Times reported that developer China Oceanwide Holdings Ltd. (code 715 on the Hong Kong stock exchange) abruptly halted a $1 billion downtown L.A. condominium, hotel and retail complex “due to a recapitalization of the project.” The development “is well underway and was expected to be completed this year.” Oceanwide shares fell by 1.4% today and are down by 79% from their 2015 highs.
Private companies are not the only ones girding for rougher seas. Today, Bloomberg notes that 23 out of 30 provincial governments have trimmed their own regional growth targets for this year relative to 2018, including Guangdong and Jiangsu, the regions with the highest GDP levels in China. Xinxiang, China’s largest province by land mass, slashed its 2019 growth target to 5.5% from 7% last year.
Caixin likewise relays that funding constraints have forced 17 separate provincial governments to cut their targets for construction under the “shantytown renovation” program (no euphemisms here). The program has drawn Beijing's scrutiny for the practice, increasingly common, of compensating displaced homeowners with cash rather than replacement housing, which “can drive more property purchases. . . because buyers can use the money for down payments on multiple homes.”
Might an otherwise routine economic slowdown metastasize into something much worse for super-encumbered China? Not if the powers that be can help it. In a report yesterday, Tim Murray of J Capital Research writes that a bond-market workaround may serve to frontload a burst of local government spending and stimulate the Chinese economy once more this spring:
The government has used legerdemain to boost funding without reneging on its commitment not to raise debt: Special Purpose Bonds (SPB). Issued by local governments, SPBs are for discrete infrastructure projects whose revenues, the issuer promises, will service the bonds. SPBs are not included in the fiscal budgets of local governments.
Chinese banks buy local government bonds under mandate, so the market for SPBs is not in doubt. . . This year, provisional approval was given in January for Rmb. 580 billion ($86 billion) of standard local government bonds and Rmb. 810 billion in SPBs to be issued in advance of the National People’s Congress [in March]. It is expected these bonds will be issued before April. This would create very strong liquidity for infrastructure projects in March.
Total expenditure in infrastructure may not rise, but we can expect more activity at the start of the construction season. Construction demand in March/April is critical for setting confidence in the economy.
Recap Jan. 29
Stocks finished slightly lower, with the S&P 500 continuing to consolidate near the midpoint of the all-time peak reached in late September and the Dec. 24 interim lows. Commodities caught a bid with gold rising above $1,310 an ounce and WTI crude popping back above $53 a barrel. Treasurys were also bid across the curve despite a mediocre seven-year note auction this afternoon, with the 10-year yield now at 2.71%.
The Fed will conclude its first meeting of the year tomorrow, with interest rate futures assigning zero odds of a rate hike. Stock bulls will be on the lookout for any dovish language from chairman Powell, particularly anything suggesting curtailment of the QT balance sheet runoff.
- Philip Grant
Monday, January 28, 2019
Strength in numbers
Fact of the day, from Bloomberg:
Fact of the day, from Bloomberg:
Mine over matter
This morning, chip maker and hardware company Nvidia Corp. (NVDA on the Nasdaq)
This morning, chip maker and hardware company Nvidia Corp. (NVDA on the Nasdaq)
Recap Jan. 28
Strength in numbers
Fact of the day, from Bloomberg:
The S&P 500 Equal Weight Index is trouncing the cap-weighted version YTD, putting up a total return of about 7.5% against 5.2% [for the S&P 500]. That ~230 basis point gap is the largest in 27 years.
Mine over matter
This morning, chip maker and hardware company Nvidia Corp. (NVDA on the Nasdaq) provided another unwelcome surprise in the form of sharply reduced fourth-quarter guidance. Revenues for the period are now projected at $2.2 billion, far below the $2.7 billion top-line guidance provided in November (which was itself cut from an initial $3.4 billion guesstimate) and the $2.91 billion logged in the last year’s fiscal fourth quarter. Profitability is likewise on the wane, with the company forecasting adjusted gross margins at about 56%, down from prior guidance of 62.5% and an average 62.6% over the past four quarters. Full results are expected on Feb. 14.
Whence came the banana peel? “Deteriorating macroeconomic conditions, particularly in China” was the primary factor according to the company press release. Increased customer price sensitivity in new, high-end graphics processing units (GPUs) and disappointing performance from its datacenter unit were also contributing factors, while several planned deals that were expected to close before quarter-end did not materialize, according to Nvidia.
Co-founder and CEO Jen-Hsun Huang offered some positive spin: “Looking forward, we are confident in our strategies and growth drivers. . . The foundation of our business is strong and more evident than ever.” Mr. Market logged his respectful disagreement, as NVDA shares fell by 14% and are now off 42% since June 29, compared to a 4% drop in the Nasdaq 100 Index.
NVDA five-year price chart. Source: The Bloomberg
It’s been a rapid change of fortunes for Santa Clara, Calif.-based Nvidia, inventor of the GPU in 1999 (“the brain of the computer,” is how the company puts it) which is used in video games, artificial intelligence and, of course, crypto-currency mining. The company rode the 2017-crypto boom to parabolic growth in both net income and share price, but it’s a different story now, as the combined crypto market cap currently stands at $112.7 billion, according to Coinmarketcap.com, down from more than $800 billion at the cyclical peak last January. As prices have retrenched, demand for equipment used to mine the digital ducats has likewise faded. The price of “add-in” memory boards, which rose as high as $1,500 in the teeth of the crypto mania, can be found online for fractions of that (the “Radeon E6460 PCIe 2.1 x16 add-in Board with Heatsink” is quoted by Symmetry Electronics at $189.04, before tax and shipping).
A bearish analysis of Nvidia in the June 29, edition of Grant’s rested on the idea that the then-underway crypto reversal would, in turn, crimp demand for the chip maker’s equipment, while a shift back toward video game GPU usage could lead to decreased demand for its high-end units and margin compression. At the same time, numerous tech peers were attempting to develop their own chips to undercut the “very expensive” GPUs (those words belong Sewon Chun, senior vice president of memory marketing at Samsung Electronics Co. Ltd) used in datacenter.
The analysis also took note of persistent selling across the company C-suite. The severe markdown in NVDA shares hasn’t quelled management’s evident bearishness, with five different officers selling shares September. On Oct. 2, senior vice president Ajay Puri rang the register on $26.3 million of stock.
It’s not just management which is eyeing the exits. On Dec. 11, Bloomberg reported that SoftBank Group Corp., which bought into the company in May 2017 and is Nvidia’s fourth-largest shareholder, was looking to sell its 4.9% NVDA stake “early [this] year,” and had hedged its position by purchasing out-of-the-money put options.
Hodl on loosely?
Recap Jan. 28
Stocks finished moderately weaker, as a late bounce helped the S&P 500 pare roughly half of its early 1.5% loss (Caterpillar, Inc. also offered weaker than expected guidance this morning). More bad corporate news hit the wires after the close, as Whirlpool Corp. guided its full-year earnings per share to well below the consensus estimate, sending shares lower by 5% in immediate reaction.
Elsewhere, commodities were hit hard with the CRB Index dropping nearly 2%, but gold managed to buck that bearish trend and remain above $1,300 an ounce, up 11% from the August interim lows. The VIX briefly rose above 20 before settling just below 19, and rates finished slightly lower across the Treasury curve. Interbank lending costs have turned lower in recent weeks, with three-month Libor now at 2.75%, down from 2.82% in late December, while The Secured Overnight Financing Rate (SOFR) now stands at 2.4%, down from 2.46% in mid-January.
- Philip Grant
Friday, January 25, 2019
Italian wedding
“Super Mario” isn’t finding things so super. At a press conference yesterday in Frankfurt, ECB president Mario Draghi said that the balance of risk “has moved to the downside,” a change from the “broadly balanced” assessment of conditions he offered six short weeks ago. The central banker went on to cite “uncertainties, in particular related to geopolitical factors” as a culprit for the recent turn for the worse.
Draghi’s remark appears at least partially directed at Europe’s problem child to the south, Italy, which has long been running harder just to stay in place. In the 12 years ended 2018, Italian nominal GDP has grown at a compound annual rate of just 0.11%, while public debt as a percentage of GDP has jumped to 130% from 100%.
The odds of much near-term improvement are scant. Last Friday, the Bank of Italy indicated that the country fell into recession in the back half of last year and cut its growth forecasts to 0.6% and 0.9% in 2019 and 2020, respectively, from prior guesstimates of 1% and 1.1%. Recent economic data have not helped: new and existing home prices logged 1.4% and 1.3% respective year-over-year declines in the third quarter, while November industrial production sank by 2.6% year-over-year. Economists had expected a 0.4% uptick.
Political risk is indeed front and center, as Italian media reports widespread rifts between populist coalition partners, the Five Star and The League parties, while Bloomberg relays that the political class “are poised for a snap election as early as this year.”
A need for economic growth is one area of agreement. Deputy prime minister and Five Star head Luigi Di Maio dismissed the Bank of Italy’s projections by telling Bloomberg that the central bank “is often wrong”, while prime minister Giuseppe Conte said Wednesday that he anticipates 1.5% output growth this year.
The stakes are high. Further economic deterioration could threaten ambitious spending plans under the populist coalition government run by the League and Five Star parties. A December agreement with the European Commission allows for a 2019 budget deficit of 2.04% of GDP, down from the original 2.4% deficit proposal which was rejected by Brussels.
Domestic political infighting aside, the Italian government still presents a united front (or target) for verbal barbs from E.U. peers. In Davos on Wednesday, the E.U. commisioner for economic affairs Pierre Moscovici turned up the rhetorical heat in describing the Italian government: “Changing Europe is one thing, destroying Europe is another thing. And that’s the difference between reform and populism, between pro Europeanism and nationalism.”
The pointed commentary isn’t just a one-way transmission. Today, prime minster Conte offered some blunt criticism of the recently signed Franco-German Treaty of Aachen, which calls for increased cooperation between the pair. Conte tells the Corriere della Sera: “Our allies certainly cannot think that we can sit at the table quietly, subscribing to decisions taken by others. . . the truth is that we have caught France and Germany with their hands in the jar.”
Meanwhile, negative interest rates continue to reign across Europe, with futures pricing in little change to the ECB’s negative 40 basis point deposit rate through year-end, while Draghi is set to retire at the end of his term this fall. Sub-zero interest rates have been no boon to the Old Continent’s banking system, as the Euro Stoxx Banks Index now trades at 0.61 times book value, down from 0.83 at year-end 2017 and less than half of the 1.27 times book currently fetched by the U.S. KBW Banks Index.
Euro Stoxx Banks Index, ten-year view. Source: The Bloomberg
As for triple-B-rated Italy (which, incidentally, borrows for 10 years at 2.64%, below the 2.75% interest rate fetched by a 10-year Treasury), Ignazio Visco, governor of the Bank of Italy and member of the ECB’s Governing Council remarked last May that “Italy’s destiny is that of Europe.”
Is that a promise or a threat?
Recap Jan. 25
A solid rally for stocks left the S&P 500 marginally in the red for the week, its first such decline of 2019, but the VIX closed at 17.5, near a two-month low. An outsize dollar selloff put a bid under the commodity complex, as gold tested $1,300 an ounce for the first time since June, as well as emerging markets, as the iShares MSCI Emerging Markets ETF reached its best close since early October.
In the bond market, Treasury yields ticked higher across the curve, while the iShares iBoxx USD Investment Grade Corporate Bond ETF rose for an eighth straight session to close at its highest since September.
- Philip Grant
Thursday, January 24, 2019
We must protect this planet
From a blog post on Virgin Galactic’s website:
From a blog post on Virgin Galactic’s website:
Junk food
The high yield drought is over.
The high yield drought is over.
Margin bawl
Behold the peculiar tale of Jiayuan International Group Ltd. (code 2768 on the Hong Kong Stock Exchange).
Behold the peculiar tale of Jiayuan International Group Ltd. (code 2768 on the Hong Kong Stock Exchange).
QT Progress report
Recap Jan. 24
We must protect this planet
From a blog post on Virgin Galactic’s website:
Virgin Galactic is proud to announce Under Armour as its Exclusive Technical Spacewear Partner to create a next generation of spacewear and astronaut performance programs.
The partnership will also see Under Armour create uniforms for Virgin Galactic’s world-class team at Spaceport America in New Mexico. Whether engineers, astronaut trainers and hosts, or mission control operatives, each member of the Virgin Galactic team will be wearing Under Armour apparel specifically chosen to enhance performance and to provide a tangible sense of shared purpose.
Perhaps also some new duds for Trump’s Space Force?
Junk food
The high yield drought is over. Today, Bloomberg reports that Altice USA, Inc. will issue $1 billion worth of 10-year senior guaranteed notes that will be used to refinance outstanding 8 5/8 notes due this year, as well as a portion of the 10 1/8 notes maturing in 2023. Price talk is set at 6.5% to 6.75% according to S&P’s LCD unit, with the books closed this afternoon and pricing expected shortly.
A successful refinancing would be a coup for single-B-plus-rated Altice, which is levered to five times consensus 2019 adjusted EBITDA. The cable operator incurred $1.5 billion in interest expense for the 12-months ended Sept. 30, three quarters of this year’s $2 billion in forecast operating income.
Indeed, the sharp post-Christmas rally in asset prices has spurred a winter thaw in junk bonds. December saw zero new issuance, the first such barren month since November 2008, and the $165 billion in newly priced deals last year was the lowest annual new supply since 2009. In contrast, four deals priced earlier this week totalling $4.15 billion, each drawing bidding interest of more than five times the original offering size.
Meanwhile, the Bloomberg Barclays U.S. High Yield Total Return Index has jumped by 3.64% in January, well ahead of both the 1.05% advance in the Bloomberg Barclays Investment Grade Index and the 2.64% gain in S&P/LSTA’s Leveraged Loan Index. In tandem, the spread on the BarCap U.S. Corporate High Yield 10-Year Index has dropped to 434 basis points from 537 basis points just three weeks ago.
Does the hot start to the year augur big things for speculative-grade credit in 2019? Marty Fridson, chief investment officer at Lehmann Livian Fridson Advisors LLC, notes that only 2001, 2003 and 2009 saw early performance on par with this year’s blistering beginning, and the index went on to enjoy resounding gains in two of those three instances (17.61% in 2003 and an incredible 43.69% in 2009). However, the Dean of High Yield cautions:
Based on that record and the hoary stock market adage, “As January goes, so goes the year,” some overeager high-yield promoters may get carried away suggesting that eye-popping gains are in store for 2019.
There is no basis even for predicting that a positive start to the year improves the chances for a full-year return greater than zero. Intra-month returns are available on the ICE BAML High Yield Index from 1991 onwards. Full-year returns have been negative in 13 out of 28 years. . . In seven of the 13 negative-price-return years, the subzero result occurred despite a positive price return in the first half of January.
Margin bawl
Behold the peculiar tale of Jiayuan International Group Ltd. (code 2768 on the Hong Kong Stock Exchange). Last Thursday, shares in the property developer endured an 80% swan-dive on no apparent news, erasing HKD $27 billion ($3.4 billion) in market capitalization.
Jiayuan initially claimed no knowledge of the reasons for the plunge, before coming clean the next day: A company owned by chairman Shum Tin Chiang was forced to sell 93.6 million Jiayuan shares (24.6 times the stock’s one-year average daily trading volume) in the open market in connection with a brokerage margin call.
On Monday, Jiayuan pointed the finger at short sellers in a meeting with investors, according to Chinese language-website qq.com and reported by Bloomberg, with Chiang claiming the shorts “sought to profit by misleading investors [and] sending messages with false information.” The company also told investors that the share plunge didn’t trip debt covenants, a claim that existing creditors might find to be cold comfort: The developer’s two-year senior secured dollar-pay bonds due in October currently fetch just under 85 cents, for a yield-to-worst of 36.97%. The stock was suspended by regulators until further notice on Tuesday after another 23% fall, a move that Bloomberg notes “came only hours after the company said trading would resume.”
QT Progress report
Another mostly steady week leaves the Fed’s portfolio of securities held outright at $3.85 trillion, down $3.9 billion from last week’s reading. Mortgage-backed securities accounted for most of the latest run-off and represent more than half of the $13.5 billion decline from the trailing four-week average, despite constituting about 42% of the portfolio.
Since QT began on Oct. 1 2017, the Fed’s total balance sheet assets are down by 9.2%.
Recap Jan. 24
A sideways showing for the S&P 500 leaves the broad average on the cusp of its first weekly decline of the year, down 1% from last Friday’s close. The Nasdaq outperformed thanks to a near-6% jump in the Philadelphia Semiconductor Index, a move that looks primed for reversal as Intel Corp. offered both relatively weak fourth quarter results and guidance that trailed consensus after the close, sending INTC shares lower by 8% in immediate reaction.
Elsewhere, Treasury yields dipped in near-lockstep across the curve, while commodities finished marginally higher as WTI crude edged over $53 a barrel. The VIX dropped back below 19.
- Philip Grant
Tuesday, January 22, 2019
Rock and a hard place
It’s not just a seasonal deep freeze. This morning’s data from Statistics Canada provided the latest evidence that things are less than hunky-dory in the Great White North, as November factory sales declined 1.4% and wholesale sales by 1%, both well below their consensus expectations of negative 0.3% and 1%, respectively. It was the weakest wholesale reading since March 2016. On Jan. 9, the Bank of Canada cut its real GDP forecast to 1.7% from 2.1% in October.
The long-running Canadian housing boom is likewise encountering icebergs, as home sales in Toronto and Vancouver plunged last year by 16% and 32%, respectively, from 2017. The Teranet-National Bank House Price Index remains in positive territory but near the lowest growth rate of the post-2008 cycle. Meanwhile, the credit-engine which propelled the housing bull run looks set to stall, as Canadian Imperial Bank of Commerce CEO Victor Dodig forecast a flat to low single-digit growth rate in mortgages for the “foreseeable future” at a Toronto conference in early January (for more on CIBC and mortgage growth, see the Feb. 9, 2018 edition of Grant’s).
Teranet-National Bank Canadian Home Price Index. Source: The Bloomberg
That housing downshift carries particularly acute risk for encumbered Canada, where the household debt-to-disposable income ratio registered at 175% at the end of the third quarter according to data from Bloomberg, well above the U.S. peak of 137% reached in 2007. A December survey from MNP Ltd. showed that 46% of respondents are avoiding insolvency by less than $200 per month, up from 40% in September. “Many [Canadians] have so little wiggle room that any increase in living costs or interest payments can tip them over the edge,” MNP president Grant Bazian commented.
Inconveniently for the Bank of Canada, inflation is also on the rise. Last Friday brought a surprisingly hot CPI report for December, with the headline figure rising 2% year-over-year against the consensus of 1.7%, with the services sector reaching its highest since 2008 with a 3.5% year-over-year jump. Overall, headline CPI averaged 2.3% year-over-year in 2018, up from 1.6% and 1.4% in the prior two years.
Much like the Fed, the BoC has been in a tightening cycle, raising rates five times since July 2017 to 1.75%. Following a stand-pat meeting on Jan. 9, BoC president Stephen Poloz highlighted the positives, observing: “The economy has been operating essentially at full capacity for about 18 months now, and inflation has been running on target. The labor market has been performing well . . . and unemployment is as low as we’ve ever seen it.” The market, however, isn’t so sure. Interest rate futures now price just 15% odds of another rate hike at the April 24 meeting; that’s down from 88% two months ago.
But would a turn toward easier money or even “QE”-like monetary stimulus provide much help for what ails Canada? Grant’s put the question to Hilliard MacBeth, portfolio manager at Richardson GMP Ltd. and author of “When the Bubble Bursts: Surviving the Canadian Real Estate Crash.”MacBeth predicts that while the BoC will indeed be forced into a dovish pivot, the central bank may not be able to accomplish much beyond currency devaluation:
The BoC displayed a readiness to change course very quickly in 2015 when rates were cut after the energy sector was hit hard.
However, with household debt higher than almost any other country at 100% of GDP, the traditional interest rate stimulus through housing is not going to work this time. The housing sector is too large and this downturn will be very deep once credit growth slows below GDP growth. Mortgage growth has already slowed sharply.
When Canada enters a recession and if the U.S. continues to grow, the BOC will face a very difficult time. Interest rate cuts, while unlikely to work on housing, will have the effect of pushing the Canadian dollar below 70 cents per U.S. dollar [from the current 75 cents and a five year average of 80 cents].
The BoC would be willing to let this happen, hoping for an export-led rebound. But it's likely that fiscal stimulus will be required when monetary policies fail to work.
Recap Jan. 22
Stocks endured a sharp pullback, with the S&P 500 falling nearly 1.5% for its biggest selloff since Jan. 3, narrowing the year-to-date gains to 5% for this young 2019. Commodities were likewise hit hard, with WTI crude dropping 2% to $53 a barrel, and Treasury yields fell moderately across the curve. The VIX closed above 20 for the first time in two weeks.
- Philip Grant
Friday, January 18, 2019
Hope springs eternal
Great Wall of worry
Good times are here again.
Good times are here again.
Dancing in the dark
Recap Jan. 18
Hope springs eternal
This afternoon, MarketWatch reports that acting director of the Federal Housing Finance Agency Joseph Otting told staff “that the regulators will announce a plan within weeks to take the government-sponsored enterprises out of conservatorship.” That was music to the ears of long-suffering Fannie and Freddie investors, as the pair’s common shares jumped by 34% and 32%, respectively while the most-actively traded preferreds gained 9% and 5%. Fannie and Freddie common shares now each trade at a slight premium to their average close since Donald Trump’s election in November 2016, while the preferreds each trade about 50% higher than their Trump-era average.
For more details on the contentious debate over the government-sponsored entities, see the Jan.8 edition of Almost Daily Grant’s.
Great Wall of worry
Good times are here again. The emphatic rebound in the stock market since late last year has pushed the S&P 500 higher by 6.5% year-to-date, erasing more than half of the fall 2018 selloff. Bottom-catchers in popular technology stocks have been even more richly rewarded, as the 10-stock NYSE FANG+ Index has surged by nearly 11% year-to-date, shaking off some major setbacks along the way. Investor darling Netflix, Inc., surprised the Street yesterday evening with weaker than expected fourth quarter results and guidance, but saw its shares decline only 4% to remain a whopping 45% above their Dec. 24 close. Even Apple, Inc., which fell 30% in the fourth quarter and another 9% on Jan. 3 after issuing its own profit warning, has seen its shares enjoy a 10% snapback over the past 11 sessions.
But for these lynchpins of the post-2009 bull market, cracks in the edifice continue to surface. A quartet of new developments concerning FANG+ Index components today:
Tesla, Inc. announced it would lay off 7% of its work force to cut costs, sending shares careening lower by 13%. Nikkei Asian Review reports that Apple supplier Foxconn Technology Co. Ltd. dismissed 50,000 temporary workers from the iPhone factory in Zhengzhou beginning in October, “significantly earlier” than recent years. The Washington Post relays news that the Federal Trade Commission is expected to levy “a record setting” fine against Facebook, Inc. for its disregard of privacy laws. Bloomberg reports that Alibaba Group Holding Ltd. is delaying new hires and imposing new travel restrictions on its employees, including “restricting business class airfares on a unit-by-unit basis, with staff only able to select a premium cabin on every fifth round trip that takes more than 20 hours.”
The question before the house: Does the powerful upside reversal signal a renewed bull market, or just a simple bear market bounce? A new white paper from Grantham, Mayo, Van Otterloo & Co. finds that U.S. equities entered bubble territory in early 2017, and that the bubble began to deflate in the fourth quarter. Author Martin Tarlie concludes: “Our advice, consistent with our portfolio positions, is to own as little U.S. equity as career risk allows.”
Dancing in the dark
The gyrating stock market seems to be itself influencing the future direction of the U.S. economy, if interest rate futures are any indication. On Oct. 2, with the S&P 500 near its highs, Fed Fund futures implied a 98% chance of at least one rate hike this year. On Dec. 28 with stocks in freefall, those odds collapsed to 8%, and have since risen back to 29%.
The policymakers are likewise keeping their options open. John Williams, president of the New York Fed, summarized his views in a speech today:
The approach we need is one of prudence, patience, and good judgement. The motto of ‘data dependence’ is more relevant than ever.
If growth continues to come in well above sustainable levels, somewhat higher interest rates may be called for at some point. However, if conditions turn out to be less robust, then I will adjust my policy views accordingly.
A reasonable viewpoint, to be sure. The only problem: The Census Bureau and Bureau of Economic Analysis remain closed thanks to the ongoing (and going) government shutdown, depriving the policymakers of key growth indicators such as gross domestic product, durable goods and retail sales.
Williams’ boss, Fed chair Jerome Powell, has likewise vacillated back and forth. A sampling of Powell’s recent comments, as tabulated by Jim Bianco of Bianco Research:
October – The funds’ rate is a long way from neutral (hawkish)
November – The funds’ rate is just below the range of estimates (dovish)
December – Balance sheet reductions are on “automatic pilot” (hawkish)
Jan. 4 – The Fed can be patient and flexible (dovish)
Jan. 10 – The balance sheet will be ‘substantially smaller’ (hawkish)
Recap Jan. 18
Another strong rally left the S&P 500 higher by 1.3% and the Dow Transports up by more than 4%, to leave each of those indices at their best closing levels since early December. WTI crude likewise made a fresh six week high near $54 a barrel, while the VIX closed below 18 for the first time since, you guessed it, early December. Treasury yields jumped across the curve, with more pronounced weakness at the short end leaving the two-year yield at 2.61%, up from 2.38% on Jan. 3.
- Philip Grant
Thursday, January 17, 2019
The man who really knew
Yesterday, John C. Bogle, founder of The Vanguard Group and the “Thomas A. Edison of indexation” (Grant’s, April 17, 2015), died at home in Pennsylvania at the age of 89. Bogle, who founded Vanguard near the S&P 500’s cyclical low ebb in 1975, spent the rest of his life advocating for his revelatory concept of tracking the overall market on the cheap. In a 1999 New York Times opinion piece, Bogle dished out a dose of reality to the frenzied bull market masses, writing: “The market is simply a gambling casino. . . beating the market is a zero-sum game, but only before costs are deducted. In the stock market casino, it is the croupiers who win.”
In 2012, Bogle explained to the Times: “My ideas are very simple; in investing, you get what you don’t pay for. Costs matter.” Three years later, Bogle looked at the big picture in making his case for passive investing at the Grant’s 2015 spring conference in New York:
The cost of investing, shared by active managers at a high cost, is roughly 2% per year. The cost of investing, shared by index investors at a low cost, is 0.05% per year. Therefore, low-cost investors, collectively, must earn higher net returns. So it is demonstrated – Q.E.D.
And that’s why indexing is now so dominant, because people are getting the message.
Indeed, Bogle lived to see his creation and its close cousin, exchange traded funds (though about that cousin, he had mixed feelings), grow into a dominant financial force. As noted Tuesday by the Financial Times, data from consulting firm ETFGI shows global ETF assets at $4.6 trillion, up from less than $100 billion in 2000 for a compound annual growth rate of 22.3%. Vanguard itself now owns 5% or more of 491 stocks in the S&P 500.
Welcome to the 'Rock
Bogle’s big idea hasn’t just served Vanguard well. Yesterday, BlackRock, Inc. (BLK on the NYSE) reported fourth quarter results, featuring a record $81 billion inflow into its iShares division of exchange-traded funds. Kyle Sanders of Edward D. Jones & Co. was impressed, telling Bloomberg: “To put up for more than $80 billion in iShares flows in a really, really tough market shows [that] they’re differentiated, and ETFs have a pretty good runway for growth.”
What’s more, the influx into ETFs continued apace as the market tumbled late in the year, with the company reporting record monthly inflows in both November and December. The stampede into ETFs has hardly abated in this young 2019: BlackRock CEO Laurence D. Fink noted that January has seen a net $13 billion inflow thus far.
Those impressive figures from iShares were enough to send BLK shares higher by more than 5% in reaction, outweighing weaker-than-expected headline earnings per share, a 9% year-over-year drop in revenues, 5% pullback in assets under management and a 320 basis point decline in operating margin, to 36.3%. BLK shares are up by 14% since Grant’s offered a bearish analysis on Sept. 30, 2016, trailing the S&P 500s 23% advance over that period. Of his star performer iShares unit, Fink had this to say on the conference call:
More and more clients are choosing ETFs as the preferred investment vehicles because of their superior structure relative to the mutual fund industry, including liquidity and, most importantly, tax efficiency.
In a follow-up interview on CNBC, Fink further explained the financial paradigm shift, and his own firm’s prominent role therein:
What I think is really differentiating us [and] changing the whole composition of the markets; we’re seeing . . . investors move away from stock picking, moving away from buying a product to working on models and really now portfolio composition.
Might the long post-2009 asset price levitation, bountifully assisted by the world’s central banks through zero or negative interest rates and various forms of QE, play a more prominent role in the ascent of ETFs, iShares and BlackRock itself? Kevin Duffy, principal at Bearing Asset Management and confirmed BLK bear, writes in to Grant’s to pose a rhetorical question:
If client inflows were strong, especially in equities, how is it that “sentiment shifted from cautious to negative [as stated by the CEO on the conference call]?” It’s almost as if Fink is saying Q4 was a stress test and the BLK model passed with flying colors. Has he dialed in the possibility of a bear market alongside fee compression and outflows?
If a prolonged bear market is headed our way, I suspect we’ll find out if the passive perpetual motion machine is designed to go in reverse.
QT Progress report
The Fed’s portfolio of securities held outright stands at $3.855 trillion this week, down $6.6 billion from a week ago. Mortgage-backed securities accounted for two-thirds of the run-off, with Treasurys supplying the balance.
Compared to the trailing four-week average, today’s figures represent a decline of $18.6 billion. Since the onset of “QT” on Oct. 1, 2017, the Fed’s total balance sheet assets are down by 9.1%.
Recap Jan. 17
Another day, another rise in the stock market, as an afternoon report that the Trump administration is considering lifting tariffs on China (since denied) helped the S&P 500 rise for a third straight day. The broad index now sits higher by 5% year-to-date, erasing exactly half of the peak-to-trough swoon in the fourth quarter on an absolute basis.
Treasury yields ticked higher with the exception of the 30-year long bond to leave the curve flatter, and commodities finished little changed. The VIX closed below 20 for a seventh straight session, matching the longest streak since the market remained near its highs in early October.
But the bulls can perhaps expect a bumpier ride tomorrow, as Netflix, Inc. reported light fourth quarter revenues and weaker-than-expected guidance for the first quarter on both the top and bottom line. NFLX shares fell as much as 5% in early reaction.
- Philip Grant
Wednesday, January 16, 2019
Gotta serve somebody
From this morning’s edition of The Wall Street Journal:
From this morning’s edition of The Wall Street Journal:
More money – more good?
According to data released on Monday from China’s General Administration of Customs,
According to data released on Monday from China’s General Administration of Customs,
Recap Jan. 16
Gotta serve somebody
From this morning’s edition of The Wall Street Journal:
For more than two months after employees at International Business Machines Corp. moved into a Manhattan building managed by office-space giant WeWork Cos., frequent elevator problems forced workers to climb the stairs of the 11-story building and prompted complaints to the company.
One of the landlords behind the building was no ordinary owner: It was Adam Neumann, WeWork’s chief executive, who leased the property to WeWork after buying it, according to people familiar with the situation.
Mr. Neumann has made millions of dollars by leasing multiple properties in which he has an ownership stake back to WeWork, one of the country’s most valuable startups. Multiple investors of the privately held company said the arrangement concerned them as a potential conflict of interest in which the CEO could benefit on rents or other terms with the company.
This afternoon, WeWork responded to the Journal’s reporting, stating: “Those transactions are reviewed and approved by the board, and they are disclosed to investors.”
More money – more good?
According to data released on Monday from China’s General Administration of Customs, December imports sank by 7.6% year-over-year while exports dropped by 4.4%. Those figures compare to consensus year-over-year growth expectations of 4.5% and 2%, respectively, and represent the biggest annual declines in a given month for each since late 2016.
Poor December aside, 2018 was a strong year for Chinese trade, as exports and imports jumped by 10% and 16% over the full-year period. But as noted by the South China Morning Post, front-loading of trading activity ahead of U.S. tariffs was largely responsible for the brisk year-over-year growth, while the most recent figures “give the first indication of the full impact of the U.S.-China trade war.”
Whether or not the direct result of trade tensions, evidence of economic trouble in the Middle Kingdom is increasingly hard to ignore. Last Friday, Reuters reported that China has lowered its GDP target for 2019 to a range of 6% to 6.5%. That’s below the 6.6% reported output gain widely expected last year, which would already be the weakest figure since 1990. With a towering leverage profile featuring banking assets of $39.1 trillion as of Sept. 30, nearly half of the $80.7 trillion 2017 world GDP as measured by the World Bank, waning economic growth could spell big trouble for both China and beyond.
For its part, the People’s Bank of China is taking action. Today, it injected a net RMB 560 billion ($83 billion) into the financial system, by far the highest one-day liquidity addition on record. While seasonal factors, including the Lunar New Year and annual tax collections played their part, the figure was more than double the RMB 270 billion influx from the People’s Bank of China a year ago. That follows last week’s cut of the reserve ratio requirement for Chinese banks by the PBOC, the fifth such rate reduction in the past year.
The central bank’s ministrations have had some positive effects. Bloomberg notes today data from ChinaBond showing that the spread of three-year triple-A-rated local government funding vehicles (which finance infrastructure and other state-directed projects) has fallen to 119 basis points over Chinese sovereign bonds, the narrowest spread in two years and down from nearly 250 basis points last fall. Perceived sovereign credit risk is likewise abating, with Chinese five-year credit default swaps dropping below 61 basis points today. That’s down from 73 basis points in late November and the most sanguine reading since early October.
Credit may be generally on the uptick, but growth in Chinese money supply continues to evaporate (Almost Daily Grant’s, Jan. 7). The December figures, which were released yesterday, show that while the broader M2 metric improved off multi-decade lows with an 8.1% year-over-year reading, M1 (which measures the most liquid forms of money) grew just 1.5% from a year ago, below the 1.6% consensus and ahead of only January 2014 as the weakest monthly reading going back to 1996. For context, M1 grew 11.7% year-over-year in December 2017 and has averaged 13.5% since March 2009.
China M1 money supply, year-over-year growth rate. Source: The Bloomberg
Ming Ming, head of fixed-income research at Citic Securities Co., aptly summarizes Grant’s long-held viewpoint in a research note yesterday: “The structure of China’s credit system is not in a good shape.”
Recap Jan. 16
Another up day for stocks left the S&P 500 at its highest close in more than a month, while narrowing the broad index’s decline from the Sept. 20 highs to less than 11%. Financials continued to carry the day as a raft of larger institutions reported fourth quarter results, with the KBW Banks Index up nearly 5% over the first three days of the week.
Rates were generally higher across the curve with the exception of the long bond to leave the curve flatter after some notable recent steepening, while commodities and the dollar both traded slightly higher. The VIX finished little changed to close below the 20 mark for a sixth straight session.
- Philip Grant
Tuesday, January 15, 2019
A reason to move
Rampant fuel theft in Mexico has attracted the attention of President Andrés Manuel López Obrador (AMLO for short). On Dec. 27, AMLO announced plans to defend the country’s oil installations from the so-called “huachicoleros” with military personnel and transport more fuel across the country in tanker trucks instead of vulnerable pipelines. Yesterday, the Mexican President suggested the government may transport gasoline via train, and called on energy companies to increase fuel imports.
The theft problem is a significant one as $3 billion of black gold was stolen last year according to government data, while state-owned oil company Petróleos Mexicanos, or Pemex, reports that illegal pipeline taps rose 45% year-over-year in the first 10 months of 2018. Then, too, the newly installed President (he took office on Dec. 1) enjoys broad public support for his initiative: According to a poll by El Financiero released yesterday, 89% of respondents agreed with the President’s theft crackdown, while 64% of approved of the pipeline closures.
The drive to combat fuel theft has yielded some results, as attorney general Alejandro Gertz Manero told reporters yesterday that three “top” (but unidentified) Pemex executives in charge of pipeline management will face prosecution for siphoning fuel, while Mexican authorities have opened some 1,700 individual cases related to the matter. But criminal justice aside, AMLO’s moves have taken a toll in the form of fuel shortages, rationing and long lines at gas stations. Regional authorities complained about the abrupt implementation of the plan. Yesterday, Reuters reported:
Officials in three affected states [said] they were not warned in advance about the supply cuts.
“There was zero coordination,” said Alejandro Guzman, head of economic development in the government of Jalisco, home to the country’s second-biggest city, Guadalajara. “We started to notice when the gas stations started closing.”
AMLO’s energy initiatives are not limited to combatting theft. Last week, Pemex announced that the government will provide $1.25 billion in capital this year, as the state-owned energy concern looks to “improve cash flow and investment through an optimized financial engineering.” Pemex carries $83 billion in outstanding bonds, faces $5.4 billion in maturities this year, and has operated in the red on a free cash flow basis in each year since at least 2008.
Baa3/triple-B-plus-rated Pemex, the eighth-largest oil producer in the world, has absorbed a precipitous fall in both output and reserves in recent years, an ominous development for such a highly leveraged enterprise. Last Wednesday, senior executives trekked up to the Big Apple to meet with investors. It didn’t seem to go particularly well, as analysts at Nomura wrote following the powwow that “we believe Pemex managers were not able to present a credible explanation,” for the company’s struggles, while Jefferies analysts said they were “disappointed by lack of a cohesive strategy.”
The buy side was even more scathing. James Craige, co-chief investment officer at Stone Harbor Investment Partners, told Bloomberg: “The CFO had no handle on the company and was not impressive at all. . . he has to go.” Craige went on to lament a “lack of clarity in the financing program, lack of clarity on how they reach production goals and lack of clarity on future concession auctions” before concluding: “If this guy is the conduit to the rating agencies, we can expect downgrades.” The bond market has been likewise unimpressed, as the Pemex senior unsecured 4 7/8 dollar-pay notes of 2024 have fallen to 94 cents on the dollar for a 375 basis point spread over Treasurys. That’s down from 101 and a 199 basis point spread in March.
The March 23, 2018 edition of Grant’s featured a bearish analysis of Pemex, suggesting that the state-owned enterprise might one day become the direct obligation of the Mexican government, since, in the words of IPD Latin America’s John Padilla: “Pemex, in any private sector context would absolutely be considered bankrupt.” A November follow-up, written after those notes had retreated to the current price of 94, concluded: “Grant’s remains bearish – emphatically.”
Recap Jan. 15
Stocks rose again, with a 1% advance pushing the S&P 500 back above 2,600 at the close for the first time in a month, while the KBW Bank Index has managed an impressive 2.2% advance over the past two days despite seemingly poor results from Citigroup, Inc. and J.P. Morgan Chase & Co. The Dow Transports were noticeable laggards, falling by nearly 1%, but after the bell, United Continental Holdings, Inc. reported far better than expected fourth quarter profitability figures, sending shares higher by more than 5% in initial reaction.
Elsewhere, another round of steepening in the Treasury curve pushed the 5-year/30-year spread above 54 basis points, approaching a 52-week high and up from less than 20 basis points in July. Commodities caught a bid with WTI crude rising back above $52 a barrel, and the VIX finished below 20 for a fifth straight session.
- Philip Grant
Monday, January 14, 2019
A negative art
This morning, San Francisco-based PG&E Corp.
This morning, San Francisco-based PG&E Corp.
Gold fingers
Today, Newmont Mining Corp. (NEM on the NYSE) announced its intention to buy peer Goldcorp, Inc.
Today, Newmont Mining Corp. (NEM on the NYSE) announced its intention to buy peer Goldcorp, Inc.
Recap Jan. 14
A negative art
This morning, San Francisco-based PG&E Corp. (PCG on the NYSE) announced it will file for bankruptcy by Jan. 29. The devastating wildfires that afflicted California last fall left Chapter 11 reorganization as “ultimately the only viable option to restore PG&E’s financial stability to fund ongoing operations and provide safe service to customers,” according to the form 8-K the company filed today. The company is facing more than $30 billion in liabilities stemming from the disaster, swamping the approximately $1.5 billion in cash and cash equivalents available as of Friday.
It’s been a steep decent for PCG, which has seen its shares plummet to $8.50 from $25 on Jan. 4 (they fell 52% today), while the senior unsecured 6.05% notes of 2034 have fallen below 84 cents on the dollar, compared to 94 ten days ago. The progression of PG&E’s credit ratings have been similarly abrupt, as Moody’s downgraded PG&E’s long-term issuer rating to B2 on Thursday from investment-grade Baa3, a five-notch demotion, while S&P also cut PG&E five notches to single-B from triple-B-minus last Monday. Each firm had downgraded PG&E by one notch in mid-November as the so-called Camp Fire, which killed more than 100 people, raged.
“Since the chief emphasis must be placed on avoidance of loss,” wrote Benjamin Graham and David Dodd in their mighty volume, “Security Analysis,” “bond selection is primarily a negative art. It is a process of exclusion and rejection, rather than of search and acceptance.” Cautionary words to mark, to be sure, though it is asking a lot of any investment committee to anticipate a plague of forest fires. Business risk is a more frequent, and usually more costly, source of surprise.
Thus, as recently as April, the senior subordinated 10 1/4 notes of American Tire Distributors, Inc. traded above par, before Goodyear Tire & Rubber Co. announced it would end its distribution ties to American, sending those bonds careening to 43 cents on the dollar a week later (American Tire filed for Chapter 11 in October). The Toys “R” Us Inc.’s senior unsecured 8 3/4 notes of 2021 likewise changed hands above par as recently as August 2017, plummeting to 12 a month later as the retailer filed for bankruptcy. “Hence,” Graham and Dodd completed their thought, “broadly speaking, there is no such thing as being unduly captious or exacting in the purchase of fixed-value investments.” Especially, one might add, in an age of suppressed interest rates.
Gold fingers
Today, Newmont Mining Corp. (NEM on the NYSE) announced its intention to buy peer Goldcorp, Inc. in a $10 billion stock-and-cash deal. At an aggregate eight million ounces of production using 2017 figures, the combined company will become the world’s largest gold miner by market cap, production and reserves. This proposed deal follows the September merger announcement between Barrick Gold Corp. and Rangold Resources Ltd.
Josh Wolfson, analyst at Desjardins Securities, writes today that Newmont got itself a deal: “Goldcorp is on the cusp of delivering material production growth and free cash flow, the shares have come under pressure [down by 49% over the past five years compared to a 12% gain for the S&P/TSX Global Gold Total Return Index] and valuation is attractive.”
The pair of high-profile mergers may precede further consolidation in the gold miners, as Barrick CEO and former Rangold boss Mark Bristow hinted in an interview with Bloomberg on Jan. 2: “Without a doubt, this industry needs transformation. We believe we have started that. We’re going to end up with a blue-chip business and on the way we’re not going to be sitting on our hands should there be other opportunities.”
When the interviewer noted that the Barrick/Rangold enterprise controls five of the top 10 gold mines in the world and asked how many more he wanted to own, Bristow quipped: “All of them,” arguing that the “industry, if it had carried on the way it was, was going to become irrelevant, [with] too few assets with too many management teams and it needs reorganization.”
Bristow’s sentiments have long been shared by John Hathaway, co-manager of the Tocqueville Gold Fund. Speaking at the Grant’s spring conference in April, Hathaway detailed the predicament faced by miners, as the price of gold remains stuck below $1,300 an ounce after having reached $1,900 in 2011:
Mine lives at multi-decade lows. Discoveries are almost non-existent. Because of the downward pressure on [mining-company] share prices, the industry has been unable to finance and therefore has cut off exploration. So we’re almost guaranteed a long period where, even with rising gold prices, there will not be a supply response.
The investment opportunity to propose here is that the large companies, which have big market caps and relatively good valuations, will be forced, in my mind, to make a number of acquisitions.
Hathaway went on to identify three smaller miners as attractive potential acquisition targets. For more details on his picks-to-click, see the April 20, 2018 edition of Grant’s.
Recap Jan. 14
Stocks absorbed a moderate loss, with the S&P 500 pulling back by 0.5% as intraday volatility continues to cool: Since the onset of 2019, the broad index has either risen or dropped by more than 1% on only two of nine trading sessions. In December, the S&P closed higher or lower by more than 1% on 10 of 19 trading days.
Elsewhere, the Treasury curve steepened a bit as the long bond came under pressure to leave the 30-year yield at 3.05%, while commodities and the dollar both finished slightly lower. The VIX gave back the bulk of its early gains to finish just below 19 for a second straight day, the calmest such stretch since early December.
- Philip Grant
Friday, January 11, 2019
The show must go on
From the Hollywood Reporter
From the Hollywood Reporter
Hair of the dog
It went down smooth.
It went down smooth.
Recap Jan. 11
The show must go on
From the Hollywood Reporter:
Creators, innovators and entrepreneurs were celebrated at the 2nd Annual WeWork Creator Awards Global Finals, which were held at the Microsoft Theater on Wednesday night.
The theater was packed with WeWork employees and before the competition started CEO Adam Neumann spoke to a vision for his company that was larger than just making a profit.
“The world was made for all of us to be all that we can be. And when we started this company with a simple concept, it was called WeWork and we wanted to create a world where people could make a life and not just a living ... because making a life means to enjoy the struggle," he said.
The contestants competed in a shark-tank style “pitch-off” in front of a panel of four judges, which included longtime tech investor Ashton Kutcher, rapper and business mogul Diddy, Gary Vaynerchuk, the CEO of VaynerX, and venture capitalist Kirsten Green.
After the confetti cannons exploded there was a surprise performance by the Red Hot Chili Peppers, who played an hourlong set that included classic hits such as "Californication," "Can’t Stop" and "Scar Tissue."
Hair of the dog
It went down smooth. Yesterday, Anheuser-Busch InBev S.A./N.V. (ABI on the Belgian Stock Exchange and BUD on the NYSE) rang in the New Year for corporate bond issuance in style, pricing a mammoth $15.5 billion offering in, appropriately enough, a six-pack of maturities ranging from 2025 to 2059. Baa1/single-A-minus-rated Anheuser Busch will use the funds to help retire $16.5 billion in shorter-term obligations, largely stemming from the company’s 2016 acquisition of SAB Miller plc., but will pay up for the privilege of doing so: The 10- and 30-year tranches were priced at respective 205 and 250 basis point spreads over Treasurys. That compares to 120 and 150 basis point premiums for the same 10- and 30-year maturities during a prior offering last April.
Wider spreads aside, encouraging signs were readily apparent from the deal. Bidding interest was robust, with the order book reaching as high as $41 billion before settling at $39 billion, leaving the issue 2.7 times oversubscribed. Pricing was also solid, with Bloomberg describing the 26 basis point concessions from secondary market prices as “reasonable” considering the beer maker was able to upsize the offering from an original $10 billion.
The bond market’s warm reception was a much needed win for highly-leveraged ABI, which saw shares spike this morning on a report that it is considering an initial public offering of its Asian operations. Positive recent developments aside, it’s been tough sledding for the beer giant, which has seen its shares slide by 31% since February, thanks to largely disappointing operating results that led to the brewer slashing its dividend in half in October to improve a flagging balance sheet. Nevertheless, on Dec. 10 Moody’s downgraded ABI’s credit rating to Baa1 (three notches above junk) from A3, while S&P has kept Anheuser-Busch debt on watch “negative” since early 2017. For good reason, as ABI’s $116 billion in net debt equates to more than five times consensus 2019 adjusted EBITDA, double the leverage ratio of Baa1/triple-B-plus-rated peer Heineken N.V.
Meanwhile, ABI’s massive $65 billion acquisition of SAB Miller (at a fancy price of 18 times the target’s trailing 12-month EBITDA) has yet to lead to much tangible benefit: Free cash flow is expected to register at just under $12 billion this year, not much changed from the $10 billion generated in 2012, when the company carried a net debt load of $35 billion, less than a third of its current burden.
ABI management still has its work cut out for it, particularly if credit spreads see another bout of widening similar to that seen last fall. A bearish analysis of ABI in the Feb. 9, 2018 edition of Grant’s made special mention of the brewing giant’s heavy near-term debt obligations and subsequent refinancing risk, as the company last year faced $46 billion in maturities through 2023 at an average coupon of just 2.8%. By way of conclusion, a metaphor:
Artificially suppressed interest rates produce a feeling familiar to drinkers – weekend drinkers only, mind you – of more than a little fine craft beer. It’s rapturous at first, and so it remains for a time. But finally you go home and go to bed, and then it’s Monday morning. Monday is dawning for mispriced corporate credit.
Recap Jan. 11
Stocks recovered from early losses to leave the S&P 500 flat by day’s end, as the broad index now sits higher by 3.5% in this young 2019, with the small cap Russell 2000 and tech-heavy NYSE FANG+ Index sporting year-to-date gains of 7.5% and 9%, respectively. Treasurys were bid across the curve with the 10-year yield finishing just under 2.7%, while commodities came under some pressure as the dollar caught a bid. The VIX finished just above 18, its lowest weekly close since the end of November.
Fourth quarter earnings season gets underway next week, with results from Citigroup, Inc. due on Monday, J.P. Morgan Chase & Co. on Tuesday and Alcoa Corp. on Wednesday, among others.
- Philip Grant
Thursday, January 10, 2019
The money of bond kings
He said it. Yesterday at the Barron’s and Grant’s co-hosted “Art and Interest Rates” event at the world famous Albright-Knox Art Gallery in Buffalo, N.Y., Jeffrey Gundlach, CEO of DoubleLine Capital and steward of $121 billion in assets, had a surprising prediction for the rapt audience: Bitcoin is on its way back to $5,000. While noting that such a call is highly speculative, Gundlach described a long bitcoin trade as “the easiest 25% gain available in the market right now.” Thanks to a 9% drop today to $3,674, a return to $5,000 from here equates to a 36% advance.
Later that evening, an attendee remarked with surprise that a particular investment topic had gone unmentioned during the wide-ranging afternoon discussion between Gundlach and James Grant: Gold. The DoubleLine boss revealed that, indeed, one of his top recommended long ideas for 2019 is the VanEck Vectors Gold Miners ETF (GDX on the NYSE ARCA).
Thanks to everyone who joined us, particularly the many who traveled great distances to attend. It was a terrific success!
QT progress report
No significant change this week, as the Fed’s portfolio of securities held outright stands at $3.862 trillion, down a mere $105 million from last week’s reading. It’s the first status-quo week since Dec. 12, with declines of $4.7 billion, $11.5 billion and $18.2 billion registered over the past three weeks.
Since the Fed began its QT balance-sheet runoff on Oct. 1, 2017, total balance sheet assets are down by 8.96%, a simple annualized pace of 7.04%.
Recap Jan. 10
The bull march continues, as stocks erased early losses to leave the S&P 500 higher by about 50 basis points, the fifth straight green finish that pushes the broad index 10.5% above its closing level on Dec. 24. A stronger dollar put a lid on commodities, but WTI crude oil managed a flat performance to finish above $52 a barrel, while the formerly-designated “waste places” were able to continue their rebound with the iShares MSCI Emerging Market ETF reaching its best close in more than a month.
Treasury yields rose across the curve, with the long end catching the worst of the selling as this afternoon’s 30-year auction saw weak pricing and soft demand; the long bond now yields 3.06%, up from 2.9% a week ago.
- Philip Grant
Tuesday, January 8, 2019
Freddie Murky-re
Yesterday, the Trump administration installed Comptroller of the Currency Joseph Otting as acting head of the Federal Housing Finance Agency, overseer of mortgage guarantors -turned wards of the state Fannie Mae and Freddie Mac. Otting replaces former Democratic congressman Mel Watt on a temporary basis, while nominee Mark Calabria awaits confirmation hearings in the Senate.
The market approves, as Fannie and Freddie common equity each jumped by 31% over the past two sessions while the most actively traded preferred shares gained 5% and 3%, respectively. Hopes that the acting boss will swiftly implement the Trump administration’s agenda help explain the bullish response, as Charles Gabriel of Capital Alpha Partners writes that Otting is: “freed to make any early moves that he, [the] Treasury or the Trump White House may have been itching to make during the cautious [Watt’s] tenure.” Isaac Boltansky of Compass Point Research & Trading agrees that Otting “has clear authority to act. . . while also providing Mark Calabria with procedural momentum when he takes the post later this year.”
What sort of actions might the Trump administration pursue with regards to Fannie and Freddie, famously nationalized by the Bush administration during the fall 2008 panic? Treasury secretary Steve Mnuchin hinted at a potential endgame for the government-sponsored enterprises in a December interview with Bloomberg Television, stating “I would like to get them out of conservatorship” and adding that “there are changes we will be able to make with a new director at the FHFA.” For his part, Calabria commented back in the fall of 2017 that the Trump administration was “committed” to that outcome, but cautioned that “if it were easy to get the GSEs out of conservatorship, it would have been done already.”
For investors in Fannie and Freddie, the proximate goal would be a return to the private ownership model which predated the 2008 bailout, an event which still rankles some observers. Back in September, Ron Haynie, vice president of mortgage finance policy for the Independent Community Bankers of America, noted in National Mortgage News the significant changes made to the original agreement in 2012:
All Fannie and Freddy earnings will be sent to the Treasury in perpetuity. After receiving $187 billion in aid from the U.S. Treasury, from 2008 to 2012, returning to profitability and stabilizing the broader mortgage market, they have cumulatively repaid more than $280 billion and counting. As one architect of the 2012 modification said, “they can never escape.”
Gary Hindes, chairman of the Delaware Bay Co. and shareholder in Fannie and Freddie, argued in the Washington Post on Sunday that the crisis-era government rescue of the GSEs was both illegitimate and unnecessary, as evidenced by their prolific earnings generation in the post-crisis years: “[Fannie and Freddie] did not ‘collapse;’ what was billed as a ‘bailout’ was actually a stick up.” In a Nov. 26 commentary, Hindes disputes the notion that the two were on death’s door upon entering conservatorship in September 2008, pointing out that Fannie and Freddie had managed to raise $6 billion in unsecured debt just three days before Uncle Sam took over, in an offering that was oversubscribed.
After spending nearly 10 years stuck in post-crisis financial purgatory, holders of Fannie and Freddie common equity and preferred shares finally have a shot at earning outsize returns through privatization. However, Chris Whalen, publisher of the Institutional Risk Analyst, thinks they should be careful what they wish for:
If you take the GSEs out of conservatorship, you’ll have to go raise money. That's what the law says. So you can put them through receivership, same way they come out as they were at inception, and then you'd have to go raise “private capital." The only thing that matters to bond investors is the federal wrapper. From a credit perspective, that is all that matters. You are "AAA" or not. Most private mortgage banks are "B" credits.
The idea of "privatizing" the GSEs is likewise fanciful. A GSE without full faith and credit is maybe a low investment grade credit with attendant funding costs. The last thing we need right now is more capacity in mortgage finance. We could get rid of 25 percent of total capacity in lending right now and it would be helpful, but not sufficient to fix the industry's pricing problem. Seriously, almost nobody is making money in mortgage lending in 2019.
GSE equity holders fundamentally misunderstand return of capital versus return on capital. Return of capital has to happen all at once. If you want to pay us back, okay, and redeem the warrants, great. Then these GSEs go back into the nether world of being not quite full faith and credit. And unlike the old days where everybody waves to one another and Fed officials would wink at central bankers and say, oh, it's okay, Fannie and Freddie really are full faith and credit. Well, no, they're not.
The bottom line is that, in order for the GSEs to function as they do today and issue debt at the spreads they do today, they have to have a federal guarantee. So when the hedge funds complain about the return of capital, they are wrong. The sweep of all GSE profits to the U.S. Treasury is payment for the use of the full faith and credit of the United States every day. Right? So to the hedge funds that own GSE common or, better yet, preferreds, I say you go right ahead, exercise the warrant, repay the Treasury and go on your merry way as a non-bank mortgage finance company, the supreme ghetto among financials. Good luck.
Recap Jan. 8
The bulls are back in town. Stocks absorbed a mid-morning selloff before pushing higher once more this afternoon to finish 1% in the green on the S&P 500, leaving the broad index nearly 10% above its Dec. 24 interim low. The Dow Transports have enjoyed a similar bounce, while the small-cap Russell 2000 and tech heavy NYSE FANG+ Index are 13% and 15% above their recent respective lows.
Elsewhere, Treasury yields rose again with the short end seeing the biggest movement, as the two-year yield finished the day at 2.58%, up 20 basis points from Thursday’s close. Commodities caught another bid despite a stronger dollar with WTI crude approaching $50 a barrel, and the VIX closed at 20.41, the lowest finish in over a month.
- Philip Grant
Monday, January 7, 2019
Supply side
Is a winter thaw forthcoming in the Sino-American trade spat? Commerce secretary Wilbur Ross raised the possibility of rapprochement in an interview with CNBC this morning, saying there is a “very good chance” of a “reasonable” agreement between the two world powers. Adding fuel to the optimism, Bloomberg reports that Chinese vice premier Liu He unexpectedly attended trade talks in Beijing today, which had been designated to take place at the “vice-ministerial” level. The clock is ticking, as the three-month trade truce agreed to by president’s Xi and Trump at the G20 meeting last fall is scheduled to expire at the end of February.
Hopes for a breakthrough aside, the Chinese are turning back on the public-spending spigots. Today, the Financial Times reports that the National Development and Reform Commission has given the green light on eight separate urban rail projects with a total value of RMB 860 billion ($125 billion) over the last month.
Financial easing is also back on the agenda, as the People’s Bank of China last Friday cut banks’ reserve ratio requirement by 100 basis points to 14.5% and 12.5% for large and small institutions, respectively, the fifth such reduction in a year. Also over the weekend, Hong Kong financial secretary Paul Chan Mo-Po wrote in a blog post that he is looking into measures to help would-be homeowners afford down payments, spurring a broad rally in property developer shares.
Regardless, some developers are scaling back their ambitions. Earlier today, China Evergrande Group announced in a filing that it is targeting a 9% growth rate in contracted sales this year. That’s down from more than 20% in 2018 and 120% two years ago (for more on Evergrande, see the June 2, 2017 edition of Grant’s). The powers that be are likewise de-emphasizing real estate. Last week, a commentary in the Communist Party People’s Daily instructed Chinese regional economies to lower their reliance on real estate-related activities to generate growth.
As Beijing looks to kickstart the Chinese growth engine, signs of trouble are increasingly apparent. Caixin’s manufacturing PMI reading fell into contraction territory in December, the first sub-50 reading for the series since 2016. Meanwhile, M2 money supply growth continues to wane, falling to 8% year-over-year in November to match the lowest annual growth rate in at least 23 years.
China M2 money supply, year-over-year growth rate. Source: The Bloomberg
As output depends on the availability of money and credit, the sharp slowdown in M2 growth indicates nothing bullish for growth. Anne Stevenson-Yang of J Capital Research writes in a commentary today:
From 2008, when the PBOC started reporting on monetary growth, through February of this year, either M1 or M2, or both, grew consistently in the teens or twenties, much higher than GDP. Since an economy’s money supply should run roughly in tandem with GDP growth, the portion of money growth in excess of economic growth should be viewed as fundamentally worthless.
And we know that China’s GDP growth is not only intentionally overstated by statisticians but systematically overstated as a consequence of unwillingness of banks to write down worthless assets.
What does it all mean? Stevenson-Yang explains:
No country has seen its “questionable” offshore assets grow at the pace of China’s. A significant portion of that money represents capital flight and straight-up theft, and very little of it is being taxed or reinvested in China. The problem will persist as long as the world is happy to buy renminbi for less than 7 to the dollar.
A weaker redback may be the long-term answer, but progress on that front has been halting. Since falling to 6.97 per dollar on Oct. 31, the renminbi has recently strengthened to less than 6.85 to the buck.
Recap Jan. 7
Another solid bid for stocks pushed the S&P 500 to its highest close since Dec. 19 and more than 8% above the Christmas Eve nadir, as outsize dollar weakness also put a bid under the commodity complex with WTI crude rising to near $49 a barrel. Treasury yields ticked higher across the board with the short end underperforming to leave the curve flatter, and the VIX finished unchanged to settle near 21.
- Philip Grant
Friday, January 4, 2019
Herding behavior
Contrarianism has its benefits.
Contrarianism has its benefits.
Apples and oranges
According to a report from Bloomberg on Wednesday,
According to a report from Bloomberg on Wednesday,
Recap Jan. 4
Herding behavior
Contrarianism has its benefits. From the New York Post:
New Yorkers trying to make good on “eat healthy” resolutions are mobbing salad joints — leaving many on long lines cursing their radicchio-strewn diets.
“You guys can go f–k yourselves!” one very hangry businessman in a Patagonia puffer vest was overheard telling his colleagues at lunchtime on Thursday, as he ditched the 100-plus-long line at Chopt on West 51st Street, between Sixth and Seventh avenues.
Meanwhile, at Sweetgreen on East 55th Street, Julie Pastor, 30, had to wait in a line of 50 people to get her guacamole-and-greens bowl.
“The line was outside the door and wrapping around the sidewalk,” she said.
“It’s a psycho line,” agreed another customer.
Diet starts next week.
Apples and oranges
According to a report from Bloomberg on Wednesday, not a single new high-yield issue debuted in December. Overall, $190 billion in speculative-grade corporate debt came to market last year, down from $330 billion in 2017 and the lightest year for new high yield supply since the annulis horribilis of 2008.
Then, too, overall inventory is on the wane. Marty Fridson, chief investment officer of Lehmann Livian Fridson Advisors LLC, reports yesterday in S&P’s LCD publication that total face value of the ICE BAML U.S. High Yield Index finished 2018 at $1.231 trillion, down for an “unprecedented” third consecutive year and 8.2% south of 2015’s high water mark of $1.341 billion.
That supply contraction may be good news for credit bulls, but still didn’t help much in the fourth quarter as the Bloomberg Barclays U.S. Corporate High Yield Index sank by 4.5%. That’s the second worst three-month showing of the past five years and ahead only of the 8% November 2015-February 2016 swoon, when numerous distressed energy credits followed the collapse in oil prices.
While the high-yield market shrinks, leveraged loans enjoy their day in the sun. The loan market overtook high yield in total size last year for the first time. Loans are senior to bonds and typically offer floating-rate coupons, a tempting feature for investors in a rising-rate environment. Then, too, loans’ commendable complete-cycle performance during the late-aughts financial crisis have helped burnish the bulls’ confidence.
But the year-end rout likewise took its toll on loans, as the S&P/LSTA Leveraged Loan Index fell a steep 2.5% in December, its worst one-month performance since August 2011, to all but wipe out what had been an excellent performance for the year (the index finished 2018 higher by 0.44%). The index didn’t trade higher in a single session from Nov. 1 to New Year’s Eve.
Leveraged loans and high yield may have sold off in relative tandem at the end of 2018, but it’s the former category that has caught the cautious analytical eye of Grant’s. A July 13 analysis detailed concerning features of the loan boom, including steadily eroding covenant protection, management incentive to call the loans when spreads decline, and, perhaps most importantly, so-called EBITDA add backs. One particularly aggressive example, from longtime Grant’s foil Bausch Health Cos, Inc., formerly known as Valeant Pharmaceuticals International, Inc.:
In calculating EBITDA, our old friend adds back “pro forma ‘run rate’ cost savings” – the money that the company expects to save through its hallmark dexterous management. So Valeant’s EBITDA is actually EBITDAH: earnings before interest, taxes, depreciation, amortization and a hunch.
EBITDA add-backs are particularly prevalent in private equity-sponsored merger and acquisition loan deals. According to LCD, the percentage of loans with a flattering EBITDA adjustment reached 53.5% of all M&A loans in the first half of last year, nearly double the 2005 pre-crisis peak. Nearly 22% of those adjustments amounted to 50% or more of the issuers total EBITDA, also about double the prior high-water mark in 2005.
Recap Jan. 4
An impressively strong December payrolls report featuring robust jobs creation and the largest year-over-year uptick in average hourly earnings since April 2009 helped put some spring in the step of beleaguered bond bears, as yields rocketed higher across the curve with the 10-year rising 11 basis points to 2.66%. Stocks likewise enjoyed a frenzied 3.4% rally on the S&P 500, erasing yesterday’s downdraft with room to spare to leave the broad index green by nearly 2% for the week.
Commodities enjoyed a surge of more than 1% in the broad CRB Index with WTI crude rising above $48 a barrel to continue its rebound, but gold bucked the bullish trend by falling back to $1,285 an ounce. The VIX finished at 21.3, the lowest weekly close since the end of November.
- Philip Grant
Thursday, January 3, 2019
Carried out
Strange doings afoot.
Strange doings afoot.
Shelter from the storm
QT Progress report
Recap Jan. 3
Carried out
Strange doings afoot. Yesterday evening’s revenue warning from Apple, Inc. not only sent shares in the Cupertino-based juggernaut lower by 10% and helped knock the broad market back into retreat (E-mini S&P 500 Futures slid by more than 50 basis points in the minutes following the announcement) but appeared to spur sharp reactions across any number of seemingly unrelated financial products. In the moment’s following the bombshell, 10-year Treasury futures ticked notably higher, with the yield dropping four basis points to 2.61%.
The currency market logged even wilder, and less intuitive, gyrations. The Japanese yen briefly surged as much as 3.8% against the U.S. dollar, 7% against the Australian dollar and nearly 9% against the Turkish lira in a straight line before swiftly retracing the bulk of those gains.
What spurred that ferocious yen bid? In a postmortem today, Bloomberg cites the Apple news as a potential factor, along with thin liquidity during the gap between U.S. and Asian trading sessions, as well as a crowded yen position. The Commodity Futures Trading Commission reported noncommercial futures positions at net short 102,271 yen contracts as of the most recent update on Dec. 18, near the most bearish positioning level of 2018. The Japanese market was also closed today, exacerbating the lack of liquidity.
But perhaps the underlying cause of those outsize currency swings is the ultra-repressive monetary policy of the Bank of Japan. The June 1 edition of Grant’s noted that Japanese savers, laboring for income under the thumb of the BoJ’s “qualitative and quantitative easing with yield curve control” regime, have looked overseas for income, particularly to Turkey.
Japanese yield-hunters had pulled back following the rout in Turkish assets over the spring and summer, but have recently returned as conditions steadied in the land of Erdogan. As of Dec. 18, the Tokyo Financial Exchange reports that open interest in lira/yen (long the former, short the latter) contracts rose to 290,164, up nearly 50% from the lows seen in late August.
Shelter from the storm
This (Big) Apple isn’t doing so well either. The Manhattan housing market continues to struggle, as the median apartment sales price registered $999,000 in the fourth quarter, down 5.8% year-over-year, with closed sales declining 3.3% according to appraiser Miller Samuel and brokerage firm Douglas Elliman’s fourth quarter market report. That’s the first sub-$1 million median sales price in three years, and marks the fifth straight quarterly year-over-year drop in transactions.
Other metrics lend further color to the slowdown. In the face of a 14% decline in full-year transactions to 10,229, inventory of active listings rose to 6,092 units, up 11.8% year-over-year. That pushed the average months to sell to 7.5, up from 6.5 months a year ago, with the listing discount from last offer price rising to 6.2% from 5.4% in the fourth quarter of 2017. It’s not all bad news, as the median price for luxury units rose 10.3% to $6.3 million, with active listing inventory declining 6.3% to 1,345 units at the upper end.
It might be tough sledding in Gotham, but things could be worse.
The formerly red-hot Hong Kong housing market fell into a deep freeze at the end of 2018, with the South China Morning Post reporting that December property sales plummeted by 58% from a year ago for the quietest December in 28 years. Meanwhile, Hong Kong-based brokerage Ricacorp Properties estimates that an additional 17,000 units will come online this year in Hong Kong, outpacing the firm’s expected apartment sales figure of 15,800 units this year. Median prices are down by 7.2% since July.
In Vancouver, December activity continued its recent swan dive (Almost Daily Grant’s, Dec. 20), declining by 46.3% from last year and the lowest level since 2000, bringing the full-year 2018 sales total to 25% below its 10-year average. The benchmark price index, which had managed to remain higher through the first 10 months of 2018 before turning negative by 1.4% year-over-year in November, sank by 2.7% from a year ago last month.
A near-term reprieve for sellers looks unlikely. Phil Moore, president of the Real Estate Board of Greater Vancouver, comments, “We’ve had record building activity in recent years and many projects will complete soon. This will provide additional housing options for home buyers across the region.”
QT Progress report
Jay Powell isn’t backing down yet. The Fed’s portfolio of securities held outright registered at $3.862 trillion, down a meaty $18 billion from a week ago (Treasurys supplied all of this week’s run-off) and down $29 billion from the trailing four-week average.
Since the Oct. 1, 2017 commencement of QT, total balance sheet assets at the Fed are down by just under 9%.
Recap Jan. 3
Stocks were pummeled, with the S&P 500 falling 2.3% to sink back within 4.5% of the Dec. 24 interim lows, as Delta Air Lines, Inc., joined Apple in cutting its profit outlook, sending the Dow Transports Index lower by 3.5%. Yield curve-flattening continued apace, with the 10-year yield settling at a 16 basis point premium to the three-month Treasury bill, while interest rate futures now point to 54% odds of a Fed rate cut by year-end with 0% odds of a hike. Less than a month ago, futures suggested 94% odds of a hike by December and 0% chance of a cut (Almost Daily Grant’s, Dec. 4).
One bullish development was commodity resilience, as the broad CRB index finished well in the green thanks to a weak dollar, with WTI crude rising back above $47 a barrel and gold approaching $1,300 an ounce.
- Philip Grant
Wednesday, January 2, 2019
Pancake breakfast
In with the new.
In with the new.
To greener pastures
The new U.S. Census Bureau population survey for the 12-months ended July 1 finds that Illinois
The new U.S. Census Bureau population survey for the 12-months ended July 1 finds that Illinois
Recap Jan. 2
Pancake breakfast
In with the new. The turn of the calendar comes not a moment too soon, as a 13.5% plunge in the fourth quarter swung the S&P 500 to a 4.38% loss last year. It wasn’t just equities, as Treasurys, corporate bonds and commodities were down 0.38%, 2.11% and 10.66% as measured by the Bloomberg Barclays Global Treasury Index, the Barclays Credit Index and the Reuters/Jefferies CRB Index, respectively.
Is the December selloff just a “glitch”, as claimed by President Trump today, or an augury? Manufacturing indices from the Dallas and Richmond Fed’s showed sharp and unexpected contractions in December, falling to minus eight and minus 5.1 respectively, compared to expectations of 15 and 15. More broadly, today’s release of the Markit U.S. Manufacturing PMI for December saw the headline figure slow to 53.8, south of the 53.9 estimate and the lightest reading since September 2017.
The rates market is also swiftly repricing for weaker economic growth on the horizon. The yield curve continues to flatten at a rapid pace, with the differential between the three-month Treasury bill and 10-year note dwindling to as low as 19 basis points this morning. That’s down from a one-year average spread of 94 basis points and the narrowest since fall 2007.
Yield spread between the 10-year note and three-month bill. Source: The Bloomberg
As the yield premium on long dated Treasurys evaporates, risks to economic growth intensify. The Cleveland Federal Reserve reported in a Dec. 14 paper (published when the aforementioned spread stood at a relatively towering 47 basis points) that their in-house model based on the slope of the yield curve suggested 24% odds of a recession in the next 12 months, up from 16.6% in October. In a strategy note this morning, Ian Lyngen of BMO Capital Markets writes that if recent history is any guide, this phenomenon suggests that the Fed may be forced to backpedal from its planned rate hikes sooner than later.
When the [3 month/10 year] spread crossed below 20 basis points in February 1989, the Fed stopped hiking at the March meeting to begin cutting policy rates in June – only four months later. In the 90s, 3 m/10s crossed this psychological line in the sand several times, and in each instance, within three months we either saw a rate cut or pause in tightening to eventually give way to cuts.
In early January 2006, after 3m/10s crossed 20 basis points for the first time, the Committee was only able to continue tightening until the August meeting (four additional hikes) where they left the target unchanged before ultimately cutting [from 5.5% to virtually zero by the end of 2008] roughly one year later.
Indeed, while Fed chairman Jerome Powell projected a pair of additional rate hikes this year following the Dec. 19 meeting, the market is now calling his bluff. Interest rate futures currently forecast a funds rate of 2.39% at year-end, down from 2.69% at the end of November and below the current 2.40% effective rate. The odds of at least one rate hike this year, which topped 90% as recently as November, currently stand at just over 10%.
The big question: If economic data and financial markets continue to deteriorate, how long before non-traditional monetary policy (a.k.a. QE4) is back on the table?
To greener pastures
The new U.S. Census Bureau population survey for the 12-months ended July 1 finds that Illinois lost more than 45,000 residents last year, or 0.35% of the total. How it misplaced them was unreported. Anyway, that’s the fifth straight annual decline in the Land of Lincoln, which is the only state in the Midwest to see a net population outflow last year.
As citizens hit the bricks, Illinois’ budget woes continue to mount. According to a report from the Illinois Commission on Government Forecasting and Accountability, the combined shortfall of five state-run pensions rose $4.1 billion year-over-year to $133.5 billion on June 30, despite a strong market and increased taxpayer infusions. Those improvements were swamped by the ongoing explosive growth in benefit liabilities, as local business news site WirePoints reports that state worker pension payouts have ballooned 1,061% between 1987 and 2016. That compares to personal income growth of 236% and state revenue growth of 176% over that period.
Jim Bianco, founder and eponym of Bianco Research, reports today that Illinois municipal debt yields an average of more than 0.50% premium spread over the S&P Municipal Bond Index, by far the highest of the 50 states but a relatively narrow premium compared to what might be fetched by, say, a distressed corporate issue (triple-B-minus-rated Illinois narrowly avoided a downgrade to junk last summer, which would have been a first for a U.S. state in the modern era).
Recent experience informs those prices, as Bianco finds that debt from Illinois and similarly-strapped New Jersey (Grant’s, April 7, 2017) have averaged total returns above 10% and 9%, respectively, since December 2016. Those figures far outpace gains in more prudently-run states like North Carolina and New Mexico, up roughly 6% and 5% respectively over that period. Bianco notes:
These high yields are why states that are run irresponsibly can continue to be that way for a long time. Illinois and New Jersey will come to market with high tax-free yields and institutional investors will jump over each other to buy.
Investors in high-flying munis like Illinois and New Jersey are essentially making a bet that the “gradual” phase of bankruptcy will continue long enough to enjoy higher returns. This works until the “suddenly” phase of bankruptcy hits, which often comes when investors least expect it.
Recap Jan. 2
The bulls started the new year in solid fashion as stocks erased pre-market losses of more than 2% on the S&P 500 to finish unchanged, while commodities caught a bid with WTI crude settling near $46.50 a barrel despite a stronger dollar. Treasury yields ticked mostly lower, with the 10-year finishing at 2.65%, and the VIX fell to 23.3, its lowest close since Dec. 14.
But after the bell, Apple, Inc. dropped a bombshell by projecting first quarter revenues of $84 billion, far below the street’s $91 billion expectation and down roughly 5% year-over-year. CEO Tim Cook cited weakness in emerging markets for the anticipated shortfall, “particularly in greater China.” AAPL shares dropped by 6% in immediate reaction.
- Philip Grant
Friday, December 21, 2018
Over a barrel
Timing is everything.
Timing is everything.
Loan shark
Let’s do a status check on the leveraged loan market,
Let’s do a status check on the leveraged loan market,
Recap Dec. 21
Over a barrel
Timing is everything. Yesterday, industrial packaging concern Greif, Inc., (GEF on the NYSE) announced it had entered a binding agreement with private equity firm H.I.G Capital LLC to purchase Caraustar Industries, Inc., a Georgia-based paperboard manufacturer, for $1.8 billion in cash.
The deal, which is expected to close in the first quarter of 2019, will be immediately accretive to gross margins and earnings per share according to the acquirer, who has identified “at least” $45 million a year in cost synergies within 36 months, on top of Caraustar’s trailing 12-month run rate EBITDA of $220 million. As for the balance sheet, Greif asserts in the press release that “strong pro-forma free cash flow is expected to drive rapid deleveraging.”
The rating agencies were unimpressed by Greif’s promise of swift debt repayment, as both Moody’s and S&P placed GEF debt on review for downgrade. S&P notes that they expect the entire $1.8 billion price tag to be financed with new borrowings, while Moody’s estimates a pro-forma leverage ratio of 4.5 times following deal completion, an aggressive structure considering GEF’s “inherent cyclicality and weak margins.” Investors were in no mood to wait for more clarity, instead dumping Greif shares to the tune of 19% yesterday, extending the stock’s losses to 41% in the last 15 months.
For a thorough, and thoroughly bearish, look at GEF, see the Sept. 22, 2017 edition of Grant’s.
Loan shark
Let’s do a status check on the leveraged loan market, which has enjoyed aggressive growth this cycle prior to the recent turn and has been the subject of a number of cautionary analyses in Grant’s (“Tomorrow’s debt hearings,” on July 13, for one). The ongoing dislocation in credit has not spared the loan realm, which was formerly the apple of investors’ eye thanks to its floating-rate structure in what had been an agreeable, rising rate environment. Yesterday’s close of 94.5 on the S&P/LSTA Leveraged Loan Price Index left that gauge at its lowest since September 2016, while bringing the year-to-date total return to less than 1%.
Index-level pain aside, the typical leveraged lender is hanging in there just fine, so far. According to data provided by S&P Global Intelligence’s LCD unit on Twitter, the percentage of S&P/LSTA issuers whose loans are trading at 80 cents on the dollar or below stands at 2.27%, far below the 12% reached in the February 2016 risk spasm, to say nothing of the mind-boggling 81% of index components that saw their loans sink south of 80 during the 2008 crucible.
In a commentary today, LCD reported that a recent survey finds that loan investors do expect defaults to rise to 2.16% by the end of next year, up from 1.63% currently but well below the 3.1% historical average.
Nevertheless, the odds suggest that more issuers will find themselves in difficulty sooner than later, if recent history is any guide. That S&P/LSTA index has dropped below 95 on four other occasions since 1998, each time then proceeding to fall below 90 (and far lower in 2008) before recovering.
S&P/LSTA Price Index, 30-year view. Source: The Bloomberg
Correlation is not causation, but recent experience implies that flagging loan performance also precedes an economic turn. On Dec. 7, Fabiano Santin of this staff spoke with Marty Fridson, chief investment officer of Lehman, Livian, Fridson Advisors LLC, and “the dean of high yield,” for historical observations about the likely path of corporate defaults following a drop in the LSTA loan index toward these mid-90s price levels. Fridson offered the following observations:
[On Dec. 6, the S&P/LSTA index closed] at 96.39. It was below that level in October 1998. According to Moody’s, the speculative-grade default rate rose from 3.03% in 1998 to 5.36% in 1999, but did not reach the cyclical peak of 9.63% until 2001.
In July 2007, the index fell to 95.70 from 99.77 the previous month. The default rate rose from 0.95% in 2007 to 5.43% in 2008 and peaked at 12.11% in 2009.
So the sample size is quite small, but a single-factor model would say that a drop in the S&P/LSTA Index to the present level has historically been a signal that default rates are about to come off the cyclical low.
So this doesn’t spell imminent catastrophe, but high yield bond returns tend to be lower during the up leg of the default rate cycle than during the down leg.
Meanwhile, the recent tumble has attracted not only attention but action from investors. LCD cites data from Lipper to report that domestic loan funds saw a record $3.29 billion of outflows for the week ended Dec. 19, outpacing the prior week’s $2.53 billion drain and the previous record outflow of $2.12 billion in August 2011, which took place in the teeth of the E.U. sovereign debt crisis and S&P’s downgrade of the U.S. government
The aggressive fund withdrawals are spurring notably broad based moves. John Wright, managing director at Bain Capital Credit, observes: “The latest price correction has been a lot faster than what we were seeing in 2015, rather than being concentrated in a select few industries.”
Recap Dec. 21
Santa was apparently too busy making toys to help the bulls this week, as yet another sharp selloff left the S&P 500 down more than 7% over this five-day stretch, extending the year-to-date loss to nearly 10% and pushing the broad index below its simple three-year average price.
Elsewhere, a solid rally in Treasurys pushed the 10-year yield to 2.78%, four basis points below yesterday’s fixing of three-month Libor. A dollar rebound pressured commodities with WTI crude sinking back to near $45 a barrel, and the VIX popped above 30 at the close for the first time since February.
Almost Daily Grant’s will resume on Jan. 2. Happy New Year!
- Philip Grant
Thursday, December 20, 2018
A turn in the tide
James Grant writes
James Grant writes
Northern exposure
QT Progress report
Recap Dec. 20
A turn in the tide
James Grant writes:
Thursday’s Wall Street Journal editorial condemning Wednesday’s rate hike ran out under the headline, “Powell to Markets: Take That.” It reminded us of a Journal editorial from Oct. 25, 1929, whose headline we reprint above.
The stock market had already crashed when William Peter Hamilton, the Coolidge-era editorialist, started typing. He wrote to observe that the Dow Jones Railroad Average had fallen to confirm a prior decline in the Industrials, thus, under Charles Dow’s technical theory, signaling a bear market.
The final two paragraphs of Hamilton’s comment seem particularly timely reading today. Thus:
There are people trading in Wall Street and many from all over the country who have never seen a real bear market, as for instance, that which began in October, 1919, and lasted for two years, or that from 1912 to 1914 which predicted the Great War if the world had then been able to interpret the signs. What is more material is that the stock market does forecast the general business of the country. The big bull market was confirmed by six years of prosperity and if the stock market takes the other direction there will be contraction in business later, although on present indications only in moderate volume.
Some time ago it was said in a Wall Street Journal editorial that if the stock market was compelled to deflate, as politicians seemed so earnestly to wish, they would shortly after experience a deflation elsewhere which would be much less to their liking.
Hamilton was not forecasting a great depression; nor, certainly, are we. Neither are we equipped to read the tea leaves of stock-price action. What we do mark is that the Powell Fed, professedly “data-dependent,” yesterday chose to continue to tighten in the face of the real-time data of falling share prices, widening credit spreads, a plunging oil price and a flattening yield curve.
In a CNBC panel discussion following the Powell press conference, a commentator insisted that there had been no “policy error,” adverse market reaction notwithstanding—it was obvious, he said. But if policy errors were obvious at the time they were perpetrated, our policy-makers would never err.
A decade’s worth of interest-rate suppression has led to an outpouring of new credit. Arguably, given the artificially low borrowing costs in place, much of this debt was mispriced at inception. Perhaps the message of the markets is that Corporate America is dependent on negligible real interest rates only and is ill-equipped to deal with substantially higher ones. If so, 2019 may feature a U-turn in monetary policy and a, perhaps, long overdue reappraisal of the judgment and operating methods of our omnipresent central bank.
Northern exposure
Is a course reversal underway in the Great White North? On Monday, The Canadian Real Estate Association reported that existing home sales dropped 12.6% year-over-year in November, while the average home price of C$488,000 represented a 2.9% decline from November 2017.
The epicenters of the long-running Canadian housing bull market have likewise seen their fortunes turn, as existing home sales in Toronto slumped by 15.2% year-over-year, outpacing the broad decline, while such transactions in Vancouver cratered by 42.3% from a year ago.
Then, too, the sharp recent decline in energy prices is making an impact on Canada’s economic picture. November CPI showed a 4.8% sequential and 1.3% decline in the energy component, helping to push headline price growth to 1.7% year-over-year, below the 1.8% consensus and down from 2.4% in October. Pain in the Canadian energy patch is severe enough that the energy and trade ministries announced a C$1.5 billion loan package for the oil and gas sector, with a bulk of those funds earmarked for exporters with “working capital needs.”
While the housing market sputters and the oil industry struggles, Canadians remain in hock. Last Friday, Statistics Canada reported that the ratio of household debt to disposable income rose to 173.8% for the third quarter, up 60 basis points sequentially and near 2017’s record 174.4%. By comparison, that figure stood at 109% in the United States last year and topped out at 144% during the prior cycle in 2007.
The heavy debt load is taking a toll, as the Office of the Superintendent of Bankruptcy reports that consumer insolvencies jumped 9.2% year-over-year in October, the biggest jump since the 2016 oil-bust aftermath. Ted Michalos, licensed insolvency trustee at Hoyes, Michalos & Associates, Inc., tells Bloomberg that: “The tide has turned, and the water’s starting to rise. Now it’s just a question of how quickly does it rise.”
Ominous economic developments and inflation downtick aside, Bank of Canada governor Stephen Poloz stayed on message in a recent interview with CTV news, stating that “The Canadian economy begins the new year in solid shape. Our fundamentals are quite solid.”
Of the BoC’s 1.75% overnight rate, Poloz indicated that he sees a target range of 2.5% to 3.5%, but gave himself plenty of rhetorical wiggle room: “Getting there, it’s a journey and we expect over time to get there. But it can be interrupted or it can be sped up, depending on how the economic data evolve.”
Talk aside, investors are increasingly certain that the BoC will back off after five rate hikes in the past 18 months, followed by a status quo result at the Dec. 5 meeting. According to interest rate futures data provided by Bloomberg, the odds of a rate hike at the Jan. 9 meeting have collapsed to 2.5%, down from 70% a month ago.
Whether BoC follows the Fed higher or follows the newly dovish route now expected by the markets, the Canadian dollar looks vulnerable. Continued tightening by Poloz and Co. would add additional strain to an economy whose dual pillars of housing and energy are both under duress, while a more dovish approach would likewise be negative for the Loonie thanks to the widening yield differential with the U.S.
Canadian dollar/U.S. dollar cross, three-year view. Source: The Bloomberg
Meanwhile, the accelerated carnage in asset prices after yesterday’s Fed funds-rate hike has led some investors to rethink the recently unthinkable. Futures currently price 1.5% odds of a U.S. rate cut by the Dec. 11, 2019 meeting, up from 0.0% one week ago.
QT Progress report
A $5 billion sequential downtick left the Fed’s portfolio of securities held outright at $3.892 trillion this week, with Treasury securities comprising about 57% of the remaining portfolio. Compared to the trailing four-week average, today’s figure is down by $13 billion, split evenly between Treasurys and mortgage-backed securities.
Since the start of QT on Oct. 1, 2017, the Fed’s total balance sheet is down by 8.34%.
Recap Dec. 20
A 1.5% drop in the S&P 500 left the broad index about 16% off its September high water mark, while the Russell 2000 and Dow Transports fell by a similar percentage. The NYSE FANG+ Index lost 3.5%, and is now negative year-to-date.
But perhaps the wilder action was in the bond market, where we saw three-month Libor briefly exceed the 10-year Treasury yield this morning, while the 30-year long bond rallied to push the yield as low as 2.96% before a late reversal left yields higher across the curve. Speculative grade corporate debt was hammered, with the iShares iBoxx High Yield Bond ETF falling to its lowest since that 2016 winter of discontent, while the Invesco Senior Loan ETF finished the day at a 1.3% discount to its net asset value, the biggest since at least 2011.
- Philip Grant
Wednesday, December 19, 2018
Recap Dec. 19
YouWork
Yesterday, Japanese telecom concern SoftBank Corp. (code 9434)
Yesterday, Japanese telecom concern SoftBank Corp. (code 9434)
Diploma see
Yesterday, Bloomberg reported that Georgetown University,
Yesterday, Bloomberg reported that Georgetown University,
Recap Dec. 19
The “dovish rate hike” turned out to be just a rate hike, as Fed chairman Jerome Powell implied in his press conference that “QT” asset sales will continue apace, setting off another sharp sell-off in equities. The S&P 500 dropped more than 1% and is now 14% below its Sept. 20 highs, while the small cap Russell 2000, Dow Transports and NYSE FANG+ Index have all entered bear market territory, down more than 20% from their own respective high water marks.
Treasury yields darted lower on the long end of the curve, pushing the 10-year to 2.76% (the lowest since May) while short rates ticked higher to pull the spread between the 2- and 30-year yields to 35 basis points, its lowest since 2007 and down from a 242 basis point average since 2010. Commodities caught a bounce after yesterday’s liquidation with WTI crude inching back above $47 a barrel, while the VIX held steady near 25.
YouWork
Japanese telecom concern SoftBank Corp. (code 9434) made its debut today as a publicly traded company on the Tokyo stock exchange. It didn’t go very well, as shares gapped lower at the open and continued to falter, eventually losing 14.5% and closing at the lows of the session. Nevertheless, one could argue the deal could have performed far worse, considering the roughly 60% valuation premium to peers NTT DoCoMo, Inc., and KDDI Corp. at the initial offering price (Grant’s, Nov. 30).
The inauspicious debut coincides with a potentially more ominous development for Masayoshi Son’s tech empire. Today, The Wall Street Journal reports that key investors in Son’s mammoth $100 billion Vision Fund are getting nervous about a cornerstone portfolio company, forcing the SoftBank boss to potentially buy them out the position:
Key investors in SoftBank’s giant tech fund have balked at a planned $16 billion investment in co-working startup WeWork Cos., leaving SoftBank chief executive Masayoshi Son to find an alternative as his ambitions hit up against the limits of his financial firepower.
The new investment would value WeWork at around $36 billion, the people said [down from a prior valuation of $45 billion one month ago], and would bring SoftBank and its affiliates’ total investment in the company to more than $24 billion.
Under the deal being discussed, SoftBank would buy out existing investors at a valuation of around $22 billion, subject to a shareholder vote.
If SoftBank is indeed “the epitome of the cycle”, as contended in the Dec. 15, 2017 edition of Grant’s, Jay Powell and friends might be rethinking their planned 2019 rate hikes sooner rather than later.
Diploma see
Yesterday, Bloomberg reported that Georgetown University, founded in 1789 and the oldest Catholic college in the U.S., will offer $305 million worth of taxable century bonds maturing in 2118.
Investors inclined to wade into the 100-year debt pool may find A2-rated Georgetown a more attractive issuer than, say, Argentina, which has defaulted time and time again (Almost Daily Grant’s, June 19, 2017), or Austria, which pays a meager 2.1% coupon, below the current measured rate of inflation (Almost Daily Grant’s, Sept. 13, 2017). Scott Richman, chief investment officer of Whitehaven Asset Management, told Bloomberg that: “We strongly believe the very selective schools will definitely be around 100 years from now.”
However, while the venerable D.C. based institution has the track record, recent financial performance is another matter: Georgetown finished $19.2 million in the red in fiscal 2018, its second straight year of operating losses. In addition, operating cash flow margins slumped to 6.4% in fiscal 2018, down from more than 10% three years earlier and well below the 14.7% median for private universities in 2017. In a Dec. 13 report, Moody’s lays bare Georgetown’s difficulties:
Below average operating margins, along with the large proportion of restricted net assets, limits the university’s buffer against uncertainty. Georgetown’s total wealth relative to operating expenses are more in line with Baa-rated private universities, and are well below those medians when measured against spendable cash and investments.
We anticipate the university will remain challenged to materially improve balance sheet flexibility, absent outsized increase in major unrestricted gifts, given the time required to fully implement cost saving initiatives.
As for the now-confirmed plan to issue century bonds, the rating agency commented last week that the issue “materially backloads the debt structure and notably increases debt service demands beginning in 2025.” Creditors aren’t worried: The Georgetown 5.06%s of 2044, issued in 2014 at par, currently trade at 102.43 cents on the dollar for a yield-to-worst of 4.49%.
Solid performance of its credit aside, are Georgetown’s financial struggles emblematic of wider pain in higher education? One thing’s for sure; the generally poor performance of endowment funds isn’t helping. A recent paper co-written by Georgetown's’ Sandeep Dahiya and David Yermack of NYU finds that from 2009 to 2016, a sample of 28,000 university endowments trailed a simple 60/40 portfolio mix of U.S. equity and Treasury allocations by 5.53% annually, with a statistically significant “alpha” [meaning excess return relative to a benchmark] of negative 1.01% per-year.
- Philip Grant
Tuesday, December 18, 2018
Polly want a virtual assistant
Status quotient
No one puts Baby in a corner.
No one puts Baby in a corner.
Recap Dec. 18
Polly want a virtual assistant
From last Friday’s edition of The Times of London:
When Rocco the parrot is peckish, he knows who to turn to — Alexa.
The African grey parrot has become so adept at giving orders to Amazon’s smart speaker system while his owner is out that he uses it to play songs, tell him jokes and even order treats.
It’s not the first time that Rocco has talked his way into trouble. He was removed from a National Animal Welfare Trust sanctuary at Great Shefford, Berkshire, for swearing too much.
And from Bloomberg on Monday:
Several of [Amazon.com, Inc.’s] online stores in North America and Europe showed various models of the Alexa-powered line of gadgets temporarily out of stock on Monday, with shipment delayed to January or beyond in some places.
Coincidence? Probably.
Status quotient
No one puts Baby in a corner. Today, Chinese president Xi Jinping stood his ground in a Beijing speech commemorating the 40 year anniversary of Deng Xiaoping’s liberal reforms, telling the assembled that “no one is in a position to dictate to the Chinese people what should and should not be done.” Bloomberg describes the ruler-for-life’s remarks as “outlin[ing] no new economic policies that might assuage investor concerns about market access or the slowing economy.”
Xi’s rhetoric aside, major changes are afoot in the bond market. As of this morning, the Chinese one-year government bond yields 2.5%, well below the 2.63% on offer in 12-month Treasury bills. The yield premium in U.S. debt runs counter to credit rating profiles, where the U.S. enjoys triple-A and double-A-plus ratings at Moody’s and S&P, respectively, four and three notches above the A1 and single-A-plus designations for the Middle Kingdom. Recent history has also been turned upside down: Over the past five years, the Chinese one-year yield has averaged 2.96%, a more-than 200 basis point premium to the 0.88% five-year average for 12-month Treasury bills.
Beijing’s borrowing costs are low (the 10-year yield of 3.38% likewise sits below its five-year average of 3.55%), but the relentless output expansion often dubbed the “Chinese economic miracle” appears to be on the wane. Headline GDP is now expected to grow at 6.2% next year according to the International Monetary Fund, downgraded from a 6.4% guesstimate in October. That's well below the 6.9% in full-year 2017 and 7.1% average growth rate over the last five years. Meanwhile, the National Bureau of Statistics reports that industrial profits grew by 3.6% year-over-year in October, the sixth consecutive monthly decline and down from 21.9% year-over-year in April.
With slowing growth comes increased difficulty for the corporate sector; record local bond defaults in 2018 are followed by a maturity wall of RMB 3.5 trillion ($507 billion) from Chinese non-financial companies next year, according to Bloomberg. Cindy Huang of S&P Global Ratings comments: “As credit lending and property sales are slowing down, private firms will face increasing liquidity pressures if their ability to make a profit worsens. Supportive measures since the third quarter did not reverse the rising default trend in November.”
China’s suddenly-cool property market is reflected by an interesting divergence. In a Dec. 10 commentary, Anne Stevenson-Yang of J Capital Research notes that while land sales are flat to down this year across China (including a 10% decline in so-called Tier 1 cities), most Hong Kong-listed developers have continued to see sales growth this year. However, “these numbers are not necessarily signs of health: Developers in China tend to sell in high volume only when they cannot access working capital loans. . . This is borne out by the pre-sale numbers. Developers are selling more of their inventory before the housing is built. This suggests a strain on cash flow.”
How will heavily-leveraged China (banking assets represent 285% of trailing four-quarter nominal GDP as of Sept. 30) respond to the weakening growth picture? Through the suppression of information by government dictum, of course. Yesterday, the South China Morning Post reported that Beijing “has ordered authorities in the country’s export hub, Guangdong province, to stop producing a regional purchasing managers’ index for the manufacturing sector as it seeks to control the flow of sensitive economic data.”
Recap Dec. 18
Stocks gave back an early rally to leave the S&P 500 little changed at the close, leaving the broad index down about 4.5% for the year with eight trading sessions remaining in 2018. Momentum outperformed slightly, with a 1% gain in the NYSE FANG+ Index, leaving that gauge 6% in the green year-to-date.
While equities managed that sideways finish, bearish price action again reigned elsewhere: Commodities were hammered once more, with the CRB Index falling 2% to its lowest since summer 2017 and WTI crude plummeting to $46 a barrel, and Treasury yields dropped again with the 10-year settling at 2.83%, two basis points above yesterday’s fixing of three-month Libor. The VIX rose back above 25, and global shipping giant FedEx Corp. surprised the market by offering weaker-than-expected EPS guidance for fiscal 2019 after the bell, sending FDX shares lower by 4% in immediate reaction.
- Philip Grant
Monday, December 17, 2018
Liquid gold
The spigots are off. On Wednesday, the Federal Reserve will conduct its final policy meeting of 2018, with a 25 basis point hike to the overnight funds rate the likely outcome; interest rate futures currently price 74% odds of policy tightening, down slightly from 78% two weeks ago. One interested observer is happy to provide chairman Jerome Powell with some free advice. This morning, Donald Trump shared his thoughts on Twitter:
It is incredible that with a very strong dollar and virtually no inflation, the outside world blowing up around us, Paris is burning and China way down, the Fed is even considering yet another interest rate hike. Take the Victory!
It’s not just leveraged real estate-speculators turned commander-in-chief who are advocating a cessation of policy tightening, which is taking place not only through rate hikes (eight and counting since December 2015) but also the ongoing “QT” asset sales. In today’s edition of The Wall Street Journal, former Fed governor Kevin Warsh and Duquesne Family Office LLC chairman Stanley Druckenmiller argue that the Fed needs to pump the brakes, particularly on QT:
The Fed’s balance sheet is where the money is. Yet it has provided little additional clarity on its balance-sheet plans since Chair Janet Yellen’s tenure. At a time of global quantitative tightening and uncertain economic prospects, the Fed’s silence on its asset holdings is contributing to the tumult. We were assured by policy makers that QE provided large benefits to the real economy. If so, won’t its reversal in the form of QT come with a cost? It can’t all be rainbows and unicorns.
Protestations by the executive branch, former colleagues and Wall Street luminaries aside, the Fed forges ahead. Although securities held outright held steady last week at $3.896 trillion, $20 billion below the trailing four-week average, total balance sheet assets are down by 8.2% since the Fed began to run off its balance sheet in October 2017.
The pace has been quickening. Thus, while Federal Reserve bank credit has declined by 7.9% over the past 12 months using the trailing four-week average, the contraction has accelerated to a 11.1% annualized rate over the past three months. Broad M2 money supply has grown by 3.9% over the past 12 months, but just 3.1% annualized since September.
Consequences of the liquidity drain are increasingly apparent, as the Druckenmiller/Warsh pair cites sharp recent drops in the banks (BKX Index is down 21% since late September and 14% in the last two weeks) and commodities (the CRB Index is down 11.6% since early October). In credit, the most speculative issues have been hammered, with the option-adjusted spread on the Bloomberg Barclays CCC and Below Index jumping to 934 basis points today from 619 basis points in early October. Today, the Financial Times reports that “not a single company has borrowed money through the $1.2 trillion U.S. high-yield corporate bond market this month.” It would be the first time since November 2008 without any new high-yield supply.
The un-bullish turn has likewise put a dent in the leveraged loan category, with the FT reporting that two deals were scratched last week after major banks including Barclays and Wells Fargo were unable to locate buyers. Those failures were no outliers. Bloomberg reports today that issuance of collateralized loan obligations (collections of loans that have been packaged and securitized) fell 25% year-over-year in the first half of December, accelerating from a 10% decline last month (for more on CLO’s, see the Sept. 7 edition of Grant’s).
S&P/LSTA Leveraged Loan Index, five-year view. Source: The Bloomberg
The broad reversal of financial conditions can indeed be laid at the feet of the Fed, according to David Rosenberg of Gluskin Sheff + Associates, Inc. At the spring 2018 Grant’s conference, Rosenberg told the audience that as the post-2008 bull run can be largely chalked up to the ultra-dovish policies of past Fed chairs Ben Bernanke and Janet Yellen, and investors should gird themselves for the opposite dynamic as monetary stimulus is withdrawn.
We’ve never had a cycle where the stock market has done what it did in the context of such weak economic growth. If I took the ratios of what the stock market does benchmarked against what the economy does in nominal and real terms, this bull market and the S&P 500 would have stopped out at 1800, not 2800. The excess is central bank liquidity. The central banks added 1000 points. Not fundamentals. Central bank liquidity.
Now people say to me: No cycle ever dies of old age. I get that. But, they die at the hands of the central bank. The Fed. Each cycle has died at the hands of the Fed. Every bear market ended by the Fed. Every recession ended by the Fed. By the same token every bull market / expansion, the Fed has its thumb prints over every expansion. There is nothing more important, not fiscal policy, not trade policy. Nothing is more important for what we do than Fed liquidity.
Slowly but surely, the pool is draining.
Recap Dec. 17
It was another ugly day, as the S&P 500 shed more than 2.5% to finish at its lowest since October 2017, while momentum stocks were strafed with the NYSE FANG+ Index losing nearly 5%. Another leg down in energy prices pushed WTI crude below $50 a barrel at the close for the first time this year, and Treasurys enjoyed a solid rally with the 10-year yield finishing at 2.86%. While government yields decline, interbank lending rates continue to jaunt higher, as three-month LIBOR rose to near 2.81% as of Friday, nearly converging with that 10-year Treasury yield.
- Philip Grant
Tuesday, December 11, 2018
Markets make opinions; central banker edition
Help wanted: Project manager
Recap Dec. 11
Markets make opinions; central banker edition
From Reuters, June 27, 2017, with the VIX at 11:
U.S. Federal Reserve Chair Janet Yellen said on Tuesday that she does not believe that there will be another financial crisis for at least as long as she lives, thanks largely to reforms of the banking system since the 2007-09 crash.
“You know probably that would be going too far but I do think we’re much safer and I hope that it will not be in our lifetimes and I don’t believe it will be,” she said.
And from CNBC this morning, with the VIX at 22:
There could be another financial crisis on the horizon, warned former Federal Reserve Chair Janet Yellen in a speech Monday night.
The former Fed chair, now a scholar at the Brookings Institute, said there remains an agenda of unfinished regulation. “I’m not sure we’re working on those things in the way we should, and then there remain holes, and then there’s regulatory pushback. So I do worry that we could have another financial crisis.″
Help wanted: Project manager
The recent economic protests by the “Yellow Vests” have ground France to a halt and turned up the heat on President Emmanuel Macron, a steadfast E.U. proponent who is stuck at an abysmal 23% approval rating according to a Les Echos poll. The embattled president responded in a speech yesterday evening, announcing a series of measures aimed at placating the citizenry including a minimum wage hike and ending taxes on overtime and pensions below €2,000 a month.
While Macron’s remedies may or may not be enough to quell the decentralized protests (Bloomberg reports that Yellow Vests plan to continue blocking roads near major cities including Strasbourg and Lyon), the impact on France’s fiscal position is clearer. This morning, budget minister Gérald Darmanin told the French senate that the 2019 budget deficit is now projected at 3.4% of GDP after accounting for a one-time 0.9% tax credit, up from 2.9% before the protestor concessions.
Energy minister François de Rugy shared his priorities during an interview on Radio Classique: “We aren’t saying that long term the debt isn’t a problem. But the first priority isn’t to discuss this with Brussels, but with the French people.” In response, Valdis Dombrovskis of the E.U. demurred: “We are monitoring closely the potential new measures being announced, but we cannot comment before they are properly announced and detailed.”
Of course, Italy is watching these developments with particular interest. In September, the coalition government led by the populist Five-Star and the League parties announced the projected budgets for the next three years will target deficits equating to 2.4% of GDP. After a series of failed negotiations, that proposed budget was rejected by the E.U. a month later, with Dombrovskis mincing no words: “Unfortunately the clarifications were not convincing to change our earlier conclusions of particularly serious non-compliance. . . It is tempting to cure debt with more debt, but at some point the debt weighs too heavy."
Sovereign credit markets also continue to give France the benefit of the doubt. The spread between double-A-rated French and triple-A German 10-year yields sits at 48 basis points, slightly above the five-year average spread of 37 basis points. Meanwhile, triple-B-rated Italy’s 10-year yield of 3.12% represents a 289 basis point spread over Germany, up from a 113 basis point gap in April and a five-year average spread of 159.
Add inflation into the mix, and holders of French 10-year sovereign debt are facing a real yield of negative 1.5%, as CPI grew 2.2% year-over-year in October. Thanks to a 2.3% CPI uptick, German 10-year debt currently sports a real yield of negative 2%. Italy, with CPI of 1.7% offers a 10-year real yield of 1.4% but with the credit risk implied by the near-junk rating.
Meanwhile, the Thursday meeting of the European Central Bank is widely expected to mark the end of the asset purchase program which has been in place since 2015 (Almost Daily Grant’s, Dec. 3). Mario Draghi, who famously told investors in 2012 he would do “whatever it takes” to preserve the euro, is set to retire next September. An increasingly unpredictable political situation coinciding with the planned withdrawal of monetary stimulus ensures that his successor will have his or her work cut out.
Recap Dec. 11
Stocks drifted sideways for a second straight day, leaving the S&P 500 at the low end of its fall range, but weakness in the Dow Transports, small-cap Russell 2000 and KBW Bank Index brought each of those gauges to respective multi-month lows. Treasury yields again jumped higher across the short end and belly, while the 10- and 30-year bonds outperformed to pull spreads tighter. Commodities held steady as the Dollar Index briefly matched its 52-week high intraday.
Almost Daily Grant’s will resume next week.
- Philip Grant
Monday, December 10, 2018
Job openings at Bloomberg
From the New York Times:
More than 18 months ago, the Manhattan district attorney’s office opened yet another investigation into fraud in the city’s $62 billion construction industry, this one involving Bloomberg L.P., the financial information and media company owned by former Mayor Michael Bloomberg, who is considering running for president in 2020.
On Tuesday, the District Attorney’s Office and the state police are expected to arrest more than a dozen executives, including senior executives in New York of Bloomberg’s global construction and facilities department, on fraud, theft and bribery charges, according to one executive briefed on the investigation and defense attorneys.
Subcontractors and vendors are accused of paying bribes and kickbacks in various forms over nearly four years to executives at Bloomberg and to two executives at Turner Construction, a general contractor that oversaw work at Bloomberg.
Phone home
Today, SoftBank Group Corp. announced the terms for the initial public offering of a 37% stake in its domestic telecom unit, SoftBank Corp., which will price at ¥1,500 ($13.3) a share and generate proceeds of ¥2.65 trillion as brisk demand triggered an overallotment option.That figure approaches the 2014 New York Stock Exchange debut of SoftBank portfolio company Alibaba, Inc., as the largest IPO in history. Shares are set to begin trading on the Tokyo Stock Exchange (code 9434) on Dec. 19.
Instead of an indicated price range that typically precedes an IPO and allows for fluctuations in investor demand, SoftBank and its CEO Masayoshi Son opted to post a single offering price, a first in the Japanese stock market. Retail shareholders accounted for about 90% of the offering’s buyers according to the Financial Times, a cohort that the company and its investment bankers courted through television commercials and door-to-door sales pitches. The FT relays another sales tactic that fits the modern investment zeitgeist:
Brokers have also told retail investors that the stock is likely to be supported by the large influx of passive money that can be expected as the newly listed company is added to various indices tracked by funds.
The unusual details don’t end there. Back in September, Bloomberg reported that the consortium of investment bankers working on the deal were required to provide roughly $9 billion in loans to SoftBank’s majority-owned, in-house venture capital arm, the Vision Fund. Stakes in five unnamed Vision Fund portfolio companies will serve as loan collateral, per Bloomberg.
The Vision Fund is certainly flush with cash. According to a regulatory filing made over the weekend, the fund has seen its assets under management grow to $98.58 billion, approaching the $100 billion target size. Not one to be accused of complacency, Son declared at a Tokyo conference in May that “Vision Fund 2 will definitely come, it’s just a matter of when.” Chief operating officer Marcelo Claure was more circumspect, stating in October that “there was no certainty” of a Vision Fund sequel.
On Friday, Reuters’ Breakingviews discussed the so-called SoftBank effect, by which a company that takes an investment from the flush fund “has the means to grind their rivals into dust, but with the pressure that comes from having to justify a generous valuation.” High-profile Vision Fund portfolio companies such as Uber Technologies, Inc. (which on Friday filed its own IPO paperwork) and WeWork Cos. are two examples of that phenomenon. New York City real estate firm Compass is another.
In September, Compass raised $400 million in a series F round led by the Vision Fund and Qatar Investment Authority, valuing the start-up at $4.4 billion. That’s double the valuation fetched at the prior round in December 2017. Consistent with financial backer Masa Son, Compass CEO Robert Reffkin is thinking big. In June, Reffkin told Bloomberg: “What books were for Amazon, the brokerage model is for us.”
Compass, which began the year with 30 offices, will finish the year with 150 and reach 300 locations by the end of next year, according to chief growth officer Rob Lehman. On Nov. 29, The Real Deal reported that Compass is launching a company-branded credit card for its real estate agents, who can pay back their charges on their “own timelines,” according to Lehman. In October, The Real Deal reported on another generous perk for agents: a company stock option program which provides for a 30% bonus for every dollar invested back in Compass. The company reported last month that more than 1,000 agents have invested some or all of their commissions back into the unicorn, a development that CEO Reffkin described thusly:
It’s not something we needed to do to raise capital. It’s purely an offering to respond to an agent’s desire to have ownership in Compass’ future success.
Three weeks ago, Compass hired Carlyle Group veteran Kristen Ankerbrandt as chief financial officer to help oversee what Reffkin termed the company’s “next stage of hypergrowth.” Ankerbrandt replaces Craig Anderson, who was on the job for just seven months.
For a detailed analysis of SoftBank, see the Nov. 30 edition of Grant’s.
Recap Dec. 10
Stocks staged a late rally, with the S&P 500 erasing near-2% intraday declines to finish modestly in the green, helped by a 1.2% gain in the NYSE FANG+ Index. Commodities were hammered as the Dollar Index approached 52-week highs, and WTI crude slumped back below $51 a barrel. Treasury yields mostly ticked higher, with the 10-year and 30-year outperforming to leave the curve flatter. The VIX gave back solid gains to finish just below 23.
- Philip Grant
Friday, December 7, 2018
Cancun swoon
Last Saturday, left-wing populist Andrés Manuel López Obrador (AMLO for short)
Last Saturday, left-wing populist Andrés Manuel López Obrador (AMLO for short)
Recap Dec. 7
Cancun swoon
Last Saturday, left-wing populist Andrés Manuel López Obrador (AMLO for short) was officially inaugurated as Mexico’s 58th president, replacing establishment predecessor Enrique Peña Nieto. AMLO wasted no time in establishing his anti-elitist bona fides, opening the opulent presidential mansion Los Pinos to the public while maintaining his own, more modest residence in the south side of Mexico City. The new president also dispatched the presidential plane, a Boeing 787 Dreamliner that cost more than $200 million, back to California where it will await a new buyer.
Changes under AMLO go well beyond the symbolic. In October, the then-president elect announced the cancellation of a partially-completed $13 billion airport expansion outside of Mexico City after a mini-referendum showed 70% of respondents opposed the project (Almost Daily Grant’s, Oct. 29). While El Universal polls show a 9% decline in AMLO's approval ratings since August, a majority of Mexicans (55.6%) still give their new president a thumbs up as of Nov. 26. Investors are another matter.
Last week, the Mexican government launched a tender offer for $1.8 billion of the $6 billion in airport bonds outstanding at prices ranging from 90 cents on the dollar to par, in return for looser covenants and a change in the revenue stream servicing the remaining debt.
News of the offer has lifted those bonds to 83 cents on the dollar from 75 prior to the announcement, but the experience has done little to build good will with creditors. Michael Leithead of EFG Asset Management tells the Financial Times that Wall Street “will be cognizant of the unpredictability of the new government. Despite the market-friendly outcome.” Sebastian Salvay, analyst at TPCG brokerage in Argentina, suggests some specific improvements to Bloomberg: “The main problem with this offer is that it doesn’t give you anything in exchange with what you give. . . you need a guarantee, collateral from government.” On Tuesday, a group of creditors claiming to own more than half of the bonds outstanding rejected the government’s proposal.
The uncertainty of the airport bond situation is one example of political risk south of the border. AMLO’s energy policy is another. During his inauguration speech, the new president declared: “Neoliberal economic policies have been a disaster,” referring to the market-friendly energy reforms put in place by his predecessor. Indeed, AMLO promised on the campaign trail to halt crude exports by 2022, while The Wall Street Journal reported in August that the then-president elect “will hold off auctioning any new oil blocks for at least two years and plans to modify laws to bolster the dominant role of state oil company Petróleos Mexicanos [a.k.a. Pemex]”.
The March 23, 2018 edition of Grant’s featured a skeptical analysis of Pemex, which was founded in 1938 with the seized assets of foreign oil companies. The bear case rests on the fact that Pemex is a debt-heavy ($103 billion in net borrowings, and a leverage ratio of nearly eight times debt to EBITDA when factoring in pension liabilities) and chronically money-losing enterprise (net income and free cash flow have both remained in the red since 2013) beset by chronic production declines.
The triple-B-plus-rated oil behemoth managed to place senior unsecured 2027 dollar bonds at a 6.5% coupon in February, an issue that traded well above par as recently as July. It’s been a different story since, with those bonds last fetching just under 94 cents on the dollar, for a yield-to-worst of 7.52%. Pemex five-year credit default swaps have likewise jumped to 333 basis points from 185 in March, while the price of Mexican sovereign credit protection has also risen, to 148 basis points from 116 at publication time.
In July, AMLO tapped Octavio Romero Oropeza, a long-time political ally with no energy experience, to lead Pemex as general manager. The company’s creditors are getting a little nervous. We suspect they will become more than a little nervous.
Recap Dec. 7
Stocks were clubbed again, with the S&P 500 wrapping up the short week nursing a near-5% loss to sink back toward the low end of its fall trading range, while the small-cap Russell 2000 broke to its lowest since September 2017, down 3% year-to-date. Treasury yields darted lower across the short end and belly, while the long bond underperformed to push the 5- and 30-year spread toward the upper end of its 2018 range, and commodities were well bid as an OPEC production cut agreement helped WTI crude rise to $52.50 a barrel while gold finished at $1,248 an ounce, just above its five-year average.
This morning’s release of November non-farm payrolls featured a 3.1% year-over-year rise in average hourly earnings, matching last month’s for the strongest reading in the series since 2009.
- Philip Grant
Thursday, December 6, 2018
Board games
This bellwether got rung. Yesterday, industrial packaging producer Greif, Inc. reported fiscal fourth quarter results that fell short of estimates, with net sales of $988 million and adjusted EPS of $1.08 trailing the Street’s consensus expectation of $1.02 billion and $1.19, respectively. That sent shares lower by 10% as investors were clearly in no mood for disappointment. CEO Peter Watson tried to put a happy face on the results, while acknowledging problems on both the cost and the demand sides of the equation:
Greif delivered a strong financial performance in fiscal 2018, despite being impacted by significant cost inflation in most areas of the business . . . at the end of fiscal 2018 we began to see signs of market softness in discrete areas of our global portfolio.
On this morning’s conference call, Watson expanded a bit on the geographic demand dispersion. While North America “is experiencing very healthy volumes,” it’s a different story elsewhere, with the CEO noting “soft” demand in China and Western Europe. Mother Nature apparently played a role in the latter development, as the company cited the “continued impact of weaker European conical drum demand due to weather.” That marks the 5th straight quarter in which GEF cited weather-related issues in its review of operations (see the Aug. 30 edition of Almost Daily Grant’s for a rundown of Greif’s prior meteorology mishaps).
Weather excuses aside, investors of all stripes should be paying attention, as the Sept. 22, 2017 edition of Grant’s termed Greif “a kind of one-company Purchasing Managers Index.” The rationale for that designation:
There’s not much technology in a 55-gallon steel drum, not much intellectual property in the soft-sided luggage called an aggregates bag. So, as industrial production goes, so goes Greif. It’s the very stock not to own, and the very dividend yield on which not to depend, on the eve of a recession.
Beyond acute cyclical exposure and a fancy valuation (29 times trailing GAAP earnings at publication time, an important distinction as 19.6% of cumulative pretax income since 2003 had taken the form of “one-time” restructuring charges), a few other factors colored Grant’s bearish assessment of Greif.
One potential stumbling block: The company had seemingly been underinvesting in its business, as GEF spent $103.5 million in capital expenditures over the prior 12 quarters, well below the $121.3 million in depreciation and amortization expense. Sure enough, CFO Lawrence Hilsheimer noted a reversal during today’s earnings call:
Compared with the prior year quarter, fourth quarter free cash flow was lower by $19 million, partially due to our conscious decision to increase our CapEx spend. . . Relative to the guidance we published at our third quarter call, fourth quarter free cash flow was impacted by higher than anticipated CapEx, cash taxes and cash restructuring.
Higher capital expenditures weren’t the only factor hindering GEF’s cash generation. Asked about a $24 million dollar hit to working capital as a result of unfavorable foreign exchange moves, Hilsheimer explained:
Currency rates have been really volatile. And when we did our guidance for cash flow for the fourth quarter, we went through our processes. And so when we saw the end results of our cash flow, I asked the team to really do a deep dive into every factor because it just did not make any sense to me.
What ultimately we found out was that the currency impacts on working capital when you get down to an account by account level of the various elements of it and some other current accounts end up being a $24 million hit in the fourth quarter. So the drag that was something that had nothing to do with mismanagement, it had everything to do just with the currency impacts to our working capital.
Then there are the so-called headline risks. In 2017, the Milwaukee Journal Sentinel published a series of stories exposing illegal dumping by GEF subsidiary Container Life Cycle Management that potentially jeopardized the health of workers, local residents and safety inspectors. Indeed, two examiners from the Environmental Protection Agency were sickened during the subsequent investigation of a CLCM facility. In January, the Journal Sentinel reported that the EPA is prepared to sue Greif if settlement negotiations break down.
Months passed, too quietly for some. In early August, Senator Tammy Baldwin of Wisconsin sent a letter to acting EPA secretary Andrew Wheeler asking for an update, stating: “I am deeply concerned the EPA has not taken swift, substantial action to protect residents by addressing the company's negligence."
Five weeks later the EPA replied to Baldwin, noting that while a soil sample at the St. Francis facility indicated no “immediate threat to human health . . . the three CLCM facilities in, and around Milwaukee, Wisconsin are already the subject of notices of violation issued by the EPA in November 2017” and that the investigation was proceeding apace, while declining to comment further. Since publication last September, GEF shares are down by 23%, lagging the 8% gain in the S&P 500 over that period.
QT progress report
The Fed’s portfolio of securities held outright fell to $3.896 trillion this week, down $12.5 billion from last week’s reading and $31.5 billion below the trailing four-week average. Treasurys accounted for this drop after mortgage-backed securities ran off the balance sheet last week.
Since the Oct. 1, 2017 commencement of QT, total assets on the Fed’s total balance sheet are down by 8.3%.
Recap Dec. 6
Stocks staged a feverish late rally, all but erasing a near-3% intraday decline on the S&P 500 after The Wall Street Journal reported that the Federal Reserve is having second thoughts about hiking the Funds rate at the Dec. 19 meeting (Fed Fund Futures now price a 69% chance of a rate increase according to Bloomberg, down from 78% on Nov. 30).
Treasury yields finished lower across the curve but well off their best levels of the day, as the 10-year yield jumped 5 basis points in the afternoon to finish around 2.88%. The CRB Commodity Index lost more than 1% despite a weaker dollar, but gold managed to inch into the green, finishing at $1,238 per ounce.
- Philip Grant
Wednesday, December 5, 2018
Schumpeter-ism, with Chinese characteristics
Creative destruction, by government fiat.
Creative destruction, by government fiat.
Franchise player
The beef wars are raging.
The beef wars are raging.
Schumpeter-ism, with Chinese characteristics
Creative destruction, by government fiat. From Caixin Global:
China wants to kill off — or possibly revive — its lurching horde of “zombie” companies by 2020.
The central government has given local governments and state-owned asset management departments three months to submit a list of money-losing companies and has required that they be restructured or disposed of by the deadline.
The deadline shows that the issue of China’s immense corporate debt, especially at state-owned enterprises (SOEs), remains on the government’s agenda. According to the latest Ministry of Finance data, China’s SOEs had 113.9 trillion yuan ($16.5 trillion) in total debt as of the end of October, up 7.7% for the year.
Franchise player
The beef wars are raging. Yesterday, CNBC reported that Burger King has debuted a promotion of once-cent Whoppers through Dec. 12, when ordered through the company app in close proximity (within 600 feet) of rival McDonald’s Corp. (MCD on the NYSE) restaurant locations. The app will then lead McDonald’s customers-turned-deserters to the nearest Burger King to claim their penny-prize.
Such aggressive promotions are one indication of a tough operating environment in fast food. Inflation in wages and commodities is another. Bloomberg reported yesterday that rising prices have narrowed the discount on fast-food hamburgers compared to more upscale concepts like Shake Shack, Inc. to 8% this year from nearly 30% in 2012, as restaurants struggle to adapt to higher labor costs while maintaining their competitive position.
During the October earnings call, McDonald’s CEO Steve Easterbrook described the environment in zero-sum terms: “I think it’s a market share fight. I don’t see many people, many out there in our sector, who are actually growing traffic at all.”
Indeed, the restaurant industry as a whole grew same-store sales by 0.8% year-over-year in October according to industry research firm TDn2K, down from 1.2% in September and 1.8% in August and well below the most recent readings of CPI inflation (2.5% year-over-year in October) or nominal GDP growth (5.5% year-over-year in the third quarter). As top-line growth has floundered, strains between asset-light franchisors and capital-intensive franchisees have intensified.
Yesterday, the National Jack in the Box Franchisee Association filed a lawsuit against its corporate parent in Los Angeles Superior Court, alleging breach of contract and seeking an audit of the company-managed marketing fund, including a “full accounting” of the fund’s activity since 2016. That follows last week’s incorporation by MCD franchisees of their own National Owners Association, a notable development considering McDonald's is the largest, most profitable and arguably best-run fast food company in the world.
Then there’s Restaurant Brands International, Inc. (QSR on the NYSE), parent company of the Burger King, Popeye’s Louisiana Kitchen and Tim Hortons brands and Grant’s pick-to-not-click on June 2, 2017, which has been locked in a contentious dispute with Tim Hortons’ franchisee group the Great White North Franchise Association.
Back in September, Restaurant Brands seized the four Tim Hortons locations owned by David Hughes, president of the GWNFA, commenting that the “franchisee agreement clearly states it is not allowable for any restaurant owner to share confidential company information with the media; disparage the company or the Tim Hortons brand in the media or with community partners and vendors; or ultimately harm the Tim Hortons brand in any way.” For his part, Hughes accused the company of retaliating against him for “shin[ing] a light on many practices and policies that are detrimental to the individual franchisees and the chain as a whole.”
Unsurprisingly, economic difficulties are driving the widening rift between the companies and store operators, with Allan Hickok of the Boston Consulting Group explaining to Restaurant Finance Monitor: “I think we’re going to have a come-to-Jesus moment about exactly what bang for the buck franchisees are getting, especially in asset-light systems.”
John Hamburger, founder and president of the Franchise Times, predicted a similar outcome to attendees of the Grant’s spring 2018 Conference back in April:
On one side you have a franchisor with no capital expenditures and no day-to-day street-level exposure collecting royalties and rents by the bushel basket, trading at double-digit multiples, all the while levering up to pump out cash out to shareholders like there’s no tomorrow. On the other side, [you have] a franchisee, one that’s actually in the trenches running these restaurants and finding out it’s not a very friendly operating environment right now.
I’m here to tell you this Shangri-La doesn’t go on forever. You can’t have one side of the franchise contract getting fabulously rich while the other side faces these headwinds alone. The concept of a moat around the franchisor is a myth. That somehow a brand can separate itself from the unit-level economics of its franchisees is not grounded in reality.
In my view, it can only mean one thing, and that’s a lid on value for asset-light franchisors, especially the ones not growing. The fact that rates are rising may force a multiple compression sooner rather than later.
U.S. markets were closed today in observance of the memorial service for President George H.W. Bush.
- Philip Grant
Tuesday, December 4, 2018
So much for the honeymoon
From Reuters:
From Reuters:
Curve sketching
Big doings in the government bond market.
Big doings in the government bond market.
Recap Dec. 4
So much for the honeymoon
From Reuters:
Brazil’s Supreme Court said on Tuesday it had authorized a federal investigation into allegations that the incoming chief of staff for far-right President-elect Jair Bolsonaro had taken illegal campaign donations.
The investigation is the second graft allegation made against a top member of Bolsonaro’s incoming government, a thorny issues as the leader was elected on a law-and-order platform a vow to end widespread political corruption exposed by the sprawling “Car Wash” investigation and other probes.
Bolsonaro’s presidential inauguration is scheduled for Jan. 1, 2019.
Curve sketching
Big doings in the government bond market. Today, the spread between the 2- and 10-year Treasury yields briefly fell below 10 basis points, the narrowest since 2007. That follows the first partial inversion of the Treasury curve since that same pre-crisis era yesterday, as the 2- and 3-year yields both topped the five year. While the long end has contributed to the latest round of curve compression, the 2.92% 10-year still sits higher by almost 50 basis points year-to-date. Instead, a sharp leg higher in short maturity yields has accomplished most of the heavy lifting.
ZIRP no more. Three month Treasury bill yield. Source: The Bloomberg
What gives? By most metrics, the economy seems to be humming along just fine. GDP grew by an annualized 3.5% in the third quarter and has averaged a 3.1% real growth clip over the last four quarters, while the November Manufacturing PMI printed at a brisk 59.3, the 23rd consecutive monthly reading north of 55 (a reading above 50 denotes expansion).
Although just a partial inversion thus far, the rise in short rates above those of longer maturity is a significant development: Each of the past seven recessions have been preceded by a fully (meaning the three-month yield outpaces the 10-year for 10 consecutive days) upside down yield curve, with an average lag time of 311 days, according to Jim Bianco, founder and eponym of Bianco Research.
But as the current inversion is just a partial one, recent history implies we can expect the real McCoy soon enough. Bianco notes that going back to 1970, each time the 2-year vs 5-year curve inverted, the 3-month vs 10-year differential (which Bianco dubs “the economist curve” due to its frequent use in academic studies) soon followed suit, concluding: “It may take a while, but once one curve inverts, they eventually all invert.”
Bianco has a theory about what’s driving the flip: An aggressive Fed tightening cycle contrasting with an uncertain inflation outlook:
Assuming inflation actually returns, all is well. The Fed is correctly leaning against the markets. However, this is not always the case. . . By our count, the Fed has engaged in nine rate hike campaigns. Since 1980, inflation has been in a downtrend. PCE has rarely exceeded 2% since 1997. Each time it has, the Fed aggressively hikes, the curve inverts and a recession ensues about a year later.
The move in the curve has got the attention of at least some in the Fed, as Dallas Federal Reserve president Robert Kaplan said in a Texas speech Monday that the prospect of curve inversion “tells me that it’s wise to be patient here,” seemingly hinting at a more dovish tilt from the non-voting member (he regains his vote in 2020).
Kaplan’s concerns have yet to be priced into the market, however. Interest rate futures currently assign 79% odds of a rate hike of a 25 basis points or more at the Dec. 19 meeting, up slightly from a 75% probability a month ago.
At the same time, there is no allowance for surprise: As far out as December 2019, futures currently assign 0.0% odds of a rate cut. We’d be so bold as to suggest that figure should be a little bit higher.
Recap Dec. 4
The recent rally ended in abrupt fashion, as stocks were splattered to the tune of a 3.2% drop in the S&P 500, with the industrials and financials groups each losing more than 4% while the NYSE FANG+ Index sank by 3.9%. Treasurys were bid across the curve with the yield on the 30-year long bond sinking nearly 9 basis points to 3.17%, its lowest since mid-September, while the VIX enjoyed a mid-day surge to close back above the 20 mark.
One relative bright spot was in commodities, as energy prices managed a flat finish with WTI crude settling just under $52 a barrel. Gold enjoyed another solid bid, closing at $1,238 an ounce, its best level since mid-July.
Both the stock market and the bond market are closed tomorrow in observance of the national day of mourning for President George H. W. Bush.
- Philip Grant
Monday, December 3, 2018
The end of the beginning
The training wheels are coming off. Next week, the European Central Bank will conduct its final meeting of 2018, and is widely expected to announce the cessation of its QE asset purchase program. The ECB began buying sovereign bonds in 2015 and added corporate debt to the mix a year later. ECB president Mario Draghi, who piloted the program, will soon be riding off into the sunset, as his term ends on Oct. 31, 2019.
As the ECB’s balance sheet has grown to €4.65 trillion, up 117% since early 2015 to equal 30% of full-year 2017 European GDP (the Fed’s balance sheet represents 21% of 2017 U.S. output by comparison), both sovereign and corporate credit spreads collapsed as investors basked in the warm glow of a non-economic buyer of first, middle and last resort.
The European Central Bank asset purchase program, visualized (sovereign bonds in blue, corporate in yellow, asset-backed securities in green and covered bonds in red). Source: ECB website
At the sovereign level, there is ample evidence that Super Mario’s exertions have thus far produced their desired effect. For instance, five-year Portuguese credit default swaps are quoted at 94 basis points and trade at an 80 basis point-premium to triple-A-rated Germany; that compares to 362 basis points and a 335 basis point spread over German CDS in early 2016. Triple-B-minus rated Portugal’s 10-year yield stands at 1.8%, down from north of 4% in early 2016.
But thanks in large part to the recent risk spasm, the pancake-like corporate spreads stemming from the ECB’s benevolent stewardship have widened. As Bloomberg notes this morning, the Bloomberg Barclays European Investment Grade Corporate spread has widened to nearly 150 basis points, up from just 73 basis points earlier this year to return to its levels seen at the commencement of corporate-bond purchases in early 2016.
The selloff in corporate bonds has erased what was one of the most noteworthy securities prices of the modern era. The Dec. 15, 2017 edition of Grant’s shined a spotlight on double-B-plus-rated Telecom Italia S.p.A., which last year achieved the seemingly impossible as its 3.25 notes of 2023 rose above 111 cents on the euro, sending the yield to a double-take inducing 0.95%. As that TI note carries not only the credit risk inherent in a sub-investment grade rating but also offered a virtually zero real yield when accounting for inflation (Italian CPI rose 0.9% year-over-year in December 2017), Grant’s termed the sub-1% yielding TI issue a kind of “inverse museum piece,” referencing the description for particularly attractive fixed income securities that have been rendered cyclically defunct.
Sure enough, the recent re-rating of corporate credit has put an end to that anomaly (or abomination), as the 3.25s of 2023 have declined to 101.5 cents on the euro, for a yield-to-worst of 2.78% and 320 basis point spread over the benchmark. In mid-November, the company fired CEO Amos Genish, the third time that TI has changed its top executive in the past two years.
What sort of unintended consequences might stem from Draghi’s monetary adventures? The March 25, 2016 edition of Grant’s featured commentary from a publicity-shy London correspondent, who had some observations and some questions about the ECB’s mission to lower borrowing costs to bottom-scraping levels:
While Draghi’s latest trick may be notched up as another success by the technocrats of Brussels and Frankfurt, one wonders if Mario should be quite so eager to please the markets. After all, at some point this debt will need to be refinanced.
Will the ECB still be expanding its balance sheet in 2020, to help peripheral issuers fund at near the same interest cost as their German counterparts? And if so, will the same accommodation be tendered for the next maturity and for the one after that? Even the universe, we are told, cannot expand forever.
The ECB may give it a go, to judge from past communiques. Shortly after the commencement of QE, ECB governing council member Vitas Vasiliauskas displayed no lack of confidence in the abilities of his fellow central bankers. In a May 2016 interview with Bloomberg, Vasiliauskas remarked:
People say the ECB is done, their box is empty. But we are magic people. Each time we take something and give it to the markets – a rabbit out of the hat.
Recap Dec. 3
Stocks ripped higher once again following a seemingly-successful round of U.S./China trade discussions over the weekend, as the S&P 500 rode a 1% rally to close within 5% of its September highs while the NYSE FANG+ Index jumped nearly 3% to narrow its post-June losses to less than 16%. Commodities were also well bid, with WTI crude ripping above $53 a barrel for its best single-day showing since June while gold gained nearly 1% to settle at $1,230 an ounce.
While the equity and commodity markets partied, the Treasury curve continues to flatten as the 2- and 5-year yields have virtually converged at 2.83% (they briefly inverted during the today’s session), while the 2- and 10-year spread cratered by 5 basis points to just 15, the narrowest since 2007.
- Philip Grant
Friday, November 30, 2018
Mobile command
Will Uncle Sam sign off on the proposed merger between T Mobile U.S., Inc. and Sprint Corporation,
Will Uncle Sam sign off on the proposed merger between T Mobile U.S., Inc. and Sprint Corporation,
Game of Monopoly
“There are now more indexes than stocks,” blared a May 2017 Bloomberg headline.
“There are now more indexes than stocks,” blared a May 2017 Bloomberg headline.
Recap Nov. 30
Mobile command
Will Uncle Sam sign off on the proposed merger between T Mobile U.S., Inc. and Sprint Corporation, the nation’s third- and fourth-largest wireless operators?
On Wednesday, an association of 14 organizations including the American Antitrust Institute, Common Cause, Consumer Reports and the Rural Wireless Association sent a letter to incoming House Judiciary and Energy & Commerce ranking members Jerry Nadler and Frank Pallone to express concerns and urge new hearings on the pending deal. The consortium asks the congressmen to ensure “stronger antitrust enforcement, protecting consumers, promoting competition, and standing up for American workers.”
Meanwhile, the Capitol Forum reported on Nov. 15 that the Department of Justice has been investigating allegations that T Mobile was “retaliating against regional carriers critical of the company’s proposed acquisition of Sprint. . . [by refusing] to discuss roaming and other agreements that would allow the carriers’ mostly rural customers to use the T-Mobile wireless network when they travel, the sources said.”
For more on Sprint and its majority owner, SoftBank Group Corp., see the freshly-published Nov. 30 edition of Grant’s.
Game of Monopoly
“There are now more indexes than stocks,” blared a May 2017 Bloomberg headline. Yesterday, John C. Bogle, Wall Street legend and founder of passive investing mainstay the Vanguard Group, blew the whistle on his wildly-successful creation. Bogle penned an opinion piece in The Wall Street Journal calling attention to the rapid growth of the passive investment industry, one he pioneered by introducing the Vanguard 500 Index Fund in 1976.
As Bogle recounts, that initial offering was an epic flop, as the targeted $250 million initial public offering instead raised $11.3 million, “falling a mere 95% short of its goal.” Forty-two years and a couple investment cycles later, and it’s a different story indeed: The Vanguard 500 Index has seen assets under management swell to $431.5 billion as of Oct. 31, while the low-cost investment “exposure” offered by passive and general underperformance of active management strategies have helped foster an industry sea change. The Vanguard founder explains:
Equity index fund assets now total some $4.6 trillion, while total index fund assets have surpassed $6 trillion. Of this total, about 70% is invested in broad market index funds modeled on the original Vanguard fund.
Yes, U.S. index mutual funds have grown to huge size, with their holdings doubling from 4.5% of total U.S. stock market value in 2002 to 9% in 2009, and then almost doubling again to more than 17% in 2018.
If historical trends continue, a handful of giant institutional investors will one day hold voting control of virtually every large U.S. corporation. Public policy cannot ignore this growing dominance, and [must] consider its impact on the financial markets, corporate governance, and regulation. These will be major issues in the coming era.
Bogle’s warning is perhaps the starkest yet, considering his unique role in ushering in the modern era of indexation.The question before the house: Is a change in government policy needed to curtail the passive behemoth, or might investors unwind the logjam themselves? Kevin Duffy, principal at Bearing Asset Management, is of the latter belief. Duffy tells Grant’s:
After 10 years of everything going in the same direction, extrapolation is the order of the day. But market forces work to prevent trees from growing to the sky.
While passive investing has a cost advantage over active investing, the indexation movement is still subject to the general laws and flaws of the investment business. Perhaps most importantly: its customers tend to act in herds and make poor decisions at major turning points. Some 257 ETFs own Apple, more than any other stock. Passive investors have heavy exposure to the winners, notably large cap technology.
At the beginning of the bull market, the FAANG companies spent $6 billion on annual R&D. Today that figure is $94 billion, or 20% of all private R&D spending. These companies have mostly picked the low hanging fruit, have their fortunes tied more to the economy (increasingly, they are the economy) and are competitively bumping into each other. These stocks went from 3% of the S&P 500 to 12% at their peak a couple of months ago, a significant driver of outperformance. After AMZN and AAPL reached $1 trillion valuations, how can these stocks not underperform over the next decade? That is what will likely derail the passive bubble: its own success.
Just as faith in market forces is lost, those forces seem to come out of nowhere and exert themselves. It wasn’t long ago that the antitrust police thought Microsoft would rule the world. . . yet Google came out of nowhere. Similarly, people wired for intervention feared Japan Inc. during the late 1980s (Donald Trump being one of them, see the March 1990 Playboy interview) and felt that drastic measures should be taken. No surprise then, that Japan has been replaced by the new economic bogeyman, China.
Recap Nov. 30
Stocks rose again, capping a terrific week for the bulls as the S&P 500 jumped nearly 5% to reach the midpoint of its fall trading range. Treasury yields dropped again, with the 10-year closing just above 3%, while a rally toward fresh 52-week highs in the Dollar Index helped push WTI crude back below $51 a barrel.
- Philip Grant
Thursday, November 29, 2018
Just a billion
From the South China Morning Post:
From the South China Morning Post:
Plumber's crack
QT Progress report
Recap Nov. 29
Just a billion
From the South China Morning Post:
The founder of Shenzhen-based Gionee, a Chinese smartphone brand on the verge of bankruptcy, has admitted he may have used company assets to gamble at a Hong Kong-listed casino in Saipan, but denied a reported loss of 10 billion yuan ($1.4 billion), saying it was only a fraction of this amount.
“I did participate in gambling in Saipan, but how could I possibly lose that much? If it is true, shares of Imperial Pacific [the casino owner] should have surged,” Liu Lirong, Gionee’s chairman and chief executive, said in an interview with Securities Times in Hong Kong at the weekend, responding to recent reports that his gambling loss of 10 billion yuan had resulted in the collapse of Gionee.
When asked how much he lost gambling, Liu told the Securities Times reporter, “a bit more than 1 billion yuan.”
Who makes dumb phones?
Plumber's crack
A strong bounce in the bond market. Since logging an interim high of 3.23% on Nov. 8, the 10-year Treasury yield has declined in 12 of the past 14 sessions, ticking below 3% today for the first time since mid-September. Dovish language from the Fed chairman Jerome Powell hinting that interest rate hikes could wrap up sooner than later catalyzed the latest move in rates.
But while the benchmark Treasury yield flutters lower, interbank borrowing costs continue to jam higher. Three-month Libor jumped by more than 3 basis points this morning, the second-largest move of the year, to 2.738%. That’s up from 1.7% at year-end and 0.7% in summer 2016, when the 10-year yield made its cyclical low of 1.36%.
Cartoon From the April 20, 2018 edition of Grant’s
What’s driving the sharp increase in bank-to-bank lending rates? As noted by Alexandra Harris of Bloomberg, the Fed’s ongoing balance sheet runoff (see below) may be playing a role. Excess banking reserves footed to $1.66 trillion as of last week, well off the $2.67 trillion peak reached during the QE-era.
U.S. excess banking reserves. Source: The Bloomberg
The burden of tightening monetary conditions is not one equally shared, as foreign banks have accounted for about half of the drop in reserves. Non-domestic banks are using commercial paper borrowings to help fill the dollar funding gap. Foreign financial commercial paper outstanding currently stands at $308 billion, just off the record $314 billion seen at the end of October and well above the five-year average of $256 billion.
Bloomberg’s Harris concludes: “Should overseas banks continue to bear the brunt of the decline in reserves, they will have to seek out alternative sources for short-term financing.”
One bank is certainly paying up for funds. Today, Italy’s UniCredit S.p.A. sold $3 billion in five year senior non-preferred dollar bonds, with Robert Smith of the Financial Times reporting that Pimco LLC bought the entire offering at a yield of 7.83%. That’s a 493 basis point premium over Treasurys and 420 basis points over the so-called mid-swap benchmark reference rate.
In January, triple-B-minus rated UniCredit issued €1.5 billion in euro-denominated five year notes at a 1% coupon and just 70 basis points over mid-swaps. Those 1% notes, issued at just under par, have since declined to 91 cents on the euro for a yield-to-worst of 3.27%, dealing investors a quick 8% (€120 million) unrealized loss after factoring in accrued interest.
While UniCredit faces its own particular problems, including an outsize portfolio of non-performing loans (a sale of dubious debt to Pimco and Fortress earlier this year took its NPLs below 20% of total loan book according to the bank), and the sharp recent rise in Italian sovereign yields, other European banks should pay heed.
For his part, UniCredit CEO Jean Pierre Mustier struck a victorious tone, telling the Financial Times: “We wanted to show we had access to the market in large size. And by doing such a large transaction with a single investor, it also conserves the capacity for new transactions.”
New transactions at what price?
QT Progress report
The Fed’s portfolio of securities held outright dropped by $8 billion this week to $3.91 trillion, following a $26 billion decline during the holiday-shortened prior week, as Treasurys and mortgage-backed securities each comprised about half of the aggregate $34 billion decline over the past two weeks.
Since QT got underway on Oct. 1, 2017, total assets on the Fed’s balance sheet have declined by 8.1%.
Recap Nov. 29
Stocks drifted sideways, with the S&P 500 maintaining a 4% gain for the week that has narrowed the recent drawdown to 6.5% off the broad index’s Sept. 20 highs. Treasury yields were bid across the curve, with the 10-year outperforming as the two- and 10-year spread narrowed 21.5 basis points, less than three basis points from the flattest of the post-crisis era in August.
Commodities caught a modest bid while the Dollar Index finished unchanged, and the VIX held near 19.
- Philip Grant
Tuesday, November 27, 2018
Door busters
It’s a buyers’ market in the Big Apple. A reader alerts Grant’s to a broker email:
I have 32 apartments left to sell at 550 Vanderbilt. On this Sunday (December 2nd) we will have a 1-day, 20% OFF SALE from 11am – 4pm.
We will be doing previews by appointment only from Wednesday – Friday.
Big River
Power up. On Nov. 16, the Republic of Tajikistan debuted its prize $3.9 billion Rogun hydroelectric power plant on the Vakhsh River in the southern end of the country, as the first of six turbines went online. Upon completion at the dam’s projected 335 meter height, it will become the world’s tallest. Agence France-Presse reports that the fully-functioning power plant will double Tajikistan’s energy output, “alleviating a long-lasting, debilitating national energy deficit.”
The dam may be partially up and running, but the tiny central Asian nation (2017 GDP per capita: $801, per the World Bank) faces an uphill climb toward realizing its goals. Construction on the Rogun dam initially began in Soviet-era 1976 before being abandoned. Rogun is also being built “in a highly seismic area, and several geologic studies have warned about the risks of building such a large dam in this setting,” Dr. Filippo Menga, lecturer in human geography at the U.K’s University of Reading, told the AFP.
It’s not just the geography that’s potentially unstable. In December 2016, the Tajik government was obliged to borrow $490 million (more than 20% of that year’s state budget according to Reuters) from the local central bank to bail out the country’s four largest banks, which had seen bad loans balloon to 58.7% of their total book as of Sept. 30, 2016. Three months later, EurasiaNet, citing Tajikistan’s Radio Ozodi, reported that local prosecutors were investigating lending practices at the institutions, with an unnamed source explaining that “some banks have been known to accept doors, windows, cows and other livestock as collateral for credit, immaterial of whether the customer was ever likely to be able to repay the debt.”
Production and financial red flags aside, intrepid investors were all too eager to fund the ambitious project. Last September, single-B-minus (“adverse business, financial, or economic conditions will likely impair the obligor's capacity or willingness to meet its financial commitments on the obligation”) rated Tajikistan sold $500 million in senior unsecured 10-year dollar bonds, at a yield of 7.125% and 506 basis point spread over Treasurys. That yield was down from an initial projection of 8%, as a $4 billion order book left the deal oversubscribed by eight times, according to the Financial Times.
Just over one year later, those bonds have declined in price to 88 cents on the dollar, for a par yield of 9.36% while the spread over Treasurys has widened to 639 basis points.
Tajikistan is not the only recently issued speculative-grade sovereign bond to suffer swift unrealized losses. The single-B-rated Republic of Ghana’s 8.63% senior unsecured dollar bonds of 2049, sold in May at a 550 basis point spread over Treasurys, last changed hands at under 85 cents on the dollar for a 10.25% yield-to-maturity and a 693 basis point spread. The single-B-plus rated Republic of Kenya issued senior unsecured 7.25% dollar bonds due in 2028 in February at a 434 basis point spread; that issue has retreated to 87 cents on the dollar, priced to yield 9.33% and a 637 basis point spread.
While frontier-market debt represents one kind of overt risk, a different sort of investment hazard lies closer to home. In September 2017, the double-A-plus-rated Republic of Austria sold 2.1% bonds maturing in 2117 at a 23 basis point premium over French soverigns due in 2066. Those century bonds have since been bid to 112 cents on the euro, now priced to yield 1.84% and a 2.4 basis point premium over the French issue maturing nearly 50 years earlier. Meanwhile, Austrian CPI rose by 2.2% year-over-year in October, bestowing upon bondholders a real yield of negative 36 basis points.
With 99 years left until maturity, Austria’s ultra-patient creditors are soon facing the loss of a price-insensitive ally: The European Central Bank is widely expected to announce a taper of its QE bond buying regime at its Dec. 13 meeting, with ECB president Mario Draghi again hinting as much during a speech in Brussels on Monday.
Recap Nov. 27
A relatively stable day for asset prices saw the S&P 500 reverse early losses to finish slightly in the green, extending yesterday’s bounce from the interim lows reached Friday. Treasury yields ticked slightly higher, while WTI crude managed to inch toward $52 a barrel despite strength in the greenback, as the Dollar Index approaches its 52-week high.
While stocks and bonds largely treaded water, interbank borrowing costs made another lurch higher as three-month LIBOR finished the day just under 2.71%; that’s up from 2.32% in September and 1.7% at year-end 2017.
- Philip Grant
Monday, November 26, 2018
China chalet
Two ships in the night. As investor attention turns toward the highly anticipated meeting between Donald Trump and Xi Jinping later this week at the G20 meeting in Argentina, a sea change in borrowing costs has taken place: For the first time since at least 2000, the yield on the one-year Treasury bill (2.58%) now exceeds its Chinese equivalent (2.5%). As recently as June, Chinese one-year sovereign debt out-yielded the U.S. by more than 100 basis points, at 3.37% compared to 2.32% stateside. In a research note last week, Bank of Montreal strategist Jon Hill wrote that the declining Chinese yields “should put further depreciation pressure on the renminbi, which would serve as a disinflation force domestically.”
Sovereign rates may be coming down in the Middle Kingdom, but that’s been no help to the encumbered property developers. Last Monday, Times China Holding Ltd. issued two-year dollar bonds at a 10.95% coupon; just 10 months ago, the same company was able to pay only 6.25% on three-year notes. Peer Agile Group Holdings Ltd. was obliged to pay a 9.5% coupon on two-year dollar denominated notes on Nov. 15, up from 8.5% for three-year paper issued in July. China Evergrande Group, featured in the June 2, 2017 edition of Grant’s, was forced to pay 11% for two-year dollar bonds last week. That compares to an 8.75% yield on eight-year bonds issued in June (those notes have fallen to 80.25 cents on the dollar for a yield-to-worst of 13.35%). Overall, Bloomberg highlights that the property developer-heavy ICE BAML Asian dollar China corporate Index now carries a near 12% yield, the highest since 2015.
The pain is not confined to the developers. Formerly acquisitive conglomerate HNA Group Co. Ltd., which went on a $40 billion corporate shopping spree between 2015 and 2017, has recently been forced to turn tail and sell assets in hopes of remaining solvent. Last Tuesday, FinanceAsia Daily made note of an instructive recent transaction:
One recent sale highlight’s HNA’s desperation. On Nov. 19, BrightSphere Investment Group, an asset management firm listed on the New York Stock Exchange, announced that Paulson & Co., a hedge fund controlled by U.S. investor John Paulson, had agreed to buy HNA’s 24.95% stake in the group.
BrightSphere said that the stake would be sold for around $371 million. Given that HNA paid $446 million for its stake in the asset management firm only 18 months ago, this equates to a loss of roughly $75 million for HNA.
In a possible swipe at the Chinese conglomerate, BrightSphere chairman James Ritchie said: “The transfer of shares to a respected institutional investor such as John Paulson will bring the clarity of ownership which is positive for all our constituencies.”
FinanceAsia Daily goes on to note that while HNA has managed to so-far trim its debt load by 10.7% in the six months ending in June, the company still sports a towering leverage ratio of more than 21 times total debt to EBITDA as of June 30.
With cash hard to come by, some of HNA’s subsidiaries are getting creative. On Nov. 14, Bloomberg reported that Qianhai Air & Shipping Exchange “is offering tickets from [fellow HNA units] Hainan Airlines or Grand China Air to repay what it owes. . . the flights can be for both domestic and international travel and are valid for five years.”
Recap Nov. 26
A strong bounce in stocks left the S&P 500 higher by 1.6% at day’s end, recouping a chunk of last week’s ugly 3.7% decline, while the NYSE FANG+ Index gained nearly 4% but still remains in bear market territory, 21% south of its June peak. The Dollar Index reversed early losses to finish in the green, but energy managed to catch a bid anyway with WTI crude ticking back to $51.50 a barrel.
Treasury yields finished higher across the board, with the 10-year settling at 3.06%. The VIX sank by more than 12% to finish below 19, its second-lowest close in more than two weeks.
- Philip Grant
Wednesday, November 21, 2018
Sturm und Drang
It’s no breaking news that Denmark’s largest financial institution, Danske Bank A/S, is mired in disrepute after being caught up in money laundering scandal involving some €200 billion flowing through its Estonian subsidiary. More topical is the allegation, levelled yesterday by whistleblower Howard Wilkinson in Danish Parliament, that Germany’s largest lender Deutsche Bank A.G. had served as correspondent for Danske Bank, helping to process as much as €150 billion in dubious payments.
On this side of the pond, Bloomberg reports today that Deutsche Bank’s efforts to mitigate risk and improve performance via the creation of a so-called central risk book for its positions have instead led to some $60 million in losses. Culprits for the misadventures include “issues with the CRB’s technology. . . the CRB may also have become too big to manage properly.”
Then, too, brisk management turnover continues apace at DB, with co-head of structured credit Armin Rothauser leaving the bank two weeks ago to “pursue other opportunities,” according to an internal staff memo cited by Bloomberg. Back in April, CEO John Cryan was dismissed “followed months of conflict on the management board and indecision on the supervisory board over whether to replace him,” per The Wall Street Journal. Chief operating officer Kim Hammonds departed soon after.
The drumbeat of dour news is taking a toll, as the New York-listed DB shares yesterday finished at an all-time low of $9.23 a share (they were listed in 2001). That’s down from $20 in December of last year and $45 in early 2014. European money center bank peers have likewise been weak, but not to the same extent; shares of Credit Suisse Group A.G., BNP Paribas S.A. and Barclays PLC are all hovering at or near their lowest levels since mid-2016.
But the alarming erosion in Deutsche Bank’s equity value has yet to make much of an impression on the rest of the A3/triple-B-plus rated bank’s capital structure. The senior unsecured 1.5% notes of 2022 last traded at just over 99 cents on the euro, while five-year DB credit default swaps currently fetch about 173 basis points, down from the interim highs of 184 basis points seen in July.
That relative resilience extends to the debt securities toward the bottom of the capital structure; i.e. junior unsecured contingent convertibles, or CoCo bonds. These regulator-approved securities (they are considered Tier 1, or “core” capital) glean their name from their convertibility to equity at the bank’s discretion, rather than investor's, as would be the case in a conventional convertible. The Bank for International Settlements describes the merits in a 2013 paper:
CoCos are hybrid capital securities that absorb losses in accordance with their contractual terms when the capital of the issuing bank falls below a certain level. Then debt is reduced and bank capitalization gets a boost. Owing to their capacity to absorb losses, CoCos have the potential to satisfy regulatory capital requirements.
The DB 6% perpetual CoCo bonds, issued in 2014, currently trade just under 90 cents on the euro for a yield-to-call of 9.59%. That’s not so far off their five-year average price of 94.3, slightly above the early July provisional lows and well north of the February 2016 nadir of 71.
DB 6% CoCos in white, vs. DB share price in orange. Source: The Bloomberg
Does the divergence between Deutsche Bank’s slumping equity value and still-presentable credit performance signify bullish opportunity, or ominous indicator of trouble ahead? Investors and regulators alike should bear in mind that the convertibility feature embedded in the CoCo bonds may serve as a source of something other than stability and market confidence, were they to be exercised. The July 11, 2014 edition of Grant’s noted that:
Conversions or write-downs, when they’re finally forced, won’t take place under wraps. The news will start a highly focused reassessment of the creditworthiness of the stricken CoCo issuer or issuers. Providers of short-dated liabilities – certificates of deposit, uninsured deposits, commercial paper – are likely to arrive at the same conclusion more or less simultaneously.
Deutsche Bank is currently leveraged at about 22 times equity capital as of Sept. 30, north of Credit Suisse’s 18 times but below BNP’s ratio of 24 times assets to capital. DB’s return on equity footed to negative 3% in the last quarter, by far the worst of those four major European banks. The derivatives book, with a notional value of €48.3 trillion according to the 2017 annual report, is four times last year’s Eurozone GDP of €12.6 trillion.
CoCo beware.
Tuesday, November 20, 2018
Tipping point
For the first time since 2008, high-yield and investment-grade Bloomberg Barclays benchmark indices priced in both euros and dollars are poised
For the first time since 2008, high-yield and investment-grade Bloomberg Barclays benchmark indices priced in both euros and dollars are poised
Recap Nov. 20
Tipping point
For the first time since 2008, high-yield and investment-grade Bloomberg Barclays benchmark indices priced in both euros and dollars are poised to finish the year in the red. Across the spectrum of securities, the balance of power seems to be shifting from sellers back to buyers, if a trio of recent developments are any indication.
Strange occurrences in the desert: Last night, The Wall Street Journal reported that Saudi Aramco has decided to shelve a proposed $40 billion corporate-bond offering that would have been utilized to fund a majority-stake purchase of Saudi Basic Industries Corp. Public outcry over the murder of U.S.-based journalist Jamal Khashoggi may have helped hinder demand, as may the precipitous recent oil price decline. But The Journal also notes that Aramco “is now worried about the level of disclosure required for a bond issue.”
Post Holdings, Inc. (POST on the Nasdaq) yesterday announced the offering of $400 million in convertible preferred shares, before cancelling the proposed deal later in the day. The company, chaired by capital allocation whiz Bill Stiritz, noted that management terminated the “entirely opportunistic” capital raise attempt after not finding the terms to its liking.
Post, a Grant’s pick-to-not-click in the Sept. 16, 2016 issue, has instead seen its share price flutter toward all-time highs despite missing earnings estimates in each of the last three quarters (Post shares are up 21% since publication, tracking the S&P 500s 23% advance). The bond market has been a bit more circumspect. Over the past two months, the senior unsecured 5s of 2026 have seen their spread over Treasurys widen to 384 basis points from 275, outpacing the 96 basis point spread widening in the iShares iBoxx High Yield ETF. Single-B-plus-rated Post currently carries net debt of 5.6 times consensus adjusted EBITDA for the fiscal year ending Sept. 30, 2019.
Then there’s Elon Musk’s vehicle to the cosmos. Yesterday, Space Exploration Technologies Corp., or SpaceX, downsized its proposed leveraged loan offering to $250 million from the initial target of $750 million, according to Bloomberg. Beyond the smaller size, pricing on the deal has firmed at 425 basis points above Libor, at the wide end of the 400-425 basis point price talk, while investors likewise managed to fortify loan covenants concerning “the definition of earnings,” according to Bloomberg. Earlier this month, Bank of America replaced Goldman Sachs, which served as lead underwriter for the IPO Musk’s Tesla, Inc. in 2010, as lead marketer for the deal.
This afternoon, The Washington Post reports that NASA will next year commence a review of SpaceX, “prompted by the recent behavior of SpaceX’s founder, Elon Musk, according to three officials with knowledge of the probe, after he took a hit of marijuana and sipped whiskey on a podcast streamed on the Internet.”
Issuers had the distinct upper hand not so long ago. In July, the French subsidiary of single-B-rated telecom conglomerate Altice Europe N.V. managed to upsize its eight-year term loan to $2.5 billion from $2 billion at a price of 400 basis points over Libor. The company’s interest expense footed to €2.5 billion ($2.2 billion) over the 12-months ended June 30, nearly double the €1.4 billion in operating income expected by the Street this year.
In November, the former Valeant Pharmaceuticals International, Inc. (now Bausch Health Companies, Inc.) upsized an eight-year senior note offering to $1.5 billion from $1 billion at 275 basis points over Libor. Use of proceeds for that bond deal was a tender offer for three separate issues maturing in 2020. At the time, credit analysts noted that “the company’s very high exposure to patent losses over the next two years” will render “its product pipeline insufficient to offset revenue and EBITDA declines in the next 12 to 18 months.”
And finally, Musk again. In August 2017, Tesla sold $1.8 billion (upsized from $1.5 billion) in eight-year senior notes at a 5.3% yield and 320 basis point spread over Treasurys. The newfound Tesla creditors were the beneficiaries of an unexpected five basis point premium from the indicated 5.25% yield, a change that Reuters reported “was a company decision to ‘sweeten the deal.’” Those notes have since fallen to 86.5 cents on the dollar, with the spread over Treasurys ballooning to 506 basis points and the yield-to-worst climbing to 7.93%.
Mr. Market has decided to further sweeten the deal.
Recap Nov. 20
Stocks fell sharply for a second day, with the S&P 500 extending its loss for the week to 3.4% to finish just under 10% below its Sept. 20 closing price.
It wasn’t tech this time as the primary culprit (the NYSE FANG+ Index kept pace with the broad market) but rather energy and retail, with another ugly leg lower to $53 a barrel in WTI crude and a rudely received earnings report from Target Corp., (TGT on the NYSE) supplying much of the damage. After an 11% decline today, Target shares are down more than 20% in just seven sessions, nearly erasing TGT’s year-to-date gains.
Elsewhere, Treasury yields generally finished little changed, although rising yields on the short end and declining yields on the long end left the curve notably flatter. Cryptos were pummeled again with bitcoin cash falling 32%, while that analogue crypto called gold fell slightly to finish near $1,222 an ounce as the dollar remains near a 52-week high. The VIX rose to 22.5, its highest close since Oct. 30.
- Philip Grant
Monday, November 19, 2018
Bailout brigade
Somebody will have to pay. California’s devastating wildfires have knocked the capital structure of utility PG&E Corp. (PCG on the NYSE) for a loop, as shares are down by 51% since Nov. 9, while the senior unsecured 6.05% bonds due 2034 have slumped to 94.5 cents on the dollar from 107.2 over that same period.
The company faces massive potential liability after reporting an outage near the location of the so-called Camp Fire, the deadliest in California history. On Friday afternoon, PCG filed an incident report disclosing the failure of a second transmission line on Nov. 8, the morning that the fire began. No definitive conclusions have been reached about the cause of the fire.
Nevertheless, analysts are sounding the alarm. Stephen Byrd at Morgan Stanley writes in a research note today that: “The key risk is that the regulator (and potentially the legislature) would seek greater asset coverage for wildfire-related damages extending beyond the value of the electric utility.” The ratings agencies are following suit. On Thursday evening, both Moody’s and S&P downgraded PCG’s credit ratings; Fitch did the same Friday.
Last week, the company drew down the entirety of its $3.3 billion bank revolving credit facility, an indication of financial distress, or of management’s determination to avoid it. PG&E credit default protection prices have gone parabolic:
PG&E Corp. five-year credit default swaps. Source: The Bloomberg
While the Golden State works to recover and PCG shareholders and creditors scramble to assess the damage, local regulators are primed to ride to the rescue. In an interview with the San Francisco Chronicle on Thursday evening, California Public Utilities Commission president Michael Picker implied that preserving the utility’s commercial well-being was a primary goal for the agency:
They need to be financially healthy to be able to provide those goods and services that ratepayers need. If they can’t borrow money, if they have liquidity problems and they can’t do vegetation management, that’s a problem. That’s not good policy, to really let them get financially unstable.
Recently passed legislation recognized the importance of financially healthy utilities to California’s electric customers, and implementing it quickly is important to achiev[ing] that goal.
In a follow-up interview with The Wall Street Journal, Picker reiterated his opinion, noting in paraphrased remarks that the regulator: “preferred that PG&E not enter into bankruptcy because it could raise its cost of borrowing, which could end up raising energy costs for its customers.”
That news was certainly welcomed by PG&E investors, as shares snapped higher by 37% on Friday. However, one prominent Silicon Valley venture capitalist takes issue with Picker’s logic, telling Grant’s:
They don't want energy costs for customers to rise, so the regulator is going to, do what exactly? Securitize claims against PG&E and pass them onto customers?
I guess if you give an implicit government underwriting, like with home loans, the cost of capital of PG&E will be lower. But if you do so by having liabilities fly past equity and debtholders and straight to either customers, or CA residents – effectively the same thing – is that really saving them money?
Open those wallets, Californians.
Recap Nov. 19
Stocks slumped to the tune of a 1.7% decline on the S&P 500, while tech was splattered with the NYSE FANG+ Index sinking 4.3% and Facebook, Inc. shares losing another 6% to reach a 52-week low, down 40% in less than four months. Crypto continued its descent, with bitcoin falling to $4,800, down from $6,400 just 10 days ago.
Elsewhere, Treasurys finished mostly stronger, with the 10-year yield easing to 3.06%, its lowest since early October. Commodities were able to buck the ugly market action as the CRB Index staged an intraday rebound with WTI crude and gold finishing at $57.50 a barrel and $1,223 per ounce, respectively. The VIX rose by 10%, closing just above the 20 mark.
- Philip Grant
Friday, November 16, 2018
Supply managment
Things are heating up a bit on the speculative end of the credit spectrum.
Things are heating up a bit on the speculative end of the credit spectrum.
Chip which
Crypto’s doppelganger indeed.
Crypto’s doppelganger indeed.
Supply managment
Things are heating up a bit on the speculative end of the credit spectrum. Over the past week, the BarCap U.S. Corporate High Yield 10-Year Spread has jumped to 403 basis points over Treasurys, up from 309 basis points on Oct. 3 and the widest spread since late 2016, although still well below the early 2016 interim wides of over 800 basis points.
Meanwhile, floating-rate leveraged loans have seen a similar downside probe, with the S&P/LSTA Leveraged Loan Price Index sinking to its own post-2016 low of 97.81, down from 98.7 on Oct. 6. Then again, the recent move is small potatoes compared to the late 2015/early 2016 shakeout, when the index plunged below 90.
Investors are positioning for more downside: As identified by David Sherman, founder and president of Cohanzick Management and paid-up Grant’s subscriber, short interest in the iShares iBoxx High Yield Corporate Bond ETF has surged recently to nearly 60% of the shares outstanding. That’s up from just over 30% this summer.
What gives? Sherman notes that while the HYG short is certainly crowded as a percentage of shares outstanding, the high frequency of trading in the ETF renders the short interest ratio (or the number of shares sold short divided by average daily volume) somewhat muted. That metric currently sits near four days to cover, well off its interim high of more than six earlier this year. On this matter, Sherman asks: “What if volume dries up? It’s going to increase volatility, and potentially drive a wider disparity between the underlying cash market and the ETF.” The portfolio manager concludes: “I have more questions than answers.”
As for the fundamental picture, Marty Fridson, chief investment officer at Lehmann, Livian, Fridson Advisors LLC notes a potential catalyst for short sellers: The concentration of credits just above junk-status that might be vulnerable to downgrade (see also the Oct. 20, 2017 edition of Grant’s). Fridson advises Grant’s by email:
The story for this cycle is the expansion of the BBB sector, with the notion that it will generate a massive wave of fallen angels that the high yield market won’t be able to absorb, driving high yield valuations much lower.
My take is that high yield bear markets are always ugly and it will be hard to tell, even after the fact, how much uglier it was this time around because of that big contingent of BBBs.
To that point, a recent report from Fitch Ratings identifies formerly triple-A, now triple-B-plus-rated General Electric as a candidate to substantially change the composition of the U.S. credit market. Fitch relays that GE’s massive debt burden represents about one-tenth of the entire $1.2 trillion junk market, were it to be downgraded.
Chip which
Crypto’s doppelganger indeed. Yesterday evening, chip maker and subject of a June 29 Grant’s bearish analysis Nvidia Corp. (NVDA on the Nasdaq) surprised the street with third quarter results featuring a top line of $3.18 billion and adjusted gross margins of 61%, both shy of the consensus $3.24 billion and 62.8% estimates. What’s more, the chip-maker projected fourth quarter revenues of just $2.7 billion, well below the $2.91 billion achieved last year and the $3.4 billion analyst consensus. Investors who had bid NVDA to an average 46 times price-to-earnings ratio over the last four quarters reacted with predictable scorn, sending shares lower by 17% intraday.
The earnings miss came despite management’s best efforts: While third quarter sales registered year-over-year growth of just over 20%, accounts receivable bulged by more than 90%.
Jen-Hsun Huang, founder and CEO of Nvidia, cited “excess channel inventory post the crypto-currency boom” as a primary culprit for the shocking miss. The numbers bear that out. Inventories footed to $1.41 billion for the quarter, up more than 65% year-over-year.
Notable too, is the shift in Huang’s storyline. On August 16, the CEO had this to say about the ebbing tide in bitcoin and its peers:
It is the case that we benefited in the last several quarters from an unusual lift from crypto. In the beginning of the year, we thought and we projected that crypto would be a larger contribution through the rest of the year, but at this time we consider it to be immaterial for the second half.
Yesterday, Huang was asked what changed and struck something of a different tone:
We were surprised, obviously. I mean, we're surprised by it as anybody else. The crypto hangover lasted longer than we expected. . . we didn't realize the magnitude of it until towards the end of the quarter.
Thursday, November 15, 2018
Delinquent youth
On Tuesday, Pennsylvania-based regional bank Customers Bancorp, Inc. (CUBI on the NYSE) announced it would restate
On Tuesday, Pennsylvania-based regional bank Customers Bancorp, Inc. (CUBI on the NYSE) announced it would restate
Bad dream
Crypto awoke with a start yesterday,
Crypto awoke with a start yesterday,
QT Progress report
Recap Nov. 14
Delinquent youth
On Tuesday, Pennsylvania-based regional bank Customers Bancorp, Inc. (CUBI on the NYSE) announced it would restate financial results for 2017 and the first half of this year. The problem stems from commercial mortgage loans that had been “incorrectly classified as held for sale instead of held for investing on the consolidated balance sheets,” according to the company’s SEC filing, resulting in a material weakness in internal controls.
Customers, a recipient of a Grant’s bearish analysis on Dec. 11, 2015 on account of rapid growth (total assets nearly tripled in the three-years ended Dec. 31 2015, to $8.4 billion) and accompanying underwriting quality concerns, has seen its fortunes turn. While total assets of $10.6 billion are little changed year-over-year, the stock now trades at 85% of book value, compared to nearly 160% at publication time.
CUBI’s misadventures aside, the credit environment appears solid. According to the Federal Reserve, credit card charge-off rates held at 3.65% in the second quarter (the most recently available data), up from 2.91% in the fourth quarter of 2015 but about in line with the seven-year average rate of 3.59%. Commercial and industrial loan portfolios have been nothing short of pristine, with a 0.27% charge-off rate in the second quarter sitting below the 0.40% seven-year average. In aggregate, a net 0.48% of all loans were written off in the second quarter, down from an average 0.69% over the past seven years, according to data from the FDIC.
Grant’s asked Christopher Whalen, publisher of the Institutional Risk Analyst and recent guest of the Current Yield podcast (advt.) about the outlook for U.S. banks. Whalen expects that high prices and rising borrowing costs will take a toll despite a relatively benign credit environment.
As rates rise, borrowers will be forced to roll over their debt and we should see some more distressed situations begin to emerge. Cash flows are stretched and asset prices are crazy, but underwriting is relatively solid. Lenders have no pricing power and are forced to compete on price, which will keep future returns muted.
Meanwhile, one month does not a trend make, but this afternoon Citigroup, Inc. reported that credit-card charge-offs jumped by nearly 10% sequentially in October, to 2.63% from 2.42%.
Bad dream
Crypto awoke with a start yesterday, as relatively stable price action in bitcoin since late October was replaced with a lurch lower in the largest digital currency, taking bitcoin below $5,500 for the first time this year on heavy trading volume. Bitcoin’s peers suffered similarly intense declines.
20-day chart of bitcoin. Source: The Bloomberg
What spurred the abrupt downdraft? Crypto news site Modern Consensus reports that the bulk of trading volume during the selloff took place on the Bitfinex exchange, and follows a Sunday announcement from Bitfinex of a 3% wire withdrawal fee for those cashing out more than twice over a 30-day period or for more than $1 million in aggregate withdrawals over the same 30 days. That’s up from a previous fee of zero, and no doubt aggravated many crypto HODLers.
On Nov. 9 Coindesk published an account detailing the difficulties that various crypto users have encountered in attempting to withdraw funds from Bitfinex:
“I am still waiting for my money – 17 business days after the event,” one customer, Jamie West, told CoinDesk Wednesday. “They even had the cheek to charge £309 for 24-hour express service,” he added.
One user, who asked to remain anonymous, shared screenshots of an email exchange with Bitfinex support, showing that they’d begun a withdrawal on Oct. 3. This user received a message from customer service, saying the money had been sent to a payment processor on Oct. 15.
Yet when asked if they’d received their money on Tuesday, the person told CoinDesk: “Not yet. Still waiting for a response.”
As for alternative explanations for the recent price decline, the quantity of bitcoin available to be mined is famously capped at 21 million. Yet the supply-constrained crypto keeps splitting in two, with bitcoin cash (itself the result of last year’s “fork,” or split, from the original bitcoin into a pair of crypto currencies) today breaking into a pair of new cryptos called bitcoin ABC (or “core bitcoin cash”) and bitcoin SV (for “Satoshi’s Vision”). That follows the Oct. 24, 2017 formation of bitcoin gold and the Feb. 28 debut of bitcoin private, both resulting from hard forks of their own.
QT Progress report
Virtually no change for a second straight week, as the Fed’s portfolio of securities held outright registered at $3.943 trillion, down $1.8 billion from a week ago. This week’s reading sits $15 billion below the trailing four-week average, and represents a 6.95% decline in the Fed’s total asset base since QT began on Oct. 1, 2017.
Recap Nov. 14
Stocks finished higher by 1% on the S&P 500 as rumors of potential progress on the U.S./China trade front continue to percolate. The NYSE FANG+ Index managed to slightly outperform despite a red showing from Facebook, Inc. following today’s New York Times report on the latest unsavory goings-on at the social network (FB is now 18% year-to-date).
Treasury yields ticked lower, with the 10-year dropping below 3.12% after reaching seven-year high of 3.24% a week ago, while another commodity selloff spared the oil patch this time, with WTI crude finishing green for a second straight day at $56.50 a barrel.
- Philip Grant
Tuesday, November 13, 2018
Venture land
Here comes the Son. Yesterday, SoftBank Group Corp. and its irrepressible CEO Masayoshi Son won regulatory approval to list its domestic telecom unit. The IPO, projected to raise about JPY 2.3 trillion ($21.1 billion), will approach Alibaba Group’s (BABA on the NYSE) 2014 global record of $25 billion. This would be par for the course for Son, who was an early, and thoroughly rewarded (on paper at least), BABA investor.
Alec Macfarlane of Breakingviews, who pencils in $23 billion in proceeds from the offering, notes that the projected valuation of nine times forward EBITDA would imply a premium over Japanese peers NTT Docomo, Inc., and KDDI Corp. (six and five times trailing EBITDA, respectively), which both enjoy significantly stronger domestic market share then SoftBank. At the same time, the mobile unit plans to dole out 85% of net profits to shareholder dividends, far higher than the 40% and 50% respective payouts offered by the less-leveraged competition.
Son has plans for the money. In September, the SoftBank boss told Bloomberg Businessweek that he intends to raise a new $100 billion fund to complement the existing $92 billion Vision Fund “every two or three years,” while spending $50 billion a year. That compares to a total $75.3 billion in venture capital industry spending in 2016, according to the National Venture Capital Association.
This is manna for Vision Fund portfolio company WeWork Cos., which has become the largest office space tenant not only in Manhattan (Almost Daily Grant’s, Oct. 10), but also the largest private occupant in Washington, D.C. and London, according to a company press release. Today, WeWork announced it has raised an additional $3 billion from SoftBank via a warrant that values the co-working company at a minimum of $42 billion, up from $20 billion in August of 2017. Artie Minson, president and COO of WeWork, said that getting additional funds from SoftBank is a relative snap: “They have two board seats. You can go through a very quick process with them given they’re inside seeing all the momentum we have.”
Momentum is the word. By comparison, publicly-traded commercial real estate services firm CBRE Group, Inc., which was founded in 1906 and generated $19.4 billion in revenue and $1.1 billion in adjusted net income over the 12-months ended Sept. 30, sports a market capitalization of $14.5 billion. Through the first three quarters of this year, WeWork reports a loss of $1.22 billion, on sales of $1.25 billion.
Gaudy valuations and grand plans aside, the jury is still out on both SoftBank and WeWork. The SoftBank euro-pay 3 1/8s of 2025 currently trade near 93.5 for a yield-to-worst of 4.27%, a pretty penny considering the negative interest rate policy contrived by the ECB’s Mario Draghi. WeWork’s 7 7/8s of 2025 likewise trade well below par, last printing just above 94 cents on the dollar for a yield to worst of 9.04%. Meanwhile, shares in Masa Son’s golden ticket, Alibaba, are going the wrong way, down by 30% since June. Recall that in April, SoftBank took out an $8 billion margin loan backed by its 28.8% stake in BABA.
For an in-depth analysis of the house that Son built, see the Dec. 15, 2017 edition of Grant’s.
Recap Nov. 13
No bounce today, as the S&P 500 gave back early gains to finish flat after yesterday’s tumble, while oil prices went into full-on liquidation mode with WTI sinking by nearly 8% to $55 a barrel, its biggest one-day drop since September 2015 and a record 12th-straight decline. On the bright side, the energy sector of the S&P held up relatively well, sinking by “just” 2.5%.
Elsewhere, Treasury yields jumped lower across the board following yesterday’s holiday, with the 10-year settling just under 3.15%, while high yield continues to struggle with the iShares iBoxx High Yield ETF falling for a 5th straight day to remain near its post 2016 election levels. The CRB Commodity Index finished nearly 2% in the red thanks to oil, while the Dollar Index also traded lower. The VIX held steady near 20.
- Philip Grant
Monday, November 12, 2018
Going south
Investors are learning the hard way to expect the unexpected in Mexico.
Investors are learning the hard way to expect the unexpected in Mexico.
Recap Nov. 12
Going south
Investors are learning the hard way to expect the unexpected in Mexico. Today, Mexican financials dropped by nearly 5% while the peso lost more than 1% against the greenback. The culprit: Senators of the Morena party advancing a proposal to cap various banking fees including ATM withdrawals. That follows the October decision by incoming president Andrés Manuel López Obrador, or AMLO, to scrap construction of a partially-completed airport near Mexico City after a referendum showed that citizens opposed the project (Almost Daily Grant’s, Oct. 29).
For his part, AMLO explained the state of play in a press conference following the airport cancellation, saying: “It’s evident from now on there is a clear division, a frontier between economic power and political power.”
Mexico’s fast-changing political environment may be throwing Wall Street for a loop, but the incoming government’s plans for state owned oil company Petróleos Mexicanos, or Pemex, may have the largest impact for investors. Recall that in August, The Wall Street Journal reported that AMLO plans to suspend oil auctions for at least two years, a stance seemingly consistent with the president-elect’s 2013 proclamation that: “Oil is the property of the nation. I am convinced that privatizing petroleum. . . betrays the country.”
The prospect of Mexico halting oil exports is a concerning one for the rating agencies, as Moody’s on Oct. 18 wrote that such a development would be “credit negative to both Pemex and to the government’s credit quality.” Fitch Ratings went a step further on Oct. 19, cutting its sovereign credit outlook for Mexico to “negative” from “stable,” thanks in large part to the prospect of diminished revenues from Pemex under the AMLO government’s plans:
Proposals for large capital investments by state-owned oil company Pemex, whose balance sheet and standalone creditworthiness have been under pressure, add to the growing risk related to contingent liabilities for the sovereign.
Pemex, which was founded in 1938 via the confiscated assets of foreign oil companies then operating in Mexico, is a fixture of the world bond market, with MXN 2.01 trillion ($103 billion) in net debt outstanding. It is the biggest corporate debt issuer within the iShares J.P. Morgan USD Emerging Market ETF (EMB is the ticker on NYSE Arca), accounting for nearly 3% of the fund’s holdings.
Pemex also featured as a pick-to-not-click from the March 23 edition of Grant’s. Declining production, a massive pension liability, negative free-cash flow position and a near 8:1 leverage ratio when factoring in the pension funding shortfall are among the corporate sins. John Padilla, partner and managing director at energy consulting firm IPD Latin America, summed it up to Grant’s: “Pemex in any private sector context would absolutely be considered bankrupt.”
Since publication of that analysis, the market has priced in a bit more trouble at the oil giant, as five-year credit default swaps have risen to 250 basis points from 185 basis points in March, while the Pemex senior unsecured 4 7/8 notes of 2024 have declined to 94.6 cents on the dollar from 101 at publication time, with the spread over Treasurys widening to 307 basis points from 199 basis points just under eight months ago.
That’s not to say that investors have abandoned the evident object of AMLO’s desire. On Oct. 16, Pemex sold $2 billion in 10-year dollar bonds priced to yield 6.5%, an offering that was nearly six times oversubscribed. In response, Pemex issued a statement that was particularly notable in what was left unsaid:
With this deal, our cash level for the end of 2018 has been strengthened and we guarantee the company’s liquidity for the start of 2019.
Recap Nov. 12
It was an ugly session, as the S&P 500 slumped by 2% with momentum stocks taking a big hit as the NYSE FANG+ Index lost more than 4%. The dollar broke to a 17-month high on the broad DXY Index, news that was not well received in the commodity complex as the CRB reversed early gains to close red for a third straight day.WTI crude continues to plumb to depths, finishing below $59 a barrel. The VIX jumped by 17%, closing above 20.
Meanwhile, the bond market was closed for Veteran’s Day but the iShares iBoxx High Yield Bond ETF got hit hard, finishing at its lowest in an even two years.
- Philip Grant
Friday, November 9, 2018
Ham and wry
Covenant-lite, with Chinese characteristics.
Covenant-lite, with Chinese characteristics.
Steady as she goes
The knives are out in the energy patch.
The knives are out in the energy patch.
Recap Nov. 9
Ham and wry
Covenant-lite, with Chinese characteristics. From Bloomberg:
A Chinese company has come up with an innovative way to placate creditors - as long as they like ham. Chuying Agro-Pastoral Group Co. said holders of 271 million yuan ($39 million) of its debt have agreed to take ham or pork gift packages instead of interest payments, according to a filing on the Shenzhen Stock Exchange on Thursday.
“Payment in kind becomes PIH (Pay In Ham)," said Owen Gallimore, head of credit strategy from Australia & New Zealand Banking Group.
Nice. We might have gone for “Payment-In-Swine” however.
Steady as she goes
The knives are out in the energy patch. Since reaching $76 a barrel on Oct. 3, the price of West Texas Intermediate crude has been in veritable free-fall, completing its record 10th straight red finish today and trading below $60 this morning to officially enter bear market territory. That pullback has narrowed the advance of so-called Texas tea to 24% since March 2017, compared to a 3% gain in the CRB Commodity Index.
Supply concerns are front and center. According to the Department of Energy, total U.S. crude oil inventories registered 431.8 million barrels last week, up 5.78 million barrels sequentially and the seventh straight weekly increase. The Energy Information Administration reports that domestic production reached 11.3 million barrels per day (mbpd) in August, a higher than expected figure that has spurred the EIA to raise its 2019 production forecast.
Meanwhile, crude production among the Organization of the Petroleum Exporting Countries has risen in each of the past five months, with October’s 33.3 million barrel-per-day pace the highest since late 2016 and well above the five-year average of 31.9 mbpd (the cartel is set for a ministry-level meeting this weekend in Abu Dhabi). Russian output is similarly on the upswing, reaching a post-Soviet era-high of 11.41 mbpd in October. There is more where that came from, according to a Wednesday dispatch in the Financial Times. Barring an agreement with Saudi Arabia, Russia is set to ratchet up its output by an additional 300,000 bpd by early next year, and “is said to be hesitant at this stage to agree to cuts,” per the FT.
Demand prospects are likewise working against the bulls, as the International Monetary Fund cut its global GDP growth forecasts for 2018 and 2019 in early October. Subsequently, OPEC and the International Energy Agency each trimmed their respective 2019 demand forecasts a few days later. Colin Fenton, managing partner at Blacklight Research, connects the dots between those guestimates and the recent price move in an analysis published yesterday:
Oil traders watched these reactions and thought they saw common judgement rather than cascading cause and effect. The projections for slower growth in 2019 seemed to match present observations of rising crude oil inventories. . . So, oil traders registered their change in expectations by selling into weakness.
All of this begs a rather important question: why, exactly, did the IMF downshift its 2019 GDP forecasts on Oct. 2? Wait for it. . .yes, the IMF explains that one of the key drivers was “the improved outlook for oil prices.”
The sudden anxiety about growth is most likely overblown. We continue to expect fresh highs for spot oil prices looking out over the next 18 months.
As for the apparent supply bulge that has helped catalyze the pullback, natural resource investors and confirmed oil bulls Lee Goehring and Adam Rozencwajg believe that fundamentals are far less bearish than recent price action would suggest. From the Goehring and Rozencwajg third quarter commentary:
Global inventories peaked at a record 4.7 billion barrels in July of 2016 (420 million barrels above the 10-year average) and have fallen steadily since. Today they stand at 4.4 billion barrels, only 30 million barrels above the 10-year average. Never have inventories fallen this far in such a short period of time.
Looking into 2019, our models suggest global inventories will continue to experience unanticipated drawdowns throughout the year.
Grant’s, bullish on oil since the March 10, 2017 issue, continues to cast our editorial lot with Blacklight and Goehring and Rozencwajg in expectation of higher prices ahead.
Recap Nov. 9
Stocks finished weaker for a second straight day, shaving this week’s advance to 2.2% on the broad S&P 500. The greenback remained bid with the Dollar Index testing fresh 52-week highs, an unwelcome development for commodity investors as the CRB Index fell to a 10-week low.
Treasury yields were bid across the curve, with the 10-year slipping back below 3.2%, little changed for the week. Nevertheless, interbank borrowing costs grind inexorably higher. Three-month Libor rose above 2.6%, up from less than 2.3% in March and 1.41% one year ago.
Three-month Libor, five-year chart. Source: The Bloomberg
- Philip Grant
Thursday, November 8, 2018
No shirt, no shoes, no problem
The economy is booming.
The economy is booming.
QT progress report
Recap Nov. 8
No shirt, no shoes, no problem
The economy is booming. Unemployment is at its lowest level since the late 1960’s according to the Bureau of Labor Statistics, while GDP growth has remained robust with an average 3.3% annualized increase so far this year. Meanwhile, the stock market remains near record highs and wage growth looks to be finally breaking out of a protracted slump after a 3.1% year-over-year jump in average hourly earnings in October.
But those facts have been no help to quick-service restaurants. On Tuesday alone, Red Robin Gourmet Burgers, Inc. (RRGB on the Nasdaq) and Tex-Mex chain Chuy’s Holdings, Inc. (CHUY on the Nasdaq) both reported weaker than expected third quarter revenues and offered full-year earnings guidance well below the analyst consensus. Fiesta Restaurant Group, Inc (FRGI on the Nasdaq) saw its shares fall 28% after missing third quarter EPS estimates, and Wendy’s Co. (WEN on the Nasdaq) surprised analysts by reporting its first decline in North American same-store sales since 2011.
What’s troubling the industry? Commentary from the c-suite provides a glimpse. RRGB’s chief financial officer Guy Constant noted that margins suffered as an increased proportion of sales came from the Tavern value menu. Steven Hislop, CEO at Chuy’s, highlighted rising costs, explaining that “our third quarter was a challenging one as we continue to face industry wide labor cost pressures, which negatively impacted our restaurant-level profitability.” The fourth quarter isn’t off to a great start, either according to FRGI CFO Lynn Schweinfurth, who told listeners on the call that: “In October, we did see a deceleration in terms of traffic across both Florida and Texas, fairly consistent with the industry [heavy rains in Texas likely played a role].”
But perhaps the most notable bit of commentary came from Wendy’s CEO Todd Penegor, who said that current conditions aren’t all they’re cracked up to be:
If you look at the economy in total, there's a lot of great tailwinds, right? We're seeing almost 10 years of economic recovery, we're seeing lowest unemployment levels in a long time, high consumer confidence, and median household [income is] at record levels. But as you look at that income growth, it's skewed significantly to higher income households. You do have workforce participation remaining well below pre-recession levels. And real wage growth is still not accelerating to the extent that we had all hoped for.
And on the low end, you start looking at folks with rent and healthcare costs starting to rise. . . we've got about 40% of our customer base that makes $45,000 or less.
John Hamburger, president of the Restaurant Finance Monitor, tells Grant’s that while rising labor costs have eroded profitability and strained operations, the benefits conferred by higher wages can be narrowly distributed:
The “strongest labor market in 50 years” means that many fast food restaurants can’t locate an adequate supply of workers to fully staff the restaurants. A lack of workers and high turnover hurts restaurant output. I was talking with a quick serve district manager a few weeks ago and he told me how understaffed he was during the previous weekend. He told me he could have done more business but his crew was incapable of high production. Another example: A quick serve restaurant by my office usually has someone taking the cash at one window and the other window dispenses the food. Now they are operating just one window because of a lack of staff.
And, finally, when people have money in their pocket, they tend to move up the scale in terms of the quality of the restaurant. That might explain why quick serve is suffering and some casual dining has shown somewhat of a renaissance.
Perhaps crystalizing the industry’s struggle is bellwether supplier and Grant’s pick-to-not-click (June 17 and Dec. 23, 2016) Middleby Corp., (MIDD on the Nasdaq) which furnishes the appliances and equipment used across the food service industry, and is having its own problems.
Yesterday, MIDD reported third quarter revenues of $713 million, short of the $723 million consensus, while gross margins shrank to 36.6% from 38.5% year-over-year “reflect[ing] lower margins on recent acquisitions.” A bevy (eight since December 2017) of recent such purchases, including a $1 billion cash deal in May for equipment maker the Taylor Company, helped goose MIDD’s top line by 20.3% (organic revenue growth totaled just 40 basis point year-over-year), but at the cost of a substantial jump in leverage. Net debt now stands at $1.88 billion, up from $866 million, pushing Middleby’s leverage ratio to 3.3 turns from just under 1.6 at this time last year.
QT progress report
No change this week. The Fed’s portfolio of securities held outright registered at $3.974 trillion, a $37 million rounding error above last week’s level. But thanks to the large run-off at the end of October, today’s reading remains $25 billion below the trailing four-week average.
Since the Oct. 1, 2017 onset of QT, the Fed’s total balance sheet assets are down by 7%.
Recap Nov. 8
Another big drop in the oil patch left WTI below $61 a barrel for the first time since March and hammered the energy sector to the tune of more than 2%, which helped drag the S&P 500 to its first red finish of the week. Treasury yields again rose more briskly at the short end to continue the recent curve compression, as the 5- and 30-year spread settled at 33 basis points, down from 42 basis points on Friday.
This afternoon, the Federal Reserve left the funds rate unchanged, as expected. Interest rate futures currently price 74% odds of a rate hike at the next meeting on Dec. 19, up from 71% a week ago.
- Philip Grant
Wednesday, November 7, 2018
Out from the cold
Swiss luxury brand Hublot is launching a new line of watches with an unusual twist.
Swiss luxury brand Hublot is launching a new line of watches with an unusual twist.
Surprise!
Now, this is passive.
Now, this is passive.
Recap Nov. 7
Out from the cold
Swiss luxury brand Hublot is launching a new line of watches with an unusual twist. The flourish comes not from a new complication on the dial, but, rather, the mode of transaction. As a celebration of the crypto-currency’s 10-year anniversary, only bitcoin will be accepted as payment for the $25,000 (that’s in fiat currency) timepiece.
CEO Ricardo Guadalupe told Bloomberg: “We can do something different. We will give the possibility to buy all our watches with cryptocurrencies in the future by the end of next year, after offering a second exclusive series.”
For some crypto enthusiasts, one thing is definitely different about this deal: Bloomberg notes that Hublot will partner with Hong Kong-based digital asset brokerage OSL to: “perform background and anti-money-laundering checks.”
Surprise!
Now, this is passive. Today, biotech firm MiMedx Group, Inc. announced that its shares will be delisted from the Nasdaq, sending the price lower by 40% and extending the year-to-date loss to 70%. The company last filed financials on Oct. 31, 2017 and announced in June it will need to restate five years of results, and noted today that its efforts will extend beyond the exchange’s Feb. 25, 2019 deadline to remain listed. MiMedx will not appeal Nasdaq’s decision, and will begin trading over-the-counter tomorrow.
The problems at MiMedx are well aired, and include the termination of CEO Parker H. Petit and chief operating officer Bill Taylor for cause this summer, a compensation claw back of four senior executives allegedly involved in misconduct and an ongoing investigation from a number of government agencies including both the Justice Department and Securities and Exchange Commission. The short interest currently stands at a whopping 60% of the float.
Not that MiMedx’s largest shareholders even noticed that the company hasn’t filed a 10-Q in more than a year. The top three holders, BlackRock, Inc., State Street Corp. and Vanguard Group, Inc., combine to control more than 28% of shares outstanding according to data from Bloomberg. Those passive behemoths have allocated MiMedx shares across nearly 100 funds ostensibly designed for a wide array of strategies, including the SPDR Portfolio Total Stock Momentum ETF, the iShares Core S&P Small Cap ETF, the Vanguard U.S. Factor Value ETF, among many others.
Pre-eminent short seller and vocal MiMedx bear Marc Cohodes tells Grant’s that the presence of those large passive holders who may know little to nothing about the individual stocks they hold can serve to artifically extend the life of such questionable enterprises as MiMedx:
The whole problem with indexation is that there are no adults at the switch. The focus of index firms is on advertising and asset gathering, rather than compliance or even simple adult supervision. This situation would never have gone on so long without the unwitting help of passive investors.
What will become of the MiMedx shares held by those passive funds? A search through the relevant prospectuses yields no mention of procedure when an underlying company faces delisting. Calls to Vanguard, BlackRock and State Street yielded no definitive answers by publication time, beyond a blanket statement from State Street that they “follow the rules as designed” by the relevant index.
Nevertheless, the passive train keeps rolling, as Pension & Investments magazine reports that total worldwide index fund assets under management jumped 13% to $13.37 trillion in the year-ended June 30, while passively managed U.S. equity assets rose by 16%, to $6.42 trillion over the same period. For context, the market capitalization of the Wilshire 5000, which tracks all listed U.S. equities, currently stands at $28.5 trillion according to the Federal Reserve Bank of St. Louis, while total worldwide equity market capitalization stood at just over $79 trillion at year-end 2017 according to the World Bank.
Advises Cohodes: “People need to know what the hell they’re in.”
Recap Nov. 7
Stocks surged, with the S&P 500 gaining more than 2% to extend its seven-day rebound to 6.5% and recoup roughly two-third of the peak-to-trough October decline. Treasury yields mostly climbed higher with the short end leading the way and the 30-year bond the positive outlier to push the curve flatter, while another soft day for commodities saw WTI crude fall to $61.5 per barrel.
The VIX, which had held near 20 through the recent rally in stocks, finally crumbled today to the tune of a 17% decline.
- Philip Grant
Tuesday, November 6, 2018
Night rider
Move over, motorists.
Move over, motorists.
Ships in the night
Uncle Sam may be drowning in red ink, but local government balance sheets continue to improve.
Uncle Sam may be drowning in red ink, but local government balance sheets continue to improve.
Recap Nov. 6
Night rider
Move over, motorists. Last week, Alphabet, Inc.’s (formerly Google) Waymo unit received regulatory permission to test fully self-driving automobiles on public roads in the Silicon Valley area of California. To soothe any fears over the safety implications of driverless beta-testing, the company released a statement:
Waymo has been testing self-driving cars for almost a decade, and we have developed extensive knowledge and expertise in gathering data and designing tests to evaluate safe performance. Safety is at the core of Waymo’s mission and everything we do, and we are committed to educating the public and working closely with policymakers to inform them about our technology and the rigorous processes we’ve put in place to test it.
However, California will have to take this on faith. The New Yorker reports that in 2011, then-Google employee Anthony Levandowski took a self-driving company Prius on a non-regulatory-approved highway jaunt, running a Camry off the road in the process.
The Prius regained control and turned a corner on the freeway, leaving the Camry behind. Levandowski and Taylor didn’t know how badly damaged the Camry was. They didn’t go back to check on the other driver or to see if anyone else had been hurt. Neither they nor other Google executives made inquiries with the authorities. The police were not informed that a self-driving algorithm had contributed to the accident.
Levandowski, rather than being cowed by the incident, later defended it as an invaluable source of data, an opportunity to learn how to avoid similar mistakes.
Today’s present-day testers will likewise encounter no shortage of variables. To that end, researchers at the Massachusetts Institute of Technology have performed a comprehensive online study of more than 2 million respondents from 233 counties in service of developing global consensus about what a self-driving vehicle might do in a sticky situation. Peter Dizikes from the MIT news office explains:
To conduct the survey, the researchers designed what they call “Moral Machine,” a multilingual online game in which participants could state their preferences concerning a series of dilemmas that autonomous vehicles might face. For instance: if it comes right down to it, should autonomous vehicles spare the lives of law-abiding bystanders, or alternately, law-breaking pedestrians who might be jaywalking? (Most people in the survey opted for the former.)
The listed results follow. Canines, felines and scofflaws, avert your eyes:
Source: MIT
In a comprehensive look at self-driving technology from the April 21, 2017 edition of Grant’s, John Adams, emeritus professor at University College London, argued that residential areas present a particularly stiff challenge:
To enable Uber without drivers – these vehicles will have to offer a door-to-door service in urban areas. In such areas autonomous vehicles will encounter many sacred cows, other road users to which they have been programmed to defer. . . The problem of deferential paralysis has yet to be addressed.
Consumers are wary. According to another MIT study conducted in May 2017, 48% of respondents said they would never purchase a full-self driving auto, with the most common reasons including: “discomfort with the loss of control. . . not trusting the technology, a disbelief that it would be robust enough to rely on exclusively, and a feeling that self-driving cars are unsafe.” What’s more, the number of respondents aged 25-34 who said they would be “fully comfortable” in fully autonomous vehicles plunged to 20%, down from 40% in the prior year’s survey (then again, a poll of buggy owners circa 1900 may have revealed similar ambivalence).
As noted in that 2017 Grant’s analysis; “it’s the human response to the planning that usually trips up the planners.” Jaywalkers may yet be safe a little while longer.
Ships in the night
Uncle Sam may be drowning in red ink, but local government balance sheets continue to improve. That’s the word from Moody’s, which today released its municipal finance ratings revisions for the third quarter showing net upgrades for a fifth straight quarter. In aggregate, 119 issues totaling $34.1 billion in municipal debt were upgraded, while 106 bonds worth just $14 billion suffered downgrades. “Ongoing favorable economic conditions” can explain the pleasant trend, according to the rating agency.
While state and local governments remain on the upswing, one particularly broad measure of corporate stress is showing the opposite. According to data provided by Epiq Systems, Inc., commercial Chapter 11 bankruptcy filings jumped to 554 in October, a 75% increase over the 316 commercial Chapter 11 filings seen last year and 79% higher than the 309 logged in September. Individual Chapter 11 filings rose by 4% year-over-year in October, to 64,175.
Are higher rates disproportionately squeezing certain consumers and businesses? Three-month Libor closed October at 2.56%, nearly double the 1.38% seen on Oct. 31, 2017.
Recap Nov. 6
The bulls notched another win, with the S&P 500 racking up a fifth green finish in six tries to close at its best level in more than two weeks, up 3% year-to-date. Treasury yields ticked higher across the curve, with the 10-year settling at 3.22% despite a stronger than expected $27 billion auction this afternoon, while commodities were hammered again despite an unchanged Dollar Index. The VIX held steady at 20.
- Philip Grant
Monday, November 5, 2018
Slim pickings
Behold, the accommodating credit markets of 2018.
Behold, the accommodating credit markets of 2018.
Something borrowed
A pair of anecdotes, from Bloomberg:
A pair of anecdotes, from Bloomberg:
Evergreen
Is the world’s second-largest economy preparing to once again rev the stimulus engines?
Is the world’s second-largest economy preparing to once again rev the stimulus engines?
Recap Nov. 5
Slim pickings
Behold, the accommodating credit markets of 2018. On Thursday evening, single-B-rated Weight Watchers International, Inc. (WTW on the Nasdaq) offered a rude surprise to shareholders in the form of weaker than expected third quarter results and a poor retention rate, sending shares tumbling by 29% Friday.
One piece of good news: On the earnings call, CFO Nicholas Hotchkin said: “given our financial and balance sheet momentum. . . we may have an opportunity to reprice our $1.5 billion term loan in the near future.”
Indeed, the company’s senior unsecured 8 5/8 notes due in 2025 remain above par, trading most recently at 105.2 cents on the dollar for a yield-to-worst of 7.11% and a 414 basis point spread over Treasurys. That’s down from the 630 basis point premium at issuance last fall.
Something borrowed
A pair of anecdotes, from Bloomberg:
WeddingWire, Inc. is in the debt markets this week, offering more than $600 million of speculative-grade loans to fund its announced take-private transaction of XO Group, Inc., the company behind “The Knot” website.
David’s Bridal, Inc. is making preparations for a bankruptcy filing if the retailer can’t reach an out-of-court deal with its creditors, according to people with knowledge of the matter . . . David’s skipped an Oct. 15 interest payment on its $270 million of 7.75 percent unsecured notes due 2020 at the request of its creditors in order to allow more time to continue negotiations about reworking the company’s debt load.
Evergreen
Is the world’s second-largest economy preparing to once again rev the stimulus engines? Last week, a Politburo meeting chaired by president Xi Jinping concluded with a statement noting that China’s “economic situation is changing, downward pressure is accelerating, and the government needs to take timely steps to counter this,” according to an Oct. 31 dispatch from Bloomberg. Katrina Ell, economist at Moody’s, likewise comments that “accepting slower growth has long been a challenge for Beijing, but now the rate of slowdown is firmly out of the comfort zone.”
Ominous signs are not hard to spot. The renminbi is down nearly 10% against the dollar since April, and growth in the M2 money supply registered at 8.3% year-over-year in September, barely half of its 20-year average. The stock market is also indicating trouble: The Shanghai Composite has lost 19.4% year-to-date and Hong Kong’s Hang Seng Index is down by 13.3%, placing those markets in the 93rd and 83rd spots, respectively, out of 94 markets rated by performance in local currencies, according to Bloomberg.
Beyond potentially discounting an economic slowdown, the stock market’s poor performance could have ramifications in its own right. The Wall Street Journal, citing an analysis from Goldman Sachs, reported on Oct. 24 that nearly 10% of mainland Chinese shares are used as loan collateral, while the sum total of equities pledged for lending has jumped to RMB 4.955 trillion ($690 billion), a seven-fold increase since 2015. Unlike the NYSE’s margin loan, China’s stock borrowing is largely used to fund corporate expenses rather than financial speculation.
Meanwhile, the real estate industry is likewise showing signs of strain, as growth in new home sales slipped to 1% sequentially in September, down from 1.5% in August, according to the National Bureau of Statistics. In Hong Kong, Centaline Mortage Broker Ltd. relays that mortgage applications in September saw their largest sequential decline in 20 years, while Ricacorp Properties Ltd. reports that the month of September also saw the fewest luxury home sales since at least 2005. Anne Stevenson-Yang of J Capital Research summarizes the state of play in an Oct. 23 analysis:
Secondary housing markets in major cities are all but frozen, and transaction growth is in decline. Anecdotally, prices seem to be declining. Both public and private statistical organizations stopped publishing data finally in 2017 after gradually degrading their statistics.
With China’s stock market in retreat and housing market potentially faltering, the property developers could be a useful indicator of broader conditions. Last week, China Evergrande Group (3333 on the Hang Seng) sold $1.8 billion in dollar-denominated bonds, paying yields as high as 13.75% on a five-year tranche. By comparison, the company was able to place senior secured notes at an 8 3/4% coupon last June (those notes currently trade near 82 cents on the dollar for a yield-to-worst of 12.76%). What’s more, chairman and executive director Hui Ka Yan personally bought more than half of the total allotment, a move that the company described as “signify[ing] Mr. Hui’s support to and confidence in the Group.”
The June 2, 2017 edition of Grant’s included a close look at Evergrande, “the world’s most encumbered and possibly most astounding property developer,” which also owns a majority stake in a soccer club as well as a mineral water brand, among other far-ranging business interests. For her part, Stevenson-Yang minced no words:
Evergrande is . . . arguably the biggest pyramid scheme the world has ever seen. Servicing the company’s mountainous debt requires constant new borrowings, and those loans in turn require that the growth continue.
Recap Nov. 5
A relatively calm session saw the S&P 500 finish modestly higher to extend its bounce to nearly 4% above last Monday’s low, despite a 1.5% drop in the NYSE FANG+ Index to leave that gauge of popular tech stocks about 16% off its June highs. The VIX remained green all day, settling just under 20.
The Treasury curve flattened a bit, with the 10-year yield finishing just under 3.2%, while the dollar and CRB Commodity Index both finished little changed.
- Philip Grant
Thursday, November 1, 2018
He said it
Here’s BlackRock, Inc. CEO Larry Fink,
Here’s BlackRock, Inc. CEO Larry Fink,
Bond Street
Let’s call it high-er yield.
Let’s call it high-er yield.
QT Progress report
Recap Nov. 1
He said it
Here’s BlackRock, Inc. CEO Larry Fink, speaking on the apparent murder of Washington Post columnist Jamal Khasogghi. From Bloomberg:
“We don’t know who is responsible for the murder,” Fink said at the New York Times DealBook conference. “Everybody has their own theories.” He didn’t elaborate. Brian Beades, a BlackRock spokesman, declined further comment.
Fink, who runs the world’s largest asset manager, said at the conference that doing business in Saudi Arabia is “not something I’m ashamed of.” He added, “We have not lost any business there,” noting that BlackRock has worked in the kingdom for 15 years.
For a critique of Larry Fink, let’s turn to Larry Fink in his annual letter earlier this year entitled “Dear CEO:”
Indeed, the public expectations of your company have never been greater. Society is demanding that companies, both public and private, serve a social purpose. To prosper over time, every company must not only deliver financial performance, but also show how it makes a positive contribution to society . . . Without a sense of purpose, no company, either public or private, can achieve its full potential.
Bond Street
Let’s call it high-er yield. The recent tumble in asset prices has not spared the lower end of the corporate credit spectrum, as the Bloomberg Barclays High Yield Index sank by 1.6% last month, its weakest one month performance since December 2015 and worst October showing since the 2008 trial-by-fire. That sent the yield-to-worst on junk bonds to 6.87% today from 6.24% on Sept. 28, blowing the spread above Treasurys to 371 basis points from 316 basis points at the end of September. At the bottom of the ratings ladder, the yield-to-worst on the Bloomberg Barclays Triple-C Index jumped above 10% yesterday, its first foray into double-digit territory since January 2017 and up from less than 8% in July.
Rough October aside, the lower end of the credit spectrum has been the place to be. The 0.93% year-to-date return in high yield and 4.3% advance in the iBoxx High Yield Triple-C Total Return Index remains far better than investment grade, as the Bloomberg Barclays Investment Grade Index is down 3.7% since Jan. 1.
Among the factors driving the outperformance: A supply drought. According to Bloomberg, speculative-grade bond issuance totaled $9 billion in October and stands at $160 billion year-to-date, the lowest since 2015 and 2009, respectively. Analysts at Bank of America Merrill Lynch expect full-year issuance to tally $205 billion, down nearly 25% from 2017. By contrast, growing popularity of floating-rate leveraged loans recently pushed the size of that market above high yield bonds for the first time, according to an Oct. 18 report from Bloomberg.
Meanwhile, relatively brisk economic growth and low absolute interest rates have helped keep defaults low, as Moody’s global speculative-grade default rate registered at 2.6% in the third quarter, down from 3.1% in the second quarter and a three-year low. The rating agencies anticipate more of the same, with Moody’s expecting defaults to edge down to 2.5% by year-end and Fitch forecasting a default rate of just 1.5% by the end of 2019. That compares to 5.8% as recently as January 2017, according to Moody’s.
Investors don’t necessarily share that rosy outlook. According to the BAML October Fund Manager Survey, “a record 85% of respondents think the global economy is in the late cycle, 11% above the prior highs of December 2007,” while a “net 38% of respondents expect [economic] deceleration, the worst outlook on global growth since November 2008.”
The question before the house: What will ultimately drive the performance of junk bonds as the calendar turns toward 2019? Martin Fridson, chief investment officer at Lehmann, Livian, Fridson Advisors LLC and “the dean of high-yield” according to Institutional Investor magazine, tells Grant’s that the rough October performance in spite of tight supply shows the limitations of supply considerations on price. Instead, economic conditions are what ultimately drive the performance of the asset class:
In general, short-run returns are a function of changes in underlying fundamentals, with valuations prior to the change not mattering much . . . If the perception increases that a recession is not far off, high yield will do much worse than the major fixed income categories. If investors conclude that a couple more years of decent (by present standards) GDP growth lie ahead, high yield will outperform them, if nothing else by virtue of collecting a bigger coupon.
The reappraisal of economic growth is causing investors to take a second look at money losing enterprises. Since October 12, the single-B-plus-rated WeWork Cos, Inc. senior unsecured 7 7/8% notes of 2025, have fallen to 92.5 cents on the dollar from 98 cents, with the spread over Treasurys jumping to 642 basis points from 531 basis points less-than three weeks ago. That’s nearly quadruple the index-level spread widening over that period. For more on WeWork, see the April 24 edition of Almost Daily Grant’s.
QT Progress report
After weeks of inertia, we got some action this time as the Fed’s portfolio of securities held outright fell to $3.942 trillion, down a hefty $31.5 billion from the prior week’s reading. Treasurys accounted for about three-quarters of the decline, and mortgage-backed securities the balance.
Since the Fed began its QT program on Oct. 1, 2017, total balance sheet assets are down by 7.1%.
Recap Nov. 1
Stocks caught another bid, with the S&P 500 extending its bounce to a 3% gain for the week, while the NYSE FANG+ contingent is up a meaty 11% from Monday’s intraday low. Treasury yields ticked a bit lower, with the 10-year settling just under 3.14%, but interbank lending rates continue to march higher with 3-month Libor jumping to another post-crisis high of 2.58%. That’s up from 1.69% at year-end.
A weak dollar helped the commodity complex, with the notable exception of oil which was hammered again following a Bloomberg report of stronger-than-expected OPEC production in October. WTI settled below $64 a barrel.
After the close, Apple, Inc. reported fourth quarter results featuring weaker-than expected iPhone sales volumes and soft guidance for the upcoming quarter. AAPL shares are down by 5% in the after market.
- Philip Grant
Tuesday, October 30, 2018
No limit hold 'em
The Bank of Japan concludes its two-day policy meeting tomorrow,
The Bank of Japan concludes its two-day policy meeting tomorrow,
Recap Oct. 30
No limit hold 'em
The Bank of Japan concludes its two-day policy meeting tomorrow, but may have already signaled its intentions. Bloomberg reports that the central bank has purchased JPY 867.6 billion ($7.7 billion) of exchange traded funds this month through Oct. 29, its largest outlay since the ETF buying program got underway in 2010 and nearly double the September figure.
A Bloomberg dispatch from Monday underscores the broad scope of the central bank’s strategy:
The BOJ aims to keep the yield on 10-year Japanese government debt around zero percent as it tries to stimulate price growth in the economy by controlling both short and long-term interest rates.
Indeed, during a March committee meeting of the Japanese lower house, BOJ deputy governor Masazumi Wakatabe bluntly declared: “There are no limits to monetary policy.”
On that front, we shall see. The BOJ had already become a top-10 shareholder in 40% of Japan’s listed companies as of late July, according to an analysis by Nikkei, while Japan Macro Advisors pegs the BOJ’s ownership of Japanese Government Bonds at 49% of total supply as of September. According to an Oct. 23 statement of account, the BOJ’s ETF holdings currently stand at JPY 21.7 trillion ($193 billion).
While Japan’s corporate sector increasingly comes under the thumb of governor Haruhiko Kuroda’s central bank and the Japanese government bond market remains in a type of suspended animation, the primary gauge directing the BOJs remarkable monetary exertions remains far from the mark: Tokyo’s core CPI grew by just 1% year-over-year in October, while nationwide CPI grew by 1.2% year-over-year in September (the most recent reading), each far below the 2% “price stability” inflation target that has catalyzed the current monetary stimulus that has been in place since 2016.
The remarkable contortions evident across Japan’s financial landscape, and so-far muted impact on the price level, beg the question of potential outcomes. Keith Anderson, co-founder of BlackRock, Inc., told the assembled throngs at the fall 2017 Grant’s conference that Japan’s massive sovereign balance sheet may be the agent of change. Anderson noted that Japan’s debt service costs remain unchanged from the 1980s despite a six-fold rise in debt, and added that a successful inflation ignition could come with nasty side effects:
Either they’re going to suffer this deflationary situation and never get out of it or, God forbid, they get out of it and create inflation, then you know you’re going to have a massive budget-deficit problem and huge interest costs.
What is the Bank of Japan going to do? I would say that one day, maybe in the next five years, the BOJ is going to announce that all of the debt they hold is forgiven. They will just go bankrupt on themselves.
Back in the present day, the central bank’s interventions have stultified trading activity in the Japanese government bond market, as multiple trading sessions have passed by this year without a single lot of benchmark bond issues changing hands (Grant’s, June 1). The lack of liquidity spurred the BOJ to consider changing the format of its bond purchases, according to a Reuters report yesterday.
Things are drying up on the corporate side as well. According to an Oct. 22 report from Bloomberg, underwriters were unable to fully place 29% of company-issued notes in September, double the six month average. Bloomberg goes on to identify a few of the issuers, including Japan Airlines Co., Japan Tobacco, Inc., Idemitsu Kosan Co. and Honda Finance Co., while noting that “spokespeople for all four companies said that’s not what they were told by the banks.”
Recap Oct. 30
Stocks caught a solid bounce with the S&P 500 rising by about 1.5% to close within 9% or so of its September highs, while a similar rebound in the NYSE FANG+ Index was followed by third quarter results from Facebook, Inc., featuring stronger-than expected earnings per share and weaker-than-expected revenues after the close (FB shares are up by 2% in initial reaction).
Elsewhere, Treasury yields ticked higher across the board to push the 10-year back above 3.11%, while a strong bid in the U.S. Dollar Index coincided with a second straight sharp selloff in the commodity complex, with WTI crude settling near $66 a barrel and gold slumping to $1,223 per ounce. The emerging markets realm likewise looks vulnerable, with both the iShares MSCI Emerging Markets ETF and iShares J.P. Morgan Dollar Emerging Markets Bond ETF both holding near their lows of the year.
- Philip Grant
Monday, October 29, 2018
Pile up
Courtesy of Raoul Pal, co-founder of Real Vision, via Twitter:
What’s the return policy?
Bolso would
There’s a new sheriff in town. Over the weekend, Brazilians elected Jair Bolsonaro, a 63-year old congressman and former army captain known for his far-right leanings and populist rhetoric, as its new president. Bolsonaro, who defeated the left-wing candidate Fernando Haddad by a 55% to 45% margin in the second round of the election on Sunday, seems to enjoy at least provisional approval from investors. After Bolsonaro was stabbed in a campaign event in early September, an event which boosted his popularity, the Bovespa Index has rallied by 13% in nominal terms and 27% in dollar terms. During this period, the iShares MSCI Emerging Market ETF has declined by 7%.
The potential for an improved budget outlook figures prominently the recent run-up in asset prices. In his victory speech, Bolsonaro promised that Brazil “will break the vicious cycle of growing debt,” in place of a “virtuous cycle of smaller deficits, falling debt and lower interest rates.”
In hopes of reining in a budget deficit that footed to 7.19% of GDP at the end of September, the president-elect and his University of Chicago-educated finance minister, Paulo Guedes, will attempt to pass pension reforms. Those budget shortfalls have contributed to rising government debt which is expected to jump to nearly 96% of GDP by 2022 from 87.3% at year-end 2017, according to the World Bank, up from 62.3% in 2014.
Those reforms have proven elusive, as three fifths of congress will need to vote in the affirmative to amend the constitution and pass the reform. A 2016 congressional effort to do so failed, while Bolsonaro’s predecessor Michel Temer was forced to abandon his attempts to overhaul Brazil’s social security system earlier this year.
Luiz Portella, founder at Novus Capital in Rio De Janiero, judges the likelihood of achieving success to be “difficult, but not impossible.” Portella, who is bullish on Brazil, tells Grant’s that “the bar is very low,” for Bolsonaro, coming on the heels of a “bear market in politics” lowlighted by the 2016 impeachment of Dilma Rousseff for corruption, followed by highly unpopular Temer regime and bribery conviction and subsequent jailing of former president Lula da Silva in April.
The bear market in Brazilian politics contrasts with a sunny outlook from investors. Brazil’s Ibovespa trades at 13 times consensus 2018 earnings, well above the 10.9 times for the MSCI Emerging Markets Index, 10.3 times forward earnings fetched by the Shanghai Composite, 8.8 times for Argentina’s Merval Index, and 5.3 times for the MOEX Russia Index. Beyond a premium valuation, Mr. Market is expecting big things; earnings per share within the Bovespa are expected to jump by 75% over the next 12 months, according to estimates tabulated by Bloomberg.
Then, too, the populist factor can produce unwelcome surprises. Today, Mexican asset prices took a dive after incoming president Andr?s Manuel López Obrador, (AMLO for short), scrapped plans to build a $13 billion airport in the Mexico City suburbs after a four-day referendum showed that almost 70% of voters opposed the project. By way of response, AMLO commented: “Our decision is to follow the referendum mandate. The citizen’s decision is rational and democratic.” Last week, AMLO remarked of the project (which is already one-third completed according to Bloomberg): “There won’t [be] macro imbalances, problems with the stock exchange, or devaluations.”
As for Brazil, an Ibope poll conducted in January showed that 14% of respondents answered in favor of pension reform while 44% were opposed. The balance were thinking it over.
Recap Oct. 29
Another wild day saw the S&P 500 lose nearly 4% from intraday peak to trough before a late rally left the broad average in the red by less than 1%, while the NYSE FANG+ Index lost nearly 4%. Treasury yields ticked slightly higher across the curve, while commodities were hammered with WTI crude sinking below $67 a barrel.
- Philip Grant
Friday, October 26, 2018
Recap Oct. 26
Paper trade
From Fox News:
From Fox News:
Wild Turkey
Is the crisis abating in the land of Erdogan?
Is the crisis abating in the land of Erdogan?
Recap Oct. 26
A near-2% selloff in the S&P 500 left the broad average 4% lower for the week and more than 9% off its Sept. 20 highs, but the NYSE FANG+ Index managed to keep pace with the market today despite Amazon.com, Inc. shares losing 8% after reporting disappointing results yesterday evening. That gauge of 10 popular tech stocks finished flat for the week.
A strong rally in Treasurys pushed the 10-year yield to near four-week lows south of 3.08%, while commodities reversed higher amid an intraday downdraft in the dollar. The VIX finished higher by 5% after again remaining in a relatively tight range.
Paper trade
From Fox News:
An extremely rare $1,000 bill described as the “Holy Grail of paper money” has been sold at auction for just over $2 million.
Auction house Stack’s Bowers Galleries sold the unusual bill for $2.04 million on Thursday evening at the 2018 Winter Whitman Expo in Baltimore.
The 1890 Treasury note is dubbed the “Grand Watermelon” on account of the large green zeros on the back of the bill. Major General George Meade, the commander of Union forces at the Battle of Gettysburg, is shown on the bill’s face.
The price appreciation to $2.04 million from $1,000 over 128 years represents a compound annual growth rate of 6.13%. Who said fiat currency doesn’t hold its value?
Wild Turkey
Is the crisis abating in the land of Erdogan? Turkey has been beset by rampant inflation, a plunging lira and yawning current account deficits, but hopeful signs have recently emerged.
On Oct. 17, Turkey managed to sell $2 billion of five-year dollar bonds at a yield of 7.5%, attracting brisk interest as the issue was covered three times over. Luis Costa, strategist at Citigroup, commented: “The ongoing current account adjustment and higher yields seem to have led some investors to take a more constructive look at Turkish assets.”
There is cause for optimism. Turkey’s current account swung into the black in August with a $2.6 billion surplus for the month, a record going back to at least 1992 and the first positive month in three years. That compares to a deficit of $7.8 billion in December. Then, too, the lira has recently stabilized at 5.55 per dollar, well off its August lows of 6.88 to a buck to spur a 24% bounce in the Borsa Istanbul 100 Index in dollar terms over the same period, while the Oct. 12 release of Pastor Andrew Brunson from Turkish custody seemingly opens the door for improved relations with the West.
Those welcome developments aside, things remain dicey, as runaway inflation (CPI rose 24.5% year-over-year in September) has forced the Turkish Central Bank to jam its one-week repo rate to 24%, up from 8% at the beginning of the year. Meanwhile, the 32% year-to-date lira decline against the dollar has put the screws to the corporate sector, which had more than 50% of its debt denominated in foreign currencies as of last year, according to Moody’s. The rating agency cautioned in a Sept. 10 report that the banking system is particularly vulnerable: “Turkish banks pose a risk to the sovereign [credit], as they rely on wholesale funding, particularly in foreign currencies, and corporate financial stress crystallizing on bank balance sheets could impair their ability to borrow from other banks.”
Moody’s warning is brought into relief by an Oct. 2 Bloomberg dispatch, which called attention to an unusual TRY 10.9 billion ($2 billion) subordinated debt sale by a trio Turkish state banks at the end of September:
Speculation [is] focusing on whether assets from the nation’s unemployment fund were deployed to boost the lenders’ capital buffers. The banks haven’t provided many details, saying the sales were private.
State-controlled Turkiye Vakiflar Bankasi TAO sold 4.99 billion liras of Tier-1 notes with a fixed rate coupon payment on a semi-annual basis. Turkiye Halk Bankasi sold 2.98 billion liras in Tier-2 debt and Turkiye Ihracat Kredi Bankasi AS, known as Eximbank, sold 2.9 billion liras Tier-2 debt last week with a 10-year maturity, completing the sale on the same day it received regulatory approval. All three were sold through private placements and yields haven’t been announced.
The large transactions come just before the banks reveal their third quarter accounts, and could be an effort to beef up capital adequacy ratios hit by the lira’s plunge, according to local analysts who asked not to be named, citing the sensitivity of the issue.
Russell Napier, independent strategist and founder of the Electronic Research Interchange, believes the worst is yet to come for the Turkey’s foreign currency borrowers, particularly the banks. Reached by Grant’s this morning, Napier remarked:
We're looking at the tip of the iceberg on massive domestic debt restructuring. It's going to be very bad for banks. Can you run a bank with no capital? If they keep cramming down [i.e. reducing the amount owed to creditors to reflect the fair market value of debt collateral, as described here] on the banks loans, their assets… mmmmm.
Turkey needs $50 to $60 billion annual capital inflows to stabilize the situation and keep current. And I don't think it's going to see that. Behind all of this is rising U.S. interest rates and a rising dollar, which we're likely to see quite a bit more of, I suspect, given today’s [strong] GDP print.
It's a bad time globally for Turkey. There are a long way from sorting out the problem. When I read commentaries, everybody talks about the exchange rate, nobody talks about domestic interest rates. And that's ultimately what crushes your credit structure.
Indeed, the one-month interbank lending rate currently sits at 26.5%, up from 13.6% in March and 8.6% in September 2016.
- Philip Grant
Thursday, October 25, 2018
Recap Oct. 25
Stocks caught a strong bounce, with the S&P 500 rising nearly 2% to narrow its loss for the week to 2.25% while the NYSE FANG+ Index enjoyed a 6% rip, although weaker than expected revenues (both this quarter and guidance) from Amazon.com, Inc. after the bell will surely test the group tomorrow. AMZN shares are currently down 9% in after-hours trading.
Elsewhere, Treasury yields ticked slightly higher across the board with underperformance from the short end pushing the curve flatter, while commodities finished a bit stronger with WTI crude settling near $67 a barrel and gold again holding just above $1,230 an ounce. The rally in stocks did little to dent options volatility, as the VIX fell by a relatively modest 5% to finish near 24.
Till the medicine takes
Leverage cuts both ways. For the latest examples of that truism, we take a closer look at a pair of highly indebted corporate mainstays who are now facing the daunting task of rehabilitating their balance sheets.
First up, Bud Lighter: Beer giant Anheuser-Busch InBev S.A. (ABI on the Belgian stock exchange and BUD on the NYSE), is listing under the weight of some $116 billion in net debt, just under five times consensus 2019 adjusted EBITDA, which largely stems from the 2016 acquisition of SABMiller Plc. for $65 billion (ABI paid a hefty 18 times EBITDA for its rival). This morning, ABI reported weaker-than expected third quarter results, featuring revenue growth of 3.6% and adjusted earnings per share of 82 cents, well short of the consensus estimates of 5% and 98 cents, respectively.
But perhaps the biggest jolt to investors was ABI’s decision to cut its dividend in half from its indicated yield of 5%, a move which will save the beer company $4 billion a year. Chief financial and technology officer Felipe Dutra described the decision in an interview with Bloomberg: “We see the volatility out there and want to be proactive.”
Investors didn’t appreciate that pre-emptive approach, as ABI shares sank by 9%, extending their loss to 27% from February to a fresh six year low. Analysts were likewise nonplussed, with James Edwardes Jones from RBC Europe Ltd. writing: “We can’t remember a more disappointing set of figures. . . Every region missed revenue growth consensus. This is not AB InBev’s finest hour.”
The turnaround won’t take place overnight. Trevor Stirling of Bernstein Research told Bloomberg: “Even with this dividend cut, it will still take AB InBev 3 or 4 years” to whittle its debt load to more manageable levels.
Creditors have at least partially shared in the pain: The ABI 3.65 senior unsecured dollar bonds of 2026 traded below 96 cents on the dollar yesterday for a yield-to-worst of 4.3% and 124 basis point pickup over Treasurys. That’s down from 99.7 cents on the dollar, a 3.4% yield and 75 basis point spread over Treasurys in February.
The Feb. 9, edition of Grant’s, citing ABI’s heavy debt load, relatively aggressive dividend and bottom-scraping yields available to the company’s creditors, concluded: “We judge there is a good chance of operational disappointment, therefore of ratings disappointment. As the market is seemingly willing to admit no possibilities but happy ones, the downside risks are palpable.”
Then there’s AT&T, Inc. (T on the NYSE) the telecom-plus-entertainment behemoth that puts ABI in the shade with a staggering $250 billion of net debt (after accounting for unfunded liabilities and capitalized operating leases), while paying a generous dividend yield that currently stands at 6.6%. Yesterday, AT&T reported third quarter results featuring weaker than expected adjusted earnings per share and an unexpected subscriber loss in its wireless division, sending shares lower by more than 8%, the largest one-day drop since 2002.
While shareholders blanched at the results, Craig Moffett, co-founder of media and telecom research firm MoffettNathanson LLC, wrote in a note yesterday that the quarterly update represented something of a turning point for the company.
AT&T [yesterday] delivered a strong quarter of free cash flow. . . bond investors should be pleased. But we’re equity analysts.
Might Ma Bell follow ABI’s lead and slice its own dividend to help pay down its borrowings? Moffett breaks down the calculus:
AT&T’s dividend is thought to be sacrosanct. But AT&T’s investment grade bond rating actually is sacrosanct. As we noted last quarter, if AT&T is forced to choose between its dividend and its bond rating, well that’s no choice at all.
The bloated balance sheet may be attracting management’s attention, but AT&T’s lenders have likewise gotten a little nervous. The Sept. 22, 2017 edition of Grant’s featured a review of the AT&T euro-denominated 1.8s of 2026, which at the time traded at 101.5 cents on the euro for a 1.6% yield-to-worst and 131 basis point spread over German bunds. Grant’s declared: “AT&T may or may not prove a sturdier credit than, say, the government of Portugal. The company’s 1.8s are priced, almost, as if T were as sturdy as Germany. For the sake of the creditors, it had better be, as the pricing leaves little room for adverse surprises.” Today, those notes have edged to 99.7 cents on the euro, for a yield-to-worst of 1.83% and a 202 basis point spread over bunds.
QT Progress report
The Fed’s portfolio of securities held outright registered at $3.974 trillion, a mere $3.2 billion below the prior reading and representing the fourth straight week of limited progress. Today’s figure is also less than $10 billion below the trailing four-week average. There could be a substantial decline next week; another round of status quo would seemingly imply the Fed is slowing down the portfolio run-off in response to recent market volatility.
Since QT began on Oct. 1, 2017, the Fed’s total balance sheet assets are down by 6.34%.
- Philip Grant
Wednesday, October 24, 2018
Recap Oct. 24
From where you sit
Last week, a pair of Deutsche Bank AG traders were convicted of conspiracy and wire fraud charges
Last week, a pair of Deutsche Bank AG traders were convicted of conspiracy and wire fraud charges
Term paper
It’s a changing of the guard.
It’s a changing of the guard.
Recap Oct. 24
Stocks were hammered to the tune of a 3.1% loss on the S&P 500, erasing the year-to-date gains on the broad index from 9% as recently as Sept. 20. It was worse in tech, with the Nasdaq 100 sinking 4.6% for its worst one-day showing since August 2011 while the formerly high-flying NYSE FANG+ contingent lost 5% to reach the cusp of a bear market, down 19.8% since June.
Treasurys were well-bid, with the 10-year yield settling near 3.11%, as was the dollar, while the CRB commodity Index finished slightly lower and gold edged higher by $2 to $1,232 an ounce. The VIX jumped 20% to finish at 25.
After the market close, Microsoft Corp. and Tesla, Inc. both announced stronger than expected headline results for their respective quarters, sending shares of each higher in immediate reaction.
From where you sit
Last week, a pair of Deutsche Bank AG traders were convicted of conspiracy and wire fraud charges related to the rigging of Libor, the interbank rate which is used to set the value of trillions of dollars of debt instruments around the world.
Reckless and selfish as the defendant’s purported actions may be, their conviction is an opportunity to ponder existential questions. The following is an open-meeting exchange between James Grant and then-Fed Governor Jeremy Stein, as documented in the July 12, 2013 edition of Grant’s:
Q. Good morning, Governor. James Grant of Grant’s Interest Rate Observer. Could you help us understand the economic difference – not the legal one, but the economic distinction – between the private manipulation of Libor, on the one hand, and the public manipulation of markets, on the other, doing business as zero interest rate policy, quantitative easing, Operation Twist, the “portfolio balance channel”? What ever did happen to the price mechanism?
A. You know, that’s a hard question for me to answer, because [laughter] I don’t see the connection between these two whatsoever. I mean, obviously, the Libor set – you know, it is a set of criminal and near-criminal activity, which is a very substantial policy concern. A lot of effort is going into trying to, you know, both reform Libor itself, look at other benchmarks, see if they’re more resilient. That’s a whole set of issues. To be frank, I just don’t see the connection to that and the monetary policy side.
Term paper
It’s a changing of the guard. A recent report from data firm Preqin projects that private equity assets under management will climb to $4.9 trillion by 2023, surpassing the $4.7 trillion managed by the hedge fund industry (hedge funds currently manage $3.6 trillion while private equity controls $3.1 billion, per the report). For his part, Preqin chief executive Mark O’Hare notes that his company’s forecast for private equity asset growth might prove conservative, as it assumes compound annual growth of 8% over the next five years, down from more than 12% annually during the post-crisis period. O’Hare went on to explain the factors behind the p.e. proliferation, namely “proven long-term performance,” and “the growing opportunities available in private debt.”
Private debt investors are certainly used to taking risks by participating in p.e.-sponsored deals. The Wall Street Journal, citing data from S&P Global’s LCD unit, reports that just under 13% of leveraged buyouts carry net debt above seven times EBITDA through the first nine months of the year, more than double the proportion of high-debt deals brought to market in 2017.
So called add-backs, or the increasingly common practice of counting prospective future cost savings at the portfolio company as pro-forma profits, figure prominently. LCD likewise reports that while 8% of merger-backed leveraged loans have carried leverage ratios in excess of seven times this year, well below 2007’s high water mark of 17%, that figure jumps to 17% when removing the hoped-for cost savings baked into the sponsor’s projections, compared to 19% in 2007.
That rising leverage has caught the attention of the ratings agencies. According to a recent study by Moody’s, 92% of private-equity backed firms rated by the agency since 2009 have debt rated at B2 (five notches below investment grade) or worse, well above the 40% of non-p.e.-backed issuers. Julia Chursin of Moody’s attributes the gap to “p.e. firms’ focus on shareholder returns and high leverage,” and warns that the “ratings of p.e.-backed companies do not bode well for them when the economy turns.”
That isn’t to say private equity holds a monopoly on issuing less-than-conventional M&A debt. Today, Bloomberg reports on United Natural Food, Inc.’s attempt to finance its acquisition of supermarket chain SuperValu, Inc. To amp up the sales effort, lead investment bank Goldman Sachs Group, Inc. made some creative changes to the structure in order to attract hedge funds who were positioned for credit distress in the to-be-acquired SuperValu.
With the United Natural Foods deal, the key was in restoring the value of roughly $470 million of net credit default swap wagers linked to SuperValu debt. The cost of those derivatives had plunged through this year on worry that the acquisition would eliminate the debt being insured.
By tweaking the loan documents to make SuperValu a co-borrower on the new debt, Goldman sparked a surge in the value of those swaps. That, along with several other concessions, helped the bank fill its order book for the loans, the people [familiar with the matter] said. It also may have saved bankers from having to offer deeper concessions that would have increased United Natural Food’s borrowing costs or even put Goldman at risk of taking a loss.
The term loan, issued yesterday at 97 cents on the dollar, ticked lower in initial trading to 96.8, priced to yield 7.32%.
- Philip Grant
Tuesday, October 23, 2018
Recap Oct. 23
Another volatile trading
Another volatile trading
Relationship counseling
The high yield drought continues.
The high yield drought continues.
High jump
The irresistible force meets the immovable object.
The irresistible force meets the immovable object.
Recap Oct. 23
Another volatile trading session featured an intraday drop of more than 2% on the S&P 500, before a late rally pushed the broad average to within 0.6% of unchanged by day’s end. Treasurys were bid across the curve, although the 10-year yield rose back to 3.17% late in the day (from 3.2% Monday) in tandem with the rally in stocks. Commodities were hammered with the CRB Index dropping more than 1% and WTI crude sinking below $67 a barrel, but gold managed to finish unchanged at $1,230 per ounce.
Relationship counseling
The high yield drought continues. According to Bloomberg, U.S. corporations have priced 272 speculative-grade bond transactions this year totaling $157 billion, the sparsest slate of fresh supply since the post-crisis year of 2009.
While the junk bond market retrenches, Uncle Sam continues to rifle out the I.O.U’s. This week, the Treasury Department is auctioning $276 billion in fresh debt, approaching the all-time record weekly issuance of $294 billion in March. Today’s $38 billion two-year note auction, the upcoming $39 billion in five-year supply and $31 billion seven-year offering all represent the largest single sale for each maturity since 2010, according to Bloomberg. Seemingly on account of that issuance imbalance, the BarCap High Yield Spread closed yesterday at 345 basis points over the 10-year Treasury, well inside the 371 basis points reached in July.
Relatively tight spreads and thin supply doesn’t mean issuers can name their price. This afternoon, Ba3/double-B-minus-rated Netflix, Inc. sold $800 million in 2029 notes priced to yield 6.375%, up from price talk of 6.25%.
For more on the breakneck pace of Treasury issuance and potential implications for borrowing costs of all stripes, see the Oct. 5 edition of Grant’s Interest Rate Observer.
High jump
The irresistible force meets the immovable object. It’s not just banking and private equity CEOs who continue to hail the strength of the economy (see yesterday’s Almost Daily Grant’s). As documented by the fine weekly review from Avondale Asset Management, corporate executives closer to the front lines of industry likewise extol the virtues of current conditions.
On Oct. 18, Nucor Corp. CEO John Ferriola remarked: “The continued strength of the U.S. economy is the primary catalyst for our earnings growth. Tax and regulatory reform, along with a robust domestic energy sector, are driving this economy.” The same day, United Rentals, Inc. president Matt Flannery described the state of the equipment lenders’ end markets as: “Healthy and growing. And if you ask our customers they’ll tell you that things look good and our branches feel the same way. We’re confident about the fourth quarter and believe the cycle has plenty of gas left in the tank.”
That optimism is certainly baked into consensus expectations. According to analyst estimates tabulated by Bloomberg, earnings per share across S&P 500 companies are expected to grow by more than 10% in calendar 2019, with revenues expected to advance by 5.5%. That anticipated growth rate would take place without the calendar effect of the 2017 corporate tax cuts, and compares to average nominal GDP growth of 4.8% over the trailing four quarters.
On that front, early indications have not been promising. Today, shares in economic bellwether Caterpillar, Inc. sold off by 8% after the construction equipment giant offered full-year 2018 guidance which lagged the Street consensus. In a follow-up interview with Bloomberg, Caterpillar chief financial officer Andrew Bonfield explained: “For a company with a $50 billion top line, you can’t grow that fast forever, otherwise you would be one of the largest growth stocks rather than a cyclical industrial. That’s just not feasible. So, it just becomes the math in the end.”
Also today, shares in conglomerate 3M Co. fell by 4% after the company cut its full-year forecast below the most bearish sell-side analyst, with every business segment underperforming expectation, according to Credit Suisse analyst John Walsh.
More broadly, Paul Hickey, co-founder of Bespoke Investment Group, told the CNBC audience this morning that the ongoing third quarter earnings season is tracking “horribly,” with about three-quarters of companies trading lower in reaction to their figures.
- Philip Grant
Monday, October 22, 2018
Don't shoot the messenger
Store credit
The economy is firing on all cylinders.
The economy is firing on all cylinders.
Recap Oct. 22
Don't shoot the messenger
From the South China Morning Post:
Chinese policymakers have been left searching for answers to the trade war with the U.S. because the domestic think tanks Beijing has called on for guidance have provided “filtered information” to avoid offending supervisors, sources close to the Chinese government and diplomatic observers said.
Store credit
The economy is firing on all cylinders. At least, that’s the verdict from third quarter earnings commentary from banking and private equity CEO’s. On Oct. 18, Blackstone Group, L.P. boss Steve Schwarzman commented: “the US economy remains in great shape by nearly any measure. Growth is strong, confidence is high and there aren’t any signs of the excess we saw ahead of the last down cycle.” Jamie Dimon, CEO of J.P. Morgan Chase & Co., remarked: “The economy could be strong for a while…wages are going up, participation is going up, credit has been written as pristine . . . as we look at the economy, we don’t see it slowing down.”
One potential warning sign: Waning supply of new credit from the big banks. As noted in the Oct. 13 edition of the New York Times, third-quarter lending growth from J.P. Morgan, Wells Fargo & Co., Citigroup, Inc. and PNC Financial Services Group, Inc. registered at 2% year-over-year, down from 2.9% in 2017 and north of 4% across 2015 and 2016.
One way to bolster those flagging stats? Move the goalposts. Today, The Wall Street Journal reports that data analytics company Fair Isaac Corp., which created the widely-used consumer FICO credit score, will soon debut a new methodology known as the UltraFico Score. The new approach, which “is designed to boost the number of approvals for credit cards, personal loans and other debt,” will take into account the borrowers’ payment history with cash transactions, and serve “as an appeal of sorts, likely boosting many applicants with less-than-ideal records,” according to The Journal’s AnnaMaria Andriotis.
On the commercial side, an Oct. 19 dispatch from the Financial Times detailed efforts by PNC to boost its lending activity to small and medium-sized businesses through an online joint venture with peer-to-peer lender OnDeck Capital, Inc. (see the Jan. 23, 2015 edition of Grant’s for more on OnDeck). Lakhbir Lamba, head of retail lending at PNC, told the FT that the digital loan business will allow eastern-U.S.-focused PNC to expand beyond its current geographical boundaries: “We want to grow our client base in small business. As we are digitizing these products, small business in this example, the notion of footprint becomes less important.”
While PNC looks to expand its online lending capabilities, Goldman Sachs Group, Inc. retrenches. On Oct. 8, Bloomberg reported that Goldman has trimmed its loan origination target for its consumer-focused online Marcus unit for next year, “reflect[ing] concern about the stage of the credit cycle and changes in market data.”
Such caution may be warranted. On Thursday afternoon, fast-growing regional institution Bank OZK (formerly known as Bank of the Ozarks, Inc.) shocked the street with a $45.5 million charge-off on a pair of unrelated nonperforming real estate projects in the Carolinas dating back to 2007 and 2008. In response, OZK shares plunged by 27% on Friday and are down 52% since March.
Recap Oct. 22
Stocks ticked marginally lower on the S&P 500, although the NYSE FANG+ Index managed a 1% bounce ahead of earnings later this week from constituents Google, Inc. and Amazon.com, Inc. Treasury yields finished slightly higher across the curve, leaving the 10-year yield at 3.2%, while a stronger dollar helped push the iShares J.P. Morgan USD Emerging Market Bond ETF back toward the lows of the year.
- Philip Grant
Friday, October 19, 2018
Agent provocateur
From Reuters:
From Reuters:
He said it
“Some of the analysts who can’t read numbers.”
“Some of the analysts who can’t read numbers.”
Bad back
Recap Oct. 19
Agent provocateur
From Reuters:
A French member of parliament has proposed that mockery of accents be outlawed, after an irate politician derided a journalist’s southwestern pronunciation before asking if anyone had a question in “understandable French”.
Laetitia Avia of President Emmanuel Macron’s ruling party said she was proposing a bill that would classify such mockery with other forms of prohibited discrimination such as on grounds of sex or race.
Roll over, Peter Sellers.
He said it
“Some of the analysts who can’t read numbers.” That’s how Cleveland-Cliffs, Inc. (CLF on the NYSE) CEO Lourenco Goncalves on today’s quarterly conference call, expressed his displeasure with certain members of the sell-side. Goncalves explained:
It's unbelievable that [big banks] still employ this type of people [sic], you should resign. . . you don't understand your own business. You are a disaster. You are an embarrassment to your parents. With this being said, we are going to use money to reward the long-term shareholders. So, if the stock continues to go down based on these kids that play with computers and somebody else's money, we are going to buy back stock. We are going to screw this guy so badly that I don't believe that they will be able to only resign. They will have to commit suicide.
He then went on to identify one particular source of his ire:
Lisa, before you call the next question, is there a guy named Matthew Korn waiting in line to ask a question. He is – he calls himself an analyst and he works for Goldman Sachs.
With that, we are done and Matthew Korn from Goldman Sachs, you can run, but you can't hide. I will see you at the Goldman Sachs Conference, very soon and bring your commodity desk guy because you owe me that for the last year. It will be easier for you if you have the commodity desk guy with you interviewing me. If you are alone, it will be a lot worse. . . Bring the commodity desk guys or girls with you because I promised you last year that I will take care of him, her next time and next time is coming. [indiscernible] I'll see you guys soon. Thanks for joining me this call today, bye now.
On the bright side, it sounds like Goldman investment bankers can safely skip writing up CLF pitchbooks, which should be a time-saver.
Bad back
The interest rate beat marches on. This morning, both the two-year Treasury yield and three-month Libor rose to fresh cycle highs of 2.90% and 2.47%, respectively, up from 0.48% and 0.26% as recently as 2015.
Such explosive moves at the short-end of the curve have helped tip the investment scales towards floating-rate leveraged loans at the expense of conventional, fixed rate high-yield bonds.
The performance figures are stark. Year-to-date, the S&P/LSTA Leveraged Loan Index is up by 4.3%, eclipsing the 1.65% return generated by the Bloomberg Barclays U.S. Corporate High Yield Index. The gap between the lowest-rated leveraged loans and high yield bonds is even wider; the J.P. Morgan Leveraged Loan Index Split B/CCC Total Return Index is up 11.58% year-to-date through this morning, almost double the 5.93% advance in the Bloomberg Barclays Capital Caa U.S. High Yield Total Return Index.
Credit investors have certainly noticed. Yesterday, Bloomberg reported that the total volume of outstanding leveraged loans overtook high yield for the first time “to cement [leveraged loan’s] status as the go-to financing source for speculative-grade companies.”
Indeed, assets under management at U.S. loan funds reached a record $184 billion in September, according to Thomson Reuters’ Lipper and S&P Global’s LCD units, the ninth straight record reading and up from just over $100 billion in February 2016. It’s not just institutions joining the fray. Lipper likewise reports that September saw $919 million in retail inflows into leveraged loan funds, also the ninth straight month of net additions.
The proliferation of leveraged loans has been so rapid that even the monetary mandarins are paying attention. Last month, former Fed chair Janet Yellen told Bloomberg that "regulators should sound the alarm.” The minutes from the Sept. 26 Federal Open Market Committee identified the loan boom as a reason “to remain mindful of vulnerabilities and possible risks to financial stability.” Across the pond, the Bank of England’s Oct. 3 Financial Policy Committee Meeting featured a similar warning, pointing to the “risk that true leverage multiples were being under-reported . . . if borrowers in leveraged loan markets inflated their earnings in leverage calculations, for example by assuming future efficiency gains.”
Sure enough, a recent analysis by S&P Global Ratings of corporate M&A deals from 2015 found that such hypothetical, future “add-backs” represented 21% of EBITDA for companies with a double-B rating and an eye-watering 50% of EBITDA of those rated single-B.
For more on the growth in leveraged loans and its impact on the credit market, see the issues of Grant’s Interest Rate Observer dated July 13, July 27, Sept. 7 and Sept. 21, among others.
Recap Oct. 19
A solid early rally was erased by mid-afternoon to leave the S&P 500 little changed today and flat for the week, while the NYSE FANG+ Index continued to underperform with a 2% decline over the past five days. Treasury yields finished higher across the board, with the short-end underperforming to pull the curve flatter, while a weaker Dollar Index helped commodities catch a modest bid.
- Philip Grant
Thursday, October 18, 2018
Road to nowhere
Consumers slammed on the brakes. The September CPI reading marked a second straight downside surprise, as the headline 2.3% year-over-year uptick was shy of the 2.4% consensus estimate and well off the 2018 high of 2.9% notched in June and July. There was one particular culprit behind the drop: The “used cars and trucks” category saw a 3% sequential decline, by far the biggest move in the 37 subcomponents which make up the broad CPI index.
The CPI contradicts more widely cited commercial data. J.D. Power and Associates reported in its September Industry Update that its price index hit a near three-year high in August, up 5.4% year-over-year. Of the strength in used-vehicle prices, J.D. Power commented: “there are no signs of it letting up.” This afternoon, J.D. Power released the September figures, which featured a modest 0.4 point sequential decline to leave the used vehicle index near those post-2015 highs, up 2.5% year-over-year.
However, there is reason to believe that the government’s data signal something important. In January, the Bureau of Labor Statistics tweaked the methodology for the used cars and trucks index to a one-month price change adjusted for depreciation, from the prior formula of three-month moving average, adjusted for depreciation, in order to “improve timeliness.”
Daniel Ruiz, founder of automotive research firm Blinders Off, LLC, likewise believes that a sea change has recently taken place. Ruiz reports that his proprietary data indicate that growth in inventories of used vehicles piled up throughout September, rising from 3.19% above their 2017 levels in the first week of the month to 6.24% year-over-year by week four. At the same time, used-vehicle prices dropped precipitously in that same fourth week of the month. Ruiz explains the connection in a recent blog post:
The sudden increase in used vehicle inventory is a strong signal that the rate of sale has slowed due to price increases that consumers are not willing to absorb. Most retail dealers have a rigid 60-day cut off for used vehicle inventory. As a vehicle nears the 60-day mark, the dealer is forced to heavily discount that vehicle or face an even greater loss by disposing of it through wholesale auction (60 days of depreciation, reconditioning expense, transportation and auction fees).
This is also likely related to the sharp drop in used vehicle values during week four of September as retail dealers returned to auction and adjusted their bids after realizing the vehicles they previously purchased did not sell at the prices they anticipated.
Reached by Grant’s to discuss his findings, Ruiz reiterated that the drop in September used-car prices measured by the CPI reflects dealers trying to clear inventory, stating that he’s “fairly certain this will show up in the numbers in a big way.”
Ruiz went on to explain the value of used vehicles as a barometer of overall industry health. After all, used prices are critical for new car sales, as almost all transactions involve a trade-in. In particular, bearish recent price action in Ford Motor Company and General Motors Company (each down about 30% since June) may be discounting significant operating pain ahead.
Used car prices are critically important. As loan terms have increased through this cycle, the time to equity increases [i.e., it takes longer for a leased vehicle to accumulate positive value at trade-in], meaning a drop in residual values has major implications for demand for new vehicles.
The rate of change (both buildup in inventories and decline in used car prices) is extremely fast. This will hurt the automakers in two ways: Incentive spending will need to rise, which hurts margins. If increased incentive spending fails to stabilize inventory levels, production will need to fall, which hurts volumes. The OEMs will not be able to respond immediately, so the fourth quarter and first quarter of next year could be ugly.
There are other indications that the CPI may be heading lower in the near-term. According to the September market report from real estate website Zillow Group, Inc., median nationwide rent declined 0.2% year-over-year in September, the first negative reading in six years. For context, the shelter component is given a 32.9% weighting in CPI calculations.
QT progress report
The Fed’s portfolio of securities held outright registered at $3.977 trillion, a modest $1.6 billion sequential decline to mark the second straight week of relative inertia and leave the portfolio less than $16 billion below the trailing four-week average.
Since QT began on Oct. 1, 2017, the Fed’s total balance sheet is down by 6.39%.
Recap Oct. 18
Stocks tumbled once more, with the S&P 500 falling 1.5% to nearly erase Thursday’s big gain, while the NYSE FANG+ Index lost 3% and now sits 16% below its June peak, compared to a 5.5% drawdown in the SPX. Treasury yields ticked lower across the board to leave the 10-year below 3.18%, and commodities were hammered as WTI crude fell below $69 a barrel, although gold managed to eke out a positive finish to settle near $1,225 an ounce.
A bit of symmetry: The Italian 10-year yield finished the day at 3.69%, almost exactly 200 basis points above its 2018 low of 1.71%, reached exactly six months ago.
- Philip Grant
Tuesday, October 16, 2018
On the back foot
It was a familiar scene to many a fund manager. This morning’s third quarter earnings release from BlackRock, Inc. (BLK on the NYSE) featured a divergence between results and reaction, as adjusted earnings per share came in well above the most bullish Wall Street estimate and assets under management rose a hearty 8%, yet the asset manager was rewarded with a 4.5% decline in its share price. Since rising by more than 60% from its fall 2016 levels, BLK has since given back the bulk of those gains and now sits higher by just 13% over that two-plus-year period, lagging the S&P 500’s 30% advance.
What’s triggered the ire of Mr. Market? While BlackRock’s iShares ETF unit continued to hoover up assets with $33.67 billion in inflows, institutional investors headed for the hills to the tune of $24.8 billion in outflows across index and active management strategies, nearly triple the prior quarter’s leakage and the worst showing since 2015. Chairman and CEO Laurence Fink made no attempt to sugarcoat the latter development, saying in a subsequent CNBC interview that “I was disappointed in the net flows,” and also telling Bloomberg: “We’re not particularly happy.”
Fee compression looks to be a source of particular agitation for BlackRock and BLK bulls. Operating margin for the quarter registered at 39%, down from 39.6% year-over-year, while the 8% year-over-year uptick in AUM (as well as an 18% jump in the technology unit headlined by the oft-heralded Aladdin risk management system) translated to overall revenue growth of just 2%.
Kevin Duffy, co-founder and principal at Bearing Asset Management, summed it up to Grant’s: “Bottom line, despite the ETF boom, fee compression is eroding revenue growth and margins. BLK is increasingly dependent on a cutthroat commodity business.”
As for the passive investment industry as a whole, the battle for market share continues apace. Recall that in July, the Vanguard Group announced it would offer nearly 2,000 external ETFs with no trading fees for users of its in-house online brokerage. On July 12, Morningstar, Inc. announced it will launch nine in-house mutual funds in the third quarter, replacing the actively managed funds that it had selected to run its $44 billion in assets, a move that could cut fees by about 20%, according to Daniel Needham, president of Morningstar’s investment management unit. For his part, Dave Natig, managing director of ETF.com, foreshadowed the price war in July 2017, telling Reuters: “Brand names on indexes matter less and less every year.”
The ZIRP and QE-induced levitation in all asset prices was particularly favorable for BlackRock. Might the opposite scenario play out? A bearish BLK analysis in the Sept. 30, 2016 edition of Grant’s drew the connection between the “bull market in everything” and the runaway success of Fink’s passive management behemoth:
Economic growth can explain only so much of America’s pan-asset-class bull market. The rising tide of money (the falling rate of interest) must also share in the glory. Active managers, futilely trying to pick stocks and bonds, have failed to match the performance of the passive managers who merely “seek exposure.” Perhaps it’s no coincidence that, since 2007, BlackRock’s assets under management have grown in tandem with the Fed’s balance sheet.
On the earnings call, Fink cited “ongoing divergent monetary policy and geopolitical uncertainty” for the flight of institutional capital. Indeed, one may wonder if the Fed’s recent pivot toward QT (as well as the planned cessation of stimulus by the ECB and BOJ), and accompanying turn in interest rates, may have a more lasting impact on the business.
As for broader ramifications of the rise in passive management, a September white paper from Acadian Asset Management might put things into perspective:
We find evidence that passive investing is modestly reducing the short-term efficacy of active, factor-oriented strategies by slowing down the convergence of mispricings. These results are consistent with a view that the rise of passive largely represents a “dumbing down” of investment activity in a way that might exacerbate mispricings but also increase their persistence.
BlackRock’s post-crisis ascent has coincided with a brutal period for those who attempt to buy low and sell high. With any luck, the House of Fink’s recent stumble augurs a turn in fortune for active management.
Recap Oct. 16
Party (back) on. Stocks ripped higher with the S&P 500 gaining more than 2% and the Nasdaq 100 nearly 3% to give the bears a taste of their own medicine following last week’s equity rout. By contrast, Treasury yields once again remained relatively inert amid the latest big move in stock prices, with the 10-year settling at 3.16%, while commodities and the Dollar Index both traded little changed to remain in the upper end of their respective 2018 ranges. The VIX dropped sharply to settle just above 17, nearly 40% below Thursday’s intraday peak.
After the close, shares in Netflix, Inc. jumped 12% in initial reaction to third quarter results that featured net subscriber additions far above the Street consensus.
- Philip Grant
Monday, October 15, 2018
Rest' stop
Tough times continue apace for the restaurant industry, as spending at eating and drinking establishments fell 1.8% on a sequential basis in September, the biggest decline since 2016, according to the U.S. Census Bureau's Advance Retail Sales data.
A glance at research firm TDn2K’s third quarter report might lead to a different conclusion. “Q3 Sees Best Restaurant Sales and Traffic Growth in Three Years” is the headline over that Oct. 11 missive. However, that three-year high in comparable-store sales was a mere 1.2% growth for the third quarter (well short of the 2.3% measured rise in consumer inflation in September), while store traffic saw an outright decline of 1.4% from a year ago. As TDn2K points out, “it is only through rising guest checks that restaurants are able to post top-line growth.”
The operating environment may be rugged, but valuations for the group remain generous. The S&P 500 Restaurants Index trades at 23.5 times trailing earnings and 14.7 times enterprise value to EBITDA, a premium to the 20 times earnings and 13.2 times EV/EBITDA currently on offer for the S&P 500. Acquisitive fast-food giant (and subject of a bearish Grant’s analysis on June 2, 2017) Restaurant Brands International, Inc., which last year bought Popeye’s Louisiana Kitchen, Inc. for 21 times EBITDA, currently fetches an EV/EBITDA multiple of over 17 times, while carrying net debt of just over five times the consensus estimate for 2018 adjusted EBITDA.
That contrast between premium valuations and less-than-stellar performance may be explained by the now-ubiquitous franchisor/franchisee model, which has allowed restaurant chains to pass operating costs on to the unit owners while maintaining steady cash flows from fees. John Hamburger, president of the Restaurant Finance Monitor, explained the situation at the 2018 Grant’s Spring Conference:
When you look at the valuations Wall Street has placed on these 100% asset-light franchisors, you’d think this is a fantastic system. On one side you have a franchisor with no capital expenditures and no day-to-day street-level exposure collecting royalties and rents by the bushel-basket, trading at double-digit multiples, all the while levering up to pump cash out to shareholders like there’s no tomorrow. On the other side, [you have] a franchisee, one that’s actually in the trenches running these restaurants and finding out it’s not a very friendly operating environment right now.
I’m here to tell you this Shangri-La doesn’t go on forever. You can’t have one side of the franchise contract getting fabulously rich while the other side faces these headwinds alone. The concept of a moat around a franchisor is a myth. That somehow a brand can separate itself from the unit-level economics of its franchisees is not grounded in reality. Something will give.
Indeed, the ongoing dispute between Restaurant Brands and a group of aggrieved franchisees of its Tim Horton’s unit known as the Great White North Franchisee Association continues to escalate. According to a Sept. 4 dispatch from the Canadian National Post, RBI seized control of the GWNFA president David Hughes’ four Tim Horton’s locations after accusing Hughes of leaking “confidential company information with the media." The week before, Hughes’ lawyer sent a letter to RBI’s legal department “alleging coffee pots have been shattering and injuring employees,” according to the report. For his part, Hughes told the Post: “This is just pure intimidation.”
While less contentious, a similar yet potentially more impactful development may be underway at the world’s largest fast-food chain. Last week, McDonald’s franchisees met in Tampa, Florida, to discuss forming an advocacy group “to address their concerns that the burger giant’s sales growth isn’t keeping pace with the costs of modeling restaurants,” according to The Wall Street Journal.
As for the outcome, franchise news-source BlueMauMau reports on Twitter that when the meeting turned to the question of whether such a self-funded advocacy group was needed, “this was answered with a resounding yes by all [400] attendees.”
Recap Oct. 15
Stocks suffered a late slide to wrap up moderately weaker on the S&P 500, with the NYSE FANG+ Index resuming its recent underperformance after a reprieve last week. Treasury yields were little changed, with the curve flattening a bit as the 10-year settled at 3.15%, while commodities enjoyed a strong day to push the CRB Index above its 2018 average as gold rose above $1,225 an ounce.
- Philip Grant
Friday, October 12, 2018
Recap Oct. 12
Tesla searches for liquidity
From Business Insider:
From Business Insider:
Honor among thieves
On Tuesday, Coindesk.com reported an eye-catching development in the digital currency realm:
On Tuesday, Coindesk.com reported an eye-catching development in the digital currency realm:
Wide bloat
Recap Oct. 12
It was a good day for the bulls, as a strong bounce in the S&P 500 narrowed the week’s losses to 4% and pushed the broad index to within 6% of the Sept. 20 peak, while the NYSE FANG+ Index outperformed for a second straight day. A solid day for commodities allowed WTI crude to rise back above $71 a barrel, and Treasury yields ticked higher with the 2- and 10-year Treasury spread approaching three month highs north of 30 basis points. The VIX reversed mid-day gains to finish down 14%.
Tesla searches for liquidity
From Business Insider:
Tesla, Inc. filed a federal trademark application dated on Monday for the name “Teslaquila” consisting of either “distilled agave liquor” or “Distilled blue agave liquor.” Shortly after, Musk tweeted a “visual approximation” of the alcohol, branded with the Tesla logo and in its signature typeface.
This afternoon, Musk hopped on Twitter to discuss climate change:
Tesla exists to help reduce risk of catastrophic climate change, which affects all species on Earth. Even if your faith in humanity is faltering, this is worth caring about. Support makes a difference. Thank you.
You heard the man: Drink tequila, save the planet.
Honor among thieves
On Tuesday, Coindesk.com reported an eye-catching development in the digital currency realm:
SpankChain, a cryptocurrency focused on the adult industry, has suffered a breach that saw almost $40,000 in ethereum (ETH) stolen. In a blog post published Tuesday, the SpankChain team disclosed the hack, saying 165.38 ETH (worth around $38,000 at the time) had been lost at around 18:00 PST on Saturday. The intrusion, which the post said was made possible by a bug in the network’s payment channel smart contract, also caused $4,000 in SpankChain’s BOOTY token to be frozen.
Luckily, this heist had a happy ending. Today, Coindesk reports in a follow-up that the hacker returned the ethereum after a telephone conversation with SpankChain CEO Ameen Soleimani.
While SpankChain and its users managed to recover their digital ducats, theft remains a significant problem. According to cybersecurity firm CipherTrace’s Third Quarter 2018 Cryptocurrency Anti-Money Laundering Report, $927 million of coins have been stolen by hackers through the first three quarters of 2018, or nearly 50 basis points of the current $201 billion market capitalization of all cryptocurrencies, as measured by Coinmarketcap.com.
Wide bloat
Yesterday, bond bulls caught a bit of a breather as the September headline CPI rose 2.3% year-over-year, below the consensus 2.4%. It was the second straight negative surprise for the indicator, after the July reading featured 2.9% headline growth, the hottest reading since December 2011.
Might the recent turn in CPI augur a cooling of the price pressure that has been building across the economy? Bond bulls sure hope so. According to the New York Fed’s Underlying Inflation Gauge, which purports to capture “sustained movements in inflation from information contained in a broad set of price, real activity, and financial data,” prices rose 3.12% year-over-year in September, a second straight sequential decline. Nevertheless, the indicator has held near the upper end of its long-term average since the summer, and remains near the 10-year Treasury yield of 3.14%.
NY Fed’s Underlying Inflation Gauge, full data set. Source: The Bloomberg
The uptick in prices is making a tangible impact. Yesterday, the Social Security Administration announced a 2.8% increase in benefits for 2019, under COLA, or the cost of living adjustment. That’s the highest since 2012 and up from 2.0%, 0.3% and 0.0% for 2018, 2017 and 2016, respectively.
Some retirees still felt the jump was insufficient. Danette Deakin of Bolivar, Missouri, told the Associated Press:
It isn’t enough of an increase that it takes care of all of the increases from health care, plus rent – our rent gets increased every year. I appreciate the COLA adjustment, and in no way am I complaining. It’s just that every single thing you can talk about goes up. It doesn’t go down.
Ms. Deakin might find agreement in corporate boardrooms across the country. Yesterday, pharmacy chain Walgreens Boots Alliance, Inc. announced it would spend $150 million to boost the wages of its in-store employees in 2019, up from an initial $100 million outlay announced in March. That follows last week’s announcement from Amazon.com, Inc. that it will raise minimum wage to $15 an hour for all employees, while also giving a raise to others who already earn above that threshold.
On Wednesday, industrial and manufacturing supplier Fastenal Company (FAST on the Nasdaq) reported a year-over-year decline in gross margins despite passing “higher incremental pricing” on to its customers, thanks in part to “higher freight costs at the branch level.” This morning, shares in industrial manufacturer Wabash National Corp. (WNC on the NYSE) sold off sharply following soft third quarter results. In explaining the miss, CEO Brent Yeagy likewise focused on pricing pressure:
On the cost side of the business, higher commodity and component costs impacted the quarterly results as raw material costs continued to escalate . . . Labor instability continued to create operating cost pressures at many of our locations. Those labor cost pressures resulted in higher levels of overtime and lower productivity.
Speaker of lower productivity, have a good weekend.
- Philip Grant
Thursday, October 11, 2018
Opposite day
Kanye West visited the White House today.
Kanye West visited the White House today.
Squeeze, Inc.
QT Progress report
Recap Oct. 11
Opposite day
Kanye West visited the White House today. Meanwhile, the finance industry enters the rap game. From the Financial Times:
As newly minted Refinitiv employees gird for a stinging round of cost cuts after its $17 billion leveraged buyout by Blackstone, the company has found one fan pledging allegiance to the new corporate brand.
A rap written by Robin Lee, a Refinitiv employee based in Asia, has been forwarded to the company’s thousands of employees and posted on its internal website, according to an email seen by the Financial Times, with a version of the song appearing online.
The rap, partly a morale booster for the indebted group’s ranks, tells so-called “Refinitivees” to spread “them wings” and take to the sky, bring the heat “every day till we die” and to change “tha game and we’ll do it with a bang”.
Back to your day jobs, everyone.
Squeeze, Inc.
Once more to the well. This morning, high-end furnishings concept RH, Inc. announced it was prepared to buy back up to $700 million of stock. No run of the mill repurchase, the size represents a substantial proportion of RH’s current $2.6 billion market capitalization, and will be funded through a combination of “existing cash, cash flow, borrowings under existing credit facilities, and proceeds from incremental borrowing arrangements,” according to the press release. A hefty contingent of shorts (38% of the float according to Bloomberg) looked to be caught offside by the announcement. Shares rose 10% in response, but remain 25% below their June peak.
The beset bears have recent experience in such dealings. Last year, RH authorized a pair of stock repurchases totaling $1 billion, or 20.22 million shares, which was enough to retire nearly half of the shares outstanding. Recent pullback aside, RH’s stock price has been on a rampage, rising to $120 a share from $25 as recently as February 2017.
RH (formerly Restoration Hardware) and its colorful CEO Gary Friedman are building a reputation as a fearsome foil for the legion of bears who circle the stock. Last September, Friedman was asked at a Goldman Sachs investor conference about the-then 52% short interest: “Listen, I don’t care. Everybody can gamble the way the want to gamble, honestly.” On Dec. 28, Friedman told the San Francisco Business Times: “People are going to bet against us. We’re going to bet on ourselves.” With his healthy attitude towards those who sell stock first and buy later, Friedman is no Dick Fuld, or Elon Musk for that matter.
However, there are fairly pressing financial reasons for Friedman et al. to bet on themselves. The moderately-levered (net debt stands at just under three times consensus 2019 adjusted EBITDA) balance sheet features a trio of zero-coupon convertible notes, with a $350 million note at a $116.09 conversion price set to mature in June 2019 and second $300 million convertible note ($118.13) scheduled to mature in July 2020, both near the current trading level of RH shares (the third, $335 million convertible, issued last year, has a conversion price of $193.65 and matures in June 2023).
The company also issued a pair of term loans last year, a $283 million, first-lien tranche priced at 1.5% over 3 month Libor and a $100 million second-lien, at 8.25% over, which RH has subsequently repaid. For context, cash and cash equivalents foot to $22.2 million as of Aug. 4, according to the most recent form 10-Q.
If the stock price sags, unrated RH could find itself compelled to refinance at less advantageous terms: A hypothetical 6% interest rate (roughly 3.6% over current Libor and below the 6.61% on offer from the Bloomberg Barclays High Yield Index) on the pair of refinanced convertibles would cost RH $39 million in annual interest expense. For context, the sell-side expects RH to generate $334 million and $355 million in operating profit in fiscal 2020 and 2021, respectively. Those estimates already assume significant margin expansion: The Street expects operating profit to reach 12.3% and 11.9% of revenue in fiscal 2020 and 2021, up from 10.3% in the trailing 12-months ended Aug. 4 and an average of 6.7% over the five years ending in fiscal 2018.
Friedman has squeezed the shorts masterfully. Now the real work begins.
QT Progress report
No change this week, as the Fed’s portfolio of securities held outright remained at $3.98 trillion, $21 billion below the trailing four-week average. Since QT began on Oct. 1, 2017, total balance sheet assets are down by 6.26%.
Recap Oct. 11
Stocks were hammered again, with the S&P 500 dropping nearly 2% to extend its losses to 5% for the week, although the recently-beleaguered NYSE FANG+ Index managed a flat finish. Treasury yields finished little changed (at least relative to the chaos in stocks) for a second straight day, while energy prices tumbled with WTI crude dropping below $71 a barrel following a larger than expected inventory build. The VIX rose another 11% to 25, still well below its February peak of 37, and gold caught a strong bid, jumping 2.5% to a two-and-a-half-month high near $1,225 an ounce.
- Philip Grant
Wednesday, October 10, 2018
Flying squirrel. Grounded.
From the Associated Press:
From the Associated Press:
And so it came to pass
During yesterday’s 2018 Grant’s fall conference at the Plaza Hotel
During yesterday’s 2018 Grant’s fall conference at the Plaza Hotel
Still the epitome of the cycle
They’re looking to make it official.
They’re looking to make it official.
Recap Oct. 10
Flying squirrel. Grounded.
From the Associated Press:
Police had to remove a woman who brought an “emotional support squirrel” on a Frontier Airlines flight headed from Orlando, Florida to Cleveland.
Frontier says the passenger had noted in her reservation that she was bringing an emotional support animal with her on Flight 1612 Tuesday night. But she did not indicate it was a squirrel.
The airline says rodents, including squirrels, are not allowed. The airline says police were called when the passenger refused to leave the plane.
The flight left for Cleveland about two hours later.
And so it came to pass
During yesterday’s 2018 Grant’s fall conference at the Plaza Hotel, Stanley Druckenmiller noted the proliferation of so-called corporate zombies, making special mention of long-lingering Sears Holdings Corp.: “Sears is still in business. Who needs that thing? What function is Sears serving in our society?"
It didn’t take long for the great investor to prove prophetic. Bloomberg reports that Sears is “laying the groundwork for a bankruptcy filing as soon as this weekend.”
A Sears restructuring may have seemed a foregone conclusion, but some creditors apparently hadn’t got the memo. S&P Global’s LCD unit reports the company’s second-lien 6.75% notes due Oct. 15 changed hands near 55 cents on the dollar this morning, down 32 points on the day.
For a more comprehensive summary of the ideas and analyses presented by Druckenmiller and the rest of the conference speakers, see the upcoming issue of Grant’s Interest Rate Observer.
Still the epitome of the cycle
They’re looking to make it official. Yesterday evening, The Wall Street Journal reported that Japanese conglomerate SoftBank Group Corp. (9984 on the Tokyo Stock Exchange and SFTBY on the American Pink Sheets) is in talks for an additional $15 billion to $20 billion investment in WeWork Cos. Such a deal would allow SoftBank to take a majority stake in the office-share unicorn, while also allocating roughly one quarter of the $92 billion Vision Fund to a single company. In the eight short years since its 2010 founding, WeWork has swiftly laid claim as the largest office tenant in both Manhattan and London, according to Bloomberg.
Peculiar features of the loss-making WeWork have been well ventilated (for a discussion of WeWork’s bespoke earnings metrics, see the Almost Daily Grant’s from April 24). How fares other realms of SoftBank chief executive officer Masayoshi Son’s corporate empire?
Today, Bloomberg reports that Uber Technologies, Inc. is preparing to issue junk bonds, at similar terms to the $1.5 billion in five- and seven-year leveraged loans that the private ride-share company sold in March. Uber remains swamped by red ink, losing $4.5 billion last year, well ahead of its $2.8 billion loss for 2016. In January, Uber sold $9.25 billion in stock to SoftBank at a blended valuation of $54 billion, nearly matching the $58 billion market capitalization of FedEx Corp. (FDX on the NYSE). In the 12-months ended May 31, FedEx generated $4.6 billion in GAAP net income.
Alibaba Group Holding Ltd. (BABA on the NYSE) has long been the crown jewel of SoftBank’s investment portfolio, as a $20 million investment for 28.8% of BABA shares in 2000 ballooned to an approximate $158 billion valuation as recently as June. It’s been a different story since, as BABA has fallen 34% in the past four months, with losses accelerating following the announced retirement of co-founder and executive chairman Jack Ma on Sept. 7. On April 6, Bloomberg reported that SoftBank took an $8 billion margin loan from a consortium of ten banks backed solely by its holdings in Alibaba shares, which were worth about $125 billion at the time. Today, the valuation of SoftBank’s BABA stake has declined to around $103 billion.
Then there’s Sprint Corp., the corporate problem-child for which Masa Son’s company paid $22 billion for an 83% stake in 2013. Following years of stagnant-to-declining revenues ($32.4 billion in the 12-months ended March 31, down from $34.5 billion in the 12-months ended March 31, 2015) and persistently negative free cash flow ($25.5 billion of cumulative red ink from March 31 2014 to March 31 2018), Sprint agreed to be acquired by peer T-Mobile U.S., Inc. in a stock deal that currently ascribes a $25 billion equity value to the target, according to data from Bloomberg. However, the merger has yet to be approved, and regulatory concerns loom large. Craig Moffett, co-founder of media and telecom research firm MoffettNathanson (and speaker at yesterday’s Grant’s fall conference – advt.), wrote on Aug. 1 that while “absent a merger, Sprint was destined for insolvency . . . the merger has no better than even odds of being approved.”
As for double-B-plus-rated SoftBank itself, the holding company’s total debt footed to $171.3 billion (excluding Sprint and Yahoo Japan liabilities, which are non-recourse to SoftBank) as of June 30, against $28 billion in trailing 12-month adjusted EBITDA and $25.4 billion in cash. During the 2018 fiscal year ended March 31, SoftBank generated $215 million in free cash flow, while paying out $432 million in dividends.
In a bearish analysis of the company in the Dec. 15, 2017 issue, Grant’s identified a pair of SoftBank credits for particular scrutiny; the senior unsecured 6s of 2025 and the perpetual 6 7/8 dollar notes, which have since fallen to 102 and 91 cents on the dollar, respectively, from 106.5 and 102 at publication time. That Dec. 15 analysis included a 1990-era truism which SoftBank creditors the world over may do well to remind themselves: “Asset values are contingent, but debt is forever.”
Recap Oct. 10
Stocks were bludgeoned, with the S&P 500 falling 3.3% and the NYSE FANG+ Index dropping 5.6% to approach bear market territory, down 18% from the June highs. Treasury yields ticked only a bit lower on the short end with the long bond yield rising slightly, notable considering the large recent rise in yields and carnage in equities today. Commodities were also hit hard, with WTI crude sinking to $72 a barrel, while the VIX jumped 42%.
It was all enough for CNBC’s Jim Cramer to declare: “I really miss Janet Yellen.”
- Philip Grant
Monday, October 8, 2018
Potemkin village
Down goes the renminbi. The redback fell by a hearty 0.8% during today’s Asian session to close at 6.926 per dollar, the weakest finish since March 2017. The renminbi’s latest leg lower follows a 100 basis point cut to the reserve ratio requirement of Chinese banks, a move which frees up RMB 750 billion ($109 billion) in liquidity.
Could the yuan trade above seven per greenback? Ken Peng, strategist at Citi Private Bank in Hong Kong, tells Bloomberg that “the RRR cut sends a strong signal that China is in an easing cycle and all external news makes the case for a stronger dollar.”
Of course, the Sino-American trade dispute figures prominently in any assessment of current conditions in the Middle Kingdom. In a meeting today with U.S. Secretary of State Mike Pompeo, foreign minister Wang Yi told the diplomat that the U.S. hard line on trade has “directly impacted our mutual trust and cast a shadow over our bilateral relations.” On Friday, data from the U.S. Census Bureau found that China imported no U.S. crude oil in August, down from just under 12 million barrels in July and the first such whiff since September 2016.
As Beijing grapples with the Trump administration, some economic indicators suggest mounting troubles in the world’s second-largest economy. The pronounced weakness in Chinese equities continues apace, with the Shanghai Composite Index sinking by nearly 4% today to extend its year-to-date loss to 18%. The weaker renminbi has likewise corresponded with a hint of capital flight, as FX reserves declined by $22.69 billion in September, the biggest drop in seven months.
Meanwhile, growth in credit and in the money supply are both slowing. According to the People’s Bank of China, the net change in aggregate financing totaled RMB 12.2 trillion ($1.7 trillion) through August, down 13% year-over-year. Chinese M2 growth likewise reached 8% year-over-year in June, the lowest in at least 20 years, and remains near that nadir.
Year-over-year change in Chinese M2 money supply. Source: The Bloomberg
Then there’s the property market. A Bloomberg dispatch from today details a less-than idyllic scene which unfolded during the just-completed Golden Week holiday:
A sales center for Xinzhou Mansion, a project of Country Garden Holdings Co. located in Shangrao, a city in Jiangxi province, was mobbed last Thursday, videos and pictures on social media show, its windows smashed by scores of protestors throwing rocks. They’re furious that Country Garden is selling units for prices around 30% lower than a year ago.
Also last week, Country Garden peer China Vanke Group Co. Ltd. announced a roughly 50% price cut to new townhouses in the city of Xiamen, according to an Oct. 2 report by the Epoch Times. The homebuilder, founded in 1984, is girding for a rough road ahead. According to Chinese publication The Paper, the theme of Vanke’s fall conference in Shenzen was “survival.”
With credit growth on the wane and the lynchpin property sector coming under (at least anecdotal) pressure, how might the government respond? Market manipulation, naturally. In an Oct. 1 commentary, Anne Stevenson-Yang of J Capital Research notes the extent of the Chinese government’s grip (and economy’s reliance) on house prices, while offering an ominous assessment of a broad downturn’s potential impact:
The whole Chinese economy surfs atop property speculation, and values of residential real estate, although in vast oversupply, have lofted higher year after year, often in double digits . . . What sustains high residential property prices, at current exchange rates exceeding most of the toniest cities in the world, is not an excess of demand over supply. It is rather a unique combination of Chinese features, including the state ownership of land and the local government allocation of it, local government dependence on rising land values, local government involvement in building materials and construction, and local controls over postable land values and sale prices. Taken together, these interventions have jacked up property prices to levels far, far beyond what any natural market would support. If real market transactions ever took control of property prices, there would be a devastating reset.
Seemingly, everyone understands that when property prices crater, that is when debt throughout the economy becomes unsupportable. Inflated property prices are the core asset base of a vast chunk of bank assets. The task for China’s government is to freeze up the markets transactions in order to trap current artificial values in property, thus making sure that consumer feel rich on paper without actually being able to pull cash out of the market. That will enable banks to maintain the high book value of property that collateralizes their loan books.
So, then, Harry Potter to the rescue?
Recap Oct.8
Stocks rebounded from an intraday dip for a flat finish on the S&P 500, despite another rough day for tech as the NYSE FANG+ Index dropped more than 1%. Commodities were generally bid despite a green finish for the U.S. Dollar Index, while the VIX rose to a three-month closing high. The bond market was closed for Columbus Day, a reprieve that Treasury bulls undoubtedly appreciate.
- Philip Grant
Friday, October 5, 2018
Cooking with gas
On Wednesday,
On Wednesday,
Basis pointers
The selloff in U.S. Treasury bonds has accelerated in recent days,
The selloff in U.S. Treasury bonds has accelerated in recent days,
QT Progress report
Recap Oct. 5
Cooking with gas
On Wednesday, the price of West Texas Intermediate crude briefly surged to nearly $77 a barrel, almost triple the low tick registered on Feb. 11, 2016. In an interview yesterday, IEA executive director Fatih Birol told Reuters: “It is now high time for all the players, especially those key producers and oil exporters, to consider the situation and take the right steps to comfort the market, otherwise I don’t see anybody benefiting.” Two weeks back, president Trump hopped on Twitter to deride OPEC for higher prices, demanding that the cartel “get prices down now!”
Presidential rhetoric aside, the pain of higher prices is particularly acute outside of the U.S., as the dollar has remained firm against most major currency pairs this year. Indeed, Brent crude priced in the Chinese Renminbi has risen by 47% since February. Brazilians, who are facing an upcoming presidential election featuring extremist candidates on either end of the political spectrum (Grant’s, Oct. 3), have absorbed a 58% rise in oil priced in the real over that same period. Oil priced in the Indian rupee has jumped by 55% in the past eight months.
Basis pointers
The selloff in U.S. Treasury bonds has accelerated in recent days, pushing the benchmark 10-year yield to 3.23%, the highest since 2011 and up from 2.01% as recently as September 2017. Treasury bulls are seemingly beset on all sides: Today’s reading of September non-farm payrolls included 2.8% year-over-year growth in average hourly earnings, marking four straight months of 2.8% or higher wage growth, the best streak since the financial crisis. The data follow a record reading of the Institute for Supply Management’s Non-Manufacturing Index for September, released Wednesday.
The scalding economy is catching the already-tightening Fed’s attention. Raphael Bostic, president of the Federal Reserve Bank of Atlanta, remarked today that the rapid pace of expansion is enough for him to change his mind and advocate for higher rates:
The incoming economic data on the real side of the economy have come in stronger than I had been expecting earlier this year. So much stronger, in fact, that the central question in my mind is whether the apparent strength in GDP and job growth is a signal that I have materially underestimated the underlying momentum of aggregate demand. If that's the case, the potential for overheating would require a higher path for rates than what I had been thinking.
Investors are definitely getting the message, as the CFTC’s Commitment of Traders report from Sept. 25 shows that non-commercial holders are net short a record 756,316 10-year futures contracts. As recently as December, speculators were net bullish on the 10-year. James McAlevey, portfolio manager of the Aviva Investors Multi-Strategy Fixed Income Fund and a confirmed member of the suddenly-crowded bear camp, told Bloomberg: “We have a structural short duration position in the U.S. because we expect the Federal Reserve will continue normalizing policy and that inflation will increase as jobs growth and wage pressure builds.”
Pressure is likewise starting to build on the Federal coffers. As noted by Bloomberg’s Lisa Abramowicz on Twitter, interest payments on Federal debt jumped to a record $523 billion in fiscal 2018, up 45% from fiscal 2012. That’s despite borrowing costs that, recent move aside, remain far below their own long term average.
Federal interest on Treasury debt (in white) vs. 10-year yield (in orange). Source: The Bloomberg
While higher rates are a clear negative for the U.S. fiscal position, the impact on commercial borrowers is more nuanced. In a note yesterday, data scientist Ben Breitholtz of Bianco Research performed an analysis of corporate bonds by industry group. Unsurprisingly, he found that “the impact of higher U.S. 10-year yields is quite negative for a slew of investment grade industries including oil & field services, natural gas, utilities and railroads.” It’s not all doom and gloom, however. Breitholtz likewise reports that “home construction, airlines, leisure, banking, and automotive have been positively impacted.”
By the same token, the impact of higher Treasury rates on the emerging market realm is a mixed one. Breitholtz finds that while “Argentina, [the] Philippines, India and Indonesia have historically struggled during higher yields, Russia, Taiwan, Colombia and [the] Czech Republic have [seen] a positive to modest impact.”
QT Progress report
Happy anniversary! Yesterday’s release of the Fed’s weekly balance sheet marks just over one year since the commencement of the unwinding of crisis (and post-crisis) era asset accumulation. This week’s reading of $3.978 trillion in securities held outright represents a $19 billion decrease from a week ago, with Treasurys representing all of the decline. Compared to the trailing four-week average, yesterday’s figure was down by $30 billion, with Treasurys accounting for about two thirds and Mortgage-Backed Securities the remainder.
Since QT began on Oct. 1, 2017, the Fed’s total balance sheet holdings are down by 6.3%.
Recap Oct. 5
Stocks fell again, with the S&P 500 retreating to 1.5% below its closing highs, while old leaders continue to struggle as the NYSE FANG+ Index fell 4% on the week and now resides roughly 12.5% off its own high water mark. Treasury yields again lurched higher across the board, while the VIX managed its first weekly close above 15 since the end of June. Gold inched back above $1,200 an ounce.
- Philip Grant
Tuesday, October 2, 2018
They ate the cake
Another large deal is in the books. Last Thursday, Envision Healthcare Corp. priced $5.45 billion in term (leveraged) loans and $1.225 billion in high-yield senior notes to finance its acquisition by private equity firm KKR & Co., Inc. Transaction highlights include a $400 million upsized term loan tranche (the high yield segment was downsized by an equal amount), an 8.75% yield on the fixed rate senior notes, and 375 basis point spread over Libor on the term loan, down from initial price talk of 400 basis points.
The investment bankers added a bit of flair to get the deal done. According to Bloomberg, salesman at Credit Suisse Group AG included “a photograph of a few crumbs of cake left on an otherwise empty plate” in marketing materials pitching the term loan. Considering that the loan saw upsized placement at a lower-than-indicated yield premium, it appears investors got the message.
As with the Blackstone Group L.P.-led consortium takeover of Refinitiv, Inc. (Almost Daily Grant’s, Sept. 11), the deal is a notable one, and not in a way that bodes well for investors. In a note last Monday, our friends at Covenant Review alerted readers to some particularly unpleasant features which await Envision creditors. Speaking of the $1.225 billion senior notes tranche, analyst Scott Josefsburg writes:
This deal includes a radical change to the customary rules regarding the payment of dividends and other Restricted Payments. KKR is seeking to eliminate entirely any financial performance test for making Restricted Payments using the build-up basket [or the portion of accumulated profits which are available for dividends, etc.]. This may be one of the most drastic covenant changes we have seen in years.
Now KKR wants the ability to take out dividends and other distributions to equity whenever, regardless of the financial health of the portfolio company, so long as there has, at some point, been enough Consolidated Net Income.
You can’t fault private equity’s past performance. According to Daniel Rasmussen in the spring 2018 edition of American Affairs, PE managed a 14.4% annual return, after fees, between 1990 and 2010, easily surpassing the 8.1% yearly gain in the S&P 500 over that period.
While the industry has subsequently lagged the S&P by 1.5% a year since 2012, the capital spigot continues to flow. Hugh MacArthur, head of global private equity at Bain & Co., noted in the firm’s 2018 Global Private Equity Report: “If it’s possible, fundraising has been too good, with an unprecedented $3 trillion raised over the past five years.” Today, Blackstone is set to raise up to $3.3 billion for a new fund that would buy stakes in alternative investment managers such as other PE firms, according to Bloomberg.
Could PE’s massive sums under management, prodigious deal making and high-wire debt issuance lead to problems down the line? A May 7 analysis from Empirical Research Partners found that U.S. private equity firms and their portfolio companies carry an aggregate debt load of between $1 trillion and $1.2 trillion, roughly equivalent to the universe of small-cap listed corporations. The analysts find that nearly 60% of outstanding PE-backed borrowings takes the form of floating rate debt, while another 9% is set to mature in the next two years and may need to be rolled over at higher interest rates (futures price in 70% odds of at least two additional rate hikes by next June, in addition to eight 25 basis point increases since December 2015). The authors continue:
That means an increase in rates of say 100 basis points would have a meaningful impact on the net interest expense line for the private equity-linked companies, pushing the annual interest expense up by 11%, or about $6 billion per annum. Interest coverage ratios among listed companies are still robust in aggregate but we don’t think that’s the case among the companies involved in private equity. The average debt/EBITDA ratio for recent transactions has been close to six times, a threshold often considered the danger zone. At the margin higher rates alone could have consequences.
If higher borrowing costs were to trigger a default cycle among private equity-linked firms, would it matter to the wider economy? That depends on who owns the debt. Banking crises have historically been devastating because they choke off credit to the whole system, whereas corporate default crises have usually been contained. So it’s significant that 60% of private equity-linked debt is sourced from term loans, often issued by a consortium of banks. Currently the loans add up to a little less than 5% of the total credit of U.S. commercial banks, which is big enough to cause a problem.
Correction
Yesterday’s ADG (“Sold to you”) cited Colliers data finding that crypto firms had leased 15% of prime Hong Kong real estate signed since January. Instead, the crypto companies represent 15% of A-grade real estate signed this year by mainland Chinese businesses. I’ve corrected my error on the Grant’s website.
Recap Oct. 2
A flat showing on the S&P 500 belied a fairly active day for stocks, as the Dow Jones Industrial Average rose to an all-time high, while the small-cap Russell 2000 and NYSE FANG+ Indices both lost more than 1%. Commodities finished little changed, while Treasury yields ticked lower with the 10-year settling at 3.05%.
- Philip Grant
Monday, October 1, 2018
Are we there yet?
Mission accomplished.
Mission accomplished.
Sold to you
While bitcoin is down 63% from its December peak, enthusiasm for the digital ducats remains brisk.
While bitcoin is down 63% from its December peak, enthusiasm for the digital ducats remains brisk.
Recap Oct. 1
Are we there yet?
Mission accomplished. Last Monday, ECB president Mario Draghi observed “a relatively vigorous pick-up in underlying inflation.” The central banker’s remarks followed a 2.3% uptick in German CPI for September, approaching the post-crisis peak of 2.4% reached on two occasions in 2011. With the ECB’s current pace of €30 billion in monthly asset purchases set to expire in December, interest rate futures point to a modest rate hike that would take the deposit rate to negative 26 basis points from its current negative 0.4% by September 2019.
While German sovereign lenders continue to labor under the yoke of substantially negative real rates (the 10-year bund yields 0.47%), Italy’s creditors face a different sort of unpleasantness. On Friday, the populist Italian coalition government delivered a 2019 budget featuring a notable uptick in the deficit from prior plans. The upsized shortfall will further stress a public debt load which currently stands at 132% of GDP, second only to Greece in the eurozone.
In response, 10-year Italian borrowing costs have jumped to 3.3% from 2.89% last Thursday, while shares in Italy’s two largest banks, Unicredit S.A. and Intesa Sanpaolo S.p.A., have fallen by 10% and 13%, respectively and remain near multi-year lows. For his part, Matteo Salvini, leader of the Northern League, isn’t worried, telling the Financial Times that “the markets will come to terms with it.”
With the ECB (for now) keeping its thumb on the scales of credit and Italy’s finances looking increasingly shaky, Telecom Italia S.p.A. (TI on the NYSE) is caught in the middle. The Italian phone and internet giant, which is rated in speculative territory by both Moody’s and S&P (Fitch rates TI’s debt at the lowest investment grade rung), saw its senior unsecured 5.25% notes of 2022 trade with a yield to maturity of less than 1% late last year. Today, the bonds change hands at just under 113 cents on the euro, priced to yield 1.32%, south of the 1.6% year-over-year rise in the Italian harmonized CPI reading for September.
Writing of Mario Draghi’s herculean monetary exertions and accompanying sub-1% borrowing costs enjoyed by speculative-grade TI, the Dec. 15, 2017 edition of Grant’s posed a rhetorical query:
To whom might the ECB sell, when the time for selling arrives? Not a financially motivated buyer, to be sure. . . Projections contained in the Euribor futures market indicate sub-zero rates for the next three years. For ourselves, we cling to the Herbert Stein econometric modeling approach: If something can’t go on forever, it won’t. This can’t, so it won’t, though it may already seem as if it had.
Sold to you
While bitcoin is down 63% from its December peak, enthusiasm for the digital ducats remains brisk. At least, that’s according to trade volume on Singapore-based exchange BitForex, which routinely sees daily transaction volume above $5 billion. That figure approaches the average turnover on the 217-year old London Stock Exchange, according to Bloomberg.
Then, again, things might not be quite on the up and up. Bloomberg likewise notes that although BitForex boasts what is easily the highest trading volume among 219 crypto venues tracked by CoinMarketCap.com, its website traffic “amounts to a tiny fraction of most peers.” The secret to BitForex’s success: Transaction fee mining, a mechanism by which active traders receive a rebate in excess of the exchange fees, which allows traders to make money by engaging in so-called wash sales. Last Wednesday (the day of the Bloomberg report) BitForex announced it will cease the practice.
Crypto prices may be down and trading volumes may be coming under scrutiny, but the industry is hardly in retreat mode. According to real estate firm Colliers International Group, Inc., crypto-focused companies have leased an aggregate 72,000 square feet of Hong Kong grade-A office space, representing 15% of the prime Hong Kong real estate signed by mainland Chinese firms in 2018. Colliers notes that the new tenants, who are paying a combined HK $10 million ($1.3 million) in monthly rent, all signed their leases after the January peak in bitcoin.
While the crypto firms advance, some familiar names retreat from the world’s most expensive office market (according to a June survey from CBRE Group, Inc.). Bloomberg notes that BNP Paribas S.A., J.P Morgan Chase & Co. and Goldman Sachs Group, Inc., have relocated at least some Hong Kong staff to less central, and less expensive, parts of the city.
Recap Oct. 1
The fourth quarter got off to a bullish start, with stocks moving higher and commodities enjoying a potent rally despite a marginally stronger dollar. Energy continued to press to fresh 2014-highs, with WTI crude and Brent exceeding $75 and $85 a barrel, respectively, while treasury yields ticked higher across the curve with the 10-year settling just above 3.08%.
- Philip Grant
Thursday, September 27, 2018
Tip of the iceberg
No news is good news. A report today from Fitch Ratings relays that September has thus far seen zero institutional leveraged loan defaults in the U.S., which would mark the second straight blemish-free month since its last occurrence in fall 2014. Eric Rosenthal, senior director of leveraged finance at the rating agency, now forecasts the loan default rate at 2% this year, below Fitch’s prior forecast of 2.5%.
Leveraged loans, which defied the 2007-2009 financial crisis, are further bolstered by the solid growth and rising rate environment which has helped lower rated corporate paper strongly outperform (Almost Daily Grant’s, June 19). With the credit environment remaining benign, issuers are feeling their oats.
Last week, The Blackstone Group, L.P. upsized its offer (to €2.75 billion from €2.5 billion) while trimming the yield spread (to 400 basis points over Euribor from 425 basis points) in the European tranche of leveraged loans used to fund its acquisition of Thomson Reuters Corp’s Refinitiv unit amid blistering demand (Almost Daily Grant’s, Sept. 11). Similarly, the Carlyle Group L.P. twice managed to trim the yield on $6.4 billion in loans backing the buyout of AkzoNobel Specialty Chemicals, which priced at 300 basis points over Libor from initial price talk of 400 to 425 basis points. Speaking of the implications of AkzoNobel’s successful debt offering, Tim Morgan, head of high yield syndicate at HSBC Bank plc observed: “I haven’t seen so much demand for euro-denominated bond and loans in some time, perhaps since before the credit crisis.”
One byproduct of the leveraged loan boom is the increasing prominence of collateralized loan obligations, structured credit products which are backed by loans. On Tuesday, S&P Global’s LCD unit alerted readers that CLO issuance has totaled $99 billion in the year to date, far above 2017’s $71 billion emission at this stage of the year and on track to exceed the record $124 billion full year issuance established in 2014. Yesterday, The Wall Street Journal reported that the Canada Pension Plan Investment Board is diving into the pool with a $285 million allocation to CLO equity tranches, which carry the highest potential payout and, accordingly, the highest risk, in the CLO structure.
The increasing ubiquity of leveraged loans has attracted the attention of at least one major financial institution. On Sunday, the Bank for International Settlements sounded the alarm in an analysis titled: “Leveraged loans, a risky resurgence?” An excerpt:
Going forward, as monetary policy normalizes, the floating rate feature of leveraged loans could trigger defaults by worsening borrowers’ debt coverage ratios (DCRs): The ratio of net operating income to debt service costs. Despite healthy corporate profits in the last few years, market participants have begun to report lower DCRs. Even the loan recovery rates during the next downturn could be smaller given that the debt cushion – i.e. the level of unsecured junior debt that absorbs losses before senior loans in a default – of leveraged loans has decreased.
Meanwhile, recent findings from S&P Global Ratings suggest that private equity deals, a significant source of leveraged loan supply, may not be quite what they seem. Institutional Investor has the details:
In an analysis of companies involved in deal making in 2015, S&P found that the earnings projections were unrealistically high on average across leveraged buyouts and mergers due to so-called add-backs – adjustments made to account for expected cost savings or an anticipated rise in revenue.
Overstated earnings in 2015 was the primary contributor to a jump in leverage over the past two years in the sample of companies reviewed by S&P, according to the report. Compared to companies’ projections, EBITDA, or earnings before interest, taxes, depreciation and amortization, turned out to be 29% lower in 2016 and 34% lower last year.
In a detailed analysis of the leveraged loan market in the July 13 edition of Grant’s, David Sherman, paid-up subscriber and principal of credit-specialist Cohanzick Management, LLC, distilled the current value proposition, or lack thereof, for leveraged loan investors: “You have no call protection, and you have no covenants. You don’t get the upside, and you get all the downside.”
QT progress report
A chunky $13.5 billion decline in mortgage-backed securities holdings brought the Fed’s portolio of securities held outright below $4 trillion for the first time since 2014, while Treasury holdings held steady ahead of month end. Compared to the trailing four-week average, today’s portfolio of $3.997 trillion is a decline of $17.6 billion.
As we approach the maiden anniversary of “QT,” which began on Oct. 1 2017, the Fed’s total balance sheet holdings are down by 5.9% year-over-year.
Recap Sept. 27
If anyone happened to look up from C-SPAN, he or she might have noticed that stocks caught a modest bid to leave the S&P 500 lower by about 0.5% for the week, while the NYSE FANG+ contingent offered another strong performance to extend its weekly gain to 3%. After the close, shares in Tesla, Inc. fell by 10% after the SEC sued CEO Elon Musk for alleged securities fraud following last month’s “funding secured” go-private misadventure.
Elsewhere, Treasury yields ticked a bit higher across the curve, while both commodities and the iShares J.P. Morgan USD Emerging Market Bond ETF both enjoyed stronger finishes despite a notable dollar rally. An auspicious sign for EM assets.
- Philip Grant
Wednesday, September 26, 2018
Rigamarole
Wither the drillers? While energy prices have enjoyed a solid rebound from their 2016 nadir, with Brent crude nearly tripling to $81 a barrel, the recovery has thus far passed over the deep water drilling contingent: Industry mainstays Transocean Ltd. (RIG on the NYSE) and Ensco plc. (ESV on the NYSE) have barely budged from their post-oil crash lows. Investor positioning suggests the pain will continue, as the pair feature hefty short interests of 21% and 17% of their respective free floats.
Transocean and Ensco five-year price chart, compared with the price of Brent crude oil. Source: The Bloomberg
On a backwards looking basis at least, the group’s listless price action has plenty of fundamental justification. Over the 12 months ended June 30, Transocean and Ensco generated $747 million and $111 million in operating cash flow, respectively. That’s down from $3.4 billion and $1.7 billion in respective cash from operations in 2015. There is also the question of overcapacity. Charlie Hockless, lead analyst for offshore at maritime research service VesselsValue, tells ShippingWatch:
People are saying that 2019 will be an exciting year for the offshore market, activity should pick up, and I agree, but the problem is that there are simply too many vessels . . . Extreme scrapping is much needed, but I don't trust owners to go through with pledges to scrap vessels once activity and healthy earnings return.
Then too, oil bulls may take a bit of pause from a recent report by Reuters senior market analyst John Kemp indicating a potential softening of U.S. demand. According to the Federal Highway Administration, traffic volumes in July were down 0.3% year-over-year on a seasonally adjusted basis, the second negative growth period in four months. The last time traffic volumes saw any monthly dips was near the end of the prior energy bull market in 2014.
When, then, might better days finally arrive? Maybe sooner rather than later. Julie Robertson, CEO of fellow driller Noble Corporation plc., told listeners at a Sept. 5 investor conference that: “The jack-up [rig] market is well underway to recovery, which is very pleasing to be able to say after this long cycle that we’ve been in.”
A day earlier, Transocean announced it will acquire Ocean Rig UDW, Inc., which emerged from bankruptcy in September 2017, for $2.6 billion in cash and stock. Oddmund Føre, vice president of oilfield service research at Rystad Energy, commented to ShippingWatch: “We expect that this [deal] will help create a less fragmented market, which will contribute [to] a quicker increase in day rates.” Erik Tønne, managing director at Clarksons Platou, concurs: “It gives you a more manageable fleet which is managed by fewer entities. So, I would be optimistic that this could induce more disciplined bidding activity and assist the utilization and day rates for the floater fleet.”
On Sept. 12, Tor Olav Trøim, chairman of rig contractor Borr Drilling reminded Reuters that the current malaise can turn quickly in the highly cyclical offshore drilling industry: “When the recovery happens, it tends to happen very fast.”
The Nov. 3, 2017 edition of Grant’s featured a bullish analysis of the Transocean and Ensco duo (“Not the FAANGs”), with the caveat that the shares represent a “rank speculation, and one that can easily go pear shaped.” By way of postscript, a bit of investment wisdom from friend of the publication Arjun Divecha:
It’s bullish indeed when a horrible situation becomes, not necessarily good, but only less horrible.
Disclosure: The author holds shares of Transocean.
Recap Sept. 26
A late slide in equities left the S&P nursing moderate losses by day’s end, while Treasurys rallied following the Fed’s widely expected rate hike to leave yields lower across the curve. The greenback likewise took the news in stride, with the Dollar Index floating marginally higher, while commodities came under pressure. The VIX saw a late spike but still finished the day south of 13.
Today’s Fed hike marks the eighth policy tightening since December 2015, but monetary policy remains far from hawkish. With August CPI rising 2.7% year-over-year and the Fed’s preferred “core PCE” metric (which excludes food and energy prices) ticking higher by 2% in the most recent July reading, the current funds rate still resides near zero on a real basis.
- Philip Grant
Tuesday, September 25, 2018
Fancy restaurant
It’s leverage on top of leverage. Yesterday Bloomberg reported that David Siegel and John Overdeck, co-chairmen of quantitative hedge fund Two Sigma Investments, L.P., raised $216 million via a collateralized fund obligation. The CFO is backed by investments in 32 separate private equity funds held by Sightway Capital, a fund that manages part of Siegel and Overdeck’s wealth.
Wray Thorn, chief investment officer of Sightway, explained the strategy to Bloomberg: “This is a really great example of how you can use data science and modeling techniques to innovate the way private equity is done. . . It’s something we hope to continue to do more of in the future.” Franklin Rudd, partner at private equity investment firm Compass Partners, was more circumspect: “It’s the same thing that leverage has done since the Egyptian times. It takes an asset that people assume is low risk because it’s diversified and allows you to borrow against it. But when markets turn around, everything goes down.”
These financially flush times present no shortage of evident opportunity for private equity, including deals with one another. Today, the Financial Times, citing data provider Preqin, reports that last year saw 576 secondary transactions, i.e., deals in which one PE shop sells a company to another PE shop, up from 394 such transactions in 2007. The PE model is to slash costs to the bone in portfolio companies, so with secondary transactions “the risk is that there is not much juice in the lemon to squeeze,” Neel Sachdev, leveraged finance partner at Kirkland & Ellis, L.L.P., told the FT.
Some operators have found a fruitful harvest in restaurant franchisors. Today, Inspire Brands, Inc., the restaurant holding company created by Roark Capital Group which operates the Arby’s Restaurant Group, Buffalo Wild Wings and Rusty Taco chains, announced it will acquire Sonic Corp. for $2.3 billion in cash, a deal which values the drive-in burger joint at 16 times EBITDA.
That price, which easily represents a record high for SONC shares, looks especially generous considering that trailing 12-month revenues of $435 million and adjusted net income of $53 million sit well below the $608 million and $61 million respectively generated in the 12 months ended Aug.31, 2015. While Sonic shareholders were predictably pleased with the 19% premium to yesterday’s close, Arby’s creditors were less than thrilled: The company’s senior unsecured 6 3/4% notes due 2026 sold off more by than two points to 96 cents on the dollar in reaction.
Then again, that price looks like a steal compared to other recent transactions. In August, JAB Holding Co. bought Panera Bread Co. for $7.5 billion, paying 18 times EBITDA. Also In August, Roark Capital’s own Focus Brands affiliate bought Jamba Juice Company for $200 million, or more than 35 times EBITDA. It’s not just PE paying up for restaurants. Last spring, publically-traded (and junk-rated) Restaurant Brands International, Inc. paid $1.8 billion, or more than 21 times EBITDA for Popeye’s Louisiana Kitchen, Inc.
Meanwhile, the restaurant industry saw its best monthly same store sales performance in nearly three years in August, according to industry analytics firm TDn2K. The catch: Comps grew at just 1.8% year-over-year, well below the year-over-year rise in headline CPI of 2.7%
Recap Sept. 25
Another lurch higher in rates briefly took the 10-year yield to 3.11%, matching the seven-year closing highs logged in May, while this afternoon’s five-year auction saw similarly weak pricing to the 2-year auction yesterday. Stocks cruised sideways, while energy managed to extend its recent strength amid a flat commodity index and unchanged greenback.
- Philip Grant
Monday, September 24, 2018
The Negotiator
Today the U.S. imposed 10% tariffs on an additional $200 billion worth of Chinese goods. As a result, President Xi Jinping is no longer negotiating with President Donald Trump, according to a dispatch from state-run Xinhua News Agency: “The door for trade talks is always open but negotiations must be held in an environment of mutual respect . . . [Negotiations] cannot be carried out under the threat of tariffs.”
While China and the U.S. butt heads over trade, Beijing looks to engender goodwill from other nations, as well as from its own populace. On Thursday, Bloomberg reported that China “is planning to cut the average tariff rates on imports from the majority of its trading partners as soon as next month.” That move follows an income tax cut enacted at the end of August that featured an increase in the annual tax-free threshold to Rmb. 60,000 ($8,800) from Rmb. 42,000 as well as expanded deductions and an expanded range of lower tax brackets.
In the past, China might respond to a slowdown by flooding the economy with credit. Might that debt-driven model be approaching the end of its rope? Last Wednesday, premier Li Kequiang, the second most senior figure in the ruling communist party, offered some less-than encouraging remarks at a World Economic Forum conference in Tianjin: “Deeply integrated into the world economy, the Chinese economy is inevitably affected by notable changes in the global economic and trade context. Indeed, we’re facing greater difficulties in keeping stable performance of the Chinese economy.”
But if Li’s remarks indicate that the trade spat is front and center, commentary in the latest edition of the China Beige Book, an independent research boutique, implies that at least one major facet of the economy is independently in the doldrums.
Manufacturing is under fire. The sector’s multi-year rally has given way to declining revenue and sharply declining profit growth. Critically, manufacturing’s plight is occurring before any meaningful American tariffs have been imposed. Absent a fall trade deal, the situation will likely deteriorate. The pace of borrowing – at 41% of firms, the highest since 2012 – sure smells a lot like panic.
Then, too, the crucial property sector is facing rocky terrain ahead. Today, Bloomberg reports that “China’s debt laden developers face a potentially devastating blow to their biggest source of financing, as authorities consider putting an end to the practice of selling apartments before they are finished.” That development augurs poorly for the group, which derives as much as 20% of its sales from the tactic according to Bloomberg. Since late January, the Shanghai Composite Property Index has tumbled by 29%, in excess of the 21% decline in the broad Shanghai Composite Index over that period.
Does a vulnerable real-estate market present the risk of broader economic pain? In a note today, Anne Stevenson-Yang of J Capital Research argues as much:
The top class of Chinese are very wealthy, probably richer in fixed assets and cash than consumers in any other country now. But few of these high net worth individuals rely on salary income. For most, income has broadly been a mix of inbound flows, including passive income from high-return, high-risk financial products and trading income from property dealing.
Those flows are at risk of decelerating faster than China’s anticipated broad, macro-deceleration. Non-financial assets are facing a growing liquidity challenge, and that is likely to reveal that their current “valuations” are totally detached from any market reality. Financial assets are increasingly victims of Ponzi dynamics that drove their high returns to investors in the absence of any real productivity returns . . . so defaults in the non-state financial services arena have become a worry for consumers and regulators alike.
Broad implications of an extended slump in real estate activity could be significant. According to Noah Research, 65% of household assets in mainland China are allocated to real estate, far above the 49% in the U.S. and 34% in Japan.
Keep an eye on the Middle Kingdom.
Recap Sept. 24
Stocks came under pressure following the China tariff headlines as well as the rumored resignation of deputy attorney general Rod Rosenstein, while a soft two-year Treasury auction this afternoon headlined another round of rising interest rates as the 10-year yield hit 3.08%. Energy was the big winner, with WTI crude rising to $72 a barrel and Brent over $80 after OPEC announced yesterday that there will be no production increases for the time being.
- Philip Grant
Friday, September 21, 2018
Your Latest Trick
British rock band Dire Straits,
British rock band Dire Straits,
Help really wanted
Inflation is stirring.
Inflation is stirring.
Recap Sept. 21
Your Latest Trick
From Marketwatch:
British rock band Dire Straits, broken up for decades, has a multimillion dollar catalogue that’s about to be sliced up for investors.
The plan securitizes royalties that are paid out every time a song from the “Money for Nothing” group is downloaded, streamed or played on the radio. It’s a similar investment to that introduced in the late-1990s with David Bowie’s own catalogue-supported “Bowie bonds.”
Quite a collaboration: Classic rock meets modern gospel.
Help really wanted
Inflation is stirring. For the latest bit of evidence, see the commentary in Markit’s September flash PMI Index, which reports that “average prices charged by service providers increased at the fastest pace since the survey began in October 2009.” Supply shortages and rising tariffs were cited by the research service as the primary culprit.
On Saturday, The Wall Street Journal reported that the Trump administration was set to move forward with an additional $200 billion in Chinese tariffs “within weeks,” in a major escalation of the Sino-U.S. trade spat. Four days later, CNNMoney reported that Wal-Mart, Inc. sent a letter to U.S. trade representative Robert Lighthizer warning that higher prices were in the offing. Of the latest round of $200 billion in tariffs to be levied on Chinese goods, Wal-Mart predicted that “the immediate impact will be to raise prices for consumers and tax American businesses and manufacturers.”
While tariffs represent one catalyst, an increasingly tight labor market figures prominently in the equation. The August reading of non-farm payrolls saw average hourly earnings rise a brisk 2.9% year-over-year, up from 2.7% in July and the hottest reading since 2009.
Anecdotes of labor shortages likewise abound. Yesterday’s edition of the Minnesota Post, describing Wednesday’s gubernatorial debates, noted the dual focus of candidates Jeff Johnson and Tim Walz on staffing concerns:
They spoke after a slate of top business, government and nonprofit thinkers, who spelled out — in sometimes dire terms — the projected shortfall in workers for certain areas, including nursing and agriculture. In nursing, there is an expected shortfall of 1,275 workers by 2020, according to data provided by Real Time Talent, a workforce project started by a large mix of public and private sector groups.
Walz and Johnson agreed the state can do much to fix the looming shortage, fueled in part by retiring baby boomers, and broadly vowed to make it happen. “I can probably speak for the both of us as we travel around the state and talk to small business owners and big business owners, this comes up more often than anything else — even more often than regulation and taxes as a difficult issue for employers,” Johnson said.
On Sept. 10, the Austin Statesman, citing a study from the Associated General Contractors of America, reported that “more than three-fourths of Texas construction firms are having trouble finding workers. . . Construction employment in the Austin-Round Rock metro area has jumped by more than 7% over the past year.”
In a Sept. 4 dispatch in the Charlotte Observer, Rich Cerretti, head of the Charlotte office of general contractor JE Dunn, explained the knock-on effects which can follow the lack of sufficient hands: “It is definitely hard to find good people. When they run out of labor, the good [firms] are not bidding future projects. You may not have the best subcontractor available or the best-priced subcontractor available. . . All that has an effect of pushing up overall project prices.”
How bad can a labor shortage get? Thirty years ago today, the Financial Times reported on the feverish hunt for workers in then-rip roaring Japan:
Unscrupulous Japanese companies, facing a nationwide shortage of university graduates, are resorting to kidnapping potential recruits to keep them out of the hands of rival employers.
Recap Sept. 21
Stocks gave back early gains to finish little changed on the S&P 500, while underperformance from the formerly-charged NYSE FANG+ Index continued with a 1.2% drop. Treasury yields finished little changed with the 10-year remaining at 3.06%, and a stronger dollar didn’t stop the commodity complex from catching a bid as WTI crude edged toward $71 a barrel.
August new home sales, a Federal Reserve rate decision and revised second quarter GDP figures are among next week’s scheduled highlights.
- Philip Grant
Thursday, September 20, 2018
Leverage lamentation
With apologies to Homer Simpson, here's to debt: The cause of, and solution to, life's financial problems.
With apologies to Homer Simpson, here's to debt: The cause of, and solution to, life's financial problems.
QT progress report
Recap Sept. 20
Leverage lamentation
With apologies to Homer Simpson, here's to debt: The cause of, and solution to, life's financial problems. As interest rates across much of the world edge higher, signs of overextended borrowers are increasingly visible. A trio of such sightings follows:
On Wednesday, Bankrate.com published a survey of U.S. homeowners, finding that almost 30% of lower-income respondents (those making $30,000 or less) viewed home equity lines of credit as a feasible method for keeping up with routine household expenses, compared to 15% overall who endorsed such a maneuver. Greg McBride, chief financial analyst for Bankrate.com, commented:
With the sorry state of emergency savings and increasing levels of consumer debt in a rising interest rate environment, it’s a matter of ‘when’ not ‘if’ more homeowners turn to home equity to find home improvements and repairs, and consolidate debt.
On the bright side, less than 1% of the 719 homeowners within the 1,000-size polling sample indicated that using home equity for plastic surgery was a good idea. At least American home prices are still rising.
Meanwhile, Down Under, the formerly white-hot housing bubble is deflating – unfortunately, the debt remains. The Reserve Bank of Australia calls heavy morgage borrowings the “main risk to financial stability” over the next two years (for more on Australian housing, see the June 15 edition of Grant’s).
Interest-only loans, in which the borrower initially pays no principal (typically through the first five years), figure prominently in the equation. According to the RBA, interest-only (IO) loans constituted nearly 40% of the Australian mortgage pool as recently as 2015.
According to analysts at UBS Securities, the Australian borrower is less than fully informed about these ubiquitous and gimmicky credit products. In a research note yesterday featuring results from the 2018 UBS Evidence Lab Mortgages Survey, the bank reports:
We are concerned with the lack of understanding of IO terms, especially by owner-occupiers (OO): Only 48% of borrowers believe their IO term expires within five years (the maximum interest-only term usually available); 18% stated they “don’t know” when their IO term expires and 8% of OO believe their interest-only term lasts more than 15 years (this product doesn’t exist).
However, the most concerning issue is a lack of understanding of the increase in repayments when the IO term expires: 34% of all IO borrowers stated they “don’t know” how much repayments will rise; 53% expect repayments to rise up to 30%, while only 13% of respondents indicated they expect their mortgage repayments to rise more than 30% (the best case for most IO borrowers).
The analysts conclude with something of an understatement:
This [survey] indicates that the majority of IO borrowers remain underprepared for the step-up in repayments they will face.
Turning to the corporate realm, so-called zombie companies, or those featuring earnings before interest and taxes insufficient to cover interest expense, are widely prevalent in North America. According to a July 19 dispatch from Bianco Research, a full 14% of the broad S&P 1500 Index is so classified, well above the world average of 10%.
In Canada, it’s even worse. Earlier this week, accounting firm Deloitte LLP released an analysis of 2,274 businesses listed on the Toronto Stock Exchange and TSX Venture Exchange, finding that 350 public companies, or nearly 16% of the group, could not service interest with operating earnings.
Those North American zombies may soon be tested. Interest rate futures in Canada and the U.S. are currently pricing 90% and 100% odds, respectively, of higher overnight interest rates by year-end (futures are pricing a status-quo RBA, with just 5% odds of a rate hike by the New Year).
By way of conclusion, a paraphrased quip from the late private equity titan Ted Forstmann: Debt is like chocolate cake. Just a little bit please.
QT progress report
Relatively little to report this week, as the Fed’s portfolio of securities held outright registered at $4.11 trillion, a decline of just under $2 billion from last week’s reading. Mortgage-backed securities supplied the change, as Treasury holdings were virtually unchanged. Likewise, the decline from the trailing four-week average is a relatively modest $10 billion.
Since QT began just under one year ago, the Fed’s total balance sheet has declined by 5.56%.
Recap Sept. 20
A notable dollar selloff cleared the way for stocks, with ongoing underperformance from the NYSE FANG+ Index not enough to prevent the S&P 500 from making a fresh record high. The soft greenback was likewise well received in emerging markets, as the major equity and dollar denominated bond ETFs both climbed while the Argentine peso and Turkish lira strengthened against the buck.
Elsewhere, Treasury yields mostly ticked higher, with the 10-year settling just above 3.06%, while commodities finished moderately higher.
- Philip Grant
Tuesday, September 18, 2018
Muppets take Manhattan
The baton has been passed. Today, The Wall Street Journal reports that eight-year old WeWork Companies, Inc. has expanded its office-space dominion to 5.3 million square feet in Manhattan, officially overtaking J.P. Morgan Chase & Co. (initially chartered in 1799 as The Manhattan Company) as the largest office tenant in the borough.
Growth across the nascent co-working industry has been little short of remarkable. According to real estate services firm CBRE Group, Inc., co-working companies have accounted for 9.7% of all new leases signed in Manhattan year-to-date through August, nearly triple the 3.3% share in 2017. As the co-working business model expands, so do prospective valuations. Today’s Journal report notes that WeWork “is in the process of raising money at a roughly $40 billion valuation.” In August 2017, SoftBank Group Corp. invested $4.4 billion at a $20 billion valuation. Nearly a third of that sum went to cash out existing investors, per the WSJ.
While WeWork’s rapid expansion has served company insiders well, the early returns for landlords are less encouraging. On Aug. 21, commercial real estate giant Cushman & Wakefield published an study of the co-working industry’s impact on building valuations via capitalization rates, i.e., net operating income divided by market value. After offering the caveat that “the data on trades of buildings with significant coworking tenants is relatively thin,” the authors continue:
An analysis of 17 building sales with co-working tenants from the past two years indicates a relationship between the reported cap rates and the proportion of the building’s square footage allocated to co-working. In those cases where 40% or less of a building was leased as co-working, the cap rate was within range or below that of other comparable sales in the area [meaning an equal or higher valuation]. However, the gap between cap rates for comparable sales and the building(s) in question expanded as the proportion of space allocated to co-working increased.
The initial results do suggest that investors seem to apply a discount as the percentage of the building that consists of co-working increases.
Attention: deficit disorder
The second longest economic expansion on record (110 months and counting going back to June 2009, and approaching the 120 month record set between 1991 and 2001), has been no help to Uncle Sam’s balance sheet. Federal debt held by the public currently stands at $15.8 trillion, or 77.5% of trailing 12 month seasonally-adjusted gross domestic product as of the second quarter. That compares to $10.4 trillion, representing 65.9% of GDP, at year-end 2011.
The 2017 Tax Cuts and Jobs Act looks to be aggravating the financial deterioration. Over the first eleven months of fiscal 2018 (the government year ends Sept. 30), federal coffers have absorbed an $898 billion shortfall, up 33% year-over-year. In August, the deficit jumped to $152 billion, up 41% year-over-year, even after factoring in accounting changes and calendar shifts.
According to updated estimates from the White House’s Office of Management and Budget, the upcoming fiscal 2019 will see a budget deficit equivalent to 5.1% of GDP, well in excess of the shortfalls seen, for instance, in recession aftermath years 2003 and 1991 of 3.3% and 4.4%, respectively. The National Bureau of Economic Research finds that over the past 50 years, the average recession has widened the fiscal deficit by 4% of GDP. That means that an ordinary business slowdown could send the U.S. deficit soaring to 9.1% of GDP, just behind the post-World War II record of 9.8% in 2009, the end of the Great Recession.
While red ink spreads, the benchmark Treasury approaches a key level. Today, the 10-year yield poked above 3.05%, up from 2.82% three weeks ago and pressing back toward the high of the year at 3.12%. A sustained break higher could be a big deal. In April, May and early August the 10-year briefly exceeded 3% before retreating, while Ben Breitholtz of Bianco Research reports yesterday that 10-year yields’ 38 basis point trading range over the past six months is among the narrowest since 1972.
Needless to say, a break higher in borrowing costs would be most unwelcome. At a return to 1990’s-era borrowing costs of 6.6%, federal interest expense would foot to $998 billion, topping the $945 billion spent on social security benefits last year (Grant’s, May 18).
Meanwhile, thanks to a rapid rise in short-term rates (today’s four-week bill auction fetched 2.02%, highest since February 2008), the Treasury curve remains near its flattest since the financial crisis, with the two- and 10-year spread hovering just below 25 basis points. Imminent Fed hikes (interest rate futures price in 80% odds of at least two more 25 basis point rate hikes by year-end) could tip the curve into inversion. The St. Louis Fed finds that each recession in the past 60 years has been preceded by that yield curve flip.
Recap Sept. 18
Stocks caught a bid despite another soft showing from the NYSE FANG+ Index (comprised of 10 equally weighted tech, internet and media stocks), which lagged after Bloomberg reported that the Department of Justice has opened a criminal investigation against Tesla, Inc. CEO Elon Musk. Although TSLA did recover somewhat to finish lower by just 3%, the FANG+ Index now sits more than 10% below its June 20 peak while the S&P 500 remains close to its high water mark.
Treasury yields darted higher, while strength in the energy patch pushed WTI crude back to $70 a barrel.
- Philip Grant
Friday, September 14, 2018
In other news
From Agence-France-Presse:
Archaeologists have found what they believe is the world’s oldest site for alcohol production, a study said [yesterday], adding a beer-like beverage may have been served in ceremonies some 13,000 years ago.
A beer-like beverage? Sounds like our ancestors stumbled upon the recipe for Bud Lite.
Tail wags the dog
As gathering financial storm clouds roil currencies, credit and equities in the formerly-designated “third world”, a trio of Latin American countries will confront the prospect of major political change in coming months. Let’s take a closer look at the situation south of the border.
Last June, Argentina managed to raise $2.75 billion from investors via a 100-year dollar bond. It didn’t take long for trouble to once again find the serial sovereign-defaulter (eight times since 1827 according to historian Carmen Reinhart), as president Mauricio Macri was obliged on Aug. 30 to ask the International Monetary Fund to expedite payment on a $50 billion bailout package agreed to this summer. That news sent those century bonds to below 70 cents on the dollar that same day (they’ve since recovered to 75). As inflation rages (CPI rose 34.4% year-over-year in August), the peso continues to hover near lifetime lows against the dollar despite yesterday’s announcement in local newspaper La Naciòn of ARS 196 billion ($5 billion) in 2019 spending cuts.
Argentina budget balance. Source: The Bloomberg
Macri, who is attempting to right the ship after the fiscally disastrous and corruption-riddled administration of predecessor Cristina Elisabet Fernández de Kirchner, faces the unenviable challenge of simultaneously pleasing his electoral constituents and foreign creditors, including the IMF. Former central bank official Mario Blejer told The Financial Times on Sept. 3: “The solution [to the crisis] is not purely economic, it’s also political. The [Macri] government will have to find consensus with additional forces in the political spectrum. They cannot continue to govern alone.” General elections are set for Oct. 27, 2019.
Politics are likewise front and center in Brazil, which is in the midst of a rancorous and highly competitive campaign season ahead of national elections in three weeks (the first round is Oct. 7, with a run-off to take place on Oct. 28 if no candidate exceeds 50%). Today, a poll conducted by XP and Pesppe showed that former army captain and far right-wing candidate Jair Bolsonaro saw his support jump to 26% from 21% a week ago to lead the pack, after he was stabbed at a campaign event on Sept. 6. Bolsonaro’s leading opponents are leftists Ciro Gomes and Fernando Haddad, while market-friendly Geraldo Alckmin languishes at 9% in the XP/Pesppe poll.
André Jakurski, founder and portfolio manager of Rio de Janerio-based JGP Gestao de Decursos Ltda., tersely summed things up to colleague Fabiano Santin: “The candidates are horrible.” Mr. Market seems to concur with Jakurski’s assessment (for the bear case on Brazil, see the issue of Grant’s dated Jan. 23, 2018). Brazil’s 10-year yield has jumped to 12.5%, up nearly 300 basis points since March, while the real has lost 23% against the dollar year-to-date and stocks have spun their wheels with the Bovespa Index slightly down in local terms in 2018.
Finally, we turn to Mexico, which just ushered in a new political era of its own with the June 1 election of Andrés Manuel López Obrador, known as AMLO. Unlike the slow-motion train wreck seemingly underway in Brazil, AMLO’s ascension has already won over financial markets, with the Mexican peso rallying to 18.9 against the dollar from 20.9 in June. On July 4, Morgan Stanley upgraded Mexican equities to “overweight” from “equal-weight.”
The populist president-elect has wasted little time on projects large and small, participating in the bilateral U.S. trade agreement with the outgoing Peña Nieto government, while announcing an aggressive austerity program that includes cancelling the pension of former presidents. Perhaps less market-friendly is AMLO’s prospective energy policy. One day after that trade agreement announcement, Reuters reported that “Mexico’s incoming government is considering indefinitely suspending auctions for oil and gas projects, and giving state-owned Pemex authority to pick its own joint-venture partners rather than holdings competitive tenders.”
Will a bullish response to the incoming AMLO administration be the correct one? Just over four year ago, Reuters reported on market concerns over “economic discipline” of a soon-to-be elected president of an emerging market mainstay:
[Officials] dismissed fears that policy would take a populist turn, jeopardizing more than a decade of strong growth.
“These [market friendly] policies will continue with the same decisiveness. The ministers who will implement them will continue in their posts; there does not appear to be a question about that,” one senior official said.
The country, and leader, in question: Recep Erdogan of Turkey. Today, Erdogan offered an ominous response to the Turkish central bank, which just hiked its overnight rate to 24% in a bid to stem the free-falling lira: “It’s currently my phase of patience but there is a limit to this patience.”
Recap Sept. 14
Stocks cruised sideways for a second straight day, with the S&P 500 wrapping up the week higher by 1.2% to close within about 30 basis points of the high water mark. Treasury yields moved higher, with the 10-year briefly exceeding 3%, while commodities came under pressure with gold dropping back below $1,200 an ounce.
- Philip Grant
Thursday, September 13, 2018
Playing Ketchup
It’s been a tale of two halves for the Kraft Heinz company.
It’s been a tale of two halves for the Kraft Heinz company.
QT progress report
Recap Sept. 13
Playing Ketchup
It’s been a tale of two halves for the Kraft Heinz Company (KHC on the Nasdaq). Born out of the 2015 merger of Kraft Food Group, Inc. and HJ Heinz Co. and blessed by cornerstone investors Berkshire Hathaway and 3G Capital, things began auspiciously. Adjusted EBITDA margins expanded to more than 31% at year-end 2016 from less than 26% in 2015, while the stock jumped 32% in the two years ended February 2017 to command a princely multiple of 34 times trailing GAAP earnings. (For our part, Grant’s offered subscribers bearish analyses of KHC on March 25, 2016 and March 10 of last year.)
Of course, it’s been a different story since that initial burst of success, as earnings and revenues have stagnated while the hefty debt load used to fund the 2015 deal has stayed in place. Since that early 2017 peak, KHC shares are down by 39%, and have lost 23% year-to-date, far in excess of the 7% decline in the S&P 500 Packaged Foods Index.
Signals from those celebrity investors have likewise been less than reassuring. On Feb. 23, Warren Buffett announced his retirement from the board following this year’s annual meeting. In August, 3G announced the sale of 20.6 million KHC shares, reducing its holding to 270.1 million shares.
One Kraft Heinz investor isn’t taking the pain lying down. Today, protestors dressed as condiments and foodstuffs paraded in front of Federal Hall and the New York Stock Exchange. Approached by Grant’s for comment, a participant explained that they were there at the behest of Prague-based activist investor Krupa Global Investments a.s. to demonstrate against Buffett and 3G’s leadership, producing an open letter to fellow investors and the Kraft Heinz board written by Krupa’s eponymous chairman, Pavol Krupa.
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Just your typical Wall Street lunch (with the Wizard of Oz). Sept. 13, 2018
In the missive, Krupa takes issue with, among other things, KHC’s focus on cost cutting at the expense of market share, a lack of strategic acquisitions after the company was rebuffed by Unilever plc. last year and excessive debt. The activist advocates for the rollout of higher margin products, a share buyback and/or a go-private transaction, noting that the investment manager would support a privatization deal “with a valuation in the range of $80 a share,” roughly a 33% premium to the current price.
Krupa wraps up with an entreaty to the Berkshire and 3G bosses:
Investors have followed Warren Buffett and Jorge Paolo Lehmann into battle inspired by the larger than life legend of these men. These investors are scarred and battle weary. They have lost retirement savings and college savings on what they viewed as a safe dividend stock, Mr. Buffett and Mr. Lehmann, save these investors who put their trust in you.
In the letter, Krupa claims to hold “approximately $100 million in Kraft Heinz stock,” although Grant’s was unable to locate any SEC 13-F filings for the firm or find Krupa Global Investors among Bloomberg’s listing of KHC holders. Until recently, Krupa was known as Arca Capital, which is listed by Bloomberg as a holder of 3,475 shares of Kraft-Heinz stock as of July 31. Grant’s unsuccessfully attempted to reach Krupa’s offices for comment, circa 7 p.m. Prague time (1 p.m. ET).
QT progress report
The Fed’s portfolio of securities held outright footed to $4.013 trillion this week, an $11.4 billion sequential decline as Treasurys suppled the run-off while mortgage-backed securities holdings remained unchanged at just under $1.7 trillion. Today’s reading is down by $22.8 billion compared to the trailing four-week average, with Treasurys accounting for roughly two thirds of that run-off.
It’s almost the one year anniversary of QT. Since the program began on Oct. 1 last year, the Fed’s total balance sheet is down by 5.5%.
Recap Sept. 13
Stocks rose yet again, pushing the S&P 500 to within 50 basis points of its high-water mark as the NYSE FANG+ Index managed a near 1% advance. A softer dollar didn’t help commodities, as the CRB Index was hammered by more than 1% with WTI crude dropping below $69 a barrel. Treasurys ticked slightly higher across the curve, after August CPI rose by 2.7% year-over-year, slightly less than expected.
- Philip Grant
Wednesday, September 12, 2018
GoFundTheUniverse
Yesterday, from Bloomberg:
A village in Switzerland has decided to go ahead with an experiment on [universal] basic income, with a payout of 2,500 francs ($2,570) per month. The next step is to raise the money to finance the plan via crowdfunding.
Presumably, the crowd will be from outside the village limits.
Low energy
Today, the Department of Energy reported a 5.3 million barrel drawdown of U.S. crude oil inventories for the week, well above the Bloomberg consensus for a 2 million barrel decline. Those bullish inventory figures, along with disruptive potential from the incoming Hurricane Florence and the impact of sanctions on Iran, OPEC’s third largest producer, helped maintain a strong bid in the energy patch as WTI reached $71 and Brent Crude leaped above $80 for the first time since May.
This week’s outsize decline builds on a sharp recent dwindling in domestic stockpiles. According to the Department of Energy, total U.S. crude inventories fell to less than 396 million barrels last week, down more than 15% year-over-year. That’s despite a steady uptick in domestic output thanks in large part to the shale boom, as DOE production held near its all-time high last week at 10.9 million barrels a day, up 17% year-over-year.
Domestic output is set to continue its rise, but perhaps not to the extent that energy bears have counted on. Thus, the International Energy Agency trimmed its 2019 U.S. production forecast to 11.5 million barrels a day in the September Short Term Energy Outlook, down more than 3% from the 11.86 million barrel estimate in May.
Then too, an anecdotal point from services giant Halliburton Co. indicates that shale activity may not be as bustling as some expected. Last Wednesday, Halliburton CEO Jeff Miller told attendees at a Barclays energy conference: “A decrease in customer urgency. . . has occurred, and we have more white space [in our calendar] than expected.” Miller likewise observed that: “We are seeing slower than expected activity ramp on several new contracts in the Middle East.”
While investors were taken by surprise, sending Halliburton shares lower by 6% on heavy trading volume, the news corresponds with the bullish thesis laid out by natural resource investors Leigh Goehring and Adam Rozencwajg. The pair’s second quarter investor letter notes that 2017 global oil discoveries of four billion barrels lagged far behind the 35 billion in global consumption, and they estimate that discoveries have trailed consumption by 210 billion barrels since 2012. Likewise, Rystad Energy estimates that capital spending in the oil and gas industry will total only $440 billion between 2015 and 2020, just over half of the $875 billion outlay in the 2010 to 2015 period.
Might a looming supply shortfall set the stage for far higher energy prices? Grant’s put the question to Goehring, who finds that U.S. demand growth is fast outpacing rising domestic production growth, while OPEC struggles to maintain its quota and non-OPEC conventional production remains below its 2010 levels.
If the U.S. output disappoints, and OPEC’s production can’t hold at [the current 32.7 million barrels a day quota] . . . then we fall into another year of steep deficits that quickly get out of control.
Energy watchers won’t have to wait too long for an update, as OPEC is scheduled to meet in Algeria later this month, with a press conference scheduled for Sept. 23. For their part, Goehring and Rozencwajg remain highly bullish on energy prices:
We believe the bull market in oil (ignored thus far every step of the way by the investment community), is set to dramatically accelerate to the upside. Stay long oil and oil-related investments.
Grant’s, also bullish on oil (see the March 10, 2017 issue for more), continues to concur with the assessment of Goehring and Rozencwajg.
Recap Sept. 12
Stocks drifted sideways in a narrow range, while a soft dollar helped buoy the commodity complex with gold ticking to a two-week high above $1,200 an ounce. The Treasury curve flattened, with the 2- and 10-year spread compressing to just 21 basis points, near the flattest since 2007. August CPI is set to be released tomorrow, with economists expecting a 2.8% year-over-year headline advance.
- Philip Grant
Tuesday, September 11, 2018
Fine print foibles
The books are open. Soon-to-be renamed Refinitiv U.S. Holdings, Inc. (formerly Thomson Reuters’ Financial and Risk U.S. Holdings, Inc., which publishes financial data through its Eikon terminal) has commenced a $13.5 billion offering of term loans and high yield debt which will help finance the company’s $17 billion acquisition by a Blackstone Group L.P.-led consortium at the end of January. The deal, which values the F&R unit at 12 times EBITDA and is expected to price next week, is the largest leveraged buyout since the financial crisis.
Shortly after the deal was announced, the Feb. 9 edition of Grant’s summarized the daunting task facing Financial and Risk’s new ownership group, and, by extension, the company’s creditors:
The deal is a giant, leveraged bet that the passive investing trend will not, in fact, crush the active managers who pay to use Eikon; that F&R can take market share from the Bloomberg terminal; that interest rates won’t spike when Blackstone comes to refinance the $14 billion of borrowings; and that the world of finance five years from now will look very much like the financial world of today.
The business risks do look to be at least somewhat reflected in the prospective compensation on offer. Max Bower and Natalie Harrison of Reuters report yesterday that price talk for the high yield senior secured and senior unsecured tranches resides in the “low 7% area and low 9% area, respectively.” Those yields would tower over the 5.11% currently on offer from the iShares iBoxx High Yield Corporate Bond ETF.
Then again, Reuters notes that while the deal is being marketed at a leverage ratio of 5.25 times adjusted EBITDA for the unsecured tranche, that already-doctored EBITDA figure has an asterisk. Anticipated but as of yet-unrealized cost savings will purportedly push Refinitiv’s adjusted EBITDA to $2.5 billion from the actual $1.9 billion annual run rate. John McClain, portfolio manager at Diamond Hill Capital Management, put it this way to Reuters:
It’s very late cycle. I don’t really like it when you see a deal with this order of magnitude of projected cost savings as you don’t really know if and when it will be realized. It will be a bit of a test for the market given the size of the deal. But Blackstone and its partners have a good reputation and deep pockets.
Covenant Review, a credit research firm, pulled no punches after taking a look at the fine print. Speaking of the high yield segment of the offering, analysts Sabrina Fox and Scott Josefsberg write:
The Notes are being marketed with extremely defective sponsor-style covenants riddled with flaws and loopholes that reflect the worst excesses of covenant erosion over the last two years.
The pair go on to cite specifics:
A wildly off-market new sponsor mutation seeks to eliminate a fundamental protection against distributions of assets to sponsors and other sponsor shenanigans at a time that the Company has become distressed.
The definition of ‘EBITDA’ would allow for ridiculous pro forma adjustments, allowing management to artificially inflate capacity throughout the covenant package.
Might this transaction stand as something of an avatar for these ebullient post-Lehman credit cycle? In 2008, private equity firms Bain Capital, LLC and Thomas H. Lee Partners conducted a $24 billion leveraged buyout of terrestrial radio station operator iHeartMedia, Inc., paying 10.8 times trailing EBITDA. Having subsequently defaulted on its debt and entered bankruptcy earlier this year, iHeartMedia is now mired in contentious negotiations with its bondholders. S&P Global Market Intelligence’s LCD Unit reported last week:
The unsecured creditors committee in the Chapter 11 proceedings of iHeartMedia asked the bankruptcy court overseeing the case to deny approval for the company’s proposed disclosure statement, calling it a “175-page document premised on indecipherable defined terms and convoluted gifting mechanics [meaning the manner in which the assets are distributed] that renders an informed judgement next to impossible.”
LCD reports that holders of iHeartMedia’s unsecured 2021 notes would see recoveries ranging between 0 and 14.45% according to the company’s plan.
Recap Sept. 11
Stocks ticked moderately higher amid renewed leadership from tech, as the NYSE FANG+ Index snapped out of its recent doldrums with a 1% advance. Treasury yields likewise moved higher, with the 10-year yield settling at 2.98%, a five-week high.
The dollar finished flat, while the iShares MSCI Emerging Markets ETF managed to reverse steep opening losses to likewise finish unchanged and the Turkish lira approached its best level against the greenback in two weeks. An encouraging showing for EM bulls today.
- Philip Grant
Monday, September 10, 2018
Wealth defect
Over the weekend, Global Financial Crisis-era policymakers Ben Bernanke, Timothy Geithner and Henry Paulson brought the band back together
Over the weekend, Global Financial Crisis-era policymakers Ben Bernanke, Timothy Geithner and Henry Paulson brought the band back together
Ma Ma, hey hey
While the U.S. stock market maintains its upward trajectory,
While the U.S. stock market maintains its upward trajectory,
Recap Sept. 10
Wealth defect
Over the weekend, Global Financial Crisis-era policymakers Ben Bernanke, Timothy Geithner and Henry Paulson brought the band back together to pen a New York Times opinion piece. After sharing their self-exonerating analysis of the events of 2007-2009 and subsequent response (which one of the three did the fact checking?), Bernanke et. al. argue for greater regulatory powers, or as they put it, “adequate firefighting tools,” to resolve future financial crises.
Blanket guarantees of bank debt by the Federal Deposit Insurance Corporation, the Fed’s emergency lending capabilities and the Treasury department’s guarantee of money market funds are among the mechanisms cited by the authors as necessary for crisis prevention and mitigation.
The trio write:
We need to make sure that future generations of financial firefighters have the emergency powers they need to prevent the next fire from becoming a conflagration. We must also resist calls to eliminate safeguards as the memory of the crisis fades. For those working to keep our financial system resilient, the enemy is forgetting.
Alternatively, the monetary mandarins could take a cue from Peter Fisher, former executive vice-president at the Federal Reserve Bank of New York and senior fellow at the Tuck School of Business. Speaking on policy normalization at the Grant’s spring conference on March 15, 2017, Fisher offered a commanding critique of the crisis-era response led by the authors of this weekend’s Times piece. Written 18 months ago, the below passage could serve as a direct rebuttal to the authors, particularly former Fed chair Bernanke:
Curiously, the Fed has acknowledged no failures. All the experiments have been successful, every one: no failures, no negative side effects, no perverse consequences, only diminishing returns.
What has been most extraordinary about extraordinary monetary policy is the awkward denial of uncertainty in defense of extraordinary actions. Wanting so badly to manipulate our expectations, the central bankers did not want to leave us any room for doubt. . .The Fed and other central banks appear to have avoided being candid about the uncertainty in order to maintain their credibility. But this is backwards. They cannot regain their credibility unless they are candid about the uncertainty and how they confront it.
The full text from Fisher’s remarks is available here. Ben Bernanke, Tim Geithner and Hank Paulson, please copy. Come to think of it, please read.
Ma Ma, hey hey
While the U.S. stock market maintains its upward trajectory, Chinese equities have been loaded for bear, with the Shanghai Composite Index and Hong Kong’s Hang Seng down 25% and 20%, respectively, from their late-January highs.
Trade wars look to figure prominently in the recent pain. On Friday, President Trump floated the idea of extending an additional $276 billion in tariffs on Chinese goods, a notable escalation from the current $50 billion tariff regime and additional $200 billion in already proposed duties. In response, Chinese foreign ministry spokesman Geng Shuang promised that “China will definitely take countermeasures to safeguard its legitimate rights and interests.”
As trade tensions ratchet and stock prices teeter, inflation stirs in the Middle Kingdom. While official government CPI readings show a gradual acceleration to 2.3% year-over-year in August, The New York Times, citing a household spending-weighted data set from economic research group Wigram Capital Advisors, reports that prices jumped 3.7% in August. That metric had remained below 2% for the bulk of 2017.
For debt-soaked China, which holds banking assets in excess of 300% of GDP, a persistent inflation uptick, and the prospect of higher interest rates, could augur trouble. Reuters reports that 20 corporate borrowers have defaulted this year as of Sept. 3 on 41 bonds worth 45.6 billion renminbi ($6.7 billion), already above 2017’s full year tally of 18 defaults worth Rmb. 39.3 billion.
With these disparate economic data points as a backdrop, Friday afternoon’s retirement announcement from Alibaba, Inc.’s (BABA on the NYSE) co-founder and executive chairman Jack Ma was a notable one. Ma, 54, told The New York Times that his departure from the e-commerce behemoth will not mark the end of an era but, rather, “the beginning of one.”
The debt-driven Chinese economic miracle has been kind to Alibaba, which has more than tripled both its revenues and adjusted net income in the three years ended March 31. It has also been kind to Ma, who has sold some 26.6 million BABA shares over the last two years, worth $4.2 billion at today’s prices, according to The Wall Street Journal.
What era is this the beginning of?
Recap Sept. 10
Stocks edged higher, as the Dow Transports Index gained nearly 2% to reach a fresh record high and pick up the slack from the recently-faltering FANG+ complex, which treaded water after a 7% drop last week. The Treasury curve flattened a bit, while a slightly weaker dollar helped commodities but wasn’t enough to prevent the iShares MSCI Emerging Market ETF from sinking to a fresh 52-week low.
- Philip Grant
Friday, September 7, 2018
Clickbait
Senators, let me be clear: We are more determined than our opponents and we will fight them. Nothing less than the integrity of our democratic institutions is at stake.
Those remarkable words were uttered not by a politician or military commander, but rather by Sheryl Sandberg, chief operating officer of Facebook, Inc., (FB on the Nasdaq) during congressional testimony on Wednesday.
As the Cambridge Analytica data misadventure (among others) have taken the social network far beyond the scope of most corporations, regulatory action from Washington appears increasingly certain. On Tuesday, entrepreneur and Facebook co-founder Eduardo Saverin told the audience at a Singapore technology summit that: “It’s not a question of if, it’s a question of the type of regulation.” The company is preparing itself. Employee headcount jumped to 25,105 in 2017 from 17,048 the year prior, and capital expenditures are expected to double to $14.7 billion this year from $6.7 billion in 2017.
Investors also seem to be girding for the heavy hand of Uncle Sam: Facebook shares have declined by 7% this week, extending their slide to 25% since offering slower than expected revenue growth guidance on July 25. Since the Aug. 11, 2017 bearish analysis in Grant’s, Facebook shares have dropped 3%, lagging the S&P 500's 17% gain over that period.
Does the price weakness offer opportunity? Analysts from Needham & Company believe so, writing on July 26 after the 20% post-earnings swoon: “We are sad about the human capital cost* of this share price correction, but we believe FB’s fundamental value, advertiser demand, [free cash flow and return on investment] remain intact.” Considering the breakneck growth in revenues, net income and free cash flow achieved by Facebook in recent years, the stock trades at just over 20 times consensus adjusted earnings per share this year, far from exorbitant by current bull market standards. The stock is up 271% over the past five years.
Likewise, the Street, with 40 “buy” ratings, six “holds” and two “sells”, expects the good times to continue. Consensus revenue and adjusted net income for 2019 stand at $69.3 billion and $28 billion, respectively, well above the $48.5 billion in revenue and $21.3 billion in adjusted net income generated in the 12-months ended June 30.
The question before the house: Are the underlying user growth metrics supplied by the company accurate? On Aug. 17, Brian Wieser of Pivotal Research (one of the two analysts with a “sell” on FB) alerted investors to a recent class action lawsuit filed against FB by online advertiser Investorvillage.com. Among other allegations, the suit contends that a “former Facebook employee. . . stated that Facebook does not care about the accuracy of information related to the number of users so long as advertising revenue is not negatively affected.”
Indeed, Wieser writes: “A check on [Aug. 16] shows that Ads Manager now indicates that a campaign with a Reach-based objective has the potential to reach 39 million 18-24 year olds, 63 million 25-34 year olds and 61 million 35-49 year olds” in the U.S. Those figures all sit far above the 31 million 18-24 year olds, 45 million 25-34 year olds and 61 million 35-49 year olds reported by the U.S. Census. Chicago-based politicans would likely approve.
Meanwhile, a survey released on Wednesday from Pew Research finds that 42% of respondents have taken a break from Facebook “for several weeks or more” in the past 12-months, while 26% “say they have deleted the Facebook app from their cellphone.”
Sandy Brasher, researcher of shorts at Rice, Volker LLC, compares Pew’s findings with Facebook’s reported growth in domestic monthly active users and finds the numbers confusing, especially considering the ongoing decline in U.S. searches for Facebook, according to Google Trends, which aggregates the popularity of various search terms (for reference, legacy social network MySpace is added to the below chart, as is Facebook’s fast-growing Instagram unit).
Facebook in blue, Instagram in yellow, MySpace in red. Source: Google Trends
The faltering search frequency and substantial phone app deletions reported by Pew draw a contrast with the company’s own metrics: Monthly active users in the U.S. and Canada totaled 241 million at the end of the second quarter, up 2.1% year-over-year. Brasher concludes to Grant’s: “Their reported user numbers seem strange to say the least.”
*Human capital, in this case, refers not to shareholders who have lost money or users who have had their privacy invaded, but rather “FB employees who had plans to sell shares to fund their life [and] just lost 1/5 of their budget, literally overnight.” The company did generate $17.7 billion in free cash flow in the past 12 months, which could present an alternative means for employee compensation compared to stock options.
Recap Sept. 7
Stocks edged a bit lower, with the S&P 500 finishing the holiday-shortened weak down by 1%, a respectable showing considering the 6% downdraft in the NYSE FANG+ Index over the past four sessions. Commodities and the dollar rose in tandem, while the strongest year-over-year gain in average hourly earnings since 2009 pushed Treasury yields well higher across the curve, with the 10-year yield settling at 2.94%.
- Philip Grant
Thursday, September 6, 2018
Multiple personalities
Yesterday, the U.S.-listed company (with a market cap greater than $500 million) with the worst performance was Coral Gables, Fla.-based Mercantil Bank Holding Corporation. The U.S.-listed company with the second best performance in yesterday’s trading? That same Mercantil Bank. The company’s voting right-carrying A-shares fell by 57%, while the non-voting B-shares closed the session up by 31% after jumping as much as 165% intraday.
Mercantil, spun off from Venezuelan bank Mercantil Servicios Financieros, C.A. on April 2 with $8.4 billion in assets and $6.3 billion in deposits, began trading on the Nasdaq exchange on Aug. 29 as an “emerging growth company” under the 2012 Jumpstart Our Businesses Act. The company’s registration filing explains the practical meaning of that desingation:
As such, we are eligible to take advantage of certain exemptions from various reporting requirements that are applicable to other public companies that are not “emerging growth companies” including, but not limited to, not being required to comply with the auditor attestation requirements of Section 404 of the Sarbanes-Oxley Act, reduced disclosure obligations regarding executive compensation in our periodic reports and proxy statements, and exemptions from the requirements of holding a non-binding advisory vote on executive compensation and shareholder approval of any golden parachute payments not previously approved.
If some investors find our securities less attractive as a result, the trading market for our securities may be reduced, and the prices of our securities may be traded at lower prices and experience greater volatility.
The volatility part is definitely covered. Over the past six trading days, Mercantil A-shares reached as high as $86 dollars a share on Sept. 4, and ticked below $6 a share on Aug. 29. The B-shares have remained range-bound by comparison, oscillating from $6 a share on Aug. 29 to $40 a share a week later. Current market capitalization is just under $2.5 billion.
The freshly spun-off entity is tightly controlled. More than 97% of the 74.2 million A-shares outstanding are owned by insiders, as are more than 58% of the non-voting B-shares.
Grant’s inquired at the company via phone and email for comment regarding the curious activity in its shares. Mum’s the word from Mercantil.
QT progress report
The Fed’s portfolio of securities held outright footed to $4.013 trillion, down by $11.4 billion from last week’s reading. It was Treasurys rolling off the balance sheet this time, while mortgage-backed securities holdings remained unchanged at $1.697 trillion. Today’s reading represents a $22.8 billion decline off the trailing four-week average.
Since the Fed began its QT portfolio run-off program last Oct. 1, total balance sheet holdings are down by 5.55%, for a simple annualized rate of 5.89%.
Recap Sept. 6
Stocks finished a bit lower led by tech, as the Philadelphia Semiconductor Index lost nearly 3% after bearish commentary from KLA-Tencor Corp. management at a Citigroup investor conference. Recent weakness in tech is not confined to the semis: The NYSE FANG+ Index has now lost nearly 10% from its June 20 peak.
Seemingly bearish action took place outside of equities as well. Treasury yields ticked lower across the curve, while a softer dollar was no help for commodities as the CRB Index finished sharply lower and WTI crude fell back to $68 a barrel. The VIX rose to its highest close in three weeks, and cryptocurrencies were hammered with bitcoin dropping below $6,500, near its 2018 low of $5,900 logged on June 29.
- Philip Grant
Tuesday, September 4, 2018
First shall be last
High-grade is a relative term. Year-to-date, the iBoxx USD Liquid Investment Grade Index is down 2.84%, far behind the more speculative end of the credit spectrum as triple-C-rated corporates have managed a 6.44% gain.
Investors are beginning to take note. The iShares iBoxx USD Investment Grade Corporate Bond ETF (LQD on NYSE Arca) saw a combined $994 million in withdrawals last Wednesday and Thursday, the largest outflow in the name since the February rout in short-volatility products. Mohit Bajaj, director of ETF trading solutions at WallachBeth Capital, commented on the withdrawal to Bloomberg: “It’s a lot, especially for as slow as it’s been in the last week of August.” In terms of price, the LQD remains just above the multiyear lows logged during the short but severe correction in early 2016.
The poor performance from investment grade credit can’t be chalked up to excess supply. According to data from Bloomberg, year-to-date issuance has totaled $889 billion through Friday, down 12% from the same period last year. Instead, rising interest rates, (3, 6 and 12-month LIBOR all remain at or near post-2008 highs) in tandem with relatively brisk economic growth, have combined to hinder the lower coupon and lower risk (of default at least) asset class.
Then too, there is credit quality, specifically the growing concentration of corporate membership at the lower end of the investment grade ratings scale. A July 25 research note from S&P Global Ratings found that U.S. nonfinancial corporate debt rated triple-B (the final full stop before junk) totaled $2.66 trillion, nearly triple the $1 trillion outstanding at the eve of the financial crisis in 2007. S&P also notes that “capital structures at many borrowers we rate. . . have become more aggressive, with leverage rising beyond historical levels.” The rating agency remains relatively sanguine, however, concluding that: “We believe that these borrowers can reduce leverage over a two year window and maintain investment-grade credit ratios.”
The bourgeoning ranks of those rated just above junk added another last week, as Moody’s downgraded Ford Motor Company to Baa3 from Baa2 (equivalent to triple-B-minus from triple-B), with a negative outlook. In announcing the downgrade, the rating agency pointed out that Ford has seen its debt jump to 3.3 times EBITDA from 2.6 times in the two years ended on June 30, while EBITDA now covers interest expense by just 1.8 times, down from 4.5 times in June 2016.
Indeed, Ford appears to be spinning its wheels operationally while debt accumulates at a brisk pace. The company is expected to generate $147 billion in revenue this year, up only modestly from the $133 billion top-line from 2012. However, total gross debt has jumped to $153 billion from $105 billion during that period according to data from Bloomberg. Some creditors have headed for the hills in light of the Moody’s downgrade, with Ford’s senior unsecured 5.29% notes of 2046 falling to less than 89 cents on the dollar for a yield-to-worst of 6.13%. Last week, that paper traded above 92 cents.
Other large cap, high-grade borrowers have seen an even more pronounced pile-up in their borrowings, to little ill effect thus far. Analysts forecast that triple-B-plus-rated Verizon Communications, Inc. will generate $131 billion in revenue this year, marginally higher than the $116 billion revenue line from 2012. However there is nothing marginal about the increase in debt over that period, as gross borrowings have ballooned to $115 billion from $52 billion since 2012. Single-A-minus-rated Anheuser-Busch InBev SA is expected to produce a $56 billion top line this year, up from $40 billion in 2012. While revenues have increased by some 43% in the past six years, gross debt has nearly tripled, to $117 billion from $44 billion.
Investors haven’t minded, yet. Verizon’s senior unsecured 5.15s of 2023 trade above 107 cents on the dollar, bestowing a 3.55% yield-to-worst and 78 basis point premium to Treasurys. The Anheuser-Busch senior unsecured 3.65s of 2026 currently trade just under 98 cents on the dollar, for a yield-to-worst of 4.02% and a 117 basis point pickup over Treasurys.
An analysis in the April 6, 2018 edition of Grant’s shed some journalistic light on the plight of those put-upon investors in so-called high-grade corporates:
Low interest rates and tight yield spreads condemn the creditors to mediocre returns (that’s the upside) or outright loss (not so much the downside as the base case). We write to remind the bondholders that they have become the doormats of Wall Street.
Recap Sept. 4
Stocks ticked modestly lower, with the NYSE FANG+ Index losing more than 1% despite Amazon.com, Inc.’s first foray above a $1 trillion market cap. A stronger dollar crimped the commodity complex, while emerging markets continued to struggle with the iShares J.P. Morgan USD Emerging Market Bond ETF tumbling to its lowest since February 2016. Treasury yields ticked higher across the board in bear steepening formation, as the 2- and 10-year spread closed above 24 basis points for the first time since Aug. 17.
- Philip Grant
Friday, August 31, 2018
Dog day afternoon
Let’s wrap up the month of August with a jumbled stew of sightings, from the ridiculous to the sublime. Without further ado, a trio of anecdotes 100% guaranteed to provide no investment value whatsoever:
On Monday, USA Today reported that Mayo, Fla. (population 1,500) has temporarily changed its name to “Miracle Whip” thanks to a marketing arrangement with processed food giant Kraft Heinz Co. (KHC on the Nasdaq). In exchange for the naming rights (not to mention its dignity), the town formerly known as Mayo will receive $25,000 in “city beautification funds.”
Solid move by Kraft Heinz. Definitely cheaper than buying Unilever.
On Monday, the Impact Shares YWCA Women’s Empowerment ETF, ticker WOMN, made its debut on the NYSE Arca exchange. The fund is based on the Morningstar Women’s Empowerment Index, which “is constructed using a rules based methodology to select companies from the Morningstar US Large-Mid Cap Index that have strong women’s empowerment practices,” according to the prospectus.
The fund sports an expense ratio of 76 basis points, as well as a familiar set of top holdings. WOMN’s current top five largest positions are: Amazon.com, Inc., Microsoft, Inc., J.P. Morgan Chase & Co., Johnson & Johnson, Inc. and Exxon Mobil Corp.
A strong lineup, albeit one seemingly identical to the male empowerment ETF.
Finally, we turn to that hotbed of international commerce and cutting edge technology known as North Korea. On Saturday, Singapore-based news organization The Straits Times, citing South Korea’s Yonhap News Agency, reports that “the first-ever Korean International Blockchain Conference will be held over two-days starting Oct.1.”
That’s not the first time that the so-called Hermit Kingdom has attempted to get into the blockchain game. On Monday, Yonhap cited the Korea Development Bank in reporting that North Korea, smitten by certain "characteristics of cryptocurrencies, including anonymity, difficulties of tracing money and cashability," may have unsuccessfully attempted to mine for bitcoin between May and July 2017.
If mining for bitcoin didn’t work, perhaps an ICO could be called for? The name “Rocketmancoin” still appears to be available.
Recap Aug. 31
Stocks cruised sideways on this final unofficial day of summer, wrapping up the week modestly in the green and leaving the S&P 500 higher by 8.5% year-to-date. Treasurys likewise held mostly steady, with some modest steepening pushing the 2- and 10-year spread above 23 basis points after it compressed to a cycle low of less than 19 basis points last Friday.
Commodities managed a flat finish despite a stronger dollar as WTI crude and gold settled at $70 a barrel and $1200 per ounce, respectively. But the green greenback did no favors for the stricken emerging markets complex as the iShares J.P. Morgan USD Emerging Market Bond Fund ETF lumbered back near multi-year lows established on Aug. 13.
- Philip Grant
Thursday, August 30, 2018
Back to the Future
It sounds vaguely familiar: A potent U.S. bull market runs headlong into an emerging markets crisis.
It sounds vaguely familiar: A potent U.S. bull market runs headlong into an emerging markets crisis.
Great moments in corporate communications
Yesterday, China Properties Group Ltd. (1838 on the Hang Seng) reported
Yesterday, China Properties Group Ltd. (1838 on the Hang Seng) reported
QT Progress Report
Recap Aug. 30
Back to the Future
It sounds vaguely familiar: A potent U.S. bull market runs headlong into an emerging markets crisis. Might the so-called Asian Contagion of 1997 and 1998 provide a roadmap for today’s investors as Argentina, Turkey, Brazil and others see their currencies spiral lower and borrowing costs lurch higher? Let’s review the script from last time for potential clues to the future.
As the S&P 500 had entered the teeth of the 1990’s bull rampage (the index was up 111% from April 1994 to July 1997), Thailand was forced to float the baht on July 2 as declining FX reserves made the country’s peg to the dollar untenable. The Bank of Thailand tried to limit the damage by raising interest rates 200 basis points to 12.5% and pledged to spend up to $5 billion to defend the baht, but to no avail. The currency lost roughly half its value in the next six months.
Thai baht/U.S. dollar cross, January 1997 to August 1999. Source: The Bloomberg
Stateside, the summer of 1997 saw choppy but largely sideways price action in the S&P 500, with an abrupt 11% decline in October all but erased by year-end. The bull market resumed in full swing in the first half of 1998, as the S&P 500 tacked on 20% through July.
But as U.S. investors resumed their party, the Thai crisis duly spread to other emerging markets, with the South Korean won and Indonesian rupiah losing 54% and 80% respectively against the dollar in 1997 and 1998. The EM crisis eventually culminated in the Russian debt default of September 1998 and subsequent bailout of U.S. hedge fund Long Term Capital Management. This time, overseas troubles made their way to the shores of the U.S., as the S&P 500 endured a 21% decline from July to October 1998, briefly entering a bear market.
But the U.S. equity bulls had an ace in the hole in the form of Federal Reserve chairman Alan Greenspan. In late September 1998, the Fed cut the federal funds rate by 25 basis points, to 5.25%. When stocks continued to fall in October, Greenspan delivered another, intra-meeting 25 basis point rate cut on Thursday, Oct. 15, 1998, right before monthly options expiration. CNN Money reported at the time that: “As the news of the rate cut hit the floor of the New York Stock Exchange, traders actually cheered and investors rushed to buy stocks and bonds.”
They had good reason to cheer. The S&P 500 fully regained its losses by the end of November, then tacked on another 30% upside through the March 2000 peak of the Nasdaq. While Greenspan’s rate cuts came from a far higher base (the current effective Fed funds rate is just 1.92%), chairman Jerome Powell could always press pause on the QT balance sheet run-off if the unfolding EM panic puts a dent in U.S. asset prices.
Great moments in corporate communications
Yesterday, China Properties Group Ltd. (1838 on the Hang Seng) reported disappointing operating results for the first half of the year featuring a 72% year-over-year revenue decline. While the outcome was disappointing, investors could at least enjoy a most entertaining “management discussion and analysis” commentary that accompanied the press release. An excerpt:
10 years ago, the U.S. printed money like crazy and exported U.S. dollars all over the world. Now the U.S. has become a global enemy, trying. . . to undermine the asset markets of other countries and the global supply chain order. No wonder the U.S. has made a lot of enemies. Fortunately, Trump does not have the same wisdom as Mao Zedong in making alliance with one while fighting another. He wants to fight the world.
Nevertheless, Chinese are savvy and resourceful. Deng Xiaoping said, “we should grope our way across the river, one step at a time.” Jiang Zemin said, “keep a low profile to make a big fortune.” Han Xin demonstrated his immense ability to endure humility [sic] in order to preserve his existence for future accomplishments. Such wisdoms contributed to the creation of incredible historic achievements one after the other.
Stateside, steel drum producer Greif, Inc. (GEF on the NYSE) and subject of a bearish analysis in Grant’s (Sept. 22, 2017) reported third quarter results following the market close yesterday, with a stronger than expected top line partially offset by a revenue forecast and implicit guidance cut for the rest of the year. One anonymity-seeking investor points out a recurring theme from the company’s last four conference calls; a bone to pick with Mother Nature:
From the fourth quarter 2017: "Operating profit before special items was negatively impacted by $5.3 million associated with adverse weather events."
First quarter 2018: "But were negatively impacted by weaker than anticipated Rigid Industrial Packaging & Services volumes in December caused by a temporary winter slowdown."
Second quarter 2018: "Our Rigid Packaging segment was impacted by customer operational interruptions, weather issues and rising raw material costs."
Third quarter 2018 (yesterday): "partially offset by significantly weaker demand from European agricultural customers due to weather, impacts from events in Brazil and continued value over volume decisions in China."
Investors bid GEF shares higher by 2% today, but be forewarned: Fall is just around the corner.
QT Progress Report
The tightening train rolls on. The Fed’s portfolio of securities held outright comes to $4.024 trillion, down $9.7 billion from a week ago as mortgage backed securities rolled off the portfolio this week. Compared to the trailing four-week average, today’s holdings represent a decline of $17.6 billion.
Since QT began just under 11 months ago, the Fed’s total balance sheet is down by 5.31%, for a simple annualized pace of 5.76%.
Recap Aug. 30
The Brazilian real, South African rand and Turkish lira each lost between 1 and 3% against the dollar, while the Argentine peso was hammered to the tune of 13.5% to a fresh record low of 38.5 per greenback. In tandem with the latest lurch wider in the EM currency realm, the stock market saw its first pullback since breaking to new highs last week, while Treasury yields dropped across the curve.
A weak stock market and flat CRB Index didn’t stop WTI crude oil from climbing back above $70 a barrel, while the VIX was also well bid, spiking by more than 10% this afternoon to settle at a near-three week high.
- Philip Grant
Wednesday, August 29, 2018
Turkish bath
In the Republic of Turkey this summer inflation and bond yields surge while the lira crumbles, down 41% year-to-date. In dollar terms, the Turkish stock market is down a whopping 53% in 2018. Now in progress is the hunt for a silver lining.
Sentiment is bad and getting worse. “Turkey entering a steep recession,” a Capitol Economics report declared today. Jason Tuvey, senior emerging markets economist at the London-based research firm, forecasts output contraction of as high as 4% year-over-year in the fourth quarter. That would be the steepest decline since 2009.
Economic sanctions imposed by the U.S. in response to the jailing of American pastor Andrew Brunson (who has since been moved to house arrest) have added one layer of agita; Less-than-comforting rhetoric from Turkish President Recep Erdogan another. Following his re-election on June 24, Erdogan appointed his son-in-law Berat Albayrak to head the newly-consolidated ministry of finance and treasury. Jared Kushner wouldn’t complain, but investors turned thumbs down.
The grim financial picture is also raising the specter of systemic stress. According to analysts at J.P. Morgan Chase & Co., Turkey is facing almost $179 billion in foreign-currency debt maturities through July 2019, a figure which equates to nearly a quarter of full-year GDP. Yesterday, Moody’s Investors Service downgraded the credit ratings of 18 banks and two non-bank financial companies, citing “a substantial increase in the risk of a downside scenario, where a further negative shift in investor sentiment could lead to a curtailing of wholesale financing.”
Might Turkey, the world’s 17th-largest economy by 2017 GDP according to the World Bank, be headed for default? The market is increasingly coming around to that possibility, as 5-year sovereign credit default swaps have spiked recently.
Turkish 5-year CDS. Source: The Bloomberg
How bad might things get? Independent strategist Russell Napier predicts in the Aug. 22 edition of his Solid Ground Fortnightly commentary: “Turkey will almost certainly be the largest emerging market default of all time, should it resort to capital controls as your analyst expects, but it could also be the largest bankruptcy of all time given the difficulty of its creditors in recovering any assets.”
Of course, high risk and outsize opportunities go hand in hand. For a sense of the latter, Grant’s spoke with value investor Haydar Acun, managing partner at Marmara Capital Asset Management in Istanbul. In an email earlier this month, Acun reminded Grant’s that Sir John Templeton achieved massive gains by investing in South Korean assets during the depths of the 1998 emerging markets crisis.
Acun, noting today the acute “boom and bust” nature of Turkish economic cycles, forecasts that the nascent crisis can abate on its own as imports fall and the current account deficit improves. Acun likewise believes that European banks will continue to lend in Turkey, as they can continue to make money thanks to sky-high interest rates. Authorities still have economic levers they can pull, such as privatizing the railways, which would raise significant capital.
Assessing the potential for sovereign default and the imposition of capital controls, Acun observes that “Turkey has never done such things before, and I don’t think they are options for the government.” As for the stock market, Acun reports that Turkish equities are currently trading at “50, 60, 70% discounts to net asset value,” with a number of companies trading with substantial net cash positons.
By way of example, construction firm Enka Insaat ve Sanayi AS (ENKAI TI) holds nearly TRY 5 billion ($773 million) in net cash against a TRY 25.3 billion market cap, and is expected to generate TRY 2.1 billion in free cash flow and TRY 2.7 billion in adjusted net income this year.
Real estate investment trust Alarko Gayrimenkul Yatirim Ortakligi AS, (ALGYO on the Istanbul exchange) currently trades at a TRY 533 million market capitalization, with TRY 471 million in cash and no debt. The company generated TRY 52.1 million in free cash flow over the 12-months ended June 30.
Pharmaceuticals company EIS Eczacibasi (ECILC TI) holds TRY 534 million in net cash, more than 20% of its TRY 2.5 billion market cap, and generated TRY 283 million in free cash flow over the 12 months ended June 30.
Recap Aug. 29
Another day, another new high on the S&P 500, as tech and consumer discretionary led the broad index to its fourth straight record close. Commodities were also bid, with WTI crude advancing back near $70 a barrel, while the Treasury curve flattened a bit amid modest strength in the long end.
But as the bull march continues, emerging markets continue to unravel. Today, the Argentine peso made another lifetime low against the dollar after president Mauricio Macri asked the IMF to accelerate the distribution of its $50 billion bailout agreed to in May.
- Philip Grant
Tuesday, August 28, 2018
Bean oh
Today, the Invesco Deutsche Bank Agriculture Fund ETF (DBA on NYSE Arca),
Today, the Invesco Deutsche Bank Agriculture Fund ETF (DBA on NYSE Arca),
Recap Aug. 28
Bean oh
Today, the Invesco Deutsche Bank Agriculture Fund ETF (DBA on NYSE Arca), which invests in a wide array of agricultural commodities, plumbed a fresh lifetime low, down 9% year-to-date and 42% from its interim highs in April 2014. The record high in the S&P 500 and neutral recent showing from the broad commodity realm (the CRB index remains near the midpoint of its one-year range) puts into relief the grim action in the grains.
DBA, 5-year chart. Source: The Bloomberg
The pain in agriculture prices can be largely attributed to soybeans according to Arlan Suderman, chief commodities economist at INTL FCStone, Inc. Suderman terms soybeans “the anchor of the grain complex.” The ongoing trade spat with China, the largest destination for U.S. agricultural exports at $12.3 billion last year, figures prominently in the equation. Following an unsuccessful round of negotiations last week, the Trump administration yesterday announced a $4.7 billion subsidy package to domestic farmers who have incurred losses as a result of foreign tariffs.
While demand prospects remain tenuous, there is no such ambiguity on the supply side. According to updated estimates from Pro Farmer following their annual crop tour, U.S. soybean production is set to reach a record 53 bushels per acre this season, topping the record of 52 per acre established in 2016 and above the 51.6 bushels forecast by the company on Aug. 10. Sherman Newlin, a farmer in Crawford County, Ill., told Bloomberg: “Soybeans [yields] are going to be phenomenal. To me, the pile still gets bigger.”
There are other problems facing U.S. farmers. China, the world’s largest soybean customer, imports beans to feed its hogs, whose numbers are now threatened by disease. Last Thursday, China’s Ministry of Agriculture and Rural Affairs confirmed the existence of African swine fever in a fourth province of the country. China, home to roughly half the world’s population of pigs, has been forced to cull tens of thousands in response to the disease as no known cure or vaccine exists. Today, the U.N.’s Food and Agriculture Organization warned that the outbreak “may spread to other Asian countries anytime.”
As news flow goes from bad to worse, some investors are loading the bearish side of the speculative boat. According to data from the Commodity Futures Trading Commission, hedge funds carried a net-short position of 40,049 futures and options contracts, which Bloomberg reports is the most bearish positioning for this time of year since 2006.
Confirmed believers in the truism that the cure for low prices is low prices, Grant’s checked in with grain expert and paid-up subscriber Keith Bronstein. Might the brutal price action be setting the stage for opportunity on the long side? Not in the immediate term, councils Bronstein:
Soybean crop development has been optimal and the tariff issue has not been resolved. I believe that Dec. 1 is the point of critical outcome on tariffs. Once we get to Jan. 1, China is safe at home on reliance upon South African supplies. This migrates the world soy surplus entirely to the U.S. At that point, I believe the U.S. would need to shift acres from soy to corn and that will require a real price adjustment.
Now we watch final corn production and wheat crops finishing weather in Europe and the former Soviet Union along with Australia. I still think world wheat numbers have a potential to ignite higher market clearing prices but that may be an October to June story, if at all. Stay tuned.
Note to grain bulls. Bring patience along with your money.
Recap Aug. 28
Stocks finished unchanged, with the S&P 500 managing to eke out another closing high thanks to strength in the real estate realm, while resources took a break from their recent run as the CRB index came under pressure despite a weaker dollar. Treasury yields rose for a second straight day, with the 10-year settling at 2.88% while the 2- and 10-year spread inched wider to 21 basis points.
- Philip Grant
Monday, August 27, 2018
Forest for the trees
On Aug. 14, quasi-state owned military-defense company Xinjiang Production & Construction Corp. defaulted on a RMB 500 million ($73 million) a 270 day note, a development which The Wall Street Journal notes “is nudging China watchers to think harder about the extent to which local governments will step in” to help encumbered borrowers meet their obligations. Public debt may soon take center stage, as so-called local government financing vehicles (LGFVs) face a sharp increase in principal repayments due. According to a Bloomberg dispatch on Friday, LGFV bonds will see $49 billion of quarterly maturities through June of next year. That’s up by 40% from the maturity schedule in 2017.
Not that the word of credit-rating agencies should be treated as gospel. On Aug. 18, Dagong Global Credit Rating Co. was barred by regulators for soliciting new business for one year. Last Thursday, Caixin Global reported the reason for the harsh penalty: Dagong “required at least 26 issuers to purchase its consulting software before it would increase their ratings or the ratings of its bonds.” The software cost $1.4 million on top of additional six figure annual service fees, according to Caixin. In January, Dagong downgraded its U.S. government debt rating to triple-B-plus from A-minus, with a negative outlook (so, adjusted for deceit, Donald Trump’s Treasury could be triple-A).
This summer has been a long, hot one for peer-to-peer lending companies. Last Tuesday, the Peterson Institute for International Economics reported that total outstanding loans in the industry collapsed to less than RMB 1 trillion in July from 1.3 trillion a month before, while 15% of all peer-to-peer lending platforms have “run into serious trouble” since the beginning of June. Author Martin Chorzempa summarizes the potential systemic risks lurking within the peer-to-peer business model:
In practice, P2P platforms in China provide guarantees, meaning that investors get no hint that risk is piling up until suddenly the platform cannot meet its obligations and goes offline. These platforms also issue wealth management-type products that have maturity mismatches, putting them at the risk of a run if spooked investors pull out their investments. The China Banking Regulatory Commission (CBRC) issued rules in August 2016 making these practices illegal, but the turmoil over the last two months indicates that numerous platforms have ignored them.
Those dual cracks in the credit façade correspond with other market indicators suggesting things are less than stellar in the Middle Kingdom. Year-to-date, the Shanghai Composite Index is down 16% in local terms, placing it among the world’s weakest performers, while the renminbi has lost 8% against the greenback since April. The government is duly looking to mitigate Mr. Market’s harsh verdict, with the People’s Bank of China announcing Friday that it has reactivated a policy known as the “counter-cyclical factor” by which local banks fix the renminbi at stronger levels to ward off unwelcome currency weakness.
On Wednesday, China’s State Council issued a statement urging banks and other lenders to keep credit flowing to small businesses, with the council suggesting timelier loan approvals and higher loan-to-value ratios among potential remedies. Also on Wednesday, Bloomberg reported that the General Administration of Customs announced it will not report import and export figures for an array of industrial, agricultural and energy commodities in July, the fourth consecutive month of radio silence. If you don't have anything nice to say...
An Aug. 20 analysis from J Capital Research brings these somewhat disparate indicators into broader relief:
Visits with friends in banks and shadow banks in Beijing, Shanghai and Chengdu this week found a banking industry that is more risk-averse than ever. The hesitancy to lend into a weak economy is making everything harder than it used to be.
Recap Aug. 27
After going more than six months in between new closing highs, the S&P 500 managed its second record finish in two tries. Resources led the way, as a soft dollar buoyed the commodity complex with gold rising back above $1,200 an ounce. Treasury yields moved higher across the board, with the 2- and 10-year spread widening a few basis points off the cycle low reached Friday.
- Philip Grant
Friday, August 24, 2018
No context, no problem
Your headline of the day (year?), from the Miami Sun Sentinel:
Your headline of the day (year?), from the Miami Sun Sentinel:
Take it all
A changing of the guard is afoot in the Big Apple.
A changing of the guard is afoot in the Big Apple.
Correction
Recap Aug. 24
No context, no problem
Your headline of the day (year?), from the Miami Sun Sentinel:
Florida candidate for Congress: Alien abduction doesn't define me
Take it all
A changing of the guard is afoot in the Big Apple. Yesterday, tech website Recode reported that WeWork Cos. is closing in on becoming the number one office space lessee in Manhattan, set to surpass incumbent J.P. Morgan Chase & Co. “any day now.”
Also yesterday, fellow tech site Geekwire relayed that WeWork is “in the midst of a massive expansion that will more than double its presence in the Seattle area.” Jon Slavet, managing director for the U.S. and Canada West at WeWork, told Geekwire that the company plans to grow to 1.5 million square feet in Seattle by early next year, from the current 900,000 square feet.
It’s not hard to find the genesis of WeWork’s rapid expansion. On June 14, The Wall Street Journal reported that SoftBank was engaged in talks with its portfolio company for a further “multibillion dollar” investment valuing WeWork at between $35 and $40 billion. That compares to a $20 billion valuation garnered by WeWork from a $4.4 billion SoftBank-led equity investment in August 2017. Nearly a third of that prior $4.4 billion was used to cash out existing shareholders, according to the Journal.
With SoftBank and its Vision Fund venture capital arm readily paying the bills, why not go for the downs? Conventional profitability is clearly no object: While WeWork managed to double its revenues to $886 million last year, net losses grew even faster to $933 million from $430 million in 2016. Bloomberg reports that closely held WeWork managed to lose less than its top-line take in the first half of this year, finishing $723 million in the red through June on $764 million in sales. Alternatively, WeWork declared in an April 24 prospectus that the company generated $233 million in “Community Adjusted EBITDA” in 2017, up from $96 million the year prior. That newfangled term of art is described thusly:
We define Community Adjusted EBITDA as Adjusted EBITDA before Growth Investments further adjusted to remove general and administrative expenses. Community Adjusted EBITDA Margin measures Community Adjusted EBITDA as a percentage of membership and service revenue and management fee income from advisory services provided to Branded Locations.
Innovation clearly takes many forms.
Anyway, the rapid growth in the short-term leasing market has duly stirred nascent competition. In June, peer company Convene LLC completed a $152 million Series D fundraising round, while in July fellow co-working operator Knotel, Inc. announced the purchase of commercial real estate data firm 42Floors, giving the acquirer “access to data and technology on over 10 billion square feet of office space,” according to the press release.
It’s safe to say WeWork is not taking this competitive encroachment lying down. From a Bloomberg dispatch yesterday:
The company is offering commercial real estate brokers worldwide a 100% commission on the first year of rent paid by any tenant who switches to WeWork from a top competitor and signs a lease by October 1. Tenants also get half off the first year’s rent if they sign for at least 12 months. That means, accounting for the discount, that WeWork’s current bonus to brokers is five times the standard commission it typically offers of 10% on the first year’s rent.
As it adds locations around the globe, the startup often offers discounts to “assist in driving initial occupancy levels,” which made its average revenue per member drop more than 6% last year, according to [the prospectus]. Its overall sales and marketing costs, meanwhile, rose from $43 million to $143 million in 2017.
The Dec. 15, 2017 edition of Grant’s termed highly indebted and highly acquisitive SoftBank the “epitome of the cycle.” Can you be out-epitomed by your own office-space portfolio company?
Correction
A blunder in yesterday’s ADG: Vancouver is Canada’s third largest city, not second. Montreal takes that slot. Back to remedial geography class for your author.
Recap Aug. 24
New highs are here at last, as the S&P 500 finally punched above its late-January peak amid strength in resources and technology. Fittingly, the bullish milestone took place on the day of Fed chairman Jerome Powell’s keynote speech in Jackson Hole, an address which the market took to be on the dovish side as evidenced by a weak dollar and strong showing from the commodity complex.
While stocks party, the yield curve continues to race toward inversion. The spread between the 2- and 10-year Treasury notes shrank to less than 19 basis points, another fresh post-2007 low.
- Philip Grant
Thursday, August 23, 2018
Canada dry
Summer is still in full swing, but things remain pretty cool in the housing market of the Great White North. According to the Canadian Real Estate Association, home sales ticked 1% lower year-over-year in July, with total transactions at their lowest since 2012. In the formerly white-hot metro Vancouver (Canada’s third-largest city) sales plunged 30% to an 18-year nadir. Year-to-date through July, nationwide activity is at its slowest since 2009, while the Teranet-National Bank Home Price Index rose by 1.75% year-over-year, also a fresh post-2009 low. Phil Moore, president of the Real Estate Board of Greater Vancouver, commented: “With increased mortgage rates and stricter lending requirements, buyers and sellers are opting to take a wait-and-see approach for the time being.”
Waiting and seeing. Teranet-National Bank House Price Index, year-over-year change. Source: The Bloomberg
The tightening macroeconomic screws don’t look set to loosen anytime soon. Last Thursday brought the release of hot inflation data, with July headline CPI rising by 3% year-over-year, well above the consensus 2.5%. That nudged the odds of a 25 basis point rate hike from the Bank of Canada at the Oct. 24 meeting to 63% from 53%, according to interest rate futures. Meanwhile, the current five-year Canadian bond yield of 2.2% remains near the seven year highs reached in May while growth in overall money supply continues to abate. According to the Bank of Canada, M2 grew by 3.67% year-over-year in June, just off the post-financial crisis low of 3.38% logged one month prior. Since the housing boom was reignited in 2009, monthly M2 growth has averaged 6.56% on a year-over-year basis.
As rates put the squeeze to the encumbered Canadian borrower (household debt stood at 178% of disposable income at year-end 2017 according to the Organization for Economic Co-operation and Development, far above the U.S. peak of 144% in 2007), the regulators are also trying to pump the brakes. Thus, on Sept. 17, the province of British Columbia will introduce a new property transfer tax, which will require homeowners to provide their citizenship information, among other data, if purchasing a home through a corporation or trust. That follows the nationwide introduction of mandatory stress tests by the Office of the Superintendent of Financial Institutions in January, which compel all homebuyers to show that they can afford interest payments at the greater of the Bank of Canada’s five-year benchmark mortgage rate or 200 basis points above the contracted rate.
On a headline basis at least, soft data, higher interest rates and unwelcome regulatory changes were nowhere to be found in the fiscal third quarter results from Canadian Imperial Bank of Commerce (CM on the Toronto Stock Exchange). This morning, CIBC announced a 25% year-over-year jump in net income while increasing the quarterly dividend by 2.3% amid a jolt in its U.S. operations following its June 2017 acquisition of Chicago-based PrivateBancorp, Inc. In response, shares rose slightly to close to within 1.5% of the all-time highs reached on Jan. 5.
CIBC’s strong bottom line results contrast with a marked slowdown in mortgage lending, an important metric considering that the bank’s exposure to domestic residential mortgages stands at 60% of its total loan book. In the third quarter, mortgage balances rose by a modest 2.5% year-over-year, a drastic slowdown from the 13% growth in the third quarter last year. Asked about results excluding the operations of the U.S. subsidiary, chief financial officer Kevin Glass noted that earnings were essentially unchanged on a sequential basis, amid “slightly higher. . . loan loss provisions in the real estate business.”
There’s more where that came from.
QT progress report
The Fed’s portfolio of securities held outright footed to $4.034 trillion this week, a modest $1.3 billion decline from the prior reading. Mortgage-backed securities represented more than 100% of the decline, as Treasury holdings increased slightly. Today’s holdings are down by $17.5 billion from the trailing four-week average.
Since the “QT” operation began on Oct. 1, the Fed’s total balance sheet holdings are down by 5.09%, for a simple annualized pace of 5.63%.
Recap Aug. 23
Waiting for Godot, 2018 style. Stocks edged lower, as the S&P 500 nears a fifth straight week of remaining within 3% of its January peak without breaking through to new highs. While the broad average treads water, the yield curve continues to collapse, as the 2- and 10-year Treasury spread fell to another cyclical low of less than 20 basis points. A solid bounce in the Dollar Index looked to pressure commodities, with the exception of WTI crude which finished near $68 a barrel.
- Philip Grant
Tuesday, August 7, 2018
Earplugs optional
Grist for a potential sequel to Dazed and Confused?
Grist for a potential sequel to Dazed and Confused?
Dark Star
Silence is golden, usually.
Silence is golden, usually.
Recap Aug. 7
Earplugs optional
Grist for a potential sequel to Dazed and Confused? From Germany’s Deutsche Welle:
Two elderly German men escaped the confines of their nursing home on Friday to attend Wacken Open Air, police said.
The nursing home alerted police after the gentlemen were found to be missing from the center. Police then found the aging metalheads at 3 a.m. at Wacken Open Air, the world’s biggest heavy metal festival. A police spokeswoman said they were "disoriented and dazed."
The men were reluctant to leave the four-day festival so police escorted them home with the help of a taxi and a patrol car.
"They obviously liked the metal festival," police spokeswoman Merle Neufeld told public broadcaster Norddeutscher Rundfunk. "The care home quickly organized a return transport after police picked them up."
You got to give the people what they want.
Dark Star
Silence is golden, usually. For a recent exception to the rule, we turn our compass north to Canada’s Constellation Software, Inc., (CSU on the TSX) a Toronto-headquartered conglomerate that strives “to acquire, manage and build market-leading software businesses,” according to the corporate web site.
For Constellation and its longtime, publicity-shy president and chairman of the board Mark Leonard (described by the Globe & Mail as the Warren Buffett of Canada), less is more and, so, the company announced on July 25 that it would no longer hold quarterly conference calls. A day later, Constellation reported weaker than expected second quarter figures, featuring a slight revenue miss and a larger shortfall on the bottom line. Adjusted earnings per share registered at $5.75, well below the consensus $6.78, while operating cash flow declined by 13%. In response, shares traded lower by 10%.
Of course, that decline was little more than a drop in the bucket to all but the most recent buyers of Constellation stock. Shares are up by 520% over the last five years, a 41% compound annual growth rate, and up by 53% from a bearish assessment in the Dec. 9, 2016 edition of Grant’s. Other corporate virtues are also readily apparent. Somewhat unusually for a growth-by-acquisition vehicle, Constellation’s balance sheet shows a net cash position, as the company finances the bulk of its M&A activity through cash from operations as opposed to debt. According to the Street (Bay Street, that is), mushrooming growth isn’t expected to abate anytime soon: Analyst consensus calls for revenues of C$3.5 billion and adjusted net income of C$570 million in 2019, far above the C$2.8 billion and C$289 million logged in the trailing 12-month period.
Those gaudy growth expectations draw something of a contrast with Constellation’s second quarter figures. While headline revenues jumped 25% year-over year, organic revenue growth registered just 4%, or 1% on a constant currency basis. Adjusted earnings before interest, taxes, depreciation and amortization (EBITDA) margins came in at 23% for the quarter, down from 26%, while adjusted net income of $52 million barely budged from the $51 million in the second quarter of 2017.
Howard Leung, an analyst at Veritas Research Investment Corp., suggested to Grant’s that the margin decline may have stemmed from faster than expected growth in staffing expense costs, particularly in professional services. Leung, who in March upgraded Constellation shares to buy from a sell, expects the margin contraction to soon abate, pointing to management’s demonstrated ability to shape up prior acquisitions.
An investor who wishes to remain anonymous put it slightly differently: “At best there is a ramp up in costs somewhere that is temporary. At worst their core high margin business is in decline.”
Clearly, the investing public has conferred the benefit of the doubt on Constellation: With shares priced at 67 times trailing adjusted EPS, just 0.71% of the float is sold short, according to data from Bloomberg. That’s a lower short interest than any of the FAANG contingent of Facebook, Inc., Apple, Inc., Amazon.com, Inc., Netflix, Inc. and Alphabet, Inc.
For our part, the company's increasingly poor disclosure and the increasing difficulty in moving the needle through acquisitions following its rapid ascent are the salient concerns. Indeed, Constellation spent C$43 million on an undisclosed number of deals in the quarter, far below the expectation of analysts at Industrial Alliance Securities, who had penciled in C$80 million in deal volume for the period. Leonard seemed to acknowledge that second point of concern in his April shareholder letter (it will be Constellation’s last such annual correspondence), albeit in hypothetical terms:
One day Constellation may find that vertical market software businesses are too expensive to rationally acquire. If that happens, I hope we'll have had the foresight and luck to find some other high return on equity non-VMS businesses in which to invest at attractive prices. I am already casting about for such opportunities. If we don’t find attractive sectors in which to invest, then we’ll return our free cash flow to our investors.
The company’s decentralized structure manifests itself in interesting ways. Asked about how recent acquisitions integrate into the company on an Oct. 27, 2017 conference call, chief investment officer Bernard Anzarouth replied:
I think about 50%, 50% of the acquisitions that we've been making have been tightly integrated to our existing operations and the other 50% are standalone operations, we can tell you that. . . But it's really hard, it's not a crisp number that I can give you.
We imagine that investors find such ballpark figures to be no problem, so long as the stock continues to go up. Of Constellation’s demonstrated desire to share as little with investors and the public as possible, Grant’s wrote:
In the absence of information, one shouldn’t dogmatize. Then again, in this case, information seems to be withheld. One is curious to know, for example, whether, ex-acquisitions, Constellation’s business is contracting or expanding. It had better be expanding, given the rise in cloud computing and app-based solutions.
A simple question for those mostly happy CSU shareholders: What’s in your portfolio, exactly?
Recap Aug. 7
Another modest gain in the S&P 500 is relegated to the back-burner, after Tesla, Inc. CEO Elon Musk pronounced on Twitter this afternoon that the company is seeking to go private at $420 a share. The evident absence of financing for such a deal (despite Musk’s initial claim to the contrary) served as no problem to investors, who bid TSLA shares higher by 10%.
In more conventional action, yields ticked higher across the Treasury curve, while a downtick in the U.S. Dollar Index afforded the beleaguered Turkish lira a respite after collapsing by nearly 5% yesterday.
- Philip Grant
Monday, August 6, 2018
Post pattern
Cleanup in aisle three. It’s been a rough road lately for the those legacy supermarket mainstays cranking out canned soup, processed cheese and boxed cereal; since July 2016, the S&P packaged foods sub industry index is down by 16%, lapped by the S&P 500’s 31% rise over that period. However, the beleaguered group got some good news last week in the form of better than expected quarterly results from industry players Kraft-Heinz Co. (KHC on the Nasdaq) and Post Holdings, Inc. (POST on the NYSE) that spurred strong bullish reactions in the share price of each. Let’s take a quick look at a pair of companies that came under the scrutiny of Grant’s in the March 25, 2016 (as well as March 10, 2017) and Sept. 16, 2016 issues, respectively.
Kraft-Heinz shares caught a near 9% pop on Friday after reporting $1 per share in adjusted earnings and $6.69 billion in revenue, above the consensus $0.92 in adjusted EPS and $6.56 billion revenue. The stronger bottom line was no thanks to margins. Adjusted net income margins footed to 17.1% for the quarter, down from 19.4% year-over year. Instead, it was cost cutting that carried the day, a testament to the thrifty ways of KHC’s majority shareholders, Brazilian private equity firm 3G Capital and Warren Buffett’s Berkshire Hathaway, Inc.
Perhaps more than results, M&A potential may explain Friday’s pop. According to the New York Post, Kraft-Heinz has entered into “exploratory talks,” with Campbell Soup Co. (CPB on the NYSE), another Grant’s pick-to-not-click from March 25, 2016 which in December paid 19 times trailing adjusted earnings before interest, taxes, depreciation and amortization (EBITDA) to acquire pretzel company Snyder’s-Lance, Inc.
Asked about potential acquisitions on Friday’s conference call, Kraft-Heinz CEO Bernardo Vieira Hees did nothing to quiet the rumor mill:
I think the food industry is an industry that has not consolidated with the same speed as other[s]. . . So we do believe looking mid or long-term that there will be more consolidation in the industry and we have not been shying [away from saying] that we want to be a force behind this when it happens.
A look at the company’s stagnant income statement can help explain KHC management’s eagerness to do a deal. Next year, the Street is penciling in $26.5 billion in revenues, $7.9 billion in adjusted EBITDA and $4.7 billion in adjusted net income, virtually unchanged from 2016’s $26.5 billion, $8.2 billion and $4.2 billion respective figures. Thanks to a 35% markdown from its February 2017 highs, Kraft-Heinz shares currently trade at 16 times consensus adjusted EPS for 2019. With net debt at $31 billion, a leverage ratio of over four times EBITDA and a triple-B credit rating at Standard & Poor’s (the last full stop before junk), a corporate marriage with the even-more encumbered