Debtors Paradise
The relentless recent rally in government bonds reached a new crescendo today

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

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

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

It's Not Easy Being Green
Environmental, social and governance-related “issues” abound at DWS Group, a former employee alleges.

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

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

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

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

“Sustainable” inflows by quarter.  Source: Morningstar

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

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

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

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

Recap Aug. 2

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

- Philip Grant

Passive Investing
The oil majors pinch pennies.

The oil majors pinch pennies. Exxon Mobil announced today that capital expenditures will foot to around $16 billion in 2021, the low end of a previously provided $16 billion to $19 billion range.  That compares to $21.4 billion last year and $31 billion in 2019.

Peer Chevron followed suit, downshifting its full-year capex guidance to $13 billion. The second-largest domestic energy company had previously penciled in $14 billion to $16 billion in capital spending through 2025, a fraction of the $39.8 billion investment seen in 2014, when West Texas Intermediate crude approached $100 a barrel. 

Equity investors were unimpressed, as shares in the pair sagged by 2% and 1%, respectively.  Yet the energy bull market quietly continues apace, as WTI pushed back above $74 in early afternoon despite a stronger dollar, approaching the multi-year highs just above $75 a barrel logged last month. 

Everybody's Talkin'
Vlad the impaled.

Vlad the impaled. Stonk trading venue extraordinaire Robinhood Markets, Inc. (HOOD on the Nasdaq) suffered a rocky start to its life as a public company yesterday, as shares sank 8.4% from their $38 per share IPO price, which was itself the low end of a previously provided $38 to $42 range. That exceeded the 8.2% decline from doomed broker MF Global in 2007 to mark the worst debut on record of any of the 51 companies that raised at least $2.1 billion, Bloomberg relays.   Soft demand from Main Street contributed to that lackluster showing, as net retail buying footed to a modest $18.8 million yesterday, per data from Vanda Research. 

That disappointment is unlikely to linger too long for senior management, as Robinhood’s $30 billion valuation compares to an $11.2 billion value obtained from a series G fundraising round just 11 months ago.  Based on yesterday’s figure, Bloomberg calculates the net worth of co-founders Vlad Tenev and Baiju Bhatt sit at $2.2 billion to $2.5 billion, respectively. Thanks to their ownership of super-voting class B shares, the pair will maintain 65% control over the company through a combined economic interest of 15.8%. 

Then, too, the rank-and-file was free to ring the register yesterday.  Robinhood noted in its S-1 filing that employees could sell up to 15% of their holdings immediately upon the listing, and another 15% three months later, instead of a more typical six-month lockup period for insiders.  That immediate selling interest perhaps contributed to yesterday’s underwhelming debut.

Of course, one bad day is just that. Asked by CNN yesterday about his expectations prior to the start of trading, Tenev name-checked the author of “The Intelligent Investor” in explaining his philosophy:

I think we’re going to be relentlessly focused on the long term, as we have been in the past and, as I think it was Benjamin Graham [sic] once said: ‘Over the long run, the markets are a weighing machine.’ So, we’d like to be a heavy company over the long term, so to speak.

Regular run-ins with regulators complicate Tenev’s vision.  In December, Robinhood coughed up a $65 million fine to the SEC to settle allegations of “misleading statements and omissions in customer communications” regarding the online broker’s practice of peddling its order flow to high frequency trading firms, a business model cornerstone which accounted for 81% of revenue in the first quarter.  One month ago, the Financial Industry Regulatory Authority (FINRA) extracted $70 million in fines and restitution penalties from Robinhood, stemming from an alleged failure to conduct due diligence on new customers and false assurances to more than 800,000 options trading users that their accounts were margin-disabled (many such derivatives automatically use margin), potentially exposing novice investors to outsize losses. 

While those levies covered alleged misconduct ranging from 2015 to 2018, more topical concerns remain. Robinhood disclosed Tuesday that FINRA is investigating the company’s compliance with “registration requirements.” The problem: CEO Tenev remains unlicensed with the self-regulatory organization, owing to a failure to complete the requisite exams demonstrating a “minimum understanding and expertise” of relevant securities industry rules.  Tenev attributed his lack of credentials to his company’s organizational structure: 

Well, to be clear, I'm the CEO of Robinhood Markets, which is a holding company, and we have a number of regulated businesses that are at the entity level under the holding company. So Robinhood Financial is an introducing broker-dealer, Robinhood Securities clearing broker-dealer. Of course, we have Robinhood Crypto and each of these businesses have their own leadership license where required. And we think that structure is reasonable given our business.

Asked by CNN correspondent Julia Chatterley whether he should not take the FINRA exams, if only to “shut everybody up,” Tenev responded: 

Yeah, we don't think that's required at this point.

Yet as watchdogs give Robinhood the side-eye and the Reddit crowd gives HOOD shares a wide berth, one contemporary thought-leader provides her imprimatur.  During yesterday’s selloff, ARK Investments founder and chief investment officer Cathie Wood bought some 1.3 million shares for the ARK Innovation ETF, a fund which aims to express the firms “investment theme of disruptive innovation.”

Recap July 30

A 50 basis point pullback in the S&P 500 pushed the broad index into the red for the week, marking the second weekly decline in the past three tries, while Treasurys remained well bid with the 10- and 30-year yields falling to 1.23% and 1.9%, respectively.  Gold slipped to $1,816 an ounce to give back a chunk of yesterday’s strong rally, bitcoin held just above $40,000 and the VIX climbed back above 18. 

- Philip Grant

VIE on the Prize
Let's talk it out.

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

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

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

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

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

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

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

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

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

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

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

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

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

Epitome of the cycle?  The bulls hope not. 

QE Progress Report
Reserve Bank Credit, or interest bearing assets on the Fed balance sheet, rose to a fresh high of $8.199 trillion, up $25 billion from a week ago.  That represents 17.7% year-over-year growth and a doubling from the March 2020 selloff, as the Fed turned on the monetary spigots in response to the pandemic. 
Recap July 29

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

- Philip Grant

Heal Thyself
They’ve fallen and they can’t get up.

They’ve fallen and they can’t get up. ATI Physical Therapy, Inc. (ATIP on the NYSE), the country’s largest outpatient provider, had an unpleasant surprise earlier this week.  In its first quarterly earnings announcement since going public last month via a merger with a blank check firm, ATI slashed its full-year 2021 guidance to $655 million in revenue and $65 million in adjusted Ebitda (using the midpoint of the provided ranges), down from previous projections of $731 and $119 million, respectively.  

Management blamed heavier than-expected staff attrition rates in tandem with “intensifying competition for clinicians in the labor market” for the shortfall, but noted that demand remains brisk and promised “a range of actions related to compensation, staffing levels and other items” to remedy the situation.  Mr. Market was unimpressed, sending shares on a 54%, two-day swan-dive. 

That emphatic decline caught Wall Street off guard, as each of the five sell-side firms covering the company had rated shares “buy” or “outperform” prior to Monday’s thunderbolt.  Analysts at Barrington Research, who promptly downgraded their assessment of ATI to “market perform,” identified some less than-reassuring details beyond the lackluster outlook:  

The company chose to release its results before it had been able to calculate income tax expense. As a result, the earnings release lacked an EPS figure. The release also lacked a share count, a balance sheet, a cash flow statement or, for that matter, a good defense for why the company’s original guidance (which was maintained up until Monday) ever made sense. 

We are shocked by what has unfolded at ATI. 

ATI’s beeline to the public market colors its current predicament.  The rehabilitation outfit agreed to merge with special purpose acquisition firm Fortress Value Acquisition Corp. II in February, a transaction completed six weeks ago.  

Apart from offering a quicker path to a public listing compared to the conventional initial public offering, the SPAC deal structure allows promoters to issue long-dated and often rosy forecasts, a practice which is verboten in the more heavily-regulated IPO process.  Thus, ATI’s February investor presentation penciled in $1.24 billion in revenue and $268 million in adjusted Ebitda for 2025, up from $785 million and $128 million, respectively, before the bug bit in 2019.  

Of course, those figures are downright conservative compared to the pie-in-the-sky projections seen in other corners of the SPAC “space.”  An April analysis from the Financial Times showed that nine blank check-backed electric vehicle-related companies that came to market last year projected an aggregate $26 billion in revenues in 2024, representing a 270% compound annual growth rate from the $139 million aggregate top line achieved last year. 


An ebbing of the late 2020 and early 2021 blind pool mania, evinced by a 32% drawdown in the Defiance Next Gen SPAC Derived ETF from its February high-water mark, has had its predictable effect on sentiment.  “Companies that go public via a SPAC tend not to have the stable, predictable business models” of those utilizing the traditional IPO process, Greg Martin, managing director at private equity market-making firm Rainmaker Securities, tells Bloomberg today. “Investors may begin to have less faith in companies that go public via a SPAC, and the quality of the SPAC sponsor is going to become increasingly important.” 

Merger proceeds are rarely the sole source of cash in SPAC deals, as outside private investors typically kick in additional funds via so-called private investment in public equity, or PIPE, financing.  But that avenue has dried up as prices pulled back, and sponsors are increasingly forced to pay up for capital, in the form of convertible bonds. 

Data from Bank of America show that recent SPAC deals have included convertible bond offerings at carried interest rates ranging from 6% to 8.5%.  That compares to an average market-wide convertible coupon of 2.3%, and a 3.6% rate for companies in need of rescue financing during the depths of the pandemic last year.   

“The same investors who once piled money into PIPEs are now asking for protections and concessions through investments like convertible debt,” Omeed Malik, founder and CEO of boutique investment bank Farvahar Partners, told tech website The Information last Friday.

A raft of prospective new entrants will further test both the market’s appetite and the mettle of sponsors. Some 421 blank check firms that have come public since the start of 2020 are still looking for an acquisition dance partner according to data from Spacinsider.com, more than two thirds of the 632 SPACs which have come public over that period. For context, a mere 59 SPACs were outstanding at the end of 2019, with four of those still in search of a merger target. Today’s hordes of hopefuls have plenty of incentive to get a deal across the finish line, as a SPAC typically provides a sponsor a two-year window to complete a merger, or else be compelled to return capital to investors.  

See the analysis “Short this index” from the Dec. 25 edition of Grant’s Interest Rate Observer for a primer on 10 SPAC-related picks-to-not-click. 

Recap July 28

Stocks and bonds took a stand-pat FOMC meeting in stride, with the S&P 500 and Nasdaq 100 indices finishing flat and slightly higher, respectively, while the 10-year yield held unchanged at 1.23%.  WTI crude caught a bid, rising above $72 a barrel, while gold edged higher to $1,808 an ounce to creep towards the upper end of its tight recent range. The VIX pulled back to 18.3, down 5% on the day. 

- Philip Grant

Power of the Purse
Senate negotiations over the proposed $1 trillion infrastructure bill

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

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

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

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

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

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

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

Might spendthrift governments help support the CPI as well? 

Recap July 27

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

- Philip Grant                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                  

A Spot of Value
The United Kingdom will post a heady 7.6% GDP growth figure in 2021,

The United Kingdom will post a heady 7.6% GDP growth figure in 2021, if a new projection from The Ernst & Young ITEM Club is on the beam. That’s up from a 6.8% guesstimate three months ago and would mark the fastest rate of output expansion since 1941.  The snappy recovery is expected to return Great Britain to its pre-virus levels by the end of the year, EY predicts today, as the GDP deficit to pre-pandemic levels narrowed to 3% in May, compared to 8% in February. 

“A virtuous cycle of positivity among businesses about rising consumer spending could boost firms’ confidence and output,” EY U.K. Chair Hywel Ball commented. “The fuel to sustain this – strong household and corporate balance sheets, and supportive fiscal and monetary policies – is there.”

Relatively inviting corporate valuations, following years of Brexit-influenced malaise and the Covid crucible, color Britain’s economic rebound.  After all, the FTSE 100 Index trades at 13 times consensus 2021 earnings, well below 17.5 times for the Stoxx Europe 600 Index, let alone the 22.6 times forward earnings price tag for the S&P 500.  Then, too, the FTSE offers a 3.4% dividend yield, compared to 2.4% for the Stoxx 600 and 1.3% for the S&P 500. 

That relatively target-rich environment has not escaped the attention of global private equity behemoths, who have engineered 13 buyouts of publicly-traded companies year-to-date at an aggregate $31 billion price tag per Dealogic, marking the busiest start to the year since 2007.

There’s more where that came from: KKR, steward of some $367 billion in assets, told the Financial Times on July 6 that it will allocate additional staff towards identifying British takeover candidates. A move to larger quarters in Mayfair’s Hanover Square is likewise on tap.  Rivals Blackstone and Carlyle are also adding senior dealmakers to focus on Great Britain, the FT notes. 

Last Friday, p.e.-sponsored aerospace and defense firm Cobham Ltd. launched a £2.58 billion ($3.55 billion) bid for peer Ultra Electronics Holdings plc at a 42% premium to Thursday’s closing price.  Ultra’s board indicated its support for the deal after the bidder pledged to provide the U.K. government with “appropriate undertakings in respect of national security.”

The recent bidding war for supermarket mainstay Wm Morrison plc brings the new dynamic into starker relief.  On July 3, SoftBank-backed Fortress Investment Group struck a deal to buy the 121-year-old chain for £9.5 billion including debt, representing a 49% premium to the company’s pre-deal share price and topping previous approaches from Clayton, Dubilier & Rice and Apollo Global Management, in what would be the largest leveraged buyout since the financial crisis. As the following price chart demonstrates, p.e.’s upbeat assessment of Morrison’s prospects marks a distinct break from the public investor’s appraisal: 

Jolted awake: Wm Morrison five-year price chart.  Source: The Bloomberg

The unfolding p.e. boom has caught the attention of equity investors.  Buyout firm Bridgepoint Group Ltd. last week enjoyed a gangbusters debut on the London Stock Exchange, with shares jumping by more than 40% in the four sessions following its Tuesday IPO pricing to value the firm at more than £4 billion.  Three days later, Sky News reported that newly-public Bridgepoint has opened preliminary talks with potential buyers of its Burger King U.K. master franchisee business.  Any sale would likely take place more than a year from now, Sky relays, though that process could be accelerated into early next year if the fast-food chain continues to see its top line expand “at a significant rate.”  

“Private equity is rampant. . . they are the dominant force now,” Martin Sorrell, founder and chair of S4 Advertising Group, told the Financial Times on July 12. “We seem to be moving away from the pandemic and everyone is feeling more ballsy.  As long as interest rates remain low there is no reason for this to change.” A senior p.e. dealmaker added that: “If you’re sitting in the States right now where the market is pretty bonkers, the U.K. looks quite attractive [by comparison].”

Might the p.e. shopping spree augur bullish things for U.K. equities as a whole?  See the April 30, Feb. 5 and Dec. 11, 2020, editions of Grant’s Interest Rate Observer for a series of picks-to-click which offer potentially compelling value propositions. 

Recap July 26

A low-key summer session suited the bulls just fine, as the S&P 500 rose another 25 basis points, logging its fifth straight green finish following last Monday’s selloff.  Treasurys came under modest pressure, with the 10- and 30-year yields edging higher to 1.29% and 1.94%, respectively, while gold remained stuck near $1,800 an ounce and WTI crude held at $72 an ounce.  The VIX finished only slightly higher at 17.6, giving back the bulk of its double-digit percentage gains in the pre-market. 

- Philip Grant



China Doll
Once is happenstance, twice is coincidence and the third time it’s enemy action.

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

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

Gimme Shelter
Euthanasia of the renters?

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

Source: The National Multifamily Housing Council

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

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

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

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

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

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

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

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

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

Transitory is a relative term.   

Recap July 23

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

- Philip Grant

Upstairs, Downstairs
We can go lower.

We can go lower.  The European Central Bank declared today that it will hold benchmark interest rates at or below their current minus 50 basis points until measured inflation gains a lasting foothold north of 2%. That strategy shift from a previous goal of near- but below-2% inflation, the ECB notes in this morning’s statement, “may also imply a transitory period in which inflation is moderately above target.” Headline Eurozone CPI advanced by 2.5% from a year ago in June but has averaged just 1.4% since the central bank took its deposit rate below zero for the first time in May 2014. 

As the mandarins in Frankfurt pledge to goose the cost of living in hopes of delivering an economic jolt, colleagues down Mexico way take a more conventional approach.  After today’s release showing a 5.75% annual CPI rise over the first two weeks of July, marking the highest reading for that period since 1999, Mexico central bank board member Jonathan Heath took to Twitter to characterize that development as “definitely bad.”  The Mexican central bank hiked its benchmark policy rate to 4.25% from 4% at its most recent meeting on June 23, reversing a similar cut four months ago and marking the first tightening move since the end of 2018.

Stock Drawer
Monday’s 1.6% decline in the S&P 500 marked the worst day for stocks in two months, but Joe and Jane six-pack were ready:

Monday’s 1.6% decline in the S&P 500 marked the worst day for stocks in two months, but Joe and Jane six-pack were ready:  Individual investors purchased a net $2.18 billion of equities during Monday’s selloff per data from Vanda Research, the largest such shopping spree on record.  For context, net retail purchases never topped $1.5 billion from June 2016 until the lockdowns began last spring but have since regularly exceeded that threshold. 

Those dip-buyers are now sitting pretty. The S&P 500 swiftly recovered over the following two days to once more approach its high-water mark and extend the streak since its last 5% drawdown to nine months, the longest stretch since 2018.  The broad index has seen a 3% pullback four times so far this year, swiftly recouping those losses on each occasion.

Much of Monday’s buying power was concentrated away from single name equities.  Exchange traded funds accounted for 44% of Monday’s retail inflows, Vanda finds, up from about 29% on an average day.  That was no fluke.  Year-to-date ETF inflows footed to $488.5 billion as of last Thursday, Bloomberg relayed last week, already on the cusp of topping the full-year record influx of $497 billion established last year with more than five months to spare. 

New products are naturally proliferating to meet that surging demand, introducing some operational quirks.  Bloomberg reports that the Direxion Low Priced Stock ETF (LOPX on the NYSE Arca), which debuts today with a mandate to target equities trading at between $2 and $5 per share, maintains a near 7% weighting in AMC Holdings Entertainment.  Following a roughly 1,800% year-to-date gain including a near six-fold advance from mid-April to early June, that leading meme stock finished trading yesterday north of $40 a share.   Though the underlying Solactive Two Bucks Index went live in April, Bloomberg notes that the AMC holding would have entered the LOPX last year, when shares fetched around $4. 

“We’re going to sell it,” relays David Mazza, head of product at ETF manager Direxion, of next month’s scheduled portfolio rebalancing. “And hopefully, we’ll buy another company that could have the same potential.”

Indeed, the hordes of retail traders bidding AMC and its meme-stonk peers represent a target market for that new ETF product. “This is a very interesting time in the market on multiple levels,” Mazza adds. “Some of the newer investors have been accustomed to only having outsized returns.”   

QE Progress Report
A chunky $95 billion weekly increase in Reserve Bank Credit pushed the quantity of interest-bearing assets on the Fed balance sheet to a new fresh high of $8.174 trillion.  That’s up 18.6% from a year ago and 117% from July 2019, prior to Mr. Market’s major malfunction. 
Recap July 22

Stocks edged into the green to leave the S&P 500 higher by 2.5% over the past three days following Monday’s selloff, while Treasurys also caught a bid after some bearish recent price action, with the 10- and 30-year yields settling at 1.27% and 1.9%, respectively. Gold went nowhere one again to finish at $1,807 an ounce, WTI crude approached $72 a barrel to continue its strong rebound and the VIX held just below 18. 

- Philip Grant

It's All Transitory
“Inflation is expected to follow a volatile course in the short term due to various supply and demand factors,”

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

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

Tack and Spend
The world’s largest miner takes a pause.

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

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

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

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

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

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

Recap July 20

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

- Philip Grant

Let Them Trade Stonks
Another blockbuster initial public offering beckons.

Another blockbuster initial public offering beckons. Commission-free trading venue Robinhood Markets, Inc., which has long marketed itself as democratizing finance for the masses, announced today that it will sell 52.4 million shares to the public at a range of $38 to $42 per share, raising upwards of $2 billion at the high end of that range.  The company will commence its IPO roadshow this week and expects to begin trading on the Nasdaq under the ticker HOOD on July 29.

Robinhood would achieve a $35 billion market cap at the top of its range, down from a prior $40 billion valuation target. That scaled-down ambition may prove wise, as larger entrants have languished in this bumper crop IPO year:  The half-dozen newcomers that raised $2 billion or more in 2021 now trade 1.4% below their average debut price, Bloomberg noted this morning. 

The platform’s rapid growth trajectory provides further succor for the bulls.   First quarter revenue of $522 million represented a 309% increase from the same period in 2020, while monthly active users more than doubled to 17.7 million.  Adjusted Ebitda swung into the black with $115 million, compared to a measured $47 million loss in the first three months of 2020. 

Yet vulnerabilities to the company’s business model could be growing more acute. While Robinhood famously charges no commission to execute its orders, the firm instead generates revenue through peddling customer order flow to high-frequency trading firms. Such payment for order flow (PFOF) represented 75% of revenues last year, and 81% of the first quarter’s top line. 

That controversial practice duly caught the eye of key regulatory figures. Noting in a speech last month that he has asked his staff to investigate payment for order flow and recommend rule changes, SEC chair Gary Gensler took aim at the broker:

Robinhood explicitly offered to accept less price improvement for its customers in exchange for receiving higher payment for order flow for itself. As a result, many Robinhood customers shouldered the costs of inferior executions; these costs might have exceeded any savings they might have thought they’d gotten from zero commission trading.

Regulatory bodies across the Atlantic turn a similarly jaundiced eye. Last week, the European Securities and Markets Authority issued a statement noting that that payment for order flow probably does not comply with so-called MiFID II regulations governing brokers’ obligations to secure best execution for their customers. 

Any protracted crackdown would sting. The company warns in today’s filing that: 

Because certain of our competitors either do not engage in PFOF or derive a lower percentage of their revenues from PFOF than we do, any such heightened regulation or ban of PFOF could have an outsize impact on our results of operations. 

Might routine cyclical shifts represent an even bigger pitfall? Runaway asset prices and widespread lockdown-induced boredom helped facilitate Robinhood’s rapid growth.  The opposite set of conditions could hardly enhance it.  To that end, a Bloomberg-compiled basket of 37 meme stocks fell by as much as 4.4% this morning, building on its worst five-day showing since February. 

Similarly, a Goldman Sachs gauge of unprofitable tech stocks has lost substantial altitude in recent months, remaining 26% below its February peak as of this afternoon. 

Goldman Sachs Non-Profitable Tech Basket, five-year view. Source: The Bloomberg

Bearish developments in the digital currency realm will likewise do Robinhood no favors. Crypto assets under custody footed to $11.6 billion as of March 31, more than triple the $3.6 billion seen at year-end, while crypto-related business accounted for 17% of first quarter revenue, compared to 4% of the top line from October to December.  For context, the price of bitcoin doubled over the three months through March, to $59,000 from $29,000, a move that has now all but completely retraced. 

Preliminary results indicate that growth has indeed slowed from the breakneck figures posted in the first quarter. The updated filing projects revenue of between $546 million and $574 million for the quarter ended June 30, marking a 135% year-over-year increase (less than half that of three months earlier) and 10% sequential advance at the high end of that provided range. Adjusted Ebitda will foot to between $59 million and $103 million for the second quarter, the company reckons, well below the $115 million posted in the first three months of the year.

As for the company’s stated goal of “democratizing finance for all,” that high-minded mission is one step closer to reality. Today’s filing notes that up to one-third of that $2 billion-plus share offering will be allocated to Robinhood users, via the IPO access feature on the trading platform.  

Then again, only near-silent partners are welcome:  Co-founders Baiju Bhatt and Vladimir Tenev, who will each own a 7.9% economic interest in Robinhood, will maintain effective control with a combined 65% voting interest in the company thanks to their ownership of super-voting class B shares. 

Democracy for some.

Recap July 19

The recent rates rally kicked into fifth gear today, as the 10- and 30-year Treasury yields each plunged by 12 basis points to their lowest since February at 1.19% and 1.81%, respectively.  That red flag was too large for stock jockeys to ignore, as the S&P 500 sank by 1.6% for its worst day in two months, trimming the year-to-date advance to 13.4%, while the VIX jumped 22% to 21.5.  WTI crude was hammered by 7% to finish near $66.5 a barrel, and gold edged lower to $1,812 an ounce. 

- Philip Grant

The Ride
The Department of Justice has opened a formal investigation into electric truck startup Lordstown Motors Corp.

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

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

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

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

Bell Bottoms
A new escalation in China’s crackdown on newly public Didi Chuxing (DIDI on the NYSE):

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

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

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

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

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

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

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

Recap July 16

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

- Philip Grant

The Few, The Proud
Yesterday’s seemingly routine 40 basis point decline in the S&P 500 included an historic footnote:

Yesterday’s seemingly routine 40 basis point decline in the S&P 500 included an historic footnote:  A whopping 429 members of that index finished lower on the day, marking the smallest decline with that many red components since at least 1996, Callie Cox, senior investment strategist at Ally Invest, relays to Bloomberg.

Of course, with the broad indices holding near record highs despite deteriorating internals, persistent strength in the usual mega-cap suspects helps explain the market’s resilience.  An octet of names, including the so-called Faamg cohort of Facebook, Amazon, Apple, Microsoft and Google parent Alphabet along with Netflix, Nvidia and Tesla, accounted for more than half of the 7.6% gain logged by the S&P 500 from May 12 through yesterday, data from Bespoke Investment Group show.  Those eight stocks now command a 27% weighting in the SPX. 

For the most part, that lopsided market cap concentration cannot be attributed to lofty valuations.  Thus, the Faamg’s traded at 27.8 times forward earnings as of June 30, Sanford Bernstein analyst Toni Sacconaghi finds, below the 30.8 times for the broader tech sector excluding that contingent.  That’s the first time the Faamg segment has traded at that particular valuation discount since 2013.   

Great expectations help explain the Faamg’s relatively cheap price-to-earnings price tag, as the Street is penciling in a forthcoming profit gusher. For instance, Amazon will generate $47.7 billion in net income in 2022, if the sell side is on the beam, compared to $21.3 billion last year.  Alphabet is expected to earn $71.4 billion in 2022, double last year’s levels, while Facebook’s bottom line will swell to $46.7 billion next year from $29.1 billion in 2020, analysts reckon. 

Yet unfriendly government policy could crimp that expected windfall, as the change in presidential administrations ushers in chilly winds for the big tech ranks. In June, the Senate confirmed Biden administration nominee Lina Khan as chair of the Federal Trade Commission, giving big tech-critical Democrats a three seat majority on the five member committee.  That appointment appeared to strike a nerve, as Amazon and Facebook have each recently filed petitions arguing that Khan should recuse herself from antitrust cases involving the pair, as her previous assertions of monopolistic behavior by big tech indicate she has already made up her mind as to their legal liabilities. For her part, the new FTC chair told the Senate in June that she has no financial conflicts that would command recusal under pertinent ethics laws. 

That fight is now shifting towards multiple fronts. Last Friday, the President signed an executive order directing the federal government to promote corporate competition. Among the key planks of that enhanced scrutiny are big tech’s mergers and acquisition strategies and data collection efforts. 

“Big tech is on the radar screen more than ever,” Eleanor Fox, professor of trade regulation at NYU Law School, told Bloomberg last week. “With Biden and the FTC on the same page, the biggest tech companies aren’t going to be able to just buy up all their competitors like before.” 

Congress likewise looks to make its mark in bringing those West Coast high-fliers down to earth.  Last month, the House Judiciary panel approved a half-dozen antitrust bills, including the “Ending Platform Monopolies Act,” which would make it easier for government to intervene and break up big tech. While those bills have yet to be put to vote on the House floor, members of the Senate Judiciary Committee on either side of the aisle are putting together similar legislation, Bloomberg reported yesterday. Chuck Grassley (R-Iowa) declared Tuesday that “we have to take some dramatic action,” while Amy Klobuchar (D-Minnesota) noted Monday that she was in negotiations with Republicans to introduce a number of bills, adding “stay tuned.” 

With Silicon Valley now firmly in Washington D.C.’s crosshairs, what will become of the bull market which has become ever more reliant on that cadre of tech giants? Longtime Merrill Lynch fixture Bob Farrell, Wall Street’s greatest market technician by the lights of 16 separate annual Institutional Investor polls and speaker at the spring 2019 Grant’s Conference, put it this way in the seventh entry of his 10 rules for successful investing: “Markets are strongest when they are broad and weakest when they narrow to a handful of blue-chip names.” 

One thing’s for sure: Antitrust-focused attorneys won’t be in want of gainful employment anytime soon. A Monday dispatch in The American Lawyer noted that law firms are scrambling to secure sufficient staffing to handle an expected influx of new business, as Uncle Sam and big tech get set to do legal battle. “I believe we’re in for a very dynamic time,” Ted Hassi, partner at Debevoise & Plimpton, told the Lawyer. “Everyone I speak to is incredibly busy.”

QE Progress Report
Reserve Bank Credit rose by $31.9 billion from a week ago, pushing interest-bearing assets on the Fed balance sheet to $8.08 trillion.  That’s up 9.9%, year-to-date, 16% from a year ago and 114% from July 2019. 
Recap July 15

Stocks came under modest pressure for a second day, with the S&P 500 and Nasdaq 100 declining by 30 and 70 basis points, respectively, to dip into negative territory for the week. Treasurys continued their relentless rally with the long bond diving to 1.93%, gold edged higher to $1,830 to maintain its warm streak and WTI slipped to $71.5 a barrel.  The VIX rose to 17 but finished well off its session high.  

- Philip Grant

All Things Reconsidered
Markets make opinions, crypto edition.

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

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

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

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

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

Bail Mary
All aboard in the Middle Kingdom:

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

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

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

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

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

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

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

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

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

Recap July 14

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

- Philip Grant

Pop and Shop
Up, up and away:

Up, up and away: This morning’s eye-catching release of the June Consumer Price Index featured no shortage of superlatives.  Headline prices jumped 0.9% sequentially (nearly double the 0.5% consensus) and 5.4% from a year ago, each at their fastest pace since 2008, while the 4.5% year-over-year advance excluding food and energy marked the hottest reading since November 1991, more than double the Federal Reserve’s 2% annual inflation target. 

Yet perhaps tellingly, interest rate futures betrayed no concern that the current price pressures will disrupt the Fed’s oft-verbalized hypothesis that inflation will prove transitory. Alex Manzara, interest rate options trader at R.J. O’Brien, relays this morning that key calendar spreads in the Eurodollar market barely budged following the CPI release, continuing to price in less than 100 basis points of Fed Funds rate hikes between December 2022 and December 2024. 

The potentially imminent downside reversal of one soaring component could help bolster that transitory rationale. Measured used vehicle prices, weighted at 3.2% of the index, sped higher by 10.5% from May and 45.2% from a year ago, accounting for nearly half of the 0.9% sequential headline increase in core CPI.  Yet other indicators suggest that the remarkable rise may finally be abating, as the Manheim Used Vehicle Value Index ticked lower by 1.3% in June from a month ago, marking the first decrease since December. 

Other data paint a different picture.  The National Federation of Independent Business survey for June found that a seasonally-adjusted, net 47% percent of owners reported raising average selling prices, the highest reading since January 1981, while a net 39% of respondents face rising employee compensation costs, up from 34% in May to mark the highest reading on record going back to 1984.  Nearly 90% of small employers attempting to add staff report finding few or no qualified candidates for the position.  

Larger corporate concerns are likewise scrambling to adjust to the new, perhaps-transitory price regime.  This morning, packaged food behemoth Conagra Brands cut its earnings forecast for the next four quarters by about 7% on account of accelerating input costs. While management now expects price pressures “to be materially higher than we anticipated,” three months ago, the c-suite promised investors an “aggressive and comprehensive action plan. . . which includes broad-based pricing [increases].”  The food at home subcomponent accounts for a 7.65% weighting in the headline CPI. 

Perhaps most concerningly for those espousing the transitory inflation argument, the crucial shelter component, which accounts for nearly one-third of the total index, could be set for a protracted upside march. For context, owners’ equivalent rent (or the estimated rental rate that homeowners could achieve), which commands a hefty 23.7% index weighting, grew by a relatively modest 2.3% from a year ago in June, while rent of primary residence (a measure of contracted rental prices), which counts for 7.6% of the total, rose by just 1.9%.  That’s well below the 3% to 4% annual increases for each seen across 2018 and 2019. 

Noting that one-year rental lease terms produce a lagging effect, and that inflation metrics capture current rents (where owners are often reluctant or legally unable to raise rents on existing tenants), rather than asking prices on vacant units, a June 9 report from Fannie Mae economist Eric Brescia concluded that changes in measured house prices typically lead the shelter metrics in CPI by about five quarters. Thus, a decline in asking rents as the bug bit last year is likely still being reflected in the data.  

As Brescia noted, the national rental market bottomed in the fourth quarter of 2020 and has since shown signs of a rapid rebound. Using a model incorporating the change in house prices, inflation expectations and rental vacancies, the economist predicts that the shelter component will account for 1.9 percentage points of the core CPI by the second quarter of 2022, approaching the Fed’s entire inflation target by its lonesome.  “If inflationary expectations move up more aggressively then we assumed or house prices fail to decelerate in 2022,” Brescia warns, “inflationary pressure would be even stronger and could persist well into 2023 or 2024.”

Meanwhile, the monetary mandarins at the Federal Reserve, evidently in no hurry to relax their unprecedented virus-era stimulus, instead adjust their rhetoric in the face of scalding inflation data. The following visual aid from rates and volatility trader Jessica Nutt via Twitter summarizes one way of looking at the current evolution, using commentary from San Francisco Fed president Mary Daly: 


Recap July 13

Treasurys initially held firm after this morning’s CPI data, but a soft long bond auction was a different story: rates ended the day well higher across the curve, with the 10- and 30-year yields settling at 1.42% and 2.05%, respectively.  Stocks similarly reversed early gains with the S&P 500 finishing lower by 35 basis points, while the VIX rose 6% to 17.  Gold edged higher to $1,808 an ounce, and WTI crude jumped back above $75 a barrel.  

- Philip Grant

Heaven's Gate
“Welcome to the dawn of a new space age,”

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

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

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

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

Dream Catcher
High hopes abound as second quarter earnings season gets underway this week.

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

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

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

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

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

Recap July 12

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

- Philip Grant

The Icky Shuffle
Talk about cashing your chips.

Talk about cashing in your chips.  Peter Thiel-backed crypto exchange startup Bullish Global will join the SPAC parade, announcing this morning that it will merge with blank check firm Far Peak Acquisition Corp., which is helmed by former New York Stock Exchange president Tom Farley.  The deal will be valued at a cool $9 billion, Bullish projects. 

This price tag is eye-catching even in the context of the current everything bubble.  Risk factors in the Bullish investor presentation put it this way: “as an early stage company entering a highly competitive market with a limited operating history, the operations of Bullish are nascent, unproven and subject to material legal, regulatory, operational, reputational, tax and other risks.”  What’s more, “Bullish has not yet fully developed, tested or launched any products.” 

As for Farley, who will serve as CEO of Bullish upon completion of the transaction, it’s back in the saddle.  Four years ago, the then-NYSE boss had this to say about short selling in testimony to the House Financial Services Committee: “It feels kind of icky and un-American, betting against a company.”

Better to be Bullish, it seems. 

Private Equity
The European Central Bank unveiled the results of its first strategy review in 18 years yesterday,

The European Central Bank unveiled the results of its first strategy review in 18 years yesterday, featuring a material tweak to its longstanding policy goal of measured inflation of near, but less than, 2% per annum.  Instead, Frankfurt will now target a 2% “symmetric” inflation rate, meaning that deviations below that figure are just as undesirable as hotter readings north of 2%.  

ECB president Christine Lagarde added in the subsequent press conference that she would utilize “especially forceful or persistent monetary policy action” in the case of stubbornly lagging inflation.  That line is telling as headline CPI has averaged just 0.9% on a year-over-year basis since the central bank first cut its deposit rate below zero in June 2014. The ECB is charged with a single mandate of maintaining price stability, as opposed to the Federal Reserve’s dual mandate of stable prices and full employment. 

“The symmetry point is something that Lagarde has been talking about for some time,” wrote Marchel Alexandrovich, senior European economist at Jefferies. “All things being equal, the new target allows the doves on the council to argue for the ECB continuing with easy monetary policy.”   The potential for even easier money looms, some believe. “Lagarde is leaving the door open for further forceful action,” Annalisa Piazza, analyst at MFS Investment Management, tells the Financial Times

Some on the policy-setting Governing Council appear reluctant to pursue such an escalation, as minutes from the June meeting published today show that the body debated scaling back asset purchases under the €1.85 trillion ($2.2 trillion) pandemic emergency purchase program, a facility which has €615 billion of funds remaining as of June 30 and is scheduled to run through March of 2022.  

In the end, the council opted for the status quo, deeming that financial conditions were “too fragile” to pull the monetary training wheels.  Lagarde had forcefully argued against early tapering in May, deeming any such discussions “far too early” and “actually unnecessary.” Benchmark German 10-year yields currently crouch at minus 0.3%, with French and Greek 10-year paper priced to yield 0.05% and 0.73%, respectively, while, between the PEPP and public sector purchase program (which ran from 2015 to 2018, then resumed in fall 2019), the ECB directly holds about €3.6 trillion of sovereign bonds, equivalent to some 37% of euro area government debt securities outstanding. 

With the sovereign bond market duly brought to heel, high-minded considerations rise to the forefront: The ECB announced yesterday an “ambitious roadmap to further incorporate climate change considerations into its policy framework.” In particular, climate change will figure in policy decisions ranging from corporate sector asset purchases to financial disclosures and risk assessment communications. “We would be failing on our mandate if we did not account for climate change when it comes to understanding and measuring inflation,” Lagarde reasoned last month.

Imminent regulatory action should complement the central bank’s eco-conscious goals. Next week, the European Commission will propose revisions to a 2003-era energy directive, mandating a 65% drop in emissions from new cars sold by 2030 from current levels with a zero emission goal by 2035. The Commission will also look to impose a Europe-wide minimum levy on jet fuel usage, per draft documents.

Those sweeping new policies won’t prove too inconvenient for the Old Continent’s elite, it seems. As Argus Media reported Tuesday, EU Commission draft rules carry an exemption for private jet usage, under a classification for aviation of passengers or goods as an “aid to the conduct of their business.” Then, too, “’pleasure’ flights, whereby an aircraft is used for ‘personal or recreational purposes’” will also enjoy an exemption from the new tax regime, Argus notes.  

Such a loophole is no small detail, as a single four-hour private flight produces eight tons of C02 emissions, equivalent to a full year’s worth of such pollution from the average citizen, Belgium based Transport & Environment finds.  Private jet emissions rose by 31% from 2005 to 2019, topping the 25% seen in commercial aviation over that period, while private travel activity returned to its pre-covid levels by July of 2020, as commercial flights languished at 60% below the prior year levels. 

That’s a relief

Recap July 9

Stocks caught a strong bid to erase yesterday’s losses, leaving the S&P 500 up by 1.1% for the week and 16.3% year-to-date, while Treasurys pulled back from their torrid recent rally with the 10- and 30-year yields jumping to 1.36% and 1.99%, respectively.  Gold rose to $1,809 for its sixth green finish in seven tries, WTI advanced to near $75 a barrel and the VIX retreated to near 16 to complete a two-day round trip. 

- Philip Grant

Team America
Keeping the band together:

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

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

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

Cain and Stable
Cryptos and blank check firms: a match made in heaven?

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

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

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

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

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

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

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

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

QE Progress Report
Reserve Bank Credit, or interest-bearing assets at the Fed, rose to $8.048 trillion, up $8 billion from last week’s reading.  That’s up 9.5% year-to-date, 14.7% over the past 52 weeks and 114% from July 2019.
Recap July 8

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

- Philip Grant

On the Boil
“The lake is so warm you feel like you’re in a hot tub,”

“The lake is so warm you feel like you’re in a hot tub,” Abi Buddington of Dresden, New York complained to NBC News yesterday regarding Seneca Lake, the deepest such body of water in the Empire State.  The apparent culprit: a gas-fired power plant on the shoreline which has been repurposed for the lucrative practice of cryptocurrency mining. 

The plant, operated by private equity-sponsored Greenidge Generation, LLC, utilizes at least 8,000 high-powered computers to accumulate digital ducats by performing mathematical crossword puzzles. The firm is looking to expand its mining operations.  

While the facility failed inspection on 16 of the 17 items reviewed by the Environmental Assessment Office last fall, the current economics of the project speak for themselves.  Greenidge CEO Jeff Kirt relays that the company mined 1,186 bitcoins at an average cost of $2,869 over the 12 months through Feb. 28, compared to the $34,000 currently fetched on the open market. 

Twin Peaks
The bond market rides again.

The bond market rides again.  As Treasury yields retain a powerful downward momentum with the long bond dipping below 2% for the first time since February, capital continues to pour into the asset class. Citing data from the Investment Company Institute, the Financial Times notes today that domestic fixed income mutual funds and ETFs have attracted $372 billion this year through June 23, more than double the $160 billion in equity flows over that period.  

That’s a pronounced divergence from overseas trends, as global equity funds have gathered a whopping $580 billion net inflow through the first two quarters of the year. This exceeds the total combined capital influx of the past two decades, Bank of America strategist Michael Hartnett finds. 

As the U.S. stock market has enjoyed a towering post-pandemic advance, with the S&P 500 virtually doubling from its March 2020 nadir to reside at its most expensive cyclically-adjusted valuation since the tech bubble, some big players look to cash in their chips. “Pension plans are today at much better funding levels, and it is a prudent strategy to lock in their equity gains and immunize the portfolio against the risk of a large drawdown in stocks,” Mark Vaselkiv, chief investment officer of fixed income at T Rowe Price, tells the FT. “We expect a further rotation into bonds from asset allocators.” 

While sticker shock and flagging internals (Almost Daily Grant’s, June 18) may make prospective U.S. equity investors think twice, the specter of non-transitory inflation continues to loom over “risk-free” Treasurys, given that benchmark interest rates remain well below zero on a real basis (the Core Personal Consumption Expenditures Price Index rose by 3.4% year-over-year in June, the hottest reading since 1992).  The corporate sector has duly taken notice of the post-pandemic regime change. A June 4 chart prepared by London-based Ruffer LLP shows that a net 35% of U.S. companies reported higher selling prices this year, the highest such proportion since at least 1986.  

A non-transitory bout of price pressures could carry major implications. A June 16 analysis from AllianceBernstein president and CEO Seth Bernstein in the FT argues that, with monetary and fiscal policy now working in concert to promote reflation along with economic recovery, fixed-income investors are facing growing duration risk as ever-dwindling yields have left bond prices increasingly sensitive to changes in interest rates.  That setup carries ramifications for the traditional 60% equity and 40% fixed income portfolio allocation, which has long benefited from a negative correlation between stocks and bonds, i.e., weakness in one asset class would typically be balanced by countervailing strength in the other. Persistent inflation could well imperil that dynamic. 

Accordingly, Bernstein believes that investors should increase allocations to so-called real assets such as infrastructure and real estate, and also pursue the anachronistic strategy of buying securities at a discount to their intrinsic worth, or value investing. Bernstein argues that “such assets generally have higher yields and so a larger part of the present value is from cash flows in the near term. Hence, they are less sensitive to shifts in long-run interest rates.”

What other lessons might financial history have to offer at this potentially pivotal moment? For an in-depth review of the prevailing conditions and factors which helped the great inflation of the 1970’s take shape, along with informed speculation of what’s to come, see the June 11 edition of Grant’s Interest Rate Observer

Recap July 6

Stocks shook off some intraday losses with the S&P 500 erasing the bulk of a near 1% pullback to finish within 20 basis points of unchanged, while the Nasdaq edged into the green to log another fresh high. Treasurys finished near their best levels of the day with the 10-year yield settling at 1.37%, down from 1.57% less than three weeks ago. A stronger dollar didn’t stop gold from pushing to near $1,800 an ounce for its best finish since June 16, though WTI crude saw a violent reversal to finish south of $74 a barrel after ticking above $77 this morning.  The VIX settled at 16.5, after ascending to near 18 in midday. 

- Philip Grant

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