Almost Daily Grant's
“Almost Daily” is the new, end-of-day delectation from Grant’s.
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Monday, September 24, 2018
The Negotiator
Today the U.S. imposed 10% tariffs on an additional $200 billion worth of Chinese goods. As a result, President Xi Jinping is no longer negotiating with President Donald Trump, according to a dispatch from state-run Xinhua News Agency: “The door for trade talks is always open but negotiations must be held in an environment of mutual respect . . . [Negotiations] cannot be carried out under the threat of tariffs.”
While China and the U.S. butt heads over trade, Beijing looks to engender goodwill from other nations, as well as from its own populace. On Thursday, Bloomberg reported that China “is planning to cut the average tariff rates on imports from the majority of its trading partners as soon as next month.” That move follows an income tax cut enacted at the end of August that featured an increase in the annual tax-free threshold to Rmb. 60,000 ($8,800) from Rmb. 42,000 as well as expanded deductions and an expanded range of lower tax brackets.
In the past, China might respond to a slowdown by flooding the economy with credit. Might that debt-driven model be approaching the end of its rope? Last Wednesday, premier Li Kequiang, the second most senior figure in the ruling communist party, offered some less-than encouraging remarks at a World Economic Forum conference in Tianjin: “Deeply integrated into the world economy, the Chinese economy is inevitably affected by notable changes in the global economic and trade context. Indeed, we’re facing greater difficulties in keeping stable performance of the Chinese economy.”
But if Li’s remarks indicate that the trade spat is front and center, commentary in the latest edition of the China Beige Book, an independent research boutique, implies that at least one major facet of the economy is independently in the doldrums.
Manufacturing is under fire. The sector’s multi-year rally has given way to declining revenue and sharply declining profit growth. Critically, manufacturing’s plight is occurring before any meaningful American tariffs have been imposed. Absent a fall trade deal, the situation will likely deteriorate. The pace of borrowing – at 41% of firms, the highest since 2012 – sure smells a lot like panic.
Then, too, the crucial property sector is facing rocky terrain ahead. Today, Bloomberg reports that “China’s debt laden developers face a potentially devastating blow to their biggest source of financing, as authorities consider putting an end to the practice of selling apartments before they are finished.” That development augurs poorly for the group, which derives as much as 20% of its sales from the tactic according to Bloomberg. Since late January, the Shanghai Composite Property Index has tumbled by 29%, in excess of the 21% decline in the broad Shanghai Composite Index over that period.
Does a vulnerable real-estate market present the risk of broader economic pain? In a note today, Anne Stevenson-Yang of J Capital Research argues as much:
The top class of Chinese are very wealthy, probably richer in fixed assets and cash than consumers in any other country now. But few of these high net worth individuals rely on salary income. For most, income has broadly been a mix of inbound flows, including passive income from high-return, high-risk financial products and trading income from property dealing.
Those flows are at risk of decelerating faster than China’s anticipated broad, macro-deceleration. Non-financial assets are facing a growing liquidity challenge, and that is likely to reveal that their current “valuations” are totally detached from any market reality. Financial assets are increasingly victims of Ponzi dynamics that drove their high returns to investors in the absence of any real productivity returns . . . so defaults in the non-state financial services arena have become a worry for consumers and regulators alike.
Broad implications of an extended slump in real estate activity could be significant. According to Noah Research, 65% of household assets in mainland China are allocated to real estate, far above the 49% in the U.S. and 34% in Japan.
Keep an eye on the Middle Kingdom.
Recap Sept. 24
Stocks came under pressure following the China tariff headlines as well as the rumored resignation of deputy attorney general Rod Rosenstein, while a soft two-year Treasury auction this afternoon headlined another round of rising interest rates as the 10-year yield hit 3.08%. Energy was the big winner, with WTI crude rising to $72 a barrel and Brent over $80 after OPEC announced yesterday that there will be no production increases for the time being.
- Philip Grant
Friday, September 21, 2018
Your Latest Trick
British rock band Dire Straits,
British rock band Dire Straits,
Help really wanted
Inflation is stirring.
Inflation is stirring.
Recap Sept. 21
Your Latest Trick
From Marketwatch:
British rock band Dire Straits, broken up for decades, has a multimillion dollar catalogue that’s about to be sliced up for investors.
The plan securitizes royalties that are paid out every time a song from the “Money for Nothing” group is downloaded, streamed or played on the radio. It’s a similar investment to that introduced in the late-1990s with David Bowie’s own catalogue-supported “Bowie bonds.”
Quite a collaboration: Classic rock meets modern gospel.
Help really wanted
Inflation is stirring. For the latest bit of evidence, see the commentary in Markit’s September flash PMI Index, which reports that “average prices charged by service providers increased at the fastest pace since the survey began in October 2009.” Supply shortages and rising tariffs were cited by the research service as the primary culprit.
On Saturday, The Wall Street Journal reported that the Trump administration was set to move forward with an additional $200 billion in Chinese tariffs “within weeks,” in a major escalation of the Sino-U.S. trade spat. Four days later, CNNMoney reported that Wal-Mart, Inc. sent a letter to U.S. trade representative Robert Lighthizer warning that higher prices were in the offing. Of the latest round of $200 billion in tariffs to be levied on Chinese goods, Wal-Mart predicted that “the immediate impact will be to raise prices for consumers and tax American businesses and manufacturers.”
While tariffs represent one catalyst, an increasingly tight labor market figures prominently in the equation. The August reading of non-farm payrolls saw average hourly earnings rise a brisk 2.9% year-over-year, up from 2.7% in July and the hottest reading since 2009.
Anecdotes of labor shortages likewise abound. Yesterday’s edition of the Minnesota Post, describing Wednesday’s gubernatorial debates, noted the dual focus of candidates Jeff Johnson and Tim Walz on staffing concerns:
They spoke after a slate of top business, government and nonprofit thinkers, who spelled out — in sometimes dire terms — the projected shortfall in workers for certain areas, including nursing and agriculture. In nursing, there is an expected shortfall of 1,275 workers by 2020, according to data provided by Real Time Talent, a workforce project started by a large mix of public and private sector groups.
Walz and Johnson agreed the state can do much to fix the looming shortage, fueled in part by retiring baby boomers, and broadly vowed to make it happen. “I can probably speak for the both of us as we travel around the state and talk to small business owners and big business owners, this comes up more often than anything else — even more often than regulation and taxes as a difficult issue for employers,” Johnson said.
On Sept. 10, the Austin Statesman, citing a study from the Associated General Contractors of America, reported that “more than three-fourths of Texas construction firms are having trouble finding workers. . . Construction employment in the Austin-Round Rock metro area has jumped by more than 7% over the past year.”
In a Sept. 4 dispatch in the Charlotte Observer, Rich Cerretti, head of the Charlotte office of general contractor JE Dunn, explained the knock-on effects which can follow the lack of sufficient hands: “It is definitely hard to find good people. When they run out of labor, the good [firms] are not bidding future projects. You may not have the best subcontractor available or the best-priced subcontractor available. . . All that has an effect of pushing up overall project prices.”
How bad can a labor shortage get? Thirty years ago today, the Financial Times reported on the feverish hunt for workers in then-rip roaring Japan:
Unscrupulous Japanese companies, facing a nationwide shortage of university graduates, are resorting to kidnapping potential recruits to keep them out of the hands of rival employers.
Recap Sept. 21
Stocks gave back early gains to finish little changed on the S&P 500, while underperformance from the formerly-charged NYSE FANG+ Index continued with a 1.2% drop. Treasury yields finished little changed with the 10-year remaining at 3.06%, and a stronger dollar didn’t stop the commodity complex from catching a bid as WTI crude edged toward $71 a barrel.
August new home sales, a Federal Reserve rate decision and revised second quarter GDP figures are among next week’s scheduled highlights.
- Philip Grant
Thursday, September 20, 2018
Leverage lamentation
With apologies to Homer Simpson, here's to debt: The cause of, and solution to, life's financial problems.
With apologies to Homer Simpson, here's to debt: The cause of, and solution to, life's financial problems.
QT progress report
Recap Sept. 20
Leverage lamentation
With apologies to Homer Simpson, here's to debt: The cause of, and solution to, life's financial problems. As interest rates across much of the world edge higher, signs of overextended borrowers are increasingly visible. A trio of such sightings follows:
On Wednesday, Bankrate.com published a survey of U.S. homeowners, finding that almost 30% of lower-income respondents (those making $30,000 or less) viewed home equity lines of credit as a feasible method for keeping up with routine household expenses, compared to 15% overall who endorsed such a maneuver. Greg McBride, chief financial analyst for Bankrate.com, commented:
With the sorry state of emergency savings and increasing levels of consumer debt in a rising interest rate environment, it’s a matter of ‘when’ not ‘if’ more homeowners turn to home equity to find home improvements and repairs, and consolidate debt.
On the bright side, less than 1% of the 719 homeowners within the 1,000-size polling sample indicated that using home equity for plastic surgery was a good idea. At least American home prices are still rising.
Meanwhile, Down Under, the formerly white-hot housing bubble is deflating – unfortunately, the debt remains. The Reserve Bank of Australia calls heavy morgage borrowings the “main risk to financial stability” over the next two years (for more on Australian housing, see the June 15 edition of Grant’s).
Interest-only loans, in which the borrower initially pays no principal (typically through the first five years), figure prominently in the equation. According to the RBA, interest-only (IO) loans constituted nearly 40% of the Australian mortgage pool as recently as 2015.
According to analysts at UBS Securities, the Australian borrower is less than fully informed about these ubiquitous and gimmicky credit products. In a research note yesterday featuring results from the 2018 UBS Evidence Lab Mortgages Survey, the bank reports:
We are concerned with the lack of understanding of IO terms, especially by owner-occupiers (OO): Only 48% of borrowers believe their IO term expires within five years (the maximum interest-only term usually available); 18% stated they “don’t know” when their IO term expires and 8% of OO believe their interest-only term lasts more than 15 years (this product doesn’t exist).
However, the most concerning issue is a lack of understanding of the increase in repayments when the IO term expires: 34% of all IO borrowers stated they “don’t know” how much repayments will rise; 53% expect repayments to rise up to 30%, while only 13% of respondents indicated they expect their mortgage repayments to rise more than 30% (the best case for most IO borrowers).
The analysts conclude with something of an understatement:
This [survey] indicates that the majority of IO borrowers remain underprepared for the step-up in repayments they will face.
Turning to the corporate realm, so-called zombie companies, or those featuring earnings before interest and taxes insufficient to cover interest expense, are widely prevalent in North America. According to a July 19 dispatch from Bianco Research, a full 14% of the broad S&P 1500 Index is so classified, well above the world average of 10%.
In Canada, it’s even worse. Earlier this week, accounting firm Deloitte LLP released an analysis of 2,274 businesses listed on the Toronto Stock Exchange and TSX Venture Exchange, finding that 350 public companies, or nearly 16% of the group, could not service interest with operating earnings.
Those North American zombies may soon be tested. Interest rate futures in Canada and the U.S. are currently pricing 90% and 100% odds, respectively, of higher overnight interest rates by year-end (futures are pricing a status-quo RBA, with just 5% odds of a rate hike by the New Year).
By way of conclusion, a paraphrased quip from the late private equity titan Ted Forstmann: Debt is like chocolate cake. Just a little bit please.
QT progress report
Relatively little to report this week, as the Fed’s portfolio of securities held outright registered at $4.11 trillion, a decline of just under $2 billion from last week’s reading. Mortgage-backed securities supplied the change, as Treasury holdings were virtually unchanged. Likewise, the decline from the trailing four-week average is a relatively modest $10 billion.
Since QT began just under one year ago, the Fed’s total balance sheet has declined by 5.56%.
Recap Sept. 20
A notable dollar selloff cleared the way for stocks, with ongoing underperformance from the NYSE FANG+ Index not enough to prevent the S&P 500 from making a fresh record high. The soft greenback was likewise well received in emerging markets, as the major equity and dollar denominated bond ETFs both climbed while the Argentine peso and Turkish lira strengthened against the buck.
Elsewhere, Treasury yields mostly ticked higher, with the 10-year settling just above 3.06%, while commodities finished moderately higher.
- Philip Grant
Tuesday, September 18, 2018
Muppets take Manhattan
The baton has been passed. Today, The Wall Street Journal reports that eight-year old WeWork Companies, Inc. has expanded its office-space dominion to 5.3 million square feet in Manhattan, officially overtaking J.P. Morgan Chase & Co. (initially chartered in 1799 as The Manhattan Company) as the largest office tenant in the borough.
Growth across the nascent co-working industry has been little short of remarkable. According to real estate services firm CBRE Group, Inc., co-working companies have accounted for 9.7% of all new leases signed in Manhattan year-to-date through August, nearly triple the 3.3% share in 2017. As the co-working business model expands, so do prospective valuations. Today’s Journal report notes that WeWork “is in the process of raising money at a roughly $40 billion valuation.” In August 2017, SoftBank Group Corp. invested $4.4 billion at a $20 billion valuation. Nearly a third of that sum went to cash out existing investors, per the WSJ.
While WeWork’s rapid expansion has served company insiders well, the early returns for landlords are less encouraging. On Aug. 21, commercial real estate giant Cushman & Wakefield published an study of the co-working industry’s impact on building valuations via capitalization rates, i.e., net operating income divided by market value. After offering the caveat that “the data on trades of buildings with significant coworking tenants is relatively thin,” the authors continue:
An analysis of 17 building sales with co-working tenants from the past two years indicates a relationship between the reported cap rates and the proportion of the building’s square footage allocated to co-working. In those cases where 40% or less of a building was leased as co-working, the cap rate was within range or below that of other comparable sales in the area [meaning an equal or higher valuation]. However, the gap between cap rates for comparable sales and the building(s) in question expanded as the proportion of space allocated to co-working increased.
The initial results do suggest that investors seem to apply a discount as the percentage of the building that consists of co-working increases.
Attention: deficit disorder
The second longest economic expansion on record (110 months and counting going back to June 2009, and approaching the 120 month record set between 1991 and 2001), has been no help to Uncle Sam’s balance sheet. Federal debt held by the public currently stands at $15.8 trillion, or 77.5% of trailing 12 month seasonally-adjusted gross domestic product as of the second quarter. That compares to $10.4 trillion, representing 65.9% of GDP, at year-end 2011.
The 2017 Tax Cuts and Jobs Act looks to be aggravating the financial deterioration. Over the first eleven months of fiscal 2018 (the government year ends Sept. 30), federal coffers have absorbed an $898 billion shortfall, up 33% year-over-year. In August, the deficit jumped to $152 billion, up 41% year-over-year, even after factoring in accounting changes and calendar shifts.
According to updated estimates from the White House’s Office of Management and Budget, the upcoming fiscal 2019 will see a budget deficit equivalent to 5.1% of GDP, well in excess of the shortfalls seen, for instance, in recession aftermath years 2003 and 1991 of 3.3% and 4.4%, respectively. The National Bureau of Economic Research finds that over the past 50 years, the average recession has widened the fiscal deficit by 4% of GDP. That means that an ordinary business slowdown could send the U.S. deficit soaring to 9.1% of GDP, just behind the post-World War II record of 9.8% in 2009, the end of the Great Recession.
While red ink spreads, the benchmark Treasury approaches a key level. Today, the 10-year yield poked above 3.05%, up from 2.82% three weeks ago and pressing back toward the high of the year at 3.12%. A sustained break higher could be a big deal. In April, May and early August the 10-year briefly exceeded 3% before retreating, while Ben Breitholtz of Bianco Research reports yesterday that 10-year yields’ 38 basis point trading range over the past six months is among the narrowest since 1972.
Needless to say, a break higher in borrowing costs would be most unwelcome. At a return to 1990’s-era borrowing costs of 6.6%, federal interest expense would foot to $998 billion, topping the $945 billion spent on social security benefits last year (Grant’s, May 18).
Meanwhile, thanks to a rapid rise in short-term rates (today’s four-week bill auction fetched 2.02%, highest since February 2008), the Treasury curve remains near its flattest since the financial crisis, with the two- and 10-year spread hovering just below 25 basis points. Imminent Fed hikes (interest rate futures price in 80% odds of at least two more 25 basis point rate hikes by year-end) could tip the curve into inversion. The St. Louis Fed finds that each recession in the past 60 years has been preceded by that yield curve flip.
Recap Sept. 18
Stocks caught a bid despite another soft showing from the NYSE FANG+ Index (comprised of 10 equally weighted tech, internet and media stocks), which lagged after Bloomberg reported that the Department of Justice has opened a criminal investigation against Tesla, Inc. CEO Elon Musk. Although TSLA did recover somewhat to finish lower by just 3%, the FANG+ Index now sits more than 10% below its June 20 peak while the S&P 500 remains close to its high water mark.
Treasury yields darted higher, while strength in the energy patch pushed WTI crude back to $70 a barrel.
- Philip Grant
Friday, September 14, 2018
In other news
From Agence-France-Presse:
Archaeologists have found what they believe is the world’s oldest site for alcohol production, a study said [yesterday], adding a beer-like beverage may have been served in ceremonies some 13,000 years ago.
A beer-like beverage? Sounds like our ancestors stumbled upon the recipe for Bud Lite.
Tail wags the dog
As gathering financial storm clouds roil currencies, credit and equities in the formerly-designated “third world”, a trio of Latin American countries will confront the prospect of major political change in coming months. Let’s take a closer look at the situation south of the border.
Last June, Argentina managed to raise $2.75 billion from investors via a 100-year dollar bond. It didn’t take long for trouble to once again find the serial sovereign-defaulter (eight times since 1827 according to historian Carmen Reinhart), as president Mauricio Macri was obliged on Aug. 30 to ask the International Monetary Fund to expedite payment on a $50 billion bailout package agreed to this summer. That news sent those century bonds to below 70 cents on the dollar that same day (they’ve since recovered to 75). As inflation rages (CPI rose 34.4% year-over-year in August), the peso continues to hover near lifetime lows against the dollar despite yesterday’s announcement in local newspaper La Naciòn of ARS 196 billion ($5 billion) in 2019 spending cuts.
Argentina budget balance. Source: The Bloomberg
Macri, who is attempting to right the ship after the fiscally disastrous and corruption-riddled administration of predecessor Cristina Elisabet Fernández de Kirchner, faces the unenviable challenge of simultaneously pleasing his electoral constituents and foreign creditors, including the IMF. Former central bank official Mario Blejer told The Financial Times on Sept. 3: “The solution [to the crisis] is not purely economic, it’s also political. The [Macri] government will have to find consensus with additional forces in the political spectrum. They cannot continue to govern alone.” General elections are set for Oct. 27, 2019.
Politics are likewise front and center in Brazil, which is in the midst of a rancorous and highly competitive campaign season ahead of national elections in three weeks (the first round is Oct. 7, with a run-off to take place on Oct. 28 if no candidate exceeds 50%). Today, a poll conducted by XP and Pesppe showed that former army captain and far right-wing candidate Jair Bolsonaro saw his support jump to 26% from 21% a week ago to lead the pack, after he was stabbed at a campaign event on Sept. 6. Bolsonaro’s leading opponents are leftists Ciro Gomes and Fernando Haddad, while market-friendly Geraldo Alckmin languishes at 9% in the XP/Pesppe poll.
André Jakurski, founder and portfolio manager of Rio de Janerio-based JGP Gestao de Decursos Ltda., tersely summed things up to colleague Fabiano Santin: “The candidates are horrible.” Mr. Market seems to concur with Jakurski’s assessment (for the bear case on Brazil, see the issue of Grant’s dated Jan. 23, 2018). Brazil’s 10-year yield has jumped to 12.5%, up nearly 300 basis points since March, while the real has lost 23% against the dollar year-to-date and stocks have spun their wheels with the Bovespa Index slightly down in local terms in 2018.
Finally, we turn to Mexico, which just ushered in a new political era of its own with the June 1 election of Andrés Manuel López Obrador, known as AMLO. Unlike the slow-motion train wreck seemingly underway in Brazil, AMLO’s ascension has already won over financial markets, with the Mexican peso rallying to 18.9 against the dollar from 20.9 in June. On July 4, Morgan Stanley upgraded Mexican equities to “overweight” from “equal-weight.”
The populist president-elect has wasted little time on projects large and small, participating in the bilateral U.S. trade agreement with the outgoing Peña Nieto government, while announcing an aggressive austerity program that includes cancelling the pension of former presidents. Perhaps less market-friendly is AMLO’s prospective energy policy. One day after that trade agreement announcement, Reuters reported that “Mexico’s incoming government is considering indefinitely suspending auctions for oil and gas projects, and giving state-owned Pemex authority to pick its own joint-venture partners rather than holdings competitive tenders.”
Will a bullish response to the incoming AMLO administration be the correct one? Just over four year ago, Reuters reported on market concerns over “economic discipline” of a soon-to-be elected president of an emerging market mainstay:
[Officials] dismissed fears that policy would take a populist turn, jeopardizing more than a decade of strong growth.
“These [market friendly] policies will continue with the same decisiveness. The ministers who will implement them will continue in their posts; there does not appear to be a question about that,” one senior official said.
The country, and leader, in question: Recep Erdogan of Turkey. Today, Erdogan offered an ominous response to the Turkish central bank, which just hiked its overnight rate to 24% in a bid to stem the free-falling lira: “It’s currently my phase of patience but there is a limit to this patience.”
Recap Sept. 14
Stocks cruised sideways for a second straight day, with the S&P 500 wrapping up the week higher by 1.2% to close within about 30 basis points of the high water mark. Treasury yields moved higher, with the 10-year briefly exceeding 3%, while commodities came under pressure with gold dropping back below $1,200 an ounce.
- Philip Grant
Thursday, September 13, 2018
Playing Ketchup
It’s been a tale of two halves for the Kraft Heinz company.
It’s been a tale of two halves for the Kraft Heinz company.
QT progress report
Recap Sept. 13
Playing Ketchup
It’s been a tale of two halves for the Kraft Heinz Company (KHC on the Nasdaq). Born out of the 2015 merger of Kraft Food Group, Inc. and HJ Heinz Co. and blessed by cornerstone investors Berkshire Hathaway and 3G Capital, things began auspiciously. Adjusted EBITDA margins expanded to more than 31% at year-end 2016 from less than 26% in 2015, while the stock jumped 32% in the two years ended February 2017 to command a princely multiple of 34 times trailing GAAP earnings. (For our part, Grant’s offered subscribers bearish analyses of KHC on March 25, 2016 and March 10 of last year.)
Of course, it’s been a different story since that initial burst of success, as earnings and revenues have stagnated while the hefty debt load used to fund the 2015 deal has stayed in place. Since that early 2017 peak, KHC shares are down by 39%, and have lost 23% year-to-date, far in excess of the 7% decline in the S&P 500 Packaged Foods Index.
Signals from those celebrity investors have likewise been less than reassuring. On Feb. 23, Warren Buffett announced his retirement from the board following this year’s annual meeting. In August, 3G announced the sale of 20.6 million KHC shares, reducing its holding to 270.1 million shares.
One Kraft Heinz investor isn’t taking the pain lying down. Today, protestors dressed as condiments and foodstuffs paraded in front of Federal Hall and the New York Stock Exchange. Approached by Grant’s for comment, a participant explained that they were there at the behest of Prague-based activist investor Krupa Global Investments a.s. to demonstrate against Buffett and 3G’s leadership, producing an open letter to fellow investors and the Kraft Heinz board written by Krupa’s eponymous chairman, Pavol Krupa.
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Just your typical Wall Street lunch (with the Wizard of Oz). Sept. 13, 2018
In the missive, Krupa takes issue with, among other things, KHC’s focus on cost cutting at the expense of market share, a lack of strategic acquisitions after the company was rebuffed by Unilever plc. last year and excessive debt. The activist advocates for the rollout of higher margin products, a share buyback and/or a go-private transaction, noting that the investment manager would support a privatization deal “with a valuation in the range of $80 a share,” roughly a 33% premium to the current price.
Krupa wraps up with an entreaty to the Berkshire and 3G bosses:
Investors have followed Warren Buffett and Jorge Paolo Lehmann into battle inspired by the larger than life legend of these men. These investors are scarred and battle weary. They have lost retirement savings and college savings on what they viewed as a safe dividend stock, Mr. Buffett and Mr. Lehmann, save these investors who put their trust in you.
In the letter, Krupa claims to hold “approximately $100 million in Kraft Heinz stock,” although Grant’s was unable to locate any SEC 13-F filings for the firm or find Krupa Global Investors among Bloomberg’s listing of KHC holders. Until recently, Krupa was known as Arca Capital, which is listed by Bloomberg as a holder of 3,475 shares of Kraft-Heinz stock as of July 31. Grant’s unsuccessfully attempted to reach Krupa’s offices for comment, circa 7 p.m. Prague time (1 p.m. ET).
QT progress report
The Fed’s portfolio of securities held outright footed to $4.013 trillion this week, an $11.4 billion sequential decline as Treasurys suppled the run-off while mortgage-backed securities holdings remained unchanged at just under $1.7 trillion. Today’s reading is down by $22.8 billion compared to the trailing four-week average, with Treasurys accounting for roughly two thirds of that run-off.
It’s almost the one year anniversary of QT. Since the program began on Oct. 1 last year, the Fed’s total balance sheet is down by 5.5%.
Recap Sept. 13
Stocks rose yet again, pushing the S&P 500 to within 50 basis points of its high-water mark as the NYSE FANG+ Index managed a near 1% advance. A softer dollar didn’t help commodities, as the CRB Index was hammered by more than 1% with WTI crude dropping below $69 a barrel. Treasurys ticked slightly higher across the curve, after August CPI rose by 2.7% year-over-year, slightly less than expected.
- Philip Grant
Wednesday, September 12, 2018
GoFundTheUniverse
Yesterday, from Bloomberg:
A village in Switzerland has decided to go ahead with an experiment on [universal] basic income, with a payout of 2,500 francs ($2,570) per month. The next step is to raise the money to finance the plan via crowdfunding.
Presumably, the crowd will be from outside the village limits.
Low energy
Today, the Department of Energy reported a 5.3 million barrel drawdown of U.S. crude oil inventories for the week, well above the Bloomberg consensus for a 2 million barrel decline. Those bullish inventory figures, along with disruptive potential from the incoming Hurricane Florence and the impact of sanctions on Iran, OPEC’s third largest producer, helped maintain a strong bid in the energy patch as WTI reached $71 and Brent Crude leaped above $80 for the first time since May.
This week’s outsize decline builds on a sharp recent dwindling in domestic stockpiles. According to the Department of Energy, total U.S. crude inventories fell to less than 396 million barrels last week, down more than 15% year-over-year. That’s despite a steady uptick in domestic output thanks in large part to the shale boom, as DOE production held near its all-time high last week at 10.9 million barrels a day, up 17% year-over-year.
Domestic output is set to continue its rise, but perhaps not to the extent that energy bears have counted on. Thus, the International Energy Agency trimmed its 2019 U.S. production forecast to 11.5 million barrels a day in the September Short Term Energy Outlook, down more than 3% from the 11.86 million barrel estimate in May.
Then too, an anecdotal point from services giant Halliburton Co. indicates that shale activity may not be as bustling as some expected. Last Wednesday, Halliburton CEO Jeff Miller told attendees at a Barclays energy conference: “A decrease in customer urgency. . . has occurred, and we have more white space [in our calendar] than expected.” Miller likewise observed that: “We are seeing slower than expected activity ramp on several new contracts in the Middle East.”
While investors were taken by surprise, sending Halliburton shares lower by 6% on heavy trading volume, the news corresponds with the bullish thesis laid out by natural resource investors Leigh Goehring and Adam Rozencwajg. The pair’s second quarter investor letter notes that 2017 global oil discoveries of four billion barrels lagged far behind the 35 billion in global consumption, and they estimate that discoveries have trailed consumption by 210 billion barrels since 2012. Likewise, Rystad Energy estimates that capital spending in the oil and gas industry will total only $440 billion between 2015 and 2020, just over half of the $875 billion outlay in the 2010 to 2015 period.
Might a looming supply shortfall set the stage for far higher energy prices? Grant’s put the question to Goehring, who finds that U.S. demand growth is fast outpacing rising domestic production growth, while OPEC struggles to maintain its quota and non-OPEC conventional production remains below its 2010 levels.
If the U.S. output disappoints, and OPEC’s production can’t hold at [the current 32.7 million barrels a day quota] . . . then we fall into another year of steep deficits that quickly get out of control.
Energy watchers won’t have to wait too long for an update, as OPEC is scheduled to meet in Algeria later this month, with a press conference scheduled for Sept. 23. For their part, Goehring and Rozencwajg remain highly bullish on energy prices:
We believe the bull market in oil (ignored thus far every step of the way by the investment community), is set to dramatically accelerate to the upside. Stay long oil and oil-related investments.
Grant’s, also bullish on oil (see the March 10, 2017 issue for more), continues to concur with the assessment of Goehring and Rozencwajg.
Recap Sept. 12
Stocks drifted sideways in a narrow range, while a soft dollar helped buoy the commodity complex with gold ticking to a two-week high above $1,200 an ounce. The Treasury curve flattened, with the 2- and 10-year spread compressing to just 21 basis points, near the flattest since 2007. August CPI is set to be released tomorrow, with economists expecting a 2.8% year-over-year headline advance.
- Philip Grant
Tuesday, September 11, 2018
Fine print foibles
The books are open. Soon-to-be renamed Refinitiv U.S. Holdings, Inc. (formerly Thomson Reuters’ Financial and Risk U.S. Holdings, Inc., which publishes financial data through its Eikon terminal) has commenced a $13.5 billion offering of term loans and high yield debt which will help finance the company’s $17 billion acquisition by a Blackstone Group L.P.-led consortium at the end of January. The deal, which values the F&R unit at 12 times EBITDA and is expected to price next week, is the largest leveraged buyout since the financial crisis.
Shortly after the deal was announced, the Feb. 9 edition of Grant’s summarized the daunting task facing Financial and Risk’s new ownership group, and, by extension, the company’s creditors:
The deal is a giant, leveraged bet that the passive investing trend will not, in fact, crush the active managers who pay to use Eikon; that F&R can take market share from the Bloomberg terminal; that interest rates won’t spike when Blackstone comes to refinance the $14 billion of borrowings; and that the world of finance five years from now will look very much like the financial world of today.
The business risks do look to be at least somewhat reflected in the prospective compensation on offer. Max Bower and Natalie Harrison of Reuters report yesterday that price talk for the high yield senior secured and senior unsecured tranches resides in the “low 7% area and low 9% area, respectively.” Those yields would tower over the 5.11% currently on offer from the iShares iBoxx High Yield Corporate Bond ETF.
Then again, Reuters notes that while the deal is being marketed at a leverage ratio of 5.25 times adjusted EBITDA for the unsecured tranche, that already-doctored EBITDA figure has an asterisk. Anticipated but as of yet-unrealized cost savings will purportedly push Refinitiv’s adjusted EBITDA to $2.5 billion from the actual $1.9 billion annual run rate. John McClain, portfolio manager at Diamond Hill Capital Management, put it this way to Reuters:
It’s very late cycle. I don’t really like it when you see a deal with this order of magnitude of projected cost savings as you don’t really know if and when it will be realized. It will be a bit of a test for the market given the size of the deal. But Blackstone and its partners have a good reputation and deep pockets.
Covenant Review, a credit research firm, pulled no punches after taking a look at the fine print. Speaking of the high yield segment of the offering, analysts Sabrina Fox and Scott Josefsberg write:
The Notes are being marketed with extremely defective sponsor-style covenants riddled with flaws and loopholes that reflect the worst excesses of covenant erosion over the last two years.
The pair go on to cite specifics:
A wildly off-market new sponsor mutation seeks to eliminate a fundamental protection against distributions of assets to sponsors and other sponsor shenanigans at a time that the Company has become distressed.
The definition of ‘EBITDA’ would allow for ridiculous pro forma adjustments, allowing management to artificially inflate capacity throughout the covenant package.
Might this transaction stand as something of an avatar for these ebullient post-Lehman credit cycle? In 2008, private equity firms Bain Capital, LLC and Thomas H. Lee Partners conducted a $24 billion leveraged buyout of terrestrial radio station operator iHeartMedia, Inc., paying 10.8 times trailing EBITDA. Having subsequently defaulted on its debt and entered bankruptcy earlier this year, iHeartMedia is now mired in contentious negotiations with its bondholders. S&P Global Market Intelligence’s LCD Unit reported last week:
The unsecured creditors committee in the Chapter 11 proceedings of iHeartMedia asked the bankruptcy court overseeing the case to deny approval for the company’s proposed disclosure statement, calling it a “175-page document premised on indecipherable defined terms and convoluted gifting mechanics [meaning the manner in which the assets are distributed] that renders an informed judgement next to impossible.”
LCD reports that holders of iHeartMedia’s unsecured 2021 notes would see recoveries ranging between 0 and 14.45% according to the company’s plan.
Recap Sept. 11
Stocks ticked moderately higher amid renewed leadership from tech, as the NYSE FANG+ Index snapped out of its recent doldrums with a 1% advance. Treasury yields likewise moved higher, with the 10-year yield settling at 2.98%, a five-week high.
The dollar finished flat, while the iShares MSCI Emerging Markets ETF managed to reverse steep opening losses to likewise finish unchanged and the Turkish lira approached its best level against the greenback in two weeks. An encouraging showing for EM bulls today.
- Philip Grant
Monday, September 10, 2018
Wealth defect
Over the weekend, Global Financial Crisis-era policymakers Ben Bernanke, Timothy Geithner and Henry Paulson brought the band back together
Over the weekend, Global Financial Crisis-era policymakers Ben Bernanke, Timothy Geithner and Henry Paulson brought the band back together
Ma Ma, hey hey
While the U.S. stock market maintains its upward trajectory,
While the U.S. stock market maintains its upward trajectory,
Recap Sept. 10
Wealth defect
Over the weekend, Global Financial Crisis-era policymakers Ben Bernanke, Timothy Geithner and Henry Paulson brought the band back together to pen a New York Times opinion piece. After sharing their self-exonerating analysis of the events of 2007-2009 and subsequent response (which one of the three did the fact checking?), Bernanke et. al. argue for greater regulatory powers, or as they put it, “adequate firefighting tools,” to resolve future financial crises.
Blanket guarantees of bank debt by the Federal Deposit Insurance Corporation, the Fed’s emergency lending capabilities and the Treasury department’s guarantee of money market funds are among the mechanisms cited by the authors as necessary for crisis prevention and mitigation.
The trio write:
We need to make sure that future generations of financial firefighters have the emergency powers they need to prevent the next fire from becoming a conflagration. We must also resist calls to eliminate safeguards as the memory of the crisis fades. For those working to keep our financial system resilient, the enemy is forgetting.
Alternatively, the monetary mandarins could take a cue from Peter Fisher, former executive vice-president at the Federal Reserve Bank of New York and senior fellow at the Tuck School of Business. Speaking on policy normalization at the Grant’s spring conference on March 15, 2017, Fisher offered a commanding critique of the crisis-era response led by the authors of this weekend’s Times piece. Written 18 months ago, the below passage could serve as a direct rebuttal to the authors, particularly former Fed chair Bernanke:
Curiously, the Fed has acknowledged no failures. All the experiments have been successful, every one: no failures, no negative side effects, no perverse consequences, only diminishing returns.
What has been most extraordinary about extraordinary monetary policy is the awkward denial of uncertainty in defense of extraordinary actions. Wanting so badly to manipulate our expectations, the central bankers did not want to leave us any room for doubt. . .The Fed and other central banks appear to have avoided being candid about the uncertainty in order to maintain their credibility. But this is backwards. They cannot regain their credibility unless they are candid about the uncertainty and how they confront it.
The full text from Fisher’s remarks is available here. Ben Bernanke, Tim Geithner and Hank Paulson, please copy. Come to think of it, please read.
Ma Ma, hey hey
While the U.S. stock market maintains its upward trajectory, Chinese equities have been loaded for bear, with the Shanghai Composite Index and Hong Kong’s Hang Seng down 25% and 20%, respectively, from their late-January highs.
Trade wars look to figure prominently in the recent pain. On Friday, President Trump floated the idea of extending an additional $276 billion in tariffs on Chinese goods, a notable escalation from the current $50 billion tariff regime and additional $200 billion in already proposed duties. In response, Chinese foreign ministry spokesman Geng Shuang promised that “China will definitely take countermeasures to safeguard its legitimate rights and interests.”
As trade tensions ratchet and stock prices teeter, inflation stirs in the Middle Kingdom. While official government CPI readings show a gradual acceleration to 2.3% year-over-year in August, The New York Times, citing a household spending-weighted data set from economic research group Wigram Capital Advisors, reports that prices jumped 3.7% in August. That metric had remained below 2% for the bulk of 2017.
For debt-soaked China, which holds banking assets in excess of 300% of GDP, a persistent inflation uptick, and the prospect of higher interest rates, could augur trouble. Reuters reports that 20 corporate borrowers have defaulted this year as of Sept. 3 on 41 bonds worth 45.6 billion renminbi ($6.7 billion), already above 2017’s full year tally of 18 defaults worth Rmb. 39.3 billion.
With these disparate economic data points as a backdrop, Friday afternoon’s retirement announcement from Alibaba, Inc.’s (BABA on the NYSE) co-founder and executive chairman Jack Ma was a notable one. Ma, 54, told The New York Times that his departure from the e-commerce behemoth will not mark the end of an era but, rather, “the beginning of one.”
The debt-driven Chinese economic miracle has been kind to Alibaba, which has more than tripled both its revenues and adjusted net income in the three years ended March 31. It has also been kind to Ma, who has sold some 26.6 million BABA shares over the last two years, worth $4.2 billion at today’s prices, according to The Wall Street Journal.
What era is this the beginning of?
Recap Sept. 10
Stocks edged higher, as the Dow Transports Index gained nearly 2% to reach a fresh record high and pick up the slack from the recently-faltering FANG+ complex, which treaded water after a 7% drop last week. The Treasury curve flattened a bit, while a slightly weaker dollar helped commodities but wasn’t enough to prevent the iShares MSCI Emerging Market ETF from sinking to a fresh 52-week low.
- Philip Grant
Friday, September 7, 2018
Clickbait
Senators, let me be clear: We are more determined than our opponents and we will fight them. Nothing less than the integrity of our democratic institutions is at stake.
Those remarkable words were uttered not by a politician or military commander, but rather by Sheryl Sandberg, chief operating officer of Facebook, Inc., (FB on the Nasdaq) during congressional testimony on Wednesday.
As the Cambridge Analytica data misadventure (among others) have taken the social network far beyond the scope of most corporations, regulatory action from Washington appears increasingly certain. On Tuesday, entrepreneur and Facebook co-founder Eduardo Saverin told the audience at a Singapore technology summit that: “It’s not a question of if, it’s a question of the type of regulation.” The company is preparing itself. Employee headcount jumped to 25,105 in 2017 from 17,048 the year prior, and capital expenditures are expected to double to $14.7 billion this year from $6.7 billion in 2017.
Investors also seem to be girding for the heavy hand of Uncle Sam: Facebook shares have declined by 7% this week, extending their slide to 25% since offering slower than expected revenue growth guidance on July 25. Since the Aug. 11, 2017 bearish analysis in Grant’s, Facebook shares have dropped 3%, lagging the S&P 500's 17% gain over that period.
Does the price weakness offer opportunity? Analysts from Needham & Company believe so, writing on July 26 after the 20% post-earnings swoon: “We are sad about the human capital cost* of this share price correction, but we believe FB’s fundamental value, advertiser demand, [free cash flow and return on investment] remain intact.” Considering the breakneck growth in revenues, net income and free cash flow achieved by Facebook in recent years, the stock trades at just over 20 times consensus adjusted earnings per share this year, far from exorbitant by current bull market standards. The stock is up 271% over the past five years.
Likewise, the Street, with 40 “buy” ratings, six “holds” and two “sells”, expects the good times to continue. Consensus revenue and adjusted net income for 2019 stand at $69.3 billion and $28 billion, respectively, well above the $48.5 billion in revenue and $21.3 billion in adjusted net income generated in the 12-months ended June 30.
The question before the house: Are the underlying user growth metrics supplied by the company accurate? On Aug. 17, Brian Wieser of Pivotal Research (one of the two analysts with a “sell” on FB) alerted investors to a recent class action lawsuit filed against FB by online advertiser Investorvillage.com. Among other allegations, the suit contends that a “former Facebook employee. . . stated that Facebook does not care about the accuracy of information related to the number of users so long as advertising revenue is not negatively affected.”
Indeed, Wieser writes: “A check on [Aug. 16] shows that Ads Manager now indicates that a campaign with a Reach-based objective has the potential to reach 39 million 18-24 year olds, 63 million 25-34 year olds and 61 million 35-49 year olds” in the U.S. Those figures all sit far above the 31 million 18-24 year olds, 45 million 25-34 year olds and 61 million 35-49 year olds reported by the U.S. Census. Chicago-based politicans would likely approve.
Meanwhile, a survey released on Wednesday from Pew Research finds that 42% of respondents have taken a break from Facebook “for several weeks or more” in the past 12-months, while 26% “say they have deleted the Facebook app from their cellphone.”
Sandy Brasher, researcher of shorts at Rice, Volker LLC, compares Pew’s findings with Facebook’s reported growth in domestic monthly active users and finds the numbers confusing, especially considering the ongoing decline in U.S. searches for Facebook, according to Google Trends, which aggregates the popularity of various search terms (for reference, legacy social network MySpace is added to the below chart, as is Facebook’s fast-growing Instagram unit).
Facebook in blue, Instagram in yellow, MySpace in red. Source: Google Trends
The faltering search frequency and substantial phone app deletions reported by Pew draw a contrast with the company’s own metrics: Monthly active users in the U.S. and Canada totaled 241 million at the end of the second quarter, up 2.1% year-over-year. Brasher concludes to Grant’s: “Their reported user numbers seem strange to say the least.”
*Human capital, in this case, refers not to shareholders who have lost money or users who have had their privacy invaded, but rather “FB employees who had plans to sell shares to fund their life [and] just lost 1/5 of their budget, literally overnight.” The company did generate $17.7 billion in free cash flow in the past 12 months, which could present an alternative means for employee compensation compared to stock options.
Recap Sept. 7
Stocks edged a bit lower, with the S&P 500 finishing the holiday-shortened weak down by 1%, a respectable showing considering the 6% downdraft in the NYSE FANG+ Index over the past four sessions. Commodities and the dollar rose in tandem, while the strongest year-over-year gain in average hourly earnings since 2009 pushed Treasury yields well higher across the curve, with the 10-year yield settling at 2.94%.
- Philip Grant
Thursday, September 6, 2018
Multiple personalities
Yesterday, the U.S.-listed company (with a market cap greater than $500 million) with the worst performance was Coral Gables, Fla.-based Mercantil Bank Holding Corporation. The U.S.-listed company with the second best performance in yesterday’s trading? That same Mercantil Bank. The company’s voting right-carrying A-shares fell by 57%, while the non-voting B-shares closed the session up by 31% after jumping as much as 165% intraday.
Mercantil, spun off from Venezuelan bank Mercantil Servicios Financieros, C.A. on April 2 with $8.4 billion in assets and $6.3 billion in deposits, began trading on the Nasdaq exchange on Aug. 29 as an “emerging growth company” under the 2012 Jumpstart Our Businesses Act. The company’s registration filing explains the practical meaning of that desingation:
As such, we are eligible to take advantage of certain exemptions from various reporting requirements that are applicable to other public companies that are not “emerging growth companies” including, but not limited to, not being required to comply with the auditor attestation requirements of Section 404 of the Sarbanes-Oxley Act, reduced disclosure obligations regarding executive compensation in our periodic reports and proxy statements, and exemptions from the requirements of holding a non-binding advisory vote on executive compensation and shareholder approval of any golden parachute payments not previously approved.
If some investors find our securities less attractive as a result, the trading market for our securities may be reduced, and the prices of our securities may be traded at lower prices and experience greater volatility.
The volatility part is definitely covered. Over the past six trading days, Mercantil A-shares reached as high as $86 dollars a share on Sept. 4, and ticked below $6 a share on Aug. 29. The B-shares have remained range-bound by comparison, oscillating from $6 a share on Aug. 29 to $40 a share a week later. Current market capitalization is just under $2.5 billion.
The freshly spun-off entity is tightly controlled. More than 97% of the 74.2 million A-shares outstanding are owned by insiders, as are more than 58% of the non-voting B-shares.
Grant’s inquired at the company via phone and email for comment regarding the curious activity in its shares. Mum’s the word from Mercantil.
QT progress report
The Fed’s portfolio of securities held outright footed to $4.013 trillion, down by $11.4 billion from last week’s reading. It was Treasurys rolling off the balance sheet this time, while mortgage-backed securities holdings remained unchanged at $1.697 trillion. Today’s reading represents a $22.8 billion decline off the trailing four-week average.
Since the Fed began its QT portfolio run-off program last Oct. 1, total balance sheet holdings are down by 5.55%, for a simple annualized rate of 5.89%.
Recap Sept. 6
Stocks finished a bit lower led by tech, as the Philadelphia Semiconductor Index lost nearly 3% after bearish commentary from KLA-Tencor Corp. management at a Citigroup investor conference. Recent weakness in tech is not confined to the semis: The NYSE FANG+ Index has now lost nearly 10% from its June 20 peak.
Seemingly bearish action took place outside of equities as well. Treasury yields ticked lower across the curve, while a softer dollar was no help for commodities as the CRB Index finished sharply lower and WTI crude fell back to $68 a barrel. The VIX rose to its highest close in three weeks, and cryptocurrencies were hammered with bitcoin dropping below $6,500, near its 2018 low of $5,900 logged on June 29.
- Philip Grant
Tuesday, September 4, 2018
First shall be last
High-grade is a relative term. Year-to-date, the iBoxx USD Liquid Investment Grade Index is down 2.84%, far behind the more speculative end of the credit spectrum as triple-C-rated corporates have managed a 6.44% gain.
Investors are beginning to take note. The iShares iBoxx USD Investment Grade Corporate Bond ETF (LQD on NYSE Arca) saw a combined $994 million in withdrawals last Wednesday and Thursday, the largest outflow in the name since the February rout in short-volatility products. Mohit Bajaj, director of ETF trading solutions at WallachBeth Capital, commented on the withdrawal to Bloomberg: “It’s a lot, especially for as slow as it’s been in the last week of August.” In terms of price, the LQD remains just above the multiyear lows logged during the short but severe correction in early 2016.
The poor performance from investment grade credit can’t be chalked up to excess supply. According to data from Bloomberg, year-to-date issuance has totaled $889 billion through Friday, down 12% from the same period last year. Instead, rising interest rates, (3, 6 and 12-month LIBOR all remain at or near post-2008 highs) in tandem with relatively brisk economic growth, have combined to hinder the lower coupon and lower risk (of default at least) asset class.
Then too, there is credit quality, specifically the growing concentration of corporate membership at the lower end of the investment grade ratings scale. A July 25 research note from S&P Global Ratings found that U.S. nonfinancial corporate debt rated triple-B (the final full stop before junk) totaled $2.66 trillion, nearly triple the $1 trillion outstanding at the eve of the financial crisis in 2007. S&P also notes that “capital structures at many borrowers we rate. . . have become more aggressive, with leverage rising beyond historical levels.” The rating agency remains relatively sanguine, however, concluding that: “We believe that these borrowers can reduce leverage over a two year window and maintain investment-grade credit ratios.”
The bourgeoning ranks of those rated just above junk added another last week, as Moody’s downgraded Ford Motor Company to Baa3 from Baa2 (equivalent to triple-B-minus from triple-B), with a negative outlook. In announcing the downgrade, the rating agency pointed out that Ford has seen its debt jump to 3.3 times EBITDA from 2.6 times in the two years ended on June 30, while EBITDA now covers interest expense by just 1.8 times, down from 4.5 times in June 2016.
Indeed, Ford appears to be spinning its wheels operationally while debt accumulates at a brisk pace. The company is expected to generate $147 billion in revenue this year, up only modestly from the $133 billion top-line from 2012. However, total gross debt has jumped to $153 billion from $105 billion during that period according to data from Bloomberg. Some creditors have headed for the hills in light of the Moody’s downgrade, with Ford’s senior unsecured 5.29% notes of 2046 falling to less than 89 cents on the dollar for a yield-to-worst of 6.13%. Last week, that paper traded above 92 cents.
Other large cap, high-grade borrowers have seen an even more pronounced pile-up in their borrowings, to little ill effect thus far. Analysts forecast that triple-B-plus-rated Verizon Communications, Inc. will generate $131 billion in revenue this year, marginally higher than the $116 billion revenue line from 2012. However there is nothing marginal about the increase in debt over that period, as gross borrowings have ballooned to $115 billion from $52 billion since 2012. Single-A-minus-rated Anheuser-Busch InBev SA is expected to produce a $56 billion top line this year, up from $40 billion in 2012. While revenues have increased by some 43% in the past six years, gross debt has nearly tripled, to $117 billion from $44 billion.
Investors haven’t minded, yet. Verizon’s senior unsecured 5.15s of 2023 trade above 107 cents on the dollar, bestowing a 3.55% yield-to-worst and 78 basis point premium to Treasurys. The Anheuser-Busch senior unsecured 3.65s of 2026 currently trade just under 98 cents on the dollar, for a yield-to-worst of 4.02% and a 117 basis point pickup over Treasurys.
An analysis in the April 6, 2018 edition of Grant’s shed some journalistic light on the plight of those put-upon investors in so-called high-grade corporates:
Low interest rates and tight yield spreads condemn the creditors to mediocre returns (that’s the upside) or outright loss (not so much the downside as the base case). We write to remind the bondholders that they have become the doormats of Wall Street.
Recap Sept. 4
Stocks ticked modestly lower, with the NYSE FANG+ Index losing more than 1% despite Amazon.com, Inc.’s first foray above a $1 trillion market cap. A stronger dollar crimped the commodity complex, while emerging markets continued to struggle with the iShares J.P. Morgan USD Emerging Market Bond ETF tumbling to its lowest since February 2016. Treasury yields ticked higher across the board in bear steepening formation, as the 2- and 10-year spread closed above 24 basis points for the first time since Aug. 17.
- Philip Grant
Friday, August 31, 2018
Dog day afternoon
Let’s wrap up the month of August with a jumbled stew of sightings, from the ridiculous to the sublime. Without further ado, a trio of anecdotes 100% guaranteed to provide no investment value whatsoever:
On Monday, USA Today reported that Mayo, Fla. (population 1,500) has temporarily changed its name to “Miracle Whip” thanks to a marketing arrangement with processed food giant Kraft Heinz Co. (KHC on the Nasdaq). In exchange for the naming rights (not to mention its dignity), the town formerly known as Mayo will receive $25,000 in “city beautification funds.”
Solid move by Kraft Heinz. Definitely cheaper than buying Unilever.
On Monday, the Impact Shares YWCA Women’s Empowerment ETF, ticker WOMN, made its debut on the NYSE Arca exchange. The fund is based on the Morningstar Women’s Empowerment Index, which “is constructed using a rules based methodology to select companies from the Morningstar US Large-Mid Cap Index that have strong women’s empowerment practices,” according to the prospectus.
The fund sports an expense ratio of 76 basis points, as well as a familiar set of top holdings. WOMN’s current top five largest positions are: Amazon.com, Inc., Microsoft, Inc., J.P. Morgan Chase & Co., Johnson & Johnson, Inc. and Exxon Mobil Corp.
A strong lineup, albeit one seemingly identical to the male empowerment ETF.
Finally, we turn to that hotbed of international commerce and cutting edge technology known as North Korea. On Saturday, Singapore-based news organization The Straits Times, citing South Korea’s Yonhap News Agency, reports that “the first-ever Korean International Blockchain Conference will be held over two-days starting Oct.1.”
That’s not the first time that the so-called Hermit Kingdom has attempted to get into the blockchain game. On Monday, Yonhap cited the Korea Development Bank in reporting that North Korea, smitten by certain "characteristics of cryptocurrencies, including anonymity, difficulties of tracing money and cashability," may have unsuccessfully attempted to mine for bitcoin between May and July 2017.
If mining for bitcoin didn’t work, perhaps an ICO could be called for? The name “Rocketmancoin” still appears to be available.
Recap Aug. 31
Stocks cruised sideways on this final unofficial day of summer, wrapping up the week modestly in the green and leaving the S&P 500 higher by 8.5% year-to-date. Treasurys likewise held mostly steady, with some modest steepening pushing the 2- and 10-year spread above 23 basis points after it compressed to a cycle low of less than 19 basis points last Friday.
Commodities managed a flat finish despite a stronger dollar as WTI crude and gold settled at $70 a barrel and $1200 per ounce, respectively. But the green greenback did no favors for the stricken emerging markets complex as the iShares J.P. Morgan USD Emerging Market Bond Fund ETF lumbered back near multi-year lows established on Aug. 13.
- Philip Grant
Thursday, August 30, 2018
Back to the Future
It sounds vaguely familiar: A potent U.S. bull market runs headlong into an emerging markets crisis.
It sounds vaguely familiar: A potent U.S. bull market runs headlong into an emerging markets crisis.
Great moments in corporate communications
Yesterday, China Properties Group Ltd. (1838 on the Hang Seng) reported
Yesterday, China Properties Group Ltd. (1838 on the Hang Seng) reported
QT Progress Report
Recap Aug. 30
Back to the Future
It sounds vaguely familiar: A potent U.S. bull market runs headlong into an emerging markets crisis. Might the so-called Asian Contagion of 1997 and 1998 provide a roadmap for today’s investors as Argentina, Turkey, Brazil and others see their currencies spiral lower and borrowing costs lurch higher? Let’s review the script from last time for potential clues to the future.
As the S&P 500 had entered the teeth of the 1990’s bull rampage (the index was up 111% from April 1994 to July 1997), Thailand was forced to float the baht on July 2 as declining FX reserves made the country’s peg to the dollar untenable. The Bank of Thailand tried to limit the damage by raising interest rates 200 basis points to 12.5% and pledged to spend up to $5 billion to defend the baht, but to no avail. The currency lost roughly half its value in the next six months.
Thai baht/U.S. dollar cross, January 1997 to August 1999. Source: The Bloomberg
Stateside, the summer of 1997 saw choppy but largely sideways price action in the S&P 500, with an abrupt 11% decline in October all but erased by year-end. The bull market resumed in full swing in the first half of 1998, as the S&P 500 tacked on 20% through July.
But as U.S. investors resumed their party, the Thai crisis duly spread to other emerging markets, with the South Korean won and Indonesian rupiah losing 54% and 80% respectively against the dollar in 1997 and 1998. The EM crisis eventually culminated in the Russian debt default of September 1998 and subsequent bailout of U.S. hedge fund Long Term Capital Management. This time, overseas troubles made their way to the shores of the U.S., as the S&P 500 endured a 21% decline from July to October 1998, briefly entering a bear market.
But the U.S. equity bulls had an ace in the hole in the form of Federal Reserve chairman Alan Greenspan. In late September 1998, the Fed cut the federal funds rate by 25 basis points, to 5.25%. When stocks continued to fall in October, Greenspan delivered another, intra-meeting 25 basis point rate cut on Thursday, Oct. 15, 1998, right before monthly options expiration. CNN Money reported at the time that: “As the news of the rate cut hit the floor of the New York Stock Exchange, traders actually cheered and investors rushed to buy stocks and bonds.”
They had good reason to cheer. The S&P 500 fully regained its losses by the end of November, then tacked on another 30% upside through the March 2000 peak of the Nasdaq. While Greenspan’s rate cuts came from a far higher base (the current effective Fed funds rate is just 1.92%), chairman Jerome Powell could always press pause on the QT balance sheet run-off if the unfolding EM panic puts a dent in U.S. asset prices.
Great moments in corporate communications
Yesterday, China Properties Group Ltd. (1838 on the Hang Seng) reported disappointing operating results for the first half of the year featuring a 72% year-over-year revenue decline. While the outcome was disappointing, investors could at least enjoy a most entertaining “management discussion and analysis” commentary that accompanied the press release. An excerpt:
10 years ago, the U.S. printed money like crazy and exported U.S. dollars all over the world. Now the U.S. has become a global enemy, trying. . . to undermine the asset markets of other countries and the global supply chain order. No wonder the U.S. has made a lot of enemies. Fortunately, Trump does not have the same wisdom as Mao Zedong in making alliance with one while fighting another. He wants to fight the world.
Nevertheless, Chinese are savvy and resourceful. Deng Xiaoping said, “we should grope our way across the river, one step at a time.” Jiang Zemin said, “keep a low profile to make a big fortune.” Han Xin demonstrated his immense ability to endure humility [sic] in order to preserve his existence for future accomplishments. Such wisdoms contributed to the creation of incredible historic achievements one after the other.
Stateside, steel drum producer Greif, Inc. (GEF on the NYSE) and subject of a bearish analysis in Grant’s (Sept. 22, 2017) reported third quarter results following the market close yesterday, with a stronger than expected top line partially offset by a revenue forecast and implicit guidance cut for the rest of the year. One anonymity-seeking investor points out a recurring theme from the company’s last four conference calls; a bone to pick with Mother Nature:
From the fourth quarter 2017: "Operating profit before special items was negatively impacted by $5.3 million associated with adverse weather events."
First quarter 2018: "But were negatively impacted by weaker than anticipated Rigid Industrial Packaging & Services volumes in December caused by a temporary winter slowdown."
Second quarter 2018: "Our Rigid Packaging segment was impacted by customer operational interruptions, weather issues and rising raw material costs."
Third quarter 2018 (yesterday): "partially offset by significantly weaker demand from European agricultural customers due to weather, impacts from events in Brazil and continued value over volume decisions in China."
Investors bid GEF shares higher by 2% today, but be forewarned: Fall is just around the corner.
QT Progress Report
The tightening train rolls on. The Fed’s portfolio of securities held outright comes to $4.024 trillion, down $9.7 billion from a week ago as mortgage backed securities rolled off the portfolio this week. Compared to the trailing four-week average, today’s holdings represent a decline of $17.6 billion.
Since QT began just under 11 months ago, the Fed’s total balance sheet is down by 5.31%, for a simple annualized pace of 5.76%.
Recap Aug. 30
The Brazilian real, South African rand and Turkish lira each lost between 1 and 3% against the dollar, while the Argentine peso was hammered to the tune of 13.5% to a fresh record low of 38.5 per greenback. In tandem with the latest lurch wider in the EM currency realm, the stock market saw its first pullback since breaking to new highs last week, while Treasury yields dropped across the curve.
A weak stock market and flat CRB Index didn’t stop WTI crude oil from climbing back above $70 a barrel, while the VIX was also well bid, spiking by more than 10% this afternoon to settle at a near-three week high.
- Philip Grant
Wednesday, August 29, 2018
Turkish bath
In the Republic of Turkey this summer inflation and bond yields surge while the lira crumbles, down 41% year-to-date. In dollar terms, the Turkish stock market is down a whopping 53% in 2018. Now in progress is the hunt for a silver lining.
Sentiment is bad and getting worse. “Turkey entering a steep recession,” a Capitol Economics report declared today. Jason Tuvey, senior emerging markets economist at the London-based research firm, forecasts output contraction of as high as 4% year-over-year in the fourth quarter. That would be the steepest decline since 2009.
Economic sanctions imposed by the U.S. in response to the jailing of American pastor Andrew Brunson (who has since been moved to house arrest) have added one layer of agita; Less-than-comforting rhetoric from Turkish President Recep Erdogan another. Following his re-election on June 24, Erdogan appointed his son-in-law Berat Albayrak to head the newly-consolidated ministry of finance and treasury. Jared Kushner wouldn’t complain, but investors turned thumbs down.
The grim financial picture is also raising the specter of systemic stress. According to analysts at J.P. Morgan Chase & Co., Turkey is facing almost $179 billion in foreign-currency debt maturities through July 2019, a figure which equates to nearly a quarter of full-year GDP. Yesterday, Moody’s Investors Service downgraded the credit ratings of 18 banks and two non-bank financial companies, citing “a substantial increase in the risk of a downside scenario, where a further negative shift in investor sentiment could lead to a curtailing of wholesale financing.”
Might Turkey, the world’s 17th-largest economy by 2017 GDP according to the World Bank, be headed for default? The market is increasingly coming around to that possibility, as 5-year sovereign credit default swaps have spiked recently.
Turkish 5-year CDS. Source: The Bloomberg
How bad might things get? Independent strategist Russell Napier predicts in the Aug. 22 edition of his Solid Ground Fortnightly commentary: “Turkey will almost certainly be the largest emerging market default of all time, should it resort to capital controls as your analyst expects, but it could also be the largest bankruptcy of all time given the difficulty of its creditors in recovering any assets.”
Of course, high risk and outsize opportunities go hand in hand. For a sense of the latter, Grant’s spoke with value investor Haydar Acun, managing partner at Marmara Capital Asset Management in Istanbul. In an email earlier this month, Acun reminded Grant’s that Sir John Templeton achieved massive gains by investing in South Korean assets during the depths of the 1998 emerging markets crisis.
Acun, noting today the acute “boom and bust” nature of Turkish economic cycles, forecasts that the nascent crisis can abate on its own as imports fall and the current account deficit improves. Acun likewise believes that European banks will continue to lend in Turkey, as they can continue to make money thanks to sky-high interest rates. Authorities still have economic levers they can pull, such as privatizing the railways, which would raise significant capital.
Assessing the potential for sovereign default and the imposition of capital controls, Acun observes that “Turkey has never done such things before, and I don’t think they are options for the government.” As for the stock market, Acun reports that Turkish equities are currently trading at “50, 60, 70% discounts to net asset value,” with a number of companies trading with substantial net cash positons.
By way of example, construction firm Enka Insaat ve Sanayi AS (ENKAI TI) holds nearly TRY 5 billion ($773 million) in net cash against a TRY 25.3 billion market cap, and is expected to generate TRY 2.1 billion in free cash flow and TRY 2.7 billion in adjusted net income this year.
Real estate investment trust Alarko Gayrimenkul Yatirim Ortakligi AS, (ALGYO on the Istanbul exchange) currently trades at a TRY 533 million market capitalization, with TRY 471 million in cash and no debt. The company generated TRY 52.1 million in free cash flow over the 12-months ended June 30.
Pharmaceuticals company EIS Eczacibasi (ECILC TI) holds TRY 534 million in net cash, more than 20% of its TRY 2.5 billion market cap, and generated TRY 283 million in free cash flow over the 12 months ended June 30.
Recap Aug. 29
Another day, another new high on the S&P 500, as tech and consumer discretionary led the broad index to its fourth straight record close. Commodities were also bid, with WTI crude advancing back near $70 a barrel, while the Treasury curve flattened a bit amid modest strength in the long end.
But as the bull march continues, emerging markets continue to unravel. Today, the Argentine peso made another lifetime low against the dollar after president Mauricio Macri asked the IMF to accelerate the distribution of its $50 billion bailout agreed to in May.
- Philip Grant
Tuesday, August 28, 2018
Bean oh
Today, the Invesco Deutsche Bank Agriculture Fund ETF (DBA on NYSE Arca),
Today, the Invesco Deutsche Bank Agriculture Fund ETF (DBA on NYSE Arca),
Recap Aug. 28
Bean oh
Today, the Invesco Deutsche Bank Agriculture Fund ETF (DBA on NYSE Arca), which invests in a wide array of agricultural commodities, plumbed a fresh lifetime low, down 9% year-to-date and 42% from its interim highs in April 2014. The record high in the S&P 500 and neutral recent showing from the broad commodity realm (the CRB index remains near the midpoint of its one-year range) puts into relief the grim action in the grains.
DBA, 5-year chart. Source: The Bloomberg
The pain in agriculture prices can be largely attributed to soybeans according to Arlan Suderman, chief commodities economist at INTL FCStone, Inc. Suderman terms soybeans “the anchor of the grain complex.” The ongoing trade spat with China, the largest destination for U.S. agricultural exports at $12.3 billion last year, figures prominently in the equation. Following an unsuccessful round of negotiations last week, the Trump administration yesterday announced a $4.7 billion subsidy package to domestic farmers who have incurred losses as a result of foreign tariffs.
While demand prospects remain tenuous, there is no such ambiguity on the supply side. According to updated estimates from Pro Farmer following their annual crop tour, U.S. soybean production is set to reach a record 53 bushels per acre this season, topping the record of 52 per acre established in 2016 and above the 51.6 bushels forecast by the company on Aug. 10. Sherman Newlin, a farmer in Crawford County, Ill., told Bloomberg: “Soybeans [yields] are going to be phenomenal. To me, the pile still gets bigger.”
There are other problems facing U.S. farmers. China, the world’s largest soybean customer, imports beans to feed its hogs, whose numbers are now threatened by disease. Last Thursday, China’s Ministry of Agriculture and Rural Affairs confirmed the existence of African swine fever in a fourth province of the country. China, home to roughly half the world’s population of pigs, has been forced to cull tens of thousands in response to the disease as no known cure or vaccine exists. Today, the U.N.’s Food and Agriculture Organization warned that the outbreak “may spread to other Asian countries anytime.”
As news flow goes from bad to worse, some investors are loading the bearish side of the speculative boat. According to data from the Commodity Futures Trading Commission, hedge funds carried a net-short position of 40,049 futures and options contracts, which Bloomberg reports is the most bearish positioning for this time of year since 2006.
Confirmed believers in the truism that the cure for low prices is low prices, Grant’s checked in with grain expert and paid-up subscriber Keith Bronstein. Might the brutal price action be setting the stage for opportunity on the long side? Not in the immediate term, councils Bronstein:
Soybean crop development has been optimal and the tariff issue has not been resolved. I believe that Dec. 1 is the point of critical outcome on tariffs. Once we get to Jan. 1, China is safe at home on reliance upon South African supplies. This migrates the world soy surplus entirely to the U.S. At that point, I believe the U.S. would need to shift acres from soy to corn and that will require a real price adjustment.
Now we watch final corn production and wheat crops finishing weather in Europe and the former Soviet Union along with Australia. I still think world wheat numbers have a potential to ignite higher market clearing prices but that may be an October to June story, if at all. Stay tuned.
Note to grain bulls. Bring patience along with your money.
Recap Aug. 28
Stocks finished unchanged, with the S&P 500 managing to eke out another closing high thanks to strength in the real estate realm, while resources took a break from their recent run as the CRB index came under pressure despite a weaker dollar. Treasury yields rose for a second straight day, with the 10-year settling at 2.88% while the 2- and 10-year spread inched wider to 21 basis points.
- Philip Grant
Monday, August 27, 2018
Forest for the trees
On Aug. 14, quasi-state owned military-defense company Xinjiang Production & Construction Corp. defaulted on a RMB 500 million ($73 million) a 270 day note, a development which The Wall Street Journal notes “is nudging China watchers to think harder about the extent to which local governments will step in” to help encumbered borrowers meet their obligations. Public debt may soon take center stage, as so-called local government financing vehicles (LGFVs) face a sharp increase in principal repayments due. According to a Bloomberg dispatch on Friday, LGFV bonds will see $49 billion of quarterly maturities through June of next year. That’s up by 40% from the maturity schedule in 2017.
Not that the word of credit-rating agencies should be treated as gospel. On Aug. 18, Dagong Global Credit Rating Co. was barred by regulators for soliciting new business for one year. Last Thursday, Caixin Global reported the reason for the harsh penalty: Dagong “required at least 26 issuers to purchase its consulting software before it would increase their ratings or the ratings of its bonds.” The software cost $1.4 million on top of additional six figure annual service fees, according to Caixin. In January, Dagong downgraded its U.S. government debt rating to triple-B-plus from A-minus, with a negative outlook (so, adjusted for deceit, Donald Trump’s Treasury could be triple-A).
This summer has been a long, hot one for peer-to-peer lending companies. Last Tuesday, the Peterson Institute for International Economics reported that total outstanding loans in the industry collapsed to less than RMB 1 trillion in July from 1.3 trillion a month before, while 15% of all peer-to-peer lending platforms have “run into serious trouble” since the beginning of June. Author Martin Chorzempa summarizes the potential systemic risks lurking within the peer-to-peer business model:
In practice, P2P platforms in China provide guarantees, meaning that investors get no hint that risk is piling up until suddenly the platform cannot meet its obligations and goes offline. These platforms also issue wealth management-type products that have maturity mismatches, putting them at the risk of a run if spooked investors pull out their investments. The China Banking Regulatory Commission (CBRC) issued rules in August 2016 making these practices illegal, but the turmoil over the last two months indicates that numerous platforms have ignored them.
Those dual cracks in the credit façade correspond with other market indicators suggesting things are less than stellar in the Middle Kingdom. Year-to-date, the Shanghai Composite Index is down 16% in local terms, placing it among the world’s weakest performers, while the renminbi has lost 8% against the greenback since April. The government is duly looking to mitigate Mr. Market’s harsh verdict, with the People’s Bank of China announcing Friday that it has reactivated a policy known as the “counter-cyclical factor” by which local banks fix the renminbi at stronger levels to ward off unwelcome currency weakness.
On Wednesday, China’s State Council issued a statement urging banks and other lenders to keep credit flowing to small businesses, with the council suggesting timelier loan approvals and higher loan-to-value ratios among potential remedies. Also on Wednesday, Bloomberg reported that the General Administration of Customs announced it will not report import and export figures for an array of industrial, agricultural and energy commodities in July, the fourth consecutive month of radio silence. If you don't have anything nice to say...
An Aug. 20 analysis from J Capital Research brings these somewhat disparate indicators into broader relief:
Visits with friends in banks and shadow banks in Beijing, Shanghai and Chengdu this week found a banking industry that is more risk-averse than ever. The hesitancy to lend into a weak economy is making everything harder than it used to be.
Recap Aug. 27
After going more than six months in between new closing highs, the S&P 500 managed its second record finish in two tries. Resources led the way, as a soft dollar buoyed the commodity complex with gold rising back above $1,200 an ounce. Treasury yields moved higher across the board, with the 2- and 10-year spread widening a few basis points off the cycle low reached Friday.
- Philip Grant
Friday, August 24, 2018
No context, no problem
Your headline of the day (year?), from the Miami Sun Sentinel:
Your headline of the day (year?), from the Miami Sun Sentinel:
Take it all
A changing of the guard is afoot in the Big Apple.
A changing of the guard is afoot in the Big Apple.
Correction
Recap Aug. 24
No context, no problem
Your headline of the day (year?), from the Miami Sun Sentinel:
Florida candidate for Congress: Alien abduction doesn't define me
Take it all
A changing of the guard is afoot in the Big Apple. Yesterday, tech website Recode reported that WeWork Cos. is closing in on becoming the number one office space lessee in Manhattan, set to surpass incumbent J.P. Morgan Chase & Co. “any day now.”
Also yesterday, fellow tech site Geekwire relayed that WeWork is “in the midst of a massive expansion that will more than double its presence in the Seattle area.” Jon Slavet, managing director for the U.S. and Canada West at WeWork, told Geekwire that the company plans to grow to 1.5 million square feet in Seattle by early next year, from the current 900,000 square feet.
It’s not hard to find the genesis of WeWork’s rapid expansion. On June 14, The Wall Street Journal reported that SoftBank was engaged in talks with its portfolio company for a further “multibillion dollar” investment valuing WeWork at between $35 and $40 billion. That compares to a $20 billion valuation garnered by WeWork from a $4.4 billion SoftBank-led equity investment in August 2017. Nearly a third of that prior $4.4 billion was used to cash out existing shareholders, according to the Journal.
With SoftBank and its Vision Fund venture capital arm readily paying the bills, why not go for the downs? Conventional profitability is clearly no object: While WeWork managed to double its revenues to $886 million last year, net losses grew even faster to $933 million from $430 million in 2016. Bloomberg reports that closely held WeWork managed to lose less than its top-line take in the first half of this year, finishing $723 million in the red through June on $764 million in sales. Alternatively, WeWork declared in an April 24 prospectus that the company generated $233 million in “Community Adjusted EBITDA” in 2017, up from $96 million the year prior. That newfangled term of art is described thusly:
We define Community Adjusted EBITDA as Adjusted EBITDA before Growth Investments further adjusted to remove general and administrative expenses. Community Adjusted EBITDA Margin measures Community Adjusted EBITDA as a percentage of membership and service revenue and management fee income from advisory services provided to Branded Locations.
Innovation clearly takes many forms.
Anyway, the rapid growth in the short-term leasing market has duly stirred nascent competition. In June, peer company Convene LLC completed a $152 million Series D fundraising round, while in July fellow co-working operator Knotel, Inc. announced the purchase of commercial real estate data firm 42Floors, giving the acquirer “access to data and technology on over 10 billion square feet of office space,” according to the press release.
It’s safe to say WeWork is not taking this competitive encroachment lying down. From a Bloomberg dispatch yesterday:
The company is offering commercial real estate brokers worldwide a 100% commission on the first year of rent paid by any tenant who switches to WeWork from a top competitor and signs a lease by October 1. Tenants also get half off the first year’s rent if they sign for at least 12 months. That means, accounting for the discount, that WeWork’s current bonus to brokers is five times the standard commission it typically offers of 10% on the first year’s rent.
As it adds locations around the globe, the startup often offers discounts to “assist in driving initial occupancy levels,” which made its average revenue per member drop more than 6% last year, according to [the prospectus]. Its overall sales and marketing costs, meanwhile, rose from $43 million to $143 million in 2017.
The Dec. 15, 2017 edition of Grant’s termed highly indebted and highly acquisitive SoftBank the “epitome of the cycle.” Can you be out-epitomed by your own office-space portfolio company?
Correction
A blunder in yesterday’s ADG: Vancouver is Canada’s third largest city, not second. Montreal takes that slot. Back to remedial geography class for your author.
Recap Aug. 24
New highs are here at last, as the S&P 500 finally punched above its late-January peak amid strength in resources and technology. Fittingly, the bullish milestone took place on the day of Fed chairman Jerome Powell’s keynote speech in Jackson Hole, an address which the market took to be on the dovish side as evidenced by a weak dollar and strong showing from the commodity complex.
While stocks party, the yield curve continues to race toward inversion. The spread between the 2- and 10-year Treasury notes shrank to less than 19 basis points, another fresh post-2007 low.
- Philip Grant
Thursday, August 23, 2018
Canada dry
Summer is still in full swing, but things remain pretty cool in the housing market of the Great White North. According to the Canadian Real Estate Association, home sales ticked 1% lower year-over-year in July, with total transactions at their lowest since 2012. In the formerly white-hot metro Vancouver (Canada’s third-largest city) sales plunged 30% to an 18-year nadir. Year-to-date through July, nationwide activity is at its slowest since 2009, while the Teranet-National Bank Home Price Index rose by 1.75% year-over-year, also a fresh post-2009 low. Phil Moore, president of the Real Estate Board of Greater Vancouver, commented: “With increased mortgage rates and stricter lending requirements, buyers and sellers are opting to take a wait-and-see approach for the time being.”
Waiting and seeing. Teranet-National Bank House Price Index, year-over-year change. Source: The Bloomberg
The tightening macroeconomic screws don’t look set to loosen anytime soon. Last Thursday brought the release of hot inflation data, with July headline CPI rising by 3% year-over-year, well above the consensus 2.5%. That nudged the odds of a 25 basis point rate hike from the Bank of Canada at the Oct. 24 meeting to 63% from 53%, according to interest rate futures. Meanwhile, the current five-year Canadian bond yield of 2.2% remains near the seven year highs reached in May while growth in overall money supply continues to abate. According to the Bank of Canada, M2 grew by 3.67% year-over-year in June, just off the post-financial crisis low of 3.38% logged one month prior. Since the housing boom was reignited in 2009, monthly M2 growth has averaged 6.56% on a year-over-year basis.
As rates put the squeeze to the encumbered Canadian borrower (household debt stood at 178% of disposable income at year-end 2017 according to the Organization for Economic Co-operation and Development, far above the U.S. peak of 144% in 2007), the regulators are also trying to pump the brakes. Thus, on Sept. 17, the province of British Columbia will introduce a new property transfer tax, which will require homeowners to provide their citizenship information, among other data, if purchasing a home through a corporation or trust. That follows the nationwide introduction of mandatory stress tests by the Office of the Superintendent of Financial Institutions in January, which compel all homebuyers to show that they can afford interest payments at the greater of the Bank of Canada’s five-year benchmark mortgage rate or 200 basis points above the contracted rate.
On a headline basis at least, soft data, higher interest rates and unwelcome regulatory changes were nowhere to be found in the fiscal third quarter results from Canadian Imperial Bank of Commerce (CM on the Toronto Stock Exchange). This morning, CIBC announced a 25% year-over-year jump in net income while increasing the quarterly dividend by 2.3% amid a jolt in its U.S. operations following its June 2017 acquisition of Chicago-based PrivateBancorp, Inc. In response, shares rose slightly to close to within 1.5% of the all-time highs reached on Jan. 5.
CIBC’s strong bottom line results contrast with a marked slowdown in mortgage lending, an important metric considering that the bank’s exposure to domestic residential mortgages stands at 60% of its total loan book. In the third quarter, mortgage balances rose by a modest 2.5% year-over-year, a drastic slowdown from the 13% growth in the third quarter last year. Asked about results excluding the operations of the U.S. subsidiary, chief financial officer Kevin Glass noted that earnings were essentially unchanged on a sequential basis, amid “slightly higher. . . loan loss provisions in the real estate business.”
There’s more where that came from.
QT progress report
The Fed’s portfolio of securities held outright footed to $4.034 trillion this week, a modest $1.3 billion decline from the prior reading. Mortgage-backed securities represented more than 100% of the decline, as Treasury holdings increased slightly. Today’s holdings are down by $17.5 billion from the trailing four-week average.
Since the “QT” operation began on Oct. 1, the Fed’s total balance sheet holdings are down by 5.09%, for a simple annualized pace of 5.63%.
Recap Aug. 23
Waiting for Godot, 2018 style. Stocks edged lower, as the S&P 500 nears a fifth straight week of remaining within 3% of its January peak without breaking through to new highs. While the broad average treads water, the yield curve continues to collapse, as the 2- and 10-year Treasury spread fell to another cyclical low of less than 20 basis points. A solid bounce in the Dollar Index looked to pressure commodities, with the exception of WTI crude which finished near $68 a barrel.
- Philip Grant
Tuesday, August 7, 2018
Earplugs optional
Grist for a potential sequel to Dazed and Confused?
Grist for a potential sequel to Dazed and Confused?
Dark Star
Silence is golden, usually.
Silence is golden, usually.
Recap Aug. 7
Earplugs optional
Grist for a potential sequel to Dazed and Confused? From Germany’s Deutsche Welle:
Two elderly German men escaped the confines of their nursing home on Friday to attend Wacken Open Air, police said.
The nursing home alerted police after the gentlemen were found to be missing from the center. Police then found the aging metalheads at 3 a.m. at Wacken Open Air, the world’s biggest heavy metal festival. A police spokeswoman said they were "disoriented and dazed."
The men were reluctant to leave the four-day festival so police escorted them home with the help of a taxi and a patrol car.
"They obviously liked the metal festival," police spokeswoman Merle Neufeld told public broadcaster Norddeutscher Rundfunk. "The care home quickly organized a return transport after police picked them up."
You got to give the people what they want.
Dark Star
Silence is golden, usually. For a recent exception to the rule, we turn our compass north to Canada’s Constellation Software, Inc., (CSU on the TSX) a Toronto-headquartered conglomerate that strives “to acquire, manage and build market-leading software businesses,” according to the corporate web site.
For Constellation and its longtime, publicity-shy president and chairman of the board Mark Leonard (described by the Globe & Mail as the Warren Buffett of Canada), less is more and, so, the company announced on July 25 that it would no longer hold quarterly conference calls. A day later, Constellation reported weaker than expected second quarter figures, featuring a slight revenue miss and a larger shortfall on the bottom line. Adjusted earnings per share registered at $5.75, well below the consensus $6.78, while operating cash flow declined by 13%. In response, shares traded lower by 10%.
Of course, that decline was little more than a drop in the bucket to all but the most recent buyers of Constellation stock. Shares are up by 520% over the last five years, a 41% compound annual growth rate, and up by 53% from a bearish assessment in the Dec. 9, 2016 edition of Grant’s. Other corporate virtues are also readily apparent. Somewhat unusually for a growth-by-acquisition vehicle, Constellation’s balance sheet shows a net cash position, as the company finances the bulk of its M&A activity through cash from operations as opposed to debt. According to the Street (Bay Street, that is), mushrooming growth isn’t expected to abate anytime soon: Analyst consensus calls for revenues of C$3.5 billion and adjusted net income of C$570 million in 2019, far above the C$2.8 billion and C$289 million logged in the trailing 12-month period.
Those gaudy growth expectations draw something of a contrast with Constellation’s second quarter figures. While headline revenues jumped 25% year-over year, organic revenue growth registered just 4%, or 1% on a constant currency basis. Adjusted earnings before interest, taxes, depreciation and amortization (EBITDA) margins came in at 23% for the quarter, down from 26%, while adjusted net income of $52 million barely budged from the $51 million in the second quarter of 2017.
Howard Leung, an analyst at Veritas Research Investment Corp., suggested to Grant’s that the margin decline may have stemmed from faster than expected growth in staffing expense costs, particularly in professional services. Leung, who in March upgraded Constellation shares to buy from a sell, expects the margin contraction to soon abate, pointing to management’s demonstrated ability to shape up prior acquisitions.
An investor who wishes to remain anonymous put it slightly differently: “At best there is a ramp up in costs somewhere that is temporary. At worst their core high margin business is in decline.”
Clearly, the investing public has conferred the benefit of the doubt on Constellation: With shares priced at 67 times trailing adjusted EPS, just 0.71% of the float is sold short, according to data from Bloomberg. That’s a lower short interest than any of the FAANG contingent of Facebook, Inc., Apple, Inc., Amazon.com, Inc., Netflix, Inc. and Alphabet, Inc.
For our part, the company's increasingly poor disclosure and the increasing difficulty in moving the needle through acquisitions following its rapid ascent are the salient concerns. Indeed, Constellation spent C$43 million on an undisclosed number of deals in the quarter, far below the expectation of analysts at Industrial Alliance Securities, who had penciled in C$80 million in deal volume for the period. Leonard seemed to acknowledge that second point of concern in his April shareholder letter (it will be Constellation’s last such annual correspondence), albeit in hypothetical terms:
One day Constellation may find that vertical market software businesses are too expensive to rationally acquire. If that happens, I hope we'll have had the foresight and luck to find some other high return on equity non-VMS businesses in which to invest at attractive prices. I am already casting about for such opportunities. If we don’t find attractive sectors in which to invest, then we’ll return our free cash flow to our investors.
The company’s decentralized structure manifests itself in interesting ways. Asked about how recent acquisitions integrate into the company on an Oct. 27, 2017 conference call, chief investment officer Bernard Anzarouth replied:
I think about 50%, 50% of the acquisitions that we've been making have been tightly integrated to our existing operations and the other 50% are standalone operations, we can tell you that. . . But it's really hard, it's not a crisp number that I can give you.
We imagine that investors find such ballpark figures to be no problem, so long as the stock continues to go up. Of Constellation’s demonstrated desire to share as little with investors and the public as possible, Grant’s wrote:
In the absence of information, one shouldn’t dogmatize. Then again, in this case, information seems to be withheld. One is curious to know, for example, whether, ex-acquisitions, Constellation’s business is contracting or expanding. It had better be expanding, given the rise in cloud computing and app-based solutions.
A simple question for those mostly happy CSU shareholders: What’s in your portfolio, exactly?
Recap Aug. 7
Another modest gain in the S&P 500 is relegated to the back-burner, after Tesla, Inc. CEO Elon Musk pronounced on Twitter this afternoon that the company is seeking to go private at $420 a share. The evident absence of financing for such a deal (despite Musk’s initial claim to the contrary) served as no problem to investors, who bid TSLA shares higher by 10%.
In more conventional action, yields ticked higher across the Treasury curve, while a downtick in the U.S. Dollar Index afforded the beleaguered Turkish lira a respite after collapsing by nearly 5% yesterday.
- Philip Grant
Monday, August 6, 2018
Post pattern
Cleanup in aisle three. It’s been a rough road lately for the those legacy supermarket mainstays cranking out canned soup, processed cheese and boxed cereal; since July 2016, the S&P packaged foods sub industry index is down by 16%, lapped by the S&P 500’s 31% rise over that period. However, the beleaguered group got some good news last week in the form of better than expected quarterly results from industry players Kraft-Heinz Co. (KHC on the Nasdaq) and Post Holdings, Inc. (POST on the NYSE) that spurred strong bullish reactions in the share price of each. Let’s take a quick look at a pair of companies that came under the scrutiny of Grant’s in the March 25, 2016 (as well as March 10, 2017) and Sept. 16, 2016 issues, respectively.
Kraft-Heinz shares caught a near 9% pop on Friday after reporting $1 per share in adjusted earnings and $6.69 billion in revenue, above the consensus $0.92 in adjusted EPS and $6.56 billion revenue. The stronger bottom line was no thanks to margins. Adjusted net income margins footed to 17.1% for the quarter, down from 19.4% year-over year. Instead, it was cost cutting that carried the day, a testament to the thrifty ways of KHC’s majority shareholders, Brazilian private equity firm 3G Capital and Warren Buffett’s Berkshire Hathaway, Inc.
Perhaps more than results, M&A potential may explain Friday’s pop. According to the New York Post, Kraft-Heinz has entered into “exploratory talks,” with Campbell Soup Co. (CPB on the NYSE), another Grant’s pick-to-not-click from March 25, 2016 which in December paid 19 times trailing adjusted earnings before interest, taxes, depreciation and amortization (EBITDA) to acquire pretzel company Snyder’s-Lance, Inc.
Asked about potential acquisitions on Friday’s conference call, Kraft-Heinz CEO Bernardo Vieira Hees did nothing to quiet the rumor mill:
I think the food industry is an industry that has not consolidated with the same speed as other[s]. . . So we do believe looking mid or long-term that there will be more consolidation in the industry and we have not been shying [away from saying] that we want to be a force behind this when it happens.
A look at the company’s stagnant income statement can help explain KHC management’s eagerness to do a deal. Next year, the Street is penciling in $26.5 billion in revenues, $7.9 billion in adjusted EBITDA and $4.7 billion in adjusted net income, virtually unchanged from 2016’s $26.5 billion, $8.2 billion and $4.2 billion respective figures. Thanks to a 35% markdown from its February 2017 highs, Kraft-Heinz shares currently trade at 16 times consensus adjusted EPS for 2019. With net debt at $31 billion, a leverage ratio of over four times EBITDA and a triple-B credit rating at Standard & Poor’s (the last full stop before junk), a corporate marriage with the even-more encumbered CPB (currently leveraged at five times consensus 2019 adjusted EBITDA) would leave management at this hypothetical combined entity with precious little room for error. The cost-cutters have their work cut out for them.
Then there’s Post, which has darted higher by 10% in the last two sessions to a fresh record high, leaving the stock up by the 18% from when we said our piece in September 2016. On Thursday, the company likewise reported mixed results for the fiscal third quarter, with stronger than expected net sales and EBITDA partially offset by weaker adjusted EPS, while management offered a full-year EBITDA forecast slightly above the consensus. In addition, Post announced the formation of a new joint venture with private equity firm Thomas H. Lee Partners to spin out its private brands business, reaping total proceeds of $875 million. In exchange, Lee will receive a 39.5% stake in the spun out entity, and preferred stock with an 11% coupon which is cumulative and can be paid-in-kind.
The results were enough to reinforce the conviction of one of POST’s biggest bulls. In response to the quarterly update, Timothy S. Ramey of Pivotal Research Group raised his price target to $120 from $105, the highest on the sell-side. Ramey detailed his rationale in a note Friday:
At 10.3 times 2019 enterprise value to EBITDA Post remains crazy cheap relative to peers with growth that is far better than its peers. Free cash flow yield is over 7%. The company is among the best managed and fastest growers in the packaged food space – this value discrepancy will not persist long in our view.
B2/single-B-plus-rated Post, which has undertaken 16 separate acquisitions since its 2012 spinoff from Ralcorp Holdings, Inc. under the auspices of widely respected chairman William P. Stiritz, carries a debt load that puts both Kraft-Heinz and Campbell’s in the shade at 5.7 times fiscal 2018 EBITDA (the company estimates that leverage will drop to 5.5 times once the private brands deal is complete). While the stock partied in reaction to Thursday’s announcement, credit investors are a bit more circumspect: The senior unsecured 5 3/4 notes of 2027, issued last October at 105.5 cents on the dollar, barely budged in reaction, currently trading at 96.79, compared to 96.6 last week.
Are the creditors seeing something that the stockholders missed? Thursday’s release did contain a detail that may give pause to the bull crowd. An anonymity-seeking investor notes to Grant’s via email:
Curiously, sell side analysts don’t seem fazed by, or even mention, the fact that on this one year anniversary of closing the deal for [U.K. breakfast cereal company Weetabix], the business has only generated $126 million [£93 million] in trailing EBITDA vs. the claim that this was a £120 million EBITDA business, pre-synergies, when they bought it. That means the £1.4 billion they paid is actually 15 times EBITDA, not the 10 times (with synergies) they touted at the time of purchase. And yet, somehow the Street still views them as great acquirers of business!
Recap August 6
Could tomorrow be the day for equity bulls? Stocks rose, with the S&P 500 closing to within 80 basis points of its record close established on January 26, a benchmark that looks all the more attainable considering the VIX volatility index simultaneously resides at its lowest since January.
Treasurys stayed in a tight range, with the 10-year yield ticking slightly lower to 2.94%. A modest rise in the greenback was enough to push the broad U.S. Dollar Index to a fresh 52-week high, while the ongoing decline in the Turkish lira is anything but modest. Currently trading at 5.31 per dollar, the lira shed 4.5% of its value today and is down by 12% vs. the buck since July 23.
- Philip Grant
Friday, August 3, 2018
Down in the bottom
From Denver’s NBC9 news:
From Denver’s NBC9 news:
Step Brothers
Like Frank Costanza, King dollar is a Phoenix, rising from Arizona.
Like Frank Costanza, King dollar is a Phoenix, rising from Arizona.
Recap August 3
Down in the bottom
From Denver’s NBC9 news:
A bear was stuck in a storm drain in Colorado Springs for about an hour but has since freed itself, according to several tweets from Colorado Parks and Wildlife's Southeast Region. The bear escaped through an open manhole after it was open for about 6 minutes.
CPW says it's possible this bear picked this storm drain because there was an open garbage receptacle filled with trash and branches from a tree filled with berries within maybe "a hundred yards away."
Prudent. After careful review, it seems likely to us that the bear was stockpiling foodstuffs ahead of Tesla earnings this week.
Step Brothers
Like Frank Costanza, King dollar is a Phoenix, rising from Arizona. After slumping throughout 2017, the buck has been on a tear of late with the broad U.S. Dollar Index jumping 7% since April. As with all such sharp price gyrations, some constituencies find it more welcome than others.
On Monday, the Bank for International Settlements published its global liquidity indicators for the first quarter 2018, finding that dollar-denominated borrowings by emerging market economies rose to a record $3.7 trillion at the end of March, up a robust 16% year-over-year. That $3.7 trillion in dollar debt towers over that of rival currencies, with euro denominated EM debt footing to €644 billion ($790 billon) and yen based borrowings totaling ¥8 trillion ($70 billion).
Among those dollar-based borrowers, China stands head and shoulders above the crowd. The Middle Kingdom alone is responsible for nearly $500 billion in dollar denominated bonds, and some observers think the debt party is far from ending. Ben Yuen, fixed-income chief investment officer for BOCHK Asset Management Ltd., tells Bloomberg he anticipates 20% annual growth in outstanding Chinese dollar bonds through the next five years, which would bring the total debt load above $1 trillion.
Of course, the recent broad-based rise in the greenback has put the squeeze to these borrowers, not least the Chinese. Since April, China’s renminbi has fallen by 9% against the buck, trading within 1% of its post-2008 lows this morning. That latest leg lower looked to get the attention of the powers that be in Beijing. During the Asian trading session, the People’s Bank of China announced it will impose a 20% reserve requirement on forward FX contracts, effectively placing a tax on those short the Rmb and spurring a near 1% intraday rebound against the dollar.
Turkey, holder of some $200 billion in dollar debt according to the BIS and the largest component of the iShares J.P. Morgan USD Emerging Market Bond ETF, likewise enjoyed a currency reprieve today as a cooler than expected July inflation reading (consumer prices rose a mere 15.9% year-over-year) spurred a 0.6% bounce in the lira against the greenback. The only problem? The lira is down by 27% since April and remains just off the record low, with declines accelerating this week after the U.S. sanctioned two senior Turkish officials in response to the ongoing detention of American pastor Andrew Brunson.
Creditors are getting nervous. The dollar-pay Turkish 5 3/4 notes of 2047, issued last May at 98.24 cents on the dollar and trading above 99 as recently as January, finished today at just over 78 cents on the dollar for a yield-to-maturity of 7.37%.
Only 29 years left until return of principal! The Turkish 5 3/4s of 2047. Source: The Bloomberg
President Recep Erdogan, who has termed high interest rates “the mother and father of all evil,” has opted to make the monetary battle a family affair. Following his June 24 re-election, Erdogan installed his son-in-law Berat Albayrak, as treasury and finance minister. For his part, Albayrak told Turkish broadcaster NTV today that: “We aim to discipline both inflation and interest rates and to reduce them to single digits by 2019.”
In a speech today, Erdogan proclaimed that Turkey is “face to face with an economic war,” before assuring listeners: “Do not worry, we will win it.” The newly re-elected president called on Turkish citizens to convert their “under the pillow” dollars and euros to liras, in order to demonstrate “a local and national resistance to the whole world.” Erdogan went on to call for Turkey to establish closer economic ties with China, including issuing bonds denominated in renminbi.
A match made…somewhere.
Recap August 3
Get the party hats ready. Another solid day for stocks lifted the S&P 500 to within one percent or so of the January closing highs, while the VIX finished below 12 for its lowest weekly close since January. Perhaps most impressively for the bulls is the fact that the rally has taken place without help from tech, as the NYSE FANG+ Index finished little changed and remains nearly 6% below its levels from Facebook, Inc.’s second quarter results last week.
Treasurys were bid across the board with the 10-year yield dropping back below 2.95%, while the dollar traded sideways and commodities rose.
- Philip Grant
Thursday, August 2, 2018
The Producers
Let’s have another look at the oil market, where the sharp advance of early summer has been all but forgotten: Even with a strong bounce to finish today at more than $69 a barrel, West Texas Intermediate Crude is down 5% from its July 10 highs. On an absolute basis, July was the worst month for black gold in an even two years.
While a steep late June run-up (Almost Daily Grant’s, June 29) and demand concerns related to the U.S./China trade spat have helped set the stage for a pullback, oil bears have also found a friend in the Organization for Petroleum Exporting Countries. July production from OPEC came to 32.6 million barrels per day, the highest level of the year and not far from November 2016’s record output of 34.1 million barrels per day. Large output gains from Saudi Arabia and Russia, as well as a return to production from Libya after a multi-week outage figure in OPEC’s rising production.
OPEC daily crude oil production since 1962. Source: The Bloomberg
For the near term at least, the prospects for upside in oil are further clouded by an ominous development in the futures curve. Today, Bloomberg reports that the gap between the near contract and the following month contract for Brent crude has swung from a 53 cent premium in June to a 63 cent discount a month later, signaling a potential surplus in supply. Marwan Younes, chief investment officer at Massar Capital Management, commented: “The increase in supply from OPEC seems to be real and it’s already translating into an overhang in supplies of Brent.”
While OPEC ramps up, the U.S. shale machine continues to hum. According to the weekly estimates from the Energy Information Administration, domestic production remains at a near-record level of 10.9 million barrels per day as of the final week of July, nearly double the levels achieved in July 2011. However, a second look at the data indicates that production might not be quite so flush. According to the latest EIA’s monthly Crude Oil and Natural Gas Production Report released on Tuesday, the revised U.S. output figures for May of 10.442 million barrels a day represents a reduction of 300,000 barrels from the prior estimate and remains below April’s 10.472 million daily output. Nevertheless, the newly slimmed-down May production figure represents a solid 13.3% uptick year-over-year.
But while rising production and the trade war garner headlines, a potentially more impactful long-term development continues apace. According to Rystad Energy, discoveries reached a record low in 2017. While the consulting firm expects 2018 discoveries to rise 30% from last year’s trough, that uptick translates to only 20 billion barrels of discoveries in 2018, well below the 33 billion barrels in additional capacity needed to keep pace with demand. Espen Erlingsen, head of upstream research at Rystad, commented:
An uptick of 30% from the abnormally low levels in 2017 might seem encouraging, but exploration and production [companies] are currently facing a low reserve replacement ratio, on average less than 10%. This is worrisome considering the impact on global oil supply in the long term.
Overall, Rystad finds that global oil and gas companies will spend $440 billion on capital expenditures between 2015 and 2020, just under half the $875 billion in capex undertaken between 2010 and 2015.
In their second quarter letter, commodity investment firm Goehring & Rozencwajg Associates, LLC contend that the lack of investment will manifest itself in far higher prices over the long-term. Principals Lee Goehring and Adam Rozencwajg write:
Not only have huge cut-backs in global upstream capital spending impacted conventional non-OPEC oil production, but our research tells us that cuts to upstream capital spending are now beginning to impact OPEC oil production as well. Algeria, Nigeria and Angola have seen their production decline by over 1 million barrels a day in aggregate over the last four years. We believe those declines are directly related to inadequate capital spending. Combined with politically related production problems in Venezuela and Libya, OPEC spare capacity is rapidly falling to zero.
We believe the bull market in oil, (ignored thus far every step of the way by the investment community) is set to dramatically accelerate to the upside.
Concurring with the viewpoint of our friends Goehring and Rozencwajg, Grant’s remains bullish on oil and a number of energy-related companies who would benefit from higher prices. For specific securities on which we bestow a bullish bent, see the March 9, 2018, Nov. 3, 2017 and March 10, 2017 issues of Grant’s.
QT progress report
The Fed’s portfolio of securities held outright footed to $4.049 trillion, a chunky $23 billion drop from a week ago in what is the largest sequential decline in the Fed’s holdings since the balance sheet runoff began last fall. Treasurys supplied all of the change, while mortgage-backed securities holdings ticked slightly higher. Compared to the trailing four-week average, today’s figure represents a $32 billion decline, comprised roughly of two-thirds in Treasurys and the balance in MBS.
Since the Fed began QT last Oct. 1, total balance sheet holdings are down by 4.49%, for a simple annualized pace of 5.30%.
Recap August 2
Stocks were bid as tech finally got off the mat, with the NYSE FANG+ Index rising by 3% to snap its string of consolidation following the 9% downdraft which followed Facebook, Inc.’s earnings miss last week.
Treasury yields finished lower across the board with the short end outperforming to leave the curve a bit steeper, while a stronger dollar pushed gold to 16 month lows near $1,200 an ounce.
- Philip Grant
Wednesday, August 1, 2018
What lies beneath
It wasn’t so bad on the surface. This morning, apparel and unmentionables company Hanesbrands, Inc. (HBI on the NYSE) reported second quarter results, featuring revenues, earnings and guidance that largely matched analyst expectations.
Behind those neutral figures lurked an unpleasant surprise: Towards the bottom of the press release, management disclosed that mass retailer Target Corporation won’t renew the contract for the exclusive C9 by Champion activewear line when it expires in January 2020. The agreement had been in place since 2004, and contributed $380 million in revenues over the past 12 months. In response, Mr. Market offered his own discount sale of HBI shares, which fell by 19%.
Stock rout aside, the sun will still come up tomorrow for HBI, as a loss of $380 million in sales represents about 6% of the company’s $6.6 billion in trailing 12-month top line, and management repeatedly stressed on the call that they don’t expect any impact to 2019 results from Target’s decision. Indeed, retail analysts at Bloomberg Intelligence write that: “The strength of the Champion brand, combined with retailers’ need for exclusive or limited products, presents an opportunity to replace some of that business in coming years.”
Management too remains optimistic. On today’s conference call, CEO Gerald Evans struck a cheerful tone in discussing the overall business outlook:
The year is really unfolding in total as we expected. Our diversification across geographies and channels and customers is working and we came in right at the midpoint of our guidance in revenue, EPS and operating profit. And so feel good about the start, feel good about the fact that we delivered our fourth consecutive quarter of organic growth [all of 0.1% year-over-year on a constant currency basis] and better than frankly our outlook for the first half of a slight decline. So real good.
For Hanesbrands, this latest chapter in its long and winding history (the P.H. Hanes Knitting Company was founded in Winston-Salem, NC in 1901, while HBI was spun out of the Sara Lee Corporation in 2006) has been one of growth-by-acquisition. The problem: Acquisitions have come easier than growth. Since October, 2013, HBI has bought nine separate businesses for some $2.3 billion, in the process raising its net debt to $4.2 billion from $1.6 billion and leverage ratio to nearly four times earnings before adjusted interest, taxes, depreciation and amortization from 2013’s 2.2 times. Meanwhile, current-year consensus free cash flow of $607 million is barely above the $548 million in FCF generated five years ago.
The deal spree has served to goose other line items besides net debt. Goodwill plus other intangible assets footed to $2.86 billion in the quarter, more than five times 2013’s combined $550.5 million figure for a compound annual growth rate of 39%. Meanwhile, the “one-time” mergers and acquisitions expenses which are excluded from adjusted net income and EBITDA figures represent a substantial chunk of earnings before interest and taxes, or operating income. In the last four calendar years, merger and acquisition expense has totaled 27%, 24%, 45% and 35% of operating income, respectively.
Grant’s offered subscribers a bearish analysis of Hanesbrands in the July 1, 2016 issue, arguing that the company’s opaque accounting practices and deal-centric strategy presented unappreciated risks to shareholders, who were then enjoying HBI’s 135% surge from the beginning of 2013. Noting that the formula for management’s incentive compensation consisted of 40% growth in adjusted EPS, 40% in growth from cash flow from operations and 20% from growth in revenues, we wrote:
It would take a C-suite of Boy Scouts not to notice how advantageous a strategy of growth-through-acquisition would be to their own personal betterment, quite apart from the benefits it provides to the company and the shareholders. For one thing, M&A boosts headline sales growth. For another, it furnishes a handy cover for earnings adjustments. As to the latter, though the Maidenform Brands transaction closed in October 2013, management continued to expense Maidenform-related acquisition and integration costs through the fourth quarter 2015.
Since Grant’s said our piece, HBI shares have dutifully lagged, falling 28% while the S&P 500 has gained 41%. So what’s next for Hanesbrands? Grant’s put the question to Brian McGough, retail analyst at Hedgeye Risk Management and vocal HBI bear. McGough feels there is more pain to come:
Hanesbrands is caught in strategic no-man’s land, pressured by competitors such as Gildan Activewear on the low end and a number of niche players at the high end, while the organic growth promised by management was nowhere to be found this quarter.
Meanwhile, the recent deal spree that has helped enrich management through incentive compensation has all but tapped out the company’s balance sheet while adding little value to shareholders. We remain bearish, seeing up to 50% additional downside in the next 1-2 years.
Correction
Yesterday’s “shiver me crypto’s” item incorrectly described the sunken Russian vessel purportedly laden with gold as a remnant from the Sino-Russian war of 1904 to 1905. Instead, it was Japan, not China with whom Russia tangled at the turn of last century.
Recap August 1
Stocks finished unchanged on the broad S&P 500, while the NYSE FANG+ Index failed to outperform despite a 6% jump in Apple, Inc. following strong earnings for the quarter. Treasury yields ticked higher across the board with the 10-year yield exceeding 3% intraday, while a modest rise in the U.S. Dollar Index was enough to pummel both commodities and emerging market debt, with the CRB Index and iShares J.P. Morgan USD Emerging Market Bond ETF falling by 1.5% and 0.8%, respectively.
- Philip Grant
Tuesday, July 31, 2018
Shiver me cryptos
On July 18,
On July 18,
C.C.C. Rider
Happy days are here for holders of some of the dodgiest credits around.
Happy days are here for holders of some of the dodgiest credits around.
Recap July 31
Shiver me cryptos
On July 18, the Daily Telegraph reported that a South Korean diving team had recovered a sunken Russian vessel containing some $130 billion worth of gold bullion. The warship was purportedly a remnant of the Battle of Tsushima from the Japanese-Russian war of 1904 to 1905.
Today comes an update to the saga courtesy of Coindesk.com, one that could be called both a twist and, in the context of 2018, par for the course:
Authorities are reportedly looking into Shinil Group, which claims to have found a Russian shipwreck from the early 1900s, for possible fraud charges. The company launched its own cryptocurrency, which investors bought with the promise of being able to redeem tokens for treasure from the ship, according to the report.
The old cliché that “a gold mine is a hole in the ground with a liar at the top” now has a worthy modern day companion.
C.C.C. Rider
Happy days are here for holders of some of the dodgiest credits around. This morning, Bloomberg’s Lisa Abramowicz noted on Twitter that the average yield on triple-C rated U.S. corporate bonds (as measured by the relevant Bloomberg Barclays Index) fell to 7.89%, the lowest level since September 2014 and nearly half of its 30-year average of 13.32%. Last week’s yield decline of 68 basis points was the biggest since 2008, while Bloomberg likewise notes that triple-C spreads also saw their biggest decline in 10 years, to 512 basis points over Treasurys.
Bloomberg Barclays Caa H/Y Yield-to-Worst Index, two-year view
Source: The Bloomberg
Year-to-date, triple-C-rated debt resides at the head of the corporate bond class with a year-to-date return of 4.42%. That compares to a 1.2% gain for overall speculative grade bonds, a 2.6% loss for investment grade and 1.6% drop for Treasurys, according to the respective Bloomberg Barclays total return indices.
What gives? As so-called risk free yields march higher and the economy continues to expand (second quarter GDP grew at an annualized 4.1% clip), the outperformance of the shakiest credits makes sense. Indeed, rating agency Moody’s predicts that the default rate will decline to 1.5% in April of next year from its current 3.7%. In a research note yesterday, Moody’s reports that its ratio of positive to negative industry sector outlooks is “unprecedented,” concluding: “credit conditions for non-financial corporate borrowers in mid-2018 are the best since the 2008-2009 recession and financial crisis.”
Other factors seem to be giving junk bonds a helping hand. According to Bloomberg, total new supply of speculative grade debt totaled just $8 billion month-to-date through this morning, putting this year on track to be the slowest single month for domestic issuance since January 2016, an unpleasant period for asset prices. That follows a total of $47.4 billion in new supply between April and June, the slowest second quarter for issuance since 2010. Bloomberg’s Brian Chappatta concludes: “Simply put, it’s hard to make a case that high-yield bonds would be a top performer without the supply shortfall holding them up.”
U.S. junk bond investors would be well-served to keep an eye on Europe, where high-yield spreads have similarly tightened 40 basis points this month amid a 27% year-over-year drop in new supply. Across the pond, at least, that drought is set to be replaced by a deluge. Bloomberg terms the upcoming European issuance calendar “jam-packed,” while Stephen Smith, high-yield syndicate manager at Barclays plc. in London, commented: “Borrowers have opted to access the market as soon as possible. . . We’ve certainly been advising clients to capitalize whenever they can, as post summer supply looks to be significant.”
Then there is liquidity. On July 22, The Wall Street Journal, citing electronic credit trading firm MarketAxess, reported that bid-ask spreads in developed European high-yield credit are up 24% this year while emerging Europe, Africa and the Middle East have seen spreads on dollar-denominated government bonds surge wider by 75%. Nathaniel Rosenbaum, credit strategist at Wells Fargo Securities, told The Journal: “The global tide of liquidity that quantitative easing spurred is now slowly, slowly moving in reverse. . . You’re starting to see small hot spots emerge in parts of the market that don’t have a natural support.”
U.S investors should pay special heed to goings-on in Europe, the Financial Times warned on July 8. Citing consulting firm Oxford Economics, the FT reports that Europeans have purchased “more than half” of U.S. issued corporate bonds in the past four years and own nearly 10% of all domestic fixed income securities.
Some unsolicited advice to holders of newly appreciated triple-C rated corporate bonds: Consider checking your local friendly bond salesman for a bid, just in case.
Recap July 31
Stocks rallied with the S&P 500 all but erasing yesterday’s decline, although the NYSE FANG+ Index could only manage a feeble 50 basis point bounce from its 9% swan dive over the prior four sessions. The dollar finished higher and commodities lower, the Treasury curve flattened with the long end catching a bid, and the VIX dropped by 10% to 12.85.
Shares in Apple, Inc. rose by 3% in immediate after-hours reaction to the company’s third quarter earnings announcement, in which the company managed to top estimates on the revenue and EPS lines despite selling fewer iPhones than expected while also offering fourth quarter revenue guidance above analyst consensus.
- Philip Grant
Monday, July 30, 2018
The Hangover
It wasn’t much of a party. Last Thursday Anheuser-Busch InBev S.A./N.V. (ABI on the Belgian stock exchange and BUD on the NYSE) reported second quarter figures that left something to be desired, as adjusted earnings per share came in light of consensus estimate despite a favorable effective tax rate. Organic volume grew 0.8% on a year-over-year basis, exactly half of the expected 1.6%. The global beer giant reiterated its expectation of accelerating growth in the second half of the year, but investors were unimpressed, sending the stock lower by 4%. Shares are in the red by 7% year-to-date, and reside 30% south of their 2015 highs.
While international growth remains solid (Budweiser revenues grew by 10.1% year-over-year outside of the U.S.), it was a different story in the Land of the Free, where the top-line shrank by 3.1%. The company press release put a positive spin on the glum news: “We delivered our best quarterly market share performance in nearly four years with a share loss of 35 basis points.”
For his part, chief financial officer Felipe Dutra didn’t mince words, telling The Wall Street Journal that there is “no silver bullet, no short term answer to some of the problems we face.” Indeed, in the U.S. at least, the seemingly relentless encroachment of craft beer on the drinking scene is causing consternation from one of Anheuser-Busch’s largest investors. Jorge Paulo Lemann, co-founder of Brazilian private equity firm 3G Capital, Inc. and ABI’s largest shareholder, lamented at an investor conference in April on “the age of disruption”:
I’ve been living in this cozy world of old brands and big volumes. We bought brands that we thought could last forever. . . You could just focus on being very efficient. All of a sudden we are being disrupted.
While shares have struggled, we judge that there is particularly good reason for ABI’s creditors to be concerned. Thanks largely to the mammoth $65 billion acquisition of SAB-Miller plc., A3/single-A-minus-rated Anheuser-Busch is awash in debt. Against the company’s reckoning of total net borrowings of $108.8 billion (which doesn’t include an additional $7 billion in preferred shares), Anheuser-Busch is expected to generate $23.1 billion in adjusted earnings before interest, taxes, depreciation and amortization in 2018, while full-year consensus free cash flow of $11.2 billion compares to $10 billion in free cash flow in 2012, when ABI carried just $35 billion in net debt.
Anheuser-Busch lenders must also contend with a generous dividend, which yields 4.17% on a trailing basis. By comparison, Baa1/triple-B-plus-rated Heineken N.V., which is leveraged at 2.6 times compared to ABI’s 4.7 times, pays a 1.68% dividend to shareholders. In the first half of the year, ABI paid out $5.1 billion in dividends, nearly double the $2.96 billion in profits attributable to equity holders. By comparison, Heineken generated €480 million ($410 million) in net operating profits and paid out €336 million in dividends in the first half of the year.
For its part, the Anheuser-Busch C-suite acknowledged the aggressive dividend on its first quarter conference call in May, with CFO Dutra replying to a question about further raising the payout: “We see dividends as a growing flow over time. However, in the short term, we don't see much room for that, given the leverage levels.”
In a November 2017 report on the company, analysts at Moody’s placed heavy emphasis on Anheuser-Busch management’s stated objectives to whittle down its debt load, writing:
ABI has a long track record of successfully integrating acquisitions. Importantly, senior management has articulated publicly that it will prioritize deleveraging, continuing to target net debt to EBITDA (company’s definition) of two times. This helps to support a relatively high rating despite leverage metrics that will be in speculative territory for several years.
While rapid deleveraging forms the crux of Moody’s upbeat assessment, evidence of progress remains scant so far, as the $108.8 billion in net debt is virtually unchanged from its year-end 2016 level. In order to reach lower-rated Heineken’s leverage ratio of 2.6, ABI would have to either slash its debt load to $61 billion from the current $108.8 billion or nearly double adjusted EBITDA to $42 billion from the $23.1 billion 2018 estimate.
The Feb. 9 issue of Grant’s contained a bearish analysis of Anheuser-Busch’s credit, arguing that the company’s aggressive financial metrics and uncertain growth potential posed risks for which bondholders are not adequately compensated. The analysis identified a pair of credits for particular scrutiny: The euro-denominated 2.7s of 2026, then trading at 111.75 cents on the euro for a yield-to-maturity of 1.2% (a 100 basis point spread to euro bonds), and the dollar bond 3.65s of 2026, which fetched 101.75 cents on the dollar to yield 3.4% and a 79 basis point spread over Treasurys. The euro-bond has since appreciated to 112.13 for a yield-to worst of 1.03% and a 116 basis point spread, while the U.S. issue has fallen to just over 98, priced to yield 3.94% while the spread has widened to 95 basis points. By way of conclusion, an allegory:
Artificially suppressed interest rates produce a feeling familiar to drinkers – weekend drinkers only, mind you – of more than a little fine craft beer. It’s rapturous at first, and so it remains for a time. But finally you go home and go to bed, and then it’s Monday morning. Monday is dawning for mispriced corporate credit.
Recap July 30
It was another tough day for tech, as the NYSE FANG+ Index absorbed another steep selloff to extend its three day decline to 9% as the poor second quarter results from Facebook, Inc., Twitter, Inc. and Netflix, Inc. continue to reverberate. The good news for equity bulls: Strength in telecom and energy helped minimize the broad damage to a 60 basis point drop in the S&P 500.
WTI crude rose back to $70 a barrel, while the Treasury curve maintained its recent steepening bias, with the 10-year yield inching back to 2.98%. The VIX popped to 14.25, the highest finish since early July.
- Philip Grant
Friday, July 27, 2018
CHHIIIINAAA!
Deleveraging, we hardly knew ye. As the Sino-American trade spat continues to hot up, Beijing has responded by further cranking the credit spigots open.
On Monday, the People’s Bank of China unleashed a record Rmb 502 billion ($72 billion) injection of medium-term lending facility funds to commercial banks, a move, the Financial Times notes, that served to expand the money supply as “no previously issued loans were scheduled to mature” on that day. On Wednesday, Bloomberg reported that the PBoC alerted certain Chinese banks that a “structural parameter” of capital requirements will be cut by 50 basis points in order “to support local financial institutions in meeting credit demand effectively.” China’s central bank has already cut its reserve ratio requirement for banks on three separate occasions this year.
State support for the economy has spilled into the fiscal realm as well as monetary: Today, Reuters reports that China “plans to put more money into infrastructure projects and ease borrowing curbs on local governments to help soften the blow” from the trade war.
The exertions have already made an impact: On Tuesday, the China Foreign Exchange Trade System reported record volume of repurchase agreements, as “bond traders have taken the slew of credit-boosting measures unveiled in the past week as a green light to borrow.” Not just in heightened activity are the looser policies being felt. The iBoxx China High Yield Total Return Index, which lost nearly 8% from January to mid-July in a slow grind lower, has promptly recouped half of that downdraft in less than two weeks.
Currency depreciation is likewise accelerating, as the yuan today completed a seventh straight weekly decline against the dollar. Since April, the renminbi has depreciated by 8% against the dollar, a 25% annualized pace. Since July 9, redbacks are down by 3% against the buck, a 44% annualized clip.
Is the weakening currency part of a Communist party plan or the result of rapid capital outflows? Brad Setser, senior fellow for international economics at the Council of Foreign Relations, thinks the former. In a July 23 blog post, Setser argues that the renminbi’s decline, if not an outright policy maneuver by the Chinese authorities, is broadly in line with their strategic interests. Noting a rising “basic balance” (the current account plus foreign direct investment) in China, Setser concludes:
That suggests, at least [to] me, that if China clearly signaled that it didn’t want the yuan to depreciate further, it could hold the line relatively easily. . . The depreciation pressure right now stems, in large part, from expectations that China wants a weaker currency in response to Trump’s tariffs and a slowing domestic economy – not uncontrolled outflow pressure.
Anne Stevenson-Yang, co-founder of J Capital Research and friend of Grant’s, has a somewhat different perspective. In a July 23 research note, Stevenson-Yang suggests that China’s credit-saturated economy (bank assets topped last year’s GDP by more than 300% and represent more than half of 2017 world GDP) is the primary force behind the recent gyrations in FX, while also arguing that the powers-that-be might ultimately hold less sway on the exchange rate than is widely believed:
The reality is that China’s currency is most intimately connected, as with any currency, to the domestic economy – debt, asset prices, real estate prices, and efficiency gains and losses rather than just trade. On that basis, this is the time for depreciation.
On the one side, Beijing faces very low growth outside of that driven mechanically by lending. Public confidence is low, and families that have wealth trapped in illiquid property are growing restive. People of means want to move abroad and want to externalize their assets. On the other side, Beijing has capital controls.
We are betting the people win.
If the yuan continues its powerwalk lower, the financial stability that Beijing covets could be put to the test. Today, Paola Subacchi of the South China Morning Post declared that the Middle Kingdom is “stuck between a rock and a hard place,” as monetary and fiscal easing designed to shoulder China’s massive debt burden stokes the risk of ongoing currency depreciation, capital flight and a potential drawdown of foreign currency reserves.
Watch the renminbi.
Recap July 27
Stocks took a dip, as the S&P 500 absorbed a moderate loss with Amazon.com, Inc. giving up the bulk of its post-earnings gains to finish barely in positive territory. Commodities and the dollar traded lower in tandem, while Treasurys were bid across the curve with the 10-year yield backing off the two month highs above 2.97% reached yesterday.
- Philip Grant
Thursday, July 26, 2018
Zuck Zuck goose
A bump in the road, or something more?
A bump in the road, or something more?
QT progress report
The break is over.
The break is over.
Recap July 26
Zuck Zuck goose
A bump in the road, or something more? As investors the world over are by now well aware, yesterday evening Facebook, Inc. (FB on the Nasdaq) shocked its cadre of bullish boosters by forecasting sharp slowdowns in both revenue growth and operating margins in coming quarters and years. What’s more, net daily active user growth of 22 million quarter-over-quarter was its smallest since early 2011, while European usage saw an outright decline and the North American daily user count remained flat. Growth that would be the envy of nearly any other large-cap (revenues and operating income jumped 42% and 33% year-over-year, respectively) was relegated to afterthought status.
In some corridors, the business update elicited disbelief. Of the dwindling growth outlook, Brent Thill, analyst at Jefferies LLC, remarked on yesterday’s conference call: “I think many investors are having a hard time reconciling that deceleration. It just seems like the magnitude is beyond anything we’ve seen, especially across a number of tech [companies] we cover.” Investors echoed Thill’s sentiments, sending FB shares down by 19%. With the company sporting a gargantuan $630 billion market capitalization heading into the report, the decline represented the single largest one-day loss of stock market value in U.S. history according to FactSet. Since Aug. 11, 2017, shares are up by 3%, compared to a 17% gain in the S&P 500.
Facebook five-year chart. Source: The Bloomberg
Of course, a dramatic fall first requires a great ascent, and few companies have enjoyed a steeper rise than Mark Zuckerberg’s social network. From July 2013 to yesterday, FB shares gained 861%, a 55% annualized pace. One can hardly argue the stock price rally was disconnected from fundamentals either. Over the trailing 12-month period, the company has generated $48.5 billion in revenues, $19.1 billion in net income and $28 billion in cash from operations. That’s up from $7.9 billion, $1.5 billion and $4.2 billion, respectively, in 2013.
But it’s a different environment in light of the Cambridge Analytica data-leaking scandal of March, one that Facebook has opted to manage through a litany of new hires and extra spending that looks set to cut into its future earnings potential. On the conference call, Zuckerberg had this to say about Facebook’s enhanced security and privacy initiatives:
Looking ahead, we will continue to invest heavily in security and privacy because we have a responsibility to keep people safe. But, as I've said on past calls, we're investing so much in security that it will significantly impact our profitability. We're starting to see that this quarter.
But, in addition to this, we also have a responsibility to keep building services that bring people closer together in new ways as well.
Now, in light of increased investment in security, we could choose to decrease our investment in new product areas, but we're not going to, because that wouldn't be the right way to serve our community and because we run this company for the long term not for the next quarter.
It’s no empty talk. Capital expenditures footed to $3.46 billion in the most recent period, well more than double the $1.44 billion capex line for the second quarter of 2017. According to yesterday’s earnings press release, current employee headcount at Facebook totaled 30,725 as of June 30, up a whopping 47% year-over-year.
Even without the baggage from Cambridge Analytica and the associated fallout, Facebook was set to brush up against commercial gravity sooner or later. There are only so many people in the world (7.6 billion according to the United Nations and Facebook reports 2.2 billion monthly active users), and only so many advertising dollars for the taking. In the Aug. 11, 2017 bearish analysis of Facebook, Grant’s suggested that “maybe growth, momentum and a dazzling stock market performance have obscured the problems that will ensure that not even Zuckerberg’s tree reaches the sky.”
That analysis incorporated the views of Pivotal Research Group’s Brian Wieser, who was one of only two analysts to label FB shares a sell, compared to 44 sell-siders who rated the stock a buy into yesterday’s earnings release. By way of reaction to the second quarter results, Wieser reiterates the simple fact underpinning his bearish thesis:
The advertising industry – and digital advertising, no less – has limits to growth, which we think is the primary factor constraining Facebook’s revenue opportunity. . . While the company is still growing at a fast clip, the days of 30% plus growth are numbered.
For investors, the pain from today’s sharp pullback is distributed far and wide. According to analysts at Goldman Sachs Group, Inc., 97 hedge funds counted Facebook as among their top-10 holdings as of the end of the first quarter. That’s the heaviest concentration of any one stock, and up from 81 funds that counted FB as a top-10 holding in September of last year. It’s not just the financial blue bloods who are taking a hit: Bloomberg’s Eric Balchunas estimates that 27% of Facebook shares are held by mutual funds, while an additional 6% are in the hands of various ETFs.
As Wall Street has accumulated, Menlo Park has vacated. The persistent, aggressive open-market sales by Facebook executives and directors that have been extensively chronicled on these pages, continue apace: In the five trading days preceding yesterday’s update, CEO Zuckerberg disposed of 1.23 million shares, generating proceeds of $262 million. Chief operating officer Sherryl Sandberg sold 55,000 shares for $11.5 million, while chief product officer Christopher Cox cashed out of 10,600 shares to the tune of $2.2 million.
As former Yankees catcher Yogi Berra once said: “You can observe a lot by just watching.”
QT progress report
The break is over. After two weeks of consolidation, the Fed’s portfolio of securities held outright registered at $4.072 trillion, a $12.6 billion decline from last week. Mortgage-backed securities were the departing asset, representing all of this week’s decline and more than 70% of the $17 billion drop-off from the trailing four-week average.
Since the Fed began its QT operation on Oct. 1, total balance sheet assets are down by 3.99%, for a simple annualized pace of 4.82%.
Recap July 26
No leadership, no problem. The bulls came out of this one in pretty good shape considering the circumstances, as the S&P 500 saw only modest losses despite the shellacking in Facebook, with the tech-heavy Nasdaq falling by just 1% and the NYSE’s FANG+ Index limiting the damage to 2.9%. A late dollar rally wasn’t enough to dislodge gains from the CRB Commodity Index or the iShares J.P. Morgan USD Emerging Market Bond ETF, and Treasury yields finished mostly higher, with the exception of the long bond.
After the close, Amazon.com, Inc. posted far higher than expected earnings per share for the second quarter, trumping a weaker top-line showing and sending the stock well higher in initial reaction. Second quarter GDP is set to be released tomorrow morning, with consensus expectation of a 4.2% annualized gain.
- Philip Grant
Tuesday, July 24, 2018
Tool time
Set it and forget it. Last Thursday Snap-on, Inc. (SNA on the NYSE) reported second quarter results that pleased the Street, with revenues topping consensus and adjusted earnings per share well above the most optimistic sell-side estimate.
It represented the firm’s 38th consecutive quarterly earnings beat dating back to the fourth quarter of 2008 and Mr. Market dutifully sent shares higher by 9.5%. Chairman and CEO Nick Pinchuk commented: “Our second quarter 2018 results demonstrated encouraging progress along our defined runways for growth and improvement.”
Kenosha, Wis. headquartered Snap-on produces high-end tools for a variety of industrial applications, as well as diagnostic and repair equipment for automobiles. A glance at the company’s financial vital signs indicates a steady corporate heartbeat: Although trailing 12-month revenues of $4.1 billion represent pedestrian growth from full-year 2014’s $3.5 billion top line, Snap-on has managed to increase its adjusted net income margin to 15.4% from 12% over that period, while free cash flow has jumped to $622 million from $323 million. The balance sheet is sturdy, with $1.1 billion in net debt virtually matching the $1.02 billion in adjusted earnings before interest, taxes, depreciation and amortization last year. Operating income of $938 million covered the $50 million in interest expense nearly 19 times over.
The conservative nature of Snap-on’s balance sheet draws a stark contrast to the company’s increasingly credit-centric business model. Long-term net finance receivables (which fund the customers of Snap-on’s franchisees) footed to $1.05 billion at the end of the second quarter, according to the company’s form 10-Q. That’s up from $612 million in second quarter 2014, for a compound annual growth rate of 14.5%. By comparison, total sales at the auto-focused Snap-on Tools Group, the company’s largest unit, footed to $412 million this quarter, up from $369 million in 2014 for a compound annual growth rate of just 2.8%. Overall, Snap-on’s financial services entity chipped in a meaty 23% of operating earnings in the most recent quarter, up from 20% in the second quarter of 2014.
That jump in financing relative to total sales comes with questions about the company’s treatment of loans that are not performing. On May 7, The Capitol Forum published an analysis of SNA’s debt collection and accounting, citing an instance in which a borrower fell in arrears within weeks, while the company continued to bill him for 17 months. Receivables are assessed for charge-off once an account becomes 120 past due, according to the company’s form 10-K. The Capital Forum concludes:
Snap-on’s failure to write off loans on a timely basis not only potentially overstates revenues and earnings but also raises questions about the value and collectability of the company’s $2 billion in accounts receivable.
On July 17, analysts at Longbow Research conducted a survey of the company’s franchisees, finding that the company exerted no small effort to maintain its streak of quarterly earnings beats:
Franchisees indicated SNA was aggressive on inventory throughout all of 2Q 2018, including increased end of quarter deals during the last two weeks of the quarter. Franchisees reported SNA removed the “hold” status on delinquent franchisees during the last week of the quarter to boost end of quarter sales. Franchisees indicate elevated inventories of big ticket items may limit spending at the third quarter Snap-On Franchisee Conference.
While Snap-on has been able to top consensus estimates like clockwork, the performance of its stock price has left something to be desired, as SNA shares have gained just 1% since June 3, 2016, compared to a 34% rise from the S&P 500. On that date, Grant’s published a bearish analysis of Snap-on, arguing that the company’s increasing reliance on credit, as well as its exposure to the then-booming (and saturated) used car market, presented underappreciated risk. Grant’s termed Snap-on: (along with Signet Jewelers Ltd.) “The case studies in the modern application of high-yield consumer credit at a late hour in the business cycle.”
At the time of publication, Snap-on was a mostly undisturbed short-sale candidate, with 3.8% of its float borrowed by short sellers. Today, that proportion has jumped to 12.8% according to Bloomberg. However, bears concerned about crowded shorts can take comfort in validation, in deed if not in word, from the SNA C-Suite. On June 5, senior vice president Thomas J. Ward sold 42,000 shares on the open market, netting himself $6.4 million. That was followed by $2.2 million of sales by secretary, vice president and general counsel Irwin Shur on June 7, and $3.5 million in sales by CEO Nick Pinchuk on June 19. Then last Thursday (earnings day), senior vice president Anup Banerjee sold $6.1 million of SNA stock on the open market. The last open market purchase by a company insider took place last August, when director Ruth Ann Gillis bought 265 shares.
Recap July 24
Stocks caught a moderate bid, while the Treasury curve flattened a bit after the notable steepening action seen in the past few days.
Commodities were mostly higher amid a flat showing for the U.S. Dollar Index, while the Chinese yuan fell to a 52-week low this morning at 6.83 per greenback before recovering somewhat. After the close, AT&T, Inc. reported weaker than expected earnings and revenue for the second quarter, sending the stock to a fresh 52-week nadir in after-hours trading.
- Philip Grant
Monday, July 23, 2018
Offer wanted
As the Fed tightens and the ECB discusses the end of EZ-money, whither the Bank of Japan?
As the Fed tightens and the ECB discusses the end of EZ-money, whither the Bank of Japan?
Recap July 23
Offer wanted
As the Fed tightens and the ECB discusses the end of EZ-money, whither the Bank of Japan? The rumor mill has been working overtime ahead of the Bank of Japan’s policy meeting next week, with Reuters reporting that the BoJ: “is in unusually active discussions . . . with changes to its interest-rate targets and stock buying techniques up for debate.” Among the potential changes being considered is an increase in the 10-year yield target to between 0.10% and 0.25% from the current zero point zero, which the BoJ introduced in 2016 under a “yield curve control” supplement to its QE program.
The report made waves, with the yield on the Japanese 10-year note more than doubling to as high as 0.09%, the biggest one-day move since December 2016. In the Japanese government bond market, the BoJ still calls the shots. According to Bloomberg, the central bank offered to buy all the bonds that sellers might wish to unload at a yield of 0.11%. There were no takers.
Of course, the absence of supply at the BOJ’s line in the sand isn’t particularly unusual. The Wall Street Journal, citing market-data firm Quick, notes that there have been six separate trading days this year in which not a single lot of the benchmark 10-year JGB changed hands.
While the BoJ’s liberal participation in financial markets has done little to spur inflation toward its 2% goal (June CPI rose just 0.7% year-over-year, down from 1.5% in February), their efforts have yielded other results that might be described as impressive. Thus, on June 26, Nikkei reported that thanks to ¥25 trillion ($227 billion) and counting in ETF purchases under QE, the BoJ has become a top-10 shareholder in nearly 40% of listed companies in Japan.
The effect is particularly pronounced for certain large-cap names with higher ETF ownership. Nikkei notes the example of Fast Retailing Co., shares of which account for 2% of all ETF purchases made by the bank according to the publication’s estimates. Nikkei concludes: “If this pace keeps up for another year, Fast Retailing shares on the open market could all but disappear.”
Needless to say, the Bank of Japan’s machinations present a predicament for banks and savers alike. Koji Fujiwara, CEO of Mizuho Financial Group, Inc. and chairman of the Japanese Bankers Association, politely observed in May: “There are concerns over side effects of the powerful monetary easing program.”
Mrs. Watanabe is long-accustomed to using a little financial alchemy to generate some more income. To that end, a research report from SMBC Nikko Securities last week suggested that bondholders in Masayoshi Son’s Softbank Group Corp. could juice returns by selling credit default swaps (a Texas hedge in Tokyo). SMBC Nikko analysts put it this way: “Even if [Softbank] CDS are volatile, since their spreads are so wide compared with yen bonds they are attractive as an investment.”
Softbank, junk-rated at S&P and Moody’s, sold a ¥40 billion institutional and ¥410 billion retail tranche in senior unsecured debt maturing in 2024 in early June, at a price-to-yield 1.57% (see the Dec. 15, 2017 edition of Grant’s for a detailed analysis of Softbank). Bloomberg Intelligence notes that the company generated $215 million in free cash flow during the fiscal year-ending March 31, less than half of the $432 million paid out in shareholder dividends during that period. The firm’s consolidated total debt stands at $165 billion, while adjusted net leverage currently stands at 8.5 times trailing earnings before interest, taxes, depreciation and amortization, excluding its commitments to the company’s in-house venture capital unit, the SoftBank Vision Fund.
In May, Son told listeners at a conference in Tokyo that there a sequel to the Vision Fund is forthcoming: “It’s just a matter of when.”
The Double Vision Fund?
Recap July 23
Treasury yields jumped across the board, particularly at the long end as the 10-year yield climbed to 2.96%, a five-week high. Stocks remained range bound, with the S&P 500 finishing slightly green while making its seventh straight close within 50 basis points of unchanged.
An intraday rebound in the Dollar Index corresponded with a bearish reversal in commodities, while the VIX also gave back early gains.
- Philip Grant
Friday, July 20, 2018
Trump tweets
From the President’s Twitter account this morning:
The United States should not be penalized because we are doing so well. Tightening now hurts all that we have done. The U.S. should be allowed to recapture what was lost due to illegal currency manipulation and BAD Trade Deals. Debt coming due & we are raising rates - Really?
The Jan. 13, 2017 edition of Grant’s featured “2017 in money – a sneak preview,” a Twitter-based timeline of our imagined future interactions between President Trump and then-Fed Chair Janet Yellen, available for all here.
And so it (almost) came to pass.
Yuan headlight
We live in interesting times. If there is any doubt after the above item, recent goings-on in China should put those to rest as the Middle Kingdom’s credit-fueled financial engine looks like it might need some repairs. While President Trump’s threat this morning to place tariffs on all $505 billion of Chinese exports to the U.S. dominates headlines, there is no shortage of other developments worthy of wider attention.
The recent bloodletting in emerging market currencies has not spared China, as the renminbi is now down by 4.5% against the greenback this month, the worst performing currency out of 31 “major” countries tracked by Bloomberg. The decline has been sharp enough to grab the attention of the People’s Bank of China, according to Charlie McElligott, strategist at Nomura, who wrote yesterday: “As Chinese financial conditions further deteriorate and market stress worsens, we actually perversely push closer to the risk-asset positive outcome of escalated PBOC stimulus and easing measures.”
Those hoping for mandarins riding to the rescue might have got their wish last night, as another intraday decline in the renminbi was reversed late in the Asian session with Bloomberg reporting that “a major Chinese bank was seen making large offers to sell dollars.”
Not just in the currency markets is the Chinese government throwing its weight around. Yesterday, Caixin reported that the PBOC “will provide additional funds to commercial lenders who invest in corporate bonds in July, particularly those who purchase bonds with lower ratings.”
There is good reason for Beijing to be nervous. Consider, for instance, the plight of the conglomerates. In recent years, the trio of HNA Group Co. Ltd., Anbang Insurance Group Co. Ltd. and Dalian Wanda Group Co. Ltd. made an international splash by buying trophy assets such as the Waldorf Astoria Hotel in New York, Hilton Hotels Corp. and AMC Entertainment Holdings, Inc. with borrowed money.
After the party comes the hangover: Dalian Wanda and HNA have been shedding asserts in recent months, while Reuters reports yesterday that Anbang is looking to sell overseas property assets on the order of $10 billion “as part of a government-backed rescue.” Three months after the government’s February takeover of Anbang, former Chairman Wu Xiaohui was convicted of fraud and embezzlement and sentenced to 18 years in jail.
But the problems in China’s private sector extend far beyond that trio of now-unspooling former roll-ups. Overall, corporate bond defaults registered at 20 through May according to the PBOC, almost matching 2017’s full year total of 22 (Almost Daily Grant’s, July 9).
On July 5, coal miner Wintime Energy Co. missed a Rmb. 11.4 billion ($1.7 billion) bond payment, becoming the largest corporate default in China this year with $3.9 billion in debt outstanding. True to form, the company’s parent “had pledged almost all its shares in the subsidiary as collateral for loans,” according to a filing made at the end of March and spotted by Bloomberg.
The default definitely caught creditors of peer Zhongrong Xinda Group Co. by surprise. Zhongrong, which is partly owned by Wintime Energy parent Wintime Holding Group Co., saw the price on its renminbi bond due in August fall to 70 cents on the Rmb. sending the yield-to-worst to an eye-popping 412%. The kicker: Zhongrong Xinda sports a pristine triple-A rating at Chinese credit rating agency United Ratings. For international context, U.S. agency Fitch Ratings downgraded Zhongrong to double-B-minus, or three notches below investment grade, in May.
Zhong and wrong, triple-A and a 412% yield. Source: The Bloomberg
Today, The Wall Street Journal also takes note of China’s faltering credit markets, citing the recent travails of developer Agile Groups Holdings Ltd. which was forced to pay 8.5% on three-year dollar bonds earlier this month. In August 2017, the same company was able to borrow for five years in dollars at just 5.125%.
The Journal quotes Mitch Reznick, co-head of credit at London-based Hermes Investment Management, who, in discussing the May dollar-bond default of China Energy Reserve & Chemicals Group Co. Ltd., offers the following nugget of wisdom:
China Energy’s default showed how-faith based investing is a road to hell.
Investors around the world, please copy.
Recap July 20
Stocks finished little changed, but Trump’s public application of pressure on the Fed appears to have made an impact elsewhere, as Treasury yields jumped in a bear steepening formation while the dollar sold off sharply.
The combination of a weaker dollar and, perhaps, a PBOC currency intervention was most welcome for industrial metals bulls, as the Bloomberg Base Metals 3-Month Price Commodity Index jumped by nearly 2%, recovering a little chunk of the near-16% decline seen in that group since June.
- Philip Grant
Thursday, July 19, 2018
Bernank the tank
Tough crowd. Federal Reserve chairman Jerome Powell is taking heat from all sides after this year’s round of stress tests for too-big-to-fail banks. At the end of June, the Fed nixed the planned dividend increases of investment banks-turned bank holding companies Goldman Sachs Group, Inc. and Morgan Stanley. In response, Morgan Stanley CEO James Gorman yesterday complained that the tests have “become increasingly demanding.” Gorman said of the 2009-era brainchild: “Ten years on, it’s time to take a fresh look. We don’t want to be chasing the last crisis, we’re trying to figure out the next one.”
From the other flank, Democratic Senators expressed their irritation with perceived soft treatment of the banks in Tuesday’s Humphrey Hawkins testimony on Capitol Hill. Speaking of The Fed’s proposal to open the stress tests to comment periods, Sherrod Brown of Ohio remarked: “That’s like letting the students help write the exam.” Of Powell’s assertion that this year’s test was “materially more stressful” than prior years, Elizabeth Warren of Massachusetts replied: “You know, I don’t know what to say. The data don’t seem to back you up on this.”
Stress tests aside it’s been pretty good sledding for the financials recently, including those scolded former investment banks. J.P. Morgan Chase & Co., Citigroup, Inc., Bank of America Corp., Morgan and Goldman all saw their shares rally after reporting second quarter earnings, and each managed double-digit percentage year-over-year jumps in net income. So too are valuations robust. According to data from Bloomberg, the S&P Financials Index trades at 1.54 times book value, up from 1.35 times on year-end 2016 and 1.03 times on Dec. 31, 2012.
But, as the Fed raises short-term interest rates while shrinking its securities portfolio via QT, the banks could be vulnerable to side effects from that comprehensive monetary tightening. Christopher Whalen, editor of The Institutional Risk Analyst and financial industry savant, explained in a blog post yesterday that the ongoing rise in short-term interest rates is putting the squeeze to net interest margins, a major source of profits for the group. Whalen expects that compression to continue:
The second quarter 2018 bank results released so far confirms the accelerating upward trend in bank funding costs. As we detail in the most recent Q2 ‘18 edition of The IRA Bank Book, the rate of increase in funding expense for all US banks should exceed the rate of growth in interest earnings by the second quarter 2019. This will mean that net interest margin or “NIM” will be shrinking, an eventuality that most market analysts and institutional wealth managers really are not prepared to accept -- much less reflect in asset allocations.
You can see this playing out in the yield curve. With the spread between the two- and 10-year yield hovering near its lowest since 2007 at just 25 basis points (down from more than 75 basis points in February) and interest rate futures pricing in greater-than-even odds of at least two 25 basis point rate hikes by year end, it seems an inverted yield curve, and the accompanying ominous implications for economic growth, might soon be in the cards.
Not to worry however, says former Fed chairman Ben Bernanke. Speaking at a roundtable event Monday with fellow crisis-era figures Timothy Geithner and Henry Paulson, Bernanke offered his two cents:
Historically the inversion of the yield curve has been a good [sign] of economic downturns [but] this time it may not. . . Everything we see about the near-term outlook for the economy is quite strong.
In other words: This time is different.
QT progress report
The pause continued. For a second straight week, the Fed’s portfolio of securities held outright remained at $4.084 trillion after a trio of substantial weekly declines through June and early July. This week’s holdings are down by $11.1 billion from the trailing four-week average, with Treasurys representing the majority of that decline.
Since the Fed began QT on Oct. 1, total assets are down by 3.68%, for a simple annualized pace of 4.55%.
Recap July 19
A sharp drop in the Chinese yuan overnight spurred comprehensive selling across emerging market currencies, with the South African rand standing out for a 226 basis point slide against the dollar.
Stocks fell, with the S&P 500 falling 40 basis points to mostly erase this week’s gains, and Treasurys were bid across the curve. Interestingly, the iShares JPMorgan USD Emerging Market Bond Fund ETF managed an unchanged finish.
Oil continued its rebound amid a flat CRB index, with WTI crude briefly trading north of $70 a barrel this morning before pulling back some.
- Philip Grant
Wednesday, July 18, 2018
Turkey club
Time for another check-up on the state of play for emerging markets, which have appeared as a rare source of angst in otherwise-calm market conditions. While the S&P 500 approaches its January peak and the MSCI World Index sits about 5% below its own January highs, the MSCI Emerging Markets Index remains on the cusp of bear market territory, at a distant 19% from the summit logged in the opening month of the year. On a price-to-earnings basis, the valuation gap has become substantial: The MSCI Emerging Market Index trades at 13.4 times trailing earnings, well below the 18.9 times which the MSCI World Index currently fetches.
Sentiment too is largely bearish. According to the Bank of America Merrill Lynch July Fund Manager Survey, “short emerging market equities” rated as the second-most crowded trade identified by investors, with a net 12% allocation. Overall, July saw a 23% plunge in emerging market equity allocation (the largest monthly drop in two years) to a net 1% underweight position. Bloomberg concurs, finding in a survey of investors, traders and strategists that a majority expect the EM selloff to continue.
While sentiment and valuation seem to provide an intriguing setup on the long side, would-be EM bulls need to contend with powerful structural factors, chiefly the tightening in U.S. financial conditions. Since February, the broad Dollar Index has risen by 7% to its highest in more than a year, while the two-year Treasury yield made another post-crisis high yesterday above 2.6%, more than doubling since September.
Meanwhile the Federal Reserve’s balance sheet runoff (QT to Fed watchers) continues apace, much to the chagrin of the Reserve Bank of India governor Urjit Patel who penned an opinion column in the Financial Times warning that the Fed will “absorb such a large share of dollar liquidity that a crisis in the rest of the dollar bond markets is inevitable” (Almost Daily Grant’s, June 4).
Then there are the more idiosyncratic risks. On June 24, Turkish president Recep Erdogan won re-election for a five-year term, earning himself sweeping new powers in the process. Erdogan, who previously railed against the Turkish Central Bank for its hawkish response (the president termed high rates “the mother and father of all evil” in May according to Reuters), to spiking inflation and a sinking exchange rate appointed his son-in-law Berat Albayrak to head the newly formed Treasury and Finance Ministry on July 9, in addition to other investor-unfriendly announcements.
In response, markets sent the Turkish 10-year yield above 18% (since eased to 17.7%), continuing the recent rise in borrowing costs from less than 12% as recently as February. On Monday, Albayrak’s new agency reported that the June budget deficit jumped to 25.6 billion lira ($5.3 billion), nearly double the 13.7 billion lira logged in the same month last year.
Also on Monday, rating agency Moody’s sounded the credit alarm on Turkey’s banks, writing: “We expect problem loans to increase to well above 4 percent over the next 12-18 months from a low 2.9% in May because of Turkey’s weak operating environment and a large number of performing loans with significant deterioration.” Meanwhile, the lira continues to spiral to fresh lifetime lows against the greenback, losing nearly half its value since the failed coup d’etat against Erdogan in the summer of 2016.
Lira/dollar exchange rate since 1990. Source: The Bloomberg
In the Aug. 12, 2016 issue, Grant’s asked Russell Napier, independent strategist and co-founder of the Electronic Research Interchange, for his biggest concern for emerging market investors. Napier replied: “Capital controls. I lived through the Mahathir [Mohamad] period when Mahathir implemented capital controls [sparking the EM crisis of 1998] . . . It changed people’s perception. When you deliquefy what everyone believes is a liquid market, then you start to get real problems where people start to liquefy other things.”
That day may be drawing closer for the lira, according to Tatha Ghose, senior EM economist at Commerzbank. Quoted in the Financial Times on July 10, Ghose warned: “If policymakers shift to a monetary policy stance that increases market concerns and leads to even more rapid lira losses, they may leave themselves with no other option but to impose capital controls.”
By way of postscript, the now 93 year-old Mahathir Mohamad is now back in power in Malaysia, winning a “stunning upset” (according toTime magazine) election in May over his one-time protégé Najib Razak.
What’s old is new again?
Recap July 18
Strength in the financials and industrials carried the day, as the S&P 500 edged higher for its fourth green finish in five tries. Treasury yields continued their recent upside grind, with the 10-year yield edging to a three-week high at 2.88%. A stronger dollar didn’t prevent the CRB Commodity Index from rallying into positive territory, with WTI crude settling near $69 a barrel, while the VIX finished just below 12.
- Philip Grant
Tuesday, July 17, 2018
Now is the winter of our streaming content
The bulls received a jump scare straight out of Stranger Things.
The bulls received a jump scare straight out of Stranger Things.
Recap July 17
Now is the winter of our streaming content
The bulls received a jump scare straight out of Stranger Things. Yesterday evening, Netflix, Inc. surprised the Street with weaker than expected second quarter revenues, lighter than expected third quarter earnings guidance and, most importantly, a slower than expected pace of net subscriber additions both internationally and in the U.S. In response, investors marked NFLX shares down by as much as 14% before a dip-buying cavalcade narrowed losses to 5%.
Of course, even that 14% markdown represents a drop in the bucket relative to the head-spinning rally enjoyed by NFLX. After today’s pullback Netflix has managed year-to-date gain of 96%, which places it at the head of the class among the New York Stock Exchange’s FANG+ Index (Twitter Inc. is second with an 85% advance for 2018). Since July 2016, Netflix shares are up by 342%.
Why shouldn’t the stock price be shooting to the stars? This year the former upstart garnered 112 Emmy Award nominations, ending HBO’s 17-year run as the most nominated network.
That success is attracting competitive attention from all corners. On June 25, entertainment website The Wrap reported on the growing ambitions of Apple, Inc. in the content business, quoting an unnamed Hollywood executive who considered them a credible player: “They’re paying real quotes and not trying to squeeze us for less and less the way the studios are on the network side. They’re formidable buyers.” It’s not just the iPhone maker that has set its sights on NFLX: In a June 28 cover story of Netflix’s ascent, The Economist notes that:
Amazon, Apple, Facebook, Youtube and Instagram are all developing programing efforts of their own. “The first thought on everyone’s mind is how do we compete with Netflix?” says Chris Silbermann, managing director at [talent agency] ICM.
Even retail giant Walmart, Inc. might join the fray, according to a report today by tech-website The Information.
Keeping up with the Joneses is no cheap proposition. Thus, in October, Netflix announced it would spend $8 billion on developing in-house content this year, up from the company’s prior $7 billion estimate. Meanwhile, analysts at Goldman Sachs, Inc. expect that figure to balloon in coming years to $22.5 billion, which would place Netflix “in spitting distance of the total currently spent on entertainment by all America’s networks and cable companies” according to The Economist.
Against $8.3 billion in current debt, Netflix has $3.9 billion in cash on hand. The company expects between $3 billion and $4 billion in negative free cash flow “burn” in 2018, up from $2 billion last year and just $128 million in 2014. So, how to finance this breakneck pace of growth? In the bond market, naturally. The company explained its fundraising strategy in yesterday’s letter to investors:
While interest rates have risen and the federal tax rate is now lower (reducing the tax shield on interest costs), we judge that our after-tax cost of debt continues to be lower than our cost of equity, so we anticipate that we’ll continue to finance our capital needs in the high yield market.
Those words caught the analytical eye of Grant’s, which retains an agnostic stance towards Netflix stock. On the company’s credit there is no such ambivalence: We are decidedly bearish, judging the risk versus reward proposition to be most unfavorable for the company’s lenders. In the March 10, 2017 analysis of the Netflix 4 3/8s of 2026, Grant’s termed the streaming media giant “case study No. 1 in investment asymmetry.” The rationale:
Netflix common (NFLX on the Nasdaq) may or may not be a good investment. It has proved a superb investment. Whether it can tack on another eight-fold rise in price over the next five years will depend in large part on management’s demarche into original content. Success could deliver immense rewards to the stockholders.
Holders of the Netflix 4 3/8s of 2026 would hardly share in the hypothetical bonanza. Interest and principal are what they signed up for, after all. The downside – always looming, especially in a business as fast changing as digital technology – is another matter. In the risk of business failure, the lenders partake only a little less fully than do the stockholders.
Since publication, those notes have fluttered lower as the stock has continued its rampage. Some unsolicited advice for the euphoric holders of Netflix common: Mind Mr. (debt) Market.
Source: The Bloomberg
Recap July 17
This old bull still has plenty of kick. The impressive reversal in NFLX helped bestow another rising tide for equity prices, as the S&P 500 ticked to within 2% of the all-time highs reached in late January. Treasurys finished little changed, while the CRB commodity index and iShares J.P Morgan USD Emerging Markets Bond ETF both managed flat showings despite a stronger dollar.
An interesting, if not particularly pleasant (for Grant’s at least) divergence in the non-fiat realm: Bitcoin caught a strong bid this afternoon, jumping nearly 9% to $7,300, while gold continues to flounder. The “money of kings” dropped another 1% to $1,225 an ounce, near a 52-week low.
- Philip Grant
Monday, July 16, 2018
Hello Altice
Many happy returns in the corporate bond market. Today, the French subsidiary of telecom operator Altice Europe N.V. priced $2.5 billion (upsized from an initial $2 billion) in eight-year term loans at 400 basis points over the London Interbank Offered Rate. With the proceeds, the company will call a portion of the $4 billion outstanding in 6% senior notes due May 2022, which will serve to extend the average maturity of the French unit’s debt to 6.8 years from 6.4 and the corporate parent’s average maturity to 6.3 years from 6.1.
Dennis Okhuijsen, CFO of Altice Europe, struck a triumphant tone, commenting in the press release: “This refinancing transaction demonstrates again Altice’s commitment to proactively manage its liabilities across its capital structure, significantly improving its maturity schedule.”
For some of Altice’s existing creditors, the new loan announcement was a less glorious occasion: Bloomberg reports that the existing B-11 $1.4 billion term loan due 2025 sold off three points in response to the new deal, as that series lacked a “most favored nation” clause (the name is borrowed from the realm of international trade) which allows existing investors to receive the same terms as later creditors. Bloomberg summarizes the aftermath: “Investors seemed to have learned their lesson. In response to pressure from potential buyers, Altice France extended the MFN provision to the eight-year life of the new loan from just 12 months when the deal was initially marketed.”
As for Altice, the highly leveraged former roll-up (now unrolling itself) is wisely striking while the iron is hot. The company is following that deal with planned offerings of $1.25 billion dollar denominated and €650 million ($761 million) euro-denominated senior secured notes, which are expected to price tomorrow according to Bloomberg. They can certainly use the leeway: Against net debt of just over €35 billion, Altice generated €8 billion in adjusted earnings before interest, taxes, depreciation and amortization through the 12-months ended March 31. Interest expense of €3 billion was double the €1.5 billion in operating income, while free cash flow footed to negative €100 million over that 12 month period.
Standard and Poor’s rates Altice single-B (“adverse business, financial, or economic conditions will likely impair the obligor's capacity or willingness to meet its financial commitments on the obligation”), while the stock market has marked down Altice shares by 25% since October 2015 (that’s despite more than doubling from the April lows), during which period the Stoxx 600 Europe Index has gained 12%.
In a May 9 research report, Craig Moffett, co-founder and one-half of the eponym of research firm MoffettNathanson LLC, aptly described the fickle treatment from investors that colored Altice’s rise and fall:
When Altice N.V., the parent company of Altice USA, was a stock market darling – yes, that does seem like a long time ago, doesn’t it? – it was viewed as the perfect amalgam of operating savvy (cost-cutting) and financial acumen (high leverage and share repurchases).
When Altice N.V. became a stock market pariah, it was because it had come to be viewed as . . . a perfect amalgam of operating short-cuts (cost-cutting) and financial risk-taking (high leverage and share repurchases).
For our part, Grant’s offered a bearish analysis of Altice in the Oct. 2, 2015 edition, when the Altice deal machine (and story) was in full swing. The company paid €17 billion for France’s SFR Group S.A. in April 2014, €7.4 billion for Portugal Telecom SGPS S.A. in November 2014, and $9.1 billion for a 70% stake in U.S. operator Suddenlink Communications in May 2015. By way of response, Mr. Market conferred a gaudy 225% rally in Altice shares in the nine month period through June 2015. Grant’s put the query to subscribers: “The question is, are the creditors quite sure they are willing to bear the risks that the intrepid management is willing to take?”
Altice’s lenders have regained their, uh, entrepreneurial spirit lately. The company’s most actively-traded bond issue, the 7 1/4 senior unsecured Eurobonds of 2022, which traded below 96 as recently as February, are now back near 103 cents on the euro, for a yield-to-worst of 5.37%.
Recap July 16
Down goes Netflix. After the close, the streaming content provider and recent star of the FANG contingent reported weaker than expected second quarter results, including net subscriber additions that came in well below consensus expectation, sending shares down by 13% in immediate reaction.
Prior to that seemingly portentous development, stocks fluttered a bit lower, while Treasury yields rose in bear steepening formation. Commodities were once again soft despite a weaker dollar, with WTI crude falling to $68 a barrel, down 8% in less than a week. The emerging markets rally also took a pause, with the iShares J.P Morgan Emerging Market Dollar Bond ETF pulling back from the six-week closing highs reached on Friday.
- Philip Grant
Friday, July 13, 2018
Community-adjusted protein
WeWork, you never disappoint. From Bloomberg:
WeWork, you never disappoint. From Bloomberg:
You get what you pay for
It’s the private-sector version of the “zero lower bound.”
It’s the private-sector version of the “zero lower bound.”
Recap July 13
Community-adjusted protein
WeWork, you never disappoint. From Bloomberg:
Co-working giant WeWork Cos. thinks it can save the environment quicker than Elon Musk.
The startup has told its 6,000 global staff that they will no longer be able to expense meals including meat, and that it won’t pay for red meat, poultry or pork at WeWork events. In an email to employees this week outlining the new policy, co-founder Miguel McKelvey said the firm’s upcoming internal “Summer Camp” retreat would offer no meat options for attendees.
“New research indicates that avoiding meat is one of the biggest things an individual can do to reduce their personal environmental impact,” said McKelvey in the memo, “even more than switching to a hybrid car.”
We concur. Saving the planet from hot air remains a daunting challenge.
You get what you pay for
It’s the private-sector version of the “zero lower bound.” Today, The Wall Street Journal reports that BlackRock, Inc. (BLK on the NYSE) has cut prices on several equity and fixed income exchange traded funds in recent weeks. Martin Small, head of BlackRock’s U.S. iShares ETF unit, told The Journal that the asset manager will make it up on volume: “Even if prices come down more, we expect volumes to grow to such a degree that profitability will expand over time.”
In lowering its own take on ETFs, BlackRock is keeping up with the corporate Joneses as industry wide fee compression continues apace. On July 2, The Vanguard Group, Inc. announced it would offer nearly 2,000 ETF’s not managed by Jack Bogle’s firm with no trading fees to users of its in-house online brokerage. Jeff DeMaso, co-editor of the (unaffiliated) publication the Independent Advisor for Vanguard Investors, explained the strategy: “This is really about getting a share of investors’ wallets. If someone stays on your platform he might be more likely to buy another Vanguard fund in the future.”
While the ETF juggernauts do battle, other contenders enter the low-cost financial arena. Yesterday, research and ratings firm Morningstar, Inc. (MORN on the Nasdaq) announced it will launch nine in-house mutual funds in the third quarter, replacing the actively managed funds that it had selected to run its $44 billion in assets, a move that chief investment officer Daniel Needham estimates could cut fees by about 20%. Mr. Market liked the sound of that, sending MORN shares up 3.5% to a record high.
That follows last October’s incursion by State Street Global Advisors, which debuted 15 new ETF’s, each of which was “priced equal to or below the lowest fee ETF” in its respective category, according to the company. That claim is an increasingly difficult one to make as competition heats up: According to analysts at J.P. Morgan Chase & Co., more than 75% of inflows into the ETF realm in the past year have been earmarked to funds charging an expense ratio of 15 basis points or less. By contrast, the average mutual fund costs about 100 basis points annually, according to a July 9 analysis by Todd Rosenbluth, senior director of ETF and mutual fund research at CFRA.
It’s not hard to imagine the beneficial impacts of the increasingly abundant, low-cost ETF and passive investment options. Today, The Journal terms the price war “a boon for investors.” Steven Bregman, president and co-founder of Horizon Kinetics, sees other, less welcome knock-on effects of the ETF boom. Speaking at the 2016 Grant’s fall conference, Bregman said of the ETF invasion:
It has distorted clearing prices in every sort of financial asset in every corner of the globe, [and] has created a massive systemic risk to which everyone who believes they are well diversified in the conventional sense are now exposed.
Bregman went on to argue that ETF heavy portfolios are far more concentrated than investors might believe, citing the Exxon Mobil Corporation’s prominence by way of example:
Aside from being 25% of the iShares U.S. Energy ETF, 22% of the Vanguard Energy ETF and so forth, Exxon is simultaneously a dividend growth stock and a deep value stock. It is in the USA Quality Factor ETF and the Weak Dollar U.S. Equity ETF. Get this: It’s both a Momentum Tilt stock and a Low Volatility stock. It sounds like a vaudeville act.
Investors must also consider the fact that ETF’s, which have proliferated during the particularly calm market seas of the post-2009 epoch, managed a less than stellar performance in the August 2015 market tumult that followed a surprise devaluation from China. On August 24, when the S&P 500 opened sharply lower, ETF’s set a record share of trading volume at 37% of the total across all U.S. exchanges. On that day, a number of funds, including the Guggenheim S&P 500 Equal Weight ETF (RSP on NYSE Arca), saw their share price diverge sharply from net asset value. While the S&P 500 Equal Weight Index bottomed out with a 4.5% intraday loss, the RSP vehicle plunged by as much as 43% intraday, before recovering.
Standing on shaky ground. The Guggenheim S&P 500 Equal Weight ETF on Aug. 24, 2015. Source: The Bloomberg
There’s no free lunch.
Recap July 13
Stocks edged higher despite weakness in the FANG’s (NYSE’s FANG+ Index finished lower by 70 basis points) to leave the S&P 500 green by 1.5% for the week and back to within 2.5% of its January record.
The Dollar Index gave back early gains and then some, which didn’t help the commodities as the CRB Index finished slightly lower but did give another lift to the suddenly buoyant iShares J.P. Morgan Emerging Markets Dollar Bond ETF, which rose to a six-week high.
Treasury yields finished lower across the board, with the long end once again outperforming. The spread between the two- and 10-year yields fell to 24.5 basis points, a fresh 11-year low.
- Philip Grant
Thursday, July 12, 2018
Two ships in the night
Now is an excellent time to buy! Or something like that. Across the U.S., house prices march higher, with the National Association of Realtors reporting that the median home price reached a record high of $264,800 in May, up 4.9% year-over-year, while the Federal Housing Finance Authority’s Price Index made its own record in the first quarter, up 7.5%. The ascent in prices comes despite a less-than brisk sales environment; existing home sales declined by 0.4% in May, against consensus expectations of a 1.5% rise, and have remained range bound for years.
While prices party, activity slumbers. FHFA Home Price Index in white, existing home sales in orange. Source: The Bloomberg
The divergence between prices and activity can be explained by tight supply. According to real estate broker Redfin Corp., the average home spent just 34 days on the market in May, eclipsing the previous record low of 36 established a month prior and 38 last year (in Denver, the average listing lasted just six days in May). Aaron Terrazas, senior economist at Zillow Group, Inc., told Reuters: “Supply is woefully inadequate to meet demand.” Trulia, Inc. reports that nationwide inventories declined 5.3% from 2017 in the second quarter, the 14th straight year-over-year drop.
Housing might be strong nationwide, but it’s a different story in New York City. Residential real estate in Manhattan has endured an ugly start to 2018 and weakness appears to be accelerating. According to brokerage firm Douglas Elliman, second quarter sales in Manhattan plunged 16.6% to 2,629 transactions, the lowest total since 2009, while the median sales price sank 7.5% year-over-year. Total inventory is up 10.7% from the second quarter last year, while the absorption rate, or months to sell existing inventories at the current pace, jumped to 8.4 months from 6 months last year.
This is no one-borough phenomenon either. Both prices and activity declined year-over-year in Brooklyn and Queens, while the Westchester suburbs saw their biggest sales drop on a percentage basis since 2011 in the second quarter, according to Elliman.
What gives? The December enactment of the Tax Cuts and Jobs Act caps state and local tax deductions at $10,000, representing a financial hit to residents of high tax localities like the New York metro area (ATTOM Data Solutions reports that the average Westchester resident coughed up more than $17,000 in property taxes last year). The new law also caps mortgage interest deductions at $750,000, down from $1,000,000 prior to its passage.
Grant’s asked Jonathan Miller, president, CEO and co-founder of eponymous real estate appraisal firm Miller Samuel, Inc., how much the changes to the tax code may be impacting behavior. Miller didn’t mince words in assessing the significance:
There is nothing positive in the tax law as it relates to housing, the best case is neutral. The worst case? As negative as you can think of.
That isn’t to say that the turn in fortunes can be solely chalked up to the taxman. The rising interest rate regime has not spared housing debt, as the average Bankrate.com mortgage rate ticked to 4.39% as of Monday, up from 3.67% in September.
But the uptick in rates is of course a national phenomenon. For New York, and specifically Manhattan, a glut of new higher-end housing (a walk through midtown in the last 10 years with an eye on the abundant skyward cranes confirms this) contrasts with a shortage in other categories. Miller explains:
The vast majority of newly developed Manhattan inventory that has come online in this cycle has been in the top 20% of the market. There is excess supply at the high end, and static or insufficient supply for the other 80%. This phenomenon is playing out around the country.
The impact of the pullback is greatest at the high end, and diminishes as prices decline. The outcome is dwindling affordability.
Asked about the potential broader implications of the soft New York market, Miller again points to affordability, while noting that sales trends typically lead price by 12 to 18 months:
The more expensive the market, the sooner you will see a slowdown in activity, higher inventories and lower prices. It’s a slow grind.
New York leads, the U.S. follows?
QT progress report
The Fed took a breather this week, as its portfolio of securities held outright registered $4.084 trillion, a (relatively) tiny $130 million uptick from last week’s reading. Both Treasury and mortgage-backed securities holdings ticked higher from July 5. However, today’s reading still represents a meaty $20.3 billion decline from the trailing four-week average.
Since the Fed began its QT portfolio unwind on Oct. 1, total assets are down by 3.69%, for a simple annualized 4.67% rate of decline.
Recap July 12
Stocks caught another upside rip, with the S&P 500 rising nearly 1% and the tech-heavy NASDAQ reaching a fresh all-time high as the FANG stocks maintained their potent bullish momentum. Treasury yields finished little changed, and commodities ticked higher with crude oil managing a modest bounce following yesterday’s 5% plunge.
Second quarter earnings season kicks into high gear tomorrow, with J.P. Morgan Chase & Co., Citigroup, Inc. and Wells Fargo & Co. among the companies scheduled to report.
- Philip Grant
Tuesday, July 10, 2018
Flat top fade
The speculators have arrived. According to the Commodity Futures Trading Commission’s weekly commitment of traders report, non-commercial, net-short positions in 10-year Treasury futures reached a record of more than 500,000 contracts as of July 3. Speculators were net long 10-year futures as recently as December.
Inflation looks to be the ace in the hole for the assembled bond bears. Headline CPI for May rose by 2.8% year-over-year, its hottest reading since early 2012 (June CPI is set to be released Thursday). The New York Fed’s Underlying Inflation Gauge paints an even starker picture: The UIG rose by 3.27% in May, the 12th straight sequential increase and the highest since 2006.
So too, has output growth remained solid. Over the past eight quarters, annualized GDP growth has averaged 2.4%, north of the 2.1% mean since the recession ended in the second quarter of 2009. Then there is the labor market: JOLTS job openings reached a record 6.84 million in April before easing in May, but still ticked higher by 17% year-over-year in that most recent reading. Anecdotally, a July 6 article by Annie Lowrey of The Atlantic describes the scene in Iowa:
Out of every 100 people who want a job, 98 or 99 have one. The rate of wage growth has doubled of late, and businesses are scrambling to find workers. “It does feel like things are a little different in the last year,” Elisabeth Buck, the president of the United Way of Central Iowa, told me. “Businesses are getting a little desperate.”
Although rising inflation and a growing economy augur well for higher interest rates, bond bears must contend not only with a crowded speculative boat but also the prospect of an inverted yield curve, a phenomenon associated with recession, a falling CPI and falling interest rates. Indeed, the Treasury curve looks flat as an old soda, with the gap between two-year and 10-year yields just 28 basis points, virtually its narrowest since 2007.
While the Fed has begun to trim its own Treasury holdings (the portfolio of securities held outright is down a bit more than 3% since QT began in October), the newly enacted tax cuts and uptick in the federal deficit has spurred a substantial uptick in supply.
So far, that additional supply appears to be overwhelming the short end. According to data from the Securities Industry and Financial Markets Association, issuance in 10-year Treasury notes totaled $144 billion in the six months through June, up a solid 7% from the three-year average. However that figure is easily eclipsed by a 12% uptick in two-year issuance through June compared to the trailing three-year period, and a 56% surge in fresh 13-week bill supply relative to the 2015-2017 mean. Overall issuance is up by 25% over the first six months of the year.
Short rates may get a further boost as futures point to 54% odds of at least two additional 25 basis point rate hikes by year end. In a note today, derivatives maven Harley Bassman predicts that the curve will finally invert in December, writing that investors should pay careful heed to recent resilience at the long end:
The signal that an iceberg is ahead is NOT that the Fed is jamming the yield curve flatter, but rather that long-term interest rates have declined by 30 basis points through the most recent Fed hike; and that this is occurring despite massively expanding supply thanks to Quantitative Tightening (QT) and the Tax Package.
With rising inflation and solid growth seemingly arguing for rising rates, and speculative positioning and a flattening yield curve potentially pointing to the opposite, what’s a potential creditor to do?
The Feb. 9 edition of Grant’s analyzed the prospects for U.S. government debt, spurred by a Federal government that is set to borrow more relative to GDP in 2018 than in any year since the climax of World War II:
The great inflation of the 1970s seemed to come from out of nowhere. With a long look in the rearview mirror, one identifies fiscal indiscipline (Vietnam, the Great Society), abetted by monetary disruption (the end of Bretton Woods) and, perhaps, by a demographic bulge, as the villains of the piece. Maybe in five to 10 years our own lapses from fiscal and monetary best practices will stand out as the causes of an inflation problem that today seems only incipient.
This is speculation. The concrete problem is that historically low interest rates afford the creditor no margin of safety. Over the past 50 years, the 10-year Treasury has delivered an average, inflation-adjusted yield of 2.3%. Today’s real yield is on the order of 0.7% (subtract a 2.1% rate of consumer price inflation from a 2.8% nominal yield, and voilà). This is not to say that yields can’t go lower, only that the value proposition is unappealing.
Unappealing, it remains.
Recap July 10
Stocks caught a modest bid, with the S&P 500 extending its winning streak to four sessions and pulling closer to the January high water mark, despite a flat showing in the NYSE FANG+ Index. Treasury yields ticked higher, led by the short end, to leave the curve flatter, while the VIX, Dollar Index and CRB Commodity Index finished little changed.
Despite that lack of broad movement, energy prices resumed their rally, with WTI crude finishing at $74.4 a barrel, up a Texas-size 59% year-over-year.
- Philip Grant
Monday, July 9, 2018
A programming note
The newest edition of the Grant's podcast, featuring a discussion of the world's points of pressure and other trenchant observations, is now available for download on iTunes, Stitcher, iHeart Radio, Google Play Music or from our website.
China check
It’s a different sort of red card. Over the weekend, the Financial Times reported that Li Yonghong, entrepreneur and owner of high-profile Italian soccer club A.C. Milan, missed a €32 million ($37.4 million) interest payment to creditor Elliott Management Corp. That puts Elliott in position to take over the club as soon as today.
Local sportswriter and A.C. Milan minority shareholder Carlo Pellegatti told the FT: “There are too many mysteries, too many invisible things about the Chinese owner. It is not possible to always continue to wait for the money.”
For debt-laden China, where banking assets exceed full-year 2017 GDP by more than 300% (for comparison, U.S. banking assets are less than 100% of GDP), Li’s money troubles serve as a reminder of the thin margin for error that accompanies high leverage. According to data from the People’s Bank of China, there have been at least 20 bond defaults through May, nearly matching 2017’s full-year total of 22.
The important property sector has also lately shown some cracks in the façade. According to an annual survey of asset managers and commercial banks by China Orient Asset Management Co. and cited by Bloomberg, the total renminbi value of bad loans within the real estate industry will jump by 20% this year. That finding comes as the Chinese government is putting the brakes on a crucial subsidy. Yesterday, the FT reported that an executive from the China Development Bank told listeners to a recent teleconference that the CDB was tightening loan approvals for its “slum redevelopment” policy, a program which has provided some $1 trillion to homebuyers since 2016. For context, total Chinese GDP last year was $12.2 trillion, according to the World Bank.
Mr. Market has gotten the message: The Shanghai Composite Property Index is down 20% year-to-date, exceeding the 14.5% loss on the broad Shanghai Composite Index. China Evergrande Group, a developer whose high short interest, sky-scraping debt burden and then-rampaging stock price was chronicled last year by Grant’s (“Ever higher,” June 2, 2017) has seen an abrupt turn in fortunes, with its 8 3/4 senior secured euro-dollar notes of 2025 falling to a fresh low of 82.5 cents on the dollar for a yield-to-worst of 12.5%.
China Evergrande 8 3/4s of 2025. Source: The Bloomberg
While un-bullish tidings appear in both credit and equities, the broad currency weakness that has befallen large swaths of the emerging markets has also made its way to the Middle Kingdom. Even after a bounce in recent sessions, the renminbi is down by nearly 4% versus the dollar since the middle of June and 5.5% since April, a substantial move considering the government’s control over FX gyrations via the so-called managed floating exchange rate.
For its part, Beijing is not just standing idly by while asset prices falter. Last week, the People’s Bank of China cut its reserve ratio requirement for banks to its lowest level since 2009. The renminbi rebound last Tuesday followed comments from the PBOC suggesting that the bank may prop up the red backs, according to Bloomberg.
But as the Sino-American trade battle begins in earnest, will Chinese government support of the markets be enough? Much as night follows day, Anne-Stevenson Yang of J Capital writes today that a post-credit boom reckoning is in store for the world’s second largest economy:
China has stretched its expansion beyond the reasonable sell-by date through forced credit expansion pushed into enterprises that had no viable way to earn a return, bridges to nowhere, and capital controls, but it cannot prolong it indefinitely. The money creation ultimately leads to deteriorating trade and investment accounts, capital flight, and deflation.
Stevenson-Yang goes on to speculate on the wider implications of an abrupt end to the credit-driven Chinese “economic miracle”:
Once the debt crisis comes, it will likely to be deflationary for the world. China will have little choice but to depreciate the currency in the face of demand for dollars, and that will force prices lower across the world. It is clear from recent weeks that the exchange value of the renminbi is now in the eye of a fiscal hurricane as it has not been for years.
Recap July 9
The bulls continue to have their way. Stocks rose for a third straight session, with the S&P 500 up by 2.6% since Thursday, to close to within 3.2% of the January highs.
A stronger dollar was no problem either: The CRB Commodity Index closed flat while the J.P. Morgan U.S. Dollar Emerging Market Bond ETF rose to its best close since the end of May. Even the pancaked Treasury curve managed to steepen a bit as the long end came
- Philip Grant
Friday, July 6, 2018
Bean there done that
Time waits for no ship. As China’s retaliatory tariffs against U.S. exports took effect earlier today, Bloomberg reports that the soybean-carrying bulk carrier Peak Pegasus accelerated towards the port of Dalian this morning in a last-ditch attempt to arrive prior to the official enactment of the new duties. The ship didn’t make it in time so a 25% tax now awaits the cargo of the Peak Pegasus and further U.S. soybean exports to China.
In anticipation of the tariffs (which Caixin describes as “likely to cause both countries pain”), soybean futures have endured a near 20% freefall from May 25 to July 5, with yesterday’s $8.39 per-bushel closing price the lowest since 2008 (a strong 4.5% bounce followed today). Jeff Kaprelian, a broker at grain advisory service The Hueber Report, told The Wall Street Journal that the new tariffs provide plenty of justification for the precipitous drop: “That is the market. There is nothing more important than Chinese demand.”
For China, the world’s largest soybean importer, the emergence of U.S. tariffs are cause to think outside the box: According to Chinese news site Sina.com, the Ministry of Agricultural and Rural Affairs recently met with a consortium of animal feed and livestock companies to discuss ways to cut back on soybean meal in animal feed.
But, for the time being, the beans must flow, and they are flowing from Brazil. According to the Chinese National Grains and Oils Information Center, the Middle Kingdom bought 1.1 million metric tons of soybeans from Brazil last week, and nothing from the U.S. Bloomberg comments: “That’s an unusual move for this time of year, when China usually starts booking U.S. supply in the months before the North American harvest starts.” That pivot is translating into prices: Bloomberg notes that the premium for August Brazilian soybean futures rose to $2.21 per bushel over American beans yesterday, the largest spread since record keeping began in 2014.
In that yawning price gap, the Brazilians see opportunity. Luis Barbieri, a board member at grain-export trade group Anec, told reporters yesterday that Brazil may buy as much as one million metric tons of U.S. soybeans by the end of the year to satisfy local demand. In availing themselves of the cheaper beans on offer to the north, Brazil would be following the advice presented in these pages by industry expert and paid-up Grant’s subscriber Keith Bronstein. On June 20, Bronstein expressed his amazement at the lack of international arbitrage being undertaken between the divergent prices on offer from the world’s two largest producers.
In addition to the prospective loss of Chinese demand, domestic farmers and soybean bulls also contend with an unfavorable supply backdrop. According to the U.S. Department of Agriculture, soybean inventories stood at 1.222 billion bushels as of June, a record level for the second quarter and up 26.5% year-over-year. The USDA likewise reports in its weekly crop assessment that 71% of soybeans are in ‘good to excellent’ condition, up 7 percentage points from 2017. Twenty-seven percent of beans are blooming, nearly double the 17% seen at this time last year. Overall soybean plantings are set to exceed corn for the first time since 1983, according to the USDA’s annual survey.
Taking inventory of the comprehensively grim fundamental picture and eye-catching price weakness, Grant’s put the question to Bronstein: Is there anything to be bullish about in soybeans? With the long-awaited tariffs now a reality, it’s all about corn. Bronstein explains:
About 8 years ago, I advised my “team" at the time that we were looking at $8 to $18 for soy for a long time to come.
What do I think at $8.50?
There has been a multi-year extension of historical soy/corn cost of production relationship due to the extraordinary growth of China. The imposition of tariffs drops the curtain on this. Thus, if corn production ends up "really abundant" and corn proceeds to $3.40 or slightly less [from its current $3.60 a bushel and one-year average of $3.65], I then use the traditional relationship of 2.20 times corn for soy. Somewhat less than $8.
Not a forecast yet, but a map.
On the one hand:
Wreck the corn crop over the next 30 days and put the price up $1 and voila! [That would push soybeans back above $10 a bushel, according to that 2.2x ratio].
On the other:
An extended tariff regimen and depressed soy becomes institutionalized.
Recap July 6
A 2% jump in the NYSE FANG+ Index catalyzed another bullish day, as the S&P 500 enjoyed a second straight march higher to finish the holiday-shortened week up by 1.5%.
Commodities were well bid as the dollar took a tumble, a development most welcome in emerging markets as the iShares J.P. Morgan U.S. Dollar Emerging Markets Bond ETF continued an impressive rebound from its June 19 interim nadir. Nevertheless, the Argentine peso, Turkish lira, and Indian rupee all remain near lifetime lows relative to the buck.
- Philip Grant
Thursday, July 5, 2018
One from the vault
On this post-holiday occasion, let’s turn back the clock to an era both far-removed and familiar. The July 7, 1989 edition of Grant’s featured an analysis of the then-soaring Japanese stock market and identified a potentially lucrative opportunity for bears. “Nikkei put warrants” was the dryly descriptive headline, and the lead paragraph, perhaps with a few tweaks, could have come from the present day:
The wonderful Herbert Stein remark about patience – “If something can’t go on forever, it won’t” – has been as good a motto as any to lose money by this epic bull market. In general, things that can’t go on forever have kept right on going. Donald Trump, “trophy” hotel prices, leveraged cable-TV companies, Wasserstein Perella & Co. and the Japanese stock market all come annoyingly to mind.
The Nikkei’s 1980’s levitation was a potent one, outpacing all subsequent bull markets in the U.S. Thus, from year-end 1982 to 1989, Japan’s benchmark index rose by 429%, a 26.3% annualized rate. To put that in context, the S&P 500 is up 310% from its March 2009 low, a 16.4% annualized clip, as compared to its 240% (25.8% annualized) rise from late 1994 to the 2000 peak.
Not all was well in Tokyo, Grant’s perceived. A deterioration in the ratio of advancing stocks to declining ones was one clue. A government regulation designed to stymie manipulation by capping the ability of any one broker to trade more than 30% of the volume in any one stock on a given day, another.
For any looking to cash in on a reversal of fortunes in the Land of the Rising Sun, we suggested a relatively obscure series of put warrants issued by investment bank Salomon Brothers International. The warrants, which were struck at prices of roughly 33,000 (the Nikkei’s then-current level), 31,000 and 28,000 expired in June 1991. The furthest out of the money, the 28,000 series, looked like a particularly compelling proposition: At the then prevailing 140 dollar-yen exchange rate, a fall to 14,000 on the Nikkei would have turned a $4.50 initial investment into a cool $100. William Fleckenstein, Seattle-based investor and longtime paid-up Grant’s subscriber, choosing the 28,000 strike, explained his thinking to Grant’s:
I gave up the first 9% [relative to the 33,000 series], but when (the Nikkei) starts rolling to the down side, I have almost three times as much leverage. What is your premise going in? The idea either works – and the market trades on reality – or they keep it going forever.
Indeed, reality soon made its return, but not until an explosive blow-off rally through 1989 provided a parting gift for the bulls. After peaking at near 39,000 on Dec. 29, 1989, the Nikkei fell by 48% to an interim low of 20,200 in October 1990. Needless to say, the 28,000 put warrants paid off handsomely.
Back in the present day, Grant’s asked Fleckenstein if any current investment opportunities present the sort of asymmetric opportunity available to Nikkei bears in that summer of 1989. Fleckenstein cited the bombed-out gold mining business though he added that neither equities nor call options can “get as mispriced as a warrant can.”
QT progress report
The newly upsized schedule began with a bang. The Fed’s portfolio of securities held outright footed to $4.084 trillion, down by a meaty $17.8 billion from last week’s reading. After weeks of mortgage-backed securities doing the heavy lifting, it was Treasurys driving the decline this time, while MBS holdings ticked slightly higher. Relative to the four-week average, securities held outright are down by $28.7 billion.
Since the Fed began its “QT” portfolio unwind on Oct. 1, total assets on the balance sheet are down by 3.72%, a simple annualized pace of 4.83%.
Recap July 5
Stocks caught a strong bid, with the S&P 500 gaining just under 1% to settle at its highest in nearly two weeks, back within 5% of the high-water mark reached in late January. The VIX, Dollar Index and CRB Commodity Index all declined, while a long-bond bid in tandem with selling pressure in the short end of the Treasury curve pushed the curve still flatter.
The spread between the two- and 10-year yield now sits at just 28 basis points, its narrowest since 2007. Meanwhile, interest rate futures point to 71% odds of another rate hike in September.
Two- vs. 10-year Treasury spread. Source: The Bloomberg
- Philip Grant
Tuesday, July 3, 2018
Bear on the 4th of July
From the Associated Press:
From the Associated Press:
From Washington D.C. to Menlo Park
Recap July 3
Bear on the 4th of July
From the Associated Press:
A bear with a taste for margaritas caused a stir in a Southern California community when it took a dip in a bubbling hot tub.
Mark Hough said he was lounging in his Altadena backyard Friday afternoon with his wife and a couple margaritas when he heard rustling, then saw the bear climbing over a fence into his yard.
They retreated inside, leaving the margaritas behind. Hough later ventured out to discover the bear lounging in the unheated hot tub. After Hough shot some video, he said the bear emerged from the water, walked over to his margarita, knocked it over and lapped it up.
Hough later spotted the bear taking a snooze in an oak tree before it disappeared down the street.
Such uncivilized behavior is no way to get invited back for fireworks.
From Washington D.C. to Menlo Park
Uncle Sam is circling Facebook, Inc. (FB on the Nasdaq). Yesterday evening The Washington Post reported that a consortium of U.S. federal agencies, including the Securities and Exchange Commission, Federal Trade Commission and the Federal Bureau of Investigation, have joined the Department of Justice in its investigation over Facebook’s handling of user data.
David Vladeck, law professor at Georgetown University and former director of the FTC’s consumer protection division, commented that the collaborative nature of the government investigation “does raise all sorts of red flags,” while The Post notes that the FTC’s probe of whether Facebook violated a 2011 consent decree agreement with the agency could yield a fine “potentially reach[ing] into the billions of dollars.” For his part, short seller James Chanos has in the past offered a helpful rule of thumb: “The FBI is never bullish.”
Investors took the news largely in stride: FB shares ticked lower by 2% today to $193.5 a share. Since Aug. 11, 2017, FB shares are up by 17%, compared to an 11% rise in the S&P 500 and 46% jump in the NYSE FANG+ Index. Analysts at Height Capital Markets downplayed the potential impact in a research note, terming the investigations mostly “Headline Risk” and asserting that large fines are unlikely. Even if the government all-stars crack the whip, Facebook’s not destined for the poor house any time soon. The company generated $18.2 billion in adjusted net income (at a 45% margin) and $17.5 billion in free cash flow in 2017, and holds $44 billion in cash and cash equivalents with no debt.
To whom much is given, much is expected. According to the sell-side, Facebook will generate $31 billion in adjusted net income during 2019, more than 50% north of 2017’s bottom line. During that period, capital expenditures are expected to more than double to $16.3 billion in 2019, from $6.7 billion last year. That inflating capital-expenditures line item coincides with a ballooning employee roster. From Facebook’s most recent form 10-Q:
Our employee headcount and the scope and complexity of our business have increased significantly, with the number of employees increasing to 27,742 as of March 31, 2018 from 18,770 as of March 31, 2017, and we expect such headcount growth to continue for the foreseeable future. In addition, we have recently announced our plans to hire a significant number of employees and contractors in order to address various safety, security, and content review initiatives.
While the Two Wall Street headquarters of Grant’s is a world away from Silicon Valley, “safety, security, and content review initiatives” do not sound to us like particularly lucrative activities. Indeed, the Aug. 11, 2017 edition of Grant’s Interest Rate Observer contained a bearish assessment of Facebook, suggesting that “maybe growth, momentum and dazzling stock market performance have obscured the problems that will ensure that not even Zuckerberg’s tree will grow to the sky.”
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After we had our say. FB shares since August. Source: The Bloomberg
Is Facebook, one of the brightest stars in the post-crisis bull market constellation, set to falter under the weight of natural growth limitations, an increasingly hostile government and punishingly high investor expectations? Maybe, but one thing’s for sure: Facebook management is not bullish on itself. The share disposition from insiders flagged in various prior editions of Almost Daily Grant’s continues apace.
CEO Mark Zuckerberg sold between 236,000 and 250,000 shares on each trading day in June pursuant to his 35 million to 75 million share sale announced last September and his fellow C-suiters have enthusiastically followed. On June 28, chief operating officer Sheryl Sandberg sold 55,000 shares, her ninth disposal of that increment since February, to net a cool $10.8 million. On June 12, chief technology officer Mike Schroepfer sold 38,009 shares for consideration of $7.3 million, while on June 11, chief product officer Christopher Cox sold 10,600 shares for $2 million. Chief financial officer David Wehner sold 10,000 shares for $1.99 million on June 20.
As Facebook’s insiders cash out, index funds take the baton. At the end of the first quarter, top holder The Vanguard Group reported a 173,634,657 share position, or 7.3% of shares outstanding. That’s up 27% from the first quarter of 2016, a time when FB shares fetched half their current level.
What’s value got to do with it?
Recap July 3
Stocks took a late tumble, as weakness in tech and the financials offset a bid from interest rate sensitive names given a lift by a broad decline in Treasury yields. Commodities couldn’t maintain an early bid despite a weaker dollar, with the CRB Index finishing unchanged, while the VIX jumped back above 16.
- Philip Grant
Monday, July 2, 2018
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How the turntables have turned
July marks not only the start to the fiscal third quarter, but also ushers in another ratcheting of the monetary screws. Starting today – officially it was yesterday, July 1, a Sunday, but how much monetary tightening do you suppose the Fed accomplished over the weekend? – the Fed’s monthly limit in its “QT” program designed to shrink its current $4.1 trillion balance sheet rose to $40 billion ($24 billion in Treasurys and $16 billion in mortgage-backed securities), from $30 billion in the second quarter. The monthly limit will reach its maximum $50 billion in October.
In pulling back from its extraordinary post-crisis accommodation, the Fed has some company. On June 14, the European Central Bank announced it will curtail its current €30 billion ($35 billion) in monthly asset purchases as of December. While ECB president Mario Draghi said he expects to maintain the current deposit rate at negative 40 basis points through next summer, rising inflation could potentially derail those plans: Year-over-year growth in German CPI has exceeded 2% for the past two months, the first back-to-back reading above that threshold since 2012. Recall the ECB’s mandate covers only “price stability,” as opposed to the dual-mandate Fed. Even the hyper-dovish Bank of Japan is getting in on the act. Bloomberg reported on Thursday that the BOJ has cut its own bond purchases for the third time in the month of June.
That hawkish turn from global central banks has put the hurt on the banks. Last Wednesday, the S&P 500 Financials Index established a fresh record losing streak by declining for a 13th straight day and now sits 12% below its January peak. Similarly bearish action across the pond leaves the Euro Stoxx Banks Index at near two year lows, down 19% from January, while, in Japan, the Topix Banks Index likewise resides at its lowest since late 2016, down 22% since January. By comparison, the MSCI World Index sits 7% below its January highs.
Is it just coincidence that the banks are selling off as monetary conditions tighten? On June 19, The Institutional Risk Analyst published an interview with Lee Adler of the Wall Street Examiner, who explained the mechanics by which quantitative easing burnished deposits and, subsequently, loan growth at financial institutions:
Under QE the Fed lent money to [the] Treasury in the form of note and bond purchases. By redeeming the notes and bonds as they mature, the Fed is effectively calling in these loans. . . The asset disappears from the Fed’s balance sheet, and so does the bank reserve deposit because the bank’s customer used it to buy the new bonds. The new bonds now exist, but the money used to purchase them was extinguished when the Treasury used it to pay off the Fed.
Deposit growth is slowly grinding to a halt. It should go negative in the next couple months, especially if [the] ECB makes more cuts to QE. Some of the ECB QE money was flowing instantly to the U.S. Since [the] ECB went from €60 billion to €30 billion in monthly QE their deposit growth has slowed and less money flowed to the U.S. to buy stocks and bonds.
Grant’s asked Christopher Whalen, editor of The Institutional Risk Analyst and financial industry expert extraordinaire, how the banks might respond to a further drop in deposits, as well as his assessment of the industry in a post-QE world:
As reserves disappear, the competition for deposits will grow apace. . . The good news, of sorts, is that loan demand is fairly limp, so a shrinkage in overall credit, which is the essence of QT, will not push up loan rates. Thus financials reflect the general noise in the market and also the fact of a flattening yield curve.
It is not higher rates that are good for banks but wider spreads. But spreads are tightening and loan profitability is at all-time lows. QT will be very bad for banks because of constrained profitability on credit. Give it 18 months and net interest margins will be shrinking as credit defaults are rising.
QE giveth, QT taketh away.
Recap July 2
Stocks recovered from moderate early losses to log a green finish on the S&P 500, with the VIX in turn backtracking from double-digit percentage gains to finish down on the day.
Treasury yields ticked a bit higher, while another round of dollar strength pressured commodities, with the CRB index falling nearly 1.5% and WTI crude slipping back below $74 a barrel. A late rally allowed the iShares J.P. Morgan USD Emerging Markets Bond ETF to avoid fresh multi-year closing lows.
- Philip Grant
Friday, June 29, 2018
Them's fightin' words
During last night’s ballgame, Cincinnati Reds first baseman Joey Votto
During last night’s ballgame, Cincinnati Reds first baseman Joey Votto
Slick Rick
We’ve got a gusher.
We’ve got a gusher.
Recap June 29
Them's fightin' words
During last night’s ballgame, Cincinnati Reds first baseman Joey Votto and Milwaukee Brewers catcher Erik Kratz engaged in a heated conversation on the field after Votto disputed a called strike with the home plate umpire. The jawing was enthusiastic enough that teammates in both dugouts spilled onto the field in anticipation of potential fisticuffs, but cooler heads prevailed and no punches were thrown.
Asked about their verbal altercation after the game, Kratz deadpanned: “Completely blown out of proportion, that’s all. We were discussing the Canadian dollar and flawed systems in our two governments.”
Good thing they stayed away from Canadian housing.
Slick Rick
We’ve got a gusher. Since June 18 West Texas Intermediate crude has ripped higher by an eye-catching 17%. The rally has not been contagious: During that period, the Dollar Index has traded sideways to consolidate recent gains, while the broad CRB commodity index is up by 2.7%.
With a barrel of WTI crude now fetching nearly triple the February 2016 lows and tearing higher on a daily basis, some market observers think we’re due for a pullback. Peter Forbes of Bianco Research reports that the firm’s fair value estimate (derived using principal component analysis from returns across other asset classes) pegs the crude price at 18% below yesterday’s close. Forbes concludes: “On balance, financial markets are pointing toward lower, not higher, oil prices.”
For energy bulls (count Grant’s among them, see the March 10, 2017 edition for more) concerned that crude may be getting ahead of itself, some comfort can be found in a recent thinning of a formerly jam-packed speculative boat. According to the Commodity Futures Trading Commission, non-commercial net long positions in crude oil registered 580,947 contracts as of June 19, that’s down 21% from the all-time high reached on Feb. 2.
Production prospects further underpin the bulls. On Tuesday, The Wall Street Journal quoted an unnamed State Department official threatening sanctions on any country that doesn’t cut Iranian oil imports to “zero” by November. Iran is the third largest producer in the Organization of Petroleum Exporting Countries cartel, exporting 2.125 million barrels per day in 2017 (roughly 2% of world production), according to data from OPEC. For his part, energy secretary Rick Perry told reporters yesterday that he is “comfortable” that other producers can step into the vacuum, commenting that he sees the sanctions as “an opportunity for OPEC members to fill this gap.”
Research firm JBC Energy isn’t so sure. Writing on the looming Iranian disruption, JBC worries: “We cannot say with certainty that the oil market would be able to replace that volume.” It doesn’t look like supply relief is forthcoming from North America. Last week Canadian production facility Syncrude was forced to shut down after a transformer blast, taking 350,000 barrels a day of supply off the market. In the U.S., a pipeline capacity shortage in the Permian basin (the world’s second most prolific oil field, behind Saudi Arabia’s Ghawar) has pushed the premium for spot crude at the Cushing, Oklahoma distribution hub over future to a record, according to Bloomberg.
The current futures curve is now in backwardation, which features higher prices for immediate delivery than futures. As for practical application, the CME defines backwardation as a “structure that suggests the market is undersupplied and/or demand is outstripping supply.” The curve stands in almost perfect contrast to the contract structure seen one year ago.
Backwardation and contango. WTI crude futures curve, now (in orange) and one year ago (in green). Source: The Bloomberg
So, too, does the demand side of the equation augur bullish things. A May 9 analysis by Blacklight Research found global oil demand to be “blistering.” Blacklight’s managing partner and head of research Colin Fenton writes:
Annual global oil demand growth is now running above two million barrels a day, according to our calculations. That’s 35% higher than the trailing five-year average. More than half of this growth is coming from the United States – a rich economy running on easy money and full employment. Oil prices would need to rise much higher to dent current demand growth.
Grant’s asked Fenton whether the past seven weeks have brought any changes to his conclusion. He replies:
No, the associated probabilities for global demand have actually gotten stronger thanks to the May 23 letter to Trump from the four US senators [urging the President to “stand up to OPEC”] and OPEC’s subsequent promise to increase output. That promise brings expected OPEC spare capacity to one percent of global demand by 3Q 2019. Given the evident problems in Venezuela, Libya, and Nigeria, that buffer looks increasingly precarious.
It's shaping up to be a long, hot summer.
Recap June 29
The final trading day of the second quarter saw stocks give back early gains and finish flat, leaving the S&P 500 up 1.7% year-to-date. Treasury yields ticked higher, as the 10-year yield finished at 2.86%, up 46 basis points for 2018. Gold, at $1,252 an ounce, is down 4% since Dec. 31, while WTI crude is up by 23%. The big winner is the VIX, which is up 44% year-to-date despite finishing today below 16.
- Philip Grant
Thursday, June 28, 2018
It's a small world
The buck stops where? The Dollar Index continues to consolidate its steep recent gains, up 7% in the last three months (a 30% annualized pace) to the cusp of a fresh 52-week high, accompanied by a two-year Treasury yield that has virtually doubled in the last nine months to 2.5%.
Those abrupt moves spell trouble for emerging market borrowers. According to the Institute of International Finance, dollar-denominated debt in the formerly designated “third world” rose to $8.25 trillion at year-end, up from $4.47 trillion in 2008. Across the globe, debtors scramble to adjust to the tightening monetary noose.
Today, the Indian rupee broke to a fresh record low against the dollar at more than 69 per greenback (63 rupees fetched a dollar in January). In tandem, India’s 10-year borrowing costs have jumped to 7.94% from less than 7.2% in April. While year-over-year rise in CPI in the world’s second most populous country registered a relatively (by EM standards) benign 4.6% in the first quarter, that figure is more than double the 2.21% reading in the quarter ended June 30, 2017.
By way of reaction, the Reserve Bank of India raised its benchmark repurchase rate by 25 basis points to 6.25% on June 6, and it is a seeming lock to do so again at the upcoming August meeting, as interest rate futures assign 100% odds of further tightening. Today the central bank waded into the FX market to the tune of a 200 billion rupees ($2.9 billion) seven-day reverse repo.
The RBI is not just responding via monetary policy. Recall that, on June 4, central bank governor Urjit Patel took to the Financial Times op-ed page to plead with the Federal Reserve to reverse their policy tightening, warning that a continuation of its balance sheet contraction will “absorb such a large share of dollar liquidity that a crisis in the rest of the dollar bond markets is inevitable.”
As for crisis, Argentina is already there. The peso remains near all-time lows against the dollar despite a $50 billion emergency loan from the International Monetary Fund, while inflation gallops (May CPI rose 26.3% from a year ago) despite a seven-day repo rate of 40%. Today, the 100-year dollar bond issued last June sank to another fresh low of 77.7 cents on the dollar. With inflation percolating and creditors spooked, economic growth is under pressure. Fausto Spotorno, chief economist at Orlando J. Ferreres & Asociados, told Bloomberg: “It’s almost certain that Argentina will fall into recession.” The stock market seems to agree, the country’s Merval Index is down by nearly 25% since January.
To the north, Brazil faces a similar quandary. The real has depreciated by 22% against the dollar since January, prompting investors to price in policy tightening via interest rate futures, while the growth outlook has slumped. Today, the central bank slashed its 2018 GDP forecast to 1.6% from 2.6%. Meanwhile, the monetary policy stewards have been working feverishly to prop up the real, nearly tripling the outstanding amount of currency swap contracts outstanding since late May to $67 billion, in lieu of burning FX reserves through outright currency sales.
Brazil FX swaps outstanding. Source: The Bloomberg
Then there’s China, which has seen a 6% devaluation in the renminbi since April (more than half of that taking place in the last eight days) while the Shanghai Composite Index has slipped into a bear market, down by 22% since January. The Middle Kingdom’s debt-addled property sector appears particularly unsuited for a rising dollar and tightening liquidity environment as the Shanghai Property Index has fallen by 30% since January to its lowest since November 2016.
The extra-encumbered conglomerate HNA Group Co., Ltd., which is in hock to the tune of $93 billion, is a particular source of concern for Beijing. A recent Bloomberg dispatch reported that: “On June 12, a senior official at the People’s Bank of China led a meeting with three regulators. . . instructing attendees to support HNA’s future bond issues.” One week later, HNA came to the bond market for the first time in five months, with subsidiary Bohai Capital Holding Co. raising Rmb 106 billion ($164 million). The unit had to cough up a 7% interest rate, a record high for the unit, yet sold only about half of the planned issuance.
HNA’s similarly aggressive attempts at securing a sounder financial footing continue apace, creating financial ripples far and wide. In the first quarter, the conglomerate trimmed its stake in Deutsche Bank by nearly half as the German banking giant remained under heavy pressure with shares down 43% year-to-date (even after the divestment, HNA remains DB’s top holder). Then, in April, HNA’s Hainan Airlines announced it would sell 20% of its shares in Brazilian airline Azul SA, then worth $138 million according to Reuters, to United Continental subsidiary Calfinco. Worried about future fire sales of HNA’s remaining stake, investors have sent Azul shares lower by 41% since April 30, promptly dealing an unrealized $55 million loss to United. Yesterday, Hainan announced in a filing that it will sell the remainder of its Azul position.
Now, as ever, the financial knee bone is connected to the thigh bone.
QT progress report
Avert your eyes, RBI: The Fed’s portfolio of securities held outright fell to $4.1 trillion, down $10 billion from a week ago. Mortgage-backed securities continued to be the source of the decline as Treasury holdings remain above their June 6 levels. Compared to the trailing four-week average, securities held outright are down by $16.8 billion, mostly due to declining MBS holdings.
Since the Fed began QT on Oct. 1, its total balance sheet is down by 3.37%, a simple annualized pace of 4.48%.
Recap June 28
Stocks caught a solid bid, with the 60 basis point rise in the S&P narrowing the week’s decline to 1.4%, while the CRB Index finished unchanged despite WTI crude jumping above $73 a barrel, a post-2014 high. Treasury yields ticked higher, with the 10-year yield backing off the three week low of 2.82% seen yesterday, and the VIX reversed early gains to finish in the red, just below 17.
- Philip Grant
Tuesday, June 26, 2018
Elevation grade
The bears are circling the corporate bond market. Short positions in dollar-denominated investment grade bonds have reached a new post-crisis high of $55 billion according to data compiled by IHS Markit, up by $7.8 billion from the start of the year. Mergers and acquisitions, more than deteriorating credit quality, may best explain the positioning. Markit points out that Comcast Corp., which is engaged in corporate battle with The Walt Disney Co. for Twenty-First Century Fox, Inc’s. assets, has seen the largest quarter-to-date increase in its credit shorts, followed by General Mills, Inc., which bought Blue Buffalo Pet Products, Inc. in April (Almost Daily Grant’s, March 15).
M&A has also figured prominently in a recent wave of supply. Last Wednesday, mass merchant Walmart, Inc. issued $16 billion worth of notes and bonds ranging from two- to 30-year maturities to fund its purchase of a majority stake in Indian e-commerce concern Flipkart Pvt Ltd. Also last week, German conglomerate Bayer AG raised $15 billion in dollar bonds as well as €5 billion in euro bonds to help refinance its takeover of agricultural behemoth Monsanto Co. Those offerings are the second and third largest of the year, trailing only CVS Health Corp.’s $40 billion bond placement to fund its takeover of Aetna, Inc.
The recent jump in M&A-related credit supply and increased short presence coincides with another lurch wider in spreads. The Bloomberg Barclays Investment Grade spread has widened to 139 basis points, its largest gap over Treasurys since the day after the 2016 elections and up more than 50% from the early February cycle low. In contrast, high-yield spreads have barely budged over that stretch.
Bloomberg Barclays USD Liquid Investment Grade Option Adjusted Spread, one-year view. Source: The Bloomberg
According to data from FactSet, investment-grade debt has been the worst performing major asset class year-to-date through June 21 with a 3.6% loss, trailing Treasurys (down by 1.4%), high-yield (green by 0.7%), stocks and commodities (both higher by more than 3%). Robert Tipp, chief investment strategist at PGIM Fixed Income, explained investors’ recent preference for junk debt to the Wall Street Journal yesterday: “High-yield has proved to be the sweet spot. It’s not too exposed to emerging markets and Europe and it’s benefiting from the strong economy.”
While rising rates and percolating inflation do indeed present an uninviting backdrop for investment grade, bond investors have other, structural factors with which to contend. Thus, the percentage of the Citigroup U.S. Broad Investment-Grade Corporate Bond Index rated triple-B, or the last full rung above junk, footed to about 47% last fall, well above the 40% so rated in 2007. At the same time, the size of the index nearly tripled over that 10-year period, to $5 trillion from $1.7 trillion (Grant’s, Oct. 20, 2017).
Then, too, the April 6, 2018 edition of Grant’s (“Doormats of Wall Street”) identified two other fundamental factors with which credit investors must contend, unrelated to composition, supply, interest rates or economic growth:
A bond is a promise to pay money, but – problem No. 1 – the value of money forever diminishes. As deflation is off the monetary-policy table, the price level goes up and up. Then, too, “senior securities” are junior in all the ways that count to a solvent enterprise. Stock options, not bond options, incentivize the managers. Earnings per share is the corporate end all, be all – problem No. 2
We creditors can’t change the world, but we can politely ask for a raise, and, if refused, we can take our business elsewhere.
Let the value restoration project continue apace.
Recap June 26
Steady as she goes. Stocks and bonds both stayed in a tight range, with the S&P 500 floating higher amid a bounce in the FAANG names, while Treasury yields finished flat or slightly lower across the curve. Commodities saw a bit more action, as the broad CRB caught a robust bid despite a stronger dollar, with WTI crude rising above $70 a barrel for the first time in more than a month.
- Philip Grant
Monday, June 25, 2018
Hungry like the wolf
We may soon find out if bigger is indeed better. On Friday evening, the New York Post reported that Kraft Heinz Co. (KHC on the Nasdaq) is “very much interested” in buying Campbell Soup Co. (CPB on the NYSE). Kraft Heinz, itself formed in a 2015 merger backed by Berkshire Hathaway, Inc. and 3G Capital, has certainly demonstrated an eagerness to do a deal, making unsuccessful overtures to Mondelez International, Inc. and Unilever plc. in recent years. Campbell shares jumped by 9% on the news, while Kraft Heinz initially traded higher before finishing unchanged.
The potential addition of Campbell’s would provide a helping hand for KHC’s earnings profile: Wells Fargo analyst John Baumgartner forecasts a 10% bump in Kraft Heinz earnings should a deal be consummated. Ken Goldman of J.P. Morgan Chase & Co., estimates potential accretion at more than 20%. Still, earnings tell just part of the story. Goldman writes: “We would be surprised if KHC wanted CPB, a company that does not solve KHC’s growth problem and is facing numerous internal challenges. So we do not expect a deal to take place. But in the end, money talks.” Then, too, Kraft Heinz may face rival suitors: The Post also notes that General Mills, Inc. (GIS on the NYSE) “is also seen as a possible Campbell buyer.”
Prospective CPB bidders wouldn’t have to worry about top-ticking: Shares are down by 33% since March 25, 2016, during which time the S&P 500 has logged a 33% gain. The company has cut its earnings forecast on at least three occasions in the past 12 months, with the most recent warning accompanied by the abrupt retirement of former CEO Denise Morrison. In December, Campbell’s paid a hefty price for snack company Snyder’s-Lance, Inc. in an attempt to diversify away from its contracting core soup business.
Early returns on the deal are less than promising: While Campbell’s debt load has nearly tripled to $9.6 billion, or 5.5 times forward adjusted earnings before interest, taxes, depreciation and amortization (EBITDA), the Street is expecting net income for the year-ending July 31, 2019 of just $822 million. That’s down from $932 million logged in the 12 months ended July 31, 2017.
As for Kraft Heinz, whose shares have similarly languished to the tune of 17% since March 2016 amid plateauing revenues (the 2019 consensus of $26.5 billion is virtually unchanged from 2016’s top line), a deal is plainly on the corporate agenda. The question is how Kraft’s existing creditors may take to a large acquisition. While not as leveraged as Campbell, KHC carries net debt at just under four times adjusted EBITDA. The company’s credit rating sits near the border of junk (S&P rates Kraft debt at triple-B, while Fitch rates the company triple-B-minus) and its two most actively traded bonds are both quoted below par.
The March 25, 2016 edition of Grant’s featured a bearish assessment of Kraft Heinz and Campbell (“Sell big food”), arguing that the then-exorbitant valuations sported by the group posed a substantial threat to investors accustomed to a low risk, defensive profile which has historically characterized consumer staples companies. The absence of top-line growth, shifting consumer tastes to organic foods from processed, and encroaching competition from foreign operators Aldi and Lidl also figured in the analysis.
After peaking on July 8, 2016 (the same day that the 10-year yield made its cycle low of 1.37%) the S&P Packaged Food Index is down by 18%. Scott Mushkin, analyst at Wolfe Research, succinctly detailed the industry’s problem a March 24, 2017 follow-up on Kraft Heinz (“Price war for Warren Buffett”): “There are just way too many assets chasing the sales.”
Up and down. The S&P 500 Packaged Foods Index, 5-year view. Source: The Bloomberg
Recap June 25
The bears were out today. A tech-centric stock selloff left the S&P 500 at its lowest close of June, while a bid in Treasurys pushed the 10-year yield to 2.88%, also its lowest since the end of May. Commodities finished well in the red, with copper making fresh 2018 lows, despite a weaker greenback, and the VIX jumped by 26% for its highest close since April.
- Philip Grant
Friday, June 22, 2018
Petal to the metal
Records are made to be broken. On June 7, a 1963 Ferrari 250 GTO was reportedly sold in a private transaction for a cool $70 million, shattering the previous $52 million record price established 2013, to say nothing of Wikipedia-documented $10.6 million sale prices in 2004, and $2.2 million in 1997. With only a few dozen models of the vintage race car known to aficionados as the “Holy Grail” in existence, the limited supply likely figured prominently in a sale price equivalent to the cost of around 5,600 2016-model Toyota Camry’s, according to local asking prices on TrueCar.
That $70 million sum may not remain the record holder for long: Sotheby’s is set to auction a 1962 250 GTO in Monterey, California on Aug. 24-25, affording collectors another opportunity to outbid one another. Ferrari historian and expert Marcel Massini recently forecast that the GTO will break the $100 million barrier in the next two to three years.
Following the prior benchmark sale in 2013, Grant’s took inventory of the skyward high-end luxury goods market (“Warranty not included”) in the context of the Fed’s then-hyperactive monetary policy, and attempted to determine the motivations of that $52 million car buyer:
Nostalgia? Automotive aesthetics? Suspicion of the currency, and of financial assets denominated in that currency, in this time of unprecedented monetary experimentation? Or maybe he just likes cars.
But, if the last-named hypothesis is correct, why do so many moneyed people like cars now?
Clearly, that was no passing infatuation. According to consulting firm Knight Frank, luxury autos have produced a whopping 334% return over the 10 years through 2017, by far the best performing subcomponent of the Knight Frank Luxury Investment Index, which is up 126% over that period (wine takes second place with a 192% 10-year return, while furniture is the worst performing component with a 32% loss).
That 126% gain stacks up pretty well against other asset classes. The S&P/Case-Shiller U.S. National Home Price Index has risen by 13% over the 10 years ending in 2017, while gold gained 60% and the Bloomberg Barclays U.S. Total Return Bond Index appreciated by 48%. Only the S&P 500’s 124% rise, with dividends reinvested, approached the performance of Knight Frank’s luxury gauge, and investors would have been obliged to patiently sit through the 50-plus percent 2008 drawdown on the way to their subsequent gains.
While the upper crust has contended with (or enjoyed) substantial inflation in asset prices, the real McCoy has been far more demure. Headline CPI rose just 17% in the 10 years ending December 2017.
Is the inflationary outcome long sought by policy makers finally upon us? Year-over-year CPI growth has remained over 2% through the first five months of 2018, reaching 2.8% in May to match its hottest reading since 2011. More broadly, the New York Fed’s Underlying Inflation Gauge, which includes CPI components as well as a variety of additional macroeconomic and financial data points, jumped to 3.27% in May, its highest reading since 2006.
New York Fed’s Underlying Inflation Gauge. Source: The Bloomberg
Thursday, June 21, 2018
Mystery fridge
Like referees in sports, it’s rarely a good thing when auditors are in the news.
Like referees in sports, it’s rarely a good thing when auditors are in the news.
QT progress report
Recap June 21
Mystery fridge
Like referees in sports, it’s rarely a good thing when auditors are in the news. Indeed, the “Big Four” have recently been receiving far more publicity than they, or their audit clients, might like. Over the course of two days last week, the U.K. Financial Review Council (FRC) issued £14.5 million ($19 million) in fines to accounting firms PricewaterhouseCoopers and KPMG following the failures off BHS Group Ltd. and Quindell plc. Bloomberg notes that that figure nearly matches the total fines handed out by the regulator throughout 2017.
Then on Monday, the FRC took the unusual step of publicly scolding KPMG for “an unacceptable deterioration” in audit quality. The rebuke follows a review of 16 of KPMG’s audits, after which the regulator declared: "50% of KPMG's FTSE 350 audits required more than just limited improvements, compared to 35% in the previous year." The regulators didn’t let KPMG’s peers off the hook either, exhorting the group: "At a time when public trust in business and in audit is in the spotlight, the Big Four must improve the quality of their audits and do so quickly.”
On Tuesday, the Financial Times published an analysis of the U.K. regulator’s less-than stringent treatment of the “goodwill” balance sheet line-item, and the liberties some companies take with goodwill, to the detriment of investors. The example of British firm Carillion Energy Services Ltd., which was audited by KPMG and which saw goodwill balloon to 35% of total assets in 2016 before declaring bankruptcy last year, figures prominently.
Natasha Landell-Mills, head of stewardship at Sarasin & Partners, told the FT that the episode demonstrated the extent to which investor protections have been eroded: “A core purpose of [audits] has always been to provide a mechanism for those providing capital to ensure their money is protected. . . Given [U.K.] accounting rules are no longer designed to protect capital – who is encircling our capital protection regime? Anyone?”
Others took a blunter tack. During the U.K. parliament’s business committee questioning of KPMG partners over the Carillion collapse, Labour MP Peter Kyle proclaimed: “I wouldn't hire you to do an audit of the contents of my fridge because when I read it I wouldn’t actually know what is in my fridge or not.”
It’s not just on the far side of the pond that KPMG finds itself in hot water. In January, the Securities and Exchange Commission (SEC) and the Justice Department accused KPMG of accessing confidential information from its regulator, the Public Company Accounting Oversight Board, then using that heads-up to correct deficiencies ahead of an inspection. Steven Peikin, co-director of the SEC’s Division of Enforcement, termed it “shocking misconduct – literally stealing the exam.”
Francine McKenna, transparency reporter at MarketWatch and speaker at the upcoming Grant's fall conference (advt.), reported more details on the investigation yesterday, including the existence of an “audit quality bonus program,” in which KPMG employees would be rewarded “if their engagements received no comments from PCAOB inspectors.”
For its part, KPMG told MarketWatch:
It is important to note that the inexcusable actions of the individuals who were separated from KPMG over a year ago were designed to subvert the PCAOB’s inspection process, and had no effect whatsoever on any of the firm’s audit opinions or clients’ financial statements.
But stocks are up; no harm, no foul. Last fall, the Center for Audit Quality conducted its 11th annual Main Street Investor Survey of 1,001 retail investors, finding a record high share (85%) of respondents proclaiming confidence in the U.S. capital markets and 78% reporting either “a great deal,” “quite a bit” or “some” confidence in public companies’ audited financials. Regarding confidence in the auditors, only 12% of respondents expressed “very little,” or “none at all.” That’s a record low in the series and less than half of the 27% who felt that way in 2009.
As said the late Richard Russell: “Markets make opinions.”
QT progress report
The Fed’s portfolio of securities held outright tallied $4.112 trillion, down by $8 billion from a week ago. Mortgage-backed securities were the source of the decline, with holdings dropping to $1.73 trillion while Treasury holdings ticked slightly higher. Compared to the trailing four-week average, today’s holdings are down by $12.6 billion.
Since the Fed began its QT portfolio unwind on Oct. 1, total assets are down by 3.14%, for a simple annualized pace of 4.28%.
Recap June 21
Stocks came under moderate pressure, with the S&P 500’s 0.6% pullback the biggest move for the recently-inert broad index in more than two weeks. Treasurys were bid with the 10-year yield dipping back below 2.9%, and the Dollar Index pushed to a fresh 2018 high this morning before reversing to finish in the red. Volatility stirred, as the VIX jumped by 15% for its strongest close since the end of May.
- Philip Grant
Wednesday, June 20, 2018
Addition by subtraction
It was only a matter of time.
It was only a matter of time.
No pain, no grain
The proof is in the pudding.
The proof is in the pudding.
Recap June 20
Addition by subtraction
It was only a matter of time. Yesterday evening, S&P Dow Jones Indices announced the removal of General Electric Co. from the Dow Jones Industrial Average as of next Tuesday, to be replaced by Walgreens Boots Alliance, Inc. That marks the conclusion of GE’s uninterrupted 111-year residence in the venerable, if not particularly intuitive (the Dow measures the nominal stock prices of its index components, unweighted by market capitalization) industrial average.
David Blitzer, managing director and chairman of the index committee at S&P, went the ‘it’s not you, it’s me,’ route, saying: “Since [1907], the U.S. economy has changed.” Blitzer tactfully neglected to mention the role that GE’s 60% slide since July 2016 (a period in which the Dow has risen by nearly 40%) and the accounting misadventures which have forced the restatement of 2016 and 2017 results, may have played in the decision.
Subscribers looking to take a walk down memory lane can find a thorough compendium of bearish GE analyses from the last 20 years of Grant’s in the Nov. 3, 2017 edition. As for the soon-to-be GE-free Dow, the industrial average saw its seventh straight decline today, its longest losing streak in over a year.
No pain, no grain
The proof is in the pudding. While stock prices gyrate to the waxing and waning of trade war headlines yet seem to go nowhere, a more tangible manifestation of rising world-tariff walls can be found in the agricultural commodities. Soybeans, cotton (both subject to a 25% Chinese duty as of July 6) and corn (also vulnerable to potential Mexican tariffs) prices are down 14%, 12% and 12% respectively from recent highs, more than double the 6% pullback in the broad CRB index from its May 23 interim peak. Soybeans and corn reversed from their multi-year highs to multi-year lows in the span of a few weeks.
That severe price action and seemingly endless escalation of trade tensions by the U.S., China and others have taken a toll. Rich Nelson, chief strategist at Allendale, Inc., explained the situation to Bloomberg: “At this point, traders are in more of a panic mode than reasonable discussions about looking at the exact potential changes on exports.”
It’s not just traders who cringe at the trade wars. Chad Hart, economist at Iowa State University, estimates that Chinese tariffs could represent a $624 million hit to Iowa’s farmers. For his part, Uncle Sam has pledged support for the agrarians, as Secretary of Agriculture Sonny Perdue cited the depression-era Commodity Credit Corporation as among “the tools” available to the federal government. However, Hart expressed doubt that significant assistance is in the immediate offing, telling Brownfield Ag News: “We’ll have to take some fairly significant hits on the market side before that type of protection kicks in.”
The rapid correction in prices has caught Mr. Market offside. According to the Commitment of Traders report data tabulated by the Commodity Futures Trading Commission, speculative net long positions in soybeans, cotton and corn approached five-year highs in recent months, with corn and cotton longs still near their most crowded levels while soybean net longs remain slightly above the five-year average.
Grant’s asked Keith Bronstein, longtime commodities investor and paid-up-subscriber, what sort of opportunities the bullish crowd sees:
In corn, the stocks-to-use ratio has declined notably in the last two years. If this year’s crop yield turns out less than optimal we could be set up for a rally [no sign of that yet, USDA data shows the highest percent of corn in good or excellent shape since 1991, according to Bloomberg].
On cotton, it had a real supply demand story. Will trade controversy disrupt? Stay tuned.
The long positioning in soybeans makes little sense to me. There is nothing exciting going on there.
As for soybeans, the trade tiff is already leading to big changes in behavior. Steve Cachia, a director at Brazilian brokerage Cerealpar, pointed out to Bloomberg the unusually strong demand for Brazilian soy deliveries in August, September and October. That’s a change from prior seasonal patterns, as the Brazilian harvest takes place in the first half of the year. Indeed, Bloomberg reports that the premium fetched by Brazilian soybeans over U.S. beans has widened by a whopping 57% this month.
How long can the price gap between American and Brazilian merchandise continue to widen? Grant’s put the question to Bronstein:
There are significant arbitrage opportunities, and no one is taking advantage. Brazilian soybean prices are at a record premium to the U.S. Countries like Japan who are still on good trading terms with the U.S. should be buying cheaper beans here. On the corporate side, if you’re a global grains player and you ship 100,000 tons of beans to the Netherlands and China, why not sell U.S. beans to the Netherlands and Brazilian beans to China? It hasn’t been happening, and no one knows why. Ten or twenty years ago this would be arbitraged.
Recap June 20
Stocks finished a bit higher, as narrow range trading persists with the S&P 500 finishing within 50 basis points of yesterday’s close for an 11th straight session. Treasury yields jumped higher, helping pressure investment grade corporates, while the sturdy stock market underpinned high yield.
Commodities enjoyed a solid bounce despite a modestly stronger dollar, and the VIX dropped back below 13.
- Philip Grant
Tuesday, June 19, 2018
We'll make it up on volume
Dance of the living dead
Mixed signals abound in the U.S. corporate credit market.
Mixed signals abound in the U.S. corporate credit market.
Recap June 19
We'll make it up on volume
From Friday’s edition of the South China Morning Post:
A hotpot restaurant in southwest China went out of business in less than two weeks after customers took advantage of a promotion that allowed them to pay 120 yuan ($19) for all they could eat for an entire month.
“We knew we would be losing money [by launching the discount promotion],” one of the owners was quoted as saying. “We wanted to accumulate more loyal clients through this strategy.”
It’s all about location. Perhaps Silicon Valley needs a new dining option?
Dance of the living dead
Mixed signals abound in the U.S. corporate credit market. While high-yield spreads remain near their tightest levels since 2007, investors have turned the cold shoulder to investment-grade in recent months: The ICE BAML U.S. Corporate Master Option Adjusted Spread has widened to 122 basis points, the largest pickup over Treasurys since April 2017. Independent research firm Cantillon Consulting notes on Twitter that high yield’s premium to investment grade stands at its narrowest since early 2007.
Particularly jarring is the action at the bottom rungs of these respective debt classes. Jason Goepfert, president of Sundial Capital Research, reports that the yield gap between triple-B-rated bonds and Treasurys has widened by 39 basis in the 90 trading days through June 11 while triple-C-rated spreads have sunk by 91 basis points during that period. Goepfert summarized his findings to Barron’s: “What we’re seeing is highly unusual.”
So what gives?
Supply differentials appear to be one factor. While investment-grade issuance has slowed, with Bloomberg tabulating $672.6 billion of new bonds coming to market this year through June 17, down 8.1% from a year ago, high-yield supply has been curtailed far more dramatically. Crowded out by increasingly popular floating-rate leveraged loans, the new supply of junk bonds has come to $109.4 billion through June 17 according to Bloomberg, that’s down 31% year-over-year. The drought in fresh high-yield supply isn’t expected to abate anytime soon. On June 15, analysts at J.P. Morgan slashed their 2018 new supply estimate to $265 billion from a prior forecast of $315 billion.
The general backdrop could also explain investors’ preference for junk. Interest rates are slowly but surely departing from their near zero post-crisis perch. The effective Federal Funds rate currently sits at 1.9%, up from 0.38% in June 2016. The two-year yield has jumped to 2.55%, compared to 0.55% two years ago.
Interest rates may be rising, but the bygone age of ZIRP continues to cast its shadow. Risk appetite remains firm with stocks at or near their highs, and corporate deaths are few and far between. Moody’s reports that the default rate for U.S. speculative-grade issuers fell to 3.7% in May, down from nearly 6% in 2016 and more than 14% in 2009. The ratings agency expects the good times to continue, forecasting the U.S. high-yield default rate to decline to 2.6% by December.
Consider the new lease on life given to companies that might face the economic grim reaper in a less forgiving interest rate world. According to Bianco Research, nearly 15% of components in the very broad S&P 1,500 index failed to generate sufficient average earnings before interest and taxes over a three year period to cover their interest expense at year-end 2017. That compares to just over 12% in the fourth quarter of 2016 and less than 6% at the end of 2007. Strip out energy, a particularly distressed realm in 2016 following the drop in West Texas Intermediate crude to below $30 a barrel from $100 in 2014, and 11.4% of the S&P 1,500 was so designated at year-end 2017. That’s exactly double the 5.7% rate of a decade prior.
The March 23 edition of Grant’s (“The nine lives of the modern leveraged company”) took inventory of that extraordinary data point, observing both the broad implications for economic dynamism and, more narrowly, the risks which lurk as a greater share of companies struggle to pay the corporate bills as borrowing costs tick higher:
In a free market, unproductive firms give way to productive ones, much to the benefit of the consuming public. In this central bank-rigged, neurologically impaired market, unproductive firms don’t necessarily give way. They survive by borrowing at low interest rates. The great question is whether the unfit could survive even a moderate rise interest rates.
That horde of corporate zombies may be tested sooner rather than later. Interest rate futures currently predict 48% odds of at least 50 basis points in additional rate hikes by year end. The market assigns greater than 25% odds of at least 75 basis points in tightening by July 2019.
Recap June 19
Stocks finished moderately lower, with outsized weakness in materials and industrials partially offset by a bid from interest-rate sensitive names. Treasury yields dropped, with the 10-year settling at 2.89%, while the Dollar Index rose above 95 for the first time since July. That strength in the buck was none too well received by the commodity complex: The broad CRB index declined by more than 1% and is now off by more than 6% from its May 23 interim highs.
- Philip Grant
Monday, June 18, 2018
Last shall be first
It’s not just your imagination.
It’s not just your imagination.
Open 'doors'
It was a different kind of rent-to-own.
It was a different kind of rent-to-own.
Recap June 18
Last shall be first
It’s not just your imagination. Analysts at Goldman Sachs reported last Wednesday that an in-house index comprised of companies with a high short interest had rallied by 8.1% in excess of the most popular hedge fund long “VIP basket” over the past six weeks. That represents a two standard deviation movement compared to the last five years.
The pain for short sellers has continued today, with 65% short interest Rent-A-Center, Inc. receiving a takeover offer (see below for more). This afternoon, GameStop Corp., of which 44% of the float is sold short according to Bloomberg, jumped nearly 20% from its morning trough after Reuters reported that the consumer electronics retailer is receiving buyout interest from private equity firms, including Sycamore Partners.
Exit, bear pursued by man.
Open 'doors'
It was a different kind of rent-to-own. This morning, furniture retailer Rent-A-Center, Inc. (RCII on the Nasdaq) announced that it will be acquired by private equity firm Vintage Capital (which had already disclosed 6% equity ownership), for total proceeds of $1.365 billion. The $15 a share cash price was upsized from $14 a week ago and $13 in November, and represents a 49% premium to RCII’s closing price in October, before the company announced it was seeking a sale.
While the news was a less-than welcome way to begin the week for a substantial cohort (more than 65% of RCII free float is sold short, according to Bloomberg), others found a little extra spring in their step. Rent-A-Center peer Aaron’s, Inc. (AAN on the NYSE), rose more than 2% on the announcement. Since June 30, 2017, Aaron’s shares are up by 14.5%, keeping pace with the rise in the S&P 500.
Furniture and consumer electronics-peddling Aaron’s and the soon-to-be private Rent-A-Center operate in the “rent-to-own” (RTO) industry, in which consumers pay to use an item, receiving it outright at the end of a lease term, so long as they remain current in their payments. The business is a credit-centric one, and interest rates are high. In a June 30 bearish analysis of Aaron’s in Grant’s, deputy editor Evan Lorenz explained the mechanics of a hypothetical transaction:
So, for example, a customer in San Antonio could buy a LG 65” Smart 4k UHD TV with webOS 3.0 for $1,408.99 outright or rent-to-own the set for 24 monthly lease payments of $99.99 (or $2,399.76 in total). If restructured as a fully amortizing loan, those 24 payments would equate to a 57.4% interest rate. Due to the high implied rate, RTO is not exactly the first option for borrowers with access to credit cards and other forms of finance.
While Aaron’s brick and mortar operations retrench, the RTO business spearheaded by its Progressive Leasing subsidiary, which finances RTO transactions in other retailers’ stores, has been doing the corporate heavy lifting. Progressive’s active doors (which the company describes as retail locations at which at least one RTO transaction was completed in the past 12 months) tallied 20,434 in the first quarter according to the company’s form 10-Q, up from 18,627 a year ago. At the same time, the company operated and franchised store count shrank to a combined 1,719 in the first quarter, down from 1,843 last year.
Growth in Aaron’s RTO business has been nothing short of explosive, as Progressive posted eye-popping year-over-year upticks of 32% and 31% in revenue and leading invoice volume, respectively in the first quarter. Good thing for Aaron’s bulls, as analyst expectations for 2018 are relatively demanding: Free cash flow is expected to more than double to $255 million from last year’s $101 million, while the projected $238 million of adjusted net income represents a 70% uptick from 2017’s $168 million bottom line. The Street is definitely expecting big things: Eight analysts rate Aaron’s shares “buy,” against just one “hold” and zero “sells.”
While Aaron’s financing business increasingly shoulders the load, general credit conditions have provided a helping hand. Aggregate past due loans (ranging from 30 days to 90-plus) registered at 11.9% in the first quarter, down sharply from 14.8% at year-end. While bad debt expense rose to 9.6% of revenues in the first quarter, up by 8.7% year-over-year, Progressive CEO Ryan Woodley told listeners on the first quarter conference call that the uptick presented no great concern:
It's [a] lesser comment on where we ended up in Q1 of 2018 and more a commentary on how exceptional levels were in Q1 of 2017. And bad debt expense this quarter was 9.6% of revenue compared to 8.7% last year. Both are low. 8.7% was exceptionally low.
The question before the house: Will it be lower for longer? That uptick in bad debt expense comes in the face of the lowest unemployment rate since 2000 and the December tax cuts. Nevertheless, the decline in credit quality has been widespread. According to the Equifax National Consumer Credit Trends Report, the severe delinquency rate on private label retail credit cards jumped to 4.65% in the first quarter, up 57 basis points year-over-year for its highest reading since 2011. Equifax also notes that private label credit card write-offs as a percentage of outstanding balances footed to 99.9 basis points, up 9.4 basis points year-over-year. That metric peaked at 121.7 basis points in December 2009.
Recap June 18
Stocks mostly erased moderate early losses to leave the S&P 500 nearly flat by day’s end, and Treasurys and the Dollar Index both finished little changed.
While current market calm is demonstrated by fresh 2018 lows in gold and a VIX at 12, emerging markets continue to tell a different story. Today, the iShares JPMorgan USD Emerging Market Bond Fund ETF broke to its lowest since early 2016, when all manner of risk assets endured a brief but severe correction.
- Philip Grant
Friday, June 15, 2018
What's in your wallet?
This morning, the Argentine peso rallied by nearly 5% against the greenback
This morning, the Argentine peso rallied by nearly 5% against the greenback
Tether ball
Will the last crypto bull please turn out the lights?
Will the last crypto bull please turn out the lights?
Recap June 15
What's in your wallet?
This morning, the Argentine peso rallied by nearly 5% against the greenback following the abrupt resignation of central banker Federico Sturzenegger. It was a brief respite, as the beleaguered currency promptly gave back those gains and more, sinking by nearly 7% to a fresh record low of 28.3 per dollar.
The continued freefall in Argentina’s currency comes despite the outsized investment made in the Land of Silver by Franklin Resources, Inc., (BEN on the NYSE), and its star fund manager, Michael Hasenstab a month ago, when the peso traded at fewer than 25 per greenback.
On May 15, the Financial Times reported that Franklin approached the Argentine government with a further $2.25 billion investment (Templeton already owned roughly half of those bond issues) in local currency “bote” bonds with five- and eight-year maturities. While Bloomberg notes that those securities carry yields of 21% and 19.9%, respectively, a 26.3% year-over-year rise in Argentina’s CPI for May bestows firmly negative real yields on those bonds, before factoring in currency depreciation.
For an early view of the liquidity and concentration risks embedded in Templeton’s portfolio, see the July 11, 2014 edition of Grant’s.
Tether ball
Will the last crypto bull please turn out the lights? The first half of 2018 has been as painful for crypto-currencies as 2017 was euphoric, with bitcoin down 54% year-to-date (its all relative, bitcoin is still up by 170% year-over-year). It’s not just the biggest digital currency which has struggled in 2018. Bitcoin peers ethereum, ripple and litecoin are down by, 35%, 76% and 58%, respectively, from their Dec. 31 levels – down, we should add, to levels that Grant’s doubted they would ever attain.
Public infatuation is dwindling along with prices. Google Trends reports that worldwide interest in bitcoin as measured by search popularity has dropped by 86% from its Dec. 23 peak. The sudden downturn in public interest is increasingly shared by Wall Street. Trading volume in the Bitcoin Investment Trust (GBTC on the over the-counter-market) has averaged 2.7 million shares in the past two months, nearly 60% below its one-year average turnover of 6.3 million shares.
Recent news flow has further tested the bullish theses underlying crypto-currencies. On Sunday, South Korean crypto exchange Coinrail was hacked, losing over $40 million worth of tokens, according to TechCrunch. On May 24, Bloomberg reported that the Justice Department and Commodity Futures Trading Commission have opened a criminal investigation into potentially illegal manipulation of bitcoin, with practices such as spoofing (placing, then cancelling illegitimate orders to create an illusion of supply or demand) and wash trading (repeatedly buying and selling a security in order to present the illusion of increased trading volume) coming under the regulators’ scrutiny.
On Wednesday, University of Texas at Austin professors John Griffin and Amin Shams released a research paper studying manipulation of bitcoin by a purportedly U.S. dollar-backed crypto called tether and Bitfinex, a crypto exchange. The pair’s findings were damning:
We are able to establish that entities associated with the Bitfinex exchange use tether to purchase bitcoin when prices are falling. Such price supporting activities are successful, as bitcoin prices rise following the periods of intervention. These effects are present only after negative returns and periods following the printing of tether. . . The buying of bitcoin with tether also occurs more aggressively right below salient round-number thresholds where the price support might be most effective.
Overall, our findings provide substantial support for the view that price manipulation may be behind substantial distortive effects in crypto-currencies . . . More generally, our findings support the historical narrative that dubious activities are not just a by-product of price appreciation, but can substantially contribute to price distortions and capital misallocation.
In a comprehensive bearish analysis of crypto-currencies in the Sept. 8 issue (“Crypto 36,000”), Grant’s raised a skeptical eye at the purportedly dollar-backed crypto-currency, which had seen its market capitalization rise $364 million in September and $53 million in April, when tether lost access to the U.S. banking system. In January, the crypto-currency’s backing organization, Tether Ltd. fired its auditor, New York-based Friedman, LLP, offering the following explanation:
Given the excruciatingly detailed procedures Friedman was undertaking for the relatively simple balance sheet of Tether, it became clear that an audit would be unattainable in a reasonable time frame.
Despite the sharp recent pullback in other cryptos, tether’s market cap has since skyrocketed to $2.6 billion. Grant’s asked then, and we repeat now: Tethered to what?
Recap June 15
Stocks finished a bit lower, as the S&P 500 capped off a range-bound week almost completely unchanged. Beyond the stable index there was plenty of sector-level action, as consumer staples and telecom both caught a strong bid while energy was bludgeoned amid a commodity rout. The broad CRB index dropped more than 1% today despite a flattish dollar, and is down nearly 5% from the multiyear highs reached on May 23.
- Philip Grant
Thursday, June 14, 2018
Phone home
It’s alive! On Tuesday, a Federal Judge ruled in favor of AT&T, Inc., (T on the NYSE) in the telecom behemoth’s quest to buy media conglomerate Time Warner, Inc. This was no narrow win for the would-be suitor: The Capitol Forum described Judge Richard Leon’s opinion as “a scorching rejection of [the Department of Justice’s] facts, evidence, and underlying theory of harm.”
With the path to a Time Warner deal officially cleared (the government announced they won’t appeal this afternoon), AT&T will grow substantially. Its target generated $31.5 billion in revenue and $6.4 billion in adjusted net income in the 12-month period ending March 31.
It’s not just the income statement which will balloon: Total debt, including operating leases and pension obligations, will foot to $249 billion, according to boutique research firm MoffettNathanson LLC. That head-spinning figure would rank the combined AT&T/Time Warner borrowings as the world’s 32nd highest sovereign debt load, between Indonesia ($335 billion) and the United Arab Emirates ($220 billion).
While absolute debt levels are one thing (indeed, the FT Alphaville notes that AT&T’s customer base is also larger than the population of many countries), the triple-B-plus rated combined company will sport a pro-forma leverage ratio of 3.9 times earnings before interest, taxes, depreciation and amortization according to MoffettNathanson. By comparison, the average triple-B-rated issuer was leveraged just under three times in 2017, according to Citigroup, Inc.
The Sept. 22, 2017 edition of Grant’s featured an analysis of (said we) mispriced euro-denominated bonds as the ECB’s highly aggressive monetary stimulus pushed corporate borrowing costs to floor-scraping levels. One such specimen, the AT&T euro-denominated 1.8s of 2026, made the cut as a pick not-to-click owing not only to its robust debt load, but also to the fact that “the dynamics of the wireless communications business seem calculated to keep a creditor awake at night.”
AT&T’s lenders aren’t missing much sleep, yet. Previously quoted at 101.5 cents on the euro to yield 1.6% in September, the bonds have since been called and replaced with an issue identical in yield and maturity on account of the regulatory-driven delay in the Time Warner merger. The “new” bonds, issued in February, currently trade at 100.75, priced to yield 1.67%.
While AT&T gorges at the bond-market trough, fellow “telecom-plus” company SoftBank Group Corp., (SFTBY on the U.S. pink sheets) is making its latest bold move. Today, the Wall Street Journal reports that the SoftBank-backed venture capital Vision Fund is in talks to make a second investment in co-working unicorn WeWork Cos., Inc. that would value the fast growing startup at a whopping $35 billion to $40 billion. That’s nearly double the $20 billion valuation bestowed on privately-held WeWork last August, when SoftBank poured $4.4 billion into WeWork’s coffers (nearly a third of those funds were used to cash out existing investors, per the WSJ).
The Journal notes that WeWork impressively doubled its revenues to $886 million last year. Less impressively, WeWork’s net loss also doubled, to $933 million. Not that net income or loss is the company’s preferred analytical metric; see the April 24 edition of Almost Daily Grant’s for a more detailed look at WeWork’s, uh, innovative financials.
As for Softbank, WeWork’s even-fancier prospective new valuation would represent a big mark-to-market gain for the Vision Fund. Writing about SoftBank and its larger than life chairman, Masayoshi Son, in the Dec. 15, 2017 issue, Grant’s offered the following speculation:
“Every cycle has its poster child,” says Brian Horey, president of Aurelian Management. You can’t be sure who it will be until upside excess has turned into its downside mirror image. But for him, and for us, Soft¬Bank is a leading contender for the cyclical laurels.
QT progress report
Everybody needs a week off once in a while. The Fed’s portfolio of securities held outright footed to $4.12 trillion, up by $3 billion from a week ago, with both its Treasury and mortgage-backed securities holdings ticking higher. Compared to the trailing four-week average, today’s reading is a decline of $8 billion in the Fed’s holdings.
Since the QT balance sheet run-off began on Oct. 1, the Fed’s total balance sheet has declined by 2.93%, a simple annualized pace of 4.11%.
Recap June 14
A rally in the Treasury complex left the 10-year yield at 2.93% and helped interest rate sensitive sectors such as utilities, telecom and real estate catch a bid, as the S&P 500 logged a modest gain.
The greenback logged a not-so modest gain, ripping higher by more than 1% on the broad Dollar Index, intensifying the pain in emerging market currencies. The Argentine peso sank to nearly 28 per dollar (it was below 26 on Tuesday), while the Turkish lira made its own cyclical low of 4.72 per buck. For his part, Turkish president Recep Erdogan promised “an operation” against Moody’s, evidently none too appreciative of recent negative commentary from the rating agency (hopefully he doesn’t read Grant’s).
The dollar strength also put a dent in commodities, with the broad CRB index dropping by more than 0.5%. Oil was the outlier, with WTI crude rising to near $67 a barrel.
- Philip Grant
Tuesday, June 12, 2018
Sunshine haymakers
The deal derby remains in full swing. Yesterday, private equity giant KKR & Co., L.P. announced a $9.9 billion leveraged buyout of hospital services firm Envision Healthcare Corp., including $5.5 billion in cash. That represents a 32% premium to the target’s early November price, before Envision announced it was seeking that shareholder manna called “strategic alternatives.”
The deal is a blockbuster not only for its size. Josh Kosman of the New York Post, citing a source close to the situation, reports that KKR has lined up financing equivalent to 7.25 times Envision’s earnings before interest, taxes, depreciation and amortization (EBITDA) to acquire its target. That figure represents a kind of breakthrough, as Obama-era regulations capping borrower leverage at six times EBITDA have been relaxed by the Trump administration. An unnamed private equity partner assessed the situation to Kosman:
Are the debt markets hot? Overheated? There is no question about it. Banks in a market like this are more focused on if they can sell [syndicate] a loan than if it is a good credit.
As for Envision, which already carried a robust debt load of nearly five times consensus 2018 adjusted EBITDA and junk credit ratings from S&P and Moody’s (the agencies put their double-B-minus and B1 respective ratings on review for downgrade following the buyout announcement), profitability remains elusive. The company lost money last year on a continuing operations basis, while the $747 million in acquisition costs and capital expenditures approached its full-year adjusted EBITDA of $909 million.
In an amendment to the form 10-K, Envision explains the winding road by which they arrive at that adjusted EBITDA figure:
We define adjusted EBITDA as earnings before interest expense, net [sic], income taxes, depreciation, amortization, transaction and integration costs, share-based compensation, impairment charges, debt extinguishment costs, gain or loss on deconsolidations, net of noncontrolling interests, changes in contingent purchase price consideration, purchase accounting adjustments related to mergers and acquisitions, the impact of the Tax Cuts and Jobs Act of 2017 and discontinued operations.
Meanwhile, the first quarter of this year saw adjusted EBITDA of $207 million, down 1.2% year-over-year. One unnamed short seller commented to Grant’s: “KKR will be scrambling to pay the interest on this deal’s debt from day one. Is private equity this desperate to do big deals?”
While domestic private equity ramps up leverage and stretches return assumptions, overseas peers are taking a more creative approach. Today, Azalea Investment Management Pte. Ltd., a wholly-owned subsidiary of Singapore’s Temasek Holdings Pte. Ltd., announced the completion of S$242 million ($182 million) Astrea IV A-1 tranche of 10-year notes with a 5-year call option, split evenly between institutional and individual investors. Investment newsletter The Edge Singapore notes that the issue “is believed to be the world’s first listed private-equity bond for retail investors.”
To say the bonds, which are backed by cash flows from a diversified portfolio of companies, attracted brisk demand would be an understatement. The A-1 tranche priced to yield 4.35%, well inside of the 4.625% initial price talk seen last week according to Bloomberg. What’s more, today’s press release reports retail investor demand at a whopping S$890 million, 7.4 times the allotment for individual investors.
Margaret Lui-Chan, CEO of Azalea, explained the purpose of the offering: “This is not a leveraging exercise; it is really about bringing the product to the marketplace.” Mission accomplished.
While broad credit conditions remain favorable (clearly), they have recently become slightly less so. Yesterday, S&P Global Market Intelligence’s LCD unit reported that the average spread to single-B-rated borrowers has ticked up to 354 basis points over the London Interbank Offered Rate, the widest of the year and up from 338 basis points at year end, which was the tightest spread since 2007 and 2008. Heavy issuance at the low end of the credit spectrum may be a factor: LCD also reports that single-B-rated borrowers have accounted for 73% of issuance so far this quarter, up from 63% in the first quarter.
Recap June 12
It was another round of muted movement for the primary asset classes. The S&P 500 inched higher for a second straight time to log its eighth green finish in nine tries and close to within 3% of its January peak, while Treasury yields ticked higher across the curve to leave the benchmark 10-year yield at 2.96%, near the midpoint of its narrow recent range. Commodities and the both dollar rose modestly, and the VIX settled near 12.
- Philip Grant
Monday, June 11, 2018
Weapons of Mass Profit
Emerging markets have taken center stage, all but one:
Emerging markets have taken center stage, all but one:
Recap June 11
Weapons of Mass Profit
Emerging markets have taken center stage, all but one: China. The renminbi has been gently appreciating (now 6.4 per dollar from 6.51 at year end), amid downward pressure on government bond yields (the 10-year note fetches 3.66%, down from 3.91% on Dec. 31) and a weak stock market (the Shanghai Composite is down by 8% for 2018). That’s not to say the Middle Kingdom is lacking for interesting developments.
Bloomberg reports that Chinese high-yield corporate bonds saw their best performance last week since September 2016, while local bond funds saw their largest allocation in over 17 months, according to research firm EPFR Global. The steep rebound follows a rough start to the year for the asset class. The Markit iBoxx USD Asia ex-Japan China High Yield Total Return Index dropped by more than 5% from its Jan. 18 peak to June 5 trough, the biggest decline in the index since January 2015.
That rebound coincided with a helping hand from the central bank. Last Wednesday, the People’s Bank of China pumped a net RMB203.5 billion ($31.8 billion) into the financial system, the most since March 2017, according to Bloomberg. Analysts at OCBC Bank Singapore commented: “The higher-than-expected long term liquidity injection against the backdrop of rising default risk shows central bank's intention to ease market concern about the credit risk."
The increased involvement from the PBOC comes as other forms of financing dry up. In another echo of that not-so-pleasant 2015 (recall the August renminbi devaluation which spurred a market rout and severe dislocation in some U.S. ETFs), Moody’s finds that Chinese brokerages curtailed their outstanding loans backed by shares to corporate borrowers for a fourth straight month in May, the longest dry stretch since 2015. Sean Hung, senior analyst at Moody’s, assessed the potential impact: “Some companies will be fail to repay their loans, and brokerages will be unable to dispose their stock holdings.”
The plight of China Energy Reserve and Chemicals Group Co. will do little to ease creditor jitters. A Bloomberg dispatch from June 6 tells the tale:
[On May 25] the company said it planned to repay its overdue $350 million notes and a coupon on its 2019 bonds, sparking a rebound in the notes, only to say later that day it had insufficient funds in its trustee account to meet both the obligations. That sent the notes tumbling again.
A couple of weeks earlier, the oil and gas producer saddled with about $2 billion in offshore notes outstanding, blamed its junior staffers for the default of its $350 million bond, saying they misread notices from Bank of Communications Trustee Ltd. about the required redemption and coupon payments, Debtwire reported. The company had said in a statement that appeared on the Hong Kong Exchange on May 27 that the default was due to “[a] tightening in credit conditions.”
The spring freeze in Chinese high-yield followed Beijing’s latest attempt to clamp down on leverage. Today, J Capital’s Anne Stevenson-Yang explains the ambitious reforms being undertaken by China’s banks in service of risk mitigation and broader deleveraging. The changes target a crucial feature of the country’s credit driven “economic miracle”, so-called wealth management products [WMPs], which offer investors (explicitly or implicitly) a guaranteed rate of return:
Regulations designed to move the banks out of speculative investing and into plain vanilla lending were issued at the end of April and will not be fully implemented until 2020, but banks are already changing their practices. The regulations principally concern investment products and how they are managed by banks.
Banks may not even implicitly guarantee rates of return when issuing investment products. They cannot manage assets in pools with products of varying maturity, a practice that lends itself to Ponzis where customers redeeming products at maturity are often paid out of funds from other investors in newly issued products. And they must reduce the amount of WMP assets they have outstanding in the interbank market.
It didn’t take long for the increased scrutiny on wealth management products to have an impact. On May 31, local media reported that the Bank of China was forced to suspend redemptions in an open-ended, fixed income WMP offering investors a 3.1% to 3.2% yield, after being inundated with redemption requests.
Bank of China is no small potatoes. Total assets stood at $3.2 trillion at the end of the first quarter, eclipsing J.P. Morgan Chase & Co.’s $2.6 trillion balance sheet by more than 20%.
Recap June 11
A quiet day for U.S. stocks and bonds saw the S&P 500 creep higher for its seventh green finish in eight tries, as the broad index continues to inch toward the record close logged in late January, while Treasury yields finished little changed as the 10-year settled at 2.95%.
A flat showing from the Dollar Index was no help to Argentina, which saw its peso plunge again to a rate of more than 26 per greenback just days after the announced $50 billion credit line from the IMF. More broadly, the iShares J.P. Morgan USD Emerging Markets Bond ETF sits a few cents above multi-year lows.
- Philip Grant
Friday, June 8, 2018
Friday deep thought
An escalator can never break, it can only become stairs. You should never see an “Escalator Temporarily out of Service” sign, just “Escalator Temporarily Stairs.” Sorry for the convenience.
- Mitch Hedburg
Knock on, drag out
The screws turn a little tighter. Yesterday afternoon, the Fed’s weekly balance sheet showed another drop in its portfolio of securities held outright, with the $4.117 trillion footing down by $9.2 billion from a week ago and by $19 billion from its trailing four-week average. Since the quantitative tightening (or QT to Fed cognoscenti) portfolio unwind began on Oct. 1, the Fed’s total assets are down by 3.06%, a simple annualized pace of 4.41%. While the balance sheet gradually deflates, the near-zero interest rates of 2008 to 2015 appear more distant in the rear view mirror. Next week, the Fed is expected to hike its overnight funds rate by another 25 basis points, to a 1.75% to 2% range.
Even this modest retrenchment from crisis-era monetary policy is causing problems in the currency markets. For emerging markets especially, signs of potential distress are increasingly widespread.
Yesterday evening, the Republic of Argentina announced a $50 billion credit line from the International Monetary Fund, the largest bailout in the history of the fund and at the top end of the $30 billion to $50 billion range expected by analysts, according to the Wall Street Journal. That news helped send the Argentine peso to fresh lifetime lows against the dollar, at now more than 25 per greenback, from fewer than 19 in January. The local central bank was obliged to jack its benchmark lending rate to 40% from 27.25% on April 26.
At 4.48 per dollar, the Turkish lira is slightly off its own lifetime nadir of 4.72 on May 25, as the Turkish central bank undergoes similar muscular tightening (much to the chagrin of President Recep Erdogan, who faces a general election on June 24). Yesterday, the Turkish central bank raised rates by 125 basis points, pushing the one-week repo rate to 17.75% and the late liquidity window rate to 20.75%, in response to May CPI inflation of 12.2% year-over-year. Collateral damage is already appearing. Yesterday, Moody’s downgraded the credit ratings of 17 Turkish banks, noting that the cost of funding has “widened significantly this year.”
Turkey (left scale) and Argentina (right scale) benchmark interest rates. Source: The Bloomberg
Argentina and Turkey have growing company in the ranks of struggling EM nations. In South Africa, the rand has fallen to its weakest level since December against the dollar while the sovereign bond due in 2026 has seen its yield rise more than 100 basis points since late March to 8.95%. Selling pressure was exacerbated by a weaker than expected first quarter GDP print on Tuesday, a data point which might make its central bank think twice about raising interest rates to keep up with the global Joneses.
In Brazil, beset not only by paralyzing trucker strikes but also a plummeting real and spiraling bond yields (see the Jan. 12, 2018 edition of Grant’s for a timely bearish analysis of Latin America’s largest economy), the local central bank has been forced to repeatedly intervene in the currency market. President Michel Temer kept a happy face in an interview with state television, asserting: “There is no risk (of a currency crisis). It is normal: The dollar is swinging around a lot.” So is the real. Even after a massive 5% rally today, Brazil’s currency has lost ground relative to the dollar over the past two weeks.
Temer is not alone in downplaying the potential hazards. Anastasia Levashova, fund manager at Blackfriars Asset Management, told Bloomberg: “If one animal gets sick in the zoo that doesn’t mean there will be contagion risk. EM is not in crisis and there is no contagion.” Geoffrey Dennis, head of global emerging market equity strategy at UBS, didn’t mince his words, commenting on Bloomberg television: “This talk about a crisis in emerging markets is just nonsense.”
Others aren’t so sure. On Wednesday, newly minted Indonesia central bank head Perry Warjiyo told the press: “We know every country must decide their policy based on domestic circumstances but look, you have to take account of your actions and the impact of your actions to other countries, especially the emerging markets.”
That follows the Monday opinion piece in the Financial Times by Reserve Bank of India governor Urjit Patel calling for the Fed to reduce its balance sheet run-off to mitigate the risks of a dollar-liquidity shortage and subsequent crisis in emerging market debt (Almost Daily Grant’s, June 4). In today’s edition of his Solid Ground fortnightly commentary, Russell Napier, independent strategist and co-founder of the Electronic Research Interchange, writes of Patel’s public entreaty:
This in itself should make investors take notice. It indicates that the private communications of the RBI fell on deaf ears within the Federal Reserve. Perhaps, most importantly, it indicates the RBI governor considers this to be a very serious matter indeed, or why else would he alert the world to an impending ‘crisis.’
Those weekly Fed balance sheet releases may soon be required reading for global investors and policymakers alike.
Recap June 8
Stocks opened in the red but the bulls soon took command, as the S&P 500 rallied through the afternoon to finish the week 1.6% higher and close to within just over 3% of the record peak reached in late January. Treasury yields ticked higher across the board, while commodities and the dollar rose in tandem.
- Philip Grant
Thursday, June 7, 2018
Notable quotable
Tandem climb
There’s a party in junk bonds, but where are the attendees?
There’s a party in junk bonds, but where are the attendees?
Recap June 7
Notable quotable
Kent Walker, senior vice president and general counsel of Google, Inc., in response to a building antitrust case by the European Commissioner for Competition, according to a report in today’s Financial Times:
The commission’s case is based on the idea that Android doesn’t compete with Apple’s iOS. We don’t see it that way. We don’t think Apple does either. Or phone makers. Or developers. Or users.
Tandem climb
There’s a party in junk bonds, but where are the attendees? Today, S&P Global Market Intelligence’s LCD unit reports that high yield issuance footed to just $15.3 billion in May, the lowest for the month since 2010, while year-to-date issuance is down by a meaty 21% from 2017 levels. That’s despite favorable price action, as the ICE Bank of America Merrill Lynch U.S. High Yield Option Adjusted Spread remains near its tightest levels of the cycle at 344 basis points over Treasurys, compared to over 700 basis points in 2016 and 2012 and nearly 2,000 basis points in 2008.
Market conditions aren’t keeping issuers away from high yield. So what is? The runaway popularity of leveraged loans appears to be the primary culprit. LCD finds that institutional issuance of tradable bank debt topped $66 billion in May, second only to the $78 billion output in January 2017 for the most prolific month on record. As the Federal Reserve looks set to continue hiking interest rates (futures currently price 85% odds of another 25 basis point tightening at the June meeting next Wednesday), the appeal of floating-rate leveraged loans naturally increases.
With the stock market well bid and corporate credit thus far unfazed by rising rates, Bloomberg reports that the J.P Morgan Leveraged Loan Index spread has dipped below 190 basis points over the London Interbank Offered Rate (Libor), the tightest level since 2007. Corey Geis, head trader at Marble Point Credit, thinks the good times for borrowers aren’t ending anytime soon: “The signals that we may get to [150 basis points over Libor] are there. I don’t think it’s a function of ‘if,’ I think it’s a function of ‘when.’”
It’s not just the spread getting squeezed. A May 16 report from Moody’s identified numerous erosions of covenants protecting investors, which could exacerbate the impact of a credit downturn. One such example:
Lenders typically expect that 100% of proceeds from asset sales would either go towards the prepayment of senior debt or be reinvested into the borrowers business. But that expectation has withered away, as exceptions have made their way into credit agreements in the form of leverage based step-downs. These step-downs permit borrowers to lower or possibly even eliminate prepayment requirements based upon hitting certain pre-defined leverage targets.
While lenders take what they can get, some borrowers live high on the hog. A Bloomberg story today details the charmed financial existence of celebrity dermatologists Katie Rodan and Kathy Fields, who stand to pocket a $600 million dividend after their skincare company, Rodan + Fields, borrowed in the leveraged loan market. Ken Monaghan, co-director of high yield at Amundi Pioneer Asset Management, summed things up aptly:
“I’m not saying anything goes, but it’s close.”
Recap June 7
A pullback in recent winners like the NYSE FANG+ Index and small-cap Russell 2,000 helped put the brakes on the recent equity strength, as the broad S&P 500 cruised sideways to finish nominally lower for its first red finish in more than a week. A lower greenback helped commodities bounce, with WTI crude rising back toward $66 a barrel, and Treasury yields moved lower across the board.
- Philip Grant
Wednesday, June 6, 2018
Windward tack
Is the government thumb finally coming off the scale? The European Central Bank may announce the end of QE as soon as next Thursday, or so hinted a speech by ECB chief economist Peter Praet in Berlin today.
The QE asset purchase program has been in place since March 2015, and is scheduled to run through September at least, but an uptick in eurozone CPI inflation to 1.9% year-over-year in May (it was in negative territory as recently as 2016) has helped set the stage for an unwind. Nick Kounis, head of macro and financial markets research at ABN Amro Bank N.V., told Bloomberg: “The bottom line is that this is the end. This is a signal that the ECB judges that the inflation conditions to wind down net asset purchases have been met.”
Mr. Market got the message. The German 10-year yield jumped nearly 10 basis points to 0.45%, while Spain’s 10-year borrowing costs rose by 10 basis points to 1.5%. Italy, where the recent ascension of populist parties the Northern League and Five Star Movement was underscored by a creditor-unfriendly speech from the new Prime Minister Giuseppe Conte yesterday, saw its two-year yield zip higher by 35 basis points to 1.36%.
As political and monetary conditions in Europe undergo abrupt change, some assets have been repricing faster than others. The Bloomberg Barclays Pan-European High Yield Option Adjusted Spread has widened to 344 basis points, up from as low as 219 basis points in October, but still well below the near-600 basis point interim peak logged in February 2016 and 1,070 at the height of the sovereign credit crisis in 2011. One of the particularly value-free (see the Dec. 15, 2017 edition of Grant’s) securities of the sub-zero/QE era, the double-B-plus-rated (the highest level of junk) Telecom Italia S.p.A. 5 1/4s of 2022, traded at 119 cents on the euro, for a yield of 0.61%. A recent selloff to less than 115 cents has sent the yield ballooning all the way to 1.14%, pre-tax of course.
In contrast, single-B-rated Greece (“Adverse business, financial or economic conditions will likely impair the obligor’s capacity or willingness to meet its financial conditions on the obligation”), which received a €5 billion aid package from lenders including the IMF in January and is negotiating with creditors for an extension of an €86 billion aid package set to expire in August, is finding increasingly generous terms from the market. The cradle of democracy announced today that it had sold €1.625 billion in six-month bills at a yield of 0.85%. That’s down from 1.07% at an auction in April and 2.78% in July 2017 for the same six-month bills. The latest floor-scraping borrowing costs surely elicit envy on this side of the Atlantic. The equivalent yield on a six-month U.S. Treasury bill maturing in November is 2.08%.
Beyond a monetary policy pivot and newly-uncertain political outcome in Italy (Europe’s third largest economy), European credit investors must contend with a third variable: The sickly price action in Deutsche Bank A.G., Europe’s fourth-largest bank by assets according to S&P Global Market Intelligence. Not only is the German behemoth’s stock price back within a few cents of its 2016 all-time lows, but its junior subordinated contingent convertible perpetual debt securities known as CoCo bonds (see the July 11, 2014 edition of Grant’s) have been in retreat, dropping to 93 cents on the euro from north of 100 as recently as mid-May.
Source: The Bloomberg
That Dec. 15, 2017 issue of Grant’s, took inventory of the extraordinary lack of compensation afforded to not-riskless debt instruments in Europe on account of the ECB’s heavy-handed administration of negative interest rates and supply scarcity, asking:
To whom might the ECB sell, when the time for selling arrives? Not a financially motivated buyer, to be sure. And when might the selling time begin? Not soon, to judge by the schedule of euro-denominated money rates that constitute the market’s best guess as to the ECB policy rates of tomorrow. Projections contained in the Euribor futures market indicate sub-zero rates for the next three years.
For ourselves, we cling to the Herbert Stein econometric modeling approach: If something can’t go on forever, it won’t. This can’t, so it won’t, though it may already seem as if it had.
Recap June 6
The bull march continues, as another strong bid pushed the S&P 500 to within about 3.5% of its January high water mark, while the small-cap Russell 2,000 and NYSE FANG+ indices continued their impressive momentum with fresh record closes of their own. Treasury yields moved higher across the curve, with the benchmark 10-year note settling at 2.97%, and the VIX fell to 11.65, its lowest since January.
- Philip Grant
Tuesday, June 5, 2018
Facial recognition
Happy days are here again for the mega-cap technology constellation known as the FANGs. After a pause earlier this year, the group’s ascent has resumed in full force recently, with the New York Stock Exchange’s FANG+ Index (comprised of ten popular tech stocks, equally weighted) breaking to another record close today.
The group has put up performance figures that would be gaudy for a small cap biotech index, let alone some of the largest companies in the world: The FANG+ Index is up by 22% since late March, 47% since August and 207% since February 2016. More broadly, Bloomberg reports today that the tech-centric Nasdaq Composite Index has exceeded its dot-com era highs in market cap relative to the S&P 500.
Strategists at Goldman Sachs Group, Inc., drawing a distinction between current conditions and the late-90’s tech bubble, are expecting the party to continue for some time. Peter Oppenheimer and Guillaume Jaisson write: “Unlike the technology mania of the 1990s, most of this success can be explained by strong fundamentals, revenues and earnings rather than speculation about the future.”
The bulls have other factors in their corner besides momentum and fundamentals. Strategists at UBS Group AG estimate that stock buybacks, dividends and M&A among S&P 500 constituents will equate to about $2.5 trillion this year, equaling about 10% of the index’s market cap and “surpassing prior peaks.” Buybacks alone among the S&P 500 companies are tracking about 80% above their 2010-2017 averages through late May, “driven primarily by tech.”
Facebook, Inc. (FB on the Nasdaq), the lead-off hitter in the FANG+ lineup, has been something of a laggard against its more buoyant peers, as FB’s market capitalization has jumped to $560 billion, up 13% from August and 102% from the 2016 lows. The social media giant, which boasted a net income margin of nearly 45% in 2017, is expected to continue its blistering growth in coming years. Against 2017 revenues of $40.7 billion, analysts expect a $57.7 billion top line this year, then $72 billion in 2019. Perhaps unsurprisingly, the Street is almost uniformly bullish: Out of the 45 analysts who cover the name, 41 say “buy,” along with two “holds” and two “sells”.
With that impressive income statement (and a cash heavy, debt-free balance sheet) in mind, Grant’s nonetheless offered a bearish view on FB shares in the Aug. 11, 2017 edition. Natural limitations to its addressable market (and growth potential), the growing risk of a regulatory snafu and management miscalculation were among the potential pitfalls cited in the analysis. Helped by strong first quarter results on April 25, FB shares have more than recovered from their late-winter tumble to reclaim all-time highs. Will the good times continue for Mark Zuckerberg and Co.?
While the recent flood of bad publicity surrounding the Cambridge Analytica data scandal has largely receded, regulatory risks are still front and center. Yesterday, the Washington Post reported: “Facebook’s arrangements with Amazon.com, Apple, BlackBerry and Samsung allowing their devices to access data from the social network’s users could further expose Facebook to steep fines and other penalties.” The Post quoted David Vladeck, a former senior official at the Federal Trade Commission, who opined: “I think the more unauthorized sharing that comes out, the more the FTC is going to be inclined to impose a significant civil penalty on Facebook.” Recall that the FTC opened an investigation into Facebook in March, per the Post.
Such perils are not confined to the U.S. Following Zuckerberg’s appearance before the European Parliament in May, which featured some seemingly less-than forthright responses from the CEO, The Capitol Forum concluded: “Facebook’s tracking of non-users and tracking of users outside its platform represent a significant enforcement risk in the short-term.”
Non-government actors are likewise looking to put the clamps down. Apple, Inc’s. software chief Craig Federighi told an audience at the company’s developer conference yesterday: “We’ve all seen these like buttons and share buttons and these comment fields, well it turns out these can be used to track you, whether you click on them or not. We’re shutting that down.”
While regulators and peers alike threaten its business model, the company must also contend with increasing apathy towards the platform from the rising generation of consumers. According to a recent study by the Pew Research Center, 51% of U.S. teenagers age 13-17 use Facebook, down from the 71% reported in a 2015 survey. The decline was offset by its Instagram unit, which 72% of teens reported they use, up from 52% in 2015, but that aggregate performance is not exactly tinder for blistering growth. Digital research site eMarketer came to an even bleaker conclusion in February after conducting a social network usage analysis:
Facebook will lose 2 million users ages 24 and younger this year, eMarketer estimates. But not all of those users are migrating to Instagram. For example, eMarketer predicts Instagram will add 1.6 million users ages 24 and younger.
One contingency who is no doubt appreciating the recent share price levitation is the Facebook C-suite, which continues to hit the bid en masse. While Zuckerberg continues near-daily sales of 200,000 to 250,000 shares as part of his previously announced plan to fund the Chan Zuckerberg Initiative, his fellow executives whittle down their own positions in the open market, or simply head for the hills.
Today, the Wall Street Journal reports that departing WhatsApp founders Jan Koum and Brian Acton forfeited $400 million and $900 million in potential stock awards, respectively, by leaving Facebook now instead of November, less than six months away (among the frictions between privacy-minded WhatsApp employees and Facebook staff is the fact that the former enjoyed “nicer bathrooms, with doors that reach the floor”).
On May 24, David Fischer, vice president of business and marketing, sold 18,096 shares to net $3.4 million. On May 16 and May 21, chief financial officer David Wehner sold 14,283 shares for proceeds of $2.6 million. Last Wednesday, chief operating officer Sheryl Sandberg sold 55,000 shares, for proceeds of $10.3 million. Since February, Sandberg has sold 385,000 shares, cashing in a cool $67.8 million.
Looks like a wise move to us.
Recap June 5
A flat finish in the S&P 500 belied stronger action elsewhere, as the NYSE FANG+ Index and small-cap Russell 2,000 both rose to fresh closing highs. Treasurys caught a bid, with the benchmark 10-year yield settling at 2.92%, and commodities rebounded from early weakness to finish in the green.
- Philip Grant
Monday, June 4, 2018
It's all relative
Last week, Ted Livingston, CEO of messaging app Kik
Last week, Ted Livingston, CEO of messaging app Kik
Submerging markets
Are the storm clouds abating in emerging markets?
Are the storm clouds abating in emerging markets?
Recap June 4
It's all relative
Last week, Ted Livingston, CEO of messaging app Kik voiced a decidedly dim view of blockchain technology. Speaking of the decentralized ledger system that underpins cryptocurrencies like bitcoin at a tech conference in Canada, Livingston said: “Almost nobody should be looking at it . . . it’s very low odds that blockchain is going to create value for you.”
The blockchain may not create value for the great unwashed masses, but it certainly created some for Kik, which raised over $100 million in an initial coin offering last year via its “Kin” token.
Submerging markets
Are the storm clouds abating in emerging markets? Over the last two weeks, the iShares J.P Morgan U.S. Dollar Emerging Market Bond ETF has steadied itself after falling to multi-year lows on May 9, and the broad Dollar Index is off by about 1% from the interim highs reached on May 29.
While the price action has improved (or at least stopped deteriorating), news flow continues to suggest that investors should keep a close eye on countries that might have been known as “waste places” in the early 20th century.
For Argentina and Turkey, whose currencies have both stabilized after plunging to record lows against the dollar in May, an uneasy status quo has settled in. Argentina, which was obliged to turn to the IMF for help as the peso legged lower again the greenback, is making progress towards loosening the purse-strings of the supranational body. This morning, IMF director Alejandro Werner proclaimed that: “Talks are well advanced.” That follows a May 31 prediction from Argentine President Mauricio Macri that a deal would be reached “in the next few days.”
Turkey, which has raised its benchmark interest rate by 600 basis points to 19.5% since May 23, saw May CPI rise by 12.2% year-over-year, the second highest reading since 2008. The latest inflation figure further complicates an uncomfortable dynamic for Turkey’s central bank: Hot inflation, rising government bond yields and a faltering currency. This constellation of facts argues for higher rates, while President Recep Erdogan (no wallflower to be sure) demands the opposite.
For another potentially instructive sign of the times, we turn to Malaysia. Today, Finance Asia reports that the newly elected government headed by the 92-year old President Mahathir bin Mohamad cancelled a high speed rail project that was to connect Kuala Lumpur and Singapore due to poor economics.
That deals a blow to China, which sponsored the venture as part of its Belt and Road Initiative. More such Belt and Road projects, including the $13.6 billion East Coast Rail Link, could be on the chopping block. Prior to his election, Mahathir proposed two alternatives for the Belt and Road undertakings: “Renegotiate,” or “even cancel . . . and pay compensation.”
A common thread exists between these IMF bailouts, chunky rate hikes and cancelled spending projects: Tighter monetary conditions. For that, our emerging-market brethren can largely thank the Federal Reserve, according to Bank of India governor Urjit Patel In an opinion piece in today’s Financial Times. Patel calls on the Fed to arrest its current QT policy:
The recent upheaval stems from the coincidence of two significant events: the Fed’s long-awaited moves to trim its balance sheet and a substantial increase in issuing U.S. Treasurys to pay for tax cuts. Given the rapid rise of the U.S. deficit, the Fed must respond by slowing plans to shrink its balance sheet.
If it does not, Treasurys will absorb such a large share of dollar liquidity that a crisis in the rest of the dollar bond markets is inevitable.
Fed chairman Jerome Powell evidently begs to differ. Powell told conference attendees at a May 8 event hosted by the IMF and Swiss National Bank that: “There is good reason to think that the normalization in advanced economies should continue to prove manageable for emerging market economies.” Powell went on to add, somewhat ominously: “Some investors and institutions may not be well positioned for a rise in interest rates, even one that markets broadly anticipate.”
Recap June 4
FAANG you very much. While the S&P 500 caught a moderate bid, the again-scalding tech sector left the broad index in the dust, with the NYSE FAANG+ Index jumping by nearly 2% to reach a fresh closing high. As tech thrived, commodities face planted, with the CRB index falling by nearly 1.5%, despite a slightly weaker finish on the U.S. Dollar Index. WTI crude dropped below $65 a barrel, continuing its rapid reversal from north of $72 a barrel two weeks ago.
- Philip Grant
Friday, June 1, 2018
Loan Star
Time for a Friday frolic through the rollicking credit markets. Borrowers continue to dictate terms of engagement to lenders across the spectrum.
The lengthy post-crisis thaw and ready assistance from global central banks has led to a pleasant problem: A drought in distressed credits. Analysts at S&P Global Fixed Income Research find that the ratio of U.S. corporate bonds trading over 1,000 basis points above the "risk-free" Treasury rate has declined to just 5.2%, its lowest level since late 2014 and down from 33.9% in February 2016.
As placid credit conditions contrast with an uptick in interest-rate volatility, the popularity of leveraged loans, which are floating-rate instruments (priced off a spread to the London Interbank Offered Rate, or Libor) and typically senior to high yield, has remained at a fever pitch. Bloomberg reports today that $120 billion worth of institutional loans were priced in May, second only to January 2017 for the most active issuance month in the post-crisis era. Bloomberg notes that the new supply is hardly overwhelming yield-thirsty investors:
Despite this frenzy of issuance there simply isn’t enough supply to meet demand and most borrowers retain the upper hand, with only some of the weakest credits getting any push back from investors.
Uber Technologies, Inc. is striking, again, while the iron is hot (see the Jan. 27, 2017 edition of Grant’s). On Wednesday, the privately held ride-hailing disruptor announced it will seek to refinance a 2016 term loan currently priced at 400 basis points above Libor to 350-375 basis points over. That follows a separate trip to the market in March, when Uber managed to place a $1.5 billion (upsized from an original $1.25 billion) term loan at a 400 basis point spread over Libor, inside of initial price talk of 425 to 450 basis points.
Uber, which was able to say ‘no thanks’ to a $3 billion investment from Warren Buffett (CEO Dara Khosrowshahi describes himself as a Buffett “fanboy,” if that’s any consolation to the spurned Berkshire Hathaway CEO), has recently managed to narrow its operating losses. The company finished the first quarter $304 million in the red before interest, taxes and excluding the proceeds of asset sales, according to the Associated Press. That compares to a $775 million loss in the fourth quarter and $4.5 billion loss in 2017 and after a $2.8 billion loss (or maybe, “community-adjusted profit”) in 2016. Reuters explains Mr. Market’s enthusiasm:
The privately-held company has generated huge interest among loan investors due to its massive valuation, which currently stands at $62 billion based on the proposed terms from a secondary stock sale announced last week, as well as the fact that so many people use the service.
Then again, uncounted people use the Post Office.
Back in the bond market, an April 30 Financial Times report of one borrower’s exploits brings present conditions into further relief. London-based telecom company Lebara Group, B.V. announced it would not meet a deadline to file financial statements, placing its €350 million floating-rate bond issue at risk of a technical default for a second time this year. In response, Lebara and its parent company, Vieo B.V., issued a statement calling for a bondholder meeting and voluntary early redemption of its debts, using language reminiscent of President Donald Trump, or perhaps Tesla, Inc., CEO Elon Musk on Twitter:
The rationale for this additional voluntary redemption is solely the unrest caused by biased media reports fueled by hedge funds shorting the bonds.
The FT”s Robert Smith wrote that day:
[The] announcement said that KPMG was carrying out the audit of Vieo and Lebara Group, while BDO were “providing account support.” The company had previously said that Grant Thornton was Vieo’s “accounting firm.”
“Vieo B.V. approached Grant Thornton Netherlands to advise on its accounts but we were unable to accept the assignment” a spokesman for the accountancy firm told the Financial Times. A spokesman for KPMG declined to comment.
All’s well that ends well. In a follow-up report yesterday, Smith noted that Lebara’s debt exchange was progressing nicely, with about 75% of the bondholders supporting a deadline extension in exchange for a €15 million equity injection from the company. The bonds have rallied to about 69 cents on the euro, up from 60 cents in late April.
Recap June 1
A roaring May payrolls report helped stocks catch a sturdy bid, with the S&P 500 rising 1% to finish the week in positive territory. Tech continued its dominance with a 2% rally. The NYSE FAANG+ Index, comprised of ten equally-weighted stocks, boasts year-to-date and 52-week gains of 26% and 51%, dusting the S&P 500’s 2% and 12% advance, respectively.
Treasury yields snapped higher across board, with the 10-year now back to 2.90% after trading below 2.76% on Tuesday. Commodities continued to trade poorly, with the broad CRB index now down more than 2% over the past five days, during which time the Dollar Index has been flat. The VIX dropped back to 13.5.
A sneak peak at the latest Grant's...
A long and a short. . .
Dear Almost Daily Grant’s Reader,
We published our flagship publication, Grant’s Interest Rate Observer, on Wednesday and I’m excited to share some details with you…
First, we discuss an essential commodity that Mr. Market has virtually left for dead. Its price is down by 83% from its peak. The combined market cap of the companies that have anything to do with it is down to around $7 billion from about $125 billion—and only 40 or so hardy survivors remain, down from about 500.
But on this global shipwreck of an asset class, Grant’s happens to be unreservedly—well, just treat yourself to our analysis.
And with this long, we pair a short…
A construction company whose revenues are soaring, but cash flow is dwindling and whose accounting is, let us say, controversial. Granted, revenue recognition is an art, not a science. But does it have to be art from the school of Dada?
In total, we present six timely, well-wrought articles in this issue. So if you’re not already “paid up,” you can learn more about Grant’s Interest Rate Observer here.
- Philip Grant
Thursday, May 31, 2018
Part and parcel
Let’s check in on the Great White North,
Let’s check in on the Great White North,
QT progress report
Recap May 31
Part and parcel
Let’s check in on the Great White North, and its long-formidable housing machine which was the subject of a Feb. 9 bearish analysis in Grant’s (“Bay Street blues”).
This morning, Canadian first quarter GDP growth registered at an annualized 1.3%, well below the 1.8% consensus and the slowest quarterly reading since the April-June quarter of 2016. While the post-2014 swoon in energy prices contributed to the prior GDP hiccup, there was a different culprit this time: Housing investment fell by an annualized 1.9%, the worst showing since the first three months of 2009.
While growth abates, inflation stirs. Canadian CPI for April rose by 2.2% year-over-year, the third straight print north of the 2% threshold. Yesterday, the Bank of Canada opted to keep the overnight lending rate unchanged at 1.25%, but noted that: “Developments since April further reinforce Governing Council’s view that higher interest rates will be warranted to keep inflation near target.” Interest rate futures currently price in an overnight rate of 1.73% by year-end.
The rise in short-yields is not only compressing the Canadian yield curve (the spread between five- and 30-year yields has flattened to just 14 basis points, down from an eight year average of 112 basis points) but is also putting the squeeze to homeowners. The Bank of Canada’s posted five-year mortgage rate (most Canadian mortgages are structured as five-year bullets subject to regular refinancing, as opposed to the 30-year fixed rate norm seen in the U.S.) has risen to 5.34% from 4.64% as recently as mid-2017.
Then there’s the B-20 regulation, implemented as of Jan. 1 by Canada’s Office of the Superintendent of Financial Institutions, which requires all borrowers to be subjected to a stress test at the greater of that benchmark rate or the contracted mortgage rate plus 200 basis points. Canadian consumers appear particularly vulnerable to an interest rate squeeze: Statistics Canada reports that household debt stood at 170.4% of personal income in the fourth quarter, just off the record high of 170.5% in the third quarter. By comparison, that metric topped out at 143% in the U.S. in 2007.
Needless to say, the combination of slower growth, tighter regulation and higher rates is an unpleasant one for Canada’s real estate industry. April sales across the country fell by 13.9% year-over-year, and marked their weakest seasonal showing since 2011, according to the Canadian Real Estate Association. Toronto, Canada’s largest city, has seen sales drop for four straight months on a seasonally-adjusted basis for the slowest start to the year since 2009. Vancouver sales plummeted to a 17-year monthly low in April, according to the local real estate board.
As the Canadian housing market retrenches, one relatively small mortgage lender can’t seem to get its numbers in order. In December, Laurentian Bank Financial Group in December announced it would need to repurchase C$304 million ($235 million) in mortgages due to “documentation issues and client misrepresentations.” A month later, Laurentian upsized that figure to C$392 million. Tuesday, the bank issued a press release cheerfully headed: “Laurentian Bank Financial Group Announces Progress on Mortgage Situation.” The text contained some less-upbeat details:
During the second quarter, CMHC [Canada Mortgage Housing Corp., the Fannie and Freddie of the north] completed a normal course audit of the bank’s portfolio insured mortgage loans. The audit highlighted similar issues as those identified in the fourth quarter of 2017, as certain mortgage loans that were inadvertently portfolio insured while they did not meet CMHC portfolio insurance eligibility criteria.
Laurentian price chart, eight-year view. Source: The Bloomberg
Indeed, the bank now expects to repurchase an additional C$125 million to C$150 million in insured mortgages. On the subsequent conference call, Laurentian CEO François Desjardins noted it was the CMHC that detected the problem, explaining that the review would last the rest of the fiscal year owing to the fact that: “These loans could not be found without opening the physical files.” Desjardins also asserted its business as usual with the CMHC, telling listeners that: “The conduit remains available with the same terms and conditions.”
Grant’s sought comment from the CMHC, whose spokesperson replied:
We actively monitor all institutions who participate in our programs. To date, we have received good cooperation from Laurentian Bank and we continue to work with them to resolve the present matter and ensure proper controls are put in place moving forward.
Laurentian Bank’s status as a CMHC Approved Lender and as an Approved Issuer is not affected by the present matter and they remain a valuable partner as [we] work to give more Canadians a place to call home.
Whether or not misery loves company, it often finds it.
QT progress report
It was MBS week at the Eccles Building. The Fed’s portfolio of securities held outright now foots to $4.126 trillion, a $9.5 billion decline from a week ago. In a reversal of recent norm, it was mortgage-backed securities accounting for more than 100% of the drop as the Treasury’s portfolio ticked slightly higher. Compared to the trailing four-week average, securities held outright have dropped by $14.5 billion, mostly consisting of MBS.
Since the Fed began the QT portfolio unwind on Oct. 1, its total assets have declined by 2.88%, for a simple annualized pace of 4.25%.
Recap May 31
Reappearing trade war risk helped drive stocks moderately lower, leaving the S&P 500 a bit less than 1% in the red for the week with one session remaining. Upward pressure in short-dated Treasury yields helped push the curve flatter, with the two- and 10-year spread reaching a fresh post-crisis low of 42 basis points, while commodities traded lower amid an unchanged greenback. The VIX ticked a bit higher to settle just above 15.
- Philip Grant
Tuesday, May 29, 2018
Zone defense
Mamma mia. The recent pain in segments of the emerging markets realm has found its way back to peripheral Europe, as political tumult spurred some remarkable price action. The Italian two-year yield more than tripled today to 2.77%, surpassing the 2010-2012 selloff for the largest one day move since the introduction of the euro in 1999. As recently as two weeks ago, the Italian two-year note yielded negative 0.07%.
While Italy’s yields are rising across the board, heavier selling at the short end is pushing the yield curve flatter. The spread between the two- and 10-year yields is now just 37 basis points, while the five-year yield of 2.98% now exceeds that of the seven-year vintage. With Italy set to auction up to €6 billion worth of five-, seven- and 10-year notes tomorrow, members of the ECB’s bond trading desk would be well served to get a good night’s sleep.
On the political ascendance of the anti-establishment Five Star Movement and League parties which have helped catalyze the recent commotion, Bianco Research LLC assesses the situation thusly:
While the story of the Eurozone imploding is one which has played out fruitlessly many times before, there may be reasons to take this episode a bit more seriously.
In the post-Brexit/Trump world, populist movements are not to be dismissed. These movements have the support of a much larger crowd than in the past.
Recent price action provides no comfort to those worrying about contagion: Greece, which was a primary culprit of the prior European credit crisis and sports a debt-to-GDP ratio of 181% according to Eurostat, saw its one-year borrowing costs surge to 3.27%, up from 1.03% on Thursday. Submerged in negative territory since June 2016, the Spanish two-year yield is almost back to sea level, now at negative 0.03%, up from negative 0.30% on Thursday.
As Europe’s periphery slides back toward financial disturbance, investors are fleeing to the loving embrace of Angela Merkel’s Germany. The German two-year yield now stands at negative 0.77%, its lowest since October and down from negative 0.59% on Thursday. That move has maintained the yawning gap between German and U.S. borrowing costs: The spread between the German and U.S. two-year yields is now up to 313 basis points, while the 10-year spread has expanded to 256 basis points, both at or near their respective records.
In a February speech in New York, ECB governor Benoît Coeuré observed that world central banks may hold as much as 90% of all German bunds. The March 23 edition of Grant’s paraphrased Coeuré’s remarks in speaking on behalf of the central bankers who have effectively snuffed out price discovery in German government debt:
We have done our work; private investors are defeated; they can do no damage to the yields that we have chosen to impose.
Of course, Germany’s put-upon non-central bank creditors find a particularly poor risk versus reward proposition. German CPI inflation grew by 1.6% year-over-year in April, leaving investors with a real yield of negative 240 basis points on two-year paper and negative 135 basis points on 10-year debt. By comparison, a 2.5% year-over-year rise in the U.S. April CPI leaves investors in 10-year Treasury’s with a positive, if de minimis real yield.
What about safety? It is apparent that no small part of the Italy population (Europe’s third largest economy) wants major political change, as evidenced by the recent electoral success of the populist parties. With less than two decades under the euro’s belt, is it such a certainty that the common currency will remain de rigueur in 2028? Even if the euro endures, cracks in the Old Continent’s banking system are beginning to grow more visible. Today, Deutsche Bank shares sank by another 5% to €9.8, and have fallen by 38% year-to-date.
As for Italy, Moody’s announced on Friday that it was placing the country’s debt on review for downgrade. Italy, which currently sports a Baa2 rating (two notches above junk) currently offers investors a 3.16% yield on 10-year debt, not far above the 2.76% on offer from the triple-A-rated U.S. Instead of pondering the cause of the recent selloff, we marvel at where Italy’s debt traded prior to the last few days in the first place.
For insight on the last question, perhaps we should ask this guy:
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Recap May 29
Widespread risk aversion left equities nursing a 1.2% decline on the S&P 500, its worst showing in nearly two months, while yields dropped by double-digit basis points across the Treasury curve. Commodities were hit hard amid dollar strength, with WTI crude finishing near $66 a barrel (down from $72 last Monday), and the VIX popped by nearly 30%.
- Philip Grant
Friday, May 25, 2018
Jumble-aya
As the Memorial Day weekend is upon us, we pause to take inventory of current financial conditions. Happy days are here again for the U.S equity (both public and private), structured credit and real estate realms.
At an investment conference on Tuesday, private equity titan David Rubenstein of the Carlyle Group observed that: "It’s easier to raise money than any time I’ve been in the business over the past 30 years or so," according to Bloomberg. Netflix, Inc., (NFLX on the Nasdaq) is certainly encountering similar investor generosity on the public side.
Netflix, one of the foremost principals of the post-2009 bull stampede and large cap standard-bearer in 2018 (the stock is up 85% year-to-date, 661% from January 2015 and 5,241% from its interim lows on the end of the recession in mid-2009), achieved a notable milestone yesterday. With a 2.6% intraday rise, the streaming content provider saw its market capitalization rise to nearly $153 billion, surpassing that of legacy behemoth Walt Disney Co., (DIS on the NYSE) which is five years away from celebrating its centennial.
A comparison of the pair’s benchmark financial metrics doesn’t fail to leave an impression. Fast-growing Netflix has more than doubled its revenues and adjusted net income in the past three years to $11.7 billion and $597 million, respectively in 2017. Disney, which posted a top line of $56.9 billion in the past year, managed an adjusted net income figure that rivals Netflix’s revenues, with $9.75 billion over the past 12 months (DIS operates on a fiscal calendar ending Sept. 30).
Free cash flow perhaps paints the starkest contrast: While Netflix burned just over $2 billion in cash last year and management expects cash burn to accelerate to $3 to $4 billion in 2018, Disney has generated $10.7 billion in FCF over the past four quarters.
“Stranger Things” is more than just a hit show.
Euphoria-type conditions are not confined to equities. The housing market is also kicking into gear. Wednesday’s release of the first quarter FHFA House Price Index showed a 1.7% sequential jump, well above the expected 0.7% advance. On Wednesday, the Commerce Department’s new home sales data for April showed the average new home price rose to a record $407,000, up 11% year-over-year.
Those gaudy gains are enticing the return of an infamous character from cycles past: The house flipper. In a May 16 blog post, Bin He, economist at CoreLogic, Inc., detailed his findings:
At a national level, the ratio of flipped properties to sales reached 6.2 percent in the first quarter of 2018, which matches the post-crash high in the first quarter of 2013. The first time it reached this level after the housing crash, home prices had just started to recover, and there were still a considerable number of distressed properties on the market.
However, the flipping dynamics have changed over time. The share of distressed properties sold has declined significantly, from 30 percent in January 2013 to 4.4 percent at the end of 2017. Additionally, as a result of six years of home price appreciation and limited for-sale inventory, in many areas, home prices have already passed the peak values reached before the market crashed.
Consequently, the acquisition cost in nominal dollars for investors has increased drastically. High acquisition cost, tight inventory, and rising flipping activities together point to possible speculation: investors are betting on continuous home price growth.
Who can blame them? It’s not like we’ve ever had a national decline in, uh, never mind.
With home prices on the march, another pre-crisis mainstay is making a triumphant return: Structured credit. A May 23 dispatch from Bloomberg reports that registration jumped by 45% for this year’s IMN Annual Investors’ Conference on [Collateralized Loan Obligations] and Leveraged Loans. Chrystalle Anstett, managing director at Eaton Partners, told the assembled throng: “No brainer, you need CLO’s in your portfolio.” Farboud Tavangar, senior portfolio manager at LCM Capital Management, cautioned that “CLO portfolios are far more aggressive,” than their pre-crash forebears, concluding that lenders “have no bargaining power.”
Indeed, according to S&P Global Intelligence’s LCD unit, the ratio of “covenant-lite” loans rose to a fresh record of 82% in April, up from 20% in 2011. Christina Padgett, a loan analyst at Moody’s, struck a stoic tone, telling the Financial Times that: “There is no point in talking about financial covenants any more, or calling a deal ‘cov-lite’. They are all cov-lite. Cov-lite is the new normal.”
One infamous name from cycles yore is dipping its toe back in the water. This morning, LCD reports that a subsidiary of AIG Group, Inc., the insurance company turned 2008-era ward of the state, is acquiring Covenant Credit Partners, “an alternative credit manager with a focus on below-investment grade corporate credit,” according to the investment firm’s website, for $900 million.
Thursday, May 24, 2018
CoCo beware
What bull market? You’d never know about the current good times on Wall Street by following the travails of Deutsche Bank AG (DB is its NYSE-listed American depository receipt). The German banking behemoth is under financial siege, beset by poor results, tumult in the C-Suite and a fast-shrinking share price.
Unflattering news has been plentiful of late. Today, Deutsche Bank announced it will reduce its global staff to “well below” 90,000 from its current 97,000 headcount. On April 20 Bloomberg reported that the bank had inadvertently wired €28 billion ($32.8 billion), or about 41% of Deutsche’s reported equity for the first quarter, in funds to an outside account. CEO Christian Sewing said today that the error resulted from an employee inputting the transfer in euros, instead of yen. Bloomberg likewise reports today that DB also accidentally transferred €21 billion to Macquarie Bank in 2014.
The newly minted CEO (who replaced John Cryan in April) did little to change the desultory mood by announcing that second quarter results would be constrained by “a revenue environment [that] remains challenging.”
That would be no break from recent experience. Revenues declined to €29 billion in 2017, down from €32.8 billion and €37 billion, in 2016 and 2015, respectively. The Street expects the top line to contract further to €26 billion this year.
As revenues dwindle, DB stock has also hit the skids, currently trading at €10.36, the lowest level since October 2016. That leaves shares priced at just 35% of first quarter book value. Rival too-big-to-fail banks such as BNP Paribas, Credit Suisse Group AG and Bank of America Corp. shares trade at 83%, 97% and 126% of book value, respectively.
But while Deutsche Bank’s share price and news coverage evoke the fraught days of 2016, one substantial difference is the performance of its contingent convertible, or “CoCo” securities.
DB share price in orange, CoCos in white. Source: The Bloomberg
CoCos are a peculiarly-structured investment specimen; perpetual debt securities which are convertible to equity or written down when the sponsoring bank runs into trouble and capital falls below a certain level. Issuers’ ability to raise equity at times of stress earns these CoCos the seal of approval of European bank regulators.
After wavering in the early-2016 risk aversion spasm, these exotic securities have performed well. The Bloomberg Barclays Contingent Capital Total Return Index has risen by more than 36% from its February 2016 nadir, topping the 29% gain in the Stoxx Europe 600 equity index over that period.
Naturally, CoCo’s solid recent performance and friendly stance from regulators have paved the way for bustling growth. MSCI calculates global CoCo supply outstanding at $675 billion as of September. That compares with €80 billion ($93 billion) in July 2014.
The risks of these untested investment contraptions were detailed in the July 11, 2014 edition of Grant’s (“Left hand, right hand”), which noted the ready potential for unintended consequences:
Conversions or write-downs, when they’re finally forced, won’t take place under wraps. The news will start a highly focused reassessment of the creditworthiness of the stricken CoCo issuer or issuers. Providers of short-dated liabilities – certificates of deposit, uninsured deposits, commercial paper – are likely to arrive at the same conclusion more or less simultaneously.
That hypothetical day of reckoning has yet to arrive. Although the Bloomberg Barclays CoCo Index lost more than 18% in the two months prior to February 2016 as DB suffered its prior wobble, last June’s wipeout of Banco Popular’s CoCo holders (the bank was sold to Banco Santander under distress) generated no ill effect on the broader asset class. Last week WisdomTree Investments, Inc. announced the launch of the WisdomTree AT1 CoCo Bond UCITS ETF on the London Stock Exchange (ticker: CCBO LN).
Now you can help bolster the tier one capital ratio of European banks from the convenience of your mobile device.
QT progress report
The Fed’s portfolio of securities held outright stands at $4.137 trillion, down by about $8 billion from last week’s reading. Once again it was a decline in Treasury holdings that accounted for the change; the Fed’s portfolio of mortgage-backed securities has now risen or remained unchanged for three straight weeks.
Compared to the trailing four-week average, securities held outright are down by just under $20 billion. Since the Fed began QT on Oct. 1, total assets are down by 2.66%, for a simple annualized pace of 4.04%.
Recap May 24
Stocks finished in the red but well off their early lows, leaving the broad S&P 500 in positive territory for the week thus far. Treasurys maintained their recent strength as a well bid seven-year note auction this afternoon helped yields move lower across the curve. The Dollar Index moved lower but recent emerging market trouble spots Turkey and Argentina saw their currencies weaken against the greenback, while gold rose back above $1,300 despite a selloff in the CRB commodity index.
- Philip Grant
Wednesday, May 23, 2018
Communication breakdown
Time for plan B. Yesterday, Bloomberg reported that debt-addled telecom operator Frontier Communications Corp. (FTR on the Nasdaq) is negotiating a potential debt restructuring with its creditors, after attempts to sell landline assets in Florida, California and Texas that the company purchased from Verizon Communications, Inc. in 2015 “failed to generate an acceptable price.”
Lindsay Gibbons, analyst at Creditsights, Inc. explained Frontier’s dilemma to Bloomberg:
The problem is that they have a weak negotiating position. If they sold Florida for less than what they paid, it wouldn’t look good and it puts a watermark on the other asset sales.
Frontier can certainly use some help with its balance sheet. Against net debt of $19.5 billion, the company is expected to generate $3.5 billion in adjusted earnings before interest, taxes, depreciation and amortization in 2018, for a leverage ratio of about 5.5 turns. Trailing 12-month interest expense of $1.52 billion exceeds consensus expectations for operating income in both 2018 and 2019. The single-B-minus rated, senior unsecured 11s of 2025, issued to help finance the purchase of those Verizon assets, fell below 80 cents on the dollar today, for a yield-to-worst of 15.72%.
The Oct. 2, 2015 edition of Grant’s (“Frontiers of junk”) featured bearish assessments of debt heavy roll- ups (now looking to un-roll themselves) Frontier and Dutch telecom Altice N.V. An anonymity seeking friend of the publication summed up the predicament facing wireline companies such as Frontier:
These firms have tried to straddle a line of providing high current income to shareholders while trying to hold on to their subscribers and keep their revenue streams from declining. Increasingly, they are trading high-margin legacy voice and circuit-switched revenue for much lower margin Internet Protocol (IP)-based revenue, and they are having to maintain fairly high levels of capex in order to provide services that are competitive with cable providers and other combatants, or else risk watching their customers defect. That’s a combo that doesn’t bode well for shareholder payouts generally.
For all of Frontier’s financial woes, the company also appears to be underinvesting in its business. While capital expenditures footed to $1.17 billion in 2017, depreciation and amortization expense was nearly double that, at $2.12 billion.
While the yield on Frontier’s junk-rated bonds goes higher, investors are set to bestow generous terms on another less-than pristine credit. Yesterday, S&P Global Intelligence’s LCD unit reported that metals company Atotech, Inc. is offering $300 million in high yield, unsecured notes with a “PIK toggle” feature, which gives the issuer the right to pay interest with additional debt instead of cash. The last such unsecured PIK offering was made in November by Sotera Health.
Covenant Review, an independent credit research firm, details some particularly issuer-friendly features to the Atotech high yield offering, observing that: “These notes will be holding company debt, with no guarantees from subsidiaries. Thus, these Notes will be structurally subordinated to all debt of the subsidiaries . . . A widely held public company could acquire The Company without triggering the Change of Control put.” Analyst Ross Hallock goes on to summarize:
The financial metrics allow for excessively liberal pro forma adjustments. Pro forma effect may be given to any “operational efficiencies” or “strategic initiatives.” In other words, pro forma adjustments may be made for just about anything.
Rarely a dull moment in high-yield.
Slumbering samurai
The rout in the Turkish lira reached a fever pitch this morning, as the currency weakened more than 5% intraday to a fresh record low of 4.92 per dollar, necessitating an extraordinary central bank meeting and 300 basis point interest rate hike to 16.5%. Although termed “a very weak response” by strategists at Brown Brothers Harriman & Co., the move seemed to work for now, as the lira recouped its early losses and rallied to 4.6 per greenback late in the U.S. session.
Turkey’s spiraling currency and local bond yields are unwelcome news for the hordes of Japanese speculators who have been reaching halfway across the world for income. Bloomberg notes today that margin traders in the Land of the Rising Sun had recently upsized their exposure to the Turkish lira, holding a net long position of 323,537 contracts as of May 15, up from 266,955 contracts at year end.
The financial connection between Turkey and Japan extends beyond currency speculation. As noted in the April 3 edition of Almost Daily Grant’s, Turkey sold ¥60 billion ($546 million) in three-year samurai notes in December, at a 1.81% coupon.
The issuer may be teetering on the financial precipice, but you wouldn’t know it from the performance of the samurai bonds. They have barely budged from a post-issuance rally and remain comfortably above par.
Meanwhile, during a speech this afternoon Turkish president Recep Erdogan called on his citizens to keep their money in lira. The million dollar (lira) question: Will Erdogan escalate his rhetoric into action, in the form of capital controls?
Recap May 23
Stocks enjoyed a late rebound to finish in the green, as a few dovish remarks in the latest FOMC meeting minutes this afternoon led to a decline in the market’s rate hike expectations (interest rate futures currently price in a 2.25% Fed Funds rate at year end, down from 2.32% yesterday). Treasury yields moved sharply lower across the board, and the dollar and commodities both finished slightly higher. The VIX sold off late to finish at its lowest close since late January.
- Philip Grant
Tuesday, May 22, 2018
Under the hood
No ZIRP? No problem, mostly. Since the Federal Reserve began its tightening regime with the first of six 0.25% increases in December 2015, the S&P 500 has cruised higher by 36% with only a pair of notable interruptions, in February 2016 and earlier this year. Rate-focused equity bulls can take further reassurance from recent history. The Fed’s prior two tightening cycles, from 2004-2006 and 1999-2000, both coincided with double-digit gains in the broad index.
Of course for the corporate realm, rising borrowing costs are a mixed blessing. While some industries shrug them off or even thrive in times of dearer money, others might wish things had stayed the way they were. Indeed, since the Fed began tightening policy, the three worst performing S&P sectors have been interest rate-sensitive real estate, telecom and consumer staples, up by 4%, 2% and 1%, respectively.
Homebuilders, which fared extremely well through 2017, have lately been consigned to the latter category. Since January, the S&P Supercomposite Homebuilder Index has flirted with bear-market territory. Following a 20% drop, the index has continued to falter even as the broad market steadied and rebounded.
A recently-skyrocketing lumber price (up 72% since June even after a 7% pullback in the last four trading days) is one ready explanation. Rising mortgage rates, and their potential impact on demand, are another potential factor. Last Thursday, Freddie Mac reported that the average fixed-rate mortgage rose to a seven-year high of 4.61%, up from 4.55% the week prior and 4.02% a year ago. The Mortgage Bankers Association forecasts that the 30-year benchmark rate will reach 5% this year, and 5.5% by the end of 2019.
The recent sickly price action in homebuilders received some fundamental confirmation this morning, as high-end operator Toll Brothers, Inc., reported weaker than expected second quarter results, including shortfalls in new orders and gross margin relative to analyst expectations, sending shares lower by 10%. While CEO Douglas Yearley, Jr. cited the jump in lumber costs as a contributing factor for the disappointment, he dismissed the role of rising rates, telling analysts on the conference call that:
They have not impacted our business. Look at the second quarter results. Our sales teams around the country have had nothing to say. All right. They've had no issues. So on the rate side, a 4.87% rate, as I mentioned, is still a low rate and is only 75 basis points up from a year ago. So right now we're very comfortable with our business and [see] no issues out there.
Indeed, despite a seven-year high in the Freddie Mac survey mortgage rate, the data series sits barely above its post-recession average of 4.13% and well below its 30-year mean of 6.5%. Likewise, the overnight Fed Funds and 10-year Treasury rates both remain well below their respective long-term averages.
But the current rising rate cycle looks far from over. Futures markets continue to predict between two and three additional Fed hikes this year, underpinned by a visible uptick in inflation with both the CPI and PCE deflator metrics at their highest in over a year. This morning, the wages subcomponent of the May Richmond Fed regional manufacturing index rose to its highest reading since 1997. Jonathan Tepper, chief editor of Variant Perception and a recent guest on the Grant’s podcast (click here to listen), details other wage-inflation sightings in a May 17 analysis of the labor market:
The [National Federation for Independent Business] compensation plans is now at the highest point in the last twenty years. Small businesses expect to raise wages, and a majority of industries are experiencing wage increases. We will see higher growth rates for hourly wages and the Employment Cost Index.
For many consumers, the bump in pay comes not a moment too soon. According to the Fed’s consumer credit data series, student loans outstanding topped $1.5 trillion in the first quarter, up 39% in the past five years and 146% since 2008. Meanwhile, the Department of Education announced Friday that starting July 1, undergraduate federal student loan interest rates are set to jump to 5.05% from the current 4.45%.
Signs of a stretched consumer are increasingly visible. The Bureau of Economic Analysis calculates the U.S. savings rate at 3.1% of disposable income for the first quarter, compared to a post-crisis average of 5.5% and 8.5% going back to 1946. Ben Breitholtz of Bianco Research likewise finds that: “Google search trends are reflecting a rise in consumer stress and waning spending patterns . . . The popularity of searches for bankruptcy, default and food stamps reached the highest since late 2008.”
That’s in year nine of the economic expansion. Falling rates giveth, rising rates taketh away.
Recap May 22
A late selloff left stocks modestly in the red, while Treasury yields inched higher across the curve and the dollar, commodities and the VIX all finished little changed. Emerging markets mostly fared well, with the iShares JP Morgan USD Emerging Markets Bond ETF enjoying its best finish in nearly two weeks. However, the Turkish lira continued its tailspin, reaching a new record low of 4.667 per greenback. The lira has lost nearly half its value since the failed coup attempt against Recep Erdogan in summer 2016.
Lira/dollar exchange rate, two-year chart. Source: The Bloomberg
-Philip Grant
Monday, May 21, 2018
Debt decision
Price action in the stock market appears healthy,
Price action in the stock market appears healthy,
A crowded table
It was an un-bullish omen.
It was an un-bullish omen.
Recap May 21
Debt decision
Price action in the stock market appears healthy, with the MSCI World Index hovering in a tight range about 6% below the all-time highs reached on Jan. 26. The bond market? Not so much.
Today, Italian sovereign yields spiked, with the two-year yield nearly tripling to 0.28%, as an already grim fiscal picture faces further erosion from a new coalition government. The anti-establishment Five Star Movement and Northern League have discussed issuing short-term credit notes called “mini-BOTs,” which former economy minister Pier Carlo Padoan described as a “disguised parallel currency.” The selloff in emerging market credits continues, with recently-issued Turkish dollar-denominated 10-year bonds sinking to a fresh price low of 91 cents on the dollar, for a yield-to-maturity of 7.33%.
Corporate issues stateside are giving their beleaguered EM and peripheral European counterparts a run for their money. Bloomberg notes that: “Debt of American companies just posted their third-worst 100-day returns since 2000, according to a JPMorgan Chase & Co. index, as tighter monetary conditions leave their mark on high-quality bonds with longer maturities.”
Meanwhile, futures markets assign an 85% probability of the Federal Reserve hiking interest rates by at least 50 basis points by year-end, from the current range of 1.50% to 1.75%.
Who will blink first, investors or the Fed?
A crowded table
It was an un-bullish omen. On Friday, Campbell Soup Co. (CPB on the NYSE) preceded its April quarter earnings release with a report announcing a “CEO Transition Plan.” CEO Denise Morrison retired, effective immediately, and was replaced on an interim basis by board member Keith McLoughlin.
As might be surmised from a CEO’s abrupt departure on earnings day, the results were not good: Campbell’s now expects fiscal year adjusted earnings per share of $2.85 to $2.90, from a prior range of $3.10 to $3.17. Shares sank by 12% in response, and are now down by 30% year-to-date and 50% from their July 2016 highs (almost exactly coinciding with the lows on the 10-year Treasury yield). For his part, interim CEO McLoughlin promised “a thorough and critical review of all aspects of our strategic and operating plans . . . everything is on the table.”
Campbell, faced with something of an existential threat as consumer tastes shift toward fresh, organic fare in place of its legacy offerings, worked to diversify its product slate under Morrison with 2015’s acquisition of Garden Fresh Gourmet and 2012’s purchase of Bolthouse Farms, among others. Then, Morrison changed tack, announcing in December a $6.1 billion deal to buy snack company Snyder’s-Lance, Inc.
The company paid a fancy price for LNCE, coughing up a 27% premium to its pre-deal closing price and just under 20 times the target’s trailing 12-month adjusted earnings before interest, taxes, depreciation and amortization (EBITDA). Snyder’s-Lance then wrapped up its time as a standalone company by offering far weaker than expected fourth quarter results in February, afflicted by shortfalls in both revenue and operating margins.
The deal has been transformative for Campbell, just not in the way the bulls would want. With total debt now at $9.6 billion, up from $3.5 billion in fiscal 2017 (the company’s fiscal year ends July 31), CPB is expected to generate $1.9 billion in EBITDA and $894 million in free cash flow in fiscal 2019. By contrast, CPB managed $1.8 billion in EBITDA and $953 million in free cash flow in fiscal 2017. Creditors are getting nervous. In March, Campbell issued $700 million in 30-year senior unsecured debt at a 4.80% coupon. Priced just below par on March 12, the bonds have promptly fallen to below 92 cents on the dollar, for a yield-to-worst of 5.36%.
Creditors’ cold feet. The CPB 4.8s of 2048. Source: The Bloomberg
Campbell is of course not the only consumer packaged-foods company struggling with secular changes in taste, overlaid on high debt. Kraft Heinz Co. (KHC on the Nasdaq) has likewise been given the cold shoulder by Mr. Market of late, with shares down by 27% year to date and 42% from its 2016 highs, despite industry-leading EBITDA margins.
The March 25, 2016 edition of Grant’s featured bearish analyses of CPB and KHC with an unambiguous headline: “Sell Big Food,” we proclaimed. The consumer packaged foods industry’s intense competition and shrinking revenues were two points of concern. Dwindling market share at the hands of niche brand, healthy (or healthier) up and coming competitors, another. Noting the pronounced popularity of this traditionally low-risk industry at the time (consumer packaged goods companies then traded at an average 25 times trailing net income), we wrote:
In the physical world, some things are inherently safe, others inherently not. Daisies and dynamite, for example. There are fewer such clear distinctions to be drawn in the world of investing . . . Mispriced investments are inherently risky.
Back in the present day, the Wall Street Journal reported over the weekend that analysts and bankers alike have identified Kraft Heinz as a potential suitor for Campbell. Whether the pair of amply levered companies do indeed look to combine or continue to go it alone, the value restoration project continues apace.
Recap May 21
Stocks were bid to start the week, with the S&P 500 gaining about 0.7% to finish at its best level since mid-March, while a late dollar selloff pushed the CRB Commodity Index to another fresh post-2015 high with WTI crude settling near $72.5 a barrel. Treasurys finished little changed.
- Philip Grant
Friday, May 18, 2018
Fun with filings
Interesting doings of late in the Securities and Exchange Commission’s EDGAR database.
Interesting doings of late in the Securities and Exchange Commission’s EDGAR database.
Recap May 18
Fun with filings
Interesting doings of late in the Securities and Exchange Commission’s EDGAR database. We now present a trio of recent filings that caught our attention. Let’s get right to it.
Yesterday, amply-levered packaged food company Post Holdings, Inc. (POST on the NYSE) filed a form S-1 draft registration statement related to a potential transaction involving its private brands business, which, unlike its legacy cold cereal unit, continues to enjoy sturdy top-line growth (10% year-over-year in the quarter ended March 31). In an accompanying press release, Post notes that options for the unit include “an initial public offering, a placement of private equity, a sale of the business or strategic combination.”
Why quote the press release instead of the S-1 itself? Post opted to file confidentially with the SEC, which first allowed companies below $1 billion in market cap to do so away from the prying eyes of investors via the 2012 JOBS Act. That privilege was extended to all companies in June 2017.
One anonymity-seeking investor familiar with Post was none too impressed, telling Grant’s:
The confidential treatment of Post’s S-1 for its private label unit only inhibits analysis of POST’s overall business. Owners of POST shares may wonder, what information is in the S-1 that management doesn’t want shareholders to see?
For more on Post, see Grant’s Interest Rate Observer, Sept. 16, 2016.
While Post keeps a low profile, the Swiss National Bank has been lightening its load. The SNB, which conjures fresh francs to buy euros in an attempt to stem unwanted appreciation in the swissie, then diversifies into an array of assets including U.S. equities, turned seller in the first quarter. The central bank’s equity portfolio, which rose to $92 billion at year end from $63 billion in 2016, declined to $82 billion as of quarter-end, according to its recently filed form 13-F. Holdings in large cap names such as Apple, Inc., Tesla, Inc., and Nike, Inc., all dropped by about 15% from their year-end levels, while the SNB’s total U.S. portfolio now comprises 2,484 holdings, down from 2,514 on Dec. 31. The gnomes are getting more selective!
The reversal comes as the Swiss have enjoyed a favorable turn of events in the forex market. The Swiss franc, which briefly traded through parity with the euro following the SNB’s early 2015 abandonment of its 1.20 euro floor, has since declined to 1.17 per euro amid ongoing interventions and a negative 0.75% deposit rate, well below the negative 0.4% on “offer” in Europe.
Is a move to less-negative interest rates perhaps the central bank’s next trick? Don’t hold your breath, says SNB president Thomas Jordan. On April 27, Jordan remarked that: “Tightening monetary conditions would be premature at this juncture, and would risk unnecessarily jeopardizing the positive economic momentum that has been established.”
Finally, we turn to the cream of the academic crop, Harvard University. Harvard Management Company returned 8.1% in fiscal 2017, trailing the 19% gain in the S&P 500 and all of its Ivy League peers (it was Harvard’s fourth last place finish in six years). A $1 billion write-down in its natural resources portfolio (Almost Daily Grant’s, May 11) was one culprit.
Newly minted endowment CEO N.P. Narvekar (he joined in December 2016) eschewed happy talk, writing that: “Our performance is disappointing and not where it needs to be. The endowment’s returns are a symptom of deep structural problems at HMC and the resultant significant issues in the portfolio.”
While the SNB is selling big tech, Harvard is buying. According to the recently filed form 13-F, the endowment’s directly managed equity holdings in the first quarter were highly concentrated: Positions in Apple, Inc., Microsoft Corp. and Alphabet, Inc. (née Google) make up an eye-opening 72% of its approximately $817 million in-house U.S. equity long portfolio. As of Dec. 31, the directly managed equity portfolio was mostly invested in ETFs. For reference, total AUM at Harvard was $37.1 billion as of September.
Coming on Monday, the latest edition of the one of a kind Grant’s podcast, with special guests Jonathan Tepper of Variant Perception and John Hempton of Bronte Capital Management. For a sample of Jonathan’s work, follow this link to a recent white paper on how to identify the next market top: http://www.variantperception.com/jimgrant
Recap May 18
Stocks finished slightly lower, wrapping up a low intensity week 0.5% in the red on the S&P 500, while Treasurys caught a bounce with yields finishing lower across the curve. Commodities held steady amid a fresh 2018 high in the Dollar Index, but emerging markets came under pressure with the iShares MSCI Emerging Markets ETF finishing at its lowest closing level since the February sell-off.
- Philip Grant
Thursday, May 17, 2018
BEN down this road
Hasenstab to the rescue! Yesterday, the Financial Times reported that financially ailing Argentina received a timely piece of assistance earlier this week, in the form of $2.25 billion in loans from asset manager Franklin Templeton (BEN on the NYSE) and its star portfolio manager, Michael Hasenstab. Argentina, which was forced to ask the IMF for assistance last week amid a spiraling peso and dwindling FX reserves, was approached by Franklin Templeton to reopen five- and eight-year local currency “Bote” bonds, according to the FT. Luis Caputo, Argentina’s finance minister, was ecstatic, telling Bloomberg that:
You can’t get a bigger sign of confidence from markets when you place a bond in pesos at a fixed-rate on one of the worst days in emerging markets this year. It is a sign of confidence in President [Mauricio] Macri, and the policies he is putting in place.
Templeton is doubling down on Argentina. While the $2.25 billion investment reported in the Financial Times is a fraction of the Bloomberg-tallied $111 billion managed by Hasenstab, his largest funds had already carried a hefty allocation to the Land of Silver: The $38 billion Global Bond Fund had a 4.5% position in Argentina as of March 31, while the EU-domiciled $20 billion Global Total Return Fund, and the $11 billion Emerging Markets Bond Fund carried 7.5% and 10.23% positions, respectively, as of April 30.
Hasenstab and Co. can use a change in fortune: Amid flagging recent performance (the Templeton Global Bond Fund has managed an three year annual return of 2.02%, lagging the 3.45% showing in the benchmark Citigroup World Government Bond Index), Templeton’s fixed income assets have flagged to $277 billion as of April 30, down from $355 billion in mid-2014. Since July 2014, BEN shares have lost 41%, compared to a 47% rise in active management peer T. Rowe Price (TROW on the Nasdaq) and a 38% gain in the S&P 500.
On July 11, 2014, Grant’s offered a bearish appraisal on Templeton (“Sell to whom?”), which was then at the tail end of a charmed run. In the 10 years through 2014, the Templeton Global Bond Fund managed a 9.2% annual return, dusting the 5.3% average global fixed-income portfolio return during that period. Despite (or because of) that success, Hasenstab’s practice of making concentrated bets in illiquid debt instruments was an underappreciated source of risk for Templeton fund investors and BEN shareholders alike, we judged:
What advice might we have for investors in the Franklin Templeton’s star-spangled bond funds? Only that, in any future rush to liquidate, it would be better to be early than late. And for the Franklin Resources’ stockholders, a question: Are you quite sure you know what you own?
Argentina has steadied itself a bit this week, with its peso currently trading at 24.3 per dollar from a close near 25 on Monday, while the dollar-pay century bonds trade at 87.5, up more than two points from the closing lows reached on May 8. Having doubled down on their bullish view on Argentina and with plenty of exposure to other emerging markets, Hasenstab’s funds appear positioned to benefit from any cessation of the recent EM troubles.
Of course, the opposite is also true. Robin Brooks, chief economist of the Institute of International Finance assesses the situation this way: “Rising global interest rates beg the question whether Argentina is an idiosyncratic case or a harbinger of things to come. We worry it might be the latter.” Harvard professor Carmen Reinhart unfavorably compared the present day to the 2013 “taper tantrum” and 2008 , telling Bloomberg that: “The overall shape [emerging markets are in] has a lot more cracks than it did five years ago and certainly at the time of the global financial crisis.”
Watch this “space.”
QT progress report
An $8.6 billion decline in the Fed’s Treasurys holdings left the central banks' portfolio of securities held outright at $4.137 trillion this week, down by $8 billion from a week ago as its mortgage-backed securities holdings ticked up slightly. Compared to the trailing four week average, securities held outright are down by $19.6 billion, $17.3 billion from of the decline from USTs and the remainder from MBS.
Since the Fed began its portfolio run-off on Oct. 1 2017, total portfolio holdings are down by 2.65%, a 4.15% simple annualized pace.
Recap May 17
Stocks finished little changed, continuing the recent consolidation in the S&P 500, which sits lower by less than 0.5% for the week, while commodities, the dollar and the VIX also drifted sideways. The treasury curve steepened as prices sold off at the back end; while the recent flattening has received plenty of attention (including here), the 30-year yield is likewise moving higher. Today’s close of 3.25% in the highest since September 2014, and compares to 2.1% on the July 2016 cyclical lows.
-Philip Grant
Tuesday, May 15, 2018
Where the rubber meets the road
The second-longest postwar expansion on record continues at a humdrum pace.
The second-longest postwar expansion on record continues at a humdrum pace.
Recap May 15
Where the rubber meets the road
The second-longest postwar expansion on record continues at a humdrum pace. Real GDP grew by 2.3% in first quarter compared to a 20-year average growth rate of 2.5%, while retail sales ex-automobiles have grown by an average 0.3% month-over-month through the first four readings of 2018, matching the 20-year average monthly growth rate.
Other indicators are seeing more substantial departures from the norm. Today, the Journal of Commerce reports on the major impact that fast-rising oil prices and post-hurricane rebuilding efforts in Texas and Florida are having on the trucking industry, as spot market rates reached a record $2.72 per mile in the week ending May 5 according to data from Morgan Stanley.
“Flatbed capacity is exceedingly tight and will likely tighten further as milder weather finally arrives in northern regions. There seems to be very large imbalances regionally; creating ‘panic’ freight buying,” one anonymous shipper said in the biweekly Morgan Stanley Truckload Index.
Rates per mile were up 10% for flatbed carrier Daseke, Inc., according to its first-quarter earnings report. Universal Logistics Holdings reported revenue per mile, excluding fuel surcharges, rose 12.7% year-over-year.
“We have not seen a rate environment like this for a long, long time, if ever,” said Robert Ragan, chief financial officer with Melton Truck Lines.
“I’ve never seen anything like this in more than 30 years in business,” added Joyce Brenny, CEO of Brenny Transportation. “Volume was at least manageable a year ago. We were doing well and rates were good. But now it’s out of control and we can’t keep up.” She said new shippers are waiting 10 to 14 days to get an available truck. Last year, the wait was about three days, and during leaner times it was as little as 24 hours.
Of course, one company’s revenue is another’s cost input. The surge in trucking rates is already taking a toll on the consumer goods realm. As noted in an April 24 Wall Street Journal dispatch, a number of senior executives commented on the unwelcome acceleration in transportation costs in the first quarter. Coca-Cola Co. reported a 20% year-over-year rise in freight expense, while Proctor & Gamble Co., Hasboro, Inc., Danone SA and Nestle SA also mentioned higher costs. Consumer staples giant Unilever PLC forecast a high-single digits to high-teens jump in U.S. freight costs this year, with chief financial officer Graeme Pitkethly observing that: “Everybody is seeing an increase.”
Meanwhile, inflation metrics are beginning to demonstrate the upward price pressures described by the logistics and consumer goods executives. April headline CPI grew by 2.5% year-over-year, its hottest reading since February 2017. The New York Fed’s Underlying Inflation Gauge (which aims to capture “sustained moves in inflation from information contained in a broad set of price, real activity and financial data”) was even starker, rising to 3.2% year-over-year in April, the highest since July 2006.
FRBNY Underlying Inflation Gauge. Source: The Bloomberg
These increasingly noisy inflationary rumblings are not lost on the bond market, which has sent the 10-year Treasury yield to as high as 3.09% (highest since 2011) today from 1.36% in mid-2016. The short end has sold off even more dramatically, with the two-year yield reaching as high as 2.58% (highest since 2008) today, up from 0.57% in mid-2016.
Federal Reserve Bank of Dallas president Robert Kaplan isn’t too worried, however. Kaplan forecast in a speech this morning that: “In the medium term, I think inflationary forces are still going to be more muted . . . Most of the forces in the world are deflationary.”
For the sake of ongoing economic growth, Kaplan had better be right. With the spread between the two- and 30-year Treasury yield remaining near multi-year lows at 63 basis points and futures markets currently pricing in a 43% likelihood of three additional 25 basis point rate hikes by December, the potential for an inverted yield curve by year end is non-trivial. San Francisco Fed president John Williams (who is set to take over the New York branch on June 18) termed yield curve inversions “a powerful signal of recessions” in an April speech.
By way of postscript, the longest postwar economic expansion in the U.S. ranged an even 10 years, from March 1991 to March 2001. With the current iteration underway since June 2009, could we be in store for a photo finish?
Recap May 15
A surging greenback and jump in Treasury yields gave equity bears their first victory in nearly two weeks, as the S&P 500 declined moderately amid underperformance from interest rate sensitive groups such as real estate and telecom. Commodities mostly held firm amid the rising dollar, but gold faltered, dropping below $1,300 an ounce for the first time in 2018.
- Philip Grant
Monday, May 14, 2018
Harder they come
It’s a brave new world in the credit market. As overall conditions remain forgiving and issuers take full advantage, leveraged loans, which are structurally senior to high-yield bonds and offer more protection against higher rates thanks to a floating rate structure, have enjoyed disproportionately rapid growth. What sort of surprises might await investors in this burgeoning category when the cyclical worm turns?
Thanks to breakneck growth, the leveraged loan market is almost as big as high-yield. According to data from Bank of America Merrill Lynch and S&P Global Market Intelligence, leveraged loans outstanding in the U.S. exceeded $1 trillion as of year-end 2017, double the year-end 2010 level. By comparison, U.S. high-yield debt outstanding footed to $1.1 trillion at the end of 2017, up less than 25% from 2010. Recent performance bears out the divergence in popularity, with the S&P/LSTA Leveraged Loan Index gaining 1.92% year-to-date, compared to a two basis point loss in the Bloomberg Barclays U.S. Corporate High Yield Total Return Index. However, over the past eight years, high-yield has outperformed handily: The Bloomberg Barclays Index has posted an 81% gain since May 2010, nearly double the 47% advance in S&P/LSTA’s Leveraged Loan Index.
As leveraged loans have taken a progressively more prominent role in credit issuance, lower credit borrowers increasingly abound. S&P Global Intelligence’s LCD unit finds that roughly half the loan market is made up of borrowers rated single-B-plus (“the obligor currently has the capacity to meet its financial commitments on the obligation”) or lower. That compares to 32% at that threshold as of 2007.
It’s not just on the ratings scale that the market has been slumming it. The share of “covenant-lite” loans, ones that are bereft of traditional legal protections for creditors against various issuer maneuvers such as piling on new debt, reached a record 77% of the leveraged loan market in April. That compares to 17% in 2007 and roughly 60% as recently as 2015.
The precipitous decline in covenant quality has recently made for some memorable deals, as issuers continue to push the envelope while docile (or desperate) creditors compete with one another to fund them. One such cyclical keepsake was discussed in the most recent edition of Grant’s (“I Can’t Believe They’re Covenants,” May 4). Another, private equity firm KKR & Co.’s recent buyout of Heartland Dental, was highlighted in a Friday dispatch from Bloomberg.
[KKR] included a bold ask: It wanted credit now for earnings that the company expected to get in the future from offices it had just opened. That helped nearly double a measure of income that will be used to test whether the dental-office services company is making enough money to keep borrowing, according to people familiar with the matter.
Guy LeBas, chief fixed-income strategist at Janney Montgomery Scott LLC, draws a provocative comparison between present day leveraged loans and another popular debt security of cycles past. LeBas told Bloomberg that:
The selling points made to buyers are remarkably similar to those made to buyers of subprime mortgages. Low default rates justify weaker documentation and covenant structures deteriorating, and there’s not a lot of pushback against it. Those are yellow flags.
Credit quality concerns are not confined to the U.S. Across the Atlantic, where European creditors face the additional burden of the ECB and its interest rate repression regime (negative overnight deposit rates and ongoing corporate credit purchases, to be specific), leveraged loan growth has zoomed past that of high yield. S&P calculates leveraged loan issuance at €120 billion last year compared to €94 billion in high yield, with €41 billion and €30 billion issued respectively, year-to-date through April. On Friday, Reuters’ International Financing Review and Loan Pricing Corporation units reported that even some investment bankers have had enough:
Several senior bankers told IFR and LPC that they are increasingly rejecting [underwriting business] solely as the covenant terms and leverage deals requested by sponsors are too aggressive.
“I’m worried about it; the documentation is not pretty. We have more internal checks and committees now on deal teams and that’s paramount,” one leveraged finance head said.
For more on this formerly obscure and increasingly noteworthy cordon of the market, tune in to the most recent edition of the Grant’s podcast, with Covenant Review founder Adam Cohen.
Recap May 14
Stocks settled unchanged, the fourth sideways showing on the S&P 500 in six attempts as volatility remains subdued with the VIX holding at 13. Treasury yields ticked higher across the curve to leave the 10-year near 3%, and commodities and the dollar ticked slightly higher in tandem.
- Philip Grant
Friday, May 11, 2018
Inter-species diplomacy
From the New York Post:
From the New York Post:
Hotel California
We can say this for emerging markets: They are definitely not boring.
We can say this for emerging markets: They are definitely not boring.
Recap May 11
Inter-species diplomacy
From the New York Post:
The owners of a private Canadian zoo have been charged after a bear from their facility was driven in a pickup truck to a Dairy Queen drive-through for an ice cream cone, according to reports.
Wildlife officials found out about the outing after the Discovery Wildlife Park posted a now-deleted video to social media earlier this year showing the 1-year-old Kodiak bear, Berkley, leaning out of the truck’s front passenger window for the frozen treat.
“Bears can smell 20 miles upwind,” the narration states in the video, which aims to provide a message of safety related to bears. Another video, which was also removed, reportedly showed the bear licking frosting off an ice cream cake.
They presumably left the bull back at the zoo. Our kind of people!
Hotel California
We can say this for emerging markets: They are definitely not boring. As investors in developed markets around the world currently enjoy mostly placid conditions, their EM brethren face the opposite. This week alone has seen no shortage of crucial developments. We now detail a trio of such notables.
Yesterday, Malaysia absorbed a seismic political shock, in the form of an upset victory by Mahathir Mohamad, 92 years young. Mohamad, who switched to the opposition party to run against incumbent Najib Razak, returns to the prime minister seat he held from 1981 to 2003 by securing the first change in power to an opposition party in Malaysia’s 61-year independent history.
Investors eager for Mr. Market to weigh in are forced to cool their heels through the weekend, as Thursday and Friday were public holidays. For now, we speculate. Andrey Kuznetsov, credit portfolio manager at Hermes Investment Management, gave his assessment to Finance Asia:
As a result of [former incumbent party Barisan Nasional’s] loss, there will be a small negative for Malaysian credit and we would expect a weaker [Malaysian Ringgit]. Investors will require a higher compensation for policy uncertainty and we will watch closely if the fiscal deficit on the back of implementation of campaign pledges will lead to higher than expected sovereign debt issuance.
While what’s old is new again in Malaysia, the Republic of Turkey contends with a more conventional struggle between market forces and a political strongman used to getting his way. In a speech in Ankara today, Turkish president Recep Erdogan railed against “FX speculators, the interest rate lobby [does that include interest rate observers?] and enemies of Turkey under the guise of credit rating firms.” Recall that Turkey was downgraded to double-B-minus from double-B by S&P on May 2, which followed a cut to Ba2 from Ba1 at Moody’s on March 7.
Erdogan has good reason to be agitated. The Turkish lira continues to spiral, breaking above 4.3 per dollar today, more than 50% below its five-year average dollar exchange rate of 2.85. Amid soaring inflation (CPI has expanded by double digits year-over-year in nine straight months), the country’s bond yields are spiking. The 10-year now yields 13.72%, up from 10.6% in September and 6.1% in May 2013. The short end is faring even worse, with the Turkish two-year yield jumping to 16.14%. That’s up from 11.6% as of September and 4.8% in May 2013.
As for the provenance of this unwelcome reaction, Erdogan has this theories: “Interest rates are the reason for inflation. Inflation is not the cause, it’s an outcome. We’ll pull down interest rates.”
Turkish two-year yield. Source: The Bloomberg
Although comparatively lacking in the rhetoric department, the financial situation in Argentina could be even more dire. The South American land of the Patagonia Mountains, Mendoza wine country and regular sovereign default was compelled to seek IMF assistance earlier this week, as its peso has been clobbered by more than 6% today and 20% in the past three weeks against the dollar, despite regular interventions by the Argentine central bank. The central bank has likewise hiked its seven-day repurchase reference rate to 40% from 27.25% on April 26, to no avail.
IMF president Christine Lagarde struck an optimistic tone after meeting with Argentine Treasury Minister Nicolas Dujovne, noting that: “I stressed my strong support for Argentina’s reforms to date, and expressed the Fund’s readiness to continue to assist the government.” That news is not exactly music to the Argentine people’s ears. An early May poll of more than 1,000 citizens found that 75% of respondents considered president Mauricio Macri’s decision to seek IMF assistance “a bad move,” according to the Associated Press.
While the IMF establishes a beachhead, Harvard University is eyeing the door. Today, Bloomberg reports that: “Harvard Management has approached investors to buy minority or majority stakes in as much as $700 million of property in Brazil, Uruguay and Argentina, and become strategic partners at the same time in an effort to reduce the endowment’s risk.”
Recap May 11
Stocks drifted sideways, wrapping up the week 2.3% in the green on the S&P 500 while the VIX volatility index closed below 13 for the first time since January. Treasury yields mostly ticked higher with the exception of the 30-year long bond, pushing the 5- and 30-year spread to just 26 basis points, the narrowest since June 2007. Commodities broke their winning streak, with energy and metals both finishing broadly lower despite a weaker greenback.
- Philip Grant
Thursday, May 10, 2018
Credit check
Bond bulls caught a reprieve. This morning’s release of the April CPI showed a 2.1% year-over-year increase in core inflation, slightly less than the consensus 2.2%. Although that figure still matches the highest reading since February of last year, the data spurred a bullish response across the Treasury curve, pushing the 10-year yield to 2.97% from an above 3% finish yesterday. Today’s bounce aside, the upward pressure in rates appears intact. The 10-year’s flirtation with 3% compares to 2.4% at year-end 2017 and a reading as low as 1.36% in July 2016.
How has corporate credit fared during this interest rate levitation? Year to date, the iShares Iboxx Investment Grade Corporate Bond ETF has traded lower by 5.4%, while its high yield counterpart has lost only 1.8%. The relative outperformance in high yield comes amid ongoing economic expansion and the powerful rally in energy prices, underpinning the second largest segment of the junk market. (Oil and gas companies comprise 14.5% of U.S. high yield, according to Bloomberg).
Credit investors who favor high-yield over investment grade have a bit of history on their side. During the prior Fed tightening cycle from July 2004 to August 2006 (when the overnight funds rate rose to 5.25% from 1%), the ICE Bank of America Merrill Lynch High Yield Option-Adjusted Spread narrowed to 349 basis points from 402 basis points. During that same period, the ICE Bank of America Merrill Lynch Investment Grade Option Adjusted Spread barely budged, widening to 97 basis points from 96.
A May 4 report from Moody’s further colors the resilience in U.S. high-yield. The ratings agency notes that the Moody’s Liquidity Stress Indicator metric matched its record low of 2.5% in April, “as speculative-grade issuers continue to benefit from a growing U.S. economy, which is fueling strong corporate earnings and cash flow.”
The robust risk appetite currently on display was crystallized by an announcement from soon-to-be Bausch Health Companies, Inc., a.k.a. Valeant Pharmaceuticals International (the company will officially change its name in July). This morning, the B3/single-B-rated, highly leveraged (7.3 times net debt to EBITDA) specialty pharmaceuticals company announced a $5.315 billion offering of loans and bonds to refinance an existing term loan, the third such debt exchange for the leverage-laden specialty pharma concern since December (Almost Daily Grant’s, March 13 and Dec. 5). For a trip down memory lane to Valeant’s high-flying days as acquisitive industry heavyweight, see the issue of Grant’s dated March 7, 2014.
Valeant is looking for more than just better interest rates from its creditors. The company likewise announced its intention to amend its existing credit agreement, including “modifying the [loan] covenants to provide the Company with enhanced operating flexibility,” according to the press release. Jim Schaeffer, co-head of public fixed income at Aegon USA Investment Management, commented to Bloomberg that: “Given the economic environment right now, you’ve got to feel pretty good that there are windows of times for companies to take advantage and refinance maturities in the 2020-to-2022 window.” Indeed. Yesterday, Moody’s reported that its Covenant Quality Indicator remained at its weakest level for a record-setting 12th consecutive month in April.
While U.S. high yield investors sleep soundly, their peers in the world’s second largest economy enjoy no such respite. This morning, Bloomberg reports that yields on Chinese dollar denominated junk bonds rose to their highest since April 2016, above 8% on average, “amid a bulging pipeline and the absence of a strong demand from mainland investors.” A separate Bloomberg dispatch yesterday noted that “Chinese companies are facing a surge in distressed events as more companies struggle with debt payments amid record bond maturities.”
How’s that for decoupling?
QT progress report
No progress this week. The Fed’s portfolio of securities held outright registered at $4.145 trillion, a $68 million uptick from a week ago. An increase in its Treasurys holdings accounted for all of the change. Compared to its trailing four-week average, the Fed’s portfolio is down by $18.4 billion, with 72% of that decline coming from USTs and the rest from its mortgage-backed-securities portfolio.
Since the onset of QT on Oct. 1, 2017, the Fed’s total assets have declined by 2.19%, a simple annualized pace of 3.54%.
Recap May 10
The bull parade continues. Stocks caught another sharp bid, with the S&P 500 rising by nearly 1% for a second straight day to reach a six week closing high, while the VIX finished lower for a sixth straight session. Commodities continued their ascent as the dollar index pulled back, and Treasury yields pushed lower across the long end of the curve amid this morning’s inflation data and a strongly bid 30-year bond auction this afternoon.
- Philip Grant
Wednesday, May 9, 2018
We have ice cream at home, kids
It was an incongruous sight in the midst of what is already the U.S.’ second-longest post-World War II economic expansion, even before the tax cuts.
It was an incongruous sight in the midst of what is already the U.S.’ second-longest post-World War II economic expansion, even before the tax cuts.
Recap May 9
We have ice cream at home, kids
It was an incongruous sight in the midst of what is already the U.S.’ second-longest post-World War II economic expansion, even before the tax cuts. Yesterday, the Wall Street Journal reported that RMH Franchise Holdings, Inc., the second-largest franchise owner of Applebee’s Restaurants, filed for Chapter 11 bankruptcy protection in Delaware court. The franchisee operates 163 locations across 15 states, mostly concentrated in the South and Midwest.
The plight of restaurant franchisees, the subject of a scintillating talk by Franchise Times Corp. president John Hamburger at the Grant’s Spring Conference, is beginning to get the attention of Wall Street. A research report from Piper Jaffray published Monday discussed the tribulations facing banks who are active in lending to restaurant franchisees. The Piper analysts conclude that:
If recent industry profitability metrics persist and certain macro headwinds remain in place (or worsen), we would expect specific reserve allocations to continue to move higher and some [net charge offs] to emerge for certain lenders.
Problems in the restaurant industry are not confined to the franchisees. This morning, The Wendy’s Company (WEN on the Nasdaq) reported first quarter results that included weaker than expected adjusted earnings before interest, taxes, depreciation and amortization as well as slower than expected same store sales growth. The company also alerted investors to “a slight decrease in net new unit growth . . . primarily driven by the timing of North American restaurant closures within the year as we continue to build a stronger system.” On the subsequent conference call, Wendy’s president and CEO Todd Penegor replied to an analyst inquiry on customer store traffic for the broader industry: “To start the year, it’s been slightly down.”
The comprehensive troubles that have befallen the restaurant industry have not spared The Middleby Corporation (MIDD on the Nasdaq), which produces kitchen appliances and capital equipment used in the food-service industry. Middleby also reported first quarter results today, which included a 6.1% year-over-year decline in operating income and a 7.2% year-over-year drop in net sales, after excluding the impact of acquisitions, foreign exchange and accounting standards. Investors were not pleased, sending MIDD shares lower by 17.5%. Since June 2016, Middleby shares have lost 10%, while the S&P 500 has gained 30%.
On the conference call, Middleby CEO Selim A. Bassoul described a schism in the food service industry between the premium products his company carries and the no-frills alternatives that might appeal to more price-conscious operators. Bassoul noted that a franchisee who is under pressure might be more inclined to shop down-market when purchasing equipment.
MIDD shares in the post-crisis era. Source: The Bloomberg
Grant’s offered subscribers a pair of bearish analyses of Middleby in 2016 (“Waiter, the check,” on June 17 and “Out of the kitchen,” on Dec. 23), arguing that the acquisition-heavy company’s long run of operational and stock market success was due to be interrupted by an overcapacity-driven slowdown in the restaurant industry (Middleby derived 59.2% of 2017 revenues and 75% of operating income from its commercial foodservice unit, according to the company’s form 10-K).
The June 16 edition drew a parallel between the post-crisis engorgement in the food service industry (and Middleby’s share price) and macroeconomic factors, namely the near-decade of microscopic interest rates administered by the Federal Reserve in response to said crisis:
It’s a tenet of these pages that low-cost debt pulls demand from the future to the ZIRPy present. Maybe the debt-fueled consolidation of big restaurant franchisees has given a temporal yank to the demand for commercial kitchen machinery.
It was quite a feast. Now, maybe time to hit the gym.
Recap May 9
The bulls have donned their track clothes. Stocks jogged higher, with the S&P 500 gaining nearly 1% to finish at a three week high, while the VIX dropped below 13.5 for the first time since Feb. 1, shortly before the volatility explosion which resulted in the demolition of the VelocityShares Daily Inverse VIX Short Term ETN. Treasury yields rose across the board with the 10-year rising back above 3%, and energy continued its rampage with WTI crude exceeding $71 a barrel despite a flat greenback.
- Philip Grant
Tuesday, May 8, 2018
Ball four
Escalator temporarily out of order. Last week, beverage packaging company Ball Corporation (BLL on the NYSE) delivered first quarter results that easily topped consensus on both the top and bottom lines amid strength in its South American operations, while reiterating its 2018 and 2019 free cash flow and EBITDA (earnings before interest, taxes, depreciation and amortization) forecasts and increasing its share repurchase authorization to boot. John Hayes, Ball’s chairman, president and CEO, didn’t curb his enthusiasm on the conference call, stating that:
Now, as we look forward for our corporation, we are on track to achieve our 2019 targets and longer term, we believe that we have a once-in-a-generation opportunity in front of us right now . . . And we are truly leaning into our efforts to ensure that the world understands with great clarity that aluminum beverage cans are indeed the most sustainable package in the beverage world.
Investors responded to all this good news with a stifled yawn, as shares edged lower by 2%. Since the fall of 2016, BLL shares have barely budged when accounting for a two-for-one stock split in summer 2017, while the market has revved higher to the tune of a near 25% advance on the broad S&P 500.
Ball’s stock price may be stuck in the mud, but the longstanding supplier of steel and aluminum cans still has a friend in Mr. Market. The company trades at a princely 36 times 2017 GAAP earnings, or, for a more fashionable metric, 11 times enterprise value to consensus 2018 adjusted EBITDA (a figure which excludes costs from “business consolidation and other activities,” according to the company’s form 10-K). Likewise, Ball’s 7% free cash flow yield compares to a near-10% free cash flow yield currently on offer in peer Crown Holdings Incorporated (CCK on the NYSE). The sell-side is bullish, with nine buy recommendations against four hold ratings. No analyst says “sell.”
So what explains Ball’s recent underperformance? Intense competition, limited pricing power in the relatively mature global beverage business and the company’s fancy valuation are three apparent constraints. Ball’s 2016 acquisition of London-based Rexam plc for $8.5 billion in cash and stock was the largest deal in the Broomfield, Colo.-headquartered institution’s long history (Ball was founded in 1880), goosing 2017 revenues and adjusted EBITDA by 41% and 62%, respectively, from their 2015 levels. At the time of the acquisition, Hayes targeted $300 million in cost synergies, some 10% of the acquisition target’s 2015 sales. On last week’s call, Hayes demurred on providing an update, telling an analyst that: “We're really not going to talk specifically about synergies because we don't want to get into a discussion about what's a synergy and what's not a synergy. We just are focused on the EBITDA as a corporation.”
A bearish analysis of Ball in the Oct. 28, 2016 edition of Grant’s (“Kicking the can”) noted the less-than bullish circumstances which colored the pair’s mutual courtship.
The tie-up between Ball and Rexam appears to be a countermeasure undertaken in reaction growing consolidation in the beverage business. Many companies invest for growth. We judge that Ball invests not to shrink.
Graham Chipcase, the former Rexam CEO, writing to his shareholders last year, seems to suggest as much: “[C]onsolidation continues in the beverage industry, with customers taking a more coordinated, global approach to procurement to help them lower costs and innovate. They are also demanding a more complex product offering as they seek differentiation and shelf appeal.” Reading Chipcase’s letter and listening to his comments on Rexam conference calls, you understand the appeal of selling out to Ball Corp.
While Ball’s leverage burden appears relatively manageable (Luxembourg-based competitor Ardagh Group carries net debt amounting to 4.8 times adjusted forward EBITDA), the company still bears interest rate risk. Ball’s $7.1 billion in total debt is frontloaded with a relatively short-term maturity schedule, including $1.5 billion in bond principal due in 2020 and an additional $1.8 billion in 2023. Overall the company’s nine bond issues carry a weighted average maturity of less than five years. We can make one fearless interest rate forecast. Ball will be rooting for lower ones.
Meanwhile, Hayes’ upbeat commentary and the recently upsized stock buyback suggests Ball is bullish on itself. Ball management? Less so. In the past year, company insiders have disposed of 268,940 shares in open market sales, netting proceeds of just under $11 million. Vice president Daniel Fisher made the lone open market purchase over the past year, of 9,000 shares on Feb. 27.
Recap May 8
Stocks traded sideways once again, as the range-bound S&P 500 has so far effortlessly digested the persistent recent strength in the dollar. Emerging markets are a different story, as the iShares J.P Morgan Emerging Market Bond ETF (EMB on NYSE Arca) fell to its lowest levels since the February 2016 quasi-bear market while Argentina announced it will seek financial relief from the I.M.F. as its peso continued its free-fall this morning. Only 99.1 years left until maturity on that century bond!
- Philip Grant
Monday, May 7, 2018
The other side of oil
As the price of oil continues to gush, with West Texas intermediate exceeding $70 a barrel for the first time since 2014 (a move made all the more impressive by concurrent strength in the dollar), potential knock-on effects in investment and consumption abound. What sort of impact might higher oil prices have beyond the energy patch?
From a producers’ perspective, a return to the $70 threshold presents competing options. Namely, to increase drilling activity or simply enjoy the improved cash flows that accompany higher prices. Ashley Petersen, lead oil analyst at Stratas Advisors, told Bloomberg that producers will find the first option to be the most compelling one: “It signals to drill. That’s for sure. It signals to them, take advantage of prices while you can.” Scott Hanold of RBC Capital Markets sees things differently, telling clients to: “Expect little change to messaging or 2018 plans as operators continue to view the rally in crude as a boon to cash flow rather than an opportunity to accelerate growth.”
In the Permian basin (the world’s second-most prolific oil field according to Forbes, eclipsed only by Saudi Arabia’s Ghawar), drilling-happy producers must contend with additional complications brought about by higher prices: Namely, supply bottlenecks. Peter Forbes of Bianco Research notes that the Permian region is expected to produce 3.18 million barrels a day (b/d) this year, above its pipeline capacity of 3.08 million b/d. Forbes concludes that “oil prices have risen enough that U.S. shale production will produce as much as raw materials and logistical constraints will allow.”
While higher prices present a high-grade problem for the production industry, the equation for consumers is less nuanced. Higher prices at the pump erode disposable income and act as a governor on consumption. According to data from the Urban-Brookings Tax Policy Center cited in an April 16 piece in the Financial Times, Americans are facing an average $400 fuel cost increase this year compared to 2016, accounting for nearly half of the $930 average gain seen by middle-class households following the fall 2017 tax cuts.
If rising gas prices represent a tax on consumers, then falling ones would seemingly provide a symmetrical benefit. However, the energy crash of 2014-2016 did not bear that out, as seasonally adjusted U.S. real GDP grew by an average of 1.9% between the fourth quarter 2014 and the first quarter 2017, well below its 30-year average quarterly figure of 2.5%. A blog post this morning from PIMCO’s Greg Sharenow and Tiffany Wilding helps explain why:
One of the principal drivers of the atypical economic response was the collapse in U.S. energy investment and the knock-on effects of other upstream industries, which together greatly reduced the net economic benefits of cheaper oil. For instance, U.S. natural gas and oil-related rig counts fell by 80% between the end of 2014 and early 2016, subtracting nearly 0.5% from U.S. real GDP growth.
So, if the benefit to consumers was offset by the curtailment of energy investment in 2014-2016, can we expect the opposite dynamic this time, with pain at the pump balanced by a boom in industry? Not necessarily, say Sharenow and Wilding. Diminished pipeline capacity, worker shortages and the proposed steel and aluminum tariffs all stand as potential impediments to an expansion in energy investment that might be expected to accompany the rally in crude. The pair contends that: “U.S. producers will more likely apply the benefits of higher prices to balance sheet repair rather than investment, while consumers will feel the burden of higher gasoline prices . . . We think investors should expect some economic headwinds and support for rising inflation.”
A whiff of stagflation in the springtime air?
Recap May 7
Stocks gave back the bulk of their early gains but still managed to finish in the green, as the S&P 500 edged back toward the upper end of its tight spring trading range amid a near-2% gain in the tech-centric NYSE FANG+ index. The dollar and commodities continued their dual advance with both the DXY and CRB indices finishing slightly higher, while Treasurys barely budged to leave the 10-year yield at 2.95%.
- Philip Grant
Friday, May 4, 2018
With the kung-fu grip
From the Associated Press:
From the Associated Press:
Pain in the ARS
Mr. Market is manic.
Mr. Market is manic.
Recap May 4
With the kung-fu grip
From the Associated Press:
Allentown, Pa. — A 2-year-old boy who climbed into a claw machine at a Pennsylvania laundromat while trying to retrieve a plush toy was rescued by emergency workers — but never got his prize.
This industrious young lad is well prepared for a future career as an investor in gold stocks.
Pain in the ARS
Mr. Market is manic. On Wednesday, the Republic of Angola sold $3 billion worth of senior unsecured notes across 10- and 30-year maturities. The west-African nation, which is rated B3 at Moody’s (six notches into junk, “judged as being speculative and a high credit risk”) and whose kwanza is “the world’s worst-performing currency in 2018” according to Bloomberg, still got a warm reception from creditors: Those 10-year notes priced to yield 8.25%, down from initial price talk of 8.5% and final guidance of 8.25-8.375%. The 30-year bonds priced at 9.375%, down from initial price talk of 9.625% and guidance of 9.375-9.5%.
Angola’s successful bond offering is placed into relief by the recent struggles of its emerging-market peers, as the snap higher in the dollar and U.S. interest rates has put the screws to a number of highly leveraged foreign borrowers. Following is a look at a trio of those hot spots:
Three weeks ago, Baa2-rated (two notches above junk) Indonesia issued seven-year euro-denominated notes at a coupon of just 1 3/4%. Today, the country shelved plans to issue more debt amid multi-year lows in the Indonesian rupiah and a pair of sovereign bond auctions that fell short of their targets. Luky Alfirman, director-general for budget financing and risk management at the Indonesian Finance Ministry, struck a sanguine tone, telling Bloomberg that: “We are not in any urgency to issue or sell these bonds at any price. When the market was in good shape, we always upsized from our indicative target. We don’t want to get cornered by the market.” The Indonesians still have a friend in Mario Draghi. Those 2025 euro notes are currently trading above par.
Twelve hundred and seventy-five basis points. That is how much the Argentine central bank has raised its benchmark repurchase rate in the past seven days, with the key rate now standing at 40% from 27.25% last Thursday. We promptly return to the Land of Silver, which was covered in Almost Daily Grant’s just three days and six hundred seventy-five basis points ago, as the central bank tries to stem the eye-watering decline in the local currency. Could the third time be the charm? The peso (ARS), which reached 22.25 per dollar this morning from 20.25 on Monday, has since eased to 21.6 per greenback, while the price of the century bonds has jumped to 88.15 cents on the dollar, up from 85.63 yesterday.
Rate hikes, Argentine-style. Source: The Bloomberg
Turkey has encountered its own share of currency woes of late, with the lira also selling off rapidly vs. the dollar (to 4.29 per greenback this morning, compared to 3.4 in September). Government debt is also struggling, with the Turkish 10-year yield rising to 13.76% from 10.59% in September. On Tuesday, S&P downgraded Turkey’s long-term debt rating to double-B-minus from double-B, citing “a deterioration in Turkey's external, inflation, and fiscal outlook beyond our previous base case.”
Political factors loom large. On April 18, President Recep Erdogan called for snap presidential and parliamentary elections to be held on June 24, instead of the initially-scheduled November 2019. His expected victory “could pave the way for a single-party state with few checks on the power of the president,” according to the Guardian.
Do the troika of tremors listed above pose broader risks to investors, in the potential form of a sequel to the 1997-1998 Asian currency crisis? We posed the question to Russell Napier, independent strategist and co-founder of the Electronic Research Interchange, who has identified Turkey as the likely progenitor of the next crisis in emerging markets in previous issues of Grant’s (see the Dec. 1, 2017 edition for instance). Now follows Napier’s complete reply:
There are key differences between the forthcoming debt crisis and the 1997 crisis. The real burden of the crisis falls upon EMs where the foreign currency debt to GDP level has reached levels where an exchange rate devaluation means significant bankruptcies. The work of Carmen Reinhart and Kenneth Rogoff suggests that this occurs, for countries not classified as debt intolerant, when the foreign currency debt to GDP ratio exceeds 35%.
Today this includes Turkey and otherwise primarily countries in Eastern Europe. The debt intolerant countries are those who regularly default on their debts with foreign currency debt to GDP ratios well below 35% and those countries are classified by Reinhart, Rogoff and Savastano in a 2003 paper as Argentina, Brazil, Chile, Colombia, Egypt, Mexico, Philippines, Turkey and Venezuela. So that is quite a list of countries.
The devaluation and subsequent mass defaults by Thai companies in 1997 was not important of itself. What was important is that it produced a major re-evaluation of EM risk and a redirection of capital flows. Similarly the Mexican crisis of 1982 became a global crisis due to the redirection of global capital flows. So if the imminent de facto default by Turkey, likely through the imposition of exchange controls, is to have a more profound impact it will be through the reconsideration of EM risk and thus the redirection of capital flows. In this regard it must be noted that in 1982 and 1997 most of the credit provided from offshore was from banks.
Today things are very different and a significant portion of the credit has been provided by bond investors in both local and foreign currency debt. In 1982 and 1997 equity investors could rush for the exit, due to theoretical liquidity in the equity markets, but debt investors could not. Today bond investors expect to be able to liquidate their portfolios and reduce their exposure but it is highly unlikely that they will find sufficient liquidity to be able to do so.
So either we have greater capital outflows, because this time both debt and equity investors can rush for the exits, or we get bond investors unable to liquidate. If we get the former we get even more downward pressure on EM exchange rates and if the later then an illiquidity event for those who hold EM debt. An inability to liquidate creates a new problem we did not have in 1982 and 1997 because such a large proportion of foreigners’ EM bond holdings are held in open-ended structures.
So this new development spreads a liquidity risk from EM to the developed world which was not something we have witnessed in previous EM busts. Of course the illiquidity falls upon the pensioners/savers of the developed world and not leveraged banks so some would see this as a good thing. We shall see how the pensioners/savers and regulators view it in due course.
The most important difference in this EM debt crisis will be the accepted remedy. All of the statements from the President of Turkey are compatible with the imposition of capital controls to bring the low interest rates and debt relief to Turkey that he has promised many times. Hard form capital controls create a de facto debt moratorium and instant illiquidity. In the Asian crisis only Malaysia responded with capital controls and this was really just as the crisis was ending in September 1998. Today the attitude to capital controls has changed and even the IMF is openly discussing ‘capital flow management’ using ‘regulatory measures.'
Also we live in a different era when market prices are not always assumed to be the correct way to allocate resources. We also have populist leaders in EM who have already shown a willingness to bypass the rule of law. The global financial system has been developed to work with record high leverage and assumes high levels of liquidity. This EM debt crisis is likely to see a much greater resort to capital controls than in 1997 and thus a rapid government enforced illiquidity event which our system is simply not designed for. So we will remember this crisis not for the pain of the disease but the pain of the remedy.
Crucially it appears from the Bank for International Settlements data [see the BIS global liquidity indicators for end-December 2017 for more] that U.S. banks will have little exposure to this EM crisis but European banks will. This has profound impacts for the future of the euro and in the shorter term the dollar/euro exchange rate. The major global impact for financial markets could come from the upward pressure on the dollar that this EM debt crisis creates, not just directly through a rush to repay dollars, debt but through a change in monetary policy in Europe necessitated by the negative impact on banks of an EM debt crisis. The scale of dollar strength is important but a major rally transfers pressure to the biggest and most important of all emerging markets - China.
Recap May 4
Stocks ripped higher, with the S&P 500 all but erasing the week’s losses as rangebound trading continues apace. Commodities continued their impressive rampage, with the broad CRB index breaking to a fresh post-2015 high and WTI crude approaching $70 a barrel, despite another green finish in the U.S. Dollar Index. Treasury yields finished little changed.
- Philip Grant
Thursday, May 3, 2018
Run for the roses
Steady as she goes in the energy patch
Steady as she goes in the energy patch
QT progress report
Recap May 3
Run for the roses
Steady as she goes in the energy patch. On Monday, the price of Brent crude closed at $75.17 per barrel, the best finish since December 2014. One week prior, WTI crude made its own multi-year closing high of $68.64. That gradual upward grind in energy prices has left the savage post-2013 selloff and February 2016 panic lows of $26 a barrel an increasingly distant memory.
The U.S. Energy Information Administration, for one, is not expecting the bull party to continue, forecasting a Brent price of $63 a barrel and WTI crude at $59 a barrel through 2018 and 2019. According to the EIA’s Short Term Energy Outlook report for April, demand questions color the agency’s caution:
Both the United States and China announced potential tariffs on several billion dollars’ worth of each other’s goods in March. A slowdown in global trade could affect oil demand and presents downside risks to the global oil consumption forecast.
Supply is also of potential concern for oil bulls: According to the Department of Energy, U.S. production reached a record 10.62 million barrels a day as of April 27, nearly 50% above the 10-year average of 7.28 million. While OPEC has curtailed its own output from the 2016 highs amid supply cut agreements, its current 31.9 million barrel a day harvest likewise sits above its own 10-year average of 30.8 million.
An overloaded speculative boat presents another potential hazard for the longs. According to the Commodity Futures Trading Commission’s Commitment of Traders, net non-commercial futures positions outstanding stood at 712,423 contracts as of April 24, near the record highs logged on Feb. 6 and almost triple the 10-year average positioning of 239,000 contracts.
Natural resource investors and affirmed oil bulls Leigh Goehring and Adam Rozencwajg are unfazed by the evident storm clouds. Goehring and Rozencwajg’s first quarter investor letter (which also includes an excellent history of the electric vehicle, which has been around since long before Elon Musk burst on the scene) features an emphatic reiteration of their expectation for higher prices:
Since we last wrote, several new developments have emerged, and our outlook has become even more bullish. Most importantly, OECD inventory data continues to confirm that the global oil market remains in substantial deficit and that this deficit is accelerating.
As predicted by our models, global demand estimates for 2018 were revised higher over the past three months by 150,000 barrels a day. While this is a step in the right direction, we continue to believe that further large-scale upward revisions are still required.
On the supply front, the lack of any material investment in the non-OPEC world outside of the U.S. is beginning to significantly impact production . . . We continue to think that a dearth of capital spending in the rest of the of the non-OPEC world will result in sub-par production over the medium term with very bullish implications.
If the above bullish thesis is on the beam, shareholders of oil and gas related equities could be in for a treat.
The pair notes that against the 160% rise in the price of oil from the February 2016 lows, the S&P Oil and Gas Exploration and Production ETF (XOP on NYSE Arca) has gained a relatively meager 63%. The VanEck Vectors Oil Services ETF has risen by just 22%. Goehring and Rozencwajg write that “the radical underperformance of energy-related equities represents a tremendous buying opportunity for investors.”
WTI crude in white, and the OIH oil servicers ETF in orange. Source: The Bloomberg
We at Grant’s agree with that assessment, offering subscribers bullish analyses of a number of energy related stocks since that 2016 winter of discontent (See issues dated Nov. 3, 2017, March 10, 2017 and March 25, 2016 among many others). One such unloved specimen, deep water-driller Transocean Ltd. (RIG on the NYSE) reported ho-hum results on Monday evening, with the stock dropping by 2.7% in reaction. However on the conference call, president and CEO Jeremy Thigpen struck an optimistic tone, telling listeners-in that:
In fact, if oil prices can remain constructive for the next few months, we believe that operator budgets for 2019 could reflect a return to offshore projects sanctioning for 2019 and beyond as the deepwater space has become a more compelling investment proposition for our customers.
Pierre Andurand, founder and chief investment officer of Andurand Commodities Fund, is Goehring, Rozencwajg and Grant’s in high def. On Sunday, Andurand posted a series of (since deleted) messages on Twitter, including: "So paradoxically these peak demand fears might bring the largest supply shock ever. If oil prices do not rise fast enough, $300 oil in a few years is not impossible."
QT progress report
The Fed’s portfolio of securities held outright footed to $4.144 trillion this week, down $17.7 billion from a week ago. More than 100% of the decline can be attributed to a drop in Treasury holdings. The Fed’s portfolio of mortgage-backed securities ticked higher by $5 million. Compared to the trailing four-week average, today’s reading represents a decline of $25.1 billion, with about 70% of that figure comprised of Treasurys and the remainder in MBS.
Since QT got underway on Oct. 1, the Fed’s total asset holdings have declined by 2.23%, for a simple annualized pace of 3.73%.
Recap May 3
Stocks rebounded from sharp early losses to leave the S&P just nominally in the red by the close, while Treasurys were bid across the curve with the 10-year yield dropping back below 2.95%. Commodities enjoyed a strong day, with the broad CRB index rallying to within hailing distance of the multi-year highs logged on April 18. That resilience is impressive considering the outsize strength in the greenback over that period.
- Philip Grant
Tuesday, May 1, 2018
Emerge overkill
The buck is breaking out. After spending nearly all of 2017 in retreat against the bulk of world currencies, the dollar has recently enjoyed a ferocious snapback, with the broad DXY Index up by 3.5% in just two weeks to approach the highs of the year. The index made four-year lows as recently as late January.
As the dollar rebounds, interest rates generally continue their own upward march. The two-year Treasury yield reached 2.51% today, up from 1.88% at year-end 2017 and 1.26% a year ago. While interest rate futures ascribe a slim 4.6% odds of a rate hike at tomorrow’s Fed meeting, the next rate decision on June 13 (which will be followed by a press conference) is looking like a lock with 92.5% odds of tightening. By year-end 2018, the market assigns an 82.4% chance of an overnight Fed Funds rate in excess of 2% from the current range of 1.5% to 1.75%.
That ongoing trudge higher in rates and abrupt dollar turnaround are already proving to be an unwelcome development for overseas borrowers. The iShares J.P. Morgan USD Emerging Markets Bond ETF traded to a 52-week low today, falling for the ninth time in twelve sessions to leave the vehicle, which is about equally made up of investment-grade and high yield issues, sporting a yield-to-worst of 5.95%. That’s a 298 basis point spread over 10-year Treasurys.
EMB vs U.S. Dollar Index, one-year chart: Source: The Bloomberg
Emerging market borrowers were not shy about availing themselves of dollar-denominated debt in the fair macro weather of 2017. Yesterday, the Bank for International Settlements released its global liquidity indicators for year-end 2017, finding that:
Against the backdrop of the depreciation of the U.S. dollar in 2017, the annual growth rate of U.S. dollar credit to non-bank borrowers in [emerging market economies] more than tripled from 3% at end-2016 to 10% at end-2017. This was primarily driven by international debt securities, which grew at an unprecedented annual rate of 22% in the second half of 2017.
That follows the IMF’s Global Financial Stability Report for April, which summarized current conditions and their accompanying risks:
A number of emerging market economies have taken advantage of benign external financial conditions to address imbalances and build buffers; in others, however, vulnerabilities have continued to build. Monetary policy normalization in advanced economies could result in a tightening of global financial conditions and a reduction in capital flows, increasing rollover risk and adversely affecting productive investment. With weaker issuers increasingly able to access capital markets and with fickle investors playing a larger role in recent years, stress amplifiers have risen.
The Argentine Republic’s recent travails provide a textbook example of the IMF’s caveat. In June, Argentina sold $2.75 billion of 100-year sovereign dollar bonds at a 7.25% coupon in a deal that was more than 3.5 times oversubscribed according to Reuters. Those bonds, initially priced at 90 cents on the dollar, rallied to near 104 in October but have since reversed amid a raft of macroeconomic trouble. The Argentine peso, which traded at less than six per dollar in 2013 and 17.3 as recently as December, now fetches nearly 22 per greenback amid persistently high budget deficits and year-over-year CPI inflation above 25%.
Last week, the Argentine central bank spent $4.3 billion in open market purchases of the peso in an attempt to staunch the selloff. When that tactic proved ineffective, the bank raised its overnight lending rate by 300 basis points to 30.25%. While the Land of Silver had steadily accumulated dollar reserves following the replacement of former president Cristina Fernandez de Kirchner with the more business- and investor-friendly Mauricio Macri, those reserves have dwindled to $56.6 billion as of April 27, down from $64.6 billion at the onset of 2018. The century bonds of 2117 have declined to fresh lows near 88 cents on the dollar, for a yield-to-worst of 8.05%. In the meantime, creditors have just over 99 years left until principal repayment.
The June 19, 2017 edition of Almost Daily Grant’s (‘Tine marches on) cited Argentina’s history as a serial sovereign deadbeat. The country has defaulted eight times in its 208 year history. New administration notwithstanding, that pace would imply default at least three times over before maturity of the century bonds based on historical precedent.
For emerging market investors who would like to give themselves a fighting chance at getting their money back, the Argentine 6 7/8 dollar bonds of 2027 are currently priced just under par for a yield to worst of 6.96%, just 110 basis points below the current yield on the century bonds. As for the broader emerging markets realm, creditors had best hope that the current dollar and rate rallies prove little more than a passing trend.
Recap May 1
Stocks finished higher thanks to a late rally, with the S&P 500 finishing more than 1% off its early-afternoon lows as strength in the tech sector (+1.5%) helped pull the broad index into the green. Treasury yields ticked modestly higher across the curve, while the dollar continued its outsize recent strength. The VIX fell below 15.5.
- Philip Grant
Monday, April 30, 2018
Persistence epitomized
Could this lingering courtship finally be consummated?
Could this lingering courtship finally be consummated?
Recap April 30
Persistence epitomized
Could this lingering courtship finally be consummated? Yesterday came the announcement of a long-anticipated, and previously thwarted, merger agreement between telecommunications operators T-Mobile US, Inc. (TMUS on the Nasdaq) and Sprint Corp (S on the NYSE). This would be an all-stock transaction, with Sprint shareholders receiving 0.10256 T-Mobile shares for each Sprint share, or 9.75 Sprint shares for each T-Mobile share. The companies forecast achieving $43 billion of cost synergies as a combined entity. Banks promise $38 billion in committed financing.
For highly-leveraged Sprint, a combination with the financially sturdier T-Mobile could be just what the doctor ordered. In response to the proposed deal, Moody’s announced it is placing Sprint’s credit ratings on review for upgrade, as “the combined company would materially improve Sprint’s standalone credit profile.” This morning, Fitch followed suit, noting that the proposed transaction “is likely to lead to a three-notch upgrade of the [issuer default ratings] and outstanding debt of Sprint Corporation based on existing assumptions.” Not only do Sprint’s creditors hope the deal goes through (the 7 5/8s bonds of both 2025 and 2026 have ticked higher in active trading). Bloomberg reports that CEO Marcelo Claure stands to cash in a $78 million windfall through stock awards and severance payments if the transaction crosses the goal line.
That is a big “if,” as evidenced by today’s 13% plunge in Sprint shares to more than reverse Friday’s rally in anticipation of the deal announcement. Regulatory factors loom large. The two companies had agreed to merger terms in 2014 but scrapped the deal after conceding that regulators would block it on antitrust grounds. In 2011, the Department of Justice did just that, rejecting a proposed merger between T-Mobile and AT&T.
A new presidential administration may help their cause this time around, but that is no guarantee. Indeed, Craig Moffett, founder and eponym of research firm MoffettNathanson LLC, estimates the likelihood of Sprint and T-Mobile being permitted to combine at 50%. Referring back to the 2011 scuttled deal, Moffett writes this morning that:
At the time, both the DOJ and the FCC made the case that we need four, not three, competitors in the wireless market in order to ensure robust competition. While leadership of both agencies has since changed (multiple times), the bulk of the rank and file staffs at both agencies remain.
And the DOJ undoubtedly feels vindicated by their 2011 decision. At the time, AT&T and T-Mobile made precisely the same arguments that Sprint and T-Mobile will make this time around: absent the merger, T-Mobile wouldn’t survive, and certainly wouldn’t be able to make the investments that would be required for it to be competitive. In the time since the DOJ blocked that deal, T-Mobile hasn’t just survived, it has flourished, launching its Uncarrier campaign and taking share in gulps. The result has been lower prices and consumer-friendly business practices such as [early termination fee] buyouts and the end of long-term customer contracts. Consumers have unambiguously benefited from the DOJ’s decision in 2011.
If the stock market’s (and Moffett’s) dim view of regulatory success is on point, Sprint bond holders may be in for a rough road. The company has generated negative $6.1 billion in free cash flow over the past three years, paid $2.38 billion in interest expense last year against $3.05 billion in operating income, and is facing $12.6 billion in debt maturities over the next four years.
Even those less-than cheerful figures are flattered by an accounting technique called the lease plan, to which Sprint and industry peers migrated in recent years from the more conventional subsidy and installment methods, making historical and inter-company comparisons far more difficult. For more details on this bit of bookkeeping magic, see the bearish analysis of Sprint bonds in the Dec. 23, 2016 edition of Grant’s.
Meanwhile, this morning’s release of the PCE deflator showed the Fed’s preferred inflationary gauge rose by 2.0% year-over-year in March, the hottest reading in over a year and well above the post-recession average of 1.4%. Recalling erstwhile Chair Janet Yellen’s July 2017 lamentation of unlimited cell phone plans’ role in holding back the Fed’s hoped-for consumer inflation, we wonder if her successor knows anyone at the DOJ.
Recap April 30
Stocks finished moderately lower on the S&P 500, but in especially un-bullish fashion as the broad index reversed early gains and finished at the low of the day. Treasury yields ticked lower at the long end, flattening the curve as the 10-year yield dropped below 2.95% from the 3.03% seen last Wednesday, and the Dollar Index continued its recent roll, rising for a fourth straight session to bring its two-week gain to nearly 3%.
-Philip Grant
Thursday, April 26, 2018
Your Face is my case
These results helped make some new friends. Facebook, Inc. (FB on the Nasdaq) pleased the Street with rousing first quarter earnings yesterday, easily topping consensus expectation on both the top and bottom lines amid stronger-than-expected reported user growth. In addition, the social networking behemoth is bullish on itself, upsizing the company stock buyback to $9 billion from the $6 billion share repurchase announced in November 2016, helping to further underpin the rally as shares rose by 9%. CEO Mark Zuckerberg kept his eye on the big picture, commenting that:
Despite facing important challenges, our community and business are off to a strong start in 2018. We are taking a broader view of our responsibility and investing to make sure our services are used for good. But we also need to keep building new tools to help people connect, strengthen our communities, and bring the world closer together.
Facebook’s strong quarter surely came as a welcome relief to the legions of bullish sell-side analysts, as 42 buy ratings compare to just two holds and two sells. At least three brokers raised their price targets in reaction, while the consensus price target of $221 a share (26% above the post-rally share price) includes expectations of a 38% year-over-year revenue increase and a 49% uptick in adjusted EBITDA in 2018.
Great expectations. Source: The Bloomberg
One of the lonely FB bears, Brian Wieser of Pivotal Research Group, is sticking to his guns. Wieser wrote this morning that: “While the overall results from the quarter were positive, nothing we heard today causes us to alter our negative view on the stock relative to consensus.” Wieser goes on to cite the erosion of time spent per user metrics in data compiled by Nielsen, natural limitations on the addressable market for advertisements and regulatory risks following the Cambridge Analytica data-harvesting revelations as potential snafu’s as the year unfolds.
For our part, we would note that the mid-March arrival of the Cambridge Analytica scandal was close enough to March 31 quarter end where any financial fallout might not have been immediately apparent. Even prior to the public proliferation of privacy concerns, Facebook’s changing cost structure could present a larger hurdle than the bull crowd anticipates. Corporate headcount totaled 25,105 people at the end of 2017 according to the form 10-K, up 47% year-over-year and 98% from two years ago. A Feb. 22 piece in The Economist notes the economically uncertain value of all those new faces:
Facebook has around 14,000 workers overseeing security, safety, compliance and community operations, twice as many as a year earlier, and that figure is likely to rise as more countries require it to find and remove objectionable content.
Capital expenditures are likewise on the upswing. In November, the company predicted that capex will double this year from the $6.73 billion figure seen in 2017. Shira Ovide of Bloomberg Gadfly notes that that figure “rivals Exxon’s capital spending to drill oil and gas out of the ground” (Exxon’s capex footed to $15.4 billion in 2017). Share-based compensation, too, is climbing. That line item totaled $3.72 billion in 2017, up from $3.22 billion in 2016 and $2.97 billion in 2015. Despite an expected $5 billion year-over-year rise in cash from operations, free cash flow is expected to decline to $15.9 billion in 2018 from $17.5 billion in the year prior, if the sell-side consensus estimate is on the beam.
While bulls may take heart in the upsized share buybacks, they overlook what management is doing with their own money. Mark Zuckerberg, who announced last September his plan to sell between 35 and 75 million FB shares to fund his charitable initiatives, has certainly not dawdled, selling at least 145,000 shares on each trading day in April so far (for context, FB has averaged 22 million shares in average daily volume over the past year). Other higher-ups are cashing out as well. Chief operating officer Sheryl Sandberg sold $8.5 million of FB stock on April 2, followed by an additional $9.2 million on April 18, while chief technology officer Mike Schroepfer unloaded $6.1 million worth of shares on April 10. This continues the aggressive selling patterns documented in prior editions of Almost Daily Grant’s (March 1, Feb. 20, Jan. 22).
Meanwhile, it’s not just the gravitational limits of the advertising market which could constrain the start-up type growth figures that the Street is expecting. There are only so many people in the world to log in and check their accounts. With respect to Facebook’s claim of 185 million daily active users in the U.S. and Canada, deputy editor Evan Lorenz notes that: “Facebook sets the minimum age for an account at 13. Yes, some kids lie but not all tweens are on the platform. Facebook claims 185 million DAU in Canada and the U.S. The World Bank estimates that there are 238.3 million people in the U.S. between the ages of 15 and 64, which is a pretty good approximation of Facebook’s target demographic and age restrictions. That would mean that 78% of Facebook’s target audience in the U.S. and Canada check Facebook every day. That seems high to me.”
Facebook (see the Aug. 11, 2017 edition of Grant’s for more) has been a great business with enviable margins and a clean balance sheet, and has made its early investors wealthy indeed. But as for its future prospects, Grant’s casts our lot with the actions of Mark, Sheryl and Mike. We remain bearish on FB.
Recap April 26
Stocks caught a strong bid, with the S&P 500 virtually erasing the week’s decline amid outperformance in the tech, consumer discretionary and energy realms, while Treasury yields dropped across the curve with the 10-year falling back below 3%. The Dollar Index extended its recent hot streak with another impressive rally, but the commodity complex managed to hold near two and a half year highs on the broad CRB Index.
- Philip Grant
Wednesday, April 25, 2018
"Smart contracts"
A short story, in two parts:
A short story, in two parts:
Dollar bill blues
Is this as good as it gets?
Is this as good as it gets?
Recap April 25
"Smart contracts"
A short story, in two parts:
From a CNBC article published this afternoon, headlined: “Nix the C-suite, soon blockchain will let armies of free agents run companies.”
The days of full-time employment and long-term job stability are coming to an end. Nasdaq estimates that 43 percent of the U.S. workforce will be freelancers by 2020, part of a growing gig economy of project-based jobs.
This morning, from Coindesk:
As many as a dozen or more ethereum-based ERC-20 smart contracts have been found to contain bugs that let attackers create as many tokens as they want.
Dollar bill blues
Is this as good as it gets? Mr. Market has been a little cranky of late, sending stocks down despite phenomenal results. With 154 components of the S&P 500 having reported as of this morning, the average sales (1.97% above consensus) and earnings surprises (7.25% above consensus) are easily the best relative performance in each metric in at least the last eight quarters, according to data from Bloomberg. On an absolute basis, the S&P 500 components have so far managed 10% year-over-year sales growth, far above the top-line growth logged in at least the prior four quarters. Yet since the commencement of earnings season on Feb. 16, the S&P 500 has dropped by 3.4%, a 17% annualized pace.
Yesterday, a number of economic bellwethers offered seemingly solid quarterly results that were met rudely: Shares in truck manufacturer Paccar, Inc. (PCAR on the Nasdaq) dropped by 7% despite topping consensus expectations for the first quarter and offering an upbeat forecast for Class 8 truck sales. Ronald E. Armstrong, chief executive officer, expressed optimism on margins, telling listeners to the earnings conference call that: “We feel good about the operating results. We have the best margins – the best operating margins in the industry.”
Industrial conglomerate 3M Co. (MMM on the NYSE) topped sales forecasts and met the Street’s expected adjusted earnings per share figure, yet shares declined by 7% after the company trimmed the upper end of its fiscal year earnings forecast. Analysts at RBC Capital Markets observed that: “While this guidance cut is relatively small, the implications are magnified, given that it is happening so early in the year.”
Masco Corporation (MAS on the NYSE), a maker of building and home improvement products, saw its shares fall by 9% despite stronger than expected revenues, as higher than expected investment spending and the “price cost relationship in plumbing and cabinetry” dinged the bottom line. Perhaps most instructively, machine and mining equipment giant Caterpillar, Inc. (CAT on the NYSE) reversed strong initial gains following impressive results, after the company CFO Brad Halverson noted on the company conference call that the first quarter “will be the high watermark for the year.”
Meanwhile, a dispatch from Bloomberg this morning details the struggle in the U.S. grocery store industry to raise prices, despite the seemingly perfect macro-economic backdrop for such hikes: Low unemployment, sturdy consumer confidence and an uptick in measured inflation. Instead, an intense competitive environment featuring foreign interlopers Aldi and Lidl, the specter of cross-industry boogeyman Jeff Bezos, as well as diminished brand loyalty on the part of consumers, have put the squeeze to the consumer packaged goods industry (a development which informed the bearish calls on packaged food companies such as Kraft-Heinz Company and Campbell Soup Company in the March 24, 2016 edition of Grant’s). Bloomberg says:
“There’s no question the balance of power has shifted,” said Gary Stibel, who runs the New England Consulting Group, which advises consumer companies. Packaged-food and consumer-product companies aren’t “creating the kind of intense” loyalties that retailers need to be able to pass on higher prices to shoppers, he said.
Overall, corporate profits have remained well above 10% of U.S. gross domestic product in every quarter since the third quarter of 2009, peaking in the fourth quarter of 2014 at 12.6% according to data compiled by the Bureau of Economic Analysis as of Dec. 31, 2017. That compares to a post-1948 average at 9.6% of GDP. In a 2014 essay in Barron’s, co-founder of Boston’s GMO Jeremy Grantham called corporate profit margins “probably the most mean-reverting series in finance.” Grantham subsequently shifted his perspective, writing in a May 2, 2017 Barron’s follow-up that: “I used to call profit margins the most dependably mean-reverting series in finance. And they were through 1997.” Increased globalization, consolidated corporate power, and lower real interest rates were among the factors that influenced the great investor to change his mind.
What if Grantham’s 2014 viewpoint turns out to be the correct one? Needless to say, equity bulls will get no help from valuations. The current Shiller Price/Earnings ratio (based on average inflation-adjusted earnings over the last 10 years) on the S&P 500 stands above 31 times, nearly double the long-term median and mean readings of 16.15 and 16.85 times, respectively.
Recap April 25
Stocks staged an impressive rebound, working higher from a near-one percent opening downdraft on the S&P 500 to leave the broad index in the green and narrow the week’s losses to 1.2%. Rates mostly continued their upward march (the short end was the bullish exception), as a weaker-than expected five-year note auction helped push yields higher with the 10-year reaching 3.03%.
- Philip Grant
Tuesday, April 24, 2018
WeBorrow
Are Tesla or Netflix bonds a little too boring for you?
Are Tesla or Netflix bonds a little too boring for you?
Impulse control
Two debt-laden ships pass in the night.
Two debt-laden ships pass in the night.
Recap April 24
WeBorrow
Are Tesla or Netflix bonds a little too boring for you? WeWork Companies, Inc. has you covered. This morning, the office-space unicorn announced a $500 million offering of unsecured seven-year notes. Rated firmly in junk territory (single-B-plus at S&P Global and double-B-minus at Fitch Ratings), the deal is expected to price on Thursday with use of proceeds slated for general corporate purposes.
The offering prospectus contains no shortage of fascinating details on WeWork. For instance, the directors and executive officers of the company hold approximately 44% of the company’s equity (mostly comprised of the supervoting B shares, where one share entitles a holder to 10 votes, as compared to one for Class A).
According to a Dec. 27, 2016 blogpost from Lawtrades.com, founders usually control somewhere around 20% of their company following a Series-B fundraising round. WeWork, by comparison, completed a Series-G round last July, which valued the company at $20 billion (Softbank Group Corp. invested $4.4 billion in WeWork one month later).
A Bloomberg report on the offering notes that one of WeWork’s biggest selling points could represent a major corporate liability when the real estate cycle shifts.
Lease flexibility, a major perk for WeWork tenants, also poses one of the company’s biggest risks. The company is subject to “mismatched terms” when it takes 10- or 20-year office leases from landlords and then offers companies month-to-month rental options, according to Fitch.
Meanwhile, high-yield investor Xavier MacDuff noted on Twitter that 2017 stock based compensation expense of $261 million represented nearly 30% of last year’s $886 million in revenues. Perhaps unsurprisingly, profitability is currently elusive for WeWork. Instead, the company has provided some alternative metrics to consult. For instance, adjusted EBITDA for 2017 footed to negative $193 million. However, “adjusted EBITDA before growth investments” (a.k.a. adjusted adjusted EBITDA) came in at positive $49 million. Then there’s “Community adjusted EBITDA,” (or, adjusted adjusted adjusted EBITDA) at positive $233 million in 2017.
Choose your own adventure.
Impulse control
Two debt-laden ships pass in the night. As rates in the U.S. mostly ride the escalator, Chinese government yields have enjoyed visible downward momentum in recent months. The 10-year Chinese government bond yield currently sits just under 3.58%, down from 3.9% on Dec. 31, 2017. The move at the short end has been even more pronounced. China’s one-year yield has dropped below 3%, down from more than 3.8% at the turn of 2018. More broadly, Bloomberg notes this morning that “Chinese bonds are the top performers so far this year, among 70 markets in the Bloomberg Barclays Global Aggregate + China index, calculated in dollars.”
While lower rates are surely welcome news for a country as highly leveraged as China (total banking assets represented 305% of GDP as of year-end 2017) the prospects of slower economic growth bear close watching. This morning, a separate Bloomberg report notes a communique from Chinese media seemingly girding its citizens for tougher times ahead:
China’s leaders are giving their strongest signal since 2015 that growth in the world’s second-largest economy could slow – and that they’re prepared to tweak policy if trade or financial risks threaten a sharp deceleration.
Hard work is needed to meet this year’s economic targets amid an increasingly complicated geopolitical situation, according to a statement released by state media Monday following a Politburo meeting led by President Xi Jinping.
“There’s a deep sense of risk underlying the calm surface, and the leadership’s attitude has changed greatly,” Deng Haiqing, chief economist at JZ Securities Co. in Beijing, wrote in a note. “The attention attached to stabilizing growth is the greatest since 2015.”
Indeed, this morning, China-levered global construction and mining equipment firm Caterpillar, Inc. reported stronger than expected first quarter results, extending gains its recent skyward stock price. Those intraday good times were emphatically reversed during the conference call, after chief financial officer Brad Halverson predicted that the first quarter “will be the high watermark for the year.”
So what ails the Middle Kingdom? Waning credit appears to be taking a toll on growth. The Chinese credit impulse (growth in borrowing as a percentage of GDP) dropped to 25.39% as of March 31, the lowest since the 2015 yuan devaluation.
Chinese credit impulse, 10-year view. Source: The Bloomberg
The decline in credit impulse colors both China’s slowing economic growth and downward pressure on interest rates. An April 16 report from J Capital Research summarizes the situation thusly:
Less credit means that companies will be unable to pay their outstanding loans and will instead rely on rollovers. That means more issuance of short-term bonds, wealth-management products, and central bank repos to make sure the system has enough liquidity.
Lower credit growth also tends to be deflationary and to make for slower fixed-asset investment growth. Indeed, the Producer Price Index, while still growing, was up just 3.1% in March and has declined every month since February 2017. As we noted above, the first quarter of 2018 witnessed commodity and asset deflation broadly.
Author Anne Stevenson-Yang summarizes the predicament facing China’s leadership as flagging growth and skyscraping debt levels seemingly argue for opposing policy responses:
The only way to generate growth is by jacking up investment levels, but authorities seem to believe they can generate a more efficient allocation of capital by using tight command-control tactics. When command-control doesn’t work, we expect the government to try stimulus again, and that will threaten the RMB. Q2 will tell us whether the borders have been sufficiently sewn up against capital flight that authorities can engage in another round.
Could another Chinese currency devaluation be in the cards? Recall that the August 2015 yuan deval was followed by a severe bout of global risk aversion, culminating in a 9% intraday decline in the S&P 500 on Aug. 24, 2015. On that day, a trading halt in eight S&P 500 stocks cascaded into an ETF pile-up featuring major dislocations to net asset value and stoppages of 42% of all equity ETF’s. Will this time be different? The bulls hope so.
Recap April 24
Stocks took a tumble, with the S&P 500 falling by 1.3% amid a barrage of bad news in the industrials realm, while tech also fared poorly with the NYSE FAANG+ index dropping by 2.3%. Treasury yields jumped at the long end, temporarily pushing the 10-year yield above 3% as the curve steepened a bit. The VIX caught a relatively modest bid, rising by 10%.
- Philip Grant
Monday, April 23, 2018
Heads I win
The interest rate-beat goes on. This morning, the 10-year Treasury yield touched 2.996%, its highest since January 2014, up from 2.41% at the end of 2017 and 2.06% in September. Movement at the short end of the curve has been even more pronounced, with the two-year yield reaching 2.47% today, up from 1.88% at year-end and 1.26% in September. Rising rates have been driven by fears of inflation. As noted by Gluskin Sheff chief economist (and recent Grant’s conference speaker) David Rosenberg on Twitter, last week’s reading of the Philadelphia Fed Manufacturing Index for April featured the prices paid and prices received components rising to seven- and 10-year highs, respectively.
Some corridors of the financial sphere are tweaking their behavior to adapt to the dearer cost of money. On April 8, the Financial Times reported on bourgeoning competition among banks for customer deposits in the U.S., noting that: “The most aggressive attempt to woo savers have been launched by Popular, a $44 billion-in-assets lender based in Puerto Rico, which is offering a 2% annual rate on an online instant access account . . . A survey of 370 bankers by Promontory Interfinancial Network, a fintech group that manages institutional deposits, found four-fifths were expecting deposit competition to increase in 2018.”
By contrast, it’s been business as usual in the high-yield credit market. The ICE BofAML US High Yield Master II Option-Adjusted Spread currently stands at 333 basis points over Treasurys, down from 363 basis points at year-end 2017. Even in the early February spasm of risk aversion which knocked 10% off the S&P 500 and vaporized numerous short-volatility positions, the high yield spread edged higher to just 382 basis points, a paucity compared to the 853 basis point interim peak reached on Feb. 10, 2016. Colleague Fabiano Santin notes that the narrowing in spreads echoes what took place during the early stages of the Fed’s prior tightening cycle, covering 2004 to 2007.
Issuers are not ignorant of their favorable current position. On Thursday, Moody’s released a report concluding that its Loan Covenant Quality Indicator gauge “finished 2017 at its weakest yearly level on record, suggesting significant future risks to loan investors . . . today’s loan investors continue to face unprecedented risks as they forfeit key levers that have traditionally been available when a borrower is starting to experience financial distress.”
This morning, Ba3/single-B-plus rated Netflix, Inc., announced an offering of $1.9 billion in 5 7/8% senior notes (upsized from an initial $1.5 billion figure) due in 2028. That follows a $1.6 billion offering of 4 7/8% senior unsecured notes of 2028 in October, currently trading at 96 cents on the dollar for a yield-to-worst of 5.40%, and €1.3 billion in euro-denominated 3 5/8 senior unsecured notes of 2027 offered in April 2017, which, under the loving embrace of Mario Draghi’s ECB, sit just below par for a yield-to-worst of 3.70%. The content juggernaut, which has seen exponential growth in its revenues, stock price and free cash flow burn in recent years, is leaning progressively harder against a bond market to finance its operations, while credit investors have thus far been all too happy to comply.
While an investment in Netflix common equity has proved extremely lucrative in recent years (the stock is up by 66% in 2018 alone), bondholders are assured of earning nothing more than the return of their principal, and some interest income. If all goes well. If it doesn’t? The March 10, 2017 edition of Grant’s (“You only get par”) took note of the particularly poor value proposition provided to creditors of such a speculative business at such modest rates of interest:
Netflix, which will celebrate its 20th birthday this summer, has adapted to changing tastes before. Maybe it will again – or maybe it won’t. If not, the stockholders may lose everything, and the noteholders, too, would likely take a haircut. Default-induced losses might reach 35% of par value, according to S&P, or 68% of par according to Moody’s (both estimates date from October 2016). Comparing the risk-reward proposition at which the noteholders are staring, we recall the candid remark of a late private-equity giant. Referring to the insurance-company bond departments who financed the leveraged acquisitions of a generation ago, the titan shook his head. What chumps, he said.
A Jan. 26, 2018 follow-up (“Like no business”) distilled the dual tracks taken by Netflix investors and creditors: “It’s a speculative business, the content business, but if it works, you, the creditors, will get your money back. The stockholders get rich. Everybody’s happy.”
NFLX 4 7/8s of 2028 in white, stock price in orange. Source: The Bloomberg
Recap April 23
Stocks drifted through a low-key session to finish unchanged on the S&P 500, while Treasury yields ticked higher across the board with the notable exception of the 30-year long bond. The greenback caught another bid, with the U.S. Dollar Index reaching a three month high. That USD strength seemed to pressure the commodity complex, as the broad CRB index fell by more than 0.50%, but energy bucked that bearish trend. WTI crude rose to nearly $69/barrel, its highest since December 2014.
- Philip Grant
Friday, April 20, 2018
In Memoriam
Martin Whitman, value investor,
Martin Whitman, value investor,
Peas in a pod
We’ll see if this one is better than cubic zirconia.
We’ll see if this one is better than cubic zirconia.
Recap April 20
In Memoriam
Martin Whitman, value investor, author and teacher extraordinaire who founded Third Avenue Management in 1986, died at the age of 93 on Monday. Whitman, who co-wrote the investment tome “Modern Security Analysis” (a copy of which has long resided on this author’s paper-strewn desk), was a great thinker as well. In an April 2009 interview with Steve Forbes, Whitman aptly identified both the harrowing financial conditions and remarkable opportunity which characterized that post-crisis era.
Well, obviously, Steve, it’s the worst thing I’ve seen in my lifetime. And the interesting thing about it, I used to say it was like ’74, or ’75. And it turned out it’s really much worse, and in many senses, much better. From the top down, from the macro view, things could not suck more than they do suck. From a bottom-up point of view, there have never been, in my lifetime, as attractive securities as are available today at the price you can get them.
In an obituary of Whitman, Barron’s noted that although the Third Avenue founder ceded his day-to-day management duties at the fund in 2012, “he scoffed at the idea of retirement and rode the subway into the office, even several years later, almost every day.”
Peas in a pod
We’ll see if this one is better than cubic zirconia. This morning, the Wall Street Journal reports that private equity giant Apollo Global Management LLC is set to conduct an IPO of its recently acquired portfolio company Diamond Resorts International, Inc., (formerly DRII on the NYSE). The Journal’s sources peg a prospective valuation for the timeshare resorts business at $4 billion. That figure would represent a big win for Apollo, which paid $2.2 billion in cash (along with the assumption of $863 million in debt) to acquire Diamond in September 2016.
For Apollo, which was founded in 1990 by Drexel Burnham Lambert alum Leon Black, the projected victory comes after some less-successful bets. Another 2016 vintage deal, this one for upscale grocer The Fresh Market, Inc., (formerly TFM on the NYSE) has run aground amid fierce competition aggravated by Amazon.com, Inc.’s purchase of Whole Foods. Those difficult operating conditions have sunk Fresh Market’s 9 3/4 notes of 2023 (issued in April 2016 at 99) to 59 cents on the dollar for a yield-to-worst of 24.33% and compelled Apollo to toss TFM a financial lifeline last October. Bloomberg noted on Oct. 11 that:
Apollo is known for trying to safeguard its investments, sometimes at the expense of other debt holders. But its recent loan to Fresh Market is unusual: The $50 million loan, without collateral, is junior to all other Fresh Market debt and pays an effective 6%. Retailer Restoration Hardware paid a 9.5% coupon in July on a secured loan also provided by Apollo.
“The company needs working capital, and Apollo needs to keep it alive to preserve its equity,” said Mark Kaufman, a senior analyst in distressed debt at brokerage firm Ramirez & Co.
On March 19, Apollo-owned teen retailer Claire’s Stores Inc., filed for bankruptcy, reaching an agreement with its creditors to restructure some $1.9 billion in debt. It didn’t take long for the reorganization to become contentious. On March 21, S&P Global Intelligence’s LCD unit reported on a dispute between Apollo and Oaktree Capital Management, which held a majority stake in Claire’s second-lien notes. While Apollo claimed that Oaktree was non-responsive when it asked for a reorganization plan proposal, the asset manager had a different recollection (from LCD):
But according to Oaktree, it did not learn until days before the Chapter 11 filing that the company was negotiating a [restructuring support agreement], and when it did become aware of that fact, it “promptly” sent a proposal to the company “premised on a valuation in line with the debtors’ management projections and which contemplated a recovery of value for holders of second-lien notes and unsecured claims.”
At that point, according to Oaktree, the company “refused to meaningfully discuss – let alone negotiate – the proposal with Oaktree.”
Turning to the contemplated reorganization plan itself, Oaktree said the plan was “deeply offensive to fundamental principles underlying the Chapter 11 process,” specifically alleging that . . . certain senior creditors will recover more than 100% of claims while junior creditors will be wiped out, that votes are “being purchased” from first-lien creditors . . . and that the new money being raised by the plan “is not even needed.”
Another unusual Apollo saga concerned Dutch company CEVA Logistics Ltd., which the private equity firm purchased in 2006 and is angling to IPO this summer according to a Feb. 26 dispatch from Reuters. On March 29, logistics industry news site The Loadstar reported on another lawsuit against Apollo by former CEVA executives, alleging that despite a valuation estimate of up to $3.75 billion from analysts at Morgan Stanley in 2013, Apollo that year surreptitiously undertook a debt-for-equity swap which wiped out their personal holdings in the company, stakes which Apollo mandated the executives hold in service of “skin in the game”:
According to court documents, one manager, who had borrowed $102,000 for the “requirement for all senior managers to have an investment in the company,” contacted the defendant in November 2012 inquiring about his investment. He was informed that “the investment remains in the care of the company. There is not currently a process that would enable you to exit the plan by selling your CEVA Investments Limited stock.”
According to the court filing, the response made no mention of CEVA Investments being in a precarious financial situation. Yet just five months later, the shareholder received the latter stating that his shares in CEVA Investments were now worthless.
Even in more conventional private equity deals does Apollo stand out from the crowd. In fall 2016, Apollo issued $1.2 billion in debt to finance its leveraged buyout of cloud computing company Rackspace, Inc., (which was the subject of a bearish Grant’s analysis on Jan. 25, 2013, subsequently falling by more than 50% before going private) under issuer-terms stark enough to draw some pointed commentary from credit analysts. From International Financing Review:
Covenant Review’s head of high-yield research Anthony Canale highlighted a provision that could even deprive bondholders of the right to a call premium in the event of a covenant breach.
“Language like this is really egregious,” he told IFR. “This is among the worst covenant packages Apollo has ever issued.”
Covenant Review called that provision “outrageous” and “unprecedented,” while rating agency Moody’s assigned the whole covenant package a grade of “weakest.”
As for Diamond Resorts, Grant’s conducted a bearish analysis of the financing-happy timeshare operator on Dec. 11, 2015, shortly before the company fell into Apollo’s embrace. While the timing of our conclusion was certainly unfortunate, (Apollo paid a 24% premium to DRII’s then-current valuation), we await Diamond’s return to the public markets with no little interest.
Recap April 20
Stocks came under pressure, with the broad S&P 500 sinking by 1% amid downside leadership from tech and the consumer realm to all but erase this week’s gains. Treasury yields jumped higher across the curve to leave the 10-year yield at 2.96%, its highest since 2014, and commodities and the dollar both managed to finish in the green.
- Philip Grant
Thursday, April 19, 2018
Notable quotable
Bill Miller, of Legg Mason Capital Management fame, on Twitter this morning:
Bill Miller, of Legg Mason Capital Management fame, on Twitter this morning:
In season
Tax day has come and gone, but, for holders of U.S. government debt, a different sort of confiscation continues apace.
Tax day has come and gone, but, for holders of U.S. government debt, a different sort of confiscation continues apace.
QT Progress report
Recap April 19
Notable quotable
Bill Miller, of Legg Mason Capital Management fame, on Twitter this morning:
Here is the way to think about Bitcoin. There are 17 million Bitcoins outstanding, each costing about $8000. Are there 17 million people in the world who could afford 1 Bitcoin? That would hoover up all the supply and corner the market.
Think?
In season
Tax day has come and gone, but, for holders of U.S. government debt, a different sort of confiscation continues apace. This morning, the 10-year Treasury yield jumped back above 2.91%, back within three basis points of the multi-year highs logged on Feb. 21. The short end has of course seen an even more pronounced move, with the two-year yield barely pausing in its run higher to 2.43% from 0.55% on July 5, 2016. Interestingly, the upward pressure on Uncle Sam’s borrowing costs has occurred independent of other key bond categories.
For instance, domestic high yield bonds have largely gone the other direction. Today, the BarCap US Corporate High Yield Spread tightened for a fifth straight session, to 311 basis points over the 10-year Treasury. That’s down from 355 basis points in the middle of February and a five year average of 399 basis points.
U.S. Government debt is likewise given the short shift relative to Europe’s economic powerhouse. The spread between the 10-year Treasury and German bund yields ballooned to a record high (going back to German reunification in 1989) of 2.34% yesterday. The two were at virtual parity as recently as June 2012.
There is an array of economic, monetary, and fiscal developments which could help explain the move. This morning’s release of the April Philadelphia Fed Business Manufacturing Index printed at 23.2, well above the consensus expectation of 21. Although just a regional survey (it covers the Pennsylvania, New Jersey and Delaware regions), the uninterrupted strength of the conditions gauge is noteworthy. April marked the seventeenth straight reading above 20 for the survey (a figure above zero denotes expansion). That compares to a 10-year average of 6.26 and is the longest uninterrupted string of 20-plus readings since the early 1970’s.
Yesterday, New York Fed President William Dudley gave a speech at Lehman College in the Bronx, arguing that the so-called neutral rate of interest (the point at which monetary policy is neither loose nor tight) is “around 1%” higher than the rate of inflation. With “core” CPI currently running at 2.1%, Dudley’s remarks imply the potential for far more rate hikes than the market currently anticipates. At the same time, the N.Y. Fed’s Underlying Inflation Gauge for March printed at 3.14%, the tenth straight sequential increase and the highest reading since July 2006, when the 10-year note yielded 4.98%.
N.Y. Fed’s Underlying Inflation Gauge (in white) against the 10-year Treasury yield (in orange). Source: The Bloomberg
Then there’s the fiscal factor. The March 23 omnibus spending bill, overlaid on last year’s tax cuts, looks to worsen an already grim budgetary picture as Federal debt has more than doubled in the past decade to $20.5 trillion as of year-end 2017. Kevin Duffy, principal at Bearing Asset Management in Dallas, noted to Grant’s that “Since DJT took office, the [annual] federal deficit has expanded by 26%. The $1 trillion mark is within reach, especially considering the Social Security and Medicare trust funds are slated to go cash flow negative in 2020.” In 2004, then Vice President Dick Cheney commented that: “Reagan proved that deficits don’t matter.” We might tweak that phrasing to, “they haven’t mattered.”
However, for all the news, data and price action seemingly auguring a new bond bear market regime, the long-time bond-bulls par excellence at Hoisington Investment Management are steadfast in calling for lower rates, an opinion of which any investor (or interest rate observer for that matter) would be wise to take heed. In the Hoisington Quarterly Review and Outlook for the first quarter 2018, Van Hoisington and Lacy Hunt take note of the tightening Fed and fiscal folly, yet come to an opposite conclusion.
Nearly nine years into the current economic expansion Federal Reserve policy actions appear to be benign, as even after six increases, the federal funds rate remains less than 2%. Changes in the reserve, monetary and credit aggregates, which have always been the most important Fed levers both theoretically and empirically, indicate however that central bank policy has turned highly restrictive. These conditions put the economy’s growth at risk over the short run, while sizable increases in federal debt will serve to diminish, not enhance, economic growth over the long run.
Important to the long-term investor is the pernicious impact of exploding debt yields. This condition will slow economic growth, and the resulting poor economic conditions will lead to lower inflation and thereby lower long-term interest rates. This suggests that high quality yields may be difficult to obtain within the next decade. In the shorter run, in accordance with [economist Milton] Friedman’s established theory, the current monetary deceleration, or restrictive monetary policy, will bring about lower long-term interest rates.
Will cyclical forces, bolstered by an aggressively tightening (and asset selling, via QT) Fed and crushing government debt burden, formulate an economic accident and lead to yet another downward break in interest rates? Investors have been well served to avoid betting against Hoisington and Hunt during the 35 year (and counting?) bull cycle in credit, but all cycles eventually turn.
QT Progress report
The Fed’s portfolio of securities held outright registered at $4.173 trillion, up by $1.94 billion from a week ago and the second straight sequential uptick. Both mortgage backed securities ($1.92 billion) and Treasury holdings ($19 million) rose week-over-week. Compared to the trailing four-week average, securities held outright are down by $6.1 billion, with the bulk of that decline ($5.8 billion) in Treasury holdings.
Since QT began on Oct. 1, 2017, The Fed’s total balance sheet has declined by 1.57%, for a simple annualized pace of 2.8%.
Recap April 19
Stocks finished moderately lower, as the S&P consumer staples index was hammered to the tune of 3.1% after cigarette maker Philip Morris International disclosed a larger than expected decline in first quarter volumes. Treasury yields ticked mostly higher across the curve (the two-year note was the bullish exception), and commodities pulled back after breaking to fresh post-2015 highs yesterday on the broad CRB Index.
- Philip Grant
Tuesday, April 17, 2018
Fjord focus
“Global debt rose to a record $237 trillion in the fourth quarter of 2017, more than $70 trillion higher from a decade earlier,
“Global debt rose to a record $237 trillion in the fourth quarter of 2017, more than $70 trillion higher from a decade earlier,
Recap April 17
Fjord focus
“Global debt rose to a record $237 trillion in the fourth quarter of 2017, more than $70 trillion higher from a decade earlier, according to an analysis by the Institute of International Finance.” That unambiguous lead, from a Bloomberg article last Tuesday, makes for a notable companion to the recent surge in U.S. borrowing costs. The London interbank offered rate, quoted at 0.28% on April 17, 2015, has rode a relentless grind higher to 2.36% as of today.
What sort of toll might rising debt loads and rising interest rates (as measured by Libor) take on leveraged speculators around the globe? One country that looks uniquely exposed to a regime change in credit is Norway, which features heavy encumbrance and less-than stringent financial regulation.
Norway’s household debt footed to 230% of disposable income as of year-end 2016, according to the Organization for Economic Co-operation and Development. That’s third highest among the OECD’s 35 country coverage realm, behind only Nordic peer Denmark and the Netherlands. That ratio has consistently inched, rather than skyrocketed, higher in recent years. The OECD calculates Norway’s 2009 household debt as having been at 206 percent of disposable income.
While a heavy Norwegian debt burden is nothing new, a recent turn in the Nordic nation’s formerly red-hot housing market bears close watching. According to Statistics Norway, the country’s house price index has enjoyed a 71% rise since the end of 2008 (house prices suffered only a shallow pullback in that infamous year), with annual gains accelerating to more than 10% in 2016, the year in which global interest rates perhaps bottomed. That housing bull market appeared to abate in 2017 as prices held steady, while the first quarter of this year saw a 1.1% year-over-year decline in the index, the first such drop since June 30, 2009. “Tighter mortgage regulations, lower population growth and a boom in construction” are among the culprits, per an April 5 dispatch from Reuters.
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They do have this going for them. Source: G Adventures
Meanwhile inflation appears to be firming. Norway’s headline CPI for March came in at 2.2%, matching February’s figure for the highest since spring of 2017. The local central bank, Norges Bank, has kept its overnight lending rate at 0.5% since March 2016 and has not raised interest rates in since 2011. The Norwegian 10-year nominal yield of 1.79% leaves bondholders more than 40 basis points in the red in real terms.
Not just in the realm of consumer debt is Norway a financial standout. While the U.S. leveraged loan market has increasingly been dominated by issuer friendly “covenant-lite” terms (S&P Global Market Intelligence’s LCD unit calculates that 77% of the $994 billion in outstanding leveraged loans are so classified, up from 60% at the end of 2014), the Norwegians have us beat once more. This morning, Bloomberg reported on the travails of Lebara Group B.V., which produces mobile phone “Sim” cards:
Debt issued in Nordic nations requires no credit rating or due diligence. Companies can claim more or less what they like when selling new debt, according to Norway’s financial-market regulator.
“In Nordic high yield you can easily think you’re buying a Ferrari and it turns out it’s not,” said Evgeny Artemenkov, a high-yield money manager at Saatstopankki in Helsinki, which bought some of the notes. “The bond was issued using different numbers from what should have been used.”
The debt has cratered more than 30 percent as Palmarium, the little-known private fund that used the bond proceeds to finance its purchase of Lebara, restated its accounts four times in six weeks. They called it a “genuine mistake.”
Norway’s financial foundation may be put to the test sooner rather than later, as forces beyond domestic inflation put the screws to interest rates. Last week, Bloomberg reported on a secondary impact of rising Libor, namely a parallel surge in Norway’s floating-rate benchmark Nibor, to which some 1 trillion kroner ($127 billion) in floating-rate securities are benchmarked.
The gyrations in the Norwegian money market rates is also once again prompting calls for an overhaul of the interbank market and how liquidity is managed. “We could see some adjustments from the central bank given the high volatility,” said Jostein Tvedt, strategist at Danske Bank in Oslo.
It seems to us that when cyclical troubles in credit reappear, those troubles will find their way to the land of Vikings and pickled herring.
Recap April 17
Stocks ripped higher again, with Netflix, Inc.’s near-10% gain after results underpinning a near 4% advance in the NYSE FAANG+ tech index and more than 1% gain in the broad S&P 500, while the VIX dropped for a sixth straight day to approach its interim lows logged in March. The Treasury curve flattened a bit with short yields drifting higher and the long end catching a bid, and the broad CRB commodity index was once again halted at the doorstep of its January interim peak, with fresh 2.5-year highs awaiting above.
- Philip Grant
Monday, April 16, 2018
Well to do
It was not an ideal start to the week. Investors in National Oilwell Varco, Inc. (NOV on the NYSE)
It was not an ideal start to the week. Investors in National Oilwell Varco, Inc. (NOV on the NYSE)
Recap April 16
Well to do
It was not an ideal start to the week. Investors in National Oilwell Varco, Inc. (NOV on the NYSE) were greeted rudely this morning by a press release providing “an operational update for the first quarter.” As frequently follows that ominous headline, the company had bad news to impart: Customer deferrals of capital equipment orders will result in sequential revenue declines across its three business lines (drilling rigs, well service and fracking pumps).
The oilfield infrastructure company now expects $160 million of adjusted EBITDA for the period, well below the analyst consensus of $189 million. National Oilwell chairman, president and CEO Clay C. Williams, attempted to mitigate the bearish revelation by commenting that “industry fundamentals continue to improve, and we remain optimistic regarding the second quarter and the remainder of the year.”
That rhetorical silver lining aside, Mr. Market saw fit to mark down NOV stock by 7% to $38 per share. The sell-side was likewise vexed. Analysts at Tudor Pickering Securities termed the numbers “considerably softer” than its expectations, while Capital One Securities, Inc., observed that today’s revelation “will rattle that [bull] thesis a bit more.” In aggregate, the Street is definitely not bullish: Bloomberg counts eight buy ratings, 22 holds and four sells among analysts who cover the company.
Even before today’s setback, it’s been a tough road of late for NOV. The company, which earned $4 billion in adjusted earnings before interest, taxes, depreciation and amortization and generated $2.8 billion in free cash flow in 2013 (the tail end of the prior energy bull market), saw its adjusted EBITDA and FCF fall to just $621 million and $640 million, respectively, in 2017. That precipitous drop-off of course coincides with the post-2014 freefall in energy prices. A barrel of West Texas Intermediate crude, which fetched $108 as recently as June 2014, sank as low as $26 in February 2016. It has since recovered to $66.
Into the teeth of that ferocious decline, Grant’s, in the issue dated Jan. 29, 2016, offered a bullish word for National Oilwell as an investment and its then-freshly spun-off NYSE-listed supply-distribution subsidiary, Now, Inc., as a speculation. The crux of the analysis: While NOV’s stock price has long acted as a leveraged proxy for broader circumstances in energy prices, the company’s solid financial position (even after multiple downgrades in 2016, Moody’s and S&P rate National Oilwell’s default risk at Baa1 and triple-B-plus, respectively, well within investment grade status) would allow time for conditions to improve and, hopefully for the longs, a new energy bull market to take shape.
As for the cyclical, mean-reverting and self-correcting interactions of supply and demand, the market historian Edward Chancellor’s Jan. 21, 2016 analysis in Reuters’ Breakingviews argued that the then-painful bear market was setting the stage for a glorious bullish future:
The old adage that “the best cure for high prices is high prices” also works in reverse. During the boom phase of the commodity supercycle, rising investment pushed supply up and prices down. In similar fashion, today’s capital spending cuts by energy producers are setting the stage for the next bull market in oil.
The basic insight of so-called capital-cycle analysis is that demand forecasts are inherently unreliable – who knows how many cars the Chinese will be driving in 20 years time? Supply is much easier to predict. As independent investment strategist Russell Napier puts it, “investors spend 90 percent of their time thinking about demand and 10 percent thinking about supply. It should be the other way around.” This explains why investors and industry insiders have read the bull phase of the commodity cycle so badly. During the boom, they fantasized about the prospects for Chinese demand, while largely ignoring the massive increase in commodity supply.
Most investors espouse a belief in mean reversion – the notion that markets return to stable equilibrium price – but they ignore how it comes about. Mean reversion largely operates through changes on the supply side. Rising output prices and profitability in most industries tend to elicit an investment response. In time, the increase in production serves to bring down prices.
As for Grant’s upbeat verdict in NOV, the jury is still out. After today’s selloff, NOV shares have returned 19.5% with dividends reinvested since publication date, while Now, Inc., shares (DNOW is the ticker) have since fallen by 14% after reversing a strong rally through 2016. That trails the 24.4% logged by the S&P 500 with dividend reinvestment and a 26% gain in the S&P 500 Energy Index during that period. Duly dissatisfied by today’s news, we remain bullish.
Source: The Bloomberg
Recap April 16
Stocks jumped higher, as the S&P 500 traded to three week highs amid broad-based strength, with all eleven sector groups well in the green. In turn the VIX dropped to a one month low and the iShares High Yield Corporate Bond ETF rose for a sixth straight day to log its highest close since the end of February. Treasury yields finished little changed, and the CRB commodity index was unable to break through the January interim highs despite a weaker dollar.
- Philip Grant
Friday, April 13, 2018
Metaphor overload
From Wednesday’s edition of the Sacramento Bee:
From Wednesday’s edition of the Sacramento Bee:
Lending labyrinth
It’s still early, but 2018 could thus far be termed, the “Year of the Whipsaw.”
It’s still early, but 2018 could thus far be termed, the “Year of the Whipsaw.”
Recap April 13
Metaphor overload
From Wednesday’s edition of the Sacramento Bee:
A fire-gutted house in Silicon Valley has hit the market for $800,000.
While that might seem a tad pricey for an uninhabitable, burned-out hulk, Realtor Holly Barr told KTVU the price reflects the value of the property, not the ruined house currently occupying the lot. The house burned down two years ago.
A post Monday on the Willow Glen Charm page on Facebook lists a $799,000 asking price. Barr told KTVU she’s already received at least 10 offers and expects to sell the property in the next few days.
On the bright side, the house’s foundation is still intact and no landslide threatens the property. So too, can a prospective buyer factor in cheap moving costs. It’s basically a steal!
Lending labyrinth
It’s still early, but 2018 could thus far be termed, the “Year of the Whipsaw.” As the major equity indices dart to and fro in a manner unseen last year, economic signals impart no obvious regime change. Unemployment is low and job growth is slow, while GDP continues to expand at a plodding rate.
Interest rates, as measured by the shape of the yield curve, are moving more decisively. While the benchmark 10-year yield remains below its December 2013 interim highs, the short end has raced higher with the two-year yield jumping above 2.3% to its highest since 2007. That divergence has compressed the spread between the two rates to less than 47 basis points, narrowest since the financial crisis. Customarily, a flat or inverted yield curve signals a market expectation of slower growth ahead.
Barring an abrupt monetary change of course, that spread looks set to narrow further. Longer yields have come down in recent months, yet interest rate futures currently price in 69% odds of at least two more 25 basis point hikes in the overnight Fed Funds rate this year, following such moves in December and March. Interbank lending rates, as measured by Libor (the London interbank offered rate), have risen even more quickly, more than erasing a 30 basis point discount to the two-year Treasury yield at the beginning of the current monetary tightening cycle.
At least one member of the Federal Reserve board is pondering an even faster turn of the short-end screws. In a speech this morning, Boston Fed president Eric Rosengren took note of the tight labor market (headline unemployment came in at just 4.1% in March, matching its post-2000 low) and forecast a further tightening of the labor market and inflation uptick. Rosengren, currently a non-voting member of the Fed, went on to provide his prescription: “Therefore, I expect somewhat more tightening may end up being needed than is currently reflected in the projected median for the federal funds rate.”
Rosengren’s remarks beg the question: What sort of consequences might follow a further rise in short-term rates, particularly in interbank lending? For the domestic money center banks at least, so far, so good. This morning, J.P. Morgan Chase & Co. reported record first quarter net income of $8.7 billion, a 35% jump year-over-year, while Citigroup, Inc. and Wells Fargo & Co. (which is in regulatory purgatory after a series of scandals) reported year-over-year gains in net income of 13% and 5.5%, respectively. According to Bloomberg, the stronger bottom lines are at least partially attributable to higher lending rates:
The largest U.S. lenders could each make at least $1 billion in additional pretax profit in 2018 from a jump in the London interbank offered rate for dollars, based on data disclosed by the companies. That’s because customers who take out loans are forced to pay more as Libor rises while the banks’ own cost of credit has mostly held steady.
“During the 2008 crisis, [rising Libor] was the sign capital markets were frozen,” said Fred Cannon, head of research at Keefe, Bruyette & Woods. “Now there’s all this liquidity, so they don’t need to borrow in the Eurodollar market,” where rates are based on Libor, he said.
Of course, for every lender there’s a borrower, and if some constituencies benefit from a change in credit conditions, others must suffer. Yesterday, a Bloomberg dispatch identified one group of unfortunates: “Default risks are rising for U.S. companies with high leverage and floating-rate debt as Libor jumps.”
While floating rate borrowers’ exposure to a rising Libor is no breaking news, the move is causing pain in far-flung places. Here’s Bloomberg again, this time on Wednesday:
Norwegian households and companies are feeling the sting from policy choices across the Atlantic. Growing U.S. deficits have triggered a deluge in Treasury bill supply, helping drive up the London interbank offered rate and a key dollar-financing indicator that feed directly into the benchmark Norwegian interbank rate.
If the surge continues, banks in the Nordic country may be forced to raise mortgage rates, perhaps giving the central bank pause as it prepares to tighten for the first time in seven years after the summer.
The Land of the Midnight Sun is particularly poorly positioned for rising borrowing costs: The Organization for Economic Co-Operation and Development calculates Norway’s ratio of household debt to disposable income at a towering 230% as of year-end 2016; only the Netherlands (270%) and Denmark (285%) are more encumbered within the OECD’s 34 country data set.
For more on Norway and its debt-heavy and negative-rate-happy Nordic peers, see the Nov. 30, 2017 edition of Almost Daily Grant’s (“Prognosis negative"). For more on the potential impact of rising borrowing costs on the legion of cash flow-negative “zombie companies” which increasingly stalk the business landscape, see the March 23, 2018 edition of Grant’s (“The nine lives of the modern leveraged company”).
Recap April 13
Stocks ticked slightly lower, allowing the broad S&P 500 to preserve the bulk of its recent gains and end the week 2% in the green. Commodities likewise remained well bid, with the CRB index finishing the week higher by nearly 4% and continuing to knock on the door of multi-year highs.
Crypto-currencies also enjoyed a bullish reversal, with the price of bitcoin jumping nearly 18% in the past two trading days. In the past year, bitcoin has acted as a decent proxy for risk appetite, with its gyrations corresponding fairly well with those of the S&P 500.
Source: The Bloomberg
- Philip Grant
Thursday, April 12, 2018
Passive aggressive
This Wall Street heavyweight still packs a punch.
This Wall Street heavyweight still packs a punch.
QT progress report
Recap April 12
Passive aggressive
This Wall Street heavyweight still packs a punch. BlackRock, Inc. (BLK on the NYSE) announced first quarter results that, on the income statement at least, came in above the Street’s consensus expectation. Adjusted earnings per share of $6.70 exceeded even the most bullish analyst forecast of $6.55, while first quarter revenues of $3.58 billion matched the sell-side’s high estimate. BlackRock CEO Laurence Fink commented: “In a challenging environment, BlackRock continued to perform well.” The market agreed. BLK shares rose by 2%, and have tacked on nearly 50% from their Sept. 30, 2016 levels, compared to a 23% gain from the S&P 500.
Source: The Bloomberg
It wasn’t all peaches and cream for the house that Fink built. BlackRock’s assets under management of $6.32 trillion trailed the $6.41 trillion analyst consensus, while net flows for its iShares ETF business declined by 46% year-over-year to $34.6 billion. Strength in the firm’s technology and risk management unit (headlined by the operating system known as “Aladdin,” BlackRock’s technological pride and joy) which grew revenues by 19% year-over-year, was a primary factor. A lower than expected tax rate helped, too.
The fast-growing, low-cost ETF and indexation businesses have contended with intense competition in recent years, as new offerings continue to emerge. Yesterday, the Financial Times reported that the international arm of Fidelity Investments, Inc., “has returned fire on its rivals in the ferocious price war being fought by investment managers in Europe – with a new range of low-cost index-tracking funds.”
The growing ubiquity of ETFs and indices is pressuring the industry bottom line. Bloomberg Intelligence calculates that “ETFs charging 0.2 percent [20 basis points] or less have accounted for 82 percent of the industry’s net flows this year, up from 77 percent in the fourth quarter.” BlackRock’s primary competitor in the realm, the Vanguard Group, is seemingly approaching the end of the line on fee cuts, according to a March 17 report by the FT:
Last year Vanguard dropped the expenses on 62 share classes – down nearly two-thirds on 2016’s number. The company cut the fees on just nine exchange traded funds, down from 42 the year before.
The average fee cut in 2016 was 2.4 basis points, which fell to 1.6bps last year, according to Daniel Wiener, editor of the Independent Advisor for Vanguard Investors, a newsletter that closely tracks the company. He said Vanguard was no longer the “champion cost cutter.”
Asked for comment on fees, a Vanguard spokesman told Grant’s that: “No other asset manager comes close to our asset-weighted complex-wide expense ratio of 0.11%.”
Meanwhile, the historic market calm that characterized 2017 has been replaced by something entirely different so far this year. The CBOE’s VIX volatility index, which averaged just over 11 last year, has jumped to nearly 18 on average in 2018 thus far. Vanguard’s founder and chairman emeritus, the estimable 66-year Wall Street veteran Jack Bogle, is definitely not downplaying the significance of this change. Bogle told CNBC last week that: “I have never seen a market this volatile to this extent in my career . . . I’ve seen two 50 percent declines, I’ve seen a 25 percent decline in one day and I’ve never seen anything like this before.”
The alarm expressed by Bogle is put into relief by a Goldman Sachs report out Wednesday. Goldman finds that:
For the first time in six years, the volatility of the S&P 500 has been greater than the volatility of the most shorted stocks. This suggests investors that short stocks (i.e. Hedge Funds) are not making big changes to their positions on a daily basis, while investors that trade at the index level are rapidly changing their positioning.
We believe it is increasingly important for portfolio managers to know how much of their stocks are owned by passive funds as that appears to be one of the primary sources of recent volatility.
For his part, Larry Fink is undaunted by the recent financial regime change. On a CNBC appearance this morning, the BlackRock boss didn’t mince words in explaining his bullish stance: “You should be 100 percent in equities. We spend too much time talking about market timing. The key for investors is to stay in the market.”
In a Sept. 30, 2016 analysis (“House of fads”), Grant’s offered a bearish view of BlackRock, contending that an interruption of the virtuous cycle of microscopic interest rates, expanding risk appetite and absent volatility could spell trouble for the behemoth asset manager.
To be clear, a bet against BlackRock is a bet on discontinuity – on a break in the central bank-induced levitation or on the fad for passive investment vehicles or on the malfunction of the technology about which BlackRock is so prone to boast.
To be sure, that discontinuity appeared no short time after (see the aforementioned BLK performance figures) and may not be here to stay in 2018. Nevertheless, as for BlackRock and central bank-induced tranquility alike, we remain bearish.
QT progress report
Steady as she goes. After last week’s $12 billion, Treasurys-driven decline, the Fed’s portfolio of securities held outright ticked higher by $30 million this week to $4.172 trillion. Holdings of mortgage-backed securities ($1 million), and Treasurys ($29 million) holdings both rose from last Thursday’s levels.
Compared to the trailing four-week average, securities held outright are down by $14.5 billion, with $8.7 billion of the decline from USTs and the balance from MBS. Since QT began on Oct. 1, 2017, the Fed’s total assets have declined by 1.62%, for a simple annualized pace of 2.99%.
Recap April 12
Stocks caught a strong bid, with the S&P 500 reaching its highest close in more than three weeks as strength in the financials, industrials and tech overcame weakness in rate-sensitive groups as UST yields jumped higher across the curve. Commodities reversed early losses despite a stronger dollar, with the broad CRB index now testing the two and a half-year highs reached in January, and the VIX dropped below 19.
- Philip Grant
Wednesday, April 11, 2018
Attention, deficit disorder
That recently-dormant beast called inflation is stirring.
That recently-dormant beast called inflation is stirring.
Recap April 11
Attention, deficit disorder
That recently-dormant beast called inflation is stirring. This morning, the Consumer Price Index for March showed a 2.4% year-over-year uptick in the headline component, with “core” CPI (that’s without food and energy) also jumping by a sturdy 2.1% year-over-year, the highest in over a year for both readings. That follows yesterday’s figures from the Labor Department reporting that the Producer Price Index jumped by 3.0% year-over-year in March. Strip out food and energy, and the 2.7% year-over-year reading was the hottest since 2011.
The private sector corroborates the government’s statistical findings. Yesterday, the National Federation of Independent Business released its Small Business Optimism Index for March, finding that a “net 25 percent plan price hikes (up 1 point), the highest reading since 2008.” The Federation cites upward pressure on wages as a catalyst: “With reports of increased compensation running high, there is more pressure to pass these costs on in higher selling prices, although tax cuts and growing operating profits alleviate some of this pressure.”
Those inflationary sightings arrive in tandem with fiscal prognostications that could be described as grim. On Monday, the Congressional Budget Office released its updated Budget and Economic Outlook: 2018-2028. The CBO now estimates that the annual budget deficit will exceed $1 trillion in 2020, two years earlier than the agency’s June 2017 forecast. Over the next 10 years, the CBO now anticipates a cumulative $12.4 trillion shortfall, that’s up 23% from last June’s estimate and represents 4.9% of expected GDP (compared to 2017’s shortfall of 3.5% of GDP). Federal debt held by the public, which footed to $14.7 trillion as of Dec. 31, 2017, is expected to virtually double to $28.7 trillion in 2028.
Does the uptick in measured inflation and the fast-deteriorating fiscal picture portend a higher interest rate regime? Not necessarily, we can infer from the work of Paul Schmelzing, history professor of Harvard University and visiting scholar at the Bank of England. Schmelzing conducted an analysis of the sovereign bond market going back to the 13th century, specifically utilizing the so-called risk free rate cobbled together from the world’s most credit-worthy borrower in each era. As documented in the Nov. 17, 2017 edition of Grant’s, Schmelzing “concludes that fiscal deficits don’t matter, at least not in the setting of bond yields [and] that the average real rate of interest since the year 1311 stands at 4.78%.”
That proposition, with the near-millennium of statistical weight which underlies it, will be put to the test. Uncle Sam is set to borrow 4.2% of GDP next year according to the CBO, the most since the end of World War II in 1945, after adjusting net issuance for the Fed’s “QT” Treasury sales (the Bernanke era would have seen greater growth in public debt relative to GDP were it not for the Fed’s asset purchases). Meanwhile, the economic backdrop remains benign. The current expansion in output stands at 106 months and counting and, as of April, is tied for second longest since 1854 when such records were first kept.
The Feb. 9 Grant’s featured an analysis of the United States’ fiscal foibles, and drew a psychological contrast between the bond market’s current complacency in the face of a torrent of new debt and the conditions which prevailed in the prior bear market of 1946-1981.
“Markets make opinions,” said the departed Richard Russell. In a bear market, new supply is perceived to be bearish, or at least not bullish (another tautology freighted with trading wisdom). Supply is thought to be bearish not, perhaps, because the supply is greater than the demand for bonds at prevailing yields and prices (though that is certainly true), but because the very thought of fixed-income securities has become repellant. That attitude, and its opposite, are years in gestation. “The bond crop never fails” was how disgusted fixed-income investors expressed their free flowing hatred (or love-hatred, as the opportunities for reinvestment of coupon income were forever improving) of an asset class that had disappointed so many for so long. From which it would follow that the Cheney/Reagan deficit doctrine [they don’t matter] is due for cyclical revision.
For the bond market, what’s old is new again.
Recap April 11
Stocks saw a moderate decline, with the S&P paring its gains from earlier in the week and remaining within a relatively tight trading range compared to the past two months. Treasurys caught a bid, with the 10-year yield edging lower to 2.78%, while commodities enjoyed a third straight rally, with the broad CRB index now up by nearly 3.5% for the week and within range of its multi-year closing highs reached on Jan. 26.
- Philip Grant
Monday, April 9, 2018
The Son also rises
This bull-market avatar is doubling down: Japan’s SoftBank Group Corp. (9984 on the Tokyo Exchange and SFTBY on the U.S. Pink Sheets) announced on Friday that it has secured an $8 billion margin loan from a consortium of investment banks backed by its stake in China’s Alibaba Group Holding, Inc. (BABA on the NYSE).
This was one for the record books. Bethany Knight of Riverside Risk Advisors LLC told Bloomberg that: “To my knowledge, I would agree that $8 billion is the largest margin loan ever.” Bloomberg notes that the loan helps SoftBank move closer to an initial public offering of its domestic telecom business Softbank Corp., which had already been utilized as collateral for prior loans. “A successful IPO – possible only after the division proves its independence by canceling debt guarantees – could help the parent raise capital and relieve some of its debt burden.”
On March 9, SoftBank launched a debt exchange offer, presenting its creditors the opportunity to swap existing bonds for new notes due in 2028 for a 100 basis point consent fee. Covenant Review, an independent credit research firm, observed that this was no act of corporate generosity. Holders of existing notes are protected by a covenant stating that if SoftBank loses its investment grade status its telecom subsidiary, Softbank Corp., will guarantee the debt. That protection is set to be eliminated.
So when investors purchased the Existing Notes, they knew that at worst either the Existing Notes would be rated investment grade or the Softbank Corp. guarantee would remain in place. If the Proposed Amendments are successful, then holders would have swapped that protection for the consent fee – and the Existing Notes could well be left with neither an investment grade rating nor a continuing guarantee from Softbank Corp. (or any other subsidiaries for that matter).
Longtime observers of SoftBank’s charismatic and brilliant CEO Masayoshi Son (who is often compared to Warren Buffett) could hardly have been surprised by this latest bold corporate maneuver. Son, who weathered a 99% loss in Softbank shares following the bursting of the late-1990’s tech bubble, has taken full advantage of the easy money and tech-happy market conditions which have pervaded in the post-2009 era. Softbank shares have advanced by 442% over the past nine years in yen terms (20.7% annualized) outpacing the Nikkei’s 142% gain (11% annualized) over that period.
That impressive rebound, burnished by timely investments in Yahoo! Japan, and the aforementioned Alibaba, has coincided with a flurry of deals, some under the umbrella of SoftBank’s buyout arm, the $100 billion Vision Fund. Last February, SoftBank bought the Fortress Investment Group for $3.3 billion, a hefty 38.6% premium. On Aug. 24, the fund paid $4.4 billion for a minority stake in private concern WeWork Companies, Inc. (founded in 2010 and now the second largest private office tenant in Manhattan). Softbank has also made substantial investments in ride-sharing unicorns Uber Technologies, Inc. and its Chinese peer, Didi Chuxing Technology Co. (which is preparing to commence operations in Mexico, according to Caixin, directly challenging its fellow SoftBank portfolio company).
#1 conglomerate. Source: Softbank presentation PowerPoint slide from Feb. 7
Masa Son’s spendthrift ways haven’t always gone over so smoothly in the company C-suite. On Feb. 26, the Wall Street Journal shed light on the friction between Son and SoftBank directors who don’t always share his deal-making enthusiasm.
Shigenobu Nagamori says he objected when Mr. Son told his board in 2016 that he wanted to pay $32 billion from Arm Holdings PLC. The U.K. chip-design firm was worth a 10th of that, Mr. Nagamori, then a Softbank outside director, says he told Mr. Son. Mr. Son paid it anyway.
To strike quickly, [Son] sometimes commits to investments before getting approval from his fund’s investment committee, some of these people say. And he often spars with his executives and board members over his proposals until they are convinced or acquiesce.
“I’ve opposed almost all of Mr. Son’s proposed investments,” says SoftBank director Tadashi Yanai, president of Fast Retailing Co., operator of Uniqlo clothing stores. Instead of acting like a speculative investor, he says, Mr. Son should focus on “real business.”
A month later, the Journal reported that the dynamics among SoftBank insiders have escalated beyond straightforward strategy disagreements. Specifically intriguing was the mysterious origins of a shareholder campaign to discredit a pair of senior executives at the company, including one (Nikesh Arora), whom the WSJ described as a one-time heir apparent to Son.
At the time, SoftBank couldn’t figure out who was behind the campaign, which the company said was based on false allegations of impropriety and which a board member later called “sabotage.” Both men denied wrongdoing and said they were victims.
People with knowledge of the matter said Alessandro Benedetti, an Italian private-equity investor, was a central figure in that campaign. They said he told associates he was working, in part, for the benefits of a SoftBank insider.
Excessive leverage and value-destructive deals, not palace intrigue, was the crux of a Dec. 15, 2017 bearish assessment of Softbank found in the pages of Grant’s. Total debt reached $154 billion as of Dec. 31, 2017 on a consolidated basis, up from $42 billion on Dec. 31, 2013. Son’s 2013 purchase of U.S. telecom operator Sprint Corp. (SoftBank paid $22 billion for an 83% stake. Sprint’s current market cap is less than $21 billion) is one potential source of trouble, an interruption of Alibaba’s charmed existence is another. The conclusion drawn by Grant’s was evident in the piece’s headline, “Epitome of the cycle:”
Mix the CEO’s exuberance with cheap debt, high leverage and record asset values. Add the excitement of today’s startling advances in robotics and artificial intelligence. Combine with the karmic report that [Saudi Crown Prince Mohammad bin Salman], the Vision Fund’s No. 1 limited partner, is also the rumored buyer of that $450 million road-show da Vinci. Totting them all up, what do you have? Perhaps a corporation destined to read about itself on page one of The New York Times – and not in a flattering way.
Recap April 9
Stocks finished green but well off their intraday highs, with the VIX a reciprocal late surge to back above 22 by the close. Treasury yields finished little changed, while commodities were bid strongly with the broad CRB index gaining 1.4%.
- Philip Grant
Friday, April 6, 2018
The overpromised land
Terrific weather, a booming tech-led economy and lots to do: Who wouldn’t want to live in the City by the Bay?
Terrific weather, a booming tech-led economy and lots to do: Who wouldn’t want to live in the City by the Bay?
Not just for Snickers bars
For all the talk of a trade war, China and the United States share major economic commonalities,
For all the talk of a trade war, China and the United States share major economic commonalities,
Recap April 6
The overpromised land
Terrific weather, a booming tech-led economy and lots to do: Who wouldn’t want to live in the City by the Bay? An April 4 dispatch from the San Francisco Business Times identifies one small hang-up for prospective NorCal dwellers:
San Francisco’s median home price surged to a new record of $1.61 million in the first quarter, amid falling supply and the booming tech industry.
Home prices were up almost 24 percent from the first quarter of 2017’s median price of $1.3 million, according to Multiple Listings Service Data analyzed by brokerage Paragon Real Estate. The price was up $100,000 from the previous quarter.
“I’m pretty surprised that we’ve started 2018 in this sort of frenzy. This may be hotter than ever,” said Patrick Carlisle, chief market analyst at Paragon. “There’s a raging hunger for people to get into homes.”
Rather rent? Real estate blog Curbed S.F. has some options, as presented in an April 5 post headed: “What $8,000 [per month] rents you in San Francisco right now.”
Unsurprisingly, most people are hard pressed to come up with such princely sums. The Feb. 26, 2018 edition of Almost Daily Grant’s (“Flowers out of your hair”) cited data from Paragon finding that only 12% of San Francisco residents manage to earn a household income of $303,000, the figure which would allow for a 20% down payment on a median-priced home in the final three months of 2017 (that’s prior to the latest sequential increase in prices).
What to do when the financial math just doesn’t add up? Hit the bricks. Mark J. Perry, economics professor at the University of Michigan, found in February that the going rate for a U-Haul rental truck from San Jose to Las Vegas was priced at a whopping $1,990, while the same van going in the other direction could be had for just $121.
The food is terrible. And the portions are so small!
Not just for Snickers bars
For all the talk of a trade war, China and the United States share major economic commonalities, including activist central banks, freewheeling fiscal policy and a love of leverage. Another, more particular similarity, automobile vending machines. Today’s Wall Street Journal explains:
Eric Zhou is interested in buying a Ford Kuga sport-utility vehicle. So last week, he picked up the car for a three-day test drive from a vending machine.
Mr. Zhou never visited a dealership or spoke to a salesperson. He booked the test drive online, then showed up at a service center where employees can identify would-be buyers using facial recognition technology. His SUV was then delivered from the eight-story “vending machine” – essentially an automated parking garage.
“This is so much more efficient and convenient than traditional dealerships,” said Mr. Zhou, 38 years old.
Stateside, the Carvana Co. (CVNA on the NYSE), is bringing that same automated auto dream to the American used car buyer. Yesterday, the Kansas City Star reported that Carvana has filed plans to build a vending machine in Kansas City, according to a local development tracking website. The new location will join existing contraptions in nine other cities located in Texas and the southeast.
Carvana itself could be described as a kind of investment contraption. Spun-off from DriveTime Automotive Group in 2014, Carvana made its public debut in April of last year as an “emerging growth company” under the 2012 JOBS Act. That designation allows CVNA “to take advantage of certain exemptions from various reporting requirements that apply to other public companies, including, but not limited to, scaled disclosure provisions with respect to financial information and executive compensation.”
The financial information that is available shows brisk top-line growth, with revenues jumping to $859 million in 2017 from $365 million in the year prior, while a generally bullish sell-side (featuring seven buy ratings, five holds and a solitary sell) expects revenues to jump to $1.8 billion this year and $3.2 billion in 2019. The stock price, which hovered in the single digits last spring, remains near recent highs north of $22 a share.
Source: The Bloomberg
As revenues increase, so do losses. Adjusted net income rose to negative $72 million this year from negative $64 million a year ago, with the Street expecting the bottom line to be $185 million in the red this year and a $57 million loss in 2019. Free cash flow of negative $279 million in 2017 will be followed by negative $226 million this year and an additional negative $142 million in 2019, if the Street is on the beam. A credit facility with Ally Financial and convertible preferred stock issuance is helping to finance this currently loss-making enterprise.
Like moths to a flame have short sellers converged on Carvana; no less than 58% of the float is sold short according to Bloomberg. So too, does the controlling family have an interesting back-story. For more, see the June 6, 2017 edition of Almost Daily Grant’s (“Full speed ahead”).
Recap April 6
Stocks were clubbed to wrap up the week, with the S&P 500 sinking back to within 1% of its 2018 nadir, while Treasury yields dropped in relative lockstep across the curve. The dollar and commodities traded lower in tandem, and the VIX ambled higher to settle near 21.5.
- Philip Grant
Thursday, April 5, 2018
Vehicle vestibule
It’s alive! Much like Frankenstein’s monster, the automobile market has been jolted back to life by an external shock, this one in the form of the hurricanes which pounded large swaths of the United States last summer. After sales ebbed to a seasonally adjusted annualized rate (SAAR) of 16.03 million in August of last year (the lowest reading since early 2014), the arrival of destructive storms such as Harvey and Irma coincided with an abrupt rebound in sales: Ward’s Automotive Group calculates an average 17.57 million SAAR in the following seven months through March.
For industry leading-used vehicle retailer CarMax, Inc., (KMX on the NYSE), the uptick in new car sales didn’t translate into much good news. CarMax reported fourth quarter earnings yesterday (covering December to February), featuring revenues and earnings per share that each came in well shy of the sell-side consensus, while same store sales declined by a meaty 8% year-over-year. KMX shares enjoyed a bounce in response, although the company’s 5% decline since February 2017 lags the 13% gain from the S&P 500 over that period.
Still in the garage. KMX in white and the SPX in orange. Source: The Bloomberg
Volume, not price, was the culprit. While Carmax’s gross profit per used vehicle inched higher to $2,147 amid a 2.5% year-over-year uptick in average selling price, used vehicle unit sales fell by 3.1% from their year-ago level. The large drop in volumes coupled with sturdy unit profits suggests a conscious decision to hold the line on pricing by KMX management, even as industrywide incentive spending continues to increase.
Average incentive spending rose for a 35th straight month in February according to Autodata, reaching $3,695 per unit from $3,594 year-over-year. For his part, CarMax CEO William Nash observed on the company’s conference call that “incentives have started to come down a bit.” Rising acquisition costs for used and wholesale vehicles were a bigger factor, with Nash noting that “the pricing environment . . . really hits us on two sides. It’s not only that acquisition prices went up on all inventory, but I also think there was pressure on the spread . . . between a late-model used car and a new car both because of our acquisition price going up and new car prices coming down in relative terms year-over-year.”
Taking inventory of an auto market that we judged vulnerable to both credit mishaps and a retrenchment in the used car prices which underpin trade-in activity, Grant’s took a bearish view on CarMax on Feb. 24, 2017 (“Disabled vehicles”). A Feb. 23, 2018 follow-up analysis (“Clunkers, Inc.”) focused on the price vs. volume conundrum facing KMX amid intensifying competitive pressures:
Strong prices were a tonic for CarMax’s revenue growth in the sweet phase of the cycle. From Feb. 28, 2009 to Nov. 30, 2015, the company’s average CarMax selling price ticked up by 23.3%, or 3.2% per annum, to $20,094. Over the same six years and nine months, the CarMax top line swelled by 93.2%, or 10.2% per annum, to $3.5 billion.
If yesterday’s results are any guide, CarMax’s decision to hold the line on pricing has taken a toll on activity. Meanwhile, the credit wheel keeps turning. CarMax’s auto finance unit reported a 21.9% year-over-year uptick in net income during the quarter as its provision for loan losses declined by 16.7% and average managed receivables jumped by 9.4%. Those sunny trends stand in seeming contrast with a Monday report from Bloomberg headed “Subprime New-Car Buyers Suddenly Go Missing from U.S. Showrooms.”
Rising interest rates and new vehicle prices are squeezing shoppers with shaky credit and tight budgets out of the market. In the first two months of the year, sales were flat among the highest-rated borrowers, while deliveries to those with subprime scores slumped 9 percent, according to J.D. Power.
As a corporate entity, CarMax is bullish on itself. On Feb. 28, 2017, the company announced a $4.55 billion share buyback, following a $2 billion repurchase authorization announced on Oct. 22, 2014. That’s no small part of KMX’s current $11.7 billion market capitalization. Those who know the company best have taken a different tack. Since the early September hurricanes, KMX insiders have sold 462,107 shares on the open market, cashing proceeds of just over $34 million. The only open market purchase during that period was of 35 shares.
QT progress report
Plenty of movement this time. The Fed’s portfolio of securities held outright footed to $4.172 trillion, a near $12 billion decline from last week’s level. It was Treasurys carrying the “QT load,”as forecast by Jim Bianco in last week’s Almost Daily Grant’s, as all of the drop came from the UST category.
Since the beginning of QT on Oct. 1, the Fed’s balance sheet has declined by 1.56%, for a simple annualized pace of 2.99%.
Recap April 5
Stocks floated moderately higher, extending yesterday’s bullish intraday reversal to push the S&P 500 back towards the middle of its wide 2018 trading range. Treasury yields climbed across the board with the curve steepening as the long end unperformed ahead of tomorrow’s March payrolls report from the Bureau of Labor Services, and the VIX fell back below 20.
- Philip Grant
Tuesday, April 3, 2018
Cold Turkey
Most developed economies feature interest rates that are visible only through a magnifying glass.
Most developed economies feature interest rates that are visible only through a magnifying glass.
I thought you were pre-med?
Spotify Technology S.A. made its publicly traded debut today,
Spotify Technology S.A. made its publicly traded debut today,
Recap April 3
Cold Turkey
Most developed economies feature interest rates that are visible only through a magnifying glass. Most lower-rated borrowers need funding. A tailor-made match? In Japan, the world’s third largest economy and an epicenter of financial repression (nominal government bond yields are negative out to 10 years, despite 12 straight quarters of positive real GDP growth), the financial matrimony of borrower and lender is being put to the test.
Yesterday, Bloomberg reported on the rising relative popularity of Japan’s Samurai bond market (meaning yen-denominated debt placed by foreigners) for lower-rated sovereign issuers, noting that “the portion of Samurai notes with triple-B level credit ratings climbed to 58 percent last fiscal year from 39 percent a year earlier.” B1-rated Ghana (at Moody’s, four notches below investment grade) and triple-B-rated Philippines are considering debt offerings, while Baa3-rated Indonesia and triple-B-minus Hungary (both one notch above junk) placed Samurai bonds last year. Akihiro Iagarashi, executive director at Nomura Securities Co., aptly summarized the driving force to Bloomberg last June: “Japanese investors used to be very conservative in terms of the credit ratings they buy. In this negative yield environment, they have to change their investment style by, for example, widening their credit horizon.”
Last December, the junk-rated Republic of Turkey sold ¥60 billion ($563 million) of three-year Samurai notes with a 1.81% coupon. Bloomberg reported that: “In another sign that investors are willing to take on risk, Turkey’s latest securities also have no guarantee from Japan’s government, unlike the previous issuance in 2014.” Ryusuke Kurihara, director of debt syndication at Daiwa Securities Group, Inc., told Bloomberg that the appearance of junk-rated Samurai bonds was “quite unusual.”
The affectionate stance taken by Japanese investors toward Turkey extended far beyond Samurai issues. In October, Bloomberg relayed data from Japan’s Investment Trusts Association showing a 27% increase in Japanese mutual fund investments in lira-denominated bonds, to ¥50.8 billion ($477 million) through August. Takeshi Yokouchi, senior fund manager at Daiwa SB Investments Ltd., assessed the situation in Turkey thusly: “Political risks are still there and the economy remains sluggish while inflation remains high – but those negative factors have already been priced in the markets.” On Jan. 23, Bloomberg reported that data from the Tokyo Exchange Inc. showed that individual Japanese investors held a record long position on the lira against the yen.
As documented in the March 23 edition of Almost Daily Grant’s, the intervening months have been unkind to Turkish currency-denominated investment exposure. The lira, which traded above ¥30 in January and fetched ¥54 as recently as December 2014, is now worth less than ¥27. Year-over-year CPI inflation has remained above 10% in 13 of the past 14 months, while President Recep Erdogan’s regime continues to aggressively consolidate power following the failed coup d’état in Summer 2016. On March 23, the lira spiked lower against the dollar, briefly reaching four per greenback during the Asian trading session. Bloomberg paraphrased Koji Fukaya, chief executive officer at Tokyo’s FPG Securities, as attributing the lira’s decline to stop-loss orders from Japanese retail investors who had been holding lira positions against the yen.
We wonder if the reach for yield on the part of local investors will attract any soul searching on the part of Japan’s monetary authorities. For its part, the Bank of Japan asserts on its website that: “When prices fluctuate, individuals and firms find it hard to make appropriate consumption and investment decisions, and this can hinder the efficient allocation of resources in the economy.”
Better that the prices fluctuate in the authorized direction.
I thought you were pre-med?
Spotify Technology S.A. made its publicly traded debut today, and the New York Stock Exchange feted its newest tech crown jewel in a manner fit for a foreign dignitary. Well, almost. The Wall Street Journal explains:
The flags that hang over the steps to the New York Stock Exchange have caused some commotion this morning. Earlier in the day, a Swiss flag was hoisted over the entrance in an apparent error (Spotify is Swedish, not Swiss).
NYSE said in a statement: “It was a momentary ode to our neutrality in the process of price discovery.”
A mid-afternoon stroll by the NYSE from our perch at Two Wall Street confirms that the geographically offending Swiss flag has been replaced by a Swedish one. Perhaps the New York Fed building needs some extra adornment?
Recap April 3
Stocks powered higher this afternoon, with the S&P 500 finishing 1.3% in the green to erase roughly half of yesterday’s nasty selloff and avert a break through the interim lows logged in early February. Treasury yields pushed higher across the curve, the dollar and commodities both held steady, and the VIX pulled back by 10% to 21.
- Philip Grant
Monday, April 2, 2018
Dear Mr. Fantasy
Who’s up for some reward-free risk? In recent years, investors with a high risk tolerance have gravitated to shares in fast growing but cash-hungry Silicon Valley concerns Netflix, Inc. and Tesla, Inc., with terrific results: The pair has delivered exponential returns over the past five years, as popular products and cultural cachet have trumped financial statements that could be described as less than stellar. The potential for further such reward colors the evident risks.
The bond market, of course, features a different calculus. Instead of the potential for outsize returns available to stockholders, the measure of success for corporate creditors is the return of their capital, along with contractual interest payments. Necessarily limited upside trains the investor mind on what can go wrong. For par value bond investors, risk aversion is the name of the game.
The dual cases of Netflix and Tesla put those logical truisms to the test. In October, Netflix issued $1.6 billion of senior unsecured notes maturing in 2028 with a 4 7/8% coupon, a spread of 256 basis points over Treasurys. Rated single-B-plus at S&P (“the obligor currently has the capacity to meet its financial commitments on the obligation”), Netflix has achieved rapid growth and stock market riches via the incineration of cash: Free cash flow registered negative $2.02 billion in 2017, while management pegged its 2018 FCF estimate at negative $3 to $4 billion, well above the Street consensus of $2.5 billion. As the company’s borrowing needs will likely increase, CEO Reed Hastings has struck a sanguine tone, writing in the fourth quarter investor letter that: “High yield has rarely seen an equity cushion so thick.”
The Jan. 26, 2018 edition of Grant’s (“Like no business”) condensed the separate propositions implicit across Netflix’s capital structure: “It’s a speculative business, the content business, but if it works out, you, the creditors will get your money back. The stockholders get rich. Everybody’s happy.” Those 4 7/8 notes have trended the wrong way of late, breaking lower to currently fetch 96.5 cents on the dollar from 99.9 in January.
Then there’s Tesla, which burned through $3.5 billion in cash last year on just under $12 billion in revenue yet enjoys a massive valuation premium to other automakers. It issued $1.8 billion (upsized from $1.5 billion) in senior unsecured notes due in 2025 at a 5.30% coupon (a 320 basis point spread over Treasurys) in August. That was up from an indicated yield of 5.25%. Reuters quoted an anonymous banker who said that the five basis point bump “was a company decision to ‘sweeten the deal’ for investors who supported the transaction.”
The bond issue, which made its first coupon payment in February, has seen its price fall sharply in recent weeks amid product recalls, another highway death of a driver who was using the “Autopilot” feature, and CEO Elon Musk’s odd April Fool’s Day jokes declaring corporate bankruptcy on Twitter. Last week, Moody’s downgraded Tesla’s rating to B3 from B2 and the rating on the 5.3% senior notes to Caa1 (“judged to be of poor standing and are subject to very high credit risk”) from B3, while the notes have fallen to 86.5 cents on the dollar for a yield to worst of 7.73%..
The Aug. 11 publication of Grant’s (“’A masterly manipulation’”) took inventory of the bond market’s accommodative stance to the offering while Tesla was conducting its investor road show, drawing a parallel with UK Chancellor of the Exchequer David Lloyd George’s exertions in support of the 3.5% War Loan of 1924. The analysis noted that operating and financial problems aside, Tesla was an issuer in the right place at the right time.
With $9 billion in high-yield sales, July was the weakest month of issuance since January 2016. “There hasn’t been much new supply and investors have cash they need to spend,” a resigned Tom O’Reilly, Neuberger Berman Group, LLC’s head of non-investment grade credit, tells the Wall Street Journal.
Time flies when you’re having fun. We can surmise the corollary: For Tesla and Netflix’s creditors, 2025 and 2028 may seem far away indeed.
Recap April 2
The second quarter got off to an unpleasant start for the bulls, as the S&P 500 sank by more than 2% to close near the interim lows logged on Feb. 8, setting up an important session tomorrow with either a bounce or fresh lows seemingly in the cards. Treasurys continued their strong rally, with the 10-year yield falling to 2.73% from 2.91% on March 21. The VIX rose by a relatively modest (compared to the stock market move) 15%, and remains in a trading range between 20 and 25.
- Philip Grant
Thursday, March 29, 2018
Bund cake
This morning, German CPI rose by 1.6% year-over-year, just below the consensus expectation of 1.7%.
This morning, German CPI rose by 1.6% year-over-year, just below the consensus expectation of 1.7%.
QT progress report
Recap March 31 and first quarter 2018
Bund cake
This morning, German CPI rose by 1.6% year-over-year, just below the consensus expectation of 1.7%. Although still south of the European Central Bank’s 2% inflation target, German inflation has nevertheless largely maintained its recent resurgence, when it jumped to an average 1.7% through 2017 from 0.5% in 2016 and 0.3% in 2015.
In response, the 10-year bund rallied, with the yield declining by half a basis point to 0.497%, for a negative real yield in excess of 1%. That negative real yield has been in force since June 2016, 15 months after the European Central Bank began its asset purchase program. Compared to the 2.74% yielding 10-year treasury, the bund likewise resembles the polar opposite of a bargain: The 225 basis point UST/bund spread is 50% above its five-year average, and compares to 211 basis points in the early February analysis in Almost Daily Grant’s ("A kind word for the 10-year").
Of course, the complacency displayed by German lenders has a ready explanation. A March 22 dispatch from Reuters deftly conveys the situation:
The European Central Bank will start buying bonds from a further seven state-owned German banks under its stimulus program, it said on Thursday, in a bid to avoid running out of debt to buy after three years of purchases.
Indeed, at a March 23 speech in New York, the ECB’s Benoît Cœuré estimated that world central banks may hold as much as 90% of all German bunds, commenting that: “In these circumstances, only very large changes in the expected supply of bonds can cause yields to rise more meaningfully.”
Meanwhile, Baa2-rated (two notches above junk) Spain, which features year-over-year CPI growth of 1.2%, matching the sovereign 10-year yield, announced today that it will auction 2021 bonds at a yield of 0.05% on April 5. On Sunday, former president of the Catalonia region Carles Puigdemont was detained in Germany on charges related to Catalonia’s October ad hoc independence referendum, which the Spanish government declared illegal. Catalonia, at just over 6% of Spain’s land mass and 16% of the country’s population, generates more than 20% of Spanish GDP and 25% of exports. Puigdemont’s arrest touched off another round of protests in Barcelona. News site The Local describes the scene:
Some threw garbage cans at Catalan police in riot gear, who responded by beating demonstrators with their batons or firing warning shots in the air.
"This Europe is shameful!" they chanted as they marched by the office of the European Commission in the Catalan capital.
The ECB’s current €30 billion ($36.9 billion) monthly asset purchase program is set to run through October, and to date there has been little indication of an extension. A piece from Bloomberg today headed “Draghi Studies Fed Exit as ECB’s Guide on What to Do and Avoid” details Frankfurt’s furtive steps as it seeks to avoid triggering a bond selloff following its exit from QE as former Fed chair Ben Bernanke did in the 2013 “taper tantrum.” One observer quoted in the story displayed particular confidence in the abilities and judgment of the monetary mandarins.
“The Fed could have reversed at any time, they could stop and correct,” said Gilles Moëc, chief European economist at Bank of America Merrill Lynch and a former Bank of France economist. “The ECB has no possibility to get it wrong.”
We wonder, is Mr. Moëc a betting man?
QT progress report
The Fed’s securities held outright footed to $4.183 trillion, an $8.6 billion decline from last week’s reading. MBS carried the load, as the Fed’s holdings declined by $8.8 billion, while Treasury holdings increased by a nominal amount (roughly $160 million) for a fourth straight week. Since QT began on Oct. 1, the Fed’s balance sheet has declined by 1.42%, or a simple annualized pace of 2.84%.
According to the Fed’s QT guidance announced last year, the balance sheet should have declined by $90 billion by the end of the first quarter. Instead that figure has totaled only $56.7 billion. Jim Bianco, president and eponym of Bianco Research, notes a few explanatory factors. Bianco observes that “The Fed owns $31 billion of Treasury securities that mature on March 31. This allows them to play catch-up, by reinvesting far less than $31 billion.” That likely explains the lack of movement on UST sales in recent weeks.
In addition, Bianco notes another important detail in the mortgage-backed securities realm, which is an especially challenging place to trade given the illiquidity of the market and uncertainty regarding principal repayments. In table 3 of the H.4.1 balance sheet, “there’s a line for commitments to buy MBS that has dropped quite a bit, from $30.4 billion last October to $12 billion today. So they would argue that reflects an ‘effective decline’ of $18 billion which goes a long way to reach their target.”
Recap March 31 and first quarter 2018
Stocks ripped higher, with the S&P 500 gaining 1.5% to narrow its first quarter loss to 1%. Treasurys and commodities were bid, and the VIX saw a double-digit decline. Other key assets logged the following performances from Jan. 2, the beginning of the first quarter:
The 10-year treasury yield finished at 2.74%, up from 2.49%.
The U.S. Dollar Index finished at 90, down by 2.35%.
WTI crude finished at $65 a barrel, up by 8%.
Gold finished at $1,325 an ounce, up less than 1%.
The iShares High Yield ETD finished at 85.6, down by 2%.
The iShares Investment Grade ETF finished at 117.4, down by 2.8.
The VIX finished at 20, up by 103%.
Tuesday, March 27, 2018
Hodl on loosely
Ah, crypto-currencies. Whether in a bull or bear market (sometimes we see both before lunch), they bore neither fans nor skeptics. The still-young 2018 has been rough for the nascent asset class, as the four most prominent vehicles (bitcoin, ethereum, ripple and litecoin) have declined by 42%, 39%, 40% and 74% respectively after logging spectacular gains last year.
Beyond financial losses, the pullback seems to be taking a toll. According to Bloomberg: “Online searches for ‘bitcoin’ fell 82 percent from December highs, according to Google Trends. Tweets that mention the coin peaked Dec. 7, at 155,600, and are now down to about 63,000, BitInfoCharts says. And the number of bitcoin transactions is off 60 percent from its record on Dec. 13, according to Blockchain.info” (Almost Daily Grant’s, March 16).
Crypto-ficcianados have lately contended with more than falling prices and waning public interest. Yesterday, Reuters reported: “Twitter, Inc. will start banning cryptocurrency advertising [today], joining Facebook and Google in a clampdown that seeks to avoid giving publicity to potential fraud or large investor losses.” In other words, the ubiquitous social media ads featuring author and investor James Altucher will be no more. Altucher himself voiced his approval, telling Recode: “There are many scams and illegitimate services out there.” This afternoon, Coinbase reports that Reddit (which bills itself as “the front page of the internet”) no longer accepts payment in bitcoin for its Reddit gold membership program.
Regulators, too, are taking a stricter stance. On Thursday, the Wall Street Journal reported that the Securities and Exchange Commission is scrutinizing up to 100 crypto-focused hedge funds: “Examiners are keen to inspect whether fund managers have bought the type of assets they advertised to investors in disclosure documents. Regulators also worry about the risk of crypto assets being stolen because hackers often attempt to breach exchanges where crypto-currencies are kept.” On March 2, Bank of England Governor Mark Carney told the Scottish Economics Conference that “the time has come to hold the crypto-asset ecosystem to the same standards as the rest of the financial system.”
Meanwhile, efforts at wider implementation of the blockchain in the financial industry have recently suffered what appear to be major setbacks. Today, Reuters reports that three separate projects undertaken by financial institutions to incorporate the distributed ledger technology have been halted. One such example:
DTCC, known as Wall Street’s bookkeeper, recently put the brakes on a blockchain system for the clearing and settlement of repurchase, or repo, agreement transactions, said Murray Pozmanter, head of clearing agency services at the DTCC.
The project, which had successfully tested with startup Digital Asset Holdings, was shelved because banks and other potential users believed the same results could be achieved more cheaply using current technology, he said. “Basically, it became a solution in search of a problem.”
As prices fall, regulators circle and big tech heads for the hills, some investors are doubling down. Yesterday, Bloomberg reported that:
While ICO’s [initial coin offerings] were supposed to disrupt venture capital, such funding in blockchain-based companies is surging, with startups raising $434 million since December, the most ever in a three-month period, according to CoinDesk data.
“If a company goes on and gets an ICO, my equity is worth more,” Frank Meehan, partner at SparkLabs Group, said. “That’s really the game right now.”
CoinDesk calculates that ICO’s have raised north of $3 billion through February, more than half of their 2017 intake. For the sake of their limited partners, VCs best choose wisely. Bloomberg goes on to note that 46% of such offerings either failed of were unable to attain funding, while 50 of 340 ICO’s have already failed this year.
Last week, CryptoKitties (which bills itself as an ethereum-based “game centered around breedable, collectible, and oh-so-adorable creatures” who can’t be “replicated, taken away, or destroyed”) raised $12 million in seed funding led by Andreessen Horowitz and Union Square Ventures, with Mark Pincus (founder of Zynga) and Fred Ehrsam (former founder of Coinbase) lining up as investors.
Meanwhile CoinDesk reports that ethereum founder Vitalik Buterin recently penned a blog post arguing for the institution of rent fees on his network, where “users would be asked to pay to use the network based on how long they’d like their data to remain accessible on the blockchain.” Evidently, permanence is a relative concept.
Recap March 27
Stocks remained in spin cycle, with the S&P 500 falling sharply this afternoon from a tight early range to finish red by nearly 2%, the fourth straight daily move in excess of 45 points. Treasurys caught a sharp bid, with the 10-year yield dropping to its lowest since early February at 2.78% and narrowing the spread over the two-year yield to 50 basis points. Commodities ticked lower with WTI crude dipping back below $65/barrel, and the VIX rose by a relatively modest 8% to settle at 22.5.
After the close, Moody’s downgraded Tesla, Inc.'s Corporate Family Rating (CFR) to B3 from B2, and unsecured note rating to Caa1 from B3, with a negative outlook. As of mid-day, the Tesla senior unsecured 5.3s of 2025 traded at 90.75 cents on the dollar, down from 92.5 yesterday.
- Philip Grant
Monday, March 26, 2018
Tough but fair
Leverage on offer
If regulators on either side of the pond have their way, it will soon be time to say tata to the London Interbank Offered Rate (Libor)
If regulators on either side of the pond have their way, it will soon be time to say tata to the London Interbank Offered Rate (Libor)
Recap March 26
Tough but fair
Apropos of Friday’s ADG item (“Ahoy, polloi!”) distinguishing between the freshly-minted dry bulk shipping ETF (ticker BDRY) and the more convoluted offerings which populate the mushrooming ETF industry, reader Tom Boucher provides a trenchant observation:
I may have been doing this too long but, isn’t the trade handle for Alpha Architect Value Momentum Trend ETF (VMOT), vomit?
Leverage on offer
If regulators on either side of the pond have their way, it will soon be time to say tata to the London Interbank Offered Rate (Libor) as the benchmark interest rate used to set the price of hundreds of trillions of dollars in debt securities the world over. Today, Bloomberg notes that the Federal Reserve Bank of New York, in tandem with the Treasury Department’s Office of Financial Research are set to debut the Secured Overnight Financing Rate (SOFR). The salient distinction between Libor and its presumed successor:
Where LIBOR relied on the expectations of bankers, SOFR is based on real transactions from a swath of firms including broker-dealers, money market funds, asset managers, insurance companies, and pension funds. It’s different from Libor as well in that it’s a secured rate, since the repo rates it’s derived from are collateralized, or backed by assets.
As financial authorities prepare to usher Libor to the exit, the benchmark reference rate has managed to make its way back into the investment spotlight. A methodical rise to 2.29% from 0.65% as the 10-year yield bottomed in July 2016 has pushed Libor’s spread over the “risk free” overnight indexed swap [OIS] rate to its highest since 2009. That type of widening would traditionally signal diminished liquidity or even credit stress.
Bhanu Baweja, deputy head of macro strategy at UBS Investment Bank, argued in an opinion piece in last Tuesday’s Financial Times that other factors explain the recent move. Baweja estimates that two-thirds of the widening can be attributed to rising Treasury bill yields (higher issuance amid the recent spending bill and tax cuts is the apparent catalyst), while the 2016 money market reform and subsequent upward pressure on commercial paper yield accounts for the rest. Baweja goes on to comment:
Does the price of funding not matter at all, then? It most certainly does. It can fundamentally alter market trends. But instead of Libor-OIS widening, which is likely a red herring, we need to focus on the right channels to detect signals of a change in the investment opportunity set.
First, watch the hit from yields to floating rate high yield credit and leveraged loans. We estimate floating rate loans to U.S. borrowers at $2.2 trillion, nearly half of which have been extended to issuers rated below double-B-minus. Our analysis shows that leveraged loan issuers will remain resilient to the next 75-100 basis point increase in Fed Funds rates, but could see their interest coverage ratios reaching dangerously low levels beyond that
.
If leveraged loans are the canary in the coal mine, then so far, so good. The S&P/LSTA Leveraged Loan Total Return Index made another new high on Friday, up by more than 18% from its February 2016 interim lows.
Source: The Bloomberg
On March 15, Bloomberg noted more issuers managed to place leveraged loans at 175 basis points over Libor (the tightest spread seen since the crisis) in the prior month than in the past ten years combined. At the same time, investors continue to accept diminished legal protection, in the form of so-called covenant-lite loans. S&P Global Intelligence’s LCD unit reported Friday that cov-lite’s share of the $984 billion leveraged loan market reached a fresh record high of 75.8% in February.
Last week, Uber Technologies, Inc., which lost $4.5 billion on $7.5 billion in revenue in 2017 and recently sold shares to Softbank at a 30% markdown from its prior valuation (see “Out of gas” from the Jan. 12 issue of Grant’s for more), tapped the leveraged loan market, hoping to borrow $1.25 billion at an indicated yield of 425-450 basis points over Libor. Investor demand was strong enough for Uber to both upsize the offering to $1.5 billion and lower its spread over Libor to 400 basis points.
Recap March 26
Stocks enjoyed a ferocious rally, with the S&P 500 surging by nearly three percent to erase nearly half of last week’s losses, while Treasury yields ticked higher across the board with the belly of the curve absorbing the bulk of the pressure. The VIX shed 15% but still finished north of 20, and crypto-currencies were down sharply with the price of bitcoin dropping back below $8,000.
- Philip Grant
Friday, March 23, 2018
Ahoy, polloi!
From Business Wire:
From Business Wire:
Cool Recep-tion
The dollar’s recent weakening against most world currencies has left one prominent exception:
The dollar’s recent weakening against most world currencies has left one prominent exception:
Recap March 23
Ahoy, polloi!
From Business Wire:
Breakwave Advisors, in partnership with ETF Managers Group (ETFMG), launches the Breakwave Dry Bulk Shipping ETF (NYSE Arca: BDRY). The Fund is the first and only freight futures exchange-traded product focusing exclusively on dry bulk shipping. BDRY provides investors direct access to an instrumental part of the global commodity market that historically has been uncorrelated -with other major asset classes.
On the one hand, a shipping industry ETF seems like a solid and logical concept. On the other, the Artificial Intelligence Powered Equity ETF (ticker AIEQ), Alpha Architech Value Momentum Trend ETF (VMOT) and the KraneShares MSCI China Environment ETF (KGRN) would seemingly have the shippers lapped when it comes to branding uh, creativity.
Cool Recep-tion
The dollar’s recent weakening against most world currencies has left one prominent exception: The Turkish lira. Since 2013, the lira has slid from less than two per greenback to three in mid-2016, briefly spiking above four overnight before pulling back to 3.96. Although, to hear the government tell it, that break above four really shouldn’t count. From Bloomberg:
“They say it rose above four. That’s not the case,” Cemil Ertem, a senior advisor to President Recep Erdogan, said in a live interview with state-run TRT TV. “At night, if one gives a quote at five, it would rise to five. It’s so shallow, there’s no liquidity. Seeing one number in the middle of the night has no significance whatsoever.”
“Yes, there’s an increase” in the [dollar/lira] exchange rate, Ertem said. “But it’s very wrong to create a perception that it went to four.”
Not only are exchange-rate scolds in the administration spokesman’s rhetorical crosshairs. The Financial Times reported Wednesday on Ertem’s blistering response to an International Monetary Fund warning over Turkey’s finances: “Cemil Ertem said [the IMF’s] call to tame inflation and rein in spending were ‘failed economic theories’ peddled by ‘dinosaurs’. He concluded, ‘we’re going to do the exact opposite.’”
Pithy retorts aside, the market seems to be leveling a verdict on Erdogan’s regime through the lira’s decline. CPI inflation in Turkey, which has averaged 8.7% over the past five years, jumped higher after the failed July 2016 coup attempt against Erdogan and has mostly remained above 10% since the beginning of 2017. Foreign exchange reserves, which have averaged over $100 billion in the past five years, footed to less than $90 billion as of March 16. The monthly current account deficit, which was less than $1 billion in August, jumped above $7 billion in December and January. That has helped push the yield on the 10-year Turkish note to 12.44%, well above its five-year average of 9.79%.
So too, does the lira’s retreat color the action in Turkish equities. Although the Borsa Istanbul 100 index has enjoyed a strong rally since the beginning of 2017 (rising by 60% in lira terms and 48% in dollars), a five-year perspective is far more currency-sensitive. The Istanbul 100 is up by 41% over that period in the local currency, but has lost 39% when measured in greenbacks.
Grant’s offered a bullish word on a basket of Turkish equities last January (“Horrible to bad,” Jan. 13) before closing that rhetorical position (“The story changed,” May 19) four months and an average 22.7% gain in dollar terms later. Today, we asked Haydar Acun, managing partner at Marmara Capital Asset Management and source of our Jan. 2017 long ideas, for his thoughts on the lira’s decline and assessment of current market conditions.
I believe the lira’s fall is not a surprise to many in light of the high and increasing current account deficit, increasing oil prices, tension with Turkey’s largest trade partners such as Germany, low foreign investment, the military operation in Syria, etc.
I would expect a correction in the market which I think long overdue thanks to crazy liquidity, Fed policy and easing investor risk concerns of international investors. Locals are also extreme risk takers in terms of careless trading activity with leverage.
Some stocks have lost touch with fundamental reality. Who on earth buys THY [Turkish Airlines, which has seen a 245% lira rally since April and now trades at 70 times trailing adjusted earnings per share] at current prices? I have no idea. There are fewer and fewer undervalued ideas, but it is still possible to find some.
The lira’s decline could have broader implications for the emerging market realm. Russell Napier, independent strategist and co-founder of the Electronic Research Interchange, told Grant’s in a Dec. 1 survey of emerging markets (“Trigger points”) that Turkey’s currency policy could potentially reverberate far beyond its borders.
Last year, Napier identified Turkey as the country most likely to ignite the next panic. Observe, he tells [deputy editor Evan] Lorenz, how Erdogan, in his railing against the so-called high interest rate lobby, recalls Mahathir Mohamad, the former prime minister of Malaysia. It was Mohamad, you’ll recall, who on Sept. 1, 1998 accelerated the Asian Financial Crisis by declaring the imposition of capital controls in Malaysia.
For his part, Erdogan forcefully (as is his wont) ruled out the imposition of capital controls in December, stating that “Turkey has a free-market economy, anyone has had the right to take their money abroad since 1989. There is no doubt this will continue.” Presidential and parliamentary elections are scheduled to be held by November 2019, at the latest.
Recap March 23
A second straight steep selloff left the S&P 500 nursing a 5.9% loss for the week to approach its Feb. 8 interim lows, while the Nasdaq shed 7.3%, its worst showing since the post China devaluation scare in August 2015. Facebook shares shed nearly 14% for the week. Treasury yields dripped again, with the 10-year note approaching the low end of its recent trading range at 2.81%, while the VIX again logged double digit percentage gains to finish near 26. Gold finished the week higher by 2.5%.
- Philip Grant
Thursday, March 22, 2018
Triple-B Gees
What does it mean when outsize moves in interest rates are met with little more than a shrug in corporate credit?
What does it mean when outsize moves in interest rates are met with little more than a shrug in corporate credit?
QT progress report
Recap March 22
Triple-B Gees
What does it mean when outsize moves in interest rates are met with little more than a shrug in corporate credit?
Yesterday, the Federal Reserve raised the benchmark funds rate by 25 basis points to a range of 1.5% to 1.75%, the fourth such hike since March of last year. As the United States’ central bank tightens the monetary screws, the two-year Treasury yield has risen to 2.28% from less than 1.3% in September, while the three-month London Interbank Offered Rate (LIBOR), the survey measuring interbank lending conditions, has made a similar jump. With short rates racing higher, the Treasury curve has all but collapsed: Spreads between the two- and 10-year yield, as well as the five- and 30-year yield are both-at or-near their flattest in since the eve of the financial crisis in 2007.
The corporate credit realm has taken in stride these substantial changes in benchmark interest rates. The Barclays U.S. Corporate High Yield spread closed yesterday at 335 basis points just above the midpoint of its 2018 range and well below its eight-year (capturing the bulk of the post-crisis era) average of 438 basis points. The Bloomberg Barclays Investment Grade spread finished yesterday at 106 basis points, some 20 basis points wider from its Feb. 2 nadir but well inside the 145 basis point average over the past eight years.
The post-recession path of the Bloomberg Barclays US Corporate Bond spread. Source: The Bloomberg
The relative calm in investment grade credit realm is particularly interesting in the light of significant changes in both the market’s size and composition. The Oct. 20, 2017 analysis in Grant’s (“Attack of the killer BBBs") began by noting that: “In 2007, less than 40% of Citigroup’s U.S. Broad Investment-Grade Corporate Bond Index was rated triple-B, i.e., the last (whole) stop before speculative grade. Today, about 47% is so classified.” This morning, the Financial Times cites data from ICE BofAML Indexes showing that total triple-B-rated issuance is approaching $3 trillion, more than double the amount of outstanding high-yield bonds.
So, too, is corporate leverage on the upswing within the triple-B category. The FT also observes: “Triple-B-rated issuers were slightly below three times levered in 2017, according to Citigroup, up from just about 2.5 times in 2015.” Last July, credit analysts at Morgan Stanley wrote that: “If the companies in our universe were rated based only on their leverage, we estimate that over a quarter of the investment grade market would have a high yield rating, using Moody’s leverage buckets across sectors.”
That Oct. 20 Grant’s article went on to identify a trio of triple-B and triple-B-minus-rated issues that seemed (to us) to offer insufficient financial reward to compensate for evident risks: The Allergan Funding SCS 3.85 senior unsecured notes of 2024 (rated triple-B at S&P), the Kohl’s Corp. 4 ¼ senior unsecured notes of 2025 (triple-B-minus) and the euro-denominated Kraft Heinz 2 ¼ senior unsecured notes of 2028 (triple-B-minus). The trio featured, in order, Allergan’s leverage ratio of four times earnings before interest, taxes, depreciation and amortization (EBITDA) operating the opaque specialty-pharma industry and an acquisition heavy business model; Kohl’s declining interest coverage in a struggling (retail) industry; and Kraft-Heinz’s 3.8 turns of leverage and declining sales amid heavy competition and apparent secular shift away from the processed foodstuffs which form the bulk of its revenues.
As Grant’s went to press, Allergan’s notes fetched 104.92 for a 3% yield-to-maturity, Kohl’s traded at 101.75 for a 4% YTM and Kraft-Heinz at 103.80 on the euro for a 1.8% YTM. They have since declined to 98.5, 100.41, and 100.34, respectively. Colleague Fabiano Santin (who worked on the original story) cautions that the bulk of the price decline in that trio can be attributed to the rise in interest rates over the past five months. Santin notes: “However, spread to Treasurys on AGN and KHC have moved 65bps and 30 bps wider, but KSS is about 35 bps tighter. The index has widened by 10 basis points from its Oct. 20 level.”
While spreads continue to imply calm investment grade seas, some investors are positioning themselves for choppy waters ahead. A March 19 dispatch from Bloomberg notes that “short interest on the iShares iBoxx Investment Grade Corporate Bond ETF (LQD on NYSE ARCA) relative to [the SPDR S&P 500 ETF, ticker SPY on NYSE ARCA] is now at its highest on record.” Meanwhile, the recent rates move has made cash positions more attractive: The yield on the one-month Treasury bill currently stands at 1.64%.
That Oct. 20 Grant’s analysis signed off with the following observation from Graham & Dodd: “The soundness of straight bond investment can be demonstrated only by its performance under unfavorable business conditions; if the bondholders needed prosperity to keep them whole, they would have been smarter to have bought the company’s stock and made the profits that flow from prosperity.”
QT progress report
The Fed’s portfolio of securities held outright footed to $4.192 trillion this week, a $5.3 billion decline from a week ago and a $2.8 billion decline from its trailing four week average. The drop was entirely due to mortgage backed securities, holdings of which fell by $5.4 billion from a week ago, while Treasury holdings ticked higher by about $160 million for a third straight week. The Treasury market’s abundant liquidity makes the Fed’s hesitance in paring its portfolio somewhat curious.
Since the start of QT on Oct. 1, the Fed’s total assets have declined by 1.22%, for a simple annualized pace of 2.53%.
Recap March 22
Stocks were hammered, with the S&P 500 breaking to fresh lows into the bell to finish more than 2.5% in the red, while Treasurys were bid across the board to leave yields sharply lower, and the dollar trended higher throughout the day to reverse overnight weakness. The VIX jumped by more than 30%, and settled above 24, its highest close since the immediate aftermath of the short-vol-blowup on Feb. 13.
- Philip Grant
Tuesday, March 20, 2018
Facial
It’s already been a long week for Mark Zuckerberg & Co. Facebook, Inc. (FB on the Nasdaq) has faced a multi-front attack following yesterday’s reports of the social network’s ties to political research firm Cambridge Analytica and the potentially illegal dissemination of millions of Facebook users’ personal data.
While FB shares have absorbed a 9% two-day selloff (the stock finished well off its lunchtime lows), media coverage has been little short of savage: The Guardian ran an article quoting former platform operations manager Sandy Parakilas, who claims that Facebook routinely and freely shared user data with numerous third parties, supplying little or no oversight. Slate Magazine tersely asked readers: “Who does Facebook serve?” Silicon Valley blog TechCrunch released a piece titled simply: “#deletefacebook.”
Perhaps most ominously for investors, governments on either side of the Atlantic are eager to involve themselves. The U.K.’s Information Commissioner’s Office is in the process of securing a search warrant of Cambridge Analytica, while Bloomberg reports this morning that the U.S. Federal Trade Commission (FTC) has likewise opened an investigation into Facebook. On Sunday, the Washington Post presaged Bloomberg’s FTC investigation scoop, with former FTC senior official David Vladeck offering an educated guess about Facebook’s potential liability:
Vladeck, now a professor at Georgetown Law, said violations of the consent decree could carry a penalty of $40,000 per violation, meaning that if news reports that the data of 50 million people were shared proves true, the company’s possible exposure runs into the trillions of dollars [multiples of FB’s $493 billion market cap]. Vladeck said that such a fine is unlikely but that the final penalty still could be very large.
Bad press has been known to blow over, and as Vladeck notes, the FTC is far from certain to extract a sum that is materially harmful to FB. So far, Facebook’s staunch sell-side support has not wavered. Of the 48 analysts who cover the name, 43 rate the shares buy, just two advise clients to do as many investors have this week and sell. The average price target of $223 sits 35% above current levels. There is certainly historical precedent for the Street’s great expectations: Facebook’s net income topped $18 billion last year from less than $4 billion in 2015, with free cash flow jumping above $17 billion last year from less than $8 billion two years prior.
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Five year price chart. Source: The Bloomberg
However, the House of Zuck faces significant threats that were apparent even prior to this week’s revelations and underpin the bearish opinion on FB logged by Grant’s (Aug. 11, 2017, and Almost Daily Grant’s Jan. 22, Feb. 20, Mar. 1). Namely, “the inherent limits on a company growing faster than the markets in which it operates, emerging intra-FANG competition, advertiser resistance to a digital duopoly, regulatory attack on the same, a vulnerable dependence on mobile devices and good old fashioned managerial overreach.”
Yesterday, the Wall Street Journal reported on the waning market-share momentum of the Facebook/Google digital ad duopoly, amid encroachment from rivals Amazon.com, Inc. and Snapchat (Snap, Inc.). “Research company eMarketer predicts the combined U.S. digital ad market share of Alphabet, Inc.’s Google and Facebook will fall for the first time this year, shrinking to 56.8% from 58.5% last year.”
User growth in the United States has stalled since the beginning of 2016 according to Pew Research (a hefty 68% of U.S. adults already use it). Brian Wieser of Pivotal Research, one of the aforementioned pair of analysts who rate Facebook shares sell, noted data from Nielsen showing an 11% year-over-year decline in time spent on the site for November. Following the recent revelations, Wieser cautioned on Sunday that: “Regulatory risks will intensify, enhanced use of data in advertising is at greater risk than before, [and] third party measurement partners may face more restrictions, frustrating advertisers.”
Consensus estimates call for a 42% rise in net income this year to $25.8 billion, with another 24% uptick in the bottom line to $32.1 billion forecast for 2019. Meanwhile, if actions speak louder than words, then Zuckerberg and his fellow executives may be the biggest FB bears of all. Last week, Facebook’s founder and CEO sold 1,150,800 shares at a volume-weighted average price of $183.73, netting proceeds of $211.4 million. Chief operating officer Sheryl Sandberg hit the bid on 55,000 shares at an average price of $183.13 for just over $10 million, and chief technology officer Mike Schroepfer sold 38,024 shares an average price of $182.53, cashing out $6.9 million.
Recap Mar. 20
Stocks floated a bit higher, stabilizing from yesterday’s drop. The dollar enjoyed a significant rally (the DXY index rose by nearly 75 basis points) but that didn’t stop WTI crude from making a near-one month high above $63.50 a barrel. Treasury yields ticked moderately higher across the curve, and the VIX sagged to 18.
The Fed is set to conclude its two-day meeting tomorrow, futures place the odds of a rate hike at 100%.
- Philip Grant
Monday, March 19, 2018
History rhymes
An excerpt from a Bloomberg dispatch this morning,
An excerpt from a Bloomberg dispatch this morning,
Rebuttal rebuttal
On Mar. 11, the Bank for International Settlements sounded the alarm on the Canadian housing market,
On Mar. 11, the Bank for International Settlements sounded the alarm on the Canadian housing market,
Recap Mar. 19
History rhymes
An excerpt from a Bloomberg dispatch this morning, headed: “HNA’s $2.2 Billion NYC Tower a Hard Sell Less Than a Year Later.”
Last year, the Chinese conglomerate bought 245 Park Ave., a late-1960s-era building that’s home to JPMorgan Chase & Co., paying one of the highest prices ever for a New York office property. Values have since dropped and HNA faces the challenge of selling a building that’s starting to lose some of its gold-plated tenants and in need of improvements that could cost its new owner more than $1 billion, said Gregory Kraut, managing partner of K Property Group, which considered buying the building and examined it closely.
HNA, among the most prolific dealmakers in recent years, is pulling back after its gorge on trophy properties helped push up New York real estate prices. Now HNA, which used borrowed money to expand and accumulated one of the biggest debt loads in China, is under pressure from the government to liquidate assets. The company has already put about $4 billion of U.S. commercial real estate on the block.
HNA’s Manhattan misadventures recall the experience of another overseas asset-gatherer in a prior heyday: specifically Japan’s Mitsubishi Estate Company, which purchased an 80% stake in Rockefeller Center for $1.4 billion on Oct. 31, 1989. Upon the consummation of that deal, Jotaro Takagi, president of Mitsubishi Estate, was quoted in the New York Times: “There is no business address in the world that has the same cachet as Rockefeller Center. It is synonymous with excellence. We are making this investment with the objective of continuing this tradition into the 21st century.” Grant’s duly chimed in, quipping at the conclusion of a Nov. 24, 1989 analysis of the then-slowing real estate market that: “Perhaps Mitsubishi Estate Co. . . . would like to buy the rest of the United States.”
The rest, as they say, is history. Japan’s Nikkei index made its blow-off highs on New Year’s Eve 1989, the real estate boom ended, as booms do, and the high-priced Rockefeller Center deal floundered. From The New York Times’ 1995 follow-up:
Mitsubishi proposed yesterday afternoon that it plans to pass ownership of the Manhattan property to Rockefeller Center Properties, Inc., the publicly traded real estate investment trust that holds the $1.3 billion mortgage on the center, according to advisers involved in negotiations to bring Rockefeller Center out of bankruptcy protection.
Rebuttal rebuttal
On Mar. 11, the Bank for International Settlements sounded the alarm on the Canadian housing market, warning that America’s northerly neighbor features credit-to-GDP and total debt-service ratios that place the country at elevated risk for a banking crisis. Avery Shenfeld, chief economist at Canadian Imperial Bank of Commerce (a.k.a CIBC, CM on the Toronto Stock Exchange and the NYSE) took exception to the findings of the central bankers’ own Swiss bank, writing that:
The [BIS] report itself has multiple warnings to treat its results with ‘considerable caution.’ That seems prudent, based on the BIS’s own track record. Two of the current warning signals look particularly likely to mislead.
The first is a measure tracking the degree to which a country’s ratio of non-financial credit to GDP is above its longer term trend. That is certainly true for Canada, but interest rates are also miles below their longer term levels . . . Moreover, as we always caution, it’s not just how much credit has been issued, but to whom. The U.S. financial crisis was triggered by large debts owed to individual households that didn’t have matching incomes. Mortgage arrears rates in Canada continue to dive.
Interest rates, while up from their summer-2016 nadir, are still low by historical standards, and Canadian mortgages in arrears footed to just 0.24% of the total as of the third quarter of 2017 (the most recently available data), according to the Canada Mortgage and Housing Corporation. That’s down from 0.28% year-over-year. However, Canada’s elevated debt levels (household debt topped 170% of disposable income in the fourth quarter, well above the 133% peak seen in the U.S. in 2007) and a pronounced reversal in the formerly red-hot housing market (February prices in Toronto dropped 12.4% year-over-year with active listings nearly tripling) will put to the test Canadian mortgage-holders ability to pay.
Relatively small changes in rates can have a big impact: Recall that most Canadian mortgages are structured as five-year bullets with re-setting maturities, as opposed to the conventional 30-year fixed rate mortgage in the U.S. In addition, the Office for the Superintendent of Financial Institution’s B-20 regulations, enacted on Jan. 1, require all mortgagors to pass a stress test using the “greater of the five-year benchmark rate published by the Bank of Canada or the contractual mortgage rate +2%.” According to the Bank of Canada, 47% of all mortgages are scheduled to reset in the year ending July 2018.
Meanwhile, the interest rate tailwind cited appears to be abating. The benchmark Canadian five-year mortgage rate has jumped more than 10% from its April lows, and has ticked back above its eight-year average (covering the period in which the Canadian housing boom accelerated).
Bank of Canada five-year conventional mortgage rate. Source: The Bloomberg
For more on the prominent role of Mr. Shenfeld’s employer, CIBC, in the Canadian housing phenomenon, see the Feb. 9 edition of Grant’s.
Recap Mar. 19
It was a rude beginning to the week, as the S&P 500 absorbed a tech-led selloff back below its 50-day moving average as Facebook (FB on the Nasdaq) shed nearly 7% following reports of a massive user data breach. The VIX jumped by 20% to finish at 19. Treasury yields ticked a bit higher across the curve, while commodities came under pressure despite a weaker dollar.
- Philip Grant
Friday, March 16, 2018
Bots gone wild
Here’s a story that no one (not least your publisher) was expecting to see in Almost Daily Grant’s
Here’s a story that no one (not least your publisher) was expecting to see in Almost Daily Grant’s
If you build it, they will come?
Interbank borrowing rates, the machinations of the Swiss National Bank and cryptocurrencies are seemingly unrelated investment entities. But are they?
Interbank borrowing rates, the machinations of the Swiss National Bank and cryptocurrencies are seemingly unrelated investment entities. But are they?
Recap Mar. 16
Bots gone wild
Here’s a story that no one (not least your publisher) was expecting to see in Almost Daily Grant’s. From yesterday’s edition of USA Today:
Facebook search was not safe for work or home on Thursday night.
Typing "video of" into the Facebook search bar yielded a disturbing result. The first autocomplete was "video of girl [not reading a book].” Jonah Bennett, a graduate student, researcher and journalist, says he was tipped off to the search bar snafu by a friend. He shared it on Twitter where others got the same search results.
A couple of hours later, Facebook results were back to normal. But then Bennett tried the search in Spanish: "videos de..." and the second result was live sex videos.
Giving Facebook employees the benefit of the doubt, we surmise that artificial intelligence “singularity” has arrived early. The next step: Getting those artificial minds out of the gutter.
If you build it, they will come?
Interbank borrowing rates, the machinations of the Swiss National Bank and cryptocurrencies are seemingly unrelated investment entities. But are they? Now follows a brief update on each, revisiting a thread made in the Aug. 11, 2017 edition of Grant’s (“In your mind”) that connects the strange bedfellows. Namely: “The thin line diving financial fact from financial fantasy.”
As the stock market indecisively bounces around near its Jan. 26 high-water mark, and the 10-year Treasury yield floats on either side of 2.85%, more decisive action is taking place in short rates. In particular, three-month LIBOR (London Interbank offered rate) has continued its parabolic ascent, rising for a 27th straight session to a post-2008 high of 2.18%. That’s up from 1.13% on a year ago (during which time the Fed has raised rates by 50 basis points), and 1.88% a month ago. In that intervening 28 days, expectations for policy tightening have increased only modestly: According to interest rate futures,the odds of a Fed Funds rate of 2% or higher by year-end currently stands at 68.6%, compared to 58.2% on Feb. 16.
LIBOR, as noted in the aforementioned edition of Grant’s, is famously “manipulation prone and derived from bankers’ opinions more than market transactions.” Nevertheless, its relentless grind higher has coincided with a recently cooling corporate bond market. A report from Bloomberg today notes that domestic corporate bonds have lost a bit of luster recently, as the premium on new deals over existing debt securities averaged 11 basis points last week, compared to a one-year average premium of just 1.3 basis points. “Investors are starting to be a little more disciplined,” Bob Summers, portfolio manager at asset manager Neuberger Berman, told Bloomberg. “They aren’t just waving in every deal now.”
The gnomes in Zurich have been known to wave in a few (equity) deals themselves. In order to keep the traditional safe haven Swiss franc from unwanted appreciation, the Swiss National Bank in 2011 instituted a currency floor against the euro by printing francs, selling them, and then buying assets such as U.S. equities with the proceeds. While the SNB abruptly abandoned the floor on Jan. 15, 2015 (anticipated in the “The balance sheet that ate Switzerland,” Grant’s, Sept. 19, 2014), and the franc has weakened to near CHF 1.17 per euro from CHF 1.07 a year ago, the SNB isn’t taking any chances.
In a statement yesterday, the central bank noted that “The situation in the foreign exchange market is still fragile” and that current policy tools “remain essential.” While a formal currency floor has been mothballed (for now), the policy tool of buying stakes in real operating businesses with digitally-conjured cash continues apace. As of Dec. 31, 2017, the SNB held $92.6 billion of U.S. equities, according to its form 13-F. That’s an increase of 46% from the $64.3 billion in holdings reported at year-end 2016. In one metric, at least, are the SNB’s machinations bearing fruit. Publically-traded shares in the central bank have gone parabolic in recent months:
Source: The Bloomberg
Finally, we turn to crypto-currencies, a realm which adeptly blurs financial fact and fantasy. After a 2017 characterized by massive gains and high volatility with the accompanying animal spirits, the early stages of 2018 have been both less exciting and less remunerative. The current price of just over $8,000 is low enough to severely crimp the profits of those who mine for them online, according to Thomas Lee of Fundstrat. "Bitcoin currently trades essentially at the break-even cost of mining a bitcoin, currently at $8,038 based on a mining model developed by our data science team," Lee wrote in a report yesterday.
The city of Plattsburgh, N.Y., isn’t too distraught over the plight of the crypto miners. Yesterday, the city council unanimously voted to impose an 18-month moratorium on bitcoin mining after residents complained about surging electricity bills brought about by those hunting crypto-riches.
Meanwhile bitcoin, which traded at less than $1,000 and nearly $20,000 at different points last year, has generally remained in a $7,000 to $11,000 per coin range in recent weeks. Bloomberg notes that the narrower trading range has coincided with waning public interest:
Internet searches for ‘Bitcoin’ have plunged . . . Online searches for ‘bitcoin’ fell 82 percent from December highs, according to Google Trends. Tweets that mention the coin peaked Dec. 7, at 155,600, and are now down to about 63,000, BitInfoCharts says. And the number of bitcoin transactions is off 60 percent from its record on Dec. 13, according to Blockchain.info.
That Aug. 11, 2017 edition of Grant’s reminded readers that “Money of the mind is the broadest definition of money. It’s bounded only by the imagination.” Well, by reality, too.
Recap Mar. 16
Stocks ticked a bit higher, as did Treasury yields. Energy prices caught a solid bid despite a green greenback, with WTI crude rising back toward the middle of its 2018 trading range above $62 a barrel. The VIX finished sharply lower.
- Philip Grant
Thursday, March 15, 2018
QT Progress report
You can’t accuse them of crushing the debt market. The Fed’s balance sheet increased for a second straight week, with securities held outright footing to $4.198 trillion, up by $8.8 billion from a week ago with an uptick both its Treasury and mortgage-backed securities holdings. The current level is almost even with the trailing four-week moving average of $4.199 trillion.
Since the introduction of QT on Oct. 1, the Fed’s total assets have declined by 1.09%, for a simple annualized pace of 2.35%.
Deal derby
At what price growth? In the consumer packaged goods industry, which has been beset by eroding revenues as customers increasingly turn away to organic/fresher/better-for-you fare as opposed to the processed foods offered by legacy companies, it sure doesn’t come cheap. A trio of industry sightings follow.
On Jan. 16, Post Holdings, Inc. (POST on the NYSE) completed the acquisition of Bob Evans Farms, Inc. for $77 a share in cash, or a total consideration of $1.61 billion. Post, which is mired in a secular contraction in its core cereal business (research firm IBIS World calculates that cereal industry revenues in the United States have declined by 3.3% annually since 2012), is understandably looking elsewhere to burnish its top line (for more see “From hunger,” Sept. 16, 2016).
To do so, the house of (chairman) Bill Stiritz is paying a healthy premium: The deal price represents 15.7 times Bob Evans’ consensus adjusted earnings before interest, taxes, depreciation and amortization [EBITDA] and 43 times consensus adjusted net income for the fiscal year ending April 30. For context, the enterprise value of the S&P 500 trades at 11.6 times consensus EBITDA for 2018, according to data from Bloomberg.
The venerable Campbell Soup Co. (CPB on the NYSE), which was a post-financial crisis pick-to click at Grant’s (“Death of bonds,” Oct. 11, 2011) before we turned bearish four and a half years later (“Sell big food,” Mar. 25, 2016), also went the acquisition route to combat secular contraction in its core business. CPB announced on Dec. 18 a deal to acquire pretzels, potato chips and popcorn purveyor Snyder’s-Lance, Inc. (LNCE on the Nasdaq) for $6.04 billion in cash, which represents 18 times the sell-side’s consensus estimate for LNCE 2018 adjusted EBITDA. The Street is expecting earnings per share growth in excess of 20% this year and next, but improved efficiency (or financial engineering) is the expected catalyst, as opposed to top-line expansion. Revenue forecasts for 2018 and 2019 of $2.24 billion and $2.28 billion are virtually identical to last year’s $2.23 billion.
In paying that $6 billion haul for Snyder’s-Lance, Campbell’s own financial position has changed – and not for the better. Moody’s noted in December that CPB’s debt ratio is set to jump to 5 times EBITDA from 2.2 times in October. Last Friday, Moody’s slashed its Campbell rating by two notches, to Baa2 from A3. S&P demoted the soupmaker to triple-B from triple-B-plus shortly after the deal announcement. On Monday, Campbell’s sold $5.3 billion in a seven part bond offering, with two floating rate notes and five fixed-rate tranches at yields ranging from 3.33% to 4.84%.
Finally, we turn to General Mills, Inc. (GIS on the NYSE), the Minnesota-based concern selling snacks, yogurt and cereals. Facing the same uphill revenue battle as its peers, GIS struck a bold deal on Feb. 23, agreeing to buy Blue Buffalo Pet Products, Inc. (BUFF on the Nasdaq), for $7.89 billion in cash. That deal price, which equates to 23 times the target’s consensus adjusted EBITDA and 33 times forecast adjusted net income for 2018, earned General Mills a two-notch downgrade in its Moody’s rating to Baa2 from A3. The 3.20s of 2027, which traded above par at year end, last changed at hands at 95.5 cents on the dollar.
As for the (soon to be) newest addition to GIS, Blue Buffalo enjoyed double-digit year-over-year revenue growth during each quarter of 2016, before top-line expansion slowed to 7.9% in 1Q 2017 then 2.8% in the second quarter of last year. In response, the company announced on Aug. 3 that it would sell its high end pet food in mass market chains Target, Kroger, Publix and Meijer. That move (BUFF told readers of its 2016 form 10-K that it sold only through specialty channels) coincided with a return to double-digit revenue growth, but far faster growth in accounts receivable. Against a 10.9% year-over-year gain in 2017 revenues, receivables jumped by 30.4%.
The Post, Campbell’s and General Mills trio have something else in common besides top-line pressures and an inclination for M&A. The price for each stock peaked in July 2016, which was when interest rates in the U.S. put in their (so-far) cyclical lows with the 10-year Treasury yield touching 1.37%. Coincidence? Maybe not.
Recap Mar. 15
Stocks finished little changed, leaving the S&P 500 lower by 1.4% this week so far after notching its best finish since that early February wipeout on Friday. The Treasury flattened a bit, while strength in the dollar didn’t bother the commodity complex.
- Philip Grant
Wednesday, March 14, 2018
QE chronicles
If a bond yields nothing and no one trades it, does it even exist?
If a bond yields nothing and no one trades it, does it even exist?
Golden ruberstamp
From the Boston Business Journal:
From the Boston Business Journal:
Recap Mar. 14
QE chronicles
If a bond yields nothing and no one trades it, does it even exist? That existential question is put into relief by a dispatch from Bloomberg this morning: Not one solitary lot of the benchmark Japanese 10-year note changed hands during Tuesday’s trading session (the market was open – we checked). Bloomberg notes that “Barclays Securities Japan rates strategist Naoya Oshikubo, summed it up, with perhaps an understatement: ‘the JGB [Japanese Government Bond] market was generally thin.’” Indeed. For context, the active (June) contract of 10-year U.S. Treasury futures saw trading volume of just under 1.7 million contracts yesterday, equating to a dollar value of $202 billion.
Of course, one needn’t look too far to the explanation for a dormant debt market in the world’s third largest economy. The Bank of Japan (BoJ) has been hard at work at its “Quantitative and Qualitative Monetary Easing” strategy since April 2013, while “Yield Curve Control” has been monetary dogma since September 2016. A zero-percent 10-year yield is part and parcel with that policy, and the BoJ is taking every measure to ensure that no pesky investors get in the way of its objectives. Bloomberg writes in the same story that “Governor Haruhiko Kuroda noted to lawmakers Wednesday that the central bank has bought 75 percent of the government bonds issued in the fiscal year ending this March.”
The JGB market’s long road to zero yields has been colored by more than BoJ monetary policy or even the worldwide bond bull market. Following the bursting of a spectacular stocks and real estate bubble of the 1980’s, the Japanese economy has been marked by stagnation: Since 1998, Japanese year-on-year CPI growth has averaged 0.1%. In that same 20-year period, Japanese year-over-year real chained GDP growth has averaged just 0.8%.
Five basis points to go: The Japanese 10-year yield, 30-year view. Source: The Bloomberg
In an effort to reach the consensus monetary Valhalla of 2% inflation, the BoJ has undertaken policy that leaves its peers in Europe and the United States in the dust: In the five years ended Feb. 28, Japan’s monetary base (comprised of money in circulation as well as bank reserves) has increased by 281% to ¥475 trillion ($4.4 trillion), or just under 31% annualized growth. By comparison, the European Central Bank has increased its monetary base by 63% over the past five years (10% annualized growth), while the Federal Reserve has overseen a 34% uptick in the U.S. monetary base, or 6% annualized. On the consumer inflation count, the BoJ has been somewhat successful. Over the past five years, average CPI growth has risen to 0.9%.
While the BoJ prints yen, the Fed is nearly six months in to its (very gradual, to be sure) balance sheet reduction while the 10-year Treasury yield has more than doubled from its July 2016 lows of 1.37%. The Wall Street Journal noted on Feb. 28 that foreign investor demand for Treasurys has been crimped by rising hedging costs as the Fed continues to raise overnight interest rates (Almost Daily Grant’s, Feb. 28). Nevertheless, Russell Napier, independent strategist and co-founder of the Electronic Research Interchange, speculates in today’s “The Solid Ground” commentary on potential consequences if Mr. and Mrs. Watanabe come to find U.S. Treasurys and their positive real yields too tempting to resist:
Might this additional relative yield tempt Japanese investors? If it does, who buys the JGBs they most likely liquidate to fund their Treasury purchases? If such a liquidation is triggered, the BOJ balance sheet expansion, given their yield target for JGBs, would accelerate just as the Fed’s balance sheet contracts.
So, the more the Fed acts to contract its balance sheet, the more it could, through enticing Japanese savers to the Treasury market, force an accelerated balance sheet expansion on the BoJ. This [effort], aimed at driving up all asset prices, while maintaining relative interest rate stability, will very clearly be over. The impacts from a decline of the yen on the international exchanges will be profound.
The yen currently trades at 106.8 per dollar, almost exactly at its 20-year average.
For its part, the central bank has evinced no lack of conviction in its goal or its methods. The BoJ website explains that “When prices fluctuate, individuals and firms find it hard to make appropriate consumption and investment decisions, and this can hinder the efficient allocation of resources in the economy.” Potential consequences of unrivaled financial repression were left unmentioned.
Golden ruberstamp
From the Boston Business Journal:
GE (NYSE: GE) paid $142.9 million in audit and related fees and tax fees to KPMG last year — more than any year since at least 2000, and perhaps longer, according to GE’s proxy filing Monday. The filings prior to 2000 do not include audit fees.
In the proxy filing, the Boston-based company asked shareholders to endorse KPMG as its auditor for another year, in the face of increased scrutiny of GE’s accounting practices. GE is under investigation by federal securities regulators for its accounting, and it recently revealed an unexpected $15 billion shortfall in its legacy insurance business. KPMG has been GE’s auditor for more than a century.
Nice work, if you can get it.
Recap Mar. 14
Stocks absorbed a second straight round of moderate selling pressure, while a strong bid at the long end of the Treasury complex pushed spreads between the two- and 10-year and the five- and 30-year yields back within a few basis point of their respective lows for the cycle. The VIX rose for a third straight day.
- Philip Grant
Tuesday, March 13, 2018
Who will guard the guards themselves?
Yesterday’s edition of the Financial Times features a remarkable, and somewhat alarming, claim:
Yesterday’s edition of the Financial Times features a remarkable, and somewhat alarming, claim:
Poutine on the ritz
Former belle of the investment-ball Valeant Pharmaceuticals International, Inc. (VRX on the NYSE and Toronto Stock Exchange) has been given the cold shoulder
Former belle of the investment-ball Valeant Pharmaceuticals International, Inc. (VRX on the NYSE and Toronto Stock Exchange) has been given the cold shoulder
Recap Mar. 13
Who will guard the guards themselves?
Yesterday’s edition of the Financial Times features a remarkable, and somewhat alarming, claim: A large proportion of worldwide accounting audits contain “serious problems.” The FT explains:
According to the International Forum of Independent Audit Regulators [IFIAR], accounting lapses were identified at two-fifths of the 918 audits of listed public interest entities they inspected last year.
The most common issue identified by these regulators was a failure among auditors to “address the reasonableness of assumptions.”
While the inherent subjectivity of management estimates would seemingly allow some room for differing interpretations, the watchdog’s next finding reads as a more direct indictment of industry practices.
The second biggest problem was a failure among auditors to “sufficiently test the accuracy and completeness of data or reports produced by management.”
Beyond the unflattering findings unearthed by the IFIAR, 2018 was already off to a rough start for the auditors. On Jan. 22, the Securities and Exchange Commission and federal prosecutors announced charges against six certified public accountants at the Public Company Accounting Oversight Board (PCAOB) and “Big Four” auditor KPMG, LLC. From the SEC’s press release:
The SEC's Division of Enforcement and Office of the Chief Accountant allege that the former PCAOB officials made unauthorized disclosures of PCAOB plans for inspections of KPMG audits, enabling the former KPMG partners to analyze and revise audit workpapers in an effort to avoid negative findings by the PCAOB. Two of the former PCAOB officials had left the PCAOB to work at KPMG. The SEC's Enforcement Division and Office of the Chief Accountant allege the third official leaked PCAOB data at the time he was seeking employment with KPMG.
“As alleged, these accountants engaged in shocking misconduct – literally stealing the exam – in an effort to interfere with the PCAOB's ability to detect audit deficiencies at KPMG," said Steven Peikin, Co-Director of the SEC's Enforcement Division.
Francine McKenna, transparency reporter at Marketwatch and alumna of two Big Four firms, wrote in a Jan. 30 analysis of the situation that the Department of Justice complaint “suggests that at least five more unnamed KPMG partners and one outside consultant either knew or chose to ignore the illegal source of the information.”
In the light of the less-than comforting findings made by the IFIAR and the U.S. government’s allegations against KPMG, Grant’s asked McKenna for her assessment of the auditing industry as a whole:
Not immune to incentives, these firms have appeared to increasingly represent the interests of the companies that hire them, instead of acting as another set of eyes for investors as they are supposed to. They audit, consult, do taxes, perform due diligence on acquisitions, then investigate if things go wrong.
Overall, it’s troubling that the auditors have largely disregarded the core tenets of professional skepticism, independence and objectivity which are critical to effective oversight. These firms are not service providers. The relationship between auditor and company is supposed to be adversarial, and if it’s not, the auditor isn’t doing their job.
As the longstanding bull market in equities remains intact, so does broad faith in those charged with making sure that corporations are operating on the up and up. On Oct. 25, the Center for Audit Quality released its 11th annual Main Street Investor Survey of 1,001 retail investors, conducted in September via the telephone and online. A record high (85%) of respondents expressed confidence in the U.S. capital markets, while 54% did so for non-U.S. markets, up sharply from 42% in 2016.
The auditors themselves also scored high marks, with 78% of investors reporting confidence in public companies’ audited financials, up from 71% two years prior and a low of 69% in 2011. The dissenting minority (those expressing “very little” or “none at all”) dropped to a record low of 12%, down from 20% in 2015 and a high of 27% in 2009.
Poutine on the ritz
Former belle of the investment-ball Valeant Pharmaceuticals International, Inc. (VRX on the NYSE and Toronto Stock Exchange) has been given the cold shoulder by the stock market since July 2015 (VRX shares down by 94% over that period while the S&P 500 has risen by 31%), but bond investors just can’t quit the Laval, Quebec specialty-pharma concern.
The reformed roll-up, a frequent bearish subject of Grant’s during its 2014-2015 heyday (“Drug dealer,” “Sacrificial creditors,” “Reality check,” “Saul Steinberg’s second coming,”) and currently attempting to deleverage its stifling debt load, made a successful visit to the bond market yesterday, offering $1.25 billion of Caa1/single-B-minus rated 2026 senior notes at 9 1/4%. Valeant will use the proceeds to launch tender offers for a trio of shorter term obligations: 6 3/8% notes due in 2020, 5 3/8% notes due in 2020, and 6 3/4% notes due in 2021. Investors clamored for more, allowing the company to upsize yesterday’s offering to $1.5 billion at the same 9 1/4% yield.
Valeant can use the breathing room. It’s $24.8 billion in net debt dwarfs its $5.6 billion market capitalization and represents a forward leverage ratio of just under eight times earnings before interest, taxes, depreciation and amortization, while interest expense of $1.8 billion is more than three times trailing operating income of $493 million (the Street expects operating income to jump to $2.5 billion this year). Meanwhile, the eight year maturity on Monday’s offering will outlast the patent protection on some of Valeant’s products. The Food and Drug Administration reminds visitors to its website that domestic patent exclusivity extends for 20 years from filing date. Orphan drug patent exclusivity lasts for seven years.
In the “business strategy” section of its most recent form 10-K, Valeant notes that: “We face increased competition from manufacturers of generic pharmaceutical products when patents covering certain of our currently marketed products expire or are successfully challenged or when the regulatory exclusivity for our products expires or is otherwise lost.”
For credit investors, “increased competition” seems to mean something else entirely.
Recap Mar. 13
Stocks came under pressure today, with the S&P 500 reversing early gains to fall by nearly 1.5% from its peak and finishing near session lows. A stronger than expected 30-year Treasury auction in early afternoon helped push yields lower across the curve, as USTs continue to consolidate after the breakout in yields seen in January. The VIX had another strong day, and has ticked higher by 15% so far this week.
- Philip Grant
Friday, March 9, 2018
We're gonna need a bigger moat
A dispatch from the New York Post:
A dispatch from the New York Post:
In out of the cold
One needn’t strain too hard to find similarities between market conditions today and the late-1990’s bull stampede.
One needn’t strain too hard to find similarities between market conditions today and the late-1990’s bull stampede.
Recap Mar. 9
We're gonna need a bigger moat
A dispatch from the New York Post:
An irate leopard paid an unexpected visit to a community in Indore, India, causing residents to panic. Some tried coaxing the animal to leave using wooden poles. The local police department and forest department teams worked together to finally sedate and remove the agitated animal. The forest department’s divisional forest officer R.K. Saxena was one of three people injured by the leopard. Details of how the big cat got into the gated community are still unclear.
A silver lining for the residents of Indore: At least they don’t have to ride the subway.
In out of the cold
One needn’t strain too hard to find similarities between market conditions today and the late-1990’s bull stampede. As the recent correction recedes from view, general investor euphoria floods to mind. The blistering ascent of the FAANG+ contingent in this cycle evokes the tech mania as the internet phenomenon first took hold.
However, a critical distinction emerges when looking beyond those corporate VIPs: Back then, expensive stocks coexisted with a number of cheap ones. In March of 2000, the market-cap weighted S&P 500 traded at 30.6 times trailing earnings, while the equal-weighted version of the broad index fetched a relatively modest 20.7 times earnings. Today, the market-cap weighted S&P 500 sports a trailing price/earnings ratio of 22.41 times, while the equal-weighted S&P 500 trades at 22.45 times trailing earnings. Value, not only relative but absolute, was on the offing for investors in 1999 even as the Nasdaq careened parabolically higher.
The Dec. 3, 1999 edition of Grant’s (“Car wreck") shined an analytical spotlight of one of these curious bargains, in the form of Tenneco, Inc. (then called Tenneco Automotive), a leading auto-parts manufacturer then trading at just 4.8 times forward net income estimates:
In the midst of a great bull stock market, there is a flourishing, parallel bear market: scores of small-cap, analog-style companies are valued as if the year were 1990, or even 1982, or even 1974, instead of 1999. Tenneco Automotive . . . could be the poster child for orphaned companies.
Of course, cheap companies are usually cheap for a reason and Tenneco had its share of warts: Stagnant revenues, rising costs and an increasingly onerous debt burden pushed its share price lower by some 65% over the prior three years, a period in which the S&P 500 soared by 95%. These disappointments had seemingly conferred commanding value with a margin of safety on Tenneco:
Possibly, of course, the company will fail to deliver even the meager results that the Street expects of it. Then what? “If they totally miss their earnings,” comments Seth A. Klarman, president of the Baupost Group, Cambridge, Mass., one of the few known bulls on the situation, “the stock is . . . cheap.”
The months passed (as they have been known to) and Tenneco remained a spectator in the New Economy-driven market ascent. On March 3, 2000 (“Valuation non sequitur"), Grant’s reviewed its positive stance on the auto-parts maker, observing the contrast between the company’s treatment in the credit market and its share price, which had cheapened further to trade at 4.5 times forward earnings.
Yet if the stock market is pricing in oblivion, the bond market is more than sanguine. If it were not, the Tenneco 11 5/8s of 2009 would not be quoted two points above par, at a price to yield 11.1%. A hot cup of coffee, Mr. Market?
By and by, Mr. Market did come to see things the bulls’ way. Since March 2000, Tenneco shares have rallied by 540%, while the S&P 500, then just beginning to unwind the late-1990’s excesses, has since gained by 99%. Relative to the auto industry as a whole, Tenneco’s Y2K-era discount appears to have closed.
Tenneco shares in white, U.S. auto sales, seasonally adjusted annual rate in orange. Source: The Bloomberg
Meanwhile, the search for bargains continues apace in a market that evokes Garrison Keillor’s Lake Wobegon: A world where all the children are above average.
Recap Mar. 9
On the ninth anniversary of the 2009 closing low, a strong reading of non-farm payrolls helped keep the bulls in the driver’s seat. The S&P 500 jumped again to finish the week more than 3% in the green, and back within 3% of the Jan. 26 closing highs. Treasury yields ticked higher, with the 10-year back near 2.90%, and energy caught a bid despite a flat dollar.
A remarkable fact courtesy of Twitter user Michael Batnick. Since Oct. 27, Amazon.com, Inc. shares are up more than 60%, adding just under $300 billion to its market cap. That figure alone would place Amazon just ouside the top-10 largest companies in the S&P 500.
- Philip Grant
Thursday, March 8, 2018
Middleby earth
Investors were left hungry. Middleby Corp., reported fourth quarter results on Feb. 27, with revenues of $632.9 million falling short of the expectation of each of the 10 sell-side analysts who proffered a forecast, while fourth quarter gross margins of 37.9% shrank by a meaty 220 basis points year-over-year. The disappointing figures were met rudely, as the MIDD stock price sold off by 12% to $118 a share (it’s since bounced to $126). Since June 2016, MIDD shares have gained 3%, lagging the S&P 500’s 31% advance during that period.
Middleby, which was founded in 1888, is in the business of manufacturing and selling equipment for commercial and residential kitchens, and the machinery used by packaged food companies. Recent years have been characterized by a parade of acquisitions. In late 2012, Middleby diversified into residential kitchen category by buying Viking Range Corp. for $361.7 million in cash. In the past five years, the company has made 22 separate acquisitions, by our count.
In explaining the fourth quarter shortfall, the company flagged weakness in its commercial unit (which contributes the bulk of revenues and operating profits), particularly dwindling demand for its ovens, broilers and fryers from restaurants. Chairman and CEO Selim A. Bassoul commented that: “Sales to our major restaurant chain customers remained impacted in the quarter as replacement purchases were less than prior years as customers evaluated new equipment solutions.”
John Hamburger, president of the Restaurant Finance Monitor (and speaker at the upcoming April 10 spring conference – advt.), told Grant’s that the restaurant industry is contending with a number of factors that may continue to constrain capital outlays on things like state of the art equipment.
Chain restaurant expansion slowed somewhat because of the economics (rising labor and rents), plus the private equity owners and boards of directors are more cognizant of capital spending. 2017 was not a good year for restaurants…many brands were sales challenged and that weighed on spending.
Fourth quarter miss aside, analysts at BMO Capital Markets believe Middleby deserves the benefit of the doubt amid a long run of success. On Tuesday they raised their price target to a Street-high $160 a share. Machinery analyst Joel Tiss, who rates MIDD shares “outperform,” writes:
With the shares trading at five-year valuation lows, we see exceptional opportunity for those investors who know the company well and recognize the excellence of its management team.
Middleby is in an elite class of companies that significantly outgrow end markets while expanding margins. This is evidenced by an unmatched track record of compounding growth rates, including 19% for revenue, 24% for operating profit, and about 31% for [earnings per share] since 2000.
On the whole, the Street is expecting Bassoul to deliver for investors. Analyst consensus calls for adjusted EPS growth of 11.3% and 10.9% in 2018 and 2019, respectively. And why not? Adjusted EPS growth has remained in the double digits in each year going back to 2010. Free cash flow has been less dynamic of late, ranging from between $221 million and $269 million in the last four years. The sell side collectively expects that line item to jump to $364 million in 2018 and $510 million in 2019.
Grant’s has cast a skeptical eye on Middleby, producing a pair of bearish analyses (“Waiter, the check,” June 17 and “Out of the kitchen,” Dec. 23) in 2016. We argued that the low rates-driven boom in restaurant capacity has allowed the company to achieve strong financial performance at the expense of future demand, while Bassoul’s acquisition-heavy and R&D-lite strategies serve to further flatter its income statement through, among other things, artificially low amortization expense.
Under the rules of purchase accounting, acquirers may apportion the assets of their acquirees as they wish for 12 long months after the transaction closes. Middleby has tended to tag those assets “goodwill and other intangibles” (GOI). Most assets so designated need not be amortized. And as they are not amortized, they do not impair the optics of reported GAAP earnings.
Indeed, goodwill ($1.26 billion) and intangibles ($780 million) account for 61% of Middleby’s total assets, according to the company’s recently released form 10-K. Meanwhile, the aforementioned Viking Range acquisition of 2012 was also a critical piece of the Middleby narrative. In particular, the story quoted an unnamed appliance retail CEO lamenting the poor quality of certain Viking products. That anecdote, in concert with declining organic revenues in the residential division, led deputy director Evan Lorenz to speculate on the potential for asset writedowns.
Few analysts will second-guess the accounting judgements of the management of a successful company or division. The fact is that the decline in sales of Viking ranges drove the aforementioned 19.6% year-over-year drop in organic sales in the residential division. Pending a timely fix – of which we see no sign – a writedown may be in store for some of the $309.1 million in GOI that the Viking transaction brought on board.
That scenario indeed came to pass in the fourth quarter: Middleby took a $58 million impairment “related to the Viking tradename.” We wonder if more such unfriendly adjustments are on the way, and also wonder if the Street’s expectation for gangbusters EPS and free cash flow growth will itself come to pass.
QT progress report
With QT like this, who needs QE? The Fed’s portfolio of securities held outright rose by $180 million from a week ago to $4.189 trillion. Both its Treasurys and mortgage-backed securities components contributed to the unexpected increase, ticking higher by $160 million and $19 million, respectively. Things look a bit more normal (if that’s the word) compared to the trailing four week average: Footings have declined by a bit more than $13 billion, with Treasurys lower by MBS holdings down by $5.5 billion. Overall, total Fed assets are down by 1.34% since the beginning of QT on Sept. 27, a simple annualized pace of 3.01%.
Not just this week has progress been halting. Bianco Research finds that the MBS run-off had already fallen behind the Fed’s target even prior to today’s uptick, with the $1.76 trillion in holdings well above the target $1.746 trillion for March 1 based the Fed’s projections.
Jerome Powell’s got some work to do.
Recap March 8
Stocks caught a bid, with the S&P 500 extending its gain for the week to 1.8% so far. Treasury yields ticked lower across the curve, and a stronger greenback pushed the Dollar Index back above 90 as this afternoon’s steel and aluminum tariff announcement featured exemptions for Canada and Mexico, as well as the possibility of other countries also getting a waiver.
- Philip Grant
Tuesday, March 6, 2018
Sentiment check
The upcoming Toronto Real Estate Wealth Expo,
The upcoming Toronto Real Estate Wealth Expo,
Hold the chicken ceviche
The geographic borders of the European Union are well defined.
The geographic borders of the European Union are well defined.
Recap March 6
Sentiment check
The upcoming Toronto Real Estate Wealth Expo, scheduled for April 7 with featured speakers including Sylvester Stallone, Alex Rodriguez and the musician Pitbull, has added a new feature to its agenda. This year, the event (which has taken place in Toronto since at least 2007) has been renamed the “Real Estate, Bitcoin & Wealth Expo.” As of this morning, Groupon was advertising the C$216 tickets at C$39, an 82% discount.
Maybe now, the Real Estate, Bitcoin, Wealth, and Value Expo.
Hold the chicken ceviche
The geographic borders of the European Union are well defined. The purview of the European Central Bank, less so. In the bond market, pronounced investor complacency remains as Mario Draghi and Co. maintain crisis-era monetary policy including a negative overnight deposit rate and corporate bond purchases at a (tapered) €30 billion monthly pace. For the latest example, we travel far from Frankfurt to Sao Paulo, Brazil.
Yesterday, Brazilian authorities arrested Pedro Faria and Helio dos Santos Junior, former CEO and vice president of global operations, respectively at BRF Brasil Foods S.A., and suspended exports at three of the company’s slaughterhouses as part of “Operation Weak Flesh,” an ongoing investigation into whether BRF covered up evidence of salmonella-contaminated food exports and bribed inspectors to look the other way. While such news is never welcome, the latest revelations are particularly unpleasant for BRF as it comes on the heels of an ongoing shareholder campaign to replace the company’s entire board of directors and a fourth quarter which Bloomberg termed “the worst results in its history.”
As analysts at BTG Pactual write, the news both explains the recent contraction in BRF’s margins and lays bare the challenge ahead as new management attempts to right the corporate ship:
In our opinion, a stricter quality control system has led BRF’s production costs to spiral in recent quarters, (presumably) explaining why gross margins haven’t recovered properly. Ultimately, yesterday’s events, with the suspension of plants and the potential to really impact BRF’s sales, could intensify the problem, meaning there’s potential for another strong downward revision to estimates, which may put BRF’s much-needed deleveraging ambitions in check.
BRF could most certainly use some deleveraging, improved profitability, or both. Against net debt of R$19.7 billion ($6.1 billion), the company managed adjusted earnings before interest, taxes, depreciation and amortization (EBITDA) of R$3.2 billion in 2017, for an unadjusted leverage ratio of 6.2:1. Analyst consensus for 2018 calls for adjusted EBITDA to jump to R$4.8 billion. Likewise, 2017 interest expense of R$1.16 billion almost matched full-year operating income of R$1.33 billion. Analysts had penciled in a near-doubling in operating income for their current year forecasts, to R$2.6 billion.
S&P, which rates BRF at triple-B-minus (on the cusp of junk status), commented yesterday that the company’s ratings “are not immediately impacted” by the bombshell report, but the ratings agency had already cast a wary eye: On Feb. 23, S&P lowered BRF’s outlook to negative, commenting that: “its credit metrics remain pressured for the rating category and weighs on a quick improvement to avoid a downgrade.”
BRF’s creditors meet these travails impassively. The company’s euro-denominated senior unsecured 2-3/4 notes due in 2022 trade at 97 cents on the euro as of this writing, for a yield-to-worst of 3.39%. The dollar denominated 4-3/4s of 2024 currently trade just above 95 cents for a yield-to-worst of 5.71%.
Are the bondholders drugged or are they just mellow?
Recap March 6
Stocks ticked a bit higher in decidedly low key action, while Treasurys also finished little changed to continue their recent inertia. Gold caught a bid, jumping back above its 50-day moving average at $1,333 per ounce.
- Philip Grant
Monday, March 5, 2018
Uber stingy?
Some side hustles are more worthwhile than others.
Some side hustles are more worthwhile than others.
Call in the Mounties
The arrival of the long awaited (or feared) B-20 mortgage regulations in the Great White North
The arrival of the long awaited (or feared) B-20 mortgage regulations in the Great White North
Recap March 5
Uber stingy?
Some side hustles are more worthwhile than others. A recent study from researchers Stephen M. Zoepf, Stella Chen, Paa Adu and Gonzalo Pozo at the MIT Center for Energy and Environmental Policy Research suggests that on the whole, drivers at ride share unicorn Uber Technologies, Inc. and its peer Lyft, Inc. are barely keeping their heads above water once costs are factored in:
We perform a detailed analysis of Uber and Lyft ride-hailing driver economics by pairing results from a survey of over 1,100 drivers with detailed vehicle cost sharing information. Results show that per hour worked, median profit from driving is $3.37 per hour before taxes, and 74% of drivers earn less than the minimum wage in their state. Thirty percent of drivers are actually losing money once vehicle expenses are included.
The researchers find that against median gross driver revenue of $0.59 per mile, vehicle operating expenses such as gas and wear-and-tear (for which the drivers are responsible) shave $0.30 cents per mile off that top line figure. For its part, Uber disputes the study’s findings, arguing that the authors utilized flawed methodology to arrive at the above figures. Jonathan Hall, Uber’s chief economist, also notes in the Medium blog post response that other studies contradict the MIT groups’ findings:
For example, a study we conducted with Alan Krueger of Princeton found that drivers across 20 of Uber’s largest US markets earned an average of $19.04 per hour, in October 2015. A more recent study with Stanford professors estimated gross hourly earnings of $21.07 for all US drivers between January 2015 and March 2017.
Uber CEO Dara Khosrowshahi chimed in on Twitter Saturday, quipping that: “MIT = Mathematically Incompetent Theories (at least as it pertains to ride sharing).”
Whether Uber’s drivers are making an hourly rate of $3.37, $21.07 or somewhere in between, the company seems to be in no position to be proffering its contractors (not employees – that would mean paying benefits) a raise. Uber lost $4.5 billion last year on $7.5 billion in revenue according to the Associated Press, more than 50% above its $2.8 billion loss in 2016. After achieving a $68 billion valuation in an August 2016 funding round, the company raised $9 billion from a consortium led by Japan’s Softbank Corp. in a two-tiered investment in January. The investors paid a $1.3 billion portion at that same $68 billion figure in an apparent attempt to maintain its prior valuation, with the remaining $7.7 billion of Masayoshi Son’s lucre valuing Uber at $48 billion, a 30% discount to the prior round.
Uber has earned a reputation for being particularly reluctant to share financial information with investors. That, and its inability to approach profitability, bothers some on Wall Street more than others. The Jan. 27, 2017 Grant’s analysis of Uber (“Not Joseph Schumpeter”), noted the contrasting approaches to the private market behemoth employed by different investment banks:
One year ago, JPMorgan Chase & Co. and Deutsche Bank AG declined the opportunity to sell Uber shares to their high net worth clients. No information, no sale, they said in so many words. Morgan Stanley was not so punctilious. In choosing to broker the stock, it had this so say to its clients, according to a Nov. 7 Bloomberg dispatch: ‘[T]he development of insights and big ideas is valuable to the investing process, whereas obsession over incremental ‘information’ flow is not.” Passive investing, indeed.
Call in the Mounties
The arrival of the long awaited (or feared) B-20 mortgage regulations in the Great White North has yet to yield a discernible impact on the Canadian housing market. January activity slowed slightly year-over-year, while prices ticked a bit higher, according to Statistics Canada.
As the business of buying and selling the only asset class with a backyard plods along, some observers are growing a little nervous about the Canadian banking system. On Feb. 23, S&P Global raised its risk assessment of Canada’s banking sector to three (signifying “intermediate credit risk in the economy”) from two (connoting low credit risk). By way of explanation, S&P wrote:
We believe that structural shifts in the residential mortgage [RM] origination process in Canada, in particular the growing share of RMs originated via brokers, compound the risks of high household debt and house prices because we believe brokers generally have less incentive than lenders to guard against fraud.
Lenders may have a stronger incentive to prevent fraud, but is it strong enough? On Feb. 28, Montreal-based Laurentian Bank of Canada (the country’s eighth largest by market cap) - which surprised Bay Street on Dec. 5, 2017 by disclosing it had identified “documentation issues and client misrepresentations” in a C$304 million pool of mortgages which had already been securitized and sold - provided an update on its first quarter conference call.
The bank fessed up to an additional C$88 million of ineligible loans which had been “inadvertently sold” to the Canada Mortgage and Housing Corp. (CMHC), the Fannie Mae and Freddie Mac of the north. Laurentian is continuing to review its mortgage pool (it expects the inspection to last through the second quarter), but the regulators aren’t exactly cracking the whip. “After discussions with CMHC, we are not required to perform a full review of the mortgages sold to CMHC securitization programs,” said the bank in a statement.
Grant’s inquired with the CMHC press office about their less-than severe response to Laurentian’s mortgage misadventure, and the agency had this to say:
We actively monitor all institutions who participate in our programs and continue to work with Laurentian Bank to ensure they have proper controls in place.
Laurentian Bank has repurchased $88 million of loans from CMHC and we have implemented some additional internal operational measures for Laurentian Bank as a result of this process. We continue to monitor Laurentian Bank’s activities and performance and will work closely with them to help improve controls.
Recap March 5
Equities enjoyed a strong rally, with the S&P 500 finishing near its best levels of the day to erase the bulk of last week’s decline, while energy prices were also notably strong amid a flat dollar. Treasurys again finished little changed; the 10-year note has recently settled into a tight trading range near a 2.9% yield after notching a four-year closing high on Feb. 21.
- Philip Grant
Friday, March 2, 2018
PE class
It’s good to be king. Private equity titan Stephen Schwarzman, the founder and CEO of the Blackstone Group (BX on the NYSE), took home $786.5 million in 2017 according to an SEC filing yesterday, largely thanks to dividends on his Blackstone partnership units. That nearly doubles his 2016 paycheck of $425 million and “underscores the health of the private equity sector,” according to the Financial Times. Competitor Leon Black of Apollo Global Management LLC took home $191.3 million, while KKR & Co.’s Henry Kravis and George Roberts earned a combined $343 million according to Bloomberg.
Michael Milken, the junk-bond monarch of the 1980’s who preceded Schwarzman in attaining compensation that towered over the field (he took home $294 million in 1986 and $550 million in 1987, per the New York Times) before falling from grace in 1989, expects the good times for Blackstone and private equity at large to continue. Milken told Bloomberg in a September interview that: “This is their golden age. You can leverage, you can borrow without covenants, and so for equity holders it affords you very unusual rates of return.”
Clearly it’s a golden age for the senior progenitors of private equity. How about their investors? A Feb. 20 analysis in American Affairs Journal found that optimism is widespread.
A recent survey of institutional investors found that 49 percent expect private equity (PE) to outperform the public equity market by a whopping 4 percent per year or more. Another 45 percent believe PE will outperform by 2-4 percent per year. Only 6 percent think returns will be comparable.
Readers may notice that the above figures add up to 100%, indicating that no constituency thinks PE may lag the public market. Author Daniel Rasmussen, founder and portfolio manager at Verdad Capital, has you covered:
The survey did not even bother to ask if investors thought PE might underperform. This is particularly shocking given that data from Cambridge Associates shows that private equity returns have lagged the Russell 2000 index by 1 percent and the S&P 500 by 1.5 percent per year over the past five years.
What about the PE manager who claims that he can improve the performance of his portfolio companies through operational expertise, cost cutting and a focus on long-term results as opposed to trying to please the Street on a quarterly basis? Rasmussen went on to cite research conducted by Verdad of 390 deals encompassing more than $700 billion in enterprise value to assess private equity’s long term track record.
In 54 percent of the transactions we examined, revenue growth slowed. In 45 percent, margins contracted. And in 55 percent, capex spending as a percentage of sales declined. Most private equity forms are cutting long-term investments, not increasing them, resulting in slower growth, not faster growth.
While survey results are mixed on operational metrics, a common thread emerges:
In 70 percent of cases, PE firms are leveraging up the businesses they buy. PE firms typically double the amount of debt on the balance sheet, from 2.5 times EBITDA [earnings before interest, taxes, depreciation and amortization] to 5 times EBITDA – the biggest financial change apparent from our study.
There is certainly no shortage of funding to be levered. Preqin reported in January that private equity raised a record $453 billion in 2017 (surpassing 2007’s record of $414 billion), leaving the industry with over $1 trillion in dry powder for future deals. Which is a lot of dry powder even if you say it fast.
To Grant’s, which had bullish things to say about Blackstone shares on a handful of occasions in 2011, 2012 and 2013 (BX shares have returned 150% over the past five years with dividends reinvested, compared to 94% in the S&P 500), the current PE zeitgeist is reminiscent of the early-aught hedge fund boom. The April 9, 2004 edition of Grant’s (“Fees and fees and fees on funds of funds of funds”) took a skeptical look at Man Group Plc., the London-based hedge fund firm which had achieved a 46% year-over-year uptick in assets under management while charging institutional investors a 4% management fee on top of a 20% performance fee. Grant’s addressed a hypothetical question of the bourgeoning and increasingly layered hedge fund business which could be equally applied to the private equity cohort today:
How can so many smart, aggressive, fee-driven and highly leveraged investors find wealth and happiness together on the same planet? With difficulty.
Recap March 2
Apparently, trade wars are good and easy to win! Stocks staged a solid intraday rebound after Trump’s latest tariff commentary, closing near session highs to break the string of +/- 1% moves at five and narrow the week’s losses to 2% on the S&P 500. The VIX sold off late to finish below 20, while Treasury yields drifted higher across the curve and dollar weakness coincided with a bid in energy and gold.
- Philip Grant
Thursday, March 1, 2018
Face bunker
The wolves continue to circle Facebook Inc. (FB on the Nasdaq),
The wolves continue to circle Facebook Inc. (FB on the Nasdaq),
QT progress report
Recap March 1
Face bunker
The wolves continue to circle Facebook Inc. (FB on the Nasdaq), as government scrutiny and competitive pressures intensify. The stock has been weak of late, down 9% from its Feb. 1 high compared to a 2% drop in the Nasdaq 100 and 5% decline in the S&P 500 over that period, but it remains higher by 537% over the past five years. We’re bearish on it.
Yesterday, Bloomberg reported that China will soon block the virtual private networks that have allowed their citizens to skirt Beijing’s restrictions on social media sites such as Facebook. Likewise, Bloomberg notes today that News Corp. CEO Robert Thomson’s long-time campaign to wrest concessions of Facebook and Google (which control 73% of the U.S. digital advertising as of the 2nd quarter of 2017, per Brian Wieser of Pivotal Research Group) is gaining traction with his peers:
At a Recode conference last month, BuzzFeed co-founder Jonah Peretti agreed that Facebook should share more revenue generated by its News Feed with media outlets. On a recent earnings call, New York Times Co. CEO Mark Thompson expressed optimism that demand for quality news has created “the possibility of direct payment from distributors.” Martin Sorrell, CEO of advertising giant WPP plc. said in January that he supported such a proposal.
“Too many publishers have been patsies,” Thomson said in an interview from News Corp.’s headquarters in midtown Manhattan, where he oversees the Wall Street Journal, Dow Jones & Co. and the New York Post. “What you are seeing, at last, is more publishers are prepared to be more vocal and that eerie collective silence has been broken.”
Facebook’s remarkable ascent has left it with a dominant share of digital ads as well as a supermajority of users. In the U.S., 68% of adults use Facebook according to a January survey conducted by Pew Research. That proportion has remained constant since the beginning of 2016. Meanwhile, Pivotal Research’s Wieser cited Nielsen data which found an 11% year-over-year per person decline in time spent on the site in November (Almost Daily Grant’s, Feb. 20). For its part, Facebook disclosed that daily active users in the U.S. and Canada ticked lower on a sequential basis in the fourth quarter, a first.
Advertisers are taking notice. Today, Reuters reports that Proctor & Gamble Co., the world’s largest advertiser, cut its digital ad budget by $200 million last year (digital spending represents a third of P&G’s $7.1 billion ad budget per Reuters). Marc Pritchard, P&G’s chief brand officer said at a conference that: “With transparent viewability data, we learned that the average view time for an ad on a mobile newsfeed is 1.7 seconds – little more than a glance – pushing us to innovate.”
The Grant’s Aug. 11 analysis of Facebook (“Concerning Mark Zuckerberg”) contended that the social media behemoth is vulnerable to resistance from different constituencies who may not share the C-Suite’s messianic visions for “build[ing] a global community that works for all of us” (that’s from the company website).
John D. Rockefeller was no more popular with 19th-century oilmen than Zuckerberg is with 21st-century magazine publishers, or with a certain kind of reader or writer who cannot share [chief operating officer Sheryl] Sandberg’s enthusiasm for “short-form snackable content.”
While Facebook’s domestic user growth runs into the laws of gravity, the company continues to struggle in its fight against that potent yet ever so hard to define scourge of fake news. Company executives have certainly not obfuscated on the questionable societal value of social media (Almost Daily Grant’s, January 22). Yesterday, Sandberg told listeners at the Morgan Stanley Technology, Media & Telecom conference that: “What the data shows is not all interactions in social media are equally good for people in terms of their psychological well-being.”
What to do about it? Hire lots more people, apparently. Facebook had 25,105 employees as of Dec. 31, 2017 according to its form 10-K. That’s up 47% year-over year. A majority of those are policing the digital airwaves, as opposed to growing the business by developing software or generating revenue by selling ads, according to a Feb. 22 bulletin from The Economist:
Facebook has around 14,000 workers overseeing security, safety, compliance and community operations, twice as many as a year earlier, and that figure is likely to rise as more countries require it to find and remove objectionable content.
Meanwhile, the share transference from company insiders to passive index funds which frequently allocate based on market capitalization (Facebook’s is $511 billion) continues apace. The Vanguard Group, BlackRock and State Street Corp are three of the top four Facebook shareholders, holding an even 17% of shares outstanding as of Dec. 31, 2017. In the fourth quarter, the trio added just under 25 million shares to their combined stakes.
The accumulating indexers are receiving substantial daily liquidity from Zuckerberg himself. The Facebook boss was a seller of 2,690,200 shares in the eleven trading days between Feb. 12 and Feb. 28, an average of 224,000 per session. Zuckerberg’s sales represented just over 1% of all trading in Facebook stock over that period.
Wise move, we reckon.
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Zuck sells, you buy. Source: The Bloomberg
QT progress report
The run-off accelerated a bit this week. The Fed’s securities held outright registered at $4.19 trillion, a $17.2 billion decline from Feb. 22. Mortgage-backed securities holdings dropped by $9.3 billion, while Treasury holdings ticked lower by $7.8 billion. Relative to its trailing four-week average, the change is similar, with a $16.6 billion drop in securities held outright, although Treasurys represent the bulk of that change with this week’s holdings down by $11 billion.
The Fed’s balance sheet has declined by 1.4% since Sept. 27, the final week before the commencement of QT, for a simple annualized pace of 3.28%.
Recap March 1
Stocks and the dollar fell in tandem following President Trump’s announced plans for tariffs on steel and aluminum, as volatility continues with the S&P 500 moving over 1% for a fifth straight session to settle near unchanged for 2018. Treasurys were bid across the curve, with the 10-year yield now at its lowest since early February. The VIX jumped back above 22.
- Philip Grant
Wednesday, February 28, 2018
Release the Kraken
After rebounding some 50% from its early-February interim nadir,
After rebounding some 50% from its early-February interim nadir,
Treasury chest
Higher yields across nearly the entire spectrum of U.S. government and corporate bonds should be met with increased demand, right?
Higher yields across nearly the entire spectrum of U.S. government and corporate bonds should be met with increased demand, right?
Recap Feb. 28
Release the Kraken
After rebounding some 50% from its early-February interim nadir, the price of bitcoin has settled into a relatively (by its wild standards) tight trading range of late and currently sits just above $10,000 per fiat greenback. Amid the low key trading comes a potentially significant development. Kraken, one of the four exchanges used to price futures on the CME Group via the Bitcoin Reference Rate, has apparently been cut off by one of its banks. The website Finance Magnates explains:
Citing “a variety of circumstances,” [Kraken] is closing its SWIFT bank accounts in USD, EUR and GBP. In addition, JPY funding accounts at Japanese Bank Sumitomo Mitsui are to cease accepting funds.
Kraken will process all of the funds that are received by midnight on the 20th of March, 2018. Funds that have been processed after that date will automatically be returned to sender.
In its letter, the exchange said: “While this is a disappointing development, we are dedicating further resources to our banking relationships and the implementation of new funding methods. We will reach out to you again when we have further details to share.”
Grant’s called the CME for reaction to the news. The exchange declined to comment, beyond noting that the Bitcoin Reference Rate published today without incident and that Kraken remains a component.
Treasury chest
Higher yields across nearly the entire spectrum of U.S. government and corporate bonds should be met with increased demand, right? Not according to recent dispatches from the Wall Street Journal and the Financial Times. This morning, the Journal’s Jon Sindreu reports on a relative paucity of foreign demand for Treasury securities despite far more attractive yields on an apples-to-apples basis. Bloomberg’s Lisa Abramowitz notes on Twitter that the two-year Treasury yield premium over the German bund is its highest since 2010. Sindreu writes:
A year ago, investors were getting around 0.5 percentage point extra for buying a 10-year Treasury and hedging the currency risk every three months, instead of purchasing a German bund, according to the Wall Street Journal’s calculations. They are now losing 00.5 percentage point – a multiyear low.
While demand sputters, Treasury supply remains robust. Yesterday, a $60 billion auction of four-week bills was priced to yield 1.495%, the highest since September 2008 and well above the 1.475% yield available in the when-issued market. A $22 billion auction of 52-week bills fetched 2.02%, the highest since the 52-week auction was reintroduced in June 2008, according to Bloomberg. Thomas Simons, economist at Jefferies, commented that: “The surge in bill supply has caused the market to cheapen up . . . there’s value in the yield. How much cash is there to absorb it?”
The investing public seems largely attuned to the bourgeoning supply and waning demand that has characterized the action in USTs. The Commodity Futures Trading Commission’s weekly Commitment of Trader’s Report for Feb. 20 showed that speculators held 955,593 10-year Treasury futures contracts short, a record quantity going back to 1992 and more than four times the average over that period. Recall that the February Bank of America Merrill Lynch Global Fund Manager survey showed that 80% of respondents expect that rates will rise over the next year (Almost Daily Grant’s, Feb. 13). Just 5% called for lower rates.
CFTC 10-year UST futures short contracts outstanding. Source: The Bloomberg