Almost Daily Grant's
“Almost Daily” is the end-of-day delectation from Grant’s.
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Friday, October 18, 2019
Today in hedging
Here's Mario Draghi,
Here's Mario Draghi,
Manifest destiny
Into the wild frontier.
Into the wild frontier.
Recap Oct. 18
Today in hedging
Here’s Mario Draghi, with less than two weeks remaining in his term as ECB president:
There are mild signs of overstretched valuations in the euro area in some riskier segments of the financial markets, as well as in real estate markets, with marked differences across regions.
Better cut rates again to be safe.
Manifest destiny
Into the wild frontier. The Financial Times reports today that Fidelity Investments, Inc. “is now engaged in a full rollout” of custodial and trade execution services for cryptocurrencies. CEO Abigail Johnson, who told the FT that the asset management firm began adding clients in the first quarter, said of the digital asset class: “It’s not going away. As long as the value is there, people will look to preserve that value.”
As traditional institutions join the crypto party, a pair of upstarts battle for market share in the futures trading market. Today, the Binance crypto exchange announced it will allow traders to apply up to 125 times leverage on their holdings of digital ducats, topping competitor BitMEX, which currently allows a staid 100 times leverage on futures.
Binance, which told reporters Monday that its bitcoin futures product has already exceeded spot trading volumes just one month after introduction, has earned the ire of its Seychelles-based rival. On Sept. 4, the BitMEX Twitter account offered a sarcastic congratulations to Binance for the roll-out, adding: “Glad to see you enjoyed reading our documentation as much as we enjoyed writing it!”
While the nascent exchanges battle it out for dominion in crypto futures, another criticism of bitcoin’s utility enters the fold. Last week, the Bank for International Settlements released a report from the G7 Working Group on so-called stablecoins (those pegged to the value of other assets), that described the functional drawbacks of current digital currencies.
The first wave of crypto assets, of which bitcoin is the best known, have so far failed to provide a reliable and attractive means of payment or store of value. They have suffered from highly volatile prices, limits to scalability, complicated user interfaces and issues in governance and regulation, among other challenges. Thus, cryptoassets have served more as a highly speculative asset class for certain investors and those engaged in illicit activities rather than as a means to make payments.
Despite its practical shortcomings, bitcoin remains the world’s most valuable crypto by far, with a $144 billion total valuation, compared to $18 billion for the next-largest crypto, ethereum. However, that ubiquity does not translate into turnover. The purportedly dollar-backed tether (USDT) stablecoin, with a mere $4 billion “market cap”, has seen year-to-date average daily trading volumes of $20.8 billion through Sept. 27, easily eclipsing $17.3 billion for bitcoin.
Tethers’ prolific trading profile is likely attributable to the stablecoin’s usage by crypto exchanges as a workaround for the know-your-customer and anti-money-laundering laws which apply to the banking system. “I don’t think people actually trust tether – I think people use tether without realizing that they are using it, and instead think they have actual dollars in a bank account somewhere,” Thaddeus Dryja, research scientist at the Massachusetts Institute of Technology, told Bloomberg.
Tether has carved out a prominent place in the crypto food-chain, but the courts lurk as a potential apex predator. Recall that in April, New York Attorney General Letitia James accused iFinex, Inc., which operates both Tether and the Bitfinex exchange, of “engaging in a cover-up to hide the apparent loss of $850 million of co-mingled and corporate funds.” Last week, a class-action lawsuit targeting iFinex contained even more incendiary accusations. From the complaint:
This action concerns a sophisticated scheme that co-opted a disruptive innovation — cryptocurrency — and used it to defraud investors, manipulate markets, and conceal illicit proceeds.
Part-fraud, part-pump-and-dump, and part-money laundering, the scheme was primarily accomplished through two enterprises — Bitfinex and Tether — that commingled their corporate identities and customer funds while concealing their extensive cooperation in a way that enabled them to manipulate the cryptocurrency market with unprecedented effectiveness.
At the heart of this scheme was Tether’s claim “that the number of (USDT) tokens in circulation will always equate to the dollars in its bank account.” This claim enabled Bitfinex and Tether to signal to the market that there was rapidly growing demand for cryptocurrencies because each USDT printed represented another U.S. dollar invested into the market.
This claim was a lie.
Tether issued extraordinary amounts of unbacked USDT to manipulate cryptocurrency prices. Because the market believed the lie that one USDT equaled one U.S. dollar, Bitfinex and Tether had the power to, and did, manipulate the market on an unprecedented scale to profit from boom-and-bust cycles they created.
For its part, Tether “vigorously disputes the findings and conclusions claimed by that source, which relied on flawed assumptions, incomplete and cherry-picked data, and faulty methodology.”
Of course, the whole kerfuffle could have been avoided had investors simply followed the advice proffered by Tether co-founder William Quigley in a Bloomberg radio interview on Sept. 4:
Whether or not tether was backed by the dollar actually wouldn’t matter if everybody agreed to take tether and to value them at a dollar themselves.
Recap Oct. 18
Stocks edged a bit lower, leaving the S&P 500 higher by 70 basis points for the week and about 1% below its July 26 highs. Gold and oil likewise finished just below unchanged, while a rally in short-dated Treasurys left the two- and 10-year spread at 17 basis points, the steepest since the end of July. The VIX finished above 14, rising for a third straight day after a 33% plunge in the five trading days ended Tuesday.
- Philip Grant
Thursday, October 17, 2019
Mystery train
The signal’s gone from green to yellow. The Association of American Railroads reports that domestic carloads and intermodal units registered at 510,820 in the week ended Oct. 12, down 7% from a year ago. Year-to-date, rail loads have slumped 4% from their 2018 levels, according to the AAR.
That slowdown has likewise translated into the results of industry mainstays. Thus, Union Pacific Corp. (UNP on the NYSE) this morning reported an 8% drop in overall volumes for the third quarter compared to last year. Revenues declined 7% from a year ago. UNP CEO Lance Fritz remarked on a CNBC interview today: "It feels to me like the economy is slowing, and it's slowing quite a bit."
Likewise, peer CSX Corp. (CSX on the NYSE) yesterday reported a 5% year-over-year revenue decline and 9% drop in intermodal volumes during the quarter compared to last year’s levels. That slowdown looks set to continue, as Mark Wallace, CSX executive vice president for sales, told conference call listeners that he expects “somewhat muted” activity during the traditionally strong fourth quarter: “Hopefully, people order a lot of stuff online and we have the pleasure and honor of moving a lot of that stuff.” Despite those top-line pressures, both UNP and CSX were able to deliver record low operating ratios (meaning expenses as a percent of net sales) in the quarter, spurring modest share price rallies in reaction.
Those operational achievements can be chalked up to so-called precision scheduled railroading (PSR), the managerial initiative pioneered by the late executive Hunter Harrison which emphasizes cost control and operational efficiency. As with the zero-based budgeting techniques used in other industries, cost gets whittled down to the bone, and investors reap the benefits.
Indeed, they have: Operating income margins within the S&P Rails Index reached 37.5% as of June 30, up from 31.7% five years earlier. That enhanced profitability has left Mr. Market duly impressed, as the index has doubled in the past five years while valuations have likewise grown richer (see the below chart). Meanwhile, the PSR regime continues apace, as a coalition of eight industry operators filed a federal lawsuit last week to force unions to negotiate over potentially trimming their crews to a single operator, from a current two per train.
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S&P Rails Index, EV to trailing Ebitda ratio; five-year chart. Source: The Bloomberg
Yet the bounties brought by the PSR concept have their limitations. An in-depth analysis of the railroad industry in the July 12 edition of Grant’s Interest Rate Observer quoted Matt Rose, former CEO of Burlington Northern Santa Fe, discussing the strategy’s inherent limitations in a December 2018 interview with Railway Age:
“[T]he easiest way to reduce operating ratio is to take out track and reduce maintenance expenses,” said Rose. But that’s hardly the deal that the industry implicitly struck with the government and the public, he observed, in the run-up to the landmark 1980 deregulation. “The Staggers Act wasn’t, ‘Railroads, haul only what you want to haul on your network,’” Rose went on. “It’s ‘Haul everything, and you have the ability and the flexibility to differentially price on your network.’ That’s the deal, and it’s in the public’s best interest to move more tons to the railroad network, not to move tons off the railroad network.”
To that end, federal regulators are scrutinizing one of the lynchpins of PSR: Railroads’ growing use of demurrage (late) fees against shippers in order to keep trains on schedule, not to mention raise additional revenues for themselves. On Oct. 7, The Surface Transportation Board released a proposed policy statement, offering new regulations requiring railroads to provide additional information on demurrage levies as well as a new rule to close loopholes which have exempted demurrage regulations on various commodities transported via boxcar. Randy Gordon, president and CEO of the National Grain and Feed Association (NFGA), minced no words over what PSR hath wrought in a May 23 press release:
We believe that in far too many cases, current demurrage and accessorial charges and practices are egregious and merely exemplify the market power of today's Class I railroads, reflecting their ability to unilaterally impose one-sided terms and conditions on their customers.
Frankly, NGFA members in some segments of our industry believe they are at a 'tipping point' in their relationship with Class I rail carriers because of these and other practices, particularly with the increased adoption of the so-called precision scheduled railroad operating model.
Indeed, the prospective abatement of a multi-year tailwind from the PSG initiatives, in tandem with premium valuations and the prospect of a cyclical economic downturn present a potentially potent bearish cocktail for the rail industry. For more, including a quartet of picks-to-not-click, see the July 12 edition of Grant’s.
Recap Oct. 17
Stocks cruised sideways for a second straight day, as the S&P 500 continues to mark time just below its high-water mark reached in late July. Treasury yields ticked higher across the curve, leaving the two- and 10-year yields at 1.60% and 1.76%, respectively. WTI crude rallied back to $54 a barrel, while gold held at $1,492 an ounce. The VIX remained below 14.
- Philip Grant
Tuesday, October 15, 2019
Is it safe?
The hits keep coming. Last week’s rolling power outages in California will be added to utility PG&E Corp.’s (PCG on the NYSE) already-substantial tab, if governor Gavin Newsom has his way. Yesterday, Newsom asked the company to provide each affected household with $100 and each small business with $250 in compensation in the form of a rebate or bill credit for the power loss, which occurred for more than 48 hours in parts of Northern California.
"It's decisions that were not made that have led to this moment in PG&E’s history and the state of California as it relates to our major investor-owned utility,” Newsom said. “It is not conditions. This is not, from my perspective, a climate change story as much as a story about greed and mismanagement."
With residents in the dark last week and politicians affixing a metaphorical bulls-eye on the company, PCG did itself no favors. On Thursday, the San Francisco Chronicle reported that 10 to 12 staff members, including the head of the gas division, held a wine tasting event for clients at the Silver Oak Winery in Napa on Monday and Tuesday (which also marked the two-year anniversary of the Camp Fire, California’s deadliest blaze). Bill Johnson, CEO of the company, subsequently apologized for the “insensitive, inappropriate [and] tone-deaf” decision to hold the event.
While the company continues to earn itself few friends, a bigger problem lurks for PCG in the form of $30 billion or so in liabilities related to the 2017 wildfires, according to a deposition from CFO Jason Wells in January. That compares to $10.6 billion in book equity as of June 30.
Last week, Judge Dennis Montali of U.S. Federal Bankruptcy Court in San Francisco issued an order ending the company’s exclusive control of its reorganization. Instead, creditors including Elliott Management will be permitted to offer their own plan in competition with one advocated by the company and shareholders ahead of a June 2020 deadline to exit bankruptcy.
Now allowed to go forward, the bondholder plan involves a recapitalization allowing creditors to take control of the company and effectively wipe out existing shareholders, who instead advocate for a mix of fresh debt and equity issuance to pay the wildfire claims.
The court’s decision spurred some unusual gloom from the sell-side, as analysts from Citigroup handicapped 75% odds of the stock going to zero on Thursday, after Judge Montali made his ruling: “[The] bond holder group now has [a] higher opportunity to win.” Shares fell 29% in reaction to the ruling and are down 59% since a bearish verdict in the Feb. 22 edition of Grant’s Interest Rate Observer.
That Feb. 22 analysis highlighted the legal and regulatory gauntlet that PCG (then sporting a $9.2 billion market cap despite being in the throes of chapter 11) faced in exiting bankruptcy with shareholder equity still intact, noting that wildfire claims of even $10 billion would impair the equity. Deputy editor Evan Lorenz added:
If climate change is making California more fire-prone and inverse condemnation [a statute holding utilities responsible for fire caused by their equipment, regardless of actual fault] remains the law of the state, there is a question of whether PG&E can, in fact, exit court protection. Before a judge can approve a bankruptcy exit plan, the plan must be feasible.
While PCG is subject to unique weather and legal factors related to its California domicile, this episode lays bare the problems inherent in the utilities industry; traditionally considered one of the “safest” segments of the stock market but one whose members consistently fail to cover property, plant and equipment spending with internal cash flow.
From the start of 2013 to June 30 of this year, PCG generated $30.8 billion in cash from operations, well below the $39.5 billion in capital expenditures incurred over that period. Yet the company paid out $4.4 billion in dividends from 2013 to 2017 before ceasing the practice following the fires. For the S&P Utilities Sector as a whole, operating cash has covered capex in only seven of the past 20 years, and only once (in 2003) did free cash flow exceed dividend distributions. Yet the group currently trades at more than 21 times earnings, compared to a 20-year average of just 15.5 times.
The Feb. 22 Grant’s put it this way: “Safety is inherent in no investment.”
Recap Oct. 15
A strong rally in stocks pushed the S&P 500 higher by 1% to leave the broad index just another 1% from its high-water mark reached in late July. Interest rates likewise rose, as the curve continues to steepen with the 10-year yield now 15 basis points above the two-year, the most since Aug. 1. Gold and WTI crude were both hammered, finishing at $1,481 an ounce and $53 a barrel, respectively, and the VIX was clubbed again to finish at 13.5, its lowest since July 29.
- Philip Grant
Monday, October 14, 2019
Disrupted
A real headline, from RealClearMarkets:
A real headline, from RealClearMarkets:
Porous the spider
Last one out, turn off the lights?
Last one out, turn off the lights?
Recap Oct. 14
Disrupted
A real headline, from RealClearMarkets:
Elizabeth Holmes Is a Visionary, and We Need More Like Her
Masa Son, are you listening?
Porous the spider
Last one out, turn off the lights? Fall has thus far been unkind to leveraged loans (floating rate, tradable bank debt issued by speculative-grade corporate borrowers), as the S&P/LSTA Leveraged Loan Index fell to 95.4 on Thursday, its lowest close since Jan. 7. That waning performance coincides with a $710 million outflow from loan mutual funds in the in the week ended Oct. 9, Lipper reports. That’s the largest in two months and brings the year-to-date withdrawal to $30.6 billion.
Perhaps the most concerning feature in the loan market is the increasing frequency of issues trading at a substantial discount to par. As noted in the below chart from Morgan Stanley, the ratio of credits within collateralized loan obligations (loans which have been packaged and securitized) trading below 90 has risen to a three-year high, well above levels seen in the December 2018 sell-off:
A broad economic slowdown (as evidenced by multiyear lows in both the manufacturing and services surveys conducted by the Institute for Supply Management) and relatively low energy prices account for some of the distress, while idiosyncratic risks also appear. Yesterday, the Financial Times reported on the public outcry over “surprise billing” in the health-care industry (when outsourced, frequently p.e.-backed providers levy hefty out-of-network expenses on unsuspecting patients), with a Stanford University study finding that such surprise billings reached 43% of emergency room visits in 2016, up from roughly 33% in 2010.
The practice has attracted the attention of Congress: KKR & Co. and Blackstone Group, Inc., owners of physician staffing companies Envision Healthcare Corp. and TeamHealth, Inc., respectively, were asked to provide “detailed information about every healthcare company they have ever owned” and attended a closed-door heading with legislators on Oct. 7. With their business models under scrutiny and revenue prospects increasingly in question, Envision and TeamHealth term loans due 2025 and 2024 fell below 81 and 80, respectively, down from 97 and 94 in early May. The pair, which are each leveraged at more than eight times trailing Ebitda according to Moody’s, have issued a combined $8.1 billion in term loans. That equals nearly 1% of total domestic leveraged loans outstanding.
As performance sags and red flags flutter, loan investors face another pitfall in the ongoing erosion of legal protections known as loan covenants. On Thursday, Bloomberg reported that a consortium of more than a dozen fund managers led by Blackstone’s GSO Capital Partners are working with underwriters “to propose new industry standards.” Among other changes, the buy-siders want more time to review the often highly complex loan covenants than the one to two days that are currently the standard.
Some industry practitioners believe change is long overdue. As, Sabrina Fox, executive advisor at the European Leveraged Finance Association, noted on Twitter:
At a certain point we need to ask ourselves what sort of market we have when investors - most of whom are not lawyers - are tasked with finding (literally hidden) risk amongst hundreds of pages of legalese with - in some cases - less than 24 hours to do so.
Of course, issuers find the status quo to be just fine. Bloomberg noted Friday that while GSO leads the charge for more time to review the fine print, another Blackstone entity is providing would-be lenders with less than 48 hours to review documents pertaining to its multibillion dollar buyout of Merlin Entertainments plc. A bit more time might be helpful: CreditSights deems the deal’s “highly porous covenant package” to be among the laxest the firm has ever seen. Maybe Blackstone can speak to Blackstone about it.
Recap Oct. 14
With the bond market closed for Columbus Day, stocks cruised sideways to leave the S&P 500 higher by 18.3% year-to-date. WTI crude fell back below $54 a barrel after climbing to a two-week high Friday, while gold rose slightly to $1,492 an ounce. The VIX sank more than 6% to 14.6, its lowest since Sept. 19.
- Philip Grant
Friday, October 11, 2019
Space force
From Bloomberg
From Bloomberg
Dine and dash
The struggles continue for the restaurant industry,
The struggles continue for the restaurant industry,
Recap Oct. 11
Space force
From Bloomberg:
Fisher Investments plans to start a diversity and inclusion task force in the wake of Ken Fisher’s vulgar comments at a conference this week, the firm’s chief executive said in a letter to employees Friday.
#Youtoo?
Dine and dash
The struggles continue for the restaurant industry, as analytics firm TDn2K reports that third quarter comparable sales fell 0.4% from a year ago. That’s the worst quarterly showing in two years, yet TDn2K expects that “sluggish sales will likely continue through the fourth quarter.” Traffic likewise continues its precipitous slide, falling 3.5% from the third quarter last year.
Adding to industry woe, dwindling sales coincide with cost pressures. Employee turnover remains at “historically high levels,” as industry staffing levels remain “a huge concern and is expected to continue,” per TDn2K. Carrol’s Restaurant Group, Inc. (TAST on the Nasdaq), which is the largest franchisee of Burger King restaurants, reported 5.2% year-over-year wage growth in the second quarter; that compares to a 1.7% average rise in the headline CPI through 2019.
The dual pressures on revenue and cost have spurred dubious strategic responses from a number of operators. As described in the Sept. 18 edition of the Restaurant Finance Monitor:
Many have raised prices, reduced portion size and spent millions of dollars on technology to cut employee hours and sell meals off-premises.
“That’s not a great strategy,” says Tim McCarthy, a former marketing agency founder and now 35-unit Raising Cane’s franchisee. “If I cheapen my product and service, charge more, and push sales to a lower margin channel (delivery) I don’t control, how does that help me?”
Yet Mr. Market has bestowed a premium valuation to the group, as the Russell 3000 Restaurants Index currently fetches an enterprise value of 17.5 times consensus 2019 Ebitda. That compares to a 12.2 times EV-to-Ebitda ratio for the S&P 500. A primary pretext for that rich valuation: The now ubiquitous asset-lite business model, in which the brands sell stores to franchisees and clip a percentage of their sales, without bearing the brunt of the current less-than-stellar operating environment (Almost Daily Grant’s, April 30).
Of course, some operators fare better than others. This morning, Wendy’s, Inc. (WEN on the Nasdaq) reported perky 4.4% same-store sales growth in the third quarter, the fastest pace since 2013. With growth easily outpacing the industry norm, the company plows full-speed ahead on delivery, announcing the planned rollout of a pair of “dark kitchens,” or delivery-only facilities with no dine-in option, by the end of the year, according to management commentary at today’s investor day. In addition, single-B-rated Wendy’s, which carries $3.3 billion in net debt (nearly eight times consensus 2019 adjusted Ebitda), is seeing brisk turnover among its franchisees, with 50% of Wendy’s 6,719 restaurants changing hands since 2013.
That eye-catching instability underscores a grim operating environment for franchisees. As noted in a Tuesday column by Jonathan Maze of Restaurant Business Online, heavy borrowing exacerbates those woes, with a pair of operators (Capital Restaurant Group, LLC and RMH Franchise Holdings, Inc.) filing for bankruptcy protection in the past year and another duo (NPC International Holdings, Inc. and Diversified Restaurant Holdings, Inc.) seeing their debt trade to distressed levels in recent months.
The Street is taking notice. An Oct. 4 report from Bernstein Research delved into the leverage buildup and associated distress currently faced by franchise industry operators:
Signs of economic stress have materialized just as the largest restaurant companies have completed their transformation into asset light, highly levered businesses; investors are increasingly worried about the risk of “piling leverage onto leverage.”
As the post-crisis economic expansion reaches month 124, the analysts note a data set which could prove relevant in the next downturn:
The Small Business Administration operates loan programs that aim to support small companies by offering guarantees to commercial bank[s] which in turn provide lower rates and better terms. Among 7(a) loans (general purpose business activities) the default rate for loans originated since 2010 is a negligible 1.3%, but for loans originated in the prior decade it is 17.2%. For 504 loans (financing for commercial real estate or equipment) the default rate for loans from 2010 on is 1.1%, but for 2000 to 2009 loans it is 20.3%.
For an in-depth industry analysis, along with updates on a trio of picks-to-not-click, see the Sept. 20 edition of Grant’s Interest Rate Observer.
Recap Oct. 11
A “phase one” trade deal between the U.S. and China helped gas the stock market higher, as the S&P 500 rose more than 1% to finish in positive territory for the week. Treasury yields jumped across the curve, with the three-month vs. 10-year spread “un-inverting” for the first time since late July. WTI crude rallied back near $55 a barrel, while gold slipped to $1,487 an ounce. The VIX dropped to 15.5.
- Philip Grant
Thursday, October 10, 2019
The King's Speech
A job opening, on LinkedIn (spotted by our friend Jim Bianco):
Who says the Fed doesn’t create jobs?
P.O. Box
It’s a gusher. The long-awaited public debut of the Saudi Arabian Oil Co. (a.k.a. Aramco) is almost a reality, as Bloomberg reports today that the state-owned behemoth is “finally going ahead” with a plan to float 2% of the company. If everything goes smoothly, Aramco will raise $40 billion, valuing the company at $2 trillion, though The Wall Street Journal reports this morning that advisors indicate a $1.5 trillion price tag “is more realistic.”
That IPO comes with hurdles both fundamental and idiosyncratic. Aramco’s long-term production capability is questionable, as the prospectus indicated relatively advanced depletion at Saudi’s Ghawar oil field, the world’s largest (Almost Daily Grant’s, April 11), and it’s fair to say that the deal comes with some unusual features. The shares will be only be listed on the Saudi’s domestic Tadawul exchange, as opposed to a global financial center such as London or New York. Then, too, the offering will be heavily marketed to domestic investors, with banks “encouraged” to lend freely to facilitate share purchases. As for the larger players, Bloomberg puts it this way:
The kingdom’s richest families, including some who had members held in Riyadh’s Ritz-Carlton Hotel during Prince Mohammed’s crackdown on corruption in 2017, have been invited to become anchor shareholders. It’s an offer they may find hard to refuse.
As Aramco works toward its long-awaited debut, the state of the U.S. IPO market could be described as less-than stellar. Since July 26, the Renaissance Capital IPO Index is down 15%, compared to a 3% drop in the S&P 500. “IPO buyers are going on strike,” Kathleen Smith, principal at Renaissance Capital, told the New York Post on Sept. 30. “We’re projecting that it’s going to be a pretty slow end of the year.”
Several high-profile names have endured particularly rocky debuts, with SmileDirectClub, Inc. shares falling 28% on its first day of trading, the worst opening since 2008. Ride-share competitors Uber Technologies, Inc. and Lyft, Inc., have seen their stock prices fall 36% and 48%, respectively, since bowing this spring, while The We Company famously pulled its offering after reportedly failing to generate sufficient demand at a $10 billion valuation. That compares to a $47 billion, SoftBank Group Corp.-led funding round just nine months ago.
Then there’s Peloton Interactive, Inc., which has absorbed a 20% stock-price drop since its Sept. 25 listing. On Tuesday, Peloton sued competitor Echelon Fitness LLC over its “cheap, copycat products” which imitate “the Peloton Bike experience.” Peleton, which sells exercise bicycles for $2,245 and describes itself as “a technology company, a media company, an interactive software company, a product design company, a social connection company, a [direct-to-consumer] retail company, an apparel company, and a logistics company” in its form S-1, posted a $203 million operating loss in the 12-months ended June 30. That compares to a $48 million loss the year prior.
Cycling in a sea of red ink, Peloton is no outlier. According to Jay R. Ritter, the Joseph B. Cordell Eminent Scholar Chair at the University of Florida, 80% of IPO’s last year sported negative earnings per share, trailing only the year 2000 for the highest ratio of money losers in the last 28 years. That threshold has crossed 60% only eight times during that period, but in every year since 2013.
Echoes with the late-90’s tech bubble extend beyond just the aggregate data. Speaking on CNBC Monday, former Nasdaq CEO Robert Greifeld observed that the IPO market “remind[s] me back of the dot-com era, when you had companies going public that had no known path to profitability.” Of We Co. in particular, Greifeld remarked: “[It is] in some ways a parody of some of the hubris you see in the start-ups.”
Recap Oct. 10
A solid rally in stocks marked the sixth time in the last seven trading days in which the S&P 500 moved more than 50 basis points. Treasurys were hammered, with the 10-year yield rising to 1.67% to nearly exceed the three-month bill yield for the first time late July, though this afternoon’s 30-year auction priced at an all-time low yield of 2.17%. WTI crude rallied 2% to approach $54 a barrel, while gold fell nearly 1% to $1,494 an ounce. The VIX sank below 18.
- Philip Grant
Wednesday, October 9, 2019
ADG 10/9: How to train your Draghi
A new frontier in "whatever it takes."
A new frontier in "whatever it takes."
Recap Oct. 9
ADG 10/9: How to train your Draghi
A new frontier in “whatever it takes.” This morning, the Republic of Greece sold €487.5 million ($535 million) in 13-week bills at a yield of negative 0.02%. Greece likewise placed €1.5 billion in notes maturing March 2029 at 1.5%, the issue attracting more than €5.4 billion in orders, according to Bloomberg. By comparison, the three-month and 10-year U.S. Treasurys yield 1.65% and 1.59%, respectively.
That’s single-B-plus-rated Greece, which was, of course, bailed out by the eurozone member states and the International Monetary Fund three times since 2010. Despite recent signs of improvement, including nine straight quarters of positive year-over-year GDP growth and a budget deficit trimmed to 1.1% of 2018 output, Greece carries government debt equal to roughly 180% of 2018 GDP, easily the highest in the euro area (Italy is next at about 134%).
It’s the latest eye-watering development on the Old Continent. Recall that as a parting “gift” ahead of his Oct. 31 departure, ECB president Mario Draghi slashed the benchmark deposit rate by 10 basis points to negative 50 basis points and reintroduced €20 billion per month in asset purchases on Sept. 12. The ECB’s balance sheet currently stands at €4.7 trillion, or 38% of last year’s eurozone GDP. That compares to $3.95 trillion and 19%, respectively, for the Federal Reserve.
Needless to say, subterranean interest rates demonstrate both the Pavlovian response to the ECB’s actions, as well as a lack of concern over an inflationary awakening (eurozone CPI grew 1% year-over-year in August). Richard Barnwell, head of macro research at BNP Paribas Asset Management, summed up the peculiar zeitgeist: “The bond market is adamant [that] it needs stimulus, but equally adamant that it doesn’t work.”
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The modern central bankers’ motto
As the ECB prepares for changes at the top, the central bank’s second-in-command suggests that policy has reached the amber zone. In an interview with Market News International released this morning, vice president Luis de Guindos remarked that “although we can reduce interest rates further, the side effects of monetary easing are becoming more and more evident and more and more tangible.” However, the No. 2 dismissed the possibility of an unwind: “A policy U-turn is something I would discard. And it would not be good anyway.”
One constituency increasingly eager to see such a 180 is Euro-area banks. In early September, Deutsche Bank A.G. CEO Christian Sewing warned of potential “grave side effects” arising from ECB policy, asserting that “in the long run, negative rates ruin the financial system.” Oswald Grüebel, who helmed Credit Suisse A.G. from 2004 to 2007, then UBS Group A.G. from 2009 to 2011, was even more blunt: “negative rates are crazy.” For his part, Draghi told reporters in Frankfurt on Sept. 12 that banks should worry more about their cost structure and adapting to new technology rather “than being angry about negative rates.”
Establishment criticism of the ECB now extends beyond the for-profit banking sector. Speaking on Sept. 13 of implications for the pension fund industry, Dutch finance minister Wopke Hoekstra said that the latest rate cut carries potentially “huge consequences for a lot of things that we think are important in the Netherlands.” Even the Bank for International Settlements, known as the central bankers’ own swiss bank, questioned the other pillar of the ECB’s strategy Monday, arguing in a report that the sharp post-2008 growth in central bank balance sheets “could result in market malfunctioning when large central bank balance sheets are eventually unwound.”
Might intensifying political backlash imperil the ECB policy stance as newcomer Lagarde gets her feet wet? Today, Unicredit SpA, Italy’s largest bank by assets, announced it will pass negative rates on to clients, charging them for depositing their funds at the institution. Denmark’s Spar Nord Bank A/S, announced last week it would apply a 0.75% levy on deposits exceeding DKR 750,000 ($110,000), while Berliner Volksbank eG, Germany’s second-largest cooperative lender, is now charging 0.5% on deposits of €100,000 and above. On Sept. 25, Deutsche Bank CFO James von Moltke suggested DBK will be “robust” about passing along negative rates, perhaps in the form of additional fees.
While the creep of negative rates into Europe at large will win the ECB few new friends, the ECB’s asset purchase program could be derailed by the courts. At the end of July Germany’s Karlsruhe constitutional court conducted a hearing over the legality of QE, as the Eurozone treaty expressly forbids member state governments from directly buying sovereign debt. On Tuesday, a coalition of German academics initiated a fresh legal challenge against the practice.
Reuters, which reported the action, assesses the litigants’ likelihood of success as “low.” Then again, it’s not less-than zero.
Recap Oct. 9
Stocks caught a bid with the S&P 500 rising nearly 1% to erase the bulk of yesterday’s losses. Volatility has returned to the stage, as the broad index has now moved up or down more than 50 basis points in five of the past six trading sessions.
Elsewhere, gold and oil both held steady, while the VIX fell back below 19. Treasury yields rose across the board, though this afternoon’s 10-year note auction priced at its lowest yield since August 2016 (a month after the 10-year reached its all-time low of 1.37%).
- Philip Grant
Tuesday, October 8, 2019
QT, we hardly knew yee
This afternoon,
This afternoon,
The dreadful wind and rain
A major snowstorm
A major snowstorm
Recap Oct. 8
QT, we hardly knew yee
This afternoon, Fed chair Jerome Powell announced his intention to once again expand the central bank’s balance sheet. Just don’t call it QE:
I want to emphasize that growth of our balance sheet for reserve management purposes should in no way be confused with the large-scale asset purchase programs that we deployed afterthe financial crisis.
New branding is clearly required. Perhaps, the open market operation formerly known as QE?
The dreadful wind and rain
A major snowstorm looks set to descend on the northern plains later this week. The Weather Channel reports this morning:
By Friday, strong low pressure will wrap up near the border of Minnesota and western Ontario, with wind-driven snow in the Dakotas, parts of Minnesota, possibly as far south as Iowa and Nebraska.
This combination of snow and wind could linger into Saturday from parts of the Dakotas into Minnesota, northern Wisconsin and Michigan’s upper peninsula.
The prospect of an early-fall frost and potential snowstorm is not a pleasant one for the farm sector, which has been beset by terrible weather as well as the Sino-American trade dispute.
Severe flooding across much of the Midwest this spring prevented the timely planting of agricultural crops. On August 29, the Illinois congressional delegation (including two senators and 18 members of congress) sent a letter to President Trump requesting federal assistance for 33 counties which endured a five month deluge through July, “the longest flood event to ever occur in Illinois.” The delegation reported that “the economic impact on the region as a result of businesses and residences being damaged is severe.”
The federal government believes things are pretty much hunky-dory. According to projections from the U.S. Department of Agriculture in late August, 2019 farm income is expected at $88 billion, up from $84 billion a year ago and the highest since 2014. Yet an analysis from the American Farm Bureau Federation disputes that claim, noting that key indicators such as cash rents on the I-State corridor (including Iowa, Indiana and Illinois) are down 11.5% with Minnesota off 12%, respectively, over the last five years. In addition, distress among the farming industry is on the rise, with the delinquency rate (loans more than 30 days past due) for commercial real-estate loans in agriculture rising to 2.5% in the first quarter of this year, up from 2.1% in the prior period (that 2.1% figure is also the long-term average).
As the plight of farmers worsen, a handful of publicly-traded businesses leveraged to the industry sport potentially significant downside risk. For bearish analysis on a trio of related companies, see the June 28 edition of Grant’s Interest Rate Observer.
But might those same dire conditions set the stage for an upside surprise in the price of agricultural commodities? The USDA’s latest crop report for the week ended Sept. 29 showed the proportion of corn acres harvested at 15%, down sharply from a 33% yield at this time last year, while soybeans stood at 14% harvested from 31% a year ago. Mature corn stocks stood at 43% compared to 92% a year ago, while 72% of the soybean crop was dropping leaves (an indicator of maturity), down from 90% last year.
Even if the forecasted October snowstorm does not materialize, an incoming cold front looks certain to inflict still more damage on crop yields. As one anonymity-seeking investor tells Grant’s, the math involving growing degree unit days (GDU is an air temperature-based metric for calculating the ability for crops to develop) looks particularly daunting as fall proceeds:
Most farmers are telling me they need another 100 to 180 more GD units. From Sept. 17 to Sept. 30, southwest Minnesota only accumulated 165 GDU total over those 14 days, and much of September was on the warm side.
There is just no way they’ll get another 100+ GDU in October. They could be lucky to get many GDU at all with this incoming cold front, and then, eventually it freezes (perhaps in the next two weeks?) and that will be that.
So, regardless of the number of bushels—the weight of those bushels will be ‘light’ (a bushel can be as low at 40 pounds and as high as 70+ pounds). Light corn has a lower carb count and lower protein count, so, lower value to ethanol users and animal feed.
Arlan Suderman, chief commodities economist at INTL FCStone, expressed similar sentiments on Twitter today:
This week's winter storm looks to be one for the history books, and virtually all the crops are still in the field. Very strong winds, Arctic air and heavy snow is not a good combination.
We typically say that temperatures must be below 28°F for two hours or more to kill a crop, but what about 30 - 31 degree with 40 mph winds for 24 hours? That would pull the heat out of the crop canopy and do a lot of damage as well.
Meanwhile, even after solid rallies today, the near-contract prices of corn ($3.96 a bushel) and soybeans ($9.21 a bushel) remain below their respective five-year averages. Agricultural commodity watchers won’t have to wait long for more information: The USDA releases its monthly WASDE crop inventory report on Thursday.
Recap Oct. 8
Stocks were hammered with the S&P 500 falling more than 1.5%, as the broad index now sits more than 4% below its July 26 high-water mark. Treasurys were bid across the curve, with the 10-year yield settling at 1.53%, 16 basis points above the record low reached in July 2016. WTI crude fell back to just over $52 a barrel, while gold advanced back to $1,504 an ounce. The VIX jumped above 20.
- Philip Grant
Monday, October 7, 2019
He said it
Here’s President Trump today, on Twitter:
As I have stated strongly before, and just to reiterate, if Turkey does anything that I, in my great and unmatched wisdom, consider to be off limits, I will totally destroy and obliterate the Economy of Turkey (I’ve done before!).
Bullish for the lira?
Put it on the tab
This morning, General Electric Co. (GE on the NYSE) announced it is freezing pension benefits for some 20,000 employees and will pre-fund $4 billion to $5 billion of its projected retirement funding for 2021 and 2022. Triple-B-plus-rated GE, which closed its pension plan to new entrants in 2012, expects those two moves to slash its projected funding shortfall by up to $8 billion. That’s roughly one-third of the company’s $22.4 billion in underfunded liabilities as of year-end 2018, the largest shortfall of any company in the Russell 1000 Index.
While GE takes drastic steps to shore up its balance sheet, the head of one of Europe’s largest pension managers expressed alarm over the state of affairs on the Old Continent. Henrik Munck, senior consultant at Insurance and Pension Denmark, told Bloomberg yesterday that “a negative spiral” could arise from the ongoing evaporation of bond yields and associated rise in liabilities faced by managers under the European Insurance and Occupational Pensions Authority (which constructs a formula used by pension managers to track their obligations).
Denmark’s 10-year sovereign yield currently stands (if that’s the word) at negative 56 basis points, while the Euro interest-rate swap curve, which Bloomberg describes as “the backbone” of the EIOPA’s calculation, has likewise collapsed in recent years (the 30-year swap currently stands at 0.24%, compared to 1.91% five years ago) as the European Central Bank has pushed the deposit rate deeper into negative territory.
The Financial Times relays that Peter Spiller, founder and principal at CG Asset Management, told attendees at a conference last week that in order to generate an inflation-adjusted £1 for retirement in 2068 through investing in gilts (British government bonds), investors must cough up £2.60 today. The U.K sovereign 3.5% notes due 2068 trade at a price-to-yield of 0.84%.
Higher interest rates in the U.S. make the pension situation only a little less daunting here. The April 5 edition of Grant’s noted the calculus offered up by Brian Slone, of Dayton, Ohio, a 13-year mem¬ber of the Millwright Local 1090 and participant in the Southwest Ohio Carpenters Pension Fund, to the Congressional Joint Select Committee on Solvency of Multiemployer Pension Plans last summer:
Someone who worked for 30 years and retired in 2000 would have contributed $85,000 over his career and received a monthly benefit of $3,130, said Slone. A younger participant who retired in 2016 would have contributed $153,000 and received a monthly benefit of $2,210 per month. And the still younger participant who retires in 2030 will have contributed $290,000 while standing to receive a monthly benefit of only $1,640.
That grim math augurs no good things for pension contributors, managers, or, (eventually) the credit of Uncle Sam. On July 24, the House of Representatives passed the so-called Butch Lewis Act, which would create a new subdivision of the Treasury Department to issue fresh debt to cover the shortfalls of insolvent multi-employer pension plans. According to the Congressional Budget Office, the legislation would tack on an additional $92 billion to the federal budget deficit over the next 10 years.
While the bill has languished in the Senate since being introduced by Sherrod Brown (D-OH) on July 25, the legislation boasts a powerful backer. On Friday, Sen. Elizabeth Warren (D-MA) declared in a statement that she “will push to pass the Butch Lewis Act to create a loan program for the most financially depressed pension plans in the country.” Warren appears to be the clear frontrunner for the Democratic presidential nomination, with her contracts trading at 51 cents on the political betting site PredictIt this afternoon, compared to 22 cents for Joe Biden and nine cents each for Hillary Clinton and Bernie Sanders.
While the implementation of Butch Lewis is no sure thing, widespread insolvency across pensions would almost certainly yield a federal response. The Jan. 26, 2018 edition of Grant’s put it this way:
Probably in no election year is actuarial science a better vote-getter than the stories of low and middle-income people who worked their whole lives for a pension (never very much even at 100 cents on the promised dollar), which financial and business circumstances are now placing on the chopping block.
As surely as Citibank got its bailout, the candidates’ pitch may go, so the retired truck drivers, construction workers and retail clerks must get theirs. And the retired firefighters and cops? Are they to be denied when their turn comes? Only one level of government has a central bank. And not by coincidence, it’s the same level of government that boasts seemingly unlimited borrowing power.
Pension crisis solved?
Recap Oct. 7
Stocks traded lower with the S&P 500 losing about 50 basis points, while Treasurys gave back a portion of recent gains with the two- and 10-year yields settling at 1.47% and 1.56%, respectively. WTI edged higher for a second straight session to $53 a barrel following eight consecutive red finishes, while gold fell to $1,491 an ounce. The VIX settled just below 18.
Interbank borrowing costs continue to fall, as three-month Libor was set below 2.03% today. That compares to more than 2.8% in late December.
- Philip Grant
Friday, October 4, 2019
Now is the winter of our streaming content
Amazon, Inc. and Walt Disney Co. are feuding over terms which the former would carry the latter’s
Amazon, Inc. and Walt Disney Co. are feuding over terms which the former would carry the latter’s
Discovery channel
The renewed bloodletting in the energy patch has seen West Texas Intermediate crude
The renewed bloodletting in the energy patch has seen West Texas Intermediate crude
Now is the winter of our streaming content
Amazon, Inc. and Walt Disney Co. are feuding over terms which the former would carry the latter’s apps on its Amazon Fire TV device (the second-largest streaming media device in the U.S., says The Wall Street Journal. There is currently no deal in place for Fire to carry the hotly anticipated Disney+ streaming-video service, which is expected to launch on Nov. 12.
Disney is likewise turning the screws on the streaming incumbent. Today, The Journal relays that the house of Mickey Mouse is refusing advertisements from Netflix, Inc. across its entertainment TV networks. Disney had initially blocked all rival streaming services from buying ad space but reversed that for all would-be competitors besides Netflix. WarnerMedia’s HBO MAX platform (a souped-up version of HBO Go) looms as still another competitor, though a dispatch from Bloomberg today details the extensive management attrition which has befallen the division following its takeover by AT&T, Inc.
The onset of intense competition is a daunting prospect for Netflix, which lost 126,000 paid U.S. subscribers in the second quarter, surprising analysts who had collectively penciled in 352,000 domestic additions. Netflix, which burned $3 billion in cash over the 12 months ended June 30, needs to respond with substantial price cuts, according to Needham Securities analyst Laura Martin (to as low as $6 a month from the current range of $9 to $16), to avert an estimated 5 million to 10 million in 2020 U.S. subscriber losses.
While NFLX shares are down 28% from early July, the company’s senior unsecured 4 7/8 notes due 2027 remain above par, priced at 102 cents on the dollar for a 314 basis point pick-up over Treasurys (that compares to 256 basis points at issuance). The Jan. 26, 2018 edition of Grant’s distilled the particularly unappealing calculus faced by creditors of double-B-minus-rated Netflix:
It’s a speculative business, the content business, but if it works, you, the creditors, will get your money back. The stockholders will get rich. Everybody’s happy.
Discovery channel
The renewed bloodletting in the energy patch has seen West Texas Intermediate crude fall for eight straight sessions through Thursday, reaching a two-month low. The rally following the September 15 attack on Saudi refining facilities has now been more than completely erased, with oil bulls beset with bad news on both the supply and demand fronts.
The World Trade Organization cut its forecast for trade growth in 2019 and 2020 on Tuesday, while the Institute for Supply Management’s September manufacturing index fell to its lowest level since the end of the financial crisis. One day later, the Energy Information Agency reported a 3.1 million barrel supply build, double the expected increase of 1.57 million.
While prices (for now at least) remain well above the sub-$30 nadir seen in the long winter of 2016, domestic operators are preparing for the worst. Bloomberg reports today that activity around the crucial Permian Basin in West Texas and New Mexico has slowed to a near-standstill, with drilling activity down 19% year-to-date. Hotel revenue-per-available-room in the Permian Basin has dwindled 21% from a year ago, compared to a 1.1% rise for the U.S. overall, according to STR, Inc. Jan Freitag, senior vice president at STR, told Bloomberg that double-digit changes in occupancy are “very, very rare. . . Normally, you get that when something like a hurricane hits.”
With energy down in the dumps, long-term help may be on the way for the bulls. A report from IHS Markit this week finds that conventional oil and gas discoveries during the last three years have plunged to a 70-year low. Keith King, senior advisor at IHS Markit, cited one key factor: “The shift of investment by U.S. independents from international exploration to shale opportunities in the United States – shorter cycle-time projects – with greater flexibility to respond to changing market conditions.”
Low prices; the cure for low prices.
- Philip Grant
Thursday, October 3, 2019
Reach and pull
As bond yields the world over continue to hug the ground, issuers reach for the sky.
As bond yields the world over continue to hug the ground, issuers reach for the sky.
Recap Oct. 3
Reach and pull
As bond yields the world over continue to hug the ground, issuers reach for the sky. Bloomberg reported on Tuesday that global corporate bond sales totaled $308 billion in September, marking the first time that new issuance topped $300 billion in a month. Corporate issuance has been particularly brisk in Europe, one of the epicenters of the negative-interest rate phenomenon. Following a record €94 billion in September supply, investment-grade European companies have placed €580 billion ($638 billion) year-to-date, setting a full-year record with three months left.
Needless to say, this vanishing interest-rate epoch has been less kind to lenders, particularly pension funds which are chasing increasingly daunting annual return targets. On Sept. 30, Pensions and Investments reported that only three of the 120 public plans tracked by the National Association of State Retirement Administrators assume an 8% annual return. That compares to 59 funds with such a hurdle in 2010. In the 12 months ended February 2019, 42 plans, or one-third of the NASRA database, trimmed their return assumptions. That helped push the median return assumption to 7.25%, down from 8% nine years earlier. Then again, who's earning 7.25%?
The paucity of available returns has predictably pushed these fiduciaries farther out the risk curve. “Because of low interest rates, we have to cast our net far and wide to search for returns,” Thijs Knaap, senior strategist at APG Asset Management, told Bloomberg.
Private equity has been all too happy to step into the void. Analytics firm eVestment finds that private equity accounted for 27% of U.S. and U.K. pension fund allocations in 2018, up from 25% a year prior. According to a projection by PricewaterhouseCoopers, pension assets allocated to “alternative investments” (including p.e. as well as property and infrastructure funds) will reach $21 trillion by 2025, up from $10 trillion in 2016, representing an 8.6% compound annual growth rate.
As the cyclical winds blow p.e.’s way, the industry doesn’t forget to reward itself. Thus, Bloomberg reported yesterday that an upcoming €210 million offering from unrated Greek phone operator WIND Hellas Telecommunications S.A. (at a mid-4% coupon) features some interesting language in the prospectus. Namely, use of proceeds include “potentially the financing of shareholder liquidity,” i.e. paying a dividend to the companies’ owners, GoldenTree Asset Management, LP and Cyrus Capital Partners, LP with those borrowed funds.
Indeed, the quality of leveraged loans, or tradable bank debt of the speculative-grade companies frequently owned by p.e. operators, is on the wane. As noted by S&P’s LCD unit today, the proportion of loans rated double-b-minus or higher has slumped to well below 40% from roughly 45% four years earlier. Over the same period, single-B or lower-rated debt now constitutes nearly 20% of the market from just over 10% in September 2015.
A July 22 academic study quantifies the risks that investors face when lending to p.e.-controlled enterprises. Brian Ayash and Mahdi Rastad of California Polytechnic University put it this way:
Tracking a sample of 484 public to private LBOs for 10 years after going private, we find a bankruptcy rate of approximately 20%, an order of magnitude greater than the 2% bankruptcy rate for the control sample.
What might explain that dramatic disparity? A Sept. 19 report from S&P Global Ratings suggests a key factor: A widespread exaggeration of earnings power. The analysis zeros in on so-called Ebitda add-backs, or cost savings that are projected to be achieved at some future date:
Our review of a large sample of merger and acquisition (M&A) and leveraged buyout (LBO) transactions that originated between 2015 and 2018 show that, overall, add-backs inflated marketing Ebitda by an average of 28% and represented 49% of reported Ebitda at deal inception.
As Ebitda (already a flattering measure) is further nipped and tucked through hypothetical cost savings, debt loads are far more burdensome than they appear.
Our data indicate that management projections at deal inception were aggressive, showing that, on average, actual reported net leverage was 3.1 turns higher than forecast for 2017 and 3.3 turns in 2018.
Overestimated earnings were the primary contributor to the leverage disparity, with reported Ebitda 35% below marketing Ebitda for both 2017 and 2018.
Meanwhile, the advisors call for an expansion in risk appetite. A February paper from Cambridge Associates concludes that “Investors may want to consider an allocation of greater than 15% to private investments. . . Families with multigenerational wealth may be particularly well positioned to consider allocating 40% or more of their assets to private investments.” More recently, a report from the government-backed British Business Bank recommended eliminating a fee cap to help allow pensioners to invest in early stage start-ups, to reap the potential for “significantly” higher returns.
After all, what better way to achieve higher returns than through paying higher fees?
Recap Oct. 3
Stocks enjoyed a solid snap-back, with the S&P 500 reversing early losses to finish higher by nearly 1% to recoup a portion of the 3% tumble over the first two days of the quarter. Treasurys enjoyed another blistering rally in bull-steepening fashion, as the two- and 10-year yields settled at 1.39% and 1.54%, respectively. WTI crude fell for an 8th straight day to finish near $52 a barrel, while gold ticked slightly higher to $1,505 an ounce. The VIX settled just above 19.
- Philip Grant
Tuesday, October 1, 2019
Utah, get me two
Tandem bicycle
Change is in the air at PMI, the trading division of
Change is in the air at PMI, the trading division of
Recap Oct. 1
Utah, get me two
From USA TODAY:
A walking beer vendor was arrested Sunday at Hard Rock Stadium in Miami for charging a fan $724 for two beers. According to a Miami-Dade Police Department affidavit obtained by USA TODAY Sports, 33-year-old vendor Nathaniel Collier used a Square reader separate from the system used by stadium company Rocket Man to temporarily get away with the scam.
That rogue vendor might have had better luck at Yankee Stadium.
Tandem bicycle
Change is in the air at PMI, the trading division of debt-saddled oil behemoth Petróleos Mexicanos (Pemex). On Friday, Pemex named Ulises Hernandez, formerly the head of resources, reserves and partnerships at the company, to head the Pemex trading division and replace 20-year veteran Víctor Briones, along with a series of other senior-level shuffles.
Speaking of the management shake-up yesterday, populist Mexican president Andrés Manuel López Obrador (AMLO) emphasized that PMI must “stay close to the government, that it is not so distant, so loose.” Of the trading unit, AMLO declared “it is a company of the nation.”
The fates of Mexico’s sovereign finances and that of Pemex are indeed increasingly intertwined. On Sept. 11, the Mexican government announced a $5 billion cash infusion into Pemex, following a $4.4 billion cash and tax break package disclosed in Mexico’s fiscal 2020 budget on Sept. 8. A day later, Pemex managed to borrow $7.5 billion to refinance a portion of $44 billion in of debt maturing over the next four years.
The issuer was certainly motivated. Patti McConachie, analyst at Columbia Threadneedle Investments, told the Financial Times that Pemex “came to market with a material discount relative to where bonds at the same maturity were trading. . . I read into it that they definitely wanted this deal to succeed.” Tim Jagger, head of emerging market debt at Columbia Threadneedle, described the operation as “kicking the can down the road a little more” and speculated that the extended maturity schedule could help delay a credit rating downgrade by 12 to 18 months.
It’s been a long, steady decline for Pemex. The company’s oil production stood at 1.68 million barrels per day in August, down from 1.8 mbpd a year earlier and far below the 3.4 mpbd high water mark seen in 2004. AMLO had previously targeted 1.8 mbpd by year-end, but signs of fatigue at the deepwater Ku-Maloob-Zaap (KMZ) field might augur still more ominously for the country’s future output (Almost Daily Grant’s, May 2).
That output slide is likewise taking a toll on the sovereign income statement. According to data from the Finance Ministry, oil revenue accounted for 16% of federal government income in the second quarter, down from more than 30% at the beginning of President Enrique Peña Nieto (AMLO’s predecessor) in 2012.
Then there’s the balance sheet. As production wanes, Pemex’s encumbrances remain, with the company on the hook for some $160 billion in net debt inclusive of pension liabilities, or nearly seven times Ebitda. Cumulative cash burn over the last 10 years stands at $72 billion.
While S&P rates Pemex at a safely-investment grade triple-B-plus, the other rating agencies beg to differ. Fitch cut its rating to junk in June, while Moody’s, which appraises Pemex debt at Baa3 (the lowest rung of investment grade), moved its outlook on the company to negative.
Creditors seem to have gotten the jump on the rating agencies. For instance, the company’s senior unsecured 5.35% notes due 2028 currently trade at 95.2 cents on the dollar, for a yield-to-worst of 5.97%. By comparison, double-B-minus-rated Petróleo Brasileiro S.A (Petrobras’) dollar-pay senior unsecured 2028 notes last changed hands above 111 for a yield-to-worst of 4.36%.
The key question: Might an accident at Pemex impugn the sovereign credit profile of AMLO’s government? On June 5, Moody’s revised its outlook on Mexican sovereign credit to negative from stable, noting that: “Weaker growth prospects in the coming years, combined with the prominent role assigned to Pemex in the context of the country’s new energy policy, is also raising concerns regarding the trajectory of government debt.”
As noted in a bearish analysis of Pemex and Mexican debt in the March 23, 2018 issue of Grant’s: “It would do the national credit profile no good if 15 percentage points of Pemex debt came to alight on the Mexican debt-to-GDP ratio.” Pemex five-year credit default swaps have subsequently risen to 314 basis points from 185 basis points, while Mexican sovereign CDS stand at 117 basis points, virtually unchanged.
Recap Oct. 1
The first day of the quarter was an inauspicious one for the bulls, as the U.S. ISM Manufacturing PMI for September registered its worst reading since June 2009, which was coincidentally the close of the Great Recession. That revelation coincided with a steep decline in stocks, as the S&P 500 fell 1.2% for its worst showing since Aug. 23.
Treasurys enjoyed a bull-steepening rally, as the two-year yield dropped to 1.54%, 10 basis points below the 10-year. Gold rose to $1,481 an ounce, while WTI crude was hammered again to finish below $54 a barrel for the first time in more than a month. The VIX jumped above 18.
- Philip Grant
Monday, September 30, 2019
Under the hood
According to research from Morgan Stanley,
According to research from Morgan Stanley,
Animalistic
Today, troubled U.K.-based closed-end investment fund Woodford Patient Capital Trust plc.
Today, troubled U.K.-based closed-end investment fund Woodford Patient Capital Trust plc.
Recap Sept. 30
Under the hood
According to research from Morgan Stanley, the proportion of loans within collateralized loan obligations (CLOs) currently trading under 90 cents on the dollar reached 8.1% at the end of August. That’s up from 6.5% a month earlier and matches the levels seen during the December 2018 selloff.
A similar deterioration has taken place in other credit cordons, with the ratio of high yield debt quoted at a 1,000 basis point premium to Treasurys jumping to 9.4% in August, the highest since November 2016 and up sharply from 6% in July. Likewise, 4.03% of loans in the S&P/LSTA Leveraged Loan Index trade below 80 cents on the dollar, up from 2.81% in July.
That increased frequency of stressed credits hasn’t translated into much at the index level. The S&P/LSTA Leveraged Loan Index currently trades at 96.3, compared to less than 94 on Dec. 27, while the ICE/BAML High Yield Index features an option adjusted spread of 399 basis points, compared to 538 basis points on Dec. 27.
Animalistic
Today, troubled U.K.-based closed-end investment fund Woodford Patient Capital Trust plc. (WPCT on the London Stock Exchange) disclosed that net asset value for the fund fell to £591 million ($727 million) as of Sept. 26, down 20% from £748 million three months earlier. It’s the latest setback for the investment vehicle, which has been beset by a liquidity crisis this year and is weighing the potential removal of founder and eponym Neil Woodford from his post.
Today, the board of WPCT said in a statement that it “continues to evaluate the position of the portfolio manager and remains in dialogue with other portfolio managers.” Said, Woodford: “I continue to believe that the majority of the businesses we have invested in are making good progress, in line with our pre-agreed milestones.” Since May, WPCT shares are down by 45%.
Similar strains have also emerged at Natixis S.A.-owned H20 Asset Management, which offers daily redemptions paired with illiquid corporate bond holdings. Following a decision by Morningstar, Inc. to suspend a rating on one of its funds in June, assets fell by more than £3 billion, or 15% of its total holdings, in three days.
A fundamental business model flaw lies at the heart of Woodford and H2O’s troubles, as the firms promise daily liquidity to investors, even while sporting investment portfolios rife with illiquid or untraded companies. That contradiction earned the derision of Bank of England Governor Mark Carney, who asserted in June that funds offering regular withdrawals while holding illiquid positions are “built on a lie.”
The conditions for that smash-up came together gradually. Woodford, declared “the U.K.’s most celebrated fund manager” by the Financial Times in 2014, instituted a 60% asset cap on “unquoted,” or illiquid, portfolio securities in 2015. One year later, the fund raised that ceiling to 80%, then in 2017 changed the designation to 80% of gross (as opposed to net) assets, perhaps reflecting an enhanced use of leverage.
The infrequent portfolio marks that come with private investing can lead to quirky outcomes. Through year-end 2018, Patient Capital reported £140.8 million in gains (both realized and unrealized) from its portfolio of unlisted companies, almost exactly offsetting £140.7 million in realized and unrealized losses from its publicly-traded book. To value its privately-held portfolio companies, Woodford generally uses its cost or the valuation from that company’s most recent funding round, but not always. The May 17 issue of Grant’s, which described WPCT as akin to a publicly-traded venture capital fund, explains:
For example, the value of Kymab Ltd., WPCT’s tenth-largest holding, a biotech startup, got a bump up to £29.4 million in 2018 from £16.9 million in 2017. “Price of recent investment/PWERM” is the rationale provided.
Studious document readers will note that the acronym stands for “probability-weighted expected return method, which considers on a probability weighted basis the future outcomes for the investment.” In other words, Kymab was “marked to model.”
Valuations and animal spirits in private markets have run unchecked for years. That can lead to painful reckonings when those high-flyers come public, as evidenced by Uber Technologies, Inc., SmileDirectClub., Inc. and Slack Technologies, Inc. Of the abrupt loss of investor confidence seen by Woodford and H20, that May 17 Grant’s put it this way:
For now, these are London’s troubles. They couldn’t happen here? Oh yes, they could.
Recap Sept. 30
Stocks caught a bid, with the S&P 500 finishing higher by 50 basis points to wrap up the third quarter with a 19% year-to-date gain and within 2% of its July 26 high-water mark. Treasurys were also stronger, with the 10-year yield falling one basis point to 1.67%, while the Dollar Index rallied again to approach the 100 level for the first time since April 2017. The rising greenback coincided with additional pain in gold and WTI crude, which fell 2% and 3% to $1,473 an ounce and $54.30 a barrel, respectively. The VIX settled just above 16.
- Philip Grant
Friday, September 27, 2019
Say it ain't so
Spotted yesterday in Gramercy by Twitter user @AlmingtonCap, former The We Company CEO Adam Neumann shows off his contrarian, individualist nature by going shoeless:
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Or the creditors got them.
One-stop shop
A flight to quality in the deep end of the credit pool? Month to date, the LCD/LSTA Leveraged Loan Index has gained 0.44%, while the triple-C-rated component of that index has lost 1.23%. On the bond side, the S&P U.S. High-Yield Corporate Bond Triple-C Total Return Index remains well below its April highs, bucking the broad trend as the Bloomberg Barclays High Yield Index reached a fresh record high on Monday.
John Cokinos, co-head of U.S. leveraged finance at RBC Capital Markets, tells Bloomberg that investors have indeed become more selective of late: “If you’re looking to finance a leveraged buyout in the wrong sector or a business vulnerable to a slowdown, that’s tougher. The loan market has limited appetite for new B3-rated [equivalent to single-B-minus] deals, and the high-yield market is pushing back on highly levered deals.”
Unsustainable leverage presents one potential explanation for the bifurcation. As the cycle drags on in what is the longest economic expansion on record, debt levels among the speculative-grade issuers continue to rise. According to recent data from CreditSights, net debt as a percentage of enterprise value among double-B-rated issuers rose to 35.9% as of the second quarter. That’s the highest of the cycle and compares to just 24.8% in the second quarter of 2014. For issuers rated between single-B-plus to triple-C, net debt reached 54.1% of enterprise value in the second quarter, up from 28.1% five years ago.
Whatever the explanation, a pair of recent deals underscore the quality divergence. Yesterday, double-B-minus-rated AMN Healthcare Services, Inc. managed to price $300 million unsecured senior notes due 2027 at a 4.625% coupon, down from initial price talk of 4.75%. AMN, which is leveraged at just under three times consensus 2019 adjusted Ebitda and has generated positive net income in each year since at least 2011, intends to use the proceeds to refinance existing debt.
On the other end of the spectrum sits newly p.e.-owned Shutterfly, Inc. On June 10, Apollo Global Management LLC announced the acquisition of the digital imaging company for $2.6 billion, a 31% premium to its share price prior to reports that Shutterfly was looking to sell itself. Single-B-rated Shutterfly, which carried three turns of leverage prior to Apollo’s leveraged buyout, posted an operating loss of $114 million in the first six months of the year, double the $57 million shortfall seen in the first two quarters of 2018. Margins are likewise on the wane, with consensus 2019 adjusted Ebitda footing to 14.8% of revenues, compared to 17.2% in 2018.
Yesterday’s offering of a series-B term loan to help finance the LBO was met with the cold shoulder from Mr. Market. The issue priced at a 600 basis point spread over Libor, which was twice widened from initial price talk of 525 basis points over. In addition, the loans were priced at 95 cents on the dollar, down from an initial 98 to 99 indicated range, with a principal amortization rate of 7% per annum, up from 5% initially. Recall that last week, Apollo was obliged to itself buy the $300 million unsecured debt tranche from the transaction, following insufficient demand from outside investors (Almost Daily Grant’s, Sept. 19).
Apollo’s Shutterfly struggles coincide with changes at the top. Yesterday, the p.e. firm announced it was shuffling its management team, with executives Matt Nord and David Sambur promoted to the dual position of co-lead partners of private equity. That co-head format is timely. One can buy a target company’s equity and the other can handle the debt.
Recap Sept. 27
A mid-day report that the White House is considering steps to limit investor flows into Chinese equities helped the bears keep control, as the S&P 500 finished the week 1% lower for its worst close since Sept. 4. Treasurys finished stronger, with the 10-year yield declining a basis point to 1.67%, while the Dollar Index remained near its highest since May 2017, pressuing WTI crude and gold which finished below $56 a barrel and $1,500 an ounce, respectively. The VIX settled just above 17.
- Philip Grant
Thursday, September 26, 2019
Dead air
The timing could hardly be worse. On Tuesday, the Federal Communications Commission issued a press release accusing Sprint Corp. (S on the NYSE) of improperly retaining government subsidies from the Lifeline low-income assistance program, instead of passing them along to 885,000 cash-strapped customers as was their obligation. In a statement, FCC chairman Ajit Pai didn’t mince words:
It’s outrageous that a company would claim millions of taxpayer dollars for doing nothing. This shows a careless disregard for program rules and American taxpayers. I have asked our Enforcement Bureau to investigate this matter to determine the full extent of the problem and to propose an appropriate remedy.
By way of explanation, a company spokesperson contended that “an error occurred” and promised that “while immaterial to Sprint’s financial results, we are committed to reimbursing federal and state governments for any subsidy payments that were collected.” Using the FCC’s reckoning of $9.25 per individual monthly subsidy, the improper payments would total approximately $98 million annually, or just under 1% of consensus adjusted Ebitda for the fiscal year ending March 31.
That assurance didn’t seem to appease Uncle Sam, as FCC commissioner Geoffrey Starks announced yesterday that this development may imperil the company’s controversial merger with T-Mobile U.S., Inc. (TMUS on the Nasdaq):
[T]his announcement directly impacts our review of the proposed merger between Sprint and T-Mobile, one of the largest wireless transactions in FCC history. Given the enormity of the apparent wrongdoing committed here, we must pause our Commission review.
How the merging parties were going to handle Lifeline was a prominent part of their merger pitch, so I am alarmed and concerned about such a massive inaccuracy in a core part of the transaction.
The FCC’s displeasure aside, chairman Pai is the only one who can delay an FCC vote, a move which “seems extremely unlikely,” an investor familiar with the situation tells Grant’s. Our source puts it this way: “If Pai and the other two Republicans [who hold a majority among the five voting members of the FCC] were willing to approve the deal prior to even drafting an order, it is unlikely that Sprint’s misconduct changes that view.” Pai circulated the draft order granting provisional approval in August, three months after indicating he would support the deal.
Yet for Sprint and T-Mobile, a bigger danger lurks in the form of a coalition of state attorneys general who have banded together in court to try to halt the deal. Last week, Pennsylvania AG Josh Shapiro announced that his office is joining the lawsuit, expanding the coalition to 18 states including New York and California. The trial is set to begin Dec. 7.
The market is expressing concern, as the discount between Sprint shares and the proposed 0.1026 exchange ratio with TMUS upon completion of the deal now stands at 31%, well above the 19% discount as of April 10, 2018, when Reuters first reported that a deal agreement was close.
Under U.S. law, plaintiffs bear the burden of proof. However, as our anonymity-seeking investor explains, applicable case law under section 7 of the Clayton Act provides plaintiffs with a so-called presumption to shift the burden of proof to defendants (such as in cases involving The Philadelphia National Bank in 1963, H.J. Heinz Co. in 2001 and Baker Hughes, Inc. in 2017). “The presumption is based on market share challenges, which clearly apply here. So, T-Mobile and Sprint will have the burden of proof. Their arguments – the DISH [asset sale] remedy, efficiencies, and Sprint as a flailing firm – are all factually weak and face case law which has rarely (or never in the case of efficiencies) used such arguments to overcome a presumption of harm in prior horizontal mergers.”
A scuttled merger would leave a standalone Sprint in a precarious position, as the company faces declining revenue, six years and counting of free cash burn, and a $41 billion net debt load (nearly four times adjusted Ebitda). Research firm MoffettNathanson, LLC concluded in a Jan. 31 report that if the deal is rejected, Sprint’s debt “will likely have to be restructured.”
A failed deal would spell further bad news for suddenly-beleaguered SoftBank Group Corp., which paid $12.1 billion for a 70% stake in 2012 (the fund currently holds 84.5% of outstanding S shares). The Vision Fund, SoftBank’s $100 billion in-house V.C. arm, has likewise seen positions in Uber Technologies, Inc. and Slack, Inc. marked down sharply in the public markets, to say nothing of the unfolding train wreck at 29% owned The We Company. Yesterday, Bloomberg reported that Goldman Sachs Group, Inc. “has approached other financial institutions” in hopes of offloading some of its $3.1 billion credit line to the Vision Fund, and is offering the debt slightly below par.
Recap Sept. 26
A bull-flattening rally in Treasurys pushed the 10-year yield to just under 1.70%, just four basis points above the two-year yield. Stocks ticked slightly lower to leave the S&P 500 down by a half-percent for the week so far, while gold and oil both traded sideways. The VIX held just below 16.
- Philip Grant
Recap Sept. 26
Wednesday, September 25, 2019
Sentiment check
Karz for Kidz, 2019 edition. From Popular Mechanics last week:
Good news! Bugatti built a car that costs less than a Mustang GT. Bad news! It's sized for kids, they're only making 500 of them, and they're all sold out.
But they're taking names for the reserve list, anyway, in case anyone who's already made a deposit subsequently decides they have a better use for $33,000.
Ya gotta believe
Yesterday afternoon the price of bitcoin fell more than $1,000 in 30 minutes to just over $8,000, the biggest one-day decline since January 2018 and its lowest finish since June. “Even for [the notoriously volatile] bitcoin, this is a pretty rare event,” Qiao Wang, director of product at crypto research firm Messari, Inc., told Coindesk.
What caused that abrupt swan-dive? Coindesk, citing an anonymity-seeking trader, speculates that the drop “may have been exacerbated by margin calls and contract liquidations on BitMEX, a Seychelles-based exchange that provides customers with 100 times leverage.”
BitMEX’s eye-catching leverage extension is only one tactic used by crypto exchanges to drive volume, as bitcoin turnover on major exchanges fell 40% in the past month according to TokenAnalyst. Yesterday, Bloomberg reported that such venues now offer generous referral programs to those who bring friends onto a particular platform.
Binance, the world’s largest crypto exchange, offers a commission equaling as much as 40% of the trading fees incurred by new traders to those providing a referral, and allows the recipient of those funds to share them with the fee-generating trader. The exchange also sports a referral “leader board” on its webpage showing one member has earned 989.37 bitcoin through the activity, worth some $8.3 million at current prices. Bloomberg opinion writer Aaron Brown guesstimates the scale: “It would not shock me to learn that referrers collectively earn $100 million to $200 million per year, and exchanges earn $400 million to $800 million from referral programs.”
As crypto exchanges scramble to win trading volume, one key player continues to fight the power. Recall that on April 25 New York Attorney General Letitia James accused iFinex, Inc., which operates both Bitfinex and Tether, of “engaging in a cover-up to hide the apparent loss of $850 million of co-mingled and corporate funds.”
Yesterday, Bitfinex, the crypto venue affiliated with purportedly dollar-backed stablecoin tether, won a stay from the Appellate Division of the New York Supreme Court allowing it to withhold documents from the AG pertaining to a $900 million loan from Tether to Bitfinex. In response to the appeals court ruling, an AG spokesperson noted that “the injunction that prohibits the movement of money between Tether and Bitfinex is still in place, that has not changed.”
The kerfuffle carries potentially significant ramifications, as tether is widely used by crypto exchanges as a workaround for know-your-customer and anti-money-laundering laws. For instance, trailing 24-hour trading volume in tether footed to $31.6 billion as of late afternoon, far above any other crypto including bitcoin at $25.3 billion. Questions over the legitimacy of tether’s claims of dollar-backing are likewise brought into relief. For his part, tether co-founder William Quigley suggested a more existential approach in an interview with Bloomberg radio on Sept. 4:
Whether or not tether was backed by the dollar wouldn’t matter if everybody agreed to take tether and to value them at a dollar themselves.
Faith on the blockchain.
Recap Sept. 25
Stocks enjoyed a solid intraday rally, erasing the bulk of yesterday’s losses and leaving the S&P 500 back within hailing distance of its July 25 highs. Treasurys were hammered, with a weaker-than expected five-year note auction this afternoon highlighting a selloff that left the 10-year yield at 1.73%, up eight basis points on the day. Gold was likewise clobbered to the tune of nearly 2%, settling at $1,504 an ounce, while WTI crude continues to unwind its post-Saudi attack gains, finishing at $56.50 a barrel. The VIX fell back to 15.5.
- Philip Grant
Tuesday, September 24, 2019
Banks for nothing
He’s positive that rates should be negative. Last Thursday, Bank of Japan governor Haruhiko Kuroda declared he is “more positive” about the prospect of further easing from the BoJ’s policy rate, which currently sits at negative 10 basis points, on account of increased risks to economic growth. Following a stand-pat meeting last week, the BoJ is now expected to again cut rates at its next gathering on Oct. 31, with interest rate futures currently pricing 54% odds of an additional 10 basis point cut at the meeting.
Following the well-worn contemporary central bank playbook in his quest to hot up the economy and stoke price inflation, Kuroda looks set to deliver more of what has not worked. In the 20 years since Japan first rolled out a zero interest rate policy, real GDP and inflation as measured by CPI have averaged 0.9% and 0.1%, respectively, on a year-over-year basis.
While two decades of virtually zero borrowing costs have brought the BoJ no closer to its stated goals, Kuroda used central bank comps to make his case for more of the same: “The BoJ may look as if it has less room for easing when its policy rate of minus 0.1% is compared to around 2% for the U.S. Federal Reserve. But the ECB has reduced its deposit rate to minus 0.5%. Compared with the ECB, the BOJ may appear to have more room for additional easing.”
In addition to sub-zero policy rates, Japan and Europe each sport banking systems that could be described as gasping for oxygen. Japan’s Topix 600 Banks Index currently trades at a paltry 0.44 times book value and generated a meager 5.31% return on equity in calendar 2018. That compares to 0.55 times book and 7.22% 2018 RoE for Europe’s STOXX Banks Index, and 1.16 times and 11.8% for the U.S. KBW Bank Index.
Japan’s depressed valuations and stunted earnings power are no accident. Shannon McConaghy, portfolio manager at Horseman Capital Management L.P. noted in a July 25 Real Vision interview that Japanese banks earn an average interest rate of just 64 basis points on new loans, well shy of the 100 basis points needed to cover basic operating expenses. Makoto Takashima, chairman of the Japanese Bankers Association, spoke up in an attempt to discourage Kuroda at a news conference last week: “It’s doubtful that deepening negative interest rates is effective for monetary easing.”
As Japan’s banks find profitability in core lending activities increasingly harder to come by, yen-denominated loans from foreign issuers are at least partially filling the void, with outstanding supply of these so-called samurai loans doubling last year to $21.5 billion. Kazuyuki Ikegami, senior counselor in the Tokyo branch of Bank of Kyoto Ltd. explained the appeal to Reuters on Sept. 9:
Regional banks have less opportunity to lend because the number of local companies is falling, and we have low margins because interest rates are so low. We need the opportunities to lend that samurai loans provide us, and they’re great because they mitigate currency risk. We’re putting more people [in] the samurai loan market.
Higher-risk options are the natural next resort. Last week, Bloomberg reported that Mitsubishi UFJ Financial Group, Inc., Japan’s largest bank, is set to arrange its first European-based collateralized loan obligation (CLO) “having already been an active buyer in the region.” CLOs, or securitized pools of leveraged loans (i.e. bank debt issued by speculative-grade issuers), have been a popular option for Mitsubishi and peers. Although national level-data on CLO exposure is spotty (Japanese regulators are conducting a survey to determine local banks’ CLO holdings, per Bloomberg), a report from UBS last December estimates that Japanese banks accounted for roughly one-third of CLO inflows in recent years and as much as three quarters of triple-A-rated CLO tranches.
Some observers spy trouble ahead. On Sunday, the Bank for International Settlements sounded the alarm over CLOs in their Quarterly Review, drawing parallels with the mortgage-backed collateralized debt obligations (CDOs) that figured so prominently in the events of 2007 to 2009.
For example, U.S. subprime mortgages without full documentation of borrowers' income increased from about 28% in 2001 to more than 50% in 2006. Likewise, leveraged loans without maintenance covenants increased from 20% in 2012 to 80% in 2018. In recent years, the share of low-rated (B-) leveraged loans in CLOs has nearly doubled to 18%, and the debt- to-earnings ratio of leveraged borrowers has risen steadily.
Weak underwriting standards reduce the likelihood of defaults in the short run but increase the potential credit losses when a default eventually occurs.
Contagion risk also looms, according to the BIS:
Banks’ prime brokerage exposure to CLO holders could result in larger losses than implied by direct exposures.
The (almost) last word goes to Claudio Borio, head of the monetary and economic department at the BIS, who remarked of the current $14.8 trillion in negative-yielding debt worldwide: “A growing number of investors are paying for the privilege of parting with their money. Even at the height of the Great Financial Crisis, this would have been unthinkable. There is something vaguely troubling when the unthinkable becomes routine.”
Haruhiko Kuroda and Mario Draghi, please copy.
Recap Sept. 24
Stocks came under pressure with the S&P 500 dropping 80 basis points, to narrow its 2019 advance to 18.4%. Treasurys enjoyed a strong bid with the 10-year yield dropping nine basis points to 1.64%, while gold rose $10 to $1,532 an ounce. WTI crude slipped to $57 a barrel, while the VIX jumped 17% to 17.4. This afternoon, the crypto complex absorbed an intense downdraft, with the price of bitcoin falling roughly $1,000 and settling at $8,560.
- Philip Grant
Monday, September 23, 2019
If you build it
Price-to-choose-your-own-adventure
At least eyeballs are countable.
At least eyeballs are countable.
Recap Sept. 23
If you build it
On Friday, S&P Dow Jones announced that homebuilder NVR, Inc. will join the S&P 500, replacing Jefferies Financial Group as of Thursday, Sept. 26. That move will mark something of a milestone, as NVR has long operated an enviable business model that has generated outsized returns. Following a 4% pullback today, NVR shares have compounded by 6,280% over the past 20 years, trouncing the 198% gain on the S&P 500 including reinvested dividends over that period.
At the Spring 2019 Grant’s Conference, John Hughes of the Quantum Capital Management identified NVR as a compelling opportunity. A unique business model plays a key role in the company’s success, Hughes explained:
They build up and down the East Coast, they are the fourth-largest homebuilder in the U.S.—and all of this is of little consequence to us. What matters most is its local market concentration, by design. It’s typical of NVR to enjoy a 20% or 30% or more market share in areas where they do build.
Since that call on April 9, NVR shares have advanced by a further 22%, compared to a 9% total return for the SPDR S&P Homebuilders ETF. Reached by Grant’s today, Hughes relayed that his fund “has not sold a share in NVR and [does] not plan to. Our positive 10-year view remains intact.”
More broadly, 12 years after the collapse of the mortgage bubble, the housing market’s vital signs look robust. August housing starts printed at 1.36 million, up 6.6% from a year ago and well above the Street expectation of 1.25 million. Building permits are likewise on the march, jumping by 7.7% year-over-year in August to 1.42 million, those figures each represent the highest readings since 2008 and compare to ten-year averages of 968,000 and 1.02 million, respectively.
U.S. housing starts by month, 20-year chart. Source: The Bloomberg
For an in-depth analysis of the U.S. housing market, along with a bullish assessment of another industry mainstay, see the July 26 edition of Grant’s Interest Rate Observer.
Price-to-choose-your-own-adventure
At least eyeballs are countable. In a note today, internet and media analysts at Barclays Capital, Inc. argue that “traditional valuation frameworks have become insufficient in a growing number of instances.” The increasing proliferation of digital businesses calls for a new approach, “as for some companies these [digitization] efforts have either not yet generated revenue, or could take years to scale, and/or [may] be cannibalistic.” Speaking of Netflix, Inc., Barclays asks “why is five to six times revenue the right number when [the company] is growing faster than software companies like Adobe, Appian and Aviva, which all trade for 10 to 20 times” sales?
Instead, the analysts suggest using “the ratio of enterprise value to adjusted/fully loaded lifetime value,” meaning “the present value of gross margins earned over the life of a customer.” The full formula is shown below, with ARPU representing average revenue per user, GM for gross margin, c is churn, i the discount rate and t representing the life of the customer with the firm in question.
The report does make note of customer acquisition costs, calculating that outlay “by using or estimating the marketing cost for a given business and normalizing it by the number of subscribers added in a period.”
While the Street tweaks its frameworks to better capture the latest new era in investing, an industry giant pivots back to basics. As noted by Zero Hedge yesterday, SoftBank Group Corp. recently listed a job opening for a valuations director.
According to the posting, a successful candidate “will be primarily responsible for determining the fair value of investments for quarterly financial reporting and providing valuable and timely insight to management on our investments.” In addition, “extensive valuation modeling experience,” including “public company comparable multiples, discounted cash flow and option pricing models” are required.
Recap Sept. 23
Stocks treaded water after a late downtick Friday pushed the S&P 500 back below 3,000, while a modest rally in rates sent the 10-year yield to 1.72%. Energy and metals both caught a bid, with WTI crude finishing at $58.50 a barrel and gold advancing to $1,523 an ounce, within $30 of the multi-year closing highs reached on Sept. 4. The VIX remained below 15.
- Philip Grant
Thursday, September 19, 2019
Masa of leverage
SoftBank Group Corp. and Vision Fund architect Masayoshi Son has doubled down, again. From Bloomberg:
[Son] has pledged 38% of his stake in the Japanese firm as collateral for personal loans from 19 banks, including Credit Suisse Group AG and Julius Baer Group Ltd., according to a June regulatory filing.
Son loaned himself around $3 billion to invest in the first Vision Fund.
The risk-loving Son, who saw $70 billion wiped from his fortune in the dot-com crash, is unlikely to be fazed. He told shareholders at the company’s June meeting that SoftBank’s investment portfolio could grow 33-fold to 200 trillion yen ($1.8 trillion) in 20 years.
All together now: The epitome of the cycle.
Polonius, call your office
As money market volatility and the Fed’s 25 basis point cut have dominated the financial news cycle, key asset gauges have hummed merrily along. The S&P 500 remains near its high water mark, up 20% year-to-date, while the yield on the Bloomberg Barclays High Yield Index fell to 5.58% this morning, the lowest since January 2018. But problems continue to bubble under the surface in speculative grade credit.
Distressed situations are increasingly commonplace. According to data from S&P Global Ratings, the ratio of high yield debt trading at a 1,000 basis point premium to Treasurys jumped to 9.4% in August, the highest since November 2016 and up sharply from 6% in July. Likewise, the proportion of loans in the S&P/LSTA Leveraged Loan Index trading below 80 cents on the dollar rose to 4.03% in August from 2.81% in July. That rise in struggling issuers corresponds with an earnings slowdown, as Creditsights finds that median trailing 12-month Ebitda across U.S. high-yield issuers rose just 6.6% from a year ago in the second quarter, down from 11.2% in the fourth quarter of last year and the slowest growth rate since the first quarter of 2017.
As the proportion of troubled credits pushes higher, issuer concessions have become more commonplace as creditors increasingly push back against their counterparties. S&P’s LCD unit reports that underwriters were forced to cut pricing on 24% of new leveraged loan issues in August, up from 20% in July and the highest of the year. More recently, a trio of notable happenings underscore this trend.
Yesterday, British tycoon Sanjeev Gupta was obliged to personally offer $150 million in equity to get a $475 million, five-year junk bond deal for his InfraBuild Australia Pty Ltd. steel and recycling business across the finish line. The reduced leverage that will result from InfraBuild’s downsized offering led Fitch Ratings to upgrade the bond to double-B from single-B, yet Bloomberg reports that the yield on the issue will approach 10%, more than double the 4.1% yield on the double-B component of the Bloomberg Barclays U.S. High Yield Index.
Last week, Claire’s Stores, Inc. withdrew a $700 million loan offering at a proposed 550 basis point spread over Libor on account of weak demand. The company, which was taken private by Apollo Global Management in a $3.1 billion leveraged buyout in 2007 and emerged from bankruptcy last year, would have seen its leverage ratio rise to 4.4 times Ebitda if the transaction had gone through from 3.3 times in February, according to Moody’s Investors Service.
A second Apollo deal has likewise received the cold shoulder from Mr. Market. Yesterday, the buyout firm bought the entire $300 million unsecured bond tranche of its debt offering to finance its acquisition of Shutterfly, Inc. Bloomberg reports that underwriters are still in the process of trying to place $1.3 billion in term loans and $500 million in secured bonds but have been met with “lackluster” demand.
Both a lender and a borrower be.
- Philip Grant
Almost Daily Grant's resumes Monday
Tuesday, September 17, 2019
Recap Sept. 17
Short-term funding markets saw a major spasm this morning, with the overnight repo rate jumping as high as 10% and pushing the Fed Funds rate to 2.25% from 2.14% yesterday. In response, the Fed injected $53 billion into the banking system, its first such intervention since the financial crisis.
Those relatively dramatic developments stood in stark contrast to what appeared to be a routine session by traditional indicators, as the S&P 500 edged higher after drifting sideways most of the day, while Treasurys were bid across the curve, WTI crude gave back a chunk of yesterday’s gains to finish at $59 a barrel and gold rose $3 to $1,501 an ounce. The VIX remained below 15 for a fourth straight day.
After the deal
Four years ago, roll-ups were the vogue of Wall Street, as so-called platform companies like Valeant Pharmaceuticals International, Inc. posted rapid earnings growth and saw their share prices go skyward. Today the strategy is in various states of disrepair, with notable roll-up investors, the Brazilian private equity firm 3G Capital Partners, in retreat. Now follows a review of recent happenings in a trio of 3G portfolio companies, each of which has been the subject of a bearish Grant’s analysis in recent years.
Packaged foods giant The Kraft Heinz Co. (KHC on the Nasdaq) is on the ropes, as KHC shares are down 34% year-to-date and 63% since an initial Grant’s appraisal in March 2016. This morning, 3G disclosed in an 8-K filing that is has divested 25.1 million shares of the company, raising some $713 million while lowering its stake in the company to 20%.
But while the firm sells, the Brazilians themselves buy. Bloomberg reports this morning that 3G insiders, including co-founder Jorge Paulo Lehmann, personally purchased some $200 million of that KHC share offering. Thanks largely to 3G and Berkshire Hathaway’s 2013 acquisition of H.J. Heinz Co. followed by the merger with Kraft Foods Group, Inc. two years later, the company carries a net debt load of $30.3 billion. That’s equivalent to five times consensus 2020 adjusted Ebitda.
While the Kraft Heinz has floundered thanks to shifting consumer tastes, brand erosion (leading to a $15.4 billion, non-cash write-down in February) and accounting problems, other factors may explain the divestment. CNBC’s David Faber reports this morning that 3G’s block sale was motivated by liquidity needs of former billionaire Eike Batista: “He needs money.”
To that end, 3G’s investment in global beer behemoth Anheuser-Busch InBev S.A./N.V. (ABI on the Belgian Stock Exchange and BUD on the NYSE) has fared far better in 2019, with shares up 51% to narrow the stock’s decline to 4% since a February 2018 Grant’s bear verdict. Yet liquidity remains front-of-mind.
Yesterday, Anheuser-Busch announced it will try once again to IPO its Asia unit, Budweiser Brewing Company APAC Ltd., targeting $4.8 billion in outside capital with an additional overallotment option of up to $1.8 billion. Earlier this summer, the company was forced to withdraw an IPO for the Asia business at a $9.8 billion fundraising target as investors balked at the valuation, with ABI instead opting to sell Australian subsidiary Carlton & United Breweries to Japan’s Asahi Group Holdings, Ltd. for $11.3 billion. Thanks in large part to the 2016 acquisition of SABMiller, plc. for $123 billion, Anheuser-Busch’s net debt currently stands at 4.7 times consensus 2020 adjusted Ebitda.
Then there’s fellow 3G portfolio company Restaurant Brands International, Inc., (QSR on the NYSE), the asset-lite franchisor that owns the Burger King, Tim Hortons and Popeye’s Louisiana Kitchen brands. Restaurant Brands is likewise deal-happy, most recently paying 19 times adjusted Ebitda for Popeye’s in 2017, helping to push its net debt to five times 2020 adjusted Ebitda.
Like Anheuser-Busch, QSR has enjoyed a strong 2019, with shares higher by 40% year-to-date and by 18% from a June 2017 bearish Grant’s analysis. But those who know the company best are heading for the exit. On Sept. 4, a 3G affiliate announced that it had sold some 17 million QSR shares, following a 24 million share disbursement in August. Unlike in Kraft Heinz, 3G insiders have likewise been persistent sellers of QSR stock over the past year, an eye-catching $3.8 billion in total.
Monday, September 16, 2019
Price gusher
The weekend drone attack on the Abqaiq processing plant in Saudi Arabia has sparked an international firestorm, with president Trump taking to Twitter to blame Iran and asserting the U.S. is “locked and loaded depending on verification.”
Whoever the culprit(s), their target is a crucial one to the world economy, as Abqaiq processes some 7 million barrels of oil per day (mbpd), equating to nearly 7% of the 101.2 million in global daily output according to the U.S. Energy Information Administration. The attacks hit their mark, as Saudi Arabia was forced to shut down 5.7 mbpd in output capacity, roughly half of the Kingdom’s daily production. Bloomberg notes that that gross supply loss marks the largest in history, topping the 5.6 mbpd in the Iranian Revolution of 1978 and 1979 and the 4.3 mbpd in the 1973 to 1974 Arab-Israeli War and oil embargo. The price of West Texas Intermediate crude jumped 14% to $62.5 a barrel this afternoon.
Hopes for a quick return to business as usual are dimming. “Damage to the Abqaiq facility is more severe than previously thought,” Amrita Sen, chief oil analyst at Energy Aspects Ltd., told Bloomberg this afternoon. “While we still believe up to 50% of the 5.7 million barrels a day of output that has been disrupted could return fairly swiftly, full resumption could be weeks or even months away.”
The supply disruption and price spike are welcome news for oil bulls, who have been forced to contend with a 20% drop in WTI crude in the 52 weeks ended Friday. In early July, fears of persistent oversupply led the Organization of the Petroleum Exporting Countries (OPEC) to extend the 1.2 mbpd in output cuts agreed to last December by an additional six months. In July, the International Energy Agency reported that global supply exceeded demand by 0.9 mbpd in the first six months of the year, predicting that 2020 will see “considerable oversupply because we are getting big growth from the United States and some other countries.”
In light of this weekend’s news, those concerns have moved to the back-burner. Saul Kavonic, head of equities research for oil and gas at Credit Suisse A.G., commented: “We have never seen a supply disruption and price response like this in the oil market. Political risk-premiums are now back on the oil-market agenda.”
The key question for oil investors: Are recent developments a one-off, or potentially a harbinger of a more sustained bullish regime? In a blog post Friday before the drone strike, resource investors Goehring and Rozencwajg LLC argued that the current backwardation term structure of oil, in which the spot price sits higher than futures (as opposed to contango, the opposite phenomenon), suggests that higher prices could be in the offing:
To understand why, consider that the future price of oil equals the current spot price plus the cost of capital and the storage cost less the ‘scarcity premium.’ This last term is the premium an oil trader is willing to pay to have crude delivered immediately. In a normal, well-supplied market, the scarcity premium is de minimis relative to the cost of capital and storage cost and the future price trades above the spot price resulting in contango.
However, when the physical market is very tight, the scarcity premium will overwhelm the cost of capital and storage and the spot price will actually trade higher than the far-dated futures contracts.
That dynamic has become more pronounced following this weekend’s events. As of this afternoon, front-month WTI and Brent crude trade roughly $10 a barrel above their respective September 2021 contracts, up from a $5 per barrel premium one week ago.
While an overseas supply shock is seizing headline space and investor attention, domestic developments could spur further upside in Texas tea. On Sept. 3, analysts at Raymond James wrote in a research report:
It now seems U.S. well productivity are tracking WAY below our model and this underperformance may reflect a significant inflection point in future global oil supply/demand balances. Specifically, over the past seven months, U.S. oil supply growth is tracking WAY below the same period last year (up less than 100,000 bpd this year vs. up nearly 600,000 bpd the same period last year).
Furthermore, for the past eight years, our model has typically predicted the highest U.S. supply growth on the street while actual production has generally come in even higher than our model. So far this year, however, U.S. oil supply growth has significantly undershot our model.
Reached by email this morning, Goehring and Rozencwajg co-founder Leigh Goehring expressed a similar belief:
Since January 1st, 2019, there has been no growth in U.S. shale oil production. Also, what is so interesting is that it looks like shale oil drilling productivity has come to a screeching halt as well. We have written extensively about how the productivity improvements in shale oil drilling have been much more a function of E&P companies “high-grading” their drilling acreage. . . i.e. they were drilling more and more tier one acreage, and less and less tier two acreage.
Although the problems in Saudi Arabia are getting all the attention today, real issues have already emerged with a vengeance in the U.S. shales. We have always said that the world oil industry is now completely dependent on just six counties in west Texas for production growth, and it now it looks like those six counties are developing large production problems.
Needless to say, continued strength in the oil market could yield many happy returns for energy investors. For a survey of potentially attractive opportunities in the sector, see the May 3 edition of Grant’s Interest Rate Observer.
Correction:
One letter, a world of difference: Friday’s edition of Almost Daily Grant’s stated that SmileDirectClub, Inc. generated $2.3 billion in adjusted Ebitda in the first six months of the year. The company instead posted $2.3 million in adjusted Ebitda over that period.
Recap Sept. 16
Stocks traded a bit lower, as the S&P 500 slipped back below the 3,000 mark, while Treasurys were well bid with the 10-year yield falling five basis points to 1.84%. Gold rallied back to the cusp of $1,500 an ounce, and the VIX remained below 15 for a forth straight session.
- Philip Grant
Friday, September 13, 2019
Everything burns
The S&P 500 has rallied by an impressive 20% year-to-date and sits at the cusp of all-time highs. Things are not so cut-and-dry in the land of the Unicorns.
Biotech company 10x Genomics, Inc. (TXG on the Nasdaq) debuted yesterday in style, with shares snapping higher by 35%. That performance is particularly impressive considering that the company was sued by publicly-traded research and diagnostics company Bio-Rad Laboratories, Inc. for patent infringement on Wednesday. Bio-Rad noted in a press release that this isn’t the first time it has taken 10x to court.
In November 2018, a Delaware jury found that 10X Genomics infringed patents licensed to Bio-Rad by the University of Chicago and awarded damages of $23.9M. In August 2019, the Delaware Court awarded Bio-Rad an additional $10.5 M in supplemental damages and interest and entered a permanent injunction against 10X Genomics.
In contrast, Mr. Market frowned on the IPO of orthodontics distributor SmileDirectClub, Inc. (SDC on the Nasdaq) yesterday, sending shares down by 28%. That drop, the worst first-day performance for a $500 million-plus IPO since at least 2000 according to Dealogic, is particularly vexing for shareholders given that SDC priced at $23 a share, above the indicated range of $19 to $22
One potential explanation for Mr. Market’s cold shoulder: SmileDirect posted a positive adjusted Ebitda of $2.3 million in the first six months of the year. As we know from this cycle, nothing scares growth investors like profitability.
That isn’t a problem for Uber Technologies, Inc., which sported a $6.5 billion operating loss on $6.3 billion in revenues for the first six months of the year. Public since May, triple-c-plus-rated Uber today priced a $1.2 billion (upsized from $750 million) in 7.5% notes due 2027 to help finance its acquisition of Dubai-based competitor Careem. A planned $1.7 billion convertible note offering is tentatively set for the first quarter of 2020.
While Uber receives a warm welcome from the junk bond market, the political arena has been less hospitable. Last week, the California legislature adopted Assembly Bill 5, which bars so-called gig-economy companies from classifying their workers as independent contractors and shifting health care, insurance and other benefits to those “contractors.” In response, Uber’s chief legal officer Tony West argued: “Drivers’ work is outside the usual course of Uber’s business, which is serving as a technology platform for several different types of digital marketplace.” If those arguments fail to catch on, Uber might be on the hook for $500 million in extra labor-related costs just from California, according to research from Barclays plc. Since coming public, UBER shares are down by 26%.
As recent IPO results have been thoroughly mixed, data-collection firm Palantir Technologies, Inc. has decided to change tack. Long rumored to be preparing an IPO of its own, Bloomberg reported last week that Palantir is instead “in talks to raise significant funding from private investors,” and will likely not come public for the next two to three years. Led by self-described socialist CEO Alex Karp, Palantir staffers have a taste for luxury. As noted in by The Wall Street Journal last November: “Palantir Entitlement Syndrome” has gained prominence as turn of phrase describing, among other things: “13-course tasting-menu lunches with lobster tail and sashimi at headquarters” and “‘artisanal bacon’ at the corporate breakfast bar.”
It’s full speed ahead for WeWork Cos., Inc. parent The We Company. In an updated S-1 filing today, We Co. announced a handful of governance changes to placate investors, including trimming the super-voting rights in the Class-C shares and removing family members of CEO Adam Neumann from the board of directors.
Nevertheless, things are trending in the wrong direction, as Reuters reports today that We’s updated projected valuation has fallen to as low as $10 billion. That’s down from a $47 billion valuation in a private funding round in January and a the $20 billion to $30 billion range reported just last week by Bloomberg. With $14.2 billion in total capital raised, We Co.’s private investors are, on balance, now well underwater.
The largest outside investor is facing particularly acute pain. At that reported $10 billion valuation, SoftBank’s Vision Fund, which has itself invested $10.7 billion for a 29% stake, would be sitting on mark-to-market losses of approximately $7.8 billion. Yet, SoftBank CEO Masa Son is apparently undaunted, as The Journal reports this afternoon that SoftBank will buy “at least $750 worth” of We Co. shares in the IPO.
Perhaps Masa might be fit for a cameo in the upcoming Joker movie?
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It’s not about the money, it’s about sending a message.
Recap Sept. 13
Thursday, September 12, 2019
The science of central banking
Investor eyes were trained towards Frankfurt
Investor eyes were trained towards Frankfurt
How now Kowtow
Recap Sept. 12
The science of central banking
Investor eyes were trained towards Frankfurt this morning as the European Central Bank sliced its benchmark deposit rate by 10 basis points to negative 50 basis points and announced €20 billion per month in fresh asset purchases.
In the accompanying statement, the ECB noted: “The Governing Council now expects the key ECB interest rates to remain at their present or lower levels until it has seen the inflation outlook robustly converge to a level sufficiently close to, but below, 2%.” Euro-area CPI rose 1% year-over-year in July, while inflation expectations, as measured by the five-year five-year inflation swap rate, sit at 1.3%.
While the ECB cuts rates further below zero in an effort to stoke inflation, the seventh-largest emerging market economy by GDP conducts its own monetary experiment. Today, the Turkish Central Bank levied a mammoth 325 basis point cut of its own, slashing the one-week repo rate to 16.5%. That follows a speech from President Recep Erdogan on Sunday in which he declared: “We are lowering and will lower interest rates to single digits in the shortest period. After [the benchmark rate] falls to single digits, inflation will also slow to single digits.”
Stimulating inflation and suppressing inflation. What can’t rate cuts do?
How now Kowtow
Yesterday, Hong Kong Stock Exchanges & Clearing Ltd. announced a surprise $39 billion bid for the London Stock Exchange Group plc. Apart from creating one of the world’s largest trading organizations, that combination would scuttle the LSE’s proposed $27 billion offer for financial data firm Refinitiv, Inc.
For Refinitiv, spun out from Thomson Reuters Corp. and acquired by The Blackstone Group, Inc. last year, losing out on the LSE’s offer would mark the latest turn in its recent saga with Chinese intervention. On Aug. 2, Refinitiv removed from its Eikon financial terminals a Reuters story detailing the efforts of Chinese Communist Party officials to incite counter-protests against demonstrators in Hong Kong. As noted by Reuters, “the Cyberspace Administration of China, or CAC, had said it would shut down the service unless it removed or blocked certain political stories.”
Those efforts were apparently insufficient to assuage the Chinese Communist Party’s displeasure, as Global Times editor Hu Xijin remarked on Twitter Sept. 2 that: “Reuters is engaged in politics on issue of Hong Kong. Its stories are [designed] to sabotage relations between HKSAR [Hong Kong Special Administrative Region] government and Beijing using journalism as a smoke screen.”
Other companies have stepped up their efforts to appease Beijing. In January 2018, Marriott International Corp. apologized to the Chinese government after referring to Hong Kong, Taiwan, Tibet and Macau as separate countries in an email questionnaire. As noted by The Washington Post, China had “temporarily requested Marriott shut down its six Chinese websites and apps as punishment,” a sanction which was lifted following an apology.
For its part, Wall Street needs no prodding to curry CCP favor. Yesterday, Bloomberg reported that J.P. Morgan Chase & Co., which is attempting to build out its China business, “has told some staff to ensure that they don’t refer to Hong Kong, Macau or self-governing Taiwan as separate countries.”
Some rhetorical flourishes go even further. On Wednesday, asset-management behemoth T. Rowe Price Group, Inc. recommended investors swap their U.S. equity holdings (rated underweight by the firm) and instead look to the Middle Kingdom. Thomas Poullaouec, head of Asia Pacific multi-asset solutions, told Bloomberg: “China is the one we have a preference [toward]. . . China is committed to manage this cycle in a very prudent way with policy measures.”
Discretion is the better part of valor.
Recap Sept. 12
A relatively weak 30-year auction, in tandem with a 2.4% year-over-year jump in “core” CPI (the hottest reading since September 2008) spelled more trouble for Treasury bulls, as the 10-year yield rose to 1.78%.
Stocks caught another bid, with the S&P 500 extending its gain for the week to 1.2% and pushing the broad index to within a few basis points of its July 26 high. WTI crude fell back to $55 a barrel, gold remained just under $1,500 an ounce, and the VIX finished near 14.
- Philip Grant
Wednesday, September 11, 2019
Flow rider
According to a recent report from Bank of America Merrill Lynch,
According to a recent report from Bank of America Merrill Lynch,
Recap Sept. 11
Flow rider
According to a recent report from Bank of America Merrill Lynch, collateralized loan obligations (CLOs) are, for the most part, in safe, unleveraged hands. Over the last five years, insurance companies held 24% of U.S. CLOs domiciled in the Cayman Islands (which include the bulk of the sector), followed by banks and mutual funds at 18% each, and pension funds at 11%.
Those hands had better be steady, as earnings growth in the companies that issue the leveraged loans (floating rate credits to speculative-grade borrowers) underying those CLOs is on the wane. On Monday, S&P’s LCD unit reported that among a sample of 202 corporate issuers, accounting for 18% of the S&P/LSTA Leveraged Loan Index, second quarter Ebitda rose an average of just 2% from a year ago and the weakest growth rate since the fourth quarter of 2016. That’s down from a 3% uptick in the first quarter and a range of 9% to 13% in growth in 2018.
As earnings growth slows, leveraged loan issuers find themselves on weaker footing. According to LCD, leverage for the average loan issuer rose to 5.6 turns of Ebitda in the second quarter, up from 5.26 turns in the first quarter. While that figure is not out of line with their trailing one-year average of 5.67 times leverage, LCD finds that issuers “operating at the extremes of credit tolerances” are on the upswing, with the percentage of issuers sporting a leverage ratio greater than 7 times jumping more than three percentage points to 18.3%.
More broadly, this provides a window into the ongoing private equity boom, as p.e. backed companies constitute 85% of the $1.2 trillion loan market. As the post-crisis economic expansion continues into a record 112th straight month, p.e. has paid ever higher prices and tacked on more debt, with Bain Capital’s 2019 Global Private Equity Report finding that the average LBO price rose to 10.9 times Ebitda last year, well above the 9.9 times seen in 2007, while leverage at p.e.-sponsored companies footed to 6 times Ebitda in 2018, compared to 4.9 times in 2007.
The S&P/LSTA Index has generated a 6.5% total return year-to-date, well below the 11.7% and 14.8% gains seen in the iBoxx USD Liquid High Yield and Investment Grade Indices. As loan performance lags, investors have headed for the exits, with a record 42 straight weeks of outflows for leveraged loan mutual funds and ETFs, according to data from Lipper. Total year-to-date outflows stand at $27.6 billion, according to J.P. Morgan, compared to $15 billion of inflows at this time last year.
Leverage can pinch, and sometimes it pinches the customers. Thus, in June 2018, hospital-based physician group Envision Healthcare Corp. was acquired by p.e. giant KKR & Co., Inc. for $9.5 billion in cash. The company has since generated a public outcry over its so-called surprise billing practices, i.e., charging much higher fees for out-of-network expenses than patients might normally expect.
In response to congressional scrutiny over surprise billing, KKR has rolled out an aggressive lobbying campaign aimed at members of Congress running for re-election in an effort to protect the company’s business model. In October 2018, KKR and Envision issued $5.45 billion in term loans, managing to saddle investors with fine print that those creditors may come to regret. Scott Josefsburg, an analyst at Covenant Review, wrote last fall:
This deal includes a radical change to the customary rules regarding the payment of dividends and other Restricted Payments. KKR is seeking to eliminate entirely any financial performance test for making Restricted Payments using the build-up basket [or the portion of accumulated profits which are available for dividends, etc.]. This may be one of the most drastic covenant changes we have seen in years.
Now KKR wants the ability to take out dividends and other distributions to equity whenever, regardless of the financial health of the portfolio company, so long as there has, at some point, been enough Consolidated Net Income.
The loan, priced at a 375 basis point spread over Libor (down from initial price talk of 400 basis points), has since fallen to just under 84 cents on the dollar from 99.75 at issuance, pushing the current all-in yield-to-maturity to 9.35%.
Recap Sept. 11
Tuesday, September 10, 2019
Flickering lights
Recap Sept. 10
Yesterday, California utility PG&E Corp. (PCG on the NYSE)
Yesterday, California utility PG&E Corp. (PCG on the NYSE)
Flickering lights
Yesterday, California utility PG&E Corp. (PCG on the NYSE) released its plan to emerge from Chapter 11. Particulars include a capped $18 billion wildfire liability fund used to compensate insurers and victims of the deadly 2017 and 2018 Northern California infernos, in tandem with fresh debt and equity issuance. The company entered bankruptcy on Jan. 29 and California governor Gavin Newsom has given PCG a June 30, 2020 deadline to emerge in order to participate in a $20 billion wildfire relief fund set up by the state.
The plan was met with some less-than enthusiastic responses from lawyers representing wildfire victims. Cecily Dumas told The Wall Street Journal: “We are not surprised that it is not an acceptable plan, but we are disappointed that it’s worse than expected.” Mike Danko dismissed the plan as: “Dead on arrival.” For his part, PCG CFO Jason Wells suggested the idea could be tweaked: “It’s a framework.”
As noted by Bloomberg, the insurers have argued that PCG owes them $18 billion, while lawyers for the victims have estimated that their own claims may exceed $40 billion. According to the company’s most recently filed form 10-Q, wildfire-related claims stood at $18.1 billion as of June 30, up from $14.2 billion three months prior. That number is expected to rise considerably, as CFO Wells stated in a Jan. 31 affidavit that potential liabilities could exceed $30 billion.
The wildfires have brought the problems with PG&E’s dated infrastructure into sharp and painful relief. On July 10, The Journal reported that company executives were aware of problems with transmission lines that were eventually responsible for 2018’s catastrophic Camp Fire, yet “repeatedly failed to perform the necessary upgrades.” In addition, in 2017 PCG found that its transmission towers were 68 years old on average (compared to a mean life expectancy of 65 years), with some as old as 108.
Meanwhile, the prospect of additional blaze-related liabilities looms large. Today, the San Francisco Chronicle reports that U.S. District Judge James Donato told PCG that he will likely allow a lawsuit against the company to proceed over the 2017 Tubbs wildfire in Santa Rosa. The Chronicle notes: “If PG&E is found responsible for the Tubbs Fire, the company’s bankruptcy would be billions of dollars more expensive than it would be otherwise.”
As PG&E attempts to restructure its liabilities, creditors and shareholders have presented competing proposals which underscore their distinct financial goals. A consortium of bondholders including Pacific Investment Management Co. and Elliott Management Corp. suggested a recapitalization, which would largely wipe out existing shareholders and transfer ownership to the creditors.
On Aug. 8, Bloomberg reported that Knighthead Capital Management and Abrams Capital Management (which own a combined 7.3% of shares outstanding) will put forth a plan featuring a $15 billion rights offering to help cover their forecast of PG&E’s liability shortfall, with the funds themselves chipping in $1.5 billion. With PCG’s market cap now at just $5.8 billion, a $15 billion rights offering would equate to issuance of up to 1.3 billion new shares vs. the 529 million shares currently outstanding.
As noted in an accompanying 13-D filing, some particularly optimistic assumptions underlie the plan: The shareholders pencil in $2.258 billion in 2021 net income. By comparison, fiscal 2017 saw a $1.65 billion bottom line for PCG, its highest figure in the past 15 years. The proposal also assumes that the utility sector maintains a 19 times price-to-earnings valuation. For context, the S&P Utilities Index has traded for an average of less than 17 times forward earnings over the last five years.
Forward price-to-earnings ratio for the S&P Utilities Index. Source: The Bloomberg
PCG shares have fallen by 43% since Feb. 22, when Grant’s produced a bearish analysis of the company. The piece noted that even prior to the disaster, PCG’s financials were on shaky ground, as $25.5 billion in operating cash flow from 2013 to 2018 was well short of the $31.9 billion in cumulative capital expenditures over that period, while the company paid some $4.4 billion in shareholder dividends from 2013 to 2017 using borrowed funds. Recent results have shown marked deterioration: Second quarter Ebitda fell to $1.06 billion, down from $1.41 billion a year ago, and revenues fell 7% to $3.9 billion over the same period.
While PCG’s liability woes could be dismissed as a company-specific outlier, Grant’s argued that investors might be well served by taking a broadly skeptical look at the utility industry as a whole:
For our part, we judge that the regulated-utility business model is vulnerable both financially and competitively. In the past 20 years, the S&P 500 utilities have covered capital expenditures out of operating cash flows in only seven years. And in only one of those seven, 2003, was free cash flow greater than common-dividend distributions. Utilities routinely spend more on property, plant and equipment than they generate in cash flow.
Then, too, accounting maneuvers represent another source of potential trouble. In 2017, PG&E amended the useful life of its energy-generating assets to up to 120 years, from a 100 year ceiling the year before. Grant’s noted the significance of that move:
Life-extension by the flick of a pen permits the classification of more current-period spending as growth capex, rather than maintenance spending. It’s only capex for growth that expands the rate base, therefore the income with which to service debt and pay dividends.
Utilities investors: What’s in your dividend?
Recap Sept. 10
Another sharp sell-off in Treasury bonds pushed the 10-year yield to 1.74%, erasing a chunk of recent gains that saw the 10-year fall to a three-plus-year low of 1.46% a week ago. The about-face in rates has coincided with a similar reversal in gold, which fell to $1,482 an ounce today from $1,553 last Wednesday. WTI crude slipped back to $57.50 a barrel, while the S&P 500 and the VIX both finished little changed.
- Philip Grant
Monday, September 9, 2019
Dueling banjos
From NBC4 New York:
From NBC4 New York:
T party
Today, hedge fund Elliott Management Corp. disclosed a $3.2 billion stake in AT&T, Inc. (T on the NYSE)
Today, hedge fund Elliott Management Corp. disclosed a $3.2 billion stake in AT&T, Inc. (T on the NYSE)
Recap Sept.9
Dueling banjos
From NBC4 New York:
A man damaged Wall Street's famous "Charging Bull" statue on Saturday by attacking it with a banjo, police said. Kevin Cevon Varlack, 42, of Dallas, was charged with criminal mischief, criminal possession of a weapon and disorderly conduct.
He was seen striking the bull with a banjo shortly after noon, police said. Photos showed the statue had cuts at the base of one of its horns.
Most hated bull market indeed.
T party
Today, hedge fund Elliott Management Corp. disclosed a $3.2 billion stake in AT&T, Inc. (T on the NYSE) and sent a letter to the company advocating for a series of actions to stir its moribund stock price. As noted by Elliott, T trades at roughly 10 times consensus 2019 EPS, far below its historical average of 12.4 times and the 18 times forward earnings valuation for the S&P 500. Over the last 10 years, T shares have returned 122% assuming reinvested dividends, compared to 229% for the S&P 500, and finished higher by 1.5% today.
Elliott argues that a $60 share price, approximately 65% upside from Friday’s closing price, is achievable through cost cuts, asset sales and a renewed focus on its core telecommunications business: “AT&T must undergo a strategic shift away from acquisitions and toward execution. Even aside from the questionable strategic value of its M&A, AT&T has spent far too much of the past decade in acquisition mode. Acquisitions require a significant allocation of time and resources – both capital and employee time – that AT&T has been unable to spare.”
AT&T’s efforts to diversify during this cycle included a pair of dubious mega-deals, the 2015 acquisition of DirecTV, Inc. for $67 billion followed by last year’s takeover of Time Warner, Inc. (now WarnerMedia) for $109 billion, at 19% and 39% premiums to their respective pre-announcement prices. Those deals have transformed AT&T’s income statement (wireless contributed only 39% of revenues in the second quarter), as well as the balance sheet. AT&T is now the world’s most encumbered nonfinancial company, with $194 billion in total debt.
Yet growth is seen wanting, as the Street pencils in $60.6 billion in adjusted EBITDA and $27 billion in free cash flow for 2020, compared to $63.8 billion and $29 billion, respectively, in the 12-months ended on June 30.
Analysts from Bloomberg Intelligence are skeptical that activist pressure will force wholesale changes at AT&T, writing that today’s letter “probably won’t prompt a change in company strategy. . . Elliott’s recommendation to spin off the DirecTV satellite business isn’t practical, in our view, as AT&T likely needs its free cash to help fund the dividend.”
Yet the company’s second-quarter results showcased Elliott’s concerns, as the DirecTV unit saw a 778,000 net subscriber loss for a meaty 8.7% year-over-year decline. In a July 24 research note, Craig Moffett of MoffettNathanson LLC suggests that WarnerMedia is a growing trouble spot: “just one year after the deal closed, events already seem to be taking over the company.” Noting the cool reception to the planned HBO Max streaming service at a hefty $17 a month, Moffett writes: “simply preserving revenues at HBO will only come at the expense of declining revenues at Turner cable networks and a truckload of lost licensing revenues at their TV studio.” The media unit reported $2.06 billion in adjusted Ebitda for the second quarter, short of the $2.22 billion consensus.
Elliott’s recommended strategy shift underscores the frailty of the growth-by-acquisition strategy. A bearish analysis of AT&T’s credit in the June 29, 2018 edition of Grant’s connected Ma Bell to a century-old study of large-scale corporate deal-making:
M&A is now—arguably, always has been—a leap in the dark. There’s no such book as The Art of Not Dealing but Rather Minding Your Own Business and Turning a Deaf Ear to the Fee-Slurping Promoters, though Arthur Stone Dewing’s The Financial Policy of Corporations, published in 1919, makes a good substitute. Dewing investigated the merger wave at the turn of the 20th century, the era today remembered as the age of the great trusts. Teddy Roosevelt’s trust-busting came later, but the market provided its own centrifugal powers of destruction.
Out of 29 such consolidations that Dewing studied, only four matched the projections of their promoters after 10 years of operations.
Since that publication date, triple-B-rated AT&T’s senior unsecured 4.3% bonds of 2042 have seen their spread over Treasurys narrow to 185 basis points from 240 and are currently priced at 105.75 cents on the dollar for a yield-to-worst of 3.92%.
Recap Sept.9
A flat showing for the S&P 500 featured some interesting price action under the surface, with the iShares S&P 500 Value ETF gaining nearly 1% while the iShares Edge MSCI USA Momentum Factor ETF lost almost 2%.
Treasury yields jumped higher in curve-steepening formation, with the two- and 10-year yields finishing at 1.59% and 1.63%, respectively. Gold and oil continued their recent divergence, with the former dropping back below $1,500 an ounce for the first time since Aug. 22 and the latter reaching $58 a barrel for the first time since the end of July. The VIX remained just above 15.
- Philip Grant
Friday, September 6, 2019
Vision zero
The office space company intent on “elevating the world’s consciousness” is set to downsize.
The office space company intent on “elevating the world’s consciousness” is set to downsize.
Recap Sept. 6
Vision zero
The office space company intent on “elevating the world’s consciousness” is set to downsize. Bloomberg reports today that ahead of its planned initial public offering, The We Company (née WeWork Cos., Inc.) is cutting its proposed IPO valuation to $20 to $30 billion from the $47 billion the company obtained in its last private funding round (Bloomberg suggests the number could be closer to the low end of the range).
In total, the Vision Fund has pumped $10.7 billion into We Co. (beginning in August 2017 at a $20 billion valuation) and owns a 29% stake. Needless to say, next week’s IPO roadshow will be critical. If We Co. is valued by the public markets at $22 billion, that would represent a $4.2 billion mark-to-market loss for SoftBank and its visionary CEO Masayoshi Son.
A valuation haircut would be a tough pill to swallow for Son and company. Bloomberg reports that Vision Fund employees are not paid out until profits have been realized, and face clawbacks of up to 20% and above for senior staff. With things currently looking grim, analysts at Bloomberg Intelligence proffer a suggestion: SoftBank “may consider injecting more capital into We Co. to gain majority control, which would enable the coworking leasing company to delay” the IPO in hopes of achieving a better price. We Co. posted a $900 million net loss in the first six months of the year, on $1.5 billion in revenues.
This comes at a bad time for SoftBank, which is in the midst of raising Vision Fund 2. While SoftBank has claimed to have already raised the $108 billion in commitments for the fund, The Wall Street Journal reported Aug. 7 that the pledges are based only on memorandums of understanding as opposed to firm commitments, while investors not named in the press release account for “the bulk” of outside funding. That figure could likewise include debt-like securities, further ‘stretching the definition of ‘capital.’”
Creative financing options abound. On Aug. 18, The Journal relayed that SoftBank was seeking to raise up to $20 billion from its own employees (including up to $15 billion from Son himself), a figure which the company itself might finance with “around 5% interest and in most cases requiring little money down.”
At the corporate level, Son likewise leverages SoftBank’s future to the success of the Unicorn-chasing Vision Fund and its portfolio of illiquid, largely money-losing technology startups. Last December, SoftBank had parted with staid but cash-generating positions like a 33.5% stake in domestic telecom subsidiary Softbank Corp. and sold a $4 billion stake in Yahoo! Japan Corp. to that telco unit in May. SoftBank’s full pivot towards tech will accelerate next year, as the company announced in early August that it will cease consolidating 85%-owned Sprint Corp. onto its financial statements, in anticipation of a successful merger with T Mobile U.S., Inc. (Almost Daily Grant’s, June 20).
At the same time, competition for attractive assets remains fierce. The Journal reported yesterday that p.e. firm Vista Equity Partners closed a new $16 billion technology fund.
For the quarter ended June 30, SoftBank reported ¥408.5 billion ($3.8 billion) in unrealized profits, as gains in Slack Technologies, Inc., OYO Hotels and Doordash, Inc. were partially offset by losses in Uber Technologies, Inc. That brings the Vision Fund’s pre-tax cumulative investment profits (which include realized and unrealized gains from investments) to $20.2 billion, from a total $71.4 billion acquisition cost basis. But the third quarter has not been kind to publicly-traded Uber and Slack, down 28% and 25%, respectively since July 1 (OYO and Doordash remain private), dealing the fund combined mark-to-market losses of approximately $3.6 billion from the pair.
As the Vision Fund portfolio shows signs of reversing its momentum, Son opts to turn once more to the yield-starved Japanese public. Today, SoftBank priced a ¥100 billion ($934 million) seven-year note at 1.38%, the second-highest coupon for a publicly traded corporate bond in Japan this year trailing only a six-year note from SoftBank at 1.64%, in April.
Of We Co.’s upcoming roadshow, an unnamed executive told Bloomberg: “fingers crossed.” The sequel is never as good as the original.
Recap Sept. 6
A weaker than expected non-farm payrolls reading might nudge the Fed towards easier policy, but financial markets mostly shrugged today with the S&P finishing flat, up 1.7% for the week and within 2% of its highs. Treasury yields likewise finished little changed, while gold extended yesterday’s losses to close near $1,500 and WTI crude rose back towards $57 a barrel. The VIX sank to near 15, its lowest since the end of July.
- Philip Grant
Thursday, September 5, 2019
Let's pretend
During an interview with Bloomberg radio yesterday,
During an interview with Bloomberg radio yesterday,
Fan depreciation day
The loan machine comes alive once more.
The loan machine comes alive once more.
Recap Sept. 5
Let's pretend
During an interview with Bloomberg radio yesterday, William Quigley, co-founder of the purportedly dollar-backed cryptocurrency tether, offered an existential perspective on his creation:
“Whether or not tether was backed by the dollar actually wouldn’t matter if everybody agreed to take tether and to value them at a dollar themselves.”
Unfortunately for tether fans, New York attorney general Letitia James appears to differ in that assessment. In April, the AG’s office accused the companies backing tether and the Bitfinex crypto exchange of “engaging in a cover-up to hide the apparent loss of $850 million of co-mingled and corporate funds,” then citing the wide-ranging Martin Act in a July filing to assert jurisdictional control over the companies in the state of New York. Two weeks ago, a state justice rejected the defendant’s request to dismiss the lawsuit, paving the way for a trial.
Fan depreciation day
The loan machine comes alive once more. The launch of a $4 billion refinancing term loan from Dell, Inc. today brings the weekly issuance of leveraged loans to $15.8 billion according to Bloomberg. That’s the busiest week for loan issuance since October of last year.
But while issuance remains healthy and defaults low (the ratio stood at 1.29% for August, well below the post-1997 average of 2.9%), the distressed ratio has spiked. According to S&P’s LCD unit, the percentage of loans in the S&P/LSTA Leveraged Loan Index trading below 80 cents on the dollar shot to 4.03% in August from 2.81% a month earlier. While that remains well short of the 12% sub-80 share in the winter of 2016, overall loan credit quality has deteriorated. Per LCD, the share of loans rated single-B and below rose to 48.41% in August, up from less than 35% in that 2016 winter of discontent. Then, too, the 2016 swoon could largely be attributed to the collapse in energy prices. By comparison, the latest move is broad-based.
Idiosyncratic pitfalls have also appeared. The Financial Times reports today that the Invesco-Oppenheimer Senior Floating Rate Fund saw its net-asset value sink to a three-plus year low, as a series of equity investments gone awry have hurt the fund’s performance. “I’m critical of it,” Brian Moriarty, analyst at Morningstar told the FT, “it’s not what investors signed up for.”
The recent uptick in distressed population (in tandem with the long slide in credit quality) and manager mission creep present a pair of risks to loan investors. An erosion in financial reporting, another. In a report today, Moody’s Investors Service declares: "The definition of Ebitda [earnings before interest, taxes, depreciation and amortization], a widely-used and fundamental measure for assessing a company’s profitability and credit profile, has been pushed to the edge in recent credit agreements.”
The analysts, led by senior covenant officer Enam Hoque, likewise note the prevalence of so-called add-backs, or credited cost savings that are projected to be achieved for three years into the future:
These long forecasts may turn out to be highly optimistic, leaving investors with little recourse as borrowers incur substantial debt, make extraordinary dividends, or sell material assets in the interim period.
According to Moody’s, 33% of deals through the first six months of the year had no limit at all on the amount of add-backs that management can credit itself. Of the remaining two-thirds, the average add-back is capped at 20% of an issuers’ Ebitda. That’s up from 15% in the first half of 2017.
The deterioration in financial reporting standards has been a long, slow one, highlighted by the rise of Ebitda in place of operating income, or Ebit, during the 1980s leveraged buyout boom. Of course, that opaque and ultimately investor-unfriendly change was not without its detractors. In June 2000, Moody’s released an analysis headlined: “10 Critical Failings of Ebitda as the Principal Determinant of Cash Flow.”
The ratings agency went on to assail Ebitda as excessively slack and easy to manipulate, terming the metric an often “misleading measure of liquidity” and asserting that “Ebitda can drift from the realm of reality.”
Evidently, what’s good for the goose isn’t always good for the gander. An analysis in the Aug. 18, 2000 edition of Grant’s, referencing that Moody’s report, offered this rule of thumb:
About a decade and a half ago, reader Michael Harkins noted that the very people who appeared to be most adamant about excluding depreciation from calculations of corporate cash flow were the ones who were divorcing their aging first wives.
Recap Sept. 5
Stocks ripped higher, with the S&P 500 extending to a near 2% gain for the week so far, while Treasurys were hammered with the two- and 10-year yields each rising 10 basis points to finish at 1.53% and 1.56%, respectively. Gold fell more than 2% to $1,519 an ounce, WTI crude held steady at $56 a barrel and the VIX fell to just over 16 from near 20 on Tuesday.
- Philip Grant
Tuesday, September 3, 2019
Devalue investor
The arrival of September brings $100 billion in additional tariffs on Chinese goods.
The arrival of September brings $100 billion in additional tariffs on Chinese goods.
Recap Sept. 3
Devalue investor
The arrival of September brings $100 billion in additional tariffs on Chinese goods. The U.S. negotiator-in-chief was back at it on Twitter this morning, promising that “when I win [reelection]. . . deal would get MUCH TOUGHER! In the meantime, China’s Supply Chain will crumble and businesses, jobs and money will be gone!” For his part, China’s ruler-for-life Xi Jinping stated in a speech today at the Central Party School in Beijing that his country faces “concentrated risks” and “must carry out a resolute struggle” against its adversaries.
The trade dispute appears to be taking a toll on the People’s Republic, as economists at Bloomberg, Oxford Economics and Bank of America Merrill Lynch each cut their respective 2020 real GDP growth forecasts to less than 6%. China reported 6.2% growth for the second quarter from a year ago, which was already its slowest pace since 1990. According to Louis Kuijs, chief Asia economist at Oxford Economics, “more policy easing is needed to convincingly stabilize economic growth.”
On that front, the Chinese Communist Party is hard at work. According to a report today from the South China Morning Post, the government’s Financial Stability and Development Committee promised “enhance[d] countercyclical measures in macroeconomic policies. . . to ensure sufficient liquidity and reasonable growth in credit.” Particulars, per the SCMP, included ordering financial institutions to issue local government spending bonds, as well as urging those local governments to “fully tap [their] investment potential.”
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Renminbi/dollar exchange rate, five-year chart. Source: The Bloomberg
The fulfillment of those government edicts may prove less than remunerative for China’s banks. Grace Wu, senior director at Fitch Ratings, said in an interview with Bloomberg television Friday that another burst of credit extension may lead to bigger problems: “What’s going to end up in the medium- and longer-term is you’re still going to have the margin pressure from the mispricing of risk. Ultimately, that’s going to have asset quality pressure down the road.”
The combination of a growth slowdown and hefty debt burden (China’s banking assets foot to $41 trillion as of June 30, representing nearly half of 2018 world GDP of $85.8 trillion) leaves China’s property sector especially vulnerable. According to an analysis from FinanceAsia, all Chinese developers who have reported first-half results have disclosed net gearing (debt-to-equity) ratios north of 50%, “typically seen as an indicator that a company is highly leveraged.”
The renminbi’s slide against the greenback is of particular concern for developer China Evergrande Group, which carries some $118 billion in net borrowings (six times consensus 2019 adjusted Ebitda) including some $18 billion in marketable dollar-denominated debt and which reported a 45% decline in earnings from its year-ago levels in the first half of the year. FinanceAsia notes that in the event of continued currency depreciation, the company “will have a tough time repaying their outstanding U.S. dollar loans.” Indeed, the company’s dollar-pay, senior secured 10.5% notes due 2024 which were issued at par in April fell to a fresh low of 91.6 on Friday according to Bloomberg, for a yield-to-worst of nearly 13%.
For Evergrande, which added some $20 billion to its debt stack in the first half of the year and which must contend with $53 billion in maturities over the next 10 months according to Bloomberg, corporate adventures (including nearly $4 billion in electric vehicle-related investments) have helped put the company into a deeper hole. Chuanyi Zhou, credit analyst at Singapore-based Lucror Analytics Pte. Ltd., writes: “Evergrande faces its biggest liquidity pressure in at least two years. It’s more difficult to borrow money, and they have a lot of debt to repay. The two kinds of pressure are squeezing them at the same time.”
The Evergrande story is far from over. An analysis in the June 2, 2017 edition of Grant’s put it this way:
We suspect that the company name will one day become proverbial, like “Bank of United States” or “Hindenburg.”
Recap Sept. 3
A dip below 50 in the August ISM Manufacturing PMI (its lowest since August 2016) helped the bears get the upper hand as the S&P 500 lost a bit less than 1%, while Treasurys rallied again with the 10-year yield falling below 1.47%. Gold rose above $1,550 intraday for the first time since April 2013, while WTI crude fell back below $54 a barrel and the VIX finished at 20.
- Philip Grant
Friday, August 30, 2019
Too much info
The Real Deal reports today
The Real Deal reports today
Pro AM
According to the Financial Times,
According to the Financial Times,
Recap Aug. 30
Too much info
The Real Deal reports today that some landlords are having second thoughts after viewing WeWork Cos., Inc.’s financials:
"There were certain things in that report I would rather not have seen," Rory Greenberg, who owns a WeWork building in Miami, told TRD reporter David Jeans. "Obviously, I'm sure a lot of it can be explained.”
Maybe these guys can help:
Pro AM
According to the Financial Times, Mexican President Andrés Manuel López Obrador (a.k.a. AMLO) is planning to allow foreign oil companies to participate in joint ventures with state-owned Petróleos Mexicanos and to resume auctions of deep water exploration blocks as early as next year. That news was good for a rally in Pemex bonds, as the dollar-pay, senior unsecured 6 3/4s of 2047 jumped one point to 94.5 cents, for a yield-to-worst of 7.21% and 569 basis point spread over Treasurys. That’s down from just above par as of March 23, 2018. The Mexican sovereign peso-denominated 30-year bond fetches a 7.5% yield, down from 7.8% in spring 2018.
Such a move would represent a major change in tack for the populist AMLO, who cancelled auctions after taking office on Dec. 1 of last year. The President’s populist and self-described “stubborn” governing style has already taken a toll, as longtime associate and finance minister Carlos Urzúa resigned via Twitter in July, citing policy disagreements with the administration. The Dos Bocas refinery project, for which AMLO rejected a trio of private bidders to award the project to Pemex (at a lower cost and faster timetable than the private companies were able to provide) supposedly loomed large in the decision.
For Pemex, problems abound. Since peaking at 3.4 million barrels per day (mbpd) in 2004 (coinciding with the high-water mark at the Cantarell field, once among the world’s largest), production has been on the wane, falling to 1.67 mbpd in July (AMLO claims that 1.8mbpd is attainable by December). Earlier this year, the deepwater Ku-Maloob-Zaap (KMZ) field, which accounted for roughly half of Pemex’s first-quarter output, saw its own decline after maintaining steady-state production for over 10 years. As deepwater fields tend to erode more quickly once a tipping point has been reached (Almost Daily Grant’s, May 2), that development is ominous indeed.
Dwindling production renders a $160 billion debt burden inclusive of pension liabilities (nearly seven times adjusted Ebitda through the 12-months ended June 30) increasingly daunting. On Feb. 15, AMLO announced a MXN 107 billion ($5.4 billion) bailout package, including tax relief and a direct recapitalization, but that wasn’t enough to mollify the rating agencies. On Jan. 29, S&P cut Pemex to triple-B-minus while, on June 6, Fitch Ratings sent Pemex into junk territory (the government announced a further $7 billion in tax rebates for Pemex in July). The company has lost money on an adjusted net income basis in each year since 2012 and has generated negative free cash flow in every year since at least 2009.
While AMLO remains upbeat on Pemex’s prospects, other government authorities express concern. In minutes from that Aug. 15 meeting, the Bank of Mexico discussed the sickly state-owned oil giant:
Most members agreed that Pemex’s situation is still a risk factor. They stated that [the company] has failed to reestablish confidence in its financial outlook due to doubts regarding the viability of increasing crude oil production.
Actions speak louder than words, and the central bank took steps at that meeting to batten down the hatches. At that Aug. 15 meeting, the Bank of Mexico undertook its first rate cut in five years (to 8% from 8.25%). That follows 3% year-over-year growth in nominal GDP for the second quarter, the lowest reading since 2013 and less than half of the average 6.8% seen over the last 10 years. The peso is down by 4.5% against the dollar in August, its worst monthly showing since last October, when AMLO surprised investors by cancelling a major airport project near Mexico City that was well underway.
The March 23, 2018 edition of Grant’s Interest Rate Observer featured an analysis of the symbiotic fortunes of Pemex and the Mexican government, concluding that the oil giant’s problems would soon become the government’s, and that creditors in each were not being adequately compensated for the substantial risks they bore. AMLO’s pivot back to allowing foreign investors could suggest that things are even worse than they appear.
Recap Aug. 30
Stocks drifted sideways to finish the week higher by a healthy 2.7% on the S&P 500, leaving the broad index near the upper end of its August range and within 3.5% of its high-water mark. The highest close for the Dollar Index since May 2017 helped pressure commodities, as WTI crude and gold finished at $55 a barrel and $1,523 an ounce, respectively, and Treasurys ended little changed with the two- and 10-year yields both settling near 1.5%. The VIX closed at 18.5.
- Philip Grant
Thursday, August 29, 2019
He said it
Meet the new boss
Same as the old boss.
Same as the old boss.
As the world turns
The recent bull stampede in rates,
The recent bull stampede in rates,
Recap Aug. 29
He said it
Uber Technologies, Inc. CEO Dara Khosrowshahi, on an interview with Bloomberg TV this afternoon:
“Uber is recession and trade-war proof.”
Meet the new boss
Same as the old boss. In remarks to the European Parliament today, incoming European Central Bank president Christine Lagarde made her stance on monetary policy crystal clear:
I don’t believe that the ECB has hit the effective lower bound on policy rates.
Lagarde went on to allow for the possibility that the negative-rate regime is damaging to euro-area banks, promising to “closely monitor whether adverse effects may emerge in the future.” Still, the former International Monetary Fund head has no qualms about this brave new financial world, stating:
All things considered, in the absence of unconventional monetary policy adopted by the ECB – including the introduction of negative rates – European citizens would be, overall, worse off.
That assertion is, of course, unprovable, but new research from a British academic finds that negative rates have led to a decrease in commercial bank lending. University of Bath finance professor Ru Xie explained:
If bank margins are compressed due to low long term yields, and if there is limited loan growth, then bank profits will fall accordingly. The decline in profits can erode bank capital bases and hitherto further limit credit growth, thus stifling any positive impact on domestic demand from negative interest rate policy.
Meanwhile, the central bank’s goal of stirring up inflation (the primary justification for negative rates) gets further and further away. The “five-year, five-year forward inflation swap”, the ECB’s preferred inflation gauge, is just 1.2% today, near the record low of 1.13% seen in June and far below the 2.1% average reading going back to 2004.
As the world turns
The recent bull stampede in rates, which has pushed the 30-year Treasury yield to less than 2% from 3.4% in November, has naturally spurred a wave of refinancings from mortgagers. The volume of applications has more than tripled since December, according to the Mortgage Bankers Association.
Banks are ramping up their infrastructure in response, as Bloomberg reports today that Wells Fargo & Co., the United States top mortgage lender, “has boosted staffing by about 10% this year and plans to keep hiring.” More broadly, the industry has added some 5,000 jobs since March, per the Bureau of Labor Statistics. As Bloomberg notes, “it’s a stark reversal from a year ago, when the Federal Reserve was hiking interest rates and banks were cutting thousands of jobs.”
Not just in staffing are lenders getting more aggressive. Last week The Wall Street Journal found that formerly strict mortgage lending standards in place through the post-crisis era “are starting to erode” as “home buyers with low credit scores or high debt levels as well as those lacking traditional employment are finding it easier to get credit.”
Those maneuvers are taking place during a time of elevated risk. A survey released yesterday by Realtor.com found that more than 36% of “active homebuyer” respondents believe that a recession will begin next year, up from less than 30% in March. Similarly, nearly 40% of wonks at the National Bureau of Economic Research polled by Realtor.com forecast a downturn in 2020.
Similarly, the August BofAML Fund Manager Survey finds that a net 34% of investors believe that a recession is likely within the next 12 months, the highest reading since October 2011. Then, too, data from Google Trends shows a substantial jump in the “recessions” term relative to “refinancing.”
Popularity over time. “Recession” in blue vs. “refinance” in red. Source: Google trends
Meanwhile, recent housing-related data have left something to be desired. Mortgage applications last week saw their biggest sequential decline since April, while pending home sales fell by 2.5% sequentially in July, far below the positive 0.3% consensus estimate.
Are mortgage lenders set to be caught offside by a cyclical turn?
Recap Aug. 29
Another strong rally in stocks extended the S&P 500’s advance to 2.7% so far this week, while weakness at the short end of the Treasury curve pushed the two-year yield to 1.52%, compared to 1.49% on the 10-year. WTI crude rallied to near $57 a barrel for its best close in more than two weeks, while gold retreated to $1,527 an ounce. The VIX fell back below 18.
- Philip Grant
Wednesday, August 28, 2019
Falling off the bike
How much does Uber Technologies, Inc. (UBER on the NYSE) really take for itself per ride? The company asserts that its take-rate stood at 18% in the six months ended June 30, down from 21% a year earlier. But an investigative report from auto-focused website Jalopnik finds a hefty 35% figure on a 14,756 fare-sample size (which Uber argues is statistically insignificant relative to the 15 million worldwide rides on the platform per day) examined by the publication.
The question is not academic. Uber classifies its drivers as “independent contractors” and thus provides no health insurance, while shifting responsibly for gas, tolls and vehicle wear-and-tear costs to those non-employees. In return, drivers have provided Uber with regular public relations headaches (recall the series of driver demonstrations surrounding the IPO, for instance) and high attrition rates, with a striking 2017 study conducted by The Information finding that just 4% of those who sign up to drive for Uber are still doing so one year later.
But if true, neither Jalopnik’s revelation nor increased scale from growth has helped to shore up a sieve-like corporate income statement. Second quarter revenues footed to $3.17 billion, up 14% year-over-year. Over the same period, adjusted Ebitda came in at a $656 million loss, more than double the $292 million shortfall seen in the three months ended June 30, 2018.
That red ink hasn’t dissuaded Wall Street from maintaining an upbeat stance, as 23 firms rate Uber shares “buy” with 11 “holds and a solitary “sell.” As the bull case does not hinge on profits, other considerations are front and center. Following second quarter results on Aug. 8, analysts at Needham Securities reiterated their “time acquisition thesis” as a primary basis for recommending the stock. Namely, that: “customers will increasingly leverage mobility platforms to re-acquire time in their lives.”
Such arguments may resonate with users who prefer the convenience of the app-based, standardized offering to the decentralized legacy taxi industry, but the rigid limits of Uber’s core business model have long been apparent to some. In a 2017 analysis published by the Transportation Law Journal, Hubert Horan of Horan Aviation Consulting (a speaker at the Grant’s fall conference on Oct. 23 – advt.) wrote:
Unfortunately, urban car-service op¬erators have never demonstrated significant scale economies, and Uber has not found any source of major margin improvements other than driver compensation cuts.
While investors in Uber and its peer Lyft, Inc. (LYFT on the Nasdaq) have fared poorly in their short public tenues, with shares down 28% and 46%, respectively, the IPO window for money-losing enterprises remains firmly ajar. Yesterday, home exercise equipment company Peloton Interactive, Inc. filed its form S-1, in preparation for listing. Peloton, which last August raised $500 million in a series-F funding round at an implied $4.15 billion valuation, is seeking an $8 billion or more public value at its debut, according to Bloomberg.
The S-1 filing contains no shortage of the messianic language regularly heard from Silicon Valley. CEO John Foley writes to would-be investors: “On the most basic level, Peloton sells happiness. But of course, we do so much more.” Indeed, the S-1 describes a corporate jack-of-all-trades: “a technology company, a media company, an interactive software company, a product design company, a social connection company, a [direct-to-consumer] retail company, an apparel company, and a logistics company.” Not mentioned: selling exercise bikes.
Despite offering pricey cycling machines that retail for $2,245 and generating strong sales growth (revenues doubled to $915 million in the 12 months ended June 30 from $435 million the fiscal year prior), Peloton’s net loss attributable to common shareholders rose nearly five-fold to $246 million from $48 million in fiscal 2018.
The last word goes to Kathleen Smith, co-founder of Renaissance Capital, who told CNBC on June 28: “Any private company that is not proceeding to go public in this market should have their head examined.”
Recap Aug. 28
Stocks caught a solid bid, with the S&P 500 rising back towards the middle of its three-week trading range, within less than 5% of its high-water mark reached on July 26. WTI crude rallied back near $56 a barrel and gold saw a small pullback to settle at $1,540 an ounce, while cryptos were slammed intraday with bitcoin falling below the $10,000 mark for the first time in four weeks.
A strong five-year auction helped the Treasury complex rally once more, as the 10-year yield remains near its all-time low of 1.37% while the 30-year long bond now yields 1.93%, well below the 2.12% effective Fed Funds rate.
- Philip Grant
Tuesday, August 27, 2019
The final frontier
It’s no breaking news that the Federal Reserve was charged with a defined mandate by Congress in 1977, namely: “to promote the goals of maximum employment, stable prices, and moderate long-term interest rates.”
However, the passage of time has seen the monetary mandarins progressively grow their congressional remit. Former Fed chair Ben Bernanke roped financial asset prices into the equation in a memorable Washington Post opinion piece on Nov. 4, 2010:
For example, lower mortgage rates will make housing more affordable and allow more homeowners to refinance. Lower corporate bond rates will encourage investment. And higher stock prices will boost consumer wealth and help increase confidence, which can also spur spending. Increased spending will lead to higher incomes and profits that, in a virtuous circle, will further support economic expansion.
The ensuing years also brought an increasingly stretched definition of stable prices, as noted by Alex J. Pollock in the July 13, 2018 edition of Grant’s Interest Rate Observer: “The Federal Reserve Reform Act of 1977, for one, does not say ‘price stability.’ It does in particular not say ‘a stable rate of inflation.’ It says ‘stable prices.”
Nevertheless, “price stability” is now the term used to couch a persistent, but slow, erosion of purchasing power. The Fed explicitly picked a 2% annual inflation target (as measured by the Core Personal Consumption Expenditures Index) in 2012, and expanded on that four years later by introducing the concept of inflation symmetry. Chicago Fed president Charles Evans put it this way on July 12: “I really think it would be useful, it ought to be part of our policy, to be aiming for inflation a bit above 2% at this point, because we’ve been under-running for so long.” In April, Evans provided specific figures: “I would communicate comfort with core inflation rates of 2.5%, as long as there is no obvious upward momentum and the path back toward 2% can be well-managed.”
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Year-over-year Core Personal Consumption Expenditures Index in white, Fed Funds rate in orange, 20-year chart. Source: The Bloomberg
Beyond targeting asset prices and advocating for “symmetrical” growth in inflation, others look to rhetoric as a mechanism to more thoroughly tame market forces. In a Financial Times opinion piece last Wednesday, Minneapolis Fed president Neel Kashkari argued that the central bank can bring the entirety of the yield curve under heel (as opposed to the overnight Funds rate) through use of so-called forward guidance:
For example, the federal funds rate effectively hit zero in late 2008, but the rate on a 10-year treasury bond stood at 3.5% for much of 2009, in part because investors assumed rates would pick back up. If the Fed had made a firm commitment to keep overnight rates at zero for the next 10 years, the 10-year treasury rate would likely have been close to zero.
So the Fed can also influence long-term rates by giving guidance about the future path of their short-term equivalents. The firmer the Fed’s commitment, the more influence it can have.
The search for influence continues into new realms. On March 25, the San Francisco Fed published a paper studying how climate change could impact monetary policy, noting: “Some have advocated that central banks use their balance sheet to support the transition to a low-carbon economy, for example, by buying low-carbon corporate bonds (Olovsson 2018).” Author Glenn D. Rudebusch cautions, however: “Such ‘green’ quantitative easing is an option for some central banks but not for the Fed, which by law can only purchase government or government agency debt.” On July 23, Axios reported that the San Francisco Fed will host a conference on Nov. 8 to discuss the "implications for monetary and prudential policy of climate change and its consequences."
Those self-conferred expansions of the congressional mandate reached a new plane today, in the form of a Bloomberg Opinion piece from former Federal Reserve Bank of New York president Bill Dudley. Dudley (who is scheduled to debate editor James Grant at the Fall 2019 conference on Oct. 23 – advt.) suggests that the Fed resist Donald Trump’s demands for more policy accommodation to help weather the economic disruption which might follow a protracted trade spat:
There’s even an argument that the election itself falls within the Fed’s purview. After all, Trump’s reelection arguably presents a threat to the U.S. and global economy.
That spicy rhetoric engendered a reply from the Fed’s PR apparatus this afternoon, asserting that “political considerations play absolutely no role” in its policymaking. As for other considerations, the flacks were silent.
Recap Aug. 27
Stocks gave back early gains to finish a bit lower, while interest rates continued to collapse with the 10-year yield falling to 1.47%, now within reach of the all-time lows reached in the summer of 2016. Resources had a good day, with WTI crude rallying back to $55 a barrel and gold ripping to another post-2013 high at $1,543 an ounce. The VIX finished back above 20.
- Philip Grant
Monday, August 26, 2019
Fiat accompli
As the European Central Bank prepares for its policy meeting on Sept. 12,
As the European Central Bank prepares for its policy meeting on Sept. 12,
Recap Aug. 26
Fiat accompli
As the European Central Bank prepares for its policy meeting on Sept. 12, the course of action appears to be set: A lowering of the benchmark deposit rate from the current negative 40 basis points, as well as a resumption of the asset purchase program that was in place from 2015 to 2018. Carsten Brzeski, chief economist at ING Germany, predicts that an additional 20 basis point rate cut and €30 billion ($33 billion) per month in QE are in the offing.
Driving that likely decision, notes Bloomberg in citing the minutes from the ECBs July 24-25 meeting, are worries “that investors are losing faith in [the central bank's] ability to revive inflation.” Euro-area harmonized CPI rose just 1% year-over-year in July, the lowest reading since November 2016.
As European interest rates continue their descent into the sub-zero vortex, stretched local banks contemplate introducing negative deposit rates to the masses. Jaime Guardiola, CEO of Banco Sabadell SA, remarked that “with a change of paradigm like the one we’re experiencing, you could say that it could be contemplated.” Commerzbank AG CFO Stephan Engels expressed similar sentiments to reporters earlier in August: “If there’s a market trend of negative rates being passed on to clients, we will have to look at that. If we were swamped with deposits as a consequence, we’d have to examine very closely how to deal with that sensibly.”
The prospect of negative rates-for-all is generating some less-than enthusiastic feedback from German leadership. Jens Weidmann, the head of Germany’s central bank, took a skeptical view of further easing in an interview with the Frankfurter Allgemeine Sonntagszeitung: “The question is whether new measures are necessary based on our inflation outlook, particularly if side effects grow and effectiveness diminishes.” Finance minister Olaf Scholz agreed, stating that he “doesn’t think it’s a good idea to charge penalties for depositors in checking accounts,” while Bavarian Premier Markus Soeder told German newspaper Bild last week that he favors a ban on negative rates for deposits up to €100,000.
Then, too, the prospect of further QE faces its own legal challenges from Europe’s largest economy. At the end of July, Germany’s constituonal court held a hearing over whether the ECB asset-purchase program is legal, as the ECB is barred from direct “monetary” financing of governments. The Financial Times noted on July 30 that if the court rules in favor of the litigants, the “Bundesbank may decide it is preferable to obey German constitutional law rather than requests of the ECB.”
While legal and political risks present themselves, the Ph.D. economists soldier on. In an interview over the weekend with Spiegel Online, former ECB vice president Vítor Constâncio defended the policy actions seen this cycle, while providing his explanation for the emergence of widespread negative interest rates for the first time in 4,000 years of financial history:
All this is the result of a phenomenon that economists call secular stagnation: In the developed economies, there is a lack of aggregate demand – or, in other words, a surplus of savings over planned investment.
There are mainly demographic reasons for this: People are getting older and saving more. In addition, there has been a greater risk aversion among investors since the financial crisis. That's why they are all looking for safe investments.
The former central banker unsurprisingly took a rosy view of the current epoch of policymaking. Of the outgoing ECB president Constâncio remarked: “I think Mario Draghi can also be very satisfied with his time in office and his place in the history books.” On this last point, Grant’s agrees, though perhaps for different reasons.
Risk of a looming recession adds further complication to the calculus. This morning’s release of the German IFO Business Climate Index for August showed a fifth straight sequential decline to a seven-year low. Clemens Fuest, president of the IFO Institute, told Bloomberg that “the situation is becoming increasingly dire. The weakness which was focused on manufacturing is now spread to other sectors.” Germany’s economic output contracted by 0.1% sequentially in the second quarter, according to the Federal Statistical Office.
A darkening economic backdrop begs the question of a policy response if still-more negative rates and a resumption of QE are not enough. Philipp Hildebrand, vice chairman of asset management behemoth BlackRock, Inc. told Bloomberg on Aug. 15 that: “The next step needs to be more than just more of the same.” Hildebrand, the former head of the Swiss National Bank, suggested the ECB consider: “putting money directly in the pockets of consumers or corporates.” That follows a July 22 essay in the Financial Times from Hildebrand’s colleague, BlackRock chief investment officer Rick Rieder, advocating that the ECB “improve private sector growth prospects by expanding its quantitative easing program to include equity investments in European companies.”
Or, how about gift cards with which to buy BlackRock mutual funds?
Recap Aug. 26
Stocks jumped higher, with the S&P 500 rising more than 1% to erase the bulk of last week’s losses, while Treasurys largely held steady to consolidate Friday’s big gains with the two- and 10-year yields both settling just under 1.54%. WTI crude edged back below $54 a barrel, while gold ticked to $1,529 an ounce to extend its recent run. The VIX fell back towards 19.
- Philip Grant
Friday, August 23, 2019
Engineering major
3G Capital giveth, 3G Capital taketh away. Now follows an update on a trio of equities part owned and operated by the Brazilian p.e. giant, each the recipient of a bearish analysis in Grant’s.
This morning, S&P cut its outlook on triple-B-minus-rated Kraft Heinz Co. (KHC on the Nasdaq) to negative from stable, citing “continuing performance erosion and lack of clarity on the company’s outlook.” It’s the latest indignity for KHC, which has seen its share price tumble by 65% since a bearish analysis in the March 25, 2016 edition of Grant’s following a series of poor results and operational missteps. The company withdrew guidance on Aug. 9 after earlier taking a $15.4 billion noncash write-down associated with the erosion of key brand values.
CEO Bernardo Hees left the company at the end of June, replaced by fellow 3G board member Miguel Patricio, fresh from a 20-year career at 3G stablemate Anheuser-Busch InBev S.A./N.V. (ABI on the Brussels Stock Exchange and BUD on the NYSE). Thanks in large part to the October 2016 acquisition of fellow dishwater brewer SABMiller plc for $65 billion (equating to roughly 18 times the target company’s Ebitda) Anheuser-Busch cut its dividend by 50% last fall to help contend with an onerous 4.8-times leverage ratio, far above the three times leverage employed by fellow Baa1-rated Heineken N.V.
This year, BUD shares have enjoyed a 44% snapback, narrowing their loss since the Feb. 9, 2018 Grant’s bearish analysis to 8% (the S&P 500 is up 7% over that period). On July 25, the company reported better-than-expected second-quarter results, including 6.2% year-over-year “organic” revenue growth and a 9.4% jump in “normalized Ebitda.” However, those figures don’t square with reality. So-called normalized Ebitda rose to $5.86 billion from $5.69 billion (just a 2.9% uptick) while as-reported revenues declined to $13.96 billion from $13.99 billion.
But as Kraft-Heinz and Anheuser-Busch have both labored to ease their respective debt burdens, a third 3G entity, Restaurant Brands International, Inc. (QSR on the NYSE), has thrived. Year-to-date, shares are up a cool 46%, and sit higher by 24% since the initial bearish analysis in Grant’s on June 2, 2017 (the S&P 500 has gained 18% over that period). The company’s 5% second lien notes due 2025 have seen their spread over Treasurys fall to 252 basis points from 280 basis points at issuance in August 2017. That move makes a soothsayer of Pershing Square Capital Management CEO William Ackman, who proclaimed from the podium at the fall 2018 conference that Grant’s is “wrong on Restaurant Brands.”
The company has maintained steady profitability at its Tim Hortons unit, while well received roll-outs such as Burger King’s Impossible Whopper and Popeyes Louisiana Kitchen’s new chicken sandwich have likewise burnished the bull view. Analysts at Bloomberg Intelligence forecast mid-single digit revenue growth in 2019, on account of the company “improving operations, launching innovative new products and continuing its rapid unit expansion.”
QSR’s recent successes have bucked broader weakness. According to industry research firm TDn2K, comparable store sales across the restaurant industry posted a 1% year-over-year decline in July, while comparable traffic fell 4% over that period. The pullback is no outlier, as TDn2K finds that same-store traffic has remained negative in every month going back to at least December 2015.
The industry struggles cast a renewed light on the dynamic between asset-lite franchisors, who collect royalties from the store-level operators, and the franchisees who face that protracted decline in traffic and persistent wage inflation, along with ambitious remodeling requirements that entail heavy capital spending. That conflict was on full display in the rancorous negotiation between Tim Horton’s and the Great White North Franchisee Association documented in the June 16, 2017 edition of Grant’s. John Hamburger, president of the Franchise Times Corp., put it this way at the Grant’s 2018 spring conference:
You can’t have one side of the franchise contract get¬ting fabulously rich while the other side faces these headwinds alone. The concept of a moat around the franchisor is a myth. That somehow a brand can separate itself from the unit-level economics of its franchisees is not grounded in reality.
The strong run in Restaurant Brands has obscured the risks of a fraying franchisor/franchisee model, as evidenced by the continued struggles of Carrols Restaurant Group, Inc., (TAST on the Nasdaq) the largest franchisee of Burger King Restaurants. With QSR shares priced at 28 times forward adjusted earnings per share and a balance sheet carrying net debt of 5.3 times forward adjusted Ebitda, risks to the bull case continue to percolate.
QSR shares in white, TAST in orange; five-year chart. Source: The Bloomberg
Meanwhile, 3G has opted to take some chips off the table following Restaurant Brands’ bull run, selling 20 million shares earlier in August to pare their position in QSR to 36.7%, according to analysts at R.W. Baird. Insiders have followed suit, with CEO José Cil, co-chairman of the board Daniel Schwartz and Burger King executive vice president Alexandre Macedo, disposing of 127,000 shares, 1.04 million shares and 100,000 shares respectively, since March.
Recap Aug. 23
News of Chinese tariffs on additional U.S. goods put pressure on stocks early, while President Trump’s mid-day Twitter broadside against Fed chair “Powel” added fuel to the bearish fire.
By day’s end, the S&P 500 suffered a 3% swan-dive, leaving the broad average nearly 2% in the red for the week. Treasurys enjoyed another ferocious rally, with the 10-year yield falling below 1.53% to draw closer to its record low of 1.37% reached in the summer of 2016. WTI crude fell back below $54 a barrel, while gold reached a fresh five-year high at $1,526 an ounce. The VIX jumped to 21.
- Philip Grant
Thursday, August 22, 2019
Silver slugger
According to data from the U.S. Treasury Department
According to data from the U.S. Treasury Department
Boom goes the dynamite
A blip on the radar, or something more?
A blip on the radar, or something more?
Recap Aug. 22
Silver slugger
According to data from the U.S. Treasury Department released last Thursday, the federal budget deficit footed to $866.8 billion through the first 10 months of the fiscal year. That’s up 27% year-over-year, and already tops the full-year 2018 gap of $779 billion, the highest shortfall since 2012.
It’s like reaching 100 RBI with two months left in the season.
Boom goes the dynamite
A blip on the radar, or something more? Recent weeks have seen the formerly-red hot leveraged loan market retrench, as Bloomberg reports today that streaming service provider Vewd Software USA LLC pulled an offering, the fifth busted loan deal in the past week. Jeff Cohen, global head of leveraged finance capital markets at Credit Suisse AG., flagged the “widely divergent pricing outcomes” seen of late, predicting that “investors are likely to remain highly selective” in their allocations.
The post-crisis era has been a boon for leveraged loans, with total domestic supply outstanding exceeding domestic high yield bond supply for the first time last year. However, the sharp downward reversal in rates this year has cooled enthusiasm for the floating-rate securities vs. fixed-rate junk bonds. Year-to-date, the Bloomberg Barclays High Yield Index has generated a 10.4% total return and the iBoxx Investment Grade Index has jumped 16%, easily besting the 6.1% gain seen from the S&P/LSTA Leveraged Loan Index.
As loan performance has lagged, investors have continued to head for the exits, with data from Lipper showing $943 million in outflows across leveraged loan mutual funds and ETFs across the five business days ended Aug. 20. Overall, retail investors have pulled money for a record 39 straight weeks. Assets under management at U.S. loan funds likewise continue to slip, falling for a ninth straight month to $142 billion in July, down 23% from October 2018.
As momentum ebbs and some deals stall, others have come to market at less favorable terms than issuers would have liked. Bloomberg notes that B3/single-B-minus-rated Total Safety U.S., Inc. was forced to offer its six-year term loan at a relatively steep discount at 93 cents on the dollar (for a meaty 600 basis point spread over Libor), while other p.e. sponsored firms such as Whataburger Restaurants LLC and Teneo Holdings LLC strengthened covenants in the face of investor resistance. Apollo Management-owned CEC Holdings, Inc., which was featured in the July 12 edition of Grant’s Interest Rate Observer, was obliged to price a $760 million term loan due 2026 at 96, a 650 basis-point spread over Libor in order to refinance a loan maturing in 2021 at a 325 basis-point spread. That compared to price talk of 550 to 575 basis points above Libor and 99 cents on the dollar, according to S&P’s LCD unit.
Steve Miller, data analyst at Covenant Review, notes that “issuers are reaching for more aggressive terms than ever before and managers are vigorously pushing back against these proposals.”
Recent concessions aside, loan investors have largely continued to swallow less-than robust legal protections from issuers. On Aug. 13, Moody’s Investors Service reported that its in-house Covenant Quality Indicator reached a record-worst level in July. Moody’s noted that a higher-than usual ratio of Ba-rated paper (towards the upper end of speculative grade) helped entice investors to those cov-lite deals.
The erosion of creditor-friendly fine print presents one concern. The potential for systemic risks stemming from portfolio concentration, another. In an Aug. 9 report, Fitch Ratings estimated “that the banks most active in the leveraged loan market have direct loan and CLO exposures averaging 30% to 40% of capital.” Overall, the rating agency pegs leveraged loan exposure at 29% of tier-one capital among U.S. banks at year-end 2018, with European banks holding the equivalent of 27% and Japanese banks 16%.
Those loan- and CLO-happy financial institutions appear to be standing on increasingly shaky ground. S&P’s LCD unit noted on Tuesday that 34% of all domestic loans issued year-to-date have come to market with no “debt cushion” below in the capital structure. That compares to just over 25% in 2016 and below 20% in 2009. Leveraged loans are typically the senior-most portion of a borrower’s capital structure, i.e., when there is no debt below the loan and the company defaults, the loan stands to absorb all losses after the equity.
The key question: Where would a continued cooling in leveraged loans leave the private equity boom? According to data from Bain Capital, the average p.e. purchase price rose to 10.9 times Ebitda last year, well above the 9.9 times seen at the peak of the prior cycle in 2007. As p.e. has largely funded its acquisitions this cycle through an accommodative loan market, the prospect of attempted exits at elevated valuations in a less friendly environment could lead to unwelcome surprises for the industry and its lenders.
Recap Aug. 22
Stocks shook off early losses to leave the S&P 500 little changed for the day, as the broad index sits near the upper end of its two-week range and green by 17% year-to-date. Treasury yields ticked higher across the board, with both the two- and 10-year yields settling near 1.62% (the three-month vs. 10-year spread remains inverted by more than 35 basis points). WTI crude and gold settled at $55 a barrel and $1,499 an ounce, respectively, and the VIX rose 6% to 16.70.
Meanwhile, economic data continue to indicate trouble, as this morning’s reading of the Markit Manufacturing PMI for August fell below 50 (indicating contraction) for the first time since September 2009.
- Philip Grant
Tuesday, August 6, 2019
Bogey board
The latest dive in interest rates pushed the global stock of negative-yielding debt above $15 trillion for the first time yesterday. That represents 25% of all outstanding worldwide bonds according to data from Deutsche Bank A.G.
Needless to say, this development further complicates life for pension funds, which have been forced into increasingly “creative” measures to maintain rates of return sufficient to meet their obligations. According to the Wilshire Trust Universe Comparison Service and noted by The Wall Street Journal today, the median return for public pension funds exceeding $1 billion in assets was 6.79% for the fiscal year-ended June 30, lagging the projected median long-term return assumption of 7.25%.
A decade of rising asset prices hasn’t been enough for some. As reported by Connecticut’s Office of Fiscal Analysis on July 19, the State Employees Retirement System saw its funding level decrease to 38% as of June 30, 2018, down from 48% in 2011. On the corporate side of the ledger, the average plan was 88% funded as of June per consulting firm Milliman, Inc., down from 94% in September 2018.
How to close the gap? Low rates have their advantages. As noted by Barron’s on July 30, Baa2-rated Federal Express Corp. (FDX on the NYSE) tapped U.S. and European credit markets for $1 billion in 3.1%, 10-year notes and a pair of €500 million ($560 million), six- and 12-year notes yielding 0.45% and 1.3%, respectively, in order to make a voluntary pension contribution. Priced two weeks ago, all three issues are currently trading comfortably above par.
A buoyant stock market offers its own potential workaround. In September 2017, Boeing Co. (BA on the NYSE) partially plugged a $20 billion pension shortfall with a $3.5 billion infusion of its own shares, including those which it had accumulated through open-market share repurchases. That move adds a sort of unconventional, embedded leverage unseen on the balance sheet (the 25% drop in BA shares from March puts this problem into some relief).
But with the bond market offering microscopic yields (at best) and the S&P 500 trading at a substantial premium to its five-year average on price-to-earnings basis (Almost Daily Grant’s, July 30), pension funds look primarily to the private markets to make up the shortfall. According to analytics firm eVestment, private equity accounted for 27% of U.S. and U.K. pension fund allocations in 2018, up from 25% a year prior. In Japan, corporate pension funds allocated a record 21.3% of assets to so-called alternative investments in March according to J.P. Morgan Asset Management, up from 12.8% in 2014.
The problem: As the bull market goes on and private equity proliferates, value is increasingly hard to come by. According to data from Bain Capital, the average p.e. purchase price footed to 10.9 times Ebitda last year, just below 2017’s record of 11 times and (un)comfortably higher than the 9.9 times seen at the peak of the prior cycle in 2007. Fancier prices are accompanied by a higher debt burden, as p.e. deals in 2018 carried an average net debt equal to just over six times Ebitda, compared to 4.9 times in 2007.
Daniel Rasmussen, founder and portfolio manager of Verdad Advisors, L.P., noted in the April 5 issue of Grant’s Interest Rate Observer that even those price and leverage figures are flattering:
By the way, that is on pro forma adjusted Ebitda numbers, which probably overstates Ebitda by about 15%. So, you’re probably in reality looking at a 13 or 14 times purchase price with seven or eight turns of net debt to Ebitda on a GAAP basis.
Considering the risks involved in paying up and levering up, recent performance from the industry has been wanting. While p.e. generated 14.4% in net annual returns from 1990 to 2010 (easily topping the 8.1% for the S&P 500), industry returns lagged both the S&P 500 and Russell 2000 indices from 2012 to spring 2018.
Of course, those five-plus years of underperformance have come during the longest U.S. expansion on record (barring a hindsight-aided declaration by the National Bureau of Economic Research). With global yield curves and purchasing manager indices alike suggesting the risk of an economic downturn, Rasmussen ventured in that April 5 Grant’s that p.e.’s past resilience through turbulent periods may not apply this time:
I think the question is not how did private equity do historically during times of recession, but how did companies that traded at those multiples and with those amounts of leverage do. And, the answer is: Companies with seven or eight turns of net debt go bankrupt at very disproportionately high rates when there is a recession.
Attention underfunded, benchmark-lagging and financially repressed pension fund managers: Thank-you notes can be directed to the offices of the Bank of Japan, European Central Bank and the Federal Reserve.
Recap Aug. 6
Stocks enjoyed a solid rebound after days of persistent selling (and, indeed, just for the record, persistent buying), with the S&P 500 rising nearly 1.5% and closing near session highs. Treasurys mostly took a pause from their relentless recent descent, though the 30-year yield edged lower to 2.24%, not far above the 2.13% effective funds rate. Gold and oil continued to diverge, with the former climbing to $1,486 per ounce while WTI crude fell to a six week low under $54 a barrel, and the VIX retreated to 20, down 19% on the day.
- Philip Grant
Monday, August 5, 2019
Shine a light
The public debut of The We Company, parent of co-working outfit WeWork Cos., Inc. draws closer. Over the weekend, Reuters reported that J.P. Morgan Chase & Co. has secured “the pole position” to lead the offering. That follows a July 23 report from The Wall Street Journal that the IPO could come as soon as September, earlier than had been widely expected. Per The Journal, that expedited timeline accompanies a sense of urgency: “One reason for the September launch target is executives at WeWork are worried that the good times won’t last, with the U.S. stock market trading near records.”
The stakes are high. According to a Bloomberg dispatch today, WeWork is set to raise up to $6 billion in a two-part debt offering, but that deal comes with a caveat: “banks will have to make good on their commitments only if at least $3 billion is raised” in the IPO. The company was most recently valued at $47 billion in a private fundraising round led by SoftBank Group Corp.
With that backdrop in mind, let’s take a stroll through WeWork’s most recently published audited financial results (Ernst & Young LLP did the honors) recently obtained by Grant’s. Despite the company’s imminent public debut, accessing the data is not easy. The documents are only available online, and printing is disabled. Each page is stamped “confidential,” with the recipient’s name, along with the date and time of publication. Unlike most web-based financial statements such as those domiciled on sec.gov, searching for specific terms is disabled.
Now, to the figures. In the quarter ended March 31, revenues footed to $728 million, more than doubling year-over-year from $342 million in first quarter 2018. Similarly, total WeWork memberships rose to 371,000 in the fourth quarter, compared to 174,000 at year-end 2017.
Unfortunately, increased scale has yet to provide any relief to the torrent of red ink. So-called community operating expenses (“exclusive of depreciation and amortization”) rose at a similar clip, doubling to $581.5 million in the first quarter from $288 million, while WeWork’s operating loss jumped to $637 million from $296 million year-over-year. Sales and marketing expense rose to $151 million, or 21% of revenues, from $63 million (19% of revenues) in the year ago period.
Meanwhile, community-adjusted Ebitda (or, adjusted adjusted adjusted Ebitda), WeWork’s signature metric, rose to $169.5 million in the first quarter from $95 million year-over-year. That gain failed to keep pace with the jump in revenues, as the “margin” declined to 27% from 29.2%.
While the financials provide little fodder for optimism, the company looks for other ways to impress investors. On July 30, CNBC reported WeWork was in talks to acquire startup SpaceIQ, which sells software to aid the efficient use of office space, a move which “could help WeWork convince Wall Street that it’s at least somewhat of a technology company.”
The bond market seems to need some persuasion. Single-B-plus-rated WeWork’s senior unsecured 7 7/8 notes due 2025 last changed hands at 96.5 cents, for a 8.66% yield-to-worst and 712 basis point spread to Treasurys. That’s well above the 491 basis points at issuance. By comparison, the Bloomberg Barclays High Yield Index has seen its option-adjusted spread widen by just 63 basis points over that period, to 397 basis points at Friday’s close.
Meanwhile, CEO Adam Neumann is ringing the register. On Thursday, The Real Deal reported that Neumann “is putting a property that he owns as a personal investment in Greenwich Village up for sale on the open market. . . The 11-story building at 88 University is place is almost fully leased to WeWork and is about to come to market with an asking price north of $110 million.” That follows the July 18 bulletin from The Wall Street Journal that the WeWork boss has already cashed out more than $700 million from the company, news that Neumann’s associates downplayed by noting that “Neumann’s borrowings against some of his WeWork shares indicate that he is bullish on the company’s long-term prospects.”
Recap Aug. 5
An overnight devaluation of the Chinese Renminbi pushed the exchange rate to more than seven per dollar for the first time since 2008 and spurred another sharp selloff, as the S&P 500 sank 3% for its worst one-day showing of the year. The broad index saw its year-to-date gains whittled to 13.5%, and sits 6% below its July 26 highs.
Treasurys ripped in near lockstep with yields declining 11 or 12 basis points across the curve and the 10-year falling to 1.72%, 35 basis points above its record close in July 2016. WTI crude fell back below $55 a barrel, while gold rose to $1,463 an ounce, its best close since May 2013. The VIX finished above 24 and has nearly doubled in the last five sessions.
- Philip Grant
Friday, August 2, 2019
I hate when that happens
From Nine News Australia:
From Nine News Australia:
Climate change field trip
From the New York Post on Wednesday:
From the New York Post on Wednesday:
See that my grave is kept clean
This roll-up is not exactly on a roll.
This roll-up is not exactly on a roll.
Recap Aug. 2
I hate when that happens
From Nine News Australia:
The 73-year-old's body was donated to science, with her family believing her remains would be used to study the effects of Alzheimer's Disease. Instead her body was sold to the US Army for explosives testing.
Maybe the Army can return the body for medical testing after it’s finished blowing it up.
Climate change field trip
From the New York Post on Wednesday:
The billionaire creators of Google have invited a who’s who of A-list names— including former President Barack Obama, Prince Harry, Leonardo DiCaprio and Katy Perry — to the Sicilian seaside for a mega-party they’ve dubbed Google Camp.
The three-day event will focus on fighting climate change – thought it’s unknown how much time the attendees will spend discussing their own effect on the environment, such as the scores of private jets they arrived in and the mega yachts many have been staying on.
Missed the party? National Geographic and The Wall Street Journal have just the thing: “The Future of Everything: Exploring Global Innovation by Private Jet.” The offer includes:
Gain unique perspectives on advances in science and technology—from brain science to climate change—with insights from National Geographic experts and Wall Street Journal reporters and editors.
The 24 day expedition starts at $92,725 per person for double-occupancy accommodations.
See that my grave is kept clean
This roll-up is not exactly on a roll. Yesterday, memorialization company (among other things) Matthews International Corp. (MATW on the Nasdaq) reported third quarter results. Management pulled no punches in the press release: “Consistent with the updated expectations that we provided last quarter, our third quarter continued to be challenging.” The particulars included an 8% year-over-year decline in sales to $379 million, 15% drop in adjusted Ebitda and 40% plunge in diluted earnings per share. Unfavorable currency fluctuations, asset sales and a higher tax rate contributed to those declines, but investors have still been unimpressed. Since a bearish analysis in the Oct. 7 edition of Grant’s, MATW shares are down 33%.
Founded in 1850, Matthews is a one member of a quasi-duopoly, sharing approximately 80% of the burial products market with Hillenbrand, Inc.’s Batesville unit. Then, too, valuation appears undemanding, with enterprise value of $1.9 billion eight times consensus adjusted Ebitda for the 12-months ending Sept. 30. The problem: Cash-strapped Americans have increasingly turned towards cremation, which costs as little as $800, compared to $7,000 for a non-high-end casket and burial. Last year, cremation accounted for slightly more than half of domestic market share, up from one-third in 2005.
As the legacy business shrinks, Matthews has diversified. The company now operates three distinct business lines. Memorialization (funeral-related services) is its legacy business, contributing 42% of revenues and roughly half of adjusted Ebitda in the third quarter. Then there’s the packaging, marketing and advertising unit SGK, which chipped in 48% of sales and 40% of adjusted Ebitda. Industrial technologies accounts for the rest.
Since 2012, Matthews has bought at least nine other companies, paying some $990 million (that compares to its current market cap of $1 billion) and has adjusted reported earnings with a slurry of one-time, acquisition-related expenses. The SEC took exception to MATW’s accounting treatment, asking the company in Feb. 2018 to “quantify the impact acquisitions had on revenues,” and then challenging: “Please explain how you concluded that these expenses are not normal, recurring, cash operating expenses necessary to operate your business.”
The company has taken more than $200 million in acquisition-related costs over that period. The magnitude of MATW’s income statement nip-and-tucks are on display in the most recent period, as adjusted third quarter EPS came in at 90 cents, nearly double the 46 cents per share “diluted” figure.
There’s also the matter of free cash flow. From that Oct. 5 Grant’s:
A glance at page 21 of the third-quarter-earnings presentation shows that free cash flow spurted to $120.7 million in 2017 from $92.6 million in 2015, or by 30.4%. But that is the Matthews version of FCF, which the company redefines as EBITDA less capex, interest and taxes; no adjustment is made for changes in working capital, i.e., for the investments Matthews must make to remain a going concern. On the more rigorous and customary calculation, FCF would have grown to $104.4 million from $92.8 million over the same three years, a rise of only 12.4%.
Not that a large cohort of shareholders would complain, or even notice. Passive investing giants BlackRock, Inc., the Vanguard Group, Inc. and State Street Corp. hold a combined 28.8% of shares outstanding. Despite its poor recent performance, Matthews belongs to an impressive cross-section of indices, including the Nasdaq Broad Dividend Achievers Index (its dividend yield is 2.6%), the S&P 1500 Positive Momentum Tilt Total Return Index, and the S&P Small Cap 600 Pure Value Index.
That Oct. 5 analysis noted that the raft of purchases has helped obscure the company’s true operating results, as Matthews management does not provide a breakout of revenues from acquisitions. Indeed, colleague Evan Lorenz noted that “adjustments to non-GAAP earnings are opaque and aggressive. . . management offers little explanation as to what acquisition-related expenses pertain too or why these charges persist as long as they do.” Then, too, double-B-rated Matthews has added substantial borrowings to aid its corporate shopping spree; net debt stands at $938 million, four times consensus adjusted Ebitda. The senior unsecured 5 1/4 notes due in 2025 last changed hands at 98.5 cents on the dollar, for a yield-to-worst of 5.53% (the spread to Treasurys has widened to 386 basis points from 295 at issuance).
Questionable accounting, passive ownership and debt-financed growth. Matthews has a bit of something for everyone.
Recap Aug. 2
Stocks fell for a fifth straight day, with the S&P 500 wrapping up the week down a meaty 3%. Treasurys likewise continue to augur trouble, with the 10-year yield dropping to 1.85%, within 50 basis points of its all-time low and more than 20 basis points below the three-month bill yield. Energy rebounded with WTI crude rising back above $55 a barrel, and gold finished slightly lower. The VIX settled above 18.
- Philip Grant
Thursday, August 1, 2019
Heart of darkness
Yesterday, a pair of senators, one from each party, introduced a bill designed to weaken the U.S. dollar by levying a tax on foreign investments. The Democrat, Sen. Tammy Baldwin (D-WI) explained: “Today, foreign investors have driven up the American dollar, helping Wall Street profit but holding back stronger economic growth. We need reforms that create a competitive American dollar and an even playing field for manufacturers, farmers and workers.” That follows a July 26 report from CNBC that President Trump held a meeting to devise ways to drive the greenback lower.
As currency wars return to the forefront, with the U.S. and Europe (among others) expressly seeking to devalue, crypto-currencies continue their 2019 revival. Year-to-date, bitcoin is up 175%, while ethereum has gained 61% and litecoin 226% (all in dollar terms), despite the highest close in more than two years yesterday in the U.S. Dollar Index.
The decentralized nature of cryptos offers a lifeline to those under the thumb of autocratic regimes, and consternation for those enforcing U.S. sanctions and other applications of international law. Coindesk reported on Tuesday that “Chinese importers in Russia are buying up to $30 million a day of [the purportedly dollar-backed crypto] tether from Moscow’s over-the-counter trading desks,” to avert domestic capital controls. In Iran, which is being squeezed by punishing economic sanctions from the U.S., the theocratic government turned tail and announced that bitcoin mining will be permitted as of Monday, per Mehr News.
More broadly, the bull case for crypto was articulated by Real Vision CEO and co-founder Raoul Pal, on a July 29 podcast with Stephen Livera:
I know all these macro guys, they’re all in it. They get it. They get the optionality. They may be complete believers, part believers. . . if it’s a 1% chance of being right and the upside is 100 times from here, you’d do this all day.
So, if it’s worth $80 trillion, let’s say you have a 10% probability, that’s $8 trillion. It’s currently worth $200 billion. So, even if there’s a 1% chance of it working. . . it’s ludicrously underpriced if any of these probabilities play out.
Bitcoin’s already substantial year-to-date gain brings potential headaches to the investor flock. On July 26, Bloomberg reported that the Internal Revenue Service “is warning more than 10,000 holders of crypto-currency that they may be subject to penalties for skirting taxes on their investments.” The agency, which in 2014 declared cryptos to be property for tax purposes, Bloomberg reported, “served a summons against digital currency exchange Coinbase, seeking details about customers who traded digital currencies from 2013 to 2015.”
While the taxman is on the lookout for his due, other government players look to crash the crypto party. Recall that in April, New York Attorney General Letitia James accused the Bitfinex Exchange (which shares ownership of the purportedly dollar-backed tether crypto) of “engaging in a cover-up to hide the apparent loss of $850 million of co-mingled and corporate funds” (Almost Daily Grant’s, May 31). Progress in remedying the shortfall has been slow in coming. Bitfinex, which borrowed $700 million from Tether through a line of credit in early 2019, announced on July 1 that it has repaid $100 million “in fiat wired to Tether’s bank account.”
Tether has seen its total supply of coins outstanding double to $4 billion in four months, while trading volumes over the past 24 hours foot to $15.8 billion, larger than any other crypto including bitcoin at $15.2 billion.
Meanwhile, the AG’s office continues to ramp up the pressure, invoking the dreaded Martin Act (which bestows upon the AG broad power to investigate securities fraud) in a June 8 filing in response to Bitfinex’s argument that its business has “nothing to do with New York investors.” The AG countered with evidence suggesting that Bitfinex had allowed New Yorkers to log into its website as recently as December 2018. The filing also notes that Phil Potter, Bitfinex’s former CEO, “resided and conducted his work from New York” between 2014 and his resignation in 2018. For more on Potter, the curious case of Bitfinex and Tether and the wider connection to the crypto phenomenon, see the June 29, 2018 edition of Grant’s.
This just in; a pair of bulletins from Coindesk this afternoon:
Crypto derivatives platform FTX has perhaps the most speculative and oddly-named futures index fund on the market: SHIT-PERP, or the Shitcoin Index Perpetual Futures.
Adult industry-oriented blockchain project SpankChain has launched a crypto-currency payments platform.
QT progress report
Parting is such sweet sorrow. The Fed’s portfolio of securities held outright registered at $3.594 trillion, down $23 billion from a week ago and $31 billion below the trailing four-week average.
This represents the final episode of the QT run-off initiated on Oct. 1, 2017. Over that 22 month stretch, the Fed’s total balance sheet assets fell by 15.2%, for an 8.6% simple annualized pace.
Recap Aug. 1
A mid-day Trump tweet announcing 10% tariffs on an additional $300 billion of Chinese goods spurred some afternoon chaos, as stocks took another dive to extend the S&P 500’s loss for the week to nearly 2.5%. Treasurys enjoyed a ferocious rally, with the two-year yield dropping to 1.75% and the 10-year settling at 1.9%, just over 50 basis points above its all-time low. Energy was hammered with WTI falling below $55 a barrel, while gold rallied to $1,443 an ounce. The VIX rose to 18, extending its gain for the week to near 50%.
- Philip Grant
Wednesday, July 31, 2019
Triple threat
Fed chair Jerome Powell accomplished
Fed chair Jerome Powell accomplished
General hospital
This morning, General Electric Corp. (GE on the NYSE)
This morning, General Electric Corp. (GE on the NYSE)
Recap July 31
Triple threat
Fed chair Jerome Powell accomplished the seemingly impossible today: he cut rates, announced the early end of balance sheet run-off AND disappointed markets.
General hospital
This morning, General Electric Corp. (GE on the NYSE) reported second quarter results, including $28.8 billion in revenues and 17 cents in earnings per share, down 4% and 6% year-over-year but north of the expected $28.7 billion and 12 cents, respectively. CEO Larry Culp termed the updated outlook “a sign of progress, a sign of stability here.” But those figures were aided by a lower than expected tax rate, and the aviation division saw orders fall 10% from a year ago thanks in part to the Boeing 737 Max saga.
Some analysts were less than impressed, with Stephen Tusa of J.P. Morgan Chase & Co. declaring that “the quarter was a miss operationally, with the combined power/renewable segments worse. . . and a material miss at aviation, the key value driver.” Gordon Haskett Research Advisors’ John Inch summarized the quarter as “a modest step back [relative to] expectations.” Mr. Market agreed, as GE common stock finished slightly lower. Since November 2007, GE shares are down 75%, compared to a 93% rise in the S&P 500 over that period.
It’s been a long, steep fall from grace for America’s former preeminent industrial concern. As early as the Sept. 14, 1990 issue and many times thereafter, Grant’s expressed a bearish view on then-CEO Jack Welch’s commercial pride and joy. That judgement was long flummoxed by GE’s routine one cent quarterly earnings “beats,” a soaring share price and a pristine triple-A credit rating. Following GE’s dramatic near-demise (and subsequent government rescue) during the 2008-era crucible, Grant’s issued the postmortem in the Sept. 18, 2009 edition:
Some day, financial historians will try to make sense of it all: the mere existence of a $100 billion GE commercial paper program (the number today seems incredible); the ideal of “shareholder value” carried to the point of alleged institutionalized fraud; an industrial company recreating itself as a highly and precariously leveraged financial institution with nary a peep of protest from the stockholders; the close brush with insolvency of a company still bearing the imprimatur, triple-A.
Finally, the historians of the future will scratch their heads to understand why Jack Welch and Alan Greenspan, icons of the late 20th century, put so much stock in an idealized “stability” that can only appear to exist in a dynamic world but can never be present in fact.
The company’s well-ventilated post-crisis struggles culminated with the Oct. 30 slashing of its dividend to a mere penny, while credit default swaps reached as high as 268 basis points on Nov. 23. In the Nov. 16, 2018 issue, Grant’s returned to the scene of now triple-B-minus-rated GE in search of value. While the company’s “mind-numbing” complexity, the run-off of its insurance operations and various contingent liabilities argued for a “wide berth” to GE common, the 5% series D perpetual preferred, then trading at 80 cents on the dollar for a 16.2% yield-to-call, offered a compelling risk vs. reward proposition in the sharp analytical judgement of colleague Fabiano Santin.
While the stock has managed only a halting recovery, those preferreds have since flourished, rising to 96 as of yesterday for a yield-to-call of 7.3%.
With that strong price run and generous yield, what might a series D preferred holder do now? A follow-up in the May 3 edition laid out the calculus:
Take a profit and pay the short-term capital-gains tax (which, for an afflicted New York resident, would total 53.5%)? Or stick with CEO Culp and his GE renovation plan, finally paying the long-term capital-gains rate (36.5% for the same overburdened New Yorker)?
With respect to tax advice, both Fabiano Santin, who performed the superb security analysis, and your editor agree that it is better not to live in New York. Fortunately, the self-directed readers of Grant’s have likely already made up their minds on this sensitive point.
Recap July 31
Stocks took a tumble with the S&P 500 finishing red by more than 1%, but well off its worst levels of the day. The Treasury curve saw notable flattening, with the two-year yield rising two basis points and the long bond dropping five, and gold lost more than 1% to settle at $1,416 an ounce. The VIX jumped to more than 16 and is up 33% so far this week.
Earlier today, the July Chicago PMI collapsed to 44.4, its worst reading since Dec. 2015.
- Philip Grant
Tuesday, July 30, 2019
Golden years
From the New York Post:
From the New York Post:
Pay now, grow later
As of last Friday, 44% of the S&P 500 had reported earnings
As of last Friday, 44% of the S&P 500 had reported earnings
More where that came from
It’s a done deal.
It’s a done deal.
Recap July 30
Golden years
From the New York Post:
Former swimsuit model Elizabeth Hoad, 49, went on live television Tuesday in the UK to wed her 6-year-old golden retriever, Logan.
Hoad wore a modest knee-length, long-sleeved white dress and an oversized white rose fascinator. Logan sported a tuxedo tailored for dogs — naturally. They even had wedding bands — her a ring and the handsome pooch a dog-sized bracelet.
After Hoad said, “I do,” officiant Hammond waited briefly for Logan’s response before taking his lack of protest as a “yes.”
No pre-pup needed.
Pay now, grow later
As of last Friday, 44% of the S&P 500 had reported earnings with 77% of those index components reporting a better than expected bottom line, according to Factset. That compares to a 70% “beat rate” across the post-crisis era, but this latest period hasn’t exactly been a high hurdle to climb. Factset reports that the S&P’s overall blended (combining those that have reported and the estimates of those yet to do so) earnings are down 2.6% year-over-year, the second straight such decline.
While Wall Street is taking it easy on corporate America this quarter, things are looking a bit more challenging in the future. Following an expected third quarter decline of 1.9% year-over-year, analysts are penciling in gains of 4.9%, 9.2% and 12.6% in the fourth quarter, first quarter 2020 and second quarter 2020, respectively. Meanwhile, those expected future earnings come at a premium: The S&P 500 currently sports a forward P/E ratio of 17.1, compared to a five-year average of 16.5 and a 10-year average of 14.8.
More where that came from
It’s a done deal. Interest rate futures are pricing 100% odds of a rate cut at tomorrow’s meeting of the Federal Open Market Committee. A trio of Fed emeriti have also weighed in, with Alan Greenspan, Janet Yellen and Bill Dudley all recently arguing for a 25 basis point cut to the funds rate.
The Fed’s presumptive cut will merely help the U.S. begin to “catch up” to the rest of the world. As noted by Bianco Research last Tuesday, almost 95% of developed market sovereign debt around the world is quoted at yields below the 2.40% Fed funds rate, up from 40% in 2015. According to Deutsche Bank, roughly 25% of all worldwide bonds trade at nominal yields below zero, including some corporate issues rated as low as single-B (well into junk territory), per BofA Merrill Lynch. As a reminder, negative nominal yields of even long-dated sovereign bonds are unheard of in 4,000 years of financial history prior to this cycle.
Overseas influence is palpable. On a July 18 television appearance, Fed vice chair Richard Clarida noted that the domestic price of money “can diverge to some extent from global rates but there’s a limit to how far that process can go, because of integrated capital markets.” Last week’s suggestion by ECB president Mario Draghi of further rate cuts from the current negative 40 basis point deposit rate further exacerbates the discrepancy. Wall Street Journal economics columnist Greg Ip sums up that line of thinking today: “A big part [of tomorrow’s rate decision] will have already been made – in Frankfurt.” Domestic rates markets are likewise pointing lower, with the 10-year yield of 2.06% comfortably below Fed Funds.
Bloomberg Businessweek captures the current zeitgeist.
Some observers believe there is much more room for rates to fall, even toward the yield-free levels seen across the globe. Writing in the Financial Times on Thursday, Bob Michele, global head of fixed income at J.P. Morgan Asset Management, lays out the bull case, citing the flood of foreign capital seeking positive nominal yields, along with the imminent end of the QT balance-sheet runoff program and the risks of a global economic slowdown aggravated by ongoing trade tensions. To avoid that outcome, Michele suggests large fiscal stimulus or monetary easing aggressive enough to steepen the yield curve and stoke reflation. Otherwise, “anything short of that risks the 10-year Treasury remaining on the well-worn path, forged by Japan and Germany, to zero.”
But while U.S. creditors ride the wave of price appreciation, Uncle Sam’s seawall of red ink continues to grow. This morning, the Treasury department announced updated marketable borrowing estimates for the third quarter, increased to $443 billion from $159 billion in April. That change is mostly attributable to the prospective lifting of the debt ceiling and accompanying rise in the Treasury’s cash balance, but the upcoming supply deluge might give UST bulls pause. Mark Cabana, head of U.S. short rates strategy at Bank of America Corp. summed it up: “It’s going to get hot and heavy in coming weeks and the market needs to be prepared for that.”
Recap July 30
Stocks fell slightly for a second day, continuing the pullback from Friday’s high-water mark close, while Treasury yields ticked a bit lower across the curve. WTI crude finished above $58 a barrel for the first time in two weeks and gold rose to $1,431 an ounce. The VIX caught another bid, settling near 14 to sit higher by 13% so far this week.
- Philip Grant
Monday, July 29, 2019
You can't do that to our pledges!
Buyer beware
The London Stock Exchange Group plc. today confirmed reports
The London Stock Exchange Group plc. today confirmed reports
Auditing Potemkin village
Recap July 29
You can't do that to our pledges!
This morning, timeshare vacation rental company Diamond Resorts International, Inc. announced it has obtained preliminary injunctions against five companies “accused of defrauding Diamond Resorts customers by falsely claiming to be associated with Diamond and then charging fees to unlawfully ‘rent’ Diamond vacation points on their behalf.” The company was purchased by Apollo Management in June 2016.
For more on Diamond’s business practices, see the Dec. 11, 2015 edition of Grant’s.
Buyer beware
The London Stock Exchange Group plc. today confirmed reports that it was in talks to buy financial data company Refinitiv, Inc. for $27 billion, including the assumption of debt.
The Blackstone Group, Inc.’s investment in Refinitiv, which was partially spun out from Thomson Reuters last year, is playing out quite nicely for the p.e. giant, with Bloomberg reporting today that the carrying value of the financial data business has nearly doubled in just 10 months.
While Blackstone is sitting pretty, the historical track record might give the LSE pause. Near the peak of the last cycle in November 2006, Blackstone acquired Equity Office Properties, then the largest publicly-traded owner and manager of office buildings in the U.S. Blackstone soon thereafter flipped portions of EOP’s portfolio, including seven buildings in New York to Macklowe Properties. Needless to say, that didn’t work out too well for Macklowe with the Great Recession looming: all seven were later seized by creditors, plus four of Macklowe’s non-Blackstone buildings.
Auditing Potemkin village
Whack-a-mole continues in the Middle Kingdom. Over the weekend, three separate state-owned Chinese banks announced an agreement to each buy “at least” 17% of Bank of Jinzhou Co., Ltd. (416 on the Hong Kong exchange). The bank, which has RMB 748 billion ($112 billion) of assets as of June 30, 2018, has seen its shares suspended since April, made the sale at a roughly 40% discount to its last closing price, per Bloomberg. The deals were completed with “support and guidance of the local government and financial supervising authorities,” according to a statement from the Bank of Jinzhou.
The trouble at Bank of Jinzhou (predicted by China expert Carl Walter on the July 5 Grant’s Current Yield podcast) follows the takeover of Baoshang Bank Co., Ltd. and represents the latest evidence that something is not right in the world’s second-largest economy. China’s reported GDP growth rate in the second quarter fell to its lowest since at least 1990, while June industrial profits dropped 3.1% year-over-year, a figure which analysts at Bloomberg Intelligence suggest “may understate the magnitude of the deterioration.”
Problems reach beyond a shaky banking system and weak macro data. Reuters reported Friday that China Construction Bank Corp. has agreed to cough up RMB 2 trillion ($291 billion) worth of “comprehensive financial support” for the Hunan province over the next five years. The region, located in the central part of the country, has seen its financial condition deteriorate to the point where the city of Leiyang “did not have enough money to pay its civil servants” in May, according to local media. As noted by prof. Christopher Balding on Twitter, the bailout represents slightly more than half of the region’s GDP.
While growth wanes and signs of trouble continue to appear across the financial system, China’s capital markets got a boost with last week’s debut of the Star Market, a science and tech-focused stock exchange styled after the Nasdaq. But as reported today by Yicai Global, China’s Securities Regulatory Commission on July 26 suspended 43 IPOs and refinancings (including some on the Star Market) while it investigates allegations that auditor Ruihua Certified Public Accountants falsified company information.
The regulators accuse Ruihua-audited chemical maker Kangde Xin Composite Material Group Co,. Ltd. of inflating profits by RMB 11.9 billion from January 2015 to December 2018. During that period, the company reported RMB 14.6 billion in adjusted gross profit and RMB 6.2 billion in net income. Ruihua, China’s second-largest auditor, inspecting the books of almost one-third of publicly-traded companies.
It takes a village.
Recap July 29
A sleepy summer session saw stocks wilt lower, while Treasurys caught a modest bid. Gold rebounded to $1,426 per ounce, and WTI crude settled at $57 a barrel. The VIX finished green but remained below 13.
- Philip Grant
Friday, July 26, 2019
What does he know about safety?
Financing secured
Easy come easy go
From the Rio Times:
From the Rio Times:
For whom the bell tolls
This afternoon, T-Mobile U.S., Inc won approval
This afternoon, T-Mobile U.S., Inc won approval
Recap July 26
What does he know about safety?
Capt. Chelsey Sullenberger, on Twitter:
Tesla announced the launch of so-called “full self-driving” features that are largely unregulated as soon as this year. This should concern everyone who will share the same streets as a driver or pedestrian.
Financing secured
SoftBank Group Corp.’s Vision Fund 2 is off and running, as the company announced commitments from a who’s who of investors, including Apple, Inc., Microsoft Corp. and Kazakhstan’s sovereign-wealth fund.
The only problem, per The Wall Street Journal:
Some of the companies named in SoftBank’s news release said talks were at an early stage. An official at one said it hadn’t given SoftBank an amount it was ready to invest and said it had to sign the memorandum of understanding so it could get a close look at the fund’s term sheet.
Easy come easy go
From the Rio Times:
In a heist, straight from a movie plot, a Brazilian gang drove onto the runway of a São Paulo airport well disguised as Federal Police and left with 123 million Brazilian Reais (US$ 32 Million) in gold.
The thieves managed to gain access to Cumbica airport Thursday, July 25th, in two trucks identical to those driven by the Federal Police; featuring exact copies of the lights, stencils, and logos of the law enforcement agency.
As Brazilian bandits covet the yellow metal, the stewards of monetary policy take a more relaxed approach. This morning, the European Central Bank announced it will not renew a 1999 agreement with its constituent national central banks that had limited sales of the money of kings.
For whom the bell tolls
This afternoon, T-Mobile U.S., Inc won approval from the Justice Department for its $26.5 billion acquisition of Sprint Corp., marking another step on the long-running regulatory odyssey. The next step for the pair: a lawsuit from a coalition of state attorneys general.
As the domestic wireless industry remains in limbo, an industry juggernaut continues to transform. On Wednesday, AT&T, Inc. (T on the NYSE) reported second quarter results, featuring $44.96 billion in revenues and $15.04 billion in adjusted Ebitda, compared to consensus estimates of $44.74 billion and $15.07 billion, respectively. The company also reiterated its full-year earnings growth forecast and CEO Randall Stephenson suggested a stock buyback might be in the cards.
On the bearish side of the ledger, the video unit, saw a hefty 946,000 net subscriber loss, far worse than the expected 586,000 loss. AT&T also lost 154,000 monthly wireless customers, worse than the 40,000 consensus retrenchment. Thanks to mega-deals including $67 billion for DirecTV, Inc. in 2014 and $110 billion for Time Warner, Inc. in 2018, Baa2/triple-B-rated AT&T carried some $223 billion in net debt as of June 30, inclusive of pension liabilities, accounting leases and working capital deficit; that’s down from just under $250 billion last fall.
That still-fearsome debt load and subscriber trends going in the wrong direction are causes for concern to Craig Moffett, co-founder and one-half eponym of telecom research firm MoffettNathanson, LLC (which rates T shares “neutral”):
Despite a business that looks, on the surface, to be almost monotonously stable – neither revenue nor EBITDA is either growing or shrinking much – AT&T’s business is in constant flux. It’s hard to imagine that this stability will last…
But, financially at least, AT&T is delivering on its stated priority: debt reduction above all else.
Yet the quarter was enough to strengthen the conviction of some T bulls. Jeff Middleswart, president at research firm Behind the Numbers, LLC, tells Grant’s today that the company’s relatively undemanding valuation (enterprise value stands at just over seven times consensus 2019 Ebitda) and sturdy cash flows allow for room to maneuver:
2019 free cash flow will be $28 billion, that was helped by securitizing Warner receivables for $2 billion. That won’t recur. So make the starting point $26 billion. Eliminate $30 billion in debt this year – that’s $1 billion in higher cash flow via reduced interest in 2020. Reduce capex by $2 billion as projects are completed in 2019; free cash flow goes to $29 billion before other revenue growth (decay) and cost savings. In 2021, we expect $31 billion.
The dividend is $15 billion, the coverage there is improving and is an attractive 6% yield. There is basically another $15 billion to play with to retire more debt and grow future cash flow via lower interest expense or retire stock and reduce the $15 billion total dividend payment. There is no pressure to repay debt as rapidly as 2019 either. The goal is probably another $20 billion paid down over 3 to 4 years – the cash to do that is definitely there.
Middleswart concludes:
To me, the margin of safety is increasing. There are warts here, there is no doubt. But, I’m looking at a $150,000 sports car that someone knocked the mirror off driving it out of the show-room that is marked down to $56,000 and I have to take on the repair bill to replace the mirror.
The bulls and bears have had their say. For more on the telecom-cum-entertainment behemoth, see the Jan. 25 edition of Grant’s.
Recap July 26
Another blistering rally left the S&P 500 higher by nearly 2% for the week and 21% year-to-date, as the bulls can seemingly do no wrong at the moment. Gold managed to eke out a modest gain and WTI crude held at $56 a barrel, and Treasury yields inched lower. The VIX closed just above 12, its lowest weekly finish since April.
- Philip Grant
Thursday, July 25, 2019
Keep digging
Today, the European Central Bank held a stand-pat meeting,
Today, the European Central Bank held a stand-pat meeting,
Yellow light
As we close out month 121 of the longest economic expansion on record,
As we close out month 121 of the longest economic expansion on record,
QT Progress report
Recap July 25
Keep digging
Today, the European Central Bank held a stand-pat meeting, keeping the benchmark deposit rate at negative 40 basis points. However, ECB president Mario Draghi indicated that rate cuts and a resumption of asset purchases are on tap for September. In the accompanying presser, the outgoing ECB chief captured the mood of central bank-levitated markets, stating that: “it’s difficult to be too gloomy today,” while the outlook “is getting worse and worse.” The German 10-year yield traded as low as negative 42 basis points, briefly crossing below the 40 basis point deposit rate.
While sovereign debt holders continue to rack up mark-to-market gains, not everyone is enamored with the prospect of still-more negative interest rates. “We already have a devastating interest rate situation today, the end of which is unforeseeable,” Peter Schneider, who represents banks in the south-eastern German state of Baden-Württemburg, told Bloomberg yesterday. “If the ECB aggravates this course, that would hit not only the entire financial sector hard, but especially savers.”
Meanwhile, policymakers down under attempt to quantify the practical limits of negative policy rates. In a paper written to New Zealand finance minister Grant Robertson in January and recently released to the public, staffers in the Treasury Department concluded: “The Reserve Bank expect rates could only fall at most 35 basis points below zero before risking the hoarding of physical cash.”
Today, the global stock of negative-yielding debt rose to $13.74 trillion, a new record.
Yellow light
As we close out month 121 of the longest economic expansion on record, let’s take a look at the state of U.S. corporate credit. Year to date, investment-grade bonds have generated a whopping 12.3% total return, while high-yield has returned 10.6%. Leveraged loans have lagged far behind, with the LSTA Index gaining just 3.3% so far this year.
That standout performance from investment-grade comes as fears of an economic slowdown percolate, while the Fed’s dovish turn has raised the relative value proposition for fixed rate IG and high-yield bonds over floating-rate loans. U.S. leveraged loan funds saw a $446 million outflow for the week ended July 17 according to Lipper, extending the streak of withdrawals to 35 straight weeks.
As loan demand cools, yields for the most creditworthy portion of collateralized loan obligations (which purchase and securitize leveraged loans; see the Sept. 7, 2018 edition of Grant’s for more) continue to climb. According to S&P’s LCD unit, spreads of triple-A CLO tranches reached a post-crisis low of 93 basis points above Libor in March, from 130 basis points in February 2017. Since then, they have reversed higher, with the index rising to 109 basis points in May, while some recent issues have come in well above that. Oaktree Capital Management L.P.’s CLO 3 triple-A tranche priced at 128 basis points above Libor on July 17, and Pikes Peak CLO 4 saw its triple-A slice set at 137 basis points over Libor on July 12.
While high yield has enjoyed a gangbusters 2019, investors have retained some reticence, as a Bloomberg story from July 18 notes that buyers are prioritizing “large, liquid issues as the economy slows. That defensive posture has led to oversubscribed offerings from higher-rated and well-known borrowers.” Sure enough, the triple-C-rated cohort of the high-yield index has lagged the group, logging a year-to-date gain of 7.6%. Despite that quasi-defensive posture on the part of investors, high-yield remains “extremely overvalued,” according to an analysis yesterday from Marty Fridson, chief investment officer of Lehmann Livian Fridson Advisors LLC.
In an investor letter circulated today, Greenlight Capital founder and president David Einhorn concurs, revealing that his fund has taken a short position against U.S. corporate credit:
Over the past few years, corporate debt has expanded dramatically, while covenant packages and other bondholder protections have weakened considerably.
Rating agencies have been complacent and allowed debt to Ebitda and debt to equity ratios to deteriorate without a corresponding reduction in credit ratings. Meanwhile, we are a decade into an economic recovery and there are signs the economy may be slowing.
QT Progress report
The Fed’s portfolio of securities held outright registered at $3.618 trillion this week, down $5.5 billion sequentially and $14.5 billion below the trailing four-week average. Mortgage-backed securities accounted for all of the weekly decline and about two thirds of the run-off compared to the trailing four-week figure.
Since the Oct. 1, 2017 beginning of QT, total balance sheet assets are down by 14.6%, for a simple annualized pace of 8.3%.
Recap July 25
Stocks lost ground, with the S&P 500 falling 50 basis points to narrow its gains for the week to less than 1% with one session remaining. The VIX popped back toward 14 and gold extended its recent pullback to sink to $1,415 an ounce while WTI crude held at $56 a barrel.
Treasurys came under notable pressure, with the 10-year yield rising back to 2.08%. This afternoon’s seven-year auction priced well higher than the when-issued, marking the third straight poor auction following similar softness from two- and five-year note offerings earlier this week.
- Philip Grant
Tuesday, July 23, 2019
Chapter two: The next chapter
SoftBank Group Corp. (9984 on the Tokyo Stock Exchange), is set to launch a sequel to its $103 billion Vision Fund (the world’s largest venture capital pool), according to a Bloomberg report today. Saudi Arabia’s Public Investment Fund is likely to kick in a similar sum to the $45 billion it contributed last time. That prospective fundraising success follows a heady period for the Vision Fund, which reported a 62% mark-to-market return through June.
For SoftBank CEO Masayoshi Son, the debut of Vision Fund 2 represents another step in his long game of technological investment. Son told Barron’s over the weekend that he sees his investments playing out over a 300 year horizon, explaining:
There were many long dynasties in Asia. We’re creating an ecosystem that can last for a long time. That’s what I’m interested in. The industrial revolution started a few hundred years ago, and still is an important part of modern life. The information revolution will last for the next few hundred years. We’re looking at the long horizon to design the architecture of our ecosystem to last, not just for my life.
A series of IPO “graduations” is further good news for the first Vision Fund, with portfolio companies such as Uber Technologies, Inc. and Slack Technologies, Inc. making their public debuts recently, while WeWork Cos., Inc. is working towards coming public later this year. Son even floated a public offering for the Vision Fund itself in May.
More bullish news comes in the form of reports that the 84% SoftBank-owned Sprint Corp. will soon see its merger with T-Mobile U.S., Inc. approved by the Justice Department, a step towards removing a major potential overhang as Sprint would have potentially needed to undergo debt restructuring without that deal.
SoftBank bulls point to Son’s golden touch (he bought a 29% stake in Alibaba in 1996 for $20 million; that position is now worth $134 billion). Chris Lane, analyst at Bernstein Research, told Barron’s that: “Masa is probably better at this than anyone, in most cases getting in early enough that the investments will ultimately prove to be value-creating.”
Barron’s, too, takes a bullish stance: “Investing in SoftBank Group offers a radically discounted bet on the future. The stock is cheap. Crazy cheap.” On a sum-of-the-parts basis, the investment weekly deems SoftBank shares to be undervalued by 30% to 50%.
Grant’s sees things differently, deeming SoftBank “the epitome of the cycle,” in the Dec. 15, 2017 issue. That imputed discount reflects carrying values (frequently driven higher by the Vision Fund itself) for illiquid, largely money-losing technology startups, not all of which will turn out as happily for the bulls as Alibaba. Then, too, the company has been selling cash-generating but slow growth assets like a 33.5% stake in domestic telecom subsidiary Softbank Corp. and selling a $4 billion stake in Yahoo! Japan Corp. to that telco unit, to continue its shopping spree. SoftBank announced another $3 billion investment in WeWork in January and a €900 million ($1 billion) in Germany’s Wirecard A.G., a hotly contested name among shorts, three months later.
Leverage looms larger in the SoftBank story than might be expected. The company, which carries some $40 billion in net debt, reported $10 billion in consolidated operating income in the fiscal year ended March 31 with $6.5 billion of that sum attributable to the domestic telco group. But said telco unit’s free cash flow (i.e. funds available to shareholders) footed to just $2.6 billion. The subsidiary, SoftBank’s most important on a cash flow basis, features net leverage of 5.2 times Ebitda and a premium valuation featuring enterprise value of 6.9 times forward Ebitda, above the 6.1 times and 4.9 times Ebitda for peers NTT DoCoMo, Inc. and KDDI Corp., the number one and two players in Japan, respectively (SoftBank Corp. is third).
A follow-up in the May 17 edition of Grant’s concluded: “Thus, absent a path to solid profitability for its numerous unicorns, SoftBank is leveraged to the goodwill of the capital markets.” Since that original salvo, SoftBank shares are up by 20%, while the dollar-denominated 6% perpetual notes have declined to 96 from 99.
The show goes on.
Recap July 23
A strong bid in equities pushed the S&P 500 back above 3,000 at the close, up nearly 20% year-to-date. Treasury yields moved higher across the board following a relatively weak two-year auction this afternoon, while energy finished green and gold lost a bit less than 1% to settle at $1,417 an ounce. The VIX was pummeled for a second straight day to fall to near 12.5.
- Philip Grant
Monday, July 22, 2019
Technical analysis
From the Daily Beast:
From the Daily Beast:
Hello Neumann
With the stock market near all-time highs and money losing IPOs seemingly coming to market daily,
With the stock market near all-time highs and money losing IPOs seemingly coming to market daily,
Modern monetary medicine
Let the bloodletting commence.
Let the bloodletting commence.
Recap July 22
Technical analysis
From the Daily Beast:
Canadian police held a somber press conference this weekend to deliver details on a double homicide, but viewers tuning in on Facebook Live were left baffled: The police officer speaking about the slaying was shown with cat ears and whiskers.
The Royal Canadian Mounted Police in British Columbia later explained that an “automatic setting” on Facebook Live had accidentally been switched on. . . After re-recording the entire press conference minus the “cat filter,” Sgt. Janelle Shoihet apologized for the “technical difficulties” viewers experienced the first time around.
Hello Neumann
With the stock market near all-time highs and money losing IPOs seemingly coming to market daily, it’s the deals that don’t happen which are sometimes more notable.
The Real Deal notes today that brokerage Rudin Management Co. spooked some landlords with stark language describing co-working giant WeWork Cos., Inc. In an offering document for 110 Wall Street, which is fully leased to WeWork, Rudin cautioned would-be buyers: “Given the single-tenant nature of 110 Wall Street, the outcomes of the asset are binary.” The management company has since pulled the property off the market, choosing to retain ownership. Signed in 2013, the WeWork lease runs for 22 more years.
As WeWork (which sports a $47 billion valuation and lost $1.9 billion last year on $1.8 billion in revenue) prepares for a potential IPO later this year, CEO Adam Neumann eyes the exit. On Thursday, The Wall Street Journal reported that Neumann “has cashed out more than $700 million from the company.” While that move might suggest limited confidence in his business’s future, Neumann’s camp counters: “his borrowings against some of his WeWork shares indicate that he is bullish on the company’s long-term prospects.”
Nothing like margin debt for building confidence.
Modern monetary medicine
Let the bloodletting commence. A headline in today’s Financial Times: “[Jerome] Powell seeks a cure for the disease of low inflation.” As James Politi writes, the Fed chair has “warned Congress that downbeat prices could lead to an ‘unhealthy dynamic’ of lower interest rates and less room to act in a downturn.”
The source of Powell’s angst: The core (excluding food and energy) personal consumption expenditures (PCE) deflator, the Fed’s preferred indicator, rose 1.6% year-over-year in May, below the central bank’s “price stability” goal of a 2% rise. Of course, it’s all relative. The core Consumer Price Index has registered at or above 2% for 15 straight months, while headline CPI has compounded at a 3.1% rate since the Fed’s chartering in 1913.
But as Powell et.al fret over an insufficient pace of purchasing power erosion, one scholar questions the very premise of the Fed’s definition of “price stability.” Alex J. Pollock, distinguished senior fellow at the R Street Institute in Washington, reviewed pertinent materials, including the 1977 Federal Reserve Reform Act and the 1978 Humphrey-Hawkins legislation (which established the Fed’s dual mandate) to determine the provenance of that 2% inflation target within the context of “price stability.” His findings, documented in the July 13, 2018 edition of Grant’s, are summarized below:
The Federal Reserve Reform Act of 1977, for one, does not say “price stability,” as Pollock notes: “It does in particular not say ‘a stable rate of inflation.’ It says, ‘stable prices.’ Does the term ‘stable prices’ mean perpetual inflation? What did Congress mean by ‘stable prices’ when it put that term into law?”
Humphrey-Hawkins, enacted the next year in response to the abomination of double-digit inflation with accompanying high rates of joblessness, foreign-exchange tumult, fiscal disarray, etc., committed the government to promote, among other blessings, “full employment, production, and real income, balanced growth, adequate productivity growth, proper attention to national priorities, and reasonable price stability.”
The law established goals for unemployment (3% or less among individuals aged 20 and up) and inflation (not more than 3%) by the fifth anniversary of the first economic report required by the act, i.e., by 1984. That was just for openers. By 1988, the 10th anniversary of the act, the government was to have achieved “a rate of inflation of zero per annum.”
Of course, things turned out differently. In 1988, 10 years after the passage of Humphrey-Hawkins, the CPI rose by 4.4%. In Congressional testimony that year, Fed chair Allan Greenspan made no mention of that zero-inflation goal. Eight years later came a formative exchange between Greenspan and future Fed chair Janet Yellen, recounted by the New York Times in 2013:
[Greenspan] saw a chance for the first time in decades to drive annual inflation all the way down to zero, achieving the price stability he had long regarded as the central bank’s primary mission.
But Janet L. Yellen, then a relatively new and little-known Fed governor, talked Mr. Greenspan to a standstill that day, arguing that a little inflation was a good thing.
So, 41 years after the Humphrey-Hawkins act, how do we read the Fed shoehorning a 2% target into reasonable price stability? “A kind of smokescreen, a convenient legislative excuse for the Fed to do what it would have done anyway,” Grant’s wrote last year.
Recap July 22
Stocks floated higher, with the S&P 500 extending its year-to-date advance to 19%. Energy prices rallied with WTI rising back above $56 a barrel, while gold held at $1,425 an ounce. Treasurys caught a modest bid, with the 10-year yield falling below 2.05%, and the VIX closed at session lows near 13.5.
- Philip Grant
Friday, July 19, 2019
What we have here is a failure to communicate
Following yesterday’s remarks from New York Fed president John Williams,
Following yesterday’s remarks from New York Fed president John Williams,
Talking his book
BlackRock, Inc. (BLK on the NYSE) reported second quarter results this morning,
BlackRock, Inc. (BLK on the NYSE) reported second quarter results this morning,
Recap July 19
What we have here is a failure to communicate
Following yesterday’s remarks from New York Fed president John Williams, who moved markets by suggesting a more-dovish FOMC than had been widely expected, the New York Fed press office walked his statements back:
This was an academic speech on 20 years of research. It was not about potential policy actions at the upcoming FOMC meeting.
That pronouncement was news to Bloomberg, which listed yesterday’s event: “Williams speaks on Monetary Policy.” Interest rate futures were similarly taken aback, with Bianco Research noting that the odds of a 50 basis point rate cut on July 31 fell below 20% this afternoon after jumping to 70% yesterday from 34%.
Anyway, the Fed now enters its quiet period ahead of the FOMC’s July 31 rate decision. That well-earned breather follows at least 12 speeches from at least eight Fed presidents over the past week, plus Wednesday’s release of the Beige Book.
Money talks – but this?
Talking his book
BlackRock, Inc. (BLK on the NYSE) reported second quarter results this morning, continuing the financial behemoth’s impressive asset collection. Fixed income inflows were characterized as “blockbuster” by Bloomberg, jumping to $110 billion from $26.4 billion year-over-year. That pushed total inflows to a record $151 billion and assets under management to $6.8 trillion from $6.3 trillion a year ago. Although revenues of $3.5 billion and net income of $1 billion represented year-over-year declines of 2% and 7%, respectively, BLK shares finished little changed and sit higher by 21% year-to-date. Since a bearish analysis in the Sept. 30, 2016 edition of Grant’s, BLK is up 31%, compared to 37% for the S&P 500.
Needless to say, the breakneck growth in indexation and ETF have been a boon to New York-based BlackRock, the world’s largest asset manager. The problem: How much is left to conquer? According to a June 28 research note from J.P. Morgan strategist Dubravko Lakos-Bujas, 60% of U.S. equity assets are already parked in passive management vehicles, with quantitative funds controlling another 20%.
But as demonstrated by the contraction in revenues and earnings despite AUM growth, fee compression looms large, as BlackRock’s operating margin slipped to 36.3% from 39.9% a year ago. Kyle Sanders, analyst at Edward Jones, commented: “The fee rate continues to tick down and that’s something that they’re going to have to outrun. You just have to grow faster, and for the most part they’re able to do that.” Kevin Duffy, principal at Bearing Asset Management and longtime BlackRock bear, points out the erosion in iShares’ profitability in the following chart:
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iShares quarterly revenue as a percentage of prior quarter AUM. Source: Bearing Asset Management.
Management commentary likewise suggests that compression is a sore subject. On June 13, managing director and head of Latin America Armando Senra told the press that BlackRock is fighting the low-cost migration: “There’s too much emphasis purely on cost. We don’t talk enough about quality. That’s not to say we’re not going to be competitive – we have to be competitive, this is a competitive industry – but I would move away from just a low-cost conversation.”
BLK’s cost conversation is indeed taking place at a whisper. On April 8, Bloomberg reported that the company cut fees on its corporate bond ETF. “But rather than shout about the move, the discount was announced without fanfare – in a footnote on page 94 of a revised filing last month.” Other players have been less reticent. On Tuesday, Fidelity announced the creation of four equity index funds charging five basis points, undercutting the Vanguard Group which charges six to 19 basis points on similar offerings.
How might BlackRock weather a bear market alongside ongoing fee compression? Just under 65% of the company’s total assets under management are invested in index funds or iShares ETFs. At the same time, base management fees accounted for 84% of BLK revenues for the first six months of the year. An interruption to the ongoing asset price levitation would spell trouble for BLK.
As for his reaction to that yet-unseen day, CEO Larry Fink may have provided a preview this morning. Appearing on CNBC, the BlackRock boss called for the European Central Bank to further ramp its policy accommodation: “If the ECB is really going to try to re-stimulate the economy in Europe, they are going to have to buy equities.”
Recap July 19
Stocks came under pressure, with the S&P 500 finishing the week with a 1.1% decline. While Treasury yields rose with the short end underperforming as expectations of a 50 basis point rate cut largely evaporated. This afternoon’s news that Iran seized a British oil tanker in the Straight of Hormuz spurred a bounce in oil prices with WTI rising above $56 a barrel, while gold pulled back more than 1% to finish at $1,425 an ounce. The VIX finished at 14.25, the high of the day.
- Philip Grant
Thursday, July 18, 2019
Fake cruise
From Motor1.com:
From Motor1.com:
He said he said she said
Three's a crowd
Business is booming for a titan of private equity.
Business is booming for a titan of private equity.
QT Progress report
Recap July 18
Fake cruise
From Motor1.com:
The Civil Police of Santa Catarina, Brazil closed a clandestine factory in the city of Itajaí alleged to be building replica Ferrari and Lamborghini models. Police discovered eight replicas in the workshop, part of a counterfeiting scheme denounced by the two Italian automakers.
The copies were sold for between 180,000 and 250,000 Brazilian Reals ($47,774 and $66,353 at current exchange rates). The shop used old car parts and other poor-quality materials, and the vehicles were made to order.
“In one of the vehicles, they were installing the engine of an [Chevrolet] Omega,” said delegate Angelo Fragelli, who was responsible for the operation, in an interview with Folha de São Paulo newspaper.
He said he said she said
On Tuesday, Chicago Fed president Charles Evans weighed in on the direction of the funds rate:
There is an argument that if I think that it takes 50 basis points before the end of the year to get inflation up, then something right away would make that happen sooner.
This afternoon, New York Fed president John Williams concurred, declaring the (unobservable) “neutral rate of interest” to be just 0.5% and advocating “swift action” to “keep interest rates lower for longer.”
Esther George of the Kansas City Fed sees things differently, telling reporters today:
When I look at the current settings for monetary policy, my own outlook suggests we will continue to see growth in the economy around or slightly above the trend rate of growth, we see an unemployment rate at a 50-year low and continued job gains as recently as the most recent employment numbers.
Across all of these parameters, inflation has remained low and stable. So for me that suggests we are in a good range in terms of thinking about monetary policy.
All three are voting members of the Federal Open Market Committee, which is scheduled to reach its next interest rate decision on July 31. George’s stand-pat inclination aside, interest rate futures price 100% odds of a cut, with traders expecting the Fed will lop either 25 or 50 basis points from the funds rate.
Three's a crowd
Business is booming for a titan of private equity. This morning, The Blackstone Group, Inc. announced that year-to-date capital inflows have reached $88 billion, putting the firm on pace to blow past a prior $100 billion fundraising target for 2019. Total assets under management rose by 24% year-over-year to $511 billion, including $150 billion in cash.
It’s been a charmed cycle to be sure for Blackstone, the subject of numerous bullish Grant’s analyses beginning in the Oct. 7, 2011 issue (BX shares have since generated a 480% total return assuming dividend reinvestment, compared to 203% for the S&P 500).
As Stephen Schwarzman’s powerhouse builds its war chest, the rest of the p.e. industry scrambles to keep up. According to Preqin’s Second Quarter Update, total fundraising across the industry stood at $109 billion, little changed year-over-year, but with just 244 funds reaching a final close, down from 399 in the second quarter of 2018.
The narrowing band of successful fundraisers isn’t dissuading new entrants, as the number of p.e. funds coming to market reached 3,951 in June, up 5% from January and a whopping 72% above the Jan. 2018 figure. At the same time, total targeted funds stood at $981 billion, little changed from January and up 32% from Jan. 2018. Notes Preqin, “this represents two years’ supply at 2018 fundraising levels, showing how crowded the fundraising market is.”
Other market mainstays eye their own entrance into the fray. On June 23, The Wall Street Journal reported that indexing giant the Vanguard Group “is evaluating partnerships to make a mix of private-equity funds available to Vanguard clients.”
As new entrants pile in, a political threat to the p.e. machine steps forward. Today, Senator Elizabeth Warren (D-MA) issued a broadside in the form of various proposals, including restrictions against so-called sale leasebacks, an end to the extraction of “transaction fees” from target companies and limitations on leverage that can be used to finance transactions. Warren commented:
For far too long, Washington has looked the other way while private equity firms take over companies, load them with debt, strip them of their wealth, and walk away scot-free — leaving workers, consumers, and whole communities to pick up the pieces.
Presidential hopeful Warren currently stands at 21% odds of winning the Democratic nomination on political betting site PredicIt, just behind Joe Biden and Kamala Harris at 23% and 22%, respectively. For in-depth analyses of other risks to the private equity boom, see the July 12 and Aug. 10, 2018 editions of Grant’s Interest Rate Observer.
QT Progress report
The Fed’s portfolio of securities held outright came in at $3.62 trillion, down $7 billion from a week ago and $18.4 billion below its trailing four-week average. Mortgage-backed securities accounted for about 80% of the sequential drop, while the decline from the four-week average was largely split between Treasurys and MBS.
Since the Oct. 1, 2017 introduction of QT, total balance sheet assets are down by 14.5%, for a simple annualized pace of 8.3%.
Recap July 18
Stocks rose a bit, with the S&P 500 narrowing its weekly loss to 0.6% with one session left. Treasurys saw bull steepening action as the short end caught a strong bid while the long bond finished slightly in the red, while gold and WTI crude continued to diverge, jumping to $1,445 an ounce and slumping to $55.5 a barrel, respectively. The VIX finished at 13.5.
- Philip Grant
Wednesday, July 17, 2019
The Wire
Yesterday, California governor Gavin Newsom signed Assembly Bill 1054,
Yesterday, California governor Gavin Newsom signed Assembly Bill 1054,
Recap July 17
The Wire
Yesterday, California governor Gavin Newsom signed Assembly Bill 1054, establishing a $21.5 billion wildfire relief fund and setting a June 30, 2020 deadline for fallen utility PG&E Corp. (PCG on the NYSE) to emerge from bankruptcy in order to participate. PG&E, which was found liable for a series of 2017 and 2018 blazes including the Camp Fire (which killed 85 people and destroyed the town of Paradise), entered Chapter 11 on Jan. 29. Investors have kept their hopes up for a swift return to business as usual, as the company still commands a $9.8 billion market cap.
There is reason for that optimism. The new legislation will allow utilities to choose between accessing designated liquidity and insurance funds which allow for fire cost coverage. While PG&E cannot participate in the scheme until it emerges from bankruptcy, analysts at Bloomberg Intelligence note today that PG&E shareholders “would face significantly less downside” if the company can achieve various safety certifications and make the necessary payments to buy in to the insurance fund post-bankruptcy.
As noted by The Mercury News yesterday, “as much as some legislators may have wanted to roundly punish bad actors among California’s electricity providers, they were mindful that even a slap on the wrist to utilities could have the unintended impact of a punch in the nose to consumers.”
But will PG&E investors avoid the proverbial knuckle sandwich? In its most recent 10-Q filing on March 31, the company disclosed $14.2 billion in existing wildfire-related liabilities. In testimony concurrent with the filing, CFO Jason Wells estimated that figure could end up topping $30 billion.
The clock is ticking for future liabilities, as claims from any new wildfire damages would take precedence over existing liabilities. A study released Sunday by the journal Earth’s Future finds that: “During 1972–2018, California experienced a five-fold increase in annual burned area, mainly due to more than an eight-fold increase in summer forest-fire extent.”
Media scrutiny continues apace. Last Wednesday, The Wall Street Journal reported that company executives were aware of problems with transmission lines that were eventually responsible for the Camp Fire, yet “repeatedly failed to perform the necessary upgrades.” In addition, PCG estimated in 2017 that its transmission towers were 68 years old on average (already above the mean life expectancy of 65 years), with some as old as 108.
The company is no stranger to bad press surrounding environmental disaster and big payouts. In 1996, PG&E was forced to pay $333 million to settle claims it dumped more than 350 gallons of chemically-poisoned water into ponds near Hinkley, Calif., an episode memorialized in the 2000 film Erin Brockovich.
It might be harder to shake the wildfire legacy costs than the bulls reckon. In a bearish analysis of PG&E in the Feb. 22 edition of Grant’s, Angelo Thalassinos, the deputy managing editor at Reorg Research, Inc., noted that the Camp Fire may act as a millstone around PCG for years to come.
The thing that jumps out at me, and the distinction here from other mega cases, is the damages and liabilities from the wildfires. It most harkens back to old Chapter 11 cases that had asbestos liabilities. . . . There is potential for continuing damages from that respect throughout the bankruptcy case and even post-emergence.
In the five months since our report, PCG shares have treaded water, lagging the 8.3% total return from the S&P 500 Utilities Index over that period. But the company’s debt has fared well, with the senior unsecured 6.05% notes of 2034 rallying to 111 cents on the dollar (from 93 in February), for a 283 basis point pickup over Treasurys.
That performance disparity seemingly reflects the unfolding political situation. On Friday, The Journal reported that creditors led by Elliott Management Corp. petitioned California lawmakers for bondholder-friendly tweaks to the bill, including allowing PG&E to issue debt to pay future wildfire claims but not existing liabilities, such as from the Camp Fire. As noted by the WSJ: “Legislators ultimately sided with bondholders on the issue.”
Victory in court for that Elliott-led bondholder group would likewise spell trouble for shareholders. Creditors have proposed injecting up to $18 billion into PCG, in return for control of the company. A court hearing at which Elliott et al. will present their arguments is scheduled for July 23.
With PCG continuing to sport a substantial market cap, investors may be underestimating the risks. That Feb. 22 Grant’s analysis broke down the pertinent numbers, concluding:
To the equity holders, it’s a daunting figure. Wildfire claims of just $10 billion (around a third of the CFO’s estimate) would impair the equity— assuming that PG&E’s asset base is not overstated through overly long depreciation schedules.
Even prior to the recent disaster, PCG’s shareholder economics looked less than compelling. From 2013 to 2018, the company generated $25.5 billion in operating cash flow, well shy of the $31.9 billion in capital expenditures over that period. In his Jan. 31 affidavit, CFO Wells forecast that cash from operations will lag capex by an additional $1.6 billion per year in 2019 and 2020. Even after suspending its dividend in December 2017, post-2013 disbursements to shareholders foot to $4.4 billion, a sum which PCG borrowed to pay.
The utility increased operating earnings to $3 billion in 2017 from $2.3 billion in 2008, while capital employed jumped to $62 billion in 2018 from $30 billion in 2008. James S. Chanos, founder and managing partner of Kynikos Associates L.P. and a PG&E bear, noted to Grant’s in February:
It’s a 2% return on incremental capital. That is below their cost of capital. They are liquidating. The utility is in effect liquidating before your eyes before any wildfire liability.
Recap July 17
Stocks came under pressure, with the S&P 500 finishing at session lows to extend its losses for the week to 1% so far. Treasurys caught a sharp bid, with the 10-year yield dropping back below 2.05%. Energy and metals prices saw a notable divergence, with WTI crude falling below $57 a barrel to extend its slide while gold rose to $1,425 an ounce, its best close since May 2013.
After the bell, Netflix, Inc. surprised the Street by disclosing just over 2 million in net paid subscriber additions for the second quarter, far below the 5 million expected. NFLX shares lost 11% in early reaction.
Tuesday, July 16, 2019
Float upstream
Yesterday, China reported that second quarter GDP growth came in at 6.2% year-over-year according to the National Bureau of Statistics, the slowest pace of output expansion on record going back to 1992. That follows Thursday’s revelation that exports to the U.S. fell by 7.8% from a year ago in June, with overall exports dipping by 1.3% year-over-year.
Of course, the slowdown in China’s self-reported growth rate comes as the Trump trade war shows no signs of cooling off. This afternoon, the U.S. president commented that negotiations “have a long way to go,” and suggested he could levy tariffs on an additional $325 billion of goods. Donald Straszheim, head of China research at Evercore ISI, summed it up: “Trade progress has been in reverse. The two sides are further apart now than in Nov-Dec 2018.”
At the corporate level, rising commercial tensions with the U.S. has caused all sorts of problems. Spencer Fung, CEO of supply-chain manager Li & Fung Ltd. (which manufactures consumer goods in the mainland for multinational corporations like Walmart, Inc. and Nike, Inc.), described the state of China’s factories as: “urgent and desperate. . . Nobody’s investing, nobody’s buying. The trade war is causing people to stop investment because they don’t know where to put the money.”
With reported growth on the wane and local supply chains in disarray, the Chinese Communist Party may need to go back to the well for more stimulus. Elliot Clarke, senior economist at Westpac Banking Corp., wrote:
Over the past year, Chinese authorities have sought to accelerate the economy by increasing credit availability and lowering its cost. Consequently growth in credit has, however, been slow in coming.
Small and medium private firms won’t be able to access capital markets anytime soon, and more work needs to be done before the quality of lending by shadow banking agents can be relied upon. Hence, improved access to credit for small and medium-sized enterprise will have to rely on the banks. Further easing by authorities is therefore a necessity, as are broader liquidity measures to reduce the overall cost of credit.
The problem: As China has relied on debt-fueled fixed asset investment to generate growth, banking assets have ballooned to $39 trillion, compared to a combined $27 trillion for the U.S. and Japan (the world’s largest and third-largest economies, respectively). The consequences of that credit expansion were on full display in May, as the failure of Baoshang Bank, a rounding error in terms of assets, led to the temporary seizing up of China’s repo markets.
The powers that be are looking to prevent wider trouble. On Friday, the National Development and Reform Commission rolled out new rules preventing property developers from taking out foreign currency debt unless used to refinance existing borrowings set to mature in less than one year. In addition, developers have to disclose both the size of the offering and use of proceeds in advance.
While property developers remain on the CCP’s radar, one local government-financing vehicle (LGFV) is reconsidering its options. On Thursday, Bloomberg reported that Tianjin Binhai New Area Construction & Investment Group Co., Ltd. shelved plans to sell a three-year dollar bond. The pulled deal, per Bloomberg, “signals growing investor angst over credit stress in Tianjin, home to several high-profile distressed cases from local state-bonds come due this year.” Tianjin-based LGFVs face a record RMB 114 billion ($16.5 billion) in maturities in 2019.
As China’s economy cools and both public and private entities work to keep their heads above water, tough choices lie ahead. At the spring 2019 Grant’s conference, Russell Napier, independent strategist and founder of the Electronic Research Interchange, predicted that the CCP, which maintains a quasi-peg to the dollar and is a de facto importer of U.S. monetary policy, will eventually seek a cheaper renminbi by allowing the currency to float freely (potentially leading to a 30% to 40% decline in the currency against the greenback, per his estimation).
The choice for Xi Jinping and friends is between a stable exchange rate and reflating the economy. With the producer price index flat year-over-year and M2 money supply growth at a virtual 20-year low, “it is not a good time to have lower cash flow when your debt-to-GDP ratio is at excessively high levels,” notes Napier. The decline in FX reserves to $3.11 trillion from $4 trillion five years ago “indicates that the glory days of undervaluation are over.”
Recap July 16
Stocks took a modest dip as volumes remain muted. The most notable move came from energy, as WTI crude fell nearly 3% to $58 a barrel after signs of easing tension between the U.S. and Iran. Treasury yields ticked higher, and the VIX remained below 13.
- Philip Grant
Monday, July 15, 2019
Get your shinebox
A friend checks in from the Long Island Expressway:
A friend checks in from the Long Island Expressway:
Swamp things
A trio of corporate situations unfolding in Washington, D.C.
A trio of corporate situations unfolding in Washington, D.C.
Recap July 15
Get your shinebox
A friend checks in from the Long Island Expressway:
Our mobile correspondent writes:
The 21st century stock tip from the shoeshine boy is the bus wrapped in an ad touting Sharespost, where anyone can “access the new private market.”
Swamp things
A trio of corporate situations unfolding in Washington, D.C. may have important ramifications for their respective investors. A quick update on each follows:
On Friday, the U.S. Court of Federal Claims dismissed a lawsuit from Oracle Corp. asserting that the Defense Department’s $10 billion Joint Enterprise Defense Infrastructure (JEDI) procurement contract was structured to unfairly favor Amazon.com, Inc.’s Web Services unit. Judge Eric Bruggink ruled that the award has not been marred by “organizational conflicts of interest,” as alleged by Oracle, and that the litigant failed by its own admission to meet the JEDI requirements in the first place.
That decision seemingly clears the way for Amazon and Microsoft, Inc. to vie for the winner-take-all contract, one that has been beset by claims of cronyism related to three former DoD employees with close ties to AWS (Almost Daily Grant’s, April 18).
For AWS, which leveraged a $600 million CIA contract in 2013 to gain commercial deals and represents a critical part of the Amazon success story (the unit chipped in 62% of consolidated operating income in the most recent quarter), the JEDI award would be the proverbial cherry on top. But obstacles remain, as the DoD inspector general and FBI public corruption unit continue a joint investigation of conflicts of interest claims.
Meanwhile, Senator Marco Rubio (R-FL) sent a letter Thursday to national security advisor John Bolton criticizing the single award structure as “contrary to industry best practices, statutory preferences, and the Administration’s Cloud Smart guidelines” and asked for a delay to the award to “ensure a fair and open process.”
Perhaps most importantly, the CIA announced in April it will shift toward a multi-cloud strategy by 2021 as opposed to continuing to exclusively rely on AWS. Of course, Amazon is fighting to protect its turf, signing a $294 million lease for its “HQ2” in Crystal City, VA, up the street from the CIA headquarters in Langley.
Next, the ongoing merger saga involving Sprint Corp. and T-Mobile U.S., Inc. The corporate suitors continue to negotiate the spin-off of wireless assets to Dish Network Corp. in their efforts to secure approval from the Department of Justice (which is forthcoming “any day,” according to Bloomberg). On Thursday, The Wall Street Journal reported that the negotiations are “dragging” and will likely extend beyond the July 29 deadline. Hang-ups include: potential restrictions on Dish flipping the spectrum assets acquired by the pair and limitations on data traffic that Dish can send through the T-Mobile network, per The Journal.
While negotiations continue apace, a coalition of more than a dozen state attorneys general who are suing to halt the merger prepare their next move. On Friday, the Capitol Forum reported that the DoJ delay will allow the group of 14 attorneys general to potentially “request that the Oct. 7 start of the trial be delayed.” Hopes for a timely deal consummation following DoJ approval are up in the air: “If it’s up to the states, a decision in the federal case wouldn’t come for some time.”
Finally, the price-gouging saga involving TransDigm Group, Inc. continues to develop. In February, an audit from the DoD inspector general found that the company charged “excess profits” on 46 out of 47 selected spare parts, including markups of as high as 4,451%.
The company agreed to pay back the $16.1 million in “excess profits” identified in the report, but that hasn’t prevented bipartisan pushback against the TDG business model. On June 14, senior officials at the DoD issued a memo directing staff to “require the submission of uncertified cost or pricing data to support prices proposed by TransDigm and its subsidiaries.”
On Friday, Sen. Charles Grassley (R-IA) wrote a letter lamenting the DoD’s inability to ascertain pricing information from its contractors and suggesting new amendments those loopholes, while Rep. Ro Khanna (D-CA), who has proposed similar legislation, commented in June: “It’s more than evident that TransDigm can’t be trusted, so singling them out is warranted.”
As noted by the Federal News Network, current law allows vendors to refuse to provide price data for individual transactions below $2 million, a statute of which TDG was all too aware. According to a report from the House Oversight Committee, TransDigm “coached” employees to maintain prices below that threshold and avoid providing cost documentation whenever possible. Fat markups appear to be a crucial feature for TransDigm, which has long pursued a roll-up business model and which carries net debt in excess of six times consensus 2019 Ebitda.
Recap July 15
Stocks recouped an early dip to finish unchanged on the S&P 500, as Citigroup, Inc. helped usher in second quarter earnings season with a similarly flat finish. Treasurys were bid across the curve as the 10-year yield dropped below 2.09%. Oil and gold both traded a bit lower, and the VIX remained below 13.
- Philip Grant
Friday, July 12, 2019
Bears on vacation
From June 29 at the Omni Hotel Mount Washington,
From June 29 at the Omni Hotel Mount Washington,
Bond-splainin'
From Bloomberg Opinion today:
From Bloomberg Opinion today:
Merger, she wrote
A pair of notable deal-related
A pair of notable deal-related
Stag party
A whiff of stagflation in the heavy summer air?
A whiff of stagflation in the heavy summer air?
Recap July 12
Bears on vacation
From June 29 at the Omni Hotel Mount Washington, via the Associated Press:
Rather than taking in the historical sights (the resort famously served as the venue for the 1944 Bretton Woods monetary agreement), the furry visitor was merely “in search of a trash can.”
Bond-splainin'
From Bloomberg Opinion today:
With some $13 trillion of bonds worldwide yielding less than zero percent, it would be easy to characterize fixed-income assets as nothing more than a giant bubble waiting to burst. Those who agree probably haven’t heard of the concept of a “Giffen good.”
Goodbye Ph.D. standard, hello B.S. standard?
Merger, she wrote
A pair of notable deal-related developments today. This morning, industrial manufacturer Hillenbrand, Inc. announced the acquisition of Milacron Holdings Corp. at a 34% premium. Seemingly recalling that high price tag deals often destroy value, Mr. Market marked down Hillenbrand shares by 13%.
This afternoon, global beer powerhouse Anheuser-Busch InBev S.A./N.V. (BUD on the NYSE; see the Grant’s Interest Rate Observer issue dated Feb. 23, 2018) announced it will not go forward with its previously announced plans to IPO its Asia Pacific subsidiary, citing “market conditions.” The listing of that unit would have raised up to $9.8 billion, according to The Wall Street Journal, providing highly-leveraged InBev with some much needed cash.
However, Bloomberg reported early this morning that the company’s proxies “had difficulty finding enough demand to price [the offering] within the current range.” That’s quite a change from less than two days ago, as Bloomberg had relayed Wednesday that the order book “was at least 1.5 times covered as of Wednesday afternoon.” BUD shares, which had rallied 43% year to date, fell 3% on the day.
Stag party
A whiff of stagflation in the heavy summer air? This morning’s release of the June producer price index showed a 2.3% year-over-year rise in the core (ex-food and energy) reading, topping the 2.1% expected. That follows a 2.1% year-over-year rise in core CPI yesterday, above the 2% consensus and representing the 16th straight month in which that metric rose by 2% or more.
Those figures have done little to assuage fears within the Fed of an insufficient inflationary pace (the Fed’s preferred gauge, the core personal consumption expenditures index, rose 1.6% year-over-year in June). “I am nervous about inflation,” declared Chicago Fed president Charles Evans (meaning not enough of it). Jerome Powell told Congress Wednesday that “there is a risk that weak inflation will be even more persistent than we currently anticipate.” Recently, both St. Louis Fed president Jim Bullard and Minneapolis Fed president Neel Kashkari advocated for “insurance” rate cuts.
While the monetary mandarins fret over inflation half of the mandate, growth worries loom large. The New York Fed’s recession indicator model rose to 32.9% in June, up from 28% in May and the highest since 2008. That gauge rose above 30% prior to the recessions in 1991, 2000 and 2008 (a glance at the 50-year trend shows few false positives). Then, too, the yield curve has remained inverted since late May with the three-month yield outpacing that of the 10-year note (itself one of the more reliable recession harbingers), while both the June Chicago Purchasing Managers’ Index and ISM Manufacturing Index’s new-order components fell to their lowest levels since December 2015. As of July 8, the Atlanta Fed’s GDPNow tracker implies that output grew at an annualized 1.4% clip for the second quarter, down from 3.1% in the first quarter.
That evident growth slowdown may be the ace in the hole for bond investors. In Hoisington Management’s second quarter letter, the stalwart bond bulls reiterate their longstanding (and so far correct) hypothesis that debt saturation will constrain growth and keep yields moving still lower:
With the current global experience of more than two decades of subnormal economic growth in the face of extreme over-indebtedness, numerous cases of sustained historically low levels of real yields have come into focus and the following analysis indicates this recent pattern is likely to persist. If debt levels as percentage of total output continue higher, then investors will likely face even lower future real yields.
But, for Treasury bulls, it’s not just the persistent rise in measured consumer and producer price indices which should be cause for concern. Yesterday’s auction of $16 billion in 30-year bonds priced at 2.66%, more than two basis points above its when-issued level at auction time. Glen Capelo, head of rates at Academy Securities, told Bloomberg that the results were eye-opening: “This is as close to a fail as we’ve seen in at least a decade.” Capelo, who has been trading Treasurys since 1986, observed the unusual backdrop that accompanied the auction: “This is the first time in my lifetime the Fed is actually trying to create inflation.”
One auction does not a trend make, but there are other worrying signs. As noted in the below chart by Bianco Research today, relative bidding interest at two, five, seven and 10-year U.S. Treasury note auctions continues a protracted decline seen throughout this cycle:
At least we’re making it up in volume.
Recap July 12
One of the lowest volume days of the year was fertile ground for the bulls, as the S&P 500 rose to another fresh high and its first ever close above 3,000. Treasurys also caught a bid, with the 10-year yield falling two basis points to 2.11%, and gold jumped to $1,414 an ounce. The VIX fell below 12.5.
- Philip Grant
Thursday, July 11, 2019
We're gonna need a bigger boat
Mexican finance minister Carlos Urzúa resigned
Mexican finance minister Carlos Urzúa resigned
QT progress report
Recap July 11
We're gonna need a bigger boat
Mexican finance minister Carlos Urzúa resigned via Twitter on Tuesday, citing “many disagreements over economic policy” within the presidential administration of Andrés Manuel López Obrador (AMLO). Alberto Ramos, chief Latin America Economist at Goldman Sachs Group, Inc., called the departure of Urzúa (who served as AMLO’s finance secretary when he was mayor of Mexico City) “an unexpected and negative development.” Mr. Market agreed, as the peso fell by 2% against the dollar in reaction. For his part, AMLO took things in stride, telling reporters yesterday that “you have to get used to the changes and there could even be other resignations.”
A major factor in Urzúa’s departure, according to The Wall Street Journal: The $8 billion refinery project in AMLO’s hometown region of Tabasco recently awarded to state-owned oil company Petróleos Mexicanos (Pemex). The oil giant is faced with a punishing $160 billion debt load inclusive of pension liabilities (nearly six times last year’s earnings before interest, taxes, depreciation and amortization), ten straight years of cash burn to the tune of $72 billion in total and steep production declines. Pemex produced 1.68 million barrels per day in June, down from a 3.4 mbpd high water mark in 2004 (Almost Daily Grant’s, May 2). Management is targeting 1.83 mbpd in output by year-end.
The rating agencies have taken notice. On June 6, Fitch Ratings cut Pemex to junk, while Moody’s could follow suit (analyst Dirk Willer of Citigroup, Inc. dubs a cut “pretty well set). In April, AMLO’s government offered $5.6 billion in tax rebates and capital injections to shore up Pemex’s finances, while in June the company signed an $8 billion syndicated loan from a consortium of banks, partly used to refinance existing obligations. AMLO celebrated that development, telling reporters: “The banks don’t act without information, they don’t take a decision like this because they like the government. They know that Pemex is in very good health.”
But there’s going to need to be more where that came from. In a June 14 report, analysts at Morgan Stanley attempted to quantify the ongoing budget gap:
Under a scenario of $60 a barrel oil and $15 billion in capex [with] production stabilizing at 1.65mbpd, the annual net Pemex funding would need to come out at around $14 billion, or $23 billion gross. These are challenging funding needs to meet, even with help from the sovereign.
While Pemex bonds suggest some discomfort with the situation (the senior unsecured 6 3/4 bonds due 2047 trade at 88 cents on the dollar for a 571 basis point pickup over Treasurys, down from 97 cents in March 2018), investor concern over the enterprise is more evident in credit default swaps, as the Pemex 5 year CDS trade at a record 252 basis point premium to Mexico sovereign CDS.
The co-dependent nature of Pemex and the government is evidenced by the fact that the oil giant contributed nearly 20% of government revenues last year. Analysts at Bloomberg Intelligence predicted yesterday that “creditors may link the abrupt resignation of [Urzúa] to the weakened financial condition of Pemex, which could drive spread convergence between Pemex and its sovereign parent.”
An analysis of the relationship between Pemex and the Mexican government in the March 23, 2018 edition of Grant’s Interest Rate Observer noted the potential for a costly Pemex bailout that would potentially imperil the sovereign profile: “It would do the national credit profile no good if 15 percentage points of Pemex debt came to alight on the Mexican debt-to-GDP ratio.” A follow-up analysis on Nov. 16, 2018 reiterated the journalistic verdict: “bearish – emphatically.”
QT progress report
The Fed’s portfolio of securities held outright registered at $3.63 trillion this week, unchanged sequentially and down $14.8 billion from two weeks ago, with Treasurys accounting for all of that run-off. Since the Oct. 1, 2017 commencement of QT, total balance sheet assets are down by 14.3%, for a simple annualized pace of 8.3%.
Recap July 11
Stocks edged a bit higher, as the S&P 500 sits slightly above unchanged for the week. But while the equity markets cruised sideways, Treasurys had a lively day as a hotter than expected June inflation (the 16th straight year-over-year rise of 2% or greater in core CPI) and weak long bond auction this afternoon pushed interest rates sharply higher across the board. That move left the 10-year yield within two basis points of crossing back above the three-month yield, nearing the first “un-inversion” since late May.
WTI crude and gold finished at $60 a barrel and $1,406 an ounce respectively, and the VIX settled just below 13.
This morning, industrial supplier and economic bellwether Fastenal Co. reported weaker than expected results and noted a slowdown in activity, in another sign of slowing industrial production.
- Philip Grant
Tuesday, July 9, 2019
Detergent needed
Canada’s housing market continues to bifurcate. In Toronto, June sales rose a snappy 10.4% from a year ago while prices ticked higher by 3% year-over-year. Tight supply helped: “Because we saw virtually no change in the number of new listings, market conditions tightened, and price growth picked up, especially for more higher density home types, which, on average, are less expensive than traditional detached homes,” noted Jason Mercer, chief market analyst at the Toronto Real Estate Board.
In Vancouver, sales fell 14.4% from a year ago and sit 34.7% below the 10-year average. The Multiple Listing Services composite benchmark price dropped 9.6% year-over-year, while total inventory for sale jumped 25.3% from a year ago. Vancouver-based realtor and analyst Steve Saretsky notes in his June market report:
With some developers reluctantly cutting prices this begins to raise questions about appraisal values moving forward. If prices continue to drop it will create problems for existing pre-sale buyers who are relying on bank appraisal values to match what they paid at the pre-sale centers a year or two earlier.
In many respects, the peak of Canada’s post-2009 "housing miracle" exceeds the U.S. version from the pre-2009 bubble. Demographia’s Housing Market Affordability Survey for 2017 found that Vancouver and Toronto ranked 291st and 273rd out of 293 world housing markets, sporting a median home price of 12.6 times and 7.9 times median household income, respectively. That compares to an 11.5 times median price to income in Los Angeles (then the most unaffordable market in the world) and 7.0 times in New York in 2007. According to the Organization for Economic Co-operation and Development, Canadian household debt reached 181% of disposable income at year-end 2017, compared to 144% for the U.S. in 2007. In 2017, 35% of the Toronto Stock Exchange’s market capitalization came from the financials, insurance and real estate sector, compared to 21% of the S&P 500 in 2007.
While Vancouver has gone into deep freeze and nationwide price growth has abated, with the Teranet-National Bank House Price Index rising 0.7% year-over-year in May (the lowest since fall 2009), the housing machine rolls on. Housing starts amounted to 246,000 in June, far above the expected 209,000 and within 7,000 units of the most active month in the last 10 years. That recent acceleration in housing starts comes on the heels of an uptick in output, as GDP growth in March and April logged 0.5% and 0.3% respectively, the best sequential two-month period since the end of 2017.
***
Widespread money laundering appears to be the wildcard in the equation, with a British Columbia-based panel pegging the flow of illegal funds in the Canadian housing market at C$5.3 billion ($4 billion) in 2018. The panel estimates that Vancouver home values are inflated by 5% through dirty money.
Likewise, a March analysis by Transparency International Canada found that between 2008 and 2018 more than 50,000 properties in the Toronto area were purchased by anonymous, privately owned corporations, representing nearly 4% of all residential transactions during that period. The practice is especially prevalent at the high end: “if a home was purchased for C$7-10 million, there is a 54% chance it is owned through a company.” That is significant because 49% of unregulated, private mortgages (which are not subject to anti money-laundering regulations) were taken out by corporate entities over the last 10 years, compared to just 3% for individual borrowers.
Today, Sam Cooper of the Global News reports that Robert Kroeker, vice-president of corporate compliance at the British Colombia Lottery Corp., resigned after the local regulator began investigating claims he told staff to “ease up” on anti-money laundering protocols at local casinos. The problem is likewise reflected in a broader lack of enforcement. According to Statistics Canada, just 316 money laundering convictions were logged between 2000 and 2016, while the United Kingdom snagged 1,435 such convictions in 2017 alone per The Wall Street Journal.
Might the Toronto supply shortage, and relative resilience of its local housing market, be at least partially attributable to the practice? Comeau told the Financial Post that “Ontario is notorious for being a money-laundering front.”
Short seller Marc Cohodes, who has expressed bearish views on at least one Canadian non-bank lender, tells Grant’s today that a lack of political will lies at the heart of the money-laundering problem:
The motto seems to be: Look the other way, everything’s fine.
They don’t want to take on the problem. Everyone wants to enjoy the status quo. The finance minister, Bill Morneau, is determined to protect the banks from the consequences of their behavior. Until real adults take over, this situation won’t improve.
Recap July 9
Stocks rebounded from early lows as the S&P 500 eked out a green finish, while Treasury yields rose a bit with the 10-year finishing at 2.06%. WTI crude oil and gold likewise enjoyed modest gains, finishing at $58 a barrel and $1,397 an ounce, respectively, and the VIX held at 14.
- Philip Grant
Monday, July 8, 2019
Hong Kong rumbles
Massive protests
Massive protests
Prosperity gospel
On Saturday, Turkish President Recep Erdogan announced he fired
On Saturday, Turkish President Recep Erdogan announced he fired
Recap July 8
Hong Kong rumbles
Massive protests in Hong Kong against a heavy-handed extradition law have grabbed the headlines, but other developments in China’s “special administrative region” deserve a close eye. On Wednesday and Thursday, the one-month Hong Kong interbank offered rate (Hibor) jumped a combined 50 basis points to nearly 3%, the highest since October 2008 and up from less than 1% as recently as February. That was followed by a similarly violent fall today back to 2.69%.
That spasm in funding costs comes ahead of the projected $9.8 billion IPO of Anheuser-Busch InBev S.A./N.V.’s Asian unit, set for debut on July 19, which can temporarily constrain liquidity as investors allocate funds to the new offerings. Indeed, Carie Li, an economist at OCBC Wing Hang Bank, told Reuters that the timing of InBev’s offering is likely influencing the Hibor move: “We haven’t seen such a large IPO for a while, and it is happening during the [June and July] dividend season when liquidity is usually tight.”
Regardless of the cause, the sharp Hibor move could prove easier for some to swallow than others. Hayman Capital Management L.P. managing partner Kyle Bass noted on Twitter Wednesday evening that corporate loans in Hong Kong “reset against Hibor monthly.” The Hong Kong money market is likewise very sensitive to short-term flows. If locals and expats lose faith in the special administrative region and take their dollars elsewhere, it could pose a problem for the city’s highly-leveraged housing market.
For more on the state of play in Hong Kong and an analysis of a speculative but potentially asymmetric investment opportunity, see the May 31 edition of Grant’s Interest Rate Observer.
Prosperity gospel
On Saturday, Turkish President Recep Erdogan announced he fired central bank president Murat Cetinkaya, one year prior to the scheduled end of his four year term in 2020.
The catalyst for that move: Cetinkaya’s refusal to cut interest rates from the current 24% benchmark rate on account of intense inflationary pressures (CPI rose 15.8% year-over-year in June, the 23rd straight double-digit reading). Indeed, Turkish newspaper Hurriyet quoted Erdogan explaining the rationale: “We told him repeatedly in economy meetings that he should cut rates. We told him that the rate cut would help inflation to fall. He didn’t do what was necessary.”
Rabobank strategist Piotr Matys commented: “By abruptly dismissing Cetinkaya, Erdogan reminded everyone who is in charge of monetary policy.” This is not the first time that sort of message has been sent. In July 2018 Erdogan named son-in-law Berat Albayrak as minister of Finance and Treasury. Albayrak traveled to New York in April to meet with investors, one of whom shared a harsh review with the Financial Times:
Another investor, who was among a small number of people who held additional private meetings with Mr. Albayrak, said that the encounter was “disastrous”, describing it as “one of the worst performances from a finance minister I have seen.”
But Erdogan’s attempts to tighten his grip have been met with increasing opposition from the political class and voters alike. Today, former deputy prime minister Ali Babacan, who served as economy minister from 2002 to 2007 and was a founding member of Erdogan’s AKP party, announced his resignation from the group on account of “deep differences” over the party’s direction. On June 23, AKP was defeated in the Istanbul mayoral election by opposition candidate Ekrem Imamoglu, a significant rebuke from Erdogan’s hometown (he was Istanbul mayor prior to being elected president).
While Erdogan attempts to keep the electorate and Mr. Market in line after taking action, Donald Trump watches enviously. On Monday, the U.S. president took to Twitter to liken the Fed to “a stubborn child” that “doesn’t know what it’s doing” following a stand-pat meeting in late June. Yet the market reaction to the change in Turkey may give Trump pause: In response to Saturday’s news, the lira fell 2% against the dollar to 5.74 per greenback today, while the yield on Turkey’s 10-year dollar-pay notes jumped 24 basis points to 7.26% and the Borsa Istanbul 100 Index fell nearly 1%.
Meanwhile, a New York Fed press release trumpeting the end of its listening tour included some language that might appeal to Trump’s (and Erdogan’s) sensibilities. John Williams, president of the New York Fed, struck an ambitious tone in an accompanying Twitter post: “We talk about monetary policy and interest rates and things, but really the Fed has a broader mandate for shared prosperity.”
Recap July 8
Fallout from Friday’s much stronger than expected jobs report has been limited, as interest rate futures continue to price 100% odds of a rate cut at the next Fed meeting on July 31. Stocks edged lower for a second straight session today, while the 10-year yield ticked higher to 2.05%, gold finished at $1,392 an ounce and WTI crude settled just above $57 a barrel. The VIX rose to near 14.
- Philip Grant
Wednesday, July 3, 2019
Justice league
Two down, one to go?
Two down, one to go?
Car man
Auto executive Lee Iacocca,
Auto executive Lee Iacocca,
Three musketeers
Yesterday was a busy one for the future of central banking,
Yesterday was a busy one for the future of central banking,
Recap July 3
Justice league
Two down, one to go? Bloomberg reports this afternoon that the Department of Justice is close to green lighting T-Mobile U.S., Inc.’s (TMUS on the Nasdaq) all-stock acquisition of Sprint Corp. (S on the NYSE). In response, Sprint stock rose slightly to $6.98, narrowing the discount to the TMUS-implied offer price to 11%. However, that gap was just 7% on June 19.
DoJ approval would leave the coalition of more than 10 state attorneys general as the final major roadblock to the deal, one which appears to still be in question based on the size of the discount. The merger appears necessary to ensure Sprint’s continued viability (Almost Daily Grant’s, March 29) and avoid a big hit to SoftBank Group Corp., which owns 85% of Sprint shares.
Car man
Auto executive Lee Iacocca, president of Ford Motor Co. and longtime CEO of Chrysler Corp., died yesterday at the age of 94. Among many other accomplishments, Iacocca was instrumental in developing and bringing to market the fabled Ford Mustang, which debuted at the 1964 World’s Fair in New York at a list price of $2,338 according to Hemming’s Daily.
Beyond their status in American culture, the cars have fared pretty well as a store of value. In January, the very first Ford Pilot Plant/Pre-production 1965 Mustang hardtop was sold at auction for $192,500. That’s a compound annual growth rate of 8.19% over 56 years.
Three musketeers
Yesterday was a busy one for the future of central banking, as a pair of names were nominated for posts at the Federal Reserve and as one for president of the European Central Bank. Let’s take a quick look at the candidates.
Christopher Waller, head of research at the St. Louis Fed, is well versed on the theory and practice of modern central banking. In a 2015 paper titled “Stabilization Policy at the Zero-Lower Bound”, Waller suggested with co-writer Paola Boel that monetary stimulus might be better targeted at private enterprise: “Our model suggests that it can be optimal for the central bank to buy private debt claims instead of government debt.”
More recently, Waller told Bloomberg Radio on June 25 that he wasn’t on board with the Fed’s policy tightening (nine hikes from December 2015 to December 2018): “We didn’t see any overheating in the economy coming, so the question was: why are we raising rates?”
The second nominee, Judy Shelton, is cut from a different cloth. Currently the U.S executive director for the European Bank for Reconstruction and Development and an informal Trump advisor, Shelton “has already faced criticism for some of her unconventional views on monetary policy” according to Bloomberg. In a May 31 interview with the Financial Times, she dared question the premise of modern central banking:
How can a dozen, slightly less than a dozen, people meeting eight times a year, decide what the cost of capital should be versus some kind of organically, market supply determined rate? The Fed is not omniscient. They don’t know what the right rate should be. How could anyone?
If the success of capitalism depends on someone being smart enough to know what the rate should be on everything. . . we’re doomed. We might as well resurrect Gosplan.
Needless to say, those ideas don’t sit well with some prominent figures. In response to that interview, former Harvard University president Larry Summers, himself a candidate for the Fed chair in 2014, attacked Shelton’s candidacy as “dangerous” (Almost Daily Grant’s, May 31).
But the biggest news by far from central bank land was the nomination of current International Monetary Fund head Christine Lagarde as president of the European Central Bank. Lagarde was greeted by another powerful rally in local sovereign bond prices, with French and Italian 10-year yields dropping five and 26 basis points to minus 11 basis points and 1.58%, respectively. Seema Shah, global investment strategist at Principal Global Advisors, told the FT that it’s safe to expect more of the same: “Markets are unfamiliar with her academic monetary leanings. Yet, going by her previous support of [outgoing president Mario] Draghi’s decisions to introduce innovative monetary policies, they’re making the safe assumption that she’s in the dovish camp.”
As with IMF predecessor Dominique Strauss-Kahn, the law has occasionally proved a thorn in Lagarde’s side. In December 2016, a French court found Lagarde guilty of “negligence by a person in position of public authority” over €404 million ($457 million) in taxpayer funds given by the then-French finance minister to businessman Bernard Tapie in 2008.
They couldn’t make it stick: Facing up to a year in prison, Lagarde was given no punishment, while the IMF said it retained “full confidence” in its boss. Lagarde declined to appeal, stating: “There’s a point in time when one has to just stop, turn the page and move on and continue to work with those who have put their trust in me.” Summers likewise weighed in, describing the verdict as “a sorry day for French justice.”
Recap July 3
The bull party rages into the fourth of July, as the S&P 500 pushed higher once more to extend its year-to-date gains to nearly 20%. At the same time, interest rates continued to dart lower with the 10-year yield falling to 1.95%, and economic indicators continue to wobble with the ISM non-manufacturing index matching its lowest reading since October 2016.
WTI crude rose back above $57 a barrel, while gold cruised sideways at $1,419 an ounce after notable recent volatility. The VIX dropped to 12.57, its lowest since February.
- Philip Grant
Tuesday, July 2, 2019
Real deal
On Friday, online luxury consignment retailer The RealReal, Inc. (REAL on the Nasdaq)
On Friday, online luxury consignment retailer The RealReal, Inc. (REAL on the Nasdaq)
Recap July 2
Real deal
On Friday, online luxury consignment retailer The RealReal, Inc. (REAL on the Nasdaq) made its public debut in style, jumping 45% from its IPO price of $20 a share. Valued at $1 billion in a Series H funding round in March, San Francisco-based RealReal, which was founded in 2011 by Julie Wainwright, former CEO of Pets.com (which famously liquidated nine months after its February 2000 IPO), now commands a $2.1 billion price tag.
RealReal’s experience caps off a bountiful second quarter for U.S. IPOs, which included 62 debuts raising $25 billion according to Renaissance Capital, LLC. That’s the second-best showing in terms of proceeds since 2000. As per tradition, early investors got the worm, with the average IPO return for the quarter clocking in at 30%. Poor showings from ride-share unicorns Uber Technologies, Inc. and Lyft, Inc. were decidedly in the minority, with surges from the likes of Beyond Meat, Inc., Chewy, Inc. and Slack Technologies, Inc. (up 500%, 50% and 40%, respectively) more representative of current zeitgeist. More big names are on the way, with WeWork Cos. Inc., Peloton, Inc. and Postmates, Inc. having filed relevant paperwork with the Securities and Exchange Commission.
Unprofitability is no obstacle. Jay R. Ritter, the Joe B. Cordell Eminent Scholar Chair at the Warrington College of Business at the University of Florida, finds that the percentage of IPOs with negative earnings per share surpassed 80% in 2018, joining 2000 as the only period in which that dubious threshold has been reached in the last 28 years. That ratio has topped 60% only eight times since 1990, but in each year since 2013.
IPO fever is making its way abroad. Today, Anheuser-Busch InBev S.A./N.V.’s Asian unit began taking orders for an offering on the Hong Kong Stock Exchange that could raise upwards of $9.8 billion, according to The Wall Street Journal. That compares to a projected $7 billion haul per the WSJ in early May and would top the $8.7 billion debut of Kraft Foods, Inc. in 2001 for the world’s largest food and beverage IPO. Also today, Bloomberg reports that the Kingdom of Saudi Arabia “is restarting preparations” for a potential IPO for the Saudi Arabian Oil Company (Aramco). The Saudis are shooting for a $2 trillion mark from Mr. Market.
The latest boom in public offerings is no cause for concern according to Barron’s, which notes in the June 28 edition that the median age of tech companies stood at 12 last year, compared to four in 1999. Barron’s concludes:
The resurgence of IPOs is no flash in the pan, no signal of a bubble re-inflated. Instead, it reflects a shift in the way that investors and entrepreneurs approach company creation, the rich supply of mature companies that have yet to come public, and investors’ insatiable hunger for growth stories.
Comparisons with the Y2K epoch aside, the current IPO frenzy can be traced back to that seemingly all-encompassing modern phenomenon: Radical monetary policy around the globe. The April 5 edition of Grant’s Interest Rate Observer featured an analysis of the forces at work:
A little-known fact about unicorns is that they feed on interest rates. They like low, little rates – the tinier, the better. It’s a preference that they share with the humans of private equity and the bulls of Wall Street.
The risk-incentivizing strategies concocted by central banks have amplified the simple financial calculus of those forecasting future performance:
The lower the interest rate you pick to discount future cash flows to the present, the fatter those cash flows appear. And in the absence of past or present positive cash flow, such projections take center state.
Skipping down to the bottom line, we judge that loss-making unicorns are queuing up to go public for no better reason than it’s now or never.
Indeed, issuers are striking while the iron is hot. Kathleen Smith, co-founder of Renaissance Capital, told CNBC Friday: “Any private company that is not proceeding to go public in this market should have their head examined. The market is wide open, and it’s not always going to be.”
A curious divergence: One might assume that the IPO wave has spurred another leg higher in Silicon Valley housing as tech employees cash out their newfound riches, but that’s not the case. An analysis today from Kate Seabaugh, senior manager at John Burns Real Estate Consulting, finds that a nationwide slowdown in residential housing markets has hit the Northern California tech epicenter particularly hard. San Jose, San Francisco and Seattle saw net resale deceleration (meaning the change in year-over-year price growth this year compared to last) in home prices of 26%, 15% and 13% respectively, in May. For instance, San Jose went from a 20% percent year-over-year price gain in May 2018 to a 6% drop this year. That’s the worst three showings out of the 33 metro areas tracked by the firm.
Recap July 2
Stocks cruised higher, with the S&P 500 notching another record close to extend its year-to-date gain to 19%, while rates continued to dive with the 10-year yield falling below 1.98%, the lowest since the November 2016 elections. Gold jumped 2% to $1,413 an ounce to erase yesterday’s losses, while energy was hammered following the OPEC meeting with WTI crude falling 5% to $56 a barrel. The VIX closed below 13 for the first time since May 3.
- Philip Grant
Monday, July 1, 2019
Expansion team
Today, the post-2009 streak of economic growth rolls into a record 121st month,
Today, the post-2009 streak of economic growth rolls into a record 121st month,
Color me repressed
Over the weekend, Agustín Carstens,
Over the weekend, Agustín Carstens,
Recap July 1
Expansion team
Today, the post-2009 streak of economic growth rolls into a record 121st month, barring a hindsight-aided recession call from the National Bureau of Economic Research.
Writing in Bloomberg today, economist Gary Shilling contends that the NBER may indeed determine that the expansion will soon, or has already, come to a close. Shilling cites the pair of large downward revisions to the March and April readings of non-farm payroll figures compiled by the Bureau of Labor Statistics. That was followed by a feeble net gain of 75,000 jobs in May (the consensus estimate was for 175,000 new jobs).
Shilling notes that “an analysis of post-World War II data reveals that employment often slides from diminishing gains to substantial declines within a few months of the onset of recessions.” The June payroll figures are set for release on Friday.
Key manufacturing data points have also turned south, with the Institute for Supply Management’s new orders index for June falling to its lowest since December 2015. On Friday, the Chicago Purchasing Managers’ Index for June likewise matched its worst reading since December 2015.
The downshift in employment growth and macro data is matched by a likely retrenchment in corporate profits. As noted by FactSet on Friday, second quarter earnings among S&P 500 companies are expected to decline by 2.6% year-over-year, which would mark the second straight quarterly earnings decline. FactSet likewise notes that 87 members of the S&P 500 issued negative guidance for the quarter (meaning below the mean analyst estimate), the highest since first quarter of 2016 and an average of 74 guidance cuts from S&P 500 components over the last five years.
Color me repressed
Over the weekend, Agustín Carstens, general manager of the Bank for International Settlements, offered words of caution to reporters following the release of the bank’s annual report.
We would stress that it is important to preserve some room for maneuver for more serious downturns. Monetary policy should be considered more as a backstop rather than as a spearhead of a strategy to induce higher sustainable growth.
Carstens likewise wondered about diminishing returns from additional easing:
How much more stimulus will you get if rates are reduced by another 25 basis points? That will produce [less] bang for your buck.
While the BIS urges caution, it’s full steam ahead for the European Central Bank. Yesterday, The Wall Street Journal reported that ECB president Mario Draghi, whose term ends on Oct. 31, is set to defy his lame-duck status with “some of the boldest policy moves of his eight-year term. . . potentially binding the hands of his successor for years.” A return to corporate and sovereign bond buying (with a potential uptick in the ownership limit to 50% of a given issue from 33%) and additional rate cuts from the current negative 40 basis point deposit rate are on the table per the WSJ. The outgoing central banker faces little resistance, as “key critics on his rate-setting committee have gone quiet as the race to lead the ECB approaches its climax.”
The bond market has received the memo, as German and French sovereign 10-year yields fell this morning to record lows of negative 36 and negative 5 basis points, respectively (vs. year-over-year CPI growth of 1.6% and 1.2% in June).
Meanwhile, the powers-that-be look to put the clamps down on European savers sticking their cash under the mattress. Earlier today, Dutch finance minister Wopke Hoekstra said in an interview with Radio 1 Journaal that the government will seek to lower the threshold for illegal cash payments to €3,000 from the current €10,000, as well as to remove the €500 note from circulation. “It will genuinely help to tackle organized crime and money laundering,” Hoekstra said.
Recap July 1
Risk appetite reigned, as an announced “trade truce” from this weekend’s G-20 meeting in Osaka helped the S&P 500 reach a fresh record close, while WTI crude edged back to $59 a barrel. By the same token, Treasury yields rose across the curve, gold got smacked by 2% to finish at $1,384 an ounce, and the VIX fell to 14, its lowest close in nearly two months.
- Philip Grant
Friday, June 28, 2019
Fill 'er up
Oil prices continue their recovery from last fall’s swoon, with WTI crude fetching $58 a barrel, up from $42 a barrel on Christmas Eve. The coming days will bring a pair of potentially crucial catalysts, with a scheduled Donald Trump-Xi Jinping meeting at the G-20 in Osaka dictating the course of the Sino/American trade spat and global oil demand, followed by Monday’s gathering of the Organization of the Petroleum Exporting Countries in Vienna, which will help set the worldwide supply agenda.
Stateside, the fallout from the shale revolution continues. The Department of Energy pegs total domestic output at 12.1 million barrels per day (mbpd) as of June 21, up 11% year-over-year and just off the record high 12.4mbpd reached at the end of May. “If U.S. production continues to grow this year,” Callum MacPherson, head of commodities at Investec plc, told Bloomberg, “OPEC may find itself in the impossible position of having to make even further cuts to balance the market when it meets later in the year.”
The sharp growth in U.S. production hasn’t necessarily been kind to those doing the pumping. Fracking giant Pioneer Natural Resources Co. (PXD on the NYSE) typifies the current environment. The company recently changed strategic course, backing off from ambitious production goals, replacing the CEO and undertaking expansive cost cutting. Newly reinstated CEO Scott Sheffield (who had retired in 2016) told The Wall Street Journal on Monday that a painful transition is underway: “We lost the growth investors. Now we’ve got to attract a whole other set.” For more on Pioneer, see the May 3 edition of Grant’s Interest Rate Observer.
Investors have indeed been migrating elsewhere. As noted by Bloomberg this morning, oil and gas companies account for just over 5% of the S&P 500. That compares to nearly 11% in 2014.
On Wednesday, the Federal Reserve Bank of Dallas released its quarterly energy survey for the eleventh district, covering Texas, southern New Mexico and northern Louisiana. The results were less than encouraging: “We are experiencing very tough, and unpredictable, business conditions.” One respondent from the exploration and production subsector commented. “I operate with the expectation that my revenue will be lower each month than the prior month.” Another remarked: “Nobody’s generating free cash flow.” An oilfield service provider commented: “Customer activity is being reduced daily, which compounds the worsening business environment.” Analysts at Simmons Energy surmised in a note Wednesday that the dark industry mood “persists today” despite a 10% uptick in WTI over the past two weeks.
In need of higher oil prices, there is reason to believe the U.S. producers’ wish may be granted. The Energy Information Agency cut its forecast for domestic full-year production to 12.32mbpd in its June productivity report, down 140,000bpd from last month’s estimate. The agency reported 8,283 drilled but uncompleted wells, down 77 from May and the lowest reading since March 2018. Baker Hughes, a GE company, reported two weeks ago that active rigs in the all-important Permian Basin (the largest shale field in the U.S.) fell to 441, also the lowest count since March 2018.
Away from the U.S., the upcoming OPEC meeting shines a light on swing producer Saudi Arabia and questions about its true capabilities. Back in April, the $12 billion bond offering of state-owned Saudi Arabian Oil Company (Aramco) included something of a revelation concerning the Ghawar oil field, one of the world’s largest with a 2017 EIA output estimate of 5.8mbpd. A recent blog post from resource investors Leigh Goehring and Adam Rozencwajg of Goehring and Rozencwajg Associates LLC explains:
While the Aramco bond prospectus does not list historical production by field, it does disclose both the so-called “Maximum Sustained Capacity” and the remaining reserves for the major fields. Ghawar’s maximum sustained capacity is 3.8 mbpd. Last year, Aramco produced at 85% of its sustained capacity, suggesting that Ghawar pumped approximately 3.3mbpd, down nearly 35% from its peak of 5mbpd in 2005.
Reached by Grant’s today, Goehring emphasized that the Ghawar output decline is permanent, rendering Saudi’s prodigious fall 2018 (in which the Kingdom produced 10.7mbpd, 11.1mbpd and 10.7mbpd across October, November and December) ancient history:
Ghawar is 60 % depleted and will continue to decline. Saudi will probably never get production over 10.5mbpd ever again.
Goehring likewise forecasts that ex-U.S., non-OPEC supply growth will turn negative by the fourth quarter, while noting that key domestic Eagle Ford and Bakken fields are both “nearing peak production and will soon start to decline.” With OPEC production on the wane (to 30.3mbpd as of May 31 from more than 33mpbd in November), Goehring concludes:
The oil market is going to significantly tighten in the second half of 2019.
Recap June 28
Stocks caught a solid bid, narrowing the week’s losses to 0.3% on the S&P 500 and leaving the broad index higher by more than 17% year-to-date through the second quarter, its best first half performance since 1997. Treasury yields and the VIX finished little changed, while energy prices came under pressure following an announcement from the European Union that it is preparing a workaround to navigate Iranian sanctions.
On the data front, another key metric indicates a slowdown, as the May Chicago purchasing managers index fell into contraction territory at 49.7 (above 50 indicates expansion), well below the 53.7 consensus and matching its weakest reading since December 2015.
- Philip Grant
Thursday, June 27, 2019
Powerfinger
Time for a survey of recent happenings in leveraged loans.
Time for a survey of recent happenings in leveraged loans.
QT progress report
Recap June 27
Powerfinger
Time for a survey of recent happenings in leveraged loans. “Aren’t all loans leveraged?” one might ask. This cohort comprises secured, floating-rate loans made by speculative borrowers, typically to fund private equity buyouts and frequently packaged into CLOs (collateralized loan obligations). Faring relatively well in the global financial crisis, leveraged loans have since become the apple of Wall Street’s eye.
Despite a relatively soft recent performance (the S&P/LSTA Loan Index sports a 52 week total return of 3.8%, well behind the 7.1% gain for the Bloomberg Barclays High Yield Index over the past year), the current cycle has been a boon to the asset class. The domestic quantity of loans outstanding has reached $1.2 trillion according to S&P’s LCD unit, more than doubling since 2012 and exceeding the supply of high-yield bonds last May for the first time ever.
While the Fed’s expected rate cuts have diminished the relative demand for floating-rate securities, sources of new supply remain plentiful. Private equity activity, which accounts for a hefty chunk of loan issuance, remains particularly robust. The Financial Times, citing data from Preqin, reports today that p.e. is sitting on a record $2.44 trillion cash pile. “Deal volume in private equity has been very good. A number of transactions have kept the machine going,” Simona Maellare, global head of financial sponsors at UBS Group A.G., tells the FT. “Deals can be financed, competition for assets is vivid, everyone has a lot of money.”
Yet various observers have viewed the breakneck growth in loans with alarm: “It'll be ugly for those companies if the economy slows down and they can't carry the debt. . . then the usual carnage goes on," Brian Moynihan, CEO of Bank of America Corp. said in a June 4 speech at the Economic Club of New York. Minutes from the May 1 Fed meeting flagged the recent growth in leveraged loans, noting that “heightened leverage and associated debt burdens could render the business sector more sensitive to economic downturns than would otherwise be the case.” Congress held a hearing on leveraged loan risks earlier this month, fulfilling the prophecy of the July 13, 2018 Grant’s leveraged loan analysis headlined “Tomorrow’s debt hearings.”
One point of concern is the erosion (or disappearance) of loan covenants, the fine print that holds the corporate borrower to a standard of behavior. LCD reckons that the proportion of loans considered covenant-light, meaning that traditional investor protections have been largely removed, remained at a record 79% in May, up from about 20% in 2007. That potentially exposes creditors to higher loss levels in the event of trouble. A report today from Moody’s Investors Service expresses alarm at the growing ability of borrowers nearing or even in default to nevertheless hive off assets – including cash – beyond the reach of creditors:
An increasing number of loan provisions require only that there be no event of default, granting the borrower access to carve-outs while in default (a default is a breach that matures into an event of default if not cured or waived within time limits; an event of default permits lenders to exercise remedies). Some loans go further, dispensing with conditionality altogether and allowing borrowers access to certain carve-outs even if an event of default exists.
As the private equity, leveraged loan and CLO trains chug along, one familiar name enthusiastically hops aboard. Last Thursday, LCD reported that Deutsche Bank A.G. (DBK in Frankfurt and DB in New York) “is planning to follow the lead of a number of U.S. banks and invest in the senior-most CLO tranches as a way to better manage excess liquidity and boost profitability.” Bloomberg notes today that Deutsche Bank is tapping cash for the endeavor that would otherwise be parked at the ECB and subject to the negative 40 basis point deposit rate.
But as Deutsche buys CLO tranches for its own account, its investment banking division has been burned by the securities which comprise a CLO. Yesterday, the FT reported that the beleaguered bank is facing large losses on a pair of loans after investors balked at the original terms, forcing DB to unload the loans at a discount and absorb the difference.
More broadly, leverage across the group continues to rise, with the share of p.e. deals leveraged more than seven times Ebitda reaching nearly 40% last year according to Loan Pricing Corp. That's from less than 20% in 2015. Then, too, there is a question about earnings quality. LCD finds that almost 56% of M&A loans featured issuer-friendly adjustments to Ebitda as of the second quarter of 2018, up from 34% in 2015; such adjustments can add 40% or more to reported earnings.
At the same time, fundamentals are on shakier ground, as year-to-date downgrades from Moody’s have totaled 156, above the 132 seen at this time last year. Upgrades, likewise, have fallen to 47 year-to-date from 54 in 2018.
An analysis in the Sept. 7, 2018 edition of Grant’s began with a universal fact of investing life, one that applies to the bourgeoning leveraged loan/CLO machine:
On Wall Street, success begets failure. Take a good idea, emulate it and embellish it, drive it into the ground like a tomato stake. Voilà: It’s a bad idea.
QT progress report
The Fed’s portfolio of securities held outright fell to $3.645 trillion, down $16 billion from a week ago and $22 billion from the trailing four-week average with mortgage-backed securities providing the sequential decline.
Commenced on Oct. 1, 2017, the QT program has seen the Fed shrink total balance sheet assets by 13.7%, at a simple annualized rate of 8.3%.
Recap June 27
Some risk aversion was visible, as the S&P 500 edged lower to remain in the red by nearly 1% for the week so far, while Treasurys caught another bid with the 10-year yield falling back to 2.01%. Both gold and oil lost some modest ground, and the VIX held just below 16.
- Philip Grant
Tuesday, June 25, 2019
Dance of the living dead
Globally, the stock of negative-yielding debt crossed a record $13 trillion on Thursday, according to data from Bloomberg. That represents 26% of global sovereign debt supply and 15.3% of nominal worldwide GDP for 2018. Stateside, the 10-year Treasury yield remains below 2%, down from 3.25% in November.
In a New York Times opinion piece last Sunday, Ruchir Sharma, chief global strategist at Morgan Stanley, discussed the fallout from the incredible shrinking interest rates. Citing a report from the Bank for International Settlements, which found that 12% of publicly listed companies around the world can be described as zombie firms (meaning they don’t earn sufficient profits with which to cover their interest payments), Sharma concluded that simple policy miscalculations are on display:
Once the crisis hit, governments erected barriers to protect domestic companies. Central banks aggressively printed money to restore high growth. Instead, growth came back in a sluggish new form, as easy money propped up inefficient companies and gave big companies favorable access to cheap credit, encouraging them to grow even bigger.
Other academic studies lend credence to Sharma’s, and the BIS’s claims. On January 22, the National Bureau of Economic Research released a paper examining the effects of low interest rates on economic dynamism. Incumbents will like what they see:
A reduction in long-term interest rates tends to make market structure less competitive within an industry. The reason is that while both the leader and follower within an industry increase their investment in response to a reduction in interest rates, the increase in investment is always stronger for the leader. As a result, the gap between the leader and follower increases as interest rates decline, making an industry less competitive and more concentrated.
When interest rates are already low, this negative effect of lower industry competition tends to lower growth and overwhelms the traditional positive effect of lower rates on growth.
In January 2017, the Organisation for Economic Co-operation and Development released Working Paper No. 1372, which reached a similar conclusion:
Evidence of a decline in productivity-enhancing reallocation is particularly significant in light of rising productivity dispersion, which would ordinarily imply stronger incentives for productive firms to aggressively expand and drive out less productive firms.
Instead, the productivity gap between frontier and laggard firms has risen, even while the forces bringing dynamic adjustment are waning. This tension is a red flag that something is wrong with productivity, but also points to a potential deterioration of the exit margin [meaning fewer firms are going to corporate heaven].
E-Z money likewise helps bring the dead back to life. As noted by Marty Fridson, chief investment officer of Lehmann, Livian, Fridson Advisors, LLC, during the Spring 2014 Grant’s Conference, the 2008-2009 default cycle was anomalously brief: “We actually had the situation where the default rate went from a record level to below average the very next year. I would submit that is physically impossible, but it did actually happen.”
Needless to say, the march lower in interest rates will help this encumbered group continue to walk the earth. As compiled by Ben Breitholtz, data scientist at Arbor Research & Trading, LLC and noted in the March 8 edition of Grant’s, the proportion of zombie companies (defined here as those whose operating income fails to cover interest expense for three straight years) in the S&P 1500 Index rose to 13.6% at the end of January. That’s up from 12.4% year-over-year and compared to less than 6% of that broad cohort in 1990. During that period, the yield on 10-year Treasury Inflation Protected Securities declined to less than 1% from more than 14%.
Breitholtz also spotted a key threshold for this undead cohort, telling Grant’s in March: “We noticed that the closer the 10-year real yield gets to 1%, there is a hypersensitivity for a lot of these overleveraged companies.” With the 10-year real yield now sitting below 20 basis points, the corporate undead continue to roam.
Recap June 25
Stocks took a dive with the S&P 500 falling 1% as commentary from the Fed’s Powell and Bullard didn’t suit Mr. Market. However, dovish expectations remain firmly ingrained, as interest rate futures price more than 50 basis points of rate cuts by September (up from 38 basis points last Tuesday) and the two-year yield remains at 1.74%, down 10 basis points from a week ago. Treasurys mostly rallied again (with the exception of that two-year) and gold inched higher to $1,422 an ounce, extending its winning streak to six straight sessions.
- Philip Grant
Monday, June 24, 2019
Gig inequality
The New Republic,
The New Republic,
Trump friends China
Whack-a-mole in the Middle Kingdom.
Whack-a-mole in the Middle Kingdom.
Recap June 24
Gig inequality
The New Republic, self-described as “a champion for equality in all its guises,” posted a job listing today for an “inequality editor.” The successful candidate will have to settle for 29.5 hours a week, 30 hours being the threshold for full-time status under the Affordable Care Act; the position “does not include benefits.”
Next up: Self-awareness editor.
Trump friends China
Whack-a-mole in the Middle Kingdom. Following the state-led takeover of small Mongolian lender China Baoshang Bank Co. in early June, evidence of stress in the Chinese economy and banking system, especially among smaller institutions, is multiplying. Bloomberg reports today that overnight pledged repurchased rates rose to 8% and seven-day pledged repo rates 18.3% today for nonbank institutions, compared to just 0.99% and 2.77%, respectively, for banks. Those elevated borrowing costs are not well timed, as Enodo Economics reports that nonbank borrowings through bond repurchases jumped to a net RMB 74.7 trillion ($11.2 trillion) in the first quarter, representing 84% of 2018 nominal GDP and up 50% year-over-year.
The wide-rippling effects of Baoshang’s failure are remarkable, considering that the lender had RMB 418 billion worth of assets on its balance sheet at year end 2016 (the most recent year in which the bank filed an annual report), barely a rounding error compared to the RMB 275.8 trillion in total Chinese banking assets as of March 31.
Earlier today, the Bank of Beijing announced it has infused RMB 2.5 billion ($364 million) into troubled conglomerate CITIC Guoan Group Co., Ltd., after Guoan failed to make debt payments by last Thursday’s deadline, according to Reuters. That follows an RMB 3 billion default by Guoan in April. The cash crunch at Guoan looks to be severe, as Asian real-estate website Mingtiandi, citing local media, reported on June 16 that the company’s long-term rental subsidiary “has been accused by landlords of not paying rent on the apartments that it leases to tenants.”
Last week, property developer China Evergrande Group announced an additional equity investment RMB 13.2 billion in Shengjing Bank Co., Ltd. (2066 on the Hong Kong exchange), doubling its ownership stake to 36%. The move is “a head scratcher” according to Jacky Wong of The Wall Street Journal: “There are no obvious synergies, and the investment returns have been lousy for Evergrande.”
Conventional synergies may be lacking, but Evergrande’s move makes more sense as a bailout. Though the RMB 6 per share deal price represents a 37% premium to Shengjing’s June 5 closing price, that figure still represents new issuance at a 38.3% discount to the bank’s book value. One anonymity-seeking China bear views the decision to issue stock at that markdown as a potentially crucial strategy shift: “In all other cases, we have seen Rube Goldberg-like efforts (perpetual preferreds, etc.) to avoid doing exactly this. Stay tuned to see if this becomes a precedent.”
On June 13, the Bank of East Asia Ltd. disclosed a “material decrease” in first half profits. The culprit: “significant post-tax impairment losses” of roughly HKD$3 billion ($390 million) on a HKD$6.2 billion loan portfolio. The Bank cited “worsening market conditions, which have impacted the commercial property sector in non-tier one cities in mainland China.”
Signs of a slowdown in China’s property market continue to accumulate. On Wednesday, Caixin reported that class-A office vacancies in tech-centric Shenzhen rose to more than 23% for the first half of 2019, a decade high.
Meanwhile, a pair of key indicators covering economic and financial health remain near their lows of this cycle. Fixed asset investment, which played a starring role in the debt fueled investment boom and accounts for nearly half of Chinese GDP, grew by 5.6% in May, down from a 10-year average of 16.7%. M2 money supply growth, the end result of money printing from the People’s Bank of China, is also on the wane, rising 8.5% year-over-year in May. That compares to a 10-year average of 14%.
Will China be able to avoid a debt-driven accident? In a note today, Anne Stevenson-Yang, co-founder of J. Capital Research, writes that with China’s economy on the ropes, an unlikely figure could be set to (unwittingly) ride to the rescue:
Trump’s preoccupation with the stock market is currently China’s best bulwark against financial disaster. As Trump bullies the Fed into a more dovish stance, the additional U.S. dollar liquidity and associated asset appreciation improve China’s visible balance of payments, push down U.S. dollar borrowing rates, and make Chinese assets look more attractive to foreign investors.
Hot money is more likely to come into China to take advantage of its higher money-market rates, while capital flight becomes less attractive. All of these things give China more time to tread water, paper over defaults, and invest more in infrastructure to buck up GDP numbers.
Stevenson-Yang draws a parallel between China’s current situation with the predicament faced by another Asian power following the bursting of its own real estate bubble:
China has already entered its “Japanese phase,” when its financial resources are being marshalled exclusively for the avoidance of crisis.
An easier Fed will buy time, but the fact remains: Chinese economy is overleveraged, and, as the Baoshang situation demonstrates, extraordinarily sensitive to disturbance.
Recap June 24
Stocks reversed early gains to edge a bit lower, the second straight modest selloff after the S&P 500 made a new high on Thursday. Treasurys caught a bid with the 10-year yield dropping four basis points to 2.01%, while gold continued its torrid run, rising to $1,420 an ounce for the first time since 2013. The VIX settled just above 15.
- Philip Grant
Friday, June 21, 2019
Tricky Dix
Let’s hit redial. The Sept. 21 edition of Grant’s Interest Rate Observer featured a bullish analysis of Dixons Carphone plc (DC/ on the London Stock Exchange), reckoning it was a cheap stock. It has since gotten cheaper, falling 36% while the FTSE All-Share Index has lost 2% over the same period. An analytical update follows.
Born of the 2014 merger between electronics retailer Dixons Retail Group Ltd. and mobile phone vendor Carphone Warehouse Group plc, the combined entity has run into all manner of misfortune: Adverse change in consumer behavior compounded by lamentable strategic decisions from the prior management team, while the chaos associated with Brexit has added an external stumbling-block.
Yesterday, Dixons disclosed a nasty surprise, as pretax profits for the fiscal year ended April 27 fell to £298 million ($378 million) from £400 million year-over-year. Company guidance for fiscal 2020 calls for pre-tax profits of £210 million (as well as £80 million in one-time charges), well below the Street consensus of £295 million. The Carphone mobile unit was the culprit, with “more pain” in the form of a “significant loss” in store for the coming year, according to CEO Alex Baldock (the former Shop Direct plc boss who took over in April 2018). The company took a £557 million non-cash write down for the year, primarily attributed to that sickly mobile division.
Those mobile troubles can be attributed to changing consumer tastes that have laid bare the problems in that unit’s business model. Customers get the phone upfront (Dixons pays for the handset), connected to one of the U.K.’s big 3 wireless providers, and pay for it, along with network charges, over the duration of the contract. In other words, cash goes out the door in bulk, then comes back gradually. What’s more, Dixons is contractually obligated to deliver certain volumes to the network carriers on the pain of hefty cash penalties for any shortfall.
But with customers increasingly opting for monthly contracts rather than locking up lengthy and expensive (read: higher margin) post-pay phone contracts, Dixons is stuck under unfavorable fixed-cost contracts with the network providers, while the capital-intensive nature of the business adds another layer of negative operating leverage. There is a light at the end of the tunnel however. As noted by Baldock on the conference call, much of that legacy burden will be lifted during fiscal 2021 as contracts expire.
While the mobile division’s woes are front and center, electronics retail is Dixons’ bread and butter, representing more than 80% of company sales. As the U.K. mobile division suffered a 4% year-over-year decline in revenues, so-called electricals ground out 1% positive comps with management forecasting further sales and profit growth in 2020. Market share is on the upswing, a “crucial” factor according to James Armstrong, senior analyst at The Analyst Research LLP, as growing share lends itself to “buying scale and central efficiencies.” On the cost front, low-hanging fruit still exists to be plucked: For instance, the two businesses continue to run separate operating systems five years after the merger.
Following the latest leg-down, Dixons shares are priced for imperfection, with a £1.55 billion enterprise value representing just over three times consensus fiscal 2020 EBITDA. The balance sheet is presentable, with £265 million in net debt and mobile contract accounts receivable of £800 million (of which management expects to realize some £500 million, per commentary on the conference call). By comparison, domestic pure-play electronics retailer Best Buy Co., Inc.’s enterprise value stands at 7.3 times forward EBITDA, and net debt of $2.5 billion compares to an expected $2.8 billion in consensus 2020 EBITDA.
One Dixons investor is taking the recent pain in stride, telling Grant’s yesterday that while the post-earnings selloff was justified, the odds are good that this year is the trough: “No real change in view for me, I think there is more than 100% upside here.” Our nameless source added to his position in the selloff.
Dixons management is at least sampling their own cooking. Today, eight separate directors reported stock purchases on the open market, led by CEO Baldock who acquired 150,000 shares at £1.1372. Early (meaning wrong) on our fall 2018 pick-to-click verdict, Grant’s remains bullish.
Recap June 21
Stocks fluttered a bit lower, as the quadruple witching options expiration didn’t yield much in the way of trading fireworks, though the VIX jumped late in the day to finish above 15.
The Treasury curve saw notable steepening, as the 30-year yield finished at 2.59% after briefly trading below 2.48% yesterday morning, while energy and gold extended their recent rally to leave WTI crude and the Money of Kings at $57.50 a barrel and $1,400 an ounce, respectively.
Nice lookin’ chart: Gold since 1920. Source: The Bloomberg
- Philip Grant
Thursday, June 20, 2019
Chickens counted
Another step forward for the never-ending merger saga.
Another step forward for the never-ending merger saga.
QT progress report
Recap June 20
Chickens counted
Another step forward for the never-ending merger saga. On Tuesday, Bloomberg reported that Sprint Corp. (S on the NYSE) and T-Mobile U.S., Inc. (TMUS on the Nasdaq) were making progress in asset sale negotiations with Dish Network Corp. (DISH), as the pair continues to seek regulatory approval for their $26.5 billion, all-stock deal announced in spring 2018. “Dish could announce a deal as soon as this week,” for the Boost Mobile prepaid brand and wireless spectrum that the pair agreed to divest in order to garner approval from the Federal Communications Commission on May 20, though talks could still fall through.
T-Mobile is indeed hedging its bets. Yesterday, Reuters relayed that Goldman Sachs Group, Inc., which is advising T-Mobile, is soliciting other bids for those assets. Reuters describes T-Mobile as “hopeful it would reach an agreement with the Justice Department by early next week.”
Resolution could come as soon as tomorrow, according to a tweet from Fox Business reporter Charles Gasparino this morning. CNBC’s David Faber pegs the odds of approval at 90%, with a divestiture of Boost and spectrum assets serving as a lynchpin for the green light.
While regulatory approval would be a huge step forward, the hopeful suitors wouldn’t be out of the woods just yet. On June 11, a group of 10 state attorneys general filed suit to block the deal, with New York AG Letitia James asserting that the combo would “cause irreparable harm to mobile subscribers nationwide.” Late this afternoon, the Capitol Forum reports that "several" additional attorneys general, including from Massachusets, intend to join the suit.
For single-B-rated Sprint, burdened by an onerous debt load and stagnant operating results, its easy to understand the urgency to consummate the deal. In early 2016, Sprint’s senior unsecured 6 7/8 notes of 2028 fell to 57 cents on the dollar and its credit default swaps implied 80% odds of a default as investors came to doubt the company’s standalone viability. A completed merger would likewise be manna for SoftBank Group Corp. (9984 on the Tokyo Stock Exchange), which holds an 84.5% equity stake in Sprint currently worth $25.6 billion.
The logic from T-Mobile’s perspective is less clear. In a note over the weekend, boutique research firm MoffettNathanson, LLC addressed this issue, writing:
What does it say about T-Mobile’s standalone prospects that they seem so hell-bent on getting a deal done… at seemingly ANY price?
Let’s try to remember why T-Mobile wanted the Sprint merger in the first place. Leave aside all the nonsense about scale and heft and competitive equilibrium. What the deal really boiled down to was two things: spectrum and industry structure. One might then reasonably ask: why would T-Mobile or Deutsche Telekom ever agree to a remedy that forfeits both benefits in order to get the deal done?
The analysis takes a dim view of the rumored Dish deal that may clear the way for regulatory approval:
We’re not sure why that deal is sensible for anyone involved. Dish, remember, already has more spectrum than they know what to do with; what they lack is money and ground facilities, and the deal described on Friday wouldn’t deliver either one. Instead, it would make both problems worse. And while Boost would help provide a baseline revenue stream in return for an upfront purchase price, the fit between Boost and Dish is, at best, superficial.
Back to T-Mobile. At what point does T-Mobile, and/or its parent company Deutsche Telekom, walk away? Hey, we tried. We turned over every stone. But we just couldn’t make it work.
At the end of the day, a bad deal is worse than no deal at all. Truth be told, there have been nagging questions about whether T-Mobile would be better off without the deal under any circumstances. Certainly, the exchange ratio never made any sense to us. And, absent a deal, T-Mobile would seemingly be in a good position to poach an awful lot of Sprint’s subscribers… without having to pay for them.
The idea of T-Mobile voluntarily selling assets to Dish would have been risible just months ago. On Oct. 25, TMUS sent a letter to the FCC asserting that Dish “intends to continue to warehouse spectrum with no benefit to customers.” As noted by Mike Dano of industry website FierceWireless, Dish has been one of the staunchest opponents of a TMUS/S tie up, arguing in an FCC petition last August that the merger would: “lead to excessive concentration in other relevant markets, and likely increase prices for consumers.”
One investor familiar with the situation tells Grant’s today that even with DOJ approval and an agreement on divestitures, Sprint and T-Mobile will have their hands full getting the deal past the state AGs:
So the solution is to give Dish additional spectrum and then position Dish with: less subs than stand-alone Sprint (and only prepaid); less or no corporate-owned stores than stand-alone Sprint; a more levered balance sheet than stand-alone Sprint (Sprint has SoftBank behind it too, whether Sprint wants to admit it or not); less spectrum than stand-alone Sprint; and no history operating a wireless business (so a start-up) vs. Sprint being an operating company?
Oh, and Dish won’t actually own its network, no matter how strong an MVNO [mobile virtual network operator] it gets. This remedy is a joke anyway you cut it. States will see this and will refile the complaint.
I’ve heard the argument that the judge will heap deference on DOJ/FCC. But that’s just not how the law works – the Clayton [Antitrust] Act is the Clayton Act, and the proposed fixes won’t change the presumption of harm. In the eyes of the law, the deal is illegal, and the parties will have their day in court to show the fix and efficiencies rebut the presumption.
Yet as far as Mr. Market is concerned, it’s a done deal: Sprint currently trades just 6% below the all-stock deal price implied by T-Mobile shares, while the senior unsecured 6 7/8 notes of 2028 last changed hands at 107 cents on the dollar for a 404 basis point spread over Treasurys.
QT progress report
The Fed’s portfolio of securities held outright fell to $3.661 trillion this week, down $6.5 billion sequentially and $11 billion from the trailing four-week average, with mortgage-backed securities holdings providing all of this week’s change.
Since the fall 2017 start of QT, total balance sheet assets are down by 13.7%, an 8.2% simple annualized pace.
Recap June 20
The tide continues to rise, as another impressive rally in stocks pushed the S&P 500 to a fresh closing high above 2,950, up 18% year-to-date. The gaudy gains were not limited to equities, as Treasury yields continued their eye-watering dive with the 10-year falling as low as 1.98% this morning from 2.5% as recently as May. Energy prices caught a strong bid after President Trump offered more bellicose commentary towards Iran on Twitter, with WTI crude jumping 6% to near $57 a barrel, and gold continued its hot streak with a 3% rise to $1,387 per ounce, its best finish since March 2014.
One potentially bearish trading indicator was a strong rebound in the VIX, which reversed an early dip below 14 to finish at 14.75, up 3% on the day.
So-called quadruple witching options expiration tomorrow could yield some early volatility.
- Philip Grant
Wednesday, June 19, 2019
Wax on wax off
Cognitive dissonance reigns supreme, as the stock market sits near an all-time high, credit spreads remain tight and the post-crisis economic recovery looks to match a record-long 120th month in June. Yet investors continue to pour their capital into perceived safer assets, sending Treasury yields diving and pushing the global supply of negative-yielding debt securities to a record $12.5 trillion. Signs of the times is the subject, beginning with a pair of anecdotes reported by Bloomberg this morning.
In South Africa, state-owned utility Eskom Holdings SOC Ltd. struggles to service its $30 billion debt load through internal cash flow generation. That hasn’t stopped its dollar-pay bonds due 2028 from returning 22.3% year-to-date as investors anticipate a helping hand from the double-B-rated South African government. That assistance better be forthcoming, according Citadel Holdings Ltd. portfolio manager Mike van der Westhuizen, who notes: “Without government support Eskom is dead in the water.”
This morning, triple-C-rated Greek lender Piraeus Bank S.A. finalized terms for €400 million ($448 million) of tier-two notes with a 9.75% coupon, as an order book exceeding €850 million helped the issue price more than 50 basis points tighter than the underwriters had expected. Sohail Malik, co-CIO and portfolio manager at Roxbury Asset Management, told Bloomberg that “Piraeus has timed this well,” capitalizing on a global “bid frenzy” for subordinated bank debt.
Risk appetite likewise continues to percolate in the U.S., as the Bloomberg Barclays High Yield Index trades at an option adjusted spread of 398 basis points over Treasurys, well below the 512 basis point average pickup going back to March 1994. More broadly, the Bloomberg Barclays U.S. Corporate Bond Index has generated a total return of 8.43% less than halfway through 2019, better than any full year since 2012. Some watchers expect more of the same, with analysts at BofA Securities writing today that psychological factors could help extend the rally:
There is only one large, reliable, source of yield for fixed income investors, which is the global corporate bond market. Should U.S. interest rate volatility recede, as U.S.-China trade related uncertainties are lifted, we expect significant foreign demand for U.S. corporate bonds to supplement near record inflows to investment grade bond funds and ETFs, leading to significantly tighter credit spreads and flatter spread curves.
A trade deal would accelerate this, but we believe this scenario would play out even without, as fixed income investors are unable to stay underweight indefinitely and - due to Fed rate cuts - the cost of staying underweight becomes prohibitive.
While the fear of missing out looms large in the minds of investors, key indicators show signs of deterioration. According to J.P. Morgan Securities, LLC, an analysis of more than 500 speculative-grade non-financial and non-utility borrowers showed a 4.3% year-over-year EBITDA decline in the first quarter (the first such contraction since 2016). Average EBITDA now covers interest expense 4.56 times on average, down from 4.78 times a year ago.
That downtick in corporate health flagged by J.P. Morgan is confirmed by a pair of metrics from Moody’s Investors Service. On June 10, the ratings agency raised its 12 month global default forecast to 2.4%, well below the post-1983 average of 4.1% but nearly double the 1.3% 12-month default guesstimate issued a month ago. Two days later, Moody’s reported that its Liquidity Stress Indicator rose to 4.5% in May, likewise comfortably below its 6.3% long-term average but at its highest level since April 2017.
Curiously, according to the BofAML June Fund Manager Survey, respondents raised their average cash balance to 5.6% from 4.6% in March, April and May, representing the biggest jump in dry powder since the 2011 European sovereign debt crisis. In addition, long U.S. Treasurys took the number one spot for the most crowded trade identified by investors for the first time ever.
Meanwhile, lower rates at the short end are a stone-cold lock according to interest rate futures, which now price 100% odds of a July rate cut following this afternoon’s stand-pat decision from the FOMC.
Recap June 19
The Fed didn’t cut rates, but price action suggested they may as well have. Most notable was another panic bid in short term Treasurys, as the two-year yield dived lower by 11 basis points to 1.74%, down from 2.39% two months ago. Stocks enjoyed a late lift, with the S&P 500 drawing closer to its April 30 peak, and gold continued its hot streak by pushing to $1,360 an ounce, its highest since July 2016. The VIX reversed early gains, falling 5% to 14.3.
- Philip Grant
Tuesday, June 18, 2019
So much winning
“The cultural level of a nation is mirrored by its rate of interest: the higher a people’s intelligence and moral strength, the lower the rate of interest.”
“The cultural level of a nation is mirrored by its rate of interest: the higher a people’s intelligence and moral strength, the lower the rate of interest.”
Recap June 18
So much winning
“The cultural level of a nation is mirrored by its rate of interest: the higher a people’s intelligence and moral strength, the lower the rate of interest.” Thus declared economist Eugen von Böhm Bawerk, according to Richard Sylla and Sidney Homer’s classic tome A History of Interest Rates. By that logic, Europe is the domain of superhumans, as the overnight deposit rate has resided below zero since June 2014 and at negative 40 basis points since March 2016.
The M.D. overseeing Europe’s monetary affairs has his own version of the Hippocratic Oath. Speaking at the ECB’s annual forum at the resort town of Sintra, Portugal today, ECB president Mario Draghi made waves by suggesting the central bank will impose still lower interest rates:
Further cuts in policy interest rates and mitigating measures to contain any side effects remain part of our tools. . . Negative rates have proven to be a very important tool in the euro area.
In the absence of improvement, such that the sustained return of inflation to our aim is threatened, additional stimulus will be required.
The implications are clear. Claus Vistesen, chief eurozone economist at Pantheon Macroeconomics, told Bloomberg: “Draghi is going to finish his tenure [set to end on Oct. 31] with a cut. The door is now open and I don’t see how they can not walk through it.” Mike Riddell, fund manager at Allianz Global Investors, noted: “The ECB has just handed the bond bulls an ammunition dump.”
Five years and counting into the negative rate era, the ECB’s increasingly radical policies designed to hot up inflation simply haven’t worked. Eurozone CPI rose just 1.2% year-over-year in May, the lowest figure in over a year. Likewise, the “five year, five year inflation swap rate,” Draghi’s preferred metric for the future inflation expectations that the central bank is so eager to manipulate, fell to a record low 1.14% on Friday, since rebounding to 1.23% but still well below the five-year average of 1.48%, let alone the ECB’s now-symmetrical, “close to 2%” bogey.
While inflation stubbornly refuses to follow the playbook, the bond market has been more easily cowed. Following Draghi’s remarks today, the French 10-year yield temporarily broke below zero for the first time ever, while Sweden (which resides outside of the eurozone currency bloc but is an E.U. member state) also saw its 10-year borrowing costs make their first ever foray into negative territory.
More broadly, the worldwide sum of negative-yielding debt instruments rose to $11.8 trillion as of yesterday, up from less than $6 trillion as recently as last fall and within range of the record $12.2 trillion seen in July 2016 (when the 10-year Treasury yielded less than 1.4%, compared to 2.06% today). Never in the 4,000 years of human history, per Sylla, were negative rates seen in substantial size prior to this cycle. The upside-down policy rate extends to the less-creditworthy members of the E.U., as Baa3/triple-B-rated Italy and B1/double-B-minus-rated Greece saw their 10-year yields fall to 2.12% and 2.51%, respectively, not far above the split-rated (triple-A at Moody’s, double-A-plus at S&P) United States.
Bloomberg’s global negative rate index by market capitalization since January 2010
The peculiar state of affairs has not seemed to help the Old Continent’s frail banking system, which lags far behind global peers in terms of profitability and valuation (Almost Daily Grant’s, May 28). As the banks list, one of the shakiest institutions continues to search for answers. Bloomberg reports today that Deutsche Bank A.G. (which has seen shares fall 84% in the last nine years to less than 21% of its year-end 2018 book value) CEO Christian Sewing is set to “purge” a number of top executives and is also “zeroing in on another round of deep trading cuts that may result in the shuttering of the U.S. equities” division.
Others take a different tack. Speaking on a conference panel this morning, Cornelius Riese, co-CEO of Frankfurt-based DZ Bank A.G. (Germany’s second-largest by assets), observed that negative rates indeed “have a huge impact on banks.” Riese ventured to offer some gentle criticism of Draghi & Co.’s grand policy experiment: “Maybe at the end of the story, in three to five years, we will notice it was a historical mistake.”
Not everyone was so circumspect. This morning, Donald Trump took to Twitter to complain:
Mario Draghi just announced more stimulus could come, which immediately dropped the Euro against the Dollar, making it unfairly easier for them to compete against the USA. They have been getting away with this for years, along with China and others.
Sad!
Recap June 18
News that Trump will meet with China’s Xi Jinping at the G-20 meeting next week helped spur another bull move, as the S&P 500 jumped 1% to close within 100 basis points of its April 30 highs. Energy prices ripped with WTI crude closing above $54 for the first time since late May, while gold moved to a new 52-week high above $1,346 an ounce. Treasurys rallied with strength in the long end pushing the curve flatter, and the VIX finished just above 15.
- Philip Grant
Monday, June 17, 2019
That was then
How the turntables have turned.
How the turntables have turned.
Everyone's a critic
A shocker this morning:
A shocker this morning:
Recap June 17
That was then
How the turntables have turned. Over the weekend, the New York Post reported that Goldman Sachs Group, Inc. CEO David Solomon has been invited to perform at European house music festival Tomorrowland later this summer, a gig which “will take DJ D-Sol’s career to a new level, according to insiders.” Solomon/DJ D-Sol already saw a recent single reach as high as number four on the Billboard Dance music charts earlier this year.
It’s a new era for Goldman, long a Wall Street investment partnership led by co-chairman John Whitehead, a Navy veteran who saw action at the invasions of Normandy and Iwo Jima before joining the firm in 1947. A 2015 Financial Times obituary of Whitehead cited a telling exchange early in his Wall Street career:
As Whitehead relates in Money and Power, How Goldman Sachs Came to Rule the World, that did not mean the partners tolerated any compromise in formality. Arriving at the office in a seersucker suit in a humid New York summer, he was accosted by Walter Sachs, scion of the firm’s co-founder and asked: “Young man, do you work at Goldman Sachs?” He confirmed that he did, only for Sachs to reply: “In that case, I would suggest that you go home right now and change out of your pajamas.”
As for the musically-inclined who don’t care for techno, alternatives abound. As noted by Jim Bianco this morning on Twitter, Fed governor Richard Clarida released an album in 2016 on Apple Music. Relevant track titles include “Gone too far,” “Take too long,” “Just can’t wait” and others.
Everyone's a critic
A shocker this morning: Patrick Drahi, founder and president of the board of telecom giant Altice N.V. as well as chairman of Altice U.S.A, Inc., announced he will acquire Sotheby’s, Inc. (BID on the NYSE) for $3.7 billion in cash. Drahi, worth some $9.3 billion according to Forbes, will take 275-year old Sotheby’s private through his appropriately named BidFair USA, LLC entity, ending the company’s 31-year run on the New York Stock Exchange.
The $57 per share deal price represents a 61% premium to Friday’s close and is 56.3% above Sotheby’s volume weighted average price over the past 30 days. BID shares had not exactly been a hot commodity of late, falling 25% from the Grant’s bearish analysis on September 7, 2018 to Friday, compared to a 10% loss from the Russell 2000 Index. Following today’s announcement, BID shares now sit higher by 19% over the past nine months and change.
For already junk-rated (Ba2 at Moody’s and double-B-minus at S&P) Sotheby’s, today’s news is seemingly a best-case outcome for management and shareholders, if not the short interest. Wendy Battleson and Giulia Costantini, co-founders of Art Strategy Partners and themselves former outspoken bears (Grant’s, April 19), have this comment:
Taking Sotheby's private was the only smart move for the company. Sotheby's requirements for complete transparency as a public company and quarterly disclosures of guarantee risk and the sizing of their art finance book were cumbersome when compared to their main competitor Christie's. Auction houses like confidentiality even within their own operations and being public simply doesn't allow that.
Sotheby’s, Inc. one-year price chart. Source: The Bloomberg
For Drahi, a self-described “longtime client and lifetime admirer of the company,” BID’s cachet looms large, as he describes Sotheby’s in the press release as “one of the most elegant and aspirational brands in the world.” Consistent with Altice’s highly leveraged business model (net debt stands at 6.8 times consensus 2019 adjusted EBITDA), Drahi will fund the deal through financing from BNP Paribas S.A., as well as by selling a portion of his stake in Altice U.S.A., Inc.
Is that move a sign of the times? A number of corporate bellwethers have recently opted to monetize existing stakes instead of raising fresh capital. On May 30, the Financial Times reported that SoftBank Group Corp.’s Vision Fund will take out $4 billion in loans, collateralized by its stakes in Uber Technologies, Inc., Guardant Health, Inc. and Slack Technologies, Inc., after encountering difficulty in raising money for a Vision Fund sequel.
The FT notes that “by borrowing against the value of publicly traded shares, SoftBank can return capital to investors in the fund while bypassing ‘lock-up’ periods that can prevent shareholders from selling stakes in newly-listed businesses.” That follows an $8 billion margin loan in April 2018 taken out by SoftBank collateralized by its stake in Alibaba Group Holding Ltd. (BABA on the NYSE). Last Thursday, The Wall Street Journal reported that Alibaba filed confidential paperwork with the Hong Kong Stock Exchange ahead of a second listing, a move which could raise upwards of an additional $20 billion per media reports.
Alternatively, some companies pursue highly dilutive offerings to scrounge cash. On Thursday, single-B-plus-rated Hertz Global Holdings, Inc. announced a rights offering of up to $750 million, a move which will help the company meet $1.5 billion in debt maturities set for 2020 and 2021 but would dilute existing shareholders by 69% if the entire allotment were exercised.
Recap June 17
Stocks gave back early gains as the S&P 500 finished just above unchanged, up 15% year-to-date and 2% below its April 30 high-water mark. WTI crude and gold both ticked lower, finishing at $52 a barrel and $1,339 an ounce, respectively, and rates mostly ticked higher. The Fed commences its two-day policy meeting tomorrow, with interest rate futures currently implying 17% odds of a rate cut on Wednesday.
- Philip Grant
Thursday, June 13, 2019
Liquidity shortage
Recovery room
Yesterday, the U.S. Treasury reported that Uncle Sam’s
Yesterday, the U.S. Treasury reported that Uncle Sam’s
QT Progress report
Recap June 13
Liquidity shortage
From Bloomberg:
The London Metal Exchange is toughening its stance on alcohol consumption with new rules that will prohibit floor traders from drinking during the workday, according to people familiar with the matter.
Maybe they could take the party to a WeWork office?
Recovery room
Yesterday, the U.S. Treasury reported that Uncle Sam’s May deficit totaled a record $208 billion, bringing the 2019 year-to-date (the fiscal year begins on Oct. 1) shortfall to $739 billion. For context, full-year 2018 and 2017 saw gaps of $779 billion and $666 billion, respectively.
The explosion in government deficits during this extended epoch of economic growth is unusual. Typically, the government ledger improves during expansions, as revenues increase and the need for emergency spending diminishes. Thanks in large part to the Trump administration’s 2017 Tax Cuts and Jobs Act, that playbook is out the window. Instead, the White House’s own Office of Management and Budget pegs this year’s deficit at 5.1% of GDP.
The flowing red ink is set to continue, if estimates from the Congressional Budget Office are on the beam. The CBO pencils in deficits averaging 4.3% of GDP each year through 2029. That compares to a 50 year average deficit of 2.9% and 2.4% as recently as 2015.
Those persistent deficits will accelerate the pileup of Treasurys, as the CBO estimates that debt held by the public will jump an additional $12.7 trillion to $28.5 trillion by year-end 2029, equal to 92% of projected GDP from 78% currently and 66% in 2011.
There’s more where that came from. The Wall Street Journal reports today that “political support for taming deficits has melted away.” The electorate is increasingly comfortable with persistent shortfalls, as a January survey from Pew Research found that 48% of respondents favored prioritizing deficit reduction, down from 72% in 2013. Then, too, former IMF economist Olivier Blanchard argued at the American Economic Association in January that as government borrowing costs have generally lagged nominal GDP in the past 75 years, debt can essentially pay for itself as long as the economy keeps growing.
Indeed, as the post-crisis economic expansion rolls into its 120th consecutive month, tying the March 1991 to March 2001 period for the longest on record, The Journal concludes that the U.S. “is on course to test just how much it can borrow.”
That complacency is understandable, considering the bond market’s forgiving stance. Since 2002, federal debt held by the public has more than quadrupled, to $16.2 trillion. Yet, as the government’s books deteriorate, interest rates march lower, with the 10-year yield now at 2.13%, compared to 4.9% 17 years ago.
An interruption of the now decade long economic expansion would accelerate those fiscal shortfalls. Over the past 50 years, recessions have spurred deficit growth equating to 4% of GDP, on average. As widely noted, the yield curve suggests that something nasty may be in the offing (Almost Daily Grant’s, June 6).
Other indicators are likewise concerning. On Monday, The Dodge Momentum Index, a leading indicator for nonresidential construction, fell 9.2% year-over-year in May, with the commercial component down 16% from a year ago. Similarly, the Architecture Billings Index, which leads nonresidential construction activity by nine to 12 months, slipped into contraction in March for the first time since 2017. After a modest rebound in April (the most recent reading), American Institute of Architects chief economist Kermit Baker commented: “In contrast to 2018, conditions throughout the construction sector recently have become more unsettled.”
As the prospect of recession hovers and investors pile into the obligations of an ever-more spendthrift government, might an inflection point be approaching? The Feb. 9, 2018 edition of Grant’s Interest Rate Observer detailed the psychological shift between current conditions (underscored by the famous line reputedly offered by Dick Cheney: “Reagan proved that deficits don’t matter”) and the fallout of the 1946 to 1981 bond bear market, in which the 30-year Treasury was quoted at 14% in 1984, offering an inconceivable inflation-adjusted yield of nine percentage points:
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 of bonds 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 repellent.
That attitude, and its opposite, are years in gestation.“The bond crop never fails” was how disgusted fixed-income investors expressed the free-floating 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 is due for cyclical revision.
QT Progress report
No change this week, as the Fed’s portfolio of securities held outright remained at $3.668 trillion, down $9.2 billion from the trailing four-week average. Since the fall 2017 commencement of QT, total balance sheet assets are down by 13.7%, an 8.3% simple annualized pace.
Recap June 13
Stocks finished little changed, leaving the S&P 500 marginally higher so far this week, while resources caught a bid with WTI crude bouncing over $52 a barrel and gold reclaiming a 52-week high at $1,341 an ounce. Another strong day for Treasurys saw the curve steepen as the short end outperformed, and the VIX remained stuck, finishing near 16 for a seventh straight session.
- Philip Grant
Tuesday, June 11, 2019
Inspector Gadget
Will the taxpayer say no más? Last week, four Democrats on the House Committee on Oversight and Reform wrote a letter to the Department of Defense Inspector General asking for a broader investigation into TransDigm Group, Inc. (TDG on the NYSE). TransDigm, which provides aerospace equipment to public and private entities including the DoD, has long been under scrutiny for its aggressive pricing. Only recently has the extent of these practices been laid bare.
A preliminary Inspector General examination from 2015 to 2017 of government contracts for 47 spare parts found that TransDigm earned “excess profits” on all but one, totaling $16.1 million of the $26.2 million total audited value. Markups ranged as high as 4,451% on some equipment. The four Democrats write:
Because you identified so many overcharges in just the small sample of contracts you examined, we believe it is highly likely that TransDigm is receiving additional excess profits that have not yet been identified.
The interest is bipartisan. On May 15, Senate Committee on Finance Chairman Chuck Grassley (R., Iowa) wrote a letter to Secretary of Defense Patrick Shanahan featuring some withering criticism of TransDigm’s business practices:
The pattern of price-gouging by TransDigm and its subsidiaries has gone unimpeded for decades. It has amassed exclusive rights to sell these spare parts to the Pentagon. In fact, the Defense Department accounted for 34% of its sales in 2017. TransDigm exploited its business model and took advantage of its sole-source position to leverage higher prices.
Monopolies invite government regulation. If that’s the road TransDigm wants to continue following, I’m here to deliver a message. The jig is up on this cozy relationship. The buck stops here.
The rising heat from Congress seems to be making an impact, as the company announced on May 24 that it would reimburse the government for $16 million. That decision followed May 15 testimony from Assistant Secretary of Defense for Acquisition Kevin Fahey that TransDigm was “gouging the taxpayers with their sickening business practices.” A TransDigm spokeswoman told the Washington Post that the “decision to voluntarily issue refunds was a demonstration of good faith and a reflection of the importance of our DoD customers.”
If so, TDG would be turning over a new leaf, according to the Capitol Forum, which reported in 2017 that the company conducted quarterly training sessions “on how best to navigate the [government] procurement process to maximize price increases. . . seminars taught subsidiary leadership to deny the government’s requests for cost and pricing information.”
Needless to say, TransDigm’s business model has been a successful one, as the company boasts an income statement that is the envy of the industry: TDG’s trailing 12-month EBITDA margins stand at a princely 48%, triple the peer group average as compiled by Bloomberg and nearly double the next highest, HEICO Corp. (HEI on the NYSE), which was identified as a world class operator by John Hughes of Quantum Capital Management, LLC at the Grant’s Spring Conference in April.
Might the rampant overcharging suggested by the Inspector General explain TransDigm’s remarkable profitability? Mr. Market gives the company its due, as TDG shares command a fancy valuation of 28 times 2019 EPS, with the company’s $40 billion enterprise value standing at 17.5 times 2019 consensus EBITDA. As noted by J.P. Morgan Securities, LLC analyst Seth Seifman, who has a “sell” rating on TransDigm, the bipartisan congressional outrage might not translate into much, in the short term at least:
TDG has a successful business model based partially on aggressive pricing and no one has alleged that the company broke the law; therefore, we have little doubt that TransDigm will remain as aggressive as ever in pushing price until Congress and/or DoD change the rules.
Not just in hiking prices does B1-rated TransDigm distinguish itself. Thanks in large part to no fewer than 22 acquisitions since 2012 (headlined by a $4 billion cash deal announced last October for Esterline Technologies Corp., at a 41% premium), TDG is highly leveraged, carrying a net debt load of 6.5 times consensus 2019 EBITDA. That compares to an average debt to EBITDA ratio of 5.2 for the average B-rated company within Moody’s Investor Service coverage universe, per an October report from the ratings agency.
Management has further tipped the capital structure scales, issuing a $22-per-share special cash dividend in September 2017 as well as a $24-per-share dividend in 2016, for a total disbursement of $2.6 billion. For context, the company generated $2.3 billion in free cash flow across 2016, 2017 and 2018 (TransDigm’s fiscal year ends on Sept. 30).
With a hefty debt burden built on a foundation of perhaps unsustainable profitability levels, TransDigm creditors have no shortage of reasons to lie awake at night. The compensation on offer? The first lien 6 1/4 notes due 2026 currently trade at 105 cents on the dollar, for a 5.14% yield-to-worst and a 323 basis point pickup over Treasurys. A government crackdown or simple interruption in TransDigm’s growth-by-acquisition model would potentially reverberate: That debt issue is the third largest in the iShares iBoxx High Yield ETF (HYG on NYSE Arca), accounting for 51 basis points of the fund’s total assets.
As for TDG stock, a 76% levitation over the past two years has chased the bears, as short interest currently stands at 5%, down from near 13% in spring 2017. As the shorts cover, TransDigm management hits the bid. Year-to-date, corporate insiders have sold 137,205 shares, cashing out some $61 million. CEO Kevin M. Stein owns just 8,300 shares for a current market value of $3.8 million. Stein took home $29 million in total compensation last year.
Recap June 11
Status quo today, as stocks gave back strong early gains to finish unchanged, while oil and gold also cruised sideways and long rates likewise held steady. The two-year yield rose to 1.93%, up from a post-2017 low of 1.83% last Monday, and the VIX closed near 16 for a fifth straight session.
- Philip Grant
Monday, June 10, 2019
Alberta king
A rebound north of the border? Toronto-area real estate saw a relatively brisk showing in May, as total transactions jumped 18.9% to 9,989, not so far below the 10-year average of 10,300, while the average sales price rose 3.8% year-over-year to C$839,000 ($629,000), within range of the C$862,000 seen in May 2017 near the peak of the market. Nationwide, GDP expanded by 0.5% sequentially in March (the most recent reading), matching the strongest growth rate since 2016. The labor market remains red hot, as the unemployment rate for May fell to 5.4%, down from 5.7% in April and the lowest on record dating back to 1976.
The stronger data have the attention of Bank of Canada governor Stephen Poloz, who told BNN Bloomberg on May 17 that he maintains a hawkish bias: “The natural tendency is for interest rates to still go up a bit.” The market seems to feel differently. On Friday, the Canadian 30-year yield closed at 1.72%, (below the current BoC 1.75% overnight rate), while interest rate futures suggest 30% odds of a rate cut by October, with no chance of a hike.
Despite the improvement in Toronto, it’s safe to say that the sun has set on Canada’s long-running housing boom. Nationwide, price growth has abated, with the Teranet-National Bank House Price Index rising just 1.2% in April, the worst reading since 2009 and well below the 2% year-over-year rise in April CPI. By comparison, April 2018 and 2017 saw year-over-year gains of 5.6% and 13.2%, respectively.
As housing cools, the leveraged Canadian consumer shows signs of strain. Canadian household borrowings rose to a record 179% of disposable income at year-end 2018, well above the 144% U.S. peak in 2007. That burden looks to be taking a toll. On Monday, the Office of the Superintendent of Bankruptcy reported that nationwide consumer insolvencies footed to 11,785 in April, down slightly from the eight-year high of 11,963 logged in March but up 9.3% year-over-year. The annual home renovation poll conducted by the Canadian Imperial Bank of Commerce (CIBC) finds that respondents plan to spend an average C$10,200 on home repairs this year, down from C$11,000 last year and C$11,800 in 2017.
A downshift in activity likewise crimped recent results from some of Canada’s largest banks. In the most recent quarter, the Royal Bank of Canada reported a 2.4% year-over-year rise in earnings from its domestic unit, the slowest growth rate in five years. Toronto-Dominion Bank’s Canadian unit saw a 1% year-over-year uptick in net income, while CIBC generated $570 million in earnings from its personal and small business banking unit, down 2.4% from a year ago. The slow- or no-growth domestic environment casts shade on some premium valuations: RBC shares currently trade at two times book value, TD Bank at 1.31 times and CIBC at 1.35 times book. By comparison, the U.S. KBW Bank Index currently trades at 1.15 times book.
CIBC, which is particularly exposed to the local housing market (see the Feb. 9, 2018 edition of Grant’s Interest Rate Observer), seems to have been caught off guard by the recent sea change. On the May 22 conference call, executive vice president Christina Kramer explained:
And that’s due to the market turning out different than we had anticipated, impacting us more than our peers due to our strategic focus. In the large urban markets, [the] pullback in activity has been more pronounced and more prolonged than we assumed.
But that shift in conditions isn’t cause for concern to the CIBC c-suite. CFO Kevin Glass remarked on the call that “there’s nothing on the horizon that would give us any indication that economic conditions are about to change significantly that would give rise to significant loan losses.” As noted by Fitch Ratings, the average impaired loan ratio for Canada’s Big Six ticked to 53 basis points in the second quarter, up from 48 basis points year-over-year but still comparable to the net 47 basis points seen among U.S. banks in the first quarter (the most recent data available), according to the St. Louis Fed. For context, the prior U.S. credit cycle culminated with a 312 basis point loan loss ratio in the first quarter of 2010.
Signs of more acute distress are evident away from the largest banks. ATB Financial, an institution owned by the Province of Alberta, reported credit metrics for its fiscal year ended March 31 that could be described as shocking. Namely, ATB’s provision for loan losses jumped to C$338 million, more than triple the C$105 million logged in 2018. That increase in bad debt led directly to a 50% drop in net income, as the pre-provision bottom line rose 12% from a year ago.
Seth Daniels, founding partner at JKD Capital Management, tells Grant’s today that ATB’s plight is instructive:
ATB Financial arguably provides the most accurate glimpse into credit quality in Alberta and can be considered another major domino to fall in the Canadian credit cycle. ATB’s impaired loans and provisions for bad debt stand in stark relief to its publicly traded financial counterparts, and potentially point to a larger problem--the systemic under provisioning for bad loans while actual impaired loans are building, thereby artificially inflating earnings and capital ratios.
Recap June 10
Stocks continued their rampage, with the S&P 500 catching another solid bid to extend its five day winning streak to more than 5% and close to within 2% of its April 30 highs. Key commodities took a breather, with WTI crude and gold each falling about 1% as the Money of Kings saw its eight-session winning streak snapped, and interest rates jumped higher with the 10-year yield rising six basis points to 2.15%. The VIX held near 16, remaining relatively sturdy during this bull move.
- Philip Grant
Friday, June 7, 2019
Step Brothers 2
Alternative lodging by the Bay
Alternative lodging by the Bay
Right place wrong time
Yesterday, Fitch Ratings downgraded Petróleos Mexicanos (A.K.A. Pemex)
Yesterday, Fitch Ratings downgraded Petróleos Mexicanos (A.K.A. Pemex)
Recap June 7
Step Brothers 2
Alternative lodging by the Bay from real estate blog Curbed San Francisco:
How much does it cost for bare minimum accommodations in San Francisco—i.e., a bed and a roof?
In the Tenderloin, that’ll be $60 per night, or $1,200 per month. That’s what the Southern California-based startup Podshare charges for one of its “pods” at the company’s first San Francisco locale.
According to the company, “A pod is a hand-built, high-end bunk bed complete with your own flat screen TV and night light.”
Renting with Podshare buys access to the bed and the communal spaces in the building in what’s essentially a hostel-like setup—complete with a dearth of privacy thanks to the wide open, multi-pod layout of rooms Podshare offers.
Behold the sharing economy.
Right place wrong time
Yesterday, Fitch Ratings downgraded Petróleos Mexicanos (A.K.A. Pemex) into junk territory (to double-B-plus from triple-B-minus) one day after cutting its rating of Mexican sovereign debt to triple-B from triple-B-plus. “This assessment,” said Fitch, "reflects the very high level of transfers to the government at the expense of underinvestment in the company’s business.” A recent $5.5 billion bailout package wasn’t enough to move the needle.
For Pemex, a vicious cycle of long-term decay is at hand: “the company continues to severely underinvest in its upstream business, which could lead to further production and reserves decline.”
The symbiotic relationship was on full display last month, when President Andrés Manuel López Obrador, or AMLO, announced that Pemex would be tasked with building a mega-refinery in his home state of Tabasco at an expected cost of $8 billion, with a targeted completion date of 2022. That’s better than anything the private sector could muster, as a trio of bidders provided cost and completion estimates ranging from $10 billion to $12 billion and 2023 to 2025.
Those heady ambitions run headlong into unpleasant facts. Pemex, which has an outstanding debt stock of $106 billion along with $54 billion in pension liabilities (combining for six times 2018 adjusted EBITDA of $28 billion), faces a protracted decline in reserves and production, as first quarter output slumped to 1.66 million barrels per day (mbpd), down 12% year-over-year and less than half of the 2004 peak of 3.4mbpd. That erosion is evident on the financial statements, as $87.5 billion in 2018 revenue is little changed from an $85.3 billion top line in 2005. Over that period, external debt less cash has jumped to $102 billion from $39 billion.
Perhaps most concerningly, the deepwater Ku-Maloob-Zaap (KMZ) oil field, which now represents more than half of Pemex’s production and has remained rock steady (the larger Cantarell field saw production peak in 2004) in recent years, saw output slide 4% in the first quarter. Though that’s far less than the 12% aggregate decline, John Padilla, partner and managing director at energy consulting firm IPD Latin America, told Grant’s last year that any drop at KMZ is ominous indeed:
They [Pemex] have managed it infinitely better [at KMZ] than what they did at Cantarell. If there is one glorious thing that they’ve been able to do to date, [it] is that they’ve been able to manage KMZ’s production well, but any field that you use secondary, tertiary recovery tech-niques . . . you squeeze it faster and there is less of it at the end. That pro¬duction will fall, and when it falls, it is going to fall very significantly.
Since a bearish analysis in the March 23, 2018 edition of Grant’s Interest Rate Observer, Pemex’s senior unsecured dollar-pay bonds due 2047 have fallen to 88 cents from 99 cents, pushing the spread over Treasurys to 572 basis points from 477 basis points. There may be more pain to come, potentially necessitating drastic measures from the Mexican government that may, in turn, augur further pain in the sovereign. Padilla summed it up: “Pemex, in any private sector context, would absolutely be considered bankrupt.”
Recap June 7
A softer than expected reading of April nonfarm payrolls did nothing to dampen raging animal spirits, as stocks enjoyed another strong rally to leave the S&P 500 higher by a meaty 4.5% for the week. A weaker dollar helped stoke a strong bounce in energy, with WTI crude rising to $54 a barrel, while gold edged to a new 52-week high at $1,341 an ounce, extending its winning streak to eight. Despite the bullish action, the VIX reversed early losses to finish near 16.
Interest rates continue to collapse, as the two- and 10-year yields finished the day at 1.85% and 2.08%, respectively, down from 2.97% and 3.24% in early November. The 10-year remains 20 basis points below the three-month bill yield.
- Philip Grant
Thursday, June 6, 2019
Grand central
Following today’s press conference at the European Central Bank, Mario Draghi struck a contented tone, assessing a “very low” probability of recession and “no probability” of deflation, while citing risks such as “protectionism, geopolitics [and] emerging markets,” which are outside of Frankfurt’s purview.
However, that sanguine outlook doesn’t mean that hawkish, or even neutral policy is called for. In his statement, Draghi said that the ECB “is determined to act in the case of adverse contingencies.”
More specifically, he told reporters that some members of the ECB governing council discussed both cutting interest rates from the current negative 40 basis point deposit rate, as well as restarting the QE program (which has already boosted balance sheet holdings to 40% of 2018 eurozone GDP, compared to 18% of 2018 U.S. GDP for the Fed). Indeed, the ECB “has considerable headroom” to restart QE, in Draghi’s judgement.
That rosy assessment, in tandem with the suggestion of still-easier money, didn’t spark Mr. Market’s interest, as the Stoxx 600 Index gave back a near 1% gain at midday to finish in the red. More broadly, Europe’s banks have floundered despite (or, perhaps because of) the ECB’s exertions. The Stoxx 600 Banks Index trades at a feeble 0.54 times book value and generated a 6.91% return on equity over the past 12 months, compared to the KBW Bank Index’s 1.2 times book and 11.7% trailing-12 month ROE.
While negative rates and indiscriminate asset purchases haven’t helped Europe’s banks, the ECB is considering tweaks to ease the burden of negative rates. Thus, today’s statement referenced “mitigating measures” that may be used to offset “possible side effects on bank-based intermediation” resulting from the policy prescriptions of Draghi et al, such as a tiering system for deposit rates.
Rather than ease back on the negative-rate throttle, the ECB suggests other remedies. On May 15, executive board member Benoit Coeuré argued that negative rates are costing banks €8 billion ($9 billion) annually, “really peanuts.” Europe has too many banks and needs industry consolidation, per Coeuré.
Stateside, central bankers indulge in their own sympathetic self-analysis. Earlier this week, the Federal Reserve conducted a confab in Chicago to culminate their nationwide “listening tour,” at which chairman Jerome Powell assured listeners that he “will act as appropriate to sustain the expansion,” as well as approvingly assessing past QE and ZIRP programs: “These policies provided meaningful support for demand.”
Tinkering was also on the agenda, as attendees debated the utility of the so-called dot plot predictions, along with the concepts of implementing nominal GDP and “average inflation” (meaning that periods of below-2% price growth should be offset by symmetrically higher ones) targeting. The Fed plans on announcing new policy goals next year.
But after all that listening, new concepts aren’t likely to be implemented soon. Fed vice chairman Richard Clarida told CNBC on Tuesday that “we are going to have a high hurdle for any major change to the [existing] framework.”
Instead, the Fed has more prosaic, and immediate concerns. Namely, the future course of interest rates. Interest rate futures now point to 98% odds of a rate cut by year end, pricing in a 1.74% funds rate compared to the current 2.38%. Two months ago, those figures were 54% and 2.23%, respectively.
There is good reason for the market’s increasingly dovish expectations. As noted by Bianco Research, LLC, the inversion of the 10-year Treasury yield below that of the three-month bill for at least 10 straight days is a reliable indicator of trouble, occurring eight times in the past 50 years and followed on each occasion by recession, 311 days later on average. Today, with the 10-year closing at 2.11% and the three-month at 2.30%, marks the 10th straight day of inversion. Jim Bianco, president and eponym of Bianco Research, writes this morning that the implications are clear:
The Fed is too tight. The longer an inversion lasts, the more damage it does to the economy. Once an inversion hits 10 consecutive days, history shows it continues for weeks, if not months. The Fed understands this. Will they heed the yield curve’s warning?
QT progress report
The Fed’s portfolio of securities held outright fell to $3.668 trillion, down $5 billion from last week’s reading and $18 billion from the trailing four-week average. As is usually the case on the first week of the month, Treasury securities accounted for the change in holdings. Since the Oct. 1, 2017 start of QT, total balance sheet assets are down by 13.6%, an 8.4% simple annualized rate.
Recap June 6
The bulls have retaken control of the proceedings, as another strong day for stocks left the S&P 500 3.3% higher for the week and back within 3.5% of its April 30 high water mark. Energy prices finally caught a bounce with WTI crude popping back over $53 a barrel, while gold managed a seventh straight green finish, advancing to $1,333 an ounce and closing within 50 basis points of a 52-week high. The Treasury curve flattened a bit after pronounced recent widening, and the VIX fell below 16.
- Philip Grant
Wednesday, June 5, 2019
The world is yours
Received in the Grant’s inbox today,
Received in the Grant’s inbox today,
The blind side
Forbes reports this afternoon that Green Bay Packers quarterback Aaron Rodgers
Forbes reports this afternoon that Green Bay Packers quarterback Aaron Rodgers
Lobby horse
The Department of Defense’s forthcoming $10 billion cloud computing award,
The Department of Defense’s forthcoming $10 billion cloud computing award,
Recap June 5
The world is yours
Received in the Grant’s inbox today, via investor Paul Isaac:
Coming soon: The first blockchain-accelerated early payment default.
The blind side
Forbes reports this afternoon that Green Bay Packers quarterback Aaron Rodgers has formed a new venture capital fund, Rx3 Partners with Byron Roth, chairman and CEO of Roth Capital Partners.
Rodgers, who threw 25 touchdowns and just two interceptions in 2018 but whose Packers failed to make the playoffs for a second straight year, commented: “With Rx3, I saw the opportunity to create an investment platform that brings together a group of like-minded influential investors and their respective networks with the backing of institutional resources.”
In other words: motion right, end-around, play-action fake on two.
Lobby horse
The Department of Defense’s forthcoming $10 billion cloud computing award, known as JEDI, has been mired in controversy and allegations of misconduct involving Amazon.com, Inc.’s web services division (AWS). Does a potential scandal involving AWS and Uncle Sam present a risk to the continuation of Amazon’s unparalleled success?
On May 24, Amazon competitor Oracle Corp. which vied for the JEDI contract and was eliminated from contention (AWS and Microsoft Corp. are the remaining bidders), filed an updated complaint with the U.S. Court of Federal Claims alleging that the procurement process for JEDI has been rife with conflicts of interest.
Oracle alleges that at least two employees, Deap Ubhi and Anthony DeMartino, improperly influenced the process to favor AWS at the expense of other competitors, as detailed by Almost Daily Grant’s on April 18. On March 4, the Federal News Network reported that the DoD Inspector General and FBI’s Public Corruption Unit have opened a joint investigation into the JEDI procurement process.
The updated court filing contains no shortage of explosive allegations:
The Department of Defense deviated from its procurement policy and did not require Ubhi, [redacted] or DeMartino (and many others) to complete conflict of interest forms and sign nondisclosure agreements prior to JEDI involvement. Consequently, several DoD officials with clear financial interests in AWS participated in JEDI in violation of applicable laws and regulations.
Mere sour grapes from a losing contestant? In its filing, Oracle cites correspondence on the Slack messaging platform suggesting that Ubhi (who worked at AWS from 2014 to 2016 before joining the Pentagon, and then returned to AWS in November 2017) pressed senior DoD official Jane Rathbun to favor a single-award approach, which is widely believed to favor AWS:
In one message, Ubhi reports “we just won this conversation’ because ‘Jane R. is now moved to our side and is supportive of a single provider.” Ubhi later advised the Defense Digital Service team to “check your email, and see Jane coming to the light”. . . In subsequent messages, Ubhi noted it “puts multi vs. single to bed once and for all hopefully (at least from a technical standpoint.”
Ubhi later indicated to [DDS general counsel Sharon] Woods that he was not worried about the “single vs. double” awardee approach and “if there are people in the building (Pentagon) that (he) need(s) to go see and school, or ally, let’s do that too.”
Beyond lobbying DoD officials to structure JEDI as a winner-take-all, Oracle claims that Ubhi used his position to accumulate intelligence about competitors cloud capabilities, while preparing for his return to Amazon:
In mid-September 2017 (during his employment discussions with AWS), Ubhi helped set up the Google Drive to act as DoD’s “repository for *everything*” JEDI related. Ubhi and the DDS team subsequently convinced all DoD JEDI participants “to data dump” everything into the Google folder.
Ubhi managed untold amounts of nonpublic and acquisition sensitive JEDI-related information based on his access to the JEDI Google drive. At some point prior to rejoining AWS, Ubhi synced the Google Team Drives to his laptop.
Amazon will have a hard time distancing itself from Ubhi’s conduct, if Oracle’s allegations are accurate:
AWS knew of Ubhi’s central JEDI role as AWS courted Ubhi to rejoin AWS. AWS also knew that Ubhi had not recused himself as legally required. Still neither Ubhi nor AWS notified DoD of the employment negotiations.
On October 2, 2017, Ubhi emailed AWS advising that he is “running point on all [JEDI] industry touch points.”
Apart from the criminal investigation into JEDI, Congress has taken a dim view of the winner-take-all approach to the massive contract. In its 2020 budget released on May 20, the House Appropriations Committee stated that due to concerns about committing to a single provider for a 10-year term:
The Committee directs that no funds may be obligated or expended to migrate data and applications to the JEDI cloud until the Chief Information Officer of the Department of Defense provides a report to the Congressional Defense Committees on how the Department plans to eventually transition to a multi-cloud environment, as described in its January 2019 Cloud Initiative Report to Congress.
That follows an early April decision from the C.I.A. to shift to a multi-cloud strategy by 2021, after signing a $600 million contract with AWS in 2013.
No matter what happens with the government investigation, the competition is collectively taking aim at AWS. Today, Microsoft and Oracle announced an agreement to connect cloud computing units by linking their respective data centers, as well as letting users log into either company with a single user name.
As for Amazon, a $10 billion award over 10 years doesn’t stand out as critical, considering the company reported $242 billion in revenue and $11.4 billion in net income over the 12 months ended March 31. But a loss of government confidence in AWS (which generated $2.2 billion of net income in the first quarter, up 57% year-over-year and representing two thirds of the consolidated total) could be significant. As a D.C.-based observer told ADG in April: “The AWS story, as sold to enterprise customers and the Street, is built upon the [C.I.A] reference case and the cash that has come in from that deal.”
Recap June 5
A second straight rally in stocks pushed the S&P 500 higher by 2.7% this week, while short-dated Treasurys partially reversed yesterday’s pullback with the two-year yield finishing at 1.84%, down from 2.22% just two weeks ago. Energy was once again hammered, with Brent crude falling below $60 a barrel this morning for the first time since January, while gold continues to diverge, finishing at $1,330 an ounce for a near-four month high. The VIX closed at 16, its lowest in two weeks.
- Philip Grant
Tuesday, June 4, 2019
Minority report
Many unhappy returns.
Many unhappy returns.
Today's debt hearings
An analysis of the leveraged loan market
An analysis of the leveraged loan market
Recap June 4
Minority report
Many unhappy returns. Thirty years ago, British ambassador Sir Alan Donald cabled home his classified report on the bloody goings-on in Tiananmen Square: “Students linked arms but were mown down. Armored personnel carriers then ran over the bodies time and time again to make, ‘pie’, and remains collected by bulldozer, incinerated and then hosed down drains. . .”
Unsurprisingly, the Xi Jinping-led government has little interest in commemorating the event, or in allowing others to pause and remember. Domestic social media platforms have “barred users from changing their profile photos and other information,” Bloomberg says, while financial data company Refinitiv has blocked all Tiananmen-related stories from its Eikon terminals, after the Cyberspace Administration of China “threatened to suspend the company’s service,” according to Reuters.
While Refinitiv may suffer a reputational knock in the West for this evident kowtow, its social credit score looks poised for an upgrade.
If only the recent trouble in China’s banking system could be so easily suppressed. Following the government’s takeover of distressed Baoshang Bank Co., the People’s Bank of China tried to calm the situation by assuring investors that no further such interventions were in the cards: “Everyone,” says a message on the PBOC website: “please don’t worry. At present we don’t have this plan.” But Bloomberg reports today that a pair of smaller institutions, Guilin Bank Co., Ltd. and Jincheng Bank Co., Ltd., have delayed plans to sell RMB 1 billion ($140 million) in tier-2 bond sales following the Baoshang news.
Over the weekend, Bank of Jinzhou, which holds $113 billion and $53 billion of assets and deposits, respectively, saw its auditor Ernst & Young Hua Ming LLP resign due to “indications that some loans to institutional customers weren’t used in ways consistent with the purposes stated in documents,” per Bloomberg. In response, the bank’s 5.5% dollar-pay perpetual bonds fell below 65 from 81 a week ago, for a 19.2% yield-to-call.
In a report on May 28, Anne Stevenson-Yang, co-founder of J Capital Research explains that the emergence of systemic balance-sheet risk is inevitable in China’s command economy:
What regulators fail to see, or at least to admit, is that there is fundamentally a contradiction between clean banks and targeted growth. The growth can be achieved only by heroic additions of credit, which has been growing at about 2.5 times the rate of GDP, itself clearly exaggerated.
Stevenson-Yang points out the contradiction between healthy reported metrics and the abrupt seizure of Baoshang and apparent stress at small and medium-size lenders:
One of the more unusual aspects of the Baoshang drama is that it’s been reported – not only that, but high-level authorities have publicly expressed concerns that there may be bank runs and financial institutions that ‘disappear.’ This is peculiar for an economy that claims to be growing at 6.5%, have average non-performing loan rates under 1.5% and that has buoyant construction and property markets.
Today's debt hearings
An analysis of the leveraged loan market (“Tomorrow’s debt hearings”) in the July 13, 2018 edition of Grant’s Interest Rate Observer predicted that a cyclical crack-up would lead to unwanted (for industry practitioners) attention from Washington. Sure enough, the House Committee on Financial Services conducted a hearing today titled: “Emerging Threats to Stability: Considering the Systemic Risk of Leveraged Lending.”
That July 2018 examination identified the erosion of creditor protection via widespread cov-lite documentation, deteriorating credit quality and aggressive earnings additions or cost-savings assumptions from issuers, called add-backs that can artificially inflate projected results. As noted by S&P’s LCD unit in a report last year, loans related to mergers and acquisitions are particularly susceptible to such add-backs of late, with a record 22% of M&A related-loans featuring add-backs greater than 50% of EBITDA in the first half of 2018, double the pre-2008 high.
Despite a suddenly-wobbly stock market, the M&A train keeps rolling. According to data from Bloomberg, more than $40 billion in corporate transactions were logged yesterday, the second-busiest deal day of the year.
Credit quality continues to wane. As noted by investment fund Driehaus Capital Management, LLC’s Twitter account this morning, the proportion of loans rated double-B (the high end of junk territory) now foot to less than 30%, down from 50% at the beginning of 2008. Single-B-rated issuers now comprise nearly 30% of loans, up from less than 10% in early ‘08.
Those red flags haven’t yielded much pain yet, as the S&P/LSTA Leveraged Loans Index has returned a solid 5.5% year-to-date, while LCD reported yesterday that the May default rate registered a skinny 0.93%, well below its historical average of 2.93%. But some investors aren’t waiting around: According to Bloomberg, the Invesco Senior Loan ETF saw its largest funds outflow on record yesterday.
Recap June 4
Remarks from Fed chairman Jerome Powell that the FOMC “will act as appropriate to sustain the expansion” helped spur a steep rally in stocks, as the S&P 500 gained 2% and the tech-heavy NYSE FANG+ Index enjoyed a 4% rebound. But Treasury yields also jumped across the curve after a sharp recent rally, perhaps suggesting that today’s action was more of a bounce off recent moves than a sea-change in investor perception.
Elsewhere, energy prices managed a feeble bounce of their own with WTI crude rising less than 1% to $53.50 a barrel, while gold finished unchanged. The VIX fell by 10% to settle near 17.
- Philip Grant
Monday, June 3, 2019
Bar none
Per USA Today:
A rat-infested pop-up bar is opening up in San Francisco later this month.
Guests who dare to venture to the Rat Bar will be served the bar's ‘signature cocktail,’ the ‘Ama-RAT-to Sour.’ It's billed as a traditional amaretto sour with a ‘rat's tail’ as garnish. Then, Rat Bar crawlers will have a half-hour to play with their newfound rodent buddies.
A rat rescue non-profit called the Ratical Rodent Rescue will be providing the rats. Just in case an attendee falls in love with a newfound rodent drinking buddy, the organization has rats up for adoption.
Tickets cost about $50 a head.
Typical San Francisco pricing. The New York City subway system provides a similar experience for just $2.75.
Dots plotted
Change is afoot. Across venture capital, high-end real estate and the retail sector of the stock market, investor behavior has seen a notable shift recently. A trio of sightings:
The Wall Street Journal reports today that SoftBank Group Corp. (9984 on the Tokyo Stock Exchange) has been “met with a chilly reception” in efforts to raise capital for a sequel to the $100 billion Vision Fund.
Contributing factors, per the Journal, include the fact that the larger investment firms generally have the capability to invest in start-ups directly and are thus reluctant to pay an additional round of fees, as well as concerns over the Vision Funds’ “lack of transparency.” Cantor Fitzgerald, L.P., tasked with raising funds for the project, approached would-be investors for commitments of as little as $50 million, a move which “tends to be a last resort for firms raising big investment pools. . . in part because of the cost of servicing multiple accounts.” Cantor scrapped the strategy “after [SoftBank] objected.”
Not just for SoftBank (termed “the epitome of the cycle in the Dec. 15, 2017 edition of Grant’s Interest Rate Observer) does the environment appear less hospitable. Last week, The Real Deal reported that Secured Capital Partners LLC., which owns a 157-acre land parcel in Beverly Hills, filed for Chapter 11 bankruptcy protection in Los Angeles federal court. Secured Capital listed the property for a record-breaking $1 billion last summer. Finding no takers, the list price was dropped to $650 million in February.
In its bankruptcy filing, Secured Capital listed $50 million to $100 million in liabilities, and assets of between $500 million to $1 billion (that was revised from less than $500,000 initially, an apparent typo). Ronald Richards, the fund’s lawyer, asserted in the filing that “the property will be sold or refinanced utilizing the best value the market or lending environment will bear.” The inability of this asset-rich, cash-poor borrower to extend terms on its debts may be a new development in this cycle.
While the winds seem to be shifting in the V.C. and real estate realms, a key corridor of the economy has fallen into deep freeze, if the stock market is any guide. Thus, independent retail analyst Mitch Nolen notes on Twitter today that apparel retailers have logged a brutal recent stretch, with each of the 24 clothing store stocks he tracks falling last month, with all but three absorbing double-digit declines in May.
More broadly, trouble in the apparel sector has spared neither the established players nor high-flying newcomers. Last week, industry mainstays Gap, Inc. and Abercrombie & Fitch Co. shares plunged 10% and 27%, respectively, after reporting weaker than expected sales in the most recent quarters. At the luxury end of the spectrum, Canada Goose Holdings, Inc. absorbed a 27% selloff last Wednesday after missing revenue expectations for the first time since its 2015 IPO. Since ripping higher by 450% from March 2017 to November of last year, GOOS shares have since lost more than 50%.
Recap June 3
News that the Federal Trade Commission is investigating Facebook, Inc. and Amazon.com, Inc. while the Department of Justice is probing Google parent Alphabet, Inc. as well as Apple, Inc. for potential antitrust violations was not well received, as the Nasdaq 100 Index lost 2% while the NYSE FANG+ Index shed 4%. On the bright side, the damage was localized, as the S&P 500 managed to finish just 25 basis points below unchanged.
Treasurys continued their head-spinning rally, as language from the Fed’s Jim Bullard suggesting a rate cut might be imminent helped push the two-year yield lower by eight basis points to 1.84%, while the 10-year yield dropped five basis points to 2.07%. Energy continued its losing streak with WTI crude falling below $53 a barrel for the first time since January, while gold jumped to a three month high near $1,325 per ounce.
- Philip Grant
Friday, May 31, 2019
Hail Mary
Sports business publication VenuesNow reported yesterday:
Social Finance, Inc., the private lender known as SoFi that specializes in refinancing student loans, has acquired naming rights for the $5.2 billion NFL stadium under construction in Inglewood, Calif., according to multiple sources.
Terms are believed to be in the range of $20 million a year over 20 years, sources said.
Buying naming rights, like erecting skyscrapers, is a bull-time endeavor.
Some corporate namesakes at the end of the 1990-2000 economic expansion:
Enron Field in Houston, CMGI Field in Foxboro, Mass., PSINet Stadium in Baltimore, Adelphia Coliseum in Nashville, Trans World Dome in St. Louis, MCI Center in Washington, D.C.
And more recently:
Chesapeake Energy Arena in Oklahoma City, American Airlines Arena in Miami, American Airlines Center in Dallas, Wachovia Center in Philadelphia, Citi Field in New York.
Ominous historical comparisons aside, it’s a pretty good day for V.C.-owned SoFi, which managed to close a $500 million funding round led by private-equity firm Silver Lake Partners at a $4.3 billion valuation, according to TechCrunch. That brings SoFi’s total funding to $2.3 billion, including a $1 billion round in fall 2015 led by SoftBank Group Corp.
This is what happens Larry
In an interview with the Financial Times today, Trump’s economic advisor and potential Fed nominee Judy Shelton offered some eye-catching remarks about the discretionary, “Ph.D. standard” of monetary policy that is currently in force:
How can a dozen, slightly less than a dozen, people meeting eight times a year, decide what the cost of capital should be versus some kind of organically, market supply determined rate? The Fed is not omniscient. They don’t know what the right rate should be. How could anyone?
In response, Lawrence Summers took to Twitter to attack:
Judy Shelton does what I would not have thought possible. She falls well below [Herman] Cain or [Stephen] Moore as a potential @federalreserve governor. Hers would be a dangerous appointment.
Another feather in her cap.
Trading sardines?
What selloff? The recent eruption in risk aversion hasn’t dented the digital HODLers, as cryptocurrencies have enjoyed a sterling start to 2019. At a current price of $8,500, bitcoin sits higher by 123% year-to-date, and touched $9,000 yesterday for the first time since spring 2018.
Michael Novogratz, founder and CEO of crypto investment fund Galaxy Digital Holdings, Ltd. told listeners on a conference call yesterday that he expects things to simmer down in the short term, forecasting a range of $7,000 to $10,000 for bitcoin, but “if I’m wrong on that, I think I’m wrong to the upside.”
To Novogratz, the latest rally is evidence of broader adoption of the digital ducats: “We have gone from, you know, crypto as an experiment, is it real? Is it tulips? To crypto is going to be a substantial part of the financial and consumer infrastructure of the world.”
But as Bloomberg reports today, bitcoin has thus far struggled to expand much beyond a trading sardine. Data from research firm Chainalysis, Inc. find that 1.3% of bitcoin transactions took place through merchants in the first four months of the year, little changed from 2017 and 2018. Kim Grauer, senior economist at Chainalysis, commented to Bloomberg: “Bitcoin economic activity continues to be dominated by exchange trading. This suggests bitcoin’s top use case remains speculative, and the mainstream use of bitcoin for everyday purchases is not yet a reality.”
There are also questions about the utility of the blockchain technology that underpins the cryptos (see, for instance, the Grant’s Current Yield podcast on Jan. 22, 2018 with Kai Stinchcombe). More recently, German central bank president Jens Weidmann told Bloomberg Wednesday that a trial project using blockchain to transfer and settle cash and securities was found lacking in terms of both costs and speed when compared to traditional methods: “The blockchain solutions did not fare better in [any] way . . . despite numerous tests in blockchain-based prototypes, a real breakthrough in application is missing so far.”
The rally in bitcoin comes as a familiar force in the background ramps up activity once more. Tether, the purportedly dollar-for-dollar-backed crypto which is widely used by crypto exchanges as a workaround for know-your-customer and anti money-laundering laws, has issued more than $1 billion in fresh supply over the last seven weeks, bringing tether outstanding to $3.1 billion as of yesterday from less than $2.1 billion on April 7.
While that $3.1 billion puts tether as the ninth-highest crypto by market cap, trading volume over the past 24 hours foots to $27.7 billion, according to Coinmarketcap.com. That nearly matches the $27 billion in 24 hour trading volume for bitcoin, which sports a market cap of $149 billion.
On April 25, New York Attorney General Letitia James accused the Bitfinex exchange (which shares ownership with Tether) of “engaging in a cover-up to hide the apparent loss of $850 million of co-mingled client and corporate funds.” Bitfinex covered Tether’s lost greenbacks with an I.O.U. Then, after that bit of prestidigitation, crypto investors supposedly sent a fresh $1 billion to purchase more tether.
The episode recalls the late 2017 explosion in tether supply, to $4.6 billion on Dec. 22 from $800 million eighteen days earlier, as bitcoin was racing to its all-time high near $20,000. A month later, Bloomberg reported that the CFTC issued subpoenas to Bitfinex and Tether on Dec. 6, 2017. By early February, bitcoin fell to $6,200.
This afternoon, Bitfinex announced on Twitter:
Due to the outage of one of our network providers we temporarily paused deposits and withdrawals. Funds are safe in cold storage. Situation should be restored ASAP. Apologies for the inconvenience.
Recap May 31
Another ugly day saw stocks slammed to the tune of 1.3% on the S&P 500, extending the post April 30 selloff to 6.5% and narrowing the year-to-date gains to just under 10% for the broad index.
Action elsewhere might have been even more bearish, as Treasurys caught another panic-type bid with the 10-year yield dropping to 2.13%, down nearly 20 basis points for the week and 21 basis points below the three-month bill yield. Interest rate futures now imply 51% odds of a rate cut at the July Fed meeting.
Energy was once again hammered, with WTI crude extending its two-day loss to nearly 10% to fall below $54 a barrel, while gold rose more than 1% to finish above $1,300 an ounce for the first time since mid-April.
- Philip Grant
Thursday, May 30, 2019
With a side of fries
Yesterday, the Department of Energy
Yesterday, the Department of Energy
Down in the bottom
Credit-centric consumer business models are in focus today,
Credit-centric consumer business models are in focus today,
QT Progress report
Recap May 30
With a side of fries
Yesterday, the Department of Energy announced the approval of gas exports from the Freeport LNG Terminal on Quintana Island, Texas. In the press release, under secretary of energy Mark Menezes laid it on thick:
Increasing export capacity from the Freeport LNG project is critical to spreading freedom gas throughout the world.
With the U.S. in another year of record-setting natural gas production, I am pleased that the Department of Energy is doing what it can to promote an efficient regulatory system that allows for molecules of U.S. freedom to be exported around the world.
Cleaner burning than tyranny gas.
Down in the bottom
Credit-centric consumer business models are in focus today, with a review of a pair of past picks-to-not-click: Signet Jewelers Ltd. (SIG on the NYSE) and Aaron’s, Inc. (AAN on the NYSE), which are featured in the issues of Grant's Interest Rate Observer dated June 3, 2016 and June 30, 2017, respectively. Since those publications, the duo’s fortunes have gone their seperate ways, with SIG shares slumping by 79% while AAN has thrived, jumping 41%. Yet the pair have more in common than the divergent price action might suggest.
Signet, the baubles retailer, has since been beset by slumping sales and P.R. woes, while the company’s highly anticipated efforts to sell its credit portfolio left the bulls wanting. In May 2017, Signet managed to unload $1 billion in prime loans at par and divested its subprime book at 72 cents on the dollar one year later. That 2016 bearish verdict from Grant’s hinged on the contention that the company’s "recency" accounting methodology flattered its underlying business metrics and credit performance. In July 2017, 55-year old CEO Mark Light resigned citing health reasons, following the departure of COO Bryan Morgan on account of “violations of company policy unrelated to financial matters.”
Aaron’s, founded in 1955, is the largest “rent-to-own” retailer in the United States. Thus, generally credit-constrained customers pay monthly rates for the use of home furnishings for a given lease term, and, if current on their payments at the end of that period, own the product outright. Customers also have the option of returning the item or purchasing it at the full list price during the lease term.
As Aaron’s brick-and-mortar business gradually shrinks under the competitive pressures partially supplied by Amazon.com, Inc., the company’s Progressive Leasing unit, a subprime lender to third-party merchants, picks up the slack. Progressive’s leasing volume (a.k.a. new sales financed by rent-to-own) jumped 14.5% year-over-year to $394 million in the first quarter, accounting for virtually all of Aaron’s consolidated 5.9% first quarter revenue growth to $1.02 billion. Locations are either company-owned or franchised, with the former increasingly prevalent. As of the first quarter, Aaron’s systemwide store count registered at 1,530, down from 1,864 at year-end 2016. Franchise locations have declined to 369 from 699 during that period.
What’s not to like? Profitability has grown while the store count shrinks. First quarter results featured $1.08 in adjusted earnings per share, well above the highest analyst estimate of $0.96. AAN has generated positive free cash flow in every year since 2015, and trades at a reasonable 14.5 times consensus 2019 earnings. The corporate balance sheet (in contrast to that of the composite Aaron’s client) is pristine, with net debt of just under $700 million compared to $430 million in trailing 12-month EBITDA, and The Street is bulled up, with eight “buy” ratings and one “hold” among the nine analysts tracked by Bloomberg.
Now for the bear case. Aaron’s has bought out 152 franchise locations in 2017 and 2018, along with two more in the first quarter. As noted in that June 2017 analysis of AAN, those repurchase transactions flatter the company’s cash flow statement. Deputy editor Evan Lorenz explained:
The cost of acquiring franchisee stores shows up in cash flows from investing activities under ‘acquisition of businesses and contracts, net of cash acquired’. The purchase price of a franchisee’s store includes that seller’s floor inventory. Normally the cost of acquiring retail stock is a charge to cash flow. Not so when you buy a store lock, stock and barrel.
So when Aaron’s leases a couch or a TV which it hauls out from the storeroom of a former franchisee, the cash-flow metrics look better than they really are. Still and all, the store net-work is declining.
In May 2017, Signet Jewelers announced the formation of a seven-year partnership with Progressive, “to provide a lease-purchase payment program to Signet customers who do not qualify for Signet’s credit programs.” The press release further spells things out, explaining that “Progressive leasing will assume any financial risk from leasing the merchandise.”
Signs of a downshift in Aaron’s credit quality are visible. According to the most recent form 10-Q, the proportion of the credit portfolio to consumers with a FICO score of 600 or below stood at 4.1% as of March 31, double the 2% figure from a year ago. At the same time, the percentage of loans to those with a FICO score of 700 or greater declined to 16.9% from 21% year-over-year. Recall that Fair Isaac Corp., changed the methodology it uses to calculate FICO scores “to boost the number of approvals for credit cards, personal loans and other debt,” according to The Wall Street Journal.
Analysts are expecting a major increase in profitability. While revenue is projected to decline to $3.3 billion in 2020 from $3.7 billion in the twelve months ended March 31, adjusted net income will rise to $295 million in 2020 from $226 million over the past 12 months if estimates are on point, indicating more than 300 basis points of margin expansion. But while the sell-side is expecting big things, Aaron’s management has been hitting the bid. Since March 21, seven corporate insiders have sold a combined 184,220 shares, cashing out some $9.7 million.
The Signet and Aaron’s pair continue to exhibit a type of corporate symmetry. As the market continues to punish Signet, which has unloaded its subprime credit exposure, Aaron’s has been rewarded for doubling down on the same.
QT Progress report
The Fed’s portfolio of securities held outright registered at $3.67 trillion, down by $8.8 billion from a week ago with mortgage-backed securities supplying the change. Since the commencement of QT, total balance sheet assets are down by 13.4%, for a simple annualized pace of 8.3%.
Also this afternoon, the New York Fed formally announced plans to reinvest the proceeds from maturing mortgage-backed securities and agency debt into Treasurys beginning in October.
Recap May 30
Stocks finished little changed, with the S&P 500 managing to eke out a green finish after back-to-back selloffs to start this holiday-shortened week. The broad average remains higher by 11% year-to-date.
Price action elsewhere remained ominous. Another sharp rally in Treasurys pushed the 10-year yield below 2.22%, now 16 basis points below the three-month bill to leave the curve inverted for a sixth straight day. Energy prices were hammered, with WTI crude falling back below $57 a barrel. The Dollar Index remained at the cusp of its 52-week high.
- Philip Grant
Tuesday, May 28, 2019
ETF phone home
Time to batten down the hatches? The Wall Street Journal reports today that the recent uptick in stock-market volatility has spurred a search for safety. Risk-mitigation, “low-vol” strategies have seen an inflow of $10 billion year-to-date, taking assets to a record $77 billion, according to data from Morningstar, Inc.
Two ETFs, the Invesco S&P 500 Low Volatility ETF (SPLV on the NYSE Arca) along with BlackRock, Inc.’s iShares MSCI Min Vol USA ETF (USMV on the CBOE’s BZX Exchange) have alone raked in $6.4 billion. Impressive recent performance at least partially explains the pair’s popularity: SPLV has gained 15.3% over the past 52 weeks, while USMV has rallied by 14%. That compares to a less-than 5% gain for the S&P 500.
Kevin Duffy, co-founder and principal at Bearing Asset Management LLC, argues to Grant’s today that such vehicles may not necessarily act as effective hedges in times of trouble, noting that the top five holdings of the iShares Min Vol ETF (Visa, Inc., Waste Management, Inc., McDonalds Corp., PepsiCo., Inc. and The Coca-Cola Co.) each carry a forward P/E ratio of more than 21 times. That compares to a 16.5 times consensus 2019 price-to-earnings ratio for the S&P 500. The fund manager asks:
Even if these businesses weather the next recession, will their valuations hold up in a bear market? Other than Visa (analysts expect 11% revenue growth next year), these companies sport mediocre growth prospects (4% at WM, PEP and KO; 2% at MCD).
More broadly, the relentless growth in the ETF industry and indexation strategies continues. ETFs pulled in $311 billion in fresh capital last year, the second-most on record following a $471 billion inflow in 2017, according to the Investment Company Institute Fact Book for 2019. The number of ETFs rose to 2,057 as of Dec. 31, nearly triple the 743 available in 2008. The ICI likewise finds that index equity mutual funds accounted for 29% of total equity mutual fund assets as of year-end, up from 14% in 2008.
But, as noted in investment firm Horizon Kinetics, LLC’s first quarter market commentary, the secular growth of indexation and ETF strategies comes during a period of historic market calm:
There is a certain price volatility that people accept with stock investing, an accepted tradeoff for the higher expected return. That volatility has been measured, and is based on 92 years of data, starting from 1926.
It is expressed as the standard deviation of share price changes, and this figure is 19.8%, meaning that in a given year, stock prices have tended (meaning roughly two-thirds of the time) to vary by as much as 20% points above and below the long-term average return. So if the expected average return is 10%, one should expect a return as high as 30% or a loss as much as 10% in most years.
The current standard deviation of the Vanguard S&P 500 ETF (VOO) over the past 3 years is 10.7%; over the last 10 years, it’s 12.7%. For the Vanguard Total International Stock ETF, the 3- and 10-year standard deviations are 10.5% and 15.9%. Both are way below the long-term figure.
In other words, the migration toward indexation seen this cycle has coincided with a historically-anomalous low-vol era. Of course, that relationship presents a potential corollary: A reversal of this trend could see volatility return with a vengeance.
How might an active manager contend with this sea change toward indexation? Perhaps by venturing outside the lines. Speaking at the Grant’s 2016 fall conference, Steven Bregman, president and co-founder of Horizon Kinetics, offered this council: “If you’re willing to take a bit of illiquidity risk – in those securities that have been discarded by the indexes – your degrees of freedom and optionality expand tremendously.”
Recap May 28
Stocks came under late pressure after a sideways start to the day, with the S&P 500 finishing at session lows, down 0.8% with traditionally defensive groups health care, utilities and consumer staples losing 1.4%, 1.6% and 1.8%, respectively. Treasurys likewise rallied sharply, with the 10-year yield falling to 2.27%, well below the 2.35% three-month bill as well as the 2.39% effective Fed Funds rate. The VIX rose 10% to 17.50.
- Philip Grant
Friday, May 24, 2019
Bouncy-bouncy
This is no joke.
This is no joke.
Damage control
Big doings in the Middle Kingdom.
Big doings in the Middle Kingdom.
House of cards
Bloomberg asserts today that Brazilian President Jair Bolsonaro’s
Bloomberg asserts today that Brazilian President Jair Bolsonaro’s
Dem bones
Yesterday, French retailer Rallye S.A.,
Yesterday, French retailer Rallye S.A.,
Recap May 24
Bouncy-bouncy
This is no joke. Tech-focused website The Next Web reported yesterday on mobility startup Cangoroo, which offers users access to pogo-sticks as they travel around Stockholm and Malmö, Sweden. CEO Adam Mikkelsen assured the skeptical publication:
It is a real venture. . . with the pogo stick, the way we’ve branded it is as a product you can actually use for last-mile transportation. A lot of people in Sweden had pogo sticks as children, so we see them using them as adults.
Bullish for the orthopedic profession, at least.
Damage control
Big doings in the Middle Kingdom. Reuters reports:
China’s financial regulators said on Friday the country’s banking and insurance regulator will take control of Inner Mongolia-based Baoshang Bank Co., Ltd. due to the serious credit risks it poses, in a rare takeover of a domestic lender.
Baoshang had a total of 156.5 billion yuan ($22.68 billion) of outstanding loans by the end of 2016, a 65% jump from the end of 2014, according to the bank’s last filing on its assets and liabilities on its website. Its non-performing loan ratio was at 1.68% as of December 2016.
The bank, which has not published an annual report since 2016, carries a double-A-plus rating from local agency Dagong Global Credit Rating Co., though Dagong cut its outlook on Baoshang to negative last year. This is the first state takeover of a Chinese bank since at least the 1990s.
The Wall Street Journal, citing local media, notes today that Baoshang was linked to missing financier Xiao Jianhua, who was apparently abducted upon returning to the Chinese mainland from Hong Kong in early 2017.
House of cards
Bloomberg asserts today that Brazilian President Jair Bolsonaro’s right wing government is beginning to teeter, with “talk of impeachment” beginning to surface just five months into his four year presidential term. Bloomberg reports that “the situation has become so tense that, earlier this month, a senior player at the heart of Brazil’s political wranglings had a nervous breakdown during an interview.”
Trouble in the Bolsonaro administration is beginning to show up in the polls. According to a May 21 XP Investments/Ipespe survey, more Brazilians disapprove than approve of Bolsonaro for the first time, while 36% of respondents say the government “is bad or terrible.” That’s up from 31% one month ago.
Those ominous signs haven’t dimmed hopes for successful pension reform, a crucial issue for Brazil. Yesterday, economy minister Paulo Guedes predicted at a São Paolo event that “in 60 days there will be a favorable surprise in the Senate.” Reuters however reports that sources in Brazil’s congress “say the government remains well short of the 308 votes required in the lower house to even take it up to the Senate.”
For his part, Marcelo Ramos, chairman of the congressional committee on pension reform, had some sharp words for the president, telling Reuters on Wednesday: “Bolsonaro despises democracy. We have to isolate his anti-democratic attitude and lack of respect for institutions, so this does not paralyze the country.”
The stakes are high. In an interview with Veja magazine published today, Guedes said: “If we don’t make the reforms, Brazil will go down in flames. There will be chaos in the public sector, both in the federal government as well as the states and municipalities.”
The economy minster also detailed his back-up plan in the event of legislative failure: “I will take a plane and go live abroad. I am already old enough to retire.”
Dem bones
Yesterday, French retailer Rallye S.A., parent company of supermarket chain Casino Guichard-Perrachon (a.k.a. Groupe Casino, CO on the Euronext Paris Exchange) entered a court-led creditor protection program, as the distressed conglomerate looks to avoid bankruptcy.
The collection of companies, each headed by majority shareholder and CEO Jean-Charles Naouri, have an interconnected structure, as the Financial Times notes a 41% decline in Casino stock since March “hurt Rallye because the parent company has used it as collateral to secure credit lines at banks.”
Nauri, who told the FT in October that those selling short his company do so “at their risk and peril,” has received unwanted attention before. In December 2015, research firm Muddy Waters initiated a short position in Casino shares, asserting that the company’s opaque, highly leveraged capital structure presented risks well beyond market expectations.
The episode is instructive beyond the specific travails of Casino and its related entities. The Jan. 15, 2016 edition of Grant’s Interest Rate Observer featured a look at European hybrid securities, which, as an anonymity-seeking, London-based correspondent noted, act as something of an investment panacea:
For ratings and regulatory purposes, a hybrid is neither exactly debt nor exactly equity. It answers the needs of leveraged issuers and yield-starved investors alike. It offers incremental returns relative to senior bonds in the same capital structure. Plainly, there must be something wrong with it.
Here, as in other areas of financial innovation, we are dealing with an arbitrage; of credit-rating methodologies, of tax rules and, yes, of investor sophistication.
The analysis identified a pair of picks-to-not click among these hybrid contraptions, including the Groupe Casino’s perpetual 4.875% note, then priced at 88 cents on the euro for a 9.5% yield-to-call. The securities, which saw the coupon reset in January to a floating rate of 357 basis points over the mid-swap benchmark, have since declined to 61 cents on the euro for a 16.6% yield-to-call.
Recap May 24
Stocks finished slightly higher after giving back bigger early gains, leaving the S&P 500 in the red by just over 1% for the week. Treasurys finished little changed, as the three-month vs. 10-year spread remained inverted for a second day, while oil bounced with WTI crude finishing near $59 a barrel. The VIX settled at 16.
- Philip Grant
Thursday, May 23, 2019
He said it
Sports talk radio mainstay and overall renaissance man Mike Francesa
Sports talk radio mainstay and overall renaissance man Mike Francesa
Fake schmooze
Today, Facebook, Inc. (FB on the Nasdaq) said
Today, Facebook, Inc. (FB on the Nasdaq) said
Yield yodel
QT Progress report
Recap May 23
He said it
Sports talk radio mainstay and overall renaissance man Mike Francesa weighed in on the stock market this morning on Twitter:
The market is quickly becoming less about finding good businesses and more about managing the day’s headlines.
Fake schmooze
Today, Facebook, Inc. (FB on the Nasdaq) said it removed 2.19 billion bogus accounts from its platform in the first quarter, more than double the 1.2 billion faux-users the company booted in the fourth quarter of 2018.
Those combined figures might represent 45% of the global population, as reckoned by the U.S. Census population clock, but Facebook reassured investors today: “Because we remove these accounts so quickly, they are never considered active and we don’t count them as monthly active users.” Instead, the company reckons that only 5% of its reported 2.38 billion monthly active user accounts are fake.
Yield yodel
Junk has been the place to be for credit investors, as the Bloomberg Barclays High Yield Index has delivered an 8.3% total return year-to-date, topping the 7.1% gain in the iBoxx Liquid Investment Grade Index and outpacing the 5.7% generated by the S&P/LSTA Leveraged Loan Index. Even after a recent pullback in prices, the ICE BAML High Yield option-adjusted spread sits at just 403 basis points over Treasurys, well below the 552 basis point average going back to 1997.
What’s driving the superior performance in high-yield? The prospect of an easier Fed is one key contributor, helping increase the perceived value of fixed-rate junk bonds as opposed to floating-rate loans. Relatively robust economic growth (GDP growth has averaged an annualized 3.3% over the last four quarters) has likewise helped, as has a buoyant stock market. Meanwhile, defaults have remained low, with Fitch Ratings forecasting that May’s trailing 12-month high-yield default rate will settle at 2%. That compares to 4.7% in calendar 2016 and 14% in 2009, per Fitch.
Some investors expect the good times to continue. Vivek Bommi, senior portfolio manager at Neuberger Berman, told Bloomberg over the weekend that the junk bond market “is very attractive, given that the fundamentals are still very good and corporate credit quality is still good.” Bommi notes that the post-crisis boom in leveraged loan issuance has shifted risks away from high-yield: “In the last 10 years, a lot of the more aggressive issuance that may have gone into the high-yield market has gone into other markets like private credit or loans.”
But with the economic expansion set to match the post-World War II record of 110 months in June and the stock market still less than 5% below its closing high-water mark, some concerning signs have emerged. Economic growth looks set to slow, as the Atlanta Fed’s GDPNow tracker indicates second quarter output growth at just 1.2%, revised down from 1.6% on May 14. Retail sales for April fell by 0.2% on a sequential basis, vs. expectations of a 0.2% gain. Resource prices likewise look to be rolling over, with the Goldman Sachs Commodity Index down 5% over the last month.
Broad cracks in credit are also appearing. On Monday, the Financial Times published an analysis showing that non-performing loans among the 10 largest commercial lenders in the U.S. jumped by 20% sequentially in the first quarter, snapping a streak of improvement in that metric dating back to 2016. Brian Foran, a bank analyst at Autonomous Research, tells the FT that unlike three years ago, when plunging oil prices pushed a number of energy-related borrowers into distress, the recent uptick is broad-based: “There hasn’t been a clear theme.”
Meanwhile, rich valuations leave little room for error. Marty Fridson, chief investment officer of Lehmann, Livian, Fridson Advisors, LLC, writes in S&P Global’s LCD publication that his fair value estimate of the ICE BAML option adjusted spread is 648 basis points, far above the 405 currently on offer. “That qualifies as an extreme overvaluation even if one interprets the Fed’s more recent retreat from its strongly stated intention to tighten rates as an effective reinstitution of quantitative easing.” Reached by Grant’s this afternoon, Fridson added that even supposing a new round of QE, high-yield is overvalued by more than 100 basis points by his analysis.
With high-yield priced for perfection, where might a yield-starved investor turn? The March 22 edition of Grant’s Interest Rate Observer offers a survey of income-producing securities that may offer an attractive substitute for junk bonds.
QT Progress report
The Fed’s portfolio of securities held outright ticked to $3.681 trillion, down $5 billion from a week ago. Mortgage-backed securities accounted for the change, as Treasury holdings remained flat at $2.11 trillion.
Since the Oct. 1, 2017 commencement of QT, the Fed’s total balance sheet assets are down by 13.4%, at a simple annualized pace of 8.3%.
Recap May 23
Risk aversion reigned supreme as stocks fell and Treasury yields darted lower, with the 10-year yield falling seven basis points to 2.32%, well below the Fed Funds Rate and once again inverted against the three-month bill.
Energy prices were hammered, with WTI crude falling 5% to less than $59 a barrel for its worst session of the year and the S&P 500 energy sector extending its two-day drop to nearly 5%, following a surprise build in yesterday’s weekly inventory report from the DoE. The VIX jumped 15% to finish just below 17.
- Philip Grant
Wednesday, May 22, 2019
In the shop
The auto industry caught a break last week, as the Trump administration announced that planned tariffs would be placed on six month delay. Global industry trade group The Alliance of Automobile Manufacturers expressed relief, commenting that “at the end of the day, you can have tariffs or investment, but you can’t have both.”
The removal of additional taxation (for now at least) is some welcome good news for an industry that has entered something of a rough patch. April U.S. auto sales footed to a seasonally adjusted annual pace of 16.4 million vehicles, down from a comparable 17.2 million pace a year ago.
Stateside, pricing remains strong both in the primary and secondary market. Kelly Blue Book pegs the average transaction price for a new auto at $36,843 in April, up 2% year-over-year. Likewise, the J.D. Power Valuation Services’ Used Vehicle Price Index rose by 1.7% year-over-year last month, with strength in the wholesale market pushing the price of used units (up to eight years old) higher by 1.4%, “the best April performance on record.” At the same time, dealers are increasingly holding the line, as incentive spending fell 6.8% year-over-year in April according to J.D. Power. That’s the tenth consecutive decrease after 54 straight months of rising incentives.
But as pricing continues to strengthen and sales remain in the upper end of the cyclical range, trends in credit augur trouble. According to data from the New York Fed, serious (meaning 90 days or more) auto loan and lease delinquencies rose to 4.69% in the first quarter, up from less than 3.5% in 2016 and just 58 basis points below the post-crisis peak of 5.27% in 2010.
As the cycle has progressed, the auto loan market has grown significantly. Thus, the New York Fed reports that first quarter auto loan and lease balances rose 4% year-over-year to $1.28 trillio, leaving that figure 65% above its first quarter 2009 level. But, as pointed out by financial blogger Wolf Richter, the number of auto-loan accounts has risen by only 34% over the same period, suggesting that “much of the increase in the auto-loan balances is the ballooning amount financed with each new loan and longer loan terms.”
Daniel Ruiz, founder of automotive research firm Blinders Off, LLC, expects that the uptick in bad auto debt will have a broader impact. Ruiz tells Grant’s by email that as the auto market is dependent on trade-in values on financed vehicles, used prices are the lynchpin to sales:
The real risk is not in the length of the loan, but rather the amount of time that it takes for the value of the asset to meet or exceed the principal balance owed on the loan. Used vehicle values have been relatively strong so far this year but not strong enough to offset the increased loan lengths and interest rates of three years past.
Aside from the risk of significant loan losses for lenders with high exposure to subprime auto loans, increased default rates will also increase wholesale volume at auctions.
Indeed, despite the strong recent pricing environment, J.D. Power notes that secondary supply is on the upswing, as auction volumes through the first four months of the year are up by 6.5% from 2018.
As for the broader health of the market, Ruiz utilizes a bespoke indicator he dubs “time-to-equity,” meaning the interval until a vehicle’s trade-in value exceeds the principal balance outstanding on a given auto loan, as a key indicator:
To sum it all up, increased wholesale volume from subprime auto loan defaults will impact used-vehicle retail inventory levels. If that happens, time-to-equity will spike, slowing new-vehicle sales further and causing an even larger increase in subprime auto loan delinquencies.
In essence, longer loan terms and higher interest rates will lead to increased time to equity going forward even if used-vehicle values remain strong. If/when used-vehicle values fall, the situation will get worse until time to equity falls sometime in the future due to shorter loan terms, lower interest rates and or a rebound in used-vehicle values; exactly what happened after our last recession.
The automakers themselves are tightening their belts. Yesterday, Ford Motor Co. announced it will cut 7,000 white-collar jobs, roughly 10% of its global salaried workforce as part of a companywide “redesign.” As noted by Bloomberg today, that brings the total number of announced global job cuts among U.S. vehicle manufacturers to 38,000 employees over the last six months.
Recap May 22
Stocks fluttered a bit lower, as a sharp oil downdraft pushed WTI crude back near $61 a barrel and the S&P Energy Index 1.5% into the red. The VIX held little changed near 15, but risk aversion was evident in rates as Treasury yields dove, with the 10-year falling to 2.38%, near the lowest of 2019 so far and below the 2.39% effective Fed Funds rate.
- Philip Grant
Tuesday, May 21, 2019
Peanut allergy
The Gauls are on the rampage, The Wall Street Journal reports today. Citing data from Dealogic, The Journal notes that French corporations have allocated a post-2008 high of roughly $100 billion to foreign acquisitions in each of the last two years (equating to roughly 4% of France’s 2018 nominal GDP) with the United States a particularly attractive target. Eighteen stateside deals have been consummated by French companies already this year.
That shopping spree coincides with an increase in France’s corporate debt load, now at 143% of GDP, up from 116% in 2008 and well above the 74% seen in the U.S., per the Bank for International Settlements. The rise in corporate debt comes as the European Central Bank marks the fifth anniversary of its foray into negative interest rates, along with the recently-paused corporate bond buying program which was in place since 2016 and held some €178 billion in assets as of April 30.
A spokesperson for drug maker Sanofi S.A., which bought Waltham, Mass.-based Bioverativ, Inc. for $11.6 billion in March 2018, got to the crux of the matter, explaining to The Journal: “Obviously, cost of funding is one of the key elements to take into account for debt-funded deals.”
While the ECB’s aggressive monetary policy has helped spur corporate consolidation, underlying economic activity remains turgid. Thus, euro-area core CPI rose to 1.3% year-over-year in April, the highest reading since April 2017 but still far below the near-2% threshold favored by the central bankers (core CPI growth has averaged 1% since the ECB pushed the deposit rate below zero). Meanwhile, the European Commission now forecasts 1.2% real GDP growth this year in the eurozone, down from a 1.9% guesstimate for 2019 at the end of last year.
But hope springs eternal. Over the weekend, ECB governing council member Klaas Knot said in an interview with Corriere della Sera that “if the economy continues to rebound. . . then I think we are on course” to reach that 2% inflation bogey. Knot attributed weak European growth to globalization, stating: “the only thing that we can do is to keep the pressure up, make sure the economy continues to perform at high levels of capacity utilization and the economy continues to print GDP numbers in excess of potential growth.”
Taking no chances, the mandarins are prepared to go back to the well. In an April press conference, soon-to-be-outgoing President Mario Draghi said that the ECB is prepared to “adjust all its instruments” if data aren’t to their liking. More specifically, the Financial Times surmises that “additional measures [designed] to keep the cost of credit cheaper for longer” will be in store if growth and inflation continue to disappoint.
Then, too, investors see no policy normalization any time soon. Interest rate futures currently predict 29% odds of a rate cut by year end and virtually no chance of a hike. One month ago, the odds of a rate cut, and rate hike were both between 7% and 8%. Meanwhile, the March 2020 three-month Euribor futures contract has risen to 100.35, suggesting a deposit rate of negative 35 basis points 10 months from now. That compares to 99.88 last spring, when investors were expecting a return to positive rates and the April 6, 2018 edition of Grant’s Interest Rate Observer suggested that call options on this instrument would be a good way to profit from the ongoing financial repression in the eurozone.
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March 2020 three-month Euribor futures, one-year chart. Source: The Bloomberg
With positive nominal interest rates not forthcoming any time soon, Europe’s financial institutions continue to falter. The Stoxx 600 Banks Index is now down 25% over the last 52 weeks, badly lagging the 5% decline in the broad Stoxx 600 Index. Bank valuations have descended into consignment-type depths, with that Stoxx gauge now trading at 0.58 times book value, less than half of the 1.23 times book value fetched by the KBW Banks Index in the U.S.
The travails of Deutsche Bank, A.G., which has seen shares plummet by 93% since 2007 and carries a €43.5 trillion ($48.8 trillion) derivatives book equal to nearly three times 2018 Eurozone GDP, are front and center. But other institutions are also attracting unwanted attention. Last week, BlackRock, Inc. backed out of a deal to rescue Banca Carige S.p.A. (founded in 1483), which the ECB had placed the Italian lender in administration in January. In response, Italian deputy prime minster Matteo Salvini told reporters: “It’s an important bank. Obviously, we won’t let things collapse.”
Don’t blame the ECB, according to governing council member Benoit Coeuré. Speaking in French parliament last Wednesday, Coeuré estimated that negative interest rates are costing eurozone banks €8 billion in annual lost income, which he termed “really peanuts.” Instead of positive nominal rates, Coeuré offered a familiar solution for the banks’ woes: Industry consolidation.
Recap May 21
Stocks rallied, with the S&P 500 rising back above yesterday’s opening level while the NYSE FANG+ Index was able to recoup about half of yesterday’s 2.7% drop. Treasury yields edged higher as rangebound action continues in rates, and the VIX finished below 15 for the first time since May 3.
- Philip Grant
Monday, May 20, 2019
Concession stand
One down, two to go?
One down, two to go?
Track changes
Morningstar reports today
Morningstar reports today
Recap May 20
Concession stand
One down, two to go? This morning, the Federal Communications Commission announced it will recommend approval of the proposed merger between Sprint Corp. (S on the NYSE) and T-Mobile U.S., Inc. (TMUS on the Nasdaq), the fourth- and third-largest wireless carriers in the U.S., respectively. That follows a Bloomberg report from Sunday evening that the pair had agreed to concessions including the divestiture of Sprint’s Boost Mobile pre-paid unit, as well as commitments to build out 5G network infrastructure in rural areas of the country.
FCC chairman Ajit Pai explained his rationale in a statement: “Two of the FCC’s top priorities are closing the digital divide in rural America and advancing United States leadership in 5G, the next generation in wireless connectivity. The commitments made today by T-Mobile and Sprint would substantially advance each of these critical objectives.”
While the FCC’s blessing is an important step for the pair, regulatory roadblocks remain. The Department of Justice must also sign off on the combination, a decision which could come relatively soon as the DoJ’s 180-day review period is set to conclude in early June. Then, too, the attorneys general of more than a dozen states have signaled opposition to the merger (Almost Daily Grant’s, March 29).
But the concessions announced today could swing the tide in the company’s favor. Bloomberg Intelligence analyst Jennifer Rie took an optimistic bent in a note today, assessing the odds of both DoJ and state attorneys general approval as “more likely than not.”
The initial reaction suggested Mr. Market concurred with Rie’s viewpoint. Sprint shares surged by as much as 27%, closing the gap to T-Mobile’s all-stock offer to just 4% following the market open. That’s down from a 26% discount seen last week. Likewise, Sprint’s senior unsecured 6 7/8 notes due 2028 jumped more than points to 104, narrowing the spread over Treasurys to 401 basis points from 501 basis points.
For its part, The Wall Street Journal notes that Pai’s endorsement “marks a departure from the stance taken by past FCC leaders who stood in the way of deals that would leave the U.S. wireless market with fewer than four nationwide competitors.” Sure enough, Bloomberg reports this afternoon that the DoJ continues to “lean against” clearing the merger, a headline which helped widen Sprint’s discount to T-Mobile’s all-stock offer back to 11% in the late afternoon.
It is no stretch to say that Sprint’s financial health might depend on the tie-up. On May 7, CEO Michel Combes referenced his company’s shaky stand-alone prospects after revealing a larger than expected loss of higher-value, postpaid wireless users: “We are making the best of the limited financial and low-band spectrum resources that we have. . . we are hopeful to complete our merger with T-Mobile.”
For an updated look at the potential broader implications of a scuttled Sprint/T-Mobile tie up, see the most recent, May 17 edition of Grant’s Interest Rate Observer.
Track changes
Morningstar reports today that a $39 billion inflow in passively-managed assets in April pushed the total to $4.3 trillion, within $6 billion of eclipsing the total assets invested in active management, (which saw a $22 billion outflow for April) for the first time.
“This is a milestone that has been a long time coming as the trend toward low-cost fund investing has gained momentum,” noted Kevin McDevitt, senior analyst at Morningstar and author of the report. McDevitt relays that active U.S. equity managers have seen funds decrease in every year since 2006, with passive strategies enjoying symmetrically-consistent growth over the same period.
With passive investing on the cusp of supremacy, the index makers mix in some active management of their own. Last week, S&P announced that Uber Technologies, Inc. (UBER on the NYSE), will be added to various S&P Dow Jones Indices, including the S&P Total Market Index, as early as tomorrow. As noted in a Bloomberg interview with an S&P spokesperson, Uber is the first company to achieve “fast-track” entry into S&P indices, since the methodology for prompt index inclusion was changed earlier this year.
As Uber gets the fast-track treatment, ride share drivers cut corners to keep their heads above water. On Thursday, Washington, D.C.’s ABC 7 news reported that drivers at Regan National Airport have been “simultaneously turn[ing] off their ride share apps for a minute or two to trick the app into thinking there are no drivers available -- creating a price surge.” Sam Sweeney reports: “These drivers tell ABC 7 they do have a sense of guilt. They say they don’t want to do this, but because Uber and Lyft keep reducing their pay, they tell us they have no choice.”
Recap May 20
A tech-led selloff left the S&P 500 down by 0.7%, while the NYSE FANG+ Index shed 2.7%, leaving that gauge of ten popular stocks down 13% from its May 6 close. Treasury yields rose across the curve, while oil bucked largely bearish commodity action to leave WTI back over $63 a barrel. The VIX held steady north of 16.
- Philip Grant
Friday, May 17, 2019
The sound of silence
An emailed invitation from the Federal Reserve Bank of New York:
An emailed invitation from the Federal Reserve Bank of New York:
Fruit flies
Chinese fruit prices have been on the march,
Chinese fruit prices have been on the march,
Influx capacitor
Yesterday, VanEck Securities Corp. rolled out
Yesterday, VanEck Securities Corp. rolled out
Recap May 17
The sound of silence
An emailed invitation from the Federal Reserve Bank of New York:
John Williams, President and CEO (Speaker)
Date: Monday, May 20, 2019
Time: 1:00 PM EDT
Subject: Welcome Remarks
Event: Fed Listens Capstone Roundtable Discussion
Organizers: Federal Reserve Bank of New York
Location: Federal Reserve Bank of New York
33 Liberty Street, New York, NY 10045
Text is not expected. Q&A with the audience in the room is expected. This event is open to the press to watch via webcast, though not to attend in-person.
In other words, on Monday you can watch the Fed listen.
Fruit flies
Chinese fruit prices have been on the march, with a benchmark index of seven fruits compiled by the Ministry of Agriculture and Rural Affairs jumping to RMB 7.59 ($1.07) per kilogram today. That’s up 23.3% from a month ago and 33.4% year-over-year.
Those figures are downright conservative compared to statistics from the Xinfadi Produce Wholesale Center in Beijing, which reports to state-run The Beijing News that its calculation of average fruit prices shows a 78% year-over-year increase to RMB 6.15, with so-called golden nuggets (A.K.A. tangerines) doubling from a year ago. For context, the World Bank pegged Chinese per capita gross national income at RMB 62,000 at year-end 2017.
Asked by Caixin for comment, a spokesperson for the National Bureau of Statistics cited extreme weather for the price spike, “but did not elaborate.”
Consumers in the Middle Kingdom have been more loquacious. The Epoch Times notes that an online article posted by the Chinese Nutrition Society urging citizens to eat a pound of vegetables and half a pound of fruit per day featured a recurring reaction in the comment section: “We cannot afford it.” Caixin likewise notes that “the phrase ‘fruit freedom’ – or the ability to buy as much fruit as one wants – [has become] a buzzword in China’s online lexicon.”
More broadly, the NBS reported yesterday that its consumer price index rose 2.5% year-over-year in April, matching the third-highest reading since 2013, with the measured rise in food prices at 6.1% year-over-year. The NBS finds that fruit prices are higher by 11.9% year-over-year, while pork prices have jumped by 14.4% on account of the African swine fever outbreak among China’s pig population (Almost Daily Grant’s, April 2).
Meanwhile, the Sino-American trade spat grinds on. On Sunday, the Chinese side offered some topical rhetoric, stating that they won’t swallow any “bitter fruit.”
Influx capacitor
Yesterday, VanEck Securities Corp. rolled out the VanEck Vectors Municipal Allocation exchange-traded fund (MAAX on the NYSE Arca).
This is no ordinary collection of muni bonds. As explained in the press release, the ETF “is designed around a proprietary model that uses momentum, along with both duration and credit risk indicators, to tactically allocate among selected VanEck Vectors Municipal Bond ETFs.”
In other words, as noted by Bloomberg’s Brian Chappatta, MAAX is “an ETF of ETFs.” For his part, Chappatta rhetorically wonders why the “traditionally buy-and-hold [muni] market need[s] an ETF that allocates among other ETFs?”
Unsurprisingly, an uptick in popularity goes a long way toward explaining the newfound financial innovation. Inflows into muni bond ETFs reached $661 million at the end of April, says Bloomberg, the second-strongest weekly capital infusion in the past eighteen months.
That comes on the heels of strong performance, as the Bloomberg Barclays Municipal Bond Index has generated a 6.8% total return over the past year, topping both the Bloomberg Barclays High Yield Index’s 6.1% and the 4.1% generated by the S&P/LSTA Leveraged Loan Index.
That strong rally has led to some fancy prices. The ratio of the 30-year benchmark municipal bond yield to the Treasury long bond fell below 87% yesterday (the lower the ratio, the more expensive munis are on a relative basis), a record low going back to at least 2001. On a shorter horizon, the ratio of 10-year benchmark munis fell to 72.5% of the comparable Treasury yield, itself near a record low.
For a survey of some less-horrifically overvalued municipal bonds, see the Feb. 9, Oct. 19, 2018 and Aug. 10, 2018 editions of Grant’s Interest Rate Observer.
Recap May 17
Stocks came under some pressure, with the S&P 500 falling back into the red for the week as higher beta groups such as industrials, tech and consumer discretionary underperformed. Gold fell for a fourth straight day after touching $1,300 an ounce on Monday, while Treasury yields finished little changed. The VIX settled near 16.
- Philip Grant
Thursday, May 16, 2019
Looney tunes
From CNN:
From CNN:
Post no bills
An update on Post Holdings, Inc., the cereal and processed food maker
An update on Post Holdings, Inc., the cereal and processed food maker
QT Progress report
Recap May 16
Looney tunes
From CNN:
A playful rabbit sculpture by Jeff Koons has become the most expensive work by a living artist ever to sell at auction.
The American artist's "Rabbit," a stainless steel figure measuring just over 3 feet tall, sold for more than $91 million Wednesday evening at Christie's in New York, smashing auction estimates.
Christie's initially estimated that Koons' faceless "Rabbit" would sell for between $50 and $70 million. But after more than 10 minutes' bidding, the winning offer came in at $80 million which -- including auctioneer's fees -- resulted in a final sale price of $91,075,000.
Evidently, Trix aren’t just for kids.
Post no bills
An update on Post Holdings, Inc., the cereal and processed food maker which was a Grant’s pick-to-not-click in the Sept. 16, 2016 issue. Since publication time, POST shares are up 36% counting dividends, compared to a 41% total return in the Russell 3000 Index. On the credit side, the senior unsecured 5% notes due 2026 last changed hands at 99.5 cents on the dollar and have generated a 15.1% total return, compared to 17% for the Bloomberg Barclays U.S. Corporate High Yield Index.
Improving margins figure prominently in the bull story. Over the 12 months ending Sept. 30 (the company’s fiscal year-end), Post will generate $382 million in adjusted net income on $5.8 billion in revenue, if analyst consensus is on the beam. That compares to just $187 million in adjusted net income on $5.2 billion in revenue two years prior.
That margin expansion is all the more impressive considering the secular decline in cereal, Post’s core business. U.S. consumers bought $8.3 billion worth of cereal in 2017 according to Nielsen. That’s down from $8.8 billion in 2016 and compares to $12.7 billion in cereal bought by Americans in 2009, per the estimate of research firm IBISWorld. In fiscal 2018, Post’s consumer brands unit chipped in 29% of revenue and 38% of gross profit.
As the legacy business shrinks, Post management wheels and deals. One day before the earnings release, Post announced the acquisition of TreeHouse Foods, Inc.’s private, ready-to-eat cereal business. Later this year, the company is expected to IPO a minority stake in the Active Nutrition segment, the highest-growth portion of the Post portfolio with a 5.5% year-over-year revenue advance in the latest quarter. Proceeds from that offering can be used to help pay down the company’s $6.2 billion debt load, which equates to five times fiscal 2019 consensus adjusted EBITDA.
Mr. Market continues to give his blessing to single-B-plus rated (“adverse business, financial, or economic conditions will likely impair the obligor's capacity or willingness to meet its financial commitments on the obligation”) Post, bestowing a relatively generous 23 times trailing adjusted earnings multiple. That compares to 14.7 times trailing earnings for the S&P 500 Packaged Foods Index.
For Post bulls, the deal-making acumen of a management team headlined by the venerated 84 year-old nonexecutive chairman William P. Stiritz, counts as a primary attraction. Since its 2012 formation as a spinoff from Ralcorp, Inc., Post has undertaken more than a dozen acquisitions, for total considerations of at least $8.2 billion (financial terms for several deals, including the recently announced TreeHouse private brands label, were undisclosed). For context, Post's current market cap is just over $8 billion.
Vicki Bryan, founder and CEO of BondAngle, LLC, tells Grant’s today that Post’s chronic deal-making helps prevent investors from getting a true picture of the company’s performance and financial health.
On top of the stream of acquisitions, Post is constantly rejiggering their segment reporting, including in the second quarter. This prevents investors from getting an apples-to-apples look at their performance. I call it ‘structured amnesia.’
Post’s financial machinations extend beyond the gathering of corporate assets. On Aug. 2, the company announced the spin-off of its private brands business into a newly formed entity called 8th Avenue Food & Provisions, in partnership with private equity firm Thomas H. Lee Partners, Inc. The unit chipped in $849 million in revenues last year, equivalent to 13.6% of Post’s top-line for fiscal 2018.
In carving out that business unit, Post received proceeds of $250 million, as well as 8th Avenue’s assumption of $625 million in debt. Post maintains 60.5% of the common equity for 8th Avenue, while Thomas H. Lee received preferred stock with a cumulative, quarterly compounding dividend, as well as the remaining 39.5% ownership in the venture. As Thomas H. Lee controls voting rights to the newly formed company, those results are no longer consolidated onto Post’s financial statements.
For her part, Bryan flags the 8th Avenue deal as a concerning one, particularly for Post’s creditors:
By spinning off the private brands unit, Post has reduced profit visibility and, more importantly, reduced asset coverage against its substantial borrowings. This is particularly worrisome considering that intangible assets such as goodwill foot to $8 billion, more than two-thirds of the $11.3 billion in total assets on the balance sheet.
What’s more, 60.5% Post-owned 8th Avenue is itself highly leveraged. Accordingly, the parent company may be currently or in the future compelled to support the unit through paying expenses or disbursing additional cash. We know that it is one of Post’s lower-margin businesses, reporting gross margins of 16.2% in the six months ended March 31, compared to 31.4% for the parent company.
In short, they have further weakened what was already a weak hand for bondholders.
QT Progress report
The Fed’s portfolio of securities held outright registered at $3.686 trillion this week, down $15.5 billion on a sequential basis, with mortgage-backed securities and Treasury holdings down by $5.8 billion and $9.7 billion, respectively, from a week ago.
Since the Oct. 1, 2017 commencement of QT, the Fed’s total balance sheet assets are down 13.3%, for a simple annualized pace of 8.4%.
Recap May 16
Stocks rose again, with the S&P 500 gaining nearly 1% to claw back to unchanged for the week after Monday’s steep selloff, back within 2.5% of the closing highs reached on April 30. Treasury yields ticked higher, with the short end underperforming to leave the curve a bit flatter, and strength in the energy patch helped WTI crude rebound to $63 a barrel. After touching 21 earlier in the week, the VIX settled below 15.5.
- Philip Grant
Tuesday, May 14, 2019
Can you hear me now?
Yesterday, Bloomberg reported that Sprint Corp. (S on the NYSE)
Yesterday, Bloomberg reported that Sprint Corp. (S on the NYSE)
Recap May 14
Can you hear me now?
Yesterday, Bloomberg reported that Sprint Corp. (S on the NYSE) and T-Mobile U.S., Inc. (TMUS on the Nasdaq) have opted for new tactics in lobbying government regulators to approve their merger announced in April 2018. In the face of apparent opposition from staffers at the Department of Justice and Federal Communications Commission, the pair (the fourth- and third-largest wireless carriers in the U.S., respectively) are discussing concessions, including potentially selling pre-paid business units or airwave licenses as well as “far less attractive options,” such as establishing a new fourth carrier which would lease network capacity from the combined entity.
On April 16, The Wall Street Journal reported that DoJ staffers told the pair the merger “is unlikely to be approved as currently structured.” That same day, the Capitol Forum relayed that the DoJ expressed “continued concerns regarding efficiencies and a potential delay in any of the deal’s benefits reaching consumers” at an early April meeting with the pair.
But investors remain relatively sanguine about single-B-plus rated Sprint’s prospects. The company’s senior unsecured 6 7/8 notes due 2028 trade near 96 cents on the dollar, while Sprint shares remain at a 26% discount to the all-stock offer price (as reflected in T-Mobile shares), both little changed from six weeks ago. That steady price action in the face of less-than encouraging media reports stands in contrast to the precipitous decline in Sprint’s bond and stock prices in early 2016, when its status as a viable enterprise came into question.
A bearish analysis of Sprint in the Dec. 23, 2016 edition of Grant’s Interest Rate Observer argued that Sprint’s stagnating top-line, persistent cash burn (negative on a free cash flow basis in each of the last four years, with more red ink in store for fiscal 2019 and 2020 according to estimates compiled by Bloomberg), and hefty debt load presented risks in excess of the prospective skimpy returns.
While likely delivered with an eye toward influencing regulators, recent language from Sprint management seems to concur with that assessment, as CEO Michel Combes remarked on the Jan. 31 conference call: “As a stand-alone company, we lack the scale to keep pace with the bigger carriers, AT&T and Verizon, in sustained capital investments and without additional low-band spectrum, we will face challenges to provide customers with coverage comparable to that of the big two carriers.”
For its part, T-Mobile management is preparing for life as a standalone company. Last week, Germany’s Handelsblatt reported that the TMUS c-suite is preparing a plan B if the merger is blocked.
As for the remedies proposed by the pair, Amir Anvarzadeh of Asymmetric Advisors writes this morning that the suggestions are both unlikely to move the needle and impractical from a business competition standpoint:
The problem is that spinning off the prepaid business (which makes the bulk of both carriers' customer base) leaves them at a huge disadvantage in terms of converting customers to post-paid users in the future.
Selling off airwaves would also be silly given that Sprint was just saying that without adequate low band radio spectrum, they will be at a great disadvantage while its 2.5Ghz spectrum is one of the most attractive assets they have. I’m not sure if either option is feasible.
Meanwhile, one anonymity-seeking investor acquainted with the situation finds the contrast between widespread reports suggesting the merger will fail to garner regulatory approval on the one hand, and the sanguine trading in Sprint’s equity and debt on the other, to be curious, telling Grant’s:
I continue to believe that the DOJ, FCC and state attorneys-general are not convinced that the proposed deal efficiencies are merger specific or verifiable enough to accept highly visible harms that inure from a permanent change in industry structure (four players to three).
Resolution to this saga is likely near. The Capitol Forum notes that the DoJ is expected to reach a final decision before early June, when the FCC’s scheduled 180-day review period comes to conclusion.
Recap May 14
Stocks staged a solid rebound with the S&P gaining nearly 1% after falling to a six-week closing low yesterday, but the broad index did lose some steam by day’s end. The VIX fell back to 18, down 12% on the day, and Treasury yields edged higher after yesterday’s strong rally with the 10-year yield rising back above the three-month by one basis point after inverting yesterday. WTI crude ticked back to near $62 a barrel.
- Philip Grant
Monday, May 13, 2019
Cut rate
The latest escalation of the U.S./China
The latest escalation of the U.S./China
Swing LO
This morning, Mexican President Andrés Manuel López Obrador (AMLO) unveiled
This morning, Mexican President Andrés Manuel López Obrador (AMLO) unveiled
Recap May 13
Cut rate
The latest escalation of the U.S./China trade spat has both countries considering their options. This morning, Hu Xijin, editor-in-chief of The Global Times, speculated on Twitter that China might retaliate against the latest tariff hikes by selling down their $1.1 trillion pile of Treasury bonds (representing nearly 7% of the $16.1 trillion in U.S. debt held by the public). But that potential supply deluge didn’t prevent a strong rally in rates: The 10-year yield dropped this morning to 2.40%, the lowest since March, crossing below the three-month bill yield to once again push the curve into inversion.
As international tensions percolate and risk appetite withers, the market increasingly expects the Fed to ride to the rescue. Interest rate futures currently price 59% odds of a rate cut by October, nearly double the 31% likelihood anticipated one month ago.
But comments from a pair of senior Fed officials suggest the FOMC is less than eager to follow Mr. Market’s suggested path. This morning, Minneapolis Fed president Neel Kashkari told CNBC that a still-robust labor market indicates no pressing need for policy support: “If we saw job growth really slowing down, then you might say. . . we need to do something. I’m not quite in that camp yet because we continue to see the job market exceed expectations.”
Fed vice chairman Richard Clarida likewise took a sanguine view in a Boston speech this morning, remarking that “the U.S. economy is operating at or close to our maximum-employment and price stability [meaning a measured 2% annual loss in purchasing power] goals.”
Jim Bianco, president and eponym of Bianco Research, argues today that the Fed would be wise to heed the market’s advice. The 10-year yield has dropped below the three-month yield on seven occasions in the last 50 years, and recession has followed each time, commencing 311 days later on average. Bianco writes:
The yield curve is a market signal that the Fed is too tight. Many think it ‘predicts’ a recession. We believe it actually ‘causes’ a recession.
A recession occurs because something ‘breaks’ the economy. FOMC policy that is overly restrictive is perhaps the leading reason an economy breaks. It is the cumulative effect of a Fed mistake week after week, month after month that causes a recession.
Swing LO
This morning, Mexican President Andrés Manuel López Obrador (AMLO) unveiled a fresh series of measures designed to bolster the cash-leaking state-owned oil company Petróleos Mexicanos (Pemex), including an $8 billion syndicated loan as well as fresh tax breaks. Proceeds from the loan will be used to refinance a portion of Pemex’s towering $106.5 billion debt load. The new measures follow a $5.5 billion aid package disbursed in March.
But with that generosity comes the expectation that Pemex will do some heavy lifting. Last Thursday, AMLO announced that his administration has rejected a trio of private company bids to build an oil refinery in his home state of Tabasco, instead tapping Pemex for the job. The outside bidders had submitted budgets in the range of $10 billion to $12 billion for the project, and anticipated completion between 2023 and 2025. Instead, Pemex will build the facility for $8 billion, and target completion by May 2022. “We’re not going to start any work we can’t finish in my term,” AMLO declared.
Count some observers as skeptical. Gonzalo Monroy, an independent energy analyst in Mexico City, told The Wall Street Journal that: “You can’t build a monster refinery like this, at such a low cost, on such a short timeline. López Obrador will have to sacrifice one of those things. That’s what the companies that were bidding on this project were saying.”
Pemex investors are likewise uneasy about the ambitious plan. Luis Maizel, senior managing director at LM Capital Group, LLC, remarked to Bloomberg: “Building it yourself is stupid, and its bad for Pemex because they don’t know what their costs will be or when they will finish it.” Maizel anticipates further government support for split-rated (triple-B-plus at S&P, triple-B-minus at Fitch) Pemex: “[AMLO] can calm things down by saying ‘we assure you that Pemex will always fulfill its obligations prior to the government withholding taxes.’”
Creditors are taking these developments in stride, as the Pemex senior unsecured 6 3/4 notes due 2047 traded at 91 cents on the dollar this morning, little changed from last week’s levels. By contrast the Mexican 4.6% dollar-pay bond due 2047 slumped to 95.8 today, down from an average 96.8 seen last week.
For more on the implications of the increasingly intertwined relationship between Pemex and its sovereign patron, see the March 23, 2018 edition of Grant’s Interest Rate Observer.
Recap May 13
Stocks were clobbered with the S&P 500 falling 2.5%, the biggest decline since Jan. 3 to leave the broad index roughly 5% below its high water mark reached April 30. Treasury yields gapped lower across the curve, and monetary alternatives rallied as gold rose above $1,300 an ounce for the first time in a month and bitcoin ripped 11% to $7,800. The VIX closed above 20 for the first time since January.
- Philip Grant
Friday, May 10, 2019
Bank teller
From Reuters:
Millions of $50 Australian dollars ($35) banknotes in Australia have an embarrassing typographical error that was overlooked by the country's central bank before they were printed and circulated.
The goof first became known on Thursday when a listener on radio outlet Triple M sent the station a magnified photo of the Reserve Bank of Australia's (RBA) new A$50 note highlighting the word "responsibility" misspelt as "responsibilty" three times.
An RBA spokeswoman said in an emailed statement to Reuters the Bank "is aware of it and the spelling will be corrected at the next print run."
Practice makes perfect.
Mr. Erdogan's wild ride
The Turkish whipsaw continues. This morning the lira rallied by 2% against the dollar after the local central bank suspended its one-week repo auction, effectively raising interest rates by 150 basis points to 25.5% without effecting a direct change to the benchmark rate. Jason Tuvey, senior emerging markets economist at Capital Economics, told Reuters that political considerations likely dictated the roundabout policy tightening: “The central bank’s moves suggest it is under political pressure to not hike interest rates, so it has to go through the back door.”
Politics indeed loom large for Turkish asset prices, as the lira swooned on Tuesday after the country’s top court annulled local election results that saw the opposition CHP party take control of the Istanbul mayoralty. The lira is down 14% against the dollar since late March, the weakest of any currency tracked by Bloomberg. The do-over elections are set for June 23.
President Recep Erdogan addressed the spiraling lira in a speech to parliament Tuesday, declaring that “full blown economic sabotage” was afoot and promising that “whatever we did to the terrorists threatening our borders, we will do the same” to those economic saboteurs.
Key indicators suggest Erdogan has some work to do. The measured rate of Turkish inflation jumped 19.5% year-over-year in April, almost double the average five-year monthly inflation rate of 10.5%. At the same time, the year-over-year change in GDP declined throughout 2018, reaching negative 3% in the fourth quarter for its worst showing since 2009. The lira has lost 66% of its value against the greenback over the last five years.
There are some signs of relief, however. According to data from the central bank, Turkish households and businesses sold a net $1.2 billion in dollars and euros in the week ended May 3, the fourth straight week of net sales of so-called hard currency.
Then, too, Turkish banks are hard at work propping up the lira. Bloomberg reports that financial institutions were selling dollars and buying lira in Asia overnight “in order to give maximum impact to their purchases.” That follows a report from the Financial Times on April 30 noting that the Turkish central bank has engaged in swap transactions with local banks designed to bulk up its holdings of FX reserves. Those moves came with some curious accounting techniques: “The central bank had told the FT that the dollars borrowed in these transactions were added to the asset side of its balance sheet while the corresponding lent liras were not deducted.” But even with those maneuvers, the coffers are dwindling. As of May 3, foreign exchange reserves fell for a third straight week to $72.5 billion, down 30% from the failed coup attempt in July 2016.
Turkey FX reserves, five-year chart. Source: The Bloomberg
Mr. Market is registering increasing concern, as Turkish credit default swaps rose to 494 basis points yesterday, almost double the five-year average of 252 basis points. Meanwhile, the 7 5/8 dollar-pay bonds due in 2029 have fallen to 96 cents, down from 104 in mid-March for a meaty 582 basis point spread to Treasurys.
With outsized risks, and commensurate potential rewards, some investors are taking the plunge.Thomas Clarke, partner and portfolio manager at William Blair International in London, told Bloomberg yesterday that: “I don’t want to lose sight of the fact that [the lira] is a very, very cheap currency with also a very, very high carry. We have a predisposition to buy more.” As for Erdogan, Clarke noted that: “he does have a lot of executive power over Turkey and Turkish institutions, but he does not have executive power over the financial markets.”
Not yet anyway.
Thursday, May 9, 2019
To infinity, and beyond
A slide from SoftBank
A slide from SoftBank
He said it
Art Cashin,
Art Cashin,
Suffer for your art
Retail magnate Yusaku Maezawa, founder of Zozo, Inc.
Retail magnate Yusaku Maezawa, founder of Zozo, Inc.
QT Progress report
Recap May 9
To infinity, and beyond
A slide from SoftBank Group Corp.’s 2018 investor presentation released today:
He said it
Art Cashin, longtime director of NYSE floor operations for UBS Financial Services, Inc., summed the market up this afternoon to CNBC:
You're living in a world where one Trump tweet can change everything.
Suffer for your art
Retail magnate Yusaku Maezawa, founder of Zozo, Inc. and the 22nd richest person in Japan with a net worth of $2 billion according to Forbes, is having cash flow troubles. On Sunday, Maezawa told his followers on Twitter that “I have no money. I spend it so quickly (smiley face).” The tycoon is amply leveraged, with 88% of his Zozo stock holdings pledged as loan collateral according to regulatory filings.
Maezawa’s liquidity shortage is no welcome news within the art world, as Bloomberg likewise notes that he has earned a spendthrift reputation by “pouring hundreds of millions of dollars into everything from Basquiat paintings to a Hermes-upholstered private jet and a down payment for a ride on Elon Musk’s rocket around the moon.” In May 2017, Maezawa shelled out a record $110.5 million for Basquiat’s Untitled. Four months later, an article on the auction house Christie’s website dubbed Maezawa “the art world’s new rock star.”
For Sotheby’s, the publicly-traded half of the global auction house duopoly and the oldest company listed on the New York Stock Exchange (BID is the ticker), the prospective retreat of a major bidder hasn’t dented an upbeat outlook. On last week’s earnings call, CEO Tad Smith told listeners that management: “feel[s] very good about second quarter results based on great works of art and strong demand from Asia and the Americas.” A decisive event looms in the form of next week’s impressionist and modern art auction in New York, which carries a low estimate of $305.5 million according to the company.
Sotheby’s shareholders are eager for good news. Since a bearish analysis in the September 8 edition of Grant’s Interest Rate Observer, shares are down by 18%, compared to an 8% drop in the Russell 2000 Index during that period.
With BID’s top-line in a holding pattern (forecast 2020 revenues of $1.04 billion trails the $1.06 billion achieved in 2017), margin expansion figures prominently in the bull case. The Street expects EBITDA to foot to 24.8% of revenues in 2020, up from 21.8% last year and 18.1% in 2017. Net income margins will likewise fatten to 13.1% in 2020 from 11.3% in 2017, if the analysts are on point. Sotheby’s and Christie’s together dominate the auction market, acting as the liquidity providers of first resort in the fine-art resale market. But an anonymity-seeking senior auction house executive told Grant’s last September that the model has its limitations:
It’s a duopoly without pricing power. That is the thing that is hard for people to understand. They always think the prices and volume go up, we are going to clip a standard commission against ever increasing prices and volumes. They must be printing money. The auction houses don’t manufacture anything. Every sale, they need to find new properties. They don’t do original issues. They don’t do IPOs. It is a pure secondary market.
Indeed, the art market acts as something of a derivative on global financial and economic conditions. Thus, according to the 2019 “Art Market Report” by Art Basel and UBS, auction sales registered at $29.1 billion last year, up 3% year-over-year and 30% from 2016, a year marred by Chinese capital controls, weak commodity prices and the short but sharp global equity selloff at the beginning of that year.
Meanwhile, the post-2008 surge in art prices has led to a quandary, as buyers have become wary of overpaying while sellers contend with the prospect of busted auctions. By way of response, the auction houses issue guarantees to attract new business, exposing themselves to losses if bidding interest fails to reach the reserve price, or to margin erosion if the piece in question is offloaded to a third-party guarantor.
To help offset those extra costs, the auction houses have recently hiked their commissions. As noted by Giulia Costantini, co-founder of Art Strategy Partners, at the Grant’s spring conference on April 9, buyers at the lower end (up to and including $400,000) can end up paying as much as 40% above the hammer price when factoring in taxes and the U.K. value-added tax.
Fellow Art Strategy Partners co-founder Wendy Battleson likewise noted that the fierce competition within the auction houses can present a perverse dynamic for Sotheby’s investors:
We also believe that when there is good news in the press about Sotheby’s that usually means very bad things. It is always shocking to us about the announcement of a wonderful sale at Sotheby’s that will be coming up in 2-3 months and there is a lot of talk about how much value there is in the sale and how important it is and on and on and on. Then you see the stock price creep up based on that news.
What people should really be doing is shorting the stock because if there is a great announcement it means that Sotheby’s went against Christie’s and potentially Phillips and pitched the business to the client that was selling. Then there was margin erosion, margin erosion, margin erosion and negotiations back and forth.
Ultimately that great piece of business that Sotheby’s is raving about is probably a loss leader and in a best-case scenario is probably breakeven. Good news at Sotheby’s means very bad news for their stock price.
QT Progress report
The Fed’s portfolio of securities held outright remained steady at $3.7 trillion following the $37 billion sequential decline of a week ago, the largest seen thus far. Since the Oct. 1, 2017 commencement of QT run-off, the Fed’s total balance sheet assets are down by 12.6%, a 7.9% simple annualized pace.
Recap May 9
Stocks recouped the bulk of early losses to leave the S&P 500 just below unchanged on the day, and down 2.5% for the week. A weaker dollar wasn’t enough to keep WTI crude from sliding below $62 a barrel and a strong rally in Treasurys pushed the 10-year yield to 2.45%, within eight basis points of a 52-week low.
- Philip Grant
Monday, May 6, 2019
Drivers' side
From the Associated Press:
From the Associated Press:
Service industry
The Toronto Real Estate Board released its monthly report for April today,
The Toronto Real Estate Board released its monthly report for April today,
Recap May 6
Drivers' side
From the Associated Press:
An organization representing for-hire drivers in New York City says its members will go on a two-hour strike against Uber and Lyft ahead of Uber's planned initial public stock offering.
The New York City Taxi Workers Alliance says its members voted not to drive for Uber or Lyft between 7 and 9 a.m. Wednesday.
San Francisco-based Uber is aiming to raise $9 billion in its initial public offering Thursday.
Service industry
The Toronto Real Estate Board released its monthly report for April today, showing a brisk 16.8% year-over-year sales uptick to 9,042 units. Prices likewise edged higher to C$820,000 ($607,000), up by 1.9% from a year ago, while average days on the market declined to 19 from 20. Though improved from 2018, those figures are well below the 11,630 transactions logged at an average price of C$921,000 and an average of nine days on the market seen in April 2017.
While Toronto’s housing market shows signs of stabilizing, action in formerly white-hot Vancouver remains at a standstill. April sales in the metro Vancouver region totaled just 1,829 according to the local real estate board, down 29.1% from a year ago and the weakest activity in April since 2000. Prices are also in retreat, with the benchmark index sliding 8.5% year-over-year to C$1,008,000, the lowest since May 2017.
Some participants still have hope. Tamara Vrooman, CEO the Vancouver City Savings Credit Union, which provides banking services for roughly one-quarter of the city’s residents, told Bloomberg: “We see no evidence of a [housing] freefall. We have certainly seen a lot of sitting on the sidelines and wait-and-see, but we’re also seeing signs that we may be at the trough.”
However, national data through the first three months of the year add further weight to the idea that the long-running Canadian housing boom is over. The Teranet-National Bank House Price Index has averaged a 1.9% year-over-year gain in January, February and March, down from 7.6% growth in the first quarter last year and 13% in 2017. The pace of new credit has slowed commensurately, with residential mortgage credit up 3.3% year-over-year in the first quarter according to the Bank of Canada, down from a 5.1% yearly advance in the first three months of 2018 and the weakest first quarter growth rate since 2001.
As housing turns, the Canadian economy is showing signs of strain. On Tuesday, Statistics Canada reported that February GDP grew just 1.1% year-over-year, below the 1.4% expected. A day later, IHS Markit reported that the Canadian manufacturing PMI slipped to 49.7 in April, the first contractionary (meaning sub-50) reading since February 2016, with the employment and new orders components falling to their lowest since September 2016 and December 2015, respectively.
But those worrisome economic signs haven’t discouraged Bank of Canada governor Stephen Poloz from maintaining a hawkish rhetorical bent. Speaking to Canadian lawmakers after keeping the overnight range unchanged at 1.75%, Poloz noted that with unemployment at a 40-year low and real rates in negative territory (March CPI grew by 2.1% year-over-year), policy tightening could be in order: “If [economic] headwinds dissipate, then interest rates would rise.” In an interview with Global News’ The West Block on April 28, Poloz blamed the recent slowdown on a variety of outside factors, including the fall 2018 decline in oil prices and “very nasty weather,” as well as the global trade war “that has basically been initiated by the United States.”
The central banker predicted that GDP growth will recover to a 2% pace by mid-year and will remain in that accelerated range through year-end 2020. In a speech today, Poloz played down the housing slowdown as a broader economic risk, stating that “the fundamentals of the Canadian housing market remain solid,” and forecasting that “growth will resume once the effects of reduced expectations for house price inflation,” along with the B-20 mortgage regulations requiring borrower stress tests, have been digested.
As Poloz talks up the economy and the prospect of higher rates, the debt-soaked Canadian consumer is up against the wall. According to a March report from Statistics Canada, household debt climbed to 178.5% of disposable income at year-end 2018, up for a fifth consecutive quarter. That compares to 85% of disposable income in the U.S. in the fourth quarter. Meanwhile, debt service chewed up 14.9% of Canadian household income in the fourth quarter, up from 14.2% year-over-year. By comparison, that metric peaked in the U.S. at 13.2% in the third quarter of 2007 and stood at 9.9% at year-end.
For an analysis of the potential ramifications of a Canadian housing bust, see the Feb. 9, 2018 edition of Grant’s Interest Rate Observer.
Recap May 6
No trade deal, no problem. Stocks recovered the bulk of steep early losses following the apparent breakdown of Sino/American trade negotiations over the weekend, leaving the S&P 500 less than 50 basis points in the red. By comparison, China’s Shanghai Composite Index lost more than 5% on the day.
Treasurys rallied across the curve, with the 10-year yield dipping below 2.5%. WTI crude edged back over $62 a barrel, and the VIX volatility index rose 20% for its highest close in six weeks.
- Philip Grant
Friday, May 3, 2019
Ticker tailor
Speaking on CNBC today,
Speaking on CNBC today,
If you build it
From last weekend's edition of the London Sunday Times:
From last weekend's edition of the London Sunday Times:
The buck stops over there
In a Wednesday speech in London, European Central Bank
In a Wednesday speech in London, European Central Bank
Recap May 3
Ticker tailor
Speaking on CNBC today, Vice President Michael Pence said the Fed should slash rates and abandon its mandate to keep prices low and stable.
Data dependence, Trump-style
If you build it
From last weekend's edition of the London Sunday Times:
The world’s first luxury development to be sold in bitcoin, which was promoted by the Conservative peer Baroness Mone, has stalled.
Mone, a former Tory business “start-up tsar”, and her partner, Doug Barrowman, launched the £250m development in September 2017 to worldwide publicity, with the promotional material saying the two residential towers would be completed by this summer.
The Aston Plaza project in Dubai, in which a two-bedroom flat was going to cost the bitcoin equivalent of about £185,000, is still being described on its website as “25% complete”, the figure used in the promotional material. However, government inspectors who visited the site at the Dubai science park in January last year described the venture as “on hold”, and construction has stopped.
The buck stops over there
In a Wednesday speech in London, European Central Bank vice president Luis de Guindos expressed concern over the state of the European banking system. The central banker noted that despite a lengthy period of economic expansion, Europe’s banks continue to earn returns on equity that fail to match their costs of capital. Indeed, the market takes a dim view of the sector, as the Stoxx 600 Banks Index trades at just 0.64 times book value, half of the 1.22 times book value fetched by the U.S. KBW Bank Index.
Perhaps unsurprisingly, de Guindos played down the role of the ECB’s aggressive monetary policy in that valuation gap, making only one passing mention of negative rates, and noting that: “European bank profitability has been structurally weak since well before unconventional monetary policy measures were introduced.” Instead, he cites inefficient cost structures, competition from non-financial companies and “cyclical factors” as the culprits constraining interest income. De Guindos concludes:
The structurally low profitability of the euro area banking sector remains a concern for financial stability and for monetary policy. Return on equity below the cost of capital is unsustainable in the long run. The causes of low profitability are for the most part structural and hence require structural solutions. Successful implementation of long-run profitable business plans is essential.
Consolidation remains necessary.
That advice follows the failed merger attempt between Deutsche Bank A.G. and Commerzbank A.G., Germany’s two largest financial institutions. Yesterday, the Financial Times published a postmortem of the scuttled transaction, noting that the pair would have needed to raise at least €8 billion to close the deal, a sum equal to nearly one-third of their combined current market cap. The FT quoted an unnamed regulator who described the break thusly: “Calling off the merger wasn’t a strategic transaction. They could just not afford the deal.”
For Deutsche Bank, the euro area’s third-largest bank by assets, it’s back to the drawing board. A dispatch from Bloomberg yesterday was headlined: “Deutsche Bank said to have virtually no new plan for what’s next.” Deutsche Bank shares currently trade at 0.24 times their Dec. 31 book value, down from 0.51 times at year-end 2017.
Recap May 3
Stocks snapped higher following a stronger than expected reading of April non-farm payrolls, with the S&P 500 gaining near 1% to edge back into positive territory for the week. That broad index is up 17.5% year-to-date.
Elsewhere, Treasury yields ticked lower with the 10-year settling at 2.53%, while oil managed to buck bearish commodity price action with WTI finishing near $62 a barrel. The VIX shed nearly 10% to fall back towards 13.
- Philip Grant
Thursday, May 2, 2019
Downhill from here
On Tuesday, Mexico’s state-owned oil company Petróleos Mexicanos (Pemex)
On Tuesday, Mexico’s state-owned oil company Petróleos Mexicanos (Pemex)
QT progress report
Recap May 2
Downhill from here
On Tuesday, Mexico’s state-owned oil company Petróleos Mexicanos (Pemex) reported an operating loss of MXN 36 billion ($1.9 billion) in the first quarter. That’s an improvement from the MXN 157 billion fourth quarter shortfall, as the rampant oil theft from company pipelines seen last fall has largely abated. Pemex likewise pledged to keep its MXN 2.1 trillion debt load stable, a move the Financial Times terms “a big change in policy.”
Chief financial officer Alberto Velázquez hailed the results: “We have advanced in all areas. The challenges will require time to resolve but the trend is clear. . . Pemex is moving in the right direction.”
Yet production continues to move in the wrong direction. First quarter output averaged 1.66 million barrels per day (mbpd), down 12% year-over-year and the lowest figure on record going back to 1990. For 2019, Pemex management is targeting 1.725 mbpd, which compares to 1.82 mbpd in 2018 and a high of 3.4 mbpd in 2004.
The Mexican government looks set to provide more help for its energy champion. Back in March, deputy finance minister Arturo Herrera told reporters that the government was considering paying up to $7 billion of Pemex’s obligations out of the public coffers. That follows a $5.5 billion rescue package including tax relief and direct recapitalization announced by President Andrés Manuel López Obrador (AMLO) in February. Pemex has some $16 billion worth of debt coming due this year and has posted negative free cash flow in every year since at least 2008.
As the state continues to cough up cash in support of Pemex, worrisome economic signs abound. Mexico's first quarter GDP contracted by 0.2% on a sequential basis, worse than any of the 11 economist estimates tabulated by Bloomberg. That follows a 6.8% year-over-year decline in gross fixed investment in December, the second-worst reading since 2009.
An analysis in the March 23, 2018 edition of Grant’s Interest Rate Observer argued that thanks to dwindling production, structural unprofitability and a hefty $166 billion in liabilities, equating to six times trailing 12-month EBITDA including pension obligations, Pemex’s debts may one day soon become those of the Mexican government.
To that end, a potentially ominous sign in Tuesday’s update: Output at the deepwater Ku-Maloob-Zaap (KMZ) oil field, which provides just over half of Pemex’s total output, fell to 837,000 barrels per day in the first quarter, down from 875,000 barrels a year ago. While that 4% decline is less severe than the aggregate 12% production drop-off, KMZ has been a rock-steady producer in the past 10 years, in contrast to the fast-depleting Cantarell oil field, which was one of the largest in the world at its 2004 peak and now generates just 158,000 bpd. Bloomberg Intelligence analyst Fernando Valle tells Grant’s today that structural factors loom large for KMZ:
Deepwater fields tend to decline quickly, and you will need capital to keep production flat. Unfortunately, as you know, Pemex required capital injections and has a very bloated cost structure, so it seems difficult to believe that they will have the wherewithal to make those required investments.
For his part, John Padilla, partner and managing director at IPD Latin America, flagged KMZ as an important catalyst in that March 2018 issue of Grant’s:
The thing to keep your eye on from Pemex’s perspective is . . . going to be when KMZ starts declining, which it will.
They [Pemex] have managed it infinitely better [at KMZ] than what they did with Cantarell. If there is one glorious thing that they’ve been able to do to date, [it] is that they’ve been able to manage KMZ’s production well, but any field that you use secondary, tertiary recovery techniques . . . you squeeze it faster and there is less of it at the end. That production will fall, and when it falls, it is going to fall very significantly.
But creditors aren’t concerned, as the company’s debt continues to rebound. After falling from near par at publication time to below 82 cents on the dollar in the fall, Pemex’s split-rated (triple-B-plus at S&P, triple-B-minus at Fitch) senior unsecured 6 3/4 bonds due 2047 have rallied back above 90, yielding a 465 basis point premium to Treasurys. Mexican sovereign credit default swaps likewise cost 114 basis points, down from 163 basis points in November.
QT progress report
The Fed’s portfolio of securities outright registered at $3.745 trillion this week, down a meaty $38 billion from a week ago for the biggest sequential decline of the program so far. Treasury holdings fell by $30 billion as the calendar flips to May, with mortgage-backed securities accounting for the remainder.
Since the Oct. 1, 2017 commencement of QT portfolio run-off, the Fed’s total balance sheet assets are down by 12.7%, for a simple annualized pace of 8.2%.
Recap May 2
Stocks finished slightly lower, extending yesterday’s selloff to leave the S&P 500 roughly 80 basis points in the red for the week so far. Treasurys also sold off with the 10-year yield rising back to 2.55%, and energy continued its pullback with WTI crude falling below $62 a barrel from $66 one week ago. The VIX jumped as high as 16 in midday before settling at 14.5.
- Philip Grant
Tuesday, April 30, 2019
Cross check
This morning, McDonald’s Corp. (MCD on the NYSE) reported mixed first quarter results. Revenues of $4.96 billion rose 2% year-over-year on a constant-currency basis to top the consensus $4.93 billion, driven by a 5.4% rise in comparable store sales. Yet that strong growth didn’t translate into improved profitability, as operating income fell 2% year-over-year to $2.09 billion. MCD shares finished the day little changed.
McDonald’s growth may be coming at the expense of its competitors. Same-store sales at Burger King, Popeye’s Louisiana Kitchen and Tim Horton’s, the trio of eateries managed by Restaurant Brands International, Inc. (QSR on the NYSE), generated same-store sales growth of 2.2%, 0.6% and negative 0.6%, respectively, in the first quarter. Overall, QSR revenues grew 1% year-over-year, matching Street expectations, driven by a 5.1% rise in restaurant count. Adjusted earnings per share fell to 55 cents from 64 cents a year ago, trailing the expected 58 cents. QSR shares fell 3% in response, and are up by 7% since June 2017, trailing the S&P 500’s 21% gain over that period.
Restaurant Brands’ difficulties are especially acute north of the border. The Tim Horton’s unit saw same-store sales contract by 0.6% and adjusted EBITDA fall by 3.2% from a year ago, while system-wide Tim Horton’s sales rose by just 0.5% on a constant-currency basis despite a 1.9% increase in the restaurant count. By way of explanation, QSR management cited adverse winter weather (what, in Canada?), along with increased promotional activity related to an advertising campaign that “did not drive the incremental engagement [the company] expected.”
Tim Horton’s is a crucial profit center of QSR, accounting for 20% of system-wide sales but 47% of total EBITDA during the first quarter.
With key operating metrics on the wane, Restaurant Brands generates shareholder value in other ways. On Jan. 23, QSR raised its quarterly dividend to 50 cents a share from 45 cents, pushing the dividend yield to 3.1% and spurring a 10% rally in the share price. The move further extends Ba3-rated QSR’s already-stretched balance sheet, as net debt stands at 5.1 times 2019 consensus EBITDA. That compares to an average 3.6 times debt to EBITDA seen in the Ba-ratings group, per an October analysis from Moody’s Investor Service.
But with an A-list cast of investors including Warren Buffett’s Berkshire Hathaway, Bill Ackman’s Pershing Square Capital and Brazilian private equity firm 3G Capital, Inc. (the majority owner), Wall Street remains unabashedly bullish on Restaurant Brands: Of the 22 sell-side analysts covering the name, 17 rate shares “buy,” with five “hold” ratings and zero “sells.” The Street likewise expects free cash flow to jump to $1.43 billion this year and $1.66 billion in 2020, well above last year’s $1.08 billion figure.
Today, QSR is valued at 18.3 times enterprise value to EBITDA, richer than the 16.8 times EV to EBITDA commanded by McDonald’s, the standard-bearer in fast food. On the credit side, Restaurant Brands’ first-lien 4 1/4 notes due 2024 trade just below par for a 209 basis point premium to Treasurys, well inside the 373 basis point spread on offer in the sub-investment grade Invesco Senior Loan ETF (BKLN on NYSE Arca).
Is that lofty valuation justified? Grant’s has argued no, laying out the bearish case for QSR’s “capital-light and debt heavy” business model in the June 2, 2017 edition. The analysis documented Restaurant Brands’ tussle with the Tim Horton's Great White North Franchisee Association, which accused the company of shifting costs from the corporate P&L to the operators in 2017, including through improper use of the franchisee marketing fund for other expenses. That discord suggested potential operating difficulties that would put a dent in QSR’s then-valuation of 38 times trailing adjusted EPS (that figure has since come down to 24 times).
More broadly, the tension between fee-generating, asset-light franchisors and their increasingly cost-squeezed franchisees continues. Even premiere operator McDonald’s is not immune. In October, 400 franchisees voted to form a self-funded alliance called the National Owners Association to advocate for their interests, including retaining control of pricing decisions. That news bodes poorly for the rest of the industry, considering the average McDonald’s generates $2.7 million per year in revenue according to monthly trade magazine QSR. That compares to $1.6 million for Wendy’s Co. and nearly double the $1.4 million average for Restaurant Brands’ Burger King.
Speaking at the Grant’s spring 2018 conference, John Hamburger, president of Franchise Times Corp., crystallized the problem:
On one side you have a franchisor with no capital expenditures and no day-to-day street-level exposure collecting royalties and rents by the bushel basket, trading at double-digit multiples, all the while levering up to pump out cash out to shareholders like there’s no tomorrow. On the other side, [you have] a franchisee, one that’s actually in the trenches running these restaurants and finding out it’s not a very friendly operating environment right now.
You can’t have one side of the franchise contract getting fabulously rich while the other side faces these headwinds alone. The concept of a moat around the franchisor is a myth. That somehow a brand can separate itself from the unit-level economics of its franchisees is not grounded in reality.
Recap April 30
An 8% post earnings downdraft in Google parent Alphabet, Inc. wasn’t enough to keep stocks out of the green, as the S&P 500 erased moderate early losses to edge back above yesterday’s close, while the tech-heavy NYSE FANG+ Index lost just 1% on the day.
Treasurys rallied across the curve, with the 10-year yield dropping back to 2.5%, and commodities could only manage a flat showing despite a weaker dollar. The VIX gave back an early rally to remain just above 13.
- Philip Grant
Monday, April 29, 2019
Come on in, the water's warm
Owe negative
The Chinese economy continues to muddle along,
The Chinese economy continues to muddle along,
Recap April 29
Come on in, the water's warm
From Bloomberg:
As equities surge to all-time highs, volatility has all but vanished. Hedge funds are betting the calm will last, shorting the CBOE Volatility Index, or VIX, at rates not seen in at least 15 years.
Large speculators, mostly hedge funds, were net short about 178,000 VIX futures contracts on April 23, the largest such position on record, weekly Commodity Futures Trading Commission data that dates back to 2004 show.
Owe negative
The Chinese economy continues to muddle along, as a series of eight indicators compiled by Bloomberg encompassing market sentiment, key commodity prices and overall business conditions showed solid levels of activity in April. That follows a 6.4% reported year-over-year GDP growth rate in the first quarter, above the expected 6.3% but below last year’s 6.6% figure, itself the slowest recorded growth rate since 1990.
But even that middling (by Chinese standards) growth has come through significant exertion, as total new credit footed to 9% of last year’s GDP in the first quarter, a figure which almost matches 2009’s (on an annualized basis) credit injection of 40% of GDP. Bloomberg China economist Qian Wan writes that “policy support is still necessary – that means the government needs to keep spending and driving investment to keep domestic demand stable.”
Loose monetary policy likewise hasn’t been able to forestall increasingly frequent signs of corporate distress. Bloomberg notes today that each of China’s four biggest banks have seen their non-performing loan ratios rise to multi-year highs in the most recent quarter, with bad loans at the Bank of China Ltd. reaching the highest since at least 2006. Data from Bloomberg likewise shows that bonds from 44 Chinese companies totaling $42.9 billion are currently “facing repayment pressure,” up 23% from the end of March. Indeed, a trio of prominent names are in the headlines for all the wrong reasons.
Today, Fitch Ratings cut its appraisal of commodity trader Tewoo Group Co.’s dollar-pay bonds by six notches, to single-B-minus from triple-B-minus following a failed debt-for-equity swap late last year. Tewoo, ranked 132nd on the Fortune Global 500 list, saw its senior unsecured 4 5/8 notes due in April 2020 plunge to 71 cents on the dollar from 95 earlier this month.
Tewoo Group 4 5/8s of 2020. Source: The Bloomberg
Over the weekend, conglomerate CITIC Guoan Group Co., Ltd. failed to make an RMB 3 billion ($450 million) bond payment. Guoan, which reported RMB 178.3 billion in total liabilities as of Sept. 30, saw local courts seize RMB 7.9 billion worth of assets in March. China Lianhe Credit Rating Agency cut its assessment of Guoan to single-A from double-A-minus on April 17. One day later, courts froze the company’s 36.4% stake in Shenzhen-listed CITIC Guoan Information Industry Co., Ltd., which boasts a current market cap of RMB 17.6 billion.
Then there’s HNA Group Co., Ltd., the once-massive roll-up now listing under the weight of its gargantuan $80 billion debt load, $25 billion of which matures in less than one year. Since reversing its acquisitive business model last year, HNA sold roughly $45 billion worth of assets in 2018 according to Caijing magazine, but it hasn’t been enough. On April 17, creditors seized golf courses and other pledged assets after the conglomerate was unable to make debt payments.
Brock Silvers, managing director at Kaiyuan Capital, told Bloomberg that we can expect more of the same: “While the company seeks further liquidity, it may become increasingly selective in honoring obligations. It’s possible that HNA might not survive 2019’s planned debt obligations in its current form.” Silvers sums it up: “The situation is dire.”
China’s efforts to control its bloated credit system carry potentially wide-ranging implications. Chinese banking assets footed to $39 trillion as of Dec. 31, equivalent to 44% of total world GDP in 2018. By comparison, the U.S. and Japan, the world’s largest and third-largest economies (China is second), hold a combined $27 trillion in bank assets.
Recap April 29
More bullish price action left the S&P 500 at a closing high for a second-straight session, while the Nasdaq 100 logged a high-water mark of its own. Commodities came under pressure despite a softer dollar, and Treasury yields rose with the two- and 10-year spread ticking to 23 basis points, its widest of the year.
- Philip Grant
Friday, April 26, 2019
'gram reaper
Trouble in paradise, 2019 style.
Trouble in paradise, 2019 style.
Augean stable
Yesterday, New York attorney general’s office announced
Yesterday, New York attorney general’s office announced
Rubber duck
This morning, Uber Technologies, Inc.
This morning, Uber Technologies, Inc.
Recap April 26
'gram reaper
Trouble in paradise, 2019 style. A (translated) headline from Milan-based online news site Affaritaliani suggests discord within the Italian governing coalition of Luigi Di Maio’s Five Star Movement and Matteo Salvini’s League:
Di Maio and Salvini no longer follow each other on Instagram
Augean stable
Yesterday, New York attorney general’s office announced a court order against iFinex, Inc., parent company of crypto-trading venue Bitfinex, for “ongoing activities that may have defrauded New York investors” that trade crypto-currencies. In the complaint, AG Letitia James didn’t mince words:
Our investigation has determined that the operators of the ‘Bitfinex’ trading platform, who also control the ‘tether’ virtual currency, have engaged in a cover-up to hide the apparent loss of $850 million of co-mingled client and corporate funds.
Bitfinex and Tether responded today with identical blog posts on their respective websites, writing that the filings “were written in bad faith and are riddled with false assertions,” while also asserting that “we have been informed that these Crypto Capital amounts are not lost but have been, in fact, seized and safeguarded.”
The AG’s involvement represents the latest chapter in the saga of Bitfinex, the exchange behind purportedly dollar-backed tether, which is used by crypto traders for conversion from fiat to crypto and back again (roughly 80% of all bitcoin trading is done through tether, according to research site CryptoCompare).
Bloomberg reported in November that the Commodity Futures Trading Commission subpoenaed Bitfinex and Tether over suspicions of manipulating the price of bitcoin. In March, Frances Coppola of Forbes spotted language changes on the Tether website to note that the so-called stablecoin is backed not only by cash but also “other assets and loans made by Tether to third parties, which may include affiliated entities.” By way of response to the AG announcement, the price of bitcoin fell 5% today to $5,250.
For an early, and in-depth, look at the curious Bitfinex/Tether relationship, see the Sept. 8. 2017 edition of Grant’s Interest Rate Observer.
Rubber duck
This morning, Uber Technologies, Inc. filed an amended form S-1 with the Securities and Exchange Commission ahead of a planned IPO later this spring. The ride-share giant set a target price range of $44 to $50 per share, valuing the company at $91.5 billion on a fully-diluted basis at the top end of the range.
That’s down from a purported $100 billion high-end valuation previously reported by The Wall Street Journal on April 10, as well as a $120 billion figure pushed by lead underwriters Goldman Sachs and Morgan Stanley last year. But that’s not to say Mr. Market has cooled too much. A top-of-the-range IPO price would value Uber at more than eight times 2018 revenues of $11.3 billion. By comparison, the NYSE FANG+ Index of ten popular tech stocks currently trades at 4.5 times 2018 sales.
As Uber sets its sights lower, the red ink continues to flow. Operating losses footed to $1.13 billion for the first three months of the year (the results have yet to be audited), up slightly from the $1.05 billion loss a year ago. In the five years ended 2018, Uber’s cumulative operating loss stands at $12.1 billion.
Perhaps more concerningly, revenue growth is dwindling. The unaudited $3.1 billion first quarter top line represents a 19% year-over-year increase. That compares to 69%, 53%, 37% and 22% year-over-year revenue increases across the first, second, third and fourth quarters of 2018, respectively. (Figures have been adjusted for divested assets in Russia and China.)
The persistent losses and top-line slowdown haven’t dented the ambitions of Uber’s c-suite. In a February interview with the Financial Times, CEO Dara Khosrowshahi outlined his long-term goals: “I want to run the bus systems for a city. I want you to be able to take an Uber and get into the subway. . . get out and have an Uber waiting for you." The Uber boss likewise drew inspiration from perhaps the premiere corporate success story of this cycle: “Cars are to us what books are to Amazon.”
Of course, Amazon was profitable on a net income basis by 2003, its ninth year of existence. By contrast, 10-year old Uber warned in its S-1 that they “expect our operating expenses to increase significantly in the foreseeable future, and we may not achieve profitability.” Colleague Fabiano Santin noted some other differences in the Nov. 2 edition of Grant’s:
Jeff Bezos’s business was something truly different, offering customer-written book reviews and suggestions of other books and products of interest. Uber lacks such differentiation. Amazon’s physical infrastructure depended mostly on scalable warehous¬es and servers, whereas Uber depends on vehicles and roads over which it has no control. Bezos had a clear plan that, from day one, was contingent only on logistics and scale, whereas Uber’s plan hinges on yet-undeveloped [self-driving] technology and the political will of governments.
Uber’s problem is a fundamental one: There is no indication that the ride-share business model, in which vehicle maintenance and other costs are shunted onto the company drivers (famously designated as “independent contractors,” rather than employees who might otherwise qualify for health insurance and other benefits) is a better one than that of legacy cab companies. Writing in Vol. 44 of Transportation Law Journal in 2017, transportation analyst Hubert Horan got to the heart of the matter:
It is inconceivable that hundreds of thousands of independent, poorly-financed Uber drivers could ever achieve lower vehicle ownership, financing, licensing and maintenance costs than professional fleet managers at tradi¬tional taxi/limo companies, or that the drivers could do a better job balancing long-term asset costs against local market revenue potential.
Not only does shifting operating costs and capital risk from Uber’s investors onto its drivers fail to eliminate them from the overall business model, but the shifting makes the costs and risks higher.
Meanwhile, ride-sharing competition continues to rage. On Wednesday, the Nikkei Asian Review reported that China’s Didi Chuxing, which is 15.4% owned by Uber, “has started recruiting drivers in Bogotá as it readies its Colombian roll out,” intensifying Didi’s attempted Latin American land grab. SoftBank Group Corp. owns a stake in both Uber and Didi.
Recap April 26
Another green day for stocks left the S&P 500 at a fresh closing high and up 1.1 % for the week. A weaker dollar didn’t prevent a sharp oil selloff, as WTI fell back below $63 per barrel following some Trump Twitter commentary. Treasurys rallied with the 10-year yield dropping to 2.5%, and the VIX fell back below 13.
- Philip Grant
Thursday, April 25, 2019
Modern monetary practice
At the end of today’s policy communique, the Bank of Japan
At the end of today’s policy communique, the Bank of Japan
Sincerely yours
Things are once again heating up in emerging markets,
Things are once again heating up in emerging markets,
QT Progress report
Recap April 25
Modern monetary practice
At the end of today’s policy communique, the Bank of Japan said it is considering “the introduction of an ETF Lending Facility, which will make it possible to temporarily lend ETFs that the Bank holds to market participants.” The BoJ’s QE program has already sucked volume out of the Japanese Government Bond market, as entire days now pass without benchmark issues changing hands. With approximately 80% of Japan’s ETF market in the hands of the BoJ, the central bank is opting to play market maker rather than take a step back.
While the BoJ eyes the securities lending business, the Swiss National Bank posted first quarter results that would make any fund manager jealous. Profits for the period registered at CHF 30.7 billion ($30.1 billion), with overall mark-to-market gains on its equity portfolio footing to CHF 17.4 billion. That compares to an overall CHF 6.8 billion loss, including CHF 3.3 billion in equity-related losses, in the first quarter last year.
In a bid to prevent unwanted currency appreciation, the SNB prints francs out of thin air, sells them to buy euros then diversifies into other assets like U.S. equities. In doing so, the gnomes have accumulated an asset stockpile equivalent to 115% of last year’s GDP, compared to 39% for the European Central Bank and 19% for the Federal Reserve. Then, too, the SNB’s negative 0.75% overnight interest rate stands apart from the ECB’s negative 0.40% deposit rate, let alone the positive 2.4% Fed Funds Rate.
Sincerely yours
Things are once again heating up in emerging markets, as a pair of mainstays appear to be running headlong into crisis.
Argentina is one such specimen, with Bloomberg noting that based on credit default swaps, the implied probability of default over the next five years had risen to 61% this morning. The country is beset on all sides, with runaway inflation (CPI rose 54.7% year-over-year in March) occurring in tandem with a sharp economic contraction as fourth quarter GDP fell 6.2% year-over-year. Even with a $56 billion bailout from the International Monetary Fund last year (the IMFs largest ever), the Argentine peso continues to sink, now trading at 45 per U.S. dollar, compared to less than 21 a year ago.
With Argentina’s economy on the ropes, an unfriendly face (to investors at least) looks to return to the scene. Left-wing former President Cristina Fernández de Kirchner appears eager to reclaim her old job, releasing a new book tomorrow titled “Sincerely.” Fernández, who oversaw Argentina’s prior descent into default in 2014 and famously feuded with creditors including Elliott Management thereafter, currently enjoys the upper hand. An April poll conducted by Buenos Aires-based consulting firm Elypsis showed 44% of respondents with a positive view of the former president, compared to 28% for the more market-minded incumbent Mauricio Macri.
Writing today, strategists at Brazil’s XP Investments note that markets appear to be pricing in a Fernández return to power and accompanying leftward lurch, a prospect which is overshadowing positive developments including an improving Argentine trade balance. The XP team concludes: “After having followed emerging markets for 18 years, we know that fundamentals are all but irrelevant in panic times like this one.”
The political upheaval has added further woe to Argentina’s beleaguered creditors. The dollar-denominated century bonds due 2117 have fallen to their lowest since issuance, now fetching 68 on the dollar for a yield-to-maturity of 10.6%.
As Argentina faces potentially drastic political change, Turkey resumes its economic slide. Today, the Turkish lira fell to its weakest level in six months, now fetching 5.95 per dollar compared to 5.2 in February. With inflation continuing to rage (CPI rose 19.7% year-over-year in March), the Central Bank of the Republic of Turkey has opted for a counterintuitive approach. Today, in announcing no change in rates, the CBRT dropped language in the statement suggesting it will tighten policy as needed.
That decision didn’t sit well with some investors. Win Thin, global head of currency strategy at Brown Brothers Harriman & Co., told Bloomberg: “This is much worse than expected and supports the view that policy has gone off the rails. . . no sane central bank would be leaning dovish at a time like this for Turkey.”
Mr. Market shrugs. The iShares J.P Morgan U.S. Dollar Bond ETF remains near 52-week highs despite the evident struggles of Turkey and Argentina, which account for a combined 6.4% of the fund’s total assets. More broadly, the U.S. Dollar Index sits at a 52-week high of its own, pressuring foreign borrowers who have seen local currencies lose value against the greenback.
Meanwhile, a pair of ominous economic signs have appeared in the last 24 hours. Bloomberg, citing data from the Dutch statistics office, reports that global trade suffered a sequential 1.9% decline in the three-months through February, the worst three-month period in a decade. Also, yesterday evening, bellwether South Korea logged a 0.3% sequential GDP decline in the first quarter compared to an expected 0.3% gain. Exports, which account for roughly half of the South Korean economy, saw volumes fall by 2.6% from the fourth quarter.
QT Progress report
The Fed’s portfolio of securities held outright registered at $3.739 trillion this week, down $4.5 billion on a sequential basis and $13.6 billion below the trailing four-week average. Mortgage-backed securities accounted for all of the decline for a second straight week.
Recap April 25
A second straight sideways showing saw the S&P 500 remain just under Tuesday’s closing highs, up by just under 1% for the week so far. Treasury yields edged higher across the board, while another dollar rip helped push WTI crude back under $65 per barrel. After spiking to a two-week intraday high in midday, the VIX retreated this afternoon to finish at 13.
- Philip Grant
Wednesday, April 24, 2019
Beast of burden
This morning, AT&T, Inc. (T on the NYSE) reported mixed first quarter results. Adjusted EBITDA of $14.8 billion topped the expected $14.76 billion, while revenues of $44.8 billion were a bit light of the $45.11 billion top-line consensus.
But as headline figures were broadly in-line, other key metrics showed sharp deterioration. Namely, subscriber counts shrank by a greater-than expected pace across the video division (which lost 627,000 compared to an expected decline of 389,000) as well as the postpaid wireless unit (down 204,000 versus a consensus loss of 50,000). Investors voted with their feet, as T shares fell by 4%. But the bond market took a different tack, as the senior unsecured 3.4% notes due 2025 climbed back above par this morning for the first time since 2016, and up from 93 cents on the dollar in late November.
For Baa2/triple-B-rated AT&T, which has undertaken a pair of ambitious acquisitions (DirecTV in 2015 for $67 billion and Time Warner, Inc. in 2018 for $110 billion) in recent years, a towering debt load is the elephant in the phone booth. The company carries $176 billion in borrowings, which, along with additional operating lease and unfunded pension liabilities, brings its total indebtedness to $213 billion, the most for any investor-owned, nonfinancial company in the world. The consolidated leverage ratio sits at 3.8 times 2019 consensus EBITDA, well above the 2.7 times average for the Baa category according to data compiled by Moody’s Investors Service in October.
Eager to avoid a credit-rating downgrade, management is now prioritizing the paydown of that debt load. In the earnings release, CEO Randall Stephenson reported that the company is “on plan to meet our de-leveraging goals with strong free cash flow and asset sales.” Concurrent with today’s first quarter results, AT&T announced it will sell office space at 30 Hudson Yards, the third-tallest building in New York, to real estate firm Related Cos. for $2.2 billion.
AT&T’s newfound emphasis on balance sheet repair at the expense of growth comes as no surprise to Craig Moffett, co-founder and one-half eponym of research firm MoffettNathanson, LLC. Speaking at the Grant’s fall 2018 conference, Moffett said AT&T will be forced to pivot toward shareholder unfriendly strategies in the pursuit of debt reduction. The analyst noted that even after coughing up that hefty price tag for Time Warner, the Street’s expectation for fiscal 2019 adjusted EBITDA remained below where it had been at the end of 2016, i.e. prior to the merger.
Following today’s first quarter results, Moffett zeroed in on the broader implications of AT&T’s strategic about-face toward creditors, and away from the stock market.
For the better part of a year, we’ve warned that AT&T’s servitude to the debt market would translate to better short-term profitability but weaker long-term growth. . . This narrative is no longer controversial; there is now broad consensus about what we will see in 2019: better EBITDA, perhaps, but weak subscriber trends.
Moffett also draws attention to the sprawling and less than complementary nature of AT&T’s asset portfolio following its corporate shopping spree:
Beyond the short-term narrative about prioritizing the debt markets (free cash flow), over the equity markets (growth), a bigger and more fundamental question looms. How do all these pieces fit together?
AT&T is delivering on their short-term free cash flow commitments, but, in the process, they are paying a rather steep long-term price.
For our part, Grant’s believes that the former Ma Bell’s machinations are something of an allegory for this EZ money era (see the Jan. 25 edition of Grant’s Interest Rate Observer for more on AT&T). Central bank administered, bottom-scraping interest rates serve to pull forward demand, incentivizing corporate investment, share buybacks and increased leverage. In a research report today, analysts at Bernstein Research suggest that this dynamic may be close to exhausting itself:
U.S. equities are highly dependent on buybacks. 2018 saw $1 trillion of buybacks announced by U.S. companies compared to a total net flow of all active and passive funds of ‘merely’ $100 billion. Many investors seem comfortable that, with the Fed on hold, U.S. corporates can merrily carry on issuing issuing triple-B-rated debt and buying back stock. We disagree.
The low quality of U.S. corporate debt plus a slowing in growth, we think, leads to rising credit spreads over the next 12 months which [will] in turn put the kibosh on buybacks.
Recap April 24
Stocks cruised to a sideways finish, with the S&P 500 hardly wandering more than a few basis points from the unchanged mark all day to consolidate yesterday’s push to a closing high-water mark. A greenback rally that pushed the U.S. Dollar Index to a ten month closing high didn’t prevent the Goldman Sachs Commodity Index from likewise finishing in the green, while Treasurys were again well bid as the 10-year yield fell back to 2.52%. The VIX edged higher to 12.8, its highest close in two weeks.
- Philip Grant
Tuesday, April 23, 2019
So, they'll have two?
An afternoon headline from The Wall Street Journal:
An afternoon headline from The Wall Street Journal:
Cyprus hill
Kicked in the 'coin
Timing is everything.
Timing is everything.
Recap April 23
So, they'll have two?
An afternoon headline from The Wall Street Journal:
Deutsche Bank Considers Forming ‘Bad Bank’
Cyprus hill
Bloomberg reports today that the Republic of Cyprus is preparing to come to market in a two-part euro bond offering with issues maturing in 2024 and 2049. Proceeds are earmarked for the repayment of an emergency €2.5 billion ($2.8 billion) Russian loan from 2012, in the teeth of the European debt crisis.
With fundamentals improving, the small E.U. member state continues to strike while the iron is hot. Just two months ago, triple-B-minus-rated Cyprus managed to place €1 billion in 15-year notes (then the longest issue in Cyprus’ history) at a 2.75% coupon. That issue was oversubscribed by eight times according to International Financing Review and has since rallied to 107 cents on the euro for a yield-to-worst of 2.19%. By comparison, the split-rated U.S. borrows at 2.57% for 10 years.
Following the banking crisis of 2012 to 2013, in which Cyprus became the first eurozone country to employ capital controls and, also, inflict haircuts on deposit holders, things are clearly on the upswing in the eastern Mediterranean. In September, S&P Global Ratings upgraded Cyprus’ credit rating to investment-grade territory, citing an anticipated growth acceleration through 2021 that will allow the government further to ease its debt burden, which stood at 102.5% of GDP as of year-end according to Eurostat, down from 108% in 2014. At a business forum last Thursday, finance minister Harris Georgiades said the government is targeting a debt to GDP ratio of 90% by the end of 2020.
Then, too, the banking system is on the mend, as an IMF research report from November found that non-performing loans had declined to 39% of debt outstanding, representing 85% of GDP, as of June 30. That’s down from 48% of total loans and 161% of GDP at the peak of the crisis in 2014.
A feel-good comeback, to be sure (move over, Tiger Woods). But 2.19%?
Kicked in the 'coin
Timing is everything. From The Wall Street Journal:
Masayoshi Son, the billionaire founder of SoftBank Group Corp., made a huge personal bet on bitcoin just as prices for the digital currency peaked, losing more than $130 million when he sold out, according to people familiar with the matter.
The investment came at the peak of the bitcoin frenzy in late 2017 after the digital currency had already risen more than 10 fold that year. The exact size of the bet couldn’t be determined, but bitcoin peaked at nearly $20,000 in mid-December 2017 and Mr. Son sold in early 2018 after bitcoin had plummeted, the people said.
Still, one needn’t weep for Masa Son, who has a net worth of $24 billion according to Forbes and whose SoftBank Group Corp. (9984 on the Tokyo Stock Exchange) is worth ¥12.6 trillion ($113 billion), with shares up a whopping 58% thus far in 2019.
A 37% year-to-date rally in Alibaba Group Holding Ltd. (BABA on the NYSE), which is 29% owned by SoftBank and now sports a market cap of $485 billion, has helped. A ¥600 billion share buyback, equal to just over 5% of SoftBank’s current market capitalization, has also contributed to the ascent. Announced on Feb. 6, the buyback was 64% completed as of the end of March, according to the company.
With shares riding high, the deal-minded Son continues to look for new targets. This afternoon, Bloomberg reports that SoftBank is considering an investment to buy 5% of German online payment company Wirecard A.G. Wirecard has seen its shares fall by more than 25% since January following investigative reports published by the Financial Times questioning the company’s accounting practices.
For more on Son and SoftBank, see the Dec. 13, 2017 and Feb. 22 editions of Grant’s Interest Rate Observer.
Recap April 23
A big day for the bulls saw the S&P 500 rise nearly 1%, finishing at a fresh record high and extending the year-to-date gains to 17%. The tech-heavy NYSE FANG+ Index jumped nearly 3% to sit higher by 29% for 2019, and within 8% of its own high-water mark.
Elsewhere, a strong U.S. dollar rally didn’t prevent another green finish in the energy patch, as WTI crude rose above $66 a barrel for the first time this year. Treasurys were also bid, with the 10-year yield falling two basis points to 2.57%.
- Philip Grant
Monday, April 22, 2019
Meet the new boss
This morning, The Kraft Heinz Co.
This morning, The Kraft Heinz Co.
Sold to you
China’s Shanghai Composite fell by nearly 2% today,
China’s Shanghai Composite fell by nearly 2% today,
Recap April 22
Meet the new boss
This morning, The Kraft Heinz Co. (KHC on the Nasdaq) announced that CEO Bernardo Hees will be leaving the company at the end of June. Hees, who was named CEO in 2015, has overseen a rough recent stretch including a $15.4 billion noncash asset write down, stagnant revenues, shrinking operating profits and a subpoena from the Securities and Exchange Commission related to questionable accounting practices. Upon his departure, Hees will return to Brazilian private equity firm 3G Capital, LLC (which owns a 22% stake in KHC), where he has been a partner since 2010.
As for succession at Kraft Heinz, 3G is keeping it in the family. Hees will be replaced by Miguel Patricio, fresh from a 20 year career at fellow 3G portfolio company Anheuser-Busch InBev S.A./N.V. (ABI on the Brussels Stock Exchange and BUD on the NYSE), most recently as chief marketing officer.
Kraft Heinz and Anheuser-Busch share something in common besides management overlap and 3G ownership: Daunting debt loads, particularly so for their investment-grade status. According to an October analysis from Moody’s, the average North American non-financial corporate rated Baa (the lowest rung of investment grade) carried net debt of 2.7 times EBITDA as of year-end 2017. By comparison, Baa3-rated Kraft-Heinz carries 4.3 turns of leverage based off 2019 consensus estimates, while Baa1-rated Anheuser-Busch is leveraged to the tune of 4.8 times estimated EBITDA.
Let it be said that Grant’s Interest Rate Observer had the Brazilians’ number. See the issues dated March 25, 2016, March 24, 2017, and Feb. 9, 2018.
Sold to you
China’s Shanghai Composite fell by nearly 2% today, following a Friday statement from the politburo describing first quarter economic conditions as “generally stable and better than expected.” Of course, an abundance of new credit figures prominently in that better than expected start to 2019, as total new financing expanded by an amount equal to 9% of last year’s GDP, rivaling the full-year pace of 2009’s massive economic stimulus (Almost Daily Grant’s, April 12).
The politburo statement potentially signifies that the burst of credit growth will be soon abating. Dai Ming, fund manager at Hengsheng Asset Management Co., told Bloomberg that “people have come to a clear consensus that there won’t be any aggressive stimulus that floods the economy with excessive liquidity, indicating limited room for valuation recovery.” Valuations have already been fattening. Even after yesterday’s pullback, the Shanghai Composite has been the best performing stock market in the world, up 29% year-to-date.
As Beijing hints that it may tap the monetary brakes, China’s corporate sector races to raise cash. Bloomberg relays today that since January, nine companies have announced plans to issue rights offerings totaling RMB 40.5 billion ($6 billion), more than double the full-year 2018 figure. Anne Stevenson-Yang of J Capital Research concurs, noting in a report today that 200 Chinese firms have conducted initial public offerings across the local A-share, Hong Kong and U.S. markets over the past 12 months, as companies look “to grab everything that is not nailed down.” Stevenson-Yang cautions that financial shenanigans are particularly prevalent among this cash-raising cohort:
Investors know well—or should know—that fraud is thick on the IPO playing grounds in China, and the incentives to generate nosebleed valuations by fraudulent means are core to the playbook. After all, there are no penalties in China for committing securities fraud in the U.S., where Chinese authorities believe U.S. regulators should look out for their own.
As we recently reported, three insiders at UXIN Ltd., an online dealer and financier of used cars that listed in the U.S. at the end of June last year, managed to take home around $450 million in cash before lock-up had even expired. Listing in an overseas market. . . is the lowest-risk way known to man of robbing a bank.
Among the tricks employed by Chinese IPO candidates to achieve more favorable valuations: Making up profits and, then, overstating capital expenditures to explain away the lack of cash on the balance sheet, generating revenues by selling products below cost (i.e. the Uber model) and using up-front fees generated from a franchise network business model to goose gross revenues on a one-time basis.
Recap April 22
Stocks erased early losses to finish little changed in very light trading, as the SPDR S&P 500 ETF saw just 38 million shares change hands, the lowest volume session since August and less than half of the one-year average daily turnover of 86 million shares.
A strong day for oil headlined the commodity action, with WTI crude approaching $66 a barrel on news the Trump administration will reportedly end sanctions waivers for Iranian exports. Treasurys sold off, with the 10-year yield rising three basis points to 2.58%, and the VIX gave back most of its early gains to finish below 12.5.
- Philip Grant
Thursday, April 18, 2019
Born on the bayou
Amazon.com, Inc.’s Web Services (AWS) unit
Amazon.com, Inc.’s Web Services (AWS) unit
QT progress report
Recap April 18
Born on the bayou
Amazon.com, Inc.’s Web Services (AWS) unit has been the engine behind the company’s spectacular recent performance, with operating income of $7.2 billion last year, up 68% year-over-year and accounting for 59% of Amazon’s total operating income. The near-consensus cadre of bullish analysts (48 out of 50 tracked by Bloomberg have a “buy” rating on Amazon) call for more of the same. But will an ongoing government kerfuffle derail the AWS miracle?
Last Wednesday, the Department of Defense (DoD) cleared itself of wrongdoing following an internal investigation into the forthcoming award of the $10 billion cloud computing Joint Enterprise Defense Initiative (JEDI) program. Yet the Pentagon’s self-exoneration was not comprehensive, as Bloomberg noted that: “The investigation uncovered evidence of unethical conduct that will be referred to the DoD inspector general for a separate review.”
The JEDI contract has been hotly contested among some of the largest cloud-computing companies in the U.S., and for good reason. The winner-take-all award has been narrowed to two contenders, AWS and Microsoft Corp. According to an updated timeline issued by a Federal judge Tuesday, the JEDI mandate will be awarded sometime after mid-July.
With the stakes high, Uncle Sam’s corporate suitors are pulling no punches. In December, recently-eliminated Oracle Corp. filed suit with U.S. Court of Federal Claims asserting that the JEDI process has been marred by conflicts of interest. The suit alleges that a pair of Amazon-connected former DoD staffers unduly influenced the proceedings in favor of AWS. One of whom, Deap Ubhi, worked in business development at AWS from 2014 to 2016 before joining the DoD, during which period he continued to praise Amazon from his Twitter account (including tweeting “once an Amazonian, always an Amazonian” in January 2017) while criticizing Oracle, Alphabet, Inc.’s Google and other Silicon Valley firms.
According to an April 5 report by The Capitol Forum, in January 2017 Ubhi lamented missing a conference call between Defense Department officials and AWS personnel, writing via email: “I am ex-AWS, and would have liked to have been on the call.” Eight months later, when acting as the DoD’s lead JEDI project manager, Ubhi asked DoD higher-ups to name him “the point of contact for all industry conversations.” After reportedly recusing himself from the JEDI procurement process in late October, Ubhi left the DoD, returning to AWS in November 2017.
In March, the Federal News Network reported that the FBI is involved in the DoD inspector general investigation, potentially signaling “some sort of wrongdoing involving DoD civilian personnel and/or DoD procurement procedures.”
In addition to Ubhi, other former DoD officials have seen their actions around JEDI come under scrutiny. In August, Vanity Fair reported that Sally Donnelly, a former senior advisor to Secretary of Defense James Mattis from January 2017 to March 2018, “sold her stake in [consulting firm] SBD Advisors, LLC for $1.17 million two days before she went to work for Mattis.” But Donnelly continued to receive payments from the company, which counted Amazon as an active client. Two weeks after Donnelly left the Pentagon, SBD was purchased by C5 Capital, “a private equity firm with direct ties to Amazon.”
Anthony DeMartino, Donnelly’s colleague at SBD, who was also named in the Oracle lawsuit, likewise consulted for Amazon before moving to the DoD to serve as Mattis’ deputy chief of staff.
The close proximity of Donnelly and DeMartino to the Secretary of Defense was a favorable development for AWS, as The Capitol Forum reported on March 15 that Mattis “expressed interest in meeting with Amazon CEO Jeff Bezos at a dinner” with Donnelly in early 2017, according to emails received via a Freedom of Information Act request. Mattis and Bezos met in Seattle in August 2017.
As controversy over JEDI continues to swirl, another government agency pivots away from the winner-take-all format. On March 22, the CIA unveiled a new Commercial Cloud Enterprise (C2E) initiative, in which the agency disclosed plans to use “multiple commercial cloud vendors that can provide” necessary services.
An anonymity-seeking, D.C.-based source believes that the CIA’s move might suggest wider government dissatisfaction with AWS, which commanded 46% of worldwide public cloud infrastructure market share as of year-end 2017 according to the International Data Corporation:
The AWS story, as sold to enterprise customers and the Street, is built upon the intelligence community (IC) reference case and the cash that has come in from that deal. The IC’s movement toward a multi-cloud environment is an admission that use of AWS has not been successful as claimed, increasing the likelihood of massive IC contracts for the other hyperscale cloud providers.
Amazon.com, Inc. ten-year stock price, 37% compound annual growth rate. Source: The Bloomberg
Continued cloud dominance is crucial to sustaining Amazon’s success. Analyst consensus calls for Amazon’s net income margin to jump to 6.4% in 2019 from 4.3% a year ago, thanks to expected growth in AWS. But at the same time, the core e-commerce business is showing signs of a slowdown, as Bloomberg estimated last week that gross merchandise volume growth fell to 19% last year from 24% and 27% in 2017 and 2016, respectively.
While the C.I.A.’s move toward multiple cloud vendors highlights the difficulty in growing AWS’ commanding public cloud market share, legal risks surrounding JEDI represent a potentially underappreciated pitfall to the AMZN bull case. Our D.C.-based observer concludes:
If AWS is found to have committed wrongdoing related to DoD’s JEDI contract, it could be debarred as a government contractor. My prediction: Amazon bulls expecting continued blistering growth from AWS will be in for disappointment.
Asked for comment on Thursday afternoon, Amazon had not responded by press time.
QT progress report
A $5 billion sequential decline in mortgage-backed securities holdings left the Fed’s portfolio of securities held outright at $3.744 trillion, a figure which sits $17.6 billion below the trailing four-week average. Since the Oct. 1, 2017 commencement of QT, total balance sheet assets are down by 11.8%, a 7.7% annualized pace.
Recap April 18
Stocks traded flat once again to finish the holiday shortened-week little changed, as the Nasdaq 100 Index managed to eke to a fresh closing high while the S&P 500 sits about 1% below its own high-water mark. Commodities finished mixed with WTI crude and gold finishing at $64 per barrel and $1,275 per ounce, respectively, and Treasurys rallied as the 10-year yield retreated from a near one-month high to 2.56%. The VIX closed just above 12, near the year-to-date low.
- Philip Grant
Tuesday, April 16, 2019
Sick Burn
Revenge of the Squares?
Revenge of the Squares?
Indication of interest
Today, Bank of America Corp. (BAC on the NYSE)
Today, Bank of America Corp. (BAC on the NYSE)
Recap April 16
Sick Burn
Revenge of the Squares? Authorities are trying to put the clamps down on Burning Man, the annual Nevada gathering “that connects each individual to his or her creative powers, to participation in community, to the larger realm of civic life, and to the even greater world of nature that exists beyond society,” according to the festival’s website. From today’s Wall Street Journal:
The Bureau of Land Management wants to encircle Burning Man’s makeshift desert town with thousands of physical barriers and have security guards screen attendees, called “Burners,” for contraband. The agency. . . is also calling for organizers to place dumpsters on site and to haul out trash privately to lessen the impact on nearby communities.
If implemented, the measures would send the festival’s total expenses up nearly 60% from its current $38 million, said Marnee Benson, the festival’s associate director of government affairs. Money isn’t the only issue, though. “The vision the BLM has laid out for Burning Man is not the vision we would choose to produce,” Ms. Benson said.
All sorts of visions have emanated from the desert festival. From an Oct. 9, 2013 GreenBiz profile of SolarCity Corp. founder Lyndon Rive:
The idea of starting SolarCity came in 2004 during a drive to the Burning Man festival with his cousin, famed tech entrepreneur Elon Musk. Rive said he wanted to start another company and that he was passionate about trying to solve global environmental challenges. Musk suggested going into solar. Musk is now chairman of SolarCity as well as CEO of Tesla Motors and SpaceX.
Indication of interest
Today, Bank of America Corp. (BAC on the NYSE) chief financial officer Paul Donofrio told listeners-in to the first quarter earnings call to expect net interest income (NII) growth of 3% this year, down from 6% in 2018.
Peer Wells Fargo & Co. (WFC on the NYSE) telegraphed similar deterioration last Thursday. CFO John Shrewsberry said he now anticipates NII will decline by 2% and 5% for 2019, down from an estimated range of plus 2% to minus 2% supplied just two months ago, owing to “tightening loan spreads resulting from a competitive market with ample liquidity and continued upward pressure on deposit pricing.”
For the money center banks, the recent rate hikes have spurred a margin-eroding consumer migration into income generating accounts. In the first quarter, Bank of America saw interest bearing deposits rise 11.8% year-over-year to $907 billion, while non-interest bearing deposits fell 9% year-over-year to $395.5 billion.
The margin pressures cited by both Bank of America and Wells Fargo were anticipated by Christopher Whalen, publisher of the Institutional Risk Analyst, in the Oct. 19 edition of Grant’s Interest Rate Observer. Arguing that rising interest rates would confer less of an advantage on the big institutions than was widely anticipated, Whalen identified the key problem:
The average cost of funds for the whole industry right now is a little over 1%. The average earnings on total earning assets is barely 3%. You’ve got about 2 points of spread. If funding costs keep rising faster than earnings, then you will see net in¬terest margin contract by Q1. How do you think the Street will react to that?
Whalen reiterated his views in a blog post Sunday, while quantifying the extent to which rising costs could impact profitability:
At Q4 2018, total funding costs for the banking industry were just shy of $40 billion. As noted in a previous comment, we expect quarterly bank funding costs to be over $60 billion by year-end 2019. To provide some perspective, the net income of the entire US banking industry was $59 billion in Q4 2018. Since 2014, when bank funding costs troughed at $11 billion per quarter, interest expense has grown four fold and at an accelerating rate.
As lending spreads have collapsed, with the 10-year yield currently offering a 17 basis point premium over the three month Treasury note compared to 267 basis points five years ago, the environment has swung from accommodative to constricting for the banks:
Between 2008 and 2014, the FOMC subsidized the U.S. banking sector to the tune of tens of billions per quarter in incremental income. Now as the financial markets slowly claw their way back to normal, banks and leveraged investors are entering a dangerous period of falling margins over funding and uncertainty about the future direction of interest rates.
Without a complete capitulation by the FOMC and short-term rate cuts, we see no avenue for banks to avoid a squeeze on net interest income in coming quarters. Yes, President Trump and Larry Kudlow are right about the Fed and interest rates.
As lending spreads contract, the credit cycle continues to age. “We are in the trough,” Whalen told Grant’s today. “Defaults are going to rise in 18 to 24 months,”
Recap April 16
A flat finish for stocks saw the S&P 500 give back early gains as well as recoup a sharp afternoon downdraft, while the tech-heavy Nasdaq 100 reached an all-time intraday high before pulling back a bit to finish just below the Aug. 29 peak.
Commodities came under pressure, with gold falling to a fresh 2019 low of $1,276 an ounce, and Treasurys were also for sale with the 10-year yield rising to 2.59%, the highest since late March.
- Philip Grant
Monday, April 15, 2019
I really think so
Last Thursday, European Central Bank
Last Thursday, European Central Bank
Strangers things
A new frontier in innovation: Annoyance-as-a-service.
A new frontier in innovation: Annoyance-as-a-service.
Down the rabbit hole
In a recent research note,
In a recent research note,
From hunger
Analytics firm TDn2K reports
Analytics firm TDn2K reports
Recap April 15
I really think so
Last Thursday, European Central Bank governing council member François Villeroy de Galhau dismissed comparisons between the Eurozone and Japan. Speaking at the International Monetary Fund’s semi-annual meeting in Washington, Villeroy noted that it might be “fashionable” to make such a comparison but retorted: “I don’t think it is accurate. The Eurozone is not a situation of Japanization.”
Yet the results in measured rate of inflation suggest some merit to the comparison. Since April 2013, the year-over-year change in Eurozone CPI inflation has averaged 0.9%, matching that of Japan during the same period.
Strangers things
A new frontier in innovation: Annoyance-as-a-service. From Bay Area online news site Mission Local:
In recent weeks, Mission residents have been receiving curious missives in their mailboxes inquiring whether they’d be game to monetize their kitchens and living rooms by having strangers drop in and start doing office work.
It’s a [pitch] from Cobo, a startup hoping to capitalize on what its founder calls “a billion-dollar market”: Placing lonely freelancers pining for company into people’s homes, monetizing that home, and taking a cut.
Down the rabbit hole
In a recent research note, UBS Group A.G. chief economist Daniel Kalt forecast tighter monetary policy in Switzerland, writing that the Swiss National Bank will likely raise interest rates from the current negative 0.75%, which is the lowest of any major central bank according to Bloomberg.
But on Saturday, SNB chairman Thomas Jordan talked about about pushing rates deeper into negative territory. In a speech in Washington, Jordan remarked that: “We always stress the point that we have room to lower interest rates still further.”
From hunger
Analytics firm TDn2K reports that comparable restaurant store sales rose by 1.15% year-over-year in March, raising the rolling three-month growth rate to 0.8%. TDn2K notes that for the first time since 2015, restaurants have managed four consecutive quarters of positive same-store sales growth.
But is that upturn in industry fortunes enough? Over the last 12 months, TDn2K’s same-store sales figure has shown an average year-over-year growth rate of 0.96%, far below the 2.3% average rise in headline CPI since April 2018.
The less-than-stellar growth profile doesn’t seem to bother Mr. Market, as the S&P Restaurants Index commands an enterprise value of a healthy 16.5 times 2019 consensus EBITDA, compared to 11.7 times enterprise value to forward EBITDA for the S&P 500 Ex-Financials Index. But as growth in sales lags behind the rate of inflation, franchise operators continue to be squeezed. According to a November franchisee survey reported by Restaurant News, almost 90% of respondents were “unsatisfied with their cash flows.”
For more on the group, including an analysis of a pair of picks-to-not-click, see the Feb. 8 issue of Grant’s Interest Rate Observer.
Recap April 15
Stocks recouped modest early losses to leave the S&P 500 within 1% of the Sept. 20 high water mark, while the Goldman Sachs Commodity Index rose back to near its 2019 high despite weakness in WTI crude and gold, which finished at $63.50 per barrel and $1,288 per ounce, respectively. Treasurys caught a modest bid with the 10-year yield finishing at 2.55%, and options volatility remains muted as the VIX settled below 12.5.
- Philip Grant
Friday, April 12, 2019
A TAM too far
In a form S-1 filed yesterday ahead of an initial public offering, Uber Technologies, Inc. calculated the total addressable market (TAM) of $5.7 trillion for its core ride share business, along with a $2.8 trillion TAM for its Uber Eats business and a $3.8 trillion total market for its Uber Freight unit. In total, the $12.3 trillion market identified by Uber for those three businesses represents 14.5% of 2018 world GDP.
The unicorn, which racked up an $11.3 billion operating loss last year, is expected to garner a valuation of $90 billion to $120 billion upon listing.
Faulty transmission
Some eye-catching credit data out of the People’s Bank of China today: Total credit grew by a record RMB 2.8 trillion ($420 billion) in March, far above the RMB 1.85 trillion consensus estimate. During the first quarter, total new financing ballooned to RMB 8.2 trillion, up 40% from a year ago and equivalent to 9% of China’s reported 2018 GDP. Extrapolated to a full year, the credit expansion is just behind the 40% jump in total financing as a percentage of GDP seen in the massive stimulus year of 2009.
That liquidity surge coincides with a “recovery extending across both sectors and geographies, with every major sector and each one of our regions showing better revenue results than Q4,” according to the China Beige Book.
Beyond opening the credit spigots, Beijing is trying to stoke economic growth in other ways. Last week, Xinhua’s Economic Information Daily reported that policymakers are crafting tax cuts and other fiscal policies to help spur consumption. In addition, the National Development and Reform Commission announced Monday that small and midsize cities (populations of between one and five million) will relax hukou, or household registrations, in a bid to boost real estate markets.
Regulators have also targeted the stock market. Bloomberg reports that nearly 700 firms bought back stock between December and January after authorities relaxed rules around the practice, up from 609 corporate buybacks in 2018 through early November. Mark Huang, analyst at Bright Smart Securities, explained to Bloomberg that: “China is looking to developed markets like the U.S., where buybacks are a key approach to sustaining a long-term bull market.”
Those exertions are bearing fruit, if asset prices are any guide. Thus, China’s Shanghai Composite Index has ripped higher by 28% year-to-date, while contracted project sales from an index of nine property developers jumped 20% in March, according to data from Bloomberg. That follows a 9.4% year-over-year advance in February property investment according to the National Bureau of Statistics, the hottest reading since 2014.
But the stimulus barrage has yet to translate into much acceleration in the money supply (M2 grew at 8.6% year-over-year, up from 8.3% average growth in 2018 but far below the 16% average since March 1996), nor improve the balance sheets of China’s debt-soaked corporations. S&P Global Ratings cut its assessment of 13 companies in the first quarter, the highest level of downgrades since 2016, with analyst Cindy Huang noting that “despite a slew of easing measures from the policy makers, small private firms still lack sufficient liquidity.” Peer Fitch Ratings has issued 30 corporate downgrades year-to-date, compared to just five upgrades. That follows a jump in yuan-denominated debt defaults to RMB 119.6 billion last year according to Singapore-based DBS Bank, four times 2017’s level.
With RMB 2 trillion of bad debt sitting on Chinese bank balance sheets according to research from UBS Group A.G., things are likely to get worse before they get better. A survey of 202 bankers conducted by China Orient Asset Management Co. finds that 83% of respondents believe that bad loans will increase in 2020.
Why that disconnect between free flowing liquidity and rising corporate distress? Zhu Min, head of Tsinghua University’s National Institute of Financial Research and former deputy governor of the PBoC, told Caixin that while a decade of easy money has goosed financial markets, stimulus has not helped larger banks adequately lend to smaller companies which need liquidity and can often offer little collateral. Zhu asks: “How can financial institutions lend money to small-to-micro companies if all of their money has been invested in the stock market?”
- Philip Grant
Thursday, April 11, 2019
A permanently low plateau
“As I say, we wish they hadn't raised,”
“As I say, we wish they hadn't raised,”
Tip of the iceberg
From Caixin
From Caixin
Field of dreams
The Saudi Arabian Oil Co. (Aramco) made history
The Saudi Arabian Oil Co. (Aramco) made history
QT Progress report
Recap April 11
A permanently low plateau
“As I say, we wish they hadn't raised,” Larry Kudlow, director of the National Economic Council, told The Hill about the Fed’s December hike. “I notice from the various reports and so forth that they've changed their view. I don't think rates will rise in the foreseeable future, maybe never again in my lifetime.”
Kudlow is 71 years old.
Tip of the iceberg
From Caixin:
Figures from China’s Ministry of Finance (MOF) show that official on-budget borrowing, known as explicit debt, of all local governments combined amounted to nearly 18.4 trillion yuan [$2.8 trillion] at the end of last year. But an official with one of the country’s financial regulatory bodies told Caixin that the unofficial, off-the-books liabilities of most provinces, known as implicit debt, could be around 2.5 times bigger. Added together, the total debt of local governments would amount to more than 70% of the country’s gross domestic product (GDP) in 2018.
Field of dreams
The Saudi Arabian Oil Co. (Aramco) made history this week by placing $12 billion in bonds in a deal that attracted a massive $100 billion order book. That’s a record level of demand for an emerging market issuer and one of the most oversubscribed bond offerings in history according to Bloomberg. By comparison, Saudi Arabia itself attracted $67 billion in orders for its international bond market debut in 2016.
That impressive order book didn’t translate into favorable price action, as all five of the 3- to 30-year Aramco tranches saw their prices decline and spreads over Treasurys widen in the first three days of trading. Yet even after that pullback, Aramco’s senior unsecured notes of 2029 trade at a 118 basis point spread, compared to 126 basis points over Treasurys for the identically rated single-A-plus Saudi sovereign 10-year note. The relationship between the pair (Aramco chairman Khalid Al-Falih is also the Saudi oil minister) is close and ambiguous enough to give some pause. One unnamed investor who met with the company told The Wall Street Journal that political unknowns loom large:
All the cash flow and [earnings] numbers are good, but who owns the reserves? It’s the Kingdom. And who takes the big decisions on whether Aramco should pay a special dividend, or help in some other way with funding Saudi? You have to assume it’s the government.
More broadly, the rabid investor appetite for Aramco debt underscores the current euphoria in credit. Year-to-date global corporate issuance stands at a record $695 billion and represents more than half of full-year 2018’s new supply of $1.34 trillion, according to data from Refinitiv. Hans Mikkelsen, head of investment-grade strategy at Bank of America Corp., summed it up: “The new issue market is wide open. It’s probably never been as open as it is now.”
Favorable market conditions have helped that record queue for Aramco debt, but what else are investors signing up for? As noted in the prospectus, Saudi Arabia’s famous Ghawar oil field (the world’s largest) is currently capable of producing just 3.8 million barrels per day, far below the Energy Information Administration’s 2017 estimate of 5.8mbpd.
That revelation comes as no surprise to Leigh Goehring and Adam Rozencwajg, the eponyms of natural resource investment firm Goehring and Rozencwajg Associates who have long argued (including on the Oct. 2, 2017 edition of the Current Yield podcast) that the Ghawar future potential is far more limited than widely believed. Reached by Grant’s this afternoon, Goehring commented:
Ghawar output will continue to decline, and we can now model it going forward. Most reservoir engineers believe that an oil field’s production will begin to decline when half the recoverable reserves are produced (there are all sorts of theories of why this is true, but it’s grudgingly accepted).
The problem with Ghawar is that we have never had an updated reserve report on what the recoverable reserves of the field might be. We have tried using various indirect methods, which led us to believe that Ghawar had about 25 billion barrels of reserve left. Given that Ghawar has produced about 75-80 billion barrels of oil already, this would mean that the field was way past its half-way point.
But these are all indirect measurements (and guesses).
However, with the publishing of the Aramco prospectus, we have now audited Ghawar numbers for the first time in almost 45 years. The numbers state (page 88 in the prospectus) that Ghawar has 48 billion barrels of liquids left. They have produced say 75 to 80 billion, so we know that total recoverable reserves are approximately 125 to 130 billion barrels. With only 48 billion barrels remaining, the field is over 60% depleted.
QT Progress report
The Fed’s portfolio of securities held outright remained at $3.748 trillion this week, a figure that sits $22 billion below the trailing four-week average. Since the Oct. 1, 2017 commencement of the QT balance sheet run-off, the Fed’s total assets are down by 11.7%, for a simple annualized pace of 7.8%.
Recap April 11
A quiet session saw stocks drift sideways, leaving the S&P 500 little changed for the week and within 1.5% of its closing high reached on Sept. 20 of last year. Commodities saw their recent winning streak emphatically snapped with the CRB Index falling more than 1%, and Treasurys traded weaker across the curve to push the 10-year yield back to 2.5%. The VIX held just above 13.
- Philip Grant
Wednesday, April 10, 2019
I'm your huckleberry
“U.S. hedge funds from time to time have appeared in this country over the last 10 years,
“U.S. hedge funds from time to time have appeared in this country over the last 10 years,
Recap April 10
I'm your huckleberry
“U.S. hedge funds from time to time have appeared in this country over the last 10 years, with the same hypothesis of shorting Canadian banks, and it hasn’t worked out very well for them,” Brian Porter, CEO of the Bank of Nova Scotia, said yesterday. “There are always going to be those that take an opposing view, and we’ll prove them wrong over the long term.”
Gabriel Dechaine, banking analyst at the National Bank of Canada, likewise came to his industry’s defense in a note today: “A trend that is making us believe that sector sentiment is becoming too bearish is the re-emergence of a vocal ‘short Canada’ investment crowd.” Dechaine writes that a Stanley Cup victory for the woebegone Toronto Maple Leafs (last title, 1967) is more likely than a jump in loan losses.
One well-known investor is publicly taking the challenge: Steve Eisman, portfolio manager at Neuberger Berman and a protagonist in Michael Lewis’ The Big Short. “Canada has not had a credit cycle in a few decades and I don’t think there’s a Canadian bank CEO that knows what a credit cycle really looks like,” Eisman, who is short various Canadian banks and mortgage lenders, fired back in an interview yesterday with BNN Bloomberg television. “I just think psychologically they’re extremely ill prepared.”
While Canadian bank advocates and their skeptics exchange words, the formerly-white hot housing market is now in deep freeze. March sales in Vancouver collapsed by 31.4% year-over-year according to the local real estate board, the worst showing since 1986 and down 46% from the 10-year average for March. Prices also lurched lower, with the benchmark detached home price falling 10.5% year-over-year to C$1.44 million ($1.08 million). Things are more stable in Toronto, where March sales and benchmark prices were little changed from a year earlier, but those figures remain 40% and 14% below their respective levels from March 2017.
As the housing market sputters, the highly-leveraged Canadian consumer displays increasing signs of distress. According to the Bank for International Settlements, Canada’s household debt stands at 100.2% of GDP as of the end of September, by far the highest ratio among G7 economies (the U.K. is next at 86.5%), while the debt service ratio, or the percentage of disposable income allocated to principal and interest payments, rose to 14.9% in the fourth quarter per Statistics Canada, just shy of the 2007 peak.
That debt burden is starting to weigh on consumers. Auto loan delinquencies rose to 0.97% at year-end according to Equifax, Inc., the highest since 2009. At the same time, 36% of new auto loans in the fourth quarter were leases, the largest such share since 2007. Bill Johnston, vice president of data and analytics at Equifax Canada Co., noted that “we’re starting to see consumer behavior shift to keep the payments as low as possible.”
On the credit card front, delinquencies of at least 90 days remained at a relatively low 0.79% as of February, down from 0.88% in the same month last year according to data from Bloomberg. But, as noted by the Royal Bank of Canada, consumers cut their average monthly payment to just 38% of outstanding balances in February, down from 50% in October and the lowest such ratio since 2015. RBC credit analyst Vivek Selot commented:
That deterioration in payment rates may be attributed to some stress on the consumer. Considering that fragile household balance sheets could be a precipitating factor for the credit cycle to turn, any signs of consumer credit quality deterioration seem worthy of attention.
Indeed, the Office of the Superintendent of Bankruptcy reports that consumer insolvencies rose 5.4% year-over-year in February, bringing the rolling three-month average to its highest level since 2011.
The slowing housing market and increased consumer stress has taken a toll on one of the banks’ primary profit centers. According to the Bank of Canada, residential mortgage growth registered at 3.2% year-over-year in February, the lowest reading since 2001 and barely half of the 6% monthly average logged since the housing boom gathered steam in 2009. Back in March, Edward Jones & Co. investment strategist Craig Fehr noted to Bloomberg that mortgages frequently represent “the largest and most profitable and steady of the businesses that these banks operate.” Fehr concluded: “The bread and butter of profitability for Canadian banks – is going to have a little less butter on the bread.” Meanwhile, expectations remain high, with a 2019 analyst consensus of 15.7% return on equity for the S&P/TSX Bank Index, up from 14.2% last year and a five year average of 15%.
For those unfazed by CEO taunts and eager to investigate the bearish case for Canada’s lenders, an analysis in the Feb. 9, 2018 edition of Grant’s Interest Rate Observer identifies one bank that stands out from the rest.
Recap April 10
Stocks caught a modest bid, recouping some of yesterday’s losses as the small-cap Russell 2000 rose more than 1% to extend its year-to-date gains past 17%. Treasurys rallied across the board as the 10-year yield dropped three basis points to 2.47%, and commodities continued their impressive advance with the CRB Index rising to a five month high with WTI crude and gold finishing at $64.5 a barrel and $1,308 an ounce, respectively.
- Philip Grant
Monday, April 8, 2019
Discount double check
The passive price war goes stealth.
The passive price war goes stealth.
Permanently high plateau 2.0
Cheez whiz
Recap April 8
Discount double check
The passive price war goes stealth. From Bloomberg today:
BlackRock, Inc., the world’s largest issuer of exchange-traded funds, has slashed the cost of its iShares Broad USD High Yield Corporate Bond ETF by waiving part of the management fee, regulatory documents show. But rather than shout about the move, the discount was announced without fanfare – in a footnote on page 94 of a revised filing last month.
Permanently high plateau 2.0
In Barron’s this weekend, J.P Morgan chief U.S. equity strategist Dubravko Lakos-Bujas offered a novel perspective on the nature of asset prices in the modern era:
We are all used to using the word “cycle”; we’re all used to looking at historical charts and graphs and equations and relationships. The reality is that maybe the word “cycle” is no longer even relevant, given that we have so much unconventional central-bank involvement.
Cheez whiz
So far this year, the Renaissance U.S. IPO Index is up a cool 32%, more than double the 15% advance logged by the S&P 500. The booming market for new issues is making bull-market noises.
This morning, CEC Entertainment, Inc., parent company of children’s restaurant Chuck E. Cheese’s, announced plans to list shares on the New York Stock Exchange. This will be no straightforward offering. Instead, the transaction will feature a reverse merger between CEC’s own parent company Queso Holdings, Inc. with a special purpose acquisition company called Leo Holdings Corp. The press release explains:
Concurrent with the closing of the transaction, Leo will domesticate as a Delaware corporation, following which Queso will merge with and into Leo with the result that CEC will continue as a wholly-owned subsidiary of Leo, which will be renamed Chuck E. Cheese Brands, Inc.
CEC was bought by Apollo Global Management, LLC in 2014 for $1.3 billion including debt. In February 2017 Reuters reported that the private equity giant had hired Deutsche Bank A.G. and Credit Suisse A.G. to solicit bids for its portfolio company, with Bloomberg reporting that Apollo was seeking a roughly $2 billion sale price.
With no buyer in hand, the deal was withdrawn six months later. As a public entity, CEC is expected to garner an enterprise valuation of about $1.4 billion, which is 7.5 times forecast 2019 adjusted EBITDA of $187 million, while the anticipated $300 million of proceeds “will be used to pay transaction expenses and de-leverage the Company’s existing capital structure.”
De-leveraging appears wise. CEC ended 2018 with total debt of $982 million, 6.5 times trailing 12-month adjusted EBITDA, while operating income of $66 million failed to cover the $76.3 million in interest expense.
As Chuck-E-Cheese’s prepares to re-join the ranks of publicly-traded companies, recent IPO Lyft, Inc. has a bone to pick with its underwriters. Digital news site The Information relayed Friday that the ride-share company, which debuted on March 29, threatened to sue Morgan Stanley after the New York Post reported the investment bank had offered Lyft investors a chance to hedge their positions through short sales, despite being subject to lock-up restrictions.
For Lyft, which generated a $943 million adjusted-EBITDA loss in 2018 on revenues of $2.2 billion and warned in its S-1 filing that it “may not be able to achieve or maintain profitability in the future,” the attention paid to short-sellers has been mutual. According to S3 Partners, LLC, short interest in LYFT exceeded 38% of the 32.5 million share float as of Tuesday, despite prohibitive borrowing costs that reached an annualized rate 101.4% as of Tuesday. Lyft stock finished the day at $70.23 a share, down from the $72 issue price and 20% below the intraday peak see on its March 29 debut.
Meanwhile, new issue supply continues apace as the IPO pipeline remains robust. This morning, social media site Pinterest, Inc. filed a form S-1 detailing plans to offer up to 75 million shares at a range of $15 to $17 per share, valuing the company at $11.3 billion using the high end of the range. That’s down from a $12.3 billion valuation achieved during the most recent fundraising round in 2017. As noted by Business Insider on March 24, an unusual bit of language in Pinterest’s filing may give some investors pause:
Pinterest's S-1 paperwork, filed publicly Friday, disclosed an unusual stipulation that retains full voting rights for CEO Ben Silbermann's shares in the company from 90 days to 540 days after his "death or permanent incapacity."
The clause means that after Silbermann dies, whoever inherits his shares will retain his super-voting powers for a period of time.
Recap April 8
A reflation-type trade headlined today’s action, as commodity prices continue to run with the CRB Index green for a fifth straight day to leave WTI crude and gold near $65 a barrel and $1,300 an ounce, respectively. Treasury yields also rose, with the 10-year finishing at 2.52%, well off the 52-week low of 2.36% reached on March 27. Stocks finished sideways, with the S&P 500 erasing early losses, and the VIX settled just above 13.
- Philip Grant
Friday, April 5, 2019
Nevertheless, he persisted
Today, the Nikkei Asian Review reports that Nomura Holdings, Inc.
Today, the Nikkei Asian Review reports that Nomura Holdings, Inc.
Recap April 5
Nevertheless, he persisted
Today, the Nikkei Asian Review reports that Nomura Holdings, Inc. (8604 on the Tokyo Stock Exchange) expects to close over 30 of its 156 domestic retail branches, “previously considered a sacred cow by the group.” In addition, Nomura will eliminate roughly half of its 11 administrative departments and “revisit its policy of maintaining hubs in Japan, the U.S. and Europe.” That comes after the investment bank reported a ¥101.2 billion ($911 million) loss for the nine months ended Dec. 31, its worst such showing since 2008.
Nomura’s misadventures are no outlier. In early March, Mizuho Financial Group, Inc. was forced to take a ¥680 billion write down that included ¥150 billion worth of losses related to its portfolio of overseas bonds (Almost Daily Grant’s, March 7). More broadly, the Tokyo Stock Exchange Bank Index has seen its return on equity decline in each of the last five years, to 5.33% in 2018 from 9.77% in 2013. The index trades at a paltry 0.47 times book value, worse than even the EURO Stoxx Bank Index’s similarly-depressed 0.62 price-to-book ratio and far below the 1.18 times book valuation commanded by the U.S. KBW Bank Index.
Of course, much like Europe, Japan’s macro-economic backdrop features negative interest rates and aggressive central bank asset purchases. The BoJ has accumulated ¥557 trillion in assets, equivalent to 101% of 2018 nominal GDP (that compares to about 39% in Europe and 19% in the U.S.), as policymakers continue to up the ante in their quest to achieve a 2% measured rate of inflation.
With its gargantuan portfolio, the BoJ wields substantial control of the country’s capital markets. As noted by the Financial Times on Sunday, the central bank now holds close to 80% of outstanding ETF assets, equating to approximately 5% of Japan’s total market capitalization, while data from Bloomberg pegs the BoJ ownership of the Japanese Government Bond Market at 43%.
Financial institutions are beginning to publicly balk at these monetary machinations. Last week, Makoto Takashima, president of Sumitomo Mitsui Banking Corp. and chairman of the Japanese Bankers Association, told Bloomberg that the Bank of Japan must “carefully consider” the impact of deepening its subzero interest rate policy: “It will be a quite difficult decision to make. Simply speaking, that would cause policy side-effects to further grow.” Back on March 3, Mizuho Bank, Ltd. CEO Koji Fujiwara expressed similar reservations over any escalation of Japan’s radical monetary policy: “I think the BoJ’s actions so far have been beneficial, but I think the time has come to look carefully at the negative side effects and reconsider.”
For his part, BoJ Governor Haruhiko Kuroda opined in March that “I don’t think our ETF buying is having any effect on market function.” The central banker said in a speech today that the BoJ “needs to continue easing persistently.” Of Japan’s banks, Kuroda attributed their profit woes to “structural factors, such as a dwindling population,” while pledging vigilance “to the risk [these structural factors] could erode [banks’] capital base and have a negative impact on financial intermediation.”
With BoJ policy already extreme by most objective measures, Kuroda’s determination to maintain ultra-loose policies in the face of banking industry protests can be potentially explained by a speech at Oxford University on June 12, 2017. In that address, the BoJ governor articulated his plan to rouse the Land of the Rising Sun from its longstanding disinflationary torpor. Namely, manipulate expectations such that citizens begin to expect rising prices, which would then presage the real McCoy:
I took office as Governor of the Bank of Japan in March 2013 and immediately introduced a monetary policy regime -- quantitative and qualitative monetary easing, (QQE) -- that is quite different from past regimes. QQE consists of two pillars: (1) directly working on people's expectations through a price stability target of 2 percent and a strong and clear commitment to doing whatever it takes to achieve this, and (2) directly encouraging a decline in long-term interest rates through large-scale purchases of long-term Japanese government bonds (JGBs).
In practice, QQE has produced its intended effects. Inflation expectations climbed notably after the introduction of QQE. This demonstrates that a strong determination by the central bank pushes up people's forward-looking inflation expectations.
On that score, success remains elusive. According to a Bloomberg survey of 2,127 Japanese households conducted in February and March, half of respondents “have never heard of” Kuroda’s grand monetary stimulus, “the highest level since the question was introduced in September 2013.” Meanwhile, year-over-year CPI inflation has averaged 0.45% over the last 36 months.
Recap April 5
Stocks rallied once again, with the S&P 500 tacking on a 2% gain this week to bring the year-to-date advance to a gaudy 15.5%.
Commodities finished higher for a sixth straight day to push the CRB Index to its best close since November, despite strength in the greenback as the Dollar Index finished within a few ticks of its own 52-week high. Treasury yields finished little changed, but with some flattening across the curve as the three month vs. 10-year spread narrowed to (positive) seven basis points.
- Philip Grant
Thursday, April 4, 2019
Off to sea once more
The May 30, 2014 issue of Grant’s featured a bullish analysis
The May 30, 2014 issue of Grant’s featured a bullish analysis
QT progress report
Recap April 4
Off to sea once more
The May 30, 2014 issue of Grant’s featured a bullish analysis of Dorian LPG Ltd. (LPG on the NYSE), which ships liquified petroleum gas (LPG) worldwide through its fleet of 22 very large gas carriers (VLGC). Trading at $20.31 a share at publication time, LPG stock cratered to $6 two years later, and currently fetch $7.22. Now following is a look at what happened and where things stand.
That May 2014 analysis noted that “a bet on Dorian is a clear bet on the earnings power of its ships – and the price of crude and on the demand for LPG.” Instead, over the last five years Dorian has been run aground by low prices, overcapacity and accompanying concerns over the appraised value of the company’s VLGC fleet.
Industry growth has been brisk, as LPG (a mix of propane and butane which can be used for cooking, heating and fuel) is a clean and relatively easy to transport form of energy. But those virtues – plus an accommodating credit market – have helped spur a capacity glut. The overall VLGC count has jumped to 270 as of Feb. 5, up from 158 as of April 2014. An additional 46 ships, representing 17% of global supply, are on order.
Dorian’s income statement reflects those difficult business conditions. Adjusted EBITDA fell to $62 million in calendar 2018, from $202 million in the fiscal year ended March 31, 2016. Meanwhile, net debt stands at a hefty $676 million, although refinancing needs are distant as the next principal repayment, in the form of a $179 million term loan, isn’t due until 2022.
The company’s latest form 10-Q addressed the potential for asset write-downs on its ships, noting that outside appraisals “showed indications of impairment on 21 of our ships.” However, a company-conducted sensitivity analysis found that no impairments would need to be taken if daily spot time charter equivalent (TCE) rates fell 25% below their 10-year average of roughly $30,000 per day, while a 30% drop would trigger $34.6 million worth of write-downs on six VLGCs. CFO Ted Young explained the discrepancy, and Dorian’s reasoning, to Grant’s:
Getting a shipbroker assessment is like getting an assessment on your home from the local realtor. It is based on last done. Well, guess what? There was no last done. No modern ships have really changed hands at all. There has been one fleet sale in 2015/16 that included some modern ECO VLGCs which was a distressed situation and the buyer clearly got a really good deal. So, those assessments will imply values that are somewhat below our depreciated carrying value.
Are better days ahead? TCE rates rebounded in the quarter ended Dec. 31, rising to $30,000 per day, up from $17,000 a day in 2016 but still well below the $45,000 seen in 2014. Then, too, the overcapacity problem is mitigated by the fact that 9% of world VLGC supply is aged 25 years or older, with another 3% between 20 and 25 years old. For its part, Dorian boasts a particularly young fleet, with an average age of 4.6 years, less than half the 9.4 year industry average.
Mr. Market has applied his own inventory discount. Dorian’s $1.08 billion enterprise value equates to roughly $49 million for each of its 22 VLGCs. In early January, peer DryShips, Inc. took delivery on four VLGCs at a price of $83.5 million per vessel. Assuming a 25 year life and five years of straight line depreciation (equating with Dorian’s average VLGC age), yields a per ship valuation of roughly $66 million.
That newer fleet, which includes three ships fitted with eco-friendly exhaust scrubbers and another ten vessels set to be retrofitted in 2019 and 2020, represents a significant competitive advantage for Dorian. Next year, the International Maritime Organization will implement new regulations that include capping the sulphur emissions of seaborne vessels/VLGCs at 0.5% from the current 3.5%, an ordinance that Bloomberg reports will be enforceable in Singapore with jail time of up to two years for violators. Young tells Grant’s that the company is well positioned for those changes:
Putting aside the scrubbers that we’ll have on ships, if you just look at some of the fuel differences we put out there the savings can be anywhere from $2,000 to $3,000 a day.
One of the big things is that the younger, newer ships, of which we have the largest fleet, end up making more money per day because freight is quoted in dollars per metric ton. When you make that calculation, from dollars per metric ton to time charter equivalent per day, the biggest part of that calculation is the fuel consumed. Our newer and fuel efficient vessels not only carry a bit more cargo but they also consume less fuel over the course of the voyage so that translates to a higher voyage return.
The company has its admirers. Last May Norway’s BW LPG Ltd., which sports a market cap of NOK 4.9 billion ($571 million) compared to Dorian’s $402 million, launched an unsolicited all-stock bid that would have left Dorian shareholders with 46% ownership of the combined entity, before withdrawing its deal in October after reportedly declining Dorian’s request to improve the terms.
At the current price and sporting a daunting leverage ratio of 10.9 times net debt to trailing 12-month EBITDA, LPG shares represent an option. Should fundamentals continue to improve, the stock should do quite well, but if they flatline or deteriorate for an extended period, Dorian will face the risk of insolvency. Short interest currently stands at 5.4% of the float, and the Street is bullish, with five “buy” ratings, one “hold” and zero “sells.”
QT progress report
The Donald is not going to like this. The Fed’s portfolio of securities held outright fell to $3.78 trillion, down a meaty $23 billion from a week ago, with Treasurys accounting for all the sequential decline. Today’s figure represents a $31.4 billion drop from the trailing four-week average.
Since the Oct. 1, 2017 commencement of the QT run-off, total balance sheet assets are down by 11.7%, for an annualized pace of 7.9%.
Recap April 4
Another rangebound session saw the S&P 500 finish higher by 0.2%, near its best levels of the day, while Treasurys also finished little changed with the 10-year yield settling at 2.51%. Commodities and the dollar both finished higher, with the CRB Index rising for a fifth straight session despite weakness in crude as WTI fell back to $62 a barrel. The VIX finished below 14.
- Philip Grant
Tuesday, April 2, 2019
They mostly come at night, mostly
It’s alive! Just after midnight eastern time,
It’s alive! Just after midnight eastern time,
I'm a hog for you baby
It’s been a tough road for the U.S. farming industry,
It’s been a tough road for the U.S. farming industry,
Recap April 2
They mostly come at night, mostly
It’s alive! Just after midnight eastern time, the price of bitcoin surged by as much as 23% to cross back over $5,000 for the first time since November, while remaining 15% in the green this afternoon.
What accounts for the abrupt liftoff in the world’s premier cryptocurrency? One potential clue is the nearly identical level of activity in tether, the purportedly dollar-backed crypto. While bitcoin (with an aggregate market value of $83.3 billion) has logged $18.7 billion of trading volume in the past 24 hours, the much-smaller tether (market value: $2.1 billion) has registered $18.8 billion over the same period, according to data from CoinMarketCap.com. By comparison, ethereum, which sports a market cap of $16.6 billion, has seen 24 hour trading volume of $8.5 billion.
For more on tether, see the Sept. 8, 2017 edition of Grant’s.
I'm a hog for you baby
It’s been a tough road for the U.S. farming industry, which is seemingly beset on all sides. Agricultural commodity prices remain low, with spot corn and soybean currently fetching $3.62 and $8.99 per bushel, respectively, each roughly 22% below their respective 10-year average prices.
Meanwhile, the ongoing Sino-American trade war continues to crimp overseas demand, as the U.S. Department of Agriculture reports that soybean deliveries to China fell more than 80% year-over-year since September. That helped push soybean stocks to a record 3.7 billion bushels as of year-end 2018.
By the same token, the USDA forecast Friday that corn plantings will rise 4.1% in 2019 to 92.8 million this year, an unwelcome development considering that “American silos are already bulging with the grain,” according to Bloomberg. Adding insult to injury, devastating floods have afflicted large swaths of the Midwest during the heart of spring planting season.
The USDA estimates that net farm incomes plunged 16% year-over-year in 2018 to $63.1 billion, down from more than $120 billion as recently as 2013. Rising operating costs play a prominent role in that shrinkage. According to the All Farms Index tabulated by the Federal Reserve Bank of Minneapolis, the prices received component fell to 84.9 in January from 95.1 in June, while prices paid registered 109.3 and has remained north of 100 since 2011.
Source: The Federal Reserve Bank of Minneapolis
Things are particularly grim in Minnesota and surrounding states. The Minneapolis Fed reports that in-state farmers have seen total input costs for seed, fertilizer, pesticides, fuel and electricity rise by 50% since 2006, after adjusting for CPI-measured inflation. As a result, Minnesota farmers reported real median net income of $26,055 last year, down 8% from 2017 and the lowest figure since the early 1980’s, per an estimate from Dale Nordquist with the University of Minnesota’s Center for Farm Financial Management.
Unsurprisingly, that one-two punch is leading to increasing distress. The Minneapolis Fed reports that the ninth district (encompassing Minnesota, Wisconsin, North and South Dakota and Montana) has seen farm bankruptcies rise to more than 100 in the 12 months ended in December, up from 46 in calendar 2015.
As farmers struggle under the weight of low prices, bulging stockpiles and the wrath of mother nature, Grant’s asked grains expert and paid-up subscriber Keith Bronstein whether a supply disruption could augur better days ahead:
The flooding is currently a localized disaster for those producers in areas affected.
Can this become sufficiently widespread to have a true impact on U S production of row crops? The answer is a resounding yes, but it is too soon to make that statement. Early planting is a boon to yields and, given relatively depressed prices, it is easy to imagine farmers making extensive use of crop insurance policies if things get very late. I think we need to revisit this in 2.5 weeks to see how conditions have changed (or not) as snow melt and runoff and rain or lack thereof play themselves out over this period.
In summary, some notable areas are experiencing great misfortune but it is not yet a “national” story.
One farm commodity that has decisively broken higher is hogs. The emergence of African swine fever in China has led to the culling of an estimated 100 million hogs, a figure that compares to the U.S. inventory of 74.3 million hogs as of the first quarter. That sudden shortage of Chinese supply has spurred a major change in world fundamentals. Arlan Suderman, chief commodities analyst at INTL FCStone, Inc., estimates that “hog feeding in China is down by more than 30%, while some estimates coming out of China are much higher than that.” The Farm Journal notes that replacing a 31% decline in Chinese output “would require all of the annual production of Canada, the U.S., Mexico and Brazil.”
That supply swing is already having a major impact, as lean hog prices have jumped to $84 per hundredweight, up 58% since Feb. 22. Bronstein observes:
China will be an increasingly aggressive buyer of pork around the world yet is not the only place experiencing the spread of this particular disease. . . China is restricting imports from Vietnam to try and preclude a more aggressive disease spread.
North America, probably thanks to distance and very advanced containment regimens, seems pretty safe now. North America should have an expanding hog population and expanding exports. With cheap feed, it’s a pretty good business to be in.
Recap April 2
A quiet day for stocks saw the S&P 500 test either side of unchanged early before settling into a sideways drift, while Treasurys rebounded from yesterday’s selloff as the 10-year yield dropped three basis points to 2.47%.
Commodities continued their recent rip, as the CRB Index finished at its best level since late November. That move is all the more impressive considering the U.S. Dollar Index also finished green and remains near a 52-week high.
- Philip Grant
Monday, April 1, 2019
Motley Crew
Asset prices are off to the races, as the S&P 500 logged a 13% gain through March 31, the best quarterly showing since the summer of 2009. Credit has likewise marched higher, with the Bloomberg Barclays High Yield Index jumping 7.3%, the steepest quarterly rise since 2003, while the Markit iBoxx Leveraged Loan Total Return Index rose by 4.8% for its best quarter since 2010.
The Fed’s dovish swivel figures prominently in the bull move in credit, as interest rate futures now expect rate cuts instead of further tightening and the “QT” asset run-off is set to end in six months. At the same time, loan defaults reached a seven-year low in March as the post-2009 economic expansion is now three months shy of a record length.
A mismatch between new supply and demand also helps. Junk bond volumes tallied $59 billion in the first quarter, down 5.5% year-over-year and the slowest pace of issuance since 2016. On the loan side, new volume fell to $85.2 billion in the first quarter, down a hefty 68% year-over-year according to data compiled by Bloomberg.
That dearth of supply has further tilted the balance of power in favor of the borrowers. On March 22, the Financial Times reported on the “near-total control” of sellers in the leveraged loan market, a development raising “concerns that a borrower could load up on more debt, extract cash from the company or seek expensive acquisitions.” Even the sharp downdraft seen at the end of 2018 has done little to level the playing field. An unnamed fund manager told the FT that “we were hoping there would be an improvement [in terms for investors] after December’s volatility, but that doesn’t seem to be the case.”
Last Thursday a report from Moody’s Investor Services noted “unprecedented flexibility” on the part of borrowers to make investments free of obligations to maintain certain leverage levels, as well as an “aggressive use of investment capacity” that allows issuers to shift assets beyond creditors’ reach, leaving investors “in uncharted territory.” Indeed, Moody’s determines that 2018 saw the weakest credit agreement protections on record, a fact that bodes ill for recoveries when the cycle turns.
On that score, a prominent cautionary tale finds itself back in the news. On Thursday, the J. Crew Group, Inc. term-loan B fell to 66 from 92 as recently as Oct. 22, 2018, after the fashion retailer reported a full-year adjusted EBITDA decline of more than 50% with cash on hand dropping to $25.7 million at the beginning of February from $107 million a year earlier. The company, taken private in 2011 by Leonard Green & Partners, L.P. and TPG Capital, earned the ire of creditors in 2017 by transferring $250 million worth of intellectual property to a foreign subsidiary (out of the grasp of supposedly-senior bondholders) and then issuing $250 million in fresh debt backed by the same IP.
A slightly different saga featuring private-equity owned PetSmart, Inc. continues to unfold. In April 2017, PetSmart bought online pet supply company Chewy, Inc. for $3.35 billion. Just over a year later, PetSmart transferred a chunk of Chewy’s equity to an unrestricted subsidiary, out of the reach of the company’s creditors. Those jilted bondholders sought legal recourse against PetSmart for alleged “fraudulent” behavior, claiming that PetSmart was already out of compliance with a fixed-charge coverage ratio test. On Thursday, a federal judge ordered the company to turn over documents related to the transfer of Chewy equity. A day later, Bloomberg reported that PetSmart creditors rejected the company’s offer to add new investor protections in return for dropping their litigation. PetSmart’s term loan reached a post-2017 high of 89 cents on the dollar Friday, potentially indicating that the lawsuit is gaining traction.
More recently, the March term loan and senior note offering financing the $10 billion leveraged buyout of Johnson Controls International plc’s car-battery unit represents another measuring stick. After analyzing the senior notes documentation, credit research firm Covenant Review called those covenants “extremely aggressive and containing numerous flaws.” Features that might make creditors cringe include “wildly off-market” compliance calculations that “arbitrarily” exclude various borrowings, as well as a “phony” test that could overlook additional debt used to fund such restricted payments and the ability to “transfer unlimited IP to unrestricted subsidiaries and other entities.” What’s more, so-called add-backs to EBITDA give “the company credit for expected revenues that have not yet been (and may not be) earned.”
As issuers continue to push the envelope, the cycle continues to age. In a March 4 interview with Bloomberg, Carlyn Taylor, global co-leader of corporate finance and restructuring at FTI Consulting, predicted that a spike in defaults is on the way, sooner or later:
The expansion is pretty long in the tooth and there's definitely a lot of buildup. The activity level of restructuring is rising, maybe not at the rate of bankruptcies, but the pipeline of companies we think are going to end up in restructuring, based on metrics that we analyze, that volume has gone up. And we're so busy, which we don't think is just market share, because we think our competitors are also very busy.
Recap April 1
The second quarter started in familiar fashion, as stocks raced higher with the S&P 500 gaining more than 1% and the financials index tacking on nearly 2.5%. Treasury yields likewise ripped higher across the curve, with the 10-year back to 2.5% from less than 2.38% on Wednesday, and commodities also enjoyed a strong rally with the CRB Index gaining 1%. WTI crude finished near $62 a barrel and is up by 42% from the Dec. 24 lows.
- Philip Grant
Friday, March 29, 2019
Blocked number
It’s crunch time for the proposed all-stock merger between Sprint Corp. (S on the NYSE) and T-Mobile U.S., Inc. (TMUS on the Nasdaq).
It’s crunch time for the proposed all-stock merger between Sprint Corp. (S on the NYSE) and T-Mobile U.S., Inc. (TMUS on the Nasdaq).
Recap March 29
Blocked number
It’s crunch time for the proposed all-stock merger between Sprint Corp. (S on the NYSE) and T-Mobile U.S., Inc. (TMUS on the Nasdaq). Yesterday, Charles Gasparino of Fox Business reported that regulators will begin their “final review” of the pending deal next Thursday, following a three week hiatus in which the Federal Communications Commission heard additional arguments from both sides of the debate.
The Trump administration appears sympathetic to the combination. Gasparino tweeted on Tuesday that T-Mobile and Sprint management were making “headway” on their lobbying efforts, with Department of Justice antitrust chief Makan Delrahim purportedly “open” to allowing the combination of America’s third- and fourth-largest wireless carriers. Back in May 2017, FCC chairman Ajit Pai told listeners at the American Enterprise Institute that the prospective consolidation of national carries to three from four wouldn’t necessarily concern him: “I don’t claim to know in a vacuum what. . . the right number of competitors should be.”
Sprint and T-Mobile have taken an offensive tack of late. On March 18, the Capitol Forum reported that the pair jointly submitted an FCC filing accusing rival Dish Network Corp. and consulting firm The Brattle Group of making “serious false statements” in producing a study “that fabricates harms on low income consumers when none exist.”
Apart from attacking its enemies, Sprint has argued that it must merge with T-Mobile to ensure its viability. On Sprint’s Jan. 28 earnings call, CEO Michel Combes told listeners that: “As a stand-alone company, we lack the scale to keep pace with the bigger carriers, AT&T and Verizon, in sustained capital investments, and without additional low-band spectrum we will face challenges to provide customers with coverage comparable to that of the big two carriers.”
The effectiveness of that tactic is in question, with Bloomberg reporting yesterday that “some U.S. officials” are “skeptical” of Sprint’s claims “that it won’t be an effective competitor if they block the merger.” One unnamed individual “said Sprint asserted it may eventually run out of cash if the merger fails.” Former FCC wireless bureau chief Fred Campbell went on the record to dub Sprint’s arguments as “relatively weak” and “probably not enough to get a merger through that’s anti-competitive.”
An analysis in the Dec. 23, 2016 edition of Grant’s drew a different conclusion, based on Sprint’s onerous debt burden, stagnant revenues and five straight years of cash burn (more of the same is expected in 2019 and 2020). Research firm MoffettNathanson, LLC concluded in a Jan. 31 report that if the deal is rejected, Sprint’s debt “will likely have to be restructured,” while Bloomberg Industries analyst Stephen Flynn writes today that “Sprint may need financial help from its 84.5% equity owner SoftBank Group Corp.” if the merger is blocked.
Mr. Market has expressed only mild concern about the deal prospects, as Sprint’s senior unsecured 6 7/8 notes due 2028 have ticked below 96 cents on the dollar, compared to above 99 a month ago. Sprint shares likewise trade at a 26% discount to the deal closing price based on T-Mobile stock price. Yet those markdowns pale in comparison to the dual credit and equity swoon in early 2016 when the company’s survival prospects appeared to be in question.
Sprint 6 7/8s of 2028. Source: The Bloomberg
A thumbs-up from federal regulators wouldn’t necessarily signal an all-clear. Dealreporter relayed yesterday that a coalition of 18 state attorneys general led by New York are considering a lawsuit to stop the deal, regardless of the DoJ and FCC’s findings. Bloomberg adds that “there’s some concern among the states that political considerations could be influencing the Justice Department’s decisions on mergers,” with Delrahim’s prior attempt to block the AT&T, Inc./Time Warner, Inc. tie up due to Trump’s “incessant criticism” of CNN one such example.
With the TMUS deal decidedly up in the air, Sprint’s problems could soon become SoftBank’s. In a commentary yesterday, Amir Anvarzadeh of Asymmetric Advisors writes that the state-level opposition and DoJ skepticism over Sprint’s claims of financial hardship as a standalone entity have pushed his forecasted approval odds south of 40%: “None of this is good news for SoftBank, which has been banking on taking Sprint’s $30 billion of net debt and its negative cash flow from its balance sheet.”
Meanwhile, SoftBank, which Grant’s dubbed “the epitome of the cycle” (it wasn’t a compliment) on Dec. 15, 2017, has enjoyed a rollicking rally. Shares have risen 48% year-to-date, as a buyback encompassing more than 10% of shares outstanding and a 32% rise in Alibaba, Inc. (SoftBank owns 29% of BABA) have provided the bullish jet fuel. Anvarzadeh writes that the Sprint saga, along with pricing pressure in SoftBank’s domestic telecom unit, may soon change the narrative: “We think investors should be positioned for these negative catalysts before the buyback program comes to completion.”
Recap March 29
Stocks rose again to leave the S&P 500 with a solid 1% gain for the week and 13% for the quarter (the best such performance since 2009), as Lyft, Inc. shares enjoyed a 9% gain in their first day of trading.
Commodities were also bid, with WTI crude popping back above $60 a barrel. Treasury yields ticked mostly higher across the board, as the 10-year yield rose back above the three-month for the first time since last Thursday.
- Philip Grant
Thursday, March 28, 2019
Prognosis negative
Today, the Financial Times reports that Deutsche Bank A.G.
Today, the Financial Times reports that Deutsche Bank A.G.
QT progress report
Recap March 28
Prognosis negative
Today, the Financial Times reports that Deutsche Bank A.G. is looking to raise between €3 billion ($3.4 billion) and €10 billion in equity to help consummate the planned merger with peer Commerzbank A.G., “a move designed to end the debate over whether Germany’s largest lender has enough capital.” That sum is not insignificant: The duo combined are worth €23.6 billion. Meanwhile, the FT notes that Deutsche Bank has raised some €30 billion since 2010, twice its standalone market cap.
The Deutsche Bank/Commerzbank saga puts into relief the struggles of Europe’s banks. More broadly, the Euro STOXX Bank Index generated an aggregate 7.51% return-on-equity last year, far behind the 11.82% ROE logged by the U.S. KBW Bank Index. The valuation gap is also substantial, as the Stoxx Bank Index trades at 0.58 times forward 2019 book value, compared to 1.12 times for the KBW U.S. Banking Index.
What gives? Borrowing costs are one key difference. The European Central Bank’s deposit rate has been negative since June 2014, penalizing banks for their reserves, while the Fed Funds rate sits at (positive) 2.4%. The less-than vigorous state of Europe’s financial institutions has gotten the attention of ECB president Mario Draghi. In a Frankfurt speech yesterday, Draghi raised the possibility of providing some assistance to the banks: “If necessary, we need to reflect on possible measures that can preserve the favorable implications of negative rates for the economy, while mitigating the side effects, if any.”
While the outgoing Draghi (his term ends on Oct. 31) didn’t elaborate on what sort of “mitigating” steps the ECB might take, Bloomberg notes that other central banks with sub-zero benchmark rates such as the Bank of Japan and the Swiss National Bank have adopted “a so-called tiering system that excludes most of the reserves commercial banks deposit from the penalty that a negative policy rate imposes.”
Draghi’s potential negative rate workaround has elicited a range of reactions from his fellow functionaries. ECB governing council member Ewald Nowotny told the press in Vienna today he “would like to see a certain mitigation” for the effects of sub-zero rates, terming the SNB’s tiering practice a “nuanced system.” ECB chief economist Peter Praet advocated further study in an interview with Bloomberg today, saying “we need to be convinced that it would address a monetary-policy question in an efficient way.” Dutch central bank governor Klaas Knot is adamantly opposed: “We as policy makers should stay far away from [tiering].” Bloomberg notes that Knot “argued that there’s little proof that banks’ low profits are the result of low interest rates.”
But as the monetary mandarins debate further interventions to minimize the “side effects, if any” of the ongoing negative-rate epoch, one observer argues that the central bankers are missing the point. In a commentary yesterday, Jeffrey Snider of Alhambra Investment Partners wrote that the ECB’s efforts to incentivize credit growth through penalizing idle reserves has backfired, demonstrating the differences between theory and practice:
It all sounds very good on the chalkboard, in the regression analysis of complex yet oversimplified computer models. Give banks reserves and then punish them when they aren’t put to good use; problem solved.
The real world, however, is much more complicated – and in many ways far simpler. Maybe banks don’t want to use reserves because the implications, meaning risks, of doing so are perceived to be consistently much greater than the deposit rate NIRP penalty.
Thus, the real solution would instead be to figure out why banks are perceiving the world this way rather than rejiggering the NIRP nonsense one more time.
Monetary competence does not come easily to the modern central bank. It has morphed into expectations manipulation, which, ironically, requires everyone to believe that it is the most technically capable instrument for policy there is. This is why we are all taught from Econ 101 forward the near infallibility of the central banker, and also why at the very same time through experience and observation we see that’s just not the case.
They really have no idea what they are doing. The ECB is not a collection of newfound doves, they are chickens without their heads. Either way, it does not amount to anything good, and adds more weight to the considerable and growing list of everything bad.
That’s not to say the ECB doesn’t have advocates for more activism. Bjorn Wahlroos, outgoing chairman of Nordea Bank, expressed eagerness for more intervention at a shareholder meeting in Helsinki today. Referencing Draghi’s famous 2012 promise to do “whatever it takes” to defend the Euro, Wahlroos said of the ECB, which carries assets on its balance sheet equivalent to 39% of 2018 Eurozone GDP (compared to the Fed’s 19% of American output): “I call upon the ECB to remember that statement and realize that they haven’t done whatever it takes.” Wahlroos believes that Draghi and co. should once again ramp up asset purchases, “on a scale that will create an upward-sloping yield curve,” in order to ensure that “any idiot who can borrow money can make money.”
QT progress report
The Fed’s portfolio of securities held outright registered at $3.77 trillion, down $6.7 billion from a week ago and $14.5 billion below the trailing four-week average. Mortgage-backed securities accounted for the bulk of this week’s decline, with Federal agency debt securities holdings also dropping by $62 million, the first change for that line item since the second week of June.
Since the fall 2017 commencement of QT, total balance sheet assets are down by 11.2%, for a simple annualized pace of 7.7%.
Recap March 28
Stocks rose a bit, leaving the S&P 500 virtually unchanged over the past two weeks and higher by 12% year-to-date. Treasury yields ticked higher across the board, while the Dollar Index enjoyed a strong rally.
The surging greenback put the crimps on gold, as the Money of Kings dropped nearly 1% to a three-week low of $1,290 an ounce, but the iShares Emerging Markets USD Bond ETF managed to rise to near its best levels of the year. The VIX fell below 14.5.
- Philip Grant
Wednesday, March 27, 2019
Play ball!
A historical quirk in tomorrow’s Opening Day schedule.
A historical quirk in tomorrow’s Opening Day schedule.
Back to the well
This morning, the Turkish offshore lira borrowing rate briefly touched 1,350%
This morning, the Turkish offshore lira borrowing rate briefly touched 1,350%
Recap March 27
Play ball!
A historical quirk in tomorrow’s Opening Day schedule. From MLB.com:
The Jacob deGrom-Max Scherzer and Blake Snell-Justin Verlander matchups represent just the third and fourth times the top two finishers in Cy Young voting faced each other the following Opening Day -- and the other two were also in the same year!
On Opening Day 1979, the 1978 winner in the AL (Ron Guidry, Yankees) took on runner-up Mike Caldwell (Brewers), while the reigning NL Cy Young winner (Gaylord Perry, Padres) faced off against Burt Hooton (Dodgers).
Back to the well
This morning, the Turkish offshore lira borrowing rate briefly touched 1,350% and settled at 750%, up from 23% on Friday. The reason for this skyward catapult? A government-manufactured shortage of liras. Today, Bloomberg reports that “some foreign banks were unable to meet their obligations at the close of trading [yesterday], forcing the central bank to extend hours for transferring funds to Turkey to 9 p.m., according to a senior Turkish official, who spoke on condition of anonymity.”
The measures imposed by Turkish President Recep Erdogan’s government have had one desired effect, as the lira has strengthened to 5.35 to the dollar, well ahead of the 5.85 conversion rate seen on Friday. That rebound was cause for celebration within Erdogan’s inner circle. The state-run Anadolu Agency quotes Treasury & Finance Minister Berat Albayrak (and the President’s son-in-law) as taunting the naysayers in Istanbul yesterday evening, asking: “Did we not witness some people claiming that one dollar would rise to eight liras, 15 liras as we head to [Sunday’s] elections? Check your phones and see how much liras to the dollar. Inshallah [God willing], it’ll be better.”
But that modest currency appreciation (the lira was 5.42 to the dollar last week) has come at the expense of other assets. The Borsa Istanbul 100 Index has seen an 8% decline through three sessions this week, including a 5.7% plunge today. The yield on Turkey’s 10-year, dollar pay bonds has jumped to 7.74% from 7.02% a week ago, while five-year sovereign credit default swaps have jumped to 459 basis points from 334 in the past week, approaching the 14-year wides of 575 basis points reached in September.
Meanwhile, the fallout has spread to other emerging market mainstays, as the South African rand fell as much as 1.7% against the dollar to its worst level since Christmas. Henrik Gullberg, currency strategist at Nomura International plc, writes today that “given prohibitively high rates in lira, it looks like the rand’s high external beta makes it the favorite currency to use as a proxy for emerging market risks.”
More broadly, the lira depreciation and sharp upward pressure on Turkish bond yields over the past year has claimed at least one institutional victim. Today, GF Securities Co. disclosed its GTEC Pandion Multi-Strategy Fund SP lost $139 million last year to leave the fund with a negative capital position and prime-broker Citigroup, Inc. holding the bag on “as much as $180 million in losses.” According to Bloomberg, Pandion’s demise “stemmed mainly from trades in the Turkish lira.”
In the Aug. 7, 2015 edition of Grant’s, Russell Napier, independent strategist and founder of the Electronic Research Interchange, suggested that the imposition of Turkish capital controls would spur a broader emerging markets crisis. Grant’s asked Napier today whether Turkey’s decision to effectively prevent investors from withdrawing capital from the country will indeed presage larger-scale trouble:
This is a major step in this direction. It will be something of a test case as to whether one can move to de facto capital controls without de jure capital controls. So, in theory capital moves freely but in practice through de facto state control of the banks, selling lira and buying foreign currency is almost impossible. Most governments have beefed up their tools for 'macro prudential regulation' and I have long argued that these can be used as capital controls.
As an example, if the government of Italy mandates that a certain percentage of Italian bank assets must be committed to Italian government debt then is that a capital control? I would argue it is, but they would say its macro prudential regulation. I have argued that the possible new monetary goal of the Fed is something unlikely to be implementable without de facto capital controls. Yield curve management, through enforced buying of Treasurys on savings institutions, is a firm of capital control and I think something that is necessary given the nature of the new strategic monetary target the Fed is discussing.
I do expect this to spread. Argentina signed a deal for the largest support package in IMF history. Even that has not been enough to stop the currency from falling to an all-time low.
Restricting the free movement of capital was imposed on Cyprus by the European Commission. We need to realize that this is not a policy only likely in emerging markets.
Turkey’s decision to jam overseas borrowing costs skyward has historical precedent. In the fall of 1997 the Hong Kong Monetary Authority took its overnight rate to 280% in a bid to protect a currency peg to the dollar as the Asian financial crisis was getting underway. Napier (who is speaking at the April 9 Grant’s spring conference – advt.), identified some crucial differences between the two situations:
The key to defending an exchange rate is not the interest rates you are prepared to set but the ensuing level of deflation you are prepared to endure. Hong Kong is not a democracy and it had a very sound commercial banking system.
In 1998 the high interest rates led to major declines in both wages and property prices. Commercial bank balance capital was not impaired by that major decline in property prices. The people did not go to the polls to demand action against lower wages as there were no polls to go to. They did not go to the streets either possibly as the PLA had just arrived. I think it is stating the obvious to say that Turkey is no Hong Kong. Hong Kong weathered all that with open capital accounts - Turkey will not.
As mentioned above, Turks turn out to vote this weekend.
Recap March 27
Stocks ticked moderately lower, as ten of eleven S&P 500 sector groups finished red but none by more than 1%, while another feverish rally in the Treasury complex saw the 30-year yield drop to 2.83%, just 43 basis points above the effective Federal Funds Rate.
Commodities came under pressure, with WTI crude and gold falling to $59 a barrel and $1,309 an ounce, respectively, as the Dollar Index enjoyed its fourth green finish in the last five sessions. The VIX edged higher to 15.
- Philip Grant
Tuesday, March 26, 2019
TRY hard
On Friday, the Turkish lira plummeted by more than 6% against the dollar.
On Friday, the Turkish lira plummeted by more than 6% against the dollar.
Depends where you sit
The hotly anticipated public debut of Lyft, Inc. is drawing a wide range of reactions.
The hotly anticipated public debut of Lyft, Inc. is drawing a wide range of reactions.
Recap March 26
TRY hard
On Friday, the Turkish lira plummeted by more than 6% against the dollar. Persistently high inflation, economic retrenchment (fourth quarter GDP fell 3% year-over-year) and dwindling foreign exchange reserves helped set the stage for that mini-panic (Almost Daily Grant’s, March 22), while a J.P. Morgan Chase & Co. analyst call for further lira depreciation likely exacerbated the rout.
Two days later, Turkish President Recep Erdogan warned that investors speculating on a weaker lira would face unpleasant side effects, telling listeners at an Istanbul campaign stop that “If you get involved in provocative acts, saying ‘foreign currencies will strengthen, this will happen, that will happen,’ you will pay a very heavy price.” It didn’t take long for Erdogan’s threats to come to pass. Over the weekend, both the country’s Banking Regulation and Supervision Agency and Capital Markets Board separately announced they were investigating J.P. Morgan.
Turkey also put the clamps down on investors looking to cash out of the local currency. Bloomberg reports today that foreigners seeking to exit their positions “are finding they cannot execute their trades because local lenders are under pressure not to provide liras, according to four bankers who declined to be identified.”
That logjam has helped drive the offshore lira rate to a staggering 367% overnight implied yield today. That’s up from 96% yesterday and 23% Friday.
Turkey’s offshore borrowing rate goes skyward. Source: The Bloomberg
The repressive measures have been moderately successful thus far; as the lira has rallied back to 5.4 per dollar, compared to 5.76 on Friday and 5.42 one week ago. Turkey is holding local elections across the country on Sunday.
Depends where you sit
The hotly anticipated public debut of Lyft, Inc. is drawing a wide range of reactions. Today, The Wall Street Journal reports that the ride-share company is expecting shares to price above the previously indicated range of $62 to $68 thanks to “strong investor demand” on the company’s roadshow. Last week, Reuters relayed that the offering was already oversubscribed by the second day of the investor tour.
With pricing for the deal expected tomorrow, analyst Tom White of D.A. Davidson is looking to get the jump on things. Last week, White gave Lyft its first “buy” rating and applied a $75 price target on the company. In an interview with Bloomberg yesterday, the analyst explained that while he can confidently forecast revenue growth, the other side of the ledger is more difficult to predict:
The expenses side is a little trickier, especially when it comes to the incentives Lyft deploys to attract drivers. They give an overall number, but you don’t understand how much is attracting riders versus drivers.
That’s where the art comes into play. With investing I think there’s an element of science and hard numbers and math, but there’s also a bit of art and creativity that you need to employ as well.
Those waiting for profitability best get themselves comfortable. White expects red ink out to at least 2022, the furthest year in his model.
While investors don’t seem to mind operating losses as far as the eye can see, a different set of Lyft stakeholders is a bit less sanguine. Yesterday, Business Insider reported that the company was forced to move the location of its San Francisco roadshow after protesting drivers blocked the entrance to the Omni Hotel.
Less art, more math. Source: Business Insider
Recap March 26
Stocks finished off their best intraday levels but still managed a solid advance on the S&P 500, with energy taking the lead as WTI crude edged back over $60 a barrel. Commodities performed well as a whole, with the CRB Index rising 0.5% despite the best close for the U.S. Dollar Index in two weeks.
Treasury yields ticked higher across the curve, as the 10-year settled at 2.42%, one basis point above the overnight Fed Funds rate. The VIX lost 9% to fall back below 15.
- Philip Grant
Monday, March 25, 2019
Platform heels
The Financial Times’ Alphaville blog relays today that a piece of cyclical history is now available on eBay:
The Financial Times’ Alphaville blog relays today that a piece of cyclical history is now available on eBay:
Turf wars
Earlier today, former Fed chair turned
Earlier today, former Fed chair turned
Private investigations
On Friday, the Securities and Exchange Commission filed suit against private
On Friday, the Securities and Exchange Commission filed suit against private
Recap March 25