Almost Daily Grant's
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Friday, December 7, 2018
Cancun swoon
Last Saturday, left-wing populist Andrés Manuel López Obrador (AMLO for short)
Last Saturday, left-wing populist Andrés Manuel López Obrador (AMLO for short)
Recap Dec. 7
Cancun swoon
Last Saturday, left-wing populist Andrés Manuel López Obrador (AMLO for short) was officially inaugurated as Mexico’s 58th president, replacing establishment predecessor Enrique Peña Nieto. AMLO wasted no time in establishing his anti-elitist bona fides, opening the opulent presidential mansion Los Pinos to the public while maintaining his own, more modest residence in the south side of Mexico City. The new president also dispatched the presidential plane, a Boeing 787 Dreamliner that cost more than $200 million, back to California where it will await a new buyer.
Changes under AMLO go well beyond the symbolic. In October, the then-president elect announced the cancellation of a partially-completed $13 billion airport expansion outside of Mexico City after a mini-referendum showed 70% of respondents opposed the project (Almost Daily Grant’s, Oct. 29). While El Universal polls show a 9% decline in AMLO's approval ratings since August, a majority of Mexicans (55.6%) still give their new president a thumbs up as of Nov. 26. Investors are another matter.
Last week, the Mexican government launched a tender offer for $1.8 billion of the $6 billion in airport bonds outstanding at prices ranging from 90 cents on the dollar to par, in return for looser covenants and a change in the revenue stream servicing the remaining debt.
News of the offer has lifted those bonds to 83 cents on the dollar from 75 prior to the announcement, but the experience has done little to build good will with creditors. Michael Leithead of EFG Asset Management tells the Financial Times that Wall Street “will be cognizant of the unpredictability of the new government. Despite the market-friendly outcome.” Sebastian Salvay, analyst at TPCG brokerage in Argentina, suggests some specific improvements to Bloomberg: “The main problem with this offer is that it doesn’t give you anything in exchange with what you give. . . you need a guarantee, collateral from government.” On Tuesday, a group of creditors claiming to own more than half of the bonds outstanding rejected the government’s proposal.
The uncertainty of the airport bond situation is one example of political risk south of the border. AMLO’s energy policy is another. During his inauguration speech, the new president declared: “Neoliberal economic policies have been a disaster,” referring to the market-friendly energy reforms put in place by his predecessor. Indeed, AMLO promised on the campaign trail to halt crude exports by 2022, while The Wall Street Journal reported in August that the then-president elect “will hold off auctioning any new oil blocks for at least two years and plans to modify laws to bolster the dominant role of state oil company Petróleos Mexicanos [a.k.a. Pemex]”.
The March 23, 2018 edition of Grant’s featured a skeptical analysis of Pemex, which was founded in 1938 with the seized assets of foreign oil companies. The bear case rests on the fact that Pemex is a debt-heavy ($103 billion in net borrowings, and a leverage ratio of nearly eight times debt to EBITDA when factoring in pension liabilities) and chronically money-losing enterprise (net income and free cash flow have both remained in the red since 2013) beset by chronic production declines.
The triple-B-plus-rated oil behemoth managed to place senior unsecured 2027 dollar bonds at a 6.5% coupon in February, an issue that traded well above par as recently as July. It’s been a different story since, with those bonds last fetching just under 94 cents on the dollar, for a yield-to-worst of 7.52%. Pemex five-year credit default swaps have likewise jumped to 333 basis points from 185 in March, while the price of Mexican sovereign credit protection has also risen, to 148 basis points from 116 at publication time.
In July, AMLO tapped Octavio Romero Oropeza, a long-time political ally with no energy experience, to lead Pemex as general manager. The company’s creditors are getting a little nervous. We suspect they will become more than a little nervous.
Recap Dec. 7
Stocks were clubbed again, with the S&P 500 wrapping up the short week nursing a near-5% loss to sink back toward the low end of its fall trading range, while the small-cap Russell 2000 broke to its lowest since September 2017, down 3% year-to-date. Treasury yields darted lower across the short end and belly, while the long bond underperformed to push the 5- and 30-year spread toward the upper end of its 2018 range, and commodities were well bid as an OPEC production cut agreement helped WTI crude rise to $52.50 a barrel while gold finished at $1,248 an ounce, just above its five-year average.
This morning’s release of November non-farm payrolls featured a 3.1% year-over-year rise in average hourly earnings, matching last month’s for the strongest reading in the series since 2009.
- Philip Grant
Thursday, December 6, 2018
Board games
This bellwether got rung. Yesterday, industrial packaging producer Greif, Inc. reported fiscal fourth quarter results that fell short of estimates, with net sales of $988 million and adjusted EPS of $1.08 trailing the Street’s consensus expectation of $1.02 billion and $1.19, respectively. That sent shares lower by 10% as investors were clearly in no mood for disappointment. CEO Peter Watson tried to put a happy face on the results, while acknowledging problems on both the cost and the demand sides of the equation:
Greif delivered a strong financial performance in fiscal 2018, despite being impacted by significant cost inflation in most areas of the business . . . at the end of fiscal 2018 we began to see signs of market softness in discrete areas of our global portfolio.
On this morning’s conference call, Watson expanded a bit on the geographic demand dispersion. While North America “is experiencing very healthy volumes,” it’s a different story elsewhere, with the CEO noting “soft” demand in China and Western Europe. Mother Nature apparently played a role in the latter development, as the company cited the “continued impact of weaker European conical drum demand due to weather.” That marks the 5th straight quarter in which GEF cited weather-related issues in its review of operations (see the Aug. 30 edition of Almost Daily Grant’s for a rundown of Greif’s prior meteorology mishaps).
Weather excuses aside, investors of all stripes should be paying attention, as the Sept. 22, 2017 edition of Grant’s termed Greif “a kind of one-company Purchasing Managers Index.” The rationale for that designation:
There’s not much technology in a 55-gallon steel drum, not much intellectual property in the soft-sided luggage called an aggregates bag. So, as industrial production goes, so goes Greif. It’s the very stock not to own, and the very dividend yield on which not to depend, on the eve of a recession.
Beyond acute cyclical exposure and a fancy valuation (29 times trailing GAAP earnings at publication time, an important distinction as 19.6% of cumulative pretax income since 2003 had taken the form of “one-time” restructuring charges), a few other factors colored Grant’s bearish assessment of Greif.
One potential stumbling block: The company had seemingly been underinvesting in its business, as GEF spent $103.5 million in capital expenditures over the prior 12 quarters, well below the $121.3 million in depreciation and amortization expense. Sure enough, CFO Lawrence Hilsheimer noted a reversal during today’s earnings call:
Compared with the prior year quarter, fourth quarter free cash flow was lower by $19 million, partially due to our conscious decision to increase our CapEx spend. . . Relative to the guidance we published at our third quarter call, fourth quarter free cash flow was impacted by higher than anticipated CapEx, cash taxes and cash restructuring.
Higher capital expenditures weren’t the only factor hindering GEF’s cash generation. Asked about a $24 million dollar hit to working capital as a result of unfavorable foreign exchange moves, Hilsheimer explained:
Currency rates have been really volatile. And when we did our guidance for cash flow for the fourth quarter, we went through our processes. And so when we saw the end results of our cash flow, I asked the team to really do a deep dive into every factor because it just did not make any sense to me.
What ultimately we found out was that the currency impacts on working capital when you get down to an account by account level of the various elements of it and some other current accounts end up being a $24 million hit in the fourth quarter. So the drag that was something that had nothing to do with mismanagement, it had everything to do just with the currency impacts to our working capital.
Then there are the so-called headline risks. In 2017, the Milwaukee Journal Sentinel published a series of stories exposing illegal dumping by GEF subsidiary Container Life Cycle Management that potentially jeopardized the health of workers, local residents and safety inspectors. Indeed, two examiners from the Environmental Protection Agency were sickened during the subsequent investigation of a CLCM facility. In January, the Journal Sentinel reported that the EPA is prepared to sue Greif if settlement negotiations break down.
Months passed, too quietly for some. In early August, Senator Tammy Baldwin of Wisconsin sent a letter to acting EPA secretary Andrew Wheeler asking for an update, stating: “I am deeply concerned the EPA has not taken swift, substantial action to protect residents by addressing the company's negligence."
Five weeks later the EPA replied to Baldwin, noting that while a soil sample at the St. Francis facility indicated no “immediate threat to human health . . . the three CLCM facilities in, and around Milwaukee, Wisconsin are already the subject of notices of violation issued by the EPA in November 2017” and that the investigation was proceeding apace, while declining to comment further. Since publication last September, GEF shares are down by 23%, lagging the 8% gain in the S&P 500 over that period.
QT progress report
The Fed’s portfolio of securities held outright fell to $3.896 trillion this week, down $12.5 billion from last week’s reading and $31.5 billion below the trailing four-week average. Treasurys accounted for this drop after mortgage-backed securities ran off the balance sheet last week.
Since the Oct. 1, 2017 commencement of QT, total assets on the Fed’s total balance sheet are down by 8.3%.
Recap Dec. 6
Stocks staged a feverish late rally, all but erasing a near-3% intraday decline on the S&P 500 after The Wall Street Journal reported that the Federal Reserve is having second thoughts about hiking the Funds rate at the Dec. 19 meeting (Fed Fund Futures now price a 69% chance of a rate increase according to Bloomberg, down from 78% on Nov. 30).
Treasury yields finished lower across the curve but well off their best levels of the day, as the 10-year yield jumped 5 basis points in the afternoon to finish around 2.88%. The CRB Commodity Index lost more than 1% despite a weaker dollar, but gold managed to inch into the green, finishing at $1,238 per ounce.
- Philip Grant
Wednesday, December 5, 2018
Schumpeter-ism, with Chinese characteristics
Creative destruction, by government fiat.
Creative destruction, by government fiat.
Franchise player
The beef wars are raging.
The beef wars are raging.
Schumpeter-ism, with Chinese characteristics
Creative destruction, by government fiat. From Caixin Global:
China wants to kill off — or possibly revive — its lurching horde of “zombie” companies by 2020.
The central government has given local governments and state-owned asset management departments three months to submit a list of money-losing companies and has required that they be restructured or disposed of by the deadline.
The deadline shows that the issue of China’s immense corporate debt, especially at state-owned enterprises (SOEs), remains on the government’s agenda. According to the latest Ministry of Finance data, China’s SOEs had 113.9 trillion yuan ($16.5 trillion) in total debt as of the end of October, up 7.7% for the year.
Franchise player
The beef wars are raging. Yesterday, CNBC reported that Burger King has debuted a promotion of once-cent Whoppers through Dec. 12, when ordered through the company app in close proximity (within 600 feet) of rival McDonald’s Corp. (MCD on the NYSE) restaurant locations. The app will then lead McDonald’s customers-turned-deserters to the nearest Burger King to claim their penny-prize.
Such aggressive promotions are one indication of a tough operating environment in fast food. Inflation in wages and commodities is another. Bloomberg reported yesterday that rising prices have narrowed the discount on fast-food hamburgers compared to more upscale concepts like Shake Shack, Inc. to 8% this year from nearly 30% in 2012, as restaurants struggle to adapt to higher labor costs while maintaining their competitive position.
During the October earnings call, McDonald’s CEO Steve Easterbrook described the environment in zero-sum terms: “I think it’s a market share fight. I don’t see many people, many out there in our sector, who are actually growing traffic at all.”
Indeed, the restaurant industry as a whole grew same-store sales by 0.8% year-over-year in October according to industry research firm TDn2K, down from 1.2% in September and 1.8% in August and well below the most recent readings of CPI inflation (2.5% year-over-year in October) or nominal GDP growth (5.5% year-over-year in the third quarter). As top-line growth has floundered, strains between asset-light franchisors and capital-intensive franchisees have intensified.
Yesterday, the National Jack in the Box Franchisee Association filed a lawsuit against its corporate parent in Los Angeles Superior Court, alleging breach of contract and seeking an audit of the company-managed marketing fund, including a “full accounting” of the fund’s activity since 2016. That follows last week’s incorporation by MCD franchisees of their own National Owners Association, a notable development considering McDonald's is the largest, most profitable and arguably best-run fast food company in the world.
Then there’s Restaurant Brands International, Inc. (QSR on the NYSE), parent company of the Burger King, Popeye’s Louisiana Kitchen and Tim Hortons brands and Grant’s pick-to-not-click on June 2, 2017, which has been locked in a contentious dispute with Tim Hortons’ franchisee group the Great White North Franchise Association.
Back in September, Restaurant Brands seized the four Tim Hortons locations owned by David Hughes, president of the GWNFA, commenting that the “franchisee agreement clearly states it is not allowable for any restaurant owner to share confidential company information with the media; disparage the company or the Tim Hortons brand in the media or with community partners and vendors; or ultimately harm the Tim Hortons brand in any way.” For his part, Hughes accused the company of retaliating against him for “shin[ing] a light on many practices and policies that are detrimental to the individual franchisees and the chain as a whole.”
Unsurprisingly, economic difficulties are driving the widening rift between the companies and store operators, with Allan Hickok of the Boston Consulting Group explaining to Restaurant Finance Monitor: “I think we’re going to have a come-to-Jesus moment about exactly what bang for the buck franchisees are getting, especially in asset-light systems.”
John Hamburger, founder and president of the Franchise Times, predicted a similar outcome to attendees of the Grant’s spring 2018 Conference back in April:
On one side you have a franchisor with no capital expenditures and no day-to-day street-level exposure collecting royalties and rents by the bushel basket, trading at double-digit multiples, all the while levering up to pump out cash out to shareholders like there’s no tomorrow. On the other side, [you have] a franchisee, one that’s actually in the trenches running these restaurants and finding out it’s not a very friendly operating environment right now.
I’m here to tell you this Shangri-La doesn’t go on forever. You can’t have one side of the franchise contract getting fabulously rich while the other side faces these headwinds alone. The concept of a moat around the franchisor is a myth. That somehow a brand can separate itself from the unit-level economics of its franchisees is not grounded in reality.
In my view, it can only mean one thing, and that’s a lid on value for asset-light franchisors, especially the ones not growing. The fact that rates are rising may force a multiple compression sooner rather than later.
U.S. markets were closed today in observance of the memorial service for President George H.W. Bush.
- Philip Grant
Tuesday, December 4, 2018
So much for the honeymoon
From Reuters:
From Reuters:
Curve sketching
Big doings in the government bond market.
Big doings in the government bond market.
Recap Dec. 4
So much for the honeymoon
From Reuters:
Brazil’s Supreme Court said on Tuesday it had authorized a federal investigation into allegations that the incoming chief of staff for far-right President-elect Jair Bolsonaro had taken illegal campaign donations.
The investigation is the second graft allegation made against a top member of Bolsonaro’s incoming government, a thorny issues as the leader was elected on a law-and-order platform a vow to end widespread political corruption exposed by the sprawling “Car Wash” investigation and other probes.
Bolsonaro’s presidential inauguration is scheduled for Jan. 1, 2019.
Curve sketching
Big doings in the government bond market. Today, the spread between the 2- and 10-year Treasury yields briefly fell below 10 basis points, the narrowest since 2007. That follows the first partial inversion of the Treasury curve since that same pre-crisis era yesterday, as the 2- and 3-year yields both topped the five year. While the long end has contributed to the latest round of curve compression, the 2.92% 10-year still sits higher by almost 50 basis points year-to-date. Instead, a sharp leg higher in short maturity yields has accomplished most of the heavy lifting.
ZIRP no more. Three month Treasury bill yield. Source: The Bloomberg
What gives? By most metrics, the economy seems to be humming along just fine. GDP grew by an annualized 3.5% in the third quarter and has averaged a 3.1% real growth clip over the last four quarters, while the November Manufacturing PMI printed at a brisk 59.3, the 23rd consecutive monthly reading north of 55 (a reading above 50 denotes expansion).
Although just a partial inversion thus far, the rise in short rates above those of longer maturity is a significant development: Each of the past seven recessions have been preceded by a fully (meaning the three-month yield outpaces the 10-year for 10 consecutive days) upside down yield curve, with an average lag time of 311 days, according to Jim Bianco, founder and eponym of Bianco Research.
But as the current inversion is just a partial one, recent history implies we can expect the real McCoy soon enough. Bianco notes that going back to 1970, each time the 2-year vs 5-year curve inverted, the 3-month vs 10-year differential (which Bianco dubs “the economist curve” due to its frequent use in academic studies) soon followed suit, concluding: “It may take a while, but once one curve inverts, they eventually all invert.”
Bianco has a theory about what’s driving the flip: An aggressive Fed tightening cycle contrasting with an uncertain inflation outlook:
Assuming inflation actually returns, all is well. The Fed is correctly leaning against the markets. However, this is not always the case. . . By our count, the Fed has engaged in nine rate hike campaigns. Since 1980, inflation has been in a downtrend. PCE has rarely exceeded 2% since 1997. Each time it has, the Fed aggressively hikes, the curve inverts and a recession ensues about a year later.
The move in the curve has got the attention of at least some in the Fed, as Dallas Federal Reserve president Robert Kaplan said in a Texas speech Monday that the prospect of curve inversion “tells me that it’s wise to be patient here,” seemingly hinting at a more dovish tilt from the non-voting member (he regains his vote in 2020).
Kaplan’s concerns have yet to be priced into the market, however. Interest rate futures currently assign 79% odds of a rate hike of a 25 basis points or more at the Dec. 19 meeting, up slightly from a 75% probability a month ago.
At the same time, there is no allowance for surprise: As far out as December 2019, futures currently assign 0.0% odds of a rate cut. We’d be so bold as to suggest that figure should be a little bit higher.
Recap Dec. 4
The recent rally ended in abrupt fashion, as stocks were splattered to the tune of a 3.2% drop in the S&P 500, with the industrials and financials groups each losing more than 4% while the NYSE FANG+ Index sank by 3.9%. Treasurys were bid across the curve with the yield on the 30-year long bond sinking nearly 9 basis points to 3.17%, its lowest since mid-September, while the VIX enjoyed a mid-day surge to close back above the 20 mark.
One relative bright spot was in commodities, as energy prices managed a flat finish with WTI crude settling just under $52 a barrel. Gold enjoyed another solid bid, closing at $1,238 an ounce, its best level since mid-July.
Both the stock market and the bond market are closed tomorrow in observance of the national day of mourning for President George H. W. Bush.
- Philip Grant
Monday, December 3, 2018
The end of the beginning
The training wheels are coming off. Next week, the European Central Bank will conduct its final meeting of 2018, and is widely expected to announce the cessation of its QE asset purchase program. The ECB began buying sovereign bonds in 2015 and added corporate debt to the mix a year later. ECB president Mario Draghi, who piloted the program, will soon be riding off into the sunset, as his term ends on Oct. 31, 2019.
As the ECB’s balance sheet has grown to €4.65 trillion, up 117% since early 2015 to equal 30% of full-year 2017 European GDP (the Fed’s balance sheet represents 21% of 2017 U.S. output by comparison), both sovereign and corporate credit spreads collapsed as investors basked in the warm glow of a non-economic buyer of first, middle and last resort.
The European Central Bank asset purchase program, visualized (sovereign bonds in blue, corporate in yellow, asset-backed securities in green and covered bonds in red). Source: ECB website
At the sovereign level, there is ample evidence that Super Mario’s exertions have thus far produced their desired effect. For instance, five-year Portuguese credit default swaps are quoted at 94 basis points and trade at an 80 basis point-premium to triple-A-rated Germany; that compares to 362 basis points and a 335 basis point spread over German CDS in early 2016. Triple-B-minus rated Portugal’s 10-year yield stands at 1.8%, down from north of 4% in early 2016.
But thanks in large part to the recent risk spasm, the pancake-like corporate spreads stemming from the ECB’s benevolent stewardship have widened. As Bloomberg notes this morning, the Bloomberg Barclays European Investment Grade Corporate spread has widened to nearly 150 basis points, up from just 73 basis points earlier this year to return to its levels seen at the commencement of corporate-bond purchases in early 2016.
The selloff in corporate bonds has erased what was one of the most noteworthy securities prices of the modern era. The Dec. 15, 2017 edition of Grant’s shined a spotlight on double-B-plus-rated Telecom Italia S.p.A., which last year achieved the seemingly impossible as its 3.25 notes of 2023 rose above 111 cents on the euro, sending the yield to a double-take inducing 0.95%. As that TI note carries not only the credit risk inherent in a sub-investment grade rating but also offered a virtually zero real yield when accounting for inflation (Italian CPI rose 0.9% year-over-year in December 2017), Grant’s termed the sub-1% yielding TI issue a kind of “inverse museum piece,” referencing the description for particularly attractive fixed income securities that have been rendered cyclically defunct.
Sure enough, the recent re-rating of corporate credit has put an end to that anomaly (or abomination), as the 3.25s of 2023 have declined to 101.5 cents on the euro, for a yield-to-worst of 2.78% and 320 basis point spread over the benchmark. In mid-November, the company fired CEO Amos Genish, the third time that TI has changed its top executive in the past two years.
What sort of unintended consequences might stem from Draghi’s monetary adventures? The March 25, 2016 edition of Grant’s featured commentary from a publicity-shy London correspondent, who had some observations and some questions about the ECB’s mission to lower borrowing costs to bottom-scraping levels:
While Draghi’s latest trick may be notched up as another success by the technocrats of Brussels and Frankfurt, one wonders if Mario should be quite so eager to please the markets. After all, at some point this debt will need to be refinanced.
Will the ECB still be expanding its balance sheet in 2020, to help peripheral issuers fund at near the same interest cost as their German counterparts? And if so, will the same accommodation be tendered for the next maturity and for the one after that? Even the universe, we are told, cannot expand forever.
The ECB may give it a go, to judge from past communiques. Shortly after the commencement of QE, ECB governing council member Vitas Vasiliauskas displayed no lack of confidence in the abilities of his fellow central bankers. In a May 2016 interview with Bloomberg, Vasiliauskas remarked:
People say the ECB is done, their box is empty. But we are magic people. Each time we take something and give it to the markets – a rabbit out of the hat.
Recap Dec. 3
Stocks ripped higher once again following a seemingly-successful round of U.S./China trade discussions over the weekend, as the S&P 500 rode a 1% rally to close within 5% of its September highs while the NYSE FANG+ Index jumped nearly 3% to narrow its post-June losses to less than 16%. Commodities were also well bid, with WTI crude ripping above $53 a barrel for its best single-day showing since June while gold gained nearly 1% to settle at $1,230 an ounce.
While the equity and commodity markets partied, the Treasury curve continues to flatten as the 2- and 5-year yields have virtually converged at 2.83% (they briefly inverted during the today’s session), while the 2- and 10-year spread cratered by 5 basis points to just 15, the narrowest since 2007.
- Philip Grant
Friday, November 30, 2018
Mobile command
Will Uncle Sam sign off on the proposed merger between T Mobile U.S., Inc. and Sprint Corporation,
Will Uncle Sam sign off on the proposed merger between T Mobile U.S., Inc. and Sprint Corporation,
Game of Monopoly
“There are now more indexes than stocks,” blared a May 2017 Bloomberg headline.
“There are now more indexes than stocks,” blared a May 2017 Bloomberg headline.
Recap Nov. 30
Mobile command
Will Uncle Sam sign off on the proposed merger between T Mobile U.S., Inc. and Sprint Corporation, the nation’s third- and fourth-largest wireless operators?
On Wednesday, an association of 14 organizations including the American Antitrust Institute, Common Cause, Consumer Reports and the Rural Wireless Association sent a letter to incoming House Judiciary and Energy & Commerce ranking members Jerry Nadler and Frank Pallone to express concerns and urge new hearings on the pending deal. The consortium asks the congressmen to ensure “stronger antitrust enforcement, protecting consumers, promoting competition, and standing up for American workers.”
Meanwhile, the Capitol Forum reported on Nov. 15 that the Department of Justice has been investigating allegations that T Mobile was “retaliating against regional carriers critical of the company’s proposed acquisition of Sprint. . . [by refusing] to discuss roaming and other agreements that would allow the carriers’ mostly rural customers to use the T-Mobile wireless network when they travel, the sources said.”
For more on Sprint and its majority owner, SoftBank Group Corp., see the freshly-published Nov. 30 edition of Grant’s.
Game of Monopoly
“There are now more indexes than stocks,” blared a May 2017 Bloomberg headline. Yesterday, John C. Bogle, Wall Street legend and founder of passive investing mainstay the Vanguard Group, blew the whistle on his wildly-successful creation. Bogle penned an opinion piece in The Wall Street Journal calling attention to the rapid growth of the passive investment industry, one he pioneered by introducing the Vanguard 500 Index Fund in 1976.
As Bogle recounts, that initial offering was an epic flop, as the targeted $250 million initial public offering instead raised $11.3 million, “falling a mere 95% short of its goal.” Forty-two years and a couple investment cycles later, and it’s a different story indeed: The Vanguard 500 Index has seen assets under management swell to $431.5 billion as of Oct. 31, while the low-cost investment “exposure” offered by passive and general underperformance of active management strategies have helped foster an industry sea change. The Vanguard founder explains:
Equity index fund assets now total some $4.6 trillion, while total index fund assets have surpassed $6 trillion. Of this total, about 70% is invested in broad market index funds modeled on the original Vanguard fund.
Yes, U.S. index mutual funds have grown to huge size, with their holdings doubling from 4.5% of total U.S. stock market value in 2002 to 9% in 2009, and then almost doubling again to more than 17% in 2018.
If historical trends continue, a handful of giant institutional investors will one day hold voting control of virtually every large U.S. corporation. Public policy cannot ignore this growing dominance, and [must] consider its impact on the financial markets, corporate governance, and regulation. These will be major issues in the coming era.
Bogle’s warning is perhaps the starkest yet, considering his unique role in ushering in the modern era of indexation.The question before the house: Is a change in government policy needed to curtail the passive behemoth, or might investors unwind the logjam themselves? Kevin Duffy, principal at Bearing Asset Management, is of the latter belief. Duffy tells Grant’s:
After 10 years of everything going in the same direction, extrapolation is the order of the day. But market forces work to prevent trees from growing to the sky.
While passive investing has a cost advantage over active investing, the indexation movement is still subject to the general laws and flaws of the investment business. Perhaps most importantly: its customers tend to act in herds and make poor decisions at major turning points. Some 257 ETFs own Apple, more than any other stock. Passive investors have heavy exposure to the winners, notably large cap technology.
At the beginning of the bull market, the FAANG companies spent $6 billion on annual R&D. Today that figure is $94 billion, or 20% of all private R&D spending. These companies have mostly picked the low hanging fruit, have their fortunes tied more to the economy (increasingly, they are the economy) and are competitively bumping into each other. These stocks went from 3% of the S&P 500 to 12% at their peak a couple of months ago, a significant driver of outperformance. After AMZN and AAPL reached $1 trillion valuations, how can these stocks not underperform over the next decade? That is what will likely derail the passive bubble: its own success.
Just as faith in market forces is lost, those forces seem to come out of nowhere and exert themselves. It wasn’t long ago that the antitrust police thought Microsoft would rule the world. . . yet Google came out of nowhere. Similarly, people wired for intervention feared Japan Inc. during the late 1980s (Donald Trump being one of them, see the March 1990 Playboy interview) and felt that drastic measures should be taken. No surprise then, that Japan has been replaced by the new economic bogeyman, China.
Recap Nov. 30
Stocks rose again, capping a terrific week for the bulls as the S&P 500 jumped nearly 5% to reach the midpoint of its fall trading range. Treasury yields dropped again, with the 10-year closing just above 3%, while a rally toward fresh 52-week highs in the Dollar Index helped push WTI crude back below $51 a barrel.
- Philip Grant
Thursday, November 29, 2018
Just a billion
From the South China Morning Post:
From the South China Morning Post:
Plumber's crack
QT Progress report
Recap Nov. 29
Just a billion
From the South China Morning Post:
The founder of Shenzhen-based Gionee, a Chinese smartphone brand on the verge of bankruptcy, has admitted he may have used company assets to gamble at a Hong Kong-listed casino in Saipan, but denied a reported loss of 10 billion yuan ($1.4 billion), saying it was only a fraction of this amount.
“I did participate in gambling in Saipan, but how could I possibly lose that much? If it is true, shares of Imperial Pacific [the casino owner] should have surged,” Liu Lirong, Gionee’s chairman and chief executive, said in an interview with Securities Times in Hong Kong at the weekend, responding to recent reports that his gambling loss of 10 billion yuan had resulted in the collapse of Gionee.
When asked how much he lost gambling, Liu told the Securities Times reporter, “a bit more than 1 billion yuan.”
Who makes dumb phones?
Plumber's crack
A strong bounce in the bond market. Since logging an interim high of 3.23% on Nov. 8, the 10-year Treasury yield has declined in 12 of the past 14 sessions, ticking below 3% today for the first time since mid-September. Dovish language from the Fed chairman Jerome Powell hinting that interest rate hikes could wrap up sooner than later catalyzed the latest move in rates.
But while the benchmark Treasury yield flutters lower, interbank borrowing costs continue to jam higher. Three-month Libor jumped by more than 3 basis points this morning, the second-largest move of the year, to 2.738%. That’s up from 1.7% at year-end and 0.7% in summer 2016, when the 10-year yield made its cyclical low of 1.36%.
Cartoon From the April 20, 2018 edition of Grant’s
What’s driving the sharp increase in bank-to-bank lending rates? As noted by Alexandra Harris of Bloomberg, the Fed’s ongoing balance sheet runoff (see below) may be playing a role. Excess banking reserves footed to $1.66 trillion as of last week, well off the $2.67 trillion peak reached during the QE-era.
U.S. excess banking reserves. Source: The Bloomberg
The burden of tightening monetary conditions is not one equally shared, as foreign banks have accounted for about half of the drop in reserves. Non-domestic banks are using commercial paper borrowings to help fill the dollar funding gap. Foreign financial commercial paper outstanding currently stands at $308 billion, just off the record $314 billion seen at the end of October and well above the five-year average of $256 billion.
Bloomberg’s Harris concludes: “Should overseas banks continue to bear the brunt of the decline in reserves, they will have to seek out alternative sources for short-term financing.”
One bank is certainly paying up for funds. Today, Italy’s UniCredit S.p.A. sold $3 billion in five year senior non-preferred dollar bonds, with Robert Smith of the Financial Times reporting that Pimco LLC bought the entire offering at a yield of 7.83%. That’s a 493 basis point premium over Treasurys and 420 basis points over the so-called mid-swap benchmark reference rate.
In January, triple-B-minus rated UniCredit issued €1.5 billion in euro-denominated five year notes at a 1% coupon and just 70 basis points over mid-swaps. Those 1% notes, issued at just under par, have since declined to 91 cents on the euro for a yield-to-worst of 3.27%, dealing investors a quick 8% (€120 million) unrealized loss after factoring in accrued interest.
While UniCredit faces its own particular problems, including an outsize portfolio of non-performing loans (a sale of dubious debt to Pimco and Fortress earlier this year took its NPLs below 20% of total loan book according to the bank), and the sharp recent rise in Italian sovereign yields, other European banks should pay heed.
For his part, UniCredit CEO Jean Pierre Mustier struck a victorious tone, telling the Financial Times: “We wanted to show we had access to the market in large size. And by doing such a large transaction with a single investor, it also conserves the capacity for new transactions.”
New transactions at what price?
QT Progress report
The Fed’s portfolio of securities held outright dropped by $8 billion this week to $3.91 trillion, following a $26 billion decline during the holiday-shortened prior week, as Treasurys and mortgage-backed securities each comprised about half of the aggregate $34 billion decline over the past two weeks.
Since QT got underway on Oct. 1, 2017, total assets on the Fed’s balance sheet have declined by 8.1%.
Recap Nov. 29
Stocks drifted sideways, with the S&P 500 maintaining a 4% gain for the week that has narrowed the recent drawdown to 6.5% off the broad index’s Sept. 20 highs. Treasury yields were bid across the curve, with the 10-year outperforming as the two- and 10-year spread narrowed 21.5 basis points, less than three basis points from the flattest of the post-crisis era in August.
Commodities caught a modest bid while the Dollar Index finished unchanged, and the VIX held near 19.
- Philip Grant
Tuesday, November 27, 2018
Door busters
It’s a buyers’ market in the Big Apple. A reader alerts Grant’s to a broker email:
I have 32 apartments left to sell at 550 Vanderbilt. On this Sunday (December 2nd) we will have a 1-day, 20% OFF SALE from 11am – 4pm.
We will be doing previews by appointment only from Wednesday – Friday.
Big River
Power up. On Nov. 16, the Republic of Tajikistan debuted its prize $3.9 billion Rogun hydroelectric power plant on the Vakhsh River in the southern end of the country, as the first of six turbines went online. Upon completion at the dam’s projected 335 meter height, it will become the world’s tallest. Agence France-Presse reports that the fully-functioning power plant will double Tajikistan’s energy output, “alleviating a long-lasting, debilitating national energy deficit.”
The dam may be partially up and running, but the tiny central Asian nation (2017 GDP per capita: $801, per the World Bank) faces an uphill climb toward realizing its goals. Construction on the Rogun dam initially began in Soviet-era 1976 before being abandoned. Rogun is also being built “in a highly seismic area, and several geologic studies have warned about the risks of building such a large dam in this setting,” Dr. Filippo Menga, lecturer in human geography at the U.K’s University of Reading, told the AFP.
It’s not just the geography that’s potentially unstable. In December 2016, the Tajik government was obliged to borrow $490 million (more than 20% of that year’s state budget according to Reuters) from the local central bank to bail out the country’s four largest banks, which had seen bad loans balloon to 58.7% of their total book as of Sept. 30, 2016. Three months later, EurasiaNet, citing Tajikistan’s Radio Ozodi, reported that local prosecutors were investigating lending practices at the institutions, with an unnamed source explaining that “some banks have been known to accept doors, windows, cows and other livestock as collateral for credit, immaterial of whether the customer was ever likely to be able to repay the debt.”
Production and financial red flags aside, intrepid investors were all too eager to fund the ambitious project. Last September, single-B-minus (“adverse business, financial, or economic conditions will likely impair the obligor's capacity or willingness to meet its financial commitments on the obligation”) rated Tajikistan sold $500 million in senior unsecured 10-year dollar bonds, at a yield of 7.125% and 506 basis point spread over Treasurys. That yield was down from an initial projection of 8%, as a $4 billion order book left the deal oversubscribed by eight times, according to the Financial Times.
Just over one year later, those bonds have declined in price to 88 cents on the dollar, for a par yield of 9.36% while the spread over Treasurys has widened to 639 basis points.
Tajikistan is not the only recently issued speculative-grade sovereign bond to suffer swift unrealized losses. The single-B-rated Republic of Ghana’s 8.63% senior unsecured dollar bonds of 2049, sold in May at a 550 basis point spread over Treasurys, last changed hands at under 85 cents on the dollar for a 10.25% yield-to-maturity and a 693 basis point spread. The single-B-plus rated Republic of Kenya issued senior unsecured 7.25% dollar bonds due in 2028 in February at a 434 basis point spread; that issue has retreated to 87 cents on the dollar, priced to yield 9.33% and a 637 basis point spread.
While frontier-market debt represents one kind of overt risk, a different sort of investment hazard lies closer to home. In September 2017, the double-A-plus-rated Republic of Austria sold 2.1% bonds maturing in 2117 at a 23 basis point premium over French soverigns due in 2066. Those century bonds have since been bid to 112 cents on the euro, now priced to yield 1.84% and a 2.4 basis point premium over the French issue maturing nearly 50 years earlier. Meanwhile, Austrian CPI rose by 2.2% year-over-year in October, bestowing upon bondholders a real yield of negative 36 basis points.
With 99 years left until maturity, Austria’s ultra-patient creditors are soon facing the loss of a price-insensitive ally: The European Central Bank is widely expected to announce a taper of its QE bond buying regime at its Dec. 13 meeting, with ECB president Mario Draghi again hinting as much during a speech in Brussels on Monday.
Recap Nov. 27
A relatively stable day for asset prices saw the S&P 500 reverse early losses to finish slightly in the green, extending yesterday’s bounce from the interim lows reached Friday. Treasury yields ticked slightly higher, while WTI crude managed to inch toward $52 a barrel despite strength in the greenback, as the Dollar Index approaches its 52-week high.
While stocks and bonds largely treaded water, interbank borrowing costs made another lurch higher as three-month LIBOR finished the day just under 2.71%; that’s up from 2.32% in September and 1.7% at year-end 2017.
- Philip Grant
Monday, November 26, 2018
China chalet
Two ships in the night. As investor attention turns toward the highly anticipated meeting between Donald Trump and Xi Jinping later this week at the G20 meeting in Argentina, a sea change in borrowing costs has taken place: For the first time since at least 2000, the yield on the one-year Treasury bill (2.58%) now exceeds its Chinese equivalent (2.5%). As recently as June, Chinese one-year sovereign debt out-yielded the U.S. by more than 100 basis points, at 3.37% compared to 2.32% stateside. In a research note last week, Bank of Montreal strategist Jon Hill wrote that the declining Chinese yields “should put further depreciation pressure on the renminbi, which would serve as a disinflation force domestically.”
Sovereign rates may be coming down in the Middle Kingdom, but that’s been no help to the encumbered property developers. Last Monday, Times China Holding Ltd. issued two-year dollar bonds at a 10.95% coupon; just 10 months ago, the same company was able to pay only 6.25% on three-year notes. Peer Agile Group Holdings Ltd. was obliged to pay a 9.5% coupon on two-year dollar denominated notes on Nov. 15, up from 8.5% for three-year paper issued in July. China Evergrande Group, featured in the June 2, 2017 edition of Grant’s, was forced to pay 11% for two-year dollar bonds last week. That compares to an 8.75% yield on eight-year bonds issued in June (those notes have fallen to 80.25 cents on the dollar for a yield-to-worst of 13.35%). Overall, Bloomberg highlights that the property developer-heavy ICE BAML Asian dollar China corporate Index now carries a near 12% yield, the highest since 2015.
The pain is not confined to the developers. Formerly acquisitive conglomerate HNA Group Co. Ltd., which went on a $40 billion corporate shopping spree between 2015 and 2017, has recently been forced to turn tail and sell assets in hopes of remaining solvent. Last Tuesday, FinanceAsia Daily made note of an instructive recent transaction:
One recent sale highlight’s HNA’s desperation. On Nov. 19, BrightSphere Investment Group, an asset management firm listed on the New York Stock Exchange, announced that Paulson & Co., a hedge fund controlled by U.S. investor John Paulson, had agreed to buy HNA’s 24.95% stake in the group.
BrightSphere said that the stake would be sold for around $371 million. Given that HNA paid $446 million for its stake in the asset management firm only 18 months ago, this equates to a loss of roughly $75 million for HNA.
In a possible swipe at the Chinese conglomerate, BrightSphere chairman James Ritchie said: “The transfer of shares to a respected institutional investor such as John Paulson will bring the clarity of ownership which is positive for all our constituencies.”
FinanceAsia Daily goes on to note that while HNA has managed to so-far trim its debt load by 10.7% in the six months ending in June, the company still sports a towering leverage ratio of more than 21 times total debt to EBITDA as of June 30.
With cash hard to come by, some of HNA’s subsidiaries are getting creative. On Nov. 14, Bloomberg reported that Qianhai Air & Shipping Exchange “is offering tickets from [fellow HNA units] Hainan Airlines or Grand China Air to repay what it owes. . . the flights can be for both domestic and international travel and are valid for five years.”
Recap Nov. 26
A strong bounce in stocks left the S&P 500 higher by 1.6% at day’s end, recouping a chunk of last week’s ugly 3.7% decline, while the NYSE FANG+ Index gained nearly 4% but still remains in bear market territory, 21% south of its June peak. The Dollar Index reversed early losses to finish in the green, but energy managed to catch a bid anyway with WTI crude ticking back to $51.50 a barrel.
Treasury yields finished higher across the board, with the 10-year settling at 3.06%. The VIX sank by more than 12% to finish below 19, its second-lowest close in more than two weeks.
- Philip Grant
Wednesday, November 21, 2018
Sturm und Drang
It’s no breaking news that Denmark’s largest financial institution, Danske Bank A/S, is mired in disrepute after being caught up in money laundering scandal involving some €200 billion flowing through its Estonian subsidiary. More topical is the allegation, levelled yesterday by whistleblower Howard Wilkinson in Danish Parliament, that Germany’s largest lender Deutsche Bank A.G. had served as correspondent for Danske Bank, helping to process as much as €150 billion in dubious payments.
On this side of the pond, Bloomberg reports today that Deutsche Bank’s efforts to mitigate risk and improve performance via the creation of a so-called central risk book for its positions have instead led to some $60 million in losses. Culprits for the misadventures include “issues with the CRB’s technology. . . the CRB may also have become too big to manage properly.”
Then, too, brisk management turnover continues apace at DB, with co-head of structured credit Armin Rothauser leaving the bank two weeks ago to “pursue other opportunities,” according to an internal staff memo cited by Bloomberg. Back in April, CEO John Cryan was dismissed “followed months of conflict on the management board and indecision on the supervisory board over whether to replace him,” per The Wall Street Journal. Chief operating officer Kim Hammonds departed soon after.
The drumbeat of dour news is taking a toll, as the New York-listed DB shares yesterday finished at an all-time low of $9.23 a share (they were listed in 2001). That’s down from $20 in December of last year and $45 in early 2014. European money center bank peers have likewise been weak, but not to the same extent; shares of Credit Suisse Group A.G., BNP Paribas S.A. and Barclays PLC are all hovering at or near their lowest levels since mid-2016.
But the alarming erosion in Deutsche Bank’s equity value has yet to make much of an impression on the rest of the A3/triple-B-plus rated bank’s capital structure. The senior unsecured 1.5% notes of 2022 last traded at just over 99 cents on the euro, while five-year DB credit default swaps currently fetch about 173 basis points, down from the interim highs of 184 basis points seen in July.
That relative resilience extends to the debt securities toward the bottom of the capital structure; i.e. junior unsecured contingent convertibles, or CoCo bonds. These regulator-approved securities (they are considered Tier 1, or “core” capital) glean their name from their convertibility to equity at the bank’s discretion, rather than investor's, as would be the case in a conventional convertible. The Bank for International Settlements describes the merits in a 2013 paper:
CoCos are hybrid capital securities that absorb losses in accordance with their contractual terms when the capital of the issuing bank falls below a certain level. Then debt is reduced and bank capitalization gets a boost. Owing to their capacity to absorb losses, CoCos have the potential to satisfy regulatory capital requirements.
The DB 6% perpetual CoCo bonds, issued in 2014, currently trade just under 90 cents on the euro for a yield-to-call of 9.59%. That’s not so far off their five-year average price of 94.3, slightly above the early July provisional lows and well north of the February 2016 nadir of 71.
DB 6% CoCos in white, vs. DB share price in orange. Source: The Bloomberg
Does the divergence between Deutsche Bank’s slumping equity value and still-presentable credit performance signify bullish opportunity, or ominous indicator of trouble ahead? Investors and regulators alike should bear in mind that the convertibility feature embedded in the CoCo bonds may serve as a source of something other than stability and market confidence, were they to be exercised. The July 11, 2014 edition of Grant’s noted that:
Conversions or write-downs, when they’re finally forced, won’t take place under wraps. The news will start a highly focused reassessment of the creditworthiness of the stricken CoCo issuer or issuers. Providers of short-dated liabilities – certificates of deposit, uninsured deposits, commercial paper – are likely to arrive at the same conclusion more or less simultaneously.
Deutsche Bank is currently leveraged at about 22 times equity capital as of Sept. 30, north of Credit Suisse’s 18 times but below BNP’s ratio of 24 times assets to capital. DB’s return on equity footed to negative 3% in the last quarter, by far the worst of those four major European banks. The derivatives book, with a notional value of €48.3 trillion according to the 2017 annual report, is four times last year’s Eurozone GDP of €12.6 trillion.
CoCo beware.
Tuesday, November 20, 2018
Tipping point
For the first time since 2008, high-yield and investment-grade Bloomberg Barclays benchmark indices priced in both euros and dollars are poised
For the first time since 2008, high-yield and investment-grade Bloomberg Barclays benchmark indices priced in both euros and dollars are poised
Recap Nov. 20
Tipping point
For the first time since 2008, high-yield and investment-grade Bloomberg Barclays benchmark indices priced in both euros and dollars are poised to finish the year in the red. Across the spectrum of securities, the balance of power seems to be shifting from sellers back to buyers, if a trio of recent developments are any indication.
Strange occurrences in the desert: Last night, The Wall Street Journal reported that Saudi Aramco has decided to shelve a proposed $40 billion corporate-bond offering that would have been utilized to fund a majority-stake purchase of Saudi Basic Industries Corp. Public outcry over the murder of U.S.-based journalist Jamal Khashoggi may have helped hinder demand, as may the precipitous recent oil price decline. But The Journal also notes that Aramco “is now worried about the level of disclosure required for a bond issue.”
Post Holdings, Inc. (POST on the Nasdaq) yesterday announced the offering of $400 million in convertible preferred shares, before cancelling the proposed deal later in the day. The company, chaired by capital allocation whiz Bill Stiritz, noted that management terminated the “entirely opportunistic” capital raise attempt after not finding the terms to its liking.
Post, a Grant’s pick-to-not-click in the Sept. 16, 2016 issue, has instead seen its share price flutter toward all-time highs despite missing earnings estimates in each of the last three quarters (Post shares are up 21% since publication, tracking the S&P 500s 23% advance). The bond market has been a bit more circumspect. Over the past two months, the senior unsecured 5s of 2026 have seen their spread over Treasurys widen to 384 basis points from 275, outpacing the 96 basis point spread widening in the iShares iBoxx High Yield ETF. Single-B-plus-rated Post currently carries net debt of 5.6 times consensus adjusted EBITDA for the fiscal year ending Sept. 30, 2019.
Then there’s Elon Musk’s vehicle to the cosmos. Yesterday, Space Exploration Technologies Corp., or SpaceX, downsized its proposed leveraged loan offering to $250 million from the initial target of $750 million, according to Bloomberg. Beyond the smaller size, pricing on the deal has firmed at 425 basis points above Libor, at the wide end of the 400-425 basis point price talk, while investors likewise managed to fortify loan covenants concerning “the definition of earnings,” according to Bloomberg. Earlier this month, Bank of America replaced Goldman Sachs, which served as lead underwriter for the IPO Musk’s Tesla, Inc. in 2010, as lead marketer for the deal.
This afternoon, The Washington Post reports that NASA will next year commence a review of SpaceX, “prompted by the recent behavior of SpaceX’s founder, Elon Musk, according to three officials with knowledge of the probe, after he took a hit of marijuana and sipped whiskey on a podcast streamed on the Internet.”
Issuers had the distinct upper hand not so long ago. In July, the French subsidiary of single-B-rated telecom conglomerate Altice Europe N.V. managed to upsize its eight-year term loan to $2.5 billion from $2 billion at a price of 400 basis points over Libor. The company’s interest expense footed to €2.5 billion ($2.2 billion) over the 12-months ended June 30, nearly double the €1.4 billion in operating income expected by the Street this year.
In November, the former Valeant Pharmaceuticals International, Inc. (now Bausch Health Companies, Inc.) upsized an eight-year senior note offering to $1.5 billion from $1 billion at 275 basis points over Libor. Use of proceeds for that bond deal was a tender offer for three separate issues maturing in 2020. At the time, credit analysts noted that “the company’s very high exposure to patent losses over the next two years” will render “its product pipeline insufficient to offset revenue and EBITDA declines in the next 12 to 18 months.”
And finally, Musk again. In August 2017, Tesla sold $1.8 billion (upsized from $1.5 billion) in eight-year senior notes at a 5.3% yield and 320 basis point spread over Treasurys. The newfound Tesla creditors were the beneficiaries of an unexpected five basis point premium from the indicated 5.25% yield, a change that Reuters reported “was a company decision to ‘sweeten the deal.’” Those notes have since fallen to 86.5 cents on the dollar, with the spread over Treasurys ballooning to 506 basis points and the yield-to-worst climbing to 7.93%.
Mr. Market has decided to further sweeten the deal.
Recap Nov. 20
Stocks fell sharply for a second day, with the S&P 500 extending its loss for the week to 3.4% to finish just under 10% below its Sept. 20 closing price.
It wasn’t tech this time as the primary culprit (the NYSE FANG+ Index kept pace with the broad market) but rather energy and retail, with another ugly leg lower to $53 a barrel in WTI crude and a rudely received earnings report from Target Corp., (TGT on the NYSE) supplying much of the damage. After an 11% decline today, Target shares are down more than 20% in just seven sessions, nearly erasing TGT’s year-to-date gains.
Elsewhere, Treasury yields generally finished little changed, although rising yields on the short end and declining yields on the long end left the curve notably flatter. Cryptos were pummeled again with bitcoin cash falling 32%, while that analogue crypto called gold fell slightly to finish near $1,222 an ounce as the dollar remains near a 52-week high. The VIX rose to 22.5, its highest close since Oct. 30.
- Philip Grant
Monday, November 19, 2018
Bailout brigade
Somebody will have to pay. California’s devastating wildfires have knocked the capital structure of utility PG&E Corp. (PCG on the NYSE) for a loop, as shares are down by 51% since Nov. 9, while the senior unsecured 6.05% bonds due 2034 have slumped to 94.5 cents on the dollar from 107.2 over that same period.
The company faces massive potential liability after reporting an outage near the location of the so-called Camp Fire, the deadliest in California history. On Friday afternoon, PCG filed an incident report disclosing the failure of a second transmission line on Nov. 8, the morning that the fire began. No definitive conclusions have been reached about the cause of the fire.
Nevertheless, analysts are sounding the alarm. Stephen Byrd at Morgan Stanley writes in a research note today that: “The key risk is that the regulator (and potentially the legislature) would seek greater asset coverage for wildfire-related damages extending beyond the value of the electric utility.” The ratings agencies are following suit. On Thursday evening, both Moody’s and S&P downgraded PCG’s credit ratings; Fitch did the same Friday.
Last week, the company drew down the entirety of its $3.3 billion bank revolving credit facility, an indication of financial distress, or of management’s determination to avoid it. PG&E credit default protection prices have gone parabolic:
PG&E Corp. five-year credit default swaps. Source: The Bloomberg
While the Golden State works to recover and PCG shareholders and creditors scramble to assess the damage, local regulators are primed to ride to the rescue. In an interview with the San Francisco Chronicle on Thursday evening, California Public Utilities Commission president Michael Picker implied that preserving the utility’s commercial well-being was a primary goal for the agency:
They need to be financially healthy to be able to provide those goods and services that ratepayers need. If they can’t borrow money, if they have liquidity problems and they can’t do vegetation management, that’s a problem. That’s not good policy, to really let them get financially unstable.
Recently passed legislation recognized the importance of financially healthy utilities to California’s electric customers, and implementing it quickly is important to achiev[ing] that goal.
In a follow-up interview with The Wall Street Journal, Picker reiterated his opinion, noting in paraphrased remarks that the regulator: “preferred that PG&E not enter into bankruptcy because it could raise its cost of borrowing, which could end up raising energy costs for its customers.”
That news was certainly welcomed by PG&E investors, as shares snapped higher by 37% on Friday. However, one prominent Silicon Valley venture capitalist takes issue with Picker’s logic, telling Grant’s:
They don't want energy costs for customers to rise, so the regulator is going to, do what exactly? Securitize claims against PG&E and pass them onto customers?
I guess if you give an implicit government underwriting, like with home loans, the cost of capital of PG&E will be lower. But if you do so by having liabilities fly past equity and debtholders and straight to either customers, or CA residents – effectively the same thing – is that really saving them money?
Open those wallets, Californians.
Recap Nov. 19
Stocks slumped to the tune of a 1.7% decline on the S&P 500, while tech was splattered with the NYSE FANG+ Index sinking 4.3% and Facebook, Inc. shares losing another 6% to reach a 52-week low, down 40% in less than four months. Crypto continued its descent, with bitcoin falling to $4,800, down from $6,400 just 10 days ago.
Elsewhere, Treasurys finished mostly stronger, with the 10-year yield easing to 3.06%, its lowest since early October. Commodities were able to buck the ugly market action as the CRB Index staged an intraday rebound with WTI crude and gold finishing at $57.50 a barrel and $1,223 per ounce, respectively. The VIX rose by 10%, closing just above the 20 mark.
- Philip Grant
Friday, November 16, 2018
Supply managment
Things are heating up a bit on the speculative end of the credit spectrum.
Things are heating up a bit on the speculative end of the credit spectrum.
Chip which
Crypto’s doppelganger indeed.
Crypto’s doppelganger indeed.
Supply managment
Things are heating up a bit on the speculative end of the credit spectrum. Over the past week, the BarCap U.S. Corporate High Yield 10-Year Spread has jumped to 403 basis points over Treasurys, up from 309 basis points on Oct. 3 and the widest spread since late 2016, although still well below the early 2016 interim wides of over 800 basis points.
Meanwhile, floating-rate leveraged loans have seen a similar downside probe, with the S&P/LSTA Leveraged Loan Price Index sinking to its own post-2016 low of 97.81, down from 98.7 on Oct. 6. Then again, the recent move is small potatoes compared to the late 2015/early 2016 shakeout, when the index plunged below 90.
Investors are positioning for more downside: As identified by David Sherman, founder and president of Cohanzick Management and paid-up Grant’s subscriber, short interest in the iShares iBoxx High Yield Corporate Bond ETF has surged recently to nearly 60% of the shares outstanding. That’s up from just over 30% this summer.
What gives? Sherman notes that while the HYG short is certainly crowded as a percentage of shares outstanding, the high frequency of trading in the ETF renders the short interest ratio (or the number of shares sold short divided by average daily volume) somewhat muted. That metric currently sits near four days to cover, well off its interim high of more than six earlier this year. On this matter, Sherman asks: “What if volume dries up? It’s going to increase volatility, and potentially drive a wider disparity between the underlying cash market and the ETF.” The portfolio manager concludes: “I have more questions than answers.”
As for the fundamental picture, Marty Fridson, chief investment officer at Lehmann, Livian, Fridson Advisors LLC notes a potential catalyst for short sellers: The concentration of credits just above junk-status that might be vulnerable to downgrade (see also the Oct. 20, 2017 edition of Grant’s). Fridson advises Grant’s by email:
The story for this cycle is the expansion of the BBB sector, with the notion that it will generate a massive wave of fallen angels that the high yield market won’t be able to absorb, driving high yield valuations much lower.
My take is that high yield bear markets are always ugly and it will be hard to tell, even after the fact, how much uglier it was this time around because of that big contingent of BBBs.
To that point, a recent report from Fitch Ratings identifies formerly triple-A, now triple-B-plus-rated General Electric as a candidate to substantially change the composition of the U.S. credit market. Fitch relays that GE’s massive debt burden represents about one-tenth of the entire $1.2 trillion junk market, were it to be downgraded.
Chip which
Crypto’s doppelganger indeed. Yesterday evening, chip maker and subject of a June 29 Grant’s bearish analysis Nvidia Corp. (NVDA on the Nasdaq) surprised the street with third quarter results featuring a top line of $3.18 billion and adjusted gross margins of 61%, both shy of the consensus $3.24 billion and 62.8% estimates. What’s more, the chip-maker projected fourth quarter revenues of just $2.7 billion, well below the $2.91 billion achieved last year and the $3.4 billion analyst consensus. Investors who had bid NVDA to an average 46 times price-to-earnings ratio over the last four quarters reacted with predictable scorn, sending shares lower by 17% intraday.
The earnings miss came despite management’s best efforts: While third quarter sales registered year-over-year growth of just over 20%, accounts receivable bulged by more than 90%.
Jen-Hsun Huang, founder and CEO of Nvidia, cited “excess channel inventory post the crypto-currency boom” as a primary culprit for the shocking miss. The numbers bear that out. Inventories footed to $1.41 billion for the quarter, up more than 65% year-over-year.
Notable too, is the shift in Huang’s storyline. On August 16, the CEO had this to say about the ebbing tide in bitcoin and its peers:
It is the case that we benefited in the last several quarters from an unusual lift from crypto. In the beginning of the year, we thought and we projected that crypto would be a larger contribution through the rest of the year, but at this time we consider it to be immaterial for the second half.
Yesterday, Huang was asked what changed and struck something of a different tone:
We were surprised, obviously. I mean, we're surprised by it as anybody else. The crypto hangover lasted longer than we expected. . . we didn't realize the magnitude of it until towards the end of the quarter.
Thursday, November 15, 2018
Delinquent youth
On Tuesday, Pennsylvania-based regional bank Customers Bancorp, Inc. (CUBI on the NYSE) announced it would restate
On Tuesday, Pennsylvania-based regional bank Customers Bancorp, Inc. (CUBI on the NYSE) announced it would restate
Bad dream
Crypto awoke with a start yesterday,
Crypto awoke with a start yesterday,
QT Progress report
Recap Nov. 14
Delinquent youth
On Tuesday, Pennsylvania-based regional bank Customers Bancorp, Inc. (CUBI on the NYSE) announced it would restate financial results for 2017 and the first half of this year. The problem stems from commercial mortgage loans that had been “incorrectly classified as held for sale instead of held for investing on the consolidated balance sheets,” according to the company’s SEC filing, resulting in a material weakness in internal controls.
Customers, a recipient of a Grant’s bearish analysis on Dec. 11, 2015 on account of rapid growth (total assets nearly tripled in the three-years ended Dec. 31 2015, to $8.4 billion) and accompanying underwriting quality concerns, has seen its fortunes turn. While total assets of $10.6 billion are little changed year-over-year, the stock now trades at 85% of book value, compared to nearly 160% at publication time.
CUBI’s misadventures aside, the credit environment appears solid. According to the Federal Reserve, credit card charge-off rates held at 3.65% in the second quarter (the most recently available data), up from 2.91% in the fourth quarter of 2015 but about in line with the seven-year average rate of 3.59%. Commercial and industrial loan portfolios have been nothing short of pristine, with a 0.27% charge-off rate in the second quarter sitting below the 0.40% seven-year average. In aggregate, a net 0.48% of all loans were written off in the second quarter, down from an average 0.69% over the past seven years, according to data from the FDIC.
Grant’s asked Christopher Whalen, publisher of the Institutional Risk Analyst and recent guest of the Current Yield podcast (advt.) about the outlook for U.S. banks. Whalen expects that high prices and rising borrowing costs will take a toll despite a relatively benign credit environment.
As rates rise, borrowers will be forced to roll over their debt and we should see some more distressed situations begin to emerge. Cash flows are stretched and asset prices are crazy, but underwriting is relatively solid. Lenders have no pricing power and are forced to compete on price, which will keep future returns muted.
Meanwhile, one month does not a trend make, but this afternoon Citigroup, Inc. reported that credit-card charge-offs jumped by nearly 10% sequentially in October, to 2.63% from 2.42%.
Bad dream
Crypto awoke with a start yesterday, as relatively stable price action in bitcoin since late October was replaced with a lurch lower in the largest digital currency, taking bitcoin below $5,500 for the first time this year on heavy trading volume. Bitcoin’s peers suffered similarly intense declines.
20-day chart of bitcoin. Source: The Bloomberg
What spurred the abrupt downdraft? Crypto news site Modern Consensus reports that the bulk of trading volume during the selloff took place on the Bitfinex exchange, and follows a Sunday announcement from Bitfinex of a 3% wire withdrawal fee for those cashing out more than twice over a 30-day period or for more than $1 million in aggregate withdrawals over the same 30 days. That’s up from a previous fee of zero, and no doubt aggravated many crypto HODLers.
On Nov. 9 Coindesk published an account detailing the difficulties that various crypto users have encountered in attempting to withdraw funds from Bitfinex:
“I am still waiting for my money – 17 business days after the event,” one customer, Jamie West, told CoinDesk Wednesday. “They even had the cheek to charge £309 for 24-hour express service,” he added.
One user, who asked to remain anonymous, shared screenshots of an email exchange with Bitfinex support, showing that they’d begun a withdrawal on Oct. 3. This user received a message from customer service, saying the money had been sent to a payment processor on Oct. 15.
Yet when asked if they’d received their money on Tuesday, the person told CoinDesk: “Not yet. Still waiting for a response.”
As for alternative explanations for the recent price decline, the quantity of bitcoin available to be mined is famously capped at 21 million. Yet the supply-constrained crypto keeps splitting in two, with bitcoin cash (itself the result of last year’s “fork,” or split, from the original bitcoin into a pair of crypto currencies) today breaking into a pair of new cryptos called bitcoin ABC (or “core bitcoin cash”) and bitcoin SV (for “Satoshi’s Vision”). That follows the Oct. 24, 2017 formation of bitcoin gold and the Feb. 28 debut of bitcoin private, both resulting from hard forks of their own.
QT Progress report
Virtually no change for a second straight week, as the Fed’s portfolio of securities held outright registered at $3.943 trillion, down $1.8 billion from a week ago. This week’s reading sits $15 billion below the trailing four-week average, and represents a 6.95% decline in the Fed’s total asset base since QT began on Oct. 1, 2017.
Recap Nov. 14
Stocks finished higher by 1% on the S&P 500 as rumors of potential progress on the U.S./China trade front continue to percolate. The NYSE FANG+ Index managed to slightly outperform despite a red showing from Facebook, Inc. following today’s New York Times report on the latest unsavory goings-on at the social network (FB is now 18% year-to-date).
Treasury yields ticked lower, with the 10-year dropping below 3.12% after reaching seven-year high of 3.24% a week ago, while another commodity selloff spared the oil patch this time, with WTI crude finishing green for a second straight day at $56.50 a barrel.
- Philip Grant
Tuesday, November 13, 2018
Venture land
Here comes the Son. Yesterday, SoftBank Group Corp. and its irrepressible CEO Masayoshi Son won regulatory approval to list its domestic telecom unit. The IPO, projected to raise about JPY 2.3 trillion ($21.1 billion), will approach Alibaba Group’s (BABA on the NYSE) 2014 global record of $25 billion. This would be par for the course for Son, who was an early, and thoroughly rewarded (on paper at least), BABA investor.
Alec Macfarlane of Breakingviews, who pencils in $23 billion in proceeds from the offering, notes that the projected valuation of nine times forward EBITDA would imply a premium over Japanese peers NTT Docomo, Inc., and KDDI Corp. (six and five times trailing EBITDA, respectively), which both enjoy significantly stronger domestic market share then SoftBank. At the same time, the mobile unit plans to dole out 85% of net profits to shareholder dividends, far higher than the 40% and 50% respective payouts offered by the less-leveraged competition.
Son has plans for the money. In September, the SoftBank boss told Bloomberg Businessweek that he intends to raise a new $100 billion fund to complement the existing $92 billion Vision Fund “every two or three years,” while spending $50 billion a year. That compares to a total $75.3 billion in venture capital industry spending in 2016, according to the National Venture Capital Association.
This is manna for Vision Fund portfolio company WeWork Cos., which has become the largest office space tenant not only in Manhattan (Almost Daily Grant’s, Oct. 10), but also the largest private occupant in Washington, D.C. and London, according to a company press release. Today, WeWork announced it has raised an additional $3 billion from SoftBank via a warrant that values the co-working company at a minimum of $42 billion, up from $20 billion in August of 2017. Artie Minson, president and COO of WeWork, said that getting additional funds from SoftBank is a relative snap: “They have two board seats. You can go through a very quick process with them given they’re inside seeing all the momentum we have.”
Momentum is the word. By comparison, publicly-traded commercial real estate services firm CBRE Group, Inc., which was founded in 1906 and generated $19.4 billion in revenue and $1.1 billion in adjusted net income over the 12-months ended Sept. 30, sports a market capitalization of $14.5 billion. Through the first three quarters of this year, WeWork reports a loss of $1.22 billion, on sales of $1.25 billion.
Gaudy valuations and grand plans aside, the jury is still out on both SoftBank and WeWork. The SoftBank euro-pay 3 1/8s of 2025 currently trade near 93.5 for a yield-to-worst of 4.27%, a pretty penny considering the negative interest rate policy contrived by the ECB’s Mario Draghi. WeWork’s 7 7/8s of 2025 likewise trade well below par, last printing just above 94 cents on the dollar for a yield to worst of 9.04%. Meanwhile, shares in Masa Son’s golden ticket, Alibaba, are going the wrong way, down by 30% since June. Recall that in April, SoftBank took out an $8 billion margin loan backed by its 28.8% stake in BABA.
For an in-depth analysis of the house that Son built, see the Dec. 15, 2017 edition of Grant’s.
Recap Nov. 13
No bounce today, as the S&P 500 gave back early gains to finish flat after yesterday’s tumble, while oil prices went into full-on liquidation mode with WTI sinking by nearly 8% to $55 a barrel, its biggest one-day drop since September 2015 and a record 12th-straight decline. On the bright side, the energy sector of the S&P held up relatively well, sinking by “just” 2.5%.
Elsewhere, Treasury yields jumped lower across the board following yesterday’s holiday, with the 10-year settling just under 3.15%, while high yield continues to struggle with the iShares iBoxx High Yield ETF falling for a 5th straight day to remain near its post 2016 election levels. The CRB Commodity Index finished nearly 2% in the red thanks to oil, while the Dollar Index also traded lower. The VIX held steady near 20.
- Philip Grant
Monday, November 12, 2018
Going south
Investors are learning the hard way to expect the unexpected in Mexico.
Investors are learning the hard way to expect the unexpected in Mexico.
Recap Nov. 12
Going south
Investors are learning the hard way to expect the unexpected in Mexico. Today, Mexican financials dropped by nearly 5% while the peso lost more than 1% against the greenback. The culprit: Senators of the Morena party advancing a proposal to cap various banking fees including ATM withdrawals. That follows the October decision by incoming president Andrés Manuel López Obrador, or AMLO, to scrap construction of a partially-completed airport near Mexico City after a referendum showed that citizens opposed the project (Almost Daily Grant’s, Oct. 29).
For his part, AMLO explained the state of play in a press conference following the airport cancellation, saying: “It’s evident from now on there is a clear division, a frontier between economic power and political power.”
Mexico’s fast-changing political environment may be throwing Wall Street for a loop, but the incoming government’s plans for state owned oil company Petróleos Mexicanos, or Pemex, may have the largest impact for investors. Recall that in August, The Wall Street Journal reported that AMLO plans to suspend oil auctions for at least two years, a stance seemingly consistent with the president-elect’s 2013 proclamation that: “Oil is the property of the nation. I am convinced that privatizing petroleum. . . betrays the country.”
The prospect of Mexico halting oil exports is a concerning one for the rating agencies, as Moody’s on Oct. 18 wrote that such a development would be “credit negative to both Pemex and to the government’s credit quality.” Fitch Ratings went a step further on Oct. 19, cutting its sovereign credit outlook for Mexico to “negative” from “stable,” thanks in large part to the prospect of diminished revenues from Pemex under the AMLO government’s plans:
Proposals for large capital investments by state-owned oil company Pemex, whose balance sheet and standalone creditworthiness have been under pressure, add to the growing risk related to contingent liabilities for the sovereign.
Pemex, which was founded in 1938 via the confiscated assets of foreign oil companies then operating in Mexico, is a fixture of the world bond market, with MXN 2.01 trillion ($103 billion) in net debt outstanding. It is the biggest corporate debt issuer within the iShares J.P. Morgan USD Emerging Market ETF (EMB is the ticker on NYSE Arca), accounting for nearly 3% of the fund’s holdings.
Pemex also featured as a pick-to-not-click from the March 23 edition of Grant’s. Declining production, a massive pension liability, negative free-cash flow position and a near 8:1 leverage ratio when factoring in the pension funding shortfall are among the corporate sins. John Padilla, partner and managing director at energy consulting firm IPD Latin America, summed it up to Grant’s: “Pemex in any private sector context would absolutely be considered bankrupt.”
Since publication of that analysis, the market has priced in a bit more trouble at the oil giant, as five-year credit default swaps have risen to 250 basis points from 185 basis points in March, while the Pemex senior unsecured 4 7/8 notes of 2024 have declined to 94.6 cents on the dollar from 101 at publication time, with the spread over Treasurys widening to 307 basis points from 199 basis points just under eight months ago.
That’s not to say that investors have abandoned the evident object of AMLO’s desire. On Oct. 16, Pemex sold $2 billion in 10-year dollar bonds priced to yield 6.5%, an offering that was nearly six times oversubscribed. In response, Pemex issued a statement that was particularly notable in what was left unsaid:
With this deal, our cash level for the end of 2018 has been strengthened and we guarantee the company’s liquidity for the start of 2019.
Recap Nov. 12
It was an ugly session, as the S&P 500 slumped by 2% with momentum stocks taking a big hit as the NYSE FANG+ Index lost more than 4%. The dollar broke to a 17-month high on the broad DXY Index, news that was not well received in the commodity complex as the CRB reversed early gains to close red for a third straight day.WTI crude continues to plumb to depths, finishing below $59 a barrel. The VIX jumped by 17%, closing above 20.
Meanwhile, the bond market was closed for Veteran’s Day but the iShares iBoxx High Yield Bond ETF got hit hard, finishing at its lowest in an even two years.
- Philip Grant
Friday, November 9, 2018
Ham and wry
Covenant-lite, with Chinese characteristics.
Covenant-lite, with Chinese characteristics.
Steady as she goes
The knives are out in the energy patch.
The knives are out in the energy patch.
Recap Nov. 9
Ham and wry
Covenant-lite, with Chinese characteristics. From Bloomberg:
A Chinese company has come up with an innovative way to placate creditors - as long as they like ham. Chuying Agro-Pastoral Group Co. said holders of 271 million yuan ($39 million) of its debt have agreed to take ham or pork gift packages instead of interest payments, according to a filing on the Shenzhen Stock Exchange on Thursday.
“Payment in kind becomes PIH (Pay In Ham)," said Owen Gallimore, head of credit strategy from Australia & New Zealand Banking Group.
Nice. We might have gone for “Payment-In-Swine” however.
Steady as she goes
The knives are out in the energy patch. Since reaching $76 a barrel on Oct. 3, the price of West Texas Intermediate crude has been in veritable free-fall, completing its record 10th straight red finish today and trading below $60 this morning to officially enter bear market territory. That pullback has narrowed the advance of so-called Texas tea to 24% since March 2017, compared to a 3% gain in the CRB Commodity Index.
Supply concerns are front and center. According to the Department of Energy, total U.S. crude oil inventories registered 431.8 million barrels last week, up 5.78 million barrels sequentially and the seventh straight weekly increase. The Energy Information Administration reports that domestic production reached 11.3 million barrels per day (mbpd) in August, a higher than expected figure that has spurred the EIA to raise its 2019 production forecast.
Meanwhile, crude production among the Organization of the Petroleum Exporting Countries has risen in each of the past five months, with October’s 33.3 million barrel-per-day pace the highest since late 2016 and well above the five-year average of 31.9 mbpd (the cartel is set for a ministry-level meeting this weekend in Abu Dhabi). Russian output is similarly on the upswing, reaching a post-Soviet era-high of 11.41 mbpd in October. There is more where that came from, according to a Wednesday dispatch in the Financial Times. Barring an agreement with Saudi Arabia, Russia is set to ratchet up its output by an additional 300,000 bpd by early next year, and “is said to be hesitant at this stage to agree to cuts,” per the FT.
Demand prospects are likewise working against the bulls, as the International Monetary Fund cut its global GDP growth forecasts for 2018 and 2019 in early October. Subsequently, OPEC and the International Energy Agency each trimmed their respective 2019 demand forecasts a few days later. Colin Fenton, managing partner at Blacklight Research, connects the dots between those guestimates and the recent price move in an analysis published yesterday:
Oil traders watched these reactions and thought they saw common judgement rather than cascading cause and effect. The projections for slower growth in 2019 seemed to match present observations of rising crude oil inventories. . . So, oil traders registered their change in expectations by selling into weakness.
All of this begs a rather important question: why, exactly, did the IMF downshift its 2019 GDP forecasts on Oct. 2? Wait for it. . .yes, the IMF explains that one of the key drivers was “the improved outlook for oil prices.”
The sudden anxiety about growth is most likely overblown. We continue to expect fresh highs for spot oil prices looking out over the next 18 months.
As for the apparent supply bulge that has helped catalyze the pullback, natural resource investors and confirmed oil bulls Lee Goehring and Adam Rozencwajg believe that fundamentals are far less bearish than recent price action would suggest. From the Goehring and Rozencwajg third quarter commentary:
Global inventories peaked at a record 4.7 billion barrels in July of 2016 (420 million barrels above the 10-year average) and have fallen steadily since. Today they stand at 4.4 billion barrels, only 30 million barrels above the 10-year average. Never have inventories fallen this far in such a short period of time.
Looking into 2019, our models suggest global inventories will continue to experience unanticipated drawdowns throughout the year.
Grant’s, bullish on oil since the March 10, 2017 issue, continues to cast our editorial lot with Blacklight and Goehring and Rozencwajg in expectation of higher prices ahead.
Recap Nov. 9
Stocks finished weaker for a second straight day, shaving this week’s advance to 2.2% on the broad S&P 500. The greenback remained bid with the Dollar Index testing fresh 52-week highs, an unwelcome development for commodity investors as the CRB Index fell to a 10-week low.
Treasury yields were bid across the curve, with the 10-year slipping back below 3.2%, little changed for the week. Nevertheless, interbank borrowing costs grind inexorably higher. Three-month Libor rose above 2.6%, up from less than 2.3% in March and 1.41% one year ago.
Three-month Libor, five-year chart. Source: The Bloomberg
- Philip Grant
Thursday, November 8, 2018
No shirt, no shoes, no problem
The economy is booming.
The economy is booming.
QT progress report
Recap Nov. 8
No shirt, no shoes, no problem
The economy is booming. Unemployment is at its lowest level since the late 1960’s according to the Bureau of Labor Statistics, while GDP growth has remained robust with an average 3.3% annualized increase so far this year. Meanwhile, the stock market remains near record highs and wage growth looks to be finally breaking out of a protracted slump after a 3.1% year-over-year jump in average hourly earnings in October.
But those facts have been no help to quick-service restaurants. On Tuesday alone, Red Robin Gourmet Burgers, Inc. (RRGB on the Nasdaq) and Tex-Mex chain Chuy’s Holdings, Inc. (CHUY on the Nasdaq) both reported weaker than expected third quarter revenues and offered full-year earnings guidance well below the analyst consensus. Fiesta Restaurant Group, Inc (FRGI on the Nasdaq) saw its shares fall 28% after missing third quarter EPS estimates, and Wendy’s Co. (WEN on the Nasdaq) surprised analysts by reporting its first decline in North American same-store sales since 2011.
What’s troubling the industry? Commentary from the c-suite provides a glimpse. RRGB’s chief financial officer Guy Constant noted that margins suffered as an increased proportion of sales came from the Tavern value menu. Steven Hislop, CEO at Chuy’s, highlighted rising costs, explaining that “our third quarter was a challenging one as we continue to face industry wide labor cost pressures, which negatively impacted our restaurant-level profitability.” The fourth quarter isn’t off to a great start, either according to FRGI CFO Lynn Schweinfurth, who told listeners on the call that: “In October, we did see a deceleration in terms of traffic across both Florida and Texas, fairly consistent with the industry [heavy rains in Texas likely played a role].”
But perhaps the most notable bit of commentary came from Wendy’s CEO Todd Penegor, who said that current conditions aren’t all they’re cracked up to be:
If you look at the economy in total, there's a lot of great tailwinds, right? We're seeing almost 10 years of economic recovery, we're seeing lowest unemployment levels in a long time, high consumer confidence, and median household [income is] at record levels. But as you look at that income growth, it's skewed significantly to higher income households. You do have workforce participation remaining well below pre-recession levels. And real wage growth is still not accelerating to the extent that we had all hoped for.
And on the low end, you start looking at folks with rent and healthcare costs starting to rise. . . we've got about 40% of our customer base that makes $45,000 or less.
John Hamburger, president of the Restaurant Finance Monitor, tells Grant’s that while rising labor costs have eroded profitability and strained operations, the benefits conferred by higher wages can be narrowly distributed:
The “strongest labor market in 50 years” means that many fast food restaurants can’t locate an adequate supply of workers to fully staff the restaurants. A lack of workers and high turnover hurts restaurant output. I was talking with a quick serve district manager a few weeks ago and he told me how understaffed he was during the previous weekend. He told me he could have done more business but his crew was incapable of high production. Another example: A quick serve restaurant by my office usually has someone taking the cash at one window and the other window dispenses the food. Now they are operating just one window because of a lack of staff.
And, finally, when people have money in their pocket, they tend to move up the scale in terms of the quality of the restaurant. That might explain why quick serve is suffering and some casual dining has shown somewhat of a renaissance.
Perhaps crystalizing the industry’s struggle is bellwether supplier and Grant’s pick-to-not-click (June 17 and Dec. 23, 2016) Middleby Corp., (MIDD on the Nasdaq) which furnishes the appliances and equipment used across the food service industry, and is having its own problems.
Yesterday, MIDD reported third quarter revenues of $713 million, short of the $723 million consensus, while gross margins shrank to 36.6% from 38.5% year-over-year “reflect[ing] lower margins on recent acquisitions.” A bevy (eight since December 2017) of recent such purchases, including a $1 billion cash deal in May for equipment maker the Taylor Company, helped goose MIDD’s top line by 20.3% (organic revenue growth totaled just 40 basis point year-over-year), but at the cost of a substantial jump in leverage. Net debt now stands at $1.88 billion, up from $866 million, pushing Middleby’s leverage ratio to 3.3 turns from just under 1.6 at this time last year.
QT progress report
No change this week. The Fed’s portfolio of securities held outright registered at $3.974 trillion, a $37 million rounding error above last week’s level. But thanks to the large run-off at the end of October, today’s reading remains $25 billion below the trailing four-week average.
Since the Oct. 1, 2017 onset of QT, the Fed’s total balance sheet assets are down by 7%.
Recap Nov. 8
Another big drop in the oil patch left WTI below $61 a barrel for the first time since March and hammered the energy sector to the tune of more than 2%, which helped drag the S&P 500 to its first red finish of the week. Treasury yields again rose more briskly at the short end to continue the recent curve compression, as the 5- and 30-year spread settled at 33 basis points, down from 42 basis points on Friday.
This afternoon, the Federal Reserve left the funds rate unchanged, as expected. Interest rate futures currently price 74% odds of a rate hike at the next meeting on Dec. 19, up from 71% a week ago.
- Philip Grant
Wednesday, November 7, 2018
Out from the cold
Swiss luxury brand Hublot is launching a new line of watches with an unusual twist.
Swiss luxury brand Hublot is launching a new line of watches with an unusual twist.
Surprise!
Now, this is passive.
Now, this is passive.
Recap Nov. 7
Out from the cold
Swiss luxury brand Hublot is launching a new line of watches with an unusual twist. The flourish comes not from a new complication on the dial, but, rather, the mode of transaction. As a celebration of the crypto-currency’s 10-year anniversary, only bitcoin will be accepted as payment for the $25,000 (that’s in fiat currency) timepiece.
CEO Ricardo Guadalupe told Bloomberg: “We can do something different. We will give the possibility to buy all our watches with cryptocurrencies in the future by the end of next year, after offering a second exclusive series.”
For some crypto enthusiasts, one thing is definitely different about this deal: Bloomberg notes that Hublot will partner with Hong Kong-based digital asset brokerage OSL to: “perform background and anti-money-laundering checks.”
Surprise!
Now, this is passive. Today, biotech firm MiMedx Group, Inc. announced that its shares will be delisted from the Nasdaq, sending the price lower by 40% and extending the year-to-date loss to 70%. The company last filed financials on Oct. 31, 2017 and announced in June it will need to restate five years of results, and noted today that its efforts will extend beyond the exchange’s Feb. 25, 2019 deadline to remain listed. MiMedx will not appeal Nasdaq’s decision, and will begin trading over-the-counter tomorrow.
The problems at MiMedx are well aired, and include the termination of CEO Parker H. Petit and chief operating officer Bill Taylor for cause this summer, a compensation claw back of four senior executives allegedly involved in misconduct and an ongoing investigation from a number of government agencies including both the Justice Department and Securities and Exchange Commission. The short interest currently stands at a whopping 60% of the float.
Not that MiMedx’s largest shareholders even noticed that the company hasn’t filed a 10-Q in more than a year. The top three holders, BlackRock, Inc., State Street Corp. and Vanguard Group, Inc., combine to control more than 28% of shares outstanding according to data from Bloomberg. Those passive behemoths have allocated MiMedx shares across nearly 100 funds ostensibly designed for a wide array of strategies, including the SPDR Portfolio Total Stock Momentum ETF, the iShares Core S&P Small Cap ETF, the Vanguard U.S. Factor Value ETF, among many others.
Pre-eminent short seller and vocal MiMedx bear Marc Cohodes tells Grant’s that the presence of those large passive holders who may know little to nothing about the individual stocks they hold can serve to artifically extend the life of such questionable enterprises as MiMedx:
The whole problem with indexation is that there are no adults at the switch. The focus of index firms is on advertising and asset gathering, rather than compliance or even simple adult supervision. This situation would never have gone on so long without the unwitting help of passive investors.
What will become of the MiMedx shares held by those passive funds? A search through the relevant prospectuses yields no mention of procedure when an underlying company faces delisting. Calls to Vanguard, BlackRock and State Street yielded no definitive answers by publication time, beyond a blanket statement from State Street that they “follow the rules as designed” by the relevant index.
Nevertheless, the passive train keeps rolling, as Pension & Investments magazine reports that total worldwide index fund assets under management jumped 13% to $13.37 trillion in the year-ended June 30, while passively managed U.S. equity assets rose by 16%, to $6.42 trillion over the same period. For context, the market capitalization of the Wilshire 5000, which tracks all listed U.S. equities, currently stands at $28.5 trillion according to the Federal Reserve Bank of St. Louis, while total worldwide equity market capitalization stood at just over $79 trillion at year-end 2017 according to the World Bank.
Advises Cohodes: “People need to know what the hell they’re in.”
Recap Nov. 7
Stocks surged, with the S&P 500 gaining more than 2% to extend its seven-day rebound to 6.5% and recoup roughly two-third of the peak-to-trough October decline. Treasury yields mostly climbed higher with the short end leading the way and the 30-year bond the positive outlier to push the curve flatter, while another soft day for commodities saw WTI crude fall to $61.5 per barrel.
The VIX, which had held near 20 through the recent rally in stocks, finally crumbled today to the tune of a 17% decline.
- Philip Grant
Tuesday, November 6, 2018
Night rider
Move over, motorists.
Move over, motorists.
Ships in the night
Uncle Sam may be drowning in red ink, but local government balance sheets continue to improve.
Uncle Sam may be drowning in red ink, but local government balance sheets continue to improve.
Recap Nov. 6
Night rider
Move over, motorists. Last week, Alphabet, Inc.’s (formerly Google) Waymo unit received regulatory permission to test fully self-driving automobiles on public roads in the Silicon Valley area of California. To soothe any fears over the safety implications of driverless beta-testing, the company released a statement:
Waymo has been testing self-driving cars for almost a decade, and we have developed extensive knowledge and expertise in gathering data and designing tests to evaluate safe performance. Safety is at the core of Waymo’s mission and everything we do, and we are committed to educating the public and working closely with policymakers to inform them about our technology and the rigorous processes we’ve put in place to test it.
However, California will have to take this on faith. The New Yorker reports that in 2011, then-Google employee Anthony Levandowski took a self-driving company Prius on a non-regulatory-approved highway jaunt, running a Camry off the road in the process.
The Prius regained control and turned a corner on the freeway, leaving the Camry behind. Levandowski and Taylor didn’t know how badly damaged the Camry was. They didn’t go back to check on the other driver or to see if anyone else had been hurt. Neither they nor other Google executives made inquiries with the authorities. The police were not informed that a self-driving algorithm had contributed to the accident.
Levandowski, rather than being cowed by the incident, later defended it as an invaluable source of data, an opportunity to learn how to avoid similar mistakes.
Today’s present-day testers will likewise encounter no shortage of variables. To that end, researchers at the Massachusetts Institute of Technology have performed a comprehensive online study of more than 2 million respondents from 233 counties in service of developing global consensus about what a self-driving vehicle might do in a sticky situation. Peter Dizikes from the MIT news office explains:
To conduct the survey, the researchers designed what they call “Moral Machine,” a multilingual online game in which participants could state their preferences concerning a series of dilemmas that autonomous vehicles might face. For instance: if it comes right down to it, should autonomous vehicles spare the lives of law-abiding bystanders, or alternately, law-breaking pedestrians who might be jaywalking? (Most people in the survey opted for the former.)
The listed results follow. Canines, felines and scofflaws, avert your eyes:
Source: MIT
In a comprehensive look at self-driving technology from the April 21, 2017 edition of Grant’s, John Adams, emeritus professor at University College London, argued that residential areas present a particularly stiff challenge:
To enable Uber without drivers – these vehicles will have to offer a door-to-door service in urban areas. In such areas autonomous vehicles will encounter many sacred cows, other road users to which they have been programmed to defer. . . The problem of deferential paralysis has yet to be addressed.
Consumers are wary. According to another MIT study conducted in May 2017, 48% of respondents said they would never purchase a full-self driving auto, with the most common reasons including: “discomfort with the loss of control. . . not trusting the technology, a disbelief that it would be robust enough to rely on exclusively, and a feeling that self-driving cars are unsafe.” What’s more, the number of respondents aged 25-34 who said they would be “fully comfortable” in fully autonomous vehicles plunged to 20%, down from 40% in the prior year’s survey (then again, a poll of buggy owners circa 1900 may have revealed similar ambivalence).
As noted in that 2017 Grant’s analysis; “it’s the human response to the planning that usually trips up the planners.” Jaywalkers may yet be safe a little while longer.
Ships in the night
Uncle Sam may be drowning in red ink, but local government balance sheets continue to improve. That’s the word from Moody’s, which today released its municipal finance ratings revisions for the third quarter showing net upgrades for a fifth straight quarter. In aggregate, 119 issues totaling $34.1 billion in municipal debt were upgraded, while 106 bonds worth just $14 billion suffered downgrades. “Ongoing favorable economic conditions” can explain the pleasant trend, according to the rating agency.
While state and local governments remain on the upswing, one particularly broad measure of corporate stress is showing the opposite. According to data provided by Epiq Systems, Inc., commercial Chapter 11 bankruptcy filings jumped to 554 in October, a 75% increase over the 316 commercial Chapter 11 filings seen last year and 79% higher than the 309 logged in September. Individual Chapter 11 filings rose by 4% year-over-year in October, to 64,175.
Are higher rates disproportionately squeezing certain consumers and businesses? Three-month Libor closed October at 2.56%, nearly double the 1.38% seen on Oct. 31, 2017.
Recap Nov. 6
The bulls notched another win, with the S&P 500 racking up a fifth green finish in six tries to close at its best level in more than two weeks, up 3% year-to-date. Treasury yields ticked higher across the curve, with the 10-year settling at 3.22% despite a stronger than expected $27 billion auction this afternoon, while commodities were hammered again despite an unchanged Dollar Index. The VIX held steady at 20.
- Philip Grant
Monday, November 5, 2018
Slim pickings
Behold, the accommodating credit markets of 2018.
Behold, the accommodating credit markets of 2018.
Something borrowed
A pair of anecdotes, from Bloomberg:
A pair of anecdotes, from Bloomberg:
Evergreen
Is the world’s second-largest economy preparing to once again rev the stimulus engines?
Is the world’s second-largest economy preparing to once again rev the stimulus engines?
Recap Nov. 5
Slim pickings
Behold, the accommodating credit markets of 2018. On Thursday evening, single-B-rated Weight Watchers International, Inc. (WTW on the Nasdaq) offered a rude surprise to shareholders in the form of weaker than expected third quarter results and a poor retention rate, sending shares tumbling by 29% Friday.
One piece of good news: On the earnings call, CFO Nicholas Hotchkin said: “given our financial and balance sheet momentum. . . we may have an opportunity to reprice our $1.5 billion term loan in the near future.”
Indeed, the company’s senior unsecured 8 5/8 notes due in 2025 remain above par, trading most recently at 105.2 cents on the dollar for a yield-to-worst of 7.11% and a 414 basis point spread over Treasurys. That’s down from the 630 basis point premium at issuance last fall.
Something borrowed
A pair of anecdotes, from Bloomberg:
WeddingWire, Inc. is in the debt markets this week, offering more than $600 million of speculative-grade loans to fund its announced take-private transaction of XO Group, Inc., the company behind “The Knot” website.
David’s Bridal, Inc. is making preparations for a bankruptcy filing if the retailer can’t reach an out-of-court deal with its creditors, according to people with knowledge of the matter . . . David’s skipped an Oct. 15 interest payment on its $270 million of 7.75 percent unsecured notes due 2020 at the request of its creditors in order to allow more time to continue negotiations about reworking the company’s debt load.
Evergreen
Is the world’s second-largest economy preparing to once again rev the stimulus engines? Last week, a Politburo meeting chaired by president Xi Jinping concluded with a statement noting that China’s “economic situation is changing, downward pressure is accelerating, and the government needs to take timely steps to counter this,” according to an Oct. 31 dispatch from Bloomberg. Katrina Ell, economist at Moody’s, likewise comments that “accepting slower growth has long been a challenge for Beijing, but now the rate of slowdown is firmly out of the comfort zone.”
Ominous signs are not hard to spot. The renminbi is down nearly 10% against the dollar since April, and growth in the M2 money supply registered at 8.3% year-over-year in September, barely half of its 20-year average. The stock market is also indicating trouble: The Shanghai Composite has lost 19.4% year-to-date and Hong Kong’s Hang Seng Index is down by 13.3%, placing those markets in the 93rd and 83rd spots, respectively, out of 94 markets rated by performance in local currencies, according to Bloomberg.
Beyond potentially discounting an economic slowdown, the stock market’s poor performance could have ramifications in its own right. The Wall Street Journal, citing an analysis from Goldman Sachs, reported on Oct. 24 that nearly 10% of mainland Chinese shares are used as loan collateral, while the sum total of equities pledged for lending has jumped to RMB 4.955 trillion ($690 billion), a seven-fold increase since 2015. Unlike the NYSE’s margin loan, China’s stock borrowing is largely used to fund corporate expenses rather than financial speculation.
Meanwhile, the real estate industry is likewise showing signs of strain, as growth in new home sales slipped to 1% sequentially in September, down from 1.5% in August, according to the National Bureau of Statistics. In Hong Kong, Centaline Mortage Broker Ltd. relays that mortgage applications in September saw their largest sequential decline in 20 years, while Ricacorp Properties Ltd. reports that the month of September also saw the fewest luxury home sales since at least 2005. Anne Stevenson-Yang of J Capital Research summarizes the state of play in an Oct. 23 analysis:
Secondary housing markets in major cities are all but frozen, and transaction growth is in decline. Anecdotally, prices seem to be declining. Both public and private statistical organizations stopped publishing data finally in 2017 after gradually degrading their statistics.
With China’s stock market in retreat and housing market potentially faltering, the property developers could be a useful indicator of broader conditions. Last week, China Evergrande Group (3333 on the Hang Seng) sold $1.8 billion in dollar-denominated bonds, paying yields as high as 13.75% on a five-year tranche. By comparison, the company was able to place senior secured notes at an 8 3/4% coupon last June (those notes currently trade near 82 cents on the dollar for a yield-to-worst of 12.76%). What’s more, chairman and executive director Hui Ka Yan personally bought more than half of the total allotment, a move that the company described as “signify[ing] Mr. Hui’s support to and confidence in the Group.”
The June 2, 2017 edition of Grant’s included a close look at Evergrande, “the world’s most encumbered and possibly most astounding property developer,” which also owns a majority stake in a soccer club as well as a mineral water brand, among other far-ranging business interests. For her part, Stevenson-Yang minced no words:
Evergrande is . . . arguably the biggest pyramid scheme the world has ever seen. Servicing the company’s mountainous debt requires constant new borrowings, and those loans in turn require that the growth continue.
Recap Nov. 5
A relatively calm session saw the S&P 500 finish modestly higher to extend its bounce to nearly 4% above last Monday’s low, despite a 1.5% drop in the NYSE FANG+ Index to leave that gauge of popular tech stocks about 16% off its June highs. The VIX remained green all day, settling just under 20.
The Treasury curve flattened a bit, with the 10-year yield finishing just under 3.2%, while the dollar and CRB Commodity Index both finished little changed.
- Philip Grant
Thursday, November 1, 2018
He said it
Here’s BlackRock, Inc. CEO Larry Fink,
Here’s BlackRock, Inc. CEO Larry Fink,
Bond Street
Let’s call it high-er yield.
Let’s call it high-er yield.
QT Progress report
Recap Nov. 1
He said it
Here’s BlackRock, Inc. CEO Larry Fink, speaking on the apparent murder of Washington Post columnist Jamal Khasogghi. From Bloomberg:
“We don’t know who is responsible for the murder,” Fink said at the New York Times DealBook conference. “Everybody has their own theories.” He didn’t elaborate. Brian Beades, a BlackRock spokesman, declined further comment.
Fink, who runs the world’s largest asset manager, said at the conference that doing business in Saudi Arabia is “not something I’m ashamed of.” He added, “We have not lost any business there,” noting that BlackRock has worked in the kingdom for 15 years.
For a critique of Larry Fink, let’s turn to Larry Fink in his annual letter earlier this year entitled “Dear CEO:”
Indeed, the public expectations of your company have never been greater. Society is demanding that companies, both public and private, serve a social purpose. To prosper over time, every company must not only deliver financial performance, but also show how it makes a positive contribution to society . . . Without a sense of purpose, no company, either public or private, can achieve its full potential.
Bond Street
Let’s call it high-er yield. The recent tumble in asset prices has not spared the lower end of the corporate credit spectrum, as the Bloomberg Barclays High Yield Index sank by 1.6% last month, its weakest one month performance since December 2015 and worst October showing since the 2008 trial-by-fire. That sent the yield-to-worst on junk bonds to 6.87% today from 6.24% on Sept. 28, blowing the spread above Treasurys to 371 basis points from 316 basis points at the end of September. At the bottom of the ratings ladder, the yield-to-worst on the Bloomberg Barclays Triple-C Index jumped above 10% yesterday, its first foray into double-digit territory since January 2017 and up from less than 8% in July.
Rough October aside, the lower end of the credit spectrum has been the place to be. The 0.93% year-to-date return in high yield and 4.3% advance in the iBoxx High Yield Triple-C Total Return Index remains far better than investment grade, as the Bloomberg Barclays Investment Grade Index is down 3.7% since Jan. 1.
Among the factors driving the outperformance: A supply drought. According to Bloomberg, speculative-grade bond issuance totaled $9 billion in October and stands at $160 billion year-to-date, the lowest since 2015 and 2009, respectively. Analysts at Bank of America Merrill Lynch expect full-year issuance to tally $205 billion, down nearly 25% from 2017. By contrast, growing popularity of floating-rate leveraged loans recently pushed the size of that market above high yield bonds for the first time, according to an Oct. 18 report from Bloomberg.
Meanwhile, relatively brisk economic growth and low absolute interest rates have helped keep defaults low, as Moody’s global speculative-grade default rate registered at 2.6% in the third quarter, down from 3.1% in the second quarter and a three-year low. The rating agencies anticipate more of the same, with Moody’s expecting defaults to edge down to 2.5% by year-end and Fitch forecasting a default rate of just 1.5% by the end of 2019. That compares to 5.8% as recently as January 2017, according to Moody’s.
Investors don’t necessarily share that rosy outlook. According to the BAML October Fund Manager Survey, “a record 85% of respondents think the global economy is in the late cycle, 11% above the prior highs of December 2007,” while a “net 38% of respondents expect [economic] deceleration, the worst outlook on global growth since November 2008.”
The question before the house: What will ultimately drive the performance of junk bonds as the calendar turns toward 2019? Martin Fridson, chief investment officer at Lehmann, Livian, Fridson Advisors LLC and “the dean of high-yield” according to Institutional Investor magazine, tells Grant’s that the rough October performance in spite of tight supply shows the limitations of supply considerations on price. Instead, economic conditions are what ultimately drive the performance of the asset class:
In general, short-run returns are a function of changes in underlying fundamentals, with valuations prior to the change not mattering much . . . If the perception increases that a recession is not far off, high yield will do much worse than the major fixed income categories. If investors conclude that a couple more years of decent (by present standards) GDP growth lie ahead, high yield will outperform them, if nothing else by virtue of collecting a bigger coupon.
The reappraisal of economic growth is causing investors to take a second look at money losing enterprises. Since October 12, the single-B-plus-rated WeWork Cos, Inc. senior unsecured 7 7/8% notes of 2025, have fallen to 92.5 cents on the dollar from 98 cents, with the spread over Treasurys jumping to 642 basis points from 531 basis points less-than three weeks ago. That’s nearly quadruple the index-level spread widening over that period. For more on WeWork, see the April 24 edition of Almost Daily Grant’s.
QT Progress report
After weeks of inertia, we got some action this time as the Fed’s portfolio of securities held outright fell to $3.942 trillion, down a hefty $31.5 billion from the prior week’s reading. Treasurys accounted for about three-quarters of the decline, and mortgage-backed securities the balance.
Since the Fed began its QT program on Oct. 1, 2017, total balance sheet assets are down by 7.1%.
Recap Nov. 1
Stocks caught another bid, with the S&P 500 extending its bounce to a 3% gain for the week, while the NYSE FANG+ contingent is up a meaty 11% from Monday’s intraday low. Treasury yields ticked a bit lower, with the 10-year settling just under 3.14%, but interbank lending rates continue to march higher with 3-month Libor jumping to another post-crisis high of 2.58%. That’s up from 1.69% at year-end.
A weak dollar helped the commodity complex, with the notable exception of oil which was hammered again following a Bloomberg report of stronger-than-expected OPEC production in October. WTI settled below $64 a barrel.
After the close, Apple, Inc. reported fourth quarter results featuring weaker-than expected iPhone sales volumes and soft guidance for the upcoming quarter. AAPL shares are down by 5% in the after market.
- Philip Grant
Tuesday, October 30, 2018
No limit hold 'em
The Bank of Japan concludes its two-day policy meeting tomorrow,
The Bank of Japan concludes its two-day policy meeting tomorrow,
Recap Oct. 30
No limit hold 'em
The Bank of Japan concludes its two-day policy meeting tomorrow, but may have already signaled its intentions. Bloomberg reports that the central bank has purchased JPY 867.6 billion ($7.7 billion) of exchange traded funds this month through Oct. 29, its largest outlay since the ETF buying program got underway in 2010 and nearly double the September figure.
A Bloomberg dispatch from Monday underscores the broad scope of the central bank’s strategy:
The BOJ aims to keep the yield on 10-year Japanese government debt around zero percent as it tries to stimulate price growth in the economy by controlling both short and long-term interest rates.
Indeed, during a March committee meeting of the Japanese lower house, BOJ deputy governor Masazumi Wakatabe bluntly declared: “There are no limits to monetary policy.”
On that front, we shall see. The BOJ had already become a top-10 shareholder in 40% of Japan’s listed companies as of late July, according to an analysis by Nikkei, while Japan Macro Advisors pegs the BOJ’s ownership of Japanese Government Bonds at 49% of total supply as of September. According to an Oct. 23 statement of account, the BOJ’s ETF holdings currently stand at JPY 21.7 trillion ($193 billion).
While Japan’s corporate sector increasingly comes under the thumb of governor Haruhiko Kuroda’s central bank and the Japanese government bond market remains in a type of suspended animation, the primary gauge directing the BOJs remarkable monetary exertions remains far from the mark: Tokyo’s core CPI grew by just 1% year-over-year in October, while nationwide CPI grew by 1.2% year-over-year in September (the most recent reading), each far below the 2% “price stability” inflation target that has catalyzed the current monetary stimulus that has been in place since 2016.
The remarkable contortions evident across Japan’s financial landscape, and so-far muted impact on the price level, beg the question of potential outcomes. Keith Anderson, co-founder of BlackRock, Inc., told the assembled throngs at the fall 2017 Grant’s conference that Japan’s massive sovereign balance sheet may be the agent of change. Anderson noted that Japan’s debt service costs remain unchanged from the 1980s despite a six-fold rise in debt, and added that a successful inflation ignition could come with nasty side effects:
Either they’re going to suffer this deflationary situation and never get out of it or, God forbid, they get out of it and create inflation, then you know you’re going to have a massive budget-deficit problem and huge interest costs.
What is the Bank of Japan going to do? I would say that one day, maybe in the next five years, the BOJ is going to announce that all of the debt they hold is forgiven. They will just go bankrupt on themselves.
Back in the present day, the central bank’s interventions have stultified trading activity in the Japanese government bond market, as multiple trading sessions have passed by this year without a single lot of benchmark bond issues changing hands (Grant’s, June 1). The lack of liquidity spurred the BOJ to consider changing the format of its bond purchases, according to a Reuters report yesterday.
Things are drying up on the corporate side as well. According to an Oct. 22 report from Bloomberg, underwriters were unable to fully place 29% of company-issued notes in September, double the six month average. Bloomberg goes on to identify a few of the issuers, including Japan Airlines Co., Japan Tobacco, Inc., Idemitsu Kosan Co. and Honda Finance Co., while noting that “spokespeople for all four companies said that’s not what they were told by the banks.”
Recap Oct. 30
Stocks caught a solid bounce with the S&P 500 rising by about 1.5% to close within 9% or so of its September highs, while a similar rebound in the NYSE FANG+ Index was followed by third quarter results from Facebook, Inc., featuring stronger-than expected earnings per share and weaker-than-expected revenues after the close (FB shares are up by 2% in initial reaction).
Elsewhere, Treasury yields ticked higher across the board to push the 10-year back above 3.11%, while a strong bid in the U.S. Dollar Index coincided with a second straight sharp selloff in the commodity complex, with WTI crude settling near $66 a barrel and gold slumping to $1,223 per ounce. The emerging markets realm likewise looks vulnerable, with both the iShares MSCI Emerging Markets ETF and iShares J.P. Morgan Dollar Emerging Markets Bond ETF both holding near their lows of the year.
- Philip Grant
Monday, October 29, 2018
Pile up
Courtesy of Raoul Pal, co-founder of Real Vision, via Twitter:
What’s the return policy?
Bolso would
There’s a new sheriff in town. Over the weekend, Brazilians elected Jair Bolsonaro, a 63-year old congressman and former army captain known for his far-right leanings and populist rhetoric, as its new president. Bolsonaro, who defeated the left-wing candidate Fernando Haddad by a 55% to 45% margin in the second round of the election on Sunday, seems to enjoy at least provisional approval from investors. After Bolsonaro was stabbed in a campaign event in early September, an event which boosted his popularity, the Bovespa Index has rallied by 13% in nominal terms and 27% in dollar terms. During this period, the iShares MSCI Emerging Market ETF has declined by 7%.
The potential for an improved budget outlook figures prominently the recent run-up in asset prices. In his victory speech, Bolsonaro promised that Brazil “will break the vicious cycle of growing debt,” in place of a “virtuous cycle of smaller deficits, falling debt and lower interest rates.”
In hopes of reining in a budget deficit that footed to 7.19% of GDP at the end of September, the president-elect and his University of Chicago-educated finance minister, Paulo Guedes, will attempt to pass pension reforms. Those budget shortfalls have contributed to rising government debt which is expected to jump to nearly 96% of GDP by 2022 from 87.3% at year-end 2017, according to the World Bank, up from 62.3% in 2014.
Those reforms have proven elusive, as three fifths of congress will need to vote in the affirmative to amend the constitution and pass the reform. A 2016 congressional effort to do so failed, while Bolsonaro’s predecessor Michel Temer was forced to abandon his attempts to overhaul Brazil’s social security system earlier this year.
Luiz Portella, founder at Novus Capital in Rio De Janiero, judges the likelihood of achieving success to be “difficult, but not impossible.” Portella, who is bullish on Brazil, tells Grant’s that “the bar is very low,” for Bolsonaro, coming on the heels of a “bear market in politics” lowlighted by the 2016 impeachment of Dilma Rousseff for corruption, followed by highly unpopular Temer regime and bribery conviction and subsequent jailing of former president Lula da Silva in April.
The bear market in Brazilian politics contrasts with a sunny outlook from investors. Brazil’s Ibovespa trades at 13 times consensus 2018 earnings, well above the 10.9 times for the MSCI Emerging Markets Index, 10.3 times forward earnings fetched by the Shanghai Composite, 8.8 times for Argentina’s Merval Index, and 5.3 times for the MOEX Russia Index. Beyond a premium valuation, Mr. Market is expecting big things; earnings per share within the Bovespa are expected to jump by 75% over the next 12 months, according to estimates tabulated by Bloomberg.
Then, too, the populist factor can produce unwelcome surprises. Today, Mexican asset prices took a dive after incoming president Andr?s Manuel López Obrador, (AMLO for short), scrapped plans to build a $13 billion airport in the Mexico City suburbs after a four-day referendum showed that almost 70% of voters opposed the project. By way of response, AMLO commented: “Our decision is to follow the referendum mandate. The citizen’s decision is rational and democratic.” Last week, AMLO remarked of the project (which is already one-third completed according to Bloomberg): “There won’t [be] macro imbalances, problems with the stock exchange, or devaluations.”
As for Brazil, an Ibope poll conducted in January showed that 14% of respondents answered in favor of pension reform while 44% were opposed. The balance were thinking it over.
Recap Oct. 29
Another wild day saw the S&P 500 lose nearly 4% from intraday peak to trough before a late rally left the broad average in the red by less than 1%, while the NYSE FANG+ Index lost nearly 4%. Treasury yields ticked slightly higher across the curve, while commodities were hammered with WTI crude sinking below $67 a barrel.
- Philip Grant
Friday, October 26, 2018
Recap Oct. 26
Paper trade
From Fox News:
From Fox News:
Wild Turkey
Is the crisis abating in the land of Erdogan?
Is the crisis abating in the land of Erdogan?
Recap Oct. 26
A near-2% selloff in the S&P 500 left the broad average 4% lower for the week and more than 9% off its Sept. 20 highs, but the NYSE FANG+ Index managed to keep pace with the market today despite Amazon.com, Inc. shares losing 8% after reporting disappointing results yesterday evening. That gauge of 10 popular tech stocks finished flat for the week.
A strong rally in Treasurys pushed the 10-year yield to near four-week lows south of 3.08%, while commodities reversed higher amid an intraday downdraft in the dollar. The VIX finished higher by 5% after again remaining in a relatively tight range.
Paper trade
From Fox News:
An extremely rare $1,000 bill described as the “Holy Grail of paper money” has been sold at auction for just over $2 million.
Auction house Stack’s Bowers Galleries sold the unusual bill for $2.04 million on Thursday evening at the 2018 Winter Whitman Expo in Baltimore.
The 1890 Treasury note is dubbed the “Grand Watermelon” on account of the large green zeros on the back of the bill. Major General George Meade, the commander of Union forces at the Battle of Gettysburg, is shown on the bill’s face.
The price appreciation to $2.04 million from $1,000 over 128 years represents a compound annual growth rate of 6.13%. Who said fiat currency doesn’t hold its value?
Wild Turkey
Is the crisis abating in the land of Erdogan? Turkey has been beset by rampant inflation, a plunging lira and yawning current account deficits, but hopeful signs have recently emerged.
On Oct. 17, Turkey managed to sell $2 billion of five-year dollar bonds at a yield of 7.5%, attracting brisk interest as the issue was covered three times over. Luis Costa, strategist at Citigroup, commented: “The ongoing current account adjustment and higher yields seem to have led some investors to take a more constructive look at Turkish assets.”
There is cause for optimism. Turkey’s current account swung into the black in August with a $2.6 billion surplus for the month, a record going back to at least 1992 and the first positive month in three years. That compares to a deficit of $7.8 billion in December. Then, too, the lira has recently stabilized at 5.55 per dollar, well off its August lows of 6.88 to a buck to spur a 24% bounce in the Borsa Istanbul 100 Index in dollar terms over the same period, while the Oct. 12 release of Pastor Andrew Brunson from Turkish custody seemingly opens the door for improved relations with the West.
Those welcome developments aside, things remain dicey, as runaway inflation (CPI rose 24.5% year-over-year in September) has forced the Turkish Central Bank to jam its one-week repo rate to 24%, up from 8% at the beginning of the year. Meanwhile, the 32% year-to-date lira decline against the dollar has put the screws to the corporate sector, which had more than 50% of its debt denominated in foreign currencies as of last year, according to Moody’s. The rating agency cautioned in a Sept. 10 report that the banking system is particularly vulnerable: “Turkish banks pose a risk to the sovereign [credit], as they rely on wholesale funding, particularly in foreign currencies, and corporate financial stress crystallizing on bank balance sheets could impair their ability to borrow from other banks.”
Moody’s warning is brought into relief by an Oct. 2 Bloomberg dispatch, which called attention to an unusual TRY 10.9 billion ($2 billion) subordinated debt sale by a trio Turkish state banks at the end of September:
Speculation [is] focusing on whether assets from the nation’s unemployment fund were deployed to boost the lenders’ capital buffers. The banks haven’t provided many details, saying the sales were private.
State-controlled Turkiye Vakiflar Bankasi TAO sold 4.99 billion liras of Tier-1 notes with a fixed rate coupon payment on a semi-annual basis. Turkiye Halk Bankasi sold 2.98 billion liras in Tier-2 debt and Turkiye Ihracat Kredi Bankasi AS, known as Eximbank, sold 2.9 billion liras Tier-2 debt last week with a 10-year maturity, completing the sale on the same day it received regulatory approval. All three were sold through private placements and yields haven’t been announced.
The large transactions come just before the banks reveal their third quarter accounts, and could be an effort to beef up capital adequacy ratios hit by the lira’s plunge, according to local analysts who asked not to be named, citing the sensitivity of the issue.
Russell Napier, independent strategist and founder of the Electronic Research Interchange, believes the worst is yet to come for the Turkey’s foreign currency borrowers, particularly the banks. Reached by Grant’s this morning, Napier remarked:
We're looking at the tip of the iceberg on massive domestic debt restructuring. It's going to be very bad for banks. Can you run a bank with no capital? If they keep cramming down [i.e. reducing the amount owed to creditors to reflect the fair market value of debt collateral, as described here] on the banks loans, their assets… mmmmm.
Turkey needs $50 to $60 billion annual capital inflows to stabilize the situation and keep current. And I don't think it's going to see that. Behind all of this is rising U.S. interest rates and a rising dollar, which we're likely to see quite a bit more of, I suspect, given today’s [strong] GDP print.
It's a bad time globally for Turkey. There are a long way from sorting out the problem. When I read commentaries, everybody talks about the exchange rate, nobody talks about domestic interest rates. And that's ultimately what crushes your credit structure.
Indeed, the one-month interbank lending rate currently sits at 26.5%, up from 13.6% in March and 8.6% in September 2016.
- Philip Grant
Thursday, October 25, 2018
Recap Oct. 25
Stocks caught a strong bounce, with the S&P 500 rising nearly 2% to narrow its loss for the week to 2.25% while the NYSE FANG+ Index enjoyed a 6% rip, although weaker than expected revenues (both this quarter and guidance) from Amazon.com, Inc. after the bell will surely test the group tomorrow. AMZN shares are currently down 9% in after-hours trading.
Elsewhere, Treasury yields ticked slightly higher across the board with underperformance from the short end pushing the curve flatter, while commodities finished a bit stronger with WTI crude settling near $67 a barrel and gold again holding just above $1,230 an ounce. The rally in stocks did little to dent options volatility, as the VIX fell by a relatively modest 5% to finish near 24.
Till the medicine takes
Leverage cuts both ways. For the latest examples of that truism, we take a closer look at a pair of highly indebted corporate mainstays who are now facing the daunting task of rehabilitating their balance sheets.
First up, Bud Lighter: Beer giant Anheuser-Busch InBev S.A. (ABI on the Belgian stock exchange and BUD on the NYSE), is listing under the weight of some $116 billion in net debt, just under five times consensus 2019 adjusted EBITDA, which largely stems from the 2016 acquisition of SABMiller Plc. for $65 billion (ABI paid a hefty 18 times EBITDA for its rival). This morning, ABI reported weaker-than expected third quarter results, featuring revenue growth of 3.6% and adjusted earnings per share of 82 cents, well short of the consensus estimates of 5% and 98 cents, respectively.
But perhaps the biggest jolt to investors was ABI’s decision to cut its dividend in half from its indicated yield of 5%, a move which will save the beer company $4 billion a year. Chief financial and technology officer Felipe Dutra described the decision in an interview with Bloomberg: “We see the volatility out there and want to be proactive.”
Investors didn’t appreciate that pre-emptive approach, as ABI shares sank by 9%, extending their loss to 27% from February to a fresh six year low. Analysts were likewise nonplussed, with James Edwardes Jones from RBC Europe Ltd. writing: “We can’t remember a more disappointing set of figures. . . Every region missed revenue growth consensus. This is not AB InBev’s finest hour.”
The turnaround won’t take place overnight. Trevor Stirling of Bernstein Research told Bloomberg: “Even with this dividend cut, it will still take AB InBev 3 or 4 years” to whittle its debt load to more manageable levels.
Creditors have at least partially shared in the pain: The ABI 3.65 senior unsecured dollar bonds of 2026 traded below 96 cents on the dollar yesterday for a yield-to-worst of 4.3% and 124 basis point pickup over Treasurys. That’s down from 99.7 cents on the dollar, a 3.4% yield and 75 basis point spread over Treasurys in February.
The Feb. 9, edition of Grant’s, citing ABI’s heavy debt load, relatively aggressive dividend and bottom-scraping yields available to the company’s creditors, concluded: “We judge there is a good chance of operational disappointment, therefore of ratings disappointment. As the market is seemingly willing to admit no possibilities but happy ones, the downside risks are palpable.”
Then there’s AT&T, Inc. (T on the NYSE) the telecom-plus-entertainment behemoth that puts ABI in the shade with a staggering $250 billion of net debt (after accounting for unfunded liabilities and capitalized operating leases), while paying a generous dividend yield that currently stands at 6.6%. Yesterday, AT&T reported third quarter results featuring weaker than expected adjusted earnings per share and an unexpected subscriber loss in its wireless division, sending shares lower by more than 8%, the largest one-day drop since 2002.
While shareholders blanched at the results, Craig Moffett, co-founder of media and telecom research firm MoffettNathanson LLC, wrote in a note yesterday that the quarterly update represented something of a turning point for the company.
AT&T [yesterday] delivered a strong quarter of free cash flow. . . bond investors should be pleased. But we’re equity analysts.
Might Ma Bell follow ABI’s lead and slice its own dividend to help pay down its borrowings? Moffett breaks down the calculus:
AT&T’s dividend is thought to be sacrosanct. But AT&T’s investment grade bond rating actually is sacrosanct. As we noted last quarter, if AT&T is forced to choose between its dividend and its bond rating, well that’s no choice at all.
The bloated balance sheet may be attracting management’s attention, but AT&T’s lenders have likewise gotten a little nervous. The Sept. 22, 2017 edition of Grant’s featured a review of the AT&T euro-denominated 1.8s of 2026, which at the time traded at 101.5 cents on the euro for a 1.6% yield-to-worst and 131 basis point spread over German bunds. Grant’s declared: “AT&T may or may not prove a sturdier credit than, say, the government of Portugal. The company’s 1.8s are priced, almost, as if T were as sturdy as Germany. For the sake of the creditors, it had better be, as the pricing leaves little room for adverse surprises.” Today, those notes have edged to 99.7 cents on the euro, for a yield-to-worst of 1.83% and a 202 basis point spread over bunds.
QT Progress report
The Fed’s portfolio of securities held outright registered at $3.974 trillion, a mere $3.2 billion below the prior reading and representing the fourth straight week of limited progress. Today’s figure is also less than $10 billion below the trailing four-week average. There could be a substantial decline next week; another round of status quo would seemingly imply the Fed is slowing down the portfolio run-off in response to recent market volatility.
Since QT began on Oct. 1, 2017, the Fed’s total balance sheet assets are down by 6.34%.
- Philip Grant
Wednesday, October 24, 2018
Recap Oct. 24
From where you sit
Last week, a pair of Deutsche Bank AG traders were convicted of conspiracy and wire fraud charges
Last week, a pair of Deutsche Bank AG traders were convicted of conspiracy and wire fraud charges
Term paper
It’s a changing of the guard.
It’s a changing of the guard.
Recap Oct. 24
Stocks were hammered to the tune of a 3.1% loss on the S&P 500, erasing the year-to-date gains on the broad index from 9% as recently as Sept. 20. It was worse in tech, with the Nasdaq 100 sinking 4.6% for its worst one-day showing since August 2011 while the formerly high-flying NYSE FANG+ contingent lost 5% to reach the cusp of a bear market, down 19.8% since June.
Treasurys were well-bid, with the 10-year yield settling near 3.11%, as was the dollar, while the CRB commodity Index finished slightly lower and gold edged higher by $2 to $1,232 an ounce. The VIX jumped 20% to finish at 25.
After the market close, Microsoft Corp. and Tesla, Inc. both announced stronger than expected headline results for their respective quarters, sending shares of each higher in immediate reaction.
From where you sit
Last week, a pair of Deutsche Bank AG traders were convicted of conspiracy and wire fraud charges related to the rigging of Libor, the interbank rate which is used to set the value of trillions of dollars of debt instruments around the world.
Reckless and selfish as the defendant’s purported actions may be, their conviction is an opportunity to ponder existential questions. The following is an open-meeting exchange between James Grant and then-Fed Governor Jeremy Stein, as documented in the July 12, 2013 edition of Grant’s:
Q. Good morning, Governor. James Grant of Grant’s Interest Rate Observer. Could you help us understand the economic difference – not the legal one, but the economic distinction – between the private manipulation of Libor, on the one hand, and the public manipulation of markets, on the other, doing business as zero interest rate policy, quantitative easing, Operation Twist, the “portfolio balance channel”? What ever did happen to the price mechanism?
A. You know, that’s a hard question for me to answer, because [laughter] I don’t see the connection between these two whatsoever. I mean, obviously, the Libor set – you know, it is a set of criminal and near-criminal activity, which is a very substantial policy concern. A lot of effort is going into trying to, you know, both reform Libor itself, look at other benchmarks, see if they’re more resilient. That’s a whole set of issues. To be frank, I just don’t see the connection to that and the monetary policy side.
Term paper
It’s a changing of the guard. A recent report from data firm Preqin projects that private equity assets under management will climb to $4.9 trillion by 2023, surpassing the $4.7 trillion managed by the hedge fund industry (hedge funds currently manage $3.6 trillion while private equity controls $3.1 billion, per the report). For his part, Preqin chief executive Mark O’Hare notes that his company’s forecast for private equity asset growth might prove conservative, as it assumes compound annual growth of 8% over the next five years, down from more than 12% annually during the post-crisis period. O’Hare went on to explain the factors behind the p.e. proliferation, namely “proven long-term performance,” and “the growing opportunities available in private debt.”
Private debt investors are certainly used to taking risks by participating in p.e.-sponsored deals. The Wall Street Journal, citing data from S&P Global’s LCD unit, reports that just under 13% of leveraged buyouts carry net debt above seven times EBITDA through the first nine months of the year, more than double the proportion of high-debt deals brought to market in 2017.
So called add-backs, or the increasingly common practice of counting prospective future cost savings at the portfolio company as pro-forma profits, figure prominently. LCD likewise reports that while 8% of merger-backed leveraged loans have carried leverage ratios in excess of seven times this year, well below 2007’s high water mark of 17%, that figure jumps to 17% when removing the hoped-for cost savings baked into the sponsor’s projections, compared to 19% in 2007.
That rising leverage has caught the attention of the ratings agencies. According to a recent study by Moody’s, 92% of private-equity backed firms rated by the agency since 2009 have debt rated at B2 (five notches below investment grade) or worse, well above the 40% of non-p.e.-backed issuers. Julia Chursin of Moody’s attributes the gap to “p.e. firms’ focus on shareholder returns and high leverage,” and warns that the “ratings of p.e.-backed companies do not bode well for them when the economy turns.”
That isn’t to say private equity holds a monopoly on issuing less-than-conventional M&A debt. Today, Bloomberg reports on United Natural Food, Inc.’s attempt to finance its acquisition of supermarket chain SuperValu, Inc. To amp up the sales effort, lead investment bank Goldman Sachs Group, Inc. made some creative changes to the structure in order to attract hedge funds who were positioned for credit distress in the to-be-acquired SuperValu.
With the United Natural Foods deal, the key was in restoring the value of roughly $470 million of net credit default swap wagers linked to SuperValu debt. The cost of those derivatives had plunged through this year on worry that the acquisition would eliminate the debt being insured.
By tweaking the loan documents to make SuperValu a co-borrower on the new debt, Goldman sparked a surge in the value of those swaps. That, along with several other concessions, helped the bank fill its order book for the loans, the people [familiar with the matter] said. It also may have saved bankers from having to offer deeper concessions that would have increased United Natural Food’s borrowing costs or even put Goldman at risk of taking a loss.
The term loan, issued yesterday at 97 cents on the dollar, ticked lower in initial trading to 96.8, priced to yield 7.32%.
- Philip Grant
Tuesday, October 23, 2018
Recap Oct. 23
Another volatile trading
Another volatile trading
Relationship counseling
The high yield drought continues.
The high yield drought continues.
High jump
The irresistible force meets the immovable object.
The irresistible force meets the immovable object.
Recap Oct. 23
Another volatile trading session featured an intraday drop of more than 2% on the S&P 500, before a late rally pushed the broad average to within 0.6% of unchanged by day’s end. Treasurys were bid across the curve, although the 10-year yield rose back to 3.17% late in the day (from 3.2% Monday) in tandem with the rally in stocks. Commodities were hammered with the CRB Index dropping more than 1% and WTI crude sinking below $67 a barrel, but gold managed to finish unchanged at $1,230 per ounce.
Relationship counseling
The high yield drought continues. According to Bloomberg, U.S. corporations have priced 272 speculative-grade bond transactions this year totaling $157 billion, the sparsest slate of fresh supply since the post-crisis year of 2009.
While the junk bond market retrenches, Uncle Sam continues to rifle out the I.O.U’s. This week, the Treasury Department is auctioning $276 billion in fresh debt, approaching the all-time record weekly issuance of $294 billion in March. Today’s $38 billion two-year note auction, the upcoming $39 billion in five-year supply and $31 billion seven-year offering all represent the largest single sale for each maturity since 2010, according to Bloomberg. Seemingly on account of that issuance imbalance, the BarCap High Yield Spread closed yesterday at 345 basis points over the 10-year Treasury, well inside the 371 basis points reached in July.
Relatively tight spreads and thin supply doesn’t mean issuers can name their price. This afternoon, Ba3/double-B-minus-rated Netflix, Inc. sold $800 million in 2029 notes priced to yield 6.375%, up from price talk of 6.25%.
For more on the breakneck pace of Treasury issuance and potential implications for borrowing costs of all stripes, see the Oct. 5 edition of Grant’s Interest Rate Observer.
High jump
The irresistible force meets the immovable object. It’s not just banking and private equity CEOs who continue to hail the strength of the economy (see yesterday’s Almost Daily Grant’s). As documented by the fine weekly review from Avondale Asset Management, corporate executives closer to the front lines of industry likewise extol the virtues of current conditions.
On Oct. 18, Nucor Corp. CEO John Ferriola remarked: “The continued strength of the U.S. economy is the primary catalyst for our earnings growth. Tax and regulatory reform, along with a robust domestic energy sector, are driving this economy.” The same day, United Rentals, Inc. president Matt Flannery described the state of the equipment lenders’ end markets as: “Healthy and growing. And if you ask our customers they’ll tell you that things look good and our branches feel the same way. We’re confident about the fourth quarter and believe the cycle has plenty of gas left in the tank.”
That optimism is certainly baked into consensus expectations. According to analyst estimates tabulated by Bloomberg, earnings per share across S&P 500 companies are expected to grow by more than 10% in calendar 2019, with revenues expected to advance by 5.5%. That anticipated growth rate would take place without the calendar effect of the 2017 corporate tax cuts, and compares to average nominal GDP growth of 4.8% over the trailing four quarters.
On that front, early indications have not been promising. Today, shares in economic bellwether Caterpillar, Inc. sold off by 8% after the construction equipment giant offered full-year 2018 guidance which lagged the Street consensus. In a follow-up interview with Bloomberg, Caterpillar chief financial officer Andrew Bonfield explained: “For a company with a $50 billion top line, you can’t grow that fast forever, otherwise you would be one of the largest growth stocks rather than a cyclical industrial. That’s just not feasible. So, it just becomes the math in the end.”
Also today, shares in conglomerate 3M Co. fell by 4% after the company cut its full-year forecast below the most bearish sell-side analyst, with every business segment underperforming expectation, according to Credit Suisse analyst John Walsh.
More broadly, Paul Hickey, co-founder of Bespoke Investment Group, told the CNBC audience this morning that the ongoing third quarter earnings season is tracking “horribly,” with about three-quarters of companies trading lower in reaction to their figures.
- Philip Grant
Monday, October 22, 2018
Don't shoot the messenger
Store credit
The economy is firing on all cylinders.
The economy is firing on all cylinders.
Recap Oct. 22
Don't shoot the messenger
From the South China Morning Post:
Chinese policymakers have been left searching for answers to the trade war with the U.S. because the domestic think tanks Beijing has called on for guidance have provided “filtered information” to avoid offending supervisors, sources close to the Chinese government and diplomatic observers said.
Store credit
The economy is firing on all cylinders. At least, that’s the verdict from third quarter earnings commentary from banking and private equity CEO’s. On Oct. 18, Blackstone Group, L.P. boss Steve Schwarzman commented: “the US economy remains in great shape by nearly any measure. Growth is strong, confidence is high and there aren’t any signs of the excess we saw ahead of the last down cycle.” Jamie Dimon, CEO of J.P. Morgan Chase & Co., remarked: “The economy could be strong for a while…wages are going up, participation is going up, credit has been written as pristine . . . as we look at the economy, we don’t see it slowing down.”
One potential warning sign: Waning supply of new credit from the big banks. As noted in the Oct. 13 edition of the New York Times, third-quarter lending growth from J.P. Morgan, Wells Fargo & Co., Citigroup, Inc. and PNC Financial Services Group, Inc. registered at 2% year-over-year, down from 2.9% in 2017 and north of 4% across 2015 and 2016.
One way to bolster those flagging stats? Move the goalposts. Today, The Wall Street Journal reports that data analytics company Fair Isaac Corp., which created the widely-used consumer FICO credit score, will soon debut a new methodology known as the UltraFico Score. The new approach, which “is designed to boost the number of approvals for credit cards, personal loans and other debt,” will take into account the borrowers’ payment history with cash transactions, and serve “as an appeal of sorts, likely boosting many applicants with less-than-ideal records,” according to The Journal’s AnnaMaria Andriotis.
On the commercial side, an Oct. 19 dispatch from the Financial Times detailed efforts by PNC to boost its lending activity to small and medium-sized businesses through an online joint venture with peer-to-peer lender OnDeck Capital, Inc. (see the Jan. 23, 2015 edition of Grant’s for more on OnDeck). Lakhbir Lamba, head of retail lending at PNC, told the FT that the digital loan business will allow eastern-U.S.-focused PNC to expand beyond its current geographical boundaries: “We want to grow our client base in small business. As we are digitizing these products, small business in this example, the notion of footprint becomes less important.”
While PNC looks to expand its online lending capabilities, Goldman Sachs Group, Inc. retrenches. On Oct. 8, Bloomberg reported that Goldman has trimmed its loan origination target for its consumer-focused online Marcus unit for next year, “reflect[ing] concern about the stage of the credit cycle and changes in market data.”
Such caution may be warranted. On Thursday afternoon, fast-growing regional institution Bank OZK (formerly known as Bank of the Ozarks, Inc.) shocked the street with a $45.5 million charge-off on a pair of unrelated nonperforming real estate projects in the Carolinas dating back to 2007 and 2008. In response, OZK shares plunged by 27% on Friday and are down 52% since March.
Recap Oct. 22
Stocks ticked marginally lower on the S&P 500, although the NYSE FANG+ Index managed a 1% bounce ahead of earnings later this week from constituents Google, Inc. and Amazon.com, Inc. Treasury yields finished slightly higher across the curve, leaving the 10-year yield at 3.2%, while a stronger dollar helped push the iShares J.P. Morgan USD Emerging Market Bond ETF back toward the lows of the year.
- Philip Grant
Friday, October 19, 2018
Agent provocateur
From Reuters:
From Reuters:
He said it
“Some of the analysts who can’t read numbers.”
“Some of the analysts who can’t read numbers.”
Bad back
Recap Oct. 19
Agent provocateur
From Reuters:
A French member of parliament has proposed that mockery of accents be outlawed, after an irate politician derided a journalist’s southwestern pronunciation before asking if anyone had a question in “understandable French”.
Laetitia Avia of President Emmanuel Macron’s ruling party said she was proposing a bill that would classify such mockery with other forms of prohibited discrimination such as on grounds of sex or race.
Roll over, Peter Sellers.
He said it
“Some of the analysts who can’t read numbers.” That’s how Cleveland-Cliffs, Inc. (CLF on the NYSE) CEO Lourenco Goncalves on today’s quarterly conference call, expressed his displeasure with certain members of the sell-side. Goncalves explained:
It's unbelievable that [big banks] still employ this type of people [sic], you should resign. . . you don't understand your own business. You are a disaster. You are an embarrassment to your parents. With this being said, we are going to use money to reward the long-term shareholders. So, if the stock continues to go down based on these kids that play with computers and somebody else's money, we are going to buy back stock. We are going to screw this guy so badly that I don't believe that they will be able to only resign. They will have to commit suicide.
He then went on to identify one particular source of his ire:
Lisa, before you call the next question, is there a guy named Matthew Korn waiting in line to ask a question. He is – he calls himself an analyst and he works for Goldman Sachs.
With that, we are done and Matthew Korn from Goldman Sachs, you can run, but you can't hide. I will see you at the Goldman Sachs Conference, very soon and bring your commodity desk guy because you owe me that for the last year. It will be easier for you if you have the commodity desk guy with you interviewing me. If you are alone, it will be a lot worse. . . Bring the commodity desk guys or girls with you because I promised you last year that I will take care of him, her next time and next time is coming. [indiscernible] I'll see you guys soon. Thanks for joining me this call today, bye now.
On the bright side, it sounds like Goldman investment bankers can safely skip writing up CLF pitchbooks, which should be a time-saver.
Bad back
The interest rate beat marches on. This morning, both the two-year Treasury yield and three-month Libor rose to fresh cycle highs of 2.90% and 2.47%, respectively, up from 0.48% and 0.26% as recently as 2015.
Such explosive moves at the short-end of the curve have helped tip the investment scales towards floating-rate leveraged loans at the expense of conventional, fixed rate high-yield bonds.
The performance figures are stark. Year-to-date, the S&P/LSTA Leveraged Loan Index is up by 4.3%, eclipsing the 1.65% return generated by the Bloomberg Barclays U.S. Corporate High Yield Index. The gap between the lowest-rated leveraged loans and high yield bonds is even wider; the J.P. Morgan Leveraged Loan Index Split B/CCC Total Return Index is up 11.58% year-to-date through this morning, almost double the 5.93% advance in the Bloomberg Barclays Capital Caa U.S. High Yield Total Return Index.
Credit investors have certainly noticed. Yesterday, Bloomberg reported that the total volume of outstanding leveraged loans overtook high yield for the first time “to cement [leveraged loan’s] status as the go-to financing source for speculative-grade companies.”
Indeed, assets under management at U.S. loan funds reached a record $184 billion in September, according to Thomson Reuters’ Lipper and S&P Global’s LCD units, the ninth straight record reading and up from just over $100 billion in February 2016. It’s not just institutions joining the fray. Lipper likewise reports that September saw $919 million in retail inflows into leveraged loan funds, also the ninth straight month of net additions.
The proliferation of leveraged loans has been so rapid that even the monetary mandarins are paying attention. Last month, former Fed chair Janet Yellen told Bloomberg that "regulators should sound the alarm.” The minutes from the Sept. 26 Federal Open Market Committee identified the loan boom as a reason “to remain mindful of vulnerabilities and possible risks to financial stability.” Across the pond, the Bank of England’s Oct. 3 Financial Policy Committee Meeting featured a similar warning, pointing to the “risk that true leverage multiples were being under-reported . . . if borrowers in leveraged loan markets inflated their earnings in leverage calculations, for example by assuming future efficiency gains.”
Sure enough, a recent analysis by S&P Global Ratings of corporate M&A deals from 2015 found that such hypothetical, future “add-backs” represented 21% of EBITDA for companies with a double-B rating and an eye-watering 50% of EBITDA of those rated single-B.
For more on the growth in leveraged loans and its impact on the credit market, see the issues of Grant’s Interest Rate Observer dated July 13, July 27, Sept. 7 and Sept. 21, among others.
Recap Oct. 19
A solid early rally was erased by mid-afternoon to leave the S&P 500 little changed today and flat for the week, while the NYSE FANG+ Index continued to underperform with a 2% decline over the past five days. Treasury yields finished higher across the board, with the short-end underperforming to pull the curve flatter, while a weaker Dollar Index helped commodities catch a modest bid.
- Philip Grant
Thursday, October 18, 2018
Road to nowhere
Consumers slammed on the brakes. The September CPI reading marked a second straight downside surprise, as the headline 2.3% year-over-year uptick was shy of the 2.4% consensus estimate and well off the 2018 high of 2.9% notched in June and July. There was one particular culprit behind the drop: The “used cars and trucks” category saw a 3% sequential decline, by far the biggest move in the 37 subcomponents which make up the broad CPI index.
The CPI contradicts more widely cited commercial data. J.D. Power and Associates reported in its September Industry Update that its price index hit a near three-year high in August, up 5.4% year-over-year. Of the strength in used-vehicle prices, J.D. Power commented: “there are no signs of it letting up.” This afternoon, J.D. Power released the September figures, which featured a modest 0.4 point sequential decline to leave the used vehicle index near those post-2015 highs, up 2.5% year-over-year.
However, there is reason to believe that the government’s data signal something important. In January, the Bureau of Labor Statistics tweaked the methodology for the used cars and trucks index to a one-month price change adjusted for depreciation, from the prior formula of three-month moving average, adjusted for depreciation, in order to “improve timeliness.”
Daniel Ruiz, founder of automotive research firm Blinders Off, LLC, likewise believes that a sea change has recently taken place. Ruiz reports that his proprietary data indicate that growth in inventories of used vehicles piled up throughout September, rising from 3.19% above their 2017 levels in the first week of the month to 6.24% year-over-year by week four. At the same time, used-vehicle prices dropped precipitously in that same fourth week of the month. Ruiz explains the connection in a recent blog post:
The sudden increase in used vehicle inventory is a strong signal that the rate of sale has slowed due to price increases that consumers are not willing to absorb. Most retail dealers have a rigid 60-day cut off for used vehicle inventory. As a vehicle nears the 60-day mark, the dealer is forced to heavily discount that vehicle or face an even greater loss by disposing of it through wholesale auction (60 days of depreciation, reconditioning expense, transportation and auction fees).
This is also likely related to the sharp drop in used vehicle values during week four of September as retail dealers returned to auction and adjusted their bids after realizing the vehicles they previously purchased did not sell at the prices they anticipated.
Reached by Grant’s to discuss his findings, Ruiz reiterated that the drop in September used-car prices measured by the CPI reflects dealers trying to clear inventory, stating that he’s “fairly certain this will show up in the numbers in a big way.”
Ruiz went on to explain the value of used vehicles as a barometer of overall industry health. After all, used prices are critical for new car sales, as almost all transactions involve a trade-in. In particular, bearish recent price action in Ford Motor Company and General Motors Company (each down about 30% since June) may be discounting significant operating pain ahead.
Used car prices are critically important. As loan terms have increased through this cycle, the time to equity increases [i.e., it takes longer for a leased vehicle to accumulate positive value at trade-in], meaning a drop in residual values has major implications for demand for new vehicles.
The rate of change (both buildup in inventories and decline in used car prices) is extremely fast. This will hurt the automakers in two ways: Incentive spending will need to rise, which hurts margins. If increased incentive spending fails to stabilize inventory levels, production will need to fall, which hurts volumes. The OEMs will not be able to respond immediately, so the fourth quarter and first quarter of next year could be ugly.
There are other indications that the CPI may be heading lower in the near-term. According to the September market report from real estate website Zillow Group, Inc., median nationwide rent declined 0.2% year-over-year in September, the first negative reading in six years. For context, the shelter component is given a 32.9% weighting in CPI calculations.
QT progress report
The Fed’s portfolio of securities held outright registered at $3.977 trillion, a modest $1.6 billion sequential decline to mark the second straight week of relative inertia and leave the portfolio less than $16 billion below the trailing four-week average.
Since QT began on Oct. 1, 2017, the Fed’s total balance sheet is down by 6.39%.
Recap Oct. 18
Stocks tumbled once more, with the S&P 500 falling 1.5% to nearly erase Thursday’s big gain, while the NYSE FANG+ Index lost 3% and now sits 16% below its June peak, compared to a 5.5% drawdown in the SPX. Treasury yields ticked lower across the board to leave the 10-year below 3.18%, and commodities were hammered as WTI crude fell below $69 a barrel, although gold managed to eke out a positive finish to settle near $1,225 an ounce.
A bit of symmetry: The Italian 10-year yield finished the day at 3.69%, almost exactly 200 basis points above its 2018 low of 1.71%, reached exactly six months ago.
- Philip Grant
Tuesday, October 16, 2018
On the back foot
It was a familiar scene to many a fund manager. This morning’s third quarter earnings release from BlackRock, Inc. (BLK on the NYSE) featured a divergence between results and reaction, as adjusted earnings per share came in well above the most bullish Wall Street estimate and assets under management rose a hearty 8%, yet the asset manager was rewarded with a 4.5% decline in its share price. Since rising by more than 60% from its fall 2016 levels, BLK has since given back the bulk of those gains and now sits higher by just 13% over that two-plus-year period, lagging the S&P 500’s 30% advance.
What’s triggered the ire of Mr. Market? While BlackRock’s iShares ETF unit continued to hoover up assets with $33.67 billion in inflows, institutional investors headed for the hills to the tune of $24.8 billion in outflows across index and active management strategies, nearly triple the prior quarter’s leakage and the worst showing since 2015. Chairman and CEO Laurence Fink made no attempt to sugarcoat the latter development, saying in a subsequent CNBC interview that “I was disappointed in the net flows,” and also telling Bloomberg: “We’re not particularly happy.”
Fee compression looks to be a source of particular agitation for BlackRock and BLK bulls. Operating margin for the quarter registered at 39%, down from 39.6% year-over-year, while the 8% year-over-year uptick in AUM (as well as an 18% jump in the technology unit headlined by the oft-heralded Aladdin risk management system) translated to overall revenue growth of just 2%.
Kevin Duffy, co-founder and principal at Bearing Asset Management, summed it up to Grant’s: “Bottom line, despite the ETF boom, fee compression is eroding revenue growth and margins. BLK is increasingly dependent on a cutthroat commodity business.”
As for the passive investment industry as a whole, the battle for market share continues apace. Recall that in July, the Vanguard Group announced it would offer nearly 2,000 external ETFs with no trading fees for users of its in-house online brokerage. On July 12, Morningstar, Inc. announced it will launch nine in-house mutual funds in the third quarter, replacing the actively managed funds that it had selected to run its $44 billion in assets, a move that could cut fees by about 20%, according to Daniel Needham, president of Morningstar’s investment management unit. For his part, Dave Natig, managing director of ETF.com, foreshadowed the price war in July 2017, telling Reuters: “Brand names on indexes matter less and less every year.”
The ZIRP and QE-induced levitation in all asset prices was particularly favorable for BlackRock. Might the opposite scenario play out? A bearish BLK analysis in the Sept. 30, 2016 edition of Grant’s drew the connection between the “bull market in everything” and the runaway success of Fink’s passive management behemoth:
Economic growth can explain only so much of America’s pan-asset-class bull market. The rising tide of money (the falling rate of interest) must also share in the glory. Active managers, futilely trying to pick stocks and bonds, have failed to match the performance of the passive managers who merely “seek exposure.” Perhaps it’s no coincidence that, since 2007, BlackRock’s assets under management have grown in tandem with the Fed’s balance sheet.
On the earnings call, Fink cited “ongoing divergent monetary policy and geopolitical uncertainty” for the flight of institutional capital. Indeed, one may wonder if the Fed’s recent pivot toward QT (as well as the planned cessation of stimulus by the ECB and BOJ), and accompanying turn in interest rates, may have a more lasting impact on the business.
As for broader ramifications of the rise in passive management, a September white paper from Acadian Asset Management might put things into perspective:
We find evidence that passive investing is modestly reducing the short-term efficacy of active, factor-oriented strategies by slowing down the convergence of mispricings. These results are consistent with a view that the rise of passive largely represents a “dumbing down” of investment activity in a way that might exacerbate mispricings but also increase their persistence.
BlackRock’s post-crisis ascent has coincided with a brutal period for those who attempt to buy low and sell high. With any luck, the House of Fink’s recent stumble augurs a turn in fortune for active management.
Recap Oct. 16
Party (back) on. Stocks ripped higher with the S&P 500 gaining more than 2% and the Nasdaq 100 nearly 3% to give the bears a taste of their own medicine following last week’s equity rout. By contrast, Treasury yields once again remained relatively inert amid the latest big move in stock prices, with the 10-year settling at 3.16%, while commodities and the Dollar Index both traded little changed to remain in the upper end of their respective 2018 ranges. The VIX dropped sharply to settle just above 17, nearly 40% below Thursday’s intraday peak.
After the close, shares in Netflix, Inc. jumped 12% in initial reaction to third quarter results that featured net subscriber additions far above the Street consensus.
- Philip Grant
Monday, October 15, 2018
Rest' stop
Tough times continue apace for the restaurant industry, as spending at eating and drinking establishments fell 1.8% on a sequential basis in September, the biggest decline since 2016, according to the U.S. Census Bureau's Advance Retail Sales data.
A glance at research firm TDn2K’s third quarter report might lead to a different conclusion. “Q3 Sees Best Restaurant Sales and Traffic Growth in Three Years” is the headline over that Oct. 11 missive. However, that three-year high in comparable-store sales was a mere 1.2% growth for the third quarter (well short of the 2.3% measured rise in consumer inflation in September), while store traffic saw an outright decline of 1.4% from a year ago. As TDn2K points out, “it is only through rising guest checks that restaurants are able to post top-line growth.”
The operating environment may be rugged, but valuations for the group remain generous. The S&P 500 Restaurants Index trades at 23.5 times trailing earnings and 14.7 times enterprise value to EBITDA, a premium to the 20 times earnings and 13.2 times EV/EBITDA currently on offer for the S&P 500. Acquisitive fast-food giant (and subject of a bearish Grant’s analysis on June 2, 2017) Restaurant Brands International, Inc., which last year bought Popeye’s Louisiana Kitchen, Inc. for 21 times EBITDA, currently fetches an EV/EBITDA multiple of over 17 times, while carrying net debt of just over five times the consensus estimate for 2018 adjusted EBITDA.
That contrast between premium valuations and less-than-stellar performance may be explained by the now-ubiquitous franchisor/franchisee model, which has allowed restaurant chains to pass operating costs on to the unit owners while maintaining steady cash flows from fees. John Hamburger, president of the Restaurant Finance Monitor, explained the situation at the 2018 Grant’s Spring Conference:
When you look at the valuations Wall Street has placed on these 100% asset-light franchisors, you’d think this is a fantastic system. On one side you have a franchisor with no capital expenditures and no day-to-day street-level exposure collecting royalties and rents by the bushel-basket, trading at double-digit multiples, all the while levering up to pump cash out to shareholders like there’s no tomorrow. On the other side, [you have] a franchisee, one that’s actually in the trenches running these restaurants and finding out it’s not a very friendly operating environment right now.
I’m here to tell you this Shangri-La doesn’t go on forever. You can’t have one side of the franchise contract getting fabulously rich while the other side faces these headwinds alone. The concept of a moat around a franchisor is a myth. That somehow a brand can separate itself from the unit-level economics of its franchisees is not grounded in reality. Something will give.
Indeed, the ongoing dispute between Restaurant Brands and a group of aggrieved franchisees of its Tim Horton’s unit known as the Great White North Franchisee Association continues to escalate. According to a Sept. 4 dispatch from the Canadian National Post, RBI seized control of the GWNFA president David Hughes’ four Tim Horton’s locations after accusing Hughes of leaking “confidential company information with the media." The week before, Hughes’ lawyer sent a letter to RBI’s legal department “alleging coffee pots have been shattering and injuring employees,” according to the report. For his part, Hughes told the Post: “This is just pure intimidation.”
While less contentious, a similar yet potentially more impactful development may be underway at the world’s largest fast-food chain. Last week, McDonald’s franchisees met in Tampa, Florida, to discuss forming an advocacy group “to address their concerns that the burger giant’s sales growth isn’t keeping pace with the costs of modeling restaurants,” according to The Wall Street Journal.
As for the outcome, franchise news-source BlueMauMau reports on Twitter that when the meeting turned to the question of whether such a self-funded advocacy group was needed, “this was answered with a resounding yes by all [400] attendees.”
Recap Oct. 15
Stocks suffered a late slide to wrap up moderately weaker on the S&P 500, with the NYSE FANG+ Index resuming its recent underperformance after a reprieve last week. Treasury yields were little changed, with the curve flattening a bit as the 10-year settled at 3.15%, while commodities enjoyed a strong day to push the CRB Index above its 2018 average as gold rose above $1,225 an ounce.
- Philip Grant
Friday, October 12, 2018
Recap Oct. 12
Tesla searches for liquidity
From Business Insider:
From Business Insider:
Honor among thieves
On Tuesday, Coindesk.com reported an eye-catching development in the digital currency realm:
On Tuesday, Coindesk.com reported an eye-catching development in the digital currency realm:
Wide bloat
Recap Oct. 12
It was a good day for the bulls, as a strong bounce in the S&P 500 narrowed the week’s losses to 4% and pushed the broad index to within 6% of the Sept. 20 peak, while the NYSE FANG+ Index outperformed for a second straight day. A solid day for commodities allowed WTI crude to rise back above $71 a barrel, and Treasury yields ticked higher with the 2- and 10-year Treasury spread approaching three month highs north of 30 basis points. The VIX reversed mid-day gains to finish down 14%.
Tesla searches for liquidity
From Business Insider:
Tesla, Inc. filed a federal trademark application dated on Monday for the name “Teslaquila” consisting of either “distilled agave liquor” or “Distilled blue agave liquor.” Shortly after, Musk tweeted a “visual approximation” of the alcohol, branded with the Tesla logo and in its signature typeface.
This afternoon, Musk hopped on Twitter to discuss climate change:
Tesla exists to help reduce risk of catastrophic climate change, which affects all species on Earth. Even if your faith in humanity is faltering, this is worth caring about. Support makes a difference. Thank you.
You heard the man: Drink tequila, save the planet.
Honor among thieves
On Tuesday, Coindesk.com reported an eye-catching development in the digital currency realm:
SpankChain, a cryptocurrency focused on the adult industry, has suffered a breach that saw almost $40,000 in ethereum (ETH) stolen. In a blog post published Tuesday, the SpankChain team disclosed the hack, saying 165.38 ETH (worth around $38,000 at the time) had been lost at around 18:00 PST on Saturday. The intrusion, which the post said was made possible by a bug in the network’s payment channel smart contract, also caused $4,000 in SpankChain’s BOOTY token to be frozen.
Luckily, this heist had a happy ending. Today, Coindesk reports in a follow-up that the hacker returned the ethereum after a telephone conversation with SpankChain CEO Ameen Soleimani.
While SpankChain and its users managed to recover their digital ducats, theft remains a significant problem. According to cybersecurity firm CipherTrace’s Third Quarter 2018 Cryptocurrency Anti-Money Laundering Report, $927 million of coins have been stolen by hackers through the first three quarters of 2018, or nearly 50 basis points of the current $201 billion market capitalization of all cryptocurrencies, as measured by Coinmarketcap.com.
Wide bloat
Yesterday, bond bulls caught a bit of a breather as the September headline CPI rose 2.3% year-over-year, below the consensus 2.4%. It was the second straight negative surprise for the indicator, after the July reading featured 2.9% headline growth, the hottest reading since December 2011.
Might the recent turn in CPI augur a cooling of the price pressure that has been building across the economy? Bond bulls sure hope so. According to the New York Fed’s Underlying Inflation Gauge, which purports to capture “sustained movements in inflation from information contained in a broad set of price, real activity, and financial data,” prices rose 3.12% year-over-year in September, a second straight sequential decline. Nevertheless, the indicator has held near the upper end of its long-term average since the summer, and remains near the 10-year Treasury yield of 3.14%.
NY Fed’s Underlying Inflation Gauge, full data set. Source: The Bloomberg
The uptick in prices is making a tangible impact. Yesterday, the Social Security Administration announced a 2.8% increase in benefits for 2019, under COLA, or the cost of living adjustment. That’s the highest since 2012 and up from 2.0%, 0.3% and 0.0% for 2018, 2017 and 2016, respectively.
Some retirees still felt the jump was insufficient. Danette Deakin of Bolivar, Missouri, told the Associated Press:
It isn’t enough of an increase that it takes care of all of the increases from health care, plus rent – our rent gets increased every year. I appreciate the COLA adjustment, and in no way am I complaining. It’s just that every single thing you can talk about goes up. It doesn’t go down.
Ms. Deakin might find agreement in corporate boardrooms across the country. Yesterday, pharmacy chain Walgreens Boots Alliance, Inc. announced it would spend $150 million to boost the wages of its in-store employees in 2019, up from an initial $100 million outlay announced in March. That follows last week’s announcement from Amazon.com, Inc. that it will raise minimum wage to $15 an hour for all employees, while also giving a raise to others who already earn above that threshold.
On Wednesday, industrial and manufacturing supplier Fastenal Company (FAST on the Nasdaq) reported a year-over-year decline in gross margins despite passing “higher incremental pricing” on to its customers, thanks in part to “higher freight costs at the branch level.” This morning, shares in industrial manufacturer Wabash National Corp. (WNC on the NYSE) sold off sharply following soft third quarter results. In explaining the miss, CEO Brent Yeagy likewise focused on pricing pressure:
On the cost side of the business, higher commodity and component costs impacted the quarterly results as raw material costs continued to escalate . . . Labor instability continued to create operating cost pressures at many of our locations. Those labor cost pressures resulted in higher levels of overtime and lower productivity.
Speaker of lower productivity, have a good weekend.
- Philip Grant
Thursday, October 11, 2018
Opposite day
Kanye West visited the White House today.
Kanye West visited the White House today.
Squeeze, Inc.
QT Progress report
Recap Oct. 11
Opposite day
Kanye West visited the White House today. Meanwhile, the finance industry enters the rap game. From the Financial Times:
As newly minted Refinitiv employees gird for a stinging round of cost cuts after its $17 billion leveraged buyout by Blackstone, the company has found one fan pledging allegiance to the new corporate brand.
A rap written by Robin Lee, a Refinitiv employee based in Asia, has been forwarded to the company’s thousands of employees and posted on its internal website, according to an email seen by the Financial Times, with a version of the song appearing online.
The rap, partly a morale booster for the indebted group’s ranks, tells so-called “Refinitivees” to spread “them wings” and take to the sky, bring the heat “every day till we die” and to change “tha game and we’ll do it with a bang”.
Back to your day jobs, everyone.
Squeeze, Inc.
Once more to the well. This morning, high-end furnishings concept RH, Inc. announced it was prepared to buy back up to $700 million of stock. No run of the mill repurchase, the size represents a substantial proportion of RH’s current $2.6 billion market capitalization, and will be funded through a combination of “existing cash, cash flow, borrowings under existing credit facilities, and proceeds from incremental borrowing arrangements,” according to the press release. A hefty contingent of shorts (38% of the float according to Bloomberg) looked to be caught offside by the announcement. Shares rose 10% in response, but remain 25% below their June peak.
The beset bears have recent experience in such dealings. Last year, RH authorized a pair of stock repurchases totaling $1 billion, or 20.22 million shares, which was enough to retire nearly half of the shares outstanding. Recent pullback aside, RH’s stock price has been on a rampage, rising to $120 a share from $25 as recently as February 2017.
RH (formerly Restoration Hardware) and its colorful CEO Gary Friedman are building a reputation as a fearsome foil for the legion of bears who circle the stock. Last September, Friedman was asked at a Goldman Sachs investor conference about the-then 52% short interest: “Listen, I don’t care. Everybody can gamble the way the want to gamble, honestly.” On Dec. 28, Friedman told the San Francisco Business Times: “People are going to bet against us. We’re going to bet on ourselves.” With his healthy attitude towards those who sell stock first and buy later, Friedman is no Dick Fuld, or Elon Musk for that matter.
However, there are fairly pressing financial reasons for Friedman et al. to bet on themselves. The moderately-levered (net debt stands at just under three times consensus 2019 adjusted EBITDA) balance sheet features a trio of zero-coupon convertible notes, with a $350 million note at a $116.09 conversion price set to mature in June 2019 and second $300 million convertible note ($118.13) scheduled to mature in July 2020, both near the current trading level of RH shares (the third, $335 million convertible, issued last year, has a conversion price of $193.65 and matures in June 2023).
The company also issued a pair of term loans last year, a $283 million, first-lien tranche priced at 1.5% over 3 month Libor and a $100 million second-lien, at 8.25% over, which RH has subsequently repaid. For context, cash and cash equivalents foot to $22.2 million as of Aug. 4, according to the most recent form 10-Q.
If the stock price sags, unrated RH could find itself compelled to refinance at less advantageous terms: A hypothetical 6% interest rate (roughly 3.6% over current Libor and below the 6.61% on offer from the Bloomberg Barclays High Yield Index) on the pair of refinanced convertibles would cost RH $39 million in annual interest expense. For context, the sell-side expects RH to generate $334 million and $355 million in operating profit in fiscal 2020 and 2021, respectively. Those estimates already assume significant margin expansion: The Street expects operating profit to reach 12.3% and 11.9% of revenue in fiscal 2020 and 2021, up from 10.3% in the trailing 12-months ended Aug. 4 and an average of 6.7% over the five years ending in fiscal 2018.
Friedman has squeezed the shorts masterfully. Now the real work begins.
QT Progress report
No change this week, as the Fed’s portfolio of securities held outright remained at $3.98 trillion, $21 billion below the trailing four-week average. Since QT began on Oct. 1, 2017, total balance sheet assets are down by 6.26%.
Recap Oct. 11
Stocks were hammered again, with the S&P 500 dropping nearly 2% to extend its losses to 5% for the week, although the recently-beleaguered NYSE FANG+ Index managed a flat finish. Treasury yields finished little changed (at least relative to the chaos in stocks) for a second straight day, while energy prices tumbled with WTI crude dropping below $71 a barrel following a larger than expected inventory build. The VIX rose another 11% to 25, still well below its February peak of 37, and gold caught a strong bid, jumping 2.5% to a two-and-a-half-month high near $1,225 an ounce.
- Philip Grant
Wednesday, October 10, 2018
Flying squirrel. Grounded.
From the Associated Press:
From the Associated Press:
And so it came to pass
During yesterday’s 2018 Grant’s fall conference at the Plaza Hotel
During yesterday’s 2018 Grant’s fall conference at the Plaza Hotel
Still the epitome of the cycle
They’re looking to make it official.
They’re looking to make it official.
Recap Oct. 10
Flying squirrel. Grounded.
From the Associated Press:
Police had to remove a woman who brought an “emotional support squirrel” on a Frontier Airlines flight headed from Orlando, Florida to Cleveland.
Frontier says the passenger had noted in her reservation that she was bringing an emotional support animal with her on Flight 1612 Tuesday night. But she did not indicate it was a squirrel.
The airline says rodents, including squirrels, are not allowed. The airline says police were called when the passenger refused to leave the plane.
The flight left for Cleveland about two hours later.
And so it came to pass
During yesterday’s 2018 Grant’s fall conference at the Plaza Hotel, Stanley Druckenmiller noted the proliferation of so-called corporate zombies, making special mention of long-lingering Sears Holdings Corp.: “Sears is still in business. Who needs that thing? What function is Sears serving in our society?"
It didn’t take long for the great investor to prove prophetic. Bloomberg reports that Sears is “laying the groundwork for a bankruptcy filing as soon as this weekend.”
A Sears restructuring may have seemed a foregone conclusion, but some creditors apparently hadn’t got the memo. S&P Global’s LCD unit reports the company’s second-lien 6.75% notes due Oct. 15 changed hands near 55 cents on the dollar this morning, down 32 points on the day.
For a more comprehensive summary of the ideas and analyses presented by Druckenmiller and the rest of the conference speakers, see the upcoming issue of Grant’s Interest Rate Observer.
Still the epitome of the cycle
They’re looking to make it official. Yesterday evening, The Wall Street Journal reported that Japanese conglomerate SoftBank Group Corp. (9984 on the Tokyo Stock Exchange and SFTBY on the American Pink Sheets) is in talks for an additional $15 billion to $20 billion investment in WeWork Cos. Such a deal would allow SoftBank to take a majority stake in the office-share unicorn, while also allocating roughly one quarter of the $92 billion Vision Fund to a single company. In the eight short years since its 2010 founding, WeWork has swiftly laid claim as the largest office tenant in both Manhattan and London, according to Bloomberg.
Peculiar features of the loss-making WeWork have been well ventilated (for a discussion of WeWork’s bespoke earnings metrics, see the Almost Daily Grant’s from April 24). How fares other realms of SoftBank chief executive officer Masayoshi Son’s corporate empire?
Today, Bloomberg reports that Uber Technologies, Inc. is preparing to issue junk bonds, at similar terms to the $1.5 billion in five- and seven-year leveraged loans that the private ride-share company sold in March. Uber remains swamped by red ink, losing $4.5 billion last year, well ahead of its $2.8 billion loss for 2016. In January, Uber sold $9.25 billion in stock to SoftBank at a blended valuation of $54 billion, nearly matching the $58 billion market capitalization of FedEx Corp. (FDX on the NYSE). In the 12-months ended May 31, FedEx generated $4.6 billion in GAAP net income.
Alibaba Group Holding Ltd. (BABA on the NYSE) has long been the crown jewel of SoftBank’s investment portfolio, as a $20 million investment for 28.8% of BABA shares in 2000 ballooned to an approximate $158 billion valuation as recently as June. It’s been a different story since, as BABA has fallen 34% in the past four months, with losses accelerating following the announced retirement of co-founder and executive chairman Jack Ma on Sept. 7. On April 6, Bloomberg reported that SoftBank took an $8 billion margin loan from a consortium of ten banks backed solely by its holdings in Alibaba shares, which were worth about $125 billion at the time. Today, the valuation of SoftBank’s BABA stake has declined to around $103 billion.
Then there’s Sprint Corp., the corporate problem-child for which Masa Son’s company paid $22 billion for an 83% stake in 2013. Following years of stagnant-to-declining revenues ($32.4 billion in the 12-months ended March 31, down from $34.5 billion in the 12-months ended March 31, 2015) and persistently negative free cash flow ($25.5 billion of cumulative red ink from March 31 2014 to March 31 2018), Sprint agreed to be acquired by peer T-Mobile U.S., Inc. in a stock deal that currently ascribes a $25 billion equity value to the target, according to data from Bloomberg. However, the merger has yet to be approved, and regulatory concerns loom large. Craig Moffett, co-founder of media and telecom research firm MoffettNathanson (and speaker at yesterday’s Grant’s fall conference – advt.), wrote on Aug. 1 that while “absent a merger, Sprint was destined for insolvency . . . the merger has no better than even odds of being approved.”
As for double-B-plus-rated SoftBank itself, the holding company’s total debt footed to $171.3 billion (excluding Sprint and Yahoo Japan liabilities, which are non-recourse to SoftBank) as of June 30, against $28 billion in trailing 12-month adjusted EBITDA and $25.4 billion in cash. During the 2018 fiscal year ended March 31, SoftBank generated $215 million in free cash flow, while paying out $432 million in dividends.
In a bearish analysis of the company in the Dec. 15, 2017 issue, Grant’s identified a pair of SoftBank credits for particular scrutiny; the senior unsecured 6s of 2025 and the perpetual 6 7/8 dollar notes, which have since fallen to 102 and 91 cents on the dollar, respectively, from 106.5 and 102 at publication time. That Dec. 15 analysis included a 1990-era truism which SoftBank creditors the world over may do well to remind themselves: “Asset values are contingent, but debt is forever.”
Recap Oct. 10
Stocks were bludgeoned, with the S&P 500 falling 3.3% and the NYSE FANG+ Index dropping 5.6% to approach bear market territory, down 18% from the June highs. Treasury yields ticked only a bit lower on the short end with the long bond yield rising slightly, notable considering the large recent rise in yields and carnage in equities today. Commodities were also hit hard, with WTI crude sinking to $72 a barrel, while the VIX jumped 42%.
It was all enough for CNBC’s Jim Cramer to declare: “I really miss Janet Yellen.”
- Philip Grant
Monday, October 8, 2018
Potemkin village
Down goes the renminbi. The redback fell by a hearty 0.8% during today’s Asian session to close at 6.926 per dollar, the weakest finish since March 2017. The renminbi’s latest leg lower follows a 100 basis point cut to the reserve ratio requirement of Chinese banks, a move which frees up RMB 750 billion ($109 billion) in liquidity.
Could the yuan trade above seven per greenback? Ken Peng, strategist at Citi Private Bank in Hong Kong, tells Bloomberg that “the RRR cut sends a strong signal that China is in an easing cycle and all external news makes the case for a stronger dollar.”
Of course, the Sino-American trade dispute figures prominently in any assessment of current conditions in the Middle Kingdom. In a meeting today with U.S. Secretary of State Mike Pompeo, foreign minister Wang Yi told the diplomat that the U.S. hard line on trade has “directly impacted our mutual trust and cast a shadow over our bilateral relations.” On Friday, data from the U.S. Census Bureau found that China imported no U.S. crude oil in August, down from just under 12 million barrels in July and the first such whiff since September 2016.
As Beijing grapples with the Trump administration, some economic indicators suggest mounting troubles in the world’s second-largest economy. The pronounced weakness in Chinese equities continues apace, with the Shanghai Composite Index sinking by nearly 4% today to extend its year-to-date loss to 18%. The weaker renminbi has likewise corresponded with a hint of capital flight, as FX reserves declined by $22.69 billion in September, the biggest drop in seven months.
Meanwhile, growth in credit and in the money supply are both slowing. According to the People’s Bank of China, the net change in aggregate financing totaled RMB 12.2 trillion ($1.7 trillion) through August, down 13% year-over-year. Chinese M2 growth likewise reached 8% year-over-year in June, the lowest in at least 20 years, and remains near that nadir.
Year-over-year change in Chinese M2 money supply. Source: The Bloomberg
Then there’s the property market. A Bloomberg dispatch from today details a less-than idyllic scene which unfolded during the just-completed Golden Week holiday:
A sales center for Xinzhou Mansion, a project of Country Garden Holdings Co. located in Shangrao, a city in Jiangxi province, was mobbed last Thursday, videos and pictures on social media show, its windows smashed by scores of protestors throwing rocks. They’re furious that Country Garden is selling units for prices around 30% lower than a year ago.
Also last week, Country Garden peer China Vanke Group Co. Ltd. announced a roughly 50% price cut to new townhouses in the city of Xiamen, according to an Oct. 2 report by the Epoch Times. The homebuilder, founded in 1984, is girding for a rough road ahead. According to Chinese publication The Paper, the theme of Vanke’s fall conference in Shenzen was “survival.”
With credit growth on the wane and the lynchpin property sector coming under (at least anecdotal) pressure, how might the government respond? Market manipulation, naturally. In an Oct. 1 commentary, Anne Stevenson-Yang of J Capital Research notes the extent of the Chinese government’s grip (and economy’s reliance) on house prices, while offering an ominous assessment of a broad downturn’s potential impact:
The whole Chinese economy surfs atop property speculation, and values of residential real estate, although in vast oversupply, have lofted higher year after year, often in double digits . . . What sustains high residential property prices, at current exchange rates exceeding most of the toniest cities in the world, is not an excess of demand over supply. It is rather a unique combination of Chinese features, including the state ownership of land and the local government allocation of it, local government dependence on rising land values, local government involvement in building materials and construction, and local controls over postable land values and sale prices. Taken together, these interventions have jacked up property prices to levels far, far beyond what any natural market would support. If real market transactions ever took control of property prices, there would be a devastating reset.
Seemingly, everyone understands that when property prices crater, that is when debt throughout the economy becomes unsupportable. Inflated property prices are the core asset base of a vast chunk of bank assets. The task for China’s government is to freeze up the markets transactions in order to trap current artificial values in property, thus making sure that consumer feel rich on paper without actually being able to pull cash out of the market. That will enable banks to maintain the high book value of property that collateralizes their loan books.
So, then, Harry Potter to the rescue?
Recap Oct.8
Stocks rebounded from an intraday dip for a flat finish on the S&P 500, despite another rough day for tech as the NYSE FANG+ Index dropped more than 1%. Commodities were generally bid despite a green finish for the U.S. Dollar Index, while the VIX rose to a three-month closing high. The bond market was closed for Columbus Day, a reprieve that Treasury bulls undoubtedly appreciate.
- Philip Grant
Friday, October 5, 2018
Cooking with gas
On Wednesday,
On Wednesday,
Basis pointers
The selloff in U.S. Treasury bonds has accelerated in recent days,
The selloff in U.S. Treasury bonds has accelerated in recent days,
QT Progress report
Recap Oct. 5
Cooking with gas
On Wednesday, the price of West Texas Intermediate crude briefly surged to nearly $77 a barrel, almost triple the low tick registered on Feb. 11, 2016. In an interview yesterday, IEA executive director Fatih Birol told Reuters: “It is now high time for all the players, especially those key producers and oil exporters, to consider the situation and take the right steps to comfort the market, otherwise I don’t see anybody benefiting.” Two weeks back, president Trump hopped on Twitter to deride OPEC for higher prices, demanding that the cartel “get prices down now!”
Presidential rhetoric aside, the pain of higher prices is particularly acute outside of the U.S., as the dollar has remained firm against most major currency pairs this year. Indeed, Brent crude priced in the Chinese Renminbi has risen by 47% since February. Brazilians, who are facing an upcoming presidential election featuring extremist candidates on either end of the political spectrum (Grant’s, Oct. 3), have absorbed a 58% rise in oil priced in the real over that same period. Oil priced in the Indian rupee has jumped by 55% in the past eight months.
Basis pointers
The selloff in U.S. Treasury bonds has accelerated in recent days, pushing the benchmark 10-year yield to 3.23%, the highest since 2011 and up from 2.01% as recently as September 2017. Treasury bulls are seemingly beset on all sides: Today’s reading of September non-farm payrolls included 2.8% year-over-year growth in average hourly earnings, marking four straight months of 2.8% or higher wage growth, the best streak since the financial crisis. The data follow a record reading of the Institute for Supply Management’s Non-Manufacturing Index for September, released Wednesday.
The scalding economy is catching the already-tightening Fed’s attention. Raphael Bostic, president of the Federal Reserve Bank of Atlanta, remarked today that the rapid pace of expansion is enough for him to change his mind and advocate for higher rates:
The incoming economic data on the real side of the economy have come in stronger than I had been expecting earlier this year. So much stronger, in fact, that the central question in my mind is whether the apparent strength in GDP and job growth is a signal that I have materially underestimated the underlying momentum of aggregate demand. If that's the case, the potential for overheating would require a higher path for rates than what I had been thinking.
Investors are definitely getting the message, as the CFTC’s Commitment of Traders report from Sept. 25 shows that non-commercial holders are net short a record 756,316 10-year futures contracts. As recently as December, speculators were net bullish on the 10-year. James McAlevey, portfolio manager of the Aviva Investors Multi-Strategy Fixed Income Fund and a confirmed member of the suddenly-crowded bear camp, told Bloomberg: “We have a structural short duration position in the U.S. because we expect the Federal Reserve will continue normalizing policy and that inflation will increase as jobs growth and wage pressure builds.”
Pressure is likewise starting to build on the Federal coffers. As noted by Bloomberg’s Lisa Abramowicz on Twitter, interest payments on Federal debt jumped to a record $523 billion in fiscal 2018, up 45% from fiscal 2012. That’s despite borrowing costs that, recent move aside, remain far below their own long term average.
Federal interest on Treasury debt (in white) vs. 10-year yield (in orange). Source: The Bloomberg
While higher rates are a clear negative for the U.S. fiscal position, the impact on commercial borrowers is more nuanced. In a note yesterday, data scientist Ben Breitholtz of Bianco Research performed an analysis of corporate bonds by industry group. Unsurprisingly, he found that “the impact of higher U.S. 10-year yields is quite negative for a slew of investment grade industries including oil & field services, natural gas, utilities and railroads.” It’s not all doom and gloom, however. Breitholtz likewise reports that “home construction, airlines, leisure, banking, and automotive have been positively impacted.”
By the same token, the impact of higher Treasury rates on the emerging market realm is a mixed one. Breitholtz finds that while “Argentina, [the] Philippines, India and Indonesia have historically struggled during higher yields, Russia, Taiwan, Colombia and [the] Czech Republic have [seen] a positive to modest impact.”
QT Progress report
Happy anniversary! Yesterday’s release of the Fed’s weekly balance sheet marks just over one year since the commencement of the unwinding of crisis (and post-crisis) era asset accumulation. This week’s reading of $3.978 trillion in securities held outright represents a $19 billion decrease from a week ago, with Treasurys representing all of the decline. Compared to the trailing four-week average, yesterday’s figure was down by $30 billion, with Treasurys accounting for about two thirds and Mortgage-Backed Securities the remainder.
Since QT began on Oct. 1, 2017, the Fed’s total balance sheet holdings are down by 6.3%.
Recap Oct. 5
Stocks fell again, with the S&P 500 retreating to 1.5% below its closing highs, while old leaders continue to struggle as the NYSE FANG+ Index fell 4% on the week and now resides roughly 12.5% off its own high water mark. Treasury yields again lurched higher across the board, while the VIX managed its first weekly close above 15 since the end of June. Gold inched back above $1,200 an ounce.
- Philip Grant
Tuesday, October 2, 2018
They ate the cake
Another large deal is in the books. Last Thursday, Envision Healthcare Corp. priced $5.45 billion in term (leveraged) loans and $1.225 billion in high-yield senior notes to finance its acquisition by private equity firm KKR & Co., Inc. Transaction highlights include a $400 million upsized term loan tranche (the high yield segment was downsized by an equal amount), an 8.75% yield on the fixed rate senior notes, and 375 basis point spread over Libor on the term loan, down from initial price talk of 400 basis points.
The investment bankers added a bit of flair to get the deal done. According to Bloomberg, salesman at Credit Suisse Group AG included “a photograph of a few crumbs of cake left on an otherwise empty plate” in marketing materials pitching the term loan. Considering that the loan saw upsized placement at a lower-than-indicated yield premium, it appears investors got the message.
As with the Blackstone Group L.P.-led consortium takeover of Refinitiv, Inc. (Almost Daily Grant’s, Sept. 11), the deal is a notable one, and not in a way that bodes well for investors. In a note last Monday, our friends at Covenant Review alerted readers to some particularly unpleasant features which await Envision creditors. Speaking of the $1.225 billion senior notes tranche, analyst Scott Josefsburg writes:
This deal includes a radical change to the customary rules regarding the payment of dividends and other Restricted Payments. KKR is seeking to eliminate entirely any financial performance test for making Restricted Payments using the build-up basket [or the portion of accumulated profits which are available for dividends, etc.]. This may be one of the most drastic covenant changes we have seen in years.
Now KKR wants the ability to take out dividends and other distributions to equity whenever, regardless of the financial health of the portfolio company, so long as there has, at some point, been enough Consolidated Net Income.
You can’t fault private equity’s past performance. According to Daniel Rasmussen in the spring 2018 edition of American Affairs, PE managed a 14.4% annual return, after fees, between 1990 and 2010, easily surpassing the 8.1% yearly gain in the S&P 500 over that period.
While the industry has subsequently lagged the S&P by 1.5% a year since 2012, the capital spigot continues to flow. Hugh MacArthur, head of global private equity at Bain & Co., noted in the firm’s 2018 Global Private Equity Report: “If it’s possible, fundraising has been too good, with an unprecedented $3 trillion raised over the past five years.” Today, Blackstone is set to raise up to $3.3 billion for a new fund that would buy stakes in alternative investment managers such as other PE firms, according to Bloomberg.
Could PE’s massive sums under management, prodigious deal making and high-wire debt issuance lead to problems down the line? A May 7 analysis from Empirical Research Partners found that U.S. private equity firms and their portfolio companies carry an aggregate debt load of between $1 trillion and $1.2 trillion, roughly equivalent to the universe of small-cap listed corporations. The analysts find that nearly 60% of outstanding PE-backed borrowings takes the form of floating rate debt, while another 9% is set to mature in the next two years and may need to be rolled over at higher interest rates (futures price in 70% odds of at least two additional rate hikes by next June, in addition to eight 25 basis point increases since December 2015). The authors continue:
That means an increase in rates of say 100 basis points would have a meaningful impact on the net interest expense line for the private equity-linked companies, pushing the annual interest expense up by 11%, or about $6 billion per annum. Interest coverage ratios among listed companies are still robust in aggregate but we don’t think that’s the case among the companies involved in private equity. The average debt/EBITDA ratio for recent transactions has been close to six times, a threshold often considered the danger zone. At the margin higher rates alone could have consequences.
If higher borrowing costs were to trigger a default cycle among private equity-linked firms, would it matter to the wider economy? That depends on who owns the debt. Banking crises have historically been devastating because they choke off credit to the whole system, whereas corporate default crises have usually been contained. So it’s significant that 60% of private equity-linked debt is sourced from term loans, often issued by a consortium of banks. Currently the loans add up to a little less than 5% of the total credit of U.S. commercial banks, which is big enough to cause a problem.
Correction
Yesterday’s ADG (“Sold to you”) cited Colliers data finding that crypto firms had leased 15% of prime Hong Kong real estate signed since January. Instead, the crypto companies represent 15% of A-grade real estate signed this year by mainland Chinese businesses. I’ve corrected my error on the Grant’s website.
Recap Oct. 2
A flat showing on the S&P 500 belied a fairly active day for stocks, as the Dow Jones Industrial Average rose to an all-time high, while the small-cap Russell 2000 and NYSE FANG+ Indices both lost more than 1%. Commodities finished little changed, while Treasury yields ticked lower with the 10-year settling at 3.05%.
- Philip Grant
Monday, October 1, 2018
Are we there yet?
Mission accomplished.
Mission accomplished.
Sold to you
While bitcoin is down 63% from its December peak, enthusiasm for the digital ducats remains brisk.
While bitcoin is down 63% from its December peak, enthusiasm for the digital ducats remains brisk.
Recap Oct. 1
Are we there yet?
Mission accomplished. Last Monday, ECB president Mario Draghi observed “a relatively vigorous pick-up in underlying inflation.” The central banker’s remarks followed a 2.3% uptick in German CPI for September, approaching the post-crisis peak of 2.4% reached on two occasions in 2011. With the ECB’s current pace of €30 billion in monthly asset purchases set to expire in December, interest rate futures point to a modest rate hike that would take the deposit rate to negative 26 basis points from its current negative 0.4% by September 2019.
While German sovereign lenders continue to labor under the yoke of substantially negative real rates (the 10-year bund yields 0.47%), Italy’s creditors face a different sort of unpleasantness. On Friday, the populist Italian coalition government delivered a 2019 budget featuring a notable uptick in the deficit from prior plans. The upsized shortfall will further stress a public debt load which currently stands at 132% of GDP, second only to Greece in the eurozone.
In response, 10-year Italian borrowing costs have jumped to 3.3% from 2.89% last Thursday, while shares in Italy’s two largest banks, Unicredit S.A. and Intesa Sanpaolo S.p.A., have fallen by 10% and 13%, respectively and remain near multi-year lows. For his part, Matteo Salvini, leader of the Northern League, isn’t worried, telling the Financial Times that “the markets will come to terms with it.”
With the ECB (for now) keeping its thumb on the scales of credit and Italy’s finances looking increasingly shaky, Telecom Italia S.p.A. (TI on the NYSE) is caught in the middle. The Italian phone and internet giant, which is rated in speculative territory by both Moody’s and S&P (Fitch rates TI’s debt at the lowest investment grade rung), saw its senior unsecured 5.25% notes of 2022 trade with a yield to maturity of less than 1% late last year. Today, the bonds change hands at just under 113 cents on the euro, priced to yield 1.32%, south of the 1.6% year-over-year rise in the Italian harmonized CPI reading for September.
Writing of Mario Draghi’s herculean monetary exertions and accompanying sub-1% borrowing costs enjoyed by speculative-grade TI, the Dec. 15, 2017 edition of Grant’s posed a rhetorical query:
To whom might the ECB sell, when the time for selling arrives? Not a financially motivated buyer, to be sure. . . Projections contained in the Euribor futures market indicate sub-zero rates for the next three years. For ourselves, we cling to the Herbert Stein econometric modeling approach: If something can’t go on forever, it won’t. This can’t, so it won’t, though it may already seem as if it had.
Sold to you
While bitcoin is down 63% from its December peak, enthusiasm for the digital ducats remains brisk. At least, that’s according to trade volume on Singapore-based exchange BitForex, which routinely sees daily transaction volume above $5 billion. That figure approaches the average turnover on the 217-year old London Stock Exchange, according to Bloomberg.
Then, again, things might not be quite on the up and up. Bloomberg likewise notes that although BitForex boasts what is easily the highest trading volume among 219 crypto venues tracked by CoinMarketCap.com, its website traffic “amounts to a tiny fraction of most peers.” The secret to BitForex’s success: Transaction fee mining, a mechanism by which active traders receive a rebate in excess of the exchange fees, which allows traders to make money by engaging in so-called wash sales. Last Wednesday (the day of the Bloomberg report) BitForex announced it will cease the practice.
Crypto prices may be down and trading volumes may be coming under scrutiny, but the industry is hardly in retreat mode. According to real estate firm Colliers International Group, Inc., crypto-focused companies have leased an aggregate 72,000 square feet of Hong Kong grade-A office space, representing 15% of the prime Hong Kong real estate signed by mainland Chinese firms in 2018. Colliers notes that the new tenants, who are paying a combined HK $10 million ($1.3 million) in monthly rent, all signed their leases after the January peak in bitcoin.
While the crypto firms advance, some familiar names retreat from the world’s most expensive office market (according to a June survey from CBRE Group, Inc.). Bloomberg notes that BNP Paribas S.A., J.P Morgan Chase & Co. and Goldman Sachs Group, Inc., have relocated at least some Hong Kong staff to less central, and less expensive, parts of the city.
Recap Oct. 1
The fourth quarter got off to a bullish start, with stocks moving higher and commodities enjoying a potent rally despite a marginally stronger dollar. Energy continued to press to fresh 2014-highs, with WTI crude and Brent exceeding $75 and $85 a barrel, respectively, while treasury yields ticked higher across the curve with the 10-year settling just above 3.08%.
- Philip Grant
Thursday, September 27, 2018
Tip of the iceberg
No news is good news. A report today from Fitch Ratings relays that September has thus far seen zero institutional leveraged loan defaults in the U.S., which would mark the second straight blemish-free month since its last occurrence in fall 2014. Eric Rosenthal, senior director of leveraged finance at the rating agency, now forecasts the loan default rate at 2% this year, below Fitch’s prior forecast of 2.5%.
Leveraged loans, which defied the 2007-2009 financial crisis, are further bolstered by the solid growth and rising rate environment which has helped lower rated corporate paper strongly outperform (Almost Daily Grant’s, June 19). With the credit environment remaining benign, issuers are feeling their oats.
Last week, The Blackstone Group, L.P. upsized its offer (to €2.75 billion from €2.5 billion) while trimming the yield spread (to 400 basis points over Euribor from 425 basis points) in the European tranche of leveraged loans used to fund its acquisition of Thomson Reuters Corp’s Refinitiv unit amid blistering demand (Almost Daily Grant’s, Sept. 11). Similarly, the Carlyle Group L.P. twice managed to trim the yield on $6.4 billion in loans backing the buyout of AkzoNobel Specialty Chemicals, which priced at 300 basis points over Libor from initial price talk of 400 to 425 basis points. Speaking of the implications of AkzoNobel’s successful debt offering, Tim Morgan, head of high yield syndicate at HSBC Bank plc observed: “I haven’t seen so much demand for euro-denominated bond and loans in some time, perhaps since before the credit crisis.”
One byproduct of the leveraged loan boom is the increasing prominence of collateralized loan obligations, structured credit products which are backed by loans. On Tuesday, S&P Global’s LCD unit alerted readers that CLO issuance has totaled $99 billion in the year to date, far above 2017’s $71 billion emission at this stage of the year and on track to exceed the record $124 billion full year issuance established in 2014. Yesterday, The Wall Street Journal reported that the Canada Pension Plan Investment Board is diving into the pool with a $285 million allocation to CLO equity tranches, which carry the highest potential payout and, accordingly, the highest risk, in the CLO structure.
The increasing ubiquity of leveraged loans has attracted the attention of at least one major financial institution. On Sunday, the Bank for International Settlements sounded the alarm in an analysis titled: “Leveraged loans, a risky resurgence?” An excerpt:
Going forward, as monetary policy normalizes, the floating rate feature of leveraged loans could trigger defaults by worsening borrowers’ debt coverage ratios (DCRs): The ratio of net operating income to debt service costs. Despite healthy corporate profits in the last few years, market participants have begun to report lower DCRs. Even the loan recovery rates during the next downturn could be smaller given that the debt cushion – i.e. the level of unsecured junior debt that absorbs losses before senior loans in a default – of leveraged loans has decreased.
Meanwhile, recent findings from S&P Global Ratings suggest that private equity deals, a significant source of leveraged loan supply, may not be quite what they seem. Institutional Investor has the details:
In an analysis of companies involved in deal making in 2015, S&P found that the earnings projections were unrealistically high on average across leveraged buyouts and mergers due to so-called add-backs – adjustments made to account for expected cost savings or an anticipated rise in revenue.
Overstated earnings in 2015 was the primary contributor to a jump in leverage over the past two years in the sample of companies reviewed by S&P, according to the report. Compared to companies’ projections, EBITDA, or earnings before interest, taxes, depreciation and amortization, turned out to be 29% lower in 2016 and 34% lower last year.
In a detailed analysis of the leveraged loan market in the July 13 edition of Grant’s, David Sherman, paid-up subscriber and principal of credit-specialist Cohanzick Management, LLC, distilled the current value proposition, or lack thereof, for leveraged loan investors: “You have no call protection, and you have no covenants. You don’t get the upside, and you get all the downside.”
QT progress report
A chunky $13.5 billion decline in mortgage-backed securities holdings brought the Fed’s portolio of securities held outright below $4 trillion for the first time since 2014, while Treasury holdings held steady ahead of month end. Compared to the trailing four-week average, today’s portfolio of $3.997 trillion is a decline of $17.6 billion.
As we approach the maiden anniversary of “QT,” which began on Oct. 1 2017, the Fed’s total balance sheet holdings are down by 5.9% year-over-year.
Recap Sept. 27
If anyone happened to look up from C-SPAN, he or she might have noticed that stocks caught a modest bid to leave the S&P 500 lower by about 0.5% for the week, while the NYSE FANG+ contingent offered another strong performance to extend its weekly gain to 3%. After the close, shares in Tesla, Inc. fell by 10% after the SEC sued CEO Elon Musk for alleged securities fraud following last month’s “funding secured” go-private misadventure.
Elsewhere, Treasury yields ticked a bit higher across the curve, while both commodities and the iShares J.P. Morgan USD Emerging Market Bond ETF both enjoyed stronger finishes despite a notable dollar rally. An auspicious sign for EM assets.
- Philip Grant
Wednesday, September 26, 2018
Rigamarole
Wither the drillers? While energy prices have enjoyed a solid rebound from their 2016 nadir, with Brent crude nearly tripling to $81 a barrel, the recovery has thus far passed over the deep water drilling contingent: Industry mainstays Transocean Ltd. (RIG on the NYSE) and Ensco plc. (ESV on the NYSE) have barely budged from their post-oil crash lows. Investor positioning suggests the pain will continue, as the pair feature hefty short interests of 21% and 17% of their respective free floats.
Transocean and Ensco five-year price chart, compared with the price of Brent crude oil. Source: The Bloomberg
On a backwards looking basis at least, the group’s listless price action has plenty of fundamental justification. Over the 12 months ended June 30, Transocean and Ensco generated $747 million and $111 million in operating cash flow, respectively. That’s down from $3.4 billion and $1.7 billion in respective cash from operations in 2015. There is also the question of overcapacity. Charlie Hockless, lead analyst for offshore at maritime research service VesselsValue, tells ShippingWatch:
People are saying that 2019 will be an exciting year for the offshore market, activity should pick up, and I agree, but the problem is that there are simply too many vessels . . . Extreme scrapping is much needed, but I don't trust owners to go through with pledges to scrap vessels once activity and healthy earnings return.
Then too, oil bulls may take a bit of pause from a recent report by Reuters senior market analyst John Kemp indicating a potential softening of U.S. demand. According to the Federal Highway Administration, traffic volumes in July were down 0.3% year-over-year on a seasonally adjusted basis, the second negative growth period in four months. The last time traffic volumes saw any monthly dips was near the end of the prior energy bull market in 2014.
When, then, might better days finally arrive? Maybe sooner rather than later. Julie Robertson, CEO of fellow driller Noble Corporation plc., told listeners at a Sept. 5 investor conference that: “The jack-up [rig] market is well underway to recovery, which is very pleasing to be able to say after this long cycle that we’ve been in.”
A day earlier, Transocean announced it will acquire Ocean Rig UDW, Inc., which emerged from bankruptcy in September 2017, for $2.6 billion in cash and stock. Oddmund Føre, vice president of oilfield service research at Rystad Energy, commented to ShippingWatch: “We expect that this [deal] will help create a less fragmented market, which will contribute [to] a quicker increase in day rates.” Erik Tønne, managing director at Clarksons Platou, concurs: “It gives you a more manageable fleet which is managed by fewer entities. So, I would be optimistic that this could induce more disciplined bidding activity and assist the utilization and day rates for the floater fleet.”
On Sept. 12, Tor Olav Trøim, chairman of rig contractor Borr Drilling reminded Reuters that the current malaise can turn quickly in the highly cyclical offshore drilling industry: “When the recovery happens, it tends to happen very fast.”
The Nov. 3, 2017 edition of Grant’s featured a bullish analysis of the Transocean and Ensco duo (“Not the FAANGs”), with the caveat that the shares represent a “rank speculation, and one that can easily go pear shaped.” By way of postscript, a bit of investment wisdom from friend of the publication Arjun Divecha:
It’s bullish indeed when a horrible situation becomes, not necessarily good, but only less horrible.
Disclosure: The author holds shares of Transocean.
Recap Sept. 26
A late slide in equities left the S&P nursing moderate losses by day’s end, while Treasurys rallied following the Fed’s widely expected rate hike to leave yields lower across the curve. The greenback likewise took the news in stride, with the Dollar Index floating marginally higher, while commodities came under pressure. The VIX saw a late spike but still finished the day south of 13.
Today’s Fed hike marks the eighth policy tightening since December 2015, but monetary policy remains far from hawkish. With August CPI rising 2.7% year-over-year and the Fed’s preferred “core PCE” metric (which excludes food and energy prices) ticking higher by 2% in the most recent July reading, the current funds rate still resides near zero on a real basis.
- Philip Grant
Tuesday, September 25, 2018
Fancy restaurant
It’s leverage on top of leverage. Yesterday Bloomberg reported that David Siegel and John Overdeck, co-chairmen of quantitative hedge fund Two Sigma Investments, L.P., raised $216 million via a collateralized fund obligation. The CFO is backed by investments in 32 separate private equity funds held by Sightway Capital, a fund that manages part of Siegel and Overdeck’s wealth.
Wray Thorn, chief investment officer of Sightway, explained the strategy to Bloomberg: “This is a really great example of how you can use data science and modeling techniques to innovate the way private equity is done. . . It’s something we hope to continue to do more of in the future.” Franklin Rudd, partner at private equity investment firm Compass Partners, was more circumspect: “It’s the same thing that leverage has done since the Egyptian times. It takes an asset that people assume is low risk because it’s diversified and allows you to borrow against it. But when markets turn around, everything goes down.”
These financially flush times present no shortage of evident opportunity for private equity, including deals with one another. Today, the Financial Times, citing data provider Preqin, reports that last year saw 576 secondary transactions, i.e., deals in which one PE shop sells a company to another PE shop, up from 394 such transactions in 2007. The PE model is to slash costs to the bone in portfolio companies, so with secondary transactions “the risk is that there is not much juice in the lemon to squeeze,” Neel Sachdev, leveraged finance partner at Kirkland & Ellis, L.L.P., told the FT.
Some operators have found a fruitful harvest in restaurant franchisors. Today, Inspire Brands, Inc., the restaurant holding company created by Roark Capital Group which operates the Arby’s Restaurant Group, Buffalo Wild Wings and Rusty Taco chains, announced it will acquire Sonic Corp. for $2.3 billion in cash, a deal which values the drive-in burger joint at 16 times EBITDA.
That price, which easily represents a record high for SONC shares, looks especially generous considering that trailing 12-month revenues of $435 million and adjusted net income of $53 million sit well below the $608 million and $61 million respectively generated in the 12 months ended Aug.31, 2015. While Sonic shareholders were predictably pleased with the 19% premium to yesterday’s close, Arby’s creditors were less than thrilled: The company’s senior unsecured 6 3/4% notes due 2026 sold off more by than two points to 96 cents on the dollar in reaction.
Then again, that price looks like a steal compared to other recent transactions. In August, JAB Holding Co. bought Panera Bread Co. for $7.5 billion, paying 18 times EBITDA. Also In August, Roark Capital’s own Focus Brands affiliate bought Jamba Juice Company for $200 million, or more than 35 times EBITDA. It’s not just PE paying up for restaurants. Last spring, publically-traded (and junk-rated) Restaurant Brands International, Inc. paid $1.8 billion, or more than 21 times EBITDA for Popeye’s Louisiana Kitchen, Inc.
Meanwhile, the restaurant industry saw its best monthly same store sales performance in nearly three years in August, according to industry analytics firm TDn2K. The catch: Comps grew at just 1.8% year-over-year, well below the year-over-year rise in headline CPI of 2.7%
Recap Sept. 25
Another lurch higher in rates briefly took the 10-year yield to 3.11%, matching the seven-year closing highs logged in May, while this afternoon’s five-year auction saw similarly weak pricing to the 2-year auction yesterday. Stocks cruised sideways, while energy managed to extend its recent strength amid a flat commodity index and unchanged greenback.
- Philip Grant
Monday, September 24, 2018
The Negotiator
Today the U.S. imposed 10% tariffs on an additional $200 billion worth of Chinese goods. As a result, President Xi Jinping is no longer negotiating with President Donald Trump, according to a dispatch from state-run Xinhua News Agency: “The door for trade talks is always open but negotiations must be held in an environment of mutual respect . . . [Negotiations] cannot be carried out under the threat of tariffs.”
While China and the U.S. butt heads over trade, Beijing looks to engender goodwill from other nations, as well as from its own populace. On Thursday, Bloomberg reported that China “is planning to cut the average tariff rates on imports from the majority of its trading partners as soon as next month.” That move follows an income tax cut enacted at the end of August that featured an increase in the annual tax-free threshold to Rmb. 60,000 ($8,800) from Rmb. 42,000 as well as expanded deductions and an expanded range of lower tax brackets.
In the past, China might respond to a slowdown by flooding the economy with credit. Might that debt-driven model be approaching the end of its rope? Last Wednesday, premier Li Kequiang, the second most senior figure in the ruling communist party, offered some less-than encouraging remarks at a World Economic Forum conference in Tianjin: “Deeply integrated into the world economy, the Chinese economy is inevitably affected by notable changes in the global economic and trade context. Indeed, we’re facing greater difficulties in keeping stable performance of the Chinese economy.”
But if Li’s remarks indicate that the trade spat is front and center, commentary in the latest edition of the China Beige Book, an independent research boutique, implies that at least one major facet of the economy is independently in the doldrums.
Manufacturing is under fire. The sector’s multi-year rally has given way to declining revenue and sharply declining profit growth. Critically, manufacturing’s plight is occurring before any meaningful American tariffs have been imposed. Absent a fall trade deal, the situation will likely deteriorate. The pace of borrowing – at 41% of firms, the highest since 2012 – sure smells a lot like panic.
Then, too, the crucial property sector is facing rocky terrain ahead. Today, Bloomberg reports that “China’s debt laden developers face a potentially devastating blow to their biggest source of financing, as authorities consider putting an end to the practice of selling apartments before they are finished.” That development augurs poorly for the group, which derives as much as 20% of its sales from the tactic according to Bloomberg. Since late January, the Shanghai Composite Property Index has tumbled by 29%, in excess of the 21% decline in the broad Shanghai Composite Index over that period.
Does a vulnerable real-estate market present the risk of broader economic pain? In a note today, Anne Stevenson-Yang of J Capital Research argues as much:
The top class of Chinese are very wealthy, probably richer in fixed assets and cash than consumers in any other country now. But few of these high net worth individuals rely on salary income. For most, income has broadly been a mix of inbound flows, including passive income from high-return, high-risk financial products and trading income from property dealing.
Those flows are at risk of decelerating faster than China’s anticipated broad, macro-deceleration. Non-financial assets are facing a growing liquidity challenge, and that is likely to reveal that their current “valuations” are totally detached from any market reality. Financial assets are increasingly victims of Ponzi dynamics that drove their high returns to investors in the absence of any real productivity returns . . . so defaults in the non-state financial services arena have become a worry for consumers and regulators alike.
Broad implications of an extended slump in real estate activity could be significant. According to Noah Research, 65% of household assets in mainland China are allocated to real estate, far above the 49% in the U.S. and 34% in Japan.
Keep an eye on the Middle Kingdom.
Recap Sept. 24
Stocks came under pressure following the China tariff headlines as well as the rumored resignation of deputy attorney general Rod Rosenstein, while a soft two-year Treasury auction this afternoon headlined another round of rising interest rates as the 10-year yield hit 3.08%. Energy was the big winner, with WTI crude rising to $72 a barrel and Brent over $80 after OPEC announced yesterday that there will be no production increases for the time being.
- Philip Grant
Friday, September 21, 2018
Your Latest Trick
British rock band Dire Straits,
British rock band Dire Straits,
Help really wanted
Inflation is stirring.
Inflation is stirring.
Recap Sept. 21
Your Latest Trick
From Marketwatch:
British rock band Dire Straits, broken up for decades, has a multimillion dollar catalogue that’s about to be sliced up for investors.
The plan securitizes royalties that are paid out every time a song from the “Money for Nothing” group is downloaded, streamed or played on the radio. It’s a similar investment to that introduced in the late-1990s with David Bowie’s own catalogue-supported “Bowie bonds.”
Quite a collaboration: Classic rock meets modern gospel.
Help really wanted
Inflation is stirring. For the latest bit of evidence, see the commentary in Markit’s September flash PMI Index, which reports that “average prices charged by service providers increased at the fastest pace since the survey began in October 2009.” Supply shortages and rising tariffs were cited by the research service as the primary culprit.
On Saturday, The Wall Street Journal reported that the Trump administration was set to move forward with an additional $200 billion in Chinese tariffs “within weeks,” in a major escalation of the Sino-U.S. trade spat. Four days later, CNNMoney reported that Wal-Mart, Inc. sent a letter to U.S. trade representative Robert Lighthizer warning that higher prices were in the offing. Of the latest round of $200 billion in tariffs to be levied on Chinese goods, Wal-Mart predicted that “the immediate impact will be to raise prices for consumers and tax American businesses and manufacturers.”
While tariffs represent one catalyst, an increasingly tight labor market figures prominently in the equation. The August reading of non-farm payrolls saw average hourly earnings rise a brisk 2.9% year-over-year, up from 2.7% in July and the hottest reading since 2009.
Anecdotes of labor shortages likewise abound. Yesterday’s edition of the Minnesota Post, describing Wednesday’s gubernatorial debates, noted the dual focus of candidates Jeff Johnson and Tim Walz on staffing concerns:
They spoke after a slate of top business, government and nonprofit thinkers, who spelled out — in sometimes dire terms — the projected shortfall in workers for certain areas, including nursing and agriculture. In nursing, there is an expected shortfall of 1,275 workers by 2020, according to data provided by Real Time Talent, a workforce project started by a large mix of public and private sector groups.
Walz and Johnson agreed the state can do much to fix the looming shortage, fueled in part by retiring baby boomers, and broadly vowed to make it happen. “I can probably speak for the both of us as we travel around the state and talk to small business owners and big business owners, this comes up more often than anything else — even more often than regulation and taxes as a difficult issue for employers,” Johnson said.
On Sept. 10, the Austin Statesman, citing a study from the Associated General Contractors of America, reported that “more than three-fourths of Texas construction firms are having trouble finding workers. . . Construction employment in the Austin-Round Rock metro area has jumped by more than 7% over the past year.”
In a Sept. 4 dispatch in the Charlotte Observer, Rich Cerretti, head of the Charlotte office of general contractor JE Dunn, explained the knock-on effects which can follow the lack of sufficient hands: “It is definitely hard to find good people. When they run out of labor, the good [firms] are not bidding future projects. You may not have the best subcontractor available or the best-priced subcontractor available. . . All that has an effect of pushing up overall project prices.”
How bad can a labor shortage get? Thirty years ago today, the Financial Times reported on the feverish hunt for workers in then-rip roaring Japan:
Unscrupulous Japanese companies, facing a nationwide shortage of university graduates, are resorting to kidnapping potential recruits to keep them out of the hands of rival employers.
Recap Sept. 21
Stocks gave back early gains to finish little changed on the S&P 500, while underperformance from the formerly-charged NYSE FANG+ Index continued with a 1.2% drop. Treasury yields finished little changed with the 10-year remaining at 3.06%, and a stronger dollar didn’t stop the commodity complex from catching a bid as WTI crude edged toward $71 a barrel.
August new home sales, a Federal Reserve rate decision and revised second quarter GDP figures are among next week’s scheduled highlights.
- Philip Grant
Thursday, September 20, 2018
Leverage lamentation
With apologies to Homer Simpson, here's to debt: The cause of, and solution to, life's financial problems.
With apologies to Homer Simpson, here's to debt: The cause of, and solution to, life's financial problems.
QT progress report
Recap Sept. 20
Leverage lamentation
With apologies to Homer Simpson, here's to debt: The cause of, and solution to, life's financial problems. As interest rates across much of the world edge higher, signs of overextended borrowers are increasingly visible. A trio of such sightings follows:
On Wednesday, Bankrate.com published a survey of U.S. homeowners, finding that almost 30% of lower-income respondents (those making $30,000 or less) viewed home equity lines of credit as a feasible method for keeping up with routine household expenses, compared to 15% overall who endorsed such a maneuver. Greg McBride, chief financial analyst for Bankrate.com, commented:
With the sorry state of emergency savings and increasing levels of consumer debt in a rising interest rate environment, it’s a matter of ‘when’ not ‘if’ more homeowners turn to home equity to find home improvements and repairs, and consolidate debt.
On the bright side, less than 1% of the 719 homeowners within the 1,000-size polling sample indicated that using home equity for plastic surgery was a good idea. At least American home prices are still rising.
Meanwhile, Down Under, the formerly white-hot housing bubble is deflating – unfortunately, the debt remains. The Reserve Bank of Australia calls heavy morgage borrowings the “main risk to financial stability” over the next two years (for more on Australian housing, see the June 15 edition of Grant’s).
Interest-only loans, in which the borrower initially pays no principal (typically through the first five years), figure prominently in the equation. According to the RBA, interest-only (IO) loans constituted nearly 40% of the Australian mortgage pool as recently as 2015.
According to analysts at UBS Securities, the Australian borrower is less than fully informed about these ubiquitous and gimmicky credit products. In a research note yesterday featuring results from the 2018 UBS Evidence Lab Mortgages Survey, the bank reports:
We are concerned with the lack of understanding of IO terms, especially by owner-occupiers (OO): Only 48% of borrowers believe their IO term expires within five years (the maximum interest-only term usually available); 18% stated they “don’t know” when their IO term expires and 8% of OO believe their interest-only term lasts more than 15 years (this product doesn’t exist).
However, the most concerning issue is a lack of understanding of the increase in repayments when the IO term expires: 34% of all IO borrowers stated they “don’t know” how much repayments will rise; 53% expect repayments to rise up to 30%, while only 13% of respondents indicated they expect their mortgage repayments to rise more than 30% (the best case for most IO borrowers).
The analysts conclude with something of an understatement:
This [survey] indicates that the majority of IO borrowers remain underprepared for the step-up in repayments they will face.
Turning to the corporate realm, so-called zombie companies, or those featuring earnings before interest and taxes insufficient to cover interest expense, are widely prevalent in North America. According to a July 19 dispatch from Bianco Research, a full 14% of the broad S&P 1500 Index is so classified, well above the world average of 10%.
In Canada, it’s even worse. Earlier this week, accounting firm Deloitte LLP released an analysis of 2,274 businesses listed on the Toronto Stock Exchange and TSX Venture Exchange, finding that 350 public companies, or nearly 16% of the group, could not service interest with operating earnings.
Those North American zombies may soon be tested. Interest rate futures in Canada and the U.S. are currently pricing 90% and 100% odds, respectively, of higher overnight interest rates by year-end (futures are pricing a status-quo RBA, with just 5% odds of a rate hike by the New Year).
By way of conclusion, a paraphrased quip from the late private equity titan Ted Forstmann: Debt is like chocolate cake. Just a little bit please.
QT progress report
Relatively little to report this week, as the Fed’s portfolio of securities held outright registered at $4.11 trillion, a decline of just under $2 billion from last week’s reading. Mortgage-backed securities supplied the change, as Treasury holdings were virtually unchanged. Likewise, the decline from the trailing four-week average is a relatively modest $10 billion.
Since QT began just under one year ago, the Fed’s total balance sheet has declined by 5.56%.
Recap Sept. 20
A notable dollar selloff cleared the way for stocks, with ongoing underperformance from the NYSE FANG+ Index not enough to prevent the S&P 500 from making a fresh record high. The soft greenback was likewise well received in emerging markets, as the major equity and dollar denominated bond ETFs both climbed while the Argentine peso and Turkish lira strengthened against the buck.
Elsewhere, Treasury yields mostly ticked higher, with the 10-year settling just above 3.06%, while commodities finished moderately higher.
- Philip Grant
Tuesday, September 18, 2018
Muppets take Manhattan
The baton has been passed. Today, The Wall Street Journal reports that eight-year old WeWork Companies, Inc. has expanded its office-space dominion to 5.3 million square feet in Manhattan, officially overtaking J.P. Morgan Chase & Co. (initially chartered in 1799 as The Manhattan Company) as the largest office tenant in the borough.
Growth across the nascent co-working industry has been little short of remarkable. According to real estate services firm CBRE Group, Inc., co-working companies have accounted for 9.7% of all new leases signed in Manhattan year-to-date through August, nearly triple the 3.3% share in 2017. As the co-working business model expands, so do prospective valuations. Today’s Journal report notes that WeWork “is in the process of raising money at a roughly $40 billion valuation.” In August 2017, SoftBank Group Corp. invested $4.4 billion at a $20 billion valuation. Nearly a third of that sum went to cash out existing investors, per the WSJ.
While WeWork’s rapid expansion has served company insiders well, the early returns for landlords are less encouraging. On Aug. 21, commercial real estate giant Cushman & Wakefield published an study of the co-working industry’s impact on building valuations via capitalization rates, i.e., net operating income divided by market value. After offering the caveat that “the data on trades of buildings with significant coworking tenants is relatively thin,” the authors continue:
An analysis of 17 building sales with co-working tenants from the past two years indicates a relationship between the reported cap rates and the proportion of the building’s square footage allocated to co-working. In those cases where 40% or less of a building was leased as co-working, the cap rate was within range or below that of other comparable sales in the area [meaning an equal or higher valuation]. However, the gap between cap rates for comparable sales and the building(s) in question expanded as the proportion of space allocated to co-working increased.
The initial results do suggest that investors seem to apply a discount as the percentage of the building that consists of co-working increases.
Attention: deficit disorder
The second longest economic expansion on record (110 months and counting going back to June 2009, and approaching the 120 month record set between 1991 and 2001), has been no help to Uncle Sam’s balance sheet. Federal debt held by the public currently stands at $15.8 trillion, or 77.5% of trailing 12 month seasonally-adjusted gross domestic product as of the second quarter. That compares to $10.4 trillion, representing 65.9% of GDP, at year-end 2011.
The 2017 Tax Cuts and Jobs Act looks to be aggravating the financial deterioration. Over the first eleven months of fiscal 2018 (the government year ends Sept. 30), federal coffers have absorbed an $898 billion shortfall, up 33% year-over-year. In August, the deficit jumped to $152 billion, up 41% year-over-year, even after factoring in accounting changes and calendar shifts.
According to updated estimates from the White House’s Office of Management and Budget, the upcoming fiscal 2019 will see a budget deficit equivalent to 5.1% of GDP, well in excess of the shortfalls seen, for instance, in recession aftermath years 2003 and 1991 of 3.3% and 4.4%, respectively. The National Bureau of Economic Research finds that over the past 50 years, the average recession has widened the fiscal deficit by 4% of GDP. That means that an ordinary business slowdown could send the U.S. deficit soaring to 9.1% of GDP, just behind the post-World War II record of 9.8% in 2009, the end of the Great Recession.
While red ink spreads, the benchmark Treasury approaches a key level. Today, the 10-year yield poked above 3.05%, up from 2.82% three weeks ago and pressing back toward the high of the year at 3.12%. A sustained break higher could be a big deal. In April, May and early August the 10-year briefly exceeded 3% before retreating, while Ben Breitholtz of Bianco Research reports yesterday that 10-year yields’ 38 basis point trading range over the past six months is among the narrowest since 1972.
Needless to say, a break higher in borrowing costs would be most unwelcome. At a return to 1990’s-era borrowing costs of 6.6%, federal interest expense would foot to $998 billion, topping the $945 billion spent on social security benefits last year (Grant’s, May 18).
Meanwhile, thanks to a rapid rise in short-term rates (today’s four-week bill auction fetched 2.02%, highest since February 2008), the Treasury curve remains near its flattest since the financial crisis, with the two- and 10-year spread hovering just below 25 basis points. Imminent Fed hikes (interest rate futures price in 80% odds of at least two more 25 basis point rate hikes by year-end) could tip the curve into inversion. The St. Louis Fed finds that each recession in the past 60 years has been preceded by that yield curve flip.
Recap Sept. 18
Stocks caught a bid despite another soft showing from the NYSE FANG+ Index (comprised of 10 equally weighted tech, internet and media stocks), which lagged after Bloomberg reported that the Department of Justice has opened a criminal investigation against Tesla, Inc. CEO Elon Musk. Although TSLA did recover somewhat to finish lower by just 3%, the FANG+ Index now sits more than 10% below its June 20 peak while the S&P 500 remains close to its high water mark.
Treasury yields darted higher, while strength in the energy patch pushed WTI crude back to $70 a barrel.
- Philip Grant
Friday, September 14, 2018
In other news
From Agence-France-Presse:
Archaeologists have found what they believe is the world’s oldest site for alcohol production, a study said [yesterday], adding a beer-like beverage may have been served in ceremonies some 13,000 years ago.
A beer-like beverage? Sounds like our ancestors stumbled upon the recipe for Bud Lite.
Tail wags the dog
As gathering financial storm clouds roil currencies, credit and equities in the formerly-designated “third world”, a trio of Latin American countries will confront the prospect of major political change in coming months. Let’s take a closer look at the situation south of the border.
Last June, Argentina managed to raise $2.75 billion from investors via a 100-year dollar bond. It didn’t take long for trouble to once again find the serial sovereign-defaulter (eight times since 1827 according to historian Carmen Reinhart), as president Mauricio Macri was obliged on Aug. 30 to ask the International Monetary Fund to expedite payment on a $50 billion bailout package agreed to this summer. That news sent those century bonds to below 70 cents on the dollar that same day (they’ve since recovered to 75). As inflation rages (CPI rose 34.4% year-over-year in August), the peso continues to hover near lifetime lows against the dollar despite yesterday’s announcement in local newspaper La Naciòn of ARS 196 billion ($5 billion) in 2019 spending cuts.
Argentina budget balance. Source: The Bloomberg
Macri, who is attempting to right the ship after the fiscally disastrous and corruption-riddled administration of predecessor Cristina Elisabet Fernández de Kirchner, faces the unenviable challenge of simultaneously pleasing his electoral constituents and foreign creditors, including the IMF. Former central bank official Mario Blejer told The Financial Times on Sept. 3: “The solution [to the crisis] is not purely economic, it’s also political. The [Macri] government will have to find consensus with additional forces in the political spectrum. They cannot continue to govern alone.” General elections are set for Oct. 27, 2019.
Politics are likewise front and center in Brazil, which is in the midst of a rancorous and highly competitive campaign season ahead of national elections in three weeks (the first round is Oct. 7, with a run-off to take place on Oct. 28 if no candidate exceeds 50%). Today, a poll conducted by XP and Pesppe showed that former army captain and far right-wing candidate Jair Bolsonaro saw his support jump to 26% from 21% a week ago to lead the pack, after he was stabbed at a campaign event on Sept. 6. Bolsonaro’s leading opponents are leftists Ciro Gomes and Fernando Haddad, while market-friendly Geraldo Alckmin languishes at 9% in the XP/Pesppe poll.
André Jakurski, founder and portfolio manager of Rio de Janerio-based JGP Gestao de Decursos Ltda., tersely summed things up to colleague Fabiano Santin: “The candidates are horrible.” Mr. Market seems to concur with Jakurski’s assessment (for the bear case on Brazil, see the issue of Grant’s dated Jan. 23, 2018). Brazil’s 10-year yield has jumped to 12.5%, up nearly 300 basis points since March, while the real has lost 23% against the dollar year-to-date and stocks have spun their wheels with the Bovespa Index slightly down in local terms in 2018.
Finally, we turn to Mexico, which just ushered in a new political era of its own with the June 1 election of Andrés Manuel López Obrador, known as AMLO. Unlike the slow-motion train wreck seemingly underway in Brazil, AMLO’s ascension has already won over financial markets, with the Mexican peso rallying to 18.9 against the dollar from 20.9 in June. On July 4, Morgan Stanley upgraded Mexican equities to “overweight” from “equal-weight.”
The populist president-elect has wasted little time on projects large and small, participating in the bilateral U.S. trade agreement with the outgoing Peña Nieto government, while announcing an aggressive austerity program that includes cancelling the pension of former presidents. Perhaps less market-friendly is AMLO’s prospective energy policy. One day after that trade agreement announcement, Reuters reported that “Mexico’s incoming government is considering indefinitely suspending auctions for oil and gas projects, and giving state-owned Pemex authority to pick its own joint-venture partners rather than holdings competitive tenders.”
Will a bullish response to the incoming AMLO administration be the correct one? Just over four year ago, Reuters reported on market concerns over “economic discipline” of a soon-to-be elected president of an emerging market mainstay:
[Officials] dismissed fears that policy would take a populist turn, jeopardizing more than a decade of strong growth.
“These [market friendly] policies will continue with the same decisiveness. The ministers who will implement them will continue in their posts; there does not appear to be a question about that,” one senior official said.
The country, and leader, in question: Recep Erdogan of Turkey. Today, Erdogan offered an ominous response to the Turkish central bank, which just hiked its overnight rate to 24% in a bid to stem the free-falling lira: “It’s currently my phase of patience but there is a limit to this patience.”
Recap Sept. 14
Stocks cruised sideways for a second straight day, with the S&P 500 wrapping up the week higher by 1.2% to close within about 30 basis points of the high water mark. Treasury yields moved higher, with the 10-year briefly exceeding 3%, while commodities came under pressure with gold dropping back below $1,200 an ounce.
- Philip Grant
Thursday, September 13, 2018
Playing Ketchup
It’s been a tale of two halves for the Kraft Heinz company.
It’s been a tale of two halves for the Kraft Heinz company.
QT progress report
Recap Sept. 13
Playing Ketchup
It’s been a tale of two halves for the Kraft Heinz Company (KHC on the Nasdaq). Born out of the 2015 merger of Kraft Food Group, Inc. and HJ Heinz Co. and blessed by cornerstone investors Berkshire Hathaway and 3G Capital, things began auspiciously. Adjusted EBITDA margins expanded to more than 31% at year-end 2016 from less than 26% in 2015, while the stock jumped 32% in the two years ended February 2017 to command a princely multiple of 34 times trailing GAAP earnings. (For our part, Grant’s offered subscribers bearish analyses of KHC on March 25, 2016 and March 10 of last year.)
Of course, it’s been a different story since that initial burst of success, as earnings and revenues have stagnated while the hefty debt load used to fund the 2015 deal has stayed in place. Since that early 2017 peak, KHC shares are down by 39%, and have lost 23% year-to-date, far in excess of the 7% decline in the S&P 500 Packaged Foods Index.
Signals from those celebrity investors have likewise been less than reassuring. On Feb. 23, Warren Buffett announced his retirement from the board following this year’s annual meeting. In August, 3G announced the sale of 20.6 million KHC shares, reducing its holding to 270.1 million shares.
One Kraft Heinz investor isn’t taking the pain lying down. Today, protestors dressed as condiments and foodstuffs paraded in front of Federal Hall and the New York Stock Exchange. Approached by Grant’s for comment, a participant explained that they were there at the behest of Prague-based activist investor Krupa Global Investments a.s. to demonstrate against Buffett and 3G’s leadership, producing an open letter to fellow investors and the Kraft Heinz board written by Krupa’s eponymous chairman, Pavol Krupa.
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Just your typical Wall Street lunch (with the Wizard of Oz). Sept. 13, 2018
In the missive, Krupa takes issue with, among other things, KHC’s focus on cost cutting at the expense of market share, a lack of strategic acquisitions after the company was rebuffed by Unilever plc. last year and excessive debt. The activist advocates for the rollout of higher margin products, a share buyback and/or a go-private transaction, noting that the investment manager would support a privatization deal “with a valuation in the range of $80 a share,” roughly a 33% premium to the current price.
Krupa wraps up with an entreaty to the Berkshire and 3G bosses:
Investors have followed Warren Buffett and Jorge Paolo Lehmann into battle inspired by the larger than life legend of these men. These investors are scarred and battle weary. They have lost retirement savings and college savings on what they viewed as a safe dividend stock, Mr. Buffett and Mr. Lehmann, save these investors who put their trust in you.
In the letter, Krupa claims to hold “approximately $100 million in Kraft Heinz stock,” although Grant’s was unable to locate any SEC 13-F filings for the firm or find Krupa Global Investors among Bloomberg’s listing of KHC holders. Until recently, Krupa was known as Arca Capital, which is listed by Bloomberg as a holder of 3,475 shares of Kraft-Heinz stock as of July 31. Grant’s unsuccessfully attempted to reach Krupa’s offices for comment, circa 7 p.m. Prague time (1 p.m. ET).
QT progress report
The Fed’s portfolio of securities held outright footed to $4.013 trillion this week, an $11.4 billion sequential decline as Treasurys suppled the run-off while mortgage-backed securities holdings remained unchanged at just under $1.7 trillion. Today’s reading is down by $22.8 billion compared to the trailing four-week average, with Treasurys accounting for roughly two thirds of that run-off.
It’s almost the one year anniversary of QT. Since the program began on Oct. 1 last year, the Fed’s total balance sheet is down by 5.5%.
Recap Sept. 13
Stocks rose yet again, pushing the S&P 500 to within 50 basis points of its high-water mark as the NYSE FANG+ Index managed a near 1% advance. A softer dollar didn’t help commodities, as the CRB Index was hammered by more than 1% with WTI crude dropping below $69 a barrel. Treasurys ticked slightly higher across the curve, after August CPI rose by 2.7% year-over-year, slightly less than expected.
- Philip Grant
Wednesday, September 12, 2018
GoFundTheUniverse
Yesterday, from Bloomberg:
A village in Switzerland has decided to go ahead with an experiment on [universal] basic income, with a payout of 2,500 francs ($2,570) per month. The next step is to raise the money to finance the plan via crowdfunding.
Presumably, the crowd will be from outside the village limits.
Low energy
Today, the Department of Energy reported a 5.3 million barrel drawdown of U.S. crude oil inventories for the week, well above the Bloomberg consensus for a 2 million barrel decline. Those bullish inventory figures, along with disruptive potential from the incoming Hurricane Florence and the impact of sanctions on Iran, OPEC’s third largest producer, helped maintain a strong bid in the energy patch as WTI reached $71 and Brent Crude leaped above $80 for the first time since May.
This week’s outsize decline builds on a sharp recent dwindling in domestic stockpiles. According to the Department of Energy, total U.S. crude inventories fell to less than 396 million barrels last week, down more than 15% year-over-year. That’s despite a steady uptick in domestic output thanks in large part to the shale boom, as DOE production held near its all-time high last week at 10.9 million barrels a day, up 17% year-over-year.
Domestic output is set to continue its rise, but perhaps not to the extent that energy bears have counted on. Thus, the International Energy Agency trimmed its 2019 U.S. production forecast to 11.5 million barrels a day in the September Short Term Energy Outlook, down more than 3% from the 11.86 million barrel estimate in May.
Then too, an anecdotal point from services giant Halliburton Co. indicates that shale activity may not be as bustling as some expected. Last Wednesday, Halliburton CEO Jeff Miller told attendees at a Barclays energy conference: “A decrease in customer urgency. . . has occurred, and we have more white space [in our calendar] than expected.” Miller likewise observed that: “We are seeing slower than expected activity ramp on several new contracts in the Middle East.”
While investors were taken by surprise, sending Halliburton shares lower by 6% on heavy trading volume, the news corresponds with the bullish thesis laid out by natural resource investors Leigh Goehring and Adam Rozencwajg. The pair’s second quarter investor letter notes that 2017 global oil discoveries of four billion barrels lagged far behind the 35 billion in global consumption, and they estimate that discoveries have trailed consumption by 210 billion barrels since 2012. Likewise, Rystad Energy estimates that capital spending in the oil and gas industry will total only $440 billion between 2015 and 2020, just over half of the $875 billion outlay in the 2010 to 2015 period.
Might a looming supply shortfall set the stage for far higher energy prices? Grant’s put the question to Goehring, who finds that U.S. demand growth is fast outpacing rising domestic production growth, while OPEC struggles to maintain its quota and non-OPEC conventional production remains below its 2010 levels.
If the U.S. output disappoints, and OPEC’s production can’t hold at [the current 32.7 million barrels a day quota] . . . then we fall into another year of steep deficits that quickly get out of control.
Energy watchers won’t have to wait too long for an update, as OPEC is scheduled to meet in Algeria later this month, with a press conference scheduled for Sept. 23. For their part, Goehring and Rozencwajg remain highly bullish on energy prices:
We believe the bull market in oil (ignored thus far every step of the way by the investment community), is set to dramatically accelerate to the upside. Stay long oil and oil-related investments.
Grant’s, also bullish on oil (see the March 10, 2017 issue for more), continues to concur with the assessment of Goehring and Rozencwajg.
Recap Sept. 12
Stocks drifted sideways in a narrow range, while a soft dollar helped buoy the commodity complex with gold ticking to a two-week high above $1,200 an ounce. The Treasury curve flattened, with the 2- and 10-year spread compressing to just 21 basis points, near the flattest since 2007. August CPI is set to be released tomorrow, with economists expecting a 2.8% year-over-year headline advance.
- Philip Grant
Tuesday, September 11, 2018
Fine print foibles
The books are open. Soon-to-be renamed Refinitiv U.S. Holdings, Inc. (formerly Thomson Reuters’ Financial and Risk U.S. Holdings, Inc., which publishes financial data through its Eikon terminal) has commenced a $13.5 billion offering of term loans and high yield debt which will help finance the company’s $17 billion acquisition by a Blackstone Group L.P.-led consortium at the end of January. The deal, which values the F&R unit at 12 times EBITDA and is expected to price next week, is the largest leveraged buyout since the financial crisis.
Shortly after the deal was announced, the Feb. 9 edition of Grant’s summarized the daunting task facing Financial and Risk’s new ownership group, and, by extension, the company’s creditors:
The deal is a giant, leveraged bet that the passive investing trend will not, in fact, crush the active managers who pay to use Eikon; that F&R can take market share from the Bloomberg terminal; that interest rates won’t spike when Blackstone comes to refinance the $14 billion of borrowings; and that the world of finance five years from now will look very much like the financial world of today.
The business risks do look to be at least somewhat reflected in the prospective compensation on offer. Max Bower and Natalie Harrison of Reuters report yesterday that price talk for the high yield senior secured and senior unsecured tranches resides in the “low 7% area and low 9% area, respectively.” Those yields would tower over the 5.11% currently on offer from the iShares iBoxx High Yield Corporate Bond ETF.
Then again, Reuters notes that while the deal is being marketed at a leverage ratio of 5.25 times adjusted EBITDA for the unsecured tranche, that already-doctored EBITDA figure has an asterisk. Anticipated but as of yet-unrealized cost savings will purportedly push Refinitiv’s adjusted EBITDA to $2.5 billion from the actual $1.9 billion annual run rate. John McClain, portfolio manager at Diamond Hill Capital Management, put it this way to Reuters:
It’s very late cycle. I don’t really like it when you see a deal with this order of magnitude of projected cost savings as you don’t really know if and when it will be realized. It will be a bit of a test for the market given the size of the deal. But Blackstone and its partners have a good reputation and deep pockets.
Covenant Review, a credit research firm, pulled no punches after taking a look at the fine print. Speaking of the high yield segment of the offering, analysts Sabrina Fox and Scott Josefsberg write:
The Notes are being marketed with extremely defective sponsor-style covenants riddled with flaws and loopholes that reflect the worst excesses of covenant erosion over the last two years.
The pair go on to cite specifics:
A wildly off-market new sponsor mutation seeks to eliminate a fundamental protection against distributions of assets to sponsors and other sponsor shenanigans at a time that the Company has become distressed.
The definition of ‘EBITDA’ would allow for ridiculous pro forma adjustments, allowing management to artificially inflate capacity throughout the covenant package.
Might this transaction stand as something of an avatar for these ebullient post-Lehman credit cycle? In 2008, private equity firms Bain Capital, LLC and Thomas H. Lee Partners conducted a $24 billion leveraged buyout of terrestrial radio station operator iHeartMedia, Inc., paying 10.8 times trailing EBITDA. Having subsequently defaulted on its debt and entered bankruptcy earlier this year, iHeartMedia is now mired in contentious negotiations with its bondholders. S&P Global Market Intelligence’s LCD Unit reported last week:
The unsecured creditors committee in the Chapter 11 proceedings of iHeartMedia asked the bankruptcy court overseeing the case to deny approval for the company’s proposed disclosure statement, calling it a “175-page document premised on indecipherable defined terms and convoluted gifting mechanics [meaning the manner in which the assets are distributed] that renders an informed judgement next to impossible.”
LCD reports that holders of iHeartMedia’s unsecured 2021 notes would see recoveries ranging between 0 and 14.45% according to the company’s plan.
Recap Sept. 11
Stocks ticked moderately higher amid renewed leadership from tech, as the NYSE FANG+ Index snapped out of its recent doldrums with a 1% advance. Treasury yields likewise moved higher, with the 10-year yield settling at 2.98%, a five-week high.
The dollar finished flat, while the iShares MSCI Emerging Markets ETF managed to reverse steep opening losses to likewise finish unchanged and the Turkish lira approached its best level against the greenback in two weeks. An encouraging showing for EM bulls today.
- Philip Grant
Monday, September 10, 2018
Wealth defect
Over the weekend, Global Financial Crisis-era policymakers Ben Bernanke, Timothy Geithner and Henry Paulson brought the band back together
Over the weekend, Global Financial Crisis-era policymakers Ben Bernanke, Timothy Geithner and Henry Paulson brought the band back together
Ma Ma, hey hey
While the U.S. stock market maintains its upward trajectory,
While the U.S. stock market maintains its upward trajectory,
Recap Sept. 10
Wealth defect
Over the weekend, Global Financial Crisis-era policymakers Ben Bernanke, Timothy Geithner and Henry Paulson brought the band back together to pen a New York Times opinion piece. After sharing their self-exonerating analysis of the events of 2007-2009 and subsequent response (which one of the three did the fact checking?), Bernanke et. al. argue for greater regulatory powers, or as they put it, “adequate firefighting tools,” to resolve future financial crises.
Blanket guarantees of bank debt by the Federal Deposit Insurance Corporation, the Fed’s emergency lending capabilities and the Treasury department’s guarantee of money market funds are among the mechanisms cited by the authors as necessary for crisis prevention and mitigation.
The trio write:
We need to make sure that future generations of financial firefighters have the emergency powers they need to prevent the next fire from becoming a conflagration. We must also resist calls to eliminate safeguards as the memory of the crisis fades. For those working to keep our financial system resilient, the enemy is forgetting.
Alternatively, the monetary mandarins could take a cue from Peter Fisher, former executive vice-president at the Federal Reserve Bank of New York and senior fellow at the Tuck School of Business. Speaking on policy normalization at the Grant’s spring conference on March 15, 2017, Fisher offered a commanding critique of the crisis-era response led by the authors of this weekend’s Times piece. Written 18 months ago, the below passage could serve as a direct rebuttal to the authors, particularly former Fed chair Bernanke:
Curiously, the Fed has acknowledged no failures. All the experiments have been successful, every one: no failures, no negative side effects, no perverse consequences, only diminishing returns.
What has been most extraordinary about extraordinary monetary policy is the awkward denial of uncertainty in defense of extraordinary actions. Wanting so badly to manipulate our expectations, the central bankers did not want to leave us any room for doubt. . .The Fed and other central banks appear to have avoided being candid about the uncertainty in order to maintain their credibility. But this is backwards. They cannot regain their credibility unless they are candid about the uncertainty and how they confront it.
The full text from Fisher’s remarks is available here. Ben Bernanke, Tim Geithner and Hank Paulson, please copy. Come to think of it, please read.
Ma Ma, hey hey
While the U.S. stock market maintains its upward trajectory, Chinese equities have been loaded for bear, with the Shanghai Composite Index and Hong Kong’s Hang Seng down 25% and 20%, respectively, from their late-January highs.
Trade wars look to figure prominently in the recent pain. On Friday, President Trump floated the idea of extending an additional $276 billion in tariffs on Chinese goods, a notable escalation from the current $50 billion tariff regime and additional $200 billion in already proposed duties. In response, Chinese foreign ministry spokesman Geng Shuang promised that “China will definitely take countermeasures to safeguard its legitimate rights and interests.”
As trade tensions ratchet and stock prices teeter, inflation stirs in the Middle Kingdom. While official government CPI readings show a gradual acceleration to 2.3% year-over-year in August, The New York Times, citing a household spending-weighted data set from economic research group Wigram Capital Advisors, reports that prices jumped 3.7% in August. That metric had remained below 2% for the bulk of 2017.
For debt-soaked China, which holds banking assets in excess of 300% of GDP, a persistent inflation uptick, and the prospect of higher interest rates, could augur trouble. Reuters reports that 20 corporate borrowers have defaulted this year as of Sept. 3 on 41 bonds worth 45.6 billion renminbi ($6.7 billion), already above 2017’s full year tally of 18 defaults worth Rmb. 39.3 billion.
With these disparate economic data points as a backdrop, Friday afternoon’s retirement announcement from Alibaba, Inc.’s (BABA on the NYSE) co-founder and executive chairman Jack Ma was a notable one. Ma, 54, told The New York Times that his departure from the e-commerce behemoth will not mark the end of an era but, rather, “the beginning of one.”
The debt-driven Chinese economic miracle has been kind to Alibaba, which has more than tripled both its revenues and adjusted net income in the three years ended March 31. It has also been kind to Ma, who has sold some 26.6 million BABA shares over the last two years, worth $4.2 billion at today’s prices, according to The Wall Street Journal.
What era is this the beginning of?
Recap Sept. 10
Stocks edged higher, as the Dow Transports Index gained nearly 2% to reach a fresh record high and pick up the slack from the recently-faltering FANG+ complex, which treaded water after a 7% drop last week. The Treasury curve flattened a bit, while a slightly weaker dollar helped commodities but wasn’t enough to prevent the iShares MSCI Emerging Market ETF from sinking to a fresh 52-week low.
- Philip Grant
Friday, September 7, 2018
Clickbait
Senators, let me be clear: We are more determined than our opponents and we will fight them. Nothing less than the integrity of our democratic institutions is at stake.
Those remarkable words were uttered not by a politician or military commander, but rather by Sheryl Sandberg, chief operating officer of Facebook, Inc., (FB on the Nasdaq) during congressional testimony on Wednesday.
As the Cambridge Analytica data misadventure (among others) have taken the social network far beyond the scope of most corporations, regulatory action from Washington appears increasingly certain. On Tuesday, entrepreneur and Facebook co-founder Eduardo Saverin told the audience at a Singapore technology summit that: “It’s not a question of if, it’s a question of the type of regulation.” The company is preparing itself. Employee headcount jumped to 25,105 in 2017 from 17,048 the year prior, and capital expenditures are expected to double to $14.7 billion this year from $6.7 billion in 2017.
Investors also seem to be girding for the heavy hand of Uncle Sam: Facebook shares have declined by 7% this week, extending their slide to 25% since offering slower than expected revenue growth guidance on July 25. Since the Aug. 11, 2017 bearish analysis in Grant’s, Facebook shares have dropped 3%, lagging the S&P 500's 17% gain over that period.
Does the price weakness offer opportunity? Analysts from Needham & Company believe so, writing on July 26 after the 20% post-earnings swoon: “We are sad about the human capital cost* of this share price correction, but we believe FB’s fundamental value, advertiser demand, [free cash flow and return on investment] remain intact.” Considering the breakneck growth in revenues, net income and free cash flow achieved by Facebook in recent years, the stock trades at just over 20 times consensus adjusted earnings per share this year, far from exorbitant by current bull market standards. The stock is up 271% over the past five years.
Likewise, the Street, with 40 “buy” ratings, six “holds” and two “sells”, expects the good times to continue. Consensus revenue and adjusted net income for 2019 stand at $69.3 billion and $28 billion, respectively, well above the $48.5 billion in revenue and $21.3 billion in adjusted net income generated in the 12-months ended June 30.
The question before the house: Are the underlying user growth metrics supplied by the company accurate? On Aug. 17, Brian Wieser of Pivotal Research (one of the two analysts with a “sell” on FB) alerted investors to a recent class action lawsuit filed against FB by online advertiser Investorvillage.com. Among other allegations, the suit contends that a “former Facebook employee. . . stated that Facebook does not care about the accuracy of information related to the number of users so long as advertising revenue is not negatively affected.”
Indeed, Wieser writes: “A check on [Aug. 16] shows that Ads Manager now indicates that a campaign with a Reach-based objective has the potential to reach 39 million 18-24 year olds, 63 million 25-34 year olds and 61 million 35-49 year olds” in the U.S. Those figures all sit far above the 31 million 18-24 year olds, 45 million 25-34 year olds and 61 million 35-49 year olds reported by the U.S. Census. Chicago-based politicans would likely approve.
Meanwhile, a survey released on Wednesday from Pew Research finds that 42% of respondents have taken a break from Facebook “for several weeks or more” in the past 12-months, while 26% “say they have deleted the Facebook app from their cellphone.”
Sandy Brasher, researcher of shorts at Rice, Volker LLC, compares Pew’s findings with Facebook’s reported growth in domestic monthly active users and finds the numbers confusing, especially considering the ongoing decline in U.S. searches for Facebook, according to Google Trends, which aggregates the popularity of various search terms (for reference, legacy social network MySpace is added to the below chart, as is Facebook’s fast-growing Instagram unit).
Facebook in blue, Instagram in yellow, MySpace in red. Source: Google Trends
The faltering search frequency and substantial phone app deletions reported by Pew draw a contrast with the company’s own metrics: Monthly active users in the U.S. and Canada totaled 241 million at the end of the second quarter, up 2.1% year-over-year. Brasher concludes to Grant’s: “Their reported user numbers seem strange to say the least.”
*Human capital, in this case, refers not to shareholders who have lost money or users who have had their privacy invaded, but rather “FB employees who had plans to sell shares to fund their life [and] just lost 1/5 of their budget, literally overnight.” The company did generate $17.7 billion in free cash flow in the past 12 months, which could present an alternative means for employee compensation compared to stock options.
Recap Sept. 7
Stocks edged a bit lower, with the S&P 500 finishing the holiday-shortened weak down by 1%, a respectable showing considering the 6% downdraft in the NYSE FANG+ Index over the past four sessions. Commodities and the dollar rose in tandem, while the strongest year-over-year gain in average hourly earnings since 2009 pushed Treasury yields well higher across the curve, with the 10-year yield settling at 2.94%.
- Philip Grant
Thursday, September 6, 2018
Multiple personalities
Yesterday, the U.S.-listed company (with a market cap greater than $500 million) with the worst performance was Coral Gables, Fla.-based Mercantil Bank Holding Corporation. The U.S.-listed company with the second best performance in yesterday’s trading? That same Mercantil Bank. The company’s voting right-carrying A-shares fell by 57%, while the non-voting B-shares closed the session up by 31% after jumping as much as 165% intraday.
Mercantil, spun off from Venezuelan bank Mercantil Servicios Financieros, C.A. on April 2 with $8.4 billion in assets and $6.3 billion in deposits, began trading on the Nasdaq exchange on Aug. 29 as an “emerging growth company” under the 2012 Jumpstart Our Businesses Act. The company’s registration filing explains the practical meaning of that desingation:
As such, we are eligible to take advantage of certain exemptions from various reporting requirements that are applicable to other public companies that are not “emerging growth companies” including, but not limited to, not being required to comply with the auditor attestation requirements of Section 404 of the Sarbanes-Oxley Act, reduced disclosure obligations regarding executive compensation in our periodic reports and proxy statements, and exemptions from the requirements of holding a non-binding advisory vote on executive compensation and shareholder approval of any golden parachute payments not previously approved.
If some investors find our securities less attractive as a result, the trading market for our securities may be reduced, and the prices of our securities may be traded at lower prices and experience greater volatility.
The volatility part is definitely covered. Over the past six trading days, Mercantil A-shares reached as high as $86 dollars a share on Sept. 4, and ticked below $6 a share on Aug. 29. The B-shares have remained range-bound by comparison, oscillating from $6 a share on Aug. 29 to $40 a share a week later. Current market capitalization is just under $2.5 billion.
The freshly spun-off entity is tightly controlled. More than 97% of the 74.2 million A-shares outstanding are owned by insiders, as are more than 58% of the non-voting B-shares.
Grant’s inquired at the company via phone and email for comment regarding the curious activity in its shares. Mum’s the word from Mercantil.
QT progress report
The Fed’s portfolio of securities held outright footed to $4.013 trillion, down by $11.4 billion from last week’s reading. It was Treasurys rolling off the balance sheet this time, while mortgage-backed securities holdings remained unchanged at $1.697 trillion. Today’s reading represents a $22.8 billion decline off the trailing four-week average.
Since the Fed began its QT portfolio run-off program last Oct. 1, total balance sheet holdings are down by 5.55%, for a simple annualized rate of 5.89%.
Recap Sept. 6
Stocks finished a bit lower led by tech, as the Philadelphia Semiconductor Index lost nearly 3% after bearish commentary from KLA-Tencor Corp. management at a Citigroup investor conference. Recent weakness in tech is not confined to the semis: The NYSE FANG+ Index has now lost nearly 10% from its June 20 peak.
Seemingly bearish action took place outside of equities as well. Treasury yields ticked lower across the curve, while a softer dollar was no help for commodities as the CRB Index finished sharply lower and WTI crude fell back to $68 a barrel. The VIX rose to its highest close in three weeks, and cryptocurrencies were hammered with bitcoin dropping below $6,500, near its 2018 low of $5,900 logged on June 29.
- Philip Grant
Tuesday, September 4, 2018
First shall be last
High-grade is a relative term. Year-to-date, the iBoxx USD Liquid Investment Grade Index is down 2.84%, far behind the more speculative end of the credit spectrum as triple-C-rated corporates have managed a 6.44% gain.
Investors are beginning to take note. The iShares iBoxx USD Investment Grade Corporate Bond ETF (LQD on NYSE Arca) saw a combined $994 million in withdrawals last Wednesday and Thursday, the largest outflow in the name since the February rout in short-volatility products. Mohit Bajaj, director of ETF trading solutions at WallachBeth Capital, commented on the withdrawal to Bloomberg: “It’s a lot, especially for as slow as it’s been in the last week of August.” In terms of price, the LQD remains just above the multiyear lows logged during the short but severe correction in early 2016.
The poor performance from investment grade credit can’t be chalked up to excess supply. According to data from Bloomberg, year-to-date issuance has totaled $889 billion through Friday, down 12% from the same period last year. Instead, rising interest rates, (3, 6 and 12-month LIBOR all remain at or near post-2008 highs) in tandem with relatively brisk economic growth, have combined to hinder the lower coupon and lower risk (of default at least) asset class.
Then too, there is credit quality, specifically the growing concentration of corporate membership at the lower end of the investment grade ratings scale. A July 25 research note from S&P Global Ratings found that U.S. nonfinancial corporate debt rated triple-B (the final full stop before junk) totaled $2.66 trillion, nearly triple the $1 trillion outstanding at the eve of the financial crisis in 2007. S&P also notes that “capital structures at many borrowers we rate. . . have become more aggressive, with leverage rising beyond historical levels.” The rating agency remains relatively sanguine, however, concluding that: “We believe that these borrowers can reduce leverage over a two year window and maintain investment-grade credit ratios.”
The bourgeoning ranks of those rated just above junk added another last week, as Moody’s downgraded Ford Motor Company to Baa3 from Baa2 (equivalent to triple-B-minus from triple-B), with a negative outlook. In announcing the downgrade, the rating agency pointed out that Ford has seen its debt jump to 3.3 times EBITDA from 2.6 times in the two years ended on June 30, while EBITDA now covers interest expense by just 1.8 times, down from 4.5 times in June 2016.
Indeed, Ford appears to be spinning its wheels operationally while debt accumulates at a brisk pace. The company is expected to generate $147 billion in revenue this year, up only modestly from the $133 billion top-line from 2012. However, total gross debt has jumped to $153 billion from $105 billion during that period according to data from Bloomberg. Some creditors have headed for the hills in light of the Moody’s downgrade, with Ford’s senior unsecured 5.29% notes of 2046 falling to less than 89 cents on the dollar for a yield-to-worst of 6.13%. Last week, that paper traded above 92 cents.
Other large cap, high-grade borrowers have seen an even more pronounced pile-up in their borrowings, to little ill effect thus far. Analysts forecast that triple-B-plus-rated Verizon Communications, Inc. will generate $131 billion in revenue this year, marginally higher than the $116 billion revenue line from 2012. However there is nothing marginal about the increase in debt over that period, as gross borrowings have ballooned to $115 billion from $52 billion since 2012. Single-A-minus-rated Anheuser-Busch InBev SA is expected to produce a $56 billion top line this year, up from $40 billion in 2012. While revenues have increased by some 43% in the past six years, gross debt has nearly tripled, to $117 billion from $44 billion.
Investors haven’t minded, yet. Verizon’s senior unsecured 5.15s of 2023 trade above 107 cents on the dollar, bestowing a 3.55% yield-to-worst and 78 basis point premium to Treasurys. The Anheuser-Busch senior unsecured 3.65s of 2026 currently trade just under 98 cents on the dollar, for a yield-to-worst of 4.02% and a 117 basis point pickup over Treasurys.
An analysis in the April 6, 2018 edition of Grant’s shed some journalistic light on the plight of those put-upon investors in so-called high-grade corporates:
Low interest rates and tight yield spreads condemn the creditors to mediocre returns (that’s the upside) or outright loss (not so much the downside as the base case). We write to remind the bondholders that they have become the doormats of Wall Street.
Recap Sept. 4
Stocks ticked modestly lower, with the NYSE FANG+ Index losing more than 1% despite Amazon.com, Inc.’s first foray above a $1 trillion market cap. A stronger dollar crimped the commodity complex, while emerging markets continued to struggle with the iShares J.P. Morgan USD Emerging Market Bond ETF tumbling to its lowest since February 2016. Treasury yields ticked higher across the board in bear steepening formation, as the 2- and 10-year spread closed above 24 basis points for the first time since Aug. 17.
- Philip Grant
Friday, August 31, 2018
Dog day afternoon
Let’s wrap up the month of August with a jumbled stew of sightings, from the ridiculous to the sublime. Without further ado, a trio of anecdotes 100% guaranteed to provide no investment value whatsoever:
On Monday, USA Today reported that Mayo, Fla. (population 1,500) has temporarily changed its name to “Miracle Whip” thanks to a marketing arrangement with processed food giant Kraft Heinz Co. (KHC on the Nasdaq). In exchange for the naming rights (not to mention its dignity), the town formerly known as Mayo will receive $25,000 in “city beautification funds.”
Solid move by Kraft Heinz. Definitely cheaper than buying Unilever.
On Monday, the Impact Shares YWCA Women’s Empowerment ETF, ticker WOMN, made its debut on the NYSE Arca exchange. The fund is based on the Morningstar Women’s Empowerment Index, which “is constructed using a rules based methodology to select companies from the Morningstar US Large-Mid Cap Index that have strong women’s empowerment practices,” according to the prospectus.
The fund sports an expense ratio of 76 basis points, as well as a familiar set of top holdings. WOMN’s current top five largest positions are: Amazon.com, Inc., Microsoft, Inc., J.P. Morgan Chase & Co., Johnson & Johnson, Inc. and Exxon Mobil Corp.
A strong lineup, albeit one seemingly identical to the male empowerment ETF.
Finally, we turn to that hotbed of international commerce and cutting edge technology known as North Korea. On Saturday, Singapore-based news organization The Straits Times, citing South Korea’s Yonhap News Agency, reports that “the first-ever Korean International Blockchain Conference will be held over two-days starting Oct.1.”
That’s not the first time that the so-called Hermit Kingdom has attempted to get into the blockchain game. On Monday, Yonhap cited the Korea Development Bank in reporting that North Korea, smitten by certain "characteristics of cryptocurrencies, including anonymity, difficulties of tracing money and cashability," may have unsuccessfully attempted to mine for bitcoin between May and July 2017.
If mining for bitcoin didn’t work, perhaps an ICO could be called for? The name “Rocketmancoin” still appears to be available.
Recap Aug. 31
Stocks cruised sideways on this final unofficial day of summer, wrapping up the week modestly in the green and leaving the S&P 500 higher by 8.5% year-to-date. Treasurys likewise held mostly steady, with some modest steepening pushing the 2- and 10-year spread above 23 basis points after it compressed to a cycle low of less than 19 basis points last Friday.
Commodities managed a flat finish despite a stronger dollar as WTI crude and gold settled at $70 a barrel and $1200 per ounce, respectively. But the green greenback did no favors for the stricken emerging markets complex as the iShares J.P. Morgan USD Emerging Market Bond Fund ETF lumbered back near multi-year lows established on Aug. 13.
- Philip Grant
Thursday, August 30, 2018
Back to the Future
It sounds vaguely familiar: A potent U.S. bull market runs headlong into an emerging markets crisis.
It sounds vaguely familiar: A potent U.S. bull market runs headlong into an emerging markets crisis.
Great moments in corporate communications
Yesterday, China Properties Group Ltd. (1838 on the Hang Seng) reported
Yesterday, China Properties Group Ltd. (1838 on the Hang Seng) reported
QT Progress Report
Recap Aug. 30
Back to the Future
It sounds vaguely familiar: A potent U.S. bull market runs headlong into an emerging markets crisis. Might the so-called Asian Contagion of 1997 and 1998 provide a roadmap for today’s investors as Argentina, Turkey, Brazil and others see their currencies spiral lower and borrowing costs lurch higher? Let’s review the script from last time for potential clues to the future.
As the S&P 500 had entered the teeth of the 1990’s bull rampage (the index was up 111% from April 1994 to July 1997), Thailand was forced to float the baht on July 2 as declining FX reserves made the country’s peg to the dollar untenable. The Bank of Thailand tried to limit the damage by raising interest rates 200 basis points to 12.5% and pledged to spend up to $5 billion to defend the baht, but to no avail. The currency lost roughly half its value in the next six months.
Thai baht/U.S. dollar cross, January 1997 to August 1999. Source: The Bloomberg
Stateside, the summer of 1997 saw choppy but largely sideways price action in the S&P 500, with an abrupt 11% decline in October all but erased by year-end. The bull market resumed in full swing in the first half of 1998, as the S&P 500 tacked on 20% through July.
But as U.S. investors resumed their party, the Thai crisis duly spread to other emerging markets, with the South Korean won and Indonesian rupiah losing 54% and 80% respectively against the dollar in 1997 and 1998. The EM crisis eventually culminated in the Russian debt default of September 1998 and subsequent bailout of U.S. hedge fund Long Term Capital Management. This time, overseas troubles made their way to the shores of the U.S., as the S&P 500 endured a 21% decline from July to October 1998, briefly entering a bear market.
But the U.S. equity bulls had an ace in the hole in the form of Federal Reserve chairman Alan Greenspan. In late September 1998, the Fed cut the federal funds rate by 25 basis points, to 5.25%. When stocks continued to fall in October, Greenspan delivered another, intra-meeting 25 basis point rate cut on Thursday, Oct. 15, 1998, right before monthly options expiration. CNN Money reported at the time that: “As the news of the rate cut hit the floor of the New York Stock Exchange, traders actually cheered and investors rushed to buy stocks and bonds.”
They had good reason to cheer. The S&P 500 fully regained its losses by the end of November, then tacked on another 30% upside through the March 2000 peak of the Nasdaq. While Greenspan’s rate cuts came from a far higher base (the current effective Fed funds rate is just 1.92%), chairman Jerome Powell could always press pause on the QT balance sheet run-off if the unfolding EM panic puts a dent in U.S. asset prices.
Great moments in corporate communications
Yesterday, China Properties Group Ltd. (1838 on the Hang Seng) reported disappointing operating results for the first half of the year featuring a 72% year-over-year revenue decline. While the outcome was disappointing, investors could at least enjoy a most entertaining “management discussion and analysis” commentary that accompanied the press release. An excerpt:
10 years ago, the U.S. printed money like crazy and exported U.S. dollars all over the world. Now the U.S. has become a global enemy, trying. . . to undermine the asset markets of other countries and the global supply chain order. No wonder the U.S. has made a lot of enemies. Fortunately, Trump does not have the same wisdom as Mao Zedong in making alliance with one while fighting another. He wants to fight the world.
Nevertheless, Chinese are savvy and resourceful. Deng Xiaoping said, “we should grope our way across the river, one step at a time.” Jiang Zemin said, “keep a low profile to make a big fortune.” Han Xin demonstrated his immense ability to endure humility [sic] in order to preserve his existence for future accomplishments. Such wisdoms contributed to the creation of incredible historic achievements one after the other.
Stateside, steel drum producer Greif, Inc. (GEF on the NYSE) and subject of a bearish analysis in Grant’s (Sept. 22, 2017) reported third quarter results following the market close yesterday, with a stronger than expected top line partially offset by a revenue forecast and implicit guidance cut for the rest of the year. One anonymity-seeking investor points out a recurring theme from the company’s last four conference calls; a bone to pick with Mother Nature:
From the fourth quarter 2017: "Operating profit before special items was negatively impacted by $5.3 million associated with adverse weather events."
First quarter 2018: "But were negatively impacted by weaker than anticipated Rigid Industrial Packaging & Services volumes in December caused by a temporary winter slowdown."
Second quarter 2018: "Our Rigid Packaging segment was impacted by customer operational interruptions, weather issues and rising raw material costs."
Third quarter 2018 (yesterday): "partially offset by significantly weaker demand from European agricultural customers due to weather, impacts from events in Brazil and continued value over volume decisions in China."
Investors bid GEF shares higher by 2% today, but be forewarned: Fall is just around the corner.
QT Progress Report
The tightening train rolls on. The Fed’s portfolio of securities held outright comes to $4.024 trillion, down $9.7 billion from a week ago as mortgage backed securities rolled off the portfolio this week. Compared to the trailing four-week average, today’s holdings represent a decline of $17.6 billion.
Since QT began just under 11 months ago, the Fed’s total balance sheet is down by 5.31%, for a simple annualized pace of 5.76%.
Recap Aug. 30
The Brazilian real, South African rand and Turkish lira each lost between 1 and 3% against the dollar, while the Argentine peso was hammered to the tune of 13.5% to a fresh record low of 38.5 per greenback. In tandem with the latest lurch wider in the EM currency realm, the stock market saw its first pullback since breaking to new highs last week, while Treasury yields dropped across the curve.
A weak stock market and flat CRB Index didn’t stop WTI crude oil from climbing back above $70 a barrel, while the VIX was also well bid, spiking by more than 10% this afternoon to settle at a near-three week high.
- Philip Grant
Wednesday, August 29, 2018
Turkish bath
In the Republic of Turkey this summer inflation and bond yields surge while the lira crumbles, down 41% year-to-date. In dollar terms, the Turkish stock market is down a whopping 53% in 2018. Now in progress is the hunt for a silver lining.
Sentiment is bad and getting worse. “Turkey entering a steep recession,” a Capitol Economics report declared today. Jason Tuvey, senior emerging markets economist at the London-based research firm, forecasts output contraction of as high as 4% year-over-year in the fourth quarter. That would be the steepest decline since 2009.
Economic sanctions imposed by the U.S. in response to the jailing of American pastor Andrew Brunson (who has since been moved to house arrest) have added one layer of agita; Less-than-comforting rhetoric from Turkish President Recep Erdogan another. Following his re-election on June 24, Erdogan appointed his son-in-law Berat Albayrak to head the newly-consolidated ministry of finance and treasury. Jared Kushner wouldn’t complain, but investors turned thumbs down.
The grim financial picture is also raising the specter of systemic stress. According to analysts at J.P. Morgan Chase & Co., Turkey is facing almost $179 billion in foreign-currency debt maturities through July 2019, a figure which equates to nearly a quarter of full-year GDP. Yesterday, Moody’s Investors Service downgraded the credit ratings of 18 banks and two non-bank financial companies, citing “a substantial increase in the risk of a downside scenario, where a further negative shift in investor sentiment could lead to a curtailing of wholesale financing.”
Might Turkey, the world’s 17th-largest economy by 2017 GDP according to the World Bank, be headed for default? The market is increasingly coming around to that possibility, as 5-year sovereign credit default swaps have spiked recently.
Turkish 5-year CDS. Source: The Bloomberg
How bad might things get? Independent strategist Russell Napier predicts in the Aug. 22 edition of his Solid Ground Fortnightly commentary: “Turkey will almost certainly be the largest emerging market default of all time, should it resort to capital controls as your analyst expects, but it could also be the largest bankruptcy of all time given the difficulty of its creditors in recovering any assets.”
Of course, high risk and outsize opportunities go hand in hand. For a sense of the latter, Grant’s spoke with value investor Haydar Acun, managing partner at Marmara Capital Asset Management in Istanbul. In an email earlier this month, Acun reminded Grant’s that Sir John Templeton achieved massive gains by investing in South Korean assets during the depths of the 1998 emerging markets crisis.
Acun, noting today the acute “boom and bust” nature of Turkish economic cycles, forecasts that the nascent crisis can abate on its own as imports fall and the current account deficit improves. Acun likewise believes that European banks will continue to lend in Turkey, as they can continue to make money thanks to sky-high interest rates. Authorities still have economic levers they can pull, such as privatizing the railways, which would raise significant capital.
Assessing the potential for sovereign default and the imposition of capital controls, Acun observes that “Turkey has never done such things before, and I don’t think they are options for the government.” As for the stock market, Acun reports that Turkish equities are currently trading at “50, 60, 70% discounts to net asset value,” with a number of companies trading with substantial net cash positons.
By way of example, construction firm Enka Insaat ve Sanayi AS (ENKAI TI) holds nearly TRY 5 billion ($773 million) in net cash against a TRY 25.3 billion market cap, and is expected to generate TRY 2.1 billion in free cash flow and TRY 2.7 billion in adjusted net income this year.
Real estate investment trust Alarko Gayrimenkul Yatirim Ortakligi AS, (ALGYO on the Istanbul exchange) currently trades at a TRY 533 million market capitalization, with TRY 471 million in cash and no debt. The company generated TRY 52.1 million in free cash flow over the 12-months ended June 30.
Pharmaceuticals company EIS Eczacibasi (ECILC TI) holds TRY 534 million in net cash, more than 20% of its TRY 2.5 billion market cap, and generated TRY 283 million in free cash flow over the 12 months ended June 30.
Recap Aug. 29
Another day, another new high on the S&P 500, as tech and consumer discretionary led the broad index to its fourth straight record close. Commodities were also bid, with WTI crude advancing back near $70 a barrel, while the Treasury curve flattened a bit amid modest strength in the long end.
But as the bull march continues, emerging markets continue to unravel. Today, the Argentine peso made another lifetime low against the dollar after president Mauricio Macri asked the IMF to accelerate the distribution of its $50 billion bailout agreed to in May.
- Philip Grant
Tuesday, August 28, 2018
Bean oh
Today, the Invesco Deutsche Bank Agriculture Fund ETF (DBA on NYSE Arca),
Today, the Invesco Deutsche Bank Agriculture Fund ETF (DBA on NYSE Arca),
Recap Aug. 28
Bean oh
Today, the Invesco Deutsche Bank Agriculture Fund ETF (DBA on NYSE Arca), which invests in a wide array of agricultural commodities, plumbed a fresh lifetime low, down 9% year-to-date and 42% from its interim highs in April 2014. The record high in the S&P 500 and neutral recent showing from the broad commodity realm (the CRB index remains near the midpoint of its one-year range) puts into relief the grim action in the grains.
DBA, 5-year chart. Source: The Bloomberg
The pain in agriculture prices can be largely attributed to soybeans according to Arlan Suderman, chief commodities economist at INTL FCStone, Inc. Suderman terms soybeans “the anchor of the grain complex.” The ongoing trade spat with China, the largest destination for U.S. agricultural exports at $12.3 billion last year, figures prominently in the equation. Following an unsuccessful round of negotiations last week, the Trump administration yesterday announced a $4.7 billion subsidy package to domestic farmers who have incurred losses as a result of foreign tariffs.
While demand prospects remain tenuous, there is no such ambiguity on the supply side. According to updated estimates from Pro Farmer following their annual crop tour, U.S. soybean production is set to reach a record 53 bushels per acre this season, topping the record of 52 per acre established in 2016 and above the 51.6 bushels forecast by the company on Aug. 10. Sherman Newlin, a farmer in Crawford County, Ill., told Bloomberg: “Soybeans [yields] are going to be phenomenal. To me, the pile still gets bigger.”
There are other problems facing U.S. farmers. China, the world’s largest soybean customer, imports beans to feed its hogs, whose numbers are now threatened by disease. Last Thursday, China’s Ministry of Agriculture and Rural Affairs confirmed the existence of African swine fever in a fourth province of the country. China, home to roughly half the world’s population of pigs, has been forced to cull tens of thousands in response to the disease as no known cure or vaccine exists. Today, the U.N.’s Food and Agriculture Organization warned that the outbreak “may spread to other Asian countries anytime.”
As news flow goes from bad to worse, some investors are loading the bearish side of the speculative boat. According to data from the Commodity Futures Trading Commission, hedge funds carried a net-short position of 40,049 futures and options contracts, which Bloomberg reports is the most bearish positioning for this time of year since 2006.
Confirmed believers in the truism that the cure for low prices is low prices, Grant’s checked in with grain expert and paid-up subscriber Keith Bronstein. Might the brutal price action be setting the stage for opportunity on the long side? Not in the immediate term, councils Bronstein:
Soybean crop development has been optimal and the tariff issue has not been resolved. I believe that Dec. 1 is the point of critical outcome on tariffs. Once we get to Jan. 1, China is safe at home on reliance upon South African supplies. This migrates the world soy surplus entirely to the U.S. At that point, I believe the U.S. would need to shift acres from soy to corn and that will require a real price adjustment.
Now we watch final corn production and wheat crops finishing weather in Europe and the former Soviet Union along with Australia. I still think world wheat numbers have a potential to ignite higher market clearing prices but that may be an October to June story, if at all. Stay tuned.
Note to grain bulls. Bring patience along with your money.
Recap Aug. 28
Stocks finished unchanged, with the S&P 500 managing to eke out another closing high thanks to strength in the real estate realm, while resources took a break from their recent run as the CRB index came under pressure despite a weaker dollar. Treasury yields rose for a second straight day, with the 10-year settling at 2.88% while the 2- and 10-year spread inched wider to 21 basis points.
- Philip Grant
Monday, August 27, 2018
Forest for the trees
On Aug. 14, quasi-state owned military-defense company Xinjiang Production & Construction Corp. defaulted on a RMB 500 million ($73 million) a 270 day note, a development which The Wall Street Journal notes “is nudging China watchers to think harder about the extent to which local governments will step in” to help encumbered borrowers meet their obligations. Public debt may soon take center stage, as so-called local government financing vehicles (LGFVs) face a sharp increase in principal repayments due. According to a Bloomberg dispatch on Friday, LGFV bonds will see $49 billion of quarterly maturities through June of next year. That’s up by 40% from the maturity schedule in 2017.
Not that the word of credit-rating agencies should be treated as gospel. On Aug. 18, Dagong Global Credit Rating Co. was barred by regulators for soliciting new business for one year. Last Thursday, Caixin Global reported the reason for the harsh penalty: Dagong “required at least 26 issuers to purchase its consulting software before it would increase their ratings or the ratings of its bonds.” The software cost $1.4 million on top of additional six figure annual service fees, according to Caixin. In January, Dagong downgraded its U.S. government debt rating to triple-B-plus from A-minus, with a negative outlook (so, adjusted for deceit, Donald Trump’s Treasury could be triple-A).
This summer has been a long, hot one for peer-to-peer lending companies. Last Tuesday, the Peterson Institute for International Economics reported that total outstanding loans in the industry collapsed to less than RMB 1 trillion in July from 1.3 trillion a month before, while 15% of all peer-to-peer lending platforms have “run into serious trouble” since the beginning of June. Author Martin Chorzempa summarizes the potential systemic risks lurking within the peer-to-peer business model:
In practice, P2P platforms in China provide guarantees, meaning that investors get no hint that risk is piling up until suddenly the platform cannot meet its obligations and goes offline. These platforms also issue wealth management-type products that have maturity mismatches, putting them at the risk of a run if spooked investors pull out their investments. The China Banking Regulatory Commission (CBRC) issued rules in August 2016 making these practices illegal, but the turmoil over the last two months indicates that numerous platforms have ignored them.
Those dual cracks in the credit façade correspond with other market indicators suggesting things are less than stellar in the Middle Kingdom. Year-to-date, the Shanghai Composite Index is down 16% in local terms, placing it among the world’s weakest performers, while the renminbi has lost 8% against the greenback since April. The government is duly looking to mitigate Mr. Market’s harsh verdict, with the People’s Bank of China announcing Friday that it has reactivated a policy known as the “counter-cyclical factor” by which local banks fix the renminbi at stronger levels to ward off unwelcome currency weakness.
On Wednesday, China’s State Council issued a statement urging banks and other lenders to keep credit flowing to small businesses, with the council suggesting timelier loan approvals and higher loan-to-value ratios among potential remedies. Also on Wednesday, Bloomberg reported that the General Administration of Customs announced it will not report import and export figures for an array of industrial, agricultural and energy commodities in July, the fourth consecutive month of radio silence. If you don't have anything nice to say...
An Aug. 20 analysis from J Capital Research brings these somewhat disparate indicators into broader relief:
Visits with friends in banks and shadow banks in Beijing, Shanghai and Chengdu this week found a banking industry that is more risk-averse than ever. The hesitancy to lend into a weak economy is making everything harder than it used to be.
Recap Aug. 27
After going more than six months in between new closing highs, the S&P 500 managed its second record finish in two tries. Resources led the way, as a soft dollar buoyed the commodity complex with gold rising back above $1,200 an ounce. Treasury yields moved higher across the board, with the 2- and 10-year spread widening a few basis points off the cycle low reached Friday.
- Philip Grant
Friday, August 24, 2018
No context, no problem
Your headline of the day (year?), from the Miami Sun Sentinel:
Your headline of the day (year?), from the Miami Sun Sentinel:
Take it all
A changing of the guard is afoot in the Big Apple.
A changing of the guard is afoot in the Big Apple.
Correction
Recap Aug. 24
No context, no problem
Your headline of the day (year?), from the Miami Sun Sentinel:
Florida candidate for Congress: Alien abduction doesn't define me
Take it all
A changing of the guard is afoot in the Big Apple. Yesterday, tech website Recode reported that WeWork Cos. is closing in on becoming the number one office space lessee in Manhattan, set to surpass incumbent J.P. Morgan Chase & Co. “any day now.”
Also yesterday, fellow tech site Geekwire relayed that WeWork is “in the midst of a massive expansion that will more than double its presence in the Seattle area.” Jon Slavet, managing director for the U.S. and Canada West at WeWork, told Geekwire that the company plans to grow to 1.5 million square feet in Seattle by early next year, from the current 900,000 square feet.
It’s not hard to find the genesis of WeWork’s rapid expansion. On June 14, The Wall Street Journal reported that SoftBank was engaged in talks with its portfolio company for a further “multibillion dollar” investment valuing WeWork at between $35 and $40 billion. That compares to a $20 billion valuation garnered by WeWork from a $4.4 billion SoftBank-led equity investment in August 2017. Nearly a third of that prior $4.4 billion was used to cash out existing shareholders, according to the Journal.
With SoftBank and its Vision Fund venture capital arm readily paying the bills, why not go for the downs? Conventional profitability is clearly no object: While WeWork managed to double its revenues to $886 million last year, net losses grew even faster to $933 million from $430 million in 2016. Bloomberg reports that closely held WeWork managed to lose less than its top-line take in the first half of this year, finishing $723 million in the red through June on $764 million in sales. Alternatively, WeWork declared in an April 24 prospectus that the company generated $233 million in “Community Adjusted EBITDA” in 2017, up from $96 million the year prior. That newfangled term of art is described thusly:
We define Community Adjusted EBITDA as Adjusted EBITDA before Growth Investments further adjusted to remove general and administrative expenses. Community Adjusted EBITDA Margin measures Community Adjusted EBITDA as a percentage of membership and service revenue and management fee income from advisory services provided to Branded Locations.
Innovation clearly takes many forms.
Anyway, the rapid growth in the short-term leasing market has duly stirred nascent competition. In June, peer company Convene LLC completed a $152 million Series D fundraising round, while in July fellow co-working operator Knotel, Inc. announced the purchase of commercial real estate data firm 42Floors, giving the acquirer “access to data and technology on over 10 billion square feet of office space,” according to the press release.
It’s safe to say WeWork is not taking this competitive encroachment lying down. From a Bloomberg dispatch yesterday:
The company is offering commercial real estate brokers worldwide a 100% commission on the first year of rent paid by any tenant who switches to WeWork from a top competitor and signs a lease by October 1. Tenants also get half off the first year’s rent if they sign for at least 12 months. That means, accounting for the discount, that WeWork’s current bonus to brokers is five times the standard commission it typically offers of 10% on the first year’s rent.
As it adds locations around the globe, the startup often offers discounts to “assist in driving initial occupancy levels,” which made its average revenue per member drop more than 6% last year, according to [the prospectus]. Its overall sales and marketing costs, meanwhile, rose from $43 million to $143 million in 2017.
The Dec. 15, 2017 edition of Grant’s termed highly indebted and highly acquisitive SoftBank the “epitome of the cycle.” Can you be out-epitomed by your own office-space portfolio company?
Correction
A blunder in yesterday’s ADG: Vancouver is Canada’s third largest city, not second. Montreal takes that slot. Back to remedial geography class for your author.
Recap Aug. 24
New highs are here at last, as the S&P 500 finally punched above its late-January peak amid strength in resources and technology. Fittingly, the bullish milestone took place on the day of Fed chairman Jerome Powell’s keynote speech in Jackson Hole, an address which the market took to be on the dovish side as evidenced by a weak dollar and strong showing from the commodity complex.
While stocks party, the yield curve continues to race toward inversion. The spread between the 2- and 10-year Treasury notes shrank to less than 19 basis points, another fresh post-2007 low.
- Philip Grant
Thursday, August 23, 2018
Canada dry
Summer is still in full swing, but things remain pretty cool in the housing market of the Great White North. According to the Canadian Real Estate Association, home sales ticked 1% lower year-over-year in July, with total transactions at their lowest since 2012. In the formerly white-hot metro Vancouver (Canada’s third-largest city) sales plunged 30% to an 18-year nadir. Year-to-date through July, nationwide activity is at its slowest since 2009, while the Teranet-National Bank Home Price Index rose by 1.75% year-over-year, also a fresh post-2009 low. Phil Moore, president of the Real Estate Board of Greater Vancouver, commented: “With increased mortgage rates and stricter lending requirements, buyers and sellers are opting to take a wait-and-see approach for the time being.”
Waiting and seeing. Teranet-National Bank House Price Index, year-over-year change. Source: The Bloomberg
The tightening macroeconomic screws don’t look set to loosen anytime soon. Last Thursday brought the release of hot inflation data, with July headline CPI rising by 3% year-over-year, well above the consensus 2.5%. That nudged the odds of a 25 basis point rate hike from the Bank of Canada at the Oct. 24 meeting to 63% from 53%, according to interest rate futures. Meanwhile, the current five-year Canadian bond yield of 2.2% remains near the seven year highs reached in May while growth in overall money supply continues to abate. According to the Bank of Canada, M2 grew by 3.67% year-over-year in June, just off the post-financial crisis low of 3.38% logged one month prior. Since the housing boom was reignited in 2009, monthly M2 growth has averaged 6.56% on a year-over-year basis.
As rates put the squeeze to the encumbered Canadian borrower (household debt stood at 178% of disposable income at year-end 2017 according to the Organization for Economic Co-operation and Development, far above the U.S. peak of 144% in 2007), the regulators are also trying to pump the brakes. Thus, on Sept. 17, the province of British Columbia will introduce a new property transfer tax, which will require homeowners to provide their citizenship information, among other data, if purchasing a home through a corporation or trust. That follows the nationwide introduction of mandatory stress tests by the Office of the Superintendent of Financial Institutions in January, which compel all homebuyers to show that they can afford interest payments at the greater of the Bank of Canada’s five-year benchmark mortgage rate or 200 basis points above the contracted rate.
On a headline basis at least, soft data, higher interest rates and unwelcome regulatory changes were nowhere to be found in the fiscal third quarter results from Canadian Imperial Bank of Commerce (CM on the Toronto Stock Exchange). This morning, CIBC announced a 25% year-over-year jump in net income while increasing the quarterly dividend by 2.3% amid a jolt in its U.S. operations following its June 2017 acquisition of Chicago-based PrivateBancorp, Inc. In response, shares rose slightly to close to within 1.5% of the all-time highs reached on Jan. 5.
CIBC’s strong bottom line results contrast with a marked slowdown in mortgage lending, an important metric considering that the bank’s exposure to domestic residential mortgages stands at 60% of its total loan book. In the third quarter, mortgage balances rose by a modest 2.5% year-over-year, a drastic slowdown from the 13% growth in the third quarter last year. Asked about results excluding the operations of the U.S. subsidiary, chief financial officer Kevin Glass noted that earnings were essentially unchanged on a sequential basis, amid “slightly higher. . . loan loss provisions in the real estate business.”
There’s more where that came from.
QT progress report
The Fed’s portfolio of securities held outright footed to $4.034 trillion this week, a modest $1.3 billion decline from the prior reading. Mortgage-backed securities represented more than 100% of the decline, as Treasury holdings increased slightly. Today’s holdings are down by $17.5 billion from the trailing four-week average.
Since the “QT” operation began on Oct. 1, the Fed’s total balance sheet holdings are down by 5.09%, for a simple annualized pace of 5.63%.
Recap Aug. 23
Waiting for Godot, 2018 style. Stocks edged lower, as the S&P 500 nears a fifth straight week of remaining within 3% of its January peak without breaking through to new highs. While the broad average treads water, the yield curve continues to collapse, as the 2- and 10-year Treasury spread fell to another cyclical low of less than 20 basis points. A solid bounce in the Dollar Index looked to pressure commodities, with the exception of WTI crude which finished near $68 a barrel.
- Philip Grant
Tuesday, August 7, 2018
Earplugs optional
Grist for a potential sequel to Dazed and Confused?
Grist for a potential sequel to Dazed and Confused?
Dark Star
Silence is golden, usually.
Silence is golden, usually.
Recap Aug. 7
Earplugs optional
Grist for a potential sequel to Dazed and Confused? From Germany’s Deutsche Welle:
Two elderly German men escaped the confines of their nursing home on Friday to attend Wacken Open Air, police said.
The nursing home alerted police after the gentlemen were found to be missing from the center. Police then found the aging metalheads at 3 a.m. at Wacken Open Air, the world’s biggest heavy metal festival. A police spokeswoman said they were "disoriented and dazed."
The men were reluctant to leave the four-day festival so police escorted them home with the help of a taxi and a patrol car.
"They obviously liked the metal festival," police spokeswoman Merle Neufeld told public broadcaster Norddeutscher Rundfunk. "The care home quickly organized a return transport after police picked them up."
You got to give the people what they want.
Dark Star
Silence is golden, usually. For a recent exception to the rule, we turn our compass north to Canada’s Constellation Software, Inc., (CSU on the TSX) a Toronto-headquartered conglomerate that strives “to acquire, manage and build market-leading software businesses,” according to the corporate web site.
For Constellation and its longtime, publicity-shy president and chairman of the board Mark Leonard (described by the Globe & Mail as the Warren Buffett of Canada), less is more and, so, the company announced on July 25 that it would no longer hold quarterly conference calls. A day later, Constellation reported weaker than expected second quarter figures, featuring a slight revenue miss and a larger shortfall on the bottom line. Adjusted earnings per share registered at $5.75, well below the consensus $6.78, while operating cash flow declined by 13%. In response, shares traded lower by 10%.
Of course, that decline was little more than a drop in the bucket to all but the most recent buyers of Constellation stock. Shares are up by 520% over the last five years, a 41% compound annual growth rate, and up by 53% from a bearish assessment in the Dec. 9, 2016 edition of Grant’s. Other corporate virtues are also readily apparent. Somewhat unusually for a growth-by-acquisition vehicle, Constellation’s balance sheet shows a net cash position, as the company finances the bulk of its M&A activity through cash from operations as opposed to debt. According to the Street (Bay Street, that is), mushrooming growth isn’t expected to abate anytime soon: Analyst consensus calls for revenues of C$3.5 billion and adjusted net income of C$570 million in 2019, far above the C$2.8 billion and C$289 million logged in the trailing 12-month period.
Those gaudy growth expectations draw something of a contrast with Constellation’s second quarter figures. While headline revenues jumped 25% year-over year, organic revenue growth registered just 4%, or 1% on a constant currency basis. Adjusted earnings before interest, taxes, depreciation and amortization (EBITDA) margins came in at 23% for the quarter, down from 26%, while adjusted net income of $52 million barely budged from the $51 million in the second quarter of 2017.
Howard Leung, an analyst at Veritas Research Investment Corp., suggested to Grant’s that the margin decline may have stemmed from faster than expected growth in staffing expense costs, particularly in professional services. Leung, who in March upgraded Constellation shares to buy from a sell, expects the margin contraction to soon abate, pointing to management’s demonstrated ability to shape up prior acquisitions.
An investor who wishes to remain anonymous put it slightly differently: “At best there is a ramp up in costs somewhere that is temporary. At worst their core high margin business is in decline.”
Clearly, the investing public has conferred the benefit of the doubt on Constellation: With shares priced at 67 times trailing adjusted EPS, just 0.71% of the float is sold short, according to data from Bloomberg. That’s a lower short interest than any of the FAANG contingent of Facebook, Inc., Apple, Inc., Amazon.com, Inc., Netflix, Inc. and Alphabet, Inc.
For our part, the company's increasingly poor disclosure and the increasing difficulty in moving the needle through acquisitions following its rapid ascent are the salient concerns. Indeed, Constellation spent C$43 million on an undisclosed number of deals in the quarter, far below the expectation of analysts at Industrial Alliance Securities, who had penciled in C$80 million in deal volume for the period. Leonard seemed to acknowledge that second point of concern in his April shareholder letter (it will be Constellation’s last such annual correspondence), albeit in hypothetical terms:
One day Constellation may find that vertical market software businesses are too expensive to rationally acquire. If that happens, I hope we'll have had the foresight and luck to find some other high return on equity non-VMS businesses in which to invest at attractive prices. I am already casting about for such opportunities. If we don’t find attractive sectors in which to invest, then we’ll return our free cash flow to our investors.
The company’s decentralized structure manifests itself in interesting ways. Asked about how recent acquisitions integrate into the company on an Oct. 27, 2017 conference call, chief investment officer Bernard Anzarouth replied:
I think about 50%, 50% of the acquisitions that we've been making have been tightly integrated to our existing operations and the other 50% are standalone operations, we can tell you that. . . But it's really hard, it's not a crisp number that I can give you.
We imagine that investors find such ballpark figures to be no problem, so long as the stock continues to go up. Of Constellation’s demonstrated desire to share as little with investors and the public as possible, Grant’s wrote:
In the absence of information, one shouldn’t dogmatize. Then again, in this case, information seems to be withheld. One is curious to know, for example, whether, ex-acquisitions, Constellation’s business is contracting or expanding. It had better be expanding, given the rise in cloud computing and app-based solutions.
A simple question for those mostly happy CSU shareholders: What’s in your portfolio, exactly?
Recap Aug. 7
Another modest gain in the S&P 500 is relegated to the back-burner, after Tesla, Inc. CEO Elon Musk pronounced on Twitter this afternoon that the company is seeking to go private at $420 a share. The evident absence of financing for such a deal (despite Musk’s initial claim to the contrary) served as no problem to investors, who bid TSLA shares higher by 10%.
In more conventional action, yields ticked higher across the Treasury curve, while a downtick in the U.S. Dollar Index afforded the beleaguered Turkish lira a respite after collapsing by nearly 5% yesterday.
- Philip Grant
Monday, August 6, 2018
Post pattern
Cleanup in aisle three. It’s been a rough road lately for the those legacy supermarket mainstays cranking out canned soup, processed cheese and boxed cereal; since July 2016, the S&P packaged foods sub industry index is down by 16%, lapped by the S&P 500’s 31% rise over that period. However, the beleaguered group got some good news last week in the form of better than expected quarterly results from industry players Kraft-Heinz Co. (KHC on the Nasdaq) and Post Holdings, Inc. (POST on the NYSE) that spurred strong bullish reactions in the share price of each. Let’s take a quick look at a pair of companies that came under the scrutiny of Grant’s in the March 25, 2016 (as well as March 10, 2017) and Sept. 16, 2016 issues, respectively.
Kraft-Heinz shares caught a near 9% pop on Friday after reporting $1 per share in adjusted earnings and $6.69 billion in revenue, above the consensus $0.92 in adjusted EPS and $6.56 billion revenue. The stronger bottom line was no thanks to margins. Adjusted net income margins footed to 17.1% for the quarter, down from 19.4% year-over year. Instead, it was cost cutting that carried the day, a testament to the thrifty ways of KHC’s majority shareholders, Brazilian private equity firm 3G Capital and Warren Buffett’s Berkshire Hathaway, Inc.
Perhaps more than results, M&A potential may explain Friday’s pop. According to the New York Post, Kraft-Heinz has entered into “exploratory talks,” with Campbell Soup Co. (CPB on the NYSE), another Grant’s pick-to-not-click from March 25, 2016 which in December paid 19 times trailing adjusted earnings before interest, taxes, depreciation and amortization (EBITDA) to acquire pretzel company Snyder’s-Lance, Inc.
Asked about potential acquisitions on Friday’s conference call, Kraft-Heinz CEO Bernardo Vieira Hees did nothing to quiet the rumor mill:
I think the food industry is an industry that has not consolidated with the same speed as other[s]. . . So we do believe looking mid or long-term that there will be more consolidation in the industry and we have not been shying [away from saying] that we want to be a force behind this when it happens.
A look at the company’s stagnant income statement can help explain KHC management’s eagerness to do a deal. Next year, the Street is penciling in $26.5 billion in revenues, $7.9 billion in adjusted EBITDA and $4.7 billion in adjusted net income, virtually unchanged from 2016’s $26.5 billion, $8.2 billion and $4.2 billion respective figures. Thanks to a 35% markdown from its February 2017 highs, Kraft-Heinz shares currently trade at 16 times consensus adjusted EPS for 2019. With net debt at $31 billion, a leverage ratio of over four times EBITDA and a triple-B credit rating at Standard & Poor’s (the last full stop before junk), a corporate marriage with the even-more encumbered CPB (currently leveraged at five times consensus 2019 adjusted EBITDA) would leave management at this hypothetical combined entity with precious little room for error. The cost-cutters have their work cut out for them.
Then there’s Post, which has darted higher by 10% in the last two sessions to a fresh record high, leaving the stock up by the 18% from when we said our piece in September 2016. On Thursday, the company likewise reported mixed results for the fiscal third quarter, with stronger than expected net sales and EBITDA partially offset by weaker adjusted EPS, while management offered a full-year EBITDA forecast slightly above the consensus. In addition, Post announced the formation of a new joint venture with private equity firm Thomas H. Lee Partners to spin out its private brands business, reaping total proceeds of $875 million. In exchange, Lee will receive a 39.5% stake in the spun out entity, and preferred stock with an 11% coupon which is cumulative and can be paid-in-kind.
The results were enough to reinforce the conviction of one of POST’s biggest bulls. In response to the quarterly update, Timothy S. Ramey of Pivotal Research Group raised his price target to $120 from $105, the highest on the sell-side. Ramey detailed his rationale in a note Friday:
At 10.3 times 2019 enterprise value to EBITDA Post remains crazy cheap relative to peers with growth that is far better than its peers. Free cash flow yield is over 7%. The company is among the best managed and fastest growers in the packaged food space – this value discrepancy will not persist long in our view.
B2/single-B-plus-rated Post, which has undertaken 16 separate acquisitions since its 2012 spinoff from Ralcorp Holdings, Inc. under the auspices of widely respected chairman William P. Stiritz, carries a debt load that puts both Kraft-Heinz and Campbell’s in the shade at 5.7 times fiscal 2018 EBITDA (the company estimates that leverage will drop to 5.5 times once the private brands deal is complete). While the stock partied in reaction to Thursday’s announcement, credit investors are a bit more circumspect: The senior unsecured 5 3/4 notes of 2027, issued last October at 105.5 cents on the dollar, barely budged in reaction, currently trading at 96.79, compared to 96.6 last week.
Are the creditors seeing something that the stockholders missed? Thursday’s release did contain a detail that may give pause to the bull crowd. An anonymity-seeking investor notes to Grant’s via email:
Curiously, sell side analysts don’t seem fazed by, or even mention, the fact that on this one year anniversary of closing the deal for [U.K. breakfast cereal company Weetabix], the business has only generated $126 million [£93 million] in trailing EBITDA vs. the claim that this was a £120 million EBITDA business, pre-synergies, when they bought it. That means the £1.4 billion they paid is actually 15 times EBITDA, not the 10 times (with synergies) they touted at the time of purchase. And yet, somehow the Street still views them as great acquirers of business!
Recap August 6
Could tomorrow be the day for equity bulls? Stocks rose, with the S&P 500 closing to within 80 basis points of its record close established on January 26, a benchmark that looks all the more attainable considering the VIX volatility index simultaneously resides at its lowest since January.
Treasurys stayed in a tight range, with the 10-year yield ticking slightly lower to 2.94%. A modest rise in the greenback was enough to push the broad U.S. Dollar Index to a fresh 52-week high, while the ongoing decline in the Turkish lira is anything but modest. Currently trading at 5.31 per dollar, the lira shed 4.5% of its value today and is down by 12% vs. the buck since July 23.
- Philip Grant
Friday, August 3, 2018
Down in the bottom
From Denver’s NBC9 news:
From Denver’s NBC9 news:
Step Brothers
Like Frank Costanza, King dollar is a Phoenix, rising from Arizona.
Like Frank Costanza, King dollar is a Phoenix, rising from Arizona.
Recap August 3
Down in the bottom
From Denver’s NBC9 news:
A bear was stuck in a storm drain in Colorado Springs for about an hour but has since freed itself, according to several tweets from Colorado Parks and Wildlife's Southeast Region. The bear escaped through an open manhole after it was open for about 6 minutes.
CPW says it's possible this bear picked this storm drain because there was an open garbage receptacle filled with trash and branches from a tree filled with berries within maybe "a hundred yards away."
Prudent. After careful review, it seems likely to us that the bear was stockpiling foodstuffs ahead of Tesla earnings this week.
Step Brothers
Like Frank Costanza, King dollar is a Phoenix, rising from Arizona. After slumping throughout 2017, the buck has been on a tear of late with the broad U.S. Dollar Index jumping 7% since April. As with all such sharp price gyrations, some constituencies find it more welcome than others.
On Monday, the Bank for International Settlements published its global liquidity indicators for the first quarter 2018, finding that dollar-denominated borrowings by emerging market economies rose to a record $3.7 trillion at the end of March, up a robust 16% year-over-year. That $3.7 trillion in dollar debt towers over that of rival currencies, with euro denominated EM debt footing to €644 billion ($790 billon) and yen based borrowings totaling ¥8 trillion ($70 billion).
Among those dollar-based borrowers, China stands head and shoulders above the crowd. The Middle Kingdom alone is responsible for nearly $500 billion in dollar denominated bonds, and some observers think the debt party is far from ending. Ben Yuen, fixed-income chief investment officer for BOCHK Asset Management Ltd., tells Bloomberg he anticipates 20% annual growth in outstanding Chinese dollar bonds through the next five years, which would bring the total debt load above $1 trillion.
Of course, the recent broad-based rise in the greenback has put the squeeze to these borrowers, not least the Chinese. Since April, China’s renminbi has fallen by 9% against the buck, trading within 1% of its post-2008 lows this morning. That latest leg lower looked to get the attention of the powers that be in Beijing. During the Asian trading session, the People’s Bank of China announced it will impose a 20% reserve requirement on forward FX contracts, effectively placing a tax on those short the Rmb and spurring a near 1% intraday rebound against the dollar.
Turkey, holder of some $200 billion in dollar debt according to the BIS and the largest component of the iShares J.P. Morgan USD Emerging Market Bond ETF, likewise enjoyed a currency reprieve today as a cooler than expected July inflation reading (consumer prices rose a mere 15.9% year-over-year) spurred a 0.6% bounce in the lira against the greenback. The only problem? The lira is down by 27% since April and remains just off the record low, with declines accelerating this week after the U.S. sanctioned two senior Turkish officials in response to the ongoing detention of American pastor Andrew Brunson.
Creditors are getting nervous. The dollar-pay Turkish 5 3/4 notes of 2047, issued last May at 98.24 cents on the dollar and trading above 99 as recently as January, finished today at just over 78 cents on the dollar for a yield-to-maturity of 7.37%.
Only 29 years left until return of principal! The Turkish 5 3/4s of 2047. Source: The Bloomberg
President Recep Erdogan, who has termed high interest rates “the mother and father of all evil,” has opted to make the monetary battle a family affair. Following his June 24 re-election, Erdogan installed his son-in-law Berat Albayrak, as treasury and finance minister. For his part, Albayrak told Turkish broadcaster NTV today that: “We aim to discipline both inflation and interest rates and to reduce them to single digits by 2019.”
In a speech today, Erdogan proclaimed that Turkey is “face to face with an economic war,” before assuring listeners: “Do not worry, we will win it.” The newly re-elected president called on Turkish citizens to convert their “under the pillow” dollars and euros to liras, in order to demonstrate “a local and national resistance to the whole world.” Erdogan went on to call for Turkey to establish closer economic ties with China, including issuing bonds denominated in renminbi.
A match made…somewhere.
Recap August 3
Get the party hats ready. Another solid day for stocks lifted the S&P 500 to within one percent or so of the January closing highs, while the VIX finished below 12 for its lowest weekly close since January. Perhaps most impressively for the bulls is the fact that the rally has taken place without help from tech, as the NYSE FANG+ Index finished little changed and remains nearly 6% below its levels from Facebook, Inc.’s second quarter results last week.
Treasurys were bid across the board with the 10-year yield dropping back below 2.95%, while the dollar traded sideways and commodities rose.
- Philip Grant
Thursday, August 2, 2018
The Producers
Let’s have another look at the oil market, where the sharp advance of early summer has been all but forgotten: Even with a strong bounce to finish today at more than $69 a barrel, West Texas Intermediate Crude is down 5% from its July 10 highs. On an absolute basis, July was the worst month for black gold in an even two years.
While a steep late June run-up (Almost Daily Grant’s, June 29) and demand concerns related to the U.S./China trade spat have helped set the stage for a pullback, oil bears have also found a friend in the Organization for Petroleum Exporting Countries. July production from OPEC came to 32.6 million barrels per day, the highest level of the year and not far from November 2016’s record output of 34.1 million barrels per day. Large output gains from Saudi Arabia and Russia, as well as a return to production from Libya after a multi-week outage figure in OPEC’s rising production.
OPEC daily crude oil production since 1962. Source: The Bloomberg
For the near term at least, the prospects for upside in oil are further clouded by an ominous development in the futures curve. Today, Bloomberg reports that the gap between the near contract and the following month contract for Brent crude has swung from a 53 cent premium in June to a 63 cent discount a month later, signaling a potential surplus in supply. Marwan Younes, chief investment officer at Massar Capital Management, commented: “The increase in supply from OPEC seems to be real and it’s already translating into an overhang in supplies of Brent.”
While OPEC ramps up, the U.S. shale machine continues to hum. According to the weekly estimates from the Energy Information Administration, domestic production remains at a near-record level of 10.9 million barrels per day as of the final week of July, nearly double the levels achieved in July 2011. However, a second look at the data indicates that production might not be quite so flush. According to the latest EIA’s monthly Crude Oil and Natural Gas Production Report released on Tuesday, the revised U.S. output figures for May of 10.442 million barrels a day represents a reduction of 300,000 barrels from the prior estimate and remains below April’s 10.472 million daily output. Nevertheless, the newly slimmed-down May production figure represents a solid 13.3% uptick year-over-year.
But while rising production and the trade war garner headlines, a potentially more impactful long-term development continues apace. According to Rystad Energy, discoveries reached a record low in 2017. While the consulting firm expects 2018 discoveries to rise 30% from last year’s trough, that uptick translates to only 20 billion barrels of discoveries in 2018, well below the 33 billion barrels in additional capacity needed to keep pace with demand. Espen Erlingsen, head of upstream research at Rystad, commented:
An uptick of 30% from the abnormally low levels in 2017 might seem encouraging, but exploration and production [companies] are currently facing a low reserve replacement ratio, on average less than 10%. This is worrisome considering the impact on global oil supply in the long term.
Overall, Rystad finds that global oil and gas companies will spend $440 billion on capital expenditures between 2015 and 2020, just under half the $875 billion in capex undertaken between 2010 and 2015.
In their second quarter letter, commodity investment firm Goehring & Rozencwajg Associates, LLC contend that the lack of investment will manifest itself in far higher prices over the long-term. Principals Lee Goehring and Adam Rozencwajg write:
Not only have huge cut-backs in global upstream capital spending impacted conventional non-OPEC oil production, but our research tells us that cuts to upstream capital spending are now beginning to impact OPEC oil production as well. Algeria, Nigeria and Angola have seen their production decline by over 1 million barrels a day in aggregate over the last four years. We believe those declines are directly related to inadequate capital spending. Combined with politically related production problems in Venezuela and Libya, OPEC spare capacity is rapidly falling to zero.
We believe the bull market in oil, (ignored thus far every step of the way by the investment community) is set to dramatically accelerate to the upside.
Concurring with the viewpoint of our friends Goehring and Rozencwajg, Grant’s remains bullish on oil and a number of energy-related companies who would benefit from higher prices. For specific securities on which we bestow a bullish bent, see the March 9, 2018, Nov. 3, 2017 and March 10, 2017 issues of Grant’s.
QT progress report
The Fed’s portfolio of securities held outright footed to $4.049 trillion, a chunky $23 billion drop from a week ago in what is the largest sequential decline in the Fed’s holdings since the balance sheet runoff began last fall. Treasurys supplied all of the change, while mortgage-backed securities holdings ticked slightly higher. Compared to the trailing four-week average, today’s figure represents a $32 billion decline, comprised roughly of two-thirds in Treasurys and the balance in MBS.
Since the Fed began QT last Oct. 1, total balance sheet holdings are down by 4.49%, for a simple annualized pace of 5.30%.
Recap August 2
Stocks were bid as tech finally got off the mat, with the NYSE FANG+ Index rising by 3% to snap its string of consolidation following the 9% downdraft which followed Facebook, Inc.’s earnings miss last week.
Treasury yields finished lower across the board with the short end outperforming to leave the curve a bit steeper, while a stronger dollar pushed gold to 16 month lows near $1,200 an ounce.
- Philip Grant
Wednesday, August 1, 2018
What lies beneath
It wasn’t so bad on the surface. This morning, apparel and unmentionables company Hanesbrands, Inc. (HBI on the NYSE) reported second quarter results, featuring revenues, earnings and guidance that largely matched analyst expectations.
Behind those neutral figures lurked an unpleasant surprise: Towards the bottom of the press release, management disclosed that mass retailer Target Corporation won’t renew the contract for the exclusive C9 by Champion activewear line when it expires in January 2020. The agreement had been in place since 2004, and contributed $380 million in revenues over the past 12 months. In response, Mr. Market offered his own discount sale of HBI shares, which fell by 19%.
Stock rout aside, the sun will still come up tomorrow for HBI, as a loss of $380 million in sales represents about 6% of the company’s $6.6 billion in trailing 12-month top line, and management repeatedly stressed on the call that they don’t expect any impact to 2019 results from Target’s decision. Indeed, retail analysts at Bloomberg Intelligence write that: “The strength of the Champion brand, combined with retailers’ need for exclusive or limited products, presents an opportunity to replace some of that business in coming years.”
Management too remains optimistic. On today’s conference call, CEO Gerald Evans struck a cheerful tone in discussing the overall business outlook:
The year is really unfolding in total as we expected. Our diversification across geographies and channels and customers is working and we came in right at the midpoint of our guidance in revenue, EPS and operating profit. And so feel good about the start, feel good about the fact that we delivered our fourth consecutive quarter of organic growth [all of 0.1% year-over-year on a constant currency basis] and better than frankly our outlook for the first half of a slight decline. So real good.
For Hanesbrands, this latest chapter in its long and winding history (the P.H. Hanes Knitting Company was founded in Winston-Salem, NC in 1901, while HBI was spun out of the Sara Lee Corporation in 2006) has been one of growth-by-acquisition. The problem: Acquisitions have come easier than growth. Since October, 2013, HBI has bought nine separate businesses for some $2.3 billion, in the process raising its net debt to $4.2 billion from $1.6 billion and leverage ratio to nearly four times earnings before adjusted interest, taxes, depreciation and amortization from 2013’s 2.2 times. Meanwhile, current-year consensus free cash flow of $607 million is barely above the $548 million in FCF generated five years ago.
The deal spree has served to goose other line items besides net debt. Goodwill plus other intangible assets footed to $2.86 billion in the quarter, more than five times 2013’s combined $550.5 million figure for a compound annual growth rate of 39%. Meanwhile, the “one-time” mergers and acquisitions expenses which are excluded from adjusted net income and EBITDA figures represent a substantial chunk of earnings before interest and taxes, or operating income. In the last four calendar years, merger and acquisition expense has totaled 27%, 24%, 45% and 35% of operating income, respectively.
Grant’s offered subscribers a bearish analysis of Hanesbrands in the July 1, 2016 issue, arguing that the company’s opaque accounting practices and deal-centric strategy presented unappreciated risks to shareholders, who were then enjoying HBI’s 135% surge from the beginning of 2013. Noting that the formula for management’s incentive compensation consisted of 40% growth in adjusted EPS, 40% in growth from cash flow from operations and 20% from growth in revenues, we wrote:
It would take a C-suite of Boy Scouts not to notice how advantageous a strategy of growth-through-acquisition would be to their own personal betterment, quite apart from the benefits it provides to the company and the shareholders. For one thing, M&A boosts headline sales growth. For another, it furnishes a handy cover for earnings adjustments. As to the latter, though the Maidenform Brands transaction closed in October 2013, management continued to expense Maidenform-related acquisition and integration costs through the fourth quarter 2015.
Since Grant’s said our piece, HBI shares have dutifully lagged, falling 28% while the S&P 500 has gained 41%. So what’s next for Hanesbrands? Grant’s put the question to Brian McGough, retail analyst at Hedgeye Risk Management and vocal HBI bear. McGough feels there is more pain to come:
Hanesbrands is caught in strategic no-man’s land, pressured by competitors such as Gildan Activewear on the low end and a number of niche players at the high end, while the organic growth promised by management was nowhere to be found this quarter.
Meanwhile, the recent deal spree that has helped enrich management through incentive compensation has all but tapped out the company’s balance sheet while adding little value to shareholders. We remain bearish, seeing up to 50% additional downside in the next 1-2 years.
Correction
Yesterday’s “shiver me crypto’s” item incorrectly described the sunken Russian vessel purportedly laden with gold as a remnant from the Sino-Russian war of 1904 to 1905. Instead, it was Japan, not China with whom Russia tangled at the turn of last century.
Recap August 1
Stocks finished unchanged on the broad S&P 500, while the NYSE FANG+ Index failed to outperform despite a 6% jump in Apple, Inc. following strong earnings for the quarter. Treasury yields ticked higher across the board with the 10-year yield exceeding 3% intraday, while a modest rise in the U.S. Dollar Index was enough to pummel both commodities and emerging market debt, with the CRB Index and iShares J.P. Morgan USD Emerging Market Bond ETF falling by 1.5% and 0.8%, respectively.
- Philip Grant
Tuesday, July 31, 2018
Shiver me cryptos
On July 18,
On July 18,
C.C.C. Rider
Happy days are here for holders of some of the dodgiest credits around.
Happy days are here for holders of some of the dodgiest credits around.
Recap July 31
Shiver me cryptos
On July 18, the Daily Telegraph reported that a South Korean diving team had recovered a sunken Russian vessel containing some $130 billion worth of gold bullion. The warship was purportedly a remnant of the Battle of Tsushima from the Japanese-Russian war of 1904 to 1905.
Today comes an update to the saga courtesy of Coindesk.com, one that could be called both a twist and, in the context of 2018, par for the course:
Authorities are reportedly looking into Shinil Group, which claims to have found a Russian shipwreck from the early 1900s, for possible fraud charges. The company launched its own cryptocurrency, which investors bought with the promise of being able to redeem tokens for treasure from the ship, according to the report.
The old cliché that “a gold mine is a hole in the ground with a liar at the top” now has a worthy modern day companion.
C.C.C. Rider
Happy days are here for holders of some of the dodgiest credits around. This morning, Bloomberg’s Lisa Abramowicz noted on Twitter that the average yield on triple-C rated U.S. corporate bonds (as measured by the relevant Bloomberg Barclays Index) fell to 7.89%, the lowest level since September 2014 and nearly half of its 30-year average of 13.32%. Last week’s yield decline of 68 basis points was the biggest since 2008, while Bloomberg likewise notes that triple-C spreads also saw their biggest decline in 10 years, to 512 basis points over Treasurys.
Bloomberg Barclays Caa H/Y Yield-to-Worst Index, two-year view
Source: The Bloomberg
Year-to-date, triple-C-rated debt resides at the head of the corporate bond class with a year-to-date return of 4.42%. That compares to a 1.2% gain for overall speculative grade bonds, a 2.6% loss for investment grade and 1.6% drop for Treasurys, according to the respective Bloomberg Barclays total return indices.
What gives? As so-called risk free yields march higher and the economy continues to expand (second quarter GDP grew at an annualized 4.1% clip), the outperformance of the shakiest credits makes sense. Indeed, rating agency Moody’s predicts that the default rate will decline to 1.5% in April of next year from its current 3.7%. In a research note yesterday, Moody’s reports that its ratio of positive to negative industry sector outlooks is “unprecedented,” concluding: “credit conditions for non-financial corporate borrowers in mid-2018 are the best since the 2008-2009 recession and financial crisis.”
Other factors seem to be giving junk bonds a helping hand. According to Bloomberg, total new supply of speculative grade debt totaled just $8 billion month-to-date through this morning, putting this year on track to be the slowest single month for domestic issuance since January 2016, an unpleasant period for asset prices. That follows a total of $47.4 billion in new supply between April and June, the slowest second quarter for issuance since 2010. Bloomberg’s Brian Chappatta concludes: “Simply put, it’s hard to make a case that high-yield bonds would be a top performer without the supply shortfall holding them up.”
U.S. junk bond investors would be well-served to keep an eye on Europe, where high-yield spreads have similarly tightened 40 basis points this month amid a 27% year-over-year drop in new supply. Across the pond, at least, that drought is set to be replaced by a deluge. Bloomberg terms the upcoming European issuance calendar “jam-packed,” while Stephen Smith, high-yield syndicate manager at Barclays plc. in London, commented: “Borrowers have opted to access the market as soon as possible. . . We’ve certainly been advising clients to capitalize whenever they can, as post summer supply looks to be significant.”
Then there is liquidity. On July 22, The Wall Street Journal, citing electronic credit trading firm MarketAxess, reported that bid-ask spreads in developed European high-yield credit are up 24% this year while emerging Europe, Africa and the Middle East have seen spreads on dollar-denominated government bonds surge wider by 75%. Nathaniel Rosenbaum, credit strategist at Wells Fargo Securities, told The Journal: “The global tide of liquidity that quantitative easing spurred is now slowly, slowly moving in reverse. . . You’re starting to see small hot spots emerge in parts of the market that don’t have a natural support.”
U.S investors should pay special heed to goings-on in Europe, the Financial Times warned on July 8. Citing consulting firm Oxford Economics, the FT reports that Europeans have purchased “more than half” of U.S. issued corporate bonds in the past four years and own nearly 10% of all domestic fixed income securities.
Some unsolicited advice to holders of newly appreciated triple-C rated corporate bonds: Consider checking your local friendly bond salesman for a bid, just in case.
Recap July 31
Stocks rallied with the S&P 500 all but erasing yesterday’s decline, although the NYSE FANG+ Index could only manage a feeble 50 basis point bounce from its 9% swan dive over the prior four sessions. The dollar finished higher and commodities lower, the Treasury curve flattened with the long end catching a bid, and the VIX dropped by 10% to 12.85.
Shares in Apple, Inc. rose by 3% in immediate after-hours reaction to the company’s third quarter earnings announcement, in which the company managed to top estimates on the revenue and EPS lines despite selling fewer iPhones than expected while also offering fourth quarter revenue guidance above analyst consensus.
- Philip Grant
Monday, July 30, 2018
The Hangover
It wasn’t much of a party. Last Thursday Anheuser-Busch InBev S.A./N.V. (ABI on the Belgian stock exchange and BUD on the NYSE) reported second quarter figures that left something to be desired, as adjusted earnings per share came in light of consensus estimate despite a favorable effective tax rate. Organic volume grew 0.8% on a year-over-year basis, exactly half of the expected 1.6%. The global beer giant reiterated its expectation of accelerating growth in the second half of the year, but investors were unimpressed, sending the stock lower by 4%. Shares are in the red by 7% year-to-date, and reside 30% south of their 2015 highs.
While international growth remains solid (Budweiser revenues grew by 10.1% year-over-year outside of the U.S.), it was a different story in the Land of the Free, where the top-line shrank by 3.1%. The company press release put a positive spin on the glum news: “We delivered our best quarterly market share performance in nearly four years with a share loss of 35 basis points.”
For his part, chief financial officer Felipe Dutra didn’t mince words, telling The Wall Street Journal that there is “no silver bullet, no short term answer to some of the problems we face.” Indeed, in the U.S. at least, the seemingly relentless encroachment of craft beer on the drinking scene is causing consternation from one of Anheuser-Busch’s largest investors. Jorge Paulo Lemann, co-founder of Brazilian private equity firm 3G Capital, Inc. and ABI’s largest shareholder, lamented at an investor conference in April on “the age of disruption”:
I’ve been living in this cozy world of old brands and big volumes. We bought brands that we thought could last forever. . . You could just focus on being very efficient. All of a sudden we are being disrupted.
While shares have struggled, we judge that there is particularly good reason for ABI’s creditors to be concerned. Thanks largely to the mammoth $65 billion acquisition of SAB-Miller plc., A3/single-A-minus-rated Anheuser-Busch is awash in debt. Against the company’s reckoning of total net borrowings of $108.8 billion (which doesn’t include an additional $7 billion in preferred shares), Anheuser-Busch is expected to generate $23.1 billion in adjusted earnings before interest, taxes, depreciation and amortization in 2018, while full-year consensus free cash flow of $11.2 billion compares to $10 billion in free cash flow in 2012, when ABI carried just $35 billion in net debt.
Anheuser-Busch lenders must also contend with a generous dividend, which yields 4.17% on a trailing basis. By comparison, Baa1/triple-B-plus-rated Heineken N.V., which is leveraged at 2.6 times compared to ABI’s 4.7 times, pays a 1.68% dividend to shareholders. In the first half of the year, ABI paid out $5.1 billion in dividends, nearly double the $2.96 billion in profits attributable to equity holders. By comparison, Heineken generated €480 million ($410 million) in net operating profits and paid out €336 million in dividends in the first half of the year.
For its part, the Anheuser-Busch C-suite acknowledged the aggressive dividend on its first quarter conference call in May, with CFO Dutra replying to a question about further raising the payout: “We see dividends as a growing flow over time. However, in the short term, we don't see much room for that, given the leverage levels.”
In a November 2017 report on the company, analysts at Moody’s placed heavy emphasis on Anheuser-Busch management’s stated objectives to whittle down its debt load, writing:
ABI has a long track record of successfully integrating acquisitions. Importantly, senior management has articulated publicly that it will prioritize deleveraging, continuing to target net debt to EBITDA (company’s definition) of two times. This helps to support a relatively high rating despite leverage metrics that will be in speculative territory for several years.
While rapid deleveraging forms the crux of Moody’s upbeat assessment, evidence of progress remains scant so far, as the $108.8 billion in net debt is virtually unchanged from its year-end 2016 level. In order to reach lower-rated Heineken’s leverage ratio of 2.6, ABI would have to either slash its debt load to $61 billion from the current $108.8 billion or nearly double adjusted EBITDA to $42 billion from the $23.1 billion 2018 estimate.
The Feb. 9 issue of Grant’s contained a bearish analysis of Anheuser-Busch’s credit, arguing that the company’s aggressive financial metrics and uncertain growth potential posed risks for which bondholders are not adequately compensated. The analysis identified a pair of credits for particular scrutiny: The euro-denominated 2.7s of 2026, then trading at 111.75 cents on the euro for a yield-to-maturity of 1.2% (a 100 basis point spread to euro bonds), and the dollar bond 3.65s of 2026, which fetched 101.75 cents on the dollar to yield 3.4% and a 79 basis point spread over Treasurys. The euro-bond has since appreciated to 112.13 for a yield-to worst of 1.03% and a 116 basis point spread, while the U.S. issue has fallen to just over 98, priced to yield 3.94% while the spread has widened to 95 basis points. By way of conclusion, an allegory:
Artificially suppressed interest rates produce a feeling familiar to drinkers – weekend drinkers only, mind you – of more than a little fine craft beer. It’s rapturous at first, and so it remains for a time. But finally you go home and go to bed, and then it’s Monday morning. Monday is dawning for mispriced corporate credit.
Recap July 30
It was another tough day for tech, as the NYSE FANG+ Index absorbed another steep selloff to extend its three day decline to 9% as the poor second quarter results from Facebook, Inc., Twitter, Inc. and Netflix, Inc. continue to reverberate. The good news for equity bulls: Strength in telecom and energy helped minimize the broad damage to a 60 basis point drop in the S&P 500.
WTI crude rose back to $70 a barrel, while the Treasury curve maintained its recent steepening bias, with the 10-year yield inching back to 2.98%. The VIX popped to 14.25, the highest finish since early July.
- Philip Grant
Friday, July 27, 2018
CHHIIIINAAA!
Deleveraging, we hardly knew ye. As the Sino-American trade spat continues to hot up, Beijing has responded by further cranking the credit spigots open.
On Monday, the People’s Bank of China unleashed a record Rmb 502 billion ($72 billion) injection of medium-term lending facility funds to commercial banks, a move, the Financial Times notes, that served to expand the money supply as “no previously issued loans were scheduled to mature” on that day. On Wednesday, Bloomberg reported that the PBoC alerted certain Chinese banks that a “structural parameter” of capital requirements will be cut by 50 basis points in order “to support local financial institutions in meeting credit demand effectively.” China’s central bank has already cut its reserve ratio requirement for banks on three separate occasions this year.
State support for the economy has spilled into the fiscal realm as well as monetary: Today, Reuters reports that China “plans to put more money into infrastructure projects and ease borrowing curbs on local governments to help soften the blow” from the trade war.
The exertions have already made an impact: On Tuesday, the China Foreign Exchange Trade System reported record volume of repurchase agreements, as “bond traders have taken the slew of credit-boosting measures unveiled in the past week as a green light to borrow.” Not just in heightened activity are the looser policies being felt. The iBoxx China High Yield Total Return Index, which lost nearly 8% from January to mid-July in a slow grind lower, has promptly recouped half of that downdraft in less than two weeks.
Currency depreciation is likewise accelerating, as the yuan today completed a seventh straight weekly decline against the dollar. Since April, the renminbi has depreciated by 8% against the dollar, a 25% annualized pace. Since July 9, redbacks are down by 3% against the buck, a 44% annualized clip.
Is the weakening currency part of a Communist party plan or the result of rapid capital outflows? Brad Setser, senior fellow for international economics at the Council of Foreign Relations, thinks the former. In a July 23 blog post, Setser argues that the renminbi’s decline, if not an outright policy maneuver by the Chinese authorities, is broadly in line with their strategic interests. Noting a rising “basic balance” (the current account plus foreign direct investment) in China, Setser concludes:
That suggests, at least [to] me, that if China clearly signaled that it didn’t want the yuan to depreciate further, it could hold the line relatively easily. . . The depreciation pressure right now stems, in large part, from expectations that China wants a weaker currency in response to Trump’s tariffs and a slowing domestic economy – not uncontrolled outflow pressure.
Anne Stevenson-Yang, co-founder of J Capital Research and friend of Grant’s, has a somewhat different perspective. In a July 23 research note, Stevenson-Yang suggests that China’s credit-saturated economy (bank assets topped last year’s GDP by more than 300% and represent more than half of 2017 world GDP) is the primary force behind the recent gyrations in FX, while also arguing that the powers-that-be might ultimately hold less sway on the exchange rate than is widely believed:
The reality is that China’s currency is most intimately connected, as with any currency, to the domestic economy – debt, asset prices, real estate prices, and efficiency gains and losses rather than just trade. On that basis, this is the time for depreciation.
On the one side, Beijing faces very low growth outside of that driven mechanically by lending. Public confidence is low, and families that have wealth trapped in illiquid property are growing restive. People of means want to move abroad and want to externalize their assets. On the other side, Beijing has capital controls.
We are betting the people win.
If the yuan continues its powerwalk lower, the financial stability that Beijing covets could be put to the test. Today, Paola Subacchi of the South China Morning Post declared that the Middle Kingdom is “stuck between a rock and a hard place,” as monetary and fiscal easing designed to shoulder China’s massive debt burden stokes the risk of ongoing currency depreciation, capital flight and a potential drawdown of foreign currency reserves.
Watch the renminbi.
Recap July 27
Stocks took a dip, as the S&P 500 absorbed a moderate loss with Amazon.com, Inc. giving up the bulk of its post-earnings gains to finish barely in positive territory. Commodities and the dollar traded lower in tandem, while Treasurys were bid across the curve with the 10-year yield backing off the two month highs above 2.97% reached yesterday.
- Philip Grant
Thursday, July 26, 2018
Zuck Zuck goose
A bump in the road, or something more?
A bump in the road, or something more?
QT progress report
The break is over.
The break is over.
Recap July 26
Zuck Zuck goose
A bump in the road, or something more? As investors the world over are by now well aware, yesterday evening Facebook, Inc. (FB on the Nasdaq) shocked its cadre of bullish boosters by forecasting sharp slowdowns in both revenue growth and operating margins in coming quarters and years. What’s more, net daily active user growth of 22 million quarter-over-quarter was its smallest since early 2011, while European usage saw an outright decline and the North American daily user count remained flat. Growth that would be the envy of nearly any other large-cap (revenues and operating income jumped 42% and 33% year-over-year, respectively) was relegated to afterthought status.
In some corridors, the business update elicited disbelief. Of the dwindling growth outlook, Brent Thill, analyst at Jefferies LLC, remarked on yesterday’s conference call: “I think many investors are having a hard time reconciling that deceleration. It just seems like the magnitude is beyond anything we’ve seen, especially across a number of tech [companies] we cover.” Investors echoed Thill’s sentiments, sending FB shares down by 19%. With the company sporting a gargantuan $630 billion market capitalization heading into the report, the decline represented the single largest one-day loss of stock market value in U.S. history according to FactSet. Since Aug. 11, 2017, shares are up by 3%, compared to a 17% gain in the S&P 500.
Facebook five-year chart. Source: The Bloomberg
Of course, a dramatic fall first requires a great ascent, and few companies have enjoyed a steeper rise than Mark Zuckerberg’s social network. From July 2013 to yesterday, FB shares gained 861%, a 55% annualized pace. One can hardly argue the stock price rally was disconnected from fundamentals either. Over the trailing 12-month period, the company has generated $48.5 billion in revenues, $19.1 billion in net income and $28 billion in cash from operations. That’s up from $7.9 billion, $1.5 billion and $4.2 billion, respectively, in 2013.
But it’s a different environment in light of the Cambridge Analytica data-leaking scandal of March, one that Facebook has opted to manage through a litany of new hires and extra spending that looks set to cut into its future earnings potential. On the conference call, Zuckerberg had this to say about Facebook’s enhanced security and privacy initiatives:
Looking ahead, we will continue to invest heavily in security and privacy because we have a responsibility to keep people safe. But, as I've said on past calls, we're investing so much in security that it will significantly impact our profitability. We're starting to see that this quarter.
But, in addition to this, we also have a responsibility to keep building services that bring people closer together in new ways as well.
Now, in light of increased investment in security, we could choose to decrease our investment in new product areas, but we're not going to, because that wouldn't be the right way to serve our community and because we run this company for the long term not for the next quarter.
It’s no empty talk. Capital expenditures footed to $3.46 billion in the most recent period, well more than double the $1.44 billion capex line for the second quarter of 2017. According to yesterday’s earnings press release, current employee headcount at Facebook totaled 30,725 as of June 30, up a whopping 47% year-over-year.
Even without the baggage from Cambridge Analytica and the associated fallout, Facebook was set to brush up against commercial gravity sooner or later. There are only so many people in the world (7.6 billion according to the United Nations and Facebook reports 2.2 billion monthly active users), and only so many advertising dollars for the taking. In the Aug. 11, 2017 bearish analysis of Facebook, Grant’s suggested that “maybe growth, momentum and a dazzling stock market performance have obscured the problems that will ensure that not even Zuckerberg’s tree reaches the sky.”
That analysis incorporated the views of Pivotal Research Group’s Brian Wieser, who was one of only two analysts to label FB shares a sell, compared to 44 sell-siders who rated the stock a buy into yesterday’s earnings release. By way of reaction to the second quarter results, Wieser reiterates the simple fact underpinning his bearish thesis:
The advertising industry – and digital advertising, no less – has limits to growth, which we think is the primary factor constraining Facebook’s revenue opportunity. . . While the company is still growing at a fast clip, the days of 30% plus growth are numbered.
For investors, the pain from today’s sharp pullback is distributed far and wide. According to analysts at Goldman Sachs Group, Inc., 97 hedge funds counted Facebook as among their top-10 holdings as of the end of the first quarter. That’s the heaviest concentration of any one stock, and up from 81 funds that counted FB as a top-10 holding in September of last year. It’s not just the financial blue bloods who are taking a hit: Bloomberg’s Eric Balchunas estimates that 27% of Facebook shares are held by mutual funds, while an additional 6% are in the hands of various ETFs.
As Wall Street has accumulated, Menlo Park has vacated. The persistent, aggressive open-market sales by Facebook executives and directors that have been extensively chronicled on these pages, continue apace: In the five trading days preceding yesterday’s update, CEO Zuckerberg disposed of 1.23 million shares, generating proceeds of $262 million. Chief operating officer Sherryl Sandberg sold 55,000 shares for $11.5 million, while chief product officer Christopher Cox cashed out of 10,600 shares to the tune of $2.2 million.
As former Yankees catcher Yogi Berra once said: “You can observe a lot by just watching.”
QT progress report
The break is over. After two weeks of consolidation, the Fed’s portfolio of securities held outright registered at $4.072 trillion, a $12.6 billion decline from last week. Mortgage-backed securities were the departing asset, representing all of this week’s decline and more than 70% of the $17 billion drop-off from the trailing four-week average.
Since the Fed began its QT operation on Oct. 1, total balance sheet assets are down by 3.99%, for a simple annualized pace of 4.82%.
Recap July 26
No leadership, no problem. The bulls came out of this one in pretty good shape considering the circumstances, as the S&P 500 saw only modest losses despite the shellacking in Facebook, with the tech-heavy Nasdaq falling by just 1% and the NYSE’s FANG+ Index limiting the damage to 2.9%. A late dollar rally wasn’t enough to dislodge gains from the CRB Commodity Index or the iShares J.P. Morgan USD Emerging Market Bond ETF, and Treasury yields finished mostly higher, with the exception of the long bond.
After the close, Amazon.com, Inc. posted far higher than expected earnings per share for the second quarter, trumping a weaker top-line showing and sending the stock well higher in initial reaction. Second quarter GDP is set to be released tomorrow morning, with consensus expectation of a 4.2% annualized gain.
- Philip Grant
Tuesday, July 24, 2018
Tool time
Set it and forget it. Last Thursday Snap-on, Inc. (SNA on the NYSE) reported second quarter results that pleased the Street, with revenues topping consensus and adjusted earnings per share well above the most optimistic sell-side estimate.
It represented the firm’s 38th consecutive quarterly earnings beat dating back to the fourth quarter of 2008 and Mr. Market dutifully sent shares higher by 9.5%. Chairman and CEO Nick Pinchuk commented: “Our second quarter 2018 results demonstrated encouraging progress along our defined runways for growth and improvement.”
Kenosha, Wis. headquartered Snap-on produces high-end tools for a variety of industrial applications, as well as diagnostic and repair equipment for automobiles. A glance at the company’s financial vital signs indicates a steady corporate heartbeat: Although trailing 12-month revenues of $4.1 billion represent pedestrian growth from full-year 2014’s $3.5 billion top line, Snap-on has managed to increase its adjusted net income margin to 15.4% from 12% over that period, while free cash flow has jumped to $622 million from $323 million. The balance sheet is sturdy, with $1.1 billion in net debt virtually matching the $1.02 billion in adjusted earnings before interest, taxes, depreciation and amortization last year. Operating income of $938 million covered the $50 million in interest expense nearly 19 times over.
The conservative nature of Snap-on’s balance sheet draws a stark contrast to the company’s increasingly credit-centric business model. Long-term net finance receivables (which fund the customers of Snap-on’s franchisees) footed to $1.05 billion at the end of the second quarter, according to the company’s form 10-Q. That’s up from $612 million in second quarter 2014, for a compound annual growth rate of 14.5%. By comparison, total sales at the auto-focused Snap-on Tools Group, the company’s largest unit, footed to $412 million this quarter, up from $369 million in 2014 for a compound annual growth rate of just 2.8%. Overall, Snap-on’s financial services entity chipped in a meaty 23% of operating earnings in the most recent quarter, up from 20% in the second quarter of 2014.
That jump in financing relative to total sales comes with questions about the company’s treatment of loans that are not performing. On May 7, The Capitol Forum published an analysis of SNA’s debt collection and accounting, citing an instance in which a borrower fell in arrears within weeks, while the company continued to bill him for 17 months. Receivables are assessed for charge-off once an account becomes 120 past due, according to the company’s form 10-K. The Capital Forum concludes:
Snap-on’s failure to write off loans on a timely basis not only potentially overstates revenues and earnings but also raises questions about the value and collectability of the company’s $2 billion in accounts receivable.
On July 17, analysts at Longbow Research conducted a survey of the company’s franchisees, finding that the company exerted no small effort to maintain its streak of quarterly earnings beats:
Franchisees indicated SNA was aggressive on inventory throughout all of 2Q 2018, including increased end of quarter deals during the last two weeks of the quarter. Franchisees reported SNA removed the “hold” status on delinquent franchisees during the last week of the quarter to boost end of quarter sales. Franchisees indicate elevated inventories of big ticket items may limit spending at the third quarter Snap-On Franchisee Conference.
While Snap-on has been able to top consensus estimates like clockwork, the performance of its stock price has left something to be desired, as SNA shares have gained just 1% since June 3, 2016, compared to a 34% rise from the S&P 500. On that date, Grant’s published a bearish analysis of Snap-on, arguing that the company’s increasing reliance on credit, as well as its exposure to the then-booming (and saturated) used car market, presented underappreciated risk. Grant’s termed Snap-on: (along with Signet Jewelers Ltd.) “The case studies in the modern application of high-yield consumer credit at a late hour in the business cycle.”
At the time of publication, Snap-on was a mostly undisturbed short-sale candidate, with 3.8% of its float borrowed by short sellers. Today, that proportion has jumped to 12.8% according to Bloomberg. However, bears concerned about crowded shorts can take comfort in validation, in deed if not in word, from the SNA C-Suite. On June 5, senior vice president Thomas J. Ward sold 42,000 shares on the open market, netting himself $6.4 million. That was followed by $2.2 million of sales by secretary, vice president and general counsel Irwin Shur on June 7, and $3.5 million in sales by CEO Nick Pinchuk on June 19. Then last Thursday (earnings day), senior vice president Anup Banerjee sold $6.1 million of SNA stock on the open market. The last open market purchase by a company insider took place last August, when director Ruth Ann Gillis bought 265 shares.
Recap July 24
Stocks caught a moderate bid, while the Treasury curve flattened a bit after the notable steepening action seen in the past few days.
Commodities were mostly higher amid a flat showing for the U.S. Dollar Index, while the Chinese yuan fell to a 52-week low this morning at 6.83 per greenback before recovering somewhat. After the close, AT&T, Inc. reported weaker than expected earnings and revenue for the second quarter, sending the stock to a fresh 52-week nadir in after-hours trading.
- Philip Grant
Monday, July 23, 2018
Offer wanted
As the Fed tightens and the ECB discusses the end of EZ-money, whither the Bank of Japan?
As the Fed tightens and the ECB discusses the end of EZ-money, whither the Bank of Japan?
Recap July 23
Offer wanted
As the Fed tightens and the ECB discusses the end of EZ-money, whither the Bank of Japan? The rumor mill has been working overtime ahead of the Bank of Japan’s policy meeting next week, with Reuters reporting that the BoJ: “is in unusually active discussions . . . with changes to its interest-rate targets and stock buying techniques up for debate.” Among the potential changes being considered is an increase in the 10-year yield target to between 0.10% and 0.25% from the current zero point zero, which the BoJ introduced in 2016 under a “yield curve control” supplement to its QE program.
The report made waves, with the yield on the Japanese 10-year note more than doubling to as high as 0.09%, the biggest one-day move since December 2016. In the Japanese government bond market, the BoJ still calls the shots. According to Bloomberg, the central bank offered to buy all the bonds that sellers might wish to unload at a yield of 0.11%. There were no takers.
Of course, the absence of supply at the BOJ’s line in the sand isn’t particularly unusual. The Wall Street Journal, citing market-data firm Quick, notes that there have been six separate trading days this year in which not a single lot of the benchmark 10-year JGB changed hands.
While the BoJ’s liberal participation in financial markets has done little to spur inflation toward its 2% goal (June CPI rose just 0.7% year-over-year, down from 1.5% in February), their efforts have yielded other results that might be described as impressive. Thus, on June 26, Nikkei reported that thanks to ¥25 trillion ($227 billion) and counting in ETF purchases under QE, the BoJ has become a top-10 shareholder in nearly 40% of listed companies in Japan.
The effect is particularly pronounced for certain large-cap names with higher ETF ownership. Nikkei notes the example of Fast Retailing Co., shares of which account for 2% of all ETF purchases made by the bank according to the publication’s estimates. Nikkei concludes: “If this pace keeps up for another year, Fast Retailing shares on the open market could all but disappear.”
Needless to say, the Bank of Japan’s machinations present a predicament for banks and savers alike. Koji Fujiwara, CEO of Mizuho Financial Group, Inc. and chairman of the Japanese Bankers Association, politely observed in May: “There are concerns over side effects of the powerful monetary easing program.”
Mrs. Watanabe is long-accustomed to using a little financial alchemy to generate some more income. To that end, a research report from SMBC Nikko Securities last week suggested that bondholders in Masayoshi Son’s Softbank Group Corp. could juice returns by selling credit default swaps (a Texas hedge in Tokyo). SMBC Nikko analysts put it this way: “Even if [Softbank] CDS are volatile, since their spreads are so wide compared with yen bonds they are attractive as an investment.”
Softbank, junk-rated at S&P and Moody’s, sold a ¥40 billion institutional and ¥410 billion retail tranche in senior unsecured debt maturing in 2024 in early June, at a price-to-yield 1.57% (see the Dec. 15, 2017 edition of Grant’s for a detailed analysis of Softbank). Bloomberg Intelligence notes that the company generated $215 million in free cash flow during the fiscal year-ending March 31, less than half of the $432 million paid out in shareholder dividends during that period. The firm’s consolidated total debt stands at $165 billion, while adjusted net leverage currently stands at 8.5 times trailing earnings before interest, taxes, depreciation and amortization, excluding its commitments to the company’s in-house venture capital unit, the SoftBank Vision Fund.
In May, Son told listeners at a conference in Tokyo that there a sequel to the Vision Fund is forthcoming: “It’s just a matter of when.”
The Double Vision Fund?
Recap July 23
Treasury yields jumped across the board, particularly at the long end as the 10-year yield climbed to 2.96%, a five-week high. Stocks remained range bound, with the S&P 500 finishing slightly green while making its seventh straight close within 50 basis points of unchanged.
An intraday rebound in the Dollar Index corresponded with a bearish reversal in commodities, while the VIX also gave back early gains.
- Philip Grant
Friday, July 20, 2018
Trump tweets
From the President’s Twitter account this morning:
The United States should not be penalized because we are doing so well. Tightening now hurts all that we have done. The U.S. should be allowed to recapture what was lost due to illegal currency manipulation and BAD Trade Deals. Debt coming due & we are raising rates - Really?
The Jan. 13, 2017 edition of Grant’s featured “2017 in money – a sneak preview,” a Twitter-based timeline of our imagined future interactions between President Trump and then-Fed Chair Janet Yellen, available for all here.
And so it (almost) came to pass.
Yuan headlight
We live in interesting times. If there is any doubt after the above item, recent goings-on in China should put those to rest as the Middle Kingdom’s credit-fueled financial engine looks like it might need some repairs. While President Trump’s threat this morning to place tariffs on all $505 billion of Chinese exports to the U.S. dominates headlines, there is no shortage of other developments worthy of wider attention.
The recent bloodletting in emerging market currencies has not spared China, as the renminbi is now down by 4.5% against the greenback this month, the worst performing currency out of 31 “major” countries tracked by Bloomberg. The decline has been sharp enough to grab the attention of the People’s Bank of China, according to Charlie McElligott, strategist at Nomura, who wrote yesterday: “As Chinese financial conditions further deteriorate and market stress worsens, we actually perversely push closer to the risk-asset positive outcome of escalated PBOC stimulus and easing measures.”
Those hoping for mandarins riding to the rescue might have got their wish last night, as another intraday decline in the renminbi was reversed late in the Asian session with Bloomberg reporting that “a major Chinese bank was seen making large offers to sell dollars.”
Not just in the currency markets is the Chinese government throwing its weight around. Yesterday, Caixin reported that the PBOC “will provide additional funds to commercial lenders who invest in corporate bonds in July, particularly those who purchase bonds with lower ratings.”
There is good reason for Beijing to be nervous. Consider, for instance, the plight of the conglomerates. In recent years, the trio of HNA Group Co. Ltd., Anbang Insurance Group Co. Ltd. and Dalian Wanda Group Co. Ltd. made an international splash by buying trophy assets such as the Waldorf Astoria Hotel in New York, Hilton Hotels Corp. and AMC Entertainment Holdings, Inc. with borrowed money.
After the party comes the hangover: Dalian Wanda and HNA have been shedding asserts in recent months, while Reuters reports yesterday that Anbang is looking to sell overseas property assets on the order of $10 billion “as part of a government-backed rescue.” Three months after the government’s February takeover of Anbang, former Chairman Wu Xiaohui was convicted of fraud and embezzlement and sentenced to 18 years in jail.
But the problems in China’s private sector extend far beyond that trio of now-unspooling former roll-ups. Overall, corporate bond defaults registered at 20 through May according to the PBOC, almost matching 2017’s full year total of 22 (Almost Daily Grant’s, July 9).
On July 5, coal miner Wintime Energy Co. missed a Rmb. 11.4 billion ($1.7 billion) bond payment, becoming the largest corporate default in China this year with $3.9 billion in debt outstanding. True to form, the company’s parent “had pledged almost all its shares in the subsidiary as collateral for loans,” according to a filing made at the end of March and spotted by Bloomberg.
The default definitely caught creditors of peer Zhongrong Xinda Group Co. by surprise. Zhongrong, which is partly owned by Wintime Energy parent Wintime Holding Group Co., saw the price on its renminbi bond due in August fall to 70 cents on the Rmb. sending the yield-to-worst to an eye-popping 412%. The kicker: Zhongrong Xinda sports a pristine triple-A rating at Chinese credit rating agency United Ratings. For international context, U.S. agency Fitch Ratings downgraded Zhongrong to double-B-minus, or three notches below investment grade, in May.
Zhong and wrong, triple-A and a 412% yield. Source: The Bloomberg
Today, The Wall Street Journal also takes note of China’s faltering credit markets, citing the recent travails of developer Agile Groups Holdings Ltd. which was forced to pay 8.5% on three-year dollar bonds earlier this month. In August 2017, the same company was able to borrow for five years in dollars at just 5.125%.
The Journal quotes Mitch Reznick, co-head of credit at London-based Hermes Investment Management, who, in discussing the May dollar-bond default of China Energy Reserve & Chemicals Group Co. Ltd., offers the following nugget of wisdom:
China Energy’s default showed how-faith based investing is a road to hell.
Investors around the world, please copy.
Recap July 20
Stocks finished little changed, but Trump’s public application of pressure on the Fed appears to have made an impact elsewhere, as Treasury yields jumped in a bear steepening formation while the dollar sold off sharply.
The combination of a weaker dollar and, perhaps, a PBOC currency intervention was most welcome for industrial metals bulls, as the Bloomberg Base Metals 3-Month Price Commodity Index jumped by nearly 2%, recovering a little chunk of the near-16% decline seen in that group since June.
- Philip Grant
Thursday, July 19, 2018
Bernank the tank
Tough crowd. Federal Reserve chairman Jerome Powell is taking heat from all sides after this year’s round of stress tests for too-big-to-fail banks. At the end of June, the Fed nixed the planned dividend increases of investment banks-turned bank holding companies Goldman Sachs Group, Inc. and Morgan Stanley. In response, Morgan Stanley CEO James Gorman yesterday complained that the tests have “become increasingly demanding.” Gorman said of the 2009-era brainchild: “Ten years on, it’s time to take a fresh look. We don’t want to be chasing the last crisis, we’re trying to figure out the next one.”
From the other flank, Democratic Senators expressed their irritation with perceived soft treatment of the banks in Tuesday’s Humphrey Hawkins testimony on Capitol Hill. Speaking of The Fed’s proposal to open the stress tests to comment periods, Sherrod Brown of Ohio remarked: “That’s like letting the students help write the exam.” Of Powell’s assertion that this year’s test was “materially more stressful” than prior years, Elizabeth Warren of Massachusetts replied: “You know, I don’t know what to say. The data don’t seem to back you up on this.”
Stress tests aside it’s been pretty good sledding for the financials recently, including those scolded former investment banks. J.P. Morgan Chase & Co., Citigroup, Inc., Bank of America Corp., Morgan and Goldman all saw their shares rally after reporting second quarter earnings, and each managed double-digit percentage year-over-year jumps in net income. So too are valuations robust. According to data from Bloomberg, the S&P Financials Index trades at 1.54 times book value, up from 1.35 times on year-end 2016 and 1.03 times on Dec. 31, 2012.
But, as the Fed raises short-term interest rates while shrinking its securities portfolio via QT, the banks could be vulnerable to side effects from that comprehensive monetary tightening. Christopher Whalen, editor of The Institutional Risk Analyst and financial industry savant, explained in a blog post yesterday that the ongoing rise in short-term interest rates is putting the squeeze to net interest margins, a major source of profits for the group. Whalen expects that compression to continue:
The second quarter 2018 bank results released so far confirms the accelerating upward trend in bank funding costs. As we detail in the most recent Q2 ‘18 edition of The IRA Bank Book, the rate of increase in funding expense for all US banks should exceed the rate of growth in interest earnings by the second quarter 2019. This will mean that net interest margin or “NIM” will be shrinking, an eventuality that most market analysts and institutional wealth managers really are not prepared to accept -- much less reflect in asset allocations.
You can see this playing out in the yield curve. With the spread between the two- and 10-year yield hovering near its lowest since 2007 at just 25 basis points (down from more than 75 basis points in February) and interest rate futures pricing in greater-than-even odds of at least two 25 basis point rate hikes by year end, it seems an inverted yield curve, and the accompanying ominous implications for economic growth, might soon be in the cards.
Not to worry however, says former Fed chairman Ben Bernanke. Speaking at a roundtable event Monday with fellow crisis-era figures Timothy Geithner and Henry Paulson, Bernanke offered his two cents:
Historically the inversion of the yield curve has been a good [sign] of economic downturns [but] this time it may not. . . Everything we see about the near-term outlook for the economy is quite strong.
In other words: This time is different.
QT progress report
The pause continued. For a second straight week, the Fed’s portfolio of securities held outright remained at $4.084 trillion after a trio of substantial weekly declines through June and early July. This week’s holdings are down by $11.1 billion from the trailing four-week average, with Treasurys representing the majority of that decline.
Since the Fed began QT on Oct. 1, total assets are down by 3.68%, for a simple annualized pace of 4.55%.
Recap July 19
A sharp drop in the Chinese yuan overnight spurred comprehensive selling across emerging market currencies, with the South African rand standing out for a 226 basis point slide against the dollar.
Stocks fell, with the S&P 500 falling 40 basis points to mostly erase this week’s gains, and Treasurys were bid across the curve. Interestingly, the iShares JPMorgan USD Emerging Market Bond Fund ETF managed an unchanged finish.
Oil continued its rebound amid a flat CRB index, with WTI crude briefly trading north of $70 a barrel this morning before pulling back some.
- Philip Grant
Wednesday, July 18, 2018
Turkey club
Time for another check-up on the state of play for emerging markets, which have appeared as a rare source of angst in otherwise-calm market conditions. While the S&P 500 approaches its January peak and the MSCI World Index sits about 5% below its own January highs, the MSCI Emerging Markets Index remains on the cusp of bear market territory, at a distant 19% from the summit logged in the opening month of the year. On a price-to-earnings basis, the valuation gap has become substantial: The MSCI Emerging Market Index trades at 13.4 times trailing earnings, well below the 18.9 times which the MSCI World Index currently fetches.
Sentiment too is largely bearish. According to the Bank of America Merrill Lynch July Fund Manager Survey, “short emerging market equities” rated as the second-most crowded trade identified by investors, with a net 12% allocation. Overall, July saw a 23% plunge in emerging market equity allocation (the largest monthly drop in two years) to a net 1% underweight position. Bloomberg concurs, finding in a survey of investors, traders and strategists that a majority expect the EM selloff to continue.
While sentiment and valuation seem to provide an intriguing setup on the long side, would-be EM bulls need to contend with powerful structural factors, chiefly the tightening in U.S. financial conditions. Since February, the broad Dollar Index has risen by 7% to its highest in more than a year, while the two-year Treasury yield made another post-crisis high yesterday above 2.6%, more than doubling since September.
Meanwhile the Federal Reserve’s balance sheet runoff (QT to Fed watchers) continues apace, much to the chagrin of the Reserve Bank of India governor Urjit Patel who penned an opinion column in the Financial Times warning that the Fed will “absorb such a large share of dollar liquidity that a crisis in the rest of the dollar bond markets is inevitable” (Almost Daily Grant’s, June 4).
Then there are the more idiosyncratic risks. On June 24, Turkish president Recep Erdogan won re-election for a five-year term, earning himself sweeping new powers in the process. Erdogan, who previously railed against the Turkish Central Bank for its hawkish response (the president termed high rates “the mother and father of all evil” in May according to Reuters), to spiking inflation and a sinking exchange rate appointed his son-in-law Berat Albayrak to head the newly formed Treasury and Finance Ministry on July 9, in addition to other investor-unfriendly announcements.
In response, markets sent the Turkish 10-year yield above 18% (since eased to 17.7%), continuing the recent rise in borrowing costs from less than 12% as recently as February. On Monday, Albayrak’s new agency reported that the June budget deficit jumped to 25.6 billion lira ($5.3 billion), nearly double the 13.7 billion lira logged in the same month last year.
Also on Monday, rating agency Moody’s sounded the credit alarm on Turkey’s banks, writing: “We expect problem loans to increase to well above 4 percent over the next 12-18 months from a low 2.9% in May because of Turkey’s weak operating environment and a large number of performing loans with significant deterioration.” Meanwhile, the lira continues to spiral to fresh lifetime lows against the greenback, losing nearly half its value since the failed coup d’etat against Erdogan in the summer of 2016.
Lira/dollar exchange rate since 1990. Source: The Bloomberg
In the Aug. 12, 2016 issue, Grant’s asked Russell Napier, independent strategist and co-founder of the Electronic Research Interchange, for his biggest concern for emerging market investors. Napier replied: “Capital controls. I lived through the Mahathir [Mohamad] period when Mahathir implemented capital controls [sparking the EM crisis of 1998] . . . It changed people’s perception. When you deliquefy what everyone believes is a liquid market, then you start to get real problems where people start to liquefy other things.”
That day may be drawing closer for the lira, according to Tatha Ghose, senior EM economist at Commerzbank. Quoted in the Financial Times on July 10, Ghose warned: “If policymakers shift to a monetary policy stance that increases market concerns and leads to even more rapid lira losses, they may leave themselves with no other option but to impose capital controls.”
By way of postscript, the now 93 year-old Mahathir Mohamad is now back in power in Malaysia, winning a “stunning upset” (according toTime magazine) election in May over his one-time protégé Najib Razak.
What’s old is new again?
Recap July 18
Strength in the financials and industrials carried the day, as the S&P 500 edged higher for its fourth green finish in five tries. Treasury yields continued their recent upside grind, with the 10-year yield edging to a three-week high at 2.88%. A stronger dollar didn’t prevent the CRB Commodity Index from rallying into positive territory, with WTI crude settling near $69 a barrel, while the VIX finished just below 12.
- Philip Grant
Tuesday, July 17, 2018
Now is the winter of our streaming content
The bulls received a jump scare straight out of Stranger Things.
The bulls received a jump scare straight out of Stranger Things.
Recap July 17
Now is the winter of our streaming content
The bulls received a jump scare straight out of Stranger Things. Yesterday evening, Netflix, Inc. surprised the Street with weaker than expected second quarter revenues, lighter than expected third quarter earnings guidance and, most importantly, a slower than expected pace of net subscriber additions both internationally and in the U.S. In response, investors marked NFLX shares down by as much as 14% before a dip-buying cavalcade narrowed losses to 5%.
Of course, even that 14% markdown represents a drop in the bucket relative to the head-spinning rally enjoyed by NFLX. After today’s pullback Netflix has managed year-to-date gain of 96%, which places it at the head of the class among the New York Stock Exchange’s FANG+ Index (Twitter Inc. is second with an 85% advance for 2018). Since July 2016, Netflix shares are up by 342%.
Why shouldn’t the stock price be shooting to the stars? This year the former upstart garnered 112 Emmy Award nominations, ending HBO’s 17-year run as the most nominated network.
That success is attracting competitive attention from all corners. On June 25, entertainment website The Wrap reported on the growing ambitions of Apple, Inc. in the content business, quoting an unnamed Hollywood executive who considered them a credible player: “They’re paying real quotes and not trying to squeeze us for less and less the way the studios are on the network side. They’re formidable buyers.” It’s not just the iPhone maker that has set its sights on NFLX: In a June 28 cover story of Netflix’s ascent, The Economist notes that:
Amazon, Apple, Facebook, Youtube and Instagram are all developing programing efforts of their own. “The first thought on everyone’s mind is how do we compete with Netflix?” says Chris Silbermann, managing director at [talent agency] ICM.
Even retail giant Walmart, Inc. might join the fray, according to a report today by tech-website The Information.
Keeping up with the Joneses is no cheap proposition. Thus, in October, Netflix announced it would spend $8 billion on developing in-house content this year, up from the company’s prior $7 billion estimate. Meanwhile, analysts at Goldman Sachs, Inc. expect that figure to balloon in coming years to $22.5 billion, which would place Netflix “in spitting distance of the total currently spent on entertainment by all America’s networks and cable companies” according to The Economist.
Against $8.3 billion in current debt, Netflix has $3.9 billion in cash on hand. The company expects between $3 billion and $4 billion in negative free cash flow “burn” in 2018, up from $2 billion last year and just $128 million in 2014. So, how to finance this breakneck pace of growth? In the bond market, naturally. The company explained its fundraising strategy in yesterday’s letter to investors:
While interest rates have risen and the federal tax rate is now lower (reducing the tax shield on interest costs), we judge that our after-tax cost of debt continues to be lower than our cost of equity, so we anticipate that we’ll continue to finance our capital needs in the high yield market.
Those words caught the analytical eye of Grant’s, which retains an agnostic stance towards Netflix stock. On the company’s credit there is no such ambivalence: We are decidedly bearish, judging the risk versus reward proposition to be most unfavorable for the company’s lenders. In the March 10, 2017 analysis of the Netflix 4 3/8s of 2026, Grant’s termed the streaming media giant “case study No. 1 in investment asymmetry.” The rationale:
Netflix common (NFLX on the Nasdaq) may or may not be a good investment. It has proved a superb investment. Whether it can tack on another eight-fold rise in price over the next five years will depend in large part on management’s demarche into original content. Success could deliver immense rewards to the stockholders.
Holders of the Netflix 4 3/8s of 2026 would hardly share in the hypothetical bonanza. Interest and principal are what they signed up for, after all. The downside – always looming, especially in a business as fast changing as digital technology – is another matter. In the risk of business failure, the lenders partake only a little less fully than do the stockholders.
Since publication, those notes have fluttered lower as the stock has continued its rampage. Some unsolicited advice for the euphoric holders of Netflix common: Mind Mr. (debt) Market.
Source: The Bloomberg
Recap July 17
This old bull still has plenty of kick. The impressive reversal in NFLX helped bestow another rising tide for equity prices, as the S&P 500 ticked to within 2% of the all-time highs reached in late January. Treasurys finished little changed, while the CRB commodity index and iShares J.P Morgan USD Emerging Markets Bond ETF both managed flat showings despite a stronger dollar.
An interesting, if not particularly pleasant (for Grant’s at least) divergence in the non-fiat realm: Bitcoin caught a strong bid this afternoon, jumping nearly 9% to $7,300, while gold continues to flounder. The “money of kings” dropped another 1% to $1,225 an ounce, near a 52-week low.
- Philip Grant
Monday, July 16, 2018
Hello Altice
Many happy returns in the corporate bond market. Today, the French subsidiary of telecom operator Altice Europe N.V. priced $2.5 billion (upsized from an initial $2 billion) in eight-year term loans at 400 basis points over the London Interbank Offered Rate. With the proceeds, the company will call a portion of the $4 billion outstanding in 6% senior notes due May 2022, which will serve to extend the average maturity of the French unit’s debt to 6.8 years from 6.4 and the corporate parent’s average maturity to 6.3 years from 6.1.
Dennis Okhuijsen, CFO of Altice Europe, struck a triumphant tone, commenting in the press release: “This refinancing transaction demonstrates again Altice’s commitment to proactively manage its liabilities across its capital structure, significantly improving its maturity schedule.”
For some of Altice’s existing creditors, the new loan announcement was a less glorious occasion: Bloomberg reports that the existing B-11 $1.4 billion term loan due 2025 sold off three points in response to the new deal, as that series lacked a “most favored nation” clause (the name is borrowed from the realm of international trade) which allows existing investors to receive the same terms as later creditors. Bloomberg summarizes the aftermath: “Investors seemed to have learned their lesson. In response to pressure from potential buyers, Altice France extended the MFN provision to the eight-year life of the new loan from just 12 months when the deal was initially marketed.”
As for Altice, the highly leveraged former roll-up (now unrolling itself) is wisely striking while the iron is hot. The company is following that deal with planned offerings of $1.25 billion dollar denominated and €650 million ($761 million) euro-denominated senior secured notes, which are expected to price tomorrow according to Bloomberg. They can certainly use the leeway: Against net debt of just over €35 billion, Altice generated €8 billion in adjusted earnings before interest, taxes, depreciation and amortization through the 12-months ended March 31. Interest expense of €3 billion was double the €1.5 billion in operating income, while free cash flow footed to negative €100 million over that 12 month period.
Standard and Poor’s rates Altice single-B (“adverse business, financial, or economic conditions will likely impair the obligor's capacity or willingness to meet its financial commitments on the obligation”), while the stock market has marked down Altice shares by 25% since October 2015 (that’s despite more than doubling from the April lows), during which period the Stoxx 600 Europe Index has gained 12%.
In a May 9 research report, Craig Moffett, co-founder and one-half of the eponym of research firm MoffettNathanson LLC, aptly described the fickle treatment from investors that colored Altice’s rise and fall:
When Altice N.V., the parent company of Altice USA, was a stock market darling – yes, that does seem like a long time ago, doesn’t it? – it was viewed as the perfect amalgam of operating savvy (cost-cutting) and financial acumen (high leverage and share repurchases).
When Altice N.V. became a stock market pariah, it was because it had come to be viewed as . . . a perfect amalgam of operating short-cuts (cost-cutting) and financial risk-taking (high leverage and share repurchases).
For our part, Grant’s offered a bearish analysis of Altice in the Oct. 2, 2015 edition, when the Altice deal machine (and story) was in full swing. The company paid €17 billion for France’s SFR Group S.A. in April 2014, €7.4 billion for Portugal Telecom SGPS S.A. in November 2014, and $9.1 billion for a 70% stake in U.S. operator Suddenlink Communications in May 2015. By way of response, Mr. Market conferred a gaudy 225% rally in Altice shares in the nine month period through June 2015. Grant’s put the query to subscribers: “The question is, are the creditors quite sure they are willing to bear the risks that the intrepid management is willing to take?”
Altice’s lenders have regained their, uh, entrepreneurial spirit lately. The company’s most actively-traded bond issue, the 7 1/4 senior unsecured Eurobonds of 2022, which traded below 96 as recently as February, are now back near 103 cents on the euro, for a yield-to-worst of 5.37%.
Recap July 16
Down goes Netflix. After the close, the streaming content provider and recent star of the FANG contingent reported weaker than expected second quarter results, including net subscriber additions that came in well below consensus expectation, sending shares down by 13% in immediate reaction.
Prior to that seemingly portentous development, stocks fluttered a bit lower, while Treasury yields rose in bear steepening formation. Commodities were once again soft despite a weaker dollar, with WTI crude falling to $68 a barrel, down 8% in less than a week. The emerging markets rally also took a pause, with the iShares J.P Morgan Emerging Market Dollar Bond ETF pulling back from the six-week closing highs reached on Friday.
- Philip Grant
Friday, July 13, 2018
Community-adjusted protein
WeWork, you never disappoint. From Bloomberg:
WeWork, you never disappoint. From Bloomberg:
You get what you pay for
It’s the private-sector version of the “zero lower bound.”
It’s the private-sector version of the “zero lower bound.”
Recap July 13
Community-adjusted protein
WeWork, you never disappoint. From Bloomberg:
Co-working giant WeWork Cos. thinks it can save the environment quicker than Elon Musk.
The startup has told its 6,000 global staff that they will no longer be able to expense meals including meat, and that it won’t pay for red meat, poultry or pork at WeWork events. In an email to employees this week outlining the new policy, co-founder Miguel McKelvey said the firm’s upcoming internal “Summer Camp” retreat would offer no meat options for attendees.
“New research indicates that avoiding meat is one of the biggest things an individual can do to reduce their personal environmental impact,” said McKelvey in the memo, “even more than switching to a hybrid car.”
We concur. Saving the planet from hot air remains a daunting challenge.
You get what you pay for
It’s the private-sector version of the “zero lower bound.” Today, The Wall Street Journal reports that BlackRock, Inc. (BLK on the NYSE) has cut prices on several equity and fixed income exchange traded funds in recent weeks. Martin Small, head of BlackRock’s U.S. iShares ETF unit, told The Journal that the asset manager will make it up on volume: “Even if prices come down more, we expect volumes to grow to such a degree that profitability will expand over time.”
In lowering its own take on ETFs, BlackRock is keeping up with the corporate Joneses as industry wide fee compression continues apace. On July 2, The Vanguard Group, Inc. announced it would offer nearly 2,000 ETF’s not managed by Jack Bogle’s firm with no trading fees to users of its in-house online brokerage. Jeff DeMaso, co-editor of the (unaffiliated) publication the Independent Advisor for Vanguard Investors, explained the strategy: “This is really about getting a share of investors’ wallets. If someone stays on your platform he might be more likely to buy another Vanguard fund in the future.”
While the ETF juggernauts do battle, other contenders enter the low-cost financial arena. Yesterday, research and ratings firm Morningstar, Inc. (MORN on the Nasdaq) announced it will launch nine in-house mutual funds in the third quarter, replacing the actively managed funds that it had selected to run its $44 billion in assets, a move that chief investment officer Daniel Needham estimates could cut fees by about 20%. Mr. Market liked the sound of that, sending MORN shares up 3.5% to a record high.
That follows last October’s incursion by State Street Global Advisors, which debuted 15 new ETF’s, each of which was “priced equal to or below the lowest fee ETF” in its respective category, according to the company. That claim is an increasingly difficult one to make as competition heats up: According to analysts at J.P. Morgan Chase & Co., more than 75% of inflows into the ETF realm in the past year have been earmarked to funds charging an expense ratio of 15 basis points or less. By contrast, the average mutual fund costs about 100 basis points annually, according to a July 9 analysis by Todd Rosenbluth, senior director of ETF and mutual fund research at CFRA.
It’s not hard to imagine the beneficial impacts of the increasingly abundant, low-cost ETF and passive investment options. Today, The Journal terms the price war “a boon for investors.” Steven Bregman, president and co-founder of Horizon Kinetics, sees other, less welcome knock-on effects of the ETF boom. Speaking at the 2016 Grant’s fall conference, Bregman said of the ETF invasion:
It has distorted clearing prices in every sort of financial asset in every corner of the globe, [and] has created a massive systemic risk to which everyone who believes they are well diversified in the conventional sense are now exposed.
Bregman went on to argue that ETF heavy portfolios are far more concentrated than investors might believe, citing the Exxon Mobil Corporation’s prominence by way of example:
Aside from being 25% of the iShares U.S. Energy ETF, 22% of the Vanguard Energy ETF and so forth, Exxon is simultaneously a dividend growth stock and a deep value stock. It is in the USA Quality Factor ETF and the Weak Dollar U.S. Equity ETF. Get this: It’s both a Momentum Tilt stock and a Low Volatility stock. It sounds like a vaudeville act.
Investors must also consider the fact that ETF’s, which have proliferated during the particularly calm market seas of the post-2009 epoch, managed a less than stellar performance in the August 2015 market tumult that followed a surprise devaluation from China. On August 24, when the S&P 500 opened sharply lower, ETF’s set a record share of trading volume at 37% of the total across all U.S. exchanges. On that day, a number of funds, including the Guggenheim S&P 500 Equal Weight ETF (RSP on NYSE Arca), saw their share price diverge sharply from net asset value. While the S&P 500 Equal Weight Index bottomed out with a 4.5% intraday loss, the RSP vehicle plunged by as much as 43% intraday, before recovering.
Standing on shaky ground. The Guggenheim S&P 500 Equal Weight ETF on Aug. 24, 2015. Source: The Bloomberg
There’s no free lunch.
Recap July 13
Stocks edged higher despite weakness in the FANG’s (NYSE’s FANG+ Index finished lower by 70 basis points) to leave the S&P 500 green by 1.5% for the week and back to within 2.5% of its January record.
The Dollar Index gave back early gains and then some, which didn’t help the commodities as the CRB Index finished slightly lower but did give another lift to the suddenly buoyant iShares J.P. Morgan Emerging Markets Dollar Bond ETF, which rose to a six-week high.
Treasury yields finished lower across the board, with the long end once again outperforming. The spread between the two- and 10-year yields fell to 24.5 basis points, a fresh 11-year low.
- Philip Grant
Thursday, July 12, 2018
Two ships in the night
Now is an excellent time to buy! Or something like that. Across the U.S., house prices march higher, with the National Association of Realtors reporting that the median home price reached a record high of $264,800 in May, up 4.9% year-over-year, while the Federal Housing Finance Authority’s Price Index made its own record in the first quarter, up 7.5%. The ascent in prices comes despite a less-than brisk sales environment; existing home sales declined by 0.4% in May, against consensus expectations of a 1.5% rise, and have remained range bound for years.
While prices party, activity slumbers. FHFA Home Price Index in white, existing home sales in orange. Source: The Bloomberg
The divergence between prices and activity can be explained by tight supply. According to real estate broker Redfin Corp., the average home spent just 34 days on the market in May, eclipsing the previous record low of 36 established a month prior and 38 last year (in Denver, the average listing lasted just six days in May). Aaron Terrazas, senior economist at Zillow Group, Inc., told Reuters: “Supply is woefully inadequate to meet demand.” Trulia, Inc. reports that nationwide inventories declined 5.3% from 2017 in the second quarter, the 14th straight year-over-year drop.
Housing might be strong nationwide, but it’s a different story in New York City. Residential real estate in Manhattan has endured an ugly start to 2018 and weakness appears to be accelerating. According to brokerage firm Douglas Elliman, second quarter sales in Manhattan plunged 16.6% to 2,629 transactions, the lowest total since 2009, while the median sales price sank 7.5% year-over-year. Total inventory is up 10.7% from the second quarter last year, while the absorption rate, or months to sell existing inventories at the current pace, jumped to 8.4 months from 6 months last year.
This is no one-borough phenomenon either. Both prices and activity declined year-over-year in Brooklyn and Queens, while the Westchester suburbs saw their biggest sales drop on a percentage basis since 2011 in the second quarter, according to Elliman.
What gives? The December enactment of the Tax Cuts and Jobs Act caps state and local tax deductions at $10,000, representing a financial hit to residents of high tax localities like the New York metro area (ATTOM Data Solutions reports that the average Westchester resident coughed up more than $17,000 in property taxes last year). The new law also caps mortgage interest deductions at $750,000, down from $1,000,000 prior to its passage.
Grant’s asked Jonathan Miller, president, CEO and co-founder of eponymous real estate appraisal firm Miller Samuel, Inc., how much the changes to the tax code may be impacting behavior. Miller didn’t mince words in assessing the significance:
There is nothing positive in the tax law as it relates to housing, the best case is neutral. The worst case? As negative as you can think of.
That isn’t to say that the turn in fortunes can be solely chalked up to the taxman. The rising interest rate regime has not spared housing debt, as the average Bankrate.com mortgage rate ticked to 4.39% as of Monday, up from 3.67% in September.
But the uptick in rates is of course a national phenomenon. For New York, and specifically Manhattan, a glut of new higher-end housing (a walk through midtown in the last 10 years with an eye on the abundant skyward cranes confirms this) contrasts with a shortage in other categories. Miller explains:
The vast majority of newly developed Manhattan inventory that has come online in this cycle has been in the top 20% of the market. There is excess supply at the high end, and static or insufficient supply for the other 80%. This phenomenon is playing out around the country.
The impact of the pullback is greatest at the high end, and diminishes as prices decline. The outcome is dwindling affordability.
Asked about the potential broader implications of the soft New York market, Miller again points to affordability, while noting that sales trends typically lead price by 12 to 18 months:
The more expensive the market, the sooner you will see a slowdown in activity, higher inventories and lower prices. It’s a slow grind.
New York leads, the U.S. follows?
QT progress report
The Fed took a breather this week, as its portfolio of securities held outright registered $4.084 trillion, a (relatively) tiny $130 million uptick from last week’s reading. Both Treasury and mortgage-backed securities holdings ticked higher from July 5. However, today’s reading still represents a meaty $20.3 billion decline from the trailing four-week average.
Since the Fed began its QT portfolio unwind on Oct. 1, total assets are down by 3.69%, for a simple annualized 4.67% rate of decline.
Recap July 12
Stocks caught another upside rip, with the S&P 500 rising nearly 1% and the tech-heavy NASDAQ reaching a fresh all-time high as the FANG stocks maintained their potent bullish momentum. Treasury yields finished little changed, and commodities ticked higher with crude oil managing a modest bounce following yesterday’s 5% plunge.
Second quarter earnings season kicks into high gear tomorrow, with J.P. Morgan Chase & Co., Citigroup, Inc. and Wells Fargo & Co. among the companies scheduled to report.
- Philip Grant
Tuesday, July 10, 2018
Flat top fade
The speculators have arrived. According to the Commodity Futures Trading Commission’s weekly commitment of traders report, non-commercial, net-short positions in 10-year Treasury futures reached a record of more than 500,000 contracts as of July 3. Speculators were net long 10-year futures as recently as December.
Inflation looks to be the ace in the hole for the assembled bond bears. Headline CPI for May rose by 2.8% year-over-year, its hottest reading since early 2012 (June CPI is set to be released Thursday). The New York Fed’s Underlying Inflation Gauge paints an even starker picture: The UIG rose by 3.27% in May, the 12th straight sequential increase and the highest since 2006.
So too, has output growth remained solid. Over the past eight quarters, annualized GDP growth has averaged 2.4%, north of the 2.1% mean since the recession ended in the second quarter of 2009. Then there is the labor market: JOLTS job openings reached a record 6.84 million in April before easing in May, but still ticked higher by 17% year-over-year in that most recent reading. Anecdotally, a July 6 article by Annie Lowrey of The Atlantic describes the scene in Iowa:
Out of every 100 people who want a job, 98 or 99 have one. The rate of wage growth has doubled of late, and businesses are scrambling to find workers. “It does feel like things are a little different in the last year,” Elisabeth Buck, the president of the United Way of Central Iowa, told me. “Businesses are getting a little desperate.”
Although rising inflation and a growing economy augur well for higher interest rates, bond bears must contend not only with a crowded speculative boat but also the prospect of an inverted yield curve, a phenomenon associated with recession, a falling CPI and falling interest rates. Indeed, the Treasury curve looks flat as an old soda, with the gap between two-year and 10-year yields just 28 basis points, virtually its narrowest since 2007.
While the Fed has begun to trim its own Treasury holdings (the portfolio of securities held outright is down a bit more than 3% since QT began in October), the newly enacted tax cuts and uptick in the federal deficit has spurred a substantial uptick in supply.
So far, that additional supply appears to be overwhelming the short end. According to data from the Securities Industry and Financial Markets Association, issuance in 10-year Treasury notes totaled $144 billion in the six months through June, up a solid 7% from the three-year average. However that figure is easily eclipsed by a 12% uptick in two-year issuance through June compared to the trailing three-year period, and a 56% surge in fresh 13-week bill supply relative to the 2015-2017 mean. Overall issuance is up by 25% over the first six months of the year.
Short rates may get a further boost as futures point to 54% odds of at least two additional 25 basis point rate hikes by year end. In a note today, derivatives maven Harley Bassman predicts that the curve will finally invert in December, writing that investors should pay careful heed to recent resilience at the long end:
The signal that an iceberg is ahead is NOT that the Fed is jamming the yield curve flatter, but rather that long-term interest rates have declined by 30 basis points through the most recent Fed hike; and that this is occurring despite massively expanding supply thanks to Quantitative Tightening (QT) and the Tax Package.
With rising inflation and solid growth seemingly arguing for rising rates, and speculative positioning and a flattening yield curve potentially pointing to the opposite, what’s a potential creditor to do?
The Feb. 9 edition of Grant’s analyzed the prospects for U.S. government debt, spurred by a Federal government that is set to borrow more relative to GDP in 2018 than in any year since the climax of World War II:
The great inflation of the 1970s seemed to come from out of nowhere. With a long look in the rearview mirror, one identifies fiscal indiscipline (Vietnam, the Great Society), abetted by monetary disruption (the end of Bretton Woods) and, perhaps, by a demographic bulge, as the villains of the piece. Maybe in five to 10 years our own lapses from fiscal and monetary best practices will stand out as the causes of an inflation problem that today seems only incipient.
This is speculation. The concrete problem is that historically low interest rates afford the creditor no margin of safety. Over the past 50 years, the 10-year Treasury has delivered an average, inflation-adjusted yield of 2.3%. Today’s real yield is on the order of 0.7% (subtract a 2.1% rate of consumer price inflation from a 2.8% nominal yield, and voilà). This is not to say that yields can’t go lower, only that the value proposition is unappealing.
Unappealing, it remains.
Recap July 10
Stocks caught a modest bid, with the S&P 500 extending its winning streak to four sessions and pulling closer to the January high water mark, despite a flat showing in the NYSE FANG+ Index. Treasury yields ticked higher, led by the short end, to leave the curve flatter, while the VIX, Dollar Index and CRB Commodity Index finished little changed.
Despite that lack of broad movement, energy prices resumed their rally, with WTI crude finishing at $74.4 a barrel, up a Texas-size 59% year-over-year.
- Philip Grant
Monday, July 9, 2018
A programming note
The newest edition of the Grant's podcast, featuring a discussion of the world's points of pressure and other trenchant observations, is now available for download on iTunes, Stitcher, iHeart Radio, Google Play Music or from our website.
China check
It’s a different sort of red card. Over the weekend, the Financial Times reported that Li Yonghong, entrepreneur and owner of high-profile Italian soccer club A.C. Milan, missed a €32 million ($37.4 million) interest payment to creditor Elliott Management Corp. That puts Elliott in position to take over the club as soon as today.
Local sportswriter and A.C. Milan minority shareholder Carlo Pellegatti told the FT: “There are too many mysteries, too many invisible things about the Chinese owner. It is not possible to always continue to wait for the money.”
For debt-laden China, where banking assets exceed full-year 2017 GDP by more than 300% (for comparison, U.S. banking assets are less than 100% of GDP), Li’s money troubles serve as a reminder of the thin margin for error that accompanies high leverage. According to data from the People’s Bank of China, there have been at least 20 bond defaults through May, nearly matching 2017’s full-year total of 22.
The important property sector has also lately shown some cracks in the façade. According to an annual survey of asset managers and commercial banks by China Orient Asset Management Co. and cited by Bloomberg, the total renminbi value of bad loans within the real estate industry will jump by 20% this year. That finding comes as the Chinese government is putting the brakes on a crucial subsidy. Yesterday, the FT reported that an executive from the China Development Bank told listeners to a recent teleconference that the CDB was tightening loan approvals for its “slum redevelopment” policy, a program which has provided some $1 trillion to homebuyers since 2016. For context, total Chinese GDP last year was $12.2 trillion, according to the World Bank.
Mr. Market has gotten the message: The Shanghai Composite Property Index is down 20% year-to-date, exceeding the 14.5% loss on the broad Shanghai Composite Index. China Evergrande Group, a developer whose high short interest, sky-scraping debt burden and then-rampaging stock price was chronicled last year by Grant’s (“Ever higher,” June 2, 2017) has seen an abrupt turn in fortunes, with its 8 3/4 senior secured euro-dollar notes of 2025 falling to a fresh low of 82.5 cents on the dollar for a yield-to-worst of 12.5%.
China Evergrande 8 3/4s of 2025. Source: The Bloomberg
While un-bullish tidings appear in both credit and equities, the broad currency weakness that has befallen large swaths of the emerging markets has also made its way to the Middle Kingdom. Even after a bounce in recent sessions, the renminbi is down by nearly 4% versus the dollar since the middle of June and 5.5% since April, a substantial move considering the government’s control over FX gyrations via the so-called managed floating exchange rate.
For its part, Beijing is not just standing idly by while asset prices falter. Last week, the People’s Bank of China cut its reserve ratio requirement for banks to its lowest level since 2009. The renminbi rebound last Tuesday followed comments from the PBOC suggesting that the bank may prop up the red backs, according to Bloomberg.
But as the Sino-American trade battle begins in earnest, will Chinese government support of the markets be enough? Much as night follows day, Anne-Stevenson Yang of J Capital writes today that a post-credit boom reckoning is in store for the world’s second largest economy:
China has stretched its expansion beyond the reasonable sell-by date through forced credit expansion pushed into enterprises that had no viable way to earn a return, bridges to nowhere, and capital controls, but it cannot prolong it indefinitely. The money creation ultimately leads to deteriorating trade and investment accounts, capital flight, and deflation.
Stevenson-Yang goes on to speculate on the wider implications of an abrupt end to the credit-driven Chinese “economic miracle”:
Once the debt crisis comes, it will likely to be deflationary for the world. China will have little choice but to depreciate the currency in the face of demand for dollars, and that will force prices lower across the world. It is clear from recent weeks that the exchange value of the renminbi is now in the eye of a fiscal hurricane as it has not been for years.
Recap July 9
The bulls continue to have their way. Stocks rose for a third straight session, with the S&P 500 up by 2.6% since Thursday, to close to within 3.2% of the January highs.
A stronger dollar was no problem either: The CRB Commodity Index closed flat while the J.P. Morgan U.S. Dollar Emerging Market Bond ETF rose to its best close since the end of May. Even the pancaked Treasury curve managed to steepen a bit as the long end came
- Philip Grant
Friday, July 6, 2018
Bean there done that
Time waits for no ship. As China’s retaliatory tariffs against U.S. exports took effect earlier today, Bloomberg reports that the soybean-carrying bulk carrier Peak Pegasus accelerated towards the port of Dalian this morning in a last-ditch attempt to arrive prior to the official enactment of the new duties. The ship didn’t make it in time so a 25% tax now awaits the cargo of the Peak Pegasus and further U.S. soybean exports to China.
In anticipation of the tariffs (which Caixin describes as “likely to cause both countries pain”), soybean futures have endured a near 20% freefall from May 25 to July 5, with yesterday’s $8.39 per-bushel closing price the lowest since 2008 (a strong 4.5% bounce followed today). Jeff Kaprelian, a broker at grain advisory service The Hueber Report, told The Wall Street Journal that the new tariffs provide plenty of justification for the precipitous drop: “That is the market. There is nothing more important than Chinese demand.”
For China, the world’s largest soybean importer, the emergence of U.S. tariffs are cause to think outside the box: According to Chinese news site Sina.com, the Ministry of Agricultural and Rural Affairs recently met with a consortium of animal feed and livestock companies to discuss ways to cut back on soybean meal in animal feed.
But, for the time being, the beans must flow, and they are flowing from Brazil. According to the Chinese National Grains and Oils Information Center, the Middle Kingdom bought 1.1 million metric tons of soybeans from Brazil last week, and nothing from the U.S. Bloomberg comments: “That’s an unusual move for this time of year, when China usually starts booking U.S. supply in the months before the North American harvest starts.” That pivot is translating into prices: Bloomberg notes that the premium for August Brazilian soybean futures rose to $2.21 per bushel over American beans yesterday, the largest spread since record keeping began in 2014.
In that yawning price gap, the Brazilians see opportunity. Luis Barbieri, a board member at grain-export trade group Anec, told reporters yesterday that Brazil may buy as much as one million metric tons of U.S. soybeans by the end of the year to satisfy local demand. In availing themselves of the cheaper beans on offer to the north, Brazil would be following the advice presented in these pages by industry expert and paid-up Grant’s subscriber Keith Bronstein. On June 20, Bronstein expressed his amazement at the lack of international arbitrage being undertaken between the divergent prices on offer from the world’s two largest producers.
In addition to the prospective loss of Chinese demand, domestic farmers and soybean bulls also contend with an unfavorable supply backdrop. According to the U.S. Department of Agriculture, soybean inventories stood at 1.222 billion bushels as of June, a record level for the second quarter and up 26.5% year-over-year. The USDA likewise reports in its weekly crop assessment that 71% of soybeans are in ‘good to excellent’ condition, up 7 percentage points from 2017. Twenty-seven percent of beans are blooming, nearly double the 17% seen at this time last year. Overall soybean plantings are set to exceed corn for the first time since 1983, according to the USDA’s annual survey.
Taking inventory of the comprehensively grim fundamental picture and eye-catching price weakness, Grant’s put the question to Bronstein: Is there anything to be bullish about in soybeans? With the long-awaited tariffs now a reality, it’s all about corn. Bronstein explains:
About 8 years ago, I advised my “team" at the time that we were looking at $8 to $18 for soy for a long time to come.
What do I think at $8.50?
There has been a multi-year extension of historical soy/corn cost of production relationship due to the extraordinary growth of China. The imposition of tariffs drops the curtain on this. Thus, if corn production ends up "really abundant" and corn proceeds to $3.40 or slightly less [from its current $3.60 a bushel and one-year average of $3.65], I then use the traditional relationship of 2.20 times corn for soy. Somewhat less than $8.
Not a forecast yet, but a map.
On the one hand:
Wreck the corn crop over the next 30 days and put the price up $1 and voila! [That would push soybeans back above $10 a bushel, according to that 2.2x ratio].
On the other:
An extended tariff regimen and depressed soy becomes institutionalized.
Recap July 6
A 2% jump in the NYSE FANG+ Index catalyzed another bullish day, as the S&P 500 enjoyed a second straight march higher to finish the holiday-shortened week up by 1.5%.
Commodities were well bid as the dollar took a tumble, a development most welcome in emerging markets as the iShares J.P. Morgan U.S. Dollar Emerging Markets Bond ETF continued an impressive rebound from its June 19 interim nadir. Nevertheless, the Argentine peso, Turkish lira, and Indian rupee all remain near lifetime lows relative to the buck.
- Philip Grant
Thursday, July 5, 2018
One from the vault
On this post-holiday occasion, let’s turn back the clock to an era both far-removed and familiar. The July 7, 1989 edition of Grant’s featured an analysis of the then-soaring Japanese stock market and identified a potentially lucrative opportunity for bears. “Nikkei put warrants” was the dryly descriptive headline, and the lead paragraph, perhaps with a few tweaks, could have come from the present day:
The wonderful Herbert Stein remark about patience – “If something can’t go on forever, it won’t” – has been as good a motto as any to lose money by this epic bull market. In general, things that can’t go on forever have kept right on going. Donald Trump, “trophy” hotel prices, leveraged cable-TV companies, Wasserstein Perella & Co. and the Japanese stock market all come annoyingly to mind.
The Nikkei’s 1980’s levitation was a potent one, outpacing all subsequent bull markets in the U.S. Thus, from year-end 1982 to 1989, Japan’s benchmark index rose by 429%, a 26.3% annualized rate. To put that in context, the S&P 500 is up 310% from its March 2009 low, a 16.4% annualized clip, as compared to its 240% (25.8% annualized) rise from late 1994 to the 2000 peak.
Not all was well in Tokyo, Grant’s perceived. A deterioration in the ratio of advancing stocks to declining ones was one clue. A government regulation designed to stymie manipulation by capping the ability of any one broker to trade more than 30% of the volume in any one stock on a given day, another.
For any looking to cash in on a reversal of fortunes in the Land of the Rising Sun, we suggested a relatively obscure series of put warrants issued by investment bank Salomon Brothers International. The warrants, which were struck at prices of roughly 33,000 (the Nikkei’s then-current level), 31,000 and 28,000 expired in June 1991. The furthest out of the money, the 28,000 series, looked like a particularly compelling proposition: At the then prevailing 140 dollar-yen exchange rate, a fall to 14,000 on the Nikkei would have turned a $4.50 initial investment into a cool $100. William Fleckenstein, Seattle-based investor and longtime paid-up Grant’s subscriber, choosing the 28,000 strike, explained his thinking to Grant’s:
I gave up the first 9% [relative to the 33,000 series], but when (the Nikkei) starts rolling to the down side, I have almost three times as much leverage. What is your premise going in? The idea either works – and the market trades on reality – or they keep it going forever.
Indeed, reality soon made its return, but not until an explosive blow-off rally through 1989 provided a parting gift for the bulls. After peaking at near 39,000 on Dec. 29, 1989, the Nikkei fell by 48% to an interim low of 20,200 in October 1990. Needless to say, the 28,000 put warrants paid off handsomely.
Back in the present day, Grant’s asked Fleckenstein if any current investment opportunities present the sort of asymmetric opportunity available to Nikkei bears in that summer of 1989. Fleckenstein cited the bombed-out gold mining business though he added that neither equities nor call options can “get as mispriced as a warrant can.”
QT progress report
The newly upsized schedule began with a bang. The Fed’s portfolio of securities held outright footed to $4.084 trillion, down by a meaty $17.8 billion from last week’s reading. After weeks of mortgage-backed securities doing the heavy lifting, it was Treasurys driving the decline this time, while MBS holdings ticked slightly higher. Relative to the four-week average, securities held outright are down by $28.7 billion.
Since the Fed began its “QT” portfolio unwind on Oct. 1, total assets on the balance sheet are down by 3.72%, a simple annualized pace of 4.83%.
Recap July 5
Stocks caught a strong bid, with the S&P 500 gaining just under 1% to settle at its highest in nearly two weeks, back within 5% of the high-water mark reached in late January. The VIX, Dollar Index and CRB Commodity Index all declined, while a long-bond bid in tandem with selling pressure in the short end of the Treasury curve pushed the curve still flatter.
The spread between the two- and 10-year yield now sits at just 28 basis points, its narrowest since 2007. Meanwhile, interest rate futures point to 71% odds of another rate hike in September.
Two- vs. 10-year Treasury spread. Source: The Bloomberg
- Philip Grant
Tuesday, July 3, 2018
Bear on the 4th of July
From the Associated Press:
From the Associated Press:
From Washington D.C. to Menlo Park
Recap July 3
Bear on the 4th of July
From the Associated Press:
A bear with a taste for margaritas caused a stir in a Southern California community when it took a dip in a bubbling hot tub.
Mark Hough said he was lounging in his Altadena backyard Friday afternoon with his wife and a couple margaritas when he heard rustling, then saw the bear climbing over a fence into his yard.
They retreated inside, leaving the margaritas behind. Hough later ventured out to discover the bear lounging in the unheated hot tub. After Hough shot some video, he said the bear emerged from the water, walked over to his margarita, knocked it over and lapped it up.
Hough later spotted the bear taking a snooze in an oak tree before it disappeared down the street.
Such uncivilized behavior is no way to get invited back for fireworks.
From Washington D.C. to Menlo Park
Uncle Sam is circling Facebook, Inc. (FB on the Nasdaq). Yesterday evening The Washington Post reported that a consortium of U.S. federal agencies, including the Securities and Exchange Commission, Federal Trade Commission and the Federal Bureau of Investigation, have joined the Department of Justice in its investigation over Facebook’s handling of user data.
David Vladeck, law professor at Georgetown University and former director of the FTC’s consumer protection division, commented that the collaborative nature of the government investigation “does raise all sorts of red flags,” while The Post notes that the FTC’s probe of whether Facebook violated a 2011 consent decree agreement with the agency could yield a fine “potentially reach[ing] into the billions of dollars.” For his part, short seller James Chanos has in the past offered a helpful rule of thumb: “The FBI is never bullish.”
Investors took the news largely in stride: FB shares ticked lower by 2% today to $193.5 a share. Since Aug. 11, 2017, FB shares are up by 17%, compared to an 11% rise in the S&P 500 and 46% jump in the NYSE FANG+ Index. Analysts at Height Capital Markets downplayed the potential impact in a research note, terming the investigations mostly “Headline Risk” and asserting that large fines are unlikely. Even if the government all-stars crack the whip, Facebook’s not destined for the poor house any time soon. The company generated $18.2 billion in adjusted net income (at a 45% margin) and $17.5 billion in free cash flow in 2017, and holds $44 billion in cash and cash equivalents with no debt.
To whom much is given, much is expected. According to the sell-side, Facebook will generate $31 billion in adjusted net income during 2019, more than 50% north of 2017’s bottom line. During that period, capital expenditures are expected to more than double to $16.3 billion in 2019, from $6.7 billion last year. That inflating capital-expenditures line item coincides with a ballooning employee roster. From Facebook’s most recent form 10-Q:
Our employee headcount and the scope and complexity of our business have increased significantly, with the number of employees increasing to 27,742 as of March 31, 2018 from 18,770 as of March 31, 2017, and we expect such headcount growth to continue for the foreseeable future. In addition, we have recently announced our plans to hire a significant number of employees and contractors in order to address various safety, security, and content review initiatives.
While the Two Wall Street headquarters of Grant’s is a world away from Silicon Valley, “safety, security, and content review initiatives” do not sound to us like particularly lucrative activities. Indeed, the Aug. 11, 2017 edition of Grant’s Interest Rate Observer contained a bearish assessment of Facebook, suggesting that “maybe growth, momentum and dazzling stock market performance have obscured the problems that will ensure that not even Zuckerberg’s tree will grow to the sky.”
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After we had our say. FB shares since August. Source: The Bloomberg
Is Facebook, one of the brightest stars in the post-crisis bull market constellation, set to falter under the weight of natural growth limitations, an increasingly hostile government and punishingly high investor expectations? Maybe, but one thing’s for sure: Facebook management is not bullish on itself. The share disposition from insiders flagged in various prior editions of Almost Daily Grant’s continues apace.
CEO Mark Zuckerberg sold between 236,000 and 250,000 shares on each trading day in June pursuant to his 35 million to 75 million share sale announced last September and his fellow C-suiters have enthusiastically followed. On June 28, chief operating officer Sheryl Sandberg sold 55,000 shares, her ninth disposal of that increment since February, to net a cool $10.8 million. On June 12, chief technology officer Mike Schroepfer sold 38,009 shares for consideration of $7.3 million, while on June 11, chief product officer Christopher Cox sold 10,600 shares for $2 million. Chief financial officer David Wehner sold 10,000 shares for $1.99 million on June 20.
As Facebook’s insiders cash out, index funds take the baton. At the end of the first quarter, top holder The Vanguard Group reported a 173,634,657 share position, or 7.3% of shares outstanding. That’s up 27% from the first quarter of 2016, a time when FB shares fetched half their current level.
What’s value got to do with it?
Recap July 3
Stocks took a late tumble, as weakness in tech and the financials offset a bid from interest rate sensitive names given a lift by a broad decline in Treasury yields. Commodities couldn’t maintain an early bid despite a weaker dollar, with the CRB Index finishing unchanged, while the VIX jumped back above 16.
- Philip Grant
Monday, July 2, 2018
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How the turntables have turned
July marks not only the start to the fiscal third quarter, but also ushers in another ratcheting of the monetary screws. Starting today – officially it was yesterday, July 1, a Sunday, but how much monetary tightening do you suppose the Fed accomplished over the weekend? – the Fed’s monthly limit in its “QT” program designed to shrink its current $4.1 trillion balance sheet rose to $40 billion ($24 billion in Treasurys and $16 billion in mortgage-backed securities), from $30 billion in the second quarter. The monthly limit will reach its maximum $50 billion in October.
In pulling back from its extraordinary post-crisis accommodation, the Fed has some company. On June 14, the European Central Bank announced it will curtail its current €30 billion ($35 billion) in monthly asset purchases as of December. While ECB president Mario Draghi said he expects to maintain the current deposit rate at negative 40 basis points through next summer, rising inflation could potentially derail those plans: Year-over-year growth in German CPI has exceeded 2% for the past two months, the first back-to-back reading above that threshold since 2012. Recall the ECB’s mandate covers only “price stability,” as opposed to the dual-mandate Fed. Even the hyper-dovish Bank of Japan is getting in on the act. Bloomberg reported on Thursday that the BOJ has cut its own bond purchases for the third time in the month of June.
That hawkish turn from global central banks has put the hurt on the banks. Last Wednesday, the S&P 500 Financials Index established a fresh record losing streak by declining for a 13th straight day and now sits 12% below its January peak. Similarly bearish action across the pond leaves the Euro Stoxx Banks Index at near two year lows, down 19% from January, while, in Japan, the Topix Banks Index likewise resides at its lowest since late 2016, down 22% since January. By comparison, the MSCI World Index sits 7% below its January highs.
Is it just coincidence that the banks are selling off as monetary conditions tighten? On June 19, The Institutional Risk Analyst published an interview with Lee Adler of the Wall Street Examiner, who explained the mechanics by which quantitative easing burnished deposits and, subsequently, loan growth at financial institutions:
Under QE the Fed lent money to [the] Treasury in the form of note and bond purchases. By redeeming the notes and bonds as they mature, the Fed is effectively calling in these loans. . . The asset disappears from the Fed’s balance sheet, and so does the bank reserve deposit because the bank’s customer used it to buy the new bonds. The new bonds now exist, but the money used to purchase them was extinguished when the Treasury used it to pay off the Fed.
Deposit growth is slowly grinding to a halt. It should go negative in the next couple months, especially if [the] ECB makes more cuts to QE. Some of the ECB QE money was flowing instantly to the U.S. Since [the] ECB went from €60 billion to €30 billion in monthly QE their deposit growth has slowed and less money flowed to the U.S. to buy stocks and bonds.
Grant’s asked Christopher Whalen, editor of The Institutional Risk Analyst and financial industry expert extraordinaire, how the banks might respond to a further drop in deposits, as well as his assessment of the industry in a post-QE world:
As reserves disappear, the competition for deposits will grow apace. . . The good news, of sorts, is that loan demand is fairly limp, so a shrinkage in overall credit, which is the essence of QT, will not push up loan rates. Thus financials reflect the general noise in the market and also the fact of a flattening yield curve.
It is not higher rates that are good for banks but wider spreads. But spreads are tightening and loan profitability is at all-time lows. QT will be very bad for banks because of constrained profitability on credit. Give it 18 months and net interest margins will be shrinking as credit defaults are rising.
QE giveth, QT taketh away.
Recap July 2
Stocks recovered from moderate early losses to log a green finish on the S&P 500, with the VIX in turn backtracking from double-digit percentage gains to finish down on the day.
Treasury yields ticked a bit higher, while another round of dollar strength pressured commodities, with the CRB index falling nearly 1.5% and WTI crude slipping back below $74 a barrel. A late rally allowed the iShares J.P. Morgan USD Emerging Markets Bond ETF to avoid fresh multi-year closing lows.
- Philip Grant
Friday, June 29, 2018
Them's fightin' words
During last night’s ballgame, Cincinnati Reds first baseman Joey Votto
During last night’s ballgame, Cincinnati Reds first baseman Joey Votto
Slick Rick
We’ve got a gusher.
We’ve got a gusher.
Recap June 29
Them's fightin' words
During last night’s ballgame, Cincinnati Reds first baseman Joey Votto and Milwaukee Brewers catcher Erik Kratz engaged in a heated conversation on the field after Votto disputed a called strike with the home plate umpire. The jawing was enthusiastic enough that teammates in both dugouts spilled onto the field in anticipation of potential fisticuffs, but cooler heads prevailed and no punches were thrown.
Asked about their verbal altercation after the game, Kratz deadpanned: “Completely blown out of proportion, that’s all. We were discussing the Canadian dollar and flawed systems in our two governments.”
Good thing they stayed away from Canadian housing.
Slick Rick
We’ve got a gusher. Since June 18 West Texas Intermediate crude has ripped higher by an eye-catching 17%. The rally has not been contagious: During that period, the Dollar Index has traded sideways to consolidate recent gains, while the broad CRB commodity index is up by 2.7%.
With a barrel of WTI crude now fetching nearly triple the February 2016 lows and tearing higher on a daily basis, some market observers think we’re due for a pullback. Peter Forbes of Bianco Research reports that the firm’s fair value estimate (derived using principal component analysis from returns across other asset classes) pegs the crude price at 18% below yesterday’s close. Forbes concludes: “On balance, financial markets are pointing toward lower, not higher, oil prices.”
For energy bulls (count Grant’s among them, see the March 10, 2017 edition for more) concerned that crude may be getting ahead of itself, some comfort can be found in a recent thinning of a formerly jam-packed speculative boat. According to the Commodity Futures Trading Commission, non-commercial net long positions in crude oil registered 580,947 contracts as of June 19, that’s down 21% from the all-time high reached on Feb. 2.
Production prospects further underpin the bulls. On Tuesday, The Wall Street Journal quoted an unnamed State Department official threatening sanctions on any country that doesn’t cut Iranian oil imports to “zero” by November. Iran is the third largest producer in the Organization of Petroleum Exporting Countries cartel, exporting 2.125 million barrels per day in 2017 (roughly 2% of world production), according to data from OPEC. For his part, energy secretary Rick Perry told reporters yesterday that he is “comfortable” that other producers can step into the vacuum, commenting that he sees the sanctions as “an opportunity for OPEC members to fill this gap.”
Research firm JBC Energy isn’t so sure. Writing on the looming Iranian disruption, JBC worries: “We cannot say with certainty that the oil market would be able to replace that volume.” It doesn’t look like supply relief is forthcoming from North America. Last week Canadian production facility Syncrude was forced to shut down after a transformer blast, taking 350,000 barrels a day of supply off the market. In the U.S., a pipeline capacity shortage in the Permian basin (the world’s second most prolific oil field, behind Saudi Arabia’s Ghawar) has pushed the premium for spot crude at the Cushing, Oklahoma distribution hub over future to a record, according to Bloomberg.
The current futures curve is now in backwardation, which features higher prices for immediate delivery than futures. As for practical application, the CME defines backwardation as a “structure that suggests the market is undersupplied and/or demand is outstripping supply.” The curve stands in almost perfect contrast to the contract structure seen one year ago.
Backwardation and contango. WTI crude futures curve, now (in orange) and one year ago (in green). Source: The Bloomberg
So, too, does the demand side of the equation augur bullish things. A May 9 analysis by Blacklight Research found global oil demand to be “blistering.” Blacklight’s managing partner and head of research Colin Fenton writes:
Annual global oil demand growth is now running above two million barrels a day, according to our calculations. That’s 35% higher than the trailing five-year average. More than half of this growth is coming from the United States – a rich economy running on easy money and full employment. Oil prices would need to rise much higher to dent current demand growth.
Grant’s asked Fenton whether the past seven weeks have brought any changes to his conclusion. He replies:
No, the associated probabilities for global demand have actually gotten stronger thanks to the May 23 letter to Trump from the four US senators [urging the President to “stand up to OPEC”] and OPEC’s subsequent promise to increase output. That promise brings expected OPEC spare capacity to one percent of global demand by 3Q 2019. Given the evident problems in Venezuela, Libya, and Nigeria, that buffer looks increasingly precarious.
It's shaping up to be a long, hot summer.
Recap June 29
The final trading day of the second quarter saw stocks give back early gains and finish flat, leaving the S&P 500 up 1.7% year-to-date. Treasury yields ticked higher, as the 10-year yield finished at 2.86%, up 46 basis points for 2018. Gold, at $1,252 an ounce, is down 4% since Dec. 31, while WTI crude is up by 23%. The big winner is the VIX, which is up 44% year-to-date despite finishing today below 16.
- Philip Grant
Thursday, June 28, 2018
It's a small world
The buck stops where? The Dollar Index continues to consolidate its steep recent gains, up 7% in the last three months (a 30% annualized pace) to the cusp of a fresh 52-week high, accompanied by a two-year Treasury yield that has virtually doubled in the last nine months to 2.5%.
Those abrupt moves spell trouble for emerging market borrowers. According to the Institute of International Finance, dollar-denominated debt in the formerly designated “third world” rose to $8.25 trillion at year-end, up from $4.47 trillion in 2008. Across the globe, debtors scramble to adjust to the tightening monetary noose.
Today, the Indian rupee broke to a fresh record low against the dollar at more than 69 per greenback (63 rupees fetched a dollar in January). In tandem, India’s 10-year borrowing costs have jumped to 7.94% from less than 7.2% in April. While year-over-year rise in CPI in the world’s second most populous country registered a relatively (by EM standards) benign 4.6% in the first quarter, that figure is more than double the 2.21% reading in the quarter ended June 30, 2017.
By way of reaction, the Reserve Bank of India raised its benchmark repurchase rate by 25 basis points to 6.25% on June 6, and it is a seeming lock to do so again at the upcoming August meeting, as interest rate futures assign 100% odds of further tightening. Today the central bank waded into the FX market to the tune of a 200 billion rupees ($2.9 billion) seven-day reverse repo.
The RBI is not just responding via monetary policy. Recall that, on June 4, central bank governor Urjit Patel took to the Financial Times op-ed page to plead with the Federal Reserve to reverse their policy tightening, warning that a continuation of its balance sheet contraction will “absorb such a large share of dollar liquidity that a crisis in the rest of the dollar bond markets is inevitable.”
As for crisis, Argentina is already there. The peso remains near all-time lows against the dollar despite a $50 billion emergency loan from the International Monetary Fund, while inflation gallops (May CPI rose 26.3% from a year ago) despite a seven-day repo rate of 40%. Today, the 100-year dollar bond issued last June sank to another fresh low of 77.7 cents on the dollar. With inflation percolating and creditors spooked, economic growth is under pressure. Fausto Spotorno, chief economist at Orlando J. Ferreres & Asociados, told Bloomberg: “It’s almost certain that Argentina will fall into recession.” The stock market seems to agree, the country’s Merval Index is down by nearly 25% since January.
To the north, Brazil faces a similar quandary. The real has depreciated by 22% against the dollar since January, prompting investors to price in policy tightening via interest rate futures, while the growth outlook has slumped. Today, the central bank slashed its 2018 GDP forecast to 1.6% from 2.6%. Meanwhile, the monetary policy stewards have been working feverishly to prop up the real, nearly tripling the outstanding amount of currency swap contracts outstanding since late May to $67 billion, in lieu of burning FX reserves through outright currency sales.
Brazil FX swaps outstanding. Source: The Bloomberg
Then there’s China, which has seen a 6% devaluation in the renminbi since April (more than half of that taking place in the last eight days) while the Shanghai Composite Index has slipped into a bear market, down by 22% since January. The Middle Kingdom’s debt-addled property sector appears particularly unsuited for a rising dollar and tightening liquidity environment as the Shanghai Property Index has fallen by 30% since January to its lowest since November 2016.
The extra-encumbered conglomerate HNA Group Co., Ltd., which is in hock to the tune of $93 billion, is a particular source of concern for Beijing. A recent Bloomberg dispatch reported that: “On June 12, a senior official at the People’s Bank of China led a meeting with three regulators. . . instructing attendees to support HNA’s future bond issues.” One week later, HNA came to the bond market for the first time in five months, with subsidiary Bohai Capital Holding Co. raising Rmb 106 billion ($164 million). The unit had to cough up a 7% interest rate, a record high for the unit, yet sold only about half of the planned issuance.
HNA’s similarly aggressive attempts at securing a sounder financial footing continue apace, creating financial ripples far and wide. In the first quarter, the conglomerate trimmed its stake in Deutsche Bank by nearly half as the German banking giant remained under heavy pressure with shares down 43% year-to-date (even after the divestment, HNA remains DB’s top holder). Then, in April, HNA’s Hainan Airlines announced it would sell 20% of its shares in Brazilian airline Azul SA, then worth $138 million according to Reuters, to United Continental subsidiary Calfinco. Worried about future fire sales of HNA’s remaining stake, investors have sent Azul shares lower by 41% since April 30, promptly dealing an unrealized $55 million loss to United. Yesterday, Hainan announced in a filing that it will sell the remainder of its Azul position.
Now, as ever, the financial knee bone is connected to the thigh bone.
QT progress report
Avert your eyes, RBI: The Fed’s portfolio of securities held outright fell to $4.1 trillion, down $10 billion from a week ago. Mortgage-backed securities continued to be the source of the decline as Treasury holdings remain above their June 6 levels. Compared to the trailing four-week average, securities held outright are down by $16.8 billion, mostly due to declining MBS holdings.
Since the Fed began QT on Oct. 1, its total balance sheet is down by 3.37%, a simple annualized pace of 4.48%.
Recap June 28
Stocks caught a solid bid, with the 60 basis point rise in the S&P narrowing the week’s decline to 1.4%, while the CRB Index finished unchanged despite WTI crude jumping above $73 a barrel, a post-2014 high. Treasury yields ticked higher, with the 10-year yield backing off the three week low of 2.82% seen yesterday, and the VIX reversed early gains to finish in the red, just below 17.
- Philip Grant
Tuesday, June 26, 2018
Elevation grade
The bears are circling the corporate bond market. Short positions in dollar-denominated investment grade bonds have reached a new post-crisis high of $55 billion according to data compiled by IHS Markit, up by $7.8 billion from the start of the year. Mergers and acquisitions, more than deteriorating credit quality, may best explain the positioning. Markit points out that Comcast Corp., which is engaged in corporate battle with The Walt Disney Co. for Twenty-First Century Fox, Inc’s. assets, has seen the largest quarter-to-date increase in its credit shorts, followed by General Mills, Inc., which bought Blue Buffalo Pet Products, Inc. in April (Almost Daily Grant’s, March 15).
M&A has also figured prominently in a recent wave of supply. Last Wednesday, mass merchant Walmart, Inc. issued $16 billion worth of notes and bonds ranging from two- to 30-year maturities to fund its purchase of a majority stake in Indian e-commerce concern Flipkart Pvt Ltd. Also last week, German conglomerate Bayer AG raised $15 billion in dollar bonds as well as €5 billion in euro bonds to help refinance its takeover of agricultural behemoth Monsanto Co. Those offerings are the second and third largest of the year, trailing only CVS Health Corp.’s $40 billion bond placement to fund its takeover of Aetna, Inc.
The recent jump in M&A-related credit supply and increased short presence coincides with another lurch wider in spreads. The Bloomberg Barclays Investment Grade spread has widened to 139 basis points, its largest gap over Treasurys since the day after the 2016 elections and up more than 50% from the early February cycle low. In contrast, high-yield spreads have barely budged over that stretch.
Bloomberg Barclays USD Liquid Investment Grade Option Adjusted Spread, one-year view. Source: The Bloomberg
According to data from FactSet, investment-grade debt has been the worst performing major asset class year-to-date through June 21 with a 3.6% loss, trailing Treasurys (down by 1.4%), high-yield (green by 0.7%), stocks and commodities (both higher by more than 3%). Robert Tipp, chief investment strategist at PGIM Fixed Income, explained investors’ recent preference for junk debt to the Wall Street Journal yesterday: “High-yield has proved to be the sweet spot. It’s not too exposed to emerging markets and Europe and it’s benefiting from the strong economy.”
While rising rates and percolating inflation do indeed present an uninviting backdrop for investment grade, bond investors have other, structural factors with which to contend. Thus, the percentage of the Citigroup U.S. Broad Investment-Grade Corporate Bond Index rated triple-B, or the last full rung above junk, footed to about 47% last fall, well above the 40% so rated in 2007. At the same time, the size of the index nearly tripled over that 10-year period, to $5 trillion from $1.7 trillion (Grant’s, Oct. 20, 2017).
Then, too, the April 6, 2018 edition of Grant’s (“Doormats of Wall Street”) identified two other fundamental factors with which credit investors must contend, unrelated to composition, supply, interest rates or economic growth:
A bond is a promise to pay money, but – problem No. 1 – the value of money forever diminishes. As deflation is off the monetary-policy table, the price level goes up and up. Then, too, “senior securities” are junior in all the ways that count to a solvent enterprise. Stock options, not bond options, incentivize the managers. Earnings per share is the corporate end all, be all – problem No. 2
We creditors can’t change the world, but we can politely ask for a raise, and, if refused, we can take our business elsewhere.
Let the value restoration project continue apace.
Recap June 26
Steady as she goes. Stocks and bonds both stayed in a tight range, with the S&P 500 floating higher amid a bounce in the FAANG names, while Treasury yields finished flat or slightly lower across the curve. Commodities saw a bit more action, as the broad CRB caught a robust bid despite a stronger dollar, with WTI crude rising above $70 a barrel for the first time in more than a month.
- Philip Grant
Monday, June 25, 2018
Hungry like the wolf
We may soon find out if bigger is indeed better. On Friday evening, the New York Post reported that Kraft Heinz Co. (KHC on the Nasdaq) is “very much interested” in buying Campbell Soup Co. (CPB on the NYSE). Kraft Heinz, itself formed in a 2015 merger backed by Berkshire Hathaway, Inc. and 3G Capital, has certainly demonstrated an eagerness to do a deal, making unsuccessful overtures to Mondelez International, Inc. and Unilever plc. in recent years. Campbell shares jumped by 9% on the news, while Kraft Heinz initially traded higher before finishing unchanged.
The potential addition of Campbell’s would provide a helping hand for KHC’s earnings profile: Wells Fargo analyst John Baumgartner forecasts a 10% bump in Kraft Heinz earnings should a deal be consummated. Ken Goldman of J.P. Morgan Chase & Co., estimates potential accretion at more than 20%. Still, earnings tell just part of the story. Goldman writes: “We would be surprised if KHC wanted CPB, a company that does not solve KHC’s growth problem and is facing numerous internal challenges. So we do not expect a deal to take place. But in the end, money talks.” Then, too, Kraft Heinz may face rival suitors: The Post also notes that General Mills, Inc. (GIS on the NYSE) “is also seen as a possible Campbell buyer.”
Prospective CPB bidders wouldn’t have to worry about top-ticking: Shares are down by 33% since March 25, 2016, during which time the S&P 500 has logged a 33% gain. The company has cut its earnings forecast on at least three occasions in the past 12 months, with the most recent warning accompanied by the abrupt retirement of former CEO Denise Morrison. In December, Campbell’s paid a hefty price for snack company Snyder’s-Lance, Inc. in an attempt to diversify away from its contracting core soup business.
Early returns on the deal are less than promising: While Campbell’s debt load has nearly tripled to $9.6 billion, or 5.5 times forward adjusted earnings before interest, taxes, depreciation and amortization (EBITDA), the Street is expecting net income for the year-ending July 31, 2019 of just $822 million. That’s down from $932 million logged in the 12 months ended July 31, 2017.
As for Kraft Heinz, whose shares have similarly languished to the tune of 17% since March 2016 amid plateauing revenues (the 2019 consensus of $26.5 billion is virtually unchanged from 2016’s top line), a deal is plainly on the corporate agenda. The question is how Kraft’s existing creditors may take to a large acquisition. While not as leveraged as Campbell, KHC carries net debt at just under four times adjusted EBITDA. The company’s credit rating sits near the border of junk (S&P rates Kraft debt at triple-B, while Fitch rates the company triple-B-minus) and its two most actively traded bonds are both quoted below par.
The March 25, 2016 edition of Grant’s featured a bearish assessment of Kraft Heinz and Campbell (“Sell big food”), arguing that the then-exorbitant valuations sported by the group posed a substantial threat to investors accustomed to a low risk, defensive profile which has historically characterized consumer staples companies. The absence of top-line growth, shifting consumer tastes to organic foods from processed, and encroaching competition from foreign operators Aldi and Lidl also figured in the analysis.
After peaking on July 8, 2016 (the same day that the 10-year yield made its cycle low of 1.37%) the S&P Packaged Food Index is down by 18%. Scott Mushkin, analyst at Wolfe Research, succinctly detailed the industry’s problem a March 24, 2017 follow-up on Kraft Heinz (“Price war for Warren Buffett”): “There are just way too many assets chasing the sales.”
Up and down. The S&P 500 Packaged Foods Index, 5-year view. Source: The Bloomberg
Recap June 25
The bears were out today. A tech-centric stock selloff left the S&P 500 at its lowest close of June, while a bid in Treasurys pushed the 10-year yield to 2.88%, also its lowest since the end of May. Commodities finished well in the red, with copper making fresh 2018 lows, despite a weaker greenback, and the VIX jumped by 26% for its highest close since April.
- Philip Grant
Friday, June 22, 2018
Petal to the metal
Records are made to be broken. On June 7, a 1963 Ferrari 250 GTO was reportedly sold in a private transaction for a cool $70 million, shattering the previous $52 million record price established 2013, to say nothing of Wikipedia-documented $10.6 million sale prices in 2004, and $2.2 million in 1997. With only a few dozen models of the vintage race car known to aficionados as the “Holy Grail” in existence, the limited supply likely figured prominently in a sale price equivalent to the cost of around 5,600 2016-model Toyota Camry’s, according to local asking prices on TrueCar.
That $70 million sum may not remain the record holder for long: Sotheby’s is set to auction a 1962 250 GTO in Monterey, California on Aug. 24-25, affording collectors another opportunity to outbid one another. Ferrari historian and expert Marcel Massini recently forecast that the GTO will break the $100 million barrier in the next two to three years.
Following the prior benchmark sale in 2013, Grant’s took inventory of the skyward high-end luxury goods market (“Warranty not included”) in the context of the Fed’s then-hyperactive monetary policy, and attempted to determine the motivations of that $52 million car buyer:
Nostalgia? Automotive aesthetics? Suspicion of the currency, and of financial assets denominated in that currency, in this time of unprecedented monetary experimentation? Or maybe he just likes cars.
But, if the last-named hypothesis is correct, why do so many moneyed people like cars now?
Clearly, that was no passing infatuation. According to consulting firm Knight Frank, luxury autos have produced a whopping 334% return over the 10 years through 2017, by far the best performing subcomponent of the Knight Frank Luxury Investment Index, which is up 126% over that period (wine takes second place with a 192% 10-year return, while furniture is the worst performing component with a 32% loss).
That 126% gain stacks up pretty well against other asset classes. The S&P/Case-Shiller U.S. National Home Price Index has risen by 13% over the 10 years ending in 2017, while gold gained 60% and the Bloomberg Barclays U.S. Total Return Bond Index appreciated by 48%. Only the S&P 500’s 124% rise, with dividends reinvested, approached the performance of Knight Frank’s luxury gauge, and investors would have been obliged to patiently sit through the 50-plus percent 2008 drawdown on the way to their subsequent gains.
While the upper crust has contended with (or enjoyed) substantial inflation in asset prices, the real McCoy has been far more demure. Headline CPI rose just 17% in the 10 years ending December 2017.
Is the inflationary outcome long sought by policy makers finally upon us? Year-over-year CPI growth has remained over 2% through the first five months of 2018, reaching 2.8% in May to match its hottest reading since 2011. More broadly, the New York Fed’s Underlying Inflation Gauge, which includes CPI components as well as a variety of additional macroeconomic and financial data points, jumped to 3.27% in May, its highest reading since 2006.
New York Fed’s Underlying Inflation Gauge. Source: The Bloomberg
Thursday, June 21, 2018
Mystery fridge
Like referees in sports, it’s rarely a good thing when auditors are in the news.
Like referees in sports, it’s rarely a good thing when auditors are in the news.
QT progress report
Recap June 21
Mystery fridge
Like referees in sports, it’s rarely a good thing when auditors are in the news. Indeed, the “Big Four” have recently been receiving far more publicity than they, or their audit clients, might like. Over the course of two days last week, the U.K. Financial Review Council (FRC) issued £14.5 million ($19 million) in fines to accounting firms PricewaterhouseCoopers and KPMG following the failures off BHS Group Ltd. and Quindell plc. Bloomberg notes that that figure nearly matches the total fines handed out by the regulator throughout 2017.
Then on Monday, the FRC took the unusual step of publicly scolding KPMG for “an unacceptable deterioration” in audit quality. The rebuke follows a review of 16 of KPMG’s audits, after which the regulator declared: "50% of KPMG's FTSE 350 audits required more than just limited improvements, compared to 35% in the previous year." The regulators didn’t let KPMG’s peers off the hook either, exhorting the group: "At a time when public trust in business and in audit is in the spotlight, the Big Four must improve the quality of their audits and do so quickly.”
On Tuesday, the Financial Times published an analysis of the U.K. regulator’s less-than stringent treatment of the “goodwill” balance sheet line-item, and the liberties some companies take with goodwill, to the detriment of investors. The example of British firm Carillion Energy Services Ltd., which was audited by KPMG and which saw goodwill balloon to 35% of total assets in 2016 before declaring bankruptcy last year, figures prominently.
Natasha Landell-Mills, head of stewardship at Sarasin & Partners, told the FT that the episode demonstrated the extent to which investor protections have been eroded: “A core purpose of [audits] has always been to provide a mechanism for those providing capital to ensure their money is protected. . . Given [U.K.] accounting rules are no longer designed to protect capital – who is encircling our capital protection regime? Anyone?”
Others took a blunter tack. During the U.K. parliament’s business committee questioning of KPMG partners over the Carillion collapse, Labour MP Peter Kyle proclaimed: “I wouldn't hire you to do an audit of the contents of my fridge because when I read it I wouldn’t actually know what is in my fridge or not.”
It’s not just on the far side of the pond that KPMG finds itself in hot water. In January, the Securities and Exchange Commission (SEC) and the Justice Department accused KPMG of accessing confidential information from its regulator, the Public Company Accounting Oversight Board, then using that heads-up to correct deficiencies ahead of an inspection. Steven Peikin, co-director of the SEC’s Division of Enforcement, termed it “shocking misconduct – literally stealing the exam.”
Francine McKenna, transparency reporter at MarketWatch and speaker at the upcoming Grant's fall conference (advt.), reported more details on the investigation yesterday, including the existence of an “audit quality bonus program,” in which KPMG employees would be rewarded “if their engagements received no comments from PCAOB inspectors.”
For its part, KPMG told MarketWatch:
It is important to note that the inexcusable actions of the individuals who were separated from KPMG over a year ago were designed to subvert the PCAOB’s inspection process, and had no effect whatsoever on any of the firm’s audit opinions or clients’ financial statements.
But stocks are up; no harm, no foul. Last fall, the Center for Audit Quality conducted its 11th annual Main Street Investor Survey of 1,001 retail investors, finding a record high share (85%) of respondents proclaiming confidence in the U.S. capital markets and 78% reporting either “a great deal,” “quite a bit” or “some” confidence in public companies’ audited financials. Regarding confidence in the auditors, only 12% of respondents expressed “very little,” or “none at all.” That’s a record low in the series and less than half of the 27% who felt that way in 2009.
As said the late Richard Russell: “Markets make opinions.”
QT progress report
The Fed’s portfolio of securities held outright tallied $4.112 trillion, down by $8 billion from a week ago. Mortgage-backed securities were the source of the decline, with holdings dropping to $1.73 trillion while Treasury holdings ticked slightly higher. Compared to the trailing four-week average, today’s holdings are down by $12.6 billion.
Since the Fed began its QT portfolio unwind on Oct. 1, total assets are down by 3.14%, for a simple annualized pace of 4.28%.
Recap June 21
Stocks came under moderate pressure, with the S&P 500’s 0.6% pullback the biggest move for the recently-inert broad index in more than two weeks. Treasurys were bid with the 10-year yield dipping back below 2.9%, and the Dollar Index pushed to a fresh 2018 high this morning before reversing to finish in the red. Volatility stirred, as the VIX jumped by 15% for its strongest close since the end of May.
- Philip Grant
Wednesday, June 20, 2018
Addition by subtraction
It was only a matter of time.
It was only a matter of time.
No pain, no grain
The proof is in the pudding.
The proof is in the pudding.
Recap June 20
Addition by subtraction
It was only a matter of time. Yesterday evening, S&P Dow Jones Indices announced the removal of General Electric Co. from the Dow Jones Industrial Average as of next Tuesday, to be replaced by Walgreens Boots Alliance, Inc. That marks the conclusion of GE’s uninterrupted 111-year residence in the venerable, if not particularly intuitive (the Dow measures the nominal stock prices of its index components, unweighted by market capitalization) industrial average.
David Blitzer, managing director and chairman of the index committee at S&P, went the ‘it’s not you, it’s me,’ route, saying: “Since [1907], the U.S. economy has changed.” Blitzer tactfully neglected to mention the role that GE’s 60% slide since July 2016 (a period in which the Dow has risen by nearly 40%) and the accounting misadventures which have forced the restatement of 2016 and 2017 results, may have played in the decision.
Subscribers looking to take a walk down memory lane can find a thorough compendium of bearish GE analyses from the last 20 years of Grant’s in the Nov. 3, 2017 edition. As for the soon-to-be GE-free Dow, the industrial average saw its seventh straight decline today, its longest losing streak in over a year.
No pain, no grain
The proof is in the pudding. While stock prices gyrate to the waxing and waning of trade war headlines yet seem to go nowhere, a more tangible manifestation of rising world-tariff walls can be found in the agricultural commodities. Soybeans, cotton (both subject to a 25% Chinese duty as of July 6) and corn (also vulnerable to potential Mexican tariffs) prices are down 14%, 12% and 12% respectively from recent highs, more than double the 6% pullback in the broad CRB index from its May 23 interim peak. Soybeans and corn reversed from their multi-year highs to multi-year lows in the span of a few weeks.
That severe price action and seemingly endless escalation of trade tensions by the U.S., China and others have taken a toll. Rich Nelson, chief strategist at Allendale, Inc., explained the situation to Bloomberg: “At this point, traders are in more of a panic mode than reasonable discussions about looking at the exact potential changes on exports.”
It’s not just traders who cringe at the trade wars. Chad Hart, economist at Iowa State University, estimates that Chinese tariffs could represent a $624 million hit to Iowa’s farmers. For his part, Uncle Sam has pledged support for the agrarians, as Secretary of Agriculture Sonny Perdue cited the depression-era Commodity Credit Corporation as among “the tools” available to the federal government. However, Hart expressed doubt that significant assistance is in the immediate offing, telling Brownfield Ag News: “We’ll have to take some fairly significant hits on the market side before that type of protection kicks in.”
The rapid correction in prices has caught Mr. Market offside. According to the Commitment of Traders report data tabulated by the Commodity Futures Trading Commission, speculative net long positions in soybeans, cotton and corn approached five-year highs in recent months, with corn and cotton longs still near their most crowded levels while soybean net longs remain slightly above the five-year average.
Grant’s asked Keith Bronstein, longtime commodities investor and paid-up-subscriber, what sort of opportunities the bullish crowd sees:
In corn, the stocks-to-use ratio has declined notably in the last two years. If this year’s crop yield turns out less than optimal we could be set up for a rally [no sign of that yet, USDA data shows the highest percent of corn in good or excellent shape since 1991, according to Bloomberg].
On cotton, it had a real supply demand story. Will trade controversy disrupt? Stay tuned.
The long positioning in soybeans makes little sense to me. There is nothing exciting going on there.
As for soybeans, the trade tiff is already leading to big changes in behavior. Steve Cachia, a director at Brazilian brokerage Cerealpar, pointed out to Bloomberg the unusually strong demand for Brazilian soy deliveries in August, September and October. That’s a change from prior seasonal patterns, as the Brazilian harvest takes place in the first half of the year. Indeed, Bloomberg reports that the premium fetched by Brazilian soybeans over U.S. beans has widened by a whopping 57% this month.
How long can the price gap between American and Brazilian merchandise continue to widen? Grant’s put the question to Bronstein:
There are significant arbitrage opportunities, and no one is taking advantage. Brazilian soybean prices are at a record premium to the U.S. Countries like Japan who are still on good trading terms with the U.S. should be buying cheaper beans here. On the corporate side, if you’re a global grains player and you ship 100,000 tons of beans to the Netherlands and China, why not sell U.S. beans to the Netherlands and Brazilian beans to China? It hasn’t been happening, and no one knows why. Ten or twenty years ago this would be arbitraged.
Recap June 20
Stocks finished a bit higher, as narrow range trading persists with the S&P 500 finishing within 50 basis points of yesterday’s close for an 11th straight session. Treasury yields jumped higher, helping pressure investment grade corporates, while the sturdy stock market underpinned high yield.
Commodities enjoyed a solid bounce despite a modestly stronger dollar, and the VIX dropped back below 13.
- Philip Grant
Tuesday, June 19, 2018
We'll make it up on volume
Dance of the living dead
Mixed signals abound in the U.S. corporate credit market.
Mixed signals abound in the U.S. corporate credit market.
Recap June 19
We'll make it up on volume
From Friday’s edition of the South China Morning Post:
A hotpot restaurant in southwest China went out of business in less than two weeks after customers took advantage of a promotion that allowed them to pay 120 yuan ($19) for all they could eat for an entire month.
“We knew we would be losing money [by launching the discount promotion],” one of the owners was quoted as saying. “We wanted to accumulate more loyal clients through this strategy.”
It’s all about location. Perhaps Silicon Valley needs a new dining option?
Dance of the living dead
Mixed signals abound in the U.S. corporate credit market. While high-yield spreads remain near their tightest levels since 2007, investors have turned the cold shoulder to investment-grade in recent months: The ICE BAML U.S. Corporate Master Option Adjusted Spread has widened to 122 basis points, the largest pickup over Treasurys since April 2017. Independent research firm Cantillon Consulting notes on Twitter that high yield’s premium to investment grade stands at its narrowest since early 2007.
Particularly jarring is the action at the bottom rungs of these respective debt classes. Jason Goepfert, president of Sundial Capital Research, reports that the yield gap between triple-B-rated bonds and Treasurys has widened by 39 basis in the 90 trading days through June 11 while triple-C-rated spreads have sunk by 91 basis points during that period. Goepfert summarized his findings to Barron’s: “What we’re seeing is highly unusual.”
So what gives?
Supply differentials appear to be one factor. While investment-grade issuance has slowed, with Bloomberg tabulating $672.6 billion of new bonds coming to market this year through June 17, down 8.1% from a year ago, high-yield supply has been curtailed far more dramatically. Crowded out by increasingly popular floating-rate leveraged loans, the new supply of junk bonds has come to $109.4 billion through June 17 according to Bloomberg, that’s down 31% year-over-year. The drought in fresh high-yield supply isn’t expected to abate anytime soon. On June 15, analysts at J.P. Morgan slashed their 2018 new supply estimate to $265 billion from a prior forecast of $315 billion.
The general backdrop could also explain investors’ preference for junk. Interest rates are slowly but surely departing from their near zero post-crisis perch. The effective Federal Funds rate currently sits at 1.9%, up from 0.38% in June 2016. The two-year yield has jumped to 2.55%, compared to 0.55% two years ago.
Interest rates may be rising, but the bygone age of ZIRP continues to cast its shadow. Risk appetite remains firm with stocks at or near their highs, and corporate deaths are few and far between. Moody’s reports that the default rate for U.S. speculative-grade issuers fell to 3.7% in May, down from nearly 6% in 2016 and more than 14% in 2009. The ratings agency expects the good times to continue, forecasting the U.S. high-yield default rate to decline to 2.6% by December.
Consider the new lease on life given to companies that might face the economic grim reaper in a less forgiving interest rate world. According to Bianco Research, nearly 15% of components in the very broad S&P 1,500 index failed to generate sufficient average earnings before interest and taxes over a three year period to cover their interest expense at year-end 2017. That compares to just over 12% in the fourth quarter of 2016 and less than 6% at the end of 2007. Strip out energy, a particularly distressed realm in 2016 following the drop in West Texas Intermediate crude to below $30 a barrel from $100 in 2014, and 11.4% of the S&P 1,500 was so designated at year-end 2017. That’s exactly double the 5.7% rate of a decade prior.
The March 23 edition of Grant’s (“The nine lives of the modern leveraged company”) took inventory of that extraordinary data point, observing both the broad implications for economic dynamism and, more narrowly, the risks which lurk as a greater share of companies struggle to pay the corporate bills as borrowing costs tick higher:
In a free market, unproductive firms give way to productive ones, much to the benefit of the consuming public. In this central bank-rigged, neurologically impaired market, unproductive firms don’t necessarily give way. They survive by borrowing at low interest rates. The great question is whether the unfit could survive even a moderate rise interest rates.
That horde of corporate zombies may be tested sooner rather than later. Interest rate futures currently predict 48% odds of at least 50 basis points in additional rate hikes by year end. The market assigns greater than 25% odds of at least 75 basis points in tightening by July 2019.
Recap June 19
Stocks finished moderately lower, with outsized weakness in materials and industrials partially offset by a bid from interest-rate sensitive names. Treasury yields dropped, with the 10-year settling at 2.89%, while the Dollar Index rose above 95 for the first time since July. That strength in the buck was none too well received by the commodity complex: The broad CRB index declined by more than 1% and is now off by more than 6% from its May 23 interim highs.
- Philip Grant
Monday, June 18, 2018
Last shall be first
It’s not just your imagination.
It’s not just your imagination.
Open 'doors'
It was a different kind of rent-to-own.
It was a different kind of rent-to-own.
Recap June 18
Last shall be first
It’s not just your imagination. Analysts at Goldman Sachs reported last Wednesday that an in-house index comprised of companies with a high short interest had rallied by 8.1% in excess of the most popular hedge fund long “VIP basket” over the past six weeks. That represents a two standard deviation movement compared to the last five years.
The pain for short sellers has continued today, with 65% short interest Rent-A-Center, Inc. receiving a takeover offer (see below for more). This afternoon, GameStop Corp., of which 44% of the float is sold short according to Bloomberg, jumped nearly 20% from its morning trough after Reuters reported that the consumer electronics retailer is receiving buyout interest from private equity firms, including Sycamore Partners.
Exit, bear pursued by man.
Open 'doors'
It was a different kind of rent-to-own. This morning, furniture retailer Rent-A-Center, Inc. (RCII on the Nasdaq) announced that it will be acquired by private equity firm Vintage Capital (which had already disclosed 6% equity ownership), for total proceeds of $1.365 billion. The $15 a share cash price was upsized from $14 a week ago and $13 in November, and represents a 49% premium to RCII’s closing price in October, before the company announced it was seeking a sale.
While the news was a less-than welcome way to begin the week for a substantial cohort (more than 65% of RCII free float is sold short, according to Bloomberg), others found a little extra spring in their step. Rent-A-Center peer Aaron’s, Inc. (AAN on the NYSE), rose more than 2% on the announcement. Since June 30, 2017, Aaron’s shares are up by 14.5%, keeping pace with the rise in the S&P 500.
Furniture and consumer electronics-peddling Aaron’s and the soon-to-be private Rent-A-Center operate in the “rent-to-own” (RTO) industry, in which consumers pay to use an item, receiving it outright at the end of a lease term, so long as they remain current in their payments. The business is a credit-centric one, and interest rates are high. In a June 30 bearish analysis of Aaron’s in Grant’s, deputy editor Evan Lorenz explained the mechanics of a hypothetical transaction:
So, for example, a customer in San Antonio could buy a LG 65” Smart 4k UHD TV with webOS 3.0 for $1,408.99 outright or rent-to-own the set for 24 monthly lease payments of $99.99 (or $2,399.76 in total). If restructured as a fully amortizing loan, those 24 payments would equate to a 57.4% interest rate. Due to the high implied rate, RTO is not exactly the first option for borrowers with access to credit cards and other forms of finance.
While Aaron’s brick and mortar operations retrench, the RTO business spearheaded by its Progressive Leasing subsidiary, which finances RTO transactions in other retailers’ stores, has been doing the corporate heavy lifting. Progressive’s active doors (which the company describes as retail locations at which at least one RTO transaction was completed in the past 12 months) tallied 20,434 in the first quarter according to the company’s form 10-Q, up from 18,627 a year ago. At the same time, the company operated and franchised store count shrank to a combined 1,719 in the first quarter, down from 1,843 last year.
Growth in Aaron’s RTO business has been nothing short of explosive, as Progressive posted eye-popping year-over-year upticks of 32% and 31% in revenue and leading invoice volume, respectively in the first quarter. Good thing for Aaron’s bulls, as analyst expectations for 2018 are relatively demanding: Free cash flow is expected to more than double to $255 million from last year’s $101 million, while the projected $238 million of adjusted net income represents a 70% uptick from 2017’s $168 million bottom line. The Street is definitely expecting big things: Eight analysts rate Aaron’s shares “buy,” against just one “hold” and zero “sells.”
While Aaron’s financing business increasingly shoulders the load, general credit conditions have provided a helping hand. Aggregate past due loans (ranging from 30 days to 90-plus) registered at 11.9% in the first quarter, down sharply from 14.8% at year-end. While bad debt expense rose to 9.6% of revenues in the first quarter, up by 8.7% year-over-year, Progressive CEO Ryan Woodley told listeners on the first quarter conference call that the uptick presented no great concern:
It's [a] lesser comment on where we ended up in Q1 of 2018 and more a commentary on how exceptional levels were in Q1 of 2017. And bad debt expense this quarter was 9.6% of revenue compared to 8.7% last year. Both are low. 8.7% was exceptionally low.
The question before the house: Will it be lower for longer? That uptick in bad debt expense comes in the face of the lowest unemployment rate since 2000 and the December tax cuts. Nevertheless, the decline in credit quality has been widespread. According to the Equifax National Consumer Credit Trends Report, the severe delinquency rate on private label retail credit cards jumped to 4.65% in the first quarter, up 57 basis points year-over-year for its highest reading since 2011. Equifax also notes that private label credit card write-offs as a percentage of outstanding balances footed to 99.9 basis points, up 9.4 basis points year-over-year. That metric peaked at 121.7 basis points in December 2009.
Recap June 18
Stocks mostly erased moderate early losses to leave the S&P 500 nearly flat by day’s end, and Treasurys and the Dollar Index both finished little changed.
While current market calm is demonstrated by fresh 2018 lows in gold and a VIX at 12, emerging markets continue to tell a different story. Today, the iShares JPMorgan USD Emerging Market Bond Fund ETF broke to its lowest since early 2016, when all manner of risk assets endured a brief but severe correction.
- Philip Grant
Friday, June 15, 2018
What's in your wallet?
This morning, the Argentine peso rallied by nearly 5% against the greenback
This morning, the Argentine peso rallied by nearly 5% against the greenback
Tether ball
Will the last crypto bull please turn out the lights?
Will the last crypto bull please turn out the lights?
Recap June 15
What's in your wallet?
This morning, the Argentine peso rallied by nearly 5% against the greenback following the abrupt resignation of central banker Federico Sturzenegger. It was a brief respite, as the beleaguered currency promptly gave back those gains and more, sinking by nearly 7% to a fresh record low of 28.3 per dollar.
The continued freefall in Argentina’s currency comes despite the outsized investment made in the Land of Silver by Franklin Resources, Inc., (BEN on the NYSE), and its star fund manager, Michael Hasenstab a month ago, when the peso traded at fewer than 25 per greenback.
On May 15, the Financial Times reported that Franklin approached the Argentine government with a further $2.25 billion investment (Templeton already owned roughly half of those bond issues) in local currency “bote” bonds with five- and eight-year maturities. While Bloomberg notes that those securities carry yields of 21% and 19.9%, respectively, a 26.3% year-over-year rise in Argentina’s CPI for May bestows firmly negative real yields on those bonds, before factoring in currency depreciation.
For an early view of the liquidity and concentration risks embedded in Templeton’s portfolio, see the July 11, 2014 edition of Grant’s.
Tether ball
Will the last crypto bull please turn out the lights? The first half of 2018 has been as painful for crypto-currencies as 2017 was euphoric, with bitcoin down 54% year-to-date (its all relative, bitcoin is still up by 170% year-over-year). It’s not just the biggest digital currency which has struggled in 2018. Bitcoin peers ethereum, ripple and litecoin are down by, 35%, 76% and 58%, respectively, from their Dec. 31 levels – down, we should add, to levels that Grant’s doubted they would ever attain.
Public infatuation is dwindling along with prices. Google Trends reports that worldwide interest in bitcoin as measured by search popularity has dropped by 86% from its Dec. 23 peak. The sudden downturn in public interest is increasingly shared by Wall Street. Trading volume in the Bitcoin Investment Trust (GBTC on the over the-counter-market) has averaged 2.7 million shares in the past two months, nearly 60% below its one-year average turnover of 6.3 million shares.
Recent news flow has further tested the bullish theses underlying crypto-currencies. On Sunday, South Korean crypto exchange Coinrail was hacked, losing over $40 million worth of tokens, according to TechCrunch. On May 24, Bloomberg reported that the Justice Department and Commodity Futures Trading Commission have opened a criminal investigation into potentially illegal manipulation of bitcoin, with practices such as spoofing (placing, then cancelling illegitimate orders to create an illusion of supply or demand) and wash trading (repeatedly buying and selling a security in order to present the illusion of increased trading volume) coming under the regulators’ scrutiny.
On Wednesday, University of Texas at Austin professors John Griffin and Amin Shams released a research paper studying manipulation of bitcoin by a purportedly U.S. dollar-backed crypto called tether and Bitfinex, a crypto exchange. The pair’s findings were damning:
We are able to establish that entities associated with the Bitfinex exchange use tether to purchase bitcoin when prices are falling. Such price supporting activities are successful, as bitcoin prices rise following the periods of intervention. These effects are present only after negative returns and periods following the printing of tether. . . The buying of bitcoin with tether also occurs more aggressively right below salient round-number thresholds where the price support might be most effective.
Overall, our findings provide substantial support for the view that price manipulation may be behind substantial distortive effects in crypto-currencies . . . More generally, our findings support the historical narrative that dubious activities are not just a by-product of price appreciation, but can substantially contribute to price distortions and capital misallocation.
In a comprehensive bearish analysis of crypto-currencies in the Sept. 8 issue (“Crypto 36,000”), Grant’s raised a skeptical eye at the purportedly dollar-backed crypto-currency, which had seen its market capitalization rise $364 million in September and $53 million in April, when tether lost access to the U.S. banking system. In January, the crypto-currency’s backing organization, Tether Ltd. fired its auditor, New York-based Friedman, LLP, offering the following explanation:
Given the excruciatingly detailed procedures Friedman was undertaking for the relatively simple balance sheet of Tether, it became clear that an audit would be unattainable in a reasonable time frame.
Despite the sharp recent pullback in other cryptos, tether’s market cap has since skyrocketed to $2.6 billion. Grant’s asked then, and we repeat now: Tethered to what?
Recap June 15
Stocks finished a bit lower, as the S&P 500 capped off a range-bound week almost completely unchanged. Beyond the stable index there was plenty of sector-level action, as consumer staples and telecom both caught a strong bid while energy was bludgeoned amid a commodity rout. The broad CRB index dropped more than 1% today despite a flattish dollar, and is down nearly 5% from the multiyear highs reached on May 23.
- Philip Grant
Thursday, June 14, 2018
Phone home
It’s alive! On Tuesday, a Federal Judge ruled in favor of AT&T, Inc., (T on the NYSE) in the telecom behemoth’s quest to buy media conglomerate Time Warner, Inc. This was no narrow win for the would-be suitor: The Capitol Forum described Judge Richard Leon’s opinion as “a scorching rejection of [the Department of Justice’s] facts, evidence, and underlying theory of harm.”
With the path to a Time Warner deal officially cleared (the government announced they won’t appeal this afternoon), AT&T will grow substantially. Its target generated $31.5 billion in revenue and $6.4 billion in adjusted net income in the 12-month period ending March 31.
It’s not just the income statement which will balloon: Total debt, including operating leases and pension obligations, will foot to $249 billion, according to boutique research firm MoffettNathanson LLC. That head-spinning figure would rank the combined AT&T/Time Warner borrowings as the world’s 32nd highest sovereign debt load, between Indonesia ($335 billion) and the United Arab Emirates ($220 billion).
While absolute debt levels are one thing (indeed, the FT Alphaville notes that AT&T’s customer base is also larger than the population of many countries), the triple-B-plus rated combined company will sport a pro-forma leverage ratio of 3.9 times earnings before interest, taxes, depreciation and amortization according to MoffettNathanson. By comparison, the average triple-B-rated issuer was leveraged just under three times in 2017, according to Citigroup, Inc.
The Sept. 22, 2017 edition of Grant’s featured an analysis of (said we) mispriced euro-denominated bonds as the ECB’s highly aggressive monetary stimulus pushed corporate borrowing costs to floor-scraping levels. One such specimen, the AT&T euro-denominated 1.8s of 2026, made the cut as a pick not-to-click owing not only to its robust debt load, but also to the fact that “the dynamics of the wireless communications business seem calculated to keep a creditor awake at night.”
AT&T’s lenders aren’t missing much sleep, yet. Previously quoted at 101.5 cents on the euro to yield 1.6% in September, the bonds have since been called and replaced with an issue identical in yield and maturity on account of the regulatory-driven delay in the Time Warner merger. The “new” bonds, issued in February, currently trade at 100.75, priced to yield 1.67%.
While AT&T gorges at the bond-market trough, fellow “telecom-plus” company SoftBank Group Corp., (SFTBY on the U.S. pink sheets) is making its latest bold move. Today, the Wall Street Journal reports that the SoftBank-backed venture capital Vision Fund is in talks to make a second investment in co-working unicorn WeWork Cos., Inc. that would value the fast growing startup at a whopping $35 billion to $40 billion. That’s nearly double the $20 billion valuation bestowed on privately-held WeWork last August, when SoftBank poured $4.4 billion into WeWork’s coffers (nearly a third of those funds were used to cash out existing investors, per the WSJ).
The Journal notes that WeWork impressively doubled its revenues to $886 million last year. Less impressively, WeWork’s net loss also doubled, to $933 million. Not that net income or loss is the company’s preferred analytical metric; see the April 24 edition of Almost Daily Grant’s for a more detailed look at WeWork’s, uh, innovative financials.
As for Softbank, WeWork’s even-fancier prospective new valuation would represent a big mark-to-market gain for the Vision Fund. Writing about SoftBank and its larger than life chairman, Masayoshi Son, in the Dec. 15, 2017 issue, Grant’s offered the following speculation:
“Every cycle has its poster child,” says Brian Horey, president of Aurelian Management. You can’t be sure who it will be until upside excess has turned into its downside mirror image. But for him, and for us, Soft¬Bank is a leading contender for the cyclical laurels.
QT progress report
Everybody needs a week off once in a while. The Fed’s portfolio of securities held outright footed to $4.12 trillion, up by $3 billion from a week ago, with both its Treasury and mortgage-backed securities holdings ticking higher. Compared to the trailing four-week average, today’s reading is a decline of $8 billion in the Fed’s holdings.
Since the QT balance sheet run-off began on Oct. 1, the Fed’s total balance sheet has declined by 2.93%, a simple annualized pace of 4.11%.
Recap June 14
A rally in the Treasury complex left the 10-year yield at 2.93% and helped interest rate sensitive sectors such as utilities, telecom and real estate catch a bid, as the S&P 500 logged a modest gain.
The greenback logged a not-so modest gain, ripping higher by more than 1% on the broad Dollar Index, intensifying the pain in emerging market currencies. The Argentine peso sank to nearly 28 per dollar (it was below 26 on Tuesday), while the Turkish lira made its own cyclical low of 4.72 per buck. For his part, Turkish president Recep Erdogan promised “an operation” against Moody’s, evidently none too appreciative of recent negative commentary from the rating agency (hopefully he doesn’t read Grant’s).
The dollar strength also put a dent in commodities, with the broad CRB index dropping by more than 0.5%. Oil was the outlier, with WTI crude rising to near $67 a barrel.
- Philip Grant
Tuesday, June 12, 2018
Sunshine haymakers
The deal derby remains in full swing. Yesterday, private equity giant KKR & Co., L.P. announced a $9.9 billion leveraged buyout of hospital services firm Envision Healthcare Corp., including $5.5 billion in cash. That represents a 32% premium to the target’s early November price, before Envision announced it was seeking that shareholder manna called “strategic alternatives.”
The deal is a blockbuster not only for its size. Josh Kosman of the New York Post, citing a source close to the situation, reports that KKR has lined up financing equivalent to 7.25 times Envision’s earnings before interest, taxes, depreciation and amortization (EBITDA) to acquire its target. That figure represents a kind of breakthrough, as Obama-era regulations capping borrower leverage at six times EBITDA have been relaxed by the Trump administration. An unnamed private equity partner assessed the situation to Kosman:
Are the debt markets hot? Overheated? There is no question about it. Banks in a market like this are more focused on if they can sell [syndicate] a loan than if it is a good credit.
As for Envision, which already carried a robust debt load of nearly five times consensus 2018 adjusted EBITDA and junk credit ratings from S&P and Moody’s (the agencies put their double-B-minus and B1 respective ratings on review for downgrade following the buyout announcement), profitability remains elusive. The company lost money last year on a continuing operations basis, while the $747 million in acquisition costs and capital expenditures approached its full-year adjusted EBITDA of $909 million.
In an amendment to the form 10-K, Envision explains the winding road by which they arrive at that adjusted EBITDA figure:
We define adjusted EBITDA as earnings before interest expense, net [sic], income taxes, depreciation, amortization, transaction and integration costs, share-based compensation, impairment charges, debt extinguishment costs, gain or loss on deconsolidations, net of noncontrolling interests, changes in contingent purchase price consideration, purchase accounting adjustments related to mergers and acquisitions, the impact of the Tax Cuts and Jobs Act of 2017 and discontinued operations.
Meanwhile, the first quarter of this year saw adjusted EBITDA of $207 million, down 1.2% year-over-year. One unnamed short seller commented to Grant’s: “KKR will be scrambling to pay the interest on this deal’s debt from day one. Is private equity this desperate to do big deals?”
While domestic private equity ramps up leverage and stretches return assumptions, overseas peers are taking a more creative approach. Today, Azalea Investment Management Pte. Ltd., a wholly-owned subsidiary of Singapore’s Temasek Holdings Pte. Ltd., announced the completion of S$242 million ($182 million) Astrea IV A-1 tranche of 10-year notes with a 5-year call option, split evenly between institutional and individual investors. Investment newsletter The Edge Singapore notes that the issue “is believed to be the world’s first listed private-equity bond for retail investors.”
To say the bonds, which are backed by cash flows from a diversified portfolio of companies, attracted brisk demand would be an understatement. The A-1 tranche priced to yield 4.35%, well inside of the 4.625% initial price talk seen last week according to Bloomberg. What’s more, today’s press release reports retail investor demand at a whopping S$890 million, 7.4 times the allotment for individual investors.
Margaret Lui-Chan, CEO of Azalea, explained the purpose of the offering: “This is not a leveraging exercise; it is really about bringing the product to the marketplace.” Mission accomplished.
While broad credit conditions remain favorable (clearly), they have recently become slightly less so. Yesterday, S&P Global Market Intelligence’s LCD unit reported that the average spread to single-B-rated borrowers has ticked up to 354 basis points over the London Interbank Offered Rate, the widest of the year and up from 338 basis points at year end, which was the tightest spread since 2007 and 2008. Heavy issuance at the low end of the credit spectrum may be a factor: LCD also reports that single-B-rated borrowers have accounted for 73% of issuance so far this quarter, up from 63% in the first quarter.
Recap June 12
It was another round of muted movement for the primary asset classes. The S&P 500 inched higher for a second straight time to log its eighth green finish in nine tries and close to within 3% of its January peak, while Treasury yields ticked higher across the curve to leave the benchmark 10-year yield at 2.96%, near the midpoint of its narrow recent range. Commodities and the both dollar rose modestly, and the VIX settled near 12.
- Philip Grant
Monday, June 11, 2018
Weapons of Mass Profit
Emerging markets have taken center stage, all but one:
Emerging markets have taken center stage, all but one:
Recap June 11
Weapons of Mass Profit
Emerging markets have taken center stage, all but one: China. The renminbi has been gently appreciating (now 6.4 per dollar from 6.51 at year end), amid downward pressure on government bond yields (the 10-year note fetches 3.66%, down from 3.91% on Dec. 31) and a weak stock market (the Shanghai Composite is down by 8% for 2018). That’s not to say the Middle Kingdom is lacking for interesting developments.
Bloomberg reports that Chinese high-yield corporate bonds saw their best performance last week since September 2016, while local bond funds saw their largest allocation in over 17 months, according to research firm EPFR Global. The steep rebound follows a rough start to the year for the asset class. The Markit iBoxx USD Asia ex-Japan China High Yield Total Return Index dropped by more than 5% from its Jan. 18 peak to June 5 trough, the biggest decline in the index since January 2015.
That rebound coincided with a helping hand from the central bank. Last Wednesday, the People’s Bank of China pumped a net RMB203.5 billion ($31.8 billion) into the financial system, the most since March 2017, according to Bloomberg. Analysts at OCBC Bank Singapore commented: “The higher-than-expected long term liquidity injection against the backdrop of rising default risk shows central bank's intention to ease market concern about the credit risk."
The increased involvement from the PBOC comes as other forms of financing dry up. In another echo of that not-so-pleasant 2015 (recall the August renminbi devaluation which spurred a market rout and severe dislocation in some U.S. ETFs), Moody’s finds that Chinese brokerages curtailed their outstanding loans backed by shares to corporate borrowers for a fourth straight month in May, the longest dry stretch since 2015. Sean Hung, senior analyst at Moody’s, assessed the potential impact: “Some companies will be fail to repay their loans, and brokerages will be unable to dispose their stock holdings.”
The plight of China Energy Reserve and Chemicals Group Co. will do little to ease creditor jitters. A Bloomberg dispatch from June 6 tells the tale:
[On May 25] the company said it planned to repay its overdue $350 million notes and a coupon on its 2019 bonds, sparking a rebound in the notes, only to say later that day it had insufficient funds in its trustee account to meet both the obligations. That sent the notes tumbling again.
A couple of weeks earlier, the oil and gas producer saddled with about $2 billion in offshore notes outstanding, blamed its junior staffers for the default of its $350 million bond, saying they misread notices from Bank of Communications Trustee Ltd. about the required redemption and coupon payments, Debtwire reported. The company had said in a statement that appeared on the Hong Kong Exchange on May 27 that the default was due to “[a] tightening in credit conditions.”
The spring freeze in Chinese high-yield followed Beijing’s latest attempt to clamp down on leverage. Today, J Capital’s Anne Stevenson-Yang explains the ambitious reforms being undertaken by China’s banks in service of risk mitigation and broader deleveraging. The changes target a crucial feature of the country’s credit driven “economic miracle”, so-called wealth management products [WMPs], which offer investors (explicitly or implicitly) a guaranteed rate of return:
Regulations designed to move the banks out of speculative investing and into plain vanilla lending were issued at the end of April and will not be fully implemented until 2020, but banks are already changing their practices. The regulations principally concern investment products and how they are managed by banks.
Banks may not even implicitly guarantee rates of return when issuing investment products. They cannot manage assets in pools with products of varying maturity, a practice that lends itself to Ponzis where customers redeeming products at maturity are often paid out of funds from other investors in newly issued products. And they must reduce the amount of WMP assets they have outstanding in the interbank market.
It didn’t take long for the increased scrutiny on wealth management products to have an impact. On May 31, local media reported that the Bank of China was forced to suspend redemptions in an open-ended, fixed income WMP offering investors a 3.1% to 3.2% yield, after being inundated with redemption requests.
Bank of China is no small potatoes. Total assets stood at $3.2 trillion at the end of the first quarter, eclipsing J.P. Morgan Chase & Co.’s $2.6 trillion balance sheet by more than 20%.
Recap June 11
A quiet day for U.S. stocks and bonds saw the S&P 500 creep higher for its seventh green finish in eight tries, as the broad index continues to inch toward the record close logged in late January, while Treasury yields finished little changed as the 10-year settled at 2.95%.
A flat showing from the Dollar Index was no help to Argentina, which saw its peso plunge again to a rate of more than 26 per greenback just days after the announced $50 billion credit line from the IMF. More broadly, the iShares J.P. Morgan USD Emerging Markets Bond ETF sits a few cents above multi-year lows.
- Philip Grant
Friday, June 8, 2018
Friday deep thought
An escalator can never break, it can only become stairs. You should never see an “Escalator Temporarily out of Service” sign, just “Escalator Temporarily Stairs.” Sorry for the convenience.
- Mitch Hedburg
Knock on, drag out
The screws turn a little tighter. Yesterday afternoon, the Fed’s weekly balance sheet showed another drop in its portfolio of securities held outright, with the $4.117 trillion footing down by $9.2 billion from a week ago and by $19 billion from its trailing four-week average. Since the quantitative tightening (or QT to Fed cognoscenti) portfolio unwind began on Oct. 1, the Fed’s total assets are down by 3.06%, a simple annualized pace of 4.41%. While the balance sheet gradually deflates, the near-zero interest rates of 2008 to 2015 appear more distant in the rear view mirror. Next week, the Fed is expected to hike its overnight funds rate by another 25 basis points, to a 1.75% to 2% range.
Even this modest retrenchment from crisis-era monetary policy is causing problems in the currency markets. For emerging markets especially, signs of potential distress are increasingly widespread.
Yesterday evening, the Republic of Argentina announced a $50 billion credit line from the International Monetary Fund, the largest bailout in the history of the fund and at the top end of the $30 billion to $50 billion range expected by analysts, according to the Wall Street Journal. That news helped send the Argentine peso to fresh lifetime lows against the dollar, at now more than 25 per greenback, from fewer than 19 in January. The local central bank was obliged to jack its benchmark lending rate to 40% from 27.25% on April 26.
At 4.48 per dollar, the Turkish lira is slightly off its own lifetime nadir of 4.72 on May 25, as the Turkish central bank undergoes similar muscular tightening (much to the chagrin of President Recep Erdogan, who faces a general election on June 24). Yesterday, the Turkish central bank raised rates by 125 basis points, pushing the one-week repo rate to 17.75% and the late liquidity window rate to 20.75%, in response to May CPI inflation of 12.2% year-over-year. Collateral damage is already appearing. Yesterday, Moody’s downgraded the credit ratings of 17 Turkish banks, noting that the cost of funding has “widened significantly this year.”
Turkey (left scale) and Argentina (right scale) benchmark interest rates. Source: The Bloomberg
Argentina and Turkey have growing company in the ranks of struggling EM nations. In South Africa, the rand has fallen to its weakest level since December against the dollar while the sovereign bond due in 2026 has seen its yield rise more than 100 basis points since late March to 8.95%. Selling pressure was exacerbated by a weaker than expected first quarter GDP print on Tuesday, a data point which might make its central bank think twice about raising interest rates to keep up with the global Joneses.
In Brazil, beset not only by paralyzing trucker strikes but also a plummeting real and spiraling bond yields (see the Jan. 12, 2018 edition of Grant’s for a timely bearish analysis of Latin America’s largest economy), the local central bank has been forced to repeatedly intervene in the currency market. President Michel Temer kept a happy face in an interview with state television, asserting: “There is no risk (of a currency crisis). It is normal: The dollar is swinging around a lot.” So is the real. Even after a massive 5% rally today, Brazil’s currency has lost ground relative to the dollar over the past two weeks.
Temer is not alone in downplaying the potential hazards. Anastasia Levashova, fund manager at Blackfriars Asset Management, told Bloomberg: “If one animal gets sick in the zoo that doesn’t mean there will be contagion risk. EM is not in crisis and there is no contagion.” Geoffrey Dennis, head of global emerging market equity strategy at UBS, didn’t mince his words, commenting on Bloomberg television: “This talk about a crisis in emerging markets is just nonsense.”
Others aren’t so sure. On Wednesday, newly minted Indonesia central bank head Perry Warjiyo told the press: “We know every country must decide their policy based on domestic circumstances but look, you have to take account of your actions and the impact of your actions to other countries, especially the emerging markets.”
That follows the Monday opinion piece in the Financial Times by Reserve Bank of India governor Urjit Patel calling for the Fed to reduce its balance sheet run-off to mitigate the risks of a dollar-liquidity shortage and subsequent crisis in emerging market debt (Almost Daily Grant’s, June 4). In today’s edition of his Solid Ground fortnightly commentary, Russell Napier, independent strategist and co-founder of the Electronic Research Interchange, writes of Patel’s public entreaty:
This in itself should make investors take notice. It indicates that the private communications of the RBI fell on deaf ears within the Federal Reserve. Perhaps, most importantly, it indicates the RBI governor considers this to be a very serious matter indeed, or why else would he alert the world to an impending ‘crisis.’
Those weekly Fed balance sheet releases may soon be required reading for global investors and policymakers alike.
Recap June 8
Stocks opened in the red but the bulls soon took command, as the S&P 500 rallied through the afternoon to finish the week 1.6% higher and close to within just over 3% of the record peak reached in late January. Treasury yields ticked higher across the board, while commodities and the dollar rose in tandem.
- Philip Grant
Thursday, June 7, 2018
Notable quotable
Tandem climb
There’s a party in junk bonds, but where are the attendees?
There’s a party in junk bonds, but where are the attendees?
Recap June 7
Notable quotable
Kent Walker, senior vice president and general counsel of Google, Inc., in response to a building antitrust case by the European Commissioner for Competition, according to a report in today’s Financial Times:
The commission’s case is based on the idea that Android doesn’t compete with Apple’s iOS. We don’t see it that way. We don’t think Apple does either. Or phone makers. Or developers. Or users.
Tandem climb
There’s a party in junk bonds, but where are the attendees? Today, S&P Global Market Intelligence’s LCD unit reports that high yield issuance footed to just $15.3 billion in May, the lowest for the month since 2010, while year-to-date issuance is down by a meaty 21% from 2017 levels. That’s despite favorable price action, as the ICE Bank of America Merrill Lynch U.S. High Yield Option Adjusted Spread remains near its tightest levels of the cycle at 344 basis points over Treasurys, compared to over 700 basis points in 2016 and 2012 and nearly 2,000 basis points in 2008.
Market conditions aren’t keeping issuers away from high yield. So what is? The runaway popularity of leveraged loans appears to be the primary culprit. LCD finds that institutional issuance of tradable bank debt topped $66 billion in May, second only to the $78 billion output in January 2017 for the most prolific month on record. As the Federal Reserve looks set to continue hiking interest rates (futures currently price 85% odds of another 25 basis point tightening at the June meeting next Wednesday), the appeal of floating-rate leveraged loans naturally increases.
With the stock market well bid and corporate credit thus far unfazed by rising rates, Bloomberg reports that the J.P Morgan Leveraged Loan Index spread has dipped below 190 basis points over the London Interbank Offered Rate (Libor), the tightest level since 2007. Corey Geis, head trader at Marble Point Credit, thinks the good times for borrowers aren’t ending anytime soon: “The signals that we may get to [150 basis points over Libor] are there. I don’t think it’s a function of ‘if,’ I think it’s a function of ‘when.’”
It’s not just the spread getting squeezed. A May 16 report from Moody’s identified numerous erosions of covenants protecting investors, which could exacerbate the impact of a credit downturn. One such example:
Lenders typically expect that 100% of proceeds from asset sales would either go towards the prepayment of senior debt or be reinvested into the borrowers business. But that expectation has withered away, as exceptions have made their way into credit agreements in the form of leverage based step-downs. These step-downs permit borrowers to lower or possibly even eliminate prepayment requirements based upon hitting certain pre-defined leverage targets.
While lenders take what they can get, some borrowers live high on the hog. A Bloomberg story today details the charmed financial existence of celebrity dermatologists Katie Rodan and Kathy Fields, who stand to pocket a $600 million dividend after their skincare company, Rodan + Fields, borrowed in the leveraged loan market. Ken Monaghan, co-director of high yield at Amundi Pioneer Asset Management, summed things up aptly:
“I’m not saying anything goes, but it’s close.”
Recap June 7
A pullback in recent winners like the NYSE FANG+ Index and small-cap Russell 2,000 helped put the brakes on the recent equity strength, as the broad S&P 500 cruised sideways to finish nominally lower for its first red finish in more than a week. A lower greenback helped commodities bounce, with WTI crude rising back toward $66 a barrel, and Treasury yields moved lower across the board.
- Philip Grant
Wednesday, June 6, 2018
Windward tack
Is the government thumb finally coming off the scale? The European Central Bank may announce the end of QE as soon as next Thursday, or so hinted a speech by ECB chief economist Peter Praet in Berlin today.
The QE asset purchase program has been in place since March 2015, and is scheduled to run through September at least, but an uptick in eurozone CPI inflation to 1.9% year-over-year in May (it was in negative territory as recently as 2016) has helped set the stage for an unwind. Nick Kounis, head of macro and financial markets research at ABN Amro Bank N.V., told Bloomberg: “The bottom line is that this is the end. This is a signal that the ECB judges that the inflation conditions to wind down net asset purchases have been met.”
Mr. Market got the message. The German 10-year yield jumped nearly 10 basis points to 0.45%, while Spain’s 10-year borrowing costs rose by 10 basis points to 1.5%. Italy, where the recent ascension of populist parties the Northern League and Five Star Movement was underscored by a creditor-unfriendly speech from the new Prime Minister Giuseppe Conte yesterday, saw its two-year yield zip higher by 35 basis points to 1.36%.
As political and monetary conditions in Europe undergo abrupt change, some assets have been repricing faster than others. The Bloomberg Barclays Pan-European High Yield Option Adjusted Spread has widened to 344 basis points, up from as low as 219 basis points in October, but still well below the near-600 basis point interim peak logged in February 2016 and 1,070 at the height of the sovereign credit crisis in 2011. One of the particularly value-free (see the Dec. 15, 2017 edition of Grant’s) securities of the sub-zero/QE era, the double-B-plus-rated (the highest level of junk) Telecom Italia S.p.A. 5 1/4s of 2022, traded at 119 cents on the euro, for a yield of 0.61%. A recent selloff to less than 115 cents has sent the yield ballooning all the way to 1.14%, pre-tax of course.
In contrast, single-B-rated Greece (“Adverse business, financial or economic conditions will likely impair the obligor’s capacity or willingness to meet its financial conditions on the obligation”), which received a €5 billion aid package from lenders including the IMF in January and is negotiating with creditors for an extension of an €86 billion aid package set to expire in August, is finding increasingly generous terms from the market. The cradle of democracy announced today that it had sold €1.625 billion in six-month bills at a yield of 0.85%. That’s down from 1.07% at an auction in April and 2.78% in July 2017 for the same six-month bills. The latest floor-scraping borrowing costs surely elicit envy on this side of the Atlantic. The equivalent yield on a six-month U.S. Treasury bill maturing in November is 2.08%.
Beyond a monetary policy pivot and newly-uncertain political outcome in Italy (Europe’s third largest economy), European credit investors must contend with a third variable: The sickly price action in Deutsche Bank A.G., Europe’s fourth-largest bank by assets according to S&P Global Market Intelligence. Not only is the German behemoth’s stock price back within a few cents of its 2016 all-time lows, but its junior subordinated contingent convertible perpetual debt securities known as CoCo bonds (see the July 11, 2014 edition of Grant’s) have been in retreat, dropping to 93 cents on the euro from north of 100 as recently as mid-May.
Source: The Bloomberg
That Dec. 15, 2017 issue of Grant’s, took inventory of the extraordinary lack of compensation afforded to not-riskless debt instruments in Europe on account of the ECB’s heavy-handed administration of negative interest rates and supply scarcity, asking:
To whom might the ECB sell, when the time for selling arrives? Not a financially motivated buyer, to be sure. And when might the selling time begin? Not soon, to judge by the schedule of euro-denominated money rates that constitute the market’s best guess as to the ECB policy rates of tomorrow. Projections contained in the Euribor futures market indicate sub-zero rates for the next three years.
For ourselves, we cling to the Herbert Stein econometric modeling approach: If something can’t go on forever, it won’t. This can’t, so it won’t, though it may already seem as if it had.
Recap June 6
The bull march continues, as another strong bid pushed the S&P 500 to within about 3.5% of its January high water mark, while the small-cap Russell 2,000 and NYSE FANG+ indices continued their impressive momentum with fresh record closes of their own. Treasury yields moved higher across the curve, with the benchmark 10-year note settling at 2.97%, and the VIX fell to 11.65, its lowest since January.
- Philip Grant
Tuesday, June 5, 2018
Facial recognition
Happy days are here again for the mega-cap technology constellation known as the FANGs. After a pause earlier this year, the group’s ascent has resumed in full force recently, with the New York Stock Exchange’s FANG+ Index (comprised of ten popular tech stocks, equally weighted) breaking to another record close today.
The group has put up performance figures that would be gaudy for a small cap biotech index, let alone some of the largest companies in the world: The FANG+ Index is up by 22% since late March, 47% since August and 207% since February 2016. More broadly, Bloomberg reports today that the tech-centric Nasdaq Composite Index has exceeded its dot-com era highs in market cap relative to the S&P 500.
Strategists at Goldman Sachs Group, Inc., drawing a distinction between current conditions and the late-90’s tech bubble, are expecting the party to continue for some time. Peter Oppenheimer and Guillaume Jaisson write: “Unlike the technology mania of the 1990s, most of this success can be explained by strong fundamentals, revenues and earnings rather than speculation about the future.”
The bulls have other factors in their corner besides momentum and fundamentals. Strategists at UBS Group AG estimate that stock buybacks, dividends and M&A among S&P 500 constituents will equate to about $2.5 trillion this year, equaling about 10% of the index’s market cap and “surpassing prior peaks.” Buybacks alone among the S&P 500 companies are tracking about 80% above their 2010-2017 averages through late May, “driven primarily by tech.”
Facebook, Inc. (FB on the Nasdaq), the lead-off hitter in the FANG+ lineup, has been something of a laggard against its more buoyant peers, as FB’s market capitalization has jumped to $560 billion, up 13% from August and 102% from the 2016 lows. The social media giant, which boasted a net income margin of nearly 45% in 2017, is expected to continue its blistering growth in coming years. Against 2017 revenues of $40.7 billion, analysts expect a $57.7 billion top line this year, then $72 billion in 2019. Perhaps unsurprisingly, the Street is almost uniformly bullish: Out of the 45 analysts who cover the name, 41 say “buy,” along with two “holds” and two “sells”.
With that impressive income statement (and a cash heavy, debt-free balance sheet) in mind, Grant’s nonetheless offered a bearish view on FB shares in the Aug. 11, 2017 edition. Natural limitations to its addressable market (and growth potential), the growing risk of a regulatory snafu and management miscalculation were among the potential pitfalls cited in the analysis. Helped by strong first quarter results on April 25, FB shares have more than recovered from their late-winter tumble to reclaim all-time highs. Will the good times continue for Mark Zuckerberg and Co.?
While the recent flood of bad publicity surrounding the Cambridge Analytica data scandal has largely receded, regulatory risks are still front and center. Yesterday, the Washington Post reported: “Facebook’s arrangements with Amazon.com, Apple, BlackBerry and Samsung allowing their devices to access data from the social network’s users could further expose Facebook to steep fines and other penalties.” The Post quoted David Vladeck, a former senior official at the Federal Trade Commission, who opined: “I think the more unauthorized sharing that comes out, the more the FTC is going to be inclined to impose a significant civil penalty on Facebook.” Recall that the FTC opened an investigation into Facebook in March, per the Post.
Such perils are not confined to the U.S. Following Zuckerberg’s appearance before the European Parliament in May, which featured some seemingly less-than forthright responses from the CEO, The Capitol Forum concluded: “Facebook’s tracking of non-users and tracking of users outside its platform represent a significant enforcement risk in the short-term.”
Non-government actors are likewise looking to put the clamps down. Apple, Inc’s. software chief Craig Federighi told an audience at the company’s developer conference yesterday: “We’ve all seen these like buttons and share buttons and these comment fields, well it turns out these can be used to track you, whether you click on them or not. We’re shutting that down.”
While regulators and peers alike threaten its business model, the company must also contend with increasing apathy towards the platform from the rising generation of consumers. According to a recent study by the Pew Research Center, 51% of U.S. teenagers age 13-17 use Facebook, down from the 71% reported in a 2015 survey. The decline was offset by its Instagram unit, which 72% of teens reported they use, up from 52% in 2015, but that aggregate performance is not exactly tinder for blistering growth. Digital research site eMarketer came to an even bleaker conclusion in February after conducting a social network usage analysis:
Facebook will lose 2 million users ages 24 and younger this year, eMarketer estimates. But not all of those users are migrating to Instagram. For example, eMarketer predicts Instagram will add 1.6 million users ages 24 and younger.
One contingency who is no doubt appreciating the recent share price levitation is the Facebook C-suite, which continues to hit the bid en masse. While Zuckerberg continues near-daily sales of 200,000 to 250,000 shares as part of his previously announced plan to fund the Chan Zuckerberg Initiative, his fellow executives whittle down their own positions in the open market, or simply head for the hills.
Today, the Wall Street Journal reports that departing WhatsApp founders Jan Koum and Brian Acton forfeited $400 million and $900 million in potential stock awards, respectively, by leaving Facebook now instead of November, less than six months away (among the frictions between privacy-minded WhatsApp employees and Facebook staff is the fact that the former enjoyed “nicer bathrooms, with doors that reach the floor”).
On May 24, David Fischer, vice president of business and marketing, sold 18,096 shares to net $3.4 million. On May 16 and May 21, chief financial officer David Wehner sold 14,283 shares for proceeds of $2.6 million. Last Wednesday, chief operating officer Sheryl Sandberg sold 55,000 shares, for proceeds of $10.3 million. Since February, Sandberg has sold 385,000 shares, cashing in a cool $67.8 million.
Looks like a wise move to us.
Recap June 5
A flat finish in the S&P 500 belied stronger action elsewhere, as the NYSE FANG+ Index and small-cap Russell 2,000 both rose to fresh closing highs. Treasurys caught a bid, with the benchmark 10-year yield settling at 2.92%, and commodities rebounded from early weakness to finish in the green.
- Philip Grant
Monday, June 4, 2018
It's all relative
Last week, Ted Livingston, CEO of messaging app Kik
Last week, Ted Livingston, CEO of messaging app Kik
Submerging markets
Are the storm clouds abating in emerging markets?
Are the storm clouds abating in emerging markets?
Recap June 4
It's all relative
Last week, Ted Livingston, CEO of messaging app Kik voiced a decidedly dim view of blockchain technology. Speaking of the decentralized ledger system that underpins cryptocurrencies like bitcoin at a tech conference in Canada, Livingston said: “Almost nobody should be looking at it . . . it’s very low odds that blockchain is going to create value for you.”
The blockchain may not create value for the great unwashed masses, but it certainly created some for Kik, which raised over $100 million in an initial coin offering last year via its “Kin” token.
Submerging markets
Are the storm clouds abating in emerging markets? Over the last two weeks, the iShares J.P Morgan U.S. Dollar Emerging Market Bond ETF has steadied itself after falling to multi-year lows on May 9, and the broad Dollar Index is off by about 1% from the interim highs reached on May 29.
While the price action has improved (or at least stopped deteriorating), news flow continues to suggest that investors should keep a close eye on countries that might have been known as “waste places” in the early 20th century.
For Argentina and Turkey, whose currencies have both stabilized after plunging to record lows against the dollar in May, an uneasy status quo has settled in. Argentina, which was obliged to turn to the IMF for help as the peso legged lower again the greenback, is making progress towards loosening the purse-strings of the supranational body. This morning, IMF director Alejandro Werner proclaimed that: “Talks are well advanced.” That follows a May 31 prediction from Argentine President Mauricio Macri that a deal would be reached “in the next few days.”
Turkey, which has raised its benchmark interest rate by 600 basis points to 19.5% since May 23, saw May CPI rise by 12.2% year-over-year, the second highest reading since 2008. The latest inflation figure further complicates an uncomfortable dynamic for Turkey’s central bank: Hot inflation, rising government bond yields and a faltering currency. This constellation of facts argues for higher rates, while President Recep Erdogan (no wallflower to be sure) demands the opposite.
For another potentially instructive sign of the times, we turn to Malaysia. Today, Finance Asia reports that the newly elected government headed by the 92-year old President Mahathir bin Mohamad cancelled a high speed rail project that was to connect Kuala Lumpur and Singapore due to poor economics.
That deals a blow to China, which sponsored the venture as part of its Belt and Road Initiative. More such Belt and Road projects, including the $13.6 billion East Coast Rail Link, could be on the chopping block. Prior to his election, Mahathir proposed two alternatives for the Belt and Road undertakings: “Renegotiate,” or “even cancel . . . and pay compensation.”
A common thread exists between these IMF bailouts, chunky rate hikes and cancelled spending projects: Tighter monetary conditions. For that, our emerging-market brethren can largely thank the Federal Reserve, according to Bank of India governor Urjit Patel In an opinion piece in today’s Financial Times. Patel calls on the Fed to arrest its current QT policy:
The recent upheaval stems from the coincidence of two significant events: the Fed’s long-awaited moves to trim its balance sheet and a substantial increase in issuing U.S. Treasurys to pay for tax cuts. Given the rapid rise of the U.S. deficit, the Fed must respond by slowing plans to shrink its balance sheet.
If it does not, Treasurys will absorb such a large share of dollar liquidity that a crisis in the rest of the dollar bond markets is inevitable.
Fed chairman Jerome Powell evidently begs to differ. Powell told conference attendees at a May 8 event hosted by the IMF and Swiss National Bank that: “There is good reason to think that the normalization in advanced economies should continue to prove manageable for emerging market economies.” Powell went on to add, somewhat ominously: “Some investors and institutions may not be well positioned for a rise in interest rates, even one that markets broadly anticipate.”
Recap June 4
FAANG you very much. While the S&P 500 caught a moderate bid, the again-scalding tech sector left the broad index in the dust, with the NYSE FAANG+ Index jumping by nearly 2% to reach a fresh closing high. As tech thrived, commodities face planted, with the CRB index falling by nearly 1.5%, despite a slightly weaker finish on the U.S. Dollar Index. WTI crude dropped below $65 a barrel, continuing its rapid reversal from north of $72 a barrel two weeks ago.
- Philip Grant
Friday, June 1, 2018
Loan Star
Time for a Friday frolic through the rollicking credit markets. Borrowers continue to dictate terms of engagement to lenders across the spectrum.
The lengthy post-crisis thaw and ready assistance from global central banks has led to a pleasant problem: A drought in distressed credits. Analysts at S&P Global Fixed Income Research find that the ratio of U.S. corporate bonds trading over 1,000 basis points above the "risk-free" Treasury rate has declined to just 5.2%, its lowest level since late 2014 and down from 33.9% in February 2016.
As placid credit conditions contrast with an uptick in interest-rate volatility, the popularity of leveraged loans, which are floating-rate instruments (priced off a spread to the London Interbank Offered Rate, or Libor) and typically senior to high yield, has remained at a fever pitch. Bloomberg reports today that $120 billion worth of institutional loans were priced in May, second only to January 2017 for the most active issuance month in the post-crisis era. Bloomberg notes that the new supply is hardly overwhelming yield-thirsty investors:
Despite this frenzy of issuance there simply isn’t enough supply to meet demand and most borrowers retain the upper hand, with only some of the weakest credits getting any push back from investors.
Uber Technologies, Inc. is striking, again, while the iron is hot (see the Jan. 27, 2017 edition of Grant’s). On Wednesday, the privately held ride-hailing disruptor announced it will seek to refinance a 2016 term loan currently priced at 400 basis points above Libor to 350-375 basis points over. That follows a separate trip to the market in March, when Uber managed to place a $1.5 billion (upsized from an original $1.25 billion) term loan at a 400 basis point spread over Libor, inside of initial price talk of 425 to 450 basis points.
Uber, which was able to say ‘no thanks’ to a $3 billion investment from Warren Buffett (CEO Dara Khosrowshahi describes himself as a Buffett “fanboy,” if that’s any consolation to the spurned Berkshire Hathaway CEO), has recently managed to narrow its operating losses. The company finished the first quarter $304 million in the red before interest, taxes and excluding the proceeds of asset sales, according to the Associated Press. That compares to a $775 million loss in the fourth quarter and $4.5 billion loss in 2017 and after a $2.8 billion loss (or maybe, “community-adjusted profit”) in 2016. Reuters explains Mr. Market’s enthusiasm:
The privately-held company has generated huge interest among loan investors due to its massive valuation, which currently stands at $62 billion based on the proposed terms from a secondary stock sale announced last week, as well as the fact that so many people use the service.
Then again, uncounted people use the Post Office.
Back in the bond market, an April 30 Financial Times report of one borrower’s exploits brings present conditions into further relief. London-based telecom company Lebara Group, B.V. announced it would not meet a deadline to file financial statements, placing its €350 million floating-rate bond issue at risk of a technical default for a second time this year. In response, Lebara and its parent company, Vieo B.V., issued a statement calling for a bondholder meeting and voluntary early redemption of its debts, using language reminiscent of President Donald Trump, or perhaps Tesla, Inc., CEO Elon Musk on Twitter:
The rationale for this additional voluntary redemption is solely the unrest caused by biased media reports fueled by hedge funds shorting the bonds.
The FT”s Robert Smith wrote that day:
[The] announcement said that KPMG was carrying out the audit of Vieo and Lebara Group, while BDO were “providing account support.” The company had previously said that Grant Thornton was Vieo’s “accounting firm.”
“Vieo B.V. approached Grant Thornton Netherlands to advise on its accounts but we were unable to accept the assignment” a spokesman for the accountancy firm told the Financial Times. A spokesman for KPMG declined to comment.
All’s well that ends well. In a follow-up report yesterday, Smith noted that Lebara’s debt exchange was progressing nicely, with about 75% of the bondholders supporting a deadline extension in exchange for a €15 million equity injection from the company. The bonds have rallied to about 69 cents on the euro, up from 60 cents in late April.
Recap June 1
A roaring May payrolls report helped stocks catch a sturdy bid, with the S&P 500 rising 1% to finish the week in positive territory. Tech continued its dominance with a 2% rally. The NYSE FAANG+ Index, comprised of ten equally-weighted stocks, boasts year-to-date and 52-week gains of 26% and 51%, dusting the S&P 500’s 2% and 12% advance, respectively.
Treasury yields snapped higher across board, with the 10-year now back to 2.90% after trading below 2.76% on Tuesday. Commodities continued to trade poorly, with the broad CRB index now down more than 2% over the past five days, during which time the Dollar Index has been flat. The VIX dropped back to 13.5.
A sneak peak at the latest Grant's...
A long and a short. . .
Dear Almost Daily Grant’s Reader,
We published our flagship publication, Grant’s Interest Rate Observer, on Wednesday and I’m excited to share some details with you…
First, we discuss an essential commodity that Mr. Market has virtually left for dead. Its price is down by 83% from its peak. The combined market cap of the companies that have anything to do with it is down to around $7 billion from about $125 billion—and only 40 or so hardy survivors remain, down from about 500.
But on this global shipwreck of an asset class, Grant’s happens to be unreservedly—well, just treat yourself to our analysis.
And with this long, we pair a short…
A construction company whose revenues are soaring, but cash flow is dwindling and whose accounting is, let us say, controversial. Granted, revenue recognition is an art, not a science. But does it have to be art from the school of Dada?
In total, we present six timely, well-wrought articles in this issue. So if you’re not already “paid up,” you can learn more about Grant’s Interest Rate Observer here.
- Philip Grant
Thursday, May 31, 2018
Part and parcel
Let’s check in on the Great White North,
Let’s check in on the Great White North,
QT progress report
Recap May 31
Part and parcel
Let’s check in on the Great White North, and its long-formidable housing machine which was the subject of a Feb. 9 bearish analysis in Grant’s (“Bay Street blues”).
This morning, Canadian first quarter GDP growth registered at an annualized 1.3%, well below the 1.8% consensus and the slowest quarterly reading since the April-June quarter of 2016. While the post-2014 swoon in energy prices contributed to the prior GDP hiccup, there was a different culprit this time: Housing investment fell by an annualized 1.9%, the worst showing since the first three months of 2009.
While growth abates, inflation stirs. Canadian CPI for April rose by 2.2% year-over-year, the third straight print north of the 2% threshold. Yesterday, the Bank of Canada opted to keep the overnight lending rate unchanged at 1.25%, but noted that: “Developments since April further reinforce Governing Council’s view that higher interest rates will be warranted to keep inflation near target.” Interest rate futures currently price in an overnight rate of 1.73% by year-end.
The rise in short-yields is not only compressing the Canadian yield curve (the spread between five- and 30-year yields has flattened to just 14 basis points, down from an eight year average of 112 basis points) but is also putting the squeeze to homeowners. The Bank of Canada’s posted five-year mortgage rate (most Canadian mortgages are structured as five-year bullets subject to regular refinancing, as opposed to the 30-year fixed rate norm seen in the U.S.) has risen to 5.34% from 4.64% as recently as mid-2017.
Then there’s the B-20 regulation, implemented as of Jan. 1 by Canada’s Office of the Superintendent of Financial Institutions, which requires all borrowers to be subjected to a stress test at the greater of that benchmark rate or the contracted mortgage rate plus 200 basis points. Canadian consumers appear particularly vulnerable to an interest rate squeeze: Statistics Canada reports that household debt stood at 170.4% of personal income in the fourth quarter, just off the record high of 170.5% in the third quarter. By comparison, that metric topped out at 143% in the U.S. in 2007.
Needless to say, the combination of slower growth, tighter regulation and higher rates is an unpleasant one for Canada’s real estate industry. April sales across the country fell by 13.9% year-over-year, and marked their weakest seasonal showing since 2011, according to the Canadian Real Estate Association. Toronto, Canada’s largest city, has seen sales drop for four straight months on a seasonally-adjusted basis for the slowest start to the year since 2009. Vancouver sales plummeted to a 17-year monthly low in April, according to the local real estate board.
As the Canadian housing market retrenches, one relatively small mortgage lender can’t seem to get its numbers in order. In December, Laurentian Bank Financial Group in December announced it would need to repurchase C$304 million ($235 million) in mortgages due to “documentation issues and client misrepresentations.” A month later, Laurentian upsized that figure to C$392 million. Tuesday, the bank issued a press release cheerfully headed: “Laurentian Bank Financial Group Announces Progress on Mortgage Situation.” The text contained some less-upbeat details:
During the second quarter, CMHC [Canada Mortgage Housing Corp., the Fannie and Freddie of the north] completed a normal course audit of the bank’s portfolio insured mortgage loans. The audit highlighted similar issues as those identified in the fourth quarter of 2017, as certain mortgage loans that were inadvertently portfolio insured while they did not meet CMHC portfolio insurance eligibility criteria.
Laurentian price chart, eight-year view. Source: The Bloomberg
Indeed, the bank now expects to repurchase an additional C$125 million to C$150 million in insured mortgages. On the subsequent conference call, Laurentian CEO François Desjardins noted it was the CMHC that detected the problem, explaining that the review would last the rest of the fiscal year owing to the fact that: “These loans could not be found without opening the physical files.” Desjardins also asserted its business as usual with the CMHC, telling listeners that: “The conduit remains available with the same terms and conditions.”
Grant’s sought comment from the CMHC, whose spokesperson replied:
We actively monitor all institutions who participate in our programs. To date, we have received good cooperation from Laurentian Bank and we continue to work with them to resolve the present matter and ensure proper controls are put in place moving forward.
Laurentian Bank’s status as a CMHC Approved Lender and as an Approved Issuer is not affected by the present matter and they remain a valuable partner as [we] work to give more Canadians a place to call home.
Whether or not misery loves company, it often finds it.
QT progress report
It was MBS week at the Eccles Building. The Fed’s portfolio of securities held outright now foots to $4.126 trillion, a $9.5 billion decline from a week ago. In a reversal of recent norm, it was mortgage-backed securities accounting for more than 100% of the drop as the Treasury’s portfolio ticked slightly higher. Compared to the trailing four-week average, securities held outright have dropped by $14.5 billion, mostly consisting of MBS.
Since the Fed began the QT portfolio unwind on Oct. 1, its total assets have declined by 2.88%, for a simple annualized pace of 4.25%.
Recap May 31
Reappearing trade war risk helped drive stocks moderately lower, leaving the S&P 500 a bit less than 1% in the red for the week with one session remaining. Upward pressure in short-dated Treasury yields helped push the curve flatter, with the two- and 10-year spread reaching a fresh post-crisis low of 42 basis points, while commodities traded lower amid an unchanged greenback. The VIX ticked a bit higher to settle just above 15.
- Philip Grant
Tuesday, May 29, 2018
Zone defense
Mamma mia. The recent pain in segments of the emerging markets realm has found its way back to peripheral Europe, as political tumult spurred some remarkable price action. The Italian two-year yield more than tripled today to 2.77%, surpassing the 2010-2012 selloff for the largest one day move since the introduction of the euro in 1999. As recently as two weeks ago, the Italian two-year note yielded negative 0.07%.
While Italy’s yields are rising across the board, heavier selling at the short end is pushing the yield curve flatter. The spread between the two- and 10-year yields is now just 37 basis points, while the five-year yield of 2.98% now exceeds that of the seven-year vintage. With Italy set to auction up to €6 billion worth of five-, seven- and 10-year notes tomorrow, members of the ECB’s bond trading desk would be well served to get a good night’s sleep.
On the political ascendance of the anti-establishment Five Star Movement and League parties which have helped catalyze the recent commotion, Bianco Research LLC assesses the situation thusly:
While the story of the Eurozone imploding is one which has played out fruitlessly many times before, there may be reasons to take this episode a bit more seriously.
In the post-Brexit/Trump world, populist movements are not to be dismissed. These movements have the support of a much larger crowd than in the past.
Recent price action provides no comfort to those worrying about contagion: Greece, which was a primary culprit of the prior European credit crisis and sports a debt-to-GDP ratio of 181% according to Eurostat, saw its one-year borrowing costs surge to 3.27%, up from 1.03% on Thursday. Submerged in negative territory since June 2016, the Spanish two-year yield is almost back to sea level, now at negative 0.03%, up from negative 0.30% on Thursday.
As Europe’s periphery slides back toward financial disturbance, investors are fleeing to the loving embrace of Angela Merkel’s Germany. The German two-year yield now stands at negative 0.77%, its lowest since October and down from negative 0.59% on Thursday. That move has maintained the yawning gap between German and U.S. borrowing costs: The spread between the German and U.S. two-year yields is now up to 313 basis points, while the 10-year spread has expanded to 256 basis points, both at or near their respective records.
In a February speech in New York, ECB governor Benoît Coeuré observed that world central banks may hold as much as 90% of all German bunds. The March 23 edition of Grant’s paraphrased Coeuré’s remarks in speaking on behalf of the central bankers who have effectively snuffed out price discovery in German government debt:
We have done our work; private investors are defeated; they can do no damage to the yields that we have chosen to impose.
Of course, Germany’s put-upon non-central bank creditors find a particularly poor risk versus reward proposition. German CPI inflation grew by 1.6% year-over-year in April, leaving investors with a real yield of negative 240 basis points on two-year paper and negative 135 basis points on 10-year debt. By comparison, a 2.5% year-over-year rise in the U.S. April CPI leaves investors in 10-year Treasury’s with a positive, if de minimis real yield.
What about safety? It is apparent that no small part of the Italy population (Europe’s third largest economy) wants major political change, as evidenced by the recent electoral success of the populist parties. With less than two decades under the euro’s belt, is it such a certainty that the common currency will remain de rigueur in 2028? Even if the euro endures, cracks in the Old Continent’s banking system are beginning to grow more visible. Today, Deutsche Bank shares sank by another 5% to €9.8, and have fallen by 38% year-to-date.
As for Italy, Moody’s announced on Friday that it was placing the country’s debt on review for downgrade. Italy, which currently sports a Baa2 rating (two notches above junk) currently offers investors a 3.16% yield on 10-year debt, not far above the 2.76% on offer from the triple-A-rated U.S. Instead of pondering the cause of the recent selloff, we marvel at where Italy’s debt traded prior to the last few days in the first place.
For insight on the last question, perhaps we should ask this guy:
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Recap May 29
Widespread risk aversion left equities nursing a 1.2% decline on the S&P 500, its worst showing in nearly two months, while yields dropped by double-digit basis points across the Treasury curve. Commodities were hit hard amid dollar strength, with WTI crude finishing near $66 a barrel (down from $72 last Monday), and the VIX popped by nearly 30%.
- Philip Grant
Friday, May 25, 2018
Jumble-aya
As the Memorial Day weekend is upon us, we pause to take inventory of current financial conditions. Happy days are here again for the U.S equity (both public and private), structured credit and real estate realms.
At an investment conference on Tuesday, private equity titan David Rubenstein of the Carlyle Group observed that: "It’s easier to raise money than any time I’ve been in the business over the past 30 years or so," according to Bloomberg. Netflix, Inc., (NFLX on the Nasdaq) is certainly encountering similar investor generosity on the public side.
Netflix, one of the foremost principals of the post-2009 bull stampede and large cap standard-bearer in 2018 (the stock is up 85% year-to-date, 661% from January 2015 and 5,241% from its interim lows on the end of the recession in mid-2009), achieved a notable milestone yesterday. With a 2.6% intraday rise, the streaming content provider saw its market capitalization rise to nearly $153 billion, surpassing that of legacy behemoth Walt Disney Co., (DIS on the NYSE) which is five years away from celebrating its centennial.
A comparison of the pair’s benchmark financial metrics doesn’t fail to leave an impression. Fast-growing Netflix has more than doubled its revenues and adjusted net income in the past three years to $11.7 billion and $597 million, respectively in 2017. Disney, which posted a top line of $56.9 billion in the past year, managed an adjusted net income figure that rivals Netflix’s revenues, with $9.75 billion over the past 12 months (DIS operates on a fiscal calendar ending Sept. 30).
Free cash flow perhaps paints the starkest contrast: While Netflix burned just over $2 billion in cash last year and management expects cash burn to accelerate to $3 to $4 billion in 2018, Disney has generated $10.7 billion in FCF over the past four quarters.
“Stranger Things” is more than just a hit show.
Euphoria-type conditions are not confined to equities. The housing market is also kicking into gear. Wednesday’s release of the first quarter FHFA House Price Index showed a 1.7% sequential jump, well above the expected 0.7% advance. On Wednesday, the Commerce Department’s new home sales data for April showed the average new home price rose to a record $407,000, up 11% year-over-year.
Those gaudy gains are enticing the return of an infamous character from cycles past: The house flipper. In a May 16 blog post, Bin He, economist at CoreLogic, Inc., detailed his findings:
At a national level, the ratio of flipped properties to sales reached 6.2 percent in the first quarter of 2018, which matches the post-crash high in the first quarter of 2013. The first time it reached this level after the housing crash, home prices had just started to recover, and there were still a considerable number of distressed properties on the market.
However, the flipping dynamics have changed over time. The share of distressed properties sold has declined significantly, from 30 percent in January 2013 to 4.4 percent at the end of 2017. Additionally, as a result of six years of home price appreciation and limited for-sale inventory, in many areas, home prices have already passed the peak values reached before the market crashed.
Consequently, the acquisition cost in nominal dollars for investors has increased drastically. High acquisition cost, tight inventory, and rising flipping activities together point to possible speculation: investors are betting on continuous home price growth.
Who can blame them? It’s not like we’ve ever had a national decline in, uh, never mind.
With home prices on the march, another pre-crisis mainstay is making a triumphant return: Structured credit. A May 23 dispatch from Bloomberg reports that registration jumped by 45% for this year’s IMN Annual Investors’ Conference on [Collateralized Loan Obligations] and Leveraged Loans. Chrystalle Anstett, managing director at Eaton Partners, told the assembled throng: “No brainer, you need CLO’s in your portfolio.” Farboud Tavangar, senior portfolio manager at LCM Capital Management, cautioned that “CLO portfolios are far more aggressive,” than their pre-crash forebears, concluding that lenders “have no bargaining power.”
Indeed, according to S&P Global Intelligence’s LCD unit, the ratio of “covenant-lite” loans rose to a fresh record of 82% in April, up from 20% in 2011. Christina Padgett, a loan analyst at Moody’s, struck a stoic tone, telling the Financial Times that: “There is no point in talking about financial covenants any more, or calling a deal ‘cov-lite’. They are all cov-lite. Cov-lite is the new normal.”
One infamous name from cycles yore is dipping its toe back in the water. This morning, LCD reports that a subsidiary of AIG Group, Inc., the insurance company turned 2008-era ward of the state, is acquiring Covenant Credit Partners, “an alternative credit manager with a focus on below-investment grade corporate credit,” according to the investment firm’s website, for $900 million.
Thursday, May 24, 2018
CoCo beware
What bull market? You’d never know about the current good times on Wall Street by following the travails of Deutsche Bank AG (DB is its NYSE-listed American depository receipt). The German banking behemoth is under financial siege, beset by poor results, tumult in the C-Suite and a fast-shrinking share price.
Unflattering news has been plentiful of late. Today, Deutsche Bank announced it will reduce its global staff to “well below” 90,000 from its current 97,000 headcount. On April 20 Bloomberg reported that the bank had inadvertently wired €28 billion ($32.8 billion), or about 41% of Deutsche’s reported equity for the first quarter, in funds to an outside account. CEO Christian Sewing said today that the error resulted from an employee inputting the transfer in euros, instead of yen. Bloomberg likewise reports today that DB also accidentally transferred €21 billion to Macquarie Bank in 2014.
The newly minted CEO (who replaced John Cryan in April) did little to change the desultory mood by announcing that second quarter results would be constrained by “a revenue environment [that] remains challenging.”
That would be no break from recent experience. Revenues declined to €29 billion in 2017, down from €32.8 billion and €37 billion, in 2016 and 2015, respectively. The Street expects the top line to contract further to €26 billion this year.
As revenues dwindle, DB stock has also hit the skids, currently trading at €10.36, the lowest level since October 2016. That leaves shares priced at just 35% of first quarter book value. Rival too-big-to-fail banks such as BNP Paribas, Credit Suisse Group AG and Bank of America Corp. shares trade at 83%, 97% and 126% of book value, respectively.
But while Deutsche Bank’s share price and news coverage evoke the fraught days of 2016, one substantial difference is the performance of its contingent convertible, or “CoCo” securities.
DB share price in orange, CoCos in white. Source: The Bloomberg
CoCos are a peculiarly-structured investment specimen; perpetual debt securities which are convertible to equity or written down when the sponsoring bank runs into trouble and capital falls below a certain level. Issuers’ ability to raise equity at times of stress earns these CoCos the seal of approval of European bank regulators.
After wavering in the early-2016 risk aversion spasm, these exotic securities have performed well. The Bloomberg Barclays Contingent Capital Total Return Index has risen by more than 36% from its February 2016 nadir, topping the 29% gain in the Stoxx Europe 600 equity index over that period.
Naturally, CoCo’s solid recent performance and friendly stance from regulators have paved the way for bustling growth. MSCI calculates global CoCo supply outstanding at $675 billion as of September. That compares with €80 billion ($93 billion) in July 2014.
The risks of these untested investment contraptions were detailed in the July 11, 2014 edition of Grant’s (“Left hand, right hand”), which noted the ready potential for unintended consequences:
Conversions or write-downs, when they’re finally forced, won’t take place under wraps. The news will start a highly focused reassessment of the creditworthiness of the stricken CoCo issuer or issuers. Providers of short-dated liabilities – certificates of deposit, uninsured deposits, commercial paper – are likely to arrive at the same conclusion more or less simultaneously.
That hypothetical day of reckoning has yet to arrive. Although the Bloomberg Barclays CoCo Index lost more than 18% in the two months prior to February 2016 as DB suffered its prior wobble, last June’s wipeout of Banco Popular’s CoCo holders (the bank was sold to Banco Santander under distress) generated no ill effect on the broader asset class. Last week WisdomTree Investments, Inc. announced the launch of the WisdomTree AT1 CoCo Bond UCITS ETF on the London Stock Exchange (ticker: CCBO LN).
Now you can help bolster the tier one capital ratio of European banks from the convenience of your mobile device.
QT progress report
The Fed’s portfolio of securities held outright stands at $4.137 trillion, down by about $8 billion from last week’s reading. Once again it was a decline in Treasury holdings that accounted for the change; the Fed’s portfolio of mortgage-backed securities has now risen or remained unchanged for three straight weeks.
Compared to the trailing four-week average, securities held outright are down by just under $20 billion. Since the Fed began QT on Oct. 1, total assets are down by 2.66%, for a simple annualized pace of 4.04%.
Recap May 24
Stocks finished in the red but well off their early lows, leaving the broad S&P 500 in positive territory for the week thus far. Treasurys maintained their recent strength as a well bid seven-year note auction this afternoon helped yields move lower across the curve. The Dollar Index moved lower but recent emerging market trouble spots Turkey and Argentina saw their currencies weaken against the greenback, while gold rose back above $1,300 despite a selloff in the CRB commodity index.
- Philip Grant
Wednesday, May 23, 2018
Communication breakdown
Time for plan B. Yesterday, Bloomberg reported that debt-addled telecom operator Frontier Communications Corp. (FTR on the Nasdaq) is negotiating a potential debt restructuring with its creditors, after attempts to sell landline assets in Florida, California and Texas that the company purchased from Verizon Communications, Inc. in 2015 “failed to generate an acceptable price.”
Lindsay Gibbons, analyst at Creditsights, Inc. explained Frontier’s dilemma to Bloomberg:
The problem is that they have a weak negotiating position. If they sold Florida for less than what they paid, it wouldn’t look good and it puts a watermark on the other asset sales.
Frontier can certainly use some help with its balance sheet. Against net debt of $19.5 billion, the company is expected to generate $3.5 billion in adjusted earnings before interest, taxes, depreciation and amortization in 2018, for a leverage ratio of about 5.5 turns. Trailing 12-month interest expense of $1.52 billion exceeds consensus expectations for operating income in both 2018 and 2019. The single-B-minus rated, senior unsecured 11s of 2025, issued to help finance the purchase of those Verizon assets, fell below 80 cents on the dollar today, for a yield-to-worst of 15.72%.
The Oct. 2, 2015 edition of Grant’s (“Frontiers of junk”) featured bearish assessments of debt heavy roll- ups (now looking to un-roll themselves) Frontier and Dutch telecom Altice N.V. An anonymity seeking friend of the publication summed up the predicament facing wireline companies such as Frontier:
These firms have tried to straddle a line of providing high current income to shareholders while trying to hold on to their subscribers and keep their revenue streams from declining. Increasingly, they are trading high-margin legacy voice and circuit-switched revenue for much lower margin Internet Protocol (IP)-based revenue, and they are having to maintain fairly high levels of capex in order to provide services that are competitive with cable providers and other combatants, or else risk watching their customers defect. That’s a combo that doesn’t bode well for shareholder payouts generally.
For all of Frontier’s financial woes, the company also appears to be underinvesting in its business. While capital expenditures footed to $1.17 billion in 2017, depreciation and amortization expense was nearly double that, at $2.12 billion.
While the yield on Frontier’s junk-rated bonds goes higher, investors are set to bestow generous terms on another less-than pristine credit. Yesterday, S&P Global Intelligence’s LCD unit reported that metals company Atotech, Inc. is offering $300 million in high yield, unsecured notes with a “PIK toggle” feature, which gives the issuer the right to pay interest with additional debt instead of cash. The last such unsecured PIK offering was made in November by Sotera Health.
Covenant Review, an independent credit research firm, details some particularly issuer-friendly features to the Atotech high yield offering, observing that: “These notes will be holding company debt, with no guarantees from subsidiaries. Thus, these Notes will be structurally subordinated to all debt of the subsidiaries . . . A widely held public company could acquire The Company without triggering the Change of Control put.” Analyst Ross Hallock goes on to summarize:
The financial metrics allow for excessively liberal pro forma adjustments. Pro forma effect may be given to any “operational efficiencies” or “strategic initiatives.” In other words, pro forma adjustments may be made for just about anything.
Rarely a dull moment in high-yield.
Slumbering samurai
The rout in the Turkish lira reached a fever pitch this morning, as the currency weakened more than 5% intraday to a fresh record low of 4.92 per dollar, necessitating an extraordinary central bank meeting and 300 basis point interest rate hike to 16.5%. Although termed “a very weak response” by strategists at Brown Brothers Harriman & Co., the move seemed to work for now, as the lira recouped its early losses and rallied to 4.6 per greenback late in the U.S. session.
Turkey’s spiraling currency and local bond yields are unwelcome news for the hordes of Japanese speculators who have been reaching halfway across the world for income. Bloomberg notes today that margin traders in the Land of the Rising Sun had recently upsized their exposure to the Turkish lira, holding a net long position of 323,537 contracts as of May 15, up from 266,955 contracts at year end.
The financial connection between Turkey and Japan extends beyond currency speculation. As noted in the April 3 edition of Almost Daily Grant’s, Turkey sold ¥60 billion ($546 million) in three-year samurai notes in December, at a 1.81% coupon.
The issuer may be teetering on the financial precipice, but you wouldn’t know it from the performance of the samurai bonds. They have barely budged from a post-issuance rally and remain comfortably above par.
Meanwhile, during a speech this afternoon Turkish president Recep Erdogan called on his citizens to keep their money in lira. The million dollar (lira) question: Will Erdogan escalate his rhetoric into action, in the form of capital controls?
Recap May 23
Stocks enjoyed a late rebound to finish in the green, as a few dovish remarks in the latest FOMC meeting minutes this afternoon led to a decline in the market’s rate hike expectations (interest rate futures currently price in a 2.25% Fed Funds rate at year end, down from 2.32% yesterday). Treasury yields moved sharply lower across the board, and the dollar and commodities both finished slightly higher. The VIX sold off late to finish at its lowest close since late January.
- Philip Grant
Tuesday, May 22, 2018
Under the hood
No ZIRP? No problem, mostly. Since the Federal Reserve began its tightening regime with the first of six 0.25% increases in December 2015, the S&P 500 has cruised higher by 36% with only a pair of notable interruptions, in February 2016 and earlier this year. Rate-focused equity bulls can take further reassurance from recent history. The Fed’s prior two tightening cycles, from 2004-2006 and 1999-2000, both coincided with double-digit gains in the broad index.
Of course for the corporate realm, rising borrowing costs are a mixed blessing. While some industries shrug them off or even thrive in times of dearer money, others might wish things had stayed the way they were. Indeed, since the Fed began tightening policy, the three worst performing S&P sectors have been interest rate-sensitive real estate, telecom and consumer staples, up by 4%, 2% and 1%, respectively.
Homebuilders, which fared extremely well through 2017, have lately been consigned to the latter category. Since January, the S&P Supercomposite Homebuilder Index has flirted with bear-market territory. Following a 20% drop, the index has continued to falter even as the broad market steadied and rebounded.
A recently-skyrocketing lumber price (up 72% since June even after a 7% pullback in the last four trading days) is one ready explanation. Rising mortgage rates, and their potential impact on demand, are another potential factor. Last Thursday, Freddie Mac reported that the average fixed-rate mortgage rose to a seven-year high of 4.61%, up from 4.55% the week prior and 4.02% a year ago. The Mortgage Bankers Association forecasts that the 30-year benchmark rate will reach 5% this year, and 5.5% by the end of 2019.
The recent sickly price action in homebuilders received some fundamental confirmation this morning, as high-end operator Toll Brothers, Inc., reported weaker than expected second quarter results, including shortfalls in new orders and gross margin relative to analyst expectations, sending shares lower by 10%. While CEO Douglas Yearley, Jr. cited the jump in lumber costs as a contributing factor for the disappointment, he dismissed the role of rising rates, telling analysts on the conference call that:
They have not impacted our business. Look at the second quarter results. Our sales teams around the country have had nothing to say. All right. They've had no issues. So on the rate side, a 4.87% rate, as I mentioned, is still a low rate and is only 75 basis points up from a year ago. So right now we're very comfortable with our business and [see] no issues out there.
Indeed, despite a seven-year high in the Freddie Mac survey mortgage rate, the data series sits barely above its post-recession average of 4.13% and well below its 30-year mean of 6.5%. Likewise, the overnight Fed Funds and 10-year Treasury rates both remain well below their respective long-term averages.
But the current rising rate cycle looks far from over. Futures markets continue to predict between two and three additional Fed hikes this year, underpinned by a visible uptick in inflation with both the CPI and PCE deflator metrics at their highest in over a year. This morning, the wages subcomponent of the May Richmond Fed regional manufacturing index rose to its highest reading since 1997. Jonathan Tepper, chief editor of Variant Perception and a recent guest on the Grant’s podcast (click here to listen), details other wage-inflation sightings in a May 17 analysis of the labor market:
The [National Federation for Independent Business] compensation plans is now at the highest point in the last twenty years. Small businesses expect to raise wages, and a majority of industries are experiencing wage increases. We will see higher growth rates for hourly wages and the Employment Cost Index.
For many consumers, the bump in pay comes not a moment too soon. According to the Fed’s consumer credit data series, student loans outstanding topped $1.5 trillion in the first quarter, up 39% in the past five years and 146% since 2008. Meanwhile, the Department of Education announced Friday that starting July 1, undergraduate federal student loan interest rates are set to jump to 5.05% from the current 4.45%.
Signs of a stretched consumer are increasingly visible. The Bureau of Economic Analysis calculates the U.S. savings rate at 3.1% of disposable income for the first quarter, compared to a post-crisis average of 5.5% and 8.5% going back to 1946. Ben Breitholtz of Bianco Research likewise finds that: “Google search trends are reflecting a rise in consumer stress and waning spending patterns . . . The popularity of searches for bankruptcy, default and food stamps reached the highest since late 2008.”
That’s in year nine of the economic expansion. Falling rates giveth, rising rates taketh away.
Recap May 22
A late selloff left stocks modestly in the red, while Treasury yields inched higher across the curve and the dollar, commodities and the VIX all finished little changed. Emerging markets mostly fared well, with the iShares JP Morgan USD Emerging Markets Bond ETF enjoying its best finish in nearly two weeks. However, the Turkish lira continued its tailspin, reaching a new record low of 4.667 per greenback. The lira has lost nearly half its value since the failed coup attempt against Recep Erdogan in summer 2016.
Lira/dollar exchange rate, two-year chart. Source: The Bloomberg
-Philip Grant
Monday, May 21, 2018
Debt decision
Price action in the stock market appears healthy,
Price action in the stock market appears healthy,
A crowded table
It was an un-bullish omen.
It was an un-bullish omen.
Recap May 21
Debt decision
Price action in the stock market appears healthy, with the MSCI World Index hovering in a tight range about 6% below the all-time highs reached on Jan. 26. The bond market? Not so much.
Today, Italian sovereign yields spiked, with the two-year yield nearly tripling to 0.28%, as an already grim fiscal picture faces further erosion from a new coalition government. The anti-establishment Five Star Movement and Northern League have discussed issuing short-term credit notes called “mini-BOTs,” which former economy minister Pier Carlo Padoan described as a “disguised parallel currency.” The selloff in emerging market credits continues, with recently-issued Turkish dollar-denominated 10-year bonds sinking to a fresh price low of 91 cents on the dollar, for a yield-to-maturity of 7.33%.
Corporate issues stateside are giving their beleaguered EM and peripheral European counterparts a run for their money. Bloomberg notes that: “Debt of American companies just posted their third-worst 100-day returns since 2000, according to a JPMorgan Chase & Co. index, as tighter monetary conditions leave their mark on high-quality bonds with longer maturities.”
Meanwhile, futures markets assign an 85% probability of the Federal Reserve hiking interest rates by at least 50 basis points by year-end, from the current range of 1.50% to 1.75%.
Who will blink first, investors or the Fed?
A crowded table
It was an un-bullish omen. On Friday, Campbell Soup Co. (CPB on the NYSE) preceded its April quarter earnings release with a report announcing a “CEO Transition Plan.” CEO Denise Morrison retired, effective immediately, and was replaced on an interim basis by board member Keith McLoughlin.
As might be surmised from a CEO’s abrupt departure on earnings day, the results were not good: Campbell’s now expects fiscal year adjusted earnings per share of $2.85 to $2.90, from a prior range of $3.10 to $3.17. Shares sank by 12% in response, and are now down by 30% year-to-date and 50% from their July 2016 highs (almost exactly coinciding with the lows on the 10-year Treasury yield). For his part, interim CEO McLoughlin promised “a thorough and critical review of all aspects of our strategic and operating plans . . . everything is on the table.”
Campbell, faced with something of an existential threat as consumer tastes shift toward fresh, organic fare in place of its legacy offerings, worked to diversify its product slate under Morrison with 2015’s acquisition of Garden Fresh Gourmet and 2012’s purchase of Bolthouse Farms, among others. Then, Morrison changed tack, announcing in December a $6.1 billion deal to buy snack company Snyder’s-Lance, Inc.
The company paid a fancy price for LNCE, coughing up a 27% premium to its pre-deal closing price and just under 20 times the target’s trailing 12-month adjusted earnings before interest, taxes, depreciation and amortization (EBITDA). Snyder’s-Lance then wrapped up its time as a standalone company by offering far weaker than expected fourth quarter results in February, afflicted by shortfalls in both revenue and operating margins.
The deal has been transformative for Campbell, just not in the way the bulls would want. With total debt now at $9.6 billion, up from $3.5 billion in fiscal 2017 (the company’s fiscal year ends July 31), CPB is expected to generate $1.9 billion in EBITDA and $894 million in free cash flow in fiscal 2019. By contrast, CPB managed $1.8 billion in EBITDA and $953 million in free cash flow in fiscal 2017. Creditors are getting nervous. In March, Campbell issued $700 million in 30-year senior unsecured debt at a 4.80% coupon. Priced just below par on March 12, the bonds have promptly fallen to below 92 cents on the dollar, for a yield-to-worst of 5.36%.
Creditors’ cold feet. The CPB 4.8s of 2048. Source: The Bloomberg
Campbell is of course not the only consumer packaged-foods company struggling with secular changes in taste, overlaid on high debt. Kraft Heinz Co. (KHC on the Nasdaq) has likewise been given the cold shoulder by Mr. Market of late, with shares down by 27% year to date and 42% from its 2016 highs, despite industry-leading EBITDA margins.
The March 25, 2016 edition of Grant’s featured bearish analyses of CPB and KHC with an unambiguous headline: “Sell Big Food,” we proclaimed. The consumer packaged foods industry’s intense competition and shrinking revenues were two points of concern. Dwindling market share at the hands of niche brand, healthy (or healthier) up and coming competitors, another. Noting the pronounced popularity of this traditionally low-risk industry at the time (consumer packaged goods companies then traded at an average 25 times trailing net income), we wrote:
In the physical world, some things are inherently safe, others inherently not. Daisies and dynamite, for example. There are fewer such clear distinctions to be drawn in the world of investing . . . Mispriced investments are inherently risky.
Back in the present day, the Wall Street Journal reported over the weekend that analysts and bankers alike have identified Kraft Heinz as a potential suitor for Campbell. Whether the pair of amply levered companies do indeed look to combine or continue to go it alone, the value restoration project continues apace.
Recap May 21
Stocks were bid to start the week, with the S&P 500 gaining about 0.7% to finish at its best level since mid-March, while a late dollar selloff pushed the CRB Commodity Index to another fresh post-2015 high with WTI crude settling near $72.5 a barrel. Treasurys finished little changed.
- Philip Grant
Friday, May 18, 2018
Fun with filings
Interesting doings of late in the Securities and Exchange Commission’s EDGAR database.
Interesting doings of late in the Securities and Exchange Commission’s EDGAR database.
Recap May 18
Fun with filings
Interesting doings of late in the Securities and Exchange Commission’s EDGAR database. We now present a trio of recent filings that caught our attention. Let’s get right to it.
Yesterday, amply-levered packaged food company Post Holdings, Inc. (POST on the NYSE) filed a form S-1 draft registration statement related to a potential transaction involving its private brands business, which, unlike its legacy cold cereal unit, continues to enjoy sturdy top-line growth (10% year-over-year in the quarter ended March 31). In an accompanying press release, Post notes that options for the unit include “an initial public offering, a placement of private equity, a sale of the business or strategic combination.”
Why quote the press release instead of the S-1 itself? Post opted to file confidentially with the SEC, which first allowed companies below $1 billion in market cap to do so away from the prying eyes of investors via the 2012 JOBS Act. That privilege was extended to all companies in June 2017.
One anonymity-seeking investor familiar with Post was none too impressed, telling Grant’s:
The confidential treatment of Post’s S-1 for its private label unit only inhibits analysis of POST’s overall business. Owners of POST shares may wonder, what information is in the S-1 that management doesn’t want shareholders to see?
For more on Post, see Grant’s Interest Rate Observer, Sept. 16, 2016.
While Post keeps a low profile, the Swiss National Bank has been lightening its load. The SNB, which conjures fresh francs to buy euros in an attempt to stem unwanted appreciation in the swissie, then diversifies into an array of assets including U.S. equities, turned seller in the first quarter. The central bank’s equity portfolio, which rose to $92 billion at year end from $63 billion in 2016, declined to $82 billion as of quarter-end, according to its recently filed form 13-F. Holdings in large cap names such as Apple, Inc., Tesla, Inc., and Nike, Inc., all dropped by about 15% from their year-end levels, while the SNB’s total U.S. portfolio now comprises 2,484 holdings, down from 2,514 on Dec. 31. The gnomes are getting more selective!
The reversal comes as the Swiss have enjoyed a favorable turn of events in the forex market. The Swiss franc, which briefly traded through parity with the euro following the SNB’s early 2015 abandonment of its 1.20 euro floor, has since declined to 1.17 per euro amid ongoing interventions and a negative 0.75% deposit rate, well below the negative 0.4% on “offer” in Europe.
Is a move to less-negative interest rates perhaps the central bank’s next trick? Don’t hold your breath, says SNB president Thomas Jordan. On April 27, Jordan remarked that: “Tightening monetary conditions would be premature at this juncture, and would risk unnecessarily jeopardizing the positive economic momentum that has been established.”
Finally, we turn to the cream of the academic crop, Harvard University. Harvard Management Company returned 8.1% in fiscal 2017, trailing the 19% gain in the S&P 500 and all of its Ivy League peers (it was Harvard’s fourth last place finish in six years). A $1 billion write-down in its natural resources portfolio (Almost Daily Grant’s, May 11) was one culprit.
Newly minted endowment CEO N.P. Narvekar (he joined in December 2016) eschewed happy talk, writing that: “Our performance is disappointing and not where it needs to be. The endowment’s returns are a symptom of deep structural problems at HMC and the resultant significant issues in the portfolio.”
While the SNB is selling big tech, Harvard is buying. According to the recently filed form 13-F, the endowment’s directly managed equity holdings in the first quarter were highly concentrated: Positions in Apple, Inc., Microsoft Corp. and Alphabet, Inc. (née Google) make up an eye-opening 72% of its approximately $817 million in-house U.S. equity long portfolio. As of Dec. 31, the directly managed equity portfolio was mostly invested in ETFs. For reference, total AUM at Harvard was $37.1 billion as of September.
Coming on Monday, the latest edition of the one of a kind Grant’s podcast, with special guests Jonathan Tepper of Variant Perception and John Hempton of Bronte Capital Management. For a sample of Jonathan’s work, follow this link to a recent white paper on how to identify the next market top: http://www.variantperception.com/jimgrant
Recap May 18
Stocks finished slightly lower, wrapping up a low intensity week 0.5% in the red on the S&P 500, while Treasurys caught a bounce with yields finishing lower across the curve. Commodities held steady amid a fresh 2018 high in the Dollar Index, but emerging markets came under pressure with the iShares MSCI Emerging Markets ETF finishing at its lowest closing level since the February sell-off.
- Philip Grant
Thursday, May 17, 2018
BEN down this road
Hasenstab to the rescue! Yesterday, the Financial Times reported that financially ailing Argentina received a timely piece of assistance earlier this week, in the form of $2.25 billion in loans from asset manager Franklin Templeton (BEN on the NYSE) and its star portfolio manager, Michael Hasenstab. Argentina, which was forced to ask the IMF for assistance last week amid a spiraling peso and dwindling FX reserves, was approached by Franklin Templeton to reopen five- and eight-year local currency “Bote” bonds, according to the FT. Luis Caputo, Argentina’s finance minister, was ecstatic, telling Bloomberg that:
You can’t get a bigger sign of confidence from markets when you place a bond in pesos at a fixed-rate on one of the worst days in emerging markets this year. It is a sign of confidence in President [Mauricio] Macri, and the policies he is putting in place.
Templeton is doubling down on Argentina. While the $2.25 billion investment reported in the Financial Times is a fraction of the Bloomberg-tallied $111 billion managed by Hasenstab, his largest funds had already carried a hefty allocation to the Land of Silver: The $38 billion Global Bond Fund had a 4.5% position in Argentina as of March 31, while the EU-domiciled $20 billion Global Total Return Fund, and the $11 billion Emerging Markets Bond Fund carried 7.5% and 10.23% positions, respectively, as of April 30.
Hasenstab and Co. can use a change in fortune: Amid flagging recent performance (the Templeton Global Bond Fund has managed an three year annual return of 2.02%, lagging the 3.45% showing in the benchmark Citigroup World Government Bond Index), Templeton’s fixed income assets have flagged to $277 billion as of April 30, down from $355 billion in mid-2014. Since July 2014, BEN shares have lost 41%, compared to a 47% rise in active management peer T. Rowe Price (TROW on the Nasdaq) and a 38% gain in the S&P 500.
On July 11, 2014, Grant’s offered a bearish appraisal on Templeton (“Sell to whom?”), which was then at the tail end of a charmed run. In the 10 years through 2014, the Templeton Global Bond Fund managed a 9.2% annual return, dusting the 5.3% average global fixed-income portfolio return during that period. Despite (or because of) that success, Hasenstab’s practice of making concentrated bets in illiquid debt instruments was an underappreciated source of risk for Templeton fund investors and BEN shareholders alike, we judged:
What advice might we have for investors in the Franklin Templeton’s star-spangled bond funds? Only that, in any future rush to liquidate, it would be better to be early than late. And for the Franklin Resources’ stockholders, a question: Are you quite sure you know what you own?
Argentina has steadied itself a bit this week, with its peso currently trading at 24.3 per dollar from a close near 25 on Monday, while the dollar-pay century bonds trade at 87.5, up more than two points from the closing lows reached on May 8. Having doubled down on their bullish view on Argentina and with plenty of exposure to other emerging markets, Hasenstab’s funds appear positioned to benefit from any cessation of the recent EM troubles.
Of course, the opposite is also true. Robin Brooks, chief economist of the Institute of International Finance assesses the situation this way: “Rising global interest rates beg the question whether Argentina is an idiosyncratic case or a harbinger of things to come. We worry it might be the latter.” Harvard professor Carmen Reinhart unfavorably compared the present day to the 2013 “taper tantrum” and 2008 , telling Bloomberg that: “The overall shape [emerging markets are in] has a lot more cracks than it did five years ago and certainly at the time of the global financial crisis.”
Watch this “space.”
QT progress report
An $8.6 billion decline in the Fed’s Treasurys holdings left the central banks' portfolio of securities held outright at $4.137 trillion this week, down by $8 billion from a week ago as its mortgage-backed securities holdings ticked up slightly. Compared to the trailing four week average, securities held outright are down by $19.6 billion, $17.3 billion from of the decline from USTs and the remainder from MBS.
Since the Fed began its portfolio run-off on Oct. 1 2017, total portfolio holdings are down by 2.65%, a 4.15% simple annualized pace.
Recap May 17
Stocks finished little changed, continuing the recent consolidation in the S&P 500, which sits lower by less than 0.5% for the week, while commodities, the dollar and the VIX also drifted sideways. The treasury curve steepened as prices sold off at the back end; while the recent flattening has received plenty of attention (including here), the 30-year yield is likewise moving higher. Today’s close of 3.25% in the highest since September 2014, and compares to 2.1% on the July 2016 cyclical lows.
-Philip Grant
Tuesday, May 15, 2018
Where the rubber meets the road
The second-longest postwar expansion on record continues at a humdrum pace.
The second-longest postwar expansion on record continues at a humdrum pace.
Recap May 15
Where the rubber meets the road
The second-longest postwar expansion on record continues at a humdrum pace. Real GDP grew by 2.3% in first quarter compared to a 20-year average growth rate of 2.5%, while retail sales ex-automobiles have grown by an average 0.3% month-over-month through the first four readings of 2018, matching the 20-year average monthly growth rate.
Other indicators are seeing more substantial departures from the norm. Today, the Journal of Commerce reports on the major impact that fast-rising oil prices and post-hurricane rebuilding efforts in Texas and Florida are having on the trucking industry, as spot market rates reached a record $2.72 per mile in the week ending May 5 according to data from Morgan Stanley.
“Flatbed capacity is exceedingly tight and will likely tighten further as milder weather finally arrives in northern regions. There seems to be very large imbalances regionally; creating ‘panic’ freight buying,” one anonymous shipper said in the biweekly Morgan Stanley Truckload Index.
Rates per mile were up 10% for flatbed carrier Daseke, Inc., according to its first-quarter earnings report. Universal Logistics Holdings reported revenue per mile, excluding fuel surcharges, rose 12.7% year-over-year.
“We have not seen a rate environment like this for a long, long time, if ever,” said Robert Ragan, chief financial officer with Melton Truck Lines.
“I’ve never seen anything like this in more than 30 years in business,” added Joyce Brenny, CEO of Brenny Transportation. “Volume was at least manageable a year ago. We were doing well and rates were good. But now it’s out of control and we can’t keep up.” She said new shippers are waiting 10 to 14 days to get an available truck. Last year, the wait was about three days, and during leaner times it was as little as 24 hours.
Of course, one company’s revenue is another’s cost input. The surge in trucking rates is already taking a toll on the consumer goods realm. As noted in an April 24 Wall Street Journal dispatch, a number of senior executives commented on the unwelcome acceleration in transportation costs in the first quarter. Coca-Cola Co. reported a 20% year-over-year rise in freight expense, while Proctor & Gamble Co., Hasboro, Inc., Danone SA and Nestle SA also mentioned higher costs. Consumer staples giant Unilever PLC forecast a high-single digits to high-teens jump in U.S. freight costs this year, with chief financial officer Graeme Pitkethly observing that: “Everybody is seeing an increase.”
Meanwhile, inflation metrics are beginning to demonstrate the upward price pressures described by the logistics and consumer goods executives. April headline CPI grew by 2.5% year-over-year, its hottest reading since February 2017. The New York Fed’s Underlying Inflation Gauge (which aims to capture “sustained moves in inflation from information contained in a broad set of price, real activity and financial data”) was even starker, rising to 3.2% year-over-year in April, the highest since July 2006.
FRBNY Underlying Inflation Gauge. Source: The Bloomberg
These increasingly noisy inflationary rumblings are not lost on the bond market, which has sent the 10-year Treasury yield to as high as 3.09% (highest since 2011) today from 1.36% in mid-2016. The short end has sold off even more dramatically, with the two-year yield reaching as high as 2.58% (highest since 2008) today, up from 0.57% in mid-2016.
Federal Reserve Bank of Dallas president Robert Kaplan isn’t too worried, however. Kaplan forecast in a speech this morning that: “In the medium term, I think inflationary forces are still going to be more muted . . . Most of the forces in the world are deflationary.”
For the sake of ongoing economic growth, Kaplan had better be right. With the spread between the two- and 30-year Treasury yield remaining near multi-year lows at 63 basis points and futures markets currently pricing in a 43% likelihood of three additional 25 basis point rate hikes by December, the potential for an inverted yield curve by year end is non-trivial. San Francisco Fed president John Williams (who is set to take over the New York branch on June 18) termed yield curve inversions “a powerful signal of recessions” in an April speech.
By way of postscript, the longest postwar economic expansion in the U.S. ranged an even 10 years, from March 1991 to March 2001. With the current iteration underway since June 2009, could we be in store for a photo finish?
Recap May 15
A surging greenback and jump in Treasury yields gave equity bears their first victory in nearly two weeks, as the S&P 500 declined moderately amid underperformance from interest rate sensitive groups such as real estate and telecom. Commodities mostly held firm amid the rising dollar, but gold faltered, dropping below $1,300 an ounce for the first time in 2018.
- Philip Grant
Monday, May 14, 2018
Harder they come
It’s a brave new world in the credit market. As overall conditions remain forgiving and issuers take full advantage, leveraged loans, which are structurally senior to high-yield bonds and offer more protection against higher rates thanks to a floating rate structure, have enjoyed disproportionately rapid growth. What sort of surprises might await investors in this burgeoning category when the cyclical worm turns?
Thanks to breakneck growth, the leveraged loan market is almost as big as high-yield. According to data from Bank of America Merrill Lynch and S&P Global Market Intelligence, leveraged loans outstanding in the U.S. exceeded $1 trillion as of year-end 2017, double the year-end 2010 level. By comparison, U.S. high-yield debt outstanding footed to $1.1 trillion at the end of 2017, up less than 25% from 2010. Recent performance bears out the divergence in popularity, with the S&P/LSTA Leveraged Loan Index gaining 1.92% year-to-date, compared to a two basis point loss in the Bloomberg Barclays U.S. Corporate High Yield Total Return Index. However, over the past eight years, high-yield has outperformed handily: The Bloomberg Barclays Index has posted an 81% gain since May 2010, nearly double the 47% advance in S&P/LSTA’s Leveraged Loan Index.
As leveraged loans have taken a progressively more prominent role in credit issuance, lower credit borrowers increasingly abound. S&P Global Intelligence’s LCD unit finds that roughly half the loan market is made up of borrowers rated single-B-plus (“the obligor currently has the capacity to meet its financial commitments on the obligation”) or lower. That compares to 32% at that threshold as of 2007.
It’s not just on the ratings scale that the market has been slumming it. The share of “covenant-lite” loans, ones that are bereft of traditional legal protections for creditors against various issuer maneuvers such as piling on new debt, reached a record 77% of the leveraged loan market in April. That compares to 17% in 2007 and roughly 60% as recently as 2015.
The precipitous decline in covenant quality has recently made for some memorable deals, as issuers continue to push the envelope while docile (or desperate) creditors compete with one another to fund them. One such cyclical keepsake was discussed in the most recent edition of Grant’s (“I Can’t Believe They’re Covenants,” May 4). Another, private equity firm KKR & Co.’s recent buyout of Heartland Dental, was highlighted in a Friday dispatch from Bloomberg.
[KKR] included a bold ask: It wanted credit now for earnings that the company expected to get in the future from offices it had just opened. That helped nearly double a measure of income that will be used to test whether the dental-office services company is making enough money to keep borrowing, according to people familiar with the matter.
Guy LeBas, chief fixed-income strategist at Janney Montgomery Scott LLC, draws a provocative comparison between present day leveraged loans and another popular debt security of cycles past. LeBas told Bloomberg that:
The selling points made to buyers are remarkably similar to those made to buyers of subprime mortgages. Low default rates justify weaker documentation and covenant structures deteriorating, and there’s not a lot of pushback against it. Those are yellow flags.
Credit quality concerns are not confined to the U.S. Across the Atlantic, where European creditors face the additional burden of the ECB and its interest rate repression regime (negative overnight deposit rates and ongoing corporate credit purchases, to be specific), leveraged loan growth has zoomed past that of high yield. S&P calculates leveraged loan issuance at €120 billion last year compared to €94 billion in high yield, with €41 billion and €30 billion issued respectively, year-to-date through April. On Friday, Reuters’ International Financing Review and Loan Pricing Corporation units reported that even some investment bankers have had enough:
Several senior bankers told IFR and LPC that they are increasingly rejecting [underwriting business] solely as the covenant terms and leverage deals requested by sponsors are too aggressive.
“I’m worried about it; the documentation is not pretty. We have more internal checks and committees now on deal teams and that’s paramount,” one leveraged finance head said.
For more on this formerly obscure and increasingly noteworthy cordon of the market, tune in to the most recent edition of the Grant’s podcast, with Covenant Review founder Adam Cohen.
Recap May 14
Stocks settled unchanged, the fourth sideways showing on the S&P 500 in six attempts as volatility remains subdued with the VIX holding at 13. Treasury yields ticked higher across the curve to leave the 10-year near 3%, and commodities and the dollar ticked slightly higher in tandem.
- Philip Grant
Friday, May 11, 2018
Inter-species diplomacy
From the New York Post:
From the New York Post:
Hotel California
We can say this for emerging markets: They are definitely not boring.
We can say this for emerging markets: They are definitely not boring.
Recap May 11
Inter-species diplomacy
From the New York Post:
The owners of a private Canadian zoo have been charged after a bear from their facility was driven in a pickup truck to a Dairy Queen drive-through for an ice cream cone, according to reports.
Wildlife officials found out about the outing after the Discovery Wildlife Park posted a now-deleted video to social media earlier this year showing the 1-year-old Kodiak bear, Berkley, leaning out of the truck’s front passenger window for the frozen treat.
“Bears can smell 20 miles upwind,” the narration states in the video, which aims to provide a message of safety related to bears. Another video, which was also removed, reportedly showed the bear licking frosting off an ice cream cake.
They presumably left the bull back at the zoo. Our kind of people!
Hotel California
We can say this for emerging markets: They are definitely not boring. As investors in developed markets around the world currently enjoy mostly placid conditions, their EM brethren face the opposite. This week alone has seen no shortage of crucial developments. We now detail a trio of such notables.
Yesterday, Malaysia absorbed a seismic political shock, in the form of an upset victory by Mahathir Mohamad, 92 years young. Mohamad, who switched to the opposition party to run against incumbent Najib Razak, returns to the prime minister seat he held from 1981 to 2003 by securing the first change in power to an opposition party in Malaysia’s 61-year independent history.
Investors eager for Mr. Market to weigh in are forced to cool their heels through the weekend, as Thursday and Friday were public holidays. For now, we speculate. Andrey Kuznetsov, credit portfolio manager at Hermes Investment Management, gave his assessment to Finance Asia:
As a result of [former incumbent party Barisan Nasional’s] loss, there will be a small negative for Malaysian credit and we would expect a weaker [Malaysian Ringgit]. Investors will require a higher compensation for policy uncertainty and we will watch closely if the fiscal deficit on the back of implementation of campaign pledges will lead to higher than expected sovereign debt issuance.
While what’s old is new again in Malaysia, the Republic of Turkey contends with a more conventional struggle between market forces and a political strongman used to getting his way. In a speech in Ankara today, Turkish president Recep Erdogan railed against “FX speculators, the interest rate lobby [does that include interest rate observers?] and enemies of Turkey under the guise of credit rating firms.” Recall that Turkey was downgraded to double-B-minus from double-B by S&P on May 2, which followed a cut to Ba2 from Ba1 at Moody’s on March 7.
Erdogan has good reason to be agitated. The Turkish lira continues to spiral, breaking above 4.3 per dollar today, more than 50% below its five-year average dollar exchange rate of 2.85. Amid soaring inflation (CPI has expanded by double digits year-over-year in nine straight months), the country’s bond yields are spiking. The 10-year now yields 13.72%, up from 10.6% in September and 6.1% in May 2013. The short end is faring even worse, with the Turkish two-year yield jumping to 16.14%. That’s up from 11.6% as of September and 4.8% in May 2013.
As for the provenance of this unwelcome reaction, Erdogan has this theories: “Interest rates are the reason for inflation. Inflation is not the cause, it’s an outcome. We’ll pull down interest rates.”
Turkish two-year yield. Source: The Bloomberg
Although comparatively lacking in the rhetoric department, the financial situation in Argentina could be even more dire. The South American land of the Patagonia Mountains, Mendoza wine country and regular sovereign default was compelled to seek IMF assistance earlier this week, as its peso has been clobbered by more than 6% today and 20% in the past three weeks against the dollar, despite regular interventions by the Argentine central bank. The central bank has likewise hiked its seven-day repurchase reference rate to 40% from 27.25% on April 26, to no avail.
IMF president Christine Lagarde struck an optimistic tone after meeting with Argentine Treasury Minister Nicolas Dujovne, noting that: “I stressed my strong support for Argentina’s reforms to date, and expressed the Fund’s readiness to continue to assist the government.” That news is not exactly music to the Argentine people’s ears. An early May poll of more than 1,000 citizens found that 75% of respondents considered president Mauricio Macri’s decision to seek IMF assistance “a bad move,” according to the Associated Press.
While the IMF establishes a beachhead, Harvard University is eyeing the door. Today, Bloomberg reports that: “Harvard Management has approached investors to buy minority or majority stakes in as much as $700 million of property in Brazil, Uruguay and Argentina, and become strategic partners at the same time in an effort to reduce the endowment’s risk.”
Recap May 11
Stocks drifted sideways, wrapping up the week 2.3% in the green on the S&P 500 while the VIX volatility index closed below 13 for the first time since January. Treasury yields mostly ticked higher with the exception of the 30-year long bond, pushing the 5- and 30-year spread to just 26 basis points, the narrowest since June 2007. Commodities broke their winning streak, with energy and metals both finishing broadly lower despite a weaker greenback.
- Philip Grant
Thursday, May 10, 2018
Credit check
Bond bulls caught a reprieve. This morning’s release of the April CPI showed a 2.1% year-over-year increase in core inflation, slightly less than the consensus 2.2%. Although that figure still matches the highest reading since February of last year, the data spurred a bullish response across the Treasury curve, pushing the 10-year yield to 2.97% from an above 3% finish yesterday. Today’s bounce aside, the upward pressure in rates appears intact. The 10-year’s flirtation with 3% compares to 2.4% at year-end 2017 and a reading as low as 1.36% in July 2016.
How has corporate credit fared during this interest rate levitation? Year to date, the iShares Iboxx Investment Grade Corporate Bond ETF has traded lower by 5.4%, while its high yield counterpart has lost only 1.8%. The relative outperformance in high yield comes amid ongoing economic expansion and the powerful rally in energy prices, underpinning the second largest segment of the junk market. (Oil and gas companies comprise 14.5% of U.S. high yield, according to Bloomberg).
Credit investors who favor high-yield over investment grade have a bit of history on their side. During the prior Fed tightening cycle from July 2004 to August 2006 (when the overnight funds rate rose to 5.25% from 1%), the ICE Bank of America Merrill Lynch High Yield Option-Adjusted Spread narrowed to 349 basis points from 402 basis points. During that same period, the ICE Bank of America Merrill Lynch Investment Grade Option Adjusted Spread barely budged, widening to 97 basis points from 96.
A May 4 report from Moody’s further colors the resilience in U.S. high-yield. The ratings agency notes that the Moody’s Liquidity Stress Indicator metric matched its record low of 2.5% in April, “as speculative-grade issuers continue to benefit from a growing U.S. economy, which is fueling strong corporate earnings and cash flow.”
The robust risk appetite currently on display was crystallized by an announcement from soon-to-be Bausch Health Companies, Inc., a.k.a. Valeant Pharmaceuticals International (the company will officially change its name in July). This morning, the B3/single-B-rated, highly leveraged (7.3 times net debt to EBITDA) specialty pharmaceuticals company announced a $5.315 billion offering of loans and bonds to refinance an existing term loan, the third such debt exchange for the leverage-laden specialty pharma concern since December (Almost Daily Grant’s, March 13 and Dec. 5). For a trip down memory lane to Valeant’s high-flying days as acquisitive industry heavyweight, see the issue of Grant’s dated March 7, 2014.
Valeant is looking for more than just better interest rates from its creditors. The company likewise announced its intention to amend its existing credit agreement, including “modifying the [loan] covenants to provide the Company with enhanced operating flexibility,” according to the press release. Jim Schaeffer, co-head of public fixed income at Aegon USA Investment Management, commented to Bloomberg that: “Given the economic environment right now, you’ve got to feel pretty good that there are windows of times for companies to take advantage and refinance maturities in the 2020-to-2022 window.” Indeed. Yesterday, Moody’s reported that its Covenant Quality Indicator remained at its weakest level for a record-setting 12th consecutive month in April.
While U.S. high yield investors sleep soundly, their peers in the world’s second largest economy enjoy no such respite. This morning, Bloomberg reports that yields on Chinese dollar denominated junk bonds rose to their highest since April 2016, above 8% on average, “amid a bulging pipeline and the absence of a strong demand from mainland investors.” A separate Bloomberg dispatch yesterday noted that “Chinese companies are facing a surge in distressed events as more companies struggle with debt payments amid record bond maturities.”
How’s that for decoupling?
QT progress report
No progress this week. The Fed’s portfolio of securities held outright registered at $4.145 trillion, a $68 million uptick from a week ago. An increase in its Treasurys holdings accounted for all of the change. Compared to its trailing four-week average, the Fed’s portfolio is down by $18.4 billion, with 72% of that decline coming from USTs and the rest from its mortgage-backed-securities portfolio.
Since the onset of QT on Oct. 1, 2017, the Fed’s total assets have declined by 2.19%, a simple annualized pace of 3.54%.
Recap May 10
The bull parade continues. Stocks caught another sharp bid, with the S&P 500 rising by nearly 1% for a second straight day to reach a six week closing high, while the VIX finished lower for a sixth straight session. Commodities continued their ascent as the dollar index pulled back, and Treasury yields pushed lower across the long end of the curve amid this morning’s inflation data and a strongly bid 30-year bond auction this afternoon.
- Philip Grant
Wednesday, May 9, 2018
We have ice cream at home, kids
It was an incongruous sight in the midst of what is already the U.S.’ second-longest post-World War II economic expansion, even before the tax cuts.
It was an incongruous sight in the midst of what is already the U.S.’ second-longest post-World War II economic expansion, even before the tax cuts.
Recap May 9
We have ice cream at home, kids
It was an incongruous sight in the midst of what is already the U.S.’ second-longest post-World War II economic expansion, even before the tax cuts. Yesterday, the Wall Street Journal reported that RMH Franchise Holdings, Inc., the second-largest franchise owner of Applebee’s Restaurants, filed for Chapter 11 bankruptcy protection in Delaware court. The franchisee operates 163 locations across 15 states, mostly concentrated in the South and Midwest.
The plight of restaurant franchisees, the subject of a scintillating talk by Franchise Times Corp. president John Hamburger at the Grant’s Spring Conference, is beginning to get the attention of Wall Street. A research report from Piper Jaffray published Monday discussed the tribulations facing banks who are active in lending to restaurant franchisees. The Piper analysts conclude that:
If recent industry profitability metrics persist and certain macro headwinds remain in place (or worsen), we would expect specific reserve allocations to continue to move higher and some [net charge offs] to emerge for certain lenders.
Problems in the restaurant industry are not confined to the franchisees. This morning, The Wendy’s Company (WEN on the Nasdaq) reported first quarter results that included weaker than expected adjusted earnings before interest, taxes, depreciation and amortization as well as slower than expected same store sales growth. The company also alerted investors to “a slight decrease in net new unit growth . . . primarily driven by the timing of North American restaurant closures within the year as we continue to build a stronger system.” On the subsequent conference call, Wendy’s president and CEO Todd Penegor replied to an analyst inquiry on customer store traffic for the broader industry: “To start the year, it’s been slightly down.”
The comprehensive troubles that have befallen the restaurant industry have not spared The Middleby Corporation (MIDD on the Nasdaq), which produces kitchen appliances and capital equipment used in the food-service industry. Middleby also reported first quarter results today, which included a 6.1% year-over-year decline in operating income and a 7.2% year-over-year drop in net sales, after excluding the impact of acquisitions, foreign exchange and accounting standards. Investors were not pleased, sending MIDD shares lower by 17.5%. Since June 2016, Middleby shares have lost 10%, while the S&P 500 has gained 30%.
On the conference call, Middleby CEO Selim A. Bassoul described a schism in the food service industry between the premium products his company carries and the no-frills alternatives that might appeal to more price-conscious operators. Bassoul noted that a franchisee who is under pressure might be more inclined to shop down-market when purchasing equipment.
MIDD shares in the post-crisis era. Source: The Bloomberg
Grant’s offered subscribers a pair of bearish analyses of Middleby in 2016 (“Waiter, the check,” on June 17 and “Out of the kitchen,” on Dec. 23), arguing that the acquisition-heavy company’s long run of operational and stock market success was due to be interrupted by an overcapacity-driven slowdown in the restaurant industry (Middleby derived 59.2% of 2017 revenues and 75% of operating income from its commercial foodservice unit, according to the company’s form 10-K).
The June 16 edition drew a parallel between the post-crisis engorgement in the food service industry (and Middleby’s share price) and macroeconomic factors, namely the near-decade of microscopic interest rates administered by the Federal Reserve in response to said crisis:
It’s a tenet of these pages that low-cost debt pulls demand from the future to the ZIRPy present. Maybe the debt-fueled consolidation of big restaurant franchisees has given a temporal yank to the demand for commercial kitchen machinery.
It was quite a feast. Now, maybe time to hit the gym.
Recap May 9
The bulls have donned their track clothes. Stocks jogged higher, with the S&P 500 gaining nearly 1% to finish at a three week high, while the VIX dropped below 13.5 for the first time since Feb. 1, shortly before the volatility explosion which resulted in the demolition of the VelocityShares Daily Inverse VIX Short Term ETN. Treasury yields rose across the board with the 10-year rising back above 3%, and energy continued its rampage with WTI crude exceeding $71 a barrel despite a flat greenback.
- Philip Grant
Tuesday, May 8, 2018
Ball four
Escalator temporarily out of order. Last week, beverage packaging company Ball Corporation (BLL on the NYSE) delivered first quarter results that easily topped consensus on both the top and bottom lines amid strength in its South American operations, while reiterating its 2018 and 2019 free cash flow and EBITDA (earnings before interest, taxes, depreciation and amortization) forecasts and increasing its share repurchase authorization to boot. John Hayes, Ball’s chairman, president and CEO, didn’t curb his enthusiasm on the conference call, stating that:
Now, as we look forward for our corporation, we are on track to achieve our 2019 targets and longer term, we believe that we have a once-in-a-generation opportunity in front of us right now . . . And we are truly leaning into our efforts to ensure that the world understands with great clarity that aluminum beverage cans are indeed the most sustainable package in the beverage world.
Investors responded to all this good news with a stifled yawn, as shares edged lower by 2%. Since the fall of 2016, BLL shares have barely budged when accounting for a two-for-one stock split in summer 2017, while the market has revved higher to the tune of a near 25% advance on the broad S&P 500.
Ball’s stock price may be stuck in the mud, but the longstanding supplier of steel and aluminum cans still has a friend in Mr. Market. The company trades at a princely 36 times 2017 GAAP earnings, or, for a more fashionable metric, 11 times enterprise value to consensus 2018 adjusted EBITDA (a figure which excludes costs from “business consolidation and other activities,” according to the company’s form 10-K). Likewise, Ball’s 7% free cash flow yield compares to a near-10% free cash flow yield currently on offer in peer Crown Holdings Incorporated (CCK on the NYSE). The sell-side is bullish, with nine buy recommendations against four hold ratings. No analyst says “sell.”
So what explains Ball’s recent underperformance? Intense competition, limited pricing power in the relatively mature global beverage business and the company’s fancy valuation are three apparent constraints. Ball’s 2016 acquisition of London-based Rexam plc for $8.5 billion in cash and stock was the largest deal in the Broomfield, Colo.-headquartered institution’s long history (Ball was founded in 1880), goosing 2017 revenues and adjusted EBITDA by 41% and 62%, respectively, from their 2015 levels. At the time of the acquisition, Hayes targeted $300 million in cost synergies, some 10% of the acquisition target’s 2015 sales. On last week’s call, Hayes demurred on providing an update, telling an analyst that: “We're really not going to talk specifically about synergies because we don't want to get into a discussion about what's a synergy and what's not a synergy. We just are focused on the EBITDA as a corporation.”
A bearish analysis of Ball in the Oct. 28, 2016 edition of Grant’s (“Kicking the can”) noted the less-than bullish circumstances which colored the pair’s mutual courtship.
The tie-up between Ball and Rexam appears to be a countermeasure undertaken in reaction growing consolidation in the beverage business. Many companies invest for growth. We judge that Ball invests not to shrink.
Graham Chipcase, the former Rexam CEO, writing to his shareholders last year, seems to suggest as much: “[C]onsolidation continues in the beverage industry, with customers taking a more coordinated, global approach to procurement to help them lower costs and innovate. They are also demanding a more complex product offering as they seek differentiation and shelf appeal.” Reading Chipcase’s letter and listening to his comments on Rexam conference calls, you understand the appeal of selling out to Ball Corp.
While Ball’s leverage burden appears relatively manageable (Luxembourg-based competitor Ardagh Group carries net debt amounting to 4.8 times adjusted forward EBITDA), the company still bears interest rate risk. Ball’s $7.1 billion in total debt is frontloaded with a relatively short-term maturity schedule, including $1.5 billion in bond principal due in 2020 and an additional $1.8 billion in 2023. Overall the company’s nine bond issues carry a weighted average maturity of less than five years. We can make one fearless interest rate forecast. Ball will be rooting for lower ones.
Meanwhile, Hayes’ upbeat commentary and the recently upsized stock buyback suggests Ball is bullish on itself. Ball management? Less so. In the past year, company insiders have disposed of 268,940 shares in open market sales, netting proceeds of just under $11 million. Vice president Daniel Fisher made the lone open market purchase over the past year, of 9,000 shares on Feb. 27.