Almost Daily Grant's
“Almost Daily” is the new, end-of-day delectation from Grant’s.
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Friday, May 25, 2018
Jumble-aya
As the Memorial Day weekend is upon us, we pause to take inventory of current financial conditions. Happy days are here again for the U.S equity (both public and private), structured credit and real estate realms.
At an investment conference on Tuesday, private equity titan David Rubenstein of the Carlyle Group observed that: "It’s easier to raise money than any time I’ve been in the business over the past 30 years or so," according to Bloomberg. Netflix, Inc., (NFLX on the Nasdaq) is certainly encountering similar investor generosity on the public side.
Netflix, one of the foremost principals of the post-2009 bull stampede and large cap standard-bearer in 2018 (the stock is up 85% year-to-date, 661% from January 2015 and 5,241% from its interim lows on the end of the recession in mid-2009), achieved a notable milestone yesterday. With a 2.6% intraday rise, the streaming content provider saw its market capitalization rise to nearly $153 billion, surpassing that of legacy behemoth Walt Disney Co., (DIS on the NYSE) which is five years away from celebrating its centennial.
A comparison of the pair’s benchmark financial metrics doesn’t fail to leave an impression. Fast-growing Netflix has more than doubled its revenues and adjusted net income in the past three years to $11.7 billion and $597 million, respectively in 2017. Disney, which posted a top line of $56.9 billion in the past year, managed an adjusted net income figure that rivals Netflix’s revenues, with $9.75 billion over the past 12 months (DIS operates on a fiscal calendar ending Sept. 30).
Free cash flow perhaps paints the starkest contrast: While Netflix burned just over $2 billion in cash last year and management expects cash burn to accelerate to $3 to $4 billion in 2018, Disney has generated $10.7 billion in FCF over the past four quarters.
“Stranger Things” is more than just a hit show.
Euphoria-type conditions are not confined to equities. The housing market is also kicking into gear. Wednesday’s release of the first quarter FHFA House Price Index showed a 1.7% sequential jump, well above the expected 0.7% advance. On Wednesday, the Commerce Department’s new home sales data for April showed the average new home price rose to a record $407,000, up 11% year-over-year.
Those gaudy gains are enticing the return of an infamous character from cycles past: The house flipper. In a May 16 blog post, Bin He, economist at CoreLogic, Inc., detailed his findings:
At a national level, the ratio of flipped properties to sales reached 6.2 percent in the first quarter of 2018, which matches the post-crash high in the first quarter of 2013. The first time it reached this level after the housing crash, home prices had just started to recover, and there were still a considerable number of distressed properties on the market.
However, the flipping dynamics have changed over time. The share of distressed properties sold has declined significantly, from 30 percent in January 2013 to 4.4 percent at the end of 2017. Additionally, as a result of six years of home price appreciation and limited for-sale inventory, in many areas, home prices have already passed the peak values reached before the market crashed.
Consequently, the acquisition cost in nominal dollars for investors has increased drastically. High acquisition cost, tight inventory, and rising flipping activities together point to possible speculation: investors are betting on continuous home price growth.
Who can blame them? It’s not like we’ve ever had a national decline in, uh, never mind.
With home prices on the march, another pre-crisis mainstay is making a triumphant return: Structured credit. A May 23 dispatch from Bloomberg reports that registration jumped by 45% for this year’s IMN Annual Investors’ Conference on [Collateralized Loan Obligations] and Leveraged Loans. Chrystalle Anstett, managing director at Eaton Partners, told the assembled throng: “No brainer, you need CLO’s in your portfolio.” Farboud Tavangar, senior portfolio manager at LCM Capital Management, cautioned that “CLO portfolios are far more aggressive,” than their pre-crash forebears, concluding that lenders “have no bargaining power.”
Indeed, according to S&P Global Intelligence’s LCD unit, the ratio of “covenant-lite” loans rose to a fresh record of 82% in April, up from 20% in 2011. Christina Padgett, a loan analyst at Moody’s, struck a stoic tone, telling the Financial Times that: “There is no point in talking about financial covenants any more, or calling a deal ‘cov-lite’. They are all cov-lite. Cov-lite is the new normal.”
One infamous name from cycles yore is dipping its toe back in the water. This morning, LCD reports that a subsidiary of AIG Group, Inc., the insurance company turned 2008-era ward of the state, is acquiring Covenant Credit Partners, “an alternative credit manager with a focus on below-investment grade corporate credit,” according to the investment firm’s website, for $900 million.
Thursday, May 24, 2018
CoCo beware
What bull market? You’d never know about the current good times on Wall Street by following the travails of Deutsche Bank AG (DB is its NYSE-listed American depository receipt). The German banking behemoth is under financial siege, beset by poor results, tumult in the C-Suite and a fast-shrinking share price.
Unflattering news has been plentiful of late. Today, Deutsche Bank announced it will reduce its global staff to “well below” 90,000 from its current 97,000 headcount. On April 20 Bloomberg reported that the bank had inadvertently wired €28 billion ($32.8 billion), or about 41% of Deutsche’s reported equity for the first quarter, in funds to an outside account. CEO Christian Sewing said today that the error resulted from an employee inputting the transfer in euros, instead of yen. Bloomberg likewise reports today that DB also accidentally transferred €21 billion to Macquarie Bank in 2014.
The newly minted CEO (who replaced John Cryan in April) did little to change the desultory mood by announcing that second quarter results would be constrained by “a revenue environment [that] remains challenging.”
That would be no break from recent experience. Revenues declined to €29 billion in 2017, down from €32.8 billion and €37 billion, in 2016 and 2015, respectively. The Street expects the top line to contract further to €26 billion this year.
As revenues dwindle, DB stock has also hit the skids, currently trading at €10.36, the lowest level since October 2016. That leaves shares priced at just 35% of first quarter book value. Rival too-big-to-fail banks such as BNP Paribas, Credit Suisse Group AG and Bank of America Corp. shares trade at 83%, 97% and 126% of book value, respectively.
But while Deutsche Bank’s share price and news coverage evoke the fraught days of 2016, one substantial difference is the performance of its contingent convertible, or “CoCo” securities.
DB share price in orange, CoCos in white. Source: The Bloomberg
CoCos are a peculiarly-structured investment specimen; perpetual debt securities which are convertible to equity or written down when the sponsoring bank runs into trouble and capital falls below a certain level. Issuers’ ability to raise equity at times of stress earns these CoCos the seal of approval of European bank regulators.
After wavering in the early-2016 risk aversion spasm, these exotic securities have performed well. The Bloomberg Barclays Contingent Capital Total Return Index has risen by more than 36% from its February 2016 nadir, topping the 29% gain in the Stoxx Europe 600 equity index over that period.
Naturally, CoCo’s solid recent performance and friendly stance from regulators have paved the way for bustling growth. MSCI calculates global CoCo supply outstanding at $675 billion as of September. That compares with €80 billion ($93 billion) in July 2014.
The risks of these untested investment contraptions were detailed in the July 11, 2014 edition of Grant’s (“Left hand, right hand”), which noted the ready potential for unintended consequences:
Conversions or write-downs, when they’re finally forced, won’t take place under wraps. The news will start a highly focused reassessment of the creditworthiness of the stricken CoCo issuer or issuers. Providers of short-dated liabilities – certificates of deposit, uninsured deposits, commercial paper – are likely to arrive at the same conclusion more or less simultaneously.
That hypothetical day of reckoning has yet to arrive. Although the Bloomberg Barclays CoCo Index lost more than 18% in the two months prior to February 2016 as DB suffered its prior wobble, last June’s wipeout of Banco Popular’s CoCo holders (the bank was sold to Banco Santander under distress) generated no ill effect on the broader asset class. Last week WisdomTree Investments, Inc. announced the launch of the WisdomTree AT1 CoCo Bond UCITS ETF on the London Stock Exchange (ticker: CCBO LN).
Now you can help bolster the tier one capital ratio of European banks from the convenience of your mobile device.
QT progress report
The Fed’s portfolio of securities held outright stands at $4.137 trillion, down by about $8 billion from last week’s reading. Once again it was a decline in Treasury holdings that accounted for the change; the Fed’s portfolio of mortgage-backed securities has now risen or remained unchanged for three straight weeks.
Compared to the trailing four-week average, securities held outright are down by just under $20 billion. Since the Fed began QT on Oct. 1, total assets are down by 2.66%, for a simple annualized pace of 4.04%.
Recap May 24
Stocks finished in the red but well off their early lows, leaving the broad S&P 500 in positive territory for the week thus far. Treasurys maintained their recent strength as a well bid seven-year note auction this afternoon helped yields move lower across the curve. The Dollar Index moved lower but recent emerging market trouble spots Turkey and Argentina saw their currencies weaken against the greenback, while gold rose back above $1,300 despite a selloff in the CRB commodity index.
- Philip Grant
Wednesday, May 23, 2018
Communication breakdown
Time for plan B. Yesterday, Bloomberg reported that debt-addled telecom operator Frontier Communications Corp. (FTR on the Nasdaq) is negotiating a potential debt restructuring with its creditors, after attempts to sell landline assets in Florida, California and Texas that the company purchased from Verizon Communications, Inc. in 2015 “failed to generate an acceptable price.”
Lindsay Gibbons, analyst at Creditsights, Inc. explained Frontier’s dilemma to Bloomberg:
The problem is that they have a weak negotiating position. If they sold Florida for less than what they paid, it wouldn’t look good and it puts a watermark on the other asset sales.
Frontier can certainly use some help with its balance sheet. Against net debt of $19.5 billion, the company is expected to generate $3.5 billion in adjusted earnings before interest, taxes, depreciation and amortization in 2018, for a leverage ratio of about 5.5 turns. Trailing 12-month interest expense of $1.52 billion exceeds consensus expectations for operating income in both 2018 and 2019. The single-B-minus rated, senior unsecured 11s of 2025, issued to help finance the purchase of those Verizon assets, fell below 80 cents on the dollar today, for a yield-to-worst of 15.72%.
The Oct. 2, 2015 edition of Grant’s (“Frontiers of junk”) featured bearish assessments of debt heavy roll- ups (now looking to un-roll themselves) Frontier and Dutch telecom Altice N.V. An anonymity seeking friend of the publication summed up the predicament facing wireline companies such as Frontier:
These firms have tried to straddle a line of providing high current income to shareholders while trying to hold on to their subscribers and keep their revenue streams from declining. Increasingly, they are trading high-margin legacy voice and circuit-switched revenue for much lower margin Internet Protocol (IP)-based revenue, and they are having to maintain fairly high levels of capex in order to provide services that are competitive with cable providers and other combatants, or else risk watching their customers defect. That’s a combo that doesn’t bode well for shareholder payouts generally.
For all of Frontier’s financial woes, the company also appears to be underinvesting in its business. While capital expenditures footed to $1.17 billion in 2017, depreciation and amortization expense was nearly double that, at $2.12 billion.
While the yield on Frontier’s junk-rated bonds goes higher, investors are set to bestow generous terms on another less-than pristine credit. Yesterday, S&P Global Intelligence’s LCD unit reported that metals company Atotech, Inc. is offering $300 million in high yield, unsecured notes with a “PIK toggle” feature, which gives the issuer the right to pay interest with additional debt instead of cash. The last such unsecured PIK offering was made in November by Sotera Health.
Covenant Review, an independent credit research firm, details some particularly issuer-friendly features to the Atotech high yield offering, observing that: “These notes will be holding company debt, with no guarantees from subsidiaries. Thus, these Notes will be structurally subordinated to all debt of the subsidiaries . . . A widely held public company could acquire The Company without triggering the Change of Control put.” Analyst Ross Hallock goes on to summarize:
The financial metrics allow for excessively liberal pro forma adjustments. Pro forma effect may be given to any “operational efficiencies” or “strategic initiatives.” In other words, pro forma adjustments may be made for just about anything.
Rarely a dull moment in high-yield.
Slumbering samurai
The rout in the Turkish lira reached a fever pitch this morning, as the currency weakened more than 5% intraday to a fresh record low of 4.92 per dollar, necessitating an extraordinary central bank meeting and 300 basis point interest rate hike to 16.5%. Although termed “a very weak response” by strategists at Brown Brothers Harriman & Co., the move seemed to work for now, as the lira recouped its early losses and rallied to 4.6 per greenback late in the U.S. session.
Turkey’s spiraling currency and local bond yields are unwelcome news for the hordes of Japanese speculators who have been reaching halfway across the world for income. Bloomberg notes today that margin traders in the Land of the Rising Sun had recently upsized their exposure to the Turkish lira, holding a net long position of 323,537 contracts as of May 15, up from 266,955 contracts at year end.
The financial connection between Turkey and Japan extends beyond currency speculation. As noted in the April 3 edition of Almost Daily Grant’s, Turkey sold ¥60 billion ($546 million) in three-year samurai notes in December, at a 1.81% coupon.
The issuer may be teetering on the financial precipice, but you wouldn’t know it from the performance of the samurai bonds. They have barely budged from a post-issuance rally and remain comfortably above par.
Meanwhile, during a speech this afternoon Turkish president Recep Erdogan called on his citizens to keep their money in lira. The million dollar (lira) question: Will Erdogan escalate his rhetoric into action, in the form of capital controls?
Recap May 23
Stocks enjoyed a late rebound to finish in the green, as a few dovish remarks in the latest FOMC meeting minutes this afternoon led to a decline in the market’s rate hike expectations (interest rate futures currently price in a 2.25% Fed Funds rate at year end, down from 2.32% yesterday). Treasury yields moved sharply lower across the board, and the dollar and commodities both finished slightly higher. The VIX sold off late to finish at its lowest close since late January.
- Philip Grant
Tuesday, May 22, 2018
Under the hood
No ZIRP? No problem, mostly. Since the Federal Reserve began its tightening regime with the first of six 0.25% increases in December 2015, the S&P 500 has cruised higher by 36% with only a pair of notable interruptions, in February 2016 and earlier this year. Rate-focused equity bulls can take further reassurance from recent history. The Fed’s prior two tightening cycles, from 2004-2006 and 1999-2000, both coincided with double-digit gains in the broad index.
Of course for the corporate realm, rising borrowing costs are a mixed blessing. While some industries shrug them off or even thrive in times of dearer money, others might wish things had stayed the way they were. Indeed, since the Fed began tightening policy, the three worst performing S&P sectors have been interest rate-sensitive real estate, telecom and consumer staples, up by 4%, 2% and 1%, respectively.
Homebuilders, which fared extremely well through 2017, have lately been consigned to the latter category. Since January, the S&P Supercomposite Homebuilder Index has flirted with bear-market territory. Following a 20% drop, the index has continued to falter even as the broad market steadied and rebounded.
A recently-skyrocketing lumber price (up 72% since June even after a 7% pullback in the last four trading days) is one ready explanation. Rising mortgage rates, and their potential impact on demand, are another potential factor. Last Thursday, Freddie Mac reported that the average fixed-rate mortgage rose to a seven-year high of 4.61%, up from 4.55% the week prior and 4.02% a year ago. The Mortgage Bankers Association forecasts that the 30-year benchmark rate will reach 5% this year, and 5.5% by the end of 2019.
The recent sickly price action in homebuilders received some fundamental confirmation this morning, as high-end operator Toll Brothers, Inc., reported weaker than expected second quarter results, including shortfalls in new orders and gross margin relative to analyst expectations, sending shares lower by 10%. While CEO Douglas Yearley, Jr. cited the jump in lumber costs as a contributing factor for the disappointment, he dismissed the role of rising rates, telling analysts on the conference call that:
They have not impacted our business. Look at the second quarter results. Our sales teams around the country have had nothing to say. All right. They've had no issues. So on the rate side, a 4.87% rate, as I mentioned, is still a low rate and is only 75 basis points up from a year ago. So right now we're very comfortable with our business and [see] no issues out there.
Indeed, despite a seven-year high in the Freddie Mac survey mortgage rate, the data series sits barely above its post-recession average of 4.13% and well below its 30-year mean of 6.5%. Likewise, the overnight Fed Funds and 10-year Treasury rates both remain well below their respective long-term averages.
But the current rising rate cycle looks far from over. Futures markets continue to predict between two and three additional Fed hikes this year, underpinned by a visible uptick in inflation with both the CPI and PCE deflator metrics at their highest in over a year. This morning, the wages subcomponent of the May Richmond Fed regional manufacturing index rose to its highest reading since 1997. Jonathan Tepper, chief editor of Variant Perception and a recent guest on the Grant’s podcast (click here to listen), details other wage-inflation sightings in a May 17 analysis of the labor market:
The [National Federation for Independent Business] compensation plans is now at the highest point in the last twenty years. Small businesses expect to raise wages, and a majority of industries are experiencing wage increases. We will see higher growth rates for hourly wages and the Employment Cost Index.
For many consumers, the bump in pay comes not a moment too soon. According to the Fed’s consumer credit data series, student loans outstanding topped $1.5 trillion in the first quarter, up 39% in the past five years and 146% since 2008. Meanwhile, the Department of Education announced Friday that starting July 1, undergraduate federal student loan interest rates are set to jump to 5.05% from the current 4.45%.
Signs of a stretched consumer are increasingly visible. The Bureau of Economic Analysis calculates the U.S. savings rate at 3.1% of disposable income for the first quarter, compared to a post-crisis average of 5.5% and 8.5% going back to 1946. Ben Breitholtz of Bianco Research likewise finds that: “Google search trends are reflecting a rise in consumer stress and waning spending patterns . . . The popularity of searches for bankruptcy, default and food stamps reached the highest since late 2008.”
That’s in year nine of the economic expansion. Falling rates giveth, rising rates taketh away.
Recap May 22
A late selloff left stocks modestly in the red, while Treasury yields inched higher across the curve and the dollar, commodities and the VIX all finished little changed. Emerging markets mostly fared well, with the iShares JP Morgan USD Emerging Markets Bond ETF enjoying its best finish in nearly two weeks. However, the Turkish lira continued its tailspin, reaching a new record low of 4.667 per greenback. The lira has lost nearly half its value since the failed coup attempt against Recep Erdogan in summer 2016.
Lira/dollar exchange rate, two-year chart. Source: The Bloomberg
-Philip Grant
Monday, May 21, 2018
Debt decision
Price action in the stock market appears healthy,
Price action in the stock market appears healthy,
A crowded table
It was an un-bullish omen.
It was an un-bullish omen.
Recap May 21
Debt decision
Price action in the stock market appears healthy, with the MSCI World Index hovering in a tight range about 6% below the all-time highs reached on Jan. 26. The bond market? Not so much.
Today, Italian sovereign yields spiked, with the two-year yield nearly tripling to 0.28%, as an already grim fiscal picture faces further erosion from a new coalition government. The anti-establishment Five Star Movement and Northern League have discussed issuing short-term credit notes called “mini-BOTs,” which former economy minister Pier Carlo Padoan described as a “disguised parallel currency.” The selloff in emerging market credits continues, with recently-issued Turkish dollar-denominated 10-year bonds sinking to a fresh price low of 91 cents on the dollar, for a yield-to-maturity of 7.33%.
Corporate issues stateside are giving their beleaguered EM and peripheral European counterparts a run for their money. Bloomberg notes that: “Debt of American companies just posted their third-worst 100-day returns since 2000, according to a JPMorgan Chase & Co. index, as tighter monetary conditions leave their mark on high-quality bonds with longer maturities.”
Meanwhile, futures markets assign an 85% probability of the Federal Reserve hiking interest rates by at least 50 basis points by year-end, from the current range of 1.50% to 1.75%.
Who will blink first, investors or the Fed?
A crowded table
It was an un-bullish omen. On Friday, Campbell Soup Co. (CPB on the NYSE) preceded its April quarter earnings release with a report announcing a “CEO Transition Plan.” CEO Denise Morrison retired, effective immediately, and was replaced on an interim basis by board member Keith McLoughlin.
As might be surmised from a CEO’s abrupt departure on earnings day, the results were not good: Campbell’s now expects fiscal year adjusted earnings per share of $2.85 to $2.90, from a prior range of $3.10 to $3.17. Shares sank by 12% in response, and are now down by 30% year-to-date and 50% from their July 2016 highs (almost exactly coinciding with the lows on the 10-year Treasury yield). For his part, interim CEO McLoughlin promised “a thorough and critical review of all aspects of our strategic and operating plans . . . everything is on the table.”
Campbell, faced with something of an existential threat as consumer tastes shift toward fresh, organic fare in place of its legacy offerings, worked to diversify its product slate under Morrison with 2015’s acquisition of Garden Fresh Gourmet and 2012’s purchase of Bolthouse Farms, among others. Then, Morrison changed tack, announcing in December a $6.1 billion deal to buy snack company Snyder’s-Lance, Inc.
The company paid a fancy price for LNCE, coughing up a 27% premium to its pre-deal closing price and just under 20 times the target’s trailing 12-month adjusted earnings before interest, taxes, depreciation and amortization (EBITDA). Snyder’s-Lance then wrapped up its time as a standalone company by offering far weaker than expected fourth quarter results in February, afflicted by shortfalls in both revenue and operating margins.
The deal has been transformative for Campbell, just not in the way the bulls would want. With total debt now at $9.6 billion, up from $3.5 billion in fiscal 2017 (the company’s fiscal year ends July 31), CPB is expected to generate $1.9 billion in EBITDA and $894 million in free cash flow in fiscal 2019. By contrast, CPB managed $1.8 billion in EBITDA and $953 million in free cash flow in fiscal 2017. Creditors are getting nervous. In March, Campbell issued $700 million in 30-year senior unsecured debt at a 4.80% coupon. Priced just below par on March 12, the bonds have promptly fallen to below 92 cents on the dollar, for a yield-to-worst of 5.36%.
Creditors’ cold feet. The CPB 4.8s of 2048. Source: The Bloomberg
Campbell is of course not the only consumer packaged-foods company struggling with secular changes in taste, overlaid on high debt. Kraft Heinz Co. (KHC on the Nasdaq) has likewise been given the cold shoulder by Mr. Market of late, with shares down by 27% year to date and 42% from its 2016 highs, despite industry-leading EBITDA margins.
The March 25, 2016 edition of Grant’s featured bearish analyses of CPB and KHC with an unambiguous headline: “Sell Big Food,” we proclaimed. The consumer packaged foods industry’s intense competition and shrinking revenues were two points of concern. Dwindling market share at the hands of niche brand, healthy (or healthier) up and coming competitors, another. Noting the pronounced popularity of this traditionally low-risk industry at the time (consumer packaged goods companies then traded at an average 25 times trailing net income), we wrote:
In the physical world, some things are inherently safe, others inherently not. Daisies and dynamite, for example. There are fewer such clear distinctions to be drawn in the world of investing . . . Mispriced investments are inherently risky.
Back in the present day, the Wall Street Journal reported over the weekend that analysts and bankers alike have identified Kraft Heinz as a potential suitor for Campbell. Whether the pair of amply levered companies do indeed look to combine or continue to go it alone, the value restoration project continues apace.
Recap May 21
Stocks were bid to start the week, with the S&P 500 gaining about 0.7% to finish at its best level since mid-March, while a late dollar selloff pushed the CRB Commodity Index to another fresh post-2015 high with WTI crude settling near $72.5 a barrel. Treasurys finished little changed.
- Philip Grant
Friday, May 18, 2018
Fun with filings
Interesting doings of late in the Securities and Exchange Commission’s EDGAR database.
Interesting doings of late in the Securities and Exchange Commission’s EDGAR database.
Recap May 18
Fun with filings
Interesting doings of late in the Securities and Exchange Commission’s EDGAR database. We now present a trio of recent filings that caught our attention. Let’s get right to it.
Yesterday, amply-levered packaged food company Post Holdings, Inc. (POST on the NYSE) filed a form S-1 draft registration statement related to a potential transaction involving its private brands business, which, unlike its legacy cold cereal unit, continues to enjoy sturdy top-line growth (10% year-over-year in the quarter ended March 31). In an accompanying press release, Post notes that options for the unit include “an initial public offering, a placement of private equity, a sale of the business or strategic combination.”
Why quote the press release instead of the S-1 itself? Post opted to file confidentially with the SEC, which first allowed companies below $1 billion in market cap to do so away from the prying eyes of investors via the 2012 JOBS Act. That privilege was extended to all companies in June 2017.
One anonymity-seeking investor familiar with Post was none too impressed, telling Grant’s:
The confidential treatment of Post’s S-1 for its private label unit only inhibits analysis of POST’s overall business. Owners of POST shares may wonder, what information is in the S-1 that management doesn’t want shareholders to see?
For more on Post, see Grant’s Interest Rate Observer, Sept. 16, 2016.
While Post keeps a low profile, the Swiss National Bank has been lightening its load. The SNB, which conjures fresh francs to buy euros in an attempt to stem unwanted appreciation in the swissie, then diversifies into an array of assets including U.S. equities, turned seller in the first quarter. The central bank’s equity portfolio, which rose to $92 billion at year end from $63 billion in 2016, declined to $82 billion as of quarter-end, according to its recently filed form 13-F. Holdings in large cap names such as Apple, Inc., Tesla, Inc., and Nike, Inc., all dropped by about 15% from their year-end levels, while the SNB’s total U.S. portfolio now comprises 2,484 holdings, down from 2,514 on Dec. 31. The gnomes are getting more selective!
The reversal comes as the Swiss have enjoyed a favorable turn of events in the forex market. The Swiss franc, which briefly traded through parity with the euro following the SNB’s early 2015 abandonment of its 1.20 euro floor, has since declined to 1.17 per euro amid ongoing interventions and a negative 0.75% deposit rate, well below the negative 0.4% on “offer” in Europe.
Is a move to less-negative interest rates perhaps the central bank’s next trick? Don’t hold your breath, says SNB president Thomas Jordan. On April 27, Jordan remarked that: “Tightening monetary conditions would be premature at this juncture, and would risk unnecessarily jeopardizing the positive economic momentum that has been established.”
Finally, we turn to the cream of the academic crop, Harvard University. Harvard Management Company returned 8.1% in fiscal 2017, trailing the 19% gain in the S&P 500 and all of its Ivy League peers (it was Harvard’s fourth last place finish in six years). A $1 billion write-down in its natural resources portfolio (Almost Daily Grant’s, May 11) was one culprit.
Newly minted endowment CEO N.P. Narvekar (he joined in December 2016) eschewed happy talk, writing that: “Our performance is disappointing and not where it needs to be. The endowment’s returns are a symptom of deep structural problems at HMC and the resultant significant issues in the portfolio.”
While the SNB is selling big tech, Harvard is buying. According to the recently filed form 13-F, the endowment’s directly managed equity holdings in the first quarter were highly concentrated: Positions in Apple, Inc., Microsoft Corp. and Alphabet, Inc. (née Google) make up an eye-opening 72% of its approximately $817 million in-house U.S. equity long portfolio. As of Dec. 31, the directly managed equity portfolio was mostly invested in ETFs. For reference, total AUM at Harvard was $37.1 billion as of September.
Coming on Monday, the latest edition of the one of a kind Grant’s podcast, with special guests Jonathan Tepper of Variant Perception and John Hempton of Bronte Capital Management. For a sample of Jonathan’s work, follow this link to a recent white paper on how to identify the next market top: http://www.variantperception.com/jimgrant
Recap May 18
Stocks finished slightly lower, wrapping up a low intensity week 0.5% in the red on the S&P 500, while Treasurys caught a bounce with yields finishing lower across the curve. Commodities held steady amid a fresh 2018 high in the Dollar Index, but emerging markets came under pressure with the iShares MSCI Emerging Markets ETF finishing at its lowest closing level since the February sell-off.
- Philip Grant
Thursday, May 17, 2018
BEN down this road
Hasenstab to the rescue! Yesterday, the Financial Times reported that financially ailing Argentina received a timely piece of assistance earlier this week, in the form of $2.25 billion in loans from asset manager Franklin Templeton (BEN on the NYSE) and its star portfolio manager, Michael Hasenstab. Argentina, which was forced to ask the IMF for assistance last week amid a spiraling peso and dwindling FX reserves, was approached by Franklin Templeton to reopen five- and eight-year local currency “Bote” bonds, according to the FT. Luis Caputo, Argentina’s finance minister, was ecstatic, telling Bloomberg that:
You can’t get a bigger sign of confidence from markets when you place a bond in pesos at a fixed-rate on one of the worst days in emerging markets this year. It is a sign of confidence in President [Mauricio] Macri, and the policies he is putting in place.
Templeton is doubling down on Argentina. While the $2.25 billion investment reported in the Financial Times is a fraction of the Bloomberg-tallied $111 billion managed by Hasenstab, his largest funds had already carried a hefty allocation to the Land of Silver: The $38 billion Global Bond Fund had a 4.5% position in Argentina as of March 31, while the EU-domiciled $20 billion Global Total Return Fund, and the $11 billion Emerging Markets Bond Fund carried 7.5% and 10.23% positions, respectively, as of April 30.
Hasenstab and Co. can use a change in fortune: Amid flagging recent performance (the Templeton Global Bond Fund has managed an three year annual return of 2.02%, lagging the 3.45% showing in the benchmark Citigroup World Government Bond Index), Templeton’s fixed income assets have flagged to $277 billion as of April 30, down from $355 billion in mid-2014. Since July 2014, BEN shares have lost 41%, compared to a 47% rise in active management peer T. Rowe Price (TROW on the Nasdaq) and a 38% gain in the S&P 500.
On July 11, 2014, Grant’s offered a bearish appraisal on Templeton (“Sell to whom?”), which was then at the tail end of a charmed run. In the 10 years through 2014, the Templeton Global Bond Fund managed a 9.2% annual return, dusting the 5.3% average global fixed-income portfolio return during that period. Despite (or because of) that success, Hasenstab’s practice of making concentrated bets in illiquid debt instruments was an underappreciated source of risk for Templeton fund investors and BEN shareholders alike, we judged:
What advice might we have for investors in the Franklin Templeton’s star-spangled bond funds? Only that, in any future rush to liquidate, it would be better to be early than late. And for the Franklin Resources’ stockholders, a question: Are you quite sure you know what you own?
Argentina has steadied itself a bit this week, with its peso currently trading at 24.3 per dollar from a close near 25 on Monday, while the dollar-pay century bonds trade at 87.5, up more than two points from the closing lows reached on May 8. Having doubled down on their bullish view on Argentina and with plenty of exposure to other emerging markets, Hasenstab’s funds appear positioned to benefit from any cessation of the recent EM troubles.
Of course, the opposite is also true. Robin Brooks, chief economist of the Institute of International Finance assesses the situation this way: “Rising global interest rates beg the question whether Argentina is an idiosyncratic case or a harbinger of things to come. We worry it might be the latter.” Harvard professor Carmen Reinhart unfavorably compared the present day to the 2013 “taper tantrum” and 2008 , telling Bloomberg that: “The overall shape [emerging markets are in] has a lot more cracks than it did five years ago and certainly at the time of the global financial crisis.”
Watch this “space.”
QT progress report
An $8.6 billion decline in the Fed’s Treasurys holdings left the central banks' portfolio of securities held outright at $4.137 trillion this week, down by $8 billion from a week ago as its mortgage-backed securities holdings ticked up slightly. Compared to the trailing four week average, securities held outright are down by $19.6 billion, $17.3 billion from of the decline from USTs and the remainder from MBS.
Since the Fed began its portfolio run-off on Oct. 1 2017, total portfolio holdings are down by 2.65%, a 4.15% simple annualized pace.
Recap May 17
Stocks finished little changed, continuing the recent consolidation in the S&P 500, which sits lower by less than 0.5% for the week, while commodities, the dollar and the VIX also drifted sideways. The treasury curve steepened as prices sold off at the back end; while the recent flattening has received plenty of attention (including here), the 30-year yield is likewise moving higher. Today’s close of 3.25% in the highest since September 2014, and compares to 2.1% on the July 2016 cyclical lows.
-Philip Grant
Tuesday, May 15, 2018
Where the rubber meets the road
The second-longest postwar expansion on record continues at a humdrum pace.
The second-longest postwar expansion on record continues at a humdrum pace.
Recap May 15
Where the rubber meets the road
The second-longest postwar expansion on record continues at a humdrum pace. Real GDP grew by 2.3% in first quarter compared to a 20-year average growth rate of 2.5%, while retail sales ex-automobiles have grown by an average 0.3% month-over-month through the first four readings of 2018, matching the 20-year average monthly growth rate.
Other indicators are seeing more substantial departures from the norm. Today, the Journal of Commerce reports on the major impact that fast-rising oil prices and post-hurricane rebuilding efforts in Texas and Florida are having on the trucking industry, as spot market rates reached a record $2.72 per mile in the week ending May 5 according to data from Morgan Stanley.
“Flatbed capacity is exceedingly tight and will likely tighten further as milder weather finally arrives in northern regions. There seems to be very large imbalances regionally; creating ‘panic’ freight buying,” one anonymous shipper said in the biweekly Morgan Stanley Truckload Index.
Rates per mile were up 10% for flatbed carrier Daseke, Inc., according to its first-quarter earnings report. Universal Logistics Holdings reported revenue per mile, excluding fuel surcharges, rose 12.7% year-over-year.
“We have not seen a rate environment like this for a long, long time, if ever,” said Robert Ragan, chief financial officer with Melton Truck Lines.
“I’ve never seen anything like this in more than 30 years in business,” added Joyce Brenny, CEO of Brenny Transportation. “Volume was at least manageable a year ago. We were doing well and rates were good. But now it’s out of control and we can’t keep up.” She said new shippers are waiting 10 to 14 days to get an available truck. Last year, the wait was about three days, and during leaner times it was as little as 24 hours.
Of course, one company’s revenue is another’s cost input. The surge in trucking rates is already taking a toll on the consumer goods realm. As noted in an April 24 Wall Street Journal dispatch, a number of senior executives commented on the unwelcome acceleration in transportation costs in the first quarter. Coca-Cola Co. reported a 20% year-over-year rise in freight expense, while Proctor & Gamble Co., Hasboro, Inc., Danone SA and Nestle SA also mentioned higher costs. Consumer staples giant Unilever PLC forecast a high-single digits to high-teens jump in U.S. freight costs this year, with chief financial officer Graeme Pitkethly observing that: “Everybody is seeing an increase.”
Meanwhile, inflation metrics are beginning to demonstrate the upward price pressures described by the logistics and consumer goods executives. April headline CPI grew by 2.5% year-over-year, its hottest reading since February 2017. The New York Fed’s Underlying Inflation Gauge (which aims to capture “sustained moves in inflation from information contained in a broad set of price, real activity and financial data”) was even starker, rising to 3.2% year-over-year in April, the highest since July 2006.
FRBNY Underlying Inflation Gauge. Source: The Bloomberg
These increasingly noisy inflationary rumblings are not lost on the bond market, which has sent the 10-year Treasury yield to as high as 3.09% (highest since 2011) today from 1.36% in mid-2016. The short end has sold off even more dramatically, with the two-year yield reaching as high as 2.58% (highest since 2008) today, up from 0.57% in mid-2016.
Federal Reserve Bank of Dallas president Robert Kaplan isn’t too worried, however. Kaplan forecast in a speech this morning that: “In the medium term, I think inflationary forces are still going to be more muted . . . Most of the forces in the world are deflationary.”
For the sake of ongoing economic growth, Kaplan had better be right. With the spread between the two- and 30-year Treasury yield remaining near multi-year lows at 63 basis points and futures markets currently pricing in a 43% likelihood of three additional 25 basis point rate hikes by December, the potential for an inverted yield curve by year end is non-trivial. San Francisco Fed president John Williams (who is set to take over the New York branch on June 18) termed yield curve inversions “a powerful signal of recessions” in an April speech.
By way of postscript, the longest postwar economic expansion in the U.S. ranged an even 10 years, from March 1991 to March 2001. With the current iteration underway since June 2009, could we be in store for a photo finish?
Recap May 15
A surging greenback and jump in Treasury yields gave equity bears their first victory in nearly two weeks, as the S&P 500 declined moderately amid underperformance from interest rate sensitive groups such as real estate and telecom. Commodities mostly held firm amid the rising dollar, but gold faltered, dropping below $1,300 an ounce for the first time in 2018.
- Philip Grant
Monday, May 14, 2018
Harder they come
It’s a brave new world in the credit market. As overall conditions remain forgiving and issuers take full advantage, leveraged loans, which are structurally senior to high-yield bonds and offer more protection against higher rates thanks to a floating rate structure, have enjoyed disproportionately rapid growth. What sort of surprises might await investors in this burgeoning category when the cyclical worm turns?
Thanks to breakneck growth, the leveraged loan market is almost as big as high-yield. According to data from Bank of America Merrill Lynch and S&P Global Market Intelligence, leveraged loans outstanding in the U.S. exceeded $1 trillion as of year-end 2017, double the year-end 2010 level. By comparison, U.S. high-yield debt outstanding footed to $1.1 trillion at the end of 2017, up less than 25% from 2010. Recent performance bears out the divergence in popularity, with the S&P/LSTA Leveraged Loan Index gaining 1.92% year-to-date, compared to a two basis point loss in the Bloomberg Barclays U.S. Corporate High Yield Total Return Index. However, over the past eight years, high-yield has outperformed handily: The Bloomberg Barclays Index has posted an 81% gain since May 2010, nearly double the 47% advance in S&P/LSTA’s Leveraged Loan Index.
As leveraged loans have taken a progressively more prominent role in credit issuance, lower credit borrowers increasingly abound. S&P Global Intelligence’s LCD unit finds that roughly half the loan market is made up of borrowers rated single-B-plus (“the obligor currently has the capacity to meet its financial commitments on the obligation”) or lower. That compares to 32% at that threshold as of 2007.
It’s not just on the ratings scale that the market has been slumming it. The share of “covenant-lite” loans, ones that are bereft of traditional legal protections for creditors against various issuer maneuvers such as piling on new debt, reached a record 77% of the leveraged loan market in April. That compares to 17% in 2007 and roughly 60% as recently as 2015.
The precipitous decline in covenant quality has recently made for some memorable deals, as issuers continue to push the envelope while docile (or desperate) creditors compete with one another to fund them. One such cyclical keepsake was discussed in the most recent edition of Grant’s (“I Can’t Believe They’re Covenants,” May 4). Another, private equity firm KKR & Co.’s recent buyout of Heartland Dental, was highlighted in a Friday dispatch from Bloomberg.
[KKR] included a bold ask: It wanted credit now for earnings that the company expected to get in the future from offices it had just opened. That helped nearly double a measure of income that will be used to test whether the dental-office services company is making enough money to keep borrowing, according to people familiar with the matter.
Guy LeBas, chief fixed-income strategist at Janney Montgomery Scott LLC, draws a provocative comparison between present day leveraged loans and another popular debt security of cycles past. LeBas told Bloomberg that:
The selling points made to buyers are remarkably similar to those made to buyers of subprime mortgages. Low default rates justify weaker documentation and covenant structures deteriorating, and there’s not a lot of pushback against it. Those are yellow flags.
Credit quality concerns are not confined to the U.S. Across the Atlantic, where European creditors face the additional burden of the ECB and its interest rate repression regime (negative overnight deposit rates and ongoing corporate credit purchases, to be specific), leveraged loan growth has zoomed past that of high yield. S&P calculates leveraged loan issuance at €120 billion last year compared to €94 billion in high yield, with €41 billion and €30 billion issued respectively, year-to-date through April. On Friday, Reuters’ International Financing Review and Loan Pricing Corporation units reported that even some investment bankers have had enough:
Several senior bankers told IFR and LPC that they are increasingly rejecting [underwriting business] solely as the covenant terms and leverage deals requested by sponsors are too aggressive.
“I’m worried about it; the documentation is not pretty. We have more internal checks and committees now on deal teams and that’s paramount,” one leveraged finance head said.
For more on this formerly obscure and increasingly noteworthy cordon of the market, tune in to the most recent edition of the Grant’s podcast, with Covenant Review founder Adam Cohen.
Recap May 14
Stocks settled unchanged, the fourth sideways showing on the S&P 500 in six attempts as volatility remains subdued with the VIX holding at 13. Treasury yields ticked higher across the curve to leave the 10-year near 3%, and commodities and the dollar ticked slightly higher in tandem.
- Philip Grant
Friday, May 11, 2018
Inter-species diplomacy
From the New York Post:
From the New York Post:
Hotel California
We can say this for emerging markets: They are definitely not boring.
We can say this for emerging markets: They are definitely not boring.
Recap May 11
Inter-species diplomacy
From the New York Post:
The owners of a private Canadian zoo have been charged after a bear from their facility was driven in a pickup truck to a Dairy Queen drive-through for an ice cream cone, according to reports.
Wildlife officials found out about the outing after the Discovery Wildlife Park posted a now-deleted video to social media earlier this year showing the 1-year-old Kodiak bear, Berkley, leaning out of the truck’s front passenger window for the frozen treat.
“Bears can smell 20 miles upwind,” the narration states in the video, which aims to provide a message of safety related to bears. Another video, which was also removed, reportedly showed the bear licking frosting off an ice cream cake.
They presumably left the bull back at the zoo. Our kind of people!
Hotel California
We can say this for emerging markets: They are definitely not boring. As investors in developed markets around the world currently enjoy mostly placid conditions, their EM brethren face the opposite. This week alone has seen no shortage of crucial developments. We now detail a trio of such notables.
Yesterday, Malaysia absorbed a seismic political shock, in the form of an upset victory by Mahathir Mohamad, 92 years young. Mohamad, who switched to the opposition party to run against incumbent Najib Razak, returns to the prime minister seat he held from 1981 to 2003 by securing the first change in power to an opposition party in Malaysia’s 61-year independent history.
Investors eager for Mr. Market to weigh in are forced to cool their heels through the weekend, as Thursday and Friday were public holidays. For now, we speculate. Andrey Kuznetsov, credit portfolio manager at Hermes Investment Management, gave his assessment to Finance Asia:
As a result of [former incumbent party Barisan Nasional’s] loss, there will be a small negative for Malaysian credit and we would expect a weaker [Malaysian Ringgit]. Investors will require a higher compensation for policy uncertainty and we will watch closely if the fiscal deficit on the back of implementation of campaign pledges will lead to higher than expected sovereign debt issuance.
While what’s old is new again in Malaysia, the Republic of Turkey contends with a more conventional struggle between market forces and a political strongman used to getting his way. In a speech in Ankara today, Turkish president Recep Erdogan railed against “FX speculators, the interest rate lobby [does that include interest rate observers?] and enemies of Turkey under the guise of credit rating firms.” Recall that Turkey was downgraded to double-B-minus from double-B by S&P on May 2, which followed a cut to Ba2 from Ba1 at Moody’s on March 7.
Erdogan has good reason to be agitated. The Turkish lira continues to spiral, breaking above 4.3 per dollar today, more than 50% below its five-year average dollar exchange rate of 2.85. Amid soaring inflation (CPI has expanded by double digits year-over-year in nine straight months), the country’s bond yields are spiking. The 10-year now yields 13.72%, up from 10.6% in September and 6.1% in May 2013. The short end is faring even worse, with the Turkish two-year yield jumping to 16.14%. That’s up from 11.6% as of September and 4.8% in May 2013.
As for the provenance of this unwelcome reaction, Erdogan has this theories: “Interest rates are the reason for inflation. Inflation is not the cause, it’s an outcome. We’ll pull down interest rates.”
Turkish two-year yield. Source: The Bloomberg
Although comparatively lacking in the rhetoric department, the financial situation in Argentina could be even more dire. The South American land of the Patagonia Mountains, Mendoza wine country and regular sovereign default was compelled to seek IMF assistance earlier this week, as its peso has been clobbered by more than 6% today and 20% in the past three weeks against the dollar, despite regular interventions by the Argentine central bank. The central bank has likewise hiked its seven-day repurchase reference rate to 40% from 27.25% on April 26, to no avail.
IMF president Christine Lagarde struck an optimistic tone after meeting with Argentine Treasury Minister Nicolas Dujovne, noting that: “I stressed my strong support for Argentina’s reforms to date, and expressed the Fund’s readiness to continue to assist the government.” That news is not exactly music to the Argentine people’s ears. An early May poll of more than 1,000 citizens found that 75% of respondents considered president Mauricio Macri’s decision to seek IMF assistance “a bad move,” according to the Associated Press.
While the IMF establishes a beachhead, Harvard University is eyeing the door. Today, Bloomberg reports that: “Harvard Management has approached investors to buy minority or majority stakes in as much as $700 million of property in Brazil, Uruguay and Argentina, and become strategic partners at the same time in an effort to reduce the endowment’s risk.”
Recap May 11
Stocks drifted sideways, wrapping up the week 2.3% in the green on the S&P 500 while the VIX volatility index closed below 13 for the first time since January. Treasury yields mostly ticked higher with the exception of the 30-year long bond, pushing the 5- and 30-year spread to just 26 basis points, the narrowest since June 2007. Commodities broke their winning streak, with energy and metals both finishing broadly lower despite a weaker greenback.
- Philip Grant
Thursday, May 10, 2018
Credit check
Bond bulls caught a reprieve. This morning’s release of the April CPI showed a 2.1% year-over-year increase in core inflation, slightly less than the consensus 2.2%. Although that figure still matches the highest reading since February of last year, the data spurred a bullish response across the Treasury curve, pushing the 10-year yield to 2.97% from an above 3% finish yesterday. Today’s bounce aside, the upward pressure in rates appears intact. The 10-year’s flirtation with 3% compares to 2.4% at year-end 2017 and a reading as low as 1.36% in July 2016.
How has corporate credit fared during this interest rate levitation? Year to date, the iShares Iboxx Investment Grade Corporate Bond ETF has traded lower by 5.4%, while its high yield counterpart has lost only 1.8%. The relative outperformance in high yield comes amid ongoing economic expansion and the powerful rally in energy prices, underpinning the second largest segment of the junk market. (Oil and gas companies comprise 14.5% of U.S. high yield, according to Bloomberg).
Credit investors who favor high-yield over investment grade have a bit of history on their side. During the prior Fed tightening cycle from July 2004 to August 2006 (when the overnight funds rate rose to 5.25% from 1%), the ICE Bank of America Merrill Lynch High Yield Option-Adjusted Spread narrowed to 349 basis points from 402 basis points. During that same period, the ICE Bank of America Merrill Lynch Investment Grade Option Adjusted Spread barely budged, widening to 97 basis points from 96.
A May 4 report from Moody’s further colors the resilience in U.S. high-yield. The ratings agency notes that the Moody’s Liquidity Stress Indicator metric matched its record low of 2.5% in April, “as speculative-grade issuers continue to benefit from a growing U.S. economy, which is fueling strong corporate earnings and cash flow.”
The robust risk appetite currently on display was crystallized by an announcement from soon-to-be Bausch Health Companies, Inc., a.k.a. Valeant Pharmaceuticals International (the company will officially change its name in July). This morning, the B3/single-B-rated, highly leveraged (7.3 times net debt to EBITDA) specialty pharmaceuticals company announced a $5.315 billion offering of loans and bonds to refinance an existing term loan, the third such debt exchange for the leverage-laden specialty pharma concern since December (Almost Daily Grant’s, March 13 and Dec. 5). For a trip down memory lane to Valeant’s high-flying days as acquisitive industry heavyweight, see the issue of Grant’s dated March 7, 2014.
Valeant is looking for more than just better interest rates from its creditors. The company likewise announced its intention to amend its existing credit agreement, including “modifying the [loan] covenants to provide the Company with enhanced operating flexibility,” according to the press release. Jim Schaeffer, co-head of public fixed income at Aegon USA Investment Management, commented to Bloomberg that: “Given the economic environment right now, you’ve got to feel pretty good that there are windows of times for companies to take advantage and refinance maturities in the 2020-to-2022 window.” Indeed. Yesterday, Moody’s reported that its Covenant Quality Indicator remained at its weakest level for a record-setting 12th consecutive month in April.
While U.S. high yield investors sleep soundly, their peers in the world’s second largest economy enjoy no such respite. This morning, Bloomberg reports that yields on Chinese dollar denominated junk bonds rose to their highest since April 2016, above 8% on average, “amid a bulging pipeline and the absence of a strong demand from mainland investors.” A separate Bloomberg dispatch yesterday noted that “Chinese companies are facing a surge in distressed events as more companies struggle with debt payments amid record bond maturities.”
How’s that for decoupling?
QT progress report
No progress this week. The Fed’s portfolio of securities held outright registered at $4.145 trillion, a $68 million uptick from a week ago. An increase in its Treasurys holdings accounted for all of the change. Compared to its trailing four-week average, the Fed’s portfolio is down by $18.4 billion, with 72% of that decline coming from USTs and the rest from its mortgage-backed-securities portfolio.
Since the onset of QT on Oct. 1, 2017, the Fed’s total assets have declined by 2.19%, a simple annualized pace of 3.54%.
Recap May 10
The bull parade continues. Stocks caught another sharp bid, with the S&P 500 rising by nearly 1% for a second straight day to reach a six week closing high, while the VIX finished lower for a sixth straight session. Commodities continued their ascent as the dollar index pulled back, and Treasury yields pushed lower across the long end of the curve amid this morning’s inflation data and a strongly bid 30-year bond auction this afternoon.
- Philip Grant
Wednesday, May 9, 2018
We have ice cream at home, kids
It was an incongruous sight in the midst of what is already the U.S.’ second-longest post-World War II economic expansion, even before the tax cuts.
It was an incongruous sight in the midst of what is already the U.S.’ second-longest post-World War II economic expansion, even before the tax cuts.
Recap May 9
We have ice cream at home, kids
It was an incongruous sight in the midst of what is already the U.S.’ second-longest post-World War II economic expansion, even before the tax cuts. Yesterday, the Wall Street Journal reported that RMH Franchise Holdings, Inc., the second-largest franchise owner of Applebee’s Restaurants, filed for Chapter 11 bankruptcy protection in Delaware court. The franchisee operates 163 locations across 15 states, mostly concentrated in the South and Midwest.
The plight of restaurant franchisees, the subject of a scintillating talk by Franchise Times Corp. president John Hamburger at the Grant’s Spring Conference, is beginning to get the attention of Wall Street. A research report from Piper Jaffray published Monday discussed the tribulations facing banks who are active in lending to restaurant franchisees. The Piper analysts conclude that:
If recent industry profitability metrics persist and certain macro headwinds remain in place (or worsen), we would expect specific reserve allocations to continue to move higher and some [net charge offs] to emerge for certain lenders.
Problems in the restaurant industry are not confined to the franchisees. This morning, The Wendy’s Company (WEN on the Nasdaq) reported first quarter results that included weaker than expected adjusted earnings before interest, taxes, depreciation and amortization as well as slower than expected same store sales growth. The company also alerted investors to “a slight decrease in net new unit growth . . . primarily driven by the timing of North American restaurant closures within the year as we continue to build a stronger system.” On the subsequent conference call, Wendy’s president and CEO Todd Penegor replied to an analyst inquiry on customer store traffic for the broader industry: “To start the year, it’s been slightly down.”
The comprehensive troubles that have befallen the restaurant industry have not spared The Middleby Corporation (MIDD on the Nasdaq), which produces kitchen appliances and capital equipment used in the food-service industry. Middleby also reported first quarter results today, which included a 6.1% year-over-year decline in operating income and a 7.2% year-over-year drop in net sales, after excluding the impact of acquisitions, foreign exchange and accounting standards. Investors were not pleased, sending MIDD shares lower by 17.5%. Since June 2016, Middleby shares have lost 10%, while the S&P 500 has gained 30%.
On the conference call, Middleby CEO Selim A. Bassoul described a schism in the food service industry between the premium products his company carries and the no-frills alternatives that might appeal to more price-conscious operators. Bassoul noted that a franchisee who is under pressure might be more inclined to shop down-market when purchasing equipment.
MIDD shares in the post-crisis era. Source: The Bloomberg
Grant’s offered subscribers a pair of bearish analyses of Middleby in 2016 (“Waiter, the check,” on June 17 and “Out of the kitchen,” on Dec. 23), arguing that the acquisition-heavy company’s long run of operational and stock market success was due to be interrupted by an overcapacity-driven slowdown in the restaurant industry (Middleby derived 59.2% of 2017 revenues and 75% of operating income from its commercial foodservice unit, according to the company’s form 10-K).
The June 16 edition drew a parallel between the post-crisis engorgement in the food service industry (and Middleby’s share price) and macroeconomic factors, namely the near-decade of microscopic interest rates administered by the Federal Reserve in response to said crisis:
It’s a tenet of these pages that low-cost debt pulls demand from the future to the ZIRPy present. Maybe the debt-fueled consolidation of big restaurant franchisees has given a temporal yank to the demand for commercial kitchen machinery.
It was quite a feast. Now, maybe time to hit the gym.
Recap May 9
The bulls have donned their track clothes. Stocks jogged higher, with the S&P 500 gaining nearly 1% to finish at a three week high, while the VIX dropped below 13.5 for the first time since Feb. 1, shortly before the volatility explosion which resulted in the demolition of the VelocityShares Daily Inverse VIX Short Term ETN. Treasury yields rose across the board with the 10-year rising back above 3%, and energy continued its rampage with WTI crude exceeding $71 a barrel despite a flat greenback.
- Philip Grant
Tuesday, May 8, 2018
Ball four
Escalator temporarily out of order. Last week, beverage packaging company Ball Corporation (BLL on the NYSE) delivered first quarter results that easily topped consensus on both the top and bottom lines amid strength in its South American operations, while reiterating its 2018 and 2019 free cash flow and EBITDA (earnings before interest, taxes, depreciation and amortization) forecasts and increasing its share repurchase authorization to boot. John Hayes, Ball’s chairman, president and CEO, didn’t curb his enthusiasm on the conference call, stating that:
Now, as we look forward for our corporation, we are on track to achieve our 2019 targets and longer term, we believe that we have a once-in-a-generation opportunity in front of us right now . . . And we are truly leaning into our efforts to ensure that the world understands with great clarity that aluminum beverage cans are indeed the most sustainable package in the beverage world.
Investors responded to all this good news with a stifled yawn, as shares edged lower by 2%. Since the fall of 2016, BLL shares have barely budged when accounting for a two-for-one stock split in summer 2017, while the market has revved higher to the tune of a near 25% advance on the broad S&P 500.
Ball’s stock price may be stuck in the mud, but the longstanding supplier of steel and aluminum cans still has a friend in Mr. Market. The company trades at a princely 36 times 2017 GAAP earnings, or, for a more fashionable metric, 11 times enterprise value to consensus 2018 adjusted EBITDA (a figure which excludes costs from “business consolidation and other activities,” according to the company’s form 10-K). Likewise, Ball’s 7% free cash flow yield compares to a near-10% free cash flow yield currently on offer in peer Crown Holdings Incorporated (CCK on the NYSE). The sell-side is bullish, with nine buy recommendations against four hold ratings. No analyst says “sell.”
So what explains Ball’s recent underperformance? Intense competition, limited pricing power in the relatively mature global beverage business and the company’s fancy valuation are three apparent constraints. Ball’s 2016 acquisition of London-based Rexam plc for $8.5 billion in cash and stock was the largest deal in the Broomfield, Colo.-headquartered institution’s long history (Ball was founded in 1880), goosing 2017 revenues and adjusted EBITDA by 41% and 62%, respectively, from their 2015 levels. At the time of the acquisition, Hayes targeted $300 million in cost synergies, some 10% of the acquisition target’s 2015 sales. On last week’s call, Hayes demurred on providing an update, telling an analyst that: “We're really not going to talk specifically about synergies because we don't want to get into a discussion about what's a synergy and what's not a synergy. We just are focused on the EBITDA as a corporation.”
A bearish analysis of Ball in the Oct. 28, 2016 edition of Grant’s (“Kicking the can”) noted the less-than bullish circumstances which colored the pair’s mutual courtship.
The tie-up between Ball and Rexam appears to be a countermeasure undertaken in reaction growing consolidation in the beverage business. Many companies invest for growth. We judge that Ball invests not to shrink.
Graham Chipcase, the former Rexam CEO, writing to his shareholders last year, seems to suggest as much: “[C]onsolidation continues in the beverage industry, with customers taking a more coordinated, global approach to procurement to help them lower costs and innovate. They are also demanding a more complex product offering as they seek differentiation and shelf appeal.” Reading Chipcase’s letter and listening to his comments on Rexam conference calls, you understand the appeal of selling out to Ball Corp.
While Ball’s leverage burden appears relatively manageable (Luxembourg-based competitor Ardagh Group carries net debt amounting to 4.8 times adjusted forward EBITDA), the company still bears interest rate risk. Ball’s $7.1 billion in total debt is frontloaded with a relatively short-term maturity schedule, including $1.5 billion in bond principal due in 2020 and an additional $1.8 billion in 2023. Overall the company’s nine bond issues carry a weighted average maturity of less than five years. We can make one fearless interest rate forecast. Ball will be rooting for lower ones.
Meanwhile, Hayes’ upbeat commentary and the recently upsized stock buyback suggests Ball is bullish on itself. Ball management? Less so. In the past year, company insiders have disposed of 268,940 shares in open market sales, netting proceeds of just under $11 million. Vice president Daniel Fisher made the lone open market purchase over the past year, of 9,000 shares on Feb. 27.
Recap May 8
Stocks traded sideways once again, as the range-bound S&P 500 has so far effortlessly digested the persistent recent strength in the dollar. Emerging markets are a different story, as the iShares J.P Morgan Emerging Market Bond ETF (EMB on NYSE Arca) fell to its lowest levels since the February 2016 quasi-bear market while Argentina announced it will seek financial relief from the I.M.F. as its peso continued its free-fall this morning. Only 99.1 years left until maturity on that century bond!
- Philip Grant
Monday, May 7, 2018
The other side of oil
As the price of oil continues to gush, with West Texas intermediate exceeding $70 a barrel for the first time since 2014 (a move made all the more impressive by concurrent strength in the dollar), potential knock-on effects in investment and consumption abound. What sort of impact might higher oil prices have beyond the energy patch?
From a producers’ perspective, a return to the $70 threshold presents competing options. Namely, to increase drilling activity or simply enjoy the improved cash flows that accompany higher prices. Ashley Petersen, lead oil analyst at Stratas Advisors, told Bloomberg that producers will find the first option to be the most compelling one: “It signals to drill. That’s for sure. It signals to them, take advantage of prices while you can.” Scott Hanold of RBC Capital Markets sees things differently, telling clients to: “Expect little change to messaging or 2018 plans as operators continue to view the rally in crude as a boon to cash flow rather than an opportunity to accelerate growth.”
In the Permian basin (the world’s second-most prolific oil field according to Forbes, eclipsed only by Saudi Arabia’s Ghawar), drilling-happy producers must contend with additional complications brought about by higher prices: Namely, supply bottlenecks. Peter Forbes of Bianco Research notes that the Permian region is expected to produce 3.18 million barrels a day (b/d) this year, above its pipeline capacity of 3.08 million b/d. Forbes concludes that “oil prices have risen enough that U.S. shale production will produce as much as raw materials and logistical constraints will allow.”
While higher prices present a high-grade problem for the production industry, the equation for consumers is less nuanced. Higher prices at the pump erode disposable income and act as a governor on consumption. According to data from the Urban-Brookings Tax Policy Center cited in an April 16 piece in the Financial Times, Americans are facing an average $400 fuel cost increase this year compared to 2016, accounting for nearly half of the $930 average gain seen by middle-class households following the fall 2017 tax cuts.
If rising gas prices represent a tax on consumers, then falling ones would seemingly provide a symmetrical benefit. However, the energy crash of 2014-2016 did not bear that out, as seasonally adjusted U.S. real GDP grew by an average of 1.9% between the fourth quarter 2014 and the first quarter 2017, well below its 30-year average quarterly figure of 2.5%. A blog post this morning from PIMCO’s Greg Sharenow and Tiffany Wilding helps explain why:
One of the principal drivers of the atypical economic response was the collapse in U.S. energy investment and the knock-on effects of other upstream industries, which together greatly reduced the net economic benefits of cheaper oil. For instance, U.S. natural gas and oil-related rig counts fell by 80% between the end of 2014 and early 2016, subtracting nearly 0.5% from U.S. real GDP growth.
So, if the benefit to consumers was offset by the curtailment of energy investment in 2014-2016, can we expect the opposite dynamic this time, with pain at the pump balanced by a boom in industry? Not necessarily, say Sharenow and Wilding. Diminished pipeline capacity, worker shortages and the proposed steel and aluminum tariffs all stand as potential impediments to an expansion in energy investment that might be expected to accompany the rally in crude. The pair contends that: “U.S. producers will more likely apply the benefits of higher prices to balance sheet repair rather than investment, while consumers will feel the burden of higher gasoline prices . . . We think investors should expect some economic headwinds and support for rising inflation.”
A whiff of stagflation in the springtime air?
Recap May 7
Stocks gave back the bulk of their early gains but still managed to finish in the green, as the S&P 500 edged back toward the upper end of its tight spring trading range amid a near-2% gain in the tech-centric NYSE FANG+ index. The dollar and commodities continued their dual advance with both the DXY and CRB indices finishing slightly higher, while Treasurys barely budged to leave the 10-year yield at 2.95%.
- Philip Grant
Friday, May 4, 2018
With the kung-fu grip
From the Associated Press:
From the Associated Press:
Pain in the ARS
Mr. Market is manic.
Mr. Market is manic.
Recap May 4
With the kung-fu grip
From the Associated Press:
Allentown, Pa. — A 2-year-old boy who climbed into a claw machine at a Pennsylvania laundromat while trying to retrieve a plush toy was rescued by emergency workers — but never got his prize.
This industrious young lad is well prepared for a future career as an investor in gold stocks.
Pain in the ARS
Mr. Market is manic. On Wednesday, the Republic of Angola sold $3 billion worth of senior unsecured notes across 10- and 30-year maturities. The west-African nation, which is rated B3 at Moody’s (six notches into junk, “judged as being speculative and a high credit risk”) and whose kwanza is “the world’s worst-performing currency in 2018” according to Bloomberg, still got a warm reception from creditors: Those 10-year notes priced to yield 8.25%, down from initial price talk of 8.5% and final guidance of 8.25-8.375%. The 30-year bonds priced at 9.375%, down from initial price talk of 9.625% and guidance of 9.375-9.5%.
Angola’s successful bond offering is placed into relief by the recent struggles of its emerging-market peers, as the snap higher in the dollar and U.S. interest rates has put the screws to a number of highly leveraged foreign borrowers. Following is a look at a trio of those hot spots:
Three weeks ago, Baa2-rated (two notches above junk) Indonesia issued seven-year euro-denominated notes at a coupon of just 1 3/4%. Today, the country shelved plans to issue more debt amid multi-year lows in the Indonesian rupiah and a pair of sovereign bond auctions that fell short of their targets. Luky Alfirman, director-general for budget financing and risk management at the Indonesian Finance Ministry, struck a sanguine tone, telling Bloomberg that: “We are not in any urgency to issue or sell these bonds at any price. When the market was in good shape, we always upsized from our indicative target. We don’t want to get cornered by the market.” The Indonesians still have a friend in Mario Draghi. Those 2025 euro notes are currently trading above par.
Twelve hundred and seventy-five basis points. That is how much the Argentine central bank has raised its benchmark repurchase rate in the past seven days, with the key rate now standing at 40% from 27.25% last Thursday. We promptly return to the Land of Silver, which was covered in Almost Daily Grant’s just three days and six hundred seventy-five basis points ago, as the central bank tries to stem the eye-watering decline in the local currency. Could the third time be the charm? The peso (ARS), which reached 22.25 per dollar this morning from 20.25 on Monday, has since eased to 21.6 per greenback, while the price of the century bonds has jumped to 88.15 cents on the dollar, up from 85.63 yesterday.
Rate hikes, Argentine-style. Source: The Bloomberg
Turkey has encountered its own share of currency woes of late, with the lira also selling off rapidly vs. the dollar (to 4.29 per greenback this morning, compared to 3.4 in September). Government debt is also struggling, with the Turkish 10-year yield rising to 13.76% from 10.59% in September. On Tuesday, S&P downgraded Turkey’s long-term debt rating to double-B-minus from double-B, citing “a deterioration in Turkey's external, inflation, and fiscal outlook beyond our previous base case.”
Political factors loom large. On April 18, President Recep Erdogan called for snap presidential and parliamentary elections to be held on June 24, instead of the initially-scheduled November 2019. His expected victory “could pave the way for a single-party state with few checks on the power of the president,” according to the Guardian.
Do the troika of tremors listed above pose broader risks to investors, in the potential form of a sequel to the 1997-1998 Asian currency crisis? We posed the question to Russell Napier, independent strategist and co-founder of the Electronic Research Interchange, who has identified Turkey as the likely progenitor of the next crisis in emerging markets in previous issues of Grant’s (see the Dec. 1, 2017 edition for instance). Now follows Napier’s complete reply:
There are key differences between the forthcoming debt crisis and the 1997 crisis. The real burden of the crisis falls upon EMs where the foreign currency debt to GDP level has reached levels where an exchange rate devaluation means significant bankruptcies. The work of Carmen Reinhart and Kenneth Rogoff suggests that this occurs, for countries not classified as debt intolerant, when the foreign currency debt to GDP ratio exceeds 35%.
Today this includes Turkey and otherwise primarily countries in Eastern Europe. The debt intolerant countries are those who regularly default on their debts with foreign currency debt to GDP ratios well below 35% and those countries are classified by Reinhart, Rogoff and Savastano in a 2003 paper as Argentina, Brazil, Chile, Colombia, Egypt, Mexico, Philippines, Turkey and Venezuela. So that is quite a list of countries.
The devaluation and subsequent mass defaults by Thai companies in 1997 was not important of itself. What was important is that it produced a major re-evaluation of EM risk and a redirection of capital flows. Similarly the Mexican crisis of 1982 became a global crisis due to the redirection of global capital flows. So if the imminent de facto default by Turkey, likely through the imposition of exchange controls, is to have a more profound impact it will be through the reconsideration of EM risk and thus the redirection of capital flows. In this regard it must be noted that in 1982 and 1997 most of the credit provided from offshore was from banks.
Today things are very different and a significant portion of the credit has been provided by bond investors in both local and foreign currency debt. In 1982 and 1997 equity investors could rush for the exit, due to theoretical liquidity in the equity markets, but debt investors could not. Today bond investors expect to be able to liquidate their portfolios and reduce their exposure but it is highly unlikely that they will find sufficient liquidity to be able to do so.
So either we have greater capital outflows, because this time both debt and equity investors can rush for the exits, or we get bond investors unable to liquidate. If we get the former we get even more downward pressure on EM exchange rates and if the later then an illiquidity event for those who hold EM debt. An inability to liquidate creates a new problem we did not have in 1982 and 1997 because such a large proportion of foreigners’ EM bond holdings are held in open-ended structures.
So this new development spreads a liquidity risk from EM to the developed world which was not something we have witnessed in previous EM busts. Of course the illiquidity falls upon the pensioners/savers of the developed world and not leveraged banks so some would see this as a good thing. We shall see how the pensioners/savers and regulators view it in due course.
The most important difference in this EM debt crisis will be the accepted remedy. All of the statements from the President of Turkey are compatible with the imposition of capital controls to bring the low interest rates and debt relief to Turkey that he has promised many times. Hard form capital controls create a de facto debt moratorium and instant illiquidity. In the Asian crisis only Malaysia responded with capital controls and this was really just as the crisis was ending in September 1998. Today the attitude to capital controls has changed and even the IMF is openly discussing ‘capital flow management’ using ‘regulatory measures.'
Also we live in a different era when market prices are not always assumed to be the correct way to allocate resources. We also have populist leaders in EM who have already shown a willingness to bypass the rule of law. The global financial system has been developed to work with record high leverage and assumes high levels of liquidity. This EM debt crisis is likely to see a much greater resort to capital controls than in 1997 and thus a rapid government enforced illiquidity event which our system is simply not designed for. So we will remember this crisis not for the pain of the disease but the pain of the remedy.
Crucially it appears from the Bank for International Settlements data [see the BIS global liquidity indicators for end-December 2017 for more] that U.S. banks will have little exposure to this EM crisis but European banks will. This has profound impacts for the future of the euro and in the shorter term the dollar/euro exchange rate. The major global impact for financial markets could come from the upward pressure on the dollar that this EM debt crisis creates, not just directly through a rush to repay dollars, debt but through a change in monetary policy in Europe necessitated by the negative impact on banks of an EM debt crisis. The scale of dollar strength is important but a major rally transfers pressure to the biggest and most important of all emerging markets - China.
Recap May 4
Stocks ripped higher, with the S&P 500 all but erasing the week’s losses as rangebound trading continues apace. Commodities continued their impressive rampage, with the broad CRB index breaking to a fresh post-2015 high and WTI crude approaching $70 a barrel, despite another green finish in the U.S. Dollar Index. Treasury yields finished little changed.
- Philip Grant
Thursday, May 3, 2018
Run for the roses
Steady as she goes in the energy patch
Steady as she goes in the energy patch
QT progress report
Recap May 3
Run for the roses
Steady as she goes in the energy patch. On Monday, the price of Brent crude closed at $75.17 per barrel, the best finish since December 2014. One week prior, WTI crude made its own multi-year closing high of $68.64. That gradual upward grind in energy prices has left the savage post-2013 selloff and February 2016 panic lows of $26 a barrel an increasingly distant memory.
The U.S. Energy Information Administration, for one, is not expecting the bull party to continue, forecasting a Brent price of $63 a barrel and WTI crude at $59 a barrel through 2018 and 2019. According to the EIA’s Short Term Energy Outlook report for April, demand questions color the agency’s caution:
Both the United States and China announced potential tariffs on several billion dollars’ worth of each other’s goods in March. A slowdown in global trade could affect oil demand and presents downside risks to the global oil consumption forecast.
Supply is also of potential concern for oil bulls: According to the Department of Energy, U.S. production reached a record 10.62 million barrels a day as of April 27, nearly 50% above the 10-year average of 7.28 million. While OPEC has curtailed its own output from the 2016 highs amid supply cut agreements, its current 31.9 million barrel a day harvest likewise sits above its own 10-year average of 30.8 million.
An overloaded speculative boat presents another potential hazard for the longs. According to the Commodity Futures Trading Commission’s Commitment of Traders, net non-commercial futures positions outstanding stood at 712,423 contracts as of April 24, near the record highs logged on Feb. 6 and almost triple the 10-year average positioning of 239,000 contracts.
Natural resource investors and affirmed oil bulls Leigh Goehring and Adam Rozencwajg are unfazed by the evident storm clouds. Goehring and Rozencwajg’s first quarter investor letter (which also includes an excellent history of the electric vehicle, which has been around since long before Elon Musk burst on the scene) features an emphatic reiteration of their expectation for higher prices:
Since we last wrote, several new developments have emerged, and our outlook has become even more bullish. Most importantly, OECD inventory data continues to confirm that the global oil market remains in substantial deficit and that this deficit is accelerating.
As predicted by our models, global demand estimates for 2018 were revised higher over the past three months by 150,000 barrels a day. While this is a step in the right direction, we continue to believe that further large-scale upward revisions are still required.
On the supply front, the lack of any material investment in the non-OPEC world outside of the U.S. is beginning to significantly impact production . . . We continue to think that a dearth of capital spending in the rest of the of the non-OPEC world will result in sub-par production over the medium term with very bullish implications.
If the above bullish thesis is on the beam, shareholders of oil and gas related equities could be in for a treat.
The pair notes that against the 160% rise in the price of oil from the February 2016 lows, the S&P Oil and Gas Exploration and Production ETF (XOP on NYSE Arca) has gained a relatively meager 63%. The VanEck Vectors Oil Services ETF has risen by just 22%. Goehring and Rozencwajg write that “the radical underperformance of energy-related equities represents a tremendous buying opportunity for investors.”
WTI crude in white, and the OIH oil servicers ETF in orange. Source: The Bloomberg
We at Grant’s agree with that assessment, offering subscribers bullish analyses of a number of energy related stocks since that 2016 winter of discontent (See issues dated Nov. 3, 2017, March 10, 2017 and March 25, 2016 among many others). One such unloved specimen, deep water-driller Transocean Ltd. (RIG on the NYSE) reported ho-hum results on Monday evening, with the stock dropping by 2.7% in reaction. However on the conference call, president and CEO Jeremy Thigpen struck an optimistic tone, telling listeners-in that:
In fact, if oil prices can remain constructive for the next few months, we believe that operator budgets for 2019 could reflect a return to offshore projects sanctioning for 2019 and beyond as the deepwater space has become a more compelling investment proposition for our customers.
Pierre Andurand, founder and chief investment officer of Andurand Commodities Fund, is Goehring, Rozencwajg and Grant’s in high def. On Sunday, Andurand posted a series of (since deleted) messages on Twitter, including: "So paradoxically these peak demand fears might bring the largest supply shock ever. If oil prices do not rise fast enough, $300 oil in a few years is not impossible."
QT progress report
The Fed’s portfolio of securities held outright footed to $4.144 trillion this week, down $17.7 billion from a week ago. More than 100% of the decline can be attributed to a drop in Treasury holdings. The Fed’s portfolio of mortgage-backed securities ticked higher by $5 million. Compared to the trailing four-week average, today’s reading represents a decline of $25.1 billion, with about 70% of that figure comprised of Treasurys and the remainder in MBS.
Since QT got underway on Oct. 1, the Fed’s total asset holdings have declined by 2.23%, for a simple annualized pace of 3.73%.
Recap May 3
Stocks rebounded from sharp early losses to leave the S&P just nominally in the red by the close, while Treasurys were bid across the curve with the 10-year yield dropping back below 2.95%. Commodities enjoyed a strong day, with the broad CRB index rallying to within hailing distance of the multi-year highs logged on April 18. That resilience is impressive considering the outsize strength in the greenback over that period.
- Philip Grant
Tuesday, May 1, 2018
Emerge overkill
The buck is breaking out. After spending nearly all of 2017 in retreat against the bulk of world currencies, the dollar has recently enjoyed a ferocious snapback, with the broad DXY Index up by 3.5% in just two weeks to approach the highs of the year. The index made four-year lows as recently as late January.
As the dollar rebounds, interest rates generally continue their own upward march. The two-year Treasury yield reached 2.51% today, up from 1.88% at year-end 2017 and 1.26% a year ago. While interest rate futures ascribe a slim 4.6% odds of a rate hike at tomorrow’s Fed meeting, the next rate decision on June 13 (which will be followed by a press conference) is looking like a lock with 92.5% odds of tightening. By year-end 2018, the market assigns an 82.4% chance of an overnight Fed Funds rate in excess of 2% from the current range of 1.5% to 1.75%.
That ongoing trudge higher in rates and abrupt dollar turnaround are already proving to be an unwelcome development for overseas borrowers. The iShares J.P. Morgan USD Emerging Markets Bond ETF traded to a 52-week low today, falling for the ninth time in twelve sessions to leave the vehicle, which is about equally made up of investment-grade and high yield issues, sporting a yield-to-worst of 5.95%. That’s a 298 basis point spread over 10-year Treasurys.
EMB vs U.S. Dollar Index, one-year chart: Source: The Bloomberg
Emerging market borrowers were not shy about availing themselves of dollar-denominated debt in the fair macro weather of 2017. Yesterday, the Bank for International Settlements released its global liquidity indicators for year-end 2017, finding that:
Against the backdrop of the depreciation of the U.S. dollar in 2017, the annual growth rate of U.S. dollar credit to non-bank borrowers in [emerging market economies] more than tripled from 3% at end-2016 to 10% at end-2017. This was primarily driven by international debt securities, which grew at an unprecedented annual rate of 22% in the second half of 2017.
That follows the IMF’s Global Financial Stability Report for April, which summarized current conditions and their accompanying risks:
A number of emerging market economies have taken advantage of benign external financial conditions to address imbalances and build buffers; in others, however, vulnerabilities have continued to build. Monetary policy normalization in advanced economies could result in a tightening of global financial conditions and a reduction in capital flows, increasing rollover risk and adversely affecting productive investment. With weaker issuers increasingly able to access capital markets and with fickle investors playing a larger role in recent years, stress amplifiers have risen.
The Argentine Republic’s recent travails provide a textbook example of the IMF’s caveat. In June, Argentina sold $2.75 billion of 100-year sovereign dollar bonds at a 7.25% coupon in a deal that was more than 3.5 times oversubscribed according to Reuters. Those bonds, initially priced at 90 cents on the dollar, rallied to near 104 in October but have since reversed amid a raft of macroeconomic trouble. The Argentine peso, which traded at less than six per dollar in 2013 and 17.3 as recently as December, now fetches nearly 22 per greenback amid persistently high budget deficits and year-over-year CPI inflation above 25%.
Last week, the Argentine central bank spent $4.3 billion in open market purchases of the peso in an attempt to staunch the selloff. When that tactic proved ineffective, the bank raised its overnight lending rate by 300 basis points to 30.25%. While the Land of Silver had steadily accumulated dollar reserves following the replacement of former president Cristina Fernandez de Kirchner with the more business- and investor-friendly Mauricio Macri, those reserves have dwindled to $56.6 billion as of April 27, down from $64.6 billion at the onset of 2018. The century bonds of 2117 have declined to fresh lows near 88 cents on the dollar, for a yield-to-worst of 8.05%. In the meantime, creditors have just over 99 years left until principal repayment.
The June 19, 2017 edition of Almost Daily Grant’s (‘Tine marches on) cited Argentina’s history as a serial sovereign deadbeat. The country has defaulted eight times in its 208 year history. New administration notwithstanding, that pace would imply default at least three times over before maturity of the century bonds based on historical precedent.
For emerging market investors who would like to give themselves a fighting chance at getting their money back, the Argentine 6 7/8 dollar bonds of 2027 are currently priced just under par for a yield to worst of 6.96%, just 110 basis points below the current yield on the century bonds. As for the broader emerging markets realm, creditors had best hope that the current dollar and rate rallies prove little more than a passing trend.
Recap May 1
Stocks finished higher thanks to a late rally, with the S&P 500 finishing more than 1% off its early-afternoon lows as strength in the tech sector (+1.5%) helped pull the broad index into the green. Treasury yields ticked modestly higher across the curve, while the dollar continued its outsize recent strength. The VIX fell below 15.5.
- Philip Grant
Monday, April 30, 2018
Persistence epitomized
Could this lingering courtship finally be consummated?
Could this lingering courtship finally be consummated?
Recap April 30
Persistence epitomized
Could this lingering courtship finally be consummated? Yesterday came the announcement of a long-anticipated, and previously thwarted, merger agreement between telecommunications operators T-Mobile US, Inc. (TMUS on the Nasdaq) and Sprint Corp (S on the NYSE). This would be an all-stock transaction, with Sprint shareholders receiving 0.10256 T-Mobile shares for each Sprint share, or 9.75 Sprint shares for each T-Mobile share. The companies forecast achieving $43 billion of cost synergies as a combined entity. Banks promise $38 billion in committed financing.
For highly-leveraged Sprint, a combination with the financially sturdier T-Mobile could be just what the doctor ordered. In response to the proposed deal, Moody’s announced it is placing Sprint’s credit ratings on review for upgrade, as “the combined company would materially improve Sprint’s standalone credit profile.” This morning, Fitch followed suit, noting that the proposed transaction “is likely to lead to a three-notch upgrade of the [issuer default ratings] and outstanding debt of Sprint Corporation based on existing assumptions.” Not only do Sprint’s creditors hope the deal goes through (the 7 5/8s bonds of both 2025 and 2026 have ticked higher in active trading). Bloomberg reports that CEO Marcelo Claure stands to cash in a $78 million windfall through stock awards and severance payments if the transaction crosses the goal line.
That is a big “if,” as evidenced by today’s 13% plunge in Sprint shares to more than reverse Friday’s rally in anticipation of the deal announcement. Regulatory factors loom large. The two companies had agreed to merger terms in 2014 but scrapped the deal after conceding that regulators would block it on antitrust grounds. In 2011, the Department of Justice did just that, rejecting a proposed merger between T-Mobile and AT&T.
A new presidential administration may help their cause this time around, but that is no guarantee. Indeed, Craig Moffett, founder and eponym of research firm MoffettNathanson LLC, estimates the likelihood of Sprint and T-Mobile being permitted to combine at 50%. Referring back to the 2011 scuttled deal, Moffett writes this morning that:
At the time, both the DOJ and the FCC made the case that we need four, not three, competitors in the wireless market in order to ensure robust competition. While leadership of both agencies has since changed (multiple times), the bulk of the rank and file staffs at both agencies remain.
And the DOJ undoubtedly feels vindicated by their 2011 decision. At the time, AT&T and T-Mobile made precisely the same arguments that Sprint and T-Mobile will make this time around: absent the merger, T-Mobile wouldn’t survive, and certainly wouldn’t be able to make the investments that would be required for it to be competitive. In the time since the DOJ blocked that deal, T-Mobile hasn’t just survived, it has flourished, launching its Uncarrier campaign and taking share in gulps. The result has been lower prices and consumer-friendly business practices such as [early termination fee] buyouts and the end of long-term customer contracts. Consumers have unambiguously benefited from the DOJ’s decision in 2011.
If the stock market’s (and Moffett’s) dim view of regulatory success is on point, Sprint bond holders may be in for a rough road. The company has generated negative $6.1 billion in free cash flow over the past three years, paid $2.38 billion in interest expense last year against $3.05 billion in operating income, and is facing $12.6 billion in debt maturities over the next four years.
Even those less-than cheerful figures are flattered by an accounting technique called the lease plan, to which Sprint and industry peers migrated in recent years from the more conventional subsidy and installment methods, making historical and inter-company comparisons far more difficult. For more details on this bit of bookkeeping magic, see the bearish analysis of Sprint bonds in the Dec. 23, 2016 edition of Grant’s.
Meanwhile, this morning’s release of the PCE deflator showed the Fed’s preferred inflationary gauge rose by 2.0% year-over-year in March, the hottest reading in over a year and well above the post-recession average of 1.4%. Recalling erstwhile Chair Janet Yellen’s July 2017 lamentation of unlimited cell phone plans’ role in holding back the Fed’s hoped-for consumer inflation, we wonder if her successor knows anyone at the DOJ.
Recap April 30
Stocks finished moderately lower on the S&P 500, but in especially un-bullish fashion as the broad index reversed early gains and finished at the low of the day. Treasury yields ticked lower at the long end, flattening the curve as the 10-year yield dropped below 2.95% from the 3.03% seen last Wednesday, and the Dollar Index continued its recent roll, rising for a fourth straight session to bring its two-week gain to nearly 3%.
-Philip Grant
Thursday, April 26, 2018
Your Face is my case
These results helped make some new friends. Facebook, Inc. (FB on the Nasdaq) pleased the Street with rousing first quarter earnings yesterday, easily topping consensus expectation on both the top and bottom lines amid stronger-than-expected reported user growth. In addition, the social networking behemoth is bullish on itself, upsizing the company stock buyback to $9 billion from the $6 billion share repurchase announced in November 2016, helping to further underpin the rally as shares rose by 9%. CEO Mark Zuckerberg kept his eye on the big picture, commenting that:
Despite facing important challenges, our community and business are off to a strong start in 2018. We are taking a broader view of our responsibility and investing to make sure our services are used for good. But we also need to keep building new tools to help people connect, strengthen our communities, and bring the world closer together.
Facebook’s strong quarter surely came as a welcome relief to the legions of bullish sell-side analysts, as 42 buy ratings compare to just two holds and two sells. At least three brokers raised their price targets in reaction, while the consensus price target of $221 a share (26% above the post-rally share price) includes expectations of a 38% year-over-year revenue increase and a 49% uptick in adjusted EBITDA in 2018.
Great expectations. Source: The Bloomberg
One of the lonely FB bears, Brian Wieser of Pivotal Research Group, is sticking to his guns. Wieser wrote this morning that: “While the overall results from the quarter were positive, nothing we heard today causes us to alter our negative view on the stock relative to consensus.” Wieser goes on to cite the erosion of time spent per user metrics in data compiled by Nielsen, natural limitations on the addressable market for advertisements and regulatory risks following the Cambridge Analytica data-harvesting revelations as potential snafu’s as the year unfolds.
For our part, we would note that the mid-March arrival of the Cambridge Analytica scandal was close enough to March 31 quarter end where any financial fallout might not have been immediately apparent. Even prior to the public proliferation of privacy concerns, Facebook’s changing cost structure could present a larger hurdle than the bull crowd anticipates. Corporate headcount totaled 25,105 people at the end of 2017 according to the form 10-K, up 47% year-over-year and 98% from two years ago. A Feb. 22 piece in The Economist notes the economically uncertain value of all those new faces:
Facebook has around 14,000 workers overseeing security, safety, compliance and community operations, twice as many as a year earlier, and that figure is likely to rise as more countries require it to find and remove objectionable content.
Capital expenditures are likewise on the upswing. In November, the company predicted that capex will double this year from the $6.73 billion figure seen in 2017. Shira Ovide of Bloomberg Gadfly notes that that figure “rivals Exxon’s capital spending to drill oil and gas out of the ground” (Exxon’s capex footed to $15.4 billion in 2017). Share-based compensation, too, is climbing. That line item totaled $3.72 billion in 2017, up from $3.22 billion in 2016 and $2.97 billion in 2015. Despite an expected $5 billion year-over-year rise in cash from operations, free cash flow is expected to decline to $15.9 billion in 2018 from $17.5 billion in the year prior, if the sell-side consensus estimate is on the beam.
While bulls may take heart in the upsized share buybacks, they overlook what management is doing with their own money. Mark Zuckerberg, who announced last September his plan to sell between 35 and 75 million FB shares to fund his charitable initiatives, has certainly not dawdled, selling at least 145,000 shares on each trading day in April so far (for context, FB has averaged 22 million shares in average daily volume over the past year). Other higher-ups are cashing out as well. Chief operating officer Sheryl Sandberg sold $8.5 million of FB stock on April 2, followed by an additional $9.2 million on April 18, while chief technology officer Mike Schroepfer unloaded $6.1 million worth of shares on April 10. This continues the aggressive selling patterns documented in prior editions of Almost Daily Grant’s (March 1, Feb. 20, Jan. 22).
Meanwhile, it’s not just the gravitational limits of the advertising market which could constrain the start-up type growth figures that the Street is expecting. There are only so many people in the world to log in and check their accounts. With respect to Facebook’s claim of 185 million daily active users in the U.S. and Canada, deputy editor Evan Lorenz notes that: “Facebook sets the minimum age for an account at 13. Yes, some kids lie but not all tweens are on the platform. Facebook claims 185 million DAU in Canada and the U.S. The World Bank estimates that there are 238.3 million people in the U.S. between the ages of 15 and 64, which is a pretty good approximation of Facebook’s target demographic and age restrictions. That would mean that 78% of Facebook’s target audience in the U.S. and Canada check Facebook every day. That seems high to me.”
Facebook (see the Aug. 11, 2017 edition of Grant’s for more) has been a great business with enviable margins and a clean balance sheet, and has made its early investors wealthy indeed. But as for its future prospects, Grant’s casts our lot with the actions of Mark, Sheryl and Mike. We remain bearish on FB.
Recap April 26
Stocks caught a strong bid, with the S&P 500 virtually erasing the week’s decline amid outperformance in the tech, consumer discretionary and energy realms, while Treasury yields dropped across the curve with the 10-year falling back below 3%. The Dollar Index extended its recent hot streak with another impressive rally, but the commodity complex managed to hold near two and a half year highs on the broad CRB Index.
- Philip Grant
Wednesday, April 25, 2018
"Smart contracts"
A short story, in two parts:
A short story, in two parts:
Dollar bill blues
Is this as good as it gets?
Is this as good as it gets?
Recap April 25
"Smart contracts"
A short story, in two parts:
From a CNBC article published this afternoon, headlined: “Nix the C-suite, soon blockchain will let armies of free agents run companies.”
The days of full-time employment and long-term job stability are coming to an end. Nasdaq estimates that 43 percent of the U.S. workforce will be freelancers by 2020, part of a growing gig economy of project-based jobs.
This morning, from Coindesk:
As many as a dozen or more ethereum-based ERC-20 smart contracts have been found to contain bugs that let attackers create as many tokens as they want.
Dollar bill blues
Is this as good as it gets? Mr. Market has been a little cranky of late, sending stocks down despite phenomenal results. With 154 components of the S&P 500 having reported as of this morning, the average sales (1.97% above consensus) and earnings surprises (7.25% above consensus) are easily the best relative performance in each metric in at least the last eight quarters, according to data from Bloomberg. On an absolute basis, the S&P 500 components have so far managed 10% year-over-year sales growth, far above the top-line growth logged in at least the prior four quarters. Yet since the commencement of earnings season on Feb. 16, the S&P 500 has dropped by 3.4%, a 17% annualized pace.
Yesterday, a number of economic bellwethers offered seemingly solid quarterly results that were met rudely: Shares in truck manufacturer Paccar, Inc. (PCAR on the Nasdaq) dropped by 7% despite topping consensus expectations for the first quarter and offering an upbeat forecast for Class 8 truck sales. Ronald E. Armstrong, chief executive officer, expressed optimism on margins, telling listeners to the earnings conference call that: “We feel good about the operating results. We have the best margins – the best operating margins in the industry.”
Industrial conglomerate 3M Co. (MMM on the NYSE) topped sales forecasts and met the Street’s expected adjusted earnings per share figure, yet shares declined by 7% after the company trimmed the upper end of its fiscal year earnings forecast. Analysts at RBC Capital Markets observed that: “While this guidance cut is relatively small, the implications are magnified, given that it is happening so early in the year.”
Masco Corporation (MAS on the NYSE), a maker of building and home improvement products, saw its shares fall by 9% despite stronger than expected revenues, as higher than expected investment spending and the “price cost relationship in plumbing and cabinetry” dinged the bottom line. Perhaps most instructively, machine and mining equipment giant Caterpillar, Inc. (CAT on the NYSE) reversed strong initial gains following impressive results, after the company CFO Brad Halverson noted on the company conference call that the first quarter “will be the high watermark for the year.”
Meanwhile, a dispatch from Bloomberg this morning details the struggle in the U.S. grocery store industry to raise prices, despite the seemingly perfect macro-economic backdrop for such hikes: Low unemployment, sturdy consumer confidence and an uptick in measured inflation. Instead, an intense competitive environment featuring foreign interlopers Aldi and Lidl, the specter of cross-industry boogeyman Jeff Bezos, as well as diminished brand loyalty on the part of consumers, have put the squeeze to the consumer packaged goods industry (a development which informed the bearish calls on packaged food companies such as Kraft-Heinz Company and Campbell Soup Company in the March 24, 2016 edition of Grant’s). Bloomberg says:
“There’s no question the balance of power has shifted,” said Gary Stibel, who runs the New England Consulting Group, which advises consumer companies. Packaged-food and consumer-product companies aren’t “creating the kind of intense” loyalties that retailers need to be able to pass on higher prices to shoppers, he said.
Overall, corporate profits have remained well above 10% of U.S. gross domestic product in every quarter since the third quarter of 2009, peaking in the fourth quarter of 2014 at 12.6% according to data compiled by the Bureau of Economic Analysis as of Dec. 31, 2017. That compares to a post-1948 average at 9.6% of GDP. In a 2014 essay in Barron’s, co-founder of Boston’s GMO Jeremy Grantham called corporate profit margins “probably the most mean-reverting series in finance.” Grantham subsequently shifted his perspective, writing in a May 2, 2017 Barron’s follow-up that: “I used to call profit margins the most dependably mean-reverting series in finance. And they were through 1997.” Increased globalization, consolidated corporate power, and lower real interest rates were among the factors that influenced the great investor to change his mind.
What if Grantham’s 2014 viewpoint turns out to be the correct one? Needless to say, equity bulls will get no help from valuations. The current Shiller Price/Earnings ratio (based on average inflation-adjusted earnings over the last 10 years) on the S&P 500 stands above 31 times, nearly double the long-term median and mean readings of 16.15 and 16.85 times, respectively.
Recap April 25
Stocks staged an impressive rebound, working higher from a near-one percent opening downdraft on the S&P 500 to leave the broad index in the green and narrow the week’s losses to 1.2%. Rates mostly continued their upward march (the short end was the bullish exception), as a weaker-than expected five-year note auction helped push yields higher with the 10-year reaching 3.03%.
- Philip Grant
Tuesday, April 24, 2018
WeBorrow
Are Tesla or Netflix bonds a little too boring for you?
Are Tesla or Netflix bonds a little too boring for you?
Impulse control
Two debt-laden ships pass in the night.
Two debt-laden ships pass in the night.
Recap April 24
WeBorrow
Are Tesla or Netflix bonds a little too boring for you? WeWork Companies, Inc. has you covered. This morning, the office-space unicorn announced a $500 million offering of unsecured seven-year notes. Rated firmly in junk territory (single-B-plus at S&P Global and double-B-minus at Fitch Ratings), the deal is expected to price on Thursday with use of proceeds slated for general corporate purposes.
The offering prospectus contains no shortage of fascinating details on WeWork. For instance, the directors and executive officers of the company hold approximately 44% of the company’s equity (mostly comprised of the supervoting B shares, where one share entitles a holder to 10 votes, as compared to one for Class A).
According to a Dec. 27, 2016 blogpost from Lawtrades.com, founders usually control somewhere around 20% of their company following a Series-B fundraising round. WeWork, by comparison, completed a Series-G round last July, which valued the company at $20 billion (Softbank Group Corp. invested $4.4 billion in WeWork one month later).
A Bloomberg report on the offering notes that one of WeWork’s biggest selling points could represent a major corporate liability when the real estate cycle shifts.
Lease flexibility, a major perk for WeWork tenants, also poses one of the company’s biggest risks. The company is subject to “mismatched terms” when it takes 10- or 20-year office leases from landlords and then offers companies month-to-month rental options, according to Fitch.
Meanwhile, high-yield investor Xavier MacDuff noted on Twitter that 2017 stock based compensation expense of $261 million represented nearly 30% of last year’s $886 million in revenues. Perhaps unsurprisingly, profitability is currently elusive for WeWork. Instead, the company has provided some alternative metrics to consult. For instance, adjusted EBITDA for 2017 footed to negative $193 million. However, “adjusted EBITDA before growth investments” (a.k.a. adjusted adjusted EBITDA) came in at positive $49 million. Then there’s “Community adjusted EBITDA,” (or, adjusted adjusted adjusted EBITDA) at positive $233 million in 2017.
Choose your own adventure.
Impulse control
Two debt-laden ships pass in the night. As rates in the U.S. mostly ride the escalator, Chinese government yields have enjoyed visible downward momentum in recent months. The 10-year Chinese government bond yield currently sits just under 3.58%, down from 3.9% on Dec. 31, 2017. The move at the short end has been even more pronounced. China’s one-year yield has dropped below 3%, down from more than 3.8% at the turn of 2018. More broadly, Bloomberg notes this morning that “Chinese bonds are the top performers so far this year, among 70 markets in the Bloomberg Barclays Global Aggregate + China index, calculated in dollars.”
While lower rates are surely welcome news for a country as highly leveraged as China (total banking assets represented 305% of GDP as of year-end 2017) the prospects of slower economic growth bear close watching. This morning, a separate Bloomberg report notes a communique from Chinese media seemingly girding its citizens for tougher times ahead:
China’s leaders are giving their strongest signal since 2015 that growth in the world’s second-largest economy could slow – and that they’re prepared to tweak policy if trade or financial risks threaten a sharp deceleration.
Hard work is needed to meet this year’s economic targets amid an increasingly complicated geopolitical situation, according to a statement released by state media Monday following a Politburo meeting led by President Xi Jinping.
“There’s a deep sense of risk underlying the calm surface, and the leadership’s attitude has changed greatly,” Deng Haiqing, chief economist at JZ Securities Co. in Beijing, wrote in a note. “The attention attached to stabilizing growth is the greatest since 2015.”
Indeed, this morning, China-levered global construction and mining equipment firm Caterpillar, Inc. reported stronger than expected first quarter results, extending gains its recent skyward stock price. Those intraday good times were emphatically reversed during the conference call, after chief financial officer Brad Halverson predicted that the first quarter “will be the high watermark for the year.”
So what ails the Middle Kingdom? Waning credit appears to be taking a toll on growth. The Chinese credit impulse (growth in borrowing as a percentage of GDP) dropped to 25.39% as of March 31, the lowest since the 2015 yuan devaluation.
Chinese credit impulse, 10-year view. Source: The Bloomberg
The decline in credit impulse colors both China’s slowing economic growth and downward pressure on interest rates. An April 16 report from J Capital Research summarizes the situation thusly:
Less credit means that companies will be unable to pay their outstanding loans and will instead rely on rollovers. That means more issuance of short-term bonds, wealth-management products, and central bank repos to make sure the system has enough liquidity.
Lower credit growth also tends to be deflationary and to make for slower fixed-asset investment growth. Indeed, the Producer Price Index, while still growing, was up just 3.1% in March and has declined every month since February 2017. As we noted above, the first quarter of 2018 witnessed commodity and asset deflation broadly.
Author Anne Stevenson-Yang summarizes the predicament facing China’s leadership as flagging growth and skyscraping debt levels seemingly argue for opposing policy responses:
The only way to generate growth is by jacking up investment levels, but authorities seem to believe they can generate a more efficient allocation of capital by using tight command-control tactics. When command-control doesn’t work, we expect the government to try stimulus again, and that will threaten the RMB. Q2 will tell us whether the borders have been sufficiently sewn up against capital flight that authorities can engage in another round.
Could another Chinese currency devaluation be in the cards? Recall that the August 2015 yuan deval was followed by a severe bout of global risk aversion, culminating in a 9% intraday decline in the S&P 500 on Aug. 24, 2015. On that day, a trading halt in eight S&P 500 stocks cascaded into an ETF pile-up featuring major dislocations to net asset value and stoppages of 42% of all equity ETF’s. Will this time be different? The bulls hope so.
Recap April 24
Stocks took a tumble, with the S&P 500 falling by 1.3% amid a barrage of bad news in the industrials realm, while tech also fared poorly with the NYSE FAANG+ index dropping by 2.3%. Treasury yields jumped at the long end, temporarily pushing the 10-year yield above 3% as the curve steepened a bit. The VIX caught a relatively modest bid, rising by 10%.
- Philip Grant
Monday, April 23, 2018
Heads I win
The interest rate-beat goes on. This morning, the 10-year Treasury yield touched 2.996%, its highest since January 2014, up from 2.41% at the end of 2017 and 2.06% in September. Movement at the short end of the curve has been even more pronounced, with the two-year yield reaching 2.47% today, up from 1.88% at year-end and 1.26% in September. Rising rates have been driven by fears of inflation. As noted by Gluskin Sheff chief economist (and recent Grant’s conference speaker) David Rosenberg on Twitter, last week’s reading of the Philadelphia Fed Manufacturing Index for April featured the prices paid and prices received components rising to seven- and 10-year highs, respectively.
Some corridors of the financial sphere are tweaking their behavior to adapt to the dearer cost of money. On April 8, the Financial Times reported on bourgeoning competition among banks for customer deposits in the U.S., noting that: “The most aggressive attempt to woo savers have been launched by Popular, a $44 billion-in-assets lender based in Puerto Rico, which is offering a 2% annual rate on an online instant access account . . . A survey of 370 bankers by Promontory Interfinancial Network, a fintech group that manages institutional deposits, found four-fifths were expecting deposit competition to increase in 2018.”
By contrast, it’s been business as usual in the high-yield credit market. The ICE BofAML US High Yield Master II Option-Adjusted Spread currently stands at 333 basis points over Treasurys, down from 363 basis points at year-end 2017. Even in the early February spasm of risk aversion which knocked 10% off the S&P 500 and vaporized numerous short-volatility positions, the high yield spread edged higher to just 382 basis points, a paucity compared to the 853 basis point interim peak reached on Feb. 10, 2016. Colleague Fabiano Santin notes that the narrowing in spreads echoes what took place during the early stages of the Fed’s prior tightening cycle, covering 2004 to 2007.
Issuers are not ignorant of their favorable current position. On Thursday, Moody’s released a report concluding that its Loan Covenant Quality Indicator gauge “finished 2017 at its weakest yearly level on record, suggesting significant future risks to loan investors . . . today’s loan investors continue to face unprecedented risks as they forfeit key levers that have traditionally been available when a borrower is starting to experience financial distress.”
This morning, Ba3/single-B-plus rated Netflix, Inc., announced an offering of $1.9 billion in 5 7/8% senior notes (upsized from an initial $1.5 billion figure) due in 2028. That follows a $1.6 billion offering of 4 7/8% senior unsecured notes of 2028 in October, currently trading at 96 cents on the dollar for a yield-to-worst of 5.40%, and €1.3 billion in euro-denominated 3 5/8 senior unsecured notes of 2027 offered in April 2017, which, under the loving embrace of Mario Draghi’s ECB, sit just below par for a yield-to-worst of 3.70%. The content juggernaut, which has seen exponential growth in its revenues, stock price and free cash flow burn in recent years, is leaning progressively harder against a bond market to finance its operations, while credit investors have thus far been all too happy to comply.
While an investment in Netflix common equity has proved extremely lucrative in recent years (the stock is up by 66% in 2018 alone), bondholders are assured of earning nothing more than the return of their principal, and some interest income. If all goes well. If it doesn’t? The March 10, 2017 edition of Grant’s (“You only get par”) took note of the particularly poor value proposition provided to creditors of such a speculative business at such modest rates of interest:
Netflix, which will celebrate its 20th birthday this summer, has adapted to changing tastes before. Maybe it will again – or maybe it won’t. If not, the stockholders may lose everything, and the noteholders, too, would likely take a haircut. Default-induced losses might reach 35% of par value, according to S&P, or 68% of par according to Moody’s (both estimates date from October 2016). Comparing the risk-reward proposition at which the noteholders are staring, we recall the candid remark of a late private-equity giant. Referring to the insurance-company bond departments who financed the leveraged acquisitions of a generation ago, the titan shook his head. What chumps, he said.
A Jan. 26, 2018 follow-up (“Like no business”) distilled the dual tracks taken by Netflix investors and creditors: “It’s a speculative business, the content business, but if it works, you, the creditors, will get your money back. The stockholders get rich. Everybody’s happy.”
NFLX 4 7/8s of 2028 in white, stock price in orange. Source: The Bloomberg
Recap April 23
Stocks drifted through a low-key session to finish unchanged on the S&P 500, while Treasury yields ticked higher across the board with the notable exception of the 30-year long bond. The greenback caught another bid, with the U.S. Dollar Index reaching a three month high. That USD strength seemed to pressure the commodity complex, as the broad CRB index fell by more than 0.50%, but energy bucked that bearish trend. WTI crude rose to nearly $69/barrel, its highest since December 2014.
- Philip Grant
Friday, April 20, 2018
In Memoriam
Martin Whitman, value investor,
Martin Whitman, value investor,
Peas in a pod
We’ll see if this one is better than cubic zirconia.
We’ll see if this one is better than cubic zirconia.
Recap April 20
In Memoriam
Martin Whitman, value investor, author and teacher extraordinaire who founded Third Avenue Management in 1986, died at the age of 93 on Monday. Whitman, who co-wrote the investment tome “Modern Security Analysis” (a copy of which has long resided on this author’s paper-strewn desk), was a great thinker as well. In an April 2009 interview with Steve Forbes, Whitman aptly identified both the harrowing financial conditions and remarkable opportunity which characterized that post-crisis era.
Well, obviously, Steve, it’s the worst thing I’ve seen in my lifetime. And the interesting thing about it, I used to say it was like ’74, or ’75. And it turned out it’s really much worse, and in many senses, much better. From the top down, from the macro view, things could not suck more than they do suck. From a bottom-up point of view, there have never been, in my lifetime, as attractive securities as are available today at the price you can get them.
In an obituary of Whitman, Barron’s noted that although the Third Avenue founder ceded his day-to-day management duties at the fund in 2012, “he scoffed at the idea of retirement and rode the subway into the office, even several years later, almost every day.”
Peas in a pod
We’ll see if this one is better than cubic zirconia. This morning, the Wall Street Journal reports that private equity giant Apollo Global Management LLC is set to conduct an IPO of its recently acquired portfolio company Diamond Resorts International, Inc., (formerly DRII on the NYSE). The Journal’s sources peg a prospective valuation for the timeshare resorts business at $4 billion. That figure would represent a big win for Apollo, which paid $2.2 billion in cash (along with the assumption of $863 million in debt) to acquire Diamond in September 2016.
For Apollo, which was founded in 1990 by Drexel Burnham Lambert alum Leon Black, the projected victory comes after some less-successful bets. Another 2016 vintage deal, this one for upscale grocer The Fresh Market, Inc., (formerly TFM on the NYSE) has run aground amid fierce competition aggravated by Amazon.com, Inc.’s purchase of Whole Foods. Those difficult operating conditions have sunk Fresh Market’s 9 3/4 notes of 2023 (issued in April 2016 at 99) to 59 cents on the dollar for a yield-to-worst of 24.33% and compelled Apollo to toss TFM a financial lifeline last October. Bloomberg noted on Oct. 11 that:
Apollo is known for trying to safeguard its investments, sometimes at the expense of other debt holders. But its recent loan to Fresh Market is unusual: The $50 million loan, without collateral, is junior to all other Fresh Market debt and pays an effective 6%. Retailer Restoration Hardware paid a 9.5% coupon in July on a secured loan also provided by Apollo.
“The company needs working capital, and Apollo needs to keep it alive to preserve its equity,” said Mark Kaufman, a senior analyst in distressed debt at brokerage firm Ramirez & Co.
On March 19, Apollo-owned teen retailer Claire’s Stores Inc., filed for bankruptcy, reaching an agreement with its creditors to restructure some $1.9 billion in debt. It didn’t take long for the reorganization to become contentious. On March 21, S&P Global Intelligence’s LCD unit reported on a dispute between Apollo and Oaktree Capital Management, which held a majority stake in Claire’s second-lien notes. While Apollo claimed that Oaktree was non-responsive when it asked for a reorganization plan proposal, the asset manager had a different recollection (from LCD):
But according to Oaktree, it did not learn until days before the Chapter 11 filing that the company was negotiating a [restructuring support agreement], and when it did become aware of that fact, it “promptly” sent a proposal to the company “premised on a valuation in line with the debtors’ management projections and which contemplated a recovery of value for holders of second-lien notes and unsecured claims.”
At that point, according to Oaktree, the company “refused to meaningfully discuss – let alone negotiate – the proposal with Oaktree.”
Turning to the contemplated reorganization plan itself, Oaktree said the plan was “deeply offensive to fundamental principles underlying the Chapter 11 process,” specifically alleging that . . . certain senior creditors will recover more than 100% of claims while junior creditors will be wiped out, that votes are “being purchased” from first-lien creditors . . . and that the new money being raised by the plan “is not even needed.”
Another unusual Apollo saga concerned Dutch company CEVA Logistics Ltd., which the private equity firm purchased in 2006 and is angling to IPO this summer according to a Feb. 26 dispatch from Reuters. On March 29, logistics industry news site The Loadstar reported on another lawsuit against Apollo by former CEVA executives, alleging that despite a valuation estimate of up to $3.75 billion from analysts at Morgan Stanley in 2013, Apollo that year surreptitiously undertook a debt-for-equity swap which wiped out their personal holdings in the company, stakes which Apollo mandated the executives hold in service of “skin in the game”:
According to court documents, one manager, who had borrowed $102,000 for the “requirement for all senior managers to have an investment in the company,” contacted the defendant in November 2012 inquiring about his investment. He was informed that “the investment remains in the care of the company. There is not currently a process that would enable you to exit the plan by selling your CEVA Investments Limited stock.”
According to the court filing, the response made no mention of CEVA Investments being in a precarious financial situation. Yet just five months later, the shareholder received the latter stating that his shares in CEVA Investments were now worthless.
Even in more conventional private equity deals does Apollo stand out from the crowd. In fall 2016, Apollo issued $1.2 billion in debt to finance its leveraged buyout of cloud computing company Rackspace, Inc., (which was the subject of a bearish Grant’s analysis on Jan. 25, 2013, subsequently falling by more than 50% before going private) under issuer-terms stark enough to draw some pointed commentary from credit analysts. From International Financing Review:
Covenant Review’s head of high-yield research Anthony Canale highlighted a provision that could even deprive bondholders of the right to a call premium in the event of a covenant breach.
“Language like this is really egregious,” he told IFR. “This is among the worst covenant packages Apollo has ever issued.”
Covenant Review called that provision “outrageous” and “unprecedented,” while rating agency Moody’s assigned the whole covenant package a grade of “weakest.”
As for Diamond Resorts, Grant’s conducted a bearish analysis of the financing-happy timeshare operator on Dec. 11, 2015, shortly before the company fell into Apollo’s embrace. While the timing of our conclusion was certainly unfortunate, (Apollo paid a 24% premium to DRII’s then-current valuation), we await Diamond’s return to the public markets with no little interest.
Recap April 20
Stocks came under pressure, with the broad S&P 500 sinking by 1% amid downside leadership from tech and the consumer realm to all but erase this week’s gains. Treasury yields jumped higher across the curve to leave the 10-year yield at 2.96%, its highest since 2014, and commodities and the dollar both managed to finish in the green.
- Philip Grant
Thursday, April 19, 2018
Notable quotable
Bill Miller, of Legg Mason Capital Management fame, on Twitter this morning:
Bill Miller, of Legg Mason Capital Management fame, on Twitter this morning:
In season
Tax day has come and gone, but, for holders of U.S. government debt, a different sort of confiscation continues apace.
Tax day has come and gone, but, for holders of U.S. government debt, a different sort of confiscation continues apace.
QT Progress report
Recap April 19
Notable quotable
Bill Miller, of Legg Mason Capital Management fame, on Twitter this morning:
Here is the way to think about Bitcoin. There are 17 million Bitcoins outstanding, each costing about $8000. Are there 17 million people in the world who could afford 1 Bitcoin? That would hoover up all the supply and corner the market.
Think?
In season
Tax day has come and gone, but, for holders of U.S. government debt, a different sort of confiscation continues apace. This morning, the 10-year Treasury yield jumped back above 2.91%, back within three basis points of the multi-year highs logged on Feb. 21. The short end has of course seen an even more pronounced move, with the two-year yield barely pausing in its run higher to 2.43% from 0.55% on July 5, 2016. Interestingly, the upward pressure on Uncle Sam’s borrowing costs has occurred independent of other key bond categories.
For instance, domestic high yield bonds have largely gone the other direction. Today, the BarCap US Corporate High Yield Spread tightened for a fifth straight session, to 311 basis points over the 10-year Treasury. That’s down from 355 basis points in the middle of February and a five year average of 399 basis points.
U.S. Government debt is likewise given the short shift relative to Europe’s economic powerhouse. The spread between the 10-year Treasury and German bund yields ballooned to a record high (going back to German reunification in 1989) of 2.34% yesterday. The two were at virtual parity as recently as June 2012.
There is an array of economic, monetary, and fiscal developments which could help explain the move. This morning’s release of the April Philadelphia Fed Business Manufacturing Index printed at 23.2, well above the consensus expectation of 21. Although just a regional survey (it covers the Pennsylvania, New Jersey and Delaware regions), the uninterrupted strength of the conditions gauge is noteworthy. April marked the seventeenth straight reading above 20 for the survey (a figure above zero denotes expansion). That compares to a 10-year average of 6.26 and is the longest uninterrupted string of 20-plus readings since the early 1970’s.
Yesterday, New York Fed President William Dudley gave a speech at Lehman College in the Bronx, arguing that the so-called neutral rate of interest (the point at which monetary policy is neither loose nor tight) is “around 1%” higher than the rate of inflation. With “core” CPI currently running at 2.1%, Dudley’s remarks imply the potential for far more rate hikes than the market currently anticipates. At the same time, the N.Y. Fed’s Underlying Inflation Gauge for March printed at 3.14%, the tenth straight sequential increase and the highest reading since July 2006, when the 10-year note yielded 4.98%.
N.Y. Fed’s Underlying Inflation Gauge (in white) against the 10-year Treasury yield (in orange). Source: The Bloomberg
Then there’s the fiscal factor. The March 23 omnibus spending bill, overlaid on last year’s tax cuts, looks to worsen an already grim budgetary picture as Federal debt has more than doubled in the past decade to $20.5 trillion as of year-end 2017. Kevin Duffy, principal at Bearing Asset Management in Dallas, noted to Grant’s that “Since DJT took office, the [annual] federal deficit has expanded by 26%. The $1 trillion mark is within reach, especially considering the Social Security and Medicare trust funds are slated to go cash flow negative in 2020.” In 2004, then Vice President Dick Cheney commented that: “Reagan proved that deficits don’t matter.” We might tweak that phrasing to, “they haven’t mattered.”
However, for all the news, data and price action seemingly auguring a new bond bear market regime, the long-time bond-bulls par excellence at Hoisington Investment Management are steadfast in calling for lower rates, an opinion of which any investor (or interest rate observer for that matter) would be wise to take heed. In the Hoisington Quarterly Review and Outlook for the first quarter 2018, Van Hoisington and Lacy Hunt take note of the tightening Fed and fiscal folly, yet come to an opposite conclusion.
Nearly nine years into the current economic expansion Federal Reserve policy actions appear to be benign, as even after six increases, the federal funds rate remains less than 2%. Changes in the reserve, monetary and credit aggregates, which have always been the most important Fed levers both theoretically and empirically, indicate however that central bank policy has turned highly restrictive. These conditions put the economy’s growth at risk over the short run, while sizable increases in federal debt will serve to diminish, not enhance, economic growth over the long run.
Important to the long-term investor is the pernicious impact of exploding debt yields. This condition will slow economic growth, and the resulting poor economic conditions will lead to lower inflation and thereby lower long-term interest rates. This suggests that high quality yields may be difficult to obtain within the next decade. In the shorter run, in accordance with [economist Milton] Friedman’s established theory, the current monetary deceleration, or restrictive monetary policy, will bring about lower long-term interest rates.
Will cyclical forces, bolstered by an aggressively tightening (and asset selling, via QT) Fed and crushing government debt burden, formulate an economic accident and lead to yet another downward break in interest rates? Investors have been well served to avoid betting against Hoisington and Hunt during the 35 year (and counting?) bull cycle in credit, but all cycles eventually turn.
QT Progress report
The Fed’s portfolio of securities held outright registered at $4.173 trillion, up by $1.94 billion from a week ago and the second straight sequential uptick. Both mortgage backed securities ($1.92 billion) and Treasury holdings ($19 million) rose week-over-week. Compared to the trailing four-week average, securities held outright are down by $6.1 billion, with the bulk of that decline ($5.8 billion) in Treasury holdings.
Since QT began on Oct. 1, 2017, The Fed’s total balance sheet has declined by 1.57%, for a simple annualized pace of 2.8%.
Recap April 19
Stocks finished moderately lower, as the S&P consumer staples index was hammered to the tune of 3.1% after cigarette maker Philip Morris International disclosed a larger than expected decline in first quarter volumes. Treasury yields ticked mostly higher across the curve (the two-year note was the bullish exception), and commodities pulled back after breaking to fresh post-2015 highs yesterday on the broad CRB Index.
- Philip Grant
Tuesday, April 17, 2018
Fjord focus
“Global debt rose to a record $237 trillion in the fourth quarter of 2017, more than $70 trillion higher from a decade earlier,
“Global debt rose to a record $237 trillion in the fourth quarter of 2017, more than $70 trillion higher from a decade earlier,
Recap April 17
Fjord focus
“Global debt rose to a record $237 trillion in the fourth quarter of 2017, more than $70 trillion higher from a decade earlier, according to an analysis by the Institute of International Finance.” That unambiguous lead, from a Bloomberg article last Tuesday, makes for a notable companion to the recent surge in U.S. borrowing costs. The London interbank offered rate, quoted at 0.28% on April 17, 2015, has rode a relentless grind higher to 2.36% as of today.
What sort of toll might rising debt loads and rising interest rates (as measured by Libor) take on leveraged speculators around the globe? One country that looks uniquely exposed to a regime change in credit is Norway, which features heavy encumbrance and less-than stringent financial regulation.
Norway’s household debt footed to 230% of disposable income as of year-end 2016, according to the Organization for Economic Co-operation and Development. That’s third highest among the OECD’s 35 country coverage realm, behind only Nordic peer Denmark and the Netherlands. That ratio has consistently inched, rather than skyrocketed, higher in recent years. The OECD calculates Norway’s 2009 household debt as having been at 206 percent of disposable income.
While a heavy Norwegian debt burden is nothing new, a recent turn in the Nordic nation’s formerly red-hot housing market bears close watching. According to Statistics Norway, the country’s house price index has enjoyed a 71% rise since the end of 2008 (house prices suffered only a shallow pullback in that infamous year), with annual gains accelerating to more than 10% in 2016, the year in which global interest rates perhaps bottomed. That housing bull market appeared to abate in 2017 as prices held steady, while the first quarter of this year saw a 1.1% year-over-year decline in the index, the first such drop since June 30, 2009. “Tighter mortgage regulations, lower population growth and a boom in construction” are among the culprits, per an April 5 dispatch from Reuters.
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They do have this going for them. Source: G Adventures
Meanwhile inflation appears to be firming. Norway’s headline CPI for March came in at 2.2%, matching February’s figure for the highest since spring of 2017. The local central bank, Norges Bank, has kept its overnight lending rate at 0.5% since March 2016 and has not raised interest rates in since 2011. The Norwegian 10-year nominal yield of 1.79% leaves bondholders more than 40 basis points in the red in real terms.
Not just in the realm of consumer debt is Norway a financial standout. While the U.S. leveraged loan market has increasingly been dominated by issuer friendly “covenant-lite” terms (S&P Global Market Intelligence’s LCD unit calculates that 77% of the $994 billion in outstanding leveraged loans are so classified, up from 60% at the end of 2014), the Norwegians have us beat once more. This morning, Bloomberg reported on the travails of Lebara Group B.V., which produces mobile phone “Sim” cards:
Debt issued in Nordic nations requires no credit rating or due diligence. Companies can claim more or less what they like when selling new debt, according to Norway’s financial-market regulator.
“In Nordic high yield you can easily think you’re buying a Ferrari and it turns out it’s not,” said Evgeny Artemenkov, a high-yield money manager at Saatstopankki in Helsinki, which bought some of the notes. “The bond was issued using different numbers from what should have been used.”
The debt has cratered more than 30 percent as Palmarium, the little-known private fund that used the bond proceeds to finance its purchase of Lebara, restated its accounts four times in six weeks. They called it a “genuine mistake.”
Norway’s financial foundation may be put to the test sooner rather than later, as forces beyond domestic inflation put the screws to interest rates. Last week, Bloomberg reported on a secondary impact of rising Libor, namely a parallel surge in Norway’s floating-rate benchmark Nibor, to which some 1 trillion kroner ($127 billion) in floating-rate securities are benchmarked.
The gyrations in the Norwegian money market rates is also once again prompting calls for an overhaul of the interbank market and how liquidity is managed. “We could see some adjustments from the central bank given the high volatility,” said Jostein Tvedt, strategist at Danske Bank in Oslo.
It seems to us that when cyclical troubles in credit reappear, those troubles will find their way to the land of Vikings and pickled herring.
Recap April 17
Stocks ripped higher again, with Netflix, Inc.’s near-10% gain after results underpinning a near 4% advance in the NYSE FAANG+ tech index and more than 1% gain in the broad S&P 500, while the VIX dropped for a sixth straight day to approach its interim lows logged in March. The Treasury curve flattened a bit with short yields drifting higher and the long end catching a bid, and the broad CRB commodity index was once again halted at the doorstep of its January interim peak, with fresh 2.5-year highs awaiting above.
- Philip Grant
Monday, April 16, 2018
Well to do
It was not an ideal start to the week. Investors in National Oilwell Varco, Inc. (NOV on the NYSE)
It was not an ideal start to the week. Investors in National Oilwell Varco, Inc. (NOV on the NYSE)
Recap April 16
Well to do
It was not an ideal start to the week. Investors in National Oilwell Varco, Inc. (NOV on the NYSE) were greeted rudely this morning by a press release providing “an operational update for the first quarter.” As frequently follows that ominous headline, the company had bad news to impart: Customer deferrals of capital equipment orders will result in sequential revenue declines across its three business lines (drilling rigs, well service and fracking pumps).
The oilfield infrastructure company now expects $160 million of adjusted EBITDA for the period, well below the analyst consensus of $189 million. National Oilwell chairman, president and CEO Clay C. Williams, attempted to mitigate the bearish revelation by commenting that “industry fundamentals continue to improve, and we remain optimistic regarding the second quarter and the remainder of the year.”
That rhetorical silver lining aside, Mr. Market saw fit to mark down NOV stock by 7% to $38 per share. The sell-side was likewise vexed. Analysts at Tudor Pickering Securities termed the numbers “considerably softer” than its expectations, while Capital One Securities, Inc., observed that today’s revelation “will rattle that [bull] thesis a bit more.” In aggregate, the Street is definitely not bullish: Bloomberg counts eight buy ratings, 22 holds and four sells among analysts who cover the company.
Even before today’s setback, it’s been a tough road of late for NOV. The company, which earned $4 billion in adjusted earnings before interest, taxes, depreciation and amortization and generated $2.8 billion in free cash flow in 2013 (the tail end of the prior energy bull market), saw its adjusted EBITDA and FCF fall to just $621 million and $640 million, respectively, in 2017. That precipitous drop-off of course coincides with the post-2014 freefall in energy prices. A barrel of West Texas Intermediate crude, which fetched $108 as recently as June 2014, sank as low as $26 in February 2016. It has since recovered to $66.
Into the teeth of that ferocious decline, Grant’s, in the issue dated Jan. 29, 2016, offered a bullish word for National Oilwell as an investment and its then-freshly spun-off NYSE-listed supply-distribution subsidiary, Now, Inc., as a speculation. The crux of the analysis: While NOV’s stock price has long acted as a leveraged proxy for broader circumstances in energy prices, the company’s solid financial position (even after multiple downgrades in 2016, Moody’s and S&P rate National Oilwell’s default risk at Baa1 and triple-B-plus, respectively, well within investment grade status) would allow time for conditions to improve and, hopefully for the longs, a new energy bull market to take shape.
As for the cyclical, mean-reverting and self-correcting interactions of supply and demand, the market historian Edward Chancellor’s Jan. 21, 2016 analysis in Reuters’ Breakingviews argued that the then-painful bear market was setting the stage for a glorious bullish future:
The old adage that “the best cure for high prices is high prices” also works in reverse. During the boom phase of the commodity supercycle, rising investment pushed supply up and prices down. In similar fashion, today’s capital spending cuts by energy producers are setting the stage for the next bull market in oil.
The basic insight of so-called capital-cycle analysis is that demand forecasts are inherently unreliable – who knows how many cars the Chinese will be driving in 20 years time? Supply is much easier to predict. As independent investment strategist Russell Napier puts it, “investors spend 90 percent of their time thinking about demand and 10 percent thinking about supply. It should be the other way around.” This explains why investors and industry insiders have read the bull phase of the commodity cycle so badly. During the boom, they fantasized about the prospects for Chinese demand, while largely ignoring the massive increase in commodity supply.
Most investors espouse a belief in mean reversion – the notion that markets return to stable equilibrium price – but they ignore how it comes about. Mean reversion largely operates through changes on the supply side. Rising output prices and profitability in most industries tend to elicit an investment response. In time, the increase in production serves to bring down prices.
As for Grant’s upbeat verdict in NOV, the jury is still out. After today’s selloff, NOV shares have returned 19.5% with dividends reinvested since publication date, while Now, Inc., shares (DNOW is the ticker) have since fallen by 14% after reversing a strong rally through 2016. That trails the 24.4% logged by the S&P 500 with dividend reinvestment and a 26% gain in the S&P 500 Energy Index during that period. Duly dissatisfied by today’s news, we remain bullish.
Source: The Bloomberg
Recap April 16
Stocks jumped higher, as the S&P 500 traded to three week highs amid broad-based strength, with all eleven sector groups well in the green. In turn the VIX dropped to a one month low and the iShares High Yield Corporate Bond ETF rose for a sixth straight day to log its highest close since the end of February. Treasury yields finished little changed, and the CRB commodity index was unable to break through the January interim highs despite a weaker dollar.
- Philip Grant
Friday, April 13, 2018
Metaphor overload
From Wednesday’s edition of the Sacramento Bee:
From Wednesday’s edition of the Sacramento Bee:
Lending labyrinth
It’s still early, but 2018 could thus far be termed, the “Year of the Whipsaw.”
It’s still early, but 2018 could thus far be termed, the “Year of the Whipsaw.”
Recap April 13
Metaphor overload
From Wednesday’s edition of the Sacramento Bee:
A fire-gutted house in Silicon Valley has hit the market for $800,000.
While that might seem a tad pricey for an uninhabitable, burned-out hulk, Realtor Holly Barr told KTVU the price reflects the value of the property, not the ruined house currently occupying the lot. The house burned down two years ago.
A post Monday on the Willow Glen Charm page on Facebook lists a $799,000 asking price. Barr told KTVU she’s already received at least 10 offers and expects to sell the property in the next few days.
On the bright side, the house’s foundation is still intact and no landslide threatens the property. So too, can a prospective buyer factor in cheap moving costs. It’s basically a steal!
Lending labyrinth
It’s still early, but 2018 could thus far be termed, the “Year of the Whipsaw.” As the major equity indices dart to and fro in a manner unseen last year, economic signals impart no obvious regime change. Unemployment is low and job growth is slow, while GDP continues to expand at a plodding rate.
Interest rates, as measured by the shape of the yield curve, are moving more decisively. While the benchmark 10-year yield remains below its December 2013 interim highs, the short end has raced higher with the two-year yield jumping above 2.3% to its highest since 2007. That divergence has compressed the spread between the two rates to less than 47 basis points, narrowest since the financial crisis. Customarily, a flat or inverted yield curve signals a market expectation of slower growth ahead.
Barring an abrupt monetary change of course, that spread looks set to narrow further. Longer yields have come down in recent months, yet interest rate futures currently price in 69% odds of at least two more 25 basis point hikes in the overnight Fed Funds rate this year, following such moves in December and March. Interbank lending rates, as measured by Libor (the London interbank offered rate), have risen even more quickly, more than erasing a 30 basis point discount to the two-year Treasury yield at the beginning of the current monetary tightening cycle.
At least one member of the Federal Reserve board is pondering an even faster turn of the short-end screws. In a speech this morning, Boston Fed president Eric Rosengren took note of the tight labor market (headline unemployment came in at just 4.1% in March, matching its post-2000 low) and forecast a further tightening of the labor market and inflation uptick. Rosengren, currently a non-voting member of the Fed, went on to provide his prescription: “Therefore, I expect somewhat more tightening may end up being needed than is currently reflected in the projected median for the federal funds rate.”
Rosengren’s remarks beg the question: What sort of consequences might follow a further rise in short-term rates, particularly in interbank lending? For the domestic money center banks at least, so far, so good. This morning, J.P. Morgan Chase & Co. reported record first quarter net income of $8.7 billion, a 35% jump year-over-year, while Citigroup, Inc. and Wells Fargo & Co. (which is in regulatory purgatory after a series of scandals) reported year-over-year gains in net income of 13% and 5.5%, respectively. According to Bloomberg, the stronger bottom lines are at least partially attributable to higher lending rates:
The largest U.S. lenders could each make at least $1 billion in additional pretax profit in 2018 from a jump in the London interbank offered rate for dollars, based on data disclosed by the companies. That’s because customers who take out loans are forced to pay more as Libor rises while the banks’ own cost of credit has mostly held steady.
“During the 2008 crisis, [rising Libor] was the sign capital markets were frozen,” said Fred Cannon, head of research at Keefe, Bruyette & Woods. “Now there’s all this liquidity, so they don’t need to borrow in the Eurodollar market,” where rates are based on Libor, he said.
Of course, for every lender there’s a borrower, and if some constituencies benefit from a change in credit conditions, others must suffer. Yesterday, a Bloomberg dispatch identified one group of unfortunates: “Default risks are rising for U.S. companies with high leverage and floating-rate debt as Libor jumps.”
While floating rate borrowers’ exposure to a rising Libor is no breaking news, the move is causing pain in far-flung places. Here’s Bloomberg again, this time on Wednesday:
Norwegian households and companies are feeling the sting from policy choices across the Atlantic. Growing U.S. deficits have triggered a deluge in Treasury bill supply, helping drive up the London interbank offered rate and a key dollar-financing indicator that feed directly into the benchmark Norwegian interbank rate.
If the surge continues, banks in the Nordic country may be forced to raise mortgage rates, perhaps giving the central bank pause as it prepares to tighten for the first time in seven years after the summer.
The Land of the Midnight Sun is particularly poorly positioned for rising borrowing costs: The Organization for Economic Co-Operation and Development calculates Norway’s ratio of household debt to disposable income at a towering 230% as of year-end 2016; only the Netherlands (270%) and Denmark (285%) are more encumbered within the OECD’s 34 country data set.
For more on Norway and its debt-heavy and negative-rate-happy Nordic peers, see the Nov. 30, 2017 edition of Almost Daily Grant’s (“Prognosis negative"). For more on the potential impact of rising borrowing costs on the legion of cash flow-negative “zombie companies” which increasingly stalk the business landscape, see the March 23, 2018 edition of Grant’s (“The nine lives of the modern leveraged company”).
Recap April 13
Stocks ticked slightly lower, allowing the broad S&P 500 to preserve the bulk of its recent gains and end the week 2% in the green. Commodities likewise remained well bid, with the CRB index finishing the week higher by nearly 4% and continuing to knock on the door of multi-year highs.
Crypto-currencies also enjoyed a bullish reversal, with the price of bitcoin jumping nearly 18% in the past two trading days. In the past year, bitcoin has acted as a decent proxy for risk appetite, with its gyrations corresponding fairly well with those of the S&P 500.
Source: The Bloomberg
- Philip Grant
Thursday, April 12, 2018
Passive aggressive
This Wall Street heavyweight still packs a punch.
This Wall Street heavyweight still packs a punch.
QT progress report
Recap April 12
Passive aggressive
This Wall Street heavyweight still packs a punch. BlackRock, Inc. (BLK on the NYSE) announced first quarter results that, on the income statement at least, came in above the Street’s consensus expectation. Adjusted earnings per share of $6.70 exceeded even the most bullish analyst forecast of $6.55, while first quarter revenues of $3.58 billion matched the sell-side’s high estimate. BlackRock CEO Laurence Fink commented: “In a challenging environment, BlackRock continued to perform well.” The market agreed. BLK shares rose by 2%, and have tacked on nearly 50% from their Sept. 30, 2016 levels, compared to a 23% gain from the S&P 500.
Source: The Bloomberg
It wasn’t all peaches and cream for the house that Fink built. BlackRock’s assets under management of $6.32 trillion trailed the $6.41 trillion analyst consensus, while net flows for its iShares ETF business declined by 46% year-over-year to $34.6 billion. Strength in the firm’s technology and risk management unit (headlined by the operating system known as “Aladdin,” BlackRock’s technological pride and joy) which grew revenues by 19% year-over-year, was a primary factor. A lower than expected tax rate helped, too.
The fast-growing, low-cost ETF and indexation businesses have contended with intense competition in recent years, as new offerings continue to emerge. Yesterday, the Financial Times reported that the international arm of Fidelity Investments, Inc., “has returned fire on its rivals in the ferocious price war being fought by investment managers in Europe – with a new range of low-cost index-tracking funds.”
The growing ubiquity of ETFs and indices is pressuring the industry bottom line. Bloomberg Intelligence calculates that “ETFs charging 0.2 percent [20 basis points] or less have accounted for 82 percent of the industry’s net flows this year, up from 77 percent in the fourth quarter.” BlackRock’s primary competitor in the realm, the Vanguard Group, is seemingly approaching the end of the line on fee cuts, according to a March 17 report by the FT:
Last year Vanguard dropped the expenses on 62 share classes – down nearly two-thirds on 2016’s number. The company cut the fees on just nine exchange traded funds, down from 42 the year before.
The average fee cut in 2016 was 2.4 basis points, which fell to 1.6bps last year, according to Daniel Wiener, editor of the Independent Advisor for Vanguard Investors, a newsletter that closely tracks the company. He said Vanguard was no longer the “champion cost cutter.”
Asked for comment on fees, a Vanguard spokesman told Grant’s that: “No other asset manager comes close to our asset-weighted complex-wide expense ratio of 0.11%.”
Meanwhile, the historic market calm that characterized 2017 has been replaced by something entirely different so far this year. The CBOE’s VIX volatility index, which averaged just over 11 last year, has jumped to nearly 18 on average in 2018 thus far. Vanguard’s founder and chairman emeritus, the estimable 66-year Wall Street veteran Jack Bogle, is definitely not downplaying the significance of this change. Bogle told CNBC last week that: “I have never seen a market this volatile to this extent in my career . . . I’ve seen two 50 percent declines, I’ve seen a 25 percent decline in one day and I’ve never seen anything like this before.”
The alarm expressed by Bogle is put into relief by a Goldman Sachs report out Wednesday. Goldman finds that:
For the first time in six years, the volatility of the S&P 500 has been greater than the volatility of the most shorted stocks. This suggests investors that short stocks (i.e. Hedge Funds) are not making big changes to their positions on a daily basis, while investors that trade at the index level are rapidly changing their positioning.
We believe it is increasingly important for portfolio managers to know how much of their stocks are owned by passive funds as that appears to be one of the primary sources of recent volatility.
For his part, Larry Fink is undaunted by the recent financial regime change. On a CNBC appearance this morning, the BlackRock boss didn’t mince words in explaining his bullish stance: “You should be 100 percent in equities. We spend too much time talking about market timing. The key for investors is to stay in the market.”
In a Sept. 30, 2016 analysis (“House of fads”), Grant’s offered a bearish view of BlackRock, contending that an interruption of the virtuous cycle of microscopic interest rates, expanding risk appetite and absent volatility could spell trouble for the behemoth asset manager.
To be clear, a bet against BlackRock is a bet on discontinuity – on a break in the central bank-induced levitation or on the fad for passive investment vehicles or on the malfunction of the technology about which BlackRock is so prone to boast.
To be sure, that discontinuity appeared no short time after (see the aforementioned BLK performance figures) and may not be here to stay in 2018. Nevertheless, as for BlackRock and central bank-induced tranquility alike, we remain bearish.
QT progress report
Steady as she goes. After last week’s $12 billion, Treasurys-driven decline, the Fed’s portfolio of securities held outright ticked higher by $30 million this week to $4.172 trillion. Holdings of mortgage-backed securities ($1 million), and Treasurys ($29 million) holdings both rose from last Thursday’s levels.
Compared to the trailing four-week average, securities held outright are down by $14.5 billion, with $8.7 billion of the decline from USTs and the balance from MBS. Since QT began on Oct. 1, 2017, the Fed’s total assets have declined by 1.62%, for a simple annualized pace of 2.99%.
Recap April 12
Stocks caught a strong bid, with the S&P 500 reaching its highest close in more than three weeks as strength in the financials, industrials and tech overcame weakness in rate-sensitive groups as UST yields jumped higher across the curve. Commodities reversed early losses despite a stronger dollar, with the broad CRB index now testing the two and a half-year highs reached in January, and the VIX dropped below 19.
- Philip Grant
Wednesday, April 11, 2018
Attention, deficit disorder
That recently-dormant beast called inflation is stirring.
That recently-dormant beast called inflation is stirring.
Recap April 11
Attention, deficit disorder
That recently-dormant beast called inflation is stirring. This morning, the Consumer Price Index for March showed a 2.4% year-over-year uptick in the headline component, with “core” CPI (that’s without food and energy) also jumping by a sturdy 2.1% year-over-year, the highest in over a year for both readings. That follows yesterday’s figures from the Labor Department reporting that the Producer Price Index jumped by 3.0% year-over-year in March. Strip out food and energy, and the 2.7% year-over-year reading was the hottest since 2011.
The private sector corroborates the government’s statistical findings. Yesterday, the National Federation of Independent Business released its Small Business Optimism Index for March, finding that a “net 25 percent plan price hikes (up 1 point), the highest reading since 2008.” The Federation cites upward pressure on wages as a catalyst: “With reports of increased compensation running high, there is more pressure to pass these costs on in higher selling prices, although tax cuts and growing operating profits alleviate some of this pressure.”
Those inflationary sightings arrive in tandem with fiscal prognostications that could be described as grim. On Monday, the Congressional Budget Office released its updated Budget and Economic Outlook: 2018-2028. The CBO now estimates that the annual budget deficit will exceed $1 trillion in 2020, two years earlier than the agency’s June 2017 forecast. Over the next 10 years, the CBO now anticipates a cumulative $12.4 trillion shortfall, that’s up 23% from last June’s estimate and represents 4.9% of expected GDP (compared to 2017’s shortfall of 3.5% of GDP). Federal debt held by the public, which footed to $14.7 trillion as of Dec. 31, 2017, is expected to virtually double to $28.7 trillion in 2028.
Does the uptick in measured inflation and the fast-deteriorating fiscal picture portend a higher interest rate regime? Not necessarily, we can infer from the work of Paul Schmelzing, history professor of Harvard University and visiting scholar at the Bank of England. Schmelzing conducted an analysis of the sovereign bond market going back to the 13th century, specifically utilizing the so-called risk free rate cobbled together from the world’s most credit-worthy borrower in each era. As documented in the Nov. 17, 2017 edition of Grant’s, Schmelzing “concludes that fiscal deficits don’t matter, at least not in the setting of bond yields [and] that the average real rate of interest since the year 1311 stands at 4.78%.”
That proposition, with the near-millennium of statistical weight which underlies it, will be put to the test. Uncle Sam is set to borrow 4.2% of GDP next year according to the CBO, the most since the end of World War II in 1945, after adjusting net issuance for the Fed’s “QT” Treasury sales (the Bernanke era would have seen greater growth in public debt relative to GDP were it not for the Fed’s asset purchases). Meanwhile, the economic backdrop remains benign. The current expansion in output stands at 106 months and counting and, as of April, is tied for second longest since 1854 when such records were first kept.
The Feb. 9 Grant’s featured an analysis of the United States’ fiscal foibles, and drew a psychological contrast between the bond market’s current complacency in the face of a torrent of new debt and the conditions which prevailed in the prior bear market of 1946-1981.
“Markets make opinions,” said the departed Richard Russell. In a bear market, new supply is perceived to be bearish, or at least not bullish (another tautology freighted with trading wisdom). Supply is thought to be bearish not, perhaps, because the supply is greater than the demand for bonds at prevailing yields and prices (though that is certainly true), but because the very thought of fixed-income securities has become repellant. That attitude, and its opposite, are years in gestation. “The bond crop never fails” was how disgusted fixed-income investors expressed their free flowing hatred (or love-hatred, as the opportunities for reinvestment of coupon income were forever improving) of an asset class that had disappointed so many for so long. From which it would follow that the Cheney/Reagan deficit doctrine [they don’t matter] is due for cyclical revision.
For the bond market, what’s old is new again.
Recap April 11
Stocks saw a moderate decline, with the S&P paring its gains from earlier in the week and remaining within a relatively tight trading range compared to the past two months. Treasurys caught a bid, with the 10-year yield edging lower to 2.78%, while commodities enjoyed a third straight rally, with the broad CRB index now up by nearly 3.5% for the week and within range of its multi-year closing highs reached on Jan. 26.
- Philip Grant
Monday, April 9, 2018
The Son also rises
This bull-market avatar is doubling down: Japan’s SoftBank Group Corp. (9984 on the Tokyo Exchange and SFTBY on the U.S. Pink Sheets) announced on Friday that it has secured an $8 billion margin loan from a consortium of investment banks backed by its stake in China’s Alibaba Group Holding, Inc. (BABA on the NYSE).
This was one for the record books. Bethany Knight of Riverside Risk Advisors LLC told Bloomberg that: “To my knowledge, I would agree that $8 billion is the largest margin loan ever.” Bloomberg notes that the loan helps SoftBank move closer to an initial public offering of its domestic telecom business Softbank Corp., which had already been utilized as collateral for prior loans. “A successful IPO – possible only after the division proves its independence by canceling debt guarantees – could help the parent raise capital and relieve some of its debt burden.”
On March 9, SoftBank launched a debt exchange offer, presenting its creditors the opportunity to swap existing bonds for new notes due in 2028 for a 100 basis point consent fee. Covenant Review, an independent credit research firm, observed that this was no act of corporate generosity. Holders of existing notes are protected by a covenant stating that if SoftBank loses its investment grade status its telecom subsidiary, Softbank Corp., will guarantee the debt. That protection is set to be eliminated.
So when investors purchased the Existing Notes, they knew that at worst either the Existing Notes would be rated investment grade or the Softbank Corp. guarantee would remain in place. If the Proposed Amendments are successful, then holders would have swapped that protection for the consent fee – and the Existing Notes could well be left with neither an investment grade rating nor a continuing guarantee from Softbank Corp. (or any other subsidiaries for that matter).
Longtime observers of SoftBank’s charismatic and brilliant CEO Masayoshi Son (who is often compared to Warren Buffett) could hardly have been surprised by this latest bold corporate maneuver. Son, who weathered a 99% loss in Softbank shares following the bursting of the late-1990’s tech bubble, has taken full advantage of the easy money and tech-happy market conditions which have pervaded in the post-2009 era. Softbank shares have advanced by 442% over the past nine years in yen terms (20.7% annualized) outpacing the Nikkei’s 142% gain (11% annualized) over that period.
That impressive rebound, burnished by timely investments in Yahoo! Japan, and the aforementioned Alibaba, has coincided with a flurry of deals, some under the umbrella of SoftBank’s buyout arm, the $100 billion Vision Fund. Last February, SoftBank bought the Fortress Investment Group for $3.3 billion, a hefty 38.6% premium. On Aug. 24, the fund paid $4.4 billion for a minority stake in private concern WeWork Companies, Inc. (founded in 2010 and now the second largest private office tenant in Manhattan). Softbank has also made substantial investments in ride-sharing unicorns Uber Technologies, Inc. and its Chinese peer, Didi Chuxing Technology Co. (which is preparing to commence operations in Mexico, according to Caixin, directly challenging its fellow SoftBank portfolio company).
#1 conglomerate. Source: Softbank presentation PowerPoint slide from Feb. 7
Masa Son’s spendthrift ways haven’t always gone over so smoothly in the company C-suite. On Feb. 26, the Wall Street Journal shed light on the friction between Son and SoftBank directors who don’t always share his deal-making enthusiasm.
Shigenobu Nagamori says he objected when Mr. Son told his board in 2016 that he wanted to pay $32 billion from Arm Holdings PLC. The U.K. chip-design firm was worth a 10th of that, Mr. Nagamori, then a Softbank outside director, says he told Mr. Son. Mr. Son paid it anyway.
To strike quickly, [Son] sometimes commits to investments before getting approval from his fund’s investment committee, some of these people say. And he often spars with his executives and board members over his proposals until they are convinced or acquiesce.
“I’ve opposed almost all of Mr. Son’s proposed investments,” says SoftBank director Tadashi Yanai, president of Fast Retailing Co., operator of Uniqlo clothing stores. Instead of acting like a speculative investor, he says, Mr. Son should focus on “real business.”
A month later, the Journal reported that the dynamics among SoftBank insiders have escalated beyond straightforward strategy disagreements. Specifically intriguing was the mysterious origins of a shareholder campaign to discredit a pair of senior executives at the company, including one (Nikesh Arora), whom the WSJ described as a one-time heir apparent to Son.
At the time, SoftBank couldn’t figure out who was behind the campaign, which the company said was based on false allegations of impropriety and which a board member later called “sabotage.” Both men denied wrongdoing and said they were victims.
People with knowledge of the matter said Alessandro Benedetti, an Italian private-equity investor, was a central figure in that campaign. They said he told associates he was working, in part, for the benefits of a SoftBank insider.
Excessive leverage and value-destructive deals, not palace intrigue, was the crux of a Dec. 15, 2017 bearish assessment of Softbank found in the pages of Grant’s. Total debt reached $154 billion as of Dec. 31, 2017 on a consolidated basis, up from $42 billion on Dec. 31, 2013. Son’s 2013 purchase of U.S. telecom operator Sprint Corp. (SoftBank paid $22 billion for an 83% stake. Sprint’s current market cap is less than $21 billion) is one potential source of trouble, an interruption of Alibaba’s charmed existence is another. The conclusion drawn by Grant’s was evident in the piece’s headline, “Epitome of the cycle:”
Mix the CEO’s exuberance with cheap debt, high leverage and record asset values. Add the excitement of today’s startling advances in robotics and artificial intelligence. Combine with the karmic report that [Saudi Crown Prince Mohammad bin Salman], the Vision Fund’s No. 1 limited partner, is also the rumored buyer of that $450 million road-show da Vinci. Totting them all up, what do you have? Perhaps a corporation destined to read about itself on page one of The New York Times – and not in a flattering way.
Recap April 9
Stocks finished green but well off their intraday highs, with the VIX a reciprocal late surge to back above 22 by the close. Treasury yields finished little changed, while commodities were bid strongly with the broad CRB index gaining 1.4%.
- Philip Grant
Friday, April 6, 2018
The overpromised land
Terrific weather, a booming tech-led economy and lots to do: Who wouldn’t want to live in the City by the Bay?
Terrific weather, a booming tech-led economy and lots to do: Who wouldn’t want to live in the City by the Bay?
Not just for Snickers bars
For all the talk of a trade war, China and the United States share major economic commonalities,
For all the talk of a trade war, China and the United States share major economic commonalities,
Recap April 6
The overpromised land
Terrific weather, a booming tech-led economy and lots to do: Who wouldn’t want to live in the City by the Bay? An April 4 dispatch from the San Francisco Business Times identifies one small hang-up for prospective NorCal dwellers:
San Francisco’s median home price surged to a new record of $1.61 million in the first quarter, amid falling supply and the booming tech industry.
Home prices were up almost 24 percent from the first quarter of 2017’s median price of $1.3 million, according to Multiple Listings Service Data analyzed by brokerage Paragon Real Estate. The price was up $100,000 from the previous quarter.
“I’m pretty surprised that we’ve started 2018 in this sort of frenzy. This may be hotter than ever,” said Patrick Carlisle, chief market analyst at Paragon. “There’s a raging hunger for people to get into homes.”
Rather rent? Real estate blog Curbed S.F. has some options, as presented in an April 5 post headed: “What $8,000 [per month] rents you in San Francisco right now.”
Unsurprisingly, most people are hard pressed to come up with such princely sums. The Feb. 26, 2018 edition of Almost Daily Grant’s (“Flowers out of your hair”) cited data from Paragon finding that only 12% of San Francisco residents manage to earn a household income of $303,000, the figure which would allow for a 20% down payment on a median-priced home in the final three months of 2017 (that’s prior to the latest sequential increase in prices).
What to do when the financial math just doesn’t add up? Hit the bricks. Mark J. Perry, economics professor at the University of Michigan, found in February that the going rate for a U-Haul rental truck from San Jose to Las Vegas was priced at a whopping $1,990, while the same van going in the other direction could be had for just $121.
The food is terrible. And the portions are so small!
Not just for Snickers bars
For all the talk of a trade war, China and the United States share major economic commonalities, including activist central banks, freewheeling fiscal policy and a love of leverage. Another, more particular similarity, automobile vending machines. Today’s Wall Street Journal explains:
Eric Zhou is interested in buying a Ford Kuga sport-utility vehicle. So last week, he picked up the car for a three-day test drive from a vending machine.
Mr. Zhou never visited a dealership or spoke to a salesperson. He booked the test drive online, then showed up at a service center where employees can identify would-be buyers using facial recognition technology. His SUV was then delivered from the eight-story “vending machine” – essentially an automated parking garage.
“This is so much more efficient and convenient than traditional dealerships,” said Mr. Zhou, 38 years old.
Stateside, the Carvana Co. (CVNA on the NYSE), is bringing that same automated auto dream to the American used car buyer. Yesterday, the Kansas City Star reported that Carvana has filed plans to build a vending machine in Kansas City, according to a local development tracking website. The new location will join existing contraptions in nine other cities located in Texas and the southeast.
Carvana itself could be described as a kind of investment contraption. Spun-off from DriveTime Automotive Group in 2014, Carvana made its public debut in April of last year as an “emerging growth company” under the 2012 JOBS Act. That designation allows CVNA “to take advantage of certain exemptions from various reporting requirements that apply to other public companies, including, but not limited to, scaled disclosure provisions with respect to financial information and executive compensation.”
The financial information that is available shows brisk top-line growth, with revenues jumping to $859 million in 2017 from $365 million in the year prior, while a generally bullish sell-side (featuring seven buy ratings, five holds and a solitary sell) expects revenues to jump to $1.8 billion this year and $3.2 billion in 2019. The stock price, which hovered in the single digits last spring, remains near recent highs north of $22 a share.
Source: The Bloomberg
As revenues increase, so do losses. Adjusted net income rose to negative $72 million this year from negative $64 million a year ago, with the Street expecting the bottom line to be $185 million in the red this year and a $57 million loss in 2019. Free cash flow of negative $279 million in 2017 will be followed by negative $226 million this year and an additional negative $142 million in 2019, if the Street is on the beam. A credit facility with Ally Financial and convertible preferred stock issuance is helping to finance this currently loss-making enterprise.
Like moths to a flame have short sellers converged on Carvana; no less than 58% of the float is sold short according to Bloomberg. So too, does the controlling family have an interesting back-story. For more, see the June 6, 2017 edition of Almost Daily Grant’s (“Full speed ahead”).
Recap April 6
Stocks were clubbed to wrap up the week, with the S&P 500 sinking back to within 1% of its 2018 nadir, while Treasury yields dropped in relative lockstep across the curve. The dollar and commodities traded lower in tandem, and the VIX ambled higher to settle near 21.5.
- Philip Grant
Thursday, April 5, 2018
Vehicle vestibule
It’s alive! Much like Frankenstein’s monster, the automobile market has been jolted back to life by an external shock, this one in the form of the hurricanes which pounded large swaths of the United States last summer. After sales ebbed to a seasonally adjusted annualized rate (SAAR) of 16.03 million in August of last year (the lowest reading since early 2014), the arrival of destructive storms such as Harvey and Irma coincided with an abrupt rebound in sales: Ward’s Automotive Group calculates an average 17.57 million SAAR in the following seven months through March.
For industry leading-used vehicle retailer CarMax, Inc., (KMX on the NYSE), the uptick in new car sales didn’t translate into much good news. CarMax reported fourth quarter earnings yesterday (covering December to February), featuring revenues and earnings per share that each came in well shy of the sell-side consensus, while same store sales declined by a meaty 8% year-over-year. KMX shares enjoyed a bounce in response, although the company’s 5% decline since February 2017 lags the 13% gain from the S&P 500 over that period.
Still in the garage. KMX in white and the SPX in orange. Source: The Bloomberg
Volume, not price, was the culprit. While Carmax’s gross profit per used vehicle inched higher to $2,147 amid a 2.5% year-over-year uptick in average selling price, used vehicle unit sales fell by 3.1% from their year-ago level. The large drop in volumes coupled with sturdy unit profits suggests a conscious decision to hold the line on pricing by KMX management, even as industrywide incentive spending continues to increase.
Average incentive spending rose for a 35th straight month in February according to Autodata, reaching $3,695 per unit from $3,594 year-over-year. For his part, CarMax CEO William Nash observed on the company’s conference call that “incentives have started to come down a bit.” Rising acquisition costs for used and wholesale vehicles were a bigger factor, with Nash noting that “the pricing environment . . . really hits us on two sides. It’s not only that acquisition prices went up on all inventory, but I also think there was pressure on the spread . . . between a late-model used car and a new car both because of our acquisition price going up and new car prices coming down in relative terms year-over-year.”
Taking inventory of an auto market that we judged vulnerable to both credit mishaps and a retrenchment in the used car prices which underpin trade-in activity, Grant’s took a bearish view on CarMax on Feb. 24, 2017 (“Disabled vehicles”). A Feb. 23, 2018 follow-up analysis (“Clunkers, Inc.”) focused on the price vs. volume conundrum facing KMX amid intensifying competitive pressures:
Strong prices were a tonic for CarMax’s revenue growth in the sweet phase of the cycle. From Feb. 28, 2009 to Nov. 30, 2015, the company’s average CarMax selling price ticked up by 23.3%, or 3.2% per annum, to $20,094. Over the same six years and nine months, the CarMax top line swelled by 93.2%, or 10.2% per annum, to $3.5 billion.
If yesterday’s results are any guide, CarMax’s decision to hold the line on pricing has taken a toll on activity. Meanwhile, the credit wheel keeps turning. CarMax’s auto finance unit reported a 21.9% year-over-year uptick in net income during the quarter as its provision for loan losses declined by 16.7% and average managed receivables jumped by 9.4%. Those sunny trends stand in seeming contrast with a Monday report from Bloomberg headed “Subprime New-Car Buyers Suddenly Go Missing from U.S. Showrooms.”
Rising interest rates and new vehicle prices are squeezing shoppers with shaky credit and tight budgets out of the market. In the first two months of the year, sales were flat among the highest-rated borrowers, while deliveries to those with subprime scores slumped 9 percent, according to J.D. Power.
As a corporate entity, CarMax is bullish on itself. On Feb. 28, 2017, the company announced a $4.55 billion share buyback, following a $2 billion repurchase authorization announced on Oct. 22, 2014. That’s no small part of KMX’s current $11.7 billion market capitalization. Those who know the company best have taken a different tack. Since the early September hurricanes, KMX insiders have sold 462,107 shares on the open market, cashing proceeds of just over $34 million. The only open market purchase during that period was of 35 shares.
QT progress report
Plenty of movement this time. The Fed’s portfolio of securities held outright footed to $4.172 trillion, a near $12 billion decline from last week’s level. It was Treasurys carrying the “QT load,”as forecast by Jim Bianco in last week’s Almost Daily Grant’s, as all of the drop came from the UST category.
Since the beginning of QT on Oct. 1, the Fed’s balance sheet has declined by 1.56%, for a simple annualized pace of 2.99%.
Recap April 5
Stocks floated moderately higher, extending yesterday’s bullish intraday reversal to push the S&P 500 back towards the middle of its wide 2018 trading range. Treasury yields climbed across the board with the curve steepening as the long end unperformed ahead of tomorrow’s March payrolls report from the Bureau of Labor Services, and the VIX fell back below 20.
- Philip Grant
Tuesday, April 3, 2018
Cold Turkey
Most developed economies feature interest rates that are visible only through a magnifying glass.
Most developed economies feature interest rates that are visible only through a magnifying glass.
I thought you were pre-med?
Spotify Technology S.A. made its publicly traded debut today,
Spotify Technology S.A. made its publicly traded debut today,
Recap April 3
Cold Turkey
Most developed economies feature interest rates that are visible only through a magnifying glass. Most lower-rated borrowers need funding. A tailor-made match? In Japan, the world’s third largest economy and an epicenter of financial repression (nominal government bond yields are negative out to 10 years, despite 12 straight quarters of positive real GDP growth), the financial matrimony of borrower and lender is being put to the test.
Yesterday, Bloomberg reported on the rising relative popularity of Japan’s Samurai bond market (meaning yen-denominated debt placed by foreigners) for lower-rated sovereign issuers, noting that “the portion of Samurai notes with triple-B level credit ratings climbed to 58 percent last fiscal year from 39 percent a year earlier.” B1-rated Ghana (at Moody’s, four notches below investment grade) and triple-B-rated Philippines are considering debt offerings, while Baa3-rated Indonesia and triple-B-minus Hungary (both one notch above junk) placed Samurai bonds last year. Akihiro Iagarashi, executive director at Nomura Securities Co., aptly summarized the driving force to Bloomberg last June: “Japanese investors used to be very conservative in terms of the credit ratings they buy. In this negative yield environment, they have to change their investment style by, for example, widening their credit horizon.”
Last December, the junk-rated Republic of Turkey sold ¥60 billion ($563 million) of three-year Samurai notes with a 1.81% coupon. Bloomberg reported that: “In another sign that investors are willing to take on risk, Turkey’s latest securities also have no guarantee from Japan’s government, unlike the previous issuance in 2014.” Ryusuke Kurihara, director of debt syndication at Daiwa Securities Group, Inc., told Bloomberg that the appearance of junk-rated Samurai bonds was “quite unusual.”
The affectionate stance taken by Japanese investors toward Turkey extended far beyond Samurai issues. In October, Bloomberg relayed data from Japan’s Investment Trusts Association showing a 27% increase in Japanese mutual fund investments in lira-denominated bonds, to ¥50.8 billion ($477 million) through August. Takeshi Yokouchi, senior fund manager at Daiwa SB Investments Ltd., assessed the situation in Turkey thusly: “Political risks are still there and the economy remains sluggish while inflation remains high – but those negative factors have already been priced in the markets.” On Jan. 23, Bloomberg reported that data from the Tokyo Exchange Inc. showed that individual Japanese investors held a record long position on the lira against the yen.
As documented in the March 23 edition of Almost Daily Grant’s, the intervening months have been unkind to Turkish currency-denominated investment exposure. The lira, which traded above ¥30 in January and fetched ¥54 as recently as December 2014, is now worth less than ¥27. Year-over-year CPI inflation has remained above 10% in 13 of the past 14 months, while President Recep Erdogan’s regime continues to aggressively consolidate power following the failed coup d’état in Summer 2016. On March 23, the lira spiked lower against the dollar, briefly reaching four per greenback during the Asian trading session. Bloomberg paraphrased Koji Fukaya, chief executive officer at Tokyo’s FPG Securities, as attributing the lira’s decline to stop-loss orders from Japanese retail investors who had been holding lira positions against the yen.
We wonder if the reach for yield on the part of local investors will attract any soul searching on the part of Japan’s monetary authorities. For its part, the Bank of Japan asserts on its website that: “When prices fluctuate, individuals and firms find it hard to make appropriate consumption and investment decisions, and this can hinder the efficient allocation of resources in the economy.”
Better that the prices fluctuate in the authorized direction.
I thought you were pre-med?
Spotify Technology S.A. made its publicly traded debut today, and the New York Stock Exchange feted its newest tech crown jewel in a manner fit for a foreign dignitary. Well, almost. The Wall Street Journal explains:
The flags that hang over the steps to the New York Stock Exchange have caused some commotion this morning. Earlier in the day, a Swiss flag was hoisted over the entrance in an apparent error (Spotify is Swedish, not Swiss).
NYSE said in a statement: “It was a momentary ode to our neutrality in the process of price discovery.”
A mid-afternoon stroll by the NYSE from our perch at Two Wall Street confirms that the geographically offending Swiss flag has been replaced by a Swedish one. Perhaps the New York Fed building needs some extra adornment?
Recap April 3
Stocks powered higher this afternoon, with the S&P 500 finishing 1.3% in the green to erase roughly half of yesterday’s nasty selloff and avert a break through the interim lows logged in early February. Treasury yields pushed higher across the curve, the dollar and commodities both held steady, and the VIX pulled back by 10% to 21.
- Philip Grant
Monday, April 2, 2018
Dear Mr. Fantasy
Who’s up for some reward-free risk? In recent years, investors with a high risk tolerance have gravitated to shares in fast growing but cash-hungry Silicon Valley concerns Netflix, Inc. and Tesla, Inc., with terrific results: The pair has delivered exponential returns over the past five years, as popular products and cultural cachet have trumped financial statements that could be described as less than stellar. The potential for further such reward colors the evident risks.
The bond market, of course, features a different calculus. Instead of the potential for outsize returns available to stockholders, the measure of success for corporate creditors is the return of their capital, along with contractual interest payments. Necessarily limited upside trains the investor mind on what can go wrong. For par value bond investors, risk aversion is the name of the game.
The dual cases of Netflix and Tesla put those logical truisms to the test. In October, Netflix issued $1.6 billion of senior unsecured notes maturing in 2028 with a 4 7/8% coupon, a spread of 256 basis points over Treasurys. Rated single-B-plus at S&P (“the obligor currently has the capacity to meet its financial commitments on the obligation”), Netflix has achieved rapid growth and stock market riches via the incineration of cash: Free cash flow registered negative $2.02 billion in 2017, while management pegged its 2018 FCF estimate at negative $3 to $4 billion, well above the Street consensus of $2.5 billion. As the company’s borrowing needs will likely increase, CEO Reed Hastings has struck a sanguine tone, writing in the fourth quarter investor letter that: “High yield has rarely seen an equity cushion so thick.”
The Jan. 26, 2018 edition of Grant’s (“Like no business”) condensed the separate propositions implicit across Netflix’s capital structure: “It’s a speculative business, the content business, but if it works out, you, the creditors will get your money back. The stockholders get rich. Everybody’s happy.” Those 4 7/8 notes have trended the wrong way of late, breaking lower to currently fetch 96.5 cents on the dollar from 99.9 in January.
Then there’s Tesla, which burned through $3.5 billion in cash last year on just under $12 billion in revenue yet enjoys a massive valuation premium to other automakers. It issued $1.8 billion (upsized from $1.5 billion) in senior unsecured notes due in 2025 at a 5.30% coupon (a 320 basis point spread over Treasurys) in August. That was up from an indicated yield of 5.25%. Reuters quoted an anonymous banker who said that the five basis point bump “was a company decision to ‘sweeten the deal’ for investors who supported the transaction.”
The bond issue, which made its first coupon payment in February, has seen its price fall sharply in recent weeks amid product recalls, another highway death of a driver who was using the “Autopilot” feature, and CEO Elon Musk’s odd April Fool’s Day jokes declaring corporate bankruptcy on Twitter. Last week, Moody’s downgraded Tesla’s rating to B3 from B2 and the rating on the 5.3% senior notes to Caa1 (“judged to be of poor standing and are subject to very high credit risk”) from B3, while the notes have fallen to 86.5 cents on the dollar for a yield to worst of 7.73%..
The Aug. 11 publication of Grant’s (“’A masterly manipulation’”) took inventory of the bond market’s accommodative stance to the offering while Tesla was conducting its investor road show, drawing a parallel with UK Chancellor of the Exchequer David Lloyd George’s exertions in support of the 3.5% War Loan of 1924. The analysis noted that operating and financial problems aside, Tesla was an issuer in the right place at the right time.
With $9 billion in high-yield sales, July was the weakest month of issuance since January 2016. “There hasn’t been much new supply and investors have cash they need to spend,” a resigned Tom O’Reilly, Neuberger Berman Group, LLC’s head of non-investment grade credit, tells the Wall Street Journal.
Time flies when you’re having fun. We can surmise the corollary: For Tesla and Netflix’s creditors, 2025 and 2028 may seem far away indeed.
Recap April 2
The second quarter got off to an unpleasant start for the bulls, as the S&P 500 sank by more than 2% to close near the interim lows logged on Feb. 8, setting up an important session tomorrow with either a bounce or fresh lows seemingly in the cards. Treasurys continued their strong rally, with the 10-year yield falling to 2.73% from 2.91% on March 21. The VIX rose by a relatively modest (compared to the stock market move) 15%, and remains in a trading range between 20 and 25.
- Philip Grant
Thursday, March 29, 2018
Bund cake
This morning, German CPI rose by 1.6% year-over-year, just below the consensus expectation of 1.7%.
This morning, German CPI rose by 1.6% year-over-year, just below the consensus expectation of 1.7%.
QT progress report
Recap March 31 and first quarter 2018
Bund cake
This morning, German CPI rose by 1.6% year-over-year, just below the consensus expectation of 1.7%. Although still south of the European Central Bank’s 2% inflation target, German inflation has nevertheless largely maintained its recent resurgence, when it jumped to an average 1.7% through 2017 from 0.5% in 2016 and 0.3% in 2015.
In response, the 10-year bund rallied, with the yield declining by half a basis point to 0.497%, for a negative real yield in excess of 1%. That negative real yield has been in force since June 2016, 15 months after the European Central Bank began its asset purchase program. Compared to the 2.74% yielding 10-year treasury, the bund likewise resembles the polar opposite of a bargain: The 225 basis point UST/bund spread is 50% above its five-year average, and compares to 211 basis points in the early February analysis in Almost Daily Grant’s ("A kind word for the 10-year").
Of course, the complacency displayed by German lenders has a ready explanation. A March 22 dispatch from Reuters deftly conveys the situation:
The European Central Bank will start buying bonds from a further seven state-owned German banks under its stimulus program, it said on Thursday, in a bid to avoid running out of debt to buy after three years of purchases.
Indeed, at a March 23 speech in New York, the ECB’s Benoît Cœuré estimated that world central banks may hold as much as 90% of all German bunds, commenting that: “In these circumstances, only very large changes in the expected supply of bonds can cause yields to rise more meaningfully.”
Meanwhile, Baa2-rated (two notches above junk) Spain, which features year-over-year CPI growth of 1.2%, matching the sovereign 10-year yield, announced today that it will auction 2021 bonds at a yield of 0.05% on April 5. On Sunday, former president of the Catalonia region Carles Puigdemont was detained in Germany on charges related to Catalonia’s October ad hoc independence referendum, which the Spanish government declared illegal. Catalonia, at just over 6% of Spain’s land mass and 16% of the country’s population, generates more than 20% of Spanish GDP and 25% of exports. Puigdemont’s arrest touched off another round of protests in Barcelona. News site The Local describes the scene:
Some threw garbage cans at Catalan police in riot gear, who responded by beating demonstrators with their batons or firing warning shots in the air.
"This Europe is shameful!" they chanted as they marched by the office of the European Commission in the Catalan capital.
The ECB’s current €30 billion ($36.9 billion) monthly asset purchase program is set to run through October, and to date there has been little indication of an extension. A piece from Bloomberg today headed “Draghi Studies Fed Exit as ECB’s Guide on What to Do and Avoid” details Frankfurt’s furtive steps as it seeks to avoid triggering a bond selloff following its exit from QE as former Fed chair Ben Bernanke did in the 2013 “taper tantrum.” One observer quoted in the story displayed particular confidence in the abilities and judgment of the monetary mandarins.
“The Fed could have reversed at any time, they could stop and correct,” said Gilles Moëc, chief European economist at Bank of America Merrill Lynch and a former Bank of France economist. “The ECB has no possibility to get it wrong.”
We wonder, is Mr. Moëc a betting man?
QT progress report
The Fed’s securities held outright footed to $4.183 trillion, an $8.6 billion decline from last week’s reading. MBS carried the load, as the Fed’s holdings declined by $8.8 billion, while Treasury holdings increased by a nominal amount (roughly $160 million) for a fourth straight week. Since QT began on Oct. 1, the Fed’s balance sheet has declined by 1.42%, or a simple annualized pace of 2.84%.
According to the Fed’s QT guidance announced last year, the balance sheet should have declined by $90 billion by the end of the first quarter. Instead that figure has totaled only $56.7 billion. Jim Bianco, president and eponym of Bianco Research, notes a few explanatory factors. Bianco observes that “The Fed owns $31 billion of Treasury securities that mature on March 31. This allows them to play catch-up, by reinvesting far less than $31 billion.” That likely explains the lack of movement on UST sales in recent weeks.
In addition, Bianco notes another important detail in the mortgage-backed securities realm, which is an especially challenging place to trade given the illiquidity of the market and uncertainty regarding principal repayments. In table 3 of the H.4.1 balance sheet, “there’s a line for commitments to buy MBS that has dropped quite a bit, from $30.4 billion last October to $12 billion today. So they would argue that reflects an ‘effective decline’ of $18 billion which goes a long way to reach their target.”
Recap March 31 and first quarter 2018
Stocks ripped higher, with the S&P 500 gaining 1.5% to narrow its first quarter loss to 1%. Treasurys and commodities were bid, and the VIX saw a double-digit decline. Other key assets logged the following performances from Jan. 2, the beginning of the first quarter:
The 10-year treasury yield finished at 2.74%, up from 2.49%.
The U.S. Dollar Index finished at 90, down by 2.35%.
WTI crude finished at $65 a barrel, up by 8%.
Gold finished at $1,325 an ounce, up less than 1%.
The iShares High Yield ETD finished at 85.6, down by 2%.
The iShares Investment Grade ETF finished at 117.4, down by 2.8.
The VIX finished at 20, up by 103%.
Tuesday, March 27, 2018
Hodl on loosely
Ah, crypto-currencies. Whether in a bull or bear market (sometimes we see both before lunch), they bore neither fans nor skeptics. The still-young 2018 has been rough for the nascent asset class, as the four most prominent vehicles (bitcoin, ethereum, ripple and litecoin) have declined by 42%, 39%, 40% and 74% respectively after logging spectacular gains last year.
Beyond financial losses, the pullback seems to be taking a toll. According to Bloomberg: “Online searches for ‘bitcoin’ fell 82 percent from December highs, according to Google Trends. Tweets that mention the coin peaked Dec. 7, at 155,600, and are now down to about 63,000, BitInfoCharts says. And the number of bitcoin transactions is off 60 percent from its record on Dec. 13, according to Blockchain.info” (Almost Daily Grant’s, March 16).
Crypto-ficcianados have lately contended with more than falling prices and waning public interest. Yesterday, Reuters reported: “Twitter, Inc. will start banning cryptocurrency advertising [today], joining Facebook and Google in a clampdown that seeks to avoid giving publicity to potential fraud or large investor losses.” In other words, the ubiquitous social media ads featuring author and investor James Altucher will be no more. Altucher himself voiced his approval, telling Recode: “There are many scams and illegitimate services out there.” This afternoon, Coinbase reports that Reddit (which bills itself as “the front page of the internet”) no longer accepts payment in bitcoin for its Reddit gold membership program.
Regulators, too, are taking a stricter stance. On Thursday, the Wall Street Journal reported that the Securities and Exchange Commission is scrutinizing up to 100 crypto-focused hedge funds: “Examiners are keen to inspect whether fund managers have bought the type of assets they advertised to investors in disclosure documents. Regulators also worry about the risk of crypto assets being stolen because hackers often attempt to breach exchanges where crypto-currencies are kept.” On March 2, Bank of England Governor Mark Carney told the Scottish Economics Conference that “the time has come to hold the crypto-asset ecosystem to the same standards as the rest of the financial system.”
Meanwhile, efforts at wider implementation of the blockchain in the financial industry have recently suffered what appear to be major setbacks. Today, Reuters reports that three separate projects undertaken by financial institutions to incorporate the distributed ledger technology have been halted. One such example:
DTCC, known as Wall Street’s bookkeeper, recently put the brakes on a blockchain system for the clearing and settlement of repurchase, or repo, agreement transactions, said Murray Pozmanter, head of clearing agency services at the DTCC.
The project, which had successfully tested with startup Digital Asset Holdings, was shelved because banks and other potential users believed the same results could be achieved more cheaply using current technology, he said. “Basically, it became a solution in search of a problem.”
As prices fall, regulators circle and big tech heads for the hills, some investors are doubling down. Yesterday, Bloomberg reported that:
While ICO’s [initial coin offerings] were supposed to disrupt venture capital, such funding in blockchain-based companies is surging, with startups raising $434 million since December, the most ever in a three-month period, according to CoinDesk data.
“If a company goes on and gets an ICO, my equity is worth more,” Frank Meehan, partner at SparkLabs Group, said. “That’s really the game right now.”
CoinDesk calculates that ICO’s have raised north of $3 billion through February, more than half of their 2017 intake. For the sake of their limited partners, VCs best choose wisely. Bloomberg goes on to note that 46% of such offerings either failed of were unable to attain funding, while 50 of 340 ICO’s have already failed this year.
Last week, CryptoKitties (which bills itself as an ethereum-based “game centered around breedable, collectible, and oh-so-adorable creatures” who can’t be “replicated, taken away, or destroyed”) raised $12 million in seed funding led by Andreessen Horowitz and Union Square Ventures, with Mark Pincus (founder of Zynga) and Fred Ehrsam (former founder of Coinbase) lining up as investors.
Meanwhile CoinDesk reports that ethereum founder Vitalik Buterin recently penned a blog post arguing for the institution of rent fees on his network, where “users would be asked to pay to use the network based on how long they’d like their data to remain accessible on the blockchain.” Evidently, permanence is a relative concept.
Recap March 27
Stocks remained in spin cycle, with the S&P 500 falling sharply this afternoon from a tight early range to finish red by nearly 2%, the fourth straight daily move in excess of 45 points. Treasurys caught a sharp bid, with the 10-year yield dropping to its lowest since early February at 2.78% and narrowing the spread over the two-year yield to 50 basis points. Commodities ticked lower with WTI crude dipping back below $65/barrel, and the VIX rose by a relatively modest 8% to settle at 22.5.
After the close, Moody’s downgraded Tesla, Inc.'s Corporate Family Rating (CFR) to B3 from B2, and unsecured note rating to Caa1 from B3, with a negative outlook. As of mid-day, the Tesla senior unsecured 5.3s of 2025 traded at 90.75 cents on the dollar, down from 92.5 yesterday.
- Philip Grant
Monday, March 26, 2018
Tough but fair
Leverage on offer
If regulators on either side of the pond have their way, it will soon be time to say tata to the London Interbank Offered Rate (Libor)
If regulators on either side of the pond have their way, it will soon be time to say tata to the London Interbank Offered Rate (Libor)
Recap March 26
Tough but fair
Apropos of Friday’s ADG item (“Ahoy, polloi!”) distinguishing between the freshly-minted dry bulk shipping ETF (ticker BDRY) and the more convoluted offerings which populate the mushrooming ETF industry, reader Tom Boucher provides a trenchant observation:
I may have been doing this too long but, isn’t the trade handle for Alpha Architect Value Momentum Trend ETF (VMOT), vomit?
Leverage on offer
If regulators on either side of the pond have their way, it will soon be time to say tata to the London Interbank Offered Rate (Libor) as the benchmark interest rate used to set the price of hundreds of trillions of dollars in debt securities the world over. Today, Bloomberg notes that the Federal Reserve Bank of New York, in tandem with the Treasury Department’s Office of Financial Research are set to debut the Secured Overnight Financing Rate (SOFR). The salient distinction between Libor and its presumed successor:
Where LIBOR relied on the expectations of bankers, SOFR is based on real transactions from a swath of firms including broker-dealers, money market funds, asset managers, insurance companies, and pension funds. It’s different from Libor as well in that it’s a secured rate, since the repo rates it’s derived from are collateralized, or backed by assets.
As financial authorities prepare to usher Libor to the exit, the benchmark reference rate has managed to make its way back into the investment spotlight. A methodical rise to 2.29% from 0.65% as the 10-year yield bottomed in July 2016 has pushed Libor’s spread over the “risk free” overnight indexed swap [OIS] rate to its highest since 2009. That type of widening would traditionally signal diminished liquidity or even credit stress.
Bhanu Baweja, deputy head of macro strategy at UBS Investment Bank, argued in an opinion piece in last Tuesday’s Financial Times that other factors explain the recent move. Baweja estimates that two-thirds of the widening can be attributed to rising Treasury bill yields (higher issuance amid the recent spending bill and tax cuts is the apparent catalyst), while the 2016 money market reform and subsequent upward pressure on commercial paper yield accounts for the rest. Baweja goes on to comment:
Does the price of funding not matter at all, then? It most certainly does. It can fundamentally alter market trends. But instead of Libor-OIS widening, which is likely a red herring, we need to focus on the right channels to detect signals of a change in the investment opportunity set.
First, watch the hit from yields to floating rate high yield credit and leveraged loans. We estimate floating rate loans to U.S. borrowers at $2.2 trillion, nearly half of which have been extended to issuers rated below double-B-minus. Our analysis shows that leveraged loan issuers will remain resilient to the next 75-100 basis point increase in Fed Funds rates, but could see their interest coverage ratios reaching dangerously low levels beyond that
.
If leveraged loans are the canary in the coal mine, then so far, so good. The S&P/LSTA Leveraged Loan Total Return Index made another new high on Friday, up by more than 18% from its February 2016 interim lows.
Source: The Bloomberg
On March 15, Bloomberg noted more issuers managed to place leveraged loans at 175 basis points over Libor (the tightest spread seen since the crisis) in the prior month than in the past ten years combined. At the same time, investors continue to accept diminished legal protection, in the form of so-called covenant-lite loans. S&P Global Intelligence’s LCD unit reported Friday that cov-lite’s share of the $984 billion leveraged loan market reached a fresh record high of 75.8% in February.
Last week, Uber Technologies, Inc., which lost $4.5 billion on $7.5 billion in revenue in 2017 and recently sold shares to Softbank at a 30% markdown from its prior valuation (see “Out of gas” from the Jan. 12 issue of Grant’s for more), tapped the leveraged loan market, hoping to borrow $1.25 billion at an indicated yield of 425-450 basis points over Libor. Investor demand was strong enough for Uber to both upsize the offering to $1.5 billion and lower its spread over Libor to 400 basis points.
Recap March 26
Stocks enjoyed a ferocious rally, with the S&P 500 surging by nearly three percent to erase nearly half of last week’s losses, while Treasury yields ticked higher across the board with the belly of the curve absorbing the bulk of the pressure. The VIX shed 15% but still finished north of 20, and crypto-currencies were down sharply with the price of bitcoin dropping back below $8,000.
- Philip Grant
Friday, March 23, 2018
Ahoy, polloi!
From Business Wire:
From Business Wire:
Cool Recep-tion
The dollar’s recent weakening against most world currencies has left one prominent exception:
The dollar’s recent weakening against most world currencies has left one prominent exception:
Recap March 23
Ahoy, polloi!
From Business Wire:
Breakwave Advisors, in partnership with ETF Managers Group (ETFMG), launches the Breakwave Dry Bulk Shipping ETF (NYSE Arca: BDRY). The Fund is the first and only freight futures exchange-traded product focusing exclusively on dry bulk shipping. BDRY provides investors direct access to an instrumental part of the global commodity market that historically has been uncorrelated -with other major asset classes.
On the one hand, a shipping industry ETF seems like a solid and logical concept. On the other, the Artificial Intelligence Powered Equity ETF (ticker AIEQ), Alpha Architech Value Momentum Trend ETF (VMOT) and the KraneShares MSCI China Environment ETF (KGRN) would seemingly have the shippers lapped when it comes to branding uh, creativity.
Cool Recep-tion
The dollar’s recent weakening against most world currencies has left one prominent exception: The Turkish lira. Since 2013, the lira has slid from less than two per greenback to three in mid-2016, briefly spiking above four overnight before pulling back to 3.96. Although, to hear the government tell it, that break above four really shouldn’t count. From Bloomberg:
“They say it rose above four. That’s not the case,” Cemil Ertem, a senior advisor to President Recep Erdogan, said in a live interview with state-run TRT TV. “At night, if one gives a quote at five, it would rise to five. It’s so shallow, there’s no liquidity. Seeing one number in the middle of the night has no significance whatsoever.”
“Yes, there’s an increase” in the [dollar/lira] exchange rate, Ertem said. “But it’s very wrong to create a perception that it went to four.”
Not only are exchange-rate scolds in the administration spokesman’s rhetorical crosshairs. The Financial Times reported Wednesday on Ertem’s blistering response to an International Monetary Fund warning over Turkey’s finances: “Cemil Ertem said [the IMF’s] call to tame inflation and rein in spending were ‘failed economic theories’ peddled by ‘dinosaurs’. He concluded, ‘we’re going to do the exact opposite.’”
Pithy retorts aside, the market seems to be leveling a verdict on Erdogan’s regime through the lira’s decline. CPI inflation in Turkey, which has averaged 8.7% over the past five years, jumped higher after the failed July 2016 coup attempt against Erdogan and has mostly remained above 10% since the beginning of 2017. Foreign exchange reserves, which have averaged over $100 billion in the past five years, footed to less than $90 billion as of March 16. The monthly current account deficit, which was less than $1 billion in August, jumped above $7 billion in December and January. That has helped push the yield on the 10-year Turkish note to 12.44%, well above its five-year average of 9.79%.
So too, does the lira’s retreat color the action in Turkish equities. Although the Borsa Istanbul 100 index has enjoyed a strong rally since the beginning of 2017 (rising by 60% in lira terms and 48% in dollars), a five-year perspective is far more currency-sensitive. The Istanbul 100 is up by 41% over that period in the local currency, but has lost 39% when measured in greenbacks.
Grant’s offered a bullish word on a basket of Turkish equities last January (“Horrible to bad,” Jan. 13) before closing that rhetorical position (“The story changed,” May 19) four months and an average 22.7% gain in dollar terms later. Today, we asked Haydar Acun, managing partner at Marmara Capital Asset Management and source of our Jan. 2017 long ideas, for his thoughts on the lira’s decline and assessment of current market conditions.
I believe the lira’s fall is not a surprise to many in light of the high and increasing current account deficit, increasing oil prices, tension with Turkey’s largest trade partners such as Germany, low foreign investment, the military operation in Syria, etc.
I would expect a correction in the market which I think long overdue thanks to crazy liquidity, Fed policy and easing investor risk concerns of international investors. Locals are also extreme risk takers in terms of careless trading activity with leverage.
Some stocks have lost touch with fundamental reality. Who on earth buys THY [Turkish Airlines, which has seen a 245% lira rally since April and now trades at 70 times trailing adjusted earnings per share] at current prices? I have no idea. There are fewer and fewer undervalued ideas, but it is still possible to find some.
The lira’s decline could have broader implications for the emerging market realm. Russell Napier, independent strategist and co-founder of the Electronic Research Interchange, told Grant’s in a Dec. 1 survey of emerging markets (“Trigger points”) that Turkey’s currency policy could potentially reverberate far beyond its borders.
Last year, Napier identified Turkey as the country most likely to ignite the next panic. Observe, he tells [deputy editor Evan] Lorenz, how Erdogan, in his railing against the so-called high interest rate lobby, recalls Mahathir Mohamad, the former prime minister of Malaysia. It was Mohamad, you’ll recall, who on Sept. 1, 1998 accelerated the Asian Financial Crisis by declaring the imposition of capital controls in Malaysia.
For his part, Erdogan forcefully (as is his wont) ruled out the imposition of capital controls in December, stating that “Turkey has a free-market economy, anyone has had the right to take their money abroad since 1989. There is no doubt this will continue.” Presidential and parliamentary elections are scheduled to be held by November 2019, at the latest.
Recap March 23
A second straight steep selloff left the S&P 500 nursing a 5.9% loss for the week to approach its Feb. 8 interim lows, while the Nasdaq shed 7.3%, its worst showing since the post China devaluation scare in August 2015. Facebook shares shed nearly 14% for the week. Treasury yields dripped again, with the 10-year note approaching the low end of its recent trading range at 2.81%, while the VIX again logged double digit percentage gains to finish near 26. Gold finished the week higher by 2.5%.
- Philip Grant
Thursday, March 22, 2018
Triple-B Gees
What does it mean when outsize moves in interest rates are met with little more than a shrug in corporate credit?
What does it mean when outsize moves in interest rates are met with little more than a shrug in corporate credit?
QT progress report
Recap March 22
Triple-B Gees
What does it mean when outsize moves in interest rates are met with little more than a shrug in corporate credit?
Yesterday, the Federal Reserve raised the benchmark funds rate by 25 basis points to a range of 1.5% to 1.75%, the fourth such hike since March of last year. As the United States’ central bank tightens the monetary screws, the two-year Treasury yield has risen to 2.28% from less than 1.3% in September, while the three-month London Interbank Offered Rate (LIBOR), the survey measuring interbank lending conditions, has made a similar jump. With short rates racing higher, the Treasury curve has all but collapsed: Spreads between the two- and 10-year yield, as well as the five- and 30-year yield are both-at or-near their flattest in since the eve of the financial crisis in 2007.
The corporate credit realm has taken in stride these substantial changes in benchmark interest rates. The Barclays U.S. Corporate High Yield spread closed yesterday at 335 basis points just above the midpoint of its 2018 range and well below its eight-year (capturing the bulk of the post-crisis era) average of 438 basis points. The Bloomberg Barclays Investment Grade spread finished yesterday at 106 basis points, some 20 basis points wider from its Feb. 2 nadir but well inside the 145 basis point average over the past eight years.
The post-recession path of the Bloomberg Barclays US Corporate Bond spread. Source: The Bloomberg
The relative calm in investment grade credit realm is particularly interesting in the light of significant changes in both the market’s size and composition. The Oct. 20, 2017 analysis in Grant’s (“Attack of the killer BBBs") began by noting that: “In 2007, less than 40% of Citigroup’s U.S. Broad Investment-Grade Corporate Bond Index was rated triple-B, i.e., the last (whole) stop before speculative grade. Today, about 47% is so classified.” This morning, the Financial Times cites data from ICE BofAML Indexes showing that total triple-B-rated issuance is approaching $3 trillion, more than double the amount of outstanding high-yield bonds.
So, too, is corporate leverage on the upswing within the triple-B category. The FT also observes: “Triple-B-rated issuers were slightly below three times levered in 2017, according to Citigroup, up from just about 2.5 times in 2015.” Last July, credit analysts at Morgan Stanley wrote that: “If the companies in our universe were rated based only on their leverage, we estimate that over a quarter of the investment grade market would have a high yield rating, using Moody’s leverage buckets across sectors.”
That Oct. 20 Grant’s article went on to identify a trio of triple-B and triple-B-minus-rated issues that seemed (to us) to offer insufficient financial reward to compensate for evident risks: The Allergan Funding SCS 3.85 senior unsecured notes of 2024 (rated triple-B at S&P), the Kohl’s Corp. 4 ¼ senior unsecured notes of 2025 (triple-B-minus) and the euro-denominated Kraft Heinz 2 ¼ senior unsecured notes of 2028 (triple-B-minus). The trio featured, in order, Allergan’s leverage ratio of four times earnings before interest, taxes, depreciation and amortization (EBITDA) operating the opaque specialty-pharma industry and an acquisition heavy business model; Kohl’s declining interest coverage in a struggling (retail) industry; and Kraft-Heinz’s 3.8 turns of leverage and declining sales amid heavy competition and apparent secular shift away from the processed foodstuffs which form the bulk of its revenues.
As Grant’s went to press, Allergan’s notes fetched 104.92 for a 3% yield-to-maturity, Kohl’s traded at 101.75 for a 4% YTM and Kraft-Heinz at 103.80 on the euro for a 1.8% YTM. They have since declined to 98.5, 100.41, and 100.34, respectively. Colleague Fabiano Santin (who worked on the original story) cautions that the bulk of the price decline in that trio can be attributed to the rise in interest rates over the past five months. Santin notes: “However, spread to Treasurys on AGN and KHC have moved 65bps and 30 bps wider, but KSS is about 35 bps tighter. The index has widened by 10 basis points from its Oct. 20 level.”
While spreads continue to imply calm investment grade seas, some investors are positioning themselves for choppy waters ahead. A March 19 dispatch from Bloomberg notes that “short interest on the iShares iBoxx Investment Grade Corporate Bond ETF (LQD on NYSE ARCA) relative to [the SPDR S&P 500 ETF, ticker SPY on NYSE ARCA] is now at its highest on record.” Meanwhile, the recent rates move has made cash positions more attractive: The yield on the one-month Treasury bill currently stands at 1.64%.
That Oct. 20 Grant’s analysis signed off with the following observation from Graham & Dodd: “The soundness of straight bond investment can be demonstrated only by its performance under unfavorable business conditions; if the bondholders needed prosperity to keep them whole, they would have been smarter to have bought the company’s stock and made the profits that flow from prosperity.”
QT progress report
The Fed’s portfolio of securities held outright footed to $4.192 trillion this week, a $5.3 billion decline from a week ago and a $2.8 billion decline from its trailing four week average. The drop was entirely due to mortgage backed securities, holdings of which fell by $5.4 billion from a week ago, while Treasury holdings ticked higher by about $160 million for a third straight week. The Treasury market’s abundant liquidity makes the Fed’s hesitance in paring its portfolio somewhat curious.
Since the start of QT on Oct. 1, the Fed’s total assets have declined by 1.22%, for a simple annualized pace of 2.53%.
Recap March 22
Stocks were hammered, with the S&P 500 breaking to fresh lows into the bell to finish more than 2.5% in the red, while Treasurys were bid across the board to leave yields sharply lower, and the dollar trended higher throughout the day to reverse overnight weakness. The VIX jumped by more than 30%, and settled above 24, its highest close since the immediate aftermath of the short-vol-blowup on Feb. 13.
- Philip Grant
Tuesday, March 20, 2018
Facial
It’s already been a long week for Mark Zuckerberg & Co. Facebook, Inc. (FB on the Nasdaq) has faced a multi-front attack following yesterday’s reports of the social network’s ties to political research firm Cambridge Analytica and the potentially illegal dissemination of millions of Facebook users’ personal data.
While FB shares have absorbed a 9% two-day selloff (the stock finished well off its lunchtime lows), media coverage has been little short of savage: The Guardian ran an article quoting former platform operations manager Sandy Parakilas, who claims that Facebook routinely and freely shared user data with numerous third parties, supplying little or no oversight. Slate Magazine tersely asked readers: “Who does Facebook serve?” Silicon Valley blog TechCrunch released a piece titled simply: “#deletefacebook.”
Perhaps most ominously for investors, governments on either side of the Atlantic are eager to involve themselves. The U.K.’s Information Commissioner’s Office is in the process of securing a search warrant of Cambridge Analytica, while Bloomberg reports this morning that the U.S. Federal Trade Commission (FTC) has likewise opened an investigation into Facebook. On Sunday, the Washington Post presaged Bloomberg’s FTC investigation scoop, with former FTC senior official David Vladeck offering an educated guess about Facebook’s potential liability:
Vladeck, now a professor at Georgetown Law, said violations of the consent decree could carry a penalty of $40,000 per violation, meaning that if news reports that the data of 50 million people were shared proves true, the company’s possible exposure runs into the trillions of dollars [multiples of FB’s $493 billion market cap]. Vladeck said that such a fine is unlikely but that the final penalty still could be very large.
Bad press has been known to blow over, and as Vladeck notes, the FTC is far from certain to extract a sum that is materially harmful to FB. So far, Facebook’s staunch sell-side support has not wavered. Of the 48 analysts who cover the name, 43 rate the shares buy, just two advise clients to do as many investors have this week and sell. The average price target of $223 sits 35% above current levels. There is certainly historical precedent for the Street’s great expectations: Facebook’s net income topped $18 billion last year from less than $4 billion in 2015, with free cash flow jumping above $17 billion last year from less than $8 billion two years prior.
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Five year price chart. Source: The Bloomberg
However, the House of Zuck faces significant threats that were apparent even prior to this week’s revelations and underpin the bearish opinion on FB logged by Grant’s (Aug. 11, 2017, and Almost Daily Grant’s Jan. 22, Feb. 20, Mar. 1). Namely, “the inherent limits on a company growing faster than the markets in which it operates, emerging intra-FANG competition, advertiser resistance to a digital duopoly, regulatory attack on the same, a vulnerable dependence on mobile devices and good old fashioned managerial overreach.”
Yesterday, the Wall Street Journal reported on the waning market-share momentum of the Facebook/Google digital ad duopoly, amid encroachment from rivals Amazon.com, Inc. and Snapchat (Snap, Inc.). “Research company eMarketer predicts the combined U.S. digital ad market share of Alphabet, Inc.’s Google and Facebook will fall for the first time this year, shrinking to 56.8% from 58.5% last year.”
User growth in the United States has stalled since the beginning of 2016 according to Pew Research (a hefty 68% of U.S. adults already use it). Brian Wieser of Pivotal Research, one of the aforementioned pair of analysts who rate Facebook shares sell, noted data from Nielsen showing an 11% year-over-year decline in time spent on the site for November. Following the recent revelations, Wieser cautioned on Sunday that: “Regulatory risks will intensify, enhanced use of data in advertising is at greater risk than before, [and] third party measurement partners may face more restrictions, frustrating advertisers.”
Consensus estimates call for a 42% rise in net income this year to $25.8 billion, with another 24% uptick in the bottom line to $32.1 billion forecast for 2019. Meanwhile, if actions speak louder than words, then Zuckerberg and his fellow executives may be the biggest FB bears of all. Last week, Facebook’s founder and CEO sold 1,150,800 shares at a volume-weighted average price of $183.73, netting proceeds of $211.4 million. Chief operating officer Sheryl Sandberg hit the bid on 55,000 shares at an average price of $183.13 for just over $10 million, and chief technology officer Mike Schroepfer sold 38,024 shares an average price of $182.53, cashing out $6.9 million.
Recap Mar. 20
Stocks floated a bit higher, stabilizing from yesterday’s drop. The dollar enjoyed a significant rally (the DXY index rose by nearly 75 basis points) but that didn’t stop WTI crude from making a near-one month high above $63.50 a barrel. Treasury yields ticked moderately higher across the curve, and the VIX sagged to 18.
The Fed is set to conclude its two-day meeting tomorrow, futures place the odds of a rate hike at 100%.
- Philip Grant
Monday, March 19, 2018
History rhymes
An excerpt from a Bloomberg dispatch this morning,
An excerpt from a Bloomberg dispatch this morning,
Rebuttal rebuttal
On Mar. 11, the Bank for International Settlements sounded the alarm on the Canadian housing market,
On Mar. 11, the Bank for International Settlements sounded the alarm on the Canadian housing market,
Recap Mar. 19
History rhymes
An excerpt from a Bloomberg dispatch this morning, headed: “HNA’s $2.2 Billion NYC Tower a Hard Sell Less Than a Year Later.”
Last year, the Chinese conglomerate bought 245 Park Ave., a late-1960s-era building that’s home to JPMorgan Chase & Co., paying one of the highest prices ever for a New York office property. Values have since dropped and HNA faces the challenge of selling a building that’s starting to lose some of its gold-plated tenants and in need of improvements that could cost its new owner more than $1 billion, said Gregory Kraut, managing partner of K Property Group, which considered buying the building and examined it closely.
HNA, among the most prolific dealmakers in recent years, is pulling back after its gorge on trophy properties helped push up New York real estate prices. Now HNA, which used borrowed money to expand and accumulated one of the biggest debt loads in China, is under pressure from the government to liquidate assets. The company has already put about $4 billion of U.S. commercial real estate on the block.
HNA’s Manhattan misadventures recall the experience of another overseas asset-gatherer in a prior heyday: specifically Japan’s Mitsubishi Estate Company, which purchased an 80% stake in Rockefeller Center for $1.4 billion on Oct. 31, 1989. Upon the consummation of that deal, Jotaro Takagi, president of Mitsubishi Estate, was quoted in the New York Times: “There is no business address in the world that has the same cachet as Rockefeller Center. It is synonymous with excellence. We are making this investment with the objective of continuing this tradition into the 21st century.” Grant’s duly chimed in, quipping at the conclusion of a Nov. 24, 1989 analysis of the then-slowing real estate market that: “Perhaps Mitsubishi Estate Co. . . . would like to buy the rest of the United States.”
The rest, as they say, is history. Japan’s Nikkei index made its blow-off highs on New Year’s Eve 1989, the real estate boom ended, as booms do, and the high-priced Rockefeller Center deal floundered. From The New York Times’ 1995 follow-up:
Mitsubishi proposed yesterday afternoon that it plans to pass ownership of the Manhattan property to Rockefeller Center Properties, Inc., the publicly traded real estate investment trust that holds the $1.3 billion mortgage on the center, according to advisers involved in negotiations to bring Rockefeller Center out of bankruptcy protection.
Rebuttal rebuttal
On Mar. 11, the Bank for International Settlements sounded the alarm on the Canadian housing market, warning that America’s northerly neighbor features credit-to-GDP and total debt-service ratios that place the country at elevated risk for a banking crisis. Avery Shenfeld, chief economist at Canadian Imperial Bank of Commerce (a.k.a CIBC, CM on the Toronto Stock Exchange and the NYSE) took exception to the findings of the central bankers’ own Swiss bank, writing that:
The [BIS] report itself has multiple warnings to treat its results with ‘considerable caution.’ That seems prudent, based on the BIS’s own track record. Two of the current warning signals look particularly likely to mislead.
The first is a measure tracking the degree to which a country’s ratio of non-financial credit to GDP is above its longer term trend. That is certainly true for Canada, but interest rates are also miles below their longer term levels . . . Moreover, as we always caution, it’s not just how much credit has been issued, but to whom. The U.S. financial crisis was triggered by large debts owed to individual households that didn’t have matching incomes. Mortgage arrears rates in Canada continue to dive.
Interest rates, while up from their summer-2016 nadir, are still low by historical standards, and Canadian mortgages in arrears footed to just 0.24% of the total as of the third quarter of 2017 (the most recently available data), according to the Canada Mortgage and Housing Corporation. That’s down from 0.28% year-over-year. However, Canada’s elevated debt levels (household debt topped 170% of disposable income in the fourth quarter, well above the 133% peak seen in the U.S. in 2007) and a pronounced reversal in the formerly red-hot housing market (February prices in Toronto dropped 12.4% year-over-year with active listings nearly tripling) will put to the test Canadian mortgage-holders ability to pay.
Relatively small changes in rates can have a big impact: Recall that most Canadian mortgages are structured as five-year bullets with re-setting maturities, as opposed to the conventional 30-year fixed rate mortgage in the U.S. In addition, the Office for the Superintendent of Financial Institution’s B-20 regulations, enacted on Jan. 1, require all mortgagors to pass a stress test using the “greater of the five-year benchmark rate published by the Bank of Canada or the contractual mortgage rate +2%.” According to the Bank of Canada, 47% of all mortgages are scheduled to reset in the year ending July 2018.
Meanwhile, the interest rate tailwind cited appears to be abating. The benchmark Canadian five-year mortgage rate has jumped more than 10% from its April lows, and has ticked back above its eight-year average (covering the period in which the Canadian housing boom accelerated).
Bank of Canada five-year conventional mortgage rate. Source: The Bloomberg
For more on the prominent role of Mr. Shenfeld’s employer, CIBC, in the Canadian housing phenomenon, see the Feb. 9 edition of Grant’s.
Recap Mar. 19
It was a rude beginning to the week, as the S&P 500 absorbed a tech-led selloff back below its 50-day moving average as Facebook (FB on the Nasdaq) shed nearly 7% following reports of a massive user data breach. The VIX jumped by 20% to finish at 19. Treasury yields ticked a bit higher across the curve, while commodities came under pressure despite a weaker dollar.
- Philip Grant
Friday, March 16, 2018
Bots gone wild
Here’s a story that no one (not least your publisher) was expecting to see in Almost Daily Grant’s
Here’s a story that no one (not least your publisher) was expecting to see in Almost Daily Grant’s
If you build it, they will come?
Interbank borrowing rates, the machinations of the Swiss National Bank and cryptocurrencies are seemingly unrelated investment entities. But are they?
Interbank borrowing rates, the machinations of the Swiss National Bank and cryptocurrencies are seemingly unrelated investment entities. But are they?
Recap Mar. 16
Bots gone wild
Here’s a story that no one (not least your publisher) was expecting to see in Almost Daily Grant’s. From yesterday’s edition of USA Today:
Facebook search was not safe for work or home on Thursday night.
Typing "video of" into the Facebook search bar yielded a disturbing result. The first autocomplete was "video of girl [not reading a book].” Jonah Bennett, a graduate student, researcher and journalist, says he was tipped off to the search bar snafu by a friend. He shared it on Twitter where others got the same search results.
A couple of hours later, Facebook results were back to normal. But then Bennett tried the search in Spanish: "videos de..." and the second result was live sex videos.
Giving Facebook employees the benefit of the doubt, we surmise that artificial intelligence “singularity” has arrived early. The next step: Getting those artificial minds out of the gutter.
If you build it, they will come?
Interbank borrowing rates, the machinations of the Swiss National Bank and cryptocurrencies are seemingly unrelated investment entities. But are they? Now follows a brief update on each, revisiting a thread made in the Aug. 11, 2017 edition of Grant’s (“In your mind”) that connects the strange bedfellows. Namely: “The thin line diving financial fact from financial fantasy.”
As the stock market indecisively bounces around near its Jan. 26 high-water mark, and the 10-year Treasury yield floats on either side of 2.85%, more decisive action is taking place in short rates. In particular, three-month LIBOR (London Interbank offered rate) has continued its parabolic ascent, rising for a 27th straight session to a post-2008 high of 2.18%. That’s up from 1.13% on a year ago (during which time the Fed has raised rates by 50 basis points), and 1.88% a month ago. In that intervening 28 days, expectations for policy tightening have increased only modestly: According to interest rate futures,the odds of a Fed Funds rate of 2% or higher by year-end currently stands at 68.6%, compared to 58.2% on Feb. 16.
LIBOR, as noted in the aforementioned edition of Grant’s, is famously “manipulation prone and derived from bankers’ opinions more than market transactions.” Nevertheless, its relentless grind higher has coincided with a recently cooling corporate bond market. A report from Bloomberg today notes that domestic corporate bonds have lost a bit of luster recently, as the premium on new deals over existing debt securities averaged 11 basis points last week, compared to a one-year average premium of just 1.3 basis points. “Investors are starting to be a little more disciplined,” Bob Summers, portfolio manager at asset manager Neuberger Berman, told Bloomberg. “They aren’t just waving in every deal now.”
The gnomes in Zurich have been known to wave in a few (equity) deals themselves. In order to keep the traditional safe haven Swiss franc from unwanted appreciation, the Swiss National Bank in 2011 instituted a currency floor against the euro by printing francs, selling them, and then buying assets such as U.S. equities with the proceeds. While the SNB abruptly abandoned the floor on Jan. 15, 2015 (anticipated in the “The balance sheet that ate Switzerland,” Grant’s, Sept. 19, 2014), and the franc has weakened to near CHF 1.17 per euro from CHF 1.07 a year ago, the SNB isn’t taking any chances.
In a statement yesterday, the central bank noted that “The situation in the foreign exchange market is still fragile” and that current policy tools “remain essential.” While a formal currency floor has been mothballed (for now), the policy tool of buying stakes in real operating businesses with digitally-conjured cash continues apace. As of Dec. 31, 2017, the SNB held $92.6 billion of U.S. equities, according to its form 13-F. That’s an increase of 46% from the $64.3 billion in holdings reported at year-end 2016. In one metric, at least, are the SNB’s machinations bearing fruit. Publically-traded shares in the central bank have gone parabolic in recent months:
Source: The Bloomberg
Finally, we turn to crypto-currencies, a realm which adeptly blurs financial fact and fantasy. After a 2017 characterized by massive gains and high volatility with the accompanying animal spirits, the early stages of 2018 have been both less exciting and less remunerative. The current price of just over $8,000 is low enough to severely crimp the profits of those who mine for them online, according to Thomas Lee of Fundstrat. "Bitcoin currently trades essentially at the break-even cost of mining a bitcoin, currently at $8,038 based on a mining model developed by our data science team," Lee wrote in a report yesterday.
The city of Plattsburgh, N.Y., isn’t too distraught over the plight of the crypto miners. Yesterday, the city council unanimously voted to impose an 18-month moratorium on bitcoin mining after residents complained about surging electricity bills brought about by those hunting crypto-riches.
Meanwhile bitcoin, which traded at less than $1,000 and nearly $20,000 at different points last year, has generally remained in a $7,000 to $11,000 per coin range in recent weeks. Bloomberg notes that the narrower trading range has coincided with waning public interest:
Internet searches for ‘Bitcoin’ have plunged . . . Online searches for ‘bitcoin’ fell 82 percent from December highs, according to Google Trends. Tweets that mention the coin peaked Dec. 7, at 155,600, and are now down to about 63,000, BitInfoCharts says. And the number of bitcoin transactions is off 60 percent from its record on Dec. 13, according to Blockchain.info.
That Aug. 11, 2017 edition of Grant’s reminded readers that “Money of the mind is the broadest definition of money. It’s bounded only by the imagination.” Well, by reality, too.
Recap Mar. 16
Stocks ticked a bit higher, as did Treasury yields. Energy prices caught a solid bid despite a green greenback, with WTI crude rising back toward the middle of its 2018 trading range above $62 a barrel. The VIX finished sharply lower.
- Philip Grant
Thursday, March 15, 2018
QT Progress report
You can’t accuse them of crushing the debt market. The Fed’s balance sheet increased for a second straight week, with securities held outright footing to $4.198 trillion, up by $8.8 billion from a week ago with an uptick both its Treasury and mortgage-backed securities holdings. The current level is almost even with the trailing four-week moving average of $4.199 trillion.
Since the introduction of QT on Oct. 1, the Fed’s total assets have declined by 1.09%, for a simple annualized pace of 2.35%.
Deal derby
At what price growth? In the consumer packaged goods industry, which has been beset by eroding revenues as customers increasingly turn away to organic/fresher/better-for-you fare as opposed to the processed foods offered by legacy companies, it sure doesn’t come cheap. A trio of industry sightings follow.
On Jan. 16, Post Holdings, Inc. (POST on the NYSE) completed the acquisition of Bob Evans Farms, Inc. for $77 a share in cash, or a total consideration of $1.61 billion. Post, which is mired in a secular contraction in its core cereal business (research firm IBIS World calculates that cereal industry revenues in the United States have declined by 3.3% annually since 2012), is understandably looking elsewhere to burnish its top line (for more see “From hunger,” Sept. 16, 2016).
To do so, the house of (chairman) Bill Stiritz is paying a healthy premium: The deal price represents 15.7 times Bob Evans’ consensus adjusted earnings before interest, taxes, depreciation and amortization [EBITDA] and 43 times consensus adjusted net income for the fiscal year ending April 30. For context, the enterprise value of the S&P 500 trades at 11.6 times consensus EBITDA for 2018, according to data from Bloomberg.
The venerable Campbell Soup Co. (CPB on the NYSE), which was a post-financial crisis pick-to click at Grant’s (“Death of bonds,” Oct. 11, 2011) before we turned bearish four and a half years later (“Sell big food,” Mar. 25, 2016), also went the acquisition route to combat secular contraction in its core business. CPB announced on Dec. 18 a deal to acquire pretzels, potato chips and popcorn purveyor Snyder’s-Lance, Inc. (LNCE on the Nasdaq) for $6.04 billion in cash, which represents 18 times the sell-side’s consensus estimate for LNCE 2018 adjusted EBITDA. The Street is expecting earnings per share growth in excess of 20% this year and next, but improved efficiency (or financial engineering) is the expected catalyst, as opposed to top-line expansion. Revenue forecasts for 2018 and 2019 of $2.24 billion and $2.28 billion are virtually identical to last year’s $2.23 billion.
In paying that $6 billion haul for Snyder’s-Lance, Campbell’s own financial position has changed – and not for the better. Moody’s noted in December that CPB’s debt ratio is set to jump to 5 times EBITDA from 2.2 times in October. Last Friday, Moody’s slashed its Campbell rating by two notches, to Baa2 from A3. S&P demoted the soupmaker to triple-B from triple-B-plus shortly after the deal announcement. On Monday, Campbell’s sold $5.3 billion in a seven part bond offering, with two floating rate notes and five fixed-rate tranches at yields ranging from 3.33% to 4.84%.
Finally, we turn to General Mills, Inc. (GIS on the NYSE), the Minnesota-based concern selling snacks, yogurt and cereals. Facing the same uphill revenue battle as its peers, GIS struck a bold deal on Feb. 23, agreeing to buy Blue Buffalo Pet Products, Inc. (BUFF on the Nasdaq), for $7.89 billion in cash. That deal price, which equates to 23 times the target’s consensus adjusted EBITDA and 33 times forecast adjusted net income for 2018, earned General Mills a two-notch downgrade in its Moody’s rating to Baa2 from A3. The 3.20s of 2027, which traded above par at year end, last changed at hands at 95.5 cents on the dollar.
As for the (soon to be) newest addition to GIS, Blue Buffalo enjoyed double-digit year-over-year revenue growth during each quarter of 2016, before top-line expansion slowed to 7.9% in 1Q 2017 then 2.8% in the second quarter of last year. In response, the company announced on Aug. 3 that it would sell its high end pet food in mass market chains Target, Kroger, Publix and Meijer. That move (BUFF told readers of its 2016 form 10-K that it sold only through specialty channels) coincided with a return to double-digit revenue growth, but far faster growth in accounts receivable. Against a 10.9% year-over-year gain in 2017 revenues, receivables jumped by 30.4%.
The Post, Campbell’s and General Mills trio have something else in common besides top-line pressures and an inclination for M&A. The price for each stock peaked in July 2016, which was when interest rates in the U.S. put in their (so-far) cyclical lows with the 10-year Treasury yield touching 1.37%. Coincidence? Maybe not.
Correction:
Yesterday’s ADG asserted that no Japanese 10-year notes traded on Tuesday. Instead, no benchmark (meaning newly issued) 10-year JGBs traded, but other cash bonds did. I have corrected my error on the Grant’s website.
Recap Mar. 15
Stocks finished little changed, leaving the S&P 500 lower by 1.4% this week so far after notching its best finish since that early February wipeout on Friday. The Treasury flattened a bit, while strength in the dollar didn’t bother the commodity complex.
- Philip Grant
Wednesday, March 14, 2018
QE chronicles
If a bond yields nothing and no one trades it, does it even exist?
If a bond yields nothing and no one trades it, does it even exist?
Golden ruberstamp
From the Boston Business Journal:
From the Boston Business Journal:
Recap Mar. 14
QE chronicles
If a bond yields nothing and no one trades it, does it even exist? That existential question is put into relief by a dispatch from Bloomberg this morning: Not one solitary lot of the benchmark Japanese 10-year note changed hands during Tuesday’s trading session (the market was open – we checked). Bloomberg notes that “Barclays Securities Japan rates strategist Naoya Oshikubo, summed it up, with perhaps an understatement: ‘the JGB [Japanese Government Bond] market was generally thin.’” Indeed. For context, the active (June) contract of 10-year U.S. Treasury futures saw trading volume of just under 1.7 million contracts yesterday, equating to a dollar value of $202 billion.
Of course, one needn’t look too far to the explanation for a dormant debt market in the world’s third largest economy. The Bank of Japan (BoJ) has been hard at work at its “Quantitative and Qualitative Monetary Easing” strategy since April 2013, while “Yield Curve Control” has been monetary dogma since September 2016. A zero-percent 10-year yield is part and parcel with that policy, and the BoJ is taking every measure to ensure that no pesky investors get in the way of its objectives. Bloomberg writes in the same story that “Governor Haruhiko Kuroda noted to lawmakers Wednesday that the central bank has bought 75 percent of the government bonds issued in the fiscal year ending this March.”
The JGB market’s long road to zero yields has been colored by more than BoJ monetary policy or even the worldwide bond bull market. Following the bursting of a spectacular stocks and real estate bubble of the 1980’s, the Japanese economy has been marked by stagnation: Since 1998, Japanese year-on-year CPI growth has averaged 0.1%. In that same 20-year period, Japanese year-over-year real chained GDP growth has averaged just 0.8%.
Five basis points to go: The Japanese 10-year yield, 30-year view. Source: The Bloomberg
In an effort to reach the consensus monetary Valhalla of 2% inflation, the BoJ has undertaken policy that leaves its peers in Europe and the United States in the dust: In the five years ended Feb. 28, Japan’s monetary base (comprised of money in circulation as well as bank reserves) has increased by 281% to ¥475 trillion ($4.4 trillion), or just under 31% annualized growth. By comparison, the European Central Bank has increased its monetary base by 63% over the past five years (10% annualized growth), while the Federal Reserve has overseen a 34% uptick in the U.S. monetary base, or 6% annualized. On the consumer inflation count, the BoJ has been somewhat successful. Over the past five years, average CPI growth has risen to 0.9%.
While the BoJ prints yen, the Fed is nearly six months in to its (very gradual, to be sure) balance sheet reduction while the 10-year Treasury yield has more than doubled from its July 2016 lows of 1.37%. The Wall Street Journal noted on Feb. 28 that foreign investor demand for Treasurys has been crimped by rising hedging costs as the Fed continues to raise overnight interest rates (Almost Daily Grant’s, Feb. 28). Nevertheless, Russell Napier, independent strategist and co-founder of the Electronic Research Interchange, speculates in today’s “The Solid Ground” commentary on potential consequences if Mr. and Mrs. Watanabe come to find U.S. Treasurys and their positive real yields too tempting to resist:
Might this additional relative yield tempt Japanese investors? If it does, who buys the JGBs they most likely liquidate to fund their Treasury purchases? If such a liquidation is triggered, the BOJ balance sheet expansion, given their yield target for JGBs, would accelerate just as the Fed’s balance sheet contracts.
So, the more the Fed acts to contract its balance sheet, the more it could, through enticing Japanese savers to the Treasury market, force an accelerated balance sheet expansion on the BoJ. This [effort], aimed at driving up all asset prices, while maintaining relative interest rate stability, will very clearly be over. The impacts from a decline of the yen on the international exchanges will be profound.
The yen currently trades at 106.8 per dollar, almost exactly at its 20-year average.
For its part, the central bank has evinced no lack of conviction in its goal or its methods. The BoJ website explains that “When prices fluctuate, individuals and firms find it hard to make appropriate consumption and investment decisions, and this can hinder the efficient allocation of resources in the economy.” Potential consequences of unrivaled financial repression were left unmentioned.
Golden ruberstamp
From the Boston Business Journal:
GE (NYSE: GE) paid $142.9 million in audit and related fees and tax fees to KPMG last year — more than any year since at least 2000, and perhaps longer, according to GE’s proxy filing Monday. The filings prior to 2000 do not include audit fees.
In the proxy filing, the Boston-based company asked shareholders to endorse KPMG as its auditor for another year, in the face of increased scrutiny of GE’s accounting practices. GE is under investigation by federal securities regulators for its accounting, and it recently revealed an unexpected $15 billion shortfall in its legacy insurance business. KPMG has been GE’s auditor for more than a century.
Nice work, if you can get it.
Recap Mar. 14
Stocks absorbed a second straight round of moderate selling pressure, while a strong bid at the long end of the Treasury complex pushed spreads between the two- and 10-year and the five- and 30-year yields back within a few basis point of their respective lows for the cycle. The VIX rose for a third straight day.
- Philip Grant
Tuesday, March 13, 2018
Who will guard the guards themselves?
Yesterday’s edition of the Financial Times features a remarkable, and somewhat alarming, claim:
Yesterday’s edition of the Financial Times features a remarkable, and somewhat alarming, claim:
Poutine on the ritz
Former belle of the investment-ball Valeant Pharmaceuticals International, Inc. (VRX on the NYSE and Toronto Stock Exchange) has been given the cold shoulder
Former belle of the investment-ball Valeant Pharmaceuticals International, Inc. (VRX on the NYSE and Toronto Stock Exchange) has been given the cold shoulder
Recap Mar. 13
Who will guard the guards themselves?
Yesterday’s edition of the Financial Times features a remarkable, and somewhat alarming, claim: A large proportion of worldwide accounting audits contain “serious problems.” The FT explains:
According to the International Forum of Independent Audit Regulators [IFIAR], accounting lapses were identified at two-fifths of the 918 audits of listed public interest entities they inspected last year.
The most common issue identified by these regulators was a failure among auditors to “address the reasonableness of assumptions.”
While the inherent subjectivity of management estimates would seemingly allow some room for differing interpretations, the watchdog’s next finding reads as a more direct indictment of industry practices.
The second biggest problem was a failure among auditors to “sufficiently test the accuracy and completeness of data or reports produced by management.”
Beyond the unflattering findings unearthed by the IFIAR, 2018 was already off to a rough start for the auditors. On Jan. 22, the Securities and Exchange Commission and federal prosecutors announced charges against six certified public accountants at the Public Company Accounting Oversight Board (PCAOB) and “Big Four” auditor KPMG, LLC. From the SEC’s press release:
The SEC's Division of Enforcement and Office of the Chief Accountant allege that the former PCAOB officials made unauthorized disclosures of PCAOB plans for inspections of KPMG audits, enabling the former KPMG partners to analyze and revise audit workpapers in an effort to avoid negative findings by the PCAOB. Two of the former PCAOB officials had left the PCAOB to work at KPMG. The SEC's Enforcement Division and Office of the Chief Accountant allege the third official leaked PCAOB data at the time he was seeking employment with KPMG.
“As alleged, these accountants engaged in shocking misconduct – literally stealing the exam – in an effort to interfere with the PCAOB's ability to detect audit deficiencies at KPMG," said Steven Peikin, Co-Director of the SEC's Enforcement Division.
Francine McKenna, transparency reporter at Marketwatch and alumna of two Big Four firms, wrote in a Jan. 30 analysis of the situation that the Department of Justice complaint “suggests that at least five more unnamed KPMG partners and one outside consultant either knew or chose to ignore the illegal source of the information.”
In the light of the less-than comforting findings made by the IFIAR and the U.S. government’s allegations against KPMG, Grant’s asked McKenna for her assessment of the auditing industry as a whole:
Not immune to incentives, these firms have appeared to increasingly represent the interests of the companies that hire them, instead of acting as another set of eyes for investors as they are supposed to. They audit, consult, do taxes, perform due diligence on acquisitions, then investigate if things go wrong.
Overall, it’s troubling that the auditors have largely disregarded the core tenets of professional skepticism, independence and objectivity which are critical to effective oversight. These firms are not service providers. The relationship between auditor and company is supposed to be adversarial, and if it’s not, the auditor isn’t doing their job.
As the longstanding bull market in equities remains intact, so does broad faith in those charged with making sure that corporations are operating on the up and up. On Oct. 25, the Center for Audit Quality released its 11th annual Main Street Investor Survey of 1,001 retail investors, conducted in September via the telephone and online. A record high (85%) of respondents expressed confidence in the U.S. capital markets, while 54% did so for non-U.S. markets, up sharply from 42% in 2016.
The auditors themselves also scored high marks, with 78% of investors reporting confidence in public companies’ audited financials, up from 71% two years prior and a low of 69% in 2011. The dissenting minority (those expressing “very little” or “none at all”) dropped to a record low of 12%, down from 20% in 2015 and a high of 27% in 2009.
Poutine on the ritz
Former belle of the investment-ball Valeant Pharmaceuticals International, Inc. (VRX on the NYSE and Toronto Stock Exchange) has been given the cold shoulder by the stock market since July 2015 (VRX shares down by 94% over that period while the S&P 500 has risen by 31%), but bond investors just can’t quit the Laval, Quebec specialty-pharma concern.
The reformed roll-up, a frequent bearish subject of Grant’s during its 2014-2015 heyday (“Drug dealer,” “Sacrificial creditors,” “Reality check,” “Saul Steinberg’s second coming,”) and currently attempting to deleverage its stifling debt load, made a successful visit to the bond market yesterday, offering $1.25 billion of Caa1/single-B-minus rated 2026 senior notes at 9 1/4%. Valeant will use the proceeds to launch tender offers for a trio of shorter term obligations: 6 3/8% notes due in 2020, 5 3/8% notes due in 2020, and 6 3/4% notes due in 2021. Investors clamored for more, allowing the company to upsize yesterday’s offering to $1.5 billion at the same 9 1/4% yield.
Valeant can use the breathing room. It’s $24.8 billion in net debt dwarfs its $5.6 billion market capitalization and represents a forward leverage ratio of just under eight times earnings before interest, taxes, depreciation and amortization, while interest expense of $1.8 billion is more than three times trailing operating income of $493 million (the Street expects operating income to jump to $2.5 billion this year). Meanwhile, the eight year maturity on Monday’s offering will outlast the patent protection on some of Valeant’s products. The Food and Drug Administration reminds visitors to its website that domestic patent exclusivity extends for 20 years from filing date. Orphan drug patent exclusivity lasts for seven years.
In the “business strategy” section of its most recent form 10-K, Valeant notes that: “We face increased competition from manufacturers of generic pharmaceutical products when patents covering certain of our currently marketed products expire or are successfully challenged or when the regulatory exclusivity for our products expires or is otherwise lost.”
For credit investors, “increased competition” seems to mean something else entirely.
Recap Mar. 13
Stocks came under pressure today, with the S&P 500 reversing early gains to fall by nearly 1.5% from its peak and finishing near session lows. A stronger than expected 30-year Treasury auction in early afternoon helped push yields lower across the curve, as USTs continue to consolidate after the breakout in yields seen in January. The VIX had another strong day, and has ticked higher by 15% so far this week.
- Philip Grant
Friday, March 9, 2018
We're gonna need a bigger moat
A dispatch from the New York Post:
A dispatch from the New York Post:
In out of the cold
One needn’t strain too hard to find similarities between market conditions today and the late-1990’s bull stampede.
One needn’t strain too hard to find similarities between market conditions today and the late-1990’s bull stampede.
Recap Mar. 9
We're gonna need a bigger moat
A dispatch from the New York Post:
An irate leopard paid an unexpected visit to a community in Indore, India, causing residents to panic. Some tried coaxing the animal to leave using wooden poles. The local police department and forest department teams worked together to finally sedate and remove the agitated animal. The forest department’s divisional forest officer R.K. Saxena was one of three people injured by the leopard. Details of how the big cat got into the gated community are still unclear.
A silver lining for the residents of Indore: At least they don’t have to ride the subway.
In out of the cold
One needn’t strain too hard to find similarities between market conditions today and the late-1990’s bull stampede. As the recent correction recedes from view, general investor euphoria floods to mind. The blistering ascent of the FAANG+ contingent in this cycle evokes the tech mania as the internet phenomenon first took hold.
However, a critical distinction emerges when looking beyond those corporate VIPs: Back then, expensive stocks coexisted with a number of cheap ones. In March of 2000, the market-cap weighted S&P 500 traded at 30.6 times trailing earnings, while the equal-weighted version of the broad index fetched a relatively modest 20.7 times earnings. Today, the market-cap weighted S&P 500 sports a trailing price/earnings ratio of 22.41 times, while the equal-weighted S&P 500 trades at 22.45 times trailing earnings. Value, not only relative but absolute, was on the offing for investors in 1999 even as the Nasdaq careened parabolically higher.
The Dec. 3, 1999 edition of Grant’s (“Car wreck") shined an analytical spotlight of one of these curious bargains, in the form of Tenneco, Inc. (then called Tenneco Automotive), a leading auto-parts manufacturer then trading at just 4.8 times forward net income estimates:
In the midst of a great bull stock market, there is a flourishing, parallel bear market: scores of small-cap, analog-style companies are valued as if the year were 1990, or even 1982, or even 1974, instead of 1999. Tenneco Automotive . . . could be the poster child for orphaned companies.
Of course, cheap companies are usually cheap for a reason and Tenneco had its share of warts: Stagnant revenues, rising costs and an increasingly onerous debt burden pushed its share price lower by some 65% over the prior three years, a period in which the S&P 500 soared by 95%. These disappointments had seemingly conferred commanding value with a margin of safety on Tenneco:
Possibly, of course, the company will fail to deliver even the meager results that the Street expects of it. Then what? “If they totally miss their earnings,” comments Seth A. Klarman, president of the Baupost Group, Cambridge, Mass., one of the few known bulls on the situation, “the stock is . . . cheap.”
The months passed (as they have been known to) and Tenneco remained a spectator in the New Economy-driven market ascent. On March 3, 2000 (“Valuation non sequitur"), Grant’s reviewed its positive stance on the auto-parts maker, observing the contrast between the company’s treatment in the credit market and its share price, which had cheapened further to trade at 4.5 times forward earnings.
Yet if the stock market is pricing in oblivion, the bond market is more than sanguine. If it were not, the Tenneco 11 5/8s of 2009 would not be quoted two points above par, at a price to yield 11.1%. A hot cup of coffee, Mr. Market?
By and by, Mr. Market did come to see things the bulls’ way. Since March 2000, Tenneco shares have rallied by 540%, while the S&P 500, then just beginning to unwind the late-1990’s excesses, has since gained by 99%. Relative to the auto industry as a whole, Tenneco’s Y2K-era discount appears to have closed.
Tenneco shares in white, U.S. auto sales, seasonally adjusted annual rate in orange. Source: The Bloomberg
Meanwhile, the search for bargains continues apace in a market that evokes Garrison Keillor’s Lake Wobegon: A world where all the children are above average.
Recap Mar. 9
On the ninth anniversary of the 2009 closing low, a strong reading of non-farm payrolls helped keep the bulls in the driver’s seat. The S&P 500 jumped again to finish the week more than 3% in the green, and back within 3% of the Jan. 26 closing highs. Treasury yields ticked higher, with the 10-year back near 2.90%, and energy caught a bid despite a flat dollar.
A remarkable fact courtesy of Twitter user Michael Batnick. Since Oct. 27, Amazon.com, Inc. shares are up more than 60%, adding just under $300 billion to its market cap. That figure alone would place Amazon just ouside the top-10 largest companies in the S&P 500.
- Philip Grant
Thursday, March 8, 2018
Middleby earth
Investors were left hungry. Middleby Corp., reported fourth quarter results on Feb. 27, with revenues of $632.9 million falling short of the expectation of each of the 10 sell-side analysts who proffered a forecast, while fourth quarter gross margins of 37.9% shrank by a meaty 220 basis points year-over-year. The disappointing figures were met rudely, as the MIDD stock price sold off by 12% to $118 a share (it’s since bounced to $126). Since June 2016, MIDD shares have gained 3%, lagging the S&P 500’s 31% advance during that period.
Middleby, which was founded in 1888, is in the business of manufacturing and selling equipment for commercial and residential kitchens, and the machinery used by packaged food companies. Recent years have been characterized by a parade of acquisitions. In late 2012, Middleby diversified into residential kitchen category by buying Viking Range Corp. for $361.7 million in cash. In the past five years, the company has made 22 separate acquisitions, by our count.
In explaining the fourth quarter shortfall, the company flagged weakness in its commercial unit (which contributes the bulk of revenues and operating profits), particularly dwindling demand for its ovens, broilers and fryers from restaurants. Chairman and CEO Selim A. Bassoul commented that: “Sales to our major restaurant chain customers remained impacted in the quarter as replacement purchases were less than prior years as customers evaluated new equipment solutions.”
John Hamburger, president of the Restaurant Finance Monitor (and speaker at the upcoming April 10 spring conference – advt.), told Grant’s that the restaurant industry is contending with a number of factors that may continue to constrain capital outlays on things like state of the art equipment.
Chain restaurant expansion slowed somewhat because of the economics (rising labor and rents), plus the private equity owners and boards of directors are more cognizant of capital spending. 2017 was not a good year for restaurants…many brands were sales challenged and that weighed on spending.
Fourth quarter miss aside, analysts at BMO Capital Markets believe Middleby deserves the benefit of the doubt amid a long run of success. On Tuesday they raised their price target to a Street-high $160 a share. Machinery analyst Joel Tiss, who rates MIDD shares “outperform,” writes:
With the shares trading at five-year valuation lows, we see exceptional opportunity for those investors who know the company well and recognize the excellence of its management team.
Middleby is in an elite class of companies that significantly outgrow end markets while expanding margins. This is evidenced by an unmatched track record of compounding growth rates, including 19% for revenue, 24% for operating profit, and about 31% for [earnings per share] since 2000.
On the whole, the Street is expecting Bassoul to deliver for investors. Analyst consensus calls for adjusted EPS growth of 11.3% and 10.9% in 2018 and 2019, respectively. And why not? Adjusted EPS growth has remained in the double digits in each year going back to 2010. Free cash flow has been less dynamic of late, ranging from between $221 million and $269 million in the last four years. The sell side collectively expects that line item to jump to $364 million in 2018 and $510 million in 2019.
Grant’s has cast a skeptical eye on Middleby, producing a pair of bearish analyses (“Waiter, the check,” June 17 and “Out of the kitchen,” Dec. 23) in 2016. We argued that the low rates-driven boom in restaurant capacity has allowed the company to achieve strong financial performance at the expense of future demand, while Bassoul’s acquisition-heavy and R&D-lite strategies serve to further flatter its income statement through, among other things, artificially low amortization expense.
Under the rules of purchase accounting, acquirers may apportion the assets of their acquirees as they wish for 12 long months after the transaction closes. Middleby has tended to tag those assets “goodwill and other intangibles” (GOI). Most assets so designated need not be amortized. And as they are not amortized, they do not impair the optics of reported GAAP earnings.
Indeed, goodwill ($1.26 billion) and intangibles ($780 million) account for 61% of Middleby’s total assets, according to the company’s recently released form 10-K. Meanwhile, the aforementioned Viking Range acquisition of 2012 was also a critical piece of the Middleby narrative. In particular, the story quoted an unnamed appliance retail CEO lamenting the poor quality of certain Viking products. That anecdote, in concert with declining organic revenues in the residential division, led deputy director Evan Lorenz to speculate on the potential for asset writedowns.
Few analysts will second-guess the accounting judgements of the management of a successful company or division. The fact is that the decline in sales of Viking ranges drove the aforementioned 19.6% year-over-year drop in organic sales in the residential division. Pending a timely fix – of which we see no sign – a writedown may be in store for some of the $309.1 million in GOI that the Viking transaction brought on board.
That scenario indeed came to pass in the fourth quarter: Middleby took a $58 million impairment “related to the Viking tradename.” We wonder if more such unfriendly adjustments are on the way, and also wonder if the Street’s expectation for gangbusters EPS and free cash flow growth will itself come to pass.
QT progress report
With QT like this, who needs QE? The Fed’s portfolio of securities held outright rose by $180 million from a week ago to $4.189 trillion. Both its Treasurys and mortgage-backed securities components contributed to the unexpected increase, ticking higher by $160 million and $19 million, respectively. Things look a bit more normal (if that’s the word) compared to the trailing four week average: Footings have declined by a bit more than $13 billion, with Treasurys lower by MBS holdings down by $5.5 billion. Overall, total Fed assets are down by 1.34% since the beginning of QT on Sept. 27, a simple annualized pace of 3.01%.
Not just this week has progress been halting. Bianco Research finds that the MBS run-off had already fallen behind the Fed’s target even prior to today’s uptick, with the $1.76 trillion in holdings well above the target $1.746 trillion for March 1 based the Fed’s projections.
Jerome Powell’s got some work to do.
Recap March 8
Stocks caught a bid, with the S&P 500 extending its gain for the week to 1.8% so far. Treasury yields ticked lower across the curve, and a stronger greenback pushed the Dollar Index back above 90 as this afternoon’s steel and aluminum tariff announcement featured exemptions for Canada and Mexico, as well as the possibility of other countries also getting a waiver.
- Philip Grant
Tuesday, March 6, 2018
Sentiment check
The upcoming Toronto Real Estate Wealth Expo,
The upcoming Toronto Real Estate Wealth Expo,
Hold the chicken ceviche
The geographic borders of the European Union are well defined.
The geographic borders of the European Union are well defined.
Recap March 6
Sentiment check
The upcoming Toronto Real Estate Wealth Expo, scheduled for April 7 with featured speakers including Sylvester Stallone, Alex Rodriguez and the musician Pitbull, has added a new feature to its agenda. This year, the event (which has taken place in Toronto since at least 2007) has been renamed the “Real Estate, Bitcoin & Wealth Expo.” As of this morning, Groupon was advertising the C$216 tickets at C$39, an 82% discount.
Maybe now, the Real Estate, Bitcoin, Wealth, and Value Expo.
Hold the chicken ceviche
The geographic borders of the European Union are well defined. The purview of the European Central Bank, less so. In the bond market, pronounced investor complacency remains as Mario Draghi and Co. maintain crisis-era monetary policy including a negative overnight deposit rate and corporate bond purchases at a (tapered) €30 billion monthly pace. For the latest example, we travel far from Frankfurt to Sao Paulo, Brazil.
Yesterday, Brazilian authorities arrested Pedro Faria and Helio dos Santos Junior, former CEO and vice president of global operations, respectively at BRF Brasil Foods S.A., and suspended exports at three of the company’s slaughterhouses as part of “Operation Weak Flesh,” an ongoing investigation into whether BRF covered up evidence of salmonella-contaminated food exports and bribed inspectors to look the other way. While such news is never welcome, the latest revelations are particularly unpleasant for BRF as it comes on the heels of an ongoing shareholder campaign to replace the company’s entire board of directors and a fourth quarter which Bloomberg termed “the worst results in its history.”
As analysts at BTG Pactual write, the news both explains the recent contraction in BRF’s margins and lays bare the challenge ahead as new management attempts to right the corporate ship:
In our opinion, a stricter quality control system has led BRF’s production costs to spiral in recent quarters, (presumably) explaining why gross margins haven’t recovered properly. Ultimately, yesterday’s events, with the suspension of plants and the potential to really impact BRF’s sales, could intensify the problem, meaning there’s potential for another strong downward revision to estimates, which may put BRF’s much-needed deleveraging ambitions in check.
BRF could most certainly use some deleveraging, improved profitability, or both. Against net debt of R$19.7 billion ($6.1 billion), the company managed adjusted earnings before interest, taxes, depreciation and amortization (EBITDA) of R$3.2 billion in 2017, for an unadjusted leverage ratio of 6.2:1. Analyst consensus for 2018 calls for adjusted EBITDA to jump to R$4.8 billion. Likewise, 2017 interest expense of R$1.16 billion almost matched full-year operating income of R$1.33 billion. Analysts had penciled in a near-doubling in operating income for their current year forecasts, to R$2.6 billion.
S&P, which rates BRF at triple-B-minus (on the cusp of junk status), commented yesterday that the company’s ratings “are not immediately impacted” by the bombshell report, but the ratings agency had already cast a wary eye: On Feb. 23, S&P lowered BRF’s outlook to negative, commenting that: “its credit metrics remain pressured for the rating category and weighs on a quick improvement to avoid a downgrade.”
BRF’s creditors meet these travails impassively. The company’s euro-denominated senior unsecured 2-3/4 notes due in 2022 trade at 97 cents on the euro as of this writing, for a yield-to-worst of 3.39%. The dollar denominated 4-3/4s of 2024 currently trade just above 95 cents for a yield-to-worst of 5.71%.
Are the bondholders drugged or are they just mellow?
Recap March 6
Stocks ticked a bit higher in decidedly low key action, while Treasurys also finished little changed to continue their recent inertia. Gold caught a bid, jumping back above its 50-day moving average at $1,333 per ounce.
- Philip Grant
Monday, March 5, 2018
Uber stingy?
Some side hustles are more worthwhile than others.
Some side hustles are more worthwhile than others.
Call in the Mounties
The arrival of the long awaited (or feared) B-20 mortgage regulations in the Great White North
The arrival of the long awaited (or feared) B-20 mortgage regulations in the Great White North
Recap March 5
Uber stingy?
Some side hustles are more worthwhile than others. A recent study from researchers Stephen M. Zoepf, Stella Chen, Paa Adu and Gonzalo Pozo at the MIT Center for Energy and Environmental Policy Research suggests that on the whole, drivers at ride share unicorn Uber Technologies, Inc. and its peer Lyft, Inc. are barely keeping their heads above water once costs are factored in:
We perform a detailed analysis of Uber and Lyft ride-hailing driver economics by pairing results from a survey of over 1,100 drivers with detailed vehicle cost sharing information. Results show that per hour worked, median profit from driving is $3.37 per hour before taxes, and 74% of drivers earn less than the minimum wage in their state. Thirty percent of drivers are actually losing money once vehicle expenses are included.
The researchers find that against median gross driver revenue of $0.59 per mile, vehicle operating expenses such as gas and wear-and-tear (for which the drivers are responsible) shave $0.30 cents per mile off that top line figure. For its part, Uber disputes the study’s findings, arguing that the authors utilized flawed methodology to arrive at the above figures. Jonathan Hall, Uber’s chief economist, also notes in the Medium blog post response that other studies contradict the MIT groups’ findings:
For example, a study we conducted with Alan Krueger of Princeton found that drivers across 20 of Uber’s largest US markets earned an average of $19.04 per hour, in October 2015. A more recent study with Stanford professors estimated gross hourly earnings of $21.07 for all US drivers between January 2015 and March 2017.
Uber CEO Dara Khosrowshahi chimed in on Twitter Saturday, quipping that: “MIT = Mathematically Incompetent Theories (at least as it pertains to ride sharing).”
Whether Uber’s drivers are making an hourly rate of $3.37, $21.07 or somewhere in between, the company seems to be in no position to be proffering its contractors (not employees – that would mean paying benefits) a raise. Uber lost $4.5 billion last year on $7.5 billion in revenue according to the Associated Press, more than 50% above its $2.8 billion loss in 2016. After achieving a $68 billion valuation in an August 2016 funding round, the company raised $9 billion from a consortium led by Japan’s Softbank Corp. in a two-tiered investment in January. The investors paid a $1.3 billion portion at that same $68 billion figure in an apparent attempt to maintain its prior valuation, with the remaining $7.7 billion of Masayoshi Son’s lucre valuing Uber at $48 billion, a 30% discount to the prior round.
Uber has earned a reputation for being particularly reluctant to share financial information with investors. That, and its inability to approach profitability, bothers some on Wall Street more than others. The Jan. 27, 2017 Grant’s analysis of Uber (“Not Joseph Schumpeter”), noted the contrasting approaches to the private market behemoth employed by different investment banks:
One year ago, JPMorgan Chase & Co. and Deutsche Bank AG declined the opportunity to sell Uber shares to their high net worth clients. No information, no sale, they said in so many words. Morgan Stanley was not so punctilious. In choosing to broker the stock, it had this so say to its clients, according to a Nov. 7 Bloomberg dispatch: ‘[T]he development of insights and big ideas is valuable to the investing process, whereas obsession over incremental ‘information’ flow is not.” Passive investing, indeed.
Call in the Mounties
The arrival of the long awaited (or feared) B-20 mortgage regulations in the Great White North has yet to yield a discernible impact on the Canadian housing market. January activity slowed slightly year-over-year, while prices ticked a bit higher, according to Statistics Canada.
As the business of buying and selling the only asset class with a backyard plods along, some observers are growing a little nervous about the Canadian banking system. On Feb. 23, S&P Global raised its risk assessment of Canada’s banking sector to three (signifying “intermediate credit risk in the economy”) from two (connoting low credit risk). By way of explanation, S&P wrote:
We believe that structural shifts in the residential mortgage [RM] origination process in Canada, in particular the growing share of RMs originated via brokers, compound the risks of high household debt and house prices because we believe brokers generally have less incentive than lenders to guard against fraud.
Lenders may have a stronger incentive to prevent fraud, but is it strong enough? On Feb. 28, Montreal-based Laurentian Bank of Canada (the country’s eighth largest by market cap) - which surprised Bay Street on Dec. 5, 2017 by disclosing it had identified “documentation issues and client misrepresentations” in a C$304 million pool of mortgages which had already been securitized and sold - provided an update on its first quarter conference call.
The bank fessed up to an additional C$88 million of ineligible loans which had been “inadvertently sold” to the Canada Mortgage and Housing Corp. (CMHC), the Fannie Mae and Freddie Mac of the north. Laurentian is continuing to review its mortgage pool (it expects the inspection to last through the second quarter), but the regulators aren’t exactly cracking the whip. “After discussions with CMHC, we are not required to perform a full review of the mortgages sold to CMHC securitization programs,” said the bank in a statement.
Grant’s inquired with the CMHC press office about their less-than severe response to Laurentian’s mortgage misadventure, and the agency had this to say:
We actively monitor all institutions who participate in our programs and continue to work with Laurentian Bank to ensure they have proper controls in place.
Laurentian Bank has repurchased $88 million of loans from CMHC and we have implemented some additional internal operational measures for Laurentian Bank as a result of this process. We continue to monitor Laurentian Bank’s activities and performance and will work closely with them to help improve controls.
Recap March 5
Equities enjoyed a strong rally, with the S&P 500 finishing near its best levels of the day to erase the bulk of last week’s decline, while energy prices were also notably strong amid a flat dollar. Treasurys again finished little changed; the 10-year note has recently settled into a tight trading range near a 2.9% yield after notching a four-year closing high on Feb. 21.
- Philip Grant
Friday, March 2, 2018
PE class
It’s good to be king. Private equity titan Stephen Schwarzman, the founder and CEO of the Blackstone Group (BX on the NYSE), took home $786.5 million in 2017 according to an SEC filing yesterday, largely thanks to dividends on his Blackstone partnership units. That nearly doubles his 2016 paycheck of $425 million and “underscores the health of the private equity sector,” according to the Financial Times. Competitor Leon Black of Apollo Global Management LLC took home $191.3 million, while KKR & Co.’s Henry Kravis and George Roberts earned a combined $343 million according to Bloomberg.
Michael Milken, the junk-bond monarch of the 1980’s who preceded Schwarzman in attaining compensation that towered over the field (he took home $294 million in 1986 and $550 million in 1987, per the New York Times) before falling from grace in 1989, expects the good times for Blackstone and private equity at large to continue. Milken told Bloomberg in a September interview that: “This is their golden age. You can leverage, you can borrow without covenants, and so for equity holders it affords you very unusual rates of return.”
Clearly it’s a golden age for the senior progenitors of private equity. How about their investors? A Feb. 20 analysis in American Affairs Journal found that optimism is widespread.
A recent survey of institutional investors found that 49 percent expect private equity (PE) to outperform the public equity market by a whopping 4 percent per year or more. Another 45 percent believe PE will outperform by 2-4 percent per year. Only 6 percent think returns will be comparable.
Readers may notice that the above figures add up to 100%, indicating that no constituency thinks PE may lag the public market. Author Daniel Rasmussen, founder and portfolio manager at Verdad Capital, has you covered:
The survey did not even bother to ask if investors thought PE might underperform. This is particularly shocking given that data from Cambridge Associates shows that private equity returns have lagged the Russell 2000 index by 1 percent and the S&P 500 by 1.5 percent per year over the past five years.
What about the PE manager who claims that he can improve the performance of his portfolio companies through operational expertise, cost cutting and a focus on long-term results as opposed to trying to please the Street on a quarterly basis? Rasmussen went on to cite research conducted by Verdad of 390 deals encompassing more than $700 billion in enterprise value to assess private equity’s long term track record.
In 54 percent of the transactions we examined, revenue growth slowed. In 45 percent, margins contracted. And in 55 percent, capex spending as a percentage of sales declined. Most private equity forms are cutting long-term investments, not increasing them, resulting in slower growth, not faster growth.
While survey results are mixed on operational metrics, a common thread emerges:
In 70 percent of cases, PE firms are leveraging up the businesses they buy. PE firms typically double the amount of debt on the balance sheet, from 2.5 times EBITDA [earnings before interest, taxes, depreciation and amortization] to 5 times EBITDA – the biggest financial change apparent from our study.
There is certainly no shortage of funding to be levered. Preqin reported in January that private equity raised a record $453 billion in 2017 (surpassing 2007’s record of $414 billion), leaving the industry with over $1 trillion in dry powder for future deals. Which is a lot of dry powder even if you say it fast.
To Grant’s, which had bullish things to say about Blackstone shares on a handful of occasions in 2011, 2012 and 2013 (BX shares have returned 150% over the past five years with dividends reinvested, compared to 94% in the S&P 500), the current PE zeitgeist is reminiscent of the early-aught hedge fund boom. The April 9, 2004 edition of Grant’s (“Fees and fees and fees on funds of funds of funds”) took a skeptical look at Man Group Plc., the London-based hedge fund firm which had achieved a 46% year-over-year uptick in assets under management while charging institutional investors a 4% management fee on top of a 20% performance fee. Grant’s addressed a hypothetical question of the bourgeoning and increasingly layered hedge fund business which could be equally applied to the private equity cohort today:
How can so many smart, aggressive, fee-driven and highly leveraged investors find wealth and happiness together on the same planet? With difficulty.
Recap March 2
Apparently, trade wars are good and easy to win! Stocks staged a solid intraday rebound after Trump’s latest tariff commentary, closing near session highs to break the string of +/- 1% moves at five and narrow the week’s losses to 2% on the S&P 500. The VIX sold off late to finish below 20, while Treasury yields drifted higher across the curve and dollar weakness coincided with a bid in energy and gold.
- Philip Grant
Thursday, March 1, 2018
Face bunker
The wolves continue to circle Facebook Inc. (FB on the Nasdaq),
The wolves continue to circle Facebook Inc. (FB on the Nasdaq),
QT progress report
Recap March 1
Face bunker
The wolves continue to circle Facebook Inc. (FB on the Nasdaq), as government scrutiny and competitive pressures intensify. The stock has been weak of late, down 9% from its Feb. 1 high compared to a 2% drop in the Nasdaq 100 and 5% decline in the S&P 500 over that period, but it remains higher by 537% over the past five years. We’re bearish on it.
Yesterday, Bloomberg reported that China will soon block the virtual private networks that have allowed their citizens to skirt Beijing’s restrictions on social media sites such as Facebook. Likewise, Bloomberg notes today that News Corp. CEO Robert Thomson’s long-time campaign to wrest concessions of Facebook and Google (which control 73% of the U.S. digital advertising as of the 2nd quarter of 2017, per Brian Wieser of Pivotal Research Group) is gaining traction with his peers:
At a Recode conference last month, BuzzFeed co-founder Jonah Peretti agreed that Facebook should share more revenue generated by its News Feed with media outlets. On a recent earnings call, New York Times Co. CEO Mark Thompson expressed optimism that demand for quality news has created “the possibility of direct payment from distributors.” Martin Sorrell, CEO of advertising giant WPP plc. said in January that he supported such a proposal.
“Too many publishers have been patsies,” Thomson said in an interview from News Corp.’s headquarters in midtown Manhattan, where he oversees the Wall Street Journal, Dow Jones & Co. and the New York Post. “What you are seeing, at last, is more publishers are prepared to be more vocal and that eerie collective silence has been broken.”
Facebook’s remarkable ascent has left it with a dominant share of digital ads as well as a supermajority of users. In the U.S., 68% of adults use Facebook according to a January survey conducted by Pew Research. That proportion has remained constant since the beginning of 2016. Meanwhile, Pivotal Research’s Wieser cited Nielsen data which found an 11% year-over-year per person decline in time spent on the site in November (Almost Daily Grant’s, Feb. 20). For its part, Facebook disclosed that daily active users in the U.S. and Canada ticked lower on a sequential basis in the fourth quarter, a first.
Advertisers are taking notice. Today, Reuters reports that Proctor & Gamble Co., the world’s largest advertiser, cut its digital ad budget by $200 million last year (digital spending represents a third of P&G’s $7.1 billion ad budget per Reuters). Marc Pritchard, P&G’s chief brand officer said at a conference that: “With transparent viewability data, we learned that the average view time for an ad on a mobile newsfeed is 1.7 seconds – little more than a glance – pushing us to innovate.”
The Grant’s Aug. 11 analysis of Facebook (“Concerning Mark Zuckerberg”) contended that the social media behemoth is vulnerable to resistance from different constituencies who may not share the C-Suite’s messianic visions for “build[ing] a global community that works for all of us” (that’s from the company website).
John D. Rockefeller was no more popular with 19th-century oilmen than Zuckerberg is with 21st-century magazine publishers, or with a certain kind of reader or writer who cannot share [chief operating officer Sheryl] Sandberg’s enthusiasm for “short-form snackable content.”
While Facebook’s domestic user growth runs into the laws of gravity, the company continues to struggle in its fight against that potent yet ever so hard to define scourge of fake news. Company executives have certainly not obfuscated on the questionable societal value of social media (Almost Daily Grant’s, January 22). Yesterday, Sandberg told listeners at the Morgan Stanley Technology, Media & Telecom conference that: “What the data shows is not all interactions in social media are equally good for people in terms of their psychological well-being.”
What to do about it? Hire lots more people, apparently. Facebook had 25,105 employees as of Dec. 31, 2017 according to its form 10-K. That’s up 47% year-over year. A majority of those are policing the digital airwaves, as opposed to growing the business by developing software or generating revenue by selling ads, according to a Feb. 22 bulletin from The Economist:
Facebook has around 14,000 workers overseeing security, safety, compliance and community operations, twice as many as a year earlier, and that figure is likely to rise as more countries require it to find and remove objectionable content.
Meanwhile, the share transference from company insiders to passive index funds which frequently allocate based on market capitalization (Facebook’s is $511 billion) continues apace. The Vanguard Group, BlackRock and State Street Corp are three of the top four Facebook shareholders, holding an even 17% of shares outstanding as of Dec. 31, 2017. In the fourth quarter, the trio added just under 25 million shares to their combined stakes.
The accumulating indexers are receiving substantial daily liquidity from Zuckerberg himself. The Facebook boss was a seller of 2,690,200 shares in the eleven trading days between Feb. 12 and Feb. 28, an average of 224,000 per session. Zuckerberg’s sales represented just over 1% of all trading in Facebook stock over that period.
Wise move, we reckon.
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Zuck sells, you buy. Source: The Bloomberg
QT progress report
The run-off accelerated a bit this week. The Fed’s securities held outright registered at $4.19 trillion, a $17.2 billion decline from Feb. 22. Mortgage-backed securities holdings dropped by $9.3 billion, while Treasury holdings ticked lower by $7.8 billion. Relative to its trailing four-week average, the change is similar, with a $16.6 billion drop in securities held outright, although Treasurys represent the bulk of that change with this week’s holdings down by $11 billion.
The Fed’s balance sheet has declined by 1.4% since Sept. 27, the final week before the commencement of QT, for a simple annualized pace of 3.28%.
Recap March 1
Stocks and the dollar fell in tandem following President Trump’s announced plans for tariffs on steel and aluminum, as volatility continues with the S&P 500 moving over 1% for a fifth straight session to settle near unchanged for 2018. Treasurys were bid across the curve, with the 10-year yield now at its lowest since early February. The VIX jumped back above 22.
- Philip Grant
Wednesday, February 28, 2018
Release the Kraken
After rebounding some 50% from its early-February interim nadir,
After rebounding some 50% from its early-February interim nadir,
Treasury chest
Higher yields across nearly the entire spectrum of U.S. government and corporate bonds should be met with increased demand, right?
Higher yields across nearly the entire spectrum of U.S. government and corporate bonds should be met with increased demand, right?
Recap Feb. 28
Release the Kraken
After rebounding some 50% from its early-February interim nadir, the price of bitcoin has settled into a relatively (by its wild standards) tight trading range of late and currently sits just above $10,000 per fiat greenback. Amid the low key trading comes a potentially significant development. Kraken, one of the four exchanges used to price futures on the CME Group via the Bitcoin Reference Rate, has apparently been cut off by one of its banks. The website Finance Magnates explains:
Citing “a variety of circumstances,” [Kraken] is closing its SWIFT bank accounts in USD, EUR and GBP. In addition, JPY funding accounts at Japanese Bank Sumitomo Mitsui are to cease accepting funds.
Kraken will process all of the funds that are received by midnight on the 20th of March, 2018. Funds that have been processed after that date will automatically be returned to sender.
In its letter, the exchange said: “While this is a disappointing development, we are dedicating further resources to our banking relationships and the implementation of new funding methods. We will reach out to you again when we have further details to share.”
Grant’s called the CME for reaction to the news. The exchange declined to comment, beyond noting that the Bitcoin Reference Rate published today without incident and that Kraken remains a component.
Treasury chest
Higher yields across nearly the entire spectrum of U.S. government and corporate bonds should be met with increased demand, right? Not according to recent dispatches from the Wall Street Journal and the Financial Times. This morning, the Journal’s Jon Sindreu reports on a relative paucity of foreign demand for Treasury securities despite far more attractive yields on an apples-to-apples basis. Bloomberg’s Lisa Abramowitz notes on Twitter that the two-year Treasury yield premium over the German bund is its highest since 2010. Sindreu writes:
A year ago, investors were getting around 0.5 percentage point extra for buying a 10-year Treasury and hedging the currency risk every three months, instead of purchasing a German bund, according to the Wall Street Journal’s calculations. They are now losing 00.5 percentage point – a multiyear low.
While demand sputters, Treasury supply remains robust. Yesterday, a $60 billion auction of four-week bills was priced to yield 1.495%, the highest since September 2008 and well above the 1.475% yield available in the when-issued market. A $22 billion auction of 52-week bills fetched 2.02%, the highest since the 52-week auction was reintroduced in June 2008, according to Bloomberg. Thomas Simons, economist at Jefferies, commented that: “The surge in bill supply has caused the market to cheapen up . . . there’s value in the yield. How much cash is there to absorb it?”
The investing public seems largely attuned to the bourgeoning supply and waning demand that has characterized the action in USTs. The Commodity Futures Trading Commission’s weekly Commitment of Trader’s Report for Feb. 20 showed that speculators held 955,593 10-year Treasury futures contracts short, a record quantity going back to 1992 and more than four times the average over that period. Recall that the February Bank of America Merrill Lynch Global Fund Manager survey showed that 80% of respondents expect that rates will rise over the next year (Almost Daily Grant’s, Feb. 13). Just 5% called for lower rates.
CFTC 10-year UST futures short contracts outstanding. Source: The Bloomberg
Likewise, the FT yesterday noted that “International investors were net sellers of U.S. corporate paper in December, only the second time this has happened in the past three years.” Both articles cite the rise in hedging costs as a primary factor in deterring foreign investors from taking the plunge on U.S. debt.
As yields rise, especially on the short end, the Fed’s policy tightening continues apace. Yesterday, chair Jerome Powell seemed to hint to Congress that four rate hikes were on the table for 2018 (he noted that the December median projection of three hikes has been followed by economic strength, an improving labor market and rising inflation). Powell also said that the Fed was “moving right along” with its QT balance sheet run-off.
Could the Fed’s unwind of the quantitative easing and zero interest rate policies of the post-2008 era hamper economic expansion which is informing that stimulus removal? Russell Napier, independent strategist and co-founder of the Exchange Research Interchange, writes in today’s “The Solid Ground” commentary that the policy tightening is already having an impact:
In the U.S. M2 [money supply] is growing at just 4.2% year on year, one of the lowest post-WWII levels, while U.S. bank credit growth was growing at just 1.9% y/y in January . . . For bank credit, if not for bond credit, there is ample evidence that higher interest rates are crimping demand and thus destroying the commercial banks’ ability to create money.
Meanwhile, the bond bulls par excellence at Hoisington Investment Management used their Q4 2017 Review and Outlook to explain their rationale for sticking to their guns, in the face of the sharp uptick in short rates and widespread bond bearishness.
We believe the full spectrum of monetary policy is aligned against stronger growth in 2018. A higher federal funds rate, the continuation of QT, low velocity [of money] and abruptly slowing money growth all put downward pressure on [economic] growth. The flatter yield curve will further tighten monetary conditions.
This monetary environment coupled with a heavily indebted economy, a low-saving consumer and well-known existing conditions of poor demographics suggest 2018 will bring economic disappointments. Inflation will subside along with growth causing lower long-term Treasury yields.
For our part, Grant’s remains bearish on bonds, but we also take careful note of the economic and positioning-related indicators which seemingly argue otherwise.
Recap Feb. 28
Stocks suffered a late sell-off for a second straight day, as the S&P finished in the red by more than 1% to wrap up February with a 3.9% loss and narrow 2018’s gain to 1.5%. The VIX in turn caught a bid this afternoon to settle just below 20.
Treasury yields ticked lower across the curve, while the greenback continued its bounce to leave the Dollar Index at a six week closing high.
- Philip Grant
Tuesday, February 27, 2018
Tone at the top
New Fed chairman Jerome Powell wasted no time in distinguishing himself
New Fed chairman Jerome Powell wasted no time in distinguishing himself
Endo times
Roll-ups can provide a magical investment ride – at least, that is, until the music stops.
Roll-ups can provide a magical investment ride – at least, that is, until the music stops.
Recap Feb. 27
Tone at the top
New Fed chairman Jerome Powell wasted no time in distinguishing himself from his predecessors in his debut Congressional testimony. While noting that the Fed “is moving right along” with its QT balance sheet run-off, Powell also noted (paraphrased by Bloomberg) that the stock market is not the economy, although it plays a factor.
Those remarks strike a contrast to Powell’s predecessor, Benjamin S. Bernanke. In a 2010 Washington Post op-ed arguing for the enactment of the second round of quantitative easing, Bernanke wrote that:
Lower corporate bond rates will encourage investment. And higher stock prices will boost consumer wealth and help increase confidence, which can also spur spending. Increased spending will lead to higher incomes and profits that, in a virtuous circle, will further support economic expansion.
Shortly after Powell’s testimony concluded, Bernanke interviewed his immediate successor Janet Yellen at the Brookings Institute in Washington. Paul Donovan, chief economist at UBS Securities, described the Fed-head pairing thusly: “Much excitement as one highly respected economist sits down to interview another highly respected economist.” As for the current occupant, Donovan takes a dimmer view: “Current Fed Chair Powell is not a highly respected economist.”
Endo times
Roll-ups can provide a magical investment ride – at least, that is, until the music stops. For the latest example of that dictum, we turn to Dublin, Ireland-based pharmaceutical concern Endo International Plc. (ENDP on the Nasdaq). Endo reported fourth quarter results this morning, with revenues and adjusted earnings per share of $768.6 million and $0.77 topping the Street estimates. The outlook was less promising: Fiscal 2018 will see revenues and adjusted EPS at 11% and 18% below the respective analyst consensus if management’s forecast is on the beam. In response, shares drifted a bit lower and finished the day at $6.81 per share, down by 93% from its April 2015 highs. Endo’s market cap has shrunk to $1.5 billion, while net debt stands at $7.3 billion.
To some readers, Endo’s business model may sound strangely familiar: Domicile in a low tax jurisdiction (the company forecasts an effective tax rate of 11% to 12% in 2018), grow through debt-funded acquisitions (17 such deals between 2010 and 2015, by our count) and slash research and development spending are the salient features which were also utilized by Valeant Pharmaceuticals, Inc.
Much like its pharma doppelganger, Endo saw its strategy reap major success as ground-scraping (and occasionally subterranean) interest rates and levitating asset prices proved a fertile environment to do deals. Revenue of $3.3 billion in 2015 was more than double 2009’s $1.5 billion top line, while adjusted EBITDA nearly tripled over that period to $1.36 billion from $460 million. Endo market cap went parabolic, with shares reaching $94.46 on April 10, 2015, from $25 at the end of 2009 (and as recently as January 2013). So, too, did the balance sheet: Net debt footed to $8.2 billion on Dec. 31, 2015. Six years prior, the company held a net cash position of $600 million.
A July 25, 2014 analysis in Grant’s (“Meet Valeant Jr.”) took a closer look at an additional feature of the Endo model that seemed unusual by traditional standards: Its habit of buying drugs that were in a clear state of decline.
Why would [then CEO and McKinsey & Co. and Valeant alum, Rajiv De Silva] buy a company with a declining earnings stream? In the wake of Endo’s purchase of DAVA, Goldman Sachs analysts Gary Nachman and Roger Kumar proposed an answer. They pointed out that, after the deal, Endo could borrow an additional $800 million and still remain in compliance with its bankers’ debt covenants. The reason? The acquisition boosts the acquirer’s reported cash flow.
The deal train rolled on through 2015. After being outbid by Valeant (who else?) for Salix Pharmaceuticals Ltd. in April, Endo wasted little time in finding its next target. In May 2015, the company bought drug maker Par Pharmaceutical Holdings, Inc., from TPG Capital Management for $8.05 billion, four times what TPG paid for Par in 2012. A May 29, 2015 follow up in Grant’s (“Wire pullers of the twenty-first century”)
documented the ambitious assumptions made by Endo management in order to predict that the Par deal would be accretive to earnings within 12 months:
For instance, Endo says it expects to cut a combined $175 million from Par’s operating and tax outlays, principally in R&D and selling, general and administrative expenses. Just how deep the knife must cut is evident in the fact that, in 2014, Par spent $119.1 million on R&D and $181.1 million on SG&A.
Legal expense is also considerable. As a filer of generic drug applications, Par is constantly doing patent-related battle with branded drug companies. It spent $90.1 million in litigation-related expenses last year. A gimlet-eyed reader observes that no such cost was acknowledged in Endo’s public representation of Par’s adjusted EBITDA. Even so, Endo expects Par to boost its revenues at a double-digit rate for the “near to medium term,” just as TPG management was able to achieve.
[So] what might deliver this boost to net income? Not a tax gimmick. Par is a “full U.S. taxpayer,” as Endo sorrowfully acknowledges. Nor, seemingly cost cuts, as they will be offset by integration expenses. Credit, rather, the low cost of financing.
De Silva departed the company within 18 months of the Par acquisition, pocketing $19.2 million in 2016 compensation. On Feb. 27, 2017 Endo took a $3.5 billion write-down, citing “the quickly evolving new realities of the U.S. generics external environment,” according to CFO Blaise Coleman. The company, also beset with litigation related to an opioid drug and other product liability, has seen its bonds come under pressure. Endo’s most actively traded issue, the 6s of 2025, currently trade at 73 cents on the dollar for a yield-to-worst of 11.69%.
Source: The Bloomberg
Credit giveth, credit taketh away.
Recap Feb. 27
Mr. Market didn’t seem to care for Jerome Powell’s relatively hawkish tone in front of Congress today, as equities fell throughout the afternoon, closing on their lows with the S&P 500 down by 1.3%. Treasury yields jumped across the short end and belly to push the curve flatter, while a strong dollar sent both gold and oil lower by more than 1%. The VIX jumped back to near 19, a 19% uptick.
- Philip Grant
Monday, February 26, 2018
Flowers out of your hair
The going rate for a one way 26 foot U-Haul rental from Las Vegas to San Jose will set you back just $121
The going rate for a one way 26 foot U-Haul rental from Las Vegas to San Jose will set you back just $121
Suggested retail price
On Friday afternoon, Reuters reported that the founding family of Nordstrom, Inc.,
On Friday afternoon, Reuters reported that the founding family of Nordstrom, Inc.,
Recap Feb. 26
Flowers out of your hair
The going rate for a one way 26 foot U-Haul rental from Las Vegas to San Jose will set you back just $121, compared to $800 for a Hertz compact car rental from the Vegas to San Jose airports. A U-Haul in the other direction? That’ll be $1,990.
That dramatic disparity was highlighted in a recent American Enterprise Institute report by Mark J. Perry, economics professor at the University of Michigan. These figures are no geographic fluke either, Perry likewise finds that a one-way U-Haul from the Bay Area to Phoenix is priced at $1,301, more than ten times the rate for those heading north from the desert.
The San Francisco metro area’s long-running economic boom, combined with an acute housing supply shortage, is the culprit. Last spring, the Paragon Real Estate Group released a research report finding that: “Approximately 14,000 units of housing have been built in San Francisco since 2010. Over the same 6 years, the number of employed residents has increased by about 100,000.”
Paragon also calculates that it would take a household income of $303,000 to afford a 20% down payment on the median priced home in San Francisco, a figure that only 12% of the city’s residents can manage. “You can’t even contemplate getting into the housing market here,” said Russell Hancock of Joint Venture Silicon Valley. “And I don’t mean just service workers, I mean highly skilled professionals. The tech elite are having a hard time affording reasonable housing in Silicon Valley. So this is difficult, this makes it very difficult for employers trying to recruit.”
They get you coming and going.
Suggested retail price
On Friday afternoon, Reuters reported that the founding family of Nordstrom, Inc., (JWN on the NYSE) has recently met with investment bankers and is finalizing a bid to take the company private. The group “is hoping to submit an offer as early as next month once the banks get approval from their credit committees to provide the financing,” an anonymity-seeking source told Reuters.
If a deal is indeed in the cards, it has been a long time coming. Back in October, the Nordstrom family’s buyout effort was thwarted by prohibitively expensive financing costs. Bloomberg reported that lenders wanted 13% interest rates on the approximately $7 billion needed to buy the company, amid the looming specter of Jeff Bezos and fears of a disastrous holiday season. Bezos is still a concern, but Nordstrom managed respectable, if unexciting, 1.2% same-store-sales growth for the fourth quarter.
The Oct. 17 edition of Almost Daily Grant’s pointed out the incongruity of the seemingly well-run, investment grade credit (Baa/triple-B-plus) Nordstrom being faced with bear market-type financing costs at the same time as the 6.5 times-leveraged, double-B-plus rated Dell was in the process of refinancing a cov-lite term loan due in 2023 at a spread of just 225 basis points over LIBOR. Nordstrom’s pre-LBO balance sheet features a leverage ratio of 1.7 times and current assets of $3.2 billion against current liabilities of $3.05 billion, while consensus operating income for the year ending Jan. 31, 2019 of $915 million covers current interest expense of $136 million by nearly seven times.
In the last four months, Mr. Market has given JWN its due, as shares have risen by 32% into Friday’s close, compared to a 16% gain in the SPDR Retail ETF and an 8% advance in the S&P 500. That in turn has pushed its market cap to $8.8 billion as of this writing, far above the $7 billion valuation the company sported in the fall during the previous buyout try.
The Nordstrom clan better get out the checkbook.
The disappointment faded. JWN in white and the SPDR Retail ETF in orange. Source: The Bloomberg
Recap Feb. 26
A fourth straight decline in the VIX helped stocks catch another bid, with the S&P 500 rising by more than 1% to close within 3.5% of its Jan. 26 closing high water mark. Treasury yields mostly ticked lower with the exception of the long bond, leaving the curve a little bit steeper, and oil and gold both rallied despite a steady greenback.
- Philip Grant
Friday, February 23, 2018
FAANG 500
Last weekend’s NASCAR Xfinity Series race at Daytona International Speedway featured some prominent financial zeitgeist.
Last weekend’s NASCAR Xfinity Series race at Daytona International Speedway featured some prominent financial zeitgeist.
Kenya hear me now
They say that bull markets climb a wall of worry. In the case of the sovereign credit market, this is a tall one.
They say that bull markets climb a wall of worry. In the case of the sovereign credit market, this is a tall one.
Recap Feb. 23
FAANG 500
Last weekend’s NASCAR Xfinity Series race at Daytona International Speedway featured some prominent financial zeitgeist. Titled the PowersharesQQQ 300, the event featured one driver (Brandon Brown in car No. 86) who was sponsored by a crypto-currency called CONO. Launched on Feb. 14, CONO is “both a crypto-currency and a sophisticated blockchain trading desk for crypto-currency,” according to its press release.
CONO founder Tony Loiacono said, "At NASCAR, technology is rounding a new corner, a corner where the blockchain, peer-to-peer edge-of-the-cloud distribution and tokenomics intersect. One example coming is to reward fans for watching and/or sharing content while learning more about #blockchain technologies."
Anyway, Tyler Reddick ended up winning the race by less than three inches, “the closest margin of victory in NASCAR history” according to Autoweek. Brown came in 36th out of 40 entrants, succumbing to a multi-car crash on lap 121.
Kenya hear me now
They say that bull markets climb a wall of worry. In the case of the sovereign credit market, this is a tall one. The Republic of Kenya on Thursday sold a pair of euro-denominated bonds, a 10-year note yielding 7 1/4% and a 30-year bond yielding 8 1/4%. The response from investors was not ambiguous: The offerings attracted a combined $14 billion in bids, leaving the issues oversubscribed by a whopping seven times.
Potential sources of trouble are manifold. On Feb. 13, Moody’s downgraded Kenya’s issuer rating to B2, (five notches below investment grade) from B1, citing “an erosion of fiscal metrics and rising liquidity risks.” On the latter point, Moody’s explained: “The [Kenyan] government will continue to face liquidity pressures due to a combination of large financing needs and an increased reliance on sources of financing with less predictable costs.”
Kenya all but needed this deal. The Kenyan shilling currently trades at 125 per euro and 102 per dollar, both near five year lows and much weaker than the averages of 114, and 95, respectively, going back to 2013. According to the International Monetary Fund, Kenya’s foreign exchange reserves totaled $6.9 billion as of Nov. 30, 2017, down from $8.7 billion in April. Inflation has cooled somewhat, with January’s 4.8% year-over-year print in Kenyan CPI down from an interim high of 11.7% logged in May. Over the past five years, CPI growth has averaged 6.7%.
Meanwhile, the extensive investor demand for Kenyan debt belies the government’s tenuous fiscal position, which includes a budget deficit of 8.9% of GDP in the most recent year (compared with 3.5% in the United States in fiscal 2017) according to Public Finance International. Yesterday, the IMF sounded the alarm, with senior representative for Kenya Jan Mikkelsen commenting:
We have been much concerned about the flow of new debts and the size of [the] fiscal deficit. It will reach a point where the debt is not manageable . . . If [the deficit] continues it would not be sustainable to maintain the debt. The government does agree with this and our advice is to lower the deficit to make sure that the debt does not increase any further.
The Kenyan debt sale harkens back to number of memorable issues in 2017. Let’s take a quick tour of three notable sales with a status report on each:
The government of Tajikistan made its debut on the sovereign credit scene last September with a $500 million 10-year senior unsecured note priced to yield 7 1/8%, down from original price talk of 8% and guidance of 7.5% (Almost Daily Grant’s, Oct. 25, 2017). B-3 rated Tajikistan features a per capita GDP of $804 according to the World Bank and the IMF estimates that 45% of the country’s GDP comprises remittance payments from citizens working overseas. The bond issue, sold at par, has come under pressure in recent weeks and currently trades at 93 cents on the dollar for a yield-to-worst of 8.12%.
The Argentinian 100-year dollar bond issued last June (Almost Daily Grant’s, June 19, 2017) has met with similarly tough sledding. Priced at 90 cents on the dollar to yield 7.91% against initial price talk of 8.25%, the century bonds spent the fall in rally mode, reaching as high as 103.95 on Oct. 30, 2017. The New Year has been less kind to the Land of Silver, as the bonds have slipped back to 93 cents on the dollar for a yield to worst of 7.65%.
Argentina 100-year bond price chart. Source: The Bloomberg
Finally, we take a glimpse at Austria. Hewn from the Austro-Hungarian Empire at the end of World War One, the Republic of Austria decided last year to get a leg up on its centenary by issuing a 100-year bond of its own in September. More highly rated than the previously mentioned issuers (Moody’s has the Republic at double-A-1), Austria priced its €3.5 billion in century bonds at a 2.1% coupon amid an order book totaling €11.4 billion.
So far so good in terms of price action, as the bonds have rallied to 107 cents on the euro from their 99.5 cents issue price, for a yield-to-worst of 1.93%. On a real basis, however, creditors are already struggling to get paid at all: Austrian CPI registered a 1.8% year-over-year rise in January, which is an improvement over last year’s 2.1% average reading. With such a long dated bond comes extreme interest rate sensitivity. A 100 basis point uptick on the yield equates to a loss of 34% of the bonds face value, or nearly 17 years of coupon payments.
Only 99.6 years to go.
Recap Feb. 23
A late plunge in the VIX was manna for asset prices, as the volatility gauge dropped below 17 to push the S&P 500 higher by more than 1.5% and leave bond yields lower across the board, while oil and the dollar both ticked higher. Gold was absent from the party, and has remained within a 3% peak-to-trough range in 2018 so far.
- Philip Grant
Thursday, February 22, 2018
Sprinting to the order book
What risk aversion? While the stock market indices whip to and fro in a manner unseen in 2017, the realm of corporate credit has maintained a distinctive calm. The Barclays U.S. Corporate High Yield 10-Year Spread settled yesterday at 3.2%, well below its 30-year average reading of 5.17%.
The aforementioned Barclays U.S. Corporate High Yield 10-Year Spread. Source: The Bloomberg
Sprint Corp. wisely went back to the well this week, issuing an upsized $1.5 billion in senior unsecured 10-year notes to hungry investors on Tuesday. Sprint said it intends to use the proceeds for general corporate purposes, including refinancing existing debt. And why not? Not only was the offering scaled up from an initial $1 billion amid an order book totaling $3.75 billion, but the 7 5/8% yield came in far below the 8% initial price talk according to S&P Global Market Intelligence’s LCD unit.
Moody’s gave the deal a qualified thumbs-up, noting that it “will provide long duration debt capital and preserve Sprint’s secured debt capacity as dry powder for any potential deterioration in credit market conditions.” In bestowing a stable outlook on Sprint’s B2 corporate family rating (“considered speculative and subject to high credit risk”) Moody’s commented on “Sprint’s improved subscriber trends, which have remained stable for the past several quarters and [a] liquidity position that is sufficient to meet near term needs.”
Given the success of Tuesday’s offering, one might think that Sprint was in strong financial condition. However, Moody’s calculates its leverage ratio at 4.6 times as of year-end (the need to use an estimate will be explained below) while trailing 12-month operating income of $3.05 billion is largely gobbled up by interest expense, which footed to $2.38 billion over the 12 months ended Dec. 31, 2017. Free cash flow over the past three fiscal years has weighed in at negative $6.1 billion.
The near future is set to be no easier, if the Street is on the beam. Consensus operating income for the fiscal year ended March 31, 2019 is $2.36 billion. Meanwhile, the company is faced with a number of principal repayments in the next four years: $12.6 billion worth of bonds are scheduled to mature through 2021, along with $460 million in term loans and a $1.85 billion revolver, according to data from Bloomberg.
In the Dec. 23, 2016 issue, Grant’s undertook a bearish analysis of Sprint (“Wrong number”) in the context of a percolating high yield market. Among other factors, we noted the highly competitive nature of the wireless telecom industry, the lack of pricing power (former Fed chair Janet Yellen specifically cited “a huge decline in cell telephone service plan prices” last June while lamenting the lack of measured inflation in the economy) and the wireless industry’s opaque accounting practices which made evaluating the company’s income statement extremely difficult. Although the financial outcome is the same in the long run, the way in which customers pay for their phones through carrier subsidies, installment plans or leases - can have a material impact on wireless vendors’ reported results on a quarterly or annual basis. Sprint’s mix is shifting toward leases. We wrote:
Under the lease plan, the company recognizes the cost of the phone as a capital expense only in the current reporting period. Only later does that sum register on the income statement, and only then as a depreciation expense. Revenues get different treatment. The company recognizes them on the income statement ratably over the life of the sales contract. You might call this the “having your cake and eating it too,” plan.
Confusion comes with the wireless territory. “The accounting changes going on in the wireless industry are so profound that it is probably not an understatement to say that almost no one understands the financials being reported,” says [Craig Moffett, founder and one-half the eponym at MoffettNathanson LLC]. “It makes comparison both between carriers and to history almost impossible.”
Last year, during a broad inventory of current conditions (“Seven singularities,” July 28, 2017), deputy editor Evan Lorenz discussed Sprint’s recent transactions designed to generate some much-needed cash. Those transactions could come back to haunt its bondholders should conditions deteriorate:
To conserve cash, Sprint has slashed spending to the bone: Network capex fell to $2 billion in fiscal year ending March 31, 2017, from $4.7 billion and $5.4 billion in fiscal years 2016 and 2015. To stave off bankruptcy– yes, bankruptcy, management began mortgaging its spectrum assets. The fewer the assets, of course, the lower the protection afforded to senior unsecured creditors in the event of bankruptcy; prospective recovery values, too, melt away along with hypothecated corporate assets.
As Sprint gets a warm welcome from the bond market, its equity has been subject to ruder treatment. Majority owned by Masayoshi Son’s SoftBank Group Corp. (see “Epitome of the cycle,” Grant’s, Dec. 15, 2017 for more on the so-called Japanese Warren Buffett), Sprint’s shares have tumbled by 43% year-over-year and sit at their lowest since June 2016, compared to a 9% drop in the S&P Telecom Index and 14% rise in the broad S&P 500 during that period. Some unsolicited advice to Sprint creditors: Take heed of Mr. (Stock) Market’s warning.
QT progress report
Some movement this week: The Fed’s assets held outright registered at $4.206 trillion this week, down just under $7 billion from last week’s reading of $4.212 trillion. Treasurys and mortgage-backed-securities holdings ticked lower by $4.1 billion and $2.6 billion, respectively, while agency-debt holdings remained unchanged. Compared to the trailing four-week average, the changes are more modest, with the total portfolio down by $3.65 billion as mortgage-backed-securities holdings remain slightly higher.
Overall, the Fed’s assets are down by 0.99% since September 27, the final showing prior to the beginning of Quantitative Tightening, for a simple annualized pace of 2.43%.
Recap Feb. 22
A soft dollar and lower VIX couldn’t help stocks hold their early gains, with the S&P 500 erasing a 1% mid-day advance to finish virtually unchanged. The broad index remains in the red by 1% for the week with one session remaining. Treasury yields ticked lower across the board, while gold and energy both caught a bid.
- Philip Grant
Tuesday, February 20, 2018
Face news
It was a busy week in the news for the world’s preeminent social-media company, Facebook, Inc.
It was a busy week in the news for the world’s preeminent social-media company, Facebook, Inc.
Short interest
We are back to the depths of the financial crisis – in interest rates.
We are back to the depths of the financial crisis – in interest rates.
Recap Feb. 20
Face news
It was a busy week in the news for the world’s preeminent social-media company, Facebook, Inc. On Friday, special counsel Robert Mueller indicted 13 Russian nationals for meddling in the 2016 U.S. presidential election, a move that spurred Rob Goldman, vice president of advertising at Facebook, to defend the company on Twitter. President Trump dutifully retweeted Goldman’s words, further ratcheting up the media’s attention on the topic.
Amid the noisy headlines concerning fake news, election interference and the like, Brian Wieser of Pivotal Research Group performed an analysis of digital-content consumption data from Nielsen that should give Facebook bulls pause. After noting that Google (including its YouTube and Waze businesses) accounted for 28.6% of time spent on digital media in November, up from 23.7% year over year, Wieser turns to the house of Mark Zuckerberg:
Meanwhile, Facebook appears to be going in the other direction. Core Facebook lost 4% in aggregated time spent despite a 6% increase in users, reflecting a 11% decline per person. These per-person declines have been relatively consistent during each of the four months for which we have comparable year-over-year data.
Wieser then observes that Facebook’s poor performance comes amid the rising popularity of Instagram, which saw a 44% time-share uptick in November 2017 with a 13% growth in its user base.
While fake news dominates the news cycle and Google powers ahead in the “eyeball wars,” the Facebook C-suite continues to hit the bid. Pursuant to his September 2017 announcement that he was selling between 35 million and 75 million shares through 2019 to fund his charitable trust (Almost Daily Grant’s, Jan. 22), Zuckerberg sold 617,200 shares of FB on the open market last week. Chief operating officer Sheryl Sandberg sold 55,000 and Chief technology officer Mike Schroepfer sold 38,050. Total proceeds for the trio footed to $124.98 million.
Facebook has of course been one of the champions of the post-2009 bull market (see the Aug. 11, 2017 issue of Grant’s, “Concerning Mark Zuckerberg,” for the full story), but in terms of short-term trading sentiment, this punishing news cycle appears to be making a dent. Since the market began to go back up on Feb. 9, the Nasdaq 100 index, which counts Facebook as a 5.5%-weighted member, has rebounded by nearly 6%. By contrast, Facebook shares have barely budged, and remain 9% below their closing highs logged on Feb. 1.
Short interest
We are back to the depths of the financial crisis – in interest rates. Over the next three days, the U.S. Treasury department is auctioning a whopping $258 billion in debt, spread across short terms bills, two-, five- and seven-year notes.
Today saw the bulk of the issuance, as $55 billion in four-week notes, $51 billion in three-month bills, and $45 billion in six-month bills found their way to investors along with $28 billion in two-year notes. The four-week bills saw their lowest bid-to-cover ratio (which measures investor demand) since 2008, while the three- and six-month bills and two-year notes all saw their highest auction yields since 2008.
The Fed’s tightening monetary policy can explain some, but not all, of the move. The current two-year yield of 2.22% represents a premium of 76 basis points to the upper end of the 1.25%-1.5% Federal Funds Rate. As recently as last September, the two yields were virtually identical.
Fed funds rate in white, two-year yield in orange. Source: The Bloomberg
The spendthrift Federal Government also deserves its fair share of the credit. Bloomberg notes that: “Increases in bill supply are considered one of the catalysts for higher funding costs across secured and unsecured markets.”
Recap Feb. 20
Stocks traded moderately lower, with the S&P 500 absorbing its first bout of visible weakness since the sharp upward reversal two Friday’s ago to narrow the year-to-date gain to 1.5%. The dollar caught a strong bid to push gold below $1,330 an ounce, while Treasury yields ticked higher across the curve. The VIX rose back above 20.
- Philip Grant
Friday, February 16, 2018
A rose by any other name
Take it away, PetaPixel:
Take it away, PetaPixel:
Soupy sales
You can’t call them Pollyannas.
You can’t call them Pollyannas.
Recap Feb. 16
A rose by any other name
Take it away, PetaPixel:
Kevin Abosch, the photographer who purportedly sold a photo of a potato for over $1,000,000 in 2016, has now become the photographer behind the world’s most expensive crypto-artwork by selling a photo of a rose on the blockchain for $1,000,000.
CNN reports that the photo, titled Forever Rose, was purchased on Valentines Day by a group of 10 collectors that included investment funds, an advisory firm, crypto projects, and a leading China-based crypto investor. There were over 150 interested buyers, and the 10 collectors who ended up purchasing the photo split the price (paid in GTO and IAMA tokens) evenly 10 ways.
Well, ADG readers, we have a treat for you. Here it is!
If any crypto-art aficionados wish to demonstrate their gratitude, checks can be sent to Two Wall Street in New York. Being old-school types, we don’t accept payment on the blockchain.
Soupy sales
You can’t call them Pollyannas. This morning, the Campbell Soup Company (CPB on the New York Stock Exchange) reported second-quarter results which at first glance looked solid. The $1.00 adjusted earnings per share and $2.18 billion in revenue both topped Wall Street consensus, while the fiscal-year adjusted-earnings outlook of $3.10–$3.17 per share came in above the sell side’s aggregate $3.10 estimate.
Nevertheless, Campbell’s management struck a non-victorious tone in its press release. Denise Morrison, the company’s president and CEO, commented: “This was a disappointing quarter, driven by continued challenges in U.S. soup and Campbell Fresh.” Investors largely agreed, as CPB shares dropped by 3% and are now 32% from their June 2016 highs, during which time the S&P 500 is higher by 31%.
A 7% year-over-year revenue decline in the core soup business was one culprit. Margins were another. On an adjusted basis, Campbell’s second-quarter gross margin came in at 35.2%, down from 38% year over year and below the consensus estimate of 37.2% in the second quarter. To explain the contraction, CPB cited “[c]ost inflation and higher supply chain costs, as well [an] as unfavorable mix.”
On Dec. 18 of last year, Campbell’s made a bold (or reckless, depending on one’s perspective) effort to stem the unwelcome top-line tightening, buying snack company Snyder’s-Lance, Inc. for $6.04 billion in cash, a 29% premium to where the target had been trading prior to the acquisition. The deal price was 19.6 times Snyder-Lance’s trailing 12-month adjusted earnings before interest, taxes, depreciation and amortization (EBITDA) and was financed by debt. The rating agencies clucked their tongues at the deal, with S&P cutting Campbell’s corporate-credit rating and Moody’s placing the company on review for downgrade, writing that CPB’s debt/EBITDA ratio would “approximate 5.0 times before synergies, which is well beyond the tolerable range for the current A3 rating.”
Grant’s wrote a bearish analysis of Campbell’s and its peer Kraft Heinz Co., which also disappointed this morning, in the March 25, 2016 issue (“Sell Big Food”). We contended that the consumer-packaged-foods giants, then priced for something resembling perfection, offered investors nothing close to the safety one might associate with such supposedly steady business models. For the then-skyscraping valuations which CPB and KHC commanded, investors were buying companies that were forced to contend with changing consumer tastes, threatening their longstanding and prominent place in the American kitchen. As we noted, “Americans may be buying the stocks. They are not—as they have done in the past—buying the products.”
Campbell’s troubles seem to be indicative of a wider problem facing the consumer-packaged-foods industry. Despite a flurry of M&A activity in recent years, these companies are struggling with one simple but critical fact, articulated by Wolfe Research’s Scott Mushkin to Grant’s back on March 24, 2017 (“Price war for Warren Buffet”): “There are too many assets chasing the sales.”
Recap Feb. 16
Stocks edged a bit upwards, with the S&P 500 finishing green for a sixth straight day to close higher by 2.5% year-to-date. Treasurys were bid across the curve, with the exception of the two-year which saw its yield tick up to 2.19%, a fresh post-2008 high and widening its margin over the S&P 500’s 1.87% dividend yield.
Commodities finished stronger despite a rallying dollar, and the VIX quietly bounced, finishing 11% from its mid-day lows despite relatively placid trading conditions.
- Philip Grant
Thursday, February 15, 2018
Crypto cottage industry
Reuters on the surge in cryptocurrency hedge funds:
Reuters on the surge in cryptocurrency hedge funds:
Free climbing
Call it vertical integration, 2018-style.
Call it vertical integration, 2018-style.
QT Progress report
Recap Feb. 15
Crypto cottage industry
Reuters on the surge in cryptocurrency hedge funds:
[Fintech research house Autonomous NEXT] recorded a record high of 226 global hedge funds with such a strategy, up from 110 global hedge funds as of Oct. 18. That itself was up from 55 funds at Aug. 29 and just 37 at the start of 2017.
Assets under management hit between $3.5 and $5 billion (£2.5 billion and £3.5 billion), according to the firm.
Free climbing
Call it vertical integration, 2018-style. Paul Davies of The Wall Street Journal reports today on the growing popularity of in-house lending arms at private-equity funds. In other words, private equity, which normally issues debt when it takes control of a target, is now serving as both borrower and lender. Davies writes:
[Private-equity firms’] credit businesses are adding to the huge growth in specialist private debt funds and retail money that has taken place in loan markets since the crisis. The flood of money into credit has driven down borrowing costs and cleared out traditional lender protections known as covenants on many loans.
The growth of debt operations at firms like Blackstone, KKR and Apollo is an important part of their expansion. They can manage loans in private-credit funds, special vehicles known as collateralized loan obligations, or CLOs, and listed business development companies, or BDCs.
Indeed, S&P Global Market Intelligence’s LCD unit calculates that collateralized-loan issuance topped $140 billion in 2017, exceeding the bumper-crop years of 2006 and 2007. Meanwhile, the steady stream of loan issuance is coming to market more and more often without the heretofore-standard investor-protection clauses known as covenants. LCD notes that the share of so-called covenant-lite issues in the $970 billion leveraged-loan market exceeded 75% in January, up from just over 60% at the beginning of 2015. By comparison, Thomson Reuters pegged the cov-lite share of leveraged loans at just 25% prior to the last default cycle in 2007–09.
Last March, Moody’s commented on the trend toward cov-lite:
"After three years of record issuance, cov-lite loans now account for the largest share ever of the U.S. leveraged loan market, while at the same time debt cushions below first-lien cov-lite loans have fallen dramatically," said Moody's analyst Julia Chursin. "This deterioration portends lower investor recoveries in the next default cycle."
For investors in the leveraged-loan and CLO market, the rising use of cov-lite is neither welcome nor particularly newsworthy. Today, Robert Smith of the Financial Times reports on European investors’ vexation with the Association for Financial Markets in Europe, a trade group which they feel is offering inadequate assistance as they try to push back against the increasingly issuer-friendly deal terms.
Influential asset managers such as AllianceBernstein and Schroders wrote a public letter to the board of AFME’s high-yield division—the closest thing the $400bn European junk bond market has to an industry trade body—expressing their dismay. These investor members of AFME took particular aim at the deteriorating quality of covenants—important clauses that restrict companies from taking reckless actions such as raising too much debt.
That was in 2015. Today the quality of these covenants in a market tapped by the likes of French telecoms conglomerate Altice and UK sports car maker Aston Martin is even worse. Asset managers such as pension funds are worried that whittling away these safeguards will leave them more exposed to losses when the credit cycle turns.
“The deterioration of covenants is really being driven by private equity sponsors and their law firms,” says Thomas Ross, a bond portfolio manager at Janus Henderson. “Often the banks themselves are not actually aware of some of the nastier terms in the deals they are selling.”
Smith goes on to note on Twitter that a recent debt offering from credit management firm Lowell GFKL Group featured a covenant that restricted dividend payments to its owners only in an “event of default,” as opposed to a more standard “default or event of default” or on stricter terms (for more on Lowell and its bonds, see “Pay me, Plc.” from the Nov. 3, 2017 issue of Grant’s).
The default designation covers a missed interest payment, prior to the event of default which follows a 30 day grace period. That one month lag would allow the lender to use the grace period to potentially strip out company assets for itself before it was in violation of the covenant. Lowell GFKL bondholders noticed the change and demanded the borrower amend the contract back to the broader default definition. However, according to Smith, lenders did not notice the change in several other deals last year and the language stayed as is.
It’s not clear whether the borrower would be able to get away with such an asset-stripping scheme as fraudulent conveyance laws would prevent that maneuver in many legal jurisdictions. The fact that borrowers tried is plenty notable.
QT Progress report
Not much progress, to report. An uptick in the Fed’s mortgage backed securities holdings, to $1.772 trillion from last week’s $1.761 trillion and a trailing four-week average of $1.765 trillion more than offset a $19 billion sequential decline in the Fed’s Treasury holdings and left its assets held outright at $4.21 trillion, higher than both last week and the trailing four-week average.
Total balance sheet assets are now down by 0.47% since Sept. 27 (right before QT started), a 1.21% simple annualized pace.
Recap Feb. 15
Stocks raced higher again, for the fifth straight day, to push the S&P to a towering 7.7% above Friday’s intraday low. Gold and crude oil also caught a bid. Bloodletting in the greenback continued, as the U.S. Dollar Index dropped below 89 for the first time since December 2014.
Treasury yields ticked modestly higher across the board, with the exception of the 30-year long bond. The curve at the back end continues to flatten: Both the 7- and 10-year and 10- and 30-year spreads sit at a fraction of their respective five-year averages.
- Philip Grant
Wednesday, February 14, 2018
Fed Zeppelin
If the Federal Reserve is worried about a financial-market accident amid rising rates and an inflationary resurgence, then they’ve done a good job bluffing.
If the Federal Reserve is worried about a financial-market accident amid rising rates and an inflationary resurgence, then they’ve done a good job bluffing.
Recap Feb. 14
Fed Zeppelin
If the Federal Reserve is worried about a financial-market accident amid rising rates and an inflationary resurgence, then they’ve done a good job bluffing. Yesterday, freshly minted Fed Chairman Jerome Powell struck a steady-as-she-goes tone at his swearing-in: “We are in the process of gradually normalizing both interest rate policy and our balance sheet.” Comparing the present day with the painful epoch of 2007–09, Powell didn’t equivocate: “The financial system is incomparably stronger and safer, with much higher capital and liquidity, better risk management, and other improvements.”
William Dudley, president of the New York Fed, provided a similar assessment during a speech back on Jan. 11: “Even if financial asset prices were to decline significantly . . . I don’t think such declines would have the destructive impact we saw a decade ago.” A week later, Dudley told the Financial Times in an interview, “It is really important to distinguish between the risk that the financial markets could decline—I think there are always risks that the financial markets could decline and could decline a great deal. And the consequences of such a decline for the real economy. It seems to me what is different now from where we were 10 years ago is [that] we have a . . . regulatory regime in place that is much more robust to financial market turbulence than we had then.” Last Thursday, in the midst of the selloff, Dudley stuck to his guns, terming the pullback “small potatoes.”
Loretta Mester, the president of the Cleveland Fed (and who is being considered for the vice chair post according to The Wall Street Journal), forecast yesterday in a speech in Ohio that policy tightening will continue apace: “If economic conditions evolve as expected, we’ll need to make some further increases in interest rates this year and next year, at a pace similar to last year’s [which featured three 25 basis-point hikes].”
After today’s hotter-than-expected CPI data, investors see the potential for an even more hawkish Fed. According to interest-rate futures, the odds of four or more 25 basis-point hikes rose to 21.6% today, up from 16.2% a day ago. Interest rates are on the march, with the two-year Treasury yield now at 2.17% from as low as 0.55% in July 2016.
With higher rates come a higher cost of capital and more attractive returns from cash, but not necessarily risk aversion. Indeed, animal spirits have recently carried the day as equities retrace last week’s tumble while credit-risk premiums remain narrow. The Bloomberg Barclays High Yield spread has ticked up lately, but it’s still well below its five-year average.
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Bloomberg Barclays High Yield, five year view. Source: The Bloomberg
Broader financial conditions remain extremely placid. In a post today, the financial blog Wolf Street points out that the St. Louis Fed Financial Stress Index, which is based on 18 weekly data series including six yield spreads, remains well below zero (which denotes “normal” financial conditions) despite the Fed’s policy tightening and “QT” balance-sheet reduction.
With brief exceptions (such as the 2013 taper tantrum) the post-2008 Fed has acted as a damper on volatility. Market sell-offs, such as the China devaluation disquiet of summer 2015, were met with promises to stay easier for longer. Now, inflation expectations are rising amid very easy financial conditions. The next time trouble finds the markets, investors conditioned to glance towards the Eccles building in D.C. for a helping hand may be underwhelmed.
Recap Feb. 14
A higher than expected reading of the January CPI led to an abundance of outsize moves. Treasury yields darted up across the board (the 10-year settled near 2.91%, up from 2.06% in September 2017) and the greenback was pummeled, with the Dollar Index shedding nearly 1%. Stocks initially sold off but turned tail by mid-morning and rose sharply from there to extend the S&P’s rebound to 6.5% above Friday's lows. Gold tested $1,355 an ounce, near the interim high of $1,360 logged in January.
- Philip Grant
Tuesday, February 13, 2018
Headline of the day
#SlowcookerTuesday
The first seven weeks of 2018 have already set off more financial fireworks than all of 2017’s.
The first seven weeks of 2018 have already set off more financial fireworks than all of 2017’s.
Recap Feb. 13
Headline of the day
From The Hill: Kansas officials say dog can't run for governor.
Perhaps it’s for the best. Harry Truman, the President from 1945-1953, purportedly once quipped: “If you want a friend in Washington, get a dog.” He didn’t say anything about the state capital.
#SlowcookerTuesday
The first seven weeks of 2018 have already set off more financial fireworks than all of 2017’s. Borrowing a page from T-Mobile CEO John Legere, we present below a “stew” of sightings on economics and investments that could influence what happens next in asset prices.
Released this morning, the February Bank of America Merrill Lynch Global Fund Manager Survey (conducted from Feb. 2 to Feb. 8, during the teeth of the recent equity correction) shows that pessimism, of sorts, is on the rise. The average equity allocation declined to 43% overweight from 55% in January and managers expect the bull market to peak with a 3,100 summit for the S&P 500. That represents a mere 17% premium to current levels.
Investors’ outlook for the bond market is less ambiguous: BAML finds that “allocations to the bonds [are] now at a record low of net 69% underweight.” In addition, only 5% of managers say global interest rates will decline over the next year, against 80% expecting the opposite, while concern over corporate footings is rising with rates: “A record net 24% of investors surveyed say global corporate balance sheets are overleveraged,” the survey observes.
Next, we turn to the Land of the Rising Sun, where a regulatory sea change might be underway. Yesterday, Nikkei Asian Review reported that “Japan’s Financial Services Agency is considering lowering the maximum leverage allowed on foreign exchange trading by individuals as soon as this spring to curb risk taking.” Proposals include a reduction of maximum leverage to 10-to-1 from the current 25-to-1, as well as increased margin-deposit requirements for currency traders. Whether related to the regulatory move or not, the yen has been on a tear, rallying below 108 per dollar from just under 113 at the beginning of the year. The last time the yen traded this rich to the greenback was shortly before the 2016 elections, at which time the S&P 500 sat about 20% lower. The Japanese government seems less than thrilled by the development. Masatsugu Asakawa, the vice minister of finance for international affairs, commented to Reuters: “We’re closely watching whether there are any speculative factors [behind the yen’s rise].”
Yen per dollar, two-year chart. Source: The Bloomberg
While fund managers reposition and a traditional safe-haven currency gathers momentum, signs of economic acceleration in the West continue to appear. Yesterday, the Federal Reserve Bank of New York released a consumer survey in which respondents forecast for the year an average wage growth of 2.73%, which Bloomberg notes is “the most since data collection began in 2013.” Recall that the January reading of non-farm payrolls featured an average hourly earnings uptick of 2.9% year on year, the highest reading since July 2009. Today, the National Federation of Independent Business’s small-business sentiment index rose to 106.9, staying near the November 2017 figure of 107.5, the highest since 1986.
With solid economic activity and accelerating wages comes a focus on inflation. The January reading of the Consumer Price Index is set to be released tomorrow. While we wait, we can note that the United Kingdom’s January CPI print registered 3.0% year over year, the fifth consecutive reading beginning with a “3” (the last time that happened was in 2011–12). Yesterday, Switzerland’s CPI print for January came in at a benign 0.7% (the fifth straight reading ranging from 0.7% to 0.8%), but it’s all relative.
Tomorrow, the Swiss government will sell a pair of long-dated bonds: a 0% coupon maturing in 2029 and a 0.5% coupon maturing in 2055. On a real basis, investors will lose money from the get-go, to say nothing of the other risks that come with lending money for extended periods.
Sometimes, old habits die hard.
Recap Feb. 13
Stocks maintained their recent momentum, with the S&P 500 shaking off early losses to finish modestly higher and extending the rebound to more than 5% from Friday’s lows. The VIX likewise trended gently lower from initial strength to finish south of 25. Treasurys flattened, with yields ticking higher across the short end while the 10-year rallied to finish below 2.83%. A weak dollar was no help to the energy market: WTI crude sank below $59 a barrel.
- Philip Grant
Monday, February 12, 2018
Out of the shadows
No pre-Lunar New Year vacation for the Chinese banks. This morning, the People’s Bank of China released January loan data showing a 43% year-over-year surge in bank lending to RMB 2.9 trillion ($460 billion), against an economist consensus of just RMB 2.05 trillion. As it turns out, this gangbusters headline number indicates a compositional shift away from off-balance-sheet “shadow banking.” The Wall Street Journal explains:
Rather than reflecting a new round of government stimulus, the unexpected spike in bank credit was primarily driven by banks bringing loans back onto their books to heed regulators’ demands, economists and analysts say. At the same time, businesses also increased their appetite for bank loans as other forms of financing became harder to come by.
Indeed, the aggregate lending metric (also known as total social financing) of RMB 3.06 trillion trailed the consensus 3.15 trillion tabulated by Bloomberg.
While January witnessed a migration in credit towards traditional banking, highly leveraged Chinese conglomerates and property companies kept up their delicate dance amid seemingly tighter financial conditions.
HNA Group Co., Ltd., which has laid out a $4 billion asset-sale plan (out of an estimated encumbrance of $95 billion) while repeatedly soliciting its own employees for funds (Almost Daily Grant’s, Feb. 1), announced last Friday the acquisition of a credit facility from China Citic Bank Corp. for RMB 20 billion ($3.2 billion) to advance its “strategic transformation.” Reuters notes that, back in December, “Citic Bank expressed concern about HNA’s liquidity problems, including repayment of a commercial acceptance bill. Citic Bank said in a statement at the time that it was working with HNA Group to resolve the issue.”
Other issues have since emerged: Last week, subsidiary HNA Real Estate Group failed to make a payment of RMB 1.7 billion ($272 million) to Citic, noting that the borrower and lender were in negotiations to “deal with the matter.” For now at least, we can consider the matter dealt with.
At least one of HNA’s peers is looking to lighten its load as well. Bloomberg reports that the Blackstone Group L.P. is in talks to potentially buy assets from conglomerate Anbang Insurance Group “in a sale overseen by the Chinese government.” Back in 2016, Hilton Worldwide Holdings, Inc. (of which Blackstone owned a 26% stake that it subsequently sold to HNA) handed over the Waldorf Astoria to Anbang for $1.95 billion, a record price for a single piece of U.S. real estate according to Forbes.com. Blackstone may be interested in the Waldorf at a non-record price.
Meanwhile, China Evergrande Group, the third-largest property developer in China, advertised a 12% discount on listed apartments last week as well as other concessions, such as accepting down payments in installments, according to Bloomberg. The company, highlighted by Grant’s last year as being fraught with peril for owners and short-sellers alike (“Ever higher,” June 2, 2017), noted on social media: “Stock investments are not reliable, buying property proves better!”
Not reliable? The Shanghai Composite Index saw a 12% peak-to-trough decline from its Jan. 24, 2017 top, compared with a 10% pullback in the S&P 500. China’s regulators seem determined to fix that. Bloomberg again has the story:
Over the weekend, the China Securities Regulatory Commission and other regulators sent informal directives to some major stockholders encouraging them to purchase more shares in the mainland-listed firms they invest in, according to the people, who asked not to be identified because the instructions were not made public. They called on some mutual funds to avoid being net sellers of equities as well.
A command economy, to be sure.
Recap Feb. 12
A measure of calm was the bullish balm, as the VIX slipped below last week’s closing lows under 26 to help the S&P 500 to a 1.4% gain. That narrowed the year-to-date loss to less than 1% on the broad index. Treasury yields finished mostly higher, with the exception of the long bond as the 5- and 30-year spread compressed a bit after widening sharply last week.
- Philip Grant
Friday, February 9, 2018
Workers of the world, unite!
A pair of probably unrelated dispatches from crypto-land:
A pair of probably unrelated dispatches from crypto-land:
Higher yield
The merry-go-round is in motion.
The merry-go-round is in motion.
Recap Feb. 9
Workers of the world, unite!
A pair of (probably) unrelated dispatches from crypto-land:
“Russian nuclear scientists under arrest for using the country's most powerful supercomputer to mine bitcoin.” —Max Seddon, of the Financial Times, on Twitter
“Elected officials in Berkeley, California, are exploring the launch of an initial coin offering to raise funding for affordable housing.” —Business Insider
Higher yield
The merry-go-round is in motion. Bloomberg’s Lisa Abramowicz noted on Twitter this morning that the State Street High Yield Corporate Bond ETF (JNK on NYSE Arca) has seen its assets under management drop by 29% to $9.8 billion, its lowest since the most unpleasant spring of 2016, and down from an all-time high of $13.8 billion on Jan. 5.
Hot money turns tail. Source: The Bloomberg
The iShares High Yield Corporate Bond ETF (NYSE Arca: HYG) has performed only slightly better: AUM is down by 22% to $15.6 billion, from more than $20 billion on Dec. 4. Nevertheless, the decline in assets of these two funds to $25.4 billion from $34 billion seems like a drop in the bucket compared with the total size of the junk-bond market, pegged at $1.53 trillion as of yesterday by S&P Global’s LCD unit.
There is more to it than that. In the Sept. 30, 2016 issue (“House of Fads”), Grant’s investigated the mechanics of the junk-bond market alongside a bearish analysis of BlackRock, Inc., the issuer of HYG (it has proven a poorly timed one: BLK shares have since rallied by 45%, compared to a 22% gain in the S&P 500).
We specifically looked at the tail-wags-the-dog function played by high-yield ETFs. How does this relationship work? James Bianco, eponym and president of Bianco Research, explained the key mechanic in those two securities, which, according to his calculations, account for upwards of 20% of the high-yield market on a daily basis: the phenomenon of “delivery in kind.” From the story:
“What that means,” Bianco explains, “is that BlackRock has been running around to high-yield managers and saying, ‘You are best committing to me if you want to get long or short high-yield.’
“In the old days, said portfolio manager might buy or sell the desired bonds piecemeal. It might have taken days. Better, the voice at the BlackRock end of the telephone goes on [this is Bianco playing the role of the BLK salesperson], ‘Buy $200 million of HYG ETF, and then call us up and give us some parameters, and we will put together an index of bonds out of HYG and we will present it to you for delivery. If you are accepting of it, we will give you $200 million worth of bonds and cancel your $200 million worth of ETF, or if you want to trade it the other way, vice versa.’
“The trade mechanism is now becoming the ETF with delivery in kind that they go back and forth with all the time,” Bianco continues. “BlackRock will say that the marketplace can self-arbitrage it. If the pricing gets out of line, you can buy the ETF or sell the ETF then do a delivery in kind and get the underlying bonds because you think they are worth more or less. Because the market prices itself to the ETF, it becomes somewhat self-fulfilling, too.”
What can possibly go wrong? Bianco and we can think of plenty. Recalling the 2015 “flash crash,” anyone can. As it is, two ETFs with a value of approximately 2% of the junk-bond market now effectively price all junk bonds.
As for price action, the JNK and HYG ETFs are each down by 1.5% over the past three sessions, but still sit well above the mid-2016 price levels, to which their assets have now plunged. We suggest that all investors, whether directly involved in high-yield or not, keep an eye on this pair.
Recap Feb. 9
Stocks enjoyed a beastly rally into the close, with a 4% trough-to-peak reversal from the intraday nadir leaving the S&P in the 500 green by 1.5% to narrow the week’s loss to 5.5%. The high yield ETFs remained modestly lower.
The Treasury curve steepened, with selling pressure in the long end leaving the benchmark 10-year note back near four year highs at 2.85%. While the Dollar Index managed to make three week highs of its own. The stronger greenback pressured the commodity complex, with WTI crude making its first foray below $60 a barrel in 2018. The VIX settled at 29 to finish higher for the week by 69% but well off the peak of just above 50 registered on Tuesday.
- Philip Grant
Thursday, February 8, 2018
Torn and Frayed
If you buy it, the EPS will come. Deal-happy apparel retailer Hanesbrands, Inc. (HBI on the New York Stock Exchange) reported fourth-quarter results this morning. Adjusted earnings of 52 cents a share matched the consensus, while net sales of $1.65 billion exceeded analyst expectations of $1.63 billion. Hanesbrands also announced the acquisition—its ninth since 2013—of Sydney, Australia-based Bras N Things for A$500 million, a purchase price 2.78 times the target’s 2017 net sales and about 10 times EBITDA (though the company plans to whittle it down to eight times “after cost and revenue synergies”).
Unfortunately for Hanesbrands investors, the good (or decent) news pretty much stopped there. Beyond the relatively solid fourth quarter (note that HBI trimmed its forecast for Q4 back on Nov. 1, 2017), Hanesbrands offered first-quarter and full-year 2018 adjusted earnings per share guidance of $0.24 and $1.76, respectively (using the midpoint of management’s range)—figures far below the $0.31 and $2.04 the Street was anticipating. This projected shortfall comes at the same time as a stronger-than-expected revenue forecast for the current quarter and year ahead. By way of explanation for the drastic margin contraction (operating profits fell to 7.3% of net sales in the fourth quarter, from 12.9% a year ago), HBI cited “higher commodity costs and increased marketing investment to support additional planned product innovation.”
The July 1, 2016 edition of Grant’s featured an analysis of Hanesbrands. Our bearish conclusion was driven by the company’s roll-up strategy, which, we contended, flattered its financial picture through the routine use of “one-time charges” related to its M&A activities. Deputy editor Evan Lorenz noted that HBI attributed $570.5 million, or more than half of its $1.1 billion in M&A spending from October 2013 to July 2016, to “acquisition, integration and other action-related charges.” As for the structure of management’s incentive compensation and its implication for investors, Grant’s offered cautionary words:
The front office pays itself according to the following formula: 40%, growth in adjusted earnings per share; 40%, growth in cash flow from operations; and 20%, growth in top-line revenues.
It would take a C-suite of Boy Scouts not to notice how advantageous a 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.
Mr. Market has given a less-than-glowing review of this strategy of late. HBI shares have lost 24% since that July 2016 issue Grant’s went to press, compared with a 28% advance in the S&P 500 consumer discretionary index, of which Hanesbrands is a member. As for its balance sheet, Baa1/double-B-rated HBI carries net debt of $3.5 billion against $830 million in full-year 2017 EBITDA, or four turns of leverage. Goodwill of $1.2 billion stands at nearly double shareholders’ equity of $686 million, and both of its most actively traded dollar bonds (the 4 5/8s of 2024 and the 4 7/8s of 2026) currently change hands at just below par.
Out of style: HBI vs S&P 500 consumer discretionary index, two year chart. Source: The Bloomberg
QT progress report
This afternoon, the Fed released its weekly H.4.1 balance sheet data. Securities held outright declined by just $19 million sequentially at $4.2 trillion, with that change entirely attributed to a drop in its Treasury holdings as MBS and agency debt stayed unchanged week-over-week. Compared to its trailing four week average, UST holdings are down by $8.4 billion, and MBS holdings are down by $6 billion, while compared to Sept. 27 (the reading prior to the balance sheet run-off), total assets are down by 0.78%, or 2.14% on a simple annualized basis.
Recap Feb. 8
New York Fed President William Dudley called the recent stock market decline “small potatoes” during an appearance on Bloomberg Television today. The spuds are growing: With a 3.8% drop in today’s session (the bulk of which taking place in the final two hours), the S&P 500 has declined 10.4% from its closing highs reached on Jan. 26, more than halfway to a bear market.
Today’s stock market decline is the fourth significant selloff in the past week, but this one had some new characteristics. Beyond leaping Treasury rates and a hyperventilating VIX which accompanied Friday and Monday/Tuesday’s declines, this one featured outsized widenings in both high yield and investment grade credit default spreads (although both remain far tighter than their early 2016 levels, for instance). In addition, traditional safe haven currencies such as the Japanese Yen and Swiss Franc both rallied sharply against the dollar, despite an otherwise solid showing from the greenback (the DXY Index finished just north of unchanged).
- Philip Grant
Tuesday, February 6, 2018
Got rich
Let’s take a break from the market mayhem and enjoy the feel-good story
Let’s take a break from the market mayhem and enjoy the feel-good story
We thought we had it rough
Recap Feb. 6
Got rich
Let’s take a break from the market mayhem and enjoy the feel-good story of 50 Cent.
Throughout 2017, a trader dipped into the VIX options market to buy calls priced at around $0.50 per contract. The financial press quickly dubbed the nameless buyer “50 Cent” (also the name of a rapper who, in 2003, released the chart-topping album Get Rich or Die Tryin’).
It had been a rough ride for Mr. Cent, as the bottom-scraping volatility levels registered through 2017 and into January 2018 undoubtedly caused many a contract to expire worthless. Pravit Chintawongvanich, head of derivatives strategy at Macro Risk Advisors, poetically explained his plight: “I think for a while '50 Cent’ became ‘30 Cent.’”
Nevertheless, he persisted. On Jan. 26, Bloomberg’s Luke Kawa reported that the volatility-seeker was at it again: “Patterns associated with the trader dubbed ‘50 Cent’ resurfaced [today] as 50,000 March VIX calls with a strike price of 24 were purchased at 49 cents a pop."
Needless to say, the volatility spasm long anticipated by the anonymous investor has come to pass. Those March 24 VIX calls, which fetched 49 cents a contract less than three weeks ago, traded as high as $5 a contract today and settled at $3.28. Elsewhere, Bloomberg noted a block transaction that turned out a tidy profit in not-so-much time:
• 260k March $15 calls were sold for $8.20 and appears to be closing a trade from Feb. 2 when ~260k were bought for ~$1.83.
Of course, for every buyer there’s a seller, and Bloomberg detailed the not-so-pleasant financial outcome for an investor who took the other side of the volatility bet:
• 260k March $25 calls were bought for $4.90 and appears to be closing a portion of a trade from Feb. 2 when ~521.2k were sold for $0.52.
We thought we had it rough
Recap Feb. 6
The bulls finally struck back, as the S&P 500 quickly climbed out of a 2% hole at the open to break into positive territory, then push higher in the afternoon to finish green by 1.75% and narrow the four day loss to 4.5%. The VIX traded in a range of between 22 and 50, before settling at 30, while a slightly higher greenback coincided with conventional selling pressure on oil and gold.
The bond market price action was less conventional. Treasury yields jumped higher across the board, as did high yield bond prices, as measured by the iShares High Yield Corporate Bond ETF (HYG). Not exactly textbook.
- Philip Grant
Monday, February 5, 2018
A kind word for the 10-year
Last week’s violent stock-market pullback was accompanied not by a flight to safety into government bonds, but rather the opposite. Much to the dismay of risk-parity practitioners (Grant’s, May 29, 2015), Treasury yields instead shot higher. The 10-year note’s ascent to a 2.85% yield, up from 2.41% at year-end 2017 and more than double its July 2016 low, has broken the bullish trendline which has been in force since the 1980s, as Bill Gross of Janus Henderson Investors plc noted on CNBC back on Jan. 10.
We avowed bond bears at Grant’s nevertheless observe that this recent lurch in yields has returned some semblance of value (on a relative basis) to the Treasury realm. A trio of sightings:
– Bloomberg’s Tracy Alloway noted Saturday on Twitter that the spread between investment-grade corporate bonds, as measured by the Bloomberg Barclays Investment Grade Option Adjusted Spread Index, dropped to just 85 basis points last week—close to its tightest level since 2005. Spreads tightening during a selloff is a little unusual, and could imply that Treasurys are trading cheap just as much as it could imply that corporates are trading rich.
– So, too, does the 10-year Treasury note’s yield premium over the German bund look robust, with the 211 basis-point spread close to a 10-year high and almost triple its average differential over the post-2008 period. While the euro has appreciated significantly against the greenback in recent months and Germany has benefited from lower inflation, the gap using real yields is still substantial. With headline CPI of 2.1% as of December, the 10-year note still produces a 75 basis-point yield. Germany, which reported a 1.6% headline CPI print for January, offers investors a negative 90 basis-point real yield.
U.S./German 10-year yield spread. Source: The Bloomberg
– Investor positioning is another factor that Treasury bears must keep in mind. According to the Commodity Futures Trading Commission, total speculative short positions on the 10-year-note futures ticked to a record-high 886,851 contracts as of Jan. 30, while net short positions in 10-year-note futures rose to 215,600 contracts, its highest since March of last year.
That March buildup was followed by a solid rally in Treasurys that took the 10-year yield to 2.2% in June from 2.6% three months prior. Could another bounce in the price of Uncle Sam’s debts be in the cards?
Vol holla
In light of the veritable explosion in options volatility as measured by the VIX Index, we return to the May 5, 2017 issue of Grant’s (“Portfolio insurance of the 21st Century”) and its examination of strategies which were designed to capitalize on the historically pleasant market conditions of 2017.
“There is a fair bit of capital. We don’t exactly know how much, but we think it is on the order of a couple of hundred of billion dollars of capital that is invested [in volatility targeting],” says Frank Brosens, co-founder of Taconic Capital. Which is to say: Get invested and keep investing as volatility falls or flattens; scale back as volatility spikes. As volatility has functionally vanished from the market, our hypothetical seller of variable annuities might be emboldened to raise its equity exposure to as much as 140%, say, of normal allocation.
“We look at this,” Brosens goes on, “and say, ‘Let’s say it’s $200 billion that is invested this way, and it was 140% invested, and if [the market] starts to trade down dramatically, it could go to being 60% invested.’” It could mean that $160 billion comes on the market for sale, not necessarily all at once, as in the week or so leading up to Oct. 19, 1987, but persistently enough to count.
Brosens goes on to compare the 2017 vol-selling regime with portfolio insurance, the infamous pseudo-hedging technique that played a contributing role in “Black Monday.”
I don’t think that we are quite at the point of portfolio insurance, but there is so much capital out there that just seems to be selling vol because it has worked, buying the market because it has worked, feeling confident that they can be invested in the market having done no work because they have these various mechanisms that will protect them if it starts to go down. Collectively, all of these strategies strike us as not so dissimilar to what we saw in ’87.”
Recap Feb. 5
Stocks were hammered again, with the S&P 500 sinking by more than 4% as the recent bid in volatility escalated to a full-on stampede, pushing the VIX parabolic to finish above 37 (its 2017 closing high was 16). Unlike Friday’s round of dual stocks-and-bonds weakness, Treasurys served their traditional port in the storm function with yields finishing sharply lower across the complex (where was that ADG 10-year item last week? – ed). The dollar finished moderately higher, pressuring the energy patch as WTI finished lower by 3%.
- Philip Grant
Friday, February 2, 2018
Prop betting in 2018
With the Super Bowl set to kick off in about 48 hours,
With the Super Bowl set to kick off in about 48 hours,
Very cold cereal
High debt and slow growth can be a perilous combination.
High debt and slow growth can be a perilous combination.
Recap Feb. 2
Prop betting in 2018
With the Super Bowl set to kick off in about 48 hours, it’s time for the manifold, and often goofy, side bets that don’t concern the outcome of the game to surface. Here’s one that the sports books probably didn’t think they would be offering a couple of years ago. From CNN Money:
The over/under for Trump tweets on Super Bowl Sunday is currently set at five, while the over/under number for tweets during the game is 3.5. Trump has been an outspoken critic of the NFL amid the widespread kneeling movement started by Colin Kaepernick during the National Anthem.
Very cold cereal
High debt and slow growth can be a perilous combination. First-quarter results at Post Holdings, Inc. (POST on the New York Stock Exchange) were, superficially at least, pleasing to the eye: Net sales of $1.43 billion, adjusted earnings of 88 cents per share, and management’s guidance for fiscal-year adjusted EBITDA, pegged at $1.22 billion–$1.25 billion, all topped consensus expectation. For their efforts, Post was rewarded with a bearish reaction that sent shares lower by as much as 7% intraday. Since interest rates bottomed out in July 2016, Post’s share price has fallen by 15% (and the S&P 500 has advanced by 35%).
Post, which has been facing a perhaps secular decline in its legacy cold-cereal business since 2009 (Grant’s, Sept. 16, 2014; Almost Daily Grant’s, Aug. 7, Sept. 19, Nov. 20), reported that its consumer-brands division, which contributed 33% to the top line, registered a 4.2% year-over-year drop in pro forma net sales this quarter. The company has responded to its dwindling numbers with a growth-by-acquisition strategy that has led to 16 deals since the end of 2012—and this has had a predictable effect on leverage. Pro forma net debt stands at $7.2 billion, up from $1.2 billion at the end of fiscal 2013 and 5.8 times greater than the high end of management’s 2018-adjusted EBITDA guidance. In 2017, more than half of operating income was gobbled up by interest expense.
The street remains largely bulled up, with sell-side analyst coverage featuring six buy ratings, two holds and no sells. Pivotal Research Group’s Timothy S. Ramey, who carries a street-high $105 price target on Post shares, wrote today that the company might look attractive to a bigger consumer packaged-food company thanks to its solid first quarter and “very cheap” valuation:
It is fair to say that Post may well be a takeover target in this market given its low valuation and attractive growth opportunities. 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.
Indeed, Post’s $10 billion enterprise value could be absorbed easily by a larger industry player such as Kraft Heinz Co., itself acquisitive and another pick-to-not-click at Grant’s (see “Price war for Warren Buffett,” March 24, 2017). Note that Kraft attempted to buy Unilever plc for more than $150 billion last year. We wonder, however, if the recent rise in rates, featuring a 10-year Treasury yield that has more than doubled from its July 2016 lows, changes the calculus for these debt-fueled roll-ups.
For B3/single-B-rated Post (well below investment-grade), the change in conditions has already had some impact. The company saw all 10 of its bonds trade above par over the summer and successfully refinanced $630 million in 6% notes due December 2022 by issuing $1 billion in 5 5/8% senior notes due December 2028. Those 5 5/8s notes are trading below par, as are the 5 3/4s of 2027, which were issued last February. The 5s of 2026 have dipped below 97 cents on the dollar after trading above 103 as recently as August.
As for the broader difficulties facing the consumer packaged-goods industry in this era of Amazon.com, Inc., we turn to veteran executive and paid-up Grant’s subscriber Gary Winder, who forecasts dark days ahead for the business model:
I believe the consumer packaged-goods industry will continue to face significant margin pressure in the future. The “Big Boys” will do their best to reduce costs and innovate. The problem will become much more difficult for leveraged mid-tier and smaller CPG companies who have big debt payments, limiting their ability to reduce price or innovate. They will be forced to take on more debt (if they can) and acquire smaller brands at inflated prices to EBITDA to give a perception of sales growth. Cheap credit has kept those companies alive (and on a short term basis, thriving). A combination of pricing pressure from retailers and more expensive debt could create quite a headwind for these companies.
For the sake of Post bulls and highly leveraged companies the world over, this jump in interest rates needs to moderate. The sooner, the better.
Recap Feb. 2
It was an ugly one, as stocks and bonds sold off sharply in tandem with the S&P falling by more than 2% while the upward surge in rates pushed the 10-year yield to 2.85%, up 45 basis points year-to-date. The VIX jumped by nearly 30% to its highest close since the 2016 election. While the S&P 500 is still in positive territory for 2018, the iShares High Yield Bond ETF sank to its lowest since March.
The cross-asset class selloff is bad news for practitioners of risk-parity (for more, see “Yesteryear’s great idea,” Grant’s, May 29, 2015). The Salient Risk Parity Index was already down by 2% for the week before today. We await its pricing after the close, but can surmise that it is not up.
- Philip Grant
Thursday, February 1, 2018
Chinese channel checkers
It’s not quite scrounging for pennies in the sofa, but it’s close.
It’s not quite scrounging for pennies in the sofa, but it’s close.
QT progress report
Recap Feb. 1
Chinese channel checkers
It’s not quite scrounging for pennies in the sofa, but it’s close. Today, The New York Times reports that HNA Group Co., Ltd., the Chinese conglomerate that owns 26% of Hilton Worldwide Hotels, Inc.(and that has run aground in recent weeks amid a punishing $90 billion debt load), has been repeatedly soliciting its own employees for funds:
The company, in an email, advertised an “employee treasure” product with an 8.5 percent return if workers handed over $1,500. A similar one dangled 9 percent. A third mentioned a return as high as 40 percent if employees ponied up $15,000.
These pitches, more than a dozen of which were reviewed by The New York Times, were not part of an employee stock program. Instead, they appear to be high interest loans, with the company as borrower and its workers as lenders.
In addition to calling on employees for funding, HNA is reversing its growth-by-acquisition strategy as it attempts to keep its head above water amid interest payments that have outpaced earnings. Yesterday, Bloomberg reported that the company told lenders it plans to sell RMB 100 billion ($16 billion) in assets in the first half of the year, with the bulk of those divestitures likely to occur in the second quarter. Bloomberg also noted that HNA held $190 billion worth of assets as of June. Real Capital Analytics pegs their worldwide real-estate holdings at $14 billion.
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HNA 6s of 2019 price chart. Source: The Bloomberg
As HNA flounders, the B1/B-plus-rated and still high-flying China Evergrande Group (3333 on the Hong Kong Stock Exchange; see “Ever higher,” from Grant’s, June 2, 2017) managed to complete a massive HK$18 billion ($2.3 billion) five-year convertible-bond sale yesterday. FinanceAsia observes, however, that the developer, whose share price is up by 433% since December 2016 (even with a 19% pullback since October 2017), had to make comprehensive concessions to get the deal done:
The perpetual was pitched at a coupon rate of 3% to 4% and a conversion premium of 50% to 60% over Evergrande’s Tuesday close of HK$27.85. . . . These terms were quickly given the cold shoulder by prospective investors.
The lackluster demand forced Evergrande to execute a massive restructuring late on Tuesday night that changed almost every aspect of the bond. In particular, the perpetual deal was restructured into a standard five-year deal with a three-year put option. . . . The developer guided investors with a new coupon range of 3.75% to 4.25% per annum . . . The conversion premium was squeezed to 40% to 45%.
In the end, the investors had their way. The notes were priced at the high end of the range—4.25%—while the initial conversion price of HK $38.99 per share was at the low end of the premium range.
These sightings beg the question: Are they merely a handful of anecdotal difficulties, or emblematic of a wider slowdown? The Dec. 18 commentary from J Capital Research argues it’s the latter. After detailing the heavy stimulus that Chinese authorities injected into the economy to keep it humming into last fall’s 19th Party Congress, co-founder Anne Stevenson-Yang writes:
Now regulators are tasked with mopping up the dangerous asset inflation. . . . That means we are in a tightening cycle. Interest rates will rise, higher taxes will be imposed, capital injections to mid-tier banks will be undertaken, new rules will curtail issuance of financial derivatives, and stimulus will be avoided. That sets up a very dangerous situation for 2018.
QT progress report
On October 1, 2017, the Federal Reserve embarked on a quest to gradually pare down its balance sheet, which had expanded to $4.5 trillion through three rounds of quantitative easing. In announcing the move, the Fed revealed it would initially sell $6 billion of treasurys and $4 billion of mortgage-backed and agency-debt securities per month, raising its quota by those same figures every three months until it reaches the monthly limits of $30 billion and $20 billion, respectively.
Three months in, treasury holdings have been whittled down to $2.447 trillion from $2.465 trillion, with the $18 billion decrease coming in as expected. While agency-debt securities have declined to $4.3 billion from $6.7 billion over the same period, holdings of mortgage-backed securities have actually risen, footing to $1.771 trillion as of Jan. 24, compared with $1.768 trillion on Sept. 24, 2017. What gives? As explained by the New York Fed’s Liberty Street Economics Blog, the Fed’s sales of MBS are affected by the nature of the securities, namely that mortgage holders have the option to prepay.
Treasury securities in the SOMA portfolio mature at fixed dates, and settlement from rollover purchases occurs on the same day as the maturity, making changes in the size of the SOMA Treasury holdings relatively smooth and predictable. In contrast, for agency MBS, principal payments from existing holdings are not received on the same days of the month that reinvestments of new MBS settle, resulting in intra-month variability in the size of the agency MBS portfolio.
In addition, transactions in the MBS market take place in the to-be-announced (TBA) market, in which the settlement of trades takes place once a month. Trading itself takes place “up to three months forward.” The blog concludes:
In sum, the gradual reduction of the SOMA agency MBS portfolio will occur with a lag because of the uncertainty surrounding principal payments and the forward-settling nature of the TBA market.
In summary, we are going to have to be patient as we anticipate the onset of “QT” in earnest. Judging by the recent action in rates, it seems like investors aren’t too keen to wait around.
Recap Feb. 1
Treasury yields continued to dart higher in bear steepening fashion, with the long bond exceeding three percent for the first time since March and the 2- and 10-year spread widening to a spacious 62 basis points, up from just under 50 basis points on Jan. 5. Meanwhile, a flat showing on the S&P 500 belied substantial sector level volatility, as telecoms rose by 2.5%, while real estate and utilities lost 1.9% and 1.6%, respectively.
Gold and oil were both bid as the Dollar Index sank to fresh post-2014 lows, and the VIX held above 13 for a fourth straight day. That last took place in April of 2017.
- Philip Grant
Wednesday, January 31, 2018
What's the matter Colonel Sanders, chicken?
Not all dividends are created equal.
Not all dividends are created equal.
Recap Jan. 31
What's the matter Colonel Sanders, chicken?
Not all dividends are created equal. For confirmation of that not so controversial fact, we turn to Dallas-headquartered Wingstop Restaurants, Inc. (WING on the Nasdaq), a quick-service chain comprising 1,088 primarily franchise-owned restaurants. Smaller locations and a takeout-focused business model (takeout contributed about 75% of 2016 sales) has been the corporate formula, and it’s been a successful one since the 1994 founding in Garland, Texas. Simplicity is the norm: Wings, fries and sides made up 92% of sales in 2016 according to the company’s most recent 10-K filing.
Thanks to an “asset lite” business model, Wingstop’s adjusted EBITDA margins of 38.5% stand far above casual dining peers Buffalo Wild Wings (BWLD on the Nasdaq) at 12.9% and Texas Roadhouse (TXRH on same) at 13.5%. The company’s revenue growth has far outpaced its peers, with the top line up by 31% from year-end 2015, compared to a 12% uptick in BWLD and 19.5% for TXRH. Analysts are expecting more of the same in the fourth quarter (results are expected on March 1), with same store sales growth expected to rise by 4.5% year-over-year. The stock price is up by 25% in January, and 64% over the past 13 months to trade at $48.5 a share, which is 58.5 times consensus 2018 adjusted earnings.
Yesterday, Wingstop announced the declaration of a $3.17-per-share special dividend, payable on Feb. 14 to holders of record on Feb. 9. In the 8-K filing announcing the move, the company explained the tax treatment of the distribution:
A portion of the special dividend that is equal to the Company’s current and accumulated earnings and profits through fiscal year end December 29, 2018 will be taxable to shareholders as a qualified dividend for U.S. federal income tax purposes. The Company expects approximately 65% - 75% of the special dividend will be in excess of the current and accumulated earnings and profits.
The excess amount will be treated as a nondividend distribution for U.S. federal income tax purposes, which will reduce the tax basis of a shareholder’s common shares.
Gary Lenhoff, chief investment officer at Great Lakes Advisors, had this to say to Grant’s: “Having insufficient cumulative earnings, the WING special dividend is a return of, rather than a return on, capital. Shareholders will no doubt celebrate that they owe no tax on having their capital returned to them.”
Leveraged recap time. Wingstop two-year chart. Source: The Bloomberg
Indeed, Wingstop’s $21 million in adjusted net income over the past twelve months, $4.6 million in cash and $4.6 million in accounts receivable on the balance sheet don’t nearly cover the $92.9 million being paid out (or back) to shareholders. For the rest, the company is turning to the bond market, in particular a $250 million credit facility featuring a $100 million term loan and $150 million revolver at a rate of 1.75% to 2.75% over LIBOR (the London Interbank Offered Rate). John Hamburger, president of the Restaurant Finance Monitor and speaker at the upcoming Grant’s spring conference on April 10, (advt) explained to Grant’s the likely rationale for the deal from the lenders’ perspective:
Wells Fargo and Citizens [Bank] are experienced franchise lenders, so my guess is the banks looked at the cash flows from the royalty stream and were comfortable with the coverages. Franchisees borrow at or around a 2.75 spread on LIBOR so why not a franchisor with “guaranteed” cash flow. Also, and this is the real reason, there is a lot of lending competition right now, so Wingstop could have shopped it around and got it done elsewhere.
Whether the company stock makes sense for new investors is another question. Wingstop, which isn’t rated by Moody’s or S&P, showed shareholders’ equity of negative $57.7 million and accumulated losses of $59.3 million on the balance sheet as of their most recent form 10-Q. Its $121.4 million in total assets include $46.6 million in goodwill, while long term debt footed to $136.7 million (3.6 turns of leverage) prior to the special dividend.
Recap Jan. 31
The Fed stood pat as Janet Yellen bid adieu, with her final meeting as chair seeing no change in overnight rates but the odds of a hike at the March 21 meeting rising to 99% from 90% yesterday, according to interest rate futures.
Stocks managed to finish slightly higher after the back to back decline to start the week, while the treasury curve flattened again with the long end erasing losses this afternoon that briefly took the 10-year yield to 2.75%. Gold and oil both caught a bid amidst a flat greenback, and the VIX stayed above 13 for the third straight day. That last happened in August.
After the close, Facebook, Inc. announced fourth quarter EPS and daily active user metrics that trailed consensus expectation, sending the stock down by 3% in initial reaction.
- Philip Grant
Tuesday, January 30, 2018
Texas hedge
What do short dollar, long equities, long oil and short options volatility trades have in common?
What do short dollar, long equities, long oil and short options volatility trades have in common?
You are what you eat
Like a bolt from Olympus arrived this morning’s press release
Like a bolt from Olympus arrived this morning’s press release
Recap Jan. 30
Texas hedge
What do short dollar, long equities, long oil and short options volatility trades have in common? Those positions have all worked like gangbusters in recent months, and investors are overwhelmingly expecting that the near future will resemble the recent past. As noted by Bloomberg yesterday, “Options traders are now the most bullish on the [British pound] sterling in almost a decade, while speculative investors have amassed the heaviest long positions on the euro ever . . . Asset managers raised net S&P 500 index future longs to 363,000 contracts, the biggest bullish position in five years.”
Meanwhile, speculative long positions in WTI and ICE Brent crude stood at more than double their respective five-year averages at the end of last week (Almost Daily Grant’s, Jan. 26). Last August, the New York Times profiled Seth M. Golden, a former logistics manager at retailer Target Corporation who has taken up day trading: In particular, shorting volatility via the VXX and UXVY exchange traded products. Golden, who told the Times that his net worth has jumped to $12 million from $500,000 over five years, explained his philosophy: “The nature of volatility is that it desensitizes over time. Which is why the index has been tracking down for so long.”
According to data from the Commodity Futures Trading Commission, Mr. Golden still has plenty of company. Net-short speculative positioning in the VIX, although less extreme than in late 2017, still sits about 50% above its five-year average. The last time speculators were net long VIX futures was in early 2016, which was also the last time that the stock market encountered significant adversity.
VIX speculative net positioning, five year chart. Source: The Bloomberg
Five years ago, right as the second leg of the post-2008 bull market was getting into full swing, Grant’s extolled the virtues of hedging (“In case the music stops”, Jan. 25, 2013), even in generally favorable conditions:
Generically, stocks are better than bonds, let us say - and at current multiples and interest rates, we so believe. And the Great Rotation out of bonds and into stocks is at last under way, let us also say. Suppose that America's economy will surprise by its strength, even in the teeth of the gale-force winds originating in Washington, D.C. Say it's all true. It does not then follow that the investment road is strewn with rose petals. "The market," observes A. Alex Porter, founding partner of Amici Capital, "is a complex system. Complex systems blow up from time to time." Ergo, hedge - at all times.
With the X-Ray vision of hindsight, that advice was not particularly well-timed for the largely correction-free stock market ascent that has characterized recent years. Nevertheless, we stick to our philosophical guns. Or at the very least, suggest that the perhaps-interconnected positioning described above might prove problematic should conditions change beyond a two-day pullback.
They have been known to.
You are what you eat
Like a bolt from Olympus arrived this morning’s press release announcing a health-care partnership from pre-eminent American businesses Amazon.com, Inc., J.P. Morgan Chase & Co., and Berkshire Hathaway, Inc.
“The ballooning costs of healthcare act as a hungry tapeworm on the American economy. Our group does not come to this problem with answers. But we also do not accept it as inevitable. Rather, we share the belief that putting our collective resources behind the country’s best talent can, in time, check the rise in health costs while concurrently enhancing patient satisfaction and outcomes,” said Berkshire Hathaway Chairman and CEO, Warren Buffett.
Buffett famously told Forbes in 2015 that: “If I eat 2700 calories a day, a quarter of that is Coca-Cola. I drink at least five 12-ounce servings. I do it everyday . . . This morning, I had a bowl of chocolate chip ice cream.”
The Oracle of Omaha likewise detailed his daily McDonalds breakfast routine in the 2017 HBO documentary “Becoming Warren Buffett”:
When I'm not feeling quite so prosperous, I might go with the $2.61, which is two sausage patties, and then I put them together and pour myself a Coke. $3.17 is a bacon, egg and cheese biscuit, but the market’s down this morning, so I'll pass up the $3.17 and go with the $2.95 [sausage, egg and cheese].
On second thought, maybe the status quo isn’t so bad after all.
Recap Jan. 30
Stocks took it on the chin for a second straight day, the first back-to-back decline of over 0.5% for the S&P 500 in 310 trading days as the AMZN/JPM/BRK announcement left the healthcare sector weaker by nearly 2%. Energy prices likewise endured a sharp pullback despite a still-moribund greenback, while upward pressure on rates continues apace with a second straight round of bear steepening on the Treasury curve pushing the 30-year yield to near 3% for the first time since April.
This afternoon, Bloomberg’s Matthew Leising reported that Bitfinex and Tether, two crypto-concerns that caught the attention of Grant’s last Sept. 8 (“Crypto 36,000”) received subpoenas from U.S. regulators in December.
- Philip Grant
Monday, January 29, 2018
Euphoria's step-children
To paraphrase former President Barack Obama, rising prices have consequences.
To paraphrase former President Barack Obama, rising prices have consequences.
Recap Jan. 29
Euphoria's step-children
To paraphrase former President Barack Obama, rising prices have consequences. As stock markets around the world enjoy bull market conditions that distinctly evoke the frenzied days of 1999, increasingly numerous examples of complacency, high risk deals and outright fraud dot the financial landscape. A trio of recent developments crystallize current conditions:
The M&A machine was hard at work over the weekend. U.S.-based investors awoke this morning to a pair of large transaction announcements, both emanating out of Mario Draghi’s Europe. French pharmaceutical giant Sanofi S.A. declared an agreement to buy Belgian biotech Ablynx N.V. for €3.9 billion ($4.8 billion) in cash, topping a bid from rival Novo Nordisk A/S. Top the bid, they sure did: The €45 a share price represents a 48% premium to Novo’s offer back on Jan. 7 and a 112% premium to Ablynx’s pre-M&A closing price on Jan. 5. For its part, double-A-rated Sanofi expects to fund the deal with debt yielding about 1%, according to company president Elias Zerhouni.
Investors in Dr Pepper Snapple Group, Inc. were also the recipients of a pleasant surprise, as European roll-up extraordinaire JAB Holding Co. announced an $18.7 billion deal for an 87% stake in the soft drink company, sending shares in the target higher by as much as 32% this morning. JAB, which also owns Panera Bread Co. and Keurig Green Mountain, Inc. (which it bought for a 78% premium in December 2015), sports a triple-B-plus rating from S&P (“exhibits adequate protection parameters. However, adverse economic conditions or changing circumstances are more likely to lead to a weakened capacity of the obligor to meet its financial commitment on the obligation”). Situated just three notches above junk, JAB should nevertheless have ready access to the ECB’s debt-market manna. The company’s six outstanding issues, maturing between 2021 and 2028, all trade above par, with yields-to-worst ranging from 0.42% (maturing in Nov. 2021) to 1.73% (maturing in May 2028).
Still fetches a premium. JAB Holdings 1 1/2s of 2021. Source: The Bloomberg
On Friday afternoon, Bloomberg reported that lawmakers in fiscally-strapped Illinois, which narrowly averted being the first state to be downgraded to junk last year, are considering a radical (or predictable, depending on one’s perspective) plan for contending with a debilitating debt load. Bloomberg puts it this way: “Borrowing $107 billion and letting it ride on the financial markets.” The State Universities Annuitants Association, which came up with the idea and is scheduled to present the proposal to the Illinois state legislature tomorrow, estimates that the plan will save the state $103 billion by 2045 through lower borrowing costs.
The size of the proposed deal is astronomical. By comparison, Illinois has $26.3 billion in general obligation bonds currently outstanding as of July, according to Moody’s. Richard Ciccarone, president of Merritt Research Services, told Bloomberg that the deal: “Will not go over well in the bond market.” The legislature may be more sympathetic to the idea. State representative Robert Martwick, who has yet to offer a position on the proposal, commented that: “When you have the largest pension debt in the world, you have to think big.” Indeed.
For the main course of our speculative stew, we naturally (re-)turn to crypto-currencies. Following the runaway success of bitcoin and peers like ethereum and ripple, a wave of imitators have trailed in their stead. Never exactly a bastion of traditional investment value, these initial coin offerings have veered towards the outright comical.
One sharp-eyed ADG reader alerts us to the PoWH coin, (PowH stands for “Proof of Weak Hands”) which markets itself as “The World’s First Autonomous and Self-Sustaining Pyramid Scheme” with a tagline: “Pyramids aren't built in a day. Carry the first bag (strikethrough) brick.” The bottom of the coin’s website features the disclaimer: “Please Note: This is not an investment or security, any and all tokens sent to the automatic mathematical gambling robot are purely for your own pleasure in participating in this absolutely insane social experiment.” So far, 572.36 ethereum tokens, equivalent to $672,615 have been “invested” in the “insane social experiment.”
Yesterday, erstwhile startup Prodeum, which “plan[ned] to bring blockchain to our fruits & vegetables,” made an abrupt exit from the web, with the proprietors evidently making off with an unknown portion of the $6.5 million they had hoped to raise. As for the coup de grace, we’ll let Bloomberg do the honors:
“Prodeum” is spelled almost the same as “Prodium,” a drug that treats urinary-tract infections, which in hindsight seems like a red flag now that the startup has disappeared with its investors’ money and left just one word on its website (it rhymes with “Venus”).
Meanwhile, today’s Toronto Globe and Mail reports that the Ontario Municipal Employees Retirement System (OMERS) “is pushing further into the rapidly expanding cryptocurrency business through the creation of an Ethereum-focused public company that is planning to raise $50 million.”
It’s a bull market all right. In equities and in absurdity.
Recap Jan. 29
No bull market today. A moderate bounce in the U.S. Dollar Index pushed stocks lower, with the S&P 500 giving up about half of Friday’s feverish advance, while crude oil and gold both finished in the red. In contrast, Treasury yields ticked higher nearly across the board, pushing the 10-year near 2.70% for the first time since early 2014. This morning, the German five-year bund yield ascended into positive territory for the first time since early 2015.
-Philip Grant
Friday, January 26, 2018
Role Tide
You gotta give the people what they want.
You gotta give the people what they want.
Soul patch
“Why are you all excited all of a sudden on shale? You know why, because you like to chit chat . . . you are an agent of disturbance,”
“Why are you all excited all of a sudden on shale? You know why, because you like to chit chat . . . you are an agent of disturbance,”
Recap Jan. 26
Role Tide
You gotta give the people what they want. At least a pair of bakeries in the U.S. have followed that perennial business axiom to its logical end, offering customers sweet treats designed to look like the laundry detergent pods that have been the source of a recent viral online craze. The New York Post has the details:
Wake N Bake Donuts in Carolina Beach, North Carolina, and Kansas-based Hurts Donut have both made pastries decorated to look like the laundry detergent pods, which are at the center of a dangerous social media trend.
The “Tide Pod challenge” has gained attention in recent weeks as a social media-fueled trend in which teenagers eat single-load laundry detergent packets and post videos.
The North Carolina doughnut shop said on its Facebook page last week that an employee came up with the idea to show “youth the difference between what to eat and what not to eat.”
Owner Danny Tangredi told WECT-TV: “I definitely didn’t think we would make a Tide Pod doughnut. But I also didn’t think people would eat Tide Pods.”
Up next: Crypto crullers?
Soul patch
“Why are you all excited all of a sudden on shale? You know why, because you like to chit chat . . . you are an agent of disturbance,” he said, pointing a finger at his questioner. “Leave us alone and leave all these issues. We had enough of shale oil and talks of shale. Please talk about anything else.”
Thus pleaded (or commanded) the Saudi oil minister Ali Al-Naimi to reporters at a May 2013 meeting of the Organization of the Petroleum Exporting Countries (OPEC). With the benefit of hindsight, the minister would have been well served to pay greater heed to the uncomfortable topic. Amid a shale led-boom in U.S. supply growth that saw Department of Energy inventories (excluding the strategic petroleum reserve) jump to 535 million barrels in March of 2017 from 325 million barrels in September 2014, energy prices of course hit the fritz in mid-2014, with WTI crude briefly falling below $30 a barrel in February 2016 from $107 a barrel in June 2014.
History rhymed today, somewhat, as current Saudi oil minister Khalid Al Falih, speaking at a Davos panel with U.S. Energy Secretary Rick Perry, took issue with a suggestion in the International Energy Agency’s Oil Market Report that “explosive” shale production growth would spur oversupply and potentially curtail prices. “I was not disputing the amazing revolution of shale . . . [but] in the overall global supply demand picture it’s not going to wreck the train.”
It’s no breaking news that energy prices have been on a tear, amid broad strength in the commodity complex and a seemingly disintegrating greenback. The oil price bid has also been driven by decisive improvements to the fundamental picture, beyond the OPEC production cuts announced in November 2016 and extended last year (they are currently in effect through 2018). On Dec. 21, Rystad Energy announced that new oil and gas discoveries dropped to a record low in 2017, both in terms of the volume of discovered resources, and the resources per field discovered. Overall, the recent recovery in prices has coincided with a substantial easing of that inventory stockpiling seen through the 2014-16 selloff.
DoE inventories in white, WTI crude price in orange. Source: The Bloomberg
Natural resource investors and friends of Grant’s Leigh Goehring and Adam Rozencwajg believe we haven’t seen anything yet. In the fourth quarter 2017 letter for their investment firm Goehring and Rozencwajg Associates, LLC, the pair contend that the durability of the shale “revolution” has been widely overstated.
Although the development of the oil shales have been a technological marvel and have provided the U.S. with a surge of production, they represent just a drop in the bucket once you take into account the collapse of conventional oil discoveries and the surge in global oil demand.
As for their forecast for the oil market’s fundamental characteristics in 2018, the duo do not mince words:
Surging demand combined with the slowdown in shale production growth and the meager growth of oil supply outside of North America means that even if OPEC were to restore all of its November 2016 production cuts (1.2 mm b/d), the 2018 oil market will remain in deficit. It’s something that few investors appreciate.
Our research has made us more convinced than ever that oil has entered a huge bull market, and that oil-related investments represent the investment of [a] lifetime.
Grant’s, which produced a pair of bullish analyses on an array of energy related plays in 2017 (“Laddered oil play,” March 10 and “Viscous black yields,” July 14), continues to expect good things for investors in the energy patch. We do however, take careful note of what appears to be an overcrowded boat on the long side. According to the CFTC’s commitment of traders report, crude oil speculative net positioning rose to a record 708,000 net long contracts on Jan. 16, more than double its five year average. It’s the same story across the pond: The ICE Brent crude commitment of traders reached a net 585,000 contracts on Jan. 23, itself a record high and also more than two times its average position over the last five years.
Recap Jan. 26
1999 is for pikers. The eye-watering rally in stocks kicked into another gear today, with a +1.2% rise in the S&P 500 leaving the broad index higher by 7.5% so far for January, on track to more than double for 2018 at its current pace. Crude oil and gold continued to fare well, rising above $66 a barrel and $1,350 an ounce respectively, while Treasury yields rose across the board. The long-bond still maintained its relative strength, with a more modest move compressing the spread between the 5- and 30-year yields to just 44 basis points, a new post-2007 benchmark.
- Philip Grant
Thursday, January 25, 2018
Issue at hand
Up to the dais stepped European Central Bank boss man Mario Draghi today.
Up to the dais stepped European Central Bank boss man Mario Draghi today.
The first $25 trillion's the hardest
Recap Jan. 25
Issue at hand
Up to the dais stepped European Central Bank boss man Mario Draghi today. His goals: To stem the recent appreciation in the euro and once again to emphasize the ECB’s comfort with the status quo, which includes €30 billion a month in asset purchases (tapered from €60 billion three months ago) through September, and a record low negative 40 basis points overnight lending rate.
The prospects for less-negative rates are dim. “Based on today's data, very few chances of rate hike this year,” asserted the central bank President. The market responded, a bit, with interest rate futures pricing 37% odds of a hike by the Dec. 13 meeting, down from 44% yesterday. Draghi also took note of the euro’s run to $1.25 from $1.05 last March against a broadly-weakening greenback, scolding U.S. Treasury Secretary Steven Mnuchin for his remarks yesterday that “Obviously a weaker dollar is good for us as it relates to trade and opportunities.” Draghi retorted:
The exchange rate has moved in part because of endogenous reasons, namely the improvement in the economy, in part due to exogenous reasons that have to do with communication. But not by the ECB, but by someone else. This someone else’s communication doesn’t comply with the agreed terms of references.
Someone else? Ouch. Of course, back on Nov. 15, after posing with freshly printed dollar bills at the Bureau of Engraving and Printing in Washington, Mnuchin told Fox News that: “I guess I should take that as a compliment that I look like a villain in a great, successful James Bond movie.” That couldn’t have gone over too well at ECB headquarters in Frankfurt.
This town ain’t big enough for the both of us
Anyway, while European monetary policy is unchanged, market conditions remain in flux. Today, the Financial Times noted that the total quantity of corporate and government debt trading with a yield below zero has dropped to $9.56 trillion, down from $10.37 trillion at the end of 2017 and more than $14 trillion at its peak in 2016. Meanwhile, the benchmark German 10-year note yield jumped by five basis points this morning to as high as (positive) 64 basis points, its highest since December 2015 and up from less than 30 basis points six weeks ago.
Despite Draghi’s evident reluctance to abandon radical monetary policy, the ECB’s diminished pace of asset purchases and the still-material odds of a rate hike this year (according to interest rate futures at least) could yet change the dynamic between issuers and investors. The FT notes that:
As the ECB tapers its bond buying, eurozone governments will sell a net €31 billion of new debt after quantitative easing purchases are taken into account, according to recent data from J.P. Morgan analysts; last year ECB bond-buying pushed net new issuance into negative territory, with €310 billion of liquidity being taken out of the market.
As far as issuers in the Old Continent, so far, so good. On Tuesday, the Kingdom of Spain sold €10 billion in 10-year notes, priced to yield 1.4%, the narrowest premium to the German bund since right before the EU sovereign debt crisis in 2010. Demand was voracious, with an order book exceeding €43 billion. The timing was impeccable. Not only was Spain just upgraded to single-A-minus at Fitch on Friday (Moody’s and S&P have them at Baa2 and triple-B-plus, respectively), but headline CPI inflation dropped to 1.1% in December, its lowest since November of 2016; this gives the 10-year notes a real yield of 0.3%. Over the 12 months of 2017, Spanish CPI averaged just under 2%.
Earlier today, triple-B-plus rated French supermarket chain Auchan Holding S.A., priced €350 million in senior unsecured two-year floating rate notes maturing on Feb. 1, 2020. Against initial price talk of 20 to 25 basis points over three-month Euribor interbank lending rate (currently at about negative 34 basis points), the notes priced at just five basis points over, for a current yield of negative 29 basis points.
The first $25 trillion's the hardest
Our fact of the day comes from Kopernik Global Investors, LLC, Portfolio Manager Mark McKinney’s recent letter: “It’s Like Déjà vu All Over Again”:
The increase in value of world stock markets in the past 18 months ($25 trillion) equals the total value of the world's stock markets at the bottom in March 2009.
Recap Jan. 25
A late uptick took the S&P 500 into the green and averted the rarely seen back to back lower finishes. The greenback bounced this afternoon after President Trump told reporters in Davos that: “The dollar is going to get stronger and stronger and ultimately I want to see a strong dollar,” while Treasurys rallied at the long end to push the curve flatter, with the 5- to 30-year spread ticking to 46.5 basis points, within range of its cycle lows of 45 basis points.
After the close, Intel shares rallied to their highest since the fall of 2000 after reporting blowout fourth quarter results, featuring revenues and adjusted gross margin well above analyst consensus.
- Philip Grant
Tuesday, January 23, 2018
Day traders delight
The revolution was not, in fact, televised. A simple press release filled the bill instead. This morning, BlackRock released its ETF Pulse Survey, a look at the pace of exchange traded fund adaptation across different demographics. The survey of individual investors found that only 27% of baby boomers (aged 52 to 70) own ETFs, compared to 42% of millennials (21 to 35) and 37% of “silvers” (aged 71 or older). Martin Small, head of BlackRock’s iShares unit in the U.S., surmised that boomers: “May still be holding onto a stock-picking mentality. They may not realize that ETFs are as easy to trade as stocks and available in virtually every market segment imaginable. As a result, many pre-retirees and investors in their early years of retirement may be overlooking the ETF revolution.”
Much as crypto-currencies run the gamut from relatively established first movers like bitcoin to ICO’s such as “Lehman Brothers Coin” (Almost Daily Grant’s, Jan. 19), so does the exchange-traded fund realm range from the simple (such as the SPDR S&P 500 ETF Trust, or SPY on NYSE Arca, which today crossed the $300 billion in assets under management for the first time), to the exotic.
For a demonstration of the latter, we turn to the BMO Rex Microsectors FANG+ Index 3x Levered ETN (FNGU on NYSE Arca) and its evil twin, the FANG+ Inverse Leveraged ETN (FNGD on same), which debuted yesterday. Bloomberg Intelligence harkened the vehicle’s debut with the apt headline: “Leveraged FANG ETNs Aim to Bring Volatility to Bored Traders.” The ETN will charge a 95 basis point expense ratio (10 times the SPY), while the underlying FANG+ Index comprises equal weighted holdings of Facebook, Inc., Apple, Inc., Amazon.com, Inc., Netflix, Inc., and Alphabet, Inc., (nee Google), as well as Alibaba Group, Baidu, Inc., Nvidia Corporation, Tesla, Inc., and Twitter, Inc,.
Eagle-eyed readers will spot that those leveraged securities are classified as ETNs, or exchange traded notes, rather than the conventional ETFs. The Wall Street Journal explained the difference on Feb. 5, 2017:
Both ETFs and ETNs track the price of things like baskets of stocks, bonds or commodities, but they do so differently. ETFs own a portion of the assets they track – an S&P 500 ETF, for instance, owns stocks that are included in the index. ETNs don’t own a portfolio of assets. They are simply debt issued by banks that promise a return to the investor linked to the performance they track.
Indeed, the registration statement filed with the SEC states that: “The notes are unsecured [and] . . . do not guarantee any return of principal.” As for the leverage factor, the document carries the following disclaimer: “The notes are riskier than securities that have intermediate- or long-term investment objectives, and may not be suitable for investors who plan to hold them for a period other than one day or who have a ‘buy and hold’ strategy . . . Investors should actively and continuously monitor their investments in the notes, even intra-day.”
The May 19, 2017 analysis in Grant’s (“Loaded for bear”) took a different tack in describing these products which evidently require a day trader’s attention (and attention span): “Take every known principal of long-term investment success, negate those precepts and multiply the negative by leverage. That would be one aspect of the 4X, 3X or 2X story.” Why? Biff Robillard, co-founder of Bannerstone Capital Management LLC, explained the problem: To make money in leveraged ETF’s, one must correctly predict not only the direction of prices, but of their realized volatility as well.
Not the implied volatility, and not the VIX per se, [but] the actual volatility that the underlying entity driving valuations will experience going forward. You have to have an opinion about that. High volatility reduces, even reverses, returns on leveraged ETFs.
The piece then goes on to demonstrate a hypothetical example:
Say that you own $100 of a thrice-leveraged ETF. On day one, the underlying index moves up by 5% - your fund as gains three times $5; it’s worth $115. Next day, the index falls by 5%; oops, your fund is now worth $97.75. Repeat across 10 days – alternating up 5% and down 5% - and you would finish with $89.23, down by 10.8%. Over the same course of choppy trading days, an unlevered fund would have lost only 1.2%.
So too, does the leverage mandate pose the potential to exacerbate market volatility, should this period of historic serenity be interrupted:
In a conventional margin account, leverage ratios fall as the value of portfolio assets rise. Not so here. An ultra ETF keeps its leverage constant by boosting its indebtedness – drawing on its swap arrangements – as the value of its assets appreciates. To bulk up in a rising market and sell down in a falling one is a technique that recalls the misadventures of portfolio insurance [an aggravating factor in the 1987 stock market crash].
For its part, BlackRock has steered clear of leveraged ETFs. CEO Laurence Fink told the audience at a Deutsche Bank-hosted investor conference in 2014 that: “We’d never do one. They have a structural problem that could blow up the whole industry one day.” That prompted a rejoinder from Trevor Hewes, spokesman for ProShares, which offers many such products: “Leveraged ETFs are well regulated, transparent products and there is no credible evidence that they have any harmful effect on the markets or our industry.”
For our part, we wonder about the soundness of ETFs as a whole, not just the plainly perilous leveraged variety. Recall the increasingly distant (in terms of time elapsed and market environment) events of Aug. 24, 2015, a steep sell-off that left the S&P 500 lower by as much as 5.2% intraday and 3.9% by the close. In that session, even straightforward ETFs were severely dislodged, with the SPY falling by nearly 8% intraday. The S&P 500 equal-weighted index dropped by as much as 4.6%, while the Guggenheim S&P 500 equal-weight ETF sank by as much as 43%, before finishing in the red by just 4%.
No leverage necessary. The Guggenheim S&P 500 equal weight ETF on Aug. 24, 2015. Source: The Bloomberg
What was that about continuously monitoring your investments again?
Recap Jan. 23
Stocks cruised higher, leaving the S&P 500 at its 12th record close through 15 sessions so far in 2018. Commodities enjoyed the ongoing U.S. Dollar slump, with WTI crude back near $65 a barrel while gold rallied above $1,340, approaching multi-year highs of around $1,361 per ounce. Treasury yields dropped across the board after a two-year note auction this afternoon saw the strongest bidding interest since September 2015.
- Philip Grant
Monday, January 22, 2018
Friend zone
You certainly can’t call them Pollyannas. In recent months, a number of higher ups at Facebook, Inc.
You certainly can’t call them Pollyannas. In recent months, a number of higher ups at Facebook, Inc.
Recap Jan. 22
Friend zone
You certainly can’t call them Pollyannas. In recent months, a number of higher ups at Facebook, Inc. have issued eyebrow-raising comments which seemingly call into question the value of social media itself.
This morning, global politics and government outreach director Katie Harbath wrote on the company blog: “From the Arab Spring to robust elections around the globe, social media seemed like a positive. The last U.S. presidential campaign changed that, with foreign interference that Facebook should have been quicker to identify, to the rise of ‘fake news’ and echo chambers.” That post is hardly the first display of public angst from prominent current employees and alums alike. On Dec. 15, director of research David Ginsburg penned a blog post asking: “Is spending time on social media bad for us?” In November, former vice president of user growth and current Social Capital CEO Chamath Palihapitiya commented during a talk at Stamford Graduate School of Business that: “I think we have created tools that are ripping apart the social fabric of how society works.”
It’s not just words. Facebook C-suite has been voting with its feet. In the golden wake of a 501% run-up in its share price over the past five years, company insiders have hit the bid en masse. Last September, CEO Mark Zuckerberg announced a plan to sell between 35 million and 75 million shares through the spring of 2019, in order “to fund the philanthropic initiatives of Mr. Zuckerberg and his wife, Priscilla Chan, in education, science and advocacy” according to filing made with the SEC. That equates to between $6.5 billion and $14 billion at the current price.
276 open market insider transactions since January 2016, 276 sells. Source: The Bloomberg
As those who know the company best have made ambivalent public statements while methodically divesting their holdings, passive investors have happily snapped up the supply. Facebook’s top five shareholders in the non-voting class-A stock, Vanguard Group, BlackRock, FMR LLC (nee Fidelity), State Street and T. Rowe Price, hold just under 25% of shares outstanding. The indexers’ ownership has likewise grown commensurately with Facebook’s surging market cap: Vanguard’s current 166 million share stake compares to 26.3 million shares as of year-end 2012. BlackRock’s 141 million shares compares to 22.7 million on Dec. 31, 2012.
Wall Street remains steadfastly bulled up, with 42 sell-side analysts rating Facebook shares “buy,” against three hold ratings and a pair of sells. One of the skeptics, Pivotal Research Group’s Brian Wieser, noted on Jan. 12 that time spent per-user on the site slowed notably over the summer.
Facebook (including Messenger but excluding Instagram) saw a decline in total person-hours (number of users multiplied by hours of consumption per person) during September of -0.1% year-over-year following a -0.9% decline in August. This represented a decline per user in each period as the unique audience on Facebook rose by +7.8% in August 2017 and by +4.7% in September 2017. Specifically, core Facebook saw a decline in time spent per user of -7.0% and -4.7% in those two months.
Last Aug. 11, Grant’s produced a skeptical analysis of Facebook (“Concerning Mark Zuckerberg”), while giving full credit “to the world beating success of the Mark Zuckerberg/Sheryl Sandberg enterprise,” as well as its pristine balance sheet, fat operating margin and spectacular share price performance. Facebook and Alphabet, Inc. (the parent company of Google), which combined took in 20% of worldwide advertisement spending (and 60% of the digital variety) in 2016, may be bumping up against the gravitational limits of their addressable market. That would render them more conventional advertising companies, subject to the cyclical limitations of that industry and potentially, stingier earnings multiples which would accompany moderated growth prospects. The comparison to another blue-chip investor darling in the 1990’s loomed large:
Coca-Cola Co. was a seemingly invincible, world-conquering growth stock 20 years ago. Roberto C. Goizueta, a CEO out of the Lord of Creation mold, liked to talk about “our virtually infinite opportunity for growth” (the italics were his). “To listen to Goizueta,” said the issue of Grant’s dated Oct. 11, 1996, “the stockholders face no meaningful risk from any contingent event because all relevant outcomes are under the control of the board of directors.” Somehow it never occurred to the bulls that a meaningful cohort of consumers would one day decide that they would rather drink water. The Coca-Cola share price peaked in 1998 and spent the next 16 years in growth-stock perdition.
Some unsolicited advice to the legion of Facebook bulls: Perhaps it is a good idea to pay attention to the actions, as well as the words, emanating from the company’s Menlo Park, California headquarters.
Recap Jan. 22
Stocks roared higher on news that the government shutdown has ended, building on Friday’s solid rally on the government shutdown’s commencement and pushing the year-to-date gains on the S&P 500 to 6%. In case there were any doubts over the intensity of the current bull market, after the close Netflix shares rallied by 9% to a fresh high after announcing stronger than expected user growth in the fourth quarter (and a forecasted $3 billion to $4 billion in negative free cash flow in 2018). Treasurys finished little changed, while strength in energy prices pushed WTI crude back near $64/barrel.
- Philip Grant
Friday, January 19, 2018
Any leeway on the baggage fee?
Score one for the TSA.
Score one for the TSA.
Coin star
It’s the future of money! It’s an empty vehicle of speculation! It’s . . . bitcoin!
It’s the future of money! It’s an empty vehicle of speculation! It’s . . . bitcoin!
Recap Jan. 19
Any leeway on the baggage fee?
Score one for the TSA. A CNBC camera crew learned the hard way that government ineptitude has its exceptions. NJ.com has the details:
At least seven members of a cable television crew were arrested after they tried to sneak a fake explosive device through a security checkpoint at Newark Liberty International Airport, the Transportation Security Administration said Thursday.
A law enforcement source with knowledge of the investigation said that the team was filming for cable network CNBC, which is based in Englewood Cliffs.
Perhaps the authorities will allow their new guests access to video equipment with which to file their segment? If so, the detained crew could wrap with the following: “Actually, airport security seems pretty tight today! Coming to you live from Rikers: This. Is. CNBC."
Coin star
It’s the future of money! It’s an empty vehicle of speculation! It’s . . . bitcoin! The feverish and ongoing debate over the role of crypto-currencies has hardly been quelled by the recent sharp reversal that took the first digital tender to more than 50% below its Dec. 17 highs. Then again, its current $11,500 price was only reached for the first time on Dec. 4, and it is up by 1,090% since the start of 2017.
Among the contingent of crypto bulls, perhaps none can match the elegantly persuasive arguments espoused by Steven Bregman and Murray Stahl, co-founders of investment advisor Horizon Kinetics, LLC. In their fourth quarter commentary, the pair draw a comparison between the emergence of the internet and the present day, while also arguing that crypto (which they term “consensus money”) deserves a portfolio allocation as a hedge against potential disturbance to the U.S. Dollar’s reserve currency status.
The IBM PC was rolled out in August 1981. Its primary market was commercial. Working in Bankers Trust Company, we didn’t get ours until about 1983. As for the household market, I was one of the skeptics. Didn’t know why I should pay $3,000 for a computer for the sole purpose of writing a letter with a keyboard instead of a pen. The internet was a decade-plus away. Microsoft, which provided the operating system for the PC, came public in 1986. How many times your money would you have made if you bought Microsoft almost any time during most that year, and held to year-end 1999, the end of the Tech Bubble?
The answer is 646x. In a $100,000 account, if you risked $1,000, and every other holding went to zero, you finished with $646,000. You didn’t have to understand technology or software to make that decision. You just had to consider the ‘what if’. Not that many people owned a PC in 1983. What if, 10 or 20 years later, it was actually popular? By 1999, pretty much every household in the developed world that wanted a PC had one. And buried inside each was the Microsoft software. It was simply a study in a product going from minimal market penetration to market saturation on a global scale over the course of 15 years. The same for consensus money, if it comes to be accepted, except that it can be much bigger, if you think about it.
What if the world became divided between those who own bitcoin and those who don’t, a world in which bitcoin assumes the reference currency status that the U.S. dollar did in the generations after World War II? It could become the greatest wealth transference experience in history. This is the reason to buy some insurance – appropriately sized – through a stable-monetary-policy consensus money. No one seems to mind – or, at least, to question – paying for homeowner’s insurance, and not just once, but year after year, decade after decade. This just needs to be the once.
Meanwhile, proponents of blockchain technology on which crypto-currencies are based continue to search for new ways to incorporate the decentralized ledger. Yesterday, Bloomberg reported that major banks including Credit Suisse Group A.G. and Wells Fargo & Co. have successfully tested this as a tool (those afflicted with 2008 shellshock should avert their eyes) “to help resurrect the packaging of home mortgages into securities.” Sort of a MERS on the blockchain.
A second item from Bloomberg yesterday lays bare the catch, when it comes to digitized ducats, free from government purview.
In less than a decade, hackers have stolen $1.2 billion worth of bitcoin and rival currency ethereum, according to Lex Sokolin, global director of fintech strategy at Autonomous Research LLP. Given the currencies’ explosive surge at the end of 2017, the cost in today’s money is much higher. “It looks like crypto hacking is a $200 million annual revenue industry,” Sokolin said. Hackers have compromised more than 14 percent of bitcoin and ether supply, he said.
Whether crypto-currencies revolutionize the world, fizzle from memory or something in between, we’ll always have the “Lehman Brothers Coin.” With its ICO set to conclude in 40 days, Lehman Brothers Coin’s website promises “low to zero risk,” while offering a compelling pitch for potential investors: “Using LEHMAN BROTHERS coin people can invest in LEHMAN BROTHERS platform and earn 1.5X return then typical investment methods.”
Recap Jan. 19
Another solid rally in stocks propelled the S&P 500 above a 5% gain for January, while the latest selloff in Treasurys pushed the 10-year yield above 2.65%, its highest since June of 2014 and within range of the 3.01% post-crisis highs logged in the late-2013 “Taper tantrum.” Although the relentless flattening of the 5- and 30-year Treasury spread has garnered plenty of attention, the current 30-year yield itself of 2.93% is actually well above the simple one year average of 2.88%.
- Philip Grant
Wednesday, January 17, 2018
Galloping from value
Whoever said markets take the stairs up and the elevator down? For a tailor-made refutation of that axiom, we turn to The Boeing Company.
Whoever said markets take the stairs up and the elevator down? For a tailor-made refutation of that axiom, we turn to The Boeing Company.
Recap Jan. 17
Galloping from value
Whoever said markets take the stairs up and the elevator down? For a tailor-made refutation of that axiom, we turn to The Boeing Company. Boeing, a Chicago-headquartered (they moved from Seattle in 2001 for tax reasons) manufacturer of commercial and military aircraft and component of the Dow Jones Industrial Average, posted a 89% share-price gain in 2017, with a virtual straight-line advance interrupted by only a handful of shallow pullbacks.
Once the calendar flipped, Boeing shares really took off (sorry). Through 11 trading sessions, BA is up by 19% to $351 a share, virtually matching the S&P 500’s full-year 2017 performance. Should the aerospace concern maintain its blistering pace, it will finish 2018 at $1,578 per share, a gain of 535%. Boeing has likewise added $33 billion in market cap since the ball dropped in Times Square; that increment alone would be enough to place it well inside the top half of the S&P 500's index weighting.
Even the Street has struggled to keep up: This week, at least three sell-side firms have raised their price targets above $400 a share. Analysts from Cowen & Co., and B. Riley, two of the newfound uber-bulls, cited that evergreen bullish catalyst known as tax reform among their rationales. In aggregate, the sell-side consensus pegs 2018 adjusted net income at $7.4 billion, which compares to the $6.6 billion bottom line expected in 2017. Fourth quarter results are set to be released on Jan. 31.
Up and over the cloud cover. Source: The Bloomberg
In the light of this pronounced euphoria exhibited by Mr. Market, a trip to the archives may be worthwhile. A decade ago, Bear Stearns was beginning to teeter, the U.K.’s Northern Rock had been the site of England’s first bank run in 150 years, and the Fed embarked on a panicky, intra-meeting 75 basis point cut to its overnight (Federal Funds) rate. The Jan. 25, 2008 edition of Grant’s (“Value restoration at a gallop”) lamented the unseemly implications of that extraordinary move by chairman Ben Bernanke and the FOMC:
The meek will inherit the earth, but not on the Fed’s watch. Monetary policy in the United States is an instrument of subsidy as well as of macroeconomic management, and the subsidized class seems always to be the feckless one. When risk is mismanaged, or speculation fails, or the bottom drops out of the S&P 500, it’s the savers who take a pay cut.
Little did we know the extent to which the Fed would, in coming years, bend to facilitate the wishes of leveraged speculators. As for the practical investment implications of the then-unfolding crisis, Grant’s offered a kind word for that theoretically exciting but in-practice harrowing state of low asset prices.
So a Great Tumult is displacing what remains of the Great Moderation. Patient, value-seeking investors will only welcome the fact. Tumult shakes loose investment bargains and stimulates new thinking. Though it also moistens the palms, quickens the pulse and disturbs – occasionally – the settled patterns of sleep, what of it? Let the value restoration project proceed.
That value restoration project concluded in the spring of 2009, after Citigroup’s then-CEO Vikram Pandit sent a letter to employees stating the bank was profitable year-to-date, followed by the suspension of FASB 157 (or the “mark to market” rule) a month later. As for the present day, the Bank of America-Merrill Lynch January fund manager survey, released yesterday, finds that hedge fund net equity exposure has risen to 49%, its highest reading since 2006.
Recap Jan. 17
Stocks barreled higher, with the S&P 500 finishing green by nearly 1% to consign yesterday’s bearish reversal into the dustbin of history. Tech led the way, but it was the semiconductors leading the charge as the Philadelphia Semiconductor Index rose by nearly 3%, while the NYSE FAANG++ index gained a modest 27 basis points. Treasury yields ticked higher across the board, with the 10-year note rising to 2.58% to test the interim highs logged last March. The long bond remained well bid on a relative basis, pushing its yield premium over the five year note to just 45 basis points.
- Philip Grant
Tuesday, January 16, 2018
Impulse purchase
Rising home prices are an economic salve of the highest order. Is the reverse also true?
Rising home prices are an economic salve of the highest order. Is the reverse also true?
Neutral zone infraction
Bloomberg:
Bloomberg:
Recap Jan. 16
Impulse purchase
Rising home prices are an economic salve of the highest order. Is the reverse also true? An article from today’s Wall Street Journal suggests we may soon find out. The Journal’s analysis concerns a regulatory-driven slump in the world’s alleged fastest-growing major economy.
In Beijing and Shanghai—two of the country’s largest markets—and other megacities, sales have stalled and prices have dropped, falling slightly in some pockets and dramatically in others.
Demand has dried up in these areas as a result of government measures including higher mortgage rates, higher down-payment requirements and limits on buying a second or third home. Would-be sellers are increasingly putting plans on hold in hope that prices will rebound.
It is cold comfort for China’s homeowners, would-be purchasers and speculators alike that the regulatory broadside could have been worse. The Journal also notes that “Beijing has held off on introducing an anticipated property tax that could curb speculation but damp prices.” Nevertheless, the effects have been significant. New home sales in Shanghai and Beijing, which hovered between 10,000 and 15,000 per month in each city through most of 2015 and 2016, slumped below 5,000 by the fall of 2017 (the property controls were implemented in late 2016). Home prices in those two cities are virtually unchanged year-over-year, a dramatic reversal from the fall of 2016 when prices in Shanghai and Beijing logged gains of 40% and 30%, respectively.
Whether the housing downturn is merely a temporary “reset” or something more severe, the implications for the Chinese economy should be worth monitoring. Moody’s estimates that the property market accounts for nearly a third of Chinese activity. Already it appears that credit creation in the world’s second largest economy is foundering: Chinese credit impulse, or new credit as a percentage of GDP, jumped from less than 22% in May of 2015 to well above 30% by early 2016 amid the percolating housing market. After holding steady for the rest of 2016, that key metric gradually faded through 2017.
China credit impulse, rolling over? Source: The Bloomberg
The calendar provides another simple yet potentially important contrast between China’s recent economic acceleration and its future prospects. The 19th Party Congress, the communist party conclave at which President Xi consolidated his authority last fall, has come and gone. The Foreign Policy Journal noted on Oct. 27 that:
The Communist Party of China Congress, held twice per decade, was a test of Xi Jinping’s efficacy as President. Leading up to the meeting, he had strongly urged all departments to turn in positive economic indicators. This drive for growth was accomplished through exports, infrastructure investment, real-estate, and debt.
Could China’s recent economic boom, politically engineered via the pulling forward of future demand, leave the nation vulnerable to a not-so-pleasant 2018? The industrial metals may tell the tale: Copper prices are roughly 65% above their interim lows reached in early 2016. Iron ore, although 30% off its early 2017 highs (see the Jan. 13, 2017 Grant’s, “Sell a non sequitur,” for more), still sits 73% above its late 2015 nadir. Steel rebar is a hearty 146% north of its end-of 2015 lows.
Neutral zone infraction
Bloomberg:
As U.S. stocks trade at all-time highs, the price tag on bearish options has dropped to a trough relative to bullish contracts. The spread between the price of one month, 25 delta [meaning strike-price points] puts and calls for the S&P 500 is roughly two standard deviations below its five-year mean, data compiled by Bloomberg show. It’s an indication of the greed – or lack of fear – in the market suppressing the CBOE’s volatility gauge.
Meanwhile, that CBOE VIX volatility index is having itself a mini-resurgence. Amid an intraday reversal in the equity indices, the VIX jumped above 12 early this afternoon, its highest reading in over two months.
Recap Jan. 16
The euphoric start to 2018 continued this morning as equity futures rallied throughout the pre-session, pushing the S&P 500 above the 2,800 mark (recall it bottomed at 666 in March 2009) for the first time this morning. That was it for the bulls, as the averages tumbled through mid-afternoon amidst a one day technical bear market in most crypto currencies (bitcoin fell 24%, ripple by 41%) and more curve flattening in U.S. Treasurys (the 5-30 spread now sits below 48 basis points, compared to 57 basis points less than a week ago) for a peak-to-trough decline of about 1.35%, before a modest recovery left the averages down slightly at day’s end.
- Philip Grant
Friday, January 12, 2018
Sword swallower
Debt: It’s what’s for dinner.
Debt: It’s what’s for dinner.
Trot to canter
A detailed look at the state of small and midsize companies comes from Golub Capital
A detailed look at the state of small and midsize companies comes from Golub Capital
Shake it off
Recap Jan. 12
Sword swallower
Debt: It’s what’s for dinner. The Middle-Eastern Sultanate of Oman served up a monster $6.5 billion helping of bonds across 5-, 10- and 30-year maturities earlier this week. True to recent form, yields for all three came in well below (15 basis points for each) their initial price talk, settling at 4.125%, 5.625% and 6.75%, respectively. For perspective, the World Bank pegs Oman’s 2016 GDP (the most recent year available) at just over $66 billion.
Muscat has been trained by Mr. Market to go big. Last March, Oman doubled its planned offering to $5 billion from $2.5 billion amidst a deluge of bidding interest ($20 billion according to Reuters), while the premium to the mid-swap benchmark reference rate was virtually identical to this week’s debt sale. On Nov. 10, S&P downgraded Oman’s long-term credit rating further into speculative grade territory (double-B from double-B-plus), noting that: “We expect that Oman's external debt will exceed its liquid external assets for the first time next year, with the gap widening over the period to 2020.”
Even prior to this week’s offering, Oman’s government debt had been surging as a percentage of GDP, jumping to 42% as of 3rd quarter 2017 from less than 5% of GDP in 2014. Meanwhile, foreign reserve assets dropped to $17.1 billion at the end of the 3rd quarter, down from $20.3 billion at year-end 2016. Analysts at Dubai-based Mashreq Bank noted that “Oman’s state budget for 2018 boosts spending while running a larger fiscal deficit, despite increasing concerns among credit rating agencies about the health of the country’s finances.” The bank does note a significant mitigating factor: The 2018 budget assumes an average oil price of just $50/barrel, a figure which looks conservative at the moment.
Still and all, is there not a better way for investors to express a bullish view on energy prices? Grant's subscribers have been presented with an array of options in the past twelve months.
Trot to canter
A detailed look at the state of small and midsize companies comes from Golub Capital, via its Middle Market Report, and bulls will like what they read. Through the first two months of the fourth quarter, the index (comprised of about 150 private U.S. companies in Golub’s loan portfolio) managed robust year-over-year earnings and revenue growth of 12.8% and 11.5%, respectively. Lawrence, E. Golub, eponymous CEO of Golub Capital, put it plainly:
Middle market companies had an outstanding fourth quarter of 2017, building on the strong performance in the third quarter. Revenue and earnings accelerated to the fastest rates of year-over-year growth since inception of the Golub Capital Altman Index [which began in Q4, 2014]. The fourth quarter’s robust growth was accompanied by profit margin expansion, which suggests that the U.S. economy has strong momentum going into 2018.
Further evidence of corporate strength comes from restaurant research and analytics firm TDn2K, which reports that the industry saw a 0.4% year-over-year gain in same store sales growth in the fourth quarter. That’s the first positive figure in two years, and a sharp turnaround from the 2.2% contraction seen in the third quarter.
Meanwhile, today’s reading of December retail sales featured a sharp upward revision to the prior month’s reading. In response, economists at Goldman Sachs raised their estimate of fourth quarter GDP to 2.9%, from 2.6% amidst “a faster pace of consumption growth.” Merrill Lynch, ditto: “The strength of the retail sales report lifted our 4Q GDP tracking estimate by 0.6% to 2.8%.”
Shake it off
Bloomberg:
JPMorgan Chase & Co. may soon have company in disclosing a fourth-quarter earnings hit tied to Steinhoff International Holdings NV. Goldman Sachs Group Inc. is also likely to disclose a loss linked to the South African retailer, according to people briefed on the firm’s financial results. Earlier Friday, JPMorgan said it recognized a $143 million mark-to-market loss in its stock-trading unit on a margin loan to a single customer. Chief Financial Officer Marianne Lake later confirmed the loss was tied to Steinhoff.
The banks have some company in cutting bait. On Jan. 8, the ECB disclosed that had sold out of its QE-based position in Steinhoff bonds. MarketAxess Daily noted the unique circumstances of the transaction:
The European Central Bank's sale of Steinhoff bonds, which it revealed this week, isn't the first time the ECB has sold bonds it holds under its corporate QE program. But this transaction differs from previous sales, as it is the first time the ECB made an executive decision to sell a bond when it had no obligation to do so. Previously, the ECB had to sell ineligible bonds that it had bought by mistake, such as some debt of French chemical group Arkema, or that became ineligible after its purchase, as was the case with Glencore, when the bond-issuing entity re-domiciled outside of the eurozone. The ECB isn't obliged to sell bonds when their ratings drop below investment-grade, while Steinhoff met all other requirements of the program.
Now there’s a public-private partnership!
Recap Jan. 12
Stocks and oil, so hot right now. Another bull stampede left the S&P 500 higher by 4.2% year-to-date after just nine trading sessions, while the latest bid in energy pushed WTI crude above $64/barrel for its best close since July 2015. Treasury yields mostly ticked higher, with the notable exception of the long bond which is evidently still basking in the glow of strong auction results earlier this week. The spread between the 5- and 30-year yields has narrowed to just 50 basis points, compared to a 150 basis point average over the last five years.
- Philip Grant
Thursday, January 11, 2018
Three sheets
Out with the old, in with the new.
Out with the old, in with the new.
Just browsing
Banca Monte dei Paschi di Siena SpA has got a friend somewhere.
Banca Monte dei Paschi di Siena SpA has got a friend somewhere.
Recap Jan. 11
Three sheets
Out with the old, in with the new. As 2018 ramps up, the Federal Reserve’s balance sheet ramps down. By way of preface, the fall of 2008’s initial “quantitative easing” foray featured the Fed buying, with newly conjured money, U.S. Treasury debt and agency mortgage backed-securities in order to put a lid on borrowing costs and hopefully staunch the financial bleeding from the then-raging crisis. So evidently successful was this program (rates dropped, financial conditions eased and asset prices recovered) that the Fed produced a pair of sequels, with the third act in the trilogy wrapping in 2014. Over that time, their balance sheet rose to $4.5 trillion (the high was $4.516 trillion in January 2015) from about $900 billion in September 2008.
The time has come, say the seers at the Eccles Building, to change course. Thus, the Federal Open Market Committee released last June the “Policy normalization principles and plans,” a relatively detailed blueprint for scaling down its asset pile, both through outright sales and halting reinvestment of maturing securities. In October, the Fed began its “quantitative tightening” regime. No one can accuse the board of acting recklessly, the initial pace of sales was just $6 billion in Treasurys and $4 billion in MBS per month. By comparison, QE3 featured a monthly purchase schedule of $45 billion in Treasurys and an additional $40 billion in agency MBS. Beginning in January, the monthly sales pace rose to $12 billion and $8 billion, respectively, with a $6 billion and $4 billion uptick each quarter to reach a monthly maximum of $30 billion and $20 billon by October.
This afternoon came the latest update from the Fed’s weekly balance sheet H4.1 release. Thus far, progress has been halting. Total securities held outright stands at $4.22 trillion, compared to $4.52 trillion shortly after the initiation of QT in October.
A magnifying glass might help. Federal Reserve total assets since the 2015 high. Source: The Bloomberg
As explained in the New York Fed’s Liberty Street Economics Blog, the nature of the Fed’s MBS holdings may lead to divergences from the planned schedule: “The gradual reduction of the SOMA agency MBS portfolio will occur with a lag because of the uncertainty surrounding principal repayments and the forward-settling nature of the TBA market.” However, a simple extrapolation of the current pace can lead us to expect the Fed will hold about $2.42 trillion in Treasurys and $1.74 trillion in agency MBS by the end of the first quarter. That represents declines of 2% and 2.2% from the respective October levels.
As for the practical implications of this nascent sea change, let us merely note the central bankers bygone asset accumulation buy-and-hold strategy coincided with an extraordinarily lucrative epoch for investors. We reiterate the headline of a Grant’s analysis from Nov. 3, 2017: “The Fed’s selling, you’re buying.”
Just browsing
Banca Monte dei Paschi di Siena SpA has got a friend somewhere. The perpetually teetering Italian bank, which was founded in 1472, was the recipient of a timely bailout from the European Commission last summer. Today, it made its triumphant return to the capital markets, managing to place €750 million in subordinated 10-year notes.
Against initial price talk of a 5.75% yield, investors positively clamored for Monte dei Paschi’s deep junk (rated Caa2 at Moody’s, “judged to be of poor standing and are subject to very high credit risk”) issue, with the debt issued at just 5.375%. More than €2.5 billion in bids adorned the order book, leaving the issue oversubscribed by north of 3.33 times.
In marked contrast to this bidding frenzy, consider the same bank’s senior secured 5 3/8s of 2026. In March of last year, just prior to its bailout, these A1-rated (“subject to low credit risk”) notes traded below 82 cents on the euro for a yield-to-worst of 8.28%.
To those repressed European investors living under the negative rate yolk of Mario Draghi and Co., we say, look west. If a high risk profile in search of yield is the mandate, the BofA Merrill Lynch US High Yield CCC or Below Effective Yield Index currently fetches 10.25%, far more than what is on offer at the Italian bank.
Recap Jan. 11
The bulls march on. Another surge in equity prices left the S&P at fresh highs, up by a non-trivial 3.5% year-to-date after only eight trading sessions. Commodities drifted sideways, with WTI crude oil consolidating its position near $63.50/barrel, while a strong 30-year Treasury bond auction this afternoon helped spur a bull reversal in rates, leaving the benchmark 10-year yield at 2.53%.
- Philip Grant
Monday, January 8, 2018
Junkyard dog
A rising tide lifts all boats, and even a few rocks. A trio of instances from the depths of corporate and sovereign borrowing now follow.
First up is what we’ll call less-than-high yield. This morning, Bloomberg reports that a breakneck rally in triple-C-rated debt (characterized by S&P as: “currently vulnerable to nonpayment and is dependent upon favorable business, financial, and economic conditions for the obligor to meet its financial commitments on the obligation”) has compressed spreads to an average of 579 basis points over Treasurys, tightest in more than three years. In the first week of 2018, triple-C spreads have compressed by 36 basis points. More broadly, the spread between the Bank of America Merrill Lynch High Yield Index and Treasurys has narrowed to 336 basis points, within one basis point of its tightest reading since July of 2007 (Pension Partners’ Charlie Bilello, @charliebilello on Twitter, spotted that one).
Next, we venture to the cradle of democracy. Greece, which has been on the dole since a 2010 credit crisis that metastasized across much of peripheral Europe and which has twice been obliged to restructure its debts, is aiming to make this the year when it puts those troubles in the rear view. Fabio Balboni, European economist at HSBC Bank PLC, wrote last week that: “In 2018, the country might finally exit its bailout program, but a clean exit might prove challenging if the eurozone fails to deliver substantial and credible debt relief.”
What happens between the Greek government, Brussels and the IMF is anyone’s guess, but Mr. Market certainly seems to have an opinion. The Greek 4 3/4s of 2019, which fell to as low as 61.5 cents on the euro in April 2015, have since rallied back above par and currently sport a yield-to-worst of just 1.44%, well below the 1.78% and 1.96% respectively on offer from U.S. one and two-year Treasury notes. Greece carries a Caa2 rating (“judged to be of poor standing and are subject to very high credit risk”) at Moody’s, whereas Uncle Sam sits at triple-A.
Finally, let’s return to Argentina, the serial defaulter (twice this century and eight times since its independence in 1810) that has enjoyed something of an economic rebound of late under the auspices of President Mauricio Macri. Real GDP growth has turned positive for three straight quarters (fourth quarter GDP is scheduled to be released on March 21) after a 2016 recession, while its FX reserves jumped to an all-time high of just under $50 billion at the end of November, compared to $20 billion at the end of 2015. Good thing, as the Argentine peso has remained in freefall against the greenback (which is itself in retreat against most major currencies), rising above 19 per dollar for the first time today, from less than five in early 2013.
Investors are clamoring to participate in the nascent turnaround. Last week, Argentina offered $9 billion in dollar bonds maturing in five, 10 and 30 years at yields of 4.625%, 6% and 6.95%, respectively. Its borrowing costs on the five and 10-year notes were slashed by 1% from a $7 billion offering made in January of last year, while $21.4 billion in demand meant this deal was oversubscribed by 2.37 times according to Bloomberg.
No one can accuse South America’s second largest country of leaving money on the table. Colleague Fabiano Santin notes that the $9 billion raised in the sale represents 75% of Argentina’s full-year foreign currency financing needs. “Emerging-market countries have had an incredible rally this week and it is a perfect timing for debt sellers like Argentina to issue bonds,” Guido Chamorro, senior investment manager of Pictet Asset Management, told Bloomberg.
We concur, while noting the corollary. It is a not-perfect time for debt buyers to be purchasing bonds.
Argentina five-year credit default swaps. Source: The Bloomberg
Recap Jan. 8
The streak is intact. Stocks rallied from a shallow opening dip to leave the S&P 500 at its fifth straight record close to begin the year, while Treasurys finished little changed across the curve. Crude oil caught a bid despite a stronger dollar, with WTI crude again testing $62/barrel. Fourth quarter earnings season will soon get underway, with J.P. Morgan Chase & Co. set to report results on Friday.
- Philip Grant
Friday, January 5, 2018
Sluggers wanted
How to generate ambitious returns in a market featuring precious few bargains?
How to generate ambitious returns in a market featuring precious few bargains?
Lender of resort
Recap Jan. 5
Sluggers wanted
How to generate ambitious returns in a market featuring precious few bargains? Swing for the fences. Two days ago, Marc Levine, chairman of the Illinois State Board of Investment, told the camera at Bloomberg Television that the pension fund is increasing its allocation in “opportunistic credit” to 8% of its $22 billion in assets; two years ago the fund had no such allocation. Likewise, the fund will devote 4.5% of its assets to “non-core real estate,” again from scratch as of two years ago.
The Dec. 20 edition of Hedge Fund Alert reports that the $23.5 billion San Francisco Employees Fund “plans to deploy some $700 million annually to private debt funds as it strives for a five-fold increase in its allocation of such vehicles . . . Private debt appeals to San Francisco Employees, in part, because it offers an ‘illiquidity premium, but with faster distributions’ than private equity.” In a similar vein, last Friday’s Almost Daily Grant’s noted that the $346 billion California Public Employees' Retirement System’s investment committee voted to trim its cash allocation to 1% from 4%.
Although corporate pensions have fared relatively well in terms of funding (the Wall Street Journal reported Tuesday that the funded ratio for Fortune 1000 companies rose to 83% in 2017, up from 81% in 2016 for a five year high), the same cannot be said for the public ones. The American Legislative council calculates that every U.S. state pension system, with the exception of Wisconsin (61.5%), is less than 50% funded.
Regardless, the funds generally target 7% to 8% annual returns for their members, across all market conditions. Jeffrey N. Saret, Barbara Zhan and Subhadeep Mitra, thematic researchers at Two Sigma Investments, L.P., wrote in Pensions & Investments magazine in March that the average return assumption of pension plans within their dataset stood at 7.6% at year-end 2015 (the most recent year available), down from 8% in 2001. However, the average annualized return for these plans from 2001 to 2015 was just 5.7%.
That shortfall is especially striking in light of the near-decade (or three-plus decades in the case of the bond market) of uninterrupted asset price appreciation. Where will the next 7.6% be found? Not on the sidewalk. The Bloomberg Barclays U.S. Corporate Unhedged High Yield Bond Index currently carries a yield-to-worst of just 5.57%.
Future prospects look no more inviting in the stock market. The cyclically-adjusted Shiller price/earnings ratio (based on the previous 10 years earnings, adjusted for inflation) stands at just over 33 times, the highest equity valuation on record, apart from 1929 and the late-90’s internet bubble, two particularly unfriendly periods for new investors. In a paper released last month, a team at Research Affiliates, LLC led by Rob Arnott studied the so-called Shiller P/E metric (CAPE), concluding that:
The CAPE ratio is not a useful timing signal for market turning points, but is a powerful predictor of long-term market returns.
Many arguments have been offered to justify elevated CAPE ratios. Most or all of the factors are inherently temporary and subject to either near-term or eventual mean reversion. Beware the consequences of assuming that elevated CAPE ratios are here to say, but if they are the “new normal,” low future returns will be as well.
Some creativity may be required in order to find a solution. Institutional Investor offered one potential avenue of salvation in its Jan. 2 article, titled: “Should Pension Funds Invest in Bitcoin?”
Lender of resort
Bloomberg: “Steinhoff International Holdings NV, the South African retailer laid low by an accounting scandal, is selling one of its more high-flying assets as it seeks liquidity to keep itself alive. The owner of U.K. discounter Poundland and bedding supplier Mattress Firm in the U.S. is in discussions with a potential buyer of a 2006 Gulfstream G550 private jet that’s shuttled executives around the world, according to a person familiar with the situation.”
If the deal with that unnamed deep-pocketed investor falls through, we have a suggestion for another potential buyer, one who is surely well acquainted with Steinhoff’s operations as an existing owner of the company’s debt.
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Recap Jan. 5
A fourth straight rally in stocks left the S&P higher by a gaudy 2.6% (69 points) for this short week, putting the broad average on pace to finally leave the bearishness of 2017 behind (nevermind) with a 163% annualized gain. Treasury yields ticked slightly higher across the board, while commodities pulled back markedly from their sharp recent advance, with the CRB index finishing weaker by nearly 1%.
- Philip Grant
Thursday, January 4, 2018
Sprinting somewhere
They finally got their merger, sort of. This morning, Sprint Corp. announced it has hired Michel Combes, the former CEO of Netherlands-based Altice N.V., as president and CFO. Regular readers of Grant’s (Oct. 2, 2015) and Almost Daily Grant’s (Nov. 6, June 22) might recognize Combes’ former employer – a prominent growth by acquisition roll-up – that has come undone amidst weaker than expected performance and the prospect of asset sales to bolster its balance sheet. Sprint shareholders appear to have considered this fact, as the stock reacted by finished the day weaker by nearly 5%.
The less-than-welcoming reception afforded Combes (who “is likely to embark on a new cost-cutting plan,” according to BTIG, LLC analyst Walt Piecyk) could also be a byproduct of investor frustration following the again-thwarted courtship of T-Mobile U.S., Inc. The two companies were reportedly in agreement on a stock-based merger in June of last year following an aborted combination in 2014, but the deal fell apart once more. Craig Moffett, founder and one-half of the nameplate at MoffettNathanson, LLC, wrote in a Nov. 27 report that the deal cancellation bodes poorly indeed for Sprint:
They forgo their share of synergies, a total that we have conservatively estimated to be $30 billion net [for context, Sprint generated $33 billion in revenue over the past 12 months], and they now have to find a way to go it alone. And even if a deal is eventually put back on the table, it would likely only be at a much less attractive exchange ratio than what had been discussed this summer. In the meantime, they face a punishing future of dramatically negative free cash flow and steep debt maturities.
Now it’s back to square one in the hyper-competitive wireless communications industry, a category that was called out by former Federal Reserve chair Janet Yellen last summer for its contribution to aggregate deflationary forces in the economy. As of its third quarter results announced in late October, Sprint carried $32 billion in net debt, supported by $11.1 billion in trailing adjusted 12-month EBITDA and $80 million (with an ‘m’) in free cash flow.
Those numbers may flatter the junk-rated (B3 at Moody’s, single-B at S&P) Sprint’s financial footing. For fiscal 2018, the sell-side expects both adjusted EBITDA and free cash flow to decline, with a consensus of $11 billion and negative $370 million, respectively. Moffett likewise noted in an Oct. 25 note that “on an accounting-adjusted basis (to eliminate the uplift from handset lease accounting), their EBITDA was $8.12 billion (assuming a $75 subsidy per handset), making their “real” leverage 3.9x. Over the next two-and-a-half-years (that is, including the balance of FY 2017), the company faces $18 billion [with a ‘b’] of debt maturities and interest payments.”
The Dec. 23, 2016 edition of Grant’s featured a critical analysis of Sprint, the wireless telephone business and the high yield credit market (“Wrong number”). Noting that the company’s senior unsecured 7 5/8 notes maturing in 2025 had rallied to 103.5 cents on the dollar from 60 cents (pushing the yield-to-maturity to 16.2%) during the pronounced bout of risk aversion seen that February, Grant’s summarized the bear case thusly:
Competition is stiff and stiffening – and that was even before the top two cable companies, Comcast Corp. and Charter Communications, Inc., announced their intention to enter the business. Retail prices are sliding relentlessly. Capital spending consumes (or should consume, according to Moody’s) 15% to 18% of network revenue. Heavy leverage turns ordinary business molehills into existential mountains. Sprint is heavily leveraged, unprofitable and – in comparison to its peers – under-invested in its own network.
Since publication time, Sprint shares are down by about 33%, the bulk of that decline taking place after the T-Mobile merger was called off. The 7 5/8s of 2025 have held up better, last trading at 105.5 for a yield-to-maturity of 6.58%. That’s down from 114 in October when the deal was still on the table.
Distressed no more, Sprint 7 5/8s. Source: The Bloomberg
Recap Jan. 4
A third straight bid in stocks left the S&P 500 green by about 2% for this young 2018, while the nominal price-weighted Dow Jones Industrial Average made its maiden voyage above the 25,000 mark. The VIX once again traded in heretofore-uncharted territory below 9, while upward pressure on short term Treasurys left the curve flatter once more. Commodities continued their stellar recent performance, with the broad CRB index ticking to a two-year high as WTI crude consolidated near $62 per barrel while gold extended its recent run to $1,322 an ounce, up by 6.5% from mid-December.
- Philip Grant
Wednesday, January 3, 2018
Sweet and sour
Even in friendly markets, borrowing has its limits. That axiom is increasingly demonstrated by a trio of acquisitive and privately held Chinese conglomerates, all former high flyers who have run afoul of creditors in recent weeks.
Dalian Wanda Commercial Property, a subsidiary of tycoon Wang Jianlin’s Dalian Wanda Group (the largest property holder in China with over 300 million square feet under its dominion), saw its credit rating cut to double-B-plus from triple-B at Fitch today after the company missed a regulatory window (it expired on Dec. 31) to issue senior notes. Fitch notes that: “Wanda’s liquidity position may come under substantial pressure if its offshore syndicated loan lenders demand for early repayment and Wanda fails to meet these demands promptly; or it fails to raise sufficient offshore liquidity to repay the $510 million second tranche of its offshore syndicated loan due in March 2018.” Following its downgrade, the second since 2016, Fitch kept Dalian Wanda Commercial Property on watch negative.
Last week, Chinese state media website The Paper reported that Wanda’s Internet Technology subsidiary will cut at least 1,000 jobs this year (it currently employs about 6,000), while Variety suggests the total could be much higher: “Some employees who joined less than a year ago were asked instead to ‘resign’ from their current positions. Including these, the staff numbers could fall from 6,000 at present to just 300, a 95% reduction.” Qu Dejun, president of Wanda Internet Technology Group, confirmed on his WeChat social media account that: “The group is readjusting in order to better develop more quickly and in a healthy manner.”
Tech-focused LeEco, which American website CNET described in 2016 as an “Apple-Samsung-Netflix-Tesla mashup”, has left creditors and suppliers alike in the lurch after its listed subsidiary, Leshi, reported a RMB 637 million ($96 million) loss in the first half of 2017. In July, a Chinese court froze $180 million of assets owned by co-founder Jia Yueting and his wife following missed loan payments, while a month ago regulators ordered Jia to return to the country to attend to his unpaid debts. Instead, Jia authorized his wife and brother to negotiate on his behalf, writing on his Weibo social media account that he needs to remain in the U.S. due to the “immense work” that is required for his electric car startup, Faraday & Future, Inc.
The Financial Times on Dec. 26 noted how LeEco’s troubles shine a spotlight on China’s less than streamlined bankruptcy system. Dan Harris, a lawyer who specializes in China, told the FT that: “Near as I can tell, [the bankruptcy process] doesn’t really exist. It’s there on paper, and I vaguely recall hearing of a few cases, but for the most part, it is ignored.” Shaun Wu, a Hong Kong-based lawyer, added that: “Creditors feel they must move swiftly and aggressively to safeguard their interests in China. There is less of a willingness to stand in line and wait for everything to be sorted.”
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A little help here? China one-year sovereign yield. Source: The Bloomberg
Perhaps the most prominent of the now-flagging Chinese conglomerates is HNA Group Co. HNA, which jumped to 170th in the 2016 Forbes 500 list of the world’s largest corporations from 464th two years prior, reported $53 billion in revenues for 2016 while making high profile deals such as buying a 25% stake in hotel chain Hilton Worldwide Holdings, Inc. from the Blackstone Group LP for $6.5 billion in cash.
Financial gravity appears to be kicking in. After three of its subsidiaries (Tianjin Airlines Co., Hainan Airlines Holding Co., and Bohai Capital Holding Co.) abandoned plans to issue debt in December, the Wall Street Journal reported on Dec. 29 that HNA pledged its Hilton stake as collateral for additional funding from a lending group led by JPMorgan Chase & Co. Today, the WSJ reported that HNA is in arears on short term loans it obtained from individual investors, including its own employees, via JBH.com, its own online lending platform.
Christopher Whalen, publisher of the Institutional Risk Analyst, interrupted his vacation to tell Grant’s that the HNA saga is well worth keeping tabs on, as the aftermath of last fall’s 19th Party Congress and President Xi’s apparent consolidation of power may allow Beijing to avoid riding to the rescue:
The rise and fall of Chinese conglomerate HNA is instructive for investors and Sinologists alike. Neither a private company nor explicitly sovereign, HNA grew to gigantic size during China's period of financial liberalization. Now with newly enthroned Emperor Xi Jinping restricting financial activities abroad, HNA may be the first significant default event of 2018.
Recap Jan. 3
The bulls maintained their firm grip on the proceedings, with stocks cruising higher to leave the S&P 500 green by 1.5% for the first two sessions of 2018, while the Treasury curve finished notably flatter. Energy prices ripped despite a dollar bounce, with WTI crude approaching $62/barrel, up by more than 40% from its June interim low. Finally, the VIX traded as low as 8.96 intraday, which Bearing Asset Management’s Kevin Duffy advises Grant’s is the lowest since at least 1991.
Duffy also relays that: “I put more weight in the 3-month VIX as a contrary indicator. This closed today at 13.30, the lowest reading of the bull market, in the 99th percentile of bullishness, and compares to an all-time low of 12.74 in 2005.”
Tuesday, January 2, 2018
Stone skipping
Parabolic price moves can make for some happy campers.
Parabolic price moves can make for some happy campers.
Ich bin ein bond bear
Last Friday’s release of German CPI for December surprised with a 1.6% year-over-year uptick,
Last Friday’s release of German CPI for December surprised with a 1.6% year-over-year uptick,
Recap Jan. 2
Stone skipping
Parabolic price moves can make for some happy campers. Ripple, the blockchain-based facilitator of interbank transactions, rode a 55% gain on Friday to finish December up by 816% and a mind-boggling 38,200% for full year 2017. That was enough to vault ripple to the second highest total valuation among cryptocurrencies at $93.5 billion according to CoinMarketCap.com, while Forbes pegs the current net worth of ripple co-founder Chris Larsen at $37.3 billion, which would make him the 15th richest American (virtually tied with former Microsoft CEO Steve Ballmer) according to the current Forbes 400 list.
No mere “trading sardine” or non-fiat store of value, this particular crypto aims to modernize the relatively staid world of interbank transactions. As the Financial Times recently explained, ripple “allows cross-border payments to be completed within 10 to 15 seconds, compared with about three days for interbank transactions using the Swift network, which was created 44 years ago by a consortium of the world’s biggest lenders.” Ripple’s website claims that the cryptocurrency has a four-second settlement time, compared to more than two minutes for ethereum (the third largest crypto) and over an hour for bitcoin.
Ripple’s blistering ascent looks to have made a prophet out of erstwhile Federal Reserve chairman and current Citadel Securities, LLC capital introduction professional Ben Bernanke. Speaking at a blockchain conference in October, Bernanke praised ripple’s potential while noting the relatively onerous existing procedure for cross-border interbank payments, calling it “an obvious area where new technologies like blockchain or these electronic currencies can be used to improve the process."
As we are fast learning, the blockchain’s potential use extends far and wide. This morning, Chanticleer Holdings, Inc. (BURG on the Nasdaq), owner of Hooters Restaurant among other brands, trumpeted MobivityMind: “a blockchain-architected platform for commerce and customer communication across brands, to power their groundbreaking cryptocurrency customer loyalty and rewards program.” Mr. Market, or the press-release scanning algorithmic bots working in his stead, liked the sound of that. BURG shares jumped by more than 100% in the pre-market, finishing the day up by 41%.
Ich bin ein bond bear
Last Friday’s release of German CPI for December surprised with a 1.7% year-over-year uptick, against the consensus of 1.5%. That pushed the average year-over-year rise in consumer prices at 1.8% for 2017, far above 2016’s 0.5% average and the 0.3% seen in 2015. Strip out energy prices, and 2017’s 1.6% mean compares to 1.2% over the prior two years.
Holders of 10-year German government bonds, which currently fetch a 0.47% nominal yield and a negative 1.2% real one, continue to show no evident concern. As CPI inflation pushes higher, borrowing costs hold steady.
Source: The Bloomberg
Amid that modest but visible inflationary onset, the bond market’s ace in the hole may not stick around for too much longer. In an interview last week with Caixin Global, the European Central Bank’s Benoit Coeure hinted that the central bank is considering an exit: “Given what we see in the economy, I believe that there is a reasonable chance that the extension of our asset purchase program decided in October can be the last.”
At the tail end of the 1946-1981 bond bear market, investors increasingly referred to Treasurys (which featured, by the end of 1982, a 10.4% nominal yield on the 10-year note against 3.8% year-over-year CPI inflation) as “certificates of confiscation.” That phrase has been understandably mothballed in the intervening decades. In the case of German 10-year sovereigns, we say it’s time to take it out of layaway.
Recap Jan. 2
The first trading day of 2018 bore an uncanny resemblance to the year just passed, as the equity indices gapped higher in the pre-market and barely looked back. Meanwhile, Treasury yields ticked higher in bear steepening fashion (long end underperforms), while outsize weakness in the greenback (the U.S. dollar index lost nearly 50 basis points) coincided with gold’s first visit above $1,315/ounce since September.
The placid conditions for stock investors have reached historic levels. Institutional Advisors notes that December marked the 13th straight month in which the S&P 500 registered a higher low, which equals the previous record established in 1959.
- Philip Grant
Friday, December 29, 2017
Auld lang sign
On the eve of the eve of the New Year, we pause to take stock – actually no.
On the eve of the eve of the New Year, we pause to take stock – actually no.
Auld lang sign
On the eve of the eve of the New Year, we pause to take stock – actually no. We pause to take debt, like seemingly everybody else with a loose dollar to invest. By way of preview (spoiler alert!), borrowers have the upper hand the world over and have not been shy about throwing their weight around. As all things are cyclical, and as New Year’s forecasts are mandatory, we hereby anoint 2018 the Year of the Lender.
Free climbing
Back on Nov. 21, S&P Global Market Intelligence’s LCD unit reported that the volume of U.S. institutional loan issuance reached a fresh record high of $468 billion, surpassing 2013 high water mark of $456 billion with more than a month left in the year. As the quantity of debt has reached a record high, the quality is plumbing new depths.
LCD likewise relays that issuance of so-called covenant-light loans (meaning without certain contractual protections normally afforded to lenders) exceeded that of high yield corporate bonds by 36% in 2017 (for context, cov-lite issuance first exceeded high yield in 2016 after lagging far behind for most of the prior decade), while the share of cov-lite loans outstanding reached a record 75% of the S&P/LSTA index by the end of December. Yesterday, the Wall Street Journal also noted the increasing pervasiveness of cov-lite, noting that 81% of loans in Europe have been of the cov-lite variety this year compared to just 21% in 2013 and quoting Adam Freeman, partner at law firm Linklaters LLP, who observed that private equity issuers “can be more aggressive and lenders will take it” amid “far too much cash trying to find too few homes.”
Under the table
In mid-December, the California Public Employees Retirement System (CalPERS) investment committee voted to change its allocation of its $346 billion investment portfolio. Greater will be CalPERS’ exposure to the stock and bond markets; its allocation to public equities is set to increase to 50% of its AUM from 46%, while fixed income will rise to 28% from 20% (although direct comparison is obscured by the fact that inflation-protected securities will be consolidated into the fixed income category). Lesser will be CalPERS’ dry powder: Cash holdings will decrease to 1% from its current 4% of the portfolio. Bloomberg noted that the only dissenter in the vote, board member JJ Jelincic “has advocated for a higher risk portfolio,” while board member Richard Costigan concurred “I am concerned, we’re leaving money on the table.”
Public pension funds are rarely known for a contrarian mindset, and CalPERS is no exception. The March 24, 2006 edition of Grant’s (“Billions buy funds”) detailed the California capital stewards’ foray into the then-blazing hot commodity realm, with the Thompson Reuters/CoreCommodity CRB Index having logged a 78% advance over the prior three years. CalPERS’ didn’t top-tick the cycle, as commodity consolidation through the rest of 2006 gave way to a strong rally in 2007, but the party ended thereafter and by the beginning of 2009 the CRB index had dropped to those early 2003 levels. One day, California pensioners may wish that CalPERS had held more than 1% cash in 2018.
Come on in, the water’s warm
The animal spirit-heavy emerging markets investment realm is the final stop on our year-end 2017 tour. Last week, the Financial Times noted that investor flows and credit fundamentals are going in opposite directions: “Global investors have raised their holdings of emerging market bonds to a three-year high, even as average EM sovereign credit ratings have plunged to their lowest level since early 2010.”
Beyond the aspersions of the ratings agencies, the timeless creditor kryptonite of inflation could be set for a resurgence, as bottom-scraping nominal yields offer investors little in the way of protection. Yesterday, the Argentine Republic raised its inflation target for 2018 and 2019 to 15% and 10%, respectively, from 10% and 5%. That sent the Argentinian peso jumping above 19 per dollar (since recovered to 18.6), compared to less than five per dollar at the end of 2012. Argentina has defaulted eight times in the last two centuries (Almost Daily Grant's, June 19), but holders of the 7 1/8s dollar bonds of 2117 are unconcerned. The century bonds, issued at 90 cents on the dollar, have remained near their recent highs above 103, currently sporting a nominal yield-to-worst of 6.86%.
The economist Herbert Stein once said that: “If something can’t go on forever, it will stop.” We venture an opinion that Stein’s philosophy can be applied to today’s credit markets at large. As to the timing of any such sea change, well . . . As much as we would like to furnish an exact month, date and year, we seem to have run out of space.
Happy New Year and thanks for reading!
- Philip Grant
Thursday, December 28, 2017
Paper pushers
Vertical integration: It’s not just for the manufacturers.
Vertical integration: It’s not just for the manufacturers.
Ink blotter
USA Today reported on Monday the travails of Florida man
USA Today reported on Monday the travails of Florida man
Recap Dec. 28
Paper pushers
Vertical integration: It’s not just for the manufacturers. The Swiss National Bank, a standout even in this activist central-banking epoch, announced a deal last Thursday designed to help consolidate its operations. The SNB purchased a 90% stake in Landqart AG, a local manufacturer of the paper used in the printing of banknotes, along with a similar 90% stake in the Landqart Management and Services, which holds the patents for Landqart AG’s printing business. In exchange, the SNB forked over cash considerations of 21.5 million francs ($22 million) to the seller, Vancouver, Canada-based Fortress Paper Ltd.
The central bank explained its rationale in a press release announcing the deal: Amidst “an acute need for liquidity at [Landqart] . . . The SNB has decided to acquire the company because, otherwise, issuance of the new Swiss banknote series would not have been guaranteed across the entire production stream. By taking this step, the SNB is ensuring the continued supply of cash and, hence, the fulfilment of its own statutory mandate.”
Located amid that hotbed of financial repression in Mario Draghi’s Europe, the Swiss bankers are compelled to work overtime in order to forestall a currency appreciation that they fear might cripple Switzerland’s export-heavy domestic economy. Accordingly, the SNB prints francs, with which to buy euros, then foreign assets.
They have been busy. As of Nov. 30, the SNB’s foreign-currency reserves totaled CHF 742 billion ($757 billion), just under 94% of the central bank’s total assets. That has pushed the central bank’s balance sheet higher by 56% over the three years ended Nov. 30 to reach 120% of Swiss GDP for 2016. By comparison, the U.S. Federal Reserve’s $4.45 trillion (and now gradually shrinking) balance sheet currently foots to less than 24% of domestic GDP in 2016.
One foreign asset class that has definitely caught its share of the Swiss’ attention is the U.S. stock market. The SNB’s most recent form 13-F filed Sept. 30 shows the central bank holding of U.S. equities at $92.7 billion, a 29% jump from the $63.4 billion reported as of year-end 2016.
A couple of printed billions here and there, and sooner or later you’re talking about real money. Or, digitized, central bank money that buys real operating businesses. Amongst the 30 companies that comprise the Dow Jones Industrial Average, the SNB has achieved top-50 shareholder status in 27 of those, with only financials Goldman Sachs Group Inc., J.P. Morgan Chase & Co. and American Express Co. passed over thus far by the gnomes (Visa Inc. and Travelers Companies Inc. made the cut).
Amidst agreeable (to say the least) financial conditions including the broad-based bull market as well as an appreciating euro, the SNB’s foreign monetary adventures have propelled its profitability. For the first three quarters of 2017, net gains on foreign currency positions have totaled CHF 30.3 billion, nearly 50% higher than the CHF 20.3 billion in mark-to-market gains logged in the first three quarters of 2016. Partially offset by lower mark-to-market gains on its gold holdings, total net profits at the SNB totaled CHF 33.7 billion through Sept. 30, a 17.5% gain year-on-year.
Mr. Market, in his generosity of spirit that has characterized 2017, has bestowed upon SNB shares (SNBN on the Zurich exchange) a year-to-date gain of 124%, compared to a 22% gain in the EURO STOXX Banks Index priced in CHF. The five year chart paints an especially cheery picture.
It’s a central banker’s world, we’re just living in it. Source: The Bloomberg
Deputy editor Evan Lorenz identified the paradox in the May 5 edition of Grant’s (“Not for widows and orphans”): “The SNB is a leveraged play on the world’s asset and currency markets, the very ones that worldwide monetary policy has bullishly (for the most part) deformed.”
Who said that printing money wasn’t a profitable line of work?
Ink blotter
USA Today reported on Monday the travails of Florida man Michael Joseph Oleksik, recently charged with criminal mischief following an incident last month at a Wells Fargo bank branch in Cocoa.
A 23-year-old Florida man told police he punched an ATM in November because it gave him too much cash. Authorities said Oleksik can be seen on surveillance video standing at the ATM, pummeling the electronic teller’s touch screen on Nov. 29.
A short time later, an apologetic Oleksik called the bank and told a manager that he punched the ATM because he was ‘angry the ATM was giving him too much money and he did not know what to do,’ records show. Oleksik also said that he was in a hurry for work and apologized for the damage to the bank's ATM.
No central banking career is forthcoming for Oleksik, we presume. He could have bought the FAANGs instead.
Recap Dec. 28
The S&P 500 nudged higher to close at the upper end of its tight holiday trading range, a few points off the closing high set on Dec. 18. Treasury yields ticked higher across the board following a tailing 7-year note auction (priced at 2.37% compared to a 2.361% When Issued), though relative outperformance in the long bond compressed the spread between the five and 30-year yields below 52 basis points for the first time since 2007. Dollar weakness and cold weather across most of the U.S. helped put a bid under energy prices, with natural gas up by 7% and WTI crude back near $60/barrel.
- Philip Grant
Tuesday, December 12, 2017
Almost Daily Crypto
Bitcoin is so early-December.
Bitcoin is so early-December.
Inflate gate
Take a bow, central bankers of the world!
Take a bow, central bankers of the world!
Recap Dec. 12
Almost Daily Crypto
Bitcoin is so early-December. Blockexplorer.com explains:
A Starbucks in Buenos Aires, Argentina was mining Monero (XMR) on customer’s devices without their permission. Twitter user Noah Dinkin noticed that a Starbucks location in Buenos Aires was utilizing their Wifi captive sign-in portal to force a 10-second delay when users first connected to the Wifi in order to mine Monero. The user originally assumed that the Starbucks Wifi was attempting to mine bitcoin, but it was in fact mining Monero. XMR is currently trading at $286.27 according to the Block Explorer Monero Price Index.
Starbucks confirmed the incident, with a PR representative telling Patrick Howell O’Neil, reporter at Cyber Scoop News, that the company ”took swift action to ensure our third-party support provider resolved the issue and made the changes needed in order to ensure our customers could use Wifi in our store safely.”
Meanwhile, the Crypto Co. (CRCW over-the-counter) mentioned in yesterday’s ADG on account of its 35-fold share price increase from Dec. 1 and modesty in its SEC filings, has undergone a slight pullback. CRCW shares, which closed yesterday at $642, finished at $223, down a bit more than 65%. That pares their-post Dec.1 gains to just over 1,100%.
Inflate gate
Take a bow, central bankers of the world! Evidence of the long-sought after return of measured inflationary pressures is accumulating. A trio of sovereign sightings in the past 24 hours:
Swedish underlying consumer price inflation (which adjusts for fluctuations in mortgage prices) for November logged at 2.0%, above the 1.8% economist consensus and the 1.7% expected by the Swedish central bank, the Riksbank. Jonas Goltermann, economist at ING Bank NV, wrote that: “The [Riksbank] policy committee will be pleased with the confirmation that inflation is back to target. But we think the dovish majority will want to keep policy accommodative for some time yet to avoid the risk that inflation falls back again.” The central bankers may be pleased, but someone should wake up Sweden’s sovereign creditors and let them know. The Swedish Government Bond 0 3/4s of May 2028 are trading at 100.72 cents on the krona, for a nominal yield-to-worst of 0.68%. If inflation holds at this level, those notes sport an annual real yield of negative 1.3%.
Mark Carney, governor of the Bank of England, has a new homework assignment. As a result of the 3.1% year-over-year increase in November’s CPI reading (the highest since March 2012), Carney will be compelled to write a letter to the chancellor of the exchequer explaining why inflation has deviated by more than 1% from the central bank’s 2% target. Food and energy prices rose by 4.0% and 6.8% year-over-year, respectively, but diverse categories such as clothing and footwear (+9.8%), household goods (+4.4%) and autos (+5.5%) demonstrated the relatively broad base of the price pressures.
So far, U.K. CPI has averaged 2.4% in the eleven monthly readings of 2017, compared to 0.6% year-over-year through 2016 and zero in 2015. Lucy O’Carroll, chief economist at Aberdeen Standard, wrote that: “It’s quite possible that inflation is now close to its peak.” For the sake of U.K. creditors’ prospective returns she had better be right. The 10-year gilt currently sports a 1.22% nominal yield (just a basis point above its simple average for 2017) and a negative 1.9% real yield, based on the November inflation reading.
Stateside, this morning’s release of the producer price index for November showed the same trend: up. The headline final demand component rose by 3.1% year-over-year and by 2.3% ex-food and energy (the highest and second highest readings in five years, respectively), bringing the average 2017 gain to 2.3% in the headline series with just one month remaining. In contrast, 2016 averaged a 0.4% year over year advance, while 2015 PPI declined by 0.9%. In this context, at least, investors in U.S. Treasurys are in slightly better shape than those in gilts or Swedish government bonds. The 10-year note yields a relatively superior 2.40%, while the Federal Reserve is expected to raise overnight interest rates at tomorrow’s meeting (futures price 100% odds).
The July 15, 2016 historical analysis in Grant’s (“Remember the Shell Union Oil 2 1/2s of 1971”) featured a cautionary tale for potential fixed-income accidents that involve no default or corporate distress.
Shell Union was a substantial and creditworthy borrower. In 1945, it showed net income of $28.7 million, cash and government securities of $118 million and a current ratio of 3:1. From balance sheet details as the press revealed, there appears to have been little net debt.
In the spring of 1946, any clairvoyant could have seen that credit risk was yesterday’s worry, particularly with so solid a citizen as Shell . . . Obviously, interest-rate risk was the coming thing. Only later, and at much higher yields, did this great truth penetrate the mind of the market.
Interest-rate risk, visualized. Source: Michael Hartnett, Bank of America Merrill Lynch
Is the credit cycle, notorious for its generation-length (or longer) trends, finally turning? Maybe not, but it sure doesn’t hurt to consider the possibility.
Correction:
Yesterday’s ADG item on the Canadian housing market featured a passage the incorrectly described rule changes mandated by the Office of the Superintendent of Financial Institutions. Beginning on Jan. 1, mortgage borrowers who put down more than 20% will be stress-tested at either the five year average posted rate, or 2% above their lender offers them, whichever is higher. Those who put down less than 20% have already been subject to a requirement to buy mortgage insurance. I have fixed my mistake on the Grant’s website.
Recap Dec. 12
A fourth straight strong finish for stocks left the S&P 500 at a new fresh high, up by 19% year-to-date with 12 trading sessions left in 2017. The VIX caught a late bounce, rallying by 5% and closing at session highs.
- Philip Grant
Following the Grant’s Christmas vacation, Almost Daily Grant’s will resume on Thursday, Dec. 28.
Monday, December 11, 2017
HELOCopter money
The adage that “trees don’t grow to the sky” is being put to the test in the Great White North.
The adage that “trees don’t grow to the sky” is being put to the test in the Great White North.
Security guard
Shares in over-the-counter name The Crypto Company,
Shares in over-the-counter name The Crypto Company,
Recap Dec. 11
HELOCopter money
The adage that “trees don’t grow to the sky” is being put to the test in the Great White North. Despite a pullback in Toronto-area home prices in recent months, the Canadian housing market stands out even in this bull market-in-everything world: The Canadian Real Estate Association’s MLS Home Price Index has risen by 130% since the beginning of 2005, more than double the 53% rise in nominal GDP over that period.
As night follows day, rising prices are met with increased supply. Thus, Bloomberg reported on Friday that Canadian developers are undertaking a record number of multiple-unit construction projects as they seek to participate in the boom. Robert Kavcic, economist at BMO Capital Markets, commented that: “Canadian home building activity remains rock solid. Builders in the biggest cities appear to be responding to supply shortages as best as possible.” The severity of these shortages, in Toronto at least, is disputable. Supply of new listings in Canada’s largest metro area has jumped by 37% year-over-year in November.
Local regulators have likewise moved to slow down the housing market’s ascent. Canada’s Office of the Superintendent of Financial Institutions (OSFI) is introducing new regulations, set to take effect on Jan. 1, which aim to tighten lending standards. Among the new requirements is a mandate that borrowers who plunk down more than 20% of the value of the home must undergo stress testing, at (according to CBC news) "either the five-year average posted mortgage rate, or two percent higher than their actual mortgage rate, whichever is higher." Those paying less than 20% are currently required to purchase mortgage insurance.
It may come as no great surprise to learn that the great Canadian housing bull market has been built on a foundation of debt. Consumer debt as a percentage of disposable income has undergone a near-constant uptick since the turn of the century, reaching a fresh high water mark of 167.8% as of the end of the second quarter, compared to 144% in the U.S. in 2007. Seth Daniels, founding partner of JKD Capital in Boston, advises Grant’s via email that the encumbrances are particularly concentrated in home equity lines of credit, or HELOCS.
HELOCs, as a percentage of GDP [13.5% as of year-end 2016], are roughly three times higher in Canada then in the US at the peak of our housing bubble in 2006. In addition to consumption (“using your house as an ATM”) and borrowing to avoid delinquencies on other debt, Canadians have been using HELOCs to fund mortgages in the shadow banking market and buy additional speculative properties—I call them weapons of mass destruction.
In an echo of the 1980’s-vintage Japanese practice of “Zaitech,” Daniels also noted in an Oct. 16 interview with MoneyGeek.com that “People in Canada have been borrowing against their home equity line of credit - to lend to subprime borrowers directly.” Indeed, this linked piece from the Toronto Globe and Mail provides a detailed roadmap for readers who wish to use their home equity for investment purposes, in service of “leveraging their real estate assets to increase their net worth.”
Back in June, executives at Home Capital Group, Inc. agreed to pay upward of C$30 million in settlements over alleged disclosure violations related to mortgage fraud in 2015. On Nov. 30, Reuters reported that “compliance officers at the Financial Services Commission of Ontario had evidence that syndicated mortgages were being marketed and sold in ways that broke the law . . . From 2011 to 2015, senior FSCO investigators rejected or ignored compliance officers’ multiple recommendations that the agency investigate or take action to rein in the marketing and sales of Fortress [Real Developments] syndicated mortgages.” Last week, Montreal-headquartered Laurentian Bank disclosed that it will need to buy back as much as $180 million of mortgages after discovering “documentation issues and client misrepresentations.”
François Desjardins, president and CEO of Laurentian, defended his bank: “We’re very different organizations and this is a very different situation than what happened at Home [Capital]. This, to us, is really a process and paperwork issue that we have to resolve.” This morning, Laurentian issued a follow-up press release stating that: “Given recent reports in the media, the Bank wants to clarify why it does not believe these matters are material to its business, capital, operations and funding.”
Daniels sees things differently, telling Grant’s that:
The mortgage inconsistencies reported at Laurentian Bank (the third major Canadian financial institution to fess up to this problem) underscores what we have long believed to be a systemic problem with Canadian underwriting practices.
Canada hasn’t seen a true credit cycle in nearly three decades, which warps the judgment of market participants and regulators alike.
Time for a refresher course?
Security guard
Shares in over-the-counter name The Crypto Company, which listed in May and traded below $20 as recently as Dec. 1, have gone on a parabolic run in the last ten days, currently fetching $642 a share. That gives the Malibu, Calif.-based business a market capitalization of $12.6 billion.
Valuing the Crypto Co. is somewhat difficult, as the only public filing on Edgar [the SEC website] is its securities offering document, in which it ticks the box “decline to disclose” under revenue range. The company’s website does note that it’s in the business of providing “institutions and individuals direct exposure to the growth of global blockchain developments.”
On that front, mission accomplished.
Recap Dec. 11
Santa Claus (rally) is coming to town: The bulls got a number of holiday treats today, with the S&P 500 cruising higher for a third straight session to log another record finish, while the VIX dropped below 9.30 to close within a few cents of the multi-year nadir logged on Nov. 3. Energy caught a bounce with WTI crude jumping back above $58/barrel, while gold dropped to its lowest since July at $1,248/ounce. Short rates resumed their upward push after a three day respite to close out last week, leaving the Treasury curve flatter.
- Philip Grant
Friday, December 8, 2017
Pik your battles
A follow-up on yesterday’s ADG
A follow-up on yesterday’s ADG
Chain, chain, chain
Is your bitcoin position burning a hole in your (virtual) pocket but fear missing out on more upside?
Is your bitcoin position burning a hole in your (virtual) pocket but fear missing out on more upside?
Macro and micro
In a Twitter bulletin this afternoon, Jeffrey Kleintop, chief global investment strategist at Charles Schwab & Co. writes
In a Twitter bulletin this afternoon, Jeffrey Kleintop, chief global investment strategist at Charles Schwab & Co. writes
Recap Dec. 8
Pik your battles
A follow-up on yesterday’s ADG on the resurgence in payment-in-kind bond structures (in which borrowers pay their lenders in extra debt instead of cash): McGraw-Hill Education, LLC, which attempted to price $250 million in PIK debt at a 9.5% yield, then a 10% yield, was forced to scrap the offering entirely amidst a lack of investor demand.
That ominous development has not translated to any evident concern from McGraw-Hill’s existing creditors. The company’s most actively traded existing senior unsecured issues, the 8 1/2s of 2019 and 7 7/8s of 2024 (both rated triple-C-plus and Caa1 by S&P and Moody’s, respectively) both remain above par as of this writing.
Chain, chain, chain
Is your bitcoin position burning a hole in your (virtual) pocket but fear missing out on more upside? Unchained Capital, Inc., a firm “led by startup veterans who are building the next generation of financial products for long-term holders of digital assets,” offers fiat-currency loans to those who wish to post their bitcoins as collateral. (Thanks to Benjamin Lavine, chief investment officer of 3D Asset Management, for passing this along.)
The company’s website entices potential customers: “Borrow up to $1,000,000 without a credit check.” Loans can range from three to 24 months terms, at annual rates ranging from 10% to 14% including fees. The company offers a relatively conservative (by traditional banking standards) 50% loan-to-value ratio. The borrower makes monthly payments.
As to the denominator of that loan-to-value calculation, the price of bitcoin is, of course, extremely volatile. Unchained states that if the price of the borrower’s collateral drops by 25%, the company will request additional collateral or principal repayment. In the event of a 45% decline in the loan collateral, Unchained reserves “the right to repossess your collateral and sell it to recover principal and any outstanding interest.”
Does Unchained use pledged coins to borrow funds for itself (i.e. re-hypothecate collateral)? No, CEO Joe Kelly told Grant’s. Unchained merely holds the collateral and borrowers can verify this via the blockchain. However, the imminent debut of bitcoin futures trading on the Chicago Mercantile Exchange could present opportunities for Unchained to get into the crypto-relending business and potentially offer more attractive interest rates to borrowers.
Grant’s also asked about the drawdown thresholds given that bitcoin has endured a number of sharp pullbacks, even during its parabolic ascent in 2017. Kelly advised us that any 25% decline would need to hold for at least 10 minutes (a lifetime in cryptocurrency trading), using the bitcoin reference rate that the CME will use on price futures, before Unchained would ask its borrowers for additional collateral. As for the more severe 45% drawdown scenario, Kelly had this to say:
A client would have been notified in the event of a 25% decline (on the way to 45%) and been asked to post collateral or pay-down principal. By the time the price got to 45% off the price at origination, we'd usually expect them to respond and post collateral. If we hit that 45% price threshold with no action from the client, the loan is technically in default and we would take the collateral and liquidate it.
45% drawdowns have occurred in bitcoin, they're just rare. We've used [bitcoin price data from 2013 to 2017] to inform our 50% loan-to-value ratio, as such a drawdown is rare and almost non-existent within a 90-day timeframe (our minimum loan period).
Macro and micro
In a Twitter bulletin this afternoon, Jeffrey Kleintop, chief global investment strategist at Charles Schwab & Co. writes: “For the 1st time in a decade the global economy has absorbed all of its excess capacity as it heads into 2018, per OECD data.”
Meanwhile, Barry Logan, senior vice president at air conditioning, heating and refrigeration equipment distributor Watsco, Inc., had this to say at the Credit Suisse industrials conference on Nov. 30:
But pretty huge inflation bias coming into 2018, we can see the OEMs being very aggressive with price, needing to be very aggressive with price and it's very good for us assuming that price remains in the market for next year, because as a distributor, we pass it through, our gross profit production increases, our fixed costs do not and it's really good for business.
Could the central banks of the developed world be finally on the cusp of getting their long-desired inflation? Be careful what you wish for.
Recap Dec. 8
Stocks caught a solid bid, pushing the S&P 500 back into positive territory for the week, while energy and the precious metals both managed to finish higher despite a stronger greenback. A third straight rally in the two-year Treasury note (the first three-day decline in the two-year yield since August) helped push the curve a bit steeper.
- Philip Grant
Thursday, December 7, 2017
Pik and choose
Pay-in-kind (PIK) toggles, a type of boomtime security in which the issuer has the option to pay its creditors not in cash,
Pay-in-kind (PIK) toggles, a type of boomtime security in which the issuer has the option to pay its creditors not in cash,
Risk on, and on
From today’s Toronto Globe and Mail:
From today’s Toronto Globe and Mail:
Recap Dec. 7
Pik and choose
Pay-in-kind (PIK) toggles, a type of boomtime security in which the issuer has the option to pay its creditors not in cash, but in additional bonds of the same nature, are coming back to the fore.
Today, publisher McGraw Hill Global Education Holdings, LLC priced a $250 million offering in five-year PIK toggle notes at a 10% coupon. On Nov. 16, privately held healthcare technology company Multiplan (a subsidiary of Polaris Intermediate Corp.) issued $1.3 billion in 8.5% PIK toggle notes priced at 99 cents on the dollar to yield 8.75% (they have since rallied to 104), the largest such deal since the financial crisis, according to S&P Global Market Intelligence. Moody’s, which rates the notes Caa2, noted in a Nov. 14 one-notch downgrade of Multiplan’s corporate family rating (citing "the company’s very high financial leverage, aggressive financial policies and significant customer concentration”) that the issuer plans to use the proceeds to pay its owners, led by private equity firm Hellman & Friedman, a $1.3 billion dividend.
While the Multiplan issue helped thrust PIK toggles back into the spotlight, the recent performance of these instruments has left little to be desired. On Tuesday, the Financial Times reported on the pay-in-kind resurgence, noting that PIK investors have fared quite well in 2016 and 2017:
PIK toggles have proven an alluring option as they paid a yield nearly twice as much as the average junk bond, according to data from ICE BofAML Indices. Portfolio managers willing to tolerate the risks of PIK toggle notes generated a total return of more than 20 per cent last year, beating the broader high-yield bond market. This year PIK toggles have returned 7.1 per cent, less than two-tenths of a percentage point behind high yield debt.
Grant’s asked “the dean of high yield debt,” author and investor Martin Fridson, for his assessment of the securities as compared to conventional high yield instruments. Fridson comments:
[The FT] said that PIK toggles yield twice as much as conventional high yield bonds. That’s true of the respective indexes, but the PIK’s are skewed toward very low-quality issues.
The option-adjusted spread versus Treasurys on PIK toggles is much greater than on the cash-pay high yield bonds (877 basis points versus 360 basis points, using the ICE BofAML Index system). That’s because 66% of the market value of PIK’s is rated triple-C or lower, versus 13% for cash pays. So it’s not the case that PIK’s are a great bargain, i.e., cheap relative to cash-pays.
As an indicator of market conditions, the superficial, kneejerk inference that the re-emergence of PIK toggles represents an anything-goes financing environment is actually the correct interpretation. My analysis found that covenant strength on new high yield bonds reached an all-time low in the third quarter. Bloomberg Intelligence, using a methodology different from mine, finds that high yield bonds are at their all-time richest valuation.
As mentioned above, PIK toggles are no newfangled gimmick. Back in the-then-raging high yield bull market of summer 1989, Grant’s published a fictional screenplay written by Seth Klarman, founder of the Baupost Group and author of “Margin of Safety” (June 23, 1989). Inspired by the film “Rainman,” which won an Academy Award for Best Picture that year, the Klarman-dreamt scene imagined a dialogue between “Raymond,” the idiot savant character and “Deal maker,” a stereotypical Wall Street type.
Deal maker: Listen, Raymond. How about Time-Warner? How can we maximize the value to Time’s shareholders?
Raymond: Free cash flow. Yeah, free cash flow. EBIT-D. EBIT-D. Earnings before interest, taxes and depreciation. Don’t pay taxes. Don’t spend depreciation. Yeah, don’t pay interest, either.
Deal maker: Don’t pay interest? We have to pay interest or the bonds will be in default.
Raymond: Pay in kind. Pay in kind. Zero coupon. Increasing rate. Free up cash. Free cash flow.
Deal maker: You’ve done it again, Raymond. We’ll pay the interest without using any cash. By the time we have to lay out a nickel of cash interest, we’ll have made 10 times our equity investment.
Raymond: I'm an excellent investor. An excellent investor.
An epilogue to that faux screenplay would come just over three months later. On Friday, Oct. 13, 1989, United Airlines parent UAL Corp. saw its planned $7 billion leveraged buyout collapse, ushering in the end of that 1980s junk bond bull market and a recession eight months later. The sequel is never as good as the original.
Risk on, and on
From today’s Toronto Globe and Mail: “A least 50 firms tied to blockchain and cryptocurrencies are set to list on Canadian stock exchanges in the next year, thanks in part to a junior market that's more comfortable with risk than other parts of the world, the head of securities firm GMP Capital, Inc. said.”
Recap Dec. 7
Stocks caught a modest bounce, with the S&P 500 now reverting to its more-routine 2017 form after a pair of sharp downward reversals to start the week. Treasury yields steepened amidst the first back-to-back rally in the two-year note since the end of October, and the VIX finished below 11 for the first time in more than a week.
- Philip Grant
Wednesday, December 6, 2017
Engine rev
In the 72 years since the conclusion of World War II, there have been 11 recessions, according to the National Bureau of Economic Research,
In the 72 years since the conclusion of World War II, there have been 11 recessions, according to the National Bureau of Economic Research,
Recap Dec. 6
Engine rev
In the 72 years since the conclusion of World War II, there have been 11 recessions, according to the National Bureau of Economic Research, or approximately one per every six-and-a-half years on average. Likewise, the post WWII epoch has featured 11 bear markets in stocks according to Yardeni Research, Inc., for the same six-and-a-half year average period between stock market declines in excess of 20%. Our current dual economic expansion will measure eight-and-a-half years on Dec. 31, yet evidence seems to imply that growth is accelerating.
Last Friday, the Wall Street Journal detailed a broad based hastening of activity in the shipping and trucking industries:
From seaports in Southern California to truck docks at Central Ohio warehouses, shipping across the U.S. is picking up at a pace that freight companies say they haven’t seen in several years . . . Freight volumes at the port of Los Angeles and Long Beach usually begin to slow as Black Friday nears, but [Shane VanDerWaag, director of intermodal services at the Dependable Cos., in Southern California] said his drivers remained as busy as ever . . . For the Port Authority of New York and New Jersey, October’s total cargo volume broke the record for the month.
The article also notes that the Cass Truckload Linehaul Index, which measures per-mile pricing for truckload carriers, jumped to a fresh all-time high in October on the strength of a meaty 5.5% year-over-year advance.
Cass Truckload Linehaul Index from 2011. Source: The Bloomberg
The suddenly brisk pace of commerce is not confined to the coasts. The Nov. 15 edition of the Minneapolis Star Tribune (thanks to Biff Robillard, president of Bannerstone Capital and paid-up Grant’s subscriber, for sharing this) noted that: “Iron ore shipments traveling from Minnesota across the Great Lakes – St. Lawrence Seaway are at the highest level they have been in a decade” with a 36% year-over-year jump in iron-ore shipments out of Duluth this year through September. The Baltic Dry Shipping Index, which has spent the post-crisis years in virtually constant descent (97% peak-to-trough) has more than doubled from February and is up nearly fivefold from its February 2016 nadir.
As a result, hard data (such as industrial production and durable goods orders) are catching up to survey and sentiment soundings, i.e., soft data, which surged post the Nov. 8, 2016 election. Bianco Research reports that hard data have since the end of October, exceeded consensus expectations at the highest rate since early 2014.
It’s not just economic data and bustling transportation pointing to a strong economy. Corporate profitability is likewise percolating. Domestic earnings via the index-adjusted S&P 500 EPS metric were up by 10.8% in the third quarter, and nearly 22% from their third quarter interim trough (recall that early 2016 was an unpleasant period for asset prices) to reach a fresh record high. According to Factset, 74% of S&P 500 companies have reported positive EPS surprises in the third quarter with 67% surprising to the upside on revenues. Factset likewise predicts the bountiful times will continue in the fourth quarter, forecasting a 10.5% year-over-year gain in EPS with all eleven S&P 500 sectors expected to report growth in the bottom line.
Companies are earning more, data are looking better, and activity is humming. Does that mean the bull market is set to continue? Not necessarily: The end of 2007 featured a surging Baltic Dry Index, a Fed Funds rate still well north of 4% and S&P 500 Index Adjusted EPS jumping by 46% in the three years ended in the third quarter of 2007.
These economic readings are coincident indicators and don’t tell us what will happen in 2018. Perhaps the tax reform bill will drive us further into financial Valhalla, or perhaps the Fed’s tightening regime (futures currently price in a 98% change of a rate hike at the Dec. 13 meeting) and acompanying rise in short term rates in tandem with flat or falling long term rates will lead to an inverted yield curve and spell the end of this charmed ascent. The cycle will turn eventually. Right?
Recap Dec. 6
A solid tech bounce (Nasdaq 100 Index up by 45 basis points, NYSE FAANG+ futures up more than 1%) failed to lift the broad S&P 500 beyond unchanged, while treasury yields ticked a bit lower across the board. A modest bid in the U.S. Dollar Index coincided with a third straight round of selling pressure in commodities to leave the CRB index lower by more than 3% for the week. Amidst a hack on bitcoin exchange NiceHash and subsequent theft of 4,000 coins worth more than $50 million, the dominant cryptocurrency rallied past $13,000 today and is up by 100% since the beginning of November.
- Philip Grant
Tuesday, December 5, 2017
Bond fun
It’s been remarkably easy sledding for the stock market of late.
It’s been remarkably easy sledding for the stock market of late.
Recap Dec. 5
Bond fun
It’s been remarkably easy sledding for the stock market of late. The S&P 500 has risen by 28% from the post-Nov. 8, 2016 election overnight lows, with the broad index absorbing just four single-day drops of over 1% in that period. In that context, the modest 6% decline in the NYSE FAANG+ futures contract since Nov. 29 and emphatic reversals of last two trading days seem all the more noteworthy.
The bond market has likewise faced a few hiccups recently, but for the senior portion of the capital markets, it’s been mostly smooth sailing. In the spirit of the Nov. 27 Grant’s podcast with Bill Fleckenstein, now follows a trio of Things You Don’t See at Market Bottoms.
Greek sovereign yields have dropped markedly following a successful debt swap conducted earlier this week and on the prospective approval of a third tranche of bailout funds from Eurogroup creditors. The Greek 10-year note now yields 4.81%, the first sub-5% yield since 2009, and down from 14% as recently as July 2015. Greece, which saw its sovereign rating upgraded to Caa2 (“judged to be speculative, of poor standing and are subject to very high credit risk”) from Caa3 by Moody’s in June, is looking to raise “at least 6 billion euros to create a cash buffer of 15 billion euros to secure 2019 financing needs,” according to Bloomberg.
Some institutional investors see compelling opportunity in the home of the first Olympic Games: Brevan Howard Asset Management is set to debut two new Greece-focused funds, with founding partner Trifon Natsis telling Bloomberg that: “We’re at a point where the tail risks have disappeared and the country is stabilizing at a low base. We anticipate a material uplift in the Greek economy and asset prices.”
Our old friend, Valeant Pharmaceuticals International, Inc. (Grant’s, March 10, 2014 among others) likewise continues to find fair weather in the credit market, managing to plance an upsized $1.5 billion offering of senior unsecured notes due in 2025 (up from the original $1 billion offer) with which to fund a tender offer for three separate bond issues maturing in 2020. Credit analysts at S&P rated the deal, which they deem leverage-neutral, at single-B-minus (“obligor currently has the capacity to meet its financial commitments”) with an estimated 10-30% recovery to lenders in the event of default. While noting Valeant’s “substantial scale and revenue diversity,” the ratings agency also cautions that amidst “the company's very high exposure to patent losses over the next two years . . .its product pipeline is insufficient to offset revenue and EBITDA declines in the next 12 to 18 months.”
The debt exchange may be leverage neutral, but Valeant itself is leverage-heavy. Against a bit more than $25 billion in net debt, Valeant is expected to generate $3.3 billion in adjusted 2018 EBITDA according to sell side analyst consensus, which equates to just over 7.5 turns of leverage. Trailing 12-month operating income of $810 million fails to cover even half of the $1.85 billion in interest expense. So far, so good, however: The bonds, priced at 98.611 cents on the dollar yesterday, have zipped above par to lasttrade at 100.5 for a yield-to-worst of 8.89%.
The final stop in our brief tour is the middle market, i.e. companies valued at $1 billion or less. Statistics compiled by PitchBook Data show that private equity transaction multiples on these middle market companies have jumped to an average of 10.7 times EBITDA, well above the 9.2 times reached in 2006 during the most recent deal-happy epoch. Likewise, the ratio of debt-to-EBITDA amongst these middle market deals has risen to 5.7 times, exceeding the 5.6 times logged in 2006.
Recap Dec. 5
An early, tech-led bounce in equity prices evaporated this afternoon, leaving the Nasdaq 100 unchanged and the S&P 500 down moderately at day’s end, while commodities suffered a second straight round of selling pressure with the CRB index falling another 65 basis points. Today’s round of Treasury curve flattening was driven mostly by strength on the long end, although the two-year yield ticked slightly higher to 1.82%., up sharply from the 1.26% seen less than three months ago.
Two-year yield since April. Source: The Bloomberg
- Philip Grant
Monday, December 4, 2017
Beanie babies redux
First came bitcoin, then came ICO’s, now comes:
First came bitcoin, then came ICO’s, now comes:
Red sea
Rising short term interest rates (almost) the world over have been one defining characteristic of financial 2017.
Rising short term interest rates (almost) the world over have been one defining characteristic of financial 2017.
Recap Dec. 4
Beanie babies redux
First came bitcoin, then came ICO’s, now comes: Cryptokitties, an ethereum-based game in which users spend real money to “buy, sell, and breed cartoon kittens.” Launched just last week, the game already represents 20% of all computations on the ethereum network. So far, the top-selling cryptokitty fetched just under 247 ethereum tokens, worth $117,712 at the time of purchase.
Grant’s contacted Zac Bissonnette, author of “The Great Beanie Baby Bubble” and paid-up subscriber, for his professional opinion on this bourgeoning digital collectible craze.
Cryptocurrencies have vastly more in common with collectibles than with investments.
There’s no utilitarian value, they don’t generate cash flows, and their value is entirely dependent on artificial scarcity—like baseball cards, Thomas Kinkade prints, comic books, etc.—all of which are categories with exceptionally poor long-term track records. Crypto kitties are a nice way of demonstrating the similarity: Once you attach cryptocurrencies to pictures of cute animals, you realize it’s a lot like a plush toy.
Red sea
Rising short term interest rates (almost) the world over have been one defining characteristic of financial 2017. For instance: The yield on China’s five-year sovereign bond, which traded as low as 2.41% in October 2016, briefly topped 4% last week, and has since recovered a bit to 3.91%. As is the case in the U.S., relative weakness in shorter-duration bonds has flattened the yield curve. China’s 10-year note yields a virtually identical 3.93%.
With that potentially significant rates action as a backdrop, a Reuters investigative piece published this morning serves as fair warning (not the first) to investors that China’s property-and-leverage-heavy financial system may be standing on shaky ground. Detailing an early 2016 apartment sale in the southern city of Shenzhen that fraudulently featured three separate purchase agreements, one for the bank with an inflated home value, one for the taxman with an understated home value, and a third, “real” document (the swindle was unveiled in court but no party was punished). Reuters asserted that the practice was far from uncommon, while noting the potential for far broader implications:
Mortgage fraud like the pair’s flouting of rules designed to protect banks is rampant in China’s roaring property market, according to interviews with buyers, sellers, and dozens of property market insiders including real estate agents, lawyers, bankers, valuers and loan middlemen from three of China’s major cities and four smaller cities. Many of these people declined to be identified because they were familiar with or involved in “re-packed” loan applications, the industry euphemism for these frauds.
“When everyone is doing it, you can’t put everyone in jail,” says [Hu Weigang, a senior partner at Guangdong Shen Dadi Law Firm], who specializes in real estate litigation.
While property prices in China continue to rise, mortgage fraud remains largely a hidden danger, much as subprime loans in the United States remained mostly out of sight ahead of the 2008 global financial crisis. The fear is that in a property correction, fraudulent mortgages would unravel, accelerating a collapse of housing prices in the world’s second biggest economy. This, in turn, would imperil China’s debt-laden financial system.
Writing in the Financial Times today, Chen Zhao, chief global strategist of Alpine Macro, offers a dissenting view to the opinion (held by Grant’s among others) that China is an economic disaster waiting to happen. Zhao argues that a high debt-to-GDP ratio, instead of signaling potential instability, is actually a function of high savings rates, which necessitate credit creation to transform savings into investment. Speaking of China in particular, Zhao writes:
Looking around the world, the levels of interest rates for different countries are negatively correlated with levels of total indebtedness. Countries that have borrowed aggressively – such as Japan, China and Singapore, have very low or zero interest rates.
China has a chronic current account surplus and has been a net creditor to the rest of the world for decades. Beijing’s outstanding public sector, valued at $4 trillion, is dwarfed by the vast assets controlled by the various levels of governments. Therefore, China’s sovereign risk is extremely low. Importantly, the balance sheets of the Chinese state-owned banks, the government and the People’s Bank of China are all interconnected. Under these circumstances, a debt crisis in China is almost impossible.
A high debt-to-GDP ratio may or may not portend trouble on its own, but China’s explosive credit growth has caused Victor Shih, associate professor of political economy at The University of California, San Diego, to sound the alarm. In a study entitled “Financial Instability in China: Potential Pathways and their Likelihood,” Shih invokes a provocative comparison to describe the Middle Kingdom’s increasing reliance on leverage:
China as a whole is a Ponzi unit. Total interest payments from June of 2016 to June of 2017 exceeded incremental increase in nominal GDP by roughly 8 trillion RMB. [$1.2 trillion]
This was not always the case . . . prior to 2011 incremental nominal GDP roughly matched or even exceeded interest payments.
The advent of high-yielding shadow banking led to the explosive growth in interest payments, and thus the need to capitalize interest payments, starting in 2012.
To be sure, the Chinese government has succeeded in avoiding the bursting of the asset bubble, but this has been achieved by a greater degree of leveraging.
This afternoon, Shih hopped on Twitter to respond to the Reuters mortgage story, commenting that: “That’s not fraud in China. That’s how every borrower, starting from the government, obtains loans in China.”
Recap Dec. 4
Stocks gapped to new highs at the open but then promptly ran out of steam, with the broad S&P 500 rolling back toward unchanged by the close and the Nasdaq 100 finishing weaker by more than 1% while the VIX finished at its highs of the day just below 12. More upward pressure in short-term Treasury yields pushed the curve flatter, while the CRB commodity index shed more than 1%. Twitter user SentimenTrader has our fact of the day: “The last time the S&P 500 futures gapped up [more than] 0.5% and traded to a multi-year high before reversing to close negative on the day was Jan. 3, 2000.”
- Philip Grant
Friday, December 1, 2017
Meet the new boss
Undoubtedly thanks to its white-knuckle price action and yuge rally of late, bitcoin has for the first time passed Donald Trump in Google search requests,
Undoubtedly thanks to its white-knuckle price action and yuge rally of late, bitcoin has for the first time passed Donald Trump in Google search requests,
Energy saver
What if the supply glut that has bedeviled energy markets since 2014 is less severe than commonly believed?
What if the supply glut that has bedeviled energy markets since 2014 is less severe than commonly believed?
Weapons of Mass Perfidy
Caixin Magazine reports yesterday that China Mingsheng bank,
Caixin Magazine reports yesterday that China Mingsheng bank,
Recap Dec. 1
Meet the new boss
Undoubtedly thanks to its white-knuckle price action and yuge rally of late, bitcoin has for the first time passed Donald Trump in Google search requests, according to the site’s analytics division and relayed by Business Insider. That breakthrough may be short-lived in light of today’s news regarding Michael Flynn’s guilty plea in the Robert Mueller probe investigation, but we wonder about the President’s response to being upstaged by crypto-mania.
Jim has a guess: “Fake currency!”
Energy saver
What if the supply glut that has bedeviled energy markets since 2014 is less severe than commonly believed? That central question was placed under the spotlight by researchers at the Massachusetts Institute of Technology. The Energy Information Administration, they argue, has overshot its future production forecasts by attributing technological advances to recent output increases, rather than producers first drilling their most productive acreage due to the low price of oil. Bloomberg has the details:
“The EIA is assuming that productivity of individual wells will continue to rise as a result of improvements in technology,” said Justin B. Montgomery, a researcher at the Massachusetts Institute of Technology and one of the study’s authors. “This compounds year after year, like interest, so the further out in the future the wells are drilled, the more that they are being overestimated.”
Margaret Coleman, the EIA’s leader of oil, gas and biofuels exploration and production analysis, said in an email “the study raises valid points” and the administration is looking to give its estimates a tighter focus.
While government supply forecasts come under scrutiny, the current rate of production decline looks to be much faster than widely understood, if a recent analysis from the Boston Consulting Group’s Jamie Webster is on the beam. Webster explained his thesis in the Petroleum Economist on Nov. 16:
Decline rates shrank in the initial phases of the price slump, as companies sought to keep existing production as high as possible by streamlining maintenance and focusing capital. Offsetting a field’s or well’s decline is, after all, often the cheapest barrel a company can bring to market. It was a way producers battened down the hatches to try to [outlast] what was at first thought to be short-lived price weakness.
As the notion that prices would stay “lower for longer” took hold, those temporary effects were undercut by the sharp drop in capex. The result was an increase in the decline rate. Rystad [Energy] estimated that 2016 had the highest decline rate of the past 25 years. It’s likely to get worse, too, as the recent deep spending cuts steepen the decline curve for the next two years. Furthermore, we can expect a long-term structural increase in the decline rate, simply because – in the absence of many new fields being developed – the average age of the producing ones is now trending upward. In 2017, we assessed the decline rate at 9+%, equating to about 8.8m [barrels a day]. That’s five times greater than the demand increment for 2017.
The questions over the prospects of domestic output growth come following yesterday’s agreement by the Organization for Petroleum Exporting Countries, along with Russia, to maintain their previously agreed upon supply cuts - which were scheduled to expire in March - through the end of 2018.
Things may likewise be (finally) looking up for the drillers if a recent transaction between Transocean (NYSE: RIG) and DEA Norge in the North Sea for work beginning in mid-2019 is any indication. According to analysts at Johnson Rice, the implied day rate for the contract came to $200,000, well above the existing contracted day rate of $180,000 for a North Sea contract on the rig, which runs through February of 2018.
The price of oil has made a furtive rebound, with West Texas Intermediate crude trading towards the upper end of its two-year trading range near $58 per barrel. WTI remains far below its 2010-2014 average of $91 per barrel, however. Grant’s, which has proffered a kind word for the prospects of Texas Tea and an array of associated securities on a few recent occasions (Nov. 3: “Not the FANGs,” March 10: “Laddered oil play” and March 25, 2016: “Investment value – ‘on,’” among others), continues to expect good things from the energy patch.
Weapons of Mass Perfidy
Caixin Magazine reports yesterday that China Mingsheng bank, the Middle Kingdom’s largest privately held financial institution, was fined RMB 27.5 million ($4.2 million) earlier this year by the local regulator for misadventures in its sale of wealth management products. The specific gripe? That Mingsheng sold WMPs that don’t exist.
Minsheng confirmed in late April that the fraud involved more than 150 customers who bought non-existent wealth management products worth about 1.65 billion yuan. Minsheng said it has since repaid clients for their losses.
Glad we solved that. All’s well that ends well.
Recap Dec. 1
Stocks recovered the bulk of steep late-morning losses on news of a possible Michael Flynn plea deal, with the S&P 500 finishing modestly in the red to maintain solid gains for the week. The bond market seemed to show a bit more concern, as high yield corporate ETFs underperformed equities and outsize strength at the long end of the Treasury curve left the spread between the five year note and 30 year bond below 65 basis points, for another low for the cycle. Solid strength in the energy complex pushed WTI crude back above $58, in range of the 52-week highs logged last week.
- Philip Grant
Thursday, November 30, 2017
Prognosis negative
For all the peculiar price contortions that have characterized our post-crisis financial world,
For all the peculiar price contortions that have characterized our post-crisis financial world,
Recap Nov. 30
Prognosis negative
For all the peculiar price contortions that have characterized our post-crisis financial world, perhaps no region features the concentration of macroeconomic oddities more than Europe’s Nordic realm. A closer look at the state of play in the land of Hamlet, and its neighbor to the northeast, now follows.
The Kingdom of Sweden, currently featuring an overnight lending rate of negative 0.50% (below the ECB’s minus 0.40% repurchase rate), appears to be in no hurry to drag its borrowing costs back from the monetary upside-down. A Nov. 21 Bloomberg dispatch quotes asset manager SEB as commenting that the Riksbank (Sweden’s central bank), “has continued to signal that high growth, an increasingly hot labor market and inflation close to target do not justify any interest rate hike soon.” Indeed, Swedish real GDP grew by 2.9% year-over-year in the third quarter. Yearly GDP growth has remained at or above 1.8% in each quarterly period since late 2013. CPI inflation is likewise awakening, with an average year-on-year growth of 1.8% in 2017 so far, compared to an average 1% advance last year and just under 0% in 2015.
The consequences of this seemingly glaring misalignment have been most evident in a gangbusters housing market. The Eurostat Swedish House Price Index grew by 8.6% year-over-year in the second quarter, the 15th straight quarter that featured an appreciation of at least 6.5%. Going back to the end of 1999, Statistics Sweden tabulates that the average home price has tacked on some 260%, or roughly 8% annualized, with near-constant appreciation only briefly interrupted by the 2008 global financial crisis. That compares to a 71.5% rise in the Federal Housing Finance Agency’s U.S. House Price Index since the turn of the century. The action in Stockholm has been particularly acute, as demonstrated by Nordea Bank’s Andreas Wallstom, who shared this chart going back to the late 19th century.
Instead of tightening monetary policy the Riksbank has responded by asking Sweden’s financial regulator (the FSA) to tighten mortgage rules, including a loan-to-value cap of 85%, stricter amortization requirements and higher rates for home buyers who borrow more than 450% of their gross income, measures to which the government agreed today. “It is . . . important to implement measures within housing and tax policies to increase the resilience of the household sector and reduce the risks” said the Riksbank in a statement quoted by Reuters on Nov. 22. The average sale price of a Swedish home currently amounts to 8.4 times per-capita income, compared to 4.4 times in the U.S.
Now to Denmark, the triple-A-rated European nation which first crossed the negative-rate-Rubicon back in 2012, a full two years before the ECB, and currently keeps its benchmark deposit rate at negative 0.65% (more than 600 basis points below its 2008-2009 interim high) despite, all together now, accelerating CPI inflation (1.2% year-on-year through 2017 on average, compared to an average of 0.3% last year and 0.5% in 2015). Forestalling unwanted currency appreciation is the goal, and to that end the Danes keep their krone pegged to the euro, although the Danmarks Nationalbank, Denmark’s central bank, abandoned a hard peg earlier this year following the Swiss National Bank’s surprise 2015 devaluation (it now uses a 2.5 percent band around its prior 7.46038 per euro line-in-the-sand).
Such policies of course have consequences, both seen and unseen. In the former category, a Nov. 27 Bloomberg report notes that the Danish Chamber of Commerce estimates that instead of interest income, the country’s banks bear annual interest cost of 437 krone ($70 million) at the current rate. Steen Bocian, chief economist of the Chamber of Commerce, commented that: “Negative rates are unfortunately costing companies on the capital front. And that’s holding investments back.”
What negative rates are most certainly not holding back is Denmark’s stock market. Over the last five years, the market-cap-weighted OMX Copenhagen 20 Index has rallied by 103%, easily topping the S&P 500’s 85% advance. So, too, have the Danes piled on the debt, as one might do when paid to borrow. According to the OECD, Denmark’s ratio of household borrowings-to-disposable income stood at 290% at year-end 2016, by far the highest among the 33 developed nations surveyed ( the Netherlands, Norway and Iceland come in second, third and fourth, respectively).
The surplus of leverage is not confined to Danish households. Earlier this week came word that twice-yearly stress tests showed “a few” (we don’t know which) of Denmark’s largest banks falling short of capital buffer requirements in a recession scenario, while those that do meet the grade do so only barely. Nationalbank chairman Lars Rohde likewise added in a statement that: “Several banks are stepping on the accelerator by easing credit standards and granting loans to more vulnerable customers.”
In an Aug. 10, 2012 analysis (“Port of Copenhagen”) that shortly followed the Danes’ initial foray into negative rates, Grant’s took inventory of the unusual situation while pointing out the highly leveraged nature of Danske Bank, the country’s largest financial institution. Speaking of a hypothetical short-sale of negative-yielding three-year Danish government bonds, Deputy Editor Evan Lorenz noted that the short-sellers’ normal obligation to pay the interest coupon would be, in this case, reversed. Lorenz continued:
If rates remained the same, you, the short seller, would come out just slightly ahead. But you could do much better if the world swung around to the view that Denmark, for all its virtues, is a tiny country with a big printing press, a highly leveraged super bank, a collapsed yield curve and a still precarious real estate situation.
The Denmark sovereign 0.25%s of 2020, which were issued earlier this year at 102.085 on the krone, currently trade a few ticks above that level for a yield-to-maturity of negative 0.539%. Paid to wait, indeed.
Recap Nov. 30
Another strong bid for U.S. equities left the S&P 500 higher by nearly 2% this week so far, despite a mixed showing from the FAANG contingent (Google and Netflix finished a bit lower) after yesterday’s pronounced tech sell-off. Commodities finished little changed outside of a sliding gold price (now around $1,275/ounce), and Treasury yields rose across the board.
- Philip Grant
Tuesday, November 28, 2017
Price is might
Let’s take a brisk tour of the most exciting, confounding, lucrative and, yes, dangerous financial realm in recent memory:
Let’s take a brisk tour of the most exciting, confounding, lucrative and, yes, dangerous financial realm in recent memory:
Recap Nov. 28
Price is might
Let’s take a brisk tour of the most exciting, confounding, lucrative and, yes, dangerous financial realm in recent memory: Bitcoin and its fellow crytocurrencies. Bitcoin, which fetched about $963 per unit on Jan. 1, changed hands at around $10,044 in mid-afternoon, good for a 944% return year-to-date. Over a five year period, its price has advanced by approximately 85,000%.
As might be expected, the digital store of value’s meteoric rise is leading to no shortage of interesting behaviors and remarks from market participants.
Elon Musk, CEO of Tesla, Inc. and SpaceX, was moved yesterday to debunk a blog post theorizing that he is in fact the mysterious Satoshi Nakamoto, the pseudonym of the still-anonymous creator of bitcoin’s source code. Meanwhile, cryto-ficionados looking to score some digital ducats have come up with an innovative solution: Using Musk’s own Tesla charging stations to mine for them. EcoMotoringNews explains:
Some creative Tesla owners came up with a way to make a few [thousand? – ed.] bucks from their parked EVs: Cryptocurrency mining.
One member of the Tesla Owners Worldwide [group] on Facebook suggested the idea, possibly in jest. Then another owner went ahead and did it, posting a photo of his setup. Some members suggested that his setup could pull as much as 3 kilowatts of power and would probably require the vehicle’s air conditioning to be on for cooling.
Last week, when the price of bitcoin still hovered near $8,000, crypto bulls caught an unwelcome surprise from the operators of a smaller e-currency called Tether (for more see the Sept. 8 Grant’s, “Crypto 36,000” and its subsection, “Tethered to What?”). Tether, which claims a one-for-one backing with U.S. dollars, announced that some $31 million worth had been stolen by hackers, and that it would not redeem the coins. A Nov. 21 piece in the New York Times noted that the operators of Tether and the largest bitcoin exchange known as Bitfinex are one and the same, and went on to mention some other curious details about the incident:
Tether and Bitfinex have insisted that the two operations are separate. But leaked documents known as the Paradise Papers, which were made public this month, show that Appleby, an offshore law firm, helped Mr. Potter and Mr. Devasini, the Bitfinex operators, set up Tether in the British Virgin Islands in late 2014.
One persistent online critic, going by the screen name Bitfinex’ed, has written several very detailed essays on Medium arguing that Bitfinex appears to be creating tether coins out of thin air and then using them to buy Bitcoin and push the price up.
Tether and Bitfinex have countered this criticism in statements on the companies’ websites and promised that every Tether is backed up by a dollar sitting in a bank account. In September, the companies provided an accounting document intended to prove that Tether is financed with real money.
Lewis Cohen, a lawyer at the law firm Hogan Lovells who advises many virtual currency projects, said the document, because of the careful way it was phrased, did not prove that the Tether coins are backed by dollars.
Among the cohort of crypto True Believers, perhaps none boasts the stature and track record of Murray Stahl, co-founder and chief investment officer of Horizon Kinetics. In a recent interview with Barron’s, Stahl was coaxed into providing his assessment of bitcoin’s potential value. To say the least, if he is on the beam, today’s levels will represent a screaming bargain.
Barron's : How high can the price go?
Stahl: I've got a value, but it is so preposterous I wouldn't tell anybody, because it is much higher than today's price; it would be meaningless to anybody. I think it is worth much, much more than what today's price is. I won't tell you a number. I'll tell you how I get to a number. So, basically the premise is that bitcoin or some cryptocurrency is accepted as a means of the exchange. Let's say that premise proves to be valid. Well then, because it is a worldwide currency it is valued by a law of no arbitrage. It has to be equal to the nominal value of all the fiat currencies in the world. At least that, maybe even more because it is non-inflationary.
Barron's : So is your price target the value of all fiat currency in the world?
Stahl: Yes, whatever that number is.
Barron’s went on to cite an estimate by The Money Project pegging the total value of the world’s fiat currency wealth at $7.6 trillion, which would make each bitcoin worth $361,000.
Needless to say, not everyone shares Stahl’s opinion. John C. Bogle, progenitor of the Vanguard Group, minced no words this afternoon at the Council for Foreign Relations, according to Bloomberg: “Avoid bitcoin like the plague. Did I make myself clear?”
Finally, a Nov. 20 Bloomberg dispatch titled “A Bitcoin Bubble? Here’s The Bet It’ll Survive the Apocalypse” details the increasing popularity of cryptocurrencies among so-called doomsday preppers.
Across the North American countryside, preppers . . . are storing more and more of their wealth in invisible wallets in cyberspace instead of stockpiling gold bars and coins in their bunkers and basement safes.
That one elicited an enthusiastic rebuttal from investor Bill Fleckenstein on the most recent Grant’s podcast:
When you can overcome the intellectual hurdle of the fact that the amount of bitcoin is supposed to be limited, but the amount of potential forks (i.e. a split of one cryptocurrency into two or more smaller ones) is unlimited and the amount of potential alternative cryptocurrencies is infinite. Oh by the way, the blockchain is what most people yap about, but yet, you don’t own it [when you buy a crypto], I submit that if you can overlook all those things . . . why can’t you overlook the fact that you need electricity in an apocalypse and you wouldn’t have any, that’s just a simple inconvenience.
Crypto is certainly one of the defining characteristics of this cycle. As for its prospects, place your bets accordingly. Or don’t.
Recap Nov. 28
Another North Korean missile launch briefly interrupted the latest rally in stocks, before the bull march resumed in force to leave the S&P green by about 1% at day’s end to mark
- Philip Grant
Monday, November 27, 2017
Rich get richer
An update on the century bonds issued by the (99-year old) Republic of Austria
An update on the century bonds issued by the (99-year old) Republic of Austria
Tractor pull
No salmon for this bear.
No salmon for this bear.
Recap Nov. 27
Rich get richer
An update on the century bonds issued by the (99-year-old) Republic of Austria in September at a 2.1% coupon (Almost Daily Grant’s, Sept. 13): Initially priced at around 99.5 cents on the euro, the bond has since enjoyed a brisk rally, last changing hands above 108.5 cents on the euro for a yield-to-worst of 1.906%. Meanwhile, October inflation via the Austrian CPI index ticked to 2.2% year-over-year, the third straight reading above 2%. Prior to this year, Austrian CPI had not breached 2% since July of 2013.
Tractor pull
No salmon for this bear. Deere & Co., (DE on the NYSE) a Grant’s pick-not-to-click since the early spring of 2016, delivered gangbusters fourth quarter results on Wednesday, easily topping analyst expectations for the quarter and full year 2017 (Deere’s fiscal year ends on Oct. 31). Forty-six percent and 87% year-on-year jumps in operating profit for its Ag & Turf and Construction & Machinery units, respectively, were among the highlights for fiscal 2017, while the company further buoyed investor sentiment by forecasting more good times in 2018.
Management’s guidance for next year features a further 22% uptick in equipment sales, driving a forecast of $2.6 billion in net income. That would represent a 19% increase from its 2017 bottom line, and sits well above analyst consensus of $2.3 billion. The stock price has reacted in tandem to these gaudy figures, with shares up by a princely 44% year-to-date and 79% since an initial March 11, 2016 analysis in Grant’s (“Borrow to Plow”) to reach new all time highs. The results were enough to turn some skeptics into believers. Deutsche Bank’s Nicole DeBlase upgraded the stock to buy from neutral on Friday, writing that: “We see a clear path to outperformance from here . . . we have gained conviction that demand has bottomed.”
With crop prices in a deep freeze since their 2013 highs and farm incomes likewise moribund, no small part of Deere’s recent success has been the virtually spotless performance of its in-house financial services arm.
Not all time highs: The Kansas City Fed Farm Income Index. Source: The Bloomberg
The unit contributed $477 million in net income in fiscal 2017 (just over 22% of Deere’s aggregate bottom line), with management forecasting an 8% uptick to $515 million in net income from its financing activities in 2018. Loan quality appears strong. We can only say “appears” because the company provided no loan performance data on the press release or conference call. Investors will have to wait for the form 10-K which should be out in mid-December. Joshua Jepsen, investor communications manager, noted on the earnings call that the provision for credit losses stood at 24 basis points at the end of the fiscal year, and forecast that number will tick to 25 basis points in 2018. Jepsen cited “lower losses on lease residual values” as the primary tailwind for the lending business.
The steady upward march of those residual values (what a piece of leased equipment is worth at the end of the lease term) has been a source of concern for the bears. In an April 8, 2016 follow-up (“Dialing for Dollars”), Grant’s wrote:
Note that the residual value must be determined as the lease is signed . . . The higher the estimated value, the easier it is for the lessor-farmer (a higher residual value means lower monthly payment) and the riskier it becomes for Deere.
Used-equipment prices dropped by 32% between the first quarter 2013 and the fourth quarter 2015. Has Deere not reflected that decline in the residual values it assigns, and has assigned, to its operating leases? [Deputy Editor Evan] Lorenz put the question to Deere. There was to be a telephone call to discuss it. At the last minute, the company cancelled the call, just as it had done on the verge of a call we had scheduled a couple of weeks earlier.
One dealer in Kansas did, in fact, report that Deere is raising residual values on some of its leases. “Is there a concern, that with all this stuff going on lease, that in two or three years’ time you might have all this stuff coming back used,” Lorenz asked him. “Not as a dealer,” the man replied. “No, that is going to be Deere’s problem. Once it leaves here it is John Deere Capital’s combine, sprayer, whatever.”
Jay Van Sciver, industrials analyst and managing director at Hedgeye Risk Management, took a dim view of Deere’s upsized fiscal 2018 guidance. Van Sciver argues that the company is basing its future assumptions on a recent flurry of demand ahead of potential tax reform, which would increase the real cost of equipment.
We suspect Deere is extrapolating a pull forward of demand from tax reform to get an expectation of sales growth on down crop receipts. By applying generous incremental margins and optimistic [selling, administrative and general expense] assumptions, Deere was able to give guidance ahead of expectations. We expect Deere to take down guidance during the year, as demand tracks weaker farm fundamentals.
We at Grant’s, duly chastened by our early/wrong verdict on Deere shares, continue to expect trouble down the pike.
Recap Nov. 27
Stocks finished little changed despite a notable downtick in high yield bonds, while the Treasury curve managed to finish a tick steeper. A mid-day bounce in the Dollar Index off two month lows coincided with a pullback in energy prices, as WTI crude backed off from the more than 2.5 year highs near $59/barrel reached on Friday.
- Philip Grant
Tuesday, November 21, 2017
Almost Daily Variety Pack
A trio of bearish Grant’s calls have recently stumbled. We briefly return, free of self-congratulation, to each with an update.
A trio of bearish Grant’s calls have recently stumbled. We briefly return, free of self-congratulation, to each with an update.
Bone broth
On second thought
No refunds
Recap Nov. 21
Almost Daily Variety Pack
A trio of bearish Grant’s calls have recently stumbled. We briefly return, free of self-congratulation, to each with an update.
Bone broth
Campbell Soup Co.’s (CPB on the NYSE) first quarter results were thin gruel to shareholders: Weaker than expected sales and a surprise 220 basis point contraction in gross margin were among the lowlights. As a result, management issued the second consecutive cut to its fiscal 2018 adjusted earnings per share guidance.
Analysts at Bernstein Research appear to have identified one source of the company’s travails: The extremely price-sensitive grocers who are fighting a battle of attrition amidst the encroachment of cut-throat German competitors Aldi and Lidl (for more see Grant’s, March 24). Analyst Alexia Howard writes today that: “Overall, this result underlines the level of disruption occurring across the space as certain retailers put pressure on suppliers to step up promotional spending at the center of the store.”
Campbell’s, which was the subject of a bearish Grant’s analysis just under two years ago, is certainly on a valuation diet (March 25, 2016). After a 32% stock price decline over the past 16 months, CPB shares are priced at about 15 times management’s new 2018 adjusted EPS forecast and sport a 3% dividend yield. The balance sheet is serviceable (Moody’s bestows a long term rating of A3, S&P at triple-B-plus). No soup for you.
On second thought
What happens when a roll-up comes un-rolled? Usually not good things for shareholders. The recent troubles at Altice N.V. serves as the latest example. The encumbered and complex European telecom, a target of bearish commentary at Grant’s (Oct. 2, 2015) and ADG (Nov. 6, and June 22), has seen its share price fall to three and a half year lows to around €8 from north of €30 in 2015.
The company issued a press release on Sunday evening titled, “Altice responds to Recent Market Speculation and Misinformation.” Bears, take note: The company has no plans to issue equity, majority shareholder Next Alt S.a.r.l. has no Altice-related margin loans, and the balance sheet will improve through future asset sales.
While equity-holders are panicking, Altice bondholders exhibit Zen-like calm: All of its outstanding issues trade north of 98 cents on the dollar and the majority are above par. On Nov. 3, the company reported third quarter results, featuring a 1.8% year-over-year revenue decline and a 1.8% year-over-year advance in adjusted EBITDA. Against some €49 billion in net debt, Altice generated €92 million in free cash flow in 2016. The street is currently expecting FCF generation of €947 million this year and €2.25 billion in 2018, although future asset sales could impact those estimates.
No refunds
Akron (Ohio)-based baubles merchant cum credit extender Signet Jewelers Ltd. (SIG on the NYSE) is having a brutal day, with shares down by more than 30% (Grant’s June 3, 2016) after reporting that same store sales fell 5% year-over-year in the three months ending Oct. 28. Management would like you to know, however, that 1.2% of the drop was due to “weather-related incidents and systems and process disruptions associated with outsourcing of the credit portfolio.”
As for the credit disruptions, Signet reorganized its lending business in May. Loans to prime customers were sold to Alliance Data Systems Corporation and ADS will underwrite Signet’s best customers going forward. Finding no buyers for its subprime book, Signet retained its less credit-worthy customers. However, Signet did find a solution for customers even it finds too dodgy to underwrite: Aarons, Inc., through its Progressive Lending Subsidiary, will henceforth fund the company’s sub-subprime borrowers (for more on Aaron’s, see the issue of Grant’s dated June 30).
Zander Rosenbluth, research analyst at Lone Star Value Management, LLC, took a dim view of the credit outsourcing disruption explanation in particular, commenting to Grant’s that:
Given management had to shave nearly 15% off EPS guidance primarily due to ‘greater than anticipated disruptions’ with the prime receivables transaction, it will be very interesting to see what kind of ‘disruptions’ occur when Signet finally sells the portfolio of subprime receivables. Not to mention, the Company plans to switch to contractual accounting [from its current “recency accounting” standard] during Q4. This wasn’t mentioned once by management or analysts this morning.
Rosenbluth also noted that Signet’s seasonal performance trends bode ill for its prospects of meeting its lowered earnings forecast:
In a strange way, management’s new guidance is even more aggressive than their previous guidance. Signet will now have to earn about 66% of their annual EPS during Q4 to meet the midpoint of their new guidance. Prior to this morning’s profit warning, that number was 62%. Historically, SIG has earned 53-54% during Q4.
Recap Nov. 21
Stocks raced higher at the open before settling into cruise-control, leaving the S&P 500 at a fresh closing high at day’s end just below 2,600. The major index is up by just over 16% year-to-date. Both energy and the precious metals caught a bid, while Treasurys continued their outsize flattening with the spread between the two and 10-year notes compressing to less than 59 basis points compared to just under 100 basis points in early June.
- Philip Grant
Monday, November 20, 2017
Cereal acquirer
Fourth quarter results from St. Louis-headquartered food manufacturer Post Holdings, Inc., could be described as a little soggy,
Fourth quarter results from St. Louis-headquartered food manufacturer Post Holdings, Inc., could be described as a little soggy,
Recap Nov. 20
Cereal acquirer
Fourth quarter results from St. Louis-headquartered food manufacturer Post Holdings, Inc., could be described as a little soggy, as the company reported weaker than expected adjusted earnings per share ($0.88 against consensus of $0.92), and introduced fiscal year 2018 adjusted EBITDA guidance of $1.16 billion (using the midpoint of management’s range) vs consensus of $1.18 billion. Pro forma for the Weetabix Ltd. acquisition, sales increased 1.4% year-over-year in the fourth quarter.
Post took a non-cash goodwill impairment charge of $26.5 million resulting “from a reassessment of long-term expectations” for its Dymatize Nutrition unit, which the company acquired in 2014 for $380 million in cash. CEO Robert V. Vitale noted on the conference call that Dymatize “is stable but at a level not supporting our initial investment.” That spurred a modest selloff in its shares, which are virtually unchanged year-to-date but still up by a handsome 153% from their October 2014 interim lows.
As a group, Wall Street analysts remain bulled up on the deal-happy concern, with six buy ratings, two holds and zero sells. Pivotal Research analyst Timothy S. Ramey wrote on Friday that: “At 10.1 times 2018 enterprise value/EBITDA [Post] remains cheap relative to peers with growth that is far better than its peers. With takeover premiums in the segment advancing, Post remains a compelling value. The Weetabix deal [Almost Daily Grant’s, Aug. 7] and now Bob Evans Farms, Inc. [Almost Daily Grant’s, Sept. 19] recharges the opportunity bank for Post with fresh cost savings and revenue growth optionality.”
Post’s rationale for expanding beyond its legacy cereals business is certainly understandable. The company noted that net sales in its consumer brand division fell by 2.9% year-over-year in the fourth quarter. That is no fluke. Research firm IBISWorld calculates that the industrywide sales in the domestic cereal business have contracted by 16.5% between 2009 and 2016.
However, the deals that Ramey references (for which Post paid just under 13 times and just over 14 times trailing EBITDA, respectively) further enlarge the company’s aggressive capital structure. Against net debt of $5.65 billion, Post has generated $943 million in trailing-12 month adjusted EBITDA, or just under 6 turns of leverage (and just under 5 turns based on the $1.16 billion adjusted EBITDA forecast for 2018), while interest expense of $315 million gobbled up more than 60% of the company’s $520 million in adjusted operating income. The company also bought back 4 million shares during fiscal 2017 for a $317.7 million outlay: $232 million remains under its current buyback authorization.
Post holdings net debt progression. Source: The Bloomberg
Meanwhile, the Dymatize impairment charge illustrates the daunting challenge faced by Post as they integrate the 14 separate businesses (per Bloomberg’s count) they have acquired since the company’s 2012 spinoff from Ralcorp Holdings. Roll-ups (companies that grow primarily by acquisition) generally share certain characteristics, including brisk reported growth using non-GAAP financial metrics, heavy debt burdens and capital markets activity that tends to elicit sympathetic treatment from sell-side analysts. Post checks all those boxes, and while its share price has held near its highs, each of its 11 outstanding bond issues has come under some degree of pressure in recent weeks. The Post single-B-rated (S&P: “the obligor currently has the capacity to meet its financial commitments on the obligation”) 5 3/4s of 2027, which traded above 107 cents on the dollar at the beginning of August, are currently quoted at 102.75 for a yield-to-worst of 5.29%.
Beyond signals from the bond market, investors in Post should take heed of the recent trouble at TreeHouse Foods, Inc., which saw its shares fall by more than 25% after it cut its fiscal year adjusted EPS forecast on Nov. 2. TreeHouse, which spent $3.56 billion to acquire the private brand unit of ConAgra Foods, Inc., and Flagstone Foods, Inc., among others in recent years, now sports a market capitalization of just over $2.5 billion.
Recap Nov. 20
Stocks drifted higher to begin the holiday-shortened week, while a rallying greenback (the DXY index rose by just under 50 basis points) helped send both energy and metals prices into retreat. Short treasury yields pushed higher once again, further compressing the yield curve to fresh post-crisis lows.
- Philip Grant
Friday, November 17, 2017
World's smallest Veolin
It was only a matter of time, but the first triple-B-rated credit (that’s two notches above junk) in Europe has managed to place debt at a negative yield.
It was only a matter of time, but the first triple-B-rated credit (that’s two notches above junk) in Europe has managed to place debt at a negative yield.
Command economy
Adam Smith’s “invisible hand” has a different connotation in Red China.
Adam Smith’s “invisible hand” has a different connotation in Red China.
Recap Nov. 17
World's smallest Veolin
It was only a matter of time, but the first triple-B-rated credit (that’s two notches above junk) in Europe has managed to place debt at a negative yield. The lucky winner is France’s Veolia Environnement S.A. (VIE on the Euronext), a Paris-based resource/waste management and utility company, which issued €500 million in three year bonds priced to yield negative 0.026%. Even better: Investor demand for the Veolia issue was such that the offering was oversubscribed by more than 4:1. Said another way, three out of four investors who wished to lose money on a yield-to-maturity basis were left disappointed.
To be sure, Veolia has in recent years made visible progress towards improving its financial footing. Net debt of €9.3 billion in 2016 is down from €10.7 billion in 2012, lowering the company’s leverage ratio down to 2.8 times from 4.0 times in 2012. Likewise, 2016 operating income covered interest expense by a bit less than five times, well above the sub-two times of interest coverage garnered in 2012. Credit analysts from S&P praised the Veolia C-suite for its “prudent and proactive liability management” in a June 2 report, while nevertheless noting that: “We assess Veolia’s risk profile as significant, given the group’s material debt.”
As noted above, Veolia’s placement stands out even in this extraordinary market for European corporate bonds. Consider a trio of other recent issues on the Old Continent:
On Tuesday came the announcement that spirits producer Diageo plc, rated single-A-minus at S&P, is selling €775 million bonds due November 2020 with a coupon of 0.00% and €500 million bonds due June 2024 with a coupon of 0.50%.
Italian luxury sports car manufacturer Ferrari N.V. likewise tapped the EU bond market to the tune of an €700 million senior unsecured offering at a 0.25% coupon due in January 2021. Ferrari, which is unrated by the bond agencies (the company didn’t get back to us when we asked why), generated free cash flow of €760 million in 2016, equivalent to almost half of its gross long term debt of just under €1.8 billion (the company holds more than €600 million in cash).
Tuesday also brought pricing for €1 billion in junior subordinated perpetual notes from Spanish utility Iberdrola S.A. at a (positive) 1.875% coupon. Iberdrola, unrated at S&P, sports a Baa3 rating at Moody’s, the bottom rung of investment grade. Iberdrola generated €4.51 billion in 2016 operating income, covering its €896 million in interest expense a bit more than five times over.
Helen Durand of Reuters wrote a Nov. 10 piece taking inventory of the evident distortions that have currently gripped the European corporate credit market. It identified as the culprit an actor well known to Grant's readership:
(hint)
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Pricing a new issue is usually straightforward, with a company’s outstanding bonds used as reference points to gauge fair value and a spread is then added to lure investors.
However, corporate spreads have snapped tighter after the ECB [in] late October announced an extension to its asset purchases until at least September 2018 to the tune of €30 billion a month.
“We’ve moved too fast, too quickly on no supply. Some curves are not curves anymore, they’re lines,” said a senior syndicate banker.
This has made assessing fair value much more difficult, especially for credits that have been squeezed by central bank purchases, which began in June 2016 and now total over €122 billion for corporate paper.
For his part, ECB chairman Mario Draghi remains defiant. Responding to criticism from bank executives over his imposition of a negative 0.40% deposit rate (it’s been less than zero since June of 2014), Draghi offered a sanguine risk-reward proposition for his radical policies:
If there are any negative effects of low rates on net interest income [for the banks] in the future, they should be largely offset by the positive effects of monetary stimulus on the other main components of profitability, such as the quality of loans and therefore on loan-loss provisions.
Needless to say, the chairman’s contention that central bank-imposed negative interest rates and an indiscriminate bid under corporate bonds will help “the quality of loans” is a debatable one. For now, potential issuers of all stripes are able to finance themselves for virtually nothing. But a crack has recently appeared in the façade: Amidst the modest selloff in U.S. high yield seen recently, the yield on that Bloomberg Barclays Pan-European High Yield Index jumped to a four month high of 2.88% on Wednesday from 2.19%, a 10 year low, recorded less than two weeks prior.
Command economy
Adam Smith’s “invisible hand” has a different connotation in Red China. Spirits manufacturer Kweichow Moutai Co., Ltd. (which formulates its wares from sorghum and wheat) has seen a sharp rally in its shares with a 135% advance from late November 2016 to its recent highs above RMB 600. That seemed to catch the attention of the powers that be, as party mouthpiece Xinhua News Agency issued a report calling for its breakneck rally to be replaced by a “slow bull.” Bloomberg takes it from there:
Within hours, the company had made its own stock exchange filing, says it hopes investors are cautious in making decisions, and that analysts’ share price targets and valuations in the market are ‘overly high.’ The result was a plunge of as much as 5.8% in the Shanghai-listed shares Friday, their biggest decline in over two years.
Recap Nov. 17
Stocks finished a bit lower to wrap up the week little changed on the S&P 500. Both energy and gold prices caught a solid bid amidst USD weakness, with the yellow metal approaching $1,300/oz for the first time in a month. The Treasury curve saw another round of outsize flattening amidst strength in the long end, while high yield corporates finished slightly lower in tandem with stock prices.
- Philip Grant
Thursday, November 16, 2017
On the other hand
Ahead of yesterday’s auction at Christie’s, which included an eye-watering $450.3 million price for Leonardo Da Vinci’s (disputed) "Salvator Mundi,”
Ahead of yesterday’s auction at Christie’s, which included an eye-watering $450.3 million price for Leonardo Da Vinci’s (disputed) "Salvator Mundi,”
Paging Hyman Minsky
“An excessive focus on stability will cause hesitation in pushing ahead with reforms and delays – a situation that could eventually lead to a ‘big crisis.’”
“An excessive focus on stability will cause hesitation in pushing ahead with reforms and delays – a situation that could eventually lead to a ‘big crisis.’”
Recap Nov. 16
On the other hand
Ahead of yesterday’s auction at Christie’s, which included an eye-watering $450.3 million price for Leonardo Da Vinci’s (disputed) "Salvator Mundi,” Bloomberg ran an item earlier this week entitled “What to Buy Instead of Art.” The piece detailed a number of handy alternatives for billionaires looking to dispense with their riches, such as “The 2017-2018 academic year’s room, board, tuition and other fees for the entire Princeton University class of 2021,” for $100 million.
Following yesterday’s record breaking placement, this morning Bloomberg offered the counterpoint: “Why $450 Million for This Painting Isn't Crazy.”
Now that is fair and balanced!
Paging Hyman Minsky
“An excessive focus on stability will cause hesitation in pushing ahead with reforms and delays – a situation that could eventually lead to a ‘big crisis.’” That warning, relayed by Caixin Global, came from Xu Zhong, head of research at the People’s Bank of China at a speech in Beijing yesterday.
Xu’s words look to signal something resembling a change in course for the world’s second largest economy, where the rapid rate of growth has been exceeded only by the breakneck pace of credit creation. Today, the Financial Times reports that Beijing has “ordered a small city in Inner Mongolia to halt construction of a RMB. 30.5 billion ($4.6 billion) subway project . . . A Baotou official, who asked not to be identified, told the Financial Times that the project was suspended shortly after Yu Zhengsheng, then the ruling Communist party’s fourth-highest ranking official, visited Baotou in August.”
To what does one attribute this apparent strategy shift? The galloping upsurge in short term borrowing costs seen worldwide (Almost Daily Grant’s, Nov. 14) stands out as one potential culprit. China is certainly not exempt from this trend: The yield on one-year government bonds has jumped above 3.6% this year, up from around 2.2% in November of 2016 and not far below Beijing's 10-year borrowing costs of 3.94%.
China one-year note yield. Source: The Bloomberg
That looks to be tightening the screws on a number of Chinese corporate borrowers. Bloomberg reported today that conglomerate HNA Group Co., “which is under scrutiny after a flurry of M&A deals since 2016, sold a 363-day $300 million note this month at a yield of 8.875%.” Annisa Lee, managing director at Nomura International Ltd., told Bloomberg that: “For some of the names, the yield on their sub-one-year notes is very close to their three-year bonds. I can also see a scenario that some companies cannot re-issue.”
Zhiwei Zhang, chief China economist at Deutsche Bank, took a closer look at the move in Chinese short rates and concluded in a note released yesterday that:
Clearly it is not because of demand in the real economy, judging by weaker investment. One plausible explanation is that financial deleveraging has caused NFBI’s [non-bank financial institutions] to reduce their (often leveraged) exposure to longer maturity assets.
The weaker investment that Zhiwei references is a significant turn for the Chinese economic engine. Growth in fixed asset investment, which accounted for a massive 45% of Chinese GDP in 2016 (Almost Daily Grant’s, Aug. 24), dropped to 5.5% in nominal terms and turned negative by 1% in real terms on a year-over-year basis in the 3rd quarter, with that real-terms contraction unseen in any quarterly period going back to at least 1995. Property sales (which accounted for nearly half of that FAI contribution to GDP in 2016) are likewise in retreat: The metric saw a sequential decline in October, both in terms of volume and overall value, for the first time in over two years.
Anne Stevenson-Yang, co-founder of J Capital Research, wrote in an Oct. 23 commentary of the critical role that the property market plays not only in the Chinese economy, but its society as a whole:
It is an asset class whose key value is optical, for the benefit of both individual and institutional investors as well as for the reigning political class. Property values are a symbol of Chinese wealth, which must be seen to be growing as a key source of legitimacy for the ruling party . . . It is clear why property values rise, but will they fall? And if they do, will that induce a financial crisis?
Indeed, the PBoC wasted little time in responding to yesterday’s data. The central bank did what central banks do these days, unleashing a hearty dose of monetary stimulus in the form of a net RMB 310 billion ($47 billion) reverse repurchase agreements liquidity injection, its largest one-day intervention since January.
As for the ever-prominent political factor, China’s 19th Party Congress, in which President Xi Jinping appeared to further consolidate his power, has come and gone. What was particularly notable was what the boss did not say: Bloomberg relays that “Xi conspicuously dropped a previous Communist Party pledge to double 2010 output [by 2020],” while instead pledging to “focus on the quality of the expansion rather than the pace of it.”
Chinese banking assets footed to RMB 247 trillion ($37.3 trillion) as of the end of the third quarter, north of 330% of the country’s RMB 74.2 trillion ($11.2 trillion) in 2016 GDP. Fair warning: The Middle Kingdom is leveraged to the gills, interest rates are rising and its economic lynchpin of fixed asset investment growth appears to be stalling.
Recap Nov. 16
Risk appetite returned to the fore, as a strong rally in equities was burnished by outsize strength in high yield corporate bonds and a nowadays-rare steepening of the Treasury curve. Energy prices ticked a bit lower across the board, while the VIX fell by nearly 10% but still remains well higher than its early November levels.
- Philip Grant
Tuesday, November 14, 2017
GE whiz
How ugly has the recent dive in General Electric’s stock price been?
How ugly has the recent dive in General Electric’s stock price been?
Rate rout
Behold, the incredible disappearing yield curve.
Behold, the incredible disappearing yield curve.
Recap Nov. 14
GE whiz
How ugly has the recent dive in General Electric’s stock price been? Richard Peterson, principal analyst at S&P Global Market Intelligence, notes that since the Nov. 8, 2016 election, GE has lost over $100 billion in market capitalization based on today’s prices at mid-day. That exceeds the total current market capitalizations of FedEx Corp., Moody’s Corporation, and BorgWarner, Inc. combined.
Rate rout
Behold, the incredible disappearing yield curve. Around the world, inflationary metrics are suddenly percolating, sending short maturity government borrowing costs upward. At the same time, long yields have generally held steady or even declined.
Consider recent data from Japan, which on Sunday reported a 3.4% year-over-year increase in producer price inflation (PPI) in October, to bring the 2017 average to a gain of 2.1%. That continues a stark upside reversal, vs. a year-over-year reading of negative-2.6% in October of last year, and an average of negative-3.2% for 2016 in aggregate. Consumer prices, while moving at a far less dramatic pace, have also turned clearly upward. Japanese CPI for October gained 0.7% year-over-year, matching the September reading for the highest since early 2015.
In the United Kingdom, this morning’s release of October consumer price inflation showed a 3.0% year-over-year uptick, maintaining September’s level at the hottest pace since early 2012. A reading of 3.1% or above would have compelled Bank of England governor Mark Carney to pen an open letter to the Chancellor of the Exchequer Philip Hammond to explain, according to the BoE website: “The reasons why inflation has increased . . . to such an extent and what the Bank proposes to do to ensure inflation comes back to the [2%] target.”
Stateside, this morning’s release of October PPI showed more of the same: Higher prices. The headline 2.8% year-over-year jump was the highest since February of 2012. While that figure is burnished by a 20% year-over-year rise in gasoline futures, the PPI ex-food and energy firmly maintained that plain upward trajectory with a 2.4% year-over-year advance in October. Strip out food and energy prices, and PPI has risen by an average of just over 1.8% through the first 10 months of the year, compared to average increases of 1.2% and 0.8% in 2016 and 2015, respectively.
With that synchronized uptick in measured prices comes a synchronized compression in government yield curves. While the Bank of Japan-dominated JGB market has sported a pancake-flat yield curve for some time, the U.S. and U.K. had as recently as 2014 both offered an additional 200 basis points of annual income for those willing to lend for 10 years versus two. Spreads are now converging it seems:
U.S. in yellow, U.K. in orange, Japan in white. Source: The Bloomberg
Meanwhile, a similar surge in Chinese borrowing costs has pushed its five-year yield to 4.01%, above the 10-year yield of 3.99%). For the world’s second largest economy and leveraged lynchpin of many a bullish hope, a flattening yield curve could be a warning sign (Chinese five-and 10 year yields also briefly inverted earlier this year, to little apparent effect).
In the U.S. at least, yields on the two-year note last exceeded the 10-year yield in early 2000 and in late 2006. In each instance, recession and substantial asset price markdowns followed in due course. Writing on Nov. 17, 2006 (“Intercontinental tightening push”) amidst a prolonged tightening cycle in which Fed Chairman Ben Bernanke raised the overnight lending rate to a now-hard to fathom 5.25% in July of that year, Grant’s hazarded a guess over the coming direction in rates:
Where will it all end? With a falling fed funds rate and a rising Japanese overnight rate, we predict. The U.S. auto and housing industries cry out for interest-rate relief, and the Japanese policy rate could hardly go much lower. No interest rate forecast is not reckless. Ours may be the least reckless of the season.
We will grade that prediction at one-out-of-two, which would either get you failed out of school or a fast-track induction into the baseball hall of fame in Cooperstown, N.Y., depending on your preferred metaphor. As for today, that inverted yield curve scenario is still a hypothetical one. It is becoming gradually less so.
Recap Nov. 14
Stocks finished modestly in the red after paring earlier losses, leaving the S&P 500 at two week lows. Other action was outright bearish, including another round of relative weakness in the high yield corporate bond ETFs, more pronounced flattening in the U.S. Treasury curve, and an outsized tandem selloff in the U.S. Dollar Index and commodity prices.
- Philip Grant
Monday, November 13, 2017
It's easy to grin
Is the global shipping industry, long mired in a turgid slog amidst overcapacity and a lukewarm economic environment, finally springing to life?
Is the global shipping industry, long mired in a turgid slog amidst overcapacity and a lukewarm economic environment, finally springing to life?
Bull market here
The Nov. 7 edition of Investors Intelligence contained something of a milestone:
The Nov. 7 edition of Investors Intelligence contained something of a milestone:
Recap Nov. 13
It's easy to grin
Is the global shipping industry, long mired in a turgid slog amidst overcapacity and a lukewarm economic environment, finally springing to life? Recent sightings abound of an acceleration in activity, with the Port of Long Beach (the second largest in the U.S.) announcing on Thursday that October saw record volumes, with a 15% uptick in twenty-foot equivalent (TEU) cargo units year-over-year. Through the first 10 months of the year, total shipment volumes are up by a sturdy 9.6% from their 2016 levels. For next year, IHS Markit forecasts global container trade growth at 4.9%.
Anecdotal evidence of something resembling a boom was pervasive on shipping companies’ third quarter conference calls. AP Moller – Maersk A/S (MAERSK-B on the Copenhagen Stock Exchange) CEO Soren Skou noted a brisk pace of activity on Nov. 7: “We continue to see strong fundamentals in container shipping. We are positively surprised about demand growth.” Gregory G. Zikos, CFO of Costamare, Inc., (CMRE on the NYSE) told listeners-in on Oct. 25 that: “There are positive signs coming from demand growth, which has been exceptional up to now this year.” Loukas Barmparis, president of Safe Bulkers, Inc., (NYSE: SB) offered this forecast on Nov. 1: “We expect that the strength of [the] charter market in the following months will push asset values substantially higher . . . We believe the prospects for global growth remain overall positive.” Robert Bugbee, president of Scorpio Bulkers, Inc., (NYSE: SALT) reported an acceleration in activity beyond their expectations on Oct. 23: “Since we last spoke in July, we ourselves, despite being bullish and confident then, have underestimated the strength of the market in each of the months that have gone through that time.”
Although some companies, such as Safe Bulkers (up 200% year-to-date) and Scorpio Bulkers (up 45% year-to-date) have handsomely rewarded a well-timed investment, the price action in the group remains generally moribund. The Dow Jones Global Shipping Index, which is little changed for 2017, sits almost 30% below its five year average and almost 50% below its 2014 interim highs, and trades at a spartan 0.79 price-to-book value ratio.
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No bull market here. Source: The Bloomberg
Beyond the prospects of the shippers themselves, the evident upturn in activity may be providing a signal for overall economic vitality. The Jan. 27 edition of Grant’s (“‘DJT’ on the New York Stock Exchange”) presented the pleasant possibility of a new paradigm of economic growth, as globalism (“trade encumbered by politics, complexity, favoritism and rent seeking”) would be replaced by globalization (“unfettered economic cross border exchange”).
Biff Robillard, president and co-founder of Bannerstone Capital Management, explained the distinction with the following analogy:
Robillard says that the world economy reminds him of a gigantic jetliner. How well it flies unburdened with, say, extra antennae jutting out from its fuselage, or with a redundant engine awkwardly bolted on to its wing.
Now, Robillard proceeds – just maybe, under the rising threat of the angry populists in America and Britain – the plane will be stripped of the oddments that have kept it from soaring. ‘Removing unnecessary drag from the airframe is a good thing if you want an efficient aircraft,’ he says. ‘Maybe that’s what capital smells coming – retractable landing gear!’
To hear the cadre of shipping executives tell it, the economic jetliner is cleared for takeoff. In terms of their stock prices at least, the shippers themselves are still taxiing on the runway. Or, as they say in the maritime trades, idling by the jetty.
Bull market here
The Nov. 7 edition of Investors Intelligence contained something of a milestone: Survey respondents describing themselves as bullish (64.4%) outnumbered their bearish (14.4%) counterparts by an even 50%. Kevin Duffy, principal of Bearing Asset Management, notes that this is the metric’s most lopsided reading since 1986.
Recap Nov. 13
Stocks shook off early weakness to finish green, while high yield bonds finished a bit weaker to resume their relative underperformance after Friday’s bounce. Another leg higher in the short end of the Treasury curve pushed the two-year yield to 1.68%, as recently as Sept. 8 it fetched less than 1.3%.
- Philip Grant
Friday, November 10, 2017
Dispatches from the upside down
Talk about lower-for-longer: Ewald Nowotny, governing council member of the European Central bank, told Austrian public broadcaster ORF in a radio interview today that the ECB will keep its benchmark deposit rate on the far side of zero (it’s currently minus-0.40%) not only through the end of this year, but through next year as well. “Realistically speaking, from this perspective, there will only be a change in interest rate policy in the year 2019,” said Nowotny.
Readers of the ECB tea-leaves expect more EZ monetary policy: Quantitative easing (albeit at a slower pace. The ECB is set to taper its current €60 billion monthly purchase pace to €30 billion in January) and negative interest rates aren’t going anywhere for the time being. “We change our ECB call,” declares Johnny Bo Jakobsen, strategist at Nordea Markets: “We now expect the ECB to extend QE once more and the first rate hike is not seen until 4Q 2019. Thus, we no longer anticipate a deposit rate hike in 1Q 2019.”
The Kingdom of Spain is taking its cues accordingly. The Iberian nation today announced plans to sell bonds next week in four maturities: 2021 at a 0.05% coupon, 2022 at 0.45%, 2027 at 1.45% and 2066 at 3.45% (size is still to be determined). For comparison, France, which is rated Aa2 at Moody’s (the third highest rung on its scale) borrows for 10 years at a 1.00% coupon. Spain, which already has existing 1.45% coupon bonds due in 2027 (they are trading a bit below 99 cents on the euro) is situated at Baa2 at Moody’s, just two notches above junk status.
On the ropes through the eurozone debt crisis of 2010 to 2012, Spain has enjoyed a resurgence in economic growth in recent years. GDP has expanded by more than 3% on a year-over-year basis in 10 straight quarters going back to June of 2015, although growth is starting to wane. The trailing four quarter average advance of 3.1% year-over-year is down slightly from 3.4% in the four quarters prior.
Political unrest has gripped the Kingdom of late, with the early-fall secession movement undertaken by Catalonia (its most prosperous region) being met with a heavy handed response from Madrid, including the imposition of direct rule. Today a Spanish Supreme Court judge set bail for five Catalonian parliament members who have been cooling their heels in jail on charges of sedition related to the Oct. 1 independence referendum. Prime Minister Mariano Rajoy told reporters yesterday that the strife could lead to lower growth: Indeed the government already revised its 2018 GDP forecast to 2.3% from 2.6%.
A substantial recent divergence in the Spanish Leading Indicators Index with GDP lends additional credence to the idea of an upcoming decline in growth.
(Leading indicators in white, GDP in orange). Source: The Bloomberg
While growth looks set to decline, inflation is stirring. The year-over-year change in Spanish CPI has jumped to an average of 2.1% in the 10 monthly readings seen this year. By contrast, 2016 and 2015 averaged year-over-year changes of negative 0.2% and negative 0.5%, respectively. Among the new issues, only the bonds maturing in 2066 offer a positive real return at that 2.1% rate of inflation.
For investors seeking alternatives, a pair of trades immediately come to mind. The Stoxx Europe 600 Index, which trades at just under 21 times trailing earnings and just over 16 times estimated 2017 earnings, sports a relatively princely dividend yield of 3.28%. If sovereign fixed income is what fits the bill, then how about 10-year U.S. Treasury notes, priced at a yield-to-worst of 2.40% and bearing a triple-A rating from Moody’s.
The ECB wants them? Let have the ECB have them.
Recap Nov. 10
Stocks finished little changed to wrap up the week sporting modest losses on the S&P 500, while high yield corporate bonds managed to snap their recent streak of underperformance with a green finish. Treasury yields jumped across the board, with the 10-year note exceeding 2.40% for the first time in two weeks. Gold was hammered down by nearly 1% on a straight line at 10AM ET this morning. Presumably the seller was either a non-economic actor with no incentive to maximize P&L, or just really had to leave early.
- Philip Grant
Thursday, November 9, 2017
Better than gold
“Billionaire’s row,” and “foreclosure auction” are not traditional neighbors on the written page, but 2017 has occasionally made for strange bedfellows.
“Billionaire’s row,” and “foreclosure auction” are not traditional neighbors on the written page, but 2017 has occasionally made for strange bedfellows.
Recap Nov. 9
Better than gold
“Billionaire’s row,” and “foreclosure auction” are not traditional neighbors on the written page, but 2017 has occasionally made for strange bedfellows. Bloomberg reports that a penthouse unit in the ultra-luxury One57 tower recently fetched $36 million from an unnamed buyer. Nigerian businessman Kola Aluko, now under investigation by the Department of Justice for alleged money laundering, purchased the unit for just under $51 million in 2014. It was listed earlier this year for $39 million after debt collection firm Campion Maverick Inc. lowered the boom on Aluko.
It wasn’t always thus. Just two short years ago, the Nov. 13, 2015 edition of Grant’s (“Too close to the sun”) chronicled the then-feverish market for luxury housing in Manhattan, with the accompanying trappings of bull market zeitgeist.
"Global elite buys trophy apartments," was the headline hung over the front page of a Financial Times advertising supplement a few weeks back. "In 2007, when we sold office buildings, everyone said, 'I want a building that has AIG or Lehman in it,'" Stephen Shapiro, a vice president of Jones Lang LaSalle in New York, was quoted as saying. "Investors across the world wanted that credit play. But today they're saying, 'I'll take real estate because it's a hard asset.' And in a city such as New York, it's liquid and chances of capital appreciation are close to 100%."
What most investors want, just as Shapiro suggests, is usually what other investors want: the Lehman-themed "credit play" in 2007, the Park Avenue condo in 2015. "People want trophy homes," Eyal Ofer, the Monaco-based shipping and real-estate magnate, was quoted as saying by Bloomberg in May. "They're a scarce commodity. And they're better than gold, because you can boast about it."
Both liquidity and capital appreciation have been in shorter supply of late at the high end. The third quarter 2017 Douglas Elliman Report for Manhattan found that the average sales price for luxury apartments came to just under $8.1 million, down 8.3% year-over-year, with number of days on market (from listing to sale) jumping to 217 from 136 in the third quarter of 2016, a 59.6% year-on-year leap. Olshan Realty corroborated those views, as their own third quarter data showed sharp decelerations in contacts signed (206) and total volume ($1.6 billion), both off by 11% year-over-year.
The downturn is garnering some detectible angst among those who make it their business to buy and sell properties on behalf of their clients. Douglas Elliman’s Sabrina Saltiel told The Real Deal that: “[Brokers] are talking about how hard it is to get a deal done in a market that many perceive is declining. Getting people to feel secure enough to pull the trigger and not feel they are catching a falling knife is difficult.”
A real estate bear market probably followed.
The proposed tax reform bill (with its cap on mortgage interest deductions) currently working its way through Capitol Hill is one potential source of agita: Mark Zandi, chief economist at Moody’s, estimated to Bloomberg that such an change could end up slashing prices by 10 percent in high end markets and 3 percent to 5 percent in total. Then again, Fox News’ Charles Gasparino reported on Monday that influential senator John McCain called the bill “DOA in the senate.”
Instead, it seems that those timeless gravitational forces of supply and demand may be behind the reversal in luxury. The Real Deal notes a forecast from appraisal firm Miller Samuel that 6,300 unsold new units will sit in want of a buyer by year end, with another 3,000 units set to come available next year. That will push inventories to 3.9 years’ worth of sales at the current pace. By comparison, Miller Samuel eponymous CEO Jonathan Miller targets one to two years’ worth of inventories as indicative of a healthy market. Miller likewise notes that: “The excess is more heavily weighted to the higher end than the lower end.”
H. Dale Hemmerdinger, chairman of Atco Properties & Management, provided a (what was at the time) contrary viewpoint, and identified the proximate cause of the now-faltering luxury real estate market to Grant’s back in 2015:
I think that anybody who thinks that the luxury market is a place to put money at the moment is nuts . . . They’re just going to be too expensive. . . For a 1,000 square-foot apartment, that is $2 million . . . How many people can afford these numbers? Also, the Russians are gone. The Chinese have been diminishing in numbers because of the crackdown in corruption . . . The market is going to get indigestion. The only question is how bad it’s going to be.
The perpetually cyclical real estate industry will surely see sunny days return to the Manhattan luxury realm, in the due course of time. As for boasting topics at cocktail parties, bitcoin should fit the bill for now.
Recap Nov. 9
Stocks rebounded from steep mid-day losses to finish moderately in the red, while the Treasury curve steepened a bit. Corporate bonds continued their sell-off, with the iShares High Yield Corporate Bond ETF (HYG) falling to its lowest close since the end of March, and energy prices enjoyed a brisk rebound from yesterday’s inventories-led decline.
- Philip Grant
Wednesday, November 8, 2017
Cycle repair
Chinese peer-to-peer lender Ppdai Group, Inc. (it’s pronounced pee-pee-dye) is set to make its New York Stock Exchange debut on Friday,
Chinese peer-to-peer lender Ppdai Group, Inc. (it’s pronounced pee-pee-dye) is set to make its New York Stock Exchange debut on Friday,
Recap Nov. 8
Cycle repair
Chinese peer-to-peer lender Ppdai Group, Inc. (it’s pronounced pee-pee-dye) is set to make its New York Stock Exchange debut on Friday, offering 17 million American Depository Shares at an expected price range of $16 to $19 for total proceeds of $323 million at the top end of that forecast. In business since the antediluvian days of 2007, Ppdai has recently been growing at a rate that would make the hottest Silicon Valley startup blush. Caixin Global News relays some particulars:
Both borrowers and service fees saw a surge in recent years. Lenders facilitated through Ppdai increased to 4.9 million in 2016 from 666,000 in 2015, while average transaction fees rose to 6.4% from 3.6% of a loan, according to the company’s IPO prospectus.
The number of transactions that Ppdai facilitates is increasing by 15% to 20% every month, a person with knowledge of the matter told Caixin. In 2016, transactions surpassed 18 billion yuan, up from 5 billion yuan in 2015 and 1.2 billion yuan in 2014, the source added.
Ppdai’s imminent entrance follows the mid-October NYSE debut of Qudian, Inc. a larger Chinese micro-lender that debuted at $24 a share, well above its per-share forecast range of $19 to $22. Qudian, which is primarily owned by Alibaba Group Holding Ltd. subsidiary Ant Financial, is described by CNBC as a “provider [of] short-term micro loans through its mobile app to China’s young workers who are looking for extra cash to be able to afford things like premium-priced apparel or concert tickets.” Against a current market capitalization of more than $8.5 billion, the company is expected to generate RMB. 5.6 billion ($843 million) in 2017 revenue and RMB. 2.7 billion ($408 million) in net income, according to estimates compiled by Bloomberg.
Investors’ warm initial embrace of the Chinese micro lenders stands in particular contrast to recent experience for their U.S.-based counterparts. Retail focused LendingClub, Inc. (LC on the NYSE) and small-business lender On Deck Capital, Inc., (ONDK on the NYSE) which both went public in late 2014, have had a tough go of it. Both have lost money in each year since and feature moribund stock prices:
Synchronized dive. LC (in white) and ONDK (in orange). Source: The Bloomberg
LendingClub shares were pummeled anew today after the company offered lighter than expected fourth quarter earnings guidance. The peer-to-peer lender, which generally does not take credit risk (On Deck does) cited weaker-than-expected performance from its lower credit borrowers, and subsequent tightening of lending standards for an expected volume shortfall. Aaron Back of the Wall Street Journal notes:
LendingClub boasted Tuesday of using ‘the latest machine learning techniques’ to build a new model. But among the specific changes it cited were that ‘we now look at a borrower’s credit behavior over time instead of a snapshot.’ This seems like something they should have been doing all along.
The business of peer-to-peer lending is something of an amalgamation of new technologies and the timeless art (not science) of credit analysis. The economy’s performance introduces another variable into the mix. The Jan. 23, 2015 edition of Grant’s (“Generation ZIRP”) argued that the peer-to-peer and e-lending phenomenon carried both the risks inherent in traditional banking as well as other potential pitfalls that were not being adequately discounted by the market.
The credit cycle is eternal, this publication has come to believe. Lenders and borrowers may be reasonable people, but they periodically miscalculate. . . It’s the credit-related business models that come and go.
[Now referring to LC and ONDK]; to glance at the valuations, you’d suppose the respective companies have cured the credit cycle . . . or possibly male pattern baldness. On Deck changes hands at 12 times book value. LendingClub at 57 times book value.
Today, LendingClub trades at under two times its book value. On Deck, a bit less than 1.5 times. Qudian is trading at a bit less than 17 times its book value of $518 million logged on June 30, according to the company prospectus.
The credit cycle may not have turned (a brief spasm of risk aversion in early 2016 aside), but the business models of the U.S. based e-lenders have nevertheless come under fire. The market’s jaundiced treatment of LC and ONDK on the one hand, and simultaneous rolling out of the red carpet for those Chinese operators, on the other, is a curious juxtaposition indeed.
Recap Nov. 8
Stocks managed to finish higher, widening their recent divergence with high yield corporate bonds as the iShares iBoxx High Yield Corporate Bond ETF (HYG) finished near its worst levels of the day and is now testing three month lows. Treasury yields ticked higher in relative lockstep to give the beleaguered steepener crowd a one day reprieve, while energy prices pulled back marginally after weekly D.O.E. inventories showed a surprise supply build and record U.S. output.
- Philip Grant
Tuesday, November 7, 2017
Top of the Rock
A bittersweet benchmark in the Land of the Rising Sun:
A bittersweet benchmark in the Land of the Rising Sun:
Where's that remote
Set your DVR’s:
Set your DVR’s:
Ephemeral ethereal
Techcrunch reports today that ethereum, the second largest crypto currency by market cap after bitcoin, is facing a significant technical problem.
Techcrunch reports today that ethereum, the second largest crypto currency by market cap after bitcoin, is facing a significant technical problem.
Recap November 7
Top of the Rock
A bittersweet benchmark in the Land of the Rising Sun: Japan’s blue-chip Nikkei 225 Index, riding an almost 20% gain in the last two months and eight consecutive green finishes, has broken through to near 23,000, its highest closing level since the early stages of 1992. Bloomberg aptly captured the zeitgeist of this powerful bull move this morning:
For Andrew Clarke, who says people laughed at him in late August when he first predicted [Nikkei] 25,000, this is starting to feel like vindication.
‘People thought I was deranged,’ said Clarke, director of trading at Mirabaud Asia Ltd. in Hong Kong. The gauge was trading lower than 20,000 when he first made his prediction. ‘Maybe I should change to 75,000 by 2020,’ he joked.
Martin Malone, a strategist at Mint Partners in London, says 26,000 in the medium term. . . ‘Our assessment remains max bull,’ Malone wrote in a note.
Why bittersweet? Today’s benchmark serves as a reminder of the generation-length economic deep freeze that has been in place in Japan since the turn of 1989 into 1990. Despite a 200% gain since the March 2009 nadir, the Nikkei still sits roughly 44% below its high water mark 27 years later.
The issue of Grant’s published 20 years ago today provides some context for that long, cold slumber. The Nov. 7, 1997 analysis “Downer and dirtier” chronicled the utter demoralization of Japanese investors as risk assets in the world’s then-second largest economy (now third) continued to flounder after the bursting of the 1980s stock and real estate bubbles. Speaking of the plight of small-cap Japanese equities, Curtis R. Freeze, president of Prospect Asset Management and head of the Prospect Japan Fund, lamented:
It’s been such a bloodbath. There has been so much money lost that nobody wants to associate themselves with [it]. It’s sad but true, but these are institutions that hold my fund and they all want to get out at the bottom. Who can blame them? It’s been such a disaster. It’s frustrating because I know the quality of the holdings in the fund.
The apparent 180-degree turn in investor sentiment poses a peculiar problem for Japan’s hands-on central bank, as chronicled by Leo Lewis of the Financial Times. After observing the Bank of Japan last year doubled its purchases of exchange traded funds to a ¥6 trillion ($53 billion) annual target, Lewis notes that the recent gangbusters price action has complicated that task:
Because the BoJ’s ETF strategy is to buy in the afternoon if the market is down in the morning, the rally has starved the BoJ of opportunities. . . The BoJ monthly purchasing totals have plunged since August. In October, when the Nikkei was on a nearly unstoppable tear, the BoJ barely bought at all. . . This theoretically leaves it with a Brewster’s Millions [referencing a Richard Pryor-John Candy comedy from the 80’s in which the title character is compelled to quickly spend a fortune] challenge of buying ¥1.6 trillion of ETFs over the remaining 40-odd trading sessions of 2017.
Perhaps the tongue-in-cheek prediction made by Andrew Clarke may wind up not too far off the mark, or perhaps the BoJ will one day effectively nationalize the country's financial assets. In any event, Japan has taught us that once entrenched, bull markets and bear markets alike are not easily dislodged.
Where's that remote
Set your DVR’s: Tomorrow, Bloomberg television is set to debut ETF IQ, “the first/only ETF TV show,” according to the Twitter account of Eric Balchunas, ETF analyst for Bloomberg.
Warren Buffett once said: “What the wise man does in the beginning, the fool does in the end.” He was probably not referring to the world of television however.
Ephemeral ethereal
Techcrunch reports today that ethereum, the second largest crypto currency by market cap after bitcoin, is facing a significant technical problem. Jon Russell explains:
A vulnerability found within a popular wallet has frozen potentially hundreds of millions of dollars of the crypto currency in a second setback in recent months.
Parity Technologies, the company behind widely-used wallet service Parity, today disclosed an issue that could enable the contents of a wallet to be wiped.
Early estimates from UCL cryptocurrency researcher Patrick McCorry suggest that at least 600,000 ETH (worth around $150 million) is frozen.
Parity continues to look into the problem. The company said on Twitter that it believes that wallets are locked. It added that projections for the amount of ETH impacted were ‘speculative.’
Speculative does seem like the right word.
Recap November 7
Stocks erased some modest losses to leave the S&P 500 little changed at day’s end, while the Treasury curve continued to collapse with the tenth straight contraction in the five and 30 year spread. High yield corporate bonds showed a bit of strain, with the iShares iBoxx High Yield Corporate Bond ETF (HYG on NYSE ARCA) falling out of a tight range to its lowest close in 10 weeks.
- Philip Grant
Monday, November 6, 2017
Iced 'tice
How much debt is too much?
How much debt is too much?
Pool cleaner
As a bookend to the evident complacency shown by Altice bondholders, consider today’s €600 million, 10-year euro bond from Benton Harbor, Mich.-based Whirlpool Corp.
As a bookend to the evident complacency shown by Altice bondholders, consider today’s €600 million, 10-year euro bond from Benton Harbor, Mich.-based Whirlpool Corp.
Recap November 6
Iced 'tice
How much debt is too much? That somewhat existential question is being put to the test by Dutch telecom giant Altice N.V., the growth-by-acquisition vehicle chaired by Patrick Drahi. Altice surprised investors on Friday by forecasting that full-year adjusted EBITDA would grow by about 6% on a constant-currency basis, down from previous guidance of high-single digit growth. That spurred a sharp selloff in its stock price, with shares plunging by more than 20% on Friday and extending their slide today to close at €12.20, for market capitalization of €19.5 billion. For context, the stock has averaged €19.60 in the past year.
The company’s disappointing performance lays bare its precarious capital structure. Against net debt of €53 billion, Altice is expected to generate a bit more than €9 billion in adjusted EBITDA in 2017. Those five-plus turns of leverage compare to a bit more than two turns for AT&T, Inc. ($116 billion in net debt against $52 billion in expected 2017 EBITDA) and a bit less than three turns for Verizon Communications, Inc. ($115 billion in net debt against $44 billion in expected 2017 EBITDA). 2016 operating income of €2.3 billion falls well short of the €3.1 billion in interest expense over that period, and the company has posted an aggregate loss of €1.89 billion on an adjusted net income basis over the past three fiscal years ended 2016.
What selloff? Altice 7 1/4s of 2022. Source: The Bloomberg
Debtholders aren’t worried. In marked contrast to the stock’s visceral reaction to Friday’s news, the Altice B3-rated (“considered speculative. . . subject to high credit risk”) senior unsecured 7 1/4s of 2022 sold off by less than a single point, and currently trade just below 106 cents on the euro for a yield-to-maturity of 5.82%. Speaking of Drahi’s admiration for, and emulation of, the risk-taking style of Liberty Media progenitor John Malone, the Oct. 2, 2015 bearish analysis of Altice in Grant’s (“Frontiers of junk”) posed the question: “Are its creditors quite sure they are willing to bear the risks that the intrepid management is willing to take?”
No complaints have yet been registered.
Pool cleaner
As a bookend to the evident complacency shown by Altice bondholders, consider today’s €600 million, 10-year euro bond from Benton Harbor, Mich.-based Whirlpool Corp. The company priced today’s offering at a coupon of just 1.1%, as initial price talk of 55 basis points spread over the mid-swaps rate benchmark was updated to 40-45 basis points, before pricing at 40 basis points over that yardstick. Paul Cohen of Bloomberg notes that the tighter pricing allowed the company to “halve a 30 basis point premium it initially offered over similar-maturity bonds it sold last year.” By comparison, the United States (what with its reserve currency status and printing press, among other advantages) pays more than double that rate to borrow for 10 years.
In seeking to explain the extraordinarily borrower-friendly terms enjoyed by Whirlpool, we can safely rule out corporate execution as a catalyst: Whirlpool’s shares continue to hover near one year lows after the company cut its fiscal year earnings forecasts on Oct. 23 (Almost Daily Grant’s, Oct. 24), including its expected free cash flow generation to $900 million from the prior guidance of $1 billion, while trailing 12-month revenues and adjusted EBITDA have barely budged from their 2015 levels (up by 1.5% and down by 2.9%, respectively). Likewise, no one would confuse Whirlpool with Berkshire Hathaway, Inc. or Apple, Inc. in terms of credit quality: the company is situated just barely on the right side of junk with a Baa1/triple-B ratings from Moody’s and S&P.
Instead, we can tip the cap (or point the finger) at Mario Draghi and his cohorts at the European Central bank for the white goods maker’s nigh-nil borrowing costs. Despite its U.S. domicile, Whirlpool falls under the ECB’s current €60 billion monthly pace of sovereign and corporate bond purchases, as explained by the following passage on the ECB website: “Thus, corporate debt instruments issued by corporations incorporated in the euro area but whose ultimate parent is not established in the euro area are eligible for purchase under the CSPP [Corporate sector purchase programme].” Colleague Fabiano Santin likewise notes that Whirlpool’s 1 1/4% notes due in 2026 are listed under the ECB’s current CSPP holdings (the central bank is mum on the size of its positions).
Add another one to the now-bulging file labeled: A good deal for the issuer.
Recap November 6
A fifth straight green finish on the S&P 500 left the broad average at another fresh high, while the Treasury curve continued to flatten to its narrowest levels since 2007. Energy prices were the main story, as the complex continued its red hot performance with WTI crude rising another 3% to top $57 per barrel and approach its interim highs logged in early January.
- Philip Grant
Friday, November 3, 2017
Finish line
Is the Australian economic engine, long firing on all cylinders, finally beginning to falter?
Is the Australian economic engine, long firing on all cylinders, finally beginning to falter?
Bjork Bucks
Attention crypto-loving experimental music fans!
Attention crypto-loving experimental music fans!
Recap November 3
Finish line
Is the Australian economic engine, long firing on all cylinders, finally beginning to falter? Today’s retail sales release for September showed a continuation of the recent slowdown in economic activity, as an unchanged sequential showing followed 0.5% and 0.3% month-on-month declines in August and July, marking the worst three month stretch since 2010.
On a year-on-year basis, September’s 1.4% gain was the lowest since June of 2013, and compares to an average year-on-year advance of 5% since 1997. Paul Dales, chief economist for Australia at Capital Economics Ltd. conveyed his alarm to Bloomberg: “The retail sector is on the ropes. Retailers discounted by more than usual and didn’t get much of a return from it.”
The downshift in retail sales activity is mirrored by a wider slowdown in economic output. While Australia hasn’t seen a recession since 1991 (the longest such streak in recorded history), year-on-year GDP growth of 1.7% and 1.8% in the first and second quarter marks the narrowest six month pace of expansion in 20 years, apart from the 2000 to 2001 and 2008 to 2009 periods.
A primary catalyst for the slowdown in consumer activity is a suddenly-listing housing market. The CoreLogic Dwelling Price Index for October was flat on a sequential basis for the second time in three months, while year-on-year growth dropped to 6.6%, down from 10.2% in June.
That, in tandem with new regulations, including a cap on interest-only home loans that has spurred a concurrent slowdown in private credit growth, was enough for a team of analysts at UBS led by George Tharenou to unequivocally declare in a Nov. 1 note that: “Australia’s world record housing boom is ‘officially’ over (after a large ‘upswing’ of 6,556% price growth in 55 years). . . There is now a persistent and sharp slowdown unfolding.”
Australia’s economic vitality seems to hinge on Tharenou et al. being off the mark. Behind the country’s uncanny streak of growth and housing appreciation is a debt burden that might be described as uncomfortably high: Household debt to income footed to 188.7% at year-end 2016, according to the Reserve Bank of Australia. By contrast, that metric peaked at just 133% during the housing bubble in the U.S.
The Land Down Under’s proximity to China, in both geographic and economic terms, plays no secondary role in its financial affairs. In a June 16 analysis of Australia (“Two hips joined”), Grant’s consulted with Hasan Tevfik, Australian equity strategist at Credit Suisse, who proffered the following data gleaned from Freedom of Information Act requests:
Tevfik calculates that foreign buyers account for 25% and 16% of all new supply in New South Wales and Victoria and that 77% of them are from China. Not surprisingly, the proportion of foreign buyers matches up with price appreciation. In the five years through May, house prices in Sydney and Melbourne, the capital cities of New South Wales and Victoria, have soared by 75% and 55%, respectively.
The flood of Chinese money has slowed to a trickle, according to a research report issued by Credit Suisse analyst Damien Boey on Oct. 30. Noting the slowdown in the Sydney housing market and declining auction clearing rates to below 60% (meaning more than four in ten properties failed to sell), Boey identified Chinese capital controls as a likely culprit:
We find that Chinese capital flows and real interest rates predict roughly 75% of the variation in NSW [New South Wales] property transfers since 2010. Stricter enforcement of capital controls has suppressed Chinese resident outflows over the past year, foreshadowing weakness in local housing demand.
The Chinese aren’t just buying fewer homes in Sydney. According to Dealogic, international mergers and acquisitions by Chinese companies are down by 27% year-on-year. Australia has thrived on the back of the “Chinese economic miracle.” That blissful economic epoch just might be reaching its conclusion.
Bjork Bucks
Attention crypto-loving experimental music fans! Icelandic singer Bjork is preparing a blockchain-based giveaway with her upcoming album. From Engadget.com:
Everyone purchasing [the] forthcoming album Utopia will get 100 Audiocoins – the two-year-old cryptocurrency originally designed for the music industry (currently worth around $0.19 each) – and will have the chance to earn more, along with other ‘crypto rewards’, by interacting with Bjork online and attending her concerts.
Engadget’s Rachel England notes that some nuances are still to be sorted out: “It's not clear yet exactly how that will work.”
One thing’s for sure, Audiocoins have lots of company. The website Coinmarketcap.com currently lists 1,255 cryptocurrencies in circulation, up from 865 on Sept. 5, less than two months ago.
Recap November 3
Stop me if you’ve heard this one before: Stocks rose, energy prices rallied and the yield curve flattened. The latest bull move in equities left the S&P 500 at a fresh record high, up by 14.5% year-to-date and sporting an 83% gain over the last five years. WTI crude finished well north of $55/bbl for its best close since February, and the spread between the five-year and 30-year Treasury yields contracted to less than 82 basis points, for the first time since late 2007.
- Philip Grant
Thursday, November 2, 2017
Crème de la credit
The Mongolian 5 5/8s of 2023, down from initial price talk of 6 1/8
The Mongolian 5 5/8s of 2023, down from initial price talk of 6 1/8
Frayed elastic
Good news first.
Good news first.
Recap November 2
Crème de la credit
The Mongolian 5 5/8s of 2023, down from initial price talk of 6 1/8% (Almost Daily Grant’s, Oct. 25) were launched on Friday at par amidst a torrent of bidding interest that featured $5.5 billion in orders for $800 million in bonds, for an oversubscription rate of nearly seven times. The Credit Suisse Liquid Western European High Yield Index, which has sported an average yield of 6.92% in the last 10 years, traded with a yield of 1.95% today.
Not all issuers can name their price however. LCD News reports that price talk for a yet-to-be issued $750 million Office Depot, Inc. loan has moved to Libor plus-700 from the prior Libor plus-500 to plus-525, with a wider original-issue discount of 97, from the original 98.5. That pushes the revised yield to maturity to an indicated 9.66%, compared to 6.88% to 7.15% range in the original guidance.
That drastic disparity of fortunes, also reflected in J.W. Nordstrom’s prospective 13% borrowing costs to undertake a leveraged buyout (Almost Daily Grant’s, Oct. 17) looks to be a function of the one man who has managed to instill agita in fixed income investors.
As far as we know, Jeff Bezos has no plans to invade Mongolia.
Frayed elastic
Good news first. Yesterday’s third quarter earnings press release from “innerwear” retailer Hanesbrands, Inc. (HBI on the NYSE) trumpeted the company’s successes, including healthy jumps in GAAP operating profit (11% year-on-year), diluted earnings per share (22% year-on-year) and operating cash flow (59% year-on-year), while operating margins expanded to 14.1% from 13% in the year-ago period. The section titled “Key Callouts for Third-Quarter 2017 results” triumphantly proclaimed that: “Hanes generated organic sales growth – as reported and in constant currency – for the first time in eight quarters.”
Mr. Market was unimpressed. HBI shares dove lower in response, falling by 9% to their lowest closing price since March. Proximate cause of the bearish reaction was a downsized earnings outlook. For the fourth quarter, Hanesbrands now expects adjusted earnings per share of $0.51 to $0.53, below the consensus estimate of $0.56. Full-year adjusted EPS guidance of $1.93 to $1.95 likewise trails the consensus $1.99. In explaining its cautious outlook, management cited a softer outlook for U.S. sales and the bankruptcy of Sears Canada, partially offset by “an estimated $15 million in sales expected from the acquisition of Alternative Apparel.”
Growth by acquisition has been the corporate M.O., as Hanesbrands has spent at least $2 billion on deal targets since 2013, or more than a quarter of the company’s current $7.4 billion market capitalization. Hanesbrands’ acquisitive ways, and the less-than conservative treatment of these deals in the company’s financial statements, first caught the attention of Grant’s last summer. A July 2016 analysis of HBI (“Inside story”) noted that in addition to a cumulative $1.1 billion in 2013 through early 2016 M&A outlays, the company took a further $570 million in “acquisition, integration and other action-related charges.” Those charges were excluded from its calculated operating margin and adjusted EPS on account of their ostensible one-time nature. The story went on to identify a very good reason for management to keep the deal train rolling:
The front office pays itself according to the following formula: 40%, growth in adjusted earnings per share; 40%, growth in cash flow from operations; and 20%, growth in top-line revenues.
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. . . For one thing, M&A boosts headline sales growth. For another, it furnishes a handy cover for earnings adjustments.
Today’s results appear to underscore the fact that headline figures at Hanesbrands should perhaps be taken with a grain of salt. An anonymity-seeking investor alerted Grant’s to a few interesting discrepancies.
Consider an announced benefit from foreign exchange. In a Q&A supplement to yesterday’s release, HBI management estimated a roughly 100 basis point benefit to its fourth quarter growth forecast from currency fluctuations, “which [is] essentially in-line with our prior expectations.” But on the second quarter conference call conducted on Aug. 1, CFO Richard Moss (who is set to retire at year end) stated that: “We have not assumed any material changes in FX rates in the back half. . . the bottom line is that FX rates shouldn't be a major player in the back half of the year for us.”
Perhaps more importantly for this serial dealmaker is its treatment of different acquisitions: While today’s release notes that organic growth calculations excluded a $15 million contribution from recently acquired GTM Sportswear, there is no mention of Pacific Brands Ltd., a much larger deal which closed in mid-July of last year (HBI paid A$ 935 million, or about $715 million, for Pacific Brands).
As that transaction took place two weeks into last year’s third quarter, year-on-year revenue comparisons necessarily flatter Hanesbrands, which of course enjoyed a full quarter of sales from Pacific Brands in 2017. Our informant crunched the numbers: “If you adjust for the estimated Pacific Brand contribution, organic sales growth in the quarter was actually negative (we estimate -0.6%).”
Grant’s bearish verdict on Hanesbrands in 2016 largely rested on the simple fact that the company’s core earnings are virtually impossible to determine. While the share price is lower (about $20 from $25.60 on July 1, 2016), business clarity remains elusive.
Recap November 2
An impactful day that featured the unveiling of the GOP tax reform bill and selection of new Fed Chair Jerome Powell yielded more of the same in financial markets: Stocks rebounded from an early slide to finish green in the broad S&P 500, energy prices ticked higher (WTI settles $54.75/bbl), and the Treasury curve flattened amidst strength in the long bond.
- Philip Grant
Tuesday, October 31, 2017
Keep on growing
An upbeat turn in the fortunes of U.S. employees, from deep in the heart of Texas:
An upbeat turn in the fortunes of U.S. employees, from deep in the heart of Texas:
Dad bod revisited
Under Armour, Inc. reported weaker than expected results for the third quarter and lowered fiscal year guidance this morning.
Under Armour, Inc. reported weaker than expected results for the third quarter and lowered fiscal year guidance this morning.
Recap October 31
Keep on growing
An upbeat turn in the fortunes of U.S. employees, from deep in the heart of Texas: Fast casual dining chain Texas Roadhouse, Inc., which employs about 52,500 people according to its most recent form 10-K, provided investors with an eye-catching data point in yesterday evening’s third quarter earnings release. In its full-year outlook, management raised its forecast for labor inflation to a range of 7% to 8%, up from previous guidance of mid-single digit growth. A decline in third quarter restaurant margins was likewise attributed to the higher costs associated with compensation increases.
Chief financial officer Scott Matthew Colosi noted the broad-based advance in wages on the earnings call: “All over the country, you hear how challenging it is with unemployment being so low to – you’re competing for talent. And so you’re having to pay almost in every position more than you did even a couple of years ago.” Tonya Robinson, vice president finance and investor relations, added: “And actually, you hear more and more people talking about that even outside the restaurant industry.” Chris Kempczinski, president of McDonalds USA, LLC proffered a similar observation on Oct. 24: “There is some commodity inflation, but the biggest drag that we’re facing right now is related to the labor investments that are being made.”
Labor staffing companies have also remarked on an apparent strengthening in overall conditions this quarter. On Oct. 24, Robert Half International, Inc. chairman and CEO Harold Messmer noted a catch-up dynamic: “Clearly we’re seeing clients starting more projects. They’re spending more money. They have more sense of urgency. Their existing staff [has been] lean because they’ve held a line so far during this recovery. So, there’s some pent up demand that results from that.” Manpower Group, Inc. CEO Jonas Prising laid it out even more plainly on the company’s Oct. 20 call: “The labor market in the U.S. is extremely tight, [it is] hard to find people.”
One potential reflection of the improved outlook in wages is the market’s assessment of Manpower itself. Shares in the staffing company have gone on a rampage of late, shooting higher by 120% since July of last year, compared to a 23% gain in the S&P 500 in that period.
Power to the people. Source: The Bloomberg
Anecdotal but broad inflationary sightings are popping up beyond the realms of labor and wages. Darius Adamzyck, president and CEO of diversified manufacturer Honeywell, Inc. commented on the company’s Oct. 20 call: “Overall we’ve probably been more challenged on the cost side this year than we’ve seen in a while.” Thomas J. Falk, CEO of consumer packaging giant Kimberly-Clark Corp. on Oct. 23: “Our commodity inflation estimate has increased somewhat from three months ago.” His colleague, CFO Maria Henry, chimed in: “It is a stronger inflation than we were expecting.” Jon Moeller, CFO of Procter & Gamble Co., identified an unexpected rise in chemicals prices on Oct. 20: “We knew we’d see higher pulp price cost going into [the] year, these costs have continued to increase beyond initial forecast ranges. Ethylene, propylene, kerosene, and the polyethylene and polypropylene resins have increased recently.”
There are some limits to this evidently broad-based inflationary uptick. Bloomberg reported this morning that Best Buy Co. halted its sales of “un-activated” Apple smartphones (meaning not set up on a specific carrier network) amidst customer backlash, after the electronics retailer priced its iPhone X and iPhone 8 inventory at $1,099 and $1,249 respectively, each a $100 premium over the quotes supplied by Apple.
Dad bod revisited
Under Armour, Inc. reported weaker than expected results for the third quarter and lowered fiscal year guidance this morning. That marked the latest setback for the now-struggling athletic apparel retailer, which, after more than tripling between year-end 2012 through September 2015, has seen its class-A shares fall by more than 75% from those September 2015 highs. In June 2015, Grant’s cast a bearish verdict on Under Armor, which you can read here.
It’s a long way from growth to value. Even after that aggressive price markdown (which includes a 56% selloff year to date), Under Armour shares are priced at nearly 30 times the consensus forecast for adjusted earnings per share in fiscal 2018.
Recap October 31
Equity investors avoided a spooky outcome, as the S&P 500 edged higher in listless, tight range trading to settle within a few points of its recent highs. Treasurys continued to flatten amidst more upward pressure on the short end of the curve, and energy prices maintained their recent momentum with WTI crude approaching $54.5/barrel.
- Philip Grant
Monday, October 30, 2017
Dollar dominated
Uncle Sam is feeling his oats.
Uncle Sam is feeling his oats.
Race to zero
A new salvo in the ETF price wars was fired today by Franklin Templeton Investments.
A new salvo in the ETF price wars was fired today by Franklin Templeton Investments.
Recap October 30
Dollar dominated
Uncle Sam is feeling his oats. Friday morning brought a brisk reading of third quarter advance GDP growth, with annualized sequential gains of 3.0%, well above the economist consensus of 2.6%. In tandem with the 3.1% pace of output growth in the second quarter, last week’s reading marked just the third instance of consecutive three-handle GDP prints since the end of 2004. Taking in the news, interest rate futures markets rendered their verdict: A rate hike is probably imminent. Futures currently price 84% likelihood of policy tightening at the Fed’s Dec. 13 meeting, little changed from last week.
The solid output and upward trajectory in U.S. short term interest rates (recent charts of three-month Libor or two-year Treasury note yields resemble that of a FAANG stock) is increasingly diverging from that of the eurozone, where growth is slower and rates lower. Euro area GDP growth has also managed some modest acceleration, printing 2.3% year-on-year in the second quarter (its best showing since 2011), but has yet to reach 3% in any single quarter since the financial crisis. Third quarter statistics are set to be released tomorrow.
The interest rate differential is even starker. While the 10-year Treasury note currently fetches lenders a modest 2.37% per annum, 10-year German bunds yield a paltry 0.38%, which Bloomberg notes is the largest interest rate spread between the two countries since the Berlin Wall came down. Spain, which is facing an existential crisis featuring the potential secession of its most prosperous region (Catalonia), borrows for 10 years at a rate of 1.51%.
U.S. (in white) vs Germany (in orange) 10-year yields. Source: The Bloomberg
Better growth and higher interest rates in the U.S. than Europe have not been reflected in the currency markets. The euro, which traded at $1.04 into year-end, has rallied against the greenback for the bulk of 2017 and currently fetches $1.16 after a recent pullback. More broadly, the U.S. Dollar Index (DXY), which was the recipient of a friendly word in the Aug. 8 edition of Almost Daily Grant’s (“The buck stops here”), is still down by more than 8% this year even after a 3.5% bounce since the beginning of September.
Current positioning could prove a tailwind for dollar bulls if the rebound persists. According to the Oct. 17 Commitment of Traders Report from the Commodity Futures Trading Commission, noncommercial (i.e., speculative) short contracts outstanding in the DXY easily exceeded noncommercial longs. The last time that happened was May 2014, after which the Dollar Index enjoyed a 25% rally through the spring of 2015.
There are of course risks to the dollar appreciation case. Carl Weinberg, chief economist and managing director at High Frequency Economics, articulated a perhaps-unlikely but certainly unpleasant hypothetical for dollar bulls in a recent appearance on CNBC: “I believe that yuan pricing of oil is coming and as soon as the Saudis move to accept it – as the Chinese will compel them to do – then the rest of the oil market will move along with them. . . Moving oil trade out of dollars into yuan will take right now between $600 billion and $800 billion worth of transactions out of the dollar.”
Race to zero
A new salvo in the ETF price wars was fired today by Franklin Templeton Investments. The mutual fund company made a splashy entrance into the largely Blackrock, Inc. and Vanguard Group-dominated ETF business by announcing a suite of 16 passive ETFs at cut rate prices. For example, The Franklin FTSE Australia ETF will charge investors an expense ratio of just nine basis points (0.09%), below the 14 basis points charged by the Vanguard Australia Index ETF and a fraction of the 48 basis point fee charged by BlackRock’s iShares MSCI Australia ETF. The Franklin FTSE Europe Hedged ETF will similarly cost nine basis points, compared to 45 basis points for the Deutsche Xtrackers MSCI Europe Hedged Equity ETF. The Franklin FTSE China ETF, at 19 basis points, will cost investors less than a third of 64 basis point fee on offer at the iShares MSCI China ETF.
Recap October 30
Stocks finished in the red to pull back from Friday’s closing highs on the S&P 500, while Treasury yields finished lower across the board with outperformance in the long end pushing the curve flatter. WTI crude oil closed above $54/barrel for the first time in more than six months.
- Philip Grant
Friday, October 27, 2017
2017, A Spaced Odyssey
From Bloomberg comes a short-list contender for headline of the year:
From Bloomberg comes a short-list contender for headline of the year:
Little dipper
Recap October 27
2017, A Spaced Odyssey
From Bloomberg comes a short-list contender for headline of the year:
This Company Added the Word ‘Blockchain’ to Its Name and Saw Its Shares Surge 394%
Consider that shareholder value unlocked.
Little dipper
Toronto-based technology conglomerate Constellation Software, Inc. (CSU on the TSX) is shining a little less brightly after the company provided its third quarter results last night in typically understated fashion (no management commentary accompanied the press release). Constellation shares pulled back from 52-week highs after the company reported a 4% year-on-year decline in adjusted net income and a meaty 11% downtick in operating cash flow from the third quarter 2016.
Today’s print represented the third straight time the company fell short of consensus estimates on the headline adjusted earnings-per-share metric. No matter: Constellation bulls have enjoyed a virtual one way trip to market Valhalla as the stock has undergone a steep levitation in recent years. Counting today’s decline, it has galloped higher by 21% year-to-date and an eye-watering 540% in the last five years (about 45% annualized) to leave it sporting a princely multiple of 64 times trailing 12-month adjusted earnings per share and 74 times GAAP EPS. By comparison, the Toronto Stock Exchange Composite Index is up by just over 4% year-to-date, and has gained a relatively measly 29% (not compounded) over the past five years.
Lower left to upper right, five-year Constellation price chart. Source: The Bloomberg
Constellation’s scintillating performance and shy public demeanor are but two of its notable characteristics. Its business model is itself unusual. The company makes acquisitions for a living: Over 300 separate software businesses constitute the corporate entity. Constellation makes little effort to integrate its array of components into a cohesive whole. On its conference call this morning, chief investment officer Bernard Anzarouth was asked how recent purchases fit into the organizational structure: “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.”
Grant’s cast a bearish appraisal of Constellation in December 2016 (“Past performance, Inc.”). Needless to say, our pronouncement did little to stem the stock’s giddy surge. As for the fundamental basis for the call, Grant’s listed the following considerations:
Competition in the software business is hotting up; competition to acquire desirable software businesses is likewise intensifying; Constellation’s disclosure falls well short of de minimis, a fact that means that investors must trust rather than know; and Constellation may be too big to match its historic feats of expansion, though shares are priced as if it will.
While Constellation’s opaque corporate structure presents an analytical challenge for bull and bear alike, one needn’t have full visibility to assess a potential hazard in the form of software-as-a-service and the lower barriers to entry it presents in the software business. From the December 2016 analysis:
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